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ANALYSIS OF MACRO ECONOMICS

UNIT II

NATIONAL INCOME ACCOUNTS

What is National Income Accounting?

National income accounting is a term which is applied to the description of

the various types of economic activities that are taking place in the

community in a certain institutional framework. In national income

accounting, we are concerned with statistical classification of the economic

activity so that we are able to understand easily and clearly the operation

of the economy as a whole. In national income accounting the following

distinctions are drawn between:

(a) forms of economic activity, namely, production, consumption, and

accumulation of wealth;

(b) sectors or institutional division of the economy; and

(c) types of transactions, such as sales and purchases of goods and

services, gifts, taxes, and other current transfers.

In national income accounting, a transactor is supposed to keep a set of

three accounts in which transactions are recorded:

(i) In the first account, incomes and outgoings relating a productive

activity of the transactor are brought together. The difference between

the two shows the profit or gain.

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(ii) The second account seeks to show how this profit and any other

income that accrues to the transactor are allocated to different uses.

The excess of income over outlay is saving.

(iii) The third account shows how this saving and any other capital

funds are used to finance the capital expenditure or to give loans to

other transactors.

Since in an economy, there are numerous transactors, therefore, they are

grouped into sectors. In a sector, accounts of a same type are consolidated.

The ‘sector accounts’ form the units in a system of national income

accounting.

Comparison of National Income Accounting and Individual Income

Accounting:

(a) Double entry book-keeping: Both national income accounting system

and individual income accounting system are based on the method of

double-entry book-keeping. For example, under individual income

accounting, a cash sale is recorded as a debit in Cash Account and as a

credit in Sales Account. Whereas, in national income accounting, the cash

transactions are not separately presented. Cash balances are recorded in

the capital transaction account. The difference is that the national income

accounting does not record the second entry in detail.

(b) Individual vs. collective individuals: Individual income accounts or

private accounts relate to an individual businessman or a corporate firm.

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Whereas, the national income accounts are closely related to all the

businessmen or corporate firms in the community.

(c) Profit and loss account: Individual income accounts are usually

presented in the form of a Profit and Loss Account or Income Statement

which shows the flow of income and its allocation during a year. The

Balance Sheet shows the stock of assets and liabilities at the end of the

year. The Profit and Loss Account of a private businessman resembles in

national income accounting to what is called the Appropriation Account.

The only difference is that in private accounting, the profit often includes

some elements of costs such as depreciation on plant and machinery and

fees paid to the directors of the company. On the other hand, in national

income accounting, these incomes are shown net. There is no counterpart

at all of a Balance Sheet in national income accounting since there is a great

difficulty in collecting such a huge bank of data accurately and completely

especially on uniform basis.

Income Statement of a Typical Firm

For the year ended on December 31, 2005

Debits Rs. Credits Rs.

By Cost of Sales:
To Sales Account
1,250,000 Wages 750,000
(50,000 units @ Rs.
25) Rent 150,000

Interest 150,000

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Profit (residual) 200,000

Total 1,250,000 Total 1,250,000

National Product Account 2004-05 (Millions of rupees)

Flow of Product Rs. Flow of Earning Rs.

Costs or Earnings:
Final Output

12,500 Wages 7,500

(500 million units @ Rs.

25) Rent 1,500

Interest 1,500

Profit 2,000

Total 12,500 Total 12,500

Uses of National Income Accounting:

(a) Clear picture of the economy: The national income accounts or social

accounts give a clear picture of the economy regarding the GDP, national

income, per capita income, saving ratio, production, consumption,

disposable income, capital expenditure, etc. It gives a clear view of the

health of the economy and the way in which it functions. It also gives a

view on the living standard of the people.

(b) Promotion of efficiency and stability of the economy: To foster the

economic growth, any government has to see what she has achieved in the

past and what has to be done in the future. For this purpose, the

preparation of national income accounts is quite inevitable for the

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promotion of economic efficiency and stability. It helps the government to

set the national priorities, such as education, inflation, unemployment,

defence, social development, and industrialisation, etc., in long-term and

medium-term planning. It also helps the planner to set the economic

objectives to be achieved in the near future. Thus it serves the purpose of

planning and controlling tool for public administrators.

(c) Measurement of economic welfare: Measurement of economic

welfare is another purpose of the preparation of social accounts. Through

social accounting, we can know at a glace to what extent the masses are

better off than at the time when planning started.

(d) Interrelationship of different sectors of the economy: Through the

study of national income accounts, the reader is in a position to inter-relate

different sectors of the economy. For example, through the study of

national income accounts, we can know that Pakistan’s industrial sector is

largely dependant on agriculture sector, because most of the raw materials

like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from

agriculture.

(e) Monetary, fiscal and trade policies: The national income accounts are

very essential for the statesmen, governments, and politicians, because

they help them to efficiently formulate different economic policies,

including monetary policy, fiscal policy and trade policy. In the absence of

national income accounts, the economic planning would be disastrous.

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Gross National Product (GNP):

GNP is the basic national income accounting measure of the total output or

aggregate supply of goods and services. It has been defined as the total

value of all final goods and services produced in a country during a year.

GNP is a ‘flow’ variable, which measures the quantity of final goods and

services produced during a year. For calculating GNP accurately, all

goods and services produced in any given year must be counted once, but

not more than once.

Approaches of Measuring GNP/GDP:

The primary purpose of national accounts is to provide a coherent and

comprehensive picture of the economy. To be concise, these estimates tend

to answer questions such as:

(a) What is the output of the economy, its size its composition, and its

uses? And

(b) What is the economic process by which this output is produced

and distributed? These questions are addressed below in relation to

estimation of GDP/GNP and final uses of the GNP.

The gross national product (GNP) is the market value of all final goods

and services, produced in the economy during a year. GNP is measured in

Rupee terms rather than in physical units of output. Gross domestic

product (GDP) is a better idea to visualize domestic production in the

economy. GDP may be derived in three ways or in combination of them.

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(i) Production Approach: It measures the contribution to output made

by each producer. It is obtained by deducting from the total value of its

output the value of goods and services it has purchased from other

producers and used up in producing its own output, i.e.:

VA = value of output – value of intermediate consumption.

Total value added by all producers equals GDP.

(ii) Income/Cost Approach: In this approach, consideration is given to

the costs incurred by the producer within his own operation, the income

paid out to employees, indirect taxes, consumption of fixed capital, and the

operating surplus. All these add up to value added.

(iii) Expenditure Approach: This approach looks at the final uses of the

output for private consumption, government consumption, capital

formation and net of imports & exports. According this approach, GDP is

the sum of following four major components:

 Personal consumption expenditure on goods and services,

 Gross private domestic investment,

 Government expenditure on goods and services, and

 Net export to the rest of the world.

The concepts of expenditure approach and cost approach have been

illustrated in the following diagram of circular flow of a simplified two-

sector economy:

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In the above diagram, the upper loop represents the ‘expenditure’ side of

the economy. Through this loop, all the products flow from business

sector to household sector. Each year the nation consumes a wide variety

of final goods and services: goods such as bread, apples, computers,

automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc.

But we include only the value of those products that are bought and

consumed by the consumers. In our ‘two-sector economy’ illustration, we

have excluded the investment expenditure, government expenditure and

taxes from GDP calculation.

The lower loop represents the ‘cost or revenue’ side of the economy.

Through this loop, all the costs of doing business flow. These costs include

wages paid to labour, rent paid to land, profits paid to capital, and so

forth. But these business costs are revenues that are received by

households in exchange of supplying factors of production to the business

sector.

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Precautions in Measuring GNP/GDP / Problems in National Income

Measurement / Dangers of National Income Accounts:

The federal statisticians and economists have to be very careful in

measuring GDP or preparing national income accounts. The following

precautionary measures should be taken:

(a) Reliable source of data: All the data for national accounts are

collected from different sources, including surveys, income tax returns,

retail sales statistics, and employment data. Inaccurate or incomplete data

can severely damage the integrity of the national accounts. The

economists have to be very careful in collection and selection of national

income accounting data.

(b) Difficulties of Measuring Some Services in Money Terms: National

Income of a country is always measured in money terms, but there are

some goods and services, which cannot be measured, in monetary terms.

Such goods include, the services of the housewife, housemaid and the

singing as a hobby by an individual. Exclusion of these services from the

national income, underestimate the national income account.

(c) Illegal Activities in the Economy/The Growth of “Black Economy”:

The “Black Economy” refers to that part of economic activity, which is

undeclared and therefore unrecorded for tax purposes and is therefore

deemed to be ‘illegal’. Many illegal activities in the economy generally

escape both the law and measurement in the national income. Such illegal

activities include, smuggling, drug trafficking and all parallel market

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transactions. Since such activities are outlawed, income earned, through

them are not captured in the national income, thus, under estimating the

national income account.

(d) Danger of double counting: While measuring GDP, we have to

distinguish between the three forms of goods:

(i) Final product: A final product is one that is produced and sold for

consumption or investment.

(ii) Intermediate good: Intermediate goods are semi-finished goods or

goods-in-process.

(iii) Raw material: Raw materials are unfinished and unprocessed goods.

To avoid double or multiple counting, it is necessary to add the value of

only those goods which have reached their final stage of production,

i.e., final goods, and to not add the value of intermediate goods and

raw materials, which are already included in the value of final goods.

GDP, therefore, includes bread but not wheat, cars but not steal.

(e) Problem of Including All Inventory Change in GNP: Firms generally

record inventories at their original cost rather than at replacement costs.

When prices rise, there are gains in the book value of inventories but when

prices fall, there are losses. So, the book value of inventories overstates or

understates the actual inventories. Thus, for correct computation of GNP,

inventory evaluation is required. This is achieved when a negative

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valuation of inventory is made for inventory gains and a positive valuation

is made for losses.

(f) Problem of Price Instability: Since national income is measured in

money terms, fluctuation in the general price level will render unstable the

measuring rod of money for national income. When prices are rising, the

national income figures are rising even though production might have

gone down. On the other hand, when prices are falling, GNP is declining

even though the production might have gone up. To solve this problem,

economist and statisticians have introduced the concept of real income.

(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses

accruing to property owners by increase or decrease in the market value of

their asset are not included in GNP computation because such changes do

not result from current economic activities. Such exclusions underestimate

or overestimate the GNP.

(h) Value added: ‘Value added’ is the difference between a firm’s sales

and its purchases of materials and services from other firms. In calculating

GDP earnings or value added to a firm, the statistician includes all costs

that go to factors other than businesses and excludes all payments made to

other businesses. Hence business costs in the form of wages, salaries,

interest payments, and dividends are included in value added, but

purchases of wheat or steel or electricity are excluded from value added.

The following table illustrates the concept of value addition in GDP:

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Table 1

Bread Receipts, Costs, and Value Added

Rupees Per be idle

(1) (2) (3)

Value
Cost of
Stages of Added
Sales Intermediat
Production (wages,
Receipts e
profit, etc.)
Materials
(1 – 2)

Wheat 2.00 0 2.00

Flour 5.50 2.00 3.50

Baked 7.25 5.50 1.75

dough

Delivered 10.00 7.25 2.75

bread

Total 24.75 14.75 10.00

(I) Non-productive transactions are excluded from GDP: The non-

productive transactions are excluded from GDP measurement. There are

two types of non-productive transactions:

(i) Purely financial transactions: Purely financial transactions are:

 All public transfer payments, which do not add to the current flow

of goods such as social security payments, relief payments,

etc.
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 All private financial transactions, such as receipt of money by a

student from his father, etc.

 Buying and selling of marketable securities, which make no

contribution to current production.

(II) Sale proceeds of second-hand goods.

