ECB : 102

Macroeconomics

Semester – I

What is Macroeconomics?

We can know the meaning of only after the origin of macro

word. It has been taken from Greek word ‘Macros, it means is
that language is “Large ‘’. Hence macroseconomics means to
analyze whole economy at wide level.

• According to Shapiro – “Macro economics deals with the

functioning of the economy as a whole
• Ackley Gardner‘s words – “Macroeconomics concerns
with such variables as the aggregate volume of the
output of on economy, with the extent to which its
resources are employed, with the size of national
income and with the general prize level.”

National Income

Concept of Stock and Flow

Stock and flow are widely used concepts in macroeconomics.

Stock refers to the value of economic variables at a point of
time and Flow indicates the same during a period of time.

Concept of Stock:

Stock refers to the amount or value of a commodity or any

variable at a particular point of time. In other words, it describes
the state of the economy at a particular time. Hence, the
concept of the stock is related to an extremely small period of
time.

For example, Suppose, on1st January 2021, The govt has 10

crore rupees as government debt in the economy. It will be
known as stock as it is valued at a particular point of time. Or,
for other examples, we can say the balance of a bank account
on a particular date would be considered as stock.

Definition : Stock is defined as a variable that is measured at a

particular point in time.

Time Dimension : Stock does not have a time dimension

attached with it.

Nature : Stock is static in nature.

Influence : Stock influences the flow, as such greater amount

of capital will lead to greater flow of services.

Examples : Bank deposits, capital, wealth, population.

Concept of Flow :

Flow refers to the amount or value of a commodity or any

variable during a particular period of time. In other words, it
describes the changes in variables of the economy during a
particular time. Hence, the concept of flow is related to a long
period of time.

For example, Suppose, during a month job, you are earning

Rs.15,000 as basic pay, 2,000 as special allowance, and
Rs.3,000 for transportation expenses. Thus, all these values
are considered as flows as these are not related to a specific
point of time.

Definition : Flow is defined as a variable which is measurable

over a period of time.

Time Dimension : Flow has a time dimension attached with it.

Nature : Flow is dynamic in nature.

Influence : Flow influences the stock, as in increased flow of

money supply in an economy results in increase in the quantity
of money.
Examples : Capital formation, income, interest on capital,
depreciation.

Mutual Dependence of Stock and Flow:

The mutual dependence of stock and flow can be explained by

an example:

Suppose, Your bank account shows Rs.50,000 on 1st January

2021. This is the stock of your savings in the account. The
continuous withdrawals from the bank account i.e. Rs.1000 per
month is a flow concept. Likewise, continuous deposits of
Rs.1500 per month are also a flow concept.

Here, the important point is that your stock of deposits depends

upon the flows of deposits into your bank account. Similarly, the
flow of withdrawals depends upon your stock of savings. Thus,
there is a mutual dependence between stock and flow.

Sectors of Macroeconomics :
 The macroeconomic sector consists of four sectors:
household, business, government, and external. But, under a
closed economy, it comprises three sectors and excludes the
external sector. A closed economy does not involve
transactions with the foreign sector. Thus, there are no exports
and imports.
Household sector

In the goods market, the household sector acts as a buyer.

They consume goods produced by the business sector.

Meanwhile, in the factor market, households supply factors

such as labor, capital, land, and entrepreneurship. In return,
they get income from wages, interest income, profits, and rent.
They then use it to buy goods and services or to save money.

In some countries, household consumption is the driver of

economic growth. They account for most of the gross domestic
product (GDP). Thus, keeping consumption healthy is a goal to
promote stable economic growth.

Several factors influence household consumption:

• Disposable income. This is the income left after the

household pays taxes. Household consumption
increases when their disposable income increases.
• Wealth. The wealth effect plays a role in influencing
consumption. Wealth is positively correlated with
consumption.
• Expectations of future income and jobs. If they are
optimistic about their future income, households will
tend to spend money on goods and services. When
income and employment prospects deteriorate (such as
during a recession), they save more and reduce
consumption on less essential goods.
• Interest rate. Households rely on loans to purchase
several items such as cars, houses, and other durable
items. When interest rates fall, they have an incentive to
apply for new loans and buy those items.
• Work as a producer: In India, there are numerous
families that own multiple small production businesses.
These families are self-employed or generate a variety
of goods and services. They create businesses that are
essentially semi-corporate in character.
 • Act like a consumer: Households are the end
customers of the companies goods and services. They
generate demand in the market based on their interests
and inclinations. Firms created and provided
commodities in response to market demand. As a result,
households decide on a country’s production line.
• Pay taxes to Govt: Households are the primary source
of tax income for the government. They are the primary
taxpaying entity. A household pays direct taxes to the
state in the form of income tax, wealth tax, estate duty,
gift tax, and so on. Similarly, a household pays the
government numerous indirect taxes such as sales tax,
customs duty, VAT, and so on. All of these tax monies
are collected for the economy’s welfare and growth.
• Work as a professional: Households provide all sorts
of professional services, such as doctors, teachers,
lawyers, and engineers. Their efforts are critical to the
country’s continued economic prosperity. People’s living
standards are raised as a result of these professional
services.
• Act as a saver: Any money left over after consumption
is set aside for savings. As a result, families receive
money after providing a variety of services to the
economy. After consumption, the remaining amount of
their income is stored in banks or financial
organizations. These savings are regarded as one of
India’s primary sources of capital generation.

Business sector or Production sector

The business sector represents the producers of goods and

services in the economy. They may be proprietorships,
partnerships, and corporations. To produce goods and
services, they buy inputs in factor markets. Then, they sell
output in the goods market to earn income.
Business sector investment spending represents the most
volatile component of GDP. Its change usually causes
economic growth to tend to fluctuate in the short term.

Meanwhile, in the long run, business investment is essential for

increasing potential output. When the net investment is positive
(actual investment is more significant than the depreciation of
fixed assets), the physical capital stock increases. It increases
the productive capacity and potential GDP, thus enabling the
economy to produce greater output in the future.

Some factors influence production and business investment:

• Input prices. For example, a reduction in raw material

prices lowers production costs, encouraging businesses
to increase production.

• Business confidence. Suppose businesses feel

confident about future demand and profits. In that case,
they are likely to invest in capital goods to increase
production capacity.
• Expected future selling price. When companies
expect future selling prices to increase, they will
increase production to anticipate higher profit margins.
The opposite effect also applies when future prices tend
to fall, for example, due to a prolonged recession.
• Tax. Taxes reduce corporate profits, disincentives
companies to increase production and investment.
• Production subsidies. An increase in subsidies lowers
production costs, encouraging businesses to increase
production.
• Capacity utilization. Suppose the utilization rate has
approached full capacity. In that case, the business will
need to increase investment spending to continue
growing and anticipate higher demand in the future.

• Interest rate. Companies often rely on external

financing, for example, by issuing debt securities. Thus,
 when interest rates are low, it reduces the cost of capital
and encourages them to invest.

Government sector

This sector provides public services and regulates several

economic activities. The government collects taxes from the
business and household sectors to finance expenses. If tax
revenue exceeds spending, the government runs a fiscal
surplus. And, if expenditure exceeds revenue, the government
operates a fiscal deficit.

By changing their spending and taxes, governments influence

the economy. They will increase spending or reduce taxes to
stimulate economic growth. Conversely, to avoid an overheated
economy, they reduce spending or raise taxes.

The central bank is part of the government sector. In some

countries, the central bank may operate under government
supervision. Meanwhile, in other countries, such as Indonesia,
they operate independently, although they remain under the
law.

In general, government spending falls into the following three

categories:

• Routine spending. This includes spending on goods

and services for day-to-day operations. Examples are
staff salaries, government office supplies, health,
education, and defense.
• Capital expenditure. This component covers spending
on infrastructure, which contributes to the capital stock
in the economy.
• Transfer payments. This consists of payments to other
sectors without involving the exchange of goods and
services. Examples of transfer payments are
unemployment benefits, income allowances for poor
families, and other social programs.
Unlike household consumption and business investment, some
government spending depends on discretionary government
policies. They do not depend on economic ups and downs but
on government decisions.

Meanwhile, some components, such as transfer payments, are

counter-cyclical. They rise during recessions and fall during
economic expansion.

Furthermore, apart from the budget, the government also

influences economic activity and the three other sectors
through regulations and policies. Price controls, competition
regulations, labor, environmental safety are some examples.

External sector

The external sector represents economic actors abroad. They

also comprise the household sector, the business sector, and
the government sector. Still, They are outside the territory of a
country.

This sector interacts with the domestic economy through

foreign trade and capital flows. Exports represent the external
sector’s demand for domestic goods and services. Meanwhile,
imports represent domestic demand for goods and services
produced by the external sector.

In international trade, the exchange involves goods and

services and involves currency to facilitate payment. Thus,
external sector trade impacts the demand for goods (economic
growth) and impacts the domestic currency exchange rate.

• Foreign investment: Foreign direct investment and

portfolio investment are the two types of foreign
investment. Until 1999-2000, the majority of foreign
direct investment (FDI) into and out of India was in the
form of equity capital. Since 2000-01, the definition of
FDI has been broadened to include, in addition to equity
capital, reinvested earnings (retained earnings of FDI
 businesses), and ‘other direct capital,’ in line with
worldwide best practices (intercorporate debt
transactions between related entities). In addition to
equity of incorporated organizations, data on equity
capital includes equity of unincorporated businesses
(mostly foreign bank branches in India and Indian bank
branches operating overseas).
• Portfolio investment: FIIs, raise money through
GDRs/ADRs by Indian firms, and funds raised through
offshore funds make up the majority of portfolio
investments. Since 2000-01, data on foreign investment
has been divided into equity capital and portfolio
investment.
• Exchange rate: The exchange rate is also one of the
parts of the external sector. It is the rate at which one
currency of a country will be exchanged with the
currency of another country. The exchange rates are of
two types. The first one is the fixed exchange rates,
which are set by a country’s central bank, whereas the
second one is floating exchange rates, which are
determined by market demand and supply.

In general, activity with the external sector depends on the

following factors:

• Domestic vs. international economic growth prospects

• Domestic interest rate-international interest rates
spread
• Domestic inflation rate vs. inflation abroad
• Domestic exchange rates with partner countries

• Trade barriers and capital flow control

• Investment climate and ease of doing business
• Government policies, whether related to economy,
business, or politics (regulation)

Conclusion:
Each of the four sectors receives compensation in lieu of
products and services from the others, resulting in a steady
flow of goods and physical services. With the advent of the
foreign sector, the model is transformed from a closed to an
open economy! The addition of the foreign sector will expose
the local economy’s interactions with other countries.
Foreigners engage with local businesses and consumers
through products and service exports and imports, as well as
financial market borrowing and lending operations. Exports are
goods and services produced inside a country’s borders that
are sold to foreigners. Each movement of money is
accompanied by an equal and opposite flow of commodities or
services.

National Income

We may define national income as the aggregate of money

value of the annual flow of final goods and services in the
economy during a given period.

The well-known writer, Paul Studenski, writes: “National

income is both a flow of goods and services and a flow of
money incomes. It is therefore called national product as often
as national income”.

National income is the most comprehensive measure of the

level of the aggregate economic activity in an economy. It is the
total income of a nation as against the income of an individual
but you must note that the term national income is not as
simple and self-explanatory as the concept of individual income
maybe.

Example: you cannot include all the income received by

individuals during a given period in the national income,
similarly not all the income that is generated in the process of
production in an economy during a given period is received by
the individuals in the economy.
The flow of national income begins when production units
combine capital and labour and turn out goods and services.
We call this Gross National Product GNP. It is the value of all
final goods and services produced by domestically owned
factors of production within a given period.

At the same time, the production units which produce goods

and services, distribute money incomes to all who help in
production in the form of wages, rent, interest and profit – we
call this as Gross National Income (GNI).

GNI comprises the total value produced within a country,

together with its income received from other countries less
similar payments made to other countries.

It may be noted from above that:

National Income is an Aggregative Value Concept: It makes

use of the value determined by the measuring rod of money as
the common denominator for the purpose of aggregating the
diverse output resulting from different types of economic
activities.

National Income is a Flow Concept: It represents a given

amount of aggregate production per unit of time, conventionally
represented by one year. Thus, national income usually relates
to a particular year and indicates the output during that year.

National income represents the aggregate value of final

products rather than the total value of all kinds of products
produced in the economy. The insistence on final goods and
services is simply to make sure that we do not double count.

Accounting & National Income Identities:

National income accounting identity is an equation that shows

relationship between an economy’s total income/expense and
its different categories i.e. personal consumption expenditure
(C), private investment (I), government spending (G) and net
exports i.e. exports (X) minus imports (M).

The relationship can be written as follows:

Y = C + I + G + X –M

It is to national income accounting what assets (A) = liabilities

(L) + equity (E) is to business accounting.

Measurement of National Income

Gross Domestic Product (GDP)

For some purposes we need to find the total income generated

from production within the territorial boundaries of an economy,
irrespective of whether it belongs to the residents of that nation
or not. Such an income is known as Gross Domestic Product
(GDP) and found as:

GDP = GNP – Net factor income from abroad

Example: If in 2010-2011, the GNP is 8,00,000 million, the

income (including tax on such incomes) received and paid
60,000 million, and 70,000 million respectively, then, the GDP
in 2010-2011 would be:

= 8,00,000 – (70,000 – 60,000)

= 7,90,000 million.

GNP as a Sum of Expenditures on Final Products

Expenditure on final products in an economy can be classified

into the following categories:

Personal Consumption Expenditure (c): The sum of

expenditure on both the durable and non-durable goods as well
as services for consumption purposes.
 Gross Private Investment (I g) is the total expenditure
incurred for the replacement of capital goods and for additional
investment.

Government Expenditure (G) is the sum of expenditure on

consumption and capital goods by the government.

Net Exports (Exports – Imports) (X – M) constitute the

difference between the expenditure or rest of the world on
output of the national economy and the expenditure of the
national economy on output of the rest of the world.

