ECONOMICS- POINT

Unit-1

Q1. Define micro and macro economics, Distinguish between them, and explain the scope,
importance and its limitations

Ans. modern economy analysis has been divided into two major branches that is micro and macro
economics. Micro economics means the economics system which deals individual economics unit
on the other hand macro economics means the economics unit which deals aggregate as a whole
that is national income, general employment, and total out –put, general price level etc.

These two concepts first time used by PROF.R.FRISCH of Oslo university in 1933.

But ,later on these two concepts systematically explained by J.M.Keynes in his famous book
“General theory of employment,interst and money”.

Distinguish between micro and macro economics:

The distinction between micro & macro economics is not very clear cut because what is micro-
economics in situation or from one point of view may become macro-economics in another point of
view.

For example: in the case of a closed economy a study of income, saving, consumption , employment
etc are macro economics on the other hand in case of open economy all these are micro-
economics.

If we go through its basic meaning then following are the important differences between them:

Micro-economics Macro-economics

It studies the individual-unit It studies total economics systems

It explains the price theory
It is a static concept
It deals with partial eqm
It assumes full-employment
It assumes general-price level given
It deals with allocation of resources
It explains the income & employment theory
It is dynamic one
It deals with general eqm
It assume less then full-employment
It assumes relative price given
It deals with optimum utilization of total
resources

Scope and importance of macro economics:

Prof. J.K.Mehta feels that so long as men live in society, the economist cannot afford to neglect the
study of macro economy. The theoretical and practical importance can be clear from the following
points:

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a) Formulation of economics policies

b) Understanding micro economy
c) Functioning of an economy system
d) Understating and controlling economic fluctuations
e) Study of economic development
f) Inflation and deflation
g) Study of national income
h) Performance of an economy
i) Nature of material welfare

a) Formulation of economics policies: it helps in the formulation of economic policies. Such as

monetary and fiscal policies during the inflationary and deflationary situation to solve the
problems of rise in prices, unemployment, depressions etc.
b) Understating micro economy: the study of macro – economics is essential for proper
understating of micro-economics. Without macro-economic no micro-economic law are
studied. For example the theory of individual firm could not have been formulated without
reference to behavior pattern of general industries. So macro-economic is treated as jungle
and micro-economic as tree.
c) Functioning of an economy: it is utmost important in getting us an idea of the functioning of
an economy system. It is very essential for a proper and accurate knowledge of the behavior
pattern of the aggregate variables. Without macro economics we are not been able to know
what type of economy system is there i.e. socialism, capitalism, or mixed economy.
d) Understating and controlling economics fluctuation: the theory of economics fluctuations
can be understood and built up only with the help of macro economics, for here , we have
to take into aggregate consumption, aggregate saving and investment in the economy.
e) Study of economic development: as a result of advanced study in macro economics, it has
become possible to give more attention to the problem of development of underdeveloped
countries. The main aim of macro economy is to promote economic welfare.
f) Inflation and deflation: Macro-economic approaches are of utmost important to analysis
and understand the effects of inflation are affected differently as a result of changes in the
value of money. Macro-economic enables us to take certain steps to counter attack the
adverse influences of inflation and deflation.
g) Study of national income: it is the study of macro-economic which has brought forward the
importance of study of national income and social accounts. With help of national income
we are in a position to know which country is developed and which is not. Again, with help
of the national income correct economic policies been formulated.

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h) Performance of an economy: macro-economic helps us to understand and analysis helps us

to understand and analyses the performance of an economy. It implies result oriented study
of an economy in terms of actual and factual achievements.
i) Nature of material welfare: macroeconomic enables us to study the nature and size of the
material welfare of the nations, the problem of measuring the social welfare is not easy,
even welfare economy does not help us at that time , we take the help of macro economics.

Limitations of macro economics:

Macro-economic analysis is very useful in studying the national problems that is – the problems
related to the whole economy but there are certain limitations too, these limitations are in the
nature of particle difficulties in formulating meaningful aggregates. The main limitations are:

a) False generalization
b) Difficulties in measuring the aggregates
c) Diversities
a) False generalization:
The aggregate approach draws the conclusion of macro level studies, this generalization results
are confusing because in macroeconomic we proceed from general to particular. So
generalization the conclusion is dangerous, irrelevant and misleading.
b) Difficulties in measuring the aggregates :
Macro economy analysis is not possible without a common measuring rod. Before the money
been invented, meaningful aggregates were difficult to find out due to heterogeneous elements
and also changing in the value of money.
c) Diversities:
The aggregative conclusion shows an average tendency and therefore do not influence all the
sectors alike. Some sectors may be possible saw a difference tendency. For example arise in
general price level, may not affect all the sectors in the same way . some may have favorable
effect while some other may be adverse effect.

Conclusion:
From the above discussion it shows that limitations associated with the macro economics
analysis affect only its practical signification, however they in way invalidated. in
macroeconomic techniques.

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2. What do you mean by circular flow of income & expenditure ? Explain it with Help of the two
sector, three sector & four sector model?

A. Circular flow means continuous circular movement of money and goods in the economy. The
concepts of circular flow of income is a simplification of which attempts to explain and show the
flow of money and goods from household to business enterprises and back to household. Circular
flow o money means that the money spent must not be hoarded and should contribute to flow to
maintain a certain level of economic activity and income.

We may explain it symbolically that is NNP=NNY=NNE . This concept was first time developed by
j.m. Keynes . He said that saving is always equal to investment .

The circular flow of income & expenditure refers to the process where by the national income &
expenditure of an economy flow in a continuous manner over a long period of time. The various
components of national income & expenditure . Such as:- saving , investment, taxation, Govt. ,
expenditure, export, import etc.

We may explain circular flow of income & expenditure in three different ways . such as :-

 Two sector model

 Three sector model
 Four sector model

Two sector model:-

In the two sector model , there is only two sectors. One is household sector and another is business
sector.

i. Household sector:-
Household sector owns all the factors of production. That is labour , land, & capital. This
sector receives income by selling the services to the business sector.
ii. Business sector:-
Business sector consists of producers who produce product and sell them to the
household sector or consumers.

Thus the household sector buys the output of product of the business sector. In return business
sector demands the factor market from the household sector.

We may explain it with help of the following chart.

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Consumption Expenditure

Product Market

Business Sector Household Sector

Factor Market

Income Payments

In the above figure left hand side indicates the business sector and right hand side indicate the
household sector. Household sector provides the factor market to the business sector. With help of
factor market (Land, Labour, Capital) business sector produce the goods and services which is
technically known as product market. Household sector consumes the goods from the business
sector that is the consumption expenditure of household sector . Business sector receives the
income in form of consumption expenditure and pays the income payment to the household
sector. With help of that household sector again demands goods and services from the business
sector . Business sectors again demands factor from the household sector. In this process income
and expenditure flow continuous.

Circular flow with savings and investment added:-

Actually in our economy two important elements are there. Those element are saving and
investment or they are inflows and leakages. Saving in the leakages and investment is the inflows or
injection.

