BC 202 Macro Economics

Subject: Macro Economics Author: Ms.
Chand Kiran
Subject Code: BC 202 Vetter: Prof. Anil Kumar
LESSON-1
Introduction to Macroeconomics
Lesson Structure
1.0 Learning Objectives
1.1 Assessment of Prior Knowledge
1.2 Scope of Macroeconomics
1.3 Importance of Macroeconomics
1.4 Types of Macroeconomics
1.5 Variables of Macroeconomics
1.6 Difference between Macroeconomics and Microeconomics
1.7 Interdependence of Macroeconomics and Microeconomics
1.8 Limitations of the Macroeconomics
1.9 Evolution of Macroeconomics
1.10Summary
1.11 Keywords
1.12 Self-assessment Tests
1.13 Study Tips

After reading this chapter you will be able to understand the concept of macroeconomics, its
importance and areas in which macroeconomics works. Through this lesson knowledge will
be imparted to you about the interrelationship of microeconomics and macroeconomics. This
lesson will be helpful for you to understand the needs to study macroeconomics.
1.1 Assessment of prior Knowledge
Macroeconomics is formed with the help of two words i.e. Macro plus Economics. The term
Macro is taken from a Greek word ‘Uakpo’ which means large and Economics refers to branch
of social science concerned with the production, consumption and distribution of goods and
services. So, macroeconomics is concerned with total production, total consumption and total
distribution at large. Macroeconomics is concerned with economy as a whole. Adam Smith,
the father of modern economics, suggested that if every buyer and seller start thinking about
their self-interest only rather than the whole economy then there will be no need to think about
the wealth, national income and welfare of a country or economy. At the early stage
economists thinks that market did not exists in the economy. Then, it is believed that market
exists but equilibrium cannot be determined through demand and supply of the products.
Later, at the end economist think that there is effect of microeconomic variables on the whole
society and country and it is necessary to study the whole economy. Macroeconomics coined
in the 16th and the 17th centuries with the Mercantilists. After that many economists like Cassel,
Marshall, Pigou and Hayek developed theory of money and general prices. Later on Keynes
developed a book on general theory of Income, Output and employment at the time of great
depression. Thus, Keynes provides a new direction to the macroeconomics through the
development of general theory in 1936. After this, due to depression in the economy, demand
for goods and services starts declining in the economy. These prevailing situations in the
economy lead to unemployment and low GDP rate. Thus, it becomes necessary for economists
to think about functioning of the economy in a new direction. Keynes tries to explain all these
facts in his book and explain these concepts very well for the economy as a whole. The theory
provided by Keynes is also termed as thoughts of Keynes. After this many other economics
tries to explain macroeconomics in different sense of economics.
Macroeconomics study all the factors related with economic aggregates like output,
employment, National income and prices in the economy. Macroeconomics does not study the
individual activities like a firm, a household or an industry.
Definitions of Macroeconomics,
According to R.G.D. Allen, “The term Macroeconomics applies to the study of relations
between broad economics aggregates.”
According to Edward Shapiro, “The major task of macroeconomics is the explanation of
what determines the economy’s aggregate output of goods and services. It deals with the
functioning of the economy as a whole”.
According to Ackley Gardner, "Macroeconomics concerns with such variables as the
aggregate volume of the output of an economy, with the extent to which its resources are
employed, with the size of national income and with the general price level"
1.2 Scope of Macroeconomics
I. Theory of National Income
Macroeconomics studies the measurement and methods of calculating national income.
This measurement involves aggregate saving, aggregate consumption and aggregate
investment.
II. Theory of International Trade
International trade refers to the exchange of goods and services among different countries
which affect the whole economy. Thus, international trade is studied under
macroeconomics.
III. Theory of Employment
Study of employment level, types of unemployment and causes behind unemployment is
studied under the scope of macroeconomics.
IV. Theory of General Price Level
General Price level is affected through the business cycles. Inflation and deflation are
two major factors studied for general price level in macroeconomics.
V. Theory of Money
In macroeconomics, various theories of money, role of money, effect of government
expenditure and income in the economy are discussed.
VI. Theory of Trade Cycles
Trade cycle represents the ups and downs in the market. These ups and downs may be
positive or negative. Study of trade cycles is included in macroeconomics as this is based
on the whole economy.
VII. Theory of Economic Growth
Macroeconomics theories are studied and applied for balanced economic growth. It is the
major objective behind any economic policy formulation.
1.3 Importance of Macroeconomics
I. Helpful in formulation of economic policies
Macroeconomics deals with the economy as a whole. It includes aggregates of all
economic factors. Economic policies of the government are related with the whole
economy. For example, during depression, it is necessary to analyze the causse behind
depression and unemployment in economy. At that time macroeconomics helps to
understand these causes and provide guidance for policy formulation. Thus,
macroeconomics helps to study the economic factors and formulation of economic
policies.
II. Helpful in understanding the functioning of an economy
Macroeconomic study the problems related with behaviour of total output, income,
employment and general price level. It is necessary to have proper and adequate
knowledge to understand the behaviour of the aggregate variables. Every country wants
proper working on these problems for the smooth running of that country. Through
macroeconomics these complex problems can be understood and solved. Thus,
Macroeconomics is helpful to understand the functioning of an economy.
III. Useful for determining National Income
The concept of National income is studied under the scope of macroeconomics. As
overall performance of any nation can only be determined through its national income.
For solving the problems related with overproduction and unemployment it is necessary
to prepare data on national income. These data on national income are helpful in
forecasting the level of economic activity and to understand the distribution of income
among different sectors of the economy.
IV. Important for Economic growth
As we had discussed earlier that macroeconomics helps in formulation of economic
policies, these policies are formed for the future growth of an economy. These policies
form basis for the stable and long run growth of an economy. There are various theories
on unemployment, general prices and national income in macroeconomics which are
helpful to solve the problems related with these issues. Thus, macroeconomics is helpful
for the economic growth.
V. Useful for the development of Micro economics
Macroeconomic is helpful to understand microeconomics. Without proper understanding
of aggregates of facts, no microeconomics law can be formed. For example, behaviour
of single firm cannot form the behaviour pattern for all firms. As behaviour of single firm
can be used for single entity but it is not useful in case of economy as a whole. The theory
was formed after considering the behaviour pattern of aggregate firms. Thus,
macroeconomics is helpful for the development of microeconomics.
VI. Helpful in Economic planning
Economic planning is formed for balanced economic development and economic
solution to different problems. Economics planning requires special knowledge and skills
as future of a nation is based in its economic planning. Formulation of economic plans
require necessary knowledge about macroeconomics concepts like mutual dependence
of different sectors, composition of national income, level of employment, etc. Thus,
macroeconomics is helpful in economic planning.
VII. Helpful to study Trade cycles
Trade cycles indicate the economic fluctuations in the economy. These fluctuations can
be understood and analyzed with the help of macroeconomics. The factors like boom,
depression and recovery cannot be studied without the adequate knowledge about
macroeconomics. To understand the trade cycles, it is important to study the aggregate
demand, aggregate consumption and aggregate production which are studied through
macroeconomics. Thus, macroeconomics is helpful to provide the solutions to these
fluctuations in the trade. It has been possible to form policies for controlling the effect of
inflation and deflation on business through detailed study of macroeconomics.
VIII. Helpful to understand monetary problems
Macroeconomics includes the concept like money, theories of money, banking and credit
system in a country. Macroeconomics provides the direction to economists to understand
these concepts and provide remedies to the monetary problems. Regular changes in the
monetary system of a country effect adversely and this adverse effect can be counteracted
by adopting the monetary measures with the help of macroeconomics. Thus,
macroeconomics helps to understand the monetary problems.
IX. Useful to analysis Unemployment
Unemployment is a major problem in developing countries. At the time of depression in
the economy it becomes necessary to understand the need and requirement of the labour.
To understand this concept economists, develop general theory of employment.
Macroeconomics provides the knowledge and understanding about this concept through
Keynesian theory of employment. This concept can be studied through aggregate
demand, aggregate supply of labour. Thus, macroeconomics provides knowledge about
the cause, effect and remedies of general employment.
1.4 Types of Macroeconomics
Types of
Macroeconomics
Macro Static Macro Comparative Macro Dynamic

Analysis Static Analysis Analysis
Figure 1-Types of Macroeconomics

I. Macro static analysis
Meaning of static is different in different subject of study. In Economics, static refers to
a state of movement at a particular level without any change. According to Clark, “It is a
state where five kinds of changes are conspicuous by their absence. The size of
population, the supply of capital, methods of production, forms of business organization
and wants of the people remain constant, but the economy continues to work at a steady
pace”. There is certainty in static state as the other variables are constant. Macro static is
best explained by Prof. Kurihara as they present macro static as a still picture of economy.
Macro static represents the static equilibrium position of the economy. Whenever an
economy is working at equilibrium point E and it is producing at a constant rate without
any change in the other variables, it is known as static state of economy at a point of time.
This equilibrium is shown through a timeless identity equation without any adjusting
mechanism:
Y=C+I
Here, Y= Total Income
C= Total Consumption
I= Total Investment
According to static Keynesian model, the interaction of aggregate supply function and
the aggregate demand function are helpful to determine the level of National Income.
This model includes the above identity equation to represent the equilibrium in the
economy. This model is shown in figure 2 as under:
Figure-2
Here, 450 line represents the aggregate supply function,

C+I+G line represent the aggregate demand function
E the intersection point represents point of effective demand through which level
of National income (OY) is shown.
Thus, macro static refers to timeless economy. It cannot be formed or destroyed. This is
an equilibrium situation. This situation cannot be changed whether the previous position
and subsequent position of the economy change or not.
II. Macro dynamic analysis
Macro dynamic analysis studies the cause of change in two equilibrium points. It analyses
the process of change which continues over a period of time. An economy may change
over a period of time in two major ways:
(a) Without changing its pattern
(b) By changing its pattern
Macro dynamic analysis is related with second type of change. This change in pattern
occurs due to change in population, capital, techniques of production, forms of business
organization and taste of the people. Macro dynamic analysis explains the forces which
brought these change in the economy. It is based on time lags, rate of change, past and
expected values of the variables. In the words of Kurihara, “Macro-dynamics treats
discrete movements or rates of change of macro-variables. It enables one to see a
‘motion-picture’ of the functioning of the economy as a progressive whole.” The
following diagram shows the operation of analysis:
Figure-3
This diagram represents the change of equilibrium from point E to E1 which shows
change in government expenditure. This is not a sudden change but it has been increased
by a process and time-lag. This process can be understood as the government increase
investment which might have result in more employment, high productivity and high
level of income. Thus, macro dynamic analysis is a method to describe the causes behind
the change in economy due to change in other variables over a period of time.
III. Macro comparative static analysis
Macro comparative static analysis was first used by a German Economist F.
Oppenheimer, in 1916. It is a method of economic analysis. According to Schumpeter,
“Whenever we deal with disturbance of a given state by trying to indicate the static
relations obtaining before a given disturbance impinged upon the system and after it, had
time to work it out. This method of procedure is known as Comparative statics”. It means
comparative statics analysis is a method where different equilibrium situation is
compared. Under Macro Static analysis, equilibrium is shown at a point E and it remains
constant at a point of time. In Macro Dynamic analysis, the point of equilibrium shifts
from point E to point to E1. Macro Comparative Static studies the variations in the
positions of equilibrium from point E to E1 due to some specific changes in other
variables. Detailed analysis of macro comparative analysis is shown through a figure as
under:
Figure-4
The initial point of equilibrium is at point E where Y (Total income) and C+I+G (total
consumption, total investment and government expenditure) intersect each other. But
after the inducement of government expenditure the equilibrium point shift from E to E1.
New equilibrium point E1 is situated at the intersection of Y and C+I+G+∆G. At this
level total income shifts from OY1 to OY2. Thus, the study between two equilibrium
points is known as Macro Comparative Static Analysis.
Macro comparative static analysis has some drawbacks also. These are discussed as
under:
(a) It ignores the problems related with economic fluctuations.
(b) This method explains only the process of change from one position to another
position of equilibrium. Complete reasons behind this change are not cleared under
this method.
(c) This method neglects the transitional period.
1.5 Variables of Macroeconomics
I. Aggregate Demand
Demand refers to that quantity of goods and services for which consumer is ready to pay
and have willingness to purchase that goods and services at different price level over a
period of time. But, Aggregate demand refers to the total expenditure incurred on the
purchase of all the finished goods and services in the economy during the period of an
accounting year. It can be defined as the total monetary expenditure incurred on the
purchase of goods and services at a specified price level on a point of time.
II. Aggregate Supply
Supply refers to production of that goods and services which a producer is willing to sell
at different prices during a period of time, when all the other factors remain constant.
Aggregate supply is the total supply or total production of goods and services in the
economy during an accounting period.
III. Aggregate Consumption
Total consumption of all goods and services in the economy during an accounting period
is known as aggregate consumption.
IV. Aggregate Investment

Investment refers to that asset which results into appreciation of income over a period of
time. In economics, it can be defined as expenditure incurred by producers to purchase
raw material so that this can be add to their capital in that year. And aggregate investment
refers to the total expenditure incurred by all the producers for purchasing raw material
in the economy to add their capital during that year.
Inflation Aggregat
Business
e
Cycle
Demand
Economic Unemploy
Policies -ment
Interest
Rate Aggregate
Macro- Supply
economic
Variables
General
Price GDP &
Level National
Income
Aggregate
Investment Exchange
Rate
Govt. Aggregate
Spending Consumption
Figure-5
V. Unemployment
Unemployment occurs when a person wants to do job but he is unable to find a job.
Unemployment can be computed on the basis of unemployment rate. It is the rate through
which the percentage of the current unemployed labour force and actively seeking
employment can be measured. High rate of unemployment leads to unfavorable
indicators of macroeconomics. High rate of unemployment leads to maximum number
of workforce who is not engaged in any work and job. This represents negative signs for
an economy.
VI. General Price level

General Price level refers to index of prices of all goods and services in the economy at
the end of a specified period of time.
VII. Exchange Rate
Exchange rate is an important macroeconomic variable as it is helpful for international
trade. Import and export among different countries is possible due to exchange rate, as
this becomes consideration for exchange of goods and services. Exchange rate refers to
that rate at which currency of one country is exchange with the currency of other country.
It can provide answer to the question that for one unit of a currency of country A how
many units of currency of country B can be obtained.
VIII. Interest Rate
Interest rate refers the cost of borrowed money. This rate is defined by monetary
authorities by using various regulations and interventions in the money market. Interest
rate is the rate which interest is paid by the borrower for use of money to lender. There
is various interest rates prevails in the economy. Interest rates can vary according to
variation in the degree of risk.
IX. Government Spending
Government spending refers to the government consumption, government investment
and transfer payments. Government spending describes the size of the public sectors in
the economy. Government spending can also be described as the expenditure incurred
by public sectors in education sector, health sector, transportation, social protection,
defense, etc. This spending is based on major two factors i.e. tax collection and borrowing
from public.
X. GDP & National Income
Gross domestic product is the total monetary value of the final goods and services
produced within national boundaries of a country during an accounting year. GDP is a
macroeconomic indicator of health of an economy. High GDP represents the increase in
output and this will lead to economic growth. Generally, GDP is also known as
measurement of national income. National income provides an idea of purchasing power
of people of a country.
XI. Inflation
Inflation refers to hike in general price level of goods and services in an economy over a
period of time. Inflation results into loss to value of money as hike in general prices leads
to pay more units of money for purchasing goods and services. When demand for goods
and services increases consequently their prices also rise and this will lead to inflation. It
means consumer is willing to pay high prices for purchasing goods and services they
want. Inflation is an important macroeconomic variable as it is interlinked with the other
variables of the macroeconomics. Like high rate of unemployment leads to low rate of
economic growth which ultimately results into risk of high inflation.
XII. Economic Policies
Economic policies are also defined as the macroeconomic indicators. There are two
major economic policies i.e. monetary policy and fiscal policy. Monetary policy is the
policy which is formed to control money supply in the economy. Fiscal policy is the
policy of government expenditure and revenue. These policies are formed by monetary
authority and government of the country.
XIII. Business Cycle
Business cycle refers to the upward and downward movements in the gross domestic
product. Business cycle defines the fluctuations in the aggregate production, trade and
activity in an economy. Business cycles involve the situation of recession and depression.
Recession means that period during which aggregate output declines. A prolonged and
deep recession is termed as depression. Thus, business cycle is an important indicator of
macroeconomics.
1.6 Difference between Macroeconomics and Microeconomics
Economics refers to the branch of knowledge concerned with production, consumption and
transfer of wealth. Economics can be further classified into two parts: microeconomics and
macroeconomics. Microeconomics is concerned with individual and business decision making
while macroeconomics is concerned with the decisions of government and business. Although
in next section we will discussed that both microeconomics and macroeconomics depends on
each other and it is not possible to study one without the knowledge of other. Still there exists
some different among microeconomics and macroeconomics. These differences among
microeconomics and macroeconomics are not rigid because parts affect the whole economy
and whole economy affects the parts in the economy. These are discussed as follows:
Table No. 1- Difference between microeconomics and macroeconomics
Sr. No. Microeconomics Macroeconomics
1. Microeconomics deals with the Macroeconomics deals with the aggregate of

individual units of an economy. individual units or the whole economy.
2. It includes individual price, individual It includes general prices, aggregate demand,

demand, individual income, etc. National income, etc.
3. Price determination and allocation of Determination of income and unemployment

resources are the major problem studied are the major problem studied under
under microeconomics. macroeconomics.
4. Two major tools i.e. demand and supply Two major tools i.e. aggregate demand (AD)
of a particular commodity is used in and aggregate supply (AS) of a particular
microeconomics. commodity is used in macroeconomics.
5. Microeconomics solves the central Macroeconomics solves the central problem of

problem of what to produce, how to full employment of resources in the economy.
produce and for whom to produce.
6. It is concerned with the equilibrium of a It is concerned with the equilibrium of level of
consumer, a producer and an industry. income and employment in an economy.
7. Microeconomics uses bottom-top Macroeconomics uses top-bottom approach for

approach for analyzing the economy. analyzing the economy.
8. It assumes that all macroeconomic It assumes that all microeconomic variables like
variables like aggregate demand, individual demand, individual income, etc. are
national income and price are constant. constant.
9. It is also known as price theory. It is also known as income theory or

employment theory.
10. It believes in Laissez-faire economy. It believes in command economy.

11. It is simple to study microeconomics. It is complex process to understand
macroeconomic due to inclusion of large
numbers.
1.7 Interdependence of Macroeconomics and Microeconomics Theory

Both macroeconomics and microeconomics are dependent on each other. As a small change
in microeconomic leads to change in macroeconomics and a little change in macroeconomics
leads to change in macroeconomics. For instance, when aggregate demand rises it leads to an
increase in individual demand for product. This increase in demand may be due to a
macroeconomic factor i.e. interest rate. Whenever there is reduction in interest rate people
borrow money from financial institutions and this increased supply of money results into
increase in demand for individual product. Due to increase in demand for product, demand for
labour in particular industry also increases consequently wage rate also increases for a
particular industry. This increased wage rate can be made possible only when there are
increased profits. Again it will be ultimately duty to increase in demand. Thus, a
macroeconomic change becomes cause for change in microeconomic variables. This
represents that there is dependence of microeconomics theory on macroeconomics theory.
Some other examples for explaining dependence of microeconomics on macroeconomics:
a. Payment made for means of production cannot be decided by an individual firm rather
than these are dependent on the demand for means of production in the whole economy.
b. Sale of an individual firm is based on the purchasing power of consumer in the whole
society.
c. For determining the demand for a product in an individual firm, it is necessary to study
the demand of society, income and employment level in the economy.
Not only microeconomics theory is dependent on macroeconomics theory but
macroeconomics theory is also dependent on microeconomics theory. Macroeconomics is the
aggregate of the entire microeconomics variable. It means macroeconomics is formed from
the different parts of microeconomics. National income is made up of income of individuals,
firms, households and industries. Every indicator of macroeconomic aggregate consumption,
aggregate investment, aggregate saving is made from microeconomic variables consumption,
investment and saving. Thus, aggregate of macroeconomics is formed by averages of the
individual quantities of microeconomic variables. For example, if an economy concentrates
all its resources for production of capital goods only, then total output of the economy will
decline. After this other sectors of the economy starts declining. Due to this activity total
output, total income and employment will be affected adversely. This adverse effect results
into unequal distribution of income. As a result, unemployment will increase and all of these
factor cause depression in the economy. Thus, any change in microeconomic variable will
results into change in macroeconomic variables.
Some other examples for explaining dependence of macroeconomics on microeconomics:
a. National income is computed with the help of individual expenditure obtained from
microeconomics.
b. Aggregate demand in the economy is computed with the help of demand of an individual
firm.
According to Gardner Ackley, “Actually, the line between macroeconomics and micro
economics theory cannot be precisely drawn. A true general theory of the economy would
clearly embrace both. It would explain individual behavior, individual I outputs, incomes and
prices and the sums or averages of individual results I would constitute the aggregates which
macroeconomics is concerned”.
The same thing is suggested by Samuelson that “There is really no opposition between Micro
and Macro Economics. Both are absolutely vital and you are only half-educated if you
understand the one while being ignored or the other”. Thus, we can conclude that both micro
and macro approaches are interrelated and interdependent on each other. Both approaches are
helpful to analyze the economy.
1.8 Limitations of the Macroeconomics
I. Macroeconomics is based on the aggregate of facts or aggregate behaviour but an
individual behaviour is may not be true for the whole economy. For example, increase in
total saving may leads to depression if these savings are not invested. Same can be seen
in case of deposits in a bank. If all the depositors withdraw money simultaneously then
this will adversely affect the banking system in the economy.
II. Macroeconomics considers all the aggregates homogenous under aggregation. But, all
the aggregates cannot be homogenous. For example, aggregate wages are computed with
the help of wages in all the occupations. If wages of teachers’ increases and wages of
clerks decreases, then aggregate wages will remain unchanged. Thus, this increase and
decrease cannot be measured due to homogeneity of aggregates.
III. Sometimes aggregate variables are not taken as important in macroeconomics. National
income is calculated with the help aggregate of individual income. But, increase in
National income does not mean that income of every individual person increase.
Sometimes, income of rich person may increase and this affects the national income.
Thus, this type of increase in income has little significance in the economy.
IV. Uncritical use of macroeconomics also becomes problem for the real word as the same
theory cannot be applied on different situations. For instance, if a policy is formed to
achieve full employment in the economy by applying structural unemployment in
individual firm and industry, then it is irrelevant for the whole economy. This can be
results into misleading information.
V. It is difficult to compute macroeconomics variables by using statistical methods.
Macroeconomics is aggregate of microeconomic variables. So, first of all microeconomic
variables are computed statistically, then these are converted into microeconomic
variables through average. This conversion is very difficult and complex process. The
conversion of results into one macroeconomic variable may be dangerous and faulty.
Thus, measurement of macroeconomics variable is a very difficult and tough process.
VI. Macroeconomics also ignores the welfare of individual. If aggregate saving is increased
at the cost of individual welfare, then it is not considered as wise decision regarding the
individual.
VII. One major problem is with macroeconomic models. These models are designed only for
developed countries of the world. Developing countries cannot take benefit of
macroeconomic models due to some difficulties.
1.9 Evolution of Macroeconomics
Macroeconomics is not formed in only one day rather it takes many years for development.
Different economists provide their own different views in their own analysis basis. These
schools of thoughts may be defined as under:
I. Adam Smith, Ricardo and J.C.B. are well known economists for classical or tradition
thoughts. These economists try to study the economic problems for the whole
economy. Thus, they are in favour of macroeconomics. Classical thoughts were based
on Say’s Law of Market and Flexibility of Wages, Rate of Interest and Prices.
According to classical thoughts full employment prevails in the economy and if there
is any situation of unemployment it prevails for short term only. At last, tradition
thoughts concerned with the auto adjustment of macroeconomics variables in the
economy.
II. After classical thoughts, a book “The General Theory of Employment, Interest and
Money” was written by the famous economist Keynes in 1936. Keynes point out the
limitations of classical thoughts and worked on modern thoughts of macroeconomics.
Keynes was against the say’s law as they did not believe that supply automatically
adjusts demand and unemployment prevails only for short term. Keynes suggested that
aggregate demand is the main cause behind unemployment and it can be reduced
through increase in aggregate demand.
III. Then, Keynes thoughts were opposed by famous economist Milton Friedman. He came
with the new-classical thoughts of macroeconomics. This school of thought suggested
that unemployment cannot be reduced by government intervention or fiscal policy.
New-classical thoughts were based on monetary measures thus it is also known as
monetarism. Friedman believed that full employment can be achieved through
variations in money supply. Supply of money directly affects the demand for product
and increase in demand leads to full employment in the economy.
IV. After this many other economists works for changes in macroeconomic thoughts. After
1960 a new theory named as Rational Expectation Theory was propounded by Prof.
Muth, Prof. Lucas and some other economists. Onward this many other changes were
also propounded in macroeconomics thoughts.
1.10 Summary
Microeconomics deals with aggregates of microeconomics variables. It is concerned with
economy as a whole. Although both macroeconomics and microeconomics depends on each
other still there are various differences among both. Major difference of microeconomics and
macroeconomics is that former is based on the study of individuals and firm’s decisions
making regarding scarce resources and the latter is based on study of aggregate of
microeconomics variables. Macroeconomics is further divided into three parts i.e. Macro static
analysis, macro comparative analysis and macro dynamic analysis. There are various variables
of macroeconomics which affect the whole economy. Study of macroeconomics is as
important as microeconomics. Scope of macroeconomics is very wide as it included theory of
money, theory of employment, theory of national income, etc. In the last section of some
schools of thoughts of macroeconomics are also described. These schools of thoughts
represent the evaluation and changes in macroeconomics analysis from time to time.
Macroeconomics has also limited applications due to its limitations but still it is a powerful
source of knowledge to understand economy. Thus, one can conclude that macroeconomics
study is an important aspect to know the whole economy. Without macroeconomics it is not
possible to measure the national income, growth rate in the economy, unemployment rate, etc.
1.11 Keywords
Microeconomics: Microeconomics refers to that branch of economics which studies the
behaviour of individuals and firms for decision making regarding allocation of scarce
resources.
Macroeconomics: Macroeconomics refers to that branch of economics which study the
economy as a whole. It is concerned with the study of aggregates of microeconomics.
National Income: National income refers to the total value of goods and services produced
in an accounting year within the boundaries of a country.
Aggregate Demand: Aggregate demand refers to average of the total demand by consumers
for all the goods and services in a country within a year.
Aggregate Supply: Aggregate supply refers to the average of the total production of all the
goods and services produced within a year in a country.
Trade Cycles: Trade cycles are also known as business cycles. A trade cycle refers to the
fluctuation in the Gross Domestic Product of an economy. These fluctuations may be upward
or downward according to the prevailing conditions in the economy.
Aggregate Consumption: Aggregate consumption refers to the total spending of individuals
and firms in the economy. It is directly related with aggregate saving because aggregate saving
is total of that portion of income which is not consumed.
Aggregate Expenditure: Aggregate expenditure refers to the sum of total consumption, total
investment, total government expenditure and total difference among exports and imports in
the economy. It can be shown as AE= C+I+G+ (E-I).
Unemployment: Unemployment refers to a situation where able people want to do job but
are not able to get work or job.

(a) Student Activities
Q.1 What do you mean by macroeconomics? How it is different from microeconomics?
Q.2 Explain the scope and importance of macroeconomics in detail.
Q.3 Define macroeconomics. Why do we need macroeconomics?
Q.4 Explain the role of macroeconomics in real world. Is macroeconomics can really be a
solution to economic problems in the economy?
Q.5 How macroeconomics is different from microeconomics? Is there any relationship exists
among these two concepts?
Q.6 Explain the different types of macroeconomics in detail.
Q.7 Explain the different macroeconomics variables affecting the economy. Also explain the
importance of macro analysis in detail.
Q.8 Explain the major issues macroeconomic issues. What are major issues arising in the
study of macroeconomics?
Q.9 How can you say that macroeconomics and microeconomics are dependent on each other?
What are the major forces behind this dependence?
Q.10 How does macro static analysis is different from macro dynamic analysis? How does
Macro comparative analysis is related with static analysis and dynamic analysis?
(b) Learning Activities
1. is father of modern economics.
2. Concept of National Income is studied under Economics.
3. Macroeconomics deals with .
4. Microeconomics concentrates on .
5. wrote the book “General Theory of Employment, Interest and Money”.
(c) Feedback of learning activities
Answers of learning activities:
1. Adam Smith
2. Macroeconomics
3. Aggregate Economic Activity
4. Individual Economic Activity
5. Prof. J. M. Keynes
1.13 Study Tips
1. Jain et al. 2019. Macroeconomics, pages 3-14, VK Global Publication Pvt. Ltd., New
Delhi.
2. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production,
pages 1 – 27, Macmillan India Limited, New Delhi.
3. Mankiw, N. G., 2000. Macroeconomics, pages 2 – 14, Macmillan Worth Publishers,
New York.
4. Jain & Ohri, 2014. Introductory Macroeconomics, pages 1-30, VK Global Publication Pvt.
Ltd., New Delhi.
5. Jhingan, 2012. Macro Economic Theory, pages 3-16, Vrinda Publication (P) Ltd., Delhi.
6. Case et al., 2018. Principles of Economics, pages 445-455, Pearson Education Limited,
Uttar Pradesh.
7. Shapiro, E. (1978). Macroeconomic analysis, 4th Edition, Chapter 1st, New York.
Subject: Macro Economics Author: Ms. Chand Kiran
LESSON-2
National Income
Lesson Structure
2.2 Concepts or Aggregates of National Income
2.3 Circular Flow of Income
2.3.1 Two Sector Model of Circular Flow of Income
2.3.2 Three Sector Model of Circular Flow of Income
2.3.3 Four Sector Model of Circular Flow of Income
2.4 Importance of National Income Analysis
2.5 Measurement of National Income
2.6 Difficulties in measurement of National Income
2.7 Some practical questions on National Income
2.8 Summary
2.9 Keywords
2.10 Self-assessment tests
2.11 Study tips

After reading this chapter you will be able to understand the concept on National Income.
You will find different methods of measurement of National income. You will learn about the
circular flow of National Income in the economy. At the end you will also find difficulties to
measure National Income. All these concepts will be useful for you to understand the role of
National Income in an economy.

