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MACRO ECONOMICS
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Q 5) a) Distinguish between GDP at market price and

GDP at factor price.
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Net National Product (NNP)/National Income/GDP at market price:

Definition and Explanation of NNP:
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"Net national Product or national income at market prices is the net market money value of all the final
goods and services produced in a country during a year. It is found out by subtracting the amount of
depreciation of the existing capital in a year from the market value of all final goods and services".
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For a continuous flow of money payments, it is necessary that a certain amount of money should be set
aside from the gross national income for meeting the necessary expenditure of wear and tear of all capital
equipment so that there should not be any deterioration in the capital and it should remain intact. If we
deduct depreciation allowance from gross national product, we get Net National Product at current market
price.
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Formula For Net National Product/National Income:

NNP at Market Price = GNP at Market Price - Depreciation

Depreciation Allowance and Maintaining Capital Intact. Here a question can be asked as to what we
actually mean by depreciation allowance and maintaining capital intact; (the words which we have used in
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explaining NNP).

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It is known to every one of us that when production is going on, the value of capital equipments does not
remain the same. A decrease in value because of wear and tear through, use, rusting, accident or

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through actions of elements, gradually take place in the building and other equipments of business. A
certain sum of money based on the value of the capital equipment and its longevity is set aside every
year from the gross annual income so that when machinery is worn out, a new capital equipment can be

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set up from the sum thus accumulated. This fund which is set aside for covering the wear and tear,
deterioration and obsolescence of the machinery is named as Depreciation Allowance. We can make
this concept more clear by taking a simple example.

Example of NNP:

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Suppose, a person buys a machinery for manufacturing cloth for $10000 only. He expects that this
machinery will last ten years and after that period, it will be partially or completely worn out. He sets aside
$1000 every year from the gross national income as a depreciation reserve of the capital equipment.

After the expiry of ten years, he accumulates $10000 and with that money he replaces the old capital

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equipment which has lived its useful life and maintains capital intact. The sum of money, i.e., $1000 which
he annually deducts from the gross annual income, is known as depreciation allowance.

It is often pointed out by economists that the calculation of depreciation allowance every year is a difficult
task.

For example, a person expects the longevity of the capital equipment, say for ten years. There is a
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possibility that machinery may last longer or it may go out of use earlier. So they say what needed is an
approximate decision regarding the' depreciation allowance. This decision should be based on high
degree of judgment and guessing about the future.

Maintaining Capital Intact. By maintaining capital intact we do not mean that capital equipments should
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remain the same. It should neither increase nor decrease. This can only by possible in a static society. In
a progressive society, the total capital equipment of a country must increase every year, otherwise the
national income will be affected adversely.

In Economics, by the phrase 'maintaining capital intact' is meant to make good the physical
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deterioration which has taken place in the capital equipment while creating income during a given period.
This can only be made by setting aside a certain amount of money every year from the annual gross
income so that when the income creating equipment becomes obsolete, a new capital equipment may be
created out. If the depreciation allowance is not set aside every year, the flow of income would not remain
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intact. It will decline gradually and the whole country will become poor.

NNP = GNP – Depreciation

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GDP/National Income at Factor Cost:

Definition and Explanation:

National income can be estimated in terms of either output or total income. When national income is
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measured by adding together all income payments made to the factors of production in a year, it is called
national income at factor cost. National income thus is the sum total of all income payments made to the
factors of production. In the words of J. Sloman:

"National income (Nl) or national income at factor cost is the aggregate earning of the four factors of
production (land, labor, capital and organization) which arise from the current production of goods and
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services by the nations' economy".

Components of National Income at Factor Cost:

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The main components of national income at factor cost are as follows:

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The factor incomes are generally divided into four categories:

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(i) Compensation to employees (ii) Interest (iii) rents and (iv) profits.

(i) Compensation to employees: It is the largest component of national income. It consists of wages and
salaries paid by the firms to the workers for their labor services.

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(ii) Interest: Interest is the payment for the use of funds in a year. The payment is made by private
businesses to households who have lent money to them.