We may explain it with help of the following flow chart.

Investment Capital Market Saving

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Consumption Expenditure

Product market

Business sector Household sector

Factor Market

Income Payments

In the above flow chart saving comes from the household sector. That saving will invested in the
capital market. Business sector receives the investment from the capital market for producing the
goods and services. Expenditure has two alternative paths that is directly via. Consumption
expenditure . Second one is indirectly via. Investment expenditure .

Saving Capital Market Investment is the directly via. Consumption expenditure.

On the other hand Investment capital market Saving is known as indirectly via.
Investment expenditure .

( capital market means the financial institutions such as :- commercial bank, Financial Institutions ,
saving Bank etc.)

In simply the households supply saving to the capital market and the firms, in turn obtain the
investment funds from the capital market.

Three sector Model :-

In three sector model, there are three sector exist in an economy. Such as :- household sector,
business sector & Govt. sector.

Circular flow of household and Govt. sector :-

While starting the three sector model first we take the circular flow between the household sector
and the Govt. sector . There are two important inflows & leakages . Those are :- taxes & Govt.
purchases.

Taxes in the form of personal income tax & commodity tax paid by the household sector are
outflows or leakages from the circular flow. But the Govt. purchases the services of the
households, makes transfer payment in the form of old age pension , unemployment relief, sickness
benefit etc are the injection or inflows of the circular flow.

Circular flow between business sector & Govt. sector :-

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All types of taxes paid by the business sector to the Govt. are leakages. On the other hand Govt.
purchase all its requirements of goods of all types from the business sector , give subsides and
makes transfer payment to firms in order to encourage their production is called injection.

Household, Govt. ,business sector taken together :-

We know that taxation is a leakages from the circular flow. It tends to reduce consumption & saving
of the household sector. Reduce consumption in turn reduces the sales and income of the firms.

On the other hand taxes on business firm tend to reduce their investment & production. The Govt.
offsets these leakages by making purchases from the business sector and buying services of the
household sector equal to the amount of taxes. In this way circular flow of income & expenditure
remain in equilibrium.

We may explain it with help of the following flow chart.

Government Government

Purchase sector

Taxes

Investment Capital market Saving

In the above chart it shows that taxes flow out of the household and business sector and go to the
Govt. The Govt. makes investment and for this purchases goods from firms and also factors of
production from households, There fore the Govt. purchases of goods and services are injection in
the circular flow of income and taxes are leakages.

If Govt. purchases exceed , net taxes then the Govt. will incur deficit equal to the difference
between the two. That is Govt. expenditure and tax. The Govt. finances it deficit by borrowing from
the capital market which receives funds from household in the form of saving. On the other hand if
net taxes exceeds Govt. purchases the Govt. will have a budget surplus. In this case the Govt.
reduces the public debt & supplies funds to the capital market which are received by firms.

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Import ants of the circular flow of income & expenditure:-

The concept of circular flow gives a clear-cut picture of the economy. By this we may know which
country is economically developed or not. Or in other words it indicates the working efficiency &
the disturbances in its functioning. It is very helpful in case of disequilibrium in the economy system
. In modern time it explains the role of leakages and their impacts on national income accounting .
It helps to Govt. to adopt proper measure to control & increase the import & export. The study of
circular flow also highlights the import ants of monetary policy to bring about the equality of saving
& investment in the economy. Similarly , the circular flow of income & expenditure points towards
the importance of fiscal policy.

From the above discussion it shows that circular flow of income & expenditure play an important
role in national income accounting. With out it we are not been able to know the exact economic
system of that country or nation. So , one of the greatest economist said it is the nervous system of
economy.

Q.3 What is national income? Explain its various method of measuring national income and its
difficulties ?

Introduction:- Concept of national income occupies a very important place in the Keynesian theory
of employment .Generally ,national income means income of the nation or it is the summation of
pre capita incomes. The concept of incomes from the very basis of the Keynesian theory of
employment. As a matter of fact, we can take income output and employment as equal to each
other. If income and output increases than employment also increased.

For the sake of simplicity and easy Keynes adopted a short period analysis . in which organization,
equipment and techniques assume are given.

Definition:- Different economist define national income in different ways.

 According to Marshal, “The labour and capital of a country, acting on its natural resources
produce annually a certain net aggregate of commodities. Material and immaterial
including services of all kind and net income due on account of foreign investments must
be added in. This is the true net annual income and revenue of the country or the national
davidant “
 According to Pigue , “The national davidant is that part of the objective income of the
commodity including of course ,income divided from abroad, which can be measure in
money “

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 According to Fisher, “ The national davidant or income consist of services as received by

ultimate consumers, whether from material or immaterial goods”
 According to Keynes, “ National income means all final goods and services which are
produced during a given period of time with in the country and abroad.”

From above the definitions , it shows that national income simply income of the nation it comes
from consumption , investment, Govt., net export , net factor income from abroad. The national
income can be expressed in national product , national income, national expenditure .

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

NY=national income , C= capital , I= investment , G = govt. , X= export , M=import, R= receipt ,

P=payment

National product :-National product means al the final goods and services which are produced
during a given period of time is known as national product. It means in this case we have take all
the three sectors final product with out duplication. Then we will get net national product .

National Income :-national income means all the income received by various factors of production
during a given period of time in the form of wage, rent, interest, profit etc.

National Expenditure:- National expenditure means the sum of expenditure of final consumption
of goods and services pulse domestic and foreign net investment .

Above three concepts are identically to each other . we may express it in following manner .

NNP=NNY=NNE

NNP=Net National product , NNY= Net National Income , NNE=Net National Expenditure

Methods of measuring National Income:-

The method of national income of the country depends upon the availability of statistics. Following
are the methods which are generally used us follows .

i. Product Method
ii. Income Method
iii. Expenditure Method
iv. Social Accounting Method
v. Combined Method

Product Method:-

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Product method otherwise known as commodity service method. In this method we find out the
market value of all goods and services produced in a country during a given period of time. In this
method we estimate all the final goods and services from primary sector , secondary sector and
service sector. The total of estimates gives us net domestic product from market price and factor
cost.

Income Method :-

This method consists in wage + rent+ interest + profit .

Expenditure Method :-

Expenditure method means all the expenses during a given period of time . Under this method we
add personal consumption expenditure , gross domestics income, Govt. goods and services and net
factor income from abroad. The three methods of measuring national income gives us the same
result . This equality of national income due to the three flows . Such as income ,output and
expenditure.

Social Accounting Method :-

This is new method . this method was developed by Richard stone . According to the social
accounting method various types of transaction are classified in different groups. Producer, traders,
final consumers etc.

Combined Method :-

It is not possible to estimate correctly the national income by adopting a particular method. Each
method has its own weakness. To solve these weakness modern economist used mixed combined
method for estimating national income. This type of method is used in under developed countries
and developing countries. In India this method was used in 1948-49 by national income committee.