In previous chapter, we have discussed about macroeconomics; National Income is a major
concept which is studied under macroeconomics. National income and wealth of England was
estimated by Sir William Petty in 1665 for the first time. Then, Gregory King also tries to
estimate national income in 1696. And Gregory King is also known as Father of Modern
National Income Accounting. During First World War Prof. Bowley and Sir Joshia Stamp
collected data for national income. After this, many economists like Prof. Stone, Meade,
Gilbert and Kuznets also worked in this direction. In India, National Income Committee was
formed to collect data for National Income in 1949. After 1952, this work was allotted to
Central Statistical Organisation (CSO) and currently this organisation published data on
national income in National Accounting Statistics.
National income may be defined as the total sum of factor incomes earned by normal residents
of a country during an accounting year. National income involves two major terms i.e. Factor
income and Normal residents of a country. Factor income refers to the income earned by
households from factor of production (land, labour, capital, entrepreneurship. Normal resident
of a country may be defined as the resident who normally resides in the country and his
economic interest lies in that country. National Income can be defined as the total value of
goods and services produced within a country during an accounting year. We can also
conclude that national income is the total outcome of all the economic activity of a country in
an accounting year.
Traditional definitions of National Income

According to Marshall, “The labour and capital of a country, acting on its natural resources,
produce annually a certain net aggregate of commodities, material and immaterial including
services of all kinds… This is the true net annual income or revenue of the country or national
dividend.”
According to A.C. Pigou, “National income is that part of the objective income of the
community, including, of course, income derived from abroad which can be measured in
money.”
Modern definitions of National Income

Profs Lipsey and Chrystral defined National Income as, “the value of the nation’s total output
and the value of the income generated by the production of that output.”
Gardner Ackley defines “National income is the sum of all (a) wages, salaries, commissions,
bonuses and other form of incomes, (b) net income from rentals and royalties, (c) interest, (d)
profit.”
So, we a large number of definition of national income and we can use the one which is easy
to understand and included every aspect of national income. In practical life, we can use any
definition because we will get same results if we use correct values and measures for
calculating national income.
2.2 Concepts or Aggregates of National Income

National income is not just a term rather than it is a complete conception which is further
classified into different concepts. National income is formed with help of many concepts
which are discussed below:
I. Gross Domestic Product

Gross domestic product (GDP) is the monetary value of total sum of all goods and
services produced within domestic territory of a country in an accounting period. It is
also known as GDP at market price because it is calculated on market price. It is a
monetary measure. Dernberg defines GDP at market price as “the market value of the
output of final goods and services produced in the domestic territory of a country
during an accounting year.” Gross Domestic Product is shown as GDPMP and
depreciation is included in it.
GDP = Market value of goods and services produced in the country + incomes earned in
the country by foreigners – incomes received by resident nationals from abroad
GDP at market price is calculated on market price of goods and services which includes
the indirect taxes like sales tax and excise duty. The grants or subsidy received from
government also reduce the market price.
II. Gross Domestic Product at Factor Cost
GDP can be computed at both market prices as well as factor cost. It is shown as GDPFC.
GDPFC refers to total value of goods and services produced during an accounting year at
the cost of production. GDPFC is dependent on gross domestic product at market price.
So, first of all we have to calculate GDP at market price then indirect taxes are deduced
and subsidies are added into GDP at market price.
GDPFC = GDPMP – Indirect Taxes + Subsidies
OR
GDPFC = Factor Income (Rent + Compensation + Interest + Profit) + Depreciation (due
to consumption of fixed capital)
GDP at factor cost may be defined as sum total of factor incomes generated in an
accounting year within the domestic territory of a country.
III. Net Domestic Product
Gross domestic product includes depreciation charges incurred due to consumption of
fixed capital. When these charges depreciation are deducted from GDP, it becomes Net
Domestic Product or NDP. It is also known as net output of a country in an accounting
year. It can be calculated as follows:
NDP = GDP – Depreciation; it is also calculated on both market price and factor cost.
NDPMP = GDPMP – Depreciation
NDPFC = NDPMP – Indirect taxes + Subsidies
IV. Nominal and Real Gross Domestic Product
GDP can be calculated on the basis of two type of prices i.e. current price and fixed price.
When GDP is calculated on current price, it is known as nominal GDP and when GDP is
calculated on fixed price in some year, it is known as real GDP. In case of nominal GDP
it becomes very difficult to compare one year GDP with another year GDP because prices
fluctuates over a period of time. And one more thing about rupee is that it is not a stable
measure of purchasing power. Due to these problems GDP may raise or fall without
growth in the economy. Thus, actual GDP cannot be determined. These are major reasons
which force us to use real GDP because here we use constant price to calculate GDP. For
this purpose, price of a base year is selected where prices are general; means these are
neither high nor low. It can be calculated as follows:
Nominal GDP = Quantity of final goods and services produced during an

accounting year × Current prices prevailing during the
accounting year
𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫
Real GDP = GDP for the current year ×
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐘𝐞𝐚𝐫 𝐈𝐧𝐝𝐞𝐱
V. Gross Domestic Product Deflator

GDP inflator is a price index which shows price changes of goods and services included
in GDP. It can be calculated as follows:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷
GDP Deflator = × 𝟏𝟎𝟎
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷
VI. Gross National Product

GNP refers to the gross national product which is total value of goods and services
produced by normal residents and non-residents in the domestic territory of a country.
Net income from abroad is the major difference among GDP and GNP because GDP
does not include factor income from abroad. This can be calculated as follows:
GNP = GDP + Net factor income from abroad
OR
GNP = money value of goods and services + Income earned by national residents from
abroad – Income earned locally but accruing to foreigners
GNP is also calculated at factor cost and market price.
GNPMP = GDPMP + Net factor income from abroad
GNPFC = GNPMP – Indirect Taxes + Subsidies
VII. Net National Product
Net National Product is the total value of goods and services produced in the domestic
territory of a country in an accounting year after deducting depreciation and by adding
net income from abroad. It is calculated through following equation:
NNP = GNP – Depreciation
NNPMP = GNPMP – Depreciation
NNPFC = NNPMP – Indirect Taxes + Subsidies
VIII. Domestic Income
Domestic income is the total factor income generated by producing goods and services
in the domestic territory of a country in an accounting year. This income is generated
with the help of own resources of a country. Domestic income includes rent, wages,
interest, dividend, direct taxes and undistributed profits. Domestic income does not
include the income generated from abroad. If we add income from abroad into domestic
income, then domestic income will become national income. Net income from abroad
may be positive or negative as it is the difference among exports and imports. If exports
exceed imports, then net income from abroad will be positive or vice-versa.
Domestic Income = National Income – Net Income from Abroad
IX. Private Income
Private may be defined as the income which is generated by private sector from any
source; which may be productive or other. It also includes retained earnings of the
corporations. According to Central Statistical Organisation, private income is total
factor income from all sources and the current transfers from the government and the rest
of the world accruing to private sector.
Private Income = Income from Net Domestic Product accruing to the Private Sector +
Net Factor Income from Abroad + Net Transfer Payments from the
Government + Net Current Transfer Payments from Rest of the World
+ Interest on National Debt
X. Personal Income
Personal income refers to the total income received by households from all sources in the
form of current transfer payments and factor incomes in an accounting year. It includes
wages, salaries, fees, commission, bonus, dividends and earnings from self- employment.
Other transfer incomes like pension, social security benefits, sickness allowances, etc.
are also included in personal income. Personal income can never be equal to national
income because personal income includes transfer payments also.
Personal Income = Private Income – Undistributed Profits – Corporate Taxes
XI. Personal Disposable Income
Personal Disposal Income is that part of income which is obtained after deducting direct
taxes, fines and fees to the government from personal income. This income can be used
by individual for any purpose which may be saving or consumption.
Personal Disposable Income = Personal Income – Personal Taxes
OR
Personal Disposable Income = Consumption + Saving
XII. Real Income
It can be defined as the national income which is calculated on the basis of general price
level in a particular year where general price is taken from that base year. It is calculated
on general prices because current prices do not provide a real estimation of national
income.
𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 𝐼𝑛𝑑𝑒𝑥
Real Income = 𝑁𝑁𝑃 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 ×
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 𝐼𝑛𝑑𝑒𝑥
XIII. Per Capita Income

Per capita income refers to average income of the people of a country in a particular year.
It can be also known as measurement of national income at current prices and constant
prices. Per capita income can be computed as follows:
𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
Per capita income =
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
Per capita income indicates the average availability of goods and services per individual
during an accounting year.
2.3 Circular Flow of Income

Everyday economic transactions and exchange take place in the economy. These transactions
go through a particular path. First of all, producer produces the goods and services and
consumer purchase these products. Money is used for this exchange. Earlier there was barter
system which has many drawbacks, but money reduces all these difficulties and become basis
for exchange. Economy runs in a particular manner as consumer provides factor of
productions to producer and producer produces goods and services for the customers. Then,
customer exchange through money and this process goes on. Money changes hands and thus
this formed a circle known as circular flow of income. Circular flow of income increases over
a period of time due to growth of population and higher level of production-distribution-
expenditure. Income and expenditure are in opposite direction in the circular flow. This flow
of income and expenditure can be shown in different sectors. These sectors are defined as
follows:
2.3.1 Two Sector Model of Circular Flow of Income
Two sector model consist major two sector i.e. Household Sector and Government
Sector. This model is based on some assumptions discussed as follows:
(a) Government Expenditure does not exist in the economy
(b) Foreign Trade does not exist in the economy
(c) Taxes do not exist in the economy.
(d) Households saving do not exist in the economy.
Figure.1 Two Sector Model of Circular Flow of Income

Although this model is unrealistic but it can provide us a basic idea about circular flow
of income. This model defines that households are the owners of factor of productions
(Land, Labour, Capital, and Entrepreneurship) and they provide these factor of
production to producer as shown in the figure. Producer offers factor payments (Rent,
Wages, Interest and Profit) for use of these factors of production. After this producer
produces goods and services and rendered these products to consumer in exchange with
money. When goods are transferred from producer to consumer, it is known as real
flow. This real flow is shown through the upper circle of the diagram. The inner circle
of the diagram presents the money flow from producer to consumer and consumer to
producer. Real flow and money flow are in opposite direction. One part of diagram is
known as factor market in which factor of production are exchanged with factor
payments. And another part of diagram is known as commodity market where goods
and services are supplied to consumer in exchange for money. Factor of production get
payment as rent for land, wages for labour, interest for capital and profit for
entrepreneurship. Due to this payment system under each head, there will be no chance
for undistributed profits. Total output of the producer will be equal to total income of
households. Here, gross income will be equal to total disposable income and there will
be equilibrium situation in the economy. This situation does not prevail in the real
economy because in real life, households save money and invest it into capital market
which is again invested for production. Through circulation of saving and investment,
equilibrium can be situated again in the economy.
2.3.2 Three Sector Model of Circular Flow of Income
This model is more realistic than two sector model. Here, we have three sectors i.e.
Household sector, Production sector and Government sector. This model involves the
government intervention in the economy but still it is based on closed economy. Closed
economy means there is no foreign trade in the economy. This model discards a major
limitation of taxes of two sector model which means taxes exists in three sector model.
Major three variables are included here:
(a) Direct Taxes

(b) Government Expenditure
(c) Transfer payment
Figure.2 Three Sector Model of Circular Flow of Income
Direct tax reduces personal disposable income which results into reduction of
consumption expenditure as well as savings. Then, the second variable government
expenditure provides an inducement to purchasing power of households and this will
increase demand for goods and services. This increase in demand leads to more
production from producer sector. Further the next variable, transfer payments by the
government are also work as injections in the circular flow of income in three sector
model. In two sector model government sector was absent and money flow was among
business sector and producer sector. Due to government sector money flow from
household gets reduced. Household sector has to pay direct taxes to government sector
and producer sector has to corporate taxes to government sector. This amount of taxes
is used for providing transfer payment to households, for purchasing goods and services
from firms and for providing subsidies. Ultimately, these will result into circular flow
because firm and household pay taxes to government and government provide these
taxes in the form of subsidies and financial aid. This situation is possible when
government has a balanced budget. If government has some deficit, then it takes loans
from capital market and in case of surplus with government then it will be invested in
capital market.
2.3.3 Four Sector Model of Circular Flow of Income
It is an advanced form of three sector model as it included foreign trade as well as the
other three sectors. Every economy is dependent on the other economy for some or the
other products. This is also known as open economy as the economy is opened for the
rest of the world. Four sectors are as follows:
(a) Household sector

(b) Producing sector
(c) Government sector
(d) Rest of the World
Figure.3 Four Sector Model of Circular Flow of Income
Household sector provide factor of production to firms, pay taxes to government sector
and import payment to rest of the world. Household sector obtain factor payment from
firms, export receipts and transfer payments from government. Similarly government
receives taxes from households and firms and borrowing from capital market in case of
deficit. Firms have to pay taxes to government, factor payment to household and import
payment to rest of the world. Firms obtain subsidies from government, factor of
production from households and export receipts from rest of the world.
Capital market got savings from producing sector, government sector and household
sector. It provides borrowings producing sector and government sector. Thus, four
sector model provides a complete circular flow of income and expenditure.
2.4 Importance of National Income Analysis

National income analysis is very important for a Nation. It gives answer to various economic
questions and problems. Every country faces some problem regarding their economy and
these problems are identified through national income analysis. It is a macroeconomic factor
which study the Net National Income. Importance of national income analysis is discussed in
detail as under:
I. National income is an important indicator for economic planning in a country. National
income gives estimation about the health of an economy and economic planning the
different ways to improve economic health of a country. So, national income is helpful
for the development of economic planning.
II. Economic planning is based on the estimation of national income and economic policy
is based on economic planning. Economic policies are formed for the development of a
nation. National income provides information about the various indicators affecting any
nation. These indicators are helpful for economic decisions and formation of economic
policies. Thus, national income is helpful in formation of Economic policies.
III. National income is also helpful to provide information about the major economic
problems. As national income analysis indicates what to produce, how to produce and
for whom to produce. Thus, one can find the solutions for these problems in order to
achieve economic development.
IV. National income also involves contribution of different sectors of production. It includes
primary sector, secondary sector and territory sector. Thus, national income provides us
knowledge about all the sector of production.
V. Inflation and Deflation are the two major indicators of national health of a country. Both
these situations are unfavorable for a country and every country tries to balance this
situation. Solution to these problems can be obtained after knowledge of these
indicators. Thus, national income analysis is important as Inflation and Deflation are
depicted through national income analysis.
VI. Every country wants to balance their country through various measures. For this
purpose, budgetary policies are also formed. Every nation wants to stay away from the
fluctuations of business cycles. These fluctuations are controlled through various
budgetary policies. Thus, national income is helpful for creation of budgetary policies.
VII. National income is also helpful to provide knowledge about national expenditure. In
calculation of national income, we segregate the total expenditure in consumption
expenditure and government expenditure. One important fact i.e. depreciation is also
studied under national income analysis. This analysis also express that liberal policy
may be dangerous for any economy.
VIII. Through calculation of national income, we came to know about the government aids
i.e. subsidies. National income analysis is helpful to balance the distribution of these
subsidies in the economy.
IX. National income analysis is also helpful for comparison among different nations. This
comparison is based on Gross Domestic Product. Thus, it also becomes basis for
comparison of standard of living of different countries.
X. National income analysis also includes exports and imports with other countries. We
also calculate foreign aids, receipts, payments and quota from other countries. It also
includes contribution of IMF, WTO, UNO, etc. Thus, national income analysis provides
knowledge about international sphere.
XI. National income analysis is also helpful to distribute the total Gross National Product in
consumer goods and defence products. If GNP is high, then more income may be used
for development and defence products and rest of the consumer products will not suffer.
XII. National income analysis includes income of both public and private sector. If more
contribution is done by public sector, then there is dominance of public sector in the
economy and vice-versa.
XIII. Data on national income are important for any economy. These data calculated on
national income are called social accounts. Here, we calculate net national income and
net national expenditure.
XIV. All the short-run economic models and long-run economic models formed by
economists are based on national income data. Thus, national income analysis is helpful
for the development of economic models.
XV. Economists try to find new theories and models in economics for development in
existing literature and national development. These researches are based on national
income data and analysis. Researchers also use various economic data about
consumption, investment, production, etc. in their research for the development of new
models and theories.
2.5 Measurement of National Income

National income can be measured as addition of value of goods and services produced in an
accounting year OR it can be expressed as total of income generated through producing goods
and services during an accounting year OR it may also be calculated as the sum of expenditure
incurred on producing goods and services in the economy. There are three major methods to
calculate national income i.e. Value added method, Income method and Expenditure method.
Thus, measurement of national income can be calculated using three different methods. These
are as follows:
I. Product Method
Product method defines national income as total value of goods and services produced
during an accounting year by all the firms in an economy. This value will also include
products work-in-progress and production for personal use by producer. This method as
also known as output method or value added method because it is addition of value to
intermediate goods at different stages of production. Total value addition by each firm
is calculated by the total output of firm minus value of the intermediate goods obtained
from other firm as input for final product.
This method can be understood with the help of an example. Like farmer sell wheat for
₹ 400, it is final output for farmer. Then, producer of wheat flour take wheat as an input
and flour as final product. After this, flour is purchased by bakers for ₹ 800 as raw
material for preparing bread. Then, the bread is sold by baker for ₹ 1000 to customer.
Hence, total output for baker is ₹ 1000. If we count total output it will be calculated as
400 + 800 + 1000 = 2200. But, this calculation is wrong in case of calculation of GDP.
Here, we can see that total output for baker includes the total output of wheat flour. This
becomes the reason for double counting. In case of calculation of GDP this problem of
double counting is avoided.
GDPMP = Ʃ GVAMP
GDPMP is calculated by adding up value addition by all the producers in the economy.
Value added = ₹ 400 + ₹ (800-400) 400 + ₹ (1000-800) 200 = ₹ 1000
National Income can be calculated as:
GDPMP - Net Indirect Taxes = GDPFC
GDPFC – Depreciation = NDPFC
NDPFC + Net Factor Income from Abroad = NNPFC
Precautions used in Expenditure method:
(i) Value of final goods and services is included in National Income.
(ii) Any product supplied at free of cost or at discount rate or sold at a profit margin,
and then it will be included in it.
(iii) Value of goods for self-consumption and imputed rent of self-occupied building
is also included in National Income.
(iv) Value obtained from leisure time or illegal activity is excluded from National
Income.
(v) Service of housewives for their home and any voluntary work are not included
in calculation of National Income.
II. Income Method
Income method refers to that method where national income is calculated from total
factor income arising from different factors of production used in producing the national
income. It is also known as Factor Share Method, Distributed Share Method and Factor
Payment Method. In this method, the value of production should be equal to the value
of income claims arising by that production. Factor Income from those households is
included who are normal resident of a country. Factor Income refers to that income
which is incurred by a person as a reward rendering factor services. Factor income
includes rent for land, wages for labour, interest for capital and profit for entrepreneurs.
National Income = Compensation to employees + Operating surplus + Mixed
Income + Net Factor Income from Abroad
Here,
Compensation of employees = wages & salaries in cash + Payments in Kind +
Employers’ contribution to social security + Pension
on Retirement
Operating Surplus = Rent + Interest + Profit (Dividend + Corporate Profit Tax +
Undistributed Profit)
Mixed Income = Mixed income refers to income earned by using own land, labour,
capital and entrepreneurship. It includes rent, interest, wages and
profit earned through own factors.
NDPFC = Compensation to employees + Operating surplus + Mixed Income
NNPFC = NDPFC + Net Factor Income from Abroad
(i) Income earned from sale of second hand goods is not included in calculation of
National Income.
(ii) Any type of wealth tax, gift tax and estate duties are excluded from the National
Income.
(iii) Illegal incomes are not included in calculation of National Income.
(iv) Any transfer payment is not included in National Income.
(v) Value of production for self-consumption and imputed rent on self-occupied
building is included in it.
III. Expenditure Method
According to Expenditure method, National income refers to total expenditure incurred
on purchase of final goods and services produced in an economy during an accounting
year. This method is also known as Consumption and Investment Method or Income
Disposal Method. National Income can be computed as follows:
National Income = Final Consumption Expenditure + Gross Domestic Capital
Formation + Net Exports - Depreciation – Net Indirect Taxes +
Net Factor Income from Abroad
Here, Final Consumption Expenditure = Private Final consumption expenditure +
Government final consumption
expenditure
Gross Domestic Capital Formation = Gross Domestic Fixed Capital Formation + the
Expenditure on Change in Stock or Inventory
Net Exports = Exports – Imports
(i) Expenditure on final goods is included and expenditure on intermediate goods or
semi-finished goods is excluded.
(ii) Expenditure on obtaining finance capital is not included in it.
(iii) Any government expenditure on old age pension, scholarship, unemployment
allowances, etc. is not included in this method.
Thus, we can conclude that there are three major methods to calculate national income.
These three methods include different factors and attributes. One method describes
items related with value addition in final products; other method includes items related
with income and the last method includes items related with expenditure. So, these
methods provide the complete knowledge of all the variables related with National
Income. Estimation of National Income can be shown as follows through a diagram:
PRODUCT METHOD INCOME METHOD EXPENDITURE METHOD
Compensation of
Gross Value Added in all Employees + Operating
three Sectors at Market Surplus + Mixed
Price Income of the Self- Private Final Consumption
Expenditure + Government Final
employed Consumption Expenditure + Gross
Domestic Fixed Capital Formation
+ Change in Stock or Inventory
Investment + Net Exports
(Exports - Imports)
GDP at Market Price
Net Domestic Income

Depreciation
GDP at Market Price
NDP at Market Price

Depreciation
Net Factor Income from
Net Indirect Taxes Abroad
NDP at Market Price
NDP at Factor Cost

Net Indirect Taxes
National Income
Net Factor Income from NDP at Factor Cost

Abroad
National Income Net Factor Income from

Abroad
National Income
2.6 Difficulties in measurement of National Income

There are various difficulties in calculation of national income. Some of these are related with
concepts and some of these are related with statistics. These are described as:
I. While measuring national income we exclude non-monetary transactions in the

economy. Services of housewives and farm output used at home are not included in
calculation of national income. Sometimes, services of housewives are excluded and
farm output used at home is included in national income but this creates anomalies.
II. Another major problem arises when foreign income is generated by a foreign firm in a
country. It creates problems of inclusion of that income. This income may be included
in national income of that country where the firm is situated or this will be included in
national income of foreign country. Thus, foreign income is also creating problem in
calculation of national income.
III. It is difficult to determine the final goods and services included under calculation of
national income because it creates problem of double counting. Thus, it is difficult to
clear the difference of final goods and semi-finished goods.
IV. National income calculation is based on national income data which may be false.
Calculation of national income requires proper accounts and data on production,
investment, consumption, etc.
V. When accounts are prepared, prices are different and when national income is calculated
prices changes. This change in price creates problem in calculation of national income.
2.7 Some practical questions on National Income:
Q.1 From the following data calculate National Income: Items (in crore)
(i) Private income 1,200 (ii) National debt interest 40 (iii) Current transfers from the
government administrative departments 40 (iv) Other current transfers from rest of the world
12 (v) Income from property and entrepreneurship accruing to government departments 16
(vi) Savings of government departmental enterprises 8.
Sol. National Income = Private income – National debt interest – Current transfers from the
government administrative departments – Other current transfers from rest of the world +
Income from property and entrepreneurship accruing to government departments + Savings
of government departmental enterprises
National Income = 1,200 crore – 40 crore – 40 crore – 12 crore + 16 crore + 8 crore = 1,132
crore = 1,132 crore.
Q.2 Calculate GDPMP and NDPMP with the help of expenditure method from the data give
below: Items (in crore)
(i) Personal disposable income 8,600 (ii) Personal savings 1,500 (iii) Fixed capital formation
3,000 (iv) Net exports (–)300 (v) Net factor income from abroad (–)500 (vi) Net indirect taxes
600 (vii) Government final consumption expenditure 2,200 (viii) Change in stock 800 (ix)
Consumption of fixed capital 450
Sol. GDPMP = Personal disposable income – Personal savings + Net exports + Fixed capital
formation + Change in stock + Government final consumption expenditure
GDPMP = 8,600 crore – 1,500 crore + (–) 300 crore + 3,000 crore + 800 crore + 2,200 crore
GDPMP = 12,800 crore
NDPMP = GDPMP – Consumption of fixed capital
NDPMP = 12,800 crore – 450 crore
NDPMP = 12,350 crore
Q.3 From the following data, calculate National Income by (a) income method, and (b)
expenditure method: Items (in crore)
(i) Private final consumption expenditure 2,000 (ii) Net capital formation 400 (iii) Change in
stock 50 (iv) Compensation of employees 1,900 (v) Rent 200 (vi) Interest 150 (vii) Operating
surplus 720 (viii) Net indirect tax 400 (ix) Employers’ contribution to social security schemes
100 (x) Net exports 20 (xi) Net factor income from abroad (-)20 (xii) Government final
consumption expenditure 600 (xiii) Consumption of fixed capital 100
Sol. (a) Income Method:
National Income = Compensation of employees + Operating surplus + Net factor Income from
abroad
National Income = 1,900 crore + 720 crore + (–) 20 crore = 2,600 crore
(b) Expenditure Method:
National Income = Private final consumption expenditure + Government final consumption

expenditure + Net capital formation + Net exports + Net factor income
from abroad - Net indirect taxes
National Income = 2,000 crore + 600 crore + 400 crore + 20 crore + (-) 20 crore - 400 crore
= 2,600 crore
Q.4 Calculate from the following data:
(a) Private Income, (b) Personal Disposable Income, and (c) Net National Disposable
Income: Items (in crore)
(i) National income 3,000 (ii) Savings of private corporate sector 30 (iii) Corporation tax 80
(iv) Current transfers from government administrative departments 60 (v) Income from
property and entrepreneurship accruing to government administrative departments 150
(vi) Current transfers from rest of the world 50 (vii) Savings of non-departmental
governments enterprises 40 Introductory Macroeconomics (iii) Economics–XII (viii) Net
indirect taxes 250 (ix) Direct taxes paid by households 100 (x) Net factor income from
abroad (–)10
Sol.(a) Private Income = National income + Current transfers from government administrative
departments + Current transfers from rest of the world – Income from property and
entrepreneurship accruing to government administrative departments – Saving of non-
departmental governments enterprises
PI = 3,000 crore + 60 crore + 50 crore – 150 crore – 40 crore = 2,920 crore
(b) Personal Disposable Income = Private income – Savings of private corporate sector
– Corporation tax – Direct taxes paid by households
Personal Disposable Income = 2,920 crore – 30 crore – 80 crore – 100 crore
= 2,710 crore
(c) Net National Disposable Income = National income + Net indirect taxes + Current
transfers from the rest of the world
Net National Disposable Income = 3,000 crore + 250 crore + 50 crore
= 3,300 crore
2.8 Summary
National income is not only a term rather than it includes various concepts related to national
income. National income is an indicator of economic health of a country. National income is
calculated with the help of three methods i.e. Income Method, Product Method and
Expenditure Method. Every method is important in its own way and includes different terms
under each method. National income analysis is very important for every country because it
becomes a basis for comparison among different nations. No doubt national income analysis
plays an important role in the economy. Still this analysis has many drawbacks which create
problems in calculation of national income. But, National income is an estimation of Net
National Income, so these problems can be removed and ignored through some measures.
2.9 Keywords
National Income- National income may be defined as the total sum of factor incomes earned
by normal residents of a country during an accounting year.
Gross Domestic Product- Gross domestic product (GDP) is the monetary value of total sum
of all goods and services produced within domestic territory of a country in an accounting
period.
Double Counting- Double counting arises when total output of the entire producer is added
up without considering that output of one producer may be input for the other producer.
Product Method- Product method defines national income as total value of goods and
services produced during an accounting year by all the firms in an economy.
Income Method- Income method refers to that method where national income is calculated
from total factor income arising from different factors of production used in producing the
national income.
Expenditure Method- According to Expenditure method, National income refers to total
expenditure incurred on purchase of final goods and services produced in an economy during
an accounting year.
2.10 Self-assessment tests
Q.1 Explain the following concepts:
(a) Domestic Income
(b) GDP
(c) GDP deflator
(d) Private Income
Q.2 What do you mean by NNPMP? How does it can be calculated from GDP?
Q.3 Distinguish domestic income and national income with the help of suitable example.
Q.4 Explain the different methods of measuring National Income in detail.
Q.5 What do you mean by National Income Analysis? Explain the major importance of
National Income Analysis.
Q.6 Differentiate between product method and expenditure method of calculating national
income.
Q.7 Elaborate income method of measuring national income. Also explain the various
precautions taken under income method.
Q.8 You are given the following information about an economy:
Gross Investment = 40, Govt. purchases of goods & service = 30, GNP = 200, X – M =
- 20, Personal Tax = 60, Govt. transfer = 25, Interest payments from the Govt. to domestic
Pvt. Sector = 15, Factor income received from the rest of the world = 7, Factor payment
made to rest of would = 9.
Calculate: a) Consumption b) GDP c) Net factor payment from abroad
d) Pvt. Saving e) Public Saving.
Q.9 The following is the information from the national income accounts for a hypothetical
country:
GNP = 5000.00, Personal Disposable Income = 4100.00, Consumption = 3800.00, X-
M = 50.00, Govt. Budget Deficit = 200.00,
Calculate Gross Investment and Government Expenditure.
Q.10 What is the difference between gross domestic product and gross national product?
Which of these two is best measure of income and why?

