Micro and Macro Economics

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

Micro-Economics or Price Theory:

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

In respect of employment, micro-economics studies only the employment in a

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

A noteworthy feature of micro-approach is that, while conducting economic

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

Importance of Micro-Economics: Micro-economics occupies a very important

place in the study of economic theory.

1. Functioning of free enterprise economy: It explains the functioning of a

free enterprise economy. It tells us how millions of consumers and
producers in an economy take decisions about the allocation of productive
resources among millions of goods and services.
2. Distribution of goods and services: It also explains how through market
mechanism goods and services produced in the economy are distributed.
 3. Determination of prices: It also explains the determination of the relative
prices of various products and productive services.
4. Efficiency in consumption and production: It explains the conditions of
efficiency both in consumption and production and departure from the
optimum.
5. Formulation of economic policies: It helps in the formulation of
economic policies calculated to promote efficiency in production and the
welfare of the masses.

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

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

limitations:

1. It does not give an idea of the functioning of the economy as a

whole. It fails to analyse the aggregate employment level of the economy,
aggregate demand, inflation, gross domestic product, etc.
2. It assumes the existence of ‘full employment’ in the whole economy,
which is practically impossible.

Macro-Economics or Theory of Income and Employment:

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

It analysis the chief determinants of economic development, and the various

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

Importance of Macro-Economics:

1. It is helpful in understanding the functioning of a complicated

economic system. It also studies the functioning of global economy.
 With growth of globalisation and WTO regime, the study of macro-
economics has become more important.
2. It is very important in the formulation of useful economic policies for
the nation to remove the problems of unemployment, inflation, rising
prices and poverty.
3. Through macro-economics, the national income can be estimated and
regulated. The per capita income and the people’s living standard are
also estimated through macro-economic study. It explains the fluctuations
in national income, per capita income, output and employment.

Limitations of Macro-Economics:

1. Individual is ignored altogether. For example, in macro-economics

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

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

Types of Equilibrium

Basically, there are three types of any equilibrium:

(a) Stable Equilibrium: There is stable equilibrium, when the object

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

(b) Unstable Equilibrium: On the other hand, the equilibrium is unstable

when a slight disturbance evokes further disturbance, so that the original position
is never restored. In this case, there is a tendency for the object to assume
newer and newer positions once there is departure from the original position.

(c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces

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

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

In the following figure 2, the stable equilibrium is shown. When in equilibrium at

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

Figure 3 represents the case of unstable equilibrium. Initially the producer is in

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

Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at

all levels of output so that the producer has no tendency to return to the old
position and every time a new equilibrium point is obtained, which is as good as
the initial one.
Other Forms of Equilibrium

(a) Short-term and Long-term Equilibrium: Equilibrium may be short-term

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

(b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an

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

The equilibrium of a single consumer, a single producer, a single firm and a

single industry are examples of partial equilibrium analysis. Marshall’s theory of
value is a case of partial equilibrium analysis. If the Marshallian method (i.e.,
partial equilibrium analysis) is to be effective, even in its own terms, when applied
to a hypothetical and idealised market, it necessary that the market should be
small enough so that its inter-dependence with the rest of the hypothetical
economy could be neglected without much loss of accuracy.

(i) Consumer’s Equilibrium: With the application of partial

equilibrium analysis, consumer’s equilibrium is indicated when he is getting
maximum aggregate satisfaction from a given expenditure and in a given set
of conditions relating to price and supply of the commodity.

(ii) Producer’s Equilibrium: A producer is in equilibrium when

he is able to maximise his aggregate net profit in the economic
conditions in which he is working.

(iii) Firm’s Equilibrium: A firm is said to be in long-run

equilibrium when it has attained the optimum size when is ideal from
the viewpoint of profit and utilisation of resources at its disposal.

(iv) Industry’s Equilibrium: Equilibrium of an industry shows that

there is no incentive for new firms to enter it or for the existing firms to
leave it. This will happen when the marginal firm in the industry is
making only normal profit, neither more nor less. In all these cases;
those who have incentive to change it have no opportunity and those
who have the opportunity have no incentive.

(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical

economist, in his book ‘Elements of Pure Economics’, created his theoretical and
mathematical model of General Equilibrium as a means of integrating both the
effects of demand and supply side forces in the whole economy. Walras’
Elements of Pure Economics provides a succession of models, each taking into
account more aspects of a real economy. General equilibrium theory is a branch
of theoretical microeconomics. The partial equilibrium analysis studies the
relationship between only selected few variables, keeping others unchanged.
Whereas the general equilibrium analysis enables us to study the behaviour of
economic variables taking full account of the interaction between those variables
and the rest of the economy. In partial equilibrium analysis, the determination of
the price of a good is simplified by just looking at the price of one good, and
assuming that the prices of all other goods remain constant.
General equilibrium is different from the aggregate or macro-economic
equilibrium. General equilibrium tries to give an understanding of the whole
economy using a bottom-top approach, starting with individual markets and
agents. Whereas, the macro-economic equilibrium analysis utilises top-bottom
approach, where the analysis starts with larger aggregates. In macro-economic
equilibrium models, like Keynesian type, the entire system is described by
relatively few, appropriately defined aggregates and functional relationships
connecting aggregate variables such as total consumption expenditure, total
investment, total employment, aggregate output and the like. In macro-economic
analysis, many important variables and relationships tend to be disappeared in
the process of aggregation.

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

(i) The first fundamental theorem is that every market equilibrium is

Pareto optimal under certain conditions, and

(ii) The second fundamental theorem is that every Pareto optimum is

supported by a price system, again under certain conditions.

Uses of General Equilibrium

1. To get an overall picture of the economy and study the problems

involving the economy as a whole or even large segments / sectors of it.

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

3. It also provides with an ideal datum of economic efficiency. It brings out

the fact that long-run competitive equilibrium is a standard of efficiency for
the entire economy. Only when the competitive economy obtains general
equilibrium shall its economic efficiency be at its peak and there shall be
no further gains made by any reallocation of resources.

4. General equilibrium also represents the state of optimum production of

all commodities, because there can be no over-production or under-
production under such conditions.

5. It also provides an insight into the way the multitudes of individual

decisions are integrated by the working of the price mechanism. It,
therefore, solves the fundamental problems of a free market
economy, viz., what to produce, how to produce, how much to produce,
etc. This analysis shows that such decisions with regard to innumerable
consumers and producers are co-ordinated by the price mechanism.
 6. The general equilibrium analysis also gives us the clue for predicting
the consequences of an economic event.

7. It also helps in the field of public policy. The formulation of a logically

consistent public policy requires a complete understanding of the various
sector markets and aspects of individual decision-making units, and the
impact of policy on the whole economy.

Limitations of General Equilibrium Analysis

1. The Walrasian general equilibrium system is essentially static. It treats

the coefficient of production as fixed. It considers the supply of resources
to be given and consistent. It also takes tastes and preferences of the
society as fixed.

2. It ignores leads and lags, for it considers everything to happen

instantaneously. It is supposed to work just in the same way as an electric
circuit does. In the real world, all economic events have links with the past
and the future.

3. Walrasian general equilibrium analysis is of little practical utility. It

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

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

General Disequilibrium (Keynesian Theory)

Neoclassical economics thinks in terms of a market system in which supply

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

Take an example of a commodity, say cellular telephone sets, its equilibrium of

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

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

Harrod Domar Growth Model

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

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

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

· Saving (S) is some proportion, s, of national income (Y) such that we

have the simple equation:

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

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

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

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

K = k

Or

ΔK = k

ΔY
 Or

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

· Finally, because net national savings, S, must equal net investment, I,

we can write this equality as:

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

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

I = ΔK = k. ΔY

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

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

Or simply

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

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

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

Y k

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

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

The additional output can be obtained from an additional unit of investment and it
can be measured by the inverse of the capital-output ratio, k, because this
inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows
that multiplying the rate of new investment, s = I / Y, by its productivity, 1 / k,
will give the rate by which national income or GNP will increase.
For example, the national capital-output ratio in an under-developed country is,
let say, 3 and the aggregate saving ratio (s) is 6% of GNP, it follows that this
country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose
that the national saving rate increased from 6% to 15% through increased taxes,
foreign aids, and / or general consumption sacrifices – GNP growth can be
transferred from 2% to 5% (15% / 3).