GNP is the aggregate of the above mentioned four categories

of consumption expenditure. That is,

GNP = C + Ig + G + (X – M)

GNP as the Total of Factor Incomes

When national income is calculated after excluding indirect

taxes like excise duty, sales tax, etc. and including subsidies
we get GNP at factor cost as this is the amount received by all
the factors of production (indirect taxes being the amount
claimed by the government and subsidies becoming a part of
factor income).

GNPFC = GNPMP – Indirect taxes + Subsidies

Net National Product (NNP)

The NNP is an alternative and closely related measure of the

national income. It differs from GNP in only one respect. GNP
is the sum of final products. It includes consumption goods plus
gross investment plus government expenditures on goods and
services plus net exports. Here Gross Investment (GI) is the
increase in investment plus fixed assets like buildings and
equipment and thus exceed Net Investment (NI) by
depreciation.
GNP = NNP + Depreciation

Note: NNP includes net private investment while GNP includes

gross private domestic investment.

We know that during the process of production, assets get

consumed or depreciated. So, during a year the net
contribution to output is the production of goods and services
minus the depreciation during the year. This is known as NNP
at market prices because it is the net money value of final
goods and services produced at current prices during the year
after depreciation.

NNP = GNP – Depreciation

= C + I g + G + (X – M) – Depreciation

= C + G + (X – M) + (I g – Depreciation)

= C + G + (X – M) + In (where In = net
investment)

= C + G + In + (X – M)

NNPFC (or National Income)

Notes Goods and services are produced with the help of

factors of production. National income or NNP at factor cost is
the sum of all the income payments received by these factors
of production.

National Income = GNP – Depreciation – Indirect taxes +

Subsidies

Since factors receive subsidies, they are added while indirect

taxes are subtracted as these do not form part of the factor
income.

NNPFC = NNPMP – Indirect taxes + Subsidies

Personal Income

As you have learnt earlier, national income is the total income

accruing to the factors of production for their contribution to
current production but it does not represent the total income
that individuals actually receive.

Two types of factors account for the difference between

national income and personal income. On the one hand, a part
of the total income which accrues to the factors of production is
not actually paid out to the individuals who own the factors of
production. The obvious instances are corporate taxes and
undistributed or retained profits. On the other hand, the total
income that individuals actually receive generally includes
some part that comes to be regarded as payment for the factor
services rendered in the current year, for example, gifts,
pensions, relief payments and other welfare payments. Such
payments are known as “transfer payments” because they do
not represent the payments made for any direct contribution to
current production.

Thus, personal income is calculated by subtracting from

national income those types of incomes which are earned but
not received and adding those types which are received but not
currently earned.

Personal Income = NNPFC- Undistributed profits –

Corporate taxes + transfer payments

Disposable Income

Disposable income is the total income that actually remains

with individuals to dispose off as they wish. It differs from
personal income by the amount of direct taxes paid by
individuals.

Disposable Income = Personal Income – Personal taxes

DI = PI – T
So,

PI = DI + T

Usually, people divide their disposable income between

consumption spending and personal saving.

We therefore have the following identities,

PI = DI + T

DI = C + S

It follows

PI = C + S + T

Problems in Measuring National Income

The problems in measurement of national income are :

• National income measures domestic economic

performance and not social welfare. For real economic
growth, there should be strong positive correlation
between the two.
• National Income understates social welfare-non-market
transactions like home-makers service and do-it-yourself
projects are not counted.
• National Income does not measure an increase in
leisure or work satisfaction or changes in product
quality.
• National Income does not accurately reflect changes in
environment like oil spills cleanup is measured as
positive output but increased in pollution is not
measured as negative.
• Per capital income is a more meaningful measure of
living standards than total national income.
 • There is a problem of double counting. However,
problem of double counting could be avoided by utilizing
the value added approach.

Example: The wheat that is used to make bread is an

“intermediate good”. The value of the bread only is counted as
part of GNP and we do not count the value of wheat sold to the
miller and the value of flour sold to the baker.

• Problems of depreciation estimation as there are

different methods of calculating or estimating
depreciation.
• Inclusion or exclusion of certain items in national income
accounting can cause confusion:
• Imputed rent of owner occupied houses is also included
in calculation of national income.

• Imputed value of goods and services produced for self

consumption are included.
• Sale and purchase of second hand goods are excluded.
• Imputed rent of owner occupied houses and production
for self-consumption are included.
• Incomes from illegal activities are not included.
• Direct taxes such as Income tax are paid by employees
from their salaries are included.

• Expenditure on purchase of old share is excluded.

• Government expenditure on all transfer payment is
excluded.
• Challenges like difficulties in getting information
especially those related to underground economy (illegal
activities).

Problems of measurement of National income in India

1. Exclusion of Real Transactions: In measuring national

income from the output side only those items which are
purchased and sold through the market are included.
However, all direct sales of various goods and services are
excluded.

In other words, GDP includes the money value of those items

which are sold through the market at current prices.

In developing countries like India a major portion of output is

not sold through the market. Yet these are produced by using
economic resources and satisfaction is derived from consuming
various non-marketed goods and services. Examples are barter
transactions and various free services rendered at personal
levels.

Many useful services are produced by members of households

for the benefit of themselves or their families. Husbands and
wives perform useful services for themselves and their families
when they prepare meals, make household repairs, and handle
their own financial affairs.

The value of these services is not included in GDP because

they do not represent services purchased through market
transactions. The value of the work people do at home for
themselves and their families has been estimated to be about
one-third of India’s GDP. If this estimate is correct, GDP
significantly undervalues the total output of the nation by
excluding non-market household production.

Perhaps you can see this more clearly if you imagine each
husband paying his wife for her services and each wife paying
her husband for his services. These services would now
become market services and would be included in GDP.
Similarly, if more people remain single and hire housekeepers
to do work that spouses would normally do without monetary
compensation, GDP will increase!

Some non-market transactions, however, are included in GDP.

For example, homeowners who live in their own homes enjoy
the housing services their homes provide. In the National
Income and Product Accounts, these owner-occupiers are
viewed as being in the business of renting their homes to
themselves. An estimate of the value of housing services
enjoyed in this way is included in GDP.

In addition, GDP accounts impute the value of farm products

consumed on farms and food, clothing, and lodging furnished to
employees. The imputed market values of these goods and
services are also included in GDP. Of course, the goods and
services made available by governments, such as national
defence, are not sold in markets.

However, their value is reflected in GDP because government

purchases of labour and products are a component of GDP.

Similarly, many workers in rural areas, engaged mainly in the

agricultural sector, get their wages in kind — in terms of food
and accommodation. But any wages and salaries paid in kind is
not included in national income. The reason is that it is not
possible to find out the market value of such factor payments
accurately.

For the same reason, income from illegal activities which are
not reported to tax authorities are excluded. Examples of such
incomes are incomes from smuggling, un-authorised gambling,
black marketing and other illegal and immoral activities. So
expenditure on the purchase of a smuggled camera is not final
expenditure and is thus not a part of national income.

Transactions in second-hand goods are also excluded for

avoiding double (multiple) counting but expenditure on repair of
an old good such as TV set or car is part of final expenditure
and is, therefore, included in national income. For all these
reasons the official estimate of GDP does not give us the
correct GDP figure.

2. The Value of Leisure: All of us place some value on our

time. We sell some of our time to employers for labour income;
however, we retain much of it for our own use of leisure. Some
of this leisure is used to render household services that escape
inclusion in GDP. The satisfaction we get from recreational
activities and other uses of our leisure time are also not
included in GDP.

3. Cost of Environmental Damage: The people of a country

may be able to enjoy more and better goods and services each
year, but they must also put up with more congestion, dirty air,
polluted water and other environmental costs that decrease the
quality of their lives. Costs are associated with pollution and
other aspects of industrial activity that damage the
environment.

The costs of environmental damage are not subtracted from the

market value of final products when GDP is calculated. Some
economists, therefore, believe that GDP overestimates the
value of output by failing to take into account environmental
costs of production.

4. The Underground Economy: India has a vast underground

economy. This economy consists of transactions that are never
reported to tax and other government authorities. It includes
transactions involving illegal goods and services, such as
trading in harmful drugs, gambling, smuggling and prostitution.
These illegal goods and services are final products that are not
included in GDP.

The transactions of the underground economy also include

activities by people who do not comply with tax laws,
immigration laws, or government regulations and who do not
report their income to tax authorities. The underground
(unofficial) economy is also called parallel economy.

5. Transfer Payments and Capital Gains: All domestic

transfer payments (personal, private and government) are
excluded from national income of a country. For example, if an
individual receives a cash gift from his father who is also a
resident of India, it will not be a part of India’s national income.
The same argument is valid if a student receives Tata
Foundation Scholarship for higher studies.

So there is transfer of income from taxpayers to bondholders.

But there is no net increase in society’s output of goods and
services in the process. And it may be a happy coincidence if
the same individual is both a taxpayer and a bondholder at the
same time. So net interest paid by government (interest paid to
individuals less interest received from state governments from
loans and advances) is not a part of national income.

However, the treatment of interest on private (corporate) bonds

and debentures is different. It is not transfer income and is thus
included in national income. The reason is that a company pays
interest on its bonds and/or debentures from its current sales
revenue for receiving a useful productive input, viz., financial
service.

However, any transfer payment from abroad will be a part of a

country’s national income. Thus, if an individual receives $
20,000 from his father who is a non-resident Indian, it will be
part of India’s national income.

Capital gains are also a form of transfer payments and are,

therefore, excluded from national income. Let us consider, for
instance, the case of an individual who sells shares in the stock
exchange and makes a capital gain of Rs. 50,000. This money
just gets transferred from the buyer to the sellers of shares. But
there is no change in society’s output of goods and services nor
is any income generated in the process.

6. Self-Consumption: A special problem arises in agriculture

which is the most dominant sector in less developed countries
(LDCs) like India. Subsistence farmers who produce food for
themselves and their family members consume a major portion
of their own output every year. Since this portion is not sold
through the market, it is excluded from GDP.
The reason is that it is difficult to measure the market value of
this output. A lot of arbitrariness is involved in the process of
measuring it.

7. Lack of Official Records: Another problem arises due to

lack of reliable data. The reason is that many people in LDCs
like India sell their output through the market no doubt but they
do not maintain any official accounts of their transactions.

For example, most roadside small traders, (retailers) as also

many business enterprises in the unorganised sectors (mainly
sole proprietorship organisations or single-owner firms) and
self-employed persons do not keep proper records of their
incomes and expenses.

This is why it is difficult to include proprietor’s income (which is

essentially a mixed income) in the national income accounts of
a country. However, in theory, such income is a part of national
income. The reason is that it is earned through market
transactions.

8. Imputed Income: Imputed income such as income from

owner-occupied houses and flats is a part of a person’s taxable
income. Therefore, it is a part of national income. Such income
is fixed on the basis on notional rent. Even if an individual
keeps his house vacant he has to pay tax on notional rent.

In this case, the value of the service rendered by the house has
to be imputed. The same thing is true of unintended
inventories. For example, if a firm is not able to sell its entire
output during the current year, the unsold stock will have to be
valued at the current market price and included in national
income.

9. Valuation of Government Service: Finally, government

services provided to people free of cost are also to be included.
However, it is very difficult to find the true values of such
services, since these are not sold through the market. As Prof.
Amit Bhaduri comments, the valuation of services of many
public goods like a museum or a park becomes highly
problematic.

This, in turn, raises the question of how to evaluate the

economic contribution, i.e., value added of the government
which is the provider of public goods like national defence, law
and order, etc. for which no market prices exist. In the absence
of market prices for many types of public services, the problem
of their valuation must be somewhat arbitrarily settled by
accounting conventions.

It may also be mentioned here that to avoid such arbitrariness,

national income accounting procedure in centrally planned or
socialist economies deliberately excludes value added by the
entire ‘service sector’ including the government. This results in
an estimate of material production in the economy excluding
services, for which the product method of accounting is better
suited.

Circular Flow of Income

Circular flow of income model shows the flow of income

between the producers and the households who buy their
goods or services. Income moves from households to
producers as the households purchase goods or services and
income moves from producers to households in the form of
wages or profits.

Circular Flow of Income in a 2 Sector Model : One of the

most important insights about the aggregate economy is that it
is a circular flow in which output and input are interrelated.
Household’s expenditures (consumption and saving) and firm’s
expenditures (wages, rents, etc.) are household’s income.
The circular flow of income model is a model used to show the
flow of income through an economy. Through showing the
leakages in the economy and the injections, the different
factors affecting the economic activities are apparent. Just like
a leakage in a bucket leads to decrease in the level of water, a
leakage in the economy leads to a decrease in economic
activity. And just like an injection into the bucket where the
water level rises, an injection in an economy leads to an
increase in economic activity.

Basic Assumptions of a Simple Circular Flow of Income

Model

• The economy consists of two sectors: households and

firms.
• Households spend all of their income (Y) on goods and
services or consumption (C). There is no saving (S).

• All output (O) produced by firms is purchased by

households through their expenditure (E).
• There is no financial sector.
• There is no government sector.
• There is no overseas sector.
In the simple two sector circular flow of income model the state
of equilibrium is defined as a situation in which there is no
tendency for the levels of income (Y), expenditure (E) and
output (O) to change, that is:

Y = E = O.

This means that all household income (Y) is spent (E) on the
output (O) of firms, which is equal in value to the payments for
productive resources purchased by firms from households.

Circular Flow of Income in a 3 Sector Model: In this model,

we introduce the government sector as well that purchases
goods from firms and factors services from households.
Between households and the government money flows from
government to the household when the government makes
transfer payments. Like old age pension, scholarship and
factors payments o the households. Money flows back to the
government when it collects direct taxes from the households.

Similarly, there are flows of money between the government

sector and firm sector. Money flows from firms to government
when the government realises corporate taxes from the firms.
Money flows from the government to the firms in form of
subsidies and payment made for the goods purchased.