1. is known as National Income.
2. Product method of calculating National Income is also known as .
3. Four factors of products are .
4. There are methods to measure National Income.
5. GDP stands for .
1. Total income earned in producing the national product
2. Value Added Method
3. Wages, Rent, Interest, Profit
4. Three
5. GDP
2.11 Study tips
1. Jain & Ohri, 2014. Introductory Macroeconomics, pages 31-61, VK Global
Publication Pvt. Ltd., New Delhi.
2. Jhingan, 2012. Macro Economic Theory, pages 19-72, Vrinda Publication (P) Ltd.,
Delhi.
3. Jain et al., 2019. Macro Economics, pages 15-27, VK Global Publication Pvt. Ltd.,
New Delhi.
4. Chaturvedi & Mittal, 2013. Macro Economics, pages 13-34, International Book
House Pvt. Ltd., New Delhi.
5. Ahuja, 2013. Macroeconomics Theory and Policy, pages 20-52, S. Chand
Publishing, New Delhi.
LESSON-3
Consumption Function
Lesson Structure
3.2 Properties of consumption function
3.3 Psychological law of consumption
3.4 Importance of Consumption Function
3.5 Theories of Consumption Function
3.6 Determinants of Consumption Function
3.7 Measures to raise the Propensity to Consume
3.8 Criticism of Propensity to consume
3.9 Summary
3.10 Keywords
3.11 Self-Assessment Tests
3.12 Study Tips
3.0 Learning Objective

After reading this chapter you will be able to understand the concept of consumption function,
its importance and emergence as the topic of study under macroeconomics. Consumption
function concepts will provide you knowledge about types of consumption function. You will
also be able to realize different theories and determinants of consumption function. Propensity
to consume and its measures are also important factor to know about consumption function
and this can be understood by this chapter.
3.1 Assessment to prior Knowledge
In 1936, J. M. Keynes developed the term ‘consumption function’ to describe the relationship
between household’s planned consumption expenditure and total income. As we know that
demand for a product is depend on price of that product, similarly consumption of a
community depends on the level of income. Consumption refers to total amount of money
spend by people on purchase of goods and services. Consumption function is related with
income-consumption relationship. Consumption function may also be known as propensity to
consume. Consumption function may be defined as functional relationship among total
consumption and gross national income. This relationship may be represented as C = f (Y),
where C is the total consumption, Y is the total Income and f represents the functional
relationship of both the factors. Y is an independent variable and C is dependent variable
which means consumption is dependent on national income. This relationship is based on a
major assumption i.e. all the factors influencing consumption will be held constant. Whenever
level of income increases in the community it will result into increase in consumption level.
But how much consumption will increase it is measured through marginal propensity to
consume.
Consumption function is different from amount of consumption. Consumption function shows

through a schedule which represents consumption at various levels of income, whereas
amount of consumption represents the amount consumed at a specific level of income. The
table 3.1 represents the schedule of consumption function which shows the amount of
consumption changes due to change in national income.
Table 3.1 Income and Consumption Level

Income Consumption
1000 550
1200 600
1400 750
1800 1000
2000 1130
2300 1300
2600 1420
This table shows that at the level of income 1000 rupees, the total consumption is 550 rupees.
As the national income increases to rupees 1400, the amount of consumption rises to rupees
750. Thus, we can say that whenever level of national income changes it cause change in
consumption level. As national income increase consumption will also increase but this
increase in consumption will not at same pace as increase in national income.
3.2 Properties of the Consumption Function

Consumption function is based on two major properties i.e. Average Propensity to Consume
and Marginal propensity to consume. These two properties are also known as technical
attributes of consumption function. Both properties are important to study for better
understanding of consumption function. Propensity to consume refers to that portion of total
income which consumers tend to spend on goods and services. These properties are discussed
in detail here:
(I) Average Propensity to Consume

Average propensity to consume refers to the ratio between total consumption expenditure
to total income. Or this may be defined as the ratio of consumption expenditure to
personal disposable income. It can be shown as:
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆

Average Propensity to consume = 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
OR
𝑪
APC =
𝒀
For example, if total consumption expenditure is 8,000 rupee and personal disposable
𝟖𝟎𝟎𝟎
income is 20,000 rupee, then APC = = 0.4 or 40%. It means 40% of the total
𝟐𝟎𝟎𝟎𝟎
income is used for consumption purpose in an economy. This can be calculated for
individual consumer using personal disposable income. APC can be presented through
Table No. 3.2.
This table represents that when income level is zero, consumption expenditure is 40
crores. This is due to expenditure on necessity goods even when national income is 0.
When national income increases consumption expenditure will increase simultaneously.
But APC starts declining from 1.20 to 0.90.
Table No. 3.2 Average Propensity to Consume
Further this can be presented through a diagram, where consumption is shown on OY

axis and income is represented on OX axis. In Fig. 3.1, CC is the consumption curve. At
ON consumption level and OY1 income level, APC situated at point A which can be
𝑂𝑁
calculated by, APC = OY1.
Fig. 3.1 Average Propensity to Consume
Some important points about APC:

(i) APC > 1, when consumption is more than national income.
(ii) APC < 1, when consumption is less than national income.
(iii) APC = 1, when consumption is equal to national income.
(iv) APC ≠ 0, because consumption cannot be zero at any level of income.
(v) APC falls continuously with the increase in national income because the portion
spent on consumption starts declining.
(II) Marginal Propensity to Consume
Marginal propensity to consume refers to change in total consumption to change in total
income. It may be described as the ratio of change in consumption expenditure due to
change in personal disposable income. It can be represented as,
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆
Marginal Propensity to Consume = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
OR
∆𝑪
MPC =
∆𝒀
For example, if total consumption expenditure increases from 8,000 to 10,000 rupee and
𝟏𝟎𝟎𝟎𝟎
personal disposable income increases 30,000 rupee, then MPC = = 0.33 or
𝟑𝟎𝟎𝟎𝟎
33%. It means 33% of the total income is used for consumption purpose in an economy.
This can be calculated as additional consumption out of additional income. MPC can be
presented through Table No. 3.3.
Table No. 3.3 Marginal Propensity to Consume
Income Consumption Change in Income Change in Consumption Marginal Propensity to
(Y) Crores Crores Crores (∆𝑌) Crores (∆𝐶) ∆𝐶
Consume =
∆𝑌
0 40 - - -
80
100 120 100 80 MPS =
100
= 0.80
80
200 200 100 80 MPS =
100
= 0.80
80
300 280 100 80 MPS =
100
= 0.80
80
400 360 100 80 MPS =
100
= 0.80
Table No. 3.3 represents that when there is change in total income from 0 to 100 crores
and consumption expenditure increases from 40 to 120 crores which lead to MPC at 0.80.
Here, the consumption curve will be a straight line because MPC remains constant at
different level of income and consumption.
Further this can be shown through a figure which represents change in income from OY1
to OY2 and change in consumption expenditure from OM to ON. MPC is situated at point
A where change in consumption and change in income is measured.
Fig. 3.2 Marginal Propensity to Consume

Some important points about MPC:
(i) MPC value ranges from 0 to 1. If all the additional income is consumed, then MPC
will be equal to 1 and when all the additional income is saved then MPC will be 0.
(ii) Marginal Propensity to Consume of poor people will be more than rich people
because a greater percentage of their increased income on consumption. But rich
people spend a smaller portion of their income on consumption because they already
enjoy high standard of living.
(iii) MPC starts declining with successive increase in income.
3.3 Psychological Law of Consumption

Psychological law of consumption is propounded by economist Keynes which shows
relationship among aggregate consumption and income. It is also known as Keynes’
Fundamental Law of Consumption. Keynes stated that with the increase in income there will
be increase in consumption expenditure but this increase in consumption is less than increase
in income. Keynes stated that, “The psychology of the community is such that when
aggregate real income is increased, aggregate consumption is increased, but not by so
much as income.”
Definition
According to Keynes, “The fundamental psychological law, upon which we are entitled
to depend with great confidence both a priori from our knowledge of human nature and
from the detailed facts of experience, is that men are disposed, as a rule, and on the
average, to increase their consumption as their income increases, but not by as much as
the increase in their income.” Further, it can be said that marginal propensity to
consume is always positive but it is less than unity.
3.3.1 Assumptions of psychological law of consumption:

Keynes psychological law is based on certain assumptions which are explained below:
I. This law is related to short period so it assumes that distribution of income, price
level, population growth, fashion, taste, behaviour of consumer, spending habits,
etc. will remain constant. Only one factor will affect the consumption i.e. Income.
II. Keynes assumes that there exists normal situation in the economy for applicability
of this law. Normal condition means there is usual and ordinary conditions in the
economy. There are no chances for the occurrence of war, revolution,
hyperinflation, etc. in the economy.
III. One another assumption is about the free capitalistic economy exist in a country.
Free capitalistic economy means the economy where the economy is free from
government intervention in context of increase and decrease in income level. It is
also known as laissez-faire capitalistic economy. Here, market is determined
through demand and supply of goods and services.
3.3.2 Explanation of the law

This law can be explained with the help of a table and diagram:
Table No. 3.4 Psychological law of consumption
Income (Y) Consumption (C) Saving (S)
0 20 -20
50 60 -10
100 100 0
150 140 10
200 180 20
This table represents the relationship among income, saving and consumption. Table shows
that there is increase in consumption with respect to increase in income but proportionate
increase in consumption is less than proportionate increase in income. Further, income may
be zero when there is no means of earning but consumption still exists because consumer can
borrow money or used their past savings at this movement. At some point, income and
consumption will equivalent to each other and saving will be zero. Onward this point,
increase in income will leads to increase in consumption but total income is not used for
consumption hence there will be increase in saving.
Fig. 3.3 Relationship of Income and Consumption and Saving
Similarly, this situation can be shown through fig. 3.3 which represents that from origin to OY E
there will be increase in consumption and there is dis-saving because either people are not earning
from any source or their income is less than their consumption expenditure. At point E,
consumption and income are equal to each other. Onward point E, there will be saving because
proportionate increase in income is greater than proportionate increase in consumption.
According to Keynes Law, if this gap between income and consumption continuously rise then
there will be deficiency of aggregate demand in context of aggregate supply at full employment
level. This will lead to low level equilibrium in the economy and this will adversely affect the
economy. Due to this situation effective demand will decrease and this will lead to unemployment
in the economy.
3.4 Importance of Consumption Function
I. Consumption function is not just a concept of discussion rather it has its own
theoretical and practical implications. Every nation depends on economic policies for
the economic development. These policies are formed after studying microeconomic
and macroeconomic factors of a nation. Consumption function is an important
macroeconomic factor and important to study. Importance of consumption function is
explained below:
II. Consumption function is an important macroeconomic factor given by Keynes.
Consumption function is help to study about income and consumption expenditure.
III. It is also important to determine the link among investment and its resultant changes
in the income of a country.
IV. Consumption function is an important tool to determine the demand and supply in the
firm and industry.
V. Consumption function is also helpful to determine value of multiplier. Value of
1
multiplier is equal to1−𝑀𝑃𝐶 . Here, MPC is marginal propensity to consume which is
studied under consumption function.

VI. Consumption function also helps to invalidates Say’s Law which states that supply
creates its own demand. But, MPC in consumption function states that whole of the
income is not spent for consumption. Due to this fact supply exceeds demand and
creates surplus in the market which creates situation of overproduction and
unemployment in the economy.
VII. Consumption function also explains the turning points of business cycle. MPC
explains that consumption did not increase as there is increase in income. Business
cycle takes downturn when MPC is less than 1 and business cycle is upturn when
consumption is stable because people are unable to cut down their consumption to full
extent of a decrease in income.
VIII. Consumption function is also important to describe the theory of employment in
macroeconomics.
3.5 Theories of Consumption Function

There are several theories of consumption function which determine consumption in the
society. Firstly, Keynes works in this direction to determine the level of consumption in the
economy. Major four theories of consumption are described here as under:
I. Absolute Income Theory

This theory is propounded by Keynes for the determination of consumption level in
the economy. Keynes stated that the level of consumption expenditure depends on the
absolute level of current income and relationship of both the variables is non-
proportionate. This theory clearly explained that the average propensity to consume
starts declining because the level of absolutes income goes up. Firstly, this theory was
given by Keynes in his General Theory. After this, further changes were made by
James Tobin and Arthur Smithies which is called Drift Hypothesis.
Absolute
Income Theory
Life Cycle
Theories of Theory
Consumption
Function Relative Income
Hypothesis
Permanent
Income
Hypothesis
Fig. 3.3 Theories of Consumption Function
II. Life Cycle Theory
Life Cycle Theory was developed by Franco Modigliani, Albert Ando and later by
Brumberg. This theory explains that household level of consumption expenditure is
not just limited to current income of a person rather than it also depends on the income
of whole life. This is based on the individual expectation for future earnings as well
as wealth over their life time. Every individual prepare himself for the future
contingencies and emergencies by keeping some money aside. Thus, consumption
expenditure decision is not based on single factor i.e. current income.
Life cycle theory is more realistic than absolute income theory. According to this
theory, consumer uses a planned pattern of consumption expenditure based on their
current and expected future wealth. For planned consumption expenditure, individual
prefer borrowings from others or spending the income of his parents in the early stages
of consumption.
III. Relative Income Theory
Relative income theory was propounded by Dorothy Brady and Rose Friedman. This
theory states that consumption expenditure does not depends on the level of current
income but it depends on the consumption expenditure of an individual with same
income level. Thus, consumption is dependent on the relative income hypothesis.
Further this theory was additionally developed by Modigliani and James S.
Duesenberry. It was stated that in case of any increase in the level of income,
consumption expenditure of individuals will change if their relative position changes.
IV. Permanent Income Theory
Another American economist Milton Friedman argued that consumption expenditure
is not based on current level of income but it is based on permanent income of
household. This permanent income involves the human and non-human capital.
Human capital refers to return on income derived from labour services and non-human
capital refers to wealth related with tangible asset lie saved money, debentures, shares,
etc. This theory includes importance of capital in determining consumption
expenditure of households. This shows relationship among consumption and
permanent income.
CP=kYP
Where,
YP is the permanent income
CP is the permanent consumption
k is the proportion of permanent income that is consumed.
3.6 Determinants of Consumption Function/ Propensity to Consume

There are various factors which are responsible for determining consumption level or
propensity to consume. There are two types of factors i.e. subjective factors and objectives
factors. Propensity to consume is influenced by nature of people. If people are more aware
about their safety and security, then they will focus on emergencies and future contingencies.
Due to this fact, the propensity to consume would be less. But, there can be adverse situation.
Propensity to consume is mainly based on income but other factors cannot be ignored. Thus,
these are described in detail.
Fig. 3.4 Determinants of Consumption Function

I. Subjective Factors
Subjective factors are psychological factors which are related with human behaviour and
social practices. These factors cannot be estimated. These factors are based on some
circumstances with individual and firms when these institutions would consume less and
save more. These factors are responsible for estimating consumption curve. These are
explained below:
(i) Farsightedness
Consumer is always uncertain about his/her future. So, they have to think about their
future in advance. Due to farsightedness, consumer always wants to save for future
needs and cutting down their present consumption. Consumer prefers reserves for
unforeseen contingencies rather than present consumption.
(ii) Enlarged income in future
Everybody wants to enhance their wealth and property with the time and
circumstances. Consumer prefers to consume less in present and save for different
types of investment. Investments are preferred because it provide future income,
interest and enlarge the earning of individuals. Thus, this factor is also responsible
for determining consumption function.
(iii)Occupational Motive
Consumption can be determined through spending and saving. Most of the persons
want to start their own business and for this they save more and spend less part of
their income. Thus, occupational objective of a person also affects consumption
function.
(iv) Miserliness
Some people had strong desire to save money or want avoid any type of risk, so they
consume less and save more.
(v) Status in Society
Today, there is rat race to become rich and having more wealth. Wealth becomes a
symbol of status. Every person wants to enlarge their wealth and status in the society.
Thus, people want to save more and consume less.
(vi) Liquidity Preference
As we have already discussed that man is always uncertain about future and every
person tends to hold some cash for future contingencies. Due to this cash position or
liquidity, consumption expenditure goes down.
(vii) Modernization
Business requires funds time to time for modernization. Modernization involves
purchase of capital assets or installation of new machinery. Thus, businessmen tend
to save more and consume less. So, consumption function is depending on
modernization decision of firm.
(viii) Financial Prudence
Every businessman wants to secure themselves from future risk, depreciation,
obsolesces and discharge debts. Thus, businessman tends to save for these future
urgencies rather than consuming that income. So, financial prudence also affects
consumption function.
II. Objective Factors
Objective factors are quantifiable factors and also known as economic factors. These are
economic factors because objectives factors changes in short-run. Changes due to
objective factors are responsible for upward and downward movement of consumption
curve. These factors are explained below:
(i) Change in Money Income
Income plays an important role in deciding consumption expenditure in a society.
Whenever money income increases demand for products and services also increases
in the society then consumption expenditure will also increase. Whenever money
income goes down, demand for products and services go down. As a result,
consumption expenditure will also go down. Thus, consumption expenditure is also
based on change in money income. However, the consumption expenditure increase
less than money increase. This is due to the fact that people want to save after
fulfilling their basic needs.
(ii) Change in Real Income
Real income means the purchasing power of a person to purchase goods and services.
This income fluctuates with inflation in the economy. If inflation increases more than
income in the society, then real income will also go down. If inflation decreases with
stable in income, then real income will go up. Consequently, increase or decrease in
the real income leads to increase or decrease in the consumption expenditure.
(iii)Windfall Gains and Losses

Consumption expenditure is also affected through sudden changes in the organisation
as well as in household’s daily life. Everything cannot be perfect and according to
thinking of human being. Sometimes there occur some favorable and unfavorable
situations in the society. Consumption expenditure also affected through whenever
there is situation of boom and as a result windfall gains occurred. Keynes also
suggested that consumption expenditure is not just affected by income but capital
gain can be equally important.
(iv) Change in Expectations
Human behaviour and attitude cannot be static in every situation. Their expectations
go on changing day by day. Expectations regarding future events had a great impact
on consumption expenditure. If people feel that there will be shortage of goods and
services in future, then they will try to consume in current time. Thus, propensity to
consume is affected through future expectations of the consumers.
(v) Fiscal Policy
Fiscal policy is known as government revenue and expenditure policy. Government
earns revenue from taxation and public debt. Government makes expenditure on
infrastructure and developmental activities of a country. Due to fiscal policy, there is
highly progressive tax system in India which leads to equal distribution of income.
This will result into shift of consumption function upwards. On the other hand, a
regressive tax structure leads to downward movement of propensity to consume in
the economy.
(vi) Wages
Wages had a great impact on propensity to consume. Classical economists viewed
that wage cut leads to higher propensity to consume. As increase in wages leads to
upward movement of consumption function and decrease in wages had unfavorable
effect on consumption function. This is due the fact that increase or decrease in wages
has direct impact on prices level in the society.
In some situations, there will be negative effect of wages cut on consumption
expenditure. Due to wage cuts, there will be unequal distribution of income and
income changes hands from more consuming to more saving hands. Thus, it may
lower the propensity to consume.
(vii) Change in Interest Rates
Interest rate can be favorable and unfavorable for propensity to consume. If the
interest rate goes up, then people will consume less and if interest rate goes down
then people will consume more and save less. Moreover, a person always wants to
earn fixed in future will choose to save less at a higher interest than at a lower rate of
interest. Propensity to consume is affected by change in rate of interest over a long
period of time.
(viii) Liquid Assets
Liquid asset means the assets which can be easily converted into cash; like: Currency,
Bank deposits, govt. bonds, etc. Thus, changes in liquid assets results into changes in
propensity to consume. Pigou, a Neo-classical economist believed that when price
decreases, there will be increase in liquid asset of the people having large amount of
liquid assets. It has been seen that people having more amount of liquid assets show
a tendency to spend more on consumption. This situation is created only when these
assets are equally distributed. Thus, we can conclude that more liquid people are
interested in more consumption.
(ix) Attraction in New Products
Sometimes availability of new products and goods also influences level of
consumption. When a new product enters in the market people start to buy it in large
quantity. It means when some new goods are introduced in the market then
consumption expenditure will increase. On the other hand, whenever there is shortage
of goods in the market then people are forced to save and propensity to consume goes
upward.
Thus, we can conclude that both the objective and subjective factors are responsible for
propensity to consume. Movement of propensity to consume is dependent on each and
every factor of determining consumption function. So, it can be said that not only income
is necessary but other factors are equally important.
3.7 Measures to raise the Propensity to Consume
I. Propensity to consume is affected by unequal distribution of income in the society. As
poor class is more than rich class in the Indian society which is a major reason behind
lower propensity to consume. If some practices are done for equal distribution or
redistribution of income among poor and rich, then marginal propensity to consume will
increase.
II. Every person want to save some money out of their total income for future needs, old-
age, medical care during illness, etc. if they are provided some social security or benefits,
old age pension and unemployment allowances by the government for future needs, then
propensity to consume may be raised.
III. Credit facility is also an important factor which leads to increase and decrease in the
consumption expenditure in the society. If people got some credit facility for purchasing
consumer durable goods like: LED, TV, Computer, etc., then margin propensity to
consume will increase.
IV. An appropriate wage policy is must for increasing propensity to consume in the society.
Wages can be studied for both the period i.e. short period and longer period. If wages
increased for short period, then it will lead to increase in consumption expenditure for
short term but propensity to consume will remain constant. Here, propensity to consume
will not increase because productivity of laborers will not increase in short period and
due to this fact cost of production will increase, so an employer will cut down number of
labours. On the other hand, if wages increased for longer period then marginal propensity
to consume will also increase.
V. Propensity to consume is also affected through size of population. If population increases
demand for products also increases and as a result of increase in demand, there will be
increased marginal propensity to consume.
VI. Demonstration effect is an important effect on propensity to consume because poor
people want to use the same products as used by rich people. Thus, poor people spend
more income and shows high propensity to consume.
VII. Urbanization is also an important factor to determine propensity to consume because
urban people have higher propensity to consume than rural people. The main reason
behind this is awareness about different products and services. Urban people have more
awareness about different products and services than rural people.
VIII. Propensity to consume can be encouraged through advertisement and other form of
media. If expenditure on advertisement is done in an organized way, then it will lead to
increase in propensity to consume. Today businessmen are spending more and more
income on advertising the product so that they can enhance the demand for products. Due
to these advertisements consume got information about new products as well existing
products. Thus, advertisement is an important tool for increasing propensity to consume.
IX. Then, transportation can also become a source for enhancing propensity to consume. Is
cheap means of transportation are developed then goods can be easily moved from one
place to another. This creates place utility and consumer can buy product from any place.
Thus, easy availability of products leads to increase in propensity to consume.
Thus, we can conclude that there are factors affecting propensity to consume. Similarly, we
found a lot of ways to improve propensity to consume in the society. If these changes are
made by individual as well as organisation then propensity to consume may be increased.
3.8 Criticism of Propensity to Consume
I. Keynes used the meaning of word ‘propensity’ as part of income which is spent by
consumer but propensity means tendency. Thus, use of this term is wrong here.
II. Some economists criticize the fact that poor have greater propensity to consume rather
than rich people. Economists are of view that it is not a new thing which is focused
too much.
III. This theory is also unrealistic because it states that with increase in income there will
be increase in saving also but increase in saving is not always exists due to increase in
income. Hazlitt economists prove this fact by using statistics of America for the period
1944-45.
IV. Assumptions of this law also restrict it because in short run the entire institutional and
psychological factor may be constant but in long run there will be change.
3.9 Summary
At the end we can conclude that consumption function is an important parameter for the
modern economics as well as for economic analysis. It has been clarified from consumption
function that consumption expenditure is affected by income of consumer. Keynes is the
economist who describes that proportionate increase in income is greater than proportionate
increase in consumption expenditure. The consumption function is also used to study the
fluctuations of business cycle in the economy. Further, study of consumption function will
provide all the information regarding income, consumption expenditure and saving in the
economy. Various theories are covered under consumption function which describes the
different aspects of consumption expenditure and income. Consumption function or
propensity to consume is not based on single factor rather than it is determined through large
number of subjective and objective factors in the economy. There are many problems
regarding propensity to consume but these can be removed with taking some precautions.
Thus, it can be said that consumption function is an important tool which is helpful for policy
formulation in the economy.
3.10 Keywords
Consumption- Consumption refers to using the utilities derived from a product or it can be
defined satisfaction through using utilities.
Propensity to consume- Propensity to consume is that amount of money which is spent by

consumer rather than saving.
Income- Income refers to the amount or money which a person receives from exchange of
goods or by providing services to others.
Expenditure- Expenditure refers to the portion of income which is used or consumed for the
purpose of purchasing goods and services from others.
Average propensity to consume- Average propensity to consume refers to the ration

between total consumption expenditure to total income.
Marginal propensity to consume- Marginal propensity to consume refers to measurement

of change in total consumption and total income.
3.11 Self- Assessment Tests

Q.1 What do you mean by consumption function? Explain the different factors affecting
consumption function.
Q.2 What are the major properties used under consumption function? Why there is
requirement of consumption function?
Q.3 Explain the different theories of Consumption function.
Q.4 What is Psychological Law of Consumption? How does it work in the economy?
Q.5 Explain the difference among Marginal propensity to consume and Average propensity
to consume with examples.
Q.6 Explain in detail about ‘Life Cycle theory of Consumption’ and ‘Permanent Income
theory of consumption’.
Q.7 What are the major importance of propensity to consume? Is there exists any measures to
raise the propensity to consume?
Q.8 Explain the following:

(a) APC (b) MPC (c) Relative Income Hypothesis
Q.9 What are the major subjective and objective factors of determining Propensity to
Consume?
Q.10 Critically examine the Keynes Law of Consumption.

1. is equal to ratio between consumption and income.
2. MPC + MPS =
3. Marginal consumption function is always .
4. Consumption depends on .
5. is the ratio of saving to income.
1. Propensity to consume
2. One
3. Less than one
4. Income
5. Propensity to save
3.12 References
1. Jain et al. 2019. Macroeconomics, pages 145-168, VK Global Publication Pvt.

Ltd., New Delhi.
2. Jain & Arora 2019. Principles of Macroeconomics, pages 69-93, VK Global
3. Chaturvedi & Mittal 2013. Macro Economics, pages 35-51, International Book
House Pvt. Ltd., New Delhi.
4. Ahuja 2013. Macroeconomics Theory and Policy, pages 149-169, S. Chand &
Company Pvt. Ltd., New Delhi.
5. Branson 1995. Macroeconomic Theory and Policy, pages 32-52, Orient Offset
Publication, New Delhi.
6. Vaish 2014. Macroeconomic Theory, pages 176-191, Vikas Publishing House Pvt.
Ltd., Noida.
LESSON-4
Investment Function
Lesson Structure
4.1 Assessment of prior knowledge
4.2 Classification of Investment Expenditure
4.3 Types of Investment
4.4 Determinants of Induced Investment
4.5 Source of Autonomous Investment
4.6 Measures to Stimulate Private Investment
4.7 Factors affecting Investment
4.8 Importance of Investment
4.9 Summary
4.10 Keywords
4.12 Study Tips

After reading this chapter you will be able to understand the meaning of investment and
investment expenditure. This chapter will provide you the knowledge about the different types
of investment and how does different investment works in the economy. Further, we will
discuss about the importance of investment and factors affecting investment decision.

