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Chapter No. 1. Macro Economics and Business Decisions

A) Unemployment and Employment Ratio.B) Balance of Payment.C) Business Cycle and Price Level.

Macro Economic Problem Macro Economic Variable

Problem of Unemployment Unemployment RatioProblem of Business Cycle General Price LevelProblem of Economic Growth National IncomeProblem of Balance of Payment Rate of Exchange

A) Unemployment and Employment RatioMacro economics deals with the economic behaviour of the society. It gives an idea of

the totals of the economy as a whole. The economy has to face fundamental problemslike unlimited wants, limited resources, unlimited use of resources, etc. Macro economicshelps the government to take appropriate decisions for solving such problems. Clearunderstanding of such problems and their variables help the society in decision making

and forward planning.For any economy, unemployment is an important problem and unemployment ratio isthe variable for considering such problem. It is the most important macro economicproblem. It is basically the unemployment of manpower. So to achieve full employment isan important objective in the economic planning. The full employment in the countryassures maximum utilization of the productive capacities and maximum national income.On the other hand, if there is less than full employment, there will be wastage ofmanpower and resources in the economy. The unemployment of manpower meansunderutilization of resources, low national income and low standard of living. So itbecomes necessary to understand the concept of full employment.

Full employment may be defined as the situation when every one who is willing and

able to work at prevailing wage rate can find a job in the line of wok in which he isqualified. Following are important features of full employment -1) Full employment of manpower The concept of full employment is used only in the

connection of manpower and not in the connection of capital, equipments or otherresources.

2) Full employment dose not mean employment to all The concept of fullemployment dose not mean employment to each and every person in the country. Wecan exclude students, housewives, old age persons, disable persons, etc. Afterexcluding all these people from the population if all are employed then we can say thatthere is full employment.

3) Full employment exist with natural unemployment Full employment dose not

mean zero unemployment in the country. In the changing environment business firmswill have to adopt new techniques and methods. As a result there may be naturalunemployment in the country. Generally 3% to 4% unemployment is considered as thenatural unemployment. If all other are employed then it is full employment.On the basis of full employment, we can estimate the unemployment in the country.

Here at first we have to consider the total labour force in the country.Total labour force = Population in the country in the age group from 18 to 62

- (students, housewives, voluntary unemployed, etc.)

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Unemployment ratio =

The unemployment ratio is an important macro economic variable. This ratio helps usto understand the gravity, seriousness of the problem of unemployment. Reduction in theunemployment ratio can be taken as an indicator of economic development. Followingpoints are necessary to be considered for unemployment ratio

Generally 3% to 4% unemployment ratio is regarded as natural unemployment. Itcan be taken as the level of full employment.

If the unemployment ratio is more than 3% to 4%, it is serious problem ofunemployment.

In India, at present the unemployment ratio is around 10%.

During the great depression of 1930, the unemployment ratio in America wasbetween 15% to 20%.

Types of UnemploymentUnemployment is said to exist when people are willing and able to work at prevailing

wage rate but do not get job. It means it is the situation in which people are jobless

against their will. It is involuntary unemployment. Following are the types ofunemployment 1) Seasonal unemployment It is a type of rural unemployment. The unemployment,

related with the agriculture season is called as Seasonal Unemployment. In case ofIndia, the agriculture working is dependent on the monsoon rain. Such agriculture canprovide working, only for some months and in the remaining period, agricultureworkers remain unemployed. It is called as seasonal unemployment.

2) Disguised unemployment It is not open unemployment but invisibleunemployment. When workers are working but adding nothing in the total productionthen it is called as disguised unemployment. It is the employment of excess butunnecessary workers. E.g if an agriculture land, 18 workers are working for getting

the production of 100 kg. which is possible by 15 workers then their is disguisedunemployment of 3 workers.

3) Educated unemployment It is a type of urban unemployment. After gettingeducational qualification, educated people can not get jobs then it is called aseducated unemployment. In case of India, it is a serious problem. Indian economy cannot provide jobs to all the educated persons and educated unemployment isincreasing every year.

4) Industrial unemployment People from rural area, come to urban area for gettingjobs in the industrial sector. But in urban area, industrial sector can not provide jobs tosuch people then it is called as industrial unemployment. Limitations of industrialsector is the basic cause behind the industrial unemployment. Slow development of

industrial sector in India creates industrial unemployment.5) Cyclical unemployment It is related with the business cycle that is business ups

and downs. In every business, there is a period of prosperity and a period ofdepression. In the period of prosperity, workers can get jobs but in the period ofdepression, they have to loose their jobs. Such unemployment is called as cyclicalunemployment.

6) Technological unemployment It is related with the use of new technology. If thenew technology can not provide jobs for all the workers then it is called as

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technological unemployment. Unemployment due to use of computers is the bestexample of technological unemployment.

7) Frictional unemployment This type of unemployment is related with the change inthe fashion of any commodity. Due to change in the fashion, the demand for suchcommodity comes down. Frictional unemployment is the result of decrease in thedemand. Due to change in the fashion, some labours can not get employment, whichis called as frictional unemployment.

8) Structural unemployment The unemployment due to defective structure ofeconomy is called as structural unemployment. It is due to defective planning ofeconomy.

B)Balance of Payment.Trade can be divided as home trade and foreign trade. The trade between two

countries is called foreign trade or international trade. The differences in the skill and thenatural endowment results in the international division of labour and specialization andfinally results in the international trade.

The trade between residents of one country with the rest of the countries is not asimple aspect. This is because of the different circumstances available in different

countries. The international trade provides receipts through exports and results in thepayments for imports. Here the concept balance of payment is used. It means exportreceipts and import payments are tabulated annually in a specific form called balance ofpayment. It is the systematic record of all the economic transactions of the residents ofone country with the rest of the world, during a given period of time which is generally oneyear. It shows the record of the transactions of assets and liabilities, creation andreduction of claims or receipts and payments of funds which take place in one countryand rest of te world.

Balance of payment may be defined as, systematic record of all economictransactions between the residence of reporting country and the residents of foreigncountries during a given period of time

Following are the features of this concept 1) Balance of payment is a statement of all economic transactions between one countryand the rest of the countries in the world. Only economic transactions are consideredhere and this concept is not related with the charitable transactions.

2) It is a record relating to a particular period of time which is generally one year.3) It includes all the transactions, current as well as capital transactions.4) Rate of exchange is the indicator showing the position of balance of payment of any

country.Adverse balance of payment is the major problem of for any developing country.

Adverse balance of payment means import exceed the export. Import substitution andexport promotion may be the solution on the problem of balance of payment.

Rate of exchange is the variable for this problem. Rate of exchange means number ofunits of one currency that have to be used for getting exchange of one unit of othercurrency. Rate of exchange is determined by two forces demand for and supply of theforeign currency. The demand for foreign currency is determined by imports and thesupply of foreign currency is determined by the exports form the country. Thus any deficitor surplus in the balance of payment is reflected by the exchange rate. If there is heavydemand in relation to supply of foreign currency, the rate of exchange would rise. It showsthe domestic currency is cheaper and the foreign currency is dearer.

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C)Business Cycle and Price Level.The economic progress of the capitalist countries has been marked by periodical and

frequent fluctuations in the tempo of economic activity in investment, in output, inemployment and in income. The dynamic forces operating in the capitalist economycreate various kinds of business or economic fluctuations. The main feature of marketoriented capitalist economy is instability. It means there is no regularity, smoothness and

a single direction in the economic life of the capitalist country. There are recurring phasesof economic expansion and contraction. They are recurring, hence are called businesscycles. The expansion phase shows all round development in the economy. There isoptimism which leads to more investments, more employment, higher level of income,etc. The expansion phase reaches the peak point. It means highest possible investment,employment and income in the country. The economy gets automatic turn and enters thecontraction phase.

In contraction phase, there is pessimistic environment in the economy. This leads toreduction in the investment, employment and income level. It reaches its bottom. Againsomething happens in the economy and it turned into expansion phase. This is called asthe business cycle. The business cycle is a major macro economic problem, which

creates significant disturbance in the working of the economic system. The businessmencannot remain ignorant about the occurrence of the business cycle. This is because thebusiness cycles change the business environment in the country. The business cycle maycreate number of disabilities and difficulties in the operation of the business firm.

