Left over topics in Economics
Topic No. 1 :
Basic Characteristics of Islamic Economy (Economic Systems)
1. Freedom of work and enterprise:
Islam has allowed freedom of work and enterprise. This is evident from the Madinitc model of
Islamic economy. A reading of the chapter of any Hadith collection in respect of agriculture,
gardening, business etc. will establish this. The Quran also clearly states that "Allah has made
business lawful for you (Sura Baqara, Ayat - 275)"
Islam essentially allows economy to operate freely according to the market forces subject to
Islamic restrictions and guidelines on production. distribution, marketing, investment trade,
exchange, wages etc. The state can also further interfere in this free economy to restore
equilibrium and establish justice and other Islamic objectives.
2. Concept of ownership:
In Islam, God is the true owner of all things. The Quran says: "To Allah belongs whatever is in
the earth". (Al- Imran). However, Allah in His mercy allows human beings to inherit wealth,
own it and use it subject to His laws as evident from the following verses:
i) The land belongs to Allah. He allows it, to be inherited by whomso ever he pleases. (Sura
Araf, Ayat: 128).
ii) Do they not see that we have created for them ----- among the things fashioned by us----cattle of which they become owners? (Sura Yasin, Ayat: 29). Islam, therefore, allows man as
Vice-gerant, to inherit from Allah (that is to own) wealth. This is indeed a trust for proper use.
We may call it Trust ownership.
3. Kinds of Ownership: In early Islam there were three kinds of ownership: private, communal
and state ownership. The books' of Hadith are full of accounts of individual ownership. This was
the standard ownership. Some important things like water, canals pastures and graveyards were
communal properties. The state owned the mines, rivers and large tracts of land. After the
conquest of Syria and Iraq, these lands were made state lands and were not allowed to go into
private ownership.
4. State Ownership:
There is no bar on state ownership of enterprise in Islam. The basic economic institutions may
be brought under state control, if this is required to establish social justice or protect the interests
of the community.
Islam protects lawful property and is in favour of confiscation of unlawful property. There are
some instances of take over of unlawful property during the period of Hazart Omar and Hazrat
Omar bin-Abdul Aziz. Lawful property can be taken over by the state only for valid social
reasons after due compensation. During the last Hajj the Prophet (SM) announced the principle
of protection of lawful property. The Quran says, "don't eat each other's property wrongfully "
(Sura Nisa,Ayat- 29).
5. Prohibition of Interest:
Islam prohibits interest. This requires a total reorganization of the economy, banking,
investment, exchange, business and international trade. Already in the last 30 years hundreds of
Islamic banks and financial institutions have been set up and this has become an alternative
mode in most Muslim countries and some non- Muslim countries. Its viability and practicability
has been accepted by economists and bankers and many consider this system superior in some
respects. A body of literature has already come up on this subject.
6. Zakat:
Islam has made Zakat compulsory on the wealth of rich Muslims. This is spent for the weaker
and distressed sections of the society. Zakat not only distributes wealth between the rich and the
poor of the society, it also influences investment, savings and allocation of income and
resources. A detailed study has been made in this regard by Dr. Monzer Kahf in his book
"Islamic Economy" American Trust Publications, USA, A rich body of literature has come up in
recent times on Zakat. The Zakat and Ushr ordinance of Pakistan can be particularly referred to
in this connection.
7. Concern for Poor:
This is a special feature of Islam. Zakat is one institution which testifies to this. In this
connection we may refer to ayat 5-6 of Sura Qasas.
We desired to show favour into those who were depressed in the earth, and to make them leaders
and to make them inheritors and to establish them on earth (Sura Qasas, Ayat: 5-6)
In these verses Allah, the Almighty has expressed His desire to show favour on the depressed
people. Islamic economy shall establish all possible institutions to carry out this desire of the
Almighty.
8. Distribution of inheritance:
Islam has not left the distribution of inheritance on the whims of a person, In Islam a person can
not favour one over the other of his relations for temporary or subjective reasons as is the rule in
the West. Islam distributes inheritable property among several groups of people:
i) Children
ii) Husband/ Wife
iii) Parents
iv) Brothers and sisters in certain situations.
This distribution has taken care of different groups keeping in view their social role,
requirements and proximity of kinship relationships. For those who remain outside the list of
inheritors. Islam has provided for wasiat (will) for all such relations if they are in a distressed
condition. A person can will upto one 3rd of his/her property for distressed relations or others
outside the inheritors.
9.MORAL VALUES CONSIDERATION:
Since Islamic economic system is derived form the religious teachings, it considers moral
values more than any other system does. It facilitates justice by means of well-defined moral
value. On the other hand, capitalism is based upon maximization of profit without taking into
consideration this moral value but just keeping in view certain government laws.
Topic No. 2: (Economic System)
Comparison of Islamic Economic System with other
Economic System
Qs. In what respect Islamic Economic System is superior to Capitalism and Socialism. Discuss?
OR
Discuss the basic principles of Islamic Economic System and and compare it with Capitalism?
Ans. Islamic Economic System possesses the character of both capitalism and
socialism and it is free from their evils. Following are the comparison of Islamic state
with others.
1. Distinguishing Characteristics
Capitalist says "Economic Freedom" to producers and Consumers.
Communism says Economic Equality achieved through state ownership of the means
of production.