Circular Flow of Income in a 4 Sector Model: In a four sector

model, an economy moves from being a closed economy to an
open economy. In an open economy imports and exports are
made. You must understand that one country’s exports are
other country’s imports. In case of a country imports, money
flows to the rest of the world and in case of exports, money
flows in from the rest of the world. An economy experiences a
trade surplus if its exports exceed its imports. On the other
hand, there is a trade deficit if imports exceed exports. Imports
act as leakages and exports as injection into the circular flow of
income in an economy.

In a 4 sector model, we have,

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

Where, Y = Income or Output

C = Household consumption expenditure

I = Investment expenditure

G = Government expenditure

X-M = Exports minus Imports

Measurement of Cost of Living

1. Consumer Price Index (CPI): The consumer price index

(CPI) is the most widely used measure of the level of prices.

It is constructed by collecting the prices of thousands of goods

and services.

We know that the GDP expresses the quantity of diverse goods

and services into a single number which is used as a measure
of the value of society’s output.

In a like manner the CPI expresses the prices of numerous

goods and services into a single index for measuring the
general price level.
The CPI is a weighted average of all prices. It is the price of a
basket of goods and services relative to the price of the same
basket in some base year.

Example:

Let us suppose our representative consumer (Mr. X) buys 5

bananas and 2 cakes every month. Then the basket of goods
consists of 5 bananas and 2 cakes and, in this case,

In this CPI, 2000 is taken as the base year. This index indicates
the cost of buying 5 bananas and 2 cakes today compared to
how much it had cost to buy the same basket in 2000.

Laspeyres Index Vs. Paasche Index: A price index with a

fixed basket of goods is called a Laspeyres index while a price
index with a changing basket is called a Paasche index. The
Laspeyres price index is based upon the relative costs of
acquiring a base period basket of goods.

Formally, it is defined as:

where p1 and p0 tefer to current prices and the base period

prices, respectively, and q0 refers to the base period market
basket of goods.

The Paasche price index measures the cost of buying today’s

market basket at the base period prices.

The Paasche index is given by:

Thus, in Laspeyres index the weighting is taken from the base
year, while in Paasche index from the current year. This means
that Laspeyres index tends to emphasise items which might be
out of date and to ignore changes in tastes or lifestyle over the
years.

Paasche index, on the other hand, runs into difficulty with new
items which are significant in the current year but have no value
because they did not exist or were not used before.

Since market basket of goods and services remains fixed over

time, the CPI tends to overestimate inflation. The main reason
is that when the prices of some goods rise sharply, consumers
have a tendency to switch their purchases to goods whose
prices have not risen as much or not at all. But the CPI ignores
the rise completely. This is known as substitution bias. The CPI
does not reflect changing consumption.

At the same time, the Laspayers cost of living index

overestimates the amount needed to compensate individuals
for price increases. This means that using the CPI to adjust
retirement pensions will tend to overcompensate the
pensioners by underestimating their retirement benefit and will
thus require more government expenditure.

Each index has its merit and drawback. So one is not

ambiguously superior to the other. When prices of different
goods are changing by different amounts, the Laspeyres index
tends to overstate the increase in the cost of living because it
ignores the fact that consumers have the opportunity to
substitute cheaper goods for expensive ones.

By contrast, the Paasche index tends to understate the

increase in the cost of living. While it takes into account the
substitution of alternative goods, it fails to reflect the loss of
consumers’ welfare’ that may result from such substitutions.
2. Gross National Product (GNP) Deflator : The GNP deflator
is simply the adjustment for inflation that is made to nominal
GNP to produce real GNP. The GNP deflator provides an
alternative to the Consumer Price Index (CPI) and can be used
in conjunction with it to analyze some changes in trade flows
and the effects on the welfare of people within a relatively open
market country.

The CPI is based upon a basket of goods and services, while

the GNP deflator incorporates all of the final goods produced by
an economy. This allows the GNP deflator to more accurately
capture the effects of inflation since it’s not limited to a smaller
subset of goods.

Calculating the Gross National Product (GNP) Deflator

The GNP deflator is calculated with the following formula:

GNP Deflator = { GNP Nominal\ Real GNP}×100

The result is expressed as a percentage, usually with three

decimal places.

The first step to calculating the GNP deflator is to determine the

base period for analysis. In theory, you can work with GDP and
foreign earnings data for the base period and current periods,
and then extract the figures needed for the deflator calculation.
However, nominal GNP and real GNP figures, as well as the
deflator charted over time, can usually be accessed through
releases from central banks or other economic entities.

Interpreting GNP Figures

The GNP deflator, as mentioned, is just the inflation

adjustment. The higher the GNP deflator, the higher the rate of
inflation for the period. The relevant question is what having an
inflation-adjusted gross national product—the real GNP—
actually tells you.
The real GNP is simply the actual national income of the
country being measured. It doesn’t care where the production is
located in the world as long as the earnings come back home.

Theory of Employment and Income

Concepts Related to Classical Theory

• Full Employment: An economy is said to be in full

employment when its entire labour force is gainfully
employed. Labour force is that part of the population of
the country which is physically and mentally able and at
the same time willing to work.

• Nominal Wage vs. Real Wage: Nominal wage is what

a worker receives in the form of money. Real wage is
what a worker can buy from the nominal wage.

Real Wage = Nominal Wage \ Price Level

• Real Rate of Interest: Nominal rate of interest is the

rate which the lender receives from the borrower in
money. Real rate of interest is rate accruing after
adjustment of inflation.

(Rate of interest = ROI, ROI in figures) Real ROI = Nominal

ROI – rate of inflation

• Value of Marginal Product of Labour (VMPL): VMPL

equals MPL multiplied by the price of the product (P) the
labour produces.

VMPL = MPL × P = MPL × AR

• It is distinguished from ‘Marginal Revenue Product of

Labour (MRPL), which equals MPL ×MR. Since in case
of perfect competition in the product market MR=AR,
VMPL=MRPL .
 • Aggregate Demand and Aggregate Supply:
Aggregate demand is the total value of final goods and
services that all sections of the economy taken together
are planning to buy at a given level of income during a
period of time. Aggregate supply is the value of final
goods and services planned to be produced in an
economy during a period.
• Supply of Money: Money supply of a country is the
stock of money on a specific day. This is the sum of
currency held outside banks and chequable deposits.
This is the money which can be directly used for
transactions.

Theory of Employment and Income

Classical analysis of determination of Equilibrium output

and Employment

To build up a classical macroeconomic model, here we will

consider a particular framework within which the classical
system can be studied.

This framework is composed of an aggregate production

function, the labour market, the money market, and the goods
market.

1. Employment-Output Determination: Labour Market:

Let us first consider the labour market where we deal with

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

The aggregate production function is: Y = f (K , L) … (3.2)

where K denotes a constant capital stock and L denotes

quantities of variable input, labour.

In the classical model, equilibrium level of output is determined

by the employment of labour. The level of output and, hence,
the level of employment is established in the labour market by
the demand for and supply of labour.

Assuming a profit-maximising economy, labour will be

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

MC = W/MPL

The condition for profit maximisation is

where W is the money wage, P is the absolute price level, and

W/P is the real wage.

We know that the MP curve for labour indicates the firm’s

demand for labour. More labour is demanded at a lower wage.
Thus, demand for labour depends inversely on real wage. The
aggregate demand curve for labour is the horizontal summation
of all individual firm’s demand curve for labour. Aggregate
labour demand function, shown in equation (3.7), is also
inversely related to the real wage rate. That is,

DL=f (W-p) …(3.7)

Like labour demand, aggregate labour supply function also

depends on the real wage rate, but in a direct manner. Thus,

SL=g (W/P)… (3.8)

These relationships (equations 3.2, 3.7 and 3.8), together with

the equilibrium condition for the labour market
DL = SL … (3.9)

determine output, employment and real wage in the classical

system.

Equilibrium real wage rate and the equilibrium level of

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

This is shown in Fig. 3.1. In the lower panel, aggregate

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

In the classical system, full employment is achieved

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

It may be added here that the volume of output and

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

2. Price Level Determination: Money Market: In this section,

we analyse the classical theory of aggregate price level
determination. To do this, money market is introduced.

How is the general price level determined? Classicists

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

So we can say that the total demand for money in an economy

is a function of money national income or output. The supply of
money and the demand for money jointly establish equilibrium
in the money market. The demand for money equation that will
be presented here is the Marshallian cash balance version of
the quantity theory of money. It is;

Md = kPY … (3.10)

where Md stands for demand for money, Y the output level, P

the price level and k is the fraction of Y that people want to hold
to facilitate transaction. Equation 3.10 states that people hold
cash balance since there is a gap between money receipts and
expenditures.

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

bank. Thus,

Ms= M …(3.11)

For equilibrium in the money market, = kPY … (3.12)

Equation (3.12) shows a proportional relationship between

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

Fig. 3.2 represents money market equilibrium where we plot

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

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

One essential feature that follows from the classical money

market is that money is neutral. This means that changes in
money stock affect only absolute prices and money wages
proportionately. Real variables such as, output, level of
employment and real wage rate remain undisturbed following a
change in money supply.
3. Interest Rate Determination: Goods Market: In the
classical model the components of aggregate demand
consumption and investment determine equilibrium interest
rate. Interest rate that guarantees that changes in the particular
components of demands do not affect the aggregate level of
commodity demand. It may be noted here that the interest rate
is a ‘real’ variable in the goods market. The goods market is
concerned with the way the fixed output or income is split
between saving and consumption. Here we determine
equilibrium rate of interest.

Saving implies a choice between present and future

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

Classicists assumed that saving (S) is an increasing function of

the rate of interest (r), that is,

S = f (r) …..(3.13)

Investment may be defined as the amount of an economy’s

product that is not consumed. Investment refers to the creation
of additional stock of capital. An investment is something that is
used to create value in future. An economy considers a number
of capital projects in each time period. It undertakes those
investment projects that yield a rate of return greater than the
market rate of interest. Thus, investment, in the classical
system, depends on the market rate of interest.

Investment is an inverse function of the rate of interest, that is,

I = f(r) ………(3.14)

The goods market equilibrium is achieved when saving is equal

to investment, i.e.,

S = I ………..(3.15)
A flexible interest rate in the classical system always brings
equality between savings and investment. Fig. 3.3 shows how
equilibrium rate of interest is determined in the classical model,
independent of the monetary sector. Saving curve (S) and
investment curve (I) are equal to each other at point E where
the equilibrium volume of saving (SE) is equal to the equilibrium
value of investment (IE). Interest rate is flexible and it adjusts to
maintain the equality between saving and investment. The
equilibrium interest rate is a real variable and in no way
influenced by the quantity of money.

1. Classical Dichotomy: One important conclusion from the

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

One important conclusion from the classical model is the

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

2. Policy Implications: The policy implication of this classical

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

Simple Keynesian theory of employment and income

determination: With and Without Government Sector

Historically, the Keynesian model follows the classical model.

The basic difference between the two is:

The classical held that unemployment cannot exist. Even if

there is any unemployment, it is self correcting. The complete
flexibility in real variable-wage, price level and rate of interest-
ensures full employment level.

Keynes believed that it is the ‘aggregate demand’, not wages,

price level and rate of interest, which determine unemployment.
Keynes also believed that government can step in to influence
the level of output and employment.

Planned Output (Income)

It is also called ‘aggregate supply’. It is the value of final

goods and services planned to be produced in an
economy during a period. Assuming a closed economy
without government, the value of planned output is nothing but
national income.

Planned Aggregate Expenditure (AE)

 It is the value of final goods and services planned to be
purchased by people in an economy during a given period. The
expenditure is classified into consumption spending (C) and
investment spending (I). This is on the assumption that the
economy is a closed economy without government. It means
there is no government expenditure (G), no exports (X), no
imports (M). In an open economy with government AE is the
sum of C,I,G and net exports.

Planned Consumption Spending

The main factors determining consumption spending are:

1. Household’s Income: It is held that as income of the

households rises, people do spend a proportion of the income
on consumption. Higher the income higher the consumption
spending.

2. Household’s Wealth: Higher the amount of wealth a

household possesses higher is the expected flow of future
income. Higher the expected flow higher the spending on
consumption.

3. Interest Rate: Interest paid is the cost of borrowing. People

do borrow to spend on consumption. Lower the rate of interest
lower the cost of borrowing. This stimulates spending. The
higher rate of interest discourages spending.

4. Household’s Expectation about Future: If there is a positive

expectation about the future Notes flow of income the current
spending may rise. Uncertainty about future income decreases
current spending.

Consumption Function

The relation between income and consumption spending is

called consumption function, assuming all other factors
influencing consumption are unchanged. It is expressed as:
 C = a + bY

Where C = Consumption spending

a = Consumption spending at zero

income

b = The proportion of the increased

income spent on consumption

Y = Income

In the function ‘a’ is constant. ‘b’ equals change in consumption

( C) divided by the change in income ( Y). The value of ‘b’ is
also called Marginal Propensity to Consume (MPC).

b = dltC\dlt Y = MPC

Graphically, if we show aggregate income (Y) on the x-axis and

the aggregate consumption (C) on the y-axis, the straight line
starting from c on the y-axis is the consumption function line.

Here, a = OC

b = slope = MPC = dlt C \ dlt Y

It is upward sloping because as income rises C rises. It is a

straight line because the slope is constant. The slope is
constant because MPC is assumed to be constant.
Planned Investment Spending (I)

Investment refers to the purchases of new capital goods like

machines, buildings, equipments, inventories of inputs and
finished products. The theory of income determination assumed
planned-investments to be fixed and not changing with change
in income. This makes the investment curve parallel to the x-
axis.
C+I curve is the Aggregate Expenditure (AE) curve. It is the
vertical sum of I and C curves. The C+I curve is parallel to the
C curve because investment spending is imagined to be
constant and does not change with the change in aggregate
income (Y).

Neo-Classical Synthesis

The Neo-classical synthesis (also referred to as the neo-

Keynesian theory) refers to the post-war macroeconomic
development which combined elements of Keynesian
macroeconomics with more classical microeconomic
theory. (This is not relevant for A-Level economics, you may be
relieved to know)

Up until the 1930s, economics had been dominated by classical

economists who argued that markets were self-regulating,
markets would clear and markets were the most efficient
method of distributing resources.

