SCH00L OF D:STANCE EDUCAT10N

STUDY MNERIALS

M.A.(Final)
(1998 Admission)

(PAPER:η
MACRO ECONOMICS
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MODULE - I
ANALYTICAL FRAMEWORK
UNIT:I
THE DEVELOPMENT OF MACRO ECONOMICS - ANALYTICAL
PROCEDURES
Macro economics is the study of the behaviour of the whole economy.
It is concerned with the determination ofthe broad aggregates in the economy
such as national product, unemployment, inflation and the balance of
payments position. The main body of macro theory applies to a developed,
capitalist economy.
THE NATURE OF MACRO ECONOMIC ANALYSIS
Macro economics deals with such overall economic problems as
recession, boom, depression, unemployment, inflation, instability and
stagnation. Its variables are such global quantities as national employment
and unemployment, the "general level" of wage rates, prices and interest
rates; and rates ofgrowth ofchange ofthe preceding variables.
Also macro economics deals with the structures or components of
some of these big aggregates or averages - but only when this seems
necessary to help understand the determination of their level of their change.
Thus, national income may need to be broken down between labour and
property incomes; gross national product among consumer goods, capital
goods and government goods, wealth in to money, other financial assets and
physical wealth, the price level between that of consumer goods and capital
goods, interest rates between those on private and on public debts, or on
short term and long term, and so on. But the break downs are made only
when because we find them crucial to understanding the levels of the
aggregates or averages, or the effects ofthese cornponents on the levels of
other important aggregates or averages. In principle, macro economics
"disaggregates" to the minimum exteltt ltecessary for understanding the
subaggregates or the individual units.
The purpose of studying macro econolnics is gaining knowledge -
understanding : partly for its own sake, but also to use in guidiqg public or
private action. All instruction in econornics attempts to provide a "tool kit"
of questions, methods. concepts and perspectives for analysing specific
problents. Macroeconornics has an exterrsive substantive as well as
rnethodological contenl. Macro economics is rrrore lhan a scientific rnethod
of analysis; it is also a body of empirical economical knowledge.
‐ 4
MACRO ECONODIIC IИ ODELS
One of the principal ways in which macroeconomics secks to obtain
useful knowledge about an economy is through the consmction and use of
models,which are dcliberately simplifled representations of the real world
‐deliberately simplifled both in the serse that they omit Or suppress much
of the detail of reality and in the sensc that they deliberately falsify
reality in a number of respects.For eXample,a model may assume an
economy without goverllment and without international∝ ononlic relations;
having an unchanging tcchnology and labour forcc;with perfect infollllation,
mobility of resources,and flexibility of prices and wages,having only two
inancial assets, money and a standard bond; and so on.
Instead of attempting to represent a rcal economy,the model dcscribes
an economy that has somc of the aspects of a real one presumably, those
believed to be quantitat市 ely the most impOrtant or those most relevant to
the kinds of questions_the model win be used to study. Instead of trying
to analysc or calculate everything that would happen in tllc real world if
some event occured or some goverlunent policy were introduced or altered,
'we analysc and calculate what would happen in thc model. This has the
ditiOnal advantage― if the model is sufflciently dmplc― tha we can
understand how and why these results rather than others, should Occur.
“ mst that the model is enough like the real world, in its essential
We
elements, to help us understand how a real economy functions.
The siinplest models even perrnit graphic representation,which assists
many to grasp more casily tte name of the interdependence among varlables.
50,Cwhat mOre complex models consist of a limited number of equations
that can be solved silnul,aneOusly,in fact,the graphic representation implies
such a set of equations and solves them simultaneously by graphic
manipulation, rather than algerbraic techniques. Obviously, to pernlit
simultaneouS S01ution, graphic or algebraic, there must be as many
lipS amOng Varal11。 s aS thCrc are varabiales to be solved for.In
申 eSP,unpや
"latiOぃ mOddS it iヽ poSlble,and ex廿 。 mdy important,for the user not
Terely to,n,中 9"lutiOns bulゃ attCmpl,3ra,p the indi宙 dual a荀 tmenも
“
and thc overall pattern of their inovement,"hich are(rcuHng in the model―
j二 ヽls O,￨1温 :tamま muitanあ ldy
1、 to hear thc pa■ ,played by a number
of instrumじ hts Whilё alζ 6 hじ arhg thじ 6rch6Stra as a whole.
Maoro oCOnOmic modolS sufflciently:1年 ge and detailed tO be really
useful for for"asting γ ‐ pplに y゛ inlulatiqtt unfOttunately「 10se tO SOme
extent their ibility to be understood. Such models can contain so many
 5 6
equations in so many unknowns that they can i)nly be solved by complex
comPuter routines.
EQUILIDRIT'M, STATICS AND DYNAMICS
A system can be said to be in equilibriumiwhen all of its significanr
variables show no change and when there are no pressures or forces for
change that will produce subsquent change in'thc values of significanl
variables. States of equilibrium need never be reilised in the economy for
equilibrium analysis to be useful tool of thinking. Corresponding to any
given set of extemal circumstances, there may be some pattem of economic
variables which would show no further tendency to change. Assuming for
the moment that there are forces in an economy that push it toward
equililbrium when it is not in that state, a ,joscription of the equilibrium
position is a description of the directions in which economic variables ale
headed. The external circumstances that determine the equilibrium may
always be changing so that equilibrium may always be changing so that
equilibrium is never attained. Nevenheless, it remains useful to know the
directions in which variables are headed at any given time. Whether they
are expected ever to reach their equilibrium yalues or not.
There are circumstances in which dise4uilibrium produces only a and useful exercise in dynamic analysis, it retains the tie to the equilihrium
tendency for further change, which may not be in the direction of equilibrium.
Even in this circumstances, it is useful to be able to identify the equilibrium
that would lead to cessation of fifther change.
States of equilibrium may be of several sorts. Since economic variables
areof both stock and flow varieties, full equlibrium would be one in
which all stocks as well as flows were stable. This would n€cessarily
mean that net flows that add to the stock would, at €quilibrium, be zero.
Such a concept of full equilibrium for the economy as a whole is that of
the classical "stationary stat€', in which the community's stock of capital
is just maintained with zero net saving and investrnent. Such a stat of
full equlibrium has questionable relevance to our economic society.
A mor€ imm€dialely applicable concept of macro economic equilibrium
is that of short-run or flow equilibrium in which flows are stable and have
no tcndency to further change. If this flow equilibrium involves posidve or
negative net change in stocks, frrll stock plus flow equilibrium is not
achieved and growth or shrinkage of stocks may contain the seeds of lat€r
change in'flows.
A third possible vadety of equilib,rium is onp of sometimes used in
analysing economic growth. This is thc moving equilibrium in which stocks
grow, but only in the same proportion with gowth of the current flows'
Thus, all relevant stock flow ratios are constant' and the accretion of stocks
has no tendency to affect the rates of current flows.
The branch of economic analysis that confines its attention to
equilibrium positions is called " Statics".The most usefirl Yariety of statics
is 'comparative statics' which compares equilibrium positions corresponding
to two or more sets of extemal circumstances. Static analysis, whether simple
or comparative, concentrates only on equilibrium positions lt does not
concern itself with the time it takes for an equlibrium position to be achieved
nor with the path by which variabtes approach their equilibrium states'
"Dynamics" is considered essentially \Yith states of disequilibrium and
with chang€. Whether the disequilibrium involves the absence of short-run
equilibrium or the condition and movemet of an economy rot in long-run
equilibrium, study of movement and change is the province of dynamic
analysis. This is sometimes oversimptified by describing dynamics as lhe
study of the moyement of economic varaiables toward equilibrium, or from
one equilibrium position to another. Although such study is an important
concept.
A more formal and sophisticated definition makes the essenbe of
dynamics to be that it studies systems or models involving relations that
hold over time. That is, relationships in which the value that obtains now
for a variable may depend not only on the simutaneous values of other
variables but also on previous values of other variables'
IHE TROBLEM OF AGGREGAIUON
Micro economic thcory has developed on s largely 'a priori' basis'
resting upon a concePt of maximisation or optimistion of Postion' together
with some presumed physiological or technoligical relationships of inPuts
and outputs. Although we may sometimes 'test" or measure these
relationships on a purely microeconomic basis' by snrdying idividual frrms
or oonsum€rs, most of our data relate to somc combinations of units' Thus'
aggregation problems arise evcn with resp€ct to rhe tcsting of conventional
so-callcd 'lriqoeconomic" theories of pricc and income distibution'
Aggregation proble,ms arc of sovcrirl ordcrs' Onc order of problcms is
statistiJ in ttre narnou, technical scose. it aris€s essentialy from the fact
′  ｌｉローーー
7 8
that there is certain element of "randornness" or "indeterminancy" irr
individual behaviour and / or a certain inaccuracy in any measurement of
individual behaviour. Our statistical method must take certain assumptions
regarding this random element.
If the distributiorr of the aggregate "independent" variables shifts
widely and erratically, rve can derive no stable or meaningful macro
functions, and. conversely, using aggregative data, we cannot "discover" the
"true" micro relationship. This apparent result is, however, subject to
several reservaticins. This results can be obtained in some cases like
investment- profit relationship if the distribution of aggregate profits among
firms changes shaply and partly and the individual micro relationships used
having different slopes.
In fact, if the micro slopes are identical, the changing distribution
profits will not make any difference.
Aggregation is a legitimate procedure when the behaviour of the
individual units subject to aggregation is basically similar and when the
distribution of tfie independent variable does not vary in an excessively
violent manner. This suggests, therefore, that it is important, in
aggregation, to group together units whose responses can be assumed to be
roughly the same and that aggregations covering widely dissimilar forms of
individual behaviour. may be dangerous, unless we are sure that the
independent variables change in roughly the same way for all units. If the
independent variable is a particular price or an interest rate, all firms or
consumers may be 4ssumed to experience roughly the same change at any
given time. Where the independent variable is income, we can be less sure.
When aggregate disposable incorne rises or falls, the individual recipients
may have experiences quite different frorn the average or aggregate. If this
is combined with a considerable variety in the individual responses ("micro
slopes"), there may be trouble.
Where we deal with large nurrrbers of units, a wide variety of
individLral incorne experience may still not be serious, provided that this
variety o1'experience is random. That is, that there is no systematic tendency
for individuals experiencing one particular kind of income moverneut to have
response rates sustantially difl'erent from the average tbr other groups. 'fhe
fact that individual profit experience varies widely is not serious for our
presumed investment furrction unless the finls whose profits fall r.vhen
aggregate profits rise can be assumed to have significantly different
investment responses than other firms.
Cenerally, the shape of the macro-relationships reflects both (a) the
shapes of the corresponding microrelations and (b) the systematic elements
in the distribution of the independent variables is of, considerable
importance for macro economics. It means that, even where we find a
reasonably stable macro relationship, its future stability may depend upon
the continuation of one or more distribution relationships. If changes in
population, distribution, consumer tastes, business structure or government
policy should alter the distribution relationships, our macro relation may be
altered, even though the corresponding micro relations are unchanged. Since
most macro economic models do not explicitly include distribution
functions, changes in the latter can upset predictions based on an assumed
stability of the macro functions.
The aggregation problem becomes considerably more difficult if the
of
underlying micro relationship is presumed to be distinctly nonlinear, as. for
example, in the case of the production functions of individual firms. Only if
every total output is always distributed in constant proportions among a fixed
number of firms does the problem of nonlinearity become remotely
manageable. Actually, however, under most circumstances, changes in its
distribution among industries and firms.
Aggregation problems can be extremely troublesome in macro
economics. Although we shall pay some attention to them from tirne to time,
in other contexts we shall often slide over them usually because macro
economists have so far not worked on them and there is nothing to report.
REAL & NOMINAL QUANTITIES
An example of the difficulties attached to using a single unit of
measurement is provided by the measurement of nationaloutput. Millions
of heterogeneous food and services cannot be measured using a common
physical unit. A common unit in which they can be mesaured is money.
National output is therefore measured by the sum of the quantity of each
good or service times its price in terms of money. The problem with this
rneasurement is that we are interested in the physical or real quantity of
national output, as this gives us some indication of the standard of living of
the rnembers of the economy. The real quantity of national output is
inaccurately rneasured by national output in money terms because this
measure rnay be increase in value. not because of an increase in the physical
quantity ofgoods and services produced, but because ofa general rise in the
level of prices. To isolate changes in the physical quantity of
output from changes in the price level, output has to be measured at
 9 l0
constant money prices. This is done by cornparing over time real output
leveis obtained by measuring national output in all the years in the prices
that ruled in orrly one of those years. This is equivalent to deflating national
output at current prices by an index of the price level. We thus get the
following definitions:
I. Money or nominal value of variable is its value in current prices.
2. Real value of variable is its value in constant prices. ie. the nominal
value deflated by an index of the price level.
Y: nominal national output (ie, measured in current prices) per
period of time, such as one year.
y= real national output (ie, measured in constant prices) per period of
time.
p: index of the aggregate price level over a given period of time.
Y:YIP
A price index is the weighted average of the prices of a limited
number (in relation to total output) of goods and services. The price of each
commodity is weighted by the proportion of total expenditure devoted to
that commodity. Because the pattern of supply and demand changes, the
proporlion of expenditure allocated to various goods changes with time. This
introduces bias in to a price index. Therefore, the weights used in
constructing a price are intermittently revised to correct this bias.
FIXED RELATryE QUANTITIES
Aggregate analysis cannot allow for changes in the cornposition of
the individual items that constitnte the aggregate. When we aggregateoverall
commodities to obtain the aggregate national output. its cornposition in tenns
of relative quantities of goods and services is assumed fixed.
This means that in tlris type of macro analysis we take relative prices
as flxed and treat the sum ofall goods and services as ifrvere a single good.
Most macro models which contain aggregate functions are corrstructed in
terms of a single aggregate output.
This rnakes for a particr.rlar problern because of the need to inclrlde
consurnption goods, rvhich are used up tbr curreut enjoyment. and capital
goods. which are used to produce future corrsumption in the sarne rnodel. If
one is assunring a single a-qgregate output. then one is assuming that the
price of consurnption goods relative to capital goods is t'ixed and therefbre
determined outside the modei.
Capital is an aggregate which is particularly difficult to measure since
it consists of heterogeneous goods, differing in age and in the kind of
technology that they embody. It is difficult to derive even a monetary
rreasllre of the value of the capital stock. The prices at which the existing
capital goods were accquired in the past do not reflect their current value.
Allowance has to be made fbr depreciation, which is difficult to calculate
accurately, and fbr the curreut replacement cost of the capital goods. There
is furlher problem of deflating the monetary value of tl-re capital stock by an
appropriate price index to obtain its real value.
Problerns arise in deriving aggregate relationship between variables
by summing over the individual components. For instance,one can postulate
a particular functional relationship by the household consumpticn and
household disposable income for each N households, but one may not be
able to derive the form of the aggregate relationship to the total consumption
and total income without making further assumptions. In the simple case of
lineraity.
C:a, * b, Yr,
Where C, is the consumption of the i'h household and yo, is the
disposable income of the i'h household. The aggregate relationship is
ＮΣＨ
Ｎ Σト
Ｎ Σト
ｈｙ
ｂ
〓
ｙ
ａ
す
︲
N
The aggregate MPC is (r-t b,yo,/y) and is the weighted average of
the individual MPCs. 'fhe weights are each household's income as a
proportion of total income. An additional variable, namely the distribution
of income, explains aggregate consumption but it is not a detenninant of
individual household consurnption.
It needs to be borne in mind that aggregation does present problems
bL( if we are to do any analysis that goes beyond the level of the individual
decision maker we have to aggregate. lmperfect knowledge of the
comparison of the aggregates one is working vvith does not necessarily mean
that one cannot produce uselul results" One cannot irrvestigate economic
behaviour of individual decision units in the econorny. The study of macro
economics therefore must be for"rnded on a tltorough understanding of the
r.rndcrlying micro theory, which rnakes predictions based on maximising
behaviour by decision units.
 t1
LINIT.2
MICRO EONOMIC FOI.JNDATIONS OF MACRO ECONOMICS
The post-war work of both Keynesian and neoclassical economists has
been increasingly influenced by the desire to build aggregate macro economic
relationships upon macro-economic foundations. Micro economic theroy
investigates individual behaviour, taking as fixed those variables that the
individual cannot alter by him or herself.The behaviour of individuals is
depicted as rational in that they attempt to maximise their own utility
subject to constraints. By proceeding in this way, micro ecomnomic models,
which determine a :imited number of variables, such as the price and
output of a particular product, keeping all other affecting variables constant.
are constructed. Micro theory is thus concerned with a single market or
a set of closely related markets which are assumed not to influence the rest
of the economy.
Macroeconomics considers the interaction of all the individual decision
units in the economy and must therefore involve general equilibrium analysis.
In micro theory we examine the consumption and saving behaviour of a
hosehold in relation to the rate of interest which is externally given to
that household. At the macro level we look at how household's savings
plans and their demand for financial assets interact with the investement and
financing plans.of firms to determine the lev....:i'interest rates in the
economy. The essential feature of macro economics is that if the
interdependence between variables and the repercussions of a change in
one variable upon the other variables together with the feedback effects on
that variable. A macro model solves for general equilibrium when all its
interrelated markets are in equilibrium.
One approach to macro economic analysis is to work with all the
micro equations of the economy and determine the prices of conlmodities
and factors of production and quantities of commodities produced by solving
the model for general equilibrium. As each commodity, factors of production
and household is represented by its own behavioural equations, such models
are difficult to handle.
The alternative and more widely used approach in macro analysis is
to suppress the individual behavioural relations and to work with broad
/procedure
aggregates.: A common is to Cerive behavioural relationships at
the individual, micro level and to generalise to the aggregate level. For
.instarrce, one hSrpothesises that a household's consumption will.vary directly
with his disposable income and then one extends this hypothesis to a
, relationship between aggregate consumption and national diaposable income.
D
MICRO ECONOI\{ICS & MACRO ECONON{ICS
Actually, the line between macro economic and micro economic theory
cannot be precisely drawn. A truly "general" theory of the economy would
clearly embrace both. It would explain individual behaviour, individual outputs,
incomes, and prices, and the sums or averages of the individual results
would constitute the aggregates with which macro economics is concerned
such a general theory, but its very generality leaves it with little substantive
content. We must approach macroeconomic problems at a macro level and
micro economic problems at a micro level.
Macro economic reasoning can take account of many limitations and
relationships that are not applicable to individual parts. For example, for any
individual or group of individuals, income and expenditure on currently
produced output obviously can and usually will be different magnitudes.
However, for a whole society, income and expenditure can be shown always
to be equal. Any individual can save without investing or invest without
having previously or currently saved; however, carefully defined, saving and
investment must be identical for the whole economy. One country's imports
may well exceed its exports, but for all countries combined, total imports and
exports must obviously be equal.
Many variables which are extremely important for explaning individual
behaviour tend to "cancel out" when we deal with aggregates. This can be
illustrated by reference to the consumption- income relationship that plays
a major role in macro economics. Consumption behaviour of the individual
family depends not only on income but on many other things such as age
of the family head, size of the family, the age of its automobile and other
durable goods erc. To explain individual or small-group consumer expenditures,
we would need to include these variables and many more. But, for the
explanation of aggregate consumption behaviour, many of these variables
cancel out, atleast in the shortrun. The age structure of the total population
changes only very slowln as does the percentago owning homes. Births,
deaths and sickness with this year alter the expenditure patterns of many
families, but the inciderrce of these in.the total population is quite predicable
￨
and stable; some families have obsolescent cars and furniture, but others t
;
 13 t4

have new9 and s0 0n. These varlables cannot be totally Overlooked in A second, more subtle assumption is that all markets are always in
dealing with aggregate beha宙 our,paracularly when we lcal With 10nger equilibrium. That is, prices are always such that no economic agent is
periods;but thett importance at One dme is slight,and they can frequently dissatisfied with the exchanges that take place. To ser what is involved in
be safely ignOred.This is One of thc mOst sigmflcant of a1l of the advantages this assumption consider the familiar analysis of a single competitive market.
of macro econ■ 1lcs.
A supply function for such a market makes the planned or desired goods
or services to the market a direct function of the market price and a demand
In particul〔 r,much of inicro∝ Ononlics has tO dO widl relative pHces function makes the amount of planned or desired purchases an inverse
of different goods and services.Higher priccs fOr oお g00d bOth attract
function of the market price. There is some equilibrium price, at which
resources tO its prOduc饉 On and cause buyers tO tra,sfer their purchases in planned or desired sales ansd purchases are equal. Exvchanges at this price
other dir∝ tiOns.It is the nuctuation of these price relationships that lnould will leave no buyer or seller with an unrealised sales or purchase plan or
and altcr the s"ucture of resourcc use. The effects Of relative prices may desire. This equilibrium price changes overtime, as supply or demand functions
largely cance1 0ut in dcaling widl the econOmy as a wh01e.If One pnce dses shift.
relative to Others,Other prices havc fallen relat市 e tO the frst.If Onc indus町 A third, and related, assumption of conventional market theories is that
or product has gained Or 10st custOmers or resources in response tO a all buyers and sellers know the prices of aii other goods in the particular
change ll reladve p五 ces,another has 10st Or goined in a way that may leave market in which they operate, as well as the prices of all other goods that
the agttate magnitudes largcly unaffected.Yet it is these intemal changes are related to buyers and sellers behaviour in the particular market. It is as
that are Oi basた concern m mた Ю econOmics.The ne」 ∝t though all prices were instantaneously posted at every location where
Of Кlattve prices
in macК Ц OnOmics can be jus● ncd.since any pHce relative not Only tO decisions are made, so that all the information useful in making purchase
ャ and sales decisions is available to all participants. This asumption is loosely
prices in gPneral but often signiflcantaHy to many other indi宙
dual p五 ces,
referred to as the agent having 'perfect information'. In reality, buyers and
国μ m m品 耐 sellers do not have such information. Instead, decisions are made in the face
1胤 :常 鵠 ∬ 胤 枇 胤 器 Fm“ of some degree of error or uncertainty about the price.
THEPIIciし ECONOMIc ASSIIMPr10NS OF MACRO ECONOMIC A fourth and more specialised assumption of simpler micro economic
nIDORY theories is that of unitary price expections. This means that, although expected
future prices may not be the same as current prices, any change in current
Most maむ ro ecOnomic theorieζ employ the assumptions abOut the prices causes an equal percentage change in all participants expectations of
behaviOur of hOI、 cholds and arlns and about■
9 markeも that jOi,thcm that futurre prices. This is not necessarily the case, often some quite different
have tradilondly been used in mた rO ccOnomic attlyds.The rrst ttζ
sump16n pattern prevails.
typically made in lhis hiCЮanalysiξ is中
,t lh,biy,r,and,cllers i1 9Th These limititations of the assumptions 5.di1irnail) made in micro
market arc sO numcrOus and indcpendent that ea9hヽ aっ
HCe taker'i not analysis may not be of major importance for micr,, . cnomic purposes,
sctdng,pHce but tl■ ng onё Set by the market hter¨ dOn of bu,crs ind.
dependirig on the type of problem considered. on the other h*nd, they may
scuers.shcc伍 、 ぉ Obヽ 10usり hOt血た 。f
Ⅲ iy面 を 、ぬ Of mぬ 鍋 ecbお 品 eζ ,
be qriiie ciucial for macro economic analysis. For if some or all of the
we win nced tO evaluat二 h6w the rcslitξ 6F平 おおth¨ ■好ぎhffe8tea b,・ assumptionl inaccurately describe .typical mi.cro economic markets, the
血 ucing mOnOpolisuQ“ 。
増polお 1%orother imperfeciy competititt mⅢ absdnie of the assumed .condition may.; eliminate or greatly weaken any
“
structures in Which pFices i3 sё t and haiht」 nOd fOi pё
Ⅲ '`

:ibdξ 6f血 0た thai tendency for average pqice lpyglS anftgggregate quantities to aBproach a
trivial duratiOn. "true" or "full" macro economic equilibrium.
 1-5
MODULE - II
I\COME AND EMPI,OYMENT DETERYIINATION:
THE COMPARATIVE STATIC EQUILTI}RIUM MODELS
UNIT-I
ONE SECTOR MODEL
ONE SECTOR NEOCLASSICAL MODEL
The neoclassical approach to macro economics is closely derived frorn
the quantity theory of money which was well developed in the r.vriting of
David Hurne. A key factor in understanding how a decentralised economy
operates is the role of money. According to quantity theory of rnoney. changes
in the money supply may have real effbcts in the short run but will not have
in the long run.
Imagine a simple economy in which the only financial asset is money.
Money is held inorder to facilitate transactions in a non-barter economy.
The existence of money rneans that time can elapse between the moment an
economic agent suplies goods or servicei in one market and the moment it
demand other goods and services in some market using the income obtained
from selling goods or labour. The amount of money which an economic
agent wishes to hold on average over a given period of time is called the
demand for money. This is demand to hold a stock of money. The quantity
of money demanded upon the value of transactions being financed over a
period and upon various factors affecting payment habits. The value of
transactions is identical to the number of transactions per period multiplied
by the average price per transactions. The money value transactions
exceeds the money value of national output since transactions include the
exchange ofintermediate goods and ofsecond-hand goods. Since data on
the value of transactions are less readily available than those for national
output, it is more useful to express the demand for money in terms of
national output. The demahd for money equation can be written as MD = kY
= kyP....(l) Where MD= demand for nominal money balances, k= constant,
Y= nominal national output over a time period, y= real national output (Y/p
=y), P = index of the aggregate price level over that time period.
Resuming the assumption of a constant k coefficient pr€supposes some
fixed relationship between the volume of transactions and the level of real
national output overa period. Multiply both sides of equation (l) by l/k = V
rve€et Mv = yP wher€ 'v' is the income velocity of circulation of money,
which is the average number of times a unit of money turns over in the
course of financing the nominal national output.
l6
To obtain tlre tlrrantity theory prediction that changes in the nroney
supply have no l<lrtq rurn real eff-ects. we need to add an equilibriLrm condition
for the rrlone.v nrarkct. I-he demand for ntoney rnust in eqLrilibrium be equal
to the actual stock ()t'nt()ney in existence. Ms. The condition for money
market eqLrilibriunr ir, Mr'= Ms.rvhere Ms = nominal money sLrpply"
M"=kyP=1lr\,)1P
To derive the quantity theory result two further assumptions are
required: 1) Real national output is fixed at an equilibrium level which is
determined by the interaction of dernand and supply for products and for
factors of productron. 2) The lnoney stock is not affected by change in
nominal income.
Ifthe money supply is then increased, the only way a new equilibrium
can be achieved as if the demand for money increases to match the enlarged
money supply. Given that the equilibrium can be restored is for the price
level to rise. This sort of analytical exercise is known as comparative static
analysis.
Economic analysis also has to specify the transmission mechanism or
type of dynamic behaviour that will adjust the economy from one
equilibrium position to another. In the quantity theory model this is done by
specifling that the demand for goods and services will be affected by any
disequilibrium in the money market. Ifthe stock of money exceeds the stock
of money in the economy, people will build up their money balances by
cutting back spending and saving more. It is here that the crucial and
distinctive feature of the quantity theory model comes in to play. Prices are
assumed flexible. If the demand for goods exceeds the supply, prices are
raised until demand is reduced and again equal to supply. If demand is less
then supply producers reduce prices until the market is cleared.
POLICY IMPLICATTONS OF THE BASIC QUANTITY THEORY
MODEL
The Policy implications of the basic quantity theory model are:-
L Changes in the money supply will disturb the economy. In particular
increases in.the money supply will raise, the price level but in the
long run leave the real variable unaffected. Continual increases in the
money supply cause inflation
2. The price mechanism enables a decentralised economy to adjust iaelf
back to equilibrium.
 t7 l8

ONE SECTOR KEYNESIAN MODIiI- An ahernative to the algebraic exposition is the keynesian cross
l'lris model is based on certain assumptions. The-y are:-
diagranr shown in figure (l.l)
=E
1) It includes only the goods market.
El=C tt II
2) There is l1o lnonetary sector.
3) It
E=C+I
assurnes an exogenously fixed price level.

ＯＬ“″〓００ ０一““ｏ﹂“∞く
4) Both the stock of capital and the labour force which when fully utilised
determine the maximum level of real output the economy can
produce, are constants

5) The firms act as profit maximisers.

6) Real consumption varies directly with real national income.
7) Investment is exogeneous.
8) Consumptiorr and income are exogenous variables.
9) It is a short-run model and determines the value of real national
outprrt for a particular period of time. Y"', Yr Y2YTEY!

The condition for static equilibrium level of real output is that the Real national income
supply of real national output (Y) equals the quantity of national
output which people wish to buy (E). FIGURE 1.1

ie.Y=E-(l) The Keynesian one sector - model : Comparactive Static and

But the aggregate demand (E) is composed of real consumption Dynamic Analysis
expenditure (l). The equilibrium condition is given by the 450 line along which Y: E.
E=C=l-(2) Aggregate demand is given by the Eo: Co +' Io schedule, the slope of which
depends on the marginal propensitv to consume. The two lines cross at the
By assumption (6). c = a-b Y where b is the VPC equilitrriurn level of national outpr.rt. Y"E. Because prices are assumed fixed
By assumption (7), I = Io :, r. ther is nothing in the model to errsurethat the equilibrium level of output is
Solving equations ( l), (2) and (3), Y -- a-lo
the same as the maximurn alnout'rt of output firms wouid be willing to
AE
(l-b) rr-ul
produce at these prices. The latter level of output is known in Keynesian
analysis as the full - employment level of national output, known as YF.
Where AE is the autol'lolrous expenditure and is known as multiplier.
AIso,c=a+b.AE The'arucial, distirrctive characteristic of a Keynesian model is that it
(1-b) can solve for an equilibriurn level of output at which the capital stock and
labour force are not fully employed. .The goods rnarket,does not clear
The iucrease in output as.a result of a permanent i.ncrease in
lrecause finns are rvilling tcl sell urore orrtput at current prices trut cannot find
by Y : l( I -b) A AE. *here l/( I -b) is the
autonolnous expenditure is given
c usto0lers.
kevnesian rn ultiplier
 L9 n
UMT-2 Y=a+I(r)
EQTJILIBRIUM OF TIIE PR.ODUCT AND MONET MARKETS s

The locus of goods - market equilibrium, values of real output and the
DERIVATION OF IS FI]NCIION -
interest rate is called the IS scheule which is derived geometrically in figure
The ISLM model brings in the connection between the real and financial Q.r)
sectors by postulating that investment is inversely dependent on the rate

∞〓 ＞“∽ Ｓ。  ・  。 ８● 場８８編・

of interest. Investment is the demand for capital goods because they will
produce additional goods and services in the fqture. When a firm buys く1)
capital goods, it must compare costs and revenues which occur at different
periods. The way of doing this is to bring all future costs and revenue to S=亀 +sY

Ｓ一
their value in the current period. This is known as the present value.
T十 一― ―
The net present value (NPV) of an investment project is given by
￨

NPV=-So R, R, R" Rn

is he initial cost of the capital equipment, Rt is the net

１
Where So

revenue expected in the te year and i the market rate of interest which is -
called the discount rate.
Given that firms have the objective of maximising their overall Npv,
which is equivalent to maximising the present value of their future expected
profits, they will adopt all investment projects which have a non- negative
NPV. If expectations improve so that the estimated net revenue stream
increases, or the price of capital goods declines, or the market rate of
interest falls, the NPV of any particular investment project will rise. This
means that there will be more investment projects with a positive Npv and
hence a great€r demand for investnent goods. In the ISLM model expecations
and the price of capital goods are taken to be constant, whereas the rate
of interst is endogeneous.
The investrnent function in the ISLM model is I = I(i). Each investment
schedule exists for a particular value of the state of expectations and the
price of capital goods.
savings are assumed to depend directly on the level of income. Savings
frrnction is given by s = - a + sY where .s' is the MpS.
For the goods market to be in equilibrium , planned investment must
equal planned saving.
ie,― a+sY=I(i)
ｌ ｉｏ
O Yl χ Rcal hcome O 1l L Investment
Fig:(2.1)Derivation of the IS curve.
Turning to quadrant I we see that when income is Yo the desired
amount of saving is So, which is transferred on the vertical axis in quadrant
2. The 45o line in quadrant 2 converts any distance along the vertical axis
in to an equal distance on the horizontal axis. Investment must equal saving
when income is Yo . The investment schedule in quadrant 3 shows that
given a paticular state of expectations and price of capital goods the rate
of interest must be io to result in a level of investrnent of Io.
The co-ordinate of io and yo is then plotted in quadrant 4. We then
have one combination of income Yo and interest rate io for which saving
equals .investment. The same process is repeated for income level y, to
obtain an interest rate i, which makes saving, when income is y, equal to
the level of investrnent. In this way we can obtain a large number of interes
rates and ouput levels for which investrnpn! equals saving and by joining
them obtain the locus of all such points which is the IS schedule.

``0′ ゛
t t,て ヽ″'´ r`, fl・ ヽ)`i ■●
 2t n
The IS schedule alone is insufficient to determine both the level of real Figure (2.2) T\e demand for money as a function of the rate of interest,
income and the interest rate. all other variables remaining constant.
DERIVAIION OF LM FI.JNCIION
Figure (2.3) plots various combinations of the level of real income and
the rate of interest which, given a particular demand function for money and
Equilibrium in the financial sector requires that the demand for monby
equals the stock of money and that the demand to hold bonds also equals a certain stock of money, (M.tlP), make the demand for money equals to the
the stock of bonds supplied suply. The locus of such real income and interest rate combinations is

ｒ
known as the LM function.
に

ｏ
,問 D=(り

Ｔ
6)
Where is the demand for real
(# )' ,value of money and ms is

the exogeneously detemined money supply.