The distinguish characteristics of an Islamic System is "Economic and Social Justice"
so that every body gets his / her due.
2. The Concept of Private Property
In a Capitalist system unlimited liberty and right of ownership for private property is
given which has resulted in the capitalist exploitation of workers. Islam allows the
right of private ownership and freedom of enterprise in limited capitalism but not
leave the property for the long period.
3. Consumption of Wealth
In Capitalism any thing can be consumed while a communist society only consumer
goods and services which are allowed to be produced in the country. In Islamic
Country only "HALAL" are allowed to be produced and consumed "HARAM" goods
and services are not allowed to be produced and consumed.
4. Production of Wealth
Capitalism motive is only profit they produced goods for only profit. In communist
society central plan authority made decision what to produce and how much to
produce. But in Islamic System only have to produce "HALAL" goods and
"HARAM" goods like alcohol drink, drug etc are not allowed.
5. Distribution of Wealth
In Capitalism concentration of wealth is goes on few hand due to unlimited right of
ownership and free competition. In communism system dicta for ship is created due to
concept of private property. In Islamic System, Due to "ZAKAT" and "SADQAT"
automatically wealth transfer to poor from rich.
6. The Role of Interest
The interest made brings equal between saving and investment to promote, capital
formation in a capitalist society. In communism, interest does not pay any role for
saving and investment. In the Islamic system interest based economic activities are
strictly banned. Hence interest is not a source of capital formation in an Islamic.
Conclusion
We conclude that Capitalist and communist are materialistic in nature and they only
looking for to satisfy the material wants of the people. But Islamic economic system
provides a fine blend of materialism and spiritualism.
Topic No. 3 (Economic Systems):
The Concept of Zakat
Zakat has two meanings in Arabic
i. That which purifies
ii. That which causes growth.
i. That Which Purifies
This indicates that Zakat purifies the human soul by keeping a person away from illegal source
of earning, eliminating the love for materialism and overcoming the sense of pride for being
wealthy.
ii. That Which Causes Growth
This means that ALLAH protected the wealth from which Zakat had been paid and in the way
the peace of mind of the person who pay Zakat.
In economics technically Zakat defined as
Zakat is a "transfer payment" which Sahib-e-Nisab muslim pay to poor given rate in the month
of RAJAB.
Assessment of Zakat
1. Sahib-e-Nisab Muslim
A muslim who owns and keeps his/her possession at least 7 1/2 total gold of 52 1/2 total silver or
cash money to the equivalents value is considered a Sahib-e-Nisab Muslim.
2. Exposed and Unexposed Wealth
Zakat is paid from two types wealth i.e. exposed (e.g. Bussiness, Salary, and goods) and
Unexposed (e.g. gold, silver, cash money etc)
3. The Rate of Zakat
If paid on atleast 7 1/2 total golds or 52 1/2 total silver or the equivalents value of cash, goods,
salary etc.
i. The rate of Zakat is 2 1/2 of total value of (cash, goods, salary, building etc)
ii. The rate of Zakat is 10% for the Agricultural Produce of land.
Beneficiares of Zakat
Beneficiares of Zakat are
1. The Poor. Those people who are below than Sahib-e-Nisab.
2. The Needy. They are the people who are unable to earn their living e.g. handicapped disabled,
unemployees person.
3.The Converts. Those who convert to Islam have right to get Zakat.
4. The Debtors. Those who heavily indebbed can get zakat to repay their Zakat.
5. Mujahideen. Zakat can also be given to Mujahideen.
It is clear that Zakat is a source of financial assistance to the poor and needy to become
economically independent.
Topic No. 4 Economic Significance / Importance of Zakat
1. Fair Distribution of Wealth
Islam does not permit that the wealth is distributed in few hands. Therefore people have to pay 2
1/2 % Zakat to poor.
2. Elimination of Class Conflict
Zakat makes the poor obliged and thus the problem of class conflict does not arise at all.
3. Economic Stability
Zakat promotes the velocity of Calculation of money due to which aggregate demand for goods
and services increases. This determines the lives of investment, income and employment on
stable footing. Hence an Islamic economy is always stable.
4. Social Security
Zakat fund not only covers the poor and the disabled but it also provides social security to the
unemployed who may later on prove to be valuable assets of the nation.
5. Discouragement of Anti-Social Activities
Zakat which is paid from (rizq-e-halal) stop muslims from anti social activities like smuggling
etc.
6. Social Welfare
Hospitals, schools, and handicrafts for the poor can be constructed by making use of the zakat
fund.
7. Self Reliance
Zakat enables peoples to take care of each others needs.
8. Control of Crimes
The Major causes of crimes particularly the poverty of people. This can be overcome by paying
Zakat regularly. Zakat decrease the crime rate.
Topic No. 5: (Macro Economics)
Keynesian Theory of Income and Employment:
Definition and Explanation:
J.M. Keynes in his famous book, 'General theory', has used two methods for the determination
of national income at a particular time:
(1) Aggregate Demand and Aggregate Supply Method.
(2) Saving Investment Method.
Both these approaches lead us to the determination of the same level of national income.
It may here be mentioned that Keynes model of income determinationis relevant in the context
of short run only.
Assumptions:
Keynes assumes that in the short run:
(i) The stock of capital, technique of production, forms of business organizations, do not change.