The expansion phase of the business cycle also creates certain difficulties; e.g. in thisphase prices are rising because of increasing demand. The result is raising labour cost,raw material cost and interest cost etc. A skillful businessman may reserve resourcesduring the expansion phase, the same resources would be used in the bad days. Arational businessman clearly analyse the past, present and future course of the businesscycle. He adopts certain methods to minimize the ill effects of business cycle.

The general price level is the primary variable of the problem of the business cycle.

The direction and magnitude of the change in the general price level may be regarded asthe signal of instability and occurrence of the business cycle. If the variations in thegeneral price level are within the range of 4% to 5% p.a. one may conclude that there iseconomic stability in the country. On the other hand, if the prices are rising or falling morethan this level, the economy has tendency of fluctuations.

Chapter No. 2 National Income

A) Meaning and Definitions of National IncomeB) Important Concepts Regarding National IncomeC) Method of Measurement

D) Significance / Application of National incomeE) Methods of Social Accounting

A) Meaning and Definitions of National Income

National income is an uncertain term, which may be used as national dividend,national output and national expenditure. The total income of the nation is called nationalincome. The aggregate economic performance of the country is measured by the national

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income data. National income data provides a summary statement of a countrysaggregate economic activity. In real terms, national income is the flow of goods andservices produced in an economy in a year or a particular period of time. Moderneconomy is a money economy. Thus the national income of a country is measured inmoney terms. It is the expression in monetary terms, of the variety of goods and servicesproduced by a nation during a year.

The concept of national income has been interpreted in following three ways

National product It consist of all the goods and services produced by the communityand exchanged for money during a year.National dividend It includes all the incomes in cash and kind, earned by the factors ofproduction in the course of generating national product.National expenditure This represents the total spending or outlay of the community onthe goods and services produced during a given year.

Considering above approaches the flow of national income can be stated as follows-National product = National dividend (Income) = National expenditure.National income is nothing but the total flow of wealth produced, distributed and

consumed. National income is not a stock concept but a flow concept. The process ofincome created and income distributed goes on at one and the same time.

National income can be defined as followsAccording to A. C. Pigou, national income is that part of objective income of thecommunity, including of course income derived from abroad, which can be measured inmoney.

According to Simon, national income is the net output of commodities and servicesflowing during the year from countrys productive system in the hands of the ultimateconsumers.

According to UNO, national income has been defined as addition to the shares ofdifferent factors, and so net national expenditure in a country is a years time.

From definition, features of national income can be stated as under 1. National income is the net output of material and immaterial goods produced by a

country during a period of one year.2. It is the monetary value of the net output of goods and services.3. Depreciation value is deducted from total output to arrive at the net output.4. Income from abroad is included in the national income.5. It refers to the net production of goods and services in the hands of consumers.

B) Important Concepts Regarding National Income

Gross National Product (G.N.P.)

Gross National Product (G.N.P.) is the basic concept in the national incomeaccounting. Gross National Product is defined as, the aggregate market value of all finalgoods and services produced in an economy during a year. It is the sum of money valueof consumption, investment, government purchase, balance between export and importand net income from investments abroad.

In an open economy GNP can be obtained by adding up the following 1. (Private domestic) Consumption expenditure (C) These are the amounts

spent by private persons on consumption.

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2. (Private domestic) Investment expenditure (I) These are the amounts spentby private business units on replacement, renewal and new investment.

3. Government expenditure on purchase (G) These are the amounts spent bygovernment on the purchase of goods and services.

4. Export Import (X M) It is the difference between total exports and totalimports of the nation. This value may be positive or negative.

5. Net income from investments abroad (R P) It is the difference between the

income received by the nationals from abroad on their foreign investment and theincome paid by them, abroad on the foreigners investment.

GNP = C + I + G + (X - M) + (R - P)

For proper understanding of GNP, we must remember following things i) GNP is the monetary measure. It is the addition of money values of all final goods

and services produced in a year.ii) In measuring GNP care must be taken to avoid double counting. In this

measurement all goods and services must be counted once and only once.Suppose, we measure the value of redymade shirt, then we cannot again measure

and include the value of cotton from which the shirt is made.iii) Goods and services which are purchased for final use are to be included in GNP.Goods and services for resale or future use in production cannot be taken in theGNP.

Gross Domestic Product (G.D.P.)

Gross domestic product is concerned with the gross domestic output or the income ofthat particular country only. It excludes income derived from abroad in the form of incomefrom investment but includes net export value. Hence, it is the concept within thatparticular country, which is purely internal one.

G.D.P. refers to the sum total of the value of the goods and services produced in thecountry by the national of the country. It refers to the money value of goods and servicesproduced within the geographical boundaries of a country. This means what everproduced by Indians and foreigners working in India will constitute GDP of India. Incomesearned by Indians outside India will not be included In GDP of India.

G.D.P. refers to the total output of goods and services produced within the economyby a particular country during a period of one year. It is the money value of total output ofa country. It can be stated as -

GDP = C + I + G + (X - M)GDP can be obtained by adding up the following 1. Personal consumption expenditure (C)2. Gross Domestic Private Investment (I)3. Government Purchase (G)4. Balance of Foreign Trade (X M)

Net National Product (N.N.P.)

Net national product refers to the value of the net output of the economy during theyear. It is obtained by deducting the value of depreciation or replacement allowance of

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the capital asset, from GNP. The word net refers to the exclusion of that part of the totaloutput, which represents depreciation. NNP represents the money value of only the netoutput of final goods and services of the country. It necessitates to deducting depreciationvalue from the total output. It is the NNP which is known as national income in general.Symbolically

NNP = GNP DepreciationNational income at factor cost is the national income in true sense. By deducting

depreciation cost from GNP, we get NNP at market price. If we deduct indirect taxes fromsuch NNP and add subsidies, we can get national income at factor cost. It is basically thesum of all incomes earned by resources supplies in the form of land, labour, capital andentrepreneur.

Here indirect taxes means the tax which is included in the price of the product e.g.sales tax, octroi, excise duty, custom duty, etc. Subsidies means government help tolower down the market price of the product, to make it available at reasonable prices tocommon people. It is necessary to deduct indirect taxes from NNP, because theyincrease the market prices of goods and services but do not constitute income for thefactors of production. It is necessary to add subsidies in NNP, because they constitutepart of personal income for the factors of production. Finally

NNP (FC) = NNP(MP) IT + SubsidiesNNP(FC) means the national income at factor cost, which is true national income.( For example, the market price of commodity X is Rs.150 including Rs.10 as

sales tax and Rs.7 as octroi. Then the factor cost will be Rs.133. Similarly market price ofcommodity Y is Rs.75 with subsidies Rs.15, then the factor cost will be Rs.90.)

National Income at Current Prices & National Income at Constant PricesWhen the national income is measured by taking into account the market prices for

the current year then, it is called national income at current prices. This conceptcalculates the money value of the output of goods and services by considering theirprices in the same or current year. For example, national income at current prices for2008-09 takes into account out and prices of 2008-09 only.

The prices of goods and services always fluctuate and do not remain constant orstable. Rise in the prices increases the national income without any material increase inthe output. So it may provide the wrong picture. So base year is selected & byconsidering the prices in the base year and output in the current year, national income iscalculated. It is known as national income at constant prices. Now consider 2001-02 asbase year. Here national income of 2007-08 can be calculated by taking into accountprices in 2001-02 output in 2007-08. This concept is more useful for comparison.

Personal Income (PI)Prof. J. M. Keynes has invented the concept of personal income. It is the sum total

of the incomes received by individuals of a country in a year. It is the total incomereceived by individuals of a country from all sources before direct taxes in one year. It isthe aggregate earned and unearned income. Personal income includes transferpayments as well as income made by the private business sector to the individuals.Personal income never includes national income because it includes transfer incomewhich is not included in the national income. It is derived from national income bydeducting undistributed corporate profits, corporate income tax and social securitycontributions. But business and government transfer payments, transfer payments from

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abroad in the form of gifts and remittances, windfall gains, etc. are the sources ofpersonal income which should be added in the national income. It can be stated as

Personal Income = National Income Undistributed Corporate Profits Corporate Income Tax Social Security Contribution + Transfer Payments etc.