(iii) Rent: Rent is all income earned by individuals for the use of their real assets such as building, farms
etc.

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(iv) Profit: Profit is the amount which is left after compensation to employees, rent, interest have been
paid out. The sum of compensation to .employees, interest, rent and profit is supposed to equal national
income at factor cost.

Q 5) b) Explain any one approach of measurement of

GDP.
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Expenditure Method:
Definition and Explanation:
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The expenditure approach measures national income as total spending on final goods and services
produced within nation during an year. The expenditure approach to measuring national income is to add
up all expenditures made for final goods and services at current market prices by households, firms and
government during a year. Total aggregate final expenditure on final output thus is the sum of four broad
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categories of expenditures:

(i) consumption (ii) investment (iii) government and (iv) Net export.
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(i) Consumption expenditure (C): Consumption expenditure is the largest component of national
income. It includes expenditure on all goods and services produced and sold to the final consumer during
the year.
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(ii) Investment expenditure (I): Investment is the use of today's resources to expand tomorrow's
production or consumption. Investment expenditure is expenditure incurred on by business firms on (a)
new plants, (b) adding to the stock of inventories and (c) on newly constructed houses.

(iii) Government expenditure (G): It is the second largest component of national income. It includes all
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government expenditure on currently produced goods and services but excludes transfer payments while
computing national income.

(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.
National income calculated from the expenditure side is the sum of final consumption expenditure,
expenditure by business on plants, government spending and net exports.
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NI = C + I +G + (X - M) Precautions

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Precautions For Expenditure Method:

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While estimating national income through expenditure method, the following precautions should be taken:

(i) The expenditure on second hand goods should not be included as they do not contribute to the current

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year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not
represent expenditure on currently produced goods and services.

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(iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions,
interest on public debt should also not be included because no productive service is rendered in
exchange by recipients of these payments.

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Q 6) a) If consumption function id C = 500 + 0.75 y,
find the value of multiplier
C = 500 + 0.75 y
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Multiplier is represented by k
Therefore k = 1/(1-MPC)
MPC = b = 0.75
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C = a + by

Hence,
k = 1/(1 - 0.75)
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k=4

Q 6) b) Explain Keynesian theory of income and

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employment.
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Keynesian Theory of Income and Employment:

Definition and Explanation:

John Maynard Keynes was the main critic of the classical macro economics. He in his book 'General
Theory of Employment, Interest and Money' out-rightly rejected the Say's Law of Market that supply
creates its own demand. He severely criticized A.C. Pigou's version that cuts in real wages help in
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promoting employment in the economy. He also opposed the idea that saving and investment can be
brought about through changes in the rate of interest. In addition to this, the assumption of full
employment in the economy is not realistic.

So long as the economy was operating smoothly, the classical analysis of aggregate economy met no
serious opposition. However, Great Depression of 1930's created problems of increasing unemployment,
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reducing national income, declining prices and failing firms increased in intensity. The classical model
miserably failed to explain and provide a workable solution for how to escape the depression.

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It was at that time when J. M. Keynes wrote his famous book 'General Theory'. In it he presented an

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explanation of the Great Depression of 1930's and suggested measures for the solution. He also
presented his own theory of income and employment. According to Keynes:

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"In the short period, level of national income and so of employment is determined by aggregate demand
and aggregate supply in the country. The equilibrium of national income occurs where aggregate demand
is equal to aggregate supply. This equilibrium is also called effective demand point".

What is Effective Demand?

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Effective demand represents that aggregate demand or total spending (consumption expenditure and
investment expenditure) which matches with aggregate supply (national income at factor cost).

In other words, effective demand is the signification of the equilibrium between aggregate demand (C+I)
and aggregate supply (C+S). This equilibrium position (effective demand) indicates that the entrepreneurs

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neither have a tendency to increase production nor a tendency to decrease production. It implies that the
national income and employment which correspond to the effective demand are equilibrium levels of
national income and employment.