Consumption function is discussed earlier in previous chapter; similarly, investment function
is an important component of aggregate demand. Before describing investment function, it is
important to elaborate the term investment which has different meanings according to its uses.
In finance, investment refers to buy shares, debentures, stocks, bonds and securities from
stock market. In economics, investment refers to the expenditure made for acquiring the
capital assets such as machinery, furniture, building, etc. So, we can understand investment
as expenditure on adding the capital assets in the organisation which ultimately results into
increase in income and production. Investment function represents the relationship between
aggregate income and aggregate investment. Keynes defines investment as real investment
which results into addition to capital equipment. He said that a person can invest his money
in two major ways i.e. either he can buy shares and stocks or he can invest the money for
buying new machinery, setting up of new office and promoting a company. Due to purchase
of share and stock only ownership will transfer but it does not affect employment in the
economy. This is beneficial only for individual as it is a financial transaction but not beneficial
for the whole society. On the other hand, the use of money for setting of premises or purchase
of machinery will leads to positive effect on employment as new employment opportunities
for society. Investment may be further described as the expenditure on the purchase of such
goods which leads to increase the overall production capacity in the economy.
Definition
According to Joan Robinson, “By investment is meant an addition to capital, such as occurs
when a new house is built or a new factory is built. Investment means making an addition to
the stock of goods in existence.”
4.2 Classification of Investment Expenditure

Investment function is based on investment expenditure which may be incurred by household,
businessmen, corporate house and government of a country. This investment expenditure may
be classified into three major parts which are explained below:
(a) Business Fixed Investment

Business Fixed Investment represents the investments in the machines, tools and
equipment which are used by businessmen for further production of goods and services.
The stock of these machines, buildings, tools and plant equipment is known as fixed
capital. Moreover, we can understand fixed investment as the expenditure made on
machinery, plants, equipment, etc. which are continuously be used for production over the
long period of time. Business fixed investment is an important component of aggregate
demand and this fixed investment is also helpful for determination of national income and
employment level in the economy. Moreover, business fixed investment also fluctuates
over a period of time and these fluctuations will result into business cycles in the free
market economy.
Fixed investment is determined by two factors i.e. real rate of interest and business
expectations. Real rate of interest refers to the difference between money rate of interest
and expected rate of inflation. Higher the real rate of interest will lead to lower desired
investment expenditure on fixed assets, while lower the real rate of interest will lead to
higher investment expenditure on fixed assets in the organisation. Further, business
expectations refer to the forecasting the future state of market by the entrepreneur. If
entrepreneur expects growth in demand for their goods and services, then they will invest
more and on the other hand if entrepreneur expects poor demand for their goods and
services then they will limit investment.
(b) Investment on Business Inventory
Every businessman holds some sort of inventory which may be in the form of raw
material, finished goods, unfinished goods and material work-in-progress. Whenever
there is change in the inventory position of an organisation, it will affect organisation.
Further, desired investment expenditure on business inventory is known as investment on
business inventory. There is volatility in investment decision regarding business inventory
because investors invest according to their future expectations. This business inventory
decision is taken for short period as this decision may fluctuate over the period of time. If
investor expects recession in near future then they will tend to reduce the investment in
business inventory and whenever investor has good business expectation, it will leads to
inducement of investment for business inventory. Expenditure on inventory also
determined through real rate of interest as higher the real rate of interest leads to higher
cost of holding stock then there will be low level of desired expenditure. On the other
hand, a reduction in real rate of interest rate leads to inducement of desired expenditure.
(c) Investment Expenditure on Residential Construction
Another important type of desired investment expenditure is investment on residential
construction which is incurred by households. Residential investment can be defined as
expenditure made by households on construction of new house, building and other
apartments for the purpose of residence or for renting out it to others. In India, residential
investment ranges from 3 percent to 5 percent of the gross domestic product. Residential
investments are determined by price of existing housing units in the society as higher the
price of existing housing units will lead to higher investment for residential construction
or for buying new house and vice-versa.
Further, government is also proving income tax rebates on the residential housing loan
which encourages investor to borrow money from financial institutions. Due to increasing
inflation rate, interest rate on housing loan also increasing and as a result of this
expenditure on residential construction will be reduced. But, demand for new houses is so
huge that investment expenditure and borrowing for residential construction cannot be
reduced.
4.3 Types of Investment

As an investor we have a large number of options for investment and as a rational person, one
has to choose where to invest out of the possible investment options and avenues. Investment
and its types become basis for better understanding of investment function in economics.
Different types of investments are discussed as under:
(a) Financial Investment

Financial investment refers to the amount of money invested for buying shares and stocks
of existing companies. Or we can say that it is the expenditure made by investor on
purchase of financial instruments. Financial investment leads to increase in total assets of
an individual but it is not significant in economy as a whole unless it is undertaken by our
residents in rest of the world.
According to Stonier and Hague, “By investment we do not mean the purchase of
existing paper security, bonds, debentures or equity, but the purchase of new factories,
machines and like.
Financial
Investment
Unplanned Real
Investment Investment
Planned Induced
Types of
Investment
Net Autonomous
Gross Private
Public
Investment
Fig. 4.1 Types of Investment
(b) Real Investment

Real investment refers to the total expenditure on the purchase of the goods which results
into increase in overall production capacity in the economy. This expenditure involves
purchase of new machinery, plant, buildings for business purpose or construction of
residential house. Real investment is can be called as net capital formation because it has
a direct impact on the production, employment and national growth.
According to Mrs. Joan Robinson, “By investment is meant an addition to capital, such
as occurs when a new house is build or a new factory is built. Investment means making
an addition to the stock of goods in existence.”
(c) Induced Investment
Induce investment is based on two major factors i.e. income and profit and it is positively
related with income level and profits. At high level of income and profit investors are
induced to invest more and when income level and profits goes down, investment level
also reduces. This type of investment may be known as profit or income elastic.
According to Prof. Keiser, “When an increase in investment is due to increase in current
level of income and production, it is known as induced investment”.
(d) Autonomous Investment
Autonomous investment is the investment which is independent of the level of the income
and output. It means this investment is not induced by level of income. It is the investment
which is made by government to enhance the level of effective demand in the economy
during the period of depression and unemployment. It may include expenditure on
construction of houses, roads, buildings and other infrastructure by government.
According to Peterson, “The autonomous investment is generally associated with such
factors as the introduction of new techniques or products, the development of new
resources or the growth of population and labour force.”
(e) Private Investment
Private investment refers to the investment made by private individual or private player
of the market with the merely motive to earn profit. This type of investment is dependent
on two major factors i.e. Marginal efficiency of capital and Rate of interest. If Marginal
efficiency of capital is greater than rate of interest, then there will more private investment
in the economy. On the other hand, if marginal efficiency of capital is less than rate of
interest then there will no private investment in the economy.
(f) Public Investment
Pubic investment refers to the investment made by central government, state government
and local self-government of a country. This investment is not made for merely profits but
it is made for social welfare and economic development of a country. This type of
investment is encouraged so that higher rate of growth is achieved in the economy.
(g) Gross Investment
Gross investment is the total investment made on capital goods at any given point of time
in an economy. Moreover, it may be defined as the total amount of money spent on capital
assets like plant and machinery, factory building, etc. Gross investment includes net
investment and replacement investment. It may be shown as:
Gross Investment = Net Investment + Replacement Investment
Here, replacement investment is the cost incurred on the maintenance of depreciating
capital assets in the business. Whenever gross investment is more than replacement
investment then there will be increase in capital stock.
(h) Net Investment
Net investment refers to the investment which arises out of increasing capital stock in the
business. According to Peterson, “Net investment is investment that enlarges economy’s
stock of real capital assets thereby, adding to productive capacity.” Net investment can be
shown as:
Net Investment = Gross Investment – Replacement Investment
(i) Planned Investment
When an entrepreneur makes a plan for investment in a systematic manner with a
particular objective, is known as planned investment. It is also known as intended
investment or Ex – ante investment or voluntary investment. As per the term planned
investment, we can describe it as voluntary investment made by investors for achieving
particular objectives. It is affected by two major factors i.e. anticipated increase in demand
and anticipated cut in the cost of production due to new technology. So, it can be termed
as cost-oriented investment because of the cost reduction technique.
(j) Unplanned Investment
Unplanned investment refers to the investment which is made without any concrete plan
or it may be random investment. Unplanned investment is involuntary investment made
by investors. Sometimes, there is sudden fall in demand and stock of goods is accumulated
in the business without any plan or objective. Thus, it is also known as unintended
investment, Ex – post investment and involuntary investment.
4.4 Determinants of Induced Investment

As we have earlier discussed about the induced investment, which is affected by increase in
income and profit in the organisation. Induced investment can be determined by two major
determinants. According to Keynes, the decision regarding investment in new project depends
on the two major determinants. These determinants are discussed as under:
(a) Marginal Efficiency of Capital
Marginal efficiency of capital may be defined as expected rate of return of a new project
or investment in the business. Marginal efficiency of capital may be defined as the ratio
between the potential return of supplementary capital and price of their supply.
According to Dillard, “the marginal efficiency of capital in general is the highest rate of
return over cost expected from producing an additional or marginal unit of the most
profitable of all types of capital assets.”
Marginal efficiency of capital may be determined through two major factors i.e.
(i) Prospective Yield
Prospective yield of an asset may be defined as the aggregate of expected revenue
from the sale of output produced during its life time but excluded variable cost. Here,
variable cost refers to the cost of raw materials, wages, advertisement, transportation,
etc. Marginal efficiency of capital depends on the long term expectations of the
entrepreneurs’ regarding the prospective yields of the capital assets. Inducement of
investment depends on the profit and loss expectations of the entrepreneur. Whenever
a new investment is made or a new project is decided then prospective yield from that
project is considers first. Expected yield is difficult to compute as one can only
estimate about the physical life of an asset but no one can predict about the economic
life of that asset because of obsolesce or physical worn out. Thus, an entrepreneur has
to critically examine all the factors while computation of flows of income or
prospective yield from capital asset.
(ii) Supply Price
Supply price does mean the supply of an existing asset to others but it is the cost of
producing a new asset in the business. Or whenever an entrepreneur wishes to buy the
capital asset, then he has to pay some price for that asset, is known as supply price of
the asset. Keynes has described supply price as the cost of acquisition or replacement
cost of an asset. Supply price may be extended to a number of years in case of services
like construction, etc. Supply price is considered as fixed in short period.
(b) Rate of Interest
If we borrow money from others, then we have to interest on that amount. Similarly, when
we purchase government securities, bonds, etc. with own money then we will get interest
from these securities. But, when we invest our money to purchase capital asset then we
have to forgo this interest. According to Keynes rate of interest can be determined by
supply of money and demand for money on two factor as basis i.e. liquidity and
preference. In short run, supply for money is assumed to be constant and rate of interest
is determined only through demand for money. Higher the interest rate will lead to lower
down the liquidity on the part of people and lower the interest rate will lead greater
preference for liquidity. On the other hand, liquidity preference has also its impact on the
rate of interest. As greater the liquidity preference will result into higher rate of interest
and smaller the liquidity preference will result into lower rate of interest. When other
things being equal, rate of interest will be high or low due to less and more of supply of
money.
4.5 Source of Autonomous Investment

Public investment is an important factor responsible for economic development of a country.
Government of a country increases and decreases the investment level as and when it is
required. Whenever there is situation of depression in the economy, private investment falls
then public investment can be made on work activities like: hospital, schools, roads, etc. Due
to public investment, there will be increase in income level as well as increase in the
employment level in the country. Following are the sources of public investment:
(a) Taxation
Taxation is a major source of investment as a public investment which is collected from
the public and spent again on public. Some of the people argue against that taxation policy
does not encourage new investment but it just a transfer of purchasing power from public
to government. There will be no effect of taxation policy on the new investment. Thus,
taxation may be a source of investment but argument against it thinks that investment
remain constant.
(b) Loans
Loans are considered as a better source than taxation policy because loans are helpful for
circulation of inactive money with the public. Loans may be of two types i.e. Private loans
and Public loans. People deposit their money into bank and banks have large surplus funds
which are circulated through the way of loans to public at reasonable rate of interest. These
loans will be helpful for economic development as it is a source of public investment.
Such loans should be stopped before full employment level is achieved in a country
because public investment through loans after full employment may lead to inflation.
(c) Deficit Financing
Sometimes, it is assumed that the best method for financing public is printing of new
currency in the economy, it is known as deficit financing. This is the easiest method of
public investment but it leads to inflation in the economy. Keynes and his supports are of
the view that if there is unemployment in the economy then new currency can be printed
and inflation is created when full employment is achieved.
Public investment should be maintained in such a way that it does not affect the private
investment in the economy. Otherwise, multiplier effect on public investment will leads to
diminishing or disappear. Thus, government should induce public investment to stimulate
private investment but it should not be done with the objective to compete with private
investment.
4.6 Measures to Stimulate Private Investment

Private investment is equally important as public investment because a country cannot achieve
their objective without one of these two investments. Government takes various measures to
improve the level of investment in the economy. Measures to stimulate private investment are
discussed as under:
(a) Reduction in taxes
It is assumed that if there are heavy tax burden on investors then investment will fall
because of increase in tax burden adversely affects marginal efficiency of capital. Many
economists like: Kurihara, Hansen, Klein, etc. are of the view that investor should not be
burdened with taxes. They suggest that income tax and corporate tax should be reduced
to encourage investment. Only those investors, who use their money for consumption and
do not invest, should be burdened with more taxes. Due to this situation investment will
be encouraged in the economy. Thus, it is important to notice that along with reduction in
taxes, government revenue should be increased by the way of indirect taxes, taxes on
luxury goods, etc.
(b) Pump priming
During the period of depression, private investment is at lowest level in the economy and
for inducement of private investment an increase in public investment is necessary. This
policy of stimulating private investment through public investment is known as pump
priming. Kurihara defined pump priming as the expenditure made by government to
dispose of depression. This policy is based on an assumption i.e. private investment has
gone down for some time. Pump priming can be done through two ways: (i) when
government borrows from banks to increase public investment and as a result of
borrowing banks will create credit. (ii) Increase in public investment results into increase
in aggregate income due to effect of multiplier. Thus, it will stimulate private investment.
(c) Decrease in the rate of interest
Many economists are of the view that private investment fluctuates with the fluctuations
in interest rates or investment is interest elastic. If volume of investment falls, then rate of
interest will increase and vice-versa. In the general theory, Keynes has given secondary
preference to rate of interest. According to Keynes investment is affected by income and
not by rate of interest because interest rate cannot fall below a specific level and
investment is affected by marginal efficiency of capital rather than rate of interest. Further,
L.R. Klein said that lower rate of interest may stimulate investment in some sectors of the
society. Thus, we can conclude that low rate of interest is conductive to investment.
(d) Wage cut policy
Wages policies are equally important to induce private investment as investment can be
increased at low wage rate. Classical economists believed that wages should be reduced
to stimulate investment because of reduction in cost of production in the economy. But,
Keynes was against of this view and he was of opinion that reduction in money wages
will not reduce the cost of production but it will lead to decrease in income of labourers.
Overall, investment can be increased by reducing the real wages through rise in price
level.
(e) Increase in government expenditure
Government expenditure is a major source to stimulate private investment in the economy.
According to Kurihara and other economists government expenditure can be divided into
three parts: (i) Government spends money on social security activities for welfare of the
society like: unemployment, education, insurance, health, etc. (ii) Government also spends
on public work activities like: roads, buildings, hospitals, etc. (iii) Government may spend
money on different projects like: irrigation project, power project, etc.
(f) Promotion of research
Some of the economists believed that expenditure on research is beneficial for stimulation
of private investment. If government spends money on research and innovation, then
research on industrial and operation field will provide various methods for the inducement
of investment.
(g) Price support policy
Fluctuations in the prices have adverse effect on the investment and it is necessary to
stabilize the prices in the economy. Government tries to stabilize the prices through
specific policy which is known as price support policy. This policy states that government
starts buying and selling in the open market to stabilize prices in the economy. When
prices of goods fall in the market then government should buy goods and stock it; this will
restore the interest of the investors.
(h) Abolition of monopolistic tendencies
Every businessman wants to create their monopoly over the market to hold a
predominance position. Keynes defined that monopolistic tendencies of big firms in the
market should be abolished, so that investment can be stimulated in the economy. Due to
increase in investment new firms will enter in the market and large number of firms will
leads to further investment in the economy.
4.7 Factors affecting Investment/ Investment Function

Investment function is the relationship among investment and its determinants. Investment
decision is influenced by a large number of factors. These factors are explained below:
Sr. No. Factor affecting Investment

1. Technology Advancement and Innovation
2. Discovery of Natural Resources
3. Government Policies
4. Foreign Trade
5. Political Environment
6. Expectations
7. Rate of Population Growth
8. Territorial Expansion
9. The Price Level
10. The Market Structure
11. Availability of Finance
12. Condition in the Labour Market
13. The Present Stock of Capital Goods
14. Aggregate Demand
15. Factors Influencing Investment in Public Sector
Fig. 4.2 Factors affecting Investment
1) Technology Advancement and Innovation

As we had earlier discussed that investment is affected by technology and new research
in the economy, same is supported by Prof. Norman F. Keiser. He believed that
introduction of new labour-saving and capital-saving techniques leads to increase in
investment in the agriculture as well as manufacturing industries. There are various
changes occurred due to technology and investment which are proven beneficial to
increase the volume of investment.
2) Discovery of Natural Resources
Invention of the natural resources like: petrol, oil, etc. will leads to increase in investment.
Discovery of new sources of natural resources will attract investors to invest more in
order to obtain the new resources. On the other hand, if production of natural resources
decreases or destroyed then there will be decrease in investment level also.
3) Government Policies
Investment is also affected through monetary and fiscal policy of the government in an
economy. Whenever government wants to expands credit and use cheap money policy
then investment will increase. On the other hand, when government wants to contract the
credit and use dear money policy then investment will decrease. Similarly, taxation and
expenditure policy of the government affects investment decision in the economy. If more
taxes are imposed by government then expectations of profit will go down and new
investment will be discouraged. On the contrary, if fewer taxes are imposed then
investment will be encouraged.
4) Foreign Trade
Foreign trade has a positive impact on the level of investment. Whenever investor expects
that foreign trade of a country will increase then he will investment more. On the contrary,
if volume of foreign trade reduces then level of investment will also fall in the economy.
5) Political Environment
Political environment is an important factor that affects business as well as investors in a
country. If there is peace and stability in the political environment of a country, then it
will induce more investment. On the other hand, if there is political disturbance, danger
of foreign aggression and instability in a country then it will adversely affect investment
level and investment will fall.
6) Expectations
Business expectations are directly related with profits in the organisation. Businessman
uses capital goods for the further production of products. So, the expectation of profit
depends upon the sale of goods produced through capital goods. If business is in good
condition and business community is positive about future growth, then there will be
increase in investments. But, when business is going through depression and business
community is pessimistic about its growth then there will be a decrease in investment.
7) Rate of Population Growth
If there is continuous increase in population in a country then it will require new houses,
schools, hospitals, roads, transportation, consumer goods, public services, etc. Thus,
increase in population leads to more investment for the above requirement of the
population. Further, according to Norman F. Keiser growth in population will leads to
increase in labour supply. So, wage rate will fall and prospective yield of invested capital
will increase.
8) Territorial Expansion
Due to increase in population, there is requirement for new territories in the economy
which require public and private investment. Thus, opening of new business houses also
affects investment.
9) The Price Level
Price is a major factor which affects investment level in the economy. If price in the
market starts increasing, then there will be increase in profits for investors and due to this
investors will be attracted towards more investment. On the other hand, if price starts
declining then it will discourage investment.
10) The Market Structure
Market structure refers to the nature of competition prevails in the market. If there is
many producer of same commodity in the market and competing with each other then
they will try to cut down their cost of production through use of new machines and
technology. These will result into increase in investment. On the contrary, if there is low
competition among producers then monopoly can be created and production will continue
through old machinery and obsolete technology. It will adversely affect investment level
in the economy.
11) Availability of Finance
Investment is also influenced through availability of finance. Two major source of
finance for a firm is internal source and external source. If a firm had more internal source
of finance like: undistributed profits and reserves, etc. then the firm is able to investment
more. Similarly, when external source of finance is easily available to firm then they are
able to invest more. However, unavailability of finance leads to decrease in investment
by a firm.
12) Condition in the Labour Market

Labour market is an equally important factor to study as other factors affecting investment
decision. If trained and skilled labourers are available in the labour market, investment
will be favorably influenced. This is due to the cordial and peaceful relationship among
labourers and employer.
13) The Present Stock of Capital Goods
If present stock of capital goods in the firm is in excess of need then there is excess
capacity in the firm and very little investment is required. On the other hand, when there
is deficiency of capital goods then the possibility for investment will be more in the firm.
14) Aggregate Demand
Aggregate demand is the total demand of all the individuals in the economy during an
accounting year. Aggregate demand also affects investment level in the economy.
Continuous increase in aggregate demand for goods and services will stimulate the
investment.
15) Factors Influencing Investment in Public Sector
Investment in public sector is influenced through the objectives like: economic
development, social welfare and defence of the country. Investment for this purposive is
independent of income or profit. If we need defence products for the security in the
country or social welfare of people, then we have to invest irrespective of profit and
income. But, it does not mean that government does not concentrate on profit or income.
Government also makes public investment to earn profits.
4.8 Importance of Investment

We had discussed about the types and factors influencing investment level in the economy.
Some other aspects of investment are also discussed under this chapter. But, still a major
aspect of investment i.e. importance of investment left behind. The following points describe
the importance of investment:
(1) Determination of income and employment

In short-run, consumption expenditure remains constant and investment expenditure plays
a key role for determination of income and employment level in the economy. Due to
multiplier effect, increase in investment leads to increase in income. This increase in
investment works as remedy against depression and unemployment. Thus, the cycle goes
on from increase in investment to increase in income then increase in output and ultimately
this will result into increase in employment. Thus, investment function is important to
determine the level of income and employment in the economy.
(2) Volatile factor
Investment is a volatile factor which fluctuates over a period of time. Investment depends
on future expectations and these expectations are subject to change. So, income and
employment level also changes. Business cycles are the results of changes in investment.
During policy formulation regarding trade cycles, it is important to measure fluctuation in
investment.
(3) Economic development
Every country tries to induce investment in different sectors because investment form
basis for the economic development. Harrod explains that investment influence both
supply and demand in the economy. Economic development is last step of cycle of
investment. Investment leads to capital formation which results into increase in production
capacity. Increased production capacity will increase the supply of goods and services
which will ultimately results into economic development.
4.9 Summary
At the end, we can conclude that investment function represents the relationship among
aggregate income and aggregate investment. Investment function is an important component
of aggregate demand. Investment function is not just for theoretical review but it should be
practically used in the economy. Investment has various types which are helpful for economic
development. Investment function also describes the factors influencing investment decisions.
These factors are helpful to determine the investment level in the economy. Further, marginal
efficiency of capital and rate of interest are also important determinants of induced
investment. Moreover, public investment also plays an important role in the economic
development. Public investment can be done through taxation, loans and deficit financing. It
is also interesting to notice that government should ensure that public investment of
government should not affect the level of private investment in the economy. Another
important term multiplier is also used in this chapter which will be described in detail in next
chapter.
4.10 Keywords
Investment - Investment refers to the expenditure made for acquiring the capital assets such
as machinery, furniture, building, etc.
Real Rate of Interest - Real rate of interest refers to the difference between money rate of
interest and expected rate of inflation.
Marginal Efficiency of Capital - Marginal efficiency of capital may be defined as the ratio
between the potential return of supplementary capital and price of their supply.
Rate of Interest - It is the rate a bank or other lender charges to borrow its money, or the rate a
bank pays its savers for keeping money in an account. The annual interest rate is the rate over
a period of one year.
Prospective Yield - Prospective yield of an asset may be defined as the aggregate of expected
revenue from the sale of output produced during its life time but excluded variable cost.
Private Investment - Private investment refers to the investment made by private individual
or private player of the market with the merely motive to earn profit.
Public Investment - Pubic investment refers to the investment made by central government,
state government and local self-government of a country.

Q.1 What do you mean by Investment? Explain the types of Investment in detail.
Q.2 What is investment expenditure? Explain the different types of investment expenditure.
Q.3 Differentiate: (a) Financial Investment and Real Investment

(b) Induced Investment and Autonomous Investment
Q.4 Explain the major determinants of induced investment in detail.
Q.5 What are the major sources of Autonomous investment in the economy?
Q.6 Differentiate: (a) Private Investment and Public Investment

(b) Voluntary Investment and Involuntary Investment
Q.7 What do you mean by inducement to invest? Discuss the factors which govern the
inducement to invest in a capitalist economy.
Q.8 What do you mean by Private Investment? Explain the measures to stimulate private
investment.
Q.9 Discuss the significance of marginal efficiency of capital and rate of interest as
determinants of investment.
Q.10 Explain the following:
(a) Gross Investment (b) Net Investment (c) Marginal Efficiency of Capital

1. Investment is an injection which increases .
2. is the difference between gross investment and net investment?
3. Increase in leads to increase in the level aggregate demand.
4. Autonomous investment is to the level of GDP.
5. An increase in leads to a movement along the marginal efficiency to
capital schedule.
1. Aggregate demand
2. Depreciation
3. Investment
4. Not related
5. Interest rates
4.12 References
1. Jain et al. 2019. Macroeconomics, pages 169-198, VK Global Publication Pvt. Ltd.,
New Delhi.
3. Chaturvedi & Mittal 2013. Macro Economics, pages 53-67, International Book House
Pvt. Ltd., New Delhi.
5. Branson 1995. Macroeconomic Theory and Policy, pages 32-52, Orient Offset
Publication, New Delhi.
Ltd., Noida.
LESSON-5
Multiplier and Principles of Acceleration
Lesson Structure
5.2 Dynamic Concept of Multiplier
5.3 Movements of the Multiplier
5.3.1 Forward action of the multiplier
5.3.2 Backward action of the multiplier
5.4 Leakages of Multiplier
5.5 Importance of Multiplier
5.6 Limitations of Multiplier
5.7 Concept of Accelerator
5.8 Working of Accelerator
5.9 Criticisms of Acceleration Principle
5.10 Summary
5.11 Keywords
5.13 Study Tips

In the last chapter the term multiplier was used which we will be discussing in this chapter.
After reading this chapter you will be able to understand the concepts of multiplier and its
working which are helpful to understand the mechanism of investment and its effect on
income. Further, we will discuss about movement of multiplier so that we can understand
forward and backward actions of the multiplier in detail. Then, another topic of concern i.e.
Principles of Acceleration is also included in this chapter. So, this chapter will provide
comprehensive knowledge about multiplier and acceleration and their effect on economy.

