Macro Economics

(Course Code: ALD2102)

 References
Title Author
1. Principles of Oliver Blanchard
Macroeconomics.
2. Macroeconomics N. Gregory Mankiw
3. Macroeconomics R. Dornbusch, S.
Fisher and R. Startz
4. Macroeconomic W.H. Branson
Theory and Policy
Chapter-1

Introduction
 The Subject Matter of
Macroeconomics and Its
Methodological Underpinnings.
Lesson Objectives:
After studying this lesson, you will be able to
• see what types of questions are raised in macroeconomics
and how they do differ from those of microeconomics;
• appreciate why macro- and microeconomic approaches are
both useful and, in fact, complementary to each other;
• see what the major macroeconomic policy objectives are;
• understand why these objectives often conflict, posing
difficult choice problem for the policy makers.
 What macroeconomics is about
• Modern economics is usually divided into two broad
domains- microeconomics and macroeconomics.
• At a very general level, one can say that the job of
macroeconomics is to analyze the behavior of the
economy as a whole. It is concerned with the overall
levels of a country's output, employment and prices.
• By contrast, microeconomics studies the behaviors of
individual decision making units such as individual
households, firms or landlords.
• In microeconomics, the unit of study is the part, not the
whole (as in macroeconomics).
• Macroeconomics deals with economy wide
variables.
• Microeconomics is concerned with decision
problems of individual decision making units,
such as households and firms
• Resource are reallocated in response to changes
in relative prices of products and factors. A study
of this process is the concern of microeconomics.
For example, if the price of product A rises relative
to the price of product B, it will be a market signal
for the producer of A to increase the production
of A, while for the producer of B it is a signal to
reduce the production of product B. Resources
are, a as result, diverted from the production of B
to the production of A. Moreover, in the interest
of cost minimization (a necessary condition for
profit maximization) firm will be induced to
employ factors of production in those activities
where they are relatively more productive.
• Macroeconomics, on the other hand, ignores the
question of whether the resources actually
employed are efficiently allocated or not, and
concentrates on the question of whether and why
some of the economy's resources remain
unutilized.
• Macroeconomics takes as given the composition
of demand and supply in various markets so as to
concentrate on economy wide issues such as
unemployment and inflation.
• In contrast, microeconomics, by ignoring the
issues of inflation and unemployment, focuses on
how individual markets allocate resources and
distribute incomes.
• It must be remembered that the basic purpose of
economics is to analyze the economic processes that
determine a society's material well-being. If this is so,
then it must be admitted that the distinction (and the
methodological difference it implies) has proved to be
immensely useful.
• A nation's material well-being depends on both how
fully the given resources are utilized by market forces
or similar institutions(a question addressed by
macroeconomics) and how efficiently the resources
(fully employed or not) are allocated (which is an
important concern of microeconomics).
• Therefore, both microeconomic and macroeconomic
analyses are important, in their own unique ways, to the
economic well-being of a country. The two approaches
are indeed complementary to each other,
 Three Key Concerns of
Macroeconomics
• During the cyclical downturn (contraction)
millions of people lose jobs and thrown into
untold suffering. In other cases, even rapidly
growing economies have been found to suffer
from sustained high unemployment. Thus an
important question that a macroeconomist has to
answer is: What determines the levels of
aggregate output and why do they fluctuate?
On the ability to find correct answer to these
questions depends the formulation of
appropriate policy response to keep
unemployment at a low level.
• The general price level may be too high and may
go on increasing for a long period. When this
happens the economy is said to be experiencing
inflation. A high inflation like high
unemployment is socially undesirable. Real rates
of interest change rapidly during inflation. Long-
term economic contracts become difficult by
undermining rational economic calculations.
Therefore, another important macroeconomic
question is: How is the general price level
determined and why does it change? An
accurate answer to this question depends on
the attainment of much desired price stability.
• Finally, a country may like to increase its rate of
economic growth on which depends its long-term
prosperity. Without long-term income growth it
cannot hope to enjoy increasing real wages and
living standards. Thus, to understand the factors
that determine the long-term growth potential of a
country is a major goal of macroeconomics
analysis. Keeping unemployment at a low level
and attaining price stability are known as
stabilization of the macroeconomy. Stabilization
is the concern of short-run macroeconomic
analysis and policy. While long-term growth of
the economy is quite important, much of
macroeconomics is concerned with short-run
stabilization problems.
The problem of conflicting Objectives
• Each of the three goals- low unemployment, price stability
and long-term growth is important in itself; and ideally each
should be pursued as earnestly as possible. Unfortunately,
often conflicts may arise in the pursuance of all three goals
simultaneously; there are undesirable trade-offs among the
goals which policymakers have to contend with.
• For example, if the budget deficit is lowered, output and
employment may fall in the short-run. To stimulate long-term
growth, investment is required in physical and human capital;
but doing this requires the sacrifice of present consumption
for the benefit of increased consumption by future
generations.
• Besides, stimulating high levels of output and employment
may cause price inflation. In fact, the choice between low
inflation and low unemployment is a matter of agonizing
(painful) policy decisions in the context of short run
stabilization.
• These conflicts give rise to differences of
opinion and approach among professional
economists, politicians and policymakers.
• What can the government do about each of the
macroeconomic ills? What should it do? What
is the best way of tackling each problem?
• These questions have been at the centre of
macroeconomics policy making for a long
time, and, not surprisingly, they have divided
the profession as it tries to develop alternative
models and interprets experiences in various
parts of the world.
 Model Questions
1. "Macroeconomic variables are based on
abstraction from reality". Is the statement true? If
so, explain why abstractions are necessary.
2. "The variables of microeconomics are 'givens' in
macroeconomics". What does this statement
mean? Is this methodological stance meaningful?
3. What is meant by stabilization of the
macroeconomy? When is it necessary?
4. "The micro vs. macro distinction in economics is
not based solely on size." Do you agree? Give
examples.
[Link] explain the subject matter of
macroeconomics. How does it differ from that
of microeconomics?
6. Do you think that the distinction between
micro- and macroeconomics is unreal and
unnecessary? Give reasons.
7. What are the key concerns of macroeconomic
policy? Explain briefly.
 Presentation
G-1: Impact of macroeconomic factors on
economic growth in Bangladesh
G-2: The Impact of Macroeconomic Variables on
Stock Prices in Bangladesh
G-3: Influence of Macroeconomic Variables on
Exchange Rates
G-4: The Impact of Macroeconomic Factors on
Firms’ Profitability
 Chapter-2
National Income Accounting

18
Measurement of Economic Activity: The
Concept of GDP and Related Issues

Lesson Objectives:
After studying this lesson, you will be able to
• understand the importance of measuring
macroeconomic performance
• see how the GDP is used as an indicator of total
output produced in the country in a given period
• appreciate why some practical compromises are
usually made in GDP computation.
19
 Introduction
• We have seen that macroeconomic analysis depends
heavily upon concepts like national output and general
price level which are basically abstract constructions.
We have also emphasized that these constructions have
been invented because they represent useful theoretical
categories the interaction among which can throw light
on how the entire macroeconomic mechanism
functions.
• But it would be poor comfort if for these theoretical
concepts, however well-defined, corresponding
quantitative measures could not be devised measures
which would faithfully, if not perfectly, represent these
concepts.

20
• In fact, when Keynes' General Theory of Employment
Interest and Money appeared in 1936, his conclusions
could not immediately be subjected to empirical tests,
because the required data corresponding to his theoretical
notions did not exist. Several years later, a system of
measurement (considerably influenced by Keynes'
theoretical structure itself) was desired. This framework
came to be known as National Income Accounting.
• The leading figure in this immensely important enterprise
was professor Simon Kuznets of Harvard University who
was awarded the Nobel Prize in Economics in 1971 for
his contribution.
• The results have not always been satisfactory, but despite
its many limitations, the framework of national accounts
has proved quite useful not only for testing existing
theories, but for the construction of more sophisticated
ones.
21
 Measuring Levels of Economic
Activity
• Major concern of macroeconomics is why
economic activities sometimes surge up and slow
down at other times. In other words, the
macroeconomist wants to know why the national
product fluctuates around the potential level form
time to time.
• More precisely, we want to know whether and
how far the national output has gone up or down;
we need a measuring rod for the nation’s
economic activity or its output.

22
The Gross Domestic Product (GDP)
• The Gross Domestic Product is the most
comprehensive measure of a country's output
in a given period.
• It is defined as the sum of the money values of
all currently produced goods and services
produced within a country during a specified
period of time, usually a year.

23
Several important features of this definition should be
carefully noted.
• First, GDP represents the money value of goods and
services (customarily called product). There could be
a mind-bogling variety of goods and services- milk,
oranges, dance performance, hair cut, transport
services, aeroplanes, tanks, missiles and so on.
• Varieties as such would not have mattered if all of them
could meaningfully be expressed in a common unit.
• The quantity of each kind of goods and services is
multiplied by its market price and then the money
values are added together to get the GDP.
• Market prices represent the relative value of
commodities i.e. the willingness to pay at the margin.

24
• Secondly, the GDP of a particular period includes
goods and services produced during that period only.
Since GDP is supposed to be a measure of production
rather than of sale, sales of items produced in previous
periods are explicitly excluded.
• This implies that many market transactions of the
current period are excluded from the calculation of
current period's GDP. For example, sales of stocks,
bonds and real estate are excluded, because they do not
represent any new production. The purchase of a used
car does not represent any new production and should
therefore, be excluded from current GDP (its original
value was included in the GDP of the period in which it
was produced); however, if the sales value included
some costs of renovation or repair, these could in
principle be part of the current GDP.
25
• Thirdly, not all currently produced goods and services are
included in current GDP. Only that part which represents
final goods and services will find place in the GDP. This
raises two question.
• First, why should a part of the currently produced goods be
excluded? Secondly, even if the principle is admitted to be
right, how would the national income accountant tell final
goods and services form those which are not?
• In order to answer these questions, we first distinguish
between intermediate goods and final goods. Final goods are
those which are purchased by their ultimate users. On the
other hand, the intermediate goods are those which are
purchased for resale, or for use in producing another good and
therefore get 'used up` in the production process.
• The intermediate goods are excluded because their inclusion
will unduly inflate the value of GDP and thus give a
misleading (and rosy!) picture of the macroeconomic health
of the country.
26
• Fourthly, if we ignore some imputations which are
sometimes successfully made, usually goods and services
that pass through organized markets get counted in the GDP.
Often the national income accountant fails to include in
GDP such activities as household work done by members,
the do-it-yourself repairs work and the value of leisure.
These very much belong in GDP, but any attempt to include
them faces two problems.
• First, it is hard to get accurate record of the amount of work
done in these categories. Second, often no meaningful
prices are available for their valuation.
• The consequences of excluding these non-market activities
can sometimes be quite serious, especially when we
compare the standard of living between developing and
developed countries on the basis of measured per capita
output.

27
 Computation of GDP: Problem of
strict conformity with definition
• First, the national income accountant has to face the
problem of valuation of government output. The output of
the private sector is valued at market prices. No such prices
are available for government output.
• 'Output' produced in government offices, services of the fire
fighters, police and defence personnel do not pass through
organized markets. (Indeed in some cases, it is difficult to
define what the government output is!).
• In the absence of market prices, the national income
accountant has no alternative but to depend on input prices.
He calculates the costs of inputs used in the production of
government output and substitute them for the value of
government output.

28
• You may ask: why doesn’t he impute a market
price to government services in the same way as
he imputes a market price for the services of
owner-occupied houses? Cann't he get a price
more comparable with valuations used in the
private sector?
• This is a complex issue. A short and simple
answer is that, in the private sector, valuation
includes the productivity of capital and
entrepreneurship, while in the government sector
neither is recognized. Of the two, the treatment of
public entrepreneurship is especially problematic,
because these is no way in which one could
impute a value to public entrepreneurship.

29
• Secondly, the way the investment goods are
actually treated in national accounts may not
appear to be strictly in accordance with the
definition. r
• The definition says that only final goods should
be included in the GDP (and intermediate goods
excluded).
• Investment goods (factories, generators, machine
tools and the like) might appear to be intermediate
goods, because they are purchased for use in
producing other goods, not because they have any
inherent value in themselves. And yet they are
included in the GDP. Why is this?
30
• To understand the rationale behind this practice,
remember that these items are never sold to final
consumers. So, where do they belong? Can they simply
be excluded as intermediate goods?
• A little reflection will convince you that these items
cannot be treated as intermediate goods in the same
sense as flour is in the production of bread, a final good
of consumption. Flour is completely used up in the
production of bread, but machine is a durable good and
is not entirely ‘used up' in the production of whatever it
is used to produce. Only a part, called depreciation, is
used up, and can logically be treated as an intermediate
good. The value of the machine minus depreciation
should then he treated as the value of final good
demanded by the firm buying it.

31
• Finally, there is another category of goods which are not
actually sold, though produced in the current period. The value
of these goods are included in GDP as inventory investment.
These goods may or may not be final goods in the strict sense.
• Consider the example of a miller who purchased 100 tons of
wheat for the production of flour at the beginning of the period.
Suppose further that his opening inventory was 30 tons of wheat,
but at the end of the period the inventory goes up to 70 tons.
What this means is that the miller could not use the entire amount
of wheat he purchased at the beginning of the period- he used
only 60 tons, the rest going to swell his inventory of wheat. The
question is how to treat this unused stock of wheat. It is clear that
the unsold stock represents current production and hence, in
some way, should find place in the GDP.

32
• There is a further problem here. Wheat is an input in
the production of flour which itself is an input in the
production of bread (a final good). So wheat as well as
flour is an intermediate good. Can an intermediate good
be included in the GDP under special circumstances?
And what are those circumstances?
• By definition, investment goods are those which are
purchased for expanding capacities to produce other
goods, including final consumption goods. If that is so,
the accumulated inventory of raw materials, semi-
finished or finished goods can be thought of as
something that enhances the capacity to produce in the
following period. In this sense, inventory increase is
like investment in plant and equipment.

33
Measurement of Economic Activity:
Need for Refinement of the GDP
Concept
After studying this lesson, you will be able to
• understand the distinction between nominal and real
GDP and why the distinction is important;
• know about two different ways of measuring inflation-
the GDP deflator and the Consumer Price Index;
• appreciate the need for distinguishing between the GDP
and GNP;
• see the difference between gross and net national
product.

34
• Often we are interested to know by how much the
physical output of a country has changed from
one period to another. For this we may try by
comparing GDP figures of various years as
defined earlier. But this has an obvious difficulty.
• This arises because GDP's are money values (sum
of price times quantity). If the GDP in 1997 is $98
and the same in 1998 is $196, we do not know for
certain how much of the increase in GDP has
been due to changes in physical output and how
much due to changes in prices.
• Assume for simplicity that a country produces
only two goods -bread and honey and consider the
numbers presented in Table 2-1.

35
36
37
• By now it should be clear that if we are
interested to know by how much real output
has changed from year to year, simple
comparison of unadjusted GDP figures will not
do, because the increase (or decrease) in raw
GDP could be due to price changes only,
quantity changes only or to both (the more
likely case). This brings us to the need for
distinguishing between what are known as
nominal GDP and real GDP.

38
 Nominal and Real GDP
• The nominal GDP is the value of a country's
total output at the prices prevailing during the
period in which the output is produced.
• The real GDP, on the other hand, measures the
total output in any given period at prices
prevailing in some base period.
• Nominal GDP is also known as GDP at current
prices, while real GDP is sometimes called
GDP at constant prices.

39
40
• When we divide nominal GDP by real GDP, we
get what is known as implicit GDP deflator

41
42
 Measurement of Inflation
• As we already know, maintaining stable prices is an
important macroeconomic goal along with maintaining
stable employment. This goal is attained, if the overall price
level can be prevented from rising or falling too rapidly.
The common measure of the price level is a price index
known as the Consumer Price Index (CPI)
• It measures the cost of a fixed basket of goods consumed by
a typical urban household. The contents of this basket are
determined usually by conducting periodic household
surveys among urban consumers. Price indexes are then
constructed by calculating the cost of this basket of goods
(and services) for different years as prices change. Each of
the index numbers expresses the cost of the market basket
of goods relative to the cost of the same basket in some base
period.

43
• Suppose that the base period is year 1990 and that
the cost of the fixed basket of goods in 1990
prices is $550. Assume further that the cost of the
same basket in year 1995 is $600. This means that
the cost of the basket of goods is 20% higher in
1995. The index number for the base year is
conventionally set at 100. Therefore, to reflect a
20% increase in prices (since the quantities are
unchanged between 1990 and 1995), the index for
1995 must be set at 120. The following
relationship may be used to calculate CPI for any
given year.

44
45
 Measurement of Inflation: CPI Vs.
GDP Deflator
• Both the consumer Price Index (CPI) and the
GDP deflator can be used to measure price
level changes (inflation). As mentioned earlier,
to get the GDP deflator for a given year we
divide that year's nominal GDP by the real
GDP of the same year. That is,

46
47
This deflator measures the change in prices between the
base year and the current year. Using the example in
Table 2-3, we can illustrate this. For example, between
1998 and 2000, the rate of inflation

48
49
• Economists generally prefer the GDP deflator as a
measure of inflation to the Consumer Price Index.
Note that the two indexes are based on different
market baskets.
• The CPI basket is based on budget of the typical
urban consumer.
• The GDP deflator, on the other hand, includes in
its basket all goods and services(including those
newly produced and imported) on which the GDP
is based. In addition, the latter basket includes
investment goods as well government output.
• Therefore, the GDP deflator is the most
comprehensive measure of inflation.

50
 GDP and GNP
• The GNP is the value of currently produced final goods and services
in a given period by domestically owned factors of production.
• How does the definition of GNP differ from that of GDP?
• Only in one important respect. For GDP, the output refers to goods
and services produced within the country by factors of production,
domestically owned or not; some may be owned by foreigners.
• For GNP, the output produced may be within or outside the country,
but the factors of production employed must be owned by the
country's nationals.
• For instance, a part of US GDP represents profits earned by Honda
Corporation of Japan from its manufacturing facilities in US. These
profits are part of Japanese GNP, because they are returns to
Japanese factors of production (capital & entrepreneurship)
employed abroad.
• Similarly, the profits of US owned enterprise in Japan (a part of
Japan's GDP, but not of Japan's GNP) are to be included in US GNP.

51
• In short, some domestically owned factors may be
employed abroad, while some foreign owned
factor may work in the home country. When these
two flows of income (in opposite directions) are
taken into account, we can calculate what may be
called "Net Factor Income from Abroad" which
can be zero, positive or negative, depending on
the relative magnitudes of the opposite flows.
Therefore, we can write with the following
identify:
GNP = GDP + Net Factor Income from Abroad.

52
• Another way of driving home the distinction is
to say the following:
• The GDP measures the output (hence income)
produced in a country, while the GNP is the
income received (not necessarily form
domestic production only) by a country.

53
 Gross And Net Domestic Product
• Capital ‘used up' in the production process should
logically be treated as an intermediate good. We
know that intermediate goods are to be excluded
form national product in order to avoid double
counting. Domestic product is 'gross' in the scense
that it does not provide for depreciation of capital.
Net Domestic Product (NDP) is equal to GDP
minus capital consumption allowance (CCA)
which is a measure of economic depreciation of
capital.
• NDP = GDP - CCA (Depreciation)

54
 Measurement of Economic Activity:
Three Approaches to GDP
Measurement
After studying this lesson, you will be able to
• understand how expenditure and income flows provide the
basic framework of national accounts
• see how GDP is calculated as sum of expenditure flows
• realize how GDP can be computed as the sum of earnings
flow
• know how GDP can be calculated as the sum of the value
added by all firms in the country
• see why all the above measures should in principle lead to
the same result.
55
Introduction
• There was hardly any discussion of how one may go about
measuring national income or national product.
• As a step in that direction, we present first a circular flow
diagram. This diagram is based on a very simple idea: the
value of final goods and services produced must equal costs
of production (properly defined).
• Or, in other words, total payments should equal total
receipts (from sale).
• It should be noted, however, that total payments just
referred to excludes one firm's payment to another for
inter-firm purchases of intermediate goods.
• The reason for this exclusion is that at the macro level,
these payments do not constitute income payments to
households or government: at the aggregate level they
cancel out.