Unlike classical theory of income and employment, Keynesian theory of income and employment
emphasizes that the equilibrium level of employment would not necessarily be full employment. It can be
below or above the level of full employment.

Determinants of Income:
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The determinants of effective demand and so of equilibrium level of national income and employment are
the aggregate demand and aggregate supply.
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(1) Aggregate Demand (C+l):

Aggregate demand refers to the sum of expenditure, households, firms and the government is
undertaking on consumption and investment in an economy. The aggregate demand price is the amount
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of money which the entrepreneurs expect to receive as a result of the sale of output produced by the
employment of certain number of workers. An increase in the level of employment raises the expected
proceeds and a decrease in the level of employment lowers it.
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The aggregate demand curve AD (C+I) would be positively sloping signifying that as the level of
employment increases, the level of output also increases, thereby increasing of aggregate demand (C+l)
for goods. The aggregate demand (C+l), thus, depends directly on the level of real national income and
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indirectly on the level of employment.

(2) Aggregate Supply (C+S):

The aggregate supply refers to the flow of output produced by the employment of workers in an
economy during a short period. In other words, the aggregate supply is the value of final output valued at
factor cost. The aggregate supply price is the minimum amount of money which the entrepreneurs must
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receive to cover the costs of output produced by the employment of certain number of workers.

The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other part is
saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S) is positively
sloped indicating that as the level of employment increases, the level of output also increases, thereby,
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increasing the aggregate, supply. Thus, the aggregate supply (C+S) depends upon the level of
employment through4he economy's aggregate production function.

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Determination of Level of Employment and Income:

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According to Keynes, the equilibrium levels of national income and employment are determined by the
interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of
income determined by the equality of AD and AS does not necessarily indicate the full employment level.

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The equilibrium position between aggregate demand and aggregate supply can be below or above the
level of full employment as is shown in the curve below.

Diagram/Figure:

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In figure (32.3), the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at point
E1which is an effective demand point. At point E1, the equilibrium of national income is OY1. Let us
assume that in the generation of OY1 level of income, some of the workers willing to work have not been
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absorbed. It means that E1 (effective demand point) is an under employment equilibrium and OY1 is under
employment level of income.

The unemployed workers can be absorbed if the level of output can be increased from OY1 to OY2 which
we assume is the full employment level. We further assume that due to spending by the government, the
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aggregate demand curve (C+I+G) rises. As a result of this, the economy moves from lower equilibrium
point E1 to higher equilibrium point E2. The OY is now the new equilibrium level of income along with full
employment. Thus E2 denotes full employment equilibrium position of the economy.

Thus government spending can help to achieve full employment. In case the equilibrium level of national
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income is above the level of full employment, this means that the output has increased in money terms
only. The value of the output is just the same to the national income at full employment level.

Importance of Effective Demand:

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The principle of effective demand is the most important contribution of J.M. Keynes. Its importance in
macro economics, in brief, is as under:
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(i) Determinant of employment. Effective demand determines the level of employment in the country. As
effective demand increases employment also increases. When effective demand falls, the level of
employment also decreases.

(ii) Say's Law falsified. It is with the help of the principle of effective demand that Says Law of Market
has been falsified. According to the concept of effective demand whatever is produced in the economy is
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not automatically consumed. It is partly saved. As a result, the existence of full employment is not
possible.

(iii) Role of investment. The principle of effective demand explains that for achieving full employment
level, real investment must equal to the gap between income and consumption. In other words,
employment cannot expand, unless investment expands. Therein lies the importance of the concept of
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effective demand.

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(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich community, the
gap between income and expenditure is large. If required investment is not made to fill this gap, it will

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lead to deficiency of effective demand resulting in unemployment.

Criticism on Keynesian Theory:

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From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from the
monetarists. Milton Friedman, the Chief advocate of monetarists rejected the Keynesianism as a whole.
The monetarists returned back to the old classical theory for the explanation of the rise in general price
level and stated that inflation is always and every where a monetary phenomenon.