The concept of multiplier was introduced in the beginning of 1930s by F.A. Kahn an
economist of Cambridge University. He defined multiplier in the context of increase in
employment level due to increase in initial investment and employment. It is known as
employment multiplier. Further, Keynes refined the concept of multiplier with reference to
increase in total income due to increase in investment income. This multiplier defined by
Keynes is known as investment multiplier or income multiplier. The spirit of multiplier is that
total increase in income, output and employment is multiple of the increase in original
increase in investment. For example, if investment of rupee 100 crores is made, then it does
not mean that income will also rise by rupee 100 crores but a multiple of it. If national income
increases by rupee 300 crores due to investment of rupee 100 crores then multiplier will be
equal to 3.
According to Keynes, “Investment multiplier tells us that when there is an increment of an
aggregate investment; income will increase by an amount which is ‘K’ times the increment of
investment.” Thus, multiplier may be defined as the ratio of increase in income to the increase
in investment. It may be shown as:
K = ∆Y/ ∆I
Here,
K stands for multiplier,
∆Y stands for change in Income,
∆I stands for change in Investment.
Thus, multiplier is simply associated with change in investment and size of multiplier
depends upon the size of marginal propensity to consume. Further, the value of multiplier
varies from unity to infinity
Diagrammatic representation of Multiplier:
We had earlier discussed that the level of national income if determined where C + I curve
intersects the 45° income curve. The same diagram is used to explain the multiplier.
Fig. 5.1 Keynesian Income Multiplier
Here, OX axis represents National Income and OY axis represents aggregate demand, C
represents marginal propensity to consume. It is assumed that marginal propensity to consume
is equal to 0.5 so that the curve C of MPC shown equals to 0.5. C + I represent the level of
aggregate demand curve which intersects the 45° line at point E so that the level of income
equal to OY1. If investment increases by the amount EH then aggregate demand curve shifts
upward to the C + I’. Thus, new aggregate demand curve intersects at point F represents the
equilibrium level of income which increases to OY2. So, the increase in investment leads to
increase in income also. Through measurement we can conclude that Y1Y2 is twice the length
of EH. This is expected because the marginal propensity to consume is equal to 0.5 here and
therefore the size of multiplier will be equal to 2.
5.2 Dynamic Concept of Multiplier

Various critics argue against Keynes as Keynes theory of investment multiplier is static
concept. This theory has no connection with dynamic process of income generation. Keynes
defines that how many times more increase in income will be reported due to increase in
investment. But, he cannot define how and what time will be required for this increase. One
important question rise here i.e. why there is increase in income is so many times more than
the initial increase in investment. Answer to this question is explained below:
For example, government made a public expenditure of rupee 100 crores on construction of
roads in rural area. Here, government has to pay wages to labourers, prices for raw material
and remuneration to other workers who are engaged in the work of road construction. Total
cost of the project will amount to rupee 100 crores and this will increase the total income of
the people equal to rupee 100 crores. But, this process not stopover here.
People will spend some part of their income for consumption purpose. Let us assume that
marginal propensity to consume of the people is 80% of the total income then they will spend
rupee 80 crores for consumption out of rupee 100 crores. This consumption expenditure will
increase the incomes of people who supply the consumer goods equal to rupee 80 crores and
receiver of this income will spend some part of this income again for consumption according
to their marginal propensity to consume. Again if they spend 80% of the income then it will
be amounted to rupee 64 crores. Thus, it will again increase the income of some other people
equal to rupee 64 crores.
In this way, the chain of consumption expenditure will be continued and income with the
public will increase. But, this additional increase in income will be gradually less because
some part of the income will be saved. Hence, the question is solved as income will not
increase by only rupee 100 crores which were initially invested by government for
construction of roads.
This process of multiplier is continuous and automatic. Moreover, multiplier is not just
affected through private and public investment rather than it is also affected through
consumption expenditure.
5.3 Movements of the Multiplier

Process of multiplier has two types of movement i.e. forward action and backward action.
Whenever, there is increase in investment then as multiplier effect, income increases many
times more than the initial investment. This is known as forward action of the multiplier. On
the other hand, whenever investment decreases then as multiplier effect, income decreases
many times more. It is known as backward action of the multiplier.
According to Prof. Samuelson, “The multiplier is a two-edge sword. It will cut for you or
against you. It will amplify new investment as we have seen. It will also amplify downward
decrease in investment.”
5.3.1 Forward action of the multiplier
Forward action of the multiplier indicates that increase in initial investment will leads to
many more times increase in the ultimate income. It can be understood through an example;
suppose initial investment increases by rupee 10 crores and multiplier is 2 then ultimate
income will increase by rupee 10 × 2 = 20 crores. Forward action of multiplier can be seen
in those countries where Marginal Propensity to Save is small and Marginal Propensity to
Consume is large. The forward action of multiplier is shown through the following diagram:
Fig. 5.2 Forward action of the Multiplier
In this figure 5.2, income is shown on X-axis and consumption is shown on Y-axis. CC curve
represents the consumption curve which is drawn with according the MPC level less than 1.
Total income is the sum of consumption and saving by an individual. Point E1 is the
equilibrium point where income level is at OY1 and consumption is at C + I. When
investment level is increases from C + I to C + I + ∆I, consequentially income level will also
raise from OY1 to OY2 which is many more times than the initial investment level. Increased
vertical difference among Y1 to Y2 is more than the difference among C + I to C + I + ∆I.
Thus, equilibrium level will shift upwards from point E1 to E1. This increase in income is
almost double to the increase in investment level. This increase in income also represents the
forward action of the multiplier. Further, in the figure 5.2, the arrow between Y1 and Y2
represents this forward movement of multiplier.
5.3.2 Backward action of the multiplier

Multiplier works in both directions i.e. forward as well as backward. Multiplier is also known
as double-edged weapon. Backward action of the multiplier is opposite to the forward action
of the multiplier. As it represents that decrease in initial investment level will results in
several times more decrease in the final income. It is also termed as reverse action of the
multiplier. For example, if initial investment level decreases from rupee 20 crores to rupee
10 crores and multiplier is 2, then final income will decrease by rupee 10 crores × 2 = rupee
20 crores. This can be shown by the figure 5.3 as below:
Fig. 5.3 Reverse action of the multiplier
In this figure 5.3, income is shown on X-axis and consumption is shown on Y-axis. CC curve
represents the consumption curve. Higher the Marginal propensity to consume will results
into greater the level of multiplier as well as greater the cumulative decline in income. Total
income is the sum of consumption and saving by an individual. Point E1 is the equilibrium
point where income level is at OY2 and consumption is at C + I. When investment level is
decreases from C + I to C + I + ∆I, consequentially income level will also decline from OY2
to OY1 which is many more times decreases than the initial investment level. Increased
vertical difference among Y2 to Y1 is more than the difference among C + I to C + I + ∆I.
Thus, equilibrium level will shift upwards from point E1 to E1. This decrease in income is
almost double to the decrease in investment level. This decrease in income also represents
the backward action of the multiplier. Further, in the figure 5.3, the arrow between Y2 and
Y1 represents this backward or reverse movement of multiplier.
Thus, we can conclude that multiplier works in the forward and backward directions in the
economy. Multiplier plays an important role for the determination of income and investment
level in the economy.
5.4 Leakages of Multiplier

Marginal propensity to consume is generally less than the total income because whole income
is not used for the consumption purpose. And the part of income which is not spent for
consumption is known as leakages from total income. Forward action of multiplier does not
exist for endlessly rather than the process of income circulation comes down. The reasons
behind this decrease in income are known as leakages in the multiplier. Several reasons for
leakages in multiplier are discussed below:
Excess Stock
of
Consumption
Goods High Liquidity
Imports
Preference
Paying of Old
Price Inflation
Debt
Purchase of Taxation
Securities System
Leakages Undistributed
Idle Saving of Profits of the
Company
Multiplier
Fig. 5.4 Leakages of Multiplier
I. Idle Saving
Idle savings are the part of increased income which is not used for consumption purpose
and it goes out of the circulation. Idle savings results into equivalent fall in marginal
propensity to consume and fall in marginal propensity to consume leads to fall in the value
of multiplier. We can conclude that higher the marginal propensity to save will leads to
leakages from the income circulation and it will also lower the value of multiplier.
II. Purchase of Shares and Government Securities
Purchase of shares and government securities are one of the major reasons behind leakages
of the multiplier. Income used for buying such old securities is cause of fall in the income
streams. This part of income is not used for consumption purpose so; it will not generate
further income for the future. Thus, there will be decrease in future income as well as
decrease in multiplier.
III. Paying of Old Debts
Whenever a person has to pay its old debt then he/she used money from increased income
and this amount used for paying debt is not used for purpose. This will lead to another
leakage of multiplier and it restricts the process of income generation through multiplier
effect.
IV. Imports
Import refers to the purchase of goods and services from the rest of the world or outside
the boundaries of a country. When income goes out of the country it will adversely affects
process of income generation. The money which goes out of the country will not generate
further income in the boundaries of that country. Hence, imports will result into leakages
in the multiplier.
V. Excess Stock of Consumption Goods
Excess stock of consumption adversely affects the multiplier in the economy. Increase in
income tends to increase the demand and this will lead to increase in consumption. If this
increased demand is fulfilled by existing stock in the economy, then new goods will not be
produced and as a result of this further production falls down as well as multiplier also goes
down. This will reduce the income stream in the process of income generation.
VI. High Liquidity Preference
Liquidity refers to the cash position with a consumer. If people prefer high liquidity; means
they want hold more cash with them, will negatively affects multiplier. As high liquidity
preference leads to less expenditure and it will restrict the process of income generation.
Thus, high liquidity preference leads to leakages in the multiplier.
VII. Price Inflation
Inflation is a situation of continuous increase in prices in the economy. If prices increase
with the increase in income, then same amount of goods can be purchased with the
increased income. Due to increased prices, people have to spend more income to buy the
same amount goods and services as before. Thus, increase in price will nullify the effect of
increase in income in the economy. Very few part of income will be left behind for the
purchase of additional goods and services. There will be little effect on the consumption of
goods and services. Thus, multiplier effect will be limited to price inflation.
VIII. Taxation System
Whenever taxes on goods and progressive tax rate on income are increased then there will
be no significant increase in consumption of goods and services even if income increases.
Increases in taxes leads to slow down the process of income generation in the economy.
Thus, taxes in the economy are considered as leakage in the multiplier.
IX. Undistributed Profits of the Companies
Undistributed profits are that part of company’s profit which is not divided among
shareholders as dividend. Undistributed profits work same as the idle saving. Many
companies do not distribute the whole profits of the company among its shareholders and
kept some part of profit as reserve. This undistributed profit is not used for further
consumption as well as it will not provide any future income in the economy. Thus,
undistributed profits are leakages in the multiplier.
5.5 Importance of Multiplier

It is very important to study the multiplier concept for economic analysis. Multiplier is very
important to study for the determination of investment and income. Further, multiplier is an
important tool for the Keynes theory of income and employment. Multiplier is very important
in different aspects in the economy. Various uses and importance of multiplier are discussed
below:
I. Concept of multiplier is helpful in understanding the income circulation process in the
economy. It is helpful to determine that increase in employment, income and output is
due to increase in investment.
II. The concept of multiplier is helpful for the better understanding of trade cycles in the
business. Trade cycles define the business fluctuations like: boom, depression, recession,
etc. Multiplier explains that increase in investment leads to increase in income. Further,
investments are increased during depression and decreased during inflations.
III. Importance of investment in economic analysis can be better understood through the
concept of multiplier. Investment is a dynamic factor which affects income as well as
employment level in the economy.
IV. Multiplier is helpful for the determination of employment level in the economy. Increase
in investments leads to increase in income and increase in income leads to increase in
output and improving the employment level.
V. Keynes define that equilibrium position is recognized when saving and investment are
equal. Concept of multiplier is a helpful factor to achieve equilibrium in saving and
investment. Whenever saving volume is low in the economy then marginal propensity to
save is a tool to determine increase in income so that required saving volume can be
obtained. Similarly, to determine the level of investment required for increase in income,
coefficient of multiplier is used.
VI. Deficit financing is also highlighted through concept of multiplier. Some of the
economists define that deficit financing is helpful to remove the bad effects of depression.
Due to deficit financing, investment increases and this increase will lead to increase in
income many more times due to multiplier effect.
VII. Keynes also used the concept of multiplier in introducing importance of public
investment during depression. In this period, if public investment is raised then there will
be increase in income many more times. Such an increase in investment tends to control
the situation of depression and unemployment in the economy.
VIII. Further, concept of multiplier is also helpful to decide that how much increase and
decrease in investment is required for balancing the prices in the economy. It means
multiplier is also helpful to control the situation of inflation and deflation.
IX. Government interference is a must according to Keynes and it is equally supported by
concept of multiplier. By introducing a little investment in the economy, government can
increase the income level many times under the impact of multiplier.
X. At last, multiplier is also important to decide the level of additional investment required
to achieve the desired rate of GDP in the economy.
5.6 Limitations of Multiplier

The above discussion about multiplier focus on investment and income and multiplier is
categories as static as well as dynamic. Multiplier is very important topic of concern as it has
various uses in the economy. However, nothing is perfect or complete in all the sense and
multiplier has also some shortcomings. These shortcomings are discussed as under:
Sr. No. Limitations of Multiplier
1. Availability of Consumer Goods
2. Net Increase in Expenditure
3. Multiplier Period
4. Net increase in Investment
5. Less than Full Employment Level
6. Autonomous Investment
7. Steady Flow of Investment
8. Closed Economy
9. Acceleration effect ignored
10. Constant Marginal Propensity to Consume
11. No change in Prices
12. Industrialised Economy
13. No change in Distribution of Income
14. Surplus Capacity in Consumer Goods Industries
15. Availability of other Resources of Production
Fig. 5.5 Limitations of Multiplier
I. Availability of Consumer Goods

Income circulation is dependent on the availability of consumer goods in adequate quantity
so that consumer can spend their increased income on these goods and income generation
process goes on. If quantity of consumer goods is not adequate in the economy, then
consumer will not be able to spend their increased income and this will restrict the
multiplier effect. Thus, it will adversely affect the income generation process.
II. Net Increase in Expenditure
Keynes define that spending may be known as expenditure which is used to increase the
stock of goods and net increase in expenditure can be obtained through increase in
expenditure of government on various projects and by reducing the taxes on goods. Further,
net expenditure can also be increased through modifying the tax structure in such way that
idle saving can be discouraged.
III. Multiplier Period
We have earlier discussed that increase in investment will leads to increase in income due
to multiplier effect but this multiplier effect does not work immediately rather than it needs
a time lag for operation. Whenever consumer receive income they can’t spend all the
income immediately and it takes a time lag between receipts of income again and its
expenditure again. If we want to recognize the effect of increase in investment on the
national income, then we have to study the effect of multiplier period. If multiplier period
is greater than there will be small number of secondary expenditure on consumption and
multiplier value will be small and vice-versa.
IV. Net increase in Investment
Direction of multiplier is very important for the determination of the value of multiplier.
Value of multiplier is dependent on the net increase in investment. Here, net increase in
investment does not mean that increase in public sector investment is supplemented by
decrease in private sector investment. In this, situation multiplier will not work. It becomes
necessary that the increase in investments should be at regular time intervals for obtaining
a high value of multiplier. Thus, level of multiplier and national income can be raised, kept
and maintained.
V. Less than Full Employment Level
Multiplier is based on some assumptions and less than full employment level in the
economy is one of these assumptions. We had earlier discussed that increase in investment
leads to increase in income, output and employment and this is possible only when all the
resources in the economy are not fully utilized. On the other hand, if there is full
employment in the economy then there will be no increase in income and output and there
will be no effect of multiplier on it.
VI. Autonomous Investment
There are two major types of investments i.e. autonomous investment and induced
investment. Induced investment is affected by profits and income whereas autonomous
investment is independent of profit motive. Moreover, value of multiplier is more than that
of autonomous investment and less than that of induced investment.
VII. Steady Flow of Investment
As we had earlier discussed that net increase in investment is necessary for the
determination of multiplier in the economy. It means there should be regular flow of
income. If investment is not made on regular basis, then the multiplier effect will go down
and initially income will raise but afterwards it stars declining and reached at its original
position. Thus, for maintaining the effect of multiplier, it is necessary that there should be
continuous increase in income.
VIII. Closed Economy
Closed economy is another important factor to determine the value of multiplier in the
economy. Multiplier works on the assumption that there is closed economy. There is
absence of international trade in the closed economy. Open economy works adversely in
the process of income generation through multiplier because imports over exports acts as
a leakage. Further, any expenditure on imports will reduce the marginal propensity to
consume and thus, it will adversely affect the value of multiplier.
IX. Acceleration effect ignored
Multiplier is related with the original investment on consumption and income only but it
ignores the effect of increased or induced consumption on investment. But the value of
multiplier will be affected by this increase in investment. This change in investment as a
result of change in consumption is known as acceleration. This acceleration is helpful to
increase the value of multiplier many times more than earlier increase but in multiplier,
effect of acceleration is ignored.
X. Constant Marginal Propensity to Consume
Assumption of multiplier becomes the limitations for multiplier and constant marginal
propensity to consume is another limitation of multiplier which is assumed as constant.
Any change in the value of MPC leads to change in value of multiplier. If value of MPC
goes down, then value multiplier will also go down and vice-versa. Thus, constant value
of marginal propensity of consume will tend to constant value of multiplier.
XI. No change in Prices
It is also assumed that there will be no change in the prices of commodities and any other
material related to commodities. If there is any change in the prices, then consumption will
be affected and change in consumption will affect the value of multiplier.
XII. Industrialised Economy
Multiplier is more effective in an industrialised economy rather than an agricultural
economy. Elasticity of demand is higher in case of industrial products than agriculture
products. Further, supply of industrial product is highly associated with its demand and
fulfilled earlier than demand for agricultural products. Thus, industrial economy will lead
to more effective for determination of multiplier.
XIII. No change in Distribution of Income
Multiplier has another limitation due to its assumption of no change in distribution of
income in the economy. It is due to the fact that change in income distribution tends to
change in marginal propensity to consume. Thus, in case of change in distribution of
income, it becomes difficult to determine the value of multiplier.
XIV. Surplus Capacity in Consumer Goods Industries
We are known to the fact that increase in initial investment tends to increase in income and
as a result of increase in income, consumption will also increase. But, consumption will
increase only if there is surplus capacity in consumer goods industries. Due to this surplus
capacity increased demand can be fulfilled. On the other hand, when there is no surplus
capacity then consumption will not be increased and multiplier will be less effective.
XV. Availability of other Resources of Production
Availability of other resources of production like: raw material, capital equipment, etc.,
besides laborers is necessary for the smooth and better working of multiplier. When there
is absence of these resources of production then multiplier will not be effective.
Thus, we can conclude that multiplier is a helpful tool to determine the income, investment,
output and employment. But, multiplier is also associated with different limitations.
Multiplier would only work with different assumptions because without these assumptions
multiplier will not be effective.
5.7 Concept of Accelerator

The multiplier and the accelerator are parallel concepts in economics and both are helpful for
the determination of income and investment level in the economy. Multiplier represents the
effect of change in investment on the income level whereas accelerator represents the effect
of change in consumption on private investment. Further, the concept of acceleration principle
was firstly introduced in economics by J. M. Clark in 1917. Afterwards, this concept was
developed by Hicks, Samuelson and Harrod with reference to business cycles.
According to Hayek, “Since the production of any given amount of final output usually
requires an amount of capital several times larger than the output produced with it during any
short period (say a year) any increase in final demand will give rise to an additional demand
for capital goods several times larger than the new final demand.”
It means whenever demand for consumer goods increase it leads to increase in demand for
the factor of production because these factor of production will be used for production of
consumer goods. Here is an important point to note that demand for factor of production i.e.
machines will increase at a faster rate than the demand for consumer goods. Thus, we can
conclude that accelerator is a function of the rate of change in consumption and not of the
level of consumption.
Further, accelerator is functional relationship among change in demand for the investment
goods due to change in the demand for the consumer goods in the economy. Moreover,
accelerator coefficient can be defined as the ratio between induced investments to net change
in the consumption expenditure. Accelerator coefficient can be shown as:
α = ΔI/ΔC, where α represents the accelerator coefficient; ΔI represents net changes in the
investments and ΔC denotes the net change in consumption expenditure. The value of
accelerator coefficient could be one or less than one. However, increase expenditure on
consumer goods leads to increase the expenditure over capital goods. Thus, accelerator value
is almost more than zero. But, accelerator coefficient can also be positive and more than unity
when there is a good deal of capital goods.
5.8 Working of Accelerator

Accelerator is as important as multiplier in the economy and both of these goes are not in
competition but are parallel to each other. Before understanding the working of accelerator it
is necessary to discuss about its assumptions. These are as follows:
(a) Capital-output ratio will be constant.
(b) Resources are easily available.
(c) There is no excess or idle capacity of the plant.
(d) The increased demand is permanent.
(e) There is elastic supply of credit and capital.
(f) An increase in output will leads to immediate increase in investment.
Working of multiplier depends on all the above assumptions and it is shown through the
following table:
Example: Life of the Machine 10 years
Period Change in Capital Gross Investment % change in
Consumption Equipment Gross investment
needed Additions Replacement Total
10% rise in 0 1000 100 Nil 10 10 100 % increase

demand 1 1100 110 10 10 20
Table No: 1. Working of Accelerator
Table no. 1 represents that life of a machine is 10 years, we require 100 machines for the
production of 1000 units of consumer goods according to constant capital output ratio i.e.
1:10. If we want to maintain the same level of production over a long period then after 10
years the machines has to be replaced and 10 machines have to be replaced after some period
of time. This is known as replacement demand.
If demand for the consumer goods increased by 10% in the market then the change in
consumption will be 1100 goods and for achieving the level of 1100 units; thus we require
110 machines as per the constant capital-output ratio i.e. 1:10. Thus, we had requirement of
20 machines out of which 10 machines are required for addition production and other 10
machines are required for replacement. Thus, we can conclude that a 10% increase in the
demand for consumption goods leads to 100% rise in the demand for investment goods.
Hence, principle of acceleration shows that a small increase in the consumption leads to many
more times increase in the induced investments.
5.9 Criticisms of Acceleration Principle

Accelerator is very important concept to discuss still it is criticize by many economists due
to its assumptions. Limitations of acceleration principle are discussed below:
I. Acceleration principle is based on an assumption of constant capital-output ratio which
is a vague assumption. But, this ratio can’t be constant in the dynamic word where
changes in capital and output are obvious.
II. The other assumption which assumes that resources should be elastic but this is possible
only when there is unemployment. If there is full employment in the economy, then it
will limits the working of acceleration principle.
III. One other limitation is due to the assumption of no excess capacity of the plant which
means that the plant is fully utilized. On the other hand, if there are some machines
which are not fully utilized or idle in the company then as a result of increase in demand
for consumer goods there will be no increase in new capital goods. Thus, acceleration
principle will fail.
IV. Acceleration principle only explains the volume of investment but it fails to explain the
timing of investments in the economy.
V. Further, timing of the investment depends on their availability and cost of financing.
Thus, principle of acceleration also does not consider availability and cost of capital
goods.
VI. Acceleration effect is assumed to be zero for the already existing and installed
equipment which can be used for production of anticipated future demand.
VII. Another assumption of acceleration states that the increased demand is permanent which
is totally vague. This assumption means acceleration principle will not work for
temporary demand.
VIII. The acceleration principle assumes that supply for credit is elastic which means
whenever there is induced investment then cheap credit will be available but it is not
possible. If cheap credit is not available or the rate of interest increases, then the
acceleration principle will fail.
IX. Principle of acceleration also ignores the expectations of the entrepreneurs in decision
making for organisation. The investment decision is not only affected by demand for the
products rather than it is also affected by future anticipations.
X. Principle of acceleration also ignores technological factors and it fails to explain the
lower turning point. Moreover, the principle of acceleration is not precise and it is
unsatisfactory.
Thus, we can conclude that the principle of acceleration works with many limitations but
still it is important to make the income generation process clear and realistic. Principle of
acceleration is shows fluctuations in income and employment due to fluctuations in capital
goods.
5.11 Summary
Multiplier explains the change in income due to the change in the investment in the economy.
Multiplier is simply associated with change in investment and size of multiplier depends upon
the size of marginal propensity to consume. One another concept i.e. acceleration, is an
important term explains the relationship of change in consumption expenditure on the induced
investment. The multiplier and the accelerator are parallel concepts in economics and both
are helpful for the determination of income and investment level in the economy. Multiplier
represents the effect of change in investment on the income level whereas accelerator
represents the effect of change in consumption on private investment. Both the concepts are
based on some assumptions which work as limitations for the applicability of multiplier as
well as acceleration principle. Working of multiplier is quite different from working of
accelerator because multiplier presents the investment and income whereas accelerator
represents expenditure and induced investment. Thus, both the concepts are equally important
to determine the income and investment. If assumption of these two functions prevails in the
economy then these can be fully utilized by the entrepreneurs in the economy.
5.12 Keywords
Multiplier- Multiplier may be defined as the ratio of increase in income to the increase in
investment.
Accelerator- Accelerator is functional relationship among change in demand for the
investment goods due to change in the demand for the consumer goods in the economy.
Income- Income refers to the money which is received by an individual or business in
exchange for providing goods and services or by way of investment.
Investment- Investment refers to that part of income which is not used for consumption
purpose today but allocated over different asset which provides income appreciation in future.
Forward movement of Multiplier- Whenever, there is increase in investment then as
multiplier effect, income increase many times more than the initial investment. This is known
as forward movement of the multiplier.
Backward movement of Multiplier- Whenever, there is decrease in investment then as
multiplier effect, income decreases many times more. It is known as backward action of the
multiplier.
Induced Investment- When an increase in investment is due to increase in current level of
income and production, it is known as induced investment.
(a)Student Activities
Q.1 Explain the concept of multiplier with an example. Also explains the importance of
multiplier in detail.
Q.2 Explain the working of an investment multiplier in the economy.
Q.3 What is an investment multiplier? Explain the various assumptions and importance of
multiplier.
Q.4 Define dynamic multiplier. Also explains the leakages in the multiplier in detail.
Q.5 What are the different movements of the multiplier? Explain it with an example.
Q.6 Differentiate between multiplier and principle of acceleration in detail.
Q.7 Elaborate the concept of accelerator with an example. Also explains the importance of
accelerator in detail.
Q.8 Explain the working of principle of accelerator in the economy.
Q.9 What is an accelerator? Explain the various assumptions and importance of accelerator.
Q.10 Discuss the limitations of multiplier and accelerator in detail.

1. Minimum value of investment multiplier is .
2. is the ratio of change in income to a given change in investment?
3. There is relationship among investment multiplier and MPC.
4. Acceleration principle was firstly introduced in economics by .
5. Acceleration principle only explains of investment but it fails to
explain of investments in the economy.
1. Equal to one
2. Investment Multiplier
3. Direct
4. J. M. Clark in 1917
5. Volume, timings
5.14 Study Tips
1. Jain et al. 2019. Macroeconomics, pages 169-192, VK Global Publication Pvt. Ltd., New
Delhi.
2. Jain & Arora 2019. Principles of Macroeconomics, pages 199-140, VK Global Publication
4. Ahuja 2013. Macroeconomics Theory and Policy, pages 207-224, S. Chand & Company
5. Branson 1995. Macroeconomic Theory and Policy, pages 32-52, Orient Offset Publication,
New Delhi.
6. Vaish 2014. Macroeconomic Theory, pages 192-236, Vikas Publishing House Pvt. Ltd.,
Noida.
LESSON-6
Classical & Keynesian Theory of Income and Employment,
Income Determination in Closed Economy
Lesson Structure
6.2 Determination of Equilibrium level of Income and Employment under Classical Theory
6.2.1 Determination of Income and Employment when there is no saving and Investment
6.2.2 Determination of Income and Employment in an Economy with Saving and Investment
6.2.3 Determination of Income and Employment: Role of Money and Prices
6.3 Criticism of Classical Theory
6.4 Keynesian Theory of Income and Employment
6.4.1 Equilibrium GDP Determination
6.4.2 Significance of Keynesian Theory of Income and Employment
6.4.3 Criticism of Keynesian Theory of Income and Employment
6.5 Income determination in a Closed Economy
6.6 Summary
6.7 Keywords
6.9 Study Tips

In this chapter, we will discuss about the macroeconomics theories i.e. theory of income,
output and employment. We will study about two major theories for determination of income,
output and employment. In the first part of this lesson, we will describe the classical theory
and in the second part Keynesian theory of income and output is explained. These theories
will be helpful for you to understand about the equilibrium level of national income. Further,
you will be able to understand the significance and criticism of both the theories. An attempt
is made to aware you about the major differences among classical theory and Keynesian
theory, so that you can easily understand about these theories. At last, we will discuss about
income determination under the closed economy or three sector model without foreign trade.
Classical economists had written on various macroeconomics concepts before the book “The
General Theory of Employment, Interest and Money” by Keynes in 1936. Classical theories
are integrated thought of different classical economists who contributed on different
macroeconomic issues. The classical economists include David Ricardo, J.B. Say, Karl Marx,
Adam Smith, etc. and neo-classical economists include A.C. Pigou, Alfred Marshall, etc.
Almost all the classical economists have expressed same views on the determination of
equilibrium level of income and employment in the economy. Classical economists assume
that unemployment exists only for short period in the economy and it will be vanished
automatically. Further, it is also assumed that full employment in the economy will achieved
only if there is free play of market forces. According to classical economists, equilibrium level
of income and output can be determined through the free play of demand and supply forces.
The second part of this lesson is about the Keynesian theory of income and employment.
Keynesian theory can be studied in three different models i.e. simple model or two sector
model, closed economy model or three-sector model and open economy model or four-sector
model. We will study about three-sector model in closed economy which includes households,
firms and the government. One thing is taken as common in all the three models i.e.
assumption of constant price even if aggregate demand and aggregate supply changes.
Further, the concept of closed economy is also an interesting fact which provides income
determination under three-sector model without foreign trade and includes government sector
in the economy. Before discussing these theories in detail, it is important to describe the
various important concepts related with these theories.
6.2 Determination of Equilibrium level of Income and Employment

Classical theory of income and output stated that equilibrium can be determined with the help
of three major situations in the economy i.e. with saving and investment, without saving and
investment and with the role of money and prices in the economy. Here, production function
and labour function are used as major factor responsible for equilibrium in the economy. This
theory is based on some of the assumptions. These are as follows:
I. Every person is a rational man and he wants maximum satisfaction in every situation.
II. Economy is free from any type of interference by the government.
III. There is perfect competition in commodity and labour market.
IV. There exists closed economy without foreign trade.
V. There will be no change in the technique of production in organisation in short period.
VI. Classical theory assumes that money is just a medium of exchange.
VII. Further, it also assumes that wages, interest and price will be flexible.
VIII. Full employment exists in the economy without any inflation.
6.2.1 Determination of Income and Employment when there is no saving and

Investment
Classical theory undertakes that national income and employment level depends on the
aggregate production and demand and supply of labour in the economy. Further, it assumes
that homogenous and divisible goods are produced in the market. Let us take output as Y
and it is produced with the help of two factors of production i.e.
(a) Labour which is shown by N and
(b) Capital, this is shown by K.
It can be shown as,
Y = F (K, N); Aggregate production is the function of labour and capital. Here, capital is
assumed as fixed and any change in the technology will leads to shift the production line.
Determination of employment and wages can be shown through a figure 6.1 of labour
market equilibrium.
Fig. 6.1 Labour-Market Equilibrium
Determination of Employment and Wages
Figure 6.1 represents that the output Y will increase only if there is increase in labour N,
with the fixed capital and constant technology. It means there is simultaneous increase in
labour and income. According to classical theory, employment of labour increases with
fixed capital but marginal product of labour would decreases due to the law of diminishing
returns of classical economists. This theory further assumes that every firm which is
engaged in production wants to maximize their profits. These firms will use labour factor
until the marginal production of labour goes equal to the real wages.
It is also interesting to note that real wage rate can be calculated as nominal wage rate
divided by the general price level i.e. Real wage rate = W/P, where W represents nominal
or money wage rate and P is the average price level. Thus, marginal product of level can be
shown as W/P = MPN. This can be concluded that by lowering the real wage rate, more and
more labour can be employed by the firms and at high rate of real wages, demand for labour
will be reduced.
Demand function of labour can be written as:
Nd = f (W/P) and in fig. 6.1, MP curve depicts the diminishing marginal product of labour
as well as demand curve of labour.
On the contrary, supply of labour depends on the income and leisure preferences of
households in the economy. According to classical economists, population does not change
in short run and supply curve of labour slopes downward.
Supply function of labour can be written as:
Ns = g (W/P), which represents that more labour will be supplied at higher wage rate and
vice-versa. We can see that the real wage rate is the point of equilibrium where supply of
labour and demand for labour cuts each other. The situation above equilibrium point
represents unemployment (AB) in the economy and situation below this point represents
excess demand for labour (CD). At equilibrium point, there is neither excess supply of
labour nor excess demand for labour. Due to competition among workers, the excess supply
of labour at wage rate (W/P)1 would force the wage rate to fall at the point of equilibrium
i.e. (W/P)0. On the contrary, if wage rate goes down to (W/P)2 then the firms will demand
more labour and thus again the real wage rate can be attained.
6.2.2 Determination of Income and Employment in an Economy with Saving
and Investment
Sometimes it is assumed that supply creates its own demand but this assumption is not valid
in practical life. It may be correct that output generates an equal amount of income but it is
not necessary that this income is used to purchase goods and services because some part of
this income may be saved and some part may be invested for future income. Thus, saving
and investment will adversely affect the demand for products. This adverse effect will cause
fall in output as well as employment level.
But, classical economists denied this deficiency of aggregate demand due to the assumption
of supply creates its own demand even in the presence of saving. Further, classical
economists believed that some part of income earned can be spent on consumer goods and
rest can be invested. The amount which is not spent is saved and invested by businessmen
equals this saving. Thus, there will be no effect of saving and investment. But, no one can
guarantee that investment will earn same income as the income from saving of the
households. Classical economist believed that change in interest rates brings the equality
between saving and investment. Whenever there is lower rate of interest then more money
can be borrowed for investment. On the other hand, higher rate of interest leads to larger
savings. Here, it is cleared that loan market will be in equilibrium at that rate of interest
where the demand for investment is equal to the supply of savings.
Fig. 6.2 changes in rate of interest bring about

equality between saving and investment
Figure 6.2 shows the changes in rate of interest bring about equality between saving and
investment. Here, interest rate i is determined with the help of intersection among
investment demand curve II and the supply of saving curve SS. High interest rate i2
represents that investment demand is less than the intended supply of saving. On the other
hand, lower interest rate i1 represents that demand for investment exceeds the supply of
saving. Thus, we can see that rate of interest I where loan market is in equilibrium and
investment and saving are equal here.
6.2.3 Determination of Income and Employment: Role of Money and Prices

