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U N I T- I

INTRODUCTION

CHAPTER

1

INTRODUCTION

TO

Economic decisions of individual
households or firms are guided by their
rational behaviour in a given market
situation. Here, in our pursuit to study
the logic of consumption or production
decision, we limit our analysis to the
determinants of choice and preferences
of households or firms, respectively.
Though the study of individual decision
units is a necessary aspect of our
enquiry into the rationale of their
economic behaviour, it is by no means
a sufficient condition for a complete
study. So, there has to be another level
of study in which the enquiry is
directed to understand the general
economic conditions in the economy. It
is this distinction between the exercises
to understand and interpret the
behaviour of individual units on the one
hand and the general state of the
economy on the other establishes the
basic difference between the subject
matter of microeconomics and
macroeconomics.
Now, what is macroeconomics all
about? In simple terms it is the study
of the economy as a whole. Everyone is
interested in knowing what is

MACROECONOMICS

happening in the economy. Perhaps, it
is the concern about the rate of
inflation, level of unemployment, decline
in the agricultural and industrial
output, fluctuations in business
activities, accumulation of foreign
exchange reserves, capital market
changes, recession in the world
economy and so on.
These are macroeconomic events
that engage the attention of governments, economists, entrepreneurs and
even ordinary people, as all of them
receive the impact of these
macroeconomic events. To understand
the forces behind the overall economic
performance, we need concepts and
theoretical frameworks and empirical
measurements to assess performance
in the given reference year. The subject
of macroeconomics accomplishes
this objective.
Macroeconomic concepts are not
often simple and direct; on the contrary,
in microeconomics concepts such as
price, profit, cost, quantity, etc. are
intuitive and easy to understand. So,
there is nothing difficult in
comprehending a basket of apples as

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INTRODUCTION

TO

MACROECONOMICS

an output and its price. But in
macroeconomics, we have a variety of
problems in the stage of definition itself.
While it is relatively easy to define and
measure individual’s income, it is not
so in the case of aggregate income and
output. The scope of macroeconomics
could be further made clear if we
attempt to distinguish it from
microeconomics.
Microeconomics and
Macroeconomics
In microeconomics we study the
individual household, individual firm
or small groupings of firms. If we study
one automobile firm or the automobile
industry it is microeconomic approach;
but when we take up the entire
manufacturing sector, we are in the area
of macroeconomics. In this sense,
macroeconomics
studies
the
aggregates of an economic system. We
need to make a separate study of these
economic aggregates because what is
true at the individual level need not be
true at the aggregate level.
Just imagine a case wherein a
single farmer produces paddy or wheat.
In terms of individual rationality, this
farmer has to produce as much output
as possible to reach the maximum level
of profit. This is perfectly logical insofar
as an individual farm is concerned. But,
what if all the farmers produce
maximum output in their respective
farms? For the economy as a whole, this
would create more problems than
good. There may be excess supply of
paddy or wheat relative to demand.
Government will have to intervene, as it

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happens in India, to take away a part
of the output to prevent prices falling
to an unremunerative level for the
farmers. Therefore, what is a good and
proper decision at the individual level
need not be so at the aggregate level. It
is to understand this difference that a
separate study of economic aggregates
is designed in macroeconomics.
Given all the aggregates such as
total employment, output, income, etc.
it is essential to find the
interrelationship between them. Does
an increase in national output mean an
increase in employment? Can the value
of foreign exchange rate be fixed in
terms of domestic country’s prices? We
will obtain meaningful explanations for
the working of the economy only if we
systematically work out the
interrelationships between the
aggregates. Hence, it is said that
macroeconomics is also the study of
relations between economic aggregates.
Basically, macroeconomics is concerned
with aggregate level of output, income
and spending for all goods and services.
In contrast, microeconomics deals
with output of individual firm and with
the spending by a single household.
Microeconomics is primarily concerned
with the allocation of resources by a
single firm or household.
Whatever microeconomics takes as
given is what macroeconomics considers
as the prime variable, whose size and
value are to be determined.
Alternatively, what microeconomics
takes as variable is considered to be
given in macroeconomics. For instance,
aggregate output of the economy is
taken as given in microeconomics but

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for example. Consider our example of a farmer given earlier. He is primarily concerned with his own output in his farm. Similarly. macro analysis assumes its importance. We seek to explain economic behaviour of individual units in the context of the state of the economy. On the other hand. macroeconomics takes the distribution of output. there is an inevitable interlink between these two major branches of economics. Similarly. as given. aggregate savings and investment are usually influenced by or a function of the pattern of savings at the micro level. That is. the twin areas of income deter mination and stabilisation and growth of the economy for m the core of macroeconomics. microeconomic variables may exert their influence on macroeconomic variables. The same thing is true of a single manufacturing firm as against the aggregate manufacturing output. which was the ruling doctrine then. it considers only the state of the aggregate output of paddy or wheat and not that of any individual farmer. Each of them attempts to focus its attention on one aspect that the other does not. when government decides its policy of procurement. An individual farmer is hardly conscious of the aggregate output of paddy or wheat. In such a context. 1 + namely households and firms. 1936) in which he questioned the basis of the then existing macroeconomics of the Classical School. Which branch of economics assumes primacy and receives maximum attention of economists depends on whether we need a study of the ‘part’ or the ‘whole’. For instance. The consumption plans of households for instance cannot be independent of the taxation of personal income and commodities. micro and macroeconomic analyses are not mutually exclusive categories. did not provide an explanation for a major John Maynard Keynes published the book General Theory of Employment. it is not always so in practice.+ + INTRODUCTORY MACROECONOMICS 4 in macroeconomics aggregate output is an important variable. + . Interest and Money (Macmillan: London. but in microeconomics it is an important variable. Individual rationality in economic behaviour is an important area of study insofar as we are concerned with demand and supply forces in the market. Emergence of Macroeconomics Interest in macroeconomics deepened after the emergence of the ‘Keynesian Revolution’. a microeconomic decision by an individual unit has to necessarily have a macroeconomic context. While it is the price system and resource allocation that occupies the centre stage in microeconomics. in the formulation of policies for arresting fluctuations in the economy’s performance and for attaining higher growth. 1 In the pre-Keynesian economic theory there was no recognition of ‘economic crises’. Both areas of economic analysis are interdependent. This is because the Classical economics. Therefore. Although microeconomics and macroeconomics areas seem to be rigidly distinct. Similarly.

and that the ‘shocks’ (that is. We may now embark upon learning macroeconomics. 2. This is the starting point of the present day macroeconomic approach. There are many variants of Keynesian approach as the subject of macroeconomics evolved since Keynes’ contribution. EXERCISES 1. which is applied extensively in policy-making. 4. + What is microeconomics? What do you understand by macroeconomics? Distinguish between micro and macroeconomics. disturbances in markets) are only temporary. This contention of the Classical economists was challenged when the Great Depression occurred in 1929. Classical economists strongly believed in the ‘automatic adjustment’ of the markets so that the system will always be in equilibrium. Give examples of macroeconomic variables.+ + INTRODUCTION TO MACROECONOMICS setback to the economy. + . 3. The system failed to automatically correct the crisis situation and therefore the failure of the Classical doctrine paved 5 the way for Keynesian theory. concentrating on the Keynesian approach to the structure and working of the macro economy.

+ UNIT-II NATIONAL INCOME AND RELATED AGGREGATES : BASIC CONCEPTS AND MEASUREMENT + .

1 Important decisions concerning savings. At the macro level. This is the basic purpose of national income accounting as it renders possible a set of procedures for measurement of income and output at the aggregate level. An individual unit such as a Household or a Firm maintains its own accounting information since it is interested to know its financial position at the end of an accounting period. Accounting is believed to be a necessary exercise for any economic unit to know its performance. output. National income accounting facilitates the measurement of macro aggregates for a given economy. as pointed out earlier. exports and imports and so on. deals with the study of aggregates expressed in terms of aggregate income.+ + CHAPTER 2 STRUCTURE OF THE MACRO ECONOMY : CIRCULAR FLOW OF NATIONAL INCOME Macroeconomics. Accounting for transactions by individual units is relatively a less complicated and a simple process as compared to macro economic accounting of aggregate output and An accounting period or a financial year often does not coincide with a calendar year. expenditure. for example. 2005. April 1. This means that we are. a financial year refers to. Ordinarily. On the basis of this appraisal national governments have to formulate their policy programmes to maximize the welfare of people. In order to determine the actual performance level of the economy. employment. 2004 to March 31. + . 1 + investment and tax payments are all made by the unit after an analysis of the accounting information available to it. accounting assumes an even greater significance as the information is used for a review of the economy’s performance during the year under study. we need to follow a framework of measurement procedures to find these aggregates and eventually we must interpret the macroeconomic behaviour in terms of movements in these aggregate measures. measuring the macroeconomic activities in the economy for a particular year. in fact.

The conceptual basis of measurement of national income begins with a depiction of the interrelated manner in which economic activities are organised in an economy. Primarily. the national income data may be viewed as a monetary manifestation of material results of human activity in the economy. They may be stated as follows: 1. Uses of National Income Accounting There are some principal uses of national income accounting. analyse and interpret the working of the economy as well. wealth is a stock concept. 2. This may be distinguished from stock variable which means that there is no change over time. National income accounting helps to find out structural changes in the economy. Hence. For example. is to provide an objective basis of evaluation and review of policies under implementation. It is not adequate to merely look at the macroeconomic aggregates but it is also equally important to learn the techniques of measuring these aggregates. They provide standards by which economic achievement of policies could be partly judged in modern times. distribution of income and actual composition of national income over time.INTRODUCTORY MACROECONOMICS 8 income for the economy as a whole. National income accounts facilitates comparison of output among nations. national income accounting has evolved as a branch of study in its own right. Income and product are flow concepts. 6. 2 3. national income accounts data not only help us to measure macroeconomic aggregates but also enable us to understand. National income statistics indicate the specific contributions of individual sectors and their growth over time. . National income accounting provides the information for assessment of the economy’s strengths and failures. National income statistics enable comparisons to be made in respect of standard of living. National income accounting shows as to how the national income is shared among the various factors of production. This is precisely the reason why the road map to the subject of macroeconomics begin with a study of national income accounting. This Flow refers to change in an economic variable over time. 5. Structure of the Macro Economy Circular flow2 of macroeconomic activity National income accounting calls for an understanding of the structure of the macro economy. It is a rather difficult and complex procedure to quantify the macro variables for accounting purpose. Hence. is to identify specific economic achievements of a country and the second. there are two basic functions of national income accounting: the first. 4. Therefore. A pictorial illustration of this interdependence between the major sectors of economic activity is called the circular flow of income and product.

We shall now explain this two-way process of mutual dependence for different sectors of the economy. Therefore.STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING simply means that every economic decision of a sector is in response to that of another. there should not be any kind of intervention by the Government in economic activities. this table was not explained by Adam Smith or those belonging to the classical school of economics. Prominent among the Physiocrats was Francois Quesnay who propounded what is called the ‘Tableau Economique’ in 1758. is an intangible product (such as advertising) that has economic value. macro economy is in effect a system of interrelationships between the decision-makers in every sector of the economy. the seller or producer receives the same amount that the buyer or consumer spends. . Physiocrats strongly believed in the existence of a natural order to guide the working of the economy and hence according to them. thereby causing a circular flow. 3 A good is a tangible object (such as a can of fruit juice or a television) that has economic value. So. the output or product or real flow from the seller to the buyer necessarily creates the income or payment or money flow from the buyer to the seller. It was Karl Marx who rediscovered this table in the mid-19th century. This Clip 2. This economic table contains the concept of circulation of wealth and a schematic presentation of the distribution of agricultural output between all classes of society. and 9 (b) Goods and services3 flow in one direction and money payments to acquire these. Though this economic table was recognised as the ‘crowning achievement’ of Physiocrats.1 Circular Flow of Income and Product The inspiration for the exposition of macro economy through a Circular Flow of Income and Product appears to have originated from the writings of Physiocrats – a group of French economists who lived in 18th century. flow in the return direction. They advocated the policy of Laissez faire which means non-interference or minimal interference of the governments in trade and other economic activities and accorded primacy to agriculture as such. The circular flow of income involves two basic principles: (a) In any exchange process. on the contrary. A service.

market for factors of production – Factor market.INTRODUCTORY MACROECONOMICS 10 would be a helpful pre-requisite to understand the concepts used in the accounting of national income as such. interest for capital. That is. Households and Firms. whatever the Firms produce. sell 4 goods and services thus produced to the Household sector for its consumption. – Households spend their entire income on consumption. and second. First. – There are only two sectors in the economy. namely. This type of interaction between Firms and Households can be described as the real flows. Consumer goods can further be classified into ‘durable’ and ‘non-durable’ variety depending upon whether they have short or long span of life in their use to the consumers. let us make the following assumptions with regard to a simple economy with only two sectors of economic activity. Firms pay the Households in the nature of wages for labour services. The Firms. Such an economy as described above has two types of markets. Firms may produce either producer goods (capital goods used for making other goods) or consumer goods that is. capital and entrepreneurial ability) and sell them to the Firms that produce goods and services. using these factor inputs. – Firms sell all that is produced to the Households. – There is no intervention of government or foreign trade. as it involves flow of goods and services. This income. These are called factor payments by Firms and factor incomes by Households. is used by Households to incur expenditure on buying consumer goods and services produced by firms. labour. goods meant for only consumption as such. market for goods and services – Product market. – Households supply factor services to Firms. rent for land and profits to entrepreneurship. – Firms hire factor services from households. Circular Flow in a Simple Two-sector Model To begin with. (ii) Exchange of goods and services between Households and Firms in response to acquiring factor services from Households corresponds to flows of income and expenditure of these two sectors. A washing machine or an air-conditioner may be called durable good while food items will fall under the category of non-durable or perishable good. Therefore. in turn. is consumed by the Households. as they do not last long. The economic interdependence between Households and Firms in this simple economy can be observed as follows: 4 (i) Household sector has the endowment of factors of production (land. in turn. .

Consumption expenditure of Household sector = Income of Firm sector 4.STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING This flow of money payments and expenditure can be described as money flows. FACTOR MARKET Fig 2. we can recognise two real flows and two money flows.1).1: The Circular Flow of Income in a Two-sector Economy . in the case of our simple economy: 1. o r p i nc ome est+ = rent +wages+ i nte r : lan d. in the circular flow diagram (Fig. Factor Payments by Firms = Factor Incomes of Household Sector 3. capita l. So. 2. As a result we can derive the following. Total production of goods and services by firms = Total consumption of goods and services by Household Sector 11 2. Hence. Real flows of production and consumption of Firms and Households = Money flows of income and expenditure of Firms and Households enditure on fin = Exp al g t u ood tp u a n d s sa servic good fo l a e o nd s in F e u se l a Mo es ne y ic rv V PRODUCT MARKET Firms or sh i ct Fa p Households Se rvi ce s r eu n e r r ep t n s To e fit ta l labour.

thanks to the operations of financial institutions and markets. which becomes injection into the circular flow. we have not considered the role of saving and investment. Financial institutions are primarily intermediaries between savers and investors. which constitutes a leakage from the circular flow of income. The saved amount is made available in the financial system. Firms are net borrowers since they have to finance new investment in plant and equipment.2. Circular Flow of Income with Financial System A wide variety of financial institutions and markets constitute the financial system 5 in our economy. they neither have a surplus nor deficit). So far. But we cannot dismiss the Here we assume that Households and Firms save part of their income. This is possible due to generation of personal savings. leakage is equal to the injection. which is the difference between household income and consumption. Therefore. Financial system is therefore very important to the working of the modern economy. enable funds transfer from ultimate lenders to ultimate borrowers. Financial institutions. understanding the macroeconomic activity will be incomplete without the inclusion of financial system in our circular flow model. or lenders and borrowers. that is. All lendings and borrowings are channelled through the financial system. in our presentation of circular flow of income. They are specialise in their respective areas of financial function. Development economists point out the significance of financial development of an economy as a concomitant outcome of economic development. But it is sometimes believed that money and finances are only a cover over the production of goods and services. Firms pay dividend and interest for the sums they have borrowed from the financial markets in the form of shares. Once we relax this assumption a financial system to which 5 INTRODUCTORY MACROECONOMICS Households and Firms can lend and from which they can borrow would become relevant. This perpetuates the circular flow between the two sectors.12 This simple circular flow highlights the following interrelationships between: – Factor Market and Product Market – Output flow and Income flow – Business production and Consumer spending Each sector is seen in its dual role: that of the buyer and seller. Saving and investment process create better prospects for capital formation. So long as lending is equal to the borrowing. the circular flow will continue indefinitely (Fig. bonds and public deposits. Firms borrow for purposes of investment. Households are the net lenders.2). through their role of intermediation. . Financial institutions pay interest to the savers as their funds are placed with them for a period of time under a contract. This is mainly due to the reason that we have assumed that the two sectors – Households and Firms are balanced spenders (that is.

Other flows include tax payments by households to government and transfer payments by governments to households. Circular Flow of Income with Government6 Whatever has been presented in the foregoing section leads us to the conclusion that under the two-sector model. Finance as some economists have held. Economic interrelationships between Households and the Government on the one hand and Firms and Government on the other are very important from the point of view of the role of Government as regulator and as an agent of promoting general welfare of the people of the country. In order to make the analysis simple.2: Circular Flow of Income in a Two-sector economy with Financial System funds flow between sectors as unimportant. All the changes which are necessitated by inclusion of Government sector are shown in Fig. the value of total output flow in our simple economy is equal to the total value of factor incomes and the value of personal consumption flow. Government purchases goods and services from Firms and labour services from Households.3.STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 13 PRODUCT MARKET of final goods and s ervi value y e ces n o ds o o a g n r d e M s m e u r vice ons s al c n i F Savings Savings Financial System Firms Households Borrowings Borrowings Factor Se rvi ces Factor Paymen ts FACTOR MARKET Fig 2. Let us now expand the two-sector model and obtain a three-sector model with the 6 inclusion of the Government sector. is only a ‘lubricant’ that makes the economy to work smoothly. Government collects Government purchases of goods and services are included in the circular flow. now onwards we will see only monetary flows. . 2.

Home economy enjoys a trade surplus when there is excess of exports over imports. scholarships. This import and export of goods and services ultimately decide what the domestic economy gains or loses in the international trade. The government makes transfer payments to the Households in the form of social security.7 Circular Flow of Income with External Sector We now need to study the international dimension of macroeconomic activity because international economic environment affects output and employment in the domestic economy.8 The four -sector model of the economy demonstrates the overall macro economic condition of income and output in the following identity: All taxes are leakages and all government expenditures are injections into the circular flow. The domestic economy and the rest of the world are connected through international trade and capital flows. etc. Note that imports are leakages and exports are injections into the circular flow of income in the economy. subsidies are given to small industries.4). In India. The external sector is also called the Rest of the World (ROW) sector and this 7 8 is connected with circular flow of domestic economy (Fig.INTRODUCTORY MACROECONOMICS Savings ngs Borr owi T Su a bs m er n s ice rv me nt se Borrowings Financial System Pay ym Firms e nt s T ra f ns T fer ax Pa es ents Savings Pa ym s r cto a F gs vin s s xe die i Sa G ov nt Government Sector s ase h c r Pu or e 14 Households Borrowings Co e nsu ur mpt i on Expend it Fig 2. 2. and other priority sectors of our economy. it suffers a trade deficit when the opposite happens.3: The Circular Flow of Income in a Three-sector Economy taxes from Households and Firms in order to finance its expenditure. . It also gives subsidies to the Firms for various purposes. export units. One country’s exports are another country’s imports.

4 : The Circular Flow of Income in a Four-sector Economy Y ≡ C + I + G + (X – M) Producing sectors Wherein G = Government Purchases Y = Income or output C = Private Consumption Expenditure on Consumer goods I= Investment expenditure by X – M = Net exports (Where. . National income accounting has several uses for economic policy and research. SUMMARY l l l l l Structure of the macro economy is given by the circular flow of income and output. National income accounting has its foundation in the circular flow model. National income accounting provides the standards by which economic activity of a country could be assessed.s p ei External Sector i tu re al e on o m i t sf r na Inc an r I nte l T t) na (Ne o i t r na I nte pt i on Expend In co me T b ce vi Su er Financial Savings System Borrowings Households nsu m en fo rE ts xp for ert Im s por ts me nt s nts xe m e y c Re ym Pa ts Co fo Tra rS ns fer Ta Pa Pay s Borrowings s ing r cto Fa Savings Firms Pay me nt s Government Sector t en m es s ax idie s 15 er s NATIONAL INCOME ACCOUNTING Sav Go ve rn se cha r Pu AND Fa ct or MACRO ECONOMY ngs OF THE Borr owi STRUCTURE Fig 2. M = Imports) The science of national income accounting is based on this identity. three-sector and four-sector models. Circular flow of income can be depicted in two-sector. X = Exports.

4. Explain the circular flow in three-sector economy. 6. 2. show that income and product flows are equal. 5. With the help of a circular flow model. . Explain the concepts of ‘leakages’ and ‘injections’ in the circular flow of income. 7. Explain the circular flow in four-sector economy. 3. What are the uses of national income accounting? What is the principle of circular flow of income and product? Explain the circular flow in two-sector economy.INTRODUCTORY MACROECONOMICS 16 EXERCISES 1.

This circular flow depiction of macroeconomic activities provides logical foundation for the concepts and measurement of national income aggregates. Hence.CHAPTER 3 NATIONAL INCOME ACCOUNTING: CONCEPTS AND MEASUREMENT The structure of the macro economy has been portrayed in the circular flow of output and income as dealt with in the previous chapter. Here. A strikingly unique feature of national income concepts is that they are quantifiable and are not abstract ones. national income measurement can be categorised into three approaches : output or product approach. There have been many attempts in the past to evolve methods of national income accounting and these efforts have contributed to the system that we have at present. Based on this. yield the same result. they render as much precision as feasible in the national income statistics. We have. the measurement procedure is actually three-fold. All these must. Gross Domestic Product : The Output Approach Gross Domestic Product (GDP) is a summary statistic. given the limitations in the estimation of national income aggregates and in the construction of national income accounts. in principle. we shall present principal methods to measure national income aggregates. the income method and the expenditure method to compute the Gross Domestic Product. greater attention is called for in the computation of this measure. income approach and expenditure approach. It is pertinent at this juncture to remind ourselves of an important observation made in respect of the circular flow of macroeconomic activities. in that context. which in turn must equal to the aggregate expenditure. In this chapter. We use the product method. As this aggregate is held to be very important for macroeconomic assessment. Measuring Gross Domestic Product Let us first take up the measurement of the value of all that is produced in the economy. which is widely used by economists and policy analysts to . This is expressed as Gross Domestic Product. stated that the value of aggregate output equals the value of aggregate income.

So. cables. plastic. NBER. He was a great pioneer in this field and due to his research efforts. Final goods are those that are meant for final use by consumers or firms. they are just a means to an end. Simon Kuznets A seminal contribution to the field of National Income and Product Accounts (NIPA) made by Simon Kuznets (1901–1985) set the trend of using national income aggregates to measure the direction of growth of economies. Let us now show the difference between final and intermediate goods with the example of producing an automobile. 1941) .INTRODUCTORY MACROECONOMICS 18 assess the rate of growth of an economy during a year. these goods are not important in their own right. Inter mediate goods are those goods that are used to produce other goods and therefore they always move from one stage of production to another in the manufacture of a final product. the strength of an economy is seen in its capability of producing final goods and services. All these items are produced by the respective firms only to be used in the production of another product. Such goods are called intermediate goods. Measurement of GDP includes only the aggregate value of final goods. foam. from a development perspective. all these are converted into integral parts of an automobile. and a variety of component parts. However. National Income and its Composition. battery. The industrial process to manufacture an automobile involves materials such as steel. paint. GDP is defined as the market value of all final goods and services produced by the factors of production located in the country during a period of one year. in our example it is the automobile. rubber. It may be useful at this stage to draw a distinction between final goods and intermediate goods. This helped immensely to understand the severe impact of the Great Depression in 1929. The automobile that is produced Clip 3. A key phrase in this definition is ‘final goods and services’ which require some elaboration.1 PIONEERS IN NATIONAL INCOME ANALYSIS In the contemporary world now. These goods are not required to enter into further stages of production or resale to change their form and content. these concepts and methods became popular only a few decades ago. national income concepts and accounting methods are widely recognised and applied to measure the economic performance of countries. GDP is generally recognised to be the primary measure. But once the process of producing an automobile starts. They are finished goods meant only for final consumption and investment. etc. The latter are not taken into account in the measurement of GDP. Also. the first national income figures for the US economy was published in 1934 as an official document of the US Senate. 1919-1938 (New York. His monumental book of two exhaustive volumes. glass.

Mahalanobis D. the Central Statistical Organization (CSO) is entrusted with the task of publishing National Accounts Statistics (NAS).R. with V. 1971). the estimation of national income was attempted by individual economists and scholars for specific years. the rationale for not taking into account the value of intermediate goods in the measure of GDP is to avoid the problem of double counting.V. Now. Double counting will only exaggerate or over-estimate the value of GDP.C. 1947) and Economic Growth of Nations : Total Output and Production Structure (Cambridge Mt. In 1949. Stone worked with John Maynard Keynes as a research assistant.R. Rao in his book National Income in British India 1931-32 (London. For his contributions.K. Gadgil as members. the most systematic work was that of V. Stone headed a United Nations project to develop standard national income accounting model. Hence. the Government of India formed the National Income Committee under the Chairmanship of P. namely. Stone during the early 1940s prepared a statistical profile of the British economy. MacMillan 1940). which formed the basis of national income estimation in the post-independence period. That is. After the World War II.V. The procedure by which we eliminate the values of intermediate goods from GDP . Richard Stone V. This was followed by two of his landmark contributions.K. In India.K. Rao and D. Mahalanobis.R. in the final stage of the assembly line is the final good. no product should be counted two or more times. P. National Product since 1869 (New York. Kuznets was honoured with the Nobel Prize in 1971 in recognition of his empirical interpretation of economic growth. Harvard University Press. NBER.NATIONAL INCOME ACCOUNTING : CONCEPTS AND MEASUREMENT 19 earned him the worldwide recognition.V. Gadgil Among these.C. prior to 1947. From then onwards the national income estimation has been steadily strengthened.R.R. Rao Another important contribution in this field is that of Richard Stone (1913-1991).

This is shown with a numerical illustration in Table 3.33 = 1. This is discussed in the following section.1 : Numerical Illustration of GNP Measurement using Value Added Method Stage I Stage II Stage III Stage IV (Wheat) (Flour) (Cake at Bakery) (Cake at Retailer) Farmer Baker Brown’s Retailer Green’s Black’s Purchases Miller White’s from other firms None Rs.50 Value of Final good = Rs. 1.08 + 0. It thus measures the value.18 = 0.50 0.50 .50 + 0. 1.07 + 0. Most goods go through multiple stages of production.05 Rent = 0.02 Property and = 0.1.50 Value Added Rs. 1.00 Value Added Rs.50 = 0.40 0.45 = 0.00 Purchases Rs.05 + None + 0.INTRODUCTORY MACROECONOMICS 20 is through the method of value added.10 + 0.00 + 0.50 Break-up of value added = 0.01 0. Value-added is defined as the difference between total value of output of a firm and value of inputs bought from other firms.09 0.20 = 0.02 0.70 None 0. 0.05 Interest Depreciation = 0.50 Value Added Value Added Rs.10 0.00 Purchases Rs. which the firm concerned has added by its process of production. Concept and Measurement of Value Added The concept of value added is very basic to the measure of GDP. 0. Consider the production and sale of a cake to the Household sector for final consumption.50 Purchases from Farmer from Miller from Baker Rs.10 None 0.29 Sum of value added 2.) 1. Since we are starting with the stage of wheat cultivation. 2. let us not go into the backward production linkages of the Table 3.03 – + + + + + 0.20 Profit = 0.05 = 0. 0.08 sales taxes + + + + + + Total (in Rs.25 0.2. It follows therefore that the value of final good will have to be equal to the sum of the value-added at each stage of production. This means that a good’s value increases at each stage until its final value is obtained in the last stage.60 Wages = 0.02 + 0.28 + 0. The process of production starts with a farmer raising wheat crop and harvesting it.

This final value of the cake is the sum of the value added from the stage of cultivation to that of retail sale at the shop. in Lakhs) (i) Closing stock of Firm A 20 (ii) Closing stock of Firm B 15 (iii) Opening stock of Firm A 5 (iv) Opening stock of Firm B 10 (v) Sales by Firm A 300 (vi) Purchases by Firm A from 100 Firm B (vii) Purchases by Firm B from 80 Firm A (viii) Sales by Firm B 250 (ix) Import of raw material 50 by Firm A (x) Exports by Firm B 30 As first step calculate the value of output for each Firm.1. 2. This procedure of value added method demonstrated for an individual product is applied at the aggregate level for the measurement of GDP. 2. That is.00. The baker makes the cake and sells it to the retailer for Rs. preceding the retail sale.50 at the retail store. This is the reason why we take the final value of the output as a sum of all values added in producing a good. he adds a value of 50 Paise. that is.50. namely. Value added by Firm A = Value of output – purchases . the cake is Rs. Then find the value added. (Rs. 2. 2. thereby adding a value of 50 paise. Step 1. the farmer’s valueadded in the cultivation stage will be just the value of his output as such (that is one rupee). On the other hand.00 + 50 Paise + 50 Paise + 50 Paise = Rs. The retailer who buys the cake from the baker sells it to the final consumer for Rs. total value added equals Rs.NATIONAL INCOME ACCOUNTING : CONCEPTS AND farmer. if we had included the value of all the intermediate stages. due to the problem of double . Therefore. 315 lakhs Step 2. the miller buys the wheat from the farmer and grinds it into flour.50.counting.50. Concepts of Value Added (i) Value of output by a Firm = Sales + Change in Stock (ii) Value Added = Value of output – Intermediate goods cost MEASUREMENT 21 (iii) Net-value added at Market Price = Gross value added at Market price – Consumption of fixed capital (Depreciation) (iv) Net-value added at Factor Cost = Net value added at Market Prices – Net indirect taxes (Net Indirect Taxes = Indirect Taxes – subsidies) (v) Net value added at factor cost = Total Factor Income Now. and sells it to the baker for Rs. cake’s value would have increased manifold. This means that the value of the final good. In the second stage. thereby adding a value of 50 paise. By this. floor three times and baked items twice. Value of output of Firm A = Sales + Change in stock (Closing stock – Opening stock) = 300 + (20 – 5) = Rs. let us look into the computation of value added as shown in the illustration below: Example 1: From the following data calculate the value added by Firm A and Firm B.1. wheat would have been counted four times.

Further in the case of goods. Durability does not imply a state of permanence. washing machines are durable consumption goods. (i) Private Consumption expenditure The private consumption component of GDP measures the money value of goods and services that are purchased by households and non-profit institutions for current use during a time period. you cannot see a service such as car insurance). While goods are tangibles. 205 lakhs Gross Domestic Product : As Sum of Expenditure GDP can be measured by taking into account all final expenditures in the economy. Value of output of Firm B = Sales + Change in stock (Closing stock – Opening stock) + Exports by Firm B = 250 + (15 – 10) + 30 = Rs. But services should necessarily be used at the time and place in which they are produced. But usually this distinction is based only on the given length of time within which consumer goods are used. For instance. There are three distinct types of expenditure as they are committed by Households. Non-durable goods are used up immediately or within a short span of time. banking service will take place at the place and time specified by the banker and customers utilise their banking facilities accordingly. Durable goods in contrast could be used for a longer period of time. consumer services. Considering the fact that consumption expenditure is a significant part of GDP. you can see a car) the services are intangibles (that is. Food items are non-durable consumption goods whereas furniture. Consumption can be divided into three sub-categories such as. 285 lakhs Step 4. These expenditures are classified into following types : (i) Private Consumption Expenditure (ii) Investment Expenditure (C) (I) (iii) Government Purchases of (G) Goods and Services (iv) Net Exports (X – M) Let us discuss these items of final expenditures with respect to the sectors concerned. Firms and Government respectively. Value added by Firm B = Value of output – purchases from Firm A = 285 – 80 = Rs. it requires special attention by economists and government. (that is. 165 lakhs Repeat the same procedure for Firm B Step 3. consumer nondurable goods and consumer durable goods. stereo equipment. consumption or use of a good can be separated from the place of its production and can be separated in time. . Private consumption is the demand for consumer goods and services. that you can consume or use a good at your convenient place or time.INTRODUCTORY MACROECONOMICS 22 from Firm B – imports by Firm A = 315 – 100 – 50 = Rs.