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The monetarists are of the view that J. M. Keynes laid more emphasis on the determinants of aggregate
demand and to a greater extent ignored the determinants of aggregate supply. The monetarists
encouraged the supply side policy and thus favored free enterprise economy for solving the problems of
unemployment and inflation.

J. R. Hicks describes Keyne's 'General Theory' as depression economics. Further, the 'General Theory

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of Keynes is applicable to the developed economies. The Keynesians concepts are not very useful for
policy purposes in less developed countries.

Q 7) a) What do you meant by marginal efficiency of

capital? Describe its determinants.
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Concept of Marginal Efficiency of Capital (MEC):
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Definition and Explanation:

Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations output
depends on its stock capital. An increase in the stock of capital increases output. The question is how
much increase in investment raises output? Well, this depends on the productivity of new capital i.e. on
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the marginal efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable
on a new capital asset over its life time.

J.M. Keynes defines marginal efficiency of capital as the:

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“The rate of discount which makes the present value of the prospective yield from the capital asset equal
to its supply price”.
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A businessman while investment in a new capital asset, examines the expected rate of net return (profit)
on it during its lifetime against the supply price of capital asset (cost of capital asset) if the expected rate
of profit is greater than the replacement cost of the asset, the businessman will invest the money in the
project.

Example:
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For example, if a businessman spends $10,000 on the purchase of a new griding machine. We assume
further that this new capital asset continues to produce goods over a long period of time. The net return
(excluding meeting all expenses except the interest cost) of the griding machine expected to be $1000
per annum. The marginal efficiency of capital will be 10%.
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(1000/10000) Χ (100/1) = 10%

Schedule:

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According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the

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various stock of capital available in the economy at a particular period of time. As the stock of capital
increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is
negatively sloped as a shown in the figure 30.7.

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Investment ($ in billion) Marginal Efficiency of Capital
20 10%
25 9%
40 7%

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70 5%
100 2%

Diagram/Curve:

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In the above table, it is shown when stock of capital is equal to $20 billion, the marginal efficiency of
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capital is 10% while at a capital stock of $100 billion, it declines to 2%. This investment demand schedule
when depicted graphically in figure 30.7 gives us the investment demand curve which goes on sloping
downward from left to right.
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FACTORS/DETERMINANTSWHICH AFFECT THE MARGINAL EFFICIENCY OF CAPITAL

1. DEMAND OF GOODS :- If the demand is greater than the marginal efficiency of capital will also be
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greater. On the other hand if the demand of goods is smaller then the marginal efficiency of capital will
also be smaller.

2. PRICE OF COMMODITIES :- With the increase in the prices of goods, marginal efficiency of capital
increases and with the fall in price the marginal efficiency of capital also falls.
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3. COST OF PRODUCTION :- With the fall in the cost of production marginal efficiency of capital
increases and with the rise in the cost, marginal efficiency of capital falls.

4. PSYCHOLOGICAL FACTOR :- If the businessman are optimistic, efficiency of capital will be higher
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and if they are pessimistic about future then marginal efficiency of capital will be low.

5. FOREIGN TRADE :- If the export demand increases, then producer will increase the investment
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because marginal efficiency of capital increases.

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6. THE QUANTITY OF CAPITAL GOODS :- If the capital goods are already in the large quantity to meet
the demand of the market, then it will not be beneficial for the investors to invest the money in the project

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and the marginal efficiency of capital will fall.

7. RATE OF POPULATION GROWTH :- If the rate of population growth is high then the demand of
various goods will increase . So it will increase the marginal efficiency of capital. It falls with the slow bith
rate.

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8. TECHNOLOGICAL ADVANCEMENT :- Inventions and technological improvement encourages
investment in various projects.So marginal efficiency of capital increases.

9. RATE OF TAXES :- If government imposes the taxes on various goods, it will increase the cost of

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production and will reduce the profit . So with the fall in profit the rate of investment and marginal
efficiency of capital both falls.