Difference between GDP and GNP:

GDP is the most widely used measure of national output in Pakistan.

Another concept is widely cited, i.e., GNP. GNP is the total output

produced with labour or capital owned by Pakistani residents, while GDP

is the output produced with labour and capital located inside Pakistan.

For example, some of Pakistani GDP is produced in Honda plants that are

owned by Japanese corporations. The profits from these plants are

included in Pakistani GDP but not in Pakistani GNP. Similarly, when a

Pakistani university lecturer flies to Japan to give a paid lecture on

‘economies of under-developed countries’, that lecturer’s salary would be

included in Japanese GDP and in Pakistani GNP.

Net National Product (NNP):

Net national product (NNP) or national income at market price can be

obtained by deducting depreciation from GNP. NNP is a sounder measure

of a nation’s output than GNP, but most of the economists work with

GNP. This is so because depreciation is not easier to estimate. Whereas

the gross investment can be estimated fairly-accurately.

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NNP equals the total final output produced within a nation during a year,

where output includes net investment or gross investment less

depreciation. Therefore, NNP is equals to:

NNP = GNP – Depreciation

It is the net market value of all the final goods and services produced in a

country during a year. It is obtained by subtracting the amount of

depreciation of existing capital from the market value of all the final goods

and services. For a continuous flow of money payments it is necessary

that a certain amount of money should be set aside from the GNP for

meeting the necessary expenditure of wear and tear, deterioration and

obsolescence of the capital and ‘it should remain intact’.

In the above definition, the phrase ‘maintaining capital intact’ is meant to

make good the physical deterioration which has taken place in the capital

equipment while creating income during a given period. This can only be

made by setting aside a certain amount of money every year from the

annual gross income so that when the income creating equipment becomes

obsolete, a new capital equipment may be created out. If the depreciation

allowance is not set aside every year, the flow of income would not remain

intact. It will decline gradually and the whole country will become poor.

National Income or National Income at Factor Cost:

National income (NI) or national income at factor cost is the aggregate

earnings of all the factors of production (i.e., land, labour, capital, &

organisation), which arise from the current production of goods and

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services by the nation’s economy. The major components of national

income are:

(i) Compensation of employees (i.e., wages, salaries, commission,

bonus, etc.);

(ii) Proprietors income (profits of sole proprietorship, partnership,

and joint stock companies);

(iii) Net income from rentals and royalties; and

(iv) Net interest (excess of interest payments of the domestic business

system over its interest receipts and net interest received from

abroad).

National income can be calculated as follows:

National Income = NNP – Indirect Taxes + Subsidies

Personal Income:

Personal Income is the total income which is actually received by all

individuals or households during a given year in a country. Personal

income is always less than NI because NI is the sum total of all incomes

earned, whereas, the personal income is the current income received by

persons from all sources. It should be noted here that all the income items

which are included in NI are not paid to individuals or households as

income. For instance, the earnings of corporation include dividends,

undistributed profits and corporate taxes. The individuals only receive

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dividends. Corporate taxes are paid to government, and the undistributed

profits are retained by firms. There are certain income items paid to

individuals, but not included in the national income, commonly known as

‘transfer payments’. Transfer payments include old age benefits, pension,

unemployment allowance, interest on national debt, relief payments, etc.

Personal income can be measured as follows:

Personal Income = NI at Factor Cost – Contributions to Social Insurance

– Corporate Income Taxes – Retained Corporate Earnings + Transfer

Payments

Disposable Income:

Disposable income is that income which is left with the individuals after

paying taxes to the government. The individuals can spend this amount as

they please. However, they can spend in categorically two ways, i.e.,

either they can spend on consumption goods, or they can save. Therefore,

the disposable personal income is equal to:

Disposable Income = Personal Income – Personal Taxes

or

Disposable Income = Consumption + Saving

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Details of National Income Accounts:

It is very important to take a brief tour of major components or particulars

of national accounts or product accounts. In this way, we can thoroughly

understand the concept of GDP/GNP:

(a) GDP Deflator: The problem of changing prices is one of the problems

economists have to solve when they use money as their measuring rod.

Clearly, we want a measure of the nation’s output and income that uses an

invariant yardstick. This problem can be solved by using ‘price index’,

which is a measure of the average price of a bundle of goods. The price

index is used to remove inflation from GDP or to deflate the GDP, that is
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why, it is also called ‘GDP deflator’. The function of GDP deflator is to

convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’.

The formula of real GDP is as follows:

Real GDP = Nominal GDP

GDP Deflator

or

Q =
PQ
P
Nominal GDP or PQ represents the total money value of final goods

and services produced in a given year, where the values in terms of the

market prices of each year. Real GDP or Q removes price changes from

nominal GDP and calculate GDP in constant prices. And the GDP

deflator or P is defined as the price of GDP.

Example:

A country produces 100,000 litres of coconut oil during the year 2005 at a

price of Rs. 25 per litre. During the year 2006, she produces 110,000 litres

of coconut oil at a price of Rs. 27 per litre. Calculate nominal GDP, GDP

deflator and real GDP (using 2005 as base year).

Solution:

Nominal GDP:

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Price × Quantity
Price Quantity
Year PQ
P Q
Nominal GDP
2005 25 100,000 2,500,000
2006 27 110,000 2,970,000

Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:

P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1

P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 =

1.08

Real GDP:

Real GDP
Nominal GDP GDP Deflator
Year (PQ/P)
PQ P
Q
2005 2,500,000 1 2,500,000
2006 2,970,000 1.08 2,750,000

Hence, during 2006, the real GDP grew by 10%.

(b) Investment and Capital Formation: Investment consists of the

additions to the nation’s capital stock of buildings, equipment, and

inventories during a year. Investment involves sacrifice of current

consumption to increase future consumption. Instead of eating more

pizzas now, people build new pizza ovens to make it possible to produce

more pizza for future consumption.

To economists, investment means production of durable capital goods.

In common usage, investment often denotes using money to buy shares

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from stock exchange or to open a saving account in a bank. In

economic terms, purchasing shares or government bonds or opening

bank accounts is not an investment. The real investment is that only

when production of physical capital goods takes place.

Investment can be further categorised as:

(i) Gross investment: Gross investment includes all the machines,

factories, and houses built during a year – even though some were bought

to replace some old capital goods. Gross investment is not adjusted for

depreciation, which measures the amount of capital that has been used up

in a year.

(ii) Net investment: Gross investment does not adjust the deaths of

capital goods; it only takes care of the births of capital. However, the net

investment takes into account the births as well as deaths of capital goods.

In other words, net investment is adjusted for depreciation. Therefore, the

net investment plays a vital role in estimating national income:

Net Investment = Gross Investment – Depreciation

(c) Government Expenditure: Government expenditures include buying

goods like from roads to missiles, and paying wages like those of marine

colonels and street sweepers. In fact, it is the third great category of flow

of products. It involves all the expenditures incurred on running the state.

However, it does not mean that GDP includes all the government

expenditures including ‘government transfer payments’. The government

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transfer payments, which include payments to individuals that are not

made in exchange for goods and services supplied, are excluded from

GDP measurement. Such transfers payments include expenditures on

pensions, old-age benefits, unemployment allowances, veterans’ benefits,

and disability payments. One peculiar government transfer payment is

‘interest on national debts’. This is a return on debt incurred to pay for

past wars or government programmes and is not a payment for current

government goods and services. Therefore, the interests are excluded

from GDP calculations.

(d) Net Exports: ‘Net exports’ is the difference between exports and

imports of goods and services. Pakistan is facing negative net export

situation since her birth, except for few years. The biggest reason is that

Pakistan is a developing nation and consistently importing capital goods

and final consumption goods from developed countries at much higher

prices. Whereas, we export raw materials and intermediate goods at lower

prices, which have less demand due to their poor quality or because of

availability of much cheaper substitute goods in the market.

CIRCULAR FLOW OF INCOME

The amount of income generated in a given economy within a period of

time (national income) can be viewed from three perspectives. These

are:

Income,
Product, and

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Expenditure.
The above assertion implies that we can view national income as either

the total sum of all income received within a particular period (income);

the total good and services produced within a particular period

(product) or total expenditure on goods and services within a given

period (expenditure). Whichever approach is used, the value we get is

the same.

The circular flow of income and product is used to show

diagrammatically, the equivalence between the income approach and

the product approach in measuring gross national product (GNP).

In analysing the circular flow of income, there are three scenarios:

1. A simple and closed economy with no government and external

transactions, i.e., two-sector economy;

2. A mixed and open economy with savings, investment and

government activity, i.e., three-sector economy; and

3. A mixed and open economy with savings, investment,

government activity and external trade, i.e., four-sector economy.

1. Circular Flow of Income in a Two-Sector Economy:

According to circular flow of income in a two-sector economy, there are

only two sectors of the economy, i.e., household sector and business sector.

Government does not exist at all, therefore, there is no public expenditure,

no taxes, no subsidies, no social security contribution, etc. The economy is

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a closed one, having no international trade relations. Now we will discuss

each of the two sectors:

(i) Household Sector: The household sector is the sole buyer of goods

and services, and the sole supplier of factors of production, i.e., land,

labour, capital and organisation. It spends its entire income on the

purchase of goods and services produced by the business sector. Since the

household sector spends the whole income on the purchase of goods and

services, therefore, there are no savings and investments. The household

sector receives income from business sector by providing the factors of

production owned by it.

(ii) Business Sector: The business sector is the sole producer and supplier

of goods and services. The business sector generates its revenue by selling

goods and services to the household sector. It hires the factors of

production, i.e., land, labour, capital and organisation, owned by the

household sector. The business sector sells the entire output to

households. Therefore, there is no existence of inventories. In a two-sector

economy, production and sales are thus equal. So long as the household

sector continues spending the entire income in purchasing the goods and

services from the business sector, there will be a circular flow of income

and production. The circular flow of income and production operates at

the same level and tends to perpetuate itself. The basic identities of the

two-sector economy are as under:

Y=C

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Where Y is Income

C is Consumption

Circular Flow of Income in a Two-Sector Economy (Saving Economy):

In a two-sector macro-economy, if there is saving by the household sector

out of its income, the goods of the business sector will remain unsold by

the amount of savings. Production will be reduced and so the income of

the households will fall. In case the savings of the households is loaned to

the business sector for capital expansion, then the gap created in income

flow will be filled by investment. Through investment, the equilibrium

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level between income and output is maintained at the original level. It is

illustrated in the following figure:

The equilibrium condition for two-sector economy with saving is as

follows:

Y=C+S or Y=C+I or C+S=C+I or

S=I

Where Y is Income

C is Consumption

S is Saving

I is Investment

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When saving and investment are added to the circular flow, there are two

paths by which funds can travel on their way from households to product

markets. One path is direct, via consumption expenditures. The other is

indirect, via saving, financial markets, and investment.

Savings:

On the average, households spend less each year than they receive in

income. The portion of household income that is not used to buy goods

and services or to pay taxes is termed ‘Saving’. Since there is no

government in a two-sector economy, therefore, there are no taxes in this

economy.

The most familiar form of saving is the use of part of a household’s income

to make deposits in bank accounts or to buy stocks, bonds, or other

financial instruments, rather than to buy goods and services. However,

economists take a broader view of saving. They also consider households

to be saving when they repay debts. Debt repayments are a form of saving

because they, too, are income that is not devoted to consumption or taxes.

Investment:

Whereas households, on the average, spend less each year than they

receive in income, business firms, on the average, spend more each year

than they receive from the sale of their products. They do so because, in

addition to paying for the productive resources they need to carry out

production at its current level, they desire to undertake investment.

