Macroeconomics for Business Bachelor in Finance & Investment Analysis Semester Two Amity University

Dr. Puja Singhal

PREFACE

Economics has proved itself as a basic discipline; its applications have a wide range. New

and newer areas are being discovered where the logic of economic reasoning and the use

of economic tools and techniques come very handy. In particular, the business

applications of economics are so numerous in number and varied in forms, that without a

basic knowledge and understanding of economics, no business, government, nation, any

international body or for that matter any organization, including the NGOs can function

in todays world. There is, thus, a need for basic training in economics followed by

applications in evaluating the rationality and optimality of business decisions taken by

any agent.

The emphasis of this e-book is on relating principles of macroeconomics at the

firm level and help in analyzing national income, consumption, investment , balance of

payments ,monetary and fiscal policy etc.

I am grateful to Amity, Dr.Shipra Maitra and all those who have directly or

indirectly helped me in preparing this course material. I sincerely believe that there is

always scope for improvement. Therefore; I invite suggestions for further enriching the

study material.

Dr. Puja Singhal

Updated Syllabus

MACRO ECONOMICS FOR BUSINESS

Course Code: BFIEN 10201

Course Objective:

This course deals with principles of macroeconomics. The coverage includes

determination of and linkages between major macro economic variables, the level of

output and prices, inflation, unemployment, GDP growth, interest rates and exchange

rates.

Course Contents:

Module I: Introduction

National Income Concepts and aggregates.

Module II: Keynesian theory of income determination

Historical background, Says law, Keynesian theory of income determination, Money & Prices; Wage - cut and employment. Multiplier analysis - Static, Dynamic.

Module III: Theories of Consumption and Investment

Consumption and investment, The absolute income hypothesis, Relative income

Hypothesis, Permanent income hypothesis, Life Cycle hypothesis. Concept of marginal

efficiency of capital and marginal efficiency of investment.

Module IV: Introduction to Money and Interest

Money: Types, Functions, Keynes Liquidity preference theory, Liquidity Trap, IS / LM

model. The anatomy of unemployment and inflation, The Phillips curve.

Module V: Balance of payment and Exchange Rate

Balance of payments, Types of disequilibrium in Balance of payments, Causes, Methods

of correcting disequilibrium, Exchange rate: Types and Theories.

Module VI: Monetary and Fiscal Policy

Monetary policy: objective and instruments, Fiscal policy: objectives and instruments.

Index

Chapter no. Subject Page .

1 Introduction 5-23

2 Keynesian theory of income determination 24-42

3 Theories of Consumption and Investment 43-69

4 Introduction to Money and Interest 70-97

5 Balance of payment and Exchange Rate 98-154

6 Monetary and Fiscal Policy 155-198

Key to End Chapter Quizzes 199

Bibliography 200

Reference Books/ e-booksource /links for reference 201

Chapter-I

Topic: Introduction

Contents:

1.1 What is Macroeconomics?

1.2 Circular flow of income

1.3 National Income Concepts and aggregates

1.4 Methods of measuring National Income

1.5 End Chapter quizzes

1.1 What is Macroeconomics?

According to Gardner Ackley, Macroeconomics concerns the over all dimensions of economic life. More specifically, macroeconomics concerns itself with such variables as aggregate volume of an economy, with the extent to which its resources

are employed, with size of national income, with the general price level.

According to P.A. Samuelson, Macroeconomics is the study of the behaviour of the economy as a whole. It examines the overall level of a nations output, employment, prices and foreign trade.

The central theme that emerges from the above definitions may be explained as

follows. Macroeconomics (from prefix "macr(o)-" meaning "large" + "economics") is a

branch of economics that deals with the performance, structure, and behavior of the

economy of the entire community, either a nation, a region, or the entire world. Along

with microeconomics, macroeconomics is one of the two most general fields in

economics. It is the study of all the aspects, namely the behavior and decision-making, of

entire economies. Macroeconomists study aggregated indicators such as GDP,

unemployment rates, and price indices to understand how the whole economy functions.

Macroeconomists develop models that explain the relationship between such factors as

national income, output, consumption, unemployment, inflation, savings, investment,

international trade and international finance. In contrast, microeconomics is primarily

focused on the actions of individual agents, such as firms and consumers, and how their

behavior determines prices and quantities in specific markets.

While macroeconomics is a broad field of study, there are two areas of research that are

emblematic of the discipline: the attempt to understand the causes and consequences of

short-run fluctuations in national income (the business cycle), and the attempt to

understand the determinants of long-run economic growth (increases in national income).

Macroeconomic models and their forecasts are used by both governments and large

corporations to assist in the development and evaluation of economic policy and business

strategy.

Development of macroeconomic theory

The term "macroeconomics" stems a similar usage of the term "macrosystem" by the

Norwegian economist Ragnar Frisch in 1933 and there was a long existing effort to

understand many of the broad elements of the field. It fused and extended the earlier

study of business fluctuations and monetary economics.

Mark Blaug, a notable historian of economic thought, proclaimed in his "Great

Economists before Keynes: 1986" that Swedish economist Knut Wicksell more or less founded modern macroeconomics.

Macroeconomic schools of thought

The traditional distinction is between three different approaches to economics: Keynesian

economics, focusing on demand; neoclassical economics based on rational expectations

and efficient markets, and innovation economics focused on long-run growth through

innovation. Keynesian thinkers challenge the ability of markets to be completely efficient

generally arguing that prices and wages do not adjust well to economic shocks. None of

the views are typically endorsed to the complete exclusion of the others, but most schools

do emphasize one or the other approach as a theoretical foundation.

Keynesian tradition

Keynesian economics was an academic theory heavily influenced by the economist John

Maynard Keynes. This period focused on aggregate demand to explain levels of

unemployment and the business cycle. That is, business cycle fluctuations should be

reduced through fiscal policy (the government spends more or less depending on the

situation) and monetary policy. Early Keynesian macroeconomics was "activist," calling

for regular use of policy to stabilize the capitalist economy, while some Keynesians

called for the use of incomes policies.

Neo-Keynesians combined Keynes thought with some neoclassical elements in the

neoclassical synthesis. Neo-Keynesianism waned and was replaced by a new generation

of models that made up New Keynesian economics, which developed partly in response

to new classical economics. New Keynesianism strives to provide microeconomic

foundations to Keynesian economics by showing how imperfect markets can justify

demand management.

Post-Keynesian economics represents a dissent from mainstream Keynesian economics,

emphasizing the importance of demand in the long run as well as the short, and the role

of uncertainty, liquidity preference and the historical process in macroeconomics.

Neoclassical tradition

For decades Keynesians and classical economists split in to autonomous areas, the former

studying macroeconomics and the latter studying microeconomics. In the 1970s New

Classical Macroeconomics challenged Keynesians to ground their macroeconomic theory

in microeconomics. The main policy difference in this second stage of macroeconomics

is an increased focus on monetary policy, such as interest rates and money supply. This

school emerged during the 1970s with the Lucas critique. New Classical

Macroeconomics based on rational expectations, which means that choices are made

optimally considering time and uncertainty, and all markets are clearing. New Classical

Macroeconomics is generally based on real business cycle models.

Monetarism, led by Milton Friedman, holds that inflation is always and everywhere a

monetary phenomenon. It rejects fiscal policy because it leads to "crowding out" of the

private sector. Further, it does not wish to combat inflation or deflation by means of

active demand management as in Keynesian economics, but by means of monetary policy

rules, such as keeping the rate of growth of the money supply constant over time.

Macroeconomic policies

In order to try to avoid major economic shocks, such as The Great Depression,

governments make adjustments through policy changes which they hope will succeed in

stabilizing the economy. Governments believe that the success of these adjustments is

necessary to maintain stability and continue growth. This economic management is

achieved through two types of strategies: Fiscal Policy and Monetary Policy

1.2 Circular flow of income

In economics, the term circular flow of income or circular flow refers to a simple

economic model which describes the reciprocal circulation of income between producers

and consumers. In the circular flow model, the inter-dependent entities of producer and

consumer are referred to as "firms" and "households" respectively and provide each other

with factors in order to facilitate the flow of income. Firms provide consumers with

goods and services in exchange for consumer expenditure and "factors of production"

from households.