The two measures of BFI are Gross Business Fixed Investment (GBFI) and Net Business Fixed Investment (NBFI). that is. then we obtain Net Business Fixed Investment. . (b) Inventory Investment is the net change in inventories of final goods The usage of fixed assets lead to their wear and tear. The Gross Private Domestic Investment shows the aggregate value in this regard.NATIONAL INCOME ACCOUNTING : CONCEPTS AND Durable goods also have their limited period of use value. Depreciation is the value of the existing capital stock that has been consumed or used up in the process of producing output. For this reason it is important to make provision for depreciation. Gross Business Fixed investment is the gross amount spent on newly provided plant and equipment. The inclusion of capital goods in the final product along with the goods and services produced by them would involve double counting. capital goods. In providing steel in any one year. after which they are given up. This using up of capital is called depreciation. Unlike the intermediate goods which are used up entirely in the process of making other goods. When investment is expressed as Gross Investment or Net Investment it means whether investment has or has not been adjusted against depreciation. we will have deducted from the domestic product the whole value of the capital good. Private final consumption will include expenditure on all these three categories mentioned here. If depreciation is deducted from it. Usually an asset is depreciated at a predetermined rate and monetary value is assigned to the rate of depreciation of a physical asset in one year. then over the whole lifespan of the capital good. (ii) Investment Investment is an addition to the stock of capital during a period. If in every year we deduct from investment (and therefore from domestic product) the amount by which capital stock has been used up over the year. That is. only a small portion (1/50th) of the mill is used. In this way we will have avoided counting in the domestic product both the asset and the goods produced by it and so shall have avoided double counting. Investment component could be classified under four categories : they are (a) Business fixed investment 1 MEASUREMENT 23 (b) Inventory investment (c) Residential construction investment (d) Public investment (a) Business Fixed Investment (BFI) is the amount spent by business units on purchase of newly produced plant and equipment. BFI is usually the result of a conscious decision by firms to augment their productive capacity. a steel mill may have a useful life of say. we must provide for consumption of fixed capital as a prerequisite in accounting the product. capital is only partially depleted in making other goods. Gross term includes depreciation while Net term is obtained after deducting the depreciation amount. 50 years. so. This is also described as capital consumption allowance1.

For example. (c) Residential Construction Investment is the account spent on the building of housing units. Changes in inventory are usually the result of unintentional short run deviations between supply and demand. Instead of doing this we take the government purchases as part of the final product. This is also expressed in terms of either gross or net depending on whether depreciation has been subtracted or not. schools etc. Conversely. a sudden fall in demand will lead to a rise in inventories of television sets until production adjusts itself to the lower level of demand.24 awaiting sale. (d) Public Investment includes all capital formation carried out by the government such as building of roads. semi-finished goods. or of materials used in the production process (inputs). These must be included since they represent currently produced output not included in the current sales of final output. In the above we have understood government as a producer of goods and services. This is called Government Transfers. government purchases from private producers would be intermediate goods and government wages and salaries would be part of the income side of the national accounts. (iii) Gover nment Purchases of Goods and Services This component summarises the government spending on goods and services. This is also given in gross or net value depending on whether depreciation has been subtracted or not. in the attempt to satisfy the sudden increase in demand. Remember that government purchases is a proxy measure for government output. At the same time we should also be aware of another function of government – that is. wholesaler or retailer). making payments to certain categories of people or firms to compensate them as a matter of its social obligation. This process will continue until production is augmented to match the increased demand. the difference between gross investment and net investment is depreciation. As a matter of fact. So. This is an important function of the government. which refer to the . if there is a sudden doubling of the demand for television sets. Stock changes play a crucial role in income determination. hospitals. the first effect of the increase in demand relative to supply will be a fall in the inventory of television sets normally held in the economy (inventory that is held by the producer. INTRODUCTORY MACROECONOMICS Now the investment component as a whole can be thought of in the following two ways : Gross Investment = Gross Business Fixed Investment + Gross Residential Construction Investment + Gross Public Investment + Inventory Investment Net Investment = Net Business Fixed Investment + Net Residential Construction Investment + Net Public Investment + Inventory Investment As pointed out earlier. it is unlikely that the production of them will also double overnight.

income earned by owners of rental housing. While measuring GDP we must include only those income flows that originate with the production of the goods and services within the particular time period. This is also known as Transfer Payments. salaries and benefits makes up the largest single component of income generated with production of GDP. Based on the expenditure flows in the economy. The components of factor income are: 1. Interest 5. that is (X – M). We include in GDP only the net interest. 2. we can arrive at the same figure for GDP on the income side as we MEASUREMENT 25 did on the product side.NATIONAL INCOME ACCOUNTING : CONCEPTS AND total value of payments made by government sector towards households and firms as income supplements and subsidies respectively. Profits 3. Mixed income Now let us look into the details of each one of these. C = Consumption expenditure by households I = Investment expenditure by firms G = Government purchases of goods and services. 3. 4. In other words GDP = C + I + G + (X – M) Where. Employee Compensation Compensation to employees in the form of wages. Gross Domestic Product is the total value of the sum of consumption and investment expenditure along with government purchases and net exports. . The meaning of rent in the national income accounts is that it is a charge for the temporary use of some capital asset. 1. Gross Domestic Product : A Measure of Income The third approach to the measurement of GDP is to compute it by addition of all factor incomes generated in the production of goods and services. and they are not counted in the GDP because there is no production of goods due to them. X-M = Net Exports. (iv) Net Exports This is the difference between Exports (X) and Imports (M) of a country. Transfer Payments are basically welfareoriented expenditures of the Government. Rent Rental income is. that is the difference between interest amount paid and the interest income received by households. kind or both. Profits Profits are the reward the owners of firms receive for being in business. Employee compensation 2. for example. Because each rupee of goods and services produced is matched by a rupee of income. Firms’ desire to earn profits is the main motivating force behind production in a market economy. Rent 4. Interest Households both receive and pay interest. Wages and salaries are payable in cash.

abroad for rendering factor services. Real and Nominal GNP Having presented the measurement of GNP it remains to be seen as how the changes in the GNP value are expressed in relation to price level changes as price changes affect the value of the national income aggregates. Since the nominal GNP measures the value of currently produced goods and services at market . Gross Domestic Product + Net Factor Income from abroad = Gross National Product Now we may distinguish between Gross National Product and Gross Domestic Product. which includes rent. it may be called as mixed income of the self employed. As we know that factor incomes include compensation to employees and income from property and entrepreneurship. This is shown in Table 3. interest. For this we must explain the two ways of computing national income data at current market prices and constant prices. Current Market Prices If the GNP (or any other related aggregates) is measured in terms of current market prices. Hence.INTRODUCTORY MACROECONOMICS 26 5. then it is referred to as Nominal GNP. Gross National Product After getting GDP we can add Net Factor Income from abroad to estimate the value of Gross National Product (GNP). How is Net Factor Income from Abroad defined? What are included in it? Net Factor Income from Abroad is the difference between the factor income received from the rest of the world.1 GDP as measured by the aggregation of factor incomes is also called as Gross Domestic Income (GDI). The difference between the two arises from Net Factor Income from Abroad. the components of Net Factor Income from abroad are : (i) Net compensation to employees (ii) Net income from property and entrepreneurship. dividends. Note that the (X – M) component of GDP represents only goods and services other than factor incomes.e. i. In other words. etc. Their relative share in GDP shows the manner in which each of these income flows changes overtime. and the income paid for factor services rendered by non-residents inside the domestic territory of the country. All the above mentioned components of income measure of the GDP have an important implication for the economy as such. Mixed Income Mixed income will include the income of own account workers and profits and dividends of unincorporated enterprises. then Net Factor Income from abroad is the difference with respect to these items received by residents abroad and given to non-residents working in the domestic territory during a given accounting year. It is possible to show by way of an illustration as to how the sum of value added is equal to the total of the above types of income earned during the process of production. (iii) Net retained earnings of resident companies abroad Hence.

To know whether GNP increase actually means an increase in the output of goods and services. we must eliminate the effect of price increases. the account for the value of current year’s GNP as if the price level is same as that of the base year. the current market prices in terms of which it is measured prevent such an exercise. As you may be aware that the price level is usually measured by the Wholesale Price Index or the Consumer Price Index Number. is the method of using constant prices. Constant Prices However. through the following illustration. let us proceed to know the method by which we obtain the value of Real GNP through the constant prices. we are supposed to express the value of current year’s GNP (Nominal GNP) in terms of prices prevailing during a reference year in the past. GNP will change when either the overall price level changes or when the actual volume of production changes or when both change simultaneously. and 2 MEASUREMENT 27 (c) Real GNP is also often used in making international comparisons of economic performance across the countries. But the nominal GNP cannot show this as we cannot segregate the change in output alone. Usually.NATIONAL INCOME ACCOUNTING : CONCEPTS AND prices. On the contrary a recession is a period in which real GNP falls consecutively. it will not be possible for us to find out how much of the increase in GNP is due to increase in prices (inflation) and how much of the increase is due to an increase in the production of goods and services. For this. Having explained the concepts of Nominal and Real GNP. Real GNP has the following advantages: (a) It is useful in finding out the effect of increased production of goods and services on the real development capacity of the economy in general. not prices. GNP that is computed at constant prices will be called the Real GNP. (b) Real GNP also enables one to make a year-to-year comparison of the changes in the growth of output of goods and services. That is. for certain purposes we may want to have a measure of output that changes only when the quantity of goods produced changes. .2 If the GNP in the current year is valued at current market prices. under this method GNP value is expressed in terms of prices prevailing in a year chosen to be the base year. This measure of only quantity change. which is called the Base year. the calculation of An index number is a representative number to decode the changes in price level. since. We shall explain. An expansion phase of the economy is a period of rising real GNP. The purpose of using constant prices is to eliminate the effect of price changes. The consumer price index number is used to represent the average change over time in the prices paid by the final consumer of a specified group of goods or services. Accordingly.

investment (computers) is Table 3.INTRODUCTORY MACROECONOMICS 28 nominal GNP and real GNP as well as GNP deflator (Table 3.012 Real GNP 15. Real GNP and the GNP Deflator Current Period Item Quantity Price (Rs) Oranges 4.2: Nominal GNP. 4452. Let us therefore find out the expenditure on each good and obtain the total expenditure at current prices.240 10.000 1.500 1. 1. Computers 5 2100 each Government 1.240 Kgs.4240 Current period investment Rs. Let us take up the calculation of nominal GNP through the expenditure approach.2).060 1 per Kg 2000 each 1 per meter 4.452 10. 4452 × 100 = 105. Consumption expenditure (oranges) is Rs.060 1 per Purchases meters meter of Cloth Base Period Expenditure (Rs) Price (Rs) Expenditure (Rs) 4.05 per kg.060 Nominal GNP 16.15300 Consumption Expenditure Deflator = Investment Deflator = Government Purchases = Current period consumption expenditure Base period consumption expenditure × 100 = Rs.0 Base period investment Rs. 1060 × 100 = 100. Let us assume that our imaginary economy has only three final goods : Oranges .Capital good and Government purchases of cloth. 10500 × 100 = × 100 = 105.10000 Current period Government purchases Base period Government purchases × 100 = Rs.0 Rs.1060 .Consumption good Computers .0 Rs.16012 = × 100 = 104.300 Deflators for the current period GNP Deflator = Nominal GNP × 100 Rs.7 Real GNP Rs.

10.000 and government expenditure is Rs. 4240. investment is Rs. So the real GNP is Rs. . New Delhi. the concept of GNP deflator requires explanation.10.16.2. 16012. 3rd Edition.1: Relationships between Different aggregates of National Income3 3 Wilfred Beckerman.NATIONAL INCOME ACCOUNTING : CONCEPTS AND Rs.1.7. Universal Book Stall. so the nominal GNP is Rs. the consumption expenditure is Rs. The GNP deflator MEASUREMENT 29 measures the average level of the prices of all the goods and services that make up GNP.500. we divide nominal GNP (Rs. We obtain GNP deflator as 104. Now.300) and multiply the results by 100. let us calculate real GNP.15. Accordingly. This is.012) by real GNP (Rs.060. 15. An Introduction to National Income Analysis. In the above example. multiplied by 100. 1999. GNP MP et )n in di ct re ta s xe FC -d ep re c ia tio (– ) ne ti nd ire ct ta xe s n GDP NNPFC FC (-) d ep re c ia tio n (–)net income from abroad ne ti nd ir e ct ta xe s (–)net income from abroad (– ) ne ti nd ire ct ta xe s NDPMP (–) GNP GDPMP d e pr ec i at io n (–)net income from abroad (– ) (– (-)net income from abroad (pr )d e n io at ec i NNPMP NDPFC Fig 3.300. calculated by valuing the current period quantities at the base period prices. It is also possible to calculate deflator for specific expenditures as we would like to know the real value of these expenditures. Finally. as mentioned before.060. 1. and government expenditure is Rs. This is also shown in Table 3. It is calculated as the ratio of nominal GNP to real GNP.

(as was done in Table 3. From this several other measures are derived. NNP at Market Prices (NNPMP) = GNPMP –Depreciation 3. ‘National’ refers to the addition of the net factor income from abroad to the domestic product. all the concepts of national income may be shown either at market prices or at factor costs. we may observe eight major national accounts concepts as given below and they may be derived following the direction given in the diagram. if the value added is arrived at by adding the payments to factors (land. wages.1. All these concepts and measures are interrelated which is shown in Figure 3. GDP at Factor Cost (GDPFC) = GDPMP – Net Indirect taxes 8. interest and profit. labour. National Disposable Income is the income from all sources to the residents of a nation for spending on consumption as well as saving during a year. On the other hand. each having its specific purpose to interpret the performance of a given economy. National Disposable Income for a country is what the Personal Disposable Income (Personal Income – Personal Taxes) is for an individual. A particular value may be expressed at Market Prices or at Factor Cost. NDP at Market Prices (NDPMP ) = GDPMP – Depreciation 4 5 6 5. cash. Current transfers from the rest of the world may include gifts.INTRODUCTORY MACROECONOMICS 30 Important Aggregates National Accounts Gross National Product is the core concept of national income accounting. So. Suppose the total value added is computed on the basis of current prices of inputs then we may call this as value added at Market Prices. From this. It is given by the following : National Disposable Income = NNPMP + Other Current Transfers from the rest of the world6 This is the maximum available income for a country. . GNP at Market Prices (GNPMP)4 = Value of all the final goods and services produced in the economy + Net Factor Income from Abroad 2. domestic product would imply the value of all goods and services produced by the normal residents of a country. consumer goods and even military equipment.1) then it is described as value added at Factor Cost. we may also include the concept of National Disposable Income. GDP at Market Prices (GDPMP) = GNPMP – Net Factor Income from Abroad 4. NDP at Factor Cost (NDPFC)= GDPFC – Depreciation National 5 Disposable Income In addition to the above. It may be necessary to give the meaning of ‘Domestic’ and ‘National’ used in National Income aggregates. GNP at Factor Cost (GNPFC) = GDPMP + Net Factor Income from Abroad – Net Indirect taxes 6. NNP at Factor Cost (NNP FC ) = GNPFC – Depreciation 7. capital and entrepreneurship) such as rent. If a quantity is expressed in terms of its current prices it is referred to as market price. In the same manner. 1. Domestic here simply means ‘domestic territory’.

The following numerical examples will help us to understand various national income aggregates. there has been a significant improvement in the statistical statements in terms of database and coverage. will be different from others.NATIONAL INCOME ACCOUNTING : CONCEPTS AND The above definitions may be understood as general principles of how these measures are conceptualised. Inventory Investment 10 ii. Gross public investment 20 viii. Imports 10 . in crores) i. Net factor income from abroad (–5) iv. Example 1: From the following data calculate the Gross National Product at Market Price through the Expenditure Method (Rs. Concepts of National Product and National Income: A Summary GNPMP = Value of all final goods and services produced in the economy+Net factor income from abroad NNPMp = GNPMp – Depreciation GDPMp = GNPMp – Net factor income from abroad NDPMp = GDPMp – Depreciation GNPFc = GNPMp – Net indirect taxes NNPFc = GNPFc – Depreciation = National income GDPFc = GDPMp – Net indirect taxes NDPFc = GDPFc – Depreciation Three Methods of Measurement of National Product (i) Expenditure Method GNP Mp = Personal consumption expenditure + Gross Investment (Gross business fixed investment + Inventory investment + Gross residential construction investment + Gross public investment) + MEASUREMENT 31 Government purchases of goods and services + Net exports (Exports – imports) + Net factor income from abroad. which constitute an aggregate measure. (iii) Value Added Method GNPMp = (Value of output in primary sector – intermediate consumption of primary sector) + (value of output in secondary sector – intermediate consumption of secondary sector) + (value of output in tertiary sector – intermediate consumption of tertiary sector) + Net factor income from aboard. Exports 20 iii. In practice each country follows its own method of compilation and hence definition of specific items. Personal consumption 350 expenditure v. Government purchases of goods and services 100 vii. Presently the SNA 1993 is being used. (ii) Income Method GNPMp = Employee compensation (wages and salaries + employers’ contribution towards social security schemes) + profits + rent + interest + mixed income + depreciation + net indirect taxes (Indirect taxes – Subsidies) + Net factor income from abroad. In India. the national accounts are prepared in accordance with System of National Accounts (SNA) since 1975. Subsequently. Gross residential 30 construction investment vi. Gross business fixed 30 investment ix.

in crores) i. in croroes) i. Depreciation 50 iv. Profits 400 viii. Interest 40 Solution: Employee Compensation which include = 750 Wages & Salaries = 700 Employers’ contribution to = 50 social security schemes + Profits = 400 + Rent = 100 + Interest = 40 INTRODUCTORY MACROECONOMICS + Mixed Income = 400 + Depreciation = 50 + Net Indirect taxes which = 200 include Indirect taxes = 300 Subsidies = 100 + Net Factor Income from Abroad = –10 =1930. 545 crores. Intermediate consumption 400 in secondary sector v. . Example 2: From the following data calculate the Gross National Product at Market Price via the Income method (Rs. GNPMp is Rs. 1380 crores. Mixed income 400 vi.000 sector ii. Value of output in secondary 900 sector vi. GNPMp is Rs. Net factor income from abroad –20 iii. Intermediate consumption in 300 tertiary sector Solution: Value of output in primary sector = 1. Rent 100 iii.000 – Intermediate consumption of primary sector = 500 + Value of output in secondary = 900 sector – Intermediate consumption in = 400 secondary sector + Value of output in tertiary = 700 sector – Intermediate consumption = 300 of tertiary sector + Net factor income from abroad = –20 = 1380 GNPMP So. Employers contribution 50 to social security schemes x. Value of output in primary 1. Net factor income from abroad –10 v.32 Solution: GNPMp = Personal consumption = 350 expenditure + Gross Investment = 90 which include: Gross Business Fixed = 30 Investment Gross Residential = 30 Construction Investment Gross public Investment = 20 Inventory Investment = 10 + Government purchases of = 100 goods and services + Net exports = 10 which include: Exports = 20 Imports = 10 +Net Factor Income From Abroad = –5 GNPMp = 545 So. Subsidies 100 vii. Indirect taxes 300 ix. Wages and Salaries 700 ii. Intermediate consumption in 500 primary sector vii.1930 crores Example 3: From the following data calculate the Gross National Product at Market Price via the Value Added method (Rs. GNPMp So the GNPMp is Rs. Value of output in tertiary sector 700 iv.

Net indirect taxes 5 iv. Gross Investment 90 ii. Personal consumption 350 expenditure vii. Government purchases of 100 goods and services So. 525 crores g) GDPFC = GDPMp – Net indirect taxes = 550 – 5 = 545 So. NNPFC = Rs. GNPMP is Rs. 550 crores = GDPMP – Depreciation d) NDPMP = 550 – 15 = 535 So. GDP. NDPFC 33 = = = = Rs. NNPMP = Rs. But in reality many transactions occur in the economy that have either nothing to do with the final goods and services produced or that they are non-market activities or illegal activities whose measurement has its own limitations. let us examine these transactions in detail. potential savers and investors buy and sell financial assets such as shares and bonds. They are (a) Buying and Selling of securities (b) Government Transfer Payments (c) Private Transfer Payments Now. (a) Buying and selling of securities In the financial markets as shown earlier in circular flow model. In the case of bonds. Net exports 10 iii. 545 crores GDPFC – Depreciation 545 – 15 = 530 Rs. it is acknowledging a debt transaction. While someone buys a share there is only a transfer of ownership right. both conceptual and empirical. Purely Financial Transactions There are three generate types of purely financial transactions. in crores) i. There is no production activity but only exchange of funds for financial claims. 530 crores c) GDPMP = GNPMP – Net Factor Income from Abroad = 545 – (–5) = 545 + 5 = 550 So. GDPFC h) NDPFC Solution: a) GNPMP = Personal consumption expenditure = + Gross investment = + Government purchases of = goods and services + Net exports = + Net factor income from abroad = GNPMP 350 90 100 10 –5 = 545 So. NDP at both factor cost and market prices.NATIONAL INCOME ACCOUNTING : CONCEPTS AND MEASUREMENT Example 4: From the following data calculate the GNP. It is a claim to ownership of assets. 530 crores Items that are Excluded from GNP Measurement It may be recalled that GNP is the measure of the value of the final goods and services produced in one year. Net factor income from abroad –5 vi. 535 crores = GNPMp – Net indirect e) GNPFC taxes = 545 – 5 = 540 So. Depreciation 15 v. We shall now enumerate a few of these transactions that are excluded in the estimation of GNP. NNP. Trading in financial instruments does . NDPMP = Rs. GDPMP = Rs. 545 crores b) NNPMP = GNPMP – Depreciation = 545 – 15 = 530 So. (Rs. GNPFC = Rs. 1. 540 crores f) NNPFC = GNPFC – Depreciation = 540 – 15 = 525 So.

gambling. But GNP includes only those transactions that occur through market activities. It is in this context. illegal arms sale are some cases in point. As such these are not included in the GNP. As in the case of non-market goods. etc. or an electrical fault can be repaired by the house owner himself or herself instead of hiring an electrician. These are examples of nonmarketed goods and services that have been consumed without using organised markets. there is a debate as to whether housewives services should be included or not. transfer payments are payments for which no goods or services are provided in exchange. the transfer payments are not included in the GNP. Employees’ social security measures. Non-market Goods and Services Many final goods and services are not acquired through regular market INTRODUCTORY MACROECONOMICS transaction – vegetables can be grown in the backyard instead of bought in the super market. This is merely a transfer of money from one individual to another. 3. (c) Private Transfer Payments Items such as pocket money given by parents to their children. Barter transactions and production for selfconsumption by household are not included in the GNP. drug trafficking. elders gifting money to the young ones are private transfer payments. Black money is the main driving force of underground economy or “parallel economy”. adhoc assistance due to certain exigencies like floods. it is difficult to fix exact market . If so. goods produced in the previous time period cannot be included in the GNP. Transfer of Used Goods GNP refers to the value of the final goods and services produced in a given year. 2. Illegal Activities GNP does not include trade in illegal goods and services even though they are final products and are purchased in market transactions. Spending on a used car simply reflects a change in the ownership of a pre-existing output. when a person buys a used car. it cannot be recognized in GNP measurement as the car was produced in an earlier year. Pension payments. and subsidies are examples for government transfer payments. drought.34 not imply production of final goods and services. crime for hire. Activities such as smuggling. As a result these illegal and concealed transactions create a huge volume of unaccounted money that is popularly called the black money. These illegal activities create an ‘underground economy’ wherein ‘production’ is unreported or unaccounted either because it is unlawful or those involved want to evade the government tax-net. Hence this is also not included in the GNP. (b) Government Transfer Payments As defined earlier. Hence. As there is no production of final goods and services in response to transfer payments. For instance. how do we value their services at current market prices? 4.

So. Hence GNP as a statistic can be misleading as the basis of overall development of an economy. other things being equal. Therefore. This means that with higher economic security the richer segment of our society would cut down their work effort. Maximisation of national income was taken synonymous with maximisation of growth. as per the law of the land. MEASUREMENT 35 Does GNP Measure Economic Welfare? For a very long period of time economists have used GNP quite uncritically as the principal measure of economic growth and development. When the levels of income increase. But that would not imply or suggest that people become worse off than before. In fact. these activities are classified under economic offenses. the main question that needs to be discussed is : Does the GNP measure economic welfare? . These rules may rigidly classify production activities to be included in or excluded from GNP. the services provided by the business sector to capture the demand for leisure-time activities could be brought under final services for inclusion in the GNP. Leisure-time activities are in great demand from the middle and richer classes of society. But a whole range of questions concerning it are being raised these days. in a modern economy. it would be very difficult to measure the intangible item like leisure and include it in the GNP.NATIONAL INCOME ACCOUNTING : CONCEPTS AND value for transactions in the underground economy. 5. which in turn means producing less GNP. In recent times more and more economists have shown keen interest to critically look at GNP as the indicator of growth and development of a nation. It may be that. hence rising GNP is good and declining GNP is bad for the economy. Nevertheless. However. Measurement of GNP is subject to the rules of national income accounting. though leisure as such cannot be measured. more leisure is better than less leisure. the resultant state of affluence would induce people to prefer more leisure than less of it. Hence their exclusion from GNP. Technically. They are such as. The Value of Leisure Leisure is regarded as an economic good. what is or ought to be growth? What happens to distribution of income and wealth with an increase of GNP? What does an increasing GNP do to the use of nonrenewable natural resources? Is there a necessary association between increase in national income and national welfare? Can the increase in national income accomplish good quality of life and human development? All these and other questions have been researched into in the recent past and at present GNP measure is under close scrutiny by economists and policy makers. there is wide range of business opportunities to provide for leisure time activities. However. choice of more leisure is simply an increase in utility. leisure per se cannot be brought within the treatment of national accounts mainly because there is no valuation possible and imputing value is both difficult and not useful for any analysis.

This requires an alternate measure. particularly in the developing countries.. illegal activities. 1975. government and private transfers. Income approach is concerned with summation of factor incomes which in turn must equal to total value added. and deterioration in the quality of life. Value and Capital. Page 172. It is important to test whether growth in GNP results in equitable distribution of income. which would allow GNP to measure human welfare. GNP deflator is used to measure the average level of the prices of all goods and services. Oxford University Press. involving categorisation such as developed. Purely financial transactions. used goods. Hence product is also income in national accounts. investment and government purchases of goods and services. we are confronted with the serious issue of inequality in the income distribution.. It is beyond the scope of this chapter to probe into the development debates over the questions narrated above. Therefore. In the product approach. developing. Suffice it to say that increase in GNP as the sole objective of development will be counter productive. sustainable development and good quality of life for people. only the final goods and services are included to facilitate the aggregation of the value added by the producing units. In the contemporary economies.Hicks. Hicks once wrote that. Some economists have suggested the concept of “green” GNP. do not get included in the GNP. . is to give people an indication of the amount they can consume without impoverishing themselves”7. less developed and least developed countries. Aggregate expenditure is obtained by adding all expenditures on consumption. non-market goods. Product approach. The process of development must create sustainable societies without endangering the natural resources and ecological systems. SUMMARY l l l l l l l l 7 Circular flow of income forms the basis for measurement of macroeconomic activities.R. Real GNP and Nominal GNP are outlined by taking the value of national product at constant prices and current prices respectively. “The purpose of income calculation.INTRODUCTORY MACROECONOMICS 36 J. Such a ‘green GNP’ would help attain a sustainable use of the natural environment and equitable distribution of the benefits of development. J. Income approach and Expenditure approach are three ways in which Gross National Product can be measured. It may be useful to debate these issues related to GNP.R. attempts to enhance GNP at any cost may create economic ‘bads’ such as poverty and pollution. etc. environmental degradation. All these and related problems have not only introduced gaps between different classes of people in terms of their social and economic status but also between nations.

What are the items that are excluded from GNP? Give reasons. Show how the sum of value added is equal to sum of factor incomes. Define: (i) GNP at market prices (ii) NNP at market prices (iii) GNP at factor cost (iv) NNP at factor cost. 17. What are the components of aggregate expenditure? 7. What is a GNP deflator? 15. Explain the value-added method with the help of an example. What are factor incomes? 8. What are transfer payments? 10. Explain the meaning of non-market activities. Explain the following terms: (a) Business fixed investment (b) Inventory investment (c) Residential construction investment (d) Public investment. Define: (a) Nominal GNP and (b) Real GNP 14. 20. 11. Section III 22. 21. What is called ‘Green GNP’? 12. 18. What is meant by double counting? Why should it be avoided? 9. Give reasons for not including leisure in GNP. What is the difference between final good and intermediate good? 5. Does GNP measure national welfare? Explain the components of factor income. Differentiate between national income at current price and constant price. Define the concept of value added. 13. Section II 16.NATIONAL INCOME ACCOUNTING : CONCEPTS AND MEASUREMENT 37 EXERCISES Section I 1. 4. 2. 19. 3. in lakhs) (i) Purchase by Firm A from the Rest of the world (ii) Sales by Firm B (iii) Purchases by Firm A from Firm B 30 90 50 . What is depreciation? 6. Calculate the value added by Firm A and Firm B from the following data: (Rs. Explain product and income approaches to measure national income.

in Crores) (i) Personal consumption expenditure 700 (ii) Wages and salaries 700 (iii) Employers contribution to social security schemes 100 (iv) Gross Business fixed investment 60 (v) Gross Residential construction investment 60 (vi) Gross public investment 40 (vii) Inventory investment 20 (viii) Profits 100 (ix) Government purchases of goods and services 200 (x) Rent 50 (xi) Exports 40 (xii) Imports 20 (xiii) Interest 20 (xiv) Mixed income 100 (xv) Net factor income from abroad –10 (xvi) Depreciation 20 (xvii) Subsidies 10 (xviii) Indirect taxes 20 25.INTRODUCTORY MACROECONOMICS 38 (iv) (v) (vi) (vii) (viii) (ix) (x) Sales by Firm A Exports by Firm A Opening stock of Firm A Closing stock of Firm A Opening stock of Firm B Closing stock of Firm B Purchases by Firm B from Firm A 110 30 35 20 30 20 50 23. Calculate value added by Firm X and Firm Y from the following data: (Rs. in lakhs) (i) Sales by Firm X 100 (ii) Sales by Firm Y 500 (iii) Purchases by households from Firm Y 300 (iv) Exports by Firm Y 50 (v) Change in stock of Firm X 20 (vi) Change in stock of Firm Y 10 (vii) Imports by Firm X 70 (viii) Sales by Firm X to Firm Y 250 (ix) Purchases by Firm Y from X 200 24. in Crores) (i) Personal consumption expenditure 700 (ii) Wages and salaries 700 . From the following data calculate the Net National Product at Market Prices by (a) Expenditure Method (b) Income Method: (Rs. From the following data calculate the Gross Domestic Product at Factor Cost by (a) Expenditure Method (b) Income Method: (Rs.

NATIONAL INCOME ACCOUNTING : CONCEPTS (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) (xiii) (xiv) (xv) (xvi) (xvii) (xviii) AND MEASUREMENT Employers’ contribution to social security schemes 100 Gross business fixed investment 60 Profits 100 Gross residential construction investment 60 Government purchases of goods and services 200 Gross public investment 40 Rent 50 Inventory investment 20 Exports 40 Interest 20 Imports 20 Net factor income from abroad – 10 Mixed income 100 Depreciation 20 Subsidies 10 Indirect taxes 20 26.000 (ii) Intermediate consumption of secondary sector 800 (iii) Intermediate consumption of primary sector 1000 (iv) Net factor income from abroad – 30 (v) Net indirect taxes 300 (vi) Value of output of tertiary sector 1. in crores) (i) Value of output in primary sector 2. From the following data calculate the Gross Domestic Product at Market Prices: (Rs.400 (vii) Value of output of secondary sector 1.800 (viii) Intermediate consumption of tertiary sector 600 39 .

U N I T .III DETERMINATION OF INCOME EMPLOYMENT AND .

1 Figure 4. It may be dealt with during higher studies in economics. C. the curve AD is the aggregate demand curve. Classical Concept of Aggregate Supply In the Classical2 concept.CHAPTER 4 AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS Introduction It is an established principle in macroeconomics that the aggregate demand and the aggregate supply together determine the level of aggregate output of goods and services. They are: (a) the Classical concept of aggregate supply. in brief. . the aggregate supply is perfectly inelastic with respect to the price level. The X-axis 1 2 measures the output of goods and services. In respect of aggregate supply there is no such clear-cut relationship with the price level. The Classical approach to macroeconomics (all writings on macroeconomics prior to that of John Maynard Keynes) believed that the economy would normally be in a state of fullemployment equilibrium. Say’s law. Pigou in 20th century. The Y-axis measures the price level. An inverse relationship could be assumed between these two variables. as the first step. That is.1. Aggregate Supply Aggregate supply is the total supply of goods and services in the economy. The aggregate demand is usually related to the price level.1 shows the aggregate demand curve. In macroeconomics we have two different kinds of aggregate supply concepts based on two different sets of assumptions. the meaning of the concepts of aggregate demand and aggregate supply are explained below. The Classical school of economics ranged from Adam Smith in the 18th century to A. aggregate employment and the general price level in an economy. Aggregate Demand Aggregate demand is the total demand for goods and services in the economy. We shall take up these two concepts one by one. In the Figure 4. maintained the impossibility of any deficiency in aggregate demand. and (b) the Keynesian concept of aggregate supply. The reason for this belief was their acceptance of Say’s law of markets. the greater the price level the lower the aggregate demand and vice versa. This means that changes in the price level have no Explanation of specific reasons for the downward sloping nature of the aggregate demand curve is beyond the scope of this book. Therefore.