(ii) He also assumes a fair degree of competition in the market.
(iii) There is also absence of government role either as a taxer or as a spender.
(iv) Keynes further assumes that the economy under analysis is a closed one. There is no
influence of exports and imports on the economy.
(1) Aggregate Demand and Aggregate Supply Method.
"In the short period, level of national income and so of employment is determined by aggregate
demand and aggregate supply in the country. The equilibrium of national income occurs where
aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand
point".
Determinants of Income:
The determinants of effective demand and so of equilibrium level of national income and
employment are the aggregate demand and aggregate supply.
(1) Aggregate Demand (C+l):
Aggregate demand refers to the sum of expenditure, households, firms and the government is
undertaking on consumption and investment in an economy. The aggregate demand price is the
amount of money which the entrepreneurs expect to receive as a result of the sale of output
produced by the employment of certain number of workers. An increase in the level of
employment raises the expected proceeds and a decrease in the level of employment lowers it.
The aggregate demand curve AD (C+I) would be positively sloping signifying that as the
level of employment increases, the level of output also increases, thereby increasing of aggregate
demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the level of real
national income and indirectly on the level of employment.
(2) Aggregate Supply (C+S):
The aggregate supply refers to the flow of output produced by the employment of
workers in an economy during a short period. In other words, the aggregate supply is the value of
final output valued at factor cost. The aggregate supply price is the minimum amount of money
which the entrepreneurs must receive to cover the costs of output produced by the employment
of certain number of workers.
The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the other
part is saved (S) in the form of inventories of unsold output. The aggregate supply curve, (C+S)
is positively sloped indicating that as the level of employment increases, the level of output also
increases, thereby, increasing the aggregate, supply. Thus, the aggregate supply (C+S) depends
upon the level of employment through4he economy's aggregate production function.
Determination of Level of Employment and Income:
According to Keynes, the equilibrium levels of national income and employment are determined
by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The
equilibrium level of income determined by the equality of AD and AS does not necessarily
indicate the full employment level. The equilibrium position between aggregate demand and
aggregate supply can be below or above the level of full employment as is shown in the curve
below.
Diagram/Figure:
In this figure , the aggregate demand curve (C+l), intersects the aggregate supply curve (OS) at
point E1 which is an effective demand point. At point E1, the equilibrium of national income is
OY1. Let us assume that in the generation of OY1 level of income, some of the workers willing to
work have not been absorbed. It means that E1(effective demand point) is an under employment
equilibrium and OY1 is under employment level of income.
The unemployed workers can be absorbed if the level of output can be increased from OY 1 to
OY2 which we assume is the full employment level. We further assume that due to spending by
the government, the aggregate demand curve (C+I+G) rises. As a result of this, the economy
moves from lower equilibrium point E1 to higher equilibrium point E2. The OY is now the new
equilibrium level of income along with full employment. Thus E2 denotes full employment
equilibrium position of the economy.
Thus government spending can help to achieve full employment. In case the equilibrium level of
national income is above the level of full employment, this means that the output has increased
in money terms only. The value of the output is just the same to the national income at full
employment level.
(2) Determination of National Income By the Equality of Saving and Investment Method:
Definition and Explanation:
This approach is based on the Keynesian definitions of saving and investment. According to
Keynes, the level of national income, in the short run, is determined at a point where planned or
intended saving is equal to planned or intended investment. Saving as defined by Keynes is that
part of income which is not spent on consumption (S = Y - C). On the other hand, investment is
the expenditure on goods and services not meant for consumption. (I = Y - C).
According to Keynes, if at any time, the intended saving is less than intended investment, it
implies that people are spending more on consumption. The rise in consumption will reduce the
stock of goods in the market. This will give incentive to entrepreneurs to increase output.
Likewise, if at anytime intended saving is greater than intended investment, this would mean that
people are spending lesser volume of money on consumption. As a result of this, the inventories
of goods will pile up. This will induce entrepreneurs to reduce output. The result of this will be
that national income would decrease. The national income will be in equilibrium only when
intended saving is equal to intended investment.
Example and Diagram/Curve:
The determination of national income is now explained with the help of saving and investment
curve below:
In this figure, income is measured on OX axis and saving and investment on OY axis. SS is the
saving curve which shows intended saying at different levels of income. The investment curve
ll/ is drawn parallel to the X axis which shows that investment does not change.
The entrepreneurs intend to invest $50 crore only irrespective of the amount of income. Saving
(SS) and investment curves (ll/) intersect each other at point M. If the conditions stated above
remain the same, the size of equilibrium level of income is 250 crore.
Disequilibrium:
Under the assumed conditions if there is inequality between saving and investment or
disequilibrium, the forces will operate in the economy and restore the equilibrium position.
Let us suppose, that the income has increased from the equilibrium level OL to ON ($300 crore).
At this level of income, desired saving is greater than the desired investment. When intended
saving exceeds planned or intended investment, the businessmen will not be able to dispose off
all their current output. They will slow down their productive activities. This will result in
reducing the number of workers employed in factories and a decrease in the income. This
process will go on until due to a decrease in income, people's saving is reduced to the level of
investment ($50 crore). The equilibrium income is $250 crore.