The circle of money flowing through the economy is as follows: total income is spent

(with the exception of "leakages" such as consumer saving), while that expenditure

allows the sale of goods and services, which in turn allows the payment of income (such

as wages and salaries). Expenditure based on borrowings and existing wealth i.e., "injections" such as fixed investment can add to total spending.

In equilibrium (Preston), leakages equal injections and the circular flow stays the same

size. If injections exceed leakages, the circular flow grows (i.e., there is economic

prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a

recession).

More complete and realistic circular flow models are more complex. They would

explicitly include the roles of government and financial markets, along with imports and

exports.

Labor and other "factors of production are sold on resource markets. These resources, purchased by firms, are then used to produce goods and services. The latter are sold on

product markets, ending up in the hands of the households, helping them to supply

resources.

ASSUMPTIONS

The basic circular flow of income model consists of six assumptions:

1. The economy consists of two sectors: households and firms. 2. Households spend all of their income (Y) on goods and services or consumption

(C). There is no saving (S).

3. All output (O) produced by firms is purchased by households through their expenditure (E).

4. There is no financial sector. 5. There is no government sector. 6. There is no overseas sector

Two sector model

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 the expenditure of buyers (households) becomes income for sellers

(firms). The firms then spend this income on factors of production such as labour, capital

and raw materials, "transferring" their income to the factor owners. The factor owners

spend this income on goods which leads to a circular flow of income.

Three Sector Model

In the real world, we know that there are more 'players' in an economy than simply

households and firms. The '3-sector' model includes the government sector. For the

purposes of the circular flow diagram, governments do two things: they tax businesses

and consumers, and they then spend this money on consumers (benefits and pensions)

and businesses (subsidies). The diagram below includes the government sector.

We now have the following situation: E = C + I + G, Y = C + S + T and Y = E in

equilibrium, so:

Y = E

C + S + T = C + I + G

S + T = I + G (by canceling the Cs)

The situation is a little more complicated now. We have two leakages (saving and

taxation) and two injections (investment and government spending). Now that we have a

situation where actual saving does not necessarily have to equal actual investment. Now,

saving and taxation together have to equal investment and government spending together.

This means that investment can be greater than saving as long as taxation is higher than

government spending (and vice versa).

Four Sector Model

We are still missing something. We have not yet included the foreign sector, or exports

and imports. Notice that in the diagram below, X denotes exports and M denotes imports.

The foreign sector box has been added on the right of the diagram. The line for imports

(M) comes out of the consumption (C) line. This is because it is the consumers who buy

these imports (like German and Japanese cars) which means that money leaks out of the

economy. The injection into the economy is the exports (X). This line rejoins the

consumption line because exports are consumption by foreigners of UK goods and

services.

So, now our equilibrium formula will look like this:

Y = E

C + S + T + M = C + I + G + X

S + T + M = I + G + X (by canceling out the Cs)

S, T and M are the leakages from an economy and I, G and X are the injections into an

economy. The economy will only be in equilibrium if injections equal leakages.

You may have seen in many textbooks the fact that National expenditure, or aggregate

planned expenditure, is equal to C + I + G + X M. The reason why M is included, but not S or T is that imports are a sub-group of consumption (or C). C includes all

consumption by UK consumers, including the consumption of imports as well as home

produced goods. This has to be taken away because it is a leakage. S and T are also

leakages, but are not contained within C, I, G or X. They are separate and not part of

expenditure, so they are not included.

1.3 National Income Concepts and aggregates

National Income and Related Aggregates

National income or national product is defined as the total market value of all the final

goods and services produced This suggests that the labor and capital of a country,

working on the natural resources produces certain net amount of goods and services, the

aggregates of which as known as national income or national product. There are many

concepts of national income which are used by different economists and all of which are

inter-related. These concepts are as follows:

1. Gross National Product at Market Price (GNP mp)

GNP mp refers to the total value of all the final goods and services produced during the

period of one year plus the net factor incomes earned from abroad during the year. The

word gross is used to indicate that the total national product includes in it that part of product which represents depreciation. Depreciation means the wear and tear of the

machinery and other fixed capital during the process of production. GNP includes the

economic activities of all the residents of a nation whether operating within the country

or outside it.

It takes into account the incomes which the residents get from rest of the world and at the

same time it excludes those incomes which arise from the economic activities within the

country but have to pay out to the non-residents operating in the country. GNP being the

monetary measure of all final goods and services produced, is widely used as an index for

judging the performance of an economy

2. Net National Product at Marker Price (NNP mp):

NNP at market price is equal to GNP minus the charges of depreciation and

replacements, where depreciation represents the values of fixed capital consumed during

the process of production.

NNP mp = GNP mp Depreciation

The concept of NNP is important because it gives an estimate of the net increase in the

output of final goods and services.

3. Net National Product at Factor Cost (NNP fc) or National Income:

NNP fc or national income is equal to the sum total of factor incomes received by the

factors of production during the year. It is equal to the sum of rent, wages, interests and

profits in a given year. The sum total of incomes of the factors of production is known as

national income or net national product at factor cost Thus, the national income is equal

to the NNP at mp minus revenue of the government by way of indirect taxes plus

subsidies provided by the government to the business sector.

NNP fc = NNP mp Indirect taxes + Subsidies

(or)

NNP fc = NNP mp net Indirect taxes

The importance of estimating national income lies in the fact that it throws light on the

distribution of income in a society. It helps to see how equitably income is distributed

in the societies. Which tells us whether there are inequalities of income distribution, and

if so, how vast is the inequalities. It is regarded as the fair measure of over all economic

activity of the nation and is therefore, commonly accepted as an index of economic

conditions prevailing in the country.

4. National Income at Current Price and Constant Price:

When the value of goods and services is found out by multiplying the quantity produced

during one year by the prices prevailing in that year, we call it National income at

Current Prices. On the other hand, when the value of goods and services is calculated by

multiplying the quantity during one year with prices of the base year, we call it National

Income at Constant Prices.

Example: (1) q1 is the quantity of final product I in year 1980 and p1 is the price of that

year.

Then, the value of the final product I = q1p1

Similarly, q2 is the quantity of final product II in year 1980 and p2 is the price of that

year.

Then, the value of the final product II = q2p2

If we add up the value of all final goods and services produced, we get National Income

at Current Prices.

So, National Income at Current Price will be: q1p1+q2p2+ .qnpn = NI at Current Prices.

(2) Suppose we want to compare the national income figures of 1980 and 1990, we may

find that the national income in 1990 is higher than that of 1980.

This increase in income may be due to (a) increase in output (b) increase in prices which

may be higher in 1990 than 1980.

To get the exact increase in real income, we need to multiply the quantity of goods

produced in 1990 with the 1980 prices.

This shows: National Income at Constant Prices: Quantity of Current period x

Prices of Base period.

Formula for Real National Income

Money National Income (Current year) x Price Index of Base year ____________________________________________________

Price Index of Current year

5 Private Income

Some of the national income accrues to the government in the form of property income

of government departments and profits of government enterprises. The government also

makes transfer payments to private sector in the form of grants, social security payments,

gifts, etc. The government pays interest on national debt which accrues to the private

sector. Private income is a measure of the income derived from national income by

adding the sum of government transfer payments and interest on national debt and

subtracting the property income of government departments and profits of government

enterprises. Transfer payments result from transactions which do not give rise to the

exchange of commodities or factor services. A payment of money is made without a

corresponding flow of goods and services in the opposite direction. It is the general

practice to consider in national accounts only payments which are in exchange for goods

and services as contributing to output. So transfer payments are not shown in the major

accounts as an addition to total product. The value of transfer payments to households is

included in the income aggregate of private income.