The Y-axis measures the price level. Say’s law states that ‘supply creates its own demand’. Gardner Ackley. The classical aggregate supply curve is shown in Figure 4. The aggregate supply curve is a vertical line at the full-employment level of output.2. which is called frictional unemployment. there could be a situation of temporary unemployment which is known as ‘frictional unemployment’.INTRODUCTORY MACROECONOMICS 42 Price level Price level AS AD Q* Output Output Fig 4. This means that there cannot be a general ‘overproduction’ or ‘glut’ in an economy that is based on a market system of production and exchange. Q* is the full-employment level of output of goods and services. The full-employment level of output of goods and services is the largest output that the economy is capable of producing. The X-axis measures the output. because work is considered to be unpleasant.2: Classical Aggregate Supply Curve effect on the aggregate supply. People Frictional unemployment is a temporary unemployment of people who move between jobs. However. Collier Macmillan.1). Say felt that people do not work for the sake of doing work. Macroeconomics. there cannot be a deficiency in aggregate demand. when all resources are fully employed.1: Aggregate Demand Curve Fig 4. This means that changes in the price level have no effect on the aggregate supply. there will be a short period of temporary unemployment. under the state of full-employment.4 Correspondingly. The theoretical foundation of this concept of aggregate supply was based upon the assumptions of (a) Say’s law of markets and (b) wage-price flexibility. If goods are produced then there will automatically be a market for them. 1978 . The curve AS is the aggregate supply curve.3 The long tradition of the Classical school of economics believed that the aggregate supply would always be at the full-employment level. 3 4 Say’s Law of Markets Say’s law of markets (named after the 18th century French economist Jean Baptiste Say) was one of the main propositions of Classical theory (Clip 4. Since it takes time for a person to switch from one job to another. at any one point of time.

Output will only be limited at the point where. In 1819. a post he held until his death in 1832. In an economy that is characterised by division of labour and exchange of goods and services. The amount demanded of other goods is equal to the value of the surplus goods (that is the quantity of goods over and above that required for self-consumption) that each man MACROECONOMICS 43 produces. he was appointed as Professor of Political Economy at the College de France. any ‘unemployment’ will be ‘voluntary’ i.AGGREGATE DEMAND AND AGGREGATE SUPPLY IN work only in order to obtain goods and services that yield satisfaction or utility. which had notable names such as Frederic Bastiat amongst its followers. a businessman. He founded the French Classical School of Economics. aggregate demand equals aggregate supply. In 1828 he published a six-volume book titled ‘A Complete Course in Practical Political Economy’. Clip 4. In 1831. His greatest claim to fame was his ‘loi des débouches’ or ‘law of markets’. each person’s production constitutes his or her demand for other goods. they produce only those goods and services in which they are relatively the most proficient.1 THE LIFE OF JEAN BAPTISTE SAY Jean Baptiste Say (1767 – 1832) was a statesman in the reign of Napoleon Bonaparte. for the entire community. and an economist. M. Instead. Say was partly responsible for the introduction of the concept of an ‘entrepreneur’ into economic theory. people do not produce all the goods and services they wish to consume. Keynes accused the Classical economists of being misled by accepting it as the mainstay of their macroeconomic theory. he was appointed to the Chair of Industrial Economy at the Conservatoire National des Arts et Métiers. At this point. ran into five editions. labour and capital. the very act of production is itself the demand for other goods. Thus. hence. and exchange the surplus (over their own needs) for the produce of others. and was used as a textbook in the American colleges of the times.e. people consciously decide not to work at the prevailing wage rate. . He began lecturing on Political Economics in 1816 and published his Catechism of Political Economy in 1817. Say’s law implies that an increase in output will generate an equal increase in income and spending. Therefore. His law became famous when J. the satisfaction of a little more leisure outweighs the sacrifice of a little more goods that could have been obtained. which found widespread fame. for every individual. In such a system. Say wrote a book titled Treatise on Political Economy in 1803. and also the division of the fundamental factors of production into three – land. income and product can always be at fullemployment level.

1). 4. Price flexibility ensures that the markets for all goods and services are in equilibrium – in every market the supply equals demand. This means that the firms are willing to produce any amount of output at the prevailing price level. It is perfectly inelastic with respect to prices. i. demand will be equal to supply in all markets. Thus. the Classical aggregate supply curve is a vertical line at the full-employment level of output. The Great Depression witnessed falling levels of output.e. Wage flexibility ensures that the market for labour is always in equilibrium. Keynes understood aggregate supply to be perfectly elastic with Real wages refer to the purchasing power of workers’ wages in terms of goods and services. output is always constant at the full-employment level regardless of the prevailing price level (Fig. the full-employment level of income and product are ensured by full flexibility in wages and prices. The Keynesian approach developed against the background of the Great Depression of the 1930’s. i. . Suppose that the market for labour (or for a good or service) is in disequilibrium due to condition of excess demand (or excess supply). The effect of wage-price flexibility is that the market for labour and the markets for goods and services will always be in equilibrium. Thus. Keynesian Concept of Aggregate Supply In the Keynesian approach. Therefore. they can increase or decrease freely and quickly.e. We shall explain below the meaning of wageprice flexibility. that is.44 According to this approach. the market automatically adjusts itself to full-employment output. the aggregate supply is perfectly elastic with respect to the price level. Say’s law of markets and wage-price flexibility ensures automatic market adjustment so that the economy always produces the full-employment level of output. This means that the aggregate supply of all goods and services equals the aggregate demand for all goods and services. that is. It is measured by the ratio of the money wage rate to the price level as measured by some price index. Wage-price flexibility will enable the wage rate (or the price) to increase (decrease) in order to eliminate the excess demand (excess supply). Wage-price Flexibility Wage-price flexibility means that (real) wages5 and prices are flexible.2). In the Classical framework. prices and employment (see Appendix 4. This means that everyone who wants employment at the prevailing wage rate gets it – thus 5 INTRODUCTORY MACROECONOMICS ensuring full employment. See the glossary for the meaning of the terms price level and price index. the real wage rate is equal to the marginal product of labour. and thus bring the market back into equilibrium by equating demand and supply. supply of labour equals demand for labour.

one implication of wage rigidity is that it may hinder the attainment of full-employment. the aggregate supply curve becomes perfectly inelastic with respect to price. At this point. Now. the aggregate supply curve becomes perfectly inelastic with respect to price. multiplied by the wage rate. the aggregate supply curve is perfectly elastic with respect to prices i. every additional unit of output requires the same increment in labour employed. Since production is carried out at constant cost. The cost of production of each additional unit of output is the incremental quantity of labour employed to produce that additional unit of output. The Keynesian aggregate supply curve is shown in Figure 4. Wage-price rigidity meant that (money) wages and prices were rigid. no further MACROECONOMICS Price level 45 AS Q* Output Fig 4. The Keynesian aggregate supply curve is perfectly elastic with respect to prices until the fullemployment level of output. then there will be involuntary unemployment to the extent of the excess supply of . the producers were willing to supply any amount of goods and services at the fixed price level. no further increases in production are possible since all resources have been fully employed. they were not free to increase or decrease. Q* is the full-employment level of output. At this point. Once the full-employment level of output has been reached.e. If wages are rigid at some level where the supply of labour is greater than the demand for labour. constant marginal product of labour and constant wage rate means that the cost of production of the incremental unit of output is also constant.3. The X-axis measures the level of output. Once the full-employment level of output has been reached. i. The theoretical foundations of the perfectly elastic aggregate supply curve were the assumptions of (a) wageprice rigidity and (b) constant marginal product of labour. Thus. Since marginal product of labour is constant.AGGREGATE DEMAND AND AGGREGATE SUPPLY IN respect to price.e.3: Keynesian aggregate supply curve increases in production are possible since all resources have been fully employed. that is. output can be expanded till the full employment level without any change in the price level. The Y-axis measures the price level. Rigid wages when coupled with constant marginal product of labour lead to rigid prices. This is because each unit increment to output costs the same to produce. Constant marginal product of labour meant that every increment of labour employed produced the same increment to output. This is quite opposite to the principles of Classical economics.

we may now analyse the concept of macroeconomic equilibrium. 1946. . the total output of goods and services produced equals the total demand for those goods and services. Keynes graduated from Cambridge University in 1905 with a mathematics tripos and embarked upon a high-flying career which would see him at various points of time as an Economist. and Professor of Economics. He died on April 21. and under-employment equilibrium.2 The Life of John Maynard Keynes John Maynard Keynes (1883 – 1946) was the eldest son of the British economist John Neville Keynes. For two years from 1906 to 1908 he served in the India Office of the British Government. Editor. who was the Registrar of Cambridge University. where he criticised the war reparations imposed on Germany as too high. At equilibrium. which led to the establishment of the IMF. Equilibrium The equilibrium between aggregate demand and aggregate supply occurs. In 1936 he wrote his revolutionary book. Cambridge during which period he wrote ‘Indian Currency and Finance’ in 1913. In appreciation of his services to his country. ‘The General Theory of Employment. The rigid wage rate. Interest and Money’. In 1944. the British Government made him the first Baron of Tilton (Lord Keynes of Tilton). and therefore the presence of involuntary unemployment). The level of aggregate employment corresponding to the equilibrium level of aggregate supply is the equilibrium level of employment. when at a particular price level. Involuntary unemployment occurs when those who seek employment at the going wage rate do not get it. then the economy will not be able to produce the full-employment level of output. His book ‘A Treatise on Money’ appeared in 1930. This equilibrium may be of two types– full-employment equilibrium. Clip 4. he took a leading part in the discussions at Bretton Woods.INTRODUCTORY MACROECONOMICS 46 labour. due to its failure to adjust downward in order to eliminate the excess supply of labour. From 1909 to 1915 he was a lecturer at King’s College. The particular price level at which equilibrium occurs is known as the equilibrium price level. a post he held till 1945. the aggregate demand is equal to the aggregate supply. and in 1919 he wrote ‘The Economic Consequences of the Peace’. In 1912 he became the editor of the Economic Journal. Having now introduced the concept of aggregate demand and the two concepts of aggregate supply. Adviser to the Government. If fullemployment cannot be attained (due to the rigidity of wages. From 1915 to 1919 he served the British treasury. is thus hindering full employment.

Corresponding to point E.4: Full-employment equilibrium MACROECONOMICS 47 Point E represents the fullemployment equilibrium. Price level Peq AS E AD Q eq Output Fig 4. The idea of underemployment equilibrium is explained in the Keynesian approach. The X-axis measures the level of output. The equilibrium is therefore a full-employment equilibrium. the equilibrium price level is Peq and the equilibrium level of output is Qeq. Under-employment Equilibrium Under-employment equilibrium is a state of equilibrium where resources are under-employed.e. As pointed out earlier. This results in under utilisation of resources. The reason for under employment equilibrium is a condition of deficiency of aggregate demand.AGGREGATE DEMAND AND AGGREGATE SUPPLY IN Full-employment Equilibrium Full-employment equilibrium is an equilibrium state where all resources in the economy are fully utilised. interaction between aggregate demand and aggregate supply. The aggregate demand curve serves only to determine the equilibrium price level. The Y-axis measures the general price level. the equilibrium level of output Q eq is also the full-employment level of output. i. When an economy is gripped by the phenomenon of depression. as there is no active or effective demand for output. The Classical school of economics believed that the full-employment equilibrium would always prevail in the economy.4. AD is the aggregate demand curve and AS is the Classical aggregate supply curve. it would be restored due to the free play of the market forces. and (b) wage-price flexibility. the producers were willing to supply any amount of goods and services at a given price level. Keynes understood aggregate supply to be perfectly elastic with respect to price that is. It is the point of intersection of the aggregate supply curve and the aggregate demand curve. The full-employment equilibrium is shown in Figure 4. Since aggregate supply is always at the full-employment level. the theoretical . They recognized the possibility that though the economy might briefly depart from this equilibrium. The theoretical foundation of this belief in full-employment equilibrium was based upon the assumptions of (a) Say’s law of markets. there is decline in economic activity. The Keynesian approach was developed against the background of the Great Depression of the 1930’s.

as against aggregate supply. The process of altering aggregate demand by the government. Given the perfectly elastic aggregate supply curve. We shall therefore look at the components of aggregate demand. and Q* is the full-employment level of output. the determination of the equilibrium level of output and employment depends only on the level of aggregate demand. The economy could thus be moved to a fullemployment equilibrium by merely increasing the level of aggregate demand to that level required for the fullemployment level of output. 4. . The Keynesian remedy for underemployment equilibrium places emphasis on increasing the level of aggregate demand for the attainment of the full-employment equilibrium level. the equilibrium level of output and employment is determined solely by the level of aggregate demand. there will be an under-employment equilibrium.5. a level of aggregate demand which is less than the full employment level of output.5: Under-employment equilibrium AD is the aggregate demand curve and AS is the aggregate supply curve. is called demand management policy. Qeq is the equilibrium level of output. The under-employment equilibrium is shown in Figure 4. The Keynesian approach to moving the economy out of the under employment equilibrium to fullemployment equilibrium was to increase the aggregate demand by the device of increasing the government expenditure on goods and services. The equilibrium price level is determined by the height of the aggregate supply curve above the X-axis. When there is deficient aggregate demand. Price level AS AD Peq E Qeq Q* Output Fig. With a perfectly elastic aggregate supply curve. Point E is an under-employment equilibrium. that is. It is an under-employment equilibrium because the equilibrium level of output Qeq is less than the full-employment level of output Q*. The increase in aggregate demand would automatically call forth an equivalent increase in aggregate supply without affecting the price level. It is the point of intersection of the aggregate demand curve and the aggregate supply curve.INTRODUCTORY MACROECONOMICS 48 foundations of the perfectly elastic aggregate supply curve were the assumptions of (a) wage-price rigidity and (b) constant marginal product of labour. and the determination of equilibrium output and employment in the Keynesian framework in the next two chapters. Peq is the equilibrium price level.

5.AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 49 SUMMARY l Aggregate demand is the total demand for goods and services in the economy. l The Classical aggregate supply curve is perfectly inelastic with respect to prices. and (b) involuntary unemployment. 3. l Equilibrium between aggregate demand and aggregate supply occurs when at a particular price level. l The theoretical basis of the Classical aggregate supply curve is (a) Say’s law of markets. Explain: (a) voluntary. aggregate demand equals aggregate supply. 2. and (b) wage-price flexibility. and (b) wage-price flexibility. l Aggregate supply is the total supply of goods and services in the economy. The aggregate supply is always at the full-employment level of output. What is aggregate demand? What is aggregate supply? How is the Classical concept of aggregate supply different from the Keynesian concept of aggregate supply? What is meant by equilibrium? Differentiate between full-employment and under -employment equilibrium. This means that firms are willing to supply any amount of output at the prevailing price level. . 6. 4. EXERCISES 1. l The Keynesian aggregate supply curve is perfectly elastic with respect to prices until the full-employment level of output. l Equilibrium may be of two types – full-employment equilibrium and underemployment equilibrium. l The theoretical basis of the Keynesian aggregate supply curve is (a) constant marginal product of labour. l Full-employment equilibrium is that equilibrium where all resources are employed to their full limit. l Under-employment equilibrium is that equilibrium where resources are not fully employed.

as the result of general optimism: businessmen and economists believed that the newly-born Federal Reserve (the Central Bank of the United States of America) would stabilize the economy. In the figure given below. the Y-axis measures the index of product of G-7 countries. and firms making consumer durables faced falling demand as well. of unprecedented length and severity. Fig A4. The U. Falls in prices—deflation—during the Depression set in motion contractions in production. Caught by surprise. There was a serious decline in economic activity. with 1929 as the base year (see Fig A4.S.S. which triggered additional falls in prices. and that the pace of technological progress guaranteed rapidly rising living standards and expanding markets.1: THE GREAT DEPRESSION In the 1930’s there was a world depression. firms making producer durables cut back production and those who feared they might soon be out of work cut back purchases of consumer durables. With prices falling at ten per cent per year.1).1 : Index of production of G-7 Countries during Great Depression . firms cut back their own plans for further purchase of producer durable goods. Federal Reserve’s attempts in 1928 and 1929 to raise interest rates to discourage speculation in the stock market brought on an initial recession. The 1920’s saw a stock market boom in the U.APPENDIX 4.

The slide into the Depression.2% of the labour force in 1933. Keynes was in favour of fiscal measures such as government spending on public works in order to stimulate aggregate demand. which blamed the high unemployment on a deficiency in aggregate demand. with increasing unemployment. with only temporary deviations from full employment. Meanwhile. Real GNP fell by 30% and it could not reach the 1929 level again till 1939. Aggregate demand was too low because of inadequate investment demand. Banking sector became panicky and the collapse of the world monetary system cast doubt on everyone’s credit. and reinforced the belief that now was a time to watch and wait. things were even worse in Great Britain. the unemployment rate rose from 3. the highest level during the course of the depression. and falling prices. This was a state of affairs significantly different from the classical world of full employment.2% of the labour force in 1929 to 25. Keynes theory provided an economic policy to combat unemployment – stimulate aggregate demand. and remained above 10% until 1936.AGGREGATE DEMAND AND AGGREGATE SUPPLY IN investors could calculate that they would earn less profit investing now than delaying investment until next year when their dollars would stretch ten per cent further. . This period of high and prolonged unemployment was the cause of great debate among economists and policy-makers as to the cause of the unemployment and the correct remedy for the problem. He propounded a revolutionary theory of macroeconomics. In fact. unemployment in Great Britain was above 10% by 1923. In the United States. Among the debaters was one John Maynard Keynes (later Lord). Unemployment remained over 10% throughout the decade. The depression started even earlier there. High unemployment began in the early 1920’s and continued into and throughout the MACROECONOMICS 51 1930’s. continued. falling production.

In the context of this chapter. This demand is influenced by many variables such as price of the goods or services. that “men are disposed. consumption and income shall be understood as referring to aggregate consumption and income. 1 This relationship between consumption and income is called the consumption function. income. wealth. to increase their consumption as their income increases. The consumption function may be represented by the following equation. as a rule and on the average. and what determines the magnitudes of these components. This relationship between consumption and income holds good for the individual. Our discussion in this connection will be based upon a simple model of Keynesian macroeconomics. for government expenditure (G) and for net exports (X-M).CHAPTER 5 AGGREGATE DEMAND AND COMPONENTS We have defined aggregate demand as the total demand for goods and services in the economy. His ‘fundamental psychological law’. for investment (I). the household. expected income. Aggregate demand (AD) is therefore given by AD = C + I + G + (X-M) We may now focus on the determinants of the individual components of aggregate demand. Keynes formulated his fundamental Psychological Law of Consumption to lay down a behavioural rule to the process of consumption activity. . but not by as much as the increase in their income”. Keynes proposed that consumption demand increases with the level of income. In this chapter we will look at the components of aggregate demand. Consumption demand and consumption function Consumption demand in microeconomics is defined as the value of commodities 1 ITS and of services that households are able and willing to buy at a particular time. holds. tastes and preferences of individuals and so on. as well as for the economy as a whole. The components of aggregate demand include goods and services demanded for private consumption (C).

Marginal propensity to consume is thus the additional or extra consumption that results from additional income. The consumption function may be plotted in a graph.2 C is assumed to be positive. and its value ranges between 0 and 1.1 shows the level of consumption for various levels of income. Figure 5.3 For example.1 shows the graph of the hypothetical consumption function. since we have ignored the role of government. then a rupee change in income causes a 0.45. Taken together. The slope of the consumption function is ‘b’.90 rupee increase in consumption. ‘Propensity’ to consume is the desire or urge to consume. it is not possible to think of a situation where there is no consumption at all. that is. Column (5) in table 5. If b is 0. C = Consumption C = Autonomous Consumption b = Marginal Propensity to Consume Y = Level of income The intercept C represents autonomous consumption.45 rupee change in consumption. This means that consumption increases with income. personal income minus personal taxes) per se. As income increases from Rs.700 (an increase of 100 rupees).600 to Rs. Consider a consumption function given by C = 100 + 0.660 (an increase of 80 rupees). “but not by as much as the increase in their income”. the consumption function will have a constant slope.8. to increase their consumption as their income increases…”. “Men are disposed. if b is 0. the disposable income is equal to income. ‘Marginal’ in economics means incremental or additional. then a rupee change in income will cause a 0. but a rupee 2 3 4 53 increase in income causes less than a rupee increase (of b) in consumption. this means that b<1. the amount of consumption expenditure when income is zero. However. (b) consumption is possible when the income is zero. It measures the rate of change in consumption per unit change in income and is also known as the Marginal Propensity to Consume (MPC). 0<b<1. the MPC is positive. a rupee increase in income causes a 0. The MPC at all levels of income is the same because of the The following two points must be kept in mind about the consumption function: (a) consumption is actually a function of disposable income (that is. By assumption. Column (1) shows the consumption expenditure at various levels of income. Where. as a rule and on the average. if b is 0. .580 to Rs. a phenomenon also called as dissaving. The values in column (1) are obtained from the consumption function. The range of ‘b’ may be deduced from the fundamental psychological law.AGGREGATE DEMAND AND ITS COMPONENTS C = C + bY C > 0.8 Y Since this is an equation of a straight line. the consumption increases from Rs. Hence.4 For example. this means that b>0.90.6. Table 5. 0 < b < I. with the help of a numerical example.1 shows how MPC is calculated.60 rupee change in consumption. The MPC is therefore 80/ 100 = 0. there is consumption even in the absence of any income. that is.

1. at any point on the 45o line.8 Y.1 can be plotted in a graph.8 particular consumption function we have used in our example.8 580 80 600 100 (80/100) = 0.8 340 80 300 100 (80/100) = 0. The consumption function crosses the 45o line at point B. greater than. it is helpful to look at the 45o line drawn from the origin.8 260 80 200 100 (80/100) = 0.8 420 80 400 100 (80/100) = 0. Since the vertical and horizontal axes have the same scale. (Constant slope and therefore constant MPC is a feature of all straight line consumption functions). because the consumption is exactly equal to the income.8 740 80 800 100 (80/100) = 0. 5. Here.8 900 80 1000 100 (80/100) = 0.500. or less than the level of income. consumption expenditure exactly equals income. At points to the . Thus.1: Consumption. the 45o line has the property that at any point on it. Fig. households are just breaking even. In our example. 5.8 820 80 900 100 (80/100) = 0.1 shows the graph of the consumption function C = 100 + 0. The 45o line therefore immediately tells us whether consumption spending (as per the consumption function) is equal to. as shown in Fig. Income and Marginal Propensity to Consume Consumption C Change in Consumption ∆C Income Y Change in Income ∆Y Marginal Propensity to Consume (MPC) = (2)/(4) = ∆C/∆Y (1) (2) (3) (4) (5) 100 - 0 - - 180 80 100 100 (80/100) = 0. At any point other than B on the consumption function.8 660 80 700 100 (80/100) = 0. the distance up from the horizontal axis (which is consumption expenditure) exactly equals the distance across from the vertical axis (which is income).INTRODUCTORY MACROECONOMICS 54 Table 5. To understand the figure. The information given in the Table 5. This point is known as the breakeven point.8 500 80 500 100 (80/100) = 0. consumption is not equal to income. the income and consumption at the breakeven point is Rs.

Dissaving is in order to help the households to finance the consumption over and above the level of income. Rs.60 could be raised for consumption. is saved. there is no other use to which it can be put. the consumption function lies above the 45 o line. at an income level of Rs.900. Therefore. The part of income. This act on the part of the household to liquidate their own assets or to go in for a loan is referred to as the process of dissaving. That is an individual would reduce his prior accumulated savings to compensate for the reduction in his income and thus maintain his consumption level.AGGREGATE DEMAND AND ITS COMPONENTS 55 C 1000 S= 80 900 Consumption Function 800 700  = 80 600 B 500  y = 100 400 C=820 300 S= .5 5 At any point to the right of B. For example. or to resort to borrowing so that Rs. that is. consumption is Rs. the consumption is Rs. This must be so. the amount of savings is the difference between the two.8  Y 100 C= 260 100 45 O o 100 200 300 400 500 600 700 800 900 1000 Y Fig 5. therefore consumption expenditure is greater than income. .8 Y left of B. consumption is greater than income at Dissaving literally means the opposite of saving. for example. The shortage in income will make them to sell the assets acquired in the past. because income is either consumed or saved. at an income level of Rs 200.80.60 MPC  200  C 80   0. which is not consumed. Savings can be measured in the graph as the vertical distance between the consumption function and the 45o line.820.1 : The Consumption Function C = 100 + 0. The household must find funds to meet this consumption expenditure. therefore consumption expenditure is less than the level of income.260. the consumption function lies below the 45o line. To sum up: when the consumption function lies above the 45 o line.

savings is an increasing function of income. Thus.2. The intercept term C is the amount of savings made when there is zero level of income. This is because income is either consumed or saved. The amount of dissaving or saving is always measured by the vertical distance between the consumption function and the 45o line. This is known as the Marginal Propensity to Save (MPS). (1 – b) is 0. This means that there is dissaving. It is already shown that C is always positive. implies a savings function. This means that there is positive saving. Suppose the MPC. Therefore C is negative. there is a dissaving of amount C .8)Y S = –100 + 0. savings increase by 0. The slope of the savings function gives the increase in savings per unit increase in income. the level of consumption is exactly equal to the level of income.INTRODUCTORY MACROECONOMICS 56 each level of income.2Y . This means that for every one rupee increase in income. Therefore. This means that the part of the increase in income. which is not consumed. Since b is less than one it follows that (1 – b) and therefore MPS is positive. along with the above equation. S = – C + (1 – b) Y = –100 + (1 – 0. that is. that is S≡Y–C This equation tells us that by definition. The consumption function. Substituting the consumption function into the above equation we can get the savings function. then the MPS. This is because of the fact that Y ≡ C + S (whether S is positive or negative). Note that the amount of autonomous consumption is exactly equal to the amount of dissaving at zero level of income. is saved. that is. The savings function relates the level of saving to the level of income. b is 0. Therefore. Using the numerical example of the consumption function we had earlier. S ≡Y–C = Y – ( C + bY)(Since C = C + bY) = Y – C – bY S = – C + (1 – b)Y This is the savings function. the level of consumption is less than the level of income. it is always the case that MPC + MPS = 1.8. saving is equal to income minus consumption. The equation below says that income that is not spent on consumption is saved. Note that MPS = 1 – b = 1 – MPC. Since negative savings is nothing but dissaving.2 rupee. we can derive the corresponding savings function. When the consumption function lies below the 45 o line. there is negative savings C at zero level of income. Consumption and Savings We shall now look into the relationship between consumption and saving. We may obtain the savings function from this relationship. this means that at zero level of income. When the two lines intersect. The slope of the savings function is (1 – b).

8 -20 20 0.8 0 20 0. This is because income is either consumed or saved. The MPS is therefore (20/100) = 0.600 to Rs.40 (an increase of Rs.2 100 1 20 0. The information given in table 5.1. Note that the sum of MPC and MPS is equal to one. As income increases from Rs.8 400 100 420 80 500 100 500 600 100 700 100 800 C+S MPC+MPS (9) (10) 0 1 0. Thus. Column (6) shows the level of savings at different levels of income. Column (10) of the table shows the sum of the MPC and MPS.8 80 20 0. which is not consumed.8 100 20 0.2 can be plotted in a graph.8 20 20 0.700 (an increase of Rs.20 to Rs. .2 600 1 660 80 0. The values in this column are obtained from the savings function. Note that (a) consumption plus saving everywhere equals income. the sum of consumption expenditure and saving must be identical to income.2: Consumption – Saving Relationship Change in Y ∆Y C Y Change in C ∆C MPC ∆C/∆Y Saving S (1) (2) (3) (4) (5) (6) Change in MPS S ∆S/∆Y ∆S (7) (8) - - 0 - 100 - 0.100).AGGREGATE DEMAND AND ITS COMPONENTS 57 Table 5.2 shows the levels of consumption and savings for various levels of income.8 60 20 0.2 300 1 0.20).8 -60 300 100 340 80 0. Columns (1) to (5) are repeated from Table 5. as shown in Fig. Column (8) in table 5. and (b) MPC + MPS = 1. The MPS is the same at all levels of income because of the particular savings function (a linear curve with constant slope) we used in our example (constant slope and therefore constant MPS is a feature of all straight line savings functions). This means that the part of the increase in income.2 700 1 100 740 80 0. Column (9) of the table shows the sum of consumption expenditure and saving at every level of income. there is no other use to which it can be put. the savings rises from Rs.8 40 20 0.2.2 200 1 -40 20 0.2.2 500 1 580 80 0.2 800 1 900 100 820 80 0.8 -100 100 100 180 80 0.2 400 1 80 0. is saved.2 1000 1 Table 5. 5.2 shows how MPS is calculated. Note that column (9) is identical to column (1). This is because income is either consumed or saved.8 -80 20 200 100 260 80 0.2 900 1 1000 100 900 80 0.

Part B shows the savings function. the amount of saving at any level of income is the vertical distance. which corresponds to an income level of 500. This is the counterpart of the consumption shown in part A. we see in part A that consumption is 500 and saving equals 0. the savings function lies 60 below the horizontal axis at an income level of 200. This is depicted in part B by the intersection of the savings function with the horizontal axis at point B. When income is 500. .60 200 100 C= 260 45o O 100 200 300 400 500 600 700 800 900 1000 Y S Part . The saving function shown in part B can therefore be directly derived from part A. In part A. between the consumption function and the 45o line.INTRODUCTORY MACROECONOMICS 58 C Part . consumption is 260 and saving is -60 (dissaving is 60).100 Fig 5. 5.2 shows the consumption function. When income is 200.2: The Consumption Function and its associated Savings Function Part A of Fig.60 300 400 B 500 S=80 600 700 800 900 1000 Y .B Savings function 100 100 S= .A 1000 S= 80 900 Consumption function 800 700 600 B 500 400 C=820 300 S= .

