BUSINESS ECONOMICS-II

(2021-22)
- Urvi Samant
MODULE 1: INTRODUCTION TO
MACROECONOMIC DATA AND THEORY
• Macroeconomics: Meaning, Scope and Importance.
• Circular flow of aggregate income and expenditure: closed and open economy models
• The Measurement of national product: Meaning and Importance - conventional and Green GNP and NNP
concepts - Relationship between National Income and Economic Welfare.
• Short run economic fluctuations: Features and Phases of Trade Cycles
• The Keynesian Principle of Effective Demand: Aggregate Demand and Aggregate Supply - Consumption
Function - Investment function - effects of Investment Multiplier on Changes in Income and Output
NET DOMESTIC PRODUCT (NDP) AND NET NATIONAL INCOME

 NDP is obtained when depreciation cost is deducted from GDP

 NDP = GDP – Depreciation (D)

Depreciation is the wear & tear of capital assets that takes place during production
process
NNI=GDP – Depreciation (D)
NNI is the net money value of final goods and services produced by the
country’s factors during a given period. It gives correct picture of the
wealth of a nation.
 NET NATIONAL PRODUCT
In the production of gross national product in a year some fixed capital that is machinery equipment wears out or falls in value as a
result of its consumption in the production process.
This consumption of fixed asset due to wear and tear is called depreciation.
Symbolically,
NNP=GNP-Depreciation (replacement investment)
This is an example of how much the country has to spend to maintain the current GNP if the country is not able to replace the
capital stock lost through depreciation then GNP will fall.

In addition a growing gap between GNP and NNP indicates decrease in excellence of capital goods while the narrowing gap
would mean that the condition of capital stock in the country is improving.
Let's assume country xyz country’s companies, citizens and entities produced $ 1 trillion worth goods and services of $ 3 trillion this
year. The assets used to produce those goods and services depreciated by $ 500 billion using the formula given above, country
xyz's NNP is :-
NNP=$ 1 TRILLION + $ 3 TRILLION - $ 0.5 TRILLION
=3.5 TRILLION
GNP DEPRECIATION NNP = GNP - DEP DECREASE IN
100 40 60 QUALITY OF
ASSETS

GNP DEPRECIATION NNP = GNP - DEP IMPROVED STOCK

100 10 90 OF ASSETS
DIFFERENCE BETWEEN GDP, GNP AND GNI
Gross Domestic Product : The GDP of a country is defined as total market value of all the
final goods and services produced by all enterprises both resident and non resident within the
domestic territory of a country in a particular year but does not include net factor income from
abroad. GDP is geographically focused, including all output within a nation's borders
regardless of whose factors of production are used to produce it. the geographic focus of
GDP facilitates International comparisons of economic activity.
Gross National Product : Gross National Product is defined as the total market value
of all final goods and services produced in a country in a particular year plus the
income which is earned by its citizens who are located abroad minus the income of
non-residents located within that country.
Gross National Income: it is the total money value of goods and services produced by the
nationals during a given year. The nationals income within or outside the geographic territory
of country is included, while foreigners’ income is excluded if they are working in the domestic
territory. GNI will be larger if receipts are more than the payments (R>P). GNI=C+I+G+(X-
M)+(R-P)
 GDP
For example Apple's output in Singapore ends up in Singapore's GDP the cars produced at Honda's Ohio plant are
counted in USA's GDP.
GDP provides the measure of aggregate output and its comparison overtime enables us to calculate the rate of economic
growth.
Economic growth = (new GDP - old GDP) ÷ old GDP.

Algebraic expression for GDP in the two cases of closed economy and open Economy are as follows:
Closed economy:-
GDP=C+I+G

Open economy:-
GDP=C+I+G+(X-M)

Where,
C= consumption expenditure on domestically produced foods
I= investment expenditure or gross capital formation
G=government expenditure on goods and services
X-M=net receipts from foreign trade on net exports i.e. exports (X) minus imports(M).
 GNP
GNP is a Measure of the value of goods and services that the nationals of the country produce regardless of where they are located.
Difference between GNP & GDP
Example If a Japanese multinational company produces cars in UK, this production will be counted towards UK GDP however if the
Japanese firms send it back to the shareholders in Japan then this outflow of profits is subtracted from GNP because UK nationals
don't benefit from this profits.
Similarly if insurance companies from UK located abroad make profit and then if this profit is sent back to UK nationals then this net
income from overseas assets will be added to its GNP.
Thus, GNP=GDP+NFIA
NFIA- Net Factor Income from Abroad
Factor incomes including wages salary rent interest and profit are generated by the residents and non residents in a country.
Example : non-residents - foreign individuals and companies from USA, UK and other countries who have acquired property such as
factories, offices, buildings, financial assets such as bonds and shares in India receives incomes in the form of rent and interest incomes
interest. Also those who have set up industrial plants are producing goods and services will receive profits. Likewise those going
abroad from India will also receive factor incomes.
So the net factor income from abroad is a difference between factor income received from abroad by normal residents of India
rendering factor services in other countries on one hand and the factor incomes paid to the foreign residents for factor services
rendered by them in the domestic territory of India on the other.
POINTS TO BE NOTED WHILE CALCULATING
NATIONAL INCOME.
1. Include only currently produced goods and services in a year; second hand goods will not be included.
2. Excludes financial transaction such as purchase and sale of assets shares funds transfer payments, because they do not involve current
production but are mere exchange.
3. Includes only final goods and not intermediate goods since the value of intermediate goods are already a part of the market price of a
final goods in the production of which they are used; so to avoid double counting intermediate goods are excluded.
4. Monetary measure value of goods and services measured in terms of money prices.
5. Inventory is included when a firm adds to its inventory of goods, awaiting for sales on shelves or raw materials which are yet to be
assembled into final form or to be sold. It involves expenditure by the firm, so inventory is included in the calculation of current GDP.
6. Imputations in national income calculation some goods and services do not have prices and are not traded in the marketplace so
imputed values are used. For example : includes services of owner-occupied housing, government services and the treatment of employer
provided health care and production meant for self consumption, etc.
7. Imputations approximate the price and quantity that would be obtained for a good or service if it was traded in the market place
8. No imputation is made for the value of goods and services sold in the underground economy (illegal transactions).
REAL VS NOMINAL GNP
Real GNP Nominal GNP
 Measures the changes in the output of  Measures GNP at current market price
the economy according to the prices of base
year i.e. GNP at constant prices  Does NOT indicate real growth of N.I.