6 Personal Incomes

Personal income is a measure of the actual current income receipt of persons from all

sources. It differs from private income in that it excludes the undistributed profits which

accrue to Private Sector but are not received by persons. It also excludes the expenditure

tax paid to government by the Private Corporate Sector. It is derived from private income

by subtracting the savings of the private corporate sector and the corporation tax.

7 Personal Disposable Income

Even the above subtractions are not sufficient to derive personal income which is actually

available for spending. Disposable personal income is derived from personal income by

subtracting the direct taxes paid by individuals and other compulsory payments made to

the government. It is a measure of amount of the money in the hands of the individuals

and available for their consumption or savings.

Some Accounting Relationships

1 GNP at factor cost +Indirect taxes Depreciation=GNP at market price

2 GNP at market price Depreciation = NNP at market price

3 NNP at market price Indirect taxes + Subsidies=NNP at factor cost

4 NNP at factor cost domestic income accruing to non-residents=NDP at factor cost

5 NDP at factor cost surplus of public undertakings-rentals/profits of statutory corporations -profit tax -income accruing to non-residents

+interest on national debt + Transfer payments=Personal Income

6 Personal income-direct taxes, fees, fines, etc. =Disposable income

1.4 Methods of measuring National Income

The methods of estimating national income of a country depend upon the availability of

proper statistics. This can be viewed from three interrelated angles, such as, in terms of

production, income and expenditure. These three terms are broadly related to GNP, GNI

and GNE respectively. The ideal national income equation shows that National Income

or NI =GNP=GNI=GNE

We know that Income is generated through production process. Normally we use this

income for purchasing goods and services. When demand for commodities goes up, we

have to produce more. Thus income leads to expenditure which again leads to increased

production. See the following figure.

The figure given above shows how production, income and expenditure are mutually

related. Economic activity is directly related to these three stages. Based on this, three

methods are used for calculating national income. They are:

(a) The product method

(b) The income method

(c) The expenditure method

The Product Method

The production method measures national income as the sum of net products produced

by the production units in the given period. Therefore, the production method involves

the following steps:

(i) Identifying the production unit (ii) Estimating their net products (iii) Valuing the goods and services (iv) Estimation of net income from abroad

The next step in the production method is the estimation of net product of each sector.

This comes from the Gross products minus the intermediate products minus the

depreciation during the process of production.

NNP = GNP Intermediate products Depreciation

The total estimates would give us Net Domestic Product at factor cost. The addition of

net income from abroad to this total would give us net national income at factor cost or

National Income.

Limitations of Product Method

a) Problem of Double Counting b) Not applicable for Tertiary Sector c) Exclusion of Non Marketed Product

The Income Method

The income method measures national income as the sum total of factor income shares

accruing to the factor owners.

Factors of Production: Land, Labour, Capital and Organization.

Factor Incomes: Rent , Wage, Interest and Profit.

One can easily aggregate all the factor incomes over a period of time and this aggregate

figure is known as national income at factor cost. There are major additions and

deductions to the national income accounting.

Additions: Income from foreign sectors in the form of rent, profits etc

Deductions: Incomes from all illegal activities: theft, rubbery, smuggling, child labor,

prostitutions etc.

Incomes to the foreign sector acting in domestic sectors.

Comparison between Product method and Income method

NI fc = NI mp Indirect tax + Subsidies. Subsidies

For the sake of convenience, economists suggests that the Product method is for Primary

sector and the Income method is for tertiary sectors

Limitations of Income Method

1) Exclusion of Non Monetary Income 2) Exclusion Of Non Marketed Services

The Expenditure Method

Because of identical relation the GNP=GNI=GNE, the expenditure of one becomes the

income of other. Hence, the GNE is calculated which will be identical with GNI. The

Expenditure in the Economy can be broadly divided into three types, such as,

(1) Consumption Expenditure

(2)Investment Expenditure, and

(3)The pure Govt. Expenditure

Consumption expenditure provides direct satisfaction where as the investment

expenditure is necessary to increase the productivity of the nation. Pure Govt.

expenditure is necessary for maintenance of law and order situation and providing the

infrastructural facilities to the nation. In details, all expenses are again dividing into five

different categories:

(i) Private Consumption Expenditure

(ii) Public Consumption Expenditure

(iii) Private Investment Expenditure

(iv) Public Investment Expenditure

(v) Pure Government Expenditure

Limitations of Expenditure Method

1) Neglects Barter system 2) Ignores Own Consumption 3) Affected by Inflation

Comparison of three Methods-

The product method is very suitable for the primary sector such as agriculture, industries etc.

The income method is appropriate for the tertiary and service sectors.

The Expenditure method is only for the calculation of identical relationship between three methods. It is because we may not get the details of all

expenditure correctly. Neither it is possible nor is it desirable to reveal all types

of expenditure. In fact, the expenditure method is only to complete the identical

relationship i.e. GNP=GNI=GNE=NI

Reconciling the three methods of Measuring National Income

The three methods of measuring national income represent three aspects of the national

income of the country, such as:

(a) National income as an aggregate of net products

(b) National income as an aggregate of factor shares

(c) National income as an aggregate of final expenditure

These represent three ways of looking the national income as:

(i) National income as viewed from the point of view of the production enterprise (ii) As

viewed from the point of view from owners of the primary factors of production, (iii) As

viewed by the purchasers of the final goods and services available in the country during a

period of time.

Difficulties in Estimating National Income

1 ) The first difficulty regarding the concept of national income relates to the treatment of

non-monetary transactions.

Example: Services of Housewife, Services of house- maid.

The services of house-maid are part of national income, but if suppose the master

marries the hose- maid, although she still performs the same services, her contribution to

the national income becomes zero. This is because now these services do not contribute

to the economic activity.

2 ) Second conceptual difficulty arises with regard to the treatment of output produced by

the foreign firms in the country . Should their income form a part of national income of

the country in which they are located? Or, should this income be treated as a part of

national income of the country to which the ownership of the firms belongs? It is

generally agreed that the income of such firm should be taken into account in the national

income of the country in which the firm is located .However, the profit earned by such

firms will be sent to their own country, and hence, would form apart of that countrys income.

3) The national income accounts involve inventory adjustments. The unused stock of the

previous year may be sold in the current year, but the income will be included in the

previous years account. This adjustment is not at all logical and creates problem in the

calculation of national income of the current year.

(4) Another difficulty in national income arises with regard to the Govt. sector .How

should we treat govt. functions like civil administration of maintenance of law and those

regarding the defense of the country? It is difficult to account the wages and salaries paid

the workers who are in service to that.

(5) There are some difficulties which are particular to underdeveloped country-: Barter

System In the underdeveloped countries there is large non monetized sector. A non-

monetized sector refers to that part of economy where output is not bought or sold with

the help of money. Money does not enter into exchange, and hence the value of

commodities is not expressed in terms of money. The problem therefore arises that what

value should be imputed to this art of output which does not enter into monetary

transactions.

(6) In underdeveloped countries, agriculture is the predominant form of economic activity

But the farming being still of subsistence in nature, a considerable amount of production

is consumed by the farmers themselves. This is that part of output which has been

produced in the country, but does not come to the market. How should we estimate such

production? Obviously, again this involves the guess work or imagination of the

satisfaction who is estimating the national income of the country.

(7) Illiteracy: A large majority of people in the underdeveloped countries being illiterate

do not keep any accounts of the actual quantity of goods they have produced. No record

of such transactions is available and the majority of the people do not have any idea about

their income and expenditure. Which again leads the inaccurate estimation of national

income?

(8) More than one Jobs: in the underdeveloped countries, there is no clear-cut

demarcation of the occupations from which people derive their income. Many people are

simultaneously engaged in more than one occupation and thus derive their income from

many source of livelihood

Example: A farmer in Slack season, takes up jobs in industries in some casual jobs like washing and painting etc. Therefore, it becomes difficult to place a worker under

particular occupation.