If we wish to depict the demand function for money on a two-dimensional
diagram, we need to hold all except one determinant constant. Figtxe (2.2)
ふ
shows the demand for money as a function of the rate of interest. Demand
schedule DoDo is plotted for a level of real national income which is
constant at Yo. The supply of money, (M.s/P) is given by the vertical line,
as it is assumed exgeneous and hence unaffected by the interest rate. If the V
0
level of output is Yo, the interest rate must be io for the demand and supply 為 Yl Rcalincome
of money to be equal. At a higher level of output , yl, the transactions Figure(2.3)Derivation of the LM function.
demand for money is greater, and hence a higher interest rate i, is required EOUtr.IBRIT]M
to make the asset demand for money lower so as to still equa6 the money
The equilibrium level of real- income and the rate of interest bring both
stock with the demand for money.
the product and money markets into equilibrium. Figure (2.4) depics the
equilibrium level of real income (Yo) and the rate of interest (i,). Equilibrium
０一”﹄ 一∽０﹄０一目Ｈ ，﹁十■  ﹁︷０

occurs at the point where the IS and LM curves ihtersect. At that intersection
point, there is only one combination of income and rate of interest at which
the supply of goods equal the demand for goods and the supply of money
equals the demand for money.

０一“﹄ 一∽０﹄０一■Ｈ  ・１ 。

ぼ
，

一Ｐ
1崎 )

。吼 )

IS Y‐ +I①
money balances S
Figure (2.4) Simultaneousoequilibrium in the goods and money markets.
 23 24

KEYNESIAN ISLM MODEL
The Keynesian ISLM model of national income determination is an
entirely dernand oriented theory. It applied to the short-run determination of
odtput when the economy is less than fully employed. The anlount of output
that is produced is determined by the quantity that is demanded.
The aggregate supply of output in this model is depicted in the figure
ｌ
demand functions could be identical but this specification of different
supply side responses results in different conclusions regarding the outcome
of given policy actions.
Specifying flexible prices in this model means that goods-market
equilibrium determines the interest rate quite independently of the money
market. This can be seen from figure (2.6)

(2.5) -lt ilperfectly el,qgpic at the,fixed price le_vel p = I until 4e futl

Ｌ

拇様こ一
erry$oy.pr.gil lpvel df &tput Y;ii ibached-,.At.$1idpq'int it betdrnes
曇
Ｄ

" conipleleli:intlastic and thc'fiied pficc'assunnpliin bieaks down. If

Ｆ

∽０
aggregate demand is less than the full-employmint level, Y, the actual

﹄
ｌ

〇一
quantity.

Ｃ一
 

一
・

Aggregate supply
０＞〇一〇０一
１

curve for national

output
﹄﹂

Yr Realincome
Figure (2.6) The neoclassical ISLM model
Pl
Yr=full employment
Given that the equilibrium level of employment is yf the equilibrium
level ofnational
rate of interest, which equates investment to the level of saving forthcoming
output
at income level "yr" is "ir". This leaves money-market equilibrium to estab-
lish the equilibrium price level. The demand for real balances which is con-
sistent with goods-market equilibrium is determined, once the equilibrium

Figure (2.5) The Keynesian ISLM model

supplied is demand-determined and identical to Yo. In the case of Yo
exceeding yf, the real quantity ofoutput is restricted to yf, and the price level
must be higher than p=l. As this model has only two indepmdent equations,
the IS function and the LM function, it can only solve for two independent
variables. These are the interest rate and the level of output in the Keynesian
version of the model.
THE NEO CLASSICAL ISLM MODEL
In the neoclassical version of the ISLM model prices and costs are
assumed to be endogeneous and the equilibrium level of real output is
determined exogeneously at yf when all resources are fully ernployed. The
major difference between the neoclassical and keynesian versions of the ISLM
model, is not in their specification of aggregate demand but in the
assumptions made about the supply side of the economy. The aggregate
output level and the interest rate are established, and is (M/P) (y,, i). For
money-market equilibrium this must equal the supply of real money bal-
ances. The nominal stock is given as m" which means that the equilibriurn
price level is that whicl'r makes the real value of mo s equal to the equilibriurn
demand for real money baiances.
COMPARATATIVE-STATIC ANALYSIS : THE KEYNESIAN MODEL
Shifts in the IS schedule:-
An increase in either investment or consumption will shift the IS
function upwards to the right, as shown in figure (2.7), where the IS
schedule shifts from [S" to ISi. A new equilibriurn is established at I,, Y,.
There will also be monetary effects of a disturbance in goods - rnarket
equilibrium which can be analysed with the ISLM rnodel. The increased
level of output results in a greater demand for money to finance transactions.
When the money supply is constant this must result in a higher rate of
 う４
interest if the demand for money is equal to the money supply. This is
illustrated in figure (2.7), where the lS schedule shifts along a fixed LM
schedule, LM".
G'
Figure (2.7) The impact of negative feedback from the monetary
sector on the size of the expenditure multiplier.
As the rate of interest rises from i" to i, are repercussions on the level
of investment, which is consequently lower than it would be had the rate of
interest remained unchanged. This is an example where negative feedback
effects occur. The initial change in the variable causes changes in other
variables which move it in the opposite direction to the initiating impulse.
The rate of interest would remain are i. if the money supply were increased
so that the LM schedule shifted to the right. [n such an event the increase in
real output would be greateg rising to y, since there are no dinincentive
effects of a higher interest rate on investment. If the rate of interest remains
unchanged, the expenditure multiplier is the same size as it is in the simple
one-sector Keynesian model. the multiplier is smaller, the more the interest
rate changes as a result of the larger transactions demand for money
consequent upon the increase in output.
A in investment or concLlmption will shift the IS function
decrease
downwards to the left and decrease output and the interest rate.
Shifts in LM function:-
An increase in the nominal supply of money will shift the LM
schedule downwards and to the rigl-rt, tiom LM. to LM, as shorvn in figure (2.8).
26
●１
〓 ︲
︲
．
Figure (2.8) The effect of an increase in the money supply.
The increase in the money stock means that at the interest rate io the
demand for money is less than the amount actually held. Consequently the
demand for bonds increases, driving up the price of bonds and hence
lowering the interest rate. A lower interest rate stimulates investment, so that
if other ixogeneous variables stay unchanged then output rises. Conversely,
an upward shift to the left of the LM function will increase the interest rate
and lower output.
COMPARATIVE STATIC ANALYSIS: THE NEOCLASSICAL
MODEL
Shifts in the IS function:-
Suppose that investment or consumption increases but the level of
output is in equilibrium at its fullemployment level, yf, where ISoand LM:
P= P intersect in figure (2.9). The IS schedule now shifts up to IS,. At the
initiai interest rate ind price level there is now excess aggregate derrand.
consequently the price level rises. As it does so the quantity of real money
balances falls and the LM function shifts to the left, eventually reaching its
ner,v equilibriurn position at LM: P
: P,. Once the price level has risen to P,
and the interest rate to i,, the demand for money has fallen suffrciently to
now equal the reduced stock ofreal money balances" J'here is no change in
real output. The rise in the interest rate has a disincentive effect on
investment that exactly offsets the initial increase in aggregate demand which
set off the process.
 n B

A reduction in aggregate demand which shifted the IS function to the UNIT.3

left would cause prices to fall. The neoclassical model is quite different from FI.SCAL AND MONEXARY FOLICY IN AIY ISLM MODEL.
the keynesian rrod"l, in which the price level is fixed. Assume the initial
equilibrium is at i,, yf, where LM : p=P, and IS, intersect' When the IS, By adding the Goverment sector to the ISLM model, we can use it to
schedule shifts down to ISo there ii deficient aggregate demand. start analysing the role and effectiveness of fiscal and monetary policies.
consequently the price level falls and the real value of the money supply THE ISLM MODEL WtfII TIIE GOVM]VIENT SBCTOR
rises. ihe LM schedule shifts down to the right. As the real money stock
increases the interest falls in order to preserve monetary equilibrium. The fall This model is developed based on certain assumptions.
in the rate of interest stimulates investment, output rises and so does 1) Consumption (c) and saving (s)are functions of disposable income
consumpton. Aggregate demand rises until it is again equal to yf' Equilibrium (Yd).
at full imployment has been restored by means of price flexibility.
2) Goverment expenditure (Go) is exogenous.
SHIFIS IN TTM, LM FT.]NCTION
3) The Goverment's tax revenues (T) are proportional to national income.
A in the nominal stock of money is shown to shift the LM
decrease
4) Aggregate demand includes Goverment expenditure as well as
function upwards from LM, : p=pr to LMo : P=P, in figure (2'1O)' Initially
with the lower money stock there is deficient aggregate demand because the investment and consumPtion.
rise in the interest rate reduces investrnent. Consequently the price level falls The analysis of the effect of the Goverment sector on the economy can
until the real value of money supply has returned to its original level. The be-readily incorporated in to the ISLM model. Based on the above
LM function therefore shifts back to its original position but is now labelled assumptions, the savings functions is given by equation (1)
LMo : p=po. The nominal money stock and the price level have fallen by
S - a + s yd --:-------- (l)
the same ploportion. Again price flexibility guarantees the restoration of
=
output at an equilibrium, full employment level. andyo=Y-r----(2)
T=ty----(3)
LM:P=P, LM:P=P, . Substituting equation (2) and equation (3) in to equation (1) we obtain

LM:P=Po ,M:p=P,
$=-a+s(1+)Y...-(4)
&LM.:P=P. By the assumption (4), goods - market equilibrium requires

Y=E=C+I+Go (5)

Disposable income is divided between saving and consumption

Yd=Y-T=C+S --(6)
ThereforeY=C+S+T --(7)
0-
Y1 ! YsY substituting equation (7) in to equation (5) and removing c from both
sides of the equation showt*that goods - market equilibrium requires
Figure (2.9) The effect of an Figure (2.10) The effect of a
increase in investment " -reduction in the S+T=[+Go------(8)
demand'when the money supply in Substituting equation (4) and equation (3) into equation (8) we obtain
economy is fully emPloYed a neoclassical model the equation for the IS function:
 m
"
the Central Bank. Fiscal policy is the management of 'the govefnment,s
I(i)+Go=― a+ S (1‐ t)y+ ty― ―‐‐(9) budget, which consists of its expenditure outflow and tax revenue i1flow, in
The geome"ical de■vatiOn of the IS function(9)iS ShOwn in agure order to affect the level of aggregale demand.
(3.1).
FOLICY ANALYSE IN A KETNESIAN MODEL
い
い ＋ ∽

(1) + Fiscal and monetary policy are examined in the context of a kcynesiau
∽
S+T=‐ a+S(1‐ t)y+ty model with idle resources. This means that an expansion of aggregaBiac;irand
(S+T)
causes an increase in real ouQut.
こキーーー壁L FI,SCAL FOLICY
￨

An expansioniuy pure fiscal policy caused by either an increase in

government expenditure or by a reduction in taxation will shift the IS schedule
upwards to the right, as shown in figure (3.2). Because we have assumecl '

・
︲´
a pure fiscal policy, the resulting Government budget deficit is financed by

 ．
Ｌ
bond sales to the public. The assumption of an unchanged money suply
allow us to asssume that the LM curve does not shift as it would if the
money supply were increased in order to finance the fiscal deficit. The
increased government spending, or increased private spenciing due to a tax
cut, stimulates ouQut, which increases from yo to yr. At a higher level of
Yl I+G income the demand for money would exceed the unchanged money supply
if the rate of interest remained unaltered. At a rate of interest of i,, ar,rU an
Quadrant I indicates the level of savings plus tax that is associated income level of y, the demand for money is once more equal to the supply
with various real income levels. If the level of real oueut is y , the level of oI money.
savings plus tax would be (s+T)". Quadrant 2 shows that, to equal (S+T).,
investrnent plus goverment expenditure must be I, * Q. The rate of interest
required to bring this about is i.. Thus we get one particular combination
of the interest rate and output level which gives goods-market equilibrium.
. An increase in the tax rate will cause thg Sl + T function to swing
towards the left. This means that for eactr oupul:level a lower interest rate
is required, so that investment is increased to compensate for the increase
in S + T in order to preserve goods-market equilibrium. Thus the IS curve
shifts down to the left. A reduction in taxation or an increase in Goverment
spending will shift the IS schedule to the right, while a change in the tax
rate will also alter the slope of the IS Schedule. An equal initial increase in
Goverment expenditure and taxation does not leave the IS function
unchanged but will shift it to the right and thus causes a net increase in
aggregate demand in the ISLM model.
yo yl y
Once the.government sector is incorpated in the ISLM model we can Figl碑 .(3.2)An expansiol響 ,P"￨,1撃 4、 pOliCy
begin analysing the impact of both fiscal and monetary policy. Moneatry
policy in this model involves the alteration of the nominal money supply by
 at
JI 32

The increase in the interest rate following a fiscal expansion will be contractionary impact ofthe interest rate on private investment. This point is
greater, the more interest - inelastic is the demand for money, since a larger illustrated by figure (3.4). Expansionary fiscal policy shifts the IS schedule
change in the interest rate is required to persuade people to hold a given from ISo to IS,. In the case of a relatively elastic money demand fuuction the
money stock at a higher level of income. This is shown in figure (3.3) LM schedule is LME. The rate of interest rises only to i,, and hence real

Figure (3.3) The size of the change in the rate of interest consequent upon a
change in the demand for money increases as the demand for
money increases as the demand for money becomes more
interest inelastic.
D^E and D^rare altemative demand for money functions with respect
to the ratL of inteiest when output is held constant, ut Yo. D"t is more elistic Figure (3.a) The expenditure'rnultiplier increases as the elasticity of the
than D"r. The demand and supply of money are initially in equilibrium when demand of money increases.
output is Yo and the interest is i". Output then increases to Y due to
expansionary fiscal policy. D"E shifts up to D,E, and Dot. Each dernand
output increases as far as y,. The fiscal policy multiplier is larger than if the
schedule shifts by the same horizontal distance. In the case of the more
elastic function the rate of interest rise only to i,E to equate the increased money demand function is rnore interest inelastic. The relevant l,M
demand for money with the constant money stock. If the demand for money schedule is then LMr. the interest rate rises lurtherto i, and consecluently tlre
is less interest-elastic, the rate of interest will rise further to i,r. Thus we rise in output to y is smaller.
have seen from figure (3.3) that the change in the rate ofinterest required to
The effectiveness of fiscal policy would not be impaired at all by an
maintain lxonetary equilibrium when output changes greater, the more
increase in the interest rate if investment were perfectly unresponsive to
interest-inelastic dernand for money. This means that the slope of the l,M
function is steeper, the more interest-inelastic is the demand for money. irrterest - rate changes. if investrnent is autonomous, the IS scl-redLrle wor"rld
be vertical. Only one level of incorne woulcl produce the level of saving equal to tlre
Since the increase in the rate of interest following a given expansionary
volurneofautonorrolrsinvestment" irigr,rre(3.5)illustralesthecasewheninvestrnerrt
fiscal policy is greater, the more interest-inelastic is the dernand for money,
is perfectly interest-inelastic; the fiscal policy rnLrltiplier is the same size as
the resulting increase in real output is smaller. This is due to the larger
 v
"
ouQut and interest rate would cause disequilibrium, since there would be an
excess supply of real money balances over the dema:td for them- The
demand for bond increases, bond prices rise and the intcreilt rate fatls' As
a risult of the reduced interest rate' investment increases and output rises'
There are two points at which the Keynesian ransmission mechanism may
fail to transmit the effects of monetary change to the real sector'
First. the interest rate may be very unresponsive to changes in money
supply due to the high interest elasticity of the demand for money' This can
be seen by fig. (3.3). Shift the money supply function to the right and
co-pare the iiterest-rate effects of this rise in the money stock along DoE
(DoE)'the
and bo'. If ttt" demand fo money function is more interest- inelastic
interest rate will not fall as'much as if thp demand for money function is
more interest-inelastic (DoI). The more interest - elastic is the demand for
money, the less the interest rate faUs for a given increase in the money
supply and the less stimulus there consequently is inYestment' Thie'means
a smaller increase in national outPut.
A setond factor which would r€nder monetary policy ineffective would
Figur(3.5) Fiscal policy is more effcctive, the less interest-elastic is be the unresponsiveness of investment and consumption to interesr
changes'
investment. Even if an increase in the money supply causcd a falt in the interest rate,
on
in.the one - s€ctor Keynesian model. The multiplier diminishes as the this would have littte effe.t on aggregate demand or, consequendy'

interest elasticity of investment increases. outPut.

With the same fiscal expansion, outPut only increases by Y6 Y, when In conclusion, the size of the money multiplier is larger
.
investmenl is interest- responsive and the IS function is ownward-sloping.' (a) the lcss interest-clastic is the demand for money and
We have thcrefcie deduc€d that the fiscal policy multiplier is larger (a) the
(b) thc trrorc intrinxt- clastic is thc demand for investmcnt goods'
more intercst - elastic is the demand for money (b) the lass interest-elastic
is the demand for investment goods. PTOLICY AI\LALY$S IN A NEOCIT{SSICAL MODEL
MONSTARY FOUCY Monaarisc wlro wort within the ncoclassic8l francwort strrcss a morc
A standard method of changing thc money supply is for the Cenual dirEct and wktely diftrsed traEmission roeclranisrn' If rhc &mand ad sryply
Bsnk to cngage in open- market oPrations in Govcmment securities. To of rnorry re ort of cquilibriua, rhcn adjusfic[t occtts acrocs-a wi& rangc
increasc'the money suply the Central Bank buys boods from the public. ln of ass.ts, inclrding goo*. X"oec ttc dernard for goods and services is
ordcr to persuade the public to hold fcwer bonds and more morcy' the air""t n ncrim oi aay disocpary bavccen dcmad for moncry and ecttal
Government has to raisc thc price of thc bonds,ie, to lower the intercst ratc.
",*lo of rooo"v. nt j.;dfictdo" for discraimry fiscat 8nd motriry pdicies
This meaos that the inerest falls in the process of monetary cxpansion ard to negrddc t" t"*i of q4gregaa dcaad is cith'r much urcalcr in the
rires if thcre is monetry conraction. q
vir:rv ovcn oon'"*ist"rrt. As thc cconmy ie caPable of sclf-
"r*fl*U"f
Jj*,tcrtt rtrc only ju*ificarkn it thn a c'hanp in tl
GovErund 's firc8l
Thc ISI-IvI modcl pres€ntcd hcrc fsaturca lhe usuil Keynesian . ln ia #aary policy vould up ad/c smooth out thc
t ir.o spced
rrnsmission rnechanism whereby anonaary Policy 8ftcts tbo aggregarc proccss of *tjtl6gnfil"
outFrl An increasc in the moncy supply at thc ciginal 4uilibrium level of
CUP/6 I unim/l000,SDE-2
 15 %

FIS'CAL HOLICY A reduction in Govemment spending or an increase in taxation would

have exactly the opposite efffects. The IS function in fgure (3.6) would shift
In the neoclassical ISLM model fiscal policy cannot alter the level of
from IS, to IS., the price level would fall, shifting the LM schedule down
real national output. It only affects the price level and the interest rate. This
from LM : P=Pr to LM. : P=Po and the interest rate would fall. In a
result is shown in figure (3.6). the IS schedule is moved up from IS to IS,, neoclassical ISLM model fiscal policy therefore has no effect on ttre equilibrium
level of real of real output but effects the division of that output between
the public and private sectors and between consumpton and investment.
LM:P=Pr
MONEIARY FOLICY
In the neoclassical ISLM model changes in the money supply only
affect the equilibrium price level and have no impact on the equilibrium
values of the real variables, tlre interest rate and the level of income. Figure
(3.7) shows the effect of an increases in the nominal stock of money which
shifts the LM schedule down to the right from LM": p=p" to LM, : p=p.

LM.: P-=Po,LM,: P=P,

0 LM,: P=Po
!t
Figure(3.6). Fiscal poliey and 'crowiding out'

by increased Government expenditure or by reduced taxation. This is financed

by bond sales, so the nominal money supply remains unchanged at M..
Excess aggregate demand results,the price level rises, reducing the real value
of the money stock and shifting the LM function upto the left. In order to
equate the now smaller stock of real balances with the demand for real
balances the interest rate must rise to i,. The higher interest rate chokes off
some private sector investment. If the expansionary fiscal policy involves
reduced taxation, the rise in the interest rate would serve to channel resources
away from investment an<! in to additional consumption. If increased Figure (3.7) Thざ neodassical modd h increase inぬ e nomiJ money
Government expenditure is the cause of the shift in the IS schedule, then supply.
the rise in the interest rate chokes off some private-sector expenditure. This The increase in the nominal money suply disturbs monetary equilibrium;
effect is known as 'crowding out" because resources are taken away from money balances are in excess supply. The consequent movement in to
the private sector in order to meet the requirements of public sector bonds reduces the interest rate, aggregate demand is stimulated and the
expenditure. The rise in the interest rate is the mechanism by which this price level rises. The price level reaches a new equilibrium value of p,, once
occurs.
 57
it has risen sufficiently to reduce the real money stock back to the
level at which it once more equals the quantity of real balances demanded
at the equilihium interest rate and outPut level' i" and yf' Equlibrium is
regained once the LM sch€dule has returned to its original position' During
thJ adjustment from one equilibrium position to another real income and
employment yill !e.af{99t9d, blt these rlillretuti to. dreir.former 'values once
the price level has attiin;d its new e(uilibrium.
If the monetary authorities kept on increasing the nominal stoqk ol
money, the process just outlined would be repeated with the pdce ievel
coflti;uously rising. A distinctiv€ foature of neoclassical analysis is that
inflation is caused by excessive monetary expansion and that controlling the
money supply is the key to reducing inflation.
LNrr4
L'NM,{PLOYMENT AND TTIE I-ABOUR MARKET
Unemployment is an emotive issue and is reJlected in the terminology
ndopted in the economic analysis of unemployment' Keyens based his
own
anaiysis of unemployment on the neoclassical theory of the labour market'
THE D${AN'D FOR LABOUR
.I'IIE LONG-RUN DE1\4AND FOR LABOI]R
In the long run the level of outP!'t produced depencls on the quantities
of labour and capital and on the state of technical knowledge' ie'y = f
(L,K,T) where Y is the real output per period of time, L is the flow of labour
services, K is the capital stock and T is the state of technical knowledge'
This is a highly aggregated production function Labour and capital are
assumed to be homogeneous factors of production'
In the noeclassical theory labour and capital are assumed to be
suhstitutable. This means that there is a whole range of possible production
techniques, each representing a particular combination of labour and caPital
to produce a given level of output.
In a growing economy the equitibrium in the labour market can be
maintained at the iunent real wage if the sock of capital grows in line with
the expansion of the labour force. Unemployment will result if the labour
force grows more rapidly than the stock of capital and if factor price
adjustrient fail to increase the demand. for labour so that it matches the
supply of labour.
38
THE SHORT‐ RllN DENIIAND FOR LA30UR
In the short run, th€ stock of capital and the state of technology are
fixed and the output will vgy with the. quantity of labour eirployed ie, y
= f (L, K,T) where K and T are constqnts. ,.1 ., . , :
The short-run demand for labour is derived from the short-run aggregate
production function. Given that firms operate in perfectly comPtitive goods
and labour market. The Price of goods and the wage rate will be unaffected
by the amount of outPut prcduced by any single firm. A profit - maximising
flrm rvill hire labour until the marginal reven\r€ product-of labotr (MPL x P)
is iust equal to the marginal cost of that libour unii (W) :
ic.MPLrP-W
.. MPL = W = W (the real wage rate)
P
The reai wage rate measures the cost of labour in real terms sin'e il
is the number crf physical units of output that can be exchangcd for onc time
unit of rvork.
TIIE SI]'PPLY OF LABOL1R
In the long run the suppiy labour is determined by factors as
of
population growth and the rate of participation of the Population io the
work-force. The supply of Iabour is the amount of labour wiiling to work
ar a particular real wage rate. Each worker is assumed lo oblain utility from
leisure time and from real income which can only be increased by forgoing
leisure. An increase in the real wage will increase the supply of labour
the substitution effect outweights the income effect
if
hours per worker only
Over the long run, the income effect has been stronger'
As real wages have risen over time so people's working hours per
week have fallen. A rise in real wage is likely to increase the labour supply
by increasing the numbff of people who wish to participate in the labour
force. Workers already in employment are induced to supply more labour
by the payment of overtime rates.
Empirical work suggests that while the long-run labour-supply function
is inelastic with respect to the real wage rate, over the short run the supply
of labour responds positively to inqeases in the real wage rate'
 9 q
IIEOCLASSICAL I.A,BOUR . MARKET EQTIILIBRII]M
ln a neoclalsical model the labour market is in equilibrium at thaqt real
\.\?ge rate which equates thc demand for labour with the supply of labour
so that the labour marker is cleared. This is depicted in Figure (4.1) at an
equilibrium real wage rate 'We' and an equilibrium e.mployment level of 'Ir'.
The equilibrium level of employ.rnent established at the market - clearing real
wage rate is consistent with full employment.
W F=g(W)
'=h(W)
D
demand for lrh6u'
L
y鳳 瀬
Ⅲ 口●
Figue (4.1) kbour-markit equilibrium
FRICTIONAL L|{EUPI.OYMENT AI\D JOB SEARCH
An eqrtibrium or full-employment level of employment does not imply
a zero level of unemploymenr Some positive amount of unemplo)ment there '
are also job vacarrcies. Therefore, we need to show that equilibrium in the
labour market is consistent with the existence of some unemployment and
vacancies. The essence of this reconciliation is that because it takes time
for workers to search for jobs and for employers to hire new .worken there
will always exist some frictional unemployment and some unfrlled vacancies.
The elistence of frictional unemployment is explained in terms of the
special characterislics of the labour market. Vacancies.and unemploymentr
servc thi 6ame -furi*innd as inventories and waiting-liiF in other markets.
In any market buyers and sellers need to get infomation on the exchange
prices which ;.e obtained by a process of search. Job-search theories of
unemployment have burgeoned in recent years. These theories seek tc'
explain uncmploymenr as the outcoire of job search by both workers and
employers in markets characterised by imperfect infonnetion which is costly
to acquire. Because of their characteristics labour market require a more
extensive search than many other markels rvhere proces are posted daily or
are displayed by retailers.
Job-search theories have an explicit choice-theoretic foundation; they
assume that workers and furns aim to maximise utility. Additional search will
bring benefits in the form of more infomation but will also incur extra costs.
For workers the opportunity cost of search is the time taken from either
leisure pursuits or work time as well as any additional transactions costs-
When an unemployed worker obtains a job after at a particular wage, he or
she needs to estimate the relative costs and benefits of acccpting the ')ffer.
The benefits will be the present value of exta income earned over future
yearc in that job. The cost will be the expected value of additional incom]ie
fmm searching longer and possibly obtaining a better job offer. The duration
of unemplo).ment will thersfore be longer, the lower the opportunity cost of
job-search and the greater the expected income from longer job search. The
higher the ratio of unemployment benefit to income from working, the lower
is the cost of job search. The expec-ted income from job search depends
on the worker's estimate of the best hjob offer he is likely to get and how
long it will take to get such an offer.
Job.search theory pedicts that unemployed workers may rcject job
offers because of incorrect information. They may think they can obtain
better wage offers and fail for sometime to realise that market conditions
have changed and that the equilibrium wage rate has changed. In a
n€oclassical model a decline io aggregate demand would be reyersed by
downward movements in the money wage rate and the price level- If
unemployed workers fail to r€alise that the equilibrium money wage has
fallen beacause they have to s€arch to find out this piece of informarion,
then they will extend their duration of unemployment. The rate of
unemployment, which depends both on the numbers uneinployed and their
duration of unemployment, will rise-
Iob search th∞ 呼h the conte対 燿
of a macro modelド ps tO ex口 Jn(→
the existenc€ of fi equilibrium Ievel of aod vacancies, together
, and (b) dre deviation
′
with an equilibrium full erptoyment level
ふ器 『
T:置 ta滉 鑑 駆
values as a result Of
appropriate wages and prices.
 4l 4)

STRUCTT'RAL UI{EMPI-OYI\,TENT directly for money wages and nor real wages. Therefore, workers are willing
to accept a cut io real wages that stems from a risiog pricc level but not
As structural changes occur in the economy some industries some
one caused by a cut in money wages, because the former affects all workers
labour-skill categories and some regions of thd couotry decline while other
more or less equally and does not alter relative rcal wagcs. In the static
expand. This results in disequilibrium with excess labour supply in contracting
int'erpretation of the Keynesian model the money wago is assumed to be
sectors whiie there is excess demand for labour in growing sectors.
fixed. It is exogeneous to the model and explained by institutional factors
Labour resources will move from declining sectors in to expanding and past history.
ones in response to wage differentials. But the adjustments takes time and
In a Keynesian model the supply of labour is within limits, perfectly
may remain incomplete. The displaced workers have different skills and live
elastic with respect to the current money wage- rat€. An examPle of a
in different locations to the new job opportunities. Retraining takes time and
Keynesian tabour supply function is drawn in figure (4.2) as schedule W,f
some displaced workers may not be capable of being retrained. The mobitity
of workers will be restricled by difficulties with rehousiirg of srong
S,. Its position depends on the fixed money wage rate W,, anil upon a
given price level P,. The demand for labour is also plotted with res,rert to
preferences for their current location. This type of unemployment is known
the money wage, holding the price level fixed at P,.
as structural unemployment. Technical change also conribute$ to structural
unemployment by altering the balance of demand and supply in specific S,:P=P,
product markets and morc generally by imp,roving labour productivity. The
distribution of unemployment and vacancies among individual indusEies and
rcgions will daermine their aggregate level for lhe economy as a wfole- So
long as some sectors experience an excess supply of labour, even if the
majority of sectors have excess labour demand, there will be a positivc level
of unemployment.
In neoclasical analysis the existence of unemployment and vacancies
does not imply that labour markets remain permanently uncleared. Aggregate
labour - market equilikium is consistent with frictional unemployment labour
markets will be continually adjusting to the changes in demand and supply ,:P=P,
which characterise dynamic economies.

KETNESIAN T]NEMPTOYMENT

Keynesian unemployment is attributed to an insufficient level of

aEgrcE te demand. The condition results from a different specification of
the labour supply function from that in neoclassical analysis. In 'The General
Theory'Keynes assumed that workers are unwilling to accept a cut in
money wages in order to secure more employment, eventhough &ey would
accept an equlvalent reduction in the real wage rate brought about by an
increase io the price level while the money wage rate remained unchanged.
Keynes did not +l$ribute thjs in to irationality on the part ofr workers but
to a desire to preierve their wage r€lativities. Workers are coricerned with
the real wage they receive and not just its money value. Because the price
level is not determined in any single labour market, workers can only bargain
Bnployment
Figure (4.2) Keynesian Labour supply function
As the money wage rises the real wage rate also rises along D,D,.
Since the price level is assumed fixed at P,' Given a money wage of W,
and a price Ieyel of P,, only OL, labour unis ar.e demauded while OLo are
supplied. Therc is an exi-ss Supply of labbur i:qtral to'Lr, L. units. The
labour market is uncleared and there is unemPloymenl
 4 4

TIIE ISYNESIAN I"ABO[]R MARKET
The relationship between the neoclassical and Keynesian specifications
of the,labour market and the derivation of the demand and supply of labour
schedules are shown in figure.(4.3).
Quadrant I in figure (4.3) shows the neoclassical demand for and
supply of labour schedules with respect to the real wage rate. The
equilibrium real wage which clears the labour n]arket is 'We'. Assume that
the money wage rate is fixed at 'W' and the price level at P,. Quadrant 2
shows what the resulting real wage.rat€ will .be in quadrant 3, the 45q lino
enables us to transfer the money wage rate from the horizontal axis of
quadrant 2 to the vertical axis of quadrant. ln quadrant 4 the co-ordinates
(W,, Lr) plot a point on the demand curve for labour with respect to the
oroney wage rate, for a given price level P,.
﹁ｌ
Ｄ ヽ
Ifthe money wage rate were fixed at a lower level, such as W then
,
from quadrant 2 we get that the corresponding real wage rate, giyen
the
price level is fixed at P,, is W From quadrant I the demand
for labow when
the real wage is Wo is L,,. In quadranr 4 the co_ordinates (W.. L,) provide
another point:relating the demand for labour and "g1e money.wage rare
when
the price level is fixed at P,. Joining all such points in quadrant 4 we get
the demand for labour schedule D,D,.
Given Keynes's hypothesis about the supply of labour then, ihe amount
of labour supplied when the money wage is fixed at Wr and the pdce ievel
at Pr is given. by schedule W, f S, in quadraut 4. The Keynes,s labour _
supply schedulti for a current money wage, W,, and p pr is horizontal
= until

point.f and thcn slopes upward!. This shape is due to Keynes,s

(1) /S assumptron
ヽ
ヽ

ihat workers are willing to accept a cut in real wages thal comes liom rise
ｗ

a
︲

in the price level but are unwilling to accept a cut in the money wage rate
ｌｗ
ｏ∞てヽ   電 ぼ

when there us unemployment.

■ Ｌｏ
，

￨
Given W, and P,, the real wage is W, and at this real wage quadrant
￨
I shows that OL,, labour
wilt be supplied. Therefore, if the price level emarns

Ｗ ｗ
at
小 ヘ
ll, -ti'e .only yay to induce more than OL, units of labour to supply
￨

themselves is to raise the real wage rate by raising the money wage
13) above
l 14o
W,.
￨

Therefore, the Keynesian aggregate labour - supply schedule conesponds

-4
￨

Sw __Ew to the neoclassical one at employment levels above O!,.