Difficulties / Problems of measurement of National Income :-

There are so many difficulties to calculate or to measure the national income . Those are :-

 Difficulty in defining nation :-

These is the difficulty of define “ Nation” in national Income, Generally , nation means a
define territory or boundary, but in economic way it is differ . It is not only explain the
income with in the country but also explains outside the country.
 It only take into monetary forms:-
National income is always measure in money. There are some other goods and services
which are difficulty to measure in terms of money. For example :- Teachers services ,
painting etc.
 There is a difficulty in double counting :-

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Double counting means we count the goods & services in primary stage as well as in the
final stage . In measuring national income if we can take this type of method than our
national income will be doubled . so solve this difficulty only the final goods and services
are taken into account.
 Difficulty in including transfer payment:-
Transfer payment means the payment of the Govt. to the general citizens in terms of
pension, unemployment allowance etc. If this included national income there is a difficulty.
 Problem in to calculate depreciation :-
Depreciation means wear and tear charges. Depreciation charge on profits which lowers
national income . When the price of capital goods are changing than the profit also
changes.

G.N.P –Deprecation =N.N.P

 Money is not an measuring rod :-
The calculation of national income in term of money is under estimation of real national
income . we know that real national means the population of countries stable / constant , if
there is increase in the national income then we may say our real national income
increases. But our economic planners estimate national income in the form of money only.
 In under developed & developing countries most of the sector are unorganized :-
In underdeveloped & developing countries most of the sectors are unorganized. It means
the income of each and every sector is not proper.
Non availability of Data:-
Adequate and correct production and cost data are not available in a developing and
underdeveloped countries . in underdeveloped and developing countries the peoples are
not maintain proper account.
 IL-Literacy:-
In developing and underdeveloped countries most of the peoples are il-literate and
educated. For that reason they does not maintain any proper account.

Conclusion:-

From the above discussion it shows that national income estimation play on important role in
macro economy. From the national income estimation we know that whether the country is
developed, developing, under developed . At present our growth rate or G.D.P rate is 8.5 but, it
was 0.5 in the year of 1950-59. Generally , the national income estimated by the planning
commission and central statistical organization and national sample survey .

Unit -2

Q.1 Discuss the basic assumptions of classical Economics?

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A. Introduction: - The classical economics is a well knit body of economic doctrines which has been
handed down from generation to generation since the days of an English economist sir. David
Ricardo. By classical economist Keynes means that the traditional or orthodox principle of
economics. The principles of David Ricardo’s and Adam Smith are modified by the J.S. Mill and
Pigou. The basic principles of classical economist were generally accepted for a long period of time.
They strongly believe in full employment.

Following are the some of the important assumption of classical economist or contents of classical
economics. Those are:-

i. Assumption of full employment

ii. Allocation of Resources
iii. Philosophy of Laissez faire policy
iv. Importance of Rate Of Interest
v. Say’s Law
vi. Role of Money
vii. Wage cut Policy
viii. Automatic Adjustment
ix. Long run Equilibrium
x. Partial Equilibrium

Assumption of Full Employment:-

By the term full employment means utilizing the natural resources in an optimum manner. It is the
important assumption of classical theory. They always believe in full employment situation. To
them full employment is an abnormal situation. According to them, “if there is less than full
employment in the economy there is always a tendency towards full employment”. According to
them, “There is involuntary unemployment”.

Allocation Of Resources :-

Classical felt that there could not be any significant mall allocation of resources as the price
mechanism acting as an invisible hand and would achieve the best and most efficient allocation of
resources. Since, the optimum allocation of a given quantity of resources was the main subject
matter of classical economist. In brief , the well known theory of value , distribution and production
formed the care of the classical economist.

Philosophy Of Laissez Faire :-

Classical had great faith in the philosophy faire of capitalism which means live alone or left alone in
business matter. It means, state should not be interfere in the economic matter. Classical believed

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in laissez faire capitalism are equal the traditional model of study from the very begging . they have
great faith in price, mechanism, profit motive, free hand perfect competition, the self existing
nature of the system. They felt that if the system is allowed toward freely economic development is
possible.

Importance Of Rate Of Interest :-

Rate of interest occupies a very important place in the classical system. It is treated as the
equilibrating mechanism between saving and investment. Because, it brings equality between the
two.

Say’s Law:-

Another essential element of classical economics is say’s law of market. The say’s law of market is
the heart of the classical system. Say’s law of market states that supply creates its own demand. In
the other word, According to J.B.Say, there cannot be general over production or general
unemployment on account of the excess of supply over demand. Because whatever is supplied or
produced is automatically exchanged for money. So, there is no ground to fear a break in the flow
of income stream in the economy hence, there cannot be any general over production or
unemployment.

Role Of Money:-

In classical system the role of money is very limited. They only taken into account money as a
medium of exchange and ignore the other important function of money. They assume that people
have only one motive for holding money that is transition motive. They completely ignore the
precautionary and speculative motive for holding money.

Wage Cut Policy:-

Classical further believed that involuntary unemployment could be easily solved by cutting wages
down as a result of free and perfect competition which always exist in labour market. Classical s
believed that employment is determined by the wage hoarsens between the workers and employs;
therefore, wage cut will reduced unemployment. This concept was first time propounded by
A.C.Pigou. It occupies a central place in the classical scheme of reasoning.

Automatic Adjustment :-

According to classical s there is automatic adjustment in the forces of demand of the forced of the
supply are self existing of full employment level. They believed in the elasticity of the economic

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system. If there any obstacles in self existing automatic mechanism, the invisible hand (current
price mechanism) takes care of the difficulties. Classical s believed that flexible price, wage, interest
system etc set things rights to bring about automatic adjustment.

Long term Equilibrium :-

The another important assumption of classical economics is the long term analysis. They strongly
believed in the long run and in long run supply automatically creates its own demand. So, their
equilibrium analysis is long term equilibrium analysis.

Partial Equilibrium:-

Classical equilibrium is partial equilibrium and not a general equilibrium. Its loss and generalization
applied to a firm or an industry. But, not to the economic system as a whole. For example: - Pigou’s
wage cut is only applicable to a particular firm or industry but, it is not applicable to whole
economic system.

Saving:-According to them saving is great private and social virtue. They thought that saving helps
the capital formation that capital formation help in the economic development.

 Keynes’s reaction on classical assumption or Keynes attack on classical s :- Keynes did not
agree any one of the classical assumption and there policy implication. Keynes criticized
each and every point of classical s according to Keynes the classical theory is a neatly the
logical of the basic of its assumption. But, this assumption is highly unrealistic.
Following are some of the important limitation of classical system. Those are :-
I. Full employment is a myth.

There is a chance of wastages of resources.

II. There is no invisible hand.
III. Rate of interest in not an equilibrium mechanism.
IV. Supply never creates its own demand.
V. Wage cut is not a proper solution.
VI. Long run analysis is not an opportunity for economic system.
VII. There is a general equilibrium.
VIII. Saving is not virtue hut, it is a vice versa.