(9) Inadequate Information: information regarding small agriculturists, household

industries, and other unorganized enterprises is generally not available .Whatever little

information is available is not adequate and reliable to estimate the national income.

(10) Biasness in statistical process: the national income accounting is a statistical process

and it involves huge time, energy and money costs. Because of these inherent difficulties,

an individual investigator may cheat in the process of accounting. He/she may give fake

information/figures only to complete the process of accounting which is very subjective

and can not be checked.

Chapter-I

Topic.Introduction

End Chapter quizzes:

Q.1. The term "macroeconomics" was coined by which economist?

(a) Ragnar Frisch

(b)Alfred Marshall

(c)Samuelson

(d)Chamberlin

Q.2 In economics, the term refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers.

(a)Product flow

(b)Circular flow

(c)Income flow

(d)Expenditure flow

Q.3 The '3-sector' model includes which sector.

(a) Foreign sector

(b)Government Sector

( c)Firms

(d) Household

Q.4 .refers to the total value of all the final goods and services produced

during the period of one year plus the net factor incomes earned from abroad during the year.

(a)GDPmp

(b)NNPmp

( c)GNP mp

(d)NNPfc

Q. 5 Which formula of Net National Product at market price is correct?

(a)NNP mp=GDPmp-Depreciation

(b) NNP mp = GNP mp Depreciation

(c )NNPmp=NNPfc-Depreciation

(d)None

Q. 6 or national income is equal to the sum total of factor incomes

received by the factors of production during the year.

(a)GDPmp

(b)GNPfc

( c) NNP fc

(d)NNPmp

Q.7 When the value of goods and services is found out by multiplying the

quantity produced during one year by the prices prevailing in that year, we call it National income

(a) at Current Prices.

(b) at Constant Prices

( c)Both

(d)None

Q8 Which income is derived from personal income by subtracting the direct

taxes paid by individuals and other compulsory payments made to the

government.

(a)Private income

(b) Disposable personal income

(c)National income

(d)None

Q9 Which method is very suitable for the primary sector such as agriculture,

industries etc.

(a)Expenditure method

(b)Income Method

( c)Product method

(d)All of the above

Q10 Which sector refers to that part of economy where output is not bought

or sold with the help of money.

(a)Primary Sector

(b)Secondary Sector

(c)Tertiary Sector

(d) A non-monetized sector

Chapter-II

Topic: Keynesian theory of income determination

Contents:

1.1 Historical background, Says law

1.2 Keynesian theory of income determination

1.3 Money & Prices; Wage - cut and employment

1.4 Multiplier analysis - Static, Dynamic.

1.5 End Chapter quizzes

1.1 Historical background, Says law

The Classical economist had assumed certain macro aspects of the economy to be given.

They provided deductive logic but little empirical support to their assumptions. Their

assumptions were called by Keynes as postulates of the classical economics. The main postulates of the classical economics are described below.

1 There is always Full Employment: - The classical economists postulated that all

employable resources- labour and capital of a country are always fully employed in the long run. If there is unemployment at any time, then there is a tendency towards full

employment, provided there is no external or government interference with the

functioning of the economy. In the classical view, full employment does not mean all the

resources are fully employed- there might be frictional and voluntary unemployment in

the state of full employment.

2 The economy is always in the state of equilibrium. The classical economists

postulated that an economy is always in the state of equilibrium. They believed that full

employment of resources generate incomes on the one hand, and goods and survives on

the other. The value of goods and services is always equal to incomes. The income

earners spend their entire income. This implies that the entire output of goods and

services is sold out. There is no general overproduction and there is no general

underproduction. According to Keynesian terminology, the aggregate demand is always

equal to aggregate supply in the long run, and the economy remains in stable equilibrium.

The Necessary Condition- The classical postulates of full employment and equilibrium

are based on the assumption that the economy works on the principles of laissez-faire. A

laissez faire system is one in which:

(i) there is complete absence of government control or regulation of private enterprise, except to ensure free competition ;

(ii) there is complete absence of monopolies and restrictive trade practices if there is any, it is eliminated by law;

(iii) there is complete freedom of choice for both the consumers and the producers; (iv) the market forces of demand and supply are fully free to take their own

course.

3 Money does not matter- The classical economists treated money only as a medium of

exchange. In their opinion, the role of money is only to facilitate the transactions. It does

not play any significant role in determining the output and employment. The levels of

output and employment are determined by the availability of real resources, that is labour

and capital.

Say's law, or the law of markets, is an economic proposition attributed to French

businessman and economist Jean-Baptiste Say (17671832), which states that in a free market economy goods and services are produced for exchange with other goods and

services, and in the process a precisely sufficient level of real income is created in order

to purchase the economy's entire output. That is to say, the total supply of goods and

services in a purely free market economy will exactly equal the total demand during any

given time period in modern terms, "there will never be a general glut," though there may be local imbalances, with gluts in one market balanced by shortages in others.

Say's formulation

In Say's language, "products are paid for with products" or "a glut can take place only

when there are too many means of production applied to one kind of product and not

enough to another" Explaining his point at length, he wrote that:

It is worthwhile to remark that a product is no sooner created than it, from that instant,

affords a market for other products to the full extent of its own value. When the producer

has put the finishing hand to his product, he is most anxious to sell it immediately, lest its

value should diminish in his hands. Nor is he less anxious to dispose of the money he

may get for it; for the value of money is also perishable. But the only way of getting rid

of money is in the purchase of some product or other. Thus the mere circumstance of

creation of one product immediately opens a vent for other products.

He also wrote:

It is not the abundance of money but the abundance of other products in general that

facilitates sales... Money performs no more than the role of a conduit in this double

exchange. When the exchanges have been completed, it will be found that one has paid

for products with products.

Assumptions and critiques

In the Keynesian interpretation, the assumptions of Say's law are:

A barter model of money "products are paid for with products;" Flexible prices all prices can rapidly adjust upwards or downwards; No government intervention.

Under these assumptions, Say's law states that there cannot be a general glut, which,

Keynesians conclude, means that there cannot be persisting high unemployment.

Since there have been a great many persisting economic crises historically, one may

either reject one or more of the assumptions of Say's law, its reasoning, or the conclusion.

Taking the assumptions in turn:

Circuitists and some post-Keynesians dispute the barter model of money, arguing

that money is fundamentally different from commodities, and that credit -bubbles

can and do cause depressions. Notably, debt owed does not change because the

economy has changed.

Keynes argued that prices are not flexible for example, workers may not take pay cuts.

Laissez faire economists argue that government intervention is the cause of

economic crises, and that left to its devices, the market will adjust efficiently.

The reasoning of the law itself is considered sound, within its assumptions.

Turning to the implication that dislocations cannot cause persistent unemployment, some

theories of economic cycles accept Say's law, and seek to explain high unemployment in

other ways, considering depressed demand for labor as a form of local dislocation. For

example, Real Business Cycle Theory advocates argue that real shocks cause recessions,

and that the market responds efficiently to these

Interpretation

Say's Law is founded on the notion that commodities are produced simply as a means to

acquire other commodities: consumption is the aim of production. By implication, in

order to obtain a desired commodity, one must first and necessarily produce a commodity

which is itself desirable. Entrepreneurs who produce undesirable commodities, or instead

produce desirable commodities but at unprofitable costs, will fail.

What's more, each desirable commodity produced will be exchanged for a commodity (or

commodities) of equal desirability and value, or nearly so. In essence then, the

fundamental description of exchange in a purely free market economy is that one

particular quantity of value is produced and exchanged for a second, commensurate

quantity of value. This suggests the principle that, across the entire economy, production

provides both the sufficient means and the sufficient ends to purchase itself. In other

words, supply equals demand.

