income and employment

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THEORY OF INCOME ANDEMPLOYMENT


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Chapter 1 An introduction to economic analysis

Chapter 2 Macroeconomic analysis: an overview

Chapter 3 Measurement of macroeconomic aggregates

Chapter 4 The simple Keynesian Model of Income determination

Chapter 5 Income determination model including money and interest

Chapter 6 fundamentals of aggregate demand and aggregate supply

Chapter 7 Money supply and banking system

Chapter 8 Aggregate supply, price levels and employment: macroeconomic equilibrium in classical

model

Chapter 9 Aggregate supply, price levels and employment: macroeconomic equilibrium in

Keynesian model

Chapter 10 Post-Keynesian macroeconomics Monetarism, rational expectations and supply-side

economics

Chapter 11 Economic fluctuations and unemployment

Chapter 12 Price stability

Chapter 13 The open economy and balance of payments: Indias balance of payments

Chapter 14 Modern macroeconomics: Fiscal policy, budget deficits and the Government Debt

Chapter 15 Modern macroeconomics: Monetary policy and Interest Rate Structure

Chapter 16 Economic growth, development and planning

Chapter 17 Trade and exchange rate policies

Chapter 18 Technology policy

Chapter 19 Industry structure and policy

Glossary


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Detailed curriculum

Overview of Macroeconomics: Microeconomics vs. Macroeconomics, fundamental Concerns of

Macroeconomic policy, Objectives and instruments of Macroeconomics, Aggregate Supply and

Aggregate Demand.

The national Income and product accounts: Gross domestic product, Two measures of National Product:

Goods-flow and earning-flow, business accounts and GDP, the problem of double counting, details of

the National Accounts.

Consumption and Investment: Consumption and saving, the consumption function, the saving function,

Investment: Determinants of Investment, The investment demand curve, shifts in the Investment

demand curve.

Aggregate demand and the multiplier: The downward-sloping Aggregate demand curve, shifts in

aggregate demand, relative importance of factors influencing demand. Output determination with

saving and investment, the meaning of equilibrium, output determination by consumption andinvestment, the multiplier, the multiplier in the AS-AD framework, the paradox of thrift.

Government, International trade,and output: Impact of fiscal policy on output, fiscal policy multipliers,

impact of international trade on GDP..


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Economics has a bold approach to solve the multi-dimensional problems facing the nation. It is useful

for eradicating poverty, unemployment and overcome problems such as inflation, stagnation, recession,

population explosion and adverse balance of payments etc. Knowledge of economics is being used for

accelerating growth in the economies of the world. Economics is a social science concerned with the use

and allocation of resources for achievement and maintenance of growth with stability.

Some important branches of economics are:

y Agricultural economicsy International economicsy Business economicsy Labor economicsy Development economicsy Natural resource economicsy Econometricsy Rural economics and rural developmenty Financial economicsy Welfare economicsy Industrial economics


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National income: concepts and measurement

Before we take up the study of theory of income determination and its fluctuations it will be useful to

understand the meaning of National Income or National Product.

National income defined

Broadly speaking, National Income or National Product is the sum total of all the commodities and

services produced by the economy as a whole during a given time, conventionally one year. In

Marshalls words, The labor and capital of country acting on its natural resources produce annually a

certain net aggregate of commodities, material and immaterial, including the services of all kind. This is

true National Income or National Dividend. It must be noted here that the value of goods and services

produced in a year must be measured in terms of money as they cannot be measured in non-monetary

terms. To overcome the difficulty, Prof. Pigou has defined as: that part of the objective income of the

community including of course income derived from abroad, which can be measured in terms of

money. According to Prof. Pigous definition only those services or commodities can be included innational income which will be exchanged in money.

Simon Kuznets defined National Income as a net output of commodity and services flowing during the

year from the countrys productive system into the hands of the ultimate consumer or into net addition

to the countrys capital goods.

There are a number of concepts pertaining to national income. For instance, Gross National Product, Net

National Product,Net National Income at Fact or Cost, Net Domestic Product at Factor Cost, Personal

Income, Disposable Income, and Real Income. One by one, these concepts are discussed below:


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Marginal Efficiency of Capital

Investment function is the second main determinant of employment within an economy. According to

Keynes marginal efficiency of capital and rate of interest are the main determinants of level of

investment. Marginal efficiency of capital is the highest rate of return over cost accruing from an

addition al asset (machine etc.). Rate of interest is determined by the supply of money and the demand

of money. Since the rate of interest is stable, marginal efficiency of capital is considered to be more

important in determining the level of investment in an economy.

Consumption function and investment function are the two major determinants of income and

employment within an economy. It has been established that consumption function is stable in short

period; hence investment function rules supreme in determining employment. We shall analyze here

the factors which determine investment.

In view of the multiple objects of spending, it is not simple to explain what determines investment in theeconomy. However, through empirical research Keynes came to the conclusion that investment in

private enterprise economy depends upon two factors; viz.; MEC (Marginal Efficiency of Capital) and

Rate of Interest.

Suppose a businessman makes an additional investment with borrowed money. He has to pay interest

on it. This is his expenditure on new investment. Even if the money belongs to him the case is the same

because now he is foregoing the interest which compares the interest he has to pay and the profit he is

expected to get on the investment. According to Keynes, the net return expected from a new unit o

capital is called Marginal Efficiency of Capital (MEC). Let us suppose that he has to pay 10% rate of

interest on the investment and the expected rate of profit or return from it is 15%. This is a worthwhileinvestment and so the inducement to invest will be more. He will continue increasing investment until

the expected rate of profit and the rate of interest become equal to each other. Thus we find that the

inducement to invest depends on Marginal Efficiency of Capital (MEC) and rate of Interest.

Investment, in Keynesian sense, does not imply purchase of existing shares or securities but it means the

production and purchase of capital goods. These capital goods include

y Plants and equipmentsy Inventoriesy Construction works either in the form of house, shop, factories or

in the form of public works like canals, dams etc.

y Net foreign investment.Classical economists believed that investment was determined by marginal productivity of capital

(actual marginal yield of capital) and rate of interest. But Keynes criticized that view. He proved that the

MEC (marginal efficiency of capital) and the rate of interest are the main determinants of investment.

