micro & macro economics utu notes

UTU Economics Notes VIMAL JOSHI

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Micro and Macro Economics

The terms ‘micro-‘ and ‘macro-‘ economics were first coined and used by Ragnar Fiscer in 1933. Micro-economics studies the economic actions and behaviour of individual units and small groups of individual units. In micro-economics, we are chiefly concerned with the economic study of an individual household, individual consumer, individual producer, individual firm, individual industry, particular commodity, etc. Whereas, when we are analysing the problems of the economy as a whole, it is a macro-economic study. In macro-economics, we do not study an individual producer or consumer, but we study all the producers or consumers in a particular economy.

Micro-Economics or Price Theory:

The term ‘micro-economics’ is derived from the Greek prefix ‘micro’, which means small or a millionth part. Micro-economic theory is also known as ‘price theory’. It is an analysis of the behaviour of any small decision-making unit, such as a firm, or an industry, or a consumer, etc. For micro-economics, in contrast to macro economic theory, the statistics of total economic activity are valueless as far as providing clues to policy decisions. It does not give an idea of the functioning of the economy as a whole. An individual industry may be flourishing, whereas the economy as a whole may be suffering.

In respect of employment, micro-economics studies only the employment in a firm or in an industry and does not concern to the aggregate employment in the whole economy. In the circular flow of economic activity in the community, micro-economics studies the flow of economic resources or factors of production from the resource owners to business firms and the flow of goods and services from the business firms to households. It studies the composition of such flows and how the prices of goods and services in the flow are determined.

A noteworthy feature of micro-approach is that, while conducting economic analysis on a micro basis, generally an assumption of ‘full employment’ in the economy as a whole is made. On that assumption, the economic problem is mainly that of resource allocation or of theory of price.

Importance of Micro-Economics: Micro-economics occupies a very important place in the study of economic theory.

1. Functioning of free enterprise economy: It explains the functioning of a free enterprise economy. It tells us how millions of consumers and producers in an economy take decisions about the allocation of productive resources among millions of goods and services.

2. Distribution of goods and services: It also explains how through market mechanism goods and services produced in the economy are distributed.

3. Determination of prices: It also explains the determination of the relative prices of various products and productive services.

4. Efficiency in consumption and production: It explains the conditions of efficiency both in consumption and production and departure from the optimum.

5. Formulation of economic policies: It helps in the formulation of economic policies calculated to promote efficiency in production and the welfare of the masses.

Thus the role of micro-economics is both positive and normative. It not only tells us how the economy operates but also how it should be operated to promote general welfare. It is also applicable to various branches of economics such as public finance, international trade, etc.

Limitations of Micro-Economics: Micro-economic analysis suffers from certain limitations:



1. It does not give an idea of the functioning of the economy as a whole. It fails to analyse the aggregate employment level of the economy, aggregate demand, inflation, gross domestic product, etc.

2. It assumes the existence of ‘full employment’ in the whole economy, which is practically impossible.

Macro-Economics or Theory of Income and Employment:

The term ‘macro-economics’ is derived from the Greek prefix ‘macro’, which means a large part. Macro-economics is an analysis of aggregates and averages of the entire (large) economy, such as national income, gross domestic product, total employment, total output, total consumption, aggregate demand, aggregate supply, etc. Macro-economics is the economic theory which looks to the statistics of a nation's total economic activity and holds that policy change designed to alter these total statistical aggregates is the way to determine economic policy and promote economic progress. Individual is ignored altogether. Sometimes, national saving is increased at the expense of individual welfare.

It analysis the chief determinants of economic development, and the various stages and processes of economic growth. Different macro-economic models of economic growth have been suggested, one of which most famous is Harrod-Domar Model. It can be applied to both developed and under-developed economies.

Importance of Macro-Economics:

1. It is helpful in understanding the functioning of a complicated economic system. It also studies the functioning of global economy. With growth of globalisation and WTO regime, the study of macro-economics has become more important.

2. It is very important in the formulation of useful economic policies for the nation to remove the problems of unemployment, inflation, rising prices and poverty.

3. Through macro-economics, the national income can be estimated and regulated. The per capita income and the people’s living standard are also estimated through macro-economic study. It explains the fluctuations in national income, per capita income, output and employment.

Limitations of Macro-Economics:

1. Individual is ignored altogether. For example, in macro-economics national saving is increased through increasing tax on consumption, which directly affects the consumer welfare.

2. The macro-economic analysis overlooks individual differences. For instance, the general price level may be stable, but the prices of food grains may have gone spelling ruin to the poor. A steep rise in manufactured articles may conceal a calamitous fall in agricultural prices, while the average prices were steady. The agriculturists may be ruined. While speaking of the aggregates, it is also essential to remember the nature, composition and structure of the components.

Equilibrium

The term equilibrium has often to be used in economic analysis. In fact, Modern Economics is sometimes called equilibrium analysis. Equilibrium means a state of balance. When forces acting in opposite directions are exactly equal, the object on which they are acting is said to be in a state of equilibrium.

Types of Equilibrium



Basically, there are three types of any equilibrium:

(a) Stable Equilibrium: There is stable equilibrium, when the object concerned, after having been disturbed, tends to resume its original position. Thus, in the case of a stable equilibrium, there is a tendency for the object to revert to the old position.

(b) Unstable Equilibrium: On the other hand, the equilibrium is unstable when a slight disturbance evokes further disturbance, so that the original position is never restored. In this case, there is a tendency for the object to assume newer and newer positions once there is departure from the original position.

(c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces neither bring it back to the original position nor do they drive it further away from it. It rests where it has been moved. Thus, in the case of a neutral equilibrium, the object assumes once for all a new position after the original position is disturbed.

When the word equilibrium is used to qualify the term value, then according to Professor Schumpeter, a stable equilibrium value is an equilibrium value that if changed by a small amount, calls into action forces that will tend to reproduce the old value; a neutral equilibrium value is an equilibrium value that does not know any such forces; and an unstable equilibrium value is an equilibrium value, change in which calls forth forces which tend to move the system farther and farther away from the equilibrium value.

In the following figure 2, the stable equilibrium is shown. When in equilibrium at point P, the producer produces an output OM and maximises his profits. In case the producer increases his output to OM2 or decreases it to OM1, the size of profits is reduced. This automatically brings in forces that tend to establish equilibrium again at P.

Figure 3 represents the case of unstable equilibrium. Initially the producer is in equilibrium at point P, where MR = MC and he is maximising his profits. If now he increases his output to OM1, he would be in equilibrium output at point P1, where he will obtain higher profits, because, at this output, marginal revenue is greater than marginal cost. Thus there is no tendency to return to the original position at P.

Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at all levels of output so that the producer has no tendency to return to the old position and every time a new equilibrium point is obtained, which is as good as the initial one.



Other Forms of Equilibrium

(a) Short-term and Long-term Equilibrium: Equilibrium may be short-term equilibrium or long-term equilibrium as in case of short-term and long-term value. In the short-term equilibrium, supply is adjusted to change in demand with the existing equipment or means of production, there being no time available to increase or decrease the factors of production. However, in case of long-term equilibrium, there is ample time to change even the equipment or the factors of production themselves, and a new factory can be erected or new machinery can be installed.

(b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an equilibrium position for a sector of the economy or for one or several partial groups of the economic unit corresponding to a particular set of data. This analysis excludes certain variables and relationship from the totality and studies only a few selected variables at a time. In other words, this method considers the changes in one or two variables keeping all others constant, i.e., ceteris paribus (others remaining the same). The ceteris paribus is the crux of partial equilibrium analysis.

The equilibrium of a single consumer, a single producer, a single firm and a single industry are examples of partial equilibrium analysis. Marshall’s theory of value is a case of partial equilibrium analysis. If the Marshallian method (i.e., partial equilibrium analysis) is to be effective, even in its



own terms, when applied to a hypothetical and idealised market, it necessary that the market should be small enough so that its inter-dependence with the rest of the hypothetical economy could be neglected without much loss of accuracy.

(i) Consumer’s Equilibrium: With the application of partial equilibrium analysis, consumer’s equilibrium is indicated when he is getting maximum aggregate satisfaction from a given expenditure and in a given set of conditions relating to price and supply of the commodity.

(ii) Producer’s Equilibrium: A producer is in equilibrium when he is able to maximise his aggregate net profit in the economic conditions in which he is working.

(iii) Firm’s Equilibrium: A firm is said to be in long-run equilibrium when it has attained the optimum size when is ideal from the viewpoint of profit and utilisation of resources at its disposal.

(iv) Industry’s Equilibrium: Equilibrium of an industry shows that there is no incentive for new firms to enter it or for the existing firms to leave it. This will happen when the marginal firm in the industry is making only normal profit, neither more nor less. In all these cases; those who have incentive to change it have no opportunity and those who have the opportunity have no incentive.

(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical economist, in his book ‘Elements of Pure Economics’, created his theoretical and mathematical model of General Equilibrium as a means of integrating both the effects of demand and supply side forces in the whole economy. Walras’ Elements of Pure Economics provides a succession of models, each taking into account more aspects of a real economy. General equilibrium theory is a branch of theoretical microeconomics. The partial equilibrium analysis studies the relationship between only selected few variables, keeping others unchanged. Whereas the general equilibrium analysis enables us to study the behaviour of economic variables taking full account of the interaction between those variables and the rest of the economy. In partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant.

General equilibrium is different from the aggregate or macro-economic equilibrium. General equilibrium tries to give an understanding of the whole economy using a bottom-top approach, starting with individual markets and agents. Whereas, the macro-economic equilibrium analysis utilises top-bottom approach, where the analysis starts with larger aggregates. In macro-economic equilibrium models, like Keynesian type, the entire system is described by relatively few, appropriately defined aggregates and functional relationships connecting aggregate variables such as total consumption expenditure, total investment, total employment, aggregate output and the like. In macro-economic analysis, many important variables and relationships tend to be disappeared in the process of aggregation.

There are two major theorems presented by Kenneth Arrow and Gerard Debreu in the framework of general equilibrium:

(i) The first fundamental theorem is that every market equilibrium is Pareto optimal under certain conditions, and

(ii) The second fundamental theorem is that every Pareto optimum is supported by a price system, again under certain conditions.



Uses of General Equilibrium

1. To get an overall picture of the economy and study the problems involving the economy as a whole or even large segments / sectors of it.

2. It shows that the quantities of demanded goods / factors are equal to the quantities supplied. Such a condition implies that there is a full employment of resources.

3. It also provides with an ideal datum of economic efficiency. It brings out the fact that long-run competitive equilibrium is a standard of efficiency for the entire economy. Only when the competitive economy obtains general equilibrium shall its economic efficiency be at its peak and there shall be no further gains made by any reallocation of resources.

4. General equilibrium also represents the state of optimum production of all commodities, because there can be no over-production or under-production under such conditions.

5. It also provides an insight into the way the multitudes of individual decisions are integrated by the working of the price mechanism. It, therefore, solves the fundamental problems of a free market economy, viz., what to produce, how to produce, how much to produce, etc. This analysis shows that such decisions with regard to innumerable consumers and producers are co-ordinated by the price mechanism.

6. The general equilibrium analysis also gives us the clue for predicting the consequences of an economic event.

7. It also helps in the field of public policy. The formulation of a logically consistent public policy requires a complete understanding of the various sector markets and aspects of individual decision-making units, and the impact of policy on the whole economy.

Limitations of General Equilibrium Analysis

1. The Walrasian general equilibrium system is essentially static. It treats the coefficient of production as fixed. It considers the supply of resources to be given and consistent. It also takes tastes and preferences of the society as fixed.

2. It ignores leads and lags, for it considers everything to happen instantaneously. It is supposed to work just in the same way as an electric circuit does. In the real world, all economic events have links with the past and the future.

3. Walrasian general equilibrium analysis is of little practical utility. It involves astronomical volumes of calculations for estimating the various quantities and practices. This makes its application practically impossible. Even the use of computers cannot be of much help because such a system cannot aid in collecting and recording the innumerable sets of prices and quantities that are required to formulate these equations. The critics further argue that even if such a solution exists, the price mechanism may not necessarily cover it.

4. Last but not least, the general equilibrium analysis falls to the ground as its star assumption of perfect competition is contrary to the actual conditions prevailing in the real world.



General Disequilibrium (Keynesian Theory)

Neoclassical economics thinks in terms of a market system in which supply equals demand in every market, so that no unemployment could ever occur. But this is an assumption. Keynes suggests a market system in which Disequilibrium can occur in some markets, including labour market, and in which the disequilibrium can spread contagiously from one market to another. Keynes’ idea was that, when this spreading disequilibrium settles down, there would be a kind of equilibrium – not supply and demand equilibrium, but often termed as ‘general disequilibrium’.

Take an example of a commodity, say cellular telephone sets, its equilibrium of demand and supply is shown in the following figure:

In the above figure, MC curve is the marginal cost curve for the commodity. Originally, the market is in equilibrium at price P1 with demand curve D1. Then, for any reason, demand for that commodity decreases to D2, Neoclassical economists tells us that the new equilibrium will be at price P3. But, in fact, the prices do not drop quite that far, instead, prices drop to P2. Perhaps this is because the businessmen do not know just how far they need to cut their prices, and are cautious to avoid cutting too much. At a price P2, the seller can sell only Qd amount of output. By producing Qd amount of output at price P2, the producers are not maximising their short-run profit. We have ‘disequilibrium’ in the sense that production is not on the marginal cost curve. At P2, the sellers can sell Qd amount of output, but they cannot produce the same amount of output. Here is a qualification. Producer might temporarily produce more that Qd, in order to build up their inventories. But there is a limit to how much inventories they want, so they will cut their production back to Qd eventually.

With a reduction of demand for cellular phones, any economist would expect a reduction in the quantity of that commodity produced. Neoclassical economics leads us to expect that the price would drop to P3 and output cut back to Qe. At the same time, a certain number of workers would be laid off and would switch their efforts into their second best alternatives, working in other industries, perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the production and layoffs would go even further, with output dropping to Qd. A reduction in income does not only reduce the demand for cellular phones, but it also reduces the demand for all other normal goods as well. This disequilibrium will spread contagiously through many different goods markets, through the effect of disequilibrium on income. So every other industry will face a reduction in demand because of the reductions in productions in many other industries.

Harrod Domar Growth Model



As we know that one of the principal strategies of development is mobilisation of domestic and foreign saving in order to generate sufficient investment to accelerate economic growth. The economic mechanism by which more investment leads to more growth can be described in terms of Harrod-Domar growth model, often referred to as the AK model.

Every economy must save a certain proportion of the national income, if only to replace worn-out or impaired capital goods (buildings, equipment, and materials). However, in order to grow, new investments representing net additions to the capital stock are necessary. If we assume that there is some direct economic relationship between the size of the total capital stock, K, and total GNP, Y – for example, if $3 of capital is always necessary to produce a $1 stream of GNP – it follows that any net additions to the capital stock in the forms of new investment will bring about corresponding increases in the follow of national output, GNP. This relationship is known as ‘capital-output ratio’ and is represented as ‘k’. in the above case ‘k’ is roughly 3:1.

If we further assume that the national savings ratio ‘S’ is a fixed proportion of national output (e.g. 6%) and that total new investment is determined by the level of total savings. We can construct the following simple model of economic growth:

· Saving (S) is some proportion, s, of national income (Y) such that we have the simple equation:

S = s .Y ---------------------------- (i)

· Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that:

I = ΔK ----------------------------- (ii)

But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as expressed by the capital-output ratio, k, it follows that:

K = k

Y

Or

ΔK = k

ΔY

Or

ΔK = k.ΔY ------------------------------- (iii)>

· Finally, because net national savings, S, must equal net investment, I, we can write this equality as:

S = I ------------------------------- (iv)

But from equations (i), (ii) and (iii), we finally get the following equation:



I = ΔK = k. ΔY

Therefore, we can rewrite the equation (iv) as follows:

S = s.Y = k.ΔY = ΔK = I --------------- (v)

Or simply

s.Y = k.ΔY -----------------------------------(vi)

Dividing both the sides of equation (vi) first Y and then by k, we obtain the following expression:

ΔY = s -------------------------------------- (vii)

Y k

Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of change or rate of growth in GNP (i.e., the percentage change in GNP).

The Harrod Domar Model, more specifically says that in the absence of government, the growth rate of national income will directly or positively related to the savings ratio (i.e., the more an economy is able to save and invest out of a given GNP, the greater the growth of that GNP will be. Harrod Domar Model further states that the growth rate of national income will be inversely or negatively related to the economic capital-output ratio (i.e., the higher k is, the lower the rate of GNP growth will be).