56
 The Circular Flow
• In the circular flow diagram (Figure 2-1) total receipts
of the producing sector (left most box) has been shown
to be $1100. Of this amount $930 accrue to the
household sector (rightmost box) as factor payments:
wages ($750), interest ($50), rent ($30), profit ($100). A
part of household income is collected by the
government as direct tax ($10). Another part is saved
($20) which flows to the business sector. The remaining
portion goes back to the producing sector as
consumption expenditures ($900). The government
collects some of the total receipt of the producing
sector in the form of indirect business tax ($40), while
the rest goes to the business sector as depreciation
($40). Therefore total payments equal $1100
[=$(930+130+40)].
57
• Total receipts of the government sector $140, which is the sum of
direct taxes ($10) and indirect taxes ($130). When the government
buys goods and services from the producing sector, this amount
($140) flows to the producing sector as government expenditure.
The business sector has in its control $60 (=$20 (savings) + $40
(indirect taxes)) which as gross investment expenditure are received
by the producing sector. In the end, the total receipts by the
producing sector amounts to $1100 (= consumption ($900) +
investment ($60) + government expenditure ($140)).
• We, therefore, see that total payments equal total receipts. Or,
equivalently, total income generated (properly defined in the
accrued sense) equals total expenditures by households, businesses
and the government. This is also attested by the fact that the total
of leakages from the flow equals the total of spending injections as
shown below:
• Total leakage = household savings + indirect taxes + direct taxes (on
household income) + depreciation = $ (20 + 130 + 10 + 40) = $200
• Total of injections = government expenditure + gross investment =
$ (140 + 60) = $ 200

58
 GDP as the Sum of Final Goods and
Services: The Expenditure Approach
• To estimate GDP as the sum of expenditures on final goods
and services by consumers, business firms and the
government would appear to be the most natural
procedure.
• For a while, we will assume that there is no foreign sector
as the demander or supplier of final goods and services. We
will later bring in the modifications which will be necessary
to our calculations if exports and imports are to be
accommodated.
• Let us use symbol C for final goods and services demanded
by consumers, I (for investment) to denote final goods
demanded by business firms and other investors, and G for
the final goods and services demanded by government.
• We can, therefore, write GDP = C + I + G ....................... (i)
59
• This relationship corresponds to the lower loop of the
circular flow diagram (Fig. 2-1).
• Household sector's consumption demand amounts to
$900, the firms' demand in the form of gross
investment is of the order of $60, and the government
spends $140 on final goods and services.
• Therefore, the GDP for the hypothetical economy
depicted in the circular flow diagram is $1,100
[=$(900+60+140)].
• his is known as the Expenditure Approach to measuring
an economy's output of goods and services. (Another
name for this approach is Product Approach).

60
 GDP as Sum of Earnings or Costs: The
Income Approach
• Let us look back at the upper loop of the circular flow
diagram. This loop shows how the total receipts (=total
expenditures = C+I+G) get distributed as payments to
factors of production, the business sector and the
government.
• Of the total receipts of $1100, $930 go to households
as factor earnings (wages, interest, rent and profit),
$130 to government as indirect business taxes and $40
to the business sector as depreciation charges.
• All these payments to different claimants exhaust total
receipts (=C+I+G).

61
 GDP as the Sum of Value Added: The
Value Added Approach
• In this approach, the GDP is measured as the sum
of the values added by all firms in the producing
sector. What is value added? It equals a firm's
revenue form selling a product minus the amount
it pays for other goods and services bought from
other firms (intermediate goods).
• Therefore the value added may be represented
as:
• Value added = wages + interest + rents + profits =
total factor payments
62
• To elaborate on this argument, let us take an
example. Suppose that a car manufacturer sells a
car for $100,000 to a buyer (a final user). In the
expenditure approach, this amount will be
recorded as a part of C. In the income approach,
the relevant question is: what income is
generated from the production of the car?
• Assume that they are the following:
Wages to employees $ 40,000
Interest to bondholders $ 6,000
Rentals of buildings $ 5,000
Profits to shareholders $ 9,000
Total : $ 60,000
63
• The remaining $40,000 must have been spent on
purchases of inputs like steel, tubing, rubber and so on.
But if we trace back, we will find that the steel or
rubber manufacturer too paid wages, interest, rents and
profits and for intermediate inputs purchased from
other firms (such as iron ore).
• In fact, for every firm the following identify must hold,
no matter whether its product is a final or intermediate
good:
Sales revenue = wages + interest + rental + profits +
purchases form other firms
• Summing over all firms in the economy, we can write
Total sales revenue = (Total wages + Total interest +
Total rents + Total profits) + Total purchases from other
firms.

64
65
Note several thing from Table 2-5.
• First, the end stage of production is bread making;
bread is the final good. Therefore $85 form part of the
GDP according the expenditure approach.
• Second, we can obtain the same contribution to GDP as
the sum of values added in all stages of production as
shown in col.(3). Here there is no need to agonize over
which stage of production is the final stage.
• Third, the total value added ($85) can also be calculated
as the difference between col.(1) total and col.(2) total.
• The former represents total receipts from all stages of
production; the latter total costs of intermediate goods
used in all stages of production.
• And by definition, the difference is total value added.

66
 Measures of Aggregate Income, and
GDP as an Index of Economics
Welfare.
After studying this lesson, you will be able to
• see how aggregate income- measures like Disposable
Income and Disposable Personal Income are derived from
aggregate output measures like GDP and NDP
• understand why these measures are necessary
• know why GDP is a poor index of a country's welfare level
• see how a suitably modified measure could serve as a
better indicator
• realize why international comparison of GDP per capita
could be quite misleading.

67
• GDP accounts are useful in themselves; but they are also
useful because they allow us to derive other measures which
are needed to understand the behavior of consumers and
businesses.
• GDP and NDP (= GDP - Depreciation) are two principal
measures of an economy's output.
• National Income (NI) is a third measure. NDP and NI, it
may be emphasized, both measure the same amount of
goods; but they value these goods differently.
• The NDP values output at market prices which include
indirect taxes (e.g. sales taxes).
• National Income (NI), on the other hand, values the same
output at factor costs.
• Factor costs represent factor incomes earned, though not
necessarily received, by the factors of production. Factor
costs are obtained as the sum of wages, interest, rents and
profits.
68
• Therefore, NDP will exceed NI by
approximately the amount of indirect taxes.
We can thus write the following relationships:
• GNP = GDP + Net factor incomes form abroad
............. (1)
• NNP = GNP - depreciation .................. (2)
• NI = NNP - Indirect Taxes ........................... (3)

69
• Apart from NI, two other important measures are
Personal Income (PI) and Disposable Personal
Income (DPI).
• PI is current income of persons form all sources.
Some of it has no relation to current production.
Examples are all types of transfer payments in
exchange for which no service is performed or no
goods offered.
• PI, therefore, is not a measure of output in the
sense GDP, NDP and NI are.
• DPI is derived form PI by deducting the amount
taken away by government as personal income
taxes. DPI is the income (from all sources)
available to people to dispose of as they please.

70
• A component of NI is profits of corporation and
unincorporated enterprises. A part of these profits is taken
away by the government as profit taxes, a part as payroll
taxes etc.
• Another part is held by the firms to build up internal funds
for business expansion. These undistributed profits are
known as retained earnings.
• As a result, the national income earned falls short of
national income received by people.
• As offsets there are all kinds of transfer payments received
by households. By taking account of these deductions and
additions, we can write
DI = NI - (Retained earnings + Profit Taxes + Payroll
taxes etc.) + Transfer Payments ... ... ... ... ... ... ... ... ... ... ... ...
(4)
• Finally, after deduction of personal taxes from DI, we get
DPI as
DPI = PI - Personal Taxes
71
• The relationship between various measures
indicated by (1), (2), (3) and (4) can be
shown pictorially as in Fig. 2-2,

72
73
74
 Beyond GDP to Net Economic Welfare (NEW)
• When the system of National Income and Product Accounts were set
up, the GDP was intended only as a measure of output, not as a
measure of welfare.
• Later, a welfare implication came to be attached to GDP: it measures
not only the level of output of a country, but also its level of welfare.
• However, protests have been voiced from time to time against this later
interpretation.
• One can claim that more GDP means more goods and services
available for present and future consumption, and hence more material
welfare.
• Few will quarrel with this. Many would, however, like to point out that
the way goods and services are defined (and measured) for national
income accounting purposes may not exactly correspond with how
they should be defined for welfare purposes.
• Therefore, several attempts have been made to correct for this
deficiency. One of the earliest attempt in this direction is knows as Net
Economic Welfare (NEW).
• It tries to adjust the conventionally measured GDP figures by including
only consumption and investment items which directly contribute to
people's economic well-being. 75
 When GDP Understates Well-being
• Leisure: Perhaps you will readily agree that the leisure
you enjoy (unless, of course, you have too much of it)
adds to your well-being. So it is for many. This is,
however, one of the several things which have no place
in GDP as conventionally compiled. This problem is
especially acute for high-income societies. As people
become more and more affluent, they work fewer
hours, deriving satisfaction from leisure in the same
way as they desire satisfaction from goods and services.
The exclusion of leisure from GDP accounting
systematically understates the level of well-being.

76
• Market Activities Only: As stated earlier, the
GDP tries to capture the market value of
goods and services; but there are many
activities which undoubtedly contribute to
well-being, but are usually excluded from GDP
for lack of market prices (because they are not
traded in organized markets). Examples are
services of housewives, do-it-yourself repairs
and maintenance, educating own children and
so on.

77
• More important perhaps in quantitative terms, at least
for some economies, are the activities curried out by the
vast underground economy. These activities include
working at a second job for cash, illegal gambling, drug
dealing, work done by illegal immigrants, bartering of
services and so on. Activities of this kind go unreported
for at least two reasons. First, some of them are illegal
(such as drug dealing) and so will invite punishment if
reported or detected. Secondly, some though not illegal
are not reported in order to avoid payment of taxes or
escape government regulations (e.g. working for tips).
Some of these underground activities do increase
national welfare (e.g. services provided by illegal
aliens), while others may do the opposite (e.g. the
services of a hired killer).
78
 GDP may also Overstate National
Welfare
Inclusion of "Bads" (as well as 'Goods')
• Some of the 'bads' (e.g. cocaine production) of the underground economy may be
excluded, but the 'bads' of the over ground economy easily find their way into GDP.
• Take the case of a natural disaster like the earthquake. Few will dispute the fact that
national welfare declines as results. Many homes and businesses are destroyed and
many people may get killed. But the irony is that in the period of reconstruction, the
GDP can show a marked increase. Why? Consumer spending will go up, for
example, when clean up operations are undertaken, or when lost household
possessions are replaced. Rebuilding of homes, businesses, schools, hospitals and
bridges will increase investment expenditures.
• Additional government spending for relief and rehabilitation will tend to raise GDP.
• All this may give the wrong impression that the country is better of as a result of the
earthquake.
• A more dramatic example will be the case of a war. War expenditures give a
tremendous boost to the current GDP.
• But there is no doubt that the country is worse off because of the destruction of
properties and human lives. Unfortunately this fact cannot be reflected in the usual
GDP numbers.

79
• Ecological Costs are Ignored
This is a case in which bad are included, despite the
fact that they reduce welfare. A modern industrial
society produces many goods and services which
may directly increase welfare, but indirectly may
harm the society. Obviously, we are talking about
the ecological damages caused by many activities.
Automobiles provide comfortable transport, but also
put noxious gases into the atmosphere. Factories
produce may valuable goods; but they also pollute
rivers by releasing harmful chemicals into them.
These are the so-called collateral damages are called
negative externalities by economists. These costs
should be netted out of the GDP as usually
measured to get a better index of national welfare.
80
• In conclusion, we must recognize that despite
its many limitations, the GDP per capita
remain the best available single measure of a
country's progress. It may be supplemented by
a series of social indicators like life
expectancy, infant mortality rates, availability
of health care, the air and water quality, degree
of urban crowding and so on. It's almost
impossible to obtain a single ideal summary
measure of economic welfare. Therefore,
economists and policy makers go on relying on
GDP with all its defects

81
 Model Questions
1. How does the National Income Accounting framework help in the
development of macroeconomic theory and practice?
2. Why are market prices used in the calculation of a country's GDP?
3. How would you justify exclusion of intermediate goods from GDP?
4. How are unused stock of raw materials treated in national income
accounting? Explain.
5. A car produced in an earlier period is sold as a used car in the current
period. As a national income accountant would you include its value
in current year's GDP? Why? Why not?
6. How are unpaid services of housewives treated in GDP calculation?
7. Why are investment goods treated as final goods demanded by firms
in national income accounts?
8. "Are all ‘final' goods are not finished goods too". Give examples.

82
9. Define GDP. Bring out its essential features.
10. Why is it not possible to strictly adhere to the
definition of GDP in actual computation?
What compromises are generally made in this
regard?
11. Examine the logic of valuing government
output at cost.

83
12. "Economists like to distinguish between nominal and real GDP,
because nominal GDP comparisons for different time periods cannot
provide a true picture of physical output changes.” Do you agree?
Give reasons.
13. How would your characterize the base year used for calculation of
real GDP? What makes the nominal and real GDP of the base year
equal?
14. Is it possible for the real GDP to decline, even when the nominal
GDP is higher ? If so, under what circumstances is that possible?
Give examples.
15. "The consumer price indexes use fixed quantity weights". Do you
agree? Why?
16. Why is the GDP deflator usually preferred by economists and
others as a measure of inflation?
17. What is an Index Number Problem? Why does it arise?
18. In what sense are CPI's pure numbers? Why are they so?
19. Explain the general circumstances in which the GDP of a country
can exceed its GNP and vice versa
20. Why do economists work with GDP figures, even though they
recognize that NDP is a better measure of the national product?
84
21. Distinguish between nominal and real GDP.
Why is that distinction necessary?
22. Discuss the two important ways in which
inflation is measured. Which one is preferred
by economists? Why?
23. How does GDP differ from NDP? For which
countries GDP is likely to exceed NDP and
why?

85
 Model Question
1. Explain the difference between government spending and government
purchases of goods and services. Which is likely to be larger?
2. Distinguish between gross and net investment. Why is the concept of net
investment important in the context of productive capacity of a country?
3. Why is saving treated as a leakage from circular flow, while investment as an
injection into it?
4. What are direct and indirect taxes?
5. Explain what types of investment are excluded from 'gross private domestic'
investment.
6. Assume that value of exports is zero, while that of imports is positive. If you add
the value of imports to the usual C+I+G total, would you overestimate the GDP?
Why?
7. "If the value added method is applied to compute GDP, it is unnecessary to
distinguish between intermediate and final goods". Refute or justify.
8. Explain how the circular flow scheme can throw light on the possibility of
computing GDP in alternative ways.
9. Why should the GDP calculated as sum of flows of expenditurs on final goods
and services be equal, in principle, to the sum of earnings properly defined?
Explain.
10. "The value added approach to GDP essentially boils down to the income
approach". Do you agree? Give reasons.
86
 Model Question
1. Define National Income, Disposable Income, and Disposable Personal
Income. Explain their relationships.
2. "National Income and Net National Product are both measures of the same
output but based on different valuations". Explain.
3. "While National Income is a measure of output, Disposable Income is not,
strictly speaking". Do you agree? Explain.
4. "GDP includes as well as excludes activities which have implications for
national welfare". Elaborate.
5. It is suggested that GDP should be supplemented by a number of social
indicators like life expectancy, literacy etc. In what context is the suggestion
relevant?
6. "If GDP per head in a poor country (P) is half that in a rich country (R), then
we can assert that a person in R is twice as well-off as one in P". Is the
statement valid? Explain.
7. Discuss briefly how supplementary measures of aggregate output and
aggregate income can be derived from GDP. Why are they useful?
8. "Whatever the merits of the GDP as a measure of aggregate output, it has
glaring defects as an index of national welfare". Comment.
87
Consumption and Investments
as Determination of Aggregate
Demand

Chapter-3

88
Lesson objectives:
After studying this lesson, you will be able to
• see why understanding consumer behavior is
important for short run stabilization as well as for
long run growth.
• understand why high-income families on the
average save more than low income families.
• see what MPC and MPS measure and how they
are related to each other.
• interpret the saving function in relation to the
consumption function.

89
 Consumer Spending and Income are
closely related
• Macroeconomics is a policy science. One kind of
policy has to do with short-run stabilization i.e. to
keep the national output and employment as close
as possible to their potential levels.
• The system of national income accounts provides
us with the data necessary to see whether and how
far the national product has deviated from the
potential (full employment) output in particular
years.

90
• The natural starting point would be to look at the
GDP identity from the expenditure side.
GDP = C + I + G + NX
• If we want to understand why the GDP tends to
fluctuate about its potential level, we must
analyze the behavior of consumers (for c),
investors (for I), government (for G) and
foreigners (for NX).
• Of these four, the consumers behavior is by far
the most important, because consumption
spending accounts for a very sizeable proportion
of total expenditures.

91
• Studying consumer behavior is also important
from the long run macroeconomic perspective.
As we know already, in the long run, the
macroeconomic concern is that of achieving
decent rates of economic growth to ensure
rising standards of living.
• The long run growth prospects fundamentally
depend on how the current national output is
deviaded between consumption an investment.

92
 Income and consumption at the
household level
• What factors determine the level of consumer
spending? There is a close and powerful relationship
between aggregate real consumption and aggregate real
disposable income.
• To understand why it is useful to look at the question at
the micro-level to start with.
• Family budget studies, however, suggest a remarkably
stable pattern in the allocation of family expenditures
among food, clothing and other major items.
• A picture of this pattern is provided in Fig. 3-1. Two
things may be noted about the income consumption
relationship.

93
94
• To continue with the first, we see that low income
families limit their spending mostly to necessities of
life- food, clothing and shelter.
• Despite this, the incomes of the poorer families often
are not sufficient to make the necessary purchases.
• For instance, families with an average income of less
than Y2 spend more than their incomes. This can be
measured by the vertical distance between the total
consumption line RT and the 45 line OQ (also called
the zero saving line for obvious reasons).
• Living beyond current income is made possible by
borrowing, or drawing on past savings, especially by
poor, older people who tend to sell-off their assets
accumulated during their working lives to finance
consumption in the old age.

95
• As the average family income rises, the amount of
dissavings declines. The breakeven point comes at an
income of Y2.
• Beyond this income level, families spend less their incomes
and build up savings.
• This kind of relationship-lower-income people dissaving
and higher income people saving; the proportion of income
devoted to basic necessities declining as income goes up - is
something we expect from microeconomic theory where the
relationship is know as the Engel curve.
• It shows how expenditure on a good changes as income
rises, but the price remains unchanged.
• The RT curve in Fig 3-1 is nothing but this relationship
obtained from family budget studies which can observe
household consumption at a point in time when most people
face the same price.

96
Income and Consumption at National
level
• The relationship that we have found to be true at the family
level can be aggregated to yield a similar relationship at the
macro level under certain simplifying assumptions.
• J.M. keynes put a great deal of emphasis on the relationship
between aggregate real consumption and aggregate real
disposable income in his theory of employment and output.
• He posited that consumption expenditures vary directly with
disposable income. This relationship is known as the
Consumption Function.
• It shows how aggregate real consumption varies as
aggregate real disposable income varies, other things
remaining constant. For this, we have first to define two
characteristics of the relationship.

97
1. The Marginal Propensity to Consume (MPC)
• It is defined as the ratio of change in consumption to the
change in income which caused it. Symbolically, it can
be expressed as
MPC = ∆C/∆Yd
where ∆C denotes change in real consumption and ∆Yd
change in real disposable income.
• For example, if MPC = 0.8, we can say that the
consumers spend 80% of their additional income for
consumption.
• Since the relationship between C and Yd is assumed to
be direct, ∆C and ∆Yd both move in the same direction
(rising or falling together).
• Therefore, the marginal propensity to consume, showing
the proportion of additional income spent for
consumption, is positive.
98
2. The Average Propensity to Consume (APC)
• It is the ratio of real consumption (C) at a
given level of real disposable income (Yd) to
that income level. In symbols,
APC = C/∆ Yd
• From APC we know what percentage of the
real disposable income is spent for
consumption, for example, if APC = 0.70 we
can say that 70% of the income is devoted to
consumption.

99
• With respect to these two characteristics, the followings
points have often been asserted, especially by Keynes:
a) The marginal propensity to consume (MPC) is positive
but less than unity (o<MPC<1)
b) The MPC is less than APC, implying that APC declines
as income rises.
• These two features of the consumption function have
been illustrated with hypothetical figures given in Table
3-1.
• The relationship can be expressed algebraically as
C = 100 + 0.8Yd
• For the data given in Table 3-1, the MPC is positive but
less than unity (= 0.8) and has been assumed constant at
all income levels. The APC declines as income rises.
Also the MPC < APC at all income levels.
100
101
 Income - Consumption Relationship
Graphically
• A graphical representation of the consumption
income relationship typical of the one shown in
Table 3-1 is given in Fig 3-2(a). As drawn, the
slope of the consumption function is positive, but
less than one. We know this from the fact that the
consumption function KM has a positive vertical
intercept of OK (=100).
• The slope measures the marginal propensity to
consume (MPC), while the intercept shows what
is known as autonomous consumption.

102
103
• The reason for calling it autonomous is that this
component of total consumption has nothing to do
with income. When Yd = o, c = OK =100. This
amounts to the dissaving by the nation as a whole.
• Geometrically, the APC can be calculated easily.
Take any point such as G on the consumption
function and join it to the origin O. The slope of
line OG is GYo/OYo which is nothing but APC by
definition (at income level, Yo).
• At income level Yo, APC = 1 (become OYo =
GYo). A little reflection will show that as income
rises above Yo, APC declines, while as income
falls from Yo, APC rises.
104
• The 45o line (or the zero - saving line) in Fig 3-2(a)
helps us to read off the amount of saving at each level
of income visually.
• For example, by construction OY2 = T'Y2, and
consumption at income OY2 is T'Y2. Therefore, saving
at this level of income is OY2 - T'Y2 = TY2 - T'Y2 =
TT', which we can see straightway from the diagram.
The consumption line KM intersects the 450 line (OF)
at point G.
• This implies that at income Yo, Yd = C, so that saving
(S) is zero, To the left of G, the consumption line is
above the zero saving line (OF) and, therefore, the
saving is negative.
• To the right of G, the consumption line is below OF,
implying positive savings. Or, stated differently, for
Y>Yo, S is positive, for Y = Yo, S = O and for Y< Yo,
S is negative.
105
 The Saving Function
• By definition, saving equals income minus
consumption.
• Consumption depends on income; saving is
whatever is left of income after consumption.
• Thus saving is also a function of income.
• Obviously, the two functions are not independent
because
Y=C+S
where S = saving out of Y.