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

The main obstacle or constraint on development, according to this theory, was

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

Limitations of the model:

1. Economic growth and economic development are not the same.

Economic growth is a necessary but not sufficient condition for development

2. Harrod Domar model was formulated primarily to protect the developed

countries from chronic unemployment, and was not meant for developing
countries.

3. Practically it is difficult to stimulate the level of domestic savings

particularly in the case of LDCs where incomes are low.

4. It fails to address the nature of unemployment exists in different countries.

In developed countries, the unemployment is ‘cyclical unemployment’, which
is due to insufficient effective demand; whereas in developing countries, there
is ‘disguised unemployment’.

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

6. The law of diminishing returns would suggest that as investment increases

the productivity of the capital will diminish and the capital to output ratio rise.

The Harrod-Domar model of economic growth cannot be rejected on the ground

of above limitations. With slight modifications and reinterpretations, it can be
made to furnish suitable guidelines even for the developing economies.
 National Income Accounts
What is National Income Accounting?

National income accounting is a term which is applied to the description of the

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

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

accumulation of wealth;

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

(c) types of transactions, such as sales and purchases of goods and

services, gifts, taxes, and other current transfers.

In national income accounting, a transactor is supposed to keep a set of three

accounts in which transactions are recorded:

(i) In the first account, incomes and outgoings relating a productive

activity of the transactor are brought together. The difference between
the two shows the profit or gain.

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

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

Since in an economy, there are numerous transactors, therefore, they are

grouped into sectors. In a sector, accounts of a same type are consolidated.
The ‘sector accounts’ form the units in a system of national income accounting.

Comparison of National Income Accounting and Individual Income

Accounting:

(a) Double entry book-keeping: Both national income accounting system

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

(b) Individual vs. collective individuals: Individual income accounts or

private accounts relate to an individual businessman or a corporate firm.
Whereas, the national income accounts are closely related to all the
businessmen or corporate firms in the community.

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

Income Statement of a Typical Firm

For the year ended on December 31, 2005

Debits Rs. Credits Rs.

By Cost of Sales:
To Sales Account
1,250,000 Wages 750,000
(50,000 units @ Rs.
25) Rent 150,000

Interest 150,000

Profit (residual) 200,000

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

National Product Account 2004-05

(Millions of rupees)

Flow of Product Rs. Flow of Earning Rs.

 Costs or Earnings:
Final Output
12,500 Wages 7,500
(500 million units @ Rs.
25) Rent 1,500

Interest 1,500

Profit 2,000
Total 12,500 Total 12,500

Uses of National Income Accounting:

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

(b) Promotion of efficiency and stability of the economy: To foster the

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

(c) Measurement of economic welfare: Measurement of economic welfare

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

(d) Interrelationship of different sectors of the economy: Through the

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

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

Gross National Product (GNP):

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

Approaches of Measuring GNP/GDP:

The primary purpose of national accounts is to provide a coherent and

comprehensive picture of the economy. To be concise, these estimates tend to
answer questions such as:

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

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

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

(i) Production Approach: It measures the contribution to output made by

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

VA = value of output – value of intermediate consumption.

Total value added by all producers equals GDP.

(ii) Income/Cost Approach: In this approach, consideration is given to the

costs incurred by the producer within his own operation, the income paid
out to employees, indirect taxes, consumption of fixed capital, and the
operating surplus. All these add up to value added.
 (iii) Expenditure Approach: This approach looks at the final uses of the
output for private consumption, government consumption, capital
formation and net of imports & exports. According this approach, GDP is
the sum of following four major components:

• Personal consumption expenditure on goods and services,

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

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

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

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

The federal statisticians and economists have to be very careful in measuring

GDP or preparing national income accounts. The following precautionary
measures should be taken:

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

(b) Difficulties of Measuring Some Services in Money Terms: National

Income of a country is always measured in money terms, but there are
some goods and services, which cannot be measured, in monetary terms.
Such goods include, the services of the housewife, housemaid and the
singing as a hobby by an individual. Exclusion of these services from the
national income, underestimate the national income account.

(c) Illegal Activities in the Economy/The Growth of “Black Economy”:

The “Black Economy” refers to that part of economic activity, which is
undeclared and therefore unrecorded for tax purposes and is therefore
deemed to be ‘illegal’. Many illegal activities in the economy generally
escape both the law and measurement in the national income. Such
illegal activities include, smuggling, drug trafficking and all parallel market
transactions. Since such activities are outlawed, income earned, through
them are not captured in the national income, thus, under estimating the
national income account.

(d) Danger of double counting: While measuring GDP, we have to

distinguish between the three forms of goods:

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

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

goods-in-process.

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

To avoid double or multiple counting, it is necessary to add the value of only

those goods which have reached their final stage of production, i.e., final goods,
and to not add the value of intermediate goods and raw materials, which are
already included in the value of final goods. GDP, therefore, includes bread but
not wheat, cars but not steal.

(e) Problem of Including All Inventory Change in GNP: Firms generally

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

(f) Problem of Price Instability: Since national income is measured in

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

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

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

Table 1
Bread Receipts, Costs, and Value Added

Rupees Per Loaf

 (1) (2) (3)
Value
Stages of Cost of Added
Sales
Production Intermediate (wages,
Receipts
Materials profit, etc.)
(1 – 2)
Wheat 2.00 0 2.00
Flour 5.50 2.00 3.50
Baked dough 7.25 5.50 1.75
Delivered bread 10.00 7.25 2.75
Total 24.75 14.75 10.00

(i) Non-productive transactions are excluded from GDP: The non-

productive transactions are excluded from GDP measurement. There are
two types of non-productive transactions:

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

• All public transfer payments, which do not add to the current

flow of goods such as social security payments, relief
payments, etc.
• All private financial transactions, such as receipt of money
by a student from his father, etc.
• Buying and selling of marketable securities, which make no
contribution to current production.

(ii) Sale proceeds of second-hand goods.

Difference between GDP and GNP:

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

Net National Product (NNP):

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

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

NNP = GNP – Depreciation

It is the net market value of all the final goods and services produced in a country
during a year. It is obtained by subtracting the amount of depreciation of existing
capital from the market value of all the final goods and services. For a
continuous flow of money payments it is necessary that a certain amount of
money should be set aside from the GNP for meeting the necessary expenditure
of wear and tear, deterioration and obsolescence of the capital and ‘it should
remain intact’.

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

National Income or National Income at Factor Cost:

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

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

bonus, etc.);

(ii) Proprietors income (profits of sole proprietorship, partnership, and

joint stock companies);

(iii) Net income from rentals and royalties; and

(iv) Net interest (excess of interest payments of the domestic business

system over its interest receipts and net interest received from
abroad).

National income can be calculated as follows:

 National Income = NNP – Indirect Taxes + Subsidies

Personal Income:

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

Personal Income = NI at Factor Cost – Contributions to Social Insurance –

Corporate Income Taxes – Retained Corporate Earnings + Transfer
Payments

Disposable Income:

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

Disposable Income = Personal Income – Personal Taxes

or

Disposable Income = Consumption + Saving

Details of National Income Accounts:

It is very important to take a brief tour of major components or particulars of

national accounts or product accounts. In this way, we can thoroughly
understand the concept of GDP/GNP:

(a) GDP Deflator: The problem of changing prices is one of the

problems economists have to solve when they use money as their
measuring rod. Clearly, we want a measure of the nation’s output
and income that uses an invariant yardstick. This problem can be
solved by using ‘price index’, which is a measure of the average
price of a bundle of goods. The price index is used to remove
inflation from GDP or to deflate the GDP, that is why, it is also called
‘GDP deflator’. The function of GDP deflator is to convert the
‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’. The
formula of real GDP is as follows:

Real GDP = Nominal GDP

GDP Deflator
 or

Q = PQ
P

Nominal GDP or PQ represents the total money value of final

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

Example:

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

Solution:

Nominal GDP:

Price × Quantity
Price Quantity
Year PQ
P Q
Nominal GDP
2005 25 100,000 2,500,000
2006 27 110,000 2,970,000
Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:

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

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

1.08

Real GDP:

Real GDP
Nominal GDP GDP Deflator
Year (PQ/P)
PQ P
Q
2005 2,500,000 1 2,500,000
2006 2,970,000 1.08 2,750,000
Hence, during 2006, the real GDP grew by 10%.
(b) Investment and Capital Formation: Investment consists of the
additions to the nation’s capital stock of buildings, equipment, and
inventories during a year. Investment involves sacrifice of current
consumption to increase future consumption. Instead of eating
more pizzas now, people build new pizza ovens to make it possible
to produce more pizza for future consumption.