The additional output can be obtained from an additional unit of investment and it can be measured by the inverse of the capital-output ratio, k, because this inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows that multiplying the rate of new investment, s = I / Y, by its productivity, 1 / k, will give the rate by which national income or GNP will increase.

For example, the national capital-output ratio in an under-developed country is, let say, 3 and the aggregate saving ratio (s) is 6% of GNP, it follows that this country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose that the national saving rate increased from 6% to 15% through increased taxes, foreign aids, and / or general consumption sacrifices – GNP growth can be transferred from 2% to 5% (15% / 3).

According to Rostow and other theorists, the countries that were able to save 15% to 20% of GNP could grow at a much faster rate than those that saved less. Moreover, this growth would then be self-sustained. The mechanisms of economic growth and development, therefore, are simply a matter of increasing national savings and investment.

The main obstacle or constraint on development, according to this theory, was the relatively low level of new capital formation in most poor countries. But if a country wanted to grow at, let say, a rate of 7% per annum and if it could not generate savings and investment at a rate of 21% (i.e., 7% × 3) of national income but could not only manage to save 15%, it could seek to fill this saving gap of 6% through either foreign aid or private foreign investment.

Limitations of the model:

1. Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development



2. Harrod Domar model was formulated primarily to protect the developed countries from chronic unemployment, and was not meant for developing countries.

3. Practically it is difficult to stimulate the level of domestic savings particularly in the case of LDCs where incomes are low.

4. It fails to address the nature of unemployment exists in different countries. In developed countries, the unemployment is ‘cyclical unemployment’, which is due to insufficient effective demand; whereas in developing countries, there is ‘disguised unemployment’.

5. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.

6. The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise.

The Harrod-Domar model of economic growth cannot be rejected on the ground of above limitations. With slight modifications and reinterpretations, it can be made to furnish suitable guidelines even for the developing economies.

National Income Accounts

What is National Income Accounting?

National income accounting is a term which is applied to the description of the various types of economic activities that are taking place in the community in a certain institutional framework. In national income accounting, we are concerned with statistical classification of the economic activity so that we are able to understand easily and clearly the operation of the economy as a whole. In national income accounting the following distinctions are drawn between:

(a) forms of economic activity, namely, production, consumption, and accumulation of wealth;

(b) sectors or institutional division of the economy; and

(c) types of transactions, such as sales and purchases of goods and services, gifts, taxes, and other current transfers.

In national income accounting, a transactor is supposed to keep a set of three accounts in which transactions are recorded:

(i) In the first account, incomes and outgoings relating a productive activity of the transactor are brought together. The difference between the two shows the profit or gain.

(ii) The second account seeks to show how this profit and any other income that accrues to the transactor are allocated to different uses. The excess of income over outlay is saving.

(iii) The third account shows how this saving and any other capital funds are used to finance the capital expenditure or to give loans to other transactors.



Since in an economy, there are numerous transactors, therefore, they are grouped into sectors. In a sector, accounts of a same type are consolidated. The ‘sector accounts’ form the units in a system of national income accounting.

Comparison of National Income Accounting and Individual Income Accounting:

(a) Double entry book-keeping: Both national income accounting system and individual income accounting system are based on the method of double-entry book-keeping. For example, under individual income accounting, a cash sale is recorded as a debit in Cash Account and as a credit in Sales Account. Whereas, in national income accounting, the cash transactions are not separately presented. Cash balances are recorded in the capital transaction account. The difference is that the national income accounting does not record the second entry in detail.

(b) Individual vs. collective individuals: Individual income accounts or private accounts relate to an individual businessman or a corporate firm. Whereas, the national income accounts are closely related to all the businessmen or corporate firms in the community.

(c) Profit and loss account: Individual income accounts are usually presented in the form of a Profit and Loss Account or Income Statement which shows the flow of income and its allocation during a year. The Balance Sheet shows the stock of assets and liabilities at the end of the year. The Profit and Loss Account of a private businessman resembles in national income accounting to what is called the Appropriation Account. The only difference is that in private accounting, the profit often includes some elements of costs such as depreciation on plant and machinery and fees paid to the directors of the company. On the other hand, in national income accounting, these incomes are shown net. There is no counterpart at all of a Balance Sheet in national income accounting since there is a great difficulty in collecting such a huge bank of data accurately and completely especially on uniform basis.

Income Statement of a Typical Firm

For the year ended on December 31, 2005

Debits Rs. Credits Rs.

To Sales Account

(50,000 units @ Rs. 25)

1,250,000

By Cost of Sales:

Wages

Rent

Interest

Profit (residual)

750,000

150,000

150,000

200,000 Total 1,250,000 Total 1,250,000

National Product Account 2004-05

(Millions of rupees)

Flow of Product Rs. Flow of Earning Rs.



Final Output

(500 million units @ Rs. 25)

12,500

Costs or Earnings:

Wages

Rent

Interest

Profit

7,500

1,500

1,500

2,000 Total 12,500 Total 12,500

Uses of National Income Accounting:

(a) Clear picture of the economy: The national income accounts or social accounts give a clear picture of the economy regarding the GDP, national income, per capita income, saving ratio, production, consumption, disposable income, capital expenditure, etc. It gives a clear view of the health of the economy and the way in which it functions. It also gives a view on the living standard of the people.

(b) Promotion of efficiency and stability of the economy: To foster the economic growth, any government has to see what she has achieved in the past and what has to be done in the future. For this purpose, the preparation of national income accounts is quite inevitable for the promotion of economic efficiency and stability. It helps the government to set the national priorities, such as education, inflation, unemployment, defence, social development, and industrialisation, etc., in long-term and medium-term planning. It also helps the planner to set the economic objectives to be achieved in the near future. Thus it serves the purpose of planning and controlling tool for public administrators.

(c) Measurement of economic welfare: Measurement of economic welfare is another purpose of the preparation of social accounts. Through social accounting, we can know at a glace to what extent the masses are better off than at the time when planning started.

(d) Interrelationship of different sectors of the economy: Through the study of national income accounts, the reader is in a position to inter-relate different sectors of the economy. For example, through the study of national income accounts, we can know that Pakistan’s industrial sector is largely dependant on agriculture sector, because most of the raw materials like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from agriculture.

(e) Monetary, fiscal and trade policies: The national income accounts are very essential for the statesmen, governments, and politicians, because they help them to efficiently formulate different economic policies, including monetary policy, fiscal policy and trade policy. In the absence of national income accounts, the economic planning would be disastrous.

Gross National Product (GNP):

GNP is the basic national income accounting measure of the total output or aggregate supply of goods and services. It has been defined as the total value of all final goods and services produced in a country during a year. GNP is a ‘flow’ variable, which measures the quantity of final goods and services produced during a year. For calculating GNP accurately, all goods and services produced in any given year must be counted once, but not more than once.



Approaches of Measuring GNP/GDP:

The primary purpose of national accounts is to provide a coherent and comprehensive picture of the economy. To be concise, these estimates tend to answer questions such as:

(a) What is the output of the economy, its size its composition, and its uses? And

(b) What is the economic process by which this output is produced and distributed? These questions are addressed below in relation to estimation of GDP/GNP and final uses of the GNP.

The gross national product (GNP) is the market value of all final goods and services, produced in the economy during a year. GNP is measured in Rupee terms rather than in physical units of output. Gross domestic product (GDP) is a better idea to visualize domestic production in the economy. GDP may be derived in three ways or in combination of them.

(i) Production Approach: It measures the contribution to output made by each producer. It is obtained by deducting from the total value of its output the value of goods and services it has purchased from other producers and used up in producing its own output, i.e.:

VA = value of output – value of intermediate consumption.

Total value added by all producers equals GDP.

(ii) Income/Cost Approach: In this approach, consideration is given to the costs incurred by the producer within his own operation, the income paid out to employees, indirect taxes, consumption of fixed capital, and the operating surplus. All these add up to value added.

(iii) Expenditure Approach: This approach looks at the final uses of the output for private consumption, government consumption, capital formation and net of imports & exports. According this approach, GDP is the sum of following four major components:

Personal consumption expenditure on goods and services, Gross private domestic investment, Government expenditure on goods and services, and Net export to the rest of the world.

The concepts of expenditure approach and cost approach have been illustrated in the following diagram of circular flow of a simplified two-sector economy:



In the above diagram, the upper loop represents the ‘expenditure’ side of the economy. Through this loop, all the products flow from business sector to household sector. Each year the nation consumes a wide variety of final goods and services: goods such as bread, apples, computers, automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc. But we include only the value of those products that are bought and consumed by the consumers. In our ‘two-sector economy’ illustration, we have excluded the investment expenditure, government expenditure and taxes from GDP calculation.

The lower loop represents the ‘cost or revenue’ side of the economy. Through this loop, all the costs of doing business flow. These costs include wages paid to labour, rent paid to land, profits paid to capital, and so forth. But these business costs are revenues that are received by households in exchange of supplying factors of production to the business sector.

Precautions in Measuring GNP/GDP / Problems in National Income Measurement / Dangers of National Income Accounts:

The federal statisticians and economists have to be very careful in measuring GDP or preparing national income accounts. The following precautionary measures should be taken:

(a) Reliable source of data: All the data for national accounts are collected from different sources, including surveys, income tax returns, retail sales statistics, and employment data. Inaccurate or incomplete data can severely damage the integrity of the national accounts. The economists have to be very careful in collection and selection of national income accounting data.

(b) Difficulties of Measuring Some Services in Money Terms: National Income of a country is always measured in money terms, but there are some goods and services, which cannot be measured, in monetary terms. Such goods include, the services of the housewife, housemaid and the singing as a hobby by an individual. Exclusion of these services from the national income, underestimate the national income account.

(c) Illegal Activities in the Economy/The Growth of “Black Economy”: The “Black Economy” refers to that part of economic activity, which is undeclared and therefore unrecorded for tax purposes and is therefore deemed to be ‘illegal’. Many illegal activities in the economy generally escape both the law and measurement in the national income. Such illegal activities include, smuggling, drug trafficking and all parallel market



transactions. Since such activities are outlawed, income earned, through them are not captured in the national income, thus, under estimating the national income account.

(d) Danger of double counting: While measuring GDP, we have to distinguish between the three forms of goods:

(i) Final product: A final product is one that is produced and sold for consumption or investment.

(ii) Intermediate good: Intermediate goods are semi-finished goods or goods-in-process.

(iii) Raw material: Raw materials are unfinished and unprocessed goods.

To avoid double or multiple counting, it is necessary to add the value of only those goods which have reached their final stage of production, i.e., final goods, and to not add the value of intermediate goods and raw materials, which are already included in the value of final goods. GDP, therefore, includes bread but not wheat, cars but not steal.

(e) Problem of Including All Inventory Change in GNP: Firms generally record inventories at their original cost rather than at replacement costs. When prices rise, there are gains in the book value of inventories but when prices fall, there are losses. So, the book value of inventories overstates or understates the actual inventories. Thus, for correct computation of GNP, inventory evaluation is required. This is achieved when a negative valuation of inventory is made for inventory gains and a positive valuation is made for losses.

(f) Problem of Price Instability: Since national income is measured in money terms, fluctuation in the general price level will render unstable the measuring rod of money for national income. When prices are rising, the national income figures are rising even though production might have gone down. On the other hand, when prices are falling, GNP is declining even though the production might have gone up. To solve this problem, economist and statisticians have introduced the concept of real income.

(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses accruing to property owners by increase or decrease in the market value of their asset are not included in GNP computation because such changes do not result from current economic activities. Such exclusions underestimate or overestimate the GNP.

(h) Value added: ‘Value added’ is the difference between a firm’s sales and its purchases of materials and services from other firms. In calculating GDP earnings or value added to a firm, the statistician includes all costs that go to factors other than businesses and excludes all payments made to other businesses. Hence business costs in the form of wages, salaries, interest payments, and dividends are included in value added, but purchases of wheat or steel or electricity are excluded from value added. The following table illustrates the concept of value addition in GDP:

Table 1

Bread Receipts, Costs, and Value Added

Rupees Per Loaf



Stages of Production

(1) (2) (3)

Sales Receipts

Cost of Intermediate Materials

Value Added (wages, profit, etc.) (1 – 2)

Wheat 2.00 0 2.00 Flour 5.50 2.00 3.50 Baked dough 7.25 5.50 1.75 Delivered bread 10.00 7.25 2.75 Total 24.75 14.75 10.00

(i) Non-productive transactions are excluded from GDP: The non-productive transactions are excluded from GDP measurement. There are two types of non-productive transactions:

(i) Purely financial transactions: Purely financial transactions are:

All public transfer payments, which do not add to the current flow of goods such as social security payments, relief payments, etc.

All private financial transactions, such as receipt of money by a student from his father, etc.

Buying and selling of marketable securities, which make no contribution to current production.

(ii) Sale proceeds of second-hand goods.

Difference between GDP and GNP:

GDP is the most widely used measure of national output in Pakistan. Another concept is widely cited, i.e., GNP. GNP is the total output produced with labour or capital owned by Pakistani residents, while GDP is the output produced with labour and capital located inside Pakistan. For example, some of Pakistani GDP is produced in Honda plants that are owned by Japanese corporations. The profits from these plants are included in Pakistani GDP but not in Pakistani GNP. Similarly, when a Pakistani university lecturer flies to Japan to give a paid lecture on ‘economies of under-developed countries’, that lecturer’s salary would be included in Japanese GDP and in Pakistani GNP.

Net National Product (NNP):

Net national product (NNP) or national income at market price can be obtained by deducting depreciation from GNP. NNP is a sounder measure of a nation’s output than GNP, but most of the economists work with GNP. This is so because depreciation is not easier to estimate. Whereas the gross investment can be estimated fairly-accurately.

NNP equals the total final output produced within a nation during a year, where output includes net investment or gross investment less depreciation. Therefore, NNP is equals to:

NNP = GNP – Depreciation

It is the net market value of all the final goods and services produced in a country during a year. It is obtained by subtracting the amount of depreciation of existing capital from the market value



of all the final goods and services. For a continuous flow of money payments it is necessary that a certain amount of money should be set aside from the GNP for meeting the necessary expenditure of wear and tear, deterioration and obsolescence of the capital and ‘it should remain intact’.

In the above definition, the phrase ‘maintaining capital intact’ is meant to make good the physical deterioration which has taken place in the capital equipment while creating income during a given period. This can only be made by setting aside a certain amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a new capital equipment may be created out. If the depreciation allowance is not set aside every year, the flow of income would not remain intact. It will decline gradually and the whole country will become poor.

National Income or National Income at Factor Cost:

National income (NI) or national income at factor cost is the aggregate earnings of all the factors of production (i.e., land, labour, capital, & organisation), which arise from the current production of goods and services by the nation’s economy. The major components of national income are:

(i) Compensation of employees (i.e., wages, salaries, commission, bonus, etc.);

(ii) Proprietors income (profits of sole proprietorship, partnership, and joint stock companies);

(iii) Net income from rentals and royalties; and

(iv) Net interest (excess of interest payments of the domestic business system over its interest receipts and net interest received from abroad).

National income can be calculated as follows:

National Income = NNP – Indirect Taxes + Subsidies

Personal Income:

Personal Income is the total income which is actually received by all individuals or households during a given year in a country. Personal income is always less than NI because NI is the sum total of all incomes earned, whereas, the personal income is the current income received by persons from all sources. It should be noted here that all the income items which are included in NI are not paid to individuals or households as income. For instance, the earnings of corporation include dividends, undistributed profits and corporate taxes. The individuals only receive dividends. Corporate taxes are paid to government, and the undistributed profits are retained by firms. There are certain income items paid to individuals, but not included in the national income, commonly known as ‘transfer payments’. Transfer payments include old age benefits, pension, unemployment allowance, interest on national debt, relief payments, etc. Personal income can be measured as follows:

Personal Income = NI at Factor Cost – Contributions to Social Insurance – Corporate Income Taxes – Retained Corporate Earnings + Transfer Payments



Disposable Income:

Disposable income is that income which is left with the individuals after paying taxes to the government. The individuals can spend this amount as they please. However, they can spend in categorically two ways, i.e., either they can spend on consumption goods, or they can save. Therefore, the disposable personal income is equal to:

Disposable Income = Personal Income – Personal Taxes

or

Disposable Income = Consumption + Saving

Details of National Income Accounts:

It is very important to take a brief tour of major components or particulars of national accounts or product accounts. In this way, we can thoroughly understand the concept of GDP/GNP:

(a) GDP Deflator: The problem of changing prices is one of the problems economists have to solve when they use money as their measuring rod. Clearly, we want a measure of the nation’s output and income that uses an invariant yardstick. This problem can be solved by using ‘price index’, which is a measure of the average price of a bundle of goods. The price index is used to remove



inflation from GDP or to deflate the GDP, that is why, it is also called ‘GDP deflator’. The function of GDP deflator is to convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’. The formula of real GDP is as follows:

Real GDP = Nominal GDP GDP Deflator

or

Q = PQ P

Nominal GDP or PQ represents the total money value of final goods and services produced in a given year, where the values in terms of the market prices of each year. Real GDP or Q removes price changes from nominal GDP and calculate GDP in constant prices. And the GDP deflator or P is defined as the price of GDP.