 Central Statistical Organization (CSO)  Changes in Nominal Income may be

calculates the GNP at constant & current for 2 reasons
prices  i) increase in Output
 Actual growth of N.I. due to increase in  ii) increase in price
output is indicated by real GNP
GROSS NATIONAL PRODUCT (GNP)
DEFLATOR
The GNP deflator is simply the adjustment for inflation that is made to nominal GNP to
produce real GNP. The GNP deflator provides an alternative to the Consumer Price Index
(CPI) and can be used in conjunction with it to analyze some changes in trade flows and the
effects on the welfare of people within a relatively open market country.
The CPI is based upon a basket of goods and services, while the GNP deflator incorporates
all of the final goods produced by an economy. This allows the GNP deflator to more
accurately capture the effects of inflation since it's not limited to a smaller subset of goods.
Calculating the Gross National Product (GNP) Deflator
The GNP deflator is calculated with the following formula:
GNP Deflator = (Nominal GNP/ Real GNP)×100
The result is expressed as a percentage, usually with three decimal places.
NI AT CURRENT PRICE &
CONSTANT PRICE
 N.I. at Current Price
Refers to sum of net money value of all goods & services produced in a
country during a year. It is obtained by multiplying physical output of goods
with current prices in that year.
 N. I. at Constant Price
It is the money value of final goods and services produced in a country in a
year, measured at base year price.
 Base Year is a normal year which is free from price fluctuations.
If we measure India’s National Income of 2013-2014 at the prices of 2004-
2005, then it is termed as ‘National Income at constant price’
 NI AT CONSTANT AND CURRENT PRICE

• As seen in Table, National income of 2013-14 at Current year prices is Rs 20,000 and at base year
prices is Rs 12,000 for the same level of output. The difference of Rs 8,000 is not real. It does not
give a true picture of economic growth as the increase is merely due to rise in prices.
• So, real growth of an economy can be measured only through National income at constant prices.
• This can be done by eliminating the effects of price change on national income with the help of a
suitable ‘Price Index’.
• Price Index is an index number which shows the change in price level between two different time
periods. It indicates whether a rise or a fall in the national income from one year to another is real or
not.
GVA GROSS VALUE ADDED

GVA is defined as the value of output less the value of intermediate consumption.
GVA=CE+OS/MI+CFC+(PRODUCTION TAX-PRODUCTION SUBSIDIES)
Where, CE= Compensation of employees
OS=Operating surplus
MI=Mixed income
CFC=Consumption of fixed capital
MEASUREMENT OF NATIONAL INCOME
The national income of a country can be measured by three alternative methods:
(i) Product Method,
(ii) Income Method, and
(iii) Expenditure Method.
1. EXPENDITURE APPROACH
Def: GDP is the total expenditure for all final goods and services produced within the country.

components of final expenditure includes - private consumption expenditure (indicated by C), government final consumption
expenditure (indicated by G), gross domestic capital formation (indicated by I) and net exports (indicated by X-M).

This method is also known as income disposal method.

GDP=C+I+G+(X-M)

Precautions while estimating GDP through expenditure method

1. Exclude second hand goods

2. Exclude purchase of shares and bonds

3. Exclude transfer payments

4. Exclude intermediate goods and include only final goods.

5. Imputed values are used for self occupied houses, employer or government provided health care.
2. OUTPUT OR VALUE ADDED
APPROACH
In this method contribution of each enterprise to the generation of flow of goods and services is
measured for this the economy is divided into different industrial sectors such as agriculture fishing
mining construction manufacturing wearing from country to country depending on its significance in
aggregate economic activities and availability of data.
GDP= Sum of value-added
Illustration
1. Farmer's value added =$2 wheat -0 (cost) = $ 2