Marginal Efficiency of Capital (MEC) is the highest rate of return over cost accruing from an additional


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unit of a capital asset. Thus before purchasing a new plant a businessman considers the supply price of

asset and the total net yield (profit minus depreciation) over the entire life time of the plant. By relating

these two forces he arrives at MEC (marginal efficiency of capital).


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According to Keynes, investment means real investment and not financial investment like purchase of

shares or securities. By real investment, Keynes means real capital assets like machines, plants,

equipments, factory buildings, residential construction, public works like canals, bridges, roads, etc. and

net foreign investment.

Investment may be of two types, viz., gross investment and net investment.

Gross investment refers to the


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Effective demand = total output = total income = employment

Aggregate demand functionAggregate supply function

Consumption Government expenditurInvestment

Prize of Income Propensity to

consume

Marginal efficiency of

capital

Rate of

Interest

Supply price of

ca ital asset

Prospective yield

from capital asset

Liquidity preference

of the people

The supply of

Money in the

country

Precautionary

motive

Transaction motive Speculative moti


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Paradox of thrift:

Saving is defined as an excess of income over consumption expenditure in a

given period of time.

The classical economists believed that saving is a virtue for an individual

because every time when he saves (i.e., spends less than his income), he

increases his savings. Now since savings of the society or community is the

aggregate of the savings of all the individuals in the society, it will also increase

total saving of the society and so it was considered a virtue for the economy

also.

But Keynes holds a different view. He says that

although community saving is sum total of all the individual savings in the

economy, yet individual saving does not always increase the community

savings. The reason is obvious since one mans expenditure is other mans

income. According to Keynes the classical economists ignored this truth which

led to their belief that saving is virtue both for an individual as well as for the

society. But the reality according to Keynes is that when one person has saved

by spending less on consumption, the other members of the community or

society would reduce their income (since one mans expenditure is another

mans income) by that extent and there would be dissaving to the same

degree. Thus according to Keynes, more a community tries to increase its

savings out of a given income, the less it is able to do so. Therefore, attempts

by individuals to increase their savings out of their given income by spending

les on consumption would result only in decreasing the aggregate savings of

the community. This is known as the famous PARADOX OF THRIFT.

According to Keynes more a

society tries to increase its

savings out of a given

income, the less it is able to

do so.


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Macro Economics deals with the overall dimensions of

the economic life of a country. It is the study of an economy as a whole. It is

concerned with such variables as the aggregate volume of output and income,

with the aggregate consumption, with the aggregate demand and supply, with

the aggregate saving, investment and employment etc, of an economy. It is for

this reason that macro economics is sometimes referred to as INCOME AND

EMPLOYMENT THEORY.

Micro Economics: - Micro Economics, on the other

hand deals with particular individuals, house holds, firms, industries or with the

problems of individuals prices or income distribution. Micro economics also

uses aggregates but not economywise totals.

Thus whereas Macro economics offers explanation for

the growth or decline of the entire economy. Micro economics explains the

economics motive, behavior of individual consumers and producers and the

growth and decline of individuals firms or industries. Since Micro economics

primarily concerns with the determination of prices of goods and factors of

production, it is sometimes referred to as Price Theory.

The earlier writers were greatly interested in Micro

economic analysis and as such most of the contents of traditional economic

theory is Price Theory, theory of firms and industries etc. Though Malthus,

Sismondi and Marx had made some contributions towards Macro economics

analysis yet the development of Macro economics started with the coming of

the Great Depression in the thirties of the 20th

century. The hyper inflation

after the First World War and large scale unemployment during the Great

Depression exposed the fallacy of self-adjusting nature of the Economic

System. This paved the way for the development of micro-economics. In

matters concerning national economic policy, we are more concerned with the

national economy as a whole rather than with small atomistic units. Therefore,

Macro economics is assuming greater importance than Micro Economics.

USES OF MICROECONOMICS:-

Micro economics is useful in achieving a worms eye

view of some very specific components of our economic system. Microeconomics studies only particular part of the economy but does not study the

economy in its totality.

Dr. Marshalls leading work Principles of Economics

published in 1890 is concerned mainly with Micro economics. Marginal

analysis is an important tool used in micro economics. Some of the important

laws of micro economics as law of diminishing utility, law of equimarginal


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utility, theory of consumers surplus have been directly derived from marginal

analysis.

Micro economics theories help to understand the

complex economic problems and suggest their solutions.

LIMITATIONS OF MICRO ECONOMICS:-

1 What is true of individual units may not be true in case of aggregatese.g. saving is good for an individual but saving on the part of total economy is

harmful because if every one begins to save, effective demand would be

reduced and unemployment may increase. In the same way wage cutting

would certainly reduce the volume of employment in an economy.

2 Micro economics is based on certain assumptions like other thingsremaining the same, full employment in the economy etc. But these

assumptions are not true in real life. So validity of micro economic theories is

doubtful.

But this does not lead us to conclude that micro economic analysis is not useful. In fact micro economic

analysis is useful for macro economic analysis. Many micro economic studies help to understand macro

economic problems e.g. the study of individual family budget can help us to understand the

consumption of the community.

USES OF MACRO ECONOMICS:-

Though Macro economics is relatively new but it has many uses:

1 It is useful for governments to formulate and execute successfully the various economicproblems. It is so because present governments are more concerned with aggregate

variables and not individual variables of the economy i.e. general price level, general level of

production, general volume of trade, general unemployment etc.

2 Modern economic system is so complex and complicated that some aggregative approachi.e. the study of macro economics which deals with aggregates namely national income,

national output, national expenditure etc. has to be depended upon.

3 Macro economics is also indispensible for purpose of developing micro economics. e.g. thelaw of diminishing marginal utility could have been formulated on the experience of masses

of individuals.

4 Macro economics helps the governments of developing economies in the formulation otheories o economic development.

5 Macro economics helps in international comparisons regarding national income, nationalconsumption and saving in different countries.