At any particular level of income. in the nature of equipment. and APS is continuously increasing as income increases. As expected. the sum of the APC and APS is always equal to one. 1 ≡ APC + APS Using the earlier examples of consumption function and savings function we can calculate the values of APC and APS for every level of income. We have APC = C/Y and APS = S/Y Now. we can find out the average savings – income ratio. At a particular income level. to the left of point B in part A. residential . This is because income is either consumed and or saved. 59 we have Y≡C+S Dividing both sides of the equation by Y we have Y/Y ≡ C/Y + S/Y Thus. To the right of point B in part A. the Average Propensity to Save (APS) is the ratio of savings to income. This is because income is either consumed and or saved.AGGREGATE DEMAND AND ITS COMPONENTS When income is 900. In general. Average Propensities to Consume and Save From the consumption function. The proof of this statement is as follows: From the relationship between income. the consumption function lies below the 45o line (consumption is less than income). consumption is 820 and saving is 80. Hence to the right of point B in part B. Similarly. APC is continuously declining as income increases. At a particular income level. at every level of income. the APC is the corresponding level of consumption divided by that level of income. Column (6) shows the sum of APC and APS. the proportion of income saved increases and the proportion of income consumed decreases. Therefore. at every level of income. the sum of APC and APS is equal to one. from the savings function. we can find out the value of the consumptionincome ratio C/Y. Investment The second component of aggregate demand is investment which means addition to the stock of capital goods. Column (3) shows how APC is calculated.3. As we can see from the above table. At any particular level of income. the APS is the corresponding level of saving divided by that level of income. This means that as income increases. savings is negative and the savings function lies below the horizontal axis. Similarly. Hence to the left of point B in part B. APS is calculated in column (5). This is done in Table 5. the ratio of consumption to income is called the Average Propensity to Consume (APC). the proportion of income that is not consumed must be saved. savings is positive and the savings function lies above the horizontal axis. The APC gives the average consumption – income relationship at different levels of income. the saving function lies 80 above the horizontal axis at an income level of 900. the consumption function lies above the 45o line (consumption is more than income). consumption and saving.

e. we will consider the determinants of investment demand.3 -60 -0.13 -40 -0. firms invest when they expect their investment will be profitable.13 1 400 420 1. it will earn them revenues greater than the costs of the investment. So. the last is usually the largest. the three elements important in understanding investment are revenues. Revenues: An investment will bring a firm additional revenue only if investing allows a firm to sell more. costs and expectations. since investment leads to capital accumulation. additions to inventory. Secondly. In general. changes in investment are the main cause of fluctuation in aggregate demand.8 1 200 260 1.3 1 300 340 1.06 1 800 740 0. then a biscuit manufacturing firm can expect an increase in its revenues by investing more in new biscuit making machines.3 Average Propensities to Consume and Save Y C APC (2)/(1) S APS (4)/(1) APC+APS (1) (2) (3) (4) (5) (6) 0 100 ∞ -100 ∞ 1 100 180 1.09 1 1000 900 0.10 1 Note: (a) ‘∞’ means infinity (b) Figures in table are rounded up to two decimal points structures or inventory.8 -80 -0. focusing on the last category of investment. due to the its volatile nature.94 40 0. Investment plays two important roles in macroeconomics. i. In this section. For example. Costs: A second important determinant of the level of investment demand is the costs of investing. it helps the economy to produce higher levels of output.92 60 0.INTRODUCTORY MACROECONOMICS 60 Table 5.90 100 0. Among the three categories of investment – purchases of residential structures. One type of cost of investment is the cost of the equipment . if the demand for glucose biscuits is very high.08 1 900 820 0. and investment in fixed plant and machinery.03 1 700 660 0.91 80 0.05 -20 -0. So investment decision depends upon the demand for the output produced by the new investment.97 20 0.05 1 500 500 1 0 0 1 600 580 0. Firstly.

at the market rate of interest. This is usually netted out from revenue to get net revenue. (This is known as Marginal Efficiency of Capital (MEC) or expected rate of return from Capital). Firms invest when they expect their investment will be profitable. The other type of cost is that associated with the funding of the investment.4: Interest Rates and Investment Project Total size of Project (Rs. the most important one is the rate of interest. This is the Keynerian framework. The relationship between investment demand and the rate of Table 5. Expectation is an individual’s guess about what is likely 61 to happen in the future. and the costs incurred in their maintenance and operation.100 invested. In other words. An investment can then be compared to a bet. at annual interest rate of (10%) (5%) (1) (2) (3) (4) (5) (6) (7) A 1 150 10 5 140 145 B 4 22 10 5 12 17 C 10 16 10 5 6 11 D 10 13 10 5 3 8 E 5 11 10 5 1 6 F 15 9 10 5 –1 4 G 10 6 10 5 –4 1 H 20 4 10 5 –6 –1 . The firms will thus have to make guesses and form expectations about the future in order to invest. However. that is it will earn them revenues greater than the costs of the investment. that present and future revenues will be greater than present and future costs. Since the capital goods usually last many years. firms tend to pay for investments by borrowing funds. Expectations: The third element in the determination of investment is the entrepreneurial expectations of the future profit. in Lakhs) Annual net revenue per Rs.100 of project at annual interest rate of (10%) (5%) Annual net Profit per Rs. it is a bet that the investment will be profitable. the future is unknown and unpredictable.AGGREGATE DEMAND AND ITS COMPONENTS and structures. Since investment depends on expectations about unpredictable future events it is very volatile. The cost of borrowing is the interest rate on borrowed funds.100 invested Cost per Rs. The interest rate is the price paid for borrowing money for a period of time. The Investment Demand Curve Of all the variables that affect investment demand.

the cost of borrowing Rs. The difference between annual revenue and annual cost is the annual net profit. that is. Columns (4) and (5) show the cost of the investment per Rs. Look at the last column of the Table 5. the investment loses money. There is a negative relationship between the rate of interest and investment demand. This gives the annual net profit corresponding to a 5% interest rate. 5 per year. Then the investment demand will fall to Rs. When annual net profit is positive.62 interest is given by the investment demand function. the lower will be the level of investment demand. 100 of the project. 100 is Rs. From column (2) we see that this totals up to Rs. Therefore. assume that.10 per year. Column (3) calculates the annual net return each year per Rs. the firms will compare the annual revenues from an investment with the annual cost of capital.4 shows the financial data for each of the investment projects. the investment makes money. (b) all investments are financed purely by borrowing at the market interest rate and (c) the projects are so long lived that there is no need for replacements. firms will undertake only those investment projects which have positive annual net profits. The cost of financing the projects would then double. at higher interest rates. fewer projects remain profitable in the face of the higher interest rate. The firms would therefore reject these two projects. Table 5.55 lakhs of investment demand. Since firms invest only in profitable projects. 100 is Rs. the investment demand decreases as the interest rate increases.4. We see from this example that a rise in the interest rate has reduced the investment demand. 30 lakhs. D. From column (6) we see that investment projects F and G become unprofitable at an interest rate of 10%. B. At 10% annual interest rate. (a) the projects yield a constant annual stream of net revenues. These are assumed to be two alternative market rates of interest 10% and 5% per year. The last two columns show the annual net profit (revenue – cost) from the investment. Government Expenditure Government expenditure or government’s demand for goods and . projects A to G will be profitable. This is because. and so on up to H. Now. The following example will make the inverse relationship between the two variables clear. The eight investment projects shown in the table are ranked in order of return. the higher the rate of interest. the costs of all projects increase while the revenues of all projects remain the same. For simplicity. Consider a simple economy where firms have numerous investment projects: project A. Now suppose that the market rate of interest increases to 10%. So profit-maximizing firms will invest in all seven projects. At this interest rate.100 invested. At a 5% annual interest rate the cost of borrowing Rs. Thus. When the annual net profit is negative. C. Column (2) shows the total size of the projects. where the cost of capital INTRODUCTORY MACROECONOMICS depends on the interest rate.

The relationship between savings and income is called the savings function. As we will see in the next chapter. is known as the marginal propensity to save. our spending on foreign goods and services has to be subtracted from the demand for domestic goods and services in order to get the correct figure for aggregate demand. is known as the marginal propensity to consume.AGGREGATE DEMAND AND ITS COMPONENTS 63 services is the third component of aggregate demand. on the level of aggregate demand. Correspondingly. SUMMARY l l l l l l l l l l l l The components of aggregate demand are consumption. The relationship between consumption and income is called the consumption function. is saved. it adds to the demand for domestic goods and services and is hence a part of aggregate demand. The government’s expenditure on goods and services constitutes government expenditure. investment. costs and expectations. The determination of income and output in the Keynesian framework depends mainly on the level of aggregate demand. The level of government expenditure is determined by government policy. Investment means addition to the stock of capital goods in the nature of structures. There is an inverse relationship between investment demand and the rate of interest. When foreigners purchase domestic goods and services. The relationship between investment demand and the rate of interest is known as the investment demand function. . varying government expenditure is an important tool for demand management. which is not consumed. Net exports is the difference between exports and imports. Three elements important in understanding investment are revenues. we are now in a position to look at the determination of income and output in the Keynesian framework. That part of income. Net Exports The fourth component of aggregate demand is net exports. Net exports is the difference between exports and imports. Having seen the various components of aggregate demand and their determinants. It shows the effect of domestic spending on foreign goods and services (imports) and foreign spending on domestic goods services (exports). which measures the change in savings per unit change in income. The slope of the consumption function. The slope of the savings function. government expenditure and net exports. which measures the change in consumption per unit change in income. equipment or inventory.

6. List the components of aggregate demand. 2. Define the marginal propensity to save. 7. 4. Which are the elements important in understanding investment? What is the investment demand function? . 5. What is the consumption function? What is the savings function? Define the marginal propensity to consume.INTRODUCTORY MACROECONOMICS 64 EXERCISES 1. 3.

If MEC is greater than the market rate of interest.40. the discounted value of the income which the capital good will yield over its life must be greater than the purchase price of that capital good. we can determine whether the investment is profitable or not.4329. C = purchase price or cost of the capital good R1 = net income from the capital good in the ith year. The machine is expected to produce a net income (after deducting the operating costs) of Rs....40 =C = 1000 1000 1000 + + + (1 + r ) (1 + r )2 (1 + r )3 1000 (1 + r ) 4 + 1000 (1 + r )5 Solving either through trial and error method or with the help of discounting tables we get the following result.. By comparing the MEC with the market rate of interest. Rn (1 + r )n Where. We may calculate the MEC of any proposed investment given the purchase price of the capital good and the expected stream of net income over the life of the capital good. An investment will be made only if it is profitable. We can calculate the Marginal Efficiency of Capital (MEC) as follows: For an income stream over n years the formula is C= R3 R1 R2 R4 + + + + (1 + r ) (1 + r )2 (1 + r )3 (1 + r )4 R5 (1 + r )5 + .05 = 5% Thus. the marginal efficiency of capital in our above example is 5%. The cost of the machine is Rs. we get the MEC as 4329. r= marginal efficiency of capital The MEC is thus the rate of return that equates the present value of the returns from the capital good with its cost.APPENDIX 5.. If MEC is less than the market rate of interest.1: INVERSE RELATIONSHIP BETWEEN THE INTEREST RATE AND INVESTMENT DEMAND As we know. investment causes an addition to the capital stock.1000 per year over its life span of five years.. r = 0. than the investment is unprofitable. then the investment is profitable.... Suppose the proposed investment is in a laddoo-making machine. which increases the productive capacity of the economy. We assume that the state of technology and employment are constant. The market rate of interest is used as a yardstick on two accounts: . In other words. In our example.

1: Marginal Efficiency Schedule of a Firm investment opportunity is the expansion of the firm’s plant at a cost of Rs. when the individual MEC schedules are added. Rangarajan and B. Marginal Efficiency Schedule The relationship between investment demand and the MEC is called the marginal efficiency schedule (MEC schedule) 1. The marginal efficiency schedule for the economy as a whole may be derived by aggregating the marginal efficiency schedules of the individual firms. then the capital costs of the various investment projects will not remain constant . This will be a continuous smooth curve because of the aggregation. we will get the aggregate MEC schedule for the economy. with an MEC of 3%. with an MEC of 10%. However. then it would be better off by lending the amount at the market rate of interest to someone else if the MEC of the proposed investment is less than the market rate of interest.it will go up. Figure A5.1000. The bold line in the diagram is the firm’s marginal efficiency schedule. with an MEC of 8%. If the MEC schedules for all firms are added horizontally. Dholakia. The aggregate MEC schedule that takes into account the increased costs of capital goods will lie below the curve This section draws on material from ‘‘Principles of Macroeconomics’’ By C. Tata McGraw-Hill Publishing Company.INTRODUCTORY MACROECONOMICS 66 l l If the firm has to use borrowed money to finance the investment.1.1 shows the marginal efficiency schedule for a hypothetical firm. These projects are arranged in order of decreasing profitability in Figure A5. If the firm is financing the investment out of its own funds. then the investment should yield a return greater than the cost of the borrowed funds (which is nothing but the market rate of interest) in order to be profitable.500. . 2002. The next most profitable 1 MEC in % 10 8 M A C H I N E 3 0 1000 SMALL MACHINE PLANT 3000 Investment expenditure Fig A5.H.1500. Suppose the most profitable investment opportunity for a firm is the purchase of a machine costing Rs. The return from the investment must be greater than its opportunity cost in order for it to be profitable. Here the market rate of interest is the opportunity cost of the investment. The next most profitable investment opportunity is the purchase of a new small machine costing Rs. The MEC schedule for a single firm is based on the assumption that the prices of capital goods are given.

2 shows the marginal efficiency of investment schedule. Since the MEI schedule is downward sloping. that takes into account the increased costs of capital goods. Figure A5. Fig A5. and no more investment will be profitable. Thus. . The concept of MEI for investment for the economy as a whole is analogous to the concept of MEC for one firm’s investment project. Only this much. Rate of interest Investment demand Fig A5. at Rs. there will be Rs. The MEI schedule will be downward sloping.3 : The Investment Demand Schedule The X-axis shows the investment demand in the economy.200 crores of investment. This shows the inverse relationship between the rate of interest and the investment demand. Such an aggregate schedule. If.2 : The Marginal Efficiency of Investment Schedule which simply aggregates the individual firms’ MEC schedules. the diminishing marginal productivity of capital will reduce the prospective returns from each successive unit of investment. Investment will be pushed up to a level where the marginal efficiency of investment will be equal to the interest rate. is called the Marginal Efficiency of Investment schedule (MEI schedule). Figure A5. This means that the marginal efficiency of investment falls as investment increases. The shape of the investment demand schedule is thus the same as that of the MEI schedule. This is because with increased investment.200 crores of investment. The quantum of investment depends on the rate of interest. the MEI is 15%. then at an interest rate of 15%. and the Y-axis shows the rate of interest. the investment demand schedule is also downward sloping. The X-axis measures investment in the economy as a whole and the Y-axis measures the marginal efficiency of investment.AGGREGATE DEMAND AND ITS COMPONENTS MEI in % 67 Investment Demand Schedule The MEI schedule does not tell us how much investment will be made.3 shows the investment demand Investment schedule. by substituting the MEI by the rate of interest we will have the investment demand schedule.

We now add desired investment (which is at fixed level Io to the consumption function. represented by the C + Io curve. This is illustrated in Fig. which is equal to Gross National Product. At every point. Determination of Equilibrium Level of Output We shall confine our analysis of the determination of the equilibrium level of output to an economy with only two sectors. EMPLOYMENT AND OUTPUT In the previous chapter we saw the components of aggregate demand. Hence.1. Output Determination by Consumption plus Investment Approach We may show output determination using the consumption plus investment (C+I) approach. The absence of the government sector and the foreign sector means that income equals output. represented by the C + I0 curve is equal to the total output. households and firms. In the Keynesian framework. the equilibrium level of output is determined solely by the level of aggregate demand. the only components of aggregate demand will be consumption demand and investment demand. The first section of this chapter will show the determination of the equilibrium level of output in the Keynesian framework. Then. . The economy is in equilibrium when aggregate demand. showing the desired level of consumption corresponding to each level of income. the (C + Io) curve lies above the CC curve by an amount equal to Io. followed by the measures to correct these problems. the aggregate demand (measured vertically) equals the total level of output (measured horizontally). the concept and working of the multiplier will be introduced. which shows total spending or aggregate demand plotted against output or income. At any point on the 45o line. 6. This gives the level of total desired spending or aggregate demand. The line CC is the consumption function.CHAPTER 6 DETERMINATION OF INCOME. The 45 o line will enable us to identify the equilibrium. The second section will deal with the problems of excess and deficient demand.

6. that is. planned spending is less than planned output. the economy is in equilibrium because the level of desired spending on consumption and investment exactly equal the level of total output. Thus. EMPLOYMENT AND OUTPUT 69 C&I C+ Io C E C + Io Io Io C 45o M Q* Output Fig.DETERMINATION OF INCOME. Consider the case when the economy is at a level of output greater than the equilibrium level M in Figure 6. where again aggregate demand equals planned output and there is no further tendency to change. the C + Io line lies below the 45o line. The economy is in equilibrium at the point where the C + I0 curve intersects the 45o line . This means that consumers and firms together would be buying less goods than firms were producing. then output will tend to increases or decreases until the two are equal again. This process of decrease in output will continue until the economy is back at output level M. The level of output corresponding to point E. . undesired increase in inventories of unsold goods (representing goods neither sold to households for consumption nor bought by firms for investment).1. This would lead to an unplanned. is the level of output 0M.1: Output Determination by Consumption plus Investment approach The aggregate demand (C + I0) curve shows the desired level of expenditure by consumers and firms corresponding to each level of output. 0M is the equilibrium level of output. At point E.1. Firms would then respond to this unplanned inventory increase by decreasing employment and hence output. 6. At any such greater level of output.point E in Fig. When planned spending is not equal to planned output. The Adjustment Mechanism Equilibrium occurs when planned spending equals planned output.

that is. This would lead to an unplanned. undesired decrease in inventories. planned spending is more than planned output.INTRODUCTORY MACROECONOMICS 70 Consider another case when the economy is at a level of output less than the equilibrium level 0M. where again aggregate demand Consumption (C) Consumption Function B O 45 o M Q* Savings Function Savings (S) O Output B Q* Output Fig 6.2: The Consumption Function and the corresponding Savings Function . This means that consumers and firms together would be buying more goods than firms were producing. This process of increase in output will continue until the economy is back at output level 0 M. the C + Io line lies above the 45o line. At any such lower level of output. Firms would then respond to this unplanned inventory decrease by increasing employment and hence output.

we can find the equilibrium level of output. Equilibrium Output By examining the interaction of savings and investment. the level of investment demand is the same at every level of output.3.3: The Investment Schedule Output . 6. 5. for simplicity. Figure 6.4 combines the savings function of Fig.3 shows the investment schedule. Here. since income always equals consumption plus saving. EMPLOYMENT AND OUTPUT equals planned output and there is no further tendency to change. these can be called complementary curves. This is because every point on the investment schedule lies at the same height above the horizontal axis. Output Determination Using the Savings Functions and the Investment Schedule Savings Function Figure 6. we will have the investment schedule. however. the investment schedule will be a horizontal line. Each point on the savings function shows the desired or planned saving at that income level. Fig. The two functions are closely related. regardless of the level of output.2 and the investment schedule of Figure 6.2 shows the consumption function and the corresponding savings function. we shall assume that firms plan to invest exactly the same amount every year.2? Recall that each point on the consumption function shows desired or planned consumption at that level of income. 6. Investment schedule We have seen in the previous chapter that the level of investment demand 71 depends mainly upon the interest rate. Investment (I) I Investment o O B M Q* Fig 6.DETERMINATION OF INCOME. If we plot on a graph the level of investment demand at every level of output (and therefore income). That is. The level of output 0Q* is the full-employment level of output. Is it not similar to Fig. Since firms plan to invest the same amount Io regardless of the level of output. Therefore.

4: Intersection of the Savings Function and the Investment Schedule . output. This intersection of the savings function and the investment schedule gives the equilibrium towards which. We will look at the mechanism of how output adjusts until planned savings and planned investment are equal. At this level of output. Thus. employment and income will remain the same. The first case is where the economy is at a level of output equal to 0M. Also.I) Savings function E Io O B M Output Fig 6. In any case. However. they will be content to continue doing exactly what they had been doing till then. When planned savings and planned investment are not equal. output will tend to adjust up or down till they are equal again.4 represent planned levels of savings and investment respectively. The second case is where the economy is at a level of output greater than 0M. actual savings or investment might be different from planned savings or investment. Meaning of the Equilibrium Point E is the point of intersection of the savings function and the investment schedule. The savings function and the investment schedule of Fig. in general. incorrect forecasting of events. at output level 0M. At the corresponding level of Savings. there is no necessity for actual saving (or investment) to be equal to planned saving (or investment). it is rightly called an equilibrium. or for a variety of other reasons. Thus. This point corresponds to a level of output M. only at point E will planned savings of households equal planned investment of firms. under three separate cases. In this case. which is the equilibrium level of output. households plan to save an amount equal to ME. Thus. planned savings of households equals planned investment of firms. firms plan to invest an amount equal to ME. Since the plans of households and firms are satisfied.INTRODUCTORY MACROECONOMICS 72 We see that the savings function and the investment schedule intersect at point E. This may be due to mistakes. output will gravitate. Investment (S. 6.

the discrepancy between planned saving and planned investment will cause firms to change their production and employment levels. undesired reduction in inventories of unsold goods. The effect of this will be to increase output till the economy returns to output level 0M. and there is thus no further tendency to change. Households are thus. The only equilibrium level of output is M. where planned savings equal planned investment. The effect of this will be to reduce output until the economy returns to equilibrium at output level 0M. where planned saving equals planned investment. The effect of this will be to cause an undesired. The third case is where the economy is at a level of output less than 0M. at this level of income households are saving more. they will act in order to correct the situation. and there is therefore no further tendency to change. In order to increase inventories to the desired. At the corresponding level of income.1 Since firms’ plans have not materialized. The effect of an undesired.DETERMINATION OF INCOME. the savings function lies below the investment schedule. they are refraining from consuming by an amount greater than firms are investing. etc. EMPLOYMENT AND OUTPUT income. The unplanned investment changes due to unplanned inventory increase or decrease. unplanned build-up of inventories of unsold goods. All three cases lead to the same inference. firms will increase production and increase employment. . Again. Planned versus Actual Amounts Till now we have repeatedly used the words ‘planned’ or ‘desired’ and ‘actual’ amounts of consumption. In order to reduce the unsold inventories to the desired level firms will cut back production and reduce employment. There is a difference between (a) the amount of planned or desired consumption or investment. Thus. the actual level of investment will be less than the planned level of 1 73 investment. At any other level of output. The distinction between the two emphasises the fact that output is at equilibrium only when firms and consumers are actually on their schedules of desired spending and Actual investment equals planned investment plus unplanned investment. unplanned inventory build-up is to increase the actual level of investment to a level greater than the planned level of investment. and (b) the actual amounts of consumption or investment that is measured after the accurrence. planned level. since firms’ plans have not materialised. where planned savings equals planned investment. the savings function lies above the investment schedule. refraining from consuming by an amount less than firms plan to invest. Therefore. they will act in order to correct the situation. thereby returning the economy to the equilibrium output and employment. that is. equals actual investment. Therefore. planned investment equals actual investment. The effect of this will be to cause an unplanned. investment. output. at this level of income households are saving an amount less than firms plan to invest. given by the consumption function or by the investment demand function.

As measured by the National Income Accounts. savings will always be identically equal to investment in a twosector economy. Crores) Output and Income Planned consumption Planned Saving (3)=(1)–(2) Planned Output and InvestIncome ment (5) = (1) Aggregate Tendency Demand of Output to (6)=(2)+(4) (1) (2) (3) (4) (5) (6) 4200 3800 400 200 4200> 4000 Decrease 3900 3600 300 200 3900> 3800 Decrease 3600 3400 200 200 3600= 3600 Equilibrium 3300 3200 100 200 3300< 3400 Increase 3000 3000 0 200 3000< 3200 Increase 2700 2800 -100 200 2700< 3000 Increase (7) . The values in column (2) are derived from the consumption function used above. Column (6) shows the level of aggregate demand at various levels of income – it is the sum of consumption demand in column (2) and investment demand in column (4). However.67Y The associated savings function is S = -1000 + 0. Column (3) represents the levels of planned saving at various levels of income. actual investment will differ from planned investment when actual sales are unequal to planned sales and firms thus face an unplanned build-up or reduction in inventories. Table 6. C +S ≡ C + I Therefore. The consumption function is C = 1000 + 0.INTRODUCTORY MACROECONOMICS 74 investment. and Table 6. Only when the level of output is such that aggregate demand equals planned output will there be no tendency for output. income and employment to change.1 shows an example using a consumption function and the associated savings function. It shows what firms actually manage to sell. The values in column (3) are derived from the savings function used above. Column (5) is a reproduction of column (1). A Numerical Example A numerical example will show why the equilibrium level of output occurs when planned spending and planned output are equal. The level of income at which consumption is exactly equal to income (that is. all income is consumed).33Y Column (2) represents the level of planned consumption at various levels of income.1: Determination of Output (All Figures in Rs. S ≡ I. This is because C+S≡Y≡C+I Y≡C+I and Y ≡ C + S.

causing output to rise.1. aggregate output will neither expand nor contract.2700 crores of output but aggregate demand is Rs.200 crores of investment goods. Firms will respond to this unplanned inventory decrease by expanding their operations. EMPLOYMENT AND OUTPUT therefore.300 crores. firms are producing Rs. The Multiplier A change in the investment spending will affect output and therefore employment. Firms will respond to this unplanned inventory build-up by sealing down their operations and thus output will decrease. Thus. Thus. In our example.100 crores in saving.4200 crores – Rs. For example.300 crores. there will be an unplanned accumulation of inventories to the tune of Rs. and will be in equilibrium. If firms are producing Rs.3600 crores.3000 crores. Thus. MPS is a constant and is equal to 1/3 and MPC is a constant and is equal to 2/3. Firms plan to invest a constant amount of Rs. If. The equilibrium level of output in our example is Rs. Only when the level of output in column (5) is equal to aggregate demand in column (6) will output be in equilibrium.200 crores as shown in column (4). It is logical that an increase in fixed investment will increase the level of output and employment through increase in productive capacity.300 crores causes a change of Rs. thus causing an increase in output. .2700 crores = Rs. and a change of Rs. then the planned spending or aggregate demand is only Rs.3600 crores. Firms’ sales will be just enough to justify continuing their current level of aggregate output. Here.400 crores. firms plan to purchase Rs. the breakeven level of income is Rs.200 crores in consumption. causing output to fall. there will be an unplanned decrease in inventories to the tune of Rs.3000 crores – Rs. each change of income of Rs. then the multiplier is 3. when firms as a whole are temporarily producing more than they can sell.100 crores causes an increase in output of Rs. In this situation. In this situation. Now. Investment is assumed to be exogenous. That is. they will expand their operations.DETERMINATION OF INCOME. When they are temporarily selling more than their current production. they will contract their 75 operations.4200 crores of output.200 crores. instead the resulting increase in output is Rs. at each level of income. savings is exactly equal to zero is known as the break-even level of income. Conversely. The opposite case is represented by the bottom row of Table 6. The operation of the multiplier ensures that a change in investment causes a change in output by an amplified amount.4000 crores. then the multiplier is 4.4000 crores = Rs.1. if an increase in investment of Rs. The multiplier is the number by which the change in investment must be multiplied in order to determine the resulting change in output. a decrease in investment will decrease the level of output and employment. which is a multiple of the change in investment. Consider the top row of the Table 6.

INTRODUCTORY MACROECONOMICS

76

We may derive an expression for the
multiplier as follows:
At equilibrium, we have
Y=C+I
i.e., income equals the sum of
consumption plus investment.
We can use the consumption
function to substitute C with the
expression C +bY, to give
Y

= C + bY + I

so Y – bY = C + I
or, Y (1–b) = C + I
or, Y =

1
( + I)
(1 – b) C

Since b is nothing but the MPC, we
have
Y=

1
( + I)
(1 – MPC) C

To find out the effect of a change in
investment on income, we differentiate
the equation to obtain
1
∆I
(1 – MPC)
So, (Change in Income) = (Multiplier)
× (Change in Investment)
The multiplier is equal to 1/(1–MPC).
It is the number by which the change in
investment must be multiplied in order
to determine the resulting change
in output.
As we can see, the size of the
multiplier depends on value of the MPC.
Since 0 < MPC < 1, the multiplier
will be greater than 1. Hence, a change
in investment will cause a ‘multiple’
change in output.
∆Y =

The actual size of the multiplier
depends on the value of MPC. For
example, if MPC is 2/3, then the
multiplier is 3. If MPC be at 4/5, the
multiplier is 5.
A numerical example will enable us
to see the operation of the multiplier.
Let the MPC be at 4/5. Suppose there
is an increase in investment of Rs.1000,
which results in the construction of a
new building. Then, the builder, the
architect and the labourers together will
get an increase in income of Rs.1000.
Since the MPC is 4/5, they will together
spend 800 (4/5 of Rs.1000) on new
consumption goods. The producers of
those consumption goods will thus have
an increase of Rs.800 in their incomes.
Since their MPC is also 4/5, they will in
turn spend Rs.640 (4/5 of Rs.800, or
4/5 of 4/5 of Rs.1000). This will cause
an increase in income of other people
by Rs.640. This process will go on, with
each new round of spending (and
therefore increase in income) being 4/5
of the previous round.
Thus, an endless chain of secondary
consumption spending is set in motion
by the primary investment of Rs.1000.
However, not only is the chain of
secondary consumption spending
endless, it is also ever-diminishing.
Eventually, the sum of the secondary
consumption expenditures will be a
finite amount.
We can calculate the total increase
in consumption plus investment
spending and therefore the total
increase in income as follows:
Rs. 1000
= 1 × Rs.1000
+
+
Rs.800
4/5 × Rs.1000

DETERMINATION

OF

INCOME, EMPLOYMENT

AND

OUTPUT

+
Rs. 640
+
Rs. 512
+
Rs. 409.6
+
..
.
Rs. 5000

+
(4/5)2 × Rs. 1000
+
(4/5)3 × Rs. 1000
+
(4/5)4 × Rs. 1000
+
..
.
[1/{1-(4/5)}] × Rs. 1000
Multiplier
We have said that the chain of
secondary consumption spending is an
endless ever-diminishing chain, whose
sum is a finite amount.
We may find the sum of the total
increase in spending by using the
formula for the sum of an infinite
geometric progression.
The sum of the total increase in
spending and the total increase in
income is:
∆Y=

1 × Rs.1000 + (4/5) × Rs.1000
+ (4/5)2 × Rs.1000 + (4/5)3 ×
Rs.1000 + …

∆Y=

Rs.1000 + [ 1 + (4/5) + (4/5)2 +
(4/5)3 +...}

The term in square brackets is of the
form of the sum of an infinite geometric
progression, whose first term is 1 and
where constant multiplier ‘r’ is 4/5.
The formula for the sum of such
an infinite geometric progression is
1/(1–r). In our case,
r = 4/5, therefore the sum of the
geometric progression is
1/[1 – (4/5)] = 5
Replacing the term in the square
brackets by 5, we have
∆Y = Rs. 1000 x 5

77

∆Y = Rs. 5000
We can see that with an MPC of 4/5,
the multiplier is 5.
We may also express multiplier in
terms of the marginal propensity to
save, that is MPS.
Multiplier =

1
1 – MPC

Since MPS= 1 – MPC, we have
Multiplier =

1
MPS

i.e., if MPS were 1/x, then the
multiplier would be x.
In our example, the MPS is 1/5. Let
the investment expenditure increase by
Rs.1000 crores. Planned saving will have
to rise till it equals the new and higher
level of investment, in order to bring
output to a new equilibrium. The only
way that saving can rise is for income to
rise. With an MPS of 1/5 and an increase
in investment of Rs.1000 crores, income
must rise by Rs.5000 crores to bring to
forth Rs.1000 crores of additional saving
to match the new investment. Hence, at
equilibrium, Rs.1000 crores of
additional investment induces Rs.5000
crores of additional income, in line with
our multiplier arithmetic.
Problems of Excess and Deficient
Demand and Measures to Correct
Them
Thus far, we have studied the
determination of output, income and
employment in the Keynesian
framework. The equilibrium level of
output, income and employment were
determined solely by the level of

INTRODUCTORY MACROECONOMICS

78

rise to a ‘deflationary gap’, which causes
the economy’s income, output and
employment to decline, thus pushing
the economy into an under employment equilibrium. Figure 6.5
depicts the situation of deficient
demand.
The Y-axis measures consumption
demand, investment demand, and their
sum the aggregate demand. The X-axis
measures the level of output and
income. OQ* is the full employment level
of output and income. (C+I)o and (C+I)1,
are two parallel aggregate demand
curves, differing only by the amount of
investment expenditure.
For the economy to be at a fullemployment equilibrium, the aggregate
demand should be for a level of output
equal to the full-employment level of
output OQ*. In other words, aggregate

aggregate demand. The economy will
be in full-employment equilibrium if the
aggregate demand is for an amount of
output that is equal to the fullemployment level of output. If the
aggregate demand is for an amount of
output less than the full employment
level of output, then it is known as
deficient demand. If the aggregate
demand is for a level of output more
than full-employment level of output,
then it is known as excess demand. We
will take up the problems of and
remedies for excess and deficient
demand individually.
Problem of Deficient Demand
If aggregate demand is for a level of
output less than the full-employment
level, then a situation of deficient
demand exists. Deficient demand gives
Aggregate
Demand

(C + I)1
F

(C + I)o

G
E

O

Deflationary
Gap

45o
M

Q*

Fig 6.5: Deficient Demand

Output & Income

This results in a situation of deficient demand. At point G. income and employment. The resulting deflationary gap created due to deficient demand is represented in Figure 6. income and employment corresponding to point E are less than the full Aggregate Demand Inflationary Gap E G (C + I)1 (C + I)0 F 45o Q* M Fig 6. until a new equilibrium is reached at point E. however.6: Excess Demand Output & income . EMPLOYMENT AND OUTPUT demand should be equal to Q*F. They will respond by reducing employment and cutting back production. the aggregate demand Q*G is less than the level of output OQ*. Q*G is less than Q*F. Suppose. This level of aggregate demand corresponds to point G on the aggregate demand curve (C+Io ).5 by FG. Firms will experience an unplanned build-up of inventories of unsold goods. Then aggregate demand is for a level of output which is less than the fullemployment level. and the economy will produce full-employment level of output OQ*. It will be noted that point E is an under-employment equilibrium. income and employment. that the aggregate demand is for a level of output Q*G. and the level of aggregate demand required to establish the fullemployment equilibrium. The deflationary gap is the difference between the actual level of aggregate demand. As a result. The economy will then be in a full employment equilibrium. The deflationary gap is a measure of the 79 amount of deficiency of aggregate demand. corresponding to the point F on the aggregate demand curve (C+I)1.DETERMINATION OF INCOME. because the aggregate demand EM is equal to output OM (since point E lies on the 45o line). The deflationary gap will set in motion forces that will cause a decline in the economy’s output. the aggregate demand curve (C+Io) lies below the 45o line. This will reduce the economy’s output. The equilibrium levels of output. This is an equilibrium.