Keynesian theory, however, suggested markets weren’t self-

regulating and could be below full employment for a
considerable time.

The neo-classical synthesis suggests that Keynes was right in

the short term, and classical economists were correct in the
long-term. Markets may be subject to short-term shocks which
put them out of equilibrium. But, in the long-term, free markets
were best for distributing resources. The neo-classical
synthesis suggests government intervention should primarily be
concentrated on the short-term, stimulating demand in a
recession, and dealing with rigidities in labour markets, such as
monopolies, minimum wages and monopsonies.

Key people in the Neo-Classical Synthesis

• John Hicks. Hicks developed the IS/LM model in 1937,

which is based on Keynesian macroeconomic insights.
• Paul Samuelson. In the post-war period, Samuelson
was one of the first economists to popularise Keynesian
theory with his amendments. His textbook, Economics:
An Introductory Analysis, first published in 1948 was
instrumental in sharing Keynesian macroeconomic
principles, alongside more classical microeconomic
theory.

Politics of the Neo-Classical Synthesis

There was a belief Keynesian economics was partly inspired by
‘Communist’ ideas. This was in the ‘McCarthyite era’ with great
suspicion of any ‘left wing’ ideas. Samuelson’s synthesis
helped to dilute Keynesian economics to give it more market-
based approach and this became the more widespread version
of Keynesian economics.

Key Elements of the Neoclassical Synthesis

Full Employment is possible. Government intervention could

help the economy be maintained close to full employment. For
example, in an economic downturn, the government could
pursue expansionary fiscal policy to boost demand. In the
1950s and 1960s, these ideas received widespread support as
most major economies experienced two decades of economic
expansion and close to full employment. Richard Nixon said in
the early 1970s ‘we’re all Keynesians now‘

Monetary and Fiscal Policy. Keynes had concentrated on the

role of fiscal policy in managing the economy. However, the
neo-Keynesians became more accepting that Monetary policy
could also be used to manage demand and the rate of
economic growth. By the late 1990s, the neo-classical
synthesis had embraced the role of monetary policy in
achieving inflation targets. (neoclassical synthesis and
monetary policy)

Phillips Curve
In the post-war period, the Phillips curve was considered a
significant aspect of economic policy. It appeared there was a
trade-off between inflation and unemployment and the
government could decide which to prioritise.

Neo-Keynesian acceptance of Neo-classical micro ideas

Keynes had rejected many of the classical microeconomic

theories, such as ergodic axion, neutral money and gross
substitution. The Neo-classical synthesis reverted to the
classical view of these microeconomic foundations.

1. Ergodic axiom. Keynes argued the future wasn’t pre-

determined, there were many unknown variables. The
neo-classical synthesis rejected this and supported the
ergodic axiom of neo-classical economics. What this
means is the neo-classical synthesis argued the future
could be determined by market fundamentals (a kind
 of efficient market hypothesis). Keynes said it couldn’t,
Keynes placed a greater role in people’s behaviour,
‘animal spirits’ and actions influencing the future.

2. Neutral Money. Neo-Keynesians believed money was

neutral (money supply didn’t affect real output). Keynes
rejected neutrality of money in the short and long-term.

3. Gross substitution. Classical economics argues

money is a close substitute for less liquid assets.
Keynes argued they are not close substitutes. If people
save more money in liquid assets, there will be a fall in
demand for physical goods. Therefore, Say’s law is
broken (supply = demand). The lack of substitution
explains why markets often fail to clear. The neo-
classical synthesis accepted the classical version of
gross substitution.

The IS-LM Model and the interaction of the Real and

Monetary Sectors.

IS-LM Model:

The IS-LM model, which stands for “investment-savings” (IS)

and “liquidity preference-money supply” (LM) is a
Keynesian macroeconomic model that shows how the market
for economic goods (IS) interacts with the loanable funds
market (LM) or money market. It is represented as a graph in
which the IS and LM curves intersect to show the short-run
equilibrium between interest rates and output.
Understanding the IS-LM Model

British economist John Hicks first introduced the IS-LM model in

1936,1 just a few months after fellow British economist John
Maynard Keynes published “The General Theory of
Employment, Interest, and Money.”2 Hicks’s model served as a
formalized graphical representation of Keynes’s theories,
though it is used mainly as a heuristic device today.

The three critical exogenous, i.e. external, variables in the IS-

LM model are liquidity, investment, and consumption.
According to the theory, liquidity is determined by the size and
velocity of the money supply. The levels of investment and
consumption are determined by the marginal decisions of
individual actors.
The IS-LM graph examines the relationship between output,
or gross domestic product (GDP), and interest rates. The entire
economy is boiled down to just two markets, output and money;
and their respective supply and demand characteristics push
the economy towards an equilibrium point.

Characteristics of the IS-LM Graph

The IS-LM graph consists of two curves, IS and LM. Gross

domestic product (GDP), or (Y), is placed on the horizontal
axis, increasing to the right. The interest rate, or (i or R), makes
up the vertical axis.

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

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

The intersection of the IS and LM curves shows the equilibrium

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

In some versions of the graph, curves display limited convexity

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

Limitations of the IS-LM Model

Many economists, including many Keynesians, object to the IS-
LM model for its simplistic and unrealistic assumptions about
the macroeconomy. In fact, Hicks later admitted that the
model’s flaws were fatal, and it was probably best used as “a
classroom gadget, to be superseded, later on, by something
better.”3 Subsequent revisions have taken place for so-called
“new” or “optimized” IS-LM frameworks.

The model is a limited policy tool, as it cannot explain how tax

or spending policies should be formulated with any specificity.
This significantly limits its functional appeal. It has very little to
say about inflation, rational expectations, or international
markets, although later models do attempt to incorporate these
ideas. The model also ignores the formation of capital and labor
productivity.

IS-LM Curve Model: Explaining Role of Government’s

Fiscal and Monetary Policies:

With the help of IS-LM curve model we can explain how the
intervention by the Government with proper fiscal and monetary
policies can influence the level of economic activity, that is,
income and employment level. We explain below the impact of
changes in fiscal and monetary policy on the economy in the
IS-LM model.
Effect of Fiscal Policy:

Let us first explain how IS-LM model shows the effect of

increase in Government expenditure on level of income. This is
illustrated in Fig. 24.6. As explained above, increase in
Government expenditure which is of autonomous nature raises
aggregate demand for goods and services and thereby causes
an outward shift in IS curve, as is shown in Fig. 24.6 where
increase in Government expenditure leads to the shift in IS
curve from IS1to IS2 Note that the horizontal distance between
the two IS curves is equal to ∆G x 1/1 –MPC which shows the
increase in income that occurs in Keynes’s multiplier model.

It will be seen from Fig. 24.6 that with the LM curve remaining
unchanged, the new IS2 curve intersects LM curve at point B.
Thus, in IS-LM model with the increase in Government
expenditure (AG), the equilibrium moves from point E to B and
with this the rate of interest rises from r1 to r2 and income level
from Y1 to Y2. Thus, IS-LM model shows that expansionary
fiscal policy of increase in Government expenditure raises both
the level of income and rate of interest.

It is worth noting that in the IS-LM model increase in national

income by Y1Y2 in Fig. 24.6 is less than EK which would occur
in Keynes’s model. This is because Keynes in his simple
multiplier model (popularly called Keynesian cross model)
assumes that investment is fixed and autonomous, whereas IS-
LM model takes into account the fall in private investment due
to the rise in interest rate that takes place with the increase in
Government expenditure. That is, increase in Government
expenditure crowds out some private investment.

Likewise, it can be illustrated that the reduction in Government

expenditure will cause a right- ward shift in the IS curve, and
given the LM curve unchanged, will lead to the fall in both rate
of interest and level of income. It should be noted that
Government often cuts expenditure to control inflation in the
economy.
Reduction in Taxes:

An alternative measure of expansionary fiscal policy which may

be adopted is the reduction in taxes which through increase in
disposable income of the people raises consumption demand
of the people. As a result, cut in taxes causes a shift in the IS
curve to the right as is shown in Fig. 24.7, from IS 1 to IS2. It
may however noted that in the Keynesian multiplier model, the
horizontal shift in the IS curve is determined by the value of tax
multiplier which is equal to ∆T x MPC/1 – MPC and causes
level of income to increase by EH.

However, in the IS-LM model, with the shift of the IS curve from
IS1 to IS2 following the reduction in taxes, the economy moves
from equilibrium point E to D and as is evident from Fig. 24.7,
rate of interest rises from r1 to r2 and level of income increases
from Y1 to Y2.

On the other hand, if the Government intervenes in the

economy to reduce inflationary pressures, it will raise the rates
of personal taxes to reduce disposable income of the people.
Rise in personal taxes will lead to the decrease in aggregate
demand. Decrease in aggregate demand will help in controlling
inflation. This case can also be shown by IS-LM curve model.

Impact of Monetary Policy:

Through making appropriate changes in monetary policy the
Government can influence the level of economic activity.
Monetary policy may also be expansionary or contractionary
depending on the prevailing economic situation. IS-LM model
can be used to show the effect of expansionary and tight
monetary policies. As has been explained above, a change in
money supply causes a shift in the LM curve; expansion in
money supply shifts it to the right and decrease in money
supply shifts it to the left.

Suppose the economy is in grip of recession, the Government

(through its Central Bank) adopts the expansionary monetary
policy to lift the economy out of recession. Thus, it takes
measures to increase the money supply in the economy. The
increase in money supply, state of liquidity preference or
demand for money remaining unchanged, will lead to the fall in
rate of interest.

At a lower interest there will be more investment by

businessmen. More investment will cause aggregate demand
and income to rise. This implies that with expansion in money
supply LM curve will shift to the right as is shown in Fig. 24.8.

As a result, the economy will move from equilibrium point E to

D and with this the rate of interest will fall from r 1 to r2 and
national income will increase from Y1 to [Link], IS-LM model
shows the expansion in money supply lowers interest rate and
raises income.

We have also indicated what is called monetary transmission

mechanism, that is, how IS-LM curve model shows the
expansion in money supply leads to the increase in aggregate
demand for goods and services. We have thus seen that
increase in money supply lowers the rate of interest which then
stimulates more investment demand. Investment demand
through multiplier process leads to a greater increase in
aggregate demand and national income.

If the economy suffers from inflation, the Government will like to

check it. Then its Central Bank should adopt tight or
contractionary monetary policy. That is, it should reduce the
money supply. IS-LM model can be used to show, as we have
seen above in case of expansionary monetary policy, that
reduction in money supply will cause a leftward shift in LM
curve and will lead to the rise in interest rate and fall in the level
of income.

IS-LM model in the open Economy under fixed exchange

rate without capital mobility.

Open economy: IS-LM model

The IS-LM (Investment Savings-Liquidity preference Money

supply) model focuses on the equilibrium of the
market for goods and services, and the money market. It
basically shows the relationship between real output and
interest rates.

It was developed by John R. Hicks, based on J. M. Keynes’

“General Theory”, in which he analysed four markets: goods,
labour, credit and money. This model, firstly named IS-LL,
appeared in his article “Mr. Keynes and the Classics: a
Suggested Interpretation”, published in 1937 in the journal
Econometrica.
In order to understand how this model works, we’ll first see how
the IS curve, which represents the equilibrium in the goods
market, is defined. Then, the LM curve, which represents the
equilibrium in the money market. Finally, we’ll analyse how the
equilibrium is reached.

IS curve: the market for goods and services

In a closed economy, the equilibrium condition in the market for

goods is that production (Y), is equal to the demand for goods,
which is the sum of consumption, investment and public
spending. This relationship is called IS. If we define
consumption (C) as C = C(Y-T) where T corresponds to taxes,
the equilibrium would be given by:

Y = C (Y- T) + I + G

We consider that investment is not constant, and we see that it

depends mainly on two factors: the level of sales and interest
rates. If the sales of a firm increase, it will need to invest in new
production plants to raise production; it is a positive relation.
With regard to interest rates, the higher they are, the more
expensive investments are, so that the relationship between
interest rates and investment is negative. The new relationship
is expressed as follows (where i is the interest rate):

Y = C (Y- T) + I (Y, i) + G

f we keep in mind the equivalence between production and

demand, which determines the equilibrium in the market for
goods, and observe the effect of interest rates, we obtain the IS
curve. This curve represents the value of equilibrium for any
interest rate.

An increasing interest rate will cause a reduction in production

through its effect on investment. Therefore, the curve has a
negative slope. The adjacent graph shows this relationship.
LM curve: the market for money

The LM curve represents the relationship between liquidity and

money. In a closed economy, the interest rate is determined by
the equilibrium of supply and demand for
money: M/P=L(i,Y) considering M the amount of money
offered, Y real income and i real interest rate, being L the
demand for money, which is function of i and Y.
The equilibrium of the money market implies that, given the
amount of money, the interest rate is an increasing function of
the output level. When output increases, the demand for money
raises, but, as we have said, the money supply is given.
Therefore, the interest rate should rise until the opposite effects
acting on the demand for money are cancelled, people will
demand more money because of higher income and less due
to rising interest rates.

The slope of the curve is positive, contrary to what happened in

the IS curve. This is because the slope reflects the positive
relationship between output and interest rates.

IS-LM model

At any point of these curves the equilibrium condition in the

corresponding market is true, but only at the point where the
two curves intersect, both equilibrium conditions are satisfied.
We can see this intersection in the following graph:
 The IS and LM curves undertake changes due to many
factors, such as different kinds of economic policies. These
variations will explain the changes in the values of production
and of interest rates taking place in the economies.
For instance, if there is an increase in government spending,
which is considered a fiscal policy, the IS curve will shift to the
right, as seen in the graph in the left. This happens because
more government spending means more production for any
interest rate. This shift, as seen in the adjacent graph, will
consequently change the equilibrium from point E1 to point E2,
with a greater level of output, but also at greater interest rates.
 [Text Wrapping Break]

On the other hand, if we consider a monetary policy, such as an

increase in the money supply, the curve that shifts will be the
LM curve, as seen in the graph in the right. An increase in the
money supply will decrease the interest rate, shifting the LM
curve to the right, thus increasing output.