Q2. Supply creates its own demand comments this statement?

Or

Critically examine the say’s law markets and how Keynes critics it?
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Or

What is say’s law of market? Does it stand its invalidity?

Introduction:

Say’s law of market is the core of the classical theory of employment. J.B.Say an earlier 19 th century
France economist propounded this concept. According to his name it is treated as the say’s law of
market. In the words of say’s, it is production which creates markets for goods. A product is no
sooner created than it, from that instant affords a market for other products to the full extent of its
own value. Nothing is more favorable to the demand of one product, than the supply of another.

In its original form the law is applicable to a barter economy where goods are ultimately sold for
goods. Every goods brought to the markets is a demand for some other goods.

Say argued that since work is unpleasant, no person will work to make a product unless he wants to
exchange it for some other product which he desires.

Therefore, the very act of supplying goods implies a demand for them. In such a situation there
cannot be general over production because whatever may be produce will automactilly demanded
by the people. So supply creates its own demand. But for the single product there is
overproduction.

This concept strongly supported by the J.S. MILL, DAVID RICARDO, and A.C. PIGOU.

Assumptions of say’s law of market:

Following are the some of the important assumptions of say’s law of market:

 Perfect competition
 More opportunities
 Wide extent of market
 No state intervention
 Flexibility of prices
 Money mistaken belief
 Long period
 No hoarding
 Consumer’s sovereignty

Explanation of the law:

Say’s law of market can be explained in three different ways, these are:

 With help of saving and investment

 Quantity theory of money
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 Pigou’s version
1. With help of saving & investment: The say’s law of market can be explained with help of
saving and investment equality. If there is any inequality between them that will
automatically equalized by rate of interest? To the classist interest is a reward for saving,
higher the rate of interest higher the saving & lower the rate of interest lower the saving.
On the contrary, lower the rate of interest, higher the demand for investment funds and
vice-versa.
J.B. SAY explained the above statement in following figure:

In the above figure in OX-axis we measured saving and investment and in OY-axis rate of
interest. II is the investment curve and SS is the saving curve. Saving curve is the increasing
function due to as rate of interest increases, saving also increases. If rate of interest
decreases then saving also declines. So the saving curve upward sloping curve.
On the other hand if rate of interest increases, investment declines because it is the
decreasing function. So the investment curve downward sloping curve.
According to classical economist, the point in which both SS & II intersect to each other that
is the point of equilibrium. In the above figure point E is the point of equilibrium.
Suppose , if there is any increase in investment than the investment curve will shift to II to I ’I’
and the equilibrium point also shift to E to E ’. This is the instable equilibrium point because
once the investment increases then the rate of interest also increased to OR to OR ’. Once
rate of interest increases then the equilibrium position will again come back to the original
equilibrium position. For our convince we have given the name E ’’ with the original rate of
interest. For that reason classist thought that rate of interest is a mechanism which can
solve the problem of saving and investment inequality.
2. Quantity theory of money:
The validity of say’s law of market in a money economy depends upon the QTM. QTM states
that price level is a function of the supply of money.
MV= PT

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M = supply of money
V = velocity
P= price level
T= transaction.

The equation tells that the total money supply (MV) equals to total value of output (PT). In
the economy V & T are assume to be constant. We know that the transaction of money is
based on the money as a medium of exchange. If we want to prove the validity of say’s law
of market, we must and should explain the QTM theoretically as well as diagrammatically.
Now let us discuss the QTM with helps of following diagram.

In the mentioned two figures represents the output and prices and the figure B represents the
money wage and price level. In figure A price level is taken on OX-axis and output is taken on OY-
axis. MV is the money supply curve which is rectangular hyperbola. This is because the equation is
MV=PT holds on all points of this curve. Given the output level OQ, there would be only one price
level i.e. OP. OP consistence with the QTM as shown by point M on MV curve.

If the QTM increases MV to M1V1 then the price level also increases to OP to OP1, Given the same
amount of output i.e OQ. In this case rise in the price level is exactly proportional to the rise in the
quantity of money i.e PP1 equivalent to MM1.

In the fig B determines the price level with help of the total QTM MV and the total output of OQ. It
is possible to determine the money wage consistent with a given real wage. W/P is the real wage
line which is an increasing function (or) it is given, when the price level is OP1 money wage is OW.
When price level raises to OP1 the money wage also rise to OW1. The wage price combination is
OW1=OP1 is consistent with the full employment real wage level W/T.

3. PIGOU’S VERSION:
Classical theory of employment (Say’s law of market) received its final version at the
hands of pigou who formulated Say’s law in terms of labour market. Acc to Pigou, under free

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competition, the tendency of economy system is too automatically and it provides the full
employment in the labour market.
Acc to him unemployment arises due to wage rigidity or stat4e intervention in the
economic matter. If the state interferes in the economic matter then he recognized the
trade unions and also passed the minimum wage act. This will leads to like in the money
wage which results unemployment situation in the economy. If state not interferes in the
economic matter then there will be no problem for unemployment situation in the
economy.
Symbolically, N=qy/w, whereas,
N= the number of workers employed.
Q=the fraction of income earned.
Y=national income
W=Money wage
N can be increased by a reduction in wage, thus the key to full employment is a
reduction in money wage. We may explain it with help of the following figure.

In the fig A, DD is the demand for labour and SS is the supply for labour, both curve are intersected
to each other at the point ‘E’, ‘E’ is the point of full employment with ow/p money wage ON F
employee are engaged. If there is any increase in the real wage rate i.e w/p to w/p1 then
employment reduced to NF to No and there is an unemployment situation been created in the
economic system. Because the SS>DD. Once the situation arises the producers declares the wage
rate and automatically unemployment situation vanished from the economy.

In the fig B, MPL is marginal productivity labour curve which is downward sloping, it
indicates that higher the wages, lower will be the employment n vice versa. Acc to Pigou’s if
the MPL is high then he or she will get more wages. If the MPL is low then he or she will get
low wages. The point in which MPL and w/p intersect to each other that point is known as
full employment.
IMPLICATION OF SAY’S LAW:

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Following are the implication of say’s law those are

 automatic adjustment,
 no general over production,
 more employed to unemployed resources,
 flexible rate of interest and wage rate,
 money as a veil,
 no general unemployment,
 production is more important than consumption,
 Free trade.

CRITICISMS:

As the depression of 1929, the depend and several years passed without sign of recovery,
say’s law was called into question in 1936, J.M.Keynes and most of the economist at that
time doubted about the say’s law of market and its validity. On this background, D.H.
Robertson and M.S Sweezy strongly criticized the say’s law of market. The classical theory of
income and employment or say’s law of market. It has been criticized by J.M. Keynes on the
following grounds:
 Possibility of deficiency of effective demand
 Possibility of general over production and unemployment
 Fallacy of aggression
 Prolonged depression
 Wage cut is not the proper solution
 Importance of short run is ignored
 Unrealistic assumption
 Underemployment

Conclusion:

From the above points it is clear that the classical model had an inconsistency. It tried to separate
the real sector from the monetary sector. The pricing process in the real sector was separated from
that in the monetary sector through the assumption of neutrality of money. This separation was
invalid as it did not have a link between the goods market and the money market.

