UNIT – 1: INTRODUCTION TO MACROECONOMICS
Meaning of Micro Economics and Macroeconomics
According to Sultz, "Micro economics is called price theory."
K.E. Boulding defines micro economics as, Micro economics is that branch of economic analysis
which studies the economic behavior of individual price, wages, particular firms, and particular
commodities, may be a person."
According to Edward Shapiro, - " Micro economics is concerned not with total output, total
employment are total spending, but with the output of particular goods and services by single firms
or industries and with the spending on particular goods and services by single households or by
households in single market."
According to A.P. Lerner, - "Micro economics consists of looking as the economy through
microscopic."
The above definitions are different in word but they convey same meaning that micro economics
is the study of individual units of economic variables."
Macroeconomics is the study of large units. It is the study of aggregate units of economic
variables like national income, national output and general price level.
K.E. Boulding defines macroeconomics as, "Macroeconomics is that branch of economic
analysis which studies not individual units but all units combined together, their behavior and
relationship."
Again, Boulding defines Macroeconomics as" Macroeconomics deals not with individual
quantities but with aggregate of these quantities, not with individual incomes but with national
income, not with individual prices but with price level, not with individual output but with national
output."
According to R.G.D. Allen, - "The terms macroeconomics applies to the study of relation between
broad economic aggregates."
According to G. Ackley, "Macroeconomics deals with the economic affairs in the large, it concerns
the overall dimensions of economic life, it studies the character of the forest independently of trees
which compose it."
According to Edward Shapiro, "In brief, macroeconomics is the study of total output, employment
and price level."
 Scope of Macroeconomics
According to the definition of macroeconomics, it is the study of aggregate unit not individual
units. The macroeconomics deals with national income, national output, general price level,
employment level which are the area of macroeconomics. The scope of macroeconomics are as
follows:
1. National Income: - The national income is main area of macroeconomics. Macroeconomics
deals with the national income, various determinant factors of national income and difficulties
in the measurement of national income. The national income is determined by equality between
aggregate demand and aggregate supply. The aggregate demand is the sum of consumption
and investment. In the same way, the aggregate supply is the sum of consumption and saving.
So, consumption, investment and saving are subject matter of macroeconomics.
2. Theory of employment: - The theory of employment is also area of macroeconomics deal
with the various theories of employment and its determinant factors. So, macroeconomics is
also called income and employment theory. It deals with the theory of trade cycle and its
phases.
3. The theory of general price level: - The theory of general price level is also area of
macroeconomics. The general price level refers to average price not price of individual
commodity and the average price can be measured by statistical instrument like index number.
Index number measures the situation of inflation or deflation in the economy and inflation is
caused by more supply of money. So, inflation, deflation, supply of money and demand for
money are the subject matter of macroeconomics.
4. Theory of economic growth: - The theory of economic growth is the area of macroeconomics.
Macroeconomics deals with the various models of economics growth like Harrod model,
Domar model and Solow model. The Domar model tells us that what should be the rate of
investment per period to maintain sustained economic growth in the economy. The theory of
economic growth is related to long run. Hence, the models of economic growth are also subject
matter of macroeconomics.
5. Modern theory of distribution: - The modern theory of distribution is also main area of
macroeconomics. Under modern theory of distribution, macroeconomics deal with the
comparative share of national income among the different groups like land, labor, capital and
producer. It explains the effect of unequal distribution of income and wealth. The
macroeconomics also explains the poverty problem, its effects and it also provide the solution
to reduce poverty.
 Static and Dynamic Analysis of Macroeconomics
There are three types of macroeconomics, which are explained below respectively:
1. Macro static: - It explains the static equilibrium determined in a given period of time. It
explains the macro economic variables like consumption, investment and income by assuming that
they are related to same period of time and there is no time lag between dependent and independent
macro-economic variables. It can be explained by the help of a diagram.
Fig-6.2
Macro Static
Aggregate. Expenditure
C+I
Y=C+I
C+I
E1
450
O
Y1
Income
Y
In this diagram, the aggregate expenditure(C+I) is measured along vertical axis and income along
horizontal axis. The 450 line is called guideline. At each and every point of this guideline the
vertical distance is equal to horizontal distance. It means that income is equal to expenditure at
each and every point of this guideline. The (C+I) curve is aggregate expenditure curve. The 'C+I'
curve is equal to the guideline at point E1. So, E1 is equilibriums point which is explained by macro
static and this equilibrium point determines the Y1E1 equilibrium expenditure and OY1 equilibrium
level of income. Hence, the task of macro static is to explain the single equilibrium determined by
single period of time.
2. Macro comparative static: - The macro comparative static deals with the two static equilibrium
points which are determined in different two period of time. It compares these equilibrium
condition but it does not tell us that what happened when economy moving from one equilibrium
point to another equilibrium point. It can be explained by the help of following diagram.
Fig-6.2
Macro Static
Aggregate. Expenditure
C+I
E2
Y=C+I
C+I+I
C+I
E1
450
O
Y1
Y2
Y
Income
In this diagram, the aggregate expenditure(C+I) is measured along vertical axis and income along
horizontal axis. The 450 line is guide line. At each and every point of it the income is equal to
aggregate expenditure. The 'C+I' is aggregate expenditure curve which has positive slope showing
the positive relationship between aggregate expenditure and the level of income. The initial
aggregate expenditure curve is equal to the guide line at point E1 from which Y1E1 equilibrium
expenditure and OY1 equilibrium level of income are determined together. Now, suppose that the
investment is increased by I consequently the 'C+I' curve shifts to the upward and takes a position
of 'C+I+I' which is equal to the guideline at point E2 from which Y2E2 equilibrium expenditure
and OY2 equilibrium level of income are determined together. The micro comparative static
compares between these two equilibrium points E1 and E2, which are determined in two different
period of time, but macro comparative static does not explain what happened moving economy
from initial equilibrium to new equilibrium point.
3. Macro Dynamic: - Macro dynamic deals with the two equilibrium points determined in
different period of time by assuming that everything is changeable. It is based on time lag analysis
between macro-economic variables like consumption and income. The macro dynamic also
explains what happened between these two equilibrium points. It can be explained by the help of
following diagram.
Fig-6.2
Macro Dynamic
C+I
E4
E6
EN
E5
E2
C+I
Aggregate.
Expenditure
E3
O
Y=C+I
C+I+I
E1
450
Y1
Income
YN
Y
In this diagram, aggregate expenditure is measured along vertical axis and level of income is
measured along horizontal axis. The 450 line is guideline where vertical distance is equal to
horizontal distance at each and every point of this guideline which means that aggregate
expenditure is equal to aggregate income at each and every point of this guideline. The 'C+I' is
aggregate expenditure curve which has positive slope, showing the positive relationship between
income and consumption. The 'C+I' curve is equal to the guideline at point E1. So, E1 is equilibrium
point from which Y1E1 equilibrium aggregate expenditure and OY1 equilibrium level of income
are determined together. Now, suppose that the investment is increased by I (=E1E2).
Consequently, the aggregate expenditure curve shifts to the upward and takes a position of
'C+I+I'. Due to shift in aggregate demand curve to the extent of E1E2, it increases the level of
income to the extent of E2E3 in the first period. The E3E4 proportion of E2E3 income is consumed
by people and it increases the level of income to the extent of E4E5 in second period. This process
will be continue as long as new equilibrium point E5 equilibrium point is not determined, From
this way, the En equilibrium point is determined which determines YNEN equilibrium aggregate
expenditure and OYN equilibrium level of income. Hence, macro dynamic explains the
disequilibrium phases passing from initial equilibrium to new equilibrium point.
 Macroeconomics and Business Environment
Manager has to take business decision. For this purpose, manager takes help of tools of
microeconomics by manager cannot be aloof from economic, social and political environment,
because production decision is affected by these environments. A manager has to keep knowledge
of such business environment like taxation policy, industrial policy, import policy, export policy
and technology. Besides these, manager has to keep knowledge about aggregate variable like
national income, general price level, employment level, money supply, exchange rate. A firm has
no any control over these externals factor. The external factors are called business environment in
managerial economics. Manager has to adjust its plant, policy and programs with change in
business environment.
1. Economic growth: - Economic activity changes due to change in income levels, future of the
economy, political activities, natural disasters, price level of raw materials. The level of economic
activity is usually measured by GDP. An increase in GDP leads to increase in aggregate demand.
In this situation, firm automatically increases in investment to increase the level of production. In
the same way, decrease in GDP leads to decrease in aggregate demand. In this situation, firm
automatically decreases investment because investment decision is not beneficial.
2. Inflation: - Mild inflation is not dangerous for economy because it leads to increase in economic
activities. Producers are encouraged to increase in production level on account of increase in profit.
But hyperinflation is very dangerous. It adversely affects to poor and middle group. The cost of
production may increase during this period.
3. Interest rate: - The change in interest rate also affect business decision when rate of interest
increase, then borrowing from financial institution will be expensive which leads to decrease in
investment.
4. Determination of general price level: - Macroeconomics gives answer of the question that
how general price level is determined. General Price level refers to average price level. The
business decision is affected by change in price level.
5. Business cycle: - Business cycle refers to fluctuation in economic activities. There are four
phases of trade cycle. They are boom, depression, recession and recovery. An individual firm
changes business decision on the basis of phases of trade cycle.
UNIT – 2: NATIONAL INCOME ACCOUNTING
Circular flow of Income and Expenditure
Circular flow means continual circular movement of money and goods in the economy. Keynes
has put the fact of the circular flow of economic activity. There is no doubt that economy is an
integrated activity for the production, distribution consumption. In caring out these economic
activities, people are involved in making transaction, i.e., buying and selling of goods and services.
Economic transactions generate two kinds of flows: flows of goods and services and flow of
money. Product and money flow are in the opposite direction. For example, when people buy
goods and services, they have to pay which is received by the seller. Similarly, when producers or
firms buy or hire factors of production, they have to make payment, which is received by factor
owner. Circular flow is an economic tool of showing the continuous movement of production,
income and the services of resources that flow between producers, resource supplier and
consumers. It is the recurring flow of products, factors, and money among the household, business,
government, and foreign sectors through the product market and financial markets.
This concept is complex in reality. For simplicity, the economy is divided into four sectors;
household sector, business sector, government sector and foreign sector and all these sectors are
combined together to explain circular flow of income and expenditure. There are different types
of the circular flow model which connect the four sectors: household, business, government, and
foreign and the three markets: product, resource, and financial to describe the economy.
 Two Sector Circular Flows
Two sectors circular flow model includes circular flow of income and expenditure between two
sectors: household sectors and business sectors. It is based on following assumptions.
i. There are only two sectors in the economy: household and business sectors.
ii. There is no government and no international trade.
iii. Business sector supply goods and services to household sector.
iv. Household supply factors of production to business sector.
From these assumptions, the two-sector circular model can be cleared by following diagram.
Product Market
Expenditure on goods and services
Supply goods and services
Business
Sector
Investment
Financial Market
Supply of factors of production
Payment of factors of production
Factor Market
Saving
Household
Sector
This figure shows circular flow of income and expenditure in the two-sector economy. The upper
half of the figure represents product market and lower half of the figure represents factor market.
Both these markets generate two kinds of flows: product flow and money flow.
In the upper half of the figure, shows product market. Business sector produces goods and services.
Business sector supplies goods and services to households, because household sector demand
goods and services. Household sector make payment for goods and services to business sector.
The flow of goods from business sector to household sector is considered as real flow and the flow
of money as payment for goods and services from households sector to business sector is
considered as money flow. The payment made by the households for goods and services create
money flow. From the figure, it is clear that goods and money flow in the opposite direction.
The lower half of the figure shows factor market. Household sector supply factors of production
to the business sector because business sector demand factors of production from household sector.
Business sector make payment as rent, wage and interest for factors of production to households
sector. The flow of factors of production from households sector to business sector is considered
as real flow and the flow of money as payment for factors of production from business sector to
households sector is considered as money flow. This makes real flow. The real flow creates money
flow.
Households save from their income after expenditure. The saving converts into investment and
flow from households sector to business sector through capital market. The saving is considered
as leakage and the investment is considered as injection. Hence, saving is equal to investment in
capital market.
 Three Sector Circular Flow Model
Three sectors circular flow model includes circular flow of income and expenditure between three
sectors: household sectors business sectors and government sectors. The three sectors circular flow
model is based on following model.
i. There are only three sectors in the economy: household, business and government sectors.
ii. There is government intervention.
iii. Government imposes tax and provides transfer of payment, subsidies.
iv. There is perfectly competitive market.
v. Foreign trade is not included in this model so export and import are no included.
vi. Business sector pays both direct and indirect tax to the government.
vii. Household sector pays direct tax to the government.
viii. Government provides transfer of payment, wage, and salaries to household sector.
ix. Government purchase goods from business sector and provides subsidies to business sector.
x. Business sector hire factors of production from the households.
xi. Government sector also hire factors of production from households.
From these assumptions, the circular flow of income and expenditure among households, business
and government sectors can be cleared by following diagram as.
Payment for goods& services
Supply goods and services
Transfer & subsidies
Tax
Government
Sector
Payment for factors
Supply factors
Transfer of payment
Tax
Payment on goods and services
Supply goods and services
Business
Sector
Investment
Financial Market
Saving
Household
Sector
Supply of factors of production
Payment of factors of production
This figure shows circular flow of income and expenditure in the three-sector economy. The upper
half of the figure represents product market and lower half of the figure represents factor market.
Middle part of the figure represents financial market. Both these markets generate two kinds of
flows: product flow and money flow.
In the upper half of the figure, shows product market. Business sector produce goods and services.
Business sectors supply goods and services to households, because household sector demand
goods and services. Household sector make payment for goods and services to business sector.
The flow of goods from business sector to household sector is considered as real flow and the flow
of money as payment for goods and services from households’ sector to business sector is
considered as money flow. The payment made by the households for goods and services create
money flow. From the figure, it is clear that goods and money flow in the opposite direction.
Household sectors pays tax to the government and government sectors provides wage salaries and
transfer of payment to the household sector. The business sector pays direct and indirect tax to the
government sector and government sector purchases goods and services from business sector.
Government sector also provides subsidies to business sector.
The lower half of the figure shows factor market. Household sector supply factors of production
to the business sector because business sector demand factors of production from household sector.
Business sector make payment as rent, wage and interest for factors of production to household’s
sector. The flow of factors of production from households’ sector to business sector is considered
as real flow and the flow of money as payment for factors of production from business sector to
households’ sector is considered as money flow. This makes real flow. The real flow creates money
flow.
Households save from their income after expenditure. The saving converts into investment and
flow from households’ sector to business sector through financial market. The saving is considered
as leakage and the investment is considered as injection. Hence, saving is equal to investment in
capital market. If government adapts deficit financing, then government can borrow from financial
market also.
 Four Sector Circular Flow Model
Four sectors circular flow model includes circular flow of income and expenditure between four
sectors: household sectors business sectors, government sectors and foreign sector. The Four
sectors circular flow model is based on following model.
i. There are four sectors in the economy: household, business, government sector and foreign
sectors
ii. There is minimum government intervention.
iii. Government imposes tax and provides transfer of payment, subsidies.
iv. There is perfect competition in both internal and external market.
v. There is well managed financial market.
vi. Business sector pays both direct and indirect tax to the government.
vii. Household sector pays direct tax to the government.
viii. Government provides transfer of payment, wage, and salaries to household sector.
ix. Government purchase goods from business sector and provides subsidies to business sector.
x. Business sector hire factors of production from the households.
xi. Government sector also hire factors of production from households.
From these assumptions, the circular flow of income and expenditure among households, business
and government sectors can be cleared by following diagram as.
Payment for goods and services
Supply of goods and services
Transfer of pay. & subs.
Government
Sector
Payment for factors of prod.
Supply factors of production
Transfer of pay. & subs.
Tax
Tax
Expenditure on goods & services
Supply goods & services
Business
Sector
Investment
Financial Market
Saving
Household
Sector
Supply of factors of production
Payment of factors of production
Export goods
Payment for export of goods.
import of manpower
Payment in Foreign exchange
Foreign
Sector
Import of goods
Payment for import
Supply factors of prod.
Payment foreign remittance
This figure shows circular flow of income and expenditure in the four-sector economy. The upper
half of the figure represents product market and lower half of the figure represents factor market.
Middle part of the figure represents financial market. Both these markets generate two kinds of
flows: product flow and money flow.
In the upper half of the figure, shows product market. Business sector produce goods and services.
Business sectors supply goods and services to households, because household sector demand
goods and services. Household sector make payment for goods and services to business sector.
The flow of goods from business sector to household sector is considered as real flow and the flow
of money as payment for goods and services from households sector to business sector is
considered as money flow. The payment made by the households for goods and services create
money flow. From the figure, it is clear that goods and money flow in the opposite direction.
Household sectors pays tax to the government and government sectors provides wage salaries and
transfer of payment to the household sector. The business sector pays direct and indirect tax to the
government sector and government sector purchases goods and services from business sector.
Government sector also provides subsidies to business sector.
The lower half of the figure shows factor market. Household sector supply factors of production
to the business sector because business sector demand factors of production from household sector.
Business sector make payment as rent, wage and interest for factors of production to household’s
sector. The flow of factors of production from households’ sector to business sector is considered
as real flow and the flow of money as payment for factors of production from business sector to
households’ sector is considered as money flow. This makes real flow. The real flow creates
money flow. Foreign sectors export goods to business sector and business sectors makes payment
for import of goods. In the same way, business sector exports goods and services to foreign sector
and foreign sector makes payment for import. Household sector supplies/exports capital and
manpower to foreign sector and foreign sector makes payment to household sectors as foreign
remittance. Foreign sector export goods and services to household sector and household sector
make payment for import of goods and services.
Households save from their income after expenditure. The saving converts into investment and
flow from households’ sector to business sector through financial market. The saving is considered
as leakage and the investment is considered as injection. Hence, saving is equal to investment in
capital market. If government adapts deficit financing, then government can borrow from financial
market also.
 Meaning of National Income
The study of National Income in economic literature is very important. The total money value of
all types of goods and services produced with nation in a year, including net income received from
foreign countries is generally said to be National Income. The National Income is divided among
the factors of production according to Marginal Product. The higher the National Income, the
greater will be share of factors of production. But it is very difficult task to define National Income
because it includes also the net income received from foreign countries which is out of boundary
of nation.
(1) Marshallian definition regarding to National Income (NI)
According to Marshall, the labor and capital of the country acting upon its natural resources
produced annually a certain net aggregate of commodities, material and immaterial including
service of all kinds. This is the true net annual income or revenue of a country on the national
dividend.”
From this definition, following important points are found:
(i) National Income is measured annually.
(ii) All types of goods and service, whether they are material or immaterial, are included while
measuring National Income.
(iii) The net income received from foreign countries is also included while measuring National
Income.
(iv) The Net National Income can be found after the deduction of depreciation of capital.
(v) The National Income is measured by production method is Marshlallian definition.
The Defects of Marshallian definition are as follows:
(i) There are various types of goods and service produced in a year within the country. So, there is
difficulty to measure National Income correctly.
(ii) There are some goods in the country, which are not exchanged in the market, rather they are
used by producers as consumption, and they are not found in market for sale. The Marshallian
definition does not tell about the evaluation of such goods.
(iii) In Marshallian definition, there is possibility of double counting while measuring National
Income.
What so ever, the Marshallian definition is very simple and popular.
(2) Piguvian Definition regarding to National Income
According to Pigou, “The National Dividend is the part of the objective income of the
community including, of course, income derived from abroad which can be measured in
money.”
Followings important points are found.
(i) The National Income is measured on the basis of product method.
(ii) According to this definition, only those goods are included which are exchanged in the market
by money and which can be measured by rod of money.
(iii) The National Income is measured annually.
(iv) Only objective income is included while measuring National Income.
(v) The net income is found after the deduction of depression of capital
(vi) The net income received from abroad is also included while measuring National Income
The defects of this definition are as follows:
(i) It is not applicable in the barter system where goods are not exchanged by money.
(ii) Under developing country, most of the goods and service are exchanged without money. So,
definition is not applicable.
(iii) It makes the field covered by national income uncertain because it included only objective
income. It does not include those goods and services which are not exchanged in market. So,
National Income may be low.
(3) Fisher’s definition regarding to National Income
Marshall and Pigou have defined the National Income on the basis of production while fisher
defined the National Income on the basis of consumption. According to Fisher, “The National
Income consists solely of service as receipt by ultimate consumers whether from their material or
nonmaterial from their human environment.”
Further Fisher has defined National Income to makes clearer that “The true National Income is
that part of annual net produced which is directly consumed during that year.”
Fisher has provided a suitable example to make clear to that National Income a piano and an
overcoat made for me this year is not a part of this year income, but an addition to capital. Only
the service rendered to use doing the year by these things are income. The fisher’s definition can
be cleared by a suitable example. Suppose that one-person purchases overcoat at price Rs. 12000
in particular year and the lifetime of that coat is 12 years. In this situation, that person annually
consumes only Rs. 1000 of that goods at that year which goes to National Income of that year. The
value of coat Rs. 12000 is only addition to capita not National Income of that year.
Following are the main points of this definition regarding to National Income:
(i) National Income is measured or defined on the basis of consumption.
(ii) Only that part of consumption is included into National Income, which is actually consumed
in that year.
(iii) Net income received by foreign counties is also included while measuring National Income.
The fisher definition is very scientific and logical as compared to Marshallian and Pigovian
definition but it is also more complex as compared to both regarding to National Income.
The main defects of Fisherian definition are as follows:
(i) There are various types of goods and services, which are consumed by more consumers so it is
very difficult to estimate net consumption consumed by more consumer in a particular year.
(ii) There are various durable goods and the lifetime of such goods cannot be estimated correctly
because some goods may transfer from one hand to other. In such situation, the estimation of net
consumption of these durable goods is very difficult. So, here the estimation of NI is very difficult.
 Different Concept of National Income
(i) Gross Domestic Product (GDP): The market value of total production of all final goods and services within a country in a particular
year earned by resident and non-resident is considered as Gross Domestic Product in which
depreciation is not deducted.
Followings are the features of GDP.
i. GDP is the money value of all final goods and services produced within a country.
ii. GDP includes the value of only final goods and services produced in a year.
iii. The value of final goods and services is calculated at the current market prices.
iv. GDP includes only current production and excludes sale or purchase of previously produced
goods.
v. GDP includes only those goods, which are marketed.
vi. GDP does not include Transfer payments like pension, unemployment allowance, etc., because
these payments do not contribute any way to production.
vii. GDP does not include capital gains.
GDP at market prices and factor cost
GDP at market price is considered as the market value of all final goods and services produced by
residents and non-residents within a country in a particular year. In the measurement of GDP,
depression is not deducted.
GDP at factor cost is considered as the sum of price paid to the all factors of production in form
of wages, profits, interest and rent for their contribution in production. The GDP at factor cost can
be obtained by deducting net indirect tax from GDP at market price. The net indirect tax is equal
to indirect tax minus subsidies.
Formula of GDP at market price and GDP at factor cost can be expressed as:
GDPMP = P1Q1 + P1Q1 + P1Q1 + .......... ... + PnQ n
GDPFc = GDPMP − Net indirect tax
Net indirect tax = Indirect taxes - Subsidies
Where
GDPMP = Gross Domestic Product at market price
GDPFP = Gross Domestic Product at Factor price
P=Market price of final goods and services
Q= Quantity of goods and services
i= Final product from 1 to n (number of final goods and services)
(i)Net Domestic Product (NDP): The market value of total production of all final goods and services within a country in a particular
year produced by resident and non-resident is considered as GDP in which depreciation is not
deducted. But when depreciation is deducted from GDP, then it will be NDP.
NDP at market prices and factor price
The money value of total production of final goods and services at actual price produced by
residents and non-residents within a country in a particular year with deducting depression is called
Net Domestic Product. Hence, NDP measured at actual market price is called NDP at market price
NDP measured as the sum of price paid to the all factors of production in the form of wages and
salaries, profit, interest and rent for their contribution in the production at goods and services is
called NDP at factor cost. NDP at market price minus net indirect tax is called NDP at factor cost.
NDPMP = GDPMP − Depreciation
NDPFc = NDPMP − Net indirect taxes
(ii) Gross National Product (GNP): If Gross National Product is widely used in different concepts of National Income. Gross National
Product is the market value of total production of all final goods and services within a country in
a particular year including net factor income received from abroad in which depreciation is not
deducted. Net factor income from abroad is the difference between the factor income earned by
residents from foreign countries and the factor income earned by foreigners from our country.
Therefore, it covers not only geographical boundaries of country but also foreign country.
Following are the features of GNP.
1. It is calculated in monetary terms.
2. It includes only final goods and services.
3. The intermediate goods are excluded to avoid double counting.
4. It includes income earned by the residents of a country within a country and abroad.
5. It does not include capital gains and transfer payments.
6. It includes only those goods, which are marketed.
GNP at market prices and factor cost
GNP measured at the actual market price is considered as GNP at market price. It is the market
value of all final goods and services produced in a particular year within nation including net factor
income from abroad.
GNP measured as the sum of price paid to the all factors of production in the form of wages and
salaries, profits, interest and rent for their contribution in production is known as the GNP at factor
cost. In GNP at factor cost, the net factor income from abroad is also included in GDP at factor
cost. In order to calculate GNP at factor cost, we have to deduct the net indirect taxes from GNP
at market price. Symbolically, it can be expressed as:
GNPMP = GDPMP + Net factor income from abroad
GNPFC = GNPMP − Net Indirect taxes
Net Indirect taxes = Indirect taxes - subsidies
(iii) Net National Product (NNP):Net National Product is the market value, which is found after the deduction of depreciation from
Gross National Product. Various types of capital goods and machines are used in the production
process to produce goods and services, they wear out, and their value fall while they are used in
production. These wear out is called depression or capital consumption allowance. So, it should
be deducted to replace new capital stock and machines after its lifetime. From this way, Net
National Product can be estimated.
NNP at market prices and factor cost
NNP measured at the actual market price is called NNP at market price whereas NNP measured
as the sum of price paid to the all factors of production in form of wages, profits, interest and rent
for their contribution in production is called NNP at factor cost where net factor income from
abroad is also included. Hence, the net indirect taxes should be deducted from NNP at market price
to calculate NNP at factor cost. Symbolically,
NNPMP = GNPMP − Depreciation
NNPFC = NNPMP − Net Indirect taxes
(iii) National Income (NI):National income is the total sum of earning of all factors of production in the firm of wages, profits,
rent and interest plus net factor income from abroad. In other words, national income means this
sum of all incomes earned by domestically owned factors of production for their contribution in
the production of goods and services. There are four factors production: land labor, capital and
organization. These factors of production receive factor reward in the form of rent, wages, interest
and profit respectively. The sum of these factor rewards earned within country gives NDP at factor
cost. When we sum up net factor income from abroad, we get GNP at factor cost. It is converted
to NI by deducting depreciation. The different stages of calculation NI are as follows:
Factor income method measuring NI
NDPFP = W + R + I + P
Where,
W = wages and salaries
R = Rent
I = interest
P = Profit
NNPFc = NDPFC + Net factor income from abroad
NI = NNPFC
Product method measuring NI
GDPMP = P1Q1 + P1Q1 + P1Q1 + .......... ... + PnQ n
NNPMP = GNPMP − Depreciation
GNPMP = GDPMP + Net factor income from abroad
NNPFC = NNPMP − Net indirect Taxes
NI = NNPFC
(iv) Personal Income (PI):Personal Income is that income, which is received by persons within a country in a particular year.
Symbolically,
PI = NI - (CI T + UC P + SS C ) + TP
Where,
PI = Personal Income
NI = National Income
CIT = Corporate Income Tax
UCP = Undistributed Corporate Profit
SSC = Social Security Contribution
TP = Transfer of Payment
Person has to pay corporate tax to the government, which is not included in Personal
Income. It should be deducted from National Income to get Personal Income. In the same way,
Undistributed Corporate Profit is not received by persons. So it should be deducted from National
Income to get Personal Income. Person has to provide provident fund and Social Security
Contribution, which is not received by a person. So, it should be deducted from National Income
to get Personal Income. Government provides Transfer of Payment to the person in the form of
old age pension, unemployment relief payment, which is received by person. So, it should be added
with National Income to get Personal Income.
(v) Disposable Income (DI): Disposable Income is found after the deduction of direct tax from Personal Income. In other
words, the total income received by all individuals and households of a country from all possible
sources after payment of direct taxes is called disposable income. Disposable income is equal to
personal income minus direct taxes. Symbolically,
DI = PI - DT
Where,
DI = Disposable Income
PI = Personal Income
DT = Direct Taxes
Disposable income is available for households and persons for consumption. However, the total
disposable income is not spent only on consumption because a part of it is saved. Thus,
DI = C + S
Where,
DI = Disposable Income
C = Consumption
S = Saving
(v) Per capita Income (PCI): The average income of the people of a country in a particular year is called per capital income of
that year. Per capital income is expressed at the current prices. In order to find the per capital
income, national income of a country in a particular year is divided by population of the country
in that year.
National Income For 2014
Per capita income for 2014 =
population for2014
The per capital income concept enables us to know average income and living standard of the
people. But it is not very reliable because in every country due to unequal distribution of national
income, a major part of it goes to the richer sections of the society and thus income received by
common people is lower than the per capita income.
Numerical Examples
Example No 1
Items
Rs. In Crore
GDP at Market Price
2,000
Net indirect taxes
50
Depreciation
400
Net factor income from abroad
500
Undistributed profit
150
Corporate income Tax
50
Transfer payments
100
Social security contribution
20
Personal taxis
200
Personal consumption expenditure
1,500
Find GDP at market price, GNP at market price, NI, PI, DI and PS.
Solution:
GNPMP = GDPMP + Net factor income from abroad
GNPMP = 2,000 + 500
GNPMP = Rs.2,500 Crore
NI = GNPMP − Net Indirect Taxes - Depreciation
NI = 2,500 − 50 − 400
NI = Rs.. 2,050 Crore
PI = NI - (UC P + CI T + SS C ) + TP
PI = 2,050 - (150 + 50 + 20) + 100
PI = Rs. 1930 crore
DI = PI - Personal taxes
DI = 1930 − 200
DI = Rs. 1730 crore
Personal Saving = DI − Personal consumption expenditur e
Personal Saving = 1730 − 1500
Personal Saving = Rs.230 Crore
Hence,
GNPMP = Rs.2,500 Crore
NI = Rs.. 2,050 Crore
PI = Rs. 1930 crore
DI = Rs. 1730 crore
Personal Saving = Rs.230 Crore
 Nominal GDP, Real GDP and GDP Deflator
Nominal GDP and Real GDP
Nominal GDP is defined as the GDP evaluated at current market prices.
Real GDP is defined as the GDP evaluated at the market prices of a particular year on the basis of
any base year. The real GDP is the value of dividing the nominal GDP by the GDP deflator and
multiplying it by 100. The formula to calculate real GDP is as follows:
Real GDP =
Nominal GDP
 100
GDP Deflator
GDP Deflator
GDP deflator measures relative changes in current prices in comparison to the prices in the base
year. It is the ratio of nominal GDP in a given year to real GDP of that year. The following formula
is used to calculate GDP deflator.
Nominal GDP
GDP Deflator =
 100
Real GDP
To calculate GDP Deflator, the information of Nominal GDP and Real GDP are required. We can
calculate real GDP from the nominal GDP. It can help to provide a more accurate picture of the
gross domestic product in the country. The GDP deflator is used as a measure of change in the
prices of goods and services produced within the nation. The rate of inflation between any two
periods can be calculated on the basis of GDP deflator. The formula to calculate rate of inflation
by GDP deflator is as follows:
Rate of Inflation =
Change in GDP Deflator
 100
GDP Deflator of previous Year
Example
The hypothetical values nominal and real GDP are given in the following table:
Year
Nominal GDP
Real GDP
2009/2010
470,269
208,481
2009/2010
542,691
209,621
2009/2010
618,961
220,489
2009/2010
719,548
233,805
2009/2010
843,294
249,903
Derive the value of GDP deflator and rate of inflation
GDP Deflator
(%)
-
GDP Deflator for the year 2009/2010 =
Nominal GDP of 2009/2010
 100
Real GDP of 2009/2010
GDP Deflator for the year 2009/2010 =
470,269
 100
208,481
GDP Deflator for the year 2009/2010= 225.56
Similarly,
GDP Deflator for the year 2010/2011=
Nominal GDP of 2010/2011
 100
Real GDP of 2010/2011
GDP Deflator for the year 2010/2011=
542,691
 100
209,621
GDP Deflator for the year 2010/2011= 258.89
Rate of inflation
(%)
-
Rate of Inflation for the year 2010/11=
Change in GDP Deflator
 100
GDP Deflator of previous Year
Rate of Inflation for the year 2010/11=
258.89 - 225.56
 100
225.56
Rate of Inflation for the year 2010/11= 14.77
Similarly, we can calculate GDP Deflator of other years. We can show GDP deflator and rate if
inflation in the following table:
Year
Nominal GDP
Real GDP
2009/2010
2009/2010
2009/2010
2009/2010
2009/2010
470,269
542,691
618,961
719,548
843,294
208,481
209,621
220,489
233,805
249,903
GDP Deflator
(%)
225.56
258.89
280.72
307.75
337.44
Rate of inflation
(%)
14.77
8.43
9.62
9.64
 Computation of National Income
Production of goods and services gives rise to income: income gives rise to demand for goods and
services: demand gives rise to expenditure: and expenditure gives rise to further production. Thus,
there is circular flow production, income and expenditure. Based on three related flows national
income can be measured by three methods:
There are three methods of measurement of National Income. They are explained below
respectively.
(i) Product Method: This method is very easy and simple methods to measure National Income (NI). First of all, Gross
Domestic Product (GDP) is estimated to measure National Income (NI) and the Gross Domestic
Product (GDP) is the total market value of production of all final goods and services produced in
different sectors of economy within a country in particular year. When net income received from
foreign countries is included with Gross Domestic Product (GDP), and then it will be Gross
National Product (GNP). When depreciation is deducted from Gross National Product (GNP), then
it will be Net National Product (NNP). When net indirect taxes are deducted from Net National
Product (NNP), then it will be National income (NI) in real sense. The computation of National
Income by product method can be cleared by following table.
Table No- 9.1: Measurement of National Income By Product Method
Sectors
Net contribution to NI
1. Agriculture sector
8000
2. Industrial sector
684
3. Manufacturing industry
63
4. Services
864
Gross Domestic Product(GDP)
9611
+ Net Income Received from abroad
+105
Gross National Product(GNP)
9716
Depreciation
-445
Net National Product(NNP)
9271
Net Indirect Tax
-150
Net National product at Factor Cost (NNPFC)
9121
Components of National income while measuring National Income by product method
i. final products of Agriculture Sector
ii. final products of industrial Sector
iii. Final product of manufacturing industry Sector
ix. Service Sector
This method is common in many countries but there is more possibility of double counting. Double
counting means certain items are counted more than once while calculating national income. It
leads to over estimation of NI. To avoid the double counting, following two methods are used.
1. Final product Method
In the final product method, national income is estimated by finding the market value of all final
goods and services produced in an economy in a year. It means that the value of intermediate
product should be excluded from the measurement of NI. But it is very difficult to avoid the double
counting because same product is used as the intermediate goods by firms and final goods by
households.
The market value of all final goods and service produced by Agriculture, industry, trade and
services within the country in a year is calculated which is known as GDP at market price.
GDPMP = P1Q1 + P1Q1 + P1Q1 + .......... ... + PnQ n
n
GDPMP =  Pi Q i
I =1
Where,
P = Price of the respective goods and services
Q = Quantity of goods and services
By adding the net factor income from abroad to GDP at MP, we get GNP at MP
GNPMP = GDPMP + Net factor income from abroad
In order to get NNP at MP, depreciation is deducted from GNP at MP
NNPMP = GNPMP + Dep.
Further deducting net indirect taxes from NNP at MP, we obtain NNP at factor cost which is
national income.
NNPFC = NNPMP − Net indirect Taxes
NI = NNPFP
(b) Value Added Method: In this method, net income is included in the measurement of National Income (NI). The difference
between the value of the output and value of input is called Gross valued added. Only the value of
the final product is added in each stage of production till it reaches in the hands of consumers. It
can be cleared by following example.
Table No – 9.2: Value Added Method
Production
Farmer
Miller
Baker
Stage of Production
Value of output
Output(Rs. )
Cost of intermediate
goods (Rs. )
GrossValue added
(Rs. )
wheat
100
100
Flour
150
100
50
Bread
250
150
100
Total
500
250
250
In the above example, there are three producing units, i.e., farmer, miller, baker. The farmer
produces wheat without incurring any cost and sells same to the miller for Rs. 10. The miller
produces flour from wheat and sells it for Rs. 150 to the baker. The value added by miller, therefore
is equal to 50. The baker makes bread with flour and sells it to the consumer for Rs. 250.
Accordingly, the value added by baker is Rs. 10. Thus the total value added is equal to Rs. 250
which is equal to the value of final product i.e., bread. This method is used to avoid the problem
of double counting.
The sum of net value added in all sectors of an economy gives NDP at factor cost. NDP at factor
cost plus net indirect taxes and depreciation gives GDP at market price. The various steps in the
calculation of NI by value added method is given below:
Net Value Added = Gross Value Added - Depreciation
NDPFC = Sum of net value added in all sectorsof an economy
NNPFC = NDPFC + Net factor income from abroad
NI = NNPFC
Alternative method,
GDPMP = Net Value Added + Depreciation + Net indirect taxes
GNPMP = GDPMP + Net factor income recived from abroad
NNPFC = GNPMP − Depreciation - Net inderect taxes
NI = NNPFC
Example
Components of NI
Gross value added in the primary sector at factor cost
Gross value added in the secondary sector at factor cost
Gross value added in the tertiary sector at factor cost
Depreciation
Net indirect taxes
GDP at market price
Net Factor income from Abroad
GNP at market price
(less) Depreciation
(less) Net indirect tax
NNP at factor cost or National income
Rs. In Crore
2,000
+1,100
+1,000
+500
+700
=5300
+100
=5400
-500
-700
=4200
Example: Calculate GDP at MP, GNP at MP, NNP at MP and NI (NNP at FC) from the following
data:
Components of NI
Rs. In Crore
Intermediate consumption of
Primary sector
500
Secondary sector
400
Tertiary sector
300
Value of output of
Primary sector
1000
Secondary sector
900
Tertiary sector
700
Net factor income for Abroad
-20
Consumption of fixed capital (Depreciation)
40
Net indirect taxes
10
GDPMP = Value Added by primary sector + Value Added by secondary sector + Value Added by tertiary sector
GDPMP = (1,000 − 500) + (900 - 400) + (700 - 300)
GDPMP = 500 + 500 + 400
GNPMP = GDPMP + Net factor income from abroad
GNPMP = 1,400 − 20
GNPMP = Rs. 1,380
NNPMP = GNPMP − Consumptio n of fixed capital
NNPMP = 1,380 − 40
NNPMP = Rs.1,330 Crore
Example:
Let, there are only three producing companies, i.e. wheat farm, textile industry and noodle industry
in a hypothetical economy in order to produce wheat, cloth and noodles respectively.
Following figures related to output, generated from these companies in that economy during a
year.
Quantity
Price
Amount
(Units)
(Per unit)
(In Rs.)
Wheat
10,000
800
Noodles
13,000
1,100
Cloth
18,000
200
Raw materials used by all companies
200,000
Depreciation
30,000
Indirect business taxes
25,000
Net receipts(R-P)/Net factor income from Abroad
40,000
Subsidies
15,000
Compute GDP at MP, GNP at MP and NI.
GDPMP = Vlaue of output - Value of raw materials used
GDPMP = P1Q1 + P1Q1 + P1Q1 - Value of raw materials
GDPMP = (10,000  800) + (18,000 200) + (13,000 1,100)P1Q1 - 200000
GDPMP = 8,000,000 + 3,600,000 + 14,300,000 - 200,000
GDPMP = Rs. 25,700,000
GNPMP = GDPMP + Net factor income from abroad
GNPMP = 25700000+ 40000
GNPMP = 25740000
NNPMP = GNPMP − Depreciation
NNPMP = 25740000− 30000
NNPMP = Rs. 25710000
NI = NNPFC = NNPMP - Net Indirect taxes
NI = NNPFC = NNPMP - (Indirect taxes - Subsidies )
NI = NNPFC = 25710000− (25000 − 15000)
NI = NNPFC = 25710000− 10000
NI = NNPFC = Rs.25700000
(2) Income method: Income method measures national income from the side of factor income. This method is also
known as the factor payment method. According to this method, the incomes received by all the
residents of a country for their productive services during a year are added up to obtain national
income. Thus, income method consists of income earned by all factors of production in the form
of wages and salaries, interest, rent and profit. All these incomes earned by individuals and
households are summed up to calculate NDP at FC. When factor income earned from abroad is
added to NDP at FC then we get NNP at FC. This method measures NDP at FC from distribution
side. NDP can be computed by summing up the incomes received by factors of production. NNP
at FC is the sum of the payment made to or income received (i.e., wages rent, interest and profit)
by the factor of production plus net factor income from abroad. The remaining two items of
payments-indirect business taxes less subsidies and depreciation are categorized as nonincome(expense) items, which are summed up to get gross income at market price.
NDPFC = wages and salary + Rent + interest + profit + income from self emplyment
NNPFC = GNPFC + Net factor income from abroad
NI = NNPFC
Alternative method
GDPMP = wages and salary + Rent + interest + profit + income from self emplyment + Depreciation + Net indirect taxes
GNPMP = GDPMP + Net factor income from abroad
NI = NNPFC = GNPMP − Depreciation - Net indirect taxes
The following hypothetical table shows how national income is calculated by income method:
In this method, the income of factors of production, the income from self-employed, indirect taxes
and depreciation are included to measure Gross Domestic Income (GDI). After them, net income
received from abroad is added with gross Domestic Income to find Gross National Income (GNI).