Hence, in order to obtain personal income, we must subtract from national incomethose types of income which are earned but not received and add those incomesreceived but not currently earned.

Disposable Income (DI)The whole personal income accruing to individual is not available to spend. A part

of the personal income has to be paid by individuals to the government by way of directtaxes. The part of personal income which left behind after payment of direct taxes iscalled disposable income. Prof. J. M. Keynes has invented the concept of disposableincome.

Disposable income is the sum of the consumption and saving of individuals. Itincludes unearned and earned income of the individuals. To obtain the disposable incomedirect taxes are deducted from personal income. So this term can be shown as

Disposable Income = Personal Income Direct Taxes

But the whole disposable income is not spent on consumption and a part of it issaved. So disposable income can also be seen as Disposable Income = Consumption Expenditure + Savings

Finally, the concept of disposable income tells us the amount of money available toindividuals and households in a year for the purpose of spending.

Per Capita Income (PCI)National income dose not provide real picture of standard of living of the individuals

or people, hence, per capita income is considered as real measure or method or indicatorof economic development of the country.

The average income of the people in a particular year is called per capita income.

It is the per head income of a person or an individual in the country. When we dividenational income by the population of the country in a particular year then we get percapita income. The term PCI is expressed as

Per Capita Income = National Income / Population

C) Method of Measurement of National Income

1) Aggregate Output Methods (Product Method)In this method, total output or production within a year duration is considered.

Aggregate output method of national income considers the supply side of economy.Every economy is divided into different sectors i.e. primary sector, secondary sector andtertiary sector. These sectors are again divided into sub-sectors. By adding output fromeach sector and sub-sector, we can get the national income.

Following are two approaches of output method Final goods approach and Valueadded approach.

Final Goods ApproachAccording to this approach national income is measured by adding up the market

value of all final goods and services produced in the economy in a year. The total value offinal goods and services consist of capital goods and consumption goods as well as

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services provided in the economy. According to final goods approach, only the moneyvalue of final or finished goods should be considered by neglecting the output ofintermediate goods and raw material. For example, while measuring output of textileindustry only the total output of cloth should be taken into account.

Value Added ApproachIn this approach, stages of production of any commodity are taken into

consideration, without considering final goods directly. All the values added in all stages

in the production are added together to get the final amount of national income. It isexpected to make the summation of increase in value of commodity at each separateproduction stage. For example raw cotton, cloth, shirt and value at the sale of shirtshould be taken into consideration.

Following precautions are necessary to take under this method 1. To avoid double counting only the value of output of final or finished goods should be

considered.2. Products kept for self consumption by the producer should be estimated correctly.3. While evaluating the output changes in the price levels must be taken into account.4. Indirect taxes should be deducted and subsidies should be added in evaluating the

output.

5. Add the value of exports and deduct the value of imports.6. Income earned from abroad is to be added,7. Depreciation value is to be deducted.

2) Aggregate Income Method

This method of measuring national income is also known as factor cost method.This method measures the income received by the people in a year through the varioussources of income. As the factors of production extend their physical and mental servicesin the production of output of the goods and services, they get rewards in the form of rent,wages, interests, profits, etc.

By adding up these rewards received by the people in a year, this method

estimates the national income. At the same time, this method also adds up income fromabroad to the total factor incomes while measuring the national income. This methodtakes into account the factor prices, which form the cost of production. So this method isalso known as factor cost method.

To measure national income with the help of this method, income of all factors ofproduction is added together. The data is collected from books of accounts, reports,income tax returns and other types of estimates. The incomes are classified into followingcategories a) Compensation to employees (wages, salaries, contribution of social security

scheme, allowances paid to government employees, etc.)b) Operating surplus (rent, interest, profits, dividend, etc.)c) Mixed income of self employment.

Following precautions are necessary to take under this method 1) Incomes received in the form of transfer income are not to be included in the national

income.2) All unpaid services like services of housewife are to be excluded.3) Rent values of self occupied premises are to be included in the national income.4) Illegal income should not be included.

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5) Receipt from sale of second hand goods should not be included but commission orbrokerage earned in the exchange should be included.

6) Windfall gains like lottery, gifts, etc. should not be included.7) Depreciation amount should be deducted.8) Undistributed profits of companies should be included.9) Net factor income from abroad is to be included.

3) Aggregate Expenditure MethodThis method is also known as total outlay method of measuring national income.By considering the different expenditures, this method measures the national income ofthe country. National income can be measured by adding up all final expenditures madefor purchases of goods and services in the country. This method takes into account thetotal expenditure incurred on the various items during a year in a country to estimate thenational income.

According to this method, total expenditure of the economy can be divided into fourcategories

In an open economy GNP can be obtained by adding up the following 1. Private domestic consumption expenditure (C) These are the amounts spent by

private persons on consumption.2. Private domestic investment expenditure (I) These are the amounts spent byprivate business units on replacement, renewal and new investment.

3. Government expenditure on purchase (G) These are the amounts spent bygovernment on the purchase of goods and services.

4. Export Import (X M) It is the difference between total exports and total importsof the nation. This value may be positive or negative.

5. Net income from investments abroad (R P) It is the difference between theincome received by the nationals from abroad on their foreign investment and theincome paid by them, abroad on the foreigners investment.

GNP = C + I + G + (X - M) + (R - P)

From this if we deduct depreciation, then we can get NNP at market price. Fromthis if we deduct indirect taxes and add subsidies, we get NNP at factor cost i.e. nationalincome.

Following precautions are necessary to take under this method 1) Expenditure made on the purchase of second hand goods should not be included.2) Expenditure made on the purchase of shares and bonds should not be included.3) Government expenditure on transfer payments should not be included.4) To avoid double counting expenditure on raw material etc. should be avoided

D) Significance / Application of National incomeNational income is very important concept in economics. It measures the economic

performance of an economy as a whole, in terms of how rapidly it is growing, howallocation of resources is made to different sectors of production activity, etc. Nationalincome expresses the current achievements of the national economy in terms of money.

All the allied problems of poverty, inequality, unemployment, pace of economic growthand economic development, etc. are studied and evaluated with the help of nationalincome analysis. Following aspects shows the application of national income1) Economic planning Economicplanning is an effective means of rapid and all round

economic development of the country. Economic planning tries to allocate and utilize

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available productive resources properly and fully so as to achieve rapid and all roundeconomic development. National income data are very much useful in economicplanning on its different fronts. Such data is useful for preparation of economic plan,collection of productive resources implementation of plans, its critical evaluation andnecessary modifications. Economic planning is needed for every productive sector,which indicates the need for national income data.

2) Regulating the economy Now a days the intervention of government in economic

decision making and regulation of the economic activities has become essential inmore or less all types of economies. It is necessary for proper working and making theprocess of development more dynamic. The interference of the government ineconomic decision making at proper timing and to the required extent is necessary. Inabsence of economic data the government cannot regulate the economy. Thecomputation of national income gives a lot of data useful for undertaking variousactivities necessary for regulating the economy.

3) Comparison of national income over time and space Any type of economyundertakes economic activities to improve the standard of living of people. It dependson which and at what extent the human wants are satisfied. The level of income of anation and the people determines the extent of satisfaction of wants and thereby the

level of standard of living. National income data provides comparison over space. Thishelps in comparing the standard of living of the people between the regions, statesand countries. This is useful in identifying the disparity in standard of living of thepeople. Such comparison is useful to determine the need of financial assistance. Thenational income data facilitate the comparison of national income of a country overtime, which indicates the changing standard of living of the people according tochange in the duration.

