com232 business economics-ii

COM 232

BUSINESS ECONOMICS - II

M. Com (M 17) – Part ISemester - II

(Compulsory)

YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITYDnyangangotri, Near Gangapur Dam, Nashik 422 222, Maharashtra

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YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY

Vice-Chancellor : Dr. M. M. SalunkheDirector (I/C), School of Commerce & Management : Dr. Prakash DeshmukhState Level Advisory CommitteeDr. Pandit Palande Dr. Suhas Mahajan Dr. V. V. MorajkarHon. Vice Chancellor Ex-Professor Ex-ProfessorDr. B. R. Ambedkar University Ness Wadia College of Commerce B.Y.K. College, NashikMuaaffarpur, Bihar Pune

Dr. Mahesh Kulkarni Dr. J. F. Patil Dr. Ashutosh RaravikarEx-Professor Economist Kolhapur Director, EDMU,B.Y.K. College, Nashik Ministry of Finance, New Delhi

Dr. A. G. Gosavi Dr. Madhuri Sunil Deshpande Dr. Prakash DeshmukhProfessor Professor Director (I/C)Modern College, Shivaji Nagar, Pune Swami Ramanand Teerth Marathwada School of Commerce & Management

University, Nanded Y.C.M.O.U., Nashik

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N I B M , Pune Y.C.M.O.U., Nashik

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School of Commerce & Management, Y.C.M.O.U., Nashik

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M. Com. (M 17) Part – I (Business Economics - II)

(Compulsory)

Semester - II

Contents Pages

Unit 1. Market Structure and Price Determination under Perfect Competition 7 to 14

Unit 2. Price Determination and Firm’s Equilibrium Under Monopoly

and Monopolistic Competition 15 to 22

Unit 3. Price Determination and Firms Equilibrium in Oligopoly Market 23 to 32

Unit 4. Methods of Measuring National Income 33 to 44

Unit 5. Determination of National Income & the Multiplier 45 to 58

Unit 6. Determination of Price level and Aggregate Supply &

Demand Shocks 591 to 66

Unit 7. Money : Supply of Money 67 to 76

Unit 8. Money : Demand for Money 77 to 87

Unit 9. Demand for Money : Recent Developments 88 to 93

Unit 10. LS-LM Model of The Economy 94 to 108

Unit 11. Balance of Payments 109 to 121

Unit 12. Foreign Exchange Market and The Exchange Rate 122 to 130


INTRODUCTION

This book of self-instructional material is based on the syllabus for the subject“Business Economics-II” (Com. 232). In practice sometimes some peoplecall this paper is Managerial Economics because most of the topics coveredby business economics and concepts, theories and tools developed thereindeal with decision making and practical management in the working of abusiness unit, a firm or enterprise.

This book deals with basic concepts in business economics - i.e. - demand,supply, elasticity, revenue and cost concepts and curves, market structure,production function, demand projection.

The authors have kept in mind the fact that students here an distantstudents, sprend over a large territory, different environment and do nothave regular interaction with feachers. Therefore, if has been our ulmosteffort to simplify, without affecting scientific quality and precision, inthe organization of SIM. Necessary numerical examples and diagrams areused in explaination.

Comment, and modification and addition if any and welcome.

The editor and authors are grateful to the authorities of the YCMOU forguidance and co-operation.

Nashik - January, 2016

J. F. PatilEditor


Business Economics - II

6 Business Economics - II

NOTES


Business Economics - II 7

NOTES

Market Structure andPrice Determination under

Perfect CompetitionUNIT 1 : MARKET STRUCTURE AND

PRICE DETERMINATION UNDERPERFECT COMPETITION

Structure

1.0 Introduction

1.1 Unit Objectives

1.2 Subject Description

1.2.1 Market Structure and Degree of Competition

1.2.2 Price Determination and Firm’s Equilibrium under PerfectCompetition

1.2.3 Features of Perfect Competition

1.2.4 Price Determination in Perfect Competition

1.3 Summary

1.4 Key Words

1.5 Exercises

1.6 Books for Further Reading

1.0 INTRODUCTION

Generally there is only one objective of any firm in the market i.e. ProfitMaximization and cost minimization. In this unit we will study the market structureand degree of competition, price and output determination under perfectcompetition. Price and output determination of the firm depends on objectives ofthe firm and the kind of market structure in which they work.

1.1 UNIT OBJECTIVES

After studying this unit, you should be able –

l To understand the market structure and degree of competition.

l To explain the features of perfect competition.

l To analyze the price determination and firms equilibrium in perfectcompetition.

1.2 SUBJECT DESCRIPTION

1.2.1 MARKET STRUCTURE AND DEGREE OFCOMPETITION

Market structure plays an important role in firm’s choice of market




NOTES

struucture of price and output. In respect of firms, production and pricing behavior,influence is quite considerable.

In simple language market means that place where some goods are boughtand sold. In an economic sense, a group of buyers and seller exchanging acommodity is called market. According to Benham, “any area over which buyersand sellers are in such close touch with one another, either directly or throughdealers, that the price obtainable in one part of the market affects the prices paidin other parts.” Cournot defines, “Economists understand by the term market notonly particular place in which things are bought and sold, but the whole of anyregion, in which buyers and sellers are in such free contact with one another thatthe price of the same goods tends to equality easily and quickly.

Generally market structure is classified on the basis of degree of competition,i.e. (l) Perfect Competition (2) Imperfect Competition- (i) MonopolisticCompetition (ii) Oligopoly (iii) Duopoly and (3) monopoly.

The features of all these types of market and other details are shortlyprovided in chart No. 1.1.

Chart 1.1

Type of No. of firms Nature of Firms controlmarket product on price

or supply

1. Perfect Very large Homogeneous NoneCompetition number of product

firms (wheatvegetablesugar etc.)

2. Imperfectcompetition

I. Monopolistic Many firms Real or Perceived Somecompetition Product

differentiation

II. Oligopoly Few firms (a) without differentiation product e.g. sugar, bread, Some chemicals etc.

(b) Differentiated products, e.g. soaps, tea, toothpastes etc.

III. Monopoly Single seller without close considerablesubstitutes butproducts, e.g. usuallygas, telephones, regulated.electricity. etc.

IV. Duopoly Two sellers Homogeneous Retaliatory



NOTES


Perfect Competition

1.2.2 PRICE DETERMINATION AND FIRM’SEQUILIBRIUM UNDER PERFECT COMPETITION

In perfect competition a large number of firms compete against each other.Perfect competition is a wider concept than pure competition. Pure competitioncomprise large number of buyers and sellers, homogeneous product, free entryand exit in the market to buyers and sellers, etc. But in perfect competition certainother conditions are also satisfied.

1.2.3 FEATURES/CHARACTERISTICS OF PERFECTCOMPETITION

1. LARGE NUMBER OF BUYERS AND SELLERS

In perfect competition the numbers of buyers and sellers are very large.The share of each seller in the total supply of a product is very small that’s whyno single firm can influence the market price by changing its supply. Therefore,in perfect competition firms are price takers not price makers. Like that in thetotal demand of the market, the share of single buyer is very small. Therefore, nosingle buyer can influence the market price by changing this individual demandfor a product. In short the status of buyers and sellers in perfect competition islike a single drop of water in the sea.

2. HOMOGENEOUS PRODUCT

It is another important feature of perfect competition. Product homogeneitymeans buyers do not distinguish between products supplied by the various firmsof an industry. Product sold in such a market is homogeneous. According to qualityappearance and other features the buyers find same product in the market. Becauseof that, no seller or producer can attract the buyers for his product and chargehigher or lower price.

3. SINGLE PRICE

In perfect competition, homogeneity of the product helps for establishing asingle price. There are large number of sellers and buyers in the market. Butbecause of homogeneous product no seller can change a higher or lower priceand no buyer will pay higher or lower price the market price.

4. FREE ENTRY AND FREE EXIT

When there is possibility of earning profit new firms can enter the market.Similarly, if the firms face the problem of losses, they can leave the market. Thereare no legal or market barriers on entry or exit of the firms.

5. PERFECT MOBILITY

The factors of productions are freely mobile between the firms. This is theanother important characteristics of perfect competition. Perfect mobility meanswithout any delay inputs like labour and capital can be shifted from one use toanother.

6. PERFECT KNOWLEDGE

The participants in perfect competition have perfect knowledge about the




NOTES

market conditions. The sellers know the supply price of the product and also thebuyers know the quality and the price of the product. Therefore both sellers andbuyers cannot take extra advantage of each other.

NO GOVERNMENT INTERFERENCE

In perfect competition Government does not interfere in any way with theworking of the market. It works automatically. Government follows the freeenterprise policy.

1.2.4 PRICE DETERMINATION IN PERFECTCOMPETITION

In perfect competition single seller or buyer can not influence the marketprice. The market price is determined by the market forces like demand and supply.Therefore the role of seller in perfect competition is that of a price taker,’ not aprice maker.’ Price determination of the firm’s equilibrium in perfect competitionis analyzed three different time periods, i.e. (a) very short run (b) short run and(c) long run.

(a) Price Determination in very Short Run under Perfect Competition

Very short run refers to supply response to change in price is nil or a timeperiod in which quantity supplied is absolutely fixed. Each firm in the market hasa stock of commodity to be sold. All firms ‘stock of goods makes the total supply.The supply curve in very short run period is perfectly inelastic as shown by lineS1 S in Fig. 1.l. In this situation, the demand condition determines the price, supplyremains inactive agent. For instance suppose that the number of student rent (ofhostel) rooms in exam period is given at OS1, so that the supply curve SS1 takesthe shape of a vertical straight line. Suppose that the demand curve for such roomsis given by the demand curve D1. At that time, supply line SS1 and demand curveD1 intersect each other at point A, determining the rent at AS1. Let us supposethat relatively large number of parents decide to send their sons and daughters inrent rooms for study purpose due to Govt. job advertisement. Consequently thedemand curve D1 shifts upward to D2. Now the new demand curve D2 intersectthe supply curve S S1 at point S1 B. In this situation students room rental risesfrom S1 A to S1 B. Thus, B is the equilibrium rate of rental. It becomes price for allthe buyers. Another example of very short run markets may be of non-perishablecommodities like milk, fish, vegetable etc.

Number of Studentrent rooms

Fig 1.1 : Determination of Market Price

CHECK YOURPROGRESS

1. What is a market?Explain marketstructure.

2. Explain thecharacteristics offeatures of perfectcompetition.

2

1



NOTES


Perfect Competition

(b) Price Determination in Short Run Under Perfect Competition

In short run period, firms cannot change their size or exit from the market.Similarly new firms cannot enter the industry. It is not possible to decrease/increasethe supply by decreasing/increasing the variable inputs in short run. Thereforethe supply curve is inelastic in short run. Fig. 1.2 (A) and 1.2 (B) give the processof price and output determination in short run. In the fig. 1.2-A DD and SS showdemand and supply curve. At price PI supply curve (SS) and demand curve (DD)intersect each other determining the price at OP1 or QP. This price is fixed for allthe firms in the industry. The firms will have to adjust their output to the priceOP1. The output determination process is shown in fig. 1.2 (B).

1.2 (A) 1.2 (B)

Fig 1.2 : Pricing under Perfect Competition : Short run

At price OP1 or QP firm can sell any quantity, the horizontal straight lineAR = MR is the demand for the firms’ product. Price being constant, its AR(Average revenue) and MR (Marginal revenue) are equal. At point E firms upwardsloping MC curve intersects AR = MR. MC = MR at point E. therefore the firmsequilibrium point is E. The perpendicular ME determines the profit maximizingoutput at OM. At this output firm’s MC = MR. It satisfies the minimum requiredcondition of maximum profit. The area of P1TNE shows the total maximum profit.It is calculated as profit = Q (AR – AC).

Suppose the price falls from OP1 to OP2 due to downward shift in demandcurve to D1D1. At that time the firm will be in equilibrium at point E. Here againfirm’s AR1 – MR1 = MC. But here average cost is larger than the average revenue(AC > AR). That’s why the firm incurs loss. But since in the short run, it may notbe desirable to close down the production, firm will try to minimize the lossthrough output adjusting (OM) where firm covers its MC, i.e. M1E1. In short runthe firms survive so long as they cover their MC.

(c) Price Determination in the Long Run Under Perfect Competition

Like short run period demand and supply forces of the market determinethe long run market price. But in the long term, the firm can adjust its size or quitthe industry and new firms can enter the industry. When average cost is lowerthan the average revenue (AC < AR), then the firms make super normal or economicprofit. Due to that new firms enter the industry causing a rightward shift in thesupply curve. Likewise, if AC > AR, firms make losses. Due to that marginalfirms exit the industry causing leftward shift in the supply curve. Both the rightwardand leftward shift in the supply curve process continues” until price is sodetermined that AC = AR, and firms earn only normal profit. The price and outputdetermination process in the long run is shown in fig. 1.3 (A) and 1.3 (B).

1

1

1

1 1




NOTES

1.3 (A) 1.3 (B)

Fig. 1.3 : Long run Equilibrium of the Firm

In Fig. 1.3 (A), DD1 is the market demand curve which is relevant for bothlong-run and short run. SS1 is the short-run supply curve. At point P1 the marketdemand curve (DD1) and the market supply curve (SS1) intersect each other andthe short run market price is determined at OPo or N1P1. At price OPo, the firmsfind their short run equilibrium at point E1 and each of them produces outputOQ1.

According to revenue and cost conditions in fig. 3(B), the firms are makingsuper normal profit of E1M per unit. It leads to increase the market supply. In thissituation new firms will enter the industry and existing firms are taking the benefitof returns to scale and expand “their plant size. It is shown by long run averagecost curve LAC. Because of that, market supply would increase and supply curveshifts rightward from SS1 to SS2. It brings down the market price from OP1 toOP1 which is the long-run equilibrium price.

1.3 SUMMARY

l This unit analyses the market condition and degree of competition,features/characteristics of perfect competition and the pricedetermination and firms equilibrium in perfect competition.

l On the basis of degree of competition market structure are classifiedinto four categories. i.e. (a) Perfect competition (b) Monopoly (3)Monopolletic Competition and (d) Oligopoly.

l Profit maximization is the basic objective of all the markets.

l There are some features/characteristics of perfect competition. i.e. largeno. of sellers and buyers, perfect knowledge about the market, free entryand free exit, perfect mobility, single price, homogeneous product etc.

l In perfect competition single seller or buyer can not influence the marketprice. The market price is determined by the market forces like demandand supply. Therefore, the role of seller in perfect competition is that ofprice taker, not a price maker. Price determination of the firm’sequilibrium in perfect competition is analysed three different timeperiods, i.e. (a) very short run (b) short run and (c) long run.

l Very short run refers to supply response to change in price or a timeperiod in which quantity supplied is absolutely fixed. Each firm in themarket has a stock of commodity to be sold. All firm’s stocks of goods

CHECK YOURPROGRESS

1. Explain the priceand output deter-mination in perfectcompetition, in

(i) Very Short run

(ii) Short run

(iii) Long run

1



NOTES

make the total supply. The supply curve in very short run period isperfectly inelastic.

l In short run period, firms can not change their size or exit from themarket. Similarly, new firms can not enter the industry. It is not possibleto decrease/increase the supply by decreasing/increasing the variableinputs in short run. Therefore, the supply curve is inelastic in the shortrun.

l Like short run period demand and supply forces of the market determinethe long run market price. But in the long term, the firm can adjust itssize or quit the industry and new firms can enter the industry.

l Price and output are determined in the perfect competition by the forcesof market demand and market supply.

1.4 KEY WORDS

l Market : Market means that place where some goods are bought andsold.

l Perfect Competition : In perfect competition a large number of firmscomplete against each other.

l Very Short run : It refers to supply response to change in price is nil.

l Short run : In short run period, firms cannot change their size or exitfrom the market. Similarly new firms cannot enter the industry. It is notpossible to decrease/increase the supply by decreasing/increasing thevariable inputs in short run. Therefore, the supply curve is inelastic inshort run.

l Long run : In the long term, the firm can adjust its size or quit theindustry and new firms can enter the industry.

1.5 EXERCISES

1. What is a market? Explain market structure.

2. Explain features/characteristics of perfect competition.

3. Explain briefly the price and output determination, in very short periodin perfect competition.

4. Diagrammaticaly analyse the price and output determination in the shortrun period in perfect competition.

5. What is meant by perfect competition? Explain long run price and outputdetermination in the perfect competition.

6. Explain the price and output determination in perfect competition.

1.6 BOOKS FOR FURTHER READING

1. Ahuja H. L. : ‘Advanced Economic Theory’, S. Chand and Co., NewDelhi.

Price Determination andFirm’s Equilibrium

Under Perfect Competition




NOTES

2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics forBusiness’, Himalaya Publishin House, Mumbai, 2005.

3. Chaturvedi D. D., Gupta S. L. and Pal Sumitra : ‘Business EconomicsText and Cases’, Galgotia Publishing Company, New Delhi, 2006.

4. Dwivedi D. M. : ‘Managerial Economics-Theory and Application’,Himalaya Publishing House, Mumbai, 2006.

5. Hirshleifer J. and A. Glazer (1997) : ‘Price Theory and Applications’,Prentice Hall of India, New Delhi.

6. Jeffrey M. Perlof : ‘Micro Economics’ (IInd Ed.), Tata Pearson EducationAsia, 2001.

7. Lipsey R. G. : ‘Introduction to Positive Economics’, Oxford UniversityPress, New Delhi.

8. Misra S. K. and Puri V. K.: ‘Economics for Managment Text and Cases’,Himalaya Publishing House, Mumbai, 2006.

9. Mithani D. M. (2008) : ‘Managerial Economics’, Himalaya PublishingHouse, Mumbai.

10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), Thomson-South-Western, 2001.

11. Patil J. F. and Others (2014) : ‘Managerial Economics’, (IIIrd Edition),Phadke Prakashan, Kolhapur.

12. Samuelson Paul A. and William D. Nordhaus (2010) : ‘Economics’,(16th Edition), Tata McGraw Hill Education Private Ltd., New Delhi,1998.

r r r



NOTES

Price Determination andFirm’s Equilibrium under

Monopoly and MonopolisticCompetition

UNIT 2 : PRICE DETERMINATION ANDFIRM’S EQUILIBRIUM UNDERMONOPOLY & MONOPOLISTICCOMPETITION

Structure

2.0 Introduction

2.1 Unit Objectives

2.2 Price determination and firm’s Equilibrium under Monopoly

2.2.1 Features / characteristics of Monopoly

2.2.2 Price Determination in the Short-run Under Monopoly

2.2.3 Price Determination in the Long-run Under Monopoly

2.3 Price Determination and Firm’s Equilibrium Under MonopolisticCompetition

2.3.1 Features / Characteristics of Monopolistic Competition

2.3.2 Price Determination in the Short-run

2.3.3 Price Determination in the Long-run

2.4 Summary

2.5 Key Words

2.6 Exercise


2.0 INTRODUCTION

We have already seen how the price and output are determined in the perfectcompetition. Cost minimization and profit maximization is the main objective ofany firm in the market. In this unit we will study the price and output determinationunder monopoly and monopolistic competition.

2.1 UNIT OBJECTIVES

This unit will enable the reader –

l To understand the features / characteristics of monopoly.

l To analyze the price and output determination and firm’s equilibrium inmonopoly.

l To understand the features / characteristics of monopolistic competition.

l To analyze the price and output determination and firm’s equilibrium inmonopolistic competition.




NOTES


2.1 PRICE DETERMINATION AND FIRMSEQUILIBRIUM UNDER MONOPOLY

The word monopoly is derived from Greek words Mono Polein which meanssingle seller. When there is only one seller of a product having no close substitutein the market, it is known as monopoly market. There are several definitions ofmonopoly. According to Joel Dean, “A monopoly market is one in which a productof lasting distinctiveness is sold.” We will adopt here general definition of puremonopoly: it means an absolute power to produce and sell a commodity whichhas no close substitute. The features of monopoly help us explain the exact meaningof monopoly. These features are as follows.

2.2.1 FEATURES / CHARACTERISTICS OF MONOPOLY

1. Single Seller

In monopoly market we find only a single seller of a product and on theother side very large number of buyers.

2. No Close Substitutes

For monopoly market it is necessary that there are no close substitutes for theproduct. Because of that the buyers have to purchase the good from the monopolist.In monopoly market the cross elasticity of product is very low.

3. Entry Prohibited

In monopoly market entry of other firms is prohibited so in short-run and long-run the monopolist can enjoy abnormal profits.

4. Price Maker

Monopolist can decide at what price the product should be sold. But monopolistpower of price fixing is limited by demand reaction.

5. Price Discrimination

Like other markets profit maximization is the main motive of monopoly market.For that, monopolist charges different prices to different buyers for the sameproduct.

6. Control On Supply

In monopoly market, the monopolist controls commodity’s entire supply.Monopolist can maximize his profit by making appropriate adjustment in thesupply.

7. No difference In Firm And Industry

In monopoly market there is only one firm. There is no difference between industryand firm. The product demand curves of industry and monopolist firm are same.It’s slope is negative from left to right.



NOTES



The monopolist charged product price is higher than the competitive price.The society’s resources are not used optimally in monopoly. Therefore monopolyreduces the social welfare. There are four main factors which cause emergence ofmonopoly. Namely a) Natural factors b) Legal sanction c) Control over criticalraw material and d) very small market.

2.2.2 PRICE DETERMINATION IN THE SHORT-RUN UNDERMONOPOLY

The monopoly firm fixes its price and output at that point where it maximizesthe total profits. (MC = MR and MC intersects MR curve from below). The priceand output determination of monopoly firm in short-run is shown in Fig. 2.1.

Fig. 2.1 : price and output determination of monopoly firm in short-run

In fig. 2.1. AR = D shows average revenue or Demand curve and MR showsMarginal revenue curve, while short run marginal cost curve and average costcurve are shown by SMC and SAC. At point A, the MR and SMC intersect eachother (MR = SMC) and the firm’s profit maximizing output is OQ. According todemand curve AR = D the firm can sale per unit at single price i.e. OP or QC,output (OQ) where and total profit are also simultaneously determined. At pointA, monopoly firm maximizes its profit at that point where per unit average costof the firm is QB or OP1 and average revenue is QC or OP1. It means the firm canearn BC (QC – QB) or P1P (OP – OP1) profit per unit. According to this the totalprofit of the monopoly firm in short run is P1 B C P (OQCP – OQBP1) as shownby the shaded area.

2.2.3 PRICE DETERMINATION IN THE LONG-RUNUNDER MONOPOLY

Prohibited entry to other firms is an important feature of monopoly market.Due to that, entry of new firms in monopoly market is not allowed in long termalso. Monopoly firm can maximize its long run profit through expansion of thesize of its plant. The price and output determination of monopoly firm in long runis shown in Fig. 2.2.

In Fig. 2.2, the AR and MR curves show average revenue or market demandand marginal revenue of the firm. The long term cost conditions are shown byLAC and LMC curves. At point Z the MR and LMC curve intersect each other(MR = MC) and the firm determines the profit maximization output, i.e. OQ1. Atthat point per unit price is fixed on Q1P1 or OC. Thus in the long term equilibriumof monopoly firm’s price is Q1P1 or OC and equilibrium output is OQ1. This

KOutput




NOTES

combination of price and output that maximizes the profit of monopoly firm isshown by shaded area i.e. CP1 SD i.e. (OQ1P1L – OQ1SD).

Fig. 2.2 Monopoly Equilibrium in the Long-run

For profit maximization monopoly firm expands its plant size and overutilizes its long term capacity. It is shown in Fig. 2.2. At point J, the LAC andLMC intersect each other, it is optimal size of the plant but the monopoly firmfixed its output at S where profit is maximum. Optimum size of the monopolyfirm’s plant will not yield the maximum profit.

2.3 PRICE DETERMINATION AND FIRM’SEQUILIBRIUM UNDER MONOPOLISTICCOMPETITION

The real market structure is neither monopoly nor perfectly competitive.Combination of the two extremes is a more realistic market. It is calledmonopolistic competition by E. H. Chamberlin. In 1933, Chamberlin publishedhis famous book “Theory of Monopolistic Competition” and introduced thisconcept. There are some important features or characteristics of monopolisticcompetition. These are as follows.

2.3.1 FEATURES / CHARACTERISTICS OF MONOPOLISTICCOMPETITION

1. Many Firms

There are many firms in monopolistic competition, These firms competewith each other. Due to large number of firms the competitive elements enter inthe market. Any individual firm’s share in the total market is insignificant.

2. Selling Cost

It includes packaging cost, discount given to the consumers and dealers,cost incurred for advertising the product etc. Through the selling cost, the productdifferentiation is highlighted. It helps to shift the demand curve. Selling cost alsoincreases the firm’s monopoly power.

3. Independent Price Policy

Under monopolistic competition the firms can adopt independent pricingpolicy. It is the result of large number of firms in the market. Every firm in



NOTES

monopolistic competition can fix its output and price without considering theother firm’s output and price.

4. Product Differentiation

In monopolistic competition every producer’s product is slightly differentthan the others. Each producer’s product is close substitute for the others withslight difference in it. Due to that, every producer gets some monopoly power.But because of close substitutes, his monopoly power is limited. Every firm inmonopolistic competition adopts some methods for product differentiation e.g.quality, trade mark, colour fragrance, design, packaging, size and shape, warrantyperiod etc.

5. Falling Demand Curve

In perfect competition the demand curve is perfectly elastic. But inmonopolistic competition it is elastic. The selling cost and differentiation of theproduct give negative slope to the demand curve of a firm.

6. Social Loss

Like monopoly, monopolistic competition creates excess capacity of thefirm and incurs additional cost for advertisement. It results in social loss to thatextent.

2.3.2 PRICE DETERMINATION IN THE SHORT-RUN

Price and output determination under monopolistic competition is similarto that under monopoly. There are three possibilities in the short-run equilibriumin monopolistic competition i.e. (a) supernormal profit (b) Normal profit (c) losses.

(A) Super Normal Profit

Fig. 2.3 shows the supernormal profits of a monopolistic firm in the short-run

Fig. 2.3 (A) : Short run Equilibrium supernormal profit

In Fig. 2.3 (A), OX axis measures output and OY axis measures price,revenue and costs. Average revenue curve and marginal revenue curves are ARand MR. Short run average and marginal cost curves are SAC and SMC.

At point E, MC = MR. It is equilibrium position of the firm. At that pointSMC intersects MR with equilibrium output ON at price OP or NQ. In this situation

CHECK YOURPROGRESS

1. Define Monopolymarket and enlistfeatures ofmonopoly.

2. Diagrammaticallyexplain the priceand outputdetermination inmonopoly.






NOTES

.the average cost of the firm is NR or OS and the average revenue is NQ or OP.Therefore; AC < AR, and it implies that the firm is making supernormal profits ofQR or PS (NQ – NR or OP – OS) per unit of output. According to this PQRS(ONQP – ONRS) is the total profits of the firm shown by shaded area.

(B) Normal Profit

Fig. 2.3 (B) describes normal profit situation of the firm

Fig. 2.3 (B) Short-run Equilibrium- Normal Profits.

In Fig. 2.3 (B), at point I, MC = MR. It is equilibrium position of the firm.At that point SMC intersects MR and equilibrium output OQ at price OP or NQ.At point Q average revenue curve (AR) is tangent to the long run average costcurve (SAC), here the average cost (AC) and the average revenue (AR) of thefirm are the same i.e. NQ or OP. Therefore, the firm is neither incurring anylosses nor making supernormal profits in this situation. But the firm makes normalprofits.

(C) Losses

Fig. 2.3 (C) : Short-run Equilibrium Losses

In the Fig. 2.3 (C), at point G, MC = MR, it is equilibrium position of the firm.At that point SMC intersects MR and equilibrium output OQ at price OA or QB.In this situation the average cost of the firm is OD or QC and the averagerevenue is OA or QB. Therefore, AC > AR and it implies that the firm is makinglosses of BC or AD (QC – QB or OD – OA) per unit of output. According to thisABCD (OQCD – OQBA) is the total losses of the firm, shown by shaded area inthe Fig.

S

SN



NOTES

2.3.3 PRICE DETERMINATION IN THE LONG-RUN

We have seen that in the short run, monopolistic firm may make supernormal profit, normal profit and losses. But in the long term all these situationsdisappear. This will happen because in the long run new firms enter the industryor existing firms exit the industry for profits / dute to losses. Its affects demandcurve and it shifts accordingly. Due to that supernormal profits disappear and thefirms will be making normal profits only. Fig. 2.4 shows long-run equilibrium ofthe firm in monopolistic competition.

Fig. 2.4 : Long run Equilibrium

Like short-run in long run also MC = MR is the equilibrium position of themonopolistic firm. There is the second condition in the long term, i.e. AC = AR.