2. Flour Making Factory = $3.5 (flour) - $2 (wheat) = $ 1.5

3. Bread Manufacturer - Britania = $ 6 Bread - $ 3.5 (flour) = $ 2.5

4. Sandwich (restaurant) = $ 8 (Sandwich) - $ 6 (Bread) = $ 2

PRECAUTIONS WHILE ESTIMATING GDP THROUGH
VALUE ADDED METHOD.
1. Exclude second hand goods
2. Imputed values are used of self occupied housing, production for self consumption
3. Exclude intermediate goods and include only final goods to avoid double counting.
4. Changes in inventory to be included.
3. INCOME APPROACH
This method approaches national income from distribution side. Under this method national income is obtained by
summing up of the incomes of all individuals of a country. The factor payments are classified into the following groups.
1. Employee Compensation including wages and salaries in cash or in kind employees contribution to social security
schemes.
2. Rent and royalty
3. Interest income
4. Profits -
Dividends, corporate income tax, retained earnings/ undistributed profits

5. Mixed income of self employed:

In case of self employed nature of business, it is difficult to separate wages for the work done by the self employed from
the surplus or profits earned by them. Therefore the incomes earned by them are mixture of wages, rent, interest and
profit.
Example: doctors, chartered accountants, consultants, family farms and other unorganised enterprises.
National Income (NNPFC) = Net Domestic ProductFC + NFIA
INCREASE IN NATIONAL INCOME IS NOT
SATISFACTORY INDEX OF GENERAL WELFARE FOR
THE FOLLOWING REASONS:
5) The national income is very difficult to measure
1) If the population rises faster than the national income,
then there will be fewer goods for each person in the accurately, so a small change in the national
population. Real national income per head is a better income may simply be due to inaccurate
measure of the welfare of a country than the total national
income. measurement. Also the s exclude production of the
2) The national income is measured in money terms, if
black money, which is not officially recorded, for
prices are rising, the national income will rise even if the example, cash payment for services, which are not
country is not producing any more goods and services. recorded, to evade taxes.
3) A rise is national income may make just a few people 6) An increase in national income would not result
better off, without helping the majority of the population. in an improvement in standard of living if it
This means that national income is not fairly distributed
increases social costs like pollution, more traffic
4) The national income will raise as a result of the congestion, more noise etc.
production of goods and services which do not directly
make us feel better off, for example, investment goods for 7) Two countries may have the same income per
industry or weapons for the armed forces. Standard of head, but their standard of living will not be the
living depends mainly on the output and consumption of
consumer goods and services. same if people in one country have
to work much longer hours than those in the other
country thus sacrificing their leisure time.
GREEN NATIONAL INCOME-GGDP
The Green Gross Domestic Product, or Green GDP for short, is an indicator of economic growth with
environmental factors taken into consideration along with the standard GDP of a country. Green GDP
factors biodiversity losses and costs attributed to climate change. Physical indicators like “carbon
dioxide per year or “waste per capita” may be aggregated to indices like the “Sustainable Development
Index”
It was first seen in the works of economist like James Tobin and William Nordhaus, eventually, the
concept got accepted as a policy initiative by many governments, notably, USA, Norway, China and
India.
Need for GGDP
1. Conventional measures come with limitations
2. Sustainability is not known-future potential is unknown with the help of conventional measures.
3. Wealth and Assets are used up- cost of using Natural capital is not adequately accounted. the
benefit of maintaining the natural capital can’t be given monetary value and thus is not accounted
in GDP.
4. Since, preserving natural capital for future generation is important thus accountability can be
achieved through GGDP.
CALCULATION:
The calculation of GGDP involves natural capital accounting. It is the process of calculating the total stocks and flow of natural resources and
services in a given ecosystem of a region. The process of production results in consumption of natural capital (Net natural capital consumption).
Therefore, in the calculation of GGDP natural capital accounting is necessary. This process involves three steps
1. Physical accounting determines the state, type and extent of resources over space and time. Both quantitative and qualitative accounting is
done. For example, measuring forest cover and water resources in both quantitative and qualitative terms is a part of natural capital accounting.
2 Monetary valuation of the natural capital is the next process. It is often a difficult process because many components of natural capital are not
traded. For example, how does one put a monetary value to the bio-diversity existing in mangroves located in urban areas?
3. The net change in natural capital in monetary terms is then incorporated into the GDP to arrive at the GGDP. GGDP is measured using the
following formula:
GGDP = GDP- Cost of Net Natural Capital Consumption
Cost of Natural Capital Consumption includes:
(i) Costs of natural resource consumption (ii) Costs of environmental depletion
Drawbacks/Criticisms
Though an extremely important concept that needs to be incorporated by policy makers of every country, the concept of GGDP has some
drawbacks. These drawbacks make its practical application somewhat difficult.
1. It may be difficult to assign monetary values to some of the natural capital components. However, with advancement of technology, more and
more accurate measurement is becoming possible.
2 GGDP measures are often not able to capture the economic and social welfare aspect of GDP growth as it gives too much importance to
environment factors alone.
3. Some critics believe that the GGDP measures only account for depletion of natural resources but these measures cannot indicate the
sustainability of the growth rate.
GREEN GNP
GNP does not take into consideration the cost in terms of (i) environmental pollution and (ii)
 NATIONAL INCOME AND ECONOMIC WELFARE
Economic welfare is the level of prosperity and standard of living of either an individual or a group of people. It is also defined as the utility gained through achievement of material
goods and services Conventional measurements of national income accounting have been traditionally used to measure economic welfare. Economic welfare depends upon efforts
made by governments to improve people's quality of life. This is done through spending on welfare through subsidies, investment in health, education, infrastructure and rural
development. Around 1960s, the world began to face problems of environmental degradation, global inequality and economic underdevelopment in many countries. During this time
many economists began to question the importance given by governments and agencies to national income accounting for estimating generation of economic welfare. In 1972,
William Nordhaus and James Tobin introduced their Measure of Economic Welfare (MEW) as an alternative to GDP. MEW adjusted national income to include the value of leisure
time and the amount of unpaid work in an economy, hence increasing the welfare value of GDP. They also included the value of the environment damage caused by industrial
production and consumption, which reduced the welfare value of GDP.
Relationship Between National Income and Welfare
Economic welfare increases with increase in welfare spending by the government, provided the spending is distributed in the desired matter. An increase in national income will
generally lead to increased capacity of governments to raise welfare spending and thus increase economic welfare. But direct relationship between national income and economic
welfare is subject to the following conditions
1. Change in size of national income: When the size of the national income increases, people earn more income and consume more goods and services. This has a positive impact on
welfare. On the other hand, a decrease in the size of the national income will have the opposite effect
2 Change in price level: National income is the market value of final goods and services produced. If the value of the national income rises due to inflation, it becomes difficult to
measure the real changes in economic welfare If prices rise without an increase in output, economic welfare will reduce because real income or purchasing power will fall