Monetarists’ views on the IS-LM model:

Monetarists greatly criticized the IS-LM model, highlighting

some different views regarding the elasticity (and therefore the
slope) of both curves. In their opinion, the LM curve is very
inelastic, while the IS curve is very elastic. The most important
thing we derive from these different views is the different
consequences and effectiveness of expansionary fiscal and
monetary policies.

Monetarists argue that monetary policies are more effective.

Take the same example as before, an increase in the money
supply. This will shift the LM curve to the right, displacing the
equilibrium from E1 to E2 in the figure below. However,
monetarists consider also two other effects: direct and indirect
wealth effect. The first one, also known as Pigouvian effect,
considers that, because of the increase in money supply,
people will consume more, shifting the IS curve and changing
the equilibrium to point E3. The second one considers that,
because of the initial drop in the equilibrium interest rates,
people will invest more, thus shifting even more the IS curve
and changing the equilibrium to point E4.

Now, monetarists are more sceptic than Keynesians about

fiscal policy. This is because, as seen in the figure below, the
initial shift of the IS curve (from point E 1 to point E2) will be
partly offset by a second shift of the same curve. This, known
as crowding-out, happens because the increase in government
spending increases interest rates, which decreases the
attractiveness of investment. Therefore, the more the
government spends, the less private capital will be invested,
which moves the equilibrium from point E2 to E3. Also, because
of higher output, money demand increases, which shifts the LM
curve to the left, to point E4.

Both views have a great army of researchers and professors

defending them, as part of the modern division on such matters
into two main doctrines: New Keynesian Economics and New
Classical Macroeconomics. All the effects presented here must
be taken into consideration when analysing the IS-LM model.
However, it must be noted that some of these conclusions
change when considering an open economy, which is analysed
by the IS-LM-BoP or Mundell-Fleming model.

Consumption Function
Consumption function refers to the functional or causal
relationships between consumption on the one hand and the
various factors determining it on the other. Your income is
considered to be the chief determinant of your consumption, so
the consumption function conventionally refers to the functional
relationship between income and consumption.

Keynes Psychological Law of Consumption and Its

Implications

Further, Keynes put forward a psychological law of

consumption, according to which, as income increases
consumption increases but not by as much as the increase in
income.

In other words, marginal propensity to consume is less than

one.

While Keynes recognized that many subjective and objective

factors including interest rate and wealth influenced the level of
consumption expenditure, he emphasized that it is the current
level of income on which the consumption spending of an
individual and the society depends.

To quote him:

“The amount of aggregate consumption depends mainly on the

amount of aggregate income. The fundamental psychological
law, upon which we are entitled to depend with great
confidence both a priori from our knowledge of human nature
and from the detailed facts of experience is that men (and
women, too) are disposed, as a rule and on an average to
increase their consumption as their income increases, but not
by as much as the increase in their income”.

In the above statement about consumption behaviour, Keynes

makes three points. First, he suggests that consumption
expenditure depends mainly on absolute income of the current
period, that is, consumption is a positive function of the
absolute level of current income. The more income in a period
one has, the more is likely to be his consumption expenditure in
that period.

In other words in any period the rich people tend to consume

more than the poor people do. Secondly, Keynes points out
that consumption expenditure does not have a proportional
relationship with income. According to him, as the income
increases, a smaller proportion of income is consumed. The
proportion of consumption to income is called average
propensity to consume (APC). Thus, Keynes argues that
average propensity to consume (APC) falls as income
increases.

The Keynes’ consumption function can be expressed in

the following form:

C = a + bYd

where C is consumption expenditure and Yd is the real

disposable income which equals gross national income minus
taxes, a and b are constants, where a is the intercept term, that
is, the amount of consumption expenditure at zero level of
income. Thus, a is autonomous consumption. The parameter b
is the marginal propensity to consume (MPC) which measures
the increase in consumption spending in response to per unit
increase in disposable income. Thus

MPC = ∆C/∆Y

It is evident from Fig. 9.1 and 9.3 the behaviour of consumption

expenditure as perceived by Keynes implies that marginal
propensity to consume (MPC) which is measured by the slope
of consumption function curve CC at a point is less than
average propensity to consume (APC) which is measured by
the slope of the line joining a point on the consumption function
curve CC to the origin (that is, MPC < APC).
This is because as income rises consumption does not
increase proportionately and as income falls consumption does
not fall proportionately as people seek to protect their earlier
consumption standards. This can be seen from Fig. 9.3 the
slope of consumption function curve CC’ measuring MPC and
the slopes of lines OA and OB which give the APC(i. e C/Y ) at
points A and B respectively are falling whereas slope of the
linear consumption function CC’ remains constant.

In Fig. 9.3 we have shown a linear consumption function with

an intercept term. In this form of linear consumption function,
though marginal propensity to consume (AC/AF) is constant,
average propensity to consume (C/F) is declining with the
increase in income as indicated by the slopes of the lines OA
and OB at levels of income F, and F2 respectively.

The straight line OB drawn from the origin indicating average

propensity to consume at higher income level F2 has a relatively
less slope than the straight line OA drawn from the origin to
point/t at lower income level Fr The decline in average
propensity to consume as the income increases implies that the
proportion of income that is saved increases with the increase
in national income of the country.
This result also follows from the studies of family budgets of
various families at different income levels. The fraction of
income spent on consumption by the rich families is lower than
that of the poor families. In other words, the rich families save a
higher proportion of their income as compared to the poor
families.

The assumption of diminishing average propensity to consume

is a significant part of Keynesian theory of income and
employment. This implies that as income increases, a
progressively larger proportion of national income would be
saved. Therefore, to achieve and maintain equilibrium at full-
employment level of income, increasing proportion of national
income is needed to be invested.

Major Implications of Consumption Function

1. Vital Importance of Investment:

One of the most important implications of Keynes’

psychological law of consumption is that it brings about the
crucial importance of investment if we want to attain higher
level of income and employment. The law says when income
increases the gap between income and consumption
increases.

The gap is to be filled by bringing more and more investment

failing which there will be shortage of effective demand and the
economy would slip down. Thus the law highlights the vital
importance of investment.

2. General over Production:

Since the marginal propensity to consume is less than unity,

with every increase in income, consumption would tend to lag
behind income which would result in overproduction and
unemployment. Thus the law tells us that there can occur a
general overproduction and unemployment.
3. Repudiation of Say’s Law:

Keynes with the help of his law of consumption repudiates

Say’s law which states supply creates its own demand. Since
the marginal propensity to consume is less than unity all that is
supplied is not automatically demanded. The supply fails to
create its own demand resulting in glut of products in the
market.

4. Need for State Intervention:

As there is no automatic and self-adjusting mechanism

between supply and demand the government should interfere
actively to ensure that aggregate effective demand does not fall
below aggregate supply.

5. Over Saving Gap:

Since the increase in consumption expenditure does not keep

pace with the increase in income, there arises the danger of
over-saving gap. This danger is more for rich countries than for
poor countries.

6. Decline in MEC:

As a result of the propensity to consume remaining stable with

an increase in income the expected rate of profitability or the
marginal efficiency of capital may tend to decline. This can be
prevented only by increasing consumption with an increase in
income because ultimately the decisions to undertake
investments are guided by the volume of consumption.

7. Income Propagation:

Keynesian theory explains the slow nature of income

propagation. Since the marginal propensity to consume is less
than unity, injection of increasing purchasing power into the
income stream leads to smaller and smaller successive
increments to income.
8. Under Employment Equilibrium:

Equilibrium would be attained at full employment only if

investment demand happens to be equal to the gap between
aggregate income corresponding to full employment and
aggregate consumption expenditure out of that income. But
Keynes believed that the typical investment demand would not
be adequate to fill the gap between the amount of income
corresponding to full employment and the consumption demand
out of that income. As such the aggregate demand and supply
schedules would intersect at a point less than full employment.

9. Secular Stagnation:

With the increase in income, since consumption cannot be

easily increased and investment demand becomes weaker and
weaker the economy may sooner or later reach a stage where
it may not be able to provide outlets for its growing savings
which is necessary for maintaining full employment. This stage
is known as secular stagnation. Such a situation could be
avoided if the consumption function were not stable.

10. Turning Points of Trade Cycle:

Keynes’ psychological law of consumption is very helpful in

explaining the turning points of the trade cycle. When the
business cycle reaches the highest point of prosperity, income
has increased, but the marginal propensity to consume being
less than unity, consumption does not increase correspondingly
and the result is the downward start of the cycle.

Similarly when the business cycle reaches the lowest point,

income has declined very low but since people do not reduce
their consumption to the full extent of decline in income, the
upward phase of the cycle starts. Thus consumption function
occupies a very important place in the theory of employment.

To Keynes investment refers to real investment which adds to

capital equipment. It leads to increase in the level of income
and production by increasing the production and purchase of
capital goods. Real investment is to be increased to maintain
stable national income growth. According to Keynes investment
depends on marginal efficiency of capital and rate of interest.

Theories of Consumption function

Absolute Income Hypothesis

“…men are disposed, as a rule and on the average, to increase

their consumption as their income increases, but not by as
much as the increase in their income”.

Whether or not this is the original statement of the absolute

income hypothesis, there is no doubt that this statement by
Keynes stimulated much empirical research to test the
hypothesis and to derive the consumption function.

Many of these studies were carried out on time series, the

general practice being to co-relate aggregate consumption
expenditures over time with aggregate disposable income and
various other variables.

The basic tenet of the absolute income theory is that the

individual consumer determines what fraction of his current
income he will devote to consumption on the basis of the
absolute level of that income. Other things being equal, a rise in
his absolute income will lead to a decrease in the fraction of
that Income devoted to consumption. The first statement of this
hypothesis was, perhaps, made by Keynes in the General
Theory. Its subsequent developments are primarily associated
with James Tobin and Arthur Smithies’— also called Drift
Hypothesis as shown in the Fig. 3.1.

According to absolute income theory (AIT) the level of

consumption expenditures depends on the absolute level of
income, with APC declining as the level of income increases.
Since the level of national income grows over time, the AIT
concludes that the APC should diminish continuously. As such,
according to AIT, the consumption-income relationship is non-
proportional, as shown in the Fig. 3.1.

In the Fig. 13.1, as income increases over time, consumption

follows the non-proportional function shown by C1, but over the
long-run the statistical evidence suggests that consumption
function follows the path of the proportional function as shown
by C3. The advocates of AIT argue that there are upward shifts
in the non-proportional consumption function as shown by the
shifts from C1 to C2 caused by change in factors other than
income like consumers spending a larger portion of any given
level of income then is historically normal, due to shifts in
population from rural to urban areas, the age and composition
of population, households spending more at every level of
income in order to purchase new consumer goods regarded as
essentials.

The AIT argues that these factors have caused the short-run,
non-proportional consumption function to shift upward in a
manner that creates an illusion of proportionality, thereby
obscuring the basic non-proportional relationship. Brown has
explained that the relationship between income and
consumption is non-proportional and rests upon habit
persistence among consumers. According to Brown, “The full
reaction of consumers to change in income does not occur
immediately but instead takes place gradually”.

Consumers react rather slowly to changes in income. Brown

felt that the decline of the effect of past habits is continuous
over time, rather than discontinuous as suggested by
Modigliani-Duesenberry [Link] as mentioned
above, according to AIT, have caused the consumption function
to shift upward by roughly the amount necessary to produce a
proportional relationship between C and Y over long-run and
thus to prevent the appearance of what would otherwise be the
non-proportional relationship that would be expected on the
basis of the income factor alone.

In the years following the appearance of the General Theory,

economists generally accepted the absolute income theory as
basically correct, but the widespread acceptance enjoyed by
this theory was short-lived. Doubts about the adequacy of the
absolute income hypothesis arose because of its apparent
inability to reconcile budget data on saving with observed long-
run trends. Estimates of national saving and other aggregate
derived by Kuznets and later by Goldsmith indicated that the
aggregate saving ratio had remained virtually constant since
the 1870s. Yet budget studies showed that the saving ratio rose
substantially with income level.

Since incomes have risen tremendously since the 1870s by

almost any standard, this would suggest according to the
absolute income hypothesis, that the aggregate saving ratio
should have moved up noticeably over time. Data made
available by Kuznets showed that during the period 1869-1929,
the ratio of consumption to national income had remained
constant while income had quadrupled.

Relative Income Hypothesis:

An answer to this apparent inconsistency is provided by the

relative income hypothesis, which seems to have been first
propounded by Dorothy Brady and Rose Friedman. Its
underlying assumption is that saving rate depends not on the
level of income but on the relative position of the individual on
the income scale. As such relative-income hypothesis implies
the assumption that spending is related to a family’s relative
position in the income distribution of approximately similar
families.

Much additional theoretical and empirical support of this

hypothesis was provided by the work of Modigliani and of
James S. Duesenberry, carried out at about the same time. The
relative income hypothesis is conceived by Duesenberry and
helps to explain the differences found between consumption
function derived from data of families classified by groups and
those derived from overall totals (time series).

Duesenberry contended that, at any given moment in time,

consumption is not particularly sensitive to current income.
People spend in a manner consistent with their relative income
position. With incomes rising or falling over the course of years,
their spending patterns change if their relative position
changes. James Tobin shows that other factors could cause
the effects that Duesenberry explained by means of relative
incomes.

Duesenberry develops the proposition that the ratio of income

consumed by an individual does not depend on his absolute
income, instead it depends upon his relative income—upon this
percentile position in the total income distribution. During any
given period, a person will consume smaller percentage of his
income as his absolute income increases if his percentile
position in income distribution improves and vice versa.

Thus, the relative income theory argues that the fraction of a

family’s income spent on consumption depends on the level of
its income relative to the income of neighbouring family’s and
not on the absolute level of the family’s income. If a family’s
income increases but its relative position on the income scale
remains unchanged because incomes of other families have
also risen at the same rate, its division of income between C
and S will remain unchanged. According to the relative income
theory, each family, in deciding on the fraction of its income to
be spent, is uninfluenced by the fact that it is twice as well off in
absolute terms and is influenced only by the fact that it is no
better off at all in relative terms

According to RIT, the level of consumption expenditures is not

determined by the absolute level of income but by the relative
level of income, with the APC declining as relative income
increases. More specifically, the RIT argues that the level of
consumption spending is determined by the household’s level
of current income relative to the highest level of income
previously earned.