雪 ￨
｀
ヽ
、
￨

1
In 4 the positions of the demand for and supply of labour
quadrant
=W
l
￨

schedules with respect to the money wage rate are fixed in relation
■ ― ― 十 一
to a
particular price level. Along schedules D, D, and W, f S, the price
: [ level is
1 1 P=Pl
Ｌ

ハヘ∧ held constant at P,. Lf

the price level changes, then both the demand tbr
Ｌ
ＴＬ

L
Ｃ

and supply of labour schedules in quadrant 4 shift. These shifts are

shown
in figure (4.4).

Figure (4.3) Keynes's labour market.

 45 4

So in Keynes's analysis, when the amount of labour willing to work

② at the existing money wage and price level exceeds the dernand for labour,

Ц   Ｗ ｗｅ
employment can be increased by policies which raise the demand for labour.
L This is done by raising the price level relative to the money wage rate.
I
When the Keynesian labour - supply function is operative, labour is
said to be 'off' the neoclassical labour - supply function. In Keynes's
I :

will occur at levels of emoployment below the market - clearing

analysis this
:
amount of employment. ie., when the actual real wage rate is stuck at a level
:
which exceeds the equilibrium real wage rate.

VOLI.]NTARY AND ITWOLI.]MARY IJNE\{PLOYMM{T

ヽ
り１ １ １

Sr:P=P, Keynesian unemployment is also involuntary unemployment. Involuntary

④
,S,: P = P, unemployment is often defined to exist when unemployed workers are willing
to work at the current real wage but are unable to find jobs. Involuntary
unemployment exists if, following an increase in the price level with an
unchanged money wage.

③ ａ
the supply of labour still exceeds the existing level of employment,
︱

ｄ
ｎ
ヽ
ト
ー

al
Dr:P=P,
O) the demand for labour is greater than the current level of employment.
ー

l' The need for this apparently elaborate definition of involuntary

unemployment is evident if we study figure (4.4). Given a money wage of
Vy', and a price level of P,, OLu units of labour are supplied at the real wage,
Figure (4.4). The Keynesian rabour market : an increasc in the price level
W, But at this real wage only OL, labour units are demanded. The excess
raises employment supply of labour, or unemployment, is,given by the distance L,Lr. However,
not all of this unemployment can be termed 'involuntary' because LeLu
Let us assume that the price level rises from pl to p2. In quadrant 2
units are only prepared to work at real wage rates which exceed the market
the w = wP identity pivots down to opr. A'. eactr
-o.,6y wagl rate the clearing real wage rate of W.. This leaves L, le as the amount of involuntary
corresponding real wage is now lower. Forlnstance, from quadranl
2 we see unemployment at W, and P,.
that at a money wage of W, and a price level of p, the conesponding real
wage is ngy W-.'. Quadrant 1 shows that at a real wage of W,r,
OL,r labour In the neoclassical model labour is always on the labour - supply
is demanded. So in quadrant 4 the co_ordinates (W, L,,) giye u pqin, o, function, as workers respond in the same way to a g .,. chance in the real
a new demand for labour scfedule D, D, with respect 6 the',non"y *ug. wage whether it is due to a price - level change or to a change in the money
rate when the price level. is pr. Becaise ihe real wage has fallen from wage. If the actual real wage exceeds the equilibrium real wage, then in
*,
1o
w,t some marginal labour units are no longer witting to work and the neoclassical analysis the ensuing unemployment is voluntary. A sufficiently
labour supply contracts along the neoclassicar labour *ppry function lrrge cut in the real wage due either to a fall in the money wage or a rise
to
LWr.' However, ol-ut units of labour are still willing to wori-ai or below the irr the price level, or perhaps to some combination-of both, would reduce
existing real wage of w,r. Thus the Keynesian labour - supply function ar he supply of labour until it equalled the demand for it.
price P, is W, g Sr.
 4t 48

FT]II EMPI,OYNM\T TIE C00DS N…

The difficulty of distinguishing between voluntary and involuntary Savings function S/P=S(1-Oy …… (1)
unemployment means that full employment, defined as existing when the lnv(stmcnt function VP=Ki1/P… …………0)
aggregate labour market clears. It is not easily measured in practice when Govcmment Expcnditure G/P=Co/P ∴… … (3)
we are dealing with the thousands of interrelated labour markets rather than
a single homogeneous labour market.

The operational problems associated with defining full employment as

existing when the level of unemployment is consistent with overall labour
- market equilibrium have led to other difinitions of full employment. Some
have defined it in terms of an arbikary percentage of unemployment which
obtained in the past, while othe6 have described in terms of a level of
unemployment which is deeemed to be desimble if not feasible.

Ilh{IT - 5
TIIE TIIREE SECTOR MACRO MODfL

The ISLM model reduces to only two independent markets or Figure(5.1) Derivation oF the aggrcgate demand schedllle
equations. So it can solve for just two endogenous variables the level of
real output and the interest rate in the Keynesian version; the price level
Tax Funclon :T/P=t(y)… ………
…… )

and the interest rate in the neoclassical version. The introduction of the Coods‐ m"tt equilbHum :S■ ■=L+C・ …
………
“
(5)

labour market provides a thid independent equation and it enables us to P P P P

solve for all thrce variables: the interest rate, the price level and the quantity Thercforc, the equation of the IS function is
of real national output. The thre€ sector macro model includes the goods,
mooey and labour markets. The aggregate demand firnction which is derived (S(1‐ う+OY=I(i1/P+Go/P ……………… (0
from the IS and LM equations takes the same basic form in both the ■E Mtt RIARKET
neoclassical and Keynesian versions of the model. The fundamental Demand for money functiOn :QDD=M(ェ 1)… ……17)
difference between the two approaches lics in their specification of the P P
supply side of the economy. Exogenous supply of mOney:M'=Mざ …………(8)
Money‐ market equilibnum :(M)D=ご ………… 19)
THE NECEr$SICAL THREESECITOR MODH. P P
The basic sp€cification of the goods and money market and hence the Equation of LM funcrOn M」 =MO,D… ………(1の
aggtrgate demand sch6dule (figure (5.1)) arc the samc in the nooclassical P P
and Keynesian versions of the model-

The specification of thc €qua$ons which makc up thc

oul below:
arc sct
鰤 。
￨ミゝI鴇剛嘘‖ 薔
聾牌噴
wage r“ e throughout its range
 0 50
PRODUCTION SECTOR
Short-run production fucntion: y = f (L,K,I) -..-.....-.--.(11)
Demand for labour function : LD = g (WP) ..................(12)
function : Ls = h (WP) ...........,......(13)
Supply of labour
Labour-ma*et equilibrium : Ij = LD = k...-...-.....-....(14)
Substituting equation (14) in to equation (il) gives
yf = f(rr) ...................(i5)
(Where \ and L. indicate market-clearing levels of real output and
employment; I and T are omitted as they remain constant).
TTIE NEOCUSSICAL AGGREGATE STII9LY FUNCTION
The aggregat€ supply function is d'- ved from the demand for labour
and supply of labour functions together with the short-run L&Eregnte
production function. The derivation is shown in figure (5.2).
The assumption of marker - clearing in the labour market (pan a) means
that the equilibrium rcal wage rate (WP)" is established, at which the level
of employment is k. There is no exc€ss supply of labour at this rcal wage
rate. Given the equilibrium level of employment, Le,
L (a) Labour Market Market (b) Aggegate
Agffegate short-run
Aggregate
︻
ｏ＞ｏコ ００ｒ﹄
o model the eq口 librium level of output ls dctennined in thc produc● on sector
fi
Figure (5.2) The neoclassical aggregate supjy:chediざ
we can read off the corrcsponding amount of real output (yf) supplied from
the short-run aggtegate production function (part b). The aggregate supply
function is depicted in (pan c) as a vertical line since it is invariant with
rpspect to the price level. A rise in the real wage rate above its equilibrium
level caused by a fall in the price level would reduce the demand for labour.
In order to secure employment unemployed workers would be willing to
ac.€pt.lower moirey wage rates than had previously ruled. Thus the money
wage rate would fall until the real wage was once more at its market -
clearing equilikium level and the excess supply of labow had bcen eliminarcd.
Real output would once more be equatr to y, Hence the equilibrium real
output ievel, y can prevail at any price level because money wages are
flodble.
TITE COMPI,EIE NEOCLASSICAL MODEL
The model is solved by requiring that overall equilibrium is simultaneously
achieved in all three sectoB. The general equilibrium where the aggregate
demand for and aggregate supply of r€sl output arc eguat is illustrated in
figue (5.3).
一
０ンＱ口 ¨
９■■“  ｐ Ｃ
・
0 yf
Rgure(5.3)The FICOClassical model
… Ⅲ Can be seen hm this diagram,shits in the aggregatc demand
schedde have effect on thc qdlttum● VOlヴ r中 OutPⅢ Ⅲ ey only affect
thC"Ce level and the money wage mte,lcaving the mmrket‐ d“ 直ng
eluilibriuln real wagc ratc unchangcd Thus in a s● ●●nary nclassical
only
 5l 52

' Ifthe nominal stock of money is increased, the locus of IS and LM

equilibrium, depicted in figure (5.1), will change, causing the AD ;rhedule Production
to shift up to rhe right. The price level will be proportionately higher. This

Ｌ
is the standard neoclassical result that a change in the nominal money stock

Ｌ
︲ 。 Ｐ
will leave the static equilibrium values of the real variables unchanged. This
property of money is referred to as the neutrality of money. Thus, given y」 yfl
the constancy of the institutional factors which influence the,demand for
money, the nominal quantity of money dtermines the price level and has no 0 :

long-run effect on the real variables. This leaves the goods - market to 4r'io)i^

Ｐｅ
determine the rateof interest and hence the division of real output between
二_J受

ｐ﹁ ０
oonsumption and investment. The equilibrium interest rate is thus independent
ヽW
of the price level in static equilibrium.
(WP)e(W/p)l W/P yl yf
THE KEYI\ESIAN TIIREE.,SECIIOR MODEL Figure (5.4) The Keynesian model : derivation of the aggregate supply function

The Keynesian three-sector model which has evolved out of the work of
Hicks, Hansen and Modigliani differs from the neo- classicla model in its
specification of the supply side of the economy. Keynes held that the
money wage rate was inflexible downwards and that workers were willing to
accept a cut in their real wage rate due to a rise in the general price level.
Keynes's specification of labour-supply behaviour results in a different
aggregate supply function from that in the neoclassical model.
TIIE COMPI.,ETE KEYI\ESIAN MODEL
The aggregate demand and supply schedules are brought together in
order to determine the values of the price level and real ouput when the
economy is in general equilibrium. This solution is shown in figure (5.5).
In contrast to the neoclassical model a shift in the aggregate demand
function does affect the level of real oueut as well as ttre piicJtevel. This
is shown in figure (5.5) when aggregata demand increases fiom AD, to ADr.
Once we have determined the equilibrium values of real output ahd

THE KEYNESXAN ACCREGATE SUPPLY FI,]NCTION

The derivation of the Keynesian aggregate supply function is shown in

figure (5.4). Part-a of figure (5.4) depicts the demand for labour as the real
wage rate varies, together with a neoclassical labour - supply schedule
which is needed to determine that the market clearing equilibrium real wage
P2
rate is (wP)e. Part-b shows what the real wage rate is for various price
Pl
Ievels given that the money wage rate is fixed at wo. Turning to part-c
AD2
of the diagram we can read off from the short-run production function that
the amount of real output supplied will be y,. The co-ordinates (p,, y,) AD2
are
ploned in Part-d to give one point on the aggregate supply schedule. 0 y
The l y2 yf
Keynesian aggregate supply function is upward - sloping since as the price Figure (5.5) Equilibrium in the keynesian three-sector model
level rises with the money wage rate fixed the real wage raie falls, thus the price level, the quilibrium level of employment is determined via the
stimulating employment and increasing the supply of output as long as an short-run production function and the labour .markgt in figure (5.4). The
excess supply of labour persists. equilibrium interest rate can be determined by the intersectiin ortr," ls una
LM functions which is established once we know y and p.

53
The crucial characteristic of the Keynesian model is that equilibrium is
consistent with involuntary unemployment: that is, with the absence of
market clearing in the labour market. This result is in complete contrast to
the neoclassical model, in which equilibrium only occurs when all markets
clear.
A MODEL OF TIIE OPEN ECONOMY
When the economy is opened to international transactions three
equilibrium conditions have to be met if the economy is to be in overall
equilibrium. These are goods market equilibrium, money market equilibrium
and foreign exchange market equilibrium.
GOODS I\,IARIGT EQT]ILIBRIT]M
For goods market equilibrium, desiied aggregate demand for the
domestic product 'E' must equal the amount supplied, 'Y'.
Y=E (equilibrium condition) - (l)
Y = C+S+T (Ways of disposing income) - (2)
E= C+I+G+X-F (Components of aggregate demand) - (3)
Using these equations we can express the equilibrium condition for
the goods market in the form of either (a) or (5).
Y - (C+I+G) = X-F (Where A = C+I+G) - (4)
(S-I) + (T-G) = X-F (Current Account Balance) - (5)
The sum of consumption (C), investment @ and govemment expenditure
(G) is known as absorption (A). Absorption is the demand by domestic
residents for goods and services, including their demand for imports.
Absorption is quite distinct from aggregate expenditure (E), which is the
demand by residents and foreigners for goods and services produced. If
,
absorption is less than national output, then the L.H.S. of both (a) and (5)
is positive. An excess of national ouQut over absorption corresponds in
equation (5) to the sum of net savings by the private sector (S-I) and net
saving by the Government (T-G) being positive. For goods market
equilibrium, the surplus of absorption over output must be sold to foreigners.
This gives a surplus on the current account (X-F is positive and equals
Y-A). If absorption exceeds the national GDP, the ex@ss demand for goods
and services by the residents must be bought from foreigners in order to
equata-aggfegatB.demarrd. and supply. In this case thp hal4pp6 on,;cBnpnt,,
accounts will be in deficit. For goods market equilibrium, the surplus of
absorption over output must be sold to foreigners.
54
A positive balance on currcnt account means that the econom,aS a
wholc is engaged in net saving. A positive current account balance is
flnanced by net lending abroad. Under a regilne of flxed exchange rates thc
acquisition of forelgn exchange rlnances any exOc,s Of exports minus imports
over the net capital ■ovL
Coiversely,a ncLatiVe balancc on curent account means that the
cconomy is using morc rcsourccs than are made available by its national
product. This excess is obtained fronl abroad and is flnanced by net
borrowing from abroad.Under a regime Of i挙 exchange ratcs,any current
account deflcit which exceeds the net private capital flow is flnancod by
selling foreign cxchange reserves. “
undcr the assump● on that the rest of the world's real output and priCe
level are fixed,the relative price of an economy's goods to foreign goods
depend on the economy's price level e)and on the exchange rate(P).
hports depend on the economy'sN.I.,the price 10vel and thc cxchange rate.
import demand functbns are r=xpF卜 (6)and F=F
The expoi and・
(p,RY)― (7).
、
For given vdues of p and P we can derive the IS function for an open
economy. This shows the various levels of the interest rate and real output
for which tte goods market is in equilibrium.A change in ρ or R● X江 10n
and govemment expenditure and other items of autonomous expOnditure
shift the IS function.
MONEY MARKEr EQuLB―
In this modcl there are 3 types of inanclal aSstts that the Govemment
sector can hold ―money, domё stic bonds and fOreign bonds. Capital
market equilibrium requires that the quantity of domestic money and the
stock of domestic bonds arc hё ld willingly by rcsidents and foreigners at
the gOing output and interest rate levels. The dcmand for real money
balances is assumed to depend on the level of real national output and on
the domestic intcrest ratc.Md=P.f(y,1)― (8)
The nominal money supply depends on the quandty of high powered
money(H)and On the parameters which make up the bank multiplier(β ).
MS=β H― (9)
The two idendties ass∝ iated with high powered money(H),One reladng
‐
お `ユ
ξヽむ
`i〔 適[dざ 'ind'th6 6th析 relati五 奎tO thё uses of H arё g市 en
by H=Q+B∫ ―(10)H=CttR― (11)Where Q is the fOreign exchange
 55
reserves Boc is the Central Bank's net holdings of Government debt,
C is the curency in circulating and R is the commercial bank reserves. From
(9) and (10), we can derive the money supply function: M' = I 1q + Boc)
- (12). Given p, the domestic money supply will increase if there is a balance
of payment surplus, if the Govemment fails to finance all its budget deficit.
FOREIGN D(CHANGE IVIARKET EQI.]ILTBRI{,]M (BOP EQT]ILIBRII-IM)
This equilibrium requires that the total currency flow is zero. The net
capital flow is asstrmed to depend on the difference between the domestic
and world interest rates.
The demand functions for exports and imports have been given by (6)
and (7). As real output rises, imports rise and so the current account
worsens, given a fixed exchange rate and a. constant domestic price level.
An increasing balance of payment deficit as aggregate demand rises can be
offset by an increased capital inflow, induced by a higher domestic interest
rate. Thus there is a locus of income and interest rates levels at which the
balance of payments is in equilibrium.
When the goods and money markets are in equilibrium and the level
of real output is determined as Yo, the balance of payments is in deficit @ig.
5O.
０一
“″︻︺毀０﹄０”〓Ｈ
Ii,I(ltp,B
B the balance on current account- It is equal to the difference between the
Real output
Figure (5.6)
The absence of simuiianmus equilibrium in the goods, monetary and
foreigir sectors of the economy.
ノ ｔ
fi
TI{E BALANCE OF PAYMENTS AND KEYI{ESTAN ANALYSs
The introdqction of trade with other econorRies widens the choices
available to consumers, producers and investors. In an open economy
consumers are no longer restricted to domestically produced goods, while
producers are no longer confined to the domestic market.
THE BALANCE OF PAYMENTS
The money flows arising from transactions in goods, services and
assets between the United Kingdom and foreign residents over a given
period of time are summarised in the balance-of- payments accounts. In the
foreign exchange market, expost purchases must equal expost sales. When
one refers to a surplus or a deficit on the balance of payments one is
referring to the sum of the items in a sub-account of the balance-of-
payments accounts, rather than to the balance-of- payments accounts as a
whole.
The most useful subd.ivision of the balance-of-payments accounts for
macro economic analysis is into the balance on current account, the balance
on capital account and official financing. These must identically sum to
zf,ro.
iq balance on current balance on Offrcial
account + caPital acoount + financing = 0
The sum of the current and capital account is called the balance for
official financing (BOF) which is often called the total culrency flow or
overall balance of payments
The balancb on current accotlirt is equal to the value of exported
goods and services, plus the value of net culrent transfers, minus the value
of imported goods and services. The balance of trade is a subdivision of
value of exported goods and the value of imported goods.
The capital account records both the borrowing and lending of funds
abroad by domestic residents and companies.
The balance for official financing (BOF) is a record of the difference
between the demand and supply of a currency by traders and investors in
the foreign exchange market over some time period. A deficit on the BOF
measures the excess supply of currency on the foreign exchange market by
raders and investors over the period. Similarly a surplus on the BOF measures
both the excess demand for currency by non-official sources on the foreign
exchange market and the resulting sale of thq currency ol]!at. market by
the Bank of England. This would lead to an incrbase in the UK rironey stock
unless offset by equal open-market sales of bonds by the Bank of England.
 58
5t

ｌ 一ｅ

１
Ｆ
ｅ

〓
0(Oy

一ｅ
Open-market sales and purchases of bonds designed to offset the impacr.on
the domestic money supply of a surplus or deficit on the BOF is called I
'sterilisation'. Therefore, the balance for official financing has repercussions we set jQte)=f where f is the marginal propensity of the domestic
If
on the UK money stock and finacial markets whenever it is not equal to €conomy. to import foreign goods at constant exchange rate e, then
zero. This makes it an important factor in the macro economic analysis of
an open economy. jF=fv
I

I{EYIIESIAN APPROACHES TO TIIE BAI.ANCE OF PAYMENIS .'. The new equilibrium condition is:
The eady Keynesian approach to the balance of pa)rments was Y=C+l+C+X- -ln
e
concemed with the determination of the current account in situations with
The IS function is
involuntary unemployment, excess domestic productive capacity, pncc rigrdity
and constant production costs in both domestic and foreign economies. Y= a+ I(i) + Go + X(e)
This approach also assumed that the Central Bank could sterilise any -Td:D=E-F-
surpluses or deficits on the BOF and thus prevent the balance of payDents
from having any effect on the domestic money supply.
In this expression f
is a function of e and will only be constant if e
stays unchanged. This IS function has the norrnal negative relationship
Let us assume that we are dealing with a small open economy under between the values of Y and i due to the effert of the level of interest rate,
the assumption that changes in its domestic incomq imports and expons i, on the volume of investment.
have an insignificagt effect on the rest of the world's incoma Also the If we assume that undq a fixed exchange rate (ex), the govemment can
economy is assumed to have involuntarj/ unemploFrent, excess capacity control the money supply, tien we can sat out ISLM model.
and a horizontal supply curve for current domestic output. An additional
assumption is that imported goods are distinct Aom domestic productign
Y= a+I(i)+Go+X(e*) (IS tunction)
and the country is specialised in the production of its export goods. s(1-t)+t+f
Undcr these assumptions, the demand for the country's exports (X) is Mo' = f(y, i) (LM function)
of foreign incomes (Y*) and the relative prices of domestic and
a ftinction P
foreign goods (pf/pd, where pd is the price level for domestic goods in These are illustrated in figure (5.7) given that p is fixed by assumption.
domestic currency and pf is the price level of foreign goods in foreign
Curency).
Df
x = xG*cfd- )where 'e' is the foreign exchange rate.
In this model, y* is exogenous and pd & pf are constants due to the
assumption of constant production costs and horizontal aggregatc supply
furrctions.
...x=X(e)
. The quantity of impors dananded (F) is a function of domestic income
(y) and relative prices. F increases as 'y' and 'e' incrcases.
F=F(Y.4)
epo'
Since Pd and Pf are constants,
F= F(J/,e)
I[c 0
_ can simplify this expression further if we assume
unchanged relative prices. total domestic expenditure on imports is a simple
that, with " !' Y' lt
Figurc (5.7) ISLM function in an opcn cconmry
hear function of domestic income.
The IS firnction will shift tom IS, to IS.'if &€re is either an autonomous
 ω
I
DEODllLE Ⅲ
increase in any of I,G and X or a decrease in the marliflal propensity to
import (f). CONSUMPI10N AND INVSTⅣ田Nぽ DEMANDS
Given a Central Bank policy that stabilises the rate of interest at ix and llNrr I
a fixed exchange rate e*, we can find the multiplier fo1 al autonomous
change in any or tn" variables in the numerator of the IS function. CONSUMPHON FINCl■ ONS
1-
ThereforfrClffi is the multiplier in the open-economy Keynesian DEFINHION OF CONSUMPrloN
model under a fixed exchange - rate system. t∬
ltttl譜 輩 嚇
The three multipliers (due to change in I,G and X) are identical due to 」 h￡ 躍 l¶ FⅧ 誂 鵠 :器 1温 覧躙 嘱
the small economy issumption. In the small economy model with a fixed thc scrvices yielded by a good, while thc aCt Of purchasing it iS cOnSumcr
exchaiige rate (e*), the balance of of payments on current account (CA) can
be written as:
CA=X-fy
CA is expressed in terms bf the domestic currency. X i_s_ a function of
撒囁
職 猟棚 F犠鸞 彙鸞 f難
「
a relatively shOrt period arc refcrred
the level of foieign real income and is therefore exogenous. Here, given the whiChソ iし ld S■ Viё ёS tO hous■ oldS are know aS COnsumer durables.The

品Tttrl∬ 淵鯵器 鷺艦∬

器 tttW器 監
fixed exchang" it" (e*) and constant pd and pf, there is only one.level of
income (y=iD at which CA = 0. Any expansion in domestic expenditure will
worsen tire balance on current account. In this case domestic absorption will
rise faster than income. This is illustrated by the vertical line CA = 0 in
figure(5.8). Any income that is greater than )Uf involves a deficit on the
u""ount, while any income smaller than )Vf involves a surplus on
鑽
龍
Over a considerable period Of time.
難柵 囃 淵 ´
",irr"rrt
the current account.
i SIMPLE CONMPHON MCr10N
^^ ^
Consumption functiOn or prop
relationship indicating how cOnsu

m肌撫∬‖胤ヽ∫「4
1喘
需棚 こ FT欄幌∬° rl
lttF:hfi」 臨 鳳fun計 鳳
・
蹴TTc結 ‰∬ :島 棚
需鵬 酬 lξ蹴 :∬ 蹴鵬」
」
躙
variablc.ThiS ShoWS that conSumption is dependent on income.There are
PL脳
X
T -T-
Fig(5.8) The current account in a fixed exchange rate ISLM model'
榊摘
W職 猟iW聯 脚 t思 0柱
:ed on the lceteris paribus'asSumption.
It has been fOund that when incOme increases cOnSumption alsO increases
For the CA = o linc to shift, it is necessary that either X changes or but by less than the income.HoWeYer ё
VCn at zero incomc COnsumption
f changes. As the increase in exports will shift the IS, function to-the right
to IS- the induced increase in domestic income from )Uf to y will lead to
a risJ'in domestic absorption and imports. Hence the improvement in the
濯響talTi楓 ∬TI洲露肥累
穐 T臨 雷T為よお
F篇 ∫
tO consume)。
current-account balance will be smaller than the increase in exports.
 61
CTIARACTERISTICS OF CONSTJMPTION FT]NCTION
The relationship between consumption and income is in real terms. In
the analysis of consumption function prices is regardel as fixed, and only
disposable income (i.e income after tax) is considered. The income that is
taken into account is the aggregate income. Another very important featurt:
of consumption function is that consumption is a stable function of income.
In consumption function analysis current consumption is functionally related
to current income. Consumption is direct function of income. However,
consumption is reversible. As income goes up consumption also goes
down. It has been found empirically that in the short run consumption may
exceed income, but is not possible in the long run, Consumption may be
disproportional but in the long run, it has been found to be proportional.
After the 'break-even point, where the consumption line meets ttre income
line (Saving line) consumption and income become equal. After the break-
even point is crossed income becomes higher than consumption. But before
before the break-even point consumption may be highei than income, as
shown in the Figure 3.1
Figure 3.1
目ｏ 〓 ０日 ヨ ∽Ｅ ｏ ｏ
0
0 If\trOOME
In the figure point B is the break - even point. Above the break even point,
saving becomes positive and below the break-even point, saving becomes
negative
PROPERTIES OR TECHMCAL ATTRIBUTES OF CONST'MPTION
FLINCIION: AVERAGE AI\D I\{ARGII{AL pROpA\[SrTmS TO CONSUME
There are mainly two technical attributes or properties of consumption
-
function.
62
l. Average propensity to consume (APC):
The APC is the ratio of consumption expenditure to a particular level
of income i.e APC = C/Y. Where C is the consumption expenditure and
Y is the level of income. In the figure 3.2 the APC is shown as l/2 or 0.5
at a level of income which is Rs. 1@. The APC can be calculated at various
levels of income. Such a type of calculation is likely to show that as income
increases the proportion of income spent on consumption decreases.
Z Marginal Propensity to Consume (MPC):
MPC is the slope of consumption line. If the C line is a straight line,
the slope is constant. But if the consumption line is a curve, consumption
will rise at a diminishing rate with the increase in income. MPC is the ratio
of change in the aggregate consumption to the change in the aggr:egaite
income. OR MPC = ACIAy In the figure 3.2 the MPC is calculated to be
ll2 or 0.5
Figure 3.2
目ｏ●０日 ●の目ｏｏ
APC = CN = 50/l0O = 0.5 at point N.
MPC = AC/AY = 50/100 = 0.5 at point P
In the above diagram, it has been found that the value of APC and
MPC are the same. However, they need not always be the same.
TECHMCAL CTIARACTERISTICS OF MFC
The following are the technical characteristics of MPC
 63 &

1. The value of MPC is always positive but less than 1. This means that Z In the case of linear consumption function of the fqrm: C = BY APC
when income increases, the whole of it is not spent on consumption. is fiual to MPC which is constant. 'Ihe consumption function will
Similarly when income goes down, consumption expenditure does not pass through the point of origin, suggesting Proportionate income -
decrease in the same proportion. Consumption expenditure never consumption relation"
becomes zero.
When Consumption function is curvi'linear:
Z MPC is greater than zero. It is always positive. This means that an
increase in income will lead to an increase in consumption. MPC 3. In the case of curvi-linear consumption function, APC is greater than
cannot be negative. MPC. This can be proved with the help of the figure 3.3. According

3. MPC goes down as income increases. to this figure, the APC is RT/OT which is greater than MPC which is
RTA4T.
4. MPC may rise, fall ('r' remain constant, depending on many factors
subjective and objectives.. During period of cyclical upswing, MPC is Figure 33
likely to fall, but during the period of downswing it is likely to rise'
However in the long run, Mrc is likely to decline.
Relationship Between MPC and APC

a. When consumption line passes through the origin, APC and MPC are
equal. r
b. When Consumption function is of the form: C= a + bY, MPC is
constant but APC is declining as income is increasing. The consumption
function is linear.
c. Ordinarily, APC and MPC both decline ,, in"o*" increases, but MPC
declines more than the decline in APC. o T INmME
d. As income goes down, MPC falls; APC will also fall but at a slower
rate.
.-$,: When consumption function is rotating upward
e. If MPC is risitig, the APC will rise although at a slower rate.
f. When MPC is constant, APC may also remain constant. APC is constant 4. When consumption function is rotating upward from right to left, the
value of both APC and MPc will rise and they will become close to
only if the consumption function passes through the origin'
each other so that two values becomes equal. In other words, when
g. APC, in some cases, may be equal to MPC: It is quite possible that the consumption function is becoming stccper, the value of APc is
50% of increased income is consumed and that 5O7o of the'existing increasing and ultimately, it becomes equal to the value of MPC. The
income is consumed. values of APC becomes constant and it does not change with the
When conzumption function is linear change in the level of ingome- Such a shift in consumption function
takes place only in the long run. ." [n the figure 3.4 there are four
l. In the case of linear consumption functions of the forms: C = a + bY
e,
where MPC is constant and positive but less than one. APC is higher consumption functions; cl, c3 and c4. The relationship between
APC and MPC would be like the following
than MPC. In such a case, APC will decline.
 “ “
2. Whcn income incrcases,the increment of income will be diy:1颯 ￨ltWecn
Figure 3.4

織脳胤轟翼:is憮 計鶴WttT・ p計 記管 埋《
品 li∬
and saving go hand in hand. What is not consumed is saved. In fact, saving
is complement of Consumption:
3 As income increascs,both consumption and sa宙 ng will increase.An
increment of income is unlike,to lcad'ё tthtt to less spe五 dittЁ 6r tO less

,W薬
撚 ¥鞠 i織 捕 蜘 糧
●０ ︼︺０日 ● ∽●ｏ ｏ

W鷺
Income lncreases.
The above thrce propositions are interrelatcd.
DYNAMIC CONStMPIION FtNし 110N

C Income
醐舗蠍Ittl欄[榊熱
鮒 蠍 聯鮒 朧 掛藤
l. In the consumption function Cl, APC = MPC = 1 (45" Line)
L In the consumption function c2, APC = MPC, but they are less tharr
one

3. In the consumption function c3, MPC is constant, positive but less

than one. APC falls with an increase in income, but APC is gteater
than MPC.
4. In the consumption function C4, MPC is constant, positive but less
than one. APC falls with an increase in income, but APC is greater
than MPC. It should be noted that the magnitudes of APC and MPC
at C3 are lower than those at C4 at the corresponding income levels. the best available appnxlmation. It is debatable whether a simple onc‐
quarter

Keynes's Psychological law of consumption

Lord Keynes has propounded a fundamental law of consumption.
This is known as psychological law of consumpion. The fundamental
propositions of this law of consumption consists of the following statements:
belo‐
1. When aggregate income increasas, consumption also increase but by Dttbuted‐ Ltt consumption function
a somewhat smaller amount. This is so because as income increases mue
and more of our wants as satisfied. Therefore, less and less is spent Much better results,howevert arc obtained by usmg a dismbuted lag,
gradually on oonsumption out of the increased income. Consumption
lfpenaiiurt increases at a less than proportionate rate, as compared to the 湊柵 織嘱 乱 ぶ誡∬朧Ⅷ
quarecr(or yOo For instance.
rate of growth of income.

cuP/6rffi 8/luI0/sDE-3*
 67

轡紳撫 鍛魃 棚
C, = 8o + ar DIr + % DI r -r -----(l)
makes this period's consumption depend on this period's and last period,s
incomes. The immediate result of a rise in income is to increase C, by a,
DI,, but next period there will be a further effect from today,s income
孵群 》
Moving・ Average cxDnSalmp“ 面 hnctiOn
irrcreases consumption by a further fraction of today's income increase.

∬淵珊鮮 儡
These a, and a, are know as "partial marginal propensities to consume,'. The
table below illustrates this and other possible formulations, on the assumption
that income has been steady at DI = 100, but in period t rises to 110 and
thereafter remains at the higher level. In the present case, we take ao=lQ

妻 l薗那 ittlMI
鞠 脚鮮警
8r= 0.5, az= O.3. The results for consumption appear under column l. As
can be seen, the "short-run marginal propensity to consume" is 0.5, the :庶

いり +瓢
"long-run MPC" is 0.8, the sum of the two partial MpC's.