4) Distribution of national income There are three aspects of the distribution ofnational income the sectoral distribution of national income distributes the nationalincome among three productive sectors known as primary sector, secondary sectorand tertiary sector. It shows the contribution of different productive sectors in the

national income. In functional distribution, the national income data shows thedistribution of national income among the factors of production i.e. land, labour, capitaland entrepreneur. Personal distribution of national income shows the state ofdistribution of national income among the people in the country.

5) Measure of economic growth The national income data is important in measuringthe degree of economic growth or development of the economy. National income isthe measure of economic growth of the country. National income is a parameter ofeconomic development. The concepts associated with national income such as GNP,NNP, GDP, Per Capita Income are used to measure the economic growth of theeconomy.Difficulties in the measurement of National IncomeMeasurement of national income is a difficult task. Difficulties in it can be classified infollowing two categories

A) Difficulties relating to concept1) Difficulties relating to definition We can provide a formal definition of national

income easily but it is very difficult to decide, which commodity or service should beincluded or excluded from the calculation of national income. For example, the incomeof paid housemade is to included in the national income but if any male member

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marries with the housemaid then her services cannot be included in the nationalincome. Similarly it is very difficult to decide about such goods and services which arenot paid in money.

2) The problem of double counting At the time of using product method, it isnecessary to avoid double counting. It is very difficult to distribute any commodity asraw material or final goods. For example, if we count the market value of bread thenwe cannot count the value of wheat used for it. It is very difficult to determine the

market values of only final goods.3) Calculation of depreciation For the estimation of national income it is necessary todeduct depreciation from fixed assets. But measuring depreciation on the capitalassets is a difficult task. No uniform rule is applicable for the calculation. Similarly nouniform rate or method is applicable for charging depreciation.

4) Estimation of the value of inventory Raw material, semi finished goods, work inprogress, intermediate goods, etc. are known as inventories in the calculation ofnational income. Computation of such inventories is also very difficult job. Any mistakein the measurement may affect the calculation of national income so carefulcalculation of it is necessary.

5) Problems regarding government sector Most of the government expenditure is on

the services including defence, law and order, public administration, etc. measuringthe market value of such services is considerably difficult. Again it is proper tomaintain secrecy regarding such matters so at any case it is not possible to measuregovernment expenditure accurately.

6) Problem regarding income from foreign firms According to some experts,income of the foreign firms should be included in the national income. But we have toconsider that profits of such firms go to original country. So inclusion of income offoreign firms creates confusion in the calculation of national income.

B) Difficulties relating to underdeveloped countries1) Lack of accounting habit Most of the population in the underdeveloped country is

illiterate and concerned with the agriculture by occupation. Most of the cultivation is forsubsistence and hence they rarely keep accounting records of their economictransactions. People who keep accounting records rarely co-operate with theauthorities. So it becomes difficult to estimate exact amount of production and itsmarket value.

2) Unorganised sector In under developed countries there is large unorganisedsector. So it is difficult to collect data regarding production, income, expenditure, etc. Itis true in case of agriculture, cottage industry, household crafts, petty traders, etc.

3) Classification problem in underdeveloped countries, household enterprise isstrong unit due to joint family system. Joint family perform a number of productionactivities. It creates the problem of classification as whether such activities areincluded or excluded form the national income.

4) Non monetary sector In underdeveloped countries, rural people carry some of theireconomic transactions in the form of barter exchange. In agriculture most of theproduction is for subsistence and it dose not enter into the market. It is difficult toestimate such non monetary sector. Even in India 20% to 30% economic activities inrural sector are of non economic nature.

5) Problem of common denominator In economy, various people perform differenteconomic activities in different sectors. It is always very difficult to measure such

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activities on the basis of uniform measurement. The person working in agriculturesector contributes higher hard work than the person working in the service sector, butmonetary valuation of later is more than the former. So the estimation of nationalincome has to face the problem of common denominator.

6) Lack of adequate and reliable data In case of developing country agricultureproduction is the main economic activity. Most of the people working in agriculture areilliterate. Information regarding income, consumption, savings, investment, etc. are not

adequately available. Lack of reliable data creates considerable problem in theestimation of national income.

Chapter No. 3 Value of Money

A) Concept of value of moneyB) Fishers ApproachC) Cambridge ApproachD) Milton Freidmans ApproachE) Index Number

A) Concept of value of money

The term value of money means purchasing power of money i.e. buying capacityof money. It is the quantity of goods and services, a unit of money can purchase. Thepurchasing power of money depends upon the level of prices of the goods and servicesto be purchased. The purchasing power of money is inversely related with the price level.Thus lower the price level, higher will be the purchasing power and higher the price level,lower will be the purchasing power. In mathematical terms, the value of money can bestated as

Vm = 1/P

Here Vm = Value of moneyP = Price level

As money can purchase any thing that has a price, the value of money should beexpressed in terms of all the things. Here we have to face practical difficulty that there arelarge number of values as there are large number of commodities. To express the valueof money in terms of all the commodities is practically not possible. For this purpose weconsider the general price level. But again which commodity should be included in thecalculation of general price level is also confusing part; so in practical sense, value ofmoney is taken as a limited and relative aspect.

B) Fishers approach

Prof. Fisher explained his approach regarding value of money in his book ThePurchasing Power of Money published in 1911. In his theory he considered medium ofexchange as the most important function of money. He explained his theory on the basisof this function and it is considered as the first theory of the value of money. This theory isalso called as quantity theory of money.

The quantity theory of money states that the value of money changes with itsquantity. Double the quantity of money and other things being equal, price will be twice ashigh as before and the value of money . Half the quantity of money and other things

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being equal, price will be half as before and the value of money will be double. In simplewords, he quantity theory of money states that the value of money is inversely relatedwith the quantity of money Prof. Fisher gave the following equation explaining therelationship between money supply, price level and value of money

MV = PT OR P = MV / THere M = Total quantity of money i.e. money supply

V = Velocity of money i.e. average number of times each unit of money is

exchanged in transaction over a period of time.T = Total volume of transactions (trade) i.e. goods and services traded by thecommunity during a given period of time.P = General price level i.e. average price per unit of trade

The above equation is called as a cash transaction equation.MV represents the supply of money and PT represents demand for money.

Velocity of money is the number of times a standard unit of money changes hands in agiven time. Therefore to determine money supply in any given time period, it is necessaryto multiply money supply by its velocity of circulation. So one years money supply will beequal to MV. Demand for money will be equal to the total value of goods and services to

be exchanged. If we use T for trade of goods and services and their average price as P;then demand for money will be equal to PT.Now Money supply = Demand for money i.e. MV = PTFishers above equation is applicable to only primary money. But money in the

modern economy is not limited to notes and coins. Now it also includes demand depositand bank (credit) money also. Fisher has extended his equation to include bank moneyas follows

MV + M V = PTIn this equation

M = Total quantity of primary moneyV = Velocity of primary money

M = Bank / credit moneyV = Velocity of bank moneyP = General price levelT = Total volume of transactions

According to Prof. Fisher the relationship between money supply, price level andvalue of money can be stated in the following words

Other things remaining unchanged 1) When money supply increases, the general price level increases and value of money

decreases.2) When money supply decreases, the general price level also decreases and value of

money increases.

Above relations can be explained with the help of following diagrams -

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In the diagram, when money supply is OX then price level is OY. When moneysupply increases up to OX and then up to OX then price level also increases up to OYand then up to OY . It gives positive relation between money supply and price level.

In the diagram, when money supply is OX then value of money is OY. Whenmoney supply increases up to OX and then up to OX then value of money decreases upto OY and then up to OY . It gives inverse relation between money supply and value ofmoney.

From above it can be stated that 1) Relationship between money supply and price level is proportionate and positive.2) Relationship between money supply and value of money is proportionate and

negative.

Assumptions of Fishers approach1) The economy is working at the full employment level, so the total production of goods

and services remains constant.2) It is possible to count the velocity of money i.e. circulation of money in the economy.3) This theory considers long period of time; normally one year4) The economy is fully monetized i.e. all exchanges and transactions take place with the

help of money.