the deficient demand caused deflationary gap has pushed the economy into an under-employment equilibrium. This has the following repercussions on the analysis of the output-cum-income axis of Figure 6. which causes a rise in the price level or inflation. are two parallel aggregate demand curves. the aggregate supply curve becomes perfectly inelastic with respect to prices. This is because real income and output cannot increase beyond the full employment level. E O Output Fig 6. Thus. Thereafter.7) prices are rigid till the fullemployment level of output. While analysing the output-cumincome axis. Problem of Excess Demand If aggregate demand is for a level of output more than the full employment level. The economy will be in a fullemployment equilibrium at point F on the aggregate demand curve (C+I) o. (C+I)o and (C+I)1. and the economy will produce fullemployment level of output OQ*. Uptil point Q*.INTRODUCTORY MACROECONOMICS 80 employment levels of output. income and employment corresponding to point F. 0Q* is the full employment level of output and income. Beyond point Q*. investment demand. Excess demand gives rise to an ‘inflationary gap’. The axis measures nominal output and income. The Y-axis measures consumption demand. as all resources are Price Level Q* is the full employment level of output. then a situation of excess demand exists. Due to the peculiar shape of the Keynesian.6 depicts the situation of excess demand. and their sum. differing only by the amount of investment expenditure. aggregate supply curve (reproduced in Figure 6. the aggregate demand.7: Keynesian Aggregate Supply Curve . increases in nominal income and output do not correspond to any change in real income and output. one important point must be kept in mind. increases in nominal income and output correspond to increases in real income and output (since prices are constant). Figure 6. The X-axis measures the level of output and income.6.

which is greater than the fullemployment level of output. under simplifying assumptions Taxes that do not change with income or other economic variables are called lump sum taxes.3 However.6 by FG. The rise in price level. the aggregate demand Q*G is greater than the level of output OQ*. the aggregate demand curve (C+I)o lies above the 45o line. which caused inflation. we may focus on the effects of government expenditure with the total taxes collected held constant. As a result. The increases in nominal income and output are merely due to increases in the price level. At point G. This is a situation of excess demand. and therefore. This level of aggregate demand corresponds to point G on the aggregate demand curve (C+I)o. In other words.DETERMINATION OF INCOME. Disposable income equals income minus taxes. the equilibrium level of employment also is the same. This is an equilibrium because the aggregate demand ME is equal to the output OM (since point E lies on the 45o line). It will be noted that the real output and real income are the same at the new 2 3 81 equilibrium E. The inflationary gap is so called because it sets in motion forces that will cause inflation or a rise in the price level. The Government Sector Before entering into a study of the measures to correct the problems of excess and deficient demand.2 In the face of taxes. Thus. specifically on output. will cause an increase in the nominal output until a new equilibrium is reached at point E. . The effect of this will be to create demand pull inflation (an aggregate demand induced rise in the price level). In fact. Suppose that the aggregate demand is for a level of output Q*G. consumption is a function of disposable income. To simplify the analysis. consumption is no longer a function of income – Rather. Then the economy under consideration becomes a three-sector economy. the economy remains at a full-employment equilibrium. it is this knowledge that led to the Keynesian policy of demand management through fiscal policy in order to correct excess of or deficiency of aggregate demand. the price level to rise. It is well known that fiscal policy (Government expenditure and tax programmes) has a major impact on economic activity. Correspondingly. given the constant real output. employment and prices. created due to the excess demand is represented in Figure 6. firms and government. The inflationary gap is the amount by which the actual aggregate demand exceeds the level of aggregate demand required to establish the full-employment equilibrium. the excess demand caused an inflationary gap. The resulting inflationary gap. All that has happened is that nominal output and income have increased due to an increase in the price level. although at a higher price level. the three sectors being households. EMPLOYMENT AND OUTPUT already fully employed. The inflationary gap is a measure of the amount of the excess of aggregate demand. it will be necessary to include the government sector in the economy.

e. rather than against disposable income.bT C1 = C – bT where C is the old consumption function i. then consumption will be reduced by an amount equal to MPC times the tax. We may plot the new consumption function as a parallel downward shift of the old consumption function.e. etc.8: Effect of Constant Tax on Consumption Function (absence of foreign trade.. at every income level the disposable income will be less than the income level by the constant amount of the tax. Finally.) we have output equals disposable income plus taxes. we can still plot the consumption function against output. output and disposable income will always differ by the same amount. Thus. Algebraically. we can . The justification of this is as follows. If income is reduced by the amount of tax. Therefore. depreciation. The decrease in consumption at every income level will be an amount MPC times the reduction in income. Since b and T are constants. In the face of constant taxes. transfers.INTRODUCTORY MACROECONOMICS 82 Aggregate Demand Inflationary Gap (C + I)1 E G (C + I)0 F 45o Q* M Output.C1 = bT This equation may be interpreted as follows: The new consumption function is uniformly less than the old consumption function by an amount equal to the MPC times the decrease in income (i. Since tax revenues are held constant. income Fig 6. we get C . This is because MPC is the change in consumption for a given change in income. we have the term bT being a constant. after taking into account such taxes. the new consumption function is C1 = C + b (Yd) Where Yd is disposable income C1 = C + b (Y–T) where T is constant taxes C1 = C + bY . The effect of this uniformly lower disposable income level is to cause a uniformly lower level of consumption. the constant tax T). C = C + bY.

investment and government expenditure. This is as regards the effect of taxes on consumption demand. This is because.9: The Effect of Government Expenditure on Aggregate Demand . Figure 6. 6. where the three sectors are households. the inclusion of government expenditure in aggregate demand causes a parallel upward shift by an amount G.8. since we are now considering a three-sector Aggregate demand C+I+G G C+I G 45o Output Fig 6.9 shows the effect of G on aggregate demand. The new aggregate demand curve C+I+G lies parallel above the old aggregate demand curve C+I. aggregate demand is equal to the sum of consumption. C is the old consumption function. Thus. Recall that in a three-sector economy. in the aggregate demand curve. We may now turn to the effect of government expenditure G on aggregate demand. EMPLOYMENT AND OUTPUT depict the new consumption function as a parallel downward shift of the old consumption function. In the following discussion. C1 is the new consumption function in the face of taxes. at every level of output the vertical distance between the C+I curve and the C+I+G curve is the constant amount of government expenditure. For simplicity. firms and government. investment and government expenditure. aggregate demand will be taken to mean the sum of consumption. The new consumption function is depicted in Fig. We are now in a position to return to the measures that can be taken to remedy the problems of excess and deficient demand.DETERMINATION OF INCOME. The amount of the downward shift will be bT. we consider government expenditure to be a 83 constant amount.

Fiscal Policy Measures We shall first consider the fiscal policy measures to increase aggregate demand. or by reducing the amount of taxes. then a situation of deficient demand exists. This increase in government expenditure is shown in Figure 6. In order to remedy the problem of deficient demand. it will restore the economy to the fullemployment equilibrium. The new level of aggregate demand is C+I+G1 corresponding to a higher level of government expenditure G1.10 depicts the situation of deficient demand in the context of the three-sector economy. This modification to the definition of aggregate demand does not however change the nature of or definition of excess and deficient demand. if aggregate demand is for a level of output less than the full employment level of output. monetary policy or both.INTRODUCTORY MACROECONOMICS 84 Aggregate Demand F C+I+G E O G Deflationary Gap 45o M Q Output Fig 6. The aggregate demand may be increased by taking recourse to fiscal policy. Figure 6. We will first consider the remedy to the problem of deficient demand. Remedy for Deficient Demand As we have seen earlier.10: Deficient Demand in a Three-sector Economy economy. If the government expenditure is increased by an amount equal to the deflationary gap. This level of aggregate demand is sufficient to keep the economy at the full employment equilibrium. thus . the aggregate demand has to be increased by an amount equal to the deflationary gap. This will move the economy to the full employment equilibrium at point F. This may be done by either increasing the level of government expenditure.11.

EMPLOYMENT AND OUTPUT 85 may be increased. As a result. The purpose of this step is to ensure the off take of the increased credit by firms. the aggregate demand may be increased. . thus combating the problem of deficient demand. If the economy’s Central Bank4 lower the Aggregate demand C+I+G1 F C+I+Go G O 45o M Q Output Fig 6. Thus. thus giving commercial banks greater ability to create credit.DETERMINATION OF INCOME. This may be done by reducing the reserve ratios. The other fiscal policy measure that will increase aggregate demand is the reduction in the level of taxes. This way. The first step is to increase the availability of credit.11: Increase in Government Expenditure 4 Reserve Bank of India (RBI) is the Central Bank for the Indian Economy. The next step is to lower the interest rate by increasing the supply of money. the level of aggregate demand Monetary Policy Measures The problem of deficient demand can also be solved by taking resort to monetary policy measures. Thus. eliminating the problem of deficient demand. consumption demand will increase by an amount of MPC times the increase in disposable income. by lowering the taxes. A reduction in the level of taxes will increase the disposable income by the amount of the reduction in taxes. This may be done in a two step manner. The aim of the monetary policy measure is to cause an increase in the investment expenditure by firms. by a mix of fiscal policy measures of increasing government expenditure and decreasing the level of taxes.increase in government expenditure by an amount FG will eliminate the problem of deficient demand. The increase in consumption demand will increase the aggregate demand by an equal amount. Recall that there is an inverse relationship between the rate of interest and the level of investment demand.

thus causing a parallel downward shift of the consumption function. it may be increased to say Rs. Fiscal Policy Measures The fiscal policy measures to reduce aggregate demand are (a) reducing the government expenditure. For example. The aggregate demand may be reduced by taking recourse to fiscal policy or to monetary policy. Remedy for Excess Demand As we have seen earlier. the aggregate demand has to be reduced by an amount equal to the inflationary gap. where tax was uniformly Rs. If the tax rate is increased it will uniformly reduce the disposable income. until the economy is restored to a fullemployment equilibrium. If the amount of taxes is increased sufficiently so that aggregate demand . the Central Bank may increase investment demand and therefore aggregate demand. the level of aggregate demand will fall. This will keep the economy at full employment equilibrium but will lower the price level and thus combat the inflation. if aggregate demand is for a level of output greater than the full employment level of output.300 crores at every level of income. then there would be an increase in investment demand. This increase in investment demand would cause an increase in aggregate demand.400 crores at every level of income. Thus.INTRODUCTORY MACROECONOMICS 86 C+I+G Aggregate Demand E G F C+I+G Aggregate Demand E G F O C1+I+G Inflationary Gap 45o M Q* Output O C1+I+G Inflationary Gap 45o M Q* Output Fig 6. and (b) increasing the amount of taxes. Figure 6. Consequently. by sufficiently lowering the interest rate.12 Excess Demand in the Context of the Three-sector Economy interest rate.12 depicts the situation of excess demand in the context of the three-sector economy. In order to remedy the problem of excess demand. then a situation of excess demand exists.

DETERMINATION OF INCOME. aggregate demand. Thus. then the price level falls and inflation is successfully combated. If the economy’s Central Bank were to increase the interest rate. by sufficiently raising the interest rate. SUMMARY l l l l l l The equilibrium level of income is that level of income where the aggregate demand equals the level of output. A mix of fiscal policy measures of reducing government expenditure and increasing the taxes are employed to combat excess demand. This gives rise to an inflationary gap. until the inflationary gap is eliminated. This decrease in investment demand would cause a decrease in aggregate demand. . A situation of excess demand arises if the aggregate demand is for a level of output that is more than the full-employment level of output. In Figure 6. Recall that there is an inverse relationship between the rate of interest and the level of investment demand. The introduction of government sector means that aggregate demand is now equal to the sum of consumption. the Central Bank may decrease investment demand and therefore. The government sector impacts the level of aggregate demand through both government expenditure and taxes. without inflation. and the price level reduced. the monetary policy measure to combat the problem of excess demand will operate through a reduction in the investment demand by firms. Monetary Policy Measures Contrary to keynesian emphasis on 87 fiscal measures for correcting encess/ deficient demand. Alternatively. This gives rise to a deflationary gap. A situation of deficient demand arises if the aggregate demand is for a level of output that is less than the full-employment level of output. if taxes are raised such that aggregate demand falls from C+I+G to C1+I+G. reduction of aggregate demand by an amount GF through the mechanism of increasing the taxes eliminates the problem of excess demand. Thus. then the economy will come back to the full employment equilibrium. and the level of planned savings equals planned investment. the level of aggregate demand may be reduced by reducing the amount of government expenditure. EMPLOYMENT AND OUTPUT falls enough to eliminate the inflationary gap. Excess and deficient demand may be corrected through fiscal policy and monetary policy measures. investment and government expenditure. then there would be a decrease in investment demand.12.

INTRODUCTORY MACROECONOMICS 88 EXERCISES 1. 4. 3. 5. 6. What is equilibrium income? What is the difference between planned and actual investment? What is multiplier? What is deficient demand? What is excess demand? How does the introduction of the government sector affect the economy? How can the problems of excess and deficient demand be combated? . 7. 2.

UNIT-IV MONEY AND BANKING .

CHAPTER 7 MONEY AND Money plays an important role in the economic system — we see the use of money at every step of life — indeed it would be hard to imagine life without money! The main function of money in an economic system is to facilitate the exchange of goods and services. In the above limited context of exchange between only eleven people. the greater will be the trading costs of barter exchange. i. Of what use is money to him? He cannot eat it. wear it or use it to exchange goods and services with others — remember he is alone on the island. It is likely that each one of them would be proficient in the production of one particular good and only average in the production of the others. This specialisation would result in a supply of goods and services of the best possible quality under the circumstances. Let us call this economy the C-C economy. He produces all the goods and services he requires for his consumption. commodity for commodity exchange economy. It would be advantageous to the group as a whole if each one specialised in the production of the good or service in which he or BANKING she was most proficient. This exchange of ‘goods for goods’ is called barter exchange.e. One is the search cost – the physical cost of . i. All eleven of them would be engaged in the production of the goods and services they require for their consumption. Now suppose that he is joined on the island by ten of his friends.e. There are two components of trading costs. Trading costs are nothing but the cost of engaging in trade. The larger the group. Imagine Robinson Crusoe living alone on an island. As the group becomes larger and larger. barter exchange could take place with minimum loss of time and effort. How would they exchange the goods and services? The simplest possible method would be to directly exchange one commodity for another. to lessen the time and effort required to carry on trade. problems begin to emerge with this direct exchange of goods for goods. The need would then arise for each one to exchange his or her good or service for the goods and services of the others.

Goldfeld and Lester V. etc. even this system will not reduce to the maximum possible extent the difficulties and costs of commodity exchange. the amount of trade that could be carried out by this method of exchange was limited. of types of capital. livestock. i.e. Such specialisation allows the utilisation of each person to the best of his or her ability and skill. etc. or it may be thought of as the cost of the deterioration in the good and its adverse effect on its desirability during the time spent searching). This will reduce the trading cost substantially by removing the necessity of simultaneously finding the preferred buyer with the preferred commodity. The main purpose of money is then to enable trade to be carried on as cheaply as possible in order to enable the maximum degree of specialisation and therefore. The utility gained from trade would be outweighed by the utility lost in the The following three sections draw on materials from ‘‘The Economics of Money and Banking’’ by Stephen M. i. of businesses. and the use of large amounts of specialised capital to reap economies of scale. New York. In the past many communities have used articles such 1 91 as seashells.e. Harper and Row. A possible solution to this problem would be to use a commonly accepted good as the medium of exchange. All this specialisation will not be possible without an equally highly developed system of exchange and trade. The longer you spend searching for such a person. the maximum amount of productivity. as medium of exchange. This simultaneous fulfilment of mutual wants by buyers and sellers is known as double coincidence of wants. This is because barter has certain inherent deficiencies as will be discussed later in this chapter. The medium of exchange has to be commonly accepted in order to facilitate exchange. More time and effort will have to be spent in searching for the person who both needs the good you have more than anything else and has the good that you need more than anything else. precious stones. pearls. each region to the maximum advantage. However. . simply because there are now more people to canvass. exchange of goods for goods1. Chandler. 8th Edition. the use of money. Barter Exchange Prior to the introduction of money as it is known today. It is the difficulty of coming across double coincidence of wants that makes direct barter (direct exchange of goods for goods) inefficient in large groups. Due to the wasteful nature of barter. The fruits of this are high standards of living and productivity. the greater will be the search cost. The second component is the disutility of waiting as perceived by the individual during the search period.MONEY AND BANKING searching for a person willing and prepared for the exchange of goods (it can be thought of as the opportunity cost of not producing more goods in the time spent searching. There is specialisation of firms. trade was carried out by barter. Modern economies are highly specialised in their respective field. 1981. of regions.

92 process of making the trade. under barter there was the lack of ‘double coincidence of wants’. Fourthly. The following will explain the difficulties involved in barter exchange. salaries. Thirdly. the barter system does not provide for any method of storing generalised purchasing power. and other prices extending over a period of time. His problem is that he has to find a provider of a bullock cart – either new or pre-existing – that matches the required specifications. rents etc. The first main drawback of barter is the absence of a common unit in terms of which can be measured the values of goods and services. Contracts requiring future payments are commonplace in any exchange economy – we enter into agreements regarding wages. People can store purchasing power for future use by holding stocks of certain commodities to be exchanged for other commodities later. Consider a situation where a person desires to exchange his cow for a bullock cart. then the value of each would have to be expressed in terms of 999 others. l The risk exists that the commodity to be repaid could increase or decrease markedly in value over the duration of the contract. interests. It would be a rare occasion when the owner of some goods or services could find someone else who both wanted the former’s good or service more than anything else and possessed that good or service that our trader wanted more than anything else. In a barter economy future payments would have to be stated in terms of specific goods or services. This type of chance. the barter system lacks any satisfactory unit to engage in contracts involving future payments. The person would most INTRODUCTORY MACROECONOMICS likely have to make some intermediate transactions – cow for horse. boat for sheep and finally sheep for the desired bullock cart. The value of a good or service means the amount of other goods and services with which it can be exchanged for in the market. The value of each good and service would have to be expressed not just as one quantity but in as many quantities as there are kinds and qualities of other goods and services in the market. horse for boat. deterioration or appreciation in . This holding of stocks of certain commodities is subject to certain problems such as costly storage. or he would have to accept something less desirable than the bullock cart. l There could be disagreement regarding which specific commodity would be used for repayment. If there were 1000 goods and services in the market. Secondly. who wants exactly the kind of cow that the person is offering. The lack of a common unit meant that no proper accounting system was possible. discovery of a bullock cart provider would be a rare occurrence. This leads to the following problems: l There could be disagreement regarding the quality of the goods or services to be repaid. thus benefiting the creditor or the debtor respectively.

10 then a pen can be had in exchange for ten monetary units (where the monetary unit in this case is the rupee). tobacco. sheep. debts of banks. or difficulty in quickly disposing of the commodity without loss if the owner wants to buy something else. wine. The value of each good or service is expressed as a price. a unit of money can purchase a lesser amount of goods and services – so the value or purchasing power of money declines. boats. If a pen is worth Rs. nickel. Purchasing power is the inverse of the average or general level of prices as measured by the consumer price index etc. debts of governments. Money will then reduce the time and energy spent in barter.MONEY AND BANKING the value of the stored commodity. Measuring values in monetary units helps in measuring the exchange values of commodities. gold.20 then a 93 notebook is worth two pens. As the general price level increases. debts of individuals. Money is a useful measuring rod of value only if the value of money itself remains constant. the exchange process tends to be highly inefficient. (3) a standard of deferred payments and (4) a store of value. It was to overcome these difficulties that money. tortoise shells. playing cards. pigs. This function of money is served by anything that is generally accepted by people in exchange for goods and services. iron. The person who owned a cow can now simply sell it to . The functions of money are to serve as: (1) a unit of value. Functions of Money Money performs four specific functions. Money as a Unit of Value The first function of money is to be a unit of value or a unit of account. Due to the above four disadvantages of the barter system. which warranted the monetisation of transactions. cowry shells. Further. tea. (2) a medium of exchange. wool. which is the number of monetary units for which the good or service can be exchanged. So. as all items will be recorded in terms of monetary units that can be added and subtracted. copper. This is similar to saying that a scale is a useful measure of length only if the length of the scale itself is constant. Some of the things that have served as money are – clay. silver. etc. money will be a useful unit of value only as long as its own value or purchasing power remains constant. This was necessitated by the increasing scale of industrialisation and commercialisation. ‘Anything’ has been quite a variety of things across places and times. If the price of a pen is Rs. accounting is simplified.10 and a notebook is worth Rs. paper. each of which overcomes the difficulties of barter. was invented by society. salt. bronze. leather. as we understand it today. The value of money is linked to its purchasing power. horses. The monetary unit is the unit in terms of which the value of all goods and services is measured and expressed. cattle. Money as a Medium of Exchange Money also acts as a medium of exchange or as a medium of payments. brass.

salaries etc. we must define what money is. This indicates the freedom of choice that the use of money offers. They know that it will be accepted at any time for any good or service and is thus a store of value. i. at the time he considers most advantageous (not necessarily immediately). or indirectly with money acting as the intermediary. by acting as an intermediary.e. Money is also called a bearer of options or generalised purchasing power. It may be noted that any asset other than money may also perform the function of store of value. However. These assets have the advantage that. land. bonds. As long as money maintains a constant value through time. they are subject to the following: (1) they may involve storage costs. A thing will have general . all trade may be considered barter – one good or service is traded for another good or service – either directly. (2) they may not be liquid in the sense that they could not be quickly converted into money without loss of value.94 the person who offers the most money for it and then buy the bullock cart from another person who offers him the best bargain. etc. However. This function will be performed well as long as money retains a constant purchasing power. A person may choose to store value in any form depending on considerations of income. it will overcome the problems associated with making future payments with specific commodities. for example. Again. we must now decide what things are to be considered as money. Examples of situations where future payments are to be made are pensions. houses. from those who offer him the best bargain (not necessarily those who bought his cow). The various types of definitions of money are as follows: Legal Definitions of Money The statement that ‘money is what the law says it is’ would sum up such a definition. principal and interest on debt. The holders of money are holders of generalised purchasing power that can be spent through time. Definitions of Money After considering the functions of money. Ultimately. The owner of the cow need not procure goods and services from those to whom he sold his cow. they yield income and may appreciate in value over time. money increases the ease of trade. and (3) they may depreciate in value. Money as a Standard of Deferred Payments If money performs the previous two functions then it may also perform the function of being the unit in terms of which deferred or future payments are stated. INTRODUCTORY MACROECONOMICS Money as a Store of Value If money becomes a unit of value and a means of payment then it may also perform the function of serving as a store of value. unlike money. He can use the money to buy the things he wants most. this function can only be performed properly if the value of money remains constant. safety and liquidity.

e. because they are not generally acceptable in payment of debt and for goods and services. i. the money supply includes coins and paper money. but are houses money? They are not. credit cards can also be placed in this category. it has the legal power to discharge debts. For example. people may not prefer legal tender in payment and refuse to sell goods and services to those offering it. Narrow vs. i. A person can however legally refuse to take payment through cheques because there is no guarantee that a cheque will be honoured by the issuer’s bank. Demand deposits of banks are fiduciary money because they are accepted as money on the basis of the trust that their issuer commands. and deposit money. Broad Definitions of Money The narrow definition of money is based upon its medium of payments function. no matter what its legal status may be. legal definitions of money are not the only determinants of what things serve as money. also included in broad money would be time and savings deposits at banks and post offices. Today. Thus. Currency. For example. a unit of value and standard of deferred payment will 95 not help narrow down the list of things that are included in money. things that are not legally defined as money for example. houses could be a unit of value and a standard of deferred payment. It is commonly accepted that anything that is generally acceptable in payment of debt and as payment for goods and services should be included in the money supply. Two of the functions of money. it is money.e. If a good is in fact generally acceptable in payment and generally used as a medium of payment. cheques may be generally acceptable as a means of payment. The broad definition of money tried to extend the money category to include some other things that have a high degree of ‘moneyness’ and are widely used as a store of value. Currency is generally acceptable and is endowed with legal tender status. However. money will include all things that perform the four functions that money does. Deposits are moneys accepted by various agencies from others to be held under stipulated terms and conditions. and a creditor who refuses. These financial assets have a . Functional Definitions of Money By functional definition. In India. This is not true of deposit money. is also called fiat money because it serves as money on the fiat (order) of the government. it is not legally entitled to receive anything else in payment of an existing debt. It may be further endowed with legal tender power. The deposits accepted by banks and post offices only are considered as constituents of alternative measures of money supply.MONEY AND BANKING acceptability if the law proclaims it as money. A cheque is an instrument that instructs the bank to transfer funds from the cheque issuer’s account to the cheque receiver. On the contrary. which are together known as currency. being legal tender.

96

high degree of moneyness or liquidity
but are not generally acceptable in
payment. We shall see some examples
of narrow and broad definitions of
money later in the chapter.
Classifications of Money
Money can be classified based on the
relationship between the face value of
money and the value of money as a
commodity (or intrinsic value). The
classifications are as follows:
Full-bodied Money: Full-bodied
money is money whose value as a
commodity for non-monetary purposes
is as great as its face value as money.
Most of the earlier commodity moneys
for e.g. gold, silver, cattle etc. were as
valuable for non-monetary purposes as
they were for monetary uses. The main
full bodied monies in modern economies
have been the coins of the standard
metal when the economy was on a
metallic standard: gold coins in a gold
standard, silver coins in a silver
standard and gold as well as silver coins
when the country was on a bimetallic
standard.
Representative Full-bodied Money:
This type of money is usually made of
paper. It is equivalent to a circulating
warehouse receipt for full-bodied coins
or their equivalent in bullion. The paper
money itself has no value as a
commodity, it is after all just a piece of
paper, but it represents in circulation
an amount of money with a commodity
value equal to the value of the money.
The advantage of this type of money is
that it is convenient to engage in trade
which requires large sums of money
(imagine carrying huge sacks of gold

INTRODUCTORY MACROECONOMICS

coins in the case of full-bodied money!).
Credit Money: This refers to money,
whose value as money is greater than
the commodity value of the material
from in which the money is made. How
can it maintain a higher value as money
than its commodity value? This is done
by limiting the quantity of money by
preventing the free and unlimited
transformation of the commodity into
money. The government will fix the
quantity of the particular type of money
to be issued and buy only as much of
the money material as needed for the
purpose. The remainder of the supply
of that commodity is left for nonmonetary purposes. This remaining
supply may be so large relative to the
demands for non-monetary uses that
the market value of the commodity will
fall below the value of the money.
Credit money is of various forms:
1. Token coins: All our coins (Rs.5, Rs.2,
Re.1, 50p, 25p, 20p, 10p, and 5p)
are token coins in the sense that their
value as money is far above the value
of the metal contained in them. If you
melt a five rupee coin and sell the
metal in the market place you would
be extremely lucky to get Rs.5 for it!
2. Representative Token Money: This is
usually of the form of paper, which is
in effect a circulating warehouse
receipt for token coins or an equivalent
amount of bullion that is backing it.
The coin or bullion backing the
representative token money is worth
less as a commodity than as money,
thus making it credit money. For
example, if Rs.10000 worth of

MONEY

AND

BANKING

representative token money is
circulated as paper money in the
economy, then Rs.10000 worth of
token coins will back it. However, the
commodity value of the token coins
will be less than Rs.10000, and so will
be the value of the bullion if instead of
token coins, bullion was backing the
representative token money.
3. Circulating promissory Currency
(notes) issued by Central Banks:
This is the greatest part of modern
currency, and includes all currency
notes in India issued by the Reserve
Bank of India. If you look at any
note you will see a legend – ‘I
promise to pay the bearer the sum
of Rs. ‘X’’ — signed by the Governor
of the RBI. This is nothing but a
circulating promissory note issued
by the RBI.
4. Deposits at Banks: These deposits
in banks e.g. savings deposits, are
claims of creditors against banks
which can be transferred from one
person to another by means of
cheques. Since the bank does not
back all the chequable deposits it
has with an equivalent amount of
financial assets or money, these
chequable deposits are credit
money. We will study how banks
may keep less than 100% reserves
backing their chequable deposits
later in the chapter.
Indian Monetary System
India is at present on the paper
currency standard. This standard is
also referred to as the managed
currency standard.

97

The term monetary standard refers
to the type of standard money used in
the economy. The standard money is
that legal money in which the
government of the country discharges
its obligations. The monetary standard
is thus synonymous with the standard
money adopted by the country’s
monetary authority. Since India’s
monetary authority, the Reserve Bank
of India (RBI) has adopted a standard
currency made of paper, India is on a
paper currency standard.
Paper currency is the main
currency of the country. It has an
unlimited legal tender, i.e. it can be used
to settle debts and make payments up
to an unlimited amount. For making
smaller payments, coins made of cheap
and light metals are used. These coins
are limited legal tender since they can
be used to make payments and settle
debts only up to a limited amount. It
would be inconvenient to settle a debt
of Rs.1000 with 50p. coins!
RBI has the sole right to issue
currency notes, other than the one
rupee note in the country. The
Government of India under the Indian
Coinage Act issues the one rupee note
and all coins. Though the Government
issues the one rupee note and coins,
the responsibility for putting them in
circulation rests with the RBI.
The system governing note issue in
India is the Minimum Reserve System.
Paper currency is not convertible into
the precious metal (gold) that is backing
it; hence the currency is said to be
inconvertible.

98

Money Supply
Having defined money we may now list
out the things that serve as money.2
Then, the money supply, i.e. the total
stock of moneys of various kinds at any
particular point of time can be
computed. By repeated measurements
at different points of time we may get a
time series of the total stock of money.
By analysing this time series in
conjunction with time series of other
economic variables such as incomes,
wages, prices, employment, etc. we can
hope to understand the effect of money
on the other variables in the economy.
It is important to note two things
regarding any measure of money
supply. First, the supply of money is a
stock variable, i.e. it does not have any
time dimension – it refers to the total
amount of money at any particular
point of time. It is not a flow variable in
the sense of income, which refers to a
rate per unit time, i.e. so many rupees
per year.
Second, the stock of money always
refers to the stock of money held by the
public. This is always smaller than the
total stock of money in existence. The
term ‘public’ includes all economic units
— households, firms, etc. except the
producers of money, i.e. the government
and the banking system. The banking
system includes the Reserve Bank of
India and all the banks that accept
demand deposits. The reason for such a
distinction is to separate the producers
or suppliers of money from the holders
2

INTRODUCTORY MACROECONOMICS

or demanders of it. This separation is
required for monetary analysis.
Measurement of Money Supply
This is an empirical matter. It involves
defining various measures of money
supply and computing their values. The
Reserve Bank of India has been
publishing data on four alternative
measures of money supply namely,
M1, M2, M3 and M4. These are defined
as follows:
M1 = C + DD + OD

C is currency held by the public. It
consists of paper currency as well as
coins. DD is the ‘demand deposits’ in
banks. Only the net demand deposits
of banks are included in money supply
because the part of demand deposits
that represents inter-bank deposits
held by one bank with another does not
constitute demand deposits held by the
public. Since money supply is defined
as money held by the public, we must
net out the inter-bank deposits to arrive
at net demand deposits in banks.
OD is ‘other deposits’ with the RBI.
These are the deposits held by the RBI
of all economic units except the
government and banks. OD includes
demand deposits of Public Financial
Institutions (like IDBI, etc.), foreign
central banks and governments, the
IMF, the World Bank, etc.
M2 = M1 + savings deposits with post
office savings banks
M3 = M1 + net time deposits of banks
M4 = M3 + total deposits with post office
savings organisation (excluding
National Savings Certificates)

The following sections draw on material from ‘‘Monetary Economics : Institutions, Theory and
Policy,’’ by Suraj B. Gupta, 1982.

Changes in C. The RBI views the four measures of money stock as representing different degrees of liquidity. we shall investigate what determines the actual amount of money stock at any point of time. It is also called aggregate monetary resources of the society. They can be drawn upon by cheque without any restriction. Acceptance of deposits The bank accepts three types of deposits from the public. For example. UTI. the medium of exchange or means of payment function of these deposits gets completed. lend to others but they are not banks in this sense of the term. draft.MONEY AND BANKING M1 and M2 are measures of narrow money. l Current Account Deposits: Deposits in current accounts are payable on demand. many FIs like LIC. post office savings banks are not banks in this sense of the term even though they accept deposits from the public. money from the public. as they do not accept chequable deposits. as these two are key players in determining the changes in the quantum of money supply. the most important being the cheque facility. M3 is most widely used measure of money supply. for the purpose of lending. Only when the ownership of these deposits has been so transferred. Liquidity means the ability to convert an asset into money quickly and without loss of value. . with M1 being the most liquid and M4 being the least liquid. We will go into money supply and changes in money supply after looking at the commercial banking system and the Central Bank. M3 and M4 are measures of broad money. These accounts are usually maintained by businesses and are used for making business payments. or investment of deposits. order or otherwise. However. repayable on demand or otherwise and withdrawable by cheque. and IDBI. the banks offer various services to the account holders for a nominal charge. and changes in the money stock over time. For example. lending alone does not make FI a bank. Banks keep regular accounts of all transactions made in a particular account and submit statements of the same to the account-holder at regular intervals. No interest is paid on these deposits. Thus the two essential functions that make banks as Financial Institutions (FIs) are accepting chequable deposits from the public and lending. This is because they do not perform the other essential function of lending. 99 Acceptance of chequable deposits is a necessary. Similarly. DD and net time deposits of banks cause changes in money stock as measured by M3. BANKING Commercial Banks Banking is defined as the accepting. but not sufficient condition for FI to be a bank. Having defined the measures of money supply. etc. Money supply will change if the magnitude of any of its constituents changes. The main functions that commercial banks perform are: 1.