… 眺
Period DI C
1 2 3 4

”””膨％％

∞ ∞ 膨 ％ ％ ％
∞

” りare tte waghts h a mO宙 ng avcrage,

t-2 md%(al■
漱踊遣∫1.+り
∞

９
０

”
t-2
１
０

漱淵難蠍邸威
t

議締 締理轟響
１
０

t+1
Ю

t+2
０
ｌ

t+3

W
If there is a two - period distributed lag, which does not include the
current period, we might have.
C,=%+a,DI,-, +arDlr_,
If, again, Bo =
…………………-6り
= 0.5, ez= 0.3, the results are shown in column
10, ar
職
2- Here the immediate MPC = 0, but the long run MpC is again 0.g. An
alternative two period distributed lag can take the form.
……
C=alLЫ D鳳 1 …あ
l md∵ ｀ percmtte d m宙 施Ome
C, = to + a, D{_, + a, (D[-, - DI u2) ------- (3)
which makes c, depends on lagged income and the lagged income increase, Lふ 監 中 ng‐ averaま m
perhaps on the ground that income increments have an effect on spending
over and above the efGct of income levels. The results with ao = 10, 8r =
0.8, q = 0.4 are shown in column 3. There the immediate MpC:O the short
run MPC = 1.2 and the long run MPC = 0.8. tf the equation be
C, = % + a, DI, + a, (D[ - DI ur) -_---__- (4)
 @ ro
Koyck Consumption function
Koyck distributed lag applied to a consumption function specifies that
current consumption is a consumption of all past incomes with the property'
that the series of coefficients of past income ierms declines geometrically.
That is (using Y to represent disposable income).
C, = % + ar Y, + a, Y,,, + a2 Y,-2 + ........... -'-------(8)
Where (a,/ar) = (a/ar) = (arla,,) = ----------> I
and a, + a, + al +.................,..+an <I
Filting this equation yields identically the same iesults by fitting an
equation in the form
C, = a + by, + cC,-,...........................(9)
Where 0<b< t and Occ<I. From this we see that the shorlrun MPC
equals the coefficient b. The long-run MPC can be easily calculated even
though it is approached only through an infinite calculated, even though it
is approached only through an infinite series, of diminishing increments. If
an initial equilibrium between C and Y is distributed by a once - and forevet
increase in Y, equilibrium is restorcd when C, = C,, = C.. Substituting in
equalion (9) we get.
C, = a + bY + cCE = a,/(t-c) + b/(l-c) Y
Then long - run MPC will be b/(l-c).
Evaluation of Dynamic Functions
In as much as simpte, nonlagged consumption function "fits" the data
from the United states national income and product accounts very closely
- explaining upto 99.5 petcent or more of the variances in anmral consumplion
spending and having other satisfactory statistical properties - it is virtually
impossible to choose between a nonlagged and any of the more complex
dynamic forms solely on the basis of goodness of fit.
Since the data do not clearly establish that one or another type of
dynamic rclationship is clearly more consistent with the "facts" then any
other, economists are likely to choose - among the many possibl€ f<.rrins -
that one which closely approximates their own ap ori theoretical preferences.
And since most economic theorists feel comfortable with the thmry uf the
rational consuming unit, which allocates its income oYertime in order to
mgximise the discounted utility of its present and fsture 'consumption most
edonomists prefer empirical functions that either involvp substantial lags or
use wealth as an exra viable, or perhaps both.
There exists one exception to this negatiYe judgement. ThE Kolcok -
lag of equation (9) does reasonably well reproduce the medium - term and
.longer - term fluctuations in the saving rate, but this is not for reasons
consistent with the underlying logic that most economists associates with
this form. In theory, the Koyck equation as in equation (8) = makes current
consumption depends on a long series of previous incomes and. perhaps
very little on any one of them, even the most recent. But the equation
actually used, equation (9), makes current consumption depends on current
income and on last period's consumption These two forms would be identical
if the relationship expressed in equation (6) held precisely in every period.
In the case, if both equations were fitted to the same data the coefficients
of one would prevent precisely into the coefficients of the other. Given
historical values of the series of Y's and a known or predicted value of Y,
either equation would predict exactly the same current consumption. And'
of course the prediction would always prove precisely cunent.
Thus dynamic consideration in the relationship of consumption to
income do not seem adequately to solve the mysteries in the explanations
of consumer spending. Perhaps the answer lies in finding variable (eg'
wealth) which along with disposable income, help to explain why consumers
spends as they do.
A CYCLICAL VERSES SECT-II.AR CONSI]MPTION FLTNCTION
Ackely (198?) argues that there is a systematic short-run relationship
betwe€n consumption and income associated with the fluctuatiolls called
"business cycles". This short run relationship, however, washes out as
recessions are followed by recoveries. In the long-run, consumption is
basically proportional to income; in the "secular function". APC and MPC
are essentially equal. But when income declines' during a business - cycle
recession, consumption declines in smaller proportion than income (with
saving sharply reduced); during the subsequent recovery, consumption rises
again, but in smaller Proportions that income (so that saving increases
sharply). Over long periods of economic gowth, the resulting short-t€rm
movements of the saving rate cancel out, thus, the APS falls sharply in
recession and rises sharpty in the recovery, but it is essentially constant on
the average for periods longer than that of the ordinary cyclical fluctuations'
 7t
MODULE M Confronting the empirical evidence
UNIT 2
FOST.KEYNESIAN CONSUMPIION FI.]NCTION HY"OTIIESES
consumption function, according to Keynes, is non- proportional in
the short-run. But it has been found that consumption-income relationship
is proportional in the long- run. These basic aiternative hypotheses on
consumption function are discussed below
ABSOLUTE TNCOME HyFOTITESIS (Arr0
The aggregate consumption function is a core element in the Keynesian
theory of income determination. He also made apriori assumptions about
the
form of the relationship between consumption and income. For a household,
and hence for the economy as a whore, consumption as a proportion of
income (the APC) was assumed to decline as income rises. The basic
form
of the early Keynesians' consumption function is that current consumption
depends on current income:
C,=a+b{
The absolute income hypothesis is the hypothesis that consumption
is a function of current income, whether the relationship is linear since
b,
the MPC, is.consrant. A further feature of this consumption function
is that
it is non-proportional; the Apc = CN = (a/y) + b declines as y is graphed
in figure 3.5(a). If the Mpc falls as income rises, then the constimption
function is nonlinear as shown by the graph of C f(y) in figure
= 3.5(b).
Figure 3.5(a) Figure 3.5(b)
〓 ｏ〓 Ｑ日 ●∽ｃｏ ｏ
Dispos6ble income
n
The consumption function was one of the first economic relationships
to be estimated in the 1940's by the then recently developed techniques of
econometrics. As with most economic relationships two types oi data,
cross-section and time-series data, are available for testing the consumption
functions. Cross-section data are provided by sampling households to
obtain information for a particular time period on their consumption
expenditure, disposable income and other relevant explanatory variables such
as family composition by age, sex and social class. such budget studies
have shown that the APC does decline with income and typically that low
income households dissave. Evidence shows that consumption functions
fitted to budgefstudy data tend to be non-linear.
The first time-series data to become available were those for the uSA
for the years 1929-41. These short-run time series data produced linear non:
proportional consumption functions. on the basis of such regression
equations, American economist at the end of the second world war attempted
to forecast post-war consumption and calculated that unless a high level of
government expenditure continued aggregate demand would be insufficient
to maintain full employment. In the event American post-war consumption
was considerably greater than had been predicted by many economists and
itappeared that the whole pre-war consumption function must have shifted
upwards.
rn 1946 Kuznets published long-run time-series data for the USA which
showed that the long-run APC had not fallen as national income had
increased, but was on the whole quite stable, and maintained a long-run
average of around 0.84- 0.89, only rising to above 0.89 when national income
fell in the decade 1929-38. From Kuznet's data is obtained a long- run
consumption function such that the long-run Apc and Mpc are both constant
and equal to k. This type of consumption function is known as a proportional
one and is written.
C=kY.
So although the early empirical work showed that budget study data
and short-run time series cata supported the AIH and Keynes's presumption
that the APC falls as income rises, the long-run data conflicted with these
conclusions. Empirical studies show that the long-run Mpc is considerably
higher than the short-run MPC. In addition, long-run consumption functions
are much more stable than short-run consumption - income relationships.
The evidence on consumption reported so far reveals that, while there
appears to be some stable relationship between consumption and income
over the long-run, the short-ruir current income alone offlers a poor explanation
 73 74

of consumption behaviour. The inadequacy of the AIH was evident by the Figure 3.6
start of the 1950's and stimulated the search for alternative theories. Two
closely related theories, the Permanent Income Hypothesis and the Life-
Cycle Hypothesis have become generally accepted as the most useful line

口ｏ●ａｃ壼“∽口ｏｏ
of approach. Both are concerned with analysing the household's choice of
consumption and saving over a long time horizon.
RE"ATTYE INCOME IIYFOIIIESIS (RtrI)
The relative income hypothesis was first put forward by Dorothy
Bready and Rose Friedman. Later on it was analysed by Duesenberry. He
wanted to reconcile the inconsistency between the time-series, (long-run
consumption function) study and cross section study (Short - term
consumption function). According to this hypothesis, the consumption
function of a person depends on the consumption function of his neighbour.
Income
According to this interdependent. This means that the consumption of a
person is hypothesis, consumption functions are not independent but In the figure, when income from OY to OY,, consumption will increase
secondly, this hypothesis says influenced by the consumption of others that along the path OCr. But the income goes down to OY, consumption will
consumption decision cannot be reversed over time. Consumption does not not fall along OC, line, but it will fall at a slower rate along the line bb as
depend on the absolute level of income but on the relative income, that is shown by the arrows. Thus, when income increases consumption increases
on the relative position of the individual on the income scale of society. at a high rate, but when income falls, consumption falls very very slowly.
Consumption depends on the percentile position of an individual in the
income distribution. consumption can change if the relative income position [,ong-run consumption - income ratio is constant. There may be some
of an individual changes in society. Consumption, in fact, is not very changes in the relative income position but in the aggregate, it will
sensitive. This fact has been supported by Modigliani. balance. It is the rate of income growth which is important in determining
the movement of the consumer on the short-run or the long-run consumption
As has been said earlier the consumption pattem of man is influenced
function. So long as income grows steadily, MPC will be equal to APC.
by the consumption pattern of his neighbours. Every man wants to imitate
and increase in consumption will be proportional to increases to income as
the higher living standard of his neighbours. He wanrs to keep up with the
consumers stay on the long-run consumption function throughout the entire
Joneses. This is called Demonstration effect in consumption. There is
period of steady income growth. During the period of recession when
another behaviour influencing consumption function. When a man lives in
income goes down, APC goes up as the consumer moves backward on the
a society of equals, he wants to demonstrate his superiority over his fellow-
beings, he wants to go ahead of Smith. Thus, when the level of income short - run consumption function. Duesenberry's consumption equation would
increases the consumption level of a person is likely to go up. be of the following form:
Another feature of Duesenberry's consumption function is that once C=aY+b(Yn/Y)Ywhere
the higher standard of living is achieved, people cannot reduce their C = Current level of consumption expenditure
consumption and standard of living. Consumption can very well go up with
Y = Current level of income
increasing income but it cannot easily come down. It is irreversible. This
is called the Ratchet effect of consumption function. Under such a situation Y = Higher level of income previously earned
a fall in income will not cause a proportionate fall in consumption. wall fall
a and b are numerical constants relating to consumption.
very slowly (at a much slower rate than the fall in income). The consumption
normally remains the same as the consumption standard of the past peak According to the RIH, if thq current and peak income grow together,
level of income. The Ratchet in consumption is shown in the figure 3.6. change in consumption is always proportional to change in income. When
 75 76

the current income rises proportionally with the peak income, the APC N N A
remains constant. The proportional relationship between income and W=Σ Σ
consumption can be shown in the figures 3.7(a) and 3.7(b). t,事 1 1 t=l t
(1+D (1+1)

r The annuity A is that constant annual sum which, if paid out over
each of the future years of the actual expected income stream, would have
●ｏ 〓 Ｑ 日 ● ∽■ｏ ｏ

づ０
the same present value as that of income stream. The annuity A is termed
permanent income. It is directly related to wealth as can be shown by
manipulating the above equation.

﹁︰ Ｊ 可
性
￨[

Time

ｌＪ
In the above figures: figure 3.7 (a) shows the Long-run proportionality
A=iW
between income and consumption. Even if income grows in spurts
consumption will still respond in the same manner (proportional). But if we
have one cycle, as shown in figure 3.7 (b), income-consumption relation
LimA=iW
becomes non-proportional. N-+Cl
PERMANENT INCOME HY"OTIIESIS (PtrD Assuming an infinite time horizon, permanent income, A is the stock
of wealth multiplied by the interest rate, or annual return on wealth. Thus
The Pemanent Income Hypothesis of Milton Friedman is based explicity permanent income in the annual amount that can be consumed annually
on the theory of intertemporal choice. On the assumption that consumers while leaving the stock of wealth intact.
take account of future income and future consumption, changes in current
Once uncertainly is introduced into the analysis, both the household
consumption by way of resulting changes in wealth. In a world of certainty,
income which friedman tenns measured income, will only affect current
future income strealn and future interest rate depend on the household's
exceptions, and the qoncept of permanent income is less clearly defined. We
permanent income is the retum on the household's human and non-human
think of it as that part of a household's measured income which is regarded
wealth. The households wealth is the present value of the futurc flow of
as stable and as reflecting the household iircorne expectations. The difference
income, which is expected by the households to be variable from year to
year. The household wealth is given by the equation:
' between permanent and measured income, which ma1, be positive or negative,
is called by Friedman transitory income and occurs due to temporary and
N χ anticipated changes in current income.
W=Σ ― Wealth constraint
Yn = \+Y,
t=l t
(1+1)
Where Y, is measured income, Y, is permanent income, Y, is transitory
income.
Where W is wealth, Y, is income in year t and i is the rate of interest Friedman assumes that consumption defined to mean the act of consuming
The same level of wealth could be attained by receiving a constant -the services for goods, is planned on the basis of permanent income and that
annual annuity, A. Then the relationship between the two variables is proportional i.e
 77
C=KYP
The coefFlcient of proportionality9 k,which is the蹴 Цプunderlying MPC
and APC is assumed to depend on thOse factors which affect the houschold's
saving decision. These factors arc houscholds preferences, the nature of
uncertainties facing thc houschOlds, the rate of interest and the ratio of
human to non‐ human wealth.Human wealth is the present valuC Of future
income that people expect to carn by using thcir personal skilis and labour.
Non― human wealth is the present valuc of income obtained from inancial
and capital asscts. The higher the ratiO of human tO non― human wealth the
greater is the incentive to save and acquire non― human wcalth.
CЮ ss‐ Section analysお :・
Friedman's propo■ ionany hypOthesis,C=kY apphes bOth to aggregate
time‐ se五 es
and hOuscholdls consumption hnctions. Cross― section studies
regress mcasured houschold consumption on to measured houschold income
using the fonowing type of regression equation:
C=a+bY
Where b is an estimate of the cЮ ss― section MPC. According to the
PIH,changes in consumption are duc only to change in pemanent income,
hence consumption will onl,change in response to changes in measured
income to the extent that previously anticipated changes in measured incomc
regardα ゴ as pcmanent and causc estimates of perlnanent income to be
re宙 sed. Thercfore,the measured MPC will be smaller than the truc MPC,
K, which is the change in consulnption duc to a change in pemanent
income. This is because movements in measured income are greatcr than
the corresponding movements in 血casured income, while changes in
consumption are duc to change is pmanent income. Since the measured
MPC is b=(△ CrAYp while K=(Δ Cノ ΔYP)and ΔY>Δ x b is biased
downwards in relation to the itrue'MPC,k.
Time・ series analysis:・
Thc PIH can also be used to reconcile the tilne― scries observation on
short and long― run consumptions over the trade cycle. Transitory income
Will bC negative in the recession and positive in the peak thusぬ 。 higher
APCs recorded in the depressiOn ycars of the 1930s relative to the secular
APC fbr the USA can bc explained by relating consumption in that period
,n
to a level of permanent income which was larger than measured income.
Similarly, the lower APCs of the second world war years can be explained
in terms of positive transitory income and negative transitory consumption
then existing.
The shorter the time period over which data are taken, the greater one
would expect to be the variability in aggregate measured income attributable
to transitory income, and thus the greater the downward bias found in the
estimates of the MPC obtained by regressing measured consumption on
measured income. The tendency for the estimated MPC to be smaller the
shorter the time period of the regression is confirmed by an examination of
the US data.
The LIFE - CYCLE HYFOTHESIS (LC[D
The life-cycle hypothesis developed by Ando, Brumberg and modigliani
is like the PIH, based on household utility maximising behaviour. Given that
the household has a known life span and tends to leave no legacies, and
also given certainly, the motive for saving is to rearrange lifetime consumption
in relation to the expected future income stream. The LCH stresses the
accumulation of non-human wealth as the means of achieving this aim.
Uncertainly provides an additional related motive of saving that of protecting
copsumption plans from the effects of unexpected falls in real income.
The typical time profile of a lifetime income stream is one that rises in
the early working years, reaches a plateau in middle years and is followed
by a sudden decline upon retirement (Y curve in the figure 3.8) To even out
the time profile of lifetime consumption a typical household will dissave or
save yery little when young, save in the middle years and dissave upon
retirement.
Figure 3.8
F
〓ｏ■ ０日 ●∽〓ｏｏ ｒ︶
．
Ｖェ
h oflife

"
It is assumed that the houscholdis current consumption (Defined as
nondurable consumption plus the rental value of consumer durables)is
proportional to its total resources,the factor of proportionality depending on
the interest rate used to di,cOunt future incomc,tastes and age of houschold.
Total resources are subdivided into current income:Yr the present valuc of
future income from human sources,YE and aCcumulated assets,A t_1,brought
forward from the pre宙 ous period.Toml resOurces are the same as ttiedmars
present valuc of an future income expected from human and non¨ human
sources which forms the basis for estimating permanent income.
The difference between the LCH and PIH is onc of emphasis,in that
the LCH is concemed cxplicitly with the Юle of asset accumulation and the
effect of agc on houschold consumption. The LCH is siinilar to thc PIH,
in that it asSumes that any changc in total resources,duc to any of the thrcc
components will cause a proportional change in planncd consumptiOn in an
future periods.The APc for a g市 en age group is therefore leduced to be
the salne for an levels of income,to fall with middle age and五 se again upon
an levels of income,to fan with middle age and risc again upon retircmcnt.
The middle years are a period when income is relatiOely high, consulner
durables hlVe becn acquired and there is need to accurnulatc assets with
which to flnance consumption upon retircment.
The result of a change in current consumption depends on the effect
of that change upon the houscholds total resources.If the change is regarded
as only temporary, it will have very little effect on current expectations
of income to be revised in the salne direction.勁 e younger is thc houschold
the more its current consumption will be affected by a change in current
income regarded as perIInanent, since there is a longer period over which
the changed leve1 0f expccted income will be discounted and hencc a large
impact on total resources.
The consumption hnction for each age group is assumed to be
T(ギ トーーーーー (1)
げ= К
Where、 おthe tOtaliresomes tt time t and T indicates the age group
to which ax〕 lunction applies. And
ギ =f(ギ ,Y・ E,へ 二‐
1)_=… … ②
呻 甲C IIS tte curmnt hcm YEぉ preSent vduc of futu“ exPccted
l■b・
Our ttome andへ l are aSSetso Making equation(2)Hnear and
“
substituting it into cquation(1)we Obtain
s
TTTET
C = c[rrY + cLr2Y +c[r3 A ----------------(3)
t t t-l
Aggregate consumption will be a weighted average of the various age
group's, consumption levels. If the economy were stationary and certainty
allowed people to fulfil their plans of consuming all their asSets before their
death, the net saving of the working population would be exactly offset by
the dissaving of the retired, given that the age structure of the population
was constant. Goods and services not consumed in the current period by
the saver would be transferred for consumption to the retired, who would
finance this by selling their assets to the savers. Net saving would be zero,
as would be not investment in a stationary economy. If national output is
constant, the saving are constant proportion of income. If the retired are
living off fixed - interest securities, they are not sharing in the growth of
national income and their dissaving is less than the saving of the working
population. Net aggregate saving is positive and provides the resources
needed for positive net investment, which is required to sustain growth.
Cross - section analysis
The LCH reconciles the non - proportional consumption function
produced by budget studies with the constancy of the long-run aggregate
APC'in a manner very similar to that of thePIH. Cross section regression
of the current consumption on current income will poduce non- proportional
consumption functions because the higher income households contain a
larger pnoportion of people who have recently experierrced an increase in
income than do the lower income housoholds. To the extent that such
increase are regarded as temporary there will be conesponding increase in
consumption and the housetrold experierrcing a tempo,rary decrease in irrorne.
Time - series analysis
The I-CH also provides s reconciliation of the cvidence on short-run
and long-run consurnption furictions. The short - run consumption function,
given by the cquation C, = OY, + q A., is non - psdpqtional, the intercept
term being given by q Ar-,
 8l
As net wealth increasing in a growing economy, so the short-run
consumption function shifts up over time, as shown by the figure 3.9.
tJ
^
, s-j'* ",,
ｃｏ●０日 ヨ∽目ｏ ｏ ９ ““Ｏ●¨“く
National Income
Cyclical variations in the APC are explained in the foflowing way. In
a recession although current income falls, expected income is not much
affected and assets can be used to sustain consumption; thus the APC
rises. In the recovery the savings ratio rises as assets are built up to the
level required to match the growth trend of income.
TOBIN AND SMITHIES'S DRIFT ITTFOTHESIS
According to drift hypothesis the basic consumption function is non
-proportional, and the APC decreases as income increases. But oyer a long
period, the behaviour of a consumer undergoes drastic changes along with
changes in his income. Over a long period of time, the consumption
function drift upwards gradually due to many factors such as population
growth, inhoduction of new products in the market, migration of people
form rural to urban areas, changing age dishibution of population, and so
on. All these factors will raise the consumption income ratio. The upward
drift in the consumption function may not be associated with the rise in
income. These changes may be independent of the level of income. The
upward drift of the short-run consumption functions (Cs) may be represented
in the figures 3.10. In the figure the short - rum consumption functions 9SI,
CS2 and CS3, drift upward and produce the long-run consumption functions,
CL, as a result of the operation of the above factors. Thus; the long - run
consumption function shows the proportionality betwe€n consumption and
income. The long-nrn .consumption function, CL, which has been formed -as
a result of the drift of shon-run consumption functions will show
equality between APC and the MPC.
&
Figure 3.10
●ｏ﹁。日 ぅ∽●ｏｏ
TIIE E\{PIRICAL STTJDY OF CONSUMPTION
Empirical studies reveals that so long as we concentrate only on
quarter movements of consumption and disposable income we have to
conclude that they fail to mnform, even faintly to the consumption function
hypothesis, which had iftplied that consumption is determined by disposable
income and that increments of disposable income will be divided in some
regular and systematic way between consumption and saving. Daniel B Suits
fitted a number of consumption functions focused on the short-term
movements of consumption and income. He concluded: "The striking fact
is that when the analysis is cenhed on quarter - to - quarter variations, the
corelation betwe€n consumption and income vanishes. The movements of
consumption in the short-run are so nearly independent of income that the
usual high correlation between consumption and income is replaced by a
substantial negatiye correlation between Consumption and saving".
. We know that in any short period; say a month or a quarter, income
changes are normally relatively small, Thus, if there are fluctuation in
consumption up or down, random or meaningful, saving wilt almost necessarily
move in the opposite direction and by roughly the same amount. Or if there
are fluctualions in income, up or down random or meaningful and
consumption fails to respond, saving will move in the same direction as
income would necessarily be offset by almost identical moyements in saving,
these irregular changes in consumption of course given rise to income.
Thus, in the short-run consumption determines income more than the reverse.
If these irregular fluctuations in colsumption were purely random, they
would tbnd to averages out to zero the ldngei the time span being
the considefed. Thus we might suppose that annudl data would show a much
more stable correspondence between changes in consumption and saving
 83
and still closer correspondence between changes in consumption and saving,
and still closer correspondence would appear if we used 2 - 3 year totals
or averages of consumption and saving. The longer the period used, the
more stable should be the correspondence of consumption changes and
saving changes with the ratio of the two changes approaching a magnitude
something like 0.9 in consumption to 0.1 in saving as the periods compared
become of the order of half - decade or decades.
But these inegularities are not purely random and that they substantially
cancel out only when we take periods of a decade or more. The long
consecutive runs of quarterly variations in consumption and income reflecting
either MPC > I or MPC < 0.5, irregularities revealed in the annual data, and
the longer movements in the saving rate all suggest that something more
than random variations or measurement errors is at work. Nor should we
simply assume that all of the erratic quartedy movement is explained by
random variation or measurement error.
Another most consistent result is that lagged consumption is a permanent income monetary policy affects aggregate demand by causing
significant explanatory variable in consumption function regression equations
even when the trend in the time series has been removed. However this
observation is consistent with a number of rationalisations - habit persistence,
emulation of social peers - as well as the permanent income - Life Cycle
approach. Using US data Hall claims that the additions of lagged income
to a consumption containing consumption logged one period does not
improve its explanatory power. This finding is consistent with the rational
expectations version of the PC - LC hypotheses.
In general one can conclude that the empirical evidence reveals that
consumption is based on a long-term view of income and that inflation
seems to lower the APC. By itself a change in current income changes
current consumption by about one-third of the income change. Variables
other than current income are required in order to predict short run changes
in consumption.
CONSLIMPTION THEORY: FOLICY IMPLICAIIONS:
The application of Keynesian demand. - management policies requires
a reasonable knowledge of the determinants of short-run consumption. As
we know, the short-run MPC is relatively small and the relationship between
current consumption and current income, even on an annual basis, is quite
erratic, while the quantitative effects of determinants other than income is
still an unsolved issue.
,There is still disagreement co,ncern the channel- through rviich
macroeconomic policy affects consumption expenditure. The traditional
Keynesian view is that dispensable income is the predominant channel in
u
this hansmission mechanism, while changes in the money supply urd int"."rt
rates have very little influence. This leaves direct and indirect tax changes
as the principal means by which the government can regulate consumption.
However, the PIH suggest a weaker influence for fiscal policy since tax
changes can only affect consumption if they alter permanent income. Thus
temporary tax changes will have no impact on consumption because they
only affect transitory income. If expectation are formed rationally, then any
tax changes which can be anticipated by households have already been
taken account of in their estimates of permanent income. As these will not
be revised when the anticipated tax changes, which are regarded as permanent
will affect consumption.
The PI-LC hypothesis give monetary policy a greater role in determine
in aggregate consumption than does the traditional Keynesian approach
with its emphasis on current disposable income. This different arises because
the PI-LC hypotheses treat consumption as determined by wealth or its
portfolio adjustment. In the monetarist transition mechanism the effect of a
change in the stock of money is thus both more direct, because consumption
depends on wealth, and more pervasive because portfolio adjustment occurs
across whole range of financial assets and goods.
MODULE 11I
TINIT 3
INVESINdM{T DEII,IAND
Investment refers to the accumulation over time by firms of real capital
goods (That is those which will yield a future flow of services). Although
investment is a smaller component of aggregate demand than is consumption
it is more volatile and so is important in Keynesian analysis as a source of
short-term changes in aggregate demand. Investment is also a crucial
variable on the supply side of the economy as it is the means by which
changes in the real capital stock are brought about. Once the investment
has been undertaken the capital goods have a specific form which includes
the amount of .labour required per unit of capital.
IITWESTMENT AND CAPITAL STOCK
Investment occurs when the stock of capital is adjusted. Since capital
depreciates over time and with use replacement investment must take place
if the size of the capital stock to remain unchanged
If the capital stock is to increase over tirne, then net investment must
occur. Economic theory relates the rate of investment to the discrepancy
between the desired and the actual stock of capital (see figure 3.11). If there
 85 &

were no adjustment costs then the capital stock would be adjusted
instantaneously from Iq to Ko', so making the speed of adjustment infinitely
fast. Therefore, in order to derive a theory of investment wc need to
corporate lags in the adjustment' of the capital stock towards its optimal
level. Spocifying investment as a lagged function of past discrePancies
between the desired and actual capital stock I = W (L (t) (\' - K,-,) where
w(L(t)) is a distdbuted lag function specifying the lags in the adjustment
Process.
Figure 3.1 I
Where Sp is the supply prices or the cost of the caPital asse'L'ki,rit2,....R,
are the prospective yields or the series of expected annual returns from the
capital asset in the years 1,2,-..-....n, i is the rate of discount which makes
the capital asset exactly equal to the present value of the expected yield
from it. Thus i is the MEC or the rate of discount vr'hich equates the two
sides of the equation . In the above equation, the term Rr/(l+i) is the present
value of capital asset, Present value is "the value now of Payment to be
received in the future". It depends on the rate of int€rest at which it is
discounted.

As amatter of fact, the MEC is the expected rate of retum over cost
of a new capital good. In order to find out whether it is worth while to
purchase a capital goods it is essential to compare the Present value of
国いく “ いＺＤ ０ ０８ ∩

capital asset with its cost or supply price. If the Present value of a caPital
good exceeds its cost of buying, it Pays to try. On the contrary, if the
present value is less than its cost, it is not worthwhile investing in that
capital good.

The same results can be had by comparing the MEC with the market
.rate of interest. If the MEC of a capital asset is higher than the market rate
of interest at which it is borrowed, it pays to purchase the capital asset, and
CAPIIAL STOCK vice versa. If the market interest rate equals the MEC of the caPital asset,
the firm is said to possess the optimum caPital stock. If the to Puchase the
THEORIES OF ITWESIMENT FIJNCIION capital assets, and vice verse. If the MEC is higher than the rate of int€rest'
In classical theory investrnent is a function of the rate of interest. The there will be a tendency to borrow funds in order to invest in new capital
KeSmesian theory considers investment as a function of income and rate of asscts. If the MEC is lower than the rate of interest, no firm will borrow
interest. In the acceleration theory investment is a function of the change to invest in capital assets. Thus the equilibnium conditions for a firm to hold
in output or income. Post-Keynesian and neo-Keynesian theories made the optimum capital stock is where the MEC equals the interest rate. "Any
refinement 0o these theories. These are briefly discussed below. disequilibrium betwean the MEC and the rate of interest can be removed by
KDN\ESAN APFROACII changing the capital stock, and hence the MEC or by changing the rate of
Keynes relates the prospective yield of a capital asset to its supply interest or both, "Since the stock of capital changes slowly, therefore, changes
price and defines the Marginal Effrciency of Capital (MEC) as "equal to the in the rate of interest are more important for bringing equilibrium.
rate of discount which would make the present value of the series of
annuities given by the retwns expected from the capital asset during its life The figure 3.12 shows the MEC curve of an economy. It has a
just equal to its supply price". Symbolically, this can be expressed as:' negative slope (From left to right downward) which indicates that the higher
the MEC the smaller the capital stock. Or, as the capital stock. increases,
.Rl ,-,, ,,.,. 82, ....... ., .Rn.
Sp + +..........................+ th'd rirEb t'ilii.'rriii id'6.ii',isi bit'ii'd oi[iliiio"i'if ih;"litu or di,iiini.t'ine
=
(l+i) (l+r)P (l+i)" retums in production. As a result, the marginal physical productivity of
- -...............(1)
-
 87
qaB,ital and the Marginal revenue will fall. In the figure when the
capital stock is OK, the MEC is Or,. As the capital increases from OK, to
OK,, the MEC falls from Or, to Orr. The net addtion to the capital stock
K, K, represents the net investment in the economy.
Figure 3.12
uic,v
ヽ
、 １
．
L
L
Capital Stock
Further, to reach the optimum (desired) capital stock in the economy,
the MEC must equal the rate of interest. If as shown in the figure the
existing capital stock is OK, the MEC is Or, and the rate of interest is at
Orr. Every one in the economy will borrow funds and invest in capital
assets. This is because the MEC (Or,) is higher than the rate of interest (at
Orr). This will continue till the MEC (Orr) comes down to the level of interest
rate (at Orr). When the MEC equals the rate of interest, the economy
reaches the level of optimum capital stock. The fall in the MEC is due to
the increase in the actual capital stock from OK, to the optimum capital
stock OKr. Thus the negative slope of the MEC curve indicates that as the
rate of interest falls the optimum stock of capital increases.
TIM MARGINAL EITICIENCY OF IT{VESIMENT (ME[)
The MEI is the rate of return expected from a given investment on a
capital asset after covering all its costs, except the rate of interest. Like the
MEC, it is the rate which equates the supply price of a capital asset to its
prospective yield. The investment on an asset will be made depending upon
the interest rate involved in getting funds from the markets.
88
If the rate of interest is high, investment is at a low level. A low rate
of interest leads to an increases in investment. The MEI schedule shows
the amount of investment demanded at various rates of interest. That is
why it is also called the investment'demand schedule or curve which has
a negative slope, as shown in figure 3.13. At Or, raG of interest, investment
is OL As the rate of interest falls to Or, investment increases to OI' figure
3.12a)
Figure 3.13(a) Figure 3.13(b)
MEI,T
0 rr
Investment Investment
To what extent the fall in the interest rate will increase investment
depends upon the elasticity of the investment demand curve or the MEI
curve. The less elastic is the MEI curve, the lower is the increase in
investment as a result of fall in the rate of interest, and vice versa.
On the other hand, given the rate of interest, the higher the MEI, the
larger shall be the volume of investment. The higher MEI implies that the
MEI curve shifs to the right. When the existing capital assets wear out they
are replaced by new ones and level of investment increases. But the amount
of induced investment depends on the existing level of total purchasing. So
more induced investment occurs when the total purchasing is higher. The
higher total purchasing tends to shift the MEI to the right indicating that
more inducement to investment takes place at a given level of interest rate
(See figure 3.14).
 89 s
Figure 3.14 Nsvertheless, it is interesting to note that jorgenson's version iii'tlassic
investment theory is not basically a thmry of "invesEnent as a function of
the interest rate" In practice, Jorgenson takes the relevant discount rate
used by enbepreneur to be much higher than the interest rate and insensitive
to changes in the latter.