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LIMITATIONS OF MACRO-ECONOMICS

1 The first limitation of macro economics is the danger of excessive generalization forindividual experiences to the economy as a whole.

2 Macro economics uses aggregates on the assumption that they are homogeneous. But thisis not true always. We always do not have homogeneous aggregates.

3 An aggregate tendency may not influence all the sectors of the economy in the samemanner. A general rise in prices, for example, may not affect all the sectors of the economy

in a similar manner.

4 Sometimes aggregates results are misleading. For example if prices of agricultural productsfall by 50% while prices of industrial goods rise by 50% then there would be no change in the

general price level. This means that government should have no new price policy. But the

correct thing is that government should have a new price policy to help agriculturalists, the

prices of whose products have fallen. Thus we can say that aggregate results are sometimes

misleading.

5 There are difficulties in measuring aggregates in many cases.CONCLUSION

However, we should not have the impression that the two analyses (micro and macro) are separate.

Rather, the two are complimentary and interdependent. It is often difficult to draw a dividing line

between Micro economics and Macro economics. After all the aggregate variables are just the sums of

individual variables. So each analysis (micro and macro) is incomplete without the other. What a firm

should pay for the services of a factor of production (say labor) is a question of micro-economics as it

relates to a firm. Now the question is whether wage rate depends upon the demand of a single firm.

Obviously not, we know that wages are related and depend upon the total demand for labor in the

economy as a whole. This involves the study of Macro economics. Thus the two approaches (micro and

macro) of economic analysis are complementary and interdependent.


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BASIC CONCEPTS

1 STOCK AND FLOWA stock is a quantity measurable at a particular point of time. It has no time dimensions. e.g.

national capital is a stock because it refers to the nations capital at a particular point of

time. Similarly, wealth of the nation is a stock. Flow is a quantity that can be measured overa specified period of time say a year. Capital formation in the economy is a flow.

2 RATIO VARIABLESSuch variables express functional relationship between two variables at a given point of

time. For example relationship between income and saving or income and consumption are

known as ratio variables. The ratio between saving and income is known as average

propensity to save (APS). Symbolically it is expressed as S/Y where S is saving and Y is

income and the ratio between consumption and income is known as average propensity to

consume (APC). Symbolically it is expressed as C/Y where C is consumption and Y is income.

3 INDEPENDENT AND DEPENDENT VARIABLESSome economic variables are independent and some are dependent variables. For exampleincome is an independent variable while consumption is a dependent variable as such one

can say that consumption is a function of income. Symbolically we can express this

functional relationship as C= f(Y) where C is consumption, f is function of and y is

income. This function al relationship shows that consumption is a function of income as

income increase, consumption also increases though less than the increase in income.

4 EQUILIBRIUMEquilibrium refers to a state of balance between two variables. We can define a state of

equilibrium as a situation in which the effective demand for every good and every factor of

production is exactly equal to the supply of it. When equilibrium is achieved there is no

tendency to change from it. So it can be said that equilibrium is the best situation.5 EX-ANTE AND EX-POST

This Basic concept is used in saving and investment. Ex-ante means, what we plan or

anticipate doing and Ex-post means what we have actually achieved or done.

For example, economists classify saving and investment into two parts:

i EX-ante saving and investment i.e. what they plan to save and invest.

ii Ex-post savings and investments i.e. what they actually save and invest.

Our plan to save and invest depends upon many independent variables like income, prices,

future outlook etc. So saving may or may not be equal to investment.


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KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION

Keynes psychological law of consumption occupies a pivotal position in the determination

of full employment in an economy.

From the early start of human civilization, it was considered a virtue to keep consumption at

the barest minimum. But nobody knew about the series of chain reactions of holding

consumption in check. Keynes analyzed the consumption function in a scientific way. He

calls it psychological law of consumption. The law states Macro behavior of consumers in

the short period. It states that there is a tendency of people to spend on consumption goods

the full amount of increase in income. This tendency is known as consumption function or

propensity to consume.

The statement of Keynes psychological law of consumption consists of three propositions

which are inter-related.

1 The first proposition is that with an increase in the aggregate income of an economy, itsexpenditure on consumption goods also increases but by less than the increase in

income. The reason is quite obvious. As the income increases, more and more wants of

the people are satisfied and thus they would be less keen to spend more. Thus the

increase on consumption expenditure would be less than the increase in income. The

balance is saved.

2 The second proposition is based on the first proposition. It says that spending andsaving are complementary. Income is always divided in some proportion between

expenditure and saving. We have said in the first proposition that as income increases

consumption expenditure would increase but less than the increase in income. It shows

that a part of the income which is not spent is saved. Thus income and expenditure go

side by side. Hence when income increases, the whole is not spent. A part is spent on

consumption and a part is saved.

3 The third proposition is derived from the first two propositions. It says that whenincome increases both consumption expenditure and saving increase. It is because when

income increases, consumption expenditure also increases though less than the

increase in income. This will also lead to an increase in saving. Thus it is clear that as

income increases both consumption and saving increase.

LIMITATIONS

Keynes psychological law of consumption is based on the following three important assumptions or

limitations:

1 It is assumed that only income of the commodity changes and other variables like incomedistribution, prices, population, etc. (i.e., propensity to consume) does not change. The

assumption is made in order to study the effect of the change in income on consumption

and saving. If these variables were to change with the change in income, Keynes law of

consumption would be shattered.


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2 It is assumed that conditions remain normal. By normal conditions we mean that thereshould be no hyper-inflation, or any other abnormal condition like war since during

abnormal condition the law may not operate.

3 It is assumed that there is no State interference in the free working of the economic forcesin the economy. Thus Keynes law of consumption holds good only in a capitalistic laissez

faire economy.

Implications of Keynes law of consumption

Keynes law of consumption has stated a very important tendency that as income increases; the

consumption also increases, but not as much as the increase in income. The increase in consumption

expenditure is always less than the increase in income. As a result of it the economy becomes low

consuming and high saving economy.