Duesenberry Hypothesis:

On a theoretical level, Duesenberry supplied psychological

support for this hypothesis, noting that a .strong tendency in our
social set up for people to emulate their neighbours and, at the
same time, to strive constantly towards a higher standard of
living. Hence, once a new, higher standard of living is obtained,
as at a cyclical peak, people are reluctant to return to a lower
level when income goes down. In other words, people seek to
maintain at least the highest standard of living attained in the
past.

On this basis, he inferred that from an aggregate time-series

point of view the relative income hypothesis could be
transformed into one expressing the saving rate as a function of
the ratio of current income to the highest level previously
reached. However, Davis suggests a variable to this approach
of Duesenberry—that previous peak consumption be
substituted for previous peak income. The basis of this is that
people get used to a certain standard of consumption, rather
than to a certain level of income, so that it is past spending that
influences current consumption rather than past income.

Prof. Duesenberry has made two significant observations on

the factors affecting consumption function which go by the
name of ‘Duesenberry Hypothesis’. According to him,
consumption expenditure of an individual is determined not only
by his current income but also by the standard of living enjoyed
by him in the past. As income falls from the previous level,
expenditure on consumption also does fall but not to the full
decrement in income because people fail to adjust their
expenditure according to the new circumstances.
For example, a lecturer who has been granted a temporary
commission in the army on account of emergency, and who
has become accustomed to enjoy a higher standard of living,
will not be able to reduce his expenditure on consumption
goods when he is demobilised. Duesenberry refers to the
tendency for the new and higher level of consumption
purchasing associated with a previously exceeded level of
income as the ‘ratchet effect’—it explains the tendency for an
economy’s consumption purchasing not to fall back to earlier
levels when its income does.

The diagram shows the essence of Duesenberry’s long-run

and short-run consumption function:

The figure shows an economy initially in long-run equilibrium at

the combination of total purchasing and consumption at point A.
To establish Duesenberry type of relationship between short-
run and long-run consumption functions. Let us consider the
effects of a decline in the level of total purchasing from initial
Rs. 500 crore to Rs. 200 crore. The consumption does not fall
to point A’, the consumption expenditures will come down to
Rs. 240 crore at point B.

On the other hand, an increase in the level of economy’s

purchasing from Rs. 500 crore to Rs. 700 crore will initially
involve only slight increase in the level of consumption
purchasing as the economy moves out short-run consumption
function 2 to the combination of income and consumption
purchasing at point C. The move occurs along short-run
function 2 in the short-run but in the long-run consumption
purchasing in the economy must finally reach at the point D.

This level represents the total amount of consumption

purchasing that will occur when the economy’s income is Rs.
700 crore and each income group in the society consumes its
traditional proportion of income to mitigate its feeling of social
inferiority. Point D is another point on the economy’s long-run
consumption function. But what will happen if the economy’s
income were to fall to Rs. 500 crore again? Will consumption
fall along point A? No, the economy will move down short-run
consumption function III to the level of consumption purchasing
shown by point E; as the economy will resist cutting its
purchases below that it enjoyed when the previous high level of
Rs. 700 crore was attained (ratchet effect).

The theory of ratchet effect maintains that high consumption

standards and high investment levels previously attained are
not easily reversed. The ratchet keeps the economy from
slipping back and loosing all the income gains attained during
the preceding expansion. Further, Duesenberry talks of the
‘Demonstration Effect’ according to which the consumption
standards of low income groups are greatly affected by the
consumption standards of high income groups.

The moment low income groups, start consuming goods used

by high income groups, the latter always try to avoid
consumption of such commodities and search for still better
commodities. Such tendencies go to increase consumption and
weaken the propensity to save.

Assumptions:

Duesenberry’s theory’, known as the relative income

hypothesis is based on a reversal of two assumptions
previously thought to be fundamental to aggregate demand
theory.

He states that:

(i) The consumption behaviour of individuals is interdependent

(rather than independent) and

(ii) Consumption relations are irreversible over time

Duesenberry uses statement

(iii) Above to develop the thesis that the percentage of income

consumed by any individual does not depend on his absolute
income but rather on his ‘percentile position in the income
distribution,’ or his relative income.

The Permanent Income Hypothesis:

It is a theory that attempts to explain away apparent

inconsistencies of empirical data on the relationship of saving
to income. Data for a single year show that, as income rises,
savings account for an increasing share of income, while data
for a long period of years show that, even though total income
rises over the years, total savings account for a fairly stable
share of total income. Milton Friedman states that this does not
occur because of changes in consumption habits at every
income level but because a study of measured income and
consumption involves inaccurate concepts of what these habits
really are.

The best known exposition of the PIH is developed by

Professor Milton Friedman—formerly of the University, of
Chicago. He says permanent income is roughly akin to lifetime
income, based on the real and financial wealth at the disposal
of the individual plus the value of one’s human capital in the
form of inherent and acquired skills and training. The average
expected return on the sum of all such wealth at the disposition
of an individual would be his permanent income. But measured
income is different from permanent income according to
Friedman.

Over a lifetime measured income ought to coincide with

permanent income, but in any one year measured income as a
result to cyclical fluctuations and because of other random
changes may depart from permanent income. But the best way
to measure permanent income, according to this hypothesis, is
through a weighted average of past and present measured
income, with less weight being given to measured income that
lies farther in the past. In any year the difference between the
measured income and permanent income is transitory income.
It may be positive or negative, but over an individual’s life time
it is essentially zero.

This theory like the relative income theory, holds that the basic
relationship between consumption and income is proportional,
but the relationship here is between permanent consumption
and permanent income. Thus, quite a different approach to the
role of income in the theory of consumer spending has been
developed by Milton Friedman. The main point of departure is
the rejection of the common concept of current income and its
replacement by what he calls permanent income.

A family’s permanent income in any one year is in no sense

indicated by its current income for that year but is determined
by the expected income to be received over a long period of
time, stretching out over a number of future years. According to
Friedman, “Permanent income is to be interpreted as the mean
income regarded as permanent by the consumer unit in
question, which in turn depends on its farsightedness”. Given
this meaning of permanent income, a family’s measured or
observed or actual income in any particular year may be larger
or smaller than its permanent income.

Friedman divides the family’s measured income in the year into

permanent income and transitory income. The measured
(actual) income is larger or smaller than its permanent income,
depending on the sum of positive and negative transitory
income components. For example, if a worker gets special
bonus in a year and does not expect to get it again, this income
element is positive transitory income and it has the effect of
raising his actual (measured) income above his permanent
income. On the other hand, if he suffers an unexpected loss
(say, on account of plant shutdown); this income element (loss)
is regarded as negative transitory income and it has the effect
of reducing his actual (measured) income below his permanent
income.

These unexpected additions and subtractions from family’s

income are expected to cannel out over a longer period
relevant to permanent income but they are present in any
shorter period. Similarly, Friedman divides measured (actual)
consumption into permanent and transitory components. A
good purchased because of an attractive reduction in sale price
or a normal purchase postponed due to the unavailability of the
goods are examples of positive and negative transitory
consumption. A family’s actual (measured) consumption in any
particular period may be larger or smaller than its permanent
consumption.

Life Cycle Hypothesis:

Life cycle hypothesis is another important attempt to explain the

difference between cyclical short-run consumption function and
secular long-run consumption function. It has been developed
by Franco Modigliani, Albert Ando and later by Brumberg—
called the life cycle hypothesis or MBA approach. It is said that
life cycle hypothesis is similar to PIH developed by Friedman.

Although, the two approaches are similar in principal yet they

are different in certain respects. Friedman’s version of PIH has
gained more attention in recent years. In the Friedman’s
approach a consumer unit is assumed to determine its standard
of living on the basis of expected returns from its resources
over its life time. These returns are expected to be constant
from year to year, though in actual practice some fluctuation
would result over time with changes in the anticipated amount
of capital resources.

The expenditures of the consumer units are set as a constant

proportion (k) of this permanent level of income. The value of
(k) varying for consumer units of different types and of different
tastes. Actual consumption and actual income deviate from
these planned, or permanent levels to the extent that transitory
factors, enter in. The Modigliani—Brumberg—Ando (MBA)
approach is essentially a permanent wealth hypothesis rather
than a ‘permanent income hypothesis’ though in practice the
two approaches converge].

In its most recent formulation, the household or consumer unit

is assumed to determine “the amount available for consumption
over life, which is the sum of the households’ net worth at the
beginning of the period—plus the present value of its non-
property income—minus present value of planned bequests.”

Thus, the relationship is essentially the same as that derived by

Friedman. In either formulation, the central tenet is the
assumption that the proportion of permanent income saved by
a consumer unit in a given period is independent of its income
(or its resources) during that period and further more that
transitory incomes may have no or little effect on current
consumption.

Concept of Investment Multiplier

Investment multiplier is an important part of economic theories

suggested by notable economist John Maynard Keynes.
According to this concept, in the event of an increase in the
investment activities either public or private which can be in the
form of private consumption spending, government spending in
an economy, there is a corresponding increase in the Gross
Domestic Product (GDP) of the economy by a value more than
the amount invested.
In simple words, investment multiplier refers to the increase in
the aggregate income of the economy as a result of an
increase in the investments done by the government in the form
of new projects.

The size of the investment multiplier is determined by the

decisions of the households in an economy in the areas of
spending (which is known as marginal propensity to consume)
or saving (known as marginal propensity to save).

The multiplier can be represented by the following formula.

K = ΔY / ΔI

Where,

ΔY = Increase in GDP or National Income

ΔI = Increase in Investment

Also,

k = 1/ 1- MPC

Where k = Investment Multiplier

MPC = Marginal Propensity to Consume

And, k = 1/ MPS

Where k = Investment Multiplier

MPS = Marginal Propensity to Save

Therefore, it can be concluded that

K = 1/ 1- MPC = 1/ MPS

It can be said that in order to find the value of the investment

multiplier, either the value of MPC or MPS should be
determined or the value of the multiplier can be determined if
MPC or MPS values are provided.

Let us understand the mechanism of investment multiplier with

an example.

Suppose the government has made an investment of 100

crores in a road construction project. This will lead to hiring of
labourers, engineers and suppliers of raw materials, logistics. In
short such an investment will lead to job opportunities for many
people. It will result in income generation, which will result in
their tendency to consume and save.

Let’s say the MPC of the labourers is 0.5, that means that for
every 1 rupee earned they spend 0.50 rupees in consumption
of goods and services.

Therefore, the investment multiplier will become,

K = 1/ 1-MPC

K = 1/ 1-0.5

K = 1/0.5

K=2

It means that for every 1 rupee invested by the government, it

will generate an income of 2 rupees.

Similarly, we can find the value of multiplier when MPS = 0.2

K = 1/MPS

K= 1/0.2

K= 5
Therefore, it can be seen that if the MPS value is less than the
multiplier, value increases and when the value of MPC is more
than the investment multiplier becomes more.

The value of MPS or MPC can be used to find the total

increase in income obtained from the initial investment by using
the following formula

K = ΔY / ΔI

and, K = 1/MPS

Therefore, in the above example an investment of 100 crores

will bring total income of

ΔY / ΔI = 1/MPS

ΔY / 100 = 1/0.2

ΔY / 100 = 5

ΔY = 500

Therefore, the total increase in income will be 500 Crores.

Simple and Dynamic Investment Multiplier

Criticism has been levied on Keynes’ theory of investment

multiplier on the ground that it is a static formulation and it has
no connection with the dynamic process of income generation.

It does not tell us what happens in between the initial increase

in investment and the final increase in income.

We have no means to know how and in what stages or time

intervals the final increase in the total income is attained.
Keynesian multiplier shows the process of income expansion
from one point of equilibrium and that too under static
assumptions. No idea is given of the actual sequence of events
and no time- lags are involved.
The whole process of income propagation is automatic,
unhampered by time or other factors. For example, it may be
remembered that multiplier does not work only when changes
in the expenditures occur as a result of private and public
investment, but also due to increases in consumption
expenditures (though Keynes assumed them to be stable in the
short-run).

Should the investment expenditures remain fixed over time a

decline in savings or a reduction in taxes may lead to increased
consumption expenditures in the long-run giving rise to
multiplier effects. Post-Keynesian writers have pointed out that
the magnitude of the multiplier is bound to be affected by time
lags, i.e., by the fact that the particular doses of investments
will take time to exert their full influence in raising income.

Meanwhile, it is just possible that fresh investments may have

taken place and may themselves cause multiplier effects. If
there are time lags, the final equilibrium position will take longer
to reach, the income rises more slowly than it would do in the
absence of lag. Keynes seems to have thought that the effects
of such lags would be unimportant. But the real multiplier,
should take into consideration the dynamic forces working in
the economy.

According to the critics, it is better to replace the Keynesian

static multiplier by the dynamic multiplier, which takes account
of changing events. Despite these observations, it is useful to
remember that Keynes discussed, though briefly, three different
concepts of the multiplier: the logical theory of the multiplier
assuming no time lag, the period analysis concept of multiplier
based on the assumption of time lags and ‘comparative statics’
timeless concept of multiplier in which the transition process or
the path is skipped over completely.

The discussion still continues. On the one hand, there were and
still are, some points which require clarification, on the other
hand, the highly simplified models of Johannsen, Kahn and
Keynes require modifications and extension in certain
directions. We should like to take up two of the many directions
with which current research is concerned.

These are as follows:

The first direction relates to the time it takes for the multiplier
process to work itself out. We speak of the multiplier effects in
the first, second, third etc. period (specially in case of dynamic
multiplier) and note that after a small number of periods the
size of the effects is very near the final equilibrium value. Thus,
we still have to know how long these periods are, whether they
last a day, a week, a month or a year.