Example:

A country produces 100,000 litres of coconut oil during the year 2005 at a price of Rs. 25 per litre. During the year 2006, she produces 110,000 litres of coconut oil at a price of Rs. 27 per litre. Calculate nominal GDP, GDP deflator and real GDP (using 2005 as base year).

Solution:

Nominal GDP:

Year Price P

Quantity Q

Price × Quantity PQ Nominal GDP

2005 25 100,000 2,500,000

2006 27 110,000 2,970,000

Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:

P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1

P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 = 1.08

Real GDP:

Year Nominal GDP PQ

GDP Deflator P

Real GDP (PQ/P) Q

2005 2,500,000 1 2,500,000

2006 2,970,000 1.08 2,750,000



Hence, during 2006, the real GDP grew by 10%.

(b) Investment and Capital Formation: Investment consists of the additions to the nation’s capital stock of buildings, equipment, and inventories during a year. Investment involves sacrifice of current consumption to increase future consumption. Instead of eating more pizzas now, people build new pizza ovens to make it possible to produce more pizza for future consumption.

To economists, investment means production of durable capital goods. In common usage, investment often denotes using money to buy shares from stock exchange or to open a saving account in a bank. In economic terms, purchasing shares or government bonds or opening bank accounts is not an investment. The real investment is that only when production of physical capital goods takes place.

Investment can be further categorised as:

(i) Gross investment: Gross investment includes all the machines, factories, and houses built during a year – even though some were bought to replace some old capital goods. Gross investment is not adjusted for depreciation, which measures the amount of capital that has been used up in a year.

(ii) Net investment: Gross investment does not adjust the deaths of capital goods; it only takes care of the births of capital. However, the net investment takes into account the births as well as deaths of capital goods. In other words, net investment is adjusted for depreciation. Therefore, the net investment plays a vital role in estimating national income:

Net Investment = Gross Investment – Depreciation

(c) Government Expenditure: Government expenditures include buying goods like from roads to missiles, and paying wages like those of marine colonels and street sweepers. In fact, it is the third great category of flow of products. It involves all the expenditures incurred on running the state. However, it does not mean that GDP includes all the government expenditures including ‘government transfer payments’. The government transfer payments, which include payments to individuals that are not made in exchange for goods and services supplied, are excluded from GDP measurement. Such transfers payments include expenditures on pensions, old-age benefits, unemployment allowances, veterans’ benefits, and disability payments. One peculiar government transfer payment is ‘interest on national debts’. This is a return on debt incurred to pay for past wars or government programmes and is not a payment for current government goods and services. Therefore, the interests are excluded from GDP calculations.

(d) Net Exports: ‘Net exports’ is the difference between exports and imports of goods and services. Pakistan is facing negative net export situation since her birth, except for few years. The biggest reason is that Pakistan is a developing nation and consistently importing capital goods and final consumption goods from developed countries at much higher prices. Whereas, we export raw materials and intermediate goods at lower prices, which have less demand due to their poor quality or because of availability of much cheaper substitute goods in the market.



Circular Flow of Income

The amount of income generated in a given economy within a period of time (national income) can be viewed from three perspectives. These are:

Income,

Product, and

Expenditure.

The above assertion implies that we can view national income as either the total sum of all income received within a particular period (income); the total good and services produced within a particular period (product) or total expenditure on goods and services within a given period (expenditure). Whichever approach is used, the value we get is the same.

The circular flow of income and product is used to show diagrammatically, the equivalence between the income approach and the product approach in measuring gross national product (GNP).

In analysing the circular flow of income, there are three scenarios:

1. A simple and closed economy with no government and external transactions, i.e., two-sector economy;

2. A mixed and open economy with savings, investment and government activity, i.e., three-sector economy; and

3. A mixed and open economy with savings, investment, government activity and external trade, i.e., four-sector economy.

1. Circular Flow of Income in a Two-Sector Economy:

According to circular flow of income in a two-sector economy, there are only two sectors of the economy, i.e., household sector and business sector. Government does not exist at all, therefore, there is no public expenditure, no taxes, no subsidies, no social security contribution, etc. The economy is a closed one, having no international trade relations. Now we will discuss each of the two sectors:

(i) Household Sector: The household sector is the sole buyer of goods and services, and the sole supplier of factors of production, i.e., land, labour, capital and organisation. It spends its entire income on the purchase of goods and services produced by the business sector. Since the household sector spends the whole income on the purchase of goods and services, therefore, there are no savings and investments. The household sector receives income from business sector by providing the factors of production owned by it.

(ii) Business Sector: The business sector is the sole producer and supplier of goods and services. The business sector generates its revenue by selling goods and services to the household sector. It hires the factors of production, i.e., land, labour, capital and organisation, owned by the household sector. The business sector sells the entire output to households. Therefore, there is no existence of inventories. In a two-sector economy, production and sales are thus equal. So long as the household sector continues



spending the entire income in purchasing the goods and services from the business sector, there will be a circular flow of income and production. The circular flow of income and production operates at the same level and tends to perpetuate itself. The basic identities of the two-sector economy are as under:

Y = C

Where Y is Income

C is Consumption

Circular Flow of Income in a Two-Sector Economy (Saving Economy):

In a two-sector macro-economy, if there is saving by the household sector out of its income, the goods of the business sector will remain unsold by the amount of savings. Production will be reduced and so the income of the households will fall. In case the savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled by investment. Through investment, the equilibrium level between income and output is maintained at the original level. It is illustrated in the following figure:



The equilibrium condition for two-sector economy with saving is as follows:

Y = C + S or Y = C + I or C + S = C + I

or

S = I

Where Y is Income

C is Consumption

S is Saving

I is Investment

When saving and investment are added to the circular flow, there are two paths by which funds can travel on their way from households to product markets. One path is direct, via consumption expenditures. The other is indirect, via saving, financial markets, and investment.

Savings: On the average, households spend less each year than they receive in income. The portion of household income that is not used to buy goods and services or to pay taxes is termed



‘Saving’. Since there is no government in a two-sector economy, therefore, there are no taxes in this economy.

The most familiar form of saving is the use of part of a household’s income to make deposits in bank accounts or to buy stocks, bonds, or other financial instruments, rather than to buy goods and services. However, economists take a broader view of saving. They also consider households to be saving when they repay debts. Debt repayments are a form of saving because they, too, are income that is not devoted to consumption or taxes.

Investment: Whereas households, on the average, spend less each year than they receive in income, business firms, on the average, spend more each year than they receive from the sale of their products. They do so because, in addition to paying for the productive resources they need to carry out production at its current level, they desire to undertake investment. Investment includes all spending that is directed toward increasing the economy’s stock of capital.

Financial Market: As we have seen, households tend to spend less each year than they receive in income, whereas firms tend to spend more than they receive from the sale of their products. The economy contains a special set of institutions whose function is to channel the flow of funds from households, as savers, to firms, as borrowers. These are known as ‘financial markets’. Financial markets are pictured in the center of the circular-flow diagram in the above figure.

Banks are among the most familiar and important institutions found in financial markets. Banks, together with insurance companies, pension funds, mutual funds, and certain other institutions, are termed ‘financial intermediaries’, because their role is to gather funds from savers and channel them to borrowers in the form of loans.

2. Circular Flow of Income in a Three-Sector Economy:

We have so far discussed the two-sector economy consisting of household sector and business sectors. Under three-sector economy, the additional sector is the government. Two-sector economy is a hypothetical economy, whereas the three-sector economy is much more realistic. The inclusion of the government sector is very essential in measuring national income. The government levies taxes on households and on business sector, purchases goods and services from business sector, and attain factors of production from household sector. The following figure illustrates three-sector economy:



In the above diagram, in one direction, the household sector is supplying factors of production to the factor market. Business sector demands the factors of production from factor market. Inputs are used by the business sector, which produces goods and services that are purchased back by the households and the government. Personal income after tax or disposable income that is received by households from business sector and government sector is used to purchase goods and services and makes up consumption expenditure (or C). The money spent in the product market is the market value of final goods and services (or GDP). That money goes to business sector that pays it back in the form of wages, rent, profits and interests.

Total spending on goods and services is known as ‘aggregate demand’. The total market value of output produced and sold is also known as ‘aggregate supply’. To measure aggregate demand in a closed economy, we simply add consumption spending (C), investment spending (I) and government spending (G). Therefore:

Y = C + I + G

Where Y is Income,

C is Consumption,

I is Investment, and



G is Government Spending.

Note that government spending (G) includes its buying of labour from factor market, buying of goods and services from product market, and transfer payments to the household sector. Transfer payments are payments the government makes in return for no service, for example, welfare payments, unemployment compensation, pension, etc. The government collects its money in the form of tax, which makes up most of the government revenue. But the government does not always balance their budgets. The government always tends to spend more than it takes in as taxes. The federal government almost always runs a deficit. The government deficit must be financed by borrowing in financial markets. Usually this borrowing takes the form of sales of government bonds and other securities to the public or to financial intermediaries. Over time, repeated government borrowing adds to the domestic debt. The ‘debt’ is a stock that reflects the accumulation of annual ‘deficits’, which are flows. When the public sector as a whole runs a budget surplus, the direction of the arrow is reversed. Governments pay off old borrowing at a faster rate than the rate at which new borrowing occurs, thereby creating a net flow of funds into financial markets.

3. Circular Flow of Income in a Four-Sector Economy:

Two-sector economy and three-sector economy are briefly discussed in previous sections. These are hypothetical economies. In real life, only four-sector economy exists. The four-sector economy is composed of following sectors, i.e.:

(i) Household sector,

(ii) Business sector,

(iii) The government, and

(iv) Transaction with ‘rest of the world’ or foreign sector or external sector.

The household sector, business sector and the government sector have already been defined in the previous sections. The foreign sector includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports (exports minus imports). The inclusion of fourth sector, i.e., foreign sector or transaction with ‘rest of the world’ makes the national income accounting more purposeful and realistic. With the inclusion of this sector, the economy becomes an open economy. The transaction with ‘rest of the world’ involves import and export of goods and services, and new foreign investment. It is illustrated in the following figure.



In four-sector economy, goods and services available for the economy’s purchase include those that are produced domestically (Y) and those that are imported (M). Thus, goods and services available for domestic purchase is Y+M. Expenditure for the entire economy include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus:

Y + M = C + I + G + X

Y = C + I + G + (X – M)

Where, C = Consumption expenditure

I = Investment spending



G = Government spending

X = Total Exports

M = Total Imports

X – M = Net Exports

Economy Leakages and Injections:

Leakages: When households engage in savings and purchase of goods and services from abroad, we experience temporary withdrawal of funds from circulation. Therefore, leakages in the circular flow are savings, taxes and imports

Injection: On the other hand, when we sell abroad (export) we receive income. More so when foreigners invest in our country the level of income will also increase. These two activities are injection into the income stream. Therefore, injections are investment, government spending and exports.

Total Leakages = Total Injections

C + I + G + (X-M) = C + S + Net Taxes

S + Net Taxes + Imports = I + G + Exports

S = I + (G – NT) + (X – M)

One way of thinking about the circular flow of income is to imagine a water tank. Investment, government spending and spending by foreigners is injected into the tank, and savings, taxes and spending on imports leak out. The injections and the withdrawals are equal to each other so the level in the tank is stable, or as economists like to say in equilibrium.

If injections are greater than withdrawals or leakages then the level in the tank will rise. If withdrawals are greater than injections then the level in the tank falls. If planned (I+G) is equal to planned (S+T), so that injections is equal to leakages and total spending is equal to total income and total demand is equal to total supply. Then we have a ‘stable economy’. If leakages are higher than injections i.e., planned savings plus taxes are greater than planned investment plus government spending (S+T > I+G), economy contracts resulting in inventory accumulation, too



little spending and drop in prices. If injections are higher than leakages, i.e., planned investment plus government spending are greater than planned saving plus taxes (I+G > S+T), economy expands resulting in more goods and services produced, and higher prices.

Theory of Employment

TYPES OF UNEMPLOYMENT:

(a) Structural Unemployment: It is also known as Marxian unemployment or long-term unemployment. It is due to slower growth of capital stock in the country. The entire labour force cannot be absorbed in productive employment, because there are not enough instruments of production to employ them.

(b) Seasonal Unemployment: Seasonal unemployment arises because of the seasonal character of a particular productive activity so that people become unemployed during the slack season. Occupations relating to agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.

(c) Frictional Unemployment: It arises when the labour force is temporarily out of work because of perfect mobility on the part of the labour. In a growing and dynamic economy, in which some industries are declining and others are rising and in which people are free to work wherever they wish, some volume of frictional unemployment is bound to exist. This is so because it takes some time for the unemployed labour to learn new trades or to shift to new places, where there is a demand for labour. Thus, frictional unemployment exists when there is unsatisfied demand for labour, but the unemployed workers are either not fit for the jobs in question or not in the right place to meet this demand.

(d) Cyclical Unemployment: It is also known as Keynesian unemployment. It is due to deficiency of aggregate effective demand. It occurs when business depression occurs. During the times of depression, business activity is at low ebb and unemployment increases. Some people are thrown out of employment altogether and others are only partially employed. This type of unemployment is due to the fact that the total effective demand of the community is not sufficient to absorb the entire productive of goods that can be produced with the available stock of capital. When the businessmen cannot sell their goods and services, their profit expectations are not fulfilled. So the entrepreneurs reduce their output and some factors of production become unemployed.

(e) Disguised Unemployment: Disguised unemployment is the most widespread type of unemployment in under-developed countries. In under-developed countries, the stock of capital does not grow fast. The capital stock has not been growing at a rate fast enough to keep pace with the growth of population, the country’s capacity to offer productive employment to the new entrants to the labour market has been severely limited. This manifests itself generally in two ways:

(i) the prevalence of large-scale unemployment in the urban areas; and

(ii) in the form of growing numbers engaged in agriculture, resulting in ‘disguised unemployment’.

In disguised unemployment, there is an existence of a very backward agricultural economy. People are engaged in production with an extremely low or zero marginal productivity. Since the employment opportunities in non-agricultural sector are not



sufficient, therefore, most of the workers are bound to work in agricultural sector. This gives rise to the concept of ‘disguised unemployment’, in which people are unwillingly engaged in occupations, where their marginal productivity is very low.

THEORIES OF EMPLOYMENT:

The theories of employment are broadly classified into two:

(a) Classical theory of employment

(b) Keynesian theory of employment.

The classical theory assumed the prevalence of full employment. The ‘Great Depression’ of 1929 to 1934, engulfing the entire world in widespread unemployment, low output and low national income, for about five years, upset the classical theorists. This gives rise to Keynesian theory of employment.

Classical Theory of Employment:

The term ‘classical economists’ was firstly used by Karl Marx to describe economic thought of Ricardo and his predecessors including Adam Smith. However, by ‘classical economists’, Keynes meant the followers of David Ricardo including John Stuart Mill, Alfred Marshal and Pigou. According to Keynes, the term ‘classical economics’ refers to the traditional or orthodox principles of economics, which had come to be accepted, by and large, by the well known economists by then. Being the follower of Marshal, Keynes had himself accepted and taught these classical principles. But he repudiated the doctrine of laissez-faire. The two broad features of classical theory of employment were:

(a) The assumption of full employment of labour and other productive resources, and

(b) The flexibility of prices and wages to bring about the full employment

(a) Full employment:

According to classical economists, the labour and the other resources are always fully employed. Moreover, the general over-production and general unemployment are assumed to be impossible. If there is any unemployment in the country, it is assumed to be temporary or abnormal. According to classical views of employment, the unemployment cannot be persisted for a long time, and there is always a tendency of full employment in the country. According to classical economists, the reasons for unemployment are:

(i) Intervention by the government or private monopoly,

(ii) Wrong calculation by entrepreneurs and inaccurate decisions, and

(iii) Artificial resistance.

The economy is assumed to be self-adjusting and perfectly competitive economy. It is the economy in which the relative values of goods and services are determined by the general relations of demand and supply. The pricing system serves as the planning mechanism.