After keeping a certain portion of the deposits as reserves. Demand deposits are payable on demand either through cheque or otherwise. However. The rule to decide which part of the savings deposits comes under which category is: ‘the average of the monthly minimum balances in the savings accounts on which interest is being paid shall be regarded as a time liability and the excess over the said amount shall be regarded as a demand liability. The Reserve Bank of India distinguishes between the demand liability portion of savings deposits (which are included under demand deposits) and the time liability portion of savings deposits (that are included under time deposits). Interest is paid on these deposits and the rate of interest rises with the term of the deposits. The different types of loans and advances made by banks are as follows: l Cash Credit – In this arrangement.’ 2. A variant of fixed deposits are recurring deposits. All current account deposits are demand deposits and all term deposits are time deposits. the bank gives the balance to borrowers in the form of loans and advances. They are not payable on demand and do not enjoy chequing facilities.g. a depositor makes a regular deposit of an agreed sum over an agreed period e. They are payable on demand and also withdrawable by cheque.100 Fixed/Term Deposits: These are deposits for a fixed term (period of time) varying from a few days to a few years. but with certain restrictions on the number of cheques issued in a period of time. The classification of savings deposits is not as straightforward because they combine features of both demand and time deposits. All l INTRODUCTORY MACROECONOMICS other deposits that are not payable on demand are called time deposits. Interest is paid on the deposits in these accounts. The moneys deposited in such accounts become payable only on the maturity of the fixed period for which the deposit was initially made. actual utilisation of credit by the customer .100 per month for 5 years. because their ownership can be transferred from person to person through cheques. Giving Loans The deposits received by the bank are not allowed to lie idle by the bank. l Savings Account Deposits: These deposits combine the features of both current account deposits and fixed deposits. Interest is paid on the deposits in these accounts but the interest paid on savings account deposits is less than that of the fixed deposits. This credit limit is determined by the bank’s estimation of the borrower’s creditworthiness. an eligible borrower is first sanctioned a credit limit upto which he may borrow from the bank. In these accounts. In monetary analysis deposits are classified into two types: demand deposits and time deposits. Rs. Only demand deposits may serve as a medium of exchange.

3. the entire loan amount becomes chargeable to interest.e. stating the amount of money owed and the time when the debt has to be settled. loans to finance working capital or as priority sector advances. and acting as a legal document in possession of the bank. semi-manufactured or finished goods. and bills receivable (dues) from others. In addition. he will present the bill of exchange to the bank for discounting. Security brokers and others whose credit needs fluctuate day to day usually take these loans. 4. if A buys goods from B. the entire loan amount becomes chargeable to interest. For example. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. life insurance policies etc. Demand Loans . The bank will deduct a commission and pay the present value of the bill to B.A demand loan is one that can be recalled on demand. Discounting Bills of Exchange A bill of exchange is a document acknowledging an amount of money owed in consideration for goods received. either in one instalment at the end of the loan. Overdrafts An overdraft is an advance given by allowing a customer to overdraw his current account upto an agreed limit. or in a number of instalments over the period of the loan. . financial assets or goods. The whole amount of the term loan sanctioned is paid in lump sum by crediting it to the loan account of the borrower. Short-term Loans – Short-term loans may be given as personal loans. If B wants the money immediately. The withdrawing power depends on the value of the borrower’s current assets. The security against these loans may be personal. Thus. he may not pay B immediately. The security for overdrafts is usually financial assets of the account holder such as shares. Upon maturity of the bill. they are loans made against some security. to be used in case of default. It has no stated maturity. debentures. These loans are secured loans. The borrower has to pay interest on the ‘drawn’ or utilised portion of the credit only. which comprise mainly stocks of goods – raw materials. the bank will secure payment from A. He may give B a bill of exchange. Overdraft is a temporary facility and the rate of interest charged on the amount of credit used is lower than that on cash credit because the risk involved and service cost of such credit is less – it is easier to liquify financial assets than physical assets. commercial banks extend the following facilities when they are requested by their customers. The borrower has to submit a stock statement of his assets to the bank showing evidence of on-going trade and production activity. Thus. i.MONEY l l AND BANKING depends upon his withdrawing power. The 101 repayment is made as scheduled.

(ii) Issuance of travellers’ cheques and gift cheques. (iv) Underwriting activities (agreeing to partly or fully purchase the whole or the unsold portion respectively of new issue of securities) and private placement of securities (selling securities not through the open market. bills. 1949. banks hold excess investments in these securities because banks can borrow against these securities from RBI and others. Payment of bills and insurance premia as per customer’s directions. debentures of Land Development Banks. etc. (iii) Safe custody of valuable goods in lockers. Other approved securities are securities approved under the provisions of the Banking Regulation Act. agent or representative of customers as well as securing documentation for air and sea passage. hundis. 7. However. . national savings certificates etc. Agency Functions of the Bank The bank performs certain agency functions for its customers in return for a commission. telegraphic transfers. Miscellaneous Functions (i) Purchase and sale of foreign exchange. Banks hold them even though the return from them is lower than that on loans and advances because they are more liquid. Acting as executors and trustees of wills. units of UTI. Investment of funds The banks invest their surplus funds in three types of securities – Government securities. Part of the banks’ investment in government securities and other approved securities are mandatory under the provisions of the Statutory Liquidity Ratio requirement of the RBI. 6. mail transfers. demand drafts. housing boards. and other securities.INTRODUCTORY MACROECONOMICS 102 5. etc. other approved securities. Purchase and sale of shares and securities on behalf of customers. The agency services provided by the banks are: (i) Transfer of funds – the bank provides facility for cheap and easy remittance of funds from place to place via instruments (ii) (iii) (iv) (v) (vi) (vii) (viii) such as the demand drafts. These include securities of State sponsored bodies like electricity boards. Collection of dividends and interest on shares and debentures on behalf of customers. but privately to selected entities). Collection of funds – the bank undertakes to collect funds on behalf of its customers through instruments such as cheques. Acting as correspondent. Government securities are securities of both the Central and State governments such as treasury bills. shares of Regional Rural Banks etc. Provision of income tax consultancy and acceptance of income tax payments of customers. or sell these securities in the open market to meet their need for cash.

The government does this. The Central Bank performs the following functions: 1.MONEY AND BANKING 103 Commercial banks Scheduled commercial banks Public sector banks SBI and its Subsidiaries Non-scheduled commercial banks Private sector banks Foreign banks Other nationalized banks Fig. The design and the control of the country’s monetary policy is its main responsibility. The country’s Central Government is usually authorized to borrow money from the Central Bank. This means that the Central Bank is obliged to back the currency with assets of equal value.1 gives a schematic classification of commercial banks. by selling local currency securities to the Central Bank. Figure 7. These assets usually consist of gold coin. foreign securities. and the domestic government’s local currency securities. This authority of the government gives it flexibility to monetize its debt. Under the present economic liberalisation. commercial banks are urged to assume certain roles which are usually outside the purview of typical commercial banking such as development banking.1: Schematic Classification of Commercial Banks As is evident from the above list. insurance in addition to commercial banking practices. gold bullion. The Central Bank The central bank is the apex institution of a country’s monetary system. it issues currency. India’s central bank is the Reserve Bank of India. All the currency issued by the Central Bank is its monetary liability. As pointed out earlier. Monetizing the government’s . When the Central Bank acquires these securities. Currency Authority The Central Bank is the sole authority for the issue of currency in the country. 7. The effect of this is to increase the supply of money in the economy. banks provide a wide range of services to their customers.

For example. the Central Bank also has the responsibility of managing the public debt. Bankers’ Bank and Supervisor (Lender of the last report) As the banker to banks. which is a monetary liability. it borrows from the Central Bank. The pool of funds with the Central Bank serves as a source from which it . The government spends the new currency and puts it into circulation. The Central Bank also advises the government on banking and financial matters. This means that the Central Bank has to manage all new issues of government loans (by advising the government on the quantum. remittance and other banking operations. services the public debt outstanding (by making sure that interest is paid on time and maturing bills are retired by repaying the principal) and nurtures the market for government securities (by ensuring that the market functions smoothly. The Central Bank also provides short-term credit to the government. the bank holds excess reserves with the Central Bank to meet any clearing drains due to settlement with other banks or net withdrawals by their account holders. and the government keeps its cash balances on current account with the Central Bank. which is a non-monetary liability. and carries out exchange. the latter paying for the bills by drawing down its stock of currency or printing currency against equal transfer of the said securities. The purpose of this stipulation is to use these reserves as an instrument of monetary and credit control.104 debt (called public debt) is the process of converting its debt (whether existing or new). lends them short-term funds and provides them with centralised clearing and remittance facilities. Putting and withdrawing currency into and from circulation are also the job of its banking department. INTRODUCTORY MACROECONOMICS As the government’s banker. so that the government can meet any shortfalls in receipts over disbursements. when the government incurs a deficit in its budget. It carries out all the banking business of the government. 3. Banker to the Government The Central Bank acts as a banker to the government – both Central as well as State governments. The banks are required to deposit a stipulated ratio of their net total liabilities (the CRR) with the Central Bank. The government borrows money by selling treasury bills to the Central Bank. the Central Bank holds a part of the cash reserves of banks. As the banker to the government. This is done by selling treasury bills to the Central Bank. 2. the Central Bank accepts receipts and makes payments for the government. with adequate supply of all maturities of existing bills and has enough liquidity to pick up the new issues of bills). In addition to this. timing and terms of such loans). The government carries on short term borrowing by selling ad-hoc treasury bills to the Central Bank. into Central Bank currency.

However. amalgamation (merging of banks) and liquidation (the winding up of banks). (b) the sensitivity of banks’ demand for borrowed funds to the differential between the banks lending rate and their borrowing rate (positive relationship). An increase in the bank rate increases the costs of securing 105 funds and of borrowing reserves from the central bank. 2. branch expansion. The control is exercised by periodic inspection of banks and the returns filed by them. It does not matter whether the securities are bought from or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank.MONEY AND BANKING can make advances to banks temporarily in need of funds. management. regulates and controls the commercial banks. In actual practise however. This will reduce the ability of banks to create credit and thus to increase the money supply. Controller of Money Supply and Credit The Central Bank controls the money supply and credit in the best interests of the economy. A rise in the bank rate will then cause the banks to increase the rates at which they lend. liquidity of assets. The bank does this by taking recourse to various instruments. those that affect only the quantity of the particular variable: 1. the banks in temporary need of funds are supposed to approach other sources first like the call money market and then only approach the Central Bank. A decrease in the bank rate will have the opposite effect. against approved securities or eligible bills of exchange. Let us first deal with the instruments of quantitative control. thus reducing the volume of credit. (c) the extent to which other rates of interest in the market change and (d) the state of supply of and demand for funds from other sources. The Central Bank supervises. When the bank gives the Central Bank a cheque for the securities. acting in its capacity as lender of last resort. Generally they are categorised as quantitative and qualitative instruments. Open Market Operations: OMO is the buying and selling of government securities by the Central Bank from/to the public and banks on its own account. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. The sale of government securities to banks will have the effect of reducing their reserves. The regulation of banks may be related to their licensing.e. the . This will then discourage businessmen and others from taking loans. 4. the effectiveness of bank rate policy will depend on (a) the degree of banks’ dependence on borrowed reserves (positive relationship). i. Bank Rate Policy: The bank rate is the rate at which the central bank lends funds as a ‘lender of last resort’ to banks.

which deal with the allocation of credit between alternative uses. Imposing margin requirement on secured loans: A margin is the difference between the amount of the loan and market value of the security offered by the borrower against the loan. 1. If the margin imposed by the Central Bank is 40%. This directly reduces the bank’s ability to give credit and therefore decrease the money supply in the economy. Successful conduct of OMO as a tool of monetary policy requires first that a well functioning securities market exists.106 Central Bank collects the amount by reducing the bank’s reserves by the particular amount. In such a situation. the Central Bank increases the reserves of the bank by the particular amount. 3. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio. Varying Reserve Requirements: Banks are obliged to maintain reserves with the Central Bank on two accounts. Under CRR the banks are required to deposit with the Central Bank a percentage of their net demand and time liabilities. Varying the SLR affects the freedom of banks to sell government securities or borrow against them from the Central Bank. This directly increases the bank’s ability to give credit and thus increase the money supply. Reducing the CRR has the effect of increasing the bank’s excess reserves. OMO becomes a ineffective tool. The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets which may be (a) excess reserves (b) unencumbered (are not acting as security for loans from the Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government) and (c) current account balances with other banks. By altering the . This affects their freedom to increase the quantum of credit and therefore the money supply. We now deal with instruments of qualitative credit control. Increasing the SLR reduces the ability of banks to give credit and vice versa. which increases its power to give credit. When the cheque clears. banks are not affected by the OMO because they buy securities with excess reserves and when they sell securities. If banks regularly and routinely resort to keeping excess reserves then the utility of such a policy will be doubtful. the amount realised is added to the excess reserves. When the Central Bank buys securities from the banks it gives the banks a cheque drawn on itself in payment for the securities. then the bank is allowed to give a loan only up to 60% of the value of the security. In developed countries like the US. Varying the CRR is a tool of monetary and INTRODUCTORY MACROECONOMICS credit control. An increase in the CRR has the effect of reducing the banks excess reserves and thus curtails their ability to give credit.

The added advantage of low interest rate regime is that it boosts investment. The government is reaching a stage where it has to borrow not for productive activities or to finance developmental works. The government can ‘retire’ costly old debt and replace with cheaper new debt. in line with the structural adjustment programme. the Central Bank can alter the amount of loans made against securities by the banks. The effect of this is to dampen investment. One suspects that the real reason for the government’s decision to lower interest rates is the fact that the interest and repayment obligations on government debt are fast reaching unsustainable levels. Moral Suasion: This is a combination of persuasion and pressure that the Central Bank applies on the other banks in order to get them to fall in line with its policy. The Central Bank frequently announces its policy position and urges the banks to fall in line. The main thrust of the reforms as per the . but rather to pay off old debts. Selective Credit Controls (SCCs): These can be applied in both a positive as well as a negative manner. and it can reduce the interest burden of its debt. 3. The Government has also gone in for reform of the Banking System in a big way. Application in a negative manner would mean using measures to restrict the flow of credit to particular sectors. there is reduction in the fluctuation of prices in the market price of securities. The effect of lower interest rates is beneficial to the state of public finances. Banks and Monetary Policy: A Recent Scenario In the present Indian macroeconomic scenario. speeches and hints to banks. The apparent reason is that the interest rates in India are too high. One important component of such policy has been the gradual downward adjustment of the structure of interest rates in favour of a lower interest rate regime. This is exercised through discussions. structural adjustment 107 programme of the economy has had implications on the monetary policy of the government. the real interest rates are therefore too high. Where it has to borrow to repay past principal is not that dangerous a state of affairs. letters.MONEY AND BANKING margin requirements. and given the low inflation rate recently. 2. Application in a positive manner would mean using measures to channel credit to particular sectors. High margin requirements discourage speculative activities with bank credit and therefore divert resources from unproductive speculative activities to productive investments. The advantages of this instrument are manifold. usually the priority sectors. Where it has to borrow to meet interest obligations on past debt is a calamitous state of public finances. By reducing speculative activities. Moral suasion can be used both for quantitative as well as qualitative credit control.

INTRODUCTORY MACROECONOMICS

108

recommendations of the Narasimhan
Committee Reports, 1991 and 1998 was
to reduce the excessively high CRR and
SLR (to increase the banks capability to
create credit), reduce and ultimately
deregulate the interest rates, give more
autonomy to the operational functioning

of the banks to increase their efficiency,
allow foreign private banks to set up
branches or subsidiaries in India and
reduce the directed, subsidized credit
to priority sectors (to allow banks to
allocate credit on commercial rather than
developmental criteria).

SUMMARY
l

l
l
l
l
l
l
l
l

l
l

The main function of money in an economic system is to facilitate the
exchange of goods and services, that is, to lessen the time and effort required
to carry on trade.
The exchange of ‘goods for goods’ is called barter exchange.
Barter becomes unwieldy as groups become larger. A possible solution is
the use of a commonly accepted good as a medium of exchange.
Barter suffers from four main drawbacks, each of which is overcome by a
specific function of money.
Money may be defined using legal definitions or functional definitions.
Money may be classified based on the relationship between the value of the
money as money, and the value of money as a commodity.
India follows a managed paper currency standard with a minimum reserve
system of note issue.
Money supply is the total stock of moneys of various kinds at any particular
point of time.
Banking is defined as the accepting, for the purpose of lending, or investment
of deposits, money from the public, repayable on demand or otherwise and
withdrawable by cheque, draft, order or otherwise.
Two essential functions of a bank are accepting deposits and giving loans.
The Central Bank is the apex institution of a country’s monetary system.
The design and control of the country’s monetary policy is its main
responsibility.

EXERCISES
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

What is the main function of money in an economic system?
What is barter?
What are the drawbacks of barter?
How does the use of money overcome the drawbacks of barter?
How can money be defined?
How can money be classified?
What monetary system does India follow?
What is money supply?
What are the various money stock measures?
What is banking?
What are the functions of commercial banks?
What are the functions of central banks?

APPENDIX 7.1: THEORY

In this chapter, we have studied only
the supply of money. We may round off
the discussion on money by
introducing the theory of demand for
money, from the Keynesian perspective.
The Keynesian theory of the demand for
money (liquidity preference) is as
follows. Keynes believed that people
demand money for three reasons or
‘motives’.
1. Transactions Motive
The reason for transactions demand is
as follows. Money is needed to carry
out ordinary day-to-day transactions.
This is the medium of exchange
function of money. The need to hold
monetary balances arises because
people in general do not have
synchronized
receipts
and
expenditures patterns. In other words,
the amount of money individuals
receive at any point of time may not be
equal to the amount of payments that
have to be made at that point of time.
For example, an individual may receive
a monthly salary but have to pay the
milkman every week. As a result he will
have to hold cash balances in order to
pay the milkman every week. If the
amount that a person receives at every
point of time equalled the amount that
he paid out at each point of time then
there would be no need to hold money
balances for transactions.

OF

LIQUIDITY PREFERENCE

The amount of transaction balances
a person must hold increases
proportionately with the money volume
of transactions. Among all the
transactions made, only some of them
will be in final goods and services. If we
assume that the ratio of GNP to the
volume of all transactions as some
constant, then we have the amount of
money balances that the public as a
whole wishes to hold for transactions
purposes depending on the level of
income.
Further, the amount of transactions
balances required varies proportionately
with the price level P at which the output
is sold. Twice as much money is
required to purchase a commodity that
costs Rs.100 as was required to
purchase the same commodity when its
price is Rs.50. The same is true for the
economy wide total of purchases PY,
where Y is real GNP.
The transactions demand may be
expressed in equation form as
Mt = k(PY)
Where,
Mt = transactions demand for money
k = constant of proportionality
P = price level
Y = real GNP

INTRODUCTORY MACROECONOMICS

110

If we assume that a change in the
price level causes a proportionate
change in the quantity of transactions
balances required, we may rewrite the
equation as:
Mt = Pk(Y)
To convert the demand for nominal
balances into real balances we divide
throughout by P to get
Mt
= k (Y )
P

where

Mt
is the demand for real
P

balances for transactions purposes.
2. Precautionary Motive
The precautionary demand for money
arises because of uncertainty regarding
future receipts and expenditures.
Precautionary balances enable people
to meet unanticipated increases in
expenditures or unanticipated
reductions or delays in receipts.
Demand for precautionary balances
varies directly with income. An
individual can and will need to
keep aside more money for this purpose
as his income increases. Since
both transactions demand and
precautionary demand are functions of
income, they may be combined so that
the equation

Mt
= k (Y ) can be used to
P

denote the demand for both (real)
transactions and precautionary
balances.
3. Speculative Motive
The speculative demand for money
arises from the speculative motive for

holding money. In the Keynesian world,
a person who buys bonds is
speculating that the interest rate will not
rise appreciably during the period in
which he intends to hold the bond. The
uncertainty regarding the future
interest rate causes people to hold
money for speculative purposes. There
is a negative relationship between the
interest rate and the market price of
a bond, or for that matter any
debt security.
People who buy bonds expect the
interest rate to fall and the prices of
bonds to rise. In other words, they
regard the present interest rate as ‘high’
and the present bond prices as ‘low’.
Those who switch from bonds to money
have opposite expectations.
Now, people who view the current
interest rate as too ‘high’ or too ‘low’
obviously have some notion in their
minds of the ‘normal’ rate of interest,
with which they compare the current
rate of interest. Given this notion of the
‘normal’ rate of interest, at any point of
time people will decide that the current
rate of interest is higher than, lower
than or equal to the normal rate of
interest.
If people view the current rate of
interest as too high, they will expect the
rate to drop as it returns to the normal
rate. At the current high rate, people
will therefore, hold bonds instead of
money. They will therefore, not only
currently enjoy the high rate of return
provided by the bonds, but will also
expect capital gains as the bond prices
rise and the interest rate falls to normal.

the curve shows that people will hold no money in speculative balances. Msp = demand for nominal speculative balances P = price level h(r) = function of r (Msp is an inverse function of r) Dividing throughout by P we get the demand for real speculative balances: msp = M sp P = h(r) We may show the relationship between msp and r in diagrammatically in Fig. cannot affect the interest rate. It is in this section of the curve that increases in money supply.1: Relationship between Interest Rate and Real Balances no one prefers money to bonds. all people hold money. as the interest rate returns to the normal rate. The higher the market interest rate. Thus.h(r) Where. and no bonds at this interest rate. To hold bonds at this interest rate is to take the almost certain risk of a capital loss as the interest rates rise and the bond prices fall.MONEY AND BANKING 111 On the other hand if people view the current interest rate as low. We may write the equation for speculative demand for money as: Msp = P. a small proportional change in the interest rate causes an infinitely larger change (in the opposite direction) in the quantum of speculative balances demanded. holding idle money is the safer policy.e.1. . we can conclude that the demand for speculative balances varies inversely with the interest rate. A7. then they will expect it to rise and bond prices to fall. At the other end of the curve. They will therefore hold money rather than bonds. This is because all people believe that the interest rate is so low that it cannot go any lower – it can only rise. r0 r1 msp msp Fig A7. Thus. This is because all people believe that the interest rate is so high that it can only fall. Thus. This section of the curve (where it becomes perfectly interest elastic) is called the liquidity trap. since it goes entirely into speculative balances. At some high interest rate r0. the lower will be the amount of real balances that people will maintain for speculative purposes. speculative demand becomes perfectly elastic with respect to interest rate (the curve becomes parallel to the X-axis). The interest lost as a result of holding money will be small in comparison to the prospective capital losses if the interest rate does indeed rise. At this interest rate. i.

APPENDIX 7. At that rate. the precautionary demand and the speculative demand. the money stock to be some given constant amount. Given the money supply and the income level. precautionary and speculative demands for money will be just equal to the supply of money. At the rate of interest r0 the demand for transactions and precautionary balances is mt and the demand for speculative balances is msp.2 : MONETARY EQUILIBRIUM The equilibrium interest rate is determined by the interaction of the curves representing the supply of money and the demand for money. The interest rate that equates the supply of money with the demand for money is called the equilibrium interest rate. i. for money at different rates of interest. The curve m d is the liquidity preference curve. It shows the demand r r0 md mt  m sp  m d Fig A7.3 below : r re md md  ms md .2.INTRODUCTORY MACROECONOMICS 112 The Total Demand for Money (liquidity preference) The total demand for money expressed in real terms is the sum of the transactions demand. This may be represented diagrammatically in Fig A7. It may be written as: md = k(Y) + h(r) For any given price level. This may be represented diagrammatically in Fig A7. we know from k what mt will be for every level of Y.e. there will be monetary AND THE INTEREST RATE equilibrium with the supply of money (ms) being equal to the demand for money. ms Fig A7.2 : Liquidity Preference Curve. and we know from h what msp will be for every level of r. Assume the supply of money. From k and h we know what the total demand for money will be for every combination of Y and r.3 : Equilibrium Rate of Interest . there will be some interest rate at which the sum of the transactions.

curve that does not correspond to the Decreasing the money supply liquidity trap. However this will occur only supply increase is ‘trapped’ in the if the money supply increase takes place speculative balances and does not affect the region of the demand for money interest rate. Consider the effect of an increase in the money supply from md. APPENDIX 7. md Altering the money supply will affect the interest rate. and bills discounted and purchased. advances.MONEY AND BANKING 113 ms ms1 The supply of money curve is a r vertical straight line because it is a constant. If money supply increases will have the opposite effect of over the section of the curve where the increasing the rate of interest. (b) investments and (c) cash.e. then all the happen when the economy is not in the additional liquidity created by the money liquidity trap as well. Reserves are the retained earnings or undistributed profits of the banks. They deal in financial assets and money. The purpose of accumulating reserves is to improve the banks’ capital position so as to better meet unforeseen . The Money Supply effect of an increase in the money supply is to cause a decrease in the interest rates from r0 to r1.4. A look at the consolidated balance sheet for all commercial banks reflects their heavy involvement in dealing with financial assets. A brief OF COMMERCIAL BANKS explanation of the assets and liabilities of banks follows: Liabilities 1. The money market is in equilibrium at interest rate re because r0 the supply of money equals the demand r1 for money.4 : Rate of Interest and Changes in this diagrammatically in fig A7. This can liquidity trap operates.ms ms to ms1. We can portray the effect of Fig A7. and is independent of the rate of interest. A glance at the table shows that banks raise the bulk of their funds by selling deposits.3 : BALANCE SHEET Commercial banks are financial intermediaries. i. the shareholders of the banks. Paid up capital is the amount of share capital contributed by the owners. and their assets comprise mainly of: (a) bank credit consisting of loans. Capital and Reserves: Capital and reserves constitute the owned funds of the banks.

Individual banks borrow from each other.00 86760.7.65 2. banks voluntarily hold extra reserves to meet daily withdrawals of cash by their account holders. Cash and balances with RBI Total Assets liabilities and unexpected losses.65 3. in Crores) % to Total 1.98 5. Cash: This item includes cash in hand and balances with other banks including the RBI. Such reserves are called statutory reserves.08 1202767. Fixed assets 20083. Assets 1. GIC and its subsidiaries.31 6.74 5.21 Total Liabilities 1535513.04 1535513. and the ICICI.94 4.30 1.29 38.13 100. Other liabilities 141420. Borrowings 107178. . Other assets 77349.30 4. which is a mandatory requirement. Banks hold balances with the RBI under the cash reserve ratio. NABARD and from other Non-Banking Financial Institutions like UTI.25 7.04 42.51 5.13 100. Capital 21497. Borrowings: Banks as a whole borrow from the RBI. Loans and advances 645743.18 1. which are allowed to lend in the inter bank call money market.INTRODUCTORY MACROECONOMICS 114 Table A. Reserves and surplus 62648. IDBI.40 2.00 Liabilities 3. Deposits Assets 1.05 5. 2002 Item Amount (Rs. This is because their business is in other peoples’ money! 2.1 Consolidated Balance Sheet of Indian Commercial Banks as on March 31. The owned funds of banks usually constitute a small source of their funds. Investments 588058. Balances with banks and money at call and short notice 117518.76 9. from the call money market and from other sources also.43 78.82 6. Besides these.33 4.

Thereafter the bank collects the amount from the debtor.4 : C REDIT C REATION OF DEPOSITS We are now in a position to look at increases in the supply of money as a result of the increase in one of the components of money. To analyse the basic economics of credit creation. deposits with the bank. The public do not alter its currency holdings. DD happens through the process of credit creation and multiple expansion of deposits. Banks lend their surplus cash in such a manner in order to earn interest without putting undue strain on their liquidity position. Bills: These may be inland or foreign.MONEY AND BANKING 2. When the RBI increases its loans to banks then reserves . 2. depending upon where the party is. These four assumptions would explain the link between the quantity of bank deposits and the quantity of reserves.e. 3. Banks accept targeting the demand deposits. All banks face the same cash reserve requirement of nearly 10%. The first policy is for RBI to lend reserves to the banks. Thus. namely. during the pendency of the bill. specifically by two policies. the volume of deposits can change only if the volume of reserves held by banks change. Increases in deposits with the bank.e. 3. i. from whom the bank has to collect payment. APPENDIX 7. it is an asset of the bank. i. Banks have no desire to hold excess reserves. The key simplifying assumptions are as follows: 1. stock brokers and other financial institutions for short periods of time varying from 1 day to 14 days. If the creditor wants the amount immediately he may get the bill discounted by a bank. The RBI determines the quantity of reserves. AND M ULTIPLE E XPANSION 4. which is nothing but a document acknowledging that payment has to be made of a certain amount at a certain 115 time for goods received. i. the bank deducts a commission and pays the creditor the amount. The person who issues the bill is the debtor and the person who accepts the bill is the creditor. These reserves are called borrowed reserves or borrowings. Money at call at short notice: This consists of money lent to other banks. This will help in understanding the process without getting too mired in detail. we may make some simplifying assumptions. As we will see. In business.e. The table illustrates the nature of business turned out by the scheduled commercial banks and this will make us understand the relative positions of liabilities and assets in banking business. there is no extranormal cash drain from the banking system due to net withdrawals by account holders. it is customary to make payments through a bill.

The RBI.100 +Rs. This will affect its Taccount as follows. Since demand deposits are included in the definition of money. it creates a demand deposit. Payment is made by adding the amount to the banks reserve account at the RBI.1000 +Rs. Deposit Expansion at the First Bank As a result of RBI’s security purchase.900 to Bank A Change in Assets Cash reserves Required reserves Excess reserves +Rs.100 as reserves under cash reserve requirement. when the bank lends.1000 deposit by adding Rs. Let us suppose that the bank chooses to make a loan. Open market operations is the buying and selling of securities by the RBI in the open market. The RBI can reduce reserves by simply selling securities.900 is excess reserves. The recipient of the loan will most likely spend it and the funds will ultimately get deposited in another bank. Consider now that the RBI purchases securities from an individual worth Rs. In other words. Thus. The seller of the security deposits the cheque with a bank and the bank passes along with the cheque to the RBI for payment.1000. The remaining Rs. We will now trace the effects of this action. after it has presented the cheque drawn on the RBI to the RBI.100 to reserves and Rs.INTRODUCTORY MACROECONOMICS 116 increase. which the bank does not want by assumption. by purchasing securities the RBI simply create reserves. When the bank makes a loan.1000 of reserves. The bank would like to convert these excess reserves into an earning asset. This will cause an alteration of the T-account (an account showing changes in the balance sheet) as below: The bank has to keep 10% of Rs. The amount of money the bank can safely lend is the amount of its excess reserves.1000 and the individual deposits the cheque with bank A. Rs. It may do this by purchasing securities or by making a loan.900 and create an equivalent amount of deposits. This means that bank A can lend Rs. the bank is creating money. i. reserves decrease.1000 . Furthermore.1000 of demand deposits. it opens an account in the name of the borrower for the amount of the loan.900 Change in Liabilities Demand deposits +Rs. bank A finds itself with an additional Rs. and when RBI reduces the loans. When RBI purchases securities it does so by writing a cheque on itself. When it clears the cheque it reduces the reserve account of the bank by the cheque amount.e. bank A has adjusted to its original Rs. as the seller of the securities receives a cheque drawn on some bank. Thus. bank A will be credited with Rs. The second way the RBI can alter the quantity of reserves is through open market operations. thus reducing total reserves.

The bank’s excess reserves have been eliminated and the bank is satisfied.0 Assume that he borrower deposited the Rs.810. the total quantity of assets and demand deposit accounts in the banking system Bank B Change in assets Cash reserves Loans Required reserves Excess reserves +Rs.900 deposited in another bank by the borrower. Following exactly the same steps and same logic as before.MONEY AND BANKING 117 earning assets in the form of loans. required reserves of Rs.810. and that someone spent the amount and it ultimately got deposited in a demand deposit account in another bank.810) and excess reserves of Rs.0 Change in Liabilities Demand deposits +Rs.100 +Rs.810 to make loans worth Rs. We have to trace the effects of this deposit.81 (being 10% of Rs.900 +Rs. The T-account will now be as follows.729. That bank would then have a deposit of Rs. Have all the effects of the initial deposit worked themselves out? Definitely not! There is still the matter of the Rs.810 of excess reserves into earning assets.900 . At each step the bank sets aside 10% of the newly acquired deposits in the form of required reserves and uses Bank B Change in Assets Cash reserves Required reserves Excess reserves +Rs.90 +Rs.729 can be used to acquire earning assets simply continuing this Bank A Change in Assets Cash reserves Loans Required reserves Excess reserves +Rs.90 + Rs.900 Change in Liabilities Demand deposits +Rs.90 Rs. Bank B will want to make profitable use of its excess reserves and decides Change in Liabilities Demand deposits +Rs. As the number of such cycles increases.810 +Rs. After it makes the loan.900 +Rs.1000 sequence. we have: The loans made by bank B were made to someone.100 Rs. its excess reserves to acquire earning assets. then bank B’s T-account will alter as follows. the remaining 90%.900 in bank B. The pattern of the sequence is as follows. This Rs. it will have converted Rs.