Another implication of Keynes law of consumption is that propensity to consume is stable and the

marginal propensity to consume is less than unity. It shows that income might increase but

consumption lags behind. If this propensity to consume is not increased, the marginal efficiency of

capital will fall and this would lead to the fall in the expected rate of profit. The demand of investment

will fall and the entire economic progress of the economy will be held up. Hence the State must

interfere in order to increase MPC.

Keynes law of consumption explains clearly that since consumption declines with the increase in

income, it is necessary to increase investment. If this is not done, increased output and employment will

not be profitable. Hence the law emphasizes the importance of investment.


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THE THEORY OF INCOME AND EMPLOYMENT

The classical economists, following Says Law of Markets assumes the existence of full employment in

an economy and the economy will normally be producing output and income corresponding to the level

of full employment. Occasional lapses from full employment are taken as abnormal and are considered

to be self-adjusting as there is always a tendency towards full employment so long as there is free play

of economic resources. Keynes has criticized the classical theory of income and employment on various

grounds. Keynes had developed his own theory of income and employment. According to Keynes, level

of income and employment in an economy depends upon the effective demand. Effective demand is the

point where aggregate demand and aggregate supply are equal. Effective demand consists of

consumption function (consumption expenditure) and investment function (investment expenditure).

Thus effective demand is the sole determinant of income and employment in an economy.

In this chapter we shall discuss both the Classical and Keynesian theories of income and employment.

The classical theory of Income and employment

Economists assume the existence of full employment. Occasional lapses from full employment are taken

as abnormal and are considered to be self-adjusting. As there is always a tendency towards full

employment so long as there is free play o economic forces. It is for this reason that they advocated for

laissez Faire policy. Any interference with the free play of economic forces would fail to bring about full

employment in an economy. The law states, Supply always creates its own demands. Thus according

to classical view, there can never be involuntary unemployment. However, they admit a certain amount

of voluntary and frictional unemployment. Voluntary unemployment is due to the refusal of work by the

workers for want of higher wages etc. Frictional unemployment arises due to such causes as ignorance

or job opportunities.

Statement of Says Law of Markets. The law of markets is propounded by J.B.Say, a French economist.

This law is the very basis of the classical theory of employment. Say rejects the old ideas that

overproduction and unemployment are of common occurrence. He believes that there can never be

general overproduction and hence general unemployment. It is so because according to his law of

markets, Supply always creates its own demand. He further says that it is production which creates

market for goods.

Explanation of the law. Say explains the law as follows:

According to him, demand of goods comes from the factor income (or householders income). The

factor income is created with every process of production. So every increase in production also

increases the factor income and thereby the demand for goods. In other words, we can say that every

increase in output generates an equivalent amount of purchasing power in circulation. This new

purchasing power is ultimately utilized in the purchase of increased output. So Says law, by saying that

supply creates its own demand, denies the possibility of deficiency of aggregate demand and hence the

possibility of overproduction and unemployment. Thus general unemployment is impossible. If at all


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there is any unemployment, it must be a temporary one and it will be cured automatically after

sometime.

Implication of Says Law of Market. Below we give some implications of Says Law of Markets. In fact,

they are the important features of the classical theory of income and employment.

1 To begin with, Says Law states that there is automatic adjustment between production andconsumption. There is no need for the Government to interfere in the working of the

economic system. If at any time supply increases, the factor income also increases which

raise the demand and soon there will again be equilibrium between supply and demand.

2 Secondly, Says Law states that since there can never be general production, there is nogeneral unemployment. If there is some unemployment, it is purely of temporary nature

and can be removed through money wage cuts. Such money wage cuts will make labor

relatively cheap and hence will lead to more employment. Thus through money wage cuts

the economy can attain the stage of full employment.

3 Thirdly, Says Law states that as long as there are unemployed resources in the economy, itis useful to employ them. The employment of these resources will increase production and

so they will cover their own costs. Hence the economy will work at full employment level.

4 Fourthly, Says Law states that saving is just a form of investment. That is whatever is savedis automatically invested. Thus there is equality between saving and investment and this

equality between the two is brought through changes in the rate of interest.

5 Lastly, Says Law states that since every economy is self-adjusting, the Government need notinterfere in economic matters. This will increases economic welfare of the economy.

Criticism of the law. In the first place, Dr. Keynes in his General Theory has criticized the classical

assumptions of full employment which is essentially based upon Says Law of markets. According to

Keynes, inequality of income and wealth has always been the most outstanding feature of every

capitalist society. The rich have always so much wealth that they cannot consume all. On the other

hand, the poor have so little wealth that they cannot fulfill all their wants. The result will be that the

total consumption or demand will fall short of total output and so deficiency in aggregate demand will

be created. This will result in overproduction and hence unemployment.

Secondly, Keynes does not accept Says Law which states that supply always creates its own demand.

This law is based on the assumption that the economy spends all its income on the purchase of goods so

that the entire output is sold. But this is not so in real life. In every economy people also save and hence

they do not spend all what they earn. Thus the demand for goods will fall short to the extent of savings.

So supply here will not be able to create its own demand. This will lead to overproduction and

unemployment. Further, Keyness doctrine of consumption function has shattered Says law of markets.

Keynes has provided that consumption lags behind income. So marginal propensity to consume is less

than unity; overproduction may arise and cause unemployment.

Thirdly, the great depression of the thirties (1929-1932) has proved the fallacy of Says law of markets

that supply creates its own demand. During the depression stocks of goods remained wit the producers.


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There was none to demand these goods. It shows that there was deficiency in aggregate demand in

relation to the aggregate supply. It means that supply could not create its own demands and hence Says

law of markets stands rejected.

Lastly, Says law of market is rejected on the basis of everyday experience. The law states that

involuntary unemployment can never exist. If at all there is unemployment, it is temporary and will cureitself in course of time. Hence Says law assumes full employment in the economy. It means that at the

existing wage rate every laborer can get employment. But, on the contrary, we see that there is always

some involuntary unemployment. People demand work but work is not available to them.

Points to remember:

The classical economists following says law assume the existence of full employment.

The law of market was propounded by J.B.Say. The law states that supply always creates its own

demand. Every increase in output generates an equal amount of purchasing power.