Determination of income and employment in classical theory can also be explained with the
introduction of money and prices. It will explain how the full employment of labour can be
assured in the economy with money and prices. Further, introduction of money will not
affect the results of the classical theory i.e. the problem of deficiency of aggregate demand
would not be experienced in the free-market.
According to the classical theory, quantity of money will only determine the price level of
output and it will not affect saving and investment level. Moreover, quantity of money
determines the price level of output and it affects wage rate. Increase in money supply leads
to change in money wages and price level in such a way that real wage rate remain constant
in the equilibrium situation and labour market will be restored automatically. Beside, this
increase money supply and change in price level equilibrium of saving and investment will
not be bothered. Classical economists assumed in the quantity theory of money which
explains that supply of money determines price level in the economy.
Quantity theory of money can be expressed as:
MV = PY
P = MV/Y
Where, M = Quantity of Money; V = Income Velocity of Circulation of Money

Y = Level of Aggregate Output (Real Income); P = Price level of Goods and Services
In classical theory, level of aggregate output is determined by the supply of productive
resources and technology will remain constant in short run. In Figure 6.3, aggregate supply
curve (AS) is shown through a vertical straight line which represents that aggregate output
remains constant and has no effect of price level. Here, V and Q remain constant and
increase in money supply will cause proportionately increase in price level.
Fig. 6.3 Increase in the quantity of money cause

proportionate rise in the price level
For example, if money supply in an economy is rupees 500 and velocity of circulation is 4,
then 500 × 4 = 2000 crores will be aggregate expenditure. MV represents aggregate
expenditure or aggregate demand curve which slopes downwards to the right. This is due to
the fact of lower price level where more quantity of goods and services purchased at the
given aggregate expenditure. When quantity of money is equal to M1, Velocity of money is
V then aggregate expenditure on goods and services will be shown by M1V and thus price
level will be determined at O P1. Now with increase in money supply from M1 to M2, V
remains constant and aggregate expenditure will move to M2V and thus price level will shift
from OP1 to OP2. It can be concluded that increase in prices will be proportionate to increase
in quantity of money.
6.3 Criticism of Classical Theory
Classical theory of income and employment is opposed by Keynes through different ways.
Classical theories are criticized due to its assumptions. The criticism of these theories is
described as under:
I. One of the assumption of classical theory is about full employment prevails in the
economy. Keynes considered this assumption unrealistic and vague.
II. Keynes also opposed the classical assumption of long term equilibrium in the economy.
He gives more emphasis on short-term equilibrium.
III. Classical economist blindly depends on Say’s Law of markets and assumed that supply
creates its own demand which assured the equilibrium in the economy. But, Keynes
totally disagrees with this concept.
IV. Further, classical economist Pigou stated that if worker accept sufficiently low wage rate
then unemployment will automatically disappear in the economy. This classical
formulation of employment theory is opposed by Keynes.
V. Classical economists believed that equilibrium in saving and investment is dependent on
flexible rates of interest but Keynes argue against it and believed that equilibrium can be
obtained through change in income rather than change in interest rates.
VI. The assumption of laissez-faire i.e. free perfect competition is not possible in the changed
conditions of modern world.
VII. One of the important assumptions of classical theory i.e. demands for money is only for
transactional and precautionary purpose. But, Keynes did not agree to this assumption
and he believed that money is also demanded for speculative purpose.
VIII. Keynes also did not agree with the classical view regarding direct and proportionate
relationship between money wages and real wages. According to Keynes, there is
negative relationship between these two.
6.4 Keynesian Theory of Income and Employment
Keynesian theory of income and employment is studied with reference to two sector economy
where all the economic decisions are taken by the household sector and the producing sector
without any interference of government. Keynesian theory is an improvement over the
classical theory of income and employment. This theory is also based on various assumptions
which are discussed as follows:
I. Keynesian theory is studied under short time period.

II. There exists perfect competition in the market.
III. Keynesian theory assumed that there is closed economy.
IV. All the factors of production are assumed constant except labour which is only variable
factor.
V. Further, technology is also assumed as constant and money is considered as a store of
value.
VI. Keynes assumes, people have an illusion that value of money remains constants and
saving and investment equilibrium are based on level of income.
Keynesian theory of income and output is discussed in detailed as under. Further, equilibrium
is also determined through different factors.
6.4.1 Equilibrium GDP Determination

Keynes describes two interrelated approaches for the determination of equilibrium GDP in
the economy. Both approaches provide the same results of equilibrium GDP. Equilibrium
refers to a state of balance or state of no change. Equilibrium in GDP refers to a level of
national income which remains constant for a particular period. It is a stage where there is
constant income or output prevails in a particular time period. These are discussed as under:
I. Aggregate Expenditure = Aggregate Output
In two sector economy, government does not interfere and economy is closed for the rest of
the world. There are only two elements for determination of national income i.e.
consumption and investment. Further, an economy is in equilibrium when aggregate
expenditure and aggregate output in the economy equals in the economy. Here, aggregate
expenditure is the total of consumption expenditure and investment expenditure. It can be
shown as; AE = C + I,
AE = Aggregate Expenditure, C = Consumption Expenditure, I = Investment Expenditure
Aggregate expenditure is the expenditure which people wish to spend during in an
accounting year. Similarly, C is the desired or planned expenditure on consumption of goods
and services by the households and I is the planned expenditure on production of goods and
services.
Income/Output/Employment
Fig. 6.4 Equilibrium GDP
Fig. 6.4 represents equilibrium level at point E where OM is the aggregate demand and OY
is the output level in the economy. Point of equilibrium E is the intersection among
aggregate demand for goods and services and aggregate supply of goods and services. Here,
aggregate demand is represented through combination of planned consumption and planned
investment. There may be two situations other than equilibrium or planned output = planned
expenditure.
The point below E represents the situation of planned output less than planned expenditure.
This is a situation of excess demand over aggregate supply which means a firm has to
expand the output and thus, production would reach at the level of equilibrium GDP. The
point above E represents the situation of planned output more than planned expenditure.
This is a situation of excess stock of goods with the firm and this will compel the firm to
reduce output level so that equilibrium can be achieved.
II. Saving (S) = Investment (I)
Another approach to equilibrium is known as saving and investment approach which is
based on the withdrawals from and injections into the circular flow of income. This
approach is helpful to determine the equilibrium GDP in the economy. Here, withdrawals
mean savings and injections means investments. Equilibrium GDP can be obtained where
planned savings and planned investments are equal to each other. We know that,
AE = C + I and Y = C + S,
So we can say that,
C + I = C + S.
Hence, S = I, which means savings equals to investments. This can be represented through
a figure:
Fig. 6.5 Equilibrium GDP: Saving and Investment
E is the equilibrium point where investment and saving are equals to each other and OYE
represents level of income, S represents savings and I represents investment. OYE Level is
the stable equilibrium level in the income. OY1 level of income shows that investments are
more than savings which results into unplanned reduction of output to meet the excess
demand in the market. Hence, output will increase until the planned investment and planned
saving are equal.
At OY2 level of income, savings exceeds an investment which means aggregate demand
falls and excess supply of commodities will lead to unplanned accumulation of output. Thus,
output will decline until it shifts towards point E where OYE equilibrium level of national
income is determined.
6.4.2 Significance of Keynesian Theory of Income and Employment
Keynesian theory provides a complete framework for the determination of income and
employment. It is significant in both the practical way as well as theoritical way. Thus,
significance of Keynesian theory can be studied as under:
Significance Keynesian
Theory of Income and
Employment
Theoretical Significance Practical Significance
• Revival of Macroeconomics
• Underemployment Equilibrium • Government

Interference
• Dynamic
• Social Accounting
• Role of Liquidity Preference • Fiscal Policy
• New Concept • Deficit Financing
• Significance of
• Psychological Law of
Consumption Investment
• Full Employment
• Basis of Fluctuations in
Employment
Fig. 6.6 Significance of Keynesian Theory of Income and Employment
I. Theoritical Significance
(a) Keynes can be known for revival of macroeconomics as discussed by mercantilists and
macroeconomics is concerned with the economic aggregates like national income,
aggregate consumption, aggregate demand, total investment, etc. Prior to the introduction
of Lord Keynes “General Theory” in 1936, classical economists gave priority to
microeconomics only. Microeconomics was considered as the solution for any problem at
macroeconomics level. Thus, Keynes revived the concept of Macroeconomics.
(b) Keynes also contributed to understand the concept of Underemployment equilibrium which
states that equilibrium can be possible under less than full employment situation in the peace
time. Before introduction of macroeconomics equilibrium is considered only when there is
full employment in the economy. Thus, Keynes provides a new direction towards
underemployment equilibrium.
(c) According to Keynes, Dynamic form is considered as important to invest in economic
analysis. Keynes focused on expectations which helped in rendering economic dynamic.
Many concepts of Keynes like liquidity preference, multiplier, etc. are influenced by the
expectations. For example, liquidity preference is dependent on future expectations and
investment are also dependent on the future expectations of earnings.
(d) According to Keynes, money which is used for speculation motive is a function of rate of
interest. As higher liquidity preference leads to high rate of interest and high rate of interest
causes fall in investment and unemployment will increase. Classical economists considered
interest as a reward for parting saving but Keynes consider interest as a reward for parting
liquidity.
(e) Keynes introduced various new concepts like multiplier, propensity to save, propensity to
consume, marginal efficiency of capital etc. wich are helpful for economic analysis. Thus,
Keynes provides a number of concepts which are used as effective tools for economic
analysis.
(f) Psychological Law of Consumption is known as most notable theoratical contribution of
Keynes for economic analysis. This law states that increase in income leads to increase in
consumption but this consumption will be less than increase in income.
(g) Keynes also described the portion in which level of income and employment changes due
to change in investment level in the economy. It means a little change in the investment
level will cause change in income level as well as employment level. Thus, employment
fluctuations are also studied by Keynes in a theoritical context.
II. Practical Significance
(a) According to Keynes, government interference is considered as an important element for
full employment in the economy. Keynes believed that government interference is necessary
in the economic sector for the benefit of people and economy. Under capitalistic economy,
full employment is not possible if government does not pressure to form policies that may
increase demand and investment. Thus, Keynes provides a service of practical significance.
(b) Social accounting is an accounting of income and expenditure of a country and government
formulates various policies which are based on social accounting. Keynes laid stress on
social accounting as he discussed national income, national consumption, national saving
and national investment. These are considered as practical significance in almost all the
countries of the world.
(c) Fiscal policy is also considered as important element with reference to full employment in
the economy. According to Keynes, government programmes for public welfare are helpful
for reduction of unemployment and poverty. Further, various programmes under fiscal
policy are also considered as beneficial for the economy.
(d) Deficit financing is a situation where budgetary deficit exists either due to borrowing from
bank or by printing new currency in the economy. Keynes believed that balanced budget is
not possible during depression and employment. These problems can be solved through
deficit budgeting and it should be kept in a limit otherwise it will lead to inflationary gap.
(e) According to Keynes, full employment in the economy can be achieved with the help of
investment. He believed that in short run consumption expenditure remains stable and thus,
aggregate demand can be enhanced by introducing investments. Thus, Keynes laid stress on
private investments and public investment which should be encouraged by government
during the time of depression and unemployment in the economy.
(f) Full employment policy becomes a major policy due to Keynesian Economic approach. Any
developed and under-developed economies laid stress on the objective of full employment.
Keynes believed that employment can be achieved through raising the aggregate demand in
the market which is a practical significance of Keynesian theory.
Thus, we can conclude that Keynesian Theory of Income and Employment is significant in
both theoretical and practical contexts. This theory is a complete revolution that has deep
impact on the entire economist. According to Harris, no economist can escape Keynes’
venom.
6.4.3 Criticism of Keynesian Theory of Income and Employment
I. The concept of equilibrium in under-employment situation is self-contradictory because
many economists criticized this concept. Further, equilibrium is possible only when there is
full employment in the economy.
II. Keynesian economics is static because he only focuses on the equilibrium but did not clarify
the movement of equilibrium position from one point to another.
III. Keynes theory is a short term economic analysis and it ignored long period equilibrium.
IV. There is an unrealistic assumption of perfect competition in the market which is not possible
in real economic world.
V. Keynesian theory is not a general theory and it is applicable in all the situation of
employment which is not correct.
VI. Keynesian theory is based on the assumption of closed economy which is unrealistic
assumption.
VII. Keynesian analysis is not so empirical and not succeeds in the modern times.
VIII. There is another unrealistic assumption i.e. all the labour units are homogeneous but labour
units are diverse in real world.
IX. Multiplier is not applicable in every situation.
X. There is lack of acceleration principle in Keynesian theory of employment and income.
XI. Further, Keynes study only about depression and unemployment but he did not study the
situation of boom and inflation.
XII. Keynes described demand-pull inflation but he ignored cost push inflation.
6.5 Income Determination in a Closed Economy

Closed income can be discussed in two major contexts i.e. two-sector economy and three-
sector economy. We had already discussed about income determination under two-sector
economy. Now, we will discuss about income determination under three-sector economy and
it includes household, business and government sector. Government influences the level of
economic activities in different ways through fiscal policies, monetary policy, industrial
policy, labour policy, wage policy, employment level, etc. Inclusion of government sector
introduces three major variables in the model which are taxes, government expenditure and
transfer payment. Three-sector model does not include foreign trade and national income can
be shown as GNP = C + I + G. Hence, government spending becomes an important element
of aggregate expenditure and taxes results into change in disposable income. With the
introduction of taxes, national income becomes: Y = C + S + T. But, equilibrium condition
make two things compulsory to be equal i.e. Aggregate demand and aggregate output.
C + I + G = C + S + T means I + G = S + T,
Now, if the government does not impose any taxes then,
S=I+G
Further, equilibrium can be determined under two situations which are discussed below:
(a) Determination of equilibrium income when C + I + G line cuts the 45° line
It is assumed that there are zero taxes and government spending exists in the economy.
National income is determined when aggregate supply equals to aggregate demand. It can
be understood with the help of a figure:
Fig. 6.7 Government Spending and Equilibrium Income

Fig. 6.7 represents that before government spending equilibrium was situated at point E1
where level of income is determined at OY1 and aggregate demand and aggregate
expenditure line cuts each other. Let us assume government spending’s are autonomous
and it is independent of level of income. When government expenditure is added to C + I,
it will form C + I + G and equilibrium will shifts from E1 to E2. New level of income is
determined at OY2. Thus, it can be concluded that an injection of government spending
results into increase in income and employment.
(b) Equilibrium Income at the Intersection of S and I + G Line
We had discussed about the injection in the form of government spending but we did not
consider leakages for equilibrium. Total injections and total leakages must be equal for
determination of equilibrium. If we assume tax does not exist in the economy then savings
will constitute leakages. Here, equilibrium can be written as S = I + G. Further, it is
assumed that both private investment and government spending are autonomous. It is
shown through line Ī which is parallel to horizontal axis, shown in Fig. 6.8. If autonomous
government spending is added in it then Ī + G is formed. Before introduction of
government spending equilibrium is situated at point E1 where line SS’ and I intersect
each other. After addition of government spending equilibrium will shift from E1 to E2.
Equilibrium level of income shifts from point OY1 to OY2.
Fig. 6.8 Government Expenditure and Equilibrium Income
Thus, this will also provide same results as we obtained in first case i.e. an increase in
government expenditure results in an increase in equilibrium level of income. Further, we
describe both the situation without effect of taxes. Now, we will discuss effect of taxes
on national income:
Whenever government imposes a tax then the amount of tax is reduced from national
income and thus remains disposable income. It can be shown as Y – T = Yd; here Y=
national income, T= tax and Yd = Disposable income. With the fall in disposable income,
people will reduce expenditure on consumption and this reduction will lead to reduction
in national income.
Fig. 6.9 Income determination with Inclusion of Taxes
Equilibrium is situated at point E without a tax, where aggregate demand curve intersect
the aggregate supply curve line and income level is determined at OY. But, with the
introduction of taxes the aggregate demand curve will shifts from C + G + I to C1 + I +G
and equilibrium shifts towards point E1. These will result into reduction of income level
from OY to OY1. Thus, introduction of taxes will lead to reduction in level of national
income.
6.6 Summary
Income determination can be done theory major two theories i.e. Classical theory and
Keynesian theory. Both the theories have their own importance and drawbacks. Classical
theory can be studied under three different situations which are, with saving and investment,
without saving and money and with role of money and prices. Whereas Keynesian theory
gives emphasis on two major dimension i.e. first, aggregate expenditure and aggregate output,
second is saving and investment. These theories are important to determine the equilibrium
level of income and output in the economy. These theories are very beneficial for the economy
but these are based on some assumptions which become drawbacks at later stage. Further,
income determination in closed economy is also studied which includes two sector model and
three sector model. Two-sector model has only two variables i.e. household and production
sector. Three-sector model has three variables i.e. households, business and government. At
last, effect of government spending and taxation effect is described in detail with diagram.
Further, role of injections as well as leakages are also studied for better understanding of
equilibrium in the economy. Thus, we can conclude that income can be determined through
both of the above said theories. Moreover, Keynes contributed a lot in macroeconomics and
he introduced many concepts of macroeconomics like multiplier, investment, aggregate
demand, aggregate investment, etc. However, Keynes described income determination under
short time period and not in long time period. Thus, Keynes was unable to remove all the
drawbacks but still his theories are used for determination of income and employment level
in different economies of the world.
6.7 Keywords
Income- The amount of money which is received regularly for providing services to others
or interest on money which is saved by a person is known as income.
Employment- It is a contract between employer and employee where the employee will
provide certain services for the reward.
Closed Economy- It is a self-sufficient economy which has no imports from rest of the world
and no exports outside the domestic territory of that country.
Aggregate Expenditure- Aggregate expenditure is the expenditure which people wish to

spend during in an accounting year.
Consumption Expenditure- It is the desired or planned expenditure on consumption of

goods and services by the households.
Investment Expenditure- It is the planned expenditure on production of goods and services.

Q.1 Explain the role of classical economists in the economic analysis. Do you agree with
classical economists? Provide reasons for your answers.
Q.2 Explain the classical theory of income and employment. What are the major criticisms of
classical theory?
Q.3 Define classical theory of income and employment. What are the main assumptions of
this theory?
Q.4 What do you mean by Keynesian theory of income and employment? What are the salient
features of this theory?
Q.5 How did GDP determination is done through Keynesian theory? What are the major
differences between Classical theory and Keynesian theory of income and employment?
Q.6 What mechanism in classical theory of income and employment is used for ensuring
equality between saving and investment in full employment?
Q.7 Explain the two major approaches to determine equilibrium under Keynesian theory of
income and employment.
Q.8 What are the major assumptions of Keynesian theory of income and employment? To
what extent these are applicable in the real world situations?
Q.9 Explain the role of Keynes in introducing new concepts of macroeconomics. Also
critically discuss the Keynesian theory of employment.
Q.10 Explain the role of government spending and taxation in the three-sector model of
economy.

1. In Keynesian Economics, equilibrium level of income implies and
.
2. In Keynesian Theory, equilibrium GDP is discussed with reference to
3. Keynes assume that aggregate supply is .
4. is the value of MPC in Keynesian model.
5. The concept of “ laissez-faire” was the contribution of .

1. Equilibrium level of output; equilibrium level of employment
2. Short-period
3. Perfectly elastic
4. Greater than zero and less than one
5. Classical Economists
6.9 Study Tips
1. Dwivedi 2019. Macroeconomics Theory and Policy, pages 54-80, Tata McGraw-Hill
Publishing Company Ltd., New Delhi.
4. Ahuja 2013. Macroeconomics Theory and Policy, pages 45-99, S. Chand & Company
5. Jhingan 2012. Macro Economic Theory, pages 217-239, Vrinda Publication (P), Delhi.
Ltd., Noida.
LESSON-7
Inflation concept and Theories
Lesson Structure
7.2 Types of Inflation
7.3 Causes of Inflation
7.4 Effects of Inflation
7.5 Theories of Inflation
7.6 Measurement of Inflation
7.7 Remedial Measures of Inflation
7.8 Summary
7.9 Keywords
7.11 Study Tips

After reading this chapter you will be able to understand about the concept of inflation and its
different types. You will also learn about the causes and effect of inflation on the economy.
Further, you will be able to understand the major theories of inflation i.e. demand pull and
cost push inflations. At the end of the lesson, we try to learn about the remedial measures to
control inflation in the economy. We will discuss all these concepts in detail under this
chapter.
Inflation is not a new phenomenon in modern times because from the earliest days of history,
people are confused and puzzle about rising prices. The same condition of inflation prevails
in the modern times also which affect almost the whole world. Inflation is a highly volatile
term which requires modification time to time. This term was first defined by neo-classical
economists as it is a galloping rise in prices due to excessive increase in the quantity of money.
Neo-classical economists also described inflation, “as a destroying diseases born out of lack
of monetary control whose results undermined the rules of business, creating havoc in markets
and financial ruin of even the prudent.” But, Keynes did not agree with the neo-classical
economists and he opposed the situation of full employment in the economy. Further, he did
not believe that full employment cause hyper-inflation due to increase in the quantity of
money. According to Keynes, there may be underemployment in the economy and an increase
in the money supply tends to increase in aggregate demand, output and employment.
Further, inflation reduces the purchasing power of each unit of currency and this will result
in increase in the prices of goods and services over time. For example, one has to spend more
to buy a packet of milk, to fill petrol tank of bike or to buy new clothes, etc. In simple words,
inflation increases the cost of living. In broader sense, inflation means a considerable and
continuous rise in the general level of prices over a long period of time.
Definition of inflation:
According to Parkin and Bade, “Inflation is an upward movement in the average level of
prices. Its opposite is deflation, a downward movement in the average level of prices. The
boundary between inflation and deflation is price stability.”
In the words of Peterson, “The word inflation in the broadest possible sense refers to any
increase in the general price-level which is sustained and non-seasonal in character.”
Thus, we can conclude that inflation refers to continuous increase in prices or we can say that
inflation reduces the purchasing power of a unit of currency. It means value of money is
falling here and it leads to prices rise. Or inflation may be defined as a situation where
supply of money increases at a rate higher than the supply of real output.
7.2 Types of Inflation

Different economists provide many types of inflation classified according to their basis.
Normally, we study about inflation on the basis of rising prices but there are various bases on
which inflation can be studied. We will discuss this classification of inflation through the
following figure:
Types of Inflation
On the Basis of On the Basis of On the Basis of Rising On the Basis of On the Basis of
Scope Time Prices Expectations Control
 Comprehensive  War time  Creeping Inflation  Anticipated  Open Inflation

Inflation Inflation  Secular Inflation Inflation  Suppressed
 Sporadic  Post war  Walking Inflation  Unanticipated Inflation
Inflation Inflation  Moderate Inflation Inflation
 Peace time  Running Inflation
Inflation  Galloping Inflation
 Hyperinflation
Fig. 7.1 Types of Inflation
I. On the basis of Scope

Scope defined the area and coverage which is affected by inflation in the economy. It can be
classified into two categories, viz. are as follows:
Comprehensive Inflation arises when the prices of all the commodities rise in the whole
economy. It is also known as Economy-wide Inflation because it affects the whole economy.
Sporadic Inflation occurs when prices of only a few commodities rises in some regions of
the economy. It is sectional in nature because it does not affect whole of the economy. For
example, Increase in food prices due to bad monsoon.
II. On the basis of Time
On the basis of time, inflation can be categorised into three types i.e. war time inflation, post
war inflation and peace time inflation. These are explained below:
War time inflation means the inflation which takes place during the period of war like
situations. This inflation occurs because in war time, priority is given to production of military
goods and capital goods. This would results into limited supply of raw material which is used
for production of essential items. Thus, production and supply of necessity goods slow down
and prices of these products rises in the market. Hence, it would results into war time inflation
in the economy.
Post War Inflation takes place very soon after the war time inflation. Whenever war ended
in any economy then government control in the country relaxed and due to reduced
government control, there will be hike in the prices. This hike in prices is faster than what
experienced in the war time.
Peace-time Inflation is just opposite to war time inflation. Prices of the commodities rise in
the economy even if there is peace in the economy. It is due to huge government expenditure
or spending on capital projects for a long time period.
III. On the basis of Rising Prices
Inflation is a phenomenon which arises due to increase in prices but this increase in price has
different stages. These are discussed below:
Creeping Inflation refers to inflation where prices rise at a very slow pace. This is the mildest
form of inflation and it is also termed as mild inflation or low inflation. Some of the
economists believed that creeping inflation takes place when prices increases but not more
than 3% per annum.
Secular Inflation occurs when creeping inflation continuous to increase for a longer period
of time. It is also known as chronic inflation because if an inflation rate continuously increases
without a downturn then it possible leads to Hyperinflation.
Walking Inflation takes place when the rate of rising prices is more than the creeping
inflation. When prices rises by more than 3% but less than 10% per annum, is known as
walking inflation. Some of the economists believed that we should take walking inflation
seriously because it gives signals for the occurrence of running inflation.
Moderate Inflation happens when prices rise by less than 10% per annum or single digit
inflation rate. Prof. Samuelson clubbed both the creeping and walking inflation into moderate
inflation. It is a stable inflation and it is not a serious economic problem.
Running Inflation occurs when there is rapid increase in the rate of rising prices. Further,
running inflation happens when price rise is more than 10% to 20% in a year.
Galloping Inflation is defined by Prof. Samuelson as it occurs when price rise by dual or
triple digit inflation rate like 30%, 40% or 999% yearly. It is also known as jumping inflation.
Hyperinflation refers to a situation where the prices rise at a very high rate and so fast that it
becomes difficult to measure its magnitude in the economy. In the situation of hyperinflation,
paper money becomes worthless and people starts trading in metals or uses the old barter
system of commerce. In quantitative terms, when rise in prices is above 1000% per annum, it
is known as hyperinflation.
IV. On the Basis of Expectations
Inflation can also be categorised on the basis of expectations because inflation can be
anticipated or predicted. Both type of inflation on the basis of expectations is described below:
Anticipated Inflation refers to the inflation where the rate of inflation is either expected or
predicted to some extent by majority of people in the economy. It is also known as expected
inflation or predicted inflation.
Unanticipated Inflation refers to the inflation where the rate of inflation is neither anticipated
nor predicted by majority of people in the economy. It is also known as unexpected inflation.
V. On the Basis of Control
It refers to government control over inflation in an economy. It can be bifurcated into two
parts which are explained below:
Open Inflation refers to inflation where government does not attempt to restrict inflation in
the economy. This case is found in free-market economy where prices are allowed to move
freely in the economy.
Suppressed Inflation refers to the inflation where government attempts to control inflation
through price control, rationing, etc. This type of inflation is also known as repressed inflation.
If government does not use control measure then it will becomes open inflation and this will
lead to corruption, black money, artificial scarcity, black marketing, etc. in the economy.
Thus, it can be concluded that on different basis inflation can be classified into different
categories. Many economists offer various types of inflation according to their convenience.
There are some other classification also like: Deficit inflation, credit inflation, scarcity
inflation, profit inflation, tax inflation, etc.
7.3 Causes of Inflation