49 531. The transfer of funds between banks that goes on in each cycle helps explain why banks try to attract deposits away from other banks.1000 and loans (credit created) has increased by Rs. The deposit expansion process can is summarised in Table A7. demand deposits (and therefore money) have increased by Rs.61 F 590. the increase is 10% smaller than in the previous one.00 729. At that point.00 1000. Computing the value for our example we get 1000/(1 – 0.00 100.00 656.00 900.10000.10 72. although it is evident that at each succeeding cycle.2 : The process of Credit Creation and Deposit Expansion (All figures are in rupees) Bank name Additional deposits (Rs. That is.00 810. demand deposits have increased by a tenfold multiple of the initial increase in reserves.44 59. a = 1000 and r = 0.00 9000.9 times the preceding term.9000. The need to set aside 10% of each addition to deposits in the form of required reserves ultimately limits the size of the expansion. As we can see. The formula for the sum of a geometric progression is a/(1–r).14 – – – – – – – – and so on – – – 10000.00 C 810. The cycles cease when all excess reserves have been converted into required reserves.9) = 10000.00 81.) (money increase) (credit increase) A 1000. as shown in the table.00 90. The bank that succeeds in drawing reserves away from other banks can increase Table A7. we have to add 1000 + 900 + 810 + … where each term is 0.00 B 900.10 590.00 D 729. as per the table.2.9. required reserves have increased by Rs.30 53.INTRODUCTORY MACROECONOMICS 118 increase.) Additional loans (Rs.) .44 478. Note that the total increase in demand deposits is the sum of the increases in each of the individual cycles.49 65.05 G 531.00 Total Additional required reserves (Rs. This amounts to finding the sum of a geometric series of the form a + ar+ ar2 + ar3 + … where in our example.90 E 656.

MONEY AND BANKING its own lending power. . An important point to be noted is that the terms ‘multiple deposit expansion’ and ‘credit creation’ refer to the banking system as a whole and not to an individual bank. For an individual bank. which is a sub multiple of the initial deposit. it may create deposits and loans only with the remaining amount. all the banks taken together are able to create demand deposits and credit several times larger than the initial deposit. In other words. after setting aside the required 119 reserves.

UNIT-V GOVERNMENT BUDGET AND THE ECONOMY .

public works etc. AND THE Implementation of these policies requires expenditure by the government. This part presents the overall picture of the financial performance of the government during the period since its last budget. 3. or does so inefficiently. The budget. and some source of funding for that expenditure. Redistributive Activities: The government redistributes income and wealth to reduce inequalities. The government has several policies it wishes to implement in the overall task of performing its functions. and seek legislative approval. by expenditures on social security. 2. The second part of the budget presents the government’s financial plans for the period up to its next budget. Activities to secure a reallocation of resources: The government has to reallocate resources in line with social and economic considerations in case the market fails to do so. subsidies. which runs from April 1 to March 31. . As a consequence of Keynesian economics. budgetary policies are considered significant in the stabilisation of the economy. The objectives that are pursued by the government through the budget are as follows: 1. The budget is the most important information document of the government. in order to inform the country. Stabilising Activities: The government tries to prevent business fluctuations and maintain economic stability through expanding public expenditure during recession and contracting the former during inflation. (Keynesian economics). One part of the budget is similar to a company’s annual report.CHAPTER 8 GOVERNMENT BUDGET ECONOMY The purpose of this chapter is to understand what a government budget is and how the government budget interacts with and affects the economy. is thereby a fiscal tool for the government to implement its various policies. Budget and its Objectives The budget is an annual statement of the estimated receipts and expenditures of the government over the fiscal year.

states also prepare budgets. Taxes are of two types – direct taxes and indirect taxes. There are three levels at which the budget impacts the economy. The Revenue Budget consists of the revenue receipts of the government and the expenditure met from such revenues. We will now undertake a classification of receipts and expenditure in order to understand how they are reflected in the Revenue and the Capital Budgets. modification of the existing tax rates or continuance of the existing tax rates are contained the budget. thereby lowering social welfare. Efficiency refers to the cost per unit of goods or services provided. The proposals of government for levy of new taxes. Budget Receipts Receipts may be classified as revenue receipts and capital receipts. wealth tax. electricity etc. there will be a tendency of the monopolist to curtail output in pursuit of profit maximising behaviour. Revenue Receipts Revenue receipts may be divided into tax revenue and non-tax revenue. and those that are paid directly by the persons to the state. then one firm can produce at a lower average cost than could more than one firm. First. corporation tax are all examples of direct taxes. sales tax. through its public enterprises. Direct taxes are those taxes levied immediately on the property and income of persons. etc. heavy manufacturing.INTRODUCTORY MACROECONOMICS 122 4. We shall however. Industries which are potential natural monopolies are railways. Tax revenues consist of the proceeds of taxes and other duties levied by the Union Government (Central Government). Management of Public Enterprises: Government undertakes commercial activities that are of the nature of natural monopolies. Income tax. is aggregate fiscal discipline. This means having control over expenditures. These usually come under state regulation because if left unregulated. Components of the Budget Governments at every level have their own constitutional processes to prepare. The second is the allocation of resources based on social priorities and the third is the effective and efficient provision of programmes and delivery of services. interest tax.1 The budget is divided into the revenue budget and the capital budget. given the quantum of revenues. Customs duties. 1 present and execute their budgets. A natural monopoly is a situation where there are economies of scale over a large range of output. This is necessary for proper macroeconomic performance. Indirect taxes are those that affect the income and property of persons through their consumption expenditures. . service Similar to Central Government. Effectiveness measures the extent to which goods and services the government provides achieves its goals. excise duties. The Capital Budget consists of capital receipts and payments. focus only on the budget of the Central Government. or attains its targets or achieves its mission.

Asian Development Bank. etc. but conferring a measurable special advantage on the fee payer’.g. borrowings by the government from the Reserve Bank of India and other parties through the sale of treasury bills. interest on funds borrowed from government credit corporations.g. recoveries of loans granted to state and union territory governments and other parties. etc. a person can avoid excise duty on biscuits by merely avoiding the purchase of biscuits. Administrative revenue is revenue that arises on account of the administrative function of the government. in crores) 172965 72140 245105 Source : Economic Survey. electricity. License fees are paid in those instances in which the government authority is invoked simply to confer a permission or privilege rather than to perform a 123 service of a more tangible and definite sort.). e. Fines and penalties are levied for an infringement of a law. college fees in government colleges.1 shows the revenue receipts of the Government of India as per budget estimates for 2002-03. registration fee for an automobile.GOVERNMENT BUDGENT AND THE ECONOMY tax are all examples of indirect taxes. Capital Receipts The main items of capital receipts are loans raised by the government from the public (these are called Market Loans). loans received from foreign governments and bodies (e. 2002-03.1: Revenue receipts of the Union Government as per 2002-03 budget estimates Item Tax revenue Non-tax revenue Total revenue receipts Amount (Rs. Fees are defined as ‘a payment to defray the cost of each recurring service undertaken by the government. tolls. etc. and are hence indirectly taxing income.g. While direct taxes are compulsory and cannot be escaped. firearm. at the time when the income is spent. small savings and deposits in the public provident fund (PPF). Non-tax revenue consists of all other revenue receipts. World Bank. Table 8. The following are some examples of different sources of administrative revenue. Commercial revenue is revenue received by the government in the form of prices paid for government-supplied commodities and services. a person can avoid paying indirect tax by refraining from entering into the particular transaction that leads to the tax being levied e. Table 8. e. They may be of the following types.g. . Government of India. primarily in the public interest. Forfeitures of basic surety or bonds are penalties imposed by courts for non-compliance with orders or nonfulfilment of contract etc. Escheat refers to the claim of the government on the property of a person who dies without having any legal heirs or without leaving a will. This includes payments for postage. Another source of revenue is interest and dividends on investments made by the government. Indirect taxes are levied on the goods and services which people consume. railway services etc.

809 8 Total Expenditure 4. in crores) 1 Interest payments 1.390 2 Major subsidies 38. 3.INTRODUCTORY MACROECONOMICS 124 Table 8. Government of India. in crores) Recovery of loans 17680 Other receipts (mainly PSU disinvestment) 12000 Borrowings and other liabilities 135524 Total Capital receipts 165204 Source : Economic Survey 2002-03. Plan expenditure and Non-Plan expenditure: Plan expenditure is that public expenditure which represents current development and investment outlays that arise due to plan proposals. Capital expenditure consists mainly of expenditure on acquisition of assets like land. equipment. Revenue expenditure and capital expenditure Revenue expenditure is the expenditure incurred for the normal running of government departments and provision of various services. In general.589 4 Revenue expenditure 3.827 6 Plan expenditure 1. Government of India. Posts and Telecommunications and nondepartmental commercial undertakings which are financed out of their internal and extra budgetary resources. as per the budget estimates for 2002-03. Expenditure Expenditure may be classified in the following three ways: 1. corporations and other parties.2 shows the capital receipts of the Government of India as per budget estimates for 2002-03. and loans and advances granted by the central government to state and union territory governments.13. generally of recurring nature. 2. However. including market borrowings and term loans from . any expenditure that does not result in the creation of assets is treated as revenue expenditure.309 (6+7) or (4+5) Source : Economic Survey 2002-03..923 3 Defence expenditure 43.500 7 Non-plan expenditure 2. Table 8. government companies.10. Table 8. Table 8. buildings. plan and non-plan.2: Capital receipts of the Union Government as per 2002-03 budget estimates Item Amount (Rs. Non-plan expenditure is all other expenditure.96. machinery. all grants given to state governments are treated as revenue expenditure even though some of the grants may be for creation of assets.40.3 shows the break up of expenditure into revenue and capital.3: Break ups of expenditure as per budget estimates for 2002-03 Sl.17. investments in shares. subsidies etc.482 5 Capital expenditure 69. interest charges on debt incurred by the government. Item Amount No (Rs. etc. Developmental and Nondevelopmental expenditure Developmental expenditure includes plan expenditure of Railways.

2001-02. the effect of a tax is to lower the consumption and therefore. Now. aggregate demand by an amount equal to the marginal propensity to consume (MPC) times the amount of the tax. Sl. ex-gratia payments to former rulers. then we will have MPC times tax is greater than expenditure. let us assume a situation where the only source of revenue is a lump sum tax.4 shows the break up of expenditure of Central. Other expenditures include that on general administration. Item No 1 Developmental expenditure 2 Defence (net) 3 Interest payments 4 Tax collection charges 5 Police 6 Others 7 Non-developmental expenditure (2+3+4+5+6) 8 Total expenditure (1+7) Amount (Rs. State and Union Territory Governments. if tax (and therefore revenue) is sufficiently higher than the government expenditure. famine relief. financial institutions to State Government public enterprises. the reduction in aggregate demand (due to the tax) is greater than . Table 8. grants and loans to foreign countries and loans for non-development purpose to other parties etc. interest payments. Then. subsidies on food and controlled cloth. as we saw from chapter VI.4 : Break-ups of expenditure of Central. police. in crores) 369266 62000 144588 8533 24383 121045 360549 125 plans) into developmental and nondevelopmental expenditure. A surplus budget is one where the estimated revenues are greater than the estimated expenditures. The effect of government expenditure is to increase the aggregate demand by the amount of the expenditure. in deficit or balanced. Non-developmental expenditures include expenditures on defence. Balanced. pensions. as per 2001-02 budget estimates. State and Union Territory Governments (including internal and extra-budgetary resources of public sector undertakings for their Type of Budget Revenue < Expenditure Deficit Revenue = Expenditure Balanced Revenue > Expenditure Surplus Let us first consider the case of a surplus budget. To simplify the analysis. Surplus and Deficit Budgets We have defined the budget as an annual statement of the estimated receipts and expenditures of the government over the fiscal year. 2002-03. It also includes developmental loans given by the Central and State Governments to nondepartmental undertakings. and other expenditures. A budget may be in surplus.GOVERNMENT BUDGENT AND THE ECONOMY Table 8. Government of India. local bodies and other parties. subject to the following conditions: Relative Sizes of estimates 729815 Source : Economic Survey. tax collection. Now.

. Thus. Since tax is equal to expenditure. capital expenditure and loans net of repayments) on one hand. The increase in aggregate demand (due to expenditure) is by an amount equal to the expenditure. This means that the tax is less than the expenditure. INTRODUCTORY MACROECONOMICS A deficit budget is one where the estimated revenue is less than the estimated expenditure. the increase in aggregate demand (due to expenditure) is greater than the decrease in aggregate demand (due to the tax). Now. Lowering aggregate demand is a good way to combat inflation that arises out of the presence of excess demand. Again. They are budget deficit. The reduction in aggregate demand (due to the tax) is equal to MPC times the tax. if tax is sufficiently less than the expenditure then the reduction in aggregate demand will be less than the increase in aggregate demand. fiscal deficit. and current revenue and net internal and external capital receipts of the government on the other. The effect of this will be to increase aggregate demand. A balanced budget will then mean that the amount of tax equals the amount of expenditure. Then. suppose that the only source of revenue is a lump sum tax. the increase in aggregate demand due to the expenditure is equal to the amount of the expenditure. The net effect is to increase aggregate demand by an amount equal to the expenditure multiplied by 1– MPC. The calculation of the budget deficit is shown in Table 8. A balanced budget is one where the estimated revenue equals the estimated expenditure. Budget Deficit The budget deficit is the difference between the total expenditure on one hand. Types of Deficit There are four different concepts of budget deficit. a surplus budget will lower aggregate demand. The net effect of this is to lower aggregate demand. Now.6.126 the increase in aggregate demand (due to expenditure). A balanced budget is therefore a policy instrument to bring the economy which is at near full-employment to a fullemployment equilibrium. Fiscal Deficit The fiscal deficit is the difference between the total expenditure of the government (by way of revenue expenditure. a surplus budget is a poor strategy in the case of a deflation and recession. It has to be financed by net internal and external capital receipts. a balanced budget will slightly increase the aggregate demand. where the economy is in an under-employment equilibrium due to deficient demand. The deficit budget is therefore a policy instrument to combat recession. thus worsening the situation. We shall analyse them individually. as it will lower the already deficient demand. However. The decrease in aggregate demand (due to the tax) is equal to MPC times the tax. primary deficit and the revenue deficit. the decrease in aggregate demand is also equal to MPC times the expenditure. Thus.

Given the same level of fiscal deficit. Revenue deficit [3 – 1] 8. Primary deficit [6 – 3(i)] 410309 113500 296809 135524 95377 18134 Source : Economic Survey. It is often used as a basic measure of fiscal irresponsibility. A low or zero primary deficit means that while its interest commitments on earlier loans have compelled the government to borrow. Government of India. The revenue deficit implies a repayment burden in the future. Primary Deficit The primary deficit is the fiscal deficit minus interest payments. Item Amount (Rs. In the present. but which finally accrue to the government. It gives information on what the government is borrowing for. . it is a measure of how much the government is borrowing in continuance of its profligate ways. the revenue deficit tells the amount the householder is borrowing to pay the grocer. how much government borrowing is going to meet expenses other than interest payments.5: Types of deficits as per 2002-03 budgetary estimates No.5 shows the various deficits as per 2002-03 Indian budget estimates. In other words. not matched by any benefits via investment. the revenue receipts plus those capital receipts which are not in the nature of borrowing. It therefore indicates. Capital expenditure 69827 5. Capital receipts 165204 (i) Recovery of loans 17680 (ii) Other receipts 12000 (mainly PSU disinvestments) (iii) Borrowings and 135564 other liabilities 3. It reflects the extent to which current government policy is adding to future burdens stemming from past policy. in Crores) 1. The extent of the fiscal deficit is an indication of how far the exchequer is living beyond its means. Revenue expenditure 340482 (i) Interest payments 117390 (ii) Major subsidies 38923 (iii) Defence expenditure43589 4. A large fiscal deficit implies a large amount of borrowings. a higher revenue deficit is worse than a lower one. rather than add a roof to the house. Revenue receipts 245105 (i) Tax revenue 172965 (ii) Non-tax revenue 72140 2. a large fiscal deficit may also fuel inflationary pressures. it is aware of the need to tighten its belt. 2002-03.GOVERNMENT BUDGENT AND THE ECONOMY and on the other hand. Revenue Deficit The revenue deficit is the excess of government’s revenue expenditures over revenue receipts. The fiscal deficit indicates the amount of borrowing the government has to do. In the analogy of the 127 household. Table 8. This creates a correspondingly large burden of interest payments in the future. Fiscal deficit [5 – 1 – 2(i) – 2(ii)] 7. Table 8. Total expenditure (i) Plan expenditure (ii) Non-plan expenditure 6.

Overall Budgetary Deficit (3 – 4) 2563 5660 Source:Economic Survey. Monetary expansion amounts to printing money to the extent of the deficit. Government of India. Item Amount (Rs. Internal (net) 248124 245561 (i) Net market loans 84410 (ii) Net small savings 11938 (iii) Net State and PPFs 31525 (iv) Special deposits on 10500 non-government PFs (v) Net miscellaneous capital receipts 107188 B. Total Outlay 729815 A. Net Capital Receipts (A+B) A. The process of monetary expansion involves the government borrowing from the Central Bank through the issue of treasury bills to the Central Bank. Current Revenue A. External (i) Net loans 1165 (a) Gross 10763 (b) Less repayments 9598 (ii) Grants 698 (iii) Revolving fund 700 5.6: Overall budgetary deficit of Central. which the government uses to fund the deficit.6) Table 8. State and Union Territory Governments as per 2001-02 budgetary estimates. Alternatively. Gap (1 – 2) Financed by: 253784 4.Non-Tax Revenue 104676 (Internal resources of public sector undertaking for the plan) (45100) 3.INTRODUCTORY MACROECONOMICS 128 The overall budgetary deficit of Central. State and Union Territory Governments is estimated using the table of budgetary transactions (Table 8. The safe level of fiscal deficit is considered to be 5% of Gross Domestic Product.Development 369266 B. . We have now seen the four concepts of deficits. the deficit may be funded by borrowing from the public through market loans etc. No. The Central bank purchases the treasury bills in return for cash. Tax Revenue (i) Income and corporation tax (ii) Customs (iii) Union excise duties (iv) Sales tax (v) Others 476031 371355 84801 54822 81720 81579 68433 B. Non-Development 360549 (i) Defence (net) 62000 (ii) Interest payments 144588 (iii) Tax collection charges 8533 (iv) Police 24383 (v) Others 121045 2. 2002-03. in Crores) 1. The deficit in a budget has to be financed in one of two ways – by monetary expansion or by borrowing.

The budget impacts the economy through aggregate fiscal discipline. EXERCISES 1. 9. 2. The government implements its policies through the budget. and developmental vs. which runs from April 1 to March 31. 4. balanced and deficit. The three concepts of deficit are – fiscal deficit. revenue deficit and primary deficit. What is a budget? What are the objectives of a budget? What are the revenue items? Define tax and non-tax revenue. Differentiate between developmental and non-developmental expenditure. The budget is divided into revenue budget and capital budget. non-developmental. resource allocation and provision of programmes and delivery of services. 6. capital. Budgets are of three types – surplus. 8.GOVERNMENT BUDGENT AND THE ECONOMY 129 SUMMARY l l l l l l l l The budget is an annual statement of the estimated receipts and expenditures of the government over the fiscal year. What is the difference between Revenue Budget and Capital Budget? Classify public expenditure. non-plan. 3. Expenditure may be classified in three ways – revenue vs. Revenue may be divided into revenue receipts and capital receipts. plan vs. 5. What is non-plan expenditure? Define: (a) Fiscal deficit (b) Budget deficit (c) Revenue deficit (d) Primary deficit How may a deficit be financed? . 7. 10.

VI BALANCE OF PAYMENTS .U N I T .

They also govern and are governed by the flow and direction of foreign trade. Meaning Foreign exchange rate is the price of one currency in terms of another. by the stability in its exchange rate. Earnings from exports and payments for imports would directly be affected by the exchange rate. mainly. Now this total expenditure also represents the demand for foreign exchange that is Japanese Yen. among other things. T ransactions in the foreign exchange market are reflected in the balance of payments account. three functions viz. by linking the currencies of different countries. This is because if an Indian buys a Japanese radio from abroad. and to protect against foreign exchange risks (also known as hedging function). Therefore. The value of Indian residents’ expenditure abroad represents a supply of rupees to the foreign exchange market.. Foreign exchange market performs. demand for foreign exchange is the demand for foreign currencies by the residents of a country. In view of the above three functions.CHAPTER 9 FOREIGN EXCHANGE RATE: MEANING AND DETERMINATION A country’s economic stability is indicated. In this chapter we shall explain foreign exchange rate determination. he will pay for it in rupees. When people wish to operate in the foreign exchange market they intend to buy or sell foreign exchange depending on their demand for and supply of foreign exchange. since the Japanese dealer will expect . to transfer the purchasing power between countries (transfer function). make the comparisons of international costs and prices. The strength of domestic currency of a country is seen against that of currencies of other countries in the world. The foreign exchange rates. to provide credit channels for foreign trade (credit function). Foreign Exchange Market The foreign exchange market is the market where the national currencies are traded for one another. It is the rate at which exports and imports of a nation are valued at a given point in time. it is important to know the forces that operate upon the determination of foreign exchange rate and the implications of changes in it for the country concerned.

(b) foreign investment in home country through joint ventures or through financial market operations. (c) foreign currencies flow into the economy due to currency dealers and speculators. and Equilibrium in the Foreign Exchange Market Price Rs/$ S$ R' S'$ Req R" D'$ D$ Qeq Q" Q' Demand and Supply of US $ Fig. The dominance of demand or supply side is linked with the nature of business fluctuations in a given time period. Indian exporters will expect to be paid in rupees. there is inflow of foreign exchange into India. for instance). flow into the domestic economy due to the following: (a) foreigners purchasing home country’s goods and services through exports. Hence. We have already pointed out that people’s intention to transact in the foreign exchange market depends upon their demand and supply position with respect to foreign exchange. foreigners have to sell their currency and buy rupees in return. Supply Side Foreign currencies. how many rupees for one US dollar. So rupees have to be exchanged for Yen in the foreign exchange market. the foreign earnings of Indian residents reflect equal earnings of foreign exchange. that US ($). Similarly. Demand and Supply Side Foreign exchange market like any other market is characterised by a downward sloping demand curve and an upward sloping supply curve. For example. (c) to purchase financial assets in a particular country. The horizontal axis measures the quantity demanded or supplied.INTRODUCTORY MACROECONOMICS 132 payment in Yen. The causal factors behind the demand and supply sides are mentioned below: Demand Side People desire to have or acquire foreign exchange for the following reasons: (a) to purchase goods and services from other countries. 9. The intersection of the supply and demand curves determines the equilibrium exchange rate (Req) and the equilibrium quantity (Qeq) of foreign currency. Hence the foreign exchange markets are influenced by the above mentioned underlying factors. So in order to buy our goods. (b) to send a gift abroad.1. The price on the vertical axis is stated in terms of domestic currency (that is. and (d) to speculate on the value of foreign currencies. This is shown in Figure 9.1 : Equilibrium in the Foreign Exchange Market .

FOREIGN EXCHANGE RATE : MEANING

AND

DETERMINATION

Now, it is necessary to understand
the slopes of demand and supply curves.
In this figure the demand curve (D$) is
downward sloping. This means that less
foreign exchange is demanded as the
exchange rate increases. This is due to
the fact that the rise in the price of foreign
exchange will increase the rupee cost of
foreign goods, which makes them more
expensive. As a result, imports will
decline. Thus, the demand for foreign
exchange will also decrease.
The supply curve (S$) is upward
sloping which means that supply of
foreign exchange increases as the
exchange rate increases. This makes
home country’s goods become cheaper
to foreigner since the rupee is
depreciating in value. The demand for
our exports should therefore increase
as the exchange rate increases. The
increased demand for our exports will
translate into greater supply of foreign
exchange. Thus, the supply of foreign
exchange increases as the exchange rate
increases.
Having shown the equilibrium in
the foreign exchange market, let us now
analyse disequilibrium conditions.
An increase in the demand for US
dollars in India will cause the demand
curve to shift to D’$ and the exchange
raise rises. Note that the increase in the
exchange rate means that more rupees
are required to buy one US dollar. When
this occurs, Indian rupee is said to be
depreciating. Currency depreciation
takes place when there is an increase
in the domestic currency price of the
foreign currency. The domestic
currency is thus relatively less valuable.

133

Similarly, an increase in the supply
of US dollars will cause the supply curve
shift to S$ and exchange rate falls to
R. In this case rupee cost of US dollar
is decreasing and the Indian rupee is
said to be appreciating. Currency
appreciation takes place when there is
a decrease in the domestic currency
price of the foreign currency. In this case
domestic currency is more valuable.
Types of Exchange Rate Regimes
The determination of foreign exchange
depends on specific international
arrangement of procedure to determine
the exchange rate of one country
vis-à-vis others. Exchange rate regimes
have evolved over time in response to
global economic events. We shall
present below major international
monetary systems that India has
implemented so far.
Fixed Exchange Rate Systems
Under this system, exchange rate is
officially declared and it is fixed. Only a
very small deviation from this fixed
value is possible. A typical fixed
exchange rate system was associated
with the Gold Standard Systems of
1880-1914. Under the Gold Standard
systems each currency value was
defined in terms of gold and hence, the
exchange rate was fixed according to
the gold value of currencies that have
to be exchanged. This was referred to
as mint par value of exchange. For
example, if one Indian Rupee is
exchangeable for 125 grams of fine gold
and the US dollar ($) for 25 grams. Then
one rupee is equal to 125/25 = 5 US
dollars. So, the price is fixed at Re.1=$5.

134

Adjustable Peg System
The gold standard was abandoned in
the 1920’s as it failed to automatically
correct the disequilibrium in countries’
balance of payments. An alternate
system of fixed exchange rate called the
Bretton Woods system was established
in 1944. Under this arrangement, the
US dollar was made directly convertible
into gold at a fixed price. Member
countries fixed their rates of exchange
as against the US dollar. The Bretton
Woods system was an adjustable peg
system. The member countries were
required to fix the parity of their
currencies with gold. A change in the
parity was possible only through a
direction from the IMF. This system was
slightly modified from the fixed
exchange rate system but the role of gold
as ultimate unit of parity was preeminent.
Fixed exchange rate system was
supported due to its advantages as
given below:
(a) Fixed exchange rates ensure that
major economic disturbances
which will weaken the economic
policies of member countries, do not
occur.
(b) Fixed exchange rates contribute to
the coordination of macro policies
of countries in an interdependent
world economy.
(c) Fixed exchange rates are more
conducive to expansion of world
trade as they prevent risk and
uncertainty in transactions.
But the critics of fixed exchange
rates have identified several drawbacks

INTRODUCTORY MACROECONOMICS

of this system. Hence, they suggest a
system of flexible exchange rates.
Flexible Exchange Rate System
Flexible exchange rates point to an
extreme situation where there is no
intervention by Central Banks. The
foreign exchange market is busy at all
times with changes in the exchange rates.
Following are the advantages
associated with flexible exchange rates.
(a) Flexible exchange rates eliminate
the need for central banks to hold
international reserves.
(b) Flexible exchange rates are helpful
to do away with barrier to trade and
capital movements.
(c) Flexible exchange rate enhances the
efficiency in the economy by
achieving optimum resources
allocation.
We have not provided a detailed
critique of both fixed and flexible rate
of exchange as it is beyond the scope of
our study here. But it must be borne
in mind that these are two extreme
positions and hence the debate on their
desirability is a continuing one.
Therefore, there have been numbers
of alternative systems suggested as
‘hybrid’ systems combining advantages
of fixed and flexible exchange rates. We
shall briefly describe their salient
features.
Wider Bands
This proposal considers the point that
Bretton Woods system allowed only 1
per cent variation on either side of the
parity values. The proposal for wider
bands states that the permissible

FOREIGN EXCHANGE RATE : MEANING

AND

DETERMINATION

variations around parity should be set
at 10 per cent, for all member countries to carry on balance of
payment adjustment easily. For
example, if a country has a balance of
payments deficit, the currency could be
depreciated up to 10 per cent from its
parity value to correct the
disequilibrium in the balance of
payments.
Crawling Peg
This is also a compromise between fixed
and flexible rates. According to crawling
peg scheme, a country specifies a parity
value for its currency and permits a
small variation around that parity
(such as ±1 per cent from parity).
However, the parity rate is adjusted
regularly by small amounts as
warranted by the position of
international reserves held by a
country, changes in money supply or
prices, or recent variations in the

135

exchange rate around the parity. In the
crawling peg concept there is ceiling
and floor limits so that it can provide
for some discipline on the part of
monetary authorities. Figure 9.2 shows
the working of crawling peg.
In this crawling peg example, the
exchange rate fluctuates within its narrow band until point A is reached. The
loss of reserves from A to B and any
other indicators of currency weakness
trigger a small devaluation in the parity value. When difficulties again occur
from point C to point D, another small
official devaluation takes place. This
new parity value continues until a reserve buildup occurs from point F to
point G, whereupon the parity value of
the home currency is raised.
Managed Floating
The final hybrid in management of
exchange rates is the managed floating.
This is characterised by some

e
(Units of home
currency per
unit of foreign
currency)
C
A

D

B

F

G

Time

Fig. 9.2 : A Crawling Peg

Since the arguments in favour of and against these two systems are inconclusive. Operation of Foreign Exchange Market Foreign exchange markets could be studied in terms of period of transaction carried out. it is called current market or the spot market. there is official declaration of rules or guidelines for intervention. and no announced times for variations. Authority take a decision to intervene if a particular situation in their judgement requires it. But we should find what the spot rate is. no prefixed parity values. On the other hand market for foreign exchange for future delivery is known as the forward market. could be vulnerable to abuse of intervention. namely. for the ith trading partner (say the USA) R i = exchange rate in Rupees/$ i R a = exchange rate in year ‘a’ i R b = exchange rate in base year ‘b’ i i R index = R a for the year ‘b’ i Rb Wi = ratio of trade volume with ith partner to total trade volume of domestic country = X i + Mi X total + M total . As we do not eliminate the effect of price changes. crawling peg and managed floating. This section has so far summarized the two major systems of exchange rates. this intervention may be coordinated with other countries as well. If the operation is of daily nature. fixed and flexible rates of exchange. If the domestic country (India) has ‘n’ trading partners then n NEER = ∑ ( R iindex ) (Wi ) i =1 Where. it is also important to find the strength of the domestic currency with respect to that of the home country’s trading partners. Besides. this may also be called as Nominal Effective Exchange Rate (NEER). The measure of average relative strength of a given currency is called the Effective Exchange Rate (EER). in the absence of rules and guidelines. This behaviour is called dirty floating. The main object in providing these details is to highlight the point that determination of exchange rate is a complex process in the international monetary system. attempts have been made to devise hybrid systems such as wider bands. A particular country could manipulate its managed float to the detriment of other countries. Sometimes. Spot Market for Foreign Exchange Spot rate of foreign exchange is certainly useful for current transactions. Managed floating. In other words.INTRODUCTORY MACROECONOMICS 136 hindrances with exchange rate movements but the intervention is discretionary on the part of monetary authorities.

For ‘n’ trading partners. an exchange rate that would be based upon constant prices. the Real Effective Exchange Rates (REER) calculates an effective exchange rate based on real exchange rates instead of nominal rates. A forward contract is entered into for two reasons: one is to minimize risk of loss due to adverse change in exchange rate or to make a profit. n REER = ∑ (RER iindex (Wi ) i=1 Findings about exchange rate appreciation or depreciation should be made with reference to REER and not solely upon NEER. The forward market consists of parties that demand or supply a given currency at some future point in time. It helps both the parties involved to hedge against risk in exchange rate at a future date. There are two versions of it. For this purpose we find out Real Exchange Rate (RER). This is based on the argument that it is the relative prices of goods and services between countries that drive the exchange rates. Since transactions contracted at one point of time are completed only at a later date.FOREIGN EXCHANGE RATE : MEANING AND DETERMINATION Where. we must have a measure that could eliminate the effect of price changes that is. We have thus far explained the meaning and determination of foreign exchange rates. In the year ‘a’ for the partner ‘i’ i i RER index = R a Price index in country ' i' in   year ' a' with base year as ' b'   Price index in India in year ' a' with base year as ' b'    Thirdly. There is no empirical support to this line of argument. The relative purchasing power parity argument relates the change in the exchange rate to the rates of inflation in the two countries. It is common to see that most of the international transactions do not occur on the same day. Forward Market for Foreign Exchange Unlike the spot market. X i = Exports to ith partner Mi = Imports from ith partner Xtotal = Total experts of domestic country Mtotal = Total imports of domestic country Secondly. Fourth measure of the spot rate is related to the equilibrium rate that would make the current account being in balance. For an economy. . Usually they materialise much later. we should pay attention to the forward exchange rate. the exchange rate stability is an important objective of its macroeconomic policies. the forward market for foreign exchange covers transactions which occur at a future date. First is called hedging and the second is called speculation. that is beyond the value date when the transaction is signed. This argument is also referred to as Purchasing Power Parity (PPP) argument. 137 The absolute purchasing power parity argument holds that commodities tend to have the same price world wide when measured in the same currency.