(b) Flexibility of prices and wages:



The second assumption of full employment theory is the flexibility of prices and wages. It is the flexibility of prices and wages which automatically brings about full employment. If there is general over-production resulting in depression and unemployment, prices would fall as a result of which demand would increase, prices would rise and productive activity will be stimulated and unemployment would tend to disappear. Similarly, the unemployment could be cured by cutting down wages which would increase the demand for labour and would stimulate activity. Thus, if the prices and wages are allowed to move freely, unemployment would disappear and full employment level would be restored. Further, the classical economists treated money as mere exchange medium. They ignored its role in affecting income, output and employment.

Say’s Law:

1. Say’s Law is the foundation of classical economics. Assumption of full employment as a normal condition of a free market economy is justified by classical economists by a law known as ‘Say’s Law of Markets’.

2. It was the theory on the basis of which classical economists thought that general over-production and general unemployment are not possible.

3. According to the French economist J. B. Say, supply creates its own demand. According to him, it is production which creates market for goods. More of production, more of creating demand for other goods. There can be no problem of over-production.

4. Say denies the possibility of the deficiency of aggregate demand.

5. The conceived Say’s Law describes an important fact about the working of free-exchange of economy that the main source of demand is the sum of incomes earned by the various productive factors from the process of production itself. A new productive process, by paying out income to its employed factors, generates demand at the same time that it adds to supply. It is thus production which creates market for goods, or supply creates its own demand not only at the same time but also to an equal extent.

6. According to Say, the aggregate supply of commodities in the economy would be exactly equal to aggregate demand. If there is any deficiency in the demand, it would be temporary and it would be ultimately equal to aggregate supply. Therefore, the employment of more resources will always be profitable and will take to the point of full employment.

7. According to Say’s Law, there will always be a sufficient rate of total spending so as to keep all resources fully employed. Most of the income is spent on consumer goods and a par of it is saved.

8. The classical economists are of the view that all the savings are spent automatically on investment goods. Savings and investments are interchangeable words and are equal to each other.

9. Since saving is another form of spending, according to classical theory, all income is spent partly for consumption and partly for investment.

10. If there is any gap between saving and investment, the rate of interest brings about equality between the two.

Basic Assumptions of Say’s Law:



(a) Perfectly competitive market and free exchange economy.

(b) Free flow of money incomes. All the savings must be immediately invested and all the income must be immediately spent.

(c) Savings are equal to investment and equality must bring about by flexible interest rate.

(d) No intervention of government in market operations, i.e., a laissez faire economy, and there is no government expenditure, taxation and subsidies.

(e) Market size is limited by the volume of production and aggregate demand is equal to aggregate supply.

(f) It is a closed economy.

Pigou’s Theory:

1. According to Professor Pigou, the unemployment which exists at any time is because of the fact that changes in demand conditions are continually taking place and that frictional resistances prevent the appropriate wage adjustment from being made instantaneously.

2. Thus, according to classical theory, there could be small amounts of ‘frictional unemployment’ attendant on changing from one job to another but there could not be ‘involuntary unemployment’ for a long period.

3. According to Professor Pigou, if people were unemployed, wages would fall until all seeking employment were in fact employed.

4. Involuntary unemployment which was found at times of depression was because of the fact that wages were kept too high by the actions of labour unions and governments. Therefore, Professor Pigou advocated that a general cut in money wages at a time of depression would increase employment.

5. According to Pigou, perfectly elastic wage policy would abolish fluctuations of employment and would ensure full employment.

6. The of the economy as described by the classical theory is depicted as follows:



Suppose the consumer saves 10% of his income. The result will be firm’s receipts fall by the same proportion. Profit will fall and the firm will tend to react by reducing the output and hence reducing the employment and income. Therefore, to avoid this problem the savings are channelled to firms through banking.

Criticism of Classical Theory:

1. Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to aggregate supply.

2. Employment in a country cannot be increased by cutting general wages.

3. There is no direct relationship between wages and employment.

4. Interest rate adjustments cannot solve savings-investment problem.

5. Classical economists have made the economy completely self-adjusting and self-reliant. An economy is not so self-adjusting and government intervention is unobvious.



6. Classical economists have made the wages and prices so much flexible. In practical, wages and prices are not so flexible. It will create chaos in the economy.

7. Money is not a mere medium of exchange. It has an essential role in the economy.

8. The classical theory has failed to explain the occurrence of trade cycles.

Keynesian Theory of Employment:

Keynes has strongly criticised the classical theory in his book ‘General Theory of Employment, Interest and Money’. His theory of employment is widely accepted by modern economists. Keynesian economics is also known as ‘new economics’ and ‘economic revolution’. Keynes has invented new tools and techniques of economic analysis such as consumption function, multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour efficiency remain constant. That is why, according to Keynesian theory, volume of employment depends on the level of national income and output. Increase in national income would mean increase in employment. The larger the national income the larger the employment level and vice versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of income’.

Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on aggregate effective demand for goods in the country. Greater the aggregate effective demand, the greater will be the volume of employment and vice versa. According to Keynes, the unemployment is the result of deficiency of effective demand. Effective demand represents the total money spent on consumption and investment. The equation is:

Effective demand = National Income (Y) = National Output (O)

The deficiency of effective demand is due to the gap between income and consumption. The gap can be filled up by increasing investment and hence effective demand, in order to maintain employment at a high level.

According to Keynes, the level of employment in effective demand depends on two factors:

(a) Aggregate supply function, and

(b) Aggregate demand function.

(a) Aggregate supply function:

1. According to Dillard, the minimum price or proceeds which will induce employment on a given scale, is called the ‘aggregate supply price’ of that amount of employment.

2. If the output does not fetch sufficient price so as to cover the cost, the entrepreneurs will employ less number of workers.

3. Therefore, different numbers of workers will be employed at different supply prices.



4. Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to induce varying quantities of employment.

5. We can have a corresponding aggregate supply price curve or aggregate supply function, which slopes upward to right.

(b) Aggregate demand function:

1. The essence of aggregate demand function is that the greater the number of workers employed, the larger the output. That is, the aggregate demand price increases as the amount of employment increases, and vice versa.

2. The aggregate demand is different from the demand for a product. The aggregate demand price represents the expected receipts when a given volume of employment is offered to workers.

3. The aggregate demand curve or aggregate demand function represents a schedule of the proceeds of the output produced by different methods of employment.

Determination of Equilibrium Level of Employment:

1. In the above diagram, AS curve shows the different total amounts which all the entrepreneurs, taken together, must receive to induce them to employ a certain number of men. If the entrepreneurs are convinced to receive OC amount of money, they will employ ON1 number of labour.

2. The AD curve shows the different total amounts which all the entrepreneurs, taken together, expect to receive at different levels of employment. If they employed ON1 level of employment, they expect to receive ON amount of proceeds from the total output.

3. At ON1 level of employment, the economy is not in equilibrium. Because the total expected amount is greater than the total amount paid:



OH > OC

4. The equilibrium level of employment is ON2, as at this point the AD curve intersects the AS curve or the AD is just equal to AS. The amount of proceeds, i.e., OM which entrepreneurs expect to receive from providing ON2 number of jobs is just equal to the amount i.e. OM which they must receive if the employment of that number of workers is to be worthwhile for the entrepreneurs.

5. If the situation is such that the total amount of money expected to be received from the sale of output exceeds the amount that is considered necessary to receive, there will be competition among the entrepreneurs to offer more employment and thus, the employment will increase. On the left of N2, AD is greater than AS, i.e., the amount expected to be received is greater than the amount considered necessary, there will be competition amount entrepreneurs to employ more labour.

6. Beyond the N2, the AD curve lies below AS curve, which means that the amount expected by the entrepreneurs is less that the amount they considered necessary to receive. Therefore, the number of persons employed will be reduced in the economy.

7. The slope of AS curve, at first rises slowly and then after a point it rises sharply. It means that at beginning as more and more men are employed, the cost of output rises slowly. But as the amount received by the entrepreneurs increases they employ more and more men. As soon as the entrepreneurs start getting OT amount, they will be prepared to employ all of the workers.

8. The AD curve, in the beginning, rises sharply, but it flattens towards the end. This shows that in the beginning as more men are employed, the entrepreneurs expect to get sharply increasing amounts of money from the sale of the output. But after employment has sufficiently increased, the expected receipts do not rise sharply.

9. Effective demand is that aggregate demand price which becomes ‘effective’ because it is equal to aggregate supply price and thus represents a position of short-run equilibrium.

10. Effective demand also represents the value of national output because the value of national output is equal to the total amount of money received by the entrepreneurs from the sale of goods and services. The money received by the entrepreneurs from the sale of goods is equal to the money spent by the people on these goods. Hence the equation is:

Effective demand = National income

= Value of national output

= National expenditure

= Expenditure on consumption goods + Expenditure on investment goods

11. It is not necessary that the equilibrium level of employment is always at full employment level. Equality between AD and AS does not necessarily indicate the full employment level. It can be in equilibrium at less that full employment or an under-employment equilibrium.



12. Actually there is always some unemployment in the economy, even in economically advanced countries.

13. According to Keynes, full employment is the level of employment beyond which further increases in effective demand do not increase output and employment.

14. At the point of intersection of AS and AD, the entrepreneurs are maximising their profits. The profit will be reduced if volume of employment is more or less that this point. Even if the point does not represent full employment.

15. AD and AS will be equal at full employment only if the investment demand is sufficient to cover the gap between the AS price and consumption expenditure. The typical investment falls short of this gap. Hence the AD curve and AS curve will intersect at a point less than full employment, unless there is some external change.

16. In the above diagram, in this situation of aggregate supply (AS), ON’ number of men were seeking employment, whereas only ON number of men could secure employment.

17. In this situation, the economy has not yet reached the full employment level, and there are still NN’ number of workers unemployed in the economy.

18. If the favourable circumstances push the economy and the AD increases so much that the entrepreneurs now find it worthwhile to employ ON’ men at the equilibrium point E’, where the economy is in full employment level.

19. The situation in which the economy is in equilibrium at the level of full employment is called the ‘optimum situation’.

20. The root cause of the under-employment equilibrium is the deficiency of AD. This deficiency is due to the fact that there is a gap between income and consumption. As income increases consumption increases but not proportionately. If the investment is increased sufficiently to cover this gap, there can be full employment. Hence the gap between income and consumption and insufficiency of investment to this gap are responsible for under-employment equilibrium.



Comparison between Classical and Keynes’ Theories:

(a) Equilibrium at full employment:

(i) According to classical theory, the economy can only be in a state of equilibrium at full employment level. Any deviation from full employment would be of short period.

(ii) Keynes’ theory is of the viewpoint that an economy can be in equilibrium even at less than full employment level. There is a small possibility of full employment in a country.

(b) Macro vs. Micro:

(i) The classical economic theory dealt with individual aspects of the economy, and relates to microeconomics.

(ii) Keynes’ theory relates to macroeconomics which studies the economy as a whole.

(c) Aggregates vs. Innumerable decisions:

(i) The classical economic theory studies the economic system in terms of innumerable decision making units, for example, producers’ equilibrium and consumers’ equilibrium.

(ii) Whereas, the Keynes’ theory deals with aggregates, for example, aggregate supply and aggregate demand.

(d) Wages and employment:

(i) Classical economists believed that a state of full employment could be brought about through cuts in money wages.

(ii) According Keynes, lowering wages will reduce the aggregate income and so effective demand which in turn reduce the level of employment in an economy.

(e) Interest:

(i) According to classical theorists, interest is the reward for ‘waiting’ or for time preference.

(ii) According to Keynes, interest is a reward for parting with liquidity.

(f) Rate of interest:

(i) According to classical theory, the rate of interest is determined by the interaction of savings and investment.



(ii) According to Keynesian theory, the rate of interest is determined at different levels of income.

(g) Statics vs. Dynamics:

(i) The classical theory is based on the conception of static economy.

(ii) The Keynesian theory is based on the conception of dynamic economy.

(h) Full employment theory vs. General theory:

(i) The classical theory relates only to full employment.

(ii) The Keynesian approach is a general theory which has a very wide application at all situations, i.e., unemployment, partial employment and near full-employment.

(i) Theory of money and prices:

(i) The classical economists had segregated the theory of money from the theory of value and output, and dealt with them as if they are unrelated to one another which is actually not the case.

(ii) Keynes’ theory is more realistic. He has integrated the theory of money and prices with the theory of income and employment in the country.

(j) Budgeting:

(i) Classical economists believed in orthodox finance and balanced budgets.

(ii) According to Keynes’ a country’s budget should reflect the financial situation, and should vary in accordance with the requirements. Keynes has not emphasised on balanced budget, because there are several developing countries with deficit budgets dictated by their economic conditions and requirements.

(k) Supply of money:

(i) According to classical economists, increase in money supply would bring about inflation and should be controlled in order to avoid the employment less than full employment.

(ii) Whereas, the Keynes’ theory states that an appropriate increase in money supply would increase employment and output and does not necessarily bring inflation.

(l) General price level vs. Individual commodity prices.



(m) Level of employment in a community vs. Employment of a particular class of labour.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of economics. His theory has several names: theory of income and employment, demand-side theory, consumption theory, and macro-economic theory. In fact, he has brought about a revolution in economic analysis, often known as ‘Keynesian Revolution’.

2. Keynes’ theory has completely demolished the idea of full-employment and forwards the idea of under-employment equilibrium. He states that employment level in the economy can only be increased by increasing investment.

3. The new economic tools and techniques developed by Keynes have enabled the today’s economists to draw correct conclusions on the economic situation of a country. Such tools are consumption function, multiplier, investment function, liquidity preference, etc.

4. Keynes has integrated the theory of money with the theory of value and output.

5. Keynes has first time introduced a dynamic economic theory, in order to depict more realistic situation of the economy.

6. He also states the reasons of excess or deficiency of aggregate demand through inflationary and deflationary gap analysis.

7. Keynes’ theory is a general theory and therefore, can be applied to all types of economic systems.

8. Keynes influenced on practical policies and criticised the policy of surplus budget. He advocated deficit financing, if that sited the economic situation in the country.

9. Keynes has emphasised on suitable fiscal policy as an instrument for checking inflation and for increasing aggregate demand in a country. He advocated extensive public work programmes as an integral part of government programmes in all countries for expanding employment.

10. He advised several monetary controls for the central bank, which in turn will act as the instrument of controlling cyclical fluctuations.

11. Keynesian theory has played a vital role in the economic development of less-developed countries.

12. He rejected the theory of wage-cut as a means of promoting full-employment.

13. Keynes’ theory has given rise to the importance of social accounting or national income accounting.

Criticism on Keynes’ Theory:



1. According to Schumpeter, the Keynes theory is a depression theory, which has limited applications.

2. Some socialist or communist economists had said that Keynes’ theory is dead if communism comes. However, even the socialist countries have strived to raise their national income by using Keynesian theory.

3. Keynesian theory is not as much dynamic and it may more properly be called comparative statics.

4. Keynesian theory has ignored microanalysis and is not helpful in the solution of the problems of individual firms and consumers.

5. Keynes has not given any place to the accelerator principle.

6. It pays excessive attention to money in economic analysis.

Relevance of Keynes’ Theory to Less-Developed Countries (LDCs) (Extended Criticism):

1. The Keynesian theory is primarily for fighting depression. The assumptions on which Keynesian theory is based are:

(a) The multiplier, and

(b) Short-term analysis.

2. In the short-term analysis, Keynes assumes that capital equipment, technology, organisation, labour and their efficiency remains constant. He thinks that the problems relating to employment in developed countries arises only on account of the deficiency of demand.

3. But the problem in case of LDCs is to increase capital equipment, to improve technology and labour efficiency. Solving this problem will take a long process; it cannot be solved in short-run.

4. The developing countries like Pakistan and India, the basic cause of unemployment is low rate of savings and investment.

5. Most of the LDCs are agriculturists and the Keynesian approach is industry-oriented. Therefore, increase in national income by deficit spending will lead to increase in demand for food. This will raise the prices of food grains. Therefore, heavy reliance on Keynesian approach could mislead the economists, and can plunge the economy into inflationary spiral.

6. The principle of multiplier does not much work in LDCs. Suppose new investments are made in the country, increased investment will lead to the establishment of new factories, workers will get employed, income will increase, demand will increase, but it does not guarantee the increase in the supply of goods because there is no excess capacity, and the supply of productive factors is not elastic. Increased income will be absorbed in high prices.

Determination of National Income



1. In the short run, the level of national income is determined by aggregate demand and aggregate supply. The supply of goods and services in a country depends on the production capacity of the community. But during the short period the productive capacity does not change.