The implication of Says law is that since supply creates its own demand, there is no possibility of

deficiency of aggregate demand and hence no possibility of overproduction and unemployment.

Keynes has criticized the law on various grounds. In his General Theory he has proved the fallacy of the

law that supply creates its own demand.

Keynesian theory of Income and Employment

(Determination of national income by equality of saving and investment)

During the pre-Keynesian era, existence of full employment was presumed. Occasional lapses from fullemployment were considered to be self-adjusting according to the Says law of markets (i.e., supply

always creates its own demand). But the existence of involuntary unemployment on a large scale

challenged the truth of full employment thesis. Keynes in his General Theory of Employment, Interests

and Money re-examined the determinants of income and employment.

The concept of aggregate demand is in the ex-ante sense. In other words, aggregate demand tells us

the total quantity of goods and services that people want to by (unlike in national income accounting).

Equilibrium level of output is that level o output at which the total desired spending on goods and

services (desired aggregate demand) is equal to the actual level of output (y).

According to Keynes, effective demand is the sole determinant of income and employment. Effective

demand is determined by the forces of aggregate demand and aggregate supply. Aggregate demand

consists of two elements. Viz., consumption expenditure (consumption function) and investment

expenditure (investment function).

So we can say


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Y=C+I

Aggregate demand schedule

(Rs. in crores )

Income Consumption Investment Aggregate demand

(Y) (C) (I) AD

0 25 50 75

50 50 50 100

100 75 50 125

150 100 50 150

200 125 50 175

250 150 50 200

Aggregate Supply Schedule

(Rs. in crores )

Income Aggregate Supply

(y) (AS)

0 0

50 50

100 100

150 150

200 200

250 250


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Income consum- Investment Saving Agg. Agg.

ption demand Supply

(y) (C) (I) (S) AD AS

0 25 50 -25 75 0

50 50 50 0 100 50

100 75 50 25 125 100

150 100 50 50 150 150

200 125 50 75 175 200

250 150 50 100 200 250


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Classical versus Keynesian analysis of income determination

Only three differences are revealed in the formal structure of the two systems of macro analysis.

(i) Keynes rejected the neo-classical function of supply of labour and assumed rigid wages(W=w ) for situation of less than full employment;

(ii) Keynes added the speculative demand for money to the neo-classical transactions andprecautionary demand for money and

(iii) Keynes assumed that income would be far more important determinant of saving(consumption) than the neo-classical rate of interest

These three theoretical innovations constitute Keynes denial of the neo-classical automatic mechanism

generating employment.

1. The classical believed in the existence of full employment in the economy and a situation of lessthan full employment was regarded as abnormal. On the other hand, Keynes considered the

existence of full employment the existence of full employment as a special case. His notion of

underemployment equilibrium is indeed revolutionary reflecting real life situation.

2. The classical analysis was based on Says law of market that supply creates its own demand.The classical school thus ruled out the possibility of overproduction. Keynes propounded the

opposite view that demand creates its own supply. To Klein, the revolution was solely the

development of a theory of effective demand.

3. The classical economics was based on the laissez-faire policy of self-adjusting economic systemwith no government intervention. But Keynes discarded the policy of laissez-faire and he

favoured state intervention.

4. Pigou, one of the foremost classical economists, favoured the policy of wage cut to solve theproblem of unemployment. But Keynes opposed such a policy both from the theoretical and

practical points of view. Theoretically, a wage-cut policy increases unemployment instead of

solving it. Practically, workers are not prepared to accept a cut in money wage.

5. The classicists emphasized the importance of saving or thrift in capital formation for economicgrowth. To Keynes saving was a private virtue and a public vice.

6. The classical economists failed to provide an adequate explanation of the cyclical phenomena.They could not explain the turning points of the business cycle satisfactorily and generally

referred to boom and depression. Keynes real contribution to business cycle analysis lies in his

explanation of turning points of the cycle. In this field as opined by Mrs. Joan Robinson

Keynesian revolution commands the field.

7.

The classicalists artificially separated the monetary theory from the value theory. Keynes, on theother hand, integrated monetary theory and value theory through the theory of output. He

regarded the rate of interest as a purely monetary phenomenon.

8. Classical economics was a microeconomic analysis which the orthodox economists tried to applyto the economy as a whole. Keynes, on the other hand, adopted the macro approach to

economic problems. Keynes approach to economic problem was dynamic rather than static. The


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fundamental flaw in Pigous analysis is that he applied partial equilibrium analysis, which is valid

in the case of individual industry. But Keynesian analysis is general equilibrium analysis.

9. The classical economists being the votaries of laissez-faire policy had no faith either in fiscalpolicy or in monetary policy. They believed in the balanced budget policy. Keynes, on the other

hand stressed the importance of deficit budget during deflation and surplus budget during

inflation along with cheap money and dear money policies respectively. He was thus a practical

economist whose models clarify both inflationary and deflationary episodes and prosperous and

depressed economies.

Despite the theoretical and practical significance of the Keynesian theory, it has its own weaknesses and

failures. Many economists consider his analysis less than adequate for meeting such special problems lie

cyclical forecasts and controls, persistent inflation, maintenance of full employment booms, secular

growth, non-linear structural relations and macro functional distribution.

Income determination model including Money and Interest: IS LMmodel

In the earlier models the focus was entirely on the goods market. Certain simplifying assumptions were

made like the investment being autonomous, thereby completely avoiding the role of interest rates (and

money supply) in determining the level of income. But, it is a known fact that interest rates and money

supply have a major role to play in the economy. Monetary policy affects the economy first by affecting

the interest rate and then by affecting aggregate demand. An increase in the money supply reduces the

interest rate, increases investment spending and aggregate demand, and thus increases equilibrium

output. Changes in monetary and fiscal policy affect the economy through the monetary a fiscal policy

multiplier.

We study two markets the goods market and they money market and their linkages through two

economic variables interest rats and income. A two-market two variable model is developed with

relation to the economic operation of each market.

The IS-LM model presented in this chapter is the basic model of aggregate demand that incorporates the

money market as well as the goods market. It lays particular stress on the channels through which

monetary and fiscal policy affect the economy. The model is broadened by introducing interest rate as

an additional determinant of aggregate demand.