3. Per capita income: The analysis of national income is incomplete without considering per capita income. If national income and population size change at the same rate, then the
per capita income will remain the same. In such a situation, there may not be any increase in welfare spending by the government. Thus, even though the national income has
increased, economic welfare may not increase
4 Expenditure pattern: With increase in national income. If people spend their rising income to acquire necessities like food, essentials, housing education, transport services, then
economic welfare will increase. If the increased income is used to spend on luxury goods due to demonstration effect or for speculative investments, then welfare generation will be
negatively impacted.
5. Production pattern: An increase in national income should be analyzed by examining the production pattern. If the national income has increased due to increased defence
production or production of luxury goods as compared to the production of essential goods and service, then economic welfare will be negatively affected.
6 Changes in income distribution Changes in national income bring about changes in income distribution Income is transferred from the people to the government through taxes and
from the government to the people through welfare spending. If the rich are taxed more to increase welfare spending, it will have a positive effect on economic welfare. Checks on
monopoly businesses, nationalising essential services, imposing heavy duties on luxury goods will increase economic welfare. On the other hand, if most of the share of national
income is generated through private sector profit and the rich enjoy tax benefits, then economic welfare will be negatively affected. However, the government has to maintain a
balance between taxation and welfare spending If the rich are taxed very heavily, they may not invest in the country and take their wealth outside. This will result in less production
and job creation and will adversely affect national income and welfare. Therefore, taxes on high-income groups need to be rational in order to increase savings, investment,
production and economic welfare.
TRADE CYCLES
MEANING
If we study the economic history of the various countries of the world, we shall find that
economic activities are marked by waves of Expansion and Contraction.
There have been times when economic activities show expansion with production,
employment, income, prices, etc. rising in accumulative manner, while at other times,
economic activities remain depressed with production, employment, income, prices, etc.
showing a continuous downward trend.
In fact, these rhythmic fluctuations are normal features of all modern capitalist economies.
These fluctuations are normally known as Trade Cycles or Business Cycles.
DEFINITION
“A Trade Cycle is composed of periods of trade characterized by rising prices and low
unemployment percentages altering with periods of bad trade characterized by falling prices
and high unemployment percentages.” – Keynes
WHY IS UNDERSTANDING THE
BUSINESS CYCLE IMPORTANT
FOR BUSINESS MANAGERS?
(a) they affect the demand for their products
(b) they affect their profits
(c) to frame appropriate policies and forward planning
FEATURES/CHARACTERISTICS
1. It is a wave like movement (expansion and contraction of trade activities)
2. All trade cycles are more or less similar in nature but not exactly same
3. Trade cycles are repetitive (recurrent) in nature, but not periodical and regular
4. Trade cycle is self reinforcing in nature
5. They are self generating in nature as it terminates one phase and starts another phase on its own
6. They practically affect every sector of the economy
7. It is international in character but all countries are not equally affected

8. The movement to prosperity to depression is more sudden, sharp and steep then movement from contraction to
expansion

9. Fluctuations are more marked in capital goods rather than consumer goods
10. The main effect of trade cycles is on profits than any other factor income
11. Prices, production and employment move in the same direction.
 PHASES: PROSPERITY, RECESSION ,DEPRESSION, RECOVERY