2. If AD increases, output will also increase and the level of national output (i.e., national income) will rise. On the other hand, if AD decreases, the national output or national income will also decrease. It follows that the equilibrium level of NI is determined by AD since the aggregate capacity remains more or less the same during the short run.

3. Thus, there are two components of effective demand:

(a) Consumption demand, and

(b) Investment demand.

4. Aggregate Demand = Consumption + Investment

i.e., AD = C + I

5. The consumption demand depends on propensity to consume and income. At a given propensity to consume, as income increases, the consumption demand will also increase.

6. In the above diagram the 45o line represents aggregate supply line and it is also called ‘income line’. This income line shows two things:

(a) Total output or aggregate supply (C + I), and

(b) National income.

7. In the above diagram, the curve C rises upward to the right which means that as income increases consumption also increases. The distance between income line and consumption line represents saving. Thus, NI = C + S or Y = C + S.



8. One noteworthy thing about propensity to consume is that it remains stable or constant during the short period. Because the propensity to consume depends on the tastes and needs of the people and these do not change in the short run.

9. Since consumption is more or less stable and cannot be varied, therefore, variation in NI depends on variation in investment.

10. Investment is the second component of AD. Investment depends on two things:

(a) Marginal efficiency of capital, and

(b) The rate of interest

11. The rate of interest is more or less stable, hence, change in investment depends on the marginal efficiency of capital (MEC).

12. The MEC means expectations of profit from investment. In other words, the expected rate of profit is called MEC.

13. The MEC depends on two factors:

(a) Replacement cost of capital goods, and

(b) Profit expectations of investors.

14. If we join the investment demand with the curve C of propensity to consume, we get AD curve C + I in which C represents consumption and I investment. The distance between propensity to consume curve C and AD curve C + I is equal to investment.

15. The level of NI will be determined at point at which the AD and AS curves intersect each other. At this point AD and AS are in equilibrium.

16. In the above diagram, the equilibrium level of income is OY. At this point the AD curve and AS curve intersect each other.

17. If the income is more than OY, than total output or AS is greater than AD (C + I), and the entire output cannot be sold out.

18. If the income is less than OY, then total output or AS is less than AD (C + I), and the entire output will be sold out. In such a situation there is a shortage of supply, but the output will be increased in order to cover the shortage and the NI will also increase.

19. OY is the equilibrium level of income which is less than full employment level, i.e., OYF. Whereas, the HF corresponds the saving.



20. The economy will be in full employment level only when investment demand increases so as to cover this saving. But there is no guarantee that investment demand will exactly be equal to savings.

Equality of Saving and Investment:

1. There is another way of determining the equilibrium level of NI, i.e., through equality of savings and investment.

2. Take the same diagram of AD and AS. At point E, the savings and investment are equal to GE. At above the point the saving is more than investment, and for income less than this point, the investment is more than saving. Saving and investment are only equal at the equilibrium level of income, and when they are not equal, the NI is not in equilibrium.

3. When at a certain level of NI intended investment by the entrepreneurs is more than intended savings by the people, this would mean that AD is greater than total output or AS, i.e.,

I > S or AD > AS

This would induce the firms to increase production raising the level of income and employment.

4. Hence, when at any level of NI, investment is greater than savings, there will be a tendency for the NI to increase.

5. On contrary, when at any level of NI, the investment demand is less than saving, it means that AD is less than AS. As a result of a decline in national output, the national income will also reduce.

6. Saving is withdrawal of some money from the income stream. On the other hand, investment is the injection of money into the income stream. If the intended investment is more than intended saving, it means that more money has been injected in the economy. This would increase the national income.

7. But when investment is just equal to saving, it would mean that as much money has been put into income stream as has been taken out of it. The result would be that the NI will neither increase nor decrease, i.e., it would be in equilibrium. The determination of NI by investment and saving is illustrated in the following diagram:



8. In the above diagram, the investment line (II curve) has been drawn parallel to the X-axis. This is done on the assumption that in any year, the entrepreneurs intend to invest a certain amount of money. That is, we assume that investment does not change with income.

9. The saving line (SS curve) shows intended saving at different levels of income.

10. The saving line and investment line intersect each other at the equilibrium point E, where the intended saving and the intended investment are equal at OY level of income. Hence OY is the equilibrium level of NI.

11. In the above diagram, there is no tendency for income to increase or decrease.

12. If the income level is greater than OY, the amount of intended investment is less than saving, as a result, the income will finally decrease.

13. If the income level is less than OY, the amount of intended investment is greater than intended saving, as a result, the income will continue to increase to the equilibrium level.

Inflationary Gap:

Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP level. This means that people are demanding more goods and services than can be produced. In other words, the implication of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand is that the price level will increase. Or we may say that there will be an inflationary gap if scheduled investment tends to be greater than full employment saving. In a situation like this, more goods will be demanded than the economic system can produce. The result will be that price will begin to rise and an inflationary situation will emerge. Thus, if full employment saving falls short of scheduled investment at full employment (which means that peoples’ propensity to spend is higher than the propensity to save), there will be an inflationary gap.



In the above diagram, C + I + G (consumption, investment and government spending) line shows the total expenditure on demand in the economy. At this level, Y is the real output, as shown by the intersection, point D, with the 45o line. YF represents a full employment level on real output. Real income of the economy, obviously cannot reach Y. At YF, total demand (C + I + G) exceeds total output, leaving a gap AB, which is the inflationary gap in the Keynesian sense.

Deflationary Gap:

The deflationary or recessionary gap is the amount by which the aggregate expenditure falls short of the full employment level of national income. It causes a multiple decline in real NI.

In the above diagram, Y is the total output at full employment level. Let us assume that the total demand is (C + I + G)’ which cuts the 45o line at B, with real output Y’, AB then is the deflationary gap.

Consumption Function



Propensity to consume is also called consumption function. In the Keynesian theory, we are concerned not with the consumption of an individual consumer but with the sum total of consumption spending by all the individuals. However, in generalizing the consumption behaviour of the whole economy, we have to draw some useful conclusions from the study of the behaviour of a normal consumer, which may be valid for all consumers’ behaviour of the economy. Aggregate consumption depends on consumption function or propensity to consume.

The economic term ‘consumption’ means the amount spent on consumption at a given level of income. ‘Consumption function’ or ‘propensity to consume’ means the whole of the schedule showing consumption expenditure at various levels of income. It tells us how consumption expenditure increases as income increases. The consumption function or propensity to consume, therefore, indicates a functional relationship between the aggregates, viz., total consumption expenditure and the gross national income. It is a schedule that expresses relationship between consumption and disposable income.

According to Keynesian theory, following are the factors that influence consumption:

(a) The real income of the individual,

(b) The past savings, and

(c) Rate of interest.

Average and Marginal Propensities to Consume:

The average propensity to consume (apc) is a relationship between total consumption and total income in a given period of time. In other words, apc is the ratio of consumption to income. Thus:

apc = C Y

Where C : Consumption

Y : Income

apc : Average propensity to consume

While, the marginal propensity to consume (mpc) measures the incremental change in consumption as a result of a given increment in income. In other words, mpc is the ratio of change in consumption to the change in income.

mpc = ΔC ΔY

Where ΔC : Incremental change in consumption

ΔY : Incremental change in income

mpc : Marginal propensity to consume



the normal relationship between income and consumption is that when income increases, consumption also increases, but by less than the increase in income. In other words, in normal circumstances, mpc is less than one. It is drawn as a straight-line with a slope of less than one. This slope indicates the percentage of additional disposable income that will be spent. It is assumed that the whole additional income is not spent, i.e., a certain amount is spent and the remainder is saved. This can be further explained with the help of following table and diagram:

Income Consumption Saving 100 75 25 120 90 30 140 105 35 180 135 45 220 165 55

In the above diagram, OL is the income line and OP is income consumption curve. The income consumption line OP lies below the income line OL. The mpc will be measured by the tangent of the angle that income consumption curve makes with X-axis.

The curve as we have drawn turns out to be straight line rising from the origin, which means that mpc is constant throughout. This, however, need not be so and the curve may well become flatter as income rises, for as more and more consumption needs have been satisfied, a greater share of an increase in income than before may be saved. The dotted curve OM represents such a relationship showing that as income rises, mpc becomes smaller and smaller.

There is a level of disposable income (DI) at which the entire income is spent and nothing is saved. This point is often known as ‘point of zero savings’. Below this level of DI, the consumption expenditure will exceed the DI. There may be cases in which the consumer has no income at all. In such cases, the income consumption curve may not rise from the origin but from farther left showing that when income is zero, consumption is not zero and that the individual is living on his past savings.

Propensity to Save:



In the above diagram, ON represents the saving-income curve. Savings at a given level of income can also be read off from the distance between a point on income-consumption curve and corresponding point on income curve (See the figure of income-consumption relationship). The marginal propensity to save (mps) can be measured by the slope of income-saving curve ON. Marginal propensity to save (mps) is the increment in savings caused by a given increment in income. The mps is always equal to one minus mpc:

Keynes’ Law of Consumption:

Keynes propounded a law based on the analysis of consumption function. This law is known as ‘Fundamental Law of Consumption’ or ‘Psychological Law of Consumption’. It states that aggregate consumption is a function of aggregate disposable income.

Propositions of the Law:

This law consists of three propositions:

(a) When aggregate income increases, consumption expenditure will also increase but by a somewhat smaller amount.



(b) When income increases, the increment of income will be divided in same proportion between saving and consumption. Consumption and saving go side by side. What is not consumed is saved. Savings is, thus, the complement of consumption.

(c) As income increases, both consumption spending and saving go up. An increment in income is unlikely to lead either to less spending or less savings than before. It will seldom happen that a person may decrease his consumption or his savings when he has got more income.

Assumptions:

(a) Habits of people regarding spending do not change or that the propensity to consume remains the same or stable.

(b) The economic conditions remain normal. There is no hyper-inflation or war or other abnormal conditions.

(c) The economy is a free-market economy. There is no government intervention.

(d) The important characteristic of the slope of consumption function is that the marginal propensity to consume (mpc) will be less than unity. This results in low-consumption and high-saving economy.

Implications:

According to Keynesian theory, the mpc is less than unity, which brings out the following implications:

(a) Since consumption largely depends on income and consumption function is more or less stable, it is necessary to increase investment fill the gap of declining consumption as income increases. If this is not done, the increased output will not be profitable.

(b) When the income increases, and the consumption are not increased, there is a danger of over-production. The government will have to step in to remedy the situation. Therefore, the policy of laissez-faire will not work here.

(c) If the consumption is not increased, the marginal efficiency of capital (MEC) will diminish. The demand for capital will also diminish, and all the economic progress will come to a standstill.

(d) Keynes’ Law explains the turning points in the business cycle. When the trade cycle has reached the highest point of prosperity, income has gone up. But since consumption does not correspondingly go up, the downward cycle starts, for demand has lagged behind. In the same manner, when the business cycle has touched the lowest point, the cycle starts upwards, because consumption cannot be diminished beyond a certain point. This is due to the stability of mpc.

(e) Since the mpc is less than unity, this law explains the over-saving gap. As income goes on increasing, consumption does not increase as much. Hence saving process proceeds cumulatively and there arises a danger of over-saving.

(f) This law also explains the unique nature of income generation. If money is injected into the economic system, it will increase consumption but to a smaller extent than



increase in income. This again is due to the fact that consumption does not increase along with increase in income.

Factors Influencing Consumption Function:

There are certain factors affecting the propensity to consume in the long-run:

1. Objective Factors:

(a) Distribution of income: It is generally observed that the average and marginal propensities to consume of the poor are greater than those of the rich. This is because the poor has a lot of unsatisfied wants and he is likely to seize every opportunity that comes his way to satisfy them. On the other hand, the rich have already a high standard of living and relatively less urgent wants remain to be satisfied, so that in their case, an addition to their incomes is more likely to be saved than spent on consumption.

(b) Fiscal policy: Fiscal policy of the government will also influence the consumption behaviour of an economy. A reduction in taxation will leave more post-tax incomes with the people and this will stimulate higher expenditure on consumptions. Similarly, an increase in taxes will depress consumption.

(c) Changes in business expectations: Business expectations by affecting the incomes of certain classes of people affect consumption function.

(d) Windfall gains and losses: The windfall losses and gains arising out of changes in capital values affect the ‘saving brackets’ mostly and not the spending sections. Hence, their influence on consumption function is not so well marked.

(e) Liquidity preferences: Another factor is the people’s liquidity preferences. If people prefer to keep their income in liquid ford, consumption is reduced correspondingly.

(f) Substantial changes in the rate of interest.

2. Subjective Factors:

(a) Individual motives to save:

(i) Building of reserves for unforeseen contingencies as illness or unemployment,

(ii) To provide for anticipated future needs such as daughter’s wedding, son’s education, etc.

(iii) To enjoy an enlarged future income by investing funds out of current income, etc.

(b) Business motives:

(i) The desire to expand business,

(ii) The desire to face emergencies successfully,

(iii) The desire to have successful management,



(iv) The desire to ensure sufficient financial provision against depreciation and obsolescence.

Measures for Raising Consumption:

1. Redistribution of income in favour of poor where propensity to consume is greater.

2. Comprehensive social security measures like unemployment doles, old-age pension, sickness insurance, etc.

3. Liberal wage policy, and

4. Credit facilities for middle and poor classes for purchasing more consumer goods.

Importance of Consumption Function:

1. Important tool of macro-economic analysis.

2. Value of the multiplier gives us a link between changes in investment and changes in income.

3. Consumption function invalidates the Say’s Law, which states that supply creates its own demand, because this theory does not hold accurate in the real world.

4. It shows the crucial importance of investment.

5. It explains the reasons of declining MEC.

6. It explains the turning points of business cycle.

Post-Keynesian Developments Regarding Consumption Function:

(a) The Ratchet Effect:

(i) Professor Duesenberry says that in matter of consumption, an individual is not merely influenced by current income, but also by standard of living in the past.

(ii) The consumers are not easily reconciled to fall in their income. They try hard to maintain their previous standard of living. This is to maintain their position among their relatives, friends and neighbours.

(iii) Consumption as a proportion of income goes up as income increases and does not fall in the same proportion as the income falls. In other words, consumption is not reversible. This is known as ‘Ratchet Effect’.

(b) Demonstration Effect:

(i) The Duesenberry Hypothesis suggests that the consumer expenditure depends on relative and not on absolute incomes. The consumption function is linear rather than curved because it is the income of a family relative to that of other families.



(ii) The ‘Demonstration Effect’ determines how much a consumer spent and how much he saves. Middle-class and poor people imitate the life style of rich people. People in under-developed countries try to follow the consumption pattern of affluent nations. This is called the ‘Demonstration Effect’, and it is dangerous as it retards the economic growth.

(c) Pigou Effect:

(i) When prices fall as a result of a cut in money wages, the purchasing power of money with a consumer increases, or there is an increase in the real value of money. People feel that they are now better off and they increase their consumption expenditure. This leads to expansion in GNP and has been referred to as ‘Pigou Effect’.

(ii) Keynes seems to be agreed that theoretically it is possible to bring about full employment by sufficiently lowering the money wages. But the process would be so slow that it could be ignored as a practical possibility. It would be more realistic to assume that wages are not so flexible (as assumed by Pigou) as to permit the working of Pigou effect to bring about full employment.

(d) Government Consumption:

(i) Another factor which affects consumption and the level of economic activity is the government expenditure.

(ii) It differs from country to country and in the same country it differs over time.

(iii) Government may have a vital role in creating employment, influencing consumption and adjusting saving through fiscal and other policies.

Theories of Consumption Function:

There are three different economic theories explaining consumption-income relationship:

(a) Absolute Income Theory: According to Keynes, on average, men increase their consumption as their income increases but not by as much as the increase in income. In other words, the average propensity to consume goes down as the absolute level of income goes up. Hence, according to this theory, the level of consumption expenditure depends upon the absolute level of income and the relationship between the two variables is non-proportionate. However, it is pointed out that although this relationship is one of non-proportionality, yet there is illusion of proportionality caused by factors other than income, viz., accumulated wealth, migration to urban areas, new consumer goods, etc. Owing to such factors as these, the consumers spend more and the relationship appears to be proportional.

(b) Relative Income Hypothesis: The Relative Income Hypothesis was first introduced by Dorothy Brady and Ross Friedman. It states that the consumption expenditure does not depend on the absolute level of income but instead the relative level of income.

According to Dussenberry, there is a strong tendency for the people to emulate and imitate the consumption pattern of their neighbours. This is the ‘demonstration effect’. The relative income hypothesis also tells us that the level of consumption spending is determined by the households’ level of



current income relative to the highest level of income earned previously. People are then reluctant to revert to the previous low level of consumption. This is ‘ratchet effect’.