Criticism on Fishers approach1) The equation MV = PT is not found in the real life.2) Assumptions like full employment, stability of production, counting of velocity of money

etc. are not practical.3) This theory is related only to the long run not to the short run.4) This theory considers only the monetary transactions and not the barter transactions.5) This theory is based on the medium of exchange as the function of money. This

theory ignores other functions of money as store of value, standard of value, unit ofaccount, etc.

6) The concept general price level used by Fisher is unrealistic.7) Some times it can be seen that prices of goods are increasing without any increase in

the money supply.8) This theory provides neutral role to money in the economy, which is unrealistic in

modern economy.9) This theory dose not provide the nature and changes in the demand for money.10)This theory dose not provide any specific standard of value of money.

Fishers quantity theory can be explained with the help of following example

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M = 500 V = 04 M = 1000 V = 05 T = 100MV + M V 500(4) + 1000(5)

T 100If quantity of money increased then,M = 1000 V = 04 M = 2000 V = 05 T = 100

MV + M V 1000(4) + 2000(5)T 100

With the double amount of quantity of money, price level increases two times as aresult value of money decreases.

B) Cambridges ApproachFishers approach of quantity theory of money enjoyed popularity in United States,

in the 20th century. In Europe, a slightly different approach was explained by Cambridgeseconomist; Dr. Marshall, Pigou, Robertson, Keynes, etc. Fisher used medium ofexchange as the basic function of money, for his quantity theory. On the other hand,Cambridges economists used store of value as the function of money.

According to the cash balance theory, the value of money is fixed at that level atwhich its supply is equated to demand. The variation in the value arises due to the

changes either in its supply or in its demand or in both. Unlike the transaction approach,cash balance approach considers the demand for and supply of money at aparticular point of time and not over a period of time.

According to the cash balance approach, the supply of money is its stock at aparticular point of time rather than its flow over a given period of time. The supply ofmoney includes cash and bank deposits which can be withdrawn by cheque. Thus thissupply of money together with demand, determines the price level or value of money inthe economy.

Demand for money was understood by Cambridges economist in a differentsense. Fisher stated in his equation that money is demanded for exchange purpose andnot for storage purpose. This was not agreed by Cambridges economist. The logic they

presented for that was, people like to keep some cash balance to meet their expectedand unexpected requirements. It is in the same way as a commercial firm creates reservefund.

Thus the demand for money, according to Cambridges school, is the totalquantity of money held by individuals, firms and government to meet their day today requirements. So the demand for money comes out of transaction andprecautionary motive. The communitys demand for money or demand to hold money incash constitutes the function of store of value

According to this school, demand for money is basically liquidity preference ofpeople. It means preference to hold liquid cash. Though person can keep his assets invarious forms like investment in real estate, fixed deposit in the bank, etc. he prefers tokeep his cash in liquid form. In this form he can withdraw it and use it any time as per hiswill. Cash has the greatest liquidity, so every individual keeps his assets in liquid form asfar as possible. This desire is referred as the liquidity preference.

To express the relationship between supply of money and demand for money,Cambridges economist formulated cash balance equations known as Cambridgesequations

Cambridges Equations

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The cash balance approach was developed by Cambridges economists, Dr. Marshall,Pigou, Robertson, etc. All the economists used independent equations for explaining therelationship between demand for money, price level and value of money. Theseequations can be stated as follows

A) Dr. Marshalls Equation

Dr. Marshalls cash balance equation is given as below M = KYHereM = Supply of moneyY = National income measured in terms of moneyK = Proportion of national income, which people want to hold in the form of money.

When K is constant, a larger money supply will cause a rise in the price level and a fallin the value of money. Similarly with a constant K, a smaller money supply will decreasethe price level and increase the value of money.

B) Prof. Pigous Equation

Prof. Pigou further developed the cash balance approach by putting forward a newequation as given below P = KR / MHereP = Value of moneyK = Proportion of national income, which people want to hold in the form of money.R = National incomeM = Supply of quantity of money

If we consider R and K as constant, value of money will decrease if money supplyincreases and value of money will increase if money supply decreases.

C) Keyness EquationKeynes regarded Pigous equation as defective and he put forward his own equationknown as the real balance quantity equation in his book A Track on Monetary Reforms.It is as follows

n = PK orP = n / K

Here,n = Total money supplyP = General price levelK = Proportion of real balances of national income, which people want to hold in the form

of money.If we take K as constant, a change in the supply of money (n) causes a direct

proportional change in price level (P). in other words a double of the quantity of money incirculation will cause a double of the price level, provided K remains constant.

D) Robetsons EquationProf. Robertson put forward the following equation

P = M / KT orM = PKT

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HereP = General price levelK = Proportion of national income, which people want to hold in the form of money.M = Total money supplyT = Total number of transactions of goods and services in the year

According to Robertson, in the short run K and T tends to remain constant. Naturally ifmoney supply (M) increases, price level (P) also increases and value of money

decreases. This equation is more simple and acceptable equation.

Criticism on cash balance approach

1) Cash balance approach considers only the consumption goods available in themarket. This approach is not related with the capital goods demanded by theeconomy.

2) This theory fails to explain all the determinants for demand for money. For example, itignores the speculative motive for holding cash. In real practice most of the investorsdemand liquid cash for this motive.

3) The cash balance approach states that the price level is influenced by the liquidity

preference of people, but in real practice there are various other factors determiningthe changes in the price level.4) Practically it is hard to observe the positive relationship between demand for money

and the value of money and the inverse relationship between demand for money andthe price level.

5) Cambridge approach neglects the effect of changing rates on interest on the prices ofgoods and services.

6) Cambridge approach assumes that K influences P and neglects the influence of P onK.

7) Cambridge equations assumes that elasticity of demand for money is unitary. But thisassumption is unrealistic in the dynamic economy.

8) Cambridge approach takes into account only the direct deposit with the bankingsector. But banks create much more deposit by circular flow of loans and deposits.9) Cambridge approach neglects the changes in the prices of intermediate goods to

change the prices of final goods.D) Milton Friedmans Approch

(The restatement of quantity theory of money)

With the publication of The General Theory of Employment, Interest and Money in1936, by J. M. Keynes, economists discarded the traditional quantity theory of money. Butat the University of Chicago, the quantity theory continued to be a central part ofdiscussion. The economists like Milton Friendman, Henry Simons, Mints, etc. developed amore comprehensive and relevant version of quantity theory of money. Milton Friedmanpublished the famous essay The Quantity Theory of Money A Restatement in 1956 inwhich he set down a particular model of quantity theory of money.

Friedman criticized the Keynesian theory. According to Friedman, the quantity theoryis a theory of demand for money and not a theory of output or money income or of theprice level. Money is an asset or capital good; as a result the demand for money formspart of capital or wealth theory.

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According to Friedman, the long run demand for money function is stable. The interestelasticity of the long run demand function for money is negligible. A change in the supplyof money causes a proportionate change in the price level or income or both. Given thedemand for money, it is possible to predict the effects of change in the supply of moneyon total expenditure and income. If the economy is operating at the less than fullemployment level, an increase in the supply of money will raise output and employmentwith a rise in total expenditure. The restatement of quantity theory of money given by

Friedman can be presented diagrammatically as below

OM is the demand for money curve. MS is the money supply curve which is perfectly

inelastic to the changes in the income. The two curves intersect at E and determine theequilibrium income OY. If the money supply rises, the MS curve shifts to the right as M S .

It creates new equilibrium at E . As a result income also rises to OY .

E) Index number

MeaningGenerally prices of all goods and services do not increase and decrease in the same

proportion. Prices of some commodities increase more than the prices of othercommodities. Despite these facts, we generally say that prices are increasing anddecreasing. Such changes in the general price level are measured by index number.Index number is a statistical device, which measures the value of money by taking intoaccount changes in the general price level. We can define index number as like The

number which measures the changes in price level or value of money, is known as indexnumber.Types of Index Numbers

The main types of index number are 1) Simple Price Index Number An index number prepared without assigning weights

to commodities is a simple price index number.2) Weighted Price Index Number When the index number is prepared by assigning

weights to the commodities is known as weighted price index number. Here weightmeans relative importance of any commodity.