In the same way, income cannot remain below this equilibrium level of $250 crore. If at any
time, income falls below the equilibrium level, then it means that people are investing more than
they are willing to save I > S. They will increase productive activities as they are making high
profits. The number of workers employed in the factories will increase. This will result in an
increase in income and higher saving. This rise in national income will go on up to a point where
saving and investment are just in balance and that will be the equilibrium level. At this point,
income will have the tendency of neither to rise nor to fall. It will be in a state of rest. It is, thus,
clear that national income is determined at a point where the intended investment is equal to
intended saving.
Topic No. 6: (Macro Economics)
What is Effective Demand?
Effective demand represents that aggregate demand or total spending (consumption expenditure
and investment expenditure) which matches with aggregate supply (national income at factor
cost).
In other words, effective demand is the signification of the equilibriumbetween aggregate
demand (C+I) and aggregate supply (C+S). This equilibrium position (effective demand)
indicates that the entrepreneurs neither have a tendency to increase production nor a tendency to
decrease production. It implies that the national income and employment which correspond to
the effective demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income and
employment emphasizes that the equilibrium level of employment would not necessarily be full
employment. It can be below or above the level of full employment.
Importance of Effective Demand:
The principle of effective demand is the most important contribution ofJ.M. Keynes. Its
importance in macro economics, in brief, is as under:
(i) Determinant of employment. Effective demand determines the level of employment in the
country. As effective demand increases employment also increases. When effective demand
falls, the level of employment also decreases.
(ii) Say's Law falsified. It is with the help of the principle of effective demand that Says Law of
Market has been falsified. According to the concept of effective demand whatever is produced in
the economy is not automatically consumed. It is partly saved. As a result, the existence of full
employment is not possible.
(iii) Role of investment. The principle of effective demand explains that for achieving full
employment level, real investment must equal to the gap between income and consumption. In
other words, employment cannot expand, unless investment expands. Therein lies the importance
of the concept of effective demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich
community, the gap between income and expenditure is large. If required investment is not made
to fill this gap, it will lead to deficiency of effective demand resulting in unemployment.
Topic No. 7: (Macro Economics)
Criticism on Keynesian Theory:
From mid 1970 onward, the Keynesian theory of employment came under sharp criticism from
the monetarists. Milton Frsadman, the Chief advocate of monetarists rejected the Keynesianism
as a whole. The monetarists returned back to the old classical theory for the explanation of the
rise in general price level and stated that inflation is always and every where a monetary
phenomenon.
The monetarists are of the view that J. M. Keynes laid more emphasis on the determinants of
aggregate demand and to a greater extent ignored the determinants of aggregate supply. The
monetarists encouraged the supply side policy and thus favored free enterprise economy for
solving the problems of unemployment and inflation.
J. R. Hicks describes Keyne's 'General Theory' as depression economics. Further, the 'General
Theory of Keynes is applicable to the developed economies. The Keynesians concepts are not
very useful for policy purposes in less developed countries.
Topic No. 8: (Macro Economics)
Inflationary and Deflationary Gaps:
J. M. Keynes in his famous book 'General Theory' put forward an analysis of unemployment and
inflation. The Keynesian theory assumes that a maximum level of national output can be
obtained at any particular time in the economy. According to him the maximum level of national
income is generally referred to as full employment level of national income. If the equilibrium
level of national income coincides with the full employment, there will be no deficiency of
aggregate demand and hence no dis-equilibrium unemployment (seasonal, frictional
unemployment can exist at this level).
Now if the equilibrium level of income as determined by the AD (aggregate demand) and AS
(aggregate supply) is not equal to the level of full employment, then two situations can arise.
Either this equilibrium level will be below the full employment level or above the lull
employment level. In case, the equilibrium income is below the potential income, it indicates the
presence of recessionary gap. If it is above the full employment income, it shows the presence of
inflationary gap. Both the situations of deflationary and inflationary gaps are situations of
disequilibrium in the economy. These gaps are now explained with the help of graphs.
Deflationary Gap/Recessionary Gap:
Definition and Explanation:
Deflationary gap is also called re-cessionary gap. When there is an insufficient demand for
goods and services in the economy, the equilibrium will occur at the lower level of full
employment income and to the left of full employment line. In other words, re-cessionary gap
occurs when the aggregate demand is not sufficient to create conditions of full employment.
The deflationary gap thus is the difference of amount by which aggregate expenditure falls short
of the level needed to generate equilibrium national income at full employment without inflation.
Example and Diagram/Figure:
The deflationary gap is illustrated in figure below:
In this diagram 31.4, the national income is measured on OX axis and aggregate expenditure on
OY axis. Let us assume initially that the aggregate expenditure curves AE° interests the 45
degree line at point E/to the left of full employment line or potential income.
The economy is operating at equilibrium income level of $150 billion which is below potential
income of $250 billion. There is a deficiency of $100 billion in aggregate expenditures. This
shortfall of national expenditure ($100 billion) below the potential income or the full
employment level of national income is called Re-cessionary Gap.
Fighting Recession:
When the economy is operating below its potential income, the government recognizes the recessionary gap in aggregate income. It increases its expenditures to stimulate the economy. The
multiplier process takes over. The increase in government expenditure shifts the AE/ curve from
AE° to AE1 increasing aggregate income to the full employment income level. Such government
action is expansionary fiscal policy.