The capital depreciation is deducted from Gross National Income (GNI) to find Net National
Income (NNI). It can be cleared by following table:
Components of NI
Wages and salaries … … … … … … … … … … …
Interest
… … … … … … … … … … … … …
Rents … … … … … … … … … … … … … …
Profits (profit tax, dividend, undistributed profit) … … … … …
Mixed income of the self-employed … … … … … … …
Depreciation
… … … … … … … … … … … …
Net indirect taxes
… … … … … … … … … … …
GDP at market price … … … … … … … … … … …
Net factor income from abroad
… … … … … … … …
GNP at market price … … … … … … … … … … …
(less) Depreciation
… … … … … … … … … … …
Net indirect taxes
… … … … … … … … … … …
NNP at factor cost
… … … … … … … … … … …
Rs. In Crore
1500
150
100
350
2000
500
700
5300
100
5400
-500
-700
4200
The important elements or components in the calculation of national income by income
method are as follows:
i. Wages and salaries: wage and salaries earned through productive activities by labor and
employees are included in the national income. It included all forms of remuneration for work like
bonuses, commissions, payments all kinds, incentive payments, employers contribution to social
security etc. The total sum of income earned by labor and employees is also called compensation
of employees that is the sum of wages and salaries and employer’s contribution to the social
security or provided funds, insurance etc.
Compensation of employees = Wages and salaries + Employers contribution to social security + Bonus +Money value of other facilities.
ii. Rent: Total rent includes the rents of land, shop, house, factory, etc. Rent received from land,
building, factory etc. are included in national income. Income earned by persons for the use of
their real property such as a house, store or farm is rent. This component also includes the estimated
rent value of owner-occupied dwellings and royalties received by persons from patents, copyrights
and rights to natural resource.
iii. Interest: Interests received from the capitals are included in the national income Interest is
expressed in net rather than gross terms. It represents the business sector’s total interest payments
to other sectors minus their total interest payments to the business sectors. All other types of
interest payments between individuals, between businesses and between government and
individuals are considered unproductive and hence fare omitted from the calculation of GDP.
iv. Profits:
a. Dividends: - Dividends earned by the shareholders from companies are included in the GDP.
b. Undistributed corporate profits: profits, which are not distributed by companies, are included
while measuring national income.
c. Profit tax: Profit tax paid by all corporations, businessmen from their profit is also included
while measuring GDP.
Profit = Undistributed profit +Dividend + Corporate income tax
v. Net indirect taxes: Net indirect tax is equal to indirect taxes less subsides. Government imposes
different type of indirect tax like excise duties, sales tax, value added tax (VAT) etc which is paid
by businesspersons. The final burdens of such taxes are borne by final consumer in the form of
higher prices. In the same way, government provides subsidies to different types of product
produced by different firms. The positive different between indirect tax and subsidies is called Net
indirect tax which is included while measuring GDP.
vi. Net income from abroad: The net factor income from abroad is included in the national
income. Net income from abroad is equal to income-received by citizens of a country from abroad
less income paid to the foreigners. It is added to GDP to get GNP.
vii. Depreciation: The depreciation amount is deducted to get net income i.e., net national product
(NNP). Depreciation is the wear and tear of fixed assets and machineries.
viii. Mixed income or income from self-employment: income earned by self-employed persons
or profit of small business or sole proprietorship or household industries is included in national
income. *
The following incomes are not considered as income so they are excluded from NI:
i. Amount received from the sale of second hand goods such as buildings, automobiles or any other
goods produced in an earlier time period.
ii. Amount received from sale of stocks or bonds.
iii. Amount received form the government in the form of transfer payment because recipients
provide no goods or service in exchange.
Income received by people from other individuals for which no productive service is provided.
This approach is not possible to use in developing countries like Nepal because of statistical
measurement problem.
(3) Expenditure Method: Generally, economy is divided into four major sectors: household, government business and
foreign. These are the major markets for the output of an economy. GDP at market price is the sum
of total final expenditures made by households as private consumption expenditure, government
as government expenditure, business as private investment expenditure and foreign sectors as net
export on final output during a particular year.
The total income generated to the economy is spent either on consumer goods or on capital goods.
Net export equals to total exports minus total imports. Export of goods from nation to foreigners
gives income to nation. Import of goods from foreign countries to nation means expenditure on
foreign goods. Thus, we add up the above four types of expenditures to get final expenditures on
gross domestic product at market prices. When net factor income from abroad is summed up to
GDP at market price, the GNP at market price can be obtained. GNP at market price can be
converted into NNP at market price by deducting depreciation from GNP. NNP at factor cost can
be obtained by deducting net indirect tax from NNP at market price. At the last, NNP at factor cost
is the national income. The calculation of national income by the method involves following steps:
GDPMP = C + I + G + (X − M )
GNPMP = GDPMP + Net income received from abroad
NNPMP = GNPMP − Depreciation
NNPFC = NNPMP − Net indirect Taxes
NI = NNPFC
Where, C=private consumption expenditure
I = Private investment expenditure
G = Government expenditure
X = Export
M = Import
X-M = Net export
The following hypothetical example shows how national income is calculated by expenditure
method:
Components of NI
Rs. In crore
Private final consumption expenditure
3500
Private investment on final goods and services
1000
Government final consumption expenditure
600
Net export
-100
Change in stock
300
GDP at market price
5300
Net factor income from abroad
100
GNP at market price
5400
(less) Depreciation
-500
NNP at market price
4900
(Less) Net indirect taxes
-700
NNP at factor cost or National income
4200
The components of national income in expenditure method are as follows:
(i) Personal consumption expenditures: It refers to as simply consumption expenditure. This
component consists of expenditures on consumer goods and services like food, clothing,
appliances, automobiles, medical care, recreation etc.
(ii) Gross private domestic investment: this component includes total investment spending by
business firms. Generally, investment is considered as buying stocks, bonds or other assets with
the intention of receiving an income or making a profit. But in economics, investment means
addition to capital stock in particular period.
Gross private domestic investment (I) = Net investment (Net capital formation) +
Depreciation + Change in stock
Change in stock (Inventories) = Closing stock – Opening stock
(iii) Government expenditure: Government expenditure includes government expenditures on
security, administration, infrastructure development and other government purchase etc. However,
the transfer payments are omitted because they do no represent part of current output of goods and
services.
(iv) Net exports of goods and services: some domestic expenditure is made to purchase foreign
goods and services which is known as the import. On the other hand, some foreign expenditure is
made to purchase domestic goods and services which is known as the export. To measure GDP
at MP in terms of total expenditures, we must include the value of exported goods and services.
Then we subtract the value of imported goods and service from out total expenditures. Hence, net
exports equals to total exports less total imports.
What is to be excluded under the heading of expenditures?
(i) It must exclude expenditure on previously produced goods.
(ii) It must also exclude all expenditures for the purchase of used assets.
(iii) It must exclude purchase of financial assets such as stock and bonds.
(iv) It must also exclude transfer payment.
(v) It must exclude expenditures on intermediate goods, such as fertilizer and seed by farmers
should be excluded.
Example: Calculate GDP at MP, NDP at FC, GNP at MP, NNP at FC and NI from the following
hypothetical national income data:
Items
Private final consumption expenditure
Government final consumption expenditure
Gross domestic capital formation
Opening stock
Closing stock
Net indirect taxes
Imports
Exports
Depreciation
Net factor income from abroad
Net export = Export - Import = 20 - 15 = 5
Net export = 20 - 15 = 5
Change in stock = Closing stock - Opening stock
Change in stock = 30 − 20
Rs. in crore
300
100
120
20
30
50
15
20
20
75
GDPMP = C + G + I + (CS − OS ) + (X - M)
GDPMP = 300 + 120 + 100 + 100 + 5 + 10
GDPMP = Rs. 535 Crore
NDPFC = GDPMP - Dep. - Net indirect tax
NDPFC = 535 − 20 − 50
NDPFC = Rs.465
GNPMP = GDPMP + Net factor income from Abroad
GNPMP = 535 + 75
GNPMP = Rs. 610
NNPFC = GDPMP - Net indirect tax - Dep
NNPFC = 610 - 50 - 20
NNPFC = Rs. 540
NI = Rs. 540
Example
Items
Private final consumption expenditure (C)
Government final consumption expenditure (G)
Gross domestic capital formation (I)
SO - SC = Change in Stock
Export –Import (X – M)
GDP at MP
Rs. in Crore
300
100
120
30-20 = 10
20 – 15 = 5
535
Net factor income from abroad (NFIA)
GNPMP
Depreciation
NNPMP
Net indirect taxes
NNPFC
75
610
20
590
50
540
Difficulties in the Measurement of National Income
Followings are the difficulties in the measurement of national Income:
(i) Definition of the term of Nation: - The term ‘Nation’ is defined by geographical or political
boundary which creates the confusion in the measurement of national income because the concept
of national income crosses political boundary and it includes the net income received by abroad.
(ii) Methods to be used: - There are various methods of measuring national income. So, it crates
the confusion that which method is to be used to measure national income. According to some
economists, the selection of appropriate method to measure national income is based on the
availability of data.
(iii) Stage of economic activity: - Some goods and services are produced in final form after the
passing various stages of production. For example, bread is produced after the production of wheat,
flour and so on which create the double counting in the measurement of the National Income but
this problem can be solved by using final product method and Value Added Method.
(iv) Types of goods and services: - There are various types of goods and services. Some goods
are exchanged in the market by money and some goods are not exchanged in the market rather it
is used by producers themselves. So, it creates the confusion that which types of goods are to be
included into national income.
(v) Problem of double counting: - The problem of double counting has to be faced while
measuring National Income. It can be solved by final product method. But sometimes, it is very
difficult to distinguish whether goods are final or intermediate. For example, tobacco is used by
person directly, then it is considered as final goods but when it is used to produce cigarette, then it
is intermediate goods, which creates the problems in the measurement of National Income.
(vi) Transfer of payment: - One of the confusion may be generated in the measurement of
National Income that whether transfer of payment is to be included or not into National Income.
The old age pension and unemployment relief payment are the examples of transfer of payment.
But it is paid by the government on the basis of collection of taxation. So, it is redistribution of
income by government. Some economists have suggested that transfer of payment should not be
included in the measurement of National Income.
(vii) Income generated by foreign firms: - One of the main problem in the measurement of
National Income is that whether the income generated by foreign firms are to be included or not.
Foreign firms are using the labor and raw materials in local level or local area. So, they are paying
wage and price to the local area. So income generated by foreign forms is to be included but profit
of such forms should be deducted while measuring National Income.
(viii) Public services: - Government is providing public services like general administration,
police, and army and so on. These services are not concerned with production sector. So, it creates
the difficulty in the measurement of National Income that they are to be included or not in National
Income.
(ix) Calculation of depreciation: - The depreciation should be deducted from Gross National
Product to measure net national product but the calculation of depreciation of capital goods are
very difficult task in the measurement of national income. Because there are various types of
capital goods used in the production process. They are durable and their values and lifetime are
different. In this situation, the value of correct depreciation cannot be estimated.
(x) Change in the value of money: - The value of money is measured by index number. The price
of goods and services are increasing time to time. So, value of money is also changing time to
time. In this situation, there is difficulty in the measurement of National Income.
(xi) Income from illegal activities: - The data of income from illegal activities are not available.
So, it creates difficulty in the measurement of National Income.
Some additional difficulties, which developing countries have to face in the measurement of
National Income, are as follows:
(xii) Large non-monetized sector: - In developing countries, there are large non-monetized
sectors. Most of the goods and services are exchanged by the help of barter system. They are not
marketed. Some goods are kept by producer themselves. In this situation, there is difficulty to
estimate value of such goods and service while measuring National Income.
(xiii) Inadequate and unreliable statistics: - In the developing countries, there is lack of adequate
statistics and the available statistics are not reliable due to lack of expert. So, there is difficulty in
the measurement of National Income.
(xiv) Illiteracy and ignorance: - In the developing countries, majority of people are illiterate and
ignorance. So, they cannot keep the record of production, income and expenditure accurately. So,
they cannot provide accurate information which is the main difficulty in the measurement of
National Income in developing countries.
(xv) Less occupational specialization: - There is less occupational specialization in the
developing countries. The different works are done by same person to earn income as farmers,
carpenters, labor and so on. Hence, the data of income are available from different sources. So,
accurate measurement of National Income is not possible.
 National Income at Current Price and Constant Price
Generally, National Income is measured on the basis of current market price and it is very useful
to evaluate the economic condition of that year in which National Income is measured. But
sometimes, it is not helpful to compare the economic condition of different years from the annual
National Income measured by current price of corresponding year because the value of money is
changing time to time and year to year. For the comparison of economic conditions of different
year by National Income of different year, the National Income must be measured by constant
price. For the measurement of National Income by constant price we have to take help of price
index number. The price index number is helpful to measure the change in the value of money. It
can be cleared by following table.
Table No-9: Nation Income at Current Price and Constant Price
Year
Gross National Income(GNI)
Price index number
Current price
Change
500
1997
500
100
 100
1998
620
104
1999
700
115
2000
750
160
100
620
 100
104
700
 100
115
750
 100
160
Gross National Income
at constant price
500
596.15
808.69
468.75
In this table, National Income at current price is increasing year to year. On the basis of this data
it can be said that the economic condition is going up in the economy. But it is not fair because the
table shows that the price is increasing from 1997 to 2000 measured by price index number. On
the basis of this price index number, National Income is increasing from 1997 to 1999 but it is
decreasing from 1997 to 2000. It proves that the National Income at current price is increasing
year to year due to inflation.
 Need/Importance of National Income Accounting
i. Indicator of economic stricture: The national income accounting is very important to
understand the contribution of various sectors to national income. It provides the knowledge of
sources of income of people and expenditure pattern in the economy. So, the estimation of National
income is considered as an important index of the economic structure of the economy.
ii. Indicator of economic welfare and international comparison: National income figures are
considered as an indicator of the people’s welfare of a country. By the help of national income
figures, it can be compared the standard of living of the people living in different countries. In the
same way, it can be compared the standard of living of the people living in the same country at
different times.
iii. Helpful to formulate economic policy and planning: National income presents the level of
aggregate economic activity in the economy. Its estimates are the important tools for economic
planning and policies. On the basis of these estimates, the government makes future plans and
policies for the development and growth of the country.
iv. Inflationary and deflationary gaps: National
income estimates provides information about
30
the existence of inflationary and deflationary gaps in the economy. They are also helpful in
formulating anti-inflationary and anti-deflationary policies.
v. Basis of budgetary policies: Modern governments prepare their budgets on the basis of national
income data and make necessary changes in taxation and borrowing policies so as to avoid
fluctuations in national income.
vi. Importance in defense and development: National income estimates enable us to determine
the proper allocation of national product between defense and development of the economy. It tells
us how much of the national income can be spared for war purposes.
vii. Provision of depreciation: National income studies show as to how national income is divided
into consumption expenditure and investment expenditure. It further guides us to make provision
for reasonable depreciation to maintain the capital stock of the country. Inadequate depreciation
allowance means living at the expense of capital, while excessive depreciation allowance leads to
unnecessary reduction in consumption.
viii. Importance in developing countries: National income data are particularly important for
developing countries like Nepal. They throw light on the importance and backwardness of various
sectors of these economies and help in formulating appropriate economic policies.
ix. Basis of social accounting: National income figures form is the basis of social accounting or
national income accounting. Social accounts are the systematic records and presentation of
national income data. The objective of social accounting is to signify the interrelations among
various constituents of national income statistics.
x. Importance in economics analysis: National income estimates help us in analyzing the
functioning, growth and anatomy of the economy. They are important in analyzing (a) the growth
of the economy, (b) the trend of various sectors, (c) the trends of factor shares, and (d) the trend
of various macro variables, such as, aggregate consumption, aggregate investment, and aggregate
saving, etc.
 Worked Out Examples
QN. 1: If GDP at MP is Rs. 3500 crore, indirect taxes are Rs. 500 crore and subsidies are
Rs. 200 crore, find out GDP at FC.
Solution:
GDPFC = GDPMP - Net indirect tax
GDPFC = GDPMP - (Indirect tax - subsidies)
GDPFC = 3500 - (500 - 200)
GDPFC = 3500 - 300
GDPFC = 3200
QN. 2: Calculate NDP of FC from the following data:
GDP at MP … … … …
Rs. 2,500 Crore
Depreciation … … …
Rs. 250 Crore
Net indirect taxes … … … Rs. 375 Crore
Solution:
NDPFC = GDPMP - Depreciation - Net indirect tax
NDPFC = 2,500 − 250 − 375
NDPFC = Rs. 1875 Crore
QN. 3: Calculate GNP at MP when GDP at MP is Rs. 5000 crore and net factor income
earned from abroad is Rs. 500 crore.
Solution:
GNPMP = GDPMP + Net Factor income from Abroad
GNPMP = 5000 + 500
GNPMP = Rs. 5500 crore
QN. 3: calculate NI from the following data:
GDP at MP…………………………….
Rs. 2,500 crore
Net factor income from Abroad ………
Rs. 500 crore
Depreciation …………………………..
Rs. 300 crore
Indirect taxes ………………………….
Rs. 250 crore
Subsidies ……………………………...
Rs. 50 crore
Solution:
NI = GDPMP + Net Factor income from Abroad - Depreciation - (Indirect tax - Subsidies )
NI = 2500 + 500 − 300 − (250 − 50 )
NI = 2500 + 500 − 300 − 150
NI = 3000 − 450
NI = Rs. 2550 crore
QN. 4: Calculate personal income from the32following hypothetical data:
National Income (NI)………………
Rs. 5000 million
Undistributed corporate profit ………
Rs. 200 million
Corporate income tax ………………
Rs. 300 million
Social security contribution…………
Rs. 300 million
Transfer payment ……………………
Rs. 250 million
Solution:
PI = NI - UCP - CIT − SSC + TP
PI = 5000 - 200 - 300 − 300 + 250
PI = Rs. 4450 million
QN. 5: Calculate total private saving of an economy when personal income is Rs. 4450
million, personal income taxes are Rs. 750 million and total private consumption expenditure
Rs. 3500 million.
Solution:
Given, PI = Rs. 4450 million
Personal income tax = Rs. 750 million
Private consumption expenditur e = Rs. 3500 million
Then
DI = PI - Personal income taxes
DI = 4450 − 750
DI = Rs. 3700 million
Private saving (S) = DI − Private consumption (C )
Private saving (S) = 3700 − 3500
Private saving (S) = Rs. 200 million
QN. 6: Calculate GDP deflator when real GDP is Rs. 1201 crore and nominal GDP is Rs.
1878.4 crore.
Solution:
Given, Real GDP = Rs.1201crore
Nominal GDP = Rs.1878.4 crore
GDP deflator =
Nominal GDP
 100
Real GDP
GDP Deflator =
1878.4
 100
1201
GDP Deflator = 156.40
QN. 7:
Calculate real GDP from the following hypothetical data:
GDP Deflator …………………….. 112.6
Nominal GDP ……………………. Rs. 1740.2 crore
Solution:
33
Nominal GDP
Real GDP =
 100
GDP deflator
1740.2
Real GDP =
 100
112.6
Real GDP = Rs.1545.47
QN. 8: Find the net value added in the government sector from the following data:
Value of service sold ……………...
Rs. 100 crore
Value of service supplied ………… Rs. 1000 crore
Intermediate consumption ………..
Rs. 200 crore
Solution:
Value of output in government sector = Value of service sold + Value of service supplied
Value of output in government sector = 100 + 1000
Value of output in government sector = Rs.1100
Net Value added = Value of output - Intermediate consumption - Depreciation
Net Value added = Rs.1100 - 200 - 0
Net Value added = Rs. 900 crore
(Note: Depreciation of service is assumed to be zero)
QN. 9: Calculate the value added and net value added at market price and net value added at factor
cost also.
Items
Rs. in Million
Subsidies
10
Sales
100
Closing stock
100
Indirect taxes
50
Intermediate consumption
300
Opening stock
200
Consumption of fixed capital
150
Solution:
Value of output at MP = Sales + Change in stock
Value of output at MP = Sales + (Closing stock − Opening stock)
Value of output at MP = 1000 + (100 − 200)
Value of output at MP = Rs.900 million
Net Value added at MP = Value of output - Intermediate consumption - Consumption of fixed capital
Net Value added = 900 − 300 − 150
Net Value added = Rs.450 million
Net Value added at FC = Net value added at market price - (Indirect taxes - Subsidies )
Net Value added at FC = 450 - (50 - 10)
Net Value added at FC = 450 - 40
34
Net Value added at FC = Rs. 410 million
QN. 10: Calculate operating surplus from the following data:
Items
Rs. in Million
Rent
5000
Profits
3000
NDP at FC
36000
Interest
2000
Royalty
500
Operating surplus = Rent + Profit + Interest + Royalty
Operating surplus = 5000 + 3000 + 2000 + 500
Operating surplus = Rs.10500 million
QN. 11: Calculate the compensation of employees from the following data:
Items
Rs. in Million
Wages and salaries
3500
Employers’ contribution to social security scheme
400
Bonus
350
Employees subscription to provident fund
300
Value of free medical facilities to employees
600
Compensation of employees = Wages and salaries + Employers’ contribution to social security scheme + Bonus +
Value of free medical facilities to employees
Compesation of employees = 3500 + 400 + 350 + 600
Compesation of employees = Rs.4850 million
QN. 12: Calculate gross and net domestic capital formation form the following data.
Items
Rs. in Crore
Net indirect taxes
100
Opening stock
250
Net domestic fixed capital formation
1800
Closing stock
400
Consumption of fixed capital (Depreciation) 150
Change in stock = Closing stock - Opening stock
Change in stock = 400 − 250
Change in stock = Rs.150
Gross Domestic capital formation = Net Domestic capital formation - Consumption of fixed capital + Change in stock
Gross Domestic capital formation = 1800 + 150 + 150
Gross Domestic capital formation = Rs. 2100 crore
Net Domestic capital formation = Gross Domestic capital formation - Consumption of fixed capital
Net Domestic capital formation = 2100 − 150
Net Domestic capital formation = Rs.1950 crore
QN. 13: Calculate personal income (IP), disposable income (DI) and private saving from the
following hypothetical national income data:
35
Items
Rs. in Crore
Gross domestic product at market price
47005
Net indirect taxes (GDP at MP)
8344
Net factor income from Abroad
-232
Depreciation
4486
Current transfer payment to households
2305
Undistributed corporate profit
1200
Profit
3000
Dividend
1500
Social security contribution
1000
Personal taxes
3200
Private consumption expenditure
30000
GNPMP = GDPMP + Net factor income from Abroad
GNPMP = 47905 + (- 232)
GNPMP = Rs. 47673Crore
NI = NNPFC
NI = GNPMP - Net indirect tax - Depreciation
NI = 47673- 8344 - 4496
NI = Rs. 34843Crore
Corporate income (Profit)Tax = Profit - Dividend - Undistributed corporate profit
Corporate income (Profit)Tax = 3000 - 1500 - 1200
Personal Income (PI) = NI - Undistributed corporate profit - Corporate income tax - Social security contribution
+ Current transfer payments to households
Personal Income(PI) = 34843- 1200 - 300 - 1000 + 2305
Personal Income(PI) = Rs. 34648Crore
Disposable Income(DI) = PI − Personal Tax
Disposable Income(DI) = 34648 − 3200
Disposable Income(DI) = Rs.31448 Crore
Private saving = DI - Private consumption expenditur e
Private saving = 31448− 30000
Private saving = Rs.1448 crore
(Note: Profit = Dividend + Undistributed profit = Corporate tax)
Calculation of real GDP, nominal GDP and GDP deflator and inflation rate
QN. Consider that an economy produces two goods A and B in year 2012 as follows:
Commodity
2012
2013
Price (Rs.)
Quantity
Price (Rs.)
Quantity
Commodity A
60
1800
62
2000
Commodity B
200
384
2040
400
Assuming 2012 as base year, find:
a. nominal GDP and real GDP for 2010 and 2013
b. Inflation rate
UNIT – 3: CONSUMPTION, SAVING AND INVESTMENT
 Meaning of Consumption Function
Consumption is defined as an act of spending income for buying goods and services to satisfy
current human wants. Consumption means expenditure of income on goods and service at a
given level of income, whereas consumption function shows the schedule of different
consumption level at different level of income. Consumption depends upon the level of income.
There is close relationship between consumption and income and this relationship is positive.
Hence, the consumption function shows the close and functional relationship between income
and consumption The functional relationship between consumption and income can be expressed
as:
Where,
C = f (Y )
C = Consumption
Y = Income
C = Consumption
f = function
According to Keynesian Theory of consumption function, the consumption varies with the
variation of income. The consumption increases when the level of income increases but increase
in consumption is always less than the increase in income, which is called psychological law of
consumption by Keynes.
Keynes explains the short run consumption function as:
C = a + bY
Where,
C = Consumption
a = Autonomous consumption
b = Marginal propensity to consume
Y = Income
The autonomous consumption is that level of consumption, which is positive and not
affected by the level of income. It is constant at every level of income. The marginal propensity to
consume is assumed constant. The marginal propensity to consume is defined as the rate of change
in consumption due to change in income. The marginal propensity to consume (b) ranges from
more than zero and less than one. Symbolically,
0  b 1
Hence, the marginal propensity to consume is assumed positive fraction. The short run
consumption function shows the non-proportional relationship between consumption and income.
The Keynesian consumption function can be cleared by following table by assuming C = 50 +
0.5Y.
Table No – 3.1. Consumption function
Y
C
0
100
200
300
400
500
50
100
150
200
250
300
In this table, the consumption level is increasing at constant rate with the increase in income. It
means that the relation between consumption and income is linear. Here, the consumption is
increasing when the level of income increasing but not to the extent of increase in income.
The consumption function can be explained by the help of following diagram.
Fig-3.1. Consumption Function
C
Y=C
400
expenditure
Consumption
500
C
300
200
100
O
A
100
200
300
400
500
Y
Income
In this diagram, consumption is measured along vertical axis and income along horizontal
axis. The 450 line is guideline. At each point of this guideline, the income is equal to consumption.
The ‘C’ is consumption line, which is drawn on the basis of table which has positive slope which
means that the consumption level increases when the level of income increases. The ‘C’ line is
passing above the origin point. Therefore, there is non-proportional relationship between C and Y.
The APC declines on this consumption line when income increases. The C = Y at point A which
is called Keynesian wolf-point.
 Psychological law of Consumption Function
The psychological law of consumption was propounded by J. M. Keynes on his book named
‘General Theory’ published in 1936 A.D. According to Keynes, people have a tendency to increase
consumption level when the level of income increases but increase in consumption is always less
than increase in income, which is called psychological law of consumption by Keynes. In the
words of Keynes, “men are disposed as a rule and on the average to increase their consumption as
their income increases but not by as much as the increase in income”.
The psychological law of consumption is based on following proposition:
(i) When aggregate income increases, consumption expenditure also increases but by a smaller
proportion than income because when income increases, people are able to satisfy their wants side
by side, so that the need to spend more on consumer goods diminishes. In fact, consumption
expenditure varies positively with income, but not in the same proportion in which income
increases.
(ii) The increased income will be divided in some ration between saving and consumption, i.e.,
Y=C+S. It means that consumption and saving move together.
(iii) Increase in income always leads to an increase in both consumption and saving.
The three prepositions of the law can be described with the help of following schedule.
Table No – 3.2. Consumption function
Income
Consumption
Y
C
0
100
200
300
400
500
50
100
150
200
250
300
Saving =Income – Consumption
S=Y–C
-50
0
50
100
150
200
(i) In this table, the increase in income is per period by 100 and the increase in consumption is per
period by 50. Hence, increase in consumption is less than the increase in income.
(ii) The increased income in each stage is divided in some ratio between consumption and saving.
(iii) Both consumption and saving are increasing with the increase in income.
The psychological law of consumption can be cleared by following diagram.
C
Fig-3.2. Consumption Function
Y=C
400
expenditure
Consumption
500
E3
300
E2
200
100
O
C
C3
E1
100
Y1
C2
200 300
Y2 Y3
400
500
Y
Income
In this diagram, consumption is measured along vertical axis and income along horizontal axis.
The 450 line is guideline. At each point of this guideline, the income is equal to consumption. The
C is consumption line, which has positive slope and it means that the consumption level increases
when the level of income increases. The C line is passing above the origin point. Therefore, there
is non-proportional relationship between C and Y. The C = Y at point E which is called Keynesian
wolf-point When income increase from OY1 to OY2, consumption also increases from E1Y1 to
C2Y2. Here, consumption increases at less proportion than income, i.e., C2Y2 < E2Y2 and C1Y1 <
E3Y3. The slope of income line is more than slope of consumption line. It means that when income
increase, consumption also increases but at a less proportion than income.
When income increases from OY1 to OY2, it is divided in some proportion between
consumption Y2C2 and saving C2E2. It proves that increased income is divided into consumption
and saving.
Here, Y1E1 > Y2E2
Y3C3 > Y2C2
C3E3 > C2E2
It implies that when income increases both income and consumption also increase.
 Technical Attributes of Consumption Function
The consumption function has two technical attributes or properties. They are described as follows:
1. Average propensity to consume (APC)
The APC is defined as the ratio between consumption and income, i.e. C/Y. Symbolically,
APC =
Where,
C
Y
APC = Average Propensity to Consumption
C = Consumption
Y = Income
2. Marginal propensity to consume (MPC)
The MPC is defined as the rate of change in consumption due to change in income. Symbolically,
ΔC
MPC =
ΔY
Where,
MPC = Marginal Propensity to Consumption
C = Consumption
Y = Income
Marginal propensity to consume and average propensity to consume can be cleared by following
table.
Table No – 3.3. Consumption function
Y
C
MPC
APC
0
50
-

100
100
0.5
200
150
0.5
0.75
300
200
0.5
0.67
400
250
0.5
0.61
500
300
0.5
0.6
1
In this table, the consumption level is increasing with the increase in income but MPC is constant
at every level of income. The APC is declining with the increase in income. It means there is nonproportional relationship between consumption and income. The consumption increases when the
level of income increases but not to the extent of increase in income.
The consumption function can be explained by the help of following diagram.
Fig-3.3.Consumption Function
400
expenditure
Consumption
C
C
300
C3
200
C2
C1
100
A3
A2
A1
C
O
100 200 300 400 500
Y1 Y2 Y3 Income
Y
In this diagram, consumption is measured along vertical axis and income along horizontal axis.
The CC is consumption line, which has positive slope, which means that the consumption level
increases when the level of income increases. The CC line is passing above the origin point.
Therefore, there is non-proportional relationship between C and Y.
At point C1, APC = C1Y1/OY1, and MPC = C1A1/OY1
At point C2, APC = C2Y2/OY2 and MPC = C2A2/Y1Y2
At point C3, APC = C3Y3/OY3 and MPC = C3A3/Y2Y3
At point C1, C2, and C3, MPC are same because C1A1/OY1 = C2A2/Y1Y2 = C3A3/Y2Y3
At point C1, C2, and C3, APC are decreasing because C1Y1/OY1 > C2Y2/OY2 > C3Y3/OY3
 Relationship between APC and MPC
1. The APC is defined as the ratio between consumption and income, i.e. C/Y. The MPC is defined
as the rate of change in consumption due to change in income, i.e., C/Y. The MPC also reflects
the rate of change in APC.
2. The consumption function is linear and non-proportional. It means that consumption is positive
at zero level of income. MPC is constant at every level of income but APC declines with the
increase in income. The APC is always greater than MPC, so the slope of APC is always greater
than the slope of MPC. It can be justified by following diagram.
expenditure
Consumption
C
Fig-3.4. Consumption Function
C
C2
C1
C
O
Y1
Y2 Income
Y
In this diagram, the slope of consumption curve CC is constant at both points C1 and C2. The slope
of CC line refers to MPC. The slope of APC is the ray line from origin to any point on CC curve.
The slope of APC is declining from Point C1 to C2, i.e., C1/Y1 > C2Y2.
3. If consumption be linear passes through origin, both APC and MPC are equal and constant. It
can be cleared by following diagram.
Fig-3.5.Consumption Function
Consumption expenditure
C
C
C2
C1
O
Y1
Y
Y2
Income
In this diagram, the slope of consumption curve C is constant at both points C1 and C2. The slope
of C line refers to MPC. The slope of APC is the ray line from origin to any point on C curve.
The C line is passing through origin. Therefore, the slope of APC is also same at each point of
C line and it is equal to MPC.
4. If consumption function be nonlinear (a) Both APC and MPC decline with an increase in
income, but the decline in MPC is more than the decline in APC, and (b) APC and MPC increase
with a decrease in income, but APC rises at a slower rate than MPC.
 Factors Affecting Consumption Function
Consumption function is affected by various determinant factors. They are as follows:
Objective Factors
(i) Change in Wage rate: - If wage level is high, then consumption level is also high in the
economy. As against, if wage level is law, then consumption level is also low in the economy,
because wage is the source of income of labor.
(ii) Change in rate of interest: - The rate of interest is one of the determinant factors of
consumption function from which consumption function is affected. The relationship between
consumption and rate of interest is negative. When rate of interest increases on the one hand saving
increases and on the other hand, consumptions decreases and vice versa.
(ii) Level of income: - Income is one of the important determinant factors of consumption
function. There is close and negative relationship between consumption and income when income
increases, certainly, the consumption also increases in the economy.
(iii) Price Level: - A decrease in the general price level leads to rise in purchasing power of the
consumer. Increase in purchasing power causes increase in consumption expenditure. On the other
hand, an increase in the general price level causes decrease in consumption expenditure of the
community.
(iv) Fiscal policy: - Taxation and government expenditure are instruments of fiscal policy. If
government increase the rate of tax, and then it reduces the disposable income in the economy. So,
people reduce their propensity to consume vice- versa. If government increases the government
expenditure in social and economic infrastructure, then it increases the level of income of the
people, which increases propensity to consume, and vice versa.
(v) Distribution of income: - If national income is equally distributed, then all people have
purchasing power. This leads to increase in the propensity to consume. As against, if national
income is unequally distributed, and then only some people have purchasing power, which tends
to decrease in propensity to consume.
(vi) Holding of Liquid Assets: -If people desire to hoard larger liquid assets, then they will have
a tendency to spend more out of their current income and the propensity to consume will increase.
Hence, the amount of liquid assets in the form of cash balance saving and government bonds in
the hands of consumers also influences the consumption function.
(vii) Credit facilities: - If there is provision of proper credit facilities like installments credits and
hire purchases in large extent, consumption expenditure increases and vice versa.
(viii) Change in expectation: -Change in future expectations also affects the consumption
function. If people expect that prices will decrease in the future, people decrease consumption
demand in present and they will buy only those things, which are very essential. As against, If
people expect that prices will increase in the future, then people increase their consumption
demand and they will buy durable and semi-durable goods . It will lead to increase in consumption
demand.
 Subjective Factors
(i) Security motive: - People save more on account of security motive to purchase land, gold etc.
in future, which reduce the consumption level of people in present. But if there is provision of
social security programs such as pension, unemployment allowances, medical insurance etc. then
people increase the consumption expenditure.
(i) Desire for social status: - People are motivated to save more for the accumulation of large
wealth. This will increase their social status or economic condition increase in saving causes to
reduce current consumption expenditure.
(i) Business motive: - Investment leads to increase in income and wealth of people. Thus, many
people wish to save from their current income so that they may be able to use accumulated saving
for investment which will increase their future income.
(viii) Demonstration effect: - Every person tries to follow the standard living of fellow being.
Such behavior of people is called demonstration effect by James S. Duesenberry. On account of
demonstration effect people consume more and their propensity to consume becomes high.
(vii) Institutional arrangement: - Business firms do not distribute entire profit to share holders
and some part of profit is undistributed for the purpose of investment in new enterprises,
which affect the consumption function. In this situation, consumption function shifts to the
downward.
 Saving function
Saving is the difference between income and expenditure. Keynes has defined the saving as
“Saving is the excess of income over consumption expenditure, or the difference between
income and expenditure on consumption”. Symbolically, it can be expressed as:
S= Y−C
Where,
S = Saving
Y = Income
C = Consumption
According to W.J. Baumol - “Saving is taken to be the source of the resources needed
to produce capital. It represents new materials and labour which could have been used for
current consumption but which, instead, is held back (saved) in order to make possible the
production of larger outputs in the future.”
According to J.L. Hanson - “Any course of action, therefore, that brings about a
reduction of consumer spending can be considered to be saving.”
In the above definitions, Keynesian definition is very simple and Baumol’s definition is
very standard, because it explains the objective of saving. These definitions are different in words
but convey the same meaning that saving is the difference between income and expenditure.
According to classical economists, saving depends upon the rate of interest. There is
positive relationship between saving and rate of interest because people save more at high rate of
interest and vice-versa. So, there is functional relationship between saving and rate of interest.
Such function is called classical saving function. But Keynes has rejected the classical saving
function. According to him, saving depends upon income rather than rate of interest. People can
save more when there income is high. So, saving varies with the variation of income directly and
positively. So, there is functional relation between saving and income which can be expressed as,
S = f(Y)
Where,
S = Saving
Y = Income
f = Function
Such function is called Keynesian saving function. This function can be expressed in equation
form as:
S = Y − C......... .......... ....... (i )
Equation (i) shows that saving is difference between income and consumption.
Consumption function can be expressed as:
C = a − bY........ .......... .....(ii)
Where,
a = Autonomous consumption
b = Marginal propensity consume
Solving equation
S = Y − (a + bY )
S = Y − a − bY
S = −a + Y − bY
S = −a + (1 - b )Y
S = −a + sY
Where,
(s = 1 - b)
s = Marginal propensity to save
b = Marginal propensity to consume.
The saving function can be cleared by following example by assuming C = 50 + 0.5Y.
Table No – 3.4.Saving function
Y
C
S
0
50
-50
100
100
0
200
150
50
300
200
100
400
250
150
500
300
200
The equation of saving function can be obtained as:
S = Y-C
Substituting the value of C, then we have
S = Y − (50 + 0.5Y)
S = −50 + Y - 0.5Y
S = −50 + Y(1 - 0.5)
S = −50 + 0.5Y
In this table, the saving is negative when income level is zero. The saving is zero when
income is 100 and the saving is increasing with the increase in income. This table shows the
different level of saving at the different level of income, which is called saving function schedule.
Fig-3.6.Saving Function
C
Y=C
400
expenditure
Consumption
500
300
C
200
S
100
50
O
-50
100
200
300
400
500
Income
Y
In this fig (3.1.), consumption and saving are measured along vertical axis and income along
horizontal axis. The 450 line is guideline where income is equal to expenditure at each and every
point. The ‘C’ line is consumption line, which is equal to the guideline at point ‘a’ where income
is equal to consumption. The difference between guideline and consumption line is increasing with
the increase in income from which saving function is derived. At point ‘a’, income is equal to
consumption. So, saving is zero and at 500 level of income the consumption is 300. So, saving is
200. From this way, the saving function is derived, which has positive slope, showing positive
relationship between income and saving.
 Technical Attributes of Saving Function
The Saving function has two technical attributes or properties. They are described as follows:
1. Average propensity to save (APS)
The APS is defined as the ratio between consumption and income. Symbolically,
S
APS =
Y
Where,
APS = Average Propensity to Save
S = Saving
Y = Income
Some part of the entire Income is consumed and the rest is saved. Symbolically,
C+S = Y
Dividing both sides by Y, then we have
C S Y
+ =
Y Y Y
 APC + APS = 1
2. Marginal propensity to save (MPS)
The MPS is defined as the rate of change in saving
due to change in income. Symbolically,
50
ΔS
MPS =
ΔY
Where,
MPS = Marginal Propensity to Saving
S = Saving
Y = Income
Some part of increased income leads to increase in consumption and the rest part of increased
income leads to increase in saving. Symbolically,
C + S = Y
Dividing both side by Y, then we have
C S Y
+
=
Y Y Y
 MPC + MPS = 1
From this result it is cleared that the relationship between APC, APS, MPC and MPS.
Marginal propensity to consume and average propensity to consume can be cleared by table.
Table No – 3.5.Saving function
Y
C
S
0
100
200
300
400
500
50
100
150
200
250
300
MPC
- 50
0
50
100
150
200
0.5
0.5
0.5
0.5
0.5
APC

1
0.75
0.67
0.63
0.6
MPS
0.5
0.5
0.5
0.5
0.5
APS
-
0
0.25
0.33
0.37
0.4
In this table consumption and saving both are increasing with the increase in income. The MPC
and MPS both are constant at each level of income. The sum of MPC and MPS is equal to 1. The
APC is declining and APS is increasing with the increase in income. This because consumption is
positive at zero level of income and saving is negative at zero level of income. The APS and The
MPS can be cleared by the help of following diagram.
S
Fig-3.7.Saving Function
Saving
S
S3
S2
O
S
Y1
Y2
Y3
Y
Income
In this diagram, saving is measured along vertical axis and income along horizontal axis. The SS
is saving line, which has positive slope, which means that the saving level increases when the level
of income increases. The SS line is passing
51 below the origin point. Therefore, there is nonproportional relationship between S and Y. The slope of SS is itself MPS, which is constant at
point S2 and S3. The slope of APS can be obtained by drawing the ray line from origin to any point
of SS line, which is increasing from point S2 to S3 with the increase in income.