Unit-3

Q1. Compare and context between the classical and Keynes theory & explain which is superior
and why?

Or

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Is Keynes’s revolutionary or evolutionary? Comment this statement?

Or

Compare & context between classical theory & Keynesian theory of income & employment? And
how Keynes proves that classical theory is outdated?

Introduction:

In the history of economics in 1930 was the most turbulent decay that set off the most rapid
advance in economic thought with the publication of Keynes’s general theory of employment,
interest and money in 1936. Keynes attacked the classical doctrine for its failure to solve the
problem of the great depression. The 1929-30s depression demoralized the faith with left of the
classical doctrine. At that time general theory was born in a favorable situation.

After the publication of general theory and its 25 th year of anniversary there has been a public
debate on it. Some says Keynesian system is totally copied or his view is not original on the other
hand some other economist strongly supported general theory and they said that nothing is original
in world and all the ideas of successive creative minds and formulates new ideas on their works and
thought. So, the Keynesian system is totally new and it is a revolutionary as well as the evolutionary
one.

Now, let us discuss what the difference between classical thought and Keynesians thought are:

 View on full-employment
 View on supply and demand
 Role of state
 View on wage –cut
 View on saving
 View on business cycle
 View on rate of interest
 View on economics
 View on capitalism
 View on budget system

View on full-employment: the classical believed in the existence of full employment in the
economy and situation of less than full-employment was regarded as abnormal. For this reason
they never thought to have a special theory for the employment.

On the other hand Keynes considered the existence of full-employment in the economy as a
special case for that reason he felt the theory of employment.

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View on supply and demand: the classical analysis was based on the say’s law of market & they
strongly believed supply side economy.

On the other hand Keynesian economy is based on the demand side economy. According to him
demand creates its own supply. On this background prof.Klein said the revolution was solely the
development of a theory of effective demand.

Role of state: the classical economics was based on the laissez fair policy of a self adjusting
economic system with no govt. intervention.

On the other hand Keynes strongly believed in the state intervention in economic matter.

View on wage –cut: to solve the problem of unemployment, classical thought that cut in way is
the proper solution for unemployment. on the other hand Keynes strongly criticised wage–cut
policy because it has both theoretical as well as practical problem . it is theoretically is un sound
and practically it is impossible .

VIEW ON SAVING

The classical emphasized the importance of saving for the economic growth. According to
them, saving means not hoarding and it will invest in a productive manner .on the other hand
Keynes said that saving was a private virtue and public vice. it means increase in aggregate
saving leads to a decline in aggregate consumption , that ultimately declines the demand for
goods and services and the final result is decline in the level of employment in an economy .

VIEW ON BUSINESS CYCLE AND BUSINESS FLUCTTUATION:

The classists artificially separated the monetary theory from the value theory.

On the other hand, Keynes integrated monetary theory and value theory .he also
brought interest theory into the domain of monetary theory .he regarded the rate of interest as
a purely monetary phenomena .while classical thought that rate of interest is neutral.

VIEW ON ECONOMICS :

The classical economics was a micro economics analysis which relates the problem of individual
consumption; individual production etc. on the hand, Keynesian theory adopted the macro
approach to economic problem. It deals with aggregate consumption, aggregate supply,
aggregate demand, aggregate prices etc. in this background proof Hansen remarked that the
general theory has helped to make us to think of economics in dynamic rather than in static
terms.

VIEW ON CAPITALISM :

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Classical believed strongly laissez capitalism. On the other hand, Keynes believed in
capitalism with state intervention.

VIEW ON BUDGET SYSTEM:

The classical economist strongly believed in the balanced budget policy to solve the problem
of inflection and deflation. On the other hand Keynes stresses the importance of deficit budget
during deflation and surplus budget during inflation. For that reason, we may say that
Keynesian system is practically oriented system than that of the classical system.

CONCLUSION AND CRITICISM:

From the above discussion we may conclude that the general theory is not evolutionary
but is revolutionary in both economic thought and policy and is a genuine departure from the
classical thought.

From the above discussion and its conclusion we cannot say that Keynesian system is the best
system because it has its own weakness and the modern economist criticized Keynesian system
in following ground.

AGGREGATE DEMAND:

In Keynesian economics A.D an important role, but he neglects the possibility that the relative
prices prevailing in the market determines the total amount of output. Again he totally neglects
the Aggregate supply function.

EFFECTIVE DEMAND:

Economists have criticized Keynes principles of effective demand for two reasons. Firstly for
taking the Aggregate supply to be stable .secondly for assuming a direct functional relationship
between effective demand and the volume of employment.

CONSUMPTION FUNCTION:

No doubt , Keynes consumption function is an epoch making contribution to the tools of

economic analysis .but the relationship does not run simply from current income to current
consumption .there are some other functions also there which influences the consumption
function . Those factors are technology, education, attitudes etc. these factors totally ignored by
the Keynes.

Investment function:

Keynes has also been criticized for formulating the functional relationship between investments
and the rate of interest. Again he made his analyses more complicated by introducing the
interrelation between rate of interest and marginal efficiency of capital to determine the level
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of investment in his analysis he totally ignored the relationship between capital stock and
investment.

Rate of interest:

The Keynesian theory of interest rate determination has been severally criticized by post –
Keynesian economists (modern economists) because while determining rate of interest. He only
takes into account the speculative motive of demand and he neglect the precautionary motive
and transaction motive and also ignores the supply for money. So question is how the rate of
interest been determined without taking supply of money and other motives and also the rate
of interest govt. by price level.

SAVING AND INVESTMENT:

Keynes did not pay as much important to saving as to investment in his analysis . Acc. To him
saving is a great social vice and his relationship between saving and investment is much more
confusing.

WAGES:

The Keynesian under employment equilibrium is based on wages rigidity. he also suggested
increased in money wage on reduction of real wage will reduces or remove un employment .
But in partial senses it is impossible said by the modern economists.

SHORT RUN ECONOMICS :

Keynes strongly believed in the short-run. Acc. To him in short-run all the economic problems
will solve. But it is impossible for developing countries.

CLOSED ECONOMY:

The Keynesian theory is based on the assumption of closed economy which excludes the impact
of foreign trade on the level of employment and income. But in modern world all most all
countries follows the open economy system. On this background Keynesian system been
criticized by the modern economist.

PERFECT COMPETION;

Another weakness of the Keynesian theory is that. it is based on the un realistic assumption of
perfect completion .

GENERAL THEORY:

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Keynes considered his theory but a special theory but actually it’s not as general theory but a
special theory which is applicable only under static condition in a perfectly competitive closed
economy.