106
Two features of the saving function may be noted.
• First, it is an increasing function of income: at
higher incomes more savings will be
forthcoming.
• Second, its slope, representing the marginal
propensity to save (MPS), is positive and less
than unity. The slope of the consumption function
(MPC) and the slope of the saving function
(MPS) are clearly related.
• Since any increase (or decrease) in income can be
used for consumption and saving, we have
107
108
• In Fig 3-2(b) the saving function (SS')
corresponds to the consumption function KM in
Fig 3-2 (a). The slope of the saving function is 0.2
because the slope of the consumption function is
0.8. As we have seen earlier, if
Yd> Yo, S> O
Yd = Yo, S = O
Yd < Yo, S< O
• When these features incorporated, the saving
function must cross the horizontal axis (Yd ) at
Yd = Yo, lie above it for Yd > Yo, and below it
for Yd < Yo.

109
 Model Question
1. Define MPC and APC. If the consumption function can be written as C =
Co + c Yd, where Co>o and o<c<1, how is APC related to MPC?
2. Define MPS, what does it measure? How is it related to MPC?
3. What is autonomous consumption? Why is it positive?
4. What happens to the consumption function if MPC rises at all income
levels, but the autonomous consumption is unchanged. Use diagram for
your answer.
5. With respect to question No. 4 above, how is the slope of the saving
function affected? Use diagram for your answer.
6. Explain the meaning of consumption function and the basic ideas underlying
its formulation.
7. Explain how the consumption and saving functions are interrelated.
8. Explain why understanding the determinants of consumer spending is
important for short run as well as long run macroeconomic policy.
9. What kind of income consumption relationship have the family budget
studies discovered? Explain.
10. Why is aggregate real disposable income singled out as a primary
determinant of aggregate real consumption? Discuss.

110
 Modern Theories of Consumer
Behavior: The Life-Cycle and
Permanent Income Hypotheses
Lesson Objectives:
After studying this lesson, you will be able to
• See what empirical evidence says about the form of the
consumption function;
• Understand why current income is not a very good
determinant of consumption;
• appreciate why wealth can have an independent
influence on consumption
• Understand how the modern theories have managed to
reconcile the apparently contradictory empirical
findings.
111
• There are serious methodological problems of
transferring the relationship based on household studies
to a relationship that could be said to be valid at the
aggregate level.
• Later, especially in the post war period, attempts have
been made to carefully estimate the income
consumption relationship empirically from aggregate
time series data. The results have puzzled the
economists, because they were apparently
contradictory.
• One type of evidence suggests that the relationship is
non-proportional (MPC<APC), as Keynes suggested.
This evidence is based on short time series data.
• The second type of evidence provided by Simon
Kuznets on the basis of long time series data shows that
the relationship is proportional (MPC = APC).

112
• The challenge before theorists is to reconcile the
apparently contradictory findings:
- why does the relationship appear to be non-
proportional in the short run?
-Why is it proportional in the long run?
-Is one type of relationship correct while the other
is wrong?
• Modern theories of consumption-the Life Cycle
Theory and the Permanent Income Theory are
attempts at this reconciliation.
• The key point here is that wealth and permanent
income play their roles in influencing
consumption behavior in addition to current
income.
113
 The Life Cycle Theory of Consumption
and Saving
• The Keynesian (or Keynesian type) consumption function is
based on the idea that consumption in a period is related to
income of that period.
• The life cycle theory (LCT) take a different view. It assumes
that a consumer takes into account his lifetime income to
smooth out the consumption flow over the life time. This means
that he will save during his working life so that he can use his
savings to finance consumption when his income are low or
none-existent (as when he is out of work, or in retirement).
• The consumption function based on LCT is of the form
C = a' Wr + b' YL ..................(1)
where Wr = real wealth of the consumers
YL = consumers labor income
a' = Marginal propensity to consume out of wealth
b' = Marginal propensity to consume out of labor income.
114
• To see how the relationship (1) is arrived at, we
make a few assumptions about a typical consumer.
He expects to live for t* years. His earning life
consists of ti years during which he expects to
earn YL per years. He begins planning his
consumption from the year he starts working. In
that sense, year 1 is his first year of work. He will
then spend ( t*- ti) years in retirement.
• Our individual now faces the following questions:
(a) What are the lifetime consumption possibilities?
(b) How to distribute total income smoothly for
consumption over the life time?

115
• To answer question (a), let us assume initially that he
has no income from assets (ie his entire income is labor
income). Then his lifetime income is YLti (annual
income times the number of working years). This
implies that his lifetime (total) consumption cannot
exceed YLti.
• As for question (b), assume for simplicity that the
consumer wants to spend at a constant rate, C, annually
during his lifetime. His lifetime consumption is, on this
assumption, cˆt* (annual consumption times the
number of years he expects to live from the year he
started working). Now we can write his life time budget
constraint as
cˆt* = YLti ... ... ... ... ... ... ... ... ... ... (2)
(life time consumption = lifetime labor income)
116
• During through by t*, we can write (2) as
cˆ = (ti/t* )YL ... ... ... ... ... ... ... ... ... ... (3)
• This says that the planned per period
consumption (c^) is proportional to labor
income per period, the constant of
proportionality being the fraction of lifetime
spent to earn income (ti/t*).

117
The Saving Function
We can now easily deduce the saving function,
using (3). Since saving is income minus
consumption in any period, we have, writing S for
saving per period,

118
Influence of Wealth on Consumption
• It is now easy to introduce the effect of wealth
into the consumer's consumption function.
• Suppose that our individual is in his q-th year of
working life and has a stock of inherited real
wealth worth Wr.
• He begins his lifetime consumption planning in
the q-th year. His labor income for the remaining
years of his working life is (ti-q)YL.
• If we add this to his inherited wealth (Wr), his
total resources to be spent on consumption
amounts to (ti-q)YL + Wr, which he will spend in
(t*-q) year (he leaves no inheritance). Thus his
lifetime budget constraint can be expressed as
119
120
• To gain a better understanding of what (3) and
(5) imply let us work with some illustrative
members.
• Assume that an individual expects to live for
75 years (t* = 75) and that his working life
lasts for 40 years (= ti). If his annual labor
income is $ 30,000, his total lifetime income
will be ($ 30,000 x 40=) $ 1,2,00,000 (= Mti)
which he will consume uniformly in 75 (= t*)
years. This makes his annual consumption (C)
equal to ($ 1,200,000 ÷75)= $ 16,000.
121
• Now suppose that he in the 15th year of his
working life (i.e. he has still 25 years of working
life left) with a real wealth of $ 300,000. His labor
income for the remaining 25 years is ($ 30,000 x
25 =) $ 750,000. This together with his wealth
stands at ($750,000 + $3000,000 =) $ 1,050,000.
• This amount he will spend equally in (75 - 15) =
60 years.
• Therefore, his annual consumption expenditure
will be ($ 1,050,000 ÷60 =) $ 17,500.
• Notice that, his annual consumption has gone up
by ($ 17,500-$ 16,000=) $ 1,500.

122
In this case, the MPC out of wealth
a' = 1/(75-15) = 0.0167,
while the MPC out of labor income,
b' = (40-15)/ 60 = 0.4167.
The consumption function (5) can be written as
Cˆ = 0.0167 Wr + 0.4167 YL
(17,500) = (5,000) + (12,500)

123
124
• The proportionality non proportionality puzzle referred
to at the beginning of this lesson can be explained with
the help of the life cycle hypothesis.
• In Fig 3-3 are shown several short term consumption
functions showing the relationship between
consumption and labor income. Each is based on
relationship of the type shown in equation (5).
• The slope of Co, for example, shows the MPC out of
labor income. The intercept, on the other hand,
represents the first term of equation (5) i.e, the
independent influence of wealth on consumption. In the
short run, the wealth effect is more-or-less constant.

125
• Therefore, whatever change in consumption is observed
would be mainly due to changes in labor income. In the
short run, MPC<APC. Over time, however, assets will
grow, causing upward shifts in the short term
consumption functions like Co in Fig 3-3.
• As a result, we expect to observe points like P, Q, R
which lies on line OT through the origin.
• Therefore, the life cycle theory accomplishes the
required reconciliation between the two apparently
contradictory pieces of evidence, and this is
accomplished by emphasizing that consumers behavior
is geared to long run consumption opportunities
consisting of lifetime income and wealth.

126
The Permanent Income Theory
• This is another attempt at reconciliation. Like the life cycle theory,
this theory too argues that consumption is related not to current but
to a long-term estimate of income. Milton Mriedman, a Nobel
laureate, who originated this theory, call this theory, 'permanent
income'.
• A consumer's current income consist of permanent income (Yp) and
a transitory component (Yt).
• Roughly speaking, the permanent income is what consumers expect
to get over a long period of time (e.g. their salaries).
• On the other hand, the transitory income (which may be positive or
negative) may be occasional receipts (tips) or payments (fines for
violating traffic rules). Simply stated the permanent income theory
states that Cp = bYp
where Cp is permanent consumption (stripped of the element caused
by transitory income), and b is the MPC out of permanent income
127
• But when we relate current consumption to current
income, we should expect to get a non- proportional
relationship (MPC < APC).
• In the case of non-proportional relationship, high-
income groups save, while the low-income groups
dissave. This is due to the fact that the high income
groups, on the overage, tend to have positive transitory
income (most of which they save).
• On the other hand, low-income group's measured
income contains negative transitory components;
Therefore, they tend to dissave in order to protect their
permanent consumption.
• This is how the permanent income theory accomplishes
the necessary reconciliation between short run non-
proportionality and long-term proportionality
controversy.
128
 Non-Income Determinants of
Consumption
Lesson Objectives:
After studying this lesson, you will be able to
• See what factors other than income can influence consumer
spending
• Understand why the influence of the rate of interest is likely
to be weak at the aggregate level
• Appreciate why liquid assets can be an important
determinant of consumption in times of changing price level
• Know why more equal income distribution may not always
stimulate aggregate consumption
• Understand why institutional saving schemes like private
pension funds can weaken the effect of income on
consumption.
129
 Non-Income Determinants of
Consumption
Rate of Interest
• It stands to common sense to argue that people would
like to consume less out of a given income (ie save
more) when the rate of interest is high than when it is
low.
• People consume less (and save more) so that for a unit of
consumption sacrificed (because of saving) at present he
can enjoy more than a unit of consumption in the future.
• The additional future consumption represents the reward
for saving, which is the rate of interest by another name.
• The higher the reward (i.e; the higher the rate of
interest), the argument goes, the higher the saving (the
lower the consumption).
130
• When the interest rate goes up, the typical
consumer is subject to two types of influences,
technically called substitution effect and
income effect. The kind of effect described
above is the substitution effect; he substitutes
future consumption more for present
consumption if the rate of interest is higher
than otherwise. This inclines him to save more.
• The income effect, however, work in the
opposite direction. The higher interest rate
increases his future income relative to his
current income.
131
• Think of low-income people who save only a
relatively small fraction of income even at high
rates of interest. For them, the substitution effect
is likely to be stronger, and therefore, their saving
can be expected to vary directly with the rate of
interest.
• The same cannot be said of high-income people
who save a relatively large fraction of their
income. The income effect for them may
outweigh the substitution effect, especially at
sufficiently high rates.
• And, in that case, a further rise in interest rate
may cause saving to fall (rather than to rise). This
is what is known as the backward bending supply
curve of saving.
132
• Many of the empirical studies on this issue
seem to indicate that the overall impact of
interest rate changes on savings (and hence on
consumption) is negligible, which is
presumably because offsetting forces-income
and substitution effects- really cancel each
other out in the aggregation process.

133
Wealth
• How much wealth a consumer has is claimed
to have some bearing on his level of
consumption (and in a sense distinct from the
one implied by the life cycle Hypothesis).
Why?
• The larger the stock of wealth, the lower its
marginal utility. Therefore, a consumer with a
lot of wealth feels less inclined to add to his
future wealth at the cost of current
consumption.
134
• Imagine two friends-Harun and Arun- each
with an annual disposable income of $ 20,000.
They have the same tastes and preference.
However, Harun is wealthier with wealth
worth $ 200,000 than Arun who has a meager
& 50,000 worth of assets.
• If the argument above holds, Harun should
save more than Arun, not just because of his
being wealthier per se, but also because of his
confidence that he can count on his wealth to
meet any future contingency, should it arise.

135
The price level
• The price level is another variable that can shift the entire
consumption function. Higher price leads to lower
consumption at any given level of real disposable income.
• Conversely, a lower price level can cause increased
consumption at each level of real disposable income.
• When the price level changes, the real disposable income (e.
g. for any given normal income) rises or fall's. As a result,
real consumption too rises or falls. These effects can be
represented by movement along a given consumption
function.
• However, any increase or decrease in real wealth caused by
price level changes will shift the entire consumption function
upward of downward, depending on the direction of price
changes.
• These shifts are due to real wealth changes, not due to real
income changes. In short, we can say that in so far as the
price level changes shift the consumption function, they work
through changes in real wealth, not in real income.
136
Inflation Rate
• Prices may be rising slowly from a high level,
or they may be rising rapidly from a low level.
The former is the case of low inflation with
high general price level, While the latter is one
of high inflation with low price level. It may
be asked whether the rate of inflation,
independently of the level of prices, can
influence consumption, one way or the other.
• The issue has something to do with how
people form expectations about future
inflation.

137
• It is sometimes suggested that if people expect
inflation to continue, or, worse still, to accelerate,
they may like to spend more out of current
income than otherwise. They may be swayed by
the feeling that `now' is the best time to buy.
Equally sensibly, others may think that inflation
will slow down and, therefore `now' is a bad time
to buy.
• Unfortunately, the empirical evidence on people's
tendency to `beat' inflation or gain from it is
mixed. Economists therefore, usually ignore the
effect of rate of inflation as a determinant of
consumption in the construction of their
macroeconomics models.
138
Distribution of Income
• A given level of aggregate disposable income
may be distributed among income classes more
equally or less equally. In general the more
equal the distribution, the larger is supposed to
be the fraction of income consumed out of a
given disposable income.

139
• Because low-income families, as family budget studies show,
tend to consume a larger proportion of there incomes than
their richer counterparts.
• The argument, however, is not wholly convincing, because it
seems to confuse high average propensity to consume with
high marginal propensity to consume.
• The average propensities may well vary across income groups.
But there is some evidence to suggest that the marginal
propensity may be the same at all levels of family income.
• In that case, a redistribution of income from the richer to the
poorer households would have virtually no effect on aggregate
consumption.
• There is another point which seems relevant here. It is about
the appropriate concept of income to be related to
consumption.
• For example, if one believes in the life cycle hypothesis about
consumption, then any redistribution of current income will
insignificantly affect lifetime income and hence the profile of
lifetime consumption. 140
Demographic Factors
• Changes in composition of the spending units in the
total consumer population can presumably have some
effect on aggregate consumption. And this effect is
likely to be independent of changes in aggregate
income (or of any other variable considered so far).
Consider all families at any given income level. Not all
of them will be expected to consume the same amount
of their income because they may differ in various
demographic characteristics. What are some of these
characteristics? We can immediately think of a few.
First, some families may have fewer members than
others; other thing equal, the latter are likely to spend
more. Second, even two families with equal number of
members may differ in their age and gender
composition; the family with more young people,
possibly children and students, may spend more.
141
• Third, families may differ by place of residence;
urban dwellers are likely to spend more than their
rural counterparts. Fourth, families may vary with
respect to racial or ethnic characteristics; non-
whites save more than whites at any given income
level. We may come up with other distinguishing
features which can influence family consumption
behavior in some ways.
• But whatever the merits of these difference in
terms of their ability to cause consumption
differences, they should not be overemphasized.
On the average and for the whole population,
these factors change quite slowly. Therefore,
these factors can safely be ignored in an analysis
of short run aggregate consumption behavior.
142
Other Factors
• We have already talked about price expectation as a
possible influence on consumption. But expectation need
not be confined to price alone. For many families,
expectations with respect to future income levels may be an
important factor in their consumption plans. Likewise
consumer expectations with respect to economic, social and
political circumstances can affect real consumption in any
period. Easy consumer credit terms can stimulate consumer
spending, especially on consumer durables like cars,
televisions etc. Moreover, the saving patterns of many
families have undergone important changes with the arrival
of long term saving commitments through life insurance
policies, private pension plans and so on. Once committed
to any of these schemes, savings become almost automatic
and hence less sensitive to changes in family disposable
incomes.

143
Investment spending: The Discounted
Present Value Approach.
After studying this lesson, you will be able to
• Explain the instability of investment spending
• see the distinction between gross and net investment
and why the distinction is important in the theory of
investment;
• appreciate why an investment decision involves
weighing of costs and potential benefits
• Understand why discounting of future benefits is
needed and how it is done
• see why the rate of investment depends, inter alia, on
the market rate of interest.

144
 Investment Spending: The Role of
Interest Rate
• Important argument of Keynes is that the capitalist market
economy is inherently unstable. It is unstable in the sense
that output and employment can often fluctuate, creating
alternate periods of booms and depressions.
• In this instability argument, investment holds the center
stage which makes a careful study of business investment
all the more important. In contrast to the stagnation
argument, Keynes has proved remarkably right in his
emphasis on investment behavior as a source of instability.
• Investment demand, though less than a quarter of the
aggregate demand, has historically proved to be quite
volatile. There is a wide agreement among economists that
this volatility arises from the uncertainty about the expected
returns from investments, expectations regarding future
returns being fragile.
145
• Expectations about future returns may be fragile for several
reasons. For example, the investor does not know with any
degree of certainty the exact working life the machine he
intends to buy. The machine may last for fewer years than
anticipated.
• More important is the possibility of technological
obsolescence. The machine may become outdated before its
physical life is fully exhausted. Will consumers' taste for the
product (the machine is to produce) change in such a way
that sales will fall off rapidly, rendering the machine useless?
Will consumers behave in the way predicted? Will the tax
policies change? Will input prices rise too much? One could
mention many more sources of uncertainties like these, but
the point is that when so many things can go wrong in the
future, the profitability of an investment that is to yield
returns for a number of years in future can only be estimated
with a large margin of error, one way or the other.

146
 Salient Features of Investment
• First, in popular usage, investment often refers to buying financial
(e.g. stokes, bonds) and existing physical (e.g. an old house) assets.
• In macroeconomics, investment has a very specific and well-
defined meaning. Investment is the value of that part an economy's
output in a period which takes the form of new structures, new
machines or equipment, and changes in inventories.
• In national income accounts, investment is often shown as
composed of (a) business fixed investment (such as plant and
machinery), (b) construction (new residential houses), and (c)
changes in inventories. Of these, the business fixed investment is the
largest component, and our discussion here will be confined to this
component only.
• Secondly, it may be recalled that investment is a flow (so much per
period), while capital is a stock (so much at a point in time). The
capital stock of a country consists of machines, equipment,
structures etc. at a point in time (say, December 31, 2000)
accumulated over the past years. Capital (stock) and investment
(flow) are obviously related. The capital stock changes only when
the flow of investment changes.
147
• Finally, a distinction have made between gross
investment and net investments to. Some
investment is required to make up a part of the
capital stock used up in the production process
during the period.
• This part of investment is called replacement
investment. Another part of investment is aimed
at expanding the productive capacity of the
economy. This is called net investment.
• Therefore, gross (or total) investment (Ig) equals
the sum of replacement investment (Ir) and net
investment (In). So we can write
Ig = Ir + In
148
 Cost & Benefits of Investment
Costs are of two types.
1. The cost of buying and installing the machine. Let this
be denoted by C.
2. The interest costs of funds needed to finance purchase
of the machine. These costs are relevant even when the
firm uses its internally generated funds. Such funds can
alternatively be used to buy an existing asset (e.g. fixed
interest bearing government bond). The interest forgone
by not buying the bond is the opportunity cost of funds
used to buy the machine. In other words, whether or not
the money is actually borrowed or comes from own
resources interest cost of funds remain relevant. We will
represent the rate of interest by `i' For instance, if i=10%
annually, the borrower pays every year $ 10 for every $
100 borrowed.
149
• Against the interest cost of the funds required
to buy the machine, there are prospective
benefits. These will come as a stream of net
revenues over the life of the machine from the
sale of products it will be used to produce.

150
• Discounting and Present Value of an Asset
• The rate (r) is clearly the rate of return on
investment we have been looking for. Keynes
called this rate the marginal efficiency of capital
(MEC). MEC is therefore the rate of discount (or
interest) which, when applied to the prospective
yields from an investment project, will make their
discounted present value (V) equal to the cost of
the investment project (C). Notice that if
V = C, r = i
V > C, r> i
V< C, r < i

151
• Investment Decision Rule and Investment Function
• Finally, we are ready to establish the rule for
investment decision by a profit maximizing firm
(assuming away or adjusting for all the risks and
uncertainties mentioned earlier). Not surprisingly this is
quite straight forward: the firm
(i) Should invest if r> i (i.e V> C)
(ii) Should not invest if if r< i (i.e V< C)
(iii) Will be indifferent if r = i (i.e V= C)
• The investment rule is usually in terms of the market
rate of interest (i) and the rate of return on investment (r
of MEC). This when r>i, investment is profitable. On
the other hand, if r<i, the investment is not worthwhile.
Intuitively, this comparison makes good sense.