The turning points of the business cycle are peak (highest point)
and trough (lowest point)
1. Expansion/Prosperity:
 In this phase there will be increased production, high capital investment in basic industries, expansion of bank
credits, rising prices, rising profits and rising employment. It is the stage of rapid expansion in the overall
economic activities.
 The highest period of prosperity is called Boom.
 The commercial banks encourage further addition to fixed capital by liberal lending policies.
 The continuous investment even after the stage of full employment results in sharp inflationary rise in prices.
 The producers are still optimistic and continues to make new investments as prices are increasing
continuously, and it finally attains a new peak.
 This will not continue indefinitely, the developing boom carries with itself the seeds of self destruction.
 Contraction soon begins to appear in the various sectors of the economy and number of limiting forces will
start affecting within the economy which weakens the expansion phase and finally converts it self into recession.
 Some of the reasons for conversion of expansion to recession are:
i. Rising costs: Increasing prices of factors of production will be more rapid then the general
price level and eventually increases the cost of production and makes further expansion less
attractive.
ii. Inability of banks to advance further loans: after continues lending in the phase of
expansion, the pressure accumulates on the reserves of the banks and now they are unable and
unwilling to grant further loans. To complement the expansion phase, it is necessary to have
continues money supply which is now not available.
iii. Declining Marginal Propensity to consume: in the expansion period, the income of
the factors of production increases and the level of consumption also increases but not in
proportion to the increase in level of income. An increasing proportion of income is
more likely to be saved rather than spent. Decline in MPC will reduce the aggregate
demand. As demand decreases, there can be the situation of over production (supply>
demand) which ultimately reduces the prices of goods and services. The reduction in price is
the symbol of transformation of expansion phase into recession phase.
2. Recession:
 The recession phase marks the end of the phase of expansion and beginning of a prolonged phase of economic
stagnation and contraction.
 The optimistic environment is now replaced by the over- pessimism characterized by feeling of hesitation,
doubt and fear.
 Enterprises do not undertake any new projects and even the projects in hand are abandoned sometimes.
 There can be liquidation in stock exchange, money market and commodity market. The bank will also start
contracting the size of credit and even the existing loans are forced to be recover as early as possible.
 Because of the contraction of bank credit the businessmen are not getting advances for the purpose of
expansion of business.
 Orders are cancelled and workers are laid-off. Sale of the existing stock of goods at the cheaper rate to get out of
the market.
New investment stops and unemployment increases in construction and other capital goods industries, too.
IMP: Fall in the interest rates is a typical feature of recession.
 Initial unemployment will rapidly fall over the other sectors of the economy as well, a cumulative
contractionary process leads to fall in production, employment and consequently income, expenditure and prices.
 The prolonged period of recession will increase the idle capacity of the productive units and new investments
will decline rapidly.
 It is having a cumulative effect, as once it starts, it goes on gathering momentum, and turns into depression.
Here the phase of recession turns into contraction.
3. Depression/Contraction:
 Depression is characterized by sharp reduction in production, massive unemployment, falling prices, falling
projects, low wage rates, contraction of bank credit, a high rate of business failure and an atmosphere of all around
pessimism.
 A decline in investment will reduce the level of production and high level of unemployment arrives, which
reduces the income and demand in the economy.
 Price fall reduces the profit level of the enterprises and may turn into negative also. Investment fall due to lack
of profitability.
 No business is ready to take a risk and do not apply for loans to the banks. The surplus with the banks increases
and the rate of interests comes down.
 Due to reduction in the demand for capital goods and some of the consumer goods many
firms close down on account of accumulated losses.
 Reduction in prices are followed by reduction in money supply and reduction in velocity of
circulation of money.
 The effect of contraction is universal but not uniform as the prices of agricultural products
and raw materials fall sharply as compared to finished goods.
 The lowest point in trade cycle is called trough.
 The economic activities are at its lowest level.
 But this cannot be a permanent situation in the economy, in fact the same forces that makes
depression so sever will work for the revival also.
 The same forces within will work out to be positive and the phase of depression will be
converted in to the phase of Recovery.
4. Recovery/ Revival phase:
 It is the situation when the economic activities take turn from the depression phase to prosperity.
 The propensity to consume cannot become zero even at the lowest point of depression. The stock
with the producers is exhausted now and the demand for the consumer goods arises.
 The demand for consumer durable also gets turned as it was postponed in the time of depression.
 The demand for the capital goods cannot be postponed for a long period of time and therefore, it
is required to be replaced or repaired.
 After a certain period of time there will be a moderate revival in the demand for durables and
capital goods from the side of consumers and producers.
 This naturally call for increase in investment, leading to increase in employment, income and
effective demand.
 Normally the phase of revival starts with the replacement demand for capital goods..
 In order to meet these demand, investment and employment in capital goods industries
increases. This leads to general increase in effective demand which in turn leads to rise in
prices and profits resulting in further investment, employment and income.
 During this phase as the marginal efficiency of capital increases which improves business
optimism.
 Rise in security’s prices also marks the start of revival process.
 Remember, these phases are seldom show a regular and periodic change, they are having
different span every time and differs from country to country.
AGGREGATE DEMAND:
Aggregate demand is the total expenditure which
at given fix prices all households and business
firms wants to make on goods and services.