At point S2, APS = S2Y2/OY2 and MPS = S2Y2/Y1Y2
At point S3, APS = S3Y3/OY3 and MPS = S3Y3/Y1Y3
At point S2, and S3, MPS are same because S2Y2/Y1Y2= S3Y3/Y1Y3
At point S2, and S3, APS are increasing because S2Y2/OY2< S3Y3/OY3
 Relationship between APC, MPC, APS and MPS
1. Short run consumption function is non-proportional. So, APC > MPC at each level of income
but APS < MPS.
2. If APC decreases steadily as income increase APS must increase steadily as income increase
because APC+APS =1.
3. If consumption income relationship is proportional, then all values MPC, APC, MPS and APS
are constant and positive fraction.
 Determinants of Saving Function
The determinant factors are those, which can effect the saving positively and negatively.
Followings are the determinant factors of saving.
(i) Level of income: - According to Keynes, saving depends upon the level of income. People can
save more when their incomes are high and vice versa. Saving increases with the increase in
income and vice versa. So, income is one of the important determinant factors of saving.
(ii) Rate of interest: - According to classical economists, saving depends on rate of interest. There
is positive relationship between saving and rate of interest. People save more when rate of interest
is high and vice-versa.
(iii) Distribution of income: - It is also important determinant factor of saving. If the distribution
of income is equal among the people in the society, then most of the people can save more. As
against, if the distribution of income is not equal among the people in the society, then most of the
people cannot save more.
(iv) Demographic factors: - The saving function is also affected by size of family. If family size
is very large, then such households cannot save more, because their maximum part of income is
spent for consumption and vice-versa.
(v) Fiscal policy: - Fiscal policy is one of the determinant factors of saving. If government reduces
rate of tax on income and expenditures, then it increases the disposable income and purchasing
power of people which increases saving. If government increases the public expenditure on various
items, then it increases the purchasing power of people in the economy, which leads to increase in
saving in economy.
(vi) Price level : - When price level increases in the economy due to increase in demand and cost
, then people cannot save more because they have to spend more money on goods and services due
to inflation.
(vi) Development of Bank and financial Institution: - The development of banks and financial
institutions is also one of the main factors to determine savings. The rapid development of banks
and financial institution in a country increases
the propensity to save of the people. The
52
development of such institution helps the people of the country to save their income easily and
quickly.
 Paradox of Thrift
According to classical economist, saving is vice and virtue both. It is source of investment and it
increases the economic development in the economy. So, classical economist has emphasized on
saving to increase the pace of development. But Keynes has rejected the classical view about
saving. According to Keynes, saving is vice but not virtue because increase in saving reduces the
level of employment, output and income. This theory has been propounded by Keynes and this
theory is called paradox of thrift. It can be cleared by following figure.
Fig-3.8 Paradox of Thrift
S, I
Saving and investment
S1
S2
I1
E1
E2
S1
I1
O
S2
Y2
Y1
Income
Y
In this diagram, saving and investment are measured along vertical axis and income along
horizontal axis. The ‘I1I1’ is investment curve, which has positive slope, showing the positive
relationship between investment and income. It means that investment increases when the level of
income increase. The initial saving curve is ‘S1S1’, which has also positive slope, showing the
positive relationship between saving and income. It means that the saving increases when the level
of income increases. One of the considerable points is that the slope of investment curve is less
than the slope of saving curve. It means that the marginal propensity to investment (MPI) is always
less than the marginal propensity to save (MPS). The economy is equilibrium at point E1 initially
by interaction between investment curve (I1I1) and saving curve (S1S1) from which OY1
equilibrium level of income is determined. Now, suppose that saving increases in the economy
due to change in determinant factor of saving. Consequently, the saving curve shifts to the left side
and takes a position of ‘S2S2’. The investment curve ‘I1I1’ is equal to the ‘S2S2’ saving curve at
point E2. Consequently, the level of income falls from OY1 to OY2. This figure tells us that when
saving increases in idle form, then it reduces consumption and investment level as a result of which
the level of income, employment and output go down which is known as paradox of thrift.
 Meaning of Investment and Investment Function
Generally, it is considered that purchasing of shares, bonds, securities, gold and silver is
investment. But in economics, it is not real investment. It is only transfer of assets from one hand
to another hand, and such transfer of assets cannot increase the level of employment and output.
In economics, the real investment is the change in capital stock in a given period of time.
Symbolically,
I t = K t − K t -1
Where,
Where,
It = Investment of t period
Kt = Capital stock of t period
Kt-1 = Capital stock of t-1 period
ΔK t = K t − K t -1
Kt = Change in capital stock
So, It = Kt
In this context, capital stock is stock concept while investment is flow concept. Suppose,
any firm had 10 machines in previous period, now, that firm has 15 machines in current period,
and then we can say that 10 machines is capital stock of previous period and 15 machines are
capital stock of current period. The change in capital stock of current period as compared to
previous period is 5 machines which are real investment in economy and such investment can
positively affect the level of output, employment and income.
In the two sectors economy, the sum of consumption and investment is considered as
aggregate demand and the level of employment and output increase when the aggregate demand
increase in the economy. In the short run, propensity to consume is almost constant. So investment
can play important role to increase macro economic variables like employment, output and income.
According to classical economists, investment depends upon the rate of interest and there
is negative relationship between investment and rate of interest. Symbolically,
I = f (r )
Where,
I = Investment
r = rate of interest
f = function
This relationship between investment and rate of interest explained by classical
economists has been adopted by Keynes and Keynes has included marginal efficiency of capital
with rate of interest in investment function. Symbolically,
I = f (r, MEC )
Where,
I = Investment
r = rate of interest
f = function
MEC = Marginal efficiency of Capital
 Types of Investment
There are two types of investment: Autonomous investment and induced investment.
1. Autonomous Investment: - Autonomous investment is that part of investment, which is not
affected by level of income. The increase or decrease in level of income cannot affect to the level
of autonomous investment because it is exogenously determined. The government expenditure is
one of the examples of autonomous investment because it is not affected by level of income, but
it affected by government policy. It can be cleared by following diagram.
Fig-3.9.Autonomous Investment
Investment
I
A
I1
O
B
Y2
Y1
I1
Income
Y
In this diagram, the ‘I1I1’ line is investment line and the shape of ‘I1I1’ line is horizontal. It means
that investment is same at every level of income. Such type of investment is called autonomous
investment, which is fixed, at every level of income.
2. Induced investment: - Induced investment is that part of investment, which is affected by level
of income. The induced investment may change due to change in level of income. When level of
income increases, the level of induced investment also increases. So, there is positive relationship
between induced investment and level of income. Private investment is one of the examples of
induced investment because private investment is made for the purpose of profit. The induced
investment can be cleared by following figure.
Fig-3.10. Induced Investment
I
Investment
I1
B
I2
I1
O
A
Y1
Y2
Y
Income
In this diagram, the ‘OI1’ line is investment line, which has positive slope, showing the
positive relationship between investment and level of income. The level of investment is increasing
with the increase in level of income. Such type of investment is called induced investment.
 Marginal Efficiency of Capital (MEC)
According to Keynes, Investment depends upon the market rate of interest and marginal efficiency
of capital. The MEC is the expected highest rate of return from additional unit of capital over its
supply price. According to Kuriharra “Marginal efficiency of capital is the ratio between the
prospective yield of additional capital goods and their supply price.” This definition can be
expressed as:
Prospective Yield
MEC =
Supply price
For example, if the supply price of capital assets is Rs. 40000 and its annual yield is Rs. 4000, then
marginal efficiency of capital becomes
4000
MEC =
 100 = 10%
40000
Hence, MEC is the percentage rate of profit expected from the purchase of a capital. The
determinants of MEC are prospective yields and supply price. Supply price is the cost of capital
while purchasing new capital goods (machines). In other words, it is the price of capital goods
which producer has to spend while purchasing it. The prospective yield is the annual return
expected from capital goods. Any machines or capital goods have its certain lifetime and the capital
goods provide the prospective yields over its lifetime. Future values are not receivable in the
present time; they are only the expected values to be received in future dates; future values are less
worth than present value. Therefore, future values are to be discounted to transform future values
into present value. The capital goods may also have scrap value, which is also called metallic
value. So, present value of prospective yield over the lifetime of capital goods must be estimated.
The MEC is that discount rate which makes exactly present value equal to supply price. The
present value can be estimated as:
R
R1
R
R +S
+ 2 2 + 3 3 + ........ + n nn
(1 + i ) (1 + i ) (1 + i )
(1 + i )
R
R
R
Rn
PV = 1 + 2 2 + 3 3 + ........ +
=S
(1 + i ) (1 + i ) (1 + i )
(1 + i )n P
PV =
Where,
PV = Present value of prospective yields
R1, R2, R3,…., Rn = income stream over a number of n years
Sn = Scrape value/Salvage value after the end of its lifetime.
1,2,3,…,n = Time period from 1 to n years.
i = Discount rate which makes present value exactly equal to supply price (SP)
It can be cleared by a suitable example. Suppose that
Supply price of capital goods = Rs. 210648.14
Life time of machine = 3 years
Annual return of that capital = 100000 per year.
Scrape value = 0
In this situation, the present value is estimated on the basis of 20% discount rate.
R
R
R
Rn
PV = 1 + 2 2 + 3 3 + ........ +
=S
(1 + i ) (1 + i ) (1 + i )
(1 + i )n P
PV =
100000 100000
100000
+
+
2
(1 + 0.2) (1 + 0.2) (1 + 0.2)3
PV = R S . 210648.15
The 20% discount rate is MEC because it makes present value exactly equal to the supply
price. Other discount rate cannot be MEC. The MEC can be found by trial and error method. The
MEC refers to internal rate of return (IRR). The MEC is very useful in decision making of
investment. According to Keynes, a producer always compares the MEC with market rate of
interest when he makes financial decision. If MEC is higher than the market rate of interest, then
the producer borrow fund to keep an additional capital goods. If MEC is less than the market rate
of interest, then the producer does not decide to invest on new capital goods. Producer reduces
actual capital stock.
 Marginal Efficiency of Investment (MEI)
The MEI is the rate of return expected from a given investment in a capital asset after covering all
its costs, except the rate in interest. MEI is the rate that equates the supply price of a capital asset
to its prospective yield. The investment in an asset will be made depending upon the interest rate
involved in getting funds from the market.
If the rate in interest is high, investment is at a low level and a low rate interest leads an increase
in investment. Thus, MEI relates the investment to the rate of interest. The MEI schedule shows
the amount of investment demand at various rates of interest. Thus, it is also called the investment
demand schedule or curve which has a negative slope, as shown in diagram.
Rate of interest
r
r1
r2
Fig-3.11. Investment Curve/MEI
A
B
MEC
0
I2
I1
Investment
I
In this diagram, rate of interest are measured along vertical axis and the volume of investment is
measured along horizontal axis. The MEI curve is marginal efficiency investment curve, which
has negative slope representing inverse relationship between MEI and rate of interest. A producer
prefers to increase investment with the fall in rate of interest. When rate of interest is r1, producer
prefers to invest I1 volume on additional capital stock. Suppose that the rate of interest falls from
r1 to r2, producer prefers to increase volume of investment from I1 to I2.
57
 Determinant Factors of Investment
The determinant factors of investment function are those, which directly and indirectly affect to
the investment function or MEC. The determinant factors of investment function are as follows:
Short run factors
Followings are the short run determinant factors of investment.
(i) Marginal Efficiency of Capital: - A producer always compares the MEC with market rate of
interest while making financial decision. If MEC is higher than the market rate of interest, then the
producer decides to invest on additional capital goods. If MEC is less than the market rate of
interest, then the producer does not decide to invest on new capital goods. In this situation,
Producer reduces actual capital stock.
(ii) Rate of interest: - Rate of interest is on the determinant factor of investment. If MEC is given,
then a rational producer invest more on capital goods when rate of interest is low and vice versa.
(iii) Expected demand: - If there is possibility of increase in expected demand in future, then
MEC will increase. Consequently, it increases the level of investment. But if there is possibility of
decrease in expected demand in future, then MEC will decrease. Consequently, it decreases the
level of investment.
(ii) Cost and price: - Cost and price are also determinant factors of investment function. If
producer expects that the cost of production will decrease and price will increase, then the MEC
will increase. Consequently, this expectation leads to increase in investment in the economy.
(iv) Change in income: - The level of investment depends upon income positively. When income
increases, it leads to increase in the level of investment and vice versa
(iii) Propensity to consume: - The MEC also depends upon propensity to consume. Increase in
MPC means increase in the effective demand in the economy, which leads to increase in
investment level, otherwise not.
(v) State of business confidence: - If businesspersons are optimistic due to favorable business
environment, then it increases the MEC and that leads to increase in level of investment and vice
versa.
(iv) liquid Assets: - The amount of liquid assets with the investors also influences the inducement
to invest. If they possess large liquid assets, the inducement to invest is high.
(iv) Government policy: - Government policy also affects investment. If the government imposes
various unnecessary burdens of taxes on the entrepreneurs and businesspersons, then the marginal
efficiency of capital will decrease. As a result, the investors will be discouraged. This will result
in the decrease in investment.
 Long run Factors
Followings are the long run determinant factors of investment.
(i) Rate of growth of population: - The rate of growth of population is also one of the determinant
factors of investment. If rate of growth of population is high, then it increases the aggregate
demand in the economy, which increases the MEC, and it leads to increase in investment in the
economy.
(ii) Development of new areas: - The government should spend on various areas like electricity
transportation, communication and so on which increases the aggregate demand and which leads
to increase in MEC and investment level.
(iii) Technological Progress: - Technological progress increases the level of investment because
producer has to adjust large plants in the production process, which takes more investment in the
economy. The technological progress helps to increase output and reduce cost of production.
(iv) New product: -If the sales prospect of a new product are high and expected revenues are more
than the costs, MEC will be high, which will encourage investment in related industries.
(iv) Industrial policy: -If the industrial policy of the government is to encourage private
investment, the inducement to investment will be increased.
(iv) Rate of investment: -If the rate of current investment in an industry is already high there is
no scope for new investment in that industry.
 Acceleration Theory of Investment
According to acceleration theory, investment is function of the change in output or income. The
acceleration principle states that an increase in the rate of output of a firm will require a
proportionate increase in the capital stock. The capital stock refers to the desired capital stock.
The acceleration principle is based upon the following assumptions.
1. The acceleration principle assumes a constant capital- output ratio in the economy.
2. It assumes that resources are easily available.
3. The acceleration principle assumes that there is no excess capacity in plants.
4. It is assumed that the increased demand is permanent.
5. The acceleration principle also assumes that there is elastic credit facility.
6. It further assumes that an increase in output immediately leads to a rise in net investment.
7. Supply price of capital goods generally does not change.
According to acceleration principle, demand of capital goods is derived from the demand for
consumer goods. In an economy, the required stock of capital depends on the change in the demand
for output.
The theory, which states that net business investment depends upon the change in the level of
output, is called acceleration principle. The acceleration principle is related with economists like
T. Caver (1914), J.M. Clark (1917) and R. Frisch (1933). The accelerator theory denies that the
level of profits play the strategic role in investment decision. But the increase in demand of output
plays important role to give pressure to firm to increase in existing capital stock. According to the
acceleration theory investment occurs to enlarge the stock of capital because more capital is needed
to produce more output. However, the acceleration principle presents the link between investment
and change in output.
On the basis of the above assumption, the simple accelerator theory is formulated with the
following equations.
Capital stock in the economy is a certain fraction /part of the output. Mathematically,
K t = λYt .......... .......... .....(i ) λ  0
Where, Kt = capital stock, in time 't'.
 = acceleration coefficient (K/Y)
Yt = Output in the same time period.
Lagging one period backward in eqn (i) Subtracting eqn (ii) from (i), we get
K t -1 = λYt -1 .......... .......... .....(ii)
K t - K t -1 = λ(Yt - Yt -1 )......... .......... .....(iii)
But by definition, net investment in any time is equivalent to the change in capital stock.
Expressing this symbolically,
I n, t = K t - K t -1 .......... .......... ...(iv)
Where, In = Net investment in time 't'.
Then from eqn (iii) and (iv), we get
I n,t = λ(Yt - Yt -1 )......... .......... ....(v )
This is one of the simple forms of the acceleration theory of investment. In eqn (5), current net
investment is dependent upon current change in the level of output. More simplicity,
I n,t = λΔYt .......... .......... ..(vi )
Where, ΔYt =Y t -Yt -1 .......... .......... ..(vii )
These possibilities are indicated from eqn (5)
(i) If Yt - Yt-1 > 0  AD There is positive net investment; the economy is expanding by
increasing its productive capacity.
(ii) If Yt - Yt-1 = 0  AD* Net investment is neither increasing nor decreasing: the economy is
just maintaining its productive capacity.
(iii) If Yt - Yt-1 < 0  AD↓ There is negative net investment i.e., there is disinvestment; the
economy loosing its productive capacity.
Eqn (5) can be expressed in gross investment tern while taking about gross investment we need to
add the replacement investment (IR) in the investment equation.
Let us suppose, the replacement investment is equal to the depreciation of the capital stock (Dt).
So, adding the Dt term on both sides of eqn (5), we get
I n, t + D t = λ(Yt - Yt -1 ) + D t .
Where, I g,t = λ(Yt - Yt -1 ) + D t = Gross investment
The theory of acceleration principle can be cleared by following example:
Suppose, acceleration, coefficient,  = 2, Replace investment (IR) =10% of initial capital stock.
Table No – 3.6.Acceleration Theory
Rs. in million
Period
output
T
1
2
3
4
5
6
7
8
9
10
Yt
500
550
625
725
800
800
850
750
700
775
Change in desired capital Replacement
output
stock
investment
IR
Yt
Kt-Yt
0
1000
100
50
1100
100
75
1250
100
100
1450
100
75
1600
100
0
1600
100
0
1600
100
-50
1500
100
-50
1400
100
75
1550
100
Net
investment
IN=Yt
0
100
150
200
150
0
0
-100
-100
150
Gross
investment
IG=IR+IN
100
200
250
300
250
100
100
0
0
250
In the above table, we have shown that output is increasing continuously upto 5th period.
Thereafter output remains constant upto 7th period and output is decreasing in late two periods.
Finally, the output again gets increased in 10th period.
We assume a constant capital output ration of 2, so the desired capital stock in column 4
is double the output given in column 2. In each time-period, there is replacement investment equal
to 10% of the capital stock existing in period 1. This gives us in column 5 an unvarying
replacement investment of 100 per time period. Net investment in any period as shown in column
6, equals  times the change in output between that period and the preceding period. Gross
investment of columns 7 is the sum of replacement and net investment of columns 5 and 6.
When the demand for output increases by 50 in period 2, new capital facilities of 100 are
wanted. In terms of investment equation, It = (Yt-Yt-1)100=2(550-500). Total expenditures for
capital goods -made up of 100 of replacement and 100 of net investment -accordingly rise from
100 in period 1 to 200 in period 2. With an accelerator of 2, the increase of 50 in expenditures for
final output produces an increase of 100 in expenditures for capital goods. Due to this net
investment in the economy appears by 100 and the gross investment teaches to 200. This is the
relationships between changes in output and the level of investment as suggested by the
acceleration principle or theory. For gross investment to increase from one period to the next,
expenditures for output must increase by ever-larger absolute amounts from one period to the next.
Gross investment will remain unchanged from one period to the next if the absolute increase in
output remains unchanged from one period to the next. This relationship is shown in table in
between the period 6 and period 7.
 Criticisms of Acceleration Theory of Investment
1. Constant capital output ratio: - This principle is based on unrealistic assumption of constant
capital output ratio. In present time there is continues improvement and invention in production
technique. This reduces capital output ratio. This principle has ignored technological progress.
2. Availability of resources: - It is based on the unrealistic assumption that resources are easily
available. It may be true when there is unemployment. But once the economy reaches the level of
full-employment, adequate resource are not available. This abstracts the operation of acceleration.
3. Ideal capacity: - This principle assumes that there is no ideal capacity. But if this is so then
accelerator theory does not hold good.
4. Supply of if capital is elastic: - It is based on the assumption that supply of capital is elastic.
But in reality, supply of capital is not elastic but inelastic.
5. Role of expectation: - The theory of acceleration ignore role of expectation. But, now a days
the expectation plays important role for new investment also.
Numerical Examples
QN. 1: Calculate APC if Y= Rs. 100 crore and C= Rs. 110 crore.
Solution.
Given Y = Rs.100 Crore
C = Rs. 80 Crore
C
80
=
= 0.8
Y 100
Q.N. 2: Find the value of MPC where increase in national income by Rs. 300 million results
increase in aggregate consumption by Rs. 400 million.
Solution:
Given,
(Y ) = Rs. Y = Rs. 100 Million
Change in income
Change in consumption (C) = Rs. Y = Rs. 400 Million
We known that,
MPC =
C
400
=
= 0.8
Y 500
Q.N. 3: Calculate APS and MPS from the following table ( complete the following table)
Income(Y)
Total Saving (S)
APS
MPS
1000
100
2000
300
3000
700
Solution:
Income(Y)
1000
2000
3000
Total Saving (S)
100
300
700
APS=S/Y
0.1
0.15
0.23
MPS
0.2
0.4
Q.N. 4: Find out saving function when C = 20 + 0.5Y
Solution:
Given,
C = 20 + 0.5Y
For saving function,
S = Y-C
S = Y - (20 + 0.5Y)
S = Y - 20 - 0.5Y
S = -20 + 0.5Y
Hence, saving function is S = -20 + 0.5Y
63
Q.N. 5: Calculate MPC when MPS = 0.4 and APS when APC = 0.2.
Given,
MPS = 0.4
MPC + MPS = 1
MPC = 1 - MPS
MPC = 1 - 0.4
MPC = 0.6
APS = 0.2
APC + APS = 1
APC = 1 - APS
APC = 1 - 0.2
APC = 0.8
QN. Find APC and MPC in the following tables and what type of consumption function exists?
Income (Y)
100
200
300
400
500
600
Consumption (C)
50
100
150
200
250
300
Solution:
Income (Y)
Consumption (C) APC=C/Y
MPC=C/Y
100
50
50/100=0.5
200
100
100/200=0.5
(100-50)/(200-100)=0.5
300
150
150/300=0.5
(150-100)/(300-200)=0.5
400
200
200/400=0.5
(200-150)/(400-300)=0.5
500
250
250/500=0.5
(250-200)/(500-400)=0.5
600
300
300/600=0.5
(300-200)/(600-500)=0.5
In conclusion, APC=MPC, so it is linear and non-proportional relationship between consumption
and income and it is considered as long run consumption function.
Given consumption function is C=40 +0.7Y.
a. interprets the given equation.
b. What is the level of consumption when income (Y) Rs. 200.
c. What must be the level of income? Show that consumption is Rs. 320.
Solution:
a. By comparing C=40 + 0.7Y with C =a +bY, we find
Autonomous consumption (a) = 40 at zero level of income. it means that people must consume 40
either form past saving or from borrowing.
Marginal propensity to consume (b) = 0.7, it means that out of total increase in income,70 percent
income goes on consumption expenditure and the remaining 30 percent goes on saving.
The given consumption function is C=40 + 0.7Y.
b. When Y=200, consumption level will be
C = 40 + 0.7(200)
C = 40 + 140
C = 180
c. when C=320, the level of income will be
C = 40 + 0.7Y
320 = 40 + 0.7Y
320 - 40 = 0.7Y
280 = 0.7Y
Y=
280
0.7
Y = Rs.400
QN. Consider the following table where C = 0.6Y.
Level of income (Y) 300
400
500
600
a. Find the level of consumption with given income.
b. Graph income and consumption line.
c. Find MPC and APC, and comment it.
Solution:
Given consumption function C= 0.6Y
Income (Y)
Consumption (C) = 0.6Y
300
0.6  300 = 180
400
0.6  400 = 240
500
0.6  500 = 300
600
0.6  600 = 360
700
0.6  700 = 420
700
C
Fig-3.1.
consumption Function
500
Y=C
Consumption
400
C
300
200
100
O
100
200
300
400
500
600
700 Y
Income
Here, MPC = 0.6 and APC = 0.6. So it is long run consumption function so that MPC = APC.
QN. Given consumption function C = 20 + 0.75Y. Find the saving function
Solution:
We know that
The equation of saving function can be obtained as:
S = Y-C
Substituting the value of C, then we have
S = Y − (20 + 0.75Y)
60
S = Y − 20 − 0.75Y
S = −20 + 0.25Y
QN. Given saving function S = -40 + 0.6Y. Find the consumption function.
Solution:
The equation of consumption function can be obtained as:
Y = C+S
Substituting the value of S, then we have
Y = C + (- 40 + 0.6Y)
Y = C - 40 + 0.6Y
40 + Y − 0.6Y = C
40 + 0.4Y = C
C = 40 + 0.4Y
QN. Given saving function is S = -100 + 0.75Y
a. Interpret the given saving function.
b. What is the level of saving when income Y is Rs. 500.
c. What must be the level of income when saving is Rs. 200.
Solution:
a. By comparing S=-100 + 0.75Y with S =-a + (1-b)Y, we find
autonomous saving(-a) = 100 at zero level of income. It means that people spend Rs. 100 on
consumption from either past saving or borrowing from others.
Marginal propensity to consume (1-b) = 0.75, it means that when increases by Rs. 1, saving
increases by Rs. 0.75.
The given saving function is S=-100 + 0.75Y
b. When Y=Rs. 500, saving level will be
S = −100 + 0.75(500)
S = −100 + 375
S = 275
c. when S=200, the level of income will be
S = −100 + +0.75Y
200 = −100 + +0.75Y
300 = 0.75Y
0.75Y = 300
Y=
300
0.75
Y = Rs. 400
QN. Given autonomous consumption is Rs. 40, marginal
61 propensity to consumption (MPS) = 0.75,
then find linear consumption and saving function.
Solution
We know that,
Linear consumption function
C = a + bY
Given, a = 40 and b = 0.75
C = 40 + 0.75Y
Similarly,
Linear saving function
S = −a + (1 − b )Y
S = −40 + (1 − 0.75)Y
S = −40 + 0.25Y
QN. considered the following table.
Income (Y)
0
200
Consumption (C) 400
500
400
600
600
700
800
800
1000
900
1200
1000
a. Derive consumption and saving function based on given date
b. What is the APC at Rs. 1000 level of income?
Solution:
a. consumption function
C = a + bY
Here, autonomous consumption (a) =400
Change in income (Y) = 200
Change in consumption (C) =100
C 100
MPC =
=
= 0.5
Y 200
Then, C = 400 + 0.5Y
Similarly,
S = −a + (1 − b )Y
Derivation of saving function
Here, S = Y - C
S = Y − (400 + 0.5Y)
S = Y − 400 − 0.5Y
S = −400 + 0.5Y
Where, autonomous saving (-a) = 400 and MPS = 0.5
b. Given, Y = 1000
C = 900
900
APC =
1000
APC = 0.9
QN. Graph the consumption, saving and income line62by using the given table.
Income (Y)
0
200
400
600
800
1000
Consumption (C)
400
500
600
700
800
900
Saving (S = Y – C) -400
-300
-200
-100
0
100
Solution:
C, S
Consumption and saving
120
0
Fig-3.1.
Consumption and Saving Function
Y=C
C
120
0
E
80
0
S
40
0
O
40
0
40
0
120
80
0
0 Income
160
0
Y
1200
1000
200
Given saving function S = -60 + 0.25Y and autonomous investment I = 40. Find level of income
and new level of saving when saving increased by 10.
Solution:
The equilibrium level of income is maintained by the equality between saving and investment.
i.e., S = I, which gives
or - 60 + 0.25Y = 40
or 0.25Y = 40 + 60
or 0.25Y = 100
or
Y=
Initially,
100
0.25
S = - 60 + 0.25  400
S = - 60 + 100
S = 40
Hence, the equilibrium level of income is Rs. 400, when investment is equal to saving.
S1 = S + S
or S1 = - 60 + 0.25Y + 10
or S1 = - 50 + 0.25Y
At given level of investment I0 = 40, then equilibrium requires
S1 = I 0
63
or - 50 + 0.25Y = 40
or 0.25Y = 90
or
Y=
90
0.25
or Y = 360
Hence, saving increase by Rs. 10 then level of income decreases by Rs. 40 (from 400 to 360). The
saving amount (S1) = -50 + 0.25  360 =40
QN. For an economy following consumption function is given: C = 60 + 0.75
a. If investment in a year is Rs. 35 millions. What will be the equilibrium level of income or output?
b. If full employment level of income is Rs. 460 million, what investment is required to be
undertaken to ensure equilibrium at full employment?
Solution:
a. given,
C = 60 + 0.75Y
I = Rs. 35 million
We know that,
Y = C + S......... .......... ..... S = I
or Y = 60 + 0.75Y + 35
or (1 - 0.75)Y = 95
or 0.25Y = 95
or Y =
95
0.25
or Y = 380
b. If full-employment level of income is Rs. 460 millions, what is level investment?
Y = C+I
or Y = 60 + 0.75Y + I
or 460 = 60 + 0.75  460 + I
or 460 = 60 + 345 + I
or 460 - 60 − 345 = I
or 460 - 405 = I
 I = Rs. 55 millions
QN. Suppose the level of autonomous investment in an economy is Rs. 200 millions and
consumption function of the economy is : C = 80 + 0.75Y
a. what will be the equilibrium level of income?
b. What will be the increase in national income if investment increases by Rs. 25 millions?
64
UNIT-IV
THEORY OF NATIONAL INCOME DETERMINATION
 Classical Theory of Employment/Say’s Law of Market
After the publication of wealth of nation written by Adam Smith in 1776 A.D., the classical era
was started. The ideas provided by Adam Smith were followed by all other economists J.B. Say,
walker and other economists. Classical economists believed that would be always full
employment. So, over production would not be barrier to new production but they accepted that
there would be two types of unemployment problems in the short run in the economy. They were
frictional and voluntary unemployment. The frictional unemployment was due to change in job by
workers. So, worker could be unemployed due to lack of adequate knowledge of job opportunities
or due to changed job. But it was short run phenomenon where workers would get sufficient
knowledge of job opportunities such unemployment problem would be solved. Voluntary
unemployment was due to refusal on the part of workers to get high wage rate in the market.
Classical economists neglected the voluntary unemployment. According to them, it was not a
serious problem because if workers want to work at going wage rate, then they will get job
opportunity. They concluded that there would be always full employment in the economy in the
long run.
The idea of classical theory regarding to full employment is based on two fundamental
economic theories: Say’s law of market and Quantity theory of money. According to Say’s law of
market, “Supply creates its own demand”. According to quantity theory of money, any change in
money supply directly affects to the price level. There is direct and proportional relationship
between money and price. It can be cleared by following equation provided by fisher.
MV = PT
Where,
M = Currency which are in circulation
V = Velocity of money
P = General Price level
T = Total volume of transaction
Velocity of money (V) and total volume of transaction (T) are assumed to be constant. So,
the above equation can also be expressed as
MV
P=
T
There is direct and proportional relationship between M and P, being V and T constant. In
this equation, P is passive factor. The price level increase due to increases in money supply but
price level does not affect to the money supply. Money is nothing, but only the medium of
exchange. So, employment and output are not affected by change in money supply. Money is
demanded for transaction purpose. So, it is not hoarded by people in the economy. The real saving
is equal to real investment in the economy. So there is always full employment in the economy.
The classical economists have presented the model in which the determination of employment and
output are explained. For the determination of employment and output, classical economists have
explained three types of markets.
(i) Product market (ii) Labor market (iii) Money market
In the product market, equilibrium is established by equality between demand and supply
of goods. Especially, they have explained production function in this market. According to them,
the Marginal Product (MP) of labor eventually declines when additional unit of labor is employed
in the production function. So, Total Product (TP) increases at decreasing rate. The equilibrium is
established in labor market by equality between demand and supply of labor. In the money market,
the equilibrium is established by equality between demand and supply of money. According to
classical economists, product market and labor market are related to real sector of the economy,
while money market is related to monetary sector of the economy. According to classical
economists, the equilibrium level of output and employment are determined by real sector of the
economy. Monetary sector of the economy cannot affect to the level of employment and output.
Labors are demanded by producer. The labor demand depends upon the real wage rate. In
other words, there is functional relationship between demand for labor and real wage rate.
Symbolically,
W
DL = f  
P
Where,
W= Money wage
P = Price level
W/P = Real wage
DL = Demand for labor
f = Function
More labors are demanded by producer at law wage rate and less no of labors at high real
wage rate. So, there is negative relationship between demand for labor and real wage rate. So,
demand for labor curve has negative slope.
Supply of labor depends upon real wage rate. In other words, there is functional
relationship between supply of labor and real wage rate. Symbolically,
W
SL = f  
P
Where,
SL = Supply of labor
W/P = Real wage
f= Function
More labors are supplied by labors themselves at high real wage and less no of labors are
supplied at low real wage rate. So, supply curve of labor has positive slope i.e. there is positive
relationship between supply of labor and wage rate.
The equilibrium real wage rate and the employment level are determined together by interaction
between demand for labor and supply of labor, and the determined employment level determines
the equilibrium level of outputs in the case of given level of production function which can be
cleared by following diagram.
Fig-1.1.
Determination of Employment and Output
Panel- A
Q
Panel-C
Q
Q=f(L)K
Q1
Output
Output
Q1
MV
O
N
N1
W/P
Panel-B
D
Money wage
Real wage
(W/P)1
W1
D
N1
Employment
Price
Panel-C
W
E1
S
P
P1
S
(W/P)1
O
O
Employment
N
O
P1
Price
P
In Panel (A), output is measured along vertical axis and employment level along horizontal
axis. The Q=f (L) K curve is production function curve where output is increasing at decreasing
rate with the increase in employment level. In panel (B), real wage rate is measured along vertical
axis and employment level along horizontal. The DL is demand for labor curve, which has negative
slope, showing the negative relationship between demand for labor and real wage rate. The SL is
supply of labor curve, which has positive slope, showing the positive relationship between supply
of labor and real wage rate. In Panel (C), the level of output is measured along vertical axis and
price level along horizontal axis. The MV is money supply curve, which has given. The negative
slope of MV curve shows the negative relationship between output and price in the case of given
money supply. In Panel (C), money wage is measured along vertical axis and price level is
measured along horizontal axis. In this panel, the ratio line between money wage and price level
is derived.
The DL curve is equal to the SL curve at point E1 in labor market from which O(W/P)1
equilibrium real wage rate and ON1 equilibrium level of employment are determined together. The
ON1 determined employment level determines the OQ1 equilibrium level of output in the given
production functions. At OQ1 level of output, the price level is OP1 on given money supply curve
(MV). From this way, the ratio between money wage and price level is derived in panel D which
is determined by labor market.
 Assumption of Classical Theory of Employment
The classical theory of employment is based on following assumption:
(i) No government regulation: - The classical theory of employment is based on the assumption
that government should not regulate the economic activities in the economy. The function of
government is to provide security to the people to save the country from external attack and from
internal attack and to operate the general administration. Government should not regulate in the
private sectors. If government regulates in the private sector, then self-adjusting process may not
operate in the economy.
(ii) Market is extendable: - The classical theory of employment and output is based on the
assumption that market is extendable. So, there is no problem of over production in the economy.
The over production cannot be barrier to new production because supply creates its own demand.
(iii) Interest rate is equilibrating mechanism between saving and investment: - The classical
theory of employment is based on the assumption that interest rate is equilibrating mechanism
between saving and investment. According to the classical theory of employment the rate of
interest determination is purely real sector phenomenon. It is determined by equality between
investment and saving. Investment refers to capital demand and saving refers to capital supply. If
investment is more than saving, then rate of interest brings equality between saving and investment
by self-adjusting process. So, real investment is always equal to real saving.
(iv) Perfect competition: - The classical theory of employment is based on the assumption of
perfect competition. Under perfect competition, the self-adjusting process may operate in the
economy. The process is not possible under monopoly market.
(v) Money is medium of exchange: - According to classical economists, money is demanded for
transaction purpose only because money is nothing but only medium of exchange. It is not hoarded
by people as idle cash, but it is immediately spend by people. So any change in money supply
cannot affect to the level of employment. It only affect to the price level.
(vi) Long run: - The classical theory of employment is based on the assumption of long run.
According to classical economists if there is unemployment problem in the short run in the
economy, then it would be solved in the long run.
 Criticisms of Classical Theory of Employment
According to classical theory of employment, there would be always full employment in the
economy. But in the real world, everywhere are unemployment problems, in this situation, the
classical theory is not realistic. Sismondi, Karl Marx and Malthus have criticized the classical
theory of employment but they were not successful because they could not develop new theory of
employment, which could replace the classical theory of employment. But Keynes has criticized
it on his book named ‘General Theory’ and he succeeded because he has launched new theory of
employment in his book published in 1976A.D. Keynes has criticized the theory on following
grounds:
(i) Supply cannot create its own demand: - The classical theory of employment is based on the
assumption that supply creates its own demand because people immediately spent their income on
goods and services. But according to Keynes it is possible in the barter systems only where there
is absence of money. But in the monetary system it is unrealistic assumption because people do
not spend their entire income on consumption but some part of the income is saved by people as
idle cash which is not invested in economy. So, it leads to break income stream on account of
which supply cannot create its own demand, because deficiency of demand occurs in the economy.
(ii) Wages cut policy cannot be cure of unemployment problems: - According to classical
economists, unemployment is caused of rigid money wage. According to them, wage rate must be
flexible. The money wage should be reduced to increase the employment level because more labors
are demanded by producers at law wage rate. So, wage cut policy is cure of unemployment
problems. But Keynes has concluded that wage cut policy is not cure of unemployment problem.
According to him, when wage rate falls, it reduces the income of the labors. Due to fall in income,
they reduce their consumption level, which leads to fall in demand of goods. It reduces the
production and employment level in the economy. So, wage cut policy increases the
unemployment problems instead of solving it.
(iii) Rate of interest cannot be equilibrating mechanism between saving and investment: According to classical economists, the rate of interest is equilibrating mechanism between saving
and investment. It means that the rate of interest makes equal between investment and saving. But
Keynes has criticized the classical view that interest is equilibrating mechanism between saving
and investment. According to Keynes, in the modern complex world, savers are not investors and
investors are not savers. But they are two different groups. So, real saving is not equal to real
investment. Only panned saving is equal to planed investment. So, interest rate cannot be
equilibrating mechanism between saving and investment.
(iv) Interest rate is not purely real sector phenomenon: - According to classical economists,
interest rate is purely real sector phenomenon. It is determined by real sector of the economy. It is
determined by equality between saving and investment but Keynes has criticized it. Interest rate is
purely monetary sector phenomenon and it is determined by equality between money demand and
money supply.
(v) Money is not only demanded for transaction purpose: - According to classical theory,
money is demanded for transaction purpose only but Keynes has criticized the classical view and
he concluded that money is also demanded for precautionary and speculative motive. So, money
demand is related to rate of interest.
(vi) No perfect competition in the real world: - The classical theory is based on the unrealistic
assumption of perfect competition but perfect competition market structure is not found in real
world. According to Edward H. Chamberlin and Mrs. Joan Robinson, Pure competition and pure
monopoly are not realistic market but monopolistic competition is realistic market.
(vii) Long run is not important: - According to classical theory, there would always be full
employment in the economy in the long run. But Keynes has criticized it and said that tomorrow
never comes. In the same way, long run ever comes. We are all dead in the long run.
(viii) Partial equilibrium analysis cannot be applied to the economy as a whole: - The classical
theory is based on partial equilibrium analysis but according to Keynes, the partial equilibrium
analysis cannot be applied to the economy as a whole. So his theory of employment is based on
the general equilibrium rather than partial equilibrium analyses.
(ix) Need of state intervention: - During depression period, profit is very low. So, private
investment is not possible. In this situation, government should increase the investment (public
expenditure) to increase the level of employment, output and income.
The classical theory of employment is based on the unrealistic assumption but it can be
said that the theory is unrealistic theory at any respect. But the theory has great importance. Keynes
also accepts the importance of classical theory of employment after achieving full employment
situation.
 Say’s Law of Market
Say’s law of market is the foundation of classical economics. This law has been named for the
French economist J.B. Say, a famous economist of 19th century. The theory of full employment of
classical economists is based on J.B. Say’s law of market. According to him, “Supply creates its
own demand”. It means that production of goods will be created demand for them too. The main
cause for creation of demand is income obtained by the factors of production. Production not only
fulfills the supply, but this will also provide employment to the people. This will result increase in
their income and demand. But, this won’t create the situation of general over-production. Due to
this, general unemployment will not be created.
Say’s law of market applies both in barter as well monetary economy. In a barter economy, a good
is produced with a purpose of exchanging it for another good. Thus, additional supply represents
additional demand. In a monetary economy, money serves as a medium of exchange. When a
factor of production is employed, it results in a production of a commodity in on the one hand and
generates income in the form payment to the factors of production on the other. The income
received is spent in the market on the purchase at goods. Thus, the employment of a factor of
production pays its own way because it increases income by an amount equal (in equilibrium
conditions) to the amount takes out of the income stream by a way of selling its products. Hence,
Say’s law, which rules out the possibility of general over production and general unemployment,
applies both in barter and money economy.
 Assumptions of Say’s Law of Market
(i) The is existence of free market economy.
(ii) There is absence of government intervention in the automatic working of the economy.
(iii) The size of market is flexible enough for expansion.
(iv) Money is only a medium of exchange.
(vi) There is closed economy, which has no international trade relations.
(vii) Perfect competition exists in both factor and product market.
(viii) Individuals are rational human beings and are motivated by self-interest.
(ix) There is no leakage in the circular flow of income between different economic units.
(x) Wages and prices are flexible.
(xi) Saving equals to investment.
Say’s law of market can be cleared by following circular flow diagram.