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Investment includes all spending that is directed toward increasing the

economy’s stock of capital.

Financial Market:

As we have seen, households tend to spend less each year than they

receive in income, whereas firms tend to spend more than they receive

from the sale of their products. The economy contains a special set of

institutions whose function is to channel the flow of funds from

households, as savers, to firms, as borrowers. These are known as

‘financial markets’. Financial markets are pictured in the center of the

circular-flow diagram in the above figure.

Banks are among the most familiar and important institutions found in

financial markets. Banks, together with insurance companies, pension

funds, mutual funds, and certain other institutions, are termed ‘financial

intermediaries’, because their role is to gather funds from savers and

channel them to borrowers in the form of loans.

2. Circular Flow of Income in a Three-Sector Economy:

We have so far discussed the two-sector economy consisting of household

sector and business sectors. Under three-sector economy, the additional

sector is the government. Two-sector economy is a hypothetical economy,

whereas the three-sector economy is much more realistic. The inclusion of

the government sector is very essential in measuring national income. The

government levies taxes on households and on business sector, purchases

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goods and services from business sector, and attain factors of production

from household sector. The following figure illustrates three-sector

economy:

In the above diagram, in one direction, the household sector is supplying

factors of production to the factor market. Business sector demands the

factors of production from factor market. Inputs are used by the business

sector, which produces goods and services that are purchased back by the

households and the government. Personal income after tax or disposable

income that is received by households from business sector and

government sector is used to purchase goods and services and makes up

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consumption expenditure (or C). The money spent in the product market

is the market value of final goods and services (or GDP). That money goes

to business sector that pays it back in the form of wages, rent, profits and

interests.

Total spending on goods and services is known as ‘aggregate demand’. The

total market value of output produced and sold is also known as ‘aggregate

supply’. To measure aggregate demand in a closed economy, we simply

add consumption spending (C), investment spending (I) and government

spending (G). Therefore:

Y=C+I+G

Where Y is Income,

C is Consumption,

I is Investment, and

G is Government Spending.

Note that government spending (G) includes its buying of labour from

factor market, buying of goods and services from product market, and

transfer payments to the household sector. Transfer payments are

payments the government makes in return for no service, for example,

welfare payments, unemployment compensation, pension, etc. The

government collects its money in the form of tax, which makes up most of

the government revenue. But the government does not always balance

their budgets. The government always tends to spend more than it takes

in as taxes. The federal government almost always runs a deficit. The

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government deficit must be financed by borrowing in financial markets.

Usually this borrowing takes the form of sales of government bonds and

other securities to the public or to financial intermediaries. Over time,

repeated government borrowing adds to the domestic debt. The ‘debt’ is a

stock that reflects the accumulation of annual ‘deficits’, which are flows.

When the public sector as a whole runs a budget surplus, the direction of

the arrow is reversed. Governments pay off old borrowing at a faster rate

than the rate at which new borrowing occurs, thereby creating a net flow

of funds into financial markets.

3. Circular Flow of Income in a Four-Sector Economy:

Two-sector economy and three-sector economy are briefly discussed in

previous sections. These are hypothetical economies. In real life, only

four-sector economy exists. The four-sector economy is composed of

following sectors, i.e.:

(i) Household sector,

(ii) Business sector,

(iii) The government, and

(iv) Transaction with ‘rest of the world’ or foreign sector or

external sector.

The household sector, business sector and the government sector have

already been defined in the previous sections. The foreign sector includes

everyone and everything (households, businesses, and governments)

beyond the boundaries of the domestic economy. It buys exports produced

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by the domestic economy and produces imports purchased by the

domestic economy, which are commonly combined into net exports

(exports minus imports). The inclusion of fourth sector, i.e., foreign sector

or transaction with ‘rest of the world’ makes the national income accounting

more purposeful and realistic. With the inclusion of this sector, the

economy becomes an open economy. The transaction with ‘rest of the

world’ involves import and export of goods and services, and new foreign

investment. It is illustrated in the following figure.

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In four-sector economy, goods and services available for the economy’s

purchase include those that are produced domestically (Y) and those

that are imported (M). Thus, goods and services available for domestic

purchase is Y+M. Expenditure for the entire economy include domestic

expenditure (C+I+G) and foreign made goods (Export) = X. Thus:

Y+M=C+I+G+X
Y = C + I + G + (X – M)
Where, C = Consumption expenditure
I = Investment spending
G = Government spending
X = Total Exports
M = Total Imports
X–M = Net Exports
Economy Leakages and Injections
Leakages: When households engage in savings and purchase of goods

and services from abroad, we experience temporary withdrawal of

funds from circulation. Therefore, leakages in the circular flow are

savings, taxes and imports

Injection: On the other hand, when we sell abroad (export) we receive

income. More so when foreigners invest in our country the level of

income will also increase. These two activities are injection into the

income stream. Therefore, injections are investment, government

spending and exports.

Total Leakages = Total Injections

C + I + G + (X-M) = C + S + Net Taxes

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S + Net Taxes + Imports = I + G + Exports

S = I + (G – NT) + (X – M)

One way of thinking about the circular flow of income is to imagine a

water tank. Investment, government spending and spending by foreigners

is injected into the tank, and savings, taxes and spending on imports leak

out. The injections and the withdrawals are equal to each other so the level

in the tank is stable, or as economists like to say in equilibrium.

If injections are greater than

withdrawals or leakages then

the level in the tank will rise. If

withdrawals are greater than

injections then the level in the

tank falls. If planned (I+G) is

equal to planned (S+T), so that

injections is equal to leakages

and total spending is equal to total income and total demand is equal to

total supply. Then we have a ‘stable economy’. If leakages are higher than

injections i.e., planned savings plus taxes are greater than planned

investment plus government spending (S+T > I+G), economy contracts

resulting in inventory accumulation, too little spending and drop in prices.

If injections are higher than leakages, i.e., planned investment plus

government spending are greater than planned saving plus taxes (I+G >

S+T), economy expands resulting in more goods and services produced,

and higher prices.

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THEORY OF EMPLOYMENT

TYPES OF UNEMPLOYMENT

(a) Structural Unemployment: It is also known as Marxian

unemployment or long-term unemployment. It is due to slower growth of

capital stock in the country. The entire labour force cannot be absorbed in

productive employment, because there are not enough instruments of

production to employ them.

(b) Seasonal Unemployment: Seasonal unemployment arises because of

the seasonal character of a particular productive activity so that people

become unemployed during the slack season. Occupations relating to

agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.

(c) Frictional Unemployment: It arises when the labour force is

temporarily out of work because of perfect mobility on the part of the

labour. In a growing and dynamic economy, in which some industries are

declining and others are rising and in which people are free to work

wherever they wish, some volume of frictional unemployment is bound to

exist. This is so because it takes some time for the unemployed labour to

learn new trades or to shift to new places, where there is a demand for

labour. Thus, frictional unemployment exists when there is unsatisfied

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demand for labour, but the unemployed workers are either not fit for the

jobs in question or not in the right place to meet this demand.

(d) Cyclical Unemployment: It is also known as Keynesian

unemployment. It is due to deficiency of aggregate effective demand. It

occurs when business depression occurs. During the times of depression,

business activity is at low ebb and unemployment increases. Some people

are thrown out of employment altogether and others are only partially

employed. This type of unemployment is due to the fact that the total

effective demand of the community is not sufficient to absorb the entire

productive of goods that can be produced with the available stock of

capital. When the businessmen cannot sell their goods and services, their

profit expectations are not fulfilled. So the entrepreneurs reduce their

output and some factors of production become unemployed.

(e) Disguised Unemployment: Disguised unemployment is the most

widespread type of unemployment in under-developed countries. In

under-developed countries, the stock of capital does not grow fast. The

capital stock has not been growing at a rate fast enough to keep pace with

the growth of population, the country’s capacity to offer productive

employment to the new entrants to the labour market has been severely

limited. This manifests itself generally in two ways:

(i) the prevalence of large-scale unemployment in the urban areas; and

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(ii) in the form of growing numbers engaged in agriculture, resulting in

‘disguised unemployment’.

In disguised unemployment, there is an existence of a very backward

agricultural economy. People are engaged in production with an

extremely low or zero marginal productivity. Since the employment

opportunities in non-agricultural sector are not sufficient, therefore, most

of the workers are bound to work in agricultural sector. This gives rise to

the concept of ‘disguised unemployment’, in which people are unwillingly

engaged in occupations, where their marginal productivity is very low.

THEORIES OF EMPLOYMENT

The theories of employment are broadly classified into two:

(a) Classical theory of employment

(b) Keynesian theory of employment.

The classical theory assumed the prevalence of full employment. The

‘Great Depression’ of 1929 to 1934, engulfing the entire world in

widespread unemployment, low output and low national income, for

about five years, upset the classical theorists. This gives rise to Keynesian

theory of employment.

Classical Theory of Employment:

The term ‘classical economists’ was firstly used by Karl Marx to describe

economic thought of Ricardo and his predecessors including Adam Smith.

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However, by ‘classical economists’, Keynes meant the followers of David

Ricardo including John Stuart Mill, Alfred Marshal and Pigou. According

to Keynes, the term ‘classical economics’ refers to the traditional or orthodox

principles of economics, which had come to be accepted, by and large, by

the well known economists by then. Being the follower of Marshal,

Keynes had himself accepted and taught these classical principles. But he

repudiated the doctrine of laissez-faire. The two broad features of classical

theory of employment were:

(a) The assumption of full employment of labour and other productive

resources, and

(b) The flexibility of prices and wages to bring about the full employment

(a) Full employment:

According to classical economists, the labour and the other resources are

always fully employed. Moreover, the general over-production and

general unemployment are assumed to be impossible. If there is any

unemployment in the country, it is assumed to be temporary or abnormal.

According to classical views of employment, the unemployment cannot be

persisted for a long time, and there is always a tendency of full

employment in the country. According to classical economists, the reasons

for unemployment are:

(i) Intervention by the government or private monopoly,

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(ii) Wrong calculation by entrepreneurs and inaccurate decisions, and

(iii) Artificial resistance.

The economy is assumed to be self-adjusting and perfectly competitive

economy. It is the economy in which the relative values of goods and

services are determined by the general relations of demand and supply.

The pricing system serves as the planning mechanism.

(b) Flexibility of prices and wages:

The second assumption of full employment theory is the flexibility of

prices and wages. It is the flexibility of prices and wages which

automatically brings about full employment. If there is general over-

production resulting in depression and unemployment, prices would fall

as a result of which demand would increase, prices would rise and

productive activity will be stimulated and unemployment would tend to

disappear. Similarly, the unemployment could be cured by cutting down

wages which would increase the demand for labour and would stimulate

activity. Thus, if the prices and wages are allowed to move freely,

unemployment would disappear and full employment level would be

restored. Further, the classical economists treated money as mere

exchange medium. They ignored its role in affecting income, output and

employment.

Say’s Law:

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1. Say’s Law is the foundation of classical economics. Assumption of

full employment as a normal condition of a free market economy is

justified by classical economists by a law known as ‘Say’s Law of

Markets’.

2. It was the theory on the basis of which classical economists thought

that general over-production and general unemployment are not

possible.

3. According to the French economist J. B. Say, supply creates its own

demand. According to him, it is production which creates market

for goods. More of production, more of creating demand for other

goods. There can be no problem of over-production.

4. Say denies the possibility of the deficiency of aggregate demand.

5. The conceived Say’s Law describes an important fact about the

working of free-exchange of economy that the main source of

demand is the sum of incomes earned by the various productive

factors from the process of production itself. A new productive

process, by paying out income to its employed factors, generates

demand at the same time that it adds to supply. It is thus

production which creates market for goods, or supply creates its

own demand not only at the same time but also to an equal extent.