10. LABOUR EFFICIENCY :- Efficiency of labour increases the marginal efficiency of capital lowers.

11. GOVERNMENT INTERFERENCE :- If the government interferes in the private business and imposes
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some restrictions then people will hesitate to invest and marginal efficiency of capital falls. On the other
hand if it encourages the private business then marginal efficiency of capital will increase.
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Q 7) : b) What do you mean by expansionary and

contractionary fiscal policies? Explain how these
policies can be used to achieve economic objective.
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Fiscal Policy
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Fiscal policy can be defined as governments actions to influence an economy through the use of taxation
and spending. This type of policy is used when policy-makers believe the economy needs outside help in
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order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an
employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal
policy may be in order.

Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy
that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal
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policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total
number of final goods and services in an economy, which include consumption, investment, government
spending, and net exports.

Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports

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Fiscal policy has an effect on each of these categories. There are two types of fiscal policy: Expansionary
and Contractionary.

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Expansionary Fiscal Policy

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When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal
policy results in increased government spending and/or lower taxes. A recession results in a recessionary

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gap meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment
situation. In order to close this gap, a government will typically increase their spending which will directly
increase the aggregate demand curve (since government spending creates demand for goods and
services). At the same time, the government may choose to cut taxes, which will indirectly affect the
aggregate demand curve by allowing for consumers to have more money at their disposal to consume

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and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand
curve to the right, which would result closing the recessionary gap and helping an economy grow.

Contractionary Fiscal Policy

Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is

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in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles),
contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing
too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this
inflationary gap a government may reduce government spending and increase taxes. A decrease in
spending by the government will directly decrease aggregate demand curve by reducing government
demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less
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money to consume and invest, thereby indirectly reducing the aggregate demand curve

Q 8) : Write short notes on any two of the following:

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(i) Accelerator Coefficient

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The Principle of Acceleration:

The principle of acceleration is based on the fact that the demand for capital goods is derived from the
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demand for consumer goods which the former help to produce. The acceleration principle explains the

process by which an increase (or decrease) in the demand for consumption goods leads to an increase

(or decrease) in investment on capital goods. According to Kurilara, “The accelerator coefficient is the
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ratio between induced investment and an initial change in consumption expenditure.”

Symbolically, v = ∆I/∆C or ∆I = v ∆C where v is the accelerator coefficient, ∆I is net change in investment

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and AC is the net change in consumption expenditure. If the increase in consumption expenditure of Rs

10 crores leads to an increase in investment of Rs 30 crores, the accelerator coefficient is 3.

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This version of the acceleration principle has been more broadly interpreted by Hicks as the ratio of

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induced investment to changes in output it calls forth. Thus the accelerator v is equal to ∆l/∆Y or the

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capital- output ratio.

It depends on the relevant change in output (∆T) and the change in investment (∆I). It shows that the

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demand for capital goods is not derived from consumer goods alone but from any direct demand of

national output.

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In an economy, the required stock of capital depends on the change in the demand for output. Any

change in output will lead to a change in the capital stock.’ This change equals v times the change in

output. Thus ∆I = v∆ Y, where v is the accelerator.

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If a machine has a value of Rs 4 crores and produces output worth Rs 1 crore, then the value of v is 4. An

entrepreneur who wishes to increase his output by Rs 1 crores every year must invest Rs 4 crores on this
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machine. This equally applies to an economy where if the value of the accelerator is greater than one,

more capital is required per unit of output so that the increase in net investment is greater than the

increase in output that causes it.

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Gross investment in the economy will equal replacement investment plus net investment. Assuming
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replacement investment (i.e., replacement demand for machines due to obsolescence and depreciation)

to be constant, gross investment will vary with the level of investment corresponding to each level of
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output.

Operation of the Acceleration Principle:

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The working of the acceleration principle is explained in Table I.

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OR
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The table traces changes in total output, capital stock, net investment and gross investment over ten time

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periods. Assuming the value of the acceleration v=4, the required capital stock in each period is 4 times

the corresponding output of that period, as shown in column (3).