PROBLEM OF UNEMPLOYMENT:

Keynes only considers the cyclical unemployment and neglects the other form of
unemployment that is (technological, fractional, structural, disguised) unemployment etc.

Unit-3

Quest; explain the relation between saving and investment theory?

Or

Saving and investment are always equal in equilibrium. Explain this statement?

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Or critically examine the ex-ante and ex-post approach to the interrelation of saving and
investment?

Ans; Introduction;

In macro analysis, Keynes saving and investment functions are as important to income analysis as
Marshall’s supply and demand curve to price analysis. Another name of the saving and investment
equality is EFFECTIVE DEMAND. It is the fundamental condition of general equilibrium analysis.
Saving and investment function arte the two pillars of the Keynesian theory of employment, income
and money. The macro economy is based upon the equality between saving and investment. Let’s
discuss now both are equal to each other.

Saving function;

We know that saving is the excess of income over expenditure [S=Y-C].Keynes aggregate supply is
the direct result as defined differently by different economists. Some says saving as the income
earned in a period minus the consumption in the same period. Some other economists said Ex-ante
saving means planned or expected saving of the economy, while Ex-post are observed saving,
whatever may be income increases and the saving also increases. So the shape of saving curve is
upward sloping. But sometimes the saving the saving may negative. For that reason saving curve
sometime intersect the ox-axis.

Now we may explain it with the help of the diagram;

In the above figure SS is the saving curve. It is upward movement. It means as the income increases,
saving also increases. In that curve, there are several points, ABEC. These are the saving points .but
all the points are not observable because some points are below the investment line. II is the
investment line. The point in which SS curve INTERSECT II curve. That is known as the observable
saving or equilibrium point. Because there is the condition is that I is always equal to S.

So according to Keynes, saving implies collective or aggregate saving of the community. According
to classical economist, saving as a great private virtue. On the other hand, Keynes says saving as a
social vice.

Now we may explain it with the help of the figure;

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The original S and I curve intersect at the point E1 and gives us the equilibrium level of income
OY1.now suppose, saving in the community increases. So that saving curve shift S1 to S2 and the
new equilibrium will be E2.as a result there is a contraction on income, it means the income level
OY1 decreases Y2.in this situation, the incomer of the community decline due to the increase in
saving. So Keynes called saving as a social vice. Because it reduces income, output and employment.

Investment function:

The term investment means the net addition to the existing stock of real capital assets such as
construction of factories, new office buildings etc. generally investment is two types;

Physical investment- Buildings, stocks, factories etc. come under physical investment.

Financial investment-on the other hand shares, bonds etc are come under financial investment. So
in Keynesian sense, he says investment includes both financial and physical investment.

Saving and investment equality:

We may explain the saving and investment equality in two ways. In classical as well as in Keynesian
way. Let’s discuss the classical view on saving and investment equality.

Classical view- according to classical view, there is an existence of full employment where saving
and investment are always equal. According to them, saving and investment are function of the
rate of interest.

Mathematically. S=f(r) ------------ (i)

I=(r) -------------- (ii)

Where; S=saving

R=rate of interest

.if we solve the above equations, then we will get the following result i.e.

SAVING(S) =INVESTMENT (I)

We may explain it with the help of the figure;

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In the above figure, in ox-axis we measure the saving and investment and in oy-axis we measure
the rate of interest. The saving curve is the upward sloping; we know that higher the rate of
interest higher will be the saving, lower the rate of interest lower will be the saving. On the other
hand, if the rate of interest is high then the lower the investment and lower the rate of interest,
higher the investment. But there is a point in which both saving and investment are intersect to
each other. That point is shown in the figure E, E’, E” are equilibrium point.

This view has been criticized by J.M.Keynes because the classical economists totally ignore the
income side. Again the view of classical theory is that there is full employment. This concept again
criticized by the Keynes. Because full employment is not a real concept.

Keynesian view:

Keynes explains the saving and investment equality in two ways;

Accounting equality:

Accounting equality means the equality in national income. He explains this concept in his book
‘general theory’ that saving and investment is necessary equal in amount for the community as a
whole, being different aspects of the something. It means saving and investment are equal in the
current period. We may explain this with the help of the equation;

St=Yt-Ct----------- (i)

It=Yt-Ct----------- (ii)

Yt-Ct is common in equations in both

 St=It

Where; S=Saving

Y=income

I=Investment

C=Consumption

T=Current period.

Keynes explains it in other way;

Yt=Ct+It---------- (i)

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Yt=Ct+It---------- (ii)

Therefore from equation (i) and (ii);

Ct+It=St+Ct

But this equation has been criticized by modern economist. They says that there is no accounting
equality and Keynes failed to describe the actual dynamic process of adjustment between saving
and investment. For that reason prof.ohlin says the equality between saving and investment is
expost equality and not an exante one.

Functional equality:

Functional equality means saving and investment are always equal only at the equation level of
income we. In other words, saving and investment are not equal but they are also equation when
the saving more than the investment .income falls and when investment is more than saving, then
income arises.

We may explain it with the help of the table;

income saving Investment

100 -15 10
200 0 20 expansion
300 15 30
400 30 40
500 45 50
600 60 60 equilibrium
700 70 69
800 79 75 contraction
900 80 79

From the above table it shows that as the income increases, saving and investment will also
increases. Initially, saving increases more than the investment. But after one point, saving equal to
investment. That is equilibrium point. After equation point, saving and investment increases in a
diminishing return.

We may explain it with the help of the diagram;

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In the above figure is the saving curve and II is the investment curve. Both are intersect to each
other at the point E. so E is the equality point. In OY’ investment is greater than saving and in OY”,
saving is greater than investment. Therefore in OY, both saving and investment are equal to each
other.

Conclusion;

From the above discussion we can easily conclude that functional relation between saving and
national income on the one hand and investment and national income on the other hand. In this
manner saving schedule indicates various amounts of saving corresponding to different level of
national income and investment schedule represents the various amounts of investment
corresponding to different level of national income. So functional equality of saving and investment
enables us to understand the behaviors of the economy. Those behaviors are rate of interest,
bonds, securities etc. The importance of all this factors should not be ignored. There is a
interrelationship between Ex-ante and Ex-post approaches to the saving and investment theory.

Unit-4

Quest; Define multiplier and explain its working?

Or

Examine the meaning, working and importance of multiplier?

Ans; introduction;

The concept of multiplier occupies an important place in Keynesian theory of

income, output and employment. This concept was first time developed by F.A.Khan in the earlier

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1930’s but Keynes later further defined it. Khan’s multiplier is investment and employment
multiplier. On the other hand Keynes multiplier is known as investment or income multiplier
Keynesian multiplier is an important tool of income propagation and business cycle analysis.
According to Keynes, employment depends on the effective demand, which in turn depends upon
consumption and investment. Symbolically Y=C+I. he mentioned that consumption function is
stable in the short run and marginal propensity to consume is less than unit.