In fig. 2.4, LAC and LMC are the long run average and marginal costcurves. AR and MR are the long run average and marginal revenue curves. Atpoint G, MC = MR, at that point LMC intersects MR and equilibrium output isOQ at OP price. Another thing is, at this point long average cost curve (AC) andthe long run average revenue curve (AR) are also equal because at point B, averagerevenue curve (AR) is tangent to the LAC curve. Therefore, at B average costcurve (AC) and average revenue (AR) are equal i.e. QB and the monopolisticfirms make only normal profit.

2.4 SUMMARY

l This unit analyses the features/characteristics as well as price and outputdetermination and firms equilibrium in monopoly and monopolisticcompetion.

l There are some features/characteristics of monopoly, i.e. single seller,no close substitue, entry prohibited, price maker, price discrimination,control on supply etc.

l At the point of MC = MR, monopoly firm also fixes its production andprice.

l Monopolist charges different prices to different buyers for the sameproduct.

l There are some features/characteristics of monopolistic competition,i.e. many firms, selling cost, independent price policy, productdifferentiation, falling demand curve, social loss etc. Shortly, inmonopolistic competition, there are large number of sellers sellingdifferentiated products.

CHECK YOURPROGRESS

1. Define Mono-polistic market andexplain its charac-teristics/features.

2. Explain the priceand output deter-mination of mono-polistic market inshort run.

3. Diagramaticrftllyexplain the long runequilibrium ofmonopolistic firm.






NOTES

2.5 KEY WORDS

l Monopoly : The word monopoly is derived from Greek words MonoPolein which means single seller.

l Monopoly Market : When there is only one seller of a product havingno close substitute in the market, is known as monopoly market.

l Monopolistic Competition : The real market structure is neithermonopoly nor perfectly competative. Combination of the two extremesis a more realistic market. It is called monopolistic competition.

2.6 EXERCISES

1. What is meant by monopoly? Explain its features.

2. Explain the price and output determination in monopoly.

3. What is meant by monopolistic competition? Explain its characteristics.

4. Explain price and output determination in monopolistic competition :(1) Short run (2) Long run.



2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics forBusiness’, Himalaya Publishing House, Mumbai, 2005.






8. Misra S. K. and Puri V. K.: ‘Economics for Management Text and Cases’,Himalaya Publishing House, Mumbai, 2006.


10. N. Gregory Mankiw : ‘Principles of Economics’, (IInd Ed.), Thomson-South-Western, 2001.



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NOTES

Price Determination andFirms Equilibrium in

Oligopoly MarketUNIT 3 : PRICE DETERMINATION AND

FIRMS EQUILIBRIUM INOLIGOPOLY MARKET

Structure

3.0 Introduction

3.1 Unit Objectives

3.2 Price Determination and Firms Equilibrium in Oligopoly

3.2.1 Characteristics / Features of Oligopoly

3.2.2 Kinked Demand Curve

3.3.3 Collusive Oligopoly

3.3.4 Price leadership Models in Oligopoly

3.3 Methods of Price Determination in Practice

3.3.1 Pricing of Multiple Products

3.3.2 Price Determination Under Dumping

3.4 Summary

3.5 Key Words

3.6 Exercises


3.0 INTRODUCTION

We have already studied three market forms, i.e. perfect competition,monopoly and monopolistic competition. But in reality we find many oligopolisticindustries or markets. In this unit we will study the characteristics of oligopoly,kinked demand curve, collusive oligopoly, price leadership models in oligopoly,pricing of multiple products and price determination under dumping etc.

3.1 UNIT OBJECTIVES

This unit will enable the reader –

l To understand characteristics/features of oligopoly.

l To analyse the Kinked demand curve.

l To explain collusive oligopoly.

l To understand the price leadership models in oligopoly.

l To analyse the methods of price determination in practice.




NOTES

3.2 PRICE DETERMINATION AND FIRMSEQUILIBRIUM IN OLIGOPOLY

Oligopoly means “competition among the few”. Oligopoly refers to fewfirms or sellers in the market selling or producing a product. In simple words,when there are two or more than two, but not many, sellers or producers of aproduct in the market it is called oligopoly. In oligopoly the number of sellers orproducers of a product generally are two to ten. There are two types of oligopoly,(a) Pure oligopoly and (b) Differentiated oligopoly. When products of few sellersare homogeneous, it is called pure oligopoly. And when products of the few sellersor firms are differentiated, it is called differentiated oligopoly.

3.2.1 CHARACTERISTICS / FEATURES OFOLIGOPOLY

The main characteristics of oligopoly market are discussed below :-

1. Few Sellers

In oligopoly market, there are few sellers (2 to 10) supplying homogeneousor differentiated products.

2. Interdependence

In oligopoly, the price and output determination of the firms have a highdegree of interdependence in their business policies.

3. Imperfect Dissemination of Information

Cost, price and product quality information related to market are usuallynot publicized.

4. Homogeneous or Differentiated Product

In pure oligopoly, the firms may be selling products like steel /Aluminium/copper etc. which are homogeneous. And in differentiated oligopoly the firmsmay be selling distinctive products like automobiles passenger cars.

5. Blockaded Entry and Exit

In .oligopoly market, there are strong restrictions of entry or exit of thefirms.

6. Advertising

In oligopoly market, firms incur excessive expenditure on advertisementsto attract consumers towards their product.

7. High Cross Elasticity

In oligopoly market, the firms have a high degree of cross elasticities ofdemand for their product, due to which, there is always a fear of retaliation byrival firms.



NOTES


Oligopoly Market

8. Lack Of Uniformity

In oligopoly market, lack of uniformity in the size of different firms is alsoan important characteristic.

9. Constant Struggle

In oligopoly market, competition consists of constant struggle of rivals.

10. Kinked Demand Curve

In oligopoly market, the firms have kinked market demand curve for theirproducts.

Fig. 3.1 : Kinked Demand Curve

3.2.2 KINKED DEMAND CURVE

Paul M. Sweezy, an American economist, and Hall and Hitch of Oxforddeveloped kinked demand curve theory. In oligopoly market, there is no tendencyon the part of the oligopolists to change the price even if the economic conditionsundergo a change. Kinked demand curve explains this price rigidity very well.According to Hall and Hitch, “Each oligopolist believes that if he lowers theprice below the prevailing levels, his competitors will follow him and willaccordingly lower their prices, whereas if he raises the price above the prevailinglevels, his competitors will not follow his increase in price.”

As shown in Fig. 3.1, kinked demand curve. (DD1) is made of two segments,i.e. relatively elastic demand curve (DK) and relatively inelastic demand curve(KD1). The kinked demand curve DD1 has a kink at point K at the given priceOP. Before the kink point K, the demand curve is flatter and after the kink itbecomes steeper. At a given price OP, the demand curve above the kink is elasticand below the kink less elastic.

Kinked Demand Curve Theory of Oligopoly Prices

The kinked average revenue curve of the oligopoly firm is an importantpoint. In Fig. 3.2 (A) the kinked AR curve, in turn, implies a discontinuous MRcurve MK LR. Thus, the kinky MR curve explains the phenomenon of pricerigidity in the theory of oligopoly prices.

Discontinuous marginal revenue curve MK LR is shown in Fig. 3.2(A). Because of that, there is no change in equilibrium output, even though marginalcost changes, the price OP does not change, there is price rigidity.




NOTES

Fig. 3.2 (A) Discontinuous Fig. 3.2 (B) OligopolyMR Curves Price rigidity

In oligopoly market, by collusion, by price leadership or through someformal agreement, once a common price is reached, it tends to remain unchangedover period of time. At the point of equilibrium price, when the MR curve of thefirm discontinues, the price and output combination at the kink tends to remainunchanged even though MC may change. It is shown in fig. 3.2 (B).

In the Fig. 3.2 (B), firms marginal cost curve can fluctuate between MCand MC1 between the range of the gap in the MR curve. This fluctuation ofmarginal cost does not disturb the equilibrium position of price and output of thefirm. Therefore, the price and output remain same, i.e. OP and OQ, despite changein the marginal costs.

3.2.3 COLLUSIVE OLIGOPOLY

There are two main types of collusion, i.e. (a) cartels and (b) price leadership.In cartel, firms jointly fix a price and output policy through agreements. As againstthis in price leadership leading firm can set the price and others follow it.

Under cartel agreements, for price and output decisions the firms establisha cartel organization, through which they establish production quotas for eachfirm, supervise market activities of the firms in the industry. Cartels are all typesof formal, informal and tacit agreements reached among the oligopolistic firmsof an industry. In some countries like U.S.A. the formations of cartels have beenmade illegal by the Govt. passing laws against them. But, in spite of the illegalityof cartels, by adopting some means and through secret devices they are still formedin U.S.A. Cartel has a board of control. This Board runs the cartel’s work. Todetermine the market share for each member of cartel is one of the main functionsof the Board. Therefore, the marginal cost (MC) and marginal revenue (MR) forthe industry are calculated by the Board. The summation of industry’s MCs ofindividual firms is the MC for industry. The total output for the industry isdetermined through the industry’s MC and MR. which on the basis of the totaloutput is allocated between them in according with respective MC. In Fig. 3.3 isshown market allocation under cartel.

In Fig. 3.3, at point C, MC = MR, the industry output is determined at OQand price at PQ or P1O or CQ is the industry marginal cost which was determinedby the intersection of industry’s MC and MR at point C. If we draw a line frompoint C and parallel to OX axis through MCb and MCa to the OY axis , we obtainthe market share of firm A and firm B. The intersection point of C2 and C, determinethe level of output for firms B and A respectively. The output of firm B isdetermined at OQb and for firm A, it is OQa and OQa + OQb = OQ. So the profit ismaximum for each firm. Therefore, the firms will not change their price andoutput. This shows the price and output stability in the collusive oligopoly.

CHECK YOURPROGRESS

1. What is oligopoly ?explain itscharacteristics.

2. Explain Sweezy’skinked demandcurve.



NOTES


Oligopoly Market

Fig. 3.3 : Price and output determination under cartel

3.2.4 PRICE LEADERSHIP MODELS IN OLIGOPOLY

As mentioned above, another form of collusive oligopoly is priceleaderships. Under price leadership, one firm sets the price and other firms followit. There are four types of price leadership.

A. Price leadership by low cost firm.

B. Price leadership of the dominant firm.

C. Barometric price leadership and

D. Exploitative or Aggressive price leadership.

(A) PRICE LEADERSHIP BY LOW COST FIRM

To simplify our analysis under this head we make following assumptions.

1. There are two firms in the market. Firm A has lower cost of productionthan B.

2. Both firms A and B produce homogeneous product.

3. Each firm has equal share in the market.

Fig. 3.4 : Price and Output determination under low cost price leadership

MCc = MCa + MCb

Y

O

A

B

CAR

MR

Uni

tCos

tand

Rev

enue

KQ Q1

P1

P1

P

b

b

a

a




NOTES

In Fig. 3.4, the low cost or largest firm (Firm A), has its cost curves asshown by ACa and MCb. Whereas rival firms (Firm B) are smaller in size, havetheir cost curves as shown by ACb and MCb. Because of economies of scale thecost of production of largest firm (A) is lower than that of firm B. According tocost and revenue situation the largest or low cost firm (A) fix its price at OP1, orBQ, and sell quantity OQ1 (MC = MR). Therefore its profit is maximum. On theother side firm (B) would be in a position to maximize its profit at OP2 price andOQ output. But due to higher price (OP2), firm (B) loses customers to firm (A).Therefore, the high cost firm (B) is forced to accept the price OP. and accept theprice leadership of the low cost firm (A).

Sometimes low cost firm (A) can eliminate other firms through cutting theprice to OP or CQ1, where firm (A) can easily sell the whole output OQ, at priceOP1 or CQ1. But at price OP1 firm (A) will make only normal profits.

(B) PRICE LEADERSHIP BY A DOMINANT FIRM

Few firms in the industry produce very large portions of the total productionand therefore they dominate the market of the product. Other small firms areincapable of making any impact on the market. As a result, the dominant firm inthe industry estimates its own demand curve and fixes its profit maximizationprice. Other small firms follow the dominant firm, it is shown in Fig. 3.5.

Fig. 3.5 : Price leadership by the dominant firm

In Fig. 3.5 DDm is the market demand curve and Sb is the total supplycurve of the small firms. According to diagram, at a given price, the dominantfirm’s market share equals the market demand less the share of small firms.

Suppose, the market price is set at OP2, the smaller firm’s total supply isP2 L which equals the market demand. Therefore, the market left to the dominantfirm is zero at price OP2 when price falls from OP2 to OP, market demand is PMout of which PK is supplied by smaller firms. The market unsupplied by thesmaller firms is KM. Thus, at price OP, the dominant firms product demand equalsPM – PM = KM, the dominant firm’s demand for the product is JN. Rememberthat the gap between DDM and supply curve PO Sb below point L (Fig. 3.5 (A))measures the dominant firm demand.

In Fig. 3.5 (B), P2 DD is the demand curve for the dominant firm. MCD andMRD are the marginal cost and revenue curve of the dominant firm respectively.OP2 is the profit maximization output of dominant firm at price P1 P3 or OP. When

DM



NOTES


Oligopoly Market

dominant firm set its price OP, other small firms in the industry have to acceptthis price and then their joint market demand curve is the straight line PM(horizontal to OX axis), Fig. 3.5 (A) For maximizing their joint profits, smallfirms will produce only PK. It is small firms profit maximizing joint output.

(C) BAROMETRIC PRICE LEADERSHIP

The firm which has a better knowledge of the prevailing market conditionsand has an ability to predict the market conditions more precisely than any othercompetitive firm is called barometric firm. It is on old, largest and experiencedfirm which protects the interest of all firms. Barometric firm assesses the changein the market conditions with regard to the demand for the production cost, productcompetition from the close substitute products etc and makes best price for all thefirms in the industry. Automatically, other firms in the industry follow it willingly.

(D) EXPLOITATIVE OR AGGRESSIVE PRICE LEADERSHIP

Under this dominant or very large firm in the industry establishes itsleadership through aggressive price policy. According to this the dominant firmcompels the other firms in the industry to follow it in respect of price.

3.3 METHODS OF PRICE DETERMINATION INPRACTICE

The main methods of price determination in practice are as follows.

3.3.1 PRICING OF MULTIPLE PRODUCTS

For any firm the most important practical problem is to decide prices ofmultiple products. Following are the major methods for pricing of multipleproducts.

(i) Full-Cost Pricing

Multiple products prices can be set proportional to full costs of each product.For calculating ‘full costs’ every product assumes its full allocated share of‘specific1 as well as ‘common’ expenses. These allocations involve subjectiveelement and usually arbitrary but after a longer experience it can be done morescientifically. It completely ignores the demand condition in the market, it is thelimitation of this method.

(ii) Marginal Or Incremental Cost Pricing

According to this method various product prices are fixed proportional tomarginal costs of each one. In simple words, for each product estimates of MCand MR have to be made to decide price (AR) of that product. Some arbitrarydivision of total marginal costs are also involved in such marginal costing, Thereis one limitation of this method, i.e. it does not take into account the marketconditions.

(iii) Demand Based Pricing

According to this method, for all the products of a firm are calculated priceelasticities of demands and then according to elasticity consideration individual




NOTES

prices are fixed. This method completely ignores the cost consideration. It is thelimitation of this method.

(iv) Conversion Cost Pricing

Costs incurred in converting raw material into finished product are calledconversion cost. In this method, first of all conversion cost is calculated. In simplewords, the cost of labour and other overheads are included in conversion cost.Thus, on the basis of every product’s pricing with a certain profit margin. It is thevalue addition. This method is not useful practically since it requires moreparticulars of costs which are not separable in multiple-products.

(v) Life-Cycle Pricing

Every product has a life cycle. In first stage, a product may enjoy some‘novelty’, then a product becomes a ‘speciality’ and at last stage it may be just a‘common’ product. It happens because in primary stage the firm may not haveany rival at all, subsequently some other firms start. After certain period the pioneerfirm suffers stiffer competition, the buyers become ‘indifferent’ to the brand andhence the product becomes common. As per this method, pricing differs, in eachof the three stages of the life cycle of every individual product in a ‘multiple-product’ firm.

3.3.2 PRICE DETERMINATION UNDER DUMPING

The term dumping is used in the context of international trade. In shortdumping means price discrimination at international level. Dumping indicatesthat firm can charge different prices for the same product from the domestic andforeign buyers. In other words, when any monopoly firm exports its product toforeign countries at lower price than the domestic market price, it is called dumping.

Dumping becomes possible and profitable only if,

a. The producer has monopoly in the foreign and domestic market.

b. Demand elasticity of the product is different in the domestic and foreignmarket.

c. Complete Market separation with no possibility of resale. Pricedetermination in dumping is shown in Fig. 3.6.

Fig. 3.6 : Price determination under dumping

In the Fig. 3.6 the AR and MR of domestic market and foreign market isgiven in part A and part B respectively. Part C shows firms MC curve and jointMRD + Fcurve which was combine by domestic and foreign MR curves. In part C,of the figure at point C the firms MC curve interest MR curve (MRD + F), and it

E = ED + EF



NOTES


Oligopoly Market

determines the firm’s profit maximising output at OE. For dividing the outputbetween foreign and domestic market, if we drawing a line from point C in part(C) parallel to output axis through part (A) and (B), we get the line CG. This lineCG interest foreign market’s MRF curve and domestic market’s MRD curve, atpoint B and A respectively. Point B, determines the profit maximizing output offoreign markets at OEF at the price of OPF. Similarly, point A, determines theprofix maximising sale in the domestic market at OED and profit maximisingprice at OPD.

According to this, we can say that, firms total profit maximising output OE= OED + OEF and the price fixed for the domestic market (OPD) is higher them theprice fixed for the foreign market (OPF). This price defferential is known asdumping.

3.4 SUMMARY

l This unit analyses characteristics/features of oligopoly, kinked demandcurve, collusive oligopoly, price leadership models in oligopoly, pricingof multiple products and price determination under dumping.

l Oligopoly means ‘competition among the few’. It refers to few firms orsellers in the market selling or producing a product.

l The main characteristics of oligopoly market are, few sellers,interdependence, homogeneous or differentiated products, advertising,blocked entry or exit, high cross elasticity, kinked demand curve etc.

l Paul M. Sweezy and Hall and Hitch developed kinked demand curvetheory.

l In collusive oligopoly, there are two main types of collusion, i.e. (a)cartels and (b) price leadership.

l In cartel, firms jointly fix a price and output policy through agreements.As against in price leadership, one firm can set the price and othersfollow it.

l Pricing of multiple products is the main method of price determinationin practice.

l The term dumping is used in the context of international trade. Dumpingmeans price discrimination at international level.

3.5 KEY WORDS

l Oligopoly : It means competition among the few. When there are twoor more them two, but not many, sellers or produces of a product in themarket it is called oligopoly.

l Cartel : In cartel, firms jointly fix a price and output policy throughagreements.

l Dominant Firms : Few firms in the industry produce very large portionsof the total production and therefore they dominate the market of theproduct.

l Dumping : The term dumping is used in the context of internationaltrade. Shortly, dumping means price discrimination at internationallevel.

CHECK YOURPROGRESS

1. Explain the pricingof multiple product.

2. How the pricedetermine indumping.




NOTES

3.6 EXERCISES

1. What is oligopoly? Explain its characteristics.

2. Diagrammatically explain Sweezy’s kinked demand curve.

3. Explain the price and output determination in a cartel?

4. Distinguish between (i) oligopoly and monopolistic competition and(ii) monopoly and monopolistic competition.

5. Define dominant price leadership model and discuss its advantages.

6. Explain the price leadership by low cost firm.

7. Shortly explain (i) barometric price leadership and (ii) exploitative oraggressive price leadership.

8. Explain the pricing of multiple products.

9. Explain the price determination in dumping.



2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics forBusiness’, Himalaya Publishing House, Mumbai, 2005.








10. N. Gregory Mankiw : ‘Principles of Economics’, (IInd Ed.), Thomson-South-Western, 2001.



r r r



NOTES

Methods of MeasuringNational IncomeUNIT 4 : METHODS OF MEASURING

NATIONAL INCOME

Structure

4.0 Introduction

4.1 Unit Objectives

4.2 Concepts of National Product

4.2.1 Methods of Measuring National Income

4.2.2 Difficulties in the Measurement of National Income

4.2.3 International Comparison of National Income

4.3 Summary

4.4 Key Words

4.5 Exercises


4.0 INTRODUCTION

Rapid and all round economic development is the main aim of every countryin the world. National income is a parameter or method of measuring economicdevelopment of the country. Through national income data we can measure theeconomic performance of the whole economy. In the period of one year orstipulated time the final outcome of all economic activities of a nation valued interms of money is called national income. It is an important macroeconomicvariable. The data or information related to national income is useful for policymakers, international comparison as well as economic forecasting. The basicconcepts of national income are used in business decisions and business analysis.This unit presents meaning of national income, concepts of national product,methods of measuring national income and international comparison of nationalincome.

4.1 UNIT OBJECTIVES

After studying this unit, you should be able –

l To understand the meaning and definitions of national income.

l To study the different concepts of national income.

l To analyse the various methods of measuring national income.

l To make international comparison of national income.




NOTES

4.2 CONCEPTS OF NATIONAL PRODUCT

4.2.1 DEFINITION OF NATIONAL INCOME

National income is an uncertain term. Therefore, it has been defined in anumber of ways. In simple language national income means the total income ofthe nation. In real terms, national income means the money value of all finalgoods and services produced in a country during a period of one year. But inmodem economy national income takes into account depreciation value. We canexplain the exact meaning of national income with the help of some definitions.

I. A. C. PIGOU

“National income is that part of objective income of the community,including of course income derived from abroad, which can be measured inmoney.”

II. MARSHALL

“The labour and capital of a country acting on its natural resources produceannually a certain net aggregate of commodities, material and immaterial includingservices of all kinds and net income due on account of foreign investments mustbe added in, this is the true net annual income or revenue of country or nationaldividend.”

III. SIMON KUZNETS

“National income is the net output of commodities and services flowingduring the year from country’s productive system in the hands of the ultimateconsumers.”

4.2.2 MEASURES OF NATIONAL INCOME

National income is the broader concept. It includes number of smallconcepts. These various concepts are also known as the measures or concepts ofnational income.

A. GROSS DOMESTIC PRODUCT (G.D.P.)

This concept is concerned with the income or output of that particularcountry only. It includes net export value but excludes income derived from abroadin the form of income from investment. According to Samuelson and Nordhaus“Gross Domestic Product is the name we give to the total dollar value of the finalgoods and services produced within a nation during a given year.” In Indian context,GDP refers to the total rupee value of the output of goods and services producedwithin the economy of India during the period of one year. GDP excludes incomefrom abroad but includes the depreciation value of the capital assets, (e.g.machinery.)

B. GROSS NATIONAL PRODUCT (G.N.P.)

GNP is an important concept in national income accounting. GNP measuresthe total flow of aggregate supply or output of goods and services at market value



NOTES

Methods of MeasuringNational Income

(money value)in the period of one year in a country, including net income fromabroad. GNP as defined is, “The total market value of all final goods and servicesproduced in a year.”

The concepts of GDP and GNP are slightly different. GDP is the outputproduced by labour and capital located inside India, whereas GNP is the grossoutput produced by labour and capital owned by Indian residents. In short, whenwe add net income from abroad to GDP then we get the GNP. While studying theconcept of GNP, we must remember following things.

(i) GNP is a monetary value. It includes money value of all types of goodsand services produced in a country during one year.

(ii) GNP is the money value of final goods and services i.e. goods andservices which are purchased for final use only and not for processingor further use in production or for resale.

(iii) For measuring G.N.P. it is necessary to avoid double counting. All goodsand services should be counted only once. Suppose, we measure thevalue of sugar, then we should not again measure and include the valueof sugarcane from which the sugar is made in G.N.P.

C. NET NATIONAL PRODUCT (N.N.P.)

It we deduct the value of depreciation of the capital assets from GNP, weget Net National Product (NNP). It refers to the value of the net output of theeconomy during the year. For calculating the NNP, it is necessary to add incomefrom abroad and to deduct the depreciation value of machinery, equipments, etc.To put it symbolically :-

NNP = GNP – D, where D = Depreciation Allowances

In the production process, some capital goods (e.g. machines, equipmentsetc.) are used. Due to use in production process, the value of these capital goodsfalls. This fall of value is known as depreciation.

D. NATIONAL INCOME AT FACTOR COST

It is also known as national income. If we add subsidies in NNP and deductindirect taxes, we get national income at factor cost. Basically it is the summationof all incomes earned by resources suppliers who contribute in the process ofproduction. (i.e. land, labour, capital and entrepreneurs). The market prices ofgoods and services increase by indirect taxes, but they do not constitute sourcesof personal income for the suppliers of factors of production. Therefore, it isnecessary to deduct indirect taxes from NNP. Similarly, subsidies are the part ofpersonal income for the suppliers of factors of production. Subsidies are notincluded in the factor prices. Therefore, it is necessary to add subsidies to NNP.This can be explained with the help of an example : Suppose a particular type ofcotton shirt sells for Rs. 500 in the market. This price includes Rs. 50 as exciseduty and Rs.50 as sales tax. It means that factors engaged in the production ofcotton shirt get Rs. 400 only and not Rs. 500. Suppose, on the other side a handloomkhadi cap is subsidised at the rate of Rs. 20 per piece. If the market price of khadicap is Rs. 60, against its cost production of Rs.80, then the factors of producingthe cap, get not only Rs. 60, but also Rs. 20, which are given by the Govt. assubsidy.




NOTES

E. PERSONAL INCOME (P.I.)

Prof. J. M. Keynes has introduced the concept of personal income. Thesum of all income actually received by all household or individuals during oneyear is known as personal income which is the aggregate earned and unearnedincome. It includes payments made by the Govt. as well as by the private businesssectors to the individual. In national income, transfer payments are not included.But they are included in personal income. Therefore P. I. is never equal to the NI.In short, we define personal income as.

Personal Income (P. I.) = National Income (N.I.)

– Corporate income tax.

– Undistributed corporate profits.

– Social security contributions.

+ Transfer payments.

F. DISPOSABLE INCOME (DI)

The households or individuals can use some part of personal income fortheir consumption or investment purpose according to their own choice. It is calleddisposable income (D. I.). The households or individuals have to pay a part ofpersonal income to the Govt. by way of direct taxes. That part of P.I., which is leftbehind after payment of direct taxes is called disposable income (DI). It is definedas –

Disposable Income (DI) = Personal Income (P. I.) – Direct taxes/personal taxes.

G. PER CAPITA INCOME (PCI)

PCI is an indicator of economic development of the country. Per capitaincome means the average income of the people in a year. If the national incomeis divided by the population of the country in a particular year, we get per capitaincome. It is expressed in symbolic form as –

National Income (NI)Per Capita Income (PCI) = ___________________

Population

H. MONEY INCOME AND REAL INCOME

On the basis of current year or base year prices national income, is dividedinto two categories i.e. National income at current prices/Money income andNational income at constant prices/Real income.

(i) Money Income

It is the income in the form of a-flow of money. In money income, theeffects due to price level changes are taken into account. Generally money incomerises because of the rise in price level, caused by increased money supply andother reasons.

(ii) Real Income

It is income in the form of a flow of purchasing power. There is inverserelationship between real income and price level. It is not found that increased or

CHECK YOURPROGRESS

1. Define NationalIncome and explainthe followingconcept.

I. GDP

II. GNP.

III. NNP

IV. PI.

V. DI.

VI. PCI.



NOTES


decreased money income means increased or decreased real income. It is onlywhen price level remains stable, decrease or increase in money income will besimilar and equal to decrease or increase in real income.

4.2.3 METHODS OF MEASURING NATIONALINCOME

National income data is generally used for economic planning, comparisonovertime and space, measurement of growth, regulating the economy anddistribution etc. There are three methods of measuring national income i.e. Theoutput or value added method, Income method and Expenditure method. We shallexplain these methods one by one.

I. THE OUTPUT OR VALUE ADDED METHOD

The output method is also known as product method. According to thismethod, the money value of all goods and services produced by all the firms of alltypes in year is measured. This method, first of all, measures total output of allgoods and services produced into three productive sectors, namely, primary,secondary and tertiary. Then it derives its money value. From this we deduct thedepreciation of capital stock, indirect taxes etc. and add income from abroad andsubsidies to obtain the figure of national income. But, there is possibility of doublecounting of goods and services. To avoid possibility of double counting, thismethod suggests two approaches, i.e. a) final goods approach and b) value addedapproach. The former measures national income by taking into account marketvalue of all final goods and services produced during a year in the country, whilethe latter considers the value added at each stage of production to arrive at thefigure of national income.