6. According to Say, the aggregate supply of commodities in the

economy would be exactly equal to aggregate demand. If there is

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any deficiency in the demand, it would be temporary and it would

be ultimately equal to aggregate supply. Therefore, the employment

of more resources will always be profitable and will take to the point

of full employment.

7. According to Say’s Law, there will always be a sufficient rate of total

spending so as to keep all resources fully employed. Most of the

income is spent on consumer goods and a par of it is saved.

8. The classical economists are of the view that all the savings are spent

automatically on investment goods. Savings and investments are

interchangeable words and are equal to each other.

9. Since saving is another form of spending, according to classical

theory, all income is spent partly for consumption and partly for

investment.

10. If there is any gap between saving and investment, the rate of

interest brings about equality between the two.

Basic Assumptions of Say’s Law:

(a) Perfectly competitive market and free exchange economy.

(b) Free flow of money incomes. All the savings must be

immediately invested and all the income must be immediately
spent.

(c) Savings are equal to investment and equality must bring about by
flexible interest rate.

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(d) No intervention of government in market operations, i.e., a laissez

faire economy, and there is no government expenditure, taxation
and subsidies.

(e) Market size is limited by the volume of production and aggregate

demand is equal to aggregate supply.

(f) It is a closed economy.

Criticism of Classical Theory:

1. Supply may not create its own demand when a part of the income is
saved. Aggregate demand is not always equal to aggregate supply.

2. Employment in a country cannot be increased by cutting general

wages.

3. There is no direct relationship between wages and employment.

4. Interest rate adjustments cannot solve savings-investment problem.

5. Classical economists have made the economy completely self-

adjusting and self-reliant. An economy is not so self-adjusting and
government intervention is unobvious.

6. Classical economists have made the wages and prices so much

flexible. In practical, wages and prices are not so flexible. It will
create chaos in the economy.

7. Money is not a mere medium of exchange. It has an essential role in

the economy.

8. The classical theory has failed to explain the occurrence of trade

cycles.

Keynesian Theory of Employment:

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Keynes has strongly criticised the classical theory in his book ‘General

Theory of Employment, Interest and Money’. His theory of employment is

widely accepted by modern economists. Keynesian economics is also

known as ‘new economics’ and ‘economic revolution’. Keynes has invented

new tools and techniques of economic analysis such as consumption

function, multiplier, marginal efficiency of capital, liquidity preference,

effective demand, etc. In the short run, it is assumed by Keynes that

capital equipment, population, technical knowledge, and labour efficiency

remain constant. That is why, according to Keynesian theory, volume of

employment depends on the level of national income and output. Increase

in national income would mean increase in employment. The larger the

national income the larger the employment level and vice versa. That is

why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of

income’.

Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on

aggregate effective demand for goods in the country. Greater the

aggregate effective demand, the greater will be the volume of employment

and vice versa. According to Keynes, the unemployment is the result of

deficiency of effective demand. Effective demand represents the total

money spent on consumption and investment. The equation is:

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Effective demand = National Income (Y) = National Output

(O)

The deficiency of effective demand is due to the gap between income and

consumption. The gap can be filled up by increasing investment and

hence effective demand, in order to maintain employment at a high level.

According to Keynes, the level of employment in effective demand

depends on two factors:

(a) Aggregate supply function, and

(b) Aggregate demand function.

(a) Aggregate supply function:

1. According to Dillard, the minimum price or proceeds which will

induce employment on a given scale, is called the ‘aggregate supply
price’ of that amount of employment.

2. If the output does not fetch sufficient price so as to cover the cost,
the entrepreneurs will employ less number of workers.

3. Therefore, different numbers of workers will be employed at

different supply prices.

4. Thus, the aggregate supply price is a schedule of the minimum

amount of proceeds required to induce varying quantities of
employment.

5. We can have a corresponding aggregate supply price curve or

aggregate supply function, which slopes upward to right.

(b) Aggregate demand function:

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1. The essence of aggregate demand function is that the greater the

number of workers employed, the larger the output. That is, the
aggregate demand price increases as the amount of employment
increases, and vice versa.

2. The aggregate demand is different from the demand for a product.

The aggregate demand price represents the expected receipts when
a given volume of employment is offered to workers.

3. The aggregate demand curve or aggregate demand function

represents a schedule of the proceeds of the output produced by
different methods of employment.

Determination of Equilibrium Level of Employment:

1. In the above diagram, AS curve

shows the different total amounts

which all the entrepreneurs, taken

together, must receive to induce

them to employ a certain number

of men. If the entrepreneurs are

convinced to receive OC amount of

money, they will employ ON1

number of labour.

2. The AD curve shows the different total amounts which all the

entrepreneurs, taken together, expect to receive at different levels of

employment. If they employed ON1 level of employment, they

expect to receive ON amount of proceeds from the total output.

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3. At ON1 level of employment, the economy is not in equilibrium.

Because the total expected amount is greater than the total amount

paid:

OH > OC

4. The equilibrium level of employment is ON2, as at this point the

AD curve intersects the AS curve or the AD is just equal to AS. The

amount of proceeds, i.e., OM which entrepreneurs expect to receive

from providing ON2 number of jobs is just equal to the amount i.e.

OM which they must receive if the employment of that number of

workers is to be worthwhile for the entrepreneurs.

5. If the situation is such that the total amount of money expected to

be received from the sale of output exceeds the amount that is

considered necessary to receive, there will be competition among the

entrepreneurs to offer more employment and thus, the employment

will increase. On the left of N2, AD is greater than AS, i.e., the

amount expected to be received is greater than the amount

considered necessary, there will be competition amount

entrepreneurs to employ more labour.

6. Beyond the N2, the AD curve lies below AS curve, which means

that the amount expected by the entrepreneurs is less that the

amount they considered necessary to receive. Therefore, the

number of persons employed will be reduced in the economy.

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7. The slope of AS curve, at first rises slowly and then after a point it

rises sharply. It means that at beginning as more and more men are

employed, the cost of output rises slowly. But as the amount

received by the entrepreneurs increases they employ more and more

men. As soon as the entrepreneurs start getting OT amount, they

will be prepared to employ all of the workers.

8. The AD curve, in the beginning, rises sharply, but it flattens

towards the end. This shows that in the beginning as more men are

employed, the entrepreneurs expect to get sharply increasing

amounts of money from the sale of the output. But after

employment has sufficiently increased, the expected receipts do not

rise sharply.

9. Effective demand is that aggregate demand price which becomes

‘effective’ because it is equal to aggregate supply price and thus

represents a position of short-run equilibrium.

10. Effective demand also represents the value of national output

because the value of national output is equal to the total amount of

money received by the entrepreneurs from the sale of goods and

services. The money received by the entrepreneurs from the sale of

goods is equal to the money spent by the people on these goods.

Hence the equation is:

Effective demand = National income

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= Value of national output

= National expenditure

= Expenditure on consumption goods +

Expenditure on investment goods

11. It is not necessary that the equilibrium level of employment is

always at full employment level. Equality between AD and AS does

not necessarily indicate the full employment level. It can be in

equilibrium at less that full employment or an under-employment

equilibrium.

12. Actually there is always some unemployment in the economy, even

in economically advanced countries.

13. According to Keynes, full employment is the level of employment

beyond which further increases in effective demand do not increase

output and employment.

14. At the point of intersection of AS and AD, the entrepreneurs are

maximising their profits. The profit will be reduced if volume of

employment is more or less that this point. Even if the point does

not represent full employment.

15. AD and AS will be equal at full employment only if the investment

demand is sufficient to cover the gap between the AS price and

consumption expenditure. The typical investment falls short of this

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gap. Hence the AD curve and AS curve will intersect at a point less

than full employment, unless there

is some external change.

16. In the above diagram, in this

situation of aggregate supply (AS),

ON’ number of men were seeking

employment, whereas only ON

number of men could secure

employment.

17. In this situation, the economy

has not yet reached the full employment level, and there are still

NN’ number of workers unemployed in the economy.

18. If the favourable circumstances push the economy and the AD

increases so much that the entrepreneurs now find it worthwhile to

employ ON’ men at the equilibrium point E’, where the economy is

in full employment level.

19. The situation in which the economy is in equilibrium at the level

of full employment is called the ‘optimum situation’.

20. The root cause of the under-employment equilibrium is the

deficiency of AD. This deficiency is due to the fact that there is a

gap between income and consumption. As income increases

consumption increases but not proportionately. If the investment is

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increased sufficiently to cover this gap, there can be full

employment. Hence the gap between income and consumption and

insufficiency of investment to this gap are responsible for under-

employment equilibrium.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of

economics. His theory has several names: theory of income and

employment, demand-side theory, consumption theory, and macro-

economic theory. In fact, he has brought about a revolution in economic

analysis, often known as ‘Keynesian Revolution’.

2. Keynes’ theory has completely demolished the idea of full-

employment and forwards the idea of under-employment equilibrium. He

states that employment level in the economy can only be increased by

increasing investment.

3. The new economic tools and techniques developed by Keynes have

enabled the today’s economists to draw correct conclusions on the

economic situation of a country. Such tools are consumption function,

multiplier, investment function, liquidity preference, etc.

4. Keynes has integrated the theory of money with the theory of value

and output.

5. Keynes has first time introduced a dynamic economic theory, in order

to depict more realistic situation of the economy.

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6. He also states the reasons of excess or deficiency of aggregate

demand through inflationary and deflationary gap analysis.

7. Keynes’ theory is a general theory and therefore, can be applied to all

types of economic systems.

8. Keynes influenced on practical policies and criticised the policy of

surplus budget. He advocated deficit financing, if that sited the economic

situation in the country.

9. Keynes has emphasised on suitable fiscal policy as an instrument for

checking inflation and for increasing aggregate demand in a country. He

advocated extensive public work programmes as an integral part of

government programmes in all countries for expanding employment.

10. He advised several monetary controls for the central bank, which in

turn will act as the instrument of controlling cyclical fluctuations.

11. Keynesian theory has played a vital role in the economic development

of less-developed countries.

12. He rejected the theory of wage-cut as a means of promoting full-

employment.

13. Keynes’ theory has given rise to the importance of social accounting or

national income accounting.

Criticism on Keynes’ Theory:

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1. According to Schumpeter, the Keynes theory is a depression theory,

which has limited applications.

2. Some socialist or communist economists had said that Keynes’

theory is dead if communism comes. However, even the socialist countries

have strived to raise their national income by using Keynesian theory.

3. Keynesian theory is not as much dynamic and it may more properly

be called comparative statics.

4. Keynesian theory has ignored microanalysis and is not helpful in

the solution of the problems of individual firms and consumers.

5. Keynes has not given any place to the accelerator principle.

6. It pays excessive attention to money in economic analysis.

Relevance of Keynes’ Theory to Less-Developed Countries (LDCs)

(Extended Criticism):

1. The Keynesian theory is primarily for fighting depression. The

assumptions on which Keynesian theory is based are:

(a) The multiplier, and

(b) Short-term analysis.

2. In the short-term analysis, Keynes assumes that capital equipment,

technology, organisation, labour and their efficiency remains

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constant. He thinks that the problems relating to employment in

developed countries arises only on account of the deficiency of

demand.

3. But the problem in case of LDCs is to increase capital equipment, to

improve technology and labour efficiency. Solving this problem will

take a long process; it cannot be solved in short-run.

4. The developing countries like Pakistan and India, the basic cause of

unemployment is low rate of savings and investment.