To economists, investment means production of durable

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

Investment can be further categorised as:

(i) Gross investment: Gross investment includes all the

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

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

Net Investment = Gross Investment – Depreciation

(c) Government Expenditure: Government expenditures include

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

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

Circular Flow of Income

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

• Income,

• Product, and

• Expenditure.

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

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

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

1. A simple and closed economy with no government and external transactions,

i.e., two-sector economy;

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

3. A mixed and open economy with savings, investment, government activity and
external trade, i.e., four-sector economy.
1. Circular Flow of Income in a Two-Sector Economy:

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

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

(ii) Business Sector: The business sector is the sole producer and supplier of goods
and services. The business sector generates its revenue by selling goods and
services to the household sector. It hires the factors of production, i.e., land,
labour, capital and organisation, owned by the household sector. The business
sector sells the entire output to households. Therefore, there is no existence of
inventories. In a two-sector economy, production and sales are thus equal. So
long as the household sector continues spending the entire income in purchasing
the goods and services from the business sector, there will be a circular flow of
income and production. The circular flow of income and production operates at
the same level and tends to perpetuate itself. The basic identities of the two-sector
economy are as under:

Y=C

Where Y is Income

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

In a two-sector macro-economy, if there is saving by the household sector out of its

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

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

or

S=I

Where Y is Income

C is Consumption

S is Saving

I is Investment

When saving and investment are added to the circular flow, there are two paths by which
funds can travel on their way from households to product markets. One path is direct, via
consumption expenditures. The other is indirect, via saving, financial markets, and
investment.
Savings: On the average, households spend less each year than they receive in income.
The portion of household income that is not used to buy goods and services or to pay
taxes is termed ‘Saving’. Since there is no government in a two-sector economy,
therefore, there are no taxes in this economy.

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

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

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

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

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

We have so far discussed the two-sector economy consisting of household sector and
business sectors. Under three-sector economy, the additional sector is the government.
Two-sector economy is a hypothetical economy, whereas the three-sector economy is
much more realistic. The inclusion of the government sector is very essential in
measuring national income. The government levies taxes on households and on business
sector, purchases goods and services from business sector, and attain factors of
production from household sector. The following figure illustrates three-sector economy:
In the above diagram, in one direction, the household sector is supplying factors of
production to the factor market. Business sector demands the factors of production from
factor market. Inputs are used by the business sector, which produces goods and services
that are purchased back by the households and the government. Personal income after
tax or disposable income that is received by households from business sector and
government sector is used to purchase goods and services and makes up consumption
expenditure (or C). The money spent in the product market is the market value of final
goods and services (or GDP). That money goes to business sector that pays it back in the
form of wages, rent, profits and interests.

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

Y=C+I+G

Where Y is Income,
 C is Consumption,

I is Investment, and

G is Government Spending.

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

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

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

(i) Household sector,

(ii) Business sector,

(iii) The government, and

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

The household sector, business sector and the government sector have already been
defined in the previous sections. The foreign sector includes everyone and everything
(households, businesses, and governments) beyond the boundaries of the domestic
economy. It buys exports produced by the domestic economy and produces imports
purchased by the domestic economy, which are commonly combined into net exports
(exports minus imports). The inclusion of fourth sector, i.e., foreign sector or transaction
with ‘rest of the world’ makes the national income accounting more purposeful and
realistic. With the inclusion of this sector, the economy becomes an open economy. The
transaction with ‘rest of the world’ involves import and export of goods and services, and
new foreign investment. It is illustrated in the following figure.
In four-sector economy, goods and services available for the economy’s purchase include
those that are produced domestically (Y) and those that are imported (M). Thus, goods
and services available for domestic purchase is Y+M. Expenditure for the entire economy
include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus:

Y+M=C+I+G+X

Y = C + I + G + (X – M)

Where,C = Consumption expenditure

 I = Investment spending

G = Government spending

X = Total Exports

M = Total Imports

X–M = Net Exports

Economy Leakages and Injections:

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

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

Total Leakages = Total Injections

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

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

S = I + (G – NT) + (X – M)

One way of thinking about the circular flow of income is to imagine a water tank.
Investment, government spending and spending by foreigners is injected into the tank,
and savings, taxes and spending on imports leak out. The injections and the withdrawals
are equal to each other so the level in the tank is stable, or as economists like to say in
equilibrium.
If injections are greater than withdrawals or leakages then the level in the tank will rise. If
withdrawals are greater than injections then the level in the tank falls. If planned (I+G) is
equal to planned (S+T), so that injections is equal to leakages and total spending is equal
to total income and total demand is equal to total supply. Then we have a ‘stable
economy’. If leakages are higher than injections i.e., planned savings plus taxes are
greater than planned investment plus government spending (S+T > I+G), economy
contracts resulting in inventory accumulation, too little spending and drop in prices. If
injections are higher than leakages, i.e., planned investment plus government spending
are greater than planned saving plus taxes (I+G > S+T), economy expands resulting in
more goods and services produced, and higher prices.

Theory of Employment
TYPES OF UNEMPLOYMENT:

(a) Structural Unemployment: It is also known as Marxian unemployment

or long-term unemployment. It is due to slower growth of capital stock in
the country. The entire labour force cannot be absorbed in productive
employment, because there are not enough instruments of production to
employ them.

(b) Seasonal Unemployment: Seasonal unemployment arises because of

the seasonal character of a particular productive activity so that people
become unemployed during the slack season. Occupations relating to
agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.

(c) Frictional Unemployment: It arises when the labour force is temporarily

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

(d) Cyclical Unemployment: It is also known as Keynesian unemployment.

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

(e) Disguised Unemployment: Disguised unemployment is the most

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

(i) the prevalence of large-scale unemployment in

the urban areas; and

(ii) in the form of growing numbers engaged in

agriculture, resulting in ‘disguised unemployment’.

In disguised unemployment, there is an existence of a very backward

agricultural economy. People are engaged in production with an
extremely low or zero marginal productivity. Since the employment
opportunities in non-agricultural sector are not sufficient, therefore, most of
the workers are bound to work in agricultural sector. This gives rise to the
concept of ‘disguised unemployment’, in which people are unwillingly
engaged in occupations, where their marginal productivity is very low.

THEORIES OF EMPLOYMENT:

The theories of employment are broadly classified into two:

(a) Classical theory of employment

(b) Keynesian theory of employment.

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

Classical Theory of Employment:

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

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

resources, and

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

(a) Full employment:

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

(i) Intervention by the government or private monopoly,

(ii) Wrong calculation by entrepreneurs and inaccurate decisions,

and

(iii) Artificial resistance.

The economy is assumed to be self-adjusting and perfectly competitive economy.

It is the economy in which the relative values of goods and services are
determined by the general relations of demand and supply. The pricing system
serves as the planning mechanism.

(b) Flexibility of prices and wages:

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

Say’s Law:

1. Say’s Law is the foundation of classical economics. Assumption of full

employment as a normal condition of a free market economy is justified by
classical economists by a law known as ‘Say’s Law of Markets’.

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

3. According to the French economist J. B. Say, supply creates its own

demand. According to him, it is production which creates market for
goods. More of production, more of creating demand for other goods.
There can be no problem of over-production.

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

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

6. According to Say, the aggregate supply of commodities in the economy

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

7. According to Say’s Law, there will always be a sufficient rate of total

spending so as to keep all resources fully employed. Most of the income
is spent on consumer goods and a par of it is saved.
 8. The classical economists are of the view that all the savings are spent
automatically on investment goods. Savings and investments are
interchangeable words and are equal to each other.