Rs. 50000 paid for factors of production
Household Sector
Business Sector
Rs. 50000 spent on goods and services
In this diagram, suppose business sector produces goods and services by the help of factors of
production. Hence, business sectors pay prices of factors of production equal to Rs. 50000, which
is the income of household sector. Household sector spends their entire income equal to Rs. 50000
on goods and services, which is the income of business sector. From this result, it can be cleared
that production of goods and services creates it demand through payment to factors of production.
If household sectors save from their income, then it will be invested by business sector in such a
way that saving is equal to investment. So there will not be problem of over-production. There
would be always full-employment in the economy.
 Implications of Say’s Law of Market
1. Self-adjusting economy: According to J.B. Say, there is an automatic adjustment of each factor
in the working of the economy. For example, if supply increases, demand also increases and
adjustment takes between them. Hence, government should not interfere in the working of the
economy.
2. No general over production: The general over production is impossible. When there is an
increase in production, the income of factors of production also increases. Consequently, new
demand is created and the increased stock of goods is sold in the market.
3. No general unemployment: Since general over production is impossible, there is also no
general unemployment. Even if there is unemployment, it is temporary and disappears after
sometimes.
4. Flexible in wages creates full employment: According to J.B. Say, wage cut creates the
situation of full employment. Hence, the government should not adopt the policy of wage rigidity
in the economy. If there is wage rigidity, the government should play active role to remove it.
5. Policy implication: The Say’s law of market is also important for policy implication. According
to this law, economy is automatically adjustable and it works without any external stimulus.
Therefore, there is no need of government interference in the economy.
 Criticisms of Say’s Law of Market
1. Supply does not create its own demand: - J.B. Say states that supply creates its own demand.
In other words, supply always equals demand because people do not hold any money. But we
know that when there is increase in income, the entire income will not be spent. A portion of it
will be saved. He believed that all that is saved
43 automatically invested. The saving and investment
become equal through the rate of interest. But this is incorrect view. The main determinant of
investment is marginal efficiency of capital. So a fall in rate of interest will not automatically
increase investment. There may be deficiency of demand and supply will not create its own
demand
2. Money demanded for other purpose: - Say’s law assumes that money is demanded as a
medium of exchange only and there is no store of value function of money. But Keynes says that
money also functions as the store of value. People demand money also for speculative purpose to
take benefit of rise in interest rate in future.
3. Economy is not self –adjusting: - According to J.B. say, economy is self-adjusting and it should
not be intervened. But in reality, due to variation in income distribution, difference in demand
between rich and poor are appearing. There is a gap between national output and consumption. In
such situation, a deficiency in aggregate demand appears and intervention of government is
required to regulate economy to the full employment level.
 Keynesian Theory of Employment /Theory of Effective Demand
The classical theory believes that there would be always full employment in the economy in the
long run. According to them unemployment was due to rigid money wage in the short run and they
suggested that money wage should be flexible and wage cut policy is cure of unemployment
problems but Keynes has criticized it. According to Keynes, wage cut policy increases the
unemployment problems rather than to solve it. According to him, unemployment was due to lack
of effective demand. Consumption increases with the increase in income but increase in
consumption is not equal to the extent of increase in income. This is because saving also increases
in the economy with the increase in income and the real saving is not equal to real investment but
only planned saving is equal to planned investment in the economy, which creates the lack of
effective demand it can be fulfilled by investment. So, Keynes has emphasized on investment to
increase the level of employment.
The employment depends upon the effective demand. There is positive relationship
between employment and effective demand. When effective demand increases, the level of
employment also increases. The effective demand is determined by equality between aggregate
demand and aggregate supply. The aggregate demand depends upon aggregate demand price,
which refers to expected rate of return from given level of employment. The expected rate of
returns varies with the variation of employment level. The expected rate of return increases at
decreasing rate with the increase in employment level because the marginal product (MP) of labour
eventually decline with the increase in number of labours. The aggregate demand curve can be
derived from the schedule of different expected rate of return at different level of employment.
The aggregate supply depends upon aggregate supply price and it refers to expected cost in the
given level of employment. The expected cost of labour is different at different level of
employment. The cost expected from labour increases at increasing rate with the increase in
employment level. The aggregate supply curve can be derived by the schedule of different
expected cost of labour at different level of employment.
The effective demand is determined by aggregate demand and aggregate supply and the
effective demand determines the equilibrium level of employment. This can be cleared by the help
of following diagram.
Fig-1.2.
Determination of Employment By Effective Demand
AS
ADP & ASP
Aggregate demand & supply price
K
H
E
AD
G
F
O
N1
Employment level
N2
N3
N
In fig-1.2., aggregate demand and supply price is measured along vertical axis and employment
level along horizontal axes. The AD curve is aggregate demand curve, which is increasing at
decreasing rate because the expected rate of returns increases with the increase in employment
level but at decreasing rate because the Marginal Product (MP) of labor eventually declines with
the increase in no of labors in the production process. The AS is aggregate supply curve, which is
increasing at increasing rate with the increase in employment level, because the expected cost from
additional unit of labor eventually increase at increasing rate. The effective demand is determined
by interactions between aggregate demand and supply curve at point E from which ON2
equilibrium level of employment is determined. According to Keynes, the ON2 level of
employment may not be full employment level of employment. At ON1 employment level, the
expected rate of return is N1G and expected cost is N1F. The expected rate of returns is more than
the expected cost of labor which leads to increase in employment level in the economy so long as
equilibrium level of employment is not determined.. At ON3 employment level, the expected rate
of returns is N3L and expected cost of labor is N3H. The expected cost of labor is greater then
expected rate of returns from labor, which leads to decrease in employment level so long as
equilibrium level of employment is not determined.
According to Keynes, the ON2 employment level may not be full employment. The
employment level can be increased by increasing investment. It can be cleared by following
diagram.
Fig-1.3.
Increase in Employment with the increase in Effective Demand
AS
ADP & ASP
Aggregate demand & supply price
K
AD
E
O
Employment level
N2
AD
N3
N
In this diagram, the effective demand is determined by interactions between aggregate demand
and supply curve at point E from which ON2 equilibrium level of employment is determined. The
employment level can be increased by increasing investment. Suppose, investment increases. As
a result, the aggregate demand curve ‘AD’ shifts upward and takes a position of ‘AD’ as a result
of which the effective demand increase from E to K point and the employment level increases from
ON2 to ON3 point
 Assumption of Effective Demand/Keynesian Theory of Employment
Keynesian theory of employment is based on following assumptions:
(i) Short run: - Keynesian theory of employment is based on the assumption of short run.
According to Keynes, long run never comes and we are all dead in the long run. So, short run is
important is important. In the short run the technology of production is constant.
(ii) Law of diminishing returns: - The theory is based on the law of diminishing returns. It means
that law of variable proportion operates in the production process. So, the Marginal Product (MP)
of labor eventually declines with the increase in additional unit of labor.
(iii) Closed economy: - The theory is based on the assumption of closed economy. The closed
economy is the national economy, which is not affected by foreign trade.
(iv) Perfect competitions: - The theory is based on the assumption of perfect competition. This
theory does hold good in the perfect competition market.
(v) Aggregative concept: - The theory is an aggregate concept, not micro concept. It is related to
general equilibrium rather than partial equilibrium analysis.
 Weakness of Keynesian Theory of Employment
Followings are the weaknesses of Keynesian theory of employment.
(i) Incomplete treatment of unemployment: - Keynesian theory of employment is incomplete
theory to solve the unemployment problem because Keynesian theory explains the technical
remedies to solve the unemployment problems.
(ii) Assumption of perfect competition: - Keynesian theory of employment is based on the
assumption of perfect competition. But the perfect competition market structure is unrealistic.
Such market structure is not found in practice. According to chamberlain, the realistic market is
monopolistic competition.
(iii) Relationship between effective demand and volume of employment: - According to
Keynes, the volume of employment depends upon the effective demand. The higher the effective
demand, the greater will be the volume of employment. But empirical study does not show the
close relationship between effective demand and volume of employment.
(iv) Concentration of an inducement to interest: - Keynes has more emphasized on investment
to increase the level of employment. But the Keynesian theory of employment does not explain
the other determinant factors to increase employment level which is the serious drawback of
Keynesian theory of employment.
(v) Too much aggregative: - This theory is too much aggregative, because it explains the
aggregate consumption, aggregate saving, national income, national output and investment level.
So, Keynesian theory of employment can only solve national economic problems, but it cannot
solve the individual problems like problem of price determination of goods.
(vi) This theory is based on short run concept: - In the short run capital, technology is assumed
to be constant. So, this concept cannot explain the full phase of trade cycle and cannot provide the
appropriate policy for the long run.
 Two Sector Model
 Concept of Two Sector Economy
The 'General Theory' published in 1936 AD where Keynes has propounded consumption function,
investment function, Marginal efficiency of capital and investment multiplier to replace classical
theory of employment and output. According to Keynes, unemployment was not due to wage
rigidity but it is due to lack of effective demand in the economy. The lack of effective demand can
be fulfilled by increasing investment, whereby income increases through multiplier. Keynes has
taken the idea of multiplier from employment multiplier propounded by R.F. Kahn.
The investment multiplier is based on following assumptions from which it is formulated.
 Assumptions of Two Sector Economy
1. National income is made by two components like consumption and investment.
2. Government sector and foreign trade sector are not included in this model. Thus, there is no tax.
There is closed economy, which is not affected by foreign sector.
3. Disposable income is equal to net national income due to lack of tax such as: Y=YD, where Y
refers to income and YD refers to disposable income.
4. Consumption function is assumed to be non-proportional such as: C = CA + cY, where ‘C’ refers
to consumption, ‘a’ refers to autonomous consumption and ‘b’ refers to marginal propensity to
consume.
5. Marginal propensity to consume which is assumed to be positive fraction, i.e.; 0 < MPC < 1.It
means that some part of the income is consumed and the rest is saved. All entire income is neither
saved nor consumed and MPC is assumed to be constant in this model.
6. It is assumed that the current consumption is function of current income.
7. Investment is assumed to be autonomous which is not related to income. There is lack of induce
investment and expressed as: I = IA where, I refers to investment and IA refers to autonomous
investment.
8. There is net increase in investment.
9. The factors of production are easily available in the economy.
!0. An industrializing economy is assumed where multiplier process continuously operate without any dispute.
11. Consumer goods are available to meet effective demand.
12. It is also assumed that there is surplus capacity industries which can produce consumer goods
to meet increased effective demand due to increase in investment.
13. It is assumed that there is no time lag in multiplier process.
14. Price is assumed to be constant.
 (i) National income Determination in two Sector Model
a. Equality between Aggregate demand and Aggregate supply Method
National Income is composition of consumption and Investment. Symbolically,
Y = C + I......... .......... .......... .......... ..(i )
Where,
Y = Income
C = Consumption
I = Investment
Consumption function can be expressed as:
C = C A + cY........ .......... .......... .......... (ii )
Where,
C = Consumption
CA = Autonomous consumption which is not related to income.
c = Marginal propensity to consume which is assumed to be positive fraction, i.e.;
0 < MPC < 1.It means that some part of the income is consumed and the rest is saved. All
entire income is neither saved nor consumed
Investment function can be expressed as:
I = I A .......... .......... .......... .......... ....(iii)
Where,
I = investment
IA =Autonomous investment
Y = C A + cY + I A .......... .......... ......... (iv)
Y - cY = C A + I A .......... .......... .......... .(v )
Y(1 - c) = C A + I A .......... .......... ........ (vi )
C + IA
Y= A
.......... .......... .......... ....... (vii )
1- c
It is equilibrium level of income in two-sector economy.
b. Equality between Investment and Saving Method
The equilibrium level of income can also be obtained by the equality between saving and
Investment method.
AD = C + I......... .......... ....(i )
AS = C + S......... .......... .(ii )
AD = AS........ .......... .....(iii )
C + I = C + S......... .......... ....(iv)
I = S........
.......... ..(v )
S = Y − C.... ....... ....... (vi )
S = Y - ( C A + cY)....... .......... (vii )
S = Y − C A - cY........ .......... (viii )
S = −C A + (1 - c)Y....... ........ (ix )
I = I A .......... .......... .......... ..(x )
I A . = -CA + (1 - c)........ .......... (xi )
- C A + (1 - c)Y = I A .......... ........ (xii )
(1 - c)Y = C A + I A .......... ....(xiii )
Y=
CA + IA
.......... .......... .(xiv )
1- c
It is equilibrium level of income in two-sector economy.
The National Income determination in two sector economy can be cleared by following table by
assuming C = 50 + o.5Y and I = 50
Y
C
I
C+I
0
50
100
150
100
100
100
200
200
150
100
250
200
100
300
300
400
250
100
350
500
300
100
400
In this table the equilibrium level of income is 300 where Y = C + I
It can be cleared by following diagram.
Fig-4.2
Determination of National Income
C+I
Y=C+I
Aggregate expenditure
A
C+I
E1
C
450
O
Y
Y1
Income
Investment & saving
I,S
B
S
F1
O
Y1
I
Income
Y
In panel A, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is called guideline and income is equal to aggregate expenditure at each and
every point of this guideline. The ‘C’ line is consumption line, which has positive slope, showing
the positive relationship between consumption, and income, which explains that consumption level
increases with the increase in income. The ‘C+I’ line is aggregate expenditure line which is parallel
to ‘C’ line because in this theory investment is assumed to be autonomous. It means that investment
is not affected by the change in level of income. The ‘C+I’ line is equal to the guideline at point
E1 from which OY1 equilibrium level of income is determined.
In panel B, Saving and investment are measured along horizontal axis and income along
horizontal axis. The ‘I’ line is equal to the ‘S’ line at point F1 from which OY1 equilibrium level
of income is determined. It is known as the equality between investment and saving method to
determine equilibrium level of income.
 (ii) Investment Multiplier
An increase in investment leads to increase in income. The rate of change in income due to change
in investment is called investment multiplier. The change in investment by I brings the change
in income by Y. It can be cleared as:
C A + I A + ΔI
.......... ........ (viii )
1− c
C + IA
ΔI
Y + ΔY = A
+
.......... ....... (ix )
1− c
1- c
C + IA
C + IA
ΔI
ΔY = A
+
-. A
.......... ...... (x )
1− c
1- c
1− c
Y + ΔY =
ΔI
.......... .......... .......... .......... (xi )
1- c
Y
1
=
.......... .......... .......... ........ (xii )
I
1- c
Y =
Where, 11-b refers to value of multiplier. It implies that income changes through multiplier due
to change in investment. The multiplier works both forward and backward.
The value of multiplier varies with variation in MPC. The higher the value of marginal
propensity to consume the higher will be value of multiplier. The relationship between value of
multiplier and value of MPC is explained in the following table.
Value of Multiplier in Different value of MPC
MPC
MPS=1-c
value of multiplier Y/I
0
1
1
1/2
1/2
2
2/3
1/3
3
3/4
1/4
4
4/5
1/5
5
8/9
1/9
9
9/10
1/10
10
1
0

The value of multiplier is less than infinitive and greater than one such as: 1 < k <  because the
MPC is less than one and greater than zero such as: 0 < MPC < 1.
The theory of multiplier can be cleared by following table by assuming following functions as C
= 50 + 0.5Y, I = 100, I=100
Y
C
I
C+I
I
C+I+I
0
50
100
150
100
250
100
100
100
200
100
300
200
150
100
250
100
350
200
100
100
400
300
300
400
250
100
350
100
450
300
100
400
100
500
500
In this table, initial equilibrium level of income is 300, because at this level of income the income
is equal to expenditure. Later on, investment is increased by 100, the income is increased by
200.This because the value of MPC is 0.5 and the value of multiplier is equal to 2.Hence, the
investment is increased by 2 times due to increase in investment.
The theory of multiplier can be cleared by following figure.
Fig-2.2
Theory of Multiplier
C+I
Y=C+I
A
Aggregate expenditure
E2
C+I+I
E1
C+I
E1
C
450
O
Investment & Saving
I,S
Y1
B
S
F2
F1
O
Y
Y2
Income
I+I
I
Y
Y2
Income
In this diagram, aggregate expenditure ‘C+I’ is measured along vertical axis and income along
horizontal axis. The 450 line is called guideline and income is equal to aggregate expenditure at
each and every point of this guide line. The ‘C’ line is consumption line, which has positive slope,
Y1
showing the positive relationship between consumption, and income, which explains that
consumption level increases with the increase in income. The ‘C+I’ line is aggregate expenditure
line which is parallel to ‘C’ line because in this theory investment is assumed to be autonomous.
It means that investment is not affected by the level of income. The ‘C+I’ line cuts the guideline
at point E1 from which OY1 equilibrium level of income is determined. Now, suppose that
investment is increased by I. consequently, the ‘C+I’ line shifts to the upward parallel and takes
a position of ‘C+I+’. The ‘C+I+’ line cuts the guideline at point E2. Consequently, the OY2
equilibrium level of income is determined. In this figure, the increase in income Y1Y2 is more than
the increase in investment by E1E1 and which is caused by multiplier. In conclusion, the level of
income increases through multiplier due to increase in investment.
In panel B, Saving and investment are measured along horizontal axis and income along
horizontal axis. The ‘I’ line is equal to the ‘S’ line at point F1 from which OY1 equilibrium level
of income is determined. Now suppose that investment increases to the extent of I (E1E1). As a
result, the ‘I+G’ line shifts and takes a position of ‘I+G+G’, which is equal to ‘S+T’ at point F2
from which the level of income increases from OY1 to OY2. It is known as the equality between
investment and saving method to determine equilibrium level of income.
 Conditions/Limitations of Theory of Multiplier
Followings are the conditions/Limitations of the operation of multiplier:
(i) Regular investment: - For the conditions of operation of multiplier, investment should be
regular. If it is not so, then the level of income cannot increase through multiplier.
(ii) No change in MPC: - The value of MPC should be constant for the operation of theory of
multiplier otherwise; there will be variation in the value of multiplier also.
(iii) Availability of consumer’s goods: - For the operation of multiplier, the consumer goods must
be available. If this is not so, then people cannot get chance to spend their income in the economy,
which results fall in value of multiplier.
(iv) Existence of closed economy: - For the operation of multiplier, there would be closed
economy which is not affected by foreign trade.
(v) Existence of less than full employment: - There should be less than full employment in the
economy. The theory of employment cannot operate in existence of full employment.
(vi) No time lag between the receipts of income and the spending of it: - The operation of
multiplier is possible if there is no time lag between receipt of income and spending of it.
(vii) Constant price level: - The price level should be constant for the operation of multiplier. If
it is flexible, then the level of income cannot be increased through multiplier due to increase in
investment.
(vii) Existence of industrialized economy: - For the operation of multiplier, the existence of
industrialized economy is essential condition.
 Leakage of Theory of Multiplier
There are some leakage of multiplier on account of which the theory of multiplier does not hold
good and the level of income is not increasing through multiplier due to increase in investment in
the economy. Such leakages are as follows:
(i) Paying of debts: - It is one of the leakages of multiplier. If increased income due to increase in
investment is used to pay debts instead of purchasing goods and services, then the level of income
cannot be increased through multiplier because this tendency reduces the propensity to consume
and after then value of multiplier.
(ii) Ideal cash balance and saving: - If increased income due to increase in investment is saved
as ideal cash balance instead of spending on consumer goods and services, then this tendency
reduces the aggregate demand in the economy. Consequently, the level of income cannot be
increased through multiplier. The theory of multiplier does not hold good in this case.
(iii) Imports: - The level of income cannot increase through multiplier in the economy because of
import. If the increased income due to increase in investment is used to import foreign goods
instead of spending on domestic goods and services, then it will reduce the demand of domestic
goods. So, multiplier does not hold good.
(iv) Purchase of securities: - If increased income due to increase in investment is used to purchase
consumer goods and services, then it reduces the effective demand in the economy. Consequently,
the level of income cannot be increased through multiplier.
(v) Inflation: - If price level increases in the economy, then the increased income goes to same
goods and services. It cannot increase the demand of new goods and services. Consequently, the
theory of multiplier does not hold good.
(vi) Taxation: - When government increases the rate of tax, then such taxation policy reduces the
disposable income of people. It reduces the propensity to consume of people.
(vii) Undistributed profit: - If the policy of corporation is not to distribute entire profit to the
shareholders and if some part of profit is undistributed, then multiplier does not hold good because
it reduces the propensity to consume and the value of multiplier.
(viii) Excess stock of consumption goods: - If there is excess stock of consumption goods in the
economy, then the increased income due to increase in investment cannot increase the demand of
new goods and there is no possibility of production of new goods.
 Importance and Use of Theory of Multiplier
Followings are the important and use of multiplier.
(i) Importance of investment: -The standard of multiplier tells us that the investment is dynamic
factor in the short run to increase the output, employment and income because the marginal
propensity to consume is constant in the short run.
(ii) Government expenditure: - The theory of multiplier tells us that the government expenditure
is essential during depression period, because the private investment is not possible during
depression period due to lack of sufficient demand. In this situation, government can increase the
employment, output and income by increasing government expenditure on social and economic
infrastructure.
(iii) To remove unemployment: - The theory of multiplier can be used to remove unemployment
in the economy by increasing investment and government expenditure which is the main
importance of theory of multiplier.
(iv) Analyzing the course of business cycle: - The theory of multiplier plays the important role
to analyze the course of business cycle. The theory of multiplier is helpful to built up anti-cyclical
period to control the business fluctuation. It tells us that how recovery phases can be achieved by
increasing investment during depression period.
 Criticisms of Theory of Multiplier
Followings are the criticisms of the theory of multiplier.
(i) No precise relationship between income and investment: - According to Henry Hazlitt, there
is no precise relationship between income and investment. So, according to Henry Hazlitt, the
theory of multiplier is myth and worthless toy.
(ii) Ignores distinguished unemployment problem: - Keynes has ignored the distinguished
unemployment problem and only considered the cyclical and involuntary unemployment. But in
the modern economy, the distinguished unemployment is one of the serious burning problems.
(iii) Ignores the effect of induced investment: - The Keynesian theory of multiplier has been
ignored the effect of induced investment, because the theory of multiplier assumes the autonomous
investment in the economy.
(iv) Equality between saving and investment: - According to Keynes, planned saving is equal
to planned investment. But the theory of multiplier does not prove it, because same part of the
income is saved which is increased through multiplier due to increase in investment.
(vi) Problem of ambiguousness: - Theory of investment multiplier is not original theory because
it is borrowed from the employment multiplier propounded by R. F. Kahn. So, there is problem of
ambiguousness.
(vi) More tautological theory: - The income increases due to increase in investment
automatically. So, Keynesian theory of investment multiplier is not new theory. It is only revision
of classical theory.
(vii) Static theory: - The Keynesian theory of investment multiplier is static theory because it
assumes that the level of income increases immediately due to increase in investment. But this
theory ignores time lags between income and expenditure. In the same way, it ignores time lag
between investment and income.
 Three Sector Model
 First Fiscal Model
(i). National Income Determination
(a) Equality between Aggregate Demand and Aggregate Supply Method
In this Model Income made with three components: consumption, investment and government
expenditure. It can be expressed as:
Y = C + I + G......... .......... .......... .......... ..(i )
Where,
Y = Income
C = Consumption
I = Investment
G = Government expenditure
Consumption can be classified into two categories: autonomous consumption and induced
consumption. It can be expressed as:
C = C + cY .......... .......... .......... .......... .(ii )
A
D
Where, C = Consumption
CA = Autonomous consumption which is not affected by change in income. It is constant
at every level of income.
c = Marginal propensity to consume which is assumed to be constant and positive
fraction such as: 0 < c < 1.It means that some part of income is consumed and the rest is
saved.
YD = Disposable income. The disposable income can be expressed as:
Y
D
= Y - T......... .......... .......... .......... .......... ...(iii )
Where,
YD = Disposable income
Y = Net income
T = Tax
In the two sectors model is equal to YD but in three sectors model Y is greater than YD.In this
model tax is assumed lump sum. The amount of tax does not increase due to increase in income.
Investment is assumed entirely autonomous and it is not affected by income. It can be expressed ii
as:
I = I .......... .......... .......... .......... .......... .(iv )
A
Where,
I= Investment
IA=Autonomous investment
Government expenditure is exogenously determined by the government and it is also assumed to
be autonomous and not affected by income. It can be expressed as:
G = G .......... .......... .......... .......... .......... .(v )
A
Where,
G = Government expenditure
GA= Autonomous government expenditure
On the basis of above assumption equation (i) can be expressed as:
Y=C
Y=C
Y=C
A
A
A
+ cY + I
D
+ G .......... .......... .....(vi )
A
+ c(Y - T ) + I
+ cY - cT + I
Y - cY = C
A
Y (1 - c ) = C
Y=
A
A
- cT + I
A
+ G .......... .......... (viii )
A
A
- cT + I
+ G .......... .......... (vii )
A
A
A
+ G .......... .......... ..(ix )
A
+ G .......... .......... (x )
C A - cT + I A + G A
(1 - c)
A
.......... .......... ........ (xi )
It is equilibrium level of income in three sector economy.
(b) The equality between saving and Investment method
The equilibrium level of income can also be obtained by the equality between saving and
Investment method.
AD = C + I + G......... .......... .......... .......... ..(i )
AS = C + S + T......... .......... .......... .......... ..(ii )
AD = AS........ ........ ...... ...... .......... ...(iii)
C + I + G = C + S + T......... .......... .......... .(iv )
I + G = S + T......... .......... .......... .......... ..(v )
S = Y − C......... .......... .......... .......... . .....(vi )
S = (Y - T) − CA . + c(Y - T) .......... .......... (vii )
S = Y − T − C A - cY + cT........ .......... .(viii )
S + T = Y − T − C A - cY + cT + T......... ..(ix )
S + T = Y − T − C A - cY + cT + T.......... .(x )
S + T = Y − C A - cY + cT........ .......... (xi )
S + T = −C A + cT + (1 - c)Y....... .......... .(xii )
− C A - cT + (1 - c)Y = I A + G A .......... ......... (xiii )
(1 - c)Y = C A - cT + I A + G A .......... .......... ..(xiv )
Y=
C A - cT + I A + G A
.......... .......... ..(xv )
1- c
It is equilibrium level of income in the three sectors model.
It can be cleared by following table by assuming C = 55 + 0.5(Y – 10),
I = 50, G = 50
Y
C=55+0.5(Y-10)
I
G
C+I+G
0
50
50
50
150
100
100
50
50
200
200
150
50
50
250
300
200
50
50
300
400
250
50
50
350
500
300
50
50
400
600
350
50
50
450
In this table, the equilibrium level of income is 300 because at this level of income is equal to
aggregate expenditure, i.e., Y = C + I +G.
It can be cleared by following diagram.
A
Aggregate expenditure
C+I
0
Y=C+I+G
C+I+G
C+I
E1
C
450
Y1
Y
Income
Leakage & injection
S,T,I & G
B
S+T
F1
0
Y1
I+G
Income
Y
In panel A, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 degree line is considered as guide line. The ‘C+I+G’ line is aggregate expenditure
line which is equal to guide line at point E1 from which OY1 equilibrium level of income is
determined. It is known as the equality between aggregate demand and aggregate supply method
to determine equilibrium level of income.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T’ line at point F1 from which
OY1 equilibrium level of income is determined. It is known as the equality between investment
and saving method to determine equilibrium level of income.
(ii) Government Expenditure Multiplier
If government expenditure increases, then income also increases in the economy. The rate of
change in income due to change in government expenditure is called government expenditure
multiplier. In the first fiscal model, the equilibrium income can be expressed as:
C - cT + I A + G A
Y= A
.......... .......... ........ (i )
(1 - c)
If government expenditure (G) is increased by G, then income also increases by Y. It can be
expressed as:
C - cT + I A + G A + ΔG
Y + ΔY = A
.......... (ii )
(1 - c)
Y + ΔY =
ΔY =
ΔY =
C A - cT + I A + G A
(1 - c)
C A - cT + I A + G A
(1 - c)
+
+
ΔG
....... (iii)
1− c
C - cT + I A + G A
ΔG
.- A
...(iv)
(1 - c)
1− c
ΔG
.......... .......... .......... .......... ....... (v )
1− c
ΔY
1
=
.......... .......... .......... .......... ......(vi )
ΔG 1 − c
It means that income increases multiplier time increase in government expenditure.
Even in this case, the value of multiplier depends upon the value of MPC. The higher the value of
MPC, the higher will be the value of multiplier. The fiscal policy with deficit budget will be
effective when the value of multiplier is high.
The government expenditure multiplier and equilibrium of income has been shown by the help of
following table by assuming following functions as C = 75 + 0.5(Y – 50), I = 50, G=50, G=50
Y
0
100
200
300
400
500
600
C=50
50
100
150
200
250
300
350
I
50
50
50
50
50
50
50
G
50
50
50
50
50
50
50
C+I+G
150
200
250
300
350
400
450
G
50
50
50
50
50
50
50
C+I+G+G
200
250
300
350
400
450
500
In this table, the equilibrium level of income is 300 because at this level of income is equal to
aggregate expenditure, i.e., Y = C + I +G. Later on, government expenditure is increased by 50,
the income is increased by 100.This because the value of MPC is 0.5 and the value of
government expenditure multiplier is equal to 2.Hence, the income is increased by 2 times due to
increase in government expenditure.
It can be cleared by following diagram.
C+I
Y=C+I+G
Aggregate expenditure
A
E2
C+I+G+G
E1
C+I+G
E1
C+I
C
450
0
Y1
Y2
Income
Y
Leakage & injection
S,T,I & G
B
F1
S+T
F2
F1
0
Y1
I+G+G
I+G
Y2
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The relationship between consumption and
income is positive and non-proportional. The ‘C+I’ line is parallel to ‘C’ line because investment
is assumed autonomous. In the same way, the ‘C+I+G’ line is parallel to ‘C+I’ line because
government expenditure is also assumed to be autonomous. The ‘C+I+G’ line is equal to guide
line at point E1 from which 0Y1 equilibrium level of income is determined. Now suppose that
government expenditure increases to the extent of E1E1'. Consequently, the ‘C+I+G’ line shifts
upward and takes a position of ‘C+I+G+G’ line which is equal to guide line at point E2 from
which 0Y2 equilibrium level of income is determined. In this diagram, the change in income by
Y1Y2 is more than the change in investment by E1E1', which is caused of the value of multiplier.
Hence, income increases through multiplier so long as full-employment income is not achieved.
In panel B, Saving, investment, Tax and government expenditure are measured along vertical axis
and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T’ line at point F1 from which
OY1 equilibrium level of income is determined. Now suppose that government expenditure
increases by G (F1F1). As a result, the ‘I+G’ line shifts and takes a position of ‘I+G+G’, which
is equal to S+T at point F2 from which the level of income increases from OY1 to OY2. It is known
as the equality between investment and saving method to determine equilibrium level of income.
(iii) Tax Multiplier
If government increases tax, then income also decreases in the economy. The rate of change in
income due to change in tax is called tax multiplier. In the first fiscal model, the equilibrium
income can be expressed as:
C - cT + I A + G A
Y= A
.......... .......... ........ (i )
(1 - c)
If tax (T) is increased by T, then income also increases by Y. It can be expressed as:
C - c(T + T ) + I A + G A
Y + ΔY = A
.......... (ii )
(1 - c )
Y + ΔY =
C A - cT - cT + I A + G A
.......... (iii)
(1 - c)
Y + ΔY =
C A - cT + I A + G A
cT
−
....... (iv )
(1 - c )
(1 - c )
C A - cT + I A + G A cT C A - cT + I A + G A
+
....(v )
(1 - c)
(1 - c)
1− c
cT
ΔY = −
.......... .......... .......... .......... ......(vi )
1− c
ΔY
c
=−
.......... .......... .......... .......... ....... (vii )
ΔT
1− c
ΔY =
It means that income decreases multiplier time increase in Tax.
Even in this case the value of multiplier depends upon the value of MPC. The higher the value of
MPC, the higher will be the value of tax multiplier.
The tax multiplier and equilibrium of income has been shown by the help of following table by
assuming following functions as C = 75 + 0.5(Y – 50), G = 100, I = 100, T =50
Y
0
100
200
300
400
450
500
600
C=75+0.5(Y-50)
50
100
150
200
250
275
300
350
I
100
100
100
100
100
100
100
100
G
100
100
100
100
100
100
100
100
C+I+G
250
300
350
400
450
475
500
550
cT
-25
-25
-25
-25
-25
-25
-25
-25
C+I+G-cT
225
375
325
375
425
450
575
525
In this table, the equilibrium level of income is 500 because at this level of income is equal to
aggregate expenditure, i.e., Y = C + I +G. Later on, tax is increased by 50; the income is
decreased by 100 due to tax multiplier.
It can cleared by following diagram.
C+I+G
Y=C+I+G
A
Aggregate expenditure
C+I+G
0
E1
E2
Leakage & injection
E1
C
450
S,T,I & G
Y2 Y1
B
Y
Income
S+T+T
S+T
F2
0
C+I+G-cT
C+I
F1
Y2 Y1
I+G
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The ‘C+I’ line and ‘C+I+G’ line is parallel
are parallel to ‘C’ line because investment and government expenditure are assumed to be
autonomous. The ‘C+I+G’ line is equal to guide line at point E1 from which 0Y1 equilibrium level
of income is determined. Now suppose that tax increases from E1 to E1'. Consequently, the
‘C+I+G’ line shifts upward and takes a position of ‘C+I+G-cT’ line which is equal to guide line
at point E2 from which 0Y2 equilibrium level of income is determined.
In panel B, Saving, investment, Tax and government expenditure are measured along vertical axis
and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T’ line at point F1 from which
OY1 equilibrium level of income is determined. Now suppose that government increases the lump
sum tax to the extent of (E1E1). As a result, the ‘C+I+G’ line shifts and takes a position of ‘C+I+GcT’, which is equal to ‘S+T’ at point F2 from which the level of income decreases from OY1 to
OY2.
(iv) Balance Budget Multiplier
What happens on income, when government increases government expenditure through equal
increases in tax? According to classical economist, balance budget is neutral it does not effect on
income because the increase in income is offset by increase in equal amount in tax. But according
to modern economist, balance budget has positive effect on income. If increase in government
expenditure is financed through equal to increase in tax, then it is called balance budget. In three
sector economy with first fiscal model the equilibrium level of income can be expressed as:
C - cT + I A + G A
Y= A
.......... .......... ........ (i )
(1 - c)
The rate of change in income due to change in government expenditure through equal change in
tax is called balance budget multiplier. In the first fiscal model, the balance budget multiplier can
be expressed as:
Y + Y =
C A - c(T + ΔT ) + I A + G A + ΔG
.......... ....(ii )
(1 - c)
If government expenditure (g) is increased by G, then income also increases by Y. It can be
expressed as:
C - cT - cT + I A + G A + ΔG
Y + Y = A
.......... .....(iii)
(1 - c)
Y + Y =
Y =
Y =
Y =
C A - cT + I A + G A ΔG - cT
+
.......... ....(iv)
(1 - c)
(1 - c)
C A - cT + I A + G A ΔG - cT C A - cT + I A + G A
+
-.
......... (v )
(1 - c)
(1 - c)
(1 - c)
ΔG - cT
.......... ...(vi )
(1 - c )
ΔG - cG
.......... ...(vii ) T = G In balance budget
(1 - c)
ΔY =
G (1 - c )
.......... ...(viii )
(1 - c )
ΔY = G......... .......... .....(ix )
ΔY
= 1.......... .......... ... .......
ΔG
(x )
It means that balance budget multiplier has positive effect on income.
It can be cleared by following table by assuming C = 100 + 0.5(Y - T), Yd = Y - T, T = 100,
= 100, G = 100, G = 100, T = 100
I
Y
0
C
50
I
100
G
100
C+I+G
250
G
100
-cT
-50
C+I+G+G-cT
300
100
200
300
400
100
150
200
250
100
100
100
100
100
100
100
100
300
350
400
450
100
100
100
100
-50
-50
-50
-50
350
400
450
500
500
600
300
350
100
100
100
100
500
550
100
100
-50
-50
550
600
In this table, the equilibrium level of income is 500 because at this level of Y = C + I +G. Later
on, government expenditure is increased by 100 through increasing equal amount of tax, the
income is increased by 100 due to balanced budget multiplier.
It can be cleared by following diagram.
C+I+G
Y=C+I+G
A
C+I+G-cT+G
Aggregate expenditure
E3
E1
C+I+G
E1
E2
C+I+G-cT
C+I
C
450
0
Y2
Y1
Y3
Income
Y
Leakage & injection
S,T,I & G
0
B
F3
F2
S+T+T
S+T
I+G+G
F1
Y2 Y1
I+G
Y3
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The relationship between consumption and
income is positive and non-proportional. The ‘C+I’ line is parallel to ‘C’ line because investment
is assumed autonomous. In the same way, the ‘C+I+G’ line is parallel to ‘C+I’ line because
government expenditure is also assumed autonomous. The ‘C+I+G’ line is equal to guide line at
point E1 from which 0Y1 equilibrium level of income is determined. Now suppose that tax
increases from E1 to E1'. Consequently, the ‘C+I+G’ line shifts downward and takes a position of
‘C+I+G-cT’ line, which reduces the level of income from OY1 to OY2. However, the increased
government expenditure is financed through equal increase in tax. Therefore, the ‘C+I+G-cT’
shifts upward and takes a position of ‘C+I+G-cT+G’ which is equal to guide line at point E3
from which 0Y3 equilibrium level of income is determined. Hence, the balance budget multiplier
is helpful to increase in income.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T’ line at point F1 from which
OY1 equilibrium level of income is determined. Now suppose that government increases lump sum
tax to the extent of E1E1. As a result, the ‘S+T’ line shifts to the right side and takes a position of
‘S+T+T’, which reduces the level of income from OY1 to OY2. However, the increased
government expenditure is financed through equal increase in tax. So the ‘I+G’ line shifts and
takes a position of ‘I+G+G’ which is equal to ‘S+T+T’ at point F3. Therefore, the level of
income increases from OY1 to OY3.
 Second Fiscal Model
(i) National Income Determination
(a) Equality between Aggregate Demand and Aggregate Supply Method
In this Model Income made with three components: consumption, investment and government
expenditure. It can be expressed as:
Y = C + I + G......... .......... .......... .......... ..(i )
Where,
Y = Income
C = Consumption
I = Investment
G = Government expenditure
Consumption can be classified into two categories: autonomous consumption and induced
consumption. It can be expressed as:
C = C + cY .......... .......... .......... .......... .(ii )
A
D
Where, C = Consumption
CA = Autonomous consumption which is not affected by change in income. It is constant
at every level of income.
c = Marginal propensity to consume which is assumed to be constant and positive fraction
such as: 0 < c < 1.It means that some part of income is consumed and the rest is saved.
YD = Disposable income. The disposable income can be expressed as:
YD = Y - T. + R......... .......... .......... .......... .......... ..(iii)
Where,
YD = Disposable income
Y = Net income
T = Tax
R = Transfer of payment. Old age pension, unemployment relied payment etc. are
example of transfer of payment.
In this model with second fiscal model, transfer of payment is also included. It is the difference
between first fiscal model and second fiscal model.
Investment is assumed entirely autonomous and it is not affected by income. It can be expressed
as:
I = I .......... .......... .......... .......... .......... .(iv )
A
Where,
I= Investment
IA=Autonomous investment
Government expenditure is exogenously determined by the government and it is also assumed to
be autonomous and not affected by income. It can be expressed as:
G = G .......... .......... .......... .......... .......... .(v )
A
Where,
G = Government expenditure
GA= Autonomous government expenditure
On the basis of above assumption equation (i) can be expressed as:
Y=C
A
+ cY + I
D
A
+ G .......... .......... .....(vi )
A
Y = C A + c(Y - T + R ) + I A + G A .......... .....(vii )
Y = C A + cY - cT + cR + I A + G A .......... ..(viii )
Y - cY = C A - cT + cR + I A + G A .......... .(ix )
Y(1 - c ) = C A - cT + cR + I A + G A .......... ..(x )
Y=
C A - cT + cR + I A + G A
.......... ......(xi )
(1 - c )
It is equilibrium level of income in second fiscal model in three sector economy.
(b) Equality between Saving and Investment Method
The equilibrium level of income can also be obtained by the equality between saving and
Investment method.
AD = C + I + G......... .......... ......... (i )
AS = C + S + T. - R......... .......... (ii )
AD = AS........ .......... .......... ......(iii)
C + I + G = C + S + T - R......... .....(iv)
I + G = S + T - R......... .......... ....(v )
S = YD − C......... .......... .......... ..(vi )
S = (Y - T + R) − C A . + c(Y - T + R).......... .....(vii )
S = Y − T + R − C A - cY + cT − cR........ ......... (viii )
S + T - R = Y − T + R − C A - cY + cT − cR + T. - R........ (ix )
S + T = Y − T + R − C A - cY + cT − cR + T - R.......... ...(x )
S + T - R = Y − C A - cY + cT − cR........ ....... (xi )
S + T - R = −C A + cT − cR + (1 - c)Y....... .(xii )
I A + G A = S + T - R......... .......... .......... ...(xiii )
− C A + cT − cR + (1 - c)Y = I A + G A .......... (xiv )
(1 - c)Y = C A - cT + cR + I A + G A ...... ........ (xv )
Y=
C A - cT + cR + I A + G A
..... ...... .....(xvi )
1- c
It is equilibrium level of income in the three sectors model
It can be cleared by the help of following table by assuming C = 75 + 0.5(Y –100 + 50),
= 50, G = 50,
Y
C=75+0.5(Y-100+50)
I
G
C+I+G
0
50
50
50
150
100
100
50
50
200
200
150
50
50
250
300
200
50
50
300
400
250
50
50
350
500
300
50
50
400
600
350
50
50
450
In this table, the equilibrium level of income is 300 because at this level of Y = C + I +G. Later
on, government expenditure is increased by 100 through increasing equal amount of tax; the
income is increased by 100 due to balanced budget multiplier.