Further, therefore, recession or depression in a purely free market economy -

characterized by a systemic imbalance of supply and demand - can only result from

suddenly massive and widespread entrepreneurial miscalculation regarding which

commodities are desirable and which production methods are efficient. According to Say,

the classical economists, and Austrian economists, such deep and wide entrepreneurial

miscalculation is impossible in a purely free market economy.

Which is not to argue, these economists maintain, that entrepreneurial miscalculation on a

much smaller scale is not possible in a purely free market economy. Due to real world

uncertainty, entrepreneurial miscalculation occurs often, giving frequent rise to

oversupply and undersupply in particular markets. When this occurs, however, relative

prices promptly adjust the exchange ratios between and among commodities to correct

the imbalances. Indeed, according to Austrians, resource scarcity and real world

uncertainty ensure that a central characteristic of a purely free market economy is the

ready and ceaseless adjustment of exchange ratios, as entrepreneurs constantly seek to

utilize the available scarce resources to best satisfy the ever changing demands of the

market.

Thus, an important implication of Say's Law is that recession do not occur because of

inadequate demand or lack of money. According to Say's Law, the production of goods

provides the means for the producers to purchase what is produced, and hence, demand

will grow as supply grows. For this reason, prosperity can be increased by increasing

production, not consumption. Another implication of Say's Law is that the creation of

more money simply results in inflation; more money demanding the same quantity of

goods does not create an increase in real demand.

Following J.M.Keynes, modern Keynesian macroeconomists argue that Say's Law only

applies when prices are fully flexible. In the short run, when prices are not flexible, a

drop in aggregate demand can cause a recession..

Say and the Keynesians are in full agreement on this point - his analysis is valid only for

an economy with fully flexible prices in both the short and long runs.

The central question, therefore, is why in the short run prices and exchange ratios fail to

readily adjust to changing circumstances so that total supply in an economy always

equals total demand. Say, the classical economists, and the Austrians contend that price

rigidities are in all circumstances the result of government interferences. Keynesians, on

the other hand, take as their analytical starting point the empirical fact of price rigidities

and argue thereupon that "capitalism" is congenitally flawed and thus necessarily is

susceptible to recession and depression.

1.2 Keynesian theory of income determination

Keynes's theory of the determination of equilibrium real GDP, employment, and prices

focuses on the relationship between aggregate income and expenditure. Keynes used his

income-expenditure model to argue that the economy's equilibrium level of output or

real GDP may not correspond to the natural level of real GDP. In the income-expenditure

model, the equilibrium level of real GDP is the level of real GDP that is consistent with

the current level of aggregate expenditure. If the current level of aggregate expenditure is

not sufficient to purchase all of the real GDP supplied, output will be cut back until the

level of real GDP is equal to the level of aggregate expenditure. Hence, if the current

level of aggregate expenditure is not sufficient to purchase the natural level of real GDP,

then the equilibrium level of real GDP will lie somewhere below the natural level.

In this situation, the classical theorists believe that prices and wages will fall, reducing

producer costs and increasing the supply of real GDP until it is again equal to the natural

level of real GDP.

Sticky prices. Keynesians, however, believe that prices and wages are not so flexible.

They believe that prices and wages are sticky, especially downward. The stickiness of

prices and wages in the downward direction prevents the economy's resources from being

fully employed and thereby prevents the economy from returning to the natural level of

real GDP. Thus, the Keynesian theory is a rejection of Say's Law and the notion that the

economy is self-regulating.

Keynes's income-expenditure model. Recall that real GDP can be decomposed into four

component parts: aggregate expenditures on consumption, investment, government, and

net exports. The income-expenditure model considers the relationship between these

expenditures and current real national income. Aggregate expenditures on investment, I,

government, G, and net exports, NX, are typically regarded as autonomous or

independent of current income. The exception is aggregate expenditures on consumption.

Keynes argues that aggregate consumption expenditures are determined primarily by

current real national income. He suggests that aggregate consumption expenditures can

be summarized by the equation

where C denotes autonomous consumption expenditure and Y is the level of current real

income, which is equivalent to the value of current real GDP. The marginal propensity

to consume ( mpc), which multiplies Y, is the fraction of a change in real income that is

currently consumed. In most economies, the mpc is quite high, ranging anywhere from

.60 to .95. Note that as the level of Y increases, so too does the level of aggregate

consumption.

Total aggregate expenditure, AE, can be written as the equation

where A denotes total autonomous expenditure, or the sum C + I + G + NX. Different

levels of autonomous expenditure, A, and real national income, Y, correspond to different

levels of aggregate expenditure, AE.

Equilibrium real GDP in the income-expenditure model is found by setting current real

national income, Y, equal to current aggregate expenditure, AE. Algebraically, the

equilibrium condition that Y = AE implies that

where

In words, the equilibrium level of real GDP, Y*, is equal to the level of autonomous

expenditure, A, multiplied by m, the Keynesian multiplier. Because the mpc is the

fraction of a change in real national income that is consumed, it always takes on values

between 0 and 1. Consequently, the Keynesian multiplier, m, is always greater than 1,

implying that equilibrium real GDP, Y*, is always a multiple of autonomous aggregate

expenditure, A, which explains why m is referred to as the Keynesian multiplier.

The determination of equilibrium real national income or GDP using the income-

expenditure approach can be depicted graphically, as in Figure 1. This figure shows three

different aggregate expenditure curves, labeled AE1, AE2, and AE3, which correspond to

three different levels of autonomous expenditure, A1, A2, and A3. The upward slope of

these AE curves is due to the positive value of the mpc. As real national income Y rises,

so does the level of aggregate expenditure. The Keynesian condition for the

determination of equilibrium real GDP is that Y = AE. This equilibrium condition is

denoted in Figure 1 by the diagonal,

Figure 1 The Keynesian income-expenditure approach to equilibrium real GDP, 45 line,

labeled Y = AE.

To find the level of equilibrium real national income or GDP, you simply find the

intersection of the AE curve with the 45 line. The levels of real GDP that correspond to

these intersection points are the equilibrium levels of real GDP, denoted in Figure 1 as Y1,

Y2, and Y3. Note that each AE curve corresponds to a different equilibrium level for Y.

Note also that each Y is a multiple of the level of autonomous aggregate expenditure, A,

as was found in the algebraic determination of the level of equilibrium real GDP.

Graphical illustration of the Keynesian theory. The Keynesian theory of the

determination of equilibrium output and prices makes use of both the income-expenditure

model and the aggregate demand-aggregate supply model, as shown in Figure 2 .

Figure 2 The Keynesian income-expenditure approach and aggregate demand and

supply

Suppose that the economy is initially at the natural level of real GDP that corresponds to

Y1 in Figure 2 . Associated with this level of real GDP is an aggregate expenditure curve,

AE1. Now, suppose that autonomous expenditure declines, from A1 to A3, causing the AE

curve to shift downward from AE1 to AE3. This decline in autonomous expenditure is also

represented by a reduction in aggregate demand from AD1 to AD2. At the same price

level, P1, equilibrium real GDP has fallen from Y1 to Y3. However, the intersection of the

SAS and AD2 curves is at the lower price level, P2, implying that the price level falls. The

fall in the price level means that the aggregate expenditure curve will not fall all the way

to AE3 but will instead fall only to AE2. Therefore, the new level of equilibrium real GDP

is at Y2, which lies below the natural level, Y1.

Keynes argues that prices will not fall further below P2 because workers and other

resources will resist any reduction in their wages, and this resistance will prevent

suppliers from increasing their supplies. Hence, the SAS curve will not shift to the right as

in the classical theory and the economy will remain at Y2, where some of the economy's

workers and resources are unemployed. Because these unemployed workers and

resources earn no income, they cannot purchase goods and services. Consequently, the

aggregate expenditure curve remains stuck at AE2, preventing the economy from

achieving the natural level of real GDP. Figure 2 therefore illustrates the Keynesians'

rejection of Say's Law, price level flexibility, and the notion of a self-regulating economy

1.3 Money & Prices; Wage - cut and employment

Keynes explained the level of output and employment in the economy as being

determined by aggregate demand or effective demand. In a reversal of Says law, Keynes in essence argued that "demand creates its own supply," up to the limit set by full

employment.

