UNIT-1

Macro Economics
Macro economics is a study of the economy as a whole, and the variables that control the macro-
economy.
The study of government policy meant to control and stabilize the economy over time, that is, to
reduce fluctuations in the economy is known as macro economics.
Macro economics also includes the study of monetary policy, fiscal policy, and supply-side
economics.

The term Macro is derived from the Greek word “MAKROS” which means large. It deals with
the aggregates such as national income, output, employment and the general price level etc,
therefore it is called the Aggregative Economics.
According to Shapiro, “Macroeconomics deals with the functioning of the economy as a whole”.
According to Boulding, “Macroeconomics deals not with individual quantities as such, but with
aggregates of these quantities, not with individual income but with national income, not with
individual output but with national output”.
Prof. Ackley defines Macro Economics as “Macro Economics deals with economic affairs ‘in the
large, it concerns the overall dimensions of economic life. It looks at the total size and shape and
functioning of the elephant of economic experience, rather than working of articulation or
dimensions of the individual parts. It studies the character of the forest, independently of the
tress which compose it.”

Why macroeconomics and not only microeconomics?

The whole is more complex than the sum of independent parts. It is not possible to describe an
economy by forming models for all firms and persons and all their cross-effects.
Macroeconomics investigates aggregate behavior by imposing simplifying assumptions (“assume
there are many identical firms that produce the same good”) but without abstracting from the
essential features.
These assumptions are used in order to build macroeconomic models. Typically, such models
have three aspects: the ‘story’, the mathematical model, and a graphical representation.

Scope of Macroeconomics
The scope of macro economics has been explained as under:-
1. Theory of National Income:-Macro economics studies the concept of national income, its
different elements, methods of its measurement and social accounting.
2. Theory of Employment:-It studies the problems of employment and unemployment. There are
different factors which determine employment. They are like effective demand, aggregate
demand, aggregate supply, total consumption, total savings and total investment etc.

3. Marco Theory of distribution:-There are macro economic theories of distribution. These

theories try to explain how the national output is distributed among the factors of production.

4. Economic development:-.Economic development is a long run process. In it, we analyze the

problems and theories of development.
5. Theory of International Trade:-It also studies principles determining trade among different
countries. Tariff's protection and free-trade polices fall under foreign trade.
 6. Theory of Money: - Changes in demand and supply of money effect level of employment.
Therefore, under macro economics functions of money and theories relating to money are
studied.
7. Theory of Business Fluctuations:-It also deals with the fluctuations in the level of employment,
total expenditure, and general price level.
8. Theory of General Price Level:-A continuous rise in the price level is called inflation. It distorts
production. It increases inequalities in the distribution of income and wealth. The common man
is injured by inflation. Deflation is the opposite of inflation. The general price level falls
continuously. Output and employment levels fall. Macro economics provides explanation
provides explanation for the occurrence of inflation and deflation.
Importance of Macro economics
1. In Economic Policies
Macro Economics is extremely useful from the view point of the fiscal policy. Modern
Governments, particularly, the underdeveloped economies are confronted with innumerable
national problems. They are the problems of over population, inflation, balance of payments,
general under production etc. The main conscientiousness of these governments rests in the
regulation and control of over population, general prices, general volume of commerce, general
productivity etc.

2. In General Unemployment
Redundancy is caused by deficiency of effectual demand. In order eradicate it, by effective demand
should be raised
increasing total investment, total productivity, total income and
consumption
Thus, macro economics has special significance in studying the causes, effects and
. of general redundancy.
antidotes

3. In National Income
The study of macro economics is very significant for evaluating the overall performance of the
economy in terms of national income. This led to the construction of the data on national income.
National income data help in anticipating the level of fiscal activity and to comprehend the
distribution of income among different groups of people in the economy.
4. In Economic Growth
The economics of growth is also a study in macro economics. It is on the basis of macro
economics that the resources and capabilities of an economy are evaluated. Plans for the overall
increase in national income, productivity, employment are framed and executed so as to raise the
level of fiscal development of the economy as a whole.
5. In Multi-dimensional Study
Macroeconomics has a very wide scope and covers multi-dimensional aspects like population,
employment, income, production, distribution, consumption, inflation, etc.
6. In Monetary Problems
It is in terms of macro economics that monetary problems can be analyzed and understood
properly. Frequent changes in the value of money, inflation or deflation, affect the economy
adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for
the economy as a whole.
 7. In Business Cycle
Moreover, macro economics as an approach to fiscal problems started after the great Depression,
thus its significance falls in analyzing the grounds of fiscal variations and in providing remedies.

8. For Understanding the Behaviour of Individual Units

For understanding the performance of individual units, the study of macro economics is
imperative. Demand for individual products depends upon aggregate demand in the economy.
Unless the causes of deficiency in aggregate demand are analyzed it is not feasible to understand
fully the grounds for a fall in the demand of individual products. The reasons for increase in
costs of a specific firm or industry cannot be analyzed without knowing the average cost
conditions of the whole economy. Thus, the study of individual units is not possible without
macro economics.

9. Helpful in understanding the functioning of an Economy

Modern economy has become a very complex affair. Several economic factors which are inter-
dependent operate in it. To have an understanding of its organization and functioning one cannot
depend on individual unit alone. Study of an economy as a whole, has therefore, become very
essential.

10. Balance of Payment

It explains factors which determine balance of payment. At the same time, it identifies causes of
deficit in balance of payment and suggests remedial measures.

Limitations of Macro Economics

1. Danger of excessive thinking in terms of aggregates: There is danger of executive thinking
in terms of aggregates which are not homogeneous. For example,2apples +3apples=5 apples is
the meaning full aggregate, similarly 2 apples +3 oranges is meaningful to some extent.

2. Aggregate tendency may not affect all sectors equally: For example, the general increase in
price affects different sections of the community or the different sectors of the economy
differently. The increase in general level of price benefits the producers, but hurts the consumers.

3. Indicates no change has occurred: The study of aggregates make us believe that no change
has occurred even if there is a change. It indicates that there is no need of new policy. For
example, a 5 percent fall in agricultural price and 5 percent rise in industrial prices does not
affect the price level.
4. Difficulty in the measurement of aggregates: There are at times, difficulties in the
measurement of aggregates. It is difficult to measure the big aggregates. This problem has now
been more or less erased by the use of calculators and the things which are not homogeneous.

5. The fallacy of composition: The aggregate economic behavior is the sum of individual
behavior. This is called fallacies of composition. What is true in case of an individual may not be
true in the case of economy as whole. For example, individual saving is a virtue, whereas the
public saving is vice. According to K.E. Boulding "These difficulties are aggregative paradoxes
which are true when used to one person, but false when used to the economy as a whole.
 6. It ignores the contribution of Individual Units: Macro economic analysis throws light only on
the functioning of the aggregates. However, in real life, the economic activities and decision
taken by individual units on private- level have their effects on the economy as a whole. Such
effects are not known by the study of macro economics.
7. Limited Application: Another limitation of macro economics is that most of the models relating
to it have only theoretical significance. They have very little use in practical life. Moreover it is
very difficult to measure various aggregates of macro economics.
Macro economic variables:
Macroeconomic variable are generally classified as:
 Endogenous Variables: These are those whose value is value is determined within the
model. Some typical endogenous variables used in macroeconomic models are national
income, consumption, savings, investment, market interest rate, price level and
employment.
 Exogenous Variables: These are those that are determined outside the models, e.g. money
supply, tax rates, government expenditures, exchange rates, etc. However depending on the
objective of analysis, endogenous variables are converted into exogenous variables, and
exogenous variables can be endogenised.
Difference between Micro and Macro Economics
Micro Economics
1. Evolution of micro economics took place earlier than macro economics.
2. It deals with an individual's economic
behavior. demand, supply,
3. It is a branch of economics, which studies individual economic variables like
price etc.
4. It has a very narrow scope i.e. an individual, a market etc.
5. Demand, supply, market forms etc. relate to micro economics.
6. It is helpful in analysis of an individual economics unit like firm.
7. Theory of demand, theory of production, price determination theory etc., develop from micro
economics.
8. The concepts of micro-economics are independent concepts.
9. These concepts have more theoretical value.
10. The concepts were popularized by the famous Alfred Marshall.
11. Worm’s eye view/ Microscopic view
12. Method of Slicing
13. It is a mortal concept
14. Simple
15. Price Theory