9. Since saving is another form of spending, according to classical theory, all

income is spent partly for consumption and partly for investment.

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

Basic Assumptions of Say’s Law:

(a) Perfectly competitive market and free exchange economy.

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

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

(d) No intervention of government in market operations, i.e., a laissez faire

economy, and there is no government expenditure, taxation and subsidies.

(e) Market size is limited by the volume of production and aggregate

demand is equal to aggregate supply.

(f) It is a closed economy.

Pigou’s Theory:

1. According to Professor Pigou, the unemployment which exists at any time

is because of the fact that changes in demand conditions are continually
taking place and that frictional resistances prevent the appropriate wage
adjustment from being made instantaneously.

2. Thus, according to classical theory, there could be small amounts of

‘frictional unemployment’ attendant on changing from one job to another
but there could not be ‘involuntary unemployment’ for a long period.

3. According to Professor Pigou, if people were unemployed, wages would

fall until all seeking employment were in fact employed.

4. Involuntary unemployment which was found at times of depression was

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

5. According to Pigou, perfectly elastic wage policy would abolish

fluctuations of employment and would ensure full employment.

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

follows:

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

Criticism of Classical Theory:

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

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

wages.

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

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

5. Classical economists have made the economy completely self-adjusting

and self-reliant. An economy is not so self-adjusting and government
intervention is unobvious.

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

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

the economy.

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

cycles.

Keynesian Theory of Employment:

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

Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on

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

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

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

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

two factors:

(a) Aggregate supply function, and

(b) Aggregate demand function.

(a) Aggregate supply function:

1. According to Dillard, the minimum price or proceeds which will induce

employment on a given scale, is called the ‘aggregate supply price’ of
that amount of employment.

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

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

supply prices.

4. Thus, the aggregate supply price is a schedule of the minimum amount

of proceeds required to induce varying quantities of employment.

5. We can have a corresponding aggregate supply price curve or

aggregate supply function, which slopes upward to right.

(b) Aggregate demand function:

1. The essence of aggregate demand function is that the greater the

number of workers employed, the larger the output. That is, the
aggregate demand price increases as the amount of employment
increases, and vice versa.

2. The aggregate demand is different from the demand for a product. The
aggregate demand price represents the expected receipts when a given
volume of employment is offered to workers.
 3. The aggregate demand curve or aggregate demand function represents
a schedule of the proceeds of the output produced by different methods
of employment.

Determination of Equilibrium Level of Employment:

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

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

3. At ON1 level of employment, the economy is not in equilibrium. Because

the total expected amount is greater than the total amount paid:

OH > OC

4. The equilibrium level of employment is ON2, as at this point the AD curve

intersects the AS curve or the AD is just equal to AS. The amount of
proceeds, i.e., OM which entrepreneurs expect to receive from providing
ON2 number of jobs is just equal to the amount i.e. OM which they must
receive if the employment of that number of workers is to be worthwhile for
the entrepreneurs.
5. If the situation is such that the total amount of money expected to be
received from the sale of output exceeds the amount that is considered
necessary to receive, there will be competition among the entrepreneurs
to offer more employment and thus, the employment will increase. On the
left of N2, AD is greater than AS, i.e., the amount expected to be received
is greater than the amount considered necessary, there will be competition
amount entrepreneurs to employ more labour.

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

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

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

9. Effective demand is that aggregate demand price which becomes

‘effective’ because it is equal to aggregate supply price and thus
represents a position of short-run equilibrium.

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

Effective demand = National income

= Value of national output

= National expenditure

= Expenditure on consumption goods +

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

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

economically advanced countries.

13. According to Keynes, full employment is the level of employment beyond

which further increases in effective demand do not increase output and
employment.

14. At the point of intersection of AS and AD, the entrepreneurs are

maximising their profits. The profit will be reduced if volume of
employment is more or less that this point. Even if the point does not
represent full employment.

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

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

17. In this situation, the economy has not yet reached the full employment
level, and there are still NN’ number of workers unemployed in the
economy.
 18. If the favourable circumstances push the economy and the AD increases
so much that the entrepreneurs now find it worthwhile to employ ON’ men
at the equilibrium point E’, where the economy is in full employment level.

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

20. The root cause of the under-employment equilibrium is the deficiency of

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

Comparison between Classical and Keynes’ Theories:

(a) Equilibrium at full employment:

(i) According to classical theory, the economy can only be

in a state of equilibrium at full employment level. Any deviation from
full employment would be of short period.

(ii) Keynes’ theory is of the viewpoint that an economy can

be in equilibrium even at less than full employment level. There is a
small possibility of full employment in a country.

(b) Macro vs. Micro:

(i) The classical economic theory dealt with individual

aspects of the economy, and relates to microeconomics.

(ii) Keynes’ theory relates to macroeconomics which

studies the economy as a whole.

(c) Aggregates vs. Innumerable decisions:

(i) The classical economic theory studies the economic

system in terms of innumerable decision making units, for example,
producers’ equilibrium and consumers’ equilibrium.

(ii) Whereas, the Keynes’ theory deals with aggregates, for

example, aggregate supply and aggregate demand.

(d) Wages and employment:

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

(ii) According Keynes, lowering wages will reduce the

aggregate income and so effective demand which in turn reduce the
level of employment in an economy.

(e) Interest:

(i) According to classical theorists, interest is the reward

for ‘waiting’ or for time preference.

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

with liquidity.

(f) Rate of interest:

(i) According to classical theory, the rate of interest is

determined by the interaction of savings and investment.

(ii) According to Keynesian theory, the rate of interest is

determined at different levels of income.

(g) Statics vs. Dynamics:

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

economy.

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

dynamic economy.

(h) Full employment theory vs. General theory:

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

(ii) The Keynesian approach is a general theory which has

a very wide application at all situations, i.e., unemployment, partial
employment and near full-employment.

(i) Theory of money and prices:

(i) The classical economists had segregated the theory of

money from the theory of value and output, and dealt with them as if
they are unrelated to one another which is actually not the case.
 (ii) Keynes’ theory is more realistic. He has integrated the
theory of money and prices with the theory of income and
employment in the country.

(j) Budgeting:

(i) Classical economists believed in orthodox finance and

balanced budgets.

(ii) According to Keynes’ a country’s budget should reflect

the financial situation, and should vary in accordance with the
requirements. Keynes has not emphasised on balanced budget,
because there are several developing countries with deficit budgets
dictated by their economic conditions and requirements.

(k) Supply of money:

(i) According to classical economists, increase in money

supply would bring about inflation and should be controlled in order to
avoid the employment less than full employment.

(ii) Whereas, the Keynes’ theory states that an appropriate

increase in money supply would increase employment and output
and does not necessarily bring inflation.

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

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

class of labour.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of

economics. His theory has several names: theory of income and
employment, demand-side theory, consumption theory, and macro-
economic theory. In fact, he has brought about a revolution in economic
analysis, often known as ‘Keynesian Revolution’.

2. Keynes’ theory has completely demolished the idea of full-

employment and forwards the idea of under-employment equilibrium. He
states that employment level in the economy can only be increased by
increasing investment.

3. The new economic tools and techniques developed by Keynes have

enabled the today’s economists to draw correct conclusions on the
 economic situation of a country. Such tools are consumption function,
multiplier, investment function, liquidity preference, etc.

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

5. Keynes has first time introduced a dynamic economic theory, in order

to depict more realistic situation of the economy.

6. He also states the reasons of excess or deficiency of aggregate demand

through inflationary and deflationary gap analysis.

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

types of economic systems.

8. Keynes influenced on practical policies and criticised the policy of

surplus budget. He advocated deficit financing, if that sited the economic
situation in the country.

9. Keynes has emphasised on suitable fiscal policy as an instrument for

checking inflation and for increasing aggregate demand in a country. He
advocated extensive public work programmes as an integral part of
government programmes in all countries for expanding employment.

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

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

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

employment.

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

Criticism on Keynes’ Theory:

1. According to Schumpeter, the Keynes theory is a depression theory,

which has limited applications.