I
It can be cleared by following diagram.
C+I
Aggregate expenditure
A
0
Y=C+I+G
C+I+G
C+I
E1
C
450
Y1
Y
Income
S,T,I & G
Leakage & injection
B
S+T-R
F1
0
Y1
I+G
Income
Y
In panel A, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guide line. The ‘C+I+G’ line is aggregate expenditure line
which is equal to guide line at point E1 from which OY1 equilibrium level of income is
determined. It is known as the equality between aggregate demand and aggregate supply method
to determine equilibrium level of income.
In panel B, Saving, investment, Tax and government expenditure are measured along vertical
axis and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T’ line at point F1 from
which OY1 equilibrium level of income is determined. It is known as the equality between
investment and saving method to determine equilibrium level of income.
(ii) Transfer of payment Multiplier
If government increases transfer of payment, then income also increases in the economy. The
rate of change in income due to change transfer of payment is called government expenditure
multiplier. In the first fiscal model, the equilibrium income can be expressed as:
C - cT + cR + I A + G A
Y= A
.......... .......... ........ (i )
(1 - c )
If transfer of payment is increased by R, then income also increases by Y. It can be expressed
as:
C - cT + c(R + R) + I A + G A
Y + ΔY = A
.......... (ii )
(1 - c )
C - cT + cR + I A + G A
cR
Y + ΔY = A
+
....... (iii )
(1 - c )
1− c
ΔY =
ΔY =
C A - cT + cR + I A + G A
cR C A - cT + cR + I A + G A
+
....(iv )
(1 - c )
(1 - c )
1− c
cR
.......... .......... .......... .......... ....... (v )
1− c
ΔY
c
=
.......... .......... .......... .......... ......(vi )
ΔR
1− c
It means that income increases through transfer of payment multiplier due to increase in transfer
of payment multiplier.
The transfer of payment multiplier and equilibrium of income has been shown by assuming
C = 75 + 0.5(Y –100 + 50), I = 50, G = 50, R =100
Y
0
100
200
300
400
500
600
C=50
50
100
150
200
250
300
350
I
50
50
50
50
50
50
50
G
50
50
50
50
50
50
50
C+I+G
150
200
250
300
350
400
450
cR
50
50
50
50
50
50
50
C+I+G+cR
200
250
300
350
400
450
500
In this table, the equilibrium level of income is 300 because at this level of Y = C + I +G. Later
on, transfer of payment is increased by 100, the income is increased by 100 due to transfer of
payment multiplier.
It can be cleared by following diagram.
Aggregate expenditure
C+I+G
C+I+G+cR
C+I+G
C+I
E2
E1
C
C
E1
0
450
S,T,I.R & G
Leakage & injection
Y=C+I+G
A
Y1 Y2
B
Income
Y
S+T-R
S+T-R-R
F1
F2
0
Y1 Y2
I+G
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The relationship between consumption and
income is positive and non-proportional. The ‘C+I’ line is parallel to ‘C’ line because investment
is assumed autonomous. In the same way, the ‘C+I+G’ line is parallel to C+I line because
government expenditure is also assumed autonomous. The ‘C+I+G’ line is equal to guide line at
point E1 from which 0Y1 equilibrium level of income is determined. Now suppose that transfer of
payment increases from E1 to E1'. Consequently, the ‘C+I+G’ line shifts upward and takes a
position of ‘C+I+G+cR’ line which is equal to guide line at point E2 from which 0Y2 equilibrium
level of income is determined.
In panel B, Saving, investment, Tax, transfer of payment and government expenditure are
measured along horizontal axis and income along horizontal axis. The ‘I+G’ line is equal to ‘S+TR’ line at point F1 from which OY1 equilibrium level of income is determined. Now suppose that
transfer of payment increases by R. As a result, the ‘S+T-R’ line shifts and takes a position of
‘S+T-R-R’, which is equal to ‘I+G’ at point F2 from which the level of income increases from
OY1 to OY2.
 Third Fiscal Model
(i) National Income Determination
(a) Equality between Aggregate demand and Aggregate Supply Method
In this Model Income made with three components: consumption, investment and government
expenditure. It can be expressed as:
Y = C + I + G......... .......... .......... .......... ..(i )
Where,
Y = Income
C = Consumption
I = Investment
G = Government expenditure
Consumption can be expressed as:
C = C + cY .......... .......... .......... .......... .(ii )
A
D
Where, C = Consumption
CA=Autonomous consumption which is not affected by change in income. It is constant
at every level of income.
c = Marginal propensity to consume which is assumed to be constant and positive
fraction such as: 0 < c < 1.It means that some part of income is consumed and the rest is
saved.
YD = Disposable income. The disposable income can be expressed as:
YD = Y - T + R......... .......... .......... .......... .......... ...(iii)
Where,
YD = Disposable income
Y = Net income
T = Tax
R = Transfer of payment
Tax function can be expressed as:
T = TA + tY........ .......... .......... .......... ..(iv)
Where,
T= Total tax
TA = Autonomous Tax which is constant at every level of income
t = marginal propensity to tax which is assumed to constant and positive fraction.
i.e., 0 < t < 1
tY = induced tax which increases with the increase in income.
In this model, tax is assumed lump sum and transfer of payment is assumed constant at every
level of income. The value of t is constant it means that tax system is assumed to be proportional.
Investment is assumed entirely autonomous and it is not affected by income. Symbolically,
I = I A .......... .......... .......... .......... .(v )
Where,
I= Investment
IA=Autonomous investment
Government expenditure is exogenously determined by the government and it is assumed
autonomous and not affected by income. It can be expressed as:
G = G A .......... .......... .......... ........ (vi )
Where,
G = Government expenditure
GA= Autonomous government expenditure
On the basis of above assumption equation (i) can be expressed as:
Y = C A + cYD + I A + G A .......... .......... .....(vii )
Y = C A + c(Y - T + R ) + I A + G A .......... .......... (viii )
Y = CA + c(Y - (Ta + tY) + R )+ I A + G A .......... .(ix )
Y = CA + cY − Ta − tY + R+ I A + G A .......... (x )
Y = CA + cY − cTa - ctY + cR + I A + G A .......... .(xi )
Y - cY + ctY = CA − cTa + cR + I A + G A ......... (xii )
(1- c + ct )Y = CA − cTa + cR + IA + G A ......... (xiii )
C A − cTa + cR + I A + G A
.......... .......... (xiv )
1 - c + ct
It is equilibrium level of income in three-sector economy with third sector economy.
Y=
(b) Equality between Investment and Saving Method
The equilibrium level of income can also be obtained by the equality between saving and
Investment method.
AD = C + I + G......... .......... .......... (i )
AS = C + S + T - R......... .......... .....(ii )
AD = AS........ .......... .......... ....... (iii)
C + I + G = C + S + T - R......... ....... (iv)
I + G = S + T - R......... .......... ..(v )
S = YD − C......... .......... .......... ......(vi )
S = (Y - T + R) − C A + c(Y - T + R).......... ... ......... ........ (vii )
S = Y − (TA + tY ) + R  − C A + cY − c(TA + tY ) + cR......... (viii )
S = Y − TA − tY + R − C A − cY + cTA + ctY − cR........ .....(ix )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + T - R....... (x )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + TA + tY - R...(xi )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + TA + tY - R...(xii )
S + T - R = Y − C A − cY + cTA + ctY − cR......(xiii )
S + T - R = IA + G A
.......... ......... (xiv )
Y − cY + ctY = C A − cTA + cR + I A + G A ......(xv )
(1 - c + ct )Y = CA − cTA + cR + I A + G A ......(xvi )
Y=
C A − cTA + cR + I A + G A .
.......... .......... ....(xvii )
1 - c + ct
It is equilibrium level of income in the three sectors model by assuming
C=50+0.5{Y-(10-0.1Y)+20},R=20, I=100 and G=100
C=50+0.5{Y-(10-0.1)+20}
Y
I
G
C+I+G
0
55
100
100
225
100
100
100
100
300
200
145
100
100
345
300
190
100
100
390
400
235
100
100
435
464
264
100
100
464
500
280
100
100
480
In this table, the equilibrium level of income is 464 because at this level of Y = C + I +G.
C+I
Aggregate expenditure
A
Y=C+I+G
C+I+G
C+I
E1
Ca +cY-cTa+ctY+cR
450
0
Y1
Income
Y
S,T,I & G
Leakage & injection
B
S+T-R
F1
Y1
I+G
Income
Y
0
In panel A, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 is considered as guide line. The ‘C+I+G’ line is aggregate expenditure line which is
equal to guide line at point E1 from which OY1 equilibrium level of income is determined. It is
known as the equality between aggregate demand and aggregate supply method to determine
equilibrium level of income.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G’ line is equal to the ‘S+T’. line at point F1 from
which OY1 equilibrium level of income is determined. It is known as the equality between
investment and saving method to determine equilibrium level of income.
(ii) Government Expenditure Multiplier
If government expenditure increases, then income also increases in the economy. The rate of
change in income due to change in government expenditure is called government expenditure
multiplier. In the first fiscal model, the equilibrium income can be expressed as:
C − cTA + cR + I A + G A
Y= A
.......... .......... (i )
1 - c + ct
If government expenditure (G) is increased by G, then income also increases by Y. It can be
expressed as:
C - cTA + cR + I A + G A + ΔG
Y + ΔY = A
.......... (ii )
(1 - c + ct )
Y + ΔY =
C A - cTA + cR + I A + G A
ΔG
+
....... (iii )
(1 - c + ct )
1 − c + ct
ΔY =
C A - cTA + cR + I A + G A
C - cTA + cR + I A + G A
ΔG
+
.- A
...(iv )
(1 - c + ct )
(1 - c + ct )
1 − c + ct
ΔY =
ΔG
.......... .......... .......... .......... ....... (v )
1 − c + ct
ΔY
1
=
.......... .......... .......... .......... ......(vi )
ΔG 1 − c + ct
It means that income increases multiplier time increase in government expenditure.
In this case the value of multiplier depends upon the value of MPC and MPT. The higher the
value of MPC or MPT, the higher will be the value of multiplier.
The government expenditure multiplier and equilibrium of income has been shown by assuming
C=50+0.5{Y-(10-0.1)+20}, I = 100, G=100, G =100
C=50+0.5{Y-(10-0.1)+20}
Y
I
G
C+I+G
G
C+I+G+G
0
55
100
100
255
100
355
100
100
100
100
300
100
400
200
145
100
100
345
100
445
300
190
100
100
390
100
490
400
235
100
100
435
100
535
464
264
100
100
464
100
564
500
280
100
100
480
100
580
600
325
100
100
525
100
625
646
364
100
100
546
100
646
In this table, the equilibrium level of income is 646 because at this level of Y = C + I +G. Later
on, the income is increased by100 due to increase in government expenditure by 50, It is caused
of government expenditure multiplier.
It can be cleared by following diagram.
Y=C+I+G
C+I
C+I+G+G
A
E2
C+I+G
Aggregate expenditure
E1
C+I
E1
Ca +cY-cTa+ctY+cR
450
0
Y1
S,T,I & G
Y2
Income
Y
Leakage & injection
B
F1
S+T-R
F2
F1
0
Y1
I+G+G
I+G
Y2
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The relationship between consumption and
income is positive and non-proportional. The ‘C+I’ line is parallel to C line because investment is
assumed autonomous. In the same way, the ‘C+I+G’ line is parallel to ‘C+I’ line because
government expenditure is also assumed autonomous. The ‘C+I+G’ line is equal to guide line at
point E1 from which 0Y1 equilibrium level of income is determined. Now suppose that government
expenditure increases from E1 to E1'. Consequently, the ‘C+I+G’ line shifts upward and takes a
position of ‘C+I+G+G’ line which is equal to guide line at point E2 from which 0Y2 equilibrium
level of income is determined. In this diagram, the change in income by Y1Y2 is more than the
change in investment by E1E1', which is caused of the value of multiplier. Hence, income increases
through multiplier so long as full-employment income is not achieved.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G’ line is equal to ‘S+T-R’ line at point F1 from
which OY1 equilibrium level of income is determined. Now suppose that government expenditure
increases by G (E1E1). As a result, the ‘I+G’ line shifts and takes a position of ‘I+G+G’, which
is equal to ‘S+T-R’ at point F2 from which the level of income increases from OY1 to OY2. It is
known as the equality between investment and saving method to determine equilibrium level of
income.
(iii) Tax Multiplier
If government increases tax, then income also increases in the economy. The rate of change in
income due to change in tax is called tax multiplier. In the first fiscal model, the equilibrium
income can be expressed as:
C − cTA + cR + I A + G A
Y= A
.......... .......... (i )
1 - c + ct
If tax (T) is increased by T, then income also increases by Y. It can be expressed as:
C - c(TA + ΔT ) + cR + I A + G A
Y + ΔY = A
.......... (ii )
(1 - c + ct )
Y + ΔY =
C A - cTA - cT + cR + I A + G A
.......... (iii)
(1 - c + ct )
Y + ΔY =
C A - cTA + I A + G A
cT
−
....... (iv)
(1 - c = ct )
(1 - c + ct )
ΔY =
C A - cTA + cR + I A + G A
cT
C - cTA + cR + I A + G A
+
.- A
...(v )
(1 - c + ct )
(1 - c + ct )
1 − c + ct
ΔY = −
cT
.......... .......... .......... .......... ......(vi )
1 − c + ct
ΔY
c
=−
.......... .......... .......... .......... ....... (vii )
ΔT
1 − c + ct
It means that income decreases multiplier time increase in Tax.
The tax multiplier and equilibrium of income has been shown by assuming
C=50+0.5(Y–(10+0.1Y)+ 20), I = 100, G =100, T =100
Y
C=50+0.5{YI
G
C+I+G
cT
C+I+G+G
(10+0.1Y)+20}
0
55
100
100
255
-50
205
100
100
100
100
300
-50
250
200
145
100
100
345
-50
295
300
190
100
100
390
-50
340
373
223
100
100
423
-50
373
400
235
100
100
435
-50
385
464
264
100
100
464
-50
414
500
280
100
100
480
-50
430
600
325
100
100
525
-50
474
In this table, the equilibrium level of income is 464 because at this level of Y = C + I +G. Later
on, the income is decreased by50 due to increase in tax by 100, It is caused of tax multiplier.
It can be cleared by following diagram.
C+I+G
Y=C+I+G
A
Aggregate expenditure
C+I+G
0
E1
E2
E1
C+I+G-cT
C+I
Ca +cY-cTa+ctY+cR
450
Y2 Y1
Y
Income
S,T,I & G
Leakage & injection
B
0
S+T-R+T
S+T-R
F2
F1
Y2 Y1
I+G
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The C line is consumption line, which has positive slope. It means that
consumption is increasing with the increase in income. The C+I line and C+I+G line is parallel are
parallel to C line because investment and government expenditure are assumed autonomous. The
C+I+G line is equal to guide line at point E1 from which 0Y1 equilibrium level of income is
determined. Now suppose that tax increases from E1 to E1'. Consequently, the C+I+G line shifts
upward and takes a position of C+I+G-cT line which is equal to guide line at point E2 from which
0Y2 equilibrium level of income is determined.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The I+G line is equal to S+T-R line at point F1 from which
OY1 equilibrium level of income is determined. Now suppose that government increases the lump
sum tax to the extent of (E1E1). As a result, the C+I+G line shifts and takes a position of C+I+GcT, which is equal to S+T-R+T at point F2 from which the level of income decreases from OY1
to OY2.
(iv) Balance Budget Multiplier
What happens on income, when government increases government expenditure through equal
increases in tax? According to classical economist, balance budget is neutral it does not effect on
income because the increase in income is offset by increase in equal amount in tax. But according
to modern economist, balance budget has positive effect on income. If increase in government
expenditure is financed through equal to increase in tax, then it is called balance budget. The rate
of change in income due to change in government expenditure through equal change in tax is called
balance budget multiplier. In the first fiscal model, the balance budget multiplier can be expressed
as:
Y=
C A − cTA + cR + I A + G A
.......... .......... (vii )
1 - c + ct
If government expenditure and tax changes, then income also changes. It can be expressed as:
Y + ΔY =
C A − c(TA + ΔT) + cR + I A + G A + ΔG
.......... .......... (vii )
1 - c + ct
Y + ΔY =
C A − cTA − cT + cR + I A + G A + ΔG
.......... .......... (vii )
1 - c + ct
Y + Y =
C A − cTA + cR + I A + G A + ΔG
ΔG - cT
+.
.......... ......... (vii )
1 - c + ct
1 - c + ct
Y=
C A − cTA + cR + I A + G A
ΔG - cT C A − cTA + cR + I A + G A
+.
...(vii )
1 - c + ct
1 - c + ct
1 - c + ct
ΔY = +
ΔG - cT
.......... ...(i )
(1 - c + ct )
ΔY =
ΔG - cG
.......... ...(i )
(1 - c + ct )
ΔY =
G (1 - c )
.......... ...(i )
(1 - c + ct )
ΔY
1− c
=
 1......... ....(i )
(1 - c + ct )
ΔG
It means that balance budget multiplier affects on income but it is not so effective.
It can be cleared by following table by assuming C=60+0.5Yd, Yd = Y – T + R, T = 10+01Y, R=10
I = 100, G = 100, G = 100
Y
0
C
55
I
100
G
100
C+I+G
255
G
100
-cT
-50
C+I+G+G-cT
305
100
200
300
400
464
500
555
564
100
145
190
235
264
280
305
309
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
300
345
390
435
464
480
505
509
100
100
100
100
100
100
100
100
-50
-50
-50
-50
-50
-50
-50
-50
350
395
440
485
514
530
555
559
In this table, the equilibrium level of income is 500 because at this level of Y = C + I +G. Later
on, the income is decreased by100 due to increase in government expenditure by increasing
equal amount of tax, It is caused of tax multiplier.
 Four Sector Model
i. National Income Determination
(a) Equality between Aggregate Demand and Aggregate Supply Method
In this Model Income made with four components: consumption, investment and government
expenditure and Export and import. It can be expressed as:
Y = C + I + G. + (X - M)........ .......... ...... (i )
Where,
Y=Income
C=Consumption
I=Investment
G=Government expenditure
X = Export
M = Import
X-M = Balance of payment
Consumption can be classified into two categories: autonomous consumption and induced
consumption. It can be expressed as:
C = C A + cYD .......... .......... .......... ....(ii )
Where, C = Consumption
CA=Autonomous consumption which is not affected by change in income. It is constant
at every level of income.
c=Marginal propensity to consume which is assumed to be constant and positive fraction
such as: 0 < c < 1.It means that some part of income is consumed and the rest is saved.
YD = Disposable income. The disposable income can be expressed as:
YD = Y - T + R......... .......... .......... ..(iii)
Where,
YD=Disposable income
Y=Net income
T=Tax
R = Transfer of payment
Tax function can be expressed as:
T = TA + tY........ .......... .......... .(iv )
Where,
T= Total tax
TA= Autonomous Tax which is constant at every level of income
t= marginal propensity to tax which is assumed to constant and positive fraction.
i.e., 0 < t < 1
tY = induced tax which increases with the increase in income.
In this model, tax is assumed lump sum and transfer of payment is assumed constant at every
level of income. The value of t is constant it means that tax system is assumed to be proportional.
Investment is assumed entirely autonomous and it is not affected by income. It can be expressed
as:
I = I A .......... .......... .......... .......... (v )
Where,
I= Investment
IA=Autonomous investment
Government expenditure is exogenously determined by the government and it is assumed
autonomous and not affected by income. It can be expressed as:
G = G A .......... .......... .......... ......... (vi )
Where,
G = Government expenditure
GA= Autonomous government expenditure
Export is assumed autonomous. It is exogenously determined. Symbolically,
X = X A .......... .......... .......... ....(vii )
Where,
X = Export
XA= Autonomous export
Import function can be expressed as:
M = M A + mY........ .....(viii )
Where,
M = Import
MA= Autonomous import
m = marginal propensity to import which is assumed positive fraction i.e 0<m<1
On the basis of above assumption equation (i) can be expressed as:
Y = C A + c{Y - T + R) + I A + G A + {X A - (M A - mY)}...... . ....... ...... (ix )
Y = C A + c(Y - (TA + tY ) + R ) + I A + G A + {X A − (M A + mY)....... ..(x )
Y = C A + c[Y - TA − tY + R] + I A + G A + {X A − M A − mY]....... ..(xi )
Y = C A + cY - cTA - ctY + cR + I A + G A + X A − M A − mY........ .(xii )
Y - cY + ctY + mY = C A - cTA + cR + I A + G A + X A − M A ......... (xiii )
(1 - c + ct + m)Y = C A - cTA + cR + I A + G A + X A − M A ......... (xiv )
C A - cTA + cR + I A + G A + X A − M A
....... ...... .......
.... (xv )
1 - c + ct + m
It is equilibrium level of income in four-sector economy with third sector economy.
Y=
(b) Equality between Investment and Saving Method
The equilibrium level of income can also be obtained by the equality between saving and
Investment method.
AD = C + I + G + X......... .......... .......... .......... ..(i )
AS = C + S + T - R - M......... .......... .......... (ii )
AD = AS........ ....... ...... ...... ...... ........ (iii)
C + I + G + X = C + S + T - R + M......... ......... (vi )
I + G + X = S + T - R + M......... .......... .......... .(v )
(vi )
S = (Y - T + R) − C A + c(Y - T + R).......... ..(vii )
S = (Y - T + R) − C A + c(Y - T + R).......... ..(viii )
S = Y − (TA + tY ) + R  − C A + cY − c(TA + tY ) + cR......
S = Y − C ....... ......... ......... ......... ......
.... ....(ix )
S = Y − TA − tY + R − C A − cY + cTA + ctY − cR..... ..... ..... .(x )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + T - R....(xi )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + TA + tY - R..... (xii )
S + T - R = Y − TA − tY + R − C A − cY + cTA + ctY − cR + TA + tY - R....(xii )
S + T - R = Y − C A − cY + cTA + ctY − cR .... ....... ..... .... .... (xvi )
S + T - R + M = Y − C A − cY + cTA + ctY − cR + M A + mY...... (xv )
S + T - R + M = I A + G A + X A .... .... .... .... .... .... ....
......(xvi )
Y − C A − cY + cTA + ctY − cR + M A + mY. = I A + G A + X A .....(xvii )
Y - cY + ctY + mY = C A − cTA = cR − M A . + I A + G A + X A .....(xviii )
C A − cTA + cR + I A + G A + X A − M A
.... .... .... .... (xix )
1 − c + ct + m
It is equilibrium level of income in four sector economy.
The equilibrium level of income in four sector economy can be cleared by assuming
C=50+0.5(Y–(10+0.1Y)+ 20), I = 100, G =100, X=200,M=20+0.2Y
Y=
Y
C
I
G
C+I+G
X
M
X-M
0
55
100
100
255
200
20
180
100
100
100
100
300
200
40
160
200
145
100
100
345
200
60
140
300
190
100
100
390
200
80
120
400
235
100
100
434
200
100
100
500
280
100
100
480
200
120
80
580
316
100
100
516
200
136
64
600
325
100
100
525
200
140
60
In this table, the equilibrium level of income is 580 in four sector economy.
It can be cleared by following diagram.
C+I+G+X-M
A
Y=C+I+G+X-M
E1
Aggregate expenditure
C+I+G+(X-M)
435
460
485
510
535
560
580
585
C+I+G+X-M
C+I+G
C+I
C+I+G-cT+G
450
0
Leakage & injection
S,T,I ,G,X,M
Y1
Income
Y
B
S+T-R+M
F1
0
Y1
I+G+X
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The C line is consumption line, which has positive
slope. The ‘C+I’ line and ‘C+I+G’ line is parallel are parallel to C line because investment and
government expenditure are assumed autonomous. The ‘C+I+G+X-M’ is aggregate expenditure
line. The distance between ‘C+I+G+X-M’ and ‘C+I+G’ line is decreasing. This is because the XM declines with the increase with increase in income. The ‘C+I+G+X-M’ line is equal to guide
line at point E1 from which 0Y1 equilibrium level of income is determined.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G+X’ line is equal to ‘S+T-R+M’ line at point F1
from which OY1 equilibrium level of income is determined.
(ii) Export Multiplier
The rate of change in income due to change in export is called export multiplier.
The change in export brings change in income. It can be cleared as:
Y=
C A - cTA + cR + I A + G A + X A − M A
.......... .......... .......... ........ (i )
1 - c + ct + m
Y + ΔY =
Y + ΔY =
C A - cTA + cR + I A + G A + X A + ΔX − M A
......... (ii )
1 - c + ct + m
C A - cTA + cR + I A + G A + X A − M A
ΔX
+
......... (iii )
1 - c + ct + m
1 - c + ct + m
C A - cTA + cR + I A + G A + X A − M A
C - cTA + cR + I A + G A + X A − M A
ΔX
+
- A
..(iv)
1 - c + ct + m
1 - c + ct + m
1 - c + ct + m
ΔX
ΔY =
.......... .......(v)
1 - c + ct + m
ΔY =
ΔY
1
=
.......... .........( vi)
ΔX 1 - c + ct + m
It is the value of export multiplier. The level of income changes through the change in export in
the economy.
The export multiplier in four sector economy can be cleared by assuming
C=50+0.5(Y–(10+0.1Y)+ 20), I = 100, G =100, X=200, M=20+0.2Y, X=100
C+I+G+(XC+I+G+(XX
M)
M)-X
0
55
100 100 255
200 20
180
435
100
535
100 100 100 100 300
200 40
160
460
100
560
200 145 100 100 345
200 60
140
485
100
585
300 190 100 100 390
200 80
120
510
100
610
400 235 100 100 434
200 100 100
535
100
635
500 280 100 100 480
200 120 80
560
100
660
580 316 100 100 516
200 136 64
580
100
680
600 325 100 100 525
200 140 60
585
100
685
713 376 100 100 576
200 163 37
613
100
713
In this table, the equilibrium level of income is 580 because at this level of Y = C+I+G+X-M.
Later on, the income is increased from 580 to 713 due to increase in export by 100. It is caused
of export multiplier.
Y
C
I
G
C+I+G X
M
X-M
The export multiplier can be cleared by following diagram.
C+I+G+X-M
Y=C+I+G+X-M
A
C+I+G+X+X-M
C+I+G+X-M
Aggregate expenditure
E2
E1
C+I+G
C+I
C
450
0
Y1
Y2
Income
Y
S,T,I ,G,X,M
Leakage & injection
B
S+T-R+M
F2
F1
0
Y1
Y2
I+G+X+X
I+G+X
Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line. The ‘C+I’ line and ‘C+I+G’ lines are
parallel to C line because investment and government expenditure are assumed to be autonomous.
The ‘C+I+G+X-M’ is aggregate expenditure line. The distance between ‘C+I+G+X-M’ and
‘C+I+G’ line is decreasing. This is because the ‘X-M’ declines with the increase in income. The
‘C+I+G+X-M’ line is equal to guide line at point E1 from which 0Y1 equilibrium level of income
is determined. Now suppose that export increases to the extent of X. Consequently, the
‘C+I+G+X-M’ curve shift upward and takes a position of ‘C+I+G+X-M+X’ which is equal to
the guide line at point E2 from which OY2 level of income is determined. The level of income
increases from OY1 to OY2 through export multiplier.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G+X’ line is equal to ‘S+T-R+M’ line at point F1
from which OY1 equilibrium level of income is determined. Now suppose that export increases to
the extent of X. Consequently, the ‘I+G+X’ curve shift upward and takes a position of ‘I+G+XX’ which is equal to ‘S+T-R+M’ line at point F2 from which OY2 level of income is determined.
The level of income increases from OY1 to OY2 through export multiplier.
(iii) Import Multiplier
The rate of change in income due to change in import is called import multiplier.
The change in export brings change in income. It can be cleared as:
ΔY
1
=
.......... .........( i)
ΔY 1 - c + ct + m
Y + ΔY =
Y + ΔY =
C A - cTA + cR + I A + G A + X A − (M A + ΔM)
.... ..... ... (ii )
1 - c + ct + m
C A - cTA + cR + I A + G A + X A − M A
ΔM
−
......... (iii )
1 - c + ct + m
1 - c + ct + m
ΔY =
C A - cTA + cR + I A + G A + X A − M A
C - cTA + cR + I A + G A + X A − M A
ΔM
−
- A
...(iv)
1 - c + ct + m
1 - c + ct + m
1 - c + ct + m
ΔY =
ΔM
...... ...... ...... (v)
1 - c + ct + m
ΔY
1
=−
.......... .......... ....(vi)
ΔM
1 - c + ct + m
It is the value of import multiplier. The level of income changes due to change in import through
import multiplier.
The equilibrium level of income in four sector economy can be cleared by assuming
C=50+0.5(Y–(10+0.1Y)+ 20), I = 100, G =100, X=200, M=20+0.2Y, M=100
Y
C
I
G
C+I+G X
M
X-M
C+I+G+(XM)
M
0
100
200
300
400
447
500
580
600
713
55
100
145
190
235
256
280
316
325
376
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
255
300
345
390
434
456
480
516
525
576
20
40
60
80
100
109
120
136
140
163
180
160
140
120
100
91
80
64
60
37
435
460
485
510
535
547
560
580
585
613
-100
-100
-100
-100
-100
-100
-100
-100
-100
-100
200
200
200
200
200
200
200
200
200
200
C+I+G+(XM)-M
335
360
385
410
435
447
460
480
485
513
In this table, the equilibrium level of income is 580 because at this level of Y = C+I+G+X-M.
Later on, the income is decreased from 580 to 713 due to increase in import by 100. It is caused
of export multiplier.
It can be cleared by following diagram.
Y=C+I+G+X-M
A
C+I+G+X-M
E1
Aggregate expenditure
C+I+G+X-M
C+I+G+X+M+M
E2
C+I+G
C+I
C+I+G-cT+G
450
0
Y1
Leakage & injection
S,T,I ,G,X,M
Y2
Income
B
Y
S+T-R+M+M
S+T-R+M
F2
F1
0
Y2
I+G+X
Y1 Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 line is considered as guideline. The income is equal to aggregate expenditure at each
point of this guideline. The ‘C’ line is consumption line, The ‘C+I’ line and ‘C+I+G’ line are
parallel to C line because investment and government expenditure are assumed to be autonomous.
The ‘C+I+G+X-M’ is aggregate expenditure line. The distance between ‘C+I+G+X-M’ and
‘C+I+G’ line is decreasing. This is because the ‘X-M’ declines with the increase with increase in
income. The ‘C+I+G+X-M’ line is equal to guide line at point E1 from which 0Y1 equilibrium
level of income is determined. Now suppose that import increases to the extent of M.
consequently, the ‘C+I+G+X-M’ curve shift downward and takes a position of ‘C+I+G+X-M-M’
which is equal to the guide line at point E2 from which OY2 level of income is determined. The
level of income decreases from OY1 to OY2 through import multiplier.
In panel B, Saving, investment, Tax and government expenditure are measured along horizontal
axis and income along horizontal axis. The ‘I+G+X’ line is equal to ‘S+T-R+M’ line at point F1
from which OY1 equilibrium level of income is determined. Now suppose that import increases to
the extent of M. consequently, the ‘S+T-R+M’ curve shift upward and takes a position of ‘S+TR+M +M’ which is equal to ‘I+G+X’ line at point F2 from which OY2 level of income is
determined. The level of income decreases from OY1 to OY2 through import multiplier.
Super Multiplier
Keynes has explained simple multiplier by assuming autonomous investment. It means that
investment is not function of income. But in reality, investment is function of income. Investment
is also positively affected by change in income. Super multiplier theory includes induced
investment to explain the rate of increase in income due to change in investment.
According to Super multiplier, national income is made by two components: consumption and
investment. Symbolically,
Y = C + I. .......... .......... .......... ......(i )
Where,
Y=income
C=consumption
I=investment
In this model, Government sector and foreign trade sector are not included
Consumption function is assumed to be non-proportional. Symbolically,
C = C A + cY........ .......... .......... .......... (ii )
Where,
C = Consumption
a = Autonomous consumption which is not related to income.
b = Marginal propensity to consume
Marginal propensity to consume is assumed to be constant and positive fraction, i.e.;0<MPC<1. It
means that some part of the income is consumed and the rest is saved.
It is assumed that the current consumption is function of current income.
Investment is assumed to be autonomous in Keynesian theory of multiplier which is not realistic.
In reality, investment is function of income. It means that the level of investment increases with
the increase in income. Under super multiplier, induce investment is included. It is also assumed
to be non-proportional. Symbolically, Investment function can be expressed as:
I = I A + iY........ .......... .......... .......... .......... (iii)
Where,
IA = Autonomous investment which is not affected by the level of income.
i = marginal propensity of investment.
Marginal propensity to investment is assumed to be positive fraction, i.e., 0<i<1
(i)National Income Determination
a. Equality between Aggregate demand and Aggregate supply Method
Substituting eqn (ii) and eqn (iii) into eqn (i), then we have,
Y = C A + cY + I A + iY........ .......... ......... (iv)
Y - cY - iY = C A + I A .......... .......... .......... .(v )
Y(1 - c - i) = C A + I A .......... .......... ......... (vi )
C + IA
Y= A
.......... .......... .......... ...... (vii )
1− c - i
It is the equilibrium level of income in two sectors economy in the case of super multiplier.
a. Equality between Investment and Saving Method
AD = C + I......... ......(i )
AS = C + S......... ......(ii )
AD = AS........ ....... (iii)
C + I = C + S......... ..(iv)
(v )
C = C A + cY........ ...(vi )
I = S......... ... .....
S = Y − C A + cY...... (vii )
S = −C A + (1- c)Y...(viii )
I = I A + iY........ ...(ix )
I A + iY = −C A + (1 - c)Y....... ....(viii )
(1 - c)Y - iY = C A + I A .......... .(viii )
(1 - c - i)Y = C A + I A ...... .....
Y=
(viii )
CA + I A
.......... .(viii )
1- c - i
The theory of super multiplier can be cleared by following table by assuming following functions
as C = 40 + 0.7Y, I = 20+0.1Y
Y
0
100
200
300
400
500
600
700
800
900
1000
C
40
110
180
250
320
390
460
530
600
670
740
I
20
30
40
50
60
70
80
90
100
110
120
C+I
60
140
220
300
380
460
540
620
700
780
860
In this table the equilibrium level of income is 300 because at this level of income is equal to
aggregate expenditure.
The equilibrium level of income in the theory of super multiplier can also be cleared by following
diagram.
C+I
Y=C+I
Aggregate expenditure
A
C+I=CA+cY+IA+iY
E1
C=CA+cY
Investment & Saving
450
0
I&S
Y1
S
B
F1
0
Income Y
Y1
I
Y2 Income
Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 is considered as guideline. The income and expenditure are equal at each point along
this guideline. The curve 'C' is consumption function, which has positive and linear slope, being
constant MPC. The 'C+I' curve is aggregate expenditure curve. The distance between ‘C’ and ‘C+I’
curve are increasing with the increase in income because of induced investment. The 'C+I' curve
intercept the guideline at point E1, thus 0Y1 equilibrium income is determined.
In panel B, Saving and investment are measured along vertical axis and income along horizontal
axis. The ‘I’ line is investment line which has positive slope, showing the positive relationship
between investment and income. The ‘S’ line is saving line which has positive slope, showing the
positive relationship between saving and income. The ‘I’ line is equal to the ‘S’ line at point F1
from which OY1 equilibrium level of income is determined.
(ii) Value of Super Multiplier
The equilibrium level of income in super multiplier can be expressed as:
C + IA
Y= A
.......... .(i )
1- c - i
There is net increase in investment. The change in investment by I brings the change in income
by Y. It can be expressed as:
C + I A + ΔI
Y + ΔY = A
..... .... ..... .... (ii )
1− c - i
C + IA
ΔI
C + IA
Y = A
+
- A
.......... ...(iii)
1− c - i 1− c - i 1− c - i
Y =
ΔI
.......... .......... .......... ......... (iv )
1- c - i
Y
1
=
.......... .......... .......... ........ (v )
I
1- c - i
Where, 11-c-i refers to value of super multiplier. It implies that Income changes through multiplier
due to change in investment. The value of super multiplier is greater than the value of simple
multiplier.
The theory of super multiplier can be cleared by following table by assuming
C = 40 + 0.7Y, I = 20+0.1Y and I=100
Y
C
I
C+I
I
C+I+I
0
40
20
60
100
160
100
110
30
140
100
240
200
180
40
220
100
320
300
250
50
300
100
400
400
320
60
380
100
480
500
390
70
460
100
560
600
460
80
540
100
640
700
530
90
620
100
720
800
600
100
700
100
800
900
670
110
780
100
760
1000
740
120
860
100
820
In this table, the initial equilibrium level of income is 300. The new equilibrium level of income
is 800. The level of income is increased by 500 due to increase in investment by 100, because the
value of super multiplier is 5.
The theory of super multiplier can also be cleared by following diagram.
Y=C+I
C+I
Aggregate expenditure
A
E2
C+I=CA+cY+IA+iY
E1
450
Investment & Saving
C+I+∆I
0
I&S
Y1
B
Y2 Income Y
F2
F1
0
C=CA+cY
Y1
S
I+∆I
I
Y2 Income Y
In this diagram, aggregate expenditure is measured along vertical axis and income along horizontal
axis. The 450 is considered as guideline. The income and expenditure are equal at each point along
this guideline. The curve 'C' is consumption function, which has positive and linear slope, being
constant MPC. The 'C+I' curve is aggregate expenditure curve. The distance between ‘C’ and ‘C+I’
curve is increasing with the increase in income because of induced investment. The 'C+I' curve
intercept the guideline at point E1, thus 0Y1 equilibrium income is determined. If investment
increased by I , then the curve 'C+I' shift to the upwards and takes a position of 'C+I+I' as
parallel which intercept the guide line at point E2, thus income is increased from OY1 to OY2
through super multiplier.
In panel B, Saving and investment are measured along vertical axis and income along horizontal
axis. The ‘I’ line is investment line which has positive slope, showing the positive relationship
between investment and income. The ‘S’ line is saving line which has positive slope, showing the
positive relationship between saving and income. The ‘I’ line is equal to the ‘S’ line at point F1
from which OY1 equilibrium level of income is determined. Now suppose that investment
increases to the extent of I. Consequently, the ‘I’ curve shift upward and takes a position of ‘I
+I’ which is equal to ‘S’ line at point F2 from OY2 level of income is determined. The level of
income increases from OY1 to OY2 through super multiplier.
For the application of super multiplier the conditions of An industrializing economy, availability
of factors of production, surplus capacity industries and constant price and regular investment are
required.
  Introduction of ISLM Model
According to Keynes, rate of interest determination is purely monetary sector phenomenon. It is
determined by monetary sector of the economy, i.e., equality between money demand and money
supply. In Keynesian approach, equilibrium level of employment is determined by effective
demand i.e., equality between aggregate demand and aggregate supply.
According to Hicks and Hanson, equilibrium level of income and rate of interest both are
determined by real sector economy and monetary sector economy both. They have presented this
model by ISLM where ‘I’ refers to investment, S refers to saving, L refers to money demand and
M refers to money supply. The equality between investment and saving refers to real sector
equilibrium and the equality between money demand and money supply refers to monetary sector
equilibrium. Neither real sector equilibrium nor monetary sector equilibrium determines
equilibrium level of income but both real sector equilibrium and monetary sector equilibrium
determines equilibrium level of income and equilibrium rate of interest. This theory of
determination of income and rate of interest is called ISLM model.
 Derivation of IS curve
The IS curve shows the different combinations of income and rate of interest where investment is
equal to saving. It shows the real sector equilibrium at different combination of income and rate
of interest. Hence, The IS curve can be derived by choosing different combinations of income and
rate of interest where investment is equal to saving. It can be cleared by following diagram.
r
r
A
r1
r1
r2
r2
D
A
E
F
B
IS
I
0 I1
I
I2
B
S
0
Y1
C
S
I=S
S
S2
S2
S1
S1
0 I1
I2
Y
Y2
I
0
Y1
Y2
Y
In panel ‘A’, rate of interest is measured along vertical axis and investment along horizontal axis.
The ‘I’ curve is investment curve which has negative slope, showing the negative relationship
between investment and rate of interest. In panel ‘B’, saving is measured along vertical axis and
investment along horizontal axis. The 450 line shows the equality between investment and saving
at each point. In panel ‘C’, saving is measured along vertical axis and income along horizontal
axis. The ‘S’ line is saving line which has positive slope showing positive relationship between
saving and income. In panel ‘D’, the different combinations of income and rate of interest have
been found on the basis of panel ‘A’, ‘B’, and panel ‘C’ where investment are equal to saving.
When rate of interest is r1, the level of investment is I1. The I1 investment is equal to S1 saving at
Y1 level of income. From this way, the combination of income and rate of interest Y1,r1 is derived
reflected by point ‘A’ in panel ‘D’. When interest rate falls from r1 to r2, the level of invest increases
from I1 to I2. The I2 investment level is equal S2 saving at Y2 level of income. From this way, the
combination income and interest rate Y2,r2 is derived reflected by ‘B’ in panel ‘D’. By adjoining
points ‘A’ and ‘B’, we can derive IS curve which has negative slope.
The slope of IS curve is negative. Let us consider point E where rate of interest is very low and
income is very high. Investment is very high due to low rate of interest and saving is very high due
to high rate of income. Hence, investment is more than saving, i.e., I>S at point E. Let us consider
point F where rate of interest is very high and income is very low. Investment is very low due to
high rate of interest and saving is very low due to low rate of income. Hence, investment is less
than saving, i.e., I<S at point F. Therefore, Point E and point F are disequilibrium points. By
adjoining these disequilibrium points, we can derive positive line.