Macro Economics Variables:

1. It evolved only after the publication of keynes' book. General theory of employment, interest
and money.
2. It deals with aggregate economic behavior of the people in general.
3. It is a branch of economics which studies aggregate economic variables, like aggregate
demand, aggregate supply, price level etc.
4. It has a very wide scope i.e. a country.
5. Aggregate demand, aggregate supply, national income etc. relate to macro economics.
6. It is helpful for analyzing the level of employment, income, economic growth etc.
7. Theory of national income, theory of employment, theory of money, theory of general price
level etc. develop from macro economics.
8. The concepts of macro economics are interdependent on one another.
9. These concepts have more practical value.
10. The concepts were popularized by the famous Lord J.M. Keynes.
11. Bird’s eye view
12. Method of Lumping
13. It is an immortal concept
14. Complex
15. Income theory

Circular Flow of Income

In economics, the terms circular flow of income or circular flow refer to a simple economic
model which describes the reciprocal circulation of income between different sectors. A
continuous flow of production, income and expenditure is known as circular flow of income. It is
circular because it has neither any beginning nor an end. The circular flow of income involves
two basic assumptions: - 1.In any exchange process, the seller or producer receives the same
amount what buyer or consumer spends. 2. Goods and services flow in one direction and money
payment to get these flow in return direction, causes a circular flow.
Two Sector Model:
It signifies that the expenditure of buyers (households) becomes income for sellers (firms). The
firms then spend this income on factors of production such as labour, capital and raw materials,
"transferring" their income to the factor owners. The factor owners spend this income on goods
which leads to a circular flow of income.The circular flow divides the economy into two sectors:
one concerned with producing goods and services, and the other with consuming them.
Resources are converted into goods and services by business, and in this transformed state travel
back to consumers. Money flows in the opposite direction. These flows involve two markets in
which exchange takes place: the resource or factor market in which business buys resources, and
the goods and services market in which business sells goods. (Some economists define a "factor
of production" as the service of some resource. If resources are land, labor, and capital, the
factors of production are the services of land, labor, and capital. We will ignore the distinction
between resources and factors of production in the discussion that follows.)
Three Sector Model
It includes household sector, producing sector and government sector. It will study a circular
flow income in these sectors excluding rest of the world i.e. closed economy income. Here flows
from household sector and producing sector to government sector are in the form of taxes. The
income received from the government sector flows to producing and household sector in the
form of payments for government purchases of goods and services as well as payment of
subsides and transfer payments. Every payment has a receipt in response of it by which
aggregate expenditure of an economy becomes identical to aggregate income and makes this
circular flow and unending.
Four Sector Model
A modern monetary economy comprises a network of four sector economy these are-
1.Household sector 2.Firms or Producing sector 3.Government sector 4.Rest of the world sector.
Each of the above sectors receives some payments from the other in lieu of goods and services
which makes a regular flow of goods and physical services. Money facilitates such an exchange
smoothly. A residual of each market comes in capital market as saving which in turn is invested
in firms and government sector. Technically speaking, so long as lending is equal to the
borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely.
However this job is done by financial institutions in the economy.
Leakages: These are those flow variables which have a negative impact on the process of
production in the economy. These variables reduce the flow of income in the economy; hence
called withdrawals or leakages. These are:
1. Savings
2. Imports
3. Taxes
Injections: These are those flow variables which cause an expansion in the process of
production in the economy. These are:
1. Investment
2. Exports
3. Government expenditure
Basically all these are expenditure variables-expenditure on the goods and services produced in
the economy. These variables affect the economy in two ways:
 Add to production capacity of the economy
 Generate demand for the produced goods and services.

Relationship between Leakages and Injections in Circular Flow

The circular flow will remain at a constant level if saving(S), Tax revenue (T), and imports (M),
which are leakages, are equal to investment (I), Government expenditure (G), and exports (X)
which are injections in the circular flow of income.

S+T+M=I+G+X

 If all leakages are equal to injections, the economy will not change.
 If leakages are greater than injections, than the income level will decline and the economy
will contract/fall into a recession.
 If injections are greater than he leakages, than the income level eill rise and the economy will
expand into a recovery.
National Income

Concept:

National income or national product is defined as the total market value of all the final goods and
services produced in an economy in a given period of time. There are many concepts of national
income which are used by different economists and all of which are inter-related.
The total net value of all goods and services produced within a nation over a specified period of
time, representing the sum of wages, profits, rents, interest, and pension payments to residents of
the nation.

It includes income from all the productive sectors such as Agricultural, Industrial and Service
Industry.

Final Goods: Final goods are those goods which have crossed the boundary line of production,
and are ready for use by their final users. Final users may be consumers and any firm. Final
goods as used by the producers are called capital goods.
Intermediate Goods: These are those goods which are not out of the boundary line of
production and are yet not ready for use by their final users. These used are largely used as raw
material.

Depreciation: A reduction in the value of an asset with the passage of time, due in particular to
wear and tear. Depreciation is a non-cash expense that reduces the value of an asset over time.
Assets depreciate for two reasons: Wear and tear.
Net factor income from abroad (NFIA): Factor income earned by our residents from abroad-
Factor income earned by non residents within our country.
Transfer Payment: A payment made or income received in which no goods or services are
being paid for, such as a benefit payment or subsidy.
A no compensatory government payment to individuals, as for welfare or social security benefits
is transfer payment. People sometimes get income without any productive activity.
Ex: Unemployment benefits, old age pensions etc.
Change in Stock: It is measured as the difference between “Closing Stock” of the accounting
year and “Opening stock” of the accounting year.
Change in Stock = Closing Stock – Opening Stock
GDPMP: GDPMP refers to the market value of final goods and services produced within the
domestic territory of a country during an accounting year.
GDPMP is the sum total of value added by all producing units within the domestic territory of a
country during the period of an accounting year.
GNPMP: Gross National Product is the total market value of all final goods and services
produced annually in a country plus net factor income from abroad.
GNP=GDP+NFIA (Net Factor Income from Abroad)
NNPMP: Net National Product is the market value of all final goods and services after allowing
for depreciation. It is also called National Income at market price. When charges for depreciation
are deducted from the gross national product, we get it. Thus,
NNP=GNP-Depreciation
Personal Income (PI): Personal Income i s the total money income received by individuals and
households of a country from all possible sources before direct taxes. Therefore, personal income
can be expressed as follows: PI = NI - Corporate Income Taxes - Undistributed Corporate Profits
- Social Security Contribution + Transfer Payments

Disposable Income (DI) : The income left after the payment of direct taxes from personal
income is called Disposable Income. Disposable income means actual income which can be
spent on consumption by individuals and families. Thus, it can be expressed as:
DI=PI-Direct Taxes

Per Capita Income (PCI): Per Capita Income of a country is derived by dividing the national
income of the country by the total population of a country. Thus,