152
 Demand Schedule for Investment
• At any point in time a firm is confronted with a number of
possible investment projects, and they can be ranked in
decreasing order of their profitability (i.e, MEC = r).
• Fig. 3-4 shows the situation for a typical firm. the firm’s
most profitable project is A which yields a return of 10% and
the least profitable is project D which brings only 4%. If the
market rate of interest is 8%, project A and B can be
profitably be undertaken and then total investment will be
$1500. Project C and D are not profitable at 8% rate of
interest.
• However, if the market rate of interest drops to 6% project C
becomes worthwhile along with project A and B. As a result,
total investment rises from $15,000 to $29,000.
• Clearly there is an inverse relationship between the market
rate of interest and the firm's investment demand: the lower
the rate of interest, the higher is investment and vice versa.
153
154
155
• But if the MEC schedules of all firms in the economy
are horizontally added up, we can expect to get
continuous downward sloping MEC schedule,.
• The reason is that when, for example, the rate of
interest falls and firms try to buy more capital goods,
capital goods price may rise, at least in the short run.
• When the cost of the machine the project) goes up,
other things constant, MEC is likely to fall on all
project for all firms. As a result, the rate of investment
will decline at each MEC.
• In other words, the MEC will shift to the left as the
prices of capital goods rise. The resulting curve is
sometimes called the marginal efficiency of investment
(MEI) curve as shows in fig, 3-5. The MEI schedule
represents the investment demand schedule for the
economy as a whole, and the curve is obviously
negatively sloped.
156
Investment Spending: The Neoclassical Stock
Adjustment Approach
After studying this lesson, you will be able to
• see why output changes are necessary for continued net
investment.
• how a firm determines its optimal capital stock
• why, along with the rate of interest, expected inflation rate
and depreciation charges should be included in the cost of
capital.
• how government policies can influence investment
behavior of firms.
• how firms adjust their actual stock of capital toward the
desired level over a period of time.
• why the MEC-based explanation of investment is implicit in
the neoclassical theory of investment.

157
• The new approach naturally begins with the question of
what determines the optimal capital stock of a firm. Firms
produce any given level of output using capital and labor
(and other inputs) and employing the best available
technology so that the cost of production is the lowest
possible.
• In order to decide how much capital to use to produce its
output, the firm must compare the contribution that
additional capital makes to profit with the cost of using that
capital. The contribution is measured by the value of the
additional output produced.
• The cost of using additional capital which is called the
rental cost of capital consists of several elements to which
we will return later. A profit maximizing firm will continue
to add to its capital (re-invest) as long as the value of the
marginal product of capital is higher than the rental cost.
• In equilibrium, therefore, value of the marginal product =
rental cost of capital.
158
 The Marginal Product of Capital
• Given the neoclassical from of the production function,
a firm can produce a particular level of output with.
many different combinations of labor and capital.
• This means that the firm can substitute capital for labor
and vice versa. The combination of capital and labor
actually chosen depends on the wage-rental ratio. As
the wage rate goes up (ie, the wage-rental ratio rises),
the firm will use (in order to minimize the cost of
producing any particular level of output) more capital
and less labor. As a result, the ratio of capital to labor
will go up.

159
• In this case, more capital is being used with
smaller amount of labor, therefore, the marginal
product of capital will fall even more. We should
then expect the MPK to fall as increasing amounts
of capital is used to produce a given output level,
as shown in fig, 3-6.
• The curve Yo in Fig, 3-6 shows how the MPK
behaves as the firm uses more and more capital
(Such as K1, Ko, K2) to produce a given output
level, Yo. Which level of capital should is used to
produce Yo depends on the rental cost of capital
(relative to the wage rate). For example if the
rental cost is rˆa , the optimal of desired capital
stock is Ko, because only at this level the rental
cost equal the marginal product of capital.
160
161
• If the rental cost were to rise to say r^b, the
firm must be compensated for this by an
increase in MPK. This will happen at point B
as the firm tries to use less capital (which is
now relatively more expensive) and more labor
(which is now relatively less expensive).
Therefore, one determinant of the optimal
(desired) capital stock that a firm will like to
have is the rental cost of capital (r^ ). The
higher the rental cost of capital (r ^), the lower
the optimal capital stock (k*) and vice versa.

162
• However, the rental cost is not the only determinant. Another
determinant, not surprisingly, is the level of output. To
appreciate how, let us look Fig 3-6 again.
• The curve Y1 represents a higher level of output than Yo. To
produce more output, more capital (and more labor) is
needed. As a result, for any given rental cost of capital, the
optional capital cost will go up as output grows.
• For instance, at. r^ = r^a, the optimal capital stock is Ko for
output Yo, but for Y1 the optimal capital stock is higher (K2).
• The general relationship among the optimal capital stock
(K*), the rental cost of capital (r^) and the level of output is
given by
K* = f(r^, Y)
• It must be noted carefully that output Y in equation is not the
current, but the expected level of output which the firm thinks
it will produce in future during the life of the capital good.
The expected output can, of course, be influenced by the
current output level.
163
 The Rental Cost of Capital
• Obviously the interest charge of buying (or hiring)
a unit of capital is one element irrespective of
whether the funds are borrowed or internally
generated,
• The other element is depreciation of the capital
good during the relevant period. Because to keep
the machine as efficient in production as it was
originally, repairs and maintenance costs have to
be incurred and these must be regarded as part
of rental costs.

164
• Therefore, by adding the depreciation charges
(d) to the rate of interest, we can write
r^=i+d.
where i = nominal rate of interest,
d = depreciation costs, and
r ^ = rental cost of capital.

165
• The interest rate in equation is the nominal interest rate,
as agreed upon in the loan contract without any reference
to future inflation. The nominal (money) value of the
marginal product of capital (MPK) goes up with the rising
price level, but the nominal interest rate agreed upon does
not. It is therefore the expected (because future inflation
can only be predicted imperfectly) real interest rate that
should be relevant for calculation of the rental cost.
• The real interest rate is the nominal interest rate minus the
rate of inflation. For example, if the nominal interest rate is
7%, while the rate of inflation is 2%, the real interest rate is
5%. Therefore, by modifying equation, we write
r ^ = i* + d
Or r^ = i –πe d
where πe is the expected rate of inflation,
i* = i - πe = real interest rate, and
d = depreciation costs.
166
• In fact, government tax and subsidy policy can
significantly alter the rental cost and hence the
optimal capital stock.
• Two main types of taxes that are directly relevant
are corporate income tax and investment tax
credit. Other things constant, if the corporate tax
rate goes up, the after-tax marginal productivity
of capital at any level of desired capital stock will
fall.
• The story is different with investment tax credits
under which a firm is allowed to deduct a certain
percentage of its investment during a year from its
taxes. The investment tax credit therefore reduces
the cost of capital.

167
• Let us now bring together the factors which influence
the desired capital stock of a firm.
• Taking account of all these factors and their
interrelationships we can write the demand for optimal
capital stock at the aggregate level (through the process
of aggregation) in the general functional form as:
K* = f (i*, d, y, t, tc)
(-) (-) (+) (-) (+)
Where, t = corporate income tax rate
tc = investment tax credit, and
other variables are as defined before.
• The positive and negative signs on the right hand side
of equation indicate in which directions K* is expected
to change as the variable above the sign changes.

168
 Adjustment Towards Capital Stock :
The flexible Accelerator Model
• Whenever the optimal stock is larger than the actual stock,
the gap can be closed only through net investment. However,
it is unlikely that the gap will be closed in one big increase in
net investment. Why?
• Two factors stand out. One has to do with time. It takes time
to conceive, plan and complete an investment project (e.g,
you will not possibly promise to raise a ten story building
overnight).
• Secondly, the quicker the adjustment, the more likely it is
that the cost of the project will be higher. For instance, a very
rapid adjustment will call for an expensive crash program
with adverse effect on regular production schedules.
• Thus it is far more reasonable to assume that firms will
adjust their capital stock in a step-by-step fashion over a
period of time rather than in one big leap.
169
Several hypotheses have been advanced to explain the
speed at which the adjustment of the actual capital
stock towards the desired stock takes place. One of
them is the accelerator model.
The older version of this model says that investment is
proportional to national output. But this explanation has
been found to be crude and deficient, and the model has
since been extensively modified and refined.
The model in its new incarnation is called the flexible
accelerator model. The basic idea underlying this model
is that firms decide to close a fraction of the gap
between desired (optional) and actual stocks in each
period and that the larger the gap the stronger is the
urge to close the gap more quickly.
170
 Model Question
1. What do you mean by proportionality and non-proportionality of income
consumption relationship?
2. How does the wealth effect on consumption help explain long-run constancy
of the average propensity to consume?
3. Give an intuitive interpretation of MPC out of wealth and MPC out of
labour income.
4. Show that equations (3) and (5) in the text are consistent for an individual
who started life with zero wealth and has been saving for `q' years.
5. In terms of Permanent Income Hypothesis, would you consume more of
your festival bonus if
a) you knew that there was a bonus every year,
b) This was the only year your bonuses were given out.
6. In what respects is Keynes’ consumption theory unsatisfactory? Explain.
7. How does the life cycle theory explain long-term proportionality of income
consumption relationship?
8. The permanent income theory and the life cycle theory are similar in their
definition of the appropriate measure of income for explaining
consumption.“ Do you agree? Give reasons for your answer.

171
• Explain why you would expect the effect of interest rate changes on
savings at the aggregate level to be quite small.
• The real value of which form of consumers wealth is affected by
changes in the price level? Why?
• "In evaluating the effect of more equal income distribution on
consumption, one has to be careful about distinguishing between
marginal and average propensities to consume. "Why?
• Why are demographic factors likely to be of some importance when
one tries to predict consumer spending?
• Do you think institutional saving schemes like private pension funds
have weakened the relationship between income and consumption
for middle income families? Give seasons for your answer.
• Discuss how the rate of interest can influence the volume of
consumer spending.
• “The redistribution of income towards poorer families can
stimulation overall consumption, but the effect is unlikely to be
empirically significant" Do you agree? Give reasons.
• “The price level changes can affect consumption by changing real
income as well as real wealth." Explain how.

172
• Explain briefly why investment spending is likely to be unstable.
• How is investment defined by economists? Mention two important
attributes of investment.
• Distinguish between gross and net investment. Why is the distinction
necessary?
• Explain why the interest costs remain relevant for investment decision,
even when the funds to buy a new capital good come from firm's own
resources (i.e, not borrowed).
• What is discounting? What does the discounted present value of future
yields?
• ‘Comparing the MEC with the rate of interest for investment decision is
equivalent to comparing the discounted present value with the cost of the
project.' Do you agree? Explain.
• Show that the discounted present value varies directly with the series of
prospective yields and inversely with the market rate of interest.
• Discuss a firm's investment decision rule. Show that a firm's investment
expenditures and the market rate of interest move in opposite directions, if
this rule is followed.
• Explain why the aggregate investment function for the economy as a whole
cannot be obtained simply by horizontally adding individual firm's MEC
schedules. In this connection, explain how such a function is derived.

173
• Explain why output changes are necessary for continued net
investment.
• "The optional stock of capital is one which a firm will like to have in
order to maximize profits". Do you agree? Give reasons for your
answer.
• Why is the marginal product of capital expected to decline when a
firm uses more and more capital with given amounts of other
inputs?
• How is the marginal productivity of capital affected by an increase
in the corporate income tax rate? Explain.
• Explain how the investment behavior of firms can be influenced
through monetary and fiscal policies.
• Discuss the flexible accelerator model of capital stock adjustment.
• What are the various elements of the rental cost of capital?
Elaborate.
• Explain why firms usually choose to adjust their capital stock slowly
over a period of time.

174
Demand Management
Policies in Theory
and Practice
Chapter-5
 Effects of Government Purchases and Tax
Reductions on Equilibrium Output and Income.
After studying this lesson you will be able to
• understand better the assumptions underlying the simple
Keynesian multiplier model.
• see why government intervention in needed to fight
macroeconomic ills.
• understand why the multiplier in presence of proportional
taxes is smaller.
• see that the size of the government expenditure multiplier is
the same as any autonomous expenditure multiplier.
• appreciate why choosing between final policy instruments is
not quite straight forward.
• understand what the paradox of thrift is and why it arises.
• In chapter 4, we presented a model of income determination
of the simple Keynesian type. Its simplicity derives from the
assumptions made. Some of the important ones are listed
below:
1. The price level is fixed; this is not a very unrealistic assumption
for an economy with massive unemployment.
2. There is no government and no foreign sector. These are only
simplifying assumptions made to highlight some key
relationships in income determination.
3. Investment is fixed. This is also a simplifying assumption,
because it abstracts from the influence of interest rate and
income on investment.
4. Only the goods market has been considered. A more realistic
model must include asset and labor markets.
• In this chapter we shall relax some of these assumptions. As a
first step, we introduce the government sector so that we can
analyze when and how the government conducts its fiscal
policy to cope with macroeconomic ills afflicting the economy.
The Government Sector
• During a recession, people suffer from unemployment and joblessness.
No wonder then that they want the government to do something about
it. But what can the government do?
• The government can directly influence the level of equilibrium income
in two different ways.
• First, we know that government spending is a component of aggregate
demand. Therefore, during a recession the government can increase
aggregate demand (and income) through its purchase of goods and
services.
• Secondly, it can reduce taxes or increase transfer payments. These
measures raise the disposable income of people and thereby tend to
increase their consumption. Since consumption is a component of
aggregate demand, tax reductions or increase in transfer payments
tend to raise aggregate demand and hence income (via the multiplier).
• When the economy is booming and inflation is high, the government
can rein in inflation by reversing the steps noted above (i.e. by
increasing taxes and reducing government expenditures).
• These steps come under what is know as fiscal policy of the
government. In short, government policy with respect to spending,
level of transfers, and the tax structure is called fiscal policy.
Government Sector and Aggregate Demand
• With the introduction of the government sector, the aggregate
demand should now be written as
AD = C + Io + G … … … … … … (1)
• Note that consumption will now depend not on income, but on
disposable income (Yd), which is the net income available to
households after paying personal income taxes. Therefore, the
consumption function (assumed linear as before) should be modified
(ignoring transfer) as
C = Co + cˆ Yd
or, C = Co + cˆ (Y-T) ... ... ... ... ... ... ... ... ... (2)
where T = taxes. We shall make two simplifying assumptions : a)
government expenditure is a fixed amount, Go; b) government
collects a fraction, t, of income as taxes. In other words,
G = Go … … … … … … (3)
and T = tY … … … … … … (4)
Substituting (4) into (2), the consumption function can be written as
C = Co + cˆ (Y-tY)
or, C = Co + cˆ (1-t)Y … … … … … … (5)
• For example, if the MPC out of disposable
income (cˆ ) is 0.8 and t= 25%, then the MPC
out of income is 0.60 (=0.8 * 0.75). Therefore
combining (1), (3) and (5),
we can express the aggregate demand function
as
AD = Co + cˆ (1-t)Y + Io + Go
or, AD = (Co+Io+Go) +cˆ (1-t)Y
or, AD = A+ cˆ (1-t) Y ---------- (6)
where now A = (Co + Io+ Go) = autonomous
expenditure.
• Aggregate demand function (6) differs from
(6') in two respects.
• First, the intercept (i.e. the level) of the AD
function (shown as AD1 in Fig 5-1) is higher,
because of the inclusion of Go (K1>K).
• Secondly, the slope of the aggregate demand
function AD1 is now smaller, because the
MPC out of income, (1-t) cˆ is lower than
MPC out of disposable income, cˆ .
• the multiplier process works through induced
consumption. In the case of taxes, the induced
consumption at each round is smaller. This
makes ΔY (and hence the multiplier) smaller.
Change in Government Expenditures and Equilibrium Income
• We can now consider the effects of a change in fiscal policy
on the equilibrium level of income. The effects of two types
of changes will be analyzed:
a) an increase in government purchases and
b) a reduction in tax rate.
• Fig. 5-2 shows the effect of an increase in G from Go to G1.
Graphically, the effect of an increase in G0 is similar to that
of an equal increase in either Io or Co, all being components
of autonomous expenditures, A,
• In particular, an increase in government expenditure by Δ G
pushes up the initial aggregate demand curve (AD0)
vertically by a distance Δ G. The new aggregate demand
curve is AD1. The equilibrium income rises from Y0 to Y1.
We can calculate the extent of increase in income (Δ Y) using
(7) according to which the equilibrium income is
Conclusion
• From our discussion above, we see that the fiscal
policy can be applied by the government to
stabilize the economy.
• To fight unemployment, for example, the
government can raise government purchases or
reduce taxes. Views differ as to which one is a
better policy instrument. Raising G has to be
legislated in many countries, and takes time;
however, it affects the aggregate demand directly.
• The tax policy affects aggregate demand only
indirectly via increase in disposable income.
Moreover, if the tax cut is regarded by people as
temporary, its effect may not at all be significant.
 The Paradox of Thrift
• Let us examine what happens in the simple Keynesian
model of income determination, when there is an
upward shift of the saving function caused by a desire
to save more at each level of income. Assume for the
moment that investment is independent of the level of
income. Then, as Fig. 5-4 shows, an upward shift of the
saving function causes the equilibrium income to fall,
thus frustrating the desire to save move.
• The shift results in an excess of saving over investment,
and income has to fall from Y0 to Y1, so that saving
falls to the level of I0. Here the desire to save more
ends up in saving the same amount as before
• But this is not the worst of it. More
realistically, the demand for investment should
depend positively on the level of income,
because more output requires more machines
and factories. What happens to saving in this
setting is illustrated in Figure 5.5. The initial
equilibrium is Y0, given by the intersection of
I and So curves. When So shifts to S1, the
equilibrium income level falls to Y1. As
income falls, investment falls (fewer machines
are now needed); saving too must fall to
maintain equilibrium.
• This is the paradox of thrift: Prosperity is
promoted by expenditures, not by savings, as
Keynes argues. (Try to save more to increase
output, you end up saving less with lower
income).
• It can, however, be shown that the paradox
holds only when there is large unemployment
and actual output is way below the potential
level. In a world of inflationary excess
demand, the paradox disappears, and increased
desire to save curbs inflation.
Goods Market Equilibrium when
Investment is not fully
Autonomous.
• In this Lesson, we bring our model a step closer to
reality by adding a component of investment which is
dependent on the rate of interest, while retaining the
assumptions of a fixed price level and a closed
economy (so that NX=0).
• Moreover, as before, we continue our attention to the
goods market only. It turns out that when investment
depends on the rate of interest, we cannot say what the
aggregate demand (AD) will be, unless we know what
the rate of interest is. This inability has a disturbing
implication for the determinacy of the equilibrium
income level.
• We do not know what the equilibrium level of income
is until we know what the rate of interest is.
• In principle, there are an infinite number equilibrium
income levels each being associated with a given rate
of interest.
Investment as a Function of the Interest Rate
• For simplicity we write the investment function as
I = Io - bi … … … … … … … (1)
Where Io = autonomous investment which is
independent of both income (Y) and the interest
rate (i), and b = a positive constant showing how
responsive investment (I) is to changes in the rate
of interest.
Note several points about the investment function
(1). First, investment is a linear function of the
rate of interest,
• Second, total investment has two components: one which is
autonomous (I0) and the other which is induced by changes
in interest rate (bi).
• Finally, total investment falls as interest rate rises and rises
when the interest rate falls. The strength of investment's
response is indicated by the slope of the investment function
(b).
• For instance, if 'b' is large, then a small change in the
interest rate will cause a large drop in investment. This
reflects the assumption that firms would like to add to their
capital stocks (i.e. invest) lured by increased profitability
brought about by lower interest rates.
• Conversely, if investment responds very little to changes in
interest rates, the I-curve in Fig. 5.6 will be nearly vertical
(very steep).
• The position of the investment curve depends on both the
slope (b) and autonomous investment (I0). For example, an
increase in I0 will cause the whole I-curve to shift to the
right.
• Comparing (3) with (4) we see that when
investment is a function of the rate of interest,
the aggregate demand depends not only on
the level of income, but also on the rate of
interest.
• For any given level of income, the higher the
rate of interest, the lower is the aggregate
demand and vice versa. For any given rate of
interest, there is a given level of aggregate
demand, and hence a given level of
equilibrium income (since Y=AD).
• We can now use this characteristic embodied in (3) to
derive the IS curve which shows various combinations
of income and the rate of interest for each of which the
goods market is in equilibrium (AD=Y).
• In Fig. 5.7 (a) the aggregate demand curve AD0 refers
to a rate of interest io, and the corresponding
equilibrium level of income is Yo. Now suppose that
the rate of interest falls to i1.
• As a result, the level of investment goes up from Io to
I1 (see Fig 5.6). This will cause a parallel shift of the
AD function from ADo to AD1, raising the equilibrium
level of income from Yo to Y1. Thus, a lower interest
rate is associated with a higher equilibrium income and
vice versa. This has been shown in Fig 5.7 (b).
• The point Eo corresponds to (io, Yo) and E1 to
(i1,Y1). By varying the interest rates and noting
the corresponding income levels, we can trace a
negatively sloped curve, IS, in Fig 5.7 (b).
• This curve is called the IS curve to underline the
fact that the pair of interest rate and income level
shown by any point on this curve represents
goods market equilibrium (AD=Y or Investment
(I) = Saving (S), comprehensively defined).
• To derive the equation of the IS curve, let us write
Y = AD
• The slope of the IS curve is smaller, the larger
the interest responsiveness of investment and
the size of the multiplier.