For the computing national income by product method, some precautionsmust be taken.

l Avoid double counting of goods and services.

l Income from abroad and subsidies must be carefully considered anddepreciation of capital stock and indirect taxes should be deducted.

l Deduct the value of imports and add the value of exports.

l Goods and services produced by the Govt. for departmental use are tobe valued and added to net national product.

II. INCOME METHOD

This method is also known as factor cost method. In the production process,factors of production like land, labour, capital and entrepreneurship co-operate.These factors of production get rewards for their services rendered in production.These factor prices (rent, wages, interest and profit) are incomes of the factors ofproduction. According to this method, if we add up income for all factors ofproduction in one year, we get national income. In short, if we take the summationof rent, wages, interest and profits in a year, we get national income. It is clearthat national income computed by the product method must be equal to nationalincome computed by the income method. For measuring national income withthe help of this method, it requires data related to factors of production. This datais compiled from income tax returns, reports, books of accounts and estimates forsmall income and published accounts etc.




NOTES

However, while measuring national income by income method, someprecautions must be taken.

l Income received from all transfer payments (gifts, pension, gambling,unemployment allowances etc.) are to be deducted from nationalincome.

l If the balance of international trade is in surplus, it will be included anddeficit will be deducted from national income.

l Services for payment should be included and unpaid services (e.g.housewife) are to be excluded.

l All indirect taxes are to be excluded from national income.

l Deduct income paid abroad and add income from abroad.

l Government subsidies should be included. But, income of the Govt.and semi Govt. undertakings is to be included in the nationalincome.

(iii) Expenditure Method

This method is also known as total outlay method. According to thismethod, national income can be measured by adding all final expendituresmade for purchase of goods and services in a year. Expenditure method takesinto account the total expenditure in a year incurred on the various items. Forsimple understanding, total expenditure of the economy can be divided into fourgroups:

l Personal consumption expenditure.

l Gross private domestic investment expenditure.

l The net foreign investment expenditure.

l Government expenditure on purchases of goods and services.

For consumption purpose, people spend large part of their income on goodsand services. This is known as personal consumption expenditure. Expenditureincurred by all firms to maintain their capital assets like plant, machinery,equipments, buildings etc. is known as gross private domestic investmentexpenditure. The difference between expenditure incurred by foreigners on ourgoods and services and our expenditure on foreign goods and services is knownas net foreign investment. For purchases of goods and services, expenditureincurred by Govt is known as Govt. expenditure on goods and services. When allthese expenditures are added up, we get gross national product. From this, if wededuct depreciation, indirect taxes and add subsidies, we get national incomewhich is also known as net national product at factor cost.

4.2.2 DIFFICULTIES IN THE MEASUREMENT OFNATIONAL INCOME

The measurement of national income is a highly complex process. Thereare number of difficulties that are faced in computing the national income. Theyare classified into two categories, (A) General difficulties and (B) Difficulties inunderdeveloped countries.



NOTES


(A) GENERAL DIFFICULTIES

1. National Income definition

There are several definitions of national income. According to thesedefinitions, it is very difficult to decide what goods and services are to be includedin national income. For example, the housewife work/service are to be includedin national income or not is a question.

2. Nature of Production

Sometimes the production of large number of goods and services isundertaken on a large scale in a year. But, according to product method, it becomesvery difficult to calculate the total output needed for measuring national income.

3. The Problem of Double Counting

It is necessary that double counting is avoided, when we measure the nationalincome by output method. Suppose, if we count the value of sugar, then we mustnot again count the value of sugarcane. To avoid this problem the market value ofonly final goods and services are to be counted.

4. Income from Illegal Activities

Income from illegal activities like black marketing, smuggling, gambling etc. isto be excluded when we calculate the national income with income method. Butin expenditure method, expenditure out of the income received from illegalactivities is taken into account. This is contradictory.

5. Measuring Depreciation

We know that to get national income, depreciation of capital assets has to bededucted from GNP. But, the capital assets depreciation will depend on the intensityof its use, technical life of the asset, nature of the asset and its maintenance, etc.So measuring the capital asset depreciation is very difficult task.

6. Income in Kind

It is necessary that all types of income is counted in national income, when weuse the income method for measuring the national income. But the countries inwhich factor prices are paid in kind, it is difficult to calculate national incomewith the help of income method.

7. Problems Regarding Govt. Services

Every country’s Govt. provides a variety of services e.g. defence, publicadministration, law and order, etc,. Calculating the market value of such Govt.services is difficult because many of these services are greatly subsidized or free.

8. Accurate and Reliable Data

When we calculate the national income with the help of any method, a lot ofreliable multi faced data is required. But, in reality it is very difficult to collectsuch type of data. Therefore, computing the national income is a very difficulttask.




NOTES

(B) DIFFICULTIES IN UNDERDEVELOPED COUNTRIES

1. Lack of Trained and Efficient Staff

For calculating the national income by any method, trained and efficientstaff is required. But, in underdeveloped countries like India it is very difficult toavail trained and efficient staff.

2. Lack of Proper Accounting Habits

Large number of people in underdeveloped countries are engaged inagricultural sector and illiterate. Because of illiteracy they rarely keep accountsof their economic transactions. Some literate people keep accounts but becauseof misunderstanding they do not co-operate with the machinery for data collection.

3. Problem of Classification

Household enterprise is the predominant unit of production inunderdeveloped countries. A number of production activities are performed bythese household enterprises simultaneously. These production activities belongto several occupational categories and groups. It is very difficult to apply modernindustrial classification in such cases.

4. Problem of Common Denominator

Number of people in the economy perform different economic functions. Itis very difficult to calculate numerous activities with a single yardstick. It is notpossible to compare and add together the work of traditional mason and amechanical engineer or peon and management consultant or novelist and cine-actor.

5. Unorganized Sectors of Production

There is always a large unorganized production sector in undeveloped countries.Unorganised sectors like agriculture, household crafts and petty traders do notuse common pattern of accounting of economic activity.

6. Existence of Non-monetised Sector

Till today in India, 20 to 30% of the economy is non-monetised. In ruralarea, people carry their economic transaction in the form of barter system.Similarly, in agriculture a huge portion of production is used for self consumption.Therefore, it does not enter the market. It is very difficult to calculate thesetransactions in terms of money.

Measurement of national income in India

In India, a combination of any two methods or all three methods is used tocalculate the national income. The Bowley- Robertson committee has suggestedthe adoption of the income method for minor sector and product or output methodfor major sectors of Indians. Against this the national income committee suggestedonly’ income method for calculation of national income in India. Today, in India,a combination of product or output and income method is used to measure thenational income. India’s national income data is obtained from annual reports ofcurrency and finance of the RBI, annual economic survey published by ministry



NOTES


of finance, Govt of India and the website (www.fmmin.nic.in) of the financeministry.

4.2.3 INTERNATIONAL COMPARISON OF NATIONALINCOME

International comparison of gross national income per capita for the year2011 (atlas method and purchasing power parity method is given in the followingtable no 4.1. The World Bank has divided all countries in the world under fourcategories, namely (a) Low income (b) Middle income (c) Low and middle incomeand (d) High income.

Table No 4.1 : Gross National Income Per Capita - 2011

Atlas Methodology Purchasing Power Group of Countries (Us dollars) Parity-PPP

(International dollars)

1. Low-income 569 1370

2. Middle incoii e 4144 7214

Lower middle income 1764 3811

Upper middle income 6563 10699

3 . Low and Middle income 3648 6397

East Asia and Pacific 4248 7266

Europe and Central Asia 7733 14306

Latin America & Caribbean 8575 11582

Middle East & North Africa 3865 X8046

South Asia 1301 3296

Sub Saharan Africa 1257 2219

4. High income 39861 38524

Euro area 38654 35243

• Source : http://databank.worldbank.org Date : 20/03/13

A comparative view of Gross Domestic Product (Purchasing PowerParity) per capita of top fifteen rich countries in the world and India is given intable No. 6.2 based on World Bank, International Monetary Fund and CIA worldfact book.

Following table (4.2) includes list of fifteen rich countries by GDP at PPPper capita, that is, the value of all final goods and services produced within acountry in a given year divided by the average (or mid-year) population for thesame year. GDP dollar estimate are derived from PPP per capita calculations.These calculations prepared by various organizations for the same country tendto differ. All figures in the table (4.2) are in current international dollars (Intl. $).

According to table (4.2), if we compare India’s GDP (PPP) per capita toother rich countries in the world, it is clear that India is not included in top 125countries in the world ranking. According to CIA world fact book, India’sGDP (PPP) per capita is only $3900, which is too much lower than the othercountries.

CHECK YOURPROGRESS

1. Explain themethods ofmeasuring Nationalincome.

2. What is mean bymethod income?Explain the diffi-culties in themeasurement ofNational income.




NOTES

Table No 4.2 : GDP (PPP) Per Capita.

Wor

ld B

ank

Inte

rnat

ion

al M

onet

ary

Fu

nd

CIA

Wor

ld F

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(200

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11)

(201

0-20

11)

(200

9-20

12)

Ban

kC

oun

try

Intl

. $Y

ear

1.L

uxem

bour

g89

012

2011

2.Q

atar

8831

420

11

3.S

inga

pore

6068

820

11

4.N

orw

ay60

405

2011

5.K

uwai

t54

283

2011

6.B

rune

i51

760

2011

7.S

wit

zerl

and

5126

220

11

8.U

nite

d S

tate

s48

112

2011

9.U

nite

d A

rab

Em

i.47

893

2011

10.

Net

herl

and

4277

220

11

11.

Aus

tria

4219

620

11

12.

Irel

and

4168

220

11

13.

Sw

eden

4146

720

11

14.

Den

mar

k40

908

2011

15.

Can

ada

4037

020

11

126.

Indi

a36

2720

11

• S

ourc

e :

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n.w

ikip

edia

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ist_

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PP

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: 20

/3/2

013

Ban

kC

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Intl

. $Y

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1.Q

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9894

820

11

2.L

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559

2011

3.S

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5971

020

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4.N

orw

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396

2011

5.B

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536

2011

6.U

nite

d S

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328

2011

7.U

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d A

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2011

8.S

wit

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4445

220

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9.S

an M

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090

2011

10.

Net

herl

and

4202

320

11

11.

Kuw

ait

4170

120

11

12.

Aus

tria

4084

720

11

13.

Aus

tral

ia40

847

2011

14.

Irel

and

4083

820

11

15.

Sw

eden

4070

520

11

130.

Indi

a36

6320

11

Ban

kC

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Intl

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1.Q

atar

1028

0020

12

2.L

iech

tens

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8940

020

09

3.L

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g80

700

2012

4.M

acau

7490

020

11

5.S

inga

pore

6090

020

12

6.N

orw

ay55

300

2012

7.H

ong

Kin

g50

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2012

8.B

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500

2012

9.U

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800

2012

10.

Uni

ted

Ara

b E

mi.

4900

020

12

11.

Sw

itze

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d45

300

2012

12.

Kuw

ait

4380

020

12

13.

Aus

tria

4250

020

12

14.

Aus

tral

ia42

400

2012

15.

Net

herl

and

4230

020

12

135.

Indi

a39

0020

12



NOTES

Methods of MeasuringNational Income4.3 SUMMARY

l National income means total income of the nation. In real terms, nationalincome means the money value of all final goods and services producedin a country during a period of one year.

l There are three important concepts of measurement of national income.

l Gross Domestic Product (GDP) is concerned with the income or outputof that particular country only.

l Gross National Product (GNP) measures the total flow of aggregatesupply or output of goods and services at market value in the period ofone year in a country, including net income from abroad.

l Net National Product (NNP) refers to the value of the net output (GNP-depreciation) of the economy during the year.

l If we add subsidies in NNP and deduct indirect taxes, we get nationalincome at factor cost.

l The sum of all income actually received by all households during oneyear is known as personal income.

l The household can use some part of personal income, for theirconsumption or investment purposes. It is called disposable income.

l Per capita income (PCI) means the average income of the people in ayear.

l Money income is the income in the form of flow of money.

l Real income is the income in the form of flow of purchasing power.

l There are three methods of measuring national income, i.e. (a) Outputmethod (b) Income method (c) Expenditure method.

l There are number of difficulties that are faced in computing the nationalincome, e.g. problem of double counting, income from illegal activities,measuring depreciation, unpaid services, lack of proper efficient staffetc.

l In India, a combination of any two or all three methods is used lo calculatethe national income.

l India’s GDP (PPP) per capita I $3900) is too much lower than the othercountries.

4.4 KEY WORDS

l National Income : It means the money value of all final goods andservices produced in a country during a period of one year.

l Gross Domestic Product (G. D. P.) : This concept is concerned withtthe income or output of that particular country only.

l Gross National Product (G. N. P.) : It measures the total flow ofaggregate supply or output of goods and services at market value (moneyvalue) in the period of one year in a country.

l Net National Product (N. N. P) : It we deduct the value of depreciationof the capital assets from G.N.P., we get NNP.




NOTES

l Personal Income (P. I.) : The sum of all income actually received byall households or individuals during one year is known as P. I. which isthe aggregate earned and unearned income.

l Disposable Income (D. I.) : The households or individuals can usesome part of personal income for their consumption or investmentpurpose according to their own choice. It is called D. I.

l Per Capita Income (P. C. I.) : It means the average income of thepeople in a year.

l Money Income : It is the income in the form of a flow of money.

l Real Income : It is the income in the form of a flow of purchasingpower.

4.5 EXERCISES1. Explain the meaning of national income and discuss the concepts of

GDP, GNP and NNP.

2. Distinguish between GDP and GNP.

3. Explain shortly the methods and difficulties in the measurement ofnational income.



2. Appannaiah H. R., Reddy D. N. and Shanthi S. : ‘Economics forBusiness’, Himalaya Publishin House, Mumbai, 2005.








10. N. Gregozy Mankiw : ‘Principles of Economics’, (IInd Ed.), Thomson-South-Western, 2001.


12. Samuelson Paul A.and William D. Nordhaus (2010) : ‘Economics’, (16th

Edition), Tata McGraw Hill Education Private Ltd., New Delhi, 1998.

r r r



NOTES

UNIT 5 : DETERMINATION OF NATIONALINCOME & THE MULTIPLIER

Structure

5.0 Introduction

5.1 Unit Objectives


5.2.1 Basic Model : Aggregate Supply and Aggregate Demand

5.2.2 Theory of National Income Determination

5.2.3 The Theory of Multiplier

5.3 Summary

5.4 Key Terms

5.5 Exercises


5.0 INTRODUCTION

Having studied the concept of national income & its measures, we nowturn to the theory of national income determination. It was J. M. Keynes, whofirst put forward a systematic analysis of factors that work together to determinenational income and general price level. The General Theory of EmploymentInterest and Money, published in 1936, gave a framework consisting of aggregatedemand and aggregate supply. Using this framework, we will explain as to howthe level of national income and price level are determined at a point of time in aneconomy. The basic model of the Keynesian theory involves derivation ofaggregate supply and aggregate demand curves for an economy consisting offour sectors. The four sectors of the economy are (a) Household sector, (b) Businesssector, (c) Government sector and (d) Foreign trade sector. The basic modeldeveloped will be used for explaining the determination of level of national incomeand prices and also for explaining the changes in both resulting either from thedemand side or supply side shocks.

5.1 UNIT OBJECTIVES

After studying this unit, you should be able to understand –

l The basic framework for an economy consisting of four sectors.

l The process of determination of national income.

l The shift in the aggregate demand curve and the multiplier effect on thenational income.

Determination of NationalIncome & The Multiplier




NOTES


5.2.1 BASIC MODEL : AGGREGATE SUPPLY ANDAGGREGATE DEMAND

The Keynesian theory of national income determination states that the levelof national income in an economy is determined by the level of effective demand.Effective demand for goods and services is that level of aggregate demand whichis equal to the aggregate supply at a point of time and thus is effective indetermining the level of national income. According to Keynes, aggregate demandin an economy, consisting of four sectors, is made up of four components namely,consumption demand (C) Investment demand (I), Government demand (G) andForeign demand (X – M). Each component of aggregate demand is determinedindependently by a set of factors. All components are added together to arrive atthe level of aggregate demand, which together with the aggregate supply determinesthe level of national income. Aggregate supply of goods and services refers to thegoods and services that are produced and supplied in an economy. Aggregatesupply of goods and services and the national product are the one and same thing,if we assume that all that is produced is supplied in the market. The productionlevel in an economy which determines the aggregate supply of goods & services,is a function of the quality and quantity of the factors of production available inthe country. Land, labour, capital, entrepreneurial talent and other raw materialare the factors that determine the level of production and thus aggregate supply ofgoods & services.

Based on above brief description the, Keynesian theory of national incomedetermination can be summarized in the form of a tree chart as below :-

National Income

Effective Demand

Aggregate Demand Aggregate Supply

Consumption Investment Land Capital otherDemand Demand raw

material

Level Propensity Rate of Marginal Labour Entrepreneurialof to of efficiency talent

Income consume interest of capital

Government ForeignDemand Demand

Public Public Exports Importsrevenue expenditure

Using the above tree chart the basic model can be developed in the followingmanner.



NOTES

A. AGGREGATE SUPPLY

Aggregate supply of goods and services refers to the total market value ofgoods and services produced and supplied in the market. As stated above, aggregatesupply in an economy is a direct function of production, which in turn is determinedby the quality and quantity of all factors of production. Higher the quantity offactors of production, higher will be the level of production and so the aggregatesupply. The Keynesian theory which explains the determination of national incomein the short run assumes the level of production and thus the aggregate supply asgiven. This is because, from the point of view of an economy as a whole, thequantities of almost all the factors of production cannot be altered (i.e. increasedor decreased) in the short run. The production level and thus the level of aggregatesupply remains to be given in the Keynesian basic model.

According to Keynes, how much will be actually produced and supplied,will therefore be determined by the level of aggregate demand. In other words, inthe short run the maximum output that an economy can produce and supply isgiven and whether the maximum output will actually be produced or not dependson the level of aggregate demand in the market. The maximum output is the fullemployment output as it will be achieved only with the full utilization of theavailable factors of production. If the level of aggregate demand is less than theone required absorbing the maximum output, the economy will attain equilibriumat less than full employment level of output. It means less than the maximumoutput will be produced and supplied.

In short, in the Keynesian model, the aggregate supply or the productionlevel is the function of quality and quantity of factors of production. Thisrelationship can be put in an equational form as below.

Y = f (L, K, N, E, O…….)

Y = Aggregate supply or the maximum output possible in the short run

f = Functional relationship

L = Labor K = Capital N = Land

E = Entrepreneurial Talent

O = Other raw material

Given the above functional relationship and assuming that all that isproduced is supplied, the aggregate supply curve will be a 45o straight line passingthrough the origin. The national income/product measured on the horizontal axiswill share a one to one relation with aggregate supply of goods and servicesrepresented on the vertical axis. As the national income/product (i.e. value ofgoods & services produced) increases the aggregate supply will also increase andvice versa.

Fig. 5.1 : Aggregate Supply


CHECK YOURPROGRESS

1. What do you meanby aggregatesupply?

2. What determinesaggregate supplyin an economy?




NOTES

B. AGGREGATE DEMAND

The Keynesian model of national income determination accords all theimportance to aggregate demand in the process of national income determination.As stated above, given the aggregate supply, it is the aggregate demand whichdetermines the level of national income. Higher the aggregate demand higherwill be the national income and vice versa.

Given the importance of aggregate demand in national incomedetermination, we need to understand how the level of aggregate demand isdetermined and what it consists of. According to Keynes and assuming a foursector economy, aggregate demand is made up of four components, eachrepresenting a sector of the economy. Aggregate demand in a four sector economywill consist of four components, namely, (1) Private consumption demand (C),(2) Private investment demand (I), (3) Government demand (G) and foreigndemand (X – M).

AD = C + I + G + X – M

Given the composition of aggregate demand, we will now discuss howeach component of aggregate demand is determined and finally how aggregatedemand curve, representing the level of aggregate demand, is derived.

I. PRIVATE CONSUMPTION DEMAND (C)

According to Keynes, consumption expenditure or demand of an individualor an economy as a whole is determined primarily by the level of income. Giventhe propensity to consume which is determined by the consumer’s tastes &preferences, level of income turns out to be the single most important factordetermining the consumption demand of an individual &, therefore, of an economyas a whole. The level of income being the most important determining factor, thequestion that comes to the front is that what kind of relationship it shares withconsumption demand (i.e. demand of private sector for consumer goods).According to Keynes, the levels of income and consumption demand /expenditureare positively correlated, meaning the later will go up with the growth in formerand vice versa. In other words, higher the level of income higher will be theconsumption expenditure and vice versa. This relationship can be expressed inthe form of an equation.

C = a + bY

Where,

C = consumption expenditure /demand

a = constant (i.e. autonomous consumption expenditure)

b = change in consumption expenditure resulting from change in income

C (i.e.) ____

Y

Y = level of income

Another important attribute about the relationship between the level ofincome and consumption expenditure is that it is not proportional. It means thoughthe consumption expenditure will increase / decrease with increase / decrease inthe level of income, the rate of increase / decrease in it will always be less. Inother words, the consumption expenditure and the level of income will move in



NOTES

the same direction but not in the same proportion. The above mentionedrelationship between the consumption demand and the level of income, whichKeynes has elaborated in his famous consumption function, can also be representedin the form of a diagram. The following diagram represents a hypotheticalconsumption function and supports the above explained relationship between theC and Y.

Fig. 5.2 : Private Consumption Demand

OY line in the above diagram is the income line and is representative ofone to one relationship between the level of income and consumption expenditure.In reality, the entire income is not spent and therefore the consumption functioncurve cannot coinside with OY line. The non proportional relationship betweenthe two will cause the consumption function curve to take the position of C curvein the diagram. The fact that ‘C’ curve is flatter than the OY line indicates thatchange in consumption expenditure is not proportional to the change in income.It should also be noted that the consumption function curve begins from point ‘A’on the ‘Y’ axis. It means at zero level of income the consumption expenditure isOA. This consumption expenditure is independent of the level of income andtherefore called autonomous consumption expenditure. Further, to the left of point‘E’, there are dissavings, while to the right of point ‘E’ there are savings.

Consumption demand, which constitutes the most important component ofaggregate demand in an economy is thus determined by the level of income.

II. PRIVATE INVESTMENT DEMAND (I)

Keynes, in his investment function, has explained as to how the investmentdecisions are made and how the extent of investment gets determined. Accordingto him, two important factors decide the level of investment of an individualinvestor and thus of the private sector of the economy. These two factors are therate of interest, which represents the cost of borrowing, and the marginal efficiencyof capital (MEC), which is proxy for the expected rate of profit from the proposedinvestment.

I = f (r/i, MEC)

The rate of interest shares the negative relationship with the investmentdemand, while the MEC shares a positive relationship. The investment decisionsand thus the level of investment will be determined by the comparison betweenrate of interest & the MEC. If the r/i is greater than MEC, investment will fall andif the r/i is lesser than MEC it will rise. The level of investment, that is, theamount of investment, will get determined at a point where the r/i and MEC areequal. The level of investment so determined, when added to the level of


Level of Income (Y)

A

Con

sum

ptio

n E

xpen

ditu

re (

C)




NOTES

consumption demand, will give us the C + I curve, which is nothing but theaggregate demand curve of an economy with two sectors, namely, the house holdsector & business sector.

Fig. 5.3 : Private Investment Demand

As can be seen from the above diagram that C+I curve is parallel to the Ccurve. The difference between the two curves represents the level of investment,which is determined by the r/i and MEC and therefore is shown as independent ofthe level of income.

III. GOVERNMENT DEMAND (G)

Government demand for consumer and capital goods represents the thirdimportant constituent of the aggregate demand in the economy. Government, asis well known, owes its presence in an economy to the requirement of maintaininginternal law & order, protecting the country from foreign attack, providing publicgoods and of carrying out programmes of mass social welfare. Government thusgenerates income in the form of taxes and spends the amount so generated forfulfilling the above mentioned requirements. How much the government will spenddepends not on the income but on the extent and urgency of fulfilling therequirements.

Aggregate demand consisting of three components thus can be derived justby adding the government expenditure (G) in to the private consumption (C) andinvestment expenditure (I). This is done in the following diagram. The differencebetween the C + I and C + I + G curve measures the government expenditure inthe economy and, as it is constant throughout, indicates that it is not dependent onthe level of income but on some other factors, which are not part of the basicmodel.

Fig. 5.4 : Government Demand



NOTES

IV. FOREIGN DEMAND (X-M)

The fourth important component of the aggregate demand is the foreigndemand and represents the foreign trade sector of the economy. By foreign demandwe mean the net of exports and imports. The foreign demand will be positivewhen the exports are greater than imports and will be negative when the case isotherwise. The exports and the imports of goods and services which aredetermined by the factors like export & import prices and elasticities, subsidies,tariffs and trade policies of the trading countries and tastes & preferences of thepeople, when added to the aggregate demand (C + I + G), will give us a newaggregate demand curve {C + I + G + (X – M)} representing a four sectoreconomy. As the foreign demand is determined by the out of the model factors,it is shown to be independent of the level of income and thus constant amountas given by the difference between the C + I + G curve and C + I + G + (X – M)curve.

Fig. 5.5 : Foreign Demand

The {C + I + G + (X – M)| curve in the above diagram is the aggregatedemand curve of an economy consisting of four sectors viz., household sector,business sector, government sector and foreign trade sector. By adding the demandcoming from the above four sectors of the economy, we get a aggregate demandcurve, which slopes upward from left to the right indicating a positive relationwith the level of income. Unlike the usual downward sloping demand curve, theaggregate demand curve shown in the above diagram slopes upward because it isexpressed against the income and not against the price level.

The basic model of the Keynesian variety thus incorporates two importantparts represented by two curves, namely, aggregate supply curve & aggregatedemand curve. Using this model, we will now explain the determination of nationalincome.

5.2.2 THEORY OF NATIONAL INCOME DETER-MINATION

As stated earlier, according to Keynes, the national income of a country isdetermined by two important factors. One is the aggregate demand, while thesecond is aggregate supply. The Keynesian model being applicable to short run,the aggregate supply (i.e. the maximum possible output) remains fixed andtherefore it is the aggregate demand that ultimately determines the national income.The previous part has elaborated the derivation of aggregate supply and aggregatedemand curves. Using the framework of aggregate supply and demand, we nowcan explains the determination of national income.


CHECK YOURPROGRESS

3. What are thecomponents ofa g g r e g a t edemand?

4. What determinesthe consumptiondemand in oneconomy?

5. How the level ofinvestment isdetermined?




NOTES

Fig. 5.6 : National Income Determination

The 45° line in the diagram is the aggregate supply curve (AS). Nationalproduct/income both in real and monetary terms will share a one to one relationwith aggregate supply. In other words; aggregate supply will go up only whenthere is growth in national product. As a result, the aggregate supply curve will bea straight line passing through the origin and will be at an equal distance fromboth the axis. We have also seen the process of derivation of the aggregate demandcurve (AD). An economy consisting of four sectors will have its aggregate demandmade up of four components, each representing the demand coming from a separatesector. The AD curve in the diagram is the aggregate demand curve. The shape ofaggregate demand curve is primarily determined by the positive relationshipbetween the level of income and consumption demand (C). The other componentsof aggregate demand, namely, investment demand, government demand and foreigndemand are determined outside the model and are therefore shown as constants atall levels of income.

The AS and AD curves intersect at point ‘E’ and therefore determine thelevel of national income equal to OY*. This level of national income is theequilibrium level of national income. Given the equality between AS & AD, noother income level will prevail in the economy. For example, if the income levelis less than the Y*, say YO, then at this lower level of income aggregate demandexceeds aggregate supply. Because of the excess demand producers will getencouraged to produce more and fulfill the excess demand. The aggregate supplywill rise until it becomes equal to the aggregate demand and the national incomeis determined at OY*. Reverse process will work if the level of income is greaterthan OY*.

The equilibrium level of national income (OY*) is not necessary to be thefull employment level of income. The full employment level of income (i.e. themaximum possible output in the short run) may be greater than the equilibriumlevel of income. If we assume that the full employment level of income is YF asshown in the diagram, then it becomes clear that the national income, determinedby the equality between aggregate supply & demand, is determined at less thanfull employment level. According to Keynes, such an equilibrium at less than fullemployment level of income is representative of the recession in the economyand is caused mainly by the deficiency in aggregate demand. As can be seen fromthe diagram that for the national income to be equal to YF, aggregate demandshould be higher than the one represented by the AD curve.



NOTES

In short, the theory of national income determination is the aggregatedemand and supply framework developed by Keynes and is the one that explainsthe determination of national income through the equality between aggregatedemand & supply of goods & services.