PCI=Total National Income/Total National Population

Methods of Measurement of National Income

1. Product Method or Value added Method
2. Income Method
3. Expenditure Method

Product Method/ Value added Method

Product method is that method, which measures domestic money by estimating the contribution
of each enterprise to production in the domestic territory of the country in an accounting year.
Product method or Value added method is also known as Industrial Origin Method or Net output
Method or Inventory Method or Commodity Service method.
Value added is the difference between value of output of an enterprise and the value of its
intermediate consumption.
Value added= Value of Output- Value of Intermediate consumption
Value of Output= Sales (if entire output of the year is sold during the year)
Value of output= Sales + Change in Stock
Value added=GDP mp

To calculate the national income by this method, we need to identify and classify productive
enterprises in three categories:
1. Primary Sector
2. Secondary Sector
3. Tertiary Sector
Primary Sector includes agriculture and allied activities such as animal husbandry fisheries,
forestry, and mining etc. The Secondary Sector includes manufacturing sector which converts the
raw materials into finished products. The Tertiary Sector is the service sector which includes
services such as banking, insurance, transport, communication and trade etc.
After classification, net value added in each sector is calculated in an accounting year. Gross
value added is found by deducting the intermediate consumption from the value of production
generated.

Precautions used in production or value added method

 1. The sale and purchase of old goods and included but the commission charges by agents in
their transaction is a part of national income.
2. Imputed value of production for self-consumption is taken into account. Because, these
goods are like those produced for the market.
3. Imputed rent on the owner occupied house is included. Because all houses have rental
value, no matter these are self occupied or rented out.
4. Value of intermediate goods is not included into the estimation of national income.
5. Services for Self-consumption are not considered while estimating value added. Because it is
difficult to estimate their market value like services of housewives.
6. Income from illegal activities is not included in national income.

Income Method
This method is also known as factor cost method. Under this method, national income is
obtained by adding the incomes such as rent, wages, interest and profit received by all persons in
the country during a year. In practice, the income figures are obtainable mostly from income tax
returns, books of accounts and published accounts. To this, net income from foreign trade and
net investment from abroad should be added.
According to income method, the net income payments received by all citizens of a country in a
particular year are added up. The net incomes earned by the factors of production in the form of
rent, wage, interest and profit aggregated but incomes in the form of transfer payments are not
included in the national income.
NDPFC= Compensation of Employees + Operating Surplus + Mixed Income
Components of Income Method
Compensation of Employees: It includes Wages and salaries in cash, Employers contribution to
social security scheme, Pension on retirement, Bonus, Allowances etc.
Operating Surplus: It includes rent and royalty, interest, profit (dividend +corporation tax+
undistributed profits).
Mixed Income: It is the income of the self employed persons such as farmers, shopkeepers,
doctors etc. They generate goods and services with the help of their own land, capital and labour
and thus earn mixed income in the form of interest, profit rent and wages. This income is
included in national income.

In India, this method is used for adding up the net income arising from trade, transport, public
administration, professional and domestic services. Due to lack of popularity of personal
accounting practices, this method cannot be fully used or practiced. This method is used only for
some minor sectors. None of these methods alone will give a more correct figure.
Precautions:
1. All transfer income which does not represent earnings from productive services such as
pension, scholarship, unemployment doles, lottery prize, etc. are not to be included as they are
not earned by participating in the current production.
2. All unpaid services like services of a housewife are to be excluded.
3. All capital gains or loss (buying an old house, or resale of property) should be excluded.
4. Direct tax, revenue to the government should be subtracted from the total income as it is only
transfer of income.
5. Undistributed profits of companies, income from government etc. should be added.
6. Subsidies given by the government should be deducted from profits of the subsidized industry.

7. Income from sale of second hand goods is not included in national income.
8. Income from sales and purchase of old shares is not included in national income.

Expenditure Method
Expenditure method is the method which measures final expenditure on gross domestic product
at market price during an accounting year. Final expenditure is equal to the gross domestic
product at market price. This is also called “Income Disposal Method”, Consumption and
Investment Method”.
According to the expenditure method, the total expenditure incurred by the society in a particular
year is added together. According to these methods total expenditure equals the national income.
Following items are included in it:
1. Private Final Consumption expenditure
2. Govt. final consumption expenditure
3. Gross domestic capital formation
4. Change in stock
5. Net exports.
1. Private Final Consumption Expenditure
It consists of expenditure on durable goods (e.g., furniture, cars, etc), non-durable goods (e.g.,
food items and toiletries) and services (e.g., hotels, educational institutions, hospitals, public
transport, etc.,) by the household consumers.
The figures of private consumption expenditure may be collected from retail trade activities
during an accounting period.
But the purchases made by non-residents and foreign visitors should be deducted from the final
consumption expenditure in the domestic market whereas direct purchases made by resident
households abroad during foreign travel should be included in consumption expenditure.
2. Government Final Consumption Expenditure
The government final consumption expenditure refers to the final consumption expenditure by
the general government and it can be arrived at by summing up (a) value of net purchases in the
domestic market, (b) net purchases abroad.
3. Gross Fixed Capital Formation
If consists of (a) Business fixed Investment, (b) Govt. Fixed Investment, (c) Investment on
residential construction.
4. Change in Stock as Inventory Investment
Change in stock is the difference between the opening stock and closing stock. All enterprises
and trading companies incur expenditure on stock of raw materials; semi finished goods or
finished goods.

5. Net Exports of Goods and Services

It is the difference between the value of exports and imports of a country during an accounting
period. What the foreigners spend on a country’s exports is the part of expenditure on the Gross
domestic product.
Precautions used in Expenditure method
1. Only expenditure on current final goods should be included so expenditure on second hand
goods must not be added in aggregate expenditure.
2. The intermediate expenditure also must not be included as it leads to double counting.
3. Expenditure on transfer payments should not be taken account of.
4. Gross domestic capital formation already has in it the replacement of machines therefore these
two items should not be separately included in aggregate expenditure.
5. Expenditure on financial transactions, e.g., shares and bonds should not be included because
these transactions do not add to the flow of goods and services but only change the ownership of
financial assets.
6. Only expenditure on final goods and services should be included in aggregate expenditure.
7. The aggregate expenditure got by adding up various components includes in itself the cost of
depreciation. Thus, we have the concept of so as to arrive at the Net Domestic Product at market
price; depreciation should be deducted from it.

Problems in measurement of National Income

There are many difficulties in measuring national income of a country accurately. The
difficulties involved in national income accounting are both conceptual and statistical in nature.
Some of these difficulties involved in the measurement of national income are discussed below:
1. Non Monetary Transactions
The first problem in National Income accounting relates to the treatment of non-monetary
transactions such as the services of housewives to the members of the families. For example, if a
man employees a maid servant for household work, payment to her will appear as a positive item
in the national income. But, if the man were to marry to the maid servant, she would perform the
same job as before but without any extra payments. In this case, the national income will
decrease as her services performed remains the same as before.
2. Problem of Double Counting
Only final goods and services should be included in the national income accounting. But, it is
very difficult to distinguish between final goods and intermediate goods and services. An
intermediate goods and service used for final consumption. The difference between final goods
and services and intermediate goods and services depends on the use of those goods and services
so there are possibilities of double counting.
3. The Underground Economy
The underground economy consists of illegal and unclear transactions where the goods and
services are themselves illegal such as drugs, gambling, smuggling, and prostitution. Since, these
incomes are not included in the national income; the national income seems to be less than the
actual amount as they are not included in the accounting.
4. Petty Production
There are large numbers of petty producers and it is difficult to include their production in
national income because they do not maintain any account.
5. Public Services
Another problem is whether the public services like general administration, police, army
services, should be included in national income or not. It is very difficult to evaluate such
services.
6. Transfer Payments
Individual get pension, unemployment allowance and interest on public loans, but these
payments creates difficulty in the measurement of national income. These earnings are a part of
individual income and they are also a part of government expenditures.
7. Capital Gains or Loss
When the market prices of capital assets change the owners make capital gains or loss such gains
or losses are not included in national income.