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The replacement investment is assumed to be equal to 10 per cent of the capital stock in period t, shown

as 40 in each time period. Net investment in column (5) equals v times the change in output between one

period and the preceding period.

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For example, net investment in period t+3=v (yt+3– Yt+2), or 40=4(115—105). It means that given the

accelerator of 4, the increase of 10 in the demand for final output leads to an increase of 40 in the
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demand for capital goods (machines).

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Accordingly the total demand for capital goods (machines) rises to 80 made up of 40 of replacement and

40 of net investment. Thus the table reveals that net investment depends on the change in total output,
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given the value of the accelerator. So long as the demand for final goods (output) rises net investment is

positive.

But when it falls net investment is negative. In the table, total output (column 2) increases at an increasing
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rate from period to t+4 and so does net investment (column 5). Then it increases at a diminishing rate

from period t+5 to t+6 and net investment declines from period t+7 to t+9, total output falls, and net
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investment becomes negative.

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Assumptions:

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The acceleration principle is based upon the following assumptions:

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1. The acceleration principle assumes a constant capital-output ratio.

2. It assumes that resources are easily available.

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3. It assumes that there is no excess or idle capacity in plants.

4. It is assumed that the increased demand is permanent.

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5. It also assumes that there is elastic supply of credit and capital.

6. It further assumes that an increase in output immediately leads to a rise in net investment.
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(ii) Kinds of Unemployment

Cyclical unemployment
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Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate
demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is
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called either demand deficient, general, or Keynesian unemployment

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Structural unemployment
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Structural unemployment occurs when certain industries decline because of long term changes in market
conditions. For example, over the last 20 years UK motor vehicle production has declined while car
production in the Far East has increased, creating structurally unemployed car workers. Globalisation is
an increasingly significant cause of structural unemployment in many countries.
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Regional unemployment

When structural unemployment affects local areas of an economy, it is called ‘regional’ unemployment.
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For example, unemployed coal miners in South Wales and ship workers in the North East add to regional
unemployment in these areas.
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Classical unemployment

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Classical unemployment is caused when wages are ‘too’ high. This explanation of unemployment

OR
dominated economic theory before the 1930s, when workers themselves were blamed for not accepting
lower wages, or for asking for too high wages. Classical unemployment is also called real
wage unemployment.

TW
Seasonal unemployment

Seasonal unemployment exists because certain industries only produce or distribute their products at
certain times of the year. Industries where seasonal unemployment is common include farming, tourism,
and construction.

NE
Frictional unemployment

Frictional unemployment, also called search unemployment, occurs when workers lose their current job
and are in the process of finding another one. There may be little that can be done to reduce this type of
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unemployment, other than provide better information to reduce the search time. This suggests that full
employment is impossible at any one time because some workers will always be in the process of
changing jobs.
ER

Voluntary unemployment

Voluntary unemployment is defined as a situation when workers choose not to work at the current
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equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour
market. There are several reasons for the existence of voluntary unemployment including excessively
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generous welfare benefits and high rates of income tax. Voluntary unemployment is likely to occur when
the equilibrium wage rate is below the wage necessary to encourage individuals to supply their labour.
CO

(iii) Output Gap

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How much spare capacity does an economy have to meet a rise in demand? How close is an economy to
operating at its productive potential? Has the recession damaged the economy’s productive potential?
These sorts of questions all link to an important concept – the output gap. The output gap is the
difference between the actual level of national output and the estimatedpotential level and is usually
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expressed as a percentage of the level of potential output.

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Negative output gap – downward pressure on inflation

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If actual GDP is less than potential GDP there is a negative output gap. Some factor resources such as

OR
labour and capital machinery are under-utilized and the main problem is likely to be higher than average
unemployment.

A rising number of people out of work indicate an excess supply of labour, which causes pressure on real

TW
wage rates. We have seen millions of people in the labour market have to accept lower pay rises in
recent years, many have seen wage freezes or actual wage cuts at a time when businesses have been
under huge pressure to control their costs.