Johannsen felt that the interval between cause and effect was
not very long; rather cause and effect proceed together hand in
hand. It is possible and even probable that his conjecture is
correct. Yet to get a correct answer, lot of empirical work and
research is required. Attempts to answer these questions were
made by F. Machlup’ and more recently by G. Ackley.

Thus, the pure theory of multiplier shows the definitional

relation between the ‘propensity to consume’ and the
‘multiplier’. Many problems which frequently arise under the
heading ‘multiplier’ lie outside the pure theory of the
multiplier. Apart from the problems mentioned above, other
problems relate to the determination of the amount of net
investment associated with a given amount of spending under
varying circumstances and the determination of the numerical
value of the multiplier.

The MPC of the individual to which Keynes fundamental

psychological law refers, is only one of many factors which are
casually important for the determination of the MPS (multiplier)
of society as a whole. Hence, we need not exaggerate the
stability of the multiplier over time.

Leakages and limitations of Investment Multiplier

1. Leakages from Income Stream : We generally observe
that as the income increases, the marginal
propensity to consume falls. As a result, the total
increase in the income that we expect to take place
on the basis of the constant MPC does not
materlise. If the people retain a part of the income
received as idle cash balances for various motives
or for the repayment of their debts an other
obligations such as personal taxes, the present
level of the consumption of the community will fall.
Further, MPC is very seldom equal to one. The
whole increment in income is not spent on
consumption. A part of it is saved which peters out
of the income stream and so increase in income in
the next round declines. Higher is the size of MPS,
smaller will be the value of multiplier due to greater
amount of leakage from theincome stream. The
various leakages from the income reduce the value
of MPC and hence thevalue of the multiplier. For the
effective working of the multiplier, the income
received should be spent so that it may come back
again as income.

2. Purchase of Old Stocks and Shares : If a part of the

increased income is used to buy old stocks and
shares instead of consumer goods, the
consumption expenditure will fall. In such a
situation, its cumulative effect on income will be
less than before.

3. Price Rise : When investment increases, the

multiplier effect of increased income may be
dissipated inituation of rising prices. Consequently,
real consumption and income will fall. Rising prices
may be the result of commodity taxation.

4. Availability of Consumer Goods: The multiplier

process leads to the income propagation through
 the expenditure on consumption goods. This
requires the availability of the consumer goods in
adequate quantities. If there is a shortage of these
goods, the additional income received by the people
may not be fully spent. In such a situation, the
consumption plans of the people will remain
unmateralised. The producers must raise the supply
of the consumer goods to prevent the causes
weakening the value of the multiplier. However, the
producers, generally do not increase the production
capacity until they are convinced that the increase
in the demand for the consumer goods is stable.

5. Imports: When the imports of the country are more

than the exports, a large part of the country’s
income will go to the foreigners. The payment of the
imports is not available for the expansion of the
internal production. The multiplier effect of this
expenditure will be transmitted abroad. To that
extent, an increase in the investment will not
increase the level of income in the country.

6. Full Employment Ceiling: When an economy

approaches the full employment level, any new
investment cannot increase the supply of the
consumer goods or the factor services. The
increased investment will have only the effect of
diverting the employed resources from the other
sectors or industries. Once the full employment
level has been reached, income, output and
employment levels will stop expanding, what so
ever the value of MPC might be. It will only result in
higher price, i.e., inflation.

The principle of Acceleration

The acceleration principle describes the effect quite opposite to

that of multiplier. According to this, when income or
consumption increases, investment will increase by a multiple
amount. When income and therefore consumption of the
people increases, the greater amount of the commodities will
have to be produced.

This will require more capital to produce them if the already

given stock of capital is fully used. Since in this case,
investment is induced by changes in income or consumption,
this is known as induced investment. The accelerator is the
numerical value of the relation between the increase in
investment resulting from an increase in income.

The net induced investment will be positive if national income

increases and induced investment may fall to zero if the
national income or output remains constant. To produce a
given amount of output, it requires a certain amount of capital.
If Yt output is required to be produced and v is capital-output
ratio, the required amount of capital to produce Yt output will be
given by the following equation:

Kt = vYt …(i)

where K, stands for the stock of capital,

Yt for the level of output or income, and

v for capital-output ratio.

This capital-output ratio v is equal to K/Y and in the theory of

accelerator this capital-output ratio is assumed to be constant.
Therefore, under the assumption of constant capital-output
ratio, changes in output are made possible by changes in the
stock of capital. Thus, when income is Yt then required stock of
capital Kt = vYt. When output or income is equal to Yt-1, then
required stock of capital will be Kt-1 = vYt-1.

It is clear from above that when income increases from Yt-1 in

period t – 1 to Yt in period, t, then the stock of capital will
increase Kt-1 from to Kt. As seen above, Kt-1 is equal to vYt-1 and
Kt is equal to vYt.

Interaction of Accelerator and Multiplier

In order to measure the total effect of initial investment

expenditure on income, it is necessary to combine the effects of
multiplier and accelerator. Economists like P A. Samuelson,
J.R., Hicks, A.H. Hansen, R.F. Harrod have attempted to
integrate the two parallel concepts of multiplier and accelerator
and analyse their combined effects.

An autonomous increase in investment by the government

increases income through induced consumption expenditure
because of multiplier effect. This increase in income and
consumption expenditure will induce an increase in private
investment due to acceleration effect. This induced increase in
investment will start generating more income through multiplier
process.

Once again, die increased income will further induce private

investment though acceleration effect. Thus we find an endless
sequence of changes in income and output, and in
consumption and investment as a result of the interaction
between the multiplier and acceleration principles.

Hansen calls the total effect of initial increase in investment on

income through the interaction of multiplier and accelerator as
leverage effect. The multiplier and the accelerator mutually tend
to strengthen each other and their interaction produces a
leverage effect, causing very large changes in income.

Similarly, J.R. Hicks has combined the principles of multiplier

and acceleration and arrived at the super-multiplier. The effect
of super-multiplier (i.e., multiplier and accelerator combined) is
much more than the simple multiplier.
Paul Samuelson has developed the following multiplier-
accelerator model which gives the combined effect of the
two principles, multiplier and accelerator:

Investment in period t is partly autonomous (I a) and partly

induced (Ii) by changes in consumption or by changes in
income, because changes in consumption, in turn, depend
upon income changes. Here la is constant and v denotes
capital-output ratio or accelerator.

If the incomes of the periods t-1 and t-2 are known, the income
for period t can be estimated as a weighted sum, the weights
depending upon the values of b and v.

The combined effect of multiplier-accelerator interaction is

illustrated through a numerical example given in Table-4.
1. Suppose that the marginal propensity to consume, b =
.5 and the acceleration coefficient, v = 2. The initial
investment Ia = Rs.100 crores as shown in Column 2.

2. In period zero, the income will increase by the amount

of initial investment (i.e., Rs.100 crores).

3. This increased income of Rs. 100 crores leads to a rise

in consumption of Rs. 50 crores (Column 3) in period 1
because MPC =.5 (i.e., C = b(Yt-1) = .5 x 100 =50).

4. This increased consumption of Rs. 50 crores induces

investment of Rs. 100 crores (Column 4) because
acceleration coefficient is 2 (i.e., Ii = v (Ct – Ct-1) = 2(50)
= 100).

5. Thus, income increases to Rs. 250 crores (Column 5 =

Columns 2 + 3 + 4) in period 1 (i.e., Y = I a + C + Ii = 100
+ 50 + 100 = 250).

6. In period 2, additional consumption expenditure is Rs.

125 crores (i.e., C = b Yt-1 = .5 x 250 = 125); the induced
investment is Rs.150 crores (i.e., Ii = v (Ct – Ct-1) = 2
(125 – 50) = 2 x 75 = 150); and the total income
generated is Rs. 375 (i.e., Y = la + C + Ii = 100 + 125 +
150 = 375).
 7. The behaviour of income as a result of combined
operation of multiplier and accelerator reveals itself in a
recurring trade cycle, repeating itself indefinitely. The
increase in income is the highest (Rs. 412.5 crores) in
period 3, which shows the peak of the cycle.

Thereafter it goes on falling till it reaches bottom of the cycle in

period 7 when income is minus 11.8. From period 8, income
again starts rising, indicating the revival phase of the cycle. The
actual behaviour of the trade cycle, however depends upon the
values of the multiplier and the accelerator.

A less than unity marginal Propensity to consume provides an

answer to the question- Why does the cumulative process
comes to a stop before a complete collapse or before full
employment?

According to Hansen, this is due to the fact that a large part of

the increase in income in each period is not spent in each
successive period. This eventually leads to a decline in the
volume of induced investment.

And when such a decline exceeds the increase in induced

consumption, a decline in income sets in. Thus, Hansen
remarks, “It is the marginal propensity to save which calls a halt
to the expansion process even when the expansion is
intensified by the process of acceleration on top of the multiplier
process”.

Investment function

In ordinary parlance, investment means to buy shares, stocks,

bonds and securities which already exist in stock market. But
this is not real investment because it is simply a transfer of
existing assets. Hence this is called financial investment which
does not affect aggregate spending. In Keynesian terminology,
investment refers to real investment which adds to capital
equipment.
It leads to increase in the levels of income and production by
increasing the production and purchase of capital goods.
Investment thus includes new plant and equipment,
construction of public works like dams, roads, buildings, etc.,
net foreign investment, inventories and stocks and shares of
new companies. In the words of Joan Robinson, “By investment
is meant an addition to capital, such as occurs when a new
house is built or a new factory is built. Investment means
making an addition to the stock of goods in existence.”

Capital, on the other hand, refers to real assets like factories,

plants, equipment, and inventories of finished and semi-finished
goods. It is any previously produced input that can be used in
the production process to produce other goods. The amount of
capital available in an economy is the stock of capital. Thus
capital is a stock concept.

To be more precise, investment is the production or acquisition

of real capital assets during any period of time. To illustrate,
suppose the capital assets of a firm on 31 March 2004 are Rs
100 crores and it invests at the rate of Rs 10 crores during the
year 2004-05. At the end of the next year (31 March 2005), its
total capital will be Rs 110 crores. Symbolically, let I be
investment and К be capital in year t, then I t = Kt– Kt- 1.

Capital and investment are related to each other through net

investment. Gross investment is the total amount spent on new
capital assets in a year. But some capital stock wears out every
year and is used up for depreciation and obsolescence. Net
investment is gross investment minus depreciation and
obsolescence charges for replacement investment. This is the
net addition to the existing capital stock of the economy.

If gross investment equals depreciation, net investment is zero

and there is no addition to the economy’s capital stock. If gross
investment is less than depreciation, there is disinvestment in
the economy and the capital stock decreases. Thus for an
increase in the real capital stock of the economy, gross
investment must exceed depreciation, i.e., there should be net
investment.

Types of Investment

1. Induced Investment: Real investment may be induced.

Induced investment is profit or income motivated. Factors like
prices, wages and interest changes which affect profits
influence induced investment. Similarly demand also influences
it. When income increases, consumption demand also
increases and to meet this, investment increases. In the
ultimate analysis, induced investment is a function of income
i.e., I = f(Y). It is income elastic. It increases or decreases with
the rise or fall in income, as shown in Figure 1.

I1 I1is the investment curve which shows induced investment at

various levels of income. Induced investment is zero at
OY1 income. When income rises to OY3 induced investment is
I3Yy A fall in income to OY2 also reduces induced investment to
I2Y2.

Induced investment may be further divided into (i) the average

propensity to invest, and (ii) the marginal propensity to invest:

(i) The average propensity to invest is the ratio of investment to

income, I/Y. If the income is Rs. 40 crores and investment is
Rs. 4 crores, I/Y = 4/40 = 0.1. In terms of the above figure, the
average propensity to invest at OY3 income level is I3Y3/ OY3
(ii) The marginal propensity to invest is the ratio of change in
investment to the change in income, i.e., I/ Y. If the
change in investment, I=Rs 2 crores and the change in
income, Y = Rs 10 crores, then I/∆Y = 2/10=0.2 In Figure
1, I/ Y =I3a/Y2Y3

vv

2. Autonomous Investment:

Autonomous investment is independent of the level of income

and is thus income inelastic. It is influenced by exogenous
factors like innovations, inventions, growth of population and
labour force, researches, social and legal institutions, weather
changes, war, revolution, etc. But it is not influenced by
changes in demand. Rather, it influences the demand.
Investment in economic and social overheads whether made by
the government or the private enterprise is autonomous.

Such investment includes expenditure on building, dams,

roads, canals, schools, hospitals, etc. Since investment on
these projects is generally associated with public policy,
autonomous investment is regarded as public investment. In
the long-run, private investment of all types may be
autonomous because it is influenced by exogenous factors.
Diagrammatically, autonomous investment is shown as a curve
parallel to the horizontal axis as I1I’ curve in Figure 2. It
indicates that at all levels of income, the amount of investment
OI1 remains constant.
The upward shift of the curve to I2I” indicates an increased
steady flow of investment at a constant rate OI2 at various
levels of income. However, for purposes of income
determination, the autonomous investment curve is
superimposed on the С curve in a 45° line diagram.

3. Determinants of the Level of Investment: The decision to

invest in a new capital asset depends on whether the expected
rate of return on the new investment is equal to or greater or
less than the rate of interest to be paid on the funds needed to
purchase this asset. It is only when the expected rate of return
is higher than the interest rate that investment will be made in
acquiring new capital assets.

In reality, there are three factors that are taken into

consideration while making any investment decision. They are
the cost of the capital asset, the expected rate of return from it
during its lifetime, and the market rate of interest. Keynes sums
up these factors in his concept of the marginal efficiency of
capital (MEC).

Concept of MEC and MEI

Marginal Efficiency of Capital:

The marginal efficiency of capital is the highest rate of return

expected from an additional unit of a capital asset over its cost.
In the words of Kurihara, “It is the ratio between the prospective
yield to additional capital goods and their supply price.” The
prospective yield is the aggregate net return from an asset
during its life time, while the supply price is the cost of
producing this asset.