5. Most of the LDCs are agriculturists and the Keynesian approach is

industry-oriented. Therefore, increase in national income by deficit

spending will lead to increase in demand for food. This will raise

the prices of food grains. Therefore, heavy reliance on Keynesian

approach could mislead the economists, and can plunge the

economy into inflationary spiral.

6. The principle of multiplier does not much work in LDCs. Suppose

new investments are made in the country, increased investment will

lead to the establishment of new factories, workers will get

employed, income will increase, demand will increase, but it does

not guarantee the increase in the supply of goods because there is no

excess capacity, and the supply of productive factors is not elastic.

Increased income will be absorbed in high prices.

DETERMINATION OF NATIONAL INCOME

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1. In the short run, the level of national income is determined by

aggregate demand and aggregate supply. The supply of goods and

services in a country depends on the production capacity of the

community. But during the short period the productive capacity

does not change.

2. If AD increases, output will also increase and the level of national

output (i.e., national income) will rise. On the other hand, if AD

decreases, the national output or national income will also decrease.

It follows that the equilibrium level of NI is determined by AD since

the aggregate capacity remains more or less the same during the

short run.

3. Thus, there are two components of effective demand:

(a) Consumption demand, and

(b) Investment demand.

4. Aggregate Demand = Consumption + Investment

i.e., AD = C + I

5. The consumption demand depends on propensity to consume and

income. At a given propensity to consume, as income increases, the

consumption demand will also increase.

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6. In the above diagram the 45o line represents aggregate supply line

and it is also called ‘income line’. This income line shows two

things:

(a) Total output or aggregate supply (C + I), and

(b) National income.

7. In the above diagram, the curve C rises upward to the right which

means that as income increases consumption also increases. The

distance between income line and consumption line represents

saving. Thus, NI = C + S or Y = C + S.

8. One noteworthy thing about propensity to consume is that it

remains stable or constant during the short period. Because the

propensity to consume depends on the tastes and needs of the

people and these do not change in the short run.

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9. Since consumption is more or less stable and cannot be varied,

therefore, variation in NI depends on variation in investment.

10. Investment is the second component of AD. Investment depends on

two things:

(a) Marginal efficiency of capital, and

(b) The rate of interest

11. The rate of interest is more or less stable, hence, change in

investment depends on the marginal efficiency of capital (MEC).

12. The MEC means expectations of profit from investment. In other

words, the expected rate of profit is called MEC.

13. The MEC depends on two factors:

(a) Replacement cost of capital goods, and

(b) Profit expectations of investors.

14. If we join the investment demand with the curve C of propensity to

consume, we get AD curve C + I in which C represents consumption

and I investment. The distance between propensity to consume

curve C and AD curve C + I is equal to investment.

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15. The level of NI will be determined at point at which the AD and AS

curves intersect each other. At this point AD and AS are in

equilibrium.

16. In the above diagram, the equilibrium level of income is OY. At this

point the AD curve and AS curve intersect each other.

17. If the income is more than OY, than total output or AS is greater

than AD (C + I), and the entire output cannot be sold out.

18. If the income is less than OY, then total output or AS is less than AD

(C + I), and the entire output will be sold out. In such a situation

there is a shortage of supply, but the output will be increased in

order to cover the shortage and the NI will also increase.

19. OY is the equilibrium level of income which is less than full

employment level, i.e., OYF. Whereas, the HF corresponds the

saving.

20. The economy will be in full employment level only when investment

demand increases so as to cover this saving. But there is no

guarantee that investment demand will exactly be equal to savings.

Equality of Saving and Investment:

1. There is another way of determining the equilibrium level of NI, i.e.,

through equality of savings and investment.

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2. Take the same diagram of AD and AS. At point E, the savings and

investment are equal to GE. At above the point the saving is more

than investment, and for income less than this point, the investment

is more than saving. Saving and investment are only equal at the

equilibrium level of income, and when they are not equal, the NI is

not in equilibrium.

3. When at a certain level of NI intended investment by the

entrepreneurs is more than intended savings by the people, this

would mean that AD is greater than total output or AS, i.e.,

I > S or AD > AS

This would induce the firms to increase production raising the level

of income and employment.

4. Hence, when at any level of NI, investment is greater than savings,

there will be a tendency for the NI to increase.

5. On contrary, when at any level of NI, the investment demand is less

than saving, it means that AD is less than AS. As a result of a

decline in national output, the national income will also reduce.

6. Saving is withdrawal of some money from the income stream. On

the other hand, investment is the injection of money into the income

stream. If the intended investment is more than intended saving, it

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means that more money has been injected in the economy. This

would increase the national income.

7. But when investment is just equal to saving, it would mean that as

much money has been put into income stream as has been taken out

of it. The result would be that the NI will neither increase nor

decrease, i.e., it would be in equilibrium. The determination of NI

by investment and saving is illustrated in the following diagram:

8. In the above diagram, the investment line (II curve) has been drawn

parallel to the X-axis. This is done on the assumption that in any

year, the entrepreneurs intend to invest a certain amount of money.

That is, we assume that investment does not change with income.

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9. The saving line (SS curve) shows intended saving at different levels

of income.

10. The saving line and investment line intersect each other at the

equilibrium point E, where the intended saving and the intended

investment are equal at OY level of income. Hence OY is the

equilibrium level of NI.

11. In the above diagram, there is no tendency for income to increase or

decrease.

12. If the income level is greater than OY, the amount of intended

investment is less than saving, as a result, the income will finally

decrease.

13. If the income level is less than OY, the amount of intended

investment is greater than intended saving, as a result, the income

will continue to increase to the equilibrium level.

Inflationary Gap:

Inflationary gap arises when consumption and investment spending

together are greater than the full employment GNP level. This means that

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people are demanding more goods and services than can be produced. In

other words, the implication of inflationary gap is that national income,

output and employment cannot rise further. The only consequence of

increased demand is that the price level will increase. Or we may say that

there will be an inflationary gap if scheduled investment tends to be

greater than full employment saving. In a situation like this, more goods

will be demanded than the economic system can produce. The result will

be that price will begin to rise and an inflationary situation will emerge.

Thus, if full employment saving falls short of scheduled investment at full

employment (which means that peoples’ propensity to spend is higher

than the propensity to save), there will be an inflationary gap.

In the above diagram, C + I + G (consumption, investment and government

spending) line shows the total expenditure on demand in the economy. At

this level, Y is the real output, as shown by the intersection, point D, with

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the 45o line. YF represents a full employment level on real output. Real

income of the economy, obviously cannot reach Y. At YF, total demand (C

+ I + G) exceeds total output, leaving a gap AB, which is the inflationary

gap in the Keynesian sense.

Deflationary Gap:

The deflationary or recessionary gap is the amount by which the aggregate

expenditure falls short of the full employment level of national income. It

causes a multiple decline in real NI.

In the above diagram, Y is the total output at full employment level. Let us

assume that the total demand is (C + I + G)’ which cuts the 45o line at B,

with real output Y’, AB then is the deflationary gap.

Consumption Function

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Propensity to consume is also called consumption function. In the

Keynesian theory, we are concerned not with the consumption of an

individual consumer but with the sum total of consumption spending by

all the individuals. However, in generalizing the consumption behaviour

of the whole economy, we have to draw some useful conclusions from the

study of the behaviour of a normal consumer, which may be valid for all

consumers’ behaviour of the economy. Aggregate consumption depends

on consumption function or propensity to consume.

The economic term ‘consumption’ means the amount spent on consumption

at a given level of income. ‘Consumption function’ or ‘propensity to consume’

means the whole of the schedule showing consumption expenditure at

various levels of income. It tells us how consumption expenditure

increases as income increases. The consumption function or propensity to

consume, therefore, indicates a functional relationship between the

aggregates, viz., total consumption expenditure and the gross national

income. It is a schedule that expresses relationship between consumption

and disposable income.

According to Keynesian theory, following are the factors that influence

consumption:

(a) The real income of the individual,

(b) The past savings, and

(c) Rate of interest.

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Average and Marginal Propensity to Consume

The average propensity to consume (apc) is a relationship between total

consumption and total income in a given period of time. In other words,

apc is the ratio of consumption to income. Thus:

apc = C
Y

Where C : Consumption

Y : Income

apc : Average propensity to consume

While, the marginal propensity to consume (mpc) measures the

incremental change in consumption as a result of a given increment in

income. In other words, mpc is the ratio of change in consumption to the

change in income.

mpc = ΔC
ΔY

Where ΔC : Incremental change in consumption

ΔY : Incremental change in income

mpc : Marginal propensity to consume

the normal relationship between income and consumption is that when

income increases, consumption also increases, but by less than the increase

in income. In other words, in normal circumstances, mpc is less than one.

It is drawn as a straight-line with a slope of less than one. This slope

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indicates the percentage of additional disposable income that will be spent.

It is assumed that the whole additional income is not spent, i.e., a certain

amount is spent and the remainder is saved. This can be further explained

with the help of following table and diagram:

Income Consumptio Saving

n
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55

In the above diagram, OL is the income line and OP is income

consumption curve. The income consumption line OP lies below the

income line OL. The mpc will be measured by the tangent of the angle

that income consumption curve makes with X-axis.

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The curve as we have drawn turns out to be straight line rising from the

origin, which means that mpc is constant throughout. This, however, need

not be so and the curve may well become flatter as income rises, for as

more and more consumption needs have been satisfied, a greater share of

an increase in income than before may be saved. The dotted curve OM

represents such a relationship showing that as income rises, mpc becomes

smaller and smaller.

There is a level of disposable income (DI) at which the entire income is

spent and nothing is saved. This point is often known as ‘point of zero

savings’. Below this level of DI, the consumption expenditure will exceed

the DI. There may be cases in which the consumer has no income at all. In

such cases, the income consumption curve may not rise from the origin but

from farther left showing that when income is zero, consumption is not

zero and that the individual is living on his past savings.

Propensity to save:

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In the above diagram, ON represents the saving-income curve. Savings at

a given level of income can also be read off from the distance between a

point on income-consumption curve and corresponding point on income

curve (See the figure of income-consumption relationship). The marginal

propensity to save (mps) can be measured by the slope of income-saving

curve ON. Marginal propensity to save (mps) is the increment in savings

caused by a given increment in income. The mps is always equal to one

minus mpc:

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Keynes’ Law of Consumption:

Keynes propounded a law based on the analysis of consumption function.

This law is known as ‘Fundamental Law of Consumption’ or ‘Psychological

Law of Consumption’. It states that aggregate consumption is a function of

aggregate disposable income.

Propositions of the Law:

This law consists of three propositions:

(a) When aggregate income increases, consumption expenditure will

also increase but by a somewhat smaller amount.

(b) When income increases, the increment of income will be divided in

same proportion between saving and consumption. Consumption
and saving go side by side. What is not consumed is saved. Savings
is, thus, the complement of consumption.

(c) As income increases, both consumption spending and saving go

up. An increment in income is unlikely to lead either to less

spending or less savings than before. It will seldom happen that a

person may decrease his consumption or his savings when he has

got more income.

Assumptions:

(a) Habits of people regarding spending do not change or that the

propensity to consume remains the same or stable.

(b) The economic conditions remain normal. There is no hyper-

inflation or war or other abnormal conditions.

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(c) The economy is a free-market economy. There is no government

intervention.

(d) The important characteristic of the slope of consumption function

is that the marginal propensity to consume (mpc) will be less than

unity. This results in low-consumption and high-saving economy.

Implications:

According to Keynesian theory, the mpc is less than unity, which brings

out the following implications:

(a) Since consumption largely depends on income and consumption

function is more or less stable, it is necessary to increase investment

fill the gap of declining consumption as income increases. If this is

not done, the increased output will not be profitable.