Therefore, all the increase in income does not go to increase consumption to the extent of
increment in income. With the result, a gap been created. That gap is technically known as
INVESTMENT. Keynes believed that the initial increment in investment increases the final income by
many times. To this relationship between an initial increase in investment and the final increase in
aggregate income is technically known as INVESTMENT MULTIPLIER / INCOME MULTIPLIER OR in
other words multiplier states the relationship between income and investment.

We may explain the multiplier in symbolically;

K= ΔY / ΔI

K =Multiplier

ΔY=Change in income

ΔI=Change in investment

We may explain it in elaborate manner;

Y=C+I

ΔY=ΔC+ΔI

ΔI=ΔY-ΔC ---------- (1)

Now by definition we know that;

K=ΔY/ΔI OR ΔY=K.ΔI ---------- (2)

From the equation (2) we find that;

ΔI=ΔY/K

Now substituting the equation (2) into (1), we get;

ΔY/K=ΔY-ΔC --------------- (3)

Further dividing (3) by ΔY, we get;

Or K=1/1-ΔC/ΔY=1/1-MPC=1/MPS

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We may

C/Y (MPC) S/C (MPS) MULTIPLIER (K)=1/MPS

0 1 1
½ ½ 2
2/3 1/3 3
¾ ¼ 4
4/5 1/5 5
8/9 1/9 9
9/10 1/10 10
1 0 INFINITY ∞

In the above it shows that the size of the multiplier varies directly with the marginal propensity
to consume and inversely with the marginal propensity to save. Since, MPC is always greater than 0
and less than 1. It means 0<MPC? 1. The multiplier is always lies in between 1 and infinite. It means
1<k<∞.

If the multiplier is 1, then whole the increment in income is saved and nothing is saved and nothing
is spend because the MPC is 0. If the multiplier is ∞, then MPC is equal to 1 and the entire
increment of income spent on consumption which leads to the limit less inflationary situation in the
country. In actual world, multiplier neither ∞ nor equal to 1. It always lies in between 1 and ∞.

Assumptions of the multiplier:

Keynes theory of multiplier works under certain assumptions which limit the operation of the
multiplier. Therefore;

 There is a change in autonomous investment and that induced investment is absent.

 Marginal propensity to consume is constant.
 Consumption is a function of current income.
 There are no time gaps in the multiplier process.
 The new level of investment is maintained steadily for the completion of the multiplier process.
 There are no changes in the prices.

Working of the multiplier:

The multiplier works in two ways;

 Forward direction.
 Reverse/backward direction.

Now let’s us discuss about following;

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Forward working:

We know that multiplier is the mechanism through which income gets propagated, as a result of
original investment. The multiplier is said to be forward, when its investment increases that brings
out a multiple increase in income by increasing consumption.

We first take the sequenced analysis resource a motion picture of the process income propagation.
An increase in investment leads to increased productions which creates income and generate
consumption expenditure. This process continuous in dwindling (cumulative) series till no further
increase in income and expenditure is possible. According to Keynes, this is a log less instantaneous
process in a static framework.

It is better to explain forward working of multiplier with help of the concrete example.

Suppose that in an economy, marginal propensity to consume is ½, investment is raised by the

100crores. This will immediately lead to rise in production and income by rupee 100crores.

½ of this new income will be immediately spend on the consumption goods whish will lead to
increase in production and income by the same amount and so on.

We may explain it help of the following;

ROUND ΔI (INCREMENT ΔY (INCREMENT ΔC=C.ΔY ΔS (ΔY-ΔC)

IN INVESTMENT) IN INCOME) C=0.5 (INCREMENT IN
SAVING)
0 100 100 50 50
1 50 25 25
2 25 12.5 12.5
3 12.5 6.25 6.25
4 6.25 3.12 2.12
5 0 0 0

In the above table it shows that an increment of rupee 100crores of investment in the primary
round leads to the same increase in income of these rupee 50 crores is saved and rupee 50crores
are spent on consumption which goes to increase income by the same amount in the second
round/flow. This dwindling process of income generation continues in the 2 nd, 3rd, 4th and 5th
round until unless increment of income is 0, saving is 0 and consumption is zero.

K=ΔY/ΔI

ΔY

ΔI

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If we put the value of above table, it gives the following result i.e.;

ΔY=K.ΔI

200=2 100

Where K=2 (MPC=1/2)

ΔI=100crore (ΔI=ΔY/ΔK=200/2)

This process of income propagation technically called forward working of the multiplier. We may
explain it with the help of the following figure;

In the side figure, in ox-axis we measure the consumption and investment. The ‘c’ curve suggests
the MPC is equal to ½. C=I is the investment curve which intersect the equal distribution curve (45
angle curve) at point E. at that point OY’ is the income suppose if there is any further increase in
investment i.e. C+I+ΔI, then that curve will intersect the equal distribution curve at E” and the
income increases OY’ to OY”. In fig A, Δ Y is twice the distance between C+I and C+I+ΔI.

In the fig B, if we take the MPS, then the result will be same by taking MPC. But it is very essential
to explain multiplier process by taking MPS. The curve ‘S’ is the saving function with a slope of 0.5
to show MPS of ½. I is the old investment curve which cut ‘S’ at point E’. So E’ is the initial
equilibrium point and OY’ is the income level. Suppose, investment increases i.e. I+ΔI, then the new
investment curve will intersect E” with OY” level of i9ncome.the level of income i.e. Y’Y” is exactly
double the increase in investment ΔI.

BACKWARD OPERATION OF MULTIPLIER/REVERSE OPERATION:

Multiplier is a double edged weapon. It works in the backward direction as much as in the forward
direction. According to prof. Samuelsson, the multipliers a two edged sword. It will cut for you

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against you. It will amplify new investment as we seen it will amplify downwards and decline
investment.

When the investment process cut down and MPC increases greater the value of multiplier and
greater the cumulative decline in income leads to the backward operation of the multiplier. We
may explain with the help of the figure;

In the above figure, SS is the saving curve. I is the investment curve. I curve intersect the saving
curve at the point E1 with OY1 level of income. When investment declines from I to I’, the income
also declines from Y1 to Y2 and the new equilibrium will be E2Y2. So the income decreases by Y1Y2.
In this case decline of income is doubled, than decline in investment.

Leakages of the multiplier;

Leakages are the potential diversions from the income stream which tend to weaken the multiplier
effect of new investment. There are several factors which are responsible for the leakages of
multiplier. Those are;

 Saving;

Higher is saving, smaller the size of multiplier.

 Strong liquidity preference;

Stronger the liquidity preference, weaker will be the multiplier process.

 Purchase of old stocks and securities;

The size of the multiplier will fall with a fall in consumption expenditure, when people buy old
stocks and shares.

 Debt cancellation;
The multiplier process will be arrested when the debtor repay debts to the government.

 Price inflation;
Price inflation is another important leaking process in multiplier. When the price of the
commodity increases, then the real income of the consumer decreases, that will restrict the
consumption whish result the multiplier process.