2. Some socialist or communist economists had said that Keynes’ theory is

dead if communism comes. However, even the socialist countries have
strived to raise their national income by using Keynesian theory.
 3. Keynesian theory is not as much dynamic and it may more properly be
called comparative statics.

4. Keynesian theory has ignored microanalysis and is not helpful in the

solution of the problems of individual firms and consumers.

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

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

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

(Extended Criticism):

1. The Keynesian theory is primarily for fighting depression. The

assumptions on which Keynesian theory is based are:

(a) The multiplier, and

(b) Short-term analysis.

2. In the short-term analysis, Keynes assumes that capital equipment,

technology, organisation, labour and their efficiency remains
constant. He thinks that the problems relating to employment in
developed countries arises only on account of the deficiency of demand.

3. But the problem in case of LDCs is to increase capital equipment, to

improve technology and labour efficiency. Solving this problem will take
a long process; it cannot be solved in short-run.

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

5. Most of the LDCs are agriculturists and the Keynesian approach is

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

6. The principle of multiplier does not much work in LDCs. Suppose

new investments are made in the country, increased investment will lead
to the establishment of new factories, workers will get employed, income
will increase, demand will increase, but it does not guarantee the increase
in the supply of goods because there is no excess capacity, and the
supply of productive factors is not elastic. Increased income will be
absorbed in high prices.
Determination of National Income
1. In the short run, the level of national income is determined by aggregate
demand and aggregate supply. The supply of goods and services in a
country depends on the production capacity of the community. But during
the short period the productive capacity does not change.

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

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

(a) Consumption demand, and

(b) Investment demand.

4. Aggregate Demand = Consumption + Investment

i.e., AD = C + I

5. The consumption demand depends on propensity to consume and

income. At a given propensity to consume, as income increases, the
consumption demand will also increase.

6. In the above diagram the 45o line represents aggregate supply line and it
is also called ‘income line’. This income line shows two things:
 (a) Total output or aggregate supply (C + I), and

(b) National income.

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

8. One noteworthy thing about propensity to consume is that it remains

stable or constant during the short period. Because the propensity to
consume depends on the tastes and needs of the people and these do not
change in the short run.

9. Since consumption is more or less stable and cannot be varied, therefore,

variation in NI depends on variation in investment.

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

things:

(a) Marginal efficiency of capital, and

(b) The rate of interest

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

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

13. The MEC depends on two factors:

(a) Replacement cost of capital goods, and

(b) Profit expectations of investors.

14. If we join the investment demand with the curve C of propensity to

consume, we get AD curve C + I in which C represents consumption and I
investment. The distance between propensity to consume curve C and
AD curve C + I is equal to investment.

15. The level of NI will be determined at point at which the AD and AS curves
intersect each other. At this point AD and AS are in equilibrium.
 16. In the above diagram, the equilibrium level of income is OY. At this point
the AD curve and AS curve intersect each other.

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

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

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

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

Equality of Saving and Investment:

1. There is another way of determining the equilibrium level of NI, i.e.,

through equality of savings and investment.

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

3. When at a certain level of NI intended investment by the entrepreneurs is

more than intended savings by the people, this would mean that AD is
greater than total output or AS, i.e.,

I > S or AD > AS

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

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

5. On contrary, when at any level of NI, the investment demand is less than
saving, it means that AD is less than AS. As a result of a decline in
national output, the national income will also reduce.
6. Saving is withdrawal of some money from the income stream. On the
other hand, investment is the injection of money into the income stream. If
the intended investment is more than intended saving, it means that more
money has been injected in the economy. This would increase the
national income.

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

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

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

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

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

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

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

Inflationary Gap:

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

In the above diagram, C + I + G (consumption, investment and government

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

The deflationary or recessionary gap is the amount by which the aggregate

expenditure falls short of the full employment level of national income. It causes
a multiple decline in real NI.

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

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

The economic term ‘consumption’ means the amount spent on consumption at a

given level of income. ‘Consumption function’ or ‘propensity to consume’ means
the whole of the schedule showing consumption expenditure at various levels of
income. It tells us how consumption expenditure increases as income increases.
The consumption function or propensity to consume, therefore, indicates a
functional relationship between the aggregates, viz., total consumption
expenditure and the gross national income. It is a schedule that expresses
relationship between consumption and disposable income.
According to Keynesian theory, following are the factors that influence
consumption:

(a) The real income of the individual,

(b) The past savings, and

(c) Rate of interest.

Average and Marginal Propensities to Consume:

The average propensity to consume (apc) is a relationship between total

consumption and total income in a given period of time. In other words, apc is
the ratio of consumption to income. Thus:

apc = C
Y

WhereC : Consumption

Y : Income

apc : Average propensity to consume

While, the marginal propensity to consume (mpc) measures the incremental

change in consumption as a result of a given increment in income. In other
words, mpc is the ratio of change in consumption to the change in income.

mpc = ΔC
ΔY

Where ΔC : Incremental change in consumption

ΔY : Incremental change in income

mpc : Marginal propensity to consume

the normal relationship between income and consumption is that when income
increases, consumption also increases, but by less than the increase in income.
In other words, in normal circumstances, mpc is less than one. It is drawn as a
straight-line with a slope of less than one. This slope indicates the percentage of
additional disposable income that will be spent. It is assumed that the whole
additional income is not spent, i.e., a certain amount is spent and the remainder
is saved. This can be further explained with the help of following table and
diagram:
 Income Consumptio Saving
n
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55

In the above diagram, OL is the income line and OP is income consumption

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

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

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

In the above diagram, ON represents the saving-income curve. Savings at a

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

Keynes’ Law of Consumption:

Keynes propounded a law based on the analysis of consumption function. This

law is known as ‘Fundamental Law of Consumption’ or ‘Psychological Law of
Consumption’. It states that aggregate consumption is a function of aggregate
disposable income.

Propositions of the Law:

This law consists of three propositions:

(a) When aggregate income increases, consumption expenditure will also

increase but by a somewhat smaller amount.

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

(c) As income increases, both consumption spending and saving go up. An

increment in income is unlikely to lead either to less spending or less
savings than before. It will seldom happen that a person may decrease
his consumption or his savings when he has got more income.

Assumptions:

(a) Habits of people regarding spending do not change or that the

propensity to consume remains the same or stable.

(b) The economic conditions remain normal. There is no hyper-inflation

or war or other abnormal conditions.

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

intervention.

(d) The important characteristic of the slope of consumption function is that

the marginal propensity to consume (mpc) will be less than unity.
This results in low-consumption and high-saving economy.

Implications:

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

(a) Since consumption largely depends on income and consumption

function is more or less stable, it is necessary to increase investment fill
the gap of declining consumption as income increases. If this is not done,
the increased output will not be profitable.

(b) When the income increases, and the consumption are not increased,
there is a danger of over-production. The government will have to step
in to remedy the situation. Therefore, the policy of laissez-faire will not
work here.
 (c) If the consumption is not increased, the marginal efficiency of
capital (MEC) will diminish. The demand for capital will also diminish,
and all the economic progress will come to a standstill.

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

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

(f) This law also explains the unique nature of income generation. If
money is injected into the economic system, it will increase consumption
but to a smaller extent than increase in income. This again is due to the
fact that consumption does not increase along with increase in income.

Factors Influencing Consumption Function:

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

1. Objective Factors:

(a) Distribution of income: It is generally observed that the average and

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

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

(c) Changes in business expectations: Business expectations by affecting

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

(e) Liquidity preferences: Another factor is the people’s liquidity

preferences. If people prefer to keep their income in liquid ford,
consumption is reduced correspondingly.

(f) Substantial changes in the rate of interest.

2. Subjective Factors:

(a) Individual motives to save:

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

unemployment,

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

son’s education, etc.

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

income, etc.

(b) Business motives:

(i) The desire to expand business,

(ii) The desire to face emergencies successfully,

(iii) The desire to have successful management,

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

and obsolescence.

Measures for Raising Consumption:

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

greater.

2. Comprehensive social security measures like unemployment doles, old-

age pension, sickness insurance, etc.

3. Liberal wage policy, and

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

Importance of Consumption Function:

1. Important tool of macro-economic analysis.

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

changes in income.