8. Price Changes
National income is the money value of goods and services. Money value depends on market
price, which often changes. The problem of changing prices is one of the major problems of
national income accounting. Due to price rises the value of national income for particular year
appends to increase even when the production is decreasing.
9. Wages and Salaries paid in Kind
Additional payments made in kind may not be included in national income. But, the facilities
given in kind are calculated as the supplements of wages and salaries on the income side.
10. Illiteracy and Ignorance
The main problem is whether to include the income generated within the country or even
generated abroad in national income and which method should be used in the measurement of
national income.

11. Second hand transactions

12. Inadequate and unrealistic statistics National Income in India

Precautions:
1. Only expenditure on current final goods should be included so expenditure on second hand
goods must not be added in aggregate expenditure.
2. The intermediate expenditure also must not be included as it leads to double counting.
3. Expenditure on transfer payments should not be taken account of.
4. Gross domestic capital formation already has in it the replacement of machines therefore these
two items should not be separately included in aggregate expenditure.
5. Expenditure on financial transactions, e.g., shares and bonds should not be included because
these transactions do not add to the flow of goods and services but only change the ownership of
financial assets.
6. Only expenditure on final goods and services should be included in aggregate expenditure.
7. The aggregate expenditure got by adding up various components includes in itself the cost of
depreciation. Thus, we have the concept of so as to arrive at the Net Domestic Product at market
price; depreciation should be deducted from it.
Unit -II
Macro Economic Framework Classical Model

Classical theory:
Classical economics is widely regarded as the first modern school of economic thought. Its major
developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John
Stuart Mill.
Classical economists claimed that free markets regulate themselves, when free of any
intervention. Adam Smith referred to a so-called invisible hand, which will move markets
towards their natural equilibrium, without requiring any outside intervention.
Assumptions of Classical Approach
1. There is existence of full employment without inflation
2. There is a laissez faire capitalist economy without government interference
3. It is a closed economy without foreign trade
4. There is a perfect competition in labour and product markets
5. Total Output of the economy is divided between consumption and investment expenditure
6. The quantity of money is given and money is only the medium of exchange
7. Wages and Prices are perfectly flexible
8. Constant Technology
9. Equality between saving and investment

Say’s Law of Market: According to Say’s Law “Supply creates its own demand”, i.e., the very
act of producing goods and services generates an amount of income equal to the value of the
goods produced. Say’s Law can be easily understood under barter system where people produced
(supply) goods to demand other equivalent goods. So, demand must be the same as supply. Say’s
Law is equally applicable in a modern economy. The circular flow of income model suggests this
sort of relationship. For instance, the income created from producing goods would be just
sufficient to demand the goods produced.
Relation between Saving-Investment: There is a serious omission in Say’s Law. If the
recipients of income in this simple model save a portion of their income, consumption
expenditure will fall short of total output and supply would no longer create its own demand.
Consequently there would be unsold goods, falling prices, reduction of production,
unemployment and falling incomes.

However, the classical economists ruled out this possibility because they believed that whatever
is saved by households will be invested by firms. That is, investment would occur to fill any
consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national
income and employment will remain unaffected.
 Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
1. According to Keynes saving is a function of national income and is not affected by changes in
the rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled
out. So Say’s Law will no longer hold.
2. The labor market is far from perfect because of the existence of trade unions and government
intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages
are more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a
fall in production as well as a fall in employment.
3. Keynes also argued that even if wages and prices were flexible a free enterprise economy
would not always be able to achieve automatic full employment.

Keynesian theory of Employment

Assumptions
1. The theory is applicable in advanced capitalistic Economy
2. Assumption of short period
3. Assumption of Perfect competition
4. Closed economy
5. It ignores the role of Government as a spender and Taxer
6. No time lag
7. Money also act as a store of value
8. Labor is the only variable factor of production
9. Under Employment Equilibrium

Saving depends upon income and Investment depends upon Rate of Interest
Keynes has strongly criticized the classical theory in his book ‘General Theory of Employment,
Interest and Money’. His theory of employment is widely accepted by modern economists.
Keynesian economics is also known as ‘new economics’ and ‘economic revolution’. Keynes had
invented new tools and techniques of economic analysis such as consumption function,
multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short
run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour
efficiency remain constant. That is why, according to Keynesian theory, volume of employment
depends on the level of national income and output. Increase in national income would mean
increase in employment. The larger the national income the larger the employment level and vice
versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of
income’.
Theory of Effective Demand:
According to Keynes, the level of employment in the short run depends on aggregate effective
demand for goods in the country. Greater the aggregate effective demand, the greater will be the
volume of employment and vice versa. According to Keynes, the unemployment is the result of
deficiency of effective demand. Effective demand represents the total money spent on
consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap
can be filled up by increasing investment and hence effective demand, in order to maintain
employment at a high level. According to Keynes, the level of employment in effective demand
depends on two factors:

(a)Aggregate supply function, and

(b)Aggregate demand function.

(a) Aggregate supply function:

According to Dillard, the minimum price or proceeds which will induce employment on a given
scale, is called the ‘aggregate supply price’ of that amount of employment. If the output does not
fetch sufficient price so as to cover the cost, the entrepreneurs will employ less number of
workers. Therefore, different numbers of workers will be employed at different supply prices.
Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to
induce varying quantities of employment.
We can have a corresponding aggregate supply price curve or aggregate supply function,
which slopes upward to right.

(b) Aggregate demand function:

The essence of aggregate demand function is that the greater the number of workers employed,
the larger the output. That is, the aggregate demand price increases as the amount of employment
increases, and vice versa. The aggregate demand is different from the demand for a product. The
aggregate demand price represents the expected receipts when a given volume of employment is
offered to workers. The aggregate demand curve or aggregate demand function represents a
schedule of the proceeds of the output produced by different methods of employment.

Difference between Classical and Keynes Model

Classical
1. Economy is in full employment
2. The wages and prices are very flexible
3. There is no need of fiscal or monetary policy
4. The Aggregate supply curve is Vertical according to classical so any rise in aggregate demand
will increase prices not production
5. There is a direct relationship between the money supply and the price level
6. Saving-investment equality is brought about by the rate of interest mechanism.
7. Supply creates its own demand
8. Laissez Faire or Capitalistic economy
9. Automatic adjustment works
10. Long run concept
11. Saving is good

Keynesian theory:

1. Economy may not be in full employment in short run

2. Wage are rigid and prices are sticky (menu cost etc)
3. Fiscal as well as monitory policy may be needed to correct the disequilibrium or improve the
efficiency of economy
 4. Aggregate supply is upward sloping in the short run so a rise in aggregate demand may rise
the production as well
5. No such direct relationship exists between the money supply and price level. The relation is
only indirect.
6. The equality between saving and investment is brought about by the income level.
7. Demand creates its own supply
8. No is no adjustments
9. No laissez Faire
10. Short run
11. Saving is bad

Consumption Function

It is a functional relationship between two aggregates i.e., total consumption and National
income. Consumption is an increasing function of income. It was developed by John Maynard
Keynes

Symbolically, C= f (Y)
Consumption expenditure increases with increase in income.
But increase in consumption is less than increase in income. It is known as Fundamental
Psychological Law”.