• This is so because an increase in the interest

rate lowers planned investment and this
reduces aggregate demand (and hence income).
• We can see that the larger the value of the multiplier
and the larger the responsiveness of investment to
changes in the rate of interest (i.e. 'b'), the lower is the
slope (the flatter is the IS curve). If investment is very
sensitive (large b), then a given change in the rate of
interest produces a large change in aggregate demand,
shifting the AD in Fig. 5.7 (a) by a larger amount than
otherwise.
• As a result, income too will rise by a large amount.
Since a given change in the interest rate produces a
large increase in income, the IS curve must be very flat.
• Conversely, if b is small (investment less sensitive to i),
then the IS curve is relatively steep.
• The multiplier too affects the steepness of the
IS curve. The larger the multiplier (i.e. the
larger the marginal propensity to consume), the
flatter the IS curve. In this case, a given fall in
the interest rate will lead to a large increase in
income, and therefore the IS curve will be flat.
The multiplier also depends on the tax rate (t);
therefore the fiscal policy can affect the slope
of the IS curve. For example, an increase in the
tax rate lowers the multiplier, making IS curve
steeper.
Shifts of IS Curves
• The IS curve the curve will shift when there is
a change in autonomous spending. For
instance, an increase in government
expenditure by increasing A will shift the IS
curve to the right.
• This means that for any given rate of interest
the income required for goods market
equilibrium must be higher.
 Money Market Equilibrium and the
LM Curve
• Today we have briefly talked about how the stock of money serves
as the basis of aggregate demand in our discussion of the classical
macroeconomic model.
• However, in the extended Keynesian models that followed, we have
been deliberately silent about the role of money in influencing the
level of aggregate demand and hence the level of income.
• In the previous lesson we have found that the rate of interest is
an important influence on aggregate demand through its effect
on planned investment.
• We do not yet know how the rate of interest is determined. For
this explanation we must turn our attention to the money market and
money market equilibrium. However, by doing this we will proceed
only a step forward towards our goal.
• For we will see that the money market equilibrium represented
by the LM curve does not give us a unique (determinate) rate of
interest; each interest rate is associated with a given level of real
income.
The Asset Market
• Money is a financial asset. As such the money
market is a part of the overall assets market in
which money, bonds, stocks and other real
assets are traded.
• However, it is convenient analytically to divide
assets into two groups-money and other assets.
The other assets are marketable claims to
future income for which we shall use the catch
-all term bonds.
Portfolio Decisions
• An individual has to decide how much of his or her financial wealth
at a given time is to be held in bonds or in money. The distribution
of a given amount of wealth between money and bonds is in fact, the
result of one and the same decision.
• For example, if you have $1000 in financial wealth and decide to
hold $800 in bond, you in fact have decided to hold $200 in money.
Likewise your decision to hold $200 in money is equivalent to a
decision to hold $800 in bonds.
• Decisions with respect to the distribution of financial wealth
between money and bonds are known as portfolio decisions. The
fact that the value of bonds and money must add up to the total
financial wealth is known as the wealth budget constraint faced by
the wealth holder. And because of this constraint we can assert that
when the money market is in equilibrium, so is the bond market.
• This greatly simplifies analysis, because we can talk of equilibrium
in the asset market by concentrating only on equilibrium in the
money market (or the bond market). Here we adopt the money
market equilibrium approach.
The Money Market : Demand and Supply
• The supply of money is determined by the central bank
(the monetary authority) of the country concerned. The
considerations which are taken into account in setting
the quantity of money by the central bank need not
detain us here.
• We will simply assume that the supply of money is
given at the level ˉM . Since we assume, as before, a
given price level, ˉ P , the real money supply becomes
ˉ M/ ˉ P
• On the demand side, the first thing to note is that the
demand for money is demand for real balances. People
hold money to make purchases. For any given volume
of purchases the nominal amount of money required
to be held varies with the price level.
• For example, to purchase two computer desks
at $100 a piece, you need to hold $200; but if
the price goes up to $200, you must hold $400
to make the same purchases. In each case, your
demand for real balances (M/P) is the same,
but the nominal demand is not.
• Secondly, the demand for money depends on the level of
real income and the interest rate. The higher the real
income, the higher is the demand for real balances. The
volume of purchases goes up with the level of real income,
and so must the demand for real balances. The relationship
between the demand for real balances and the rate of
interest is slightly more tricky. We know that money held
in cash yields no income. Therefore, holding money has an
opportunity cost in terms of income forgone.
• Suppose that for $100 we can buy a bond and earn an
income of $5 per annum. But if you keep $100 in cash you
sacrifice the opportunity of earning $5 for the convenience
of holding cash.
• The higher the interest rate, the higher is the cost, and hence
the lower your demand for cash, because you will try harder
than before to economize on your cash holding. This
makes the demand for real balances an inverse function
of the rate of interest.
• Now if the demand for real balances increase
with the level of real income and decrease with
the rate of interest, we can write the demand
function for money as
L = kY - hi (k,h > 0) … … …… … … (1)
where k and h are parameters showing the
sensitivity of the demand for real balances and
interest rate respectively.
For instance, if h = 2 and the interest rate rises by
one percentage point the real demand for money
will fall by 2 real dollars.
Determination of the Interest Rate for Given Real Income
• In Fig. 5.9 we have drawn demand curves for money as
downward slopping lines, their absolute slope being 'h' in
accordance with the demand function given in relation (1).
• The position of the curves is defined by the level of real
income, given the value of 'h'. The higher the levels of real
income, the further out the L- curves from the origin.
• We have drawn two demand curves in Fig. 5.9
corresponding to two levels of real income, Yo and Y1,
where Y1>Yo.
• In the same figure, the supply of real balances has been
shown as a vertical line, because of our assumption that the
supply of money ˉ M is exogenously given by the monetary
authority and that the price level is fixed at P . If the
demand for money is given by Lo (Yo), the money market
clears (supply equals demand), if the rate of interest is io.
• In other words if the level of real income and the
rate of interest are respectively Yo and io,
equilibrium prevails in the money market.
However, this is not the only combination of
interest rate and income which ensures money
market equilibrium.
• To see why assume that the demand curve Lo (Yo)
shifts upwards to L1 (Y1) when the real income
rises from Yo to Y1. The excess demand for
money that results at the original interest rate (io)
will push the interest rate up to i1 so that the
money market is again in equilibrium for Y=Y1
and i=i1.
• In Fig.5.10, these two combinations of i and Y
have been plotted in the i-Y space as points Eo
and E1.
• From Fig.5.9 we can see that for money market
equilibrium higher real incomes requires (are
associated with) higher interest rates.
• Repeating the procedure for all possible levels of
income and recording the relevant (i,Y) pairs, we
can trace out the curve labeled LM in Fig.5.10.
• The LM curve shows all combinations of the rate
of interest and the level of income such that the
money market is in equilibrium.
• The LM curve is positively sloped. Starting
with an equilibrium (a point on the LM curve)
when the rate of interest goes up, the demand
for real balances falls, and to compensate for
this fall, the level of real income must rise
sufficiently to restore equilibrium.
• Therefore, for money market to be in
equilibrium, the higher the interest rate the
higher must be the level of income. We can
quite simply drive the equation of the LM
curve algebraically. Money market equilibrium
requires that
• The slope of the LM curve varies positively
with the income sensitivity of demand for
money and inversely with the interest
sensitivity.
• The LM curve shifts to the right when the real
money supply goes up.
• For points to the right of the LM curve there is
excess demand for money, while those to the
left represent excess supply
• As an illustration compared point E0 with point
E1 in Fig.5.11.
• Eo represents money market equilibrium
(being on the LM curve), while E1 does not
(being off the LM curve).
• The higher income at E1 means that the
demand for money is larger at E1 than at E0,
because i = io in both cases, since the real
money supply is unchanged, there must be an
excess demand for money at E1.
Fiscal and Monetary Policies in the AD
-AS Framework
After studying this lesson, you will be able to
• see how simultaneous equilibrium in goods and money
markets is necessary to determine a unique level of
income and the rate of interest.
• understand what the aggregate demand curve for the
economy shows and how it is derived.
• have an educated guess about why the aggregate supply
curve usually is positively sloped and why it becomes
steeper as the actual output approaches the potential level.
• see how both the output and price levels are jointly
determined in the AD-AS framework.
• understand how the tools of fiscal and monetary policies
are employed to fight unemployment and inflation.
 Fiscal and Monetary Policies in AD-AD
Framework
• In previous lecture, we have described how the goods and money
markets achieve equilibrium in isolation, assuming as in the simple
Keynesian model, that the price level is fixed. The assumption of a
fixed price level (which is later relaxed) implies that the level of output
is demand driven. If we know what the aggregate demand is in
equilibrium, we also know what the equilibrium output and income is,
because the aggregate supply adjusts passively (and completely) to the
level of aggregate demand.
• However, as we have seen, the introduction of the rate of interest as a
determinant of aggregate demand makes equilibrium output
determination a little more complicated. Considering the goods market
equilibrium and money market equilibrium separately is inadequate for
determinate outcomes. To determine the unique level of equilibrium
income and the rate of interest, equilibrium in both the markets must be
addressed simultaneously.
General Equilibrium: Goods and Money Markets
• Simultaneous equilibrium in the goods and money
markets is achieved when the level of income and the
rate of interest are such that both markets clear.
• In Fig.5.12 this condition is satisfied when i=io and
Y=Yo, given the exogenous variables such as the real
money supply and the fiscal policy (which define the
position of the IS and LM curves). These values of i
and Y correspond to the intersection of IS and LM
curves at Eo. It is clear that given these curves, (io, Yo)
is the only pair at which both the goods market and the
money market are in equilibrium.
• All other combinations will represent disequilibrium in
either or both markets.
• For example, the combination represented by E1 (i1, Y1)
clears the goods market (it is on IS), but not the money
market, where there is excess supply of money.
• On the other hand, at point E2 (i1, Y2), we have money
market equilibrium (it is on LM), but disequilibrium in the
goods market where there is an excess supply.
• We can also have disequilibrium in both markets. E3 (i1, Yo)
represents such a possibility; in this case, there is excess
supply in the goods as well as the money market.
• Given the IS and LM curves, if i≠io and Y≠Yo, forces will
be set up to move them towards (io, Yo), though the path of
adjustment towards equilibrium may be different depending
on circumstances assumed.
The Aggregate Demand
• As we have mentioned before, the AD curve
shows the levels of output demanded at various
prices such that for each price goods and asset
markets are simultaneously in equilibrium. For
example, suppose that the price level assumed
constant while drawing the LM curve in Figure
5.12 is P0. Then the equilibrium output Y0
demanded (i.e. planned expenditure) at this price
level (P0) is consistent with simultaneous
equilibrium is goods and money markets.
The Aggregate Demand Curve
• Recall that the LM curve shifts when the real
money supply (M/ P ) changes. The real money
supply changes with changes in the nominal
money supply (M) or in the price level (P).
• In Figure 5.13 (a), the money market equilibrium
shown by LM0 is drawn for P = P0, so that given
the goods market equilibrium shown by the IS
curve, the simultaneous equilibrium in goods and
money market is given by the interest-income pair
(i0, Y0). This equilibrium corresponds to the price
income combination (P0,Y0). In Figure 5.13(b),
this pair is shown in P-Y space as point E0. This is
obviously a point on the aggregate demand curve.
• Now suppose that the price level falls from P0 to P1, while the
money supply remains fixed at M. The resulting increase in real
money supply (now M/P1) shifts the LM curve in Fig. 5.13(a) to
LM1, yielding a new equilibrium income (= expenditure) of Y1.
• Since Y1 corresponds to P1 (<P0), we have another point on the AD
curve, shown as point E2 in Fig 5.13(b). By doing the same exercise
of changing price and finding corresponding income (and
expenditure) levels, we can trace out a downward sloping curve AD,
as shown in Fig. 5.13(b).
• This is the aggregate demand curve we are seeking which shows the
various combinations of price and income consistent with
simultaneous equilibrium in money and goods markets.
• The AD curve is negatively sloped. Let us see why. When the
price level falls (and hence the real money supply goes up), an
excess supply of money develops in the money market at the
original interest rate. For the market to clear, the rate of interest has
to fall. The lower interest rate then leads to higher investment and
higher output via the multiplier.
• What factors determine the slope of the AD curve? Not
surprisingly, these are none other than those determining the slopes
of IS and LM curves, because AD is derived from these very curves.
You can easily convince yourself that
1. The larger the interest responsiveness of the demand for money (h)
and the smaller the interest sensitivity of investment demand (b), the
steeper is the AD curve.
2. The smaller the multiplier (α) and the larger the income
responsiveness of the demand for money (k) the steeper the AD curve.
• It can be easily established that an expansionary fiscal policy by
shifting the IS curve to the right can shift the AD curve in the same
direction, because given the LM curve (and hence the price level),
the equilibrium output demanded will be higher at that price level.
An expansionary monetary policy (i.e. increasing the supply of
money) can lead to the same effect. When the money supply goes up
with the price level remaining unchanged, the real money stock goes
up. As a result, the equilibrium output demanded goes up at the
given price level. This of course means that the whole AD curve
shifts rightward.
The Aggregate Supply Curve
• In Figure 5.14, we have drawn an AS curve
with a positive slope indicating that only at
higher and higher prices will the firms supply
larger and larger amounts of output.
• The reason is that as the amount of output produced goes
up, inputs become scarcer and costlier, raising the unit costs
of production. If the price level is unchanged, profit per unit
(the difference between price and unit cost) will fall and
production will be less attractive. Therefore, to restore
profitability prices have to be raised as output goes up.
• When the output is low and the inputs are plentiful, more
output can be supplied with modest increases in prices. But
as the capacity output, Yp (also called the potential output)
is approached each unit increase in output requires larger
and larger increase in prices, because per unit costs rise
rapidly. Incidentally, the potential output is the highest
output level which the economy is capable of producing
given labor and other resources and technological
knowledge. All this explains why the aggregate supply
curve AS that we have drawn in Figure 5.14 is relatively flat
at lower output levels and steep at higher levels of output.
The Complete AD-AS Model: Fiscal and Monetary
Policies
• Figure 5.15 is intended to show how the price level and
the level of output are determined by the interaction of
forces acting on the demand and supply sides of the
economy. Given the aggregate demand schedule AD0
and the aggregate supply schedule AS in Figure 5.15,
the equilibrium output level is Y0 and the price level is
P0. The vertical line, Yp shows the potential output
which in the situation depicted is higher than the actual
output (supplied and demanded). The output-gap
measured by Yp-Y0 is known as the recessionary gap.
The existence of this gap implies that some of the
resources including labor are involuntarily unemployed.
• Unemployment being socially wasteful and undesirable, the government can
come forward to combat it with tools of fiscal and monetary policies (supply
management is ignored here as a possibility). Clearly the actual output (Y0) is
lower than the potential output (Yp), because the aggregate demand is not high
enough to encourage firms to employ all available resources for production.
• In other words, the cause of the malady is a deficiency of aggregate demand,
and in terms of demand management, expansionary fiscal policy (lowering
taxes or raising government expenditures) or expansionary monetary policy
(increasing the money supply) can make up for the slack.
• In terms of Fig.5.15, these policies can shift the aggregate demand to the level
shown by AD1 so that the output gap (and the corresponding unemployment) is
eliminated.
• Notice that the output expansion is also accompanied by a rise in the price level,
which in itself may be a source of concern if inflation is already high. On the
other hand, when inflation threatens because the aggregate demand is too high,
the authority can resort to contractionary monetary policy (lowering money
supply) or contractionary fiscal policy (lowering government expenditures or
raising taxes). These are known as demand management policies because these
are used to set the aggregate demand at the desired level.
• Since both the fiscal and the monetary policy can be
deployed for demand management, one can ask which one
should be preferred and when. There is, unfortunately no
straightforward answer to this question, because in any
concrete situation the decision has to depend on a set of
complex issues including what are known as lags in
recognition, action and effectiveness of these policies.
• Moreover, the authority has the option of using both
monetary and fiscal policies in different combinations,
known as fiscal-monetary mix. By varying the mix of
policies the authority can move the compositions of output
in the desired direction. For example, an expansionary
monetary policy will stimulate investment, while an
expansionary fiscal policy will stimulate consumption (and
production of consumption goods).
 Model Questions
• Mention of some of the assumptions underlying the
Keynesian multiplier model. Why are these assumptions
made?
• How can a government fight unemployment and inflation
through its fiscal policy? Explain.
• Explain why the value of the multiplier is smaller in the
presence of proportional taxes.
• Explain how the paradox of thrift arises and when it is valid.
• Explain diagrammatically how an increase in government
purchases can raise income and output.
• "What an increase in government expenditure can do in the
fight against inflation can be done equally well by tax
reductions." Do you agree? Give reasons for your answer.
• "Although both the interest sensitivity of investment spending (b)
and the MPC (via the multiplier, α) determine the slope of the IS
curve, a necessary condition for a negatively sloped IS curve is that
the value of b>0." Explain.
• When would you expect the IS curve to be vertical? Explain
diagrammatically.
• Given that b>0, the greater the value of the multiplier (α), the flatter
the IS curve. Why?
• Which way is the IS curve expected to shift if there is an increase in
autonomous investment? Explain.
• What does the IS curve show? Why is it usually negatively sloped?
Give reasons for your answer.
• What are the determinants of the slope of the IS curve? What change
would you expect in the slope of the IS curve, if investment
becomes more responsive to the rate of interest?
• Explain why the points off the IS curve represent disequilibrium in
the goods market.
• Why is the demand for money a demand for real balances?
• Explain why the demand for money varies inversely with
the rate of interest.
• Why is the LM curve positively sloped?
• How is the interest sensitivity of the demand for money
related to the slope of the LM curve?
• What happens to the position of the LM curve when the
supply of money goes up with the price level constant?
• What does the LM curve represent? Explain how this curve
can he geometrically derived.
• "At points to the right of the LM curve, there is an excess
demand for money, and at points to the left, there is excess
supply of money." Explain with reasons.
• Under what circumstances might the LM curve be
horizontal? Explain intuitively.
• What factors determine the slope of the AD curve? How is the slope
of the AD curve related to the effectiveness of expansionary
monetary or fiscal policies? Examine diagrammatically.
• What determines the effect of an increase in money supply on
equilibrium income? Explain.
• If the authority is interested to expand output, but does not want the
interest rate to rise, what fiscal-monetary policy mix would you
recommend and why?
• Why is it said that the authority can change the composition of
output by appropriate changes in monetary-fiscal policy mix?
• Diagrammatically explain how the simultaneous equilibrium in
goods and asset markets leads to determinate income level and the
rate of interest.
• What does the aggregate demand curve show? How is it derived?
• Explain with the help of diagram how fiscal and monetary policies
can be used to fight unemployment and inflation.
Aggregate Supply
& Business
Cycles