Inflation is caused when aggregate demand exceeds aggregate supply of goods and services
in the economy. So, we have to discuss the factors affecting aggregate demand and aggregate
supply. These factors are discussed in detail here:
I. Factors affecting Demand
Both Keynesian and monetarists are of the view that inflation is caused due to increase in
aggregate demand. The following factors are responsible for increase in demand.
(a) Increase in supply of money leads to increase in aggregate demand which will results
into inflation. Further, higher the growth rate of the money supply, the higher will be
the inflation rate.
(b) Increase in the disposable income of consumer is another cause for increase in
aggregate demand. Disposable income may be increased through reduction in taxes,
rise in national income or reduction in the savings of the people.
(c) Government spending is another reason behind increase in aggregate demand.
(d) Whenever there is increase in consumer spending then it will results into increase in
aggregate demand.
(e) Aggregate demand is also increased through cheap monetary policy or the policy of
credit expansion because cheap monetary policy leads to increase in money supply.
(f) Sometimes, government borrow money from public and printing more notes to meet
its necessary expenses which resulted into deficit financing. This will raise aggregate
demand in relation to aggregate supply and thereby it will cause deficit-induced
inflation.
(g) Further, expansion of private sector in the economy also tends to increase in aggregate
demand. Huge investment results into increase in employment and income and so it
will create more demand for commodities.
(h) Black money in all the countries exist due to corruption, tax evasion, etc. which results
into increase in aggregate demand. Black money creates unnecessary demand in the
economy.
(i) Whenever government of a country repay its loan to public then public get more money
to spend on the commodities. This increase in money supply leads to increase in
aggregate demand.
(j) Sometimes demand for domestic products increases in the foreign market and foreign
currency enters into domestic boundaries. Thus, this foreign currency tends to increase
in money supply with public and hence, aggregate demand will increase.
II. Factors affecting Supply
Decrease in supply is the second important variables which cause inflation. Decrease in
supply is caused due to many factors explained below:
(a) If there is shortage of factor of production or excess capacity of the plant then there
will be shortage of goods in the market. This shortage will raise the prices of the
commodities in the market.
(b) Another reason for decrease in supply of commodities in the market is industrial
disputes. In some countries, trade unions are very powerful and they will resorts to
strikes due to their demands in the organisation. This strike and lock-out will results
into decrease in production and hence, there will be decrease in supply.
(c) Natural calamities also adversely affect the supply of commodities such as agricultural
products. Natural calamities involve situations like drought and floods. These
calamities will results into shortage of food products and raw material. Hence, it will
create inflationary pressure in the economy.
(d) Sometimes, artificial scarcity is also created by the hoarders and speculators who want
to create black marketing in the market. Hence, these practices will results into decrease
in supplies of goods and raise their prices.
(e) When a country produces more goods for the purpose to export rather than for domestic
consumption. This will creates shortages of commodities in the domestic market and
hence this will leads to inflation in the economy.
(f) Sometimes, producers also focus on the production of comfort and luxury products
rather than producing essential commodities of basic needs and create shortage of
consumer goods in the market. This leads to increase inflation in the economy.
(g) If industries in the country are using old machines and out-dated technology for
production then the law of diminishing returns operates. This will increase the cost per
unit of production; hence it will raise the prices of the commodities.
(h) Inflation is a world-wide phenomenon and when price rise in major industrial countries
then it will affect rest of the countries. Whenever prices of a commodity from major
industries increase, then prices in other countries will also be raised.
7.4 Effects of Inflation

Normally, we assume that inflationary situation is not good for an economy but sometimes,
Inflationary pressure in an economy may generate its good effects on the economy. Inflation
may affect an economy in both the ways i.e. positive effects and negative effects. These are
explained as under:
Effects of Inflation
Positive Effects Negative Effects
 Higher Profits  Fall in the Real Income of Fixed-
 Higher Investment Income Groups
 Higher Production  Inequality in the distribution of Income
 Higher Employment and Income  Upset the Planning Process
 Possibility of Higher Income for the  Increase in Speculative Investment
Shareholders  Harmful impact on Capital
 Gain for the Borrowers Accumulation
 Lenders will lose
 Harmful impact on Export Income
Fig. 7.1 Effects of Inflation
I. Positive effects of Inflation
Inflation is not always unfavourable for the economy because in some situations, inflation
had positive effects on the economy. These situations involve creeping inflation and
walking inflation in the economy. Positive effects of inflation are discussed below:
(a) Inflation is beneficial for producers because they can sell their products on higher prices
and earn higher profits in the market.
(b) During inflation, entrepreneurs and investors get additional incentives for the
investment made by them. They can earn higher prices on their investment.
(c) Due to higher productive investment, production of goods and services will also
increases during inflation.
(d) Increase in production of goods and services leads to increase in factor of production
during inflation. So, it can be perceived that there will be increase in employment as
well as income opportunities in the economy.
(e) During inflation, if the companies are earning higher profits then they will declare
dividends for their shareholders. Hence, dividend income of the shareholders will rise
during inflationary period.
(f) Inflation refers to decrease in the value of money or decrease in purchasing power of
money. If the rate of interest to be paid by borrower is less than the inflation rate then
the borrower will gain. It is due to the fact that real value of money which is returned
by the borrower will be less than that of money borrowed earlier.
II. Negative effects of Inflation
Whenever inflation goes beyond the creeping and walking stage then it will have negative
impact on the economy. Limited level of inflation can bear by an economy and at this stage
it may be beneficial for economy. But, high degree of inflation had negative effects on the
economy. These negative effects are as follows:
(a) Inflation had negative effect on the real income of fixed-income groups. Real income
means purchasing power of money. During inflation, real income of workers, salaried
people and pension earner adversely affected.
(b) During inflation, the profits of businessmen and entrepreneurs increasing whereas the
real income of fixed income group declines. Thus, inflation leads to inequality in the
distribution of income.
(c) During inflation, prices of goods, raw material and factors increases and continuously
more money has to spent on the investment projects taken up during the planning
period. If more financial resources cannot be raised by the Government then planning
process will be disturbed.
(d) Further, inflation is major reason for increasing speculative activities in the economy.
If the prices rise at a very fast pace then speculative investment will increases. These
types of investments do not help in the creation of productive capital in the economy.
(e) If there is continuous increase in prices then people will prefer goods rather than money
and thus, consumption will increase in the economy. As a result of increase in
consumption the intensity to save goes downward and it will adversely affects capital
accumulation in the economy.
(f) As we have earlier discussed that borrowers will gain during inflation; this will become
reason for loss of lenders. This is due to the fact that lenders perceived an amount
having lower value than before.
(g) If prices of the export items also increase during inflation then their demand in the
foreign market will decreases. Thus, this increase in prices leads to fall in the export
income of a country.
Thus, we can conclude that inflation had both positive as well as negative impact on the
economy. But, the impact depends on the degree of inflation because a small degree of
inflation can have positive impact on economy whereas high degree of inflation leads to
negative impact on the economy.
7.5 Theories of Inflation

Different economists have given different theories on inflation, out of which some theories
are similar to each to other and some theories are different. Further, these theories are
categorized by different economists according to their convenience and use. Some of the
economists categorized these theories as classical theories and neo-classical theories.
Classical theories are collectively contribution of Jean Bodin, Richard Cantillon, John Locke,
David Hume, Adam Smith and William Petty. Another version of classical theories of
inflation is known as neo-classical theories of inflation which were developed by the
Cambridge Economists. Afterwards, Keynes made an important contribution to theories of
inflation and he focus on inflationary gap of demand and supply in the market. Theories of
inflation are extended with the time passes and then modern theories of inflation are
introduced. We will discuss these theories in detail.
Demand - Pull
Inflation
Theories of Cost - Push

Inflation Inflation
Others
Fig. 7.3 Theories of Inflation
I. Demand-Pull Inflation
Demand-pull inflation occurs when the aggregate demand increases more rapidly than the
aggregate supply in the market. This theory is also known as tradition theory of inflation
which is based on the fact that inflation is cause due to excess demand over supply of goods
and services at existing price. In modern income theory, demand-pull refers to an excess
of aggregate money demand relative to full employment/output level in the economy.
Various economists like Friedman, Hawtrey, Golden Weiser, etc. considered inflation as a
monetary phenomenon and strongly support this theory. As a result of excess demand
prices will raise and excess demand will pull inflation i.e. demand-pull inflation.
Fig. 6.4 Demand-Pull Inflation: Excess Demand over Supply
In Fig. 6.4, LRAS represents long run aggregate supply, AD represents aggregate demand.
If aggregate demand shift from AD1 to AD2 more rapidly than long run aggregate supply
curve, then firm will raise the prices of their products from P1 to P2 which results into
inflation. This inflation is pulled by excess aggregate demand, thus it is known as demand
–pull inflation.
II. Cost-Push Inflation
This theory opposed the view that inflation is caused due to demand-side factors alone.
There are others factors which are responsible for inflation in the economy. Under cost-
push inflation, price rise due to rise in the cost of raw materials and wages. Sometimes,
some producers or workers may raise the prices of their products above the level which
prevails in the market. It has been seen that during recession period aggregate demand
decrease than supply then prices should also decrease but it did not happen. The cost-push
inflation is caused by monopoly which is created by some monopoly groups of the society.
It has been seen in the society that labour unions succeed in their demand for higher wages
from the industries. Higher wages leads to increase in prices thus is creates wage push
inflation which is a part of cost push inflation. Not only labour unions but monopolistic
and oligopolistic also increase their profit margin and increase the prices which is known
as profit push inflation. Similarly, there can be supply shock inflation.
Fig. 6.5 Cost-Push Inflation
Fig. 6.5 shows cost-Push inflation, here AD shows to aggregate demand and AS shows
aggregate supply. Is there is increase in AS1 to AS2 then GDP will move from Y1 to Y2
and prices will increase from P1 to P2. This will leads to inflation in the economy. Thus, it
can be concluded that cost of factor of production also push inflation in the economy and
excess demand is not only a reason for inflation.
III. Others
There is a middle group of economists who believed in structural theories of inflation.
These theories stressed that market power is one of the important reason behind inflation.
The supporters of structural theories stated that inflation arises due to lack of structural
adjustments in the economy. Structural theories can be divided into two parts i.e. Mark-up
theory and Bottle-Neck Inflation. These are discussed as under:
Mark-Up Theory of inflation is given by Prof. Gardner Ackley who describe that
inflation is not occurs only due to the demand and cost forces in the economy. Whereas he
described that inflation occurs due to cumulative effect of demand pull and cost push
activities. Prof. Gardner has provided a model for mark-up inflation in which both the
factors i.e. demand and cost, are determined. Increase in demand tends to increase in prices
of products because customers have to spend more on products. On the other hand, if goods
are sold to businesses then the cost of production increases and prices of products also
increases. Similarly, a rise in wage results in increase in cost of production which would
results into increase the prices of products.
Bottle-Neck Inflation was introduced by Prof. Otto Eckstein who describe that the direct
relationship between wages and prices of products is the major reason behind inflation. Or
we can say that inflation take place when there is simultaneous increase in wages and prices
of products. He believed that inflation occurs due to the boom situation in capital goods
and wage-price level. He observe the inflationary situation and advocated that prices of
almost every industry is higher during the period of inflation but very few industries shows
rapid price hike than the rest of the industries. These industries are termed as bottle neck
industries and these are responsible for increase in prices of goods and services.
Thus, we can say that there are various theories which are propounded by different
economists at different time intervals. But, mostly demand-pull theory and cost-push
theory are used in the modern times. But, we should have knowledge about the other
theories of inflation for better understanding of this concept. Further, these theories are
helpful to form basis for future measurement of inflation in the economy.
7.6 Measurement of Inflation

Inflation can be measured through two different methods i.e. Consumer Price Index (CPI) and
GDP Deflator. We will learn these two methods with the help of examples and different
formulas. These are explained below:
I. Consumer Price Index

Consumer Price Index or CPI measures changes in price from the consumer perspective.
CPI can be known as a measure of price changes in consumer goods and services such as
food, clothing, gasoline and automobiles except housing costs and mortgage interest
payments. It shows changes in the prices of a market basket of goods and services
purchased by consumers. CPI also helps in the measurement of cost of living of consumers.
The U.S. Bureau of labour statistics defined, ‘CPI is a measure of the average changes over
time in the prices paid by urban consumers for a market basket of consumer goods and
services.’
Thus, CPI is a statistical estimate constructed with the help of prices of items that represent
the economy, whose prices are collected periodically. The annual percentage change in
CPI is taken as a measure of inflation.
Formula:
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒌𝒆𝒕 𝑩𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓
CPI of a Year = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒌𝒆𝒕 𝑩𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓 × 𝟏𝟎𝟎%
𝑪𝑷𝑰 𝒊𝒏 𝑷𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒀𝒆𝒂𝒓−𝑪𝑷𝑰 𝒊𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓
Inflation in Year 2 = × 𝟏𝟎𝟎%
𝑪𝑷𝑰 𝒊𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓
Example,
Suppose the market basket of a typical consumer contains 4 breads and 2 eggs. Year 2005
is considered as base year. The Table represents per unit cost of commodities and cost of
basket.
Year Per Unit Price Per Unit Price of Cost of Basket (₹)
of Bread (₹) Egg (₹)
4×1 + 2×2 = 8
2005 1 2
4×2 + 2×3 = 14
2006 2 3
4×3 + 2×4 = 20
2007 3 4
Table no. 7.1 represents price per unit and cost of Basket
CPI for different Year:
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒌𝒆𝒕 𝑩𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒂 𝒀𝒆𝒂𝒓
CPI of a Year = 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑴𝒂𝒓𝒌𝒆𝒕 𝑩𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓 × 𝟏𝟎𝟎%
8
YEAR 2005 = × 100% = 100
8
14
YEAR 2006 = × 100% = 175
8
20
YEAR 2007 = × 100% = 250
8
Inflation rate for the years:
𝑪𝑷𝑰 𝒊𝒏 𝑷𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒀𝒆𝒂𝒓−𝑪𝑷𝑰 𝒊𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓

Inflation in Year 2 = × 𝟏𝟎𝟎%
𝑪𝑷𝑰 𝒊𝒏 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓
175−100
Inflation Rate for YEAR 2006 = × 100% = 75%
100
250−175
Inflation Rate for YEAR 2007 = × 100% = 43%
175
II. GDP Deflator
GDP deflator is the measurement of changes in the overall prices of newly produced goods
and services that are ready for consumption. It is a helpful tool to determine the rate of
inflation through converting output measured at current market prices into constant base
year prices. In other words, GDP deflator measures the relationship between nominal GDP
(total output measured at current prices) and real GDP (total output measured at constant
base year prices). It measures the current level of prices relative to the level of prices in the
base year. Calculation of GDP Deflator is shown through an example given below:
Formula:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑷𝒓𝒊𝒄𝒆)
𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 (𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓 𝑷𝒓𝒊𝒄𝒆)
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟐−𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟏

Rate of Inflation = × 𝟏𝟎𝟎
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟏
Example,
Suppose the market basket of a customer contains bread and egg, price per unit of products
and quantity of the products is given in table no. 7.2. Further, Nominal GDP is calculated
in the last column of the Table. Now, we have to calculate the GDP Deflator and Inflation
rate on the basis of GDP Deflator.
Per
unit Quantit Per
price of y of unit Quantit Nominal GDP (₹)
Bread Bread price of y of Egg
Year (₹) (₹) Egg (₹) (₹)
2005 1 100 2 50 1×100 + 2×50 = 200
2006 2 150 3 100 2×150 + 3×100 = 600
2007 3 200 4 150 3×200 + 4×150 = 1200
Table No. 7.2 Represents price per unit, quantity and Nominal GDP
Computation of Real GDP:
Year 2005 is taken as base year for calculating real GDP,
Year 2005 = 1×100 + 2×50 = 200
Year 2006 = 1×150 + 2×100 = 350
Year 2007 = 1×200 + 2×150 = 500
Computation of GDP Deflator:
𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 (𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑷𝒓𝒊𝒄𝒆)

𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 (𝑩𝒂𝒔𝒆 𝒀𝒆𝒂𝒓 𝑷𝒓𝒊𝒄𝒆)
200
Year 2005 = × 100% = 100%
200
600
Year 2006 = × 100% = 171.4%
350
1200
Year 2006 = × 100% = 240%
500
Computation of Rate of Inflation:
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟐−𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟏

Rate of Inflation = × 𝟏𝟎𝟎
𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓 𝒊𝒏 𝒀𝒆𝒂𝒓 𝟏
171−100
Rate of Inflation in Year 2006 = × 100% = 71%
100
240−171
Rate of Inflation in Year 2007 = × 100% = 40.35%
171
7.7 Remedial Measures of Inflation
Most of the economists believed that inflation beyond creeping and walking stage are
dangerous for the economy and it will prove disastrous if these are not controlled. So,
economists suggest some measures to control inflation. These measures can be divided into
three parts. These are as follows:
Measures to
Control Inflation
Monetary Fiscal Other

Measures Measures Measures
 Bank Rate
Policy  To Increase
 Cash Reserve  Reduction in Production
Ratio Unnecessary  Rational Wage
 Open Market Expenditure Policy
Operation  Increase in Taxes  Price Control
 Statutory  Increase in  Rationing
Liquidity Ratio Saving
 Selective  Surplus Budgets
Control  Public Debt
Controls
 Moral Suasion
Fig. 6.6 Measures to Control Inflation

I. Monetary Measures
Many economists and monetarists argue that inflation is a monetary phenomenon and arise
due to increase in the money supply in excess of its optimum level. Thus, they believed
that inflation can be controlled through monetary measures which are greatly effective in
controlling demand-pull inflation. The monetary measures which are used widely in the
economy are discussed as under:
(a) Bank Rate Policy is one the important measures which is used to control inflation in
the economy through use of Bank rate tool. Bank rate is the rate at which Central bank
of a country lends money to other domestic and commercial banks. When there is
excess money supply in the country then central bank increases the bank rate so that
money supply can be controlled and vice-versa. Increased bank rate leads to low
borrowing by commercial bank from central bank and thus, flow of money from
commercial bank to the public reduces.
(b) Cash Reserve Ratio is the ratio or proportion of total demand and time deposits which
is maintained by commercial banks. One part of this proportion is maintained as cash
in hand and the other part is statutory reserve which is known as cash reserve. During
inflation, commercial banks increase the cash reserve ratio so that they can control the
excess money supply in the market. More cash reserve means more cash will put to
reserve and less cash left for public and thus, Inflation can be controlled.
(c) Open Market Operations are another measure to control inflation in the economy.
Open market operation refers to sale and purchase of government securities and debts
by the central banks to general public in the open market. In order to control inflation,
central bank sold the government securities to general public through commercial
banks so that excess money of public can be captured by central bank.
(d) Statutory Liquidity Ratio is another monetary measure to control inflation and it is
one of the non-tradition methods of control used by RBI. Statutory Liquidity Ratio is
the minimum proportion of bank’s daily demand and time liabilities which is to be kept
by commercial banks in the form of liquidity assets. In order to control inflation, RBI
increases the Statutory Liquidity Ratio so that banks left with small amount of money
for lending to public.
(e) Moral Suasion is a technique of moral persuasion and pressure in general and the
banks which are not following rules. The central bank uses this technique to adopt a
lending policy in line with the objectives of the general monetary policy. The central
bank uses this technique through discussion, letters and speeches of the authorities
when the traditional methods of monetary control do not work. The central Bank uses
this moral persuasion for implementing monetary policy for controlling inflation.
(f) Selective Credit Controls is the method that RBI uses to regulate the distribution of
bank credit between the various sectors on the selective basis. RBI uses selective credit
control measures to prevent banks from lending money for speculative hoardings of
essential commodities like food grains, oil seeds and agricultural products. Thus,
inflation can be controlled.
II. Fiscal Measures
Monetary policy is an effective measure of control inflation in the economy but it is not
only one measure to control inflation. Thus, fiscal measures are introduced as measure to
control inflation. Fiscal measures are highly effective in the field of government
expenditure, personal consumption expenditure, private and public investment. These are
described as follows:
(a) Inflation can be controlled if unnecessary expenditure on non-developmental activities
by government is reduced. This is also a good measure of private expenditure because
private expenditure is dependent on government demand for goods and services.
(b) Further, inflation can be controlled when rates of direct taxes and indirect taxes raises.
But, the rate of taxes should not be so high so as to discourage saving, investment and
production. Government should prepare a tax collecting system so that tax evaders can
be penalised. Thus, all these efforts will be helpful to control inflation in the economy.
(c) Excess money supply can be controlled through encouraging savings in the market.
This will tend to reduce the disposable income of people and personal expenditure will
reduce. Hence, inflation can be controlled.
(d) One of the important fiscal measures to control inflation is to adopt anti-inflationary
budgetary policy.
(e) Further, government should stop repayment of public debt and postpone it for the future
date until there is controlled inflationary pressure in the economy.
III. Others
There are some other measures which are helpful to control inflation in the economy. These
are based on aggregate demand and aggregate supply. These are as follows:
(a) Inflation can be controlled if production of essential commodities is increased.
(b) There should be rational wage and income policy in an organisation. Under
hyperinflation, government freeze wages, income, profits and dividends to control it.
(c) Another direct control to check inflation is to control prices in the economy.
(d) Further, rationing is another measure to control inflation. Rationing focus on
distributing consumption of scarce goods so that resources can be made available to
large number of consumers. Rationing is thus, helpful to stabilize prices in the
economy.
Thus, we can conclude that there are various monetary, fiscal and other measures to control
inflation in the economy. Here, Inflation is considered as a monster for economy and these
measures works as weapons through which government should fought with the monster.
7.8 Summary
Inflation is not just a word rather it is a phenomenon which affects economy as a whole. Every
country faces this situation one or the other time. Inflation is considered as unfavorable for
the growth of an economy but it is not right for all types of inflation. There are different types
of inflation and degree of their effect is different on economy. Thus, creeping and walking
inflation is not considered as dangerous rather than these have positive impact on the
economy. We have learned about various reasons behind the inflation. After a research of
long time, various theories are introduced by different economists for better understanding of
inflation. Two major theories of inflation are focused in modern times i.e. Demand-pull
inflation and Cost-push inflation. Many economists find different methods for the
measurement of inflation and these are used all over the world. Further, various economists
suggests different measures to control inflation like monetary measures, fiscal measures and
others. Thus, it is well said that inflation is a poison for the economy and its timely treatment
is a must.
7.9 Keywords
Inflation- Inflation refers to continuous increase in prices or it reduces the purchasing power
of a unit of currency.
Creeping Inflation- It refers to inflation where prices rise at a very slow pace. This is the
mildest form of inflation and it is also termed as mild inflation or low inflation.
Walking Inflation- It takes place when the rate of rising prices is more than the creeping
inflation. When prices rises by more than 3% but less than 10% per annum, is known as
walking inflation.
Hyperinflation- It refers to a situation where the prices rise at a very high rate and so fast that
it becomes difficult to measure its magnitude in the economy.
Demand-Pull Inflation- Demand-pull inflation occurs when the aggregate demand increases
more rapidly than the aggregate supply in the market.
Cost-Push Inflation- Under cost-push inflation, prices rise due to rise in the cost of raw
materials and wages.

Q.1 What do you mean by Inflation? What are the major causes of inflation in an Economy?
Q.2 How does Inflation measured? What are major two methods of measuring Inflation with
example?
Q.3 What are the different types of Inflation? How do they are different from each other?
Q.4 Differentiate between Demand-Pull Inflation and Cost-Push Inflation.
Q.5 Explain the difference between Walking inflation and Hyperinflation. What are the
major features of both of these types of inflation?
Q.6 Explain the major theories of Inflation in detail. Does these theory are helpful for the
basic understanding of Inflation?
Q.7 What are the remedial measures for controlling inflation in the economy?
Q.8 What is Inflation? Explain the different effects of inflation in the economy.
Q.9 Write short note on: Open and Suppressed Inflation; Predictable and Unpredictable
Inflation.
1. When the rise prices are very slow like that of a snail is called .
2. The reason for existence of proportional relationship between money stock and price
level is .
3. Inflation saving and capital formation.
4. Due to an easy availability of consumer’s spending rises.
5. A cut in government spending is adapted to .
1. Creeping Inflation
2. Full employment
3. Reduces
4. Credit
5. Reduce inflation
7.11 Study Tips
1. Dwivedi 2019. Macroeconomics Theory and Policy, pages 389-460, Tata McGraw-
Hill Publishing Company Ltd., New Delhi.
Ltd., Noida.
LESSON-8
Business Cycle
Lesson Structure
8.2 Features of Business Cycles
8.3 Phases of a Business Cycle
8.4 Causes of Business Cycles
8.5 Effects of Business Cycles
8.6 Theories of Business Cycle
8.7 Measures to Control Business Cycles
8.8 Summary
8.9 Keywords
8.11 Study Tips

After reading this chapter you will learn about the existence of fluctuations in Gross Domestic
Product in the economy and reasons responsible for these fluctuations. After learning this
concept, we will discuss about the effects of business cycles on economic growth. Afterwards,
you will be able to understand the different views of economists about business cycles which
are given through theories of business cycles. At the end of the chapter, an attempt is made to
aware you about the various measures to control business cycles in the economy.

The business cycle is the downward and upward movement of gross domestic product (GDP)
around its long-term growth trend. It is also known as the economic cycle or trade cycle.
Duration of a market cycle is the period of time which contains a single series boom and
contraction. These fluctuations typically involve periods of relatively rapid economic growth
and period of decline. Over the past two centuries, many capitalist countries such as the USA
and Great Britain have registered rapid growth in the economy. Yet economic growth has not
followed a consistent and smooth upward path in these countries. There has been a long-run
upward trend in Gross National Product (GNP), but substantial short-run variations in
economic activity have occurred on a regular basis, i.e. shifts in production, revenue, jobs and
prices around this long-run trend. The period of high income, production and employment
was referred to as the period of expansion, growth or prosperity, and the period of low income,
output and employment was defined as the period of contraction, recession, decline or
downswing. These periods of fluctuations are known as business cycles.
Definition:
J.M. Keynes writes, “A trade cycle is composed of periods of good trade characterized by
rising prices and low unemployment percentages with periods of bad trade characterized by
falling prices and high unemployment percentages.”
According to Parkin and Bade’s, “The business cycle is the periodic but irregular up-and-
down movements in economic activity measured by fluctuations in real GDP and other
macroeconomic variables. A business cycle is not a regular, predictable, or repeating
phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large
degree, unpredictable.”
The span of a business cycle was not of the same length; it varied from a minimum of two
years to a maximum of ten to twelve years, although it was also believed in the past that
demand fluctuations and other economic indicators around the world displayed repeated and
frequent trends of alternating expansion and contraction cycles. In addition, however, there
was no clear evidence of the same definite length of very regular cycles. For only two or three
years, some business cycles have been very brief, while others have continued for several
years. In addition, there were large swings away from the trend in some cycles and in others
these swings were of moderate.
Economists have focused on researching the causes and consequences and the scale of such
oscillations in nations ' economic activities. Throughout economics, the study of periodic
business activity fluctuations, which is an unavoidable part of economic growth, is referred
to as the business cycle or trade cycle.
8.2 Features of Business Cycles

Though different business cycles occurs at different time and these all have different features
but there are some common features of business cycles. These are described as under:
I. Business cycles occur on a regular basis. Although they do not show the same regularity, they
have certain different phases such as expansion, peak, contraction, or depression and trough.
Further, the length of business cycle varies significantly from a minimum of two years to a
maximum of ten to twelve years.
II. Business cycles are occurs at the same time whole economy. These do not bring about changes
in any industry or sector, but they affect the whole economy. For example, in all industries or
sectors of the economy, unemployment or recession happens at the same time.
III. It has been observed that variations occur not only in production levels but also in other
variables such as employment, expenditure, consumption, interest rates and price levels at the
same time.
IV. Investment and consumption of durable consumer goods such as cars, houses and refrigerators
are mostly affected by the cyclical fluctuations.
V. Further, it has been seen that the use of non-durable goods and services during the various
phases of business cycles does not vary greatly. Past business cycle data show that households
maintain a high level of stability in consumption of non-durable goods and services.
VI. There is immediate effect of depression and expansion on inventories of products. The
inventories tend to grow beyond the desired level during depression and this tends to a
reduction in consumer demand. On the contrary, the inventories go below the desired level
during recovery period. This encourages entrepreneurs to place more orders for goods that are
picked up by production and stimulate capital goods investment.
VII. Profits fluctuate more than any other type of income during fluctuations in the economy. It is
difficult to predict economic conditions and profits due to business cycles. Profits can even
become negative during the depression era, and many companies go bankrupt.
VIII. Business cycles are not limited to specific area only but these are international in nature. When
fluctuations start in one country then they also spread to other countries due to international
trade among countries.
IX. Business cycles have a wave-like pattern of movement. Rising prices, production and
employment leads to upward movement whereas falling prices and employments tends to
downward movement.
8.3 Phases of a Business Cycle

Business cycle has different stages according to upward and downward fluctuations in the
economy. Different economists provided different views on business cycle and its stages.
Typically, there are major four parts of business cycle i.e. Expansion, Peak, Contraction and
Trough. But, some economists believed that there are six stages in business cycles i.e.
Expansion, Peak, Recession, Depression, Trough and Recovery. These are shown through a
diagram:
Fig. 8.1 Stages of Business Cycle
I. Expansion
Expansion is the first step of the business cycle. Economic indicators such as employment,
production, output, wages, sales, competition, and the provision of goods and services are
rising at this point. In this stage, debtors pay their debts on time, pace of money supply is
high, and level of investment is also high. This process continues till there are favorable
economic conditions for growth in the economy. Thus, all the positive conditions in the
economy lead to increase in flow of income.
II. Peak
The economy reaches at a saturation point or at peak, which is the second stage of business
cycle. There is maximum growth at this stage in the economy and economic indicators such
as production, profit, sale and employment cannot rise anymore above this point. Further,
price rates are highest but this increase in prices gradually decreases the demand for consumer
goods. This point is a turning point in the economic growth cycle and consumers have to
restructure their monthly budgets at this level.
III. Recession
Recession is the third stage which follows peak phase. In this phase, demand for goods and
services starts decline rapidly. But, producers do not immediately notice this decline in
demand and production continues which results into excess supply in the market and hence,
prices tend to decline. Consequently, all positive economic indicators like income, production,
wages, savings, investments, etc. starts falling in the economy and this all will results into
recession.
IV. Depression
Recession converts into depression when there is a general decline in all the economic
activities. It means there is reduction in production of goods and services, employment,
income, demand and prices in the economy. This decline in economic activity tends to
decrease in bank deposits and thus, credit expansion stops and consequently, bank rate also
falls in the economy. Thus, a situation of depression captures an economy.
V. Trough
In the stage of depression, growth rate falls below the normal level of growth and it became
negative. Further, it declines until the factor prices, demand and supply of goods and services
reach at their lowest point. Eventually, the economy reaches to the next stage i.e. trough. It is
the negative saturation point of an economy. At this stage, there is complete decrease in
national income and expenditure. At this stage, it became difficult for debtors to pay their
debts and rate of interest will increase in the economy. Further, investors will not invest in the
stock market and investment level goes down. During this period, many weak organizations
leave the industry and economy reaches at a lowest level of shrinking.
VI. Recovery
The economy comes to the recovery stage after this point. This is a reversal stage from the
recession to recovery and in this process economy starts to rebound from the negative rate
of growth. Demand begins to rise because of the lowest prices and therefore supply also begins
to respond. The economy starts developing with a positive attitude towards investment and
thus, employment and production will also increase. Employment starts increasing and
lending also shows positive signs due to accumulated cash balances with the banks. In this
phase, producers replace the depreciated capital, leading to new investment in the process of
production. The stage of recovery continues until the economy reaches to expansion stage.
8.4 Causes of Business Cycles