5.2.3 THE THEORY OF MULTIPLIER

The factors that make up the aggregate demand in the economy, viz.,consumption demand, investment demand, government demand and foreigndemand, do not remain constant. When viewed over a period of time, these factorskeep on changing. Any changes in these components of aggregate demand bringabout a multiple times change in national income. Such a multiple times changein national income is called multiplier. Multiplier refers to the number of timesthe total change in national income is greater than the change in any componentof aggregate demand. A change in any component of the aggregate demand causeseither an upward or downward shift in aggregate demand and such a shift bringsabout a multiple times change in national income. For example, an increase ininvestment will shift the aggregate demand curve upward and consequently theequality between AD and AS curves will take place at a higher point on AS curve.The national income will rise and the rise will be many times more than theincrease in investment. Such an effect on national income is called the multipliereffect and happens when there is change in either investment demand, governmentexpenditure or foreign demand. Accordingly, there is investment multiplier,government expenditure multiplier and foreign trade multiplier.

In short, the effect of the change in any one component of the aggregatedemand brings about a multiple times change in national income and thereforethe effect is called multiplier. Due to the working of multiplier, a given change ineither investment, government expenditure or foreign demand brings about aseveral times more change in national income. Here, we will discuss the effect ofchange in investment on national income in terms of investment multiplier.

Investment Multiplier

The investment multiplier refers to the total change in national incomeresulting from a given change in investment. It is expressed as the ratio of totalchange in national income to a given change in investment. Thus,

YK = ___I

Where K = Multiplier

Y = Change in income

I = Change in investment

Suppose, the investment expenditure increases by Rs. 10 Crores and as aresult, the national income increases by Rs. 30 Crores. It means the increase inincome is three times the increase in investment. Thus multiplier is -

30K = ___10

K = 3

Now the question arises as to why the change in national income is many timesmore than the initial change in investment. The answer to this question lies in the


CHECK YOURPROGRESS

6. What is multiplier?

7. Explain the rela-tionship betweenMPC and the valueof multiplier?




NOTES

logic that one man’s expenditure is another man’s income. It is because of thislogic that initial investment expenditure becomes the income of several groups ofpeople and consequently the total income generated becomes multiple of the initialinvestment made. How many times the income will be greater than the initialinvestment made depends on the marginal propensity to consume (MPC), whichindicates the change in consumption expenditure resulting from the change inincome. The MPC is expressed as the ratio of change in consumption expenditureto change in income, that is C / Y. It is the value of MPC which determines thevalue of multiplier. Higher the value of MPC, higher will be multiplier quotientand vice versa.

The relationship between the MPC and multiplier is expressed in the formof a following equation,

1k = ________

1 – MPC

Suppose, MPC is 0.25, then the multiplier quotient will be

1k = _______

1 – 0.25

k = 1.33

This means the total change in income will be 1.3 times greater than theinitial investment.

If the MPC is higher at 0.5, then the multiplier quotient will be

1k = ______

1 – 0.5

k = 2

The multiplier quotient of 2 implies that the change in income will be twicethe change in initial investment.

Having understood the relationship between the MPC & the multiplier, wewill now turn to explain the working of multiplier which is based on the logic thatone man’s expenditure is another man’s Income.

Suppose the government decides to spend Rs 1000 Crores on a project ofroad construction and also assume that the MPC is 0.5. Given the initial investmentand the MPC, let us now see how the new income generated becomes twice theinitial investment made.

The project of road construction of Rs. 1000 Crore will provide employmentto those who were unemployed. So in the beginning the investment of Rs 1000Crores will become the income of those employed on the project. Given the MPCof 0.5, these income recipients will spend Rs 500 Crores on consumption. The Rs500 Crores spent will be received by some other people as their income and thosewho receive the amount will again spend Rs 250 Crores on consumption. Therecipients of Rs 250 Crores will again spend Rs 125 Crores, thereby generatingincome of the same amount to some other people. In this way, the process ofincome generation will begin and will continue till the initial investment becomeszero or the new savings generated become equal to the initial investment. In theprocess, the total income generated will be twice the initial investment madebecause the MPC is 0.5 and therefore the multiplier quotient will be 2.



NOTES

The process of income generation is summarized in the following table.

Rounds of Initial New New consumption Newincome investment income (MPC = 0.5) Savings

generation (Rs. Crores) (Rs. Crores) (Rs. Crores) (Rs. Crores)

First 1000.0 1000.0 500.0 500.0

Second – 500.0 250.0 250.0

Third – 250.0 125.0 125.0

Fourth – 125.0 62.5 62.5

Fifth- – 62.5 31.25 31.25

– – – – –

– – – – –

– – – – –

– – – – –

Last – 0.0 0.0 0.0

Total 1000.0 2000.0 1000.0 1000.0

As can be seen from the above table that the new income generated is twotimes the initial investment made. The working of multiplier can also be explainedin terms of a shift in AD curve.

Fig. 5.7 : Working of Multiplier

The increase in investment by I shifts the aggregate demand curve to newposition AD1. The new AD curve includes a new component of I, as a result ofwhich a process of income generation begins and increases the income by amultiple amount. In the numerical example taken above the income increases bytwo times because the MPC is assumed to be equal to 0.5. In the diagram above,the increase in investment is shown as I, while the resulting increase in incomeis shown as Y, A comparison will reveal that the increase in income is actuallytwice the increase in investment.

It should be noted that the multiplier can also work in reverse direction. Inother words, a decrease in investment will bring about a multiple times decreasein income. It should also be noted that the extent of the multiplier will depend onthe following factors. These factors represent the leakages in the process of income





NOTES

generation and can dilute the effect of multiplier. In other words, the increase inincome may not be the one given by the value of multiplier, if these leakages arepresent. These leakages are,

1. Imports : Income will increase by lesser extent if a part of income isspent on imports.

2. Payment of Past Debt : The multiplier will fail to produce full effecton income if people use a part of their increased income for paying theirold debts.

3. Hoarding : Hoarding of a part of newly generated income will alsoreduce the effect of multiplier on income.

4. Inflation : If the economy is operating at full employment level of output,the multiplier will work in nominal terms and not in real terms. Onlythe money incomes will rise due to rising prices and not the real income.

5. Taxes : If a part of the increased income is taken away by the governmentin the form of taxes, then also the extent of increase in income will belesser.

In this way the multiplier explains the process by which the effect of theincrease in investment is observed on the income. Similar effect on income isobserved if there is increase in government expenditure or reduction in governmenttaxes and increase in foreign expenditure on domestic goods. The impact of theincrease in government expenditure or reduction in taxes on income is termed asfiscal multiplier, while that of increase in foreign demand or expenditure as foreigntrade multiplier. The principle of multiplier is thus used not only in assessing theimpact of increase in investment on income but also to assess the impact of increasein government expenditure and foreign expenditure on income. The principle ofmultiplier, despite its limitation, has thus emerged as an important tool of analyzingthe impact of changes in investment, public expenditure, taxes and foreign tradeon the economy.

5.3 SUMMARY

The theory of national income determination, as put forward by Keynes,makes use of the basic principles of demand and supply to explain thedetermination of national income. According to Keynes, national income of acountry is determined primarily by the level of aggregate demand, as the aggregatesupply is given and remains unchanged in the short run. So, the national incomeis determined at a point where the aggregate demand equals the given aggregatesupply.

Aggregate demand is made up of four components, if we assume a foursectors economy. Private consumption demand (C), private investment demand(I), government demand (G) and foreign demand (X – M) are those fourcomponents of demand in a four sector economy. Thus, in a four sector economythe aggregate demand is the sum of the above four components.

AD = C + I + G + (X – M)

In the short run, given the aggregate supply, the level of aggregate demand,made up of C + I + G + (X – M), determines the level of national income. In the



NOTES

short run, the national income so determined not necessarily be the full employmentlevel of income. Deficiency in aggregate demand in relation to given aggregatesupply determines the national income at less than full employment level ofresources.

Given a four sector economy, the theory of multiplier explains the effect ofchange in any component of the aggregate demand on the level of national income.The theory of multiplier primarily explains the multiplier effect that a given changein investment produces on the level of national income. The principle of multiplier,despite its limitations, has emerged as an important tool of analyzing the impactof changes in investment, public expenditure, taxes and foreign trade on theeconomy.

5.4 KEY TERMS

l Aggregate Demand : It refers to the total demand for goods and servicesof an economy and includes consumption demand, investment demand,government demand and foreign demand.

l Aggregate Supply : If indicates the total goods and services producedand supplied at a point of time in an economy.

l Effective Demand : The level of aggregate demand which is equal tothe aggregate supply in the short run and is therefore is effective indetermining the level of national income.

l Multiplier : Multiplier is the force that produces many times moreincrease in national income following the increase in any of thecomponent of aggregate demand.

5.5 EXERCISES

1. Explain the derivation of aggregate supply.

2. Explain how the aggregate demand is derived for a four sector economy.

3. Discuss the theory of national income determination.

4. What do you mean by multiplier? Explain its working.

5. Elaborate the impact of change in taxes on the level of national incomeusing the aggregate demand & supply framework.


1. Ackley G. (1978) : ‘Macro Economics : Theory and Policy’, MacMillan,New York.

2. Ahuja H. L. (2001) : ‘Macroeconomics : Theory and Policy’, S. Chandand Company Ltd., New Delhi.

3. Bhatia H. L. (2006) : “International Economics”, Vikas PublishingHouse Pvt. Ltd., New Delhi.





NOTES

4. Gupta Suraj B. (1997) : “Monetary Economics : Institutions, Theoryand Policy”, S. Chand and Company Ltd., New Delhi.

5. Hossain Akhtar & Choudhary Anis (1998) : “Open EconomyMacroeconomics for Developing Countries”, Edward Elgar,Chentenham, U.K.

6. Jadhav Narendra (1994) : “Monetary Economics for India”, MacMillanIndia Ltd., New Delhi.

7. Jhingan M. L. (1975) : “Advanced Economic Theory (Micro and MacroEconomics)”, Vikas Publishing House Pvt. Ltd., New Delhi.

8. Shapiro E. (1996) : “Macro Economic Analysis”, Galgotia Publications,New Delhi.

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NOTES

UNIT 6 : DETERMINATION OF PRICELEVELAND AGGREGATESUPPLY & DEMAND SHOCKS

Structure

6.0 Introduction

6.1 Unit Objectives


6.2.1 Determination of Price Level

6.2.2 Aggregate Supply & Demand Shocks

6.3 Summary

6.4 Key Terms

6.5 Exercises

6.6 Books for further reading

6.0 INTRODUCTION

The aggregate demand and aggregate supply framework discussed in theprevious unit can also be used to explain the determination of price level. Byexpressing the aggregate demand and supply against the price level, a newframework consisting of downward sloping demand curve and upward slopingsupply curve can be developed to explain the process of determination of pricelevel. Using the same framework, the effects of shifts in aggregate demand curve(i.e. AD Shocks) and aggregate supply curve (i.e. AS Shocks) on the level ofnational income and price level can be analysed.

6.1 UNIT OBJECTIVES

This unit will familiarise the students with –

l The process of determination of price level and national income.

l How the shifts in aggregate supply curve, resulting from nationalcalamities, shortage of inputs, sudden rise in input prices etc. affect thenational income and price level.

l How the shifts in aggregate demand curve, resulting from politicaluncertainties, prolonged wars, recession in other countries etc. affectthe national income and price level.

Determination of Price Leveland Aggregate Supply &

Demand Shocks




NOTES


6.2.1 DETERMINATION OF PRICE LEVEL

The theory of national income determination discussed above using theaggregate demand & supply framework developed by Keynes is applicable toshort run and assumed that the price level is stable. According to Keynes, in theshort run resources are not fully utilized and therefore increase in production ispossible without any increase in cost of production. In other words, due to theunemployment of resources, more resources can be hired at the same prices andtherefore production can be increased without any increase in the cost ofproduction. This is what makes the aggregate supply curve perfectly elasticindicating the possibility of increase in supply without any increase in price level.However, once the full employment of resources is reached, aggregate supplybecomes perfectly inelastic as no more increase in production is possible. Aperfectly inelastic aggregate supply curve indicates that it is only the price levelthat will rise with every rise in aggregate demand as no increase in production/supply is possible due to full employment of resources.

Aggregate supply curve, which expresses the aggregate supply of goods &services against the price level, will therefore have two parts, one perfectly elasticand another perfectly inelastic. The perfectly elastic part is horizontal straightline and indicates the possibility of increase in production without any increasein cost of production and therefore price level. The other part which is perfectlyinelastic is represented by a vertical straight line and indicates the impossibilityof increase in production and supply even if the price level increases. The perfectlyelastic part of the supply curve is associated with the name of Keynes as he believedin the less than full employment of resources in the short run. The perfectly inelasticpart is attached with the classical economists as they believed in full employmentof resources.

Before we draw a aggregate supply curve made up of two parts discussedabove, let us consider one more possibility put forward by Monetarists like MiltonFriedman. According to Monetarists, aggregate supply curve can be upward slopingfrom left to right indicating the possibility of increase in production but only withthe increase in cost of production. Monetarists maintain that as the economyreaches full employment level, there is bound to be some increase in cost ofproduction. This happens because, towards the full employment level, the resourcesbecome short in supply and therefore to attract them to one employment fromanother, higher prices are to be offered. So, towards the full employment level,the factors of production become available only at higher factor prices. The risingfactor prices cause the cost of production to rise with every attempt to increasethe production. Consequently, aggregate supply curve becomes upward slopingas the economy approaches full employment of resources. An aggregate supplycurve made up of all the three parts discussed above is drawn in the followingdiagram.

The aggregate demand curve which we used in the previous part was upwardsloping curve. A demand curve usually is a downward sloping curve. The differencelies in what the demand is expressed against. The aggregate demand curve of theprevious part was upward sloping because it represented aggregate demand against



NOTES


Demand Shocks

the income. When the aggregate demand is expressed against the price level, thedemand curve will be a downward sloping curve reflecting the inverse relationbetween demand & price. In this part, we are going to use the downward slopingaggregate demand curve, which expresses demand against price level.

Having discussed the shapes of aggregate supply & aggregate demand curve,we now can explain as to how both the national income and price level aredetermined simultaneously and how both change with the change in aggregatedemand.

The determination of national income & price level simultaneously andthe change in both is shown in the below diagram, AS is the aggregate supplycurve made up of three parts, a horizontal part representing less than fullemployment situation, an upward sloping part representing near full employmentsituation and a vertical part representing full employment situation. AD1, AD2,AD3, AD4, AD5 and AD6 arc the aggregate demand curves representing differentlevels of demand. A, B, C, D, E & G are the points where both aggregate supplyand demand become equal and therefore simultaneously determine the nationalincome & price level. For example, AD1 intersects the AS curve at point ‘A’ andthus the national income and price levels are determined as OY1 and OP1respectively.

Fig. 6.1 : Determination of Price Level

So long as the economy operates at less than full employment level, anyincrease in aggregate demand (say to AD2 ) will cause only the national incometo rise (from OY1 to OY2), without any increase in price level. As the economyapproaches full employment state, an increase in aggregate demand (say to AD3)will cause both the national income and price level to rise. Rise in both the nationalincome & price level with the increase in aggregate demand will continue tohappen until the economy reaches full employment. Once the full employmentstate is reached, any further increase in aggregate demand will (as shown by AD5or AD6) cause only the price level to rise without any increase in national income.

Thus, given the shape of the aggregate supply curve, an increase in aggregatedemand will change national income, price level or both depending upon whichpart of the aggregate supply curve the economy is operating on. If the economy is




NOTES

operating on the horizontal part, an increase in aggregate demand will increaseonly the national income and the price level will remain unchanged. The upwardsloping part of the aggregate supply curve however will cause both the nationalincome & price level to increase following the increase in aggregate demand. Onthe vertical part of the aggregate supply curve, it is only the price level that willrespond to the change in aggregate demand, national income remaining the same.

In short, the change in national income and price level is thus the functionof the aggregate supply curve and the level of aggregate demand.

6.2.2 AGGREGATE SUPPLY & DEMAND SHOCKS

The national income & price level determined by the level of aggregatedemand and aggregate supply can change suddenly when either the aggregatedemand or the aggregate supply experiences a shock. AD and AS shocks arethose big & adverse changes in aggregate demand & supply respectively, whichdisturb the initial equilibrium and bring about unfavourable changes in nationalincome & price level. In a nutshell, sudden, big and unfavourable changes inaggregate demand & supply are called the AD & AS shocks. Sudden & harmfulchanges in aggregate demand are very rare. However, aggregate supply is veryoften subject to sudden& harmful changes, which sometimes turn out to bedisastrous. AD shocks are manmade and therefore controllable, while the ASshocks result from some exogenous factors and therefore are beyond the controlof policy makers.

In this part, we propose to discuss the AD & AS shocks and the impact thatthey have on the national income & price level.

AS Shocks

A shock to the aggregate supply refers to a sudden and drastic fall in it dueto some exogenous factors. In other words, an AS shock refers to a situation inwhich aggregate supply falls in relation to aggregate demand and causes thenational income to fall and price level to go up. A fall in national income is followedby a fall in employment level and therefore the supply shock causes the higherprice level (i.e. inflation ) to co-exist with higher unemployment. The factors thatusually cause a AS shock are exogenous and non-controllable. Such factors includethe following :-

1. Climatic changes like draughts and floods : These adversely affectthe agricultural production and there by create a shortage.

2. Natural calamines like earthquakes & tsunami : These also disturbthe existing production facilities and therefore cause the supply shortfall.

3. Labour problems like strikes, lockouts, paucity of skilled labour,etc.

4. Shortage of inputs and sudden rise in their prices : e.g. sudden risein the price of oil in the recent past.

In case of India, all the four factors have caused adverse changes in aggregatesupply several times in the past. It is because of these factors that India has been

CHECK YOURPROGRESS

1. What a horizontalport of aggregatesupply curveindicates?

2. When theaggregate supplycurve becomesvertical?



NOTES


Demand Shocks

a country, where high inflation continues to co-exist with high rate ofunemployment. Globally, a well known supply shock is the one which resultedfrom the sudden and huge hike in the price of crude oil. It was in 1973–74 and in1979–80 that crude oil prices skyrocketed and created a situation of what is calledas stagflation. Stagflation, a new term coined around this time, indicates aparadoxical situation in which high inflation co-exists with high unemploymentrate.

Fig. 6.2 : As Shock

To explain the AS shock, we have used the upward sloping portion of theaggregate supply curve. As discussed in the previous part, an upward slopingaggregate supply curve indicates the possibility of increasing supply only withthe rise in price level. The initial equilibrium in the diagram is given by point Elwhere AD1 and AS1 intersect and thus determine the level of national incomeequal to Yl and price level equal to P1. Now, suppose a supply side shock in theform of a sudden rise in input prices due to conspiracy among the sellers (i.e.cartelization) causes the AS curve to shift to left and take a new position AS2.Given the AD curve, the equilibrium changes to point E2, with fall in nationalincome to YO and rise in price level to P2. Both the fall in national income andrise in price level are unfavourable and therefore their co-occurrence is called ashock.

Though it is difficult to cure a supply side shock and restore the normalequilibrium in the economy, two ways are suggested to tackle the supply sideshock. The first way is the classical one and relies on the wage price flexibility. Itis through the wage price flexibility that the initial equilibrium is restoredautomatically. The unemployment (i.e. fall in income) created by supply sideshock lowers the money wages and increases the demand for labour. As a result,the cost of production falls on the one hand, while on the other the unemploymentdisappears and the economy returns to its pre-supply shock equilibrium.

The second way is the Keynesian way and recommends expansionary fiscalor monetary policy to increase the employment level. An expansionary fiscal ormonetary policy will shift the AD curve to the right as shown in the diagram(AD2). The new equilibrium is established at point E3, with national incomereturning to the pre-shock level. However, this restoration of national income toits pre-shock level involves a cost in the form of a higher price level (P3).




NOTES

AD Shocks

Like the AS shock, an AD shock occurs when a exogenous factor causes asudden and drastic fall in aggregate demand in relation to aggregate supply. Thefactors that normally reduce the aggregate demand in a big and surprising wayare political uncertainty in the country, prolonged wars, impact of the recessionin other countries and so on. These exogenous factors cause a sudden fall inaggregate demand and create a recessionary situation in the country. If timely andproper action is not organized then there are chances of the economy going into adeep recession (i.e. depression)

Fig. 6.3 : AD Shock

Political uncertainty, for example, discourages people from spending andtherefore demand for both consumer goods and capital goods registers a drasticdecline. Deficiency in demand, as is well known, is certainly what takes theeconomy into recession. Given the aggregate supply, a fall in aggregate demandlowers both the national income and price level. This is shown in the alongsidediagram.

The initial equilibrium in the diagram is given by the point E1, with nationalincome of Y1 and price level of P1. When a demand side shock like politicaluncertainty in the country causes the aggregate demand curve to shift to left to anew position AD2, the equilibrium changes from E1 to E2 and consequently bothnational income and price level fall to YO and PO respectively.

Point E2 in the diagram, resulting from the demand side shock, is thus therepresentative of recessionary situation in the country. The best way to curerecession/depression, as suggested by Keynes, is to follow expansionary fiscaland monetary policy.

6.3 SUMMARY

The framework of aggregate demand and supply, used to explain thedetermination of national income, can also be used to explain the determinationof price level. Given the downward sloping aggregate demand curve, the pricelevel, national income and change in them depend on the shape of the aggregatesupply curve.

CHECK YOURPROGRESS

3. What is a ASShock?

4. What do you meanby a AD Shock?



NOTES

An aggregate supply curve, which poses aggregate supply against the pricelevel, is a combination of three parts. Which part the economy is operating ondetermines whether the national income will change or the price level and themagnitude of change, following the change in aggregate demand.

AD and AS shocks are the unfavourable and sudden changes in aggregatedemand and aggregate supply respectively, which create a situation of recessionor stagflation in the economy.

6.4 KEY TERMS

l AS Shock : It refers to a situation wherein a sudden and drastic fall inaggregate supply of goods and services, which causes the national tofall and price level to go up.

l AD Shock : An AD shock is a sudden and drastic fall in aggregatedemand resulting in fall in both national income and price level.

6.5 EXERCISES

1. Discuss the process of determination of general price level usingaggregate demand and supply framework.

2. Comment on the shape of the aggregate supply curve made up of threeparts.

3. Explain how the national income and price level changes with the changein aggregate demand.

4. Discuss the supply side shocks and their impact on the national income& price level.

5. What do you mean by a AD shock? What impact will it have on thenational income & price level.







Demand Shocks




NOTES





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NOTES

UNIT 7 : MONEY : SUPPLY OF MONEY

Structure

7.0 Introduction

7.1 Unit Objectives


7.2.1 Definition and Kinds of Money

7.2.2 Functions of Money

7.2.3 Supply of Money

7.3 Summary

7.4 Key Terms

7.5 Exercises


7.0 INTRODUCTION

The study of macroeconomics involves the study of the whole economy.How the national income, employment and general price level are determinedforms the core area of macroeconomics. The previous unit has taken us throughthe deep sea of macroeconomics. To some extent, we have now understood thefunctioning of macro economy. The economy as whole consists of two sectorswhich are inter-connected. These sectors are product/real sector and monetarysector. How the real sector attains equilibrium is what we have studied in theprevious unit. The monetary sector equilibrium, which is established when supplyand demand for money become equal, is what we propose to discuss in this unit.Monetary sector, in a sense, forms the basis of real sector as it is the availabilityof money which ultimately decides the aggregate demand in the economy.Aggregate demand along with the aggregate supply determines the state of theeconomy by determining the level of national income, employment & price level.Money therefore decides the status of a nation at the macro level. Those whobelong to the Monetarist school of thought thus maintain that money is the onlything that matters.

Having underscored the importance of money in an economy, we proposeto study the meaning, kinds, functions and the supply of money in this unit.

7.1 UNIT OBJECTIVES

This unit will help the students understand –

l The term money and it’s different kinds.

l The functions of money.

l The term supply of money

l The constituents of money supply in an economy.

Money : Supply of Money




NOTES


7.2.1 DEFINITION AND KINDS OF MONEY

The barter systems which involved exchange of goods for goods, sufferedfrom number of difficulties like lack of double coincidence of wants, lack of acommon measure of value, difficulty of sub-division, lack of store of value andlack of standard of deferred payments. It was to overcome these difficulties thatmoney was invented and in the words of Crowther, it represented one of the mostfundamental inventions made by man.

Definition of money is an area of great controversy. Several economistshave tried to define it on the basis of different criterias. The criterias used aremostly the different functions of money developed over the years. Some definitionshave emphasized the general acceptability character of money, while others havestressed the functions of money . Today, money is used not only as a medium ofexchange, but to perform several other tasks. As the functions of money havegrown with the modernization of the society, it has not been possible to give aperfect definition of money. However, the definitions so far put forward by differenteconomists certainly helps us understand the true nature of money. Some of thedefinitions of money that help us understand the true meaning of the term aregiven here.

1. Hartley Withers : “Money is the stuff with which we buy and sellthings.”

2. Seligman : “Money is a thing that possesses general acceptability “

3. D. H. Robertson : “Money is anything which is widely accepted inpayment for goods, or in discharge of other kinds of businessobligations.”

4. G. D. H. Cole : “The essence of money is that it can be passed fromhand to hand in one act of circulation after another.”

5. Walker : “Money is what money does.”

6. Crowther : “Money is anything that is generally acceptable as a meansof exchange (i.e. as a means of settling debts) and that at the same timeacts as a measure and a store of value.”

From the above definitions of money, it is clear that money is somethingthat possesses general acceptability and facilitates the transactions of goods andservices. As stated above, giving a perfect definition of money is not possible asthe functions of money, on the basis of which the money is defined, have increasedover the years. The definitions given above therefore touch either the generalacceptability feature of money or the primary functions of money. The definitionsof Seligman, Robertson and Cole are narrow as they emphasise only the generalacceptability character of money and do not provide the justification for whatmakes money generally acceptable. Definitions of Hartley Withers and Crowtherare also narrow as the functions emphasized in them are only the primary functions.The definition of money given by Walker however stands out as it in a senseemphasises all the functions that money performs. According to walker’s definition,money is anything that performs the functions of money. However, this way ofdefining money is an easy way, and accords equal importance to all functions ofmoney.



NOTES

In conclusion it can be said that money is defined on the basis of twoimportant aspects, one is the character of money as generally acceptable and thesecond is the functions that money performs. Judged on this ground, the Crowther’sdefinition appears to be the best of all, as it incorporates both the aspects in thedefinition.

KINDS OF MONEY

Money in its present form is not a sudden and abrupt discovery, but hasevolved over the years through different stages. It has developed through a longprocess of evolution spread over several centuries. A journey in to the historyreveals that variety of things were used as money. Animals, different types ofcommodities and metals were used as money. However, the quest for conveniencehas led man to give up the inconvenient forms of money and adopt the convenientones. The money thus has passed though several stages from ancient times to themodern times. These stages of development of money, when studied, give usdifferent kinds of money which were in usage in the past and are in usage atpresent. The historical evolution of money provides us with the following kindsof money.

1. Animal money

2. Commodity money

3. Metallic money

4. Paper money

5. Credit money

1. ANIMAL MONEY

In the most primitive stage of human civilization, commodities which werein great demand were used as money. There is enough evidence to prove that inthe most ancient times animals were used as means of exchange. Agriculturebeing the only occupation in those times, the importance of animals, particularlycattles, in agricultural activities provided them a place of pride. Cattles wereconsidered the most important form of wealth and therefore almost in every partof the known world animals like cow, ox, goat, sheep, etc. were used as standardmedium of exchange. Using animals as money however was not much convenient.Lack of standardization, indivisibility, perishability, uncertain supply, lack of easyportability and the maintenance expenditure were the important problemsassociated with the usage of animals as money and therefore the humans wereforced to search for something new.

2. COMMODITY MONEY

Problems associated with the animal money forced people to use differentcommodities as money. Commodities to be used as the money were primarilydetermined by the location of the community, the climatic conditions of the region,cultural and economic development of the region and so on. Those communitieswhich lived by the seashore used shells and dried fish as money, while communitiesliving in cold environment preferred animal skins and furs as a means of exchange.Other commodities which qualified as money in the ancient hunting communitieswere spears, bows, arrows, elephant tusks, bird feathers, tiger claws and jaws.The agricultural communities on the other hand used things like grains, cloth andother agricultural stuff as money. It was thus the stage of development of the


CHECK YOURPROGRESS

1. What is money?

2. What are the kindsof money?

3. What do you meanby paper money?




NOTES

community as reflected in the primary occupation that determined the commoditiesto be used as money.

However, the use of commodities as money also involved problems likelack of standardization, lack of portability, indivisibility etc. These problems havecaused the commodity money to go out of usage and give place to a new form ofmoney.