Chapter-6
 Short-Run & Long-Ran Aggregate
Supply Curve
After studying this lesson, you will be able to
• see what the aggregate supply curve shows
• understand why distinguishing between short-run
and long-run aggregate supply is of crucial
importance.
• realize why the short-run aggregate supply is
positively sloped, while the long run aggregate
supply curve is vertical.
• appreciate why some macroeconomists claim that
even the short-run supply curve is vertical.
Short Run and Long-Run Aggregate Supply Curves
• In our discussions so far, we concentrated most of our
attention on the derivation of the aggregate demand
curve. In chapter 5, we introduced the aggregate supply
with a few brief comments.
• This should not give the impression that the aggregate
supply is perhaps less important than aggregate demand
in macroeconomic analysis. This is far from true. Over
the last quarter century. i.e. economists have come
round to the view that aggregate supply is critical to
understanding how the macro economy evolves over
time.
• In modern macroeconomics, the distinction between the
short run and the long run aggregate supply is crucial.
• In the short run, the aggregate supply together with aggregate
demand can explain the ups and downs in output in the
economy. But in the long run (a decade or more, perhaps),
economic growth or rising living standard is unthinkable
without increases in the aggregate supply. Therefore, the
question “How steep is the aggregate supply curve” is the
main controversy in modern macroeconomics.
• In the long run, as we will see, the aggregate supply curve is
vertical, though economists may disagree on the time span
which should be designated as the long run. The long run
output is then determined by aggregate supply alone, while the
price level depends both on aggregate demand and aggregate
supply.
• By contrast, both the price level and the output level are
determined in the shot-run by aggregate demand and aggregate
supply, because the aggregate supply curve is positively sloped.
Moreover, the magnitude of the slope of the aggregate supply
curve determines how a given expansion (or contraction) in
aggregate demand is split into short-run price and output
changes.
The Short-Run Aggregate Supply Curve
• Generally speaking, the aggregate supply curve
describes the behavior of the production side of
the economy. The aggregate supply curve shows
for each possible price the quantity of goods and
services that the firms in the economy will be
ready to produce, other things equal.
• In the shout-run, the higher the price level, the
larger is the amount of output supplied (other
thing being equal). In other words, the short-run
aggregate supply curve is upward sloping for a
considerable range of output.
• A typical upward sloping short-run aggregate supply curve
is shown in Figure 6.1. It is easy to see why the curve slopes
upward. The firms are motivated to produce by the prospect
of profits. But the profit to be had from a unit of output
produced is given by the difference between the price at
which it can be sold and its average cost of production. That
is
per unit profit = price - unit cost.
• Therefore, what happens to the unit profit as the price level
rises depends on how the unit cost responds to output
expansion.
• If the unit cost lags behind the price rise, firms will be
encouraged to increase output. Are there reasons to suppose
that this is what is likely to happen in the short-run? The
answer is yes, because labor and some other inputs used by
firms can be obtained at relatively fixed prices for some
period of time (though not for ever).
• For instance, many firms employ workers on the basis of
long term contracts (ranging from one to three years) which
specify money wage rates for the period (with partial
adjustments for price changes in the mean time).
• Even where there are no labor unions and hence no such
labor contracts, it is quite rare for wages to be raised more
than once a year. This inflexibility of wage costs to changes
in market conditions is of some importance for firms
because labor costs constitute quite a significant proportion
of total costs. What is true for labor costs is often true for
some other inputs (such as raw materials and components)
which are also purchased on the basis of long-term
contracts.
• Moreover, some input prices fixed by the government are
slow to change. Examples are the prices for electricity, gas,
water and telephone services. Of course, none of these
contracts or fixed prices last for ever; but many of them last
long enough to allow unit costs to lag behind the price level.
• Now if the selling prices rise (due to changes in market
conditions, e.g. shifts in demand) while wages and
other input costs remain relatively fixed, per unit profit
goes up, and firms will be keen to step up production.
The opposite happens when the price level falls: the
profit margin is reduced and firms respond by cutting
back on production. This type of behavioral response
from firms makes the short-run aggregate supply
curve upward sloping.
• To summarize, the reason why the short run
aggregate supply curve is positively sloped is that in
the short run labor and other input costs are fixed (or, at
any rate, do not rise as fast as the price level) so that
higher prices mean higher profit margins and, therefore,
higher production.
• One more comment about the shape of the short run aggregate
supply function is in order. Look at the particular curvature with
which we have drawn the aggregate supply curve in Figure 6.1. It is
flat at low levels of output and gets progressively steeper at
higher output levels.
• At low levels of output capacity utilization is low and lots of
resources are unutilized. In this situation, if there is an increase in
demand, firms can increase output by raising prices modestly,
because unit costs are expected to rise slowly.
• The aggregate supply curve is therefore, relatively flat. By contrast,
when the economy is booming and demand is very strong, the
economy has very little capacity or other resources. Here attempts to
acquire more resources for additional production will cause the unit
cost to rise more sharply than before.
• Therefore, prices have to rise in a commensurate fashion. On the
demand side too, high prices are unlikely to be aggressively fought
by consumers because of the prevailing high wages. Therefore, the
slope of the shot-run aggregate supply function (which reflects the
response of costs to output expansion) generally rises as the degree
of resource utilization increases.
Shifts in the aggregate Supply Curve
• The aggregate supply curve shifts whenever the factors (the
“other things”) that determine its position change. What are
these factors?
• One set of factors is obviously the input prices (prices of
raw materials, energy, labor and so on). If any of these
prices goes up, the unit cost will rise, and therefore, the
supply curve will shift upward, implying that the same level
of output will be supplied at higher prices. Conversely,
lower input prices will move the aggregate supply curve in
the opposite dissection, allowing the firms to supply given
amount of output at lower prices than before.
• Another factor that impinges on the unit cost of production
and, therefore, on the position of the aggregate supply
curve, is the state of technology. For example, a
technological breakthrough increases the productivity of
labor (or of capital) and tends to reduce per unit cost. When
this happens, the aggregate supply curve shifts downward.
• Finally, the most obvious factor should not
escape our notice; the availability of labor
and capital. The larger the size of the labor
force or of the stock of capital, the greater is
the economy’s capacity to produce, and the
further out the aggregate supply curve will be
from the origin. Therefore, as the labor force
grows over time and the stock of capital
increases through investment, the aggregate
supply curve will shift outward, and the
economy will be able to supply more output at
any given price level than before.
Long-Run Aggregate Supply curve
• The short-run inflexibility of some components of cost
vanishes in the long run. Wage contracts, rent agreements,
regulated prices-all become variable and subject to negotiation
in the long-run. Labor unions, for example, see that their real
wages have in the mean time been eroded by inflation; they
will insist on compensation through higher money wages. If
the general price level goes up say, by 10%, all elements of
cost (wages, rents, regulated prices etc) will ultimately rise by
10%. That is, the unit costs rise in proportion to the rise in
the price level.
• In this scenario, firms will be unable to profit from higher
levels of aggregate demand. In the long run, when all elements
of costs have fully adjusted to higher prices, the equilibrium
output will get back to the potential level (Yp). Therefore, in
the long run, the aggregate supply curve is vertical at the
level of potential output (corresponding to the natural rate of
unemployment) as shown in Fig-6.2.
• This curve can, of course, shift to the right as the potential
output grows over time owing to accumulation of capital,
growth of the labor force, or improvement in technology.
• Incidentally, note that some macroeconomists claim that the
aggregate supply curve is vertical even in the short run.
Their agreement is that people anticipate inflation and do so
correctly. Therefore, in negotiating long-term wage
contracts they allow for price changes. As a result, the very
basis for short run output response to higher prices
disappears, and the aggregate supply curve becomes.
• In this case, expansionary fiscal or monetary policy cannot
reduce unemployment even in the short run. Most
economists, however, disagree with this position and stick
to the view that in the short run higher prices can bring forth
higher output (i.e. the short run aggregate supply curve is
positively sloped).
 Business Cycles : Genesis and
Features
After studying this lesson, you will be able to
• know what the natural rate of unemployment
is;
• know that real output does not grow smoothly
along the trend path;
• understand why the real output fluctuates
around the trend giving rise to business cycles;
• see what the different phases of the business
cycles are and how they are related.
• From our discussion in the previous lesson, we know that the aggregate
supply in the long run equals the potential output. The potential output, it
may be recalled, is the level of output which the fully employed labor force
of a country can produce in a given period.
• The term full-employment is used here in the economic, not physical,
sense. At any time, some people will be in-between jobs, quitting some and
looking for others. When the members of the labor force other than these
people find job at the existing rate of remuneration, they are treated as
employed.
• In the economic sense, then, full employment exists when those who want
to be employed at the going wage rate are employed. This definition of full
employment allows for unemployment of those between jobs. These people
make up the group known as the frictionally unemployed. The rate of
unemployment corresponding to this situation is also call the natural rate
of unemployment (or full employment rate of unemployment!).
• The actual rate, can of course, fall short of, or exceed, the natural rate,
depending on circumstances in the market. When the economy is booming,
demand is high and business expectation cheerful, the actual rate may be
less than the natural rate of unemployment (and the actual output exceeds
the potential level). On the other hand, when the demand is weak and
business optimism is ebbing, the actual rate of unemployment may exceed
the nature rate (and actual output is below the potential output).
• The potential output can grow over time, as
mentioned earlier, if a nation’s labor force grows,
capital stocks increase though investment and
technological improvements take place.
• In Fig 6.3 curve shows the trend path of real
(potential) output over-time. Unfortunately,
factors are not fully employed, and output is not
at the potential level, all the time, no matter how
much we long for stable, steady growth. Actual
output fluctuates, instead, around the trend level.
• The reasons for these fluctuations are complex but the
basic mechanism can be illustrated with the help of the
tools of aggregate supply and aggregate demand.
• Consider Fig-6.4 which depicts how the equilibrium
price-output combination is determined in the AD-AS
framework. In panel (a), the levels of AD and AS are
such that the equilibrium output is at the potential level,
Yp. Now suppose that for some reasons (say, a drop in
real exports), ADo falls to AD1, causing the output
level to fall from the potential level (Yp) to Y1 which
corresponds to a rate of unemployment higher than the
natural rate. On the other hand, if AD surges ahead
(say, because of an exogenous growth in real exports),
the aggregate demand curve shifts to AD2, raising the
real output to Y2. As a result, unemployment falls
below the natural rate.
• Fluctuations in output and employment can equally come from
the supply side, as illustrated in Fig. 6.4(b), where as a result of
a leftward shift of the aggregate supply curve, the actual output
goes down from the potential level Yp to Y1, causing
unemployment rate to go above the natural rate. This is a case
of an unfavorable supply shock, arising from, say, a rise in
the price of an important input like energy, or a crop
failure. The supply shock may be favorable too, as in the case
of a bumper crop, or a substantial fall in important input prices.
In this latter case, the actual output will overshoot the potential
level, and unemployment will fall below the natural rate.
• In short, actual output can fluctuate around the trend because
of shifts in demand and supply conditions. These fluctuations
generate what are known as business cycles, and through
these cycles are tied together inflation, unemployment and
growth experienced by an economy. More formally, business
cycles are irregular, but readily identifiable, patterns of
expansions and contractions in economic activity around the
path of trend growth.
Features of the Business Cycle
• The patterns of business cycles are irregular,
and no two business cycles are quite the same.
You may wonder why they are called ‘cycles’
at all. Irregular though they are, the business
cycles have a family resemblance, exhibiting
some identifiable phases, as shown in Figure-
6.5.
• Identifying a business cycle may conveniently begin with a
definition of a recession.
• A recession refers to a situation in which the economic
activity is declining.
• During a recession consumer purchases decline sharply.
As a result, inventories accumulate unexpectedly, especially
in those industries which produce consumer durables like
automobiles, television sets and washing machines. If
consumers face financial difficulties or, are pessimistic
about their future incomes, they can easily postpone
purchases of these goods. When a recession hits the
economy, business profits drop, and as firms cut back on
production in the face of accumulating inventories, real
GDP falls. But with the fall in real GDP, incomes of
workers fall which in run leads to further fall in consumer
purchases. Businesses respond by reducing investment in
plant and equipment. Unemployment mounts, and inflation
slows down. The recession ends with the trough, which is
the time when the economic activity is at its lowest.
• The recessionary phase is followed by a period of
expansion (also called recovery). Output increases, and
profits, employment, wages, prices and interest rates tend to
rise in general.
• In summary, business cycles show that actual output does
not grow smoothly along the trend; it fluctuates irregularly
around the trend. From the peak, the actual output falls to
trough via recession, and then to another peak through
recovery, only to nosedive into another recession and so on.
Note carefully from Figure-6.5 that output movements are
irregular with respect to both time and size. For instance,
the duration of recession (1) in Figure-6.5 is larger than
those of recession (2) and recession (3). Similarly, the
periods of recovery during expansion are unequal. On the
other hand, the depths of recessions are not the same, nor
are the heights of expansion. It is also important to note that
the recovery may be incomplete i.e. the recovery may hit a
peak before it reaches the potential output (see Figure
6.5, peak 2 which is below the potential line).
 Model Questions
• Explain why a distinction between the short run and the long run
aggregate supply curve is important in macroeconomic analysis.
• What determines the slope of the short run aggregate supply
curve? How is it related to the degree of resource utilization?
• “According to some economists, even the short-run aggregate
supply curve is likely to the vertical” How do they justify this
position?
• What factors determine the position of the short-run aggregate
supply function? Discuss each of them briefly.
• Why is the long run aggregate supply function vertical at the
potential output level? When and why will it shift to the right?
What is the implication of a vertical AS for demand management
policies?
• What is the natural rate of unemployment?
How is it related to the potential level of
output?
• What are the business cycles? Try to guess
why no two cycles are similar.
• In what sense, a recovery can be incomplete?
Can you guess why? Attempt a general
explanation of why real output does not grow
smoothly along the trend path.
• What are the different phases of business
cycles? Discuss their characteristics.
Unemployment

Chapter-7
Problems, Significance and Measures
of Unemployment
After reading this lesson you should understand and
know the answers to the following questions:
• How persistent is the problem of unemployment?
• How pervasive are the effects of unemployment?
• How are official employment and unemployment
figures obtained?
• What are the flaws of the methods of
measurement used?
Problems of unemployment and its significance
• Some amount of unemployment is inevitable in any economy, however
efficient the economy is. Unemployment beyond this inevitable level,
tolerable or intolerable, is a problem which is experienced by all the
countries irrespective of their stage of development. Unemployment may
some time imply not only the under-utilization of labor force but also
under-utilization of other factors of production and low level of output
too. Unemployment, if it is a prolonged one, brings great misery for the
victim. It also entails huge social cost to the extent that the whole social
fabric may be endangered. Though high rate of unemployment as
experienced during the great depression is less likely to occur at present in
advanced market economies, whenever unemployment rate approaches
double digit figure in such countries, government, political parties,
industrialists and businessmen as well as common men express deep
concern.
• In underdeveloped countries like ours official unemployment figures do not
reflect the gravity of the problem. Production activities in such countries
are carried out under arrangements significantly different from those in
advanced countries. Composition of output in underdeveloped countries is
different from that in developed countries too.
• An appraisal of types, causes and impact of unemployment are essential for
better understanding of the implications of unemployment.
Measures of unemployment
• Total population in a country may be seen as sum of
total labor force and number of persons not in the labor
force.
• Total labor force, on the other hand, includes civilians
employed, armed forces involuntarily and unemployed
people.
• Unemployment rate for civilian population is obtained
by using the following expression.
Unemployment rate (U) = Number of total involuntarily
unemployed (TU)/ Civilian Labor Force (CLF) x 100%
where CLF = Civilian Unemployed and Civilian
Employed Labor Force or Civil Labor Force
The above expression gives unemployment rate for
civilian labor force.
• For Total Labor Force (LF) unemployment rate is given
by U' = TU/LF x 100%. As is obvious U>U'.
• In the above formulation each unemployed person who is seeking a
job in the reference period is assigned equal weight. Duration of
unemployment is not at all considered. All employed persons are
also assigned equal weights though. There are part-time employees
and these may be disguised unemployment among the employed
people. These formulations also ignore the problem suffered by
those who badly need job but are sure that they won't get any
and out of frustration they stop seeking jobs.
• On the other hand a simple reference period for all economic
activities, as is obvious, may exaggerate or under report
unemployment problems as a significant number of jobs are season-
specific.
• A modified measure or rate of unemployment, U" is given by the
following expression:
U" = (TU/LF).t = (LF-TE).t/(LF)
where t is the proportion of total time the unemployed are, on average,
out of work and TE is total employed.
• Some other problems are encountered in measuring the rate of
unemployment for the economy as a whole. How many days a year and how
many hours a day a person has to be engaged in work in order to be
considered to be employed in a year. We may agree about number of days
and number of hours for a particular industry, location and community. But
such number will vary across different sectors, communities and locations.
Rate of unemployment for the economy as a whole also fails to reflect the
following:
• A person fully employed in terms of time criterion may have a very low
level of income too inadequate to meet the basic needs.
• An employed person may not be satisfied with his job because he does not
have a job appropriate to education and skill acquired by him. He may have
neither job satisfaction nor a satisfactory level of income.
• In family-based economic activities in agriculture and cottage industries
work and output are shared by family members. There may arise situations
when some of the workers can be shifted from those activities without
adversely effecting the level of output. The positive relationship between
employment and output apparently does not hold in this case if we do not
adjust employment rate by actual length of time an individual worker work
in a year. As surplus workers leave the activity family members left at home
will have to work longer hours, and or greater number of days a year.
Types of Unemployment
• Firstly we introduce three categories of unemployment: Open or
Visible Unemployment, Hidden Unemployment and Disguised
Unemployment.
• Official unemployment figures published from time to time present
Open or Visible Unemployment figures. Openly unemployed people
make a part of the labor force. They are reported to be looking for
job in the reference period without any luck.
• Hidden unemployment refers to the people who are not even
considered as constituting a part of the labor force by the official
statistics. These people had unsuccessfully searched for jobs for a
pretty long period of time without any success. They become so
frustrated that they subsequently abandoned job search. When the
government conducted the labor force or employment survey, such
people reported that they were not looking for jobs. Such reporting
reflects frustration rather that deliberation.
• More complex is the phenomenon of Disguised
Unemployment. This unemployment occurs in case of
family based enterprises with small amount of land or /
and capital. Family members do all the work. While
work load is shared by all working members of the
family, output is shared by both working and non
working members of the family. There may be instance
(too many family members too little capital and land to
work with) when some of the workers can be
withdrawn from the family work without causing any
decline in level of output. Working members left in the
family farm, will have to work for longer hours a day.
Assuming that they will have to work so many hours
considered as the norm, the number of withdrawn
persons represent Disguised Unemployment equivalent.
• We can also distinguish between two other types of unemployment: Natural
Unemployment and Cyclical Unemployment.
• The latter type of unemployment occurs during recessions. Natural rate of
Unemployment refers to a roughly stable rate of unemployment below which
the actual rate of unemployment seldom dips.
• Natural Unemployment is comprised of Frictional and Structural
Unemployment.
• Structural Unemployment occurs due to mismatch between location and
skill requirements of vacancies and location and skills possessed by the
unemployed persons.
• Frictional Unemployment occurs even if wages are perfectly flexible and
appropriate and adequate number of job opportunities are available in the
locations where unemployed persons live. This type of unemployment occurs
mainly because job search and recruitment of personnel are time consuming
processes.
• Cyclical Unemployment occurs when aggregate demand expressed in money
terms declines and at the same time presence of long term wage and price
contracts prevent the inflation rate from shifting down rapidly enough in
response to slower nominal GNP growth. In this case level of real wage that
prevails is found to be greater than the level necessary to clear the labor
market. At that wage number of persons seeking job exceeds the number the
employers demand giving rise to Involuntary Unemployment.
• Voluntary Unemployment at a particular wage is represented by number of
persons in the work force who are not willing to work at that wage level.
• The last type of unemployment we consider is Seasonal
Unemployment. This type of unemployment occurs due to presence
of some season-specific production activities and uneven spread of
employment opportunities throughout the year. Seasonal
Unemployment may be considered as Natural Unemployment.
Natural Unemployment
• No market economy has ever fully employed its labor force. There
seems to be a minimum level below which the rate of
unemployment seldom dips. This rate of unemployment is called
natural rate of unemployment. When the rate of unemployment
equals the natural rate, the number of people involuntarily
unemployed is equal to number of job positions remaining vacant,
i.e. theoretically speaking there is full employment or equilibrium in
the labor market. If an attempt is made to reduce the rate of
unemployment below the natural rate there would be an upward
pressure on wages. Conversely, if unemployment rate is higher than
the natural rate wages would tend to decline. In the absence of
change of labor productivity rise of wages would lead to rise of
prices, while fall of wages would lead to fall of prices. That is why
natural rate of unemployment is also called Non-Accelerating
Inflation Rate of Unemployment (NAIRU).
Beveridge Curve
• If the vacancy rate is a reasonable measure of excess labour
demand, then the vacancy rate in inversely related to the
rate of unemployment. The inverse relationship between the
vacancy rate and the unemployment is known as the
Beveridge curve.
• In the figure 7.1 below we present a family of Beveridge
curves. Beveridge curve would shift leftward to the origin
as the labour market becomes more efficient in matching
the workers with the jobs. The point of intersection between
the relevant Beveridge curve and a 450 straight line through
the origin shows the natural rate of unemployment
associated with theoretically full employment level of
income.
• As the figure 7.1 shows with a higher level of efficiency
(E2) of labor market natural rate of unemployment rate is
6% while with lower level of efficiency (E0), natural rate of
unemployment rises to 12%.
• As said earlier Natural unemployment is comprised of two
different types of unemployment: (1) Frictional (turnover)
and (2) Structural (mismatch) unemployment.
Frictional Unemployment
• This type of unemployment occurs even if wages are
perfectly flexible and appropriate job opportunities are
available for the unemployed in the same location. In the
real world there will always be some workers who have
retired from or just entering into labor force. Some workers
voluntarily quit their jobs or are suspended, and search
better or similar jobs or are in the midst of the process of
accepting and subsequently joining a new job. Some laid off
workers may get their jobs back in the same firm. Finding
suitable jobs and filling vacancies both time consuming
processes. There will always be some job seekers who are
between jobs. Frictional or Turnover unemployment refers
to the unemployment experienced by those groups of
workers.
Economic Interpretation of Frictional Unemployment
• There may be valid economic reasons why a youngster should
refuse a job offer rather than accept it or why should he quit a job.
Foregone earnings from such jobs may be considered as an
investment for job search. If the return of this investment in the form
of offer of jobs ensuring higher wages for longer period in the future
and better working condition, the investment may appear to them to
be worthwhile. Increase of rate of tax on wage or/and increase in
unemployment benefits have the potential to make the length of
search time longer. Many workers on lay off may not have the
incentive to seriously search new job- they would rather wait to be
recalled to their old jobs. Entry into job search may be lessened by
reducing the reasons behind quitting and re-entry and initial entry
into labor force in order to reduce frictional unemployment.
• Alternatively or simultaneously economic incentives that
unnecessarily prolong the search may be reduced. Providing easy
access to information about appropriate jobs may be useful in both
the options.
Structural Unemployment
• This type of unemployment occurs when
vacancies and unemployment coexist but
locations and skills of the vacancies do not match
with the locations and skills acquired by the
unemployed people. While Turnover or Frictional
unemployment for a group of workers may be of
short duration, Mismatch or Structural
unemployment has much longer duration.
• Unemployed people must know what skill they
must learn or what location they must go for
getting jobs or both. They need to learn new
appropriate skills and or meet necessary expenses
to move to a new location to get a job.
Economic Interpretation of Structural Unemployment
• For the sake of convenience let us assume that there is a mismatch between
the skill requirements of vacant jobs and present skill of currently
unemployed individuals.
• On the other hand, if difference between wages of skilled and unskilled
workers is small, the incentive to acquire skill may be impaired. Ability
to read, write, understand instruction, perform arithmetic is essential for
receiving training. But such education is not provided by industrial
employers. Same is the case with some training which is general in nature.
Due to the public good nature of education and basic skills those have to be
provided solely by the government. Employers cannot reap the full benefit
from such training investment. The employee may quit long before
completion of the training program conducted by the employers.
• When the skills taught are specific to a particular job in a farm, the training
can be financed by paying the employee less than his productivity during
the training period. Sometimes employees choose much older or otherwise
less qualified people for training so that probability of quitting after the
completion of training program is lessened. Private sector provision of
specific skills may turn out to be inadequate as well as inappropriate due to
change of demand of different skills caused by unforeseen expansion or
contraction of the size different industries.
• Besides, there may be a lack of synchronization between
graduation of technical or general students on the one hand
and emergence of vacancies and commencement of
recruitment.