Deflationary gap thus represents the difference between the actual aggregate demand and the
aggregate demand which is required to establish the equilibrium at full employment level of
Income.
Inflationary Gap:
Definition and Explanation:
An inflationary gap is just the opposite of deflationary gap. It is said to exist when equilibrium
income exceeds full employment income. It is created due to the effective demand being in
excess of the full employment level. It is the difference between equilibrium income and full
employment income (potential income) when equilibrium income exceeds the full employment
income. Here people are trying to buy more goods and services than can be produced when all
resources are fully employed. There is too much money chasing too few goods. The result is that
the excess demand pulls up prices and there is inflation. The excess demand for goods and
services is being met in money terms but not real, terms.
Example and Diagram/Figure:
An inflationary gap is explained with the help of figure below:
In this figure 31.5 aggregate expenditure curve AE° intersects the aggregate production curve (45
degree helping line) at point E/ to the right of potential line or full employment line (FE).
The equilibrium level of income is $200 billion whereas the potential income is $100 billion.
When the equilibrium income exceeds potential income, there is said to be inflationary gap
which in the diagram is $100 billion. The excess expenditure of $100 billion causes upward
pressure on prices when there is no additional output produced.
Fighting Inflation:
Whenever there is an inflationary gap in the economy, the government adopts deflationary fiscal
policy of lowering government expenditure or raising taxes. It also adopts deflationary monetary
policy for reducing the amount of money in the economy.
Conclusions
(i) When equilibrium income is below its potential income level, the difference is
called deflationary gap. The government can increase its expenditure to stimulate the economy.
(ii) When equilibrium income exceeds the potential income, the difference is called
an inflationary gap. To prevent inflation. Keynes believes that the government should exercise
contractionary fiscal policy, cutting government expenditure, raising taxes etc.
Topic No. 9: (Macro Economics)
What is Fiscal Policy?
Definition and Explanation:
The classical economists were of the view that the economy automatically moves towards full employment in the
long run. They ruled out the possibility of over production and hence unemployment in the long period. The role of
the government in the economy, according to the classical economists, should be the minimal.
The J. M. Keynes in his famous book, "General Theory of Employment, Interest and Money", disagreed with the
views of the classical economists that the economy has the tendency to move towards full employment in the long
run.
He was of the strong view that the government must interfere in economic matters to achieve full employment, to
prevent inflation and to promote rapid economic growth. In order to achieve the macro economic goals, he stressed
that the government must step in and use government expenditure and taxes for changing the size of national
income and the tempo of aggregate economic activity in the country. The use of deliberate changes in government
expenditure and or taxes to achieve certain national economic goals is called Fiscal Policy.
Fiscal policy thus is the deliberate change in government spending and taxes to stimulate or slow down the
economy. In the words of F.R. Glahe:
"By fiscal policy is meant the regulation of the level of government expenditure and taxation to achieve full
employment without inflation in the economy".
J. M. Keynes describes fiscal policy as the steering wheel for the aggregate economy.
Objectives/Goals of Fiscal Policy:
The objectives of fiscal policy differ with the state of development in the country. In advanced countries of the
world, the goal of fiscal policy may be the maintenance of full employment without inflation. In developing
countries, the objectives of fiscal policy may be to achieve maximum level of employment and reduction in
economic inequalities. However, the main goals of fiscal policy are in brief as under:
(i) Removing Deflationary Gap:
J. M. Keynes is of the view that fiscal policy can play a major role in lifting the economy out of depression and
closing the deflationary gap. When the economy is in depression, it is faced with rising unemployment, falling
income, severe declining investment and shrinking of economic activities. The government, by undertaking public
works programme, increases its expenditure which helps in raising the level of aggregate demand out employment in
the economy.
The government can also induce changes in aggregate investment by reduction of taxes, tax relieves, abolition of
sales tax, reducing excise duties etc. The tax relief measures are also an effective methods to raise the level of
aggregate demand and removing deflationary gap from the economy.
(ii) Fiscal Policy in Inflation:
If the economy of a country is faced with inflationary gap, then anti cyclical fiscal policies should be adopted to
bring down the prices and for closing the inflationary gaps. The main fiscal measures to bring down the excess
demand in the economy are: (a) reduction in government expenditure, (b) increase in taxes and (c) creating a budget
surplus.
By adopting contractionary fiscal policy, the aggregate demand curve shifts downward and the economy begins to
operate at the desired potential level of income.
(iii) Counter Cyclical Fiscal Policy:
Another important objective of fiscal policy is to minimize the fluctuations in aggregate demand so that the
economy is always at its target and potential level of income. The fluctuations in the economy which are associated
with the business cycles can be smoothed in a number of ways.
For example, when the aggregate demand rises rapidly in the expansionary phase of the business cycle, it can be
tuned by reducing government expenditure or raising taxes. This will help in dampening down the expansionary
phase. In the recessionary phase, the problem of unemployment and low growth can be covered and remedied by
cutting taxes and raising government expenditure. If timely counter cyclical fiscal measures are adopted the
problems of excess or deficiency of demand will never be severe and the economy operates at the potential level of
income which is called fine tuning.