Consumption Schedule It is the tabular representation of various amounts of consumption

expenditure corresponding to different levels of income.
Consumption is basically of two types:
 Autonomous Consumption:
This is the level of consumption which does not depend on income. The argument is that even
with zero income you still need to buy enough food to eat, through borrowing or running down
savings.

 Induced Consumption:
This is that level of consumption which depends on income and varies at different level of
income. When income increases, induced consumption also increases.

This function can be written as C= Ca + bY

Where
C= Total consumption
Ca= Autonomous Consumption
By=Induced Consumption (b= Marginal Propensity to consume and Y= income)
 Ca+bY

Induced
Consumption

Autonomous
Consumption
Consumption

 Propensity to Consume
Propensity to consume is of two kinds:
Average Propensity to Consume
Marginal Propensity to Consume

 Average Propensity to consume:

APC is the ratio of total consumption to total income. It is found by dividing the total
consumption with total income.
APC= C/Y
 Marginal Propensity to consume:
MPC is defined as the ratio of change in consumption to change in change in income. It is found
by dividing the change in consumption expenditure with the change in income.
MPC = C/ Y

Characteristics of MPC
1.It is always positive
2.It is greater than zero and less than utility
3.MPC of the poor class is higher
4.Constant MPC in the long period
5.Falling MPC in the short period
6.MPC can be greater than 1 in abnormal conditions
 Saving Function

Saving function may be defined as a schedule showing amounts that will be saved at different
level of income.

S=f(Y)

Saving increases with increase in income and decreases with decrease in income, i.e., saving is
income elastic.

 Propensity to Save

Average Propensity to Save: APS is the ratio between total saving (S) and total income (Y) at a
given level of income and employment in the economy.

APS= S/Y
Marginal Propensity to Save: MPS is defined as the ratio of change in consumption to change
in income. It is found by dividing the change in consumption expenditure with the change in
income.

MPS= S/ Y

Relationship between Consumption and Saving Function

1. When consumption is more than income than saving is negative or when consumption graph is
above to income graph than saving is negative.
C>Y, than S becomes -S
2. When consumption becomes equals to income or consumption graph meet to income graph at
that time saving is zero.
C=Y, than S=0
3. When consumption is less than income or consumption graph is below to income than saving
increases and becomes positive.
C<Y, than S becomes +S
Relationship between APC and APS

We know that APC = C/Y and APS = S/Y

Y=C+S
Divide both side by Y Y/Y = C/Y + S/Y
1 = C/Y + S/Y
1 = APC + APS
1 - APC = APS

Relationship between MPC and MPS

We know that MPC = dC/dY and MPS = dS/dY

Y=C+S
And, dY= dC+dS Divide both side by dY dY/dY = dC/dY + dS/dY 1 = dC/dY + dS/dY
1 = MPC + MPS
1 - MPC = MPS

Investment Function

An investment function is a concept or strategy within economics that helps to identify the
connection between shifts in the national income and the investment patterns that take place
within that particular national economy. In this type of situation, a function would be any
variable within the framework of the economy that would motivate investors to change their
typical buying and selling habits as a means of either taking advantage of the economic shift in a
bid to increase their returns or to minimize the amount of loss incurred as a result of that shift. In
weighing variables, the investor will consider the current level of gross domestic product (GDP)
as well as the average interest rates that currently apply within the economy.
The investment function is a summary of the variables that influence the levels of aggregate
investments. It can be formalized as follows:
I=f(r, Y,q)

Types of Investment
Different types or kinds of investment are discussed in the following points.

1. Autonomous Investment

Investment which does not change with the changes in income level, is called as Autonomous or
Government Investment. Autonomous Investment remains constant irrespective of income level.
Which means even if the income is low, the autonomous, Investment remains the same. It refers
to the investment made on houses, roads, public buildings and other parts of Infrastructure. The
Government normally makes such a type of investment.

2. Induced Investment

Investment which changes with the changes in the income level is called as Induced Investment.
Induced Investment is positively related to the income level. That is, at high levels of income
entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption
expenditure increases this leads to an increase in investment of capital goods, in order to produce
more consumer goods.

3. Financial Investment

Investment made in buying financial instruments such as new shares, bonds, securities, etc. is
considered as a Financial Investment.
However, the money used for purchasing existing financial instruments such as old bonds, old
shares, etc., cannot be considered as financial investment. It is a mere transfer of a financial asset
from one individual to another. In financial investment, money invested for buying of new shares
and bonds as well as debentures have a positive impact on employment level, production and
economic growth.

4. Real Investment

Investment made in new plant and equipment, construction of public utilities like schools, roads
and railways, etc., is considered as Real Investment.
Real investment in new machine tools, plant and equipments purchased factory buildings, etc.
increases employment, production and economic growth of the nation. Thus real investment has
a direct impact on employment generation, economic growth, etc.

5. Planned Investment
Investment made with a plan in several sectors of the economy with specific objectives is called
as Planned or Intended Investment. Planned Investment can also be called as Intended
Investment because an investor while making investment, make a concrete plan of his
investment.
6. Unplanned Investment

Investment done without any planning is called as an Unplanned or Unintended Investment.

In unplanned type of investment, investors make investment randomly without making any
concrete plans. Hence it can also be called as Unintended Investment. Under this type of
investment, the investor may not consider the specific objectives while making an investment
decision.

"The marginal efficiency of capital is equal to that rate of discount which would make the present value
of the series of annuities given by the returns expected from the capital asset during its life just equal to
its supply price." - J.M.Keynes, General Theory.
This theory suggests investment will be influenced by:
1.The marginal efficiency of capital
2.The interest rates

Generally, a lower interest rate makes investment relatively more attractive.If interest rates, were
3%, then firms would need an expected rate of return of at least 3% from their investment
tojustify investment. If the marginal efficiency of capital was lower than the interest rate, the
firm would be better off not investing, but saving the money. Why are interest rates important for
determining the Marginal efficiency of capital? To finance investment, firms will either borrow
or reduce savings. If interest rates are lower, it's cheaper to borrow or their savings give a lower
return making investment relatively more attractive.

Marginal Efficiency of Capital - A cut in interest rates from R1 to R2 will increase investment
to I2. The alternative to investing is saving money in a bank, this is the opportunity cost of
investment. If the rate of interest is 5% then only projects with a rate of return of greater than 5%
will be profitable.

Factors which shift the Marginal Efficiency of Capital

1. The cost of capital. If capital is cheaper, then investment becomes more attractive. For
example, the development of steel rails made railways cheaper and encouraged more investment.
2.Technological change. If there is an improvement in technology, it can make investment more
worthwhile.
3. Expectations and business confidence. If people are optimistic about the future, they will be
willing to invest because they expect higher profits. In a recession, people may become very
pessimistic, so even lower interest rates don't encourage investment. (e.g. during recession 2008-
12, interest rates were zero, but investment low)
4. Supply of finance. If banks are more willing to lend money investment will be easier.
5. Demand for goods. Higher demand will increase profitability of capital investment.
6. Rate of Taxes. Higher taxes will discourage investment. Sometimes, governments offer tax
breaks to encourage investment.

Marginal Efficiency of Investment

Marginal efficiency of investment, in economics, expected rates of return on investment as
additional units of investment are made under specified conditions and over a stated period of
time. A comparison of these rates with the going rate of interest may be used to indicate the
profitability of investment. The rate of return is computed as the rate at which the expected
stream of future earnings from an investment project must be discounted to make their present
value equal to the cost of the project.