• On the other structural unemployment may also result from

discrimination against a particular sex, race or region.
In certain cases those occur due to long standing customs,
values and social pressure while in some cases there may be
some valid economic reason for employers in
discriminating. Mismatch due to inappropriate location is
mainly caused by the inability of the married people with
children to move from one city (or town) to another city (or
town) especially when both husband and wife work.
• Another reason for such mismatch is simply the fact that the
unemployed persons do not know location of vacant job
positions.
Cyclical Unemployment
• An economy with an unemployment rate above the
natural rate is said to have Cyclical unemployment.
Cyclical unemployment, hence, is the difference
between actual rate of unemployment minus the
natural rate of unemployment.
• This type of unemployment occurs during
recessions. During recession total spending and output
fall, prices keep on falling. Aggregate demand falls
short of aggregate supply in the product market.
• In the labor market too overall demand for labor is low
compared to over all supply. During recession
unemployment does not remain confined to few
economic activities, individuals or groups, rather it
becomes pervasive.
Voluntary and Involuntary Unemployment
• Classical and Neoclassical economists would argue that
in a frictionless economy with perfectly flexible wages
and prices involuntary unemployment is ruled out.
• Figure 7.2 shows demand and supply of labor curves
DL SL and equilibrium money wage OW0 in a perfectly
competitive framework. If there is no friction (an
unrealistic assumption), at OW0 money wage there will
be no involuntary unemployment. Some in the labor
force may remain unemployed at this level of wage,
because they won't work at any wage rate below or
equal to OW0. But they are regarded as voluntarily
unemployed. Voluntary Unemployment at a particular
wage level is number of persons in the labor force who
are not working at the wage level.
• At any wage above OW0 there will be varying level of
unemployment rising with the increase of money wage. At OW1, PQ
level of unemployment, known as involuntary unemployment
emerges. Voluntary unemployment at this level of wage QT.
• At OW2 involuntary unemployment shots up to RS while voluntary
unemployment declines to SV. Involuntary unemployment at a
particular wage level is the number of persons in the labor force
who want to work at that wage level but do not get any work. If
wages are flexible involuntary employment cannot exist but for a
very short period of time as excess supply of labor would drive
wage downward to equilibrium level of wage OW0.
• Frictional employment if it once occurs due to mismatch between
location and skill of vacancies and those of unemployed persons,
would disappear over time if relative wages are flexible.
• In a changing world, however there will be some Frictional
unemployment, as the mismatch could frequently occur. Similarly
some unemployment due to information and search problem would
prevail irrespective of the degree of flexibility of wages.
• Involuntary unemployment except for a vary
short period is ruled out by flexible wage. But
economic history records periods of recessions
when a large number of qualified works are
unable to get jobs at the going wage for a long
period of time.
• Keynes on other hand, opined that labor market
is characterized by downward rigidity of
money wages. When there is a downward shift of
demand for labor for labor consequent on a
decline on aggregate demand for goods and
services, downward rigidity of wage cause
involuntary unemployment (see figure 7.3)
• In figure 7.3 OW0 represent pre recession equilibrium level
of money wage at which full employment occurred. The
equilibrium level of wage is determined by supply and
demand of labor represented by SLO and DLO curves
receptively.
• Equilibrium level of employment was ON0. As recession
sets in aggregate demand for goods and services shifts
downward which causes a downward shift demand of
labor curve to D/L. If money wage fails to move down
ward at all or if it moves downward by a magnitude less
than what is the necessary to bring equality between
demand and supply of labor again in changed
circumstances, involuntary unemployment would emerge.
If money wage level does not fall at all level of involuntary
unemployment would be equal to N2N0.
• At this stage we must explain why money wage fails to fall
from a certain level in spite of the presence of excess
supply of labor at that wage level.
• There are several reasons which are not mutually exclusive
for the downward wage stickiness (or rigidity).
(1) Wages may be kept at a level higher than equilibrium
money wage by employers themselves so that workers find
it costly to shirk and have the incentive to self monitor.
Employees may shirk whenever they are not monitored. If
workers are paid low wages, one may take the risk of shirking
since loss of job following his being caught while shirking
may imply insignificant financial loss. He may have another
job probably with a slightly lower wage level. If, on the other
hand, the wage is set at a high level (above the market clearing
level), the worker won't take the risk of shirking as job loss
will imply a significant financial loss. Besides, low level of
wage induces workers to take part time jobs and or spend time
in searching better jobs. Higher wage would ensure more
attention, time and effort to the work.
(2) Whatever may be the level of unemployment the workers
working in a firm for pretty long period of time, may acquire some
bargaining power. They might have already received some on job
training. At minimum they have learnt about the working condition,
have been familiar with different formalities and procedure practiced in
the firm. If a new man is employed, time and money have to be spent
for him to make him as knowledgeable and efficient as his senior co-
workers. Besides, there are search and retrenchment costs associated
with new recruitment. This reality may often lead to higher wage offer
in the face of wage bargaining rather than dismissal of old workers
even in a situation characterized by excess supply of labor.
3) Lastly, workers and employers may enter into an implicit or explicit
long term contract. There is no scope of reducing the wage level within
the contract period. When the contract period expires there may be
no need to reduce wage as there is pervasive optimism in the
business environment. If employers and workers are risk averse they
will prefer a specific wage rate to a set of wage levels with different
probabilities. So fixed wage level will actually be contracted in workers
–firm negotiations especially if firms are risk neutral.
Costs of Unemployment
Cost of Frictional and Structural unemployment
• In such cases frictional unemployment is unavoidable. In assessing
cost due to this type of unemployment we should consider the
following:
(1) cost arising form loss of output, (2) disutility from doing an
unsatisfactory job, and (3) non utilization or incomplete utilization
of skill, education of actual or potential workers.
• Structural unemployment comprises the rest of natural
unemployment. It occurs as we have learnt due to a mismatch
between the skill and or location requirement of job vacancies and
the present skills and or location of unemployed individuals. This
type of unemployment entails:
(1) Private costs to the individuals: These include lost income and
erosion of job skills and reduction of the probability of getting a
suitable job in the future
(2) Social costs. These include unemployment and welfare benefits to
be paid by the government, costs of additional crimes committed by the
unemployed people as well as costs of illness and even suicide
experienced by the unemployed or his family. If such unemployment is
concentrated in a particular region and or in a particular community the
social harmony may be destroyed.
Cost of Cyclical Unemployment
• Costs of cyclical unemployment include
among others output lost because the
economy is not at full employment and an
unemployment rate greater than the natural
rate of unemployment. The rate of
unemployment in excess of natural rate of
unemployment is found to be positively
associated with actual real GNP relative to
natural real GNP.
• Output declined by a higher percentage during
recession than unemployment rate for the following
reasons:
(1) The loss to the society in terms of wages the
unemployed workers could get and taxes they could pay
as some of the unemployed become discouraged and drop
out of the labor force.
(2) Take home pay of many of the people who are still
employed declines as overtime hours are cut.
(3) Business profits decline sharply as firms are forced
to keep some of the employees (with valuable skill and or
at key positions) even when demands for the product
progressively declines.
(4) As recession continues government revenue receipts
full leading to a fall in government expenditure too.
Labor market in Bangladesh: An overview
Unemployment: Pattern and Trend
• Bangladesh labor market is characterized by a very high rate of labor force
growth, low employment growth rate and declining labor absorption in the
manufacturing sector. Agriculture still remains the major source of
employment while 82% of labor force is engaged in rural sector. Both
agriculture and manufacturing sectors share of employment suffered a decline
over time. The decline in the relative share of agriculture employment was not
matched by an increase in the share of manufacturing employment, as
expected in the development process. The share of non tradable sector spread
across formal and informal economic activities in the urban areas increased
significantly. Male workers still dominate the labor market of Bangladesh. Female-
male ratio in the labor force had risen even during the era preceding the recognition
of some of the activities performed by women as economic activities in 1989. The
ratio however seems to have declined or stagnated to approximately 6:10 in the late
1990s.
• Another important feature of the labor market in Bangladesh is that informal
sector employment provides 87% of total employment in the economy.
Contribution of informal sector to total employment ranges from as high as 97.3%
in agricultural and 43% in manufacturing to as low as 20% in financial and
business services in case of employed male. In case of female employed those
proportion are 98.8%, 65.9% and 26.7% respectively. It may be noted here that
informal sector employment is characterized by low level of income, job insecurity
and absence of fringe benefits, leave, medical facilities etc. Informal sector is a
more important source of employment for female than male labor force.
• Though labor law of this country does not permit
employment of children labor it constitutes more then
10% of the labor force. Most of them are engaged in
informal sector. A significant part of child labor was
displaced form the RMG industries (formal private sector)
during the early 1990s following the enactment of Harkin
Bill in the US senate. Most of these children of poor or
broken families have no honest means of surviving other
than working in the informal sector.
• Visible or open unemployment rate in the economy was
estimated to be 2.3% of labor force in 1981. It dropped to
1.1% in 1986 but rose to 2.5% in 1996. Urban
unemployment rate in 1996 was 4.5% while rural
unemployment rate was estimated to be. 2.1%. Rate of rural
unemployment rate for women is lower than that for men.
The case is reverse for urban areas. While rural
unemployment rate is found to be lower rural sector
experiences significant underemployment.
Wage setting process
• In Bangladesh the movement of real wages (general as well as sectorial
wages) exhibits a slight upward trend with year-to-year fluctuation around
the trend. The behavior of real wages which show some measures of
downward stickiness reflects the wage setting and wage adjustment
mechanisms operating in the economy. In the public sector Wage and
Productivity Commission awards wage structure from time to time.
Minimum Wage Board declares, at irregular intervals, minimum wages for
different activities in the formal sector. In general, minimum wages are
fixed for industries marked by absence of organized labor. In the formal
private sector characterized by organized labor wages are determined by
collective bargaining. However public sector wages work as reference level
in the wage negotiations especially for industries spread over both public
and private sector.
• In the vast private and informal segment of labor market wage is
determined by market forces. For most of the activities/industries in
informal private sector oligopolistic market for labor is found to exist.
Public sector wages are found to have poor link with productivity. Public
sector wages are found to have risen even when the public sector
enterprises had been persistently incurring losses or labor productivity had
fallen. In the formal sector dominated by state owned enterprises a positive
association was found between trade union presence and wage and
employment at the industry level. Such impact has somewhat dampened in
case of employment in the past ten years or so.
Problems of Different Categories of Labour
Force
1. Youth labour force
Youth (aged between 15-17 years) constitute
from one third to two fifth of the labor fore. They
are likely to be more mobile, skilled as well as
educated than those in higher age groups.
Unfortunately the most unemployed in
Bangladesh belong to this age group.
Unemployment rate among this labor force has
increased rather significantly since the mid
1980s.
2. Skilled labor force
During 1985-1994 number of skilled personnel almost doubled. Government
make primary education universal. In recent time incentive in the form of
scholarship and food grant was given to encourage female education.
Government expenditure on education rose up sharply in the last decade and
half or so. The irony is that unemployed skilled and semiskilled workers are
found to coexist with significant number of vacancies in both private and
public sector. This paradoxical outcome can be accounted for by:
(1) Low revenue earning of government and donors pressure led to
retrenchment of redundant labor and staff
(2) Training provided by formal institutions are inappropriate, inadequate
and outdated in a significant number of cases.
(3) Personal attachment to employers gets significant importance during
recruitment Relatives, friends, people coming from the same village or
district from which the employer himself hailed get preference over
others. Such recruits appear to be more trustworthy to the employers and they
can be easily caught if they happen to cheat or commit any crime.
(4) Unskilled workers are given on-the-job training or they simply learn
by doing and seeing. During the learning process unskilled workers are given
wages less their productivity- so that investments in those workers are
automatically financed.
3. Educated Unemployment
Side by side with increase of literacy rate and significant
increase of the number of graduates and post graduates
unemployment rate for persons with education actually
increased during 1983-1984 to 1995-1996. It is interesting
to note that unemployment rate of persons with no
education actuation actually declined. Concentrating on
sex and location specific unemployment rate, it was found
that unemployment rate among educated male has gone
up irrespective of level of education received or place of
residence. Same thing has happened for educated female
who has received education beyond S.S.C level. For
women who received education below S.S.C level
unemployment rate has declined both in urban and rural
areas.
 Model questions
Concepts for review
• Labor Force
• Official Unemployment Rate
• Beveridge Curve
• Visible (Open) Unemployment
• Downward Wage Stickiness
• Hidden Unemployment
• Disguised Unemployment
• Natural Unemployment
• Okun's Law Fictional (Turnover) Unemployment
• Cyclical Unemployment
• Unemployment
• Involuntary Unemployment
• Voluntary Unemployment
• Why does not official figure of unemployment rate truly reflect the
problem of unemployment in Bangladesh?
• Present a brief account of unemployment problem of Bangladesh.
Do you think that low open unemployment rate of Bangladesh is but
a poor indicator of the serious unemployment and underemployment
problem of this country? Why or Why not?
• Show that perfectly flexible wages can reduce, but not eliminate,
both involuntary unemployment and structural unemployment.
• Why do we observe wages higher than market clearing wages?
• Why is educated unemployment rate rising in Bangladesh?
• 'No market economy, however efficient, can get rid of natural
unemployment'. Explain the comment.
• What measures can be taken to reduce frictional unemployment.
• Briefly discuss what can be done to reduce Structural
unemployment rate.
• Why is the problem of Cyclical unemployment more appalling than
that of Structural or Frictional unemployment.
Inflation