3. METALLIC MONEY

With the passage of time and progress of society, precious metals like gold, silver, copper, etc came to be used as money. This development in the evolutionof money helped a great deal in overcoming the difficulties associated with theanimal and commodity money. Portability, durability, divisibility and utility madethe metals a close to perfect form of money. Though in the beginning, the metalmoney differed in size, shape and weight, with the minting of coins, the differencesand imperfections were considerably removed. Though the metallic money wasfar superior than the earlier forms of money, it too was not free from defects.Possibility of theft, lack of easy portability, considerable depreciation of the coinsafter a long period use etc. made the metallic money an unattractive form ofmoney.

4. PAPER MONEY

During the past, people were under impression that money is somethingthat is valuable itself and therefore animals, commodities and precious metalswere being used as money. This misconception of the people has died down overthe years and people have how realized that money is needed not for its own sakebut for the sake of buying goods and services. This change in mind set of thepeople paved the way for the adoption of paper money.

The possibility of theft associated with the metal money led people to carrypaper receipts issued by the gold smiths and lenders against the metal money keptwith them. This development marked the beginning of paper money. Later on,governments, owing to the short supply of metals, started issuing paper currencynotes. Initially these notes were convertible in to gold or silver, but today theconvertibility character of paper money has become a thing of the past as peoplehave developed faith in these notes. The paper money has now come to becomeas good as gold or silver. The paper money has helped people get rid of almost allthe inconveniences associated with earlier versions of money.

5. CREDIT MONEY

The last form that money has assumed is the bank money or credit money.Paper currency notes have now been replaced by credit money as it is easy tocarry and use and there is almost zero possibility of loss. The bank money orcredit money refers to the bank deposits, which are withdrawable by using cheques,demand drafts, debit cards and credit cards. The bank money has eliminated therequirement of holding and carrying paper money for the conduction oftransactions. Instruments like cheques, drafts & debit cards have made itconsiderably easy to make payments and therefore, the paper money is now onthe verge of becoming obsolete. The internet banking is further going to make itconvenient for the people to carry out the variety of transactions and take ustowards the money less economy.



NOTES

7.2.2 FUNCTIONS OF MONEY

The most important function of money is to facilitate the transactions ofgoods and services, that is, serve as a means of payment. With the passing time &progress of the society, money has come to perform several other functions. Somefunctions of money are primary in the sense that they are to be compulsorilyperformed. If these functions are not preformed, then the stuff which is to becalled money will not be called so. There are some other functions which are lessimportant and therefore are called secondary. Money also performs some functionas per the requirement of the situation. These functions are contingent functions.

The functions of money are thus of three types. They are –

(1) Primary functions

(2) Secondary functions

(3) Contingent functions

1. PRIMARY FUNCTIONS

The primary functions of money are the basic or fundamental functions ofmoney. The medium of exchange function and measure of value function are thetwo functions of money that form this category.

(A) Medium of exchange : This function of money is so important that it ison the basis of this function that money is defined very often. It is becauseof this function that many difficulties experienced under the barter systemwere addressed. As a medium of exchange, money helps people to buygoods and services. Money thus provides people with purchasing power.People exchange money for goods, instead of exchanging goods forgoods. Money thus serves as mediator.

(B) Measure of value : This is the second important function of money,whereby it helps in measuring the value of goods & services that are tobe exchanged. Before the exchange takes place, it is very essential thatthe goods which are to be exchanged have a specific value. It is in termsof money that value of goods and services is decided first and then theyare exchanged. The medium of exchange function & measure of valuefunction are thus interlinked.

2. SECONDARY FUNCTIONS

The secondary functions of money are derived from the primary functionsof money. In other words, secondary functions emerge as a consequence of theprimary functions. Money performs these functions as a corollary of the primaryfunctions. This category of secondary functions includes two functions : (A)Standard of deferred payments and (B) Store of value.

A. Standard of deferred Payments : When we say that money serves asa means of payment, it serves as means of both, present and futurepayments. In other words, money acts as a medium not only in currenttransactions but also in future transactions. The term deferred paymentsimplies delayed payments or future payments. When goods are purchasedon credit (that is, by taking loan), payment is to be made in future. Insuch a case something that is stable in value should be used so that thecreditor/seller has the assurance of certain amount. Under the bartersystem, goods due to their perishable or deteriorating nature fail to serve





NOTES

as a means of future payments. Goods lent may not remain same invalue when returned. Thus, money is used as means of future paymentsand this is what greatly facilitates and simplifies lending and borrowingoperations which are part and parcel of a modem society.

B. Store of Value : The failure of the barter system has shown us thatusing goods for storing value or wealth is not a sensible option. Money,because of its stable value and liquid character serves as the best meansof storing wealth. Value of money is fairly stable. Though it can fluctuatewith the fluctuations in price level, the Central Bank usually doesn’tallow the later to fluctuate too much. Further, compared to other durablethings like precious metals in which wealth can be stored, money ismore or in fact cent percent liquid. Money therefore surfaces as the bestmeans of storing value or wealth.

3. CONTINGENT FUNCTIONS

Besides the above discussed primary & secondary functions of money, thereare some other functions which money performs as a requirement of the situationor the stage of economic growth of a country. These functions of money are calledthe contingent functions as they are dependent on the stage of economic growthor the situation.

A. Division of national income : National income of a country is the resultof collective efforts made by the four broad categories of factors ofproduction. Land, labour, capital & entrepreneur contribute in thegeneration of income and are later entitled to their due shares. Nationalincome is thus first generated and then divided among those whocontribute in its generation. Division of national income among thefactors of production becomes easy when we use money. National incomeis expressed in terms of money and distributed in accordance with relativecontributions of the factors of production.

B. Equalization of marginal utility : Maximizing behaviour on the partof both consumer & producer, as given by the utility analysis &production function analysis respectively, is possible only when moneyis used to measure the utilities from different goods and factors ofproduction. This function of money helps the consumer to maximizehis satisfaction from the consumption of goods & services and theproducer to maximize his profit from the use of different factors ofproduction.

C. Basis of credit system : Credit, like money, plays very vital role intoday’s economy. It fuels majority of the productive activities that takeplace in an economy and thus helps in pulling the tempo of economicdevelopment ahead. However, the credit, which possesses the capacityto support productive activities in the economy, derives its strength fromthe money. Credit can be expanded and the credit system can bedeveloped only when there is enough money available in circulation.Money thus serves as base of credit.

D. Transfer of value : Money also helps in transferring the value fromone place to another and from one person to another. It is due to theexistence of money that even the value of immovable stuff can betransferred between places & people. This was not possible under bartersystem.



NOTES

From the above discussion, it is clear that money performs variety offunctions. However, it is the primary & secondary functions of money whichconstitute the basic or main functions and therefore they are attributed to themoney in the following manner : “Money is a matter of functions four; a medium,a measure, a standard, a store.”

7.2.3 SUPPLY OF MONEY

Money has been defined as anything that is generally acceptable & can beused for buying goods & services. In other words, money should primarily serveas medium of exchange. Money can serve as medium of exchange only when it isliquid. It means the liquidity character of the money helps it to serve as mediumof exchange. Liquidity is an attribute which reflects the ease with which an assetcan be converted into spendable form without any delay and loss. From this pointof view, money can be defined as anything that is available in liquid or spendableform. This is because unless money is available in spendable form it won’t serveas a medium of exchange and if it fails to serve as medium of exchange it won’tbe called money. It thus becomes clear that money and liquidity go hand in hand.

Given the close association between money and liquidity, the supply ofmoney should mean all those things that are available in spendable form and thuscan be used by the people for making payments, both present & future. In otherwords, money supply should consist of all such assets which are available inliquid or spendable form. Given this requirement, we can include two importantitems in the term supply of money.

1. Coins & currency notes : These are cent percent liquid and thereforerepresent a first important constituent of money supply.

2. Demand deposits : Demand deposits with the banking system representthe second important component of money supply. These deposits, asthey can be withdrawn through cheques at any time, turn out to be asliquid as the coins & currency notes are.

Constituents of money supply

Having understood the meaning of the term supply of money & what itshould consist of, we can here have a brief review of the two approaches to theconstituents of supply of money.

The traditional approach represents a narrow view about the constituentsof supply of money and favours the inclusion of coins & currency notes anddemand deposits with banks into the supply of money. The traditional approachmaintains that it is only the coins, currency notes & demand deposits that areavailable in spendable form and therefore they qualify as the components of supplyof money.

The modern approach to the constituents of supply of money takes a broaderview and favours the inclusion of near money assets like time deposits with banks,debentures, shares, government securities, etc. into the supply of money. Moderneconomists maintain that the near money assets, though not as liquid as coins &currency notes are, can be made liquid with some delay and cost. These assets arethus withdrawable, and can serve as a medium of exchange. Therefore, they areto be included in the term supply of money.

Among the two approaches, the modern approach to the constituents ofsupply of money appears far superior to the traditional approach. However,





NOTES

measurement of money supply in accordance with the modern approach ispractically a difficult task. As is well known, changes in money supply affect thefunctioning of the whole economy. Given this, a desirable impact on the economycan be achieved only by regulating the supply of money, which in turn requiresproper measurement of money supply. It is from this point of view that modernapproach turns out to be a better choice, as it favours the inclusion of near moneyassets in money supply.

Given the theoretical perspectives on the constituents of supply of money,Reserve Bank of India since 1977 started following four measures of money supply,which are organized in the descending order of liquidity. These four measures ofmoney supply are M1, M2, M3 & M4 and cover not only the liquid assets likecoins, currency notes & demand deposits, but also the near money assets liketime deposits. The four measures of money used by RBI include following items.

M1 = Coins & currency notes (C) + Net demand deposits with banks(DD) + Other deposits with RBI (OD).

M2 = M1 + Post office saving deposits.

M3 = M1 + Net time deposits with banks.

M4 = M3 + Total deposits with post offices.

Of the four measures of money supply, M1 is the most liquid measure,while the M4 is least liquid. M1 is called the narrow measure of money supply,while M3 the broad measure of money supply. Further M1 measure of moneysupply is the same as implied in the traditional approach, while the M4, to someextent, is the one stressed by the modern approach. Though RBI has designed theabove mentioned four measures of money supply for India, it has been emphasingand using, for all practical purposes, only two measures, namely, M1 and M3.

In conclusion, the term money supply refers to all those assets which areeither liquid or can be made liquid without much delay and cost. An importantpoint to note about the term money is that it refers to all liquid assets held by thepublic at a point of time. By public, we mean the users of money (i.e. household& firms) and not the producers of money (i.e. the government, the central bank &commercial banks). Further the supply of money is measured at a point of timeand not over a period of time.

HIGH POWERED MONEY (H)

The discussion on the supply of money will be incomplete if no referenceis made to the concept of high powered money. The supply of money as given byMl or any other measure of money supply discussed above will derive its strengthfrom what is called as high powered money or base money. The high poweredmoney is the actual money in circulation and determines the total money supplyin an economy. The difference between total money supply as given by Ml andthe high powered money (H) can be understood by looking at the items includedin each.

M1 = C + DD + OD

H = C + CR + OD

As already discussed in the previous section, M1, the narrow measure ofmoney supply, includes coins & currency notes, demand deposits created by banks



NOTES

& other deposits with the RBI. Whereas, high powered money (H) includes coins& currency notes, cash reserves with banks (CR) and other deposits with the RBI.The comparison of Ml with H reveals that it is the DD in Ml and CR in H that isthe only difference between the two. However this difference is very important inthe theory of money supply as the CR in H represents the base of DD in M1. Thedemand deposits created by the banking system derive their strength from thecash reserves maintained. In other words, it is on the basis of cash reservesmaintained that banks create demand deposits. An important thing to note here isthat the demand deposits created on the basis of cash reserves are many timesmore than the cash reserves. This becomes possible due to the credit creationcarried out by the banks.

The relationship between the DD and CR gets carried to the relationshipbetween M1 and H. M1, which denotes total money supply in an economy, derivesits strength from H and is many times more than the later, H therefore impartspower to M1, that is, total money supply in an economy, and therefore is calledmoney with high power. The number of times the M1 will be greater than H iscalled the money multiplier and is given by,

M1 M = ___

H

The following diagram makes the relationship between M1 & H more clear.

As can be seen from the abovediagram that total supply of moneyas given by Ml is several times morethan H, mainly because of themultiple of demand deposits (DD)created on the basis of certain cashreserves (C R) by the banks. Thehigh powered money, as it possessesthe power of determining totalsupply of money, is called basemoney or reserve money orgovernment money.

7.3 SUMMARY

The money, which has assumed paramount importance in modern economy,performs four important functions viz., medium of exchange, measure of value,standard of deferred payments and store of value. Money, in its present form, hasevolved through different stages. The forms that it assumed include animal money,commodity money, metallic money, paper money and credit money.

Supply of money refers to all those assets that are available in spendableform and thus can be used by the people for making payments, both the present &future. As such money supply includes coins, currency notes, demand depositswith banks and all other near money assets that can be converted in to cash withoutmuch delay and cost. In India, RBI uses four different measures of money supply.They are M]} M2, M3 and M4. High powered money is that form of money supplywhich represents the base of total money supply in the system.


CHECK YOURPROGRESS

4. What is creditmoney?

5. D i s t i n g u s i hbetween themedium ofexchange functionand the measure ofvalue function ofmoney.

6. Elaborate the termsupply of money.

7. What do you meanby high poweredmoney?

Fig. 7.1 : Money Multiplier




NOTES

7.4 KEY TERMS

l Money : Money is anything that is generally acceptable and serves as amedium of exchange.

l Supply of Money : It refers to the total quantum of money available inthe system and includes all those assets which are liquid or are availablein spendable form.

l High Powered Money : This represents the actual money in circulation,forms the basis of total money supply in the system and includes coinsand currency notes, cash reserves with the banks and other depositswith the RBI.

7.5 EXERCISES

1. What is money? Explain the evolution of money.

2. Discuss in brief the importance of money in an economy.

3. Elaborate the important functions of money.

4. What do you mean by supply of money? Discuss the RBI’s approach tothe supply of money.










r r r



NOTES

UNIT 8 : MONEY : DEMAND FOR MONEY

Structure

8.0 Introduction

8.1 Unit Objectives

8.2 Subject Discription

8.2.1 Demand for Money

8.2.2 The Monetary sector Equilibrium under the Keynesian System

8.3 Summary

8.4 Key Terms

8.5 Exercises


8.0 INTRODUCTION

As elaborated in the previous unit, the monetary sector constituets animportant sector of the economy. The real sector, represented by the aggregatedemand and supply, derives its strength from the monetary sector. In other words,the equilibrium in the real sector, which provides us with the level of nationalincome, employment and price level, is determined by the equilibrium in themonetary sector. The monetary sector as stated earlier consist of supply of moneyand demand for money. Previous unit made us familier with the term moneysupply and its different constituents. Moreover, it also introduced to us the conceptof high powered money, which forms the basis of the total money supply in aneconomy.

Having studied the supply of money side in the previous unit, we shallproceed to get ourselves acquainted with the concept of demand for money andits determinants.

8.1 UNIT OBJECTIVES

This unit will introduce to us –

l The concept of demand for money.

l The approaches to the demand for money.

l The Keynesian theory of monetary sector equilibrium.


8.2.1 DEMAND FOR MONEY

Demand for money refers to the people’s desire to hold money withthemselves for different purposes. Why people desire to hold money is an area

Money : Demand forMoney




NOTES

where lot of research has gone and different economists have tried to answer thisquestion in their own ways. In this section, we will present an account of theways different economists have answered the above mentioned question. In otherwords, here we will discuss the approaches put forward so far to the concept ofdemand for money.

We have discussed the functions of money in the previous unit. We knowthat money serves as a medium of exchange, a store of value, a measure of value,and a standard of deferred payments. Among the four important function of moneywhich function or functions play important role in creating demand for money.This is where there are differences in opinion and therefore we have severalapproaches to the concept of demand for money. We will discuss these approachesin detail in the following manner.

A. CLASSICAL APPROACH

Though the classical approach to the term demand for money is associatedwith the classical economists like David Hume and J. S. Mill, it was Irving Fisherwho gave it a concrete form by putting forward his famous equation of exchange.

The classical economists believed that money is not demanded for its ownsake, but for the sake of buying goods and services. In other words, people needmoney because it facilitates the transactions of goods and services. It is the buyingpower of money which makes people demand it. Money is thus demanded becauseit serves as a medium of exchange. Classical economists thus emphasized themedium of exchange function of money. In their opinion the quantity of moneythat people (i.e. households and firms) would require would be determined by thetwo important factors, namely, the total quantity of goods and services that are tobe transacted during a given period and velocity of circulation of money.

The total quantity of goods and services to be transacted (to be paid forduring a period) multiplied by their price level will give us the amount whichpeople will need or demand. The amount so arrived at will facilitate the conductionof the transactions. The amount demanded by the people will thus be a directfunction of the value of total transactions. In other words, the demand for moneywill go up with the value of total transactions and will fall with fall in it. Thesecond factor that will determine the people’s demand for money is the velocityof circulation of money, which indicates the number of times a unit of money willbe used. Given the number of transactions to be carried out, lesser quantity ofmoney will be required, if velocity of money goes up and more quantity of moneywill be needed if it falls. People’s demand for money is thus an inverse functionof velocity of circulation of money.

The above discussion on the demand for money can be better explainedwith the help of Fisher’s equation of exchange, which actually seeks to explainthe direct and proportional relationship between the quantity of money and pricelevel.

MV = PT

Where, M = Quantity of money .

V = Velocity of circulation of money.

P = Price level.

T = Volume of transactions.



NOTES

The equation of exchange stated above implies that volume of money[quantity of money (M) multiplied by the velocity of money (V)], will be equalto the value of transactions [price level (P) multiplied by the volume of transactions(T)].

Manipulating the equation of exchange, the classical demand for moneyfunction (Md) can be stated as follows :-

PTMd = ____

V

The above equation implies that the demand for money (i.e. the amount ofmoney which people must hold) is the positive function of price level and thevolume of transactions and negative function of the velocity of circulation ofmoney. In other words, demand for money increases either with the increase inprice level and volume of transactions or with the decrease in velocity of money.It, on the other hand, decreases either with the decrease in price level and volumeof transactions or with the increase in velocity of money.

Given the above function of demand for money and the relationship impliedin it, we can find out the demand for money with the help of a hypotheticalnumerical example. Suppose the ‘V’ is 4, the ‘T’ during a year is 10000 and ‘P’ isRs. 20, then the demand for money (Md) will be -

PTMd = ____

V


20 x 10000 = __________

4

= Rs. 50,000

The classical explanation of the demand for money is however incompleteone as it only stresses the medium of exchange functions of money and ignoresthe store of value function. It is mechanical in the sense that it only indicates thatvalue of total transactions will always be equal to the volume of money. It takesthe objective route and ignores the subjective nature of demand for money andthe motives behind it.

B. THE CAMBRIDGE APPROACH

The Cambridge approach is also known as the Cash Balance Approach andis associated with the names of Marshall, Pigou and Robertson. This approachstressed the store of value function of money by introducing a slight change inthe Fisherian equation discussed above. Though the Cambridge approach to thetheory of demand for money is similar to the Fisherian approach, it differs fromthe later in that it interprets demand for money as demand for cash balances. Inother words, people demand money because they wish to hold cash balances withthem as ready purchasing power.

The Cambridge approach thus interprets the demand for money as the cashbalances held by the people as ready purchasing power and not the amountspent on goods and services. In a nutshell, instead of considering the total amountspent on goods and services as demand for money, the Cambridge approachconsiders only the fraction of nominal income (i.e. money income) as demand formoney.

CHECK YOURPROGRESS

1. What do you meanby demand formoney?

2. Why according tothe classicalApproach peopledemand money?

3. Explain the mainarguments ofc a m b r i d g eApproach to thedemand for money.




NOTES

The Cambridge approach is stated in the form of an equation which is asbelow,

Md = kPY

Where,

Md = demand for money

P = Price level

Y = Real national income (i.e. national income in terms of goodsand services produced)

k = The proportionality factor. It indicates the fraction of nominalnational income that people wish to hold in the form of cashbalances as ready purchasing power.

The above equation, thus, expresses the demand for money explicitly asthat fraction of money income which people want to keep with themselves ascash balances. It also makes people’s demand for money a direct and positivefunction of money income. It means the amount which people want to hold withthemselves varies positively with the nominal national income. Following theCambridge equation stated above, the demand for money can be computed in thefollowing manner. Suppose, k = 0.25, P = Rs. 20 and Y = 10,000, then the demandfor money will be.

Md = kPY

= 0.25*20*10000

= 0.25*2,00,000

= Rs. 50,000.

In this way, Cambridge approach to the demand for money maintains thatdemand for money means the fraction of nominal national income which peoplewant to hold with them as ready purchasing power. In their opinion, money thusserves not only as a medium of exchange but also a means of storing value. TheCambridge approach, in contrast to the Classical / Fisherian approach whichrecognizes demand for money as what people ‘have to hold’ to carry outtransactions, takes it as what people ‘want to hold’. The Fisherian approach, asgiven by equation of exchange, has considered the velocity of money (V), whilethe Cambridge approach has incorporated demand for money (k) explicitly in toits equation. However both these variables, namely, ‘V’ and ‘k’ are reciprocal ofeach other. It means both move in opposite direction (i.e. V = l/k or k = 1/V).

In conclusion, the Cambridge approach stands out as better theory of demandfor money as it explicitly expresses the demand for money in its equation as afraction of nominal income which people want to hold with them.

C. THE KEYNESIAN APPROACH

The Keynesian approach to the demand for money is actually the extensionof Cambridge approach . Keynes, though belonged to the Cambridge school ofthought, maintained slightly different views on people’s demand for money. Thebasic difference between the Cambridge approach and the Keynesian approach isthat the former considers only one motive behind the people’s desire to holdmoney with them, while the later states in all three motives. As per the Cambridge



NOTES

approach, people hold money with them for carrying out future transaction,whereas Keynesian approach introduces two more motives. Further, Keynesianapproach treats money as an asset in which people want to store the value. InKeynesian theory, the another asset that people store the value in is bonds. Amongthe two assets, the asset that people prefer for storing value is money due to itsliquidity character. Money is the most liquid asset and therefore people’s preferencefor money, in Keynes view, is actually the preference for liquidity. It is forincorporating this aspect of liquidity preference that Keynesian theory of demandfor money is termed as the theory of liquidity preference. In Keynesian sense, thedemand for money is the demand for liquidity.

Having outlined the difference between the Cambridge approach and theKeynesian approach, the question that arises is why after all people have strongpreference for liquidity, that is, why they want to hold money with them. Asstated above, Keynes has given three motives which prompt people for holdingmoney. These three motives are : 1) The transaction motive, 2) The precautionarymotive and 3) The speculative motive. Corresponding to these three motives theKeynesian approach splits the total demand for money in to three parts, viz. thetransaction demand for money, the precautionary demand for money and thespeculative demand for money. Let us explain these three motives behind thepeople’s demand for money.

I. TRANSACTION MOTIVE (Mt)

According to Keynes, this is the primary reason why people want to holdcash balances with them. This motive is the same as ‘k’ in the Cambridge approach.As the ck’ denoted people’s desire to hold cash balances for carrying outtransactions, the transaction motive in Keynesian approach also indicates the same.People receive income periodically, while they have to make paymentscontinuously. People therefore generally confront a gap between the receipt ofincome & the payments for purchases made continuously. It is this gap betweenthe receipts and payments that forces people to keep certain cash balances withthem in order to carry out their day to day transactions.

Though the people’s demand for money for transaction purpose dependson factors like the level of income, the spending habits and the time gap betweenthe receipt of income and payments, it is the level of income that primarilydetermines the transactions demand for money. The Keynesian approach thusstates the function of transaction demand for money in the following manner.

Mt = f (Y)

Where,

Mt = The transaction demand for money.

f = The functional relationship.

Y = The level of income.

The function for transaction demand for money states that the demand formoney under the transaction motive is a positive function of the level of income.This means an increase in income is followed by an increase in transaction demandfor money and vice versa. People can hold more cash balances for transactionpurpose only when their income level goes up.





NOTES

II. PRECAUTIONARY MOTIVE (Mp)

This motive represents the second reason why people wish to hold moneywith them. The unexpected contingencies that people encounter in their life areto be properly dealt with. As a precaution therefore people maintain some amountof money with them so that as and when the unpredictable events like illness,unemployment, etc. occur, they can adequately deal with them. The money heldunder this motive is thus maintained as precaution and therefore it is termed asthe precautionary demand for money. According to Keynes, the money held underthis motive is also the positive function of level of income. This is because thoughthe unforeseen contingencies are the same, a greater amount can be earmarkedfor dealing with them only when income level goes up. Thus,

Mp = f (Y)

Where,

Mp = The precautionary demand of money.

f = The functional relationship.

Y = The level of income.

The combination of money demanded for transaction purpose andprecautionary purpose is referred to as ‘active balance’, as it does not remain idlefor a long period of time. The relationship between the two types of demand formoney and the level of income is represented in the following diagram.

Fig. 8.1 : Transaction & Precautionary Demand for Money

The upward sloping line through the origin in the above diagram indicatesthe positive relationship between the level of income & the combined demand formoney under transaction & precautionary motive.

III. SPECULATIVE MOTIVE (Ms)

This represents the third reason why money is demanded by people and themost important contribution made by Keynes in the area of monetary and macroeconomics. People always have a speculator hidden in themselves. It is thisspeculator who always tries to take advantage of the fluctuating market conditions.By holding cash balances under this motive, people enable themselves to takeadvantage of the fluctuations in the market conditions, to be specific fluctuationsin the market rate of interest.

As stated in the beginning of the Keynesian approach, people can storevalue in two types of assets, viz., money and bonds. A bond as we know is a fixed



NOTES

income earning asset and earns income in the form of rate of interest. The rate ofinterest, according to Keynes, not only represents the rate of return (i.e. income)on bonds, but also the cost of holding money. So, if people hold money under thismotive they will have to incur cost in terms of the rate of interest foregone, whichthey could have earned by putting their money in bonds. The money balanceswhich people will hold with them for speculation purpose will therefore bedetermined by the rate of interest. Greater amount held would mean greater lossin terms of the interest foregone and vice versa. Thus people will be induced tohold the greater amount of money for speculation purpose only when the rate ofinterest is low as it would translate in to smaller loss in terms of the interest rateforegone. At a higher rate of interest, on the other hand, smaller amount will beheld under the speculative motive.

The rate of interest and the speculative demand for money share inverserelationship. There is one more way this inverse relationship can be explained.The interest rate and the bond prices are inversely related. When people expectthe rate of interest to go up, they will hold more cash with them so, that when theinterest rate does go up and bond prices fall, they will be able to buy them atlower prices. So, when the rate of interest actually goes up people switch frommoney to bonds, meaning their speculative cash balances fall in response to anincrease in rate of interest. Reverse will happen when the rate of interest declines.The inverse relationship between the rate of interest and the speculative demandfor money (i.e. speculative cash balances) is presented in the following function& diagram. It is however to be noted that this inverse relationship will not holdtrue at a very low rate of interest. As shown in the diagram, at a very low rate ofinterest (r*) the speculative demand for money will be perfectly elastic, meaningthat at this rate of interest people would hold as much cash with them forspeculation purpose as supplied. This happens because the cost of holding money,that is, the rate of interest, is very low and bond prices very high. This situation,as shown in the diagram is described as the liquidity trap. It implies that at a verylow rate of interest people have infinite preference for liquidity.

Ms = f (r/i)

Where,

Ms = Speculative demand for money.

f = Functional relationship.

r/i = Rate of interest.

Fig. 8.2 : Speculative Demand for Money





NOTES

TOTAL DEMAND FOR MONEY

The Keynesian approach to the demand for money presented above in termsof three motives can be summarized in the following manner. According to Keynes,the total demand for money has three components, namely, the transaction demandfor money, precautionary demand for money and the speculative demand formoney. The first two are the products of level of income, while the third a productof rate of interest. Thus, the total demand for money, that is, the total amount ofmoney which people would like to hold with them, can be stated in the followingway.

Md = Mt + Mp (Y) +Ms (r/i)

Based on the above equation, the total demand for money curve can bedrawn in the following manner.

Fig. 8.3 : Total Demand for Money

As shown in the above diagram, total demand for money curve (Mt + Mp +Ms) can be drawn by horizontally adding the transaction, the precautionary andspeculative demand for money at each rate of interest. It is to be noted that in part‘A’ of the diagram, the transaction & precautionary demand for money is shownby an inelastic curve (i.e. vertical to ‘Y’ axis). This is because these two componentsof total demand for money are independent of the rate of interest. In part ‘C’ ofthe diagram, we get total demand for money curve, which is parallel to speculativedemand for money curve, but horizontally away from the vertical axis by theamount equal to the transaction & precautionary demand for money.