The relative income theory states that if current and peak incomes grow together changes in consumption are always proportional to change in income. That is, when the current income rises proportionally with peak income, the apc remains constant.

This proportionality relationship can be illustrated by the following diagram:

Income and consumption lines (Y and C) show proportional relationship, when income grows steadily. Similarly, if income grows in spurts and dips, the response of the consumption is same. Thus Y’ and C’ lines show proportional relationship.

(c) Permanent Income Hypothesis: Friedman draws a distinction between permanent consumption and transitory consumption. Permanent consumption stands for that part of consumer expenditure which the consumer regards as permanent and the rest is transitory. Distinction can also be made between durable and non-durable consumer goods. Durable consumption is concerned with purchasing capital assets and in the case of non-durable goods the act of consumption destroys the good. Ordinary consumer expenditure relates to non-durable consumption, i.e., consumption of goods which are quickly used in consumption. These are the ‘flow’ items since a flow of them is being continuously consumed. On the other hand, durable consumption, which relates to the purchase of capital assets, is an act of investment. These are ‘stock’ items.

According to Friedman, permanent consumption (Cp) is a function of:

(i) Rate of interest,

(ii) Rates of consumer’s income from property and his personal effort, i.e., human and non-human wealth, and

(iii) Consumer’s preference for immediate consumption multiplied by permanent income (Yp).



The permanent income theory really emphasises the important role of capital assets or wealth in determining the size of consumption. It shows how both income and consumption are closely linked with the consumer’s wealth. It is capital and wealth, which affects the level of consumption rather than consumer’s income.

(d) Life Cycle Hypothesis: According to Life Cycle Hypothesis, the consumption function is affected more by consumer’s whole life income rather than his current income. This view has been put forward by Modigliani, Brumberg and Ando. The permanent income hypothesis focuses attention on the income of the consumer earned in recent past as well as expected future earnings (and wealth). But the life cycle hypothesis states the consumption function depends upon consumer’s whole life income. In childhood, the consumer earns nothing but spends all the same (his parents spend on him); in the middle age, when he comes to have a family, he earns and spends. But he will be earning more than he spends. He tries to save enough to maintain himself in his old age when he will not be able to earn or earn much. Over his life span, the consumer tries to maintain a certain uniform standard and with that end in view he organises whole life’s uneven income flows of cash receipts. In other words, he will arrange his income and expenditure in such a manner as to maintain a certain standard of living which he desires.

The ‘Life Cycle Hypothesis’ seems to be quite realistic and plausible. It may be noted, however, that this hypothesis emphasises income as derived from wealth more than cash receipts. It also draws our attention to the fact that the consumers have to make a choice between immediate consumption and accumulating of assets for future use.

Investment

Investment, in the theory of income and employment, means, an addition to the nation’s stock of capital like the building of new factories, new machines as well as any addition to the stock of finished goods or the goods in the pipelines of production. Investment includes addition to inventories as well as to fixed capital. Thus, investment does not mean purchase of existing securities or titles, i.e., bonds, debentures, shares, etc. Such transactions do not add to the existing capital but merely mean change in ownership of the assets already in existence. They do not create income and employment. Real investment means the purchase of new factories, plants and machineries, because only newly constructed or created assets create employment or generate income.

Types of Investment:

1. Gross and Net Investment: Net investment means gross investment minus depreciation. In the theory of income and employment, investment means net investment.

2. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or anticipated investment. Ex-post investment is actually realised investment, or the investment which is not merely planned but which is actually invested or implemented.

3. Private and Public Investment: Private investment is on private account and public investment is by the State or local authorities. The private investment is influenced by marginal efficiency of capital (MEC) i.e., profit expectations and the rate of interest. Therefore, the private investment is profit-elastic. In public investment, the profit motives do not enter into consideration. It is undertaken for social good and not for private gain.



4. Autonomous and Induced Investment: Autonomous investment is independent of income level, and depends on population growth and technical progress. Such investment does not vary with the level of income. In other words, it is income-inelastic. The influence of change in income is not altogether ruled out. The examples of autonomous investment are ‘long range’ investments in houses, roads, public buildings and other forms of public investment. Such investment is generally done by the State as necessitated by the growth of population and facilitated by technical progress and not as a result of change in NI. These investments are independent of changes in income and are not governed by profit motive. They are generally made by governments and local authorities for promoting general welfare.

Induced investment varies with NI. Changes in NI bring about changes in aggregate demand which in turn affects the volume of investment. When NI increases, AD too increases, and investment has to be undertaken to meet this increased demand. Thus induced investment is income-elastic.

Investment is made by the people as a result of changes in income level or consumption. It is also influenced by price changes, interest changes, etc., which affect profit possibilities. It is undertaken for the sake of profit or income and it changes with a change in income. Thus, induced investment is governed by profit motive.

Factors Affecting Investment:

1. Marginal Efficiency of Capital (MEC) or expected rate of profit: MEC or expected rate of profit the most important factor affecting private investment. If the business expectations are good or if the MEC is high, more investment will be made. On the contrary, if there is an economic depression in the country or there are bleak prospects of profits, investment will be discouraged. Thus, the fluctuations in investment are mainly caused by the fluctuations in the MEC.

2. Rate of interest: The second important factor affecting investment is rate of interest. The rate of interest does not quickly change; it is more or less sticky or constant. Hence, the inducement to invest, by and large, depends on the MEC. For a suitable investment condition, the rate of return or profit must at least equal to rate of interest. So long as the expected rate of return exceeds the rate of interest, investment will continue to be made. In other words, the MEC must never fall below the current rate of interest, if investment is to be worthwhile.

3. Excess capacity: There are some other factors that affect investment. Excess capacity is one of them. If a firm has already ‘excess capacity’ and can easily handle increased future demand, it will not go in for further investment in capital equipment.

4. Technological progress: Technological progress also affects current level of investment. For instance, a new invention may render the present capital stock of a firm obsolete and adversely affect its ability to compete. In this case, further investment will be called for.

5. Political and security conditions: This factor has become one of the major important factors that affect the investment, esp. with reference to under-developed countries including Pakistan. Political instability, poor security arrangements and society’s negative attitude towards investment companies can badly damage the investment environment, and the country can be suffered from poverty and unemployment due to lack of investment. Countries like Kenya, Zimbabwe, Sudan, etc. are the worst victims.



Marginal Efficiency of Capital (MEC):

MEC is the highest rate of return expected from an additional unit of a capital asset over its cost. It is the expected rate of profitability of a new capital asset. J.M. Keynes has defined MEC as being equal to the rate of discount which would make the present value of the series of annuities given by the returns expected from the capital assets during its life just equal to the supply price. Symbolically it is expressed as:

Where Sp denotes supply price or replace cost of the asset, R1, R2,…..Rn are the prospective annual returns or yield from the capital asset in the year 1, 2, and n respectively. i is the rate of discount which makes the capital asset exactly equal to the present value of the expected yield from it.

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule. The MEC schedule shows a functional relationship between MEC and the amount of investment in a given type of capital asset at a particular period of time for the whole economy.

In the above diagram, the marginal efficiency of capital is represented by MEC curve. It slopes downward from left to right which means that as investment increased its marginal efficiency goes down.

Investment at any time depends on the rate of interest prevailing at that time. If the rate of interest is 5%, the investment is US $750 million, because, at this level, MEC is equal to the rate of interest. The MEC represents the investor’s return and the rate of interest is his cost. Obviously, the return on capital must at least be equal to the rate of interest, which is its cost.

Investment (In Million US $)

MEC / Rate of Interest (In %)

200 10 250 9 400 7 750 5 1000 3



Suppose the rate of interest goes down to 3%, then it will become worthwhile to invest US $1,000 million. Thus, the MEC and the rate of interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the extent to which the volume of investment would change consequent upon changes in the rate of interest. If MEC is relatively interest-elastic, a little fall in the rate of interest will result in a considerable expansion in the volume of investment. On the other hand, if the MEC is relatively interest-inelastic, then a considerable fall in the rate of interest may not lead to any increase in the volume of investment.

Shifts in MEC: As the expectations regarding the prospective yields change, the MEC will change too and the MEC curve will shift upwards or downwards. It is illustrated in the following diagram:

Suppose a war breaks out or demand for goods increases on account of some other reason. As a result, entrepreneurs’ expectations of profit will rise high and the investment demand curve or the MEC curve will shift upwards to MEC’. This means that at a given rate of interest, investment will be greater than before. From the above diagram, it will be seen that whereas the rate of interest i, investment was OM before, it now becomes OM’. Similarly, if for some reason demand for goods has decreased bringing down the MEC to MEC” at the same rate of interest i, investment will only be OM” as compared with OM before.



Influence of Rate of Interest: The rate of interest along with the MEC determines the volume of investment. If the rate of interest is higher than the MEC, it will not be profitable to create a new physical asset. This is because we assume that the aim of individual investor is to maximise the money profits. Two courses of action are open to invest, either he can use his money to crease additional physical assets, i.e., he can invest in the Keynesian sense of the term, or else he can lend his money to others at a certain rate of interest. Now, if MEC is lower than the current rate of interest, it is more profitable to lend money rather than use it for creating new assets. On the other hand, if MEC is higher than the rate of interest, it is better to invest more. At the point, where MEC equals the current rate of interest, we have the equilibrium level of investment.

Factors of MEC:

The marginal efficiency of capital depends upon psychological and objective factors:

1. Psychological Factors: Whenever a firm undertakes an investment, it estimates its MEC in the light of the experience of the past, existing conditions and guesses about the future conditions. If the businessmen are optimistic about the future, they will estimate the MEC higher and if they are pessimistic about the further business condition, naturally the MEC will be estimated low.

2. Objective Factors:

(a) MEC and the Market: If the market of a particular commodity is wide and is expected to grow further, the investment in that project will be favourable and the MEC high. On the other hand, if the demand of a particular commodity is limited and is expected to decline in the future, the investment will be discouraged in that project and the MEC will be low.

(b) Rate of Growth of Population: MEC is also influenced by the rate of growth of population. If population is growing at a rapid speed, it is usually believed that the demand of various classes of goods will increase. So a rapid rise in the growth of population will increase the MEC and a slowing down in its rate of growth will discourage investment and thus reduce MEC.

(c) Technological Development: If inventions and technological development take place in the industry, the prospect of increase in the net yield brightens up. For example, the development of automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc. So we can say that inventions and technological developments encourage investment in various projects and increase MEC.

(d) Existed Capital Goods: If the quantity of any particular type of goods is available in abundance in the market and the consumers can partially or fully meet demand, then it will not be advantageous to invest money in that particular project. So in such cases, the MEC will be low.

(e) Current Rate of Investment: Another influence on the MEC is the rate of investment currently going on in a particular industry. If in a relevant field, much investment has already taken place and the rate of investment currently going on in that industry is also very large, then new investors will hesitate to invest their money in that direction. As the anticipated net yield from that project will be very small, so they can invest money in such project only if they expect extremely favourable demand conditions.



(f) Rate of Taxes: MEC is directly influenced by the rate of taxes levied by the government on various commodities. When taxes are levied, the cost of commodities is increased and the revenue is lowered. When profits are reduced, MEC will naturally be affected. It will be low, if taxes are very high and high if taxes are low.

Multiplier and Accelerator

(Determination of National Income Continued)

THE MULTIPLIER:

Keynes’ Multiplier Theory gives great importance to increase in public investment and government spending for raising the level of income and employment. Both consumption and investment create employment. But both have complementary relationship with one another. When investment increases, consumption increases too and helps in creating employment. It is only when the level of full employment has been reached that investment and consumption become competitive instead of being complementary; then increase in one will reduce the other, one will be at the expense of the other.

Kahn’s Employment Multiplier:

Kahn’s Multiplier is known as Employment Multiplier, and Keynes’ Multiplier is known as Investment Multiplier. According to Kahn’s Employment Multiplier, when government undertakes public works like roads, railways, irrigation works then people get employment. This is initial or primary employment. These people then spend their income on consumption goods. As a result, demand for consumption goods increases, which leads to increase in the output of concerned industries which provides further employment to more people. But the process does not end here. The entrepreneurs and workers in such industries, in which investment has been made, also spend their newly obtained income which results in increasing output and employment opportunities. In this way, we see that the total employment so generated is many times more than the primary employment.

Suppose the government employs 300,000 persons on public works and, as a result of increase in consumer goods, 600,000 more persons get employment in the concerned industries. In this way, 900,000 persons have been able to get employment, that is, three times more people are now employed. In other words, Kahn’s employment multiplier means that by the government undertaking public works many more times total employment is provided as compared with initial employment.

Keynes’ Income or Investment Multiplier:

Keynes’ income multiplier tells us that a given increase in investment ultimately creates total income which is many times the initial increases in income resulting from that investment. That is why it is called income multiplier or investment multiplier. Income multiplier indicates how many times the total income increases by a given initial investment.

Suppose Rs. 100 million are invested in public works and as a result there is an increase of Rs. 300 million in income. In this case, income has been increased 3 times, i.e., the multiplier is 3. If ΔI represents increase in investment, ΔY indicates increase in income and K is the multiplier, then the equation of multiplier is as follows:



----------------------------------- (i)

The multiplier is the numerical co-efficient showing how large an increase in income will result from each increase in investment. The multiplier is the number by which the change in investment must be multiplied in order to get the resulting change in income. It is the ratio of change in income to the change in investment. If an investment of Rs. 50 million increases income by Rs. 150 million, the income multiplier is 3 and if Rs. 200 million, the multiplier is 4 and so on.

In the following multiplier equation, the relationship between income and investment is determined through marginal propensity to consume:

------------------------------------(iii)

Where:

(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

--------------------------------------((iii)

It should be noted that the size of multiplier varies directly with the size of mpc. When the mpc is high, the multiplier is high and when the mpc is low, the multiplier is also low.

The multiplier works not only in money terms but also in real terms. In other words, the increase in income takes place not only in the form of money but in the form of goods and services.

Example 1:

mpc is ¾

Initial investment is Rs. 1,000 million

Required:

(a) Multiplier,

(b) Marginal propensity to save,

(c) Increase in the level of national income, and

(d) Conclusion.



Solution:

(a) Multiplier (K):

(b) Marginal Propensity to Save (mps):

(c) Increase in the level of NI:

(d) Conclusion:

From the above example, we can see that with an initial primary investment of Rs. 1,000 million, with an mpc at ¾ and multiplier at 4, gives rise to an increase of Rs. 4,000 million in the level of national income.

Example 2:

Calculate mpc, mps and multiplier (K):

mpc mps K 4/6 ? ? ½ ? ? ? ¼ 4 ? 1/7 ? 1 ? ? 0 ? ?

Solution:



mpc mps K

4/6 2/6 3

½ ½ 2

¾ ¼ 4

6/7 1/7 7

1 0 α (infinity)*

0 1 1**

* If the mpc is 1, the mps will be zero and the multiplier will be infinity; and a given dose of investment (let say, Rs. 1,000 million) will automatically create full employment.

** If the mpc is 0, the mps will be 1 and the multiplier will be 1 so that total increase in income will just equal the increase in primary investment.

Keynes multiplier theory is also very helpful in the determination of national income. In his book, ‘General Theory of Employment, Interest and Money’, he has contradicted the viewpoint of the classical economists. He is of the opinion that if an economy operates at a level of equilibrium it is not necessary that there should be a high level of employment in a country. It is just possible that there may be millions of people unemployed. So according to Keynes, if any country wishes to achieve level of employment, it can only do so through the changes in the magnitude of investment.



According to Keynes’ theory, there are two main methods of measuring the equilibrium level of NI, i.e.:

(a) The AD-AS Approach, and

(b) The Saving Investment Approach

(a) AD-AS Approach: For explaining the determination of level of income in a two-sector economy, we assume an economy in which there is no international trade, no government role and in which corporations retain no earnings. In this simplest model of economy, the level of income is determined at a point where the AD intersects the AS. It is depicted as below:

In the above diagram, the national income is determined at the point where AD curve (C+I) cuts the AS curve (C+S), i.e., at E. The multiplier effect is also shown in this diagram. The curve C represents the mpc which is assumed to be ½. That is why the slope of curve C is 0.5. Since the AD curve (C + I) cuts the 45o angle line at E, OY1 is the level of income determined. If now investment is increased to EH (ΔI) we can find out the increase in income (ΔY). As a result of investment EH, the AD curve shifts upwards to C + I’. This new AD curve cuts the AS curve (45o angle line) at F, so that OY2 income is determined. Thus, income increases by Y1Y2 as a result of investment increase of EH, which (Y1Y2) is double of EH.