MULTIPLIER

The concept of multiplier occupies an important place in Keynesian theory of Income, Output
and Employment. It is an important tool to analyze the effect of the changes in planned
investment on the level of income. The concept of multiplier was first developed y R.F. Kahn a
Cambridge economist in his article.
There are three types of multiplier:
1. Investment Multiplier (Two sectors)
2. Balanced Budget Multiplier (Three sector)
3. Foreign Trade Multiplier (Four Sectors)

Investment Multiplier (Multiplier in two sector model)

According to the keynes, “Investment multiplier tells us that when there is an increment of
aggregate investment, income will increase by an amount which is K times the increment of
investment.”

In the words of Kurihara, “The multiplier is the ratio of change in income to the change in
investment.
Formula of Investment Multiplier:
K= Y/ I (1) Y= K. I
Here, K=Multiplier, Y= Change in Income, I= Change in Investment.

Relation between Investment Multiplier and Marginal Propensity to consume

K= Y/ I
We also know that, Y=C+I
Y= C+ I
I= Y- C
Here, I= change in Investment, Y=change in Income, C= Change in consumption
Putting the value of I in equation 1
K = Y/ Y- C ( I = Y- C)
K = Y/ Y
Y/ Y- C/ Y OR

K= 1/1- C/ Y K= 1/1-MPC K= 1/MPS

OR ( C/ Y=MPC) OR (1-MPC=MPS)
Balanced Budget Multiplier (Multiplier in three sector model)

Balanced budget multiplier (BBM) is relevant only in a closed economy in which government
expenditure and tax are the important tools in the working of BBM.
Mr Wllich in his article, “Multiplier effect of Balanced Budget” published in Economertrica
explains very clearly that public expenditure covered by taxes had an income generating effect,
independent of numerical value of MPC and MPS.

Working of BBM
He working of balanced budget or the process of income determination on under balanced
budget can be discuss on the basis of income determination model of Keynes under C+I+G. In
such a case we start first with some equilibrium level of income determined on the basis of
consumption and increase in investment expenditure. After that we increase government
expenditure but government expenditure is not covered by tax and then examines the impact on
income and employment when government expenditure is covered by direct taxes.

Example: Let C= 25+0.75Y I=20

On the basis of AD and AS approach, equilibrium level of income is Y= 25 + 0.75Y + 20=180
i.e. 80 crores.
If now government expenditure is increased by Rs. 25 and suppose government expenditure is
not covered by tax, than the income will increase by simple multiplier times the government
expenditure. It is proved as under:
Y= C+I+G
Y= 25+0.75+20+25 Y-0.75Y=25+20+25
Y (1-0.75) = 70
Y=70/1-0.75
Y=280 crores

Foreign Trade Multiplier (Multiplier in Four Sectors Models)

The concept of foreign Trade multiplier, in an open economy, explains the estimated effect on
country’s national income and employment due to excess of its exports over imports.
A country carrying foreign trade with another country may come to have excess of exports and
imports. Income earned as a result of excess of exports over imports is like an injection in the
income stream, and has the same multiplier effect on domestic income and employment as
created by the initial increase in domestic Investment. The ratio of the final increase in income
due to an initial increase in exports over imports is called foreign trade multiplier. Symbolically,
Kf = Y/ X

The foreign trade multiplier also known as export multiplier operates like the investment
multiplier of Keynes. It may be defined as the amount by which national income of a nation will
be raised by a unit increase in domestic investment on exports. As exports increase there is an
increase in the income of all persons associated with the exports industries. These in turn create
demand for goods. But this is dependent upon their marginal propensity to save (MPS) and
marginal propensity to import (MPM). The smaller these two propensities are, the larger will be
the value of multiplier and vice versa.

In very simple terms we can say that foreign trade multiplier is a concept that states that net
exports (exports minus imports) may magnify the impact on nation's income.
 UNIT-3
INFLATION

It is a steady an upward movement in the level of prices, decreasing purchasing power over a
period of time, usually one year. Inflation can be defined as a continuous increase in the general
price level of goods & services in the economy. According to Prof. Crowther, Inflation is a state
in which the value of money is falling and prices are rising. According to Prof. Kemmerer,
Inflation means too much currency in comparison to the physical volume of business done.
Keynes stated that the rise in the price level after the point of full employment is true Inflation.

Measures of Inflation
In India, inflation is measured by using WPI (wholesale price Index). An index of several goods
& services is prepared. India’s WPI is a weighted index of 435 commodities; it means price rise
of all commodities will not be treated equally.

Example: The price rise of rice will have more weight-age than a price rise of a car. That is
because rice is consumed by a large number of people as compared to a car.
In USA, UK, China CPI (Consumer price index) is used to measure inflation. In India, WPI is
reported by Labour Bureau, Government of India.

Types of Inflation

1. On the basis of rate of inflation

a) Open Inflation: In a free market economy, prices go up freely due to supply-demand imbalances
leading to open inflation. It is not checked by government. Since market is allowed to function
without interference, it is called open inflation.
b) Suppressed inflation: On the other hand suppressed inflation occurs in a controlled economy
where the upward pressure on prices is not allowed to influence the quoted or managed prices.
According to Milton Friedman suppressed inflation is dangerous than open inflation.
2. On the basis of degree of control
a) Creeping inflation: There is moderate rise in prices of 2-3 percent per annum in creeping
inflation. It is generally considered good for a growing economy. Mildly rising prices result in
 faster growth of output as they raise the profit margins of firms and encourage them to produce
more.
b) Walking Inflation: When price increase over a decade between 30-40 percent or at the rate of 3.4
percent per annum that inflation is also known as walking inflation.
c) Running Inflation involves more accelerated movements in prices than in case of either creeping
or walking. When price are rising at the rate of about 10 percent per annum or about 100 percent
in a decade, it may be treated as a state of running inflation. It is a warning signal. Suitable
measures are required to take place.
d) Hyper Inflation: In these types of inflation price rise at double or triple digit rates per annum.
Hyper inflation is extreme form of inflation. It seriously cripples the economy. When there is no
control over running inflation, then the situation comes under hyper inflation.

3. On the basis of Degree of causes

a) Cost-Push Inflation: Aggregate supply is the total volume of goods and services produced by an
economy at a given price level. When there is a decrease in the aggregate supply of goods and
services stemming from an increase in the cost of production, we have cost-push inflation. Cost-
push inflation basically means that prices have been "pushed up" by increases in costs of any of
the four factors of production (labor, capital, land or entrepreneurship) when companies are
already running at full production capacity. With higher production costs and productivity
maximized, companies cannot maintain profit margins by producing the same amounts of goods
and services.
b) Demand-Pull Inflation: Demand-pull inflation occurs when there is an increase in aggregate
demand, categorized by the four sections of the macro economy: households, businesses,
governments and foreign buyers. When these four sectors concurrently want to purchase more
output than the economy can produce, they compete to purchase limited amounts of goods and
services. Buyers in essence "bid prices up", again cause inflation. This excessive demand, also
referred to as "too much money chasing too few goods", usually occurs in an expanding
economy.

Causes of Inflation:

Inflation means there is a sustained increase in the price level. The main causes of inflation are
either excess aggregate demand (economic growth too fast) or cost push factors (Supply side
factors). The main cause of inflation is the increase in the demand of goods and services and at
the same time decrease in the supply of goods and services.