We first have to derive the IS curve for the goods market. The IS curve shows combinations of interest

rates and levels of income such that the goods market is in equilibrium. Increases in the interest rate

reduce aggregate demand by reducing investment spending. Thus, at higher interest rates, the level of

income at which the goods market is in equilibrium is lower: The IS curve slopes downwards.

Then, we shall study the asset market and derive the LM curve. The demand for money is a demand or

real balances. The demand for real balances increases with income and decreases with the interest


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rates, the cost of holding money rather than other assets. With an exogenously fixed supply of real

balances, the LM curve, representing money market equilibrium, is upward sloping.

Next, the interest rate and level of output are jointly determined by simultaneous equilibrium of the

goods and money markets. This occurs at the point of intersection of the IS and LM curves.

Finally, The IS and LM curves together determine the aggregate demand schedule. The aggregate

demand schedule maps out the IS LM equilibrium holding autonomous spending and the nominal

money supply constant and allowing prices to vary.

In the previous chapter we looked at a simple model of the goods market and found the value of GDP at

which equilibrium output equaled aggregate demand. We had one market goods cleared by one

variable GDP(Y). The first thing we do in this chapter is introduce the interest rate into the goods

market (via investment demand), leaving us with one market and two variables, GDP and the interest

rate (i). We will eventually call the goods market equation the IS curve.

Next we introduce the money market, where equilibrium is determined when the demand for moneyequals the supply of money. The demand of money depends on income and interest rates. The supply of

money is set by the Central Bank. Solving for equilibrium in the money market again gives us one market

and two variables, GDP and the interest rate. We will eventually call the money market equilibrium the

LM curve.

Finally, we put the goods and money markets together, giving us two markets (goods and money) and

two variables (GDP and the interest rate). The IS-LM model finds the value of GDP and the interest rate

which simultaneously clear the goods and money markets.

The good market and the IS curve

In this section we derive a goods market equilibrium schedule, the IS curve. The IS curve (or schedule)

shows combinations of interest rates and levels of output such that planned spending equals income.

The IS curve is derived in two steps. First, we explain why investment depends on interest rates. Second,

we insert the investment demand function in the aggregate demand identity just as we did with the

consumption function in the last chapter and find the combination of income and interest rates that

keep the goods market in equilibrium.


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The L-M Curve

The L-M schedule sets out all of the possible combinations of real output, y and the rate of interest, r

consistent with equilibrium in the money market.

The money market will be in equilibrium if

MD = MS

where

MD is the Demand for Money

and MS is the Money Supply

In the foregoing analysis, we will be examining the demand and supply of real balances.

i.e. MD/P = MS/P

where P is the price level

MD/P is the demand for real balances

MS/P is the real money supply

To make progress, we will examine the determinants of real money demand and real money supply.

The Demand for Money

In general, we can write that

MD/P = g(y, r)

where y is income and r is the rate of interest.

This expression indicates that the demand for real money balances depends on real income and the rate

of interest. To examine this more closely, we follow Keynes and partition money demand into 3

components or motives for holding money. Viz

y Transactions motivey Precautionary motivey Speculative motiveThe Transactions Motive for Holding Real Balances

Let the real money demand for transactions purposes be MDT/P

MDT is the amount of money carried around by an agent in a period in order to undertake known

transactions.

Keynes argued that the demand for real transactions balances will depend on the level of real income.


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i.e. MDT/P = f(y)

As real incomes rise, people will be able to afford to satisfy a greater range of wants and needs and will

plan to make a greater level of known expenditures in a period.

Therefore (MDT/P)/y > 0

This expression says that, as real incomes rise, the demand for real balances for transactions purposes

will also rise.

The Precautionary Motive for Holding Real Balances

Let the real money demand for precautionary purposes be denoted by

MDP/P

Where MDP is the amount of money held by an individual in a period in order to cater for unforeseen or

unpredictable transactions.

The demand for real balances for precautionary purposes will also depend on the level of real income.Thus

MDP/P = g(y)

As real incomes rise, the type and price of unforeseen or impulse purchases will also increase. Thus,

(MDP/P)/y > 0

i.e. as real incomes rise, the demand for real precautionary balances will likewise rise.

The Speculative Motive for Holding Real Balances

Denote the money demand for speculative balances as

MDS/P

It is this motive for holding money that links money demand to the rate of interest. Recall that the

classical economists regarded the interest rate as being determined in the capital market by

The flow of savings (supply of loanable funds)

The flow of investment (demand for loanable funds)

Classicists viewed that the rate of interest adjusted quickly to balance savings and investment.

Keynes rejected this view by arguing that the rate of interest was determined in the money market

There are several accounts/models which can be deployed to justify a relationship between MDS and r.

We will consider a simple account based on the notion of the Opportunity Cost (OC) of Holding Money.

There is a slightly fuller account in Appendix L-M

The opportunity cost of holding money can be regarded as what is lost by not holding your wealth in the

form of interest bearing assets. In simple approaches, there are 2 ways of holding wealth


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Money pays no interest

Bonds pay a rate of interest per period

Clearly, the OC of holding money is the interest payments foregone

N.B

. You can conceptualise money as notes, coins and zero interest bearing bank accounts such ascheque accounts. The alternative to this would be to hold interest bearing accounts (deposit or savings

accounts) or less liquid assets such as bills, bonds shares etc.

The argument is simple. If interest rates rise, the OC of holding money rises and people will hold less

money and more bonds. We can represent this insight graphically in Figure 1. At a low rate of interest,

r1 the incentive to switch from money into bonds is not great and people will tend to hold (demand)

more money, MDS1. At a high interest rate, r0 , the OC of holding money is high and people will

economise on money holdings (MDS0)

The Supply of Money

The real money supply / supply of real balances is denoted by MS/P. As prices rise the real money supply falls

and vice versa.

The money supply is taken to be exogenously determined and controlled by the monetary authority / central

bank. Thus, the money supply does not depend on either r or y and is a policy instrument which can be

changed at the behest of the authorities.