It is clear, therefore, that the multiplier is 2. It is also calculated as below:



(a) Saving-Investment Approach: In order to simplify the analysis of income determination we imagine an economy (1) where there are no taxes levied by the government, (2) the corporations retain no earnings, and (3) there are no changes in the level of prices. The equilibrium level of NI is determined at a point where planned or intended saving is equal to planned or intended investment, or in other words, where the saving intersect the investment. It is further explained with the help of following diagram:

The above diagram shows the multiplier effect of an increase in investment on the equilibrium level of income. SS is the supply curve and II is the investment curve showing the total level of investment of OI. These two curves intersect each other at the equilibrium point E where is income is OY1. If now there is a change in investment from OI to OI’, i.e., an increase of II’, then the II curve will shift to the position of I’I’ and the two curves I’I’ and SS intersect each other at the new equilibrium point E’, where the income is OY2. Now it is clear that when mps is ½, an increase in investment by II’ (let say Rs. 10 million) has led to the increase in income by Y1Y2 (let say Rs. 30 million). Obviously the value of the multiplier is equal to 3.

Limitations of Multiplier:

(a) Efficiency of production: If the production system of the country cannot cope with increased demand for consumption goods and make them readily available, the incomes generated will not be spent as visualised. As a result, the mpc may decline.

(b) Regular investment: The value of the multiplier will also depend on regularly repeated investments. A steadily increasing investment is essential to maintain the tempo of economic activity.

(c) Multiplier period: Successive doses of investment must be injected at suitable intervals if the multiplier effect is not to be lost.

(d) Full employment ceiling: As soon as full employment of the idle resources is achieved, further beneficial effect of the multiplier will practically cease.

Leakages of Income Stream and Their Effect on the Multiplier:



As we know that as income increases, consumption does not increase to the same extent or proportionately, because a part of the income is saved. The part of the income that is saved is as if a leakage from the flow of income stream. These leakages obstruct the growth of national income. In the absence of these leakages, mpc would have been unity. The consumption expenditure would have increased 100 per cent of the increase in income and there would have been full employment. The following are the principal leakages:

(a) Paying off debts: It generally happens that a person has to pay a debt to a bank or to another person. A part of his income goes out in repaying such debts and is not utilised either in consumption or in productive activity. Income used to pay off debts disappears from the income stream. If, however, the creditor uses this amount in buying consumer goods or in some productive activity, then this sum will generate some income, otherwise not.

(b) Idle cash balances: It is well known that people keep with them ready cash which is neither used productively nor in purchasing consumer goods. Keynes has mentioned three motives for holding ready cash for liquidity preference, viz., transactions motive, precautionary motive and speculative motive. This means that the re-spent part of income goes on decreasing. In this way, a part of the initial expenditure leaks out of the income stream.

(c) Imports: The part of the money spent by country for importing goods also leaks out of the country’s income stream. It does not encourage or support any business or industry in the country. This is specially so if the imports do not help the trade and industry of the country or if they are not used for export promotion. The net import is a leakage.

(d) Purchase of existing securities: Some people purchase securities (saving certificates) from others and the seller of securities can hoard this money. This money also leaks out of the income stream. This may also be valid in case of purchase of shares, debentures, bonds, insurance policy, or some other financial investment. If this invested money is not used in productive areas, there will be a leakage in the income stream.

(e) Price inflation: Inflationary situation is also responsible for leakage. In such a situation, investment does not help in generating employment or increasing income. If there is already full employment in the country, increase in investment, far from increasing demand for consumer goods, it decreases it as a result of which employment in the consumer goods industries contracts and demand for capital goods decreases. Whatever increase in income there is, it is spent in high prices and it does not help in creating income and employment.

As a result of leakages of income from the main income stream of the country, the multiplier effect of the primary or initial investment in increasing income is reduced. If somehow these leakages are plugged, the multiplier effect of investment in generating income and employment would increase. If they cannot be plugged altogether, they should be reduced or the propensity to consume should be increased or propensity to save should be reduced, otherwise the new investment will not have full effect in increasing income and employment.

Importance of Multiplier:

Keynes’ principle of multiplier has a great role in removing the Great Depression of 1929-34. These days governments are actively interfere in the economic affairs of the community through multiplier. Its importance is further explained as below:



1. The multiplier principle focuses on the importance of public investment, which is the key to remove unemployment during the days of depression. An investment of Rs. 1 million can create income and employment worth many times, and can help the government to remove unemployment from the country.

2. During the days of depression, the private entrepreneurs are discouraged to invest in the economy. Therefore, to fill this gap, the government comes forward and undertakes the investment in her own hands. Hence, the demand for consumer goods increases and also the level of NI and employment increases on account of the working of the multiplier.

3. When the demand for goods increases and incomes rise owing to government investment, the profit expectations of the entrepreneurs go up and as a result the MEC rises.

4. When the government makes investment in public works to fight depression and unemployment, private investment is encouraged on account of the operation of the multiplier. The confidence of private investors is restored, and hence helps in further removing the economic depression of the country.

Assumptions of Multiplier:

The following certain essential conditions / assumptions for the operation of multiplier:

1. The supply curve of output should be elastic. In other words, when demand for certain goods or services increases, its supply can be increased without much difficulty.

2. There is excess productive capacity in consumer goods industries, so that the supply of goods can be easily increased when demand increases.

3. The supply of raw materials and working capital should also be elastic.

4. There should be ‘involuntary unemployment’. That is, there are people who want work at the prevailing wage rate, but are not getting it.

Criticism on Keynes’ Multiplier Theory:

Many economists including the classical economists and the economists from third world countries have strongly criticise the Keynes’ Multiplier Theory. It is explained in brief as below:

1. Keynes’ multiplier theory assumes that the supply of output, raw materials and working capital is elastic, i.e., it can be increased whenever required. But, according to critics, this condition cannot be fulfilled in an under-developed country (UDC), where there is a continuous vicious cycle of poverty. The whole economy is based on agriculture, and there is a dearth of capital equipment, skill labour and technology. The existing industries cannot fulfill the increased demand. Moreover, the government is so poor to invest in public works.

2. According to Keynes’ multiplier theory, there is excess productive capacity in consumer goods industries. But according to critics, there is a little excess productive capacity in poor countries; therefore, this theory cannot be applied to UDCs.



3. Another condition of Keynes’ theory is that there should be ‘involuntary unemployment’. That is, there are people who want work at the prevailing wage rate, but are not getting it. Whereas, in UDCs, there is ‘disguised unemployment’, and most of the workers are self-employed, therefore, this condition cannot be fulfilled in such countries.

4. According to critics, this theory can only be applied to economically advanced and highly industrialised countries, and cannot be applied to under-developed countries, which are pre-dominantly agricultural countries. In UDCs, the heavy plant and machineries, and skilled labour are not easily available and the supply cannot be increased quickly.

THE ACCELERATOR:

The multiplier describes the relationship between investment and income, i.e., the effect of investment on income. The multiplier concept is concerned with original investment as a stimulus to consumption and thereby to income and employment. But in this concept, we are not concerned about the effect of income on investment. This effect is covered by the ‘accelerator’. The term ‘accelerator’ should not be confused with the accelerator in cars. It does not make the investment to grow faster and faster.

The term ‘accelerator’ is associated with the name of J.M. Clark in the year 1914. it has been proved a powerful tool of economic analysis since then. Keynes, astonishingly, has altogether ignored this concept. That is why, the concept of accelerator is not considered the part of Keynesian theory.

According the principle of accelerator, when income increases, people’s spending power increases; their consumption increases and consequently the demand for consumer goods increases. In order to meet this enhanced demand, investment must increase to raise the productive capacity of the community. Initially, however, the increased demand will be met by over-working the existing plants and machinery. All this leads to increase in profits which will induce entrepreneurs to expand their plants by increasing their investments. Thus a rise in income leads to a further induced investment. The accelerator is the numerical value of the relation between an increase in income and the resulting increase in investment.

(Figures in Rs. ‘000)

Years Demand Required Stock of Capital

Replacement Cost

Net Investment

Gross Investment

2007 500 5 machines 1500

1 machine 300 0 machine 300

2008 500 5 machines 1500


2009 800 8 machines 2400

1 machine 300

3 machines 900 1200

2010 1000 10 machines 3000

1 machine 300

2 machines 600 900

2011 1000 10 machines 3000


2012 800 8 machines 2400

1 machine 300

– 2 machines 600 – 300

Cost per machine: Rs. 300,000 per machine

In the above example, suppose we are living in a world, where the only commodity produced is cloth. Further suppose that to produce cloth Rs. 100,000, we require one machine worth Rs.



300,000, which means that the value of the accelerator is 3 (i.e., the capital-output ratio is 1:3). That is, if demand rises by Rs. 100,000, additional investment worth Rs. 300,000 takes place. If the existing level of demand for cloth remains constant, let us say, at Rs. 500,000, then to produce this much cloth we need five machines worth Rs. 1.5 million. At the end of one year, let us suppose, that one machine becomes useless as a result of wear and tear, so that at the end of one year, a gross investment of Rs. 300,000 must take place to replace the old machine in order that the stock of capital is capable of producing output worth Rs. 500,000.

In the third period, i.e., the year 2009, demand rises to Rs. 800,000. To produce output worth Rs. 800,000, we need 8 machines. But our previous stock consisted of only 5 machines. Thus if we are to produce output worth Rs. 800,000, we must install 3 new machines, worth Rs. 900,000. The net investment for the year 2009 will be Rs. 900,000 and with the replacement cost of one machine Rs. 300,000, our gross investment jumps from Rs. 300,000 in the year 2008 to Rs. 1.2 million in the year 2009. A 60 per cent increase in demand led to a 400 per cent increase in gross investment. Here we have a glimpse of the powerful destabilising role of accelerator.

Assumptions of the Accelerator:

1. Under the principle of accelerator, it is assumed that there is no excess capacity existing in the consumer goods industries. No machines are lying idle and shift working is not possible.

2. In capital goods industries, it has been assumed that there is an existence of surplus capacity. If there is no excess capacity in capital goods industries, increased demand for machines could not lead to increase in the supply of machines.

3. Output is flexible. The machine-making industry or capital goods industry can increase its output whenever desired.

4. The size of the accelerator does not remain constant over time. It value will be affected by the businessmen’s calculations regarding the profitability of installing new plants to make more machines on the basis of their probable working life.

5. The demand for machines will remain stable in the future, although the increase in demand has suddenly cropped up.

Trade Cycles

Trade cycles refer to regular fluctuations in the level of national income. It is a well-observed economic phenomenon, though it often occurs on a generally upward growth path and has a variable time span, typically of three years.

In trade cycles, there are upward swings and then downward swings in business. The periods of business prosperity alternate with periods of adversity. Every boom is followed by a slump, and vice versa. Thus, the trade cycle simply means the whole course of trade or business activity which passes through all phases of prosperity and adversity.

Several suggestions have been put forward as to the cause of cycles. The most well known are developed by Samuelson, Hicks, Goodwin, Phillips and Kalecki in the 1940s and 1950s, combine the multiplier with the accelerator theory of investment. More recently, attention has been paid to the effects of shocks to the economy from technology and taste changes.

Phases of Trade Cycles:



Typically economists divide business cycles into two main phases – depression and recovery. Boom and slump mark the turning points of the cycles:

(a) Depression: In this phase, the whole economy is in depression and the business is at the lowest ebb. The general purchasing power of the community is very low. The productive activity, both in the production of consumer goods and the production of capital goods, is at a very low level. Business settles down at a new equilibrium point with a low level of prices, costs and profits. It may last for a number of years. Following are the characteristics of depression:

(i) The volume of production and trade shrinks,

(ii) Unemployment increases,

(iii) Overall prices fall,

(iv) Profits and wages fall, thus, the income of the community falls to a very low level,

(v) Aggregate expenditure and the effective demand come down,

(vi) There is a general contraction of credit and little opportunity to invest,

(vii) Stock markets show that prices of all shares and securities have fallen to a very low level,

(viii) Interest rates decline all round,

(ix) Practically, all construction activity – whether in buildings or machinery, comes to an end.

(b) Recovery: This phase is also known as ‘expansion’. The depression period of trade cycle ends in the recovery period. The economic situation has now become favourable. Money is cheap and so are the other materials and the factors of production. Productive activity has been increased. The entrepreneurs have now sufficient financial backing. Constructional and allied industries are receiving orders and employing more workers, thus creating more income and employment. This stimulates further investment and production. The whole economy is moving faster towards the boom.

(c) Boom: Boom or peak is the turning point of the trade cycle. It is the highest point of economic recovery. The typical features of boom are as follows:

(i) A large number of production and trade,

(ii) A high level of employment and job opportunities in sufficient amount to permit a good deal of labour mobility,

(iii) Overall rising prices,

(iv) A rising structure of interest rates, so that a bullish tendency rules stock exchanges,

(v) A large expansion of credit and borrowing,



(vi) High level of investment, i.e., manufacturing or machinery

(vii) A rise in wages and profits so that the community’s income rises, and

(viii) Operation of the economy at optimum capacity.

(d) Recession: It is a sharp slow down in economic activity, but it is different from depression or slump which is more severe and prolonged downturn.

Just as depression created the conditions of recovery, similarly, the boom conditions generate their own checks. All idle factors have been employed and further demand must raise their prices, but the quality is inferior. Less efficient workers have to be taken on higher wages.

Rate of interest rises and so also of the necessary materials. The costs have after all started the upward swing. They overtake prices ultimately and the profit margins are first narrowed and then begin to disappear. The boom conditions are almost at an end.

Then starts the downward course. Fearing that the era of profits has come to a close, businessmen stop ordering further equipment and materials. The prudent businessmen want to get out altogether and cuts down his establishment ruthlessly. The government applies the axe mercilessly. The bankers insist on repayment. The bottlenecks appear, stocks accumulate. Desire for liquidity all round. This accentuates the depression.

The trade cycle is depicted in the following diagram:

Theories of Trade Cycle:

(a) Climatic Theory: It is said that there are cycles of climate. For some years the climate is favourable and then comes an unfavourable turn. Changes in climate bring about changes in agricultural production. The cycle of agricultural production results in a cycle of industrial activity, for industry is deeply affected by the state of agricultural production.

One of the famous climatic theories is ‘Jevons’ Sunspot Theory’. According to Stanley Jevon, spots appear on the face of the sun at regular intervals. These spots affect the emission of heat from the sun, which, in turn, conditions the degree of rainfall. The rain affects agriculture, which, in turn, affects trade and industry. That is how trade cycles are caused.



(b) Psychological Theory: According to psychological theory of trade cycle, there are moods of optimism alternating the moods of pessimism in the economy, without any tangible basis. At some stage, people just think that trade is good and that it is going to remain good. Business activity is intensified and becomes feverish. Then, all of a sudden, people start thinking that the period of prosperity has lasted long enough and adversity is round the corner. Thus, although there was no valid reason for depression to come about, but it is brought about by the people themselves. It is all psychological.

(c) Under-Consumption Theory: According to under-consumption theory, there is too much of saving during a boom and further additions to saving reduce the level of consumption. A reduction in the level of consumption, in the face of increasing productive capacity, must sooner or later lead to the collapse of the boom. This theory is associated with the names of J. A. Hobson and Major Douglas.

(d) Monetary Theory: R.G. Hawtrey was a firm believer in monetary theory. According to him, variations in flows of money are the sole and sufficient determinants of business activity and account for alternating phases of prosperity and depression. When the business prospects are good, the banks freely extent credit facilities. The businessmen go on expanding their business, entering into further and further commitments with the banks. A huge superstructure of credit is built up and this superstructure can be maintained by cheap money conditions. But a point reached, when banks think that they have gone a bit too far in the matter of advances. Probably their reserve ratio fallen dangerously low. In self-defence, they apply the brake, curb further expansion of credit, and begin to recall advances. This sudden suspension of credit facilities proves a bombshell in the business community. Businessmen have to sell their stocks in order to repay. This general desire for liquidity depresses the market, and may even led to bankruptcy for certain firms.

(e) Over-Investment Theory: According to over-investment theory, fluctuations in the rate of investment are the main causes of trade cycles. Investment becomes excessive during the boom. That investment during the boom is borne out by the fact that investment goods industries expand faster than consumption goods industries during the upward phase of the cycle. During the depression, investment goods industries suffer more than consumption goods industries.

(f) Keynes’ Theory: According to Keynes, the business cycle is a rhythmic fluctuation in the overall level of income, output and employment. According to him, fluctuations in economic activity are caused by fluctuations in the rate of investment. And fluctuations in the rate of investment are caused mainly by fluctuations in the marginal efficiency of capital. The rate of interest, which is the other determinant of investment, is more or less stable and does not play a significant role in cyclical fluctuations in investment.