The Keynesians approach, though superior to the earlier ones, has beencriticized on the ground that it unrealistically segregates the total demand formoney in to three components and assumes only two forms of assets, viz, moneyand bonds, in which people store the value.

8.2.2 THE MONETARY SECTOR EQUILIBRIUMUNDER THE KEYNESIAN SYSTEM

By monetary sector of the economy, we mean that sector which deals withthe supply of and demand for money. It can also be described as that sector ormarket where those who supply money & those who demand money come together.The monetary sector attains equilibrium when the supply of money and demandfor money become equal. The previous sections of this unit have talked about thedetermination of supply of money and the demand for money.

CHECK YOURPROGRESS

4. D i s t i n g u i s hbetween thecambridge and theK e y n e s i a nApproachs to thedemand for money.

5. What do you meanby active balance?

6. What determinesthe speculativedemand formoney?

7. What do youunderstand by‘liquidity trap’?



NOTES

By supply of money, we mean coins, currency notes, demand deposits andother similar assets which are liquid and are thus in a spendable form. The totalsupply of money in circulation, as we have learned, is determined by the highpowered money, which in turn owes its determination to the monetary authorityof the country, meaning the government & the central bank. In India’s case, thesupply of money is fixed by the government of India & the RBI.

In the Keynesian framework, the supply of money is perfectly inelastic,meaning that it remains constant in the short run and therefore the money supplycurve (Ms) takes the vertical shape as shown in the diagram below. The verticalsupply of money curve also indicates that the supply of money is independent ofthe rate of interest.

The total demand for money curve, representing the horizontal summationof transaction, precautionary and speculative demand for money, is shown in thediagram as a negatively sloping curve (Md). Note that the negative slope of thetotal demand for money curve is the result of inverse relationship observed betweenthe rate of interest and the speculative demand for money.

The supply of money curve (Ms) and the demand for money curve (Md)intersect at point ‘E’ and determine the equilibrium rate of interest equal to rE.

Fig. 8.4 : Monetary Sector Equilibrium

As shown in the above diagram, the monetary sectors attains equilibriumat point ‘E’, as it is at this point that supply of and demand for money havebecome equal. The interest rate (rE) corresponding to this equilibrium point willprevail in the market. Any other interest rate would mean either the supply ofmoney is greater than the demand for money (at r2) or the former is smaller thanthe later. For instance, at r2, the supply of money exceeds the demand by PQ. Themonetary authority is supplying more money than what people wish to hold withthem. This will pull the interest rate down till the equilibrium is restored at apoint ‘E’ and rate of interest becomes rE.

8.3 SUMMARY

In economics, demand for money implies people’s desire to hold moneywith themselves for different purposes. Why people want to hold money withthemselves is an area where there is no consensus among economists. Differenteconomists have tried to answer the question why people wish to hold moneywith themselves in their own ways. As a result, we come across several approaches





NOTES

to the demand for money. Each approach to the demand for money attempts toexplain as to why people hold money with themselves by emphasing one or theother function of the money. In other words, people’s demand for money isexplained by taking into account one or more functions of money.

The classical approach as put forward by Irving Fisher emphasises themedium of exchange function of money, while the Cambridge approach lays morestress on the store of value function of money. The Keynesian approach pinpointsthree important motives behind the people’s demand for money. They aretransaction motive, precautionary motive and speculative motive. The Keynesianapproach also provides us with a framework of demand for and supply of moneyto explain as to how the monetary sector of the economy attains its equilibriumand how the rate of interest is determined, which connects the monetary sectorwith the real sector of the economy by influencing investment demand (I) in theeconomy.

8.4 KEY TERMS

l Demand for Money : This refers to the people’s desire to hold moneywith themselves for different purposes.

l Transaction Demand for Money : Money held or demanded by thepeople for carrying out their transactions.

l Precautionary Demand for Money : Money held or demanded by thepeople for dealing with unexpected events.

l Speculative Demand for Money : Money held or demanded by thepeople for the speculation purpose, that is, for taking advantage of themarket fluctuations.

8.5 EXERCISES

1. Explain in brief the term demand for money.

2. Elaborate the Classical approach to the demand for money.

3. Illustrate the concept of demand for money as implied in the Cambridgeapproach.

4. Explain the Keynesian approach to the demand for money. How is itdifferent from the classical approach?

5. What are the important features of Classical, Cambridge and Keynesianapproaches to the demand for money?






NOTES







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NOTES

UNIT 9 : DEMAND FOR MONEY : RECENTDEVELOPMENTS

Structure

9.0 Introduction

9.1 Unit Objectives


9.2.1 Portfolio Theory of Demand for Money

9.2.2 Friedman’s Approach

9.3 Summary

9.4 Key Terms

9.5 Exercises


9.0 INTRODUCTION

All the three approaches to the demand for money discussed in the previousunit have their shortcomings. They have been criticised on some important grounds.The Keynesian approach to the demand for money, which marks improvementover the Classical and the Cambridge approaches, also suffers from somedrawbacks. For example, it unnecessarily segregates the people’s demand formoney in to three parts based on three motives and assumes the transaction andprecautionary demand for money as interest inelastic. The real world experiencehowever doesn’t support this. Further, Keynesian approach considers money andbonds as the only two forms of assets in which people can hold their wealth. Thisalso is unrealistic in modern times when various alternatives are available. It wasbecause of these shortcomings that modifications have been made to the Keynerianapproach and new approaches have been put forward to explain the term demandfor money in a more realistic form.

9.1 UNIT OBJECTIVES

This unit will explain to us –

l The Portfolio approach to the demand for money.

l The Freidman’s approach to the demand for money.


9.2.1 PORTFOLIO THEORY OF DEMAND FORMONEY

The Keynesian theory of demand for money discussed in the previous unithas been criticized on two important grounds and accordingly new approaches to



NOTES

the theory of demand for money have been put forward. The Keynesian theorysegregates an individual’s total demand for money into three parts, each partbeing devoted to a particular motive. The motives resulting into separation oftotal demand for money into three parts are the transaction motive, theprecautionary motive and the speculative motive. According to critics, separationof total money held into three parts for three motives is not possible. Money heldto satisfy one motive is always available to satisfy another one. Thus there is noneed of holding money separately for each motive. In their view therefore theKeynesian way of dividing the total money holdings into three components isunrealistic one. The second criticism is levelled against the Keynesian propositionthat makes transaction demand for money interest inelastic. According to critics,money held for any propose, be it a transaction or speculative, will be affected bythe rate of interest, which represents the cost of holding money.

Given the shortcomings of the Keynesian theory of demand for money,new theories have been developed on the Keynesian lines of thinking, but togive a more realistic explanation of demand for money. One such theory isassociated with the name of James Tobin, who explained the speculative demandfor money or the liquidity preference in terms of the behaviour towards risk. Hedisagreed with the Keynesian notion that an individual either holds cash or bonds,but not both simultaneously. In other words, an individual will not have acombination of cash and bonds in his portfolio. His portfolio will either containall cash and zero bonds or all bonds and zero cash. What an individual’s portfoliowill contain will be determined by the expectations about the future rate of interestor bond prices.

Though Tobin’s conclusion regarding the shape of the liquidity preferencecurve (negatively sloping indicating inverse relationship between rate of interest& speculative balances) is similar to that of Keynes, he supports it on the basis ofindividual’s behaviour towards risk and maintains that the individual’s portfoliowill have both cash and bonds. Whether the portfolio will contain more of cash ormore of bonds will depend upon the type of the individual, that is, whether he isa risk taker or risk avert.

According to Tobin, whenever an individual holds bonds against the cash,he shoulders the risk of capital loss or gain on account of the uncertaintysurrounding the future bond prices. Given the risk associated with the holding ofbonds, an individual’s portfolio composition will depend on whether he is a risklover or risk avert. A risk lover, according to Tobin, is more likely to hold all hisassets in bonds and will not be required to be induced by higher rate of interest todo so. The risk avert individual on the other hand will keep his portfolio morediversified and will tilt towards more bonds only when the rate of interest increasesto compensate for the additional risk involved in keeping more bonds & lesscash.

Tobin maintains that in actual practice more people are risk avert ratherthan risk takers. Risk averts people, according to him, will compare the elementof risk and expected return from the investment in bonds, while deciding theportfolio composition.

To explain how an individual reaches an optimal combination of bondsand speculative balances (i.e. optimal portfolio), we need to take the help ofindifference curve analysis. Such an exercise presented below will revealthat a risk avert individual will hold both bonds & speculative balances in hisportfolio.

Demand for Money : RecentDevelopments




NOTES

Fig. 9.1 : Portfolio Theory of Demand for Money

The above figure illustrates the optimal decision making by an individualwith regard to the composition of his portfolio. The distribution of total assetsinto idle cash balances and bonds is shown in the lower part of the figure and thetrade off between risk measured on the horizontal axis and expected returnmeasured on the vertical axis in the upper part. The expected return will be afunction of the rate of interest and the expected capital gain or loss. If we assumea rate of interest of r1; the optimal combination will be OC of risk combined withOB of expected return as represented by point K.1 in the upper part of the diagram.This optimal combination of risk and return would mean the individual will haveOE part of his assets in bonds and YF part in idle cash.

If we assume that rate of interest goes up to r2, the expected return at everylevel of risk would increase, as shown by the leftward movement in the risk returntrade off curve from r1 to r2. A rise in the interest rate (like the rise in price inindifference curve analysis) will produce two effects, namely, income effect andsubstitution effect. The income effect would prompt the investor to take less risk(as the income has already gone up due to rise in interest rate), while the substitutioneffect will drive the investor towards more risk (as the cost of holding idle cashbalances has increased following the rise in interest rate). Whether the investorwill go for more risk or otherwise will depend upon which effect of the rise ininterest rate is stronger. If the substitution effect is stronger as shown in the diagram,the investor will go for more risk and his new optimal combination will be OD ofrisk and OA of return. Accordingly, his investment in bonds will increase fromOE to OG and cash holding will fall from YF to YH.

In conclusion, the Tobin’s analysis of demand for money helps us obtainthe same result as that of Keynesian. The demand for money and rate of interestshare the inverse relationship and the shape of the speculative demand for moneycurve is negatively sloping. However, using the indifference curve analysis andby assuming that the substitution effect outweighs the income effect, Tobin, unlikeKeynes, concludes that an individual’s portfolio will consist of both the bondsand idle cash balances.



NOTES

9.2.2 FRIEDMAN’S APPROACH

Milton Friedman, the father of monetarism, propounded his own theory ofdemand for money as a theory of demand for any other durable good. Accordingto him, money should be treated like any other durable goods or an asset. Byapplying the standard theory of demand for durable goods to explain the demandfor money, he pinpointed the important factors that will determine the demandfor money as an asset and formed his own function.

If we recall the standard theory of demand for a durable good, it won’t bedifficult for us to find out the determining factors of demand for money. As thedemand for a durable good is a function of its price, consumer’s income, prices ofcomplimentary and substitute goods, consumers taste and preferences and so on,the demand for money as an asset, according to Friedman, will be the function ofgenera] price level, income, rate of return on consumer durable goods, rate ofreturn on alternative assets like bonds and equities, human capital and the tasteand preferences of the holders of money.

According to Friedman, people wish to hold money as an asset or a durablegood because it renders services to the holder in the form of convenience, securityand liquidity. Though the services rendered by the money balances are notquantifiable like the rate of return on other assets, according to Friedman, it isthese services that induce people to hold money. Given the reason why peoplehold money, how much money they will hold depends on the factors like pricelevel, income, rates of return on alternative assets and taste & preferences of themoney holders? Friedman short listed the factors determining people’s demandfor money in the form of a function.

M = f (P, Y, rd, r

b, r

e, W, t).

Where,

M = Demand for money.

P = General price level.

Y = Real income.

rd = Rate of return on consumer durable goods given by the expected

rise in price level.

rb = Rate of return on bonds.

re = Rate of return on equities.

w = Ratio of non human wealth to human wealth.

t = Money holder’s taste and preferences, which are affected by utilitydetermining factors like economic stability.

The above function of demand for money formulated by Milton Friedmanreveals that he went far beyond the traditional monetary theory which linked themoney demand only with the price and income levels. Friedman, linked the moneydemand with an important factor, that is, the cost of holding money or cashbalances, measured in terms of the interest income foregone from other alternativeassets like durable goods, equities and bonds. According to Friedman, the moneyholder’s demand for money will vary inversely with the rates of return on thesealternative assets. Another important factor incorporated by Friedman, in hisfunction is the ratio of non human wealth to human wealth. By human wealth,Friedman refers to the money holder’s earning capacity which is the product of


CHECK YOURPROGRESS

1. What is the basicargument of Port-folio theory?

2. Explain the maincriticisms levelledagainst Keynesianapproach.

3. What according tofriedman deter-mines the demandfor money?




NOTES

his education and training undergone. Greater the ratio of non-human wealth tohuman wealth, higher is possibility of converting the later in to former.Consequently, the demand for money will be higher. The last factor that influencesthe demand for money, in Friedman’s view, is the taste & preferences of the moneyholder. Greater preference for liquidity would mean higher demand for moneyand vice versa.

In conclusion, Friedman’s approach to the demand for money enhances theKeynesian demand for money function by incorporating other importantdeterminants of demand for money in to it. The kind of impact that thesenewly added variables will have on demand for money is also dealt with by theFriedman in his approach. While specifying the new demand for money function,Friedman applied the simple theory of demand for consumer durables. However,like the standard theory of demand for consumer durables, Friedman’s theoryalso fails to quatify the relative impact that determinant’s of demand for moneywill have on it.

9.3 SUMMARY

The recent developments in the theory of demand for money represent themodifications introduced by the Tobin and Friedman in the demand for moneyfunction. Both Tobin and Friedman have extended the demand for money functiondeveloped by Keynes and have considered money as one of many assets in whichpeople store their wealth.

Using the indifference curve analysis, Tobin reaches the same conclusionas the Keynesian approach and it reveals that an individual’s portfolio will consistof both the bonds and idle cash balances. Milton Friedman, on the other hand,extended the Keynesian demand for money function by incorporating otherimportant determinants of demand for money like the rates of return on equities,consumer durables, real income, ratio of non human wealth to human wealth andtaste and preferences of the wealth holder. In short, while specifying the newdemand for money function, Friedman applied the simple theory of demand forconsumer durables.

9.4 KEY TERMS

l Portfolio : If refers to the composition of basket representing variousassets in which individuals hold their money or wealth.

l Monetarism : It is a school of thought which assigns the most importantrole to money in an economy. According to this school, money is theonly thing that matters.

9.5 EXERCISES

1. Discuss the portfolio approach to the demand for money.

2. Elaborate the Friedman’s approach to the demand for money.

3. Distinguish between the Keynesian demand for money function and theFriedman’s demand for money function.



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UNIT 10 : IS - LM MODEL OFTHE ECONOMY

Structure

10.0 Introduction

10.1 Unit Objectives


10.2.1 IS-LM Model – An Introduction

10.2.2 IS-LM Model with Government Sector

10.2.3 IS-LM Model with Foreign Trade

10.2.4 Aggregate Demand & Aggregate Supply

10.2.5 Macroeconomic Issues

10.3 Summary

10.4 Key Terms

10.5 Exercises


10.0 INTRODUCTION

The macroeconomic developments and changes and their impact on thefunctioning of the economy can be analysed in right manner only when we havea macroeconomic model at our disposal which captures interdependence betweenthe product market and money market of the economy and explains howequilibrium is established in both the markets simultaneously. Such a model whichcombines the real sector and monetary sector of the economy to explain how therate of interest and level of income is simultaneously determined is popularlyknown as the IS-LM model of the economy.

The IS-LM model is basically an interest rate determination theorydeveloped by Prof. Hicks and Prof. Hanson by bringing about a synthesis betweenthe classical and loanable fund theory of interest and the Keynesian theory ofinterest. The synthesis brought about in the form of IS-LM model explains howthe rate of interest and level of income are related in both the goods market andmoney market of the economy. The IS-LM model, though is a interest ratedetermination theory, also represents a macroeconomic model of the economyand explains how various macroeconomic variables are interconnected.

In this chapter, we shall first develop the IS-LM framework to explainsimultaneous determination of rate of interest and level of income by combiningthe goods market and the money market. The same framework will then beextended to include government sector and foreign trade sector. Finally, theIS-LM framework will be used to derive the aggregate demand (AD) andaggregate supply (AS) curves so as to explain the determination of price leveland income.



NOTES

10.1 UNIT OBJECTIVES

After studying this unit, you would be able to understand –

l The functioning of economy and how equilibrium is established in itstwo important sectors viz. real sector and monetary sector.

l How incorporation of government and foreign trade sector in to theeconomy affects the equilibrium.

l How the rate of interest and level of income are simultaneouslydetermined.

l The determination of level of income and price level through the equalitybetween aggregate demand (AD) and aggregate supply (AS).


10.2.1 IS-LM MODEL – AN INTRODUCTION

This section devotes itself to developing the IS-LM framework of a simpleeconomy consisting of two sectors, namely, goods sector and money sector. TheIS curve explains the equilibrium in the real or goods sector. The IS curve givesus various combinations of rate of interest and level of income at which savingsare equal to investments. The LM curve on the other hand represents moneymarket equilibrium achieved at various levels of income and rate of interest wheredemand for money (Liquidity Preference) is equal to supply of money.

The goods market equilibrium as given by the IS curve requires that supplyof goods & services is equal to the demand for goods & services. In other words,it requires that all income is spent. The national income identity tells us thatincome is either spent or saved, which means.

Y = C + S

Where,

Y = Income

C = Consumption

S = Savings

For the entire income to be spent, savings are to be matched by investment.So the goods market equilibrium requires

S = I

Where,

S = Savings

I = Investment

We know that savings are the function of level of income, as also the rateof interest, while investment is a function rate of interest. So, the goods marketequilibrium will involve following three equations.

Saving function : S = F (Y)

Investment function : I = F (r/i)

Equilibrium condition: S = F (Y) = I f (r/i)

IS - LM Model of theEconomy




NOTES

The money market equilibrium will be attained when the liquidity preferenceof the people is equal to the supply of money fixed by the monetary authority ofthe country. The Keynesian liquidity preference theory tells us that demand formoney (i.e. liquidity preference) is a function of both the level of income and therate of interest, while the supply of money, as it is fixed by the monetary authority,has nothing to do with the either of them. So, the money market equilibrium, asLM curve is going to reflect, will require.

Md = Ms

The equilibrium condition of the money market can be rewritten as,

Md = F (Y, r/i) = Ms

The left side of the above equation indicates the demand for money as afunction of level of income (transaction & precautionary motive) and rate ofinterest (speculative motive)

Given the conditions for equilibrium in both the markets, we can now turnto the derivation of IS and LM curves, which will represent goods and moneymarket equilibriums respectively.

GOODS MARKET EQUILIBRIUM

The goods market equilibrium as given by the IS curve can be explainedwith the help of following diagram, involving four parts.

Fig. 10.1 : Goods Market Equilibrium

In part A of the diagram, investment is shown as a inverse function of rateof interest. When the rate of interest is 6%, investment level is determined as

IS



NOTES

Rs. 20. This investment level is shown to be equal with saving in part B. Part C ofthe diagram, which represents saving function, indicates that for savings to be Rs.20, level of income should be Rs 120. This gives us a combination of 6% rate ofinterest and Rs 120 as level of income. In the same way, a 5% rate of interest willbe consistent with the level of income of Rs 130. As 5% rate of interest willdetermine investment of Rs 30 and for savings to be Rs 30, income level shouldbe Rs 130.

The two combinations of rate of interest and level of income as shown bypoints E & E1 in part D of the diagram will give us the IS curve. The IS curve soderived represents goods market equilibrium. In other words the IS curve givesus all those combinations of rate of interest and level of income where savingsare equal to investment, that is, demand for goods and services is equal to supplyof goods and services. Any other comnination lying off the IS curve, either to theright or to the left, will indicate disequilibrium in the goods market (e.g.combinations M & N in the diagram)

MONEY MARKET EQUILIBRIUM

As explained earlier money market equilibrium requires that demand formoney is equal to supply of money at a given level of income and rate of interest.The LM curve as derived in the following diagram, will give us all suchcombinations of level of income and rate of interest where the demand and supplyof money are in equilibrium.

Fig. 10.2 : Money Market Equilibrium

Part A of the diagram indicates that 6% rate of interest will determine thespeculative demand for money of Rs 40. Given the supply of money of Rs. 100,





NOTES

transaction demand for money (Mt) will be Rs. 60 and this level will be consistentwith a level of income of Rs. 120, as shown in part C of the diagram. This givesus a combination of 6% rate of interest and Rs. 120 as level of income (Point E).If the rate of interest is lower at 5%, money demand for speculation purpose willbe Rs. 50 and consequently money demand for transaction purpose will be Rs.50. This level of transaction demand for money is possible only when the level ofincome is Rs. 100. A level of income of Rs. 100 is therefore consistent with therate of interest of 5%. This is shown in part D of the diagram as point El. Joiningthese combinations of income & rate of interest (Point E & E1) will give us theLM curve, sloping upward from left to right and indicating various combinationsof level of income & rate of interest at which money market is in equilibrium, thatis, money demand is equal to money supply. Any other point off the LM curve,lying either to the right or left, implies disequilibrium (Point M and N)

EQUILIBRIUM WITH IS LM FRAMEWORK

As explained above, the goods market equilibrium is given by the IS curveand the money market equilibrium by the LM curve. Equilibrium in goods marketrefers to a situation where in at a given rate of interest and level of income thedemand for goods is equal to supply of goods (i.e. savings are equal to investment).The Money market equilibrium on the other hand is possible when for a givencombination of rate of interest and level of income the demand for money equalsthe supply of money. Given the descriptions of the IS and LM curves, asimultaneous equilibrium in both the markets (i. e. goods market & money market)will be established at a point where two curves intersect each other. Such a pointis shown in the following diagram indicating a situation wherein for a givencombination of rate of interest and level of income not only is the goods marketin equilibrium but the money market is also in balance.

Fig. 10.3 : IS-LM Framework

As shown in the above diagram, point ‘E’ is the intersection point betweenIS and LM curves. It indicates that for a combination of 6% rate of interest andlevel of income of Rs. 120, both the markets are simultaneously in equilibrium.The above diagram and point ‘E’ in it, therefore, indicates equilibrium in aneconomy consisting of two markets, viz. goods market & money market. Anyother point in the diagram (other than point ‘E’) will indicate disequilibrium eitherin goods market or in money market or in both the markets.

CHECK YOURPROGRESS

1. What an IS curverepresents?

2. How an IS curve isderived?

3. Explain thederivation of theLM curve.

4. Explain howincome and rate ofinterest ared e t e r m i n e ds imul taneous lyusing IS - LMframework.



NOTES

10.2.2 IS-LM MODEL WITH GOVERNMENT SECTOR

If we consider an economy consisting of three sectors, adding thegovernment sector to a simple two sector model, the IS-LM framework and theequilibrium will change in the following manner. The addition of the governmentsector to the simple two sector model would mean government spending is addedto the investment schedule and taxes are included in savings schedule. Thisincorporation will change the equilibrium condition in goods market from S = Ito S + T = I + G. The goods market equilibrium requires the aggregate demand forgoods and services to be equal to aggregate supply of goods and services. Withthe government sector added, this is possible only when the leakages from thereal income stream in the form of saving and taxes (S + T) are exactly matched bythe compensating injections in the form of investment and government purchases(I + G).

With balanced budget and independence of the government spending andtaxes of the level of income, a Rs. 20 increase in government spending will shiftthe I curve to the right by Rs. 20. The matching rise of Rs. 20 in taxes will firstreduce the private savings by Rs. 10 (assuming Mps of 0.5). So when the reducedprivate savings by Rs. 10 are added with the rise in taxes of Rs. 20, the ‘S’ curvewill shift leftward by Rs. 10. The new curves will be I + G and S + T as shown inthe following diagram.

Fig. 10.4 : IS - LM Frameworks with Government Sector

The initial equilibrium is given by point E in part D of the diagramwhere 6% rate of interest and Rs. 120 as level of income ensures simultaneous


R R




NOTES

equilibrium in goods and money market. A Rs. 20 increase in governmentexpenditure shifts the I curve to a new position, I + G. Given the MPS of 0.5 andresulting multiplier quotient of 2, the impact of increase in government spendingof Rs. 20 should produce a double increase in income and should take it to Rs.160. However, income increase by Rs. 20 only and settles at Rs. 140, as shown bypoint E1 in part D of the diagram. This happens because the rise in income isaccompanied by the rise in rate of interest, which reduces the private investmentby Rs. 10. So, the increase in government spending by Rs. 20 effectively becomesthe increase of Rs. 10 and therefore, due to the working of multiplier, incomeincreases by Rs. 20, to settle at Rs. 140, along with the rate of interest of 7 %.

If we take the balanced budget assumption, a Rs. 20 increase in governmentexpenditure (as shown by the 1 + G curve in part A) will require a matchingincrease in taxes. The Rs. 20 increase in taxes will first reduce the private savingsby Rs. 10 (given the MPS of 0.5), as shown by the rightward shift in saving curvefrom S1 to S2. In part C of the diagram, when the reduced private savings areadded with the rise of Rs. 20 in taxes, the S2 curve will shift leftward to assumethe position shown by S2 + T curve. This leftward shift in the savings curve to S2

+ T will cause the IS curve to take a new position as 1S3. This new IS3 curvealong with the LM curve gives us a new equilibrium point E2, where the rate ofinterest of 6.5 % is consistent with the level of income of Rs. 130.

In short, given the assumption of balanced budget and independence of thegovernment spending and taxes of the level of income, the simple two sector IS-LM framework extended to include the government sector (with balanced budgetof Rs. 20) shifts the equilibrium position from point E to E2 .The combination ofincome and rate of interest, changes from Rs. 120 and 6% respectively to Rs. 130and 6.5%. The new combination of income and rate of interest as shown by pointE2 in part D, ensures simultaneous equilibrium in three sectors of the economy,viz., goods sector, monetary sector and government sector.

10.2.3 IS-LM MODEL WITH FOREIGN TRADE

We shall now extend the IS-LM framework to include foreign trade ascaptured in the balance of payments accounts. Balanced of payments is a systematicrecord of a country’s transactions with the rest of the world. The BOPs is madeup of two accounts, namely, the current account and capital account. The balanceof payment is always in equilibrium as the surplus/deficit on one account ismatched by the deficit/surplus on another account of the BOPs. In other words,surplus/deficit on current account of the BOPs is matched by the deficit/surpluson capital account and therefore balance of payments always balances.

In order to derive a balance of payments curve, indicating BOP equilibriumat various combinations of income and rate of interest, we will make the followingassumptions. First, we assume that exports are determined exogenously, that is,by factors outside the domestic economy. Second, we make imports a positivefunction of level of income. This will mean the X-M balance changes inverselywith the domestic income level. The higher level of income would mean higherimports and therefore, the X- M balance (net export balance) will be smaller.Reverse will happen with lower level of income. This is shown in the part C ofthe diagram. The third assumption that we make relates to the capital account ofBOPs. We assume the net capital outflow as an inverse function of domestic rateof interest, with interest rates in other countries given. This implies higher interestrate in domestic economy will result in to smaller net capital outflow (capital

CHECK YOURPROGRESS

5. Explain the threesector equilibriumusing IS-LMframework withgovernment sector.

6. Explain how theequilibrium isimpacted with theinclusion offoreign tradesector in to the IS-LM framework.



NOTES

outflow < capital inflow) and vice versa. Part A of the diagram below shows thisinverse relationship between domestic rate of interest and net capital outflow.

As stated above, for the balance of payments to be in equilibrium sum ofbalance on its two accounts need to be zero. The surplus on one account needs tobe matched by deficit on other account and deficit on one need to be offset bysurplus on other. This relationship between the current and capital account of theBOPs, is shown in part B of the diagram.

Given the above mentioned assumptions and relationships, the balance ofpayments/functions’ curve is derived in part D of the diagram. In the part A of thediagram, 6% rate of interest is shown to have produced a net capital outflow ofRs. 30. Part B shows the equally between net capital outflow and net exportbalance. Given the net capital outflow of Rs. 30, the net export balance will beRs. 30 at a level of income of Rs. 120. This is shown in part C of the diagram. So,balance of payments equilibrium is ensured at a rate of interest of 6% and level ofincome of Rs. 120. This is shown in, Part D of the diagram by point ‘E’. In otherwords point ‘E’ of part D gives us a combination of rate of interest (6%) andincome level (Rs. 120), which ensures balance of payments equilibrium, that is,equality between current account balance (X-M) and capital account balance(NCO).