(b) When the income increases, and the consumption are not

increased, there is a danger of over-production. The government

will have to step in to remedy the situation. Therefore, the policy of

laissez-faire will not work here.

(c) If the consumption is not increased, the marginal efficiency of

capital (MEC) will diminish. The demand for capital will also

diminish, and all the economic progress will come to a standstill.

(d) Keynes’ Law explains the turning points in the business cycle.

When the trade cycle has reached the highest point of prosperity,

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income has gone up. But since consumption does not

correspondingly go up, the downward cycle starts, for demand has

lagged behind. In the same manner, when the business cycle has

touched the lowest point, the cycle starts upwards, because

consumption cannot be diminished beyond a certain point. This is

due to the stability of mpc.

(e) Since the mpc is less than unity, this law explains the over-saving

gap. As income goes on increasing, consumption does not increase

as much. Hence saving process proceeds cumulatively and there

arises a danger of over-saving.

(f) This law also explains the unique nature of income generation. If

money is injected into the economic system, it will increase

consumption but to a smaller extent than increase in income. This

again is due to the fact that consumption does not increase along

with increase in income.

Factors Influencing Consumption Function:

There are certain factors affecting the propensity to consume in the long-

run:

1. Objective Factors:

(a) Distribution of income: It is generally observed that the average

and marginal propensities to consume of the poor are greater than

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those of the rich. This is because the poor has a lot of unsatisfied

wants and he is likely to seize every opportunity that comes his way

to satisfy them. On the other hand, the rich have already a high

standard of living and relatively less urgent wants remain to be

satisfied, so that in their case, an addition to their incomes is more

likely to be saved than spent on consumption.

(b) Fiscal policy: Fiscal policy of the government will also influence

the consumption behaviour of an economy. A reduction in taxation

will leave more post-tax incomes with the people and this will

stimulate higher expenditure on consumptions. Similarly, an

increase in taxes will depress consumption.

(c) Changes in business expectations: Business expectations by

affecting the incomes of certain classes of people affect consumption

function.

(d) Windfall gains and losses: The windfall losses and gains arising

out of changes in capital values affect the ‘saving brackets’ mostly

and not the spending sections. Hence, their influence on

consumption function is not so well marked.

(e) Liquidity preferences: Another factor is the people’s liquidity

preferences. If people prefer to keep their income in liquid ford,

consumption is reduced correspondingly.

(f) Substantial changes in the rate of interest.

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2. Subjective Factors:

(a) Individual motives to save:

(i) Building of reserves for unforeseen contingencies as illness or

unemployment,

(ii) To provide for anticipated future needs such as daughter’s

wedding, son’s education, etc.

(iii) To enjoy an enlarged future income by investing funds out of

current income, etc.

(b) Business motives:

(i) The desire to expand business,

(ii) The desire to face emergencies successfully,

(iii) The desire to have successful management,

(iv) The desire to ensure sufficient financial provision against

depreciation and obsolescence.

Investment

Investment, in the theory of income and employment, means, an addition

to the nation’s stock of capital like the building of new factories, new

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machines as well as any addition to the stock of finished goods or the

goods in the pipelines of production. Investment includes addition to

inventories as well as to fixed capital. Thus, investment does not mean

purchase of existing securities or titles, i.e., bonds, debentures, shares, etc.

Such transactions do not add to the existing capital but merely mean

change in ownership of the assets already in existence. They do not create

income and employment. Real investment means the purchase of new

factories, plants and machineries, because only newly constructed or

created assets create employment or generate income.

Types of Investment:

1. Gross and Net Investment: Net investment means gross investment

minus depreciation. In the theory of income and employment,

investment means net investment.

2. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or

anticipated investment. Ex-post investment is actually realised

investment, or the investment which is not merely planned but

which is actually invested or implemented.

3. Private and Public Investment: Private investment is on private

account and public investment is by the State or local authorities.

The private investment is influenced by marginal efficiency of

capital (MEC) i.e., profit expectations and the rate of interest.

Therefore, the private investment is profit-elastic. In public

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investment, the profit motives do not enter into consideration. It is

undertaken for social good and not for private gain.

4. Autonomous and Induced Investment: Autonomous investment is

independent of income level, and depends on population growth

and technical progress. Such investment does not vary with the

level of income. In other words, it is income-inelastic. The influence

of change in income is not altogether ruled out. The examples of

autonomous investment are ‘long range’ investments in houses,

roads, public buildings and other forms of public investment. Such

investment is generally done by the State as necessitated by the

growth of population and facilitated by technical progress and not

as a result of change in NI. These investments are independent of

changes in income and are not governed by profit motive. They are

generally made by governments and local authorities for promoting

general welfare.

Induced investment varies with NI. Changes in NI bring about

changes in aggregate demand which in turn affects the volume of

investment. When NI increases, AD too increases, and investment

has to be undertaken to meet this increased demand. Thus induced

investment is income-elastic.

Investment is made by the people as a result of changes in income

level or consumption. It is also influenced by price changes, interest

changes, etc., which affect profit possibilities. It is undertaken for the

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sake of profit or income and it changes with a change in income.

Thus, induced investment is governed by profit motive.

Factors Affecting Investment:

1. Marginal Efficiency of Capital (MEC) or expected rate of profit:

MEC or expected rate of profit the most important factor affecting

private investment. If the business expectations are good or if the

MEC is high, more investment will be made. On the contrary, if

there is an economic depression in the country or there are bleak

prospects of profits, investment will be discouraged. Thus, the

fluctuations in investment are mainly caused by the fluctuations in

the MEC.

2. Rate of interest: The second important factor affecting investment is

rate of interest. The rate of interest does not quickly change; it is

more or less sticky or constant. Hence, the inducement to invest, by

and large, depends on the MEC. For a suitable investment

condition, the rate of return or profit must at least equal to rate of

interest. So long as the expected rate of return exceeds the rate of

interest, investment will continue to be made. In other words, the

MEC must never fall below the current rate of interest, if investment

is to be worthwhile.

3. Excess capacity: There are some other factors that affect investment.

Excess capacity is one of them. If a firm has already ‘excess capacity’

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and can easily handle increased future demand, it will not go in for

further investment in capital equipment.

4. Technological progress: Technological progress also affects current

level of investment. For instance, a new invention may render the

present capital stock of a firm obsolete and adversely affect its

ability to compete. In this case, further investment will be called for.

5. Political and security conditions: This factor has become one of the

major important factors that affect the investment, esp. with

reference to under-developed countries including Pakistan. Political

instability, poor security arrangements and society’s negative

attitude towards investment companies can badly damage the

investment environment, and the country can be suffered from

poverty and unemployment due to lack of investment. Countries

like Kenya, Zimbabwe, Sudan, etc. are the worst victims.

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule. The

MEC schedule shows a functional relationship between MEC and the

amount of investment in a given type of capital asset at a particular period

of time for the whole economy.

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In the above diagram, the

marginal efficiency of

capital is represented by

MEC curve. It slopes

downward from left to

right which means that as

investment increased its

marginal efficiency goes

down.
Investment MEC /
(In Million Rate of Interest Investment at any time
US $) (In %)
depends on the rate of
200 10
250 9 interest prevailing at that
400 7 time. If the rate of interest is
750 5
1000 3 5%, the investment is US

$750 million, because, at this level, MEC is equal to the rate of interest. The

MEC represents the investor’s return and the rate of interest is his cost.

Obviously, the return on capital must at least be equal to the rate of

interest, which is its cost. Suppose the rate of interest goes down to 3%,

then it will become worthwhile to invest US $1,000 million. Thus, the MEC

and the rate of interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the

extent to which the volume of investment would change consequent upon

changes in the rate of interest. If MEC is relatively interest-elastic, a little

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fall in the rate of interest will result in a considerable expansion in the

volume of investment. On the other hand, if the MEC is relatively interest-

inelastic, then a considerable fall in the rate of interest may not lead to any

increase in the volume of investment.

Influence of Rate of Interest: The rate of interest along with the MEC

determines the volume of investment. If the rate of interest is higher than

the MEC, it will not be profitable to create a new physical asset. This is

because we assume that the aim of individual investor is to maximise the

money profits. Two courses of action are open to invest, either he can use

his money to crease additional physical assets, i.e., he can invest in the

Keynesian sense of the term, or else he can lend his money to others at a

certain rate of interest. Now, if MEC is lower than the current rate of

interest, it is more profitable to lend money rather than use it for creating

new assets. On the other hand, if MEC is higher than the rate of interest, it

is better to invest more. At the point, where MEC equals the current rate

of interest, we have the equilibrium level of investment.

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MULTIPLIER AND ACCELERATOR

THE MULTIPLIER:

Keynes’ Multiplier Theory gives great importance to increase in public

investment and government spending for raising the level of income and

employment. Both consumption and investment create employment. But

both have complementary relationship with one another. When

investment increases, consumption increases too and helps in creating

employment. It is only when the level of full employment has been

reached that investment and consumption become competitive instead of

being complementary; then increase in one will reduce the other, one will

be at the expense of the other.

Kahn’s Employment Multiplier:

Kahn’s Multiplier is known as Employment Multiplier, and Keynes’

Multiplier is known as Investment Multiplier. According to Kahn’s

Employment Multiplier, when government undertakes public works like

roads, railways, irrigation works then people get employment. This is

initial or primary employment. These people then spend their income on

consumption goods. As a result, demand for consumption goods

increases, which leads to increase in the output of concerned industries

which provides further employment to more people. But the process does

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not end here. The entrepreneurs and workers in such industries, in which

investment has been made, also spend their newly obtained income which

results in increasing output and employment opportunities. In this way,

we see that the total employment so generated is many times more than

the primary employment.

Suppose the government employs 300,000 persons on public works and, as

a result of increase in consumer goods, 600,000 more persons get

employment in the concerned industries. In this way, 900,000 persons

have been able to get employment, that is, three times more people are

now employed. In other words, Kahn’s employment multiplier means

that by the government undertaking public works many more times total

employment is provided as compared with initial employment.

Keynes’ Income or Investment Multiplier:

Keynes’ income multiplier tells us that a given increase in investment

ultimately creates total income which is many times the initial increases in

income resulting from that investment. That is why it is called income

multiplier or investment multiplier. Income multiplier indicates how

many times the total income increases by a given initial investment.

Suppose Rs. 100 million are invested in public works and as a result there

is an increase of Rs. 300 million in income. In this case, income has been

increased 3 times, i.e., the multiplier is 3. If ΔI represents increase in

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investment, ΔY indicates increase in income and K is the multiplier, then

the equation of multiplier is as follows:

----------------------------------- (i)

The multiplier is the numerical co-efficient showing how large an increase

in income will result from each increase in investment. The multiplier is

the number by which the change in investment must be multiplied in

order to get the resulting change in income. It is the ratio of change in

income to the change in investment. If an investment of Rs. 50 million

increases income by Rs. 150 million, the income multiplier is 3 and if Rs.

200 million, the multiplier is 4 and so on.

In the following multiplier equation, the relationship between income and

investment is determined through marginal propensity to consume:

------------------------------------(iii)

Where:

(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

--------------------------------------((iii)

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It should be noted that the size of multiplier varies directly with the size of

mpc. When the mpc is high, the multiplier is high and when the mpc is

low, the multiplier is also low.

The multiplier works not only in money terms but also in real terms. In

other words, the increase in income takes place not only in the form of

money but in the form of goods and services.

Keynes multiplier theory is also very helpful in the determination of

national income. In his book, ‘General Theory of Employment, Interest and

Money’, he has contradicted the viewpoint of the classical economists. He

is of the opinion that if an economy operates at a level of equilibrium it is

not necessary that there should be a high level of employment in a

country. It is just possible that there may be millions of people

unemployed. So according to Keynes, if any country wishes to achieve

level of employment, it can only do so through the changes in the

magnitude of investment.