The aggregate demand curve slopes upwards

from left to right. It means that as the level of
employment and income increase aggregate
demand price also increases With increase in
income, people tend to spend a small amount of
income on consumption goods, Hence with
increase in output and employment, aggregate
demand price increases at a diminishing rate The
slope of the curve diminishes will increase in
employment. The figure below depicts an
aggregate demand function.
AGGREGATE SUPPLY
The main aim of an entrepreneur in a capitalist society is to earn profits. The producer will
employ workers in such a way as to maximise profits. The aggregate supply function slopes
upwards. The shape of aggregate supply function depends entirely on technical conditions of
production. It is decided by the manner in which cost rises in response to expansion of
employment. The figure below shows the aggregate supply function. F shows full employment
level.
EFFECTIVE DEMAND
The intersection of the aggregate demand function with aggregate supply function determines
the level of income and employment which is called effective demand. The aggregate supply
schedule represents costs involved at each possible level of employment. The aggregate
demand schedule represents the expectation of maximum receipts of the entrepreneur at
each possible level of employment.
The point E, where the aggregate demand curve intersects the aggregate
supply curve is called the point of effective demand. The equilibrium level of
employment is ONF. This is not necessarily full employment. If the level of
employment is more or less than ON, the profits will be less than maximum.
ONF level of employment is the full employment level in the diagram since at
this level of employment the aggregate supply curve AS is vertical in shape.
Hence ON level of employment is less than full employment. This happens
because investment demand is insufficient to fill the gap between income and
consumption.

For reaching full employment, employment level has to be increased. For this
either the aggregate supply curve should be lowered or aggregate demand
should be increased. Increasing the aggregate supply curve will necessitate
increase in the productivity. This is a long run problem. Keynesian theory is
concerned with short run analysis. Hence raising the aggregate demand is
possible. This shifts the equilibrium point to E1. This is the full employment
equilibrium. Any expansion of demand beyond E1 will lead to inflation.
 INCOME

EMPLOYMENT

EFFECTIVE
DEMAND

AGGREGATE AGGREGATE
DEMAND SUPPLY
FUNCTION FUNCTION

CONSUMPTION INVESTMENT
EXPENDITURE EXPENDITURE

PROPENSITY TO RATE OF MARGINAL GOVERNMENT

INCOME CONSUME INTEREST EFFICIENCY OF EXPENDITURE
CAPITAL

SUPPLY OF DEMAND FOR

MONEY MONEY
THE KEYNESIAN PRINCIPLE
OF EFFECTIVE DEMAND:
As seen in effective demand, aggregate demand is important to reach full employment level, thus its determinants are
explained as follows

In a two sector closed economy aggregate expenditure, aggregate demand consists of two components. first there is a
consumption demand and secondly there is a demand for capital goods which is called investment demand.

AD = C + I

Where AD=aggregate demand, C=Consumption demand, I= Investment demand

Consumption function

It is the relationship between income and consumption expenditure,

• Consumption expenditure is a positive function of income

As per Keynes, fundamental psychological law, an individual increases his consumption expenditure when his income
increases. however the increase in consumption is less than increase in income.

The consumption function in a linear form can be expressed as: C=Ca+ bY , Ca>0, 0<b<1
DIAGRAM
In the equation

Ca is the intercept on the y-axis showing positive level of consumption at zero level of income it is known as autonomous
consumption.

The constant 'b' denotes the slope of consumption function. It is known as marginal propensity to consume (MPC). It indicates
increase in consumption for unit of increase in income.

In the figure national income is measured along the x-axis and consumption demand (C) is shown on the y-axis. In the figure a
straight line OZ which make the 45 degree angle with the x-axis has been drawn.

Straight line OZ with 45 degree angle with the x-axis represents the reference income line to measure the difference between the
consumption and level of income. This is also often called income line A curve 'C' has also been drawn which represents
consumption function, C=a+bY of the community.

The curve of consumption function slopes upwards from left to right which shows that as income increases the amount of
consumption demand also increases.

After the point of equality (Y=C) the gap between consumption function Curve 'C' and the income line OZ represents the saving of
the community.

The reason for this is that a part of the income is consumed and a part is saved.

I.e. national income = consumption + saving

This is also written as y is equals to C + S, the gap between the consumption function curve C and the income line OZ goes on
increasing as income increases in other words the amount of savings or saving gap increases as income increases.
APC and MPC

APC is defined as the ratio of consumption to income for different levels of income.

APC=C/Y

MPC measures the response of consumption spending to a change in income.

MPC=∆C/∆Y

As B is less than 1, it implies that if income increases by a rupee, only a fraction will be spent on
consumption, that is if B is 0.60, then for every rupee increase in income, consumption will increase by 60
paise.

Keynes views on investment

The other component of aggregate demand is investment which is crucial factor in determination of
equilibrium level of national income. investment demand depends upon two factors:

1. Marginal efficiency of capital (profit expectation) &

2. Rate of interest.
INVESTMENT
In Keynesian theory of income determination, profit expectation changes even in short run and cause fluctuations
in investment while rate of interest is comparatively stable, therefore fluctuation in the level of investment
demand chiefly depends on the changes in marginal efficiency of capital;

investment does not vary with change in income but it is indirectly related with income. In actual practices when
the level of income rises the demand for goods will also rise and this will favourably affect the expectation of
entrepreneurs for making profits so rise in profit expectation will raise the marginal efficiency of capital which in
turn will increase the level of investment.