NEGKETI\IESIAN AI?ROACII

An adequate theory of investmelrt requires both a good theory of

demand for capital (the desired capital stock, K) and a good theory of
adjustsnent of the actual to the desired stock. Although Jorgenson may have
provided a fuller and more sophisticated theory of capital - by showing that
the desired stock depends not only on the level of outPut also on the
Jorgenson's "Neoclassical" Investment Theory interest rate, relative prices, and tax rates - his theory of adjustment is the
Dale Jorgenson developed a sophistical reformulation of the classical same simple and unsophisticated one used in the simple accelerator version.
theory of investment which he, and others, have used to derive the In this section, we outline how one prominent Proponent of the acceleration
specifications of investment equations for a wide variety of empirical work. principle has built an expectations mechanism into his investment theory.
From the theory of a profit maximising firm, Jorgenson derives the ESITM,'S INCOME'VMSION OF TIIE ACCE-MATION
following condition for the optimum capital stock (K)' for a firm at any and PRINCIPLE"MMANE{T
every point of time.
P Robert Eisner is perhaps the most enthusiastic of recent proPonents of
the acceleration principle theory of investment, and among the most vigorous
\'=Y x
-C, in attacking altemative theories. In particular, he stresses that the simple
form simplicity assume that any cument change in sales is seen by
where the production function at any point in time is here taken as of entrepreneurs to be a lasting change. If it were not expected to be a lasting
"Cobb - Douglas" form:
change, thero are alternative means of adjusting to it without ordering new
Y, = 0K1, l,-1 where equipment. Thus, firms are properly cautious about responding to cufient
increases or drops in sales ufitil they are convinced that a genuine change
Y - the firm's real output. His theory of investment can be simplified
︱

AS
has occurred - rather than a mere random "blip" - and one which is likely
ノ

to be relatively lasting.
K, = K,'
ー

This is, each firm always has exactly its optimum stock of capital or To rePresent the sorting out Process by which firms eYaluate current
ー

i'* = K" changes in their sales, Eisner borrows Friedman's concePt of "Permanent"
ー

where I,N is net investment. Gross investment is given by changes, representing a Permanent change by some weighted moving average
ナ

of past changes. Thus, the investment function should make gross investment
,,"Jruoffi*u\, depend on a distributed lag of current and previous changes of sales plus
ー

a term rePresenting replacement investment as proportionate to the previous

ヽ

period's capital stock. Indeed, the empirical form of the investment equation
ノ
〆
 91 I

may appearfiaじ ndcal with Jorgensonls,except that■ lacks thc P/Q(件 めtem be required to bring the size of their capital stock up to that appropriate to
which creates that variable acceleration coefflcient. their best estimate of \ Instead of (4) their behaviour is thus described by.

ｎ
n

■
f=α Σ βi△ Y+δK(乃 i=1)

等
biY,-i -P (t-6)Iq., ----(5) where 0< p<1.

ｉ
︲
〓
i=O t― i t-1
Although I〕 isner also recognizes that there may be lags between For statistical estimation purposes, either (4) or (5) would be represented as
invesment decisions and their exccution‐ and even variable lags,renecting
supply constraints― he makes no erort to bulld these into his sPcciFlcation n
of the modci for statistical testing. IG, = A) bi Y,-i -BK'r (rbi=1)-------(6)
AN組 川 RM劇 Ⅵ ]FORMULAT10N OF IIE ACCELRATION THEORY i=l

The simple fomulation of the accelmtor dleory explains net invesment The differences between (3) and (6) resembles those between (1) and
as itting any gap whth apprs between today's optimlm stock of capital (2), that is the use of Y instead of AY, and the opposite signs of the terms
taken as proportional to today!s output,and i"Sterdayゝ optinlum stock, in K_,. From a statistical regression based on (6), one could, accepting the
taken as proportional to yesterdayヽ output. theory incorporated in (4), interpret the value found for coeffrcient A to be
the acceleration coefficient and the value of coefficient B to represent (l-6),
■=“■‐δ
ヽ1-… …‐
(1) from which an estimate of 6 is easily derived on the other hand, if the
Si“ e Yesterday's acml stOck is known at the dme of today!s invesment accepted theory is that incorporated in (5), one would need to use an
decision,as well as the fraction of that which will wear outゎ 山り we can independent estimate of 6 along with the computed coefficient B to infer a
instead and PerhapS more realお 饉call"write the cquation for the simple value for B. From this, given the computed coefficient. A, an acceleration
aoleration theory as coefficient cr could be inferred.

■=αX+(1め ヽ1--lⅢ …
19) Post - Keynesian Apprmch.
Folbwing Eisner we may replace the△ Yt of(1)With a Weighted mo宙 ng Keynesian theory of investment has been modified in recent years as
aVeFage Of past△ Y!S: a process of capital accumulation (not just a flow approach to investment).
Keynes related rate of interest to investrnent. However, behind the propensity
n
■OΣ b直.+詢町10卜 1)一 一‐
to consume, there is the consideration of real rate of return on investment.
(3)
i=1
Marginal efficiency schedule is a function of such variables as capital stock,
credit availability, income level, growth, profit, rate of interest and the value
We may similarly ch∞ se to replace tte x of our altemttive fomul江 lon(2) of cash balance. An important post keynesian development is the apparent
with a wcighted moving average of past Y=s. We would then have tendency of some parts of corporate earning cash flow to go into investment
spending. On the side of inducement to invest, the most important
n development has been the introduction of the relation between capital stock
■嗜 ЫX.― (卜う町 1の 卜 一一 )1)‐ and output as a determinant of investment choice, This has permitted the
i=1 conversion of static equilibrium keynesian system into cycles. The modern
“ approach is to look upon investment as a process of accumulating capital
ハ:夕 類 鍋 t′ ば ,颯 s翻 凛 1(tu′ 靭 騨卒
』 鮨 ″n鯛 離 i中 ゛げ 賜 y,C種 即 燎 stock to the desired level of capital stock. The level of actual investment is
of Y♪ assulnes that,b∝ "爆
ause the estimate of L iS uncemin,frms in erecも ,
a by-product of the relation between the actual stock and the adjustment
discount thcir best esdmate of l by inVesang somewhat less than would
business cycle and growth models have been built up. Investment propensity
 % v
can be treated as a topic in the theory of capital. It has also been found that changes in factors that affect the size of the desired capital stock may
that investment is not completely insensitive to interest rates. When the have little or only substantially lagged, effects on investment.
borrowing cost is very high, investment is reduced. These post keynesian
theories were discussed below. Financial theories, which explain investment in terms of financial
variables obviously require further theories that explain the determination of
FII{ANCIAL THEORIES OF INVESTMEIYT these financial variables. Important among these theories are profits theory
of investment and the cash-flow theory of Duesenberry.
There are a
number of economic theories and related empirical studies
which suggest the importance of "financial" factor affecting the volume of PROFTTS THEORY OF ITWESIMEI\T
investnient. One might assume that such factors had already been adequately
The profits theory regards profits, in particular undistributed profits, as
accounted for in the determination of the rate of interest -which constitutes
a source of internal funds for financing investment. Investment depends on
the explicit or the implicit cost of funds to firms for investment purposes,
profits and profits, in turn depend on income. In this theory profit relate
and which is presumably compared with the rates of returns on investment
to the level of current profits and of the recent past. If the total income and
in deciding whether and how much to invest. But the factor stressed in the
total profits are high, the retained earnings of firms are also high, and vice
financial theories of investment are factors over and beyond the rate of
versa. Retained earnings are of great importance for small and large firms
interest and the usual determinants thereof.
when the capital market is imperfect because it is cheaper to use them. Thus
Among the economists stressing financial factors have been Meyer if the profits are high, the retained earning are also high. The cost of capital
and Kuh, Duesenberry, W.Locke Anderson and many others. Most of these
is low and the optimal capital stock is large. That is why firms prefer to
reinvest their extra profits for making investments instead of keeping them
have supported their hypotheses with substantial empirical analyses that
demonstrate significant correlations, either in the aggregate, or on cross
in banks in order to buy securities or to give dividends to shareholders.
section, or both, between fluctuations in, or differences in, investment and
Contrariwise when their profits fall, they cut their investment projecs. This
in various financial magnitudes. is the liquidity version of the profits theory.
Another version is that the optimal capital stock is a function of
These theories are of perhaps two main types: expected profit. If the aggregate profits in the economy and business profits
are rising they may lead to the expectation of their continued increase in the
1. Theories that make the current volume of internal cash flow (or some
future. Thus expected profits are some function of actual profits in the past.
principal element thereof) a primary determinant of investment.
K', = f (rt-,)
Z Theories that explain why periods of heavy investment tend to be self-
limiting because of the impact they have on firm's balance sheets. As Where K', is the optimal capital stock and f(n.,) is some function of
debts accumulate relative to equity, their ability to borrow decreases. past actual profits.
Time is then required for rebuilding of equity mainly through use of
Shapiro .developed the profits theory of investment in which total
retained earnings to reduce debts or
accumulate reflatively liquid
financial assets. In particular heavy short-term borrowing from bank
profis vary directly with the income level. For each level of profit, there is
an optimal capital stock. The optimal capital stock varies directly with the
after a time deters not only further extension of bank loans but other
level of profits. The interest rates and level of profits, in turn, determine
extensions of credit until short-term debts can be consolidated into
the optimal capital stock. For any particular level of profit, the higher the
long-term issues.
i. t-. .iri 1.,. , I :, . interest rate, the.smaller'level of .profit;.the higher.the interest rate; the
In a more general sense, these theories stress that financial limitations smaller will be the optimal capital stock, and vice versa. This version of the
curtail the extend of a firm's invesffnent at any point in time: thus, they show profits theory is explained in the figures 3.15
 % %

Figure 3.15 curve shifts upwards to MEI, in part (D). Since K2. > Kl, net investment
is positive. This is shown by MEI, in part (D) so when profits increase to
P2 with the rise in income to Y2, the optimal capital stock K2* being greater
than the actual capital stock Kl, r 6Vo interest rate, investment increases
.p from 13 to 14 in part (E) which is equal to net investment MEI2 in part (D).
'2
The combination of 14 and Y2 establishes point B on the upward sloping
I curve.

To sum up, in the profits theory of investment, the level of aggregate

profis varies with the level of national income, and the optimal capital stock
χＦ

Ｌｒ

亀︱ ︱ ︱
Ｋ Ｉ Ｉ
varies with the level of aggregate profis. If at a particular level of profits
0 C) the optimal capital stock exceeds the actual capital stock, there is an increase
in investment to meet the demand for capital. But the relationships between
aggregate profis and national income are not proportional.

DTIESEI\IBERRY'S CASH FI,O\il THEORY OT INVESTMENT

Yi
In his version of the cash flow theory, Duesenberry postulates that
￨ aggregate profits (p) depends positively on national income but negatively
l*t, MEC,
on the stock of capital, or in a linear version.
I fi = aY - bK -----------------------(l)
K',qK Taking account of lags, this become:
Incume Investment Capital Stock fi, = uY,-, - bK,-, -----------------(2)
The curve Z in part (A) shows that total profits vary directly with If dividends depend positively both on profits and previously retained
income, when the income is Yl, profits are Pl and with an increase in income earnings, then it can be seen that retained earnings, (and thus investment)
to Y2, profits rise to P2. Part (B) shows that the interest rate and profits level depends in a complicated way upon income @ositively) and upon capital
determine the capital stock. In part (C), the MEC curve is drawn for each stock (negatively). Simplifying greatly the lag structure, Duesenbeny ari'ived
level of profits, given the actual capital stock and the rate of interest. As at the following
such, the curve MEC, relates the profits level Pl to this optimum capital
stock K,- when r 6Vo is the interest rate. The higher curve MEC, relates I,= oY,-, - px,-r----- ----(3)
profits level P2 to the higher optimal capital stock Kr', given the same rate
The preceding investment theory makes investment depend on purely
of interest of r 67o.
financial considerations, that is, cash flow. But it is instructive to recognize
The combination of 13 investment and Yl income level establishes that such a theory is extremely similar in form, if not in derivation, to an
point A on the investment curve I in part (E) of the figure. investment theory that rests upon the fundamental idea of the acceleration
principle namely an optimum relationship of capital to output, as can be seen
Now begin with Pl level of profits and Yl income level in part (A) so
by comparing equation (2) and (3).
that at r 6Vo interest rate in part (C), the optimal capital stock is K2.
Assuming again that the actual capital stock is Kl, the optimal capital stock Suppose we rewrite equation (3) as
is greater than the actual, K2' >K1 at this profit - income combination. Here
the MEC2 is higher then r 67o interest rate by RM. As a result, the MEI, It = p((odp) \, - K,_,)
 s7

Investment witl then be zero when (o/0) Y,r = K,r. We can identify
(cdp)Y,, as last period's optimum capital stock, and (crlp) as the optimum
capital-to-output-ratio-which is also the acceleration coefficient'
Thus, at least the cash-flow version of ths finan6ial- thmry and 'the
acceleration theory are surely not as remote in ultimate derivation as they
are usually made to aPpear. One can argue, in a most general way, that the
technological considerations which basically underlie the accelerator model
operate not so much as direct technological restraints or spurs to
entrepreneurial behaviour but rather, primarity, as determinants or profitable
business operations. Although the simple acceleration principle makes no
- cut. The technological
reference to the price system, that is merely a shofi
relationship that underlie the accelerator actually guide behaviour through
their effect on prices, costs, volume, and ultimately profits And prodits
affect firm's ability to finance investment both directly through cash flow
and indirectly by improving the borrowing c+a1itf nroftable firms'
1.f
New Classical Appmach
The idea of new classical sppriiach cii rationdl expe.tations apProach
(REA) was first introduced by John Muth in an article published in 196l'
But the idea gained momentum only in 1970s REA has been developed'
among others, by Robert Lucas, Thomas Sargent' Edward Prescott and Neil
Wallace and Robcrt Bano* According to REA, individual form exceptiors
using information efficiently and rationally' and do not make systematic
mistalcs in fuming expecratiors. REA aims at buitding all of macrmmnics
on explicit micro foundations. ie., on the assumptions of utility maximisation
for individual consum€r and profit maximisation for producers, and in the
market The emphasis on marka being in equilihium is a very firdamental
tenet of IIEA.
of capital that should be used in econometric models lmagine two stylized
political environments for the investment tax credit ln the first' the credit is
enacted rarely, but once it is enacted, it remains in force for a while
in the
in effect for short
second, the credit is enacted freq'Jently but only remains
periods of time.
jusr
Now consider the cost of caPital when a investment tax credit is
enacted. In the second environment the cost of capital will be appreciably
lower. The reason is simple. In the second environment the probability of
the tax credit's disappearing is very high. Investors, in this world, anticipate
an high equipment. This would occurs because the resale value of the
undepieciatid part of the equipment witl be higher withour the credit' because
new investors will have to buy machines without the benefit of the credit'
The anticipated capital gain from the likely removal of the credit lowers the
cost of capital to firm.
TOBIN's qRATIO
James Tobin (1969) has proposed a theory that makes the economy
wide rate of investment depends on the ratio of the aggregate malket value
of the outstanding stock o1 equities Plus bonds to the aggregate stock of
capital - the physical stock of plant and equipment valued at cufrent costs
of'productiorr oi acquisition investment is hypothesised to depend positively
on the q ratio, where.
Rate of retum on inYestrnent
q=
Cost of caPital
marks
The rate of retum on investment is that rate of discount, e which
project
ttre prescnt value of tlp exPecEd rct cash flow from as invesfiErf
equat to the pnce Prad for the capiral equiFlent' In thc equation bel'ow'

αΣ曰
Aoco,rding to tllc n€oclassical model of Jorgpnsor' the &sircd capitsl
$toch ard lrcncs invcstmcnt, dcpends intimstcly on thc coct of capital that 州
is, in esserrcc, equival€nt to the rental co8t for a unit of caPiBL This Ental Av=
cost is &ff€cted by inter€st rat€s, @iation and taxcs' Thc investment tsr
(1ザ
6edil, which allows a corpor,ation b writc a fraction of rpw invesmient of
Av = net prcsent value -1)WhG
investment project
expenditrru off its taxcs, is Potartialy an impdtslt policy tml fm sffccting
thc cost of capital and invcs0rrcnt. Al.{,=Change in net cash flow due to the adoption of thc i1/es6}ent
Lrras obs€rved thtt the Politicrlbviromiatt in which the inv€stntEDt project.
tax crEdit operatcd hd impctant implir:ations 'fc mersuring dre truc cost
' cuP/6lm/m/10006DF-4
 99
lCXl

The rate of retum On investment is the valuc of e which will make the
pcsmt vJuc of me expected change hぬ er― ヽ配者cash■ ows, Δ MOpULE rV
N,cqual to pkl the initial cost Of the,capital equipment DEMAND FOR MONET. FOST KEYNESIAN DEVEIOPIVIEI\TS
α ベ IJNIT.l
pkI= Σ
0) POST KEYNESIAN THEORIES ON DEIVIAND TOR MONET
t=1 (1+1)t FI]NC'IION

In empirical work at an aggregate level p and has to be measured as the In the Keynesian approach, the demand for money is due to idle
balance and active balance. The hansaction demand is technically determined
average rate of return on the existing capital stock valued at its current
and asset demand is treated as a matter of economic choice. In order to
replacement cost:
remove this unsatisfactory dichotomy, two approaches have been suggested.
N l. The demand for money is one and single. It cannot be segregated
avcragc p= (3) into transaction and precautionary demands on the one haird, and
. pkK speculative demand, on the other

Empirical estimate for q rvill be 2- Baumol and robin have explained the transaction thcory on the basis
of capital theory. Latane, Friedman and Meltzer, among others,attempted
v to fit demand functions for money. These post keynesian approaches
' q = ------ are explained below.
pkK BAUMOL'S IIWEI\TORY THEORETIC APPROACTL
Hence, q is alternatively called the 'valuation raiio since it is the ratio of the william J Baumol approached the theory of transaction demand for
market value of the firm to the replacement cost of its real assets. money from the point of view of business inventory contror. prof. Baumol
pointed out that the transaction demand for money is also influenced by the
POLICY MFASURES WHICH AFFECT II\TVES'TMENT rate of interest, as the speculative demand for money. If the rate of interest
is high, the fiansaction demand for money becomes low. similarry, when the
Fiscaly Policy
rate of interest is lower, the transaction demand for money .uy u" higher,
Fiscaly policy can influence the level of private - sector investnicnt specially above a critical rate of interest. Thus the transaction dimand curve
through two distinct channels. on the demand side it may affect the level for money will consist of two'curves (See Figure 4.1). The top portion of
of future expected demand for output, while on the cost side rax changes the curve would be elastic
can alter the cost of capital services. The latter has been the main instrument
whereby governments have tried directly to influence the level anci
composition of investment. 0
日
Monetary Policy x%
〇
0
Monetary policy affect investment by inducing a process of portfolit->
ぼ
adjustment. Porttblio adjustment following an expansion in the money stock
increases Tobin's q ritio b1, raising firm's slock - rnarket vaiuation and scr
stimulates investmerrt.
Money dcmnd
 l0t
and the bottom portion of the curve would be vertical, showing that below
the crucial rate of interest (XVo) the transaction demand for money will
remain the same, and above the crucial rate, the transaction demand for
money would be negatively slopped meaning inYe6e relationship between
the transaction demand for money and the rate of interest.
Baumol applied capital theory to the analysis of the transaction demand
lor money. Here money balance held to make expenditure are considered as
kind of inventory and objective of the individual is to make the cost associated
'4 ith the inventory however, when money (Cash) is held t() make expenditure.
1wo types of costs are there.
l. Conversion cost of bond into money
1. Sacrifice oi interest
'l'he interest cost is an opportunity cost and the non-inlclest cost xre
mailing expenses, brokerage fees and so on. Therefore, an-v amount of
nroney -hotding involves a decision to minimise that sum of these costs.
'ihe lollowing assumDtions are made in this anaiysis.
l. Bond market is pedect
:. Transaction flow in a steady manner and they can be easily foreseen
-1. 'Ihe individual has it given uniform expenditure to make over a givcn
pe od of time.
.1.
it is possible to convert bond into money and money into bond.
5. The interest cost (r) is assumed to be fixed for the given period.
6. The non-interest cost/brokerage (b) is also assumed to bc constant
over the given Period.
We further assume that the individual has a given uniform expenditure
(Y) to make over a given time period and that (K) is the size of each
withdrawal. Then Y/K is the number of withdrawals during the time period
(Generally a year). Since of average cash withdraw (in t, and t, Periods of
time). is (I?2), the total interest cost of holding cash balance will be
r(IV2) and non - interest cost for the total numbff of withdrawal will be
b(Y/K) the problem then is to minimise the sum of these two costs (C)
associated with money - holding.
. capital.gain or loss (B) from holding interest - bearing bonds/ assets is
Or, Minimise C= (K2) + b(Y/K)
The optimal value of K can be formd by minimising the total inventory
cost (C) Different (C) With resPect to (K), setting the derivation equal to
zero and solving the equation yields
r02
K=
Thus this th€ory says that the transaction demand for money is
inversely related to the rate of interest. If the. brokerage fees increase, the
individual firm wili make lesser number of withdrawals of cash. However.
when (b) increase tirms will withdraw more c,ash at a time, reducing the
number of withdrawals. Baumol's analysis o[ transaction demand for money
is the analysis of demand for real balances. I{ence' money illusion is
conspicuous by its absence.
TORIN's PORTFOLIO MODEL
prof. Tobin has refined thc Keynesian speculative dcmlnd for mone]'
by explaining litluitiity preierence as a behaviour torvards risk ihcie are
,rf
rDainly rhree typcs investors:
1. 'I'he risk ioi'crs/gamblers who put all their we.rith on gambling
2. The plungers will put either all their wealth into bonds or wiil kccp il
in cash: and
3. The risk evertors or .Jiversifiers always try to diversify risk of ioss
arising irom bords.'fhe majority {rf invcstors beiong to this cless.
liisk arises when the probability distribution of the outcomc is I no'\ n
but the specific result of particuiar action is not known. Howevcr, irr this
case of uncertainty, the probability dislribution is conrpletely unkno*'n. The
basic burden of Tobin's analysis is to tr:rnsform Keynes's liquidity preference
theory from the theory of uncertainly to the theory of risk. According to
'lbbin, liquidity preference can be regarded as the preference for less risky
form of investment.
Liquidity preference theory is very relevant for tho risk evettors or
diversifiers. Whereas the holding on bonds involves the risk of capital loss.
The holding of cash does not involve any such loss. But at the same time,
cash holding implies sacrifice of interest income, Diversifieis generally
prefer to
hold a mixed portfolio: Some cash and some bonds. Every investo$
act on the basis of his subjection estimate of probability distribution of risk
and retum involved in an investment. Tobin assumes that the expected
lways zero. The portfolio of an investor consists of cash (C) and bond
(B) a d the sum of the Proportioo of their values would be one (1). Rate
of interest is (r). The retum on portfolio (U) is:
 103
{I=B(r+G)
Now the expressed values of (G) being zero, the expected return will
depends on (B) and (r). In the case of fixed interest rate there is no risk.
The only risk is due to capital gains or losses. we can represent the risk
as the standard deviation (o) of returns (U).
How much wealth should be held in casir (C), and how much in bonds
@) is explained with the help of the figure 4.2. rn the figure risk is measured
horizontally and return vertically or is
︵つ ソ日ご日 ■８８ ｘ国 ｒｔ
Figure 4.2
ｍ Ｍ  〓一
Ｂ
一Ｓト
N Q
the budget line of the investor. The portfolio consists of money (c) bond
(B). The indifference curves indicate the risks evertor's growing demand for
higher expected returns for additional risk. This risk evertor will fix up the
equilibrium portfolio at the point of tangency (p) between the indifference
proportionality between risk and the share of portfolio held in bonds. when
a perpendicular is drawn form P onto the line oe, the point (L) is generated
which determines the division of the portfolio between cash and bond.
Thus, an investor will keep oM amount of his wealth in the form of bond
(B) and MN in the form of cash. oN measures the amount of wealth to be
invested by the risk evertors.
This equilibrium (P) will not be distribuied so long as the rate of
interest remains unaltered. A higher rate of interest will mean higher demand
for bond and lower demand for cash. The case of increases in the rate of
interest, the budget.line goes upward and ultimately becomes tangent to a
104
higher indifference curve. This means that rcturns increase in relations to
risk and the investor selects a portfolio where the proportion of cash holding
goes down and the proportion of bond holding goes up this is shown in
the figure 4.3.
It is clear fromthe diagram that as the rate of interest increases, the
budget line goes up form R1 and P3 and the equilibrium point line goes up
from R1 and P3 and bond-holding increase from OB1 and OB3 and cash-
holding decrease from BIN to B3N Thus, we find that when the rate of
interest goes up, the demand for money (Cash) goes down. When this
inverse relationship in graphed, we get the usually continues speculative
demand schedule.
Figure 4.3
Ｂ ﹂ Ｂ
Ｉ
〓一
■澤
３ Ｎ
This theory is superior to Keynesian liquidity preference theory of
speculative demand for money Tobin in his analysis takes into account both
money and bond holdings by an investor and not simply money or bond
as is done by Keynes. Also Tobin's theory proceeds from the assumption
that the expected value of capital gain or loss from holding interest - bearing
'asset is always zero.
FRTmMAN'S RESU\TEVIE{T OF QUANTTTY THEORY
Milton Friedman in 1956 in his "studies in the Quantity Theory of
Money" re-established the supremacy of classical quantity theory and has
established a new monetary school known as the Chicago School of
Economics.
 105
Friedman observes that quantity theory is primarily a theory of demand
for money. The amount that a person holds depends upon the opportunity
cost of money - holding and the amount of wealth in his possession.
Friedman has given a very broad conceptualisation of wealth which includes
all sources of wealth. He has categorized wealth into human and non-
human wealth. The rate of interest express the relationship between stock
which is wealth and the flow which is income. The relationship among
wealth (W), interest (r) and income (Y) can be expressed in the form of an
equation which shows wealth as capitalised income:
W=Y/rorW.r=Y.
According to Friedman, there are five different alternatives of holding
wealth: (a) money (b) bonds (c) equities (d) physical capital and (e) human
capital. His demand function for money can be expressed as:
16P
M=f (Y,Rr,u ,WU)
P&
Where, M = demand for money, Y_=-lermanent income, P = hice level,
ru = bond yields, rc = equity yields, i t = expected rate of change of
price - level, W = the ratio of income from non-human to human wealth,
U = tastes and preferences of wealth owners.
However, since the demand for money is the demand for real balances,
Friedman's demanil function for money can be expressed in the following
equation.
MY16P
--f(-rrr5f"r---,W,U)
PPP6t
Essentially there are the following four major sets of factor influencing
the demand for money.
l. Demand for money is influenced by the opportunity cost of holding
money. According to Friedman, interest elasticity of the demand for
. money is positive but very low.
Z Demand for money would be influenced by the changes in real income.
The relationship between the two is direct, though not proportional.
The real income elasticity of demand for money is not equal to unit.
but is more than one (1.8).
3. According to Friedman, the demand for money .raries directly and
proportionately with the change in the real price level. This is the
same as the classical view.
Itr
4. The rate of change of price level also influences significantly the
demand for money. There is an inverse relationship between the rat of
change in the price and the demand for money in the economy.
Friedman, however states that the long - run demand function for
money is highly stable. He says that since the demand function for money
is stable, all changes in economic activity become essentially supply -
oriented ie. money supply remains always a crucial factor. Given the stability
of demand function for money the relationship among the variables like
income (Y), money demand (M) and price level (P) can be predicted fairly
accurately for the long - run. To him, price stability can be maintained in
an economy if the rate of growth of money is more or less matched with
the rate of growth of output. But it is very diffiiult to predict the relationship
between money and economic activity in the short - run. To Friedman, the
relationship between money and aggregate demand is direct and very
conscious. However, he has denied the Keynesian liquidity trap hypothesis.
Friedman's analysis is superior to Keynesian analysis in that the tbrmer
says that people hold one stock of money and not two balances - idle and
active balances. Friedman considers different types of asset.s , and not alone
bond or cash. However the following points of criticism can be levelled
against. Friedman's theory:.
a. His income is a wealth variable. It has created some minor confusions
of stock and flow concept in the writings of Chicago economists.
Permanent income has to be calculated from the past income, leading
to expected income. Such a calculation of lagged income a is a
problem in view of the interrelations among income, rate of interest and
wealth.
b. It is a partial equilibrium analysis depending alone on the monetary
sector.
c. In this theory the rate of interest does not play any role' Friedman has
not taken into account the role of non - bank financial intermediaries
influencing the demand for money.
d. Friedman has neglected the transaction demand for money
e. He has not shown as to how the price expectations is formed
g. It is a timeless static analysis.
However, in spite of the above points of criticism it has been noted
that Friedman has given a new dimension to the analysis of demand for
money, and it has mamny novel features.
 ta
GT]RLEY AND SIIAW ON THE DEMAND FOR MONEY
Gurley and shaw demonstrated that at a particular rate of interest the
real demand for money is equal to the real stock of money. At any higher
rate of interesl, there is an excess stock of money and at any Iower rate of
interesl, there is an excess demand for money. The rate of desired money
balances to totai financial assets portfolio varies inverseiy with the rate of
interest.
According to Gurely and Shaw. some minimum amount of liquidity is
indispensable and the demand schedule fbr money is vertical in its upper
leaches, The real demand fbr money is relatively low at ,l higher rate of
rnterest, and high at a low rate of interest. However, if deflation is expected
iirere tnay be a change from money to bonds. The demand schedulc lirr
,noney is a profits of spending units prcference between money and bonds
at oniy one leyel of real income. if there is any increase in the transilction
demand for money with an increase in real income. the immediate result is
a higher rate of interest in the money market to result is a higher rate of
nterest in the morrcy'rnarket to rcpress ths e,\ccss demafld schedule ts Unrr
:, slight nr-risancc.
Public debt management can be used a s a technique that affects the
demand for money. When the nominal bonds arc r.r-r1ced by real bonds. the
der arrd for money may be affected. Money is oL r, rtral ir its etfect on
its real variables. Money is a defence tgainst trlnsaction costs of buying
and selling plimary securities and against the possibility of a rise in the rate
of interest or a fall in the price level.
When there are real bonds having a productiyity clause, a wealth
effoct Dray stimulate the demand for money if the increased variety of
financial assets raises the scale of desired portfolio. ADy change in the
marketability of securities that are alternative to money in financial asset
portfolio, may affect the demand for money. The amount of money demanded
is not dependent only on the liquidity of money, but it is also dependent
on the relatiye attraction of the money at its price of othet assets at their
respective prices.
To them, the Non - Bank Financial Intermediaries (NBFIS) Create direct
securities by purchase of primary securities and can create excess supply
and demand for money. The assets of the NBFIS are close substitutes for
money. The rate of interest initially rises if the growth of assets of the
NBFIs results in a net increase in the demand for money and the rate of
108
interest. They also lend out money on a larger scale to the public when
there is general credit restriction in the economy. The effect of the
inroduction of the NBFIS on the demand for money can be expressed with
the help of figure 4.4 (A) and (B).
Diagram (A) shows the monetary equilibrium (Money market equilibrium)
when the demand for money and the supply of real money balance intersect
to determine the equilibrium rate of interest (rJ. Part (B) of the diagram
shows the impact of the presence of NBFIs. Since the liquid assets of NBFIs
are close substitute for money, the circulation of such assets among people
FrGURE4.4 (A) FrGI,]RE 4.4 (B)
^
場ｅｅ〓 ﹂ｏ２‘“
場２ ● ■ ﹂ｏ２ｃ“
f---
|edrrces the demanci lirr rnoney. lhis is sho\r'n by th. Icli\\.,rd ,.hift in the
[)D curve. Thus, the new demand curve for money as I result ot introduction
Lrf NBFIs, is DlDl. The money demand, then, is reduced by MMI at ro rate
r)f interest- Howevcr. since the nominal stock of money is unch{nged, and
the price level is constani the rate of intgrest comes down from r0 to .r
All this has impoftant implications in monetary economics. According
to Gurley and Shaw, the apparent effect of indirect financing by the NBFIs
is to reduce the rate of interest eveD at the liquidity trap. Thus, in case
of where the NBFIs are present, the liquidity trap can be created at a much
lower rate of interest than what is suggested by Keynes.
With the introduction of NBFIS The stock of money becomes a
smaller proportion of total assets. Thus, the velocity of circulation will
increase. But the yelocity of circulation will be less reliable index of the rate
of interest. The presence of the MFIs will cause a change in the relationship
by shifting the velocity function to the right (See figure 4.5). Since the
NBFIS can circulate more and more of their assets,which are close substitutes
for money and since they can increase their loans and advances by tiquidating
 ta
the government securities with them, they can virtually put an obstacle
in the way of the working of a tight (restrictive) Monetary policy.
FIGURE4.5
一∽０﹄０一Ｃ ︼︺０ 〇一““
I.ATAI\E S DHVIAND FT]NCTION FIOR MONEY
H. Latane introfluced a new pragmatic approach to the formulation of
demand for money. He found that a simplg linear relationship between the
ratio of money (Currency and demand deposits) to income and the reciprocal
of high grade long - term interest rates fitted well with the historical data.
Latane has tested a function of the following form.
Y/lvI = f(v) "
On the basis of this type of function, Latane got a Keynesian type
of liquidity preference curve. According to him, the demand for money
depends both on income and the long - term interest rate. His analysis is
similar to and also different from Friedman's analysis both of them used
different time periods Friedman's analysis. Both of them used different time
periods and definitions of money. In Latane's analysis money include
curency plus demand deposits. But Friedman takes into account also the
'time deposit. However, Latane has shown that his formulation fits well the
subsequent data. He explains that over the period covered by Friedman's
calculations, time deposits grew more rapidly than demand deposits and the
long -term rate of interest declined from 6.4 percent to 2.9 percent.
Latane adduces evidence for the existence of a liquidity tap, although
he preferred to explain it by the cost of bond transactions rather than by
Keyne's speculative demand for money approach. Friedman demand function
for money does not fit the subsequent data, as found by Latane. Latane
says that this is so because the secular decline in velocity has reversed
itself over time. Latane's analysis would attribute this to the subsequent
upward movement of the rate of interest. Latane comes to the conclusion
110
that the relation between (V) (income velocity of money) and (r) (rate of
interest) is a constant. Latane in his approach has used i.linear relationship
between income velocity and the rate of interest where,
V= Y/IVI
This will yield the demand function for money as,
- Md=Y/V
If wealth is assumed to be measured by income capitalised at long term
rate of interest , the quantity of money demanded in Latane's qnalysis can
be expressed as a function of interest and wealth or wealth and income.
PATINKIN'S INTEGR
^TION
OF MONEIARY AIU) VALUE THEORY: TIm
REAL BAI.ANCEEFTECT.
Don Patinkin in his monumental work "Money interest and Prices:
criticise the Cambridge economists.for the homogeneity postulate and the
dichotomisation of goods and money markets and then reconciles the two
markets through the real balance effects.
The homogeneity postulate states that the demand and supply of
goods are effected only by relative prices. It means that a doubling of
money prices will have no effect on the demand and supply of goods. Thus
this homogeneity postulate preludes the price level from affecting the goods
market as well as the money market. Patinkin criticise this postulate for its
failure to have any determinate theory of money and prices.
Dichotomisation of goods and money markets means that the relative
price level is determined by the demand and supply of goods. and the
absolute price level is determined by the demand and supply of money. Like
the homogeneity postulate this assumption also implies that the price level
has absolutely no effect on [he monetary sector of the ecclnomy and the
level of monetary prices, in turn has no effect on the real sector of the
economy.
After condemning the neo-classical assumption r ...,r:lod lbove, Patinkin
integrates the rnoney market and the goods market otr'the ,:conomy which
depend not only on relative prices but also on real balances. Real balances
mean the real purchasing power of the stock of cash holdings .,i' the
peopie.
When the price level changes. it affects the purchasing por','cr of
pt1)ple's cash holding.r ii1 tuin. aft'ects the denrand and suppl,v of gclods.
T'his is tire real baiiilur,"r '-:ff-ect Plitinkin clenie-c the ,:xistence cl the
 ill
homogeneity postulate' lnd the dichotomisation assumption through this
effect. For this, Patinkin introduces the stock of real balance (M/P) held by
community as an influence on their demand for goods. Thus, the demand
for a commodity depends upon real balance as well as relative prices. Now
if the price level rises, this will reduce the real balance of the people who
will spend less than before. This implies a fall in the demand for goods ancl
the consequent fall in the price level. Contrariwise, a fall in the price level
increases the real balances thereby increasing the demand for goods and the
price level. Thus absolute price plays a crucial role not only in the money
market but also in the real sector of the economy. Patinkin further points
out that "once the real and monetary data of an economy with outside
money are specified, the equilibrium values of relative prices, the rate of
interest, and the absolute price level are simultaneously determined by all
the markets of the economy. In this way Patinkin also introduces the real
balance effect in the general equilibrium analysis.
According to Patinkin, the real balance implies that people do not
suffer from "money illusion" They are interest only in the real value of their
cash holdings. That is a doubling of the quantity of money will lead to
a doubling of the price level, but relative prices and the real balance will
remain constant and the equilibrium of the economy will not be changed.
Patinkin analysis is illustrated diagrammatically in the figure 4.6 by
using the IS and LM curves because the IS curve represent the goods
sector and LM curve the monetary sector of the economy. To begin with,
we take a situation when the economy is in equilibrium at OY f level of
income when the IS and the
Figure:4.6
一∽０﹄０一目︼﹄０ ハ
〓““
hi
Income
112
LM curves intersect at point A and thc rate of interest is Or. Thus
OYf is the full employment level of income. Suppose at this level the
quantity of money is increased, given the same rate of interest O■ Thc
increased money supply, shown by LMl curve, leads to increased demand
and thc consequent rise in the price level. Further this increascd money
supply raises the demand for bonds thereby lo、 vc)ring the rate of interest to
Orl.
The fall in the rate of interest encourages investment and incomc
which further increase the price level in the goods markete. The rise in the
pHce level is implicit in the increase in income froln OYf to OYl,at the new
equilibrium point B.At this stage Patinkints real balance effect starts operating
to restore thc full employment equilibrium leve1 0Y■ with the rise in the price
level thc rcal balances of the people are reduccd who accordingly start
spending icss than before. This lcads to a faH the demand for goods and
consequent fall in the pricc level. On the other hand to maintain the same
real balances,people increase the demand for money and consequently the
rate of interest rises. Thesc are shown by thc upward shifting of the LMl
curve to its original pOsidon as the LM curve and of the LMl curve to its original
position as the LM curve and of the rate of interest to Or from 01
respecttvely. Thus the mll emp10yment equilibrium is re― established at OYf
level through the real balance effect.
CRHIECISMS
Patinkin's analysis of the real balance effect has been severly c五 ticised
by Johnson,Archibald and Lipsey9 Lloyl and Other economists.Johnson
points out that there is■ o nced for the real balancc effect so long as the
real analysis is conflned to equilibHum situations.Archibald and Lipsey
regard Pakinkin's analysis of the real balance erect as cOnceptually
inadequate` According to thm Patinkin traces the real balanccs analysis as
a short‐ run phenommon and docs not woFk it Out hough long runi Shaw
has criticid Patinkin for his failure to analyse the.manner in whiCh the
incusc tt the monetary wealth contes about.According to himγ Pati:よ in
simply assumes a doubling of money balances andlanalyses only;the
resulmt』 Lts:h practics money stock does■ ot change in thiS m田 直
AN MPO― RY D― ND=コ DR MOW MODL・
Thお model of the demand for moneyヽ b暉● On Ⅲ diChOtomLed
Keynesr‐ Tobin‐ Baumol mottve approach as exprestt by the fonowing
equation
 １３ １ ︰ １ １
113 114