In "classical" economic theory -- Keynes's term for the economics prior to General

Theory (and specifically that of Arthur Pigou) -- adjustments in prices would

automatically make demand tend to the full employment level. Keynes, pointing to the

sharp fall in employment and output in the early 1930s, argued that whatever the theory,

this self-correcting process had not happened.

In the classical theory, the two main costs are those of labor and money. If there was

more labor than demand for it, wages would fall until hiring began again. If there was too

much saving, and not enough consumption, then interest rates would fall until either

people cut saving or started borrowing. These two price adjustments would always

enforce Say's Law, and therefore the economy would be at the optimal level of output.

During the Great Depression, the classical theory defined economic collapse as simply a

lost incentive to produce. Mass unemployment was caused only by high and rigid real

wages.

To Keynes, the determination of wages is more complicated. First, he argued that it is not

real but nominal wages that are set in negotiations between employers and workers, as

opposed to a barter relationship. Second, nominal wage cuts would be difficult to put into

effect because of laws and wage contracts. Even classical economists admitted that these

exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term

contracts, increasing labor-market flexibility. However, to Keynes, people will resist

nominal wage reductions, even without unions, until they see other wages falling and a

general fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wages

would have to fall more than prices. However, doing so would reduce consumer demand,

so that the aggregate demand for goods would drop. This would in turn reduce business

sales revenues and expected profits. Investment in new plants and equipmentperhaps already discouraged by previous excesseswould then become more risky, less likely. Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This

could make the economy spiral downward as those who had money would simply wait as

falling prices made it more valuablerather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can

make a depression deeper as falling prices and wages made pre-existing nominal debts

more valuable in real terms

1.4 Multiplier analysis - Static, Dynamic

The concept of multiplier was first developed by F.A.Kahn in the early 1930s. The

concept was later refined by Keynes. F.A.Kahn developed the concept of multiplier with

reference to the increase in employment, direct as well as indirect, as a result of initial

increase in investment and employment. Later on Keynes propounded the concept of

multiplier with reference to the increase in total income, direct as well as indirect, as a

result of original increase in investment and income

Kahns Multiplier is known as Employment Multiplier and Keynes multiplier is known as Investment or Income multiplier. The Value of Multiplier or k =1/1-MPC

Assumptions of Multiplier Effect

The marginal propensity to consume remains constant throughout as the income increases.

There is a net increase in investment over the preceding year.

There is no any time-lag between the increase in investment and the resultant increment in income.

Excess capacity exists in the consumer good industries.

The Multiplier Equation Derivation

We know the value of national output equals aggregate spending. Thus we have,

Y = C+I

Let us now suppose that investment increases by I. This will result in an increase in aggregate consumption expenditure and real national income.

Hence, any change in income Y is always equal to (Y) = C + I

Dividing both sides by y, we get:

1 = C / Y + I / Y

1 - C / Y = I / Y

since C / y is the MPC and I / y is reverse of multiplier.

We have 1/ multiplier = 1- MPC

Which yields the following result :

Multiplier = 1 / 1- MPC.

A Numerical Example of the Multiplier Model

The multiplier model presented above may be illustrated with a numerical example.

Q Suppose the multiplier for two sector economy is computed to be 4. Derive the

following.

(a) the saving function

(b) the consumption function

Solution-

Multiplier (m)=4

Formula of m m=1/(1-mpc)

By putting the value of m in above formula

4=1/(1-mpc)

Assuming mpc=b, mps=1-b

(a) Saving function: S=-a +(1-b)Y

=-a+(1-0.75)Y

Or =-a+0.25Y

(b) Consumption function=a+by

=a+0.75Y

The multiplier process

An initial change in aggregate demand can have a much greater final impact on the level

of equilibrium national income. This is commonly known as the multiplier effect and it

comes about because injections of demand into the circular flow of income stimulate

further rounds of spending in other words one persons spending is anothers income and this can lead to a much bigger effect on equilibrium output and employment.

Consider a 300 million increase in business capital investment for example created when an overseas company decides to build a new production plant in the UK. This will

set off a chain reaction of increases in expenditures. Firms who produce the capital goods

that are purchased will experience an increase in their incomes and profits. If they in turn,

collectively spend about 3/5 of that additional income, then 180m will be added to the

incomes of others.

At this point, total income has grown by (300m + (0.6 x 300m).

The sum will continue to increase as the producers of the additional goods and services

realize an increase in their incomes, of which they in turn spend 60% on even more goods

and services.

The increase in total income will then be (300m + (0.6 x 300m) + (0.6 x 180m).

The process can continue indefinitely. But each time, the additional rise in spending and

income is a fraction of the previous addition to the circular flow.

Multiplier effects can be seen when new investment and jobs are attracted into a

particular town, city or region. The final increase in output and employment can be far

greater than the initial injection of demand because of the inter-relationships within the

circular flow.

The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the 1930s when John

Maynard Keynes suggested it as a tool to help governments to achieve full employment.

This macroeconomic demand-management approach, designed to help overcome a shortage of business capital investment, measured the amount of government spending

needed to reach a level of national income that would prevent unemployment.

The higher is the propensity to consume domestically produced goods and services, the

greater is the multiplier effect. The government can influence the size of the multiplier

through changes in direct taxes. For example, a cut in the basic rate of income tax will

increase the amount of extra income that can be spent on further goods and services.

Another factor affecting the size of the multiplier effect is the propensity to purchase

imports. If, out of extra income, people spend money on imports, this demand is not

passed on in the form of extra spending on domestically produced output. It leaks away

from the circular flow of income and spending.

The multiplier process also requires that there is sufficient spare capacity in the

economy for extra output to be produced. If short-run aggregate supply is inelastic, the

full multiplier effect is unlikely to occur, because increases in AD will lead to higher

prices rather than a full increase in real national output. In contrast, when SRAS is

perfectly elastic a rise in aggregate demand causes a large increase in national output.

The construction boom and multiplier effects

A study has found that the British construction sector alone has driven a fifth of UK GDP

growth in the past year and 34% of net job creation in the past two years. The

construction boom has been caused by the combination of large projects like Terminal 5,

the Channel Tunnel Rail Link, Wembley Stadium and the Scottish Parliament with a

revival in house building, heavy expenditure by the public sector on new schools and

hospitals and a surge in home improvement expenditure.

The study provides compelling evidence on the multiplier effects of major capital

investment projects. 'One characteristic of construction activity is that it feeds through to

many other related businesses. It has "backward linkages" into the likes of building

materials; steel, architectural services, legal services and insurance, and most of these

linkages tend to result in jobs close to home. This makes a boom in construction

peculiarly powerful in fuelling expansion in the economy - for a given lift in building

orders, the multiplier effect may be well over two. This means that every building job

created will generate at least two others in related areas and in downstream activities such

as retailing, which benefits when building workers spend their wages. Other industries,

particularly those where much of the output value comes in the form of imported

components, might have a multiplier of less than 1.5 for new projects'.

Static Multiplier

Static Multiplier is also known by names viz. comparative static multiplier , simultaneous multiplier , logical multiplier , timeless multiplier , lagless multiplier .

It implies that change in investment causes in income instantaneously. It means that there is no time lag between the change in investment and change in income.

The moment a Rupee is spent on investment project, societys income increases by a multiple of Re 1.

K=1/1-MPC

Dynamic Multiplier

The change in the income as a result of change in investment is not instantaneous. There is a gradual process by which income changes as a result of change in

investment. The process of change in income involves a time-lag.

Since Multiplier process works through the process of income generation and consumption ,the time lag involved is the gap between the change in income and

the change in consumption at different stages

The Dynamic Multiplier is essentially stage by stage computation of the change in income resulting from the change in investment till the full effect of the

multiplier is realised.