 Derivation of LM curve
The LM curve shows the different combinations of income and rate of interest where money
demand is equal to money supply. It shows the monetary sector equilibrium at different
combination of income and rate of interest. Hence, The LM curve can be derived by choosing
different combinations of income and rate of interest where money demand is equal to money
supply. It can be cleared by following diagram.
r
A
D
r
LM
r1
r1
r2
r2
Md s
0
Ms
I1
Md s
I2
B
0
F
B
E
Y1
Y2
Y
C
S
M1
A
kY
T1
T2
0
M1
Ms
0
Y1
Y2
Y
In panel ‘A’, rate of interest is measured along vertical axis and investment along horizontal axis.
The ‘Mds’ curve is investment curve which has negative slope, showing the negative relationship
between speculative demand for money and rate of interest. The speculative demand for money is
perfectly elastic at minimum rate of interest where people expect that the rate of interest cannot
increase below this rate. In panel ‘B’, money supply is measured along vertical axis and again
money supply along horizontal axis. The 450 degree line on horizontal axis shows fixed money
supply and it is nothing but one of the technique. In panel ‘C’, transaction demand for money is
measured along vertical axis and income along horizontal axis. The ‘kY’ line is transaction demand
for money line, which has positive slope showing positive relationship between transaction
demand for money and income. It shows proportional relationship between transaction demand
for money and income. In panel ‘D’, the different combinations of income and rate of interest have
been found on the basis of panel ‘A’, ‘B’, and panel ‘C’ where money demand are equal to money
supply. When rate of interest is r1 and income is Y1 the money demand is equal to money supply.
From this way, the combination of income and rate of interest Y1,r1 is derived reflected by ‘A’ in
panel ‘D’. When rate of interest is r2 and income is Y2, the money demand is equal to money
supply. From this way, the combination income and rate of interest Y2,r2 is derived reflected by
point ‘D’ in panel ‘D’. By adjoining points ‘A’ and ‘B’, we can derive LM curve, which has
positive slope.
The slope of LM curve is Positive. Let us consider point E where rate of interest is very low and
income is very high. Speculative demand for money is very high due to low rate of interest and
transaction demand for money is very high due to high level of income. Hence, total money
demand is more than the fixed money supply, i.e., Md > Ms at point E. Let us consider point F
where rate of interest is very high and income is very low. Speculative demand for money is very
low due to high rate of interest and transaction demand for money is very low due to low level of
income. Hence, total money demand is less than the fixed money supply, i.e., Md < Ms at point F.
Therefore, Point E and point F are disequilibrium points. By adjoining these disequilibrium points,
we can derive negative line. It proves that the slope of LM curve cannot be negative.
 Determination of Equilibrium rate of Interest and Income by ISLM Model
According to Hicks and Hanson, the equilibrium rate of interest and income are determined by
interaction between real sector equilibrium and monetary sector equilibrium. In the real sector
equilibrium, saving is equal to investment and in the monetary sector equilibrium; money demand
is equal to money supply. It can be cleared by following diagram.
Fig-2.2
Interaction of ISLM
r
LM
Rate of interest
E2
•
r1
•
E6
• E5
• E1
E4
•
E3
•
IS
O
Y
Y1
Income
In this diagram, rate of interest is measured along horizontal axis and income along horizontal
axis. The ‘IS’ is investment-saving equality curve which shows real sector equilibrium that is the
various combinations of income and rate of interest where investment are equal to saving. The
‘LM’ is money demand and supply equality curve, which shows monetary sector equilibrium that
is the various combinations of income and rate of interest where money demand and money supply
are equal. The IS is equal to LM at point E1 where there is real sector and monetary sector
equilibrium both from which i1 equilibrium rate of interest and Y1 equilibrium level of income are
determined together.
For the determination of equilibrium rate of interest, both real sector and monetary sector
equilibrium are necessary. Let us consider points E2 and E3. The E2 and E3 are points of IS point
curve but not points of LM curve. The investment is equal to saving but money demand is not
equal to money supply at these points. Hence, there is real sector equilibrium but not monetary
sector equilibrium. Let us consider points E3 and E4. The E3 and E4 are points of LM curve but not
points of IS curve. The money demand is equal to money supply but investment is not equal to
saving at these points. Hence, there is monetary sector equilibrium but not real sector equilibrium.
Let us consider Point E6. The point E6 is neither point of IS curve nor point of LM curve. Hence,
Investment is not equal to saving and money demand is not equal to money supply. There is no
both real sector and monetary sector equilibrium. The E1 is only one point where there is
investment is equal to saving and money demand is equal to money supply, i.e., real sector and
monetary sector equilibrium both.
 Mathematical Derivation of ISLM Model
Mathematical Derivation of IS curve
Mathematical Derivation of LM curve
C = co + c1Y
Md = Md T + Md S
I = b0 − b1r
Md T = m 2 Y
S = Y-C
M d = m 2 Y + m0 - m1r
S = Y - (c0 + c1Y)
Ms = M *
b0 − b1r = -c0 + (1 - c1 )Y
M* = m 2 Y + m0 - m1r
(1- c1 )Y = c0 + b0 - b1r
M* − m0 + m1r = m 2 Y
Y=
c 0 + b 0 - b1r
(1 - c1 )
m 2 Y = M* − m0 + m1r
Y=
c0 + b0
b1r
−
(1 - c1 ) (1 - c1 )
Y=
M * − m 0 m1
+
r
m2
m2
. Shift in IS curve and Effect on Equilibrium level of Income
The IS curve shifts due to change due to change in government expenditure, private investment
and tax. When IS curve shifts one position to another position, it brings change in rate of interest
and income. The IS curve shifts to the right side due to increase in government expenditure or
increase in private investment or decrease in tax and It brings increase in equilibrium rate of
interest and income. The IS curve shifts to the left side due to decrease in government expenditure
or increase in private investment or decrease in tax. It brings decrease in equilibrium rate of interest
and income. It can be cleared by following diagram.
Fig-2.2
Shift in IS curve and
Effect on Equilibrium Income
Rate of interest
r
LM
E2
r2
r1
E1
IS1
O
Y1 Y2
IS2
Y
Income
In this diagram, rate of interest is measured along vertical axis and income along horizontal axis.
The IS1 is initial investment-saving equality curve and the LM is initial money demand-supply
equality curve. The IS1 is equal to LM curve at point E1 from which r1 equilibrium rate of interest
and Y1 equilibrium level of income are determined simultaneously. Now, suppose that government
expenditure increases in the economy as a result of which the IS curve shifts to the right side and
takes a position of IS2. The IS2 is equal to LM curve at point E2. Consequently, the rate of interest
increases from i1 to r2 and the level of increases from Y1 to Y2.
 Shift in LM curve and Effect on Equilibrium Income
The LM curve shifts due to change in money demand and money supply. When LM curve shifts
one position to another position, it brings change in rate of interest and income. The LM curve
shifts to the right side due to increase in money supply and It brings decrease in equilibrium rate
of interest and increase in income. The LM curve shifts to the left side due to decrease in money
supply. It brings decrease in equilibrium rate of interest and income. It can be cleared by following
diagram.
Fig-2.2
r
Shift in IS curve and
Effect on Equilibrium Income
LM1
Rate of interest
LM2
r1
r2
E1
E2
IS
Y
Income
In this diagram, rate of interest is measured along vertical axis and income along horizontal axis.
The IS1 is initial investment-saving equality curve and the LM1 is initial money demand-supply
O
Y1 Y2
equality curve. The IS is equal to LM1 curve at point E1 from which r1 equilibrium rate of interest
and Y1 equilibrium level of income are determined simultaneously. Now, suppose that money
supply increases in the economy because of which the LM1 curve shifts to the right side and takes
a position of LM2. The LM2 is equal to IS curve at point E2. Consequently, the rate of interest
decreases from r1 to r2 and the level of increases from Y1 to Y2.
 Shift in IS and LM curves both and Effect on Equilibrium level of Income
When government increases government expenditure, then the IS curve shift to the right side.
Consequently, the rate of interest increases one hand and level of income increases other hand. But
if money supply increases at the same amount of government expenditure, then the rate of interest
falls and it reaches in initial level and the level of income further increases. It can be cleared by
following diagram.
Fig-2.2
r
Shift in IS curve and
Effect on Equilibrium Income
Rate of interest
LM1
LM2
E2
r2
r1
E1
E2
IS2
IS1
Y
Y1 Y2 Y3 Income
In this diagram, rate of interest is measured along vertical axis and income along horizontal axis.
The IS1 is initial investment-saving equality curve and the LM1 is initial money demand-supply
equality curve. The IS1 is equal to LM1 curve at point E1 from which r1 equilibrium rate of interest
and Y1 equilibrium level of income are determined simultaneously. Now, suppose that government
adapts expansionary fiscal policy by increasing government expenditure or decrease in tax in the
economy as a result the IS1 curve shifts to the right side and takes a position of IS2. The IS2 is equal
to LM curve at point E2. Consequently, the rate of interest increases from r1 to r2 and the level of
increases from Y1 to Y2. Now, suppose that central bank adapts expansionary monetary policy by
increasing money supply in the economy then the LM1 curve shifts to the right side and takes a
position of LM2. The LM2 is equal to IS2 curve at point E3. Consequently, the rate of interest
decreases from r1 to r2 and the level of increases from Y2 to Y3. Here, the shift in IS curve is equal
to shift in LM curve.
O
 Fiscal Policy and Effect on Equilibrium Level of Income
Expansionary Fiscal Policy: If government adapts expansionary fiscal policy, then it affect on
rate of interest and income. Expansionary policy means to increase in government expenditure or
reduction in tax. The expansionary fiscal policy is helpful to increase in income in the economy.
It can be cleared by following diagram.
r
i
D
A
LM
r2
r2
r1
r1
E1
E1
E2
I2
I1
0
S
IS1
I1 I1 I2
B
I
I=S
0
S
IS2
Y
Y1 Y1 Y2
C
S
S2
S1
S1
0
0
Y
I
The I1 is initial investment curve in panel ‘A’ and the S is initial saving curve in panel ‘C’. The
450 line in panel ‘B’ shows equality between investment and saving. The initial IS curve is IS1 on
I1 investment and S saving curve. The LM is money demand-supply equality curve at different rate
of interest and income. The initial IS1 curve is equal to the LM curve at point E1 from which r1 rate
of interest and Y1 equilibrium income are determined simultaneously. Now suppose that
government adapts expansionary fiscal policy because of which the initial investment curve shifts
to the right side. It brings shift in IS curve and the initial IS1 curve shifts to the right side and takes
a position of IS2 which is equal to the LM curve at point E1. Consequently, the rate of interest
increases from r1 to r2 and the level of income increases from Y1 to Y1.
. Monetary Policy and Effect on Equilibrium level of Income
Expansionary Monetary Policy: If central Bank adapts expansionary monetary policy, then it
affect on rate of interest and income. Expansionary monetary policy means to increase in money
supply. The expansionary monetary policy is helpful to increase in income in the economy. It can
be cleared by following diagram.
r
i
A
D
LM1
r1
r1
r2
r2
E1
LM2
E2
E1
Md S
0
Md T
S1 S2
M
d
S
IS
0
Y
Y1Y1 Y2
Md T
B
C
M2
kY
M1
T2
T1
T1
0
M1 M2
Md S
0
Y
The Mds is initial money demand for speculative curve in panel ‘A’ and the M1M1 is initial money
supply curve in panel ‘B’ and kY is transaction demand for money curve. The IS curve is initial
investment-saving equality curve. The LM1 is money demand-supply equality curve at different
rate of interest and income. The initial IS curve is equal to the LM1 curve at point E1 from which
r1 rate of interest and Y1 equilibrium income are determined simultaneously. Now suppose that
central Bank adapts expansionary monetary policy because of which the initial Money supply
curve shifts to the right side. It brings shift in LM1 curve and the initial LM1 curve shifts to the
right side and takes a position of LM2 which is equal to the IS curve at point E1. Consequently,
the rate of interest decreases from r1 to r2 and the level of income increases from Y1 to Y1.
NUMERICAL EXAMPLES
QN. The following equations describe an economy.
C = 10 + 0.5Y
I = 190 − 20i
Derive the equation of IS curve and represent it graphically.
Solution:
Product market is equilibrium when
Y = AD = C + I
Y = 10 + 0.5Y + 190 − 20i
Y - 0.5Y = 120 - 20i
0.5Y = 120 - 20i
120 20
Y=
i
0.5 0.5
YIS = 240 − 40i
i
Y
0
240
1
200
2
160
3
120
4
80
5
40
6
0
QN. Given the following data about the monetary sector of the economy
M d = 0.4Y - 80i , and MS = 1200
Where Md is demand for money, Y is income level, i is rate of interest and Ms is money supply.
a. Derive the equation for LM function.
b. Give the economic interpretation of the LM curve. Draw LM curve from the above data.
Solution:
a. For money market equilibrium
Md = MS
0.4Y - 80i = 1200
0.4Y - 1200 = 80i
0.4Y = 1200 + 80i
YLM = 3000 + 200i
I
Y
0
3000
1
3200
2
3400
3
3600
4
3800
5
4000
6
4200
QN. For an economy the following function are given:
C = 100 + 0.8Y
M s = 120
S = −100 + 0.2Y
M d = 0.2Y - 5i
I = 120 − 5i
Find out:
a. IS equation and curve
b. LM equation and curve
c. Equilibrium level of income and interest rate.
Real sector equilibrium
I=S
120 - 5i = −100 + 0.2Y
120 + 100 - 5i = 0.2Y
220 - 5i = 0.2Y
0.2Y = 220 - 5i
monetary sector equilibrium
Ms = Md
120 = 0.2Y − 5i
5i = 0.2Y − 120
0.2
120
i=
Y −
5
5
i = 0.04Y − 24
220 5
i
0.2 0.2
120 = 0.2Y − 5i
Y = 1100 − 25i
120 + 5i = 0.2Y
25i = 1100 − Y
0.2Y = 120 + 5i
120
5
Y=
+
i
0.2 0.2
Y=
i=
1100
1
−
Y
25
25
i = 44 − 0.04Y
Y = 600 + 25i
Interaction between Real sector of the economy and monetary sector of the economy
Y = 1100 − 25i
Y = 1100 − 25(0.04Y - 24)
Y = 1100 − Y + 600
2Y = 1700
Y = 850
Hence, the equilibrium level of income is 850
Substituting the value of Y into LM equation, then we have
i = 34 − 24
i = 34 − 24
i = 10
Hence, the equilibrium rate of interest is 10 %.
QN. Given C = 102 + 0.7Y, I = 150 – 100i, MS = Rs. 300 million, MT = 0.25Y, MSP = 124 – 200i.
Find
(a) Find the equilibrium level of income and the equilibrium rate of interest, and
(b) Find the level of C, L, and I when the economy is in equilibrium.
(c) If the money supply increases by Rs. 17 million, what happens to the equilibrium level of
income and interest rate?
(d) Compute C, I, MT and MSP at the new equilibrium?
Soln:
(a) Equilibrium level of income and rate of interest
Commodity market equilibrium
Y = C+I
Y = 102 + 0.7Y + 150 − 100i
Y - 0.7Y = 252 − 100i
0.3Y = 252 − 100i
0.3Y + 100i = 252......... .......... .(i )
Money market equilibrium
Md = MS
M d = M T + M SP
M d = 0.25Y + 124 − 200i
MS = 300
0.25Y + 124 − 200i = 300
0.25Y − 200i = 300 - 124
0.25Y − 200i = 176.......... .......... ..(ii )
Interaction between commodity market equilibrium and money market equilibrium
Solving equation (i) and equation (ii), then we have
0.3Y + 100i = 252......... (i )
0.25Y − 200i = 176.......... (ii )
Multiplying eqn (i) by 2 and multiplying eqn (ii) by 1, then we have
0.6Y + 200i = 504........ (i)
0.25Y − 200i = 176.......... (ii )
0.85Y = 680
 Y = Rs.800 Million
Substituting, Y = Rs. 800 million in equation (i) we get
0.25(800)− 200i = 176
200 − 200i = 176
200 - 176 = 200i
24 = 200i
24
i=
200
i = 0.12
i = 12%
(b) When rate of interest is 12% and income is 800, The level of consumption, investment and
money demand will be
Consumption
C = 102 + 0.7Y
C = 102 + 0.7(800)
C = 102 + 560
C = 662 million
Investment
I = 150 − 100i
I = 150 − 100(0.12)
I = 150 − 12
I = Rs. 138 million
Money demand
L = M T + MSP
L = 0.25Y + 124 − 200i
L = 0.25(800)+ 124 − 200(0.12)
L = 200 + 124 − 24
L = Rs.300 million
(c) If the money supply increases by Rs. 17 million, the equilibrium level of income and interest
rate will be
0.25Y + 124 − 200i = 300 + MS
0.25Y + 124 − 200i = 300 + 17
0.25Y + 124 − 200i = 317
0.25Y − 200i = 317 - 124
0.25Y − 200i = 193
IS=New LM
0.3Y + 100i = 252......... (i )
0.25Y − 200i = 193.......... (ii )
Multiplying (i) by 2 and (ii) by 1, then we have
0.6Y + 200i = 504........ (i)
0.25Y − 200i = 193.......... (ii )
0.85Y = 697
Y = Rs. 820 million
Substituting, Y = Rs. 820 million in equation (i) we get
0.25(820)− 200i = 193
205 − 200i = 193
205 - 193 = 200i
12 = 200i
200i = 12
i=
12
200
i = 0.06
i = 6%
Hence, increase in Money supply by 17 results increase in income by 820 and fall in interest by 6%.
(d) When rate of interest is 6% and income is 820, the level of consumption, investment and money
demand will be
Consumption
C = 102 + 0.7Y
C = 102 + 0.7(820)
C = 102 + 574
C = 676 million
Investment
I = 150 − 100i
I = 150 − 100(0.06)
I = 150 − 6
I = Rs. 144 million
Money demand
L = M T + MSP
L = 0.25Y + 124 − 200i
L = 0.25(820)+ 124 − 200(0.06)
L = 205 + 124 − 12
L = Rs.317 million
Find (a) the equilibrium income level and interest rate, and (b) the levels of C, I, MT and MSP in
equilibrium (c) Show what happens to the equilibrium conditions if autonomous investment falls
to Rs. 97 million when
I = 120 − 150i
C = 89 + 0.6Y
MS = 275
M T = 0.1Y
MSP = 240 − 250i
Soln:
(a) For IS
Y = C+I
Y = 89 + 0.6Y + 120 - 150i
Y - 0.6Y = 89 + 120 - 150i
0.4Y = 209 - 150i
0.4Y + 150i = 209 .......... (i)
For LM
L = M T + MSP
L = 0.1Y + 240 - 250i
L=M
0.1Y + 240 - 250i = 275
0.1Y - 250i = 275 - 240
0.1Y - 250i = 35 .......... ...(ii)
Solving eqn (i) and (ii)
0.4Y + 150i = 209 .......... (i)
0.1Y - 250i = 35 .......... ...(ii)
Multiplying eqn (ii) by 4 and equation (i) by 1, then we have
0.4Y + 150i = 209 .......... (i)
-
0.4Y - 1000i = 140 .......... ...(ii)
+
+
1150i = 69
i = 0.06
i = 6%
Substituting I = 0.06 into eqn (i) then we have
0.4Y + 150(0.06) = 209
0.4Y + 9 = 209
0.4Y = 209 − 9
0.4Y = 200
Y = 500
(b) At Y = Rs. 500 million and i = 0.06
C = 89 + 0.6(500)
C = 89 + 0.6(500)
C = Rs.389 million
I = 120 − 150(0.06)
I = 120 − 150(0.06)
I = Rs.111 million
M T = 0.1(500)
M T = Rs. 50 million
MSP = 240 − 250(0.06)
MSP = 225
(c) If I = Rs. 97 million, the IS equation becomes
Y = 89 + 0.6Y + 97 - 150i
Y - 0.6Y = 186 - 150i
0.4Y + 150i = 186.......... ..(iii)
The IS shift due to change in investment but LM curve remains unchanged
IS1 = LM
0.4Y + 150i = 186.......... ..(iii)
0.1Y - 250i = 35 .......... ...(ii)
Multiplying eqn (i) by 1 and eqn (ii) by 4, then we have
0.4Y + 150i = 186.......... ..(iii)
0.4Y - 1000i = 140 .......... ...(ii)
+
1150i = 46
i = 0.04
i = 4%
Substituting I = 0.04 into eqn (i) , then we have
0.4Y + 150(0.04) = 186
0.4Y + 6 = 186
0.4Y = 186 − 6
0.4Y = 180
Y = 450
The decrease in investment from Rs. 120 million to Rs. 97 million leads to decrease in income
from Rs. 500 million to Rs. 450 million and rate of interest decreases from 6% to 4% in the
economy.
QN. Find IS curve from the following information:
−
I = 200 − 2000i, C = 10 − 0.5(Y − T), S = −10 + 0.5(Y − T), G = T = 40
a. Find IS equation. Find the level of income at 6% rate of interest.
b. Find new equilibrium level of income when government expenditure increases by Rs.100
million and tax rate decreases by 5% with rate of interest 6% rate of interest.
Soln:
Putting these values into I = S
200 − 2000i = -10 + 0.5(Y - 40)
200 − 2000i = -10 + 0.5Y − 20
200 + 20 + 10 = 0.5Y + 2000i
230 = 0.5Y + 2000i
0.5Y + 2000i = 230
0.5Y = 230 - 2000i
Y=
230 2000
i
0.5 0.5
Y = 460 - 4000i
QN. Find equilibrium level of income and rate of interest from the following information:
−
C = 100 + 0.75(Y − T), I = 200 − 2000i, G = Rs.100 million, T = 80 + 0.20Y
Y = C+I+G
Y = 100 + 0.75(Y - T) + 200 - 2000i + 100
Y = 100 + 0.75{Y - (80 + 0.2Y)} + 200 - 2000i + 100
Y = 100 + 0.75{Y - 80 − 0.2Y} + 200 - 2000i + 100
Y = 100 + 0.75{0.8Y - 80} + 200 - 2000i + 100
Y = 100 + 0.6Y − 60 + 200 - 2000i + 100
Y - 0.6Y = 340 - 2000i
0.4Y = 340 - 2000i
Y = 850 − 5000i
When rate of interest = 6%
Then equilibrium level of income will be
Y = 850 − 5000(0.06)
Y = 850 − 300
Y = Rs.550million
b. If government expenditure increases by Rs. 100 million with constant rate of interest 6%, then
new equilibrium level of income will be
Y = 100 + 0.75{Y - (80 + 0.2Y)} + 200 - 2000i + 100 + 100
Y = 500 + 0.75{Y - 80 − 0.2Y} - 2000i
Y = 500 + 0.75{0.8Y - 80} - 2000i
Y = 500 + 0.6Y − 60 - 2000i
Y - 0.6Y = 440 - 2000i
0.4Y = 440 - 2000i
0.4Y = 440 - 2000(0.06)
0.4Y = 440 - 120
0.4Y = 320
Y = Rs.800 million
Here, IS equation will be
Y = 1100 - 5000i
Conclusion: Due to increase in government expenditure by Rs. 100 million, equilibrium income
increases by Rs. 250 million, i.e. 800 - 550 = 250.
QN. Find equilibrium level of income and rate of interest from the following information:
−
C = 100 + 0.75(Y − T), I = 200 − 2000i, G = Rs.100 million,T = 80 + 0.20Y,
M T = 0.5Y, MSP = 100 − 2500i, MS = Rs.200 million
Soln
Derivation of IS curve
Y = C+I+G
Y = 100 + 0.75(Y - T) + 200 - 2000i + 100
Y = 100 + 0.75{Y - (80 + 0.2Y)} + 200 - 2000i + 100
Y = 100 + 0.75{Y - 80 − 0.2Y} + 200 - 2000i + 100
Y = 100 + 0.75{0.8Y - 80} + 200 - 2000i + 100
Y = 100 + 0.6Y − 60 + 200 - 2000i + 100
Y - 0.6Y = 340 - 2000i
0.4Y = 340 - 2000i
IS equation → Y = 850 − 5000i
Derivation of LM curve
Md = Ms
M T + M SP = M S
0.5Y + 100 − 2500i,= 200
0.5Y = 200 − 100 + 2500i,
0.5Y = 100 + 2500i,
LM equation → Y = 200 + 5000i,
Interaction between IS and LM curve
IS equation → Y = 850 − 5000i
LM equation → Y = 200 + 5000i,
IS = LM
850 − 5000i = 200 + 5000i
850 − 200 = 5000i + 5000i
650 = 10000i
i = 0.065
Substituting i = 0.065 into Y= 850 – 5000i, then we have
Y = 850 − 5000(0.065)
Y = 850 − 325
Y = Rs. 525 million
When money supply increases by Rs. 100 million
Numerical Examples
QN. 1: Calculate APC if Y= Rs. 100 crore and C= Rs. 110 crore.
Solution.
Given Y = Rs.100 Crore
C = Rs. 110 Crore
C 110
=
= 1.1
Y 100
Q.N. 2: Find the value of MPC where increase in national income by Rs. 300 million results
increase in aggregate consumption by Rs. 400 million.
Solution:
Given,
(Y ) = Rs. Y = Rs. 100 Million
Change in income
Change in consumption (C) = Rs. Y = Rs. 400 Million
We known that,
MPC =
C
400
=
= 0.8
Y 500
Q.N. 3: Calculate APS and MPS from the following table ( complete the following table)
Income(Y)
Total Saving (S)
APS
MPS
1000
100
2000
300
3000
700
Solution:
Income(Y)
1000
2000
3000
Total Saving (S)
100
300
700
APS=S/Y
0.1
0.15
0.23
Q.N. 4: Find out saving function when C = 20 + 0.5Y
Solution:
Given,
C = 20 + 0.5Y
For saving function,
S = Y-C
S = Y - (20 + 0.5Y)
S = Y - 20 - 0.5Y
S = -20 + 0.5Y
Hence, saving function is S = -20 + 0.5Y
Q.N. 5: Calculate MPC when MPS = 0.4 and APS when APC = 0.2.
Given,
MPS = 0.4
MPC + MPS = 1
MPC = 1 - MPS
MPC = 1 - 0.4
MPC = 0.6
APS = 0.2
APC + APS = 1
MPS
0.2
0.4
APC = 1 - APS
APC = 1 - 0.2
APC = 0.8
Q.N. 6: Calculate equilibrium national income when C = 20 + 0.6Y and I = Rs. 500 billion.
Solution:
Given,
C = 20 + 0.6Y
I = Rs. 500 billion
For equilibrium national income,
Y = C+I
Y = 20 + 0.6Y + 500
Y - 0.6Y = 20 + 500
Y(1 - 0.6) = 20 + 500
520
Y=
0.4
Y = 1300
Hence, equilibrium national income is Rs. 1300.
QN. 7: Calculate coefficient of multiplier when consumption is C = 10 + 0.9Y.
Solution:
Given,
C = 10 + 0.9Y
MPC = 0.9
Coefficient of Multiplier
K=
1
1
1
=
=
= 10
1 − MPC 1 − 0.9
0.1
QN. 8: Find the coefficient of multiplier when MPC = 0.8, 0.75, 1/3 and MPS = 0.1
Solution:
When MPC = 0.8
K=
1
1
1
=
=
=5
1 − MPC 1 − 0.8 0.2
When MPC = 0.75
K=
1
1
1
=
=
=4
1 − MPC 1 − 0.75 0.25
When MPC = 1/3
K=
1
1
1
=
=
= 1.5
1 − MPC 1 − 1/3 2/3
When MPS = 0.1
K=
1
1
=
= 10
MPS
0.1
UNIT-V
INFLATION, UNEMPLOYMENT AND BUSINESS CYCLE
 Meaning of Inflation
Generally, inflation means increase in general price level and decrease in value of money. This
is because there is inverse relationship between price level and value of money. When general
price level increases, the value of money decreases. The cause of inflation is the increase in money
supply. The term inflation is defined by different economists in different manner.
According to Crowther, - “Inflation means a state in which the value of money is falling, i.e. the
prices are rising. “
According to Coulbourn, - “Inflation is too much money chasing to few goods.”
According to Edward Shapiro, - “Inflation is a persistent and appreciable rise in the general level
of price.”
According to G. Ackley, - “We can define inflation as a persistent and appreciable rise in the
general level of prices.”
These clearly make inflation means rising prices, not high prices. From these definitions,
it is clear that
(i) The quantity of money is increasing during inflation.
(ii) The value of money is decreasing during inflation.
(iii) Prices of goods are increasing during inflation.
 Characteristics of Inflation/Features
Followings are the characteristics of inflation: (i) Long run process: - Inflation is related to increase in price of goods and services and this
process is long run process.
(ii) Dynamic process: - Inflation is dynamic process and it can be estimated in the long run.
(iii) Economic process: - Inflation is economic process, which is created by defect in economic
activities.
(iv) Increase in demand and decrease in production: - Inflation is caused by increase in demand
and decrease in production.
(V) Mild inflation is not dangerous: - Mild inflation is not dangerous for economy. It increases
economic activities but hyperinflation and running inflation are dangerous for economic
development.
(VI) Communicable Disease: - The inflation is communicable disease. It can move from one
sector to another sectors and one country to another countries.
 Types of Inflation
There are different types of inflation, which can be classified as under
1. On the basis of Speed/Rate of change
a. Creeping inflation: when the annual rate of inflation is up to 3%, it is called creeping inflation
It has no negative impact on the economy. It creates positive effect on investment, production and
employment.
b. walking inflation: when the rate of rise in price level is in the range of 3 to 7% per-annum or
less than 10%, it is called walking inflation. It is a warning signal for the government to control it
before turns into running inflation.
c. running inflation: This is also called galloping inflation. When the price level rises at a rate of
speed of 10 to 20% per annum, it called running inflation. It affects the poor and middle classes
people adversely. If it is not controlled, it turns into hyper- inflation.
d. Hyper inflation: When price level rises more than 20% per annum, it is called hyper inflation.
This is the last stage of inflation, which starts after the full-employment level is reached. Keynes
considers this type of inflation as the true inflation.
2. On the basis of government reaction/ On the basis of Nature
a. Open inflation: If the government does not make any effort to control the price rise and the
market mechanism is allowed to functions without any intervention, it is known as open inflation.
b. Suppressed inflation: If the government checks the price rise through price control and
rationing, it is called suppressed inflation. Once these measures are withdrawn, the demand for
goods increases and the suppressed inflation becomes open inflation.
 Theories of Inflation
(i) Demand pull inflation: - Demand pull inflation occurs when the aggregate demand increases
due to increase in government expenditure, private investment, reduction in tax, increase in tax,
increase in money supply. Consequently, price level increases in the economy on the one hand and
level of income on the other hand so long as full employment level of income is not achieved. But
when full employment level of income is achieved, the level of price only increases with the
increase in aggregate demand. There are some causes on account of which the aggregate demand
increases in the economy which results in inflation. They are as follows:
P
Fig-6.1
Demand-Pull Inflation
AS
E3
Price
P3
E2
P2
P1
E1
AD3
AD2
AD1
O
Y1
Y2
Y
Income
In this fig (6.1.), general price level is measured along vertical axis and income along horizontal
axis. The ‘AS’ is aggregate supply curve which is perfectly inelastic after E2 point. The initial
aggregate demand curve is ‘AD1’ which is equal to the ‘AS’ curve at point E1 from which OP1
price and OY1 income are determined. Now suppose that aggregate demand increase in the
economy. Consequently, the ‘AD1’ curve shifts upward and takes a position of ‘AD2’ which is
equal to the ‘AS’ curve at point E2 from which OP2 price and OY2 income are determined. Further,
suppose that aggregate demand increases in the economy. Consequently, the ‘AD2’ curve shifts to
the upward and takes a position of ‘AD3’ which is equal to the ‘AS’ curves at point ‘AS’. In this
case, price increases from OP2 to OP3 but the level of income remains constant. It results inflation.
ii. Cost-push inflation
Cost-push inflation occurs in the economy due to increase in cost. Any increase in cost also results
inflation in the economy. The cost increases due to increase in wage, profit margin and price of
international trade. The level of income falls on the one hand and price level increases on the other
hand because of cost-push inflation. It can be cleared by following diagram.
Fig-6.2
Cost-Push Inflation
T
S
Price
P
P3
AS3
P2
P1 AS2
E3
K
E2
32
AD
AS1
O
M
E1
Y3
Y2
Y1
Income
Y
In this fig (6.2.), income is measured along horizontal axis and general price level along
vertical axis. The ‘AD’ is aggregate demand curve and the initial aggregate supply curve is
‘AS1MT’. The ‘AD’ demand curve is equal to the ‘AS1MT’ aggregate supply curve at point E1
from which OP1 price and OY1 income are determined together. Now suppose that cost of
production increases in the economy and ‘AS1MT’ aggregate supply curve shifts upward and takes
a position of ‘AS2KT’. The ‘AD’ aggregate demand is equal to the ‘AS2KT’ aggregate supply
curve at point E2 from which OP2 price and OY2 income is determined. The price increases from
OP1 to OP2 and income decreases from OY1 to OY2. In conclusion, when cost of production
increases the general price level increases on one hand and the national income decreases on the
other hand which is dangerous inflation in the economy.
 Causes of Demand pull Inflation
There are some causes on account of which the aggregate demand increases in the economy which
results in inflation. They are as follows:
(a) Increase in money supply and bank credit: - When government increases the money supply
by using the printing press, then it increases the purchasing power of people. So, people increases
consumption level which results inflation. When commercial banks increases the activity of credit
creation by providing loan more than bank reserve, then inflation occurs in the economy because
it increases consumption and investment both from which the aggregate demand increase in the
economy.
(b) Increase in public expenditure: - If government increases the public expenditure on various
items like general and development expenditure by using deficit financing, then it increases the
purchasing power of people and it increases the consumption level which results inflation.
(iii) Increase in private expenditure: - If private sector increases the consumption and investment
in the economy, then it increases the aggregate demand, which results inflation.
(iv) Increase in export: - When government increases the export for the correction of balance of
payment, then there will be shortage of goods in domestic market, which increases the demand of
goods. So, economy experiences inflation.
(v) Reduction in tax: - If government reduces the rate of tax, then it increases the disposable
income of people. So, people consume more. As a result, the aggregate demand increases in the
economy. Consequently, it leads to inflation.
(vi) Repayment of past debts: - If government repays the past debt to the people, then it increases
the aggregate demand in the economy, which causes inflation.
 Causes of Cost- push Inflation
(ii) Cost-push inflation: - Any increase in cost also results inflation in the economy. The cost
increases due to increase in wage, profit margin and price of international trade. They are explained
below.
(a) Increase in wage: - Wage is a part of cost. If labour union forces to the producer to increase
in wage without increase in efficiency of labour and marginal productivity, then producer is
compelled to increase in wage, which increase the cost of production. This results in inflation.
(b) Increase in profit margin: - Profit is also a part of cost of production. If producer increase
the profit margin without any innovation and effort, then it increases the cost of production and
prices of goods which results inflation in the economy.
(c) International prices of goods: - Generally, inflation occurs due to increase in prices of foreign
goods. In Nepal, the inflation is mainly caused by increase in price of fuel, which results increase
in transportation cost. Due to increase in transportation cost, the price is increased rapidly in the
domestic market.
 Effects of Inflation
(i) Effects on productivity: - The mild inflation is not dangerous because it increases the pace of
economic development because it increases profit, output and employment. But hyper-inflation is
very dangerous because it adversely affects to the production in the economy.
(a) Decrease in the value of money: - The value of money decreases due to inflation. It increases
the expenditure and reduces the saving. Consequently, it reduces the capital formation which
results decrease in investment, decrease in production and increase in unemployment.
(b) Change in the structure of production: - Inflation changes the structure of production. It
decreases the production resources from the production of necessary goods to luxurious goods. So,
there will be scarcity of necessary goods.
(c) Decline in the quality of product: - During inflation, demand is very high. So there is no
difficulty to sale any types of goods by producer. So producer reduces the quality of goods to earn
maximum profit. Hence, inflation tends to reduce quality of goods.
(e) Hoarding of goods: - During inflation producer and traders unnecessarily hoard goods by
expecting high prices in future to earn maximum profit. So, there is scarcity of goods in the market.
In the same way, consumers also hoard goods so that he could not feel scarcity of goods.
(f) Speculative activities: - Inflation increases the speculative activities in the economy by
attracting profit because during inflation price is uncertain.
(g) Loss of faith in domestic currency: - During inflation, the value of domestic currency is
decreases continuously. So, people loose faith in domestic currency. So, they begin to buy foreign
currency having stable value.
(ii) Effect on distribution: - Inflation depends on the distribution of income explained below: (a) Fixed income group: - The inflation is not beneficial for fixed income group like service
holders because the cost of living increases rapidly. So, inflation hurts them.
(b) Debtors and creditors: - Inflation is beneficial to the debtors. If debtors repay to the creditors
when the value of money is decreasing but inflation is not beneficial to the creditors because
creditors receive the money when the value of money is decreasing in the economy.
(c) Wage and salary earners: - Generally, inflation is not beneficial to the wage and salary earners
although the wage and salary are rising by collective bargaining but wage always lags behind the
price of goods and during inflation, cost of living is also increasing. So, inflation hurts the wage
and salary earners.
(d) Producers: - Inflation is especially beneficial to the producers because they experiences
windfall gain. During inflation, the cost of production is increasing at a low rate while prices of
inventories goods are increasing at fast rate. So, producers are able to earn more profit.
(e) Investors: - There are two types of investors. One type of investors are investing their money
on equities an shares and they are earning variable income; while another type of investors are
investing their money on bonds and debentures. The investors who are not earning fixed income
but variable income, they experience benefit during inflation. But those investors who are earning
fixed income, experience loss during inflation.
(f) Farmers: - Inflation is beneficial to farmers because during inflation prices of agricultural
goods are increasing rapidly but cost of production is increasing slowly.
(iii) Non-economic effects: - Inflation adversely affects to the political and social environment
because inflation creates the instability in political environment. It increases black marketing,
robbery, corruption in the society such situation had been experienced by German before 1st world
war.
 Remedies of Inflation
Mild inflation is not dangerous for economy because it is helpful to economic development in the
country but running and hyperinflation are very dangerous for economic development. So, it must
be controlled by government by using various instruments of monetary and fiscal policy. They are
explained below:
(i) Monetary measures: - Inflation is due to economic disturbance. So, it can be controlled by
monetary measures. The instruments of monetary policy are as follows.
(a) Increase in bank rate: -The rate charged by central bank to the commercial bank while
providing loan is known as bank rate. If central bank experiences inflation in the economy, then
central bank increases the bank rate. Consequently, the market rate of interest also increases. When
market rate of interest charged by commercial bank to the people increases, then it reduces the
consumption and investment both. In turn, it reduces aggregate demand in the economy from
which inflation can be controlled.
(b) Open market operation: - Open market operation is one of the important instruments of
monetary policy. Under this method, central bank sales the government security to the people and
people also buy securities by drawing deposits from the commercial banks which reduces the cash
reserve with banks. As a result of which, commercial banks are not able to create credit sufficiently
due to low cash reserve which can control the inflation in the economy.
(c) Required reserve ratio: - Every commercial bank has to keep some proportion of cash reserve.
It may be 5 to 10 or more, which is legally determined by central bank. If central bank experiences
inflation in the economy, then central bank increases the required reserve ratio which reduces the
bank reserve of commercial banks. Consequently, the credit creation power of commercial banks
certainly fall as a result of which money supply decrease and inflation can be controlled.
(ii) Fiscal measures: - Fiscal policy is related to government policy with the adjustment of public
revenue and public expenditure by government to achieve some macro economic goal is
considered as fiscal policy. There are various instruments of fiscal policy, which can be used to
control inflation in the economy. They are explained below.
(a) Taxations: - If government experiences inflation in the economy, then government imposes
various type of tax. In the same way, government
increases the rate of tax, its base and its coverage,
85
which reduces the purchasing power of people directly. Consequently, people reduce their
consumption level in the economy, which also reduces aggregate demand in the economy, thereby
inflation can be controlled.
(b) Reduction in government expenditure: - The government expenditure is one of the important
instruments of fiscal policy. If government experiences inflation in the economy, then government
reduces the public expenditure on various items expenses on general expenditure, which reduces
the purchasing power. So, people reduce consumption level as a result of which aggregate demand
decreases and price also decreases. From this way, inflation can be controlled.
(c) Public borrowing: - Sometimes government borrows from people for the collection of
revenue, which reduces the purchasing power of people. Consequently, it reduces inflationary
pressure in the economy.
(d) Over valuation: - Sometimes government adopts revaluation policy from which prices of
foreign goods will be low but prices of domestic goods will be high in the international market,
which increases the imports of goods, and decrease exports of goods. As a result of which there
will be availability of goods in the domestic market from which inflation can be controlled.
(iii) Other measures: - there are also other measures from which inflation can be controlled which
is called non-monetary measures, which are as follows:
(a) Output adjustment: - The level of output should be increase in the economy to control
inflation such measure is called output adjustment.
(b) Price control and rationing: - Government should control the price by using rationing and
quota system.
Monetary measures are important instrument to control inflation but sometimes it is not so
effective because it indirectly works in the economy while fiscal measures are effective measures
to control inflation because it directly works in the economy to control inflation. Other measures
like price control, rationing and quota system are not possible in the case of privatization and
liberalization.
 Computation of Rate of Inflation
The inflation rate between two periods of time is measured by the percentage increase in the
relevant price from the first period to the second period. By assuming 100% to price index of base
year, the change in price index between base year and current year is compared. The formula of
inflation rate can be expressed as:
Rate of Inflation (r) =
Pt − Pt −1
 100
Pt -1
Where, Pt-1= value of the price indeed in the first period
Pt= value of the price index in the second period
The rate of inflation may be computed using either by producer’s price index or by consumer’s
price index or by GDP deflator.