MD

S1/PMD

S0/P

MD

S/P

r1

r0

Figure 1 - Speculative Demand for Money


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Equilibrium in the Money Market

We can take our expressions for transactions, precautionary, speculative balances and the money supply and

set them out in Figure 2 . Here, re is the rate of interest/ price of bonds at which agents in the economy

willingly hold the issued real money stock.

Changes in the Money Supply

Suppose the Central Bank decided to increase the money supply from MS0 to M

S1. This would cause the money

supply line to shift out as seen in Figure 3. The money supply schedule shifts but the money demand curve is

unaffected because income, which determines transactions and precautionary holdings has not changed

r

MD/P

re

Figure 2- Equilibrium in the Money Market

MS/P

MD/P

MD

S/P

MD

T/P +

MD

P

MD/P = M

S/P

MD/P

& MS/P

MS1/PM

S0/P

re

0

re

1

r


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Following the increase in the money stock, money holdings are greater than those required to finance known

and precautionary transactions. Agents will attempt to purchase bonds driving up their price and down the

rate of interest from re

0 to re

1. The price of bonds will rise/ rate of interest fall until the increased money stock

is willingly held.

Thus, changes in r, the rate of interest, are the mechanism which re-equilibriate the money market. There is noa priori reason why r should also serve to equate savings and investment as the classical school believes.

Deriving the L-M Schedule

The L-M curve is defined as all values of r and y consistent with equilibrium in the money market. This suggests

that to derive the L-M schedule we should vary y and establish what happens to r in order to restore money

market equilibrium.

If y increases, both the transactions and speculative demand for money will increase out of a fixed real money

stock. This will require agents to sell bonds in order to finance higher known and precautionary purchases. If

there is increased selling pressure on the fixed stock of bonds, then the price of bonds will fall (i.e. the interestrate will rise). This is set out in Figure 4a for the case when income rises from y0 to y1 to y2 and where we

assume a linear money demand curve

We obtain the L-M curve by mapping r versus y. As real income increases the transactions and

precautionary demand for real balances increases out of a fixed real money stock. This necessitates

bond sales which drive down the price of bonds/ up the rate of interest in order to restore equilibrium in

the money market.

r

MD/P

Figure 4a Deriving the L-M Curve

MD/P (y=y2)

MS/P

MD/P (y=y1)

MD/P (y=y0)


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What Determines the Slope of the L-M Schedule

The slope of the L-M curve depends on

1. the interest sensitivity/ elasticity of the speculative demand for money2. the income elasticity of money demandYou should attempt to construct L-M schedules for different interest and income elasticities

What causes the L-M Schedule to Shift

The L-M curve is sets out all the combinations of r and y consistent with equilibrium in the money market.

Equilibrium in the money market results when MD/P = MS/P. The L-M curve is derived by varying real income

given a fixed real money stock and examining the changes in r required to maintain money market equilibrium.

If the real money stock changes, then a new L-M curve will be engendered.

The real money stock is the nominal money supply deflated by some measure of the price level. Thus:-

1. A rise in the real money stock results when either the nominal money supply rises or the price level falls.2. A fall in the real money supply results when either the nominal money supply falls or the price level rises.Consider a rise in the real money supply from (MS/P) to (MS/P)*.

r

y

Figure 4b Deriving the L-M Curve

y0 y1 y2

r0

r1

r2


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At the original level of the money stock, MS/P, the equilibrium rate of interest when y = y0 is r0. As incomeincreases to y1, the money demand schedule shifts up to M

D/P(y1). The higher money demand from a fixed

money stock causes agents to sell bonds to obtain money for increased transactions and precautionary

purposes. This causes the interest rate to rise until the money market returns to equilibrium at the higher

interest rate, r1. Mapping r versus y we obtain L-M.

When income is y0, an increase in the money stock from (MS/P) to (MS/P)* causes an excess supply of money

for transactions and precautionary purposes. Agents attempt to purchase bonds, increasing the demand for

bonds from a fixed supply. This drives up bond prices and down interest rates from r0 to r0* until the expanded

money supply is willingly held.

If income rises from y0 to y1 and the money supply is at the higher level (MS/P)*, there is an increased demand

for money for transactions and precautionary purposes. Agents attempt to sell bonds driving down the bond

price and pushing up the rate of interest from r0* to r1*. The L-M schedule for the expanded money stock is L-

M*.

MD/P(y0)

MD/P(y1)

y0 y1

r0*

r0

r1*

r1

(MS/P) (M

S/P)*r

real MD

& Ms

r

y

Figure 5: An Increase in the Money Stock causes the L-M

Curve to Shift Outwards.


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Thus, at any level of income, lower interest rates are necessary to equilibriate the money market given a rise in

the money supply. The higher money stock results in excess balances for transactions and precautionary

purposes which agents use to attempt to increase purchases of bonds. This drives up bond prices and down

the rate of interest. Therefore at any level of income, interest rates must fall to restore money market

equilibrium. Hence, a rise in the real money stock causes the L-M schedule to shift outwards.

Explain the concept of effective demand. In what respect is it important for the determination of level of

employment?

Keynes, measured employment in terms of national output or income. Thus greater the output greater shall

be the employment, and lesser the output lesser shall be the employment. But national output, in turn ,

depends upon effective demand.

In equilibrium,

Effective demand =National output or income =Employment

By effective demand we mean not mere desire but desire backed by ability and willingness to buy both consu


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KEYNESIAN THEORY AND UNDERDEVELOPED ECONOMIES.

Keynesian theory of employment does not apply in case of underdeveloped economies. The main

reason is that Keynes advocated his theory in the context of developed countries such as U.K., U.S.A etc.