If the supply price of a capital asset is Rs. 20,000 and its

annual yield is Rs. 2,000, the marginal efficiency of this asset is
2000/20000 × 100/1 = 10 per cent. Thus the marginal efficiency
of capital is the percentage of profit expected from a given
investment on a capital asset.

Keynes relates the prospective yield of a capital asset to its

supply price and defines the MEC as “equal to the rate of
discount which would make the present value of the series of
annuities given by the returns expected from the capital assets
during its life just equal to its supply price.”

Symbolically, this can be expressed as:

SP =R1/ (1+i) + R2 (1+i)2 + Rn/(1+i)n

Where Sp is the supply price or the cost of the capital asset,

R1 R2… and Rn are the prospective yields or the series of
expected annual returns from the capital asset in the years, 1,
2… and n, i is the rate of discount which makes the capital
asset exactly equal to the present value of the expected yield
from it.

This i is the MEC or the rate of discount which equates the two
sides of the equation. If the supply price of a new capital asset
is Rs 1,000 and its life is two years, it is expected to yield Rs
550 in the first year and Rs 605 in the second year. Its MEC is
10 per cent which equates the supply price to the expected
yields of this capital asset.

Thus

(Sp) Rs 1000 = 550/(1.10) + (605)/(1.10)2 = Rs. 500 + 500

In equation (1), the term R1/(1+i) is the present value (PV) of
the capital asset. The present value is “the value of payments
to be received in the future.” It depends on the rate of interest
at which it is discounted.

Suppose we expect to receive Rs 100 from a machine in a

year’s time and the rate of interest is 5 per cent. The present
value of this machine is

R1 / (1+ i) =100/(1.05) = Rs 95.24

If we expect Rs 100 from the machine after two years then its
present value is100/ (1.05)2 = Rs 90.70. The present value of a
capital asset is inversely related to the rate of interest. The
lower the rate of interest, the higher is the present value, and
vice versa. For instance, if the rate of interest is 5 per cent, PV
of an asset of Rs 100 for one year will be Rs 95.24; at 7 per
cent interest rate, it will be Rs 93.45; and at 10 per cent interest
rate, it will be Rs 90.91.

The relation between the present value and the rate of interest
is shown in Figure 3, where the rate of interest is taken on the
horizontal axis while the present value of the project on the
vertical axis. The curve PR shows the inverse relation between
the present value and the rate of interest. If the current rate of
interest is ii the present value of the project is P1 On the other
hand, a higher rate of interest (i2) will lead to a lower present
value (P2) when the present value curve (PR) cuts the
horizontal axis at point (Z), the net present value becomes
zero.
As a matter of fact, the MEC is the expected rate of return over
cost of a new capital asset. In order to find out whether it is
worthwhile to purchase a capital asset it is essential to compare
the present value of the capital asset with its cost or supply
price. If the present value of a capital asset exceeds its cost of
buying, it pays to buy it. On the contrary, if its present value is
less than its cost, it is not worthwhile investing in this capital
asset.

The same results can be had by comparing the MEC with the
market rate of interest. If the MEL of a capital asset is higher
than the market rate of interest at which it is borrowed, it pays
to purchase the capital asset, and vice versa. If the market
interest rate equals the MEC of the capital asset, the firm is
said to possess the optimum capital stock.

If the MEC is higher than the rate of interest, there will be a

tendency to borrow funds in order to invest in new capital
assets. If the MEC is lower than the rate of interest, no firm will
borrow to invest in capital assets. Thus the equilibrium
condition for a firm to hold the optimum capital stock is where
the MEC equals the interest rate.

Any disequilibrium between the MEC and the rate of interest

can be removed by changing the capital stock, and hence the
MEC or by changing the rate of interest or both. Since the stock
of capital changes slowly, therefore, changes in the rate of
interest are more important for bringing equilibrium. The above
arguments which have been applied to a firm are equally
applicable to the economy.

Figure 4 shows the MEC curve of an economy. It has a

negative slope (from left to right downward) which indicates that
the higher the MEC, the smaller the capital stock. Or, as the
capital stock increases, the MEC falls. This is because of the
operation of the law of diminishing returns in production.

As a result, the marginal physical productivity of capital and the

marginal revenue fall. In the figure, when the capital stock is
OK1, the MEC is Or1. As the capital increases from OK1to
ОK2 the MEC falls from Or1 to Or2 .The net addition to the
capital stock K1K2 represents the net investment in the
economy.

Further, to reach the optimum (desired) capital stock in the

economy, the MEC must equal the rate of interest. If, as shown
in the figure, the existing capital stock is OK 1 the MEC is
Or2 and the rate of interest is at Or1 Everyone in the economy
will borrow funds and invest in capital assets.

This is because MEC (Or1) is higher than the rate of interest (at
Or2). This will continue till the MEC (Or1) comes down to the
level of the interest rate (at Or2). When the MEC equals the rate
of interest, the economy reaches the level of optimum capital
stock. The fall in the MEC is due to the increase in the actual
capital stock from OK2 to the optimum (desired) capital stock
OK2.

The increase in the firm’s capital stock by K1K2 is the net

investment of the firm. But it is the rate of interest which
determines the size of the optimum capital stock in the
economy. And it is the MEC which relates the amount of
desired capital stock to the rate of interest. Thus the negative
slope of the MEC curve indicates that as the rate of interest
falls the optimum stock of capital increases.

The Marginal Efficiency of Investment (MEI):

The marginal efficiency of investment is the rate of return

expected from a given investment on a capital asset after
covering all its costs, except the rate of interest. Like the MEC,
it is the rate which equates the supply price of a capital asset to
its prospective yield. The investment on an asset will be made
depending upon the interest rate involved in getting funds from
the market. If the rate of interest is high, investment is at a low
level.

A low rate of interest leads to an increase in investment. Thus

the MEI relates the investment to the rate of interest. The MEI
schedule shows the amount of investment demanded at
various rates of interest. That is why, it is also called the
investment demand schedule or curve which has a negative
slope, as shown in Fig. 5(A). At Or1 rate of interest, investment
is OF. As the rate of interest falls to Or2, investment increases
to ОI”.
To what extent the fall in the interest rate will increase
investment depends upon the elasticity of the investment
demand curve or the MEI curve. The less elastic is the MEI
curve, the lower is the increase in investment as a result of fall
in the rate of interest, and vice versa.

In Figure 5 the vertical axis measures the interest rate and the
MEI and the horizontal axis measures the amount of
investment. The MEI and MEI’ are the investment demand
curves. The MEI curve in Panel (A) is less elastic to investment
which increases by I’I’’. This is less than the increase in
investment I1I”2 shown in Panel (B) where the MEI’ curve is
elastic. Thus given the shape and position of the MEI curve, a
fall in the interest rate will increase the volume of investment.

On the other hand, given the rate of interest, the higher the
MEI, the larger shall be the volume of investment. The higher
marginal efficiency of investment implies that the MEI curve
shifts to the right. When the existing capital assets wear out,
they are replaced by new ones and level of investment
increases.
But the amount of induced investment depends on the existing
level of total purchasing. So more induced investment occurs
when the total purchasing is higher. The higher total purchasing
tends to shift the MEI to the right indicating that more
inducement to investment takes place at a given level of
interest rate.

This is explained in Figure 6, where MEI1 and МЕI2 curves

indicate two different levels of total purchasing in the economy.
Let us suppose that the MEI, curve indicates that at Rs 200
crores of total purchasing, OI1 (Rs 20 crores) investment occurs
at Or1 interest rate. If total purchasing rises to Rs 500 crores,
the MEI1 curve shifts to the right as МЕI2 and the level of
induced investment increases to OI2 (Rs 50 crores) at the same
interest rate Or1.

Economic Fluctuations :

Economic fluctuations describe the economy’s ups and downs.

When the economy grows, businesses can grow as well and
make higher profits. By contrast, when the economy slows
down, firms make less money, and profits decline. These
fluctuations are often referred to as business cycles. However,
that term is somewhat misleading because it suggests that they
follow a regular and predictable pattern. In reality, however,
nobody knows when and by how much the economy is going to
shift.

Trade Cycle: Nature and Characteristics

A trade cycle refers to fluctuations in economic activities

specially in employment, output and income, prices, profits etc.
It has been defined differently by different economists.
According to Mitchell, “Business cycles are of fluctuations in the
economic activities of organized communities. The adjective
‘business’ restricts the concept of fluctuations in activities which
are systematically conducted on commercial basis.
The noun ‘cycle’ bars out fluctuations which do not occur with a
measure of regularity”. According to Keynes, “A trade cycle is
composed of periods of good trade characterised by rising
prices and low unemployment percentages altering with periods
of bad trade characterised by falling prices and high
unemployment percentages”.

Features of a Trade Cycle:

1. A business cycle is synchronic. When cyclical

fluctuations start in one sector it spreads to other
sectors.

2. In a trade cycle, a period of prosperity is followed by a

period of depression. Hence trade cycle is a wave like
movement.

3. Business cycle is recurrent and rhythmic; prosperity is

followed by depression and vice versa.

4. A trade cycle is cumulative and self-reinforcing. Each

phase feeds on itself and creates further movement in
the same direction.

5. A trade cycle is asymmetrical. The prosperity phase is

slow and gradual and the phase of depression is rapid.

6. The business cycle is not periodical. Some trade cycles

last for three or four years, while others last for six or
eight or even more years.

7. The impact of a trade cycle is differential. It affects

different industries in different ways.

8. A trade cycle is international in character. Through

international trade, booms and depressions in one
country are passed to other countries.

Control of trade cycle

 1. Fiscal Measures: During the period of boom, decrease
in public expenditures, increase in taxes and increase in
public debt. On the other hand, during the period of
depression, the policy of increase in public
expenditures, decrease in taxes and decrease in public
debt is adopted by the government.

2. Monetary Measures: Monetary measures mean that

control of money and credit supply in the country. When
we are facing boom or inflation, the central bank
reduces the total quantity of money in circulation. The
bank can adopt different measures like bank rate policy,
open market operations and rationing of credit etc.
On the other hand, incase of depression, the central
bank can increase the quantity of money by lowering the
bank rate or purchasing the securities and discounted
the bills of exchange.

3. International measures: Today every country has

trade relation with other countries. If there is inflation or
deflation in one country, it can be easily be carried top
other countries, the example of great depression can be
given. Business cycle is an international phenomena
and it should be tackled on international level. Different
measures have been suggested by the economists to
control the business fluctuations effectively. Such as:
(a). Control of international production.

(b). International bill stock control and international investment

control.

4. State control of private investment: If the govt. controls the

private investment, cyclical fluctuations can be controlled within
limits while the other economists who this agree with the above
view, they say that private investment will be discouraged. But
J.M. Keynes says that if we adopt the middle way we can
control the fluctuations.
Global Recession

What Is a Global Recession?

A global recession is an extended period of economic decline

around the world. A global recession involves more or less
synchronized recessions across many national economies, as
trade relations and international financial systems transmit
economic shocks and the impact of recession from one country
to another.

The International Monetary Fund (IMF) uses a broad set of

criteria to identify global recessions, including a decrease in per
capita gross domestic product (GDP) worldwide. According to
the IMF’s definition, this drop in global output must coincide
with a weakening of other macroeconomic indicators, such as
trade, capital flows, and employment.

Understanding Global Recessions

Macroeconomic indicators have to wane for a significant period

of time to classify as a recession. In the United States, it is
generally accepted that GDP must drop for two consecutive
quarters for a true recession to take place, based on analysis
by the National Bureau of Economic Research (NBER), which
is considered the national authority in declaring and
dating business cycles. For global recessions, the IMF plays a
role similar to the NBER.

While there is no official definition of a global recession, the

criteria established by the IMF carry significant weight because
of the organization’s stature across the globe. Unlike the
NBER, the IMF does not specify a minimum length of time
when examining global recessions. In contrast to some
definitions of a recession, the IMF looks at additional factors
beyond a decline in GDP. There must also be a deterioration of
other economic factors, which include trade, capital flows,
industrial production, oil consumption, the unemployment
rate, per-capita investment, and per-capita consumption.
Ideally, economists would be able to simply add the GDP
figures for each country to arrive at a “global GDP.” The vast
number of currencies used throughout the world makes the
process considerably more difficult. Though some
organizations use exchange rates to calculate the aggregate
output, the IMF prefers to use purchasing power parity (PPP)—
that is, the amount of local goods or services that one unit of
currency can buy rather than the amount of foreign currency it
can buy—in its analysis.

History of Global Recessions

Up until 2020, according to the IMF, there have been four

global recessions since World War II, beginning in 1975, 1982,
1991, and 2009. In 2020, the IMF declared a new global
recession, which it dubbed the Great Lockdown, caused by the
widespread implementation of quarantines and social
distancing measures during the COVID-19 outbreak. This is the
worst global recession on record since the Great Depression.

Contagion and Insulation

The impact and severity of the effect of a global recession on a

country vary based on several factors. For example, a
country’s trading relationships with the rest of the world
determine the scale of impact on its manufacturing sector. On
the other hand, the sophistication of its markets and investment
efficiency determine how the financial services industry is
affected.

Example of a Global Recession

The Great Recession was an extended period of extreme

economic distress observed around the world between 2007
and 2009. World trade plunged by over 15% between 2008 and
2009 during this recession. The scale, impact, and recovery of
the downturn varied from country to country.
The U.S. experienced a major stock market correction in 2008
after the housing market collapsed and Lehman Brothers filed
for bankruptcy.5 Economic conditions had already turned down
by the end of 2007 and major indicators such as unemployment
and inflation hit critical levels with the collapse of the housing
bubble and ensuing financial crisis.

The situation improved a few years after the stock market

bottomed in 2009, but other nations experienced much longer
roads to recovery. Over a decade later, the effects can still be
felt in many developed nations and emerging markets.

According to economic research conducted for the NBER, the

United States would have suffered limited shocks to its
economy if the 2008 recession had not originated within its
borders. This is mainly because it has limited trading
relationships with the rest of the world in comparison to the size
of its domestic economy.

On the other hand, a manufacturing powerhouse such as

Germany would have suffered regardless of the robustness of
its internal economy because it has a vast number of trade
linkages with the rest of the world.