 Producer Price Index (PPI)
The PPI is an index of the prices charged by business for crude, intermediate and finished goods.
Because these prices represent various stages of production, some goods enter the PPI as many as
three times as a crude goods (e.g., wheat sold by the farmer), as an intermediate goods (flour sold
by the mill), and as a finished goods (bread sold by the baker to a food retailer). A PPI is published
for crude goods, intermediate goods, and finished goods to avoid the double counting that exists
in the PPI for goods at all stages of production prices in the PPI are weighted as they are in the
CPI. Movements in the PPI can be used to forecast the CPI, however, because the PPI does not
include services, such forecasts are subject to error when the principal cause of inflation derives
from increases to the prices of services.
 Measurement of Inflation through Producer’s Price Index (PPI)
There are two methods of construction the PPI which are explained with the help of the following
examples:
1. Unweighted Index Number:
a. Simple Aggregative Method
In this method, producer’s price index is the outcome of the sum of prices for the current year
divided by the sum of actual prices for the base year.
Commodity
Price in 1999
Price in 2001
P0
P1
A
15
20
B
40
60
C
5
10
D
20
25
E
30
45
P0 = 110
P1 = 160
P01 =
 P1
 100
 P1
Where, P0 = Price index number for current year with respect to base year
P0 = Sum of the prices for base year
P1 = Sum of the prices for current year
Index Number (P01 ) =
160
 100
110
Index Number (P01 ) = 145.45
The percentage increase in price level for current year (or rate of inflation) = 145.45 - 100 = 45.45%
b. Simple Average of Price Relative Method.
commodity
Prices in 1998
P0
Price in 2000
P1
A
15
18
B
20
22
C
10
13
D
25
26
E
5
10
N=5
P1
 100 = P
P0
18
 100 = 120
15
22
 100 = 110
20
13
 100 = 130
10
26
 100 = 104
25
10
 100 = 200
5
P = 664
Log P
2.0792
2.0414
2.1139
2.0170
2.3010
logP = 10.5525
According to this method, the price index number is the outcome of the sum of price relatives divided by
the number of items. Here, price relative is the ration of the price of the current year and the price of base
year, multiplied by 100.
 P 664
P01 (AM) =
=
= 132.80
N
5
132.8 - 100
 100 = 32.8%
100
  logP 
 10.5525
P01 (GM) = AL 
 = AL 
 = AL (2.1105) = 128.97
5 
 N 

Rate of Inflation =
128.97 - 100
 100 = 28.97%
100
2. Weighted Index Number
a. Weighted Aggregative Method
In this method, different weights are assigned to the items according to their relative importance. Quantity
weights are used as weights. Many formulae have been developed to estimate the price index number.
However, Fisher’s ideal index is considered as the best method.
Rate of Inflation =
Commodity
A
B
C
D
Base
Year
P0
2
8
10
4
Current
Year
Q0
50
100
30
20
P1
3
10
15
6
Q1
40
90
25
18
P0q0
P1q1
P1q0
P0q1
100
800
300
80
120
900
375
108
150
1000
450
120
80
720
250
72
p0q0=1280
p1q1=1503
p1q0=1720
p0q1=1122
 P1q 0  P1q1

 100
 P0 q 0  P0 q 1
1720 1503
P01 =

 100
1280 1122
P01 =
P01 = 1.3436  1.3396  100
P01 = 1.3416100 = 134.16
Rate of Inflation =
134.16 - 100
 100 = 34.16%
100
b. Weighted Average of Relative Method
In this method, an indeed number is the outcome of the sum of the product of price relatives and weights
divided by the sum of all weights by formula.
 PW
P01 =
W
P
Here, P = 1  100, W = Weight
P0
 Consumer Price Index (CPI)
The consumer price index number is also known as cost as living index number. Consumer price
index is a measure of the overall cost of the goods and services bought by typical consumers. It
does not include capital goods purchased by firms and goods and services purchased by the
government. But it includes household purchases of imports. The need for the construction of
consumer price index arises because the general price index does not reflect the exact impact of
price changes on the cost of living of different section of the society. This is due to the fact that all
people do not consume similar commodities and utilize similar services. Person belonging to
different section of the society do not by same types of goods and services. There are variations
on the basis of their socio-economic status. Even within the same group of people, there may be
variation in consumption pattern from place to place. Low and middle-income groups do not buy
costing fruits and vegetables; do not consult costly doctors for medical care. They do not use
refrigerator, LCD TV, AC etc. In short, while constructing CPI for a particular section of people,
we should include only those items, which are generally consumed by that section of people. How
particular group is affected with the changing behavior of prices of different commodities it is
necessary to construct CPI for different section of the people.
 Measurement of Inflation through consumer price index (CPI)
The CPI can be calculated in two ways:
1. Aggregate expenditure method or weighted aggregate method: In this method, quantizes
consumed in the base year are taken as weight. The formula for this method is given below:
Σp q
CPI = 1 0  100
Σp 0 q 0
2. Family budget method: In this method, first price relatives of all commodities are calculated and
then weighted. The formula for this method is given below:
p

Σ 1  100p 0 q 0
p

CPI =  0
 100
Σp 0 q 0
Σpw
CPI =
Σw
Where, P = P0  100 (price relative)
P0
w = p 0 q 0 (value of the commodity cosnumed)
Ex. 1. construct CPI number for the year 2013 from the data given below:
Commodity
Base year 2012
Price in 2013
Price (P0)
Quantity(q0)
A
25
16
35
B
36
7
48
C
12
4
16
D
6
3
10
E
28
4
28
What change in the CPI in 2013 has taken place as compared to 2012? Find inflation rate.
Solution:
Commodity
A
B
C
D
E
CPI =
p0
25
36
12
6
28
q0
16
7
4
3
4
p1
35
48
16
10
28
p0q0
400
252
48
18
112
 p0q0=830
p1q0
560
336
64
30
112
 p1q0=1102
Σp1q 0
 100
Σp 0 q 0
CPI =
1102
 100
830
CPI = 132.77
Hence, the CPI of 2013 has been increased figure (132.77-100) =32.77%
Inflation rate =
132.77 - 100
 100
100
Inflation rate = 32.77%
EX. 2: From the following table, find CPI number and rate of inflation.
Commodity
Units
2010
79
Price
Quantity
Price
Wheat
Quintals
1000
10
1100
Rice
Quintals
1500
15
1700
Cloth
Meters
50
50
40
Solution:
Commodity
Wheat
Rice
Cloth
Units
Quintals
Quintals
Meters
p0
1000
1500
50
q0
10
15
50
p1
1100
1700
40
q1
6
18
30
p1
 100 and w = p1q 0
p0
Σwp
CPI number for the current year 2011 =
Σw
3849925
CPI number for the current year 2011 =
35000
Where, P =
CPI number for the current year 2011 = 109.998
Rate of Inflation =
109.998- 100
 100
100
p0q0
10000
22500
2500
p
110
113.33
80
 p0q0=35000
2011
Quantity
6
18
30
wp
1100000
2549925
200000
 p0q0=3849925
Rate of Inflation = 9.998%
 Meaning of Unemployment
Workers are capable to work and they are preparing to work at existing wage rate in the economy
but they are not getting any job due to lack of job opportunities, such situation is called
unemployment.
Unemployment is defined as the non-availability of jobs for people who are able and willing to
work at the existing wage-rate. It is a problem to both developed and developing countries. It
creates problems like poverty, inequality, robbery, prostitutions, theft, crime etc. Therefore,
solving unemployment problem or creating employment opportunities has been major objective in
all economies of the world.
People who are either unfit for work due to mental or physical reasons or do not want to work, e.g.
sadhus, are excluded from the category of unemployed.
Here, again if there is engagement in some occupation does not necessarily mean absence of
unemployment. People, who are partially employed or engaged in inferior jobs, though they can
do better jobs are not adequately employment. It is called the sate of underemployment, which is
equally harmful for the prosperity of the country. In the free market economic system, full
employment is almost impossible. The best that can be dome is to keep the number of unemployed
people as low as possible. In the developing countries like Nepal unemployed can be reduced by
increasing investment in human and physical capita, development of infrastructure and industrial
sector.
 Types of Unemployment
1. Open unemployment: Open unemployment is defined as the situation in which some workers
have no any work to do. They are willing to work at the existing wage rate but they are forced to
remain unemployed in the absence of work. These workers are completely idle. Such kind of
unemployment is found in the developed countries like USA, UK, Japan, etc.
2. Underemployment: Underemployment is defined as the situation in which employed persons
are working but less than they are capable of it. In this situation, people do not get the job or work
they are capable of doing or they are trained for. They possess abilities and expertise to do the type
of work that could yield larger income. But due to the non-availability of suitable as per their
abilities and expertise, they join inferior occupation.
3. Disguised unemployment: Disguised unemployment is defined as the situation in which a
person seems as employed but infact he is not employed. In this type of unemployment, the
unemployed person is not visible or he/she is hidden. That’s why, this type of unemployment is
also known as the hidden unemployment.
In this type of unemployment, too many persons are involved in a work or persons are more than
actually required. This type of unemployment problem is found in agriculture sector of developing
countries. Due to lack of employment opportunities outside agriculture sector, all members of the
family are found to be engaged in farming even it is not necessary. If we reduce the involved
persons in agriculture, the total production will not decrease because marginal productivity of
some workers is zero.
4. Cyclical unemployment: cyclical unemployment is defined as the type of unemployment that
results due to operation of trade cycle or business cycle. Trade cycle refers to the regular upward
and downward movement in business or overall economic activities. When business or economic
activities are going down, aggregate demand decreases. For which, less production is needed and
consequently, fewer workers are needed. This brings result of unemployment problem. During the
period of Great Depression in 1930s, large number of labor force was unemployed in the developed
countries, especially in USA and Europe.
5. Seasonal unemployment: Seasonal unemployment is defined as the situation in which people
are out of work and looking for a job during the off-season. For example, ice-crème vendors during
the winters and ski-lift operator during the summer are out of work or they become unemployed.
Similarly, farm labors also remain unemployed except planning and harvesting season. And it is
common type of unemployment both in the developed and developing countries.
6. Frictional unemployment: Frictional unemployment defined as the situation in which people
are looking for new or better job and employers are looking for right workers. It is also known as
the search unemployment because it occurs when people leave job and searching for new job. The
main cause of frictional unemployment is imperfect information regarding job vacancies (demand
for labor) and supply of labor. Therefore, it is of short- term nature. This kind of unemployment is
usually found in the developed countries.
7. Structural unemployment: Structural unemployment is defined as the situation in which
occurs due to the changes in structure of the economy. The main cause of structural unemployment
is a mismatch between the skills needed for available jobs. This kind of unemployment usually
exists in the developing countries like Nepal where unemployment is structural in nature. Here the
large numbers of people are unemployed because of under developed structure of the economy.
This can be solved only through rapid economic development.
Structural unemployment can also occur due to introduction of new technology in the production
process. It replaces man with machines.
8. Educated unemployment: Educated unemployment refers to unemployment among the
educated people, i.e. matriculates and higher educated. This is the problem of both developed and
developing countries. Some of these people may be openly unemployed or under employed. It
means that some of the educated people may be doing no any work or may be in inferior jobs. It
is because they may not be able to get work suitable to their qualification or their skill and ability
may be less than the required for job. In Nepal, large number educated people are unemployed
because or non-availability of job. It can be solved by the development of industrial sector.
 Philip Curve
A. W. Philips has presented on empirical theory of inflation in 1959. This is commonly known as
Philips Curve hypothesis. The Philips curve expresses the relationship between percentage
change in wage rate and percentage change in unemployment in the economy. Philip derived
the empirical relationship that when unemployment is high, the rate of increase in money wage
rates is low. This is because workers are reluctant to offer their services at less than the
prevailing rates when the demand for labor is low and unemployment is high so that wage rates
fall very slowly. On the other hand, when unemployment is low, the rate of increase in money
wage rates is high. This is because, when the demand for labor is high and there are very few
unemployed we should expect employer to bid wage rates up quite rapidly.
It can be cleared by following diagram.
W
Wage rate
W1
Fig-6.2
Philip Curve
A
B
W2
C
W3
PC
O
U1
U2
U3
U
Unemployment rate
In this diagram, wage rate is measured along horizontal axis and unemployment rate along
horizontal axis. The PC is Philip Curve which has negative slope and convex to the origin. It means
that there is negative relationship between rate of wage and rate of unemployment. The wage rate
falls with the increase in unemployment rate but at decreasing rate. When unemployment rate is
U1, the wage rate is W1 reflected by point ‘A’. When rate of unemployment increases from U1 to
U2, the wage rate falls from W1 to W2 reflected by point ‘B’. In the same way, when rate of
unemployment increases from U2 to U3, the wage rate falls from W2 to W3 reflected by point ‘C’.
By adjoing points A, B and point C, the Philip curve is derived.
 Concept of Deflation and its causes
Deflation means the process of decrease in general price level and increase in value of money.
Hence, deflation is opposite position of inflation. According to Crowther “ deflation is the state of
economy where the value of money is increasing that is prices are falling” According to A.C. Pigou
“ deflation is the state of fall in prices which occurs at that time when the output of goods and
services increase more rapidly than the volume of money income in the economy.”
Followings are the causes of deflation.
(i) Reduction is supply of money: - When central bank issues more paper money by adapting
cheap monetary policy, then it brings the state of deflation in the economy.
(ii) Control of credit: - When central bank controls the credit creation power of commercial banks,
it decreases the total quantity supply of money, which results deflation.
(iii) Increase in output: - If output of goods and services increase rapidly more than the volume
of money income, then it leads to deflation in the economy.
(iv) Increase in rate of tax: - If government increases the rate of tax, then it leads to fall in
disposable income, which results deflation.
(v) Increase in public debt: - If government increases the activity of internal borrowing from
people, then it reduces the volume of money income with people. As a result of which, the situation
of deflation occurs.
 Concept of Stagflation
Stagflation: Stagflation is a new term, which has been added to economic literature in the 1970s.
The word ‘stagflation” is the combination of stag plus flation, taking ‘stag’ from stagnation and
‘flation’ from inflation. Thus, it is a paradoxical situation where the economy experiences
stagnation or unemployment along with a high rate of inflation. It is, therefore, also called
inflationary recession. The level of stagflation is measured in the US by the discomfort index,
which is a combination of the unemployment rate and the inflation rate measured by the price
deflator for GNP.
One of the principle causes of stagflation has been restriction in the aggregate supply. When
aggregate supply reduced, there is a fall in output and employment and the price level rises. A
reduction in aggregate supply may be due to a restriction in labor supply. The restriction in labor
supply, in turn, may be caused by a rise in money wages on account of strong unions or by a rise
in the legal minimum wage rate, or by increased tax rates which reduce work-effort on the part of
workers.
When wage rise, firms are forced to reduce production and employment. Consequently, there is a
fall in real income and consumer expenditure. Since the decline in consumption will be less than
the fall in real income, there will be excess demand in the commodity market which will push up
the price level. The situation of stagflation has been shown in following diagram.
P
Fig-6.2
Situation of stagflation
Price level
S2
E2
P2
P1
S1
E1
D1
O
N1
N2
N
Employment level
In this diagram, price level is measured along vertical axis and employment level along horizontal
axis. The D1 is initial demand curve and S1 is initial supply curve. Both are equal at point E1 from
which P1 price level and N1 employment level are determined together. Now suppose supply fall
and the S1 supply curve shifts and takes a position of S2. The S2 curve is equal to D1 at point E2.
As a result, the price level increases from P1 to P2 and employment level fall from N1 to N2. It is
the situation of stagflation.
 Meaning of Trade Cycle
Trade cycle is also called business cycle and it is the main characteristics of capitalist economy.
In a free and capitalist economy, national income, employment level, price level along with their
determinant factors keeps on changing from time to time. Therefore, various economic ups and
downs are the normal situation of the free economy, i.e. like waves and tides in the sea. The
situation of prosperity and depression keeps on occurring in the free and capitalist economy. In
this situation of prosperity in the economy, the economic development will be in the positive
direction and vice versa. It means that during prosperity, income, output, employment and price
level, all macro-economic variables are very high and vice versa. Such ups and downs in the
economic activities are called trade cycle. It is defined by different economists in different manner.
According to F. Benham, - “Trade cycle refers to a period of prosperity followed by a period of
depression.”
According to W.C. Mitchell, - “Business cycles are a type of fluctuations found in the aggregate
economic activity of nation that organize their work mainly in business enterprises”.
According to J. M. Keynes, - “ A trade cycle composed of period of good trade characterized by
rising prices and low employment percentages alternating with periods of bad trade characterized
by falling prices and high unemployment percentages.”
From the above definitions, it is cleared that trade cycle is the fluctuation in the economic
activities like income, employment, output and general price level in the capitalist economy as a
result of which sometimes prosperity and sometimes depression occurs.
 Characteristics of Trade Cycle
Followings are the characteristics of trade cycle:
(i) Cyclical Nature: - The nature of trade cycle is generally cyclical, i.e. after the creation of trade
cycle, the ups and downs fluctuation will be of recurring and repetitive. Consequently, the
depression occurs after the state of prosperity and prosperity after the state of depression
continuously and cyclically.
(ii) Regularity: - According to some economists, there is regularity in the fluctuation of trade
cycle or the state of prosperity and the state of depression occurs in a fixed period.
(iii) Wave like movement: - The movement of trade cycle is just like the sea waves. In capitalist
economy, depression after prosperity and prosperity after depression occurs in wave like
movement.
(iv) International: - In modern economy, the nature of trade cycle becomes international. So trade
cycle starts at one section of the economy and expands throughout the country and it expands from
one country to another country.
(v) Unequal effect: - The effect of trade cycle in all sectors of the economy is not equal. The effect
of trade cycle is more on capital goods as compared to consumption goods. The trade cycle affects
more on wholesale price as compared to retail prices
(vi) Features of capitalist economy: - The trade cycle occurs in the capitalist economy where
there is free trade and where there is no government regulation and control. So, it is the
characteristics of capitalist economy.
 Types of Trade Cycle
Followings are the types of trade cycle.
(i) Juglar cycles: - This cycle has been described by French economists Juglar in 19th century. The
time period of this cycle is about 10 years.
(ii) Kitchin cycles: - This cycle has been described by British economist Joseph Kitchin. This is
known as short cycles. The time period of this cycle is about 40 months.
(iii) Long waves: -This cycle has been propounded by Russian economist Kondratiff. This cycle
is known as long run waves. The time period of this cycle is from 50 years to 60 years. In this time
period, many short cycles are included.
(iv) Building cycles: - This cycle is related to construction works. The time period of this cycle is
about 18 years.
(v) Kuznets cycles: - this cycle has been described by American economist Simon Kuznets. The
time period of the cycle is from 16 years to 22 years.
 Phases of Trade Cycle
Trade cycle is the characteristic of free capitalistic economy, where ups and downs occur one after
another. The fluctuation can be classified into four phases of trade cycle, which are explained
below.
(i) Depression : - It is a period during which income, employment , output and general price level
are very low. During this period, prices of goods are very low. So producer and businessman have
to bear loss. So, they reduce the investment level on production. . Consequently, the level of
employment and output goes down. Businesspersons and producers become pessimistic due to low
profit. In the same way, labours become pessimistic due to low wage and low employment level.
During this period, credit activities go down but bank reserves increase. So, resources are underutilized during this period. Farmers are also pessimistic due to low price of agricultural product.
In the same way, service holders are also pessimistic due to low wage. The value of money is very
high during this period.
(ii) Recovery: - The recovery phase starts after depression. When price of goods starts to increase,
then it increases the profit of producer. So, producers start to increase investment level in the
economy. Consequently, bank reserve starts to fall and bank credit starts to increase. Financial
institutions become optimistic. The producers are also optimistic due to increase in profit. In the
same way, labours are also optimistic due to increase in employment level and wage rate. In the
economy, national income and output both start to increase. Farmers are also optimistic due to
increase in price of agricultural product.
(iii) Boom: - It is a period, which starts after recovery phase. During this period price is very high.
So, profit is also very high. Consequently, the businesspersons and producers are over optimistic.
So during this period, the investment level is very high. Consequently, employment, income and
output level are also very high. Labors, shareholders, service holders are optimistic. But in some
cases, they have to bear loss, because price is always lag behind the wage. Consequently, the
purchasing powers of labours, shareholders and farmers decrease. During this period, speculative
activities increase in the economy. Sometimes producer produces over production due to over
estimation, which starts to follow recession. During this period, the bank credit is very high but
the bank reserve is very low.
(iv) Recession: - The recession is a period, which starts after boom. During boom period,
producers and businesspersons are over optimistic. So, they increase the investment. In such a
way, that there occurs over production in the economy which leads to fall in price in the economy
Economic Activities
and which bring the recession phase. When the prices of goods start to fall, it will be continuing
in the economy. Consequently, the business profit starts to fall. The shareholders, businessman,
producers start to be pessimistic due to low profit. So, they start to decrease investment level in
the economy which leads to fall in employment level, output and income level. Labours start to be
pessimistic due to low employment level and low wage. Farmers are also pessimistic due to fall in
price of agricultural product. Bank reserve starts to increase but bank credit starts to fall. So,
financial institution also starts to be pessimistic. At last, it brings depression period in the economy.
The phases of trade cycle can be cleared with the help of following diagram.
Fig- Trade Cycle
Y
C
D
B
A
O
Time period
t
(A) Depression Phase (B) Recovery Phase (C) Boom Phase (D) Recession Phase
In this figure, economic activities are measured along vertical axis and time period along horizontal
axis. The economy is in depression period reflected by point A, where economic activities are very
low. The economy is moving from A to B. It means that it is moving from depression to recovery
phase, in which economy activities are increasing. The cycle is moving from B to C points. It
means that economic activities are moving from recovery to Boom, where income is high. After
point C, the cycle is moving from C to D, it means that economic activities are moving from Boom
to recession where economic activities are declining. From this way, boom occurs after depression
and depression occurs after boom. Such fluctuation is called trade cycle.
The four phases of trade cycle and their effects can be illustrated in short in the following diagram.
2. Recovery
(i) Rise in aggregate demand
(ii) Rise in price
(iii) Rise in profit
(iv) Rise in employment
3. Prosperity
(i) High aggregate demand
(ii) High price
(iii)High profit
(iv)High Employment
1. Depression
(i) Low aggregate demand
(i) Low price
(ii) Low profit
(iii) Low Employment
4. Recession
(i) Fall in aggregate demand
(ii) Fall in price
(iii) Fall in profit
(iv) Fall in employment
 Controlling of Trade Cycle
Ups and down in economic activities creates economic instability is dangerous for economic
development because it make confusion and hurt to society. So it should be controlled. The
business cycle can be controlled by following measures.
Measures of Fiscal policy
There are various instruments of fiscal policy. They are: taxation, government expenditure, public
borrowing. If government feels depression in the economy then government decreases rate of tax,
increases government expenditure and makes payment of past borrowing to people. As a result,
aggregate demand increases and thereby income, output, and employment all macro economic
variables start to increase in the economy. But If government feels boom in the economy, then
government increases rate of tax, decreases government expenditure and increase borrowing
activities from people. As a result, aggregate demand decreases and thereby income, output, and
employment all macro economic variables start to decrease in the economy. Hence, government
can control fluctuation in economic activities by variation of rate of tax, government expenditure
and government borrowing.
Measures of monetary policy
There are various instruments of monetary policy. They are: bank rate policy, open market
operation and required reserve ratio. If central bank feels depression in the economy, then central
bank decreases bank rate, purchasing securities by open market operation and decreases required
reserve ratio. As a result, aggregate demand increases and thereby income, output, and
employment all macro economic variables start to increase in the economy. But If central bank
feels boom in the economy, then central bank increases bank rate, increase the sale of securities
by open market operation and increases required reserve ratio. As a result, aggregate demand
decreases and thereby income, output, and employment all macro economic variables start to
decrease in the economy. Hence, central bank can control fluctuation in economic activities by
variation of bank rate, purchase and sale of securities by the help of open market operation and
required reserve ratio.
Other measures:
In open market, generally fluctuation in economic activities can be controlled by used fiscal and
monetary policy instruments. But there are also other instruments to control business cycle. They
are explained below respectively.
(i) Government can control fluctuation in economic activities by using price control policy.
(ii) Government can control fluctuation in economic activities by provision of unemployment
insurance
(iii) Government can control fluctuation in economic activities by fixing minimum price.
(iv) Government can increase economic activities by development of infrastructure
(v) Government can control fluctuation in economic activities by the help of international
cooperation
 Numerical Examples
QN. Find consumer price index for 2005, 2006 and 2007.
Basket of Quantity
Price in Price in Price in Q0
goods
of goods
2005
2005
2005
X
4
1
2
3
Y
2
2
3
4
Solution:
Basket of q0
goods
P0
P1
P2
p0
p1
p2
p0q0
p1q0
p2q0
P3
X
4
1
2
3
1  4 = Rs. 4
2  4 = Rs. 8
3  4 = Rs. 12
Y
2
2
3
4
2  2 = Rs. 4
3  2 = Rs. 6
4  2 = Rs. 8
p0q0 = Rs. 8
p1q0 = Rs. 14
p2q0 = Rs. 20
CPI of 2005 =
Σp 0 q 0
Rs. 8
 100 =
 100 = 100
Σp 0 q 0
Rs. 8
CPI of 2006 =
Σp1q 0
Rs.14
 100 =
 100 = 175
Σp 0 q 0
Rs. 8
CPI of 2007 =
Σp 2 q 0
Rs. 20
 100 =
 100 = 250
Σp 0 q 0
Rs. 8
QN. From the following data compute rate of inflation.
GDP deflator for 2011- 12 = 275.6
GDP deflator for 2012 - 13 = 300.7
Solution:
Rate of Inflation =
Change in GDP deflator
 100
Previous GDP deflator
Rate of Inflation =
300.7 - 275.6
 100
275.6
Rate of Inflation = 9.11%
QN. If PIN for all goods was increased from 210.6 in 2010-11 to 216.8 in 2011.12. Find the
inflation rate.
Solution:
Change in PIN
Rate of Inflation =
 100
Previous PIN
Rate of Inflation =
216.8 - 210.6
 100
210.6
Rate of Inflation = 2.94%
QN. Calculate rate of inflation 2013, considering the following data:
Year
2011
2012
2013
CPI
210
225
260
What would be real GDP in 2013 if nominal GDP is Rs. 860 thousand?
Real GDP in 2013 =
Nominal GDP
 100
CPI
Real GDP in 2013 =
860
 100
260
(CPI = GNP deflator)
Real GDP in 2013 = 330.77 thousand
QN. Consumer price Index (CPI) of a country changes from 380, 385, 391, and 398 in the first
second, third and fourth year respectively, find inflation in those year respectively, find inflation
in those year.
Solution:
Calculation of inflation
385 - 380
Rate of Inflation for second year =
 100 = 1.32%
380
Rate of Inflation for third year =
391- 385
 100 = 1.56%
385
398 - 391
 100 = 1.79%
391
QN. Calculate consumer price index and rate of inflation from the following table.
Commodity
Base Year
Current Year
P0
q0
P1
q1
Orange
3
55
4
45
Apple
9
100
12
95
Mango
11
35
15
30
Solution:
Commodity Base year
Current year
P0q0
P1q1
P1q0
P0
q0
P1
q1
Orange
3
55
4
45
165
180
220
Apple
9
100
12
95
900
1140
1200
Mango
11
35
15
30
385
450
525
 P0q0
 P1q1
 P1q0
Rate of Inflation for forth year =
=1450
CPI =
P1q 0
1945
 100 =
 100 = 134.12
P0 q 0
1450
Rate of inflation =
=1770
=1945
P0q1
135
855
330
 P0q1
=1320
134.12 − 100
 100 = 34.12%
100
UNIT-6
MACROECONOMIC POLICY
Macro economic policy is defined as a program of economic action undertaken by government to
control, regulate and manipulate macro-economic variables to achieve certain predetermined
economic goals. The economic goals are to increase in employment opportunities, to reduce
poverty, to reduce income and wealth inequality, to reduce regional imbalance, to correct adverse
balance of payment, to achieve price stability etc. Government uses fiscal and monetary policy
instruments to achieve predetermined economic goals. The instruments of fiscal policy are
government expenditure, taxation, public borrowing and the instruments of monetary policy are
bank rate, open market operation and required reserve ratio. In conclusion, macro economic policy
is combined operation of fiscal and monetary policy to achieve macro economic goals in the
economy.
5.4. Objectives of Macroeconomic Policy
(i) Full employment: - Unemployment is very dangerous for economic development. It creates
social insecurity. Therefore, the main objective of macroeconomic policy is to achieve full
employment. Government can increase employment opportunities by increasing aggregate
demand in the economy.
(ii) Economic development: - The objective of macro economic policy is to increase pace of
economic development. For the purpose of increase the pace of economic development, saving
should be increase in the economy, because saving is source of investment. For this purpose
government uses various instruments of fiscal and monetary policy.
(iii) Price stability: - The objective of macro economic policy is to achieve price stability. It
creates the situation of inflation and deflation, which are very dangerous for economic
development. Government plays important role to achieve price stability by using various
instruments of macroeconomic policy.
(iv) Foreign exchange rate stability: - The objective of macro economic policy is to achieve
foreign exchange rate stability. Foreign exchange rate instability adversely affects to international
trade and balance of payment. It also affects the international price, employment and output.
(vi) Correct balance of payment: - Every developing country has been facing the problem of
adverse balance of payment. So, adverse balance of payment should be corrected. So the correction
of adverse balance of payment is one of the objective of macroeconomic policy.
(v) Capital formation: - It is the main objective of fiscal policy in the developing countries
because in these countries the per capital income is very low. So, saving and investment are also
low. Consequently, income, employment and output level are also low. So, the pace of economic
development is also low.
(vi) Resources mobilization: - The resources mobilization is main objective of macroeconomic
policy. Government can play important role to mobilize resources from unproductive sector to
productive sector, from agriculture sector to non-agricultural sector from production of luxurious
goods to necessary goods undesirable to desirable sector.
(vi) Reduction in economic inequality: - Economic inequality means income inequality and
regional imbalance. It creates serious problem of struggle between haves and haves not which is
not beneficial to economic development. Therefore, the reduction in economic inequality is one of
the objectives of macro economic policy.
5.4. Meaning of money supply
The term supply of money means the total stock of money held by the people (individuals and
business firms) in spend-able form. It is total amount of money available in the economy at
particular point in time. It is both stock and the flow concepts. When money supply is considered
at a point of time, it is stock concept and when it is viewed over a period of time, it is flow. One
unit of money is used several times during a period of time. The average number of times a unit
of money changes hands during given period of time is known as velocity of money.
Money supply data are recorded and published by the central bank of the country. Changes in
money supply affect price level, business cycle and economic growth of the country. Thus, while
formulation monetary policy the central bank manipulates the supply of money according to the
objectives of the monetary policy.
There are two viewpoints regarding constituents of money supply, (a) traditional and (b) modern.
According to traditional viewpoint, money supply includes coins, notes (legal tender money) and
bank money (checkable bank deposit with commercial bank). Acceding modern view point the
supply of money includes not only legal tender money and bank money but also fixed deposit with
banks, financial assets with non-banking financial institutions, financial intermediaries(like
provident fund building societies), treasury bills, bill of exchange, bonds and equities.
5.4 Source of Money Supply
There are mainly three sources of money supply.
1. Central Bank: - Central bank is highest monetary authority of a country. It is the main source
of money supply in the economy. The money supplied by the central bank is known as high power
money. Central bank of every country has the power to issue currency. It prints notes and mints
coins. It can increase or decrease the quantity of money in the economy by increasing or decreasing
the notes and coins. The currencies created by central bank are backed by reserves, its value is
guaranteed by the government, and it is the source of all other forms of money.
2. Commercial bank: - Commercial banks are the second important source of money supply. The
money created by commercial banks is known ‘credit money’. Banks create money from the
deposits brought to them. Banks receives deposits from the following sources:
a. households saving deposited with banks
b. Payment received (by cheque or draft) from the central bank for sale of government bonds.
c. payments received from abroad and deposited with the bank, and
d. Money deposited for convenience in transaction.
3. Non-banking financial intermediaries (NBFLs): - According to economists, J. G. Gurley and
E.S. Shaw financial claims against the no-banking financial intermediaries are the substitutes for
the money. Therefore, the increase or decrease in the volume assts of non-banking financial
intermediaries also affects the money supply in the economy.
5.4. Meaning of Monetary policy
Monetary policy is the adjustment of money demand and money supply by central bank to
achieve some objectives of nation. Increase in money supply is sometime not beneficial to the
country, because it creates various problems like inflation. Decrease in money supply as compared
to money demand is also not beneficial for the economic development, because it creates deflation,
unemployment problems and so on. So, central bank always tries to manage the money demand
and controls the money supply to achieve economic objectives. Such efforts of central bank are
called monetary policy.
The monetary policy has been defined by different economists in different manner.
According to Henry C. Murphy, - “Monetary policy is the policy of increasing or
decreasing the cost and availability of money for business purposes as a means of influencing the
general level of prices, incomes and employment.”
According to Edward Shapiro,- “ Monetary policy is the central bank’s control over the
money supply as an instrument for achieving the objective of general economic policy.”
From above definitions, it is clear that monetary policy is a policy used by central bank to
affect on income, employment, output and general price level into desirable direction and the
instruments used by central bank are called instrument of monetary policy.
5.4. Instruments of Monetary policy
Followings are the instruments of monetary policy:
1. Quantitative instruments:
a. Bank rate policy
b. open market operation
c. Required reserve ration
2. Qualitative instruments:
a. Credit rationing
b. Change in lending margins
c. Regulation on Consumer credit
d. moral suasion
e. publicity
f. Direct action
5.4. Types of Monetary policy
a. Expansionary monetary policy: - Monetary policy, which is designed to increase money supply
or increase in bank credit, is called expansionary monetary policy. Central bank can increase
money supply or bank credit by decreasing bank rate, increasing purchase of securities by open
market operation and reducing required reserve ratio.
b. Concretionary monetary policy: - Monetary policy, which is designed to decrease money supply
or decrease in bank credit, is called contrationary monetary policy. Central bank can decrease
money supply or bank credit by increasing bank rate, increasing sale of securities by open market
operation and increasing required reserve ratio.
8.2  Objectives of Monetary Policy
Followings are the objectives, significance, and instruments of monetary policy in
developing countries
(i) Full employment: - For the purpose of achieving full employment, the private investment
should be increase to increase in employment level in the economy. For this purpose, the central
bank reduces the bank rate and required reserve ratio, which tend to fall in market rate of interest,
which increases the loan for consumption and investment in the private sector. Hence, aggregate
demand increases in the economy, which increases the employment level.
(ii) Economic development: - For the purpose154
of increase the pace of economic development;
saving should be increase in the economy, because saving is source of investment. So, central bank
encourages expanding departments to commercial banks and financial institutions in the remote
areas which increase the rate of saving. In the same way, the rate of investment should be increase
to increase the pace of economic development. In this situation, central bank tries to reduce market
rate of interest to increase the money supply by reducing bank rate and required reserve ratio,
which provides the sufficient chance to commercial bank for credit creation.
As a result of which, it increase aggregate demand and at last it increases the pace of economic
development.
(iii) Price stability: - It creates the situation of inflation and deflation, which are very dangerous
for economic development. So, it is one of the most important objectives of monetary policy. For
the purpose of price stability, central bank can play important role in the developing countries. If
central bank experiences inflation, then central bank tries to reduce money supply by controlling
credit creation of commercial banks. For this purpose, central bank increases the bank rate and
required reserve ratio, which increases the market rate of interest and reduces the power of credit
creation of commercial banks. Consequently, it reduce the aggregate demand from which inflation
can be controlled and vive-versa for deflation.
(iv) Foreign exchange rate stability: - Foreign exchange rate instability adversely affects to
international trade and balance of payment. It also affects the international price, employment and
output. So, foreign exchange rate stability is one of the important objectives of monetary polices.
In the developing countries, foreign exchange should be kept stable. For this purpose, the central
bank controls the devaluation of domestic currency as compared to foreign exchange again and
again by monetary policy. The change in foreign exchange rate should be for the correction of
balance of payment, otherwise not.
(vi) Correct balance of payment: - Every developing country has been facing the problem of
adverse balance of payment. So, adverse balance of payment should be corrected by central bank
by controlling foreign exchange by the help of monetary policy because the foreign exchange is
essential to import necessary goods, capital goods, machinery fuel, medicines and raw materials.
Central bank should control the foreign currency to import unnecessary goods within the nation.
Foreign currency can play important role to increase the pace of economic development. For this
purpose, central bank can play important role by controlling foreign exchange.
8.2  Meaning of Fiscal Policy
The term ‘fiscal’ had been borrowed from Greek word ‘Basket’ which refers to pocket of
government. In Italian language, the term ‘fiscal’ refers to treasury. Hence, the public finance is
the subject, which explains the operation of treasury of government. After great depression
of.1930, the fiscal policy has been developed rapidly by many economists like Keynes and Hanson.
They told public finance as fiscal policy. The fiscal policy has been defined by different economists
in different ways.
According to Philip E. Taylor, - “Public finance is concerned with the operation of public
treasury. Hence, to the degree that it is science, it is the fiscal science it’s policies are fiscal policies,
its problems are fiscal problems.”
According to Henry C. Murphy, - “Fiscal policy is the policy that government receipts and
expenditures should be consciously planned, particularly in their aggregate amounts, so as to affect
beneficial changes in the overall level of incomes, prices and unemployment. “
From these definitions, it is clear that fiscal policy and public finance is science but public
finance is broad concept as compared to fiscal policy because it includes all subject matters like
taxation, public expenditure, and public borrowing
internal and external foreign aids and so on.
155
Fiscal policy is the adjustment and operation of government revenue and expenditure by
government consciously to achieve some special achievement of objective of nation in the
economy so that it positively affects on national income, output, employment and general price
level.
7.1  Types of Fiscal Policy
a. Expansionary Fiscal policy: - The deficit budget policy adapted by government for the purpose
of increase in aggregate demand is called expansionary fiscal policy. If government expenditure is
more than government revenue then it is called deficit budget. Such policy is adapted by
government to increase income, employment and income in the economy.
b. Contrationary fiscal policy: -The surplus budget policy adapted by government for the purpose
of decrease in aggregate demand is called contrationary fiscal policy. If government expenditure
is less than government revenue then it is called deficit budget. Such policy is adapted by
government to reduce inflationary pressure in the economy.
7.1  Instruments of Fiscal Policy
Followings are the instruments of fiscal policy:
1. Budgetary policy
a. Deficit budget
b. Surplus budget
2. Public Expenditure
a. Regular expenditure
b. Development budget
3. Public Revenue
a. Tax Revenue: Direct and indirect tax
b. Non-tax Revenue
4. Public borrowing
a. Internal borrowing
b. External borrowing
7.2  Objectives of Fiscal Policy
The economic problems faced by development countries may be different. The problems
of development countries is to maintain high sustain economic growth but the problems of
development counties is to achieve economic development by effecting various macro economic
variables like National income , employment, national output and general price level. So, the
objectives of fiscal policy are different in the case of developed and developing countries. The
fiscal policy can play important role to increase to pace of economic development in developing
countries by the help of various instrument of fiscal policy. The objectives and significance of
fiscal policy are as follows:
(i) Capital formation: - It is the main objective of fiscal policy in the developing countries because
in these countries the per capital income is very low. So, saving and investment are also low.
Consequently, income, employment and output level are also low. So, the pace of economic
development is also low. Fiscal policy can increase the capital formation in the economy by using
the fiscal instrument. Government increases the public expenditure on various items after the
collection of sufficient revenue from tax and non-tax revenue to increase the employment, income
and output level. So the collection of tax is one of the capital formations in the government sector
because in developing countries capital formation is not possible in the private sector due to low
income and demonstration effect because people are spending on unproductive goods like gold,
silver and expensive luxurious goods. In this situation, government can control such consumption
level by charging high tax on such goods. From this way, government can also increase the rate of
saving from which capital formation is possible.
(ii) Resources mobilization: - Government can play important role to mobilize resources from
unproductive sector to productive sector by the help of fiscal instruments like taxation and public
expenditure. In the same way, government can mobilize resources from production of luxurious
goods to necessary goods and from agriculture sector to non-agricultural sector. For this purpose,
government charges high rate of tax on undesirable production of goods from which resources,
which are using undesirable goods, mobilize to production of desirable goods.
(iii) Price stability: - Inflation and deflation both are dangerous for economic development
because it creates instability is price. So, it should be controlled for economic development. Price
instability means fluctuation is general price level. Government can play important role to control
inflation and deflation by the help of fiscal instrument. If government experiences inflation in the
economy, then government increases the rate of tax and reduces the public expenditure and viceversa. By doing so, government achieves price stability in the economy.
(iv) Reduction in economic inequality: - Economic inequality means income inequality and
regional imbalance. It creates serious problem of struggle between haves and haves not which is
not beneficial to economic development. In this situation, government can play important role to
control such inequality by the help of fiscal instruments. In this situation, government uses the
progressive tax system. In this tax system, government charges high rate of tax to rich persons and
spends more on backward person. By doing so, government can reduce income inequality to some
extent.
(v) Promotes employment opportunities: - The main problem is in developing countries is
unemployment. Therefore, to increase employment is main objective of fiscal policy. For this
purpose government increases the public expenditure by using deficit financing in various items
like social overhead capital (drinking water , health, sanitation) and economic overhead capital
(electricity, road, construction) . By doing so, government can increases employment opportunities
in the economy. In the same way, government can promote private investment by the help of
reduction in tax, by providing subsidy and so on.
