Unit - I: Nature and Scope of Macro Economic Issues

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ECONOMIC FOUNDATION OF BUSINESS ENVIRONMENT
UNIT - I
NATURE AND SCOPE OF MACRO ECONOMIC ISSUES
1.1
INTRODUCTION Any business that wants to prosper and survive has to understand that it is not operating in an isolated environment, and hence should analyze the internal and external environment in which it is operating and take appropriate decisions. One of the important environmental factors that affect any business is the economic environment in which the business is operating. Hence, as a management student, you need to understand the economic variables that shape the economic environment. The businesses should be concerned both about the microenvironment which consists of the firm, the market and the competitors and the macro environment. This course aims at providing you with an understanding of the important issues in macroeconomics that affect the overall performance of an economy, which in turn decides the individual business performance. Macroeconomics as a subject really emerged in the 1930s as a panacea for the Great Depression when there was a complete collapse of business, and unemployment rates rose to historically high levels. The theoretical framework for much of macroeconomics and the major policy debates, which continue even today, emerged at that time. John Maynard Keynes founded the science of macroeconomics when he tried to understand the economic mechanisms that produced the Great Depression.
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Macroeconomics is the study of the economy at the aggregate level. It goes beyond understanding the behaviour of individual economic units and the determination of prices in particular markets, which is the subject of microeconomics. It tries to understand the activities of households and business as a group in addition to the behavior and role of local and national governments. To study macroeconomics we must begin with a solid understanding of the individual behavior of these households, business firms, and government entities such that there is consistency with behavior in aggregate. In particular, it focuses on the interaction of the goods, labour, and assets market in the economy and tries to explain how economic behaviour and policies affect the overall functioning of these markets. It also studies the subsequent impact of these interactions on variables such as output, employment, wages, prices, money supply, interest rates, inflation, the budget, debt, balance of payment, and exchange rates. In order to analyze such a wide range of issues at the aggregate level, macroeconomics offers theoretical frameworks and models to abstract from and simplify many of the facts and key relationships that describe the economy. One of the important macroeconomic tools that helps in explaining the major trends in output and prices is the aggregate demand and supply analysis. Thus, to start with, in this unit we will discuss how the field of macroeconomics developed, the important concerns of the subject, and some of the important macroeconomic variables and their relationship, giving greater importance to the measurement of national income. 1.2 Learning objectives This unit aims at providing an understanding of
Overview of macroeconomics How the various macro economic variables affect an economy using aggregate demand and supply analysis. How to measure national income Define GDP, GNP and NNP
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Understand the three methods of calculating national income Distinguish correctly between nominal and real values Understand and calculate implicit price deflators Understand the nature and scope of planning and how India uses planning for its economic growth
1.3 Overview of Macroeconomics

Economics is a social science that studies how different societies allocate scarce resources to meet the unlimited wants and needs of its members. It studies how societies distribute these scarce resources among different people so that they are used efficiently to produce valuable commodities. The resources are considered scarce because they are available only in limited quantities compared to human desires, which are unlimited. Given the limited resources and unlimited wants of human being, making the best use of these scarce resources is highly important for any society. An economy is producing efficiently when it cannot make anyone economically better off without making someone else worse off. Since economics is concerned with the human desire and potential to produce, which varies among various members of the society, it studies the human social behavior - behavior of individuals and interaction among these individuals. The term originates from two Greek words oikon and nomos, which means laws of household. This field of study might also be considered as the science of human progress; that is, how choices are made such that living standards of individual human beings improve. Improvement in living standards includes: lower infant mortality, the provision of basic and essential health care, appropriate shelter and infrastructure, and meeting basic physiological needs of every human being. It may also include developing political and social systems that celebrate human initiative, creativity and spirit. The essence of economics is to find out how to organize society in a way that will lead to most efficient use of resource. Economists have adopted
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different approaches to analyze various economic problems. One useful approach is through study of the ways in which the production is managed to produce goods and services. If we take this approach to understand economics, then we need to understand technology, how to create it and how to efficiently use it. Since the production system is not the only system that affects the economic system, we also need to acknowledge the political system that exists and its potential to influence the problem of distribution. Thus, an economic system must cater to the physical needs of human beings and satisfy their wants and desires that provide much of the incentive for human progress. Macroeconomics is a subject that tries to address some of the big questions like why do some countries enjoy a standard of living many times greater than others? Why do some countries grow at a very fast rate while others have stagnated growth? What impact does the change in oil prices have upon the economy? What impact does the political decisions made by the government have on the economy? These questions force us to examine key economic issues such as investment levels, infrastructure development, improvements in education and technological growth. Understanding these issues is important since we need to prioritize and choose economic action that will bring prosperity. The study of macroeconomics helps us to interpret the past, comprehend the present and predict the future. When we look at the macroeconomy, we look at the sum of all individual production and consumption choices. Since production is constrained on the aggregate by the scarcity of resources, macroeconomics is the study of trade offs in the allocation and use of resources within and across different time periods. We can think of macroeconomics as an investigation of the economys production and consumption possibility frontier, of the factors that determine the position and shape of this frontier, and the process by which particular point is chosen in this frontier.
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Production possibility frontier is the alternative combination of final goods and services that can be produced in a given time period or across time periods with available resources and technology. The production possibility frontier shown in figure 1.1 tells us what are the various combinations of goods and services possible with the given resources of a country.
Luxury goods and services (car, )
Essential goods and services (food, .)
Figure 1.1 Production possibility frontier
To understand the production possibility frontier, let us consider the case of an island economy which produces only two goods, milk and rice. In a given period of time, the islanders may choose to produce either only milk or only rice or a combination of the two according to the following table.
Milk Rice
(thousands of bottles) (thousands of tons)

0 5 9 12 14 15 15 14 16 9 5 0
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When we plot the above data in a graph we will get the production possibility frontier for the island as in figure 1.2.
Fig. 1. 2 Sample PPF curve
The PPF shows all efficient combination of output for this island economy when the factors of production are fully utilized. Thus the curve shows the maximum production possible by the economy. The economy can choose to operate anywhere on the curve or inside the area of the curve. Economic growth, productivity, employment and availability of resources, efficiency, relative and absolute prices, investment and consumption decisions, and state of technology, which are all important subjects for analysis in macroeconomics, affect the nature of this frontier and where society lies on this frontier in a static and dynamic sense. Thus macroeconomics is really an analysis of how this frontier and the equilibrium point on this frontier are determined and evolve due to interaction of the product, factor, and assets markets, policies and exogenous factor. In this course we will discuss these markets in detail. 1.3.1 Goals of Macroeconomics Macroeconomics helps us to understand the different forces that shape our economy, how the economys performance can be improved, and how economic outcomes can be affected. By providing us with this understanding, it helps us to forecast the future of the economy, what is likely to happen to various macroeconomic variables including prices, demand, income and employment. There are five major goals in macroeconomics, which are:
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1. Full employment 2. Price Stability 3. Efficiency 4. Economic growth 5. Equity We can also consider many other goals, but these goals broadly encompass an entire spectrum of issues t hat are st udied in macroeconomics. Many of these goal complement or conflict with each other. For instance the goalsof stable prices tends to encourage efficient resource allocation whereas the goals of low unemployment may come at the cost of higher inflation. Thus prioritizing is important when pursuing various goals of macroeconomics. 1.4 Schools of Thought There are two distinct schools of thought, the classical or monetarist school and the Keynesian/activist school. The classical/ monetarist view is that markets are efficient and laissez-faire (market that takes care of itself) is the best means of achieving desired outcomes. Government intervention in the economy only creates distortions and inefficiencies. Any disequilibrium is temporary or created by government intervention. Proponents of the Keynesian school of thought on the other hand, believe that there are inherent rigidities and inefficiencies in the market system which prevent the economy from reaching a desirable equilibrium position. Modern versions of the classical and Keynesian schools are represented by the new classical / neo-monetarist and new Keynesian schools of thought. These schools of thought retain their basic differences in ideological position regarding the role of markets versus governments but also incorporate variables such as expectations, information flows, flexibility of market prices and wages, and structural rigidities to explain how markets function.
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The monetarist versus Keynesian debate has led to very different explanations for economic variables such as aggregate supply, unemployment, and inflation, for the economys response to anticipated and unanticipated policy changes and exogenous shocks and for other macroeconomic processes. 1.5 Macro Economic Variables Macroeconomic variables can be classified into four categories namely, target variables, intermediate variables, indicative variables and instrument variables. The target variables are the ultimate goal variables of an economy. National income is one of the important target variables that every economy tries to maximize since it represents the purchasing power of the individuals. Other target variables include price stability, social justice and globalization. Price stability is important since fluctuation negatively affects the real value of all variables, distorts income distribution and foreign exchange rates, affects the nominal interest rates and distorts taxes. Social justice is measured through unemployment, poverty, and income distribution among the households of the country. The goal of any economy is to minimize this variable to the maximum extent possible. Globalization is another target variable that is considered by an economy since no country wants to be left behind in the era when globalization is happening at a rapid pace. The instrument variables are those variables that are determined by the policy maker which include fiscal and monetary policies (stabilizing tools) and agriculture, industry, trade and labour policies (regulation tools). The intermediate variables include variables like money supply, interest rate, savings, investment, bank credit, foreign exchange rate, imports, exports, etc. These variables are called intermediate variables since they lie between the instruments and target variables. Indicator variables provide signals to indicate the direction of the movement of the economy. We will discuss how some of these variables affect the economy of a country in detail. By understanding the measurement of the macroeconomic variables, you can monitor the economy, find the causes of the business cycles, and realize the importance of economic growth.
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We can understand the relationship between various macroeconomic variables using aggregate demand and supply analysis. The macroeconomic variables can be categorized based on whether they affect the aggregate demand or aggregate supply. Variables such as price level, potential output, capital, labour and technology determine the aggregate supply. Variables such as Money, spending and taxes and other variables determine the aggregate demand. The interaction of aggregate demand and supply determines the level of output, employment inflation and foreign trade in an economy. Before we discuss these variables further, let us understand the two terms aggregate demand and aggregate supply. As we have already discussed, in an economy, the scarce resources are converted into goods and services to cater to the unlimited wants of the people. Hence, any economy tries to produce a combination of various goods and services depending on the level of demand for these goods. As we have already discussed, the production possibility frontier gives the various possible combination of goods and services that can be produced in an economy. Out of these possibilities, the demand for these goods and services determines what combination is produced in that economy. This concept is known famously as the choice between guns and butter. This choice is very important for an economy, which is evident from the experience of the Soviet Union. Since, Soviet Union chose guns over butter for its people to consume without realizing the problem of such a choice, it led to failure of the economy and ultimately failure of communistic ideology. Having understood the production possibility frontier and the importance of the choice that an economy makes, let us see in detail how it is determined in an economy. Aggregate supply is the total quantity of goods and services that the countrys business firms are willing to produce and sell in a given period. Aggregate supply depends upon the price and cost levels and the productive capacity (determined by the availability of productive inputs mainly labour and capital and the availability of managerial and technical efficiency, which help in combining the inputs) of the economy. At high price levels, businesses would like to sell everything they can produce.
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As the price level goes down, the amount of supply in the economy also goes down. We can graphically represent aggregate supply as shown in figure 1.3 by AS curve. In the graph, the price index is used to represent the price of all goods and services that are produced in the economy. We will discuss price indices in detail, when we discuss the measurement of national income in the later section. Aggregate demand is the total amount that the economy is willing to spend in a given period. The aggregate demand includes demand for cars and other consumption goods by consumers, demand for plant, machinery & equipment by the businesses, demand for the missiles and various consumption goods by the government and net exports. The level of demand is determined by the price as which these goods and services are offered. As the price of the products goes down, the economy is willing to buy in more quantity and can be graphically represented as given in figure 1.3 by AD curve.
Price Index for all commodities
P 250 200 150 100 50 0 E
AS
AD Q 0 1000 2000 3000 4000 5000 Real GDP (billions)
Figure 1.3 Interaction of Aggregate Demand and Aggregate Supply
The Figure 1.3 shows and aggregate demand and aggregate supply schedule. The figure shows that only at point E where the price is 120, the people are willing to buy exactly the amount that businesses are willing
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to produce and sell and hence the macroeconomic equilibrium is achieved at this point for that economy. At prices above 120, say 150, producers would want to sell more than the purchasers would want to buy leading to goods piling up in the inventory of firms. Eventually, firms would cut down on their prices narrowing the gap between demand and supply until the equilibrium is reached at price 120, where the equilibrium quantity is 3000 billion. Once the equilibrium is reached, the buyers do not wish to change the quantities they demanded, nor do the sellers wish to change the quantities they supplied, and there is no pressure on the price level to change. 1.5.1 National income Human Welfare is the most important concern of Macroeconomics. However, it is not very easy to calculate, particularly when the relevant measure is the welfare of the society as a whole. In order to provide a solution, macroeconomists measure welfare in terms of the amount of goods and services i.e., output produced within an economy. If an economy produces more output, it can meet more of the demands of the society. National income is the flow of goods and services produced in an economy in a particular period a year. Modern economy is a money economy. Thus, national income of the country is expressed in money terms. We may say that national income is a money measure of the value of net aggregate of goods and services becoming available annually to the nation as a result of the economic activities of the community at large, consisting of households or individuals, business firms, and social and political institutions. GDP or gross domestic product is the value of all the final goods and services produced in the economy in a given time period. It is a measure of aggregate economic activity. We use GDP per capita, which is GDP divided by the population in the economy, to measure living standards. We will reserve the discussion on the measurement of national income and analysis of national income for later and will move on to the next macroeconomic variable.
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1.5.2 Investment, Savings and Employment Saving means economic surplus. It may be defined as an accounting difference between current income and current consumption. According to Keynes, it can be defined as the excess of income over expenditure of consumption. In the case of an individual, saving. is that part of income which is not consumed by him and in the case of the community, it is the aggregate of the unconsumed part of the national income of all members of the community. We can represent saving symbolically S = Y C where S denotes Saving Y stands for income and C stands for Consumption This symbolic expression of saving is applicable to both the individual as well as the community. Savings is the function of income and as income increases, savings also increases and vice versa. Savings depends on the propensity to save, which can be derived from the propensity to consume. The consumption function is a stable function of income in the short period, which makes the saving function also a stable one. Aggregate domestic savings are the sum of savings made by the households, firms and the government.
Household
saving = Disposable personal income consumption expenditure

Firm Saving = Government
Profits (Dividends+ Business taxes)
saving = Public revenue current expenditure
Savings of households and firms taken together constitute private savings. Governments savings constitute public savings. Therefore, total savings is the sum of private and public saving. The rate and size of savings in an economy are determined by a multitude
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of factors including level of income, income distribution, consumption motivation, wealth, habit, population, political stability, security of life, taxation structure, government efforts to control inflation, rate of interest and other subjective factors ( precaution, foresight, calculation, improvement etc.) Equality between savings and investment is regarded as an essential condition of equilibrium level of income, output and employment by Keynes as well as classical economists. The classical economist believes in the economys equilibrium at full employment level. In their view, saving-investment equality is brought about by the mechanism of the rate of interest. Keynes presented an entirely different theory form that of classical theory in which he rejected the postulate of the rate of interest being a strategic or equilibrium variable that will bring about equality between investment and savings in full employment. According to him, the savings- investment equality is a condition of equilibrium at any level of employment. In Keyness view, investment does not depend on the level of income. It mainly depends on dynamic factors such as population growth, territorial expansion, progress of technology and the business expectations of the entrepreneurs. Keynes explained the savings and investment relation in terms of scheduled relation. His equation of Saving = Investment, S = I is analogous to that of supply and demand equation S = D in ordinary markets. Employment of labour is an important macroeconomic variable. It usually refers to the employment of workers who are engaged in an act of production. When a worker is employed in the production process he feels the pain of physical and mental stress which can lead to fatigue or tiredness after some hours of work apart from sacrificing his leisure time. Hence the worker expects a compensation for the economic contribution he makes by participating in the production process. Since the worker is employed in the creation of some type of utility or output, the value of this output is used for compensating the workers.
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1.5.3 Inflation In modern economies, inflation has become a common and even chronic problem in both developed and underdeveloped economies. Different economists define this phenomenon in different ways. Let us start our discussion on inflation with a few of these definitions. Inflation is a rise in the general level of prices, measured against some baseline of purchasing power. It is understood by more people as a substantial and rapid general increase in the level of prices and consequent deterioration of the value of money. The common feature of inflation is the price rise, the degree of which may be measured by price indices. Inflation is statistically measured in terms of the percentage increase in the price index per unit of time. The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. There are atleast two distinct views of the concept of inflation, namely a pure monetary phenomenon and post full employment phenomenon. Monetarists in general, regard inflation as a purely monetary phenomenon. They believe that monetary effects dominate all others in setting the rate of inflation, or broadly speaking, monetarists, and those who believe that the interaction of money, interest and output dominate over other effects It is held that when money supply exceeds the normal absorbing capacity of the economy, it leads to persistently rising prices. In other words, when there is over-expansion of money supply and too much money saving too few goods, inflation occurs. Inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods , when the growth of national income in money units is greater than its growth in physical units. According to the quantity theory of money, other things being equal, if money supply increases, there is inflation. But, the theory failed to explain the phenomenon of hyper-inflation, where the rise in prices may cause an increase in money supply which, in turn may cause further rise in prices and this vicious spiral of the dynamic process of inflation makes it difficult to distinguish cause and effect.
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In the Keynesian view, rising prices in all situations cannot be termed as inflation. In a situation of underemployment, when an increase in money supply and rising prices are accompanied by an expansion of output and employment, inflation does not occur. Sometimes due to bottlenecks in the economy, the increase in money supply may cause costs and prices to increase more than the expansion of output and employment. This is known as semi-inflation. Once full-employment level is reached, the entire increase in money supply is reflected by rising prices, which is the case of true inflation. Inflation occurs in a situation where there is an increase in demand expressed through more money spending but no corresponding increase in production either due to bottlenecks operating in the economy or because the economy has already reached the full employment level. Thus, rising prices in all situations cannot be termed as inflation. Real inflation occurs only when the entire increase in the money supply is reflected simply by rising prices , once the full employment level is reached. Keynes mentions the following four related terms while discussing the concept of inflation
Reflation: It is a situation of rising prices, deliberately undertaken to relieve depression. With rising prices, employment, output and income also increase till the economy reaches the full-employment.
Inflation: It occurs when prices rise after the full employment is reached. It is a long term operating dynamic process of persistently rising price levels, which is irreversible in the short run. It is usually characterized by an overflow of money and credit. In fact, the root cause of inflation is the expansion of money supply beyond the normal absorbing capacity of the economy.
Disflation: When prices are falling due to anti-inflationary measures adopted by the authorities, with no corresponding decline in the existing level of employment, output and income.
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Deflation: It is a condition of falling prices accompanied by the decreasing level of employment, output and income. Deflation is just the opposite of inflation.
Other theories, such as those of the Austrian school of economics, believe that inflation of the general price level and of specific prices is a result from an increase in the supply of money by central banking authorities. 1.5.3.1 Measures of inflation Measuring inflation is a question of Econometrics, which is, finding objective ways of comparing nominal prices to real activity. In many places in economics, real variables need to be compared, in order to calculate GDP, effective interest rate and improvements in productivity. Each inflationary measure takes a basket of goods and services, then the prices of the items in the basket are compared to a previous time, then adjustments are made for the changes in the goods in the basket itself. For example if a month ago canned corn was sold in 10 oz. jars, and this month it is sold in 9.5 oz jars, then the prices of the two cans have to be adjusted for the contents. The result is the amount of increase in price which is attributed to inflation and not to improvements in productivity. This means that there are many measures of inflation, depending on which baskets of goods and services are used as the basis for comparison. Depending on the context, we can use different kinds of inflation measures to determine the real change in prices. 1.5.3.2 Commonly used measures of inflation Examples of common measures of inflation include:
Consumer price indexes (CPIs) which measure the price of a selection of goods purchased by a typical consumer. Producer price indexes (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer
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to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be passed on as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity.
Wholesale price indexes, which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indexes. Commodity price indexes, which measure the change in price of a selection of commodities. In the present commodity price indexes are weighted by the relative importance of the components to the all in cost of an employee. GDP Deflators use an entire economy as the basket of goods and services, rather than some particular subset. The term deflator in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the US economy. Purchasing Power Parity adjusts for the inflationary effects of goods being non-tradable between two or more economies, for example land prices, to compare standard of living purchasing power between two economies. PPP adjustments are, therefore, measuring inflation in location, rather than in time. Many inflation series numbers are also published for particular geographic regions. For example, the US Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US. Historical Inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than on those compiled at the time. It is also used to adjust
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for the differences in real standard of living for the presence of technology. This is equivalent to not adjusting the composition of baskets over time. We will discuss some of these price indices once again when we discuss measures of GDP. We will reserve the detailed discussion on inflation to unit 3 where we discuss unemployment, inflation and their relationship and the effect of government policies on these variables. 1.5.4 Balance of Payment The Balance of Payments BOP is an account of all transactions between one country and all other countriestransactions that are measured in terms of receipts and payments. From the Indian perspective, a receipt represents any Rupees flowing into the country or any transaction that requires the exchange of foreign currency into Rupees. A payment represents Rupees flowing out of the country or any transaction that requires the conversion of Rupees into some other currency. The three main components of the Balance of Payments are the current account, capital account and balancing account. 1. The Current Account includingMerchandise(ExportsandImports), Investment income (rents, profits, interest) 2. The Capital Account measuring Foreign investment in the U.S. and U.S. investment abroad, and 3. The Balancing Accountallowingforchangesinofficialreserveassets (SDRs, Gold, other payments) Balance of payment account is based on a double-entry book keeping: each transaction is recorded twice. Payment to a foreigner is a debit. And a receipt from him is a credit. In other words, transactions leading to foreign exchange supply are a credit and receipt from them is a debit. In general exports are credits and imports are debits. Like income from them export of goods, interest and dividend income received from abroad is treated as credit items as they provide foreign currencies.
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1.5.5 Exchange Rate The exchange rate between two currencies specifies how much one currency is worth in terms of the other. If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted in financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency.
The nominal exchange rate is the rate at which an organization can trade the currency of one country for the currency of another.
The real exchange rate (RER) is an important concept in economics, though it is quite difficult to grasp concretely. It is defined by the model: RER = e (P/P*), where e is the exchange rate, as the number of foreign currency units per home currency unit; where P is the price level of the home country; and where P* is the foreign price level.
Unfortunately, this compact and simple model for RER calculations is only a theoretical ideal. In practical usage, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity (PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection. PPP would imply that the RER is the rate at which an organization can trade the goods and services of one economy (e.g. country) for those of another. More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential. We will discuss the balance of payment and exchange rates in further detail in Unit 5 when we will discuss the external sector, where these variables play a role.
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1.6
National income National Income is always expressed with reference to a time interval, since it is meaningless to talk of national income without mentioning the period over which it is generated. This is because it is a flow and not a stock. In other words, income is generated every year and at different rates. National income is usually measured and shown with reference to a year or as annual flow; it is thus, an amount of total production per unit of time. National income accounting emerged as an important tool in economic decision-making only after World War II. Prior to the Great Depression of 1929-30, national income accounting was mostly an academic exercise. Only after the great depression and Keynes published his seminal work titled General Theory of Employment, Interest, and Money in 1936, which analysed the causes of the depression, that the governments started recognizing the need for national income estimation ad other related aggregates to provide the basic framework for policy decisions and economic analysis. In India, national income estimation was pioneered by Dadabhai Naoroji way back in 1876 when the main purpose of it was to point out poverty and low living standards of the average Indian and serve as ammunition against colonial rule. However, these earlier accounts suffered from serious conceptual and statistical defects and limitations, in addition to being politically biased. After independence, in 1949, the government of India appointed a National Income Committee for estimating national income. Today, national income accounting has a central role in policymaking and economic analysis in all countries. Economic policies, plans, and development programmes are formulated only after a careful study of national income data and other related aggregates. International comparisons are made based on the national income estimates. Macroeconomic performance is judged based on key national income indicators. National income accounts are a set of systematic statistical statements which reflect the value of the total output produced in various sectors of
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the economy, such as agriculture, industry, trade, banking, etc., together with details of distribution of factor incomes among different groups and final expenditure of the economy. They are a measure of aggregate economic activity and show major economic flows and statistical relationship among the various sectors and sub sectors of the economy. National income accounting serves three basic functions, namely,
Provides a simplified framework for understanding the interrelationship between the innumerable transactions that take place in an economy and to hold together the different pieces of the economy Helps identify economic problems and provides an objective basis for evaluating economic policies and performances
Provides the framework for making long-term economic policy decisions and programmes
In national income accounting, the concept of national income has been interpreted in three ways. 1. National Product: It consists of all the goods ands services produced by the community and exchanged for money during a year. It does not measure goods and services which are not paid for. 2. National Dividend: It consists of all the incomes, in cash and kind, accruing to factors of production in the course of generating the national product.
3. National Expenditure: This represents the total spending or outlay of the community on the goods and services produced during a given year. Since income is the source of expenditure, national expenditure constitutes the disposable income, which is equal to national income. Indeed, one mans income is another mans expenditure. When a person buys vegetables, it is his expenditure, but is the vegetable vendors income. When the vegetable vendor spends part of his income in buying groceries, it becomes the income for the groceries merchant and so on. In a sense, therefore, the sum of expenditure of all agents of production is equal to the total income received by the factors of production during that year.
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In fact, there is a fundamental equality between the total income and total expenditure of the community, as ones expenditure becomes another persons income in the economy. Hence there is a large circular flow established in which each expenditure creates an income, which in turn is spent and creates other incomes. Therefore, this total national income will be equal to the total national expenditure. The identity of the three factors of the flow of national income may be expressed as: National Expenditure = National Product = National Income or dividend. When we analyse the above three concepts, we find that national income is nothing but the total flow of wealth produced, distributed and consumed. It is not that the income is first earned and then gradually spent or distributed, or alternatively, it is not that the expenditure first takes place and then an income is earned. As a matter of fact the process of income creation and income distribution goes on simultaneously. According to the total production approach, it is the money value of goods and services produced by agents of production during the course of the year. According to income approach, it is the sum of income of agents of production, profits of public enterprises, and income from government companies. According to the total expenditure approach, national income is the sum total of expenditure of agents of production. Keynes has suggested three approaches to national income which are more suitable and practicable in the macro-analysis of income and employment is as follows: 1. Income-expenditure approach in which total expenditure of consumption and investment goods constitute total income. 2. Factor income approach in which national income is measured as the aggregate of income received by all the factors of production 3. Sales proceeds minus cost approach in which national income is measured as the aggregate of sales minus cost.
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From Keynesian analysis, modern concepts of national income have been evolved which are more dynamic and content. Modern economists consider national income as a flow in three forms: income, output and expenditure. When goods are produced by the firms, factors of production comprising households are paid income. These income receipts are spent by the household sector on consumption and their savings are mobilized by the producers for investment spending. Likewise a circular flow is constituted between income and expenditure. Obviously, income, output and expenditure flows are always equal per unit of time. When we examine the interrelationship between the three definitions of national income, which are national income in terms of total production, total expenditure and total income, we find the circular flow of income. 1. 6. 1 Circular Flow of Income The circular flow of income activities can be described as follows. The firms hire the factors of production to produce goods and services. The factors of production create real income. The factors of production are paid out of this real income, in terms of money as a reward for their services. They, in turn, spend this income on goods. This demand, in turn, spends this income which leads to expenditure that creates demand for goods. The flow is from production to income generation to expenditure, and from expenditure to production. The circular flow of income can be understood in terms of the two sector model, the three sector model and the four sector model. The two sector model describes the circular flow of income in terms of flow between the firms and the households where households offer their services in the factor market and buy goods for consumption in the goods market. The firms supply goods to households as a reward for their services and such flow is termed as real flow in the economy. The factor payments are not made in kind but in terms of money which is utilized by the households in purchasing goods and services produced by the firm, thus resulting in circular flow between the firms and the households. Thus according to this model the national income is represented by the following equation, Y = C+ I
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Where Y stands for national income C stands for Consumption expenditure and I stands for the investment expenditure. The three sector model includes the government sector in describing the circular flow of income. Government acts both as a consumer and producer in the modern economies. It has its own sources of income and expenditure. It collects taxes (compulsory payments levied by authorities without any regard for service rendered by it) both from the firms and the households. Withdrawing some amount from the households and the firms for payment of taxes is called leakages which reduces the flow of income. The government spends income accumulated as such in activities designed to offer benefits to both the firms (subsidies for production, purchase of goods for collective use by the society) and the households (social spending on education, health, housing, etc.).After including the government spending, the equation will be where G stands for government expenditure. In the four sector model, circular flow of income is studied by including the foreign sector in addition to households, business firms and the government sector. The inclusion of foreign sectors leads to fresh inflow of income to the circular flow through foreign transactions. Exports cause an injection of money by creating income for the domestic firms. Imports are considered leakages from the circular flow since they are expenditure incurred by the household sector to purchase goods from foreign countries, which will become income for firms in foreign countries and hence does not flow back into the economy. The circular flow of income according to the four sector model is depicted in the following diagram.
Y = C+I +G
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Taxes and loans G Business sector
Government Sector
Taxes and loans C Household sector
Consumption expenditure Factor payments X
X Foreign sector Transfer payments
Export & Transfer payments
C represents expenditure on factor services G represents government purchases X represents payment for imports
Figure 1. Circular Flow of Income according to four sector model. Figure 1 shows the circular flow of money of the four sector open economy with taxes and imports as leakages from the circular flow on the righthand side and government purchases and exports on the left hand side. Forms of transaction like imports, exports and transfer payments are shown arising from the households, the firms and the government. The combined activities of these sectors will cause inflow and outflow of funds thus forming balance of payments sectors. Inclusion of foreign sector in the income equation will be shown as follows. Y = C +I+G+(X-M) as we have already discussed, is the gross domestic product. If the export is greater than the import, net income earned abroad would be positive. On the other hand, if the export is lower than the import the net income earned would be negative and cause the GNP to be lower than the GDP of a country.
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1.6.2 Measures of output/income GDP, GNP and NNP constitute the three fundamental measures of an economys productive performance. We have already discussed
Gross domestic product (GDP) is the total value of output of goods and services produced in a county in a given period of time regardless of the ownership of the factors of production It therefore includes both consumer and capital goods and the output of both the private and public sectors. Gross national product (GNP) is the total output produced by domestically owned factors some of which may be located abroad It is calculated from GDP by adding on net property income from abroad. Net national product (NNP) is GNP less the depreciation of the nations capital stock.
Now, let us discuss these measures in detail and understand these macroeconomic variables that determine these measures. 1.6.2.1 Gross National Product (GNP) In calculating national income, we add up all the goods and services produced in a country. Such a total represents the gross value of final products turned out by the whole economy in a year, which is technically called gross national product. The term gross indicates the inclusions of the provision for the consumption of the capital asset, for instance, depreciation or replacement allowances. GNP thus may be defined as the aggregate market value of all final goods and services produced during a given year. The concept of final goods and services stands for finished goods and services, ready for consumption of households and firms, and excludes raw materials and work- in progress inventory and such other intermediary products. More specifically, all sales to households, business investment expenditures, and all government expenditure are treated as final products. But intermediary goods purchased by business firms are obviously regarded as final goods. If we include it in calculating output,
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the value of this good which is also included in the final good produced will lead to double counting. In an open economy, GNP may be obtained by adding up the value of all consumption goods which are currently produced, value of all capital goods produced (gross investment), which implies the increase in inventories and gross products of buildings and equipments which included the provision for the consumption of the capital assets (depreciation and replacement allowances), governmental expenditure of various goods for rendering certain services to the benefit of the entire society, the value of net product which is the difference between the total exports and imports of the nation and the net amount earned abroad (difference between income earned by the nation through foreign investment and the income paid to the foreigners investment). GNP at market price, thus, represents GNP = C +I+G+(X-M) +(R-P) where C stands for consumption goods, I for capital goods or gross investment G for government services X for exports M for imports R for income receipts from abroad, and P for income paid abroad. GNP is the basic social accounting measure of the total output; it represents the final products ready for consumption, valued at current market prices.
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1.6.2.2 Gross Domestic Product (GDP) GDP is calculated as the total of values of output of goods and services in the country without adding net factor incomes received from abroad. Thus, it is measured at market prices as GDP = C +I+G+(X-M) 1.6.2.3 Net National Product It refers to the value of the net output of the economy during a year and is calculated by deducting the value of depreciation or replacement allowances of the capital assets from the GNP. Depreciation means wear and tear of machinery in the process of production and these machines have to be replaced at some future point when they become useless or outdated. NNP = GNP D where D stands for depreciation allowances. NNP is the value of total consumption plus the value of net investment of the community. In calculating NNP we take depreciation into account. But we do not consider capital appreciation, which is the increase in value of fixed assets, as the total quantity of the fixed assets remains the same. However, technically national income is obtained by deducting indirect taxes from the net product measured at current market prices, which is called NNP at factor cost. To distinguish between National income at market price and factor cost, let us understand that National income at market price is the price of the aggregate output at current market prices, which also includes some element of taxes and subsidies. Of the various measures of national income, GDP and GNP are considered most important. Let us compare these two measures to note down some important points about these measures:
Both GNP and GDP are time bound measurements, which refer to only current production and services, usually within a given year or quarter of a year.
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Both GNP and GDP include only the value of final goods and services to avoid double counting. The value of intermediate goods and services, which go into the production of a good are, not included. At each stage of manufacturing, only the value added to the product at that particular stage of manufacture is counted towards GDP or GNP. However, you need to remember that it is not so easy to distinguish the intermediate and final products. Some outputs are not sold in the market and so there are no observed prices to value these products. In such cases, the output is valued at the cost of the inputs needed to produce them. This is usually done for government outputs and services. Some goods that are produced in a year, but not sold, such as a firms stockpile of inventories, are counted in that years GDP or GNP. Inventories are treated as if they were bought by the firm that produced them even though this purchase never takes place. Even though capital goods are intermediate goods that are used in the production process, in national income accounting they are counted as final goods that are bought by the firms.
1.6.2.4 Real versus Nominal GDP Nominal GDP is the money value of output in a given period in current money terms whereas real GDP is the actual physical amount of output produced during a given time period. Changes in real GDP refer to changes in physical production over different time periods by adjusting for price changes over this period. The goods are valued at constant prices. Real GDP enables us to see how much of change in output over two periods is due to changes in prices and how much of it is due to changes in actual physical production. For instance, if we want to compare todays GDP with GDP in 1985, we remove effects of price changes between these two periods. We multiply todays physical output by an index of 1985 prices and find out what todays output would have been worth if it had been sold at 1985 prices ( We will discuss price indices later).
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Thus, real GDP is a better indicator than nominal GDP of the actual performance of the economy in terms of producing goods and services. Real GDP growth measures how much output has really increased in an economy. The nominal versus real distinction will become clear when we look at price indices and inflation in the later sections.
1.6.3 Measuring GDP