Diagram:
Keynesian Fiscal Policy in the Short Run
In figure 27.1 (A), it is shown how an increase in government spending increases the level of national income in the
short run. The increase in government spending from G 0 to G, shifts the C + I + G0 line upward and increases the
level of income from Oy0 to Oy1.
In figure 27.1 (B), it is shown how an increase in taxes and reduction in government expenditure leads to a decrease
in national income in the short run. It is clear from the diagram that as the level of tax increases and government
expenditure falls down, the aggregate demand curve C + I + G 1 shifts downward. The equilibrium income falls from
Oy0 to Oy1.
(iv) Equilibrium in Balance of Payments:
The level of national income is also affected by the balance of payments position of the country. If the country has a
favorable balance of payments, it will lead to increase in income. The rise in aggregate demand will shift the
demand line upward and will increase the level of national income. The fall in the balance of payments has the
opposite effect. The government uses fiscal policy in such a way that the balance of payments remains in
equilibrium in the short run.
(v) Economic Growth:
The elements of Keynes fiscal policy were developed in 1930's. Since then, the Keynesian fiscal policy is in action.
The economists believe even now that if the economy is operating below its potential level, the increase in
government expenditure and cut in taxes is the perfect medicine to bring the economy back to its full employment
level. The economists stress that government should encourage investment to increase the rate of capital formation
by using timely proper fiscal measures. The government borrowing for financing schemes of development, the
increase in ratio of savings to national income, cut in taxes to increase investment spending can accelerate the rate of
capital for nation in the country and lead toeconomic growth.
Principles/Tools of Fiscal Policy:
The government uses various fiscal principles/tools in order to achieve rapid economic growth. The main tools
of fiscal policy are grouped under two main heads:
(1) Discretionary Fiscal Policy.
(2) Non Discretionary Controls.
(1) Discretionary Fiscal Policy:
By discretionary policy is meant the deliberate changing of taxes and government spending by the central authority
for the purpose of offsetting cyclical fluctuations in output and employment. The discretionary fiscal policy has
short, as well as long-run objectives.
The short-run counter cyclical fiscal policy aims at eliminating business fluctuations and maintaining moderate
stability. In case of deflationary situation, the long-run program of fiscal policy is to raise the level of income and
employment in the country. In case of sustained long-run inflationary gap in the economy, the objective of fiscal
policy is to reduce the average level of purchasing' power. Let us now examine the short and long run tools of
discretionary fiscal policy in more detail.
Short Run and Long Run Counter Cyclical Fiscal Policy:
The main weapons or stabilizers of short-run and long run discretionary fiscal policy are: (i) Precautions or Guide
map, (ii) Changes in tax rates (iii) Varying public works expenditure, (iv) Credit aids and (v) Transfer payments.
(i) Guide maps: In a capitalistic, society, the entrepreneurs are not aware of each other investment plans. They,
therefore, in competition with one another over-invest capital in a particular industry or industries and thus cause
overproduction and unemployment in the economy, similarly, in depression period, there is no agency to guide
them, If government publishes the total investment plans and marginal efficiency of capital in various industries,
much of the investment can proceed at a moderate speed and there can be stability to some extent in income, output
and employment.
(ii) Changes in tax rates: it is an important weapon of fiscal policy for eliminating the swings of the business cycle.
When the government finds that planned investment is exceeding planned savings and the economy is likely to be
threatened with inflationary gap, it increases the rate of taxes. The higher taxes, other things remaining the same,
reduce the disposable income of the people they are forced to cut down their expenditure. The economy is, thus,
saved from the inflationary situation.
(iii) Varying public works expenditure: Another important factor which influences economic activity is public
expenditure. In times of depression, the government can contribute directly to the income stream by initiating public
works programs and in boom period, it can withdraw funds from the income stream by curtailing them. This policy
have the followinglimitations:
(iv) Credit aids: The government can also avert depression by offering long term credit aids to the needy
industrialists for starting or expanding the business. It can also give financial help to insurance companies and
bankers to prevent their failures.
(v) Transfer payments: Variation in transfer expenditure programs can also help in moderating the business cycle.
When the business is brisk, the government can refrain from giving bonuses to the workers and thus can lessen the
pressure of too great spending to some extent. When the economy is in recession, these payments can be released
and more bonuses can be given to stimulate aggregate effective demand.
(2) Non Discretionary Control:
Automatic or Built in Stabilizers:
The automatic fiscal stabilizers are those which contribute to keep economic system in balance without human
control. These controls are built into the economy and so are called built in stabilizers. The main automatic stabilizer
is given below:
Progressive Income Tax:
Personal income taxes are the largest source of revenue to the government. The tax rate, the individuals pay on their
rising income is progressive. When the disposable income of the people increases in the boom period, the higher
amount of tax reduces disposable income, reduces consumption and decreases the aggregate demand which help in
curbing economic boom. A reduction in income tax increases disposable personal income, increases consumption,
increases aggregate demand and thus helps in curbing recession. The expansionary and contractionary fiscal policies
can be summed up and brought under two approaches.
First: Demand Side Fiscal Policy.
Second: Supply Side Fiscal Policy.
(i) Demand side policy: It was originated as a direct result of Keynesian belief. According to Keynes, during
recession, the goal is to raise aggregate demand to the full employment level. This objective may be achieved by (a)
an increase in government spending (G), (b) a decrease in tax revenue (T) brought about by reduction in tax rates.