3) Wholesale Price Index Number The type of index number which is prepared takinginto account the wholesale prices of the commodities is a wholesale price indexnumber.

4) Retail Price Index Number An index number which is prepared on the basis ofretail prices of the commodities is a retail price index number.

5) Cost of Living Index Number The type of index number which is formulated toassess the changes in the cost of living of people or a section of population is the costof living index number.

6) Industrial Index Number It refers to an index number which is prepared to examinethe trends in the industrial output.

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7) Wage Index Number The type of index number which is prepared to study thechanges in the wages is the wage index number.

Steps for Construction of Index Number

1) Determination of Purpose It is necessary to determine the objectivefor constructing index number. There may be several purposes of constructing an

index number. The purposes may be to study fluctuations in the value of money, thecost of living and so on. Any index number can be used only for one purpose sodetermination of purpose is essential.

2) Selection of Base Year It is necessary to select a year as the baseyear, so as to prepare an index number. While selecting a base year, it is necessary totake precautions regarding normal or average economic conditions. Periods of war,drought, flood, famines etc. should not be taken as base year.

3) Preparing List of Commodities It requires making the choice of thecommodities to prepare an index number. The number of commodities to be selectedshould be related to the purpose of construction of index number.

4) Selection of Prices The price index number tries to compare prices of

commodities between base year and current year. Prices should be selected of theselected goods and concerning the objective of an index number.5) To present price in percentages It is a necessary stage in

constructing an index number. The price of every commodity in the base year is takenas 100. Then the changes in the current year are presented in the form ofpercentages.

6) To find out average of prices It is required to find out the averages ofthe percentages of prices both in the base year as well as the current year and then tocompare two averages.

7) Assigning weights to commodities In the case of weighted indexnumber, assigning weights to the commodities is essential. Weight is the relative

importance of the commodity in the list of commodities.Construction of Index NumbersGenerally there are two types of index numbers

i) Simple index numberii) Weighted index number

Simple index number is helpful to understand general changes in price level. On theother hand, weighted index number is more scientific and precise, because a certainweight is given to each commodity on the basis of its importance in the total expenditure.The methods, principles, planning or stages in the constructions of index number are:

Construction of Simple Price Index NumberSuppose we are preparing simple index number for families of middle income

group. Here we take 1999-00 as the base year and 2008-09 as the current year. Weconsider the prices of five commodities, wheat, rice, cloth, milk and house rent. Thefollowing table explains how simple index number is prepared.

Commodity 1999-00 2008-09Price (Rs) Index Price (Rs) Index

Wheat 10 / Kg. 100 20 / Kg. 200Rice 12 / Kg. 100 18 / Kg. 150

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Cloth 25 / Meter. 100 50 / Meter. 200Milk 10 / Litre 100 20 / Litre 200Rent 200 / Month 100 500 / Month 250Total 500 1000

Average 100 200

In the above example, we get index number 200 for the year 2008-09 by assuming

1999-00 as the base year. It means that the prices of 2008-09 had increased two timesduring 1999-00 to 2008-09. Here we have given 100 as price index for each commodity inthe base year and we divided the sum of index numbers of all the commodities by thenumber of commodities. Naturally, the price level of the base year is shown by indexnumber 100.

Construction of Weighted Price Index NumberSimple price index gives equal weights to all the commodities. That is why simple

price index number does not represent price changes accurately. This defect on thesimple price index number can be removed by weighted price index number. Asmentioned above, weighted price index number is more scientific method of measuring

changes in the general price level or value of money. In the case of weighted price indexnumber we have to do one thing, to give weightage to the commodity. Let us take onepractical example of preparing weighted price index number.

Suppose we are going to prepare price index for families for middle income group.Here we take 1999-00 as a base year and 2008-09 as the current year. The selectedcommodities are wheat, rice, cloth, milk and house rent. The following table explains howweighted index number is prepared.

Commodity Weight 1999-00 2008-09Price Simple Weighted Price (Rs) Simple Weighted

Wheat 5 10 / Kg. 100 500 20 / Kg. 200 1000Rice 4 12 / Kg. 100 400 18 / Kg. 150 600Cloth 3 25 / Met. 100 300 50 / Met. 200 600Milk 2 10 / Lt. 100 200 20 / Lt. 200 400Rent 1 200 / Mth.100 100 500 / Mth. 250 250Total 15 1500 2850

Average 100 190

From the above example, it becomes clear that while preparing the weighted indexnumber, we multiply the price of commodity by given weight. Then we divide total sum bytotal weight.In above example, we get index number 190 for the year 2008-09 by assuming 1999-00

as the base year. It means that the prices of 2008-09 had increased by 90% during 1999-00 to 2008-09.

Difficulties in Preparing Price Index NumberPreparing the index number is very difficult and complex. Difficulties in preparing index

number are as under 1) Difficulty of selecting base year The base year should not be an abnormal year

like drought year, war period or a year of internal instability etc. During the period of

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war and drought prices not stable. So selection of such an abnormal year as baseyear will not give us real changes in the price level over a period of time. It is verydifficult to find such year which is normal year.

2) Difficulty of selecting representative commodities Selection of commoditiesdepends on the purpose of the index number. As the consumption patterns of urbanindustrial workers and rural agricultural workers are different, it is not proper to selectthe same commodities while prepare cost of living index number for them. It is difficult

to select the commodities purchased by them.3) Difficulty of selecting proper prices This is major problem in preparing indexnumber. Because retail prices differ from place to place or market to market. So whichprice should be taken for construction is a difficult job.

4) Difficulty of assigning weight It is very difficult to assign weights to the variouscommodities. So it becomes an obstacle in preparing the index number.

5) Number of goods and services It is better to select a large number of commoditiesto get a more representative and accurate index number. All the importantcommodities used in the average family consumption must be considered whilepreparing an index number.

6) Useful for specific purpose Different index numbers are useful for the construction

for different purpose. It is very difficult to select such index number which is suitablefor our purpose.7) Difficulty to select proper method of average Different methods are available for

constructing index number. Which method is to be selected creates problem in theconstruction of index number.

Importance of Index Number

1) To measure value of money Index numbers are very helpful for the measuring ofchanges in the price level and value of money.

2) To measure changes in the cost of living To measure the changes in the cost ofliving of workers and employees in the private, as well as public sector is important. Ifprice level is increased the purchasing power of workers is decreased it means livingstandard is decreased and vice-versa.

3) To measure changes in production National Statistical Organisation employsindex numbers to measure increase or decrease in national income, agriculturalproduction, industrial production etc.

4) Useful for economic planning The planning authority can adopt proper monetarypolicy, fiscal policy, trade policy etc. with the help of index numbers.

5) Changes in wages Index numbers are useful to determine changes in the wages.Dearness allowance is determined on the basis of index number.

6) Other usesa) To determine taxation policyb) To measure statistical changesc) Useful for producers and tradersd) Useful for credit controle) State of affairs in foreign trade

Limitation on Index Number

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Index numbers are very important and helpful for various things. But there are sometheoretical limitations on index numbers as under

1) Weighted index numbers are prepared for more scientific measurement of changes inthe price level. But assigning weight involves subjective element. If weight is changedindex number also changes. There is no scientific method of assigning weights.

2) Index numbers are statements of tendency. They are not as accurate as formulae andequations in other sciences.3) A particular index number is prepared with a specific objective in view. It cannot be

used for any other objective.4) It is not possible to prepare general index number by considering all the goods and

services together.5) Index numbers are not useful for international comparison as there are quantitative

and qualitative difference in the standard of living and other aspects of economic lifeof people of the different countries.

Chapter No. 4 Theory of Income and Employment

A) Says Law of Market and Its CriticismB) Keynesian Income and Employment TheoryC) Shifts in Demand.