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

4. It shows the crucial importance of investment.

5. It explains the reasons of declining MEC.

6. It explains the turning points of business cycle.

Post-Keynesian Developments Regarding Consumption Function:

(a) The Ratchet Effect:

(i) Professor Duesenberry says that in matter of consumption, an

individual is not merely influenced by current income, but also by
standard of living in the past.

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

(iii) Consumption as a proportion of income goes up as income increases

and does not fall in the same proportion as the income falls. In other
words, consumption is not reversible. This is known as ‘Ratchet
Effect’.

(b) Demonstration Effect:

(i) The Duesenberry Hypothesis suggests that the consumer

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

(ii) The ‘Demonstration Effect’ determines how much a consumer spent

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

(c) Pigou Effect:

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

(ii) Keynes seems to be agreed that theoretically it is possible to bring

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

(d) Government Consumption:

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

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

(iii) Government may have a vital role in creating employment,

influencing consumption and adjusting saving through fiscal and other
policies.

Theories of Consumption Function:

There are three different economic theories explaining consumption-income

relationship:

(a) Absolute Income Theory: According to Keynes, on average, men

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

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

According to Dussenberry, there is a strong tendency for the

people to emulate and imitate the consumption pattern of their
neighbours. This is the ‘demonstration effect’. The relative
income hypothesis also tells us that the level of consumption
spending is determined by the households’ level of current
income relative to the highest level of income earned previously.
People are then reluctant to revert to the previous low level of
consumption. This is ‘ratchet effect’.

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

This proportionality relationship can be illustrated by the following

diagram:

Income and consumption lines (Y and C) show proportional

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

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

(i) Rate of interest,

(ii) Rates of consumer’s income from property and his personal

effort, i.e., human and non-human wealth, and

(iii) Consumer’s preference for immediate consumption multiplied by

permanent income (Yp).

The permanent income theory really emphasises the important role of

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

(d) Life Cycle Hypothesis: According to Life Cycle Hypothesis, the

consumption function is affected more by consumer’s whole life income
rather than his current income. This view has been put forward by
Modigliani, Brumberg and Ando. The permanent income hypothesis
focuses attention on the income of the consumer earned in recent past as
well as expected future earnings (and wealth). But the life cycle
hypothesis states the consumption function depends upon consumer’s
whole life income. In childhood, the consumer earns nothing but spends
all the same (his parents spend on him); in the middle age, when he
comes to have a family, he earns and spends. But he will be earning
more than he spends. He tries to save enough to maintain himself in his
old age when he will not be able to earn or earn much. Over his life span,
the consumer tries to maintain a certain uniform standard and with that
end in view he organises whole life’s uneven income flows of cash
receipts. In other words, he will arrange his income and expenditure in
such a manner as to maintain a certain standard of living which he
desires.
 The ‘Life Cycle Hypothesis’ seems to be quite realistic and plausible. It
may be noted, however, that this hypothesis emphasises income as
derived from wealth more than cash receipts. It also draws our attention
to the fact that the consumers have to make a choice between immediate
consumption and accumulating of assets for future use.

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

Types of Investment:

1. Gross and Net Investment: Net investment means gross investment

minus depreciation. In the theory of income and employment, investment
means net investment.

2. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or

anticipated investment. Ex-post investment is actually realised
investment, or the investment which is not merely planned but which is
actually invested or implemented.

3. Private and Public Investment: Private investment is on private account

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

4. Autonomous and Induced Investment: Autonomous investment is

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

Induced investment varies with NI. Changes in NI bring about changes in

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

Investment is made by the people as a result of changes in income level or

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

Factors Affecting Investment:

1. Marginal Efficiency of Capital (MEC) or expected rate of profit: MEC

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

2. Rate of interest: The second important factor affecting investment is rate

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

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

4. Technological progress: Technological progress also affects current

level of investment. For instance, a new invention may render the present
capital stock of a firm obsolete and adversely affect its ability to compete.
In this case, further investment will be called for.
 5. Political and security conditions: This factor has become one of the
major important factors that affect the investment, esp. with reference to
under-developed countries including Pakistan. Political instability, poor
security arrangements and society’s negative attitude towards investment
companies can badly damage the investment environment, and the
country can be suffered from poverty and unemployment due to lack of
investment. Countries like Kenya, Zimbabwe, Sudan, etc. are the worst
victims.

Marginal Efficiency of Capital (MEC):

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

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

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule. The MEC

schedule shows a functional relationship between MEC and the amount of
investment in a given type of capital asset at a particular period of time for the
whole economy.
 Investment MEC /
(In Million Rate of Interest
US $) (In %)
200 10
250 9
400 7
750 5
1000 3

In the above diagram, the marginal efficiency of capital is represented by MEC

curve. It slopes downward from left to right which means that as investment
increased its marginal efficiency goes down.

Investment at any time depends on the rate of interest prevailing at that time. If
the rate of interest is 5%, the investment is US $750 million, because, at this
level, MEC is equal to the rate of interest. The MEC represents the investor’s
return and the rate of interest is his cost. Obviously, the return on capital must at
least be equal to the rate of interest, which is its cost. Suppose the rate of
interest goes down to 3%, then it will become worthwhile to invest US $1,000
million. Thus, the MEC and the rate of interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the extent
to which the volume of investment would change consequent upon changes in
the rate of interest. If MEC is relatively interest-elastic, a little fall in the rate of
interest will result in a considerable expansion in the volume of investment. On
the other hand, if the MEC is relatively interest-inelastic, then a considerable fall
in the rate of interest may not lead to any increase in the volume of investment.
Shifts in MEC: As the expectations regarding the prospective yields change, the
MEC will change too and the MEC curve will shift upwards or downwards. It is
illustrated in the following diagram:

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

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

Factors of MEC:

The marginal efficiency of capital depends upon psychological and objective

factors:

1. Psychological Factors: Whenever a firm undertakes an investment, it

estimates its MEC in the light of the experience of the past, existing
conditions and guesses about the future conditions. If the businessmen
are optimistic about the future, they will estimate the MEC higher and if
they are pessimistic about the further business condition, naturally the
MEC will be estimated low.

2. Objective Factors:

(a) MEC and the Market: If the market of a particular commodity is

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

(b) Rate of Growth of Population: MEC is also influenced by the rate

of growth of population. If population is growing at a rapid speed, it
is usually believed that the demand of various classes of goods will
increase. So a rapid rise in the growth of population will increase
the MEC and a slowing down in its rate of growth will discourage
investment and thus reduce MEC.

(c) Technological Development: If inventions and technological

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

(d) Existed Capital Goods: If the quantity of any particular type of

goods is available in abundance in the market and the consumers
can partially or fully meet demand, then it will not be advantageous
 to invest money in that particular project. So in such cases, the
MEC will be low.

(e) Current Rate of Investment: Another influence on the MEC is the

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

(f) Rate of Taxes: MEC is directly influenced by the rate of taxes

levied by the government on various commodities. When taxes are
levied, the cost of commodities is increased and the revenue is
lowered. When profits are reduced, MEC will naturally be affected.
It will be low, if taxes are very high and high if taxes are low.

Multiplier and Accelerator

(Determination of National Income Continued)

THE MULTIPLIER:

Keynes’ Multiplier Theory gives great importance to increase in public investment

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

Kahn’s Employment Multiplier:

Kahn’s Multiplier is known as Employment Multiplier, and Keynes’ Multiplier is

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

Suppose the government employs 300,000 persons on public works and, as a

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

Keynes’ Income or Investment Multiplier:

Keynes’ income multiplier tells us that a given increase in investment ultimately

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

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

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

The multiplier is the numerical co-efficient showing how large an increase in

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

In the following multiplier equation, the relationship between income and

investment is determined through marginal propensity to consume:

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

Where:
(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

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

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

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

Example 1:

mpc is ¾

Initial investment is Rs. 1,000 million

Required:

(a) Multiplier,

(b) Marginal propensity to save,

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

(d) Conclusion.
 Solution:

(a) Multiplier (K):

(b) Marginal Propensity to Save (mps):

(c) Increase in the level of NI:

(d) Conclusion:

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

Example 2:

Calculate mpc, mps and multiplier (K):

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

mpc mps K

4/6 2/6 3

½ ½ 2

¾ ¼ 4

1/7 7
6/7

1 0 α (infinity)*

0 1 1**
*
If the mpc is 1, the mps will
be zero and the multiplier will be infinity; and a given dose of investment (let say, Rs. 1,000
million) will automatically create full employment.