Fig. 10.5 : IS-LM Framework iwth Foreign Trade Sector

At a somewhat higher rate of interest of 6.5%, the net capital outflow willbe smaller at Rs. 25. Balance of payments equilibrium requires current accountbalance or net export balance to be Rs. 25. This net export balance is possible atan income level of Rs. 130. So we obtain another combination of rate of interestand level of income at which balance of payments is in equilibrium. Thiscombination is given by point E1 in part D of the diagram. The two combinationsof income & rate of interest, as given point E & E1, will give us the BP function,sloping upward from left to right. This BP function or curve, like the IS or LMcurves, is a locus of points of all those combinations of income and rate of interestat which the balance of payments balances.


NCO




NOTES

EQUILIBRIUM IN FOUR SECTOR MODEL

Using the IS-LM framework extended to include the government and foreigntrade sector, it can be shown as to how equilibrium is established simultaneouslyin all the four sectors of the economy. This is done in the following diagram.

The above diagramshows equilibrium in a foursector model. The IS + Gcurve represents all thecombination of rate ofinterest and income level atwhich the goods sectoralong with the governmentsector is in equilibrium, thatis, the demand for goodsand services is equal to itssupply. The LM curveshows all thosecombinations of rate ofinterest and level of incomeat which money market isin equilibrium. BP curve, inthe same way, represents

equilibrium in foreign trade sector of the economy. These three curves interest atpoint E and give us a combination of rate of interest (6.5%) and level of income(Rs. 130) which ensures simultaneous equilibrium in all the four sectors of theeconomy.

The four sector equilibrium shown in the above diagram can get disturbedif there is change in any of the factors affecting either the goods market equilibrium(the IS curve), or the money market equilibrium (the LM curve) or the balance ofpayments equilibrium (the BP curve). Furthermore, if there is disequilibrium inthis four sectors model, equilibrium can be established by effecting changes inany of the sectors of the economy. In other words, the three curve representingfour sectors of the economy can be shifted rightward or leftward to restoreequilibrium by selecting appropriate policy options.

10.2.4 AGGREGATE DEMAND & AGGREGATE SUPPLY

The IS-LM framework that we have developed so far has been developedon the basis of an important assumption of stable price level. The impact of thechange in price level on the framework we have developed can be analyzed in thefollowing manner and on the basis of that analysis, we can derive the aggregatedemand curve, which will represent the inverse relationship between the pricelevel and aggregate demand for goods & services.

Before deriving the aggregate demand curve, we will take aggregate supplycurve, involving three ranges, as shown in the part B of the diagram. The firstrange of the aggregate supply curve (AS) is a perfectly elastic portion indicatingthe possibility of increase in supply without any increase in price level. This is aKeynesian range and is representative of less than full employment situation orrecession in the economy. The second range is the upward sloping portion of theAS curve and is associated with monetarists. This range implies that increase insupply is possible only when there is increase in price level. This is because,

Fig. 10.6 : Equilibrium in Four Sector Model



NOTES

according to monetarists, as the economy approaches full employment state, someincrease in input cost is inevitable and to cover this rising cost price level mustsufficiently rise. The third range is the classical range and is representative ofstate of full employment. The vertical portion indicates that no increase is possiblein supply beyond this level irrespective of any level of rise in price level. Giventhe shape of the aggregate supply curve, we can now explain how aggregatedemand curve is derived from the IS - LM frame work.

Fig. 10.7 : IS - LM Model and AD and AS Framework

Here we are assuming that IS curve is unaffected by the changes in pricelevel. The impact of change in price level on the LM curve is considered only.The LM curve is derived on the assumption of stable price level. Now, we shalldrop that assumption and shall see how change in price level will affect the LMcurve through its effect on supply and demand for money. It should be noted thatwhile deriving the LM curve, real supply of money (Md/P) and real demand formoney (ML/P) were considered. Given the real demand for money, any fall inprice level would increase the real supply of money. This will shift the LM curveto the right. The result will be fall in rate of interest and increase in income level.This means at a lower price level larger quantity of output (higher real income) isdemanded. This inverse relationship is shown in part B of the diagram. This inverserelationship between the price level and aggregate demand for goods and servicescan be justified in the following manner. When there is fall in price level, realmoney supply exceeds real money demand. It means people are left with morereal cash balances than they wish to hold. This lowers the rate of interest, as aresult of which investment demand rises thereby causing the real income level torise. In other words, demand for goods and services increases following thedecrease in price level.


AS




NOTES

The process of derivation of the aggregate demand curve is explained inthe above diagram. As the price level falls from P5 to P4, P3, P2 and to P1, theLM curve shifts right from LM5 to LM 4, LM3, LM2 and to LM1. As a result.income level increases from Y1 to Y2, Y3, Y4 and Y5. The combinations oflower price level and higher level of income are shown in the lower part of thediagram. When these points are joined (E1, E2, E3, E4, E5), we get a downwardsloping aggregate demand curve indicating inverse relationship between pricelevel and aggregate demand for goods and services. The aggregate demand curve‘AD’ intersects the aggregate supply curve ‘AS’ at point E4 and as a result theprice level and level of income are determined as P2 and Y4 respectively.

10.2.5 MACRO ECONOMIC ISSUES

The IS-LM model developed above gives us a macroeconomic picture ofan economy. It explains how various sectors of the economy are interconnectedeither through the rate of interest or through the level of income and how theyattain equilibrium simultaneously for a combination of rate of interest and levelof income. The IS - LM model, with government sector and foreign sector included,can be used to study macroeconomic problems and find out the solutions to them.The policy options available to the government for addressing variousmacroeconomic problems are to be evaluated first before their adoption so as toavoid policy mistakes and aggravation of macroeconomic problems. It is in thisrespect that IS-LM model turns out to be greatly handy.

Having underscored the usefulness of the IS -LM model, we will now brieflyreview the macroeconomic problems that generally afflict an economy. Addressingthese macroeconomic problems is very important from the point of view ofmacroeconomic stability and economic growth and therefore, they are everywheretaken by the horn in economic policy formulation.

1. FASTER, SUSTAINABLE AND INCLUSIVE ECONOMICGROWTH

The most important macroeconomic issue is economic growth. Bothdeveloped and developing countries strive hard for economic growth. The ultimateobjective of all economic activities is economic progress and therefore, steps aretaken to take the economy to higher growth path.

Economic growth or development is a long term process and requiressustained increase in capital formation. The developed countries have succeededin raising the rate of capital formation considerably and therefore have grownmuch faster than other less developed countries during the 19th and 20th century.Their present concern is not to raise the rate of capital formation and the rate ofeconomic growth but to maintain the progress they have achieved over a longperiod, through the exploitation of markets in other countries. The markets ofdeveloped countries, by this time, have saturated and therefore there are hardlyany investment opportunities in these developed countries. Tapping the marketsof other developing countries and searching investment avenues in them is whatis required on the part of developed countries.

Developing countries on the other hand face the challenge of raising therate of capital formation, which is found to be low due to low per capita income.There exist a wide gap between the per capita income levels of developed countriesand developing countries. Developing countries for long have been trapped in the



NOTES

vicious circle of low income, low savings and low investments and thereforethere economic performance has been far from impressive. Though some lessdeveloped countries have turned developing i.e., the process of development hasbegun in them, the pace of growth is not satisfactory. Further, the structural changes,which are to be witnessed during the process of development, are not taking place.In many developing countries, agriculture continues to be a dominant sector ofthe economy in terms of its contribution to national income, employment andexports.

Another growth related challenge that both developed and developingcountries face is that of making the growth sustainable. The environmental damagethat takes place during the process of development has raised the questions aboutthe sustainability of growth process. Unless due attention is paid to the conservationof environment, the benefits of economic growth that present generations areenjoying will not be available to the future generations.

From the point of view of developing countries, along with the faster andsustainable growth, making the growth inclusive is also important. This requiresjust distribution of the benefits of economic growth.

In short, achieving faster growth and ensuring its sustainability andinclusiveness, is the most important macroeconomic issue. Both developed anddeveloping countries are confronted with this macroeconomic challenge, to alesser or greater degree, and are required to act decisively to address the same.

2. INFLATION

Rising prices, a natural corollary of growth process, is anothermacroeconomic challenge faced by both developed and developing countries.Acceleration of the growth rate of the economy naturally generates someinflationary pressure in the economy. Failure on the government’s part incontrolling rising prices ,can nullify the benefits of faster economic growth. Theinflationary genie represents a great threat to any economy. Once this genie is outof the bottle, it can create havoc in the economy. Inflation, of an intolerable level,shakens the faith of people in national currency by reducing its purchasing power,aggravates the problem of poverty by adversely affecting the real incomes, widensthe inequalities of income and wealth, creates balance of payments problems,adversely affects saving and jeopardizes the entire growth process.

Control of inflation should therefore receive topmost priority in anyeconomic policy that government decides to adopt.

3. POVERTY & UNEMPLOYMENT

Poverty & unemployment are the two socially undesirable issues that arenormally left untouched in the process of growth. Growth process by itself failsto ensure percolation of its benefits to the grass root level people. In other words,the trickledown effect of the growth fails to materialize .This is what creates andaggravates the problem of poverty. As a result, the economy gets divided into twoparts of haves and have nots. Division of the economy in to two parts of the havesand have nots can be a cause of wide spread social unrest and destabilize thewhole economy. Poverty problem therefore needs to be taken seriously, and effortsare to be made for its eradication, if the growth process is to be stable and is toperpetuate in to the long term. Distribution of the cake is as much important asgrowth in its size.





NOTES

The problem of poverty as stated above is, in a sense, a problem ofunemployment. These two problems are so much interwoven in each other thatwhen one exists another by default is present and therefore solution to one is asolution to another. The growth process can take care of the problem of poverty,if it is sufficiently job creating. In a bid to accelerate the rate of growth of theeconomy, countries opt for the capital intensive technologies and one that doesn’tsuit their local conditions. This is what makes the faster growth jobless and createsand aggravates the problem of unemployment.

Developing countries in particular are the ones worst affected by thesetwin problems. These are countries where these problems are found in differentand chronic form. The form of poverty generally found in developing countries isabsolute, wherein people find it difficult to fulfil even their basic needs. In somecases, people die of starvation. Such a form of poverty is tremendously dangerousand can be a cause of high social tension. Perpetuation of such a form of povertyand that too in high magnitude can endanger the entire growth process and thereforeneeds to be taken head-on. Similarly, the problem of unemployment witnessed incase of developing countries is of different type. It is deep rooted in to the structureof economies of these countries that its minimization and finally eradicationrequires structural changes in to the economy.

Disguised unemployment, educated unemployment, seasonalunemployment and frictional unemployment are the forms of unemployment foundin developing countries and are the ones, who’s eradication needs direct andconcerted attack on them.

Poverty and unemployment are the two burning macroeconomic issues thatcontinue to afflict the developing countries in particular.

4. TRADE CYCLES

Economic history of the world reveals that economic progress of no countryhas been smooth and continuous. This is particularly true of countries whichdecided to go with the capitalist way. Capitalist countries, as also the socialistones, have always and everywhere succumbed to the ups and downs in theirprogress. Their journey so far has seen both good and bad roads. They have seentheir economies waxing at some times and wanning at others. Their nationalincomes, employment levels, price levels, and other macroeconomic variableshave fluctuated over the years. During some years they moved northward, whileduring others they marched southward. These fluctuations in macroeconomicvariables, the ups and downs witnessed, are popularly known as business or tradecycles in economic jargon.

The classical philosophy based on the Say’s law of market ruled out thepossibility of trade cycles and considered full employment as all time reality. Thegreat depression of I930’s however gave a severe blow to this type of thinkingand it was J. M. Keynes, who, in his famous book “General Theory”, proved that,not full employment, but less than full employment is the normal feature of aneconomy. He pointed out the possibility of deficiency of demand and resultingrecession and made a strong case for government intervention through monetaryand fiscal policy to clear the economic mess.

Inevitability of trade cycles has made the objective of steady economicgrowth a guiding star and countries, both developed and developing, are found

CHECK YOURPROGRESS

7. What are the majormacro economicissues?

8. What do you meanby sustainabledevelopment?

9. What is meant byfiscal irresponsi-bility?



NOTES

struggling to minimize the impact of trade cycles on their economies. Thoughplenty of research has gone into understanding the nature and causes of tradecycles, they continue to come in the way of almost all countries.

5. FISCAL IRRESPONSIBILITY

Fiscal irresponsibility, as reflected in large and unsustainable fiscal deficit,is another macroeconomic issue that has become a headache of many economiesand has derailed the growth process in them. Not only that, it has resulted into amacroeconomic crisis involving high level of current account deficit, exchangerate depreciation and sudden capital outflow, drying of foreign investment, defaulton foreign debt servicing and resulting humiliation in international arena. Countrieslike India have experienced this type of crisis.

Several developing countries and even the developed ones havemisinterpreted the Keynesian idea of pump priming and active governmentintervention in to the economy. Governments have assumed larger and largerresponsibilities involving rapid growth in public expenditure unsupported bysimilar growth in public revenues. This has widened the gap between publicexpenditure and revenue. In other words, budget deficits have grown tremendously.Budget deficit, through its effect on aggregate demand, keeps the current accountdeficit at high level (hypothesis of twin deficits) and can create a macroeconomiccrisis like situation.

In developing counties, the governments have been spending recklessly,while in case of developed countries, as the 2008 crisis has shown, governmentscontinue to follow the Keynesian suggestion of pump priming. Both developedand developing countries continue to live with high budget deficits and thereforewith the possibility of encountering a major economic crisis. Budget deficitstherefore represent a major cause of concern.

10.3 SUMMARY

Classical and even the Keynesian models of the macro economy sufferfrom a major drawback. They consider the real and monetary sectors ofthe economy independent of each other and therefore go on explaining theequilibrium in them in isolation. This however is not realistic. The two sectors ofthe economy, viz., real and monetary, are interdependent and therefore thereinterdependence needs to be taken in to consideration while developing amacroeconomic model.

The IS-LM model, as developed by Hicks and Hansen, is the one that hasfilled the above mentioned gap in macroeconomic modelling. The model representsa framework in which simultaneous equilibrium is established in both the sectorsof the economy for a given combination of rate of interest and level of income.The model, further extended to include the government and foreign sector, becomesa four sector and complete macroeconomic model of the economy, capable ofanalyzing macroeconomic problems and assessing the impact of major economicpolicy changes made.

The IS-LM model, developed with the assumption of flexible price level,leads us to aggregate demand and aggregate supply model, where we get to knowabout the determination of price level and national income.





NOTES

10.4 KEY TERMS

l IS Curve : A downward sloping curve representing a locus ofcombinations of levels of income and rates of interest at which the savingare to investment.

l LM Curve : An upward sloping curve which represents variouscombinations of levels of income and rates of interest at which thedemand for money is equal to supply of money.

l Inclusive Growth : Growth which benefits everybody in the economy.

l Sustainable Growth : Growth which is not achieved at the cost ofdamage to environment.

10.5 EXERCISES

1. Discuss how equilibrium is attained in a two sector economy with IS-LM framework.

2. Discuss in detail the macroeconomic issues faced by an economy.

3. Elaborate the IS-LM model extended to include the government sector.

4. Explain the derivation of balance of payment function.

5. Discuss the determination of income and price level using the AD andAS framework.

6. Comment on the shape of the aggregate supply ( AS ) curve.










r r r



NOTES

UNIT 11 : BALANCE OF PAYMENTS

Structure

11.0 Introduction



11.2.1 Balance of Payments Accounts

11.2.2 Composition of Balance of Payments

11.2.3 Disequilibrium in the Balance of Payments – Causes & Types

11.2.4 Free Trade V/s. Protection

11.3 Summary

11.4 Key Terms

11.5 Exercises


11.0 INTRODUCTION

There is no country in this world which is self sufficient in every respect. Itmeans it produces everything that it’s people desire. Every country importssomething from other countries or exports something to other countries. Thishappens because producing everything domestically is either not possible orinvolves higher cost. Countries therefore produce those things that they canproduce efficiently and export them to other countries in exchange for things thatthey cannot produce efficiently. The outcome of this is international trade or tradebetween countries, which needs to be systematically recorded.

It is here that balance of payments comes into the picture. It represents arecord of all transactions of a country with the rest of the world. It is an importantindicator of country’s economic standing in international area and reveals whetherthe trade is beneficial to a country or not. It also throws light on movements inexchange rate of country’s currency. According to Kindleborger, balance ofpayments refers to “A systematic record of all economic transactions between theresidents of the reporting country and residents of foreign countries during agiven period of time”.

In this part, we will get ourselves acquainted with the concept of balanceof payments, its composition, and disequilibrium in balance of payments and alsowith the policies of free trade and protection.


After studying this unit, you would be able to –

l Understand the concept of balance of payments and its structure.

l Study the causes and types of disequilibrium in balance of payments.

Balance of Payments




NOTES

l Perform a comparative analysis of policy of free trade and policy ofprotection.


11.2.1 BALANCE OF PAYMENTS ACCOUNTS

As started above balance of payments is a systematic record of country’seconomic transactions with other countries of the world. However, before westudy the concept and composition of balance of payments, the concept of balanceof trade needs to be mentioned and understood as it was in use in the past.

Balance of trade is narrow concept and refers to the value of exports andimports of visible items only. In other words, balance of trade takes into accountmovement of goods only. The difference between the value of exports of goodsand the value of imports of goods is called balance of trade. If the difference ispositive, value of exports of goods exceeds the value of imports of goods, thebalance of trade is said to be favorable. On the contrary, if the difference is negative,the value of exports of goods is less than the value of import of goods, it is termedas unfavorable.

With the passage of time, the international trade has grown and expandedto cover trade in invisible items (i.e. services) and trade in capital also. Accordingly,the concept of balance of trade has given place to the concept of balance ofpayments, which not only takes into account the trade in visible items, but alsothe trade in invisible items and capital.

At present, the concept of balance of payments is in fashion as it is muchbroader than the concept of balance of trade and reveals the complete picture ofthe country’s economic transactions with the rest of the world.

11.2.2 COMPOSITION OF BALANCE OF PAYMENTS

Balance of payments is generally made up of two accounts, namely, currentaccount and capital account.

A. CURRENT ACCOUNT :-

The current account of the balance of payments is the one which recordscountry’s transactions in goods and services with other countries. Transactions ofgoods are recorded on the visible account and transactions of services on invisibleaccount.

Visible account is also known as ‘Trade Account’ or ‘Merchandise Account’.All receipts and payments arising on account of the export and import of goodsare recorded in the trade account.

The invisible account usually records all the international payments arisingon account of the exchange of services that takes place between two countries.The services exchanged include services rendered by banking, insurance andshipping companies, tourist traffic, etc. The exchange of these services leadsto international payments in the form of interest and dividends, tourist fees,



NOTES

unilateral payments such as gifts, subsidies, etc, which are recorded on the invisibleaccount.

In short, the current account of the balance of payments consists of twosub-accounts, viz., visible account and invisible account, which record the tradein goods and trade in services respectively.

B. CAPITAL ACCOUNT :-

The capital account of the balance of payments is connected with thetransactions of capital and gold. Transactions of capital involve capital movementseither for a short period of time or for a long period of time. Under the category ofshort term transactions of capital we have short term deposits held by foreigners,purchase of short term securities such as secondary shares, treasury bills, etc.speculative transactions of foreign currency, etc.

The long term transactions of capital include all those transactions thatinvolve long term capital movements. Investment in debentures, shares and bonds,long term loans, purchase of physical assets are the important examples of longterm transactions of capital.

The capital account also records the movement of gold and changes inforeign exchange reserves held by the central bank of a country for the purpose ofstabilizing the exchange rate of the home currency.

11.2.3 DISEQUILIBRIUM IN THE BALANCE OFPAYMENTS – CAUSES & TYPES

In order to understand the concept of disequilibrium in balance of payments,we need to first understand the nature of transactions recorded in it. When all thetransactions recorded in balance of payments are taken into consideration thebalance of payments always balances. In other words, if the transactions recordedon current and capital account are taken into consideration, irrespective of theirnature; the balance on the balance of payments comes to zero, that is, the balanceof payments balances. This happens because the deficit on the current account ismatched by surplus on capital account and a surplus on current account is offsetby a deficit on capital account. It means, there are some items on capital accountwhich are manipulated to match either the deficit or surplus on current account.These items on capital account are accommodative in nature. They accommodatethe deficit or surplus on current account. Deficit on current account, resultingfrom higher import payments than export earnings, needs to be covered up. It ishere that government normally takes the help of accommodative items like loansand investment, which are recorded on capital account. The current account deficit,thus, leads to surplus on capital account as government borrows from othercountries, international institutions and financial institutes to make up the deficiton current account.

A surplus on current account, generated through higher export earningsthan import payments, is offset by outflow of capital on account. In other words,the surplus on current account creates deficit on capital account. Surplus on currentaccount represents extra foreign exchange earned which is to be investedsomewhere outside the country. It therefore goes out of the country in the form of

Balance of Payments

CHECK YOURPROGRESS

1. What is balance oftrade?

2. D i s t i n g u i s hbetween currentaccount and capitalaccount of BOPs.

3. What do you meanby disequilibriumin BOPs?




NOTES

a loan or investment and gets recorded on the capital account, leading thereby tothe emergence of deficit on the same.

It thus becomes clear from the above discussion that balance of paymentsalways balances because of the accommodative nature of some items recorded onthe capital account. The items or transactions which are not accommodative areautonomous in nature. The balance of payments thus records two types oftransactions. They are (a) Autonomous transactions and (b) Accommodativetransactions.

Autonomous transactions take place on their own. They are the ones whichare not manipulated by the government with a particular purpose. For example,import and export of goods and services, long term investments and loans are theresults of people’s decisions made on the basis of market signals. There is nointervention in these decisions. Accommodative transactions, on the other hand,are manipulated by the government. They do not happen on their own. Theirhappening is largely connected with the status on the front of autonomoustransactions. It is these accommodative items like short term borrowings andinvestments that make up the deficit or surplus on the front of autonomoustransactions.

Given the nature of transactions recorded in balance of payments, It won’tbe right if all transactions, both autonomous and accommodative, are taken intoaccount while working out the balance on balance of payments. It is only theautonomous transactions that can give us the true picture about balance on balanceof payments. Balance of payments will be in balance or in equilibrium only whenthe net of autonomous transactions comes to zero. However, if the net ofautonomous transactions is not zero, that is, the inflow generated by thesetransactions is either greater or smaller than the outflow resulting from them,then balance of payments is said to be in disequilibrium. When the autonomoustransactions generated inflow is smaller than outflow, the balance of payments issaid be in deficit and when the case is reverse , it is said to be in surplus.

In short, the balance or payments disequilibrium occurs when theautonomous transactions generated inflow and outflow are not equal. All thetransactions on current account are autonomous in nature. In case of capitalaccount, however, not all transaction are autonomous. For finding out whetherthe balance of payments is in equilibrium or disequilibrium, we therefore takeinto account the current account balance and the balance on the front ofautonomous capital movements recorded on the capital account. So,

Balance on Balance of Payments = Current Account balance + the net ofautonomous capital movements.

Causes of Disequilibrium in Balance of Payments

Having understood the concept of disequilibrium in balance of paymentsas a state in which the autonomous transactions generated inflows are either greateror smaller than the autonomous transactions generated outflows, we now turn tothe factors that create such a state. Several factors can be held responsible for thedisequilibrium in balance of payments. The important among them can be enlistedas below. An important thing to note at this juncture is that the term disequilibriumis normally used to refer to the deficit in balance of payments, which is



NOTES

unfavourable and therefore needs to be immediately corrected. Therefore, whileenlisting the factors responsible for disequilibrium in balance of payments, factorsthat create deficit are enlisted.

1. Development Programmes

This is the most important reason for unfavourable balance of payments incase of less developed countries. Such countries, with the aspiration of developingfast, undertake large number of development programmes, which are capitalintensive. Lack of capital forces the less developed countries to import capitalgoods from developed countries, leading to a state in which outflows exceed theinflows. In short, deficit in balance of payments occurs when developmentprogrammes undertaken require greater imports, outstripping the exports.

2. Pressure of Population

Rapid growth in population is another important reason behind thedisequilibrium in balance of payments of less developed countries. Risingpopulation requires the domestic supply of goods to rise as faster as necessary tofeed the population. Failure on the supply front forces these less developedcountries to resort to large imports of essential goods like food grains. The resultis imports exceed exports and the balance of payments turns unfavourable.

3. Domestic Price Rise

Export competitiveness of a country largely depends on the domestic pricelevel. If the domestic prices, particularly that of export items, rise much fasterthan the prices in other countries, the export competitiveness gets adverselyaffected. Further, due to rising domestic prices imported goods become attractive,leading to increase in imports. Domestic price rise thus causes the exports todecrease and imports to increase, thereby creating a deficit or unfavourable statein balance of payments of the country.

4. Foreign Loans

Less developed countries heavily borrow from the developed countries toinitiate the process of development. Development aspirations of less developedcountries are much bigger than the ones supported by their domestic saving andinvestment levels. This requires them to depend heavily on the foreign loans andinvestments. The servicing of foreign debt in the form of interest and principalpayment and return on investment result into an unfavourable balance of payments.

5. Trade Cycles

Cyclical fluctuations in economic activity may also cause the balance ofpayments disequilibrium. Slowdown in economic activity or depression in othercountries will adversely affect the exports of a country and cause the balance ofpayments to go in to disequilibrium.

6. Natural Factors

Natural calamities like drought, floods, etc. lower the agriculture production,which in turn leads to fall in industrial production due to falling demand on the

Balance of Payments




NOTES

one hand and shortage of raw material on the other. All this reduces the exportablesurplus of a country concerned and also increases the imports from other countries,thereby creating an unfavourable balance of payments situation.

7. Demonstration Effect

People in less developed countries usually follow the living style of peoplein advanced countries. This is called the demonstration effect, which causes theimports of a country to stay higher, thereby creating disequilibrium in balance ofpayments.

8. Fall in Demand

Less developed countries largely depend on the exports of agricultural goodsand raw material to developed countries. However, over the years most of thedeveloped countries have increased their domestic production of food grains andraw materials to such an extent that they no longer need to import such goodsfrom developing countries. As a result, developing countries have seen their exportsfalling and the balance of payments situation worsening.

9. Changes in National Income

Changes in national income affect the demand for imports and supply ofexports and thereby the balance of payments position of a country concerned. Incase of developing countries, a rise in national and per capita income may lead tohigher imports, if the import demand is highly income elastic, and thus cause thebalance of payments to turn unfavourable.

10. Political Factors

Balance of payments position of a country is also affected by the politicalsituation in that country. Political instability in a country and resulting frequentchanges in economic policy adversely affect the production level and lead to fallin exports.

11. Other Factors

Besides the above factors, several other factors may also affect the balanceof payments status of a country through their impact on exports and imports.They are changes in tastes and preferences of the people, invention of cheapersubstitutes , changes in technology, development of alternative sources of supply,etc.

Types of Disequilibrium in Balance of payments

Based on the above mentioned causes of disequilibrium in balance ofpayments, we can have three types of disequilibrium: (1) Cyclical Disequilibrium,(2) Secular or Fundamental Disequilibrium, (3) Structural Disequilibrium.

1. Cyclical Disequilibrium

Cyclical disequilibrium in balance of payments is the result of fluctuationsin economic activities, which are popularly known as trade or business cycles.Trade Cycles are those ups and downs in major macro economic variables like



NOTES

national income and price level, which through their impact on exports and importsdetermine the state of balance of payments of a country. Trade cycles mainlyconsist of two phases of prosperity and depression and the impact on balance ofpayments depends not only on the phase of trade cycle but also on the elasticityof demand and supply of imports and exports.

During the phase of prosperity, both incomes and prices rise and bringabout changes in import and export levels. If the income elasticity of demand forimports & the price elasticity of demand for exports is greater than unity, thephase of prosperity will cause imports to rise and exports to fall thereby causingthe balance of payments to turn unfavourable. During the phase of depressionhowever the elasticity quotient of greater than one will help lower the deficit inbalance of payments.

In case of less developed countries, the imports are highly income elastic,while the exports highly price inelastic. Consequently, both the phases of tradecycle keep their balance of payments in disequilibrium. During prosperity, highlyincome elastic import demand causes the imports to exceed exports and duringthe phase of depression highly price inelastic demand for exports fails to boostthe exports thereby keeping the exports lower than imports. So, both the phasesof trade cycle keep the balance of payments situation of a less developed countryunfavourable.