A) Says Law of Market

The economic ideas developed by Adam Smith to Karl Marx which were held true fornearly 100 years are named by Keynes as classical economics. The classicaleconomists were of the view that, in a free capitalist economy in the long run fullemployment is the normal phenomenon

The classical theory of employment is based on Says Law of Market. J. B. Say aFrench economist published his book entitled, Treatise on Political Economy in 1803. Inhis book, he has developed a law of market which is known as Says Law of Market. Thisis the demand supply law, which studies the demand supply behaviour in the economy

and their equilibrium position.

Statement Every supply creates its own demand

According to Say, It is the production which creates markets for goods. Nothing ismore favourable to the demand of one product, than the supply of another. So supplyand demand are always balanced. There is no possibility of overproduction andunemployment in the long run. So full employment is normal situation.

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The supply itself creates demand or market. No separate efforts are required toundertake to create the demand for the commodity. This is true in case of one commodityas well as all the commodities in the economy. This provides equilibrium betweendemand and supply of a single as well as all the commodities.

Land, labour, capital and organisation are the factors of production used to undertakethe production of a commodity. As the factors render their physical and mental servicesfor the production of a commodity, they are paid rewards in terms of rent, wages, interest

and profit. People use the factor income to buy commodities. Thus the supply createsdemand for itself. Hence demand and supply equilibrium is achieved. The same thinghappens in case of all the commodities and services in the economy. That is why, theequilibrium between aggregate demand and aggregate supply is established in theeconomy.

Money works as a medium of exchange .hence all the income received by people isspent on consumption. There is possibility of savings; but savings is another form ofspending, which is invested in the production activity. So supply and demand are alwaysbalanced. There is no possibility of overproduction and unemployment in the long run.Suppose due to wrong calculations, supply of a particular commodity is greater thandemand for that commodity, it will be compensated by less production of other

commodity. Hence full employment is a normal situation in the economy.

Assumptions1) Perfect competition in the market.2) Free economy.3) Full employment.4) Expanding market.5) No government intervention.6) Money is only a medium of exchange.7) Saving and investment are interest elastic.

ExampleSays law of market can be better explained with the help of following example

suppose the production of 1000 meter cotton cloth is to be made. The building owner,labourers, sellers of raw cotton, entrepreneur, etc. get remuneration for their participationin the production activity. The employment, income, demand and output generated isrepresented as follows

Land Rent Rs.1000Labour Wages Rs.5000Interest Rs.1000Raw cotton price Rs.10000Entrepreneur Profit Rs.3000Total income generated Rs.20000In the above example, the production activity generates the supply of 1000 meters

cotton cloth per day and income generation is worth of Rs.20000 to different factors ofproduction. These factors of production will purchase or demand cotton cloth or any otherproduct. Thus the supply creates its own demand.

This way production activity is the beginning of an economy. Production has foureffects as

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a) It results in the output of goods and services for sale in the market. (supply)b) It generates employment to different factors of production.c) It generates income to different factors of production as remuneration.d) It generates demand for goods and services as factors of production generate

demand out of their income.In brief, on the one hand goods are brought for sale in the market and on the other

hand money income is given to make purchases. Thus in the production process supply

itself creates its own demand.

Implications of the Says LawThe important implications of Says Law are

1) Automatic equilibrium The first implication of Says law of market is automaticequilibrium between different variables is being achieved. They are demand supply,savings investment, etc.

2) General over production impossible Every supply creates its own demand. Withthe increase in the supply demand also increases. Hence demand supply equilibriumis achieved. So the general over production is impossible in the economy.

3) No general unemployment An important implication of Says law is, with the

increase in the production, the employment also increases, which results to fullemployment in the economy. Hence problem of general unemployment dose not existin the economy.

4) Capitalism in the economy According to Say, free economy or the capitalism is theautomatic working economy, which automatically adjusts the crises arose and all theeconomic decisions are taken automatically.

5) Non-intervention of the government There is no need of government interventionin the working of the economy. Every economic decisions are made automatically. Allthe economic problems including unemployment, poverty are automatically solved inthe economy.

Criticisms1) According to critics the supply of goods dose not create its own demand.2) It is not true that the supply of labour automatically adjust to its demand.3) People do not spend their entire income and that they do save a part of their income

for future use.4) The withdrawal of purchasing power from the income due to saving results in a

deficiency of aggregate demand which leads to over production.5) The fact of the operation of trade cycle (great depression in 1929-32) goes against the

law.6) The critics pointed out that unemployment exist in all the capitalist countries.7) Perfect competition is unrealistic market situation.

B)Keynesian Income and Employment Theory.

Classical economist believed that, a capitalist economy is generally in equilibriumat full employment level. According to Prof. Says law of market, every supply creates itsown demand of the equal value. As a result in the capitalist economy, unemployment andoverproduction is not possible. Keynes dissatisfied with the classical theory and criticizingit, he propounded a scientific and modern theory of employment. Prof. J. M. Keynes

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propounded his theory in his famous book The General Theory of Employment, Interestand Money published in 1936.

According to Keynes, income depends upon the output and any change in thelevel of output means a change in the employment level. Whenever income and outputincreases, employment also increases. They move in the same direction and are mutuallyinterdependent.

StatementEmployment determines output and income in the economy. Employment isdetermined by the effective demand. Higher the effective demand the higher the level ofemployment. Lower the effective demand then lower the level of employment

Assumptions1) Existence of perfect competition in the market.2) Existence of free capitalist economy.3) Existence of closed economy with absence of international trade.4) Short run period is available.5) Availability of labour at existing rate of wages.

6) Technique of production, efficiency of labour, capital formation, etc. are constant.7) Non intervention of government.

Explanation

1) Macro economic concepts Keynes for the first time used and propounded macroeconomic concepts like national income, national output, total employment, aggregatedemand, aggregate supply, effective demand, etc. According to Keynes, output andincome are determined by the employment in the country. It is the effective demand,which determines the level of employment and thereby output and income in thecountry. Higher the effective demand, the employment, output and income also

remains higher. This shows that deficiency in the effective demand is the basic causeof problem of unemployment. To solve the problem of unemployment, to increase theeffective demand is the measure.

2) Principle of effective demand Effective demand is the central idea of Keynestheory. The term effective demand shows the total demand for goods and services atvarious levels of employment. It refers to the total expenditure on total outputproduced. The demand at which aggregate demand price and aggregate supplyprice are equal is the effective demand.Accordingly there are two determinants ofeffective demand Aggregate Demand Function (ADF) and Aggregate SupplyFunction (ASF).

3) Aggregate Demand Function The sum total of money expected from sale of outputproduced is the ADF. It is the amount of money which the entrepreneurs expect toget by selling the output produced at a particular level of employment. It is theexpected revenue at a particular level of employment. It is also called as demandprice. With the increase in the level of employment, the revenue expected rises and atlower level employment, it declines. Keynes expressed the ADF as D = f (N) here

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D is the proceeds expected from the employment of N men. ADFis showndiagrammatically as follows

The ADF curve slopes upwards from left to right, because as the level of employmentincreases aggregate demand price also rises.

4) Aggregate Supply Function ASF is the minimum level of revenue expected by theproducers from the sale of output. If the producers do not get this minimum amountof money, they cannot maintain the given level of employment. It shows the cost ofproduction, which is also called as the supply price. The ASF has been expressed byKeynes as Z = f(N) Here Z is aggregate supply price of the output from employmentof N men. ASF is shown in the following diagram

The ASF curve slopes upwards from left to right, which indicates that the ASF riseswith the increase in the level of employment. But when the economy reaches the levelof full employment, the ASF curve becomes parallel to Y axis. At this stage with the

increase in the ASF, it is not possible to provide more employment as there is situationof full employment.

5) Equilibrium According to Keynes theory, the equality between the ADF and ASFdetermines the effective demand. It is the effective demand which determines theequilibrium level of employment, output and income.

The equilibrium in the economy is achieved at underemployment level and not atthe full employment level. The equilibrium condition is one at which prices are equal tocost i.e. no profit and no loss. Same has applied by Keynes in the theory. Theintersection point of ADF (prices) and ASF (cost) is the point of effective demand. Theequilibrium level of output, income and employment is determined at the equilibriumdemand.