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

Keynes multiplier theory is also very helpful in the determination of national

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

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

(a) The AD-AS Approach, and

(b) The Saving Investment Approach

(a) AD-AS Approach: For explaining the determination of level of income in

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

In the above diagram, the national income is determined at the point

where AD curve (C+I) cuts the AS curve (C+S), i.e., at E. The multiplier
effect is also shown in this diagram. The curve C represents the mpc
which is assumed to be ½. That is why the slope of curve C is 0.5. Since
the AD curve (C + I) cuts the 45o angle line at E, OY1 is the level of income
determined. If now investment is increased to EH (ΔI) we can find out the
increase in income (ΔY). As a result of investment EH, the AD curve shifts
upwards to C + I’. This new AD curve cuts the AS curve (45o angle line) at
F, so that OY2 income is determined. Thus, income increases by Y1Y2 as
a result of investment increase of EH, which (Y1Y2) is double of EH.
 It is clear, therefore, that the multiplier is 2. It is also calculated as below:

(a) Saving-Investment Approach: In order to simplify the analysis of income

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

The above diagram shows the multiplier effect of an increase in

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

Limitations of Multiplier:

(a) Efficiency of production: If the production system of the country cannot

cope with increased demand for consumption goods and make them
readily available, the incomes generated will not be spent as visualised.
As a result, the mpc may decline.

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

(c) Multiplier period: Successive doses of investment must be injected at

suitable intervals if the multiplier effect is not to be lost.

(d) Full employment ceiling: As soon as full employment of the idle

resources is achieved, further beneficial effect of the multiplier will
practically cease.

Leakages of Income Stream and Their Effect on the Multiplier:

As we know that as income increases, consumption does not increase to the

same extent or proportionately, because a part of the income is saved. The part
of the income that is saved is as if a leakage from the flow of income stream.
These leakages obstruct the growth of national income. In the absence of these
leakages, mpc would have been unity. The consumption expenditure would have
increased 100 per cent of the increase in income and there would have been full
employment. The following are the principal leakages:

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

(b) Idle cash balances: It is well known that people keep with them ready
cash which is neither used productively nor in purchasing consumer
goods. Keynes has mentioned three motives for holding ready cash for
liquidity preference, viz., transactions motive, precautionary motive and
speculative motive. This means that the re-spent part of income goes on
decreasing. In this way, a part of the initial expenditure leaks out of the
income stream.
 (c) Imports: The part of the money spent by country for importing goods also
leaks out of the country’s income stream. It does not encourage or
support any business or industry in the country. This is specially so if the
imports do not help the trade and industry of the country or if they are not
used for export promotion. The net import is a leakage.

(d) Purchase of existing securities: Some people purchase securities

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

(e) Price inflation: Inflationary situation is also responsible for leakage. In

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

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

Importance of Multiplier:

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

1. The multiplier principle focuses on the importance of public

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

2. During the days of depression, the private entrepreneurs are discouraged

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

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

4. When the government makes investment in public works to fight

depression and unemployment, private investment is encouraged on
account of the operation of the multiplier. The confidence of private
investors is restored, and hence helps in further removing the economic
depression of the country.

Assumptions of Multiplier:

The following certain essential conditions / assumptions for the operation of

multiplier:

1. The supply curve of output should be elastic. In other words, when

demand for certain goods or services increases, its supply can be
increased without much difficulty.

2. There is excess productive capacity in consumer goods industries,

so that the supply of goods can be easily increased when demand
increases.

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

elastic.

4. There should be ‘involuntary unemployment’. That is, there are people

who want work at the prevailing wage rate, but are not getting it.

Criticism on Keynes’ Multiplier Theory:

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

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

3. Another condition of Keynes’ theory is that there should be ‘involuntary

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

4. According to critics, this theory can only be applied to economically

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

THE ACCELERATOR:

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

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

According the principle of accelerator, when income increases, people’s

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

(Figures in Rs. ‘000)

Years Demand Required Replacemen Net Gross
Stock of t Investment Investment
 Capital Cost
5 machines 1 machine
2007 500 0 machine 300
1500 300
5 machines 1 machine
2008 500 0 machine 300
1500 300
8 machines 1 machine 3 machines
2009 800 1200
2400 300 900
10 1 machine
2 machines
2010 1000 machines 300 900
600
3000
10 1 machine
2011 1000 machines 300 0 machine 300
3000
8 machines 1 machine –2
2012 800 2400 300 machines – 300
600
Cost per machine: Rs. 300,000 per machine

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

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

Assumptions of the Accelerator:

1. Under the principle of accelerator, it is assumed that there is no excess

capacity existing in the consumer goods industries. No machines are
lying idle and shift working is not possible.
 2. In capital goods industries, it has been assumed that there is an
existence of surplus capacity. If there is no excess capacity in capital
goods industries, increased demand for machines could not lead to
increase in the supply of machines.

3. Output is flexible. The machine-making industry or capital goods

industry can increase its output whenever desired.

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

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

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

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

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

Phases of Trade Cycles:

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

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

(i) The volume of production and trade shrinks,

(ii) Unemployment increases,

(iii) Overall prices fall,

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

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

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

invest,

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

(viii) Interest rates decline all round,

(ix) Practically, all construction activity – whether in buildings or

machinery, comes to an end.

(b) Recovery: This phase is also known as ‘expansion’. The depression

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

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

(i) A large number of production and trade,

(ii) A high level of employment and job opportunities in sufficient

amount to permit a good deal of labour mobility,

(iii) Overall rising prices,

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

(v) A large expansion of credit and borrowing,

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

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

(viii) Operation of the economy at optimum capacity.

(d) Recession: It is a sharp slow down in economic activity, but it is different

from depression or slump which is more severe and prolonged downturn.

Just as depression created the conditions of recovery, similarly, the boom

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

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

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

The trade cycle is depicted in the following diagram:

Theories of Trade Cycle:

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

One of the famous climatic theories is ‘Jevons’ Sunspot Theory’.

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

(b) Psychological Theory: According to psychological theory of trade cycle,

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

(c) Under-Consumption Theory: According to under-consumption theory,

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

(d) Monetary Theory: R.G. Hawtrey was a firm believer in monetary theory.
According to him, variations in flows of money are the sole and sufficient
determinants of business activity and account for alternating phases of
prosperity and depression. When the business prospects are good, the
banks freely extent credit facilities. The businessmen go on expanding
their business, entering into further and further commitments with the
banks. A huge superstructure of credit is built up and this superstructure
can be maintained by cheap money conditions. But a point reached,
when banks think that they have gone a bit too far in the matter of
advances. Probably their reserve ratio fallen dangerously low. In self-
defence, they apply the brake, curb further expansion of credit, and begin
to recall advances. This sudden suspension of credit facilities proves a
bombshell in the business community. Businessmen have to sell their
stocks in order to repay. This general desire for liquidity depresses the
market, and may even led to bankruptcy for certain firms.
(e) Over-Investment Theory: According to over-investment theory,
fluctuations in the rate of investment are the main causes of trade cycles.
Investment becomes excessive during the boom. That investment during
the boom is borne out by the fact that investment goods industries expand
faster than consumption goods industries during the upward phase of the
cycle. During the depression, investment goods industries suffer more
than consumption goods industries.

(f) Keynes’ Theory: According to Keynes, the business cycle is a rhythmic

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

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

due to:

(i) changes in the prospective yields, and

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

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

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

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

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

(All figures in billion Rs.)