What is a foreign exchange rate? Define foreign exchange market. crawling peg and managed floating are also followed by some countries.INTRODUCTORY MACROECONOMICS 138 Today. 6. some hybrid systems such as wider bands. 7. Those interested could study similar disturbances that have occurred in other parts of the world as well. we find that any problem with the exchange rate could create enormous difficulties not only for the country concerned but to others as well. 3. 5. What are: (a) spot. 2. 8. in the mid-1990’s we witnessed the East Asian currency crisis mainly triggered by fluctuation and instability of the currencies in East Asia. Apart from two extremes of fixed exchange and flexible exchange rates. 4. Foreign exchange market plays many roles to transfer purchasing power. Equilibrium in the freely fluctuating foreign exchange market is brought about by the intersection demand for and supply of foreign exchange. and (b) forward markets in foreign exchange? Define: (a) NEER (b) REER and (c) RER. SUMMARY l l l l l l Foreign exchange rate has become an important variable that engages the attention of all those who are concerned with foreign trade. Distinction between spot and forward markets help understand the complex operation in the foreign exchange market. . Instability in the exchange rate could give rise to currency crises. EXERCISES 1. Differentiate between fixed and flexible exchange rates. Describe the equilibrium in the foreign exchange market. Recently. What is a parity value? Explain the meaning of crawling peg and managed float. to provide credit and help in hedging operations.

both real and financial. the expenditure of consumers. Kindleberger Homeward. Let us consider the first.2 Relation between National Income and Balance of Payments Economic activity usually generates two types of transactions that give rise to international payments and receipts. ‘The balance of payments of a country is a systematic record of all economic transactions between the residents of the reporting country and the residents of foreign countries during a given period of time’1. On the other hand. open economies react sharply to events that are occurring in the rest of world sector. investors and government in addition to the expenditure of foreigners on the country’s exports International Economics. p. government and their agencies. the BOP accounts are maintained and they constitute an important part of the national income accounts. those arising from the purchase and sale of existing assets. Firstly. They are: who is a 1 2 resident? What is a economic transaction? Resident of a country ordinarily includes individuals. The BOP accounts are a summary of international transaction of a country for a given period. In our four sector circular flow diagram given in Chapter 2. business units. An economic transaction is an exchange of value: a process in which “there is transfer of title to an economic good. it has been shown that the external sector influences the working of an open economy. ibid . Macroeconomic phenomena cannot be confined with a particular economy. are two questions that need to be answered. 457. Illinois. In order to record the overseas transactions of a country. the rendering of an economic service from residents of one country to residents of other countries.CHAPTER 10 BALANCE OF PAYMENTS: MEANING AND COMPONENTS The Balance of Payment (BOP) Accounts are an important aspect of the study of macro economy. Charles P. activities arising from production and sale of current output and secondly. Irwin. Here. In an open economy. which is production and sale of current output. that is a financial year.

It does not consider the exchange of services rendered such as shipping. . Short-term official capital Account For each of these given categories. Dennis R. By convention. Unilateral transfer account 3. Hence. payment of interest and dividend or expenditure by tourists which are also known as invisible items. International Economics. 3 4 INTRODUCTORY MACROECONOMICS Balance of Payments takes into account the exchange of both visible and invisible items. that is imports (M). Funds that go out are entered in an account that shows what they are spent on and also in an account that shows where they came from. Short-term private capital account 5. Add the goods and services purchased from abroad by the domestic sectors. Long-term capital account 4.1. income generated must be equal to income disposed off. Irwin 1992. savings (S) and taxes (T). 471. specific types of transactions are shown as debits or credits. total amount of debits must equal total amount of credits. C+I+G+X=C+S+T+M Simplifying this we obtain I+X+G=S+T+M Here I. Appleyard and J. debit items and credit items are entered with a minus sign and plus sign respectively. Of course. Structure of Balance of Payment Accounting The transactions are recorded in the balance of payments accounts in double-entry book keeping. 3 Each international transaction undertaken by the country will result in a credit entry and debit entry of equal size. Illinois.140 generates the nation’s production of goods and services. The income generated by this can be shown in the following expression: Y=C+I+G+X This income is disposed off in the purchase of consumer goods and services (C). the balancing item Errors and Omissions must be included to ‘balance’ the BOP accounts. in equilibrium planned injections must be equal to total planned leakages. Field Homeward. G and X are injections into the income stream and S. As international transactions are recorded in double-entry accounting. This is shown in Table 10. T and M are leakages there from. Balance of Trade and Balance of Payments Balance of Trade takes into account only those transactions arising out of the exports and imports of goods (the visible items). p.4 Double-entry book keeping is an accounting principle requiring funds that come in to be entered in an account that shows where they came from and also in an account that shows where they are put. the balance of payments represents a better picture of a country’s economic transactions with the rest of the world than the Balance of Trade. Following expression gives the way income is disposed off: Y=C+S+T+M According to national income accounting. Goods and services account 2. Therefore. So. the BOP accounting must always balance: that is. Transactions in BOP are classified into five major categories as given below: 1. insurance and banking.

1: Classification on System of Debits and Credits in the Balance of Payments Accounts Debits (-) Credits (+) CATEGORY . Decrease in short-term foreign assets owned by home country private citizens. Decrease in long-term foreign assets owned by home country citizens and government.BALANCE OF PAYMENTS: MEANING AND COMPONENTS 141 Table 10. rice.) or services (banking services. Since there are two major categories of accounts in the BOP accounts statement. B.II Unilateral Transfers (Gifts) made Unilateral transfers (Gifts) received CATEGORY . Imports of Services B. Imports of Goods A. Decrease in short-terms home country asset owned by foreign governments (official monetary authorities). Decrease in long-term home country assets owned by foreign private citizens and governments. Exports of Goods B. B. A. CATEGORY . that is. Decrease in short-term foreign assets owned by home country government (official monetary authorities). Decrease in short-term home country assets owned by foreign private citizens. current and capital accounts. Increase in short-term home country asset owned by foreign governments. B. etc. CATEGORY .I A. Increase in short-term foreign assets owned by home country government (official monetary authorities). (official monetary authorities). Current Account The Current Account records imports and exports of goods and services and unilateral transfers. Exports of Services CATEGORY .IV A. machinery. Increase in long-term foreign assets owned by home country private citizens and government. insurance .III A. an explanation of current and capital account is in order at this stage to understand their components. Exports. Increase in long-term home country assets owned by foreign private citizens and governments. whether of goods (steel. A. B. Increase in short-term foreign assets owned by home country private citizens. A. B. B.V A. Increase in short-term home country assets owned by foreign private citizens.

1. tourism services to foreign tourists in India. Private unrequited transfers are gifts that domestic residents receive from or make to foreign residents. The transfer of funds from the parent company abroad to the subsidiary company in the domestic country so that the subsidiary can acquire assets in the domestic country is another type of direct investment. Capital Account The Capital Account records all international transactions that involve a resident of the domestic country changing his assets with a foreign resident or his liabilities to a foreign resident. The net value of balances of visible trade and of invisible trade and of INTRODUCTORY MACROECONOMICS unilateral transfers is the balance on current account. or payments that the residents of a country make without getting anything in return. Such business transactions form the major part of private direct investment overseas. BOP accounts differentiate between trade in goods and trade in services.) are entered as positive items in the account. and other nongovernment entities. 4. Unilateral transfers or unrequited transfers are receipts which residents of a country receive. from developed countries or to developing countries. Imports are recorded as negative items in the account because imports cause an outflow of foreign exchange from the country. etc. businesses. i. Similar transactions by individuals could be the purchase of a house abroad. Official transactions: Transactions affecting assets and liabilities by the government and its agencies. etc. The balance of exports and imports of goods is called the balance of visible trade. The various forms of capital account transactions are given below. An example of such an investment is the acquisition of a firm in one country by a firm in another country. An example of this would be Indians in Gulf countries sending back money to their relatives in India. 2. Direct investment: It is the act of purchasing an asset and at the same time acquiring control of it (other than the ability to re-sell it). The bulk of foreign investment is private.e. and the balance of exports and imports of services is called the balance of invisible trade.142 services. 1. Private transactions: These are transactions that are affecting assets or liabilities by individuals. 3. Portfolio investment: It is the acquisition of an asset that does not . The terms are used because goods are visible to the eye but services are invisible to the eye. receipts or payments for which there is no quid pro quo. Official unrequited transfers is the receipt of or giving of foreign aid. 2. etc. Receipts from abroad are entered as positive items and payments abroad are entered as negative items. This is because exports cause an inflow of foreign exchange into the country.

or when smuggling occurs. capital outflows are awarded a negative sign and capital inflows are awarded a positive sign. By convention. Other items in the Balance of Payments The remaining items that cannot be categorised into the two preceding categories constitute the other items in the balance of payments. As a result such transactions are not autonomous. They may arise due to the presence of sampling of transactions rather than recording each individual transaction (for example instead of recording each of a thousand exports of lemons.e. The first of these items is the change in the domestic country’s official reserve assets. Thus. SDR allows a country to avail of foreign exchange in proportion to the quantum of the country’s deposit of its currency with the IMF under the SDR scheme. etc.e. These reserves of a country are held in the form of foreign currency or foreign currency securities. The net value of the balances of direct and portfolio investment is called the balance on capital account. The changes in the country’s reserves must reflect the net value of all other items in the BOP. Errors and omissions: These are to take into account the difficulty of accurately recording all the wide variety of transactions that take place in the accounting period. An example of such investment is the purchase of shares in a foreign company or of bonds issued by a foreign government. In contrast to this. or loans made to foreign firms or governments. official reserve transactions are carried out by the government and the central banks in pursuit of some international economic policy objective. gold and Special Drawing Rights (SDR) with the IMF. They are included since the full balance of payments account must balance. Reduction in these assets will be used to finance expenditures abroad. i. These items are as follows: 1. not with a view to bring their consequences on the balance of payments or on the exchange rate. i. businessmen under-reporting sales abroad to 143 avoid taxes. They are so called because they are entered into with some independent motive. An increase in these reserves will appear as a debit because purchasing assets . Reductions appear as a credit item in the BOP (because their sale causes foreign exchange inflow into the country). they may multiply an average lemon export figure by thousand). while keeping an eye on such transaction’s effect on the BOP and the exchange rate. the purchase of an asset from another country appears as a negative item on the capital account for the purchasing country (there is outflow of foreign exchange). 2. Official reserve transactions: All transactions except those in this category may be termed as autonomous transactions.BALANCE OF PAYMENTS: MEANING AND COMPONENTS give the purchaser control over the asset. due to dishonesty.

The BOP is in surplus if the autonomous receipts are greater than autonomous payments. This means that the foreign country has some net claims against the domestic country. 2002-03. Let us explain their meaning. Government of India. The table 10. Autonomous items in the BOP refer to international economic transactions that take place due to some economic motive such as profit maximization. Foreign central banks will hold part of their reserve assets in the form of rupees. These items are often called above the line items in the BOP. accommodating items.INTRODUCTORY MACROECONOMICS 144 Table 10.1 gives the components of India’s Balance of Payments and changes over the last decade. economists use the terms such as autonomous items. will cause an outflow of foreign exchange. If foreign central banks increase the amount of official reserve assets held in India it will appear as a positive item because their purchase of our rupee securities or rupees will cause inflow of foreign exchange into India. The second of these transactions is the change in foreign official assets in India. . These transactions are independent of the state of the country’s balance of payments.1: India’s Balance of Payments Sl. Autonomous and Accommodating Items In the discussion of these various balances in BOP account. The balance of payments is in deficit if the autonomous receipts are less than autonomous payments. above the line items and below the line items in the balance of payments. This means that the domestic country has some net claims against the foreign country. Item No 1990-91 2001-02 1 Exports 18477 44915 2 Imports 27915 57618 3 Trade Balance -9438 -12703 4 Invisibles (net) -242 14054 (i) Non-factor services 980 4199 (ii) Investment income -3752 -2654 (iii) Private Transfers 2069 12125 (iv) Official transfers 461 384 -9680 1351 6 External assistance (net) 2210 1204 7 Commercial borrowing (net) 2248 -1147 8 IMF (net) 1214 0 9 NR deposits (net) 1536 2754 10 Rupee debt service -1193 -519 103 5286 97 3266 (ii) FIIs 0 1505 (iii) Euro equities & others 6 515 12 Other flows (net) 2284 2828 13 Capital account total (net) 8402 10406 14 Reserve use (-increase) 1278 -11757 5 Current Account Balance 11 Foreign investment (net) of which (i) FDI (net) Source: Economic Survey.

The monetary authority may deploy a surplus by purchasing foreign securities. or by borrowing from foreign monetary authorities. new and better substitutes to existing products and changes in costs will bring about a change in trade flows and hence BOP over a period of time. Domestic sectors also receive the impact of BOP deficit. foreign currency or gold. Economic Factors • Large-scale development expenditure that may cause large imports. such as government financing. or by borrowing from the IMF.BALANCE OF PAYMENTS: MEANING AND COMPONENTS The monetary authorities may finance a deficit by depleting their reserves of foreign currencies. A chronic BOP deficit leads to downgrading the economy in the world community. In a flexible rate set-up. Disequilibrium in Balance of Payments There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or 145 deficit. . These causes are broadly categorized into (a) Economic factors (b) Political factors and (c) Social factors. This appears as an increase in reserves. leaving less settlement work for the monetary authorities. preference and fashions may affect imports and exports. the monetary authority of the country concerned and the IMF undertake certain corrective measures to deal with the disequilibrium in the BOP. much of the deficit and surplus will be automatically wiped out by an adjustment in the exchange rates. This will be shown as decrease in reserves. • Cyclical fluctuations in general business activity such as recession or depression. • High domestic prices may result in imports. The official settlements approach to the balance of payments looks at the net monetary transfer that has been made by the monetary authorities in settlement. Hence. Note that the official settlements approach assumes importance in a fixed exchange rate set-up. every country in its economic agenda strives hard to perform well in its international trade in order that it will not enter into problems of BOP disequilibrium. So. The assumption made in this approach is that the monetary authority is the ultimate financier of any deficit in the balance of payments or the ultimate recipient of any surplus. • New sources of supply. Social Factors Changes in tastes. The official settlements are seen as an accommodating item in order to keep the BOP identity. Balance of payments disequilibrium is a serious issue for policy makers. Political Factors Political instability may cause large capital outflows and dampen the inflows of foreign capital. Accommodating items in the BOP refer to transactions that occur because of other activity in the BOP. Accommodating items are also referred to as below the line items.

Overall balance of payments is important for economic policy. 7. Explain the relationship between Balance of Payments and National income Accounts.INTRODUCTORY MACROECONOMICS 146 SUMMARY l l l l Balance of Payment accounts is an integral part of the national income accounts. . Define accommodating and autonomous items. 3. and (b) Capital Account. BOP accounts are maintained in a double-entry accounting structure. Explain the components of: (a) Current Account. Disequilibrium in the BOP undermines the economic fundamentals of a nation. EXERCISES 1. 6. Describe the causes for disequilibrium in the BOP. 5. Define Balance of Trade and Balance of Payments Explain the five categories of classifying transactions. 4. 2. Give the structure of Balance of Payment Accounts in India.

2004 Actual Investment The actual amount of investment that took place. April 1. The APC gives the average consumption — income relationship at different levels of income. . Adjustable Peg Adjustable peg system is one in which member countries fix or ‘peg’ their currencies’ rate of exchange against one particular currency. Autonomous Items A term used in the BOP Accounts. The fixed or ‘pegged’ exchange rate could be adjusted under certain conditions. measured after the fact.GLOSSARY Accommodating Items A term used in BOP Accounts. Ordinarily. measured after the fact. hence the term adjustable peg. Aggregate Demand The total demand for goods and services in the economy. a financial year refers to. for example. Accounting Period An accounting period or a financial year often does not coincide with a calendar year. Aggregate Supply Total supply of goods and services in the economy. 2003 to March 31. such as government financing. Administrative Revenue Revenue that arises on account of the administrative function of the government. that refer to transactions that occur because of other activity in the BOP. the ratio of consumption to income is called the Average Propensity to Consume. Average Propensity to Consume At any particular level of income. (APC). Actual Savings The actual amount of savings that took place. that refer to international economic transactions that take place due to some economic motive such as profit maximization.

Bearer of Options Money is a bearer of options because it gives the freedom to its possessor to either hold it or to spend it on any commodity. Balance of Payments The balance of payments of a country is a systematic record of all economic transactions between the residents of the reporting country and residents of foreign countries during a given period of time. For example. against approved securities or eligible bills of exchange. i. Barter Exchange The exchange of ‘goods for goods’ is called barter exchange.e. Balance of Trade Those transactions that arise out of the exports and imports of goods. which can be purchased from anyone. the Average Propensity to Save (APS) is the ratio of savings to income. It does not consider the exchange of services rendered such as shipping. payment of interest and dividend or expenditure by tourists Balanced Budget It is a budget where the estimated revenue equals the estimated expenditure. insurance and banking. which runs from April 1 to March 31. then 2000 is the base year. Bank Rate The bank rate is the rate at which the central bank lends funds as a ‘lender of last resort’ to banks. it is a year chosen to be the basis for comparison of the value of a particular variable with the value of that variable in another year. . if we are comparing the price level in 2003 with that in 2000. Budget The budget is an annual statement of the estimated receipts and expenditures of the government over the fiscal year. Bills of Exchange A document acknowledging an amount of money owed in consideration for goods received. Base Year It is a reference year in the past.148 INTRODUCTORY MACROECONOMICS Average Propensity to Save At any particular level of income.

small savings and deposits in the public provident fund (PPF). World Bank.). and bills receivable (dues) from others. Capital Receipts Items included in capital receipts are loans raised by the government from the public (these are called Market Loans). Capital Expenditure Consists mainly of expenditure on acquisition of assets like land. government companies. borrowings by the government from the Reserve Bank of India and other parties through the sale of treasury bills. . Capital Consumption Allowance Monetary value assigned to the rate of depreciation of a physical asset in one year. buildings. Asian Development Bank. which comprise mainly stocks of goods — raw materials. and current revenue and net internal and external capital receipts of the government. loans received from foreign governments and other international bodies (For example. corporations and other parties. equipment. recoveries of loans granted to state and union territory governments and other parties. etc. and loans and advances granted by the central government to state and union territory governments. Capital Budget A statement of the estimated capital receipts and payments of the government over the fiscal year. etc. machinery. semi-manufactured or finished goods. which runs from April 1 to March 31. investments in shares. It has to be financed by net internal and external capital receipts.GLOSSARY 149 Budget Deficit The budget deficit is the difference between the total expenditure on one hand. etc. Cash Credit Credit which is advanced against the value of the borrower’s current assets. C-C Economy An economy in which commodities are exchanged for commodities.

i. A pictorial illustration of the inter dependence between the major sectors of economic activity. as well as coins. revenues derived from the government from their public enterprises. They can be drawn upon by cheque without any restriction. . that is all the notes issued by the Central Bank. Credit Money This refers to money. or variations in the exchange rate .150 Cash Reserve Ratio Circular Flow Commercial Revenue Consumption Function Constant Prices INTRODUCTORY MACROECONOMICS The portion of net demand and time liabilities every bank is required to deposit with the RBI. Currency Authority The authority for the issue of currency in the country. However.e. The relationship between consumption and income. Deposits in current accounts that are payable on demand. whose value is greater than the commodity value of the material from which the money is made. Prices prevailing in the base year. Revenue received by the government in the form of prices paid for government— supplied commodities and services. A situation in which there is an increase in the domestic currency price of the foreign currency. Crawling Peg A scheme by which a country specifies a parity value for its currency and permits a small variation around that parity (such as ±1 per cent from parity). Currency Appreciation A situation in which there is a decrease in the domestic currency price of the foreign currency. Currency Currency consists of paper currency. changes in money supply or prices. Currency Depreciation Current Account Deposits Deferred Payments Payments which are to be made in the future. the parity rate is adjusted regularly by small amounts as warranted by the position of international reserves held by a country. No interest is paid on these deposits.

local bodies and other parties Those taxes that are levied immediately on the property and income of persons. It also includes developmental loans given by the Central and State Governments to non-departmental undertakings. . wealth tax. Posts and Telecommunications and nondepartmental commercial undertakings financed out of their internal and extra budgetary resources. A demand loan is one that can be recalled on demand. Counting product two or more times is called double counting. The value of the existing capital stock that has been consumed or used up in the process of producing output.GLOSSARY Deficient Demand Deficit Budget Deflationary Gap Demand Loans Depreciation Developmental Expenditure Direct Tax Dividend Double Counting 151 If the aggregate demand is an amount of output which is less than the full employment level of output. including market borrowings and term loans from financial institutions to State Government public enterprises. and those that are paid directly by the consumers to the state. The amount paid out annually to shareholders. The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower. A budget where the estimated revenue is less than the estimated expenditure. It has no stated maturity. by the company whose stock is owned by the shareholders. corporation tax are all examples of direct taxes. and the level of aggregate demand required to establish the full-employment equilibrium. It is a measure of the amount of aggregate demand deficiency. The difference between the actual level of aggregate demand. Development expenditure includes plan expenditure of Railways. interest tax. Double counting will exaggerate or over -estimate the value of GDP. then it is known as deficient demand. Income tax.

The market for factors of production. college fees in government colleges. the aggregate demand is equal to the aggregate supply. A payment to defray the cost of each recurring service undertaken by the government. It is the point at which the total output of goods and services produced equals the total demand for those goods and services. Land receives rent. All the claims of the government on the property of a person who dies without having any legal heirs or without leaving a will. Goods that have a long life span in their use to consumers. primarily in the public interest. then it is known as excess demand. The measure of average relative strength of a given currency with respect to other currencies.152 Double-entry Accounting Durable Goods Effective Exchange Rate Equilibrium Escheat Excess Demand Factor Incomes Factor Market Fee Fiat Money INTRODUCTORY MACROECONOMICS An accounting principle requiring funds that come in to be entered in an account that shows where they came from and also in an account that shows where they are put. but conferring a measurable special advantage on the fee payer. capital receives interest and entrepreneurs receive profits. Money that serves as money on the fiat (order) of the government. . For example. when at a particular price level. Incomes received by the factors of production for their contribution to the production process. Funds that go out are entered in an account that shows for what they are spent on and also in an account that shows where they came from. If the aggregate demand is for a level of output more than full-employment level of output. labour receives wages. The equilibrium between aggregate demand and aggregate supply occurs.

GLOSSARY Fiduciary Money Final Goods Financial Intermediaries Fine Fiscal Deficit Fiscal Discipline Fiscal Policy Fiscal Year Fixed Deposits Fixed Exchange Rate Flexible Exchange Rate Forfeitures 153 Money which is accepted as money on the basis of the trust that its issuer commands. Fiscal discipline is having control over expenditures. . The difference between the total expenditure of the government and the revenue receipts plus those capital receipts which are not in the nature of borrowing. Institution that receive funds from savers and lends them to borrowers. Under this system exchange rate is officially declared and it is fixed. The fiscal year runs from April 1 to March 31. A situation where there is no official intervention in the foreign exchange market. Fines are amounts levied for an infringement of a law. They are finished goods meant only for final consumption or Investment. Government’s expenditure and tax policy together is known as its fiscal policy. etc. The exchange rate is determined by the interaction of supply and demand in the foreign exchange market. These are deposits for a fixed term (period of time) varying from a few days to a few years. Only a very small deviation from this fixed value is possible. etc. Those that are meant for final use by consumers or firms. Penalties imposed by courts for noncompliance with orders or non-fulfillment of contract. pension funds. but which finally accrue to the government. given the quantum of revenues. These include depository institutions such as banks and non-depository institutions such as mutual funds. These goods are not required to enter into further stages of production or resale to change their form and content.

Temporary unemployment of people who are between jobs. through their consumption of goods and services. Intermediate goods are those goods which are used to produce other goods and therefore they always move from one stage of production to another in the manufacture of a final product.154 Forward Rate Frictional Unemployment Full-bodied Money Full-employment Equilibrium GNP Deflator Hedging Inconvertible Currency Inflationary Gap Intermediate Goods Indirect Taxes Inventory INTRODUCTORY MACROECONOMICS Exchange rate that prevails in a forward contract for the purchase or sale of foreign exchange. or of materials used in the production process (inputs). Stocks of final goods awaiting sale. An equilibrium where all resources in the economy are fully utilised. multiplied by 100. The average level of the prices of all the goods and services that make up GNP. The inflationary gap is a measure of the amount of the excess of aggregate demand. It is the amount by which the actual aggregate demand exceeds the level of aggregate demand required to establish the full-employment equilibrium. Investment Demand Function The relationship between investment demand and the rate of interest. Since it takes time for a person to switch from one job to another. or other assets that back it. at any one point of time there will be a small amount of temporary unemployment. semifinished goods. It is calculated as the ratio of nominal GNP to real GNP. . Those taxes that are levied on goods and services. Activity that is designed to minimize risk of loss Currency that is not convertible into the precious metal (gold). They only affect the income and property of persons indirectly. Full-bodied money is money whose value as a commodity for non-monetary purposes is as great as its value as money.

against which it may issue any amount of notes. and a creditor who refuses it may not demand anything else in payment of an existing debt. . M4 These are measures of the money stock that are reported by the RBI. M2. Macroeconomics Study of relations between broad economic aggregates Managed Floating This is a hybrid of fixed and flexible exchange rates. License Fee Fees that are paid in those instances in which the government authority is invoked simply to confer a permission or privilege rather than to perform a service of a more tangible and definite sort. and decrease in liquidity from M1 to M4. and the bank rate. It is characterized by some intervention in the exchange rate movements but the intervention is discretionary on the part of monetary authorities. firearm. Lump Sum Tax Taxes that do not change with income or other economic variables. Marginal Propensity to Save The change in savings per unit change in income Minimum Reserve System A system of note issue whereby the Central Bank has to keep a minimum reserve of assets backing its notes. This means that the Central Bank is obliged to back the currency with assets of equal value Monetary Policy The policies of the Central Bank in exercising its control over money. M3. etc. Monetary Liability It is the liability of the Central Bank arising out of its currency issue. For example. Liquidity The ability to convert an asset into money quickly and without loss of value.GLOSSARY Legal Tender 155 Money that has the legal power to discharge debts. reserve requirements. Marginal Propensity to Consume The change in consumption per input change in income. The instruments of monetary policy are mainly open-market operations. interest rates and credit conditions. registration fee for an automobile. M1.

Multiplier It is the number by which the change in investment must be multiplied in order to determine the resulting change in output. Natural Monopoly A natural monopoly is a situation where there are economies of scale over a large range of output. Money Supply Total stock of moneys of various kinds at any particular point of time in an economy. ex-gratia payments to former rulers. Nominal Effective Exchange Rate (NEER) The measure of average relative strength of a given currency with respect to other currencies without eliminating the effect of price change. etc. It also include expenditure on general administration. subsidies on food and controlled cloth. etc Nominal GNP GNP measured in terms of current market prices. interest payments. Moral Suasion This is a combination of persuasion and pressure that the Central Bank applies on the other banks in order to get them to fall in line with the Central Bank’s policy. tax collection.156 INTRODUCTORY MACROECONOMICS Monetary Standard Type of standard money used in the economy. which is a monetary liability. Non-developmental Expenditure Expenditures on defence. Moneyness Having characteristics of money. Monetizing Debt The process of converting government debt (whether existing or new). . Non-durable Goods Goods that have a short life span in their use to consumers. police. then one firm can produce at a lower average cost than could more than one firm. Money Flow All the payments to factors of production and expenditure on goods and services in the circular flow of income . Industries which are potential natural monopolies are railways. grants and loans to foreign countries and loans for non-development purpose to other parties. famine relief. into Central Bank currency. electricity. which is a nonmonetary liability. pensions.

That public expenditure which represents current development and investment outlays that arise due to plan proposals. that country is on a paper currency standard. When a monetary authority adopt a standard currency made of paper in a country. Fiscal deficit minus interest payments. Is that public expenditure which does not represent current development and investment outlays that arise due to plan proposals. An amount levied for an infringement of a law. An index number that shows how the average price of a bundle of goods has changed over a period of time. This is a tool of the Central Bank for monetary control. In a fixed exchange rate system.GLOSSARY Non-market Goods Non-plan Expenditure Non-tax Revenue Open Market Operations Overdraft Paper Currency Standard Parity Value Penalty Plan Expenditure Planned Investment Planned Savings Price Index Price Level Primary Deficit 157 These are goods that have been consumed without using organized markets. . This value is known as the parity value of the currency. Buying and selling of securities by the RBI in the open market. It indicates how much of the government borrowing is going to meet expenses other than interest payments. All revenue receipts that do not arise out of taxes. The average level of prices prevailing in an economy. An advance given by allowing a customer to overdraw his current account upto an agreed limit. the value of a currency will be fixed in terms of another currency or in terms of gold. The amount of planned or desired investment given by the investment demand function. The amount of planned or desired savings given by the savings function. It is measured by the price index.

Revenue Budget A statement of the estimated revenue receipts of the government and the expenditure met from such revenues. Rest of the World The rest of the countries in the world. Saving Income which is not consumed and not paid out in the form of taxes. In general. Real Flow The flow of factor services and goods and services in the circular flow of income. Revenue Expenditure Expenditure incurred for the normal running of government departments and provision of various services. subsidies. Representative Full Bodied Money It is equivalent to a circulating warehouse receipt for full-bodied coins or their equivalent in bullion. Real Effective Exchange Rate (REER) An effective exchange rate based on real exchange rates instead of nominal rates.158 INTRODUCTORY MACROECONOMICS Promissory Notes A promissory note is a promise to pay the bearer of the note a certain sum. . The representative full-bodied money itself has no value as a commodity. but it represents in circulation an amount of money with a commodity value equal to the value of the money. Resource Allocation The manner in which an economy distributes its resources among the potential uses in order to produce a particular set of final goods. excluding the domestic country. Real GNP GNP that is computed as per constant prices. any expenditure that does not result in the creation of assets. Revenue Deficit The excess of government’s revenue expenditures over revenue receipts. Real Exchange Rate The exchange rate that is based constant prices. interest charges on debt incurred by the government. Representative Token Money This is usually in the form of paper. etc. which is in effect a circulating warehouse receipt for token coins or an equivalent amount of bullion that is backing it.

If goods are produced then there will automatically be a market for them. Standard Money Legal money by which the government of a country discharges its obligations. .GLOSSARY 159 Savings Account Deposits These deposits combine the features of both current account deposits and fixed deposits. but with certain restrictions on the number of cheques issued in a period of time. Savings Function The relationship between savings and income. They are payable on demand and also withdrawable by cheque. They are given as personal loans. usually the priority sectors. Spot Rate Exchange rate that prevails in the spot market for foreign exchange. working capital finance or as priority sector advances. Search Cost It is the physical cost of searching the time spent in searching. This means that there cannot be a general ‘overproduction’ or ‘glut’ in an economy that is based on a market system of production and exchange. For example. Subsidies Payments by government to firms or households that provide or consume a commodity. Statutory Liquidity Ratio The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets. Say’s Law of Markets ‘Supply creates its own demand’. Short-term Loans Loans given for a short period of time. government may subsidize food by paying for a part of the food expenditures of low-income households. Selective Credit Controls Measures used to channel the flow of credit to particular sectors. Surplus Budget It is one where the estimated revenues are greater than the estimated expenditures. Interest is paid on the deposits in these accounts.

It measures the value which the firm concerned has added by its production process. Trading Costs The cost of engaging in trade. they can increase or decrease freely and quickly. Value Added Value added is defined as the difference between total value of output of a firm and value of inputs brought from other firms. that is. . Wage-price Flexibility A situation in which (money) wages and prices are flexible.160 INTRODUCTORY MACROECONOMICS Tax Revenue All the proceeds of taxes and other duties levied by the Central Government. for all member-countries to carry on balance of payments adjustment easily. Wider Band It is a modification of the Bretton Woods system that states that the permissible variations around parity should be set at 10 per cent. some resources are under-employed. Under-employment Equilibrium A state of equilibrium where all resources are not fully utilised. Transfer Payments Payments made where there is no good or service received in exchange. Token Coins Coins whose value as money is far above the value of the metal contained in them. The effect of wage-price flexibility is that the market for labour and the markets for goods and services will always be in equilibrium. that is.