1. Demand pull inflation

If the economy is at or close to full employment then an increase in AD leads to an increase in

the price level. As firms reach full capacity, they respond by putting up prices leading to
inflation. AD can increase due to an increase in any of its components C+I+G+X-M

The link between output and inflation suggests that there will be a similar link between inflation
and unemployment, The Phillips curve initially showed a link between money wages and
unemployment, it was then argued an increase in wages would lead to inflation
Factors affecting demand are as under:
i. Taste and preferences
ii. Seasonal demand
iii. Natural calamities
iv. Price of substitute goods
iv. Increase in money supply
v. Increase in consumer spending
vi. Cheap monetary policy
vii. Black Money
ix. Increase in public expenditure

2. Cost Push Inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There will
be a shift to the left in the AS.
Cost push inflation can be caused by many factors

1. The Labor Market

If trades unions can present a common front then they can bargain for higher wages, this will
lead to wage inflation.

2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will
become more expensive leading to an increase in inflation

3. Raw Material Prices,

The best example is the price of oil, if the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost push inflation.
E.g. in early 2008, there was a spike in the price of oil to over $150 causing a rise in inflation.

4. Profit Push Inflation

When firms push up prices to get higher rates of inflation.

5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.

Impact of Inflation

1. Effects on Distribution of Income

i. Businessmen
ii. Debtors & Creditors
iii. Investors
iv .Fixed Income Group
v. Agricultural community
 2. Effects on Economic Activities

i. Distortion of Price Mechanism

ii. Hindrance in capital formation
iii. Uncertainty and confusion
iv. Hoarding and Black Marketing
v. Deterioration of quality of product
vi. Adverse effect on pattern of Investment
vii. Loss of flexibility in economic system

3. Social, Political &Moral effects

Remedies:

1. Monetary measures- Classical economists are of the view that inflation can be checked by
controlling the supply of money. Some of the important monetary measures to check the
inflation are as under:
a) Increasing Bank rate
b) Sale of government securities/Open market operations
c) High Reserve ratio
d) Issue of new currency

2. Fiscal measures- Measures taken by the government to control inflation.

a) Decrease in public expenditure- One of the main reasons of inflation is excess public expenditure
like building of roads, bridges etc. Government should drastically scale down its non essential
expenditure.
b) Delay in payment of old debts: Payment of old debts that fall due should be postponed for
sometime so that people may not acquire extra purchasing power.
c) Increase in taxes: Government should levy some new direct taxes and raise rates of old taxes.

d) Over valuation of money: To control the over valuation of money it is essential to encourage
imports and discourage exports.

3. Other measures
a) Expansion of output
b) Encouragement to saving
c) Overvaluation
d) Proper wage policy
e) Indexing
f) Population control
g) Rationing
Introduction to IS-LM Model
Macro Economic General equilibrium is an integration of money, interest and income through
the product and money markets. The integration is realized through the Hicks-Hansen
diagrammatic framework known as IS-LM Model.
Hicks & Hansen add the effects of interest rates on spending, and thus income and the
dependence of the financial markets on income. Interest rates & income are determined jointly
by equilibrium in the goods & financial markets.
The IS–LM model is a macroeconomic tool that demonstrates the relationship between interest
rates and real output, in the goods and services market and the money market. The intersection of
the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in
both markets.

IS curve represents the equality of investment & saving to show the product market equilibrium.
LM curve on the other hand is the expression of the equality of money demand (L) & money
supply (M) & represents the money market equilibrium. The product market equilibrium is also
known as “real sector equilibrium” & the money market equilibrium is also known as “monetary
sector equilibrium”.

Product Market Equilibrium

Product market is in equilibrium when desired saving & investment are equal or aggregate
supply (Y) is equal to aggregate demand (C+I).

Assumption
a) Closed economy
b) No government spending or taxes
c) Consumption & saving are the function of income
d) Investment is a function of rate of interest

I) Y=C+I
C= C(Y)...............(1)
I= I (r)..................(2)
Y=C(Y) + I(r)……(3)
II) Y=C+S, so, I=S
S=S(Y)
I=I(r)
S(Y) = I(r)

IS curve is also a locus of points showing alternate combinations of interest rate & income at
which the commodity market clears. That is why the IS curve is called the commodity market
equilibrium schedule. The IS curve is a graphical representation of the product market
equilibrium condition that planned investment be equal to saving and it shows the level of
 income that will yield equality of planned investment & saving at different possible interest
rates.

IS curve thus shows various combinations of interest rates & income at which there is equally
between S & I.

Properties of IS curve
1. Slope of IS curve is negatively sloped because a higher level of interest rate reduces investment
spending, thereby reducing aggregates demand & thus the equilibrium level of income.

2. Shifts in IS curve
i. If autonomous spending increases, the IS curve will shift to the right.
ii. If saving reduces, the IS curve will shift to the right & vice versa.
iii. If an autonomous investment increases, the IS curve will shift to the right & vice versa.

Money Market:
Money market is in equilibrium when demand for money and supply of money are equal.To
simplify the analysis we take two sector model.
Assumptions:
i. Closed Economy
ii. No government spending or taxes
iii. The financial market is confined to only money transactions & other forms of income
earning assets.
Equilibrium in the money market exists when the demand for money is equal to the supply of
money.

Properties of LM curve:
i. The slope of LM curve: The LM curve is positively sloped. This means that an increase in the
interest rate reduces the demand for money.
ii. The Shift of the LM curve: The money supply is held constant along the LM curve. It
follows that a change in the money supply shifts the LM curve.

Product Market:

Product market is where goods and services produced by businesses are sold to households.
The households use the income they receive from the sale of resources to purchase the products.
The money they spend is returned to the businesses as revenue. Product market regulation is an
economic term that describes restrictions in the market.
 UNIT-3
MONETARY POLICY

Instruments
Monetary Policy means the policy by which the government of a country and the central bank try
to control the supply of the money and the availability of credit in the system , with a view to
achieve economic stability.

There are two instruments of monetary policy:-

1. Quantitative instruments
2. Qualitative instruments.

Qualitative
The qualitative measures do not regulate the total amount of credit created by the commercial
banks. These measures make distinction between good credit and bad credit and regulate only
such credit, which creates economic instability. Therefore, qualitative measures are known as the
selective measures of credit control.

Qualitative credit control measures include:

(i)Change in margin requirements
(ii)Consumer credit regulation
(iii)Moral suasion
(iv)Direct action

(i) Change in margin requirements

Generally, commercial banks give loan against ‘stocks or ‘securities’. While giving loans against
stocks or securities they keep margin. Margin is the difference between the market value of a
security and its maximum loan valueIf central bank feels that prices of some goods are rising due
to the speculative activities of businessmen and traders of such goods, it wants to discourage the
flow of credit to such speculative activities. Therefore, it increases the margin requirement in
case of borrowing for speculative business and thereby discourages borrowing. This leads to
reduction is money supply for undertaking speculative activities and thus inflationary situation is
arrested.
On other contrary, central bank can encourage borrowing from the commercial banks by
reducing the margin requirement. When there is a grater flow of credit to different business
activities, investment is increased. Income of the people rises. Demand for goods expands and
deflationary situation is controlled.
(ii) Consumer credit regulation:

Now-a-days, most of the consumer durables like T.V., Refrigerator, Motorcar, etc. are available
on installment basis financed through bank credit. Such credit made available by commercial
banks for the purchase of consumer durables is known as consumer credit.
If there is excess demand for certain consumer durables leading to their high prices, central bank
can reduce consumer credit by (a) increasing down payment, and (b) reducing the number of
installments of repayment of such credit.
On the other hand, if there is deficient demand for certain specific commodities causing
deflationary situation, central bank can increase consumer credit by (a) reducing down payment
and (b) increasing the number of installments of repayment of such credit.