LIMITATIONS OF MULTIPLIER:

On theoretical plane, the multiplier principle seems to be very attractive, but in actual

practice things may not materialise as desired. Its working is subject to several

limitations.

(i) Efficiency of Production: If the production system of the country can not cope with

increased demand for consumption goods and make them readily available, the incomes

generated will not be spend as visualised. As a result the marginal propensity to consume

may decline.

(ii) Regular Investment: The value of the multiplier will also depend on regularly

repeated investments. A steadily increasing investment is essential to maintain the tempo

of economic activity.

(iii) Multiplier Period: Successive doses of investment must be ignored be injected at

suitable intervals if the multiplier effect is not be lost.

dellHighlight

(iv) Full employment ceiling: As soon as full employment of the idle resources is

achieved, further beneficial effect of multiplier will practically cease.

LEAKAGES OF THE MULTIPLIER:

The following are the principal leakages of the multiplier.

(i) Paying off Debts: It generally happens that a person has to pay a debt to a bank or to

another person. A part of this income goes out in repaying such debts and is not utilized

either in consumption or in productive activity. Income used to pay off debts disappears

from the income stream. If, however, the creditor uses this amount in buying consumer

goods or in some productive activity, then this sum will generate some income, otherwise

not.

(ii) Idle Cash Balances: It is well known that people keep with them ready cash which is

neither used productivity nor in purchasing consumer goods. Keynes has mentioned three

motives for holding ready cash for liquidity preferences viz transaction motive,

precautionary motive and speculative motive. This means that the resent part of income

goes on decreasing. In this way, a part of the initial expenditure leaks out of the income

stream. The cash may be kept in current account for saving account. But it is kept away

from the expenditure all right, it would have otherwise added, to the future income.

(iii) Purchase of old Stocks and Securities: If a part of the increased income is used in

buying old stock and securities instead of consumer goods, the consumption expenditure

will fall and its cumulative effect on income will be less than before.

(iv) Price Inflation: When increased income investment leads to price inflation the

multiplier effect on increased income may be dissipated on higher price.

(v) Net Imports: If increased income is spent on the purchase of imported goods it acts as

leakage out of the domestic income stream. Such expenditure fails to affect the

consumption of domestic goods.

(vi) Undistributed Profits: If undistributed profit of joint stock companies not distributed

to share holders in the form of dividend but are kept in reserved fund it is a leakage from

income stream and the multiplier process will be arrested.

Applicability of Multiplier Theory to LDC

According to the multiplier theory, the higher the MPC, the higher the rate of multiplier.

It is equally true that the lower the income, the higher the MPC. The World Bank

Development Reports show that the less developed countries (LDCs) have a lower per

capita income and lower rate of saving and investment compared to the developed

countries (DCs). The lower rate of saving indicate that LDCs have a relatively higher

MPC. This implies that multiplier must be higher in LDCthan in developed countries

(DCs). And therefore a given amount of autonomous investment should result in a much

higher employment and output in LDCs than in DCs. It follows that the rate of economic

growth resulting from additional investment must be much higher in the LDCs than in

DCs. But that is not true: the multiplier and the rate of growth are both lower in LDcs

compared to those in Dcs. This creates a paradoxical situation which is called Keynes MPC and the multiplier paradox. It is, therefore, generally agreed that the logic of Keynesian multiplier does not apply to the LDCs. The reason for non-applicability of the

multiplier theory to the LDCs is that the assumptions and conditions under which Keynes

had formulated his theories do not hold for the LDCs. Keynes had had developed his

theories in the background of the Great Depression during the early 1930s.The Great

Depression had affected mostly the developed countries, that is, the countries which had

grown beyond the stage of, what Rostow called, take-off. Besides, Keynesian theory of multiplier assumes: (i) a high level of industrial development (ii) involuntary

unemployment (iii) existence of excess capacity, and (iv) elastic supply curves. It is

widely known fact that most of these assumptions do not hold in the LDCs.

Chapter-II

Topic- Keynesian theory of income determination

End Chapter quizzes :

Q.1. Supply creates its own demand was given by which economist?

(a) J.B. Say

(b)Keynes

(c)Fisher

(d)Robinson

Q.2 What is the formula of Aggregate Consumption?

(a)Aggregate Consumption=C+mps

(b) Aggregate Consumption=C+mpc(Y)

(c)Aggregate Consumption=C+I

(d)Aggregate Consumption=C+S

Q.3 The concept of multiplier was first developed by

(a) F.A.Kahn

(b)Keynes

( c)Fisher

(d) None of the above

Q.4 Keynes multiplier is known as

(a) Fiscal Multiplier

(b)Accelerator

( c)Investment Multiplier

(d)Employment Multiplier

Q. 5 Static Multiplier is also known by name-

(a) Comparative static multiplier

(b) Simultaneous multiplier

(c ) logical multiplier

(d)All of the above

Q. 6 To boost employment, real wages had to go down who gave this concept

(a)Classical economist

(b)J.B.Say

( c) Keynes

(d)None

Q.7 The Value of Multiplier is

(a) k =1/1-MPC

(b)k=1-MPC/1

( c) k=1/1-MPS

(d)k=1-MPS/1

Q8 Who gave the concept of Employment Multiplier

(a)J.B.Say

(b) Keynes

(c)Kahn

(d)Samuelson

Q9 is essentially stage by stage computation of the change in income resulting from the change in investment till the full effect of the

multiplier is realised

(a)Employment multiplier

(b)Income Multiplier

( c) Dynamic Multiplier

(d)All of the above

Q10 Who postulated that an economy is always in the state of equilibrium

(a)Keynes

(b) Classical economists

(c)Pigou

(d) Fisher

Chapter-III

Topic: Theories of Consumption and Investment

Contents:

1.1 Consumption and investment

1.2 The absolute income hypothesis

1.3 Relative income Hypothesis

1.4 Permanent income hypothesis

1.5 Life Cycle hypothesis

1.6 Concept of marginal efficiency of capital

1.7 Marginal efficiency of investment.

1.8 End Chapter quizzes

1.1 Consumption and investment

Consumption

Consumption is the value of goods and services bought by people. Individual buying acts

are aggregated over time and space. Consumption is normally the largest GDP

component. Many persons judge the economic performance of their country mainly in

terms of consumption level and dynamics

Composition

First, consumption may be divided according to the durability of the purchased objects.

In this vein, a broad classification separates durable goods (as cars and television sets)

from non-durable goods (as food) and from services (as restaurant expenditure). These

three categories often show different paths of growth.

Second, consumption is divided according to the needs it satisfies. A commonly used

classification identifies ten chapters of expenditure:

People in different position in respect to income have systematically different structures

of consumption. The rich spend more for each chapter in absolute terms, but they

spend a lower percentage in income for food and other basic needs. The percentage

values of an aggregation over all the households in a country can thus be used for

judging income distribution and the development level of the society.

The rich have both higher levels of consumption and savings. In differentiated product

markets, the rich can usually buy better goods than the poor. This happens also because

they tend to use different decision making rules. In other words, consumption depends on

social groups and their behaviours, as well as their proneness to advertising.

Third, for exactness' sake, one should distinguish "consumption" as use of goods and

services from "consumption expenditure" as buying acts. For durable goods this

difference may be relevant, since they are used for long time periods.

1. Food

2. Clothing and foot wear

3. Housing

4. Heating and energy

5. Health

6. Transport

7. House furniture and appliances

8. Communication

9. Culture and schooling

10. Entertainment

Fourth, only newly produced goods enter into the definition of consumption, whereas the

purchase of, say, an old house is not considered consumption, since it was already

counted in the GDP of the year in which it was built.

Determinants

Current income is the most relevant determinant of consumption. Income comes from

labour (employment and wages), capital (e.g. profits leading to dividends, rents, etc.),

remittances from abroad.