According to Keynes’ theory, there are two main methods of measuring

the equilibrium level of NI, i.e.:

(a) The AD-AS Approach, and

(b) The Saving Investment Approach

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(a) AD-AS Approach:

For explaining the

determination of level of

income in a two-sector

economy, we assume an

economy in which there is

no international trade, no

government role and in

which corporations retain no earnings. In this simplest model of

economy, the level of income is determined at a point where the AD

intersects the AS.

In the above diagram, the national income is determined at the point

where AD curve (C+I) cuts the AS curve (C+S), i.e., at E. The multiplier

effect is also shown in this diagram. The curve C represents the mpc

which is assumed to be ½. That is why the slope of curve C is 0.5. Since

the AD curve (C + I) cuts the 45o angle line at E, OY1 is the level of income

determined. If now investment is increased to EH (ΔI) we can find out the

increase in income (ΔY). As a result of investment EH, the AD curve shifts

upwards to C + I’. This new AD curve cuts the AS curve (45 o angle line) at

F, so that OY2 income is determined. Thus, income increases by Y1Y2 as a

result of investment increase of EH, which (Y1Y2) is double of EH.

It is clear, therefore, that the multiplier is 2. It is also calculated as below:

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(a) Saving-Investment Approach: In order to simplify the analysis of

income determination we imagine an economy (1) where there are no taxes

levied by the government, (2) the corporations retain no earnings, and (3)

there are no changes in the level of prices. The equilibrium level of NI is

determined at a point where planned or intended saving is equal to

planned or intended investment, or in other words, where the saving

intersect the investment. It is further explained with the help of following

diagram:

The above diagram shows the

multiplier effect of an increase

in investment on the

equilibrium level of income. SS

is the supply curve and II is the

investment curve showing the

total level of investment of OI.

These two curves intersect each

other at the equilibrium point E

where is income is OY1. If now there is a change in investment from

OI to OI’, i.e., an increase of II’, then the II curve will shift to the
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position of I’I’ and the two curves I’I’ and SS intersect each other at

the new equilibrium point E’, where the income is OY2. Now it is

clear that when mps is ½, an increase in investment by II’ (let say Rs.

10 million) has led to the increase in income by Y1Y2 (let say Rs. 30

million). Obviously the value of the multiplier is equal to 3.

Limitations of Multiplier:

(a) Efficiency of production: If the production system of the country

cannot cope with increased demand for consumption goods and make

them readily available, the incomes generated will not be spent as

visualised. As a result, the mpc may decline.

(b) Regular investment: The value of the multiplier will also depend on

regularly repeated investments. A steadily increasing investment is

essential to maintain the tempo of economic activity.

(c) Multiplier period: Successive doses of investment must be injected at

suitable intervals if the multiplier effect is not to be lost.

(d) Full employment ceiling: As soon as full employment of the idle

resources is achieved, further beneficial effect of the multiplier will

practically cease.

Leakages of Income Stream and Their Effect on the Multiplier:

As we know that as income increases, consumption does not increase to

the same extent or proportionately, because a part of the income is saved.

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The part of the income that is saved is as if a leakage from the flow of

income stream. These leakages obstruct the growth of national income. In

the absence of these leakages, mpc would have been unity. The

consumption expenditure would have increased 100 per cent of the

increase in income and there would have been full employment. The

following are the principal leakages:

(a) Paying off debts: It generally happens that a person has to pay a debt

to a bank or to another person. A part of his income goes out in repaying

such debts and is not utilised either in consumption or in productive

activity. Income used to pay off debts disappears from the income stream.

If, however, the creditor uses this amount in buying consumer goods or in

some productive activity, then this sum will generate some income,

otherwise not.

(b) Idle cash balances: It is well known that people keep with them ready

cash which is neither used productively nor in purchasing consumer

goods. Keynes has mentioned three motives for holding ready cash for

liquidity preference, viz., transactions motive, precautionary motive and

speculative motive. This means that the re-spent part of income goes on

decreasing. In this way, a part of the initial expenditure leaks out of the

income stream.

(c) Imports: The part of the money spent by country for importing goods

also leaks out of the country’s income stream. It does not encourage or

support any business or industry in the country. This is specially so if the

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imports do not help the trade and industry of the country or if they are not

used for export promotion. The net import is a leakage.

(d) Purchase of existing securities: Some people purchase securities

(saving certificates) from others and the seller of securities can hoard this

money. This money also leaks out of the income stream. This may also be

valid in case of purchase of shares, debentures, bonds, insurance policy, or

some other financial investment. If this invested money is not used in

productive areas, there will be a leakage in the income stream.

(e) Price inflation: Inflationary situation is also responsible for leakage.

In such a situation, investment does not help in generating employment or

increasing income. If there is already full employment in the country,

increase in investment, far from increasing demand for consumer goods, it

decreases it as a result of which employment in the consumer goods

industries contracts and demand for capital goods decreases. Whatever

increase in income there is, it is spent in high prices and it does not help in

creating income and employment.

As a result of leakages of income from the main income stream of the

country, the multiplier effect of the primary or initial investment in

increasing income is reduced. If somehow these leakages are plugged, the

multiplier effect of investment in generating income and employment

would increase. If they cannot be plugged altogether, they should be

reduced or the propensity to consume should be increased or propensity

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to save should be reduced, otherwise the new investment will not have full

effect in increasing income and employment.

Importance of Multiplier:

Keynes’ principle of multiplier has a great role in removing the Great

Depression of 1929-34. These days governments are actively interfere in

the economic affairs of the community through multiplier. Its importance

is further explained as below:

1. The multiplier principle focuses on the importance of public

investment, which is the key to remove unemployment during the days of

depression. An investment of Rs. 1 million can create income and

employment worth many times, and can help the government to remove

unemployment from the country.

2. During the days of depression, the private entrepreneurs are

discouraged to invest in the economy. Therefore, to fill this gap, the

government comes forward and undertakes the investment in her own

hands. Hence, the demand for consumer goods increases and also the

level of NI and employment increases on account of the working of the

multiplier.

3. When the demand for goods increases and incomes rise owing to

government investment, the profit expectations of the entrepreneurs go up

and as a result the MEC rises.

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4. When the government makes investment in public works to fight

depression and unemployment, private investment is encouraged on

account of the operation of the multiplier. The confidence of private

investors is restored, and hence helps in further removing the economic

depression of the country.

Assumptions of Multiplier:

The following certain essential conditions / assumptions for the operation

of multiplier:

1. The supply curve of output should be elastic. In other words, when

demand for certain goods or services increases, its supply can be

increased without much difficulty.

2. There is excess productive capacity in consumer goods industries, so

that the supply of goods can be easily increased when demand

increases.

3. The supply of raw materials and working capital should also be

elastic.

4. There should be ‘involuntary unemployment’. That is, there are

people who want work at the prevailing wage rate, but are not

getting it.

Criticism on Keynes’ Multiplier Theory:

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Many economists including the classical economists and the economists

from third world countries have strongly criticise the Keynes’ Multiplier

Theory. It is explained in brief as below:

1. Keynes’ multiplier theory assumes that the supply of output, raw

materials and working capital is elastic, i.e., it can be increased

whenever required. But, according to critics, this condition cannot

be fulfilled in an under-developed country (UDC), where there is a

continuous vicious cycle of poverty. The whole economy is based

on agriculture, and there is a dearth of capital equipment, skill

labour and technology. The existing industries cannot fulfill the

increased demand. Moreover, the government is so poor to invest in

public works.

2. According to Keynes’ multiplier theory, there is excess productive

capacity in consumer goods industries. But according to critics,

there is a little excess productive capacity in poor countries;

therefore, this theory cannot be applied to UDCs.

3. Another condition of Keynes’ theory is that there should be

‘involuntary unemployment’. That is, there are people who want work

at the prevailing wage rate, but are not getting it. Whereas, in

UDCs, there is ‘disguised unemployment’, and most of the workers

are self-employed, therefore, this condition cannot be fulfilled in

such countries.

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4. According to critics, this theory can only be applied to economically

advanced and highly industrialised countries, and cannot be applied

to under-developed countries, which are pre-dominantly agricultural

countries. In UDCs, the heavy plant and machineries, and skilled

labour are not easily available and the supply cannot be increased

quickly.

THE ACCELERATOR:

The multiplier describes the relationship between investment and income,

i.e., the effect of investment on income. The multiplier concept is

concerned with original investment as a stimulus to consumption and

thereby to income and employment. But in this concept, we are not

concerned about the effect of income on investment. This effect is covered

by the ‘accelerator’. The term ‘accelerator’ should not be confused with the

accelerator in cars. It does not make the investment to grow faster and

faster.

The term ‘accelerator’ is associated with the name of J.M. Clark in the year

1914. it has been proved a powerful tool of economic analysis since then.

Keynes, astonishingly, has altogether ignored this concept. That is why,

the concept of accelerator is not considered the part of Keynesian theory.

According the principle of accelerator, when income increases, people’s

spending power increases; their consumption increases and consequently

the demand for consumer goods increases. In order to meet this enhanced

demand, investment must increase to raise the productive capacity of the

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community. Initially, however, the increased demand will be met by over-

working the existing plants and machinery. All this leads to increase in

profits which will induce entrepreneurs to expand their plants by

increasing their investments. Thus a rise in income leads to a further

induced investment. The accelerator is the numerical value of the relation

between an increase in income and the resulting increase in investment.

(Figures in Rs. ‘000)

Required
Replacement Net Gross
Years Demand Stock of
Cost Investment Investment
Capital
5 1 machine
2007 500 machines 300 0 machine 300
1500
5 1 machine
2008 500 machines 300 0 machine 300
1500
8 1 machine
3 machines
2009 800 machines 300 1200
900
2400
10 1 machine
2 machines
2010 1000 machines 300 900
600
3000
10 1 machine
2011 1000 machines 300 0 machine 300
3000
8 1 machine – 2
2012 800 machines 300 machines – 300
2400 600
Cost per machine: Rs. 300,000 per machine

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In the above example, suppose we are living in a world, where the only

commodity produced is cloth. Further suppose that to produce cloth Rs.

100,000, we require one machine worth Rs. 300,000, which means that the

value of the accelerator is 3 (i.e., the capital-output ratio is 1:3). That is, if

demand rises by Rs. 100,000, additional investment worth Rs. 300,000 takes

place. If the existing level of demand for cloth remains constant, let us say,

at Rs. 500,000, then to produce this much cloth we need five machines

worth Rs. 1.5 million. At the end of one year, let us suppose, that one

machine becomes useless as a result of wear and tear, so that at the end of

one year, a gross investment of Rs. 300,000 must take place to replace the

old machine in order that the stock of capital is capable of producing

output worth Rs. 500,000.

In the third period, i.e., the year 2009, demand rises to Rs. 800,000. To

produce output worth Rs. 800,000, we need 8 machines. But our previous

stock consisted of only 5 machines. Thus if we are to produce output

worth Rs. 800,000, we must install 3 new machines, worth Rs. 900,000. The

net investment for the year 2009 will be Rs. 900,000 and with the

replacement cost of one machine Rs. 300,000, our gross investment jumps

from Rs. 300,000 in the year 2008 to Rs. 1.2 million in the year 2009. A 60

per cent increase in demand led to a 400 per cent increase in gross

investment. Here we have a glimpse of the powerful destabilising role of

accelerator.

Assumptions of the Accelerator:

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1. Under the principle of accelerator, it is assumed that there is no

excess capacity existing in the consumer goods industries. No

machines are lying idle and shift working is not possible.