(iii) Moral suasion:

Moral suasion means persuasion and request. To arrest inflationary situation central bank
pursuades and request the commercial banks to refrain from giving loans for speculative and
non-essential purposes. On the other hand, to counteract deflation central bank pursuades the
commercial banks to extend credit for different purposes.
Central bank also appeals commercial banks to extend their wholehearted co-operation to
achieve the objectives of monetary policy. Being the monetary authority directions of the central
bank are usually followed by commercial banks.

(iv) Direct Action:

This method is adopted when a commercial bank does not co-operate the central bank in
achieving its desirable objectives. Direct action may take any of the following forms:
Central banks may charge a penal rate of interest over and above the bank rate upon the
defaulting banks;
Central bank may refuse to rediscount the bills of those banks which are not following its
directives;

Central bank may refuse to grant further accommodation to those banks whose borrowings are in
excess of their capital and reserves.

Quantitative instruments
Quantitative instruments broadly include the following:-

1. Bank rate: it is the rate at which the central bank of a country is prepared to give credit to the
commercial banks. Increase in bank rate increases the interest rates, and demand for credit gets
reduced. On the other hand decrease in bank rate lowers the rate of interest and credit becomes
cheap, and demand for credit expands.

2. Open market operations: It refers to purchase and sale of securities in the open market by the
central bank. By selling the securities, central bank reduces the purchasing power of the system.

3. Change in minimum reserve ratio: Minimum reserve ratio refers to the minimum percentage
of a bank total deposit which is required to be kept with the central bank. All the banks have to
keep with the central bank a certain percentage of their deposits in the form of cash reserve ratio

4. Change in liquidity ratio: Every bank is required to maintain a fixed percentage of its assets
in the form of cash or other liquid assets called liquidity ratio. With a view to reducing the flow
of credit, in the market central bank enhances the liquidity ratio. However in case of expansion
of credit liquidity ratio is reduced.
 Objectives of Monetary Policy
The objectives of a monetary policy in India are similar to the objectives of its five year plans. In
a nutshell planning in India aims at growth, stability and social justice. After the Keynesian
revolution in economics, many people accepted significance of monetary policy in attaining
following objectives.

Let us now see objectives of monetary policy in detail :-

1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary
policy can influence economic growth by controlling real interest rate and its resultant impact on
the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the
investment level in the economy can be encouraged. This increased investment can speed up
economic growth. Faster economic growth is possible if the monetary policy succeeds in
maintaining income and price stability.
2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as
Price Instability. Inflation are harmful to the economy. Thus, the monetary policy having an
objective of price stability tries to keep the value of money stable. It helps in reducing the
income and wealth inequalities. When the economy suffers from recession the monetary policy
should be an 'easy money policy' but when there is inflationary situation there should be a 'dear
money policy'.
3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of
any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in
the exchange rate, the international community might lose confidence in our economy. The
monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by
altering the foreign exchange reserves tries to influence the demand for foreign exchange and
tries to maintain the exchange rate stability.
4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffers from
the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to
maintain equilibrium in the balance of payments. The BOP has two aspects i.e. the 'BOP Surplus'
and the 'BOP Deficit'. The former reflects an excess money supply in the domestic economy,
while the later stands for stringency of money. If the monetary policy succeeds in maintaining
monetary equilibrium, then the BOP equilibrium can be achieved.
5. Full Employment: It refers to absence of involuntary unemployment. In simple words 'Full
Employment' stands for a situation in which everybody who wants jobs get jobs. However it
does not mean that there is a Zero unemployment. In that senses the full employment is never
full. Monetary policy can be used for achieving full employment. If the monetary policy is
expansionary then credit supply can be encouraged. It could help in creating more jobs in
different sector of the economy.
6 .Neutrality of Money: Economist such as Wicksted, Robertson have always considered money as
a passive factor. According to them, money should play only a role of medium of exchange and
not more than that. Therefore, the monetary policy should regulate the supply of money. The
change in money supply creates monetary disequilibrium. Thus monetary policy has to regulate
the supply of money and neutralize the effect of money expansion. However this objective of a
monetary policy is always criticized on the ground that if money supply is kept constant then it
would be difficult to attain price stability.
7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy are
maintaining economic equality. However in recent years economists have given the opinion that
the monetary policy can help and play a supplementary role in attainting an economic equality.
Monetary policy can make special provisions for the neglect supply such as agriculture, small-
scale industries, village industries, etc. and provide them with cheaper credit for longer term.
This can prove fruitful for these sectors to come up. Thus in recent period, monetary policy can
help in reducing economic inequalities among different sections of society.

Limitations of Monetary policy

1. Lack of cooperation by commercial banks
2. Unorganized sector
3. Lack of banking habits of people
4. Problem in forecasting of Inflation and deflation
5. Time lag

FISCAL POLICY
Fiscal Policy refers to the methods employed by the government to influence and monitor the
economy by adjusting taxes and/or public spending. In doing so, the government aims to find a
balance between lowering unemployment and reducing the inflation rate. The main tools of
Fiscal Policy are changes in the composition of taxation and government spending.
Definitions
“By fiscal policy we denote to government actions afflicting its receipts and outlays
which are ordinarily taken as measured by the government’s receipts, its surplus or deficit.”
“A policy under which the government uses its outlay and revenue programmes to
produce desirable effects and avoid undesirable effects on the national earnings, manufacturing
and employment.”

Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at
short run goals of full employment and price level stability.”

Objectives of Fiscal Policy

The following are the objectives –

1. To uphold and accomplish full employment.
2. To alleviate the price level.
3. To soothe the development rate of financial system.
4. To sustain symmetry in the balance of payment.
5. To endorse the monetary development of under developed nations.
Instruments of Fiscal Policy:

Following are the main instruments of fiscal policy:

 Public Expenditure
Public Expenditure means expenditure incurred by the government of a country. It generates
sufficient influence on aggregate demand and development activities of a country. The
expenditure can be of two types:
I. Expenditure incurred by the government to get goods and services. It directly influences
aggregate demand.
II. Public expenditure incurred on pensions, scholarships, educational and medical facilities
to people etc. This expenditure is known as Transfer Payment. It also raises aggregate
demand.

 Taxation
Modern states are welfare oriented states and they have to use money to achieve this end. Tax is
the main source to acquire money. Aggregate demand can also be influenced by taxes.
Government collects money by imposing different taxes to finance public expenditure and to
manage various development activities. Mainly, taxes can be classified into two groups-
I. Direct Tax: Direct tax reduces the income of the people and a part of their income goes
into the government treasury.
II. Indirect Tax: Indirect taxes lead to a rise in prices of goods.
Both direct and indirect taxes lead to the reduction in aggregate demand.

 Public Debt
The third instrument of fiscal policy is public debt. Public debt means debt taken by the
government from people or from the governments of other countries. The government has to take
the help of public debt if public expenditure exceeds public revenue. Public debt can be of two
types: Internal and External.

 Deficit Financing
A public expenditure has to be incurred for economic development. This amount can be
collected only through the public debt, taxation etc. So deficit financing has to be introduced.
When there emerges a deficit due to excess of public expenditure over public revenue, this
deficit is met with either by borrowing from the central bank or by issuing new notes. Deficit
financing can be used to meet government expenditure. It increases aggregate demand.
References:

Books:
1. Dwivedi, D. N., (2005) Macro Economics, McGraw Hill Education.
2. Dr. Kumar Raj, Gupta Kuldip, (2009) Business Economics-II (Macro), UDH publishers
3. Jain T.R., Ohri V.K., (2009) Principal of Macro Economics, VK Publication
4. Agarwal, ((2010)) Macroeconomics Theory and Policy, 1st edition, Pearson Education.