Chapter-8
 Definition, Measures and Types of
Inflation
After reading this lesson you should understand
and know the following:
• Ambiguity surrounding the concept of
inflation and a working definition of inflation.
• Different measures of inflation
• Rate of inflation and types of inflation.
What is inflation?
Inflation may be defined as a persistent and
appreciable rise in the general price level with
the following clarifying note:
• 1) most of the prices must have constant rise at
lest over a period of one year, and
• (2) general price level must rise at an annual
rate of 5% or more.
Measures of Inflation
• Rate of inflation in year t may be worked out
using the following expression:
Rate of inflation in year t = (general price level in
year t - general price level in year t-1) x 100.
• A price index is a measure of general price level
and is a weighted average of the prices of a
number of goods and services.
• The most important and frequently used price
indexes are the consumer Price Index (CPI); the
GDP Implicit Deflator and the Producer Price
Index (PPI).
The Producer Price Index
• PPI is similar to CPI in construction. It
however measures the prices of large number
of goods (and not services) at the level of their
first commercial transaction. This index is
widely used by businesses. Prices are either
wholesale prices or farm gate prices. Both CPI
and PPI use fixed quantity weights for prices.
GDP Implicit Deflator
• Unlike the CPI or the PPI, GDP Implicit
Deflator uses variable weights for prices. This
deflator is primarily used to get a measure of
growth of real output over time. This covers
final goods and services and considers all
sectors of the economy. This deflator for a
particular year is obtained by dividing the
nominal GDP of that year by the real GDP of
the same year.
Rate of Inflation and Types of Inflation
• On the basis of annual rate of increase
sustained rises in prices are sometimes called
creeping (less than 5%), walking inflation (5-
10)%, trotting (two digit rates but less than
50%) and galloping or hyper inflation (more
than 50% to 3 or 4 digit rates).
• The following three types of inflation are very
often mentioned.
Moderate Inflation: This denotes single digit annual inflation
rates. Prices rise predictably and people trust money. Long
term contracts are kept in terms of money during moderate
inflation.
Galloping Inflation: This type of inflation denotes two or
three digit percentage annual rise of general price level. When
such inflation occurs for a pretty long time most contracts are
adjusted to price increases or accounts are kept in terms of a
stable foreign currency. Preference for money holding greatly
diminishes. Financial markets wither away as capital flows
abroad. Even then economies experiencing galloping inflation
are found to survive in many instances.
Hyper Inflation: Such inflation denote annual price rise at a
rate of more than 1000%. Real demand for money falls
drastically, relative prices become highly unstable causing
serious distortion. A profound change in income distribution
occurs and a moral and an economic disequilibrium take place.
• Economies are reported to have survived or even prospered
during a period of hyper inflation. An important distinction
in effects in inflation occurs in an economy when it shifts
from unanticipated inflation to anticipated inflation.
• If people had become familiarized to stable general price
level or creeping inflation and then all on a sudden face
double digit inflation, they cannot readily adjust their
behavior in the changed circumstances. Such an inflation is
called Unanticipated Inflation.
• When general price rises and the rate at which it would rise
are anticipated people can better adjust with the process to
mitigate the adverse effects of inflation. Such an inflation is
called Anticipated Inflation.
• Such a phenomenon is observed in societies where prices
keep rising at more or less constant rate for a pretty long
time even though growth rate of prices may be a double
digit number.
 Analysis and Explanation of Inflation
in Different Macro Model
After studying this topic you should understand
and know the following:
• Classical model of inflation.
• Explanation of Cost-push and Demand-pull
inflation.
• Difference between Cost-push and Demand-
pull inflation.
• What is validation of inflation?
Classical Model:
• Treatment of Expectation
Adjustment to rising prices depends on how expectations
are formed by different agents of the economy. So far as
labor market is concerned the employers (business firms)
know for certain what money wages they would pay
during a period. Furthermore, they are assumed to have
more or less perfect knowledge of what would be the
prices of the product since (i) they are the price setters in
case of at least a few foods and services and (ii) they have
better access to information regarding changes in
exogenous variables and price determining process.
Workers, on the other hand, know for certain what money
wages they will be paid but they have to guess what
would be the prices of the product they will purchase
during the period as well as real wage. Labor supply
would be a function of expected real wage.
• Inflation in classical model is a purely
monetary phenomenon characterized by rise
in prices only. Output and employment are
determined solely by real forces in the
classical model.
• Types of Expectations
Apart form the naive expectation formation
process incorporated in classical model there are
two important mechanisms for formation of
expectation. One mechanism is basically
backward-looking and use error-correction
method to make Adaptive Expectation, the
other is forward-looking and use the model and
all the relevant information and is called
rational expectation.
• If ADC keeps shifting rightward period after
period we would have sustained increase in
price and output. Once we reach full
employment output level (i.e. vertical
segment of ASC) further rightward shift of ADC
will only lead to price rise. See figure 8.6.
Demand-Pull and Cost-Push Inflation
• Inflation can be broadly categorized into Demand Pull
Inflation and Cost-Push Inflation. Both types of inflation are
characterized by excess demand.
Demand Pull Inflation
• In AD-AS model a rightward shift of Aggregate Demand
Curve (ADC) unaccompanied by any shift of Aggregate
Supply Curve (ASC) will create excess demand and
generate a tendency of price rise. Changes in the parameters
of exogenous elements associated with IS and LM curve
underlying the ADC may cause such rightward shift of
ADC. For instance any of the following-an increase in
propensity to consume, a decline in tax rate, an increase
in money supply, an increase in propensity to invest and
an increase in government expenditure may increase the
level of aggregate demand at each level of prices.
• A shift of ADC to the right causes excess
demand to the magnitude of YoY1 at old
equilibrium price, Po, Note that ADCo and
ASCo represent the initial aggregate demand
and aggregate supply curve respectively. See
figure 8.7
• The excess demand raises the prices. This
leads to a fall of quantity demanded and a rise
of quantity supplied. The economy
subsequently moves from the equilibrium
point A to the new equilibrium point B.
• Change in Product Market
As excess demand is created price level begins to
move upward. If we assume that right ward shift
of ADC was caused entirely by rightward shift
of IS0 (IS curve in figure 8.7, drawn
corresponding to initial equilibrium price, P0) to
IS1. Such a price rise would not let the economy
move to B with same level of price, P0 but a
higher level of income, Y1. As price rises both
IS1 (P0) and LM (P0) would shift to the left since
an increase in price causes real balance decline
and reduce real net exports. See figure 8.8
Change in Labor Market
• In the labor market price rise causes a rightward shift
of demand for labor curve. Supply of labor curve
shifts leftward due to change in expected price. If rate
of change in actual price exceeds rate change in
expected price both employment and output (we
assume that technology and quality and efficiency of
inputs remain unchanged) would rise. See figures 8.9a
and 8.9b.
• Going back to figure 8.7 we find that as aggregate
demand shifts to the right, the price rise causes
aggregate demand to fall but aggregate supply to rise.
Hence excess demand disappears and a new
equilibrium with a higher price level, P´ as well as a
higher level of output, Y´ is reached.
Cost Push Inflation
• In contrast to Demand-Pull Inflation, Cost Push Inflation
is caused by upward or leftward shift of ASC. Such
upward shift may be the result of the following changes:
(1) labors demand higher wage at the same price for each level
of employment,
2) employers demand higher level of return for same level of
employment,
(3) cost of raw materials and energy goes up.
• Whatever may be the initial reason such leftward shift of
ASC would cause price level to rise while output would
decline. There is however an ambiguity as to the impact on
employment. This impact depends upon the specific reason
causing the leftward shift of ASC. See figure 8.10.
• The analysis that follows concentrates on Cost-Push
Inflation caused by an upward or leftward shift of
supply of labor curve.
• An upward shift of labor supply curve may occur
due to (1) increase of the expected prices level (2)
increased preference for leisure (3) migration (4)
restriction on entry of some segments of population into
work force.
• We assume that labor supply curve has shifted due to
increase of workers' preference for leisure. For same
amount of work or employment they now demand
higher nominal wage. As is obvious, at the initial
equilibrium price (P0) there will be excess demand of
magnitude Y0Y2. See figure 8.10. So price will rice.
• In the labor market due to increased preference
for leisure and consequent leftward shift of labor
supply curve, a new equilibrium could have been
achieved with much lower level of employment
and output, had the price level remained
unchanged (see figures 8.11a and 8.11b).
• As price continues to rise labor demand curve
shifts from DN (P0) to DN (P1) to DN (P2) .... and
supply of labor function is shifted further leftward
from SN (P e0 ) to SN(P e1 ) to SN(P e2 ) ..... .
• Points A, B and C are pre-shift labor market
equilibrium points while R, S and T are post shift
equilibrium points (see figure 8.11a).
Difference between Demand-Pull and Cost-
Push Inflation
• The basic difference between Demand Pull and
Cost Push inflation is that in the former case
both price and output rise and in the latter
case price rises but output falls.
• When demand pull inflation occurs
employment increases. The impact on
employment is however uncertain in case of
Cost Push inflation.
• In practice, it is however very difficult to separate
Demand-Pull from Cost-Push inflation.
• In both the cases excess demand appears at the
beginning. But prices and wages may rise in an
unending sequence, rendering it difficult to know
whether price increased first due to increase in
aggregate demand or price increase followed wage
increase caused by leftward shift of labor supply curve
as well as aggregate supply curve.
• It should be noted here that the above analysis does not,
explain sustained price rise i.e. inflation, rather it
explains why price should rise when aggregate demand
curve shift to the right or aggregate supply curve shifts
to the left and excess demand appears.
There may be sustained price rise in the following
circumstances:
Suppose an economy is in equilibrium at a full employment
level of output and the government is committed to maintain
full employment. (Note that there is natural rate of
unemployment to co-exist with theoretical full employment).
Let there be cost-push inflation caused by leftward shift of
ASC due to autonomous increase in wage-this will cause price
rise and some unemployment too. Government may increase
its expenditure to reduce unemployment. Price will further rise
as labor supply function will again shift to the left to maintain
real wage level. This process called Wage- Price Spiral
repeats itself due to government's commitment to maintain full
employment and workers endeavor to resists decline in real
wage. As is obvious aggregate demand has to continue to
expand to hold the unemployment rate to the level of the
natural rate. In the economics literature this process is known
as Validation of Inflation.
Fully Anticipated Inflation
It should have the following characteristics:
1. Inflation is universally and accurately anticipated;
2. All savings are held in bonds, stocks, or savings accounts
earning nominal interest rate;
3. An inflation of x% raises the market nominal interest rate
for both saving and borrowing by exactly x% and there is no
ceiling on nominal interest rate;
4. Wage and salary contracts as well as pensions are fully
indexed;
5. Tax thresholds, tax brackets, fines and other payments fixed
by law are also indexed;
6. Only real (not nominal) interest income is taxable, and only
the real cost of borrowing is tax deductible;
7. Absolute prices of all goods and services as well as factors
of production rise at the same rate due to inflation so that
relative prices remain unaffected.
• Cost of anticipated inflation in a fully indexed
economy as mentioned above emerge mainly due
to the practice of holding currency (notes and
coins).
• The purchasing power of currency progressively
declines as inflation continues. Since interest is
not paid on currency holdings three effects called
'shoe leather cost', 'inflation tax' and "capital
intensity effects" arise. Besides there are 'menu cos
‘ which arise due to rewriting payments contracts
and changing price tags associated with
indexation.
Shoe Leather Cost: When inflation is fully anticipated in an
indexed economy nominal interest rate will rise at the same
rate as price. People would then keep less real balance and
some money will be transformed into interest earning assets.
By doing so people would face inconvenience of illiquidity
and they would go to financial institutions more frequently to
obtain cash. The time and resource costs of the frequent trips
to such institutions are termed as 'shoe leather cost' of
inflation.
Inflation Tax: When inflation is fully anticipated real income
remain unchanged but real value of cash balance declines
while in case of zero rate of inflation the real value of income
as ell as real balance both remain unchanged. The decline of
real balance has similar effect as imposition of a tax. What we
lose in terms of our command over real resources is gain to the
government. This is called inflation tax. We must compare the
cost with the benefit of this inflation tax which depends on
what government does with its additional command over real
resources.
Capital Intensity Effect: Fall of real worth of
cash balances during inflation encourages people
to shift their money holding to assets with
positive return - causing a substitution of
physical capital for money. The increase in
capital may raise output but it may lead
subsequently to fall of total output due to
diminishing marginal product of capital.
Other Costs and Impact of Inflation
Menu Costs of Inflation: When inflation is fully anticipated,
the sellers are required to re-quote prices frequently. This
involves a cost. The cost would be significant if there is high
inflation rate.
Fiscal Drag or Bracket Drift: If the tax threshold and tax
brackets are not indexed inflation may require some people
who did not pay tax in earlier periods to pay income tax now
although their real income has not changed. Tax rate would
rise during inflation and real tax proceeds would also be
higher. The rise in average tax burden implies that after tax
real income declines.
Impact on Saving Decision: If nominal interest earnings are
taxed, the saving decision is distorted. The decision to save
depends on what would be the real after tax rate. Taxation of
nominal interest earning reduces the after tax real interest
income.
• Unanticipated Inflation
Impact on Investment on Houses
During unanticipated inflation people in order to acquire
houses may borrow from financial institutions and keep the
house under mortgage which is fixed in nominal terms. Capital
value of the house increases but liability and its time frame of
the borrower remains unchanged. This capital gain is at the
expense of creditor, the building society. The savers having
deposits with such societies would lose.
Impact on Consumption
It may be wise to buy a commodity now even through
borrowing. The interest earned on saving may not be enough
to purchase the commodity later. Unanticipated inflation hurts
those who save for their retirement. They would be more
adversely affected if prices of the commodities included in
their bundle of consumption increase at higher rate. There will
also be a shift from private to public sector as government
turns out to be net debtor. Holders of bonds will also suffer.
Income redistribution effect
Wages generally lag behind prices. Wage earning of the workers
who are not organized are likely to suffer most. Pension earners
also suffer. During inflation income is usually shifted form
wage to profit. Output increases along the short run aggregate
supply curve in response to an expansionary policy as long as
workers fail to anticipate inflation and as a consequence wage
falls. But such fall cannot continue as infinitum. Government
may interfere or resistance may grow among workers. If
commodities cannot be exported as their price go up lack of
adequate aggregate demand may put a brake on profit.
Impact on Trade
Inflation, whether anticipated or not, adversely affects balance
of trade. If a certain country experiences inflation while its
trading partners do not, then its export will decline while import
would increase resulting a fall of employment. This effect may
be somewhat offset by a substantial depreciation of the
domestic currency - but this may increase the domestic inflation
rate.
Phillips Curve
• Whatever may be the adverse impacts of inflation, high
inflation rate are found to go hand- in- hand with high
output and employment at least in the short run. Over the
long run there seems to be no sustained relation between a
country's inflation rate and its level or growth of output or
employment.
• The Phillips Curve better called Price Phillips Curve shows
the trade-off between inflation rate and rate of
unemployment. In the short run as the Phillips curve
demonstrates an economy can achieve higher employment
only if it accepts higher rate of inflation. The original
Philips Curve introduced by A.W. Phillips depicts an
inverse relationship between wage increase and
unemployment. The phenomenon of original Phillips curve
or Wage Phillips curve has the following theoretical basis.
• The rate of increase of wage rate, W* is hypothesized to
depend positively on the excess demand for labor as shown
in the following expression:
• Hence the government cannot move the
economy up along a downward sloped Phillips
Curve. The effects of persistent shocks to
private demand (consumption and investment)
on real wage would also be anticipated. Such
shocks may affect employment only when they
first appear.
• In such a condition, there is no role for
stabilization policy in the rational expectation
case.
Anti-inflation Policy:
• Recessionary Cure for Inflation
Proponents of this cure base their prescription on Phillips
Curve analysis. If the natural rate of unemployment prevails,
the economy would experience a constant rate of inflation. Use
of contractionary monetary and/or fiscal policy would cause
fall of inflation rate but unemployment rate would go up
causing output fall below potential output consistent with
natural rate of unemployment. By how much unemployment
rate would fall would depend on slope of Phillips Curve. If the
Phillips Curve is relatively flat reduction of inflation rate by
one percentage point will require bigger increase in
unemployment rate than if the Phillips Curve is relatively
steep. Thus there would be greater reduction in output as well
as employment in case of a relatively flat Philip's Curve. The
precise magnitude of the fall of output is shown by the Okun's
Curve
• Price and Income Policy as a Cure for Inflation
This policy is based on consensus between the national
government and labor unions of a country. A comprehensive
accord between government and labor unions would cover,
under such a scheme, a wide range of issues like wages and
salaries occupational health and safety and matters pertaining
to industrial relation. Workers give the undertaking that they
would strive for the achievement of its wage objectives over
time. The government commits to maintain after-tax real
income through wage-tax deals and wage indexation.
Government also ensures fall of cost of living index in
response to fall in wage claims. Government introduces
Medicare to maintain social wage. This approach shifted the
Phillips curve downward but made it flatter. Implementation of
this policy becomes difficult if a section of workers believe
that their jobs are indispensable and there is a shortage of
supply of their type of workers. Rigidity of this system affect
the relative variability of wages and prices. This may lead to
resource misallocation.
• Reducing natural Rate of Unemployment
An altogether different approach would be to reduce natural
rate of unemployment [also called non-accelerating inflation
rate of unemployment (NAIRU)] itself instead of sacrificing
some employment for a period of uncertain length for attaining
price stability. The so called natural rate of unemployment is
neither a natural or static concept nor it is necessarily socially
desirable. It varies over time with demographic change,
occupational composition of different sections of population,
mobility of individuals, access to information and kinds of
external shock. The natural unemployment rate is likely to be
higher than optimum rate of unemployment.
Through improving the access to information and supply of
information frictional and structural unemployment can be
reduced. A close cooperation and liaison between skill training
institutes, employers and job seekers would reduce
unemployment rate. Government may overprotect the
unemployed people form hardship of unemployment and
reduce their effort level to look for appropriate job.
Model questions
Money and
Monetarism
Chapter-9
 Money and Monetary Aggregate
What is Money?
• Anything that is generally accepted as a means of payment would qualify as money.
Convention and the prevailing stage of economic development determine what
would be regarded as money in a society.
• Money performs some basic functions: (1) it serves as a medium of exchange, (2) it
is used as a store of value, (3) it serves as a unit of account and (4) it is a standard
of deferred payment.
• For a society at a point of time fully developed money is that which, apart from
being generally accepted as a means of payment, performs all those four functions.
Being generally acceptable to all sellers who offer goods or services, money
eliminate the problem of lack of double coincidence and difficulties of apportioning
a unit of a good or service frequently met in a barter economy.
• A large variety of goods has served as a medium of exchange in different societies
at different times. Money performs better as a medium of exchange when it has the
following characteristics:
(1) it is readily recognizable and acceptable,
(2) it has a high value for its weight and volume,
(3) it is divisible, and
(4) it cannot easily be forged.
Types of Monetary Aggregates
• In some countries including Bangladesh there still prevail some non-monetised
sectors or activities. The most widely used measure of money is narrow money, M-1
which includes currency (notes and coins) held by public and non-interest bearing
current or demand deposits of non-bank public in commercial banks.
• Cheques drawn against those deposits are not money. They represent devices by
which a transfer of a specific amount of money is made from the demand deposit of
one party (an individual or a firm or government) to another party. For many years,
currency and commercial bank demand deposits held by the public were the only
assets that qualified as money according to narrow definition of money, M-1.
• Since 1980 M-1 has been renamed as M-1A. Deposits in Negotiable Order of
Withdrawal Accounts (NOW accounts) at savings and loan associations and
commercial banks, Automatic Transfer Service from savings to demand deposits
account (ATS account), Credit Union Share Draft accounts, and Demand Deposits
Accounts at mutual savings banks are now added to M-1A derive a broader concept
of money supply called M-1B. Cheques can be drawn against those accounts either
directly or indirectly.
• M-2 is obtained by adding savings deposits, small denomination (less than $100,000)
time deposits, overnight Eurodollars, money market deposit accounts, overnight
purchase agreements and money market neutral funds to M-1B.
• Another money stock measure, M-3 is obtained by adding to M-2 several other items,
the most important of them being large denomination ($100,000 or more) deposits at
all depository institutions.
• In Bangladesh M-1 includes notes and coins in circulation and demand deposits. M-
2 in Bangladesh is obtained by adding savings deposits and time deposits to M-1.
• M=Money supply (narrow definition)
• Cpub = Currency held by public . Currency in bank
vaults of commercial banks or central bank is not
included. Notes and coins issued by government and
Central Bank and held by the public are included.
• Dpub = Demand deposits held by public in the
commercial banks.
• h = proportion of M held in the form of currency (notes
& coins) by the public.
• (1-h) = proportion of M held in the form of deposit in
commercial banks.
• z = proportion of demand deposits which must be kept
in The Central bank by commercial banks and deposits
• RRe = Amount of deposit which must be kept as
reserve in The Central bank by commercial banks.
• We may recall that according to the narrow
definition of money supply (referred to as M-1
or M-1A) the money supply (from now
onward this will be represented by M unless
we move to a broader definition of money
supply) is represented by equation(1).
M=Cpub+Dpub … … … … … … (1)
Where Cpub=h.M … … … … … (2)
Dpub=(1-h).M … … … … … … (3)
Furthermore,
RRe=z. Dpub = z.(1-h).M … … … … … … (4)
• Equations (2) and (3) respectively shows that (i) currency held by
the public is h times M, and (ii) demand deposits held by public is (1
-h) times M. Equation (4) shows amount of deposits held by public,
which must be kept as reserve in central bank by commercial banks,
RRe as a proportion of Dpub or as a proportion of M (narrow
definition)
• Amount of reserves provided by a Central bank includes two types
of reserves: un-borrowed reserves (RU) and borrowed reserves
(RB). Central bank provides RU through buying of securities issued
by the government in the open market, while RB is provided
through lending by the central bank to commercial banks by
discounting bills of exchange at its disposal. These reserves are,
however, used up in the following manner: Banks keep certain
portion of the reserves obtained as required reserves (RRe), excess
reserve, REx, and some of the RU will end up as currency in the
hands of the public, Cpub. Hence we can write the following
identity:
RU+RB = R = RRe+REx+Cpub … … … … … … (5)
where R is total reserve.
• If the central bank wants to increase the money supply it may increase RU
through purchase of government securities from commercial banks.
Commercial banks may, in order to make new loans and create new
deposits, sell such securities if it does not have any excess reserve or if
wants to lend a bigger amount and create deposits more than its excess
reserve permits.
• The same purpose of the central bank is served if (1) it lowers discount rate
so that RB increases and net free reserve (RF) falls provided that REx
lowers, or remains constant or does not rise as much as RB rises; and (2)
central bank lowers z (proportion of demand deposits which must be kept
in The Central bank by commercial banks and deposits) so that commercial
banks can lend more to the public and create demand deposits if it is
willing to do so.
• On the other hand, commercial banks and non-bank public together, on
their own, can expand money supply through (1) public's having greater
preference for demand deposits vis-a-vis cash in hand, and (2) drawing
down free reserve (RF) either through using excess reserve or borrowing
more from the central bank through having their bills of exchange
discounted by the central bank.
• So measures taken by one party (central bank or commercial banks or non-
bank public) to change money supply can be supported or resisted by the
other for their own reasons. So money supply cannot be treated as a purely
exogenous phenomenon.
Multiple Expansion of Deposits by Commercial Banks
• Commercial banking system, as a whole, along with the central bank can
create deposits a few times greater than the initial dose of deposits kept with
it.
• Suppose the Central Bank buys Tk. 1000 worth of government bonds from an
individual X. The central bank pays the individual by issuing a cheque drawn
on the central bank for Tk.1000. The seller deposits the cheque in his/her
checking account at commercial bank A. His/her deposit with A increases by
Tk. 1000 and the commercial bank's liability to public increases by Tk. 1000
also. A's deposit with the central bank increases by Tk. 1000 also. If legal
reserve ratio is 20% bank A can lend Tk. 800 to another individual and credit
the amount to the borrower's deposit account on which the borrower can write
cheques. Suppose this new borrower deposits his/her cheque in the account of
a new bank B. So his/her deposit with B will increase by Tk. 800 and, up to
this point, deposit in commercial banks will rise by Tk. 1000 + 800. What
was done by bank A can be repeated by bank B who may lend Tk. 640 to still
another person. This action may end up by increase of deposit by Tk. 640
held by still another bank C. This process may continue if no borrower uses
cheques and cash to meet transaction demand. Deposits created in successive
rounds are Tk. 1000, 800, 640, 512, ... ....
• The sum of these deposits would be 1000X[1-(4/5)n]/[1-(4/5)] where n
represents number of rounds. If n is sufficiently large, sum of created deposits
would be Tk. 5000 which is five times the proceeds obtained from sale of
government securities.
• Expansion of credit to such a scale, off course, depends
upon some stringent conditions:
(1) There should not be any excess reserve at any point,
(2) The borrowers should always use cheques and
whoever receives payment in cheques from the borrower
also uses cheques for transaction purposes so that there is
no leakage in favor of currency,
(3) While 20% of the new deposit is kept as legal reserve
all of the remaining 80% of the deposit would be used to
lend to private borrowers,
(4) There are people willing to borrow money from the
commercial bank at the prevailing rate of interest, and
(5) The central bank would not change the reserve ratio
requirement.
• Money Supply Process in Bangladesh
The monetary authorities (Bangladesh Bank and
Scheduled Banks) in Bangladesh use the
following balance sheet approach to obtain so
called monetary aggregate, M-2 [cash in
circulation (C) + demand deposit (D) + time
deposits (T)]
 Demand, Impact and Role of Money
in Economy
Demand for Money
• Transaction demand, precautionary demand
and speculative demand for money together
constitute total demand for money.
Transaction Demand for Money
Transaction demand for money arises due to lack of
synchronization between income receipts and expenditure
payments. Households and firms are assumed to know
precisely the amount and timing of such receipts and
payments. If all transactions were certain and perfectly
synchronized there would be no need to hold money for
transaction purposes. A person (or firm) receiving his (its)
income would spend the income immediately so that need
for transaction balance would not arise. Even in the case
of non-synchronization, people could have used assets
which are close substitutes of money, to meet the
transaction demand had such assets been costlessly and
instantaneouly convertible into money.
Precautionary Demand of Money
Precautionary demand for money arises when there
is uncertainly about the timing and amount of
income or receipt, and expenditure. A fixed income
earner may face situation like sudden breakdown of
some essential consumer durables, incidence of
major disease, invitation to a marriage ceremony,
death of a close relative etc. A firm may face a
sudden slump or a very profitable investment
opportunity involving a big fund. The amount of
money that households a firms wish to hold as a
precaution against such contingencies is called the
precautionary demand for money.
The Speculative Demand for Money
Two types of balance mentioned earlier actually
highlight the demand for money as a medium of
exchange and hence are directly more relevant for
M-1A (or M-1 as called earlier in developed
countries or still called so in this part of the world).
Precautionary demand goes to certain length in
explaining part of the saving deposits or other
deposits and assets less liquid than demand deposits.
They are part of M-1B or M-2. Speculative demand
for money emphasizes the store of value function of
money. Those deposits and assets have to be
considered in determining the speculative demand
of money.
Impact of Money on Output:
Money in Classical Macroeconomic Model
In the classical macroeconomic model money cannot
affect real output and employment. Classical model based
on the premises of perfect flexibility of prices of goods,
services and factors of production, and perfect
competition portrays the economy as always operating at
full employment or at its potential output level. Any
increase in money supply in such a model will shift the
aggregate demand curve to the right. Price level would
rise as a consequence but there would be no lasting impact
on output or employment as wage will adjust upward so
that old real wage as well as output and employment will
be restored. Aggregate Supply curve is vertical – so that
rightward shift of aggregate demand curve would
ultimately raise the prices but not output or employment
level as shown in figure 9.2
Money can affect real output and employment if
wages are rigid downward. Suppose that wage is not
allowed to fall below W1 either by a decree of
government or trade union pressure while a lower
wage level W0 can clear the labor market. In such a
situation the level of real wage and general price
level will be higher than that compatible with
equilibrium in labor market and money market.
There will prevail some involuntary unemployment
of magnitude N1N2 (see figure 9.3). If money supply
is increased, price will rise and equilibrium real
wage and full employment output can be achieved.
An improvement in the technology may bring
about a prospect of higher real wages,
employment, output but lower money wages and
general price level. Downward rigidity of money
wages deprives the economy of higher output
and the workers of higher real wage and
employment. Through increase of money supply,
employment and output can be positively
affected in such a situation.
Money in Keynesian Macro-Model
• The Keynesian approach insists on wage-price inflexibility
and a flat or positively sloped aggregate supply curve as
shown in figure 9.4. An increase in money supply is likely
to shift aggregate demand curve to the right except in a
liquidity trap situation. Such a rightward shift causes
increases in output and employment alone (in case of a
horizontal aggregate supply curve) or accompanied by price
rise (in case of a upward sloping supply curve).
• A positively sloped aggregate supply curve permitting
increase in output due to increase in money supply, is
possible even if wages are flexible. In such a situation it is
necessary that actual rate of wage increase (decrease) is
exceeded by actual rate of price increase (decrease). Change
in money supply is likely to affect output more at a higher
level of output and rate of interest as speculative demand
for money is highly elastic at low rate of interest.
Model Question