Keynes built his theory on certain assumptions keeping a developed economy in mind but those

assumptions do not hold good in case of underdeveloped economies as their problems are quite

different from those of developed economies. The nature of unemployment in under-developed

countries is quite different. In the developed countries the unemployment is generated due to lack of

effective demand. Such unemployment is the emergence of conditions of depression which is purely

temporary and this type of unemployment is called cyclical unemployment or involuntary

unemployment. He suggested three important measures to be taken by the government to remove this

type of unemployment, namely (a) Supervision; (b) Public works programme; and monetary and fiscal

measures. The above tools or remedies to remove cyclic unemployment work well in case of developed

countries but do not apply in case of underdeveloped countries. The main reason for the non-

applicability of Keynesian tools or remedies in underdeveloped countries is that Keynes advocated his

theory in the context o a developed economy which was caught in the grip of depression and was facing

cyclical unemployment which is purely a temporary phenomenon and can be cured by the Keynesian

tools as said above. But the nature of unemployment in underdeveloped economies like India is quite

different from that of the developed economy.

Nature of unemployment in underdeveloped countries: The main cause of unemployment in the

developed countries is the lack of effective demand which is the result of less expenditure on

consumption and investment goods.

Because of less demand, volume of production fall in factories and consequently unemployment follows.

This type of unemployment is purely temporary and can be removed by Keynesian tools or remedies like

public works programme, monetary and fiscal policies. These measures will increase the effective

demand and remove the unemployment.With the help of these measures more money can be injected

in the country which in turn would increase the purchasing power of the people and thereby increase

the effective demand. The increase in effective demand would increase the level of unemployment.But

the nature of unemployment in underdeveloped countries is quite different from that in developed

countries. There is the chronic and permanent unemployment in underdeveloped countries.

Unemployment in underdeveloped countries arises mainly due to lack of capital resources and

technology. As a result of lack of capital resources people remain unemployed permanently. Further,

underdeveloped countries suffer from over-population and being predominantly agricultural countries

all the members of the family work on agricultural land but actually all of them are not required to work

there. Such people, no doubt, are seen working but actually there is no work for them and of these

people are removed from the work; there would be no loss in production. Thus these people are

unemployed in disguise and this type of unemployment is known as disguised unemployment and it

exists on a very large scale in underdeveloped countries. Therefore, Keynesian tools fail to remove

unemployment in underdeveloped countries.


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Keynesian assumptions do not hold good in underdeveloped countries:

Further, Keynes advocated his theory on certain assumptions which are valid in developed countries but

do not hold good in underdeveloped countries and for this reason also Keynesian theory is not

applicable in underdeveloped countries.

(1) Keynes assumption of unemployment is of short period (as exists in developed country) but inunderdeveloped countries the problem of unemployment is chronic and permanent.

(2) Keynes prescribes the remedy for cyclic unemployment which is due to lack of effective demandbut nature of unemployment in an underdeveloped country is different. Here there is disguised

unemployment and chronic unemployment due to lack of capital resources and technology.

(3) Keynes assumes that both labor and capital remain unemployed. This type of situation can beseen in developed countries but not in underdeveloped countries. In underdeveloped countries

it is labour that remains unemployed and not the capital since there is always a lack of capital.

(4) Keynes advocated his theory on the assumption of the closed economy which does not haveeither imports or exports but this assumption does not hold good in underdeveloped countries

because these countries have trade relation with other countries also.

Keynesian tools and remedies do not apply to underdeveloped countries:

1 Increase in effective demand: According to Keynes the level of effective demand determinesthe level of employment in a country. Thus to increase the employment effective demand

must be increased by raising the investment. This is true in a developed country but not in

an underdeveloped country since MEC (Marginal Efficiency of Capital) i.e. business

expectation is low and also other necessary factors needed for investment are lacking. So as

a result of increase in money supply, money income increases but the production does not

increase and consequently prices start increasing. Thus in an underdeveloped economy,

creation of credit money or deficit financing would not be enough to simulate investmentand have monetary measures simply to generate inflationary forces. Hence in

underdeveloped countries level of employment cannot be increased by increasing the

effective demand.

2 Propensity to consume: Keynes assumption which is based on a developed economy is thatwhen income increases, propensity to consume decreases and propensity to save increases.

But this is not true in case of an underdeveloped country. In underdeveloped countries the

propensity to consume does not increase with the increase in income. It remains equal to

unity i.e. it remains very high when income increases. The reason is that the standard of

living in these countries is very low and most of the expenditure is incurred on food grains.

These countries being dominantly agricultural countries cultivate more food grains andconsume more for self-consumption than for market. The result is that even with increase in

consumption, production does not increase and as a result of it the price starts rising.

3 Investment multiplier: It is an important tool of Keynesian theory. The existence of non-monetized economy also presents a problem in underdeveloped countries. So even though

the marginal propensity to consume is higher in these countries and therefore multiplier

should be higher yet in actual practice it fails to stand, because the increased demand is


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directed towards consumption goods (food etc.) industry which fails to offer effective

additional employment. Since the supply curve of food is highly inelastic in short period,

increase in the value of output need not necessarily lead to an increase in the volume of

output.

Underdeveloped countries are primarily agricultural countries. The agricultural producer is reluctant toact in the same way as the entrepreneur in developed countries as visualized by Keynes. Thus

investment multiplier does not function properly. The multiplier principle functions only when the

following assumptions are satisfied:

1. Existence of involuntary unemployment2. An industrial economy with rising supply curve3. Excess capacity in consumption good industries4. Elastic supply of working capital

But these assumptions do not hold good in case of underdeveloped countries. According to the view of

Mrs. Robinson, the existence of disguised unemployment introduces complications in the formal

scheme of General Theory of Employment. Where disguises unemployment prevails, increase in

income increases consumption not saving. Thus the working of multiplier theory fails and savings fail to

be equal to investment due to hoarding habit of the people in the underdeveloped countries. Household

enterprises prevail instead of market economy. They produce more for self consumption rather than or

market. The result is that even with increase in consumption, production does not increase and

consequently prices begin to increase. In the opinion of Dr. V.K.R.V.Rao the application of Keynesian

theory of employment in underdeveloped countries will lead to increase in prices rather than increasing

income and employment.

Thus, we conclude that Keynesian theory of employment is not applicable to underdeveloped countriesor two reasons: (i) assumptions of Keynesian theory do not hold good in these countries; and (ii)

Keyesian tools or remedies are not applicable to these countries.

income and employment

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