Aggregate demand function:-

AD = C + I

In the Keynesian model investment is assumed to be at enormous that is independent of the income level
aggregate demand function will has mainly depend on consumption function.

AD=Ca+bY+I

In the figure a given amount of investment demand, independent of the level of income is added to upward
sloping consumption function curve to get aggregate expenditure curve C + I.
CIRCULAR FLOW OF INCOME
In the circular flow model, the inter-dependent entities of producer and consumer are referred to as
"firms" and "households" respectively and provide each other with factors in order to facilitate the
flow of income. Firms provide consumers with goods and services in exchange for consumer
expenditure and "factors of production" from households. More complete and realistic circular flow
models are more complex. They would explicitly include the roles of government and financial
markets, along with imports and exports.
The basic circular flow of income model consists of seven assumptions:
1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods & services or consumption (C). There is no
saving (S).
3. All output (O) produced by firms is purchased by households through their expenditure (E).
4. There is no financial sector.
5. There is no government sector.
6. There is no overseas sector.
7. It is a closed economy with no exports or imports.
Circular flows are classified as: Real Flow and Money Flow:
a) Real Flow- In a simple economy, the flow of factor services from households to firms and
corresponding flow of goods and services from firms to households s known to be as real flow.
Assume a simple two sector economy- household and firm sectors, in which the
households provides factor services to firms, which in return provides goods and services to
them as a reward. Since there will be an exchange of goods and services between the two
sectors in physical form without involving money, therefore, it is known as real flow.
c) Money Flow- In a modern two sector economy, money acts as a medium of exchange
between goods and factor services. Money flow of income refers to a monetary payment from
firms to households for their factor services and in return monetary payments from households
to firms against their goods and services. Household sector gets monetary reward for their
services in the form of rent, wages, interest, and profit form firm sector and spends it for
obtaining various types of goods to satisfy their wants. Money acts as a helping agent in such
an exchange.
 CIRCULAR FLOW OF INCOME: CLOSED (TWO
SECTOR MODELS):
Labour, land, Capital and Flow of Goods and Services
Entrepreneur

Households Firms Firms Households

Wages, Rent, Interest and Profit

Consumption Expenditure
 CIRCULAR FLOW OF INCOME: CLOSED (TWO
SECTOR MODELS) AD=C+I
Labour, land, Capital and Flow of Goods and Services
Entrepreneur

Investment Saving
Saving Investment
Households Firms Firms Households

Wages, Rent, Interest and Profit

Consumption Expenditure
CIRCULAR FLOW OF INCOME: CLOSED (TWO
SECTOR MODELS)
This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend
this income on factors of production such as labour,
capital and raw materials, "transferring" their income to
the factor owners. The factor owners spend this income
on goods which leads to a circular flow of income.
CIRCULAR FLOW OF INCOME: CLOSED (THREE
SECTOR MODELS)
Government
Taxes Taxes

Households Firms

Saving Investment
Transfer Payments (wages, salaries) Govt. Exp. (Investment)
Government
EXPLANATION
In a modern economy the government plays a imp role in the functioning and
governing of the economic system of a country. Governments decide on policy
measures, spend on economic and administrative activities by collecting money from
its citizens in the form of taxes. This is income of government.
Government spends its income in form of transfer payments, salaries to government
employees, purchase of goods and services etc.
Thus, leakages in the form of savings and taxes arise in the circular flow of income.
They get injected back to the circular flow in the form of investments and government
spending.
CIRCULAR FLOW OF INCOME: OPEN(FOUR SECTOR
MODELS) AD=C+I+G+(X-M)
Foreign market
Import
Foreign Export
Export Payments
Remittance Manpower
Receipts
Government
Taxes Taxes