，
Md=Mt+Msp MODULETV
[,NIT 2
=g(i,y)+h(i)
EMPIRICAL EVIDENICE OF TIIE MOIIE"T DB\{AND FI]I\CTION
The use of a demand- for - moncy function based on the rate of
Theoretical work on the demand for money has given rise to a number
intercst and measured income makes possible a general equilibrium model of
of questions that have been subject to considerable empirical testing. The
the economy that is flexible, illuminating and not roo complicated.
.most impo ant of these are as follows.
The dichotomized formulation of the Keynes - Tobin - Baumol money l. Is the demand for money correctly specified in real terms? If it is, one
demand function is chosen over the nondichotomized version because ir would expect the price elasticity of the demand for nominal money
as a better expository balances to be 1.0?
seryes device to illuminate certain historical
controversies in macro - economic theory. 2 Is the demand for money htter expressed as a function of income or
of wealth ? Transaction dpmand for money suggests income, whereas
The demand - fbr - money curves are der.ived in the figure 4.7 Figure in the asset demand for money approach it is wealth that places a
(a) gives the transactions demand - for - money curves that results from the constraint upon the size of the individual's Fofolio. What is the size
Keynes - Baumol approach. Figure (b) is the speculative demand curve for of the income or wealth elasticity of the demand for money?
money resulting from the Keynes - Tobin approach to the demand for non_ 3. Arc the interest. rate as a significant determinant of the demand for
transaction balances. Horizontally summing the speculative demand curve money and if so what is the size of the interest rate elasticity?
with each aansaction demand curve one at a time, gives us the total demand 4. Are the coefficients which related the demand for money to its
for money curves. Each curve represents total money demand at a given determining variables stable over time or do they vary so erratically
level of income. These total demand curves merge at an inreresr ratc of ic that it is not possible to predict what lhe demand for money will be
showing that in this panicular money demand function the liquidity trap on the basis of given values of its determinants.
hypothesized by Keynes exists at ic.
THEDEINIIIONOF MONEY
Figure 4.7 A further question facing empirical researchers concerns the most
satisfactory definition of money in a modesr economy with a complex financial
(a1 0) ●) system. The crucial distinguishing feature of and subject which is to be
called 'money' is that it must be genemlly accept€d as a medium of exchange.
Now a days coins have a metallic content which, if melted of down, is worth
less than the face - value of the coin. Paper hotes have a value stemming
from than their products costs. 'A UK flbank- rote declaims its promise
to pay the bearer indicates is."thi,.ndes,. as.woll .as coins, are legal tender
and regarded by law as an'acceptabfe means of payment. In modern
economies current - account bank'deposis (or sight deposits) are payable
in cash on demand and can be transferred by cheque. As they are
generally acceptable as a means of payment, dight deposits are defined to
Transactions demand Speculative deinarid Tot-al defiand for monel
be money.

UK ofiicial statistics present several definitions of the money supply.

The narrow definition of money is ML It consists of notes and coins in
●
︱ 卜一聾¨
l15
circulation with the non-bank public plus sterling current - account bank
deposits. A broader definition of money is sterling M3 6 M3). This
includes notes and coins in circulation together with the domestic secior's
total sterling current and deposit account with banking institution. An even
brOader definition is M3, which is 9U3 plus foreign currency bank accounts
held by domestic residents.
GivOn these alternative measures of the money supply, an important
'question for empirical work has been whether a nzurow definition of money
which excludes time deposits is a better specification of what is money than
a broad measure which includes them.
TIIE IDET{TIFICATION PROBLEM
Any research in this area is faced with the identification problem that
the available data are for the supply of money and not for the demand for
money. Most econometric studies particularly earlier ones, assumed often
implicitly, that the demand for money was always equal to the supply of
money. Figure 4.8 illustrates two kinds of rationale for this assumption.
Figures 4.8
一∽０﹄０︺目︼︺Ｏ ｏ一““
Money Balances
Along the demand for money function, DD, all variables which determine
the demand for money, other than the interest rate, are kept constant. If the
monetary authorities operate a target fof the interest rate, which may very
116
overtime, then they need to supply that quantity of money which people
wish to hold at the target rate of interest. The money supply is thus demand
determined and, depending on the interest - rate target, is a horizontal
schedule such as I{o S. or M,S. alternatively the money OB is willingly from
io to il so that the new quantity of money supply schedule shifts along an
unchanged demand schedule, the demand function is identified let us now
suppose that the demand for money fails to adjust instantaneously to an
exogeneous change in the money supply. When the money supply increases
from OA and OB the interest rate stuck at io. The demand for money would
be OA but the amount actually held would be OB. The demand for money
would be incorrectly measured if money stock data are used.
E\,IPIRICAL WORK
Many studies have tried to solve this problem by allowing for non -
instantaneous adjustment and distinguishing between the short-run and
long rum demand for money. Most economists during 1950's and 1960's
were satisfied that the results for the united kingdom, and especially for the
USA, showed the demand for money to be a stable function of income.
wealth and the rate of interest.
In the turbulent 1970s the estimated demand for money function
appeared to break down. Estimates of the demand for money in the 1970s
derived on the basis of estimated coefficients in demand for money regression
equations differed widely from the actual money stock. Attempts to re-
estimate regression equations failed to give coefficients which remained
stable over time, or else produced unsatisfactorly lag estimates.
Two conclusions can be drawn from this. One is that the demand for
money is not stable after all. The other is that the demand for money
function is stable but the pre-1970 studies failed to identify it because of
faulty specification and lack of data. There is not much to say about the
first possible conclusion so we shall concentrate on examining the second
one.
Several lines of investigation have been pursued in order to explain
why the earlier studies failed tg identify a stable demand for money function
given that one does exists. The explanations can be grouped in two
categories depending on whether or not they accept that both the short-run
and long-run demand for money can be assumed to equal the existing
money stock.
A plausible case can be made that Ml is demand - determined. If
people do not want to hold currency or'current - account deposits, then
 ' 117
they move into time deposits or close substitutes. If people want nxrre cash
then up until now it has been the UK authorities, policy to supply it.
Cclghlan and Hendry specified the demand equation so that the dependent
variable is nominal Ml balances. The independent variables. income, the
interest rate and the price level, are'allowed to have different lags and not
the same lag structure as in the earlier studies. They report estimates ol'
the demand for Ml which are reasonably stable and produce acceptable
forecast of Ml demand when projected beyond the sample period. The
failure of the earlier studies is thus attributed to mis-specifying the dynamics
of money demand adjustment.
Explaining the behaviour of the demand for M3 in terms of a re-
specification of thc conventional cquation (that is one which treat the
demand for money as equal, (that the demand function for m3 should
include its own rate of interest since portfolio holders shift between time
deposits and near monies in response to the interest differential between
them. However, when Flaache and Artis and l,ewis included a measure of the
own rate of interest in M3 demand estimates to rejects the hypothesis of
instability. Another explanation is that the various institutional changes
which have .beet the money supply process make it difficult to identify an
underlying stable demand for money function.
The altemative approach to the problem is ro rejeit the assumfiiion
that the money supply always equal the amount of rnoney demanded. This
is the approach taken by Artis and Lewis, who argue that because there was
a sharp increase in the money supply in the mid-1970's it remained for
several years in excess of the demand for money. This graphs the regreision
of the increase of velocity, MIY on intemrest rate using data for l92O-5'7:
tog IWY = 4.718 - 0.584 log r.
The values of M/Y for 1958 - 79 were then plotted in relation to thc
curve estimated from 192G57 data. The fact that mtrst of the later observations
of WY lie close to the estimated curve gives some indication of a stable
demand schedule. The years 1973-76 lie well above the line, indicating a
considerable fall in velocity during and following the period of rapid monetary
expansion.
ft\9 ryqney sypply is be.ltgr charagqg5lsed aF exqgeleqgs. ra1hc1, !h.1q.
as demand determined, then the interest rate is determined by the interaction
of the dcmand and supply of money. If one then treaLs the interest rate as
an independent variable in a dcmand for money study, as do single equation
demand for money estimations, one mis-species the function. This also
lt8
applies to the otirer 'independent' variable such as real income and the price
level. ldeally the demand for money should be estimated as part of a
cornplete model of the economy. Since this is a difficult thing to do varit>us
simplified approaches have been tried (for example by Artis and Lewis and
Laidler). Artis and Lewis treat the interest rate as the variable which bears
the main brunt of adjustment when the demand and supply of money are
in disequilibrium. They therefore obtain estimates of the demand for money
coefficients by regressing the rate of interest, the dependent variable, on to
the money supply, treated, as an independent variable. Ileasonable results,
indicative of stability. are obtained for M3. They also try an alternative
version of specifying money as the independent variable. This inverse of
velocity, IWY is relatcd to real income, the interest rate, lagged IvI/Y and a
variable designed to capture exogenous ihanges in the money supply'
Improved resutts and evidence of stability are reported, particularly for MI.
Laumas, using a variable paramcters estimation method, also finds in favour
of a stable demand for money function.
David Lai<tler, a student of Friedman, wished to explore the role of
interest rates in a money demand equation much like Friedman's- Studying
annual post-war data, Laidler (1966) reports the following tyPe of ordinary
least squares results:
In M = 2.018 + 0.67 In Yp - O.l4In R R'! = 0.84
(021) (0.02)
Laider concludes, "it is possible to find a stable relationship between
the demand for money and the rate of intcrest............the interest elasticity of
the demand for money function is probably in the range ctf - 0.15 to -0.20."
Note also the coefficient of permanent income is less than one, 0.67, indicating
inelastic money demand with respcct to Permrincnt income.
Robert Crsh (197I) examined the extreme Keynesian version of money
demand, rhe liquidity trap. lf Keynesian - Type Speculators are a major force
in setting irrterest rates, rates should be sequentially determincd ovcr tinre.
If in thc plevious period rates rise, spoculators react this period to reduce
them, always trying to maintain the nominal rate. I{owever, Crouch, cxantining
weekly, rnonthly and annual lags of R changes to prior R changes evidence
but again only
of sequential rate movements. He also examined the
r1ldpryp,gfs(,yfl-q,oP.s?ru#j,91,g",:1, &*ni,,l,g,".yi{?Igg.th31,?pf-l?",olt.c"t}!g
ratisdncons.oisiomoveasreactionstopriorchanges.
. Given that we can accept that a stable denrand for money function
exists, we can proceed to summarise the answers given in the empirical
Iiterature to the questions posed earlier.
 l19
l. Money is correctly specified in real terms. Some studies using nominal
money riemand have produced price coefficient of under 1.0, indicating
an adjur;tment lag
If one thinks that the demand for different types of money are quite
distinct, with income determining one type and, perhaps wealth another,
then the question of whether income or wealth is the better determinant
of a generalised demand for money function is not a sensible one to
pose. h, fact the literature has not indicated a clear preference for
either wtalth or income. Both, used as altemative independent variables,
are alm,.rst 4lways found significant. The estimated income/wealth
elasticitv has been reported at 1.0 or slightly under. The evidence that
technical and institution changes have over time enabled people to
economise on money holdings seems quite strong.
Empirical studies have used a variety of measures of the rate of
interestiboth for the short-term rate and the long-term rate, including
the,yield on equities. Some researchers @.g Hamburger) favour
including at least two rates of return in order to reflect range of assets.
The common use of a single interest rate, on treasury bills or on
government bonds, is more within the Keynesian tradition. There is
general agreement that the demand for money is negatively interest
elastic, though there is much less agreement as to whether the interest
elasticity remains stable overtime. Estimates of the interest elasticity
range from about - 0.7 to 0-1, with - 0.5 as a rough average. There is
little evidence that the demand for money is highly interest elastic.
IMPLICATION OF DIFTERM{T DHT,IAND FI]NCIIONS FOR MONEXARY
FOUCY
Classical View
In the classical system, the main function of money is to act as a
medium of exchange. It is to determine the general level of prices at which
goods and services will be exchanged. This relationship between money
and the price level is explained in terms of the quantity theory of money.
The classical quantity theory of money states that the price level is action
function of the supply of money. Algebracially, MV - PI where, M,V P and
T are the supply of money, Velocity of money, price level and the volume
of transactions. The equation tells that the total money supply MV equal
the total value of output PT in the economy. Assuming V and T to be
constant, a change in the supply of money causes a proportional change
in the price level. Thus money, accotding to the classicists, is a veil. It
is neutral in its effects on the econoiny.
tn
The classicists believed that there was always full employment in the
At the same time, they recognised the existence of unemployment.
economy.
In the event of downward rigidity of money wages. Such a situation can
be corrected by an expansionary monetary policy' Suppo-se the monetary
authority increase the money supply given the velocity of money and the
level of real output. With ihe increase in demand for goods and services'
This, in turn, raiies the price level. The rise in price level reduces the real
wage which provides incentive for employers to expand employment and
out[ut totuard the full employment level. Thus an expansionary monetary
policy is effective in restoring full employment in the classical system.
Keynesian View
In the Keynesian analysis, monetary policy plays a crucial role in
affecting activity. It contents that a change in the supply of
""un
""onolni"
roor"y p".-un"ntly cirange such variables as the rate of interest' the
uggr"gut" dernand, and the level of employment, output and income'
Keynes believed in the existence of unemployment equilibrium. This
implies tiut un increase in money supply can bring about permanent increase
in the level of output. The ultimate influence of money supply on- the prices
level depends upon its.influence on aggregate demand and the elasticity of
the supply of aggregate outPut.
In a situation of unemployment. Keynes advocated cheap money policy,
So when the supply of money is increased, its first effect is on the rate of
interest which tlnds to fall. Given the MEC, a fall in the rate of interest
will increase invesfinent. The increased investment will raise effective demand
through the multiplier effect thereby increasing income, output and
employment. Sinci the supply curve of factors of production is perfectly
etaitii in a situation of unemployment, wage and nonwage factors are
available at a constant rate of remuneration. There being constant returns
to scale, prices do not rise with the increase in output so long as there
is unemployment, wage and on wage increase in output so long as there is
unemployment. Unier these circumstances output and employment will
increase in the same proportion as effective demand, and the effective
demand will increase in the same proportion as the supply of money'
But
once full employment is reached, output ceases to respond at all to changes
in the supply of ,non"y beyond the level of full employment would raise the
price level in the classical fashion'
In the Keynesian analysis, the rate of interest is determined by the
demand for and supply of mbney. If either the demand for interest
would
change. The suppiy of *on"y is determined by the other words' the money
supply of money is determined by the other words, the money supply curve
i, ilif""tfy ineiastic. The precautionary and speculative purposes. Money
 t2t
held for transactions and precautionary motives depends upon the level of
income. The speculative demand for money depends upon the rate of
interest.
It is expectations about changes in bond p,i:es or in the market rate
of interest that determine the speculative demand for money. Keynes
considered only two types of assets in his analysis, money and bonds.
Money does not yield anything explicitly and bonds pay an explicit rate of
interest. . Therefore people wish to hold bonds rather than liquid money
because interest is paid to bond-holders. Keynes held of interest. Th;
higler the rate of interest, the lower the demand for money and vice versa.
This negative relationship between the demand for money and the rate of
interest- provides a link between changes in the supply of money and the
level of economic activity.
In Keynesian analysis given an interest - inelastic investment function
monetary policy will be ineffective. Thus keynes believed on the basis of
his experience that monetary policy operated under certain limitations. The
effectiveness of monetary policy depends on first, the increase in the supply
of money reduces the rate of interest provided the demand for money does
not become infinite and second, the reduction in the rate of interest increases
investment demand, the reduction it is not inelastic to the rate of interest.
These limitations become more serious during depression and thus monetary
nollcy become ineffective. In fact, Keynes advocated supplementing monetary
policy with fiscal policy during depression
Post - Keynesian View
The modern monetary economists reject the keynesian view that the
link between the supply of money and output is the rate of interest. The
ryodern monetary policy is based on the portfolio adjustment process. When
the central bank purchases securities in the open market. It sets in motion
substitution and wealth effects as the publiC portfolio consists of a wide
variety of effects will ultimately increase aggregate money demand and
expand output. The transmission mechanism is explained as under.
Substitution effects:
The neo-keynesians widened considerably the portfolio of assets to
include not only govemment securities but also induitrial bonds, equities,
savings mortgages etc. They contend that "Financial assets are the closest
substitutes for money and that, consequently, increases in the supply of
money will have their effect eventually on the level of economic activity by
bringing.about increases in them output of capital goods industries.
The monetarist led by Friedman are of the view that excess money
balance will be used to purchase not only financial assets but also real
assets such as houses, lend, consumer durables etc. So when the central
12,
bank purchases securities and their price increase and yield fall, the demand
for financial and real assets increases with the increase in their demand, their
prices rise. But the rise in the prices of real assets rise, their production is
encouraged which, in turn, rises the demand for resources used in their
production. Moreover, there is also increase in the demand for services as
a result of increase in the demand for services as a result of real assets.
Thus an expansionary monetary policy leads to an increase in dt'mand,
prices and expenditures for financial and real assets and for seivices
through substitution of assets and for service through substitution effect.
The transmission mechanism operates through the initial change in the
interest rates on securities and relative prices of both financial and reai
assets. These changes lead to the substitution of assets holdings which
imply changes in the demand for real assets and services.
Wealth effects:m
There is a lot of controversy between the neo-keynesisan and the
Friedmaninan regarding the wealth effect. According to the Neo-Keynesians
when the central bank engages in open market operations by purchasing
securities, it leads to decline in market interest rates. This productes a
wealth effect which results from the fact that at a lower rate of interest the
present or the capitalised value of the expected income stream of financial
or real capital assets increases. As people feel wealtheir they buy more of
all assets in their portfolios, and consequently increase their demand for
consumer nondurable
According to Friedmanis, an open market operation which exchange
money for bonds increases the nominal wealth of society. This is a direct
wealth effect. A fall in the rate of interest increases the market value of the
existing capital stock, thereby raising the nominal wealth of society. This
is the interest-induced wealth effect. Both these wealth effects lead to an
increase in the net wealth. As a result, individuals buy financial and real
assets including consumer durables.
With regard to monetary policy and its transmission mechanism, the
Radcliffe committe (1959) relied on a wider concept of liquidity rather on
money supply as the determinant of the total effective demand for goods
and services. It did not favour reliance on monetary policy as a stabilisation
tool because monetary policy failed to keep in nice balance an economy
subject to major strains It, therefore, recommended greater reliance on fiscal
policy.
Professor Gurle and shaw hold the view that the influence of non-bank
financial intermediaries has weakened the ability of the central
bank to
control aggregate demand. They, therefore, advocate the control of non-bank
financial intermediaries for the success of monetary policy.
 . 123
MODI.]LE.V
TTIESUPPLY OFMONET
I.JNIT. 1 instruments of credit which, although not 'ffue money' in the sense that they
DEF'IMTIONS OF SI.]PPLY OF MONET
The supply of money consists of the following:-
1. COrNS
These are insignficant in volume, being issued for the convenience
of small, every day transactions.
2. NOTI,ES
From the seventeeth century, paper currency began to form an
increasing proportion of British money and eventually parliament had to
exercisi: a strict control over the'fiduciary issue' - the note issue in excess
of the value of gold held by the Bank of England. Today, however, notes
like coins, are regarded as the shall change of the monetary system, and
so sufficient are always made amountable for the practical convenience of
the public.
3. BANK DEFOSITS
While purchase of every day goods - bus rides, newspaper, drinks
etc. are usually paid for in coins and notes, about 80 percent (in.value)of
all transactions are effected by cheque or credit card. When a person writes
a cheque, the bank is instructed to transfer deposits standing in his or her
account to the person to whom money is owned. Bank deposits therefore
act as money.
OTHER TORI\{S OFMONET
There is really no hard and fast dividing line between what is money
and what is not. "True Money" confers complete liquidity on its holder and,
in the last resort, only bank notes and sovereigns do this, for other coins
are limited in legal tender. But when considering what serves as money in
our economy the nrore practical approach is to start from the idea that
"money is what money does". Cheques as we have seen, are money for
this reason, though they represent nothing more than current deposits in a
bankt'Yet;"rin,advaneed, eeoRomies,'theques fortri'the major parf of 'money'
in use.
Indeed, although deposits hgld by bank customers in deposit account
are subject to seven day's notice of withdrawal, such notice will in practice
tu
be waived by the bank will the loss of some interest. Thus sums in deposit
account can be regarded as 'near' money.
And, in pursuing our argument in the same direction, we find other
can be spent anywhere in their present form, nevertheless fulfil the functions
of money, if only within a limited sphere. But we must be careful to see
clearly how and when they add to the money supply. Deposits can be
'created' by banks only because their clearing system enables them to
economise in cash. In this the banks hold a unique position, other forms
of credit add to the money supply only when they are not covered by cash
held idle to an equal amount. Thus when a person buys a postal order to
cover his 'pools' entry the cash he pays in may be put into circulations
again by the post office before the order is presented by the pools firm.
Thus, to some extent, postal orders can form an addition to the money
supply, for they are doing the work of money. This is true, too of other
instruments of credit - credit bills of exchange, trade credit and book entry
a settlements replacing cash.
TTIE OTTICIAL DET'INITION OF THE ST.]PPLY OF MONEY
While there may be no hard and fast dividing line between money and
certain other assets, the acceptance by the Government of the view that the
money supply is an important influence in the economy required that it be
defined so that it can be measured and monitored as a guide to policy. To
allow for varying degrees of 'moneyness' there were a number of definition,
but today there are two broad classifications.
Narrow money refers to money balances which are readily available to
finance current spending. ie as a medium of exchange for transactions
purpose. Broad money reflects the overall liquidity in the economy through
the private sectors holdings of assets which, while a store of value, can be
converted with relative ease and without capital loss into spending on
goods and services. The concept of money supply has, thus, now been
widened to include 4 measures of money supply viz, Ml, M2, M3 and M4
Measure I which is called Ml includes.
a. Currency notes and coins with the public excluding cash on hand of
all bank
b. Demand deposits of all commercial and co-operative banks, excluding
inter-bank deposits. 口 ″ q、 ,■ 、
ノIrtri,(っ ′o今 ハ
、 ヽ
"
c. Other deposits with the RBI
Since the amount under heading (c) other deposits with the RBI is very
small or negligible the main components of M1 can be taken as (a) and (b)
 125 t26

viz. currency notes and coins with the public plus the demand deposits with INSIDE MONEY AND OUTSIDE MONDT
the bank. Measure 2 which is called M2 includes
In a rudimentary economy money was Government debt, issued in
a. Ml Plus payment for governmental puichase of goods and services or in transfer
b. Saving deposits with the Post office saving banks. This measure of payments. It was a claim held by consumers and firms against government.
money takes into account the deposits kept with the post office savings From the stand point of the private sectors, it was a net external or outsides
banks. since these deposits also reflea the amount of liquidify available claim. Given the nominal amount of this outside money its real value. varied
in the economic system. Measure 3 or M3 includes inversely with the price level, and each such change in its real value
a) Ml plus represented a wealth transfer between the private sector and government.
b) Time deposits of all commerical and co-operative This wealth transfer affected private demand for money, goods and labour
banks.
but it was assumed not to effect government demand. Therefore, the wealth
This measure of money supply takes into account apart from the
transfer due to change in the price level, had a net effect on aggregate
currency and deposits, the time deposits of the banks as well. since the
demand for money goods and labour. The conclusion foflowed that only
time deposits of the bank are not as liquid as the demand deposits they can
one price level was appropriate to general equilibrium in any particular real
certainly be withdrawn on a short-notice and hence form a part of aggregate
context; any other price level would produce imbalance on all markets. The
monetary resoluces in the economy.
price level, in other words, was determinate in the rudimentary economy.
Measure 4 or M4 which comprises of
a. M3 plus In the second model, money is still government debt, but it is issued
in payment for government purchases of private securities. It is a claim of
b. Total deposits with the post offrce saving organization excluding national
consumers and firms against the world outside the private sectors, but it is
saving certificate.
counter balanced by private debt to the world outside, that is, to government
Thus, M4 which includes all types of money available in the economy in this model. It is based on internal debt, so we refer to it as 'inside' money.
is the least liquid among these 4 measures of money supply.
Given the nominal amount of inside money, its real value varies inversely
TIIE MONET SI.]PPLY FT]NCIION with the price ievel. The government monetary system neither loses or
gains in real terms by such variations in the real amount of its debt because
A money sup,ply function takes account of the behaviour of the banking
there is an equal change in the real value of its claims, against firms. And
system and the public can be written as
the two private sectors together do not lose real wealth to government as
1+ CU
一

the price level rises nor gain real wealth as the price level falls. That is,
Ｈ

M_
CU + r (i, io, r*, o)
m (i, i, r* CU, o)H
Here we have written the money multiplie 'm' as a function of interest
rates, the discount raie, required reserves, the currency deposit ratio and the
variability of deposit flows.
Given the stock of high powered money, the supply of money increases
with the money multiplier m. The multiplier in turn, increases with the level
of market interest rates, and decreases with the discount rate, the required
reserve ratio and the currency - deposit ratio. we refer the above equation
as the supply function besause it describes the behaviour that determines
the money supply given Ei.
a change in the price level does not result in a wealth transfer between the
private economy and government when money is inside money. Instead it
results merely in a wealth fiansfer between consumers and firms, the former
gaining and the latter losing in our second model when the price level falls.
This transfer is a distribution effect of price level instability that we are
pledged, by neoclassical rules of static analysis, either to treat as a short-
run phenomenon or to neglect.
The proof that our second model, with only inside money, is really a
money economy and not simply a barter economy can be put in a homely.
intivtive way. Although the private economy issues bonds, and so can
adopt the nominal stock of bonds to any price level in order to maintain
some one real stock oJ bonds, it
-has, np control over nominal money. Hence
it cannot adapt the nominal stock of money of any price level in order to

1 . I i rr , . 'i . .