Fluctuations in MEC or the expected rate of profit on new investment are due to:

(i) changes in the prospective yields, and

(ii) changes in the cost or supply price of the capital goods.

Towards the end of the boom, the decline in the prospective yields on capital is due, in first instance, to the growing abundance of capital goods which lowers the MEC. The turning point from expansion to contraction is, thus, explained by the collapse of MEC. As investment falls, because of the decline in MEC, income also falls. The multiplier works in reverse direction.



Just as the collapse of MEC is the main cause of the upper turning point in the trade cycle, similarly the lower turning point, i.e., change from recession to recovery, is due to the revival of MEC. The interval, between the upper turning point and the start of recovery, is conditioned by two factors:

(i) the time necessary for wearing out of durable capital assets, and

(ii) the time required to absorb the excess stocks of goods left over from the boom.

(g) Theory of Interaction Between Multiplier and Accelerator:Theory of Interaction Between Multiplier and Accelerator: The Keynes theory has ignored the acceleration effect on trade cycle. According to this theory, trade cycle is result of the interaction between multiplier and accelerator. An autonomous increase in the level of fixed investment raises income by a marginal amount according to the value of the multiplier. This increase in total income will induce further increase in investment through acceleration effect. When this happens, the chain of causation is linked round in a ‘loop’; investment affects income, which in turn affects investment. Take a look of the following table:

(All figures in billion Rs.)

Period

Autonomous Investment (Deviation from Base Period)

Induced Consumption C = Y × mpc

ΔC Induced Investment I = ΔC × Accelerator

Total Deviation of Income from Base Period Y = C + I

(1) (2) (3) (4) (5) (6) Rs. Rs. Rs. Rs. Rs. 0 0 0 0 0 0 1 10 0 0 0 10 2 10 6.7 6.7 13.4 30.1 3 10 20.0 13.3 26.6 56.6 4 10 37.8 17.8 35.6 83.4 5 10 55.6 17.8 35.6 101.2 6 10 67.5 11.9 23.8 101.3 7 10 67.6 0.1 0.2 77.8 8 10 51.8 -5.0 -10.0 51.8 9 10 34.6 -5.0 -10.0 34.6 10 10 23.0 -5.0 -10.0 23.0 11 10 15.4 -5.0 -10.0 15.4 12 10 10.2 -5.0 -10.0 10.2



13 10 6.8 -3.4 -6.8 10.0 14 10 6.6 0.1 0.2 16.8

In the above table, the mpc is assumed to be 2/3, accelerator to be 2 and there is one-period lag. One-period lag means that an increase in income in one period induces an increase in consumption in the succeeding period. In the above table, an autonomous investment of Rs.10 billion is added up each period. In the first period, an autonomous increase in investment of Rs.10 billion gives rise to an increase in income of only Rs. 10 billion. It does not induce increase in consumption in period 1, as we have assumed a lag of one period.

Now with mpc of 2/3, the increase in income of Rs. 10 billion in period 1 induces an increase in consumption of Rs. 6.7 billion (10 × 2/3) in period 2. With the value of accelerator as 2, there will be induced investment of Rs. 13.4 billion (6.7 × 2) in the period 2. Now the total increase in income in period 2 over the base period will be equal to the autonomous investment of Rs. 10 billion which is maintained in the second period plus induced consumption of Rs. 6.7 billion plus induced investment of Rs. 13.4 billion (total increase in income in period 2 = Rs. 30.1 billion). Now in the third period, the consumption would be 30.1 × 2/3 = Rs. 20 billion. The formula for income for this purpose is follows:

Income = Autonomous Investment + Induced Investment + Induced Consumption

The increase in consumption (ΔC) in period 3 is Rs. 13.3 billion (i.e., Rs. 20 billion – Rs. 6.7 billion). This increase in consumption of Rs. 13.3 billion will induce investment of the value of Rs. 26.6 billion in period 3. Thus, the total increase in the income in period 3 over the base period is equal to Rs. 56.6 billion. Under the combined effect of multiplier and accelerator, the income increases up to the 6th period, but, beyond the 6th period, it begins to decrease. 1st to 6th is the stage of expansion or upswing. The 6th one is a turning point and from 6th onward is the phase of contraction or down swing.

In the above table, it has been assumed that there is no limitation of productive resources. In other words, there is no full employment ceiling. The above table conveys the idea about interaction between the multiplier and accelerator and its impact on national income.

As there is a limit to the increase in NI set by the full employment ceilings, Professor Hicks explains the different phases of trade cycle with the help of following diagram:



In the above diagram, AA is the line representing autonomous investment. The multiplier and autonomous investment together determine the equilibrium level of income shown by the line LL. This line is also known as ‘floor line’. The national income grows from one year to the next along with this floor line. The line EE shows the equilibrium time path of national income determined by autonomous investment and the combined effect of multiplier and accelerator. FF is the full employment ceiling. It is the line that shows the maximum national output at any period of time.

Starting from point E, the economy will be in equilibrium moving along the path EE determined by the combined effect of multiplier and accelerator and the growing level of autonomous investment. When the economy reaches P0 along the path EE, suppose there is an external shock. There is an outburst of investment due to certain innovations or jump in government investment. When the economy experiences such an outburst of autonomous investment, it pushes the economy above the equilibrium path EE after point P0. The rise in autonomous investment due to external shock causes NI to increase at a greater rate than shown by the slope of EE. This increase in NI will cause further increase in induced investment through acceleration effect. The increase in induced investment causes NI to increase by a magnified amount through multiplier.

Thus, under the combined effect of multiplier and accelerator, NI or output will rapidly expand along the path from P0 to P1. But this expansion must stop at P1, because this is the full employment ceiling. The limited human and material resources of the economy do not permit a greater expansion of NI. Therefore, when point P1 is reached, the rapid growth of NI must come to an end. It is assumed that the full employment ceiling grows at the same rate as autonomous investment. Therefore, FF slopes gently unlike the greater slope of the line from P0 to P1. When point P1 is reached, the economy must grow at the same rate as the usual growth in the autonomous investment.

For a short time, the economy may crawl along the full employment ceiling FF. But because NI has ceased to increase at the rapid rate, the induced investment via accelerator falls off to the level consistent with the modest rate of growth. But the economy cannot crawl along its full employment ceiling for a long time. The decline in induced investment, when NI, and hence consumption, ceases to increase rapidly, initiates a contraction in the level of income and business activity. Thus, there is a slackening off at P2 and the level of NI moves towards EE. Investment falls off rapidly and multiplier works in the reverse direction.

The fall in NI and output resulting from the sharp fall in induced investment will not stop on touching the level EE but will go further down. The economy must consequently move all the way down from point P2 to point Q1. But at point Q1, the floor has been reached. NI will not fall further, because this is the equilibrium level given by the working of ordinary multiplier and autonomous investment free from simultaneous operation of the accelerator. The economy may crawl along the floor through the path Q1 to Q2. In doing so, there is a growth in the level of NI. This rate of growth as before induces investment and both the multiplier and accelerator come into operation, and the economy will move towards Q3 and the full employment ceiling FF. This is how interaction between multiplier and accelerator causes economic fluctuations as explained by Professor Hicks.

(h) Kaldor’s Contribution to Modern Trade Cycle Theory: Kaldor has also used a modified and more realistic form of accelerator and investment function in trade cycle theory. According to the conventional concept of accelerator, the investment or demand for capital depends upon the rate of change of the level of economic activity (i.e., the level of income and employment). Whereas, according to Kaldor’s point of view, the demand for investment or capital goods depends upon the level of activity rather than the rate of change of that level. It should be remembered that in Kaldor’s analysis the level of activity means the level of national output, income and employment. In Kaldor's model



of trade cycle, the capital accumulation by raising the productive capacity affects the investment decisions of the entrepreneurs. The effect of the capital accumulation on the investment decision of the entrepreneurs makes the investment function non-linear in the real world (that is, investment-incomes or investment-employment curve is not a straight line). Through this non-linear investment function, Kaldor has explained the conditions of stability and instability of an economy, which are described as below:

In his theory, Kaldor has used ex-ante concepts of saving and investment, i.e., ex-ante saving and ex-ante investment. Ex-ante investment means planned net addition to the stock of fixed capital and inventories of goods. This ex-ante investment differs from the realised, actual or ex-post investment by the amount of unintended accumulations or dis-accumulations of inventories of goods which arise due to difference between the planned and realised sales goods. Ex-ante saving means the savings planned by the people for a period if they had accurately forecast their incomes. Therefore, unexpected changes in the level of income will make the realised or ex-post saving different from the planned or ex-ante saving.

When ex-ante investment exceeds the ex-ante saving, the level of activity or income and employment will rise and vice versa. The equilibrium level of activity (income and employment) is determined at which ex-ante investment is equal to ex-ante saving.

(i) Linear Saving and Investment Functions: Let us now see how Kaldor explains the stability and instability of the level of economic activity and the course of trade cycle. Kaldor takes first the cases of linear (straight line) saving and investment functions.

In the above diagram, linear investment and saving function is shown. The investment curve II is steepier than saving curve SS. The two functions intersect each other at the equilibrium point C, at which the income is determined to be Y0. But this equilibrium between ex-ante saving and ex-ante investment is unstable, because, if once this equilibrium is disturbed, the economy will move either towards hyper-inflation or towards collapse.

Now consider the following diagram for a stable condition:



In the above diagram, the investment curve II is less steeply inclined than the saving curve SS. In this case any disturbance, which sends the economy on either side of the equilibrium level, will not reinforce itself and the economy will tend to come back to its equilibrium level Y0. But such a stability is also not realistic because economic system in the real world shows great instability. Both the cases of linear ex-ante saving and ex-ante investment functions are quite unrealistic and therefore Kaldor has ruled them out. According to him, in the real world, both the saving and investment functions are non-linear, that is, they are not straight lines. The trade cycles or the fluctuations in the economy are explained by non-linear saving and investment functions.

(ii) Non-Linear Saving and Investment Functions: The following figure describes the non-linear saving and investment functions:

In the above diagram, the shapes of the investment curve II and the saving curve SS are not straight. They are cyclical and fluctuating. Both the functions intersect each other at



three different points, i.e., A, B and C. Equilibrium at point B is quiet unstable. Above point B, investment exceeds saving and, therefore, once as a result of some disturbing investment exceeds saving, the income (i.e., the level of activity) will go on moving upward till point C is reached, and below point B saving exceeds investment and any disturbance which moves the system below point B, the level of activity or income will go on moving downward till point A is reached. Above point C, saving exceeds investment and, therefore, if the system does above point C, it will come back to it. Therefore, the system is stable upward. On the other hand, below point C, investment exceeds saving and, therefore, any disturbance which sends the system below point C, it will be corrected by the return to the point C. Thus, the level of activity or income at point C is also stable downward. It, therefore, follows that the level of activity or income is in stable equilibrium at point C.

Point A also represents a stable equilibrium. Above point A, saving exceeds investment and below point A, investment exceeds saving, which means that the level of activity will tend to return to point A if any disturbance, causing movement either upward or downward, occurs. It, therefore, follows that both the extreme points C representing boom period and A representing depression, are stable equilibrium points. This means that economy should tend to be in stable equilibrium at either a very high or a very low level of activity. This is, however, a quiet unlikely and improbable result since in the real world the economy is not found to be stable at these extreme levels of activity. This trade cycle is also known as ‘self-generating trade cycle’.

Kaldor has explained this ‘self-generating trade cycle’ through the shifts or changes in the investment function and saving function. According to Kaldor, when the level of investment is very high, production of consumer goods increases and as a result both consumption and saving increase. This means that saving function SS will shift upward when the high level of activity is reached. Besides, with a high level of investment the opportunities for further investment may become temporarily restricted and as a result of this investment function curve II tends to shift downward. Thus, when the economy is at a high level of activity, i.e., at point C, the saving function curve SS tends to move upward and the investment function curve II tends to move downward and consequently the point C tends to move down and point B tends to move up as in the following figure (a), until they meet each other at the combined point BC as in figure (b). at the combined point BC, the economy is in unstable downward position. The contraction in the level of activity will continue further until point A is reached.



The economy will not go below point A, because, saving and investment are in stable equilibrium at this point. But according to Kaldor, reversal movement of the cycle will start because the investment function curve will shift downward. Given the level of activity at A, investment in machines or equipment may not be sufficient to cover the depreciation. This creates opportunities for more investment, which causes the investment function curve to move upward. With the level of activity A, as the investment function curve II moves upward relative to the saving function curve SS, the point B will separate from point C and tend to move towards A as in the following figure 7 (a). The investment function curve II will go on shifting upward till combined point AB is reached in figure 7(b).

But the combined point AB is unstable upward, for above combined point AB, investment exceeds saving. As a result, the expansion in the level of activity will not stop at point AB but will continue until once again point C is reached. Now, with the point C representing again the situation of boom having been reached, the investment opportunities once again will become restricted and as a result the movement of contraction in the level of activity will start once again and the whole process of contraction and then expansion will be repeated again. This is how Kaldor shows that the occurrence of trade cycles in a free market economy is self-generating.

Policy for Trade Cycle:

(a) Monetary Policy: A country must always formulate and follow an appropriate monetary policy so as to avoid the occurrence of booms and slumps. Monetary policy embraces banking and credit policy relating to loans and interest rates as well as the monetary standard and public debt and its management. It influences the volume of credit base and, through it the volume of bank credit and thus the general level of prices and of economic activity. When boom conditions are developing, bank rate is raised and thus credit is contracted with the consequent brake upon the undue expansion of business activity. In a depression, a policy of cheap money may be adopted to stimulate business investment and thus assist recovery.

The bank credit policy involves two types of controls, i.e., the qualitative and the quantitative. The quantitative control is aimed at general tightening or easing of the credit system as the situation may demand. It is exercised by influencing the reserves of the banks. The qualitative or selective control seeks to regulate particular type of credit. Its object is to stimulate, restrict or stabilise bank advances for specific business schemes.



But there are limitations of monetary policy relating to bank rate and open market operations. Its success will depend on how far certain assumptions are true. For example, how far the various member of the banking system are prepared to accept the lead given by the central bank; how far the banks can make their borrowers use their credits for purposes for which such credits have actually been created; further, how far monetary causes are responsible for the economic fluctuations; and still further, and most important, whether the business community will adjust their investment exactly in accordance with the altered rates of interest.

(b) Fiscal Policy: Since public expenditure in all modern states constitutes a fairly respectable proportion of the total national income, fiscal policy is bound to affect the level of prices, production and employment, irrespective of the fact whether this policy is deliberately aimed at this or not. Fiscal policy consists of two elements, i.e., public spending or the policy of public works, and appropriate taxation.

In a year of depression, that is, when private investment is at a low ebb, the deficiency in investment will have to be made up by large capital outlay by the state, and conversely, during the upward swing of the cycle, the state will have considerably to cut down its spending programme. Thus, during the depression years, the state must be ready to spend beyond its current revenues. In other words, the state should be prepared to have deficit budgets during depression. Conversely, there should be surplus budgets during the years of prosperity. To put it another way, instead of having balanced budgets every year, the state should aim at budget-balancing over a series of years.

On the revenue side, rates and taxes should be lowered during depression, while they should be raised during boom years. To stimulate business investment during depression, not only the rates of taxes should be lowered but also more liberal allowances for depreciation and obsolescence, etc., should be granted.

Thus, fiscal policy, which is also known as the contra-cyclical management of public finance, may be operated both through public revenues and public expenditure.

(c) International Measures: So far we have discussed individual national efforts at economic stabilisation. But trade cycle is an international phenomenon and no country is hermetically scaled from the rest of the world. In fact, this international aspect creates complications and makes crisis control all the more difficult.

The measures which are suggested to be adopted on an international scale are: International Production Control, International Buffer Stocks and International Investment Control. International Production Control envisages control of production and prices of the importance primary products. The difficulties of such control are indeed formidable, notably because agriculture in countries like India and Pakistan is usually carried on a small scale and more as a mode of living than business, so that even though it ceases to be profitable, it will be continued. But production control, as far as possible, combined with buffer stocks to counteract sudden changes in supply and demand, will go a long way in preventing rise or fall in their prices, which give rise further to serious fluctuations in the entire economy.

An international investment control for developing backward regions would help in raising the standards of living of their people and thus reduce the inequalities in the standard of living of different peoples. Such reduction in those inequalities is bound to strengthen the forces of stabilisation.

micro & macro economics utu notes

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