Autonomous Total
Investment Induced Induced Deviation of
Period (Deviation Consumption ΔC Investment Income from
from C = Y × mpc I = ΔC × Accelerator Base Period
Base Period) Y=C+I
(1) (2) (3) (4) (5) (6)
Rs. Rs. Rs. Rs. Rs.
0 0 0 0 0 0
1 10 0 0 0 10
2 10 6.7 6.7 13.4 30.1
3 10 20.0 13.3 26.6 56.6
4 10 37.8 17.8 35.6 83.4
5 10 55.6 17.8 35.6 101.2
6 10 67.5 11.9 23.8 101.3
7 10 67.6 0.1 0.2 77.8
8 10 51.8 -5.0 -10.0 51.8
9 10 34.6 -5.0 -10.0 34.6
10 10 23.0 -5.0 -10.0 23.0
11 10 15.4 -5.0 -10.0 15.4
12 10 10.2 -5.0 -10.0 10.2
13 10 6.8 -3.4 -6.8 10.0
14 10 6.6 0.1 0.2 16.8
In the above table, the mpc is assumed to be 2/3, accelerator to be 2 and there is
one-period lag. One-period lag means that an increase in income in one period
induces an increase in consumption in the succeeding period. In the above
table, an autonomous investment of Rs.10 billion is added up each period. In the
first period, an autonomous increase in investment of Rs.10 billion gives rise to
an increase in income of only Rs. 10 billion. It does not induce increase in
consumption in period 1, as we have assumed a lag of one period.

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

Income = Autonomous Investment + Induced Investment + Induced Consumption

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

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

As there is a limit to the increase in NI set by the full employment ceilings,

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

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

Thus, under the combined effect of multiplier and accelerator, NI or output

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

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

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

(h) Kaldor’s Contribution to Modern Trade Cycle Theory: Kaldor has also
used a modified and more realistic form of accelerator and investment
function in trade cycle theory. According to the conventional concept of
accelerator, the investment or demand for capital depends upon the rate
of change of the level of economic activity (i.e., the level of income and
employment). Whereas, according to Kaldor’s point of view, the demand
for investment or capital goods depends upon the level of activity rather
than the rate of change of that level. It should be remembered that in
Kaldor’s analysis the level of activity means the level of national output,
income and employment. In Kaldor's model of trade cycle, the capital
accumulation by raising the productive capacity affects the investment
decisions of the entrepreneurs. The effect of the capital accumulation on
the investment decision of the entrepreneurs makes the investment
function non-linear in the real world (that is, investment-incomes or
investment-employment curve is not a straight line). Through this non-
linear investment function, Kaldor has explained the conditions of stability
and instability of an economy, which are described as below:
In his theory, Kaldor has used ex-ante concepts of saving and investment,
i.e., ex-ante saving and ex-ante investment. Ex-ante investment means
planned net addition to the stock of fixed capital and inventories of goods.
This ex-ante investment differs from the realised, actual or ex-post
investment by the amount of unintended accumulations or dis-
accumulations of inventories of goods which arise due to difference
between the planned and realised sales goods. Ex-ante saving means
the savings planned by the people for a period if they had accurately
forecast their incomes. Therefore, unexpected changes in the level of
income will make the realised or ex-post saving different from the planned
or ex-ante saving.

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

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

In the above diagram, linear investment and saving function is shown.

The investment curve II is steepier than saving curve SS. The two
functions intersect each other at the equilibrium point C, at which the
income is determined to be Y0. But this equilibrium between ex-ante
saving and ex-ante investment is unstable, because, if once this
equilibrium is disturbed, the economy will move either towards hyper-
inflation or towards collapse.
Now consider the following diagram for a stable condition:

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

(ii) Non-Linear Saving and Investment Functions: The following figure

describes the non-linear saving and investment functions:
In the above diagram, the shapes of the investment curve II and the
saving curve SS are not straight. They are cyclical and fluctuating. Both
the functions intersect each other at three different points, i.e., A, B and C.
Equilibrium at point B is quiet unstable. Above point B, investment
exceeds saving and, therefore, once as a result of some disturbing
investment exceeds saving, the income (i.e., the level of activity) will go on
moving upward till point C is reached, and below point B saving exceeds
investment and any disturbance which moves the system below point B,
the level of activity or income will go on moving downward till point A is
reached. Above point C, saving exceeds investment and, therefore, if the
system does above point C, it will come back to it. Therefore, the system
is stable upward. On the other hand, below point C, investment exceeds
saving and, therefore, any disturbance which sends the system below
point C, it will be corrected by the return to the point C. Thus, the level of
activity or income at point C is also stable downward. It, therefore, follows
that the level of activity or income is in stable equilibrium at point C.

Point A also represents a stable equilibrium. Above point A, saving

exceeds investment and below point A, investment exceeds saving, which
means that the level of activity will tend to return to point A if any
disturbance, causing movement either upward or downward, occurs. It,
therefore, follows that both the extreme points C representing boom period
and A representing depression, are stable equilibrium points. This means
that economy should tend to be in stable equilibrium at either a very high
or a very low level of activity. This is, however, a quiet unlikely and
improbable result since in the real world the economy is not found to be
stable at these extreme levels of activity. This trade cycle is also known
as ‘self-generating trade cycle’.
Kaldor has explained this ‘self-generating trade cycle’ through the shifts or
changes in the investment function and saving function. According to
Kaldor, when the level of investment is very high, production of consumer
goods increases and as a result both consumption and saving increase.
This means that saving function SS will shift upward when the high level of
activity is reached. Besides, with a high level of investment the
opportunities for further investment may become temporarily restricted
and as a result of this investment function curve II tends to shift
downward. Thus, when the economy is at a high level of activity, i.e., at
point C, the saving function curve SS tends to move upward and the
investment function curve II tends to move downward and consequently
the point C tends to move down and point B tends to move up as in the
following figure (a), until they meet each other at the combined point BC
as in figure (b). at the combined point BC, the economy is in unstable
downward position. The contraction in the level of activity will continue
further until point A is reached.

The economy will not go below point A, because, saving and investment
are in stable equilibrium at this point. But according to Kaldor, reversal
movement of the cycle will start because the investment function curve will
shift downward. Given the level of activity at A, investment in machines or
equipment may not be sufficient to cover the depreciation. This creates
opportunities for more investment, which causes the investment function
curve to move upward. With the level of activity A, as the investment
function curve II moves upward relative to the saving function curve SS,
the point B will separate from point C and tend to move towards A as in
the following figure 7 (a). The investment function curve II will go on
shifting upward till combined point AB is reached in figure 7(b).
 But the combined point AB is unstable upward, for above combined point
AB, investment exceeds saving. As a result, the expansion in the level of
activity will not stop at point AB but will continue until once again point C is
reached. Now, with the point C representing again the situation of boom
having been reached, the investment opportunities once again will
become restricted and as a result the movement of contraction in the level
of activity will start once again and the whole process of contraction and
then expansion will be repeated again. This is how Kaldor shows that the
occurrence of trade cycles in a free market economy is self-generating.

Policy for Trade Cycle:

(a) Monetary Policy: A country must always formulate and follow an

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

The bank credit policy involves two types of controls, i.e., the qualitative and the
quantitative. The quantitative control is aimed at general tightening or easing of
the credit system as the situation may demand. It is exercised by influencing the
reserves of the banks. The qualitative or selective control seeks to regulate
particular type of credit. Its object is to stimulate, restrict or stabilise bank
advances for specific business schemes.
 But there are limitations of monetary policy relating to bank rate and open
market operations. Its success will depend on how far certain
assumptions are true. For example, how far the various member of the
banking system are prepared to accept the lead given by the central bank;
how far the banks can make their borrowers use their credits for purposes
for which such credits have actually been created; further, how far
monetary causes are responsible for the economic fluctuations; and still
further, and most important, whether the business community will adjust
their investment exactly in accordance with the altered rates of interest.

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

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

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

Thus, fiscal policy, which is also known as the contra-cyclical management of

public finance, may be operated both through public revenues and public
expenditure.

(c) International Measures: So far we have discussed individual national

efforts at economic stabilisation. But trade cycle is an international
phenomenon and no country is hermetically scaled from the rest of the
world. In fact, this international aspect creates complications and
makes crisis control all the more difficult.

The measures which are suggested to be adopted on an international scale are:

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

An international investment control for developing backward regions would help

in raising the standards of living of their people and thus reduce the inequalities
in the standard of living of different peoples. Such reduction in those inequalities
is bound to strengthen the forces of stabilisation.