ノ
 tn
maintain the desired real stock of money. Given nominal money, there is only
one price level that provides to colrumers to desired portfolio mix of real
bonds and real position has no ne;t effect, it is true, on aggregate private
wealth, but it does have effects on composition of this wealth that will tend
to drive the price level back to its starting point. Price inflation and dismibution
effects between private debtors and creditors we are pledged to put aside,
but there is still a portfolio mix or diversification effect that makes the price
level determinate.
A COMBINATION OF INSIDE AND OUTSIDE MONEY
Now we imagine that nominal money consists no longer of inside
money alone, as in the basic version of our second model where it was
created exclusively on the basis of domestic business bonds in the monetary
systern's portfolio, or of outside money, alone, as in our rudimentary economy
where it was a net claim of the private sectors against government. Instead,
nominal money is now composed of a combination of inside and outside
money, the latter created say, on the basis of gold in the monetary systems
portfolio. This change in specifications certainly makes the second model
more realistic, but it does more than that. The important results is that
monetary policy ceases to be trivial or neutral and that some nominal stock
of money is uniquely right for each state of general equilibrium.
Imagine that balanced growth is occurring at some rate n in all real and
nominal stocks and flows, with relative prices and the absolute price level
stable. The stock of money has both inside and outside components, with
each increasing at rate n. If the monetary system doubles the rate of
expansion for total nominal money and both of its elements, the only effect
is doubling of other.nominal variables including the price level. But if the
monetary system doubles the rate of expansion in nominal money solely by
accelerating purchases of business bonds there are real effects. Then the
monetary system absorbs a larger share of real bond issues, leaving a
smaller share for private investors. The adjustment in private portfolio -
balance requires some decline in the rate of interest, some increase in the
growth rate of capital and income and an increase in the price level
proportionately smaller than the rise in rate of monetary expansion. Conversely,
if the monetary system takes up a smaller proportion of real bond issues,
expanding outside money rather than inside money, the real effects begin
with a rise in thme bond rate and restraint on real growth.
t28
NEI.JTRALXTT OF MONEY
An important requirement for a strong casual link from the stock of
money to the price level is the neutrality of money proposition by which the
level of real income is independent of the stock of money
If the nominal stock of money is increased, the locus of IS and LM
equilibrium values of the real variables unchanged. This property of money
is referred to as the neutrality of money. Thus it can be said that given
the constancy of institutional factors which influence the demand for money,
which is a stable function of its determinants the nominal quantity of money
determines the price level and has no long run effect on real variables.
If money is not neutral so that real income rises in response to
monetary expansion, then the growth in the money supply itself generates
a demand for additional money balances in order to higher real value of
transactions. However, money is not necessarily neutral (monetarists view)
in the short run. If the rate of growth in the money supply is accelerated
so that the expected rate of inflation lies below the actual rate, then there
will be an increase in real output. This means that for any given increase
in the rate of growth of the money supply the rate of inflation will be lower
in the short-run than in final equilibrium when expected inflation has become
to actual inflation.
I.]MT .2
TTIE MONEY MI.JIjIIPI,IM.
In this chapter we develop a simple diagrammatic approach to money
stock determination. We will show how the supply of high-powered money,
which is determined by the Fed, interacts with the demand for high powered
money arising from currency demand by the public and bank reserve demand,
in determining the equilibrium stock of money.
At any point in time we have a given stock of high powered money
or a given monetary base which is determined by the Fed. We denote that
stock of high-powered money H, where the bar shows that it is exogenous.
As we noted above, high-powered money is used for two purposes. First,
the public holdings of currency are one use of high powered money. And
second, banks hold their reserves in the form of high powered money. The
demand for high-powered money Hd, according by arises from currency
demand CU by the public, and reserve demand by commercial banks RE.
Hd=CU+RE-(1)
 tn 130

The balance between supply and demand for high powered money of the money stock. The fraction is larger the higher the reserve ratio r. It
requires that is lower the higher the currency - deposits ratio CU.
-H=Hd=CU+RE-(2) We now have developed expression for both reserve and currency in
The next step is to develop the right - hand side of equation (2), the

∞
terms of money and the CU and r ratios. Substituting equation (3a) and (5)

一
demand for high powered money, in terms of the ratios cu or r, as well as as the total demand for high-powered money in equation (1) we obtain.

］¨
the money stock M. We start with the currency holdings of the public which

Ｈ   〓
r
can be expressed in terms of the money stock M and the currency deposit

一
一
M十

  
― ― 一 M

  

一
ratio cu: 〕

 
lJH〔 [J

］
 

ヽＤノ
 ′
′
CU

′″
〓・・
CU= …… M― ― ― M

・・
(3) ― ― 一 (6)

・
■、
M

Or CU=(il:;) M… 一 一 ―(3a)
In eq. (3) we have simply multiplied and divided by the money supply
M and then substituted the definition of the money stock. M=D+CU. In
moving from eq (3) to eq (3a), we have divided numerator and denominator
of the term in parentheses by deposits D, and then substituted the definition
of the currency - deposits ratio "o?. Equation 3(a) gives us an expression
for currency demand in terms of the currency - deposit ratio and the money
stock. The equation says that the public wants to hold a fraction CV/
(l+CU) of their money balances in the form of currency. The higher CU.
the higher the fraction of money balances the public wants to hold in the
form of money, and the lower the fraction to be held in the form of deposits.
We can proceed in a manner parallel to eq (3) in deriving an expression
￨ for reserves in terms of the money stock and the reserve ratio r. Here we
write reserves as
、
、
Equation(6)showS the relation between the dcmand fOr high― po■ ered
moncy IIt the rcscrve and currency ratios, and the money supply.
Next,Substitute eq(6)into eq。 (2)thus equating the demand for high
powered money Hd to the supply of high powered moncy H:
・ mM_。
The last step is to turn eq。 (7)around tO read:
M働 百
③
―
Equation(8)is the inal forln that expresses the moncy stock in terms
of the ttree deterlninants,H,CU and■ The cquatlon states that thc money
stock is higher the higher the supply of high powered money.FШ tter more,
the money stock is higher the lowcr the reserve ratio and the lower the
currency ratio. Low restte and curency ratios imply that banks and the

p.E *t ' RE \ public demand relatively little high‐ powered nloney per dollar of nloney
r\r f (-J" ----(4) i stock, and therefore a given supply of high― powered moncy can support a
\,)"= larger stock of money.
Dividing both numcrator and denominator of the term in parentheses The relationship betwcen the money stock and high Powercd money
by D and using the definitiorrs c,f; and t=f; is illustrated in flgws l.Thc horizontal une shOws tte glven supply of high
powered money n.The demand for high‐ powered Eloney is shown as the
Ru= /l\"
\ r*cu/
------(s) upw“ sloping schedule.That schedule sIЮ ws the demand for high powered
money Hd assoctated with each level of the nloney stock and thus represent
equation(o. The slope of the schedule is qual to the tem in parenthesis
Equation(5)stateS that reserve demand is equal to a■ action r/cl+CtD
in equation c6y,(cu.r)(lCり .1時 O pOints dwrve noticc hcre.First tha
CUPr6100m…
 131
slope is less than I if the reserve deposit ratio r is less than 1, as it is
indeed. Second we observe that the slope is larger and closer to unity, the
larger the reserve - deposit ratio and the larger the currency deposit ratio.
Point E in Fig. 1 shows the equilibrium between the supply and
demand for high powered money. Given CU and r and a stock of high
powered money H, the equilibrium money stock is M". If the money stock
were larger, say Mr. there would be an excess demand for high powered
money, and conversely if the money stock were below M-.
Figure l. Money stock determination.
H
High powered
Money
づ
Equation (8) and Fig. 1 give us the mechanics of the determination of
the money supply. Now we want to develop a more intuitive economic
interpretation of money - stock determination. In the process we will show
why we talk about the monetary base as 'high-powered money",'and we will
introduce the concept of the money multiplier. The principal idea is that the
public and banks have preference about the composition of their balance
sheets. More specifically, the public wants to hold a particular fraction. CU/
(l+CU) of their totally money holding in the form of currency. Banks want
to hold a fraction r of their deposit liabilities in the form of reserves. Both
the demand for currency and the demand for reserves are a demand for high
powered money. Given the supply of high powered money, there is a unique
level of the money stock such that, first, the public and banks have their
preferred composition (r and CU) of balance sheets, and second, the demand
for high powered money is equal to the supply. In this sense we speak of
tr, CU and r as the principal determinants of the money supply.
rfr
The interpretation of the equilibrium money stock brings out the fact
that an increase in r or Cu would raise the demand for high-powered money
at each level of the stock of money. In Fig. 2 we show this as an upward
rotation of the demand for high-powered money from Hd, to Hd,. The figure
shows that the increased demand for high-powered money gives rise to a
decline in the equilibrium money stock Ml.
Figure 2: An increase in the demand for high powered money
H
High powered
Money
一
Ｈ
0 Mr Mo Money Stock, M
The effect of an increase in the supply of high-powered money is
Shgwn in figure 3. An ingrease in the supply of monetary base shifls the
HH schedule upward by AH. At the initial money stock the supply of high-
powered money exceeds the demand. The money supply expands until we
reach point Er, where we have a new equilibrium with a higher stock of
money. We will not discuss yet what causes the money supply to expand
when there is an excess of high powered money, but will instead concentrate
on the relation between the expansion in high-powered money, AH, and the
increase in the equilibrium stock of money. We note, from fig 3 that the
increases in the equilibrium. money stock exceeds the increases in high
powered money. A dollar increase in high powered money increase the
money stock by a multiple of $1. This is the reason why we refer to the
monetary base as "high powered" money
Fig. 3: An increase in the monetary base
High powered
Money
Mo Money Stock, M
 133
The precise relationship botween the increase in the monetary base
and increase in the equilibrium money stock depends obviously on the
slope of the Hd schedule in figure 1. A steap slope means that a given
stock of high powered money supports only a small stock of money.
conversely, when the slope is very flat, a given supply of monet4ry._base
leads to a large stock of money. The t€rm (l+CUy(CU+r).in €quatios. (8) is
the reciprocal of the slope of the Hd schedute and is called the money
multiplier. The ratio tells us by how much an increase in high-powered
money, H, increase the money stock.
劇=働 轟 一 18⇒
It is apparent from equation (8a) that, the lower the Ctl ad r rarios.
the larger the multiplier. fhe Iower the increase in demand for high-powered
money per dollar increase in the money stock the larger the increase in the
money stock u,e require for the increased moneta.), base to be absorbed,
Assume that, as in the United states CU = 0.35 and r = 0.16 so that the
multiplier is 2.64 (= 1.35/0.51), In this case a $ I increase in high-powered
rnoney Jeads to au expansion of the money stock of $ 2.64.
An increase in the Monev stock of $ I
ruises rhe demancl for high
powered money only by a fraction. In our example, using eq.(6) ir raises the
demand for monetary base by 38 cents. This immediately suggests that an
expansion of the money stock equal to $ 1/0.38 = $ 2.64 is required to create
a $ I increase in demand for high powered money. This is the multiplier
relation between the monetary base and the equilibrium money stock. The
lower the demand for high-powered money per dollar money stock, the
larger the increase in money required to absorb a given increase in the
monetary base.
The money muttiplier is sufficiently important and cenual to warrant
some new notation. Let on denote the money multiplier ; notation we can
rewrite the equation for the money supply in equation (8) as
M=MH_(8b)
1+CU
M= _ ____-_{9,
r+CU
tu
This shows that the money supply is determined by two factors: (1)
high-powered money, which is conholled by the.Fed, and-.(2)^ths.money
multiplier, which reflects the currency and reserve behaviour of the public
and commercial bank.
InFpection ofEq. (9) irnmediately shows that be{ause the reserve
deposit is less than the money multiplier is larger than l. In our example,
l,
it is equal to 2.64. The actual figures suggest that the money multiplier is
far from constant. Since the fed controls. H, it would be able to control M
exactly if the multiplier were constant. However, the money multiplier varies
not cntirely predictably and it is not always possible tbr the fed to get the
money supply at precisely the jevel it wants.
. UNIT.3
DETERMINATION OF MONEY ST'PPI-Y
This chapter examines the detennination of the nroney supply rn an
economy. Althrrugh each economy has different finarcial institutions and
practices which influence the determination of the stock of Drcne1,, there is
c common theorelicrl framework for analysing money r;uppl]. dcteminalion
rnd this wc examine in this chapter.
TINANCIAI, INTERMF,I)IATION:
Now a days brnk deposits cover almost 807. of the money stock.
Thus a theory of money supply determination must include a theory of
bank behaviour. A bank borrows from people willing to deposit cash with
it in return for a claim on the bank in the form of a bank deposit. Qash
is an asset t{r the bank, while deposits are a liability sinc€ the bank must'
repay ihem on demand (Current accounts) or on short notice (deposit
account). The bank, knowing that at any one time only a small proportion
of its deposit holders will demand to convert their deposits into cash can
be make a profit by acquiring interest-earning assets in the form of bank
loans.
A bank is a financial intermediary. It borrows from one set of economic
agents by issuing liabilities on itself. There are financial assets to the bank
creditors. The bank then lends to another set of agents, who issue claims
on themselves, which the bank holds as assets. In the absence of a
financial intermediary an agent who wished to spend in excess of its income
and borrow money would have to do so directly from some othel agents
who wished to saye and acquire financial assets. Financial intermediaries
provides asset holders with assets which are more liquid than those issued
 135 L'X

be exchanged for cash. The concept of liquidity embraces the transactions Where R = Cash reserves held by banks and it is assumed that all
costs of changing an asset into cash, the time that has to elapse before the bank in the economy maintain a fixed reserve ratio of r.
the asset is due to be repaid in cash and the risk of capital loss when 3. A desired currency - deposit ratio
encashing the assets. The less liquid an assets, the higher in general is
C
the rate of return in order to compensate its holder for illiquidity. Since a
bank deposit is more liquid than a bank loan a bank can pay its deposit
c=-(0<c<1)_(3)
D
holders less in interest than it charges its borrowers. The margin between
interest payments on deposits and the interest received on loan is sufficient Substituting C = CD frqm equation (3) into equation (1)
to cover operating expenses over and above those directly charged for on We get 14 = (1+C) D - (4)
current account and so provides banks with a profit. R+C
As a result of financial intermediation, a whole stock of financial Adding equations (2) and (3) gives r + c =- - (5)
assets and liabilities is built up over time and offers lenders and borrowers D
a range of financial instruments which different in marketability, risk and Rearranging equation (5) we get
rate of return. R{C
A MECIIAMSTIC MODEL OF BANK DEFOSIT DETERMINAIION D= _(6)
r+C
A bank only needs to holds a relatively small proportion of its total -
Substituting (6) into (4) gives
assets in the form of non-earning cash. This cash is known as reserve
assets because it is held in reserve to ensure that the bank remains solvent 1+C
(R+C)=M(R+C)-(7)
by always being able to repay its current account depositors on demand.
The ratio of reserve assets to total assets is called the reserve ratio. Here 6{c)
we assume that the reserve ratio is fixed at r either by the bank's own The term M = hB is known as a bank multiplier since the
practices or by government dictate. The currency part of the money supply money supply, M is some positive multiple, M, of R+C. The bank multiplier
is held either by banks as reserve assets or as currdncy in circulation with is considerably larger than 1.0 since r and c are quite small number. The
the non-bank sector. We assume that the non-bank pubic have a desired total amount of eurrency held in circulation with the public and as bank
ratio in which they hold currency and bank deposits and that this remains cash reserves, R+C, is known as high-powered money.,or as the monetary
fixed at c. base, since one extra unit of high-powered money H, gives rise to a multiple
increase in the total money supply. Thus money supply equation can be
We now have three relationships which can be manipulated to obtain
summarised as M = MH - (8).
an expression for the supply of money. They are as follows.
A BEHAVIOI.]RAL MODEL OF MONET SI.]PPLY DEf,MMINATION
1. A definition of money supply
- Behavioural models of the money supply process treat bank
M=C+D-(l)where as firms. Abank produces an output of banking services which can for
M = Money Supply simplicity be regarded as varying directly with the volume of bank deposits
C = Currency in circulation with non-bank public created by the bank. Attention is then focused on bank deposits as a proxy
D = Bank Deposits for bank output. The production of bank deposits incur costs and these are
of two kinds. First, there are the real resource costs of employing capital
2. A bank reserve ratio and labour to manage and operate bank accounts and bank loans. Second,
R there are the interest payments banks need to pay in order to attract
r=- (0<r<1)-(2) deposits and hence gain reserve against which bank loans can be extended.
\ 'Iherefore, we can exprebs a bank's cost function as.
 ty 138

Z = Z(D) +Dr iD - (1) charges. To know how these interest rates alter with the volume of aeposits
produeed by the whole banking industry we need to introduce behavioural
whercZ= Bank costs
functions for the bank's depositors and borrower. Let us assume that non-
Z (D) = rcal resource costs, which depend on the total volume of
bank public can hold four types of assets. These arc currency, sight deposis
deposits, and we assume dzldD >0.
time deposits and loans to the ultimate borrowers in the economy who can
iD = rate of interest paid on time deposits
either borrow directly from the non-bank public or from banks. We now
Dr = volume of item deposits need to specify the non-bank sector's demand functions for these four
D = Volume of time sight deposits assets.

A bank's revenue depends on the level of bank charges, a, it levies
per unit of sight deposits, and on the interest rate obtained on bank loans,
iL. For simplicity we assume just one type of bank loan. The volume of
bank loans is the amount of total deposits minus the amount held as cash
reserves. That is, loans, D - R. We know that R = rD. substituting for R
in the expression for loans gives loans = (l-r)D. Therefore, the bank's
interest income is D(l-r)il and total bank revenues are.
The non-bank public's demand to hold currency is related to such
long -term trends as the size, coyerage and sophistication of thc banking
system. The movement from rural to urban centres has decreased the
demand for currency, as has the development of bank and credit cards. The
desire to evade tax and the extent of the black economy increase the
demand for curency. A decline in confidence in the solvency of the banking

REV=aD+D(1-r)i-(2) system as occurred in the U.S.A in the 1930s, also increases the proPortion
of the money supply held as currency. In the sho( run one would expect
Where D = Sight deposits. Bank Profits, fIB, are therefore
the dernanC for currency to vary inversely with the rate of retums on bank
fIB = a D' + D (1-r) iL - Z (D) - DriD - (3)
deposits. The curency - deposit ratio, C, is no longer constant as in the
mechanistic model but falls as the rate of interest on dePosits iD, rises.
. If the banking industry is competitive, then the interest rates on
deposits and on bank loans will remains unchanged when an individual Similarly the ratio of sight to time deposits will fall as iD rises. Finally as
bank charges its quantity of deposits. Differentiating assets holders can either hold money or bonds (loans) the demand for all
with respect to D we get the usual profit - maximising condition for types of money can be expected to fall as the bond rate and bank loan rate,
a perfectly competitive firm: which we assume are both equal to iL, rise relative to the dePosit rate.
砂一
が 一⑪

ｌヴ

Ｔ ︲
ｄ
Ｄ  一 Ｄ
ｒ

位   一 ｄ

ヽ
ｒ

Therefore, given a constant volume of high - powered money, the

 ｄ
く

，
Ｄ
‘

０
＋
＋
Ｄ

〓
ｔ

- (4) banking system as a whole can only increase its volume of deposits by
Ｊ
ι

ｄ
Ｄ

The term in the first set of brackets is marginal revenue, which for
a competitiye bank is constant given a fixed ratio of sight to time deposits
the term in the second set of brackets is marginal costs, which rises with
the volume of deposits because cf the assumption of an increasing marginal
of bank
cost function for the real resource costs
management.
For a competitive banking industry as a whole io and i" will not
remain constant, as the volume of deposits and loans made by all the banks
putting up the interest rate on time deposits and so attracting more cash
reserves by persuading the public to hold less currency. The banking
industry's marginal cost curve for deposit production, given by term in thc
second set of brackets in e4uation (4) is shown in the figure below. Marginal
costs rise both because of increasing marginal management cost rise and
asset and liability
both because of the higher interest rate needed to attract more dePosits
by lowering the non-bank public's currency - deposit ratio.
 1" 140

it will have to lower its lending rate. The profit maximising monopoly or
Marginal Revenue joint profit - maximising oligopoly will equate margi al revenue with marginal
ⅣR A for a monopoly cost and produce only OD. deposits. The monopoly industry will charge
system
& a higher loan rate and provide a lower deposit rate than would a competitive
MC .banking. industry.
Marginal cost Factors influcncing the supply of money
Alll
If in real capital goods becomes more profitable and the
inyestment
demand for bankloans dses, then the banking industry's average and
Ac marginal revenue curves will shift to the right in the above figure. Bank can
only extend more credit by attracting more cash reserves. Civen that all
other factors remain unchanged, in particular the amount of high powered
money, bank reserves can only be increased by putting up the rate on time
deposits. The non-bank sector is induced to hold a smaller currency -
deposits latio so that a higher proportion of high powered rncney is held
ty the banks. The banks theretbre move up the marginal cost curve.
Total bank deposits expands and both deposit and loans rates rise. In terms of banks
dcposits(0 multiplier approach the currency - deposit ration has falien hecause ioand
i,_have risen causing the bank multiplier to become larger. So introducing
The banking Indusary: Determination o{ the quality of bank deposis the behavioural relationship transforms the bank multiplier from a fixed
parameter to a b€haviour variable and makes the money supply vary directly
To derive the banking industry's average I' ". L' function we need tct v/ith the demand for bank loans.
introduce the demand by borrowers for bank lolns. The demand for bank
Ioans depends directly on the demand fot consumers credit and for
If the currency ratio rose bscause of a change in the public tastc for
currency, then the banks would face an upward shift in their marginal costs.
investment funds. This will increase if the interest rate on bank loans falls
At each level of deposits bank would have to pay a higher deposit rate to
or if an increase in expected future income and profits raises the denrand attmct deposits. The loan rate would rise along an unchanged bank average
for credit. Thus we can write.
revenue function and fewer bank loans would be demanded. The total
LD = f (iL, x) (dLVdiL < 0) ------ (5) amount of deposits outstanding would contract.

WhereX stands for all other factors influencing the demand for bank
loans. So if x is constant, rhe banking system can only expand loans and
hence deposits by lowering the bank lending rate The average revenue
from bank deposit creation therefore declines for the industry as a whole
as deposits are expanded. A comPetitive banking industry will expand
deposits up the level at which average revenue equals marginal cost This
occurs at OD deposits in the figure.
the banking industry is a monopoly or collusive oligopoly' then the
If
industry's marginal revenue will lie below its average revenue function'
Unlike the co-:petitive case each hank will find that when it expands loans
If there were an exogeneous expansion in the amount of high powered
money, due, say, to the actions of the monetary authorities then banks
would need to pay less to depositors to attract a given volume of dme
deposits. This means that the marginal cost function would shift down to
the right in the aboye figure. Bank would low their lending rate, more
bank loans would be demanded and deposits would thus expand.
TIIE MOMY SLIPPLY AS AN EXOGEiTIOUS VARIABLE
In the mechanistic model the money supply is completely exogenous.
Provided that high-powered money. H, is exogenously given the money
supply is also exogenous because the money multiplier, m is fixed. In the
 t4r 142

behavioural model, however, the money supply is partry endogenous

because we know that the domestic money supply tends to move directly with H.
the reserve ratio and the currency ratio vaiy with interest rates and hence
The money supply, M., can be modelled by
with the demand for the various assets and liabilities created by the financial
system. However, provided that H is still exogenous and that r and
c are M'=rnH=m(FR+DC) ----- (s)
related to interest rates in a stable manner, the money supply still Where m is the bank multiplier. Therefore
exhibits
a strong element of exogeneity. The ress c and r u*y, tire greater the
degree of exogeneity. The typical monetarist view of it *oi"y AM.=mAH=m(AFR+ADC)
supply ----- (6)
accords with the behavioural model. The money multiplier " is noi a fixed Equations (4) and (6) shows that for the money supply to stay constant
parameter it does vary but in a stable manner ana without
large and sudden we must have
changes. If H rises c"lt9, the money supply rises (falrs) ind-ependently
of △DC≡ ― FR≡ ― ΔBoF
the state of the demand for money, and so portfolio disequilibrium …―
―… ¨ (7)
between
the demand and supply of money is created. If the monly supply ADC in equation (7) represents the open-market operation in government
exceeds
the amount people wish to hold, portfolio adjustment occurs u, ti" debt that are necessary to sterilise the BOF.
money balances are spent on goods, services and other financial "^""r,
assets.
This portfolio adjustment affects prices, wages and interest rates. Thus one of the crucial difference between KEYNESIAN and monerary
the models of the open economy is that the former assume that the central
view that the money suppry can be changed independently of the demand
for money lies at the heart of monetarist analysii. bank can sterilise the effects of the BoF on the money stock, while the
latter are models, in which sterilisation does not occur. Given the difficulty
TJMT.4 of sterilising a persistent surplus or deficit over an extended time period,
MONEY, CAPTTAL rLows Keynesian models are necessarily short run.
AND TIrE OPEN ECONOMY
In an open economy high powered money issued by the central bank TIIE MI.]I\DUI . FLEI\,IING KEYNESIAN MODEL
must be backed by either foreign exchange reseryes, ER, or government At the start of the 1960s Mundell and Fleming, who had been colleagues
debt, DC. Therefore. at the Intemational Monetary Fund. extended the Keynesian open-economy
H≡ FR+DC model to include capital flows. They postulated that net iapital flows
---- (1)
between countries occurred in response to difference between domestic and
_ where H is high powered money. That portion of H which is backed
by government debt represents the central bank's creation of domestic
foreign interest rates when expectations about exchange rate change were
static. They modelled the balance of payment on capital account (Cep) uv
credit, DC Any increase, H in the stock of high_powered money a function of the form.
must be
matched by an increase in foreign reserves, FR or an increase
in central CAp=y(i_ir)
bank domestic credit, DC or both, therefore. ------- (8)
AH = AFR + ADC ------ (2) Here i is the domestic rate of interest, while i, is the foreign rate of
interest, which is exogenous if one makes the s-'ril country asiumption.
when the central bank purchase (sells) domestic currency in the cAP increases as the positive difference between i :r.l it increases, so that
foreign exchange marke! foreign exchange reserves fall (rise) by
an equivalent
amount. Thus the change in foreign reserves, AFR, for any period must d(cap)
equal the balance for official financing (BOF). Therefore =y i> 0
0i
駅 =BOF -------- (3)
and From the definition of the balance for official financing we have
AH = BOF + ADC ------- (4) BOF = Current account and capital account
 r43 t44

Substituting from equation (8) fcr the capital account and from equation
CA = X - fy for the current account in this definition. gives B9F, ,PU,'
BOF =x(e) - f(e) y+ V (i - ir) --- (9)
I
Here e is the exchange rate expressed in terms of foreign curency per
unit of domestic curency, Y is domestic income in constant domestic
prices, while X (e) and f (e) are exports and the rrrarginal propensity to BOF3

ノ
import both expressed as functions of the exchange rate, e.

ノ
ノ
Equation (9) is the equation for the foreign exchange market in the
Mundell - Fleming model. The rest of the Mundell-feming model is identical
to the open economy ISLM model except that the money supply equation
becomes equation (5). Remembering that BOF = AFR, where AFR is the
change in foreign reseryes of the central bank, we can rewrite (9) as

AFR=x(e)-f (e)Y+ ry(i-i,) --(10)