2. In capital goods industries, it has been assumed that there is an

existence of surplus capacity. If there is no excess capacity in capital

goods industries, increased demand for machines could not lead to

increase in the supply of machines.

3. Output is flexible. The machine-making industry or capital goods

industry can increase its output whenever desired.

4. The size of the accelerator does not remain constant over time. It

value will be affected by the businessmen’s calculations regarding

the profitability of installing new plants to make more machines on

the basis of their probable working life.

5. The demand for machines will remain stable in the future, although

the increase in demand has suddenly cropped up.

Business Cycles

Trade cycles refer to regular fluctuations in the level of national income. It

is a well-observed economic phenomenon, though it often occurs on a

generally upward growth path and has a variable time span, typically of

three years.

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In trade cycles, there are upward swings and then downward swings in

business. The periods of business prosperity alternate with periods of

adversity. Every boom is followed by a slump, and vice versa. Thus, the

trade cycle simply means the whole course of trade or business activity

which passes through all phases of prosperity and adversity.

Several suggestions have been put forward as to the cause of cycles. The

most well known are developed by Samuelson, Hicks, Goodwin, Phillips

and Kalecki in the 1940s and 1950s, combine the multiplier with the

accelerator theory of investment. More recently, attention has been paid to

the effects of shocks to the economy from technology and taste changes.

Phases of Trade Cycles:

Typically economists

divide business cycles

into two main phases –

depression and recovery.

Boom and slump mark

the turning points of the

cycles:

(a) Depression: In this phase, the whole economy is in depression and the

business is at the lowest ebb. The general purchasing power of the

community is very low. The productive activity, both in the production of

consumer goods and the production of capital goods, is at a very low level.

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Business settles down at a new equilibrium point with a low level of

prices, costs and profits. It may last for a number of years. Following are

the characteristics of depression:

(i) The volume of production and trade shrinks,

(ii) Unemployment increases,

(iii) Overall prices fall,

(iv) Profits and wages fall, thus, the income of the community falls to a
very low level,

(v) Aggregate expenditure and the effective demand come down,

(vi) There is a general contraction of credit and little opportunity to invest,

(vii) Stock markets show that prices of all shares and securities have fallen
to a very low level,

(viii)Interest rates decline all round,

(ix) Practically, all construction activity – whether in buildings or

machinery, comes to an end.

(b) Recovery: This phase is also known as ‘expansion’. The depression

period of trade cycle ends in the recovery period. The economic situation

has now become favourable. Money is cheap and so are the other

materials and the factors of production. Productive activity has been

increased. The entrepreneurs have now sufficient financial backing.

Constructional and allied industries are receiving orders and employing

more workers, thus creating more income and employment. This

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stimulates further investment and production. The whole economy is

moving faster towards the boom.

(c) Boom: Boom or peak is the turning point of the trade cycle. It is the

highest point of economic recovery. The typical features of boom are as

follows:

(i) A large number of production and trade,

(ii) A high level of employment and job opportunities in sufficient

amount to permit a good deal of labour mobility,

(iii) Overall rising prices,

(iv) A rising structure of interest rates, so that a bullish tendency rules

stock exchanges,

(v) A large expansion of credit and borrowing,

(vi) High level of investment, i.e., manufacturing or machinery

(vii) A rise in wages and profits so that the community’s income rises, and

(viii) Operation of the economy at optimum capacity.

(d) Recession:

It is a sharp slow down in economic activity, but it is different from

depression or slump which is more severe and prolonged downturn.

Just as depression created the conditions of recovery, similarly, the boom

conditions generate their own checks. All idle factors have been employed

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and further demand must raise their prices, but the quality is inferior. Less

efficient workers have to be taken on higher wages.

Rate of interest rises and so also of the necessary materials. The costs have

after all started the upward swing. They overtake prices ultimately and

the profit margins are first narrowed and then begin to disappear. The

boom conditions are almost at an end.

Then starts the downward course. Fearing that the era of profits has come

to a close, businessmen stop ordering further equipment and materials.

The prudent businessmen want to get out altogether and cuts down his

establishment ruthlessly. The government applies the axe mercilessly.

The bankers insist on repayment. The bottlenecks appear, stocks

accumulate. Desire for liquidity all round. This accentuates the

depression.

Theories of Trade Cycle:

(a) Climatic Theory: It is said that there are cycles of climate. For some

years the climate is favourable and then comes an unfavourable turn.

Changes in climate bring about changes in agricultural production. The

cycle of agricultural production results in a cycle of industrial activity, for

industry is deeply affected by the state of agricultural production.

One of the famous climatic theories is ‘Jevons’ Sunspot Theory’. According

to Stanley Jevon, spots appear on the face of the sun at regular intervals.

These spots affect the emission of heat from the sun, which, in turn,

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conditions the degree of rainfall. The rain affects agriculture, which, in

turn, affects trade and industry. That is how trade cycles are caused.

(b) Psychological Theory: According to psychological theory of trade

cycle, there are moods of optimism alternating the moods of pessimism in

the economy, without any tangible basis. At some stage, people just think

that trade is good and that it is going to remain good. Business activity is

intensified and becomes feverish. Then, all of a sudden, people start

thinking that the period of prosperity has lasted long enough and

adversity is round the corner. Thus, although there was no valid reason

for depression to come about, but it is brought about by the people

themselves. It is all psychological.

(c) Under-Consumption Theory: According to under-consumption

theory, there is too much of saving during a boom and further additions to

saving reduce the level of consumption. A reduction in the level of

consumption, in the face of increasing productive capacity, must sooner or

later lead to the collapse of the boom. This theory is associated with the

names of J. A. Hobson and Major Douglas.

(d) Monetary Theory: R.G. Hawtrey was a firm believer in monetary

theory. According to him, variations in flows of money are the sole and

sufficient determinants of business activity and account for alternating

phases of prosperity and depression. When the business prospects are

good, the banks freely extent credit facilities. The businessmen go on

expanding their business, entering into further and further commitments

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with the banks. A huge superstructure of credit is built up and this

superstructure can be maintained by cheap money conditions. But a point

reached, when banks think that they have gone a bit too far in the matter

of advances. Probably their reserve ratio fallen dangerously low. In self-

defence, they apply the brake, curb further expansion of credit, and begin

to recall advances. This sudden suspension of credit facilities proves a

bombshell in the business community. Businessmen have to sell their

stocks in order to repay. This general desire for liquidity depresses the

market, and may even led to bankruptcy for certain firms.

(e) Over-Investment Theory: According to over-investment theory,

fluctuations in the rate of investment are the main causes of trade cycles.

Investment becomes excessive during the boom. That investment during

the boom is borne out by the fact that investment goods industries expand

faster than consumption goods industries during the upward phase of the

cycle. During the depression, investment goods industries suffer more

than consumption goods industries.

(f) Keynes’ Theory: According to Keynes, the business cycle is a

rhythmic fluctuation in the overall level of income, output and

employment. According to him, fluctuations in economic activity are

caused by fluctuations in the rate of investment. And fluctuations in the

rate of investment are caused

mainly by fluctuations in the

marginal efficiency of capital. The

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rate of interest, which is the other determinant of investment, is more or

less stable and does not play a significant role in cyclical fluctuations in

investment.

Fluctuations in MEC or the expected rate of profit on new investment are

due to:

(i) changes in the prospective yields, and

(ii) changes in the cost or supply price of the capital goods.

Towards the end of the boom, the decline in the prospective yields on

capital is due, in first instance, to the growing abundance of capital goods

which lowers the MEC. The turning point from expansion to contraction

is, thus, explained by the collapse of MEC. As investment falls, because of

the decline in MEC, income also falls. The multiplier works in reverse

direction.

Just as the collapse of MEC is the main cause of the upper turning point in

the trade cycle, similarly the lower turning point, i.e., change from

recession to recovery, is due to the revival of MEC. The interval, between

the upper turning point and the start of recovery, is conditioned by two

factors:

(i) the time necessary for wearing out of durable capital assets, and

(ii) the time required to absorb the excess stocks of goods left over from

the boom.

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Policy for Trade Cycle:

(a) Monetary Policy: A country must always formulate and follow an

appropriate monetary policy so as to avoid the occurrence of booms

and slumps. Monetary policy embraces banking and credit policy

relating to loans and interest rates as well as the monetary standard

and public debt and its management. It influences the volume of

credit base and, through it the volume of bank credit and thus the

general level of prices and of economic activity. When boom

conditions are developing, bank rate is raised and thus credit is

contracted with the consequent brake upon the undue expansion of

business activity. In a depression, a policy of cheap money may be

adopted to stimulate business investment and thus assist recovery.

The bank credit policy involves two types of controls, i.e., the

qualitative and the quantitative. The quantitative control is aimed at

general tightening or easing of the credit system as the situation may

demand. It is exercised by influencing the reserves of the banks. The

qualitative or selective control seeks to regulate particular type of

credit. Its object is to stimulate, restrict or stabilise bank advances for

specific business schemes.

But there are limitations of monetary policy relating to bank rate and

open market operations. Its success will depend on how far certain

assumptions are true. For example, how far the various member of

the banking system are prepared to accept the lead given by the

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central bank; how far the banks can make their borrowers use their

credits for purposes for which such credits have actually been

created; further, how far monetary causes are responsible for the

economic fluctuations; and still further, and most important,

whether the business community will adjust their investment

exactly in accordance with the altered rates of interest.

(b) Fiscal Policy: Since public expenditure in all modern states constitutes

a fairly respectable proportion of the total national income, fiscal policy is

bound to affect the level of prices, production and employment,

irrespective of the fact whether this policy is deliberately aimed at this or

not. Fiscal policy consists of two elements, i.e., public spending or the

policy of public works, and appropriate taxation.

In a year of depression, that is, when private investment is at a low ebb,

the deficiency in investment will have to be made up by large capital

outlay by the state, and conversely, during the upward swing of the cycle,

the state will have considerably to cut down its spending programme.

Thus, during the depression years, the state must be ready to spend

beyond its current revenues. In other words, the state should be prepared

to have deficit budgets during depression. Conversely, there should be

surplus budgets during the years of prosperity. To put it another way,

instead of having balanced budgets every year, the state should aim at

budget-balancing over a series of years.

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On the revenue side, rates and taxes should be lowered during depression,

while they should be raised during boom years. To stimulate business

investment during depression, not only the rates of taxes should be

lowered but also more liberal allowances for depreciation and

obsolescence, etc., should be granted.

Thus, fiscal policy, which is also known as the contra-cyclical management

of public finance, may be operated both through public revenues and

public expenditure.

(c) International Measures: So far we have discussed individual national

efforts at economic stabilisation. But trade cycle is an international

phenomenon and no country is hermetically scaled from the rest of the

world. In fact, this international aspect creates complications and makes

crisis control all the more difficult.

The measures which are suggested to be adopted on an international scale

are: International Production Control, International Buffer Stocks and

International Investment Control. International Production Control

envisages control of production and prices of the importance primary

products. The difficulties of such control are indeed formidable, notably

because agriculture in countries like India and Pakistan is usually carried

on a small scale and more as a mode of living than business, so that even

though it ceases to be profitable, it will be continued. But production

control, as far as possible, combined with buffer stocks to counteract

sudden changes in supply and demand, will go a long way in preventing

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rise or fall in their prices, which give rise further to serious fluctuations in

the entire economy.

An international investment control for developing backward regions

would help in raising the standards of living of their people and thus

reduce the inequalities in the standard of living of different peoples. Such

reduction in those inequalities is bound to strengthen the forces of

stabilisation.

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