During a period of rapid inflation, the goal is to lower aggregate demand to the full employment level. The fiscal
policy will be (a) a decrease in government expenditure (b) an increase in taxes brought about by rise in the rates.
(ii) Supply side fiscal policy: It is a new approach to fiscal policy. The modern economists are of view that fiscal
policies can also influence the level of economic activity through their impact on aggregate supply. When the firms
experience, an increase in resource costs due to a sharp rise in the world price of a major raw material say oil, the
higher costs causes a decrease in aggregate supply creating a recessionary gap. Therefore, an expansionary fiscal
policy in the form of reduced corporate taxes and pay roll tax can help in closing the recessionary gap. Conversely,
an increase in the corporate tax rate and pay roll tax etc., can help in closing the inflationary a gap.
(iii) Unemployment compensation: In advanced countries of the world, people receive unemployment
compensation and other welfare payments when they are out of job. As soon as they get employment, these
payments are stopped. When national income is increasing, the unemployment fund grows due to two main reasons:
(a) The government receives greater amount of payroll taxes from the employees and (b) the unemployment
compensation decreases.
Thus, during boom years, the unemployment compensation reserve funds help in moderating the inflationary
pressure by curtailing income and consumption. When the economy is contracting, unemployment, consumption and
other welfare payments augment the income stream and they prove a powerful factor increasing income, output and
employment in the country. In the words of Samuelson:
"During boom years, therefore, the unemployment reserve fund grows and exerts stabilizing pressure against too
great spending. Conversely, during years of slack employment, the reserve funds are used to pay out income to
sustain consumption and moderate the decline".
(iv) Farm aid programs: Farm aid programs also stabilize against the wave like cyclical fluctuations. When the
prices of the agricultural products are falling and the economy is threatened with depression, government purchases
the surplus products of the farmers at the set prices. The income and total spending of the agriculturists thus remain
stabilized and the contraction phase is warded off to some extent. When the economy is expanding, the government
sells these stocks and absorbs the surplus purchasing power. It, thus, reduces inflationary potential by increasing the
supply of goods and contracting the pressure of too great spending.
(v) Corporate saving and family savings: The credit of having automatic or built in stabilizer does not go to the
state alone. The corporations and companies and wise family members withhold part of the dividends of the boom
years to pay in the depression years. Thus holding back some earnings of good years contracts the purchasing power
and releasing of money in poorer years expands the purchasing power of the people. Similarly, wise persons also try
to save something during the prosperous days in order to spend the savings in the rainy days.
Limitation of built in stabilizers: The automatic or built in stabilizers can no doubt minimize the upward and
downward movements of business cycle to some extent but they cannot help in achieving full employment without
inflation. They can be used as a first line of defense but they cannot cure the economic ills of the society. So the
policy makers have to be vigilant and adopt other suitable fiscal measures which can counter cyclical fluctuation in
the economy.
Topic No. 10: (Macro Economics)
Circular Flow of National Income in a Two Sector Economy
or Circular Flow Model:
Definition of Circular Flow Model:
A simple circular flow model of the macro economics containing two sectors (business and household) and two
markets (product and factor) that illustrates the continuous movement of the payments for goods and services
between producers and consumers. The payment flow between the two sectors and two markets is conveniently
divided into four segments representing consumption expenditures, gross domestic product, factor payments, and
national income.
The modern economy is a monetary economy. In the modern economy, money is used as a medium of exchange.
While analyzing the circular flow of income in a two sector model of the economy, we assume:
Assumptions of Circular Flow Model:
(i) There are only two sectors in the economy, household sector and business sector.
(ii) The business sector (or the firms) hires factors of production owned by the household sector and it is the sole
producer of goods and services in the economy.
(iii) The household sector (or the households) is the sole buyer of goods and services. It spends its entire income on
the goods and services produced by the business sector. They are also suppliers of labor and various of other factors
of production.
(iv) The business sector sells the entire output to households. It does not store. There are, therefore, no inventories.
(v) There are no savings and investment in the economy.
(vi) The household sector receives income by selling or renting the factors of production owned by it.
(vii) Government does, not exist for all such practical purposes (No public expenditures, no taxes, no subsidies, no
social insurance contribution, etc.).
(viii) The economy is closed one having no international trade relations.
In this hypothetical economy stated above, we explain the circular flow of economic life.
Principles of Circular Flow of National Income:
In the simple circular flow of income and product, there are two principles which are involved.
First. In the business transactions, the sellers of goods receive exactly the same amount which the buyers spend on
them.
Second. The goods and services flow in one direction and money payment flow in the other direction.
Explanation of Circular Flow of National Income:
In a two sector economy, there are business firms which produce goods and services. The other sector is households
which supplies their factors services to the firms and also buy goods and services produced by them. The households
supply the economic resources to the firms and receive payments in terms of money. There is, thus, a flow of money
corresponding to the flow of economic resources. These money incomes are spent by households on goods and
services produced by the firms. With this the money comes back to the firms. This circular flow of income in fact is
the mutual dependence of the two sectors of modern economy.
Diagram of Circular Flow of Income:
The circular flow of income in a two sector economy is explained with the help of figure 23.1.