Households Firms

Saving Investment
Transfer Payments (wages, salaries) Govt. Exp. (Investment)
Government
EXPLANATION
Export of goods and services as well as foreign investments and borrowings result in the inflow
of money. Similarly, all the import, investment abroad and lending to other countries lead to
outflow of money. All this is clubbed under foreign sector – 4th sector.
For sake of simplicity we assume that only households and firms deal with the rest of the
world. Both the sectors have exports and imports. The households export labor services and
receive remittances. Similarly, the firms export and import goods and services. Both the
households and firms will heave net exports(X-M) showing the balance between the receipts
and payments involved. Net exports could be positive or negative. Taking net exports of both
households and firms, the magnitude of circular flow will be more if X>M, it will be less if
X<M and the volume of circular flow will be left unaffected if X=M.
Conclusion: if saving equals investment (S=I), Government expenditure equals taxes (G=T) and
exports equals imports (X=M), there will be equilibrium in all the sectors.
KAHN’S EMPLOYMENT
MULTIPLIER- 1ST TO DEVELOP
THE CONCEPT
Kahn’s Multiplier is known as Employment Multiplier, and Keynes’ Multiplier
is known as Investment Multiplier. According to Kahn’s Employment
Multiplier, when government undertakes public works like roads, railways,
irrigation works then people get employment. This is initial or primary
employment. These people then spend their income on consumption
goods. As a result, demand for consumption goods increases, which leads
to increase in the output of concerned industries which provides further
employment to more people. But the process does not end here. The
entrepreneurs and workers in such industries, in which investment has been
made, also spend their newly obtained income which results in increasing
output and employment opportunities. In this way, we see that the total
employment so generated is many times more than the primary employment.
SHIFT IN AGGREGATE
DEMAND AND MULTIPLIER
The multiplier model tells us how much output or income may change as the AD shift due to an
initial change in expenditure.
In a two sector economy AD is a sum of C+I. Though both undergo change from one period to
another, consumption function is relatively more stable than the investment function. Thus, initial
changes in income occur more due to the shifts in the investment function. This implies that C+I
curve shifts mainly due to investment function.
Multiplier
The multiplier can be defined as the amount by which there occurs a change in equilibrium level of
income due to a change in autonomous aggregate expenditure (for e.g. autonomous investment by
one unit will lead to income increase by multiple of it).
The essence of multiplier is that total increase in income, output or employment is manifold the
original increase in investment for e.g. if investment equal to Rs. 100 crores is made , then the
income will not rise by Rs. 100 crores only but a multiple of it. If as a result of investment of Rs. 100
crores, the national income increases by Rs. 300 crores, then multiplier is equal to 3.
Multiplier is equal to the ratio of increment in income to the increment in investment.
Therefore, k=∆Y/∆I. Where k is investment multiplier.
Assumptions of Multiplier are:
1. MPC is assumed to be constant.
2. No time lag- Increment in income takes place
instantly as a result of increment in investment.
3. Excess capacity exists in the consumer goods
industries i.e. the output of consumer goods is
responsive to effective demand for these.
4. There is net increase in investment.

Limitations/ Existence of leakages of multiplier are:

1. Higher Marginal Propensity to Save.
2. Debt Cancellation
3. Hoarding of cash balances
4. Purchase of old stocks and securities
5. Net imports
6. Inflation
7. Unrealistic assumption of no time lag
8. Full employment Ceiling
WORKING OF MULTIPLIER
Suppose, government invests Rs 100 crore in establishment of a fertilizer factor. The
first impact of this new investment will be that the income of employees engaged in
this factory will go up by Rs 100 crore. If their marginal propensity to consume
(MPC) is 3/4th or 75%, they will spend Rs 75 crore (3/4th of 100) on new
consumption goods.
This is not the end of the story. The producers of these goods will have an extra
income of Rs 75 crore. If MPC of producers is also 3/4th, they in their turn will spend
Rs 56.25 crore (3/4 of 75). So, this process will go on, with each round of expenditure
being 3/4th of the previous round and in this way the production and national
income will go on increasing round after round. The process of increase in income
stops when change in income becomes equal to change in saving.
The process of working of multiplier is further illustrated in the following table. This
is based on the assumption that initial increase in investment = Rs 100 crore and
MPC = 75% (or 3/4th).
 WORKING OF
MULTIPLIER

The above table clearly shows that Initial increase in

investment of Rs 100 crore has resulted in an increase of
additional income of Rs 400 crore, i.e., the resultant
increase in income is multiple of initial increase in
investment.
Thus, in this case Multiplier (K) = 400/100 = 4 or K =
∆Y/∆I. Keeping in view the significance of concept of
investment multiplier, Keynes suggested that in the
situations of unemployment and depression, government
should Increase volume of its investment in public utility
works to give quick start to economy.
DIAGRAMMATIC PRESENTATION
 EXPLANATION
It will be seen from the figure that aggregate demand for C + I which intersects the 45o line at point E so the level of income equal
to OY1 is determined. As a consequence of increase in investment by EH, the aggregate demand curve shifts upward to the new
position C + I'. This new aggregate demand curve C + I' intersects the 45o income line at point F so that the equilibrium level of
income increases to OY2.Hence as a result of net increase in investment equal to EH, the income has increased by Y1Y2 is greater
than EH. On measuring, it will be found that Y1Y2 is twice the length of EH. This is so because MPC is 1/2 and therefore the size
of multiplier will be equal to 2.

The multiplier can be illustrated through saving investment diagram also. With the given saving and investment Curves level of
income equal to OY1 is determined. Now suppose that there is an increase in investment by the amount II' with this increase in
investment the investment curves shift to the new dotted I'I'.

This new investment curves I'I' intersect the saving curve at point F and a new equilibrium has reached that the level of income
OY2. A glance at the figure 2 will reveal that the increase in income is twice the increase in investment.

Uses of multiplier

The concept of multiplier is useful in the assessment of the overall increase in national income due to one shot increase in
investment or due to change made in the fiscal policy and also foreign trade policy.

To plan economic growth of the country suppose a country has an income of rupees hundred billion and it's MPC is 0.8 the value
of multiplier is 5. Thus, the country can plan to double its national income over a period of time through a one shot investment, in
the following manner-

Planned growth = rupees hundred billion, so required investment is 20 billion it means that increasing national income by rupees
hundred billion requires an additional investment of rupees 20 billion, all other things being constant or given.