This indicates the amount of sterilisation that the central bank has to Alternative possible shapes of the BOF = 0 function
carry out in order to keep the stock of domestic money balances constant TheBoF,functionrepresentsanimperfectinternationalcapitalmalket'
so that capital flows are not ,"ty responsive to the differential
at the current rate of exchange. Under a fixed exchange rate it is possible domestic
in the short run to sterilise the effects of AFR on the money supply andforeigninterestrates.TheBoF3functionrepresentsperfectinternational
very large
through open market operations provided that AFR is not too large. However, capital ,iouitity where any different in interest rates sets up
flows. i{ere foreign securities are perfect substitutes for domestic
due to the difficulty in sterilising a persistent deficit or surplus over the
"uiiruf
securities. with perfect capital mobility, sterilisation of the effects of AFR
long run, the BOF will have to be zero for a long-run equilibrium solution.
on the mLrney stock becomes impossible due to the large
size of AFR- BOF2
Hence given a fixed exchange rate, the equilibrium solution for the foreign .is capital mobility'
an intermediate case between very imperfect and perfect
exchange market becomes.
All points below and to the rightof a BOF = 0 function in the figure
0=X(e) -f(e)y+ y (i-ir) ― ― ― ― ―
(11)
represent a deficit on the BOF, wtrite all points above and to the left of
the function represent of BoF surplus. Given that the Marshall - Learner
Given the exchange rate, e, the BOF = 0 equation becomes a function
conditions hold and that domestic prices do not adjust completely to a
relating i and y. This must show a positive (or non - negative) relationship of the
change in the exchange rate, then a depreciation or devaluation
between i and y, as an increase in domestic income at the given exchange 0 function to the right from BOFI
domJstic crrrency will shift the BOF =
rate will lead to a deterioration in the current account. For the BOF to siay in the level of foreign interest rate also
to BOFr, in the figure. An increase
equal to zero, the current - account deterioration must be offset by a capital leadsto-op*u.ashiftintheBoF=0functionshifttotheleftfromBOFI,
a higher
account improvement. This will only occur if the domestic rate of interest. to BOF,sinci an increase in the foreign rate of intcrest' \ '-reeuiret
i, rises relative to the foreign rate of interest, ir. Therefore the BOF = 0 domesticlevelofinterest,i,tokeepgOf=0'TheotherformsoftheBOF
will have identical upward
function will have one of the forms shown in the following figure. These = 0 function that are illustrated in ttre figure
alternatiw forms are labelled, 1,2, arrd, 3. shifts.Similarly,afallini,willleadtoadownwardshiftinalltheformsof
t7 the BOF = 0 function illustrated in the figure
 t45
The shifts in the BOF = 0 function that occur in response to changes
in foreign interest rates imply that domestic interest rates cannot depart
too far from the level of foreign interest rates, as such a departure will
cause problems with the balance of payments.
Under flexible exchange rates the foreign exchange market cquilibrium
condition is identical to equation (11). In this case, unlike the fixed exchange
rate case, the exchange rate adjusts to bring into equality the demand and
supply of domestic currency in the foreign exchange market. Under a clean
float AFR must always be equal to zero and the exchange rate must
continually adjust in order to clear foreign exchange market.
We can now set out the complete Mundell -Fleming model. It is
composed of equation (ll) which represents equilibrium in the foreign
exchange market, the IS function in equation.
a+I(i)+Go+X(e*)
Y= --- (12)
S(l+t)+t+f
representing goods-ma.rket equilibrium and the LM function in equation
M"
" =f (y, i) -*-- (13)
P opposite effects, lowering the Price level and raising the exchange rate'
representing money-market equilibrium, assuming that the central bank can
sterilise the effects of any foreign reserve changes on the money stock. If
we assume involuntary unemployment, excess capacity, a horizontal
aggregate supply curve for domestic output, and we make the small -
economy assumption, then we can proceed to solve this system of three
equations in the three unknowns e, y and i.
NFOCT^ASSICAL YETSION OF THE MI.]NDEI,L. FLEMING MODEL
The original models by Mundell and Fleming assumed a Keynesian
aggregate supply function and investigated the effectiveness of monetary
and fiscal policy under different exchange -rate regimes. We can now
modify this model by assuming a neoclassical aggregate supply function
while keeping all lhe other assumptions of the model. Here devialions
from the equilibrium level of output can only occur in the short run due
to either the impact of unacticipated events or to lags in the adjustment of
prices and wages to either changes in the money supply or the level of
nominal expenditure in the economy.
In such a neoclassical economy, monetary'and iiscal policy can,have
no effect on output and employnlent over the medium to long run. What
146
they affect under fixed exchange rates is the BOF and the domcstic price
levll. Under flexible exchange rates it is the exchange rate and the price
level which are affected. Fiscal policy will also affect the proportion of
output consumed or allocated by the state.
Under a fixed exchange rate. an expansionary policy will lead to a
deterioration in the BOF. and where domestic goods are differentiated from
foreign goods it will lead to a fise in the price of domestic goods as a result
of the increase in domestic expenditure. A monetary contraction will have
to opposite effect on both the BOF and the price of domestic goods'
Because of its effect on the BOR monetary Policy is not feasible over
the
Iong run under fixed exchange rates.
Under flexible exchange rates a monetary expansion will lower interest
rates, and this will cause a capital outflow and a rise in domestic exPnditurc'
This will result in a fall in the exchange rate and a rise in the price level'
Once the price level and the exchange rate have fully adjusted to the
aon"y atotk, interest rates will return to their previous levels and the
economy will return to equilibrium at the original level of income and the
previous level of real absorption. The relative price of domestic to foreign
ioods witl return to its previous level. A monetary
contraction will have the
ASSE'T MARIGTS, EXPECTAIIONS AND EXCHANGE RAIT^S
By focusing on intemational capital flows, the Mundell Fleming model
was the first to itress the major role that asset market equilibrium and
asset
the balance of
market adjustment play in ditermining exchange rates and
payments. Prior to this, work on the derminants of exchange rates had
,t the effects of relative prices on the flow of goods and services
"rsed
and concentrated on the cu ent account. Following the Mundell-Flemng
model most modern work has stressed the dominant role that asset market
equitibrium plays in determining exchange rate and the balance of-payments'
Tiri. i, p".t'i"uiorly true of thi monetary and portfolio approaches to the
balance of payments and exchange-rate determination'
The Mundell-Fleming model has several weaknesse-s that have
,timulated further theoretical work. It assumes a constant capital
flow in
response to an interest-rate differential, rather than a ponfolio lhift
that has
a large impact in the short-run and then dies away in a stationary
economy'
may be a long-run capital flow' but this will
In , iro*ing ecol1omy therc
be much smaller than the short run portfolio shift brought about by a
charge in iniercst rates This may be l useful simplification for short-run
 t47
analysis but is very misleading if applied to medium-term economic policy
making extonding over several years. This simplification allows the rncdel
to run a continuous current account deficit and a capital account surplus
over an indefinite period with an expansionary fiscal policy under flexible
exchange rates or with a fixed exchange rate when the BOF=O function is
more interest-elastic than the LM function. This. together with the
assumption ofstatic expectations, prevents the current account from affecting
the exchange rate.
Recent work by Dornbusch and Fischer on asset market determination
of exchange rates brings back the current account as a determinant of the
exchange rate. The model set out by them has a neoclassical supply function
for domestic goods and flexible prices. Domestic goods are differentiated
from foreign goods, and to induce foreigners to buy more of them they
have to fall in price relative to the price of foreign goods. The exchange
rate is flexible and adjusts to maintain foreign exchange market equilibrium.
Therefore, BOF = 0 at all times and the capital account exactly offsets by
any current-account deficits or surpluses. Here a surplus on the curent
account implies a capital-account deficit. Domestic absorption is below
domestic income and the excess of income over absorption is spent on the
net acquisition of foreign assets. This leads to an increase in domestically
held wealth reaches a point where it is so large in relation to domestic
income that no further accumulation is called for, so that domestic absorption
rises to match income. Equilibrium is then restored to the current account.
The rise in absorption leads to an equal absolute fall in the net
purchase of foreign securities. Part of the increase in absorption will be
spent on domestic goods as they are differentiated from foreign goods, so
that only part of the increase in absorption leads to a demand for foreign
curency on the foreigrr exchange market. The fall in net purchase of foreign
securities leads to an equal fall in demand for foreign currency on the
foreign exchange. market. Therefore, the net increase in domestic wealth
brought about by a currency surplus eventually leads to an excess supply
of foreign currency on the foreign exchange markel and the domestic clrrrency
will therefore appreciate. A similar analysis shows that a current-account
deficit will lead to a depreciation of the domestic currency.
Given the effect that the current account has on the exchange rate in
this model, expectations of economic decision makers about exchange - rate
changes must be consistent with the model's predictions, otherwise their
expectations will be consistently 'wrong. Therefore, dxpectations of futurt
exchange rates will be affected by the state of the current account, and
`′ ν J、 ( t“ ` ′o` ` ′ :● ´ )'i・ ′ '' ,● ヽ1,,1、 o lで
148
people will act in with those expectations. These actions will also affect the
current exchange rate.
If the assumption of static expectations is removed, as in the Dornbusch
and Fisher model, then a differential can exist between domestic and foreign
interest rates without provoking large capital flows. Funds will be moved
from one country to another as long as a higher return can be obtained for
them with the same risk. A firm located in one country will move funds to
another country as long as it can make more money in terms of domestic
currency than it can make by buying domestic securities. The amount that
it will make on its purchase of foreign securities will depend on both the
foreign interest rate and the percentage change in the exchange rate between
the time that it bought the foreign securities and the time rhat it sold them
in order to repatriate the funds. There will be no advantage to moving
funds from one country to another if.
i=ir-g'"
-(14)
Here i is the domestic
rate of interest, i, is the foreign rate of interest
and gee is the expected proportional rate of appreciation in the exchange
rate, e, where e is the number of units of foreign crurency per unit of
domestic cturency.
Expression (14) is called the interest parity theorem and it forms an
important part of many curent open-economy macro models. The interest-
parity theorem has the important implication that one can no longer predict
the direction of capital flows from interest-rate differentials alone. If the
domestic interest rate, i, is lower than the foreign rate of interest i, minus
the expected growth in the exchange rate, g"" (i<ir - g), then there will be
a capital outflow from the domestic economy. However, i could be greater
then i, but still less than i, - t. if g!. is negative because a depreciation of
the domestic curency is expected in the near future. Thus a positive interest
differential need not mean a positive capital flow once one abandons the
unrealistic assumption of static expectations. Thus capital flows are affected
by expectations of exchange rate changes as well as by interest-rate
differentials.
Another implication of the interest-parity theorem is that an analysis
of how expectations are formed, particularly exchange rate expectation is an
important part of any open economy micro model. Currently it is recognized
that expectations will always turn out to,.be incorrect if therexpectations
generating mechanism used in the model produce expectations for any
, ,′ . . '`14 _._' ｀ ' ￨ ′￨
 149
particular point in time dlat are inconsistent with the models predictions.The
rational expecセ ltions appЮ ach specifles dle expected value of its detenninants.
The radonal‐ expectations approach is ,oW COmmonly used to generate
exchange rate expectations in open economy models.
IINIT‐ 5
MONErARY APPROACH TO BALANCE OF PAYMENTS
The monetary approach to the balancc of payments and exchange rate
dctelll.ination is a currcndy popular version of thc assct market approach.
This analyses change in the cxchange ratc and the B()F in terms of stock
attuSment in the money markct in which the supply and dcmand for money
attuSt SO that all domestic money balances are cventually willingly held.In
this approach changes in econonlic vanables will affect thじ BOF and the
exchange rate through their impact on the demand for and,upply of money
balancOs.This stock attustment approach springs from the fact that a
necessary condition for a non― zero BOF is some initial difference betwcen
the public's actual money stock and the pubHc desired money stock.
This necessary condition for a non― zero B()F can be denved fronl the
deFlnition of the BOF and the absorption approach.By deflnition the BOF
iS equal to the current account plus the capital account.From the absorption
approach, the current account is identicaHy equal tO natiOnal income, X
nlinus domestic absorption, A. The capital account is identicaHy equal to
non― offlcial borrowing abroad and sale of real assets abroad nlinus non―
。frlcial lending abroad and purchase of real assets abroad. Now borrowing
abroad involves the sale of a flnancial asset abroad, while lending abroad
is the purchase of a rlnancial a,set abrOad. Thercfore, thc capital account
is identicany equal tO the sale of real and flnancial assets abroad, SFi minus
the purchase of real and rlnancial assets abroad,PF; Therefore we can write.
BOF=(Y― A)十 (SF 孔 )‐ (1)
In the domestic economy we can look at an domcstic transactions
bctween non― central bank residents in real and flnancial assets. IIcre asset
ptthascs t)by dOmesuc resident from domestic resdenも must nece,Sarny
equal assa sJes(sp by domestic residents to domcsdc residents,as they
器1朧 :謂驚 :ぶ h滞`織
鵠轟∬:灘ё
ギ :電 ユ
轟灘
of asscts by the central bank involves it in the cxpansion of the domestic
credit componcnt of high― powered money,II while a sale of assets by the
lfX)
central bank involves a contraction in domestic credit and H` モλing our
identity SD=PD We Can write.
BOF=(Y― A)+(SF+SD ■ LD)
―(2)
=(Y― A)+(S― P)
Here P is the total purchases of assets by domestic residents frtrm all
sources excluding the domestic central bank, while S is the total sale of
assets by domestic resident to every one except the central bank. Now
national income Y, is equal to the sale of final goods and services by
domestic resident, while absorption. A, is equal to the purchase of final
goods and services by domestic residents. Therefore, we must have
BOF = (Total sales of goods, services and assets by domestic residents
, excluding the central bank) minus (Total purchases of goods,
services and assets by domestic residence excluding the central
bank) ---- (3)
.
From this identity derived above we can see that a necessary condition
for a deficit on the BOF .is that current purchase by non-central bank
domestic residents of goods, services and assets must be larger than their
total sales of goods, services and assets. This differences can only be
financed by domestic residents either running down their cash balances, or
by their sale of assets to the central bank in exchanges for funds to finance
the difference between total purchases and sales. Now this purchase of
assets by the central bank involves an increase in the central bank's creation
of domestic credit. Therefore, a deficit on the BOF necessarily involves
either dishoarding by domestic residents or an increase in the central bank's
creation of domestic credit. In a similar way we can show that a BOF surplus
necessarily involves either an increase in hoarding by domestic residents or
a decline in domestic credit created by the central bank.
In the absence of change in domestic credit created by the central
bank, a BOF deficit can only persist while domestic resident are continuing
to run down their cash balances (dishording). In this case the money stock
would shrink automatically as the central bank purchased the excess supply
of its currency on the foreign exchange market with some of its foreign
exchange reserves. Here AII = AFR and these are both negative. Now we
know that AM'= mAlI, so that money supply must contract. The resulting
dec'tine'in money balances'must'eventually'bring dishoaidlng to'arr end as
domestic residents reach their desired level of money holdings. As this
occurs, domestic absorption, or net asset purchaser by domestic residents
 15l t9
or both, will fall as domestic residents reach their desired holding of wealth .han this, then the profit making opportunity will result in trader arbitrating
in relation to current income and their desired portfolio mix. Therefore, given goods from one market to the other. Competition between profit. Making
a sufficiently stable demand for money function, dishoarding will come to trader will lead towards equalization of prices. However, over the short run
an end within a reasonably short time span, provided that the central bank prices in different markets may depart from the law of one price if these are
does not indulge in continuous credit creation. In this case, given adequate lags in the reaction of traders to profitable opportunities. If the country
foreign exchange reserves, the BOF deficit will cure itself. concerned has competitors in all its product lines, then we can write the law
of one price as
Similarly, in the absence of change in central bank domestic credit, a
surplus on the BOF will lead to an increase in H and in the domestic money I
p=-pf __(4)
supply. The surplus requires continual hoarding by domestic residents and
e
will come to an end as they achieve their desired holding of money balances
and wealth and their desired portfolio mix. Once this has been achieved, Here P is the domestic price level, Pf is the foreign price level and
abSorption and net asset purchase adjust to keep wealth and the portfolio e is the exchange rate expressed as units of foreign curency per unit of
mix at their desired levels and this results in a zero BOF as purchases and domestic currency.
sales by domestic residents become equal to each other. Therefore, in the
The neoclassical aggregate supply function implies that, other than in
absence of continuous central bank destruction of domestic credits, a BOF
the very short run real income, y is not affected by the level of aggregate
surplus must come to an end within a reasonably finite time horizon.
demand in money terms, but is determined by the underlying real factors in
The monetary factors underlying BOF dehcits and surpluses led to the the economy. Here Y = Y, whereY is fixed exogenously but may be growing
development of the monetary approach to the balance of payment, but this over time.
approach would not be a particularly useful way of predicting the BOF if We can now set out the complete small economy model:
the demand for money were very unstable. Therefore, exponents of the
monetary approach assume a stable demand for money function. In addition, MD=Pf(y,i) Demand for money - (5)
they usually assume that aggregate domestic expenditure is positively affected M'=M(FR+DC) Supply of money - (6)
by the stock of wealth held by domestic residents and by the excess supply
of domestic money balances.
i = ir- g"" Interest-parity theorem - (7)
I Law of one price - (4)
MOI\EIARY ANALYSEI.]NDER A FD(u) EXCTIANGE RATE P-:pf
e
The simplest monetary model of the balance of payments assumes a
stable demand for money function, a money supply function as in equation Y= Y Neoclassical supply function - (8)
Ms =MH =M (FR+DC), the interest parity theorem as in equation i = ir = M'=MD=M Equilibrium condition - (9)
9"", the law of one price and a neoclassical supply function. Such a model
is developed by H.G. Johnson in 'The Monetary Approach to the Balance By substituting for the demand and supply of money in equation (9)
from equations (5) and (6) we get.
of payments'. In addition we assume that we are dealing with a small open
economy in the sense that it cannot significantly affect the world money M (FR + DC) = Pf (Y, i) - (10) gives
stock, price level or interest rate. D
FR=:f (y,i) - DC ------(ll)
The law of one price states that the price in terms of a common M
currency of any treatable commodity in any two markets will differ at most
by the cost of transport, tariffs and difference in retail costs involved in the If we assume that the bank multiplier, M, is a constant, and if we
moving goods from one market to the other. If the price difference is larger totally differentiate equation (11) with respect to time, t, we ger.
 153 154

d(FR) | r dp af(y,i) dy Ef(v.it ai d(DCh )=ギ d(DC)

dt
{ffy.i):-+p:
m( dt 0y -+
dt
p: --
di dt -}dt t
---ft:l
等 {"f ttyg〕
Here the term on the left hand side is the rate of change of foreign
reserves at the Central Bank. This is the same as BOF written as a rate of
d(DC)

ｒ ‘ Ｌ

ｎ
Ｈ
change over time, or BOF (t) Now, if we divide both sides of equation (12)

＋
〓

０わ
――
―(17)
y gy}
by the stock of money, M, and manipulate each term in the right hand side dt
of the equation we get Where H is high powered money. If we assume for the moment that

竿ゝi{gp+れ y gy+蒟 乳
}里
g∝
:__O the foreign price, Pf is constant and that the economy is stationary, then gpf
= O and gy = 0; substituting these values into equation (17) reduces it to.

К ЮhegЮwm mじ h濯
Here gP t∬ dom∝ dc"ce LVd,4わ ,
d(FR)
dt
―
d(DC)
dt
――
―――
(18)
gy refers to the growth rate in real income; gi refers to the growth rate
in the rate of interest and gr. refers to the growth rate in central Bank Under these circumstances any attempt by the central bank to increase
domestic credit, the cenfral banl created component of H. Now rnry is the the money stock by expanding high powered money, H, though increased
income elasticity of the demand for money and ?tui is the interest elasticity domestic credit creation will be nullified by an exactly offsetting shrinkage
of the demand for money. in the foreign reserve component of H. This is shown by equation (18). In
this fixed exchange rate case the domestic money stock is completely
Given a fixed exchange rate, which is expected to stay fixed, there is endogenous and adjusts completely to the demand for money.
a zero expected growth in the exchange rate, so that g""=o. From our small
economy assumption, i, is exogenous and we can assume it is fixed. MONEIARY ANALY$S I.]NDER A FLEXIBLE UCIIANGE RATE
Substituting these results into equation (7) transforms the interest parity A monetary model which we will use to anaiyses the effects of monetary
theorem into policy under a flexible exchange rate is identical to that of fixed exchange
- rate case. It is composed of equation (4) - (9) inclusive. The only difference
1=lf …… … (14)
in the flexible exchange rate case is that the exchange rate, e adjusts in
Hence we can deduce that there is no growth in the interest and gi response to demand and supply in the foreign exchange market. Under a
= 0. Taking natural logarithms of both sides of the law of one price equation clean float e adjusts to clear the foreign exchange market. The BOF is zero and
(4), and then differentiating through with respect to time we get. the stock of foreign exchange reseryes remains constant, so that 9Q=0
o =sDpf -oDe
op ------(15) rins complete control Bt
".
tr,"
nominal money stock, as there ate no induced foreign reserve flows to alter
Under fixed exchange rates, the exchange rate, e, does not change so
the money stock from the level set by the central bank through its open-
that ge = O. Therefore, the growth in the domestic price level, gp, must be
market operations.
equal to the growth in the foreign price level, gpf, under a fixed exchange
rate. Using these results to substitute into equation (13) we get A necessary condition for a zero BOF is that the demand for domestic
money must always adjust to equal the domestic money stock. Under a
BoF(t)= clean float the domestic money stock is determined by the central Bank.
tr} - ------- (r6)
',,{,r,.^ ,
** Therefore, in order to clear the foreign exchange market the adjustment in
the exchange rate must alter the demand for money so that it equals the
Now, as BOF (0 = d (FR)/dt and g,. =* H rhis can also be predetermined nominal money stock. It does this through its impact on the
written as domestic price level and interest rate.
 155 156

""Since 1n this casc a positive rate of foreign inaation causes an appreciation

the ciomestic monetary authorities can control domestic stock of
money they can also determine the domestic rate of inflation. One can see
this from the fact that equilibrium under a clean float requires BOF (t) in
equation (13) to be zero. Thus we get.
0=下 ig〕_弓
「 Igp+ny gy+rし } gDC ¨ ― ― ―
(19)
If we multiply through by the bank multiplies, m, and remember that
M = rnH, we can write this as
0 = Bp +rt\y gy + rnigi CDc---(20)
T If therc is no forcign reserves under a clean
Rearranging terms in equation (20) we get
*o=# r*-trysr+ migi) ----(2t)
The term in breu brackets on the right hand side of equation (21) is
the rate of growth in the demand for money due to the rate of growth of
real output and to any rate of change in the domestic interest rate. The rate
of growth of the domestic money supply is given by in equation (21). Thus
domestic inflation accelerates (that is gp>o) when the rate of growth in
domestic credit exceeds the rate of growth in the domestic money bupply.
In contrast to the fixed exchange rate case where the domestiC rate of
inflexible exchange rates the domestic inflation rate is affected by the rate
of domestic credit expansion. This result follows directly from the exogeneity
of the money stock under a clean float.
However, the exchange rate only remains unchanged if the domestic
r,a!e of inflation is equal to the world inflation rate. We have already shown
this when, using the law of one price,. we derived equation (15). Thus the
exchange rate will .appreciate when foreign countriei inflate more rapidly
than the domestic cbuntry and depreciate if the world inflation rate is lbwer
than domestic inflation. We frst simplify equation (21) by assuming a constant
interest rate, so that gi = 0. We then substitute the resulting expression for
B, in equation (21) in to equation (15).
This gives
ge=≒ ‐ +nyら ‐
fg∝ ② the data are consistent with the mOnetary approach. Reserve losses are
Equation (22) shows that an increase in the foreign rate of inflation or
in the rate of g:.:wth of domestic real income will tend to appreciate the
of thc exchangc rate However the domestic price level stays constant
because there is no excess rate of growth in domestic credit.This,together
with the law on one price,ensure that the exchange rate appreciates so as
to prcvcnt the rise in prices in tems of foreign currency affecting pHces in
terrns of domestic currency. If and forcign prices are falling, then the
exchange rate in pnces in terln of foreign currency affecting pHces in terlns
of domestics currency. If and foreign priccs are falling, then the exchange
rate must be depreciating.Thus under flexible exchangc rate thc behaviour
Of the exchangc rate depcnds on thc domestic country's inflation rate vis‐
a― vis other countries,and this in turn depends on domestic monetary policy.
■oat so that DC = H and gi
=0,then equation(2の simplifles to
gc=g〆 _gDC+η υ gy 二―
一――(4)
Now if gpF=O and gy=° Wc have the simplest case of the mOnctary
model where跳 =gDC
Hcrc the rate of growth of the cichange rate is equal in size, but
opposite in sign,to the growth of domestic credit.An increase in domestic
credit icads to deprcciation, while a dec"asO in domestic credit leads to an
appreciation,ofthe do呼 ,tic Currency. In this case any increase in domestic
credit expansion must lead to an increaso in the pricc level,and the rate of
domesdc idatiOn win be cxactly matched by the rate of currency depreciadon
given our assumption that gpF=gy=° .This is demonstrated from equation
(15),whiCh together with equation(25)and g〆 =O giles瓦 =gp=gDC
EMPIRICAL¶ 日31Б oF¶□E MONErARY APPROACH
LikC all"W development in economics,the monetary approach has
spawned a vast empirical Hterature.This has su可 ∝ted thC data from a vast
rang9 0f C9untries to cconottetHc tests to see whether they are consistent
with the predictions of the monetary approach.
The empi五 cal studies of countries undcr a rlxed exchange ratc rlnd that
relat(xi tO domestic credit expansion,and under flxed Oxchange rats national
inflation rates of OECD countries did not vary any more than the innation

::",':":: :::::, T:':,: :.ir l, (ff).:*- :l:j'",T::i: ;::i".:.::li: :::" rates among US cities,whilc devaluation had a temporary positive effect on
the BOF which could be offset by excessivc cttx五 t expansion.
sufficiently to meet the increase demand for money due to real income `

growth, then we must have g. = gpr Under nexible exchange rates the monetary approach has becn used to
--:----(23) predict the exchange rate. It has been relatively successful in prcdicating

\lt!,rll.rO--ttr...,
 157
movements in bila{eral exchange rates. For example, Bilson uses the monetary
approach to model the sterling / deutsche mark exchange rate. In this model
money markets in both countries have a partial - adjustment process in
disequilibrium. His estimated model is consistent with the monetary approach
and there are significant coefficients on the money variable in his estimating
equation.
The results in-modelling the UK effective exchange rate are much
patchy. Haache and Town end found no statistically significant coefficients
on the monetary variables in their model of the effective exchange rate for
the pound. On the other hand, Beenstock et al found statistically significant
effects on the effective exchange rate from the money stock. They concluded
that the monetary approach was not rejected by the data. However, they
also found that a broader asset market approach which included bond
stocks gave better results then the monetary approach, but the coefficient
of the money stock on the exchange rate was four times as large as that
on the stock of bonds. This last result implies that the monetary approach
should be extended to included other asset stocks. This is the new direction
for theoretical work in the monetary tradition.
UMT-6
DEXVIAI\D. DETERMINED VIEW OF TTMMONDT SI.'PPLY PROCESS
An alternative view, held by anti-monetarists is that the supply of
money is determined by the demand for money and so cannot be changed
independently of the demand for money. There are a number of facets to the
demand - determined view of the money supply process. One critique of
the multiplies model is that the reserve and currency rations and highly
variable and so make the multiplier unstable. Another critique relates to the
way the banking system, particularly in the United Kingdom, actually
operates. The Bank of England does not and cannot restrict bank's access
the reserves because the banking system must be kept liquid to maintain
confidence in its solvency. Hence an increase in the demand for bank credit
would be always met by banks because they know they will always obtain
extra reserves from the Bank of England.
A more extreme critique, such as that provided by Kaldor, Maintains
that the view of the money supply process described by mechanistic and
behaviouristic models are totally inapplicable in a credit economy. In such
an economy it is liquidity and the availability of credit which influence
spending decisions rather than the money supply as such. This is because
money cannot be' pioperlli' distinguiShed 'from the liabilities of non'bank
financial intermediaries as these are very close substitutes to bank deposits.
158
The view that this intangible variable, liquidity is the crucial monetary
variable was at its most influential in the early 1960's following the putlication
of the Radciffe reports.
A further development of this view is the argument that the amount
of financial intermediary deposits is determined by the demand of them. If
the private sector wants more credit, this will be created for its by the
financial system. If the short-run marginal cost function for deposit production
is gently sloped, then an increase in the demand for bank loans will shift
the average and marginal revenues out to the right and gives rise to a
considerable expansion in the money supply. The long the time horizon, the
flatter the marginal cost function as banks and other financial institutions
devise new ways of meetings the demand for credit. If the long - run
marginal cost function for deposit production is gently sloped, then an
increase in the demand for bank and other financial institutions devise new
ways of meeting the demand for credit. It the long-run marginal cost
function is horizontal, then the output of deposits is completely demand-
determined. In this model the supply of money can only be contracted if
the demand for credit is reduced.
The Kaldor type view of the money supply process is criticised on the
grounds that it confuses the demand for credit with the demand for money.
Bank borrowers want credit in order to finance expenditure, they do not
want to hold their bank loans as money. The bank deposits spent by bank
borrowers end up in the asset portfolios of other economic agents who may
not want to hold money. So although the extra money comes into existence
because of a demand for credit there can still be an excess supply of money
over and above the amount people want to hold.
MOI\E^T SUPPI,Y DEf,ERMINATION IN AN OPU\ ECONOMY
Extending the discussion to an open economy alters the analysis of
money supply determination quite fundamentally.
& Money supply determination under fixed exchange rates:
Under a fixed exchange rate system or a managed float, the balance for
offrcial finance, BOF, can be in deficit or in surplus. If it is in surplus, this
means that over the relevant perid there has been a net inflow of foreign
exchange and the total stock of foreign curency reserves has risen. In the
United Kingdom foreign exchange reserves are held in the exchange
equalization account (EEA) which is operated by the Bank of England. A net
increase in the stock of foreign exchange reserves arises because British
c._な ЛいrnnATrOnron■ o′ Л∩■
 159
residents have been net sellers of goods, services and assets to foreigners.
In return British residents receive foreign exchange which they convert into
sterling by selling to EEA. British resident's holdings of sterling money
balances have thus increased, and since this sterling has been supplied via
the Bank of England, it is high-powered money. We have therefore arrived
at the important fact that in an open economy high powered money increase
as a result of a surplus on BOF. The BOF source of H is not under the direct
control of the Central Bank, unlike the closed economy case.
If the BOF is in deficit, then foreign exchange reseryes decline over the
relevant period. The EEA is a net seller of foreign exchange to British
resident who have to run down their sterling balances in order to acquire
the foreign exchange needed to finance their net purchases of goods, services
and assets from foreigners. The high powered money stock therefore declines
when the BOF is in-deficit.
The increase (decrease) in H that results from a surplus (deficit) on
the BOF gives rise to a multiple expansion (contraction) of the money
supply. The central bank can try to prevent an imbalance on the BOF from
affecting the domestic money supply by engaging in offsetting open-market
operations in government debt. This activity is known as sterilization. If,
for instance, the BOF is in surplus so that H would otherwise increase, the
EEA sells government debt to the value of the BOF surplus to the non-bank
domestic sector. The open market sales redrice H and so offset the increase
in H that would otherwise occur when there is an inflow of foreign exchange
reserves. Similarly when the BOF is in deficit and H would otherwise decline,
the EEA stabilizes by engaging in open market purchase of govemment debt
from the non-bank domestic sector. The debt purchase put H into the hands
of the non-goyernment sector and so offset the decline that would otherwise
occur because of the deficit on BOF.
In an open economy with a fixed exchange rate of with a managed
float, the following identity holds for the sources of high-powered money.
PSBR ( + When Net sales of
N{= Government Government debt
is in deficit tonon-bank
domestic Sector
and to forei
From this identity we can see that there need be no direct relationship
between H and the PSBR or BOF because the monetary authorities can
engage in offsetting open-market operations. This is particulady so in the
short run. However, over the longer run, it is difficult for the authorities to
160
continue sterilizing the monarch effects of an imbalance on the BOF. This
is because sterilization involves persuading wealth - holders to alter continually
their portfolio balance between money and bonds. For example sterilization
the effects of a surplus, on BOF involves increasing the proportion of bonds
to money that the non- bank private sector holds and so means raising the
rate of interest. This attracts more funds from foreign financial investors,
so reinforcing the balance of payments surplus. A similar argument follows
fbr attempts to serialize a deficit on BOF. Now the interest rates has to fall
as the ratio of money to bonds, increase. Foreign capital flows out, so
perpetuating the BOF deficit.
An important conclusion which emerges from the analysis of how the
BOF affects the domestic money supply is that a country which operates
a fixed exchange rate a managed float cannot have an exogenously determined
money supply unless it can stabilized successfully. Monetarists are more
dubious than Keynesians about ability of the monetary authorities to sterilize
the effects of BOF imbalances on the domestic money stock. Therefore,
monstrosities regard the domestic money supply as being endogenous under
a fixed exchange rate of managed float. The money supply cannot be
controlled by the monetary authorities because it is affected by the BOF,
which in turn depends on the decisions of private sector economic agents,
given the exchange with the authorities decide to maintain.
If foreign currency flows cannot be sterilized then the government
cannot choose buth the exchange rate and the money supply as independent
policy target. If the govemment chooses a particular exchange rate, then
the money supply has to adjust to be consistent with it.
THE MONE"T SUPfl,Y UNDER. PMFECILY FLD(IBI,E D(CTIANGE RATES
Under perfectly flexible exchange rates the BOF remains at zero because
the exchange rate adjusts to achieve over all balance of payments equilibrium.
Since BOF is zero it has of effect on the domestic money supply. The
domestic supply of money is therefore exogenous because H is exogenous
in the same way as in a closed economy. The government can now select
the stock of money as a policy target, but has to accept what ever rate of
exchange as consistent with the money supply target.
The monetarist position is that the money supply in a closed economy
,rr in open economy with flexible exchange rates has a large element of
exogeneity. Although the bank multiplier, m, does vary to some extent in the
short run with interest rate change, these variations are not large and erratic.
The money base, H is ultimately under the government's control and this
 l6t
gives it contrdl over lhe r.Jney supply. Howeyer, if the exchange rate is
managed. thcn the*resuhing imbalances. in BOF afferr H so lhat lhe domestic
money supply is endogenous. Anti-monetarists argue that the money supply
is not exogenous under any circumstances because the multiplier M varies
substantially and erratically and because H is not under the monetary
authorities control. Inst€ad they have to vary H in response to the privcte
sector's demand for credit and money, hence the money supply always
adjusts to whatever lhe demand for it is.
L]I\UT _ 7
RADCLIIIF . SAYERS THESIS ON MOI{EY ST]PPLY
There were various monetary developments since the eady 1960's and
the scepticism about the policy of money stock conrol reached a peak with
the publication of the Radcliff committee's report. The radcliffe committee
found that the response of expenditure to change in int€rest rates was rather
weak, and hence saw a very limited role for monetary policy. Moreover, in
so far as the authorities was !o try to use monetary policy at all, they should
try to act on the liquidity position as a whole rather than on the quantity
of money. It was perfectly consistent with its Keynesian views on the
tansmission mechanism for the bank to execute monetary policy through
operating on intercst rates directly rather than through control of the money
stock. In 1959, the Radcliffe committee enshrined in its report a precise
statement of what came to be called 'New Orthodoxy' of monetary control
based on a liquid asset ratio. The statement was: 'The supply of Treasury
Bills and not the supply of cash has come to be the effective regulatory
base of the domestic monetary syst€m'.
d The report presents a vigorous attack on the importance of the money
supply -
to the extent of arguing that money cannot even be defined.
Besides it also pointed out that the second line in the Keynesian Chain;
belween intersst rate changcs and investnent was not sEong, leaving only
a tenuous connection between money and income,
The new tansmission mechanism they developed rested on two key
ideas : -
l. Expenditure was linked not to money but to liquidity.
2 Liquidity could be influenced by manipulated interest rates.
The liquidity, substitutability among assets and definition of money,
ilterest rates and credit rationing, credit rationing and credit availability,
cuP/6108/0E/lmusDEd
162
financial intermediaries and velocity of Radcliffe report will be discussed in
detail.
LIQI,NDNY SUBSTITTIIABILITY AMONG ASSETS AND DEFINITION OF
MONET.
The sayers/Radcliffe attack on both quantity theory and policy took
c theoretical as well as an empirical form and led to one of the best known
features of the report: its unwillingness to define money. Plainly if money
cannot be defined it cannot be a key variable in spending decisions and it
is meaningless to discuss controlling it. The argument that it is not definable
rests on the absence of a clear criterion for the inclusion of specific assets
in the monetary aggregate.
If money cannot be defined it follows by definition that velocity can
be anything. Note content with having aryued that the denominator of V
is meaningless, further argument is developed to back up Radcliffe's famous
conclusion that "... we cannot find any reason for supposing, nor any
experience in monetary history indicating, that there is any limit ro the
velocity of circulation..." The more liquid is an asset, the more substitutable
it is for money, in this sense of providing potential purchasing power.
The extent of use of non-bank credit and the division betwecn "active"
and "idle" money balances determine velocity while the authorities can
always affect (if not perfecdy control) the supply of money, velocity is
determined by the behaviour of the holders of money and of banks and
other credit institutions - the private sector. If the private sector acts in such
a way as to raise velocity while the authorities attempt to re6trict spending
by reducing the money supply, the attempted restrictibn will be frustrated.
The expansion of non-bank credit in a boom is precisely such a rcsponse
on the part of the private sector to tle constraints of an inelastic supply
of mcans of payment. The velocity offs€t of monetary policy could be
complete, if all those intending to spend could always helpless to influence
aggrcgate dcrnand. In rhis spectra which tlte rcport raises in seeing non limit,
in principle, to velocity.
The division betwesn sense and nonsense in this argum€nt can only
be seen by making just the arbitrary aggregation to the money qUantity.
ConEast the behaviour of velocity under the same circumstanc€s but using
trvo different definition of money- One can shows that the broadcr one's
definition of money, the less will be the variation in velocity.
To h.ve perfect contid over cpending telocity must be eith€r predicate
a @nstant or a stable function of measurable variables or be itself controllable.
 163
Radcliffe rightly rejected the potion of v as a behavioural variable it is the
outcome of attempts to spend in a given financial climate it depends inter
alia, on the use of non-bank credit it is not independent of M.
Radcliffe's unwillingness to define money had important policy
consequences. For it was concluded that the quantity of money was a
variable of no significance. Banks were singled out for attention chiefly on
the ground of administrative convenience. There is a brief mention of their
role as "Key lenders" but no discussion of what that might mean; in
ta
1, in which the demand and supply of loans are functions of r", the effect
of a rise in ro is to shift S, to the left. Conventional analysis would predict
that r, would rise in response to excess demand for loans but interest -
insensitivity of the demand for loans would prevent loans from falling
significantly. Lending falls only slightly, from Lo to L,.
Figure-l Credit Rationing
SL

Ｌ        １
particular there was no suggestion that an expanded volume of deposits
could provide a reserve base for expansion of non- bank intermediaries, just

′
as change in the cash base permits bank expansion.
INTEREST RATES AND CREDTT RATIONING
The naditional keynesian conception of monetary policy gives interest
rates a key role. Changes in interest rates have two effects on lenders: They

ヽ一︼
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“ｏ﹁ ｏ一
DL

︻︼
dffect the relative profitability of different earning assets and they affect the

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〓００﹄０
“ｏｏ︺︺国
liquidity of lenders port - folios by changing capital values'.

ｏ■

“●“
In order to analysis their proposition in terms of the supply and
demand for funds, suppose we have one type of lending institution, whose 0 L・ Ll
L
assets comprise some reserve asset, R, Government securities, G and loans, ln contrast, Radcliffe thought that lending rates did not adjust rapidly;
L. The latter two eam interest at rates ro and r, respectively. The willingness a shift in the supply curve of loans would therefore lead to credit rationing.
to supply loans depends on relatives rate of return and on reserves, given In the period before rates adjust, new lending falls to Lr. At the old interest
the overall size of the lender's portfolio. rate rm , L, ir as much as these institutions are now prepared to lend.
There is now excess demand for loans. Funds must be "rationed" among
∂SL ∂SL ∂SL those desiring to borrow.
SL=te,rc,■ ,), ……………>o― ――― <0 -… ‐
>0 It can be seen that the assumption of credit rationing restores much
aR [凛 G ∂rL of the potential power of monetary policy. A credit squeeze to which banks
respond by rationing credit rather than raising loan rates is in no way
Private demand for loans depends on y, and expected profits II": weakened by the low interest sensitivity of. demand for credit. It is whether
money is easy or tight, not whether it is cheap or dear, that matters.
∂
■ ∂
■
DL=ち (rL'ぽ ) く0, ――………… >0 CREDIT RIIIIIOIIING AND CREDIT AVAII-A.BILITY
―記 肝 The last statement of Radcliffe is ambiguous. From context we know
that it refers to credit rationing, but it is quite consistent with repaid adjustment
A rise in ro has a negative effect on S,- for two reasons: The usual of credit markets to new equilibrium positions and absence of credit rationing.
substitution and wealth effects. A higher rate of returns on government In general deficit spending is influenced by both the cost and availability
/ securities increases their attractiveness relatively to loans. In additions the of funds: The demand for loans function describes the extent to which
lower market value of government securities already held reduces the lenders' positional borrowers are willing to go into debt, at every level of borrowers
liquidity. This has a negative effect on s, by increasing the cost of obtaining cost. But it is the amount of funds they actually