Cumulated savings in the past can be squeezed in case of necessity and give rise to a

jump in consumption, similarly with what happens with wealth increase, due for

instance to stock exchange boom or house prices boom.

Expectations on future income, especially if concerning short-term credible events, may

also play an important role.

At household level, there are many possible rules set to control monthly, weekly or even

daily consumption expenditure. They relate not only to income but also to the following

factors among others:

1. General lifestyles, in particular attitudes toward savings or consumption as "values" in

itself;

2. A standard level of consumption the family tries to maintain over time;

3. Decisions regarding active saving strategies, like an investment scheme for pension

aims.

4. The relative success of past investment in shares or other financial instruments; in fact,

a stock-exchange boom is likely to promote a euphoria tide with growing consumption.

5. opportunities of consumer credit, depending in turn by interest rates and marketing

strategies by banks and special consumer credit institutions;

6. Past decisions on durables. For instance, a family having bought a car will reduce

expenditure on public transport in favour e.g. of fuel;

7 Status symbols diffusion - "social musts" - that can be favoured by a pro-diffusion of innovation tax.

8. New employment perspectives, also as far as the corresponding investments in

human and physical capital are concerned;

9. Innovative sale proposals in terms of both new products and new services, effectively

advertised

10. Temporary money (cash) excess.

According to age of the decision-maker, individual and household consumption varies,

both in values and composition. Thus, aggregate consumption may be influenced by

demographic factors, such as an older and older population, even though one should not

rely too much on these relationships since demographic variables are extremely slow

in changes, whereas consumption clearly reacts to economic climate.

Other things equal, a higher price level (inflation) reduces the real current income, thus

real consumption.

Impact on other variables

A GDP component as it is, consumption has an immediate impact on it. An increase of

consumption raises GDP by the same amount, other things equal. Moreover, since

current income (GDP) is an important determinant of consumption, the increase of

income will be followed by a further rise in consumption: a positive feedback loop has

been triggered between consumption and income

An autonomous increase of consumption, if at the same level of income, would reduce

savings, but the positive loop just described (known as the "Keynesian multiplier") will

imply an increase of income level with a positive impact on future savings.

If directed to goods and services produced abroad, an increase of consumption will

immediately push up imports, while a similar indirect effect will result from consuming

domestic products requiring foreign raw materials, energy, semi-manufactured goods.

Since usually the States separately tax consumption (say with a VAT tax), an increase of

consumption will also boost this type of State revenue, as well as import duties revenue

in the case of imported goods. The growth mechanism of consumption-income will also

provide State revenue through income taxes.

To the extent firms decide to invest forecasting future demand and comparing it with

present production capacity, an increase of consumption may induce new investment. In

particular

1. Soaring consumption raises the production capacity utilization, with positive effects on

profits

2. It improves expectations on future demand;

3. It improves the financial conditions for funding investment both through profits and

loans.

If exports are a second-best solution for domestic firm, an increase of domestic

consumption might decrease export, since at the same level of production firms would

prefer to sell inside the country.

An increased demand may also induce firms to increase prices, the more so when they

operate at full production capacity or they operate on monopolized markets. Thus

increased price level and accelerated inflation can be an effect of booming consumption.

Consumption can lead to CO2 emissions in the atmosphere, thus contributing to climate

change.

Long-term trends

In Western countries, consumption has always grown in the last 50 years, except in few

deep recessions. Its growth is smoother than investment's rise or net exports' growth. In

particular, services have always systematically grown at a fairly steady pace, non-

durables have often mirrored the business cycle and durables have often over-shot the

fluctuations in GDP.

Sustainable lifestyles, based on satisfaction of basic needs, green consumer goods,

dematerialisation, and carbon footprint off-setting, will be more and more relevant in the

future.

Business cycle behaviour

As the main component of GDP, it is pro-cyclical almost by definition: any large fall in

consumption would reduce GDP. Consumption has a smoother dynamics than GDP.

During a recovery, it sustains and stabilises the trend. Durable goods are particularly

cyclical and they may peak shortly before GDP.

Consumption Function

The consumption function is the starting point in the Keynesian economics analysis of

equilibrium output determination. It captures the fundamental psychological law put forth

by John Maynard Keynes that consumption expenditures by the household sector depend

on income and than only a portion of additional income is used for consumption.

This function is presented either as a mathematical equation, most often as a simple linear

equation, or as the graphical consumption line. In either form, consumption is measured

by consumption expenditures and income is measured as disposable income, national

income, or occasionally gross domestic product.

The primary purpose of the consumption function the basic consumption-income relation

for the household sector, which is the foundation of the aggregate expenditures line used

in Keynesian economics.

The consumption function makes it easy to divide consumption into two basic types.

Autonomous consumption is the intercept term. Induced consumption is the slope. Of no

small importance, the slope of the consumption function is also the marginal propensity

to consume (MPC).

First, the Equation

The consumption function can represent in a general form as:

C = f(Y)

where: C is consumption expenditures, Y is income (national or disposable), and f is the

notation for a generic, unspecified functional form.

Depending on the analysis, the actual functional form of the equation can be linear, with

a constant slope, or curvilinear, with a changing slope. The most common form is linear,

such as the one presented here:

C = a + bY

where: C is consumption expenditures, Y is income (national or disposable), a is the

intercept, and b is the slope.

The two key parameters that characterize the consumption function are slope and

intercept.

Slope: The slope of the consumption function (b) measures the change in

consumption resulting from a change in income. If income changes by $1, then

consumption changes by $b. This slope is generally assumed and empirically

documented to be greater than zero, but less than one (0 < b < 1). It is

conceptually identified as induced consumption and the marginal propensity to

consume (MPC).

Intercept: The intercept of the consumption function (a) measures the amount of

consumption undertaken if income is zero. If income is zero, then consumption is

$a. The intercept is generally assumed and empirically documented to be positive

(0 < a). It is conceptually identified as autonomous consumption

The Graph

The consumption function is also commonly presented as a diagram or consumption line,

such as the one presented in the exhibit to the right. This line, labeled C in the exhibit is

positively sloped, indicating that greater levels of income generate greater consumption

expenditures by the household sector. The specific consumption function illustrated in

this exhibit is:

C = 1 + 0.75Y

For reference, a black 45-degree line is also presented in this exhibit. Because this line

has a slope of one, it indicates the relative slope of the consumption line.

The two primary characteristics of the consumption function--slope and intercept--also

can be identified with the consumption line.

Slope: The slope of the consumption line presented here is positive, but less than

one. In this case the slope is equal to 0.75. Click the [Slope] button to highlight.

Intercept: The consumption line intersects the vertical axis at a positive value of

$1 trillion. Click the [Intercept] button to highlight.

And Other Factors

The consumption function captures the relation between consumption and income.

However, income is not the only factor influencing consumption.

C = f(Y, OF)

where: C is consumption expenditures, Y is income (national or disposable), and now OF

is specified as other factors affecting consumption. These other factors, officially referred

to as consumption expenditures determinants, include a range of influences. Some of the

more notable consumption determinants are consumer confidence, interest rates, and

wealth.

Consumer confidence is the general optimism or pessimism the household sector has

about the state of the economy. More optimism means more consumption. Interest rates

affect the cost of borrowing the funds used to purchase durable goods. Higher interest

rates mean less consumption. Wealth is the financial and physical assets owned by the

household sector. More financial wealth means more consumption, while more physical

assets mean less consumption.

These determinants cause consumption expenditures to change even though income does

not change. Or another way of stating this, determinants cause consumption expenditures

to change at every level of income. For a linear consumption function, this change is

reflected by a change in the intercept term (a). For a consumption line, the change is seen

as an upward or downward shift.

Investment

Investment is the active redirection of resources/assets to creating benefits in the future;

the use of resources/assets to earn income or profit in the future. It is related to saving or

deferring consumption Investment is involved in many areas of the economy, such as

business management and finance no matter for households, firms, or governments. An

investme