In this figure, it is shown that the economy consists of two sectors (1) households and business. In the upper top of
this figure, the resources such as land, capital, labor and entrepreneurial ability flow from households to business
firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the
households as factors payments such as rent, wages, interest and profit.
In the lower pipe line, money flows from households to firms as consumption expenditure made by the households
on the goods and services produced by the firms. The flow of goods and services is in opposite direction from
business firms to households. We, thus, find that money flows from business firms to households as factor payments
and then it flows back from households to firms. Thus there is in fact a circular flow of income. This circular flow of
money or income continues year after year. This Is how the economy functions.
Topic No. 11: (Macro Economics)
Measurement of Gross Domestic Product (GDP) in Current
Price and Constant Price orDifference Between Nominal
GDP and Real GDP:
Definition and Explanation of Nominal GDP:
The gross domestic product (GDP) is the total market value of all the final goods and services produced within an
economy in a given year. When all the components of GDP are valued a their current prices in the market, it is
called nominal gross domestic product. Nominal GDP measures national income ruling at the time and thus takes
no account of inflation.
In many applications of macro economics, the nominal GDP is not considered a measure of growth and welfare.
Why this is so is explained by taking a simple example of two good economy and two years.
Example:
Let us assume that an economy produces 100 pens and 50 books in the year 2001. The , price of one pen is $1 and
that of the book is $2 in the market. The total value of the goods produced is $200 in the year 2001 .
(100 pens x $1 per pen) + (50 books x $2 per book)
(100)
+
(100)
=
$200
Suppose that in the year 2002, the production of the two goods, pens and books remains the same, but their prices
get doubled. The total value of the goods then would be $400.
(100 pens x $2) + (50 books x $4)
200
+
200 = $400
The nominal GDP in the year 2001 is $200 and is $400 in the year 2002. The nominal GDP has increased by 100%
even though the physical production of goods has remained the same. So, if we use the nominal GDP to measure
growth of the economy, we will be misled into thinking that production has grown. What all has really happened is a
rise in the price level. The standard of living of the people will increase only if (i) the economy produces larger
quantity of goods than the previous year and (ii) the goods are sold at normal prices in the market.
The economists while studying the changes in the economy need a measure of output which shows an actual
increase in production of goods and it is not affected by changes in their prices. To get this problem solved, the
economist use a measure called Real GDP.
Definition and Explanation of Real GDP:
Real gross, domestic product (Real GDP) is the production of goods and services valued at constant prices. It is also
defined as GDP adjusted for price changes. It is a measure of output that reflects actual income in. production,
separate and part from any price changes that may have occurred in the economy during the year.
Example For Calculating Nominal GDP and Real GDP:
Let us take a simple example of a two good economy and of two years to explain the concept of Real GDP. The
table given below shows the nominal GDP for two years 2001 and 2002.
Price and Quantity
Year
Price of Pen Quantity
($)
Produced (Pens)
Price of Book ($)
Quantity
(books)
2001
1
100
2
50
2002
2
150
3
100
Produced
Calculating Nominal GDP:
2001
($1 per pen x 100 pens) + ($2 per book x 50 books) = $200
2002
($2 per pen x 150 pens) + ($3 per book x 100 books) = $600
Calculating Real GDP:
2001
2002
($1 per pen x 100 pens) + ($2 per book x 50 books) = $200
($1 per pen x 150 pens) + ($2 per book x 100 books) = $350
We find that real GDP has increased from $200 in the year 2001 to $350 in the year 2002. This increase is due to
increase in quantities of goods produced because the prices are held fixed at base year levels. The real GDP enables
us to see how much real income has changed from one year to another.
Measuring Price Changes Overtime:
We can measure the changes in prices of goods overtime by an index called GDP Deflator.
Definition of GDP Deflator:
GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100.
Formula For GDP Deflator:
GDP Deflator = Nominal GDP x 100
Real GDP
1
Calculating the GDP Deflator:
2001
2002
$200/$200 x 100 = 100
$600/$350 x 100 = 171
For the year 2002, the value of GDP deflator as worked out is $171 and was 100 in the base year. This means that
the price level has increased by 71% from the base year.
Base Year:
The year from which a financial or economic index is first calculated. It is normally set at an arbitrary level of 100.
Any year can be chosen as a base year, but it is generally desirable to use a fairly recent one. New, more up to date
base years are periodically introduced. An average value for a number of years can also be used as a base year.
Topic No. 12(Micro Economics)
THE PRODUCTION POSSIBILITIES CURVE
Definition
A curve depicting all maximum output possibilities for two or more goods given a set of inputs
(resources, labor, etc.). The PPF assumes that all inputs are used efficiently.
A production possibilities curve shows the combinations of goods and services that the economy
is capable of producing with its existing techniques of production. Because it outlines the
boundaries, or limits, of the economy’s ability to produce output, it is sometimes called a
production possibilities frontier. Any point along or inside the frontier represents a combination
of goods that the economy can produce; any point above the curve is beyond the economy’s
present production capacity.
As indicated on the chart above, points A, B and C represent the points at which production of
Good A and Good B is most efficient. Point X demonstrates the point at which resources are not
being used efficiently in the production of both goods; point Y demonstrates an output that is not
attainable with the given inputs.
Among others, factors such as labor, capital and technology will affect where the production
possibility frontier lies. The PPF is also known as the production possibility or transformation
curve.