6) Schedule and Diagram With the help of following schedule, equilibrium can beshown

Aggregate Demand and Aggregate Supply Schedule

Employment ASF ADF Profit/Loss Effect onIn lakh Rs. Cr. Rs.Cr. Rs. Cr. Employment

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10 1000 1750 750 profit increase20 2000 2500 500 profit increase30 3000 3250 250 profit increase40 4000 4000 no profit/loss equilibrium50 5000 4750 250 loss decrease60 6000 5500 500 loss decrease

From the above schedule it is clear that, from 10 lakh to 30 lakh level ofemployment ADF is greater than ASF and the entrepreneurs enjoy profits. So there istendency to increase the employment. At 40 lakh employment, ASF and ADF areequal and economy obtains equilibrium. At 50 and 60 lakh employment, ASF isgreater than ADF and entrepreneurs suffer losses. So there is tendency to decreaseemployment. Finally equilibrium level of employment is settled at 40 lakh employment,were ASF is equal to ADF.

In the above diagram, ADF is the upward sloping aggregate demand functioncurve and ASF is the upward sloping aggregate supply function curve. ASF is steeperthan ADF because rise in the cost of production (ASF) is faster than rise in prices (ADF).These two curves, ADF and ASF intersect each other at point E, which is the point ofeffective demand (ASF = ADF) It is the equilibrium level of employment as shown by ON.

Criticism on Keynes Theory

1) Keynes theory is based on unrealistic assumptions like perfect competition, closedeconomy, etc.

2) Keynes theory neglects long run analysis as it explains only the short run analysis.3) The concept of effective demand is vague concept which is not easy to determine.4) Keynes theory is not applicable to agriculture, underdeveloped and socialist economy.5) According to critics, there is no direct relationship between effective demand and level

of employment as assumed by Keynes.6) Keynes theory deals more with recovery from depression.7) According to critics, the concept of underfullemployment equilibrium itself is not a

stable equilibrium.8) Keynes has given excess importance to ADF and has neglected ASF by assuming it

as stable.

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C) Shifts in Demand

According to Keynesian Income and Employment Theory,Aggregate DemandFunction (ADF) and Aggregate Supply Function (ASF) are two determinants of effectivedemand. Keynes assumed aggregate supply function remains constant in the short run.He assumed static economic model which neglects the possibility of technological andother changes of dynamic nature. Again he assumed short period analysis during whichprevailing conditions are unlike to change. Therefore, he assumed ASF curve as givenand constant. He concentrated his analysis on the aggregate demand function i.e. ADF.

The aggregate demand schedule shows how much money the community is

expected to spend on the products resulting at various levels of employment. Theaggregate demand schedule is an important factor in the employment theory that is whysometimes this theory is also called as the Theory of Aggregate Demand.

Keynes theory states that, the equilibrium level of employment is determined bythe actual level of aggregate demand with a given aggregate supply function. The greaterthe point of equilibrium, higher will be the employment level. As ASF remains constant, itis the ADF which becomes effective in determining the level of employment. In order toraise the level of employment in the economy, it requires an increase in the effectivedemand by raising the level of aggregate demand. In graphical terms higher the level of

ADF curve, with given ASF curve, the higher will be the level of employment. It is shownin the following diagram

In the diagram, the curve ADF indicates an employment level up to ON at point Eof the effective demand. The curve ADF is at the higher level and shows higher level ofemployment at ON at point E of the effective demand. Thus the diagram shows that thehigher aggregate demand function shows the higher level of employment.

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Chapter No. 5 Consumption and Investment

A) Consumption Function A.P.C., M.P.C.

B) Investment Function, MEC and its Importance.C) Multiplier and Acceleration and its Practical Significance.D) Optimization Techniques for Business.

A) Consumption Function A.P.C., M.P.C.According to Keynesian Income and Employment Theory, it is the effective

demand which determines the level of employment, output and income. AggregateDemand Function (ADF) and Aggregate Supply Function (ASF) are two determinants ofeffective demand. In the short run ASF remains constant so it is the ADF whichdetermines the effective demand. The ADF is determined by the consumption functionand investment function. Thus consumption function is one of the determinant of ADF

which is also known as the propensity to consume.Meaning of Consumption FunctionThe functional relationship between the level of income and the level of

consumption expenditure is known as consumption function. It shows the share orproportion of income spent by the people on consumption. According to Keynes, as thelevel of income increases, the level of consumption expenditure also increases; howeverthe increase in the consumption expenditure is less than the increase in the income.

Consumption expenditure of the economy means the total consumptionexpenditure of the society. It is the sum of all consumption expenditure of all theindividuals and families in the society. Consumption function may be defined as, thefunctional relationship between amount of income and the amount of consumption

expenditure. It can be given as follows C = f (Y)

Here C = Consumption expendituref = Function ofY = Level of income

Numerical ExampleThe consumption function is the schedule of the various amounts of consumption

expenditure corresponding to different levels of income.The concept of consumptionfunction can be explained with the help of numerical example

Consumption Function (in crore Rs.)

Income Level (Y) Consumption (C) Savings (S)00 05 - 525 25 0050 40 1075 50 25100 60 40125 62.5 62.5

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As shown in the schedule, we have different levels of income and different levels ofconsumptions corresponding to the income. At first the consumption expenditureincreases with the increase in the income. Income goes up from Rs.25 crores to Rs.50crores. Consumption expenditure also increases from Rs.25 crores to Rs.40 crores. Withthe increase in income, consumption increases but less than proportionately i.e. in everyround, income increases by Rs.25 crores; but consumption dose not increases in thesame proportion. It lags behind the income because a) with increase in income basic

wants are satisfied b) with the increase in income savings increases to make futureprovision. With increase in income savings increases faster than consumptionexpenditure.

On the basis of consumption schedule, OC consumption curve is drawn. OZ is thezero savings line making 45 angle to OX axis. All the points on OZ line representsconsumption is equal to income (C=Y) and savings are zero. At the point B consumptionis equal to income i.e. Rs.25 crores. After this point, with the increase in the income,consumption also increases but less than proportionately. By joining the points ofconsumption expenditure corresponding to different levels of income OC curve is drawn.OC is consumption curve which lies below OZ curve.

Average Propensity to Consumption ( APC )APC indicates the amount spent on consumption out of given level of income. It is

the level of consumption expenditure to the given level of income. It represents thepercentage share of total income spent on total consumption. It is found by dividingconsumption expenditure by income. Symbolically it can be represented as follows

APC = C / YWhere APC = Average propensity to consume

C = Consumption expenditure &Y = income

Suppose income is Rs.100 crores and consumption expenditure is Rs.60 crores.Thus 60% of income is spent on consumption so APC is 60% or 0.6.

As the income increases, APC decreases, because the proportion of income spenton consumption decreases. In the same way APC increases with the increases in theincome. The importance of the concept APC can be described as 1) It shows the nature and direction of change in the demand for consumption goods.2) It gives the an idea regarding the APS; as APS = 1 APC3) The APC is low in the developed countries, but high in underdeveloped countries.4) The industrial development of the economy depends on the APC and APS.

Marginal Propensity to Consume ( MPC )

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When the income changes, consumption expenditure also changes. MPC is theratio of the change in the consumption expenditure to the change in the income. Itrepresents the percentage share of changed income spent on consumption. Symbolicallyit can be represented as follows

MPC = C / YWhere MPC = Marginal propensity to consume

C = Change in the consumption expenditure

Y = Change in the incomeSuppose income has gone up from Rs.100 crores to rs.150 crores and as a resultconsumption expenditure has gone up from Rs.60 crores to Rs.80 crores. Then MPC canbe calculated as

MPC = C / YMPC = 20 / 50 = 0.4 or 40%

Following are the features of MPC 1) The MPC remains always positive.2) The value of MPC remains between more than zero and less than one.3) With the increase in income, MPC decreases so MPC is more for poor people and

less for rich people.

These two concepts APC and MPC can be explained with the help of followingschedule

APC and MPC Schedule

Income Consumption APC = C/Y MPC = C/ Y(Rs. Crorers) (Rs. Crorers)

Documents

Eco. BBA II.doc