(vi) Correct adverse balance of payment: - Adverse balance of payment must be corrected by
government by using the fiscal instruments. Government can play important role in correcting the
adverse balance of payment by using import and export duties, which are the main instrument of
fiscal policy. Government increases the import duties to control or reduce imports. In the same
way, government reduces the export duties to promote export. By doing so, government can
increase the export and reduce the import and can correct the adverse balance of payment.
5.4. Meaning of Deficit Financing
One of the major objectives of developing countries in present time has been to achieve high
economic growth rate or to accelerate economic development. For this, the government
deliberately creates deficit in the budget. In this
context, deficit implies the deficit in the total
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budget comprising of revenue and capital budget. The deficit in the revenue budget is a desirable
situation. This shows the inability of the government to collect adequate resource for economic
development.
There may be great deficit in capital budget. It is because the investment expenditure of the
government exceeds the public debt, small saving scheme and the assistance received from
external source (loan and grant). Some part of this gap is met from the saving of the revenue
budget. But the revenue budget may not be sufficient. Consequently, there is deficit in overall
budget. This situation is known as deficit financing. Deficit financing is considered as the
government policy of increasing the rate of capital formation of the country.
5.4. Role and Importance of Deficit Financing
The roles of Deficit financing are as follows:
1. Remove Depression: There is deficiency of money at the period of depression. Hence, in order
to remove this deficiency, the government may resort to deficit financing.
2. Remove Deficiency of Private Investment: The private investment might not be adequate in
the country. Due to the deficiency of investment production activities does not take place rapidly
in the country. On account of this the government may spend more than revenue by either printing
notes or borrowing. This removes the deficiency of private investment.
3. Meet war Time Expenditure: The expenditure of the government increases tremendously
during the wartime. Thus, the government may resort to deficit financing in order to meet the
wartime expenditure.
4. Financing Economic development: The developing counties make great programs for
economic development. However, these counties lack sufficient resources to carry out these
programs. Hence, the government resorts to deficit financing in order to finance the development
plans.
5.4. Budget: Meaning and Components
The term Budget is English word. It is also called budget in Nepali. The term 'budget' is derived
from the French word bougette. It means the leather bag. Walpole, who was the 'chancellor of
Exchequer' of England, used to put documents in a leather bag in 1773 A.D. Since that time, the
term budget became familiar. Now, budget means the proposals inside the bag, not the bag itself.
Budget is considered as powerful means to achieve economic stability, economic growth and
equitable distribution of income and wealth.
The term budget has been defined by different economists in different manner. According
to Bastable - " The budget has come to mean the financial arrangement for a given period with the
usual implication that the have been submitted to the legislature for approval."
According to Taylor- "The budget is the master financial plan of a government. It brings together
estimates of anticipated revenues and proposed expenditures for the budget period, and from these
estimates the activities to be undertaken and the means of their financing can be inferred."
According to World Bank- "The annual budget is usually the legal authority for public spending.
It is ideally one year slice of a medium term expenditure plan."
From the above-mentioned definition, it is cleared that budget means plans of government's
expenditure and income in which it is estimated of expenditure on various activities of government
on the basis of priority and it is also estimated the sources of revenue to meet estimated
expenditure.
5.4. Components of Budget
The finance minister of a country presents budget in the parliament before the start of each fiscal
year. The budget so presented has following components:
1. Summary of economic progress:
In the budget, first of all the summary of the economic progress in the country during the current
fiscal year is presented. It includes revenue mobilization, expenditure, price situation, foreign
exchange reserve, foreign trade, and foreign assistance, rate of economic growth,. Similarly, the
main problems and the challenges of the economy are also being described.
2. Objectives:
The objectives taken into consideration while estimating the revenue and expenditure of the
concerned fiscal year are being mentioned in the budget. For example, Nepal’s budget for the fiscal
year 2009/2010 has laid down following objectives:
a. To help in the formulation of new constitution according to people’s aspiration and giving
completeness to peace process
b. Generate employment opportunity by encouraging the role and investment of cooperative,
private and public sector according to the concept of inclusive development,
c. To give emphasis on the development of large physical and economic infrastructure for high
rate of economic growth,
d. To increase relief, rehabilitation and reconstruction to those affected by conflict, and
e. To provide relief to people by price control and improvement in supply system.
3. Expenditure estimate:
The estimate of expenditure is divided into two parts-regular and development. The estimated
amount in different headings of regular and development expenditure is clearly specified.
Similarly, by what percentage that amount is lower or higher than the actual of the last year and
the revised estimate of the current year is shown. The reason for the expenditure more or less is
also shown.
4 Revenue proposals:
The sources, from which the revenue will be collected for the coming fiscal year, are mentioned
in the revenue proposal. It includes direct taxes, indirect taxes, and sources of non-tax revenue
including foreign assistance. On the revenue side, as well the actual of previous year and the
revised estimate of current year are mentioned. it facilitates the comparison of the revenues of
different years. The rationales and the method of imposing tax are mentioned in the tax proposal.
5. Sources of financing Deficit
Finally, the sources of financing deficit in the budget caused by the inadequacy of revenue and
foreign grant are mentioned. Such deficit is met from bilateral and multilateral foreign loan and
the internal loan raised form banking and non-banking sector. If this is still insufficient, it is spent
from nation’s reserve. In the source of financing deficit side as well, the actual of previous year
and the revised estimate of the current year are presented.
UNIT-7
MACROECONOMIC ISSUES
5.4. Meaning of Balance of Payment
The export and import of goods is called balance of payment. Under balance of trade only
import of export of visible goods are included. The visible goods are those, which are recorded in
custom office. If the export of visible goods is more than the import of visible goods, the balance
of trade is considered to be favorable for nation. As against, if export of visible goods is less than
the import of visible goods, then the balance of trade is considered to be unfavorable for nation. If
the export of visible goods is more than the import of visible goods, then the balance of trade is
considered to be balanced for nation.
Balance of payment is broadly defined. Under balance of payment, the import and export
of all goods and services are included either they are visible or invisible. The invisible goods and
services are those, which are not recorded in custom office. Hence, under balance of payment, the
balance of trade is also included. The balance of trade is one of the parts of balance of payment.
Balance of payment is always balanced. Balance of payment includes two types of account:
current account and capital account. The capital account adjusts, when current account is not
balanced. If export is more than the import of goods and services in current account, the balance
of payment is considered to be favorable of nation. But If export is less than the import of goods
and services in current account, the balance of payment is considered to be unfavorable for nation.
It can be cleared by following suitable example.
Credit/Receipts
Particulars
Balance of payment Account
Debit/Payment
Amount Particulars
Amount
Current Account
1. Export of goods
2. Export of services
3. Receives of Returns from
investment invested in foreign
countries
4. Miscellaneous
Sub-Total
200
100
200
100
600
1. Import of goods
2. Import of services
3. Payment of returns of
investment invested by foreigners
within Nation
4. Miscellaneous
Sub-Total
300
200
200
100
800
Capital Account
5. Receives short run loan
6. Receives long run loan
7. Sales of gold and assets
Sub-Total
200
100
100
400
5. Providing short run loan
6. Providing long run loan
7. Purchase of gold and assets
Sub-Total
80
60
60
200
Grand Total
1000
Grand Total
10000
Followings are the features of balance of payment.
(i) It adopts a double-entry book keeping system. It has two sides: credit side and debit side.
Receipts are kept in credit and payments are kept in debit side.
(ii) In accounting sense, total credit must be equal total debit, which is known as balance of
payment is always balance.
(iii) It is a systematic record of all economic transaction between one country and the rest of the
world.
(iv) It is related to a year of period of time.
(v) It consist of all visible and invisible items.
5.4 Components of Balance of Payment
Followings are the components of balance of payment.
1. Current Account: -The current account of the balance of payments statement relates to real
and short-term transactions. It contains receipts and payment on account of exports and import of
visible and invisible items.
2. Capital Account: -The capital account includes only the capital natures of foreign aid, debt
forgiveness and migrant transfer.
3. The official settlements account/Financial Account -It includes the foreign direct investment,
other investment assets and liabilities.
4. Official reserves Account: - Official reserve represents the holding by the government the
means of repayment that are generally accepted for the settlement of international claims.
4. Net Errors and Omissions:- To equalize the debit and credit the account of net errors and
omission is added under the balance of payments summary sheet.
8.1  Concept of Exchange Rate
Foreign exchange refers to the currency of another country. In other words, the money of one
nation held by citizens of another nation either as currency or as deposits in banks is called foreign
exchange.
The foreign exchange rate is the rate at which one country’s money can be turned into another’s.
The foreign currencies are exchanged or transferred in foreign exchange market. This, an exchange
rate is simply the rate at which one currency can be exchanged for another currency. For example,
if the rate of exchange between US dollar and Nepalese rupees is $1 = NRS 90, this tells us that
each US dollar we give up purchases 90 Nepalese rupees.
The foreign exchange rate is the important determinant of the prices of exports and imports in
international trade. The change in foreign exchange rate has direct impact on external trade balance
and domestic economy. It provides us a basis for understanding the causes and impacts of
fluctuation in foreign exchange rate on the performance of an economy.
The market where foreign exchange is treated is called foreign exchange market. This includes
both spot market for immediate dealing and future markets for delivery on future dates at pre-
arranged prices. There is no one place for this market, which operates via computers and telephone
connections.
8.1  Types of Exchange Rate Determination of Exchange Rate
One of the question arise here that how exchange rate is determined. The answer of this question
depends upon the type of exchange rate system. There are two systems for the determination of
exchange rate. They are flexible exchange rate system and fixed exchange rate system. They are
explained below respectively.
a. Flexile exchange rate system
An exchange rate determined by the forces of demand for and supply of foreign exchange without
government effort to keep it stable is known as flexible exchange rate or floating exchange rate.
There is no central bank intervention at all in the foreign exchange market and determination of
exchange rate is left to market forces. Just like any goods and services, the exchange rate of a
nation’s currency in terms of any foreign currency depends on the market demand for and supply
of foreign currency. The process of determination of exchange rate (assuming the US Dollar as a
foreign exchange in terms of Nepalese rupees) is explained below.
Demand of foreign exchange (Demand for US dollar): - The main purpose of demand for dollar
is to purchase foreign goods from America. The demand for dollars depends on its price in terms
of NRs. The higher the price of dollar in terms of NRs, the lower will be demand of dollar. Other
things being equal, the lower the price of a dollar in terms of NRS, the lower the cost of purchasing
US items for those who hold NRs. For example, suppose that current price of a personal computer
in the US is $ 200. If the current exchange rate is NRS 90 per dollar, Nepalese citizen have to pay
NRS 18000. If the current exchange rate were only NRS 80 per dollar, then Nepalese citizen has
to pay only NRS 16000 for same computer. Naturally, the US goods are now more attractive to
Nepalese citizens because the price of foreign goods in terms of dollar is low. A lower exchange
rate increases the demand of foreign currency because it increases demand for export. Therefore,
the demand curve for dollar is downward sloping.
Supply of foreign exchange (Supply of US dollar): - Supply of foreign currency depends upon
the desire of US citizens to purchase of Nepalese goods. Demand of Nepalese currency by
foreigners to purchase of Nepalese goods is the162
source of supply of foreign currency. Foreign
currency is supplied by foreigners to purchase Nepalese goods. Other things being equal, an
increase in the exchange rate of dollars in terms of NRS is likely to increase the quantity supply
of foreign exchange. For example, suppose the price of a Pasmina’s woolen sweater available as a
US import is NRS 2700. If the exchange rate is 90 NRS per dollar, the price of sweater in dollars
is $30. Now suppose the exchange rate increases to 100 NRS. The price of sweater in dollars is
now only $27. Naturally, the Nepalese goods are now more attractive to US citizens because its
price in terms of dollar is low. A higher exchange rate increases the quantity of dollar supplied to
foreign exchange market because it increases US demand for imports. Therefore, the supply curve
of dollars for a foreign currency slopes upwards.
Determination of equilibrium exchange rate: - The equilibrium foreign exchange rate is
determined in the foreign exchange market by the interaction of demand for and supply of foreign
exchange (US dollar). The determination of foreign exchange rate can be cleared by following
diagram.
Price NRS per dollar)
P
Fig-6.2
Determination of Exchange Rate
Surplus of dollar
S
100
106
90
E1
80
Shortage of dollar
O
40
D
Q
50 60
Number of dollars per day
(in millions)
Price NRS per dollar)
In this diagram, quantity of US dollar and price of US dollar in terms of NRS is measured along
horizontal axis and vertical axis respectively. The equilibrium price of the dollar is 90 NRS per
US dollar. If price of dollar is NRS 100, then there will be surplus of dollar, which gives the
pressure to decrease in price of dollar. If price of dollar is NRS 80, then there will be surplus of
dollar, which gives the pressure to increase in price of dollar.
If demand of dollar increases, then it leads to increase in exchange rate and vice versa. It supply
of dollar decreases, then it leads to decrease in exchange rate and vice versa. It can be cleared by
following diagram.
Fig-6.2
P
Change of Exchange Rate
S1
100
S2
E2
E1
90
E3
80
D2
D1
O
40
50 60
Q
Number of dollars per day
(in millions)
In this diagram, the D1 is equal to S1 at point E1, from which Rs. 90 exchange rate for $1. Now
suppose that the demand of foreign exchange increases and The D1 demand curve shifts upward
and takes a position of D2, which is equal to S1 at point E2. As a result, the exchange rate increases
from 90 to 100. But if supply of exchange rate increases, then S1 shifts and takes a position of S2,
which is equal to D1 at point E3. As a result, the exchange rate falls from Rs. 90 to Rs. 80.
Fixed Exchange Rate System
Price NRS per dollar)
A system in which a country’s exchange rate remains constant is called fixed exchange rate. A
fixed exchange rate exists when central bank specify the rate at which domestic currency will
exchange against foreign currencies. In this system, central bank control foreign currencies to
maintain specified exchange rate to neutralize changes in supply or demand for foreign currency
in the foreign exchange market so that the exchange rate neither appreciates nor depreciates against
foreign currencies. It can be cleared by following diagram.
P
Fig-6.2
Change of Exchange Rate
S1
S2
97
D2
D1
O
M
N
Q
Number of dollars per day
(in millions)
In this diagram, quantity of US dollar and price of US dollar in terms of NRS is measured along
horizontal axis and vertical axis respectively. If D1 and S1 are the original demand and supply
107
curves for US dollar on the foreign exchange market and the exchange rate is initially US $1=NRS
97. Assume that $1 = NRS 97 is the agreed fixed exchange rate by government. The foreign
exchange market is initially in equilibrium. Now if there is an increase in supply of US dollar, then
the supply curve will shift to S2. In a free market, the exchange rate would depreciate. In this
situation, the central bank compels to purchase the MN excess supply of US dollar in the foreign
exchange market at this rate of exchange. As a result, the demand curve of US dollar shifts to D2.
Consequently, the rate of exchange remains constant. When there is upward pressure on currency,
the central bank acts in the opposite way to avoid appreciation.
If there is decrease in supply
of US dollar, the supply curve will shift to S1. In a free market, the exchange rate would appreciate.
In this situation, the central bank compels to sale the MN quantity of US dollar in the foreign
exchange market at this rate of exchange. As a result, the demand curve of US dollar cannot shifts
to D1. Consequently, the rate of exchange remains constant.
8.1  Meaning of Economic Growth and Economic Development
Generally, the terms economic development and economic growth are used in same sense. But in
economics the term economic development is broadly defined than the term economic growth.
First, the meaning of economic growth should be understood to visualize the concept of economic
development. Economic growth refers to increase in the aggregate level of national, income output
and employment over time. Economic growth is measured by per capita income of an economy.
If there is sustained rise in per capita income over long time period, there is economic growth.
Economic development includes something more than economic growth. Economic development
means growth plus positive change and upward movement of entire social system. Thus, economic
development is a dynamic concept. The economic growth is necessary condition for economic
development but it is not sufficient condition, because there may be growth without development.
Economic development must address the following three evils of human life, poverty, inequality
and unemployment. If any one of these problems have been growing worse, then there is no
economic development even if per capital income is increased by double.
8.1  Sources of Economic Growth
1. Natural resources: Natural resources are source of economic growth. If an economy has enough
supply of natural resources, then there is no doubt the possibility of economic growth in the
economy. But is not sufficient condition for economic growth because skilled manpower is
essential to exploit the natural resources. it may help it to expand. However, natural resources on
their own are not enough.
2. Capital formation: capital formation is one of the more important source of economic growth.
More capital formation means more production, and more production means more growth. Saving
is the source of investment and investment is one of the important determinat factor of economic
development.
3. Rate of savings: The rate of saving must be high. The higher the rate of saving, greater will be
rate of investment in the economy. It means more growth in the future.
4. Technological progress: Technological progress is also important source of economic growth.
This boosts the potential level of output of the economy. The pace of technological change will
depend on scientific skills, quality of education and research.
5. Human capital: Human capital is the one of the most important sources of economic growth.
It means that education, health, skill etc. Until and unless, human capital is developed, it is not
possible to achieve higher economic growth in the country. Human capital increases productivity,
which is vital for economic growth of the country.
8.1  Meaning of Privatization
The term privatization is used in different senses. But the real meaning of privatization refers to
lease the public enterprises (PEs), also popularly called state–owned enterprises (SOEs) , to the
private sector for a particular period, to give management contract to the private sector and to
transfer the partial or complete shares to the private sector.
In the words of Susan K. Jones, “the term ‘Privatization’ refers to any shift in activity from the
public to the private sector. This could involve merely the introduction of private capital or
management expertise into a public sector activity. But more typically, it involves the transfer of
ownership of public enterprises to the private sector.”
According to the World Bank (WDR-1988), “privatization is broadly defined as increased private
sector participation in the management and ownership of activities and assets controlled and owned
by government.”
In the words of Mary Shirley-“ Privatization is broadly defined to include not only the sale of state
assets, but also privatizing the management of state activities through contracts and leases, and
contracting out activities that were previously done by the state”.
In brief, privatization is the transfer of ownership of public enterprises to the private sector.
Since last few decades, there is a wave of privatization of public enterprises throughout the world.
This is due to the inefficiencies of the public enterprises and growing financial burden to the
government.
Privatization may be done in different forms such as:
• Privatization of management or management contract: In this method, the management of
the public enterprises is given to the private sector for certain period or to lease the public
enterprises to the private sector for definite period. This method helps to retain the ownership of
government and also to increase the efficiency of public enterprises.
• Partial privatization or joint ownership: In this method, the minority or majority shares of
public enterprises are divested to the private sector. There is joint ownership of the government
and the private sector. This method is useful to increase the efficiency of public enterprises by
combining the managerial expertise of the private sector and the financial strength of the
government.
• Complete privatization: In this method, the government makes divesture of complete
ownership of public enterprises to the private sector by selling all the assets.
Benefits of Privatization
8.1  Benefits of Privatization
The basis reason behind the need of privatization is to increase efficiency and increasing efficiency
means enabling the public enterprise to achieve socio-economic goals. The benefits of
privatization may be explained as follows:
1. Reduce budget deficit: The budget deficit is increasing in the country. Due to this, the burden
of public debt and the rate of inflation are increasing. Hence, selling public enterprises is
considered to be relatively an easy method of reducing debt.
2. Resource mobilization: The government receives funds directly from the sale of public
enterprises. The funds received can be utilized in other urgent works. Besides, the government can
collect adequate revenue in the form of direct and indirect taxes from the efficient privatized
enterprises. In other words, privatization also contributes to public revenue.
3. Increase in efficiency: There is no political interference and government financial support in
privatized enterprises. This increases efficiency. The increase in efficiency means increase in
production and reduction in cost. This increases the financial return and improves the quality of
goods and services produced. This benefits the enterprise, government and the people.
4. Increase competition: The privatization creates domestic and foreign competition. Hence, the
enterprises are encouraged to produce goods quality goods at lower cost. The people are able to
get good quality goods at cheaper price. The enterprises indulge in innovation and research. This
benefits both the people and the country.
5. Efficient use and allocation of resources: The privatization leads to efficient use and allocation
of resources. The market regulates the firms and induces them to achieve productive and allocate
efficiency.
6. Fulfillment of social objectives: The goods are produced in large quantity at lower price by the
private sector. The people can receive goods
166 and service at lower price. This fulfils the social
objective of public sector.
7. Diluting strength of trade unions: Privatization is also a means of diluting the trade unions of
the pubic enterprises. But the trade unions do not become weak.
8. Access to private finance: The enterprises get access to private finance or get finance from
private sector due to privatization. Due to this, the private firms can work in the new markets.
9. Reduction of extra tax burden: The government should impose extra tax on the people to meet
the deficit of the public enterprises. Tax reduces the purchasing power of people. But Privatization
reduces the extra burden of taxes to be imposed due to the inefficiency of public enterprises.
10. Development of domestic capital market: If the small investors could be attracted by the sale
of government asset, it leads to the widening of the ownership of shares. This in turn leads to the
development of domestic capital market.
8.1  Demerits of Privatization
There are various defects and problems of privatization. Therefore, the pace of privatization in
developing countries is very slow. Privatization took place in rapid pace only in industrial countries
such as United Kingdom and France. The main defects found in privatization are as follows:
1. Create Unemployment: Privatization may create unemployment due to large-scale lay off. The
condition of labor becomes worse because of unemployment. The employees and workers oppose
privatization due to the fear of losing the job.
2. Fear of the emergence of private monopoly: there is the fear of private monopoly. The public
monopoly is better than the private monopoly. The political parties oppose privatization due to the
danger of emergence of private monopoly in place of public monopoly.
3. Benefit to only few: Privatization benefits only few persons such as shareholders and managers,
but cost is borne by many taxpayers, customers and workers who contributed to public enterprises.
4. Fear of foreign Dominance: There is the fear of the foreign dominance due to privatization in
developing countries. It is because foreigners are able to purchase the public enterprises.
5. Minimize gain: The corruption and lack of transparency in privatization minimize the gain of
privatization. This may enrich the public officials and the businesspersons but harm the people and
the nation.
6. Consumer exploitation: the main objective of private firms is to earn profit, not to provide
social welfare. So, the privatized enterprises may exploit the consumers by charging high price for
the purpose of earning high profit.
7. Remote areas neglected: The main objective of private firms is to earn profit. Therefore, private
firms operate their production activities in urban area, but neglect remote area.
8. Increase in inequalities: privatization is beneficial to rich persons but not beneficial to poor
persons. So privatization increases economic inequalities.
8.1  Problems of Privatization
The privatization is very difficult in Nepal. The main problems are as follows.
1. Lack of people’s habit on industrial investment,
2. Less development of the capital market,
3. Lack of adequate fund with the individuals to purchase large industry
4. Lack of managerial and technical skill
5. Foreign investors not being attracted due to the small size of the domestic market
167
6. The private sector not being attracted due to the inadequate availability of infrastructure like
transport, telecommunication and electricity,
7. Political opposition due to the possibility of concentration of wealth and unequal distribution of
income and wealth
7. Opposition by the staffs and workers for the fear of losing employment,
8. People do not like the entry of foreigners in domestic industries
9. Difficulty of making accurate evaluation of the assets of the public enterprises
11. Lack of sufficient legal arrangement for privatization
12. The fear of government monopoly turning into private monopoly due to the low development
of the private sector
8.1  Meaning of Liberalization
Liberalization means to believe the economy free from government control and to promote the
private sector. Economic liberalization means the process of shifting the economy from
government control to market economy. Nepal has adopted the policy of economic liberalization
after the restoration of democracy in the country in 1990 AD. Based on the policy of liberalization
various sectors, such as, monetary, financial and legal have been reformed, and public enterprises
have been privatized.
According to World Bank, “liberalization means freeing prices, trade and entry to markets from
state controls while stabilizing the economy”.
Liberalization decentralizes production decisions to enterprise and households. The government
does not directly control the prices like prices of goods and service, rate of interest, wages, rent
etc.; which are determined by market forces. People are free to run business and trade. Likewise,
people are free to enter the market and produce the goods on competitive basis. In brief,
liberalization policy primarily supports a rapid shift toward a market economy and spontaneous
growth of the private sector. Liberalization may take place in two fronts-domestic sector and
external sector. Liberalization in the domestic sectors refers to the reforms made to affect the
transactions that take place within the country. Liberalization in the external sector refers to the
reforms made to affect the transaction or a country with the rest of the world, for example, export
and import of goods and services and the flow of private and institutional capital.
8.1  Benefits of Liberalization
1. Rapid economic growth: Economic liberalization plays a crucial role in economic growth. The
experiences show that economic liberalization has been successful in rapid growth in output. It has
increased labor productivity and output.
2. Improvement in living standards: economic liberalization is an instrument to increase living
standards of people. Experience shows that the living standard of the people has been increased in
those countries because of adopting liberalization policy due to increase in economic activities and
employment opportunities.
3. Increase in exports: Economic liberalization helps to increase exports and earn valuable
foreign exchange. The liberalization of foreign trade helps to link a country with rest of the world,
which helps to boost exports.
4. Improvement in state enterprises: Public enterprises have been a burden to almost all
countries due to their inefficiency. The liberalization policy leads to reform state enterprises
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because liberalization policy encourages market competition, better marketing and financial
management. Consequently, they are able to achieve their objective of uplifting the economic
welfare of people.
5 Emergence of new businesses: Liberalization leads to the emergence of new businesses. It
increases private sector economic activities, promotes investment and employment. This, in turn,
increases national income and raise standard of living of people by creating more employment
opportunities.
6. Foster competition: Liberalization promotes competition, which is turn, leads to innovation,
research, efficient use, and allocation of resources efficiency in production. The consumers
may substantially benefit from improved products and lower prices. Besides, competition leads
to innovation, research, efficient use, and allocation of resources.
8.1  Defects of Liberalization
1. Distribution of resources: Under liberalization, those people benefit most, which have more
resources. Those who do not have or have these resources less, drop to the marginal point under
the pressure of liberalization.
2. International comparative advantage: some countries are very much forward and some
countries are very much backward. In such a situation, the weak economies cannot compete with
strong economies. Therefore, the liberalization policy is beneficial to developed countries.
3. Outward oriented policies: Liberalization prescribes outward oriented policies. But outward
oriented policies are beneficial only to developed countries not to less developed countries like
Nepal. The external openness increases imports rapidly. But the export cannot be increased in the
same rate. It creates balance of payment problem.
4. Competition: Price, market and competition are the heart of liberalization. In developing
countries there are only few firms leading to monopoly and oligopoly. Hence, there is not
competition in the real sense.
5. Role of government: There is lack of infrastructure such as road, railway, air service,
telecommunication, electricity in less developed countries. The development of such sector
requires a large amount of investment. But the private sector is not interested in such investments.
Therefore, the role of government is essential to development of such infrastructure.
8.1  Meaning of Globalization
The term ‘Globalization’ had entered into development literature in early 1980. The term
globalization is in common use these days. Globalization is characterized by increase in flow of
trade, capital, and information, as well as mobility of individuals, across borders. It is not a new
phenomenon.
Globalization implies increasing and continuous integration between different countries of the
world. Globalization is of different types such as economic, political, cultural and environmental.
Here we focus only on economic globalization.
According to Zia Qureshi, “Globalization is the growing international integration of markets
for goods, services and capital.”
According to Michael P. Todaro, “Globalization is the increasing integration of national
economies into global markets.”
From this definition it is cleared that globalization implies the free flow of labor, services, capital,
trade and technology between different countries of the world. In globalization the mobility of
goods, services, and capital are free across national boundary.
8.1  Benefits of Globalization
Some of the benefits of globalization are as follows:
1. Wider markets for trade: Globalization increases free trade between nations. Due to
globalization, there is a worldwide market for the companies. So developing countries can increase
the volume of their exports. This is a great opportunity to earn foreign exchange by exporting
products in large scale.
2. Larger inflow of capital and technology: Globalization allows investors in developed nations
to invest in developing nations. Globalization facilitates transfer of capital such as foreign direct
investment.
3. Improved access to technology: Countries will have greater access to advanced technology.
Improvement in technology promotes efficiency and productivity and leads to higher economic
growth.
4. Increase in production: Due to the presence of a worldwide market, there is an increase in the
production due to the increase in specialization, productivity and economies of scale.
5. Increase in standard of living: Due to the increase in economic activities, more employment
opportunities are created. This helps to increase per capital income of the people. People are able
to consume variety of goods produced in different countries at relatively cheaper price.
6. Technological development: There is a lot of technological development. Domestic firms
adopt advanced technology from spill over effects of the multinational companies.
7. Increase in communication: Global mass media connects all the people in the world and
creates knowledge spill over. Globalization leads to enhancement in the information flow between
geographically remote locations.
8. Greater transport facility: Globalization brings greater case and speed of transportation for
goods and people. International travel and tourism increases.
9. Internationalization of services: Rapid advance in telecommunication and information
technology are expanding boundaries of the tradability in services. For developing countries,
promising new avenues for exports are opening. These avenues are especially in relatively laborintensive long-distance services such as data processing, software programming etc. This alone
can potentially double these countries’ export of commercial service.
10. Promotes economic growth: Globalization promotes faster economic growth. Faster
economic growth helps in poverty reduction.
8.1  Defects of Globalization
Some of the defects of globalization are as follows:
1. Dominance: There is a threat of multinational corporations ruling the word because there is a
lot of economic power with such corporations.
2. Colonization: Nations, who are poor, are also giving up the reins in the hands of a foreign
company, which might again lead to a sophisticated form of colonization.
3. Economic disruptions: There is increased likelihood of economic disruptions in one nation
affecting all nations. International capital market integration and the potential volatility of capital
flows, which comes with it, make macrocosmic management in developing countries more
complex.
4. Spread of a materialistic lifestyle: There is the possibility of spread of materialistic lifestyle
and attitude that sees consumption as the path to prosperity.
5. Loss of national sovereignty: Multinational corporations having strong financial strength may
hurt national sovereignty. There is the fear of loss of local control over economic policies and
developments.
6. Environmental Degradation: The overuse of the natural resources in order to fulfill the needs
of the people of developed countries may
lead to environmental degradation. Decreases in
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environmental soundness may also occur as polluting multinational corporations take advantage
of weak regulatory rules in developing countries.
7. Unequal Distribution of Benefits: Globalization may widen the gap between different nations
in terms of distribution of benefits. Free trade mostly favors rich countries. Most of the benefits of
globalization are taken by developed countries. It is because economically weaker nations cannot
compete with the economically strong nations.
8. Loss of domestic market: Globalization results into stiff competition in trade. This is a threat
to domestic industries since local companies cannot compete with financially strong multinational
companies. Local industries might lose even their domestic markets. There is the fear of the
disappearance of old and traditional industries.
8.1  Meaning of Foreign Direct Investment (FDI)
The investment made in any country by the foreign investors is known as foreign direct investment
(FDI). If a foreign investor acquires the ownership of the asset of the firm already established in a
country and controls the enterprise it is called foreign direct investment. Foreign direct investment
is the investment made by foreign investors in order to control assets and manage production
activities in those countries.”
According to IMF, “Foreign direct investment is investment by resident in one economy in an
enterprise that is resident in another economy in order to control or exert significance influence
over the management of that enterprise.”
The investments made by multinational enterprises are goods example of foreign direct
investment. This is different from other private capital flow since it is induced by long run prospect
of profit making in the production activities directly controlled by the investors.
8.1  Benefits of Foreign Direct Investment (FDI)
The significance of FDI for the developing countries is as follows:
1. Large capital available: The FDI has been an important source of private external finance to
the developing countries. Since the foreign direct investors are financially strong, they make
available a large and cheap capital in the form of direct investment. The inflow of foreign capital
raises the level of investment in the country.
2. Take risks: The foreign direct investors take great risks by investing their capital in the
developing countries, since these countries lack adequate infrastructure such as transport,
communication, and power. Similarly, the market is small and there is the scarcity of the inputs
like raw materials and skilled labor. Foreign investors diversify their risks outside their home
market and gain access to profitable opportunities throughout the world.
3. Increase production facilities: The foreign direct investors invest in production facilities of
developing countries such as electricity, transport, and communication. This increases the
productive capacity of the country. Productivity increases also due to the use of appropriate
technology and managerial expertise.
4. Transfer of skill and technology: The greater significance of FDI lies in the transfer of skill
and advanced technology. Since such technologies are transferred through direct investment, it is
important to the developing countries.
5. Correct Adverse balance of payment: FDI produces finished goods for the domestic and
foreign markets from foreign capital. Hence, FDI helps to correct adverse balance of payment.
6. Human capital development: FDI is helpful for development of human capital because FDI
offer gain employee training in the course of operating new businesses.
7. Stimulate domestic investors: FDI stimulates
domestic entrepreneurs by making available
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money, inputs and infrastructure and by providing training and experience. The foreign direct
investors bring superior techniques of marketing which is helpful like to inform the customers to
create demand.
8. Filling saving, foreign exchange, revenue and Management Gaps: Foreign direct investors
help in filling saving, foreign exchange, revenue and management gaps.
9. Increase Economic growth: FDI increase economic growth of the country by increasing
investment in various sectors. Thus, it helps to reduce poverty, increase employment and raise the
standard of living of the people of the developing countries.
8.1  Defects of Foreign Direct Investment (FDI)
The main defects of FDI are as follows:
1. Export profits and less contribution to public revenue: Foreign investors export more profit
to their countries but their contribution to public revenue is less than due to liberal tax concessions.
2. High salaries and little impact on developing scarce skills: Foreign investors provide
relatively very high salaries to the local workers than local firms. It increases economic inequality.
The FDIs may have little impact on developing local sources of scarce skills and resources.
3. Danger to domestic industries: The foreign direct investment is dangerous to domestic
industries. If there is competition from domestic firms, they fix the price of their products
artificially low. Due to this, the local firms will have to close down the business. If some forms
are able to stand up to competition the FDIs take control of those firms by purchasing major share
of those companies.
4. Transfer of inferior technology: The foreign direct investors may transfer inferior and highcost technology. They also try to minimize the transfer to technology. For this, they undertake
research and development works only in their headquarters, do not employ the local people and
keep the technology with themselves.
5. Regional imbalance: The foreign direct investors generally establish their companies in big
cities having infrastructure facilities. It increases regional imbalance and helps in maintaining
dualism of economic structure.
6. Adverse effects on balance of payment: The initial impact of foreign direct investment is to
improve foreign exchange earnings. The long run impact may be to reduce foreign exchange
earnings on both current and capital accounts, because they repatriate a large amount of money in
the form or royalty profit, interest, and dividend.
7. Influence on internal politics and government policies: The foreign direct investors try to
influence internal politics and government policy by providing bribe to the members of parliament.
8.1  Concept of Foreign Employment
Working abroad for earning money is called foreign employment. Labor migration for overseas
employment has rapidly increased, particularly after globalization. The Nepalese economy is
increasingly becoming dependent on remittance sent home by migrant workers. At a time when
the country’s major economic indicators do not display a good picture, remittances have played a
vital role in keeping the economy afloat. After the restoration of democracy, the overseas migration
and remittances has become instrument to reduce poverty and improve standard of living of
Nepalese people. The labor Act, 1985, foreign Employment Act, 1985 are helpful for facilitating
foreign employment and opening up avenues for the private sector .The Nepalese people have
started to move in the Gulf countries since 1985 for foreign employment . Such trend for foreign
employment has been increasingly continued in the recent years. It is also recorded that 109
countries are open for foreign employment as decided by the Nepal Government. The contribution
of remittance to GDP was increasingly significant over the years.
8.1  Benefits of Foreign Employment
1. Reduce unemployment in the country: There is severe problem of unemployment in the
country. Foreign employment helps to solve the problem of unemployment in the country.
2. Remittance income: Another benefit of foreign employment is that it helps to increase
remittance income in the country. The amount of remittance income depends on the number or
workers going abroad for foreign employment.
3. Skilled and trained manpower: The worker who returns to the home country after some years
is generally skilled and trained manpower. Their knowledge and skill can be utilized to create new
opportunities in the country.
4. Increase standard of living: The standard of living of the members of the family living in the
home country increases. This is due to the money that is sent by the worker who is working in the
foreign country.
5. Poverty reduction: Remittance income received from the foreign employment increases
household income, which is helpful to increase living standard and reduces poverty. Currently,
there is decrease in poverty in Nepal because of remittance income form foreign employment.
8.1  Defects of Foreign Employment
1. Brain drain: Foreign employment provides the employment opportunities to skillful and
educated persons in foreign countries. Thus, most of educated people of developing countries are
leaving the own country for foreign employment in developed countries. It is the situation of brain
drain in developing country.
2. Mismanaged family: Migration of parents can leave families of young children with inadequate
guidance and an additional burden of household responsibilities, which can lead to mismanage in
family.
3. Create dependency and hurt the economic growth: It is also argued that remittance receipt
form foreign employment can also create dependency. It may reduce recipients’ incentive to work,
and thus slowing economic growth.
4. Human costs: Remittance may also have human costs. Migrants have to remain separated from
families, and incur risks to find work in another country. They may have to work extremely hard
enough to save enough to send remittances.
5. Create inflationary pressure: - The level of consumption of Nepalese people has increased
every year due to the inflow of remittance. This leads to increase aggregate demand of goods and
services in the market. As a result, the price of goods and services are increasing every day in the
market.
6. Increase in imports: - Due to the remittance income of household increases and a large part of
the income spent on purchases of manufacturing and durable expensive goods.
7. Shortage of Labor: - Due to the foreign employment, youth workers are migrating outside of
the country. There is a heavy flow of rural workers in foreign employment. It creates the shortage
of labor in rural agriculture and industrial sector of the country.
8.1  Meaning of Market Failure
Market failure is said to be exist if price mechanism fails to allocate resources efficiently. As a
result, there exists either underproduction or overproduction. For example, in free market
economy, the merit goods like education, health are under produced. But the demerit goods like
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cigarettes, alcohols, etc are overproduced. Public goods like defense, lighthouse, street light, etc
are also under-produced in free market economy. Therefore, market failure exists when price of
the product does not include social cost and benefits but only includes private cost and benefits.
8.1  Types of Market Failure
(i) Failure by market structure: - The first type of market failure is the failure by market
structure. There should be enough seller and buyers in the market to get the beneficial effect of
competition or there should be at least the possibility of the easy entry of new firms. Such
conditions are not fulfilled in some markets. The market for water, telephone, electricity comes
under this category. If a single firm, which is called natural monopoly, can serve a particular
market efficiently, it has market power. It can earn economic profit by limiting the output and by
charging high price. Due to this reason, the price and output of public utilities are being regulated.
(ii) Failure by incentive: - The second type of market failure is the failure by incentive. It the
production and consumption of goods and service social price and cost is different from private
price and cost of producers and consumers.
In this way, since market imperfection or market, failure does not give the signal of appropriate
cost and benefit the government should play an active role in the economy.
8.1  Sources of Market Failure
Market failure is a situation at which goods are either under produced or overproduced than the
society desirable. This means market mechanism fails to allocate resources in efficient manner.
There are four basic sources of market failure.
1. Market power: - If a firm has a certain degree of monopoly power then the firm can restrict the
output in order to increase price of the product. Few goods will be produced than the desired. There
exist strong barriers to enter new firms into monopoly and oligopoly markets so that firm may
enjoy excessive profit even in long run.
2. Incomplete information: - If the consumers and producers do not have perfect information
about the market condition, they cannot make optimal decision due to lack of information.
Producers may produce less or more of the commodity by proper estimation of demand due to lack
of perfect information. Consumer may demand more or less of the commodity due to incomplete
information. For example, consumer may demand less of vaccines due to lack of information so
the producers are producing less than the quantity to be produced.
3. Externalities: -Market failure arises due to existence of externality. An externality is said to
arise if a third party is affected by the decision and actions of other. For example, creation of park
provides benefit to those people who do not pay for them. such benefit is called ‘spill-over benefit.
Use of loudspeakers on marriage ceremonies harms the people by causing atmosphere and noise
pollution. Even the people who do not benefit from these pollutants bear a cost in terms of loss of
welfare. Such cost borne by the people are known as ‘spill over cost. The spillover costs and
spillover benefits are jointly called externalities. The market mechanism does not compensate who
are affected by externalities.
4. Public goods: - The public goods are non-rival and non-excludable. Non-rival means as more
and more people consume, the product is not diminished. Similarly, not excludable means that
once the goods has been provided for one consumer, it is impossible et stop other consumers from
benefiting from the goods. Defense, light house, etc are example of public goods. The existence
of public goods means scarce resources are not allocated as desirable, i.e., public goods are under
produced or never produced in free market economy.
Supply of money is divided on the basis of how much of an effect monetary policy can have on
each. Monetary policy of the country affects the supply of narrow more directly compared to broad
money supply.
1. Narrow Money: Money is anything that serves as a commonly accepted medium of exchange.
The most important concept is transactions money M1, which is the sum of coins and paper
currency in circulation outside the bank, plus checkable deposits or demand deposits. It is called
narrow money. M1 is the most appropriate measure of money as a means of payment.
2. Broad Money: Another important monetary aggregate is broad money
125 (called M2), which
includes assets such as savings accounts in addition to coins, paper currency and checkable
deposits. Broad money M2 sometime called asset money or near money includes M1 as well as
savings accounts in banks and similar assets that are very close substitutes for transactions money.
Examples of such near-monies in M2 are deposits in a savings account, a money market mutual
fund account operated by the stockbroker, a deposit in money market and deposit account run by
a commercial bank. Broad money is not transaction money because they cannot be used as means
of exchange for all purchases. They are forms of near money as they can be converted into cash
very quickly with no loss of value.
Narrow Money (M1 ) = C + D
Where,
C = Currency in circulation,
D = Demand deposit
Broad Money (M 2 ) = C + D + TD
Where,
TD = Time deposi