GDP can be valued at market prices or at factor cost. Valuation at market prices includes indirect taxes like sales tax and excise duty and subsidies, and is not necessarily the same as the price received by the sellers. Valuation at factor cost reflects the net price received by the seller, i.e., the market price less the excess of indirect taxes over subsidies. To measure output in terms of what it fetches on the market, we measure it at market prices and to measure output in terms of what it costs in terms of the factors of production, we measure it at factor costs. There are three approaches to measure GDP whether nominal or real. Two of these approaches concentrate on output data while the third approach uses the fact that the value of output must accrue as income to someone. These approaches are namely, the expenditure/ final goods approach, value-added approach, and income approach to national income accounting. We will discuss these approaches in detail later in the next unit. We will now discuss some of the other important measures in national income accounting. 1.6.4 Personal Income Personal income is the income accruing to households after adjustments in national income. We can obtain personal income by subtracting from national income the part that accrues to the corporate sector and add to it dividends which households receive, the transfers they receive from the government and personal interest income. Thus, PI = NI corporate profits social security and other contributions net interest + Dividends + government transfers + personal interest income.
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1.6.5 Personal Disposable income Personal disposable income is the personal income adjusted for personal taxes. Thus, PDI = PI personal taxes This is the income that actually determines consumption and savings decision in the economy.
1.6.6 Price indicators

We can use price indicators to compare average prices of a common basket of goods and services over two different periods. Price indicators are a very important part of national income accounts for three reasons
Price stability or combating inflation is one of the key goals of macroeconomics. Movements in price indices enable us to understand changes in the price levels and accordingly undertake policy measures to realize price stability and control inflation. In order to find the economic growth as given by the growth rate of output in the economy, we need to adjust the nominal value of the output to changes in the price levels. Price indices enable us to separate changes in value of production/ expenditure/ income into their price and real output components.
We can use price indices to deflate monetary or nominal figures and adjust for changes in the purchasing power of money.
The three important price indices are the consumer price index (CPI), the wholesale price index (WPI), and the implicit GDP deflator. 1.6.6.1 Consumer Price Index (CPI) The consumer price index is the most widely used price index. The CPI is a weighted average of prices for a market basket of goods and services commonly purchased by households, at the retail level, and expressed in relation to a base year with an index value of 100. The CPI excludes
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exports and includes imports and converts them into a single index to measure the overall level of prices. We can construct CPI by determining the composition of the market basket and the importance of each item in terms of its share in total expenditures from the surveys. Based on the relative importance of each item in terms of its share in total expenditures we can assign weights to them. The market basket and the weights remain the same until a new survey is conducted and the basket is revised. This is typically done once in 10 years or so. Price surveys for this market basket are however, conducted regularly?. CPI = Picurrent * Qibase * 100 Pibase * Qibase The CPI compares the cost of buying certain bundle of goods in a current year with the cost of buying the same bundle in the base year. If 1982 is the base year and we are constructing the CPI for 1992, then it is given by CPI = Pi1993 * Qi1982 * 100 Pi1982 * Qi1982 Where the base year (1982) index is 100. If this ratio equals 200, it means that the cost of buying the same market basket of goods doubled between 1982 and 1993. The CPI is thus a relative not absolute measure of changes in prices. When the CPI uses the base year quantities to compare the total expenditure for two years it is called Laspeyres index. Alternatively, when one uses the current year quantities to construct the index it is called Paasche index and is given by
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Picurrent * Qicurrent * 100 Pibase * Qicurrent Note that the Laypeyres index which is based on fixed quantities tends to overstate the cost of living, since when prices rise, due to fixed basket, this index does not allow for the possibility of substitution with less costly goods. The Paasche index allows for substitution in the basket but understates the effect on the cost of living from a price rise as it does not reflect the reduction in welfare arising from consumption of substitutes. An ideal index is an average of the two indices. The CPI is constructed using the Laspeyres index approach, i.e., in terms of base year quantities. In India, we use the Laspeyres index but use WPI to calculate inflation. CPI can be used
As an indicator of the degree and sources of inflationary pressures in the economy
For deflating nominal variables in order to obtain their real values To determine the real value of spending for individual components of expenditure in the economy.
Real spending in current year = Nominal spending in current year / Ratio of current year CPI to base year CPI
To deflate the value of money wages and thus it plays an important role in wage negotiations. (Dearness allowance revisions)
To distinguish between nominal and real rates of return. Real interest rate = nominal interest rate inflation rate measured by percentage change in CPI
Movements in the CPI also play an important role in the formation of expectations and in the determination of wages, product prices, interest rates, aggregate supply, and exchange rates in the economy.
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1.6.6.2 Wholesale Price Index (WPI) The WPI is the weighted average of the prices for a market basket of goods that are commonly purchased by firms in a given period. It is constructed from the input prices at the level of first significant commercial transactions. The WPI market basket consists of important inputs in the production process, including raw materials and semi-finished goods. The construction of WPI is similar to that of CPI. Since the WPI measures prices at ? an early stage of the distribution system, it signals inflationary pressures in the economy before the CPI. It also signals movements in the CPI since higher costs to producers are eventually passed on as higher prices for households. 1.6.6.3 Implicit GDP Deflator The implicit price deflator or GDP deflator is another important price indicator for the economy. It is the broadest measure of changes in the economys price levels as it measures the changes in prices between the base and current year for all output in an economy. This is in contrast to the CPI and WPI which only look at prices for a given market basket of goods and services. The implicit price deflator is a Paasche index as it looks at current quantities. The implicit price deflator is defined as the ratio of nominal to real GDP for a given year. It is the price of a typical unit of output relative to its price in the base year. To get the deflator, we first need to determine the real GDP, which is the physical amount of output holding prices fixed. We can calculate the real GDP by using the following steps: i. Record expenditures in current prices for each good and service.
ii. Measure price changes for each item and construct a price index for each item with the same base period. iii. Deflate each item by dividing expenditures in the current period by the price relative to the base year prices iv. Add all the outputs thus obtained in constant prices
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Hence, real output is determined by aggregating the deflated values of individual expenditure items. Deflating is the process of finding the real value of some monetary magnitude by dividing by some appropriate price index. Since it is impossible to collect price data on each item, we use price indices for the principal components of expenditures such as personal consumption, investment, government expenditures, etc. The implicit deflator is then calculated as the ratio of nominal output in current prices to real output in constant prices and multiplying the ratio by 100. The index is called implicit as there are no predetermined weights unlike the CPI and WPI. 1.6.6.4 Problems with the indices There are several problems with the CPI. Comparison across years that are far apart are likely to be misleading and erroneous as the weights and the market basket under comparison tend to become unrepresentative of the market CPI has an upward bias where it tends to put too much weight on those items whose prices have increased and too little on items whose prices have declined. WPI also suffers from similar problems as the CPI, though probably less as input availability and firms preferences for inputs are likely to change less than for final products. 1.7 Indian Economic Planning Planning has been one of the pillars of economic growth and development in India. Economic planning is a technique used to realize the predetermined and well-defined goals laid down by a Central Planning Authority. One of the comprehensive definitions of planning defines it as the making of major economic decisions, what and how much to be produced; how, when, and where it is to be produced; to whom it is to be allocated; by the conscious decision of a determinate authority, on the basis of a comprehensive survey of the economic system as a whole. Planning Commission of India defines planning under a democratic system as the technical coordination, by disinterested experts, of the consumption,
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production, investment, trade and income distribution in accordance with social objectives set by bodies and representatives of the country. To understand the importance of the Planning Commission in India and the impact of the plans developed by it, we need to know about how it evolved in India. 1.7.1 Evolution of Planning in India The Soviet Union was the first country in the world which endeavoured to attain economic Development through its Five Year Plan in as early as 1928. Jawaharlal Nehru who visited the USSR long before our Independence, personally viewed the achievements of planned development and stressed the importance of planning in India. However Netaji Subash Chandra Bose was the first to give it a concrete base and shape. When he became the Congress President in 1938, in his presidential address at Haripura, he spoke of the need for a planning commission. Consequently the National Planning Committee was formed. Based on the resolution of the Congress in 1947, the concept of planned development of India was laid down. The credit of planning in India goes to Shri Vishveswaraya who was the first to attempt at formulating a systematic plan for the economic reconstruction of India. His book Planned Economy for India was published in 1943. His efforts led to the establishment of the National Planning Committee by the National Congress Party. But the committees work was disrupted by the outbreak of the Second World War. Many plans were formulated by various people, but remained just as plans and were never implemented. Soon after Independence, the concept of planned development in India was laid down by a resolution of the Congress and led to the setting up of a planning commission in March, 1950. Subsequently, many organizations were set up in both the states and the centre to prepare policy programmes and to evaluate various schemes to be included in the planning framework. The Planning Commission in India is a multi-body consisting of Eminent Public Personalities, Administrators, Economists and Technical Experts.
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The Prime Minister of India is the Chairman of the commission and gives direction on all major issues relating to the planning of the country. The chairman is the legal head of the commission; but the deputy chairman, who is a full time member, takes care of the day-to day operations of the commission. 1.7.2 Functions of the Indian Planning Commission 1. To assess the available resources of the country including material, capital and human resources and investigate the possibilities of augmenting deficient resources 2. To formulate a plan for the most effective and balanced utilization of the countrys resources 3. To identify the stages to carry out the plan and to determine the priorities of the plan 4. To determine the factors that would impede economic development and to establish the conditions required for successfully implementing the plan. 5. To determine the nature of the machinery that will be necessary for securing the successful execution of each stage of the plan in all its aspects. 6. To periodically appraise the progress achieved in the execution of each stage of the plan and to make recommendations towards policy adjustments and necessary action. Even though the planning commission in India was created as a temporary staff agency, over time it has become very essential and a permanent feature of the Indian Planning Machinery. 1.7.3 Objectives of Indian Economic Planning The commission submits the draft of plans priorities, quantum of outlays, sources of necessary funds to the National Development Council (NDC) which is a consultative body that acts as a coordinator between the States and the Planning Commission.
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Economic planning has been viewed as a panacea for many perils that exist in an economy. The objectives of Indian plans have gradually evolved over time depending upon the circumstances in which these plans were formulated. When the first plan was launched, India was facing many problems including low growth in total output, high growth in population which created a large demand for consumption of goods post-war shortages, requirement of rehabilitation of refugees and the need for reconstruction of economy after the war. These circumstances did not allow development oriented objectives and hence it was confined to agricultural and infrastructural development. It aimed at correcting the imbalance in the economy by overall balanced development that ensures increase in national income and steady progress in standard of living. Since the industrial base was very poor in the economy, the second plan concentrated on rapid industrialization of the economy, especially in basic and heavy industries. Industrialization required a strong capital base and hence India started vigorous planning to raise the saving and investment rate. The basic objective of Indian Economic Planning is the economic development of the country. It has certain short and long-term objectives. As we have discussed, as the planning process evolved, depending on the circumstances prevailing and problem faced by each plan, the short term objectives varied from plan to plan. Shortly, we will discuss the major objectives of each of the ten five year plans in detail. Before that we will briefly discuss certain long-term objectives of planning which have remained static and made the country move in the direction of steady progress. They include high rate of economic growth, promotion of social justice, self-reliance, full employment, and modernization. Raising the standard of living by increasing national and per capita income has been the first and foremost objective of all the plans in the country. Increasing the national income by producing more goods and services became the prime objective of our developmental plans. By attaining a higher growth rate of national income in comparison to the rate of population growth in the country, we can raise the per capita income.
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Apart from concentrating on the growth of national income through mere production, planners also look at proper distribution of the surplus or wealth created in the economy to ensure improvement in the standard of living of all the sections of the society. Since growth unaccompanied by social justice is not desirable in a democratic country like India, another important objective of our plans is to provide and promote social justice. We can achieve this objective by eradicating poverty and by reducing inequalities in income, wealth and power distribution. To ensure equality in international relationships and to reduce our vulnerability to international pressures and disturbances, our planners have taken, making our economy self-reliant as the third major objective of our plans. We can attain self-reliance by reducing and ultimately eliminating dependence on foreign aid and as a step towards that, we have achieved self-sufficiency in food grains. One of the main goals of our plans has been eliminating unemployment and underemployment and the main hurdle in achieving this has been the explosion of population in the country. Our planners are trying to deal with this problem through proper man power planning. We can attain modernization by making structural and institutional changes in economic activities that will lead to greater efficiency and productivity. We have been pursuing modernization through the use of advanced technological developments in various sectors of the economy. We have achieved self-reliance in food grains by modernization in the agricultural sector. Our planners are promoting the use of computers and electronic equipments, application of advanced techniques wherever feasible, especially in the fields of logistics and machineries industries to achieve the objective of modernization that will help us to refrain from dependence on foreign assistance.
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1.8 Summary In this section we have discussed that
Economics is a study of how societies allocate their scarce resources to meet the unlimited wants of people. Macro economics is a study of the economy in the aggregate. Aggregate supply is the total of all products that the businesses in the economy are willing to supply Aggregate demand is the demand for total good by the different sectors of the market. Analysis of aggregate demand and supply and how equilibrium is reached in an economy will help us in understanding the macroeconomic variables Some of the macroeconomic variables include national income, investment, savings, employment, inflation, balance of payment and exchange rate National income is the flow of goods and services produced in an economy in a particular period and can be measured in different ways. Circular flow of income analysis using two-sector, three-sector and four sector models helps us in understanding how national income is determined in an economy National income can be determined using measures such as GDP, GNP, NNP. Price indicators play an important role in measuring national income. Some of the price indicators include CPI, WPI and Implicit GDP Deflator. Economic planning aims at facilitating the achievement of the economic goals of a country
Review Questions
1. Why do you think understanding the subject of Macroeconomics is important ? 2. What are the various goals of Macroeconomics ? 3. How can you classify the macroeconomic variables?
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4. Why is National Income considered as important macro economic variable? 5. What are the four types of inflation ? 6. How can you measure inflation? 7. What are the three main components of Balance of Payment? 8. What are the three ways in which the concept of national income has been interpreted? 9. What do you understand by analyzing circular flow of income ? 10. How can you measure GDP? 11. There are three goods consumed in an economy. These are small cars, radios and shirts. The prices and quantities for each good in 2005 are given below along with their prices in 2006.
2005 P Rs. Small Car Radio Shirt 200000 Q units
2006
20 300000 800 800
1000 2500 500 400
i.
Calculate the price index for 2006. ii. Calculate the inflation rate between the two years.
iii. If nominal spending across all goods equals Rs. 10, 00, 000, find the value of real spending using the price index from (i) as the deflator. 12. Assume last years GDP was Rs. 6000 billion. This years nominal GDP is Rs. 7175 billion and the GDP deflator for this year is 130. What is real GDP this year? What is the growth rate of real GDP? 13. Why is economic planning important?
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UNIT - II
ANALYSIS OF NATIONAL INCOME
2.1 Introduction In the preceding unit we discussed , some basic concepts of national income. In this unit, we shall discuss a more profound topic of a theoretical nature that is the theory of national income determination. Our main concern in this chapter is to answer the question: How is the equilibrium level of national income determined? The answer to this question was provided by John Maynard Keynes and hence, we will start with the Keynesian perspective of income determination. Before we start our discussion on the determination of national income, let us briefly discuss the methods of estimating national income. 2.2 Learning Objectives 1. To learn the Keynesian model of income determination 2. To understand the impact of fiscal policy on income determination 3. To know what a business cycle is and understand how these cycles are created with the help of theories of business cycles. 4. To understand the basics of fiscal policy 2.3 Determination of National Income In national income estimates, by definition, we have to count all those goods and services produced in the country and exchanged against money during the year. Thus, whatever is produced is either used for consumption
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or saving. Thus national output can be computed at any of the three levels, namely, production, distribution and expenditure. Accordingly, three methods of estimating national income may be used, viz, the output method, income method and expenditure method. 2.3.1 Output Method This method measures the output of the country and is also called as the inventory method. It involves the assessment, through census, of the gross value of production of goods and services produced in different economic sectors by all the productive enterprises in the economy. The symbolic expression for this method may be given as follows: Y = (Pr-D) + (S-T) + (X M) + (R-P) .2.1 Where Y = national income Pr = domestic output of all production sectors D = depreciation allowance S = subsidies T = indirect taxes X = exports M = imports R = receipt from abroad P = payment made abroad When using this method, there are certain precautions that we must take against the danger of double counting. To avoid double counting, we must add only the final products. Raw materials and intermediate goods should not be added as that would lead to double counting. There are two approaches to avoid the possibility of double counting in the measurement of national income.
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1. Final goods method 2. Value added method In the final goods method of estimating national income, only the final value of goods and services are computed, ignoring all intermediate transactions. Intermediate goods are involved in the process of producing final goods the final flow of output purchased by consumers. Thus, the final output includes the value of intermediate goods. In the value added method, a summation of the increase in value, at each separate production stage, leading to output in the final form is used for estimating the national income. From the total value created at a given stage, we should thus subtract all the costs of materials and intermediate goods not produced in that stage. In other words, the value of inputs at a given stage should be deducted from the value of output. 2.3.2 Census of Income Method In this method, the income of all factors of production is added together. The data are compiled from books of accounts, reports, and published accounts. The following classification of income is considered as comprehensive, (a) wages and salaries, (b) supplemental labour income (social security etc) (c) earnings of self-employed or professional income, (d) dividends, (e) undistributed profits (retained earning of firms), (f) interest, (g) rent, (h) profit of state enterprises. However, transfer payments like gift subsidies, etc. should be subtracted from the total factor income. Thus, national income is equal to the factor income minus transfer payments. This method is also known as factor cost method. Thus, the national income of a country at factor cost is equivalent to the sum total of disbursements of their factors income which can be symbolically expressed as: Y = (w + r + i +)+(XM)+(R-P) ..2.2
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Where Y = national income w = wages r = rent i = interest = profits X = exports M = imports R = receipt from abroad P = payment made abroad 2.3.3 The Expenditure or Outlay Method National income on the expenditure side is equal to the value of consumption plus investment. In this method, we have to estimate private and pubic expenditure on consumer goods and services, add the value of investment in fixed capital and stocks, with due consideration for net positive or negative inventories, and add the value of exports and deduct the value of imports. This method is not as popular as the previous ones. To express it in symbolic terms, Y = (C+I+G) + (X M) + (R-P) .2.3 Where C = consumption expenditure I = investment expenditure G = government purchases X = exports M = imports
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R = receipt from abroad P = payment made abroad Now that we have discussed the three methods of estimating national income, let us discuss the Keynesian theory of estimating national income in detail. In Keyness analytical framework, the entire economy is divided into four sectors, viz., household sector, firms or business sector, government sector, and foreign sector. When we discussed the circular flow of income, we discussed the two sector, three sector, and four sector model. Let us recall the two sector model. When an economy is in the state of equilibrium the following conditions must be fulfilled. Factor payments = Wages + Interest + Rent + Profit Wages + Interest + Rent + Profit = Household Income Value of output = Factor Payments Household income = Household Expenditure Household Expenditure = Value of output The amount of goods and services that firms produce constitute the Aggregate Supply (AS). Its value equals factor payments. The household expenditure represents the Aggregate Demand (AD). According to Keynesian theory of income determination, the equilibrium is reached where aggregate demand (AD) equals the aggregate supply (AS). 2.3.4 Process of Income Determination Aggregate demand depends on the plans of the household to spend, which may not always match with the aggregate supply, which is determined by the producers production plan. Therefore, AD may not always be equal to AS, but this situation will create a condition of equality. When households do not spend their entire income as they set aside
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some part it as savings for future consumption, AD will be less than AS. Under this condition, firms are not able to sell their total output and hence end up with piling up inventory. If they reduce the price to get rid of the unsold stock, they incur losses. To avoid such situation, the producers will cut down their production levels for which they start hiring lower quantities of factors of production. As a result factor payments go down resulting in lower income for households. This process continues till the household expenditure plan and the firms production plans reach an equilibrium level. On the contrary, if AD> AS which may be due to consumption of past savings, firms find that they are producing less than what households are willing to buy. Therefore, in order to increase their earnings, firms hire larger quantities of factors of production and make larger factor payments, which results in increased household income. If the households continue to spend more than their current income, total production continues to grow. Since there is a limit to increase in consumption levels, AS and AD will be ultimately in balance and national income will be determined at this level. Once the level of national income is determined, it remains at this level until equilibrium is disturbed. 2. 4 Keynesian Theory of National Income Determination Before we discuss how income is determined in the Keynesian theory, we need to be aware of the assumptions made by Keynes, when he proposed the theory, which include:
output is below its full-employment level ((output at current employment Y < output at full employment Y*);
the price level is rigid (P = const), i.e. changes in aggregate demand have no effect upon the price level;
aggregate supply is absolutely elastic (AS curve is horizontal), i.e. firms can produce as many goods and services as they know the buyers will want to buy (under the condition of high unemployment, firms have no problem to hire additional workers and increase output);
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the money wages are rigid (sticky); when unemployment is high, workers cant claim the increase in wages (W = const), thus the costs of inputs dont change; the interest rate is rigid (i = const); national output = national income (it means that depreciation and indirect taxes are not concerned); taxes are only direct and are paid only by households.
According to the Keynesian theory, the equilibrium level of national income is determined where aggregate demand equals aggregate supply. To understand the meaning and behaviour of aggregate supply and aggregate demand, let us analyze it in terms of income and expenditure. Aggregate supply refers to the total value of goods and services produced and supplied in an economy per unit in time, which includes both consumers and producers of goods. We can arrive at the total value of the national output by multiplying the quantity of goods and services produced per unit time by their respective prices.
400
Expenditure Rs. Billion AS = C +S E C +I C
300
200
100 50 I Income Rs. Billion 100 200 300
Figure 2.1. National Income Determination
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If all that is produced in an economy is sold, then aggregate supply grows at a constant rate of increase in output as indicated by the aggregate supply schedule AS at 45o in figure 2.1. In Keynesian theory of income determination, aggregate income is equal to consumption plus saving (C+S). 2.4.1 Aggregate Demand The aggregate demand implies the effective demand which equals actual expenditure. The aggregate effective demand means the aggregate expenditure made by the society per unit of time. Aggregate demand is composed of the aggregate demand for consumer goods (C) and aggregate demand for producer goods or capital goods (I). Thus, AD = C+I. In the Keynesian framework, investment (I) is assumed to remain constant in the short-run at all levels of income. But consumption is a function of income and can be expressed as C = a +bY where, a is a constant denoting the consumption level when the income is 0 and b is the proportion of income consumed. The AD function can now be expressed as AD = a +bY+I Income Determination It can be seen in the figure 2.1 that AS and AD are equal only at one level of income and expenditure, and therefore, the equilibrium level of the national income is determined at that level. If for some reason, AD exceeds AS or AS exceeds AD, the adjustment process will take place till the equilibrium is reached. The AS schedule is drawn on the assumption that total income (Y) is always equal to the total expenditure E. The AS schedule therefore, has a constant slope of 1. Having briefly discussed the theory of national income determination, let us now discuss in detail the relationship between consumption (C), saving (S) and National Income (Y) with a view to understanding the
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process of national income determination in a theoretical mode. Let us first look into the relationship between income and consumption, generally expressed through consumption function. 2.4.2 Consumption Function The consumption function states the relationship between income and consumption. The total demand for consumer goods and services accounts for the largest proportions of the aggregate demand in an economy and plays a crucial role in the determination of national income. The total household consumption expenditure in an economy depends on the total current disposable income of the people. According to Keynes, the consumption function stems from a fundamental psychological law. The law states that propensity to consume decreases with increases in real income. In simple words, when the real income of the society increases in the short-run, its total consumption increases, but not by an equal amount of increase in the income. The Keynesian hypothesis of income-consumption relationship was later termed as the absolute income hypothesis. The Keynesian aggregate consumption function makes the following propositions:
The consumption increases as disposable income increases, but not by the amount of absolute increases in the income.
As the absolute level of disposable income tends to rise, the proportion of income spent on consumption tends to remain constant.
Up to a certain level of Y, C >Y, these properties of consumption function have been shown by the C schedule in figure 2.2.
Consumption is a fairly stable function of income.

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Consumption Expenditure C
P
?C
A
?Y
Disposable income Figure 2.2. Disposable Income
2.4.3 Marginal and average Propensity to Consume The marginal propensity to consume (MPC) refers to the marginal income spent on consumer goods and services. The proportion of the total income consumed is known as average propensity to consume (APC). The APC, which is the fraction of total income spent on consumer goods, can be symbolically represented as C/Y. The APC tells the producers what proportion of the total output can be disposed of or what proportion of the total cost of production can be recovered from the sale of consumer goods and services. MPC refers to the relationship between change in consumption C and change in income Y and is expressed as C/Y. According to the Keynesian consumption function, marginal propensity to consume decreases with increase in income. This logic is applicable only at the individual level. At the aggregate level, however, the economists have found empirically a constant marginal propensity to consume. The relationship between income and consumption can be expressed through a linear consumption function as C = a +bY. The MPC can be derived from this linear consumption function as follows. C = a +bY, then C + C = a + b(Y +Y) = a + bY+ bY and C = -C + a + bY+ bY. Since C = a+bY, by substituting for C, we get C = -a - bY+ a + bY+ bY. 2.4
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Hence, C = bY.
2.5
By dividing both the sides of the above equation by Y, we get C/Y = b. Thus b in the consumption function represents MPC. According to Keynesian theory of consumption , C/Y is always less than unity but greater than zero, i.e., 0 < C/Y < 1. 2.4.4 Savings Function Savings is also a function of income. At the aggregate level, Y = C+S. Therefore, S = Y-S. Savings is thus a part of the income that is not consumed. Savings can therefore be derived from the consumption function. S = Y-C We know that, C = a +bY. By substituting for C in the above equation, we get, S = Y a bY S = -a + (1-b) Y 2.6 This is called the savings function. As b = MPC, 1 b = 1 - eC/eY 2.7
is the marginal propensity to save (MPS). 2.4.5 Equilibrium of national income: Two sector model The two-sector model consisting of households and firms, assumes the absence of the government and foreign sectors. Income determination with these sectors will be discussed in subsequent sections. We stated above, equilibrium level of national income or national output is
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determined at a level where aggregate demand for output ( C + I ) is equal to aggregate supply of incomes (C+S). Thus, equilibrium condition for national income as aggregate demand is equal to aggregate supply, which can be expressed as C+I = C+ S Since C is common to both the sides in the above equation, the equilibrium conditions may be expressed as I = S. Given this condition of equilibrium, the determination of national income can be illustrated graphically as given below in figure 2.3, by using only C+I and C+S schedules, or by using only I and S schedules.
Y = C+ S C+I Excess Demand E C E I Undesired accumulation of inventory
E B 0 A
The determination of national income through both the sets of schedules has been presented in figure 2.3. The Keynesian model of income determination as given above assumes that investment (I) is exogenously determined outside the model, and that in the short-run, supply of investment goods is inelastic and investment is constant. For all levels of output the investment schedule (I) is a straight horizontal line. The aggregate demand is shown by the C+I schedule and the aggregate supply schedule by C+S which intersect each other at point E. At this point, C+ I = C+S. Thus, the equilibrium level of national income is determined at this point. This equilibrium will remain stable in the short-run, since at point E the expected sale proceeds are equal to the realized value. The
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entrepreneurs trying to maximize their profits achieve their objective when they produce and sell goods worth the equilibrium level of income. Any excess production beyond the equilibrium level will result in undesired accumulation of inventories which will reduce profit. Similarly production below this level will leave the aggregate demand in excess of supply leaving scope for further production and profit. 2.5 Changes in Aggregate Demand and the Multiplier In this section let us discuss the effect of change in the aggregate demand on the level of national income and introduce the concept of multiplier. Aggregate demand may change due to change in either C or I or both. But since consumption is a function of income, C cannot change unless Y changes. In the short run, therefore, AD changes due to changes in the investment (I) only. If we assume that aggregate demand increases due to increase in investment I may be a result of autonomous investment expenditure by the business enterprises or by the government. Now let the aggregate demand increase from C+I to C +I +I. It may be inferred from the theory of income determination that when the aggregate demand increases due to I, the level of national income will also increase. The theory of multiplier tells that national income increases by some multiple of I. The numerical value of the multiple is known as the investment multiplier. Thus, multiplier is a number which gives a multiple increase in national income due to a given increase in investment, i.e., I. That is, if m is the multiplier then Y = I x m, and m = Y/I. 2.5.1 The Dynamics of Investment Multiplier The dynamics of a multiplier tells us how a I multiplies itself into Y. As we already know, investment is the expenditure on factors of productionlabour and capital. Therefore, when an investment is made, it increases the income of those who supply capital goods and labour exactly by the amount of investment expenditure which means that income Y equal to I is generated in the first period. Since C is a function of Y, the increase in income Y leads to increase in consumption C depending on the marginal propensity to consume. Those who supply goods and services
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to the tune of C, earn an income equal to bY (where mpc = b) in the second period. They too consume b times bY = b2 Y and this process goes on. Since b<1, bnY goes on diminishing in the process of income generation and until it tends to zero. In this process, a series of new incomes are generated leading to increase in the national income. The series of income over n periods may be expressed as Y = I + bY+ b2"Y++ bnY Y = I (1/1-b) 2.8
Once Y is calculated, the investment multiplier (m) can be obtained as m = Y/I. The whole process is known as dynamic multiplier and it presumes that I is a one-time investment, I remains constant, the new demands for consumer goods are met with new production and the price remains constant. 2.5.2 Limitations of Multiplier Despite its important uses in macroeconomic analysis, the concept of multiplier has certain limitations which should be borne in mind while using this concept. 1. The multiplier formula m = I / (1-mpc), implies that the higher the mpc, the higher the multiplier. It means that the less developed countries which have in general, a higher mpc must grow at a much higher rate than the developed countries, which with a lower mpc. But this is not true. This means that the actual multiplier does not depend on mpc alone. It depends on a number of other factors also. 2. The working of the multiplier assumes that those who earn income as a result of certain autonomous investment, who continue to spend a certain percentage of their newly earned income on consumption. This assumption may not hold in reality, since people may like to spend a part or whole of their additional income on payment of past debts, purchase of existing durable goods and other assets, share and bonds from the shareholders and bondholders and purchase of imported goods. These
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are all called as leakage in the consumption flows, which reduces the rate of multiplier. 3. The working of multiplier is based on the assumption that the goods and services are available in adequate supply. But, if goods and services are in scarcity as is the case in scarcity- ridden countries, the actual consumption expenditure will be reduced whatever the rate of mpc. Consequently, the multiplier will be reduced if expenditure continues to increase in the phase of scarcity; it generates inflation, not real income. 4. Under the condition of the full employment, the theory of multiplier does not work in real terms. Because, goods and services cannot be produced in excess of their full employment level. 2.6 Three Sector Model of Income Determination In the previous section, we discussed the two sector models of income determination as proposed by Keynes. Real economy, however, contains government and foreign sectors apart from the firms and the household sector that were considered in the two sector model. In the three sector model of income determination we will understand the effect of government spending and taxation on income. The inclusion of government into the model affects aggregate demand through government expenditures and taxation. Government expenditures are an injection into the economy whereby they add to the aggregate demand and taxation is an extraction from the economy whereby it reduces the aggregate demand. The government expenditure and taxation affect the national income to the extent of their net multiplier effect. When we include the government into the three sector model, we make an assumption that the government follows a balanced budget policy. In other words, government expenditure (G) equals the amount of taxes it collects (T). Aggregate demand (AD) in the sector is defined as AD = C + I + G and aggregate supply (AS) as AS = C + S + T. The equilibrium level of national income is reached when C+S+T=C+I+G Hence Y = C + I + G where
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Disposable income Yd = Y T T = lump sum tax C = a +bYd = a + b (Y T) By substituting for C in the income equation, we get, Y = a + b (Y T) + I + G Y bY = a bT + I + G Y = (1/1-b) (a bT + I + G) 2.7 The Role of Fiscal Policy In this section we will analyse the effect of changes in governments fiscal policy on the equilibrium level of national income. Fiscal policy is the economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded. Fiscal policy and monetary policy are the macroeconomic tools that governments have at their disposal to manage the economy. Fiscal policy is the deliberate change in government spending, government borrowing or taxes to stimulate or slow down the economy. It contrasts with monetary policy, which describes the policies about the supply of money to the economy. Fiscal policy refers to the deliberate changes made by the govenrment in its expenditure (G) and tax revenue (T). We will reserve further discussion on the fiscal policy to a later section of this unit. In this section we will analyse the impact of changes in fiscal policy on income determination in three stages. 2.8 The Effect Of Government Expenditure To start with, we will discus the effect of change in the government spending on the equilibrium level of the national income through its multiplier effect. Let us suppose that the government makes expenditure
2.9
2.10
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only on the purchase of goods and services and that there is no transfer payment. When all the other variables remain constant, the impact of government expenditure on the level of national income is similar to that of autonomous changes in investment. We know that in the three sector model, the equilibrium level of national income is given by the equation Y = (1/1-b) (a bT + I + G). Let the government expenditure increase by G. This will result in the increase of national income by Y through the process of multiplier. The equilibrium level of national income can be expressed as Y + Y = (1/1-b) (a bT + I + G + G). 2.11
The effect of G on the level of national income can be obtained by subtracting equation 2.10 from equation 2.11. , when we get Y = (1/1-b) G 2.12
By dividing both the sides of the equation 2.12 by G, we get the government expenditure multiplier (Gm) as Gm = eY/eG = (1/1-b) 2.13
Note that government expenditure multiplier is the same as the investment multiplier. 2.9 The Impact of Change in Lump Sum Tax When compared to the effect of changes in government expenditure, the impact of a change in lump sum tax (eT) on the level of national income is negative and smaller, if eT = eG. To analyse the impact of changes in taxes on the level of national income, let us recall the equilibrium condition for national income as given by the equation 2.10 and incorporate in it eT and its impact on Y. A change in tax (T) by eT, the level of national income will change by eY. By incorporating eT and eY in equation 2.10 we get,
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Y + eY = (1/1-b) [a b (T + eT) + I + G)] = (1/1-b) (a bT - bT + I + G). .2.14
By subtracting equation 2.10 from 2.14, we get the effect of T on the level of national income, which is Y = (1/1-b) (b T) = (-b/ 1-b) T .2.15
The tax multiplier (T m) can be obtained by dividing both sides of the equation 2.14, by T. Thus T m = Y/ T = -b/ 1-b Since b = mpc and mpc < 1, [ T m = -b/(1-b)] < [Gm = (1/1-b)] .2.17 From the expression 2.17, we can infer that
.2.16
T multiplier is smaller than the G-multiplier The effect of taxation on the level of national income is negative whereas that of government expenditure is positive
From the above two points we can conclude that if G = T, national income will increase, but we do not know by how much it will increase. Thus in the next stage, we will try to answer this question. 2.10 The Balanced Budget Multiplier In the previous two stages we discussed the G multiplier keeping taxes as constant and T multiplier by keeping the government expenditure as constant. In this stage, we will discuss the impact of simultaneous and equal change in G and T on the level of national income. When G = T, the government budget is said to be balanced. The effect of balanced budget on the national income is analysed by balanced budget theorem
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or balanced budget multiplier effect. The balanced budget theorem states that the balanced budget multiplier is always equal to one and hence it is also called as unit multiplier theorem. To understand the theorem, let us recall the equilibrium equation 2.10. By incorporating G and T (while G = T) and the resulting combined change in income, Y, the equilibrium level of income can be expressed as Y + Y = (1/1-b) [a b (T + T) + I + G + G] 2.18
By subtracting equation 2.10, from the above equation 2.18, we get, Y = (1/1-b) [b T + G] 2.19
Since T = G, we can rewrite the above equation 2.19 as Y = (1/1-b) [b G + G] = (1/1-b) (1 b)G Y = G 2.20
We can obtain the balanced budget multiplier (Bm) by dividing both the sides of equation 2.18 by G. Bm = Y / G = G/ G = 1 We can also arrive at the balanced budget multiplier by adding the T and G- multipliers. Thus, Bm = Tm + Gm By incorporating the values of Gm and Tm we get Bm = 1/1-b - b/(1-b) = (1-b)/ (1-b) =1
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Thus, the balanced budget multiplier (Bm) is equal to unity. It implies that if eG = eT, national income increases exactly by the amount of increase in government expenditure. 2.10.1 Proportional Income Tax and Balanced Budget Multiplier We have so far analysed the fiscal policy effects on national income assuming an autonomous lump sum tax. In reality, however, the tax system uses both lump sum and proportional taxes. Hence the tax function takes the form of T = Ta + t Y 2.21
where T a = autonomous lump sum tax, and t = the rate of proportional income tax, also called as the marginal propensity to tax. Let us begin the analysis by recalling the equation 2.9 which is Y = a + b (Y T) + I + G By substituting for T from equation 2.21 in 2.9 we get, Y = a + b [Y (Ta + t Y)] + I + G By solving equation 2.22 for Y, we get, Y = a + bY bT a - bt Y + I + G Y - bY + bt Y = a bT a + I + G (1 - b + bt )Y = a bT a + I + G Hence, Y = [1/( 1 - b + bt )] [a bT a + I + G ] 2.23 2.22
Now if we incorporate the change in government expenditure G in the above equation 2.23, we get Y + Y= [1/( 1 - b + bt )] [a bT a + I + G + G] 2.24
By subtracting equation 2.22 from the equation 2.24, we get Y= [1/( 1 - b + bt )] G 2.25
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We can obtain the balanced budget multiplier (Bm) with proportional tax by dividing both the sides of equation 2.25 by G. Bm = Y / G = [1/( 1 - b + bt )]
2.11 Four Sector Model of Income Determination

In the three sector model that we discussed, we analysed income determination in a closed economy. To understand income determination in an open economy, let us turn to the four sector model which includes the effect of foreign trade along with the firms, households and government. In the case of foreign trade, exports(X) are injections and imports (M) are the outflows from the economy which causes the level of income to increase and decrease respectively. In the national income analysis, only the net of exports over the imports (X M ) is considered. Therefore, when X > M, there is an increase in national income and if X<M, there is a decrease in national income. To further our discussion on the effect of foreign trade on national income, we need to understand the export and import functions. The export of a country is dependant on a multitude of factors which include
Prices of domestic goods in comparison with goods available in other countries Export subsidies Tariffs and trade policies of importing countries Income elasticity (the responsiveness of demand to the changes in income) of demand for imports in the importing countries Domestic level of imports
Out of these factors, only the first two are in the control of the domestic economy. Hence, the other variables cannot be included in the government
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policy variables. For the sake of simplicity, thus, we assume that the exports are determined by factors operating outside the economy under consideration. Hence, in the income determination model, X is considered to be given i.e., autonomous Xa. Similar to the exports, the imports are also determined by a number of factors such as
Import prices in comparison to domestic prices The level of domestic tariffs Domestic trade policy Income-elasticity of imports The level of income The level of exports
Here again, many of the factors are out of the control of the economy and hence, for simplification, we assume that the imports depend on the level of domestic income and the marginal propensity to import (mpm). Thus we can specify the import function as M = Ma + g Y Where Ma = autonomous imports, g = eM/eY = mpm, assumed to be constant. Having specified the X and M functions, we can now arrive at the equilibrium equation of national income in the four sector model as, Y = C+ I + G + (X M) Where C = a + bYd I = Ia G= Ga
2.26
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X = Xa M = Ma + gY Yd = Y T a By substitution, we can rewrite the equation 2.26 as Y = a + b Y b Ta + Ia + Ga + Xa Ma gY Y - b Y + gY = = a + b T a + Ia + Ga + Xa Ma Y = [1/(1-b+g)] [a + b T a + Ia + Ga + Xa Ma] ...2.27
The term 1/(1-b+g) in the above equation 2.27 is the foreign trade multiplier, when the consumption and imports are both a linear function of domestic income. We can arrive at this foreign trade multiplier (Fm) by considering increase in exports X by X, keeping other variables constant. Y + Y = [1/(1-b+g)] [a + b T a + Ia + Ga + Xa + X Ma] ...2.28 By subtracting equation 2.27 from equation 2.28, and dividng it by X on both sides, we get Y = [1/(1-b+g)] X Fm = Y/X = 1/(1-b+g)] Where b is the marginal propensity to consume (mpc) And g is the marginal propensity to import (mpm) When b= g in equation 2.29, the foreign trade multiplier becomes equal to unity.
2.29
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2.12 Consumption Models In this section, we will look at some interesting models and theories to explain two parts of aggregate expenditure, namely, consumption spending and investment spending. These models are based on microeconomic fundamentals. These alternative models have policy implications and hence it is important for us to understand these models. 2.12.1 Consumption Spending Consumption is the most important part of aggregate expenditure. It is the main determinant of income. Therefore, a detailed understanding of consumption is critical to understanding the determination of equilibrium income and fluctuations in income. In the Keynesian model, consumption is determined solely by disposable income. Keynes notion of MPC stems from his view of human psychology, that individuals spend more when income rises but that they do not spend the entire increase in their income. The Keynesian model predicts that the average propensity to consume (APC = C/ Y) declines with income. This is because saving is like a luxury good with the rich tending to save a greater proportion of their income than the poor. In Keynes view, the interest rate has little short term influence on consumption. The empirical evidence on the Keynesian model of consumption is mixed. Studies using short time series data tend to support the fact that MPC lies between 0 and 1 and that income is an important determinant of consumption. However, studies of long time series data indicate that the average propensity to consume is very stable over long periods of time and that despite higher income, one does not get large increases in the rate of savings as would be predicted by the Keynesian model. Over short time series studies, the APC does decline but over longer time series,
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it is stable. This would indicate that the consumption functions are different in the short run and the long run as shown below.
C Long-run consumption function
Short -run consumption function
Several theories of consumption have emerged to explain this fact. In this section we will discuss three of these theories in brief. 2.12.1.1 Intertemporal consumption Individuals decide on their consumption across different time periods subject to a multiperiod budget constraint. They maximize utility intertemporally (Maximize utility across different time periods). Consumers maximize utility by setting the marginal rate of substitution (marginal rate of substitution of X for Y is the quantity of Y which would just compensate the consumer for the loss of the marginal unit of X) in consumption across two periods equals the relative price of consuming between the two periods. The main feature that differentiates it from the Keynesian specification of consumption is that consumption is a function of lifetime income and not merely the current income. Consumers look at the present value of current and future income. They respond to the changes in the relative price of consumption (changes in the interest rate) between two periods based on their preferences, whether they are borrowers or lenders, whether they face liquidity constraints or not, policies such as taxes on savings, et. Thus, consumption is determined by a richer set of variables than predicted by the Keynesian model.
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2.12.1.2 Life Cycle (LC) Hypothesis One of the most important alternative theories of consumption is Modiglianis life cycle model of consumption and savings. In many ways it is similar to the intertemporal model. According to this theory, individuals are believed to base their current consumption decisions on their lifetime plan to maximize utility temporally. Families take into consideration both current and future expected income while making consumption decisions to smooth their consumption pattern over their lifetime, between working and retirement years. They save during their working years and live off savings during their retirement years to maintain smooth consumption levels. Consumers do not want a large drop in their living standard when they retire. Another important feature of the LC model is that, wealth in addition to income affects consumption. Wealth includes holding of physical assets, human capital, bonds, etc. The net worth of an individual or family (Assets Liabilities) is a determinant of consumption. Thus, individuals look at the present discounted value of their assets and income to decide on their consumption spending. Since wealth does not vary proportionately with income over short periods of time, the average propensity to consume declines over short time periods, in line with the Keynesian model. But over long time periods, wealth and income tend to move together which would explain the stable APC over long time series data. So, in the short run, one is moving along a given consumption function, while in the long run, there is a shift in the consumption function due to increase in wealth, thus preventing the APC from declining. An important implication of the LC model is that savings vary over a persons lifetime. Young families with few assets and many wants and with expectations of higher future wages go into debt in their early years and save later on in their lives. Middle aged individuals save in anticipation of their retirement years and retired people dissave (deplete their saving). The consumption and savings functions of population in different age groups affect the overall consumption and saving propensities of the nation.
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2.12.1.3 Permanent Income Hypothesis (PIH) Another very important model of consumption is the permanent income hypothesis developed by Milton Friedman. This model also assumes that consumption depends on lifetime income based on intertemporal decisions. According to this model, income is not regular; it changes randomly and temporarily across years. Hence, we can decompose the income into its permanent and transitory components. Individuals look at their permanent income over their lifetime in determining consumption in each period. Permanent income is the expected flow of income from the stock of human and non human wealth. Therefore, future income again affects current consumption. According to this model, consumption depends mainly on permanent income and borrowings and savings is used to smooth consumption in response to transitory changes in income. People save in their good years to carry them through in their bad ones. Thus, when there is an increase in permanent income, it is consumed completely while when there is increase in transitory income, it is spread out over ones lifetime. The permanent income hypothesis has important policy implications. For instance, temporary tax cuts are likely to have a small effect on consumption spending. The role of expectation is also very important in this model since essentially one is dealing with intertemporal consumption choice. If individuals use all available information, then, only unexpected policy changes would cause changes in consumption spending. Even a permanent tax cut if expected would already be factored into expected lifetime income and thus planned consumption. The discussion of the three alternative theories of consumption indicates that the Keynesian demand model grossly simplifies the nature of consumption spending. In reality, consumption spending depends on many other factors. According to these models, consumption rises when there are capital gains arising from increased value of assets, even if no extra income is received in the current period. This implies that the interest rate which affects returns to many assets is also a determinant of the
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consumption. Thus lifetime income and wealth together determine the pattern of current and future savings and consumption. Apart from income and wealth, other factors that affect the consumption expenditure include expectations, confidence in the economy, prices, credit availability, interest rates etc. 2.13 Business cycle The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. The business cycle refers to the periodic fluctuations of economic activity about its long term growth trend. The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), alternating with periods of relative stagnation or decline (contraction or recession). These fluctuations are often measured using the real gross domestic product. One of the governments main roles is to smooth out the business cycle and reduce its fluctuations. Business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degrees, unpredictable. Hence to call it as cycles is rather misleading as they dont tend to repeat at fairly regular time intervals. Most observers find that their lengths (from peak to peak, or from trough to trough) vary, so that cycles are not mechanical in their regularity. Since no two cycles are alike in their details, some economists dispute the existence of cycles and use the word fluctuations (or the like) instead. Others see enough similarities between cycles that the cycle is a valid basis of studying the state of the economy. A key question is whether or not there are similar mechanisms that generate recessions and/or booms that exist in capitalist economies so that the dynamics that appear as a cycle will be seen again and again. 2.13.1 Phases of Business Cycle Business cycles, the periodic booms and slumps in economic activities, are generally compared to ebb and flow. The ups and downs in the economy are reflected by the fluctuations in aggregate economic
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magnitudes, including production, investment, employment, prices, wages, bank credits, etc. The upward and downward movements in these magnitudes show different phases of business cycles. Basically, there are only two phases in a cycle, viz., prosperity and depression. However, considering the intermediate stages between prosperity and depression, a business cycle is identified as a sequence of four phases:
Expansion of economic activities (A speedup in the pace of economic activity) Peak of boom or prosperity (The upper turning of a business cycle) Contraction (A slowdown in the pace of economic activity) Trough (The lower turning point of a business cycle, where a contraction turns into an expansion) Recovery an Expansion
The five phase of the business cycle are depicted in figure 2.4. When there are no business cycles, the growth of the economy can be shown by a steady growth line as indicated in the figure. The various phases of business cycles are shown by the line of cycle which moves up
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and down the steady growth line. The expansion phase, which is indicated by the line of cycle moving above the steady growth line, marks the beginning of the prosperity in the economy. This phase is characterized by increase in output, employment, investment aggregate demand, sales, profits, bank credits, wholesale and retail prices, per capita output and a rise in standard of living. The growth rate eventually slows down and reaches its peak. The peak is generally characterized by slacking in the expansion rate and the end of expansion. It indicates the beginning of the downward slide in the economic activities from the peak. The phase of recession begins when the downward slide in the growth rate becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, though the realized growth rate may still remain above the steady growth line. The economy enjoys a period of prosperity as long as growth rate exceeds or equals the expected steady growth rate. But when the growth rate goes below the steady growth rate, it marks the beginning of depression in the economy. In a stagnated economy, depression begins when the growth rate turns negative. The span of depression spreads over a period during which growth rate stays below the zero growth rate in a stagnated economy. Trough is the phase during which the down-trend in the economy slows down and eventually stops. After trough, the economic activities once again register an upward movement with a lapse of time. Trough is the period of most severe strain on the economy. When the economy registers a continuous and rapid upward trend, it enters a phase of recovery. In this stage the growth rate may still be less than the steady growth rate, but still the economy once again enters the phase of expansion. If economic fluctuations are not controlled by the government, business cycles continue to recur. 2.13.2 Preventing Business Cycles Because the periods of stagflation are painful for many who lose their jobs, pressure arises for politicians to try to smooth out the oscillations. An important goal of all Western nations since the Great Depression has
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been to limit the dips. Government intervention in the economy can be risky, however. No one argues that managing economic policy to even out the cycle is an easy job in a society with a complex economy, even when Keynesian theory is applied. According to some theorists, notably nineteenth-century advocates of communism, this difficulty is insurmountable. Karl Marx in particular claimed that the recurrent business cycle crises of capitalism were inevitable results of the systems operations. In this view, all that the government can do is to change the timing of economic crises. The crisis could also show up in a different form, for example as severe inflation or a steadily increasing government deficit. Worse, by delaying a crisis, government policy is seen as making it more dramatic and thus more painful. Good forecasts of cyclical turning points are critical to improve policy decisions. Monetary and fiscal policy helps to smooth the cycle out as well. 2.13.3 Traditional Business Cycle Models The main types of business cycles enumerated by Joseph Schumpeter and others in this field have been named after their discoverers or proposers: 1. the Kitchin Inventory Cycle (3-5 years) 2. the Juglar Cycle ( 7-11 years) 3. The Kuznets infrastructural investment cycle (15-25 years) 4. the Kondratieff wave or cycle (45 60 years) Even longer cycles are occasionally proposed, often as multiples of the Kondratieff cycle.
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2.13.4 Theories of Business Cycle A systematic study of business cycles is a relatively recent development that started in the nineteeth century. The classical economist believed that the world economic behaviour can be represented by the Law Supply creates its own demand; only inflexible wage and interest rates lead to unemployment in the economy and that the market forces would, by themselves, maintain stability in the economy. Even though important contributions were made to the theory of business cycles prior to the Great Depression, the study of business cycle still remained outside the purview of the general economic theory. Keynes was the one to introduce business cycle into the general theoretical framework of economy. There are a number of trade cycle theories that have been proposed by contributors like Metzler, Harrod, Kalecki, Samuelson, Hicks, Goodwin, etc. Out of the various theories on business cycle, we will restrict our discussion to the Pure monetary theory and Multiplier Accelerator Interaction Theory 2.13.4.1 The Pure Monetary Theory of Business Cycle The business cycle theories that laid emphasis on the monetary and credit system in their analysis are jointly known as monetary theory of business cycle. According to this theory, the main cause of business fluctution is the unstable monetary and credit system in the economy. The cyclical process is basically caused by the fluctuations in the money supply and bank credit. The business cycles are succesive phases of inflation and deflation and all changes in the levels of economic activities are only a result of changes in money flows. When money supply falls, prices decrease, profits decrease resulting in fall of production. Likewise, when the mony supply increases, prices rise, profits increase resulting in increase in total output.
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According to this theory, the principal factor affecting the money supply is the credit mechanism, which in the modern econmies is the volume of credit created by the banking system. The expansion of bank credit starts of the upswing of the business cycle and it continues till there is credit expansion. The banks expand credit facility as they find that in the given conditions, it is profitable to offer credit on easier terms motivating entrepreneurs to increase production. Consequently, bank credit is offered to different types of capital formation activities. As the profitability has increased, the entrepreneurs continue to borrow for capital investment, even when the interest rates begin to move upwards. Till the upward swing continues, the general level of price also increases as the demand increases at a faster rate when compared to increase in supply beyond a certain limit. The supply increases at a lower rate due to limited production capacity and the new investments cannot be made in the short run. Thus, credit expansion accelerates the process of economic expansion and helps rise in prices reinforcing the upswing in the cycle.After the expansion process becomes self-sustaining, it needs no further inducement from the banking ssytem. Hence, the banking system starts restraning their credit expansion which results in the reversal of the process of prosperity. As the credit expansion comes to an end, entrepreneurs can no longer obtain bank credit for expanding their business operations. Due to lack of credit, the entrepreneurs find it difficult to meet their payment obligations and to maintain inventories at the existing levels. So they deplete their inventories and cancel the orders for purchase of input which marks the beginning of downswing. 2.13.4.2 Multiplier- Accelerator Theory of Business Cycle In his General Theory, Keynes had argued that it was the dynamics of expectations that generated cycles by affecting the marginal efficiency of investment and subsequently the multiplier and output. Nevertheless, Keynes did not venture into explaining the nature and causes of business cycle.
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Roy Harrod in his theory of the trade cycle tried to explore the relationships between the Keynesian multiplier and accelerator-type investment functions to explain a growing, progressive economy with and without cycles. The principle of the multiplier as proposed by Keynes is that if investment increases, there will be an increase in output because of a multiplier relationship between equilibrium output and the autonomous components of spending. The principle of the accelerator, as laid out by Albert Aftalion (1913) and John Maurice Clark (1917), was that investment decisions on the part of firms are at least in part dependent upon expectations of future increases in demand, which may, in turn, be extrapolated from any current or past increases in aggregate demand or output. Thus, the multiplier principle implies that investment increases output whereas the acceleration principle implies that increases in output will themselves induce increases in investment. In the multiplier accelerator models, these two principles are put together to examine the dynamic properties of investment and output as they affect each other and to examine how they generate business cycles. Roy F. Harrod attempted to formalize a Keynesian growth model and was not much successful. John Hicks sought to recast Harrods unstable multiplier-accelerator dynamics into cyclical ones by having explosive trajectories bang up against floors and ceilings. To this end, Hicks employed the formalism of dynamical difference equations, that had been introduced in a similar context by Paul Samuelson in his income-expenditure oscillator and by Lloyd Metzler in his inventory cycle. We will discuss in this section, the Samuelsons model as a representative of this tradition. 2.13.4.3 Samuelsons Model This model is regarded as the first step towards the integration of principles of multiplier and accelerator. In his model, he shows how the interaction of multiplier and accelerator results in income generation and increase
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consumption and investment demands more than expected, causing economic fluctuations. In his model, investment is assumed to be composed of three parts. The first part is autonomous investment, which is the investment undertaken due to factors outside the control of the economy such as new inventions in the field of production technology and of new markets. The second is investment induced by interest rates and the final part is investment induced by changes in consumption demand, which is called derived investment. Now, let us discuss the interaction process of multiplier and accelerator in brief. When autonomous investment takes place in an economy, peoples income increases and the process of multiplier begins. Depending on the marginal propensity to consume, the increase in income results in the increase in demand for consumer goods and services. If there is no excess production capacity, the existing capacity of production will not be adequate to meet the increase in demand. Hence, the producers trying to meet this growing demand undertake new investments, which is derived investment. With this, the acceleration process starts. Due to derived investment, the income rises further, which in turn results in increase in demand for consumer goods and services. Thus, the multiplier and accelerator interact with each other and make the income grow at a much faster rate than expected, which is called the multiplier acceleration interaction. Samuelson makes the following assumptions when proposing his model:
no excess production capacity one year lag in consumption one year lag in increase in consumption and investment no government activity and no foreign trade
According to his model the economy will be in equilibrium when Yt = Ct + I t 2.30
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Where Yt is the national income, Ct = a Yt-1 is the consumption expenditure, and It is the investment expenditure, all in time period t and a is mpc. We can express the investment is a function of consumption function with a one-year lag as It = b (Ct Ct-1) where b represents capital - output ratio that determines the accelerator By substituting for Ct and It in equilibrium equation 2.30, we get Yt = a Yt-1 + b (Ct Ct-1) = a Yt-1 + b (a Yt-1 a Yt-2) 2.31
The above equation 2.31 is the final form of equilibrium equation from which we can infer that
We can arrive at any past or future income if we know the values of a and b and income for two years The rate of income variation would depend on the values of a and b.
In his model Samuelson has shown the various kinds of cycles that would be generated by different combinations of a and b which include damped non-oscillation, damped oscillation, explosive oscillation and explosive non-oscillation. 2.14. Fiscal Policy Fiscal policy is the economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded. Fiscal policy and monetary policy are the macroeconomic tools that governments have at their disposal to manage the economy. Fiscal policy is the deliberate change in government spending, government borrowing or taxes to stimulate or slow down the economy. It contrasts with monetary policy, which describes the policies about the supply of money to the economy.
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The objectives of the fiscal policy are derived from the aspirations and goals of the society. Please recall that we have already discussed the possible macroeconomic goals in the first unit. Since the economic, political and social conditions are different for different countries, the objectives of the fiscal policy may also vary. However, the most common objectives of the fiscal policy of different countries are: 1. economic growth 2. promotion of employment 3. economic stability 4. social justice or equity Irrespective of the objectives and their order of priorities, the two basic tools used by the fiscal policy are:
Taxation Public expenditure
2.14.1 Economic effects of fiscal policy Fiscal policy is used by governments to influence the level of aggregated demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates, are the best way to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. However, such policies have commonly resulted in deficit spending. During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian
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Theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability. Despite the importance of the fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. 2.15 Summary
The national income may be computed using the output or inventory method which measures output as the gross value of production
The Census method measures income by including income of all factors of production
The Expenditure or outlay method measures output by estimating the private and public expenditure on consumer and producer goods and services
John Maynard Keynes has proposed his theory of income determination based on his assumptions about the economy.
He suggested that equilibrium in an economy is determined by the aggregate supply and aggregate demand
The consumption function gives the relationship between income and consumption
The marginal propensity to consume is the marginal income spent on consumer goods and services.
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The income determination can be understood by two-sector( consumer and producer), three sector (consumer, producer, and government) and four-sector (consumer, producer, government and external sector) models
Multiplier is the number which gives a multiple increase in national income due to increase in investment Fiscal policy of the government determines the level of public expenditure and revenue which affects the income Consumption models explain how consumption function will affect income determination Business cycle is the periodic but irregular up and down movement in economic activity, which is determined by various macroeconomic variables. The business cycle includes expansion, peak, contraction, trough phases There are various theories which explain the reason for these business cycles. Through fiscal policy, the government can control business cycles.
Review Questions 1. What are the three methods of estimating national income? 2. In Keynesian perspective, how is national income determined? 3. What is the role of aggregate supply and aggregate demand in determination of national income? 4. What is marginal propensity to consume? 5. Compare the two-sector, three-sector and four-sector models in determining equilibrium income 6. Explain the dynamics of investment multiplier.
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7. How does the short-term consumption function differ from the long-term consumption function? 8. What do you understand when you compare intertemporal model, life-cycle hypothesis and permanent income hypothesis ? 9. What are the phases of business cycle and how does the economic policy of government effect the business cycle? 10. What does the multiplier-accelerator model suggest?
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UNIT - III
ANALYSIS OF MONEY MARKET
3.1 Introduction Money can be defined in various ways. It represents an implicit social contract by society between present and future purchasing power. It is a form of asset which represents claims by individuals and firms against the government and financial institutions and a liability of the latter. In this unit we will discuss money, the factors determining the demand and supply of money and analyse the nature of money market equilibrium, the LM curve. Before that we will discuss the goods market equilibrium, the IS curve. This will help us in understanding the integration of goods and money market, which we will discuss in the next unit. 3.2 Money Money confers immeasurable benefits to our commercial life in our modern society. Money may be regarded as something, which is generally used as a means of payment and accepted for the settlement of debts. Money was invented as a panacea for the difficulties and inconveniences caused by the earlier barter system of transaction due to increased volume of trade and specialization. Some of the difficulties of the Barter system that necessitated an alternative system of transaction include,
the need for double coincidence of wants (to allow mutual exchange) lack of common measure of value (each commodity cannot be expressed in terms of every other commodity
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want of means of sub-division (difficulty in exchanging divisible and indivisible goods) lack of standard of deferred payment or credit transactions lack of existence of generalized purchasing power (perishable goods cannot be stored as wealth for future use).
Hence to overcome these difficulties it was thought that exchange of goods should be made indirect by using some medium in between, wherein money came into picture. Money as medium of exchange first started in the form of commodities, which included a great variety of items. When silver and gold were used as commodity money, the government was not required to guarantee its value since these metals had their own intrinsic value. The market through the demand and supply of money regulated the quantity of money in the market. This system also had various shortcomings, which led to the development of the stable currency system where paper money is used, which is governed by the central bank of the country. In this system money is not wanted for its intrinsic value, but for its ability to buy any good that you want. Once paper money came into existence it became easy to carry money wherever we go and store it. Till the time paper note helps you to buy the things you want and pay all your bills, it serves the function of money. Whether the entry of paper money for transaction has influenced any of the major macroeconomic variables like GDP growth, employment and unemployment, and the inflation rate is an important question that requires analysis and deliberation. An Answer to these questions will help us find out whether the central bank of the country can regulate the economy through its monetary policy. 3.3 Demand for Money The concept of demand for money can be interpreted in two different ways, depending upon the two notions relating to the nature and functions of money. As we have already discussed, there are two fundamental
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functions of money. It acts both as a medium of exchange and store of value. There is a medium of exchange concept of the demand for money. To the classical economists money is demanded by the people only as a medium of exchange and, therefore implies that it is not demanded for its own sake. Thus they believed that the demand for money is essentially for money to spend, or for the act of transactions. This means that the demand for money emerges from the volume of transactions of goods and services to be carried on during a given period of time. Thus, according to them, the demand for money was determined by the total quantity of goods and services that had to be paid for during a given period. Further, the quantity of money people require to hold for their transactions depends on the velocity of circulation of money. This view is also called as transaction approach to the demand for money There is also a store of value concept of money as proposed by the modern economists. According to them, the demand for money is the demand to hold the demand for cash balances. Money is not just meant for spending. It can be held as a form of wealth or asset, which commands other forms of wealth in exchange, all the time since money is most liquid form of asset and can serve as the efficient store of value. So, it is demanded for its own sake. In this sense, the demand for money is the inverse of the velocity of circulation. We can say either that the demand for money has increased, or the velocity of circulation, the rate of spending has diminished, or conversely. In short, the modern approach to the demand for money stresses the publics need for cash, or money balances, as a store of value of money at a particular point of time. In this context, it involves obviously peoples preference to hold liquid cash, or money rather than other assets, as a store of value. This desire for money is described by Keynes as liquidity preferences. Thus, according to him, the demand for money is a demand for liquidity or liquidity preferences. Hence the modern approach to the demand for money has been designated as the cash- balance or liquidity preference approach.
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Now, viewing the demand for money in its modern terminology, the question may be asked why should there be demand for money to hold or why do people prefer to keep idle cash balances and obvious answer is provided by the subjective considerations of individuals regarding liquidity motives for their satisfaction of which they desire to hold money balances. Keynes distinguished three such motives which induce people to hold money, namely, the transaction motive, the precautionary motive and the speculative motive. To Keynes the total demand for money implies total cash balances. Analytically, total cash balances may be classified into two parts, which are active balances and idle cash balances. 3.3.1 Active Cash Balances Active cash balances relate to the demand for money paid under transaction and precautionary motives. In other words, transactions demand for money and precautionary demand for money together constitute active cash balances held by the people. 3.3.2 Transaction Demand for Money Money being a medium of exchange, the primary demand for money balances arises directly out of its use for carrying on ordinary trade and business affairs of the economy. The transaction-prompted demand for money arises on account of the lack of synchronization between receipts and payments. Individuals, in general, do not receive money income as frequently as they make payments. Thus, when income is received at discreet intervals of time, but is paid out more or less continuously against the exchange of goods and services, it is inevitable that people should need a certain stock of money all the time in order to carry out their transactions. Briefly, thus, the transactions motive concerns the demand for money balances as a medium of exchange as a means of bridging the gap between periodic receipts and payments. Keynes, in dealing with the transactions motive, recognized both an income and a business motive. The income motive refers to the transaction motive of the households, that is, the consumer class. From the consumers perspective, the amount of money which he will hold to satisfy the
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transactions motive will depend both on the size of his income and on the intervals of time between receipts of the various instalments and then its payments. As income increases, there is an income motive for increasing transaction demand for money. The business motive refers to the transactions motive of the entrepreneurs. Business men require money balances to meet business expenses like payment for new materials and transport, payment of wages and salaries and allied current expenditure. Money held by producers for these purposes is said to be held to satisfy the business motive. Money balances held under this motive will depend upon the turnover of the firm. The larger the turnover, the larger will be the demand for money. It follows, therefore that the amount of money balances held under the transactions motive will depend on the time and size of firms earnings and on the turnover of the business. As business grows, the amount of money demanded for the transactions motive will rise. The transactions demand for money is income determined, and is relatively stable, because income does not change suddenly. Moreover, changes in the rate of interest have no such influence in changing the transactions demand. It is determined by the level of income. Thus, the transactions demand for money is interest-inelastic. 3.3.3 Precautionary Demand for Money Apart from transaction purposes, people desire to hold additional money balances against unforeseen emergencies. Thus the second reason for holding money balances is the precautionary motive. The money balances which people hold under the precautionary motive will be devoted to fulfilling the functions of a store of value. Out of prudence, people keep some liquid reserves or cash balances to provide for unexpected events such as illness, accidents, unemployment or some ceremonial occasions. The precautionary demand for money depends largely on the uncertainty of future receipts and expenditures. This demand is very sensitive to the anticipation of the level of income. However, future uncertainty is an important factor in determining the precautionary demand for money.
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Therefore, when uncertainty is present, people tend to hold money balances to act as a buffer against unforeseen events. Naturally, the precautionary demand for money varies with the type of emergency expected. The increased desire for liquidity, related to precautionary motive, is described by Keynes as the desire for security as to the future cash equivalent of a certain proportion of total resources. Thus, the precautionary demand for money is income determined and is relatively stable. The larger the income of the individual, the larger the cash balance set aside for future unforeseen events. 3.3.4 Idle cash balances According to Keynes, a section of people in the community hold cash balances for speculative purposes. This demand for money held under the speculative motive is referred to as the demand for idle balances. The motive arises from uncertainty about the future rates of interest. More precisely, the speculative demand for money represents the demand for cash being invested rapidly, as and when attractive opportunities for monetary investments appear. The speculative motive, in fact confines itself to the store of value property of money. Money held under this motive constitutes a store of value, a liquid asset, which the holder intends to use for gambling or to make a speculative gain as in investment in securities at an opportune moment. Thus, the speculative motive concerns an increase in the demand for money balances as a means to realize a gain in anticipation of likely changes in the value of bonds ( a form of security asset), but also, in expected changes in the value of a variety of assets. We must remember that people hold cash balances just to preserve liquidity. But the holding of cash in itself does not provide a yield, nor does it satisfy any want directly. Real assets like jewelry, ornaments, etc. give the pleasure of snob appeal. A car is meant for riding, a house for shelter or rental revenue, shares for yielding dividend, bonds and time deposits to yield interest payments and so on, whilst money kept idle begets nothing. One has therefore to pay an opportunity cost for preserving
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liquidity in terms of yield forgone. The yield forgone in keeping cash balances is usually measured in terms of prevailing market rate of interest. The rate of interest is, thus, the cost of being liquid. Thus, at any time, when people have a desire for liquidity they are supposed to consider the cost elements involved. But in holding the active balances, there is the main consideration of convenience and prudence which induces them to have the least consideration for the rate of interest. There is always an inverse relationship between the speculative demands for idle cash balances and the rates of interest. When people expect the prices of fixed income-yielding assets, like bonds, to fall, more balances will be held in cash, than what are just required to satisfy the other two motives. If people expect the rate of interest to fall and prices of bands to rise, there will be an increased tendency to hold bonds and other near-money assets than cash. Thus, the speculative demand for money will be less. The speculative demand for money is a function of the rate of interest. It is much interest-elastic. When the interest rate is high, speculative cash balances are minimal, and when the rate of interest is low, the demand for speculative balance may become insatiable. The speculative demand for money as against transactions and precautionary demand is incomedetermining. The purpose of holding money under the speculative motive is to take advantage of rise in the interest rate in future and earn more. Increased speculative demand for money represents increased preference for liquidity. So, it is sometimes called as liquidity proper. It indicates the preference for money as the most liquid asset rather than any other asset. It is most sensitive and is interest-elastic. 3.3.5 Total Demand Balances The communitys total demand for money depends upon the transactions and precautionary motive and the speculative motive. However, the demand for money held under a particular motive is difficult to identify in reality. Hence, the total cash balances depends on the combined factors relating to these motives. So, the total demand for money is the sum of
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the demand for active and idle balances which depends upon the level of national income and the rate of interest. The demand for active balances is perfectly income-inelastic and changes in proportion to the changes in income. 3.4 Money Supply Money supply is a stock as well as a flow concept. When money supply is viewed at a point of time, it is a stock of money held by the public on a particular date. It refers to the total of currency notes, coins and demand deposits with banks that is held by the public. When viewed over a period of time, money supply becomes a flow concept. A unit of money is spendable as well as respendable. Thus, it may be spent several times during a given period passing from one hand to another in the spending process during a given year and is referred to as the velocity of circulation of money. The flow of money is measured by multiplying a given stock of money held by the public with the velocity of circulation of money. According to Fischer, the flow of money supply over a period of time is MV where M represents stock of money held by the public and V represents velocity of circulation. 3.4.1 Constituents of Money Supply In view of complexities of money in a modern economy there are different views held by the monetary analyst regarding the composition of money supply. These views may be broadly classified into the traditional approach and the modern approach According to the traditional view, money supply is composed of (i) currency money and legal tenders (coins and currency notes) (ii) bank money (chequable demand deposits with commercial banks). Currency money is regarded as the high-powered money because it is a legal tender. The backbone of the currency system is the central bank notes and coins. This is because generally the central bank possesses the
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monopoly of notes issue. In certain countries, the treasury also issues notes or coins along with the central bank. For example, if you consider India, one rupee notes are issued and managed in circulation by the Government of India. The rest of the notes and coins are issued and managed by the Reserve Bank of India. The supply of paper money or notes in the country depends on the system laid down and worked out for the regulation of the note issue and the nature of the banking against note issue. In India, minimum reserve method is the principle governing the issue today. However, the particulars of denominations of currency in circulation as well as the proportion of the total money supply which is held in the form of currency are governed by sections of the public. The treasury, the central bank and the commercial bank are merely agents through which the preference of the public is expressed. The action of the public in choosing to hold more or less currency or more or less of particular denominations is normally influenced by the following factors
The physical volume of trade and transactions and the nature of the trade whether wholesale or retail. (retail transaction may require coins and notes of small denominations)
The Price Level The methods of payment (cheque or cash) The volume of demand deposits The banking behaviour of people The distribution of national income among different groups of people The method of taxation, public loans, deficit financing etc.
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3.4.2 Bank Money The commercial banks demand deposits are generally referred to as a constituent of money supply, because they are transferable by cheques in the settlement of debts. It is through payments made by cheques that the volume of demand deposits undergoes constant change. The creation of bank money or demand deposits depends on the credit creation activities of the banks, which is based on the cash volume held by them. The bank money, as such, is regarded as secondary money. The relative amounts of the constituents of money supply, viz., currency money and demand deposits, depend upon the degree of monetization of the economy and the banking habits in the country. According to the modern approach, money supply includes (i) Coins (ii) Currency notes (iii) Banks, demand deposits (iv) Time deposits with banks (v) Financial assets and (Vi) Bonds and equities. In short, the modern view extends the phenomenon of money to the whole spectrum of liquidity in the asset portfolio of the individuals in a modern economy. The controversy about the components of money supply has arisen on account of the difference of opinion regarding the significance and relationship between money supply and price level and the efficacy of monetary policy in a modern economy. The general recognition of the store of value function of money has given rise to the fairly widely accepted phenomenon of substitutability between money traditionally defined as a medium of exchange and the whole spectrum of financial assets obtained in an economy. Based on different notions of defining money in a modern economy there are four major approaches regarding the appropriate measure of money stock namely:
Traditional Approach: It emphasizes the significance of money as a medium of exchange and holds that money supply is constituted by currency money plus chequable demand deposits of banks held by the public. Conventionally, thus, the stock money at a point of
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time is measured by aggregating the issue of currency note and the amount of demand deposits with bank
Monetarist Approach: This approach holds that money includes all those things which are perfect substitutes for one another. Thus according to their view, money supply constitutes currency plus demand deposits plus time deposits Gurley Shaw approach: According to this approach, totality of financial liabilities of monetary and non-monetary financial intermediaries as a whole and not the quantity of money alone determines the spending decisions of the public- households and the firm. Thus, their concept of money supply includes all alternatives, liquid store value such as currency, demand deposits, time deposits , equity share, units of Unit Trust, etc. Liquidity Approach: This approach offers a completely new line of thinking and a much wider concept of money supply. Money supply is just a part of the wider structure of liquidity that is relevant to the spending decisions of the commodity. Prices are affected by the spending decision of the people which in turn is determined by the general liquidity of the economy. Hence, the concept of money supply should be viewed in terms of general liquidity which includes cash, all kinds of bank deposits, deposits with other institutions, nearmoney assets, and the borrowing facilities available.
3.4.3 Reserve Bank of Indias Measure of Money Stock Holding a notion of the liquidity approach to money, the RBI sums up the following assets as aggregate monetary resources. 1. Currency (C) 2. Demand Deposits of Banks (DD) 3. Other deposits of the RBI (OD) 4. Post Office Saving Deposits
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5. Time Deposits of banks; and 6. Time Deposits of post offices Money supply is both an economic and a policy-controlled variable. Money supply as an economic variable is influenced by the portfolio behaviour of the public and banks. As a policy controlled variable changes in money supply are effected by the monetary authoritys view and action regarding the appropriate size of the primary as well as secondary money. From the stand point of money as a medium of exchange, the monetary aggregates are fundamentally composed of those assets possessing the attribute of superior liquidity. The Reserve Bank of India has adopted four measures of money in a descending order of liquidity criteria as follows. 1. M1 = currency notes and coins with the public+ Demand Deposits with all commercial banks+ Other deposits held with RBI. 2. M2 = M1+ Savings deposits with Post Office Savings Banks. 3. M3 = M1 + Time Deposits of all commercial and cooperative banks 4. M4 = M3 + Total deposits with the Post office savings organization From the view point of monetary management, M1 signifies a flow, whereas M3 refers to stock and both should be tackled with due care. 3.5 Determinants of Money Supply The major determinants of the quantity of money in an economy are: 1. The size of the monetary base 2. Communitys choice regarding cash and credit proportions in holding money; and 3. The cash reserve ratio
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3.5.1 Monetary Base An important determinant of the extent of the money supply in a modern economy is the magnitude of the monetary base. Monetary base refers to the supply of funds available for use either as cash or as central banks reserve. Money supply varies directly in relation to the changes in this base. The monetary base is composed of the following:
Monetary gold stock Reserve assets, such as government securities, bonds and bullion, etc with the central bank, and Amount of central bank credit outstanding
Generally, the amount of monetary gold stock whether coined or used, as a backing for gold certificates, is being used either as cash or as bank reserves. The amount of monetary gold stock in an economy is determined by 1. the stock of gold accumulated in the past 2. the net addition made to monetary gold stock from the current domestic production of gold, and 3. the imports and exports of gold. The monetary base is also formed by the reserve assets of the central bank (on the basis of which it can issue notes) and by central bank credit. When a central bank increases its loans and investments it makes payments to borrowers or sellers of securities (other than commercial banks), either by paying cash or by giving a deposit credit with itself. In any case, this tends to uplift the reserve funds of the commercial bank. The relative importance of these three components of monetary base, however, varies with different monetary systems. Under the pure gold standard, the monetary gold stock assumes significance, whereas, under the convertible paper standard, as is commonly adopted today, the stock
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of monetary gold has no importance in the monetary base as such. The present day monetary base is determined by currency money and the central bank credit. 3.5.2 Communitys Choice The relative amount of cash and demand deposits which the community wishes to hold has great significance in determining the money supply. If the community chooses to make payments by cheques rather than by cash in a greater proportion, then larger will be total volume of money that will be maintained by a given monetary base. This is because one rupee in the hands of public supports only itself, whereas when it is with a commercial bank it can serve several rupees of money in the form of derivative demand deposits. Thus, the same amount of money can support a larger stock of aggregate money supply in an economy with banking development than in the economy without adequate banking facilities. Further, the communitys preference for money as a liquid asset also depends on the extent of monetization. In an economy with high degree of monetization, people would demand more money. So, there will be a pressure on the government to create more supply of money to cater to the growing needs of the economy. 3.5.3 Cash reserve Ratio The cash reserve ratio is also an important determinant of the quantity of money in the modern economy because it determines the multiplier coefficient of credit creation by banks. 3.6 Money Supply Function The money supply function expresses the supply behaviour in the money market as the functional relationship between the quantity of money supplied and its determinant variables. A commonly adopted money supply function is a function in terms of the rate of interest, which can be expressed as Ms = f(i) where Ms /i>0. Here, Ms denotes a marginal change in money supply, i implies a marginal change in interest rate I, while >0 represents a positive change or an increase.
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However, money supply is a function of many variables. The factors influencing the money supply are
the quantity of total legal tenders possessed by the banks l, the cash reserve ratios for demand deposits and time deposits d r, and tr respectively the rate of interest i, and the national income Y
Thus Ms = f (l, dr, t r, i, Y), where Ms /l>0 , Ms /dr<0, Ms / tr <0 Ms /i>0 Ms /Y>0 . Here, the factors l, dr, and tr are under the control of the central bank, while factors such as I and Y are determined by the market forces. Thus, money supply is determined jointly by the action of central bank, the commercial banking system and the general public. According to this view, variables such as income, rate of interest and other money market conditions are determined by the money supply rather than they being determinants of money supply. The recent view holds that the money supply is determined by interest rates and other market forces which influence the behaviour of the public in deciding its money holding ratio between currency and demand deposits, as well as between time deposits and demand deposits, so also, the commercial banks distribution of assets, between liquidityyielding assets and interest earning loans and advances. This view suggests that the action of the public and the commercial banks with regard to the money supply dominates the action of the central bank in effecting money supply. Hence, there is no predictable association between the size of money supply and the magnitude of variables controlled by the monetary authority. 3.7 Velocity of circulation of Money In order to find out the total supply of money over a period of time, we have to consider the velocity of circulation of money, which is the basic function of a medium of exchange to be re-spent. A single unit of money is spent several times during a given period passing from one person to
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another. The average number of times money circulates from one hand to another is termed as the velocity of circulation of money. Hence, the supply of money during a given period is the total amount of money in circulation multiplied by the average number of times it has changed hands during that period. In algebraic term, the supply of money during a given period is MV where M refers to the total amount of money in circulation and V refers to the average number of time that each unit of money is used for transactions of goods and services in a particular period. The velocity of circulation of money depends upon the following factors:

Time unit of income receipts Methods and habits of payment Degree of regularity of income receipts Distribution of national income Business conditions, inflation and deflation Development of financial system Rapidity of transportation of money Liquidity preference function
As the velocity of circulation of money is influenced by these complex forces, it is not easy to determine the velocity of circulation of money during a given period and various precautions and considerations must be taken while measuring it. 3.8 Money Creation: Changes in Money Supply Changes in money supply arise out of the action of the treasury, the central bank and the commercial banks or the money creating agencies in any country. They acquire assets of various kinds and issue in payment liabilities on debts, payable on demand, that are in monetary form and readily and generally acceptable in settlement of debts, and in the the making of payments. Thus, money supply consists of the debts of the money creating agencies.
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The two most important agencies in the structure of money and credit, in any country, are the commercial and central banks. The commercial banks are private institutions and the creators of the largest element of the money supply, namely, demand deposits. The central bank is an agency of the government, which exercises central control over the monetary structure of the country. It has also a partial or total monopoly of notes issue. In addition, there is money created by the state treasury. Generally, the treasury issues coins of small denomination (e.g. the Government of Indias one rupee notes), which are legal tender for payment of small debts only and which the public uses for making small payments. 3.8.1 Commercial Banks Commercial banks have the power to create demand deposits by granting loans. When a bank lends or advances credit to its customer, it does not usually give direct cash but opens an account in the customers name with itself. Then, the bank allows him to withdraw the sum by drawing cheques on his account. Thus, when the commercial banking system expands its loans and investments, it creates demand deposits which constitute a part of money supply in the modern economy. In the banking system as a whole, this process of credit or deposit creation has a multiple expansion. As such, the credit creation activities of the bank lead to changes in the money supply. 3.8.2 State Treasury and Central Bank The central bank indirectly affects the supply of money by varying the reserve funds available to the commercial banks. The central bank, with its various methods of quantitative credit control, like the bank rate, open market operations, and the variations in the reserve requirements, can influence the reserve funds of the commercial banks and their credit creating capacity. When the bank rate is lowered, open market purchase policy is pursued or the reserve ratio is decreased, the reserve funds of the commercial banks swell, and their lending capacity increases and credit expands, which results in increase in money supply and vice versa.
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Similarly, the magnitude of treasury fiscal operations by the State can also have their effect upon the quantity of bank reserve which in turn affects the total amount of money supply. The treasury can control the money supply through open market operations of treasury bills and other government securities and debt management. Total money supply is affected when the government creates money by resorting to the printing press (Deficit financing technique of the State). Deficit financing will cause an increase in the currency money which, in turn may boost deposits, and thereby results in considerable expansion of money supply. Deficit financing usually has an inflationary impact on the economy as a whole when the rate of production in the economy is less than the increase in money supply. Government can create money supply also by borrowing from the banking system commercial banks and the central bank and spending it which leads to a creation of demand deposits in favour of the government treasury in exchange for government securities. Since treasury deposits are not regarded as money supply, the government must spend it to seek and increase the money supply. When the government spends it, recipient among members of the public will get the amount and, hence, there will be shift of money from the government to the public. The publics purchasing power increases and when this goes to this commercial bank as primary deposits, their reserve fund increases, which lead to credit expansion. This is how public borrowing leads to money creation. When the government borrows money from the public directly, the money supply with the public may shrink initially, but when it is spent by the government, the money supply will again increase. The governments fiscal policy also exerts considerable pressure on the money supply. When the government follows a favourable budget policy, i.e. the revenue of the government exceeds expenditure, then the excess of revenue over expenditure will be transferred from the public to the government. To that extent, the money supply with the public is reduced. The process, in turn, also may reduce the bank reserves and there may be contraction of credit, thereby causing a decrease in money supply.
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Conversely, the money supply will increase when the government follows a deficit budget policy. The government should coordinate the monetary and financial policy for effective monetary management. The effectiveness of any monetary or fiscal tool depends upon various factors like
Presence or absence of counterbalancing measures Divergence of objectives between monetary and fiscal policies Business and economic conditions Political atmosphere Banking institutions Nature of money market, etc.
Some economists believe that fiscal weapons in monetary control are more effective than the monetary policy and weapons of credit control used by the monetary authority, that is, the central bank. 3.8.3 Non-banking Financial intermediaries When the concept of money supply is viewed in terms of the liquidity, the role of non-banking financial intermediaries (NBFIs) has to be traced in the creation of various forms of liquid assets as store of value. NBFIs include a wide variety of financial institutions from mutual savings societies to the insurance companies and development banks. In India, NBFis refer to the financial institutions in the range of development banks, insurance companies, UTI, hire-purchase financial institutions, chit funds, loans and finance companies. Their importance lies in dealing with medium and long-term funds in the capital market in the country. NBFIs main function is the transferring of funds from surplus savings unit to deficit units, thus facilitating different types of credit. The level of
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business activity in a modern economy is, thus, not influenced by the currency money and bank money used in the investment-spending process but also the borrowing facilities made available by the NBFIs. In short, it must be recognized that NBFIs have a significant role to play in creating financial claims which serve as near-money and pose a potential threat to the efficiency of traditional monetary policy just confined to the control of banks credit. 3.9 Money Market Equilibrium Finance is the integral part of modern business. Financial market refers to the institutional arrangements for dealings in financial assets and credit instruments of different types and in essence, are the credit markets. Credit is generally required and supplied on short-term or long-term bases and we can classify the financial market based on this criterion as money market and capital market. Money market refers to the institutional arrangements facilitating borrowing and lending of short-term funds, whereas, capital market is for the long-term funds. In this chapter we are going to learn about the money market and how equilibrium is achieved in this market. Before we discuss the money market and how the equilibrium in money market is reached, let us briefly discuss how the equilibrium in the goods market. The understanding of goods and money market will helps us understand the integration of commodity and money market which we will discuss in the next unit. 3.9.1 Goods Market equilibrium The investment-savings or IS curve represents equilibrium in the product market. It shows the combination of interest rates and income levels for which the goods market clears. In other words, the IS curve represents all combinations of the interest rate and income where planned and actual spending and income are equal and where planned and actual investment and savings are equal.
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The IS curve is really an extension of the income determination model, where investment is no longer exogenous, but a function of the interest rate. As we have already discussed, interest rates are an important determinant of investment spending. Now, we include interest rate as a determinant of aggregate expenditure through investment demand. Investment spending is taken to be a negative function of the interest rate in the economy. It is a negative function since firms typically borrow to buy investment goods. A rise in the interest rate increases borrowing costs and lowers expected profits, which makes firms less willing to borrow and invest. We can represent the investment function in an equation as follows: I = br where r is the interest rate, I is the investment, b> 0 and measures the interest sensitivity of investment and refers to autonomous investment spending. The investment schedule can be depicted in the graph as follows:
br I Figure 3.1 Investment schedule

The slope of the investment schedule is 1/b. The investment schedule reflects the fact that when there is a decline in the interest rate, the profitability of investment rises and there is greater addition to the capital stock and a rise in planned investment. Also, larger the value of b, flatter the investment schedule and the more responsive is the investment spending to changes in the interest rate. A flat investment
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schedule reflects high sensitivity of investment spending to changes in interest rate. Deriving the IS curve With the inclusion of interest rates as a determinant of investment, we get a modifies aggregate expenditure function. Assuming a closed economy. AE = C+I+G = + MPC. Yd + br + G = + MPC. (1-t)Y +MPC. Tr + br + G = br + MPC (1-t) Y Where the intercept is given by br (where = + + G + MPC. Tr) The equilibrium is reached when the modifies aggregate expenditure function intersects with the 45 degree line for income. When the interest rate rises, the AE function shifts down as the intercept of this function given by br declines. This is because investment demand falls pulling down aggregates expenditure at any given income level. The downward shift in AE function lowers the equilibrium income level where the AE line intersects the 45 degree Y line. This means that product market equilibrium (where AE = Y ) is represented by an inverse relationship between the interest rate and Y. In general, the IS schedule is derived by taking the point where the AE line and the 45 degree line representing Y intersect, for different interest rate levels. The higher the interest rate, the lower the corresponding equilibrium Y level. Combining these different points in which the interest rate and Y intersect, we get the negatively sloping IS curve or the goods market equilibrium schedule as shown in the figure 3.2. Position of IS curve depends on the levels of autonomous spending /
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expenditure. This is because if A increases, at the same interest rate Y will also increase, thus shifting the IS curve upward. The equation for the IS curve can be derived by using the equilibrium condition that income must equal planned spending at any point on an IS curve. Therefore, along the IS curve Y = AE = + MPC (1-t) Y - br Y = 1/(1 MPC (1-t)) * ( br) = o( br) where o = 1/(1 MPC (1-t)) is the government spending multiplier. The IS curve equation clearly shows that the higher the interest rate, the lower the level of income or output.
AE
AE AE
45o Y1 r r2 r1 IS Y2
Y Y1 Y2 Figure 3.2 Deriving IS Curve
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The equation of the IS curve indicates that the product market equilibrium depends on the existing structure of the economy, including autonomous spending (which is a function of tastes, resources, government budgets and expectations), the marginal propensity to spend and save, the tax rate, the responsiveness of spending and wealth to the interest rate, and the actual interest rate prevailing in the economy. We will discuss how the actual interest rate in the economy is determined in unit IV where we will discuss the interaction between the money and goods market. The slope of the IS curve depends on the structural parameters of the system including the tax rate, the marginal propensity to consume, and the sensitivity of investment to the interest rate. If b is high, then investment is very sensitive to the changes in the interest rate and the IS curve is relatively flat. Small changes in the interest rate gives rise to large shifts in the aggregate expenditure line and thus a larger change in equilibrium income. The higher the value of the multiplier 1/(1 MPC (1-t)), the flatter the IS curve. This may be due to a high value of MPC or a low tax rate. A shallower IS curve means that income is highly responsive to changes in the investment spending. The position of the IS curve depends on the level of autonomous spending (transfer payment, government spending, investment, or consumption). When there is an increase in autonomous expenditures, given some interest rate, then the AE curve shifts up by the extent of this increase in A. As a result the equilibrium income rises. This means that for any given interest rate, the corresponding level of income where the product market clears is higher. This is equivalent to a shift out of the IS curve. The extent of the shift in the IS curve is given by the product of multiplier and the change in autonomous spending which is 1/(1 MPC (1-t)) * . The IS curve represents the equilibrium in the product market and points along the IS curve represent product market clearing (the desire to buy and produce goods is equal). The points off the IS curve represent disequilibrium in terms of excess supply or demand in the goods market.
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3.9.2 Money Market In a money market, funds may be borrowed for periods varying from a day, a week, three to six months and against different types of instruments such as bills of exchange, short-term securities, bankers acceptance, etc., called near money. Money market is a short-term credit market and an essential feature of it is the dealings in assets of relative liquidity. It meets the short-term requirements of borrowers and provides liquidity or cash to the lenders. Even though it differs from the capital market in terms of the time period, there is a certain amount of overlapping between transactions in short and long-term loans. The same institutions may deal with both the types of financial markets But there are certain institutions such as investment houses, mortgage banks, financial corporations, etc. which mainly deal the long-term finance, while other institutions like discount houses and commercial banks deal only in short-term loans. Money market is not a place that exists in a specific physical location, but any arrangement that brings about a direct or indirect contact between the borrower and the lender. The basic function of the money market is to provide facilities for adjustment of liquidity positions of commercial banks, business corporations, non-banking financial institutions and other investors. The short-term money market is the place where the pull on the banking system is first felt in periods of pressure, and it is the place where ease in the banking system is first felt in periods of monetary overabundance. Central banks generally confine their operations to the short-tertm money market, as this gives them very good position from which to influence cost and demand, availability and supply of money. 3.9.2.1 Constituents of the money market The money market is composed of several financial agencies that deal with different types of short-term credit. Some of the important components include
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1. Call Money market: A market for extremely short period loans is referred to as the call money market. Bill brokers and dealers in stock exchange usually borrow money at call loans from the commercial banks. These loans are given for a very short duration, which does not exceed seven days. There are no collateral securities demanded against these loans. The borrower has to repay the loans immediately, whenever called for. As such, these loans are described as call loan or call money. Inter-bank call money is very common in India. 2. Collateral Loan Market When loans are offered against collateral securities like stocks and bonds, the loans are called collateral loans and the market as the collateral loan market. 3. Acceptance Market It refers to the market for bankers acceptance involved in trade transactions. A bankers acceptance in a draft drawn by an individual or firm upon a bank ordering it to pay to the order of the designated party (or to bearer) a certain sum of money at a particular future date and this draft is accepted by the bank. Unlike cheques, the bankers acceptances are used mainly in financing the movement of goods in the international trade. The bankers acceptance can be easily stored or discounted in the money market called the acceptance market. 4. Bill Market It is a market in which short-term papers or bills are bought and sold. The most important type of short term papers are the bills of exchange and treasury bills. The bills of exchange is a written unconditional order signed by the drawer requiring the party to whom it is addressed (the drawee), to pay on demand or at a fixed or determinable future time a definite sum of money to the order of a specified person or to the bearer. Such bill of exchange are discounted and rediscounted by commercial banks to lend credit to the bill holder or to borrow from central bank. Bills of exchange are commercial
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papers, on the other hand, treasury bills or government papers. Treasury bills are short-term government security, usually at 91 days duration, sold by the central bank on behalf of the government. A particular aspect of treasury bills is that, there is no prior fixing of the rate of interest borne by them. The treasury offers the bills on the basis of the competitive bidding. Thus, one who is satisfied with the lowest interest will be allotted the bills. Discounting being the main process of exchange of credit in this segment of the money market, they are also referred to as the discount market. 3.9.2.2 Institutions of the Money Market Commercial banks, non-banking financial institutions, acceptance houses, bill brokers, with the Reserve Bank at the apex level constitute the major institutions of the money market. Commercial banks are the most important group of the operators in the money market. Commercial banks usually employ their excess funds to grant short-term loans to the money market. They discount and rediscount the commercial papers such as bills of exchange and facilitate trade and commerce by mobilizing the flow of money. In the bill market of advanced countries, acceptance houses and bill brokers are the important institutions. Acceptance house specializes in acceptance or guaranteeing of trade bill. Discount houses and bill brokers and dealers buy and sell bills drawn on the acceptance houses and other bill also. Non-banking financial intermediaries, insurance companies and other financial business corporations also operate in the money market with their short-term lendable resources. The central bank occupies the highest place in the money market. It is the financial or monetary authority and is regarded as an apex institution. The central bank is the lender of the last resort and controller of the money market. There are money markets of a sort in almost every economy in the form of institutions dealing with short-term credit. Some of these markets are highly developed while others are relatively underdeveloped.
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3.9.2.3 Characteristics of Money Market A developed money market has the following characteristics:
A well organized banking system A central bank that provides the ultimate liquidity as well as regulates the working of the money market Adequate availability of credit instruments which are of the highest quality and negotiable at ease A large number of sub-markets, each specializing in a particular type of short-term assets, like bills of exchange, treasury bills, and short-term government bonds An integrated structure where submarkets will complement each other Perfect mobility of funds throughout the money market Sensitivity towards the impact of internal and international includeness
A central bank must establish and maintain close and constant relationship with the other components of the money market, if it is to carry out its functions efficiently. The central bank can have effective control over the money market only when the market is closely knit, widely expansive and closely coordinated. A lack of any of the above-mentioned characteristics obviously produces a less developed money market called the underdeveloped money market. The characteristic features of an underdeveloped money market are that it may have unorganized commercial banking system; its central bank may not be possessing adequate capacity and power to influence and control the entire money market. An underdeveloped money market is also characterized by the absence of adequate credit instruments and agencies. The more unorganized the money market is, the greater the difficulties of the central bank to exercise control over the banking system. Thus, an underdeveloped money market is a great handicap to smooth monetary management by the central bank.
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3.9.2.4 The Structure of the Indian Money Market The Indian money market is composed of two categories of financial agencies, namely, organized and unorganized. The organized sector contains well established, scientifically managed financial institutions. At the apex, there is Reserve Bank of India, which leads the money market and controls the banking sector. There are joint-stock commercial banks. These commercial banks are of two types, namely, scheduled and nonscheduled. The unorganized sector contains agencies which have diversified policies, lack uniformity and consistency in the lending business. It includes indigenous bankers in the country who control nearly 50 percent of the rural finance. 3.9.2.5 Characteristics of the Indian Money Market The money market in India is not only a heterogeneous entity, but is also not well organized. It possesses a number of drawbacks of an underdeveloped money market some of which are listed below: 1. The unorganized sector in India is enriched by widely scattered, indigenous banks, moneylenders, chit funds, etc. which lacks the scientific organization, being unorthodox in approach, stagnant and ill-organized. 2. The organized and unorganized sectors of the Indian money market are not coordinated well 3. There is wide divergence in the structure of the interest rates and in the lending policies of the different financial institutions. Especially, moneylenders charge exorbitant rates of interest and lend money mainly for unproductive purposes. 4. The Indian money market is inelastic as well as unstable. 5. The bill market, an important part of the organized sector is underdeveloped in India as compared to the advanced countries.
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6. Banking habit is not much developed in our country and cash transactions are more popular than credit transactions 7. Financial agencies get involved in retail trade, agriculture, and other business activities along with lending operations. 8. Indigenous bankers lack any regularity or coordination with the commercial banks and other organized sectors of the money market. On account of the disorganized condition of the money market, the RBI is not able to enforce its monetary measures effectively in order to realize the objectives of a uniform monetary policy and its influence over credit control. 3.10 Money Market Equilibrium In the money market, the point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. In the previous section, we discussed how the government controls the money supply in the economy through its manipulation of the amount of reserves in the economy. The governments money supply behaviour is not dependent on the interest rate and hence the money supply curve is vertical. In other words, the government uses its three tools, namely, required cash reserve ratio, the discount rate and open market operations to achieve its fixed target for the money supply.
Interest rate, r Excess Supply of money
r1
r* r2
Md Excess Demand for money Money M Md1 Ms Md2
Figure 3.1 Adjustments in the money market
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In figure 3.1, we have shown the vertical money supply curve and the downward sloping money demand curve. The equilibrium is reached when the quantity of money in circulation Ms- is equal to the quantity of money demanded Md, which occurs at the interest r * . To understand how the equilibrium is reached at r * , we need to understand the adjustment mechanism. The government treasury sells government securities (bonds) more or less continuously to finance any budget deficit. When government issues bonds to buyers, it is borrowing from them, and hence must pay interest on the bond value to attract buyers. Let us understand the adjustment mechanism by analyzing what happens when the interest rate is not r * . First, consider the interest rate r 1 where the quantity of money supplied exceeds the quantity of money demanded Md1. This means there is more money in circulation than households and firms want to hold. At r1, firms and households will attempt to reduce their money holdings by buying bonds. When there is excess money in circulation, it seeks a way to earn interest when demand for bond is high those looking to borrow money by selling bonds will find that they can do so at a lower interest rate. Thus, if the interest rate is initially high enough to create an excess money supply in the economy, the interest rate will immediately fall, discouraging people from moving out of money and into bonds. Now consider interest rate r 2, where the quantity of money demanded Md2 exceeds the money supply currently in circulation, households and firm do not have enough money on hand to facilitate ordinary transaction. They will try to adjust their holdings by shifting assets out of bonds and into their checking accounts. At the same time, the continuous flow of new bonds being issued must also be absorbed. In order to sell bonds in an environment where there is excess demand for money and people are willing to adjust their asset holdings to shifts out of bonds, the government has to offer a higher interest rate to the people who buy them. Thus, if the interest rate is initially low enough to create an excess demand
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for money, the interest rate will immediately rise, discouraging people from moving out of bonds and into money. 3.10.1 Changing the money supply to affect the interest rate With an understanding of the money market equilibrium, we can now see how the government can affect the interest rate. To understand this phenomenon more clearly let us analyse it graphically as shown in figure 3.3 Suppose that the government wants to reduce the current interest rate rt to r. It can do so by expanding the money supply.
Interest rate, r
Excess Supply of money
rt r'
Money M Ms0 Ms1
Md
Figure 3.3 The Effect of an increase in the Supply of Money on the Interest Rate
To increase the money supply, the government can reduce the cash reserve requirement, cut down the discount rate, or buy government securities in the open market, all of which will expand the quantity of reserves in the system enabling the banks to make more loans whereby the money supply expands. In the figure the actual money supply Ms0 increases to Ms1. At the interest rate rt, there is excess of money supply which puts a downward pressure on the interest rate as the households and firms try to buy bonds with their money to earn that high interest rate. As this happens, the interest rate falls, and it continues to fall until it reaches the new equilibrium interest rate r. At this point Ms1 = Md, and the market is in equilibrium.
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If the government wants to push the interest rates up, it would contract the money supply by increasing the reserve requirement, by raising the discount rate, or by selling government securities in the open market which would result in Ms0 shifting to the left and increased interest rate. 3.10.2 Increase in Income and Shifts in the Money Demand Curve Changes in the money supply are not the only factors that influence the equilibrium interest rate. Any shift in the demand for money can also affect the interest rate. As we have already discussed in the previous section, money demand depends both on the interest rate and the volume of transactions. We can use aggregate level of income (Y) for making a rough estimate of the volume of transactions. As there is a positive relationship between money demand and the aggregate level of income, increase in Y denotes a higher level of real economic activity, where there is increase in production, income and the volume of transactions in the economy. Consequent to this, the demand for money on the part of the firms and households in aggregate is higher resulting in the shift of demand curve to the right.
Interest rate, r
Ms r2
r2
Md1
r1 Md0
Money, M Figure 3.3. The effect of increase in income on the interest rate
Figure 3.3 illustrates the shift in demand curve. As Y increases, it causes

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the money demand curve to shift from Md0 to Md1. Similarly any decrease in Y would shift the money demand curve to the left, and the equilibrium interest rate to fall. The money demand curve may also shift when there is a change in the price level. If the price level rises, the money demand curve shifts to the right, since people want more money to buy goods and services at higher price levels. With the quantity of money supply unchanged, the interest rate must rise to reduce the quantity of money demanded to the unchanged quantity of money supplied a movement along the money demand curve. Thus, an increase in the price level is like an increase in the aggregate level of income; both cause rightward shift of demand curve, resulting in increased equilibrium interest rate and vice versa. 3.11 Monetary Policy Money and credit in modern economy exercise vital influence upon the course, nature and volume of economic activities in an economy. Hence monetary policy plays a crucial role in moulding the economy. An appropriately conceived monetary policy can significantly aid in economic growth and prosperity by adjusting the money supply to the needs of the growth by channeling the flow of money into the desired productive network and by making institutional credit arrangement for specified fields of economic pursuit. Monetary policy can also be used for controlling the inflation and deflation in the economy. Monetary policy refers to the policy measures of the central bank to control availability, cost and use of money and credit in the country with the help of monetary measures. An ideal monetary policy may be defined as the efforts that are taken to reduce the disadvantages to a minimum and increase the advantages, resulting from the existence and operation of a monetary system. The central bank of a country is the traditional agent, which formulates and operates monetary policy. By its monetary policy, the central bank pursues to administer and control the countrys money supply including
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the currency and demand deposits and to manage the foreign exchange rates. In India, monetary policy comprises the decisions of the government and the Reserve Bank of India which directly influence the volume and composition of the money supply, the size and distribution of credit, the level and structure of interest rates, and directly and indirectly affect the other variables such as saving and investment, output, income and prices. The objective and scope of monetary policy are conditioned by the economic environment and the viewpoint of time. Monetary policy has to be structured and operated within the institutional framework of the monetary system of the country. In a broad sense however, the monetary policy should be aligned with the fiscal policy and debt management for controlling the economy. Recall our discussion on the fiscal policy and its impact of the national income in the previous unit. A sound monetary policy is the main prerequisite of a successful and comprehensive programme of developmental planning. Since economic growth is a real phenomenon and not a monetary one, a proper monetary policy is essential but not sufficient condition for achieving growth. Money plays a dynamic role by activating the idle resources and allocating the resources appropriately and efficiently. In a developed economy monetary policy aims at regulating the monetary measure whereas in developing economies monetary policy essentially aims at controlled expansion to facilitate economic growth and restrain inflationary pressure at the same time. In the Indian context, the prime objective of the monetary policy is to accelerate the economic development in an environment of reasonable price stability. The generally accepted important goals of monetary policy include:
Neutrality of Money: The purpose of money is just to facilitate transactions without creating disturbances in the functioning of the
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economy. Hence, the money supply in the economy should be controlled in such a way that, the total output, total transactions, and prices of goods and services be the same as in a moneyless economy. Thus, under the policy of neutral money, the monetary authority has to keep the quantity of money perfectly stable, i.e., the quantity of money is to be kept constant in all circumstances, for cyclical fluctuations are primarily caused by changes in the money supply Business cycles under neutral money policy are expected to be comparatively milder. But this assumption has been criticized by many and valid reasons are given to prove that neutral money policy cannot check the occurrences of business cycles in an economy.
Exchange Stability: Maintenance of stable exchange rates is an essential condition to create international confidence and to promote international trade on the largest scale. The objective of exchange rate stability could be achieved by achieving equilibrium in the balance of payment through monetary policy. A restrictive monetary policy tends to reduce a countrys balance of payment by reducing the demand for both domestic and imported goods, reduces prices of domestic goods making imported goods less attractive, and higher interest rates makes borrowing less attractive for foreign countries. Even though exchange rate stabilization helps in maintaining international economic relationship, as a goal of the monetary policy
it can be achieved only at the cost of internal price stability, which is of prime importance for the smooth functioning and progress of the domestic economy, and may seriously affect the economy of a country whose prosperity is independent for foreign trade, as inflationary or deflationary movements are passed on to countries through fixed exchange rates. In todays modern economy, where most of the countries are members of International monetary fund, the exchange rate stability has lost its importance. The IMF has established a system of free multilateral trade.
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Price Stabilisation: Two of the chief disadvantages of the monetary system under capitalism are price fluctuations and cyclical variations. Thus, according to many economists including Keynes, a more important aim of monetary policy is to achieve and maintain price stabilization and normal course of business activity through appropriate credit regulation measures adopted by the central bank. The goal of price stabilization implies that in general the average price level as measured by wholesale price index or consumer price index should not be allowed to vary beyond narrow margins. A policy of price stabilization is objectionable as
it is difficult to determine the price level to be selected for stabilization it will remove much of the price incentives for businesses leading to stagnation in production price changes are a symptom rather than a cause of cyclical fluctuation and monetary policy has no control over it, and it ignores the dispersion of individual prices (which together constitute the average price level) which are more important in triggering economic activity in the system. Variations in price levels are useful for the successful working of the price mechanism for economic adjustment in the free market economy. Stability in prices in the face of declining costs adversely affects economic relations and functioning There can be disharmonies and dislocations in the economic system even when the prices are stable It is not very feasible since the central bank has no control over the non-banking financial intermediaries that control a large volume of credit activities in the economy Alternatively, the monetary authority may follow a policy of either rising or falling price levels. When the inflation in the economy is
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rising at a rapid pace, it may adopt a falling prices policy as an antiinflationary measure. Similarly, in an inexpedient deflationary situation, it may follow a rising prices policy with the aim of restoring prices to the previous level and thus attain a reasonable degree of price stabilization. There is a near unanimity now that there is no long-run trade-off between growth and inflation, i.e., monetary policy cannot permanently raise output above its potential through inflationary policies. Any attempts to raise output above the economys potential will be eventually reflected in higher inflation.
Full Employment: Since Keynes, most economists consider full employment as the foremost and ideal objective monetary policy. Full employment means that unemployment is reduced to short intervals of standing by, with a certainty that one without a job, currently, will be wanted in the previous job or a new job within his power, soon. Full employment is only a precondition to social welfare and hence we must use it along with other economic resources with maximum efficiency and productivity. Recall our discussion on employment in Unit I, where we discussed saving and investment at the point of full employment. The obvious objective of a monetary policy is to attain equilibrium between savings and investment at full employment. The main task of the monetary policy is to find a level of interest rates, which exactly equals the investment demand with full employment. Economic Growth: While economic growth is unquestionably a primary goal of any economy, as an objective of monetary policy, it is questionable. Many economists considered monetary policy as a short-run policy that aims at full employment and mitigating cyclical fluctuations. But, recently it has been proved that full employment is not enough and economic development is important for providing a high standard of living to the people.
Monetary policy can contribute to the achievement of economic growth through a flexible monetary policy, where a restrictive monetary policy
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will be applied when there is excess demand in the economy and an expansionist credit policy will be adopted when there is a deficiency of aggregate demand. It can also help economic development by creating a favourable environment for saving and investment, by aiming for price stabilization. As savings is the main source of capital formation, when savings increase under favourable circumstances, it accelerates capital formation, which in turn accelerates economic growth. To summarize, we can say that, monetary policy is necessarily concerned with all the major objectives of economic policy, namely, exchange rate stability, price and economic stability, full employment, and economic growth. These objectives are to some extent, in conflict with each other. Thus, the monetary authorities confront the challenge of prioritizing these objectives depending on the economic situation in which they are making decisions. 3.11.1 Structure & Framework of Monetary Policy in India In the Indian economy, structural reforms were initiated since the early 1990s, which included industrial deregulation, liberalisation of the foreign trade and investment regime, public enterprises reform and financial sector liberalisation. These reforms aimed at reorienting the Indian economy towards a market-oriented economy to foster greater efficiency and growth. The monetary policy in India has been affected by these wide-ranging reforms. Monetary policy framework had to contend with a number of changes in its operating environment brought about primarily by financial and external sector liberalisation.
the process of financial liberalisation necessitates a greater market orientation in view of the shift to a market-oriented economy from a control-oriented regime.
financial liberalisation has led to the emergence of financial conglomerates with implications for financial stability
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globalisation has posed several challenges for monetary management emanating from swings in international commodity prices from large and sudden movements in capital flows and exchange rates advances in information technology are revolutionising payment and settlement practices and are speeding up the spread of information In order to face these challenges, during the 1990s, monetary policy in India revisited issues related to objectives, intermediate targets, instruments and operating procedures of monetary policy.
3.11.1.1 The Framework of Indian Monetary Policy Since independence, Indian Monetary policy has pursued the twin objectives of price stability and ensuring adequate credit to productive sectors of the economy. The relative emphasis of these two objectives depends on the underlying economic conditions and the monetary policy species it from time to time. Even after the introduction of the structural reforms, credit availability remains an important objective of monetary policy in India. In the pre-1990s period, credit allocation and administered pricing, along with inefficiencies and distortions, ensured a reasonable level of credit flow in the desired direction at the desired price. The cost of inefficiencies and distortions created by such policy had to be borne in different ways, including statutory preemptions - as high as 63.5 per cent of the incremental deposits of banks in 1992. Even after liberalisation, deregulation and enabling environment of comfortable liquidity at a reasonable price, banks continued to charge interest rates to various categories of borrowers by their category per se -whether agriculture or small scale industry - rather than based on actual assessment of risks for each borrower, thus affecting the credit flow at reasonable interest rates. Hence, the Reserve Bank of India has been trying to reduce transaction and information costs to make credit available to such sectors at reasonable interest rates. With the opening up of the economy since the early 1990s, financial stability has emerged as one of the key considerations of monetary policy.
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Monetary management has to face the challenges posed by large capital flows and volatility in exchange rates. Since 1993-94 (excepting one year, 1995-96), due to large capital flows and surpluses in the current account, the overall balance of payments have recorded persistent growth. The Reserve Bank has absorbed such large surpluses in its foreign exchange reserves. The distinction between short term and long-term flows is conceptually clear. However, in practice, it is not always easy to distinguish between the two for operational purposes. At any given time, some flows could be of an enduring nature whereas others could be temporary and, hence, reversible, and what appears to be short-term could last longer and vice versa, imparting a dynamic dimension to judgment about their relative composition. In a scenario of uncertainty facing the authorities in determining the temporary or permanent nature of inflows, it is sensible to suppose that such flows are temporary until we can firmly establish such flows to be of a permanent nature. Large purchases of foreign exchange by the Central bank from the market have an expansionary effect on domestic money supply and, therefore, monetary policy has to manage episodes of volatility in the foreign exchange market. Although capital flows have been largely stable, reflecting a cautious approach to capital account liberalisation, there have been nonetheless a few episodes of volatility in capital flows and exchange rates. As maintaining orderly conditions in the foreign exchange market is an important objective of monetary policy, monetary authorities have to face potential conflicts between the interest rate and exchange rate objectives. Financial stability concerns arise also due to the move from a Governmentdominated financial system to a market-oriented one. Financial stability entails:
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ensuring uninterrupted financial transactions maintenance of a level of confidence in the financial system amongst all the participants and stakeholders, and absence of excess volatility that unduly and adversely affects real economic activity.
Such financial stability has to be particularly ensured when the financial system is undergoing structural changes to promote efficiency. In India, the vulnerability to real sector shocks has the potential to affect financial stability significantly. The major sources of shocks in India are very sharp increases in oil prices and extraordinary monsoon failures with consequent impact on the agricultural sector. Therefore, the weight to financial stability in India is higher than in many other countries. Financial integration and innovations have also necessitated refinements in the strategies and tactics of monetary policy in India. The Reserve Bank has made the following changes to face the current challenges:
Changed the policy framework from monetary targeting to multiple indicator approach A significant shift towards market-based instruments away from direct instruments of monetary management Liquidity management framework has been introduced in which market liquidity is now modulated through a mix of open market operations and changes in reserve requirements and standing facilities, reinforced by changes in the policy rates. The introduction of the Market Stabilisation Scheme has provided further flexibility to the Reserve Bank in its market operations.
Over the past few years, the process of monetary policy formulation has become relatively more articulate, consultative and participative with external orientation, while the internal work processes have also been re-engineered to focus on technical analysis, coordination, horizontal
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management, rapid responses and being market savvy. The stance of monetary policy and the rationale are communicated to the public in a variety of ways, the most important being the monetary policy statements. The communications strategy and provision of timely information at regular intervals have facilitated the conduct of policy in an increasingly marketoriented environment.
3.12 Summary
Money can be defined as an implicit social contract by society between present and future purchasing power
According to the classical view, money is demanded by people only as a medium of exchange (Transactionary demand)
Modern economists suggest that money is demanded for its store value also (Precautionary demand)
Money can also be held for speculative motive Money supply is the stock of money held by the public on a particular date.
The flow of money is measured by multiplying stock money supply by velocity of circulation.
Velocity of circulation of money is the average number of times money circulates from one hand to another in an economy.
RBI measures money stock as an aggregate of monetary resources viz., currency, demand deposits of banks, other deposits of RBI, post office savings deposits, time deposits of banks and post offices.
Money supply is both economic and policy controlled variable. Money supply is a function of the quantity of legal tenders possessed by banks, the cash reserve ratio, the rate of interest and the national income
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Commercial and Central banks are two important agencies that determine the structure of money and credit The government should coordinate the monetary and fiscal policies for effective monetary management Equilibrium can be explained using the investment-savings or IS curve, which shows the combination of interest rates, and income levels for which the goods market clears. Money market is a short-term credit market and an essential feature of it is the dealings in assets of relative liquidity The money market is composed of several financial agencies that deal with different types of short-term credit including Call Money market, Collateral Loan Market, Acceptance Market and Bill Market In the money market, the point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. If the government wants to push the interest rates up, it would contract the money supply by increasing the reserve requirement, by raising the discount rate, or by selling government securities in the open market Monetary policy refers to the policy measures of the Central bank to control availability, cost and use of money and credit in the country with the help of monetary measures. Money market refers to the institutional arrangements facilitating borrowing and lending.
Review Questions 1. Why is analysis of money market important? 2. What are the functions of money? 3. What are the determinants of money demand?
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4. What can you infer from the modern approach to money supply? 5. How does RBI measure the money stock in the country? 6. What are the various determinants of money supply? 7. What do you understand by the term velocity of circulation of money? 8. What is the role of commercial banks, central banks and non-banking financial intermediaries in creation of money supply? 9. How can you derive IS curve? 10. What are the important components of money market? 11. How will you describe the characteristics of money market? 12. What do you know about the Indian Money Market? 13. How is equilibrium achieved in Money Market? 14. How can the government affect the interest rate? 15. What is the importance of monetary policy?
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UNIT - IV
Integration of Commodity and Money Market
4.1 Introduction In this unit, we will discuss how the equilibrium in an economy is reached where we consider the integration of commodity or goods market and money market. To understand the integration process we will use the IS (goods market equilibrium schedule) and the LM (Money market equilibrium schedule) analysis. Unemployment and inflation are two of the important issues that affect an economy. Inflation is understood by many as a substantial and rapid general increase in the price levels and consequent deterioration in the value of money over a period of time. We have discussed inflation and employment as macroeconomic variables affecting an economy. In this unit we will discuss the theories that explain the phenomena of inflation and unemployment and the relationship between the two. 4.2 Learning Objectives In this unit we will learn about
Interaction of IS- LM curves to understand how equilibrium is reached in an economy Interaction of fiscal and monetary policies The inflation and its causes
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Theories of inflation The labour market How inflation and unemployment are related
4.3 Interaction of IS- LM curves The product market equilibrium (IS) schedule is combined with the money market equilibrium (LM) schedule to analyse equilibrium for the economy as a whole and how it is affected by the monetary and fiscal policies. The IS and LM curves put together give the equilibrium level of income and interest rates for the economy. Where the two curves intersect, both the goods and money market clear. Since the money and assets markets are linked through the wealth constraint, this interaction point also represents equilibrium in the assets market. So, the IS and LM curves together determine equilibrium for the economy as a whole where the economy consists of the product, money and assets markets, and all three in equilibrium. Let us assume that price level is fixed and consider how equilibrium is determined by combining the two curves.
r LM
r*
IS Y* Y
Figure 4.1 Interaction of IS and LM Curves
The diagram above shows that there is some specific interest rate and
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some specific income level Y* where the economy is in equilibrium. At point E, where the two curves intersect, the goods and assets markets clear. Here the interest rate and income are such that the existing stock of money held and planned spending equal output. The assumption is that the price level is constant and that firms are willing to supply whatever amount of output that is demanded at the price level. Firms produce their planned output level and there are no unintended changes in inventories. Individuals also have their desired portfolio combinations. Taking the equations for the IS and LM curves we can determine r* and Y*. The equilibrium solution for r* and Y* are given below. Y* = A + b M/ hP and r* = k/h * A 1/(h+ko b) *(M/P) where o= 1/(1-MPC(1-t)) and = o(1+k ob/h ) The solution for r* and Y * indicate that the equilibrium level of Y depends on the level of autonomous spending, on the stock of money supply, and on the structural parameters of the economy, namely K, b, h, and the parameters affecting the multiplier which are MPC and the tax rate (in the closed economy). A higher level of money balances, higher autonomous spending, a higher multiplier (high MPC, low tax rate), low income elasticity of money demand, and high interest elasticity of money demand imply a higher equilibrium level of income. The equilibrium level of the interest rate is likewise a function of these same parameters, the nature of the relationship being evident from the equilibrium condition derived above. The interesting thing that we can note here is the effect on the multiplier when the IS and LM curves are combined. From the Y* equation, we see that the multiplier for a change in autonomous spending is smaller when we introduce the money market into the picture. Previously it was o and now it is o/ (1+kob/h). The reduced multiplier effect can be understood as follows.
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Suppose there is an increase in autonomous spending A, the IS curve shifts out as a result of it. However, we will not get the full effect of the increase in spending on income, as there is an impact on the interest rate through the money market. This is because the higher level of autonomous expenditures implies higher money demand for transactions purposes and a shift away from asset demand for money. Given a fixed money supply, higher money demand causes an increase in the interest rate. The higher interest rate is just sufficient to choke off the excess money demand and restore equilibrium in the money market. The goods market is affected by the shift in the money market equilibrium as the higher interest rate lowers all spending, particularly investment spending that is sensitive to interest rate changes. This is also called crowding out as the expansionary fiscal policy (higher government expenditure) crowds out private investment. Therefore, the net impact on equilibrium Y is less than in the case when we do not allow for changes in the money market and interest rates. As opposed to an increase in Y of oA for the simple multiplier earlier, we get a smaller increase in Y of [o/ (1+kob/h)] A when we introduce the money market and allow for the crowding out effect. Due to the link between the goods and money markets, when the IS curve shifts out due to the rise in autonomous expenditures, the economy does not simply move from point E to point B. At point B there is excess demand for money and so the money market does not clear. The new equilibrium is at point E where both the goods market and money markets clear. The net change in Y is dampened by the interest rate effect on spending. Therefore, the multiplier is also smaller than previously. We have already discussed this concept of crowding out when we discussed money supply. Next, consider a change in the money supply. As noted earlier, this causes the LM curve to shift out. The equilibrium interest rate falls and the equilibrium income level rises in the economy. The reason is that the higher money supply at the prevailing levels of money demand leads to an excess supply of money. Equilibrium is possible only when the interest
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rate falls at each level of income to sufficiently raise the asset demand for money and absorb the excess supply. So we move to a lower interest rate and higher levels of income. The lower interest rate stimulates investment spending and the higher income level generates sufficient savings to meet the higher level of investment and maintain goods market equilibrium. 4.3.1 Interaction of Fiscal and Monetary Policies We shall consider the effects of fiscal and monetary policies and how the two can be used in conjunction to stabilize output. Suppose there is an increase in government expenditures. This shifts out the IS curve and given unchanged money supply, raises the equilibrium interest rate and output in the economy. If the monetary authorities want to stabilize the interest rate then they must increase money supply shifting out the LM curve and reduce the interest rate to its initial level. However, in doing so, there is a further increase in output.
LM LM r2 r1 IS IS Y1 Y2 Y IS Y1 Y2 Y3 r1 LM
IS Y
Figure 4.2 Interaction of fiscal and monetary policies
Note that in this case, the increase in money supply is just enough to offset the crowding out effect of an increase in government expenditures. We get the full multiplier effect of increased government spending and not the smaller multiplier effect when we allow for the interest rate effect. If instead, the monetary authorities want to stabilize output, then they would contract the money supply, shifting back the LM curve sufficiently
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to bring back Y to its initial level. However, in doing so they would also drive up interest rates further. Thus, there are important policy tradeoffs and the authorities cannot stabilize both variables. They must decide on the right course of policy given their priorities. Now consider an increase in taxes. This reduces spending in the economy and shifts back the IS curve. Given LM curve this causes the equilibrium interest rate and output to decline. To stabilize output, monetary authorities would need to increase money supply. While this would bring back Y to its initial level or prevent it from declining much, there would be a larger decline in the interest rate. The mechanism by which output is restored is that though higher taxes reduce consumption spending, the expansionary monetary policy induces investment by lowering the interest rate and thus reverting the decline in expenditures and thus output. The above case clearly demonstrates that the impact of fiscal policy depends on the monetary policy adopted by the monetary authorities. There are macro econometric models of the economy which are based on these theories and which try to quantify the effect of various policies on the economy. Econometric disturbances can also cause shifts in the IS and LM curves. Exogenous changes in the demand for goods and services affect the position of the IS curve. Keynes has discussed the animal spirit of the investors and self-fulfilling optimism and pessimism in investment spending. Thus, low confidence in the economy could be self-fulfilling by causing a decline in investment. The IS curve would shift to the left lowering equilibrium income and employment, thus validating the pessimism. Increased consumer confidence in the economy would raise consumption spending today, shifting up the consumption function and thus shifting out the IS curve. This would raise equilibrium output and income. Shocks to the LM curve can result from exogenous changes in money demand. Deregulation of the financial sector and introduction of new financial instruments can cause an outward shift in the money demand function (altering velocity perhaps). Then given the money supply, this would raise interest rates and the LM curve would shift up causing a decline in output and a higher equilibrium interest rate.
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Monetary and fiscal policy can be used together, especially if they are well timed to offset these exogenous shocks and stabilize output and employment. 4.4 Modern Views On Inflation For all practical purposes, Emile James defined inflation as a selfperpertuating and irreversible upward movement of prices, caused by an excess of demand over capacity to supply. Here Prof. James points out that excess demand may be demand for investment as well as for consumer goods. The phrase capacity to supply in the definition stresses that any increase in demand at a given moment constitutes a call for an increase in production. If the productive apparatus can meet the challenge, there will be no inflation. Inflation can come about only if expansion in production or supply is held back by some obstacle, such as full employment of resources or occasionally, by some facilities, and market imperfections. In this sense, the term inflation is also applicable to an economy where a rise in the price level may not lead to increased output beyond a certain stage due to the existence of bottlenecks, even though the stage of full employment is not attained. Briefly, then, apart from price rises, the existence of excess demand is regarded as an essential characteristic of inflation. It is generally believed that inflation is accompanied by a growth in employment. However, in recent years, the world has been experiencing a situation in which the price level has been continually rising, but simultaneously, there has been a rise in the rate of unemployment and stagnation in the rate of growth. To describe this situation, Professor Samuelson has coined a new term, stagflation. As Samuelson says, Stagflation involves inflationary rises in prices and wages at the same time so that people are able to find jobs, and firms are unable to find customers for what their plants can produce. Professor Brahmananda coined the term stagflation to describe inflation in India, which had the unique characteristic of recession accompanied by inflation. He described inflation as a state in which the scale and rate of growth of bank credit as well as the pattern of credit
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location have got so much out of alignment with the stock and the rate of growth of basic goods and their productivity in the system of production that the rate of price rise in basic goods appears as a parameter to all sectors of the community. 4.5 Features Of Inflationary Economy The following are the strategic features of an inflationary economy: 1. There is a continually rising price trend, whether it is measured through wholesale price index (WPI) or consumers price index (CPI). 2. The money supply is in excess of the requisite production and exchange needs of the economy. There is undeserving excess of monetary liquidity adding fuel to the fire. 3. There is over-expansion of credit by the banks. 4. A good part of the flow of credit is supplied to unproductive channels, speculative activities, and sick and non-viable units of production. In many cases, there is no direct relaxation between the bank loans and physical capacities of the enterprises. 5. There is lack of financial discipline on the part of the government. The budget is usually large with large deficits of revenue and capital account.
6. A large number of commodities are in short supply paving the way the sectoral price disequilibrium. 7. Artificial scarcity is commonly caused by hoarding activities and has become conspicuous for traders, producers and consumers. 8. The rate of return of speculative hoarding of commodities, precious metals like gold and silver, and investments in immovable properties land, buildings, flats, etc. are higher and more fascinating than the rate of returns on shares, and bonds in an inflationary economy. 9. Interest rates in the unaccounted and unorganized sectors tend to be higher than those in the organized sectors of the money market.
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10. Labour unrest, strikes, lockouts, etc. are common. Organised labour force successfully resists any reduction in real wages and pushes up the money-wages, thereby accelerating the process of cost-push inflation. 11. In an inflationary economy, the government is trapped in the cobweb of ever increasing public expenditure, larger budgets, higher taxes, larger public debts, huge deficit financing and a large number of controls, which, in turn, encourage black money and dual accounting system, black marketing, smuggling and other anti-social activities on account of the deterioration of the communitys morals in general, caused by inflation. In fact, an economy is inflationary because it is inflationary. There tends to be a vicious circle of inflation when it is curbed immediately. In the long period, the state of unchecked inflation becomes a built-in feature of the economy and people expect the rate of inflation to accelerate further. 4.6 Theories Of Inflation Different economists have put forward different views on the phenomenon of inflation. We may survey briefly the main approaches to inflation. There are two basic approaches to the problem of the sources of inflation. The first is the Quantity Theory of Money Approach and the Excess Demand Thesis. 4.6.1 The Quantity Theory of Money Approach The first approach is based on the traditional quantity theory of money. According to this approach, other things being equal, if the money supply increases, prices rise and inflation occurs as a consequence. As we have seen in the previous sections, economists like Friedman, Hawtrey, Goldenweiser, etc. who looked upon inflation as a pure monetary phenomenon, vigorously advocated this theory. It follows from the Fisherian Quantity Theory version that says:
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P = MV/T When V and T remain constant under full-employment equilibrium condition of the economy, an increase in the stock of money M implies a direct proportionate rise of the price level P. Likewise, the income theory equation too implies the same thing. Thus whenP = Y/O where if the real output (O) remains constant under full employment, an increase in Y the money income caused by an increased flow of money supply (M), tends to cause the price level (P) rise. The Quantity Theory of Money however, does not explain the phenomenon of hyper-inflation where it is the rise in prices that may cause an increase in the money supply, which in turn may cause a further rise in prices. In fact the phenomenon of money and prices chasing each other in a vicious spiral is so indivisible that it is not very easy to determine which is the cause and which is the effect. Moreover, the theory is quite misleading and confusing if one were to analyse a situation of depression in which the government resorts to the usual fiscal and monetary techniques counteracting the evils of depression and the result is both increase in money supply and a rise in prices. A price rise which is necessary for revival of economic activity should not be considered as inflationary because inflation is generally harmful to the economy. 4.7 Demand Pull Vs Cost Push Inflation Broadly speaking, there are two schools of thought regarding the possible causes of inflation. One school views the demand-pull element as an important cause of inflation, while the other group of economists holds that inflation is mainly caused by the cost push element. 4.7.1 Demand-pull Inflation According to the demand-pull theory, prices rise in response to an excess of aggregate demand over existing supply of goods and services. The demand-pull theorists point out that inflation (demand-pull) might be caused, in the first place, by an increase in the quantity of money, when the economy is operating at full employment level. As the quantity of
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money increases, the rate of interest will fall and, consequently, investment will increase. This increased investment expenditure will soon increase the income of the various factors of production. As a result, aggregate consumption expenditure will increase leading to an effective increase in the effective demand. With the economy already operating at the level of full employment, this will immediately raise prices, and inflationary forces may emerge. Thus, when the general monetary demand rises faster than the general supply, it pulls up prices (commodity prices as well as factor prices, in general). Demand-pull inflation, therefore, manifests itself when there is active cooperation, or passive collusion, or a failure to take counteracting measures by monetary authorities. Demand-pull or just demand inflation may be defined as a situation where the total monetary demand persistently exceeds total supply of real goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. However, demand-pull inflation can also occur without an increase in the money supply. This can happen when either the marginal efficiency of capital increases or the marginal propensity to consume rises, so that investment expenditure may rise, thereby leading to a rise in the aggregate demand which will exert its influence in raising prices beyond the level of full employment already attained in the economy. According to the demand-pull theorists, during the process of demand inflation, rise in wages accompanies or follows the price rise as a natural consequence. Under the condition of rising prices, when the rate of profit is increasing, producers are inclined in general to increase investment and employment, in that they bid against each other for labour, so that labour prices (i.e. wages) may rise. In short, the inflationary process, described by the demand-inflation theory, implies the following sequences. Increasing demand - increasing prices increasing costs increasing income increasing demand increasing prices and so on.
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It should be noted that the concept of demand-pull inflation is associated with a situation of full employment where an increase to aggregate demand cannot be catered to by a corresponding expansion in the supply of all output. There can be many reasons for such excess monetary demand. 1. There may be an increase in the public expenditure (G) in excess of public revenue. This might have been made possible (or rendered necessary) through public borrowings from banks or through deficit financing, which implies an increase in the money supply. 2. There may be an increase in the autonomous investment (I) in firms, which is in excess of the current savings in the economy. Hence, the flow of total expenditure tends to rise, causing an excess monetary demand leading to an upward pressure on prices. 3. There may be an increase in the marginal propensity to consume (MPC), causing an excess monetary demand. This could be due to the operation of demonstration effect and such other reasons. 4. In an open economy, an increasing surplus in balance of payments also leads to an excess demand. Increasing exports also have an inflationary impact because there is a generation of money income in the home economy, due to export earnings but, simultaneously, there is reduction in the domestic supply of goods because products are exported. If an export surplus is not balanced by increased savings, or through taxation, domestic spending will be in excess of the value of domestic output, marketed at current prices. 5. A diversion of resources from the consumption goods sector either to the capital goods sector or the military sector (for producing war goods) will lead to an inflationary pressure because while the generation of income and expenditure continue, the current flow of real output decreases on account of the high gestation period involved in these sectors. Again the opportunity cost of war goods is quite high in terms of the consumption goods meant for the civilian sector.
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This leads to an exclusive monetary demand for the goods and services against their real supply, causing the prices to move up. It is said that the demand-pull inflation can be averted through deflationary measures adopted by the monetary and fiscal authorities. Thus, passive policies are responsible for demand-pull inflation. Thus we have discussed some of the theories that explain inflation. Now, let us look at the labour market and understand the reasons behind unemployment and how unemployment and inflation are related in the following section. 4.8 The Labour Market Markets are broadly classified as goods market, money market and labour market. Here, we closely look at labour markets role in macro economy. First, we shall consider the classical view that the wages always adjust to clear the labour market. We then consider why labour may not always clear, and why unemployment may exist. This will lead to the understanding of the relationship between inflation and unemployment. 4.8.1 The basic concepts of labour market The unemployment rate is expressed as the number of unemployed people as a percentage of labour force. Persons unemployed and actively seeking a job are only considered under unemployment. Those who stop looking for work are considered out of the labour force and are no longer considered under unemployment. We have to realize that, even if the economy is running at near full capacity, there will always be unemployment, even if it is a very small percentage of labour force. The system remains dynamic due to the students who graduate from colleges and training programmes who seek employment, the businessmen who seek employment when their business makes loss, by persons seeking career changes, and employers who seek right workers. This type of
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unemployment called frictional and structural unemployment is inevitable and may be desirable. We will now consider the nature of cyclical unemployment, namely, the increase in unemployment occurring during recession and depressions. When the economy contracts, the unemployment rate rises. During the Great Depression the unemployment rate remained over 17% for nearly a decade. Employment tends to fall when aggregate output falls and vice versa. A decline in demand for labour does not necessarily mean that the unemployment will rise, though a decline in demand for labour will initially create an excess supply of labour. Hence, the wage rate will fall until the labour supply again equals the quantity of labour demanded restoring the equilibrium in the labour market. At the new lower wage rate everyone who wants a job will get one. If the quantity of labour demanded and supplied is brought into equilibrium by rising and falling wage rates, the only unemployment rate will be due to frictional and structural unemployment. This is the classical view of unemployment prevalent till Keynes introduced his concepts. 4.8.2 The Unemployment Rate and the Classical View If the labour market works well, as assumed by the classical economist, we have to account for the fact that the unemployment rate at times seems high. Some economists argue that the unemployment rate is not a good measure for working of labour market. People are laid off because of industries contraction and if their skill is constrained for specific tasks they cannot easily find alternative jobs. For example, when composing with computers developed, manual composers who lose jobs cannot easily find alternative jobs. One reason is they believe that the industry will again revive and will not develop new skills, considering their unemployment as temporary. As the government does not include such factors while calculating he unemployment rate, it is not necessarily an accurate indicator of whether the labour market is working properly.
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If the degree to which the industries are changing, the economy fluctuates over time, there will be more people like our manual composer. This will cause the measured unemployment rate to fluctuate. If the quantity of labour supplied at the current wage rate is equal to the quantity demanded at the current wage rate, the labour market may appear to work well. Whenever there is an upward sloping supply curve in the market, the quantity supplied at a higher price is always greater than the quantity supplied at the equilibrium price. Economists who view unemployment in this perspective do not consider it as a major problem. If unemployment is a major macroeconomic problem, we have to explore the reasons for its existence. Some of the reasons are, sticky wages, efficiency wage theory, imperfect information and minimum wage loss. Let us discuss each one of these reasons in brief detail. 4.8.2.1 Sticky Wages Sticky wages means that the equilibrium wage gets stuck at a particular level and does not fall when the demand for labour falls. This is illustrated in figure 4.3, where W0 is the original wage (equilibrium wage), D0 is the original demand and D1 is the new demand. When the demand decreases from D0 to D1, the resulting unemployment is S0 to S1-,whereS0 is the quantity of labour that households want to supply at the rate W0 and S1 is the amount of labour the firms want to hire at W0. Hence (S0 - S1-)indicatetheunemployment.Butthestickywage explanation assumes the conclusion as premise. There is one reason macroeconomics has been in a state of flux for so long. The existence of unemployment continues to be a puzzle. Hence a number of major alternative theories have been proposed.
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Wage rate
Unemployment
W0 W*
D0 D1 S1 S* S0
Units of labour
Figure 4.3. Sticky Wages
One explanation for downwardly sticky wages is that the firms enter into social (implicit) contracts with the workers that they will not cut wages. It seems that extreme events are necessary for firms to cut wages like Great Depression, threat of bankruptcy, etc. Another argument, namely, relative wage explanation of unemployment holds that workers are concerned about their wages relative to wages in other firms and may be unwilling to accept wage cuts (unless other workers are receiving similar cuts). There may be an implicit understanding between firms and workers that the firm will not do anything that will make their workers worse off relative to workers in other firms. Explicit contracts are those signed between workers unions and employer for a specific period (1-3 years). Here the wages do not fluctuate with the economy. Instead the workers will be laid off. The workers and the firms surely know at the time when the contract is signed, that the wages cannot be cut. Because, negotiating wages is costly and time consuming. Contracts are a way of bearing these costs at no more than 1,2, or 3 years. 4.8.2.2 Efficiency Wage Theory This theory holds that the productivity of workers increases with wage rates and the firms may have incentive to pay more above the wages. The firms demand for labour would be no lower but the higher wage rate would cause the quantity of labour supplied to increase. Hence the
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quantity of labour supplied exceeds labour demanded at the new higher wage, that is, at efficiency wage rate leading to unemployment. 4.8.2.3 Imperfect Information The firms may have imperfect information on the wage rate that they need to set to clear the labour market. They may not choose to set their wages at the correct level and hence unemployment may arise. If the economy is simple, the firms may be able to correct the mistake within a few months. But in a complex economy it may take more time 4.8.2.4 Minimum Wage Loss This explains a small fraction of unemployment. If the minimum wage set by law is more than the equilibrium price, unemployment will result. Teenagers who have relatively little job experience will be hurt more by minimum wage laws. If the minimum wage laws prevent wages from falling below a fixed level, many workers will not be able to find jobs and hence unemployment increases. 4.8.3 Short-run relationship between unemployment rate and inflation To understand the relationship between unemployment rate and inflation, we need to first know the relationship between aggregate income Y and unemployment rate U. An increase in Y means more labour is needed and hence reduction in U. Thus, U and Y are negatively related as indicated in figure 4.4.
Price level, P
Unemployment rate, U
Figure 4.4. The Relationship between Unemployment rate and the Inflation rate
The curve in 4.4 is not considered to be important in macroeconomics. Alternatively, Philips Curve as shown in figure 4.3, relating unemployment
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with inflation rate is used to explain the relationship between the two. The inflation rate is the percentage change in the price level, not the price level itself.
Inflation rate (percentage of change in P ) %
Unemployment rate, U % Figure 4.5. The Phillips Curve Figure 4.4 and 4.5 imply different things. Figure 4.4 shows that the price level remains
Figure 4.4 and 4.5 imply different things. Figure 4.4 shows that the price level remains the same if the unemployment rate remains the same. The Phillips curve shows that inflation rate remains the same if the unemployment remains unchanged. The Phillips curve focuses on most studied macroeconomic relationship. 4.8.4 Phillips Curve In the 1950s and 60s, (in U.S) there was a remarkably smooth relationship between the unemployment rate and the rate of inflation and the higher the unemployment rate was, the lower the rate of inflation. The Phillips curve in figure 4.3 shows a trade-off between inflation and unemployment. That is, to lower the inflation rate, we must accept a higher unemployment rate, and to lower the unemployment rate we must accept a higher rate of inflation. In the 1960s and 70s, The Phillips curve was relied upon to explain the inflation. Inflation appeared to respond in a fairly predictable way to changes in the unemployment rate and during that time policy discussions revolved around the Phillips curve. During that time, it was considered that the role of policy makers was to choose a point on the curve. The Phillips curve broke down in the 1970s and 80s when there was no particular relationship between unemployment and inflation. To understand why the Phillips curve was stable during 1960-70s while it became
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unstable in the 1970s 80s, let us use demand-supply analysis. If the aggregate demand (AD) curve shifts from year to year while the aggregate supply (AS) curve remains the same, the price and income each year will lie on the AS curve. The plot of the relationship between the price and income will be upward sloping. Correspondingly, the plot of relationship between unemployment rate and the rate of inflation will be a curve that slopes downwards. Thus, we can see a negative relationship between unemployment rate and the inflation rate. If both the AS and AD curves shift simultaneously, however, there is no systematic relationship between price and income and thus no systematic relationship between the unemployment rate and the inflation rate. One of the important factors that cause the AS curve to shift is the price of imports.(Remember that the supply curve will shift when input prices change, and input prices are affected by the price of imports, particularly the oil prices). 4.8.4.1 Expectations And The Phillips Curve Another reason the Phillips Curve is not stable is the expectations. If a firm expects other firms to raise their prices, the firm may raise the price of its own product. If all firms are behaving in this way, then prices will rise because they are expected to rise. In this sense, expectations are self-fulfilling. Similarly, if inflation is expected to be high in the future, negotiated wages are likely to be higher than if inflation is expected to be low. Wage inflation is thus affected by expectations of future price inflation. Because wages are input costs, prices rise as firms respond to the higher wage costs. Thus in a vicious circle, price expectations affect wage contracts which eventually affect prices themselves. If the rate of inflation depends on expectations, then the Philips Curve will shift as expectations change. For example, if inflation is expected to be high, it will result in an increase in rate of inflation even when the unemployment rate remains the same. In this case, The Phillips Curve will shift to the right. Similarly, if the inflation is expected to be low, the
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Philips Curve will shift to the left there will be less inflation at any given level of the unemployment rate. It so happened that inflationary expectations were quite stable in the 1950s and 1960s. The inflation rate was moderate during most of this period, and people expected it to remain moderate. With inflationary expectations not changing very much, there were no major shifts of the Phillips Curve, which helps explain its stability during the period. Towards the end of the 1960s, inflationary expectations began to increase, primarily in response to the actual increase in inflation that was occurring because of the tight economy caused by the Vietnam War. Inflationary expectations increased even further in the 1970s as a result of large oil price increases. These changing expectations led to shifts of the Phillips Curve, which is another reason the curve was not stable during the 1970s. 4.8.5 Short-Run Trade-Off Between Inflation And Unemployment The Phillips Curve broke down during the 1970s which means that apart from unemployment, there are other things that affect inflation. Just as the relationship between price and quantity demanded along a standard demand curve shifts, when income or other factors change, so does the relationship between unemployment and inflation change when other factors change. In 1975, for example, inflation and unemployment were both high. As we explained earlier, this stagflation was caused partly by an increase in oil costs that shifted the aggregate supply curve to the left and partly by expectations of continued inflation that kept prices rising despite high levels of unemployment. In response to this situation, the Federal Reserve (Fed) pursued a contractionary monetary policy, which shifted the AD curve to the left and led to even higher unemployment. By 1977, the rate of inflation had dropped from over 11 percent to about 6 per cent. So the rise in the unemployment rate did lead to a decrease in inflation, which reflects the trade-off. There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves much
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more than simply choosing a point along a nice, smooth curve. When unemployment rises, other things being equal, inflation falls. 4.8.6 The Long-Run Aggregate Supply Curve, Potential GDP, and the Natural Rate of Unemployment Many economists believe that the AS curve is vertical in the long run. In the short run, we know that some input prices (which are costs to firms) lag increases in the overall price level. If the price level rises without a full adjustment of costs, firms profits will be higher and output will increase. In the long run, however, input prices may catch up as output price increases. If input prices rise in subsequent periods, driving up costs, the short-run aggregate supply curve will shift to the left, and aggregate output will fall. Assume the initial equilibrium is at the intersection of and aggregate demand the long-run aggregate supply curve. Now consider a shift of the aggregate demand curve. If input prices lag changes in the overall price level, aggregate output will rise. (This is a movement along the short-run AS curve) In the longer run, input prices may catch up. For example, next years labor contracts may make up for the fact that wage increases did not keep up with the cost of living this year. If output prices catch up in the longer run, the AS curve will shift and drive aggregate output back. If input prices ultimately rise by exactly the same percentage as output prices, firms will produce the same level of output as they did before the increase in aggregate demand. Aggregate output can be pushed above potential GDP in the short run. When aggregate output exceeds potential GDP, there is upward pressure on input prices and costs. The unemployment rate is already quite low, firms are beginning to encounter the limits of their plant capacities, and so forth. At levels of aggregate output above, costs will rise, the AS curve will shift to the left, and the price level will rise. Thus potential GDP is the level of aggregate output that can be sustained in the long run without inflation. This story is directly related to the Phillips Curve. Those who believe the AS curve is vertical in the long run at potential GDP also believe the Philips Curve is vertical in the long run at some natural rate of
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unemployment. The natural rate of unemployment refers to unemployment that occurs as a normal part of the functioning of the economy. It is sometimes taken as the sum of frictional unemployment and structural unemployment. The logic behind the vertical Philips Curve is that whenever the unemployment rate is pushed below the natural rate, wages begin to rise, thus pushing up costs. This leads to a lower level of output, which pushed the unemployment rate back up to the natural rate. At the natural rate, the economy can be considered to be at full employment. 4.8.7 The Long-Run Phillips Curve : The Natural Rate of Unemployment If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment that is the unemployment rate that is consistent with the notion of a fixed long run output at potential GDP. U is the natural rate of unemployment. 4.8.8 The Non Accelerating Inflation Rate Of Unemployment (NAIRU) The long run vertical Phillips Curve is a graph with the inflation rate on the vertical axis and the unemployment rate on the horizontal axis. The natural rate of unemployment is U. In the long run, according to advocates of the long run vertical Philips curve, the actual unemployment rate moves to U* because of the natural workings of the economy. Many economists believe in the relationship between the change in the inflation rate and the unemployment rate. The value of the unemployment rate where the PP curve crosses zero is called the nonaccelerating inflation rate of unemployment (NAIRU). If the actual unemployment rate is to the left of the NAIRU, the change in the inflation rate will be positive. Conversely, if the actual unemployment rate is to the right of the NAIRU, the change in the inflation rate is negative. Before about 1995, proponents of the NAIRU theory argued that the value of the NAIRU in the United States was around 6 per cent. By the end of 1995, the unemployment rate declined to 5.6 per cent, and by the end of 1999, the unemployment rate was down to 4.1 per cent. If the NAIRU were 6 percent, one should have seen a continuing increase in the inflation rate beginning about 1995. In fact, the 1995 to 1999 period
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saw slightly declining inflation. Not only did inflation not continually increase, it did not even increase once to a new higher value and then stay there. As the unemployment rate declined during this period, proponents of the NAIRU lowered their estimates of it, more or less in line with the actual fall in the unemployment rate. This can be justified by arguing that there have been continuing favorable shifts of the PP curve, such as possible increased foreign competition. Critics have argued that this procedure is close to making the NAIRU theory vacuous. Macroeconomists are currently debating whether equations estimated under the NAIRU theory are good approximations. More time is needed before any definitive answers can be given. 4.9 Summary
The product market equilibrium (IS) schedule is combined with the money market equilibrium (LM) schedule to analyse equilibrium for the economy as a whole and how it is affected by the monetary and fiscal policies. Monetary and fiscal policy can be used together, to offset the exogenous shocks and stabilize output and employment. Inflation can be defined as a self-perpertuating and irreversible upward movement of prices caused by an excess of demand over capacity of supply An inflationary economy possesses features such as continually rising prices, excess money supply, over-expansion of credit by the banks, etc Two basic approaches that explain the sources of inflation are the Quantity Theory of Money Approach and the Excess Demand Thesis. According to Quantity Theory of Money approach, other things being equal, if the money supply increases, prices rise and inflation occurs as a consequence.
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According to the demand-pull theory, prices rise in response to an excess of aggregate demand over existing supply of goods and services. Increasing demand - increasing prices increasing costs increasing income increasing demand increasing prices and so on. The unemployment rate is expressed as the number of unemployed people as a percentage of labour force. Persons unemployed and actively seeking a job are only considered under unemployment. Some of the reasons for unemployment are, sticky wages, efficiency wage theory, imperfect information and minimum wage loss. Phillips curve can be used to explain the relationship between unemployment and inflation when there is no change in aggregate supply. If both the AS and AD curves shift simultaneously, however, there is no systematic relationship between price and income and thus no systematic relationship between the unemployment rate and the inflation rate.
Review Questions 1. How is the equilibrium achieved in the economy when the IS and LM curves interact? 2. How can fiscal and monetary policies be used for stabilizing output? 3. What is the modern view on inflation? How does it differ from the traditional view? 4. What are the characteristics of inflationary economy? 5. Describe the quantity theory of money approach? 6. According to the demand-pull theory, what causes inflation? 7. Define unemployment rate.
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8. What are the four major reasons of unemployment? 9. Why did Phillips curve fail to explain the relationship between unemployment and inflation in the US in the 1970s? 10. What is the relation between expectation and Phillips curve?
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UNIT - V
Analysis of the External Sector
5.1 Introduction International trade is the trade or exchange of goods between two or more countries. Scientific and technological developments have enabled contact, communication and trade between people from distant parts of the globe. Trade between Tamils and Romans took place thousands of years back and today international trade has grown in volume and extent so that, even the existence of a nation may be threatened by loss of trade with other countries. We have already discussed the role of international trade in the economy when we discussed the four-sector model of circular flow of income and balance of payment. In this unit, we will discuss in detail why countries trade with each other, the role of trade multiplier and the role of trade policy. International trade grows due to territorial division of labour and regional specialization in the countries of the world; in turn, it helps in the growth of the same factors, namely, regional specialization. We can distinguish international trade from domestic trade based on the following characteristic features:
Due to immobility of factors of production such as labour, capital and natural resources between different countries, the prices of same commodities may differ considerably in different countries
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Due to wide diversities in climate, language, culture and customs, the international markets are heterogeneous. That is, there are considerable differences in buyer behaviour in different countries. Existence of differences in national groups and political units influences the national policies and governmental controls to be widely different in different countries. Differences in currencies require the need for evolving common standards of exchange between currencies. The socio-economic policies of different countries, which aim to protect special interests within the countries considerably, influence the International trade (e.g. Currently, the policy of subsidies to farmers has evolved as a major hitch in international trade, especially between developed and developing countries).
All these features, which differentiate international trade from domestic trade have led to the development of the subject of international economics. International economics is growing in importance as a field of study because of the rapid integration of international economic markets. More and more, businesses, consumers and governments realize that their lives are increasingly affected, not just by what goes on in their own town, state or country, but by what is happening around the world due to globalization. World economy is facing a fundamental shift where we are moving away from relatively self-contained national economies isolated from each other by barriers of distance, time zones, languages, government regulation, culture and business systems, towards a world in which national economies are merging into an interdependent global economic system through the process of globalization. In this globalized economy, the volume of goods, services and investment crossing national borders have expanded faster than world output every year during the last two decades of the 20 th century. Globalization has been facilitated by international organizations such as World Trade Organization (WTO) and leaders of worlds powerful economies
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advocating free trade among nations. With globalization, many products that we use are obtained from all over the world. Globalization has increased the opportunities for a firm to expand its revenues by selling around the world and reduce its cost by producing in nations where key inputs are cheap. Regulatory and administrative barriers to international trade have come down. Nations have transformed their economies by privatizing state-owned enterprises, deregulating markets, increasing competition welcoming foreign investment in businesses from all around the world to expand internationally. During the early 1900s many countries of the world erected formidable barriers to international trade and foreign direct investment. Many of the barriers to trade took the form of high tariffs on imports of manufactured goods. Due to retaliatory trade policies of countries, trade barriers were raised to very high levels, which led to the Great Depression in 1929. Hence, advanced industrial nations, under the umbrella of the General Agreement on Tariffs and Trade (GATT) tried to remove the barriers to free flow of goods, services and capital between nations and the past data indicate that the efforts have been fruitful. In economics, we are interested in finding out the reasons behind international trade in general and specifically the drivers that force the world towards greater globalization. For understanding why countries trade between each other, we should know the advantages and disadvantages of International Trade. 5.2 Advantages of International Trade It boosts international specialization and geographical division of labour resulting in optimum utilization of worlds natural resources, thus making it a win-win situation for all the parties participating in the game. Total output and exchangeable values of possessions of each country increases, thus improving the standard of life and quality of life throughout the world. (e.g the introduction of European Common Market has considerably improved the living standards in all the member countries). Improvement in cultural exchanges and ties between different countries helps in
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developing more cohesiveness in human community. Foreign trade eases local scarcity of food or other essential goods, temporary or long-standing, considerably. Improvement in international cooperation and appreciation of cultural diversity will lead to stable peace in the long run. International competition results in improvement of production quality and research and development of skill and new technological innovations. 5.3 Disadvantages of International Trade Rapid depletion of localized resources and raw materials may result in greater imbalances. For example, a country having oil as its major resource will be adversely affected by fast depletion of its oil resources. International competition tends to suppress local industry at developing stage and ultimately even kill it. Dumping of unwanted goods by advanced countries may result in economic slavery of developing countries, affecting their capital foundation and growth rate. Self-sufficient and self-reliant economy will decline in such countries. 5.4 Classical Theory of International Trade The theory of comparative advantages formulated by Daniel Ricardo in 1815 is regarded as the classical theory of international trade. This theory has been put forth as an alternative to Adam Smiths principles of absolute cost advantage. The theory has been developed based on a theorem, which states that, other things being equal, a country tends to specialize and export those commodities in whose production it has maximum comparative advantage. Ricardos two country, two commodity onefactor model has been developed with the following assumptions. 1. Labour is the only productive factor 2. Cost of production is measured in terms of labour units. 3. Labour is homogeneous and perfectly mobile domestically, but immobile internationally 4. Unrestricted free trade exists. 5. There is constant return to scale.
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6. There is full employment equilibrium, and 7. There is perfect competition. ( There are large number of buyers and sellers in the market that individuals have no influence and the market decides the price of the products). To illustrate the concept of comparative advantage, let us take an example. A country having comparative advantage in the production of wheat, sugar and cotton may trade these commodities with a country, which may have comparative cost advantage in the production of steel and paper. It may trade with another country for oil, manure or wine in which that country may have comparative cost advantage. Illustration of comparative cost differences:
Cost of production in labour units Country R I Country S Comparative cost ratio Commodity A Commodity B 60 90 75 100 A = 3/4 B 0.8 0.9
Domestic exchange ratio A = 2/3 B
Country R has absolute advantage in production of both A and B over country S, but comparative cost advantage is greater for commodity A whose relative cost of production is 80% of that of S, while with respect to B it is 90% of that of S. Country S had least comparative disadvantage in the production of commodity B. Therefore, country R will produce commodity A and trade it with country S that produces commodity. For example if country R requires 100 units of commodity A and 200 units of commodity B and produce both domestically it will cost 24000. Similarly, if country S wants 300 units of commodity A and 100 units of commodity B and produce both domestically it will cost 32500 for country B, thus in total it costs 56500. If both the countries decide to enter into trade with each other, where country R produces only commodity A and country S produces only commodity B and trade, country R has to spend 24000
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for production of 400 units of commodity A, and country B has to spend 30000 for producing 300 units of commodity B. Since, country R has absolute advantage, it can sell to country B for some profit in exchange of commodity B from country S. Thus, both the countries can share the saving of 2500 accrued by the comparative advantage. As the example suggests, this theory claims that both the trading countries gain from the trade. Comparative cost advantages in labour units have been modified in terms of cost of production by taking into account the variations in wage rates in the trading countries. This may alter the relative comparative advantages. But wage rates may not alter so as to convert the advantage into disadvantage. Prof. Taussig has proposed a modified theory of comparative cost advantage in which cost of production is measured in terms of money. To understand Taussigs theory, you may assume that one labour unit, say a man day, costs Rs. 120 in country R and Rs. 132 in country S and analyse Taussigss theory. You can also repeat the analysis with modified rates of Rs. 180 in country R and Rs. 140 in country S. The classical theory of comparative advantage has many limitations, which may be suggested by the assumptions on which it is based. We may enumerate them as follows. As the theory is based on labour as the only factor affecting cost of production, the effect of cost of non-labour factors of production may have a different state of comparative advantage. The assumption of homogeneity of labour is a serious limitation of the theory and has been discarded subsequently. The theory assumes constant returns for additional production while in fact the cost diminishes for surplus production as per the elasticity of supply and demand. The theory assumes full employment and had to be modified based on employment conditions. As the theory ignores transport costs, the actual cost may tend to nullify or boost the comparative advantage. International trade involves large number of countries and commodities and Ricardos two-country two-commodity and one factor model is too inadequate for realistic assessment. In spite of the limitations, it may be appreciated that it has initiated a model for assessment of comparative advantage and the model has been
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subsequently modified to account for the limitations and it is still appreciated as having an elegant logical structure. As the theory assumes free trade with perfect competition, its conclusion that all the parties in the game gain, is illusory with respect to trade between developed and developing countries. Hence, these countries try to enhance their condition by planned production and regulation of foreign trade and seek to develop import substitutions. 5.5 Modern Theory of International Trade
5.5.1 Development of Ohlins theory B. Ohlins modern theory of international trade is based on the general equilibrium approach. Ohlin accepts Ricardos comparative cost difference as the basis of international trade. However, he considered Ricardos theory as incomplete as it does not explain the causes for comparative cost differences. For him, international trade is only a special case of inter-regional trade and does not have much substantial difference. He has pointed out that establishment of exchange rates for various currencies have eliminated the need for separate theory for international trade. Accepting the theory of comparative cost difference (of Ricardo) as the basis for international trade Ohlin seeks to explain the real cause for this difference and tries to establish it on a more logical footing. According to him, trade results on account of different relative prices of different goods in different countries and the relative commodity price difference is the result of relative costs and factor price differences in different countries which, in turn, are due to differences in factor endowments in different countries. Thus, trade occurs between different countries because different countries have different factor endowments. Hence, Ohlins theory is also called the factor endowment theory. He considered factors such as national frontiers, tariff barriers, different languages, and customs as only temporary obstacles to the free flow of
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trade between countries, and hence will collapse at a stage giving place to the fundamental principle of general value theory which he called, the mutual interdependence price theory. According to the theory, the prices of a commodity are determined by the total demand and supply forces in the market. But the cost of production comprises prices paid to factors of production, which also includes consumers as producing agents for the commodity, and hence the price of commodity rests on mutual interdependence. Ohlin developed a simplified static model based on the following assumptions: 1. There are two factors, namely, labour and capital 2. Two countries I and J exists such that I is labour abundant and B is capital rich 3. There are two goods L and C such that L is labour intensive and C is capital intensive 4. There is perfect competition in both the commodity and factor markets 5. All the production functions are homogeneous of the first degree 6. There are no transport costs or other impediments to trade With these assumptions, he has explained the meaning of comparative advantage or relative price difference and sought to prove the factor price equilibrium theorem. We can present the interpretation of Ohlins theory based on these assumptions as follows:
Two countries will involve in a trade if the relative prices of goods (say L and C) are different. That is, trade will result when a country can buy goods cheaper from outside than it can produce them domestically.
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Under competitive market conditions, prices are equal to average costs. i.e., relative price differences are because of cost differences, which are due to factor price differences in the two countries.
Supply and demand determine the factor prices. For a given demand, a capital rich country has a lower capital price and a labour intensive country will have a cheaper labour price.
Defining the factor price ratio as the ratio of price of labour to the price of capital it is taken as a model parameter. Product L being labour intensive will be cheaper in country I while C will be cheaper in country J. Therefore, country I will tend to specialize in L and J will tend to specialize in C. These differences will persist due to international immobility of factors of production. (Globalization is an attempt to create mobility for the factors of production). Thus, by interpreting the Ohlins model, we can arrive at the following conclusions: i. Differences in commodity prices in the two countries are the basis of international trade. ii. Differences in factor endowments cause the differences in commodity prices. iii. A capital rich country specializes in capital-intensive products and a labour abundant country specializes in labour- intensive products. In his illustration, Ohlin used Australia and England. While Australia is rich in capital (land), it has scanty labour force. England though, also rich in capital has greater availability of cheap labour. Hence, Australia was selling capital-intensive products such as wheat, wool and meat to England, purchasing in return labour-intensive industrial products. Ohlin also points out that relative price differences will lead to absolute price differences when the exchange rate between the two countries is settled. He claims that his conclusions though derived from a simple model can be extended to multi-product, multi-nation trade and makes the following observations:
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The theory can be extended to any number of regions without making any change in the methods or altering the conclusions; only the theory would become more complex. It is not necessary that the regions should have disproportionate factor supply. Even if the factor prices are the same in the two countries, presence of large market can encourage specialization Qualitative differences in different factors in two regions may make it difficult to compare relative differences in the two regions. This may be solved by classifying all these factor under different groups. It is the demand and supply that are more important for comparison than homogeneity of factors. Transport costs, ignored in the initial analysis can be subsequently included in a modified model to determine their effect on prices and trade. The assumption of the constant cost is not necessarily a draw-back of the model as it is not necessary for validity of the theory.
However, the assumption of full employment and perfect competition are not realizable in practice, because of international monopoly and absence of free trade. But without these assumptions the theory could not have been developed. 5.5.2 Comparison with Classical Theory i. Ricardo presents a separate theory for international trade, while in modern theory, international trade is treated by adding a space dimension to domestic trade theory.
ii. The Classical theory is a one-factor (labour) theory while The modern theory includes capital as second factor. iii. Unlike the classical theory, the modern theory is a multiple market theory of pricing. iv. The classical theory tries to establish normative economics while the modern theory contributes to the development of positive economics.
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v.
The classical theory stresses on the quality differences of labour in two countries while the modern theory emphasizes on the difference in factor endowments.
vi. Ricardo does not explain the basis of comparative cost differences. Ohlins theory explains it by taking into account the differences in quantity of all factors and also it takes into account the wide differences in factor endowments for different goods. This is the significant difference and improvement over classical theory. 5.5.3 Empirical Tests of the Factor Endowment Theory Any theory starts as a hypothesis formed though observations of field realities and is strengthened by methodical verifications through systematically constructed and conducted tests. Some of the important test that helped in strengthening the theory are described as below 5.5.3.1 MacDougalls Test MacDougall made an attempt to find out whether a countrys exports consists of goods involving the use of relatively abundant factors or not. He compared the export shares of UK and USA, two capital abundant countries. Contrary to expectation, Englands export of capital-intensive goods was so negligible as to refute Ohlins theory. But the test was criticized for using a wrong parameter (horsepower) as a measure of capital-intensity. In fact, horse power should have been treated as labour assisted by mechanical power. 5.5.3.2 Leontief Paradox Another study of American exports by Leontief also led to another similar unexpected observation that though America is a capital-intensive country, it exports mostly labour-intensive goods. This is known in economics literature as the Leontief paradox.
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5.5.3.3 Bharadwajs study Bhardwajs study of bilateral trade between India and USA has shown that America exports to India more labour intensive goods while Indian exports to America mostly capital-intensive goods which is quite contrary to Ohlins theory. Though the selected empirical tests lead to results contradicting the doctrine, critics tend to support Ohlins theory and try to point out the imperfections in the test samples as well as the loop holes in inferences. It is quoted that study of exports of Japan has not produced such contrary results as to disprove Ohlins theory. Probably, we can remark that Ohlins theory has not really been tested so far, and cannot be put to empirical test because of its unrealistic and restrictive assumptions. Finally, Ohlins factor proportion analysis is regarded as an explanation of the international trade phenomenon. It is one of the several possible explanations that follows. Some are enumerated below: i. Differences in factor supply
ii. Differences in factor efficiency iii. Differences in the state of technological advancement iv. Differences in communitys scale of preferences and relative demands v. Differences in the economies of scale
vi. Differences in population growth and economic needs vii. Differences in the rates of capital formulation. There are two ways to adjust an international monetary disequilibrium. Such a disequilibrium will induce payment imbalances at the existing exchange rate. The authorities can allow exchange rates to adjust in response, which will alter the values of national money supplies to accommodate what is demanded and thereby prevent or eliminate the payments imbalances. Alternatively, the authorities can intervene to
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maintain the existing exchange rates and thereby alter the national money supply to accommodate what is demanded. In the former case the individual countries are able to control independently their money supply and should be prepared to suffer exchange rate volatility. In the latter case the reverse hold true. In practice, both methods are combined in various ways. In this section let us analyze the ways in which monetary disequilibrium induces payment imbalances and the way in which exchange- rate variations can eliminate or prevent them. There are three channels of adjustment, namely adjustments in income, prices and international capital movements. Let us now once again consider the equilibrium equation. Suppose that India is trading with France. The Indian equilibrium income is determined by S+M=I+X Where S indicates saving I indicates investment M represents import and X represents exports Let us analyse this graphically using figure 5.1.
Investment plus Exports Savings Plus Import E A C S+M I +X + ?(I+X)
5.1
I+X
Y + ?Y
Income Y
Figure 5.1. Equilibrium Indian Income
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Now, Indian exports are simply French imports, which depend upon French income. From the point of view of India, French income is exogenous, and so is X. Therefore, the right-hand side of the equation is exogenous (i.e. outside the control of India) and hence is represented by a horizontal line in the graph. The left-hand side depends upon Y and is represented by an upward sloping curve. The distance OD represents the sum of investment and exports. Suppose that the Indian investment plus exports increase, say by the amount (I+X) represented by the distance DE, due to either increase in either one or both investment I or French imports. Then, the equilibrium moves from A to C, and Indian income increases by Y as represented by distance AB . Thus, the increase in income Y is related to the increase (I+X) in autonomous expenditure as Y = [1/(mps + mpm)] (I+X) 5.2
where mps represents the marginal propensity to save and mpm is the marginal propensity to import. The term 1/(mps+mpm) is called the foreign trade multiplier. The foreign trade multiplier is the amount by which the equilibrium national income of an open economy will be raised by a unit increase in investment or in exports. We can also look at the equilibrium in a slightly different way. If we rearrage the equation 5.1 as S I = X M, where (S I ) is the excess of saving over domestic investment, which must be zero in a closed economy, and ( X- M) is the net exports or trade balance. Let us illustrate the equilibrium graphically using figure 5.2 In the figure, S- I has a positive slope because an increase in income raises the saving and leaves investment untouched, and X M slopes down because the income increase raise M but not X (exogenous). The equilibrium is arrived at point T where S I is equal to X M . This graph has the advantage of explicitly showing the two major variables that are determined in equilibrium, namely, national income and trade balance.
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Exports X minus Import M Saving S Minus Investment I I
XM S I T Trade balance at equilibrium IncomeY National Income at equilibrium Figure 5.2. Equilibrium Income and trade balance
We can arrive at the following conclusions from our discussion on foreign trade multiplier:
The foreign trade multiplier is smaller than the multiplier in a closed economy since mpm is added to the denominator. Thus, an increase in I will cause a smaller increase in income than if the foreign trade were absent
The international sector becomes another source of disturbance influencing income. An increase in exports causes the same level of increase in income as an increase in investment. Also, national income can be influenced by changing import demand. By using tarrifs, quotas or other restriction on the import of specific goods, the demand for imports can be brought down causing the trade balance to increase resulting in increased national income.
Policies that influence the national income will also influence the trade balance. Suppose Indians increase I, causing income to rise from Y to Y + Y, the trade balance will fall and vice versa. The implication is that in making the expenditure policy, the authorities will wish to consider its effects an both on the national output and trade balance.
5.6
Trade Policy Tools Trade policies come in many varieties. Generally they consist of either taxes or subsidies, quantitative restrictions or encouragements, on either
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imported or exported goods, services and assets. Let us briefly describe some of policies that countries have implemented or have proposed implementing 5.6.1. Import Tariff An import tariff is a tax collected on imported goods. A tariff is any tax or fee collected by a government. There are two basic ways in which tariffs may be levied: specific tariffs and ad valorem tariffs. A specific tariff is levied as a fixed charge per unit of imports. So irrespective of the value of the product, the quantity determines the tariff. An ad valorem tariff is levied as a fixed percentage of the value of the commodity imported. Ad valorem is Latin for on value or in proportion to the value. Different tariffs are generally applied to different commodities. Governments rarely apply the same tariff to all goods and services imported into the country. Countries have a tariff schedule which specifies the tariff collected on every particular good and service. 5.6.2 Import Quotas Import quotas are limitations on the quantity of goods that can be imported into the country during a specified period of time. If an import quota is set below the free trade level of imports, it is called a binding quota. If a quota is set at or above the free trade level of imports then it is referred to as a non-binding quota. Goods that are illegal within a country effectively have a quota set equal to zero. Thus many countries have a zero quota on narcotics and other illicit drugs. There are two basic types of quotas: absolute quotas and tariff-rate quotas. Absolute quotas limit the quantity of imports to a specified level during a specified period of time. Sometimes these quotas are set globally and thus affect all imports while sometimes they are set only against specified countries. Absolute quotas are generally administered on a firstcome first-served basis. For this reason, many quotas are filled shortly after the opening of the quota period. Tariff-rate quotas allow a specified quantity of goods to be imported at a reduced tariff rate during the specified quota period.
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5.6.3 Voluntary Export Restraint Voluntary export restraint is a restriction set by a government on the quantity of goods that can be exported out of a country during a specified period of time. It is referred to as voluntary since it is implemented upon the insistence of the importing nations. Typically VERs arise when the import-competing industries seek protection from a surge of imports from particular exporting countries. VERs are then offered by the exporter to appease the importing country and to avoid the effects of possible trade restraints on the part of the importer. Thus VERs are rarely completely voluntary. Also, VERs are typically implemented on a bilateral basis, that is, on exports from one exporter to one importing country. 5.6.4 Export Taxes An export tax is a tax collected on exported goods. As with tariffs, export taxes can be set on a specific or an ad valorem basis. 5.6.5 Export Subsidies Export subsidies are payments made by the government to encourage the export of specified products. As with taxes, subsidies can be levied on a specific or ad valorem basis. The most common product groups where export subsidies are applied are agricultural and dairy products. Most countries have income support programs for their nations farmers. These are often motivated by national security or self-sufficiency considerations. Farmers incomes are maintained by restricting domestic supply, raising domestic demand, or a combination of the two. By encouraging exports, the government will reduce the domestic supply and eliminate the need for the government to purchase the excess. 5.6.6 Other Policies A Voluntary Import Expansion (VIE) is an agreement to increase the quantity of imports of a product over a specified period of time
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A Government Procurement Policy requires that a specified percentage of purchases by the central or state governments be made from domestic firms rather than foreign firms. Health and Safety Standards regulate the use of some goods, such as pharmaceuticals. These regulations can have an effect upon trade patterns even though the policies are not designed based on their effects on trade. Red-tape barriers refers to costly administrative procedures required for the importation of foreign goods. Red-tape barriers can take many forms. A red-tape barrier may arise if multiple licences must be obtained from a variety of government sources before importation of a product is allowed. 5.7 Summary International trade is the trade or exchange of goods between two or more countries. International trade grows due to territorial division of labour and regional specialization in the countries of the world in turn it helps in the growth of the same factors namely regional specialization. International Trade boosts international specialization and geographical division of labour resulting in optimum utilization of worlds natural resources, thus making it a win-win situation for all the parties participating in the game Rapid depletion of localized resources and raw materials may result in greater imbalances. The theory of comparative advantages formulated by Daniel Ricardo in 1815 is regarded as the classical theory of international trade. The classical theory has been developed based on a theorem, which states that, other things being equal, a country tends to specialize and export those commodities in whose production it has maximum comparative advantage.
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Ohlin developed a simplified static model based on certain assumptions. Ohlins theory explains basis of comparative cost differences by taking into account the differences in quantity of all factors and also it takes into account the wide differences in factor endowments for different goods. This is the significant difference and improvement over classical theory MacDougalPs Test Leontief Paradox, and Bharadwajs studyare some of the empirical tests of the Factor Endowment or Ohlins Theory
Ohlins factor proportion analysis is regarded as an explanation of the international trade phenomenon There are two ways to adjust an international monetary disequilibrium. Authorities can allow exchange rates to adjust in response or intervene to maintain the existing exchange rates and thereby alter the national money supply to accommodate what is demanded
The foreign trade multiplier is smaller than the multiplier in a closed economy since mpm is added to the denominator. The international sector becomes another source of disturbance influencing income Policies that influence the national income will also influence the trade balance. Various trade policy tools like import tariff, export tariff, export subsidies can affect international trade. Review Questions 1. What are the characteristice that differentiate international trade from domestic trade ? 2. Why is international economics as a field of study gaining
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importance ? 3. What are the advantages and disadvantages of International Trade ? 4. What are the assumptions made by Ricardo in his theory on International trade ? 5. Illustrate comparative advantage with an example 6. Compare Ohlins theory with classical theory of international trade 7. Describe the various tests of the factor endowment theory. 8. What are the various trade policies that affect international trade ? 9. Comment on Indian trade policy.
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Unit - I: Nature and Scope of Macro Economic Issues

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ECONOMIC FOUNDATION OF BUSINESS ENVIRONMENT

NATURE AND SCOPE OF MACRO ECONOMIC ISSUES

Anna Universtiy Chennai

ECONOMIC FOUNDATION OF BUSINESS ENVIRONMENT

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1.3 Overview of Macroeconomics

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Essential goods and services (food, .)

Figure 1.1 Production possibility frontier

(thousands of bottles) (thousands of tons)

Anna Universtiy Chennai

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Fig. 1. 2 Sample PPF curve

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Price Index for all commodities

P 250 200 150 100 50 0 E

AD Q 0 1000 2000 3000 4000 5000 Real GDP (billions)

Figure 1.3 Interaction of Aggregate Demand and Aggregate Supply

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saving = Disposable personal income consumption expenditure

Profits (Dividends+ Business taxes)

saving = Public revenue current expenditure

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Anna Universtiy Chennai

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Anna Universtiy Chennai

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Taxes and loans G Business sector

Taxes and loans C Household sector

Consumption expenditure Factor payments X

X Foreign sector Transfer payments

Export & Transfer payments

Anna Universtiy Chennai

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1.6.3 Measuring GDP

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1.6.6 Price indicators

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As an indicator of the degree and sources of inflationary pressures in the economy

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