The fluctuations in the economy occur due a large number of factors. These factors can be
divided into major categories i.e. Internal Factors and External Factors. These are explained
through a diagram:
Causes of Business Cycle
Internal Factors External Factors

Change in Demand Wars
Fluctuations in Investments Technology Shocks
Macroeconomics Policies Natural Factors
Supply of Money Population Expansion
Fig. 8.2 Causes of Business Cycle
I. Internal Factors
Internal factors are related with the mechanism within the economic system. There will be
self-generating business cycle which means every expansion will raise recession and
contraction, and every contraction will in turn raise the revival and expansion in a never-
ending chain. These factors are explained as under:
(a) Keynes stated that change in demand leads to change in economic activity. Whenever
there is an increase in demand then firms start producing more goods to meet the increased
demand. It will lead to more production, more workers, more employment, and higher
profits. This will cause the economy to boom. Yet excessive demand can also lead to
inflation. On the other hand, if the demand falls so does the economic activity also falls.
This can even lead to depression in the economy if it lasts for a longer period of time.
(b) Besides fluctuations in demand, investment fluctuations are one of the major causes of
business cycles. Investments can fluctuate on the basis of many variables such as economy
interest rates, entrepreneurial interest, income expectations, etc. Rising investment will
lead to increased economic activity and growth. A decline in investment will have the
opposite effect and can lead to a downturn or even depression in the economy.
(c) Monetary policies and economic policies will also result in changes in the business cycle
phases. If monetary policies seek to expand economic activity by encouraging investment,
the economy would boom. On the other side, we will see a slowdown or recession in the
economy if there is an increase in taxes or interest rates.
(d) Business cycles are purely monetary phenomenon i.e. monetary policy affects business
cycles. Therefore change in the supply of money would results into the fluctuations of
trade. Increase in money will positively affect growth and expansion in the market. But
too much supply of money can also cause inflation. And the reduction in money supply
would lead the economy to recession.
II. External Factors
The external factors are those factors which cause business cycles due to fluctuations in
something outside the economic system. Such external factors are explained below:
(a) Economic resources are used to make special goods such as weapons, arms, and other war
goods of this kind during wars and unrest time in the economy. The focus shifts from
consumer goods to capital goods and this will result in reduction in income, employment
and economic activities. So the economy is going to suffer a slowdown during war time.
After war time, the priority would shift to reconstruction of infrastructure like houses,
buildings, highways, bridge, etc. which are necessary for economic development.
(b) New and exciting technology always boosts the economy and it would lead to new
investment, higher employment, higher incomes and higher profits in the economy. For
example, the invention of modern mobile phones becomes a reason for an enormous boost
in the telecommunications industry.
(c) Further, Natural disasters such as floods, droughts, hurricanes, etc. can destroy crops and
cause enormous losses to the farming sector. Food shortages would leads to higher prices
and high inflation in the economy. In addition, there may also be a reduction in demand
for capital goods.
(d) If population growth is out of control, this could be an economic problem. Population
growth is generally higher than economic growth and hence, total savings of economy
would begin to decline. Afterwards, investment will also be reduced and the economy will
be faced with stagnation or recession.
8.5 Effects of Business Cycles

Business cycles have both the good and bad effects on the economy and it depends on the
different stages of business cycles. We will learn about effects of fluctuations through
different stages.
During expansion phase, companies grow rapidly and create more jobs in the economy. This
will lead to increase in employment. If the economy grows at a relatively fast rate, it puts
upward pressure on prices of consumer goods and services which results into inflation.
During peak phase, many economic indicators, like a drop in the number of new jobs added
to the economy, an increase in the unemployment rate can signify the peak of expansion
phase. Now, the economy is no longer growing, retail sales are declining and economic output
is also declining in the economy. All of these variables can result in further job loss and often
result into contraction phase in the economy.
The contraction phase of the business cycle is the phase where the economy begins to shrink.
Economists stated that this period is a period of recession or trough in the business cycle. At
this stage, economic output starts decreasing which results into job losses and there will be an
increase in unemployment rate in the economy. During periods of economic contraction, the
money flow decreases because consumer spending goes down.
During recovery phase, economic output starts increasing and business also begin to expand.
Thus, the employment rate is also rises even if the unemployment rate is falling. The economic
recovery period of a business cycle can be difficult to forecast because other factors might
cause a short-term stimulation in the economy but does not necessarily indicate a permanent
recovery.
8.6 Theories of Business Cycle

A large number of theories were propounded by various economist time to time for better
understanding of the concept of business cycle. In the first half of twentieth century, many
new theories and concepts regarding business cycles are introduced. However, in nineteenth
century, many classical economist like Adam Smith, Miller, and Ricardo, have conducted a
study on business cycles. Afterwards many other economists, such as Keynes and Hick, had
provided a different framework to understand business cycles. We will discuss some of the
major theories out of different theories as under:
I. Hawtrey's Monetary Theory

The traditional theorists of the business cycle considered monetary and credit system
important for analyzing business cycles. Theories developed by these traditional theorists are
therefore called monetary theory of business cycle. This monetary theory states that the
business cycle is the result of change in the conditions of the monetary and credit market.
Hawtrey, the main supporter of this theory, stated business cycles are results of continuous
phase of inflation and deflation. According to him, fluctuations in the economy are due to
change in money flow in the economy. For example, there would be changes in prices,
income, and total output when there is an increase in the supply of money and this leads to
economic growth. On the contrary, a decrease in the supply of money will result in a fall in
prices, income and total output which leads to a downturn in an economy. Afterwards Hawtrey
explained that credit mechanism influence the money flow in the economy and Banking
system is important for increasing money flow through credit system.
There will be an upward trend of economic growth when the volume of bank credit increases
and this growth will be continued till this volume of bank credit increases. Further, banks
provide credit facilities to general public and organizations because it is profitable for banks.
These credit facilities are helpful for organizations to perform their business operations. This
process overall leads to increase in investment opportunities and capital of businessmen also
increased through it. Hence, production of organization increases and supply of its products
also rose to a limit. This tends to increase in demand for products in market over supply of
products and consequently, the prices of products will be raised. Hence, it can be seen that
credit expansion is helpful for the economic growth of a nation. On the other hand, this process
can be reversed if the banks start withdrawing credit from market. Hence, this theory provides
business fluctuations on the basis of monetary factors.
But, this theory fails at some of the grounds like it focuses only on monetary factors and
ignored non-monetary factors. Then, it describes only the recession (Downturn) and
expansion (Upward movement) stage of business cycle but ignores the intermediate stages.
Further, through credit mechanism it is assumed that businessmen are more concerned about
interest rate but it is not true as businessmen are more concerned about future opportunities.
Hawtrey's
Monetary
Theory
Hayek's
Samuelson's
Monetary
Model of
Over-
Business
Investment
Cycle
Theory
Theories
of
Business
Sun Spot Schumpeter's
Theory Cycles Innovation
Theory
The
Keynes's
Psychological
Theory
Theory
Fig. 8.3 Theories of Business Cycle

II. Hayek's Monetary Over-Investment Theory
The monetary over-investment theory of business cycle was propounded by F.A. Hayek. This
theory focused on natural rate of interest and market rate of interest. Hayek stated that when
natural rate of interest equals to market rate of interest then the economy will be in equilibrium
and there will be full employment. Trade cycles caused due to imbalance between the market
rate of interest and natural rate of interest. When the market rate of interest is higher than
natural rate of interest then the economy will be in depression. On the contrary when market
rate of interest is less than the natural rate of interest then the economy will be in prosperity
phase of business cycle.
When the market interest rate is low in the economy, the demand for investment funds will
be more than supply of savings. The demand for the investment funds is met by the increase
in supply of money and thus the interest rate will fall. Low rate of interest induces producer
to borrow money from banks and more money leads to increase in production of capital goods.
Hence, producer will use capital-intensive techniques for the production which results into
fall in cost and increase in profits. At the same time, factor of production shifts from
consumption goods to capital goods which results into fall in the production of consumer
goods and increase in prices of consumer goods. Hence, consumption of consumer goods falls
and forced saving increases due to decrease in consumption which is invested for the
production of capital goods. At last, there will be increase in production of capital goods. On
the contrary, the producer will earn more profits because of increase in prices of consumer
goods. High profits lead to increase in higher remuneration for the factor of production in
comparison with the producers of capital goods. Thus, this increase in prices tends to
atmosphere of prosperity in the economy.
Hayek described that when there is continuous rise in the prices of factors, the rise in
production cost will decrease in profits of producer. Producer of capital goods will invest less
in the expectation of loss in the future. Thus, the natural interest rate will fall. Consequently,
banks put restrictions on loans and this will lead to reduction in production of capital goods
by producers. Producers have to adopt the labour-intensive technique which results into less
investment for capital goods. Afterwards, demand for money reduces and market rate of
interest will increase more than the natural interest rate. Now, more factors of productions
cannot be used for consumer goods as compared to capital goods which tends to decrease in
prices of factor of production and some of resources become unemployed. The whole process
will be reversed and there will be continuous reduction in the prices of goods and factors in
the economy and hence, depression captures the economy.
Hayek tries to explain business cycle with monetary over-investment concept but still there
are some loopholes in this theory. Firstly, the assumption of full employment and equilibrium
is a vague. Then, only interest rates are not enough to describe business fluctuations. Further,
Hayek gives more preference to forced saving which is not right concept. Thus, it is an
incomplete theory of trade cycle.
III. Schumpeter's Innovation Theory
The Innovation theory of business cycle is associated with the name of Joseph Schumpeter.
He found that innovations in business are major reason behind change in investment and
business fluctuations. According to Schumpeter said, “Business cycles are almost exclusively
the result of innovations in the industrial and commercial organization. Innovations are such
changes of the combination of the factors of production as cannot be effected by infinitesimal
steps or variations on the margin. Innovation consists primarily in changes in methods of
production and transportation, or changes in industrial organization, or in the production of a
new article, or opening of a new market or of new sources of material.” He designed a model
with two stages i.e. first approximation and second approximation.
First Approximation study the effect of innovative ideas on the economy at first instance
and it is the beginning stage in which the economy is in equilibrium. Here, Marginal Cost =
Marginal Revenue and Average Cost = Price and there is no involuntary unemployment in
the economy. At this stage, there is neither surplus fund nor idle funds with the businessmen
and innovators have only one source of fund i.e. Banks. When the innovators got funds from
bank then they purchase inputs for the production of innovative ideas. If there is increase in
prices of output, then there will be increase in prices of products and competitors will start
coping innovation. Thus, output and profits of organization will increase. But, it will increase
to a certain limit, afterwards profit shows downtrend due to decrease in output prices. Here,
debtors have to pay their debts to bank and flow of money will decrease. Hence, there will be
recession in the economy.
Second Approximation study the effect of first approximation and it is related with the
speculation of future economic conditions. In this stage, customer expects that there will be
an increase in prices of the durable goods in near future; so they start buying goods in the
present time with borrowed money. If prices start declining then debtors are in the worst
period because they are unable to repay the loan and this will leads to depression in the
economy.
Schumpeter shows different view on business cycle but his theory is not free from criticism.
Assumption of bank as the only source of fund is not right because there are other source of
fund prevails in the economy. Further, Innovations are not only the cause of business cycles.
At last, full employment assumption is not realistic.
IV. The Psychological Theory
The Psychological theory was introduced by Prof. A.C. Pigou who stated that business cycles
happen due to changes in the psychology of industrialists and businessmen. Normally,
business class people react so much to the changing conditions of the economy which become
reason behind cyclical fluctuations in the economy. Pigou believed that expectations depends
on some real factors such as good harvests, wars, natural calamities, industrial disputes,
innovations, etc. he divided the causes of business cycles into two categories i.e. Impulses and
Conditions. Impulses mean the causes which set a process in motion; whereas, conditions can
be defined as the way through which the process passes and upon which the impulses act.
Pigou further divided the impulses into two parts: (a) the expectations of businessmen and (b)
the actual resources owned by businessmen. Normally expectations depend on the psychology
of businessmen and he can control over resources. But some expectations do not generate
cyclical fluctuations and these expectations are parallel to the actual changes in the economy.
Pigou found that when expectations deny their realistic basis then there may error in
forecasting fluctuations. This type of expectations creates disturbance in the economy and
such error caused due to (i) deviation in the actual and anticipated demand of consumer, (ii)
the continuous and unpredictable changes in the values of economic variable and (iii) due to
long gestation periods.
Happening of such error in any sector of the economy leads to spread in the same direction.
If once this impulse starts working on the conditions, then it continuously work. Here, the
wave of optimism and pessimism occur. Whenever businessmen have a feeling of optimism
about the future prospectus, then there will be increase in demand for investment resources
and there would be inter-industrial relations which would induce businessmen in other
industries. Consequently, there will be emergence of boom conditions in the economy.
But, this wave of optimism is replaced by pessimism due to gestation period of production.
Sometimes high expectations for future lead to excess production which creates problem for
producer to sale these products at high prices. But, it is not easy to sale the products at high
prices and there will be a stock of inventories. This turns optimism into pessimism and there
will be slump in the economy. Hence, this theory advocated that booms and slumps occur due
to optimism and pessimism wave of businessmen and industrialists.
Although, this theory uses a new area of concern to describe business cycles still there are
various lacunas in this theory. These are: (i) In real sense it is not a theory of business cycle
because it cannot define phases of business fluctuations. (ii) It also fails to describe periodicity
of business fluctuations. (iii) It ignores monetary factors affecting fluctuation and (iv) It is
unable to explain the reason behind deficiency of demand.
V. Keynes's Theory
This theory of business cycle was developed by Keynes in 1930s when the whole world was
going through great depression. This theory of business cycle is also known for Keynes reply
to classical economists. Keynes described that the demand for consumer and capital goods
will be helpful in determination of income, employment and output. Here, total investment
and expenditure on goods and services is more and the level of production also increases. As
a result of increase in production there will be increase in employment and income level. On
the contrary, if total demand decreases then level of production would also decrease. Thus,
the income, output and investment level also decreases in the economy.
Keynes advocated that expected rate of profit is the marginal efficiency of capital. When the
expected rate of profit is greater than the current rate of interest then the investor would invest
more. On the contrary, marginal efficiency of capital can be determined through expected rate
of return and replacement cost of capital goods. Similarly, marginal efficiency of capital
increases due to new innovations in the economy because it is assumed that prices would rise
in near future. Whereas, it decreases when there is decrease in prices, increase in cost and
inefficiency of production process.
Keynes believed that investors are positive about economic conditions during expansion
phase and they over-estimate the rate of return on investments. But, this rate increases until
the full employment is not achieved in the economy and when the economy is on the direction
of full employment, it is termed as boom phase. During this phase, investor did not consider
the decline in marginal efficiency of capital and rate of interest. Hence, the profit from
investment start decreasing and this situation is known as contraction or recession phase.
During contraction or recession, investment opportunities falls down and even banks do not
provide credit due to lack of funds. Hence, rate of interest is higher so that people can be
diverted to savings and as a result demand for products also decreases and economy reaches
to the phase of depression.
Further, Keynes also introduced three types of propensities to understand the business cycle
i.e. Propensity to save, propensity to consume and propensity to marginal efficiency of capital.
He also introduced another concept which is known as multiplier and it represents the change
in income level due to change in investments. Keynes propounded that the expansion in
business cycle occurs due to increase in marginal efficiency of capital. This would encourage
investors to invest and thus, there will be increase in income of individual as well as rate of
consumption. Hence, profits of businessmen also increase which leads to increase in total
income and investment level in the economy. As a result, there will be recovery phase in the
economy.
However, Keynes describes the theory of business cycle very well. But, some economists
criticize his theory by some points like: this theory fails to explain the recurrence of business
cycle and it ignores the role of accelerator in business cycle. Further, Keynes provided only a
systematic framework not the whole concept.
VI. Sun Spot Theory
This theory is the oldest theory of business cycle and it is developed in 1875 by Stanley
Jevons. Sun-spot may be defined as the storms on the earth of the sun caused by violent
nuclear explosions. This theory is propounded by the fact on which Jevons believed that sun
spots affected weather on the earth. We are dependent on agriculture in older time and
agriculture is dependent on weather conditions. The changes in agriculture output affect the
industry and these changes spread throughout the economy. Some of the other economists
also believed that there is change in climate and weather due to sun spots. They think that
these weather cycles become the reason for fluctuations in agricultural output. Earlier, when
there is lack of monsoon and drought in India, it affects the whole economy because these
fluctuations reduce income of the farmer as well as demand for the products of industries.
Thus, industrial recession occurs in the economy. This theory did not provide the complete
concept of business cycle and modern economists do not accept these theories.
VII. Samuelson's Model of Business Cycle
Samuelson Model was post Keynesian model of business cycle and he emphasized on the
multiplier and accelerator concepts to explain the business cycle. Samuelson used two
different concepts; one is autonomous investment and the other is derived investment.
Whenever, autonomous investment occurs in the economy then the level of income also
increases and then the concept of multiplier arises. When there is increase in consumer level
then the demand for consumer goods also increases. The supply of consumer goods should
satisfy the demand for consumer goods. This is possible only when the large quantity of goods
and services are produced in the economy. This will increase the investment by businessmen
on production techniques. Thus, consumption affects the demand for investment and it is
known as derived investment. This shows a sign of acceleration which results in increase in
income. Again an increase in income leads to increase the demand for goods. Hence, the
multiplier and accelerator interact with each other and income will grow at higher rate than
expected. Samuelson introduced this theory with certain assumptions that the production
capacity is limited and consumption take place after gap of one year. There will be closed
economy. The equilibrium is shown as:
Yt = Ct + It
Where, Yt = National income
Ct = Total consumption expenditure
It = Investment expenditure
t = Time period
According to the assumption that consumption takes place after a gap of one year, the
consumption function would be represented as follows:
Ct = α Yt-1
Where, Yt-1 = Income for t-1 time period
α = ΔC/ΔY (multiplier propensity to consume)
Investment and consumption has a time lag of one year; therefore, the investment
function can be expressed a follows:
It = b (Ct –Ct-1 )
Where, b = capital/output ratio (helps in determination of acceleration)
By putting the value of Ct and It in the first equation of national income, we get
Yt = α Yt-1 + b (Ct – Ct-1)
If Ct = α Yt-1, then Ct-1 = α Yt-2 . Putting the value of Ct-1 in the preceding equation, we get
Yt = α Yt-1 + b (α Yt-1 -α Yt-2)
Yt = α (1 + b) Yt-1 – abYt-2 (equation for equilibrium)

With the help of preceding equation, the income level for past and future can be determined
if the values of a, b and income of two preceding years are given. It can be depicted from the
preceding equation that the changes in income level can be affected by the values of α and b.
The different combinations of α and b give rise to fluctuations in business cycles as

shown in Figure-4:
Fig. 8.4 Business Cycles and Combination of Parameters a and b
Figure-4 demonstrates the different phases of business cycles in the areas A, B, C, and D.
With the help of the following points, the types of various cycles represented by A, B, C and
D are described in detail:
A: Refers to the area where the level of income increases or decreases at the rate of decline
and reaches a new point of balance. The change in the level of income would only be one-
way. It results in damped non-oscillation, as shown in Figure 8.5,
Fig. 8.5 Business Cycle Pattern in Area A

B: Refers to the region where points, a and b, together create cycles of amplitude that slowly
decrease. The process continues until the cycles are disrupted and the equilibrium of the
economy. It results in damped oscillation.
Fig.8.6 Business Cycle Pattern in Area B
C: Refers to the area in which points, a and b, together makes amplitude cycles that become
larger. This represents explosive oscillations.
Fig. 8.7 Business Cycle Pattern in Area C
D: Refers to the area at which the income level is increasing or decreasing at the exponential
rate. This process continues till cycles reach at the bottom. It represents one-way explosion
and results in explosive oscillations.
Fig. 8.8 Business Cycle Pattern Area D
E: Refers to the point at which the oscillations are of equal amplitude.
Thus, this model represents the business cycle through different points. But there are some
drawbacks in this model. These are: (a) It does not explain the business cycle completely. (b)
Ignores other factors which can influence business cycle. (c) Assumption of constant
capital/output ration is not true.
8.7 Measures to Control Business Cycles

Different economists provide a different method or measure to control business fluctuations.
These measures are used for controlling business fluctuations and stabilizing the economic
activity. These measures can be divided into three parts:
I. Monetary Policy
Monetary policy is controlled by a country's central bank and it works as a method of
controlling business fluctuations. The central bank adopts a number of ways of regulating
credit quantity and quality. It increases its bank rate, sells securities in the open market, raises
the reserve ratio, and adopts a range of selective credit control measures, such as increasing
margin requirements and controlling consumer credit, to regulate the growth of money supply
during a boom. Therefore, a dear money approach is implemented by the central bank.
Commercial borrowing becomes more dear, difficult and selective. Efforts are being made to
regulate the economy's excess money supply. The central bank implements an easy or cheap
monetary policy to control recession and depression. This leads to increase in reserves of
commercial banks and it reduces bank rate. Further, central bank purchases securities in the
open market so that money flow in the market can be increased. It cuts the credit margin of
banks so that more money can be provided to consumer as a loan.
II. Fiscal Policy
Monetary policy alone cannot handle the business cycles. Compensatory fiscal policy
should therefore be applied to it. During a boom, fiscal controls are highly effective in
reducing excessive government spending, personal spending on consumption, and private
and public expenditure. On the other hand, during a crisis, they help to increase government
spending, personal consumption spending, and private and public expenditure.
During Boom: The government tries to reduce unnecessary spending on non-development
programs during a boom in order to reduce the demand for goods and services. This is also
helpful to check private spending but it is very difficult the government expenditure.
Further, it is difficult to find essential and non-essential activities. Therefore, government
comes with taxation system. The government is raising the rates of personal, corporate and
commodity taxes to cut personal spending.
The government frequently follows the policy of having a budget surplus when government
revenues are higher than expenditures. This is achieved by increasing tax rates or reducing
government expenditures or both. It tends to reduce sales and aggregate demand through the
reverse process of multiplier. Another budgetary step that is usually taken is to borrow more
from the economy that has the effect of reducing the supply of money with the public.
Therefore, the servicing of public debt should be suspended and deferred to some future
date when the economy stabilizes.
During Depression: In this stage government raise public spending, lowers taxes, and adopts
a policy of budget deficit. Such policies tend to increase aggregate demand, production,
profits, employment and prices. An increase in public expenditure would raise the aggregate
demand for goods and services and it will lead to higher income through the multiplier.
Public expenditure includes construction of roads, canals, dams, parks, schools, hospitals,
and other construction works. This will create demand for the labour in the market. The
government is also increasing its spending on welfare programs such as unemployment
insurance and other social security initiatives to raise demand for consumer goods
industries.
III. Direct Control
Major objective of direct control is to ensure proper allocation of resources for price
stability in the economy. They are intended to affect the economy's strategic points and they
impact particular consumer and producers. These are in the form of licensing rationing,
price and wage controls, export taxes, currency caps, quotas, monopoly regulation, etc. They
are more effective in addressing inflationary pressure bottlenecks and shortages. Its success
depends on an effective and fair administration being in place. Otherwise it will lead to
black marketing, coercion, long queues, speculation, and so on.
8.8 Summary
Most of the people thought that Business cycle and Inflation are inter-related terms. But, they
are different from each other in macroeconomics. Inflation is a term which describes
continuous increase in prices whereas business cycles refer to the fluctuation or upward and
downward movement of GDP of an economy. Business cycle is a complete concept and it is
necessary to understand this concept as a consumer, businessmen, producer, economists,
industrialists, etc. It represents the waves in the economy and further we had learnt about the
positive and negative effects of these fluctuations. These fluctuations can be helpful for us till
these are in limit but when these fluctuations go out of our control then they affect the whole
economy. Various theories are given for the better understanding of this concept. It is
necessary to control the trade fluctuations when they cross the limits because these are
dangerous to economic growth. Different economists suggest various measures to control
business cycles. But, single method of control cannot work and thus, all the methods of control
should work simultaneously. Thus, we can sum up it with a thought of Keynes.
Keynes, “The right remedy for the trade cycles is not to be found in abolishing booms and
thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us
permanently in a quasi-boom.”
8.9 Keywords
Business Cycle- The business cycle is the downward and upward movement of gross
domestic product (GDP) around its long-term growth trend.
Expansion- It is the phase of the business cycle during which output is increasing.
Recession- It is the phase of the business cycle during which output is falling.
Depression- When there is a deep and prolonged recession, it is known as Depression.
Peak- The turning point in the business cycle between an expansion and a contraction; during
a peak in the business cycle, output has stopped increasing and begins to decrease.
Trough- The turning point in the business cycle between a recession and an expansion; during
a trough in the business cycle, output that had been falling during the recession stage of the
business cycle bottoms out and begins to increase again.
Recovery- When GDP begins to increase following a contraction and a trough in the business
cycle; an economy is considered in recovery until real GDP returns to its long-run potential
level.
8.10 Self-Assessment Questions Self-assessment Tests
Q.1 What is business cycle? Explain the different phases of business cycle in detail.
Q.2 Explain Business Cycle and its characteristics. Also describe the effects of business
cycle in the economy.
Q.3 Explain the Hawtrey’s monetary theory of business cycle in detail.
Q.4 Critically examine the Samuelson’s model of business cycle. Also explain its different
point model.
Q.5 What are different theories of business cycles? Explain any two theories in detail.
Q.6 What is business Cycle? What are major causes behind business cycles?
Q.7 Define the term Trade Cycle. Also explain the different measures taken by government
to control trade cycles.
Q.8 What are different phases of business cycle? Explain with diagram.
1. Decrease in GDP for at least 6 month is called .
2. Low point of GDP during a business cycle is called .
3. unemployment is due to downturn in the business cycles.
4. The four phases of business cycles are .
5. The theory of business cycles which is based on solar activity is known as
1. Recession
2. Throgh
3. Cyclical
4. Peak, Recession, Throgh, Recovery
5. Sunspot Theory
8.11 Study Tips
3. Shapiro Edward, Macro Economic Analysis, Fourth Edition, 1978, p.378.

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Subject: Macro Economics Author: Ms.

1.0 Learning Objectives

1.1 Assessment of Prior Knowledge

1.2 Scope of Macroeconomics

1.3 Importance of Macroeconomics

1.4 Types of Macroeconomics

1.5 Variables of Macroeconomics

1.6 Difference between Macroeconomics and Microeconomics

1.7 Interdependence of Macroeconomics and Microeconomics

1.8 Limitations of the Macroeconomics

1.9 Evolution of Macroeconomics

1.12 Self-assessment Tests

1.13 Study Tips

1.0 Learning Objectives

Macro Static Macro Comparative Macro Dynamic

Figure 1-Types of Macroeconomics

Here, 450 line represents the aggregate supply function,

IV. Aggregate Investment

VI. General Price level

1. Microeconomics deals with the Macroeconomics deals with the aggregate of

2. It includes individual price, individual It includes general prices, aggregate demand,

3. Price determination and allocation of Determination of income and unemployment

5. Microeconomics solves the central Macroeconomics solves the central problem of

7. Microeconomics uses bottom-top Macroeconomics uses top-bottom approach for

9. It is also known as price theory. It is also known as income theory or

10. It believes in Laissez-faire economy. It believes in command economy.

1.7 Interdependence of Macroeconomics and Microeconomics Theory

1.12 Self-assessment Tests

2.1 Assessment of prior Knowledge

2.2 Concepts or Aggregates of National Income

2.3 Circular Flow of Income

2.3.1 Two Sector Model of Circular Flow of Income

2.3.2 Three Sector Model of Circular Flow of Income

2.3.3 Four Sector Model of Circular Flow of Income

2.4 Importance of National Income Analysis

2.5 Measurement of National Income

2.6 Difficulties in measurement of National Income

2.7 Some practical questions on National Income

2.10 Self-assessment tests

2.11 Study tips

2.0 Learning Objectives

2.1 Assessment of prior Knowledge

Traditional definitions of National Income

Modern definitions of National Income

2.2 Concepts or Aggregates of National Income

I. Gross Domestic Product

Nominal GDP = Quantity of final goods and services produced during an

V. Gross Domestic Product Deflator

VI. Gross National Product

XIII. Per Capita Income

2.3 Circular Flow of Income

Figure.1 Two Sector Model of Circular Flow of Income

2.3.2 Three Sector Model of Circular Flow of Income

(a) Direct Taxes

(a) Household sector

Figure.3 Four Sector Model of Circular Flow of Income

2.4 Importance of National Income Analysis

2.5 Measurement of National Income

Figure.4 Four Sector Model of Circular Flow of Income

Net Domestic Income