2. Secular or Fundamental Disequilibrium

Fundamental disequilibrium in balance of payments implies a long termdisequilibrium usually experienced by less developed countries. These economies,in their initial years of development, have a strong urge for development andtherefore undertake plenty of development programmes. Paucity of capitaldomestically, forces them to rely heavily on the import of capital goods fromother countries. Development being a long term process, imports stay highercontinuously for a long period of time. Further, in case of them, exports are notlikely to support the higher imports due to lack of international competitiveness.Moreover, higher development aspirations require high level of savings andinvestment. Here too, less developed countries knock the doors of developedcountries or international financial institutions. These factors keep them dependenton developed countries for a long period of time and their dependence gets reflectedin disequilibrium in their balance of payments.

Fundamental disequilibrium is thus the one which is deep rooted into theless developed economies and gets corrected only after a long period of time, thatis, only when the economies of these countries become fundamentally strong anddevelopment level improves to considerable extent.

3. Structural Disequilibrium

Another type of disequilibrium which is peculiar to less developed countriesis the structural disequilibrium. Less developed countries are structurally suchthat they have their agricultural sector contributing a great share of their nationalincome, national employment and exports. Once the development process begins,a structural change accompanies whereby the agricultural sector losses its placeof dominance. However, in the initial years of development, the structure of lessdeveloped countries keeps them largely dependent on other countries for the overall

Balance of Payments




NOTES

development of the economy and particularly for the development of industrialsector. Moreover, the less developed countries also house several structuralrigidities, which need to be removed for putting them on to a self sustaining pathof development and for reducing their dependence on other countries.

Infrastructural bottlenecks, underdeveloped or undeveloped markets andother important institutions, inadequate diversification of export basket, delaysin policy formulation and implementation, etc. are some of the structural problemsthat less developed countries live with in the initial years of their developmentand therefore remain dependent on other countries. This is what keeps their balanceof payments in disequilibrium until the structural problems are addressed.

11.2.4 FREE TRADE V/S. PROTECTION

Free trade and protection are the two different and opposite types of policiespertaining to trade between countries. Policy of free trade implies a policy whichallows free movement of goods and services across boundaries. In other wordsunder free trade policy no restrictions are placed on the movement of goods. Onthe contrary, the policy of protection refers to a situation where in restrictions areimposed on the movement of goods and services between countries with theobjective of protecting home industries. According to Adam Smith, free tradedenotes “that system of commercial policy which draws no distinction betweendomestic and foreign commodities and, therefore, neither imposes additionalburdens on the later, nor grants any special favours to the former”. The policy ofprotection, on the other hand, indicates an opposite system in which discriminationis done between domestic and foreign commodities and additional burdens areimposed on the later, while the former are offered special favours.

Choice of a trade policy is a controversial issue. Whether a country shouldfollow a free trade policy or a protectionist policy is an area where economistshave failed to reach a consensus. There are some who have strongly advocated apolicy of free trade as the best for everyone, while there are others who haveopted in favour of a protectionist policy. In this section, we will discuss thearguments made by economists in favour of both, the policy of free trade and thepolicy of protection.

A. The Policy of Free Trade

The policy of free trade has been upheld by several economists includingclassical economists like Adam Smith, David Ricardo and others, particularly onthe ground of benefits arising out of specialization and division of labour. In thewords of Paul Samuelson, the case in favour of free trade policy can be summedas follows: “Free Trade promotes a mutually profitable regional division of labour,greatly enhances the potential real national product of all nations, and makespossible higher standard of living all over the globe.”

The arguments extended in support of the free trade policy can be discussedin the following manner.

1. Division of Labour and Specialization

Free international trade enables all participating countries to fully exploitthe scarce available resources in the best possible manner through division of



NOTES

labour and specialization. Every country gains by specializing in those lines ofproductions in which it enjoys comparative cost advantage. In other words, everycountry produces those goods which it can produce more cheaply and exportsthem to other countries in exchange of those goods which it cannot producecheaply. In this way, all countries benefit and enjoy higher standard of living.

2. Economies of Scale

Free international trade enhances the size of the market and makes it possiblefor an industry to reap the economies of scale or benefits of large size. An industryfrom a participating country may not enjoy these benefits if it produces only forthe domestic market.

3. Variety in Choice

Free international trade provides the consumers of participating countrieswith a greater variety of choice. Wide variety of goods become available toconsumers and this is what improves the welfare level to a great extent. Withoutinternational trade or with restrictions placed on trade, consumers in manycountries would have to go without those goods which they wish to consume.

4. Stiff Competition

Free international trade will prevent the emergence of monopolies and willpromote competition as producers from all countries producing similar goodswill compete with each other. Consumers will enjoy all the benefits associatedwith stiff competition in the market place among the sellers.

5. Insurance against Natural Calamities

Countries which are hit by natural calamities like famines, floods,earthquakes, etc. on a regular basis enjoy a kind of insurance with free internationaltrade. Free trade provides such countries with an alternative in the form of importsof those goods whose supply is adversely affected due to natural calamities.

6. Economic Development

Free international trade helps the less developed countries to secure higherlevel of development by providing access to cheaper and qualitative sources ofraw material, machinery, capital equipments, technical knowhow, managerial talentand entrepreneurship.

From the above arguments, it becomes clear as to why a country should optfor a free trade policy. However, the gains from free international trade will flowto the surface only when all countries act alike. In other words, the benefits oftrade will become available only when all countries participate in trade and followthe rules of the game. Further, there can be some countries which due to theirdisadvantageous position, are to be provided with special and differential treatment.Moreover, the developed and strong countries should be honest enough and shouldbe fair in the treatment that they offer to the less developed or weak countries. Inshort, the free trade policy will result into win-win situation for all countries onlywhen the trade is free in true sense as also fair from the point of view of weakcountries.

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NOTES

B. The Policy of Protection

The policy of protection is a policy deliberately adopted by the governmentto protect the domestic industries from foreign competition. This is done eitherby imposing restrictions on import of foreign goods or by giving subsidies to thedomestic industries. The objective is to promote domestic industries and therebysafeguard national interest. In short, the policy of protection implies a policywhereby attempts are made to restrict imports and boost exports. The policy ofprotection normally involves imposition of restrictions like import duties, importquotas, import bans, exchange rationing, state trading etc. on imports and givingsubsidies and tax exemptions to the exports.

The policy of protection is usually advocated for developing countries duringinitial phase of their development. The main arguments advanced in favour of thepolicy of protection are as below.

1. Protecting Infant Industries

It was Alexander Hamilton of America and Friedrich List of Germany whofirst supported the policy of protection on the grounds of protection to the infantindustries. An infant industry is one which is newly started and lacks the experienceand financial strength to compete in the market place. The infant industriestherefore are to be protected and nursed during their formative period so that theyget a chance to grow and develop competitive strength. Once the infant industriesgrow and become mature, the protection given to them can be withdrawn. Inshort, the policy of protection is based on a well known saying, “Nurse the baby,protect the child, and free the adult.”

2. Diversification of Industries

Free international trade leads to specialization. Countries specialize in thoselines of production in which they have comparative cost advantage. However,specialization can turn out to be dangerous in times of difficulties, as it resultsinto lopsided development and overdependence of a country on other countries.As countries are dependent on other countries for the import of some commodities,there is a risk of blackmailing during the time of war. Further, overdependence onsome industries, which the country specializes in, can prove to be risky whensuch industries are affected by disturbances like crop failures and depression.According to the advocates of protectionist policies, these risks associated withfree trade and specialization can be avoided by developing as many industries aspossible by offering them protection against foreign competition.

3. Development of Basic Industries

Key or basic industries like iron and steel, coal, heavy chemicals, power,machine making, etc are very important from the point of view of rapidindustrialization of a country. These industries support other industriesby providing raw material and other important inputs. Development of basicindustries leads to the development of other industries in the economy andthus helps in developing a strong industrial base of a country. The policy ofprotection is advocated for supporting these basic industries, as they areindispensable from the point of view of rapid industrialization and economicdevelopment of a country.

CHECK YOURPROGRESS

4. Explain the causeof disequilibrium inBOPs.

5. How cyclicaldisequilibrium inBOPs is differentfrom seculardisequilibrium?

6. Argue in favour offree trade policy.

7. What are the meritsof protectionistpolicy?



NOTES

4. Employment Generation

A labour surplus country like India can benefit a great deal from the policyof protection as it will help address the problem of unemployment. The policy ofprotection will facilitate the development of domestic industries and thereby raisethe level of employment in the country. The employment will get created not onlyin those industries which are offered protection, but also in those industries whichwill get developed due to the development of protected industries.

5. Correcting Balance of Payments Disequilibrium

Less developed countries, which often experience adverse balance ofpayments, can have it in order by following the policy of protection. Exports canbe boosted by offering export subsidies and other exemptions and imports can berestricted by imposing tariffs and quotas. The unfavourable gap between exportsand imports thus can be minimized through the policy of protection. The policyof protection is therefore advocated on the ground that it helps the less developedcountries in correcting disequilibrium in their balance of payments.

6. Anti-Dumping Policy

Policy of protection is also vindicated on the grounds of an anti-dumpingmeasure. Dumping, which means selling goods at a lower price in foreign marketsthan in home market, is undertaken to capture the foreign country markets. It isan act of international price discrimination and anti competition. Countries whichsuffer from dumping of foreign goods in their home market can adopt the policyof protection as an anti dumping measure and can protect their domesticmanufacturers against unfair competition.

7. Defence Industries

According to this argument, the industries producing defence material areimportant from national security point of view and therefore are to be protected.

8. Revenue Generation

The policy of protection is also recommended as an avenue of generatingrevenue for the government.

9. Patriotism

It is also said that policy of protection helps in developing a spirit ofnationalism and patriotic sentiments among people.

10. Conservation of National Resources

Many believe that free international trade leads to the fast depletion ofnational resources, which can prove to be detrimental to growth in the long run.Sustainability of growth requires conservation of national resources and it is inthis respect that policy of protection is favoured over free trade.

Having underscored the importance of policy of protection, one should notjump to the conclusion that it is the best policy, particularly from the perspectiveof less developed countries. In other words, one should not turn a blind eye towards

Balance of Payments




NOTES

the evils of protection such as loss to the consumers, inefficiency, corruption,emergence of monopolies and so on. Importance of the policy of protection remainsundisputable in the initial years of development and from the point of view ofdeveloping countries. However, the policy should not be adopted as a permanentpolicy. In short, protection should be offered as a medicine, in suitable doses,when the industry is ill and should be discontinued as soon as the industry returnsto normal health and vigour.

11.3 SUMMARY

International trade relations, which are important from the point of viewof economic efficiency and maximization of world output and welfare, arerecorded in respect of every trading country in the form of Balance of Payments.Balance payments, which consists of two accounts called current account & capitalaccount, represents a systematic record of country’s trade relations with the restof the world. Though the balance of payments always balances, in reality it canbe in disequilibrium if the accommodative items recorded on the capital accountof the balance of payments are left out. Disequilibrium in balance of paymentsindicates a situation in which inflow and outflow of money, resulting from exportsand imports of goods and services and autonomous capital movements are notequal. Disequilibrium can occur on account of several factors like developmentprogrammes adopted, domestic inflation, etc and can be of three types, namely,cyclical disequilibrium, fundamental disequilibrium and structural disequilibrium.

Policy of a country with respect to international trade can be one ofpromoting it or that of opposing it. The former is termed as the policy of freetrade and the later policy of protection. Both the types of policies have theirmerits and demerits.

11.4 KEY TERMS

l Balance of Trade : This refers to the balance arrived at on the basis ofdifference between the value of exports and value of imports of visibleitems (i.e. goods) only.

l Current Account : This is an account of the balance of payments andrecords exports and imports of both visible and invisible items (i.e. goodsand services).

l Capital Account : This is another account of the balance of paymentswhich records the inflow and outflow of capital.

l Disequilibrium BOPs : A state in which the receipts and paymentsarising on account of the international transactions are not in balance.

11.5 EXERCISES

1. What do you mean by balance of payments? Discuss its structure indetail.

2. Discuss the concept of disequilibrium in balance of payments.



NOTES

3. Elaborate the causes and types of disequilibrium in balance of payments.

4. Distinguish between the policy of free trade and the policy of protection.Discuss the arguments in favor of both.










r r r




NOTES

UNIT 12 : FOREIGN EXCHANGE MARKETAND THE EXCHANGE RATE

Structure

12.0 Introduction



12.2.1 Foreign Exchange Market

12.2.2 Demand for and Supply of Foreign Exchange

12.2.3 Determination of Exchange Rate

12.3 Summary

12.4 Key Terms

12.5 Exercises


12.0 INTRODUCTION

International trade in goods and services and in capital requires that theparticipating countries first exchange their currencies, in order to be able toexchange goods and services and capital. The market where such exchange ofcurrencies of different countries takes place is called foreign exchange marketand the rate at which such exchange of currencies takes place is called exchangerate.

The working of the foreign exchange market and the determination ofexchange rate is an important area dealt with in economics. In this unit we proposeto get ourselves acquainted with the foreign exchange market and the determinationof exchange rate.


This unit will introduce the students to –

l The concept of foreign exchange.

l The functioning of foreign exchange market.

l The process of exchange rate determination.


12.2.1 FOREIGN EXCHANGE MARKET

International trade which involves exchange of goods and servicesrequires at the first place the exchange of currencies. For example, trade between



NOTES

India and U.S.A. first requires the participating entities (i.e. exporters andimporters) to first exchange currencies, namely, rupees and dollars. The placewhere such exchange of currencies takes place is called the foreign exchangemarket. Foreign exchange market is thus a prerequisite for the conduction ofinternational trade.

In the words of Kindleberger, “A foreign exchange market is a place whereforeign moneys are bought and sold.” Though the term foreign exchange marketis defined to mean a place where exchange of currencies takes place, it is notconfined to a geographical area. It, in fact, refers to the entire institutional andcommunicational network which is being used by the sellers and buyers forexchanging different currencies. Sellers and buyers of foreign currencies do notgather at a physical place to exchange each other’s currencies, instead they performthis task, sitting at their own place, through the institutional and communicationnetwork which has become available over the years as part of the economicdevelopment. Such institutional and communication network includes the centralbanks, commercial banks, other financial institutions, foreign exchange dealersand brokers as also the modern communication means like telegraphs, telephones,internet etc.

Foreign exchange market thus refers to the institutions engaged in andcommunication means used in facilitating the sale & purchase of foreigncurrencies. An Indian person, who is in need of dollars, will deposit his rupees ina bank (who deals in foreign exchange) and collect the dollars from it. The bankwill provide the foreign currency either directly (out of its own holdings) or bybuying if from another bank.

Kinds of Foreign Exchange Market

Based on the nature of transactions carried out in foreign exchange market,two categories are made. One is called the sport market and the another forwardmarket.

a) Spot Market : Under the spot market, the transactions are settledimmediately. In other words, spot transaction involves immediatedelivery of foreign exchange by the seller to the buyer. The rate at whichsuch delivery takes place is the spot rate of exchange. The spot exchangerate is the prevailing exchange rate in the market.

b) Forward Market : Forward market refers to that segment of the foreignexchange market which deals in future or forward transactions in foreignexchange. Under this segment the seller agrees to sell the foreigncurrency to the buyer at some future date and at a rate settled now. Theforward transaction is like an agreement, entered into between the sellerand buyer of foreign currency and requires the former to sell the foreigncurrency to the later at a future date and at a price decided now. The rateat which the transaction in forward market is settled is called forwardexchange rate.

Types of Transactions in Foreign Exchange Market

The transactions taking place in foreign exchange market can be classifiedin three categories. They are (a) Hedging (b) Arbitrage and (c) Speculation.

Foreign Exchange Marketand the Exchange Rate




NOTES

A. HEDGING :-

The forward market segment of the foreign exchange market provides thisfacility of hedging to the importers and exporters. When the exchange rate isflexible, both the importers and exporters run the risk of loss from the transactionsthat they are part of. Under the flexible exchange rate system, the exchange ratemovements are not predictable and therefore there is lot of uncertainty involved.Importers are not sure as to how much they will have to pay and exporters are notsure as to how much they will receive. Importers incur loss if the domestic currencydepreciates and exporters loose if the domestic currency appreciates. Both theimporters and exporters can protect themselves against the risk arising out offluctuations in exchange rate by entering into future contracts.

An importer can protect himself against the exchange rate risk by enteringinto a contract of purchasing the foreign currency for import payment in othercountries in advance. So, at a rate decided now he will have access to the requiredamount of foreign exchange for import payment. In the same manner, exporterscan avoid the loss by agreeing to sell foreign exchange at a rate decided now andat a future date when his export payment is due. So, the exporter will have accessto the expected amount of domestic currency from his exports.

The above mentioned act of the importers and exporters of protectingthemselves against the exchange rate risk is called the act of hedging.

B. ARBITRAGE :-

Arbitrage means the exchange rate differential between two or more foreignexchange markets. Under this type of activity market participants try to takeadvantage of the exchange rate differential that exists between two or more marketsby simultaneously purchasing and selling a particular currency. The currency,whose exchange rate is different in two or more markets, will be purchased inthat market where its price is low and will be sold in that market where its price ishigh. The exchange rate differential will be the profit of those who engagethemselves into this arbitrage activity.

The arbitrage activity, as it involves transfer of currency from a low pricemarket to a high price market, will wipe out the difference and establish equalityin exchange rates of that particular currency in all foreign exchange markets.

C. SPECULATION :-

Speculation is the third type of activity seen in foreign exchange marketand is performed by those who wish to take advantage of the fluctuations inexchange rate. As against the exporters and importers who try to protect themselvesagainst the risk arising out of the fluctuations in exchange rate through hedging,speculators love the risk and try to make profit from the fluctuations in exchangerate by predicting the direction of change in exchange rates. The speculators,based on their expectations, sell those currencies which are likely to depreciateand buy those which are likely to appreciate in near future. In this way, speculatorsmake profit by predicting the future movements in exchange rates in advance. Ifhowever the predictions of speculators go wrong they end up with loss.



NOTES

12.2.2 DEMAND FOR AND SUPPLY OF FOREIGNEXCHANGE

The foreign exchange market is the market where price of one currency isdetermined in terms of another. In other words, it is the market where exchangerate between currencies is determined. The basis however for the determinationof exchange rate, which is the price of one currency in terms of another, like inthe markets of other things, is the demand for and supply of foreign exchange.The participants in the foreign exchange market are either the demanders orsuppliers of foreign exchange. Those who demand foreign exchange includeentities like importers and domestic investors, while the suppliers are entitieslike exporters and foreign investors. This section discusses the demanders andsuppliers of foreign exchange, that is, the sources of demand and supply of foreignexchange.

Demand for Foreign Exchange

Those who need the foreign exchange for one reason or another are theones who create demand for foreign exchange. Importers, domestic investors whowish to invest abroad, foreign exchange dealers, central bank are the importantentities who create demand for foreign exchange. These entities can be discussedas the sources of demand in the following manner.

1. IMPORT OF GOODS AND SERVICES

The first important source of demand for foreign exchange is the import ofgoods and services. Those who want to import goods from another country arcfirst required to convert their home currency into the foreign currency (i.e. thecurrency of the country from whom the goods will be imported). Importers, whenthey go for converting their home currency into the foreign currency, they actuallycreate demand for foreign currency. Similarly, importers of services also are theones who create demand for foreign exchange. Medical and educational services,tourist services and financial services like banking and insurance are also theimportant sources of demand for foreign exchange. Patients going abroad formedical treatment need foreign exchange and obtain it by converting their homecurrency into the foreign currency.

2. DOMESTIC INVESTORS

Domestic investors who look for attractive investment opportunities in othercountries also represent an important source of demand for foreign exchange.Higher rate of return on foreign assets, lack of investment opportunities in thedomestic market and tax exemptions offered in other countries encourage domesticinvestors to think about investing abroad, thus creating demand for foreigncurrency.

3. FOREIGN EXCHANGE DEALERS

Foreign exchange dealers are the banks, financial institutions and brokerswho deal in foreign exchange on behalf of their customers. These dealers act bothas demanders and suppliers of foreign exchange.





NOTES

4. CENTRAL BANKS

Central banks entrusted with the task of maintaining the exchange rate ofdomestic currency also either demand or supply the foreign exchange. Centralbank of a country participates into the foreign exchange market as demander offoreign currency when the domestic currency exhibits the tendency of appreciation.In order to prevent the appreciation of the domestic currency, the central bankwill buy foreign currency and sell domestic currency in exchange. The centralbank of a country thus represents an important source of demand for foreigncurrency.

Given the abovementioned sources of demand for foreign exchange, itshould be noted that the demand, as usual, is an inverse function of price, here theexchange rate. The demand for foreign exchange curve will thus slope downwardfrom left to right.

Supply of Foreign Exchange

The supply of foreign exchange in to the market mainly comes from theexporters, foreign investors, foreign exchange dealers and central banks.

1. Exports of Goods & Services

This represents the most important source of supply of foreign exchange.Exporters of both goods and services are paid in terms of the foreign exchange orcurrencies, which they sell in foreign exchange market and get domestic currencyin return. It means they supply the foreign exchange which they receive for theirexports and take their domestic currency in return. However, the exporters whowish to import something from foreign countries will use the foreign exchangeearned through exports for import purpose, instead of supplying the same into theforeign exchange market.

2. Foreign Investors

Foreign investors investing in a country are also the one of the importantsource of supply of foreign exchange. For the investment purpose, the foreigninvestors will first convert their currencies (i.e. foreign exchange) in to thecurrency of that country which they want to investin. They thus supply theforeign exchange and receive domestic currency in return which they use for theinvestment purpose.

3. Foreign Exchange Dealers

Banks, financial institutions and other private brokers as foreign exchangedealers supply foreign exchange to those who want it.

4. Central Banks

As central banks buy foreign exchange with a view to instil stability to theexchange rate, they also supply it for the same purpose. The central bank of acountry therefore represents an important source of supply of foreign exchange.

As in case of the other things, the supply of foreign exchange and theexchange rate (i.e. the price of the domestic currency) move in the same direction.As a result, the supply curve of foreign exchange as usual slopes upward fromleft to right.

CHECK YOURPROGRESS

1. What is foreignexchange?

2. What do youunderstand byforeign exchangemarket?

3. D i s t i n g u i s hbetween the spotmarket and forwardmarket.

4. Explain the types oftransactions inforeign exchagemarket.



NOTES

12.2.3 DETERMINATION OF EXCHANGE RATE

The exchange rate is the rate at which the currency of one country isexchanged for that of another. It also implies the price of one currency in terms ofanother. For instance, if Rs. 55 are exchanged for $ 1 or the other way round, theexchange rate between rupee and dollar is Rs. 55 = $ I. It also means that the priceof Rs. 55 in terms of dollar is $ 1 or the price of one dollar in terms of rupees isRs. 55.

The exchange rate, as it is the price of one currency in terms of another, isdetermined by the market forces of demand and supply. This however is possibleonly when the country concerned has decided to go with flexible exchange ratesystem. Under the fixed exchange rate system, the exchange rate is decided bythe government and the demand for and supplies of foreign exchange have norole to play in its determination. The exchange rate is fixed by the governmentand maintained by the central bank at the fixed level through the interventionsinto the foreign exchange market. The central bank intervention either impliesselling the foreign currency or buying it in the foreign exchange market. Thoughthe exchange rate is fixed under the fixed exchange rate system, it can be alteredwith prior permission of the monitoring institution like IMF which worked as thewatchdog of international monetary system in the post World War II period. Thefixed exchange rate system thus allows for devaluation or revaluation of theexchange rate.

The flexible exchange rate system is the one in which the invisible forcesof demand & supply decide the exchange rate and it fluctuates or changes inaccordance with the changes in them. We have discussed the sources of demandand supply of foreign exchange in the previous section. We have also noted therethat demand for foreign exchange is an inverse and supply of foreign exchange isa positive function of exchange rate. Given this relationship, we end up with adownward sloping demand curve and upward sloping supply curve of foreignexchange, as shown in the following diagram.

Fig. 12.1 : Determination of Exchange Rate





NOTES

It can be seen from the above diagram that Dl is demand curve of foreignexchange and S1 is the supply curve of foreign exchange. Both the curves intersectat point E which means the demand for and supply of foreign exchange becomeequal and thus the exchange rate of Rs.50 = $1 is determined. No other exchangerate will prevail in the market, as at exchange rates other than the one indicatedby point E (Rs. 50 = $1), either the supply will be greater than the demand or thesupply will be less than the demand. For instance, at the exchange rate of Rs. 70= $1, the supply is greater than the demand, that is, more quantity of dollars issupplied than the one which is demanded. Consequently, the exchange rate fallsuntil it reaches again the equilibrium level of Rs. 50 = $1. Reverse process willtake place when the exchange rate is Rs. 30 = $ 1. So under the free play ofmarket forces of demand & supply, the exchange rate will settle at a point wherethe demand and supply of foreign exchange become equal to each other.

Under the flexible exchange rate system, though the exchange rate isdetermined by the demand and supply of foreign exchange, it can change wheneverthere is change in either of them. The demand and supply of foreign exchangewill change whenever there is change in the underlying forces, discussed inthe previous section. For example, any increase in import demand will resultin to increase in demand for foreign exchange which in turn will cause theexchange rate to move up, that is the price of dollar to increase. Reverse willhappen when there is fall in imports. In the same way, rise in exports will increasethe quantity of dollars supplied into the foreign exchange market, thereby causingthe supply curve to shift to the right and exchange rate to fall, that is, price ofdollars to fall.

Purchasing Power Parity & Exchange Rate

The previous section discussed the determination of exchange rate whenthe exchange rate system adopted is a flexible one and the market forces of demand& supply are allowed to work freely. The theory discussed above therefore is wellknown as the market theory of exchange rate determination.

Another theory of exchange rate determination, which can be termed asthe crude version of the market theory, is the purchasing power parity theorypropounded by a Swedish economist Prof. Gustav Cassel in the 1930’s. Thistheory applies to those countries which are on inconvertible paper currency andthere are no capital movements. Under such a situation the exchange rate betweenthe currencies of two countries will be determined by the purchasing powers ofthe two respective currencies. The exchange rate will be determined at a pointwhere the purchasing powers become equal.

We take the example of India and U.S.A. and assume that both are oninconvertible paper currency. We further assume that a ball point pen costs Rs. 50in India and $1 in U.S.A. It means the purchasing power of Rs. 50 in India and $1in U.S.A. is the same ball point pen. The purchasing power of Rs. 50 is equal tothe purchasing power $1. The purchasing power parity theory of exchange ratedetermination therefore states that the exchange rate between rupee & dollar willbe

Rs. 50 = $l

The exchange rate determined on the basis of purchasing power will changewhenever there is change in the purchasing powers of respective currencies. It is

CHECK YOURPROGRESS

5. Explain the sourcesof demand forforeign exchange.

6. What accounts forthe supply offoreign excange?

7. Explain the role ofpurchasing powerof currency inexchange ratedetermination.



NOTES

well known in economics that purchasing power is an inverse function of pricelevel. An increase in domestic price level will reduce the purchasing power ofdomestic currency and thus cause the exchange rate to depreciate. In the aboveexample, if we assume that the price of the ball point pen moves up to Rs.75, thenthe new exchange rate between rupee and dollar will be –

Rs. 75 = $1

The rupee will appreciate, when the price level falls in India. Assumingthat the price of the ball point pen falls to Rs25 the exchange rate will changeto –

Rs. 25 = $1

The purchasing power parity theory thus underscores the importance ofpurchasing power of domestic currency in exchange rate determination. The theoryhowever suffers from several drawbacks as it ignores the importance of otherfactors like capital movements in exchange rate determination.

12.3 SUMMARY

International trade in goods and services and in capital requires the tradingcountries to first trade their currencies, that is, exchange their currencies. Therate of exchange is the rate at which such exchange of currencies takes place andthe market where it takes place is called the foreign exchange market. It is thedemand for & supply of foreign exchange which act together to determine theexchange rate under the flexible exchange rate system. Under the fixed exchangerate system however, the exchange rate is fixed by the government and maintainedat the fixed level. In the absence of capital movements, it is the purchasing powerof the currencies that determines the exchange rate between the differentcurrencies.

12.4 KEY TERMS

l Foreign Exchange : A name given to any foreign currency.

l Exchange Rate : The rate at which the currency of one country isexchanged for that of another.

l Hedging : An act observed on the part of both exporters and importerswhereby attempts are made to protect themselves against the exchangerate risk.

l Arbitrage : Differential between the exchange rates prevailing in twoor more foreign exchange markets.

l Foreign Exchange Market : A network of institutions andcommunicative means used to exchange currencies of different countries.

12.5 EXERCISES

1. What is foreign exchange market? What are its types?





NOTES

2. Explain the sources of demand for and supply of foreign exchange indetail.

3. Discuss how the exchange rate is determined under the market theory.

4. Explain the purchasing power parity theory of exchange ratedetermination.










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