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 New imports;
If increase in income is spent on the purchase of imported goods, it acts as a leakage out of the
domestic income stream.

 Undisturbed profit;
Undisturbed profit with the companies tends to reduce the income and expenditure on
consumption goods whish weakens the multiplier process.

 Taxation;
Taxation policy is another important factor which weakens the multiplier process.

 Public investment programs;

No doubt the public investment programs helps in income and employment generation, but it
creates unhealthy atmosphere in private sector that will restrict the multiplier process.

Importance of the multiplier;

The concept of multiplier is one of the important contributions of Keynes to the income and
employment theory.
 It helps in the investment, trade cycle.
 Saving and investment equality.
 Formulation of economic policy.
 To achieve full employment.
 To understand the phenomena of inflation, deflation and deficit financing.

Limitations;

No doubt the introduction of multiplier analysis in income theory is one of the Keynes path
breaking contributions in as much as it has not only enriched economic analysis but also profoundly
affected economic policy. But this concept is not the original one of the Keynes. So, the modern
economists criticized the concept of multiplier and its limitations in following grounds.

 It is not a dynamic CONCEPT;

Keynesian concept of multiplier is not a dynamic one. Because the relation between income and
consumption is not so simple.

 AVALAIBILITY OF THE CONSUMER goods;

The process of income generation is subject to the availability of consumer goods, and then the
multiplier will work well. But in real world, the availability of the consumer goods are lacking.
For that reason multiplier function also was limited.

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 Simple assumptions;
The assumption made by the multiplier is very simple. These assumptions say nothing new. So
the modern economists’ criticized it.

 Strange and vague concept;

Prof. Hazlitt has criticized the concept of multiplier. According to him, he calls it as a strange
concept, as a myth and much ado about nothing.

 Tautological;
Tautology implies unnecessarily repeating an established fact in different words without
purpose. It means we know that once the investment increases, that will increase the income.
So there is no need for explaining the concept of multiplier.

 Deficit financing;
It gives undue importance to the policy of deficit financing. In the modern world deficit finance
play an important role. But Keynes ignored it.

Unit-4

Q.2. Do you think that Keynesian system applicable to under development!

Or

Is Keynesian theory applicable to underdeveloped country?

Ans. Introduction:-The Keynesian theory is not applicable to every social economic set up. It only applies to
advanced democratic capitalist economics. According to Schumpeter wrote practically Keynesian is a
seedling which cannot be transplanted in to foreign soil. It dies there and becomes poisonous before it dies.

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But, left in English soil this seedling is a healthy thing and shade. All this applies to every bit of advice that
Keynes ever offered.

Before we study the applicability of Keynesian economics to underdeveloped countries it is essential to

analysis the assumptions of Keynesian economics than we examine whether those assumption are
applicability to underdeveloped countries or not.

Assumption Of Keynesian Theory:-

 Keynesian theory is based on existence of cyclical unemployment.

 The Keynesian theory is a short run analysis.
 The Keynesian theory is based on closed economy.
 Keynesian assumes excess supply of labor.
 Lastly, utilization of resources concept is totally wrong.

The assumption on which the Keynesian theory is based is not applicable to the conditions prevailing in
under developed countries. Now it is a time to discuss the principle tools of the Keynesian theory to test
their validity to under developed countries. Those tools are:-

 Effective Demand
 Proportionate to Consume
 Saving
 Marginal efficiency of capital
 Rate of interest
 Multiplier

Effective Demand: - Unemployment is caused by the deficiency of effective demand. To solve this problem
Keynes suggested the stepping up of consumption and non-consumption expenditures. Unfortunately, in
underdeveloped country there is no in-voluntary unemployment but, there is a disguised unemployment. In
under developed country unemployment situation arises because of lake of economic structure. On the
other hand advanced country unemployment is caused due to lake of complimentary resources. So,
Keynesian theory of effective demand is not applicable to under developed country.

Proportionate to Consume :- Another important tool of Keynesian economics is the proportionate to

consume. Which explains the relation between consumption and income? It means when income increases
consumption also increases but, less than the increment in income. But, in underdeveloped countries these

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relationship between not hold good. Because, people are very poor and when their income increases they
spend more on consumption goods because there tendency is to meet there unfulfilled wants. For that
reason marginal propensity to consume is very high as compare to advance country.

Saving:- According to Keynes saving as social vice. For it is excess of saving that leads to a decline in
aggregate demand. This idea is not applicable to underdeveloped countries because, saving is essential for
underdeveloped country. Capital formation is the key to economic development and capital formation is
possible through increased saving on the part of people. So, the Keynesian concept not applicable to
underdeveloped country. For under developed country saving is a virtue not vice.

Marginal Efficiency of Capital:- Another important determinant of the Keynesian economics is marginal
efficiency of capital. According to Keynes one of the important determinants of investment is the M.E. of
capital. There is an inverse relation between investment and M.E. of capital falls and when investment
increases M.E. of capital decreases. In underdeveloped country this type of relation is not applicable because
investment is low level. Same also M.E. of capital also low. This is due to lake of capital and other resources.
That is small size in market etc. All these factors keep investment at a low level.

Rate of Interest :- The rate of interest is the second determinant of investment in the Keynesian system .The
rate of interest depend upon liquidity preference . According to Keynes lower the rate of interest higher will
be liquidity preference and higher the rate of interest lowers the liquidity preference. But, in under
developed country this concept is not applicable because of liquidity preference for transaction and
precautionary motive is very high then that for speculative motive there for liquidity preference a fails to
explain or influence the rate of interest.

The multiplier :- The multiplier means the relationship between an initial increases in investment and the
final increases in aggregate income. Keynes give the name of income multiplier or invest multiplier or
multiplier id the mechanism of income propagation, through it act in the reverse direction also. The concept
of multiplier is conceded as one of Keynes path breaking contribution because it helps in the study of public
sectors contribution and control of the trade cycle. According to Dr. Rao , “Keynes never formulated the
economic problems of underdeveloped countries nor did he discuss the relevance to these countries for
either the objective or the policy that he purposed for the more developed countries . So, multiplier
concepts operate in an underdeveloped county like India. Mainly due to two reasons:-

i. Involuntary unemployment is not found

ii. The supply of agriculture and non-agriculture output is inelastic.

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Policy Measure:- The policy which had been adopted by Keynes not applicable to under developed
countries. Because, in underdeveloped countries there is always a rise in the price of the commodity same
also there is a unemployment situation which is conical in nature and there is lake of capital formation. Over
all this problem Keynes is not been able to succeed.

Conclusion:-

From the above discussion it shows that Keynesian theory is not been applicable to underdeveloped
countries because of the above reasons on this back ground proof. Das Gupta says the theory as a whole
may be in applicable but its tools taken separately are of great use in analyzing and solving the problems of
underdeveloped economics, and as those economics are becoming more developed, they afford greater
changes of Keynesian application.

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