NE
Positive output gap – upward pressure on inflation

• If actual GDP is greater than potential GDP then there is a positive output gap.
• Some resources including labour are likely to be working beyond their normal capacity e.g. making extra
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use of shift work and overtime.
• The main problem is likely to be an acceleration of demand-pull and cost-push inflation.
• A positive output gap is associated with countries where an economy is over-heating because of fast
and rising demand - a good example of this might be countries such as India and China
ER

(iv) Saving Function

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Saving is defined as the difference between disposable income and consumption: S= Y-C, where S is

saving, Y is income and С is consumption.

CO

Thus the level of saving depends on the level of income. This is illustrated in Table 1.
RA
IQ

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K
OR
TW
Column (3) of the Table shows that when income is zero or very low, people dissave (minus Rs 20 crores

or Rs 10 crores). They have to consume even if they are not earning or their consumption expenditure

NE
(Rs 70 crores) is more than their income (Rs 60 crores).

When income (Rs 20 crores) equals consumption expenditure (Rs 120 crores), savings are zero. As
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income increases further by Rs 60 crores, their savings increase by Rs 10 crores. It shows that as income

increases savings also increase but by less than proportionately.

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This relation between saving and income is called the propensity to save or the saving function. It is
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represented as S = f (Y). Thus the saving function indicates a functional relationship between S and Y,

where S is the dependent and Y is the independent variable, that is, S is determined by Y.

This relationship is based on the assumption “other things being equal” which means that all influences
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on savings are held constant and that income and saving increase by a constant amount, that is, income

increases by Rs 60 crores and saving by Rs 10 crores, as shown in Table 1.

IQ

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The propensity to save curve is shown in Fig. 1 where income is taken on the horizontal axis and saving

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on the vertical axis. The entire S curve with a definite position and slope is the propensity to save curve.

OR
The figure shows that below point Y, savings are negative because people disserve. At Y, savings are

zero. Above Y, savings increase with the rise in income. The S curve is linear (straight line) because the

rise in income and savings is at constant rates (Rs 60 crores and Rs 10 crores respectively).

TW
The propensity to save is of two types: The average propensity to save and the marginal propensity to

save, which we explain below.

NE
The Average Propensity to Save (APS):

The APS is the ratio of saving to income. It is found by dividing saving by income, or APS = S/Y. It tells us

about the proportion of each income level that people will save i.e., they will not spend on consumption.
CE
For example, in Table 1 at an income level of Rs 180 crores, the consumption expenditure is Rs 170

crores and the savings are Rs 10 crores.

ER

The APS is 0.06 which means that people save 6 per cent of their income, as shown is column (4) of the

Table. It is to be noted that as income increases, the average propensity to consume (APQ decreases
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from 0.94 to 0.92. But APS increases from 0.06 to 0.08.

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Diagrammatically, the APS is any point on the S curve. In Fig. 2, point S, measures the APS of the S

curve which is S1Y1/OY1.

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The Marginal Propensity to Save (MPS):

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The MPS is the ratio of the change in saving to the change in income. It can also be defined as the rate of

change in APS as income changes. It can be found by dividing a change in saving by a change in
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income, i.e., S/ Y. For example, in Table 1 when income increases from Rs 180 crores to Rs 240

K
crores, savings increase from Rs 10 crores to Rs. 20 crores so that Y = Rs. 60 (=240-180) crores

OR
and S = Rs 10 (= 20 – 10) crores and the MPS = 10/60 = 0.17. It means that 17 per cent of income is

saved, as shown in column (5) of the Table. It is constant at 0.17 because AS/AY= 10/60 is constant.

Diagrammatically, the MPS is measured by the gradient or slope of the S curve at a point or over a small

TW
range. This is shown in Fig. 3 by AB/BC where AB is the change in saving S and ВС is the change in

income Y.

NE
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Thus APS and MPS are two different concepts. The APS relates total saving to total income. On the other

hand, the MPS relates a change in saving to a change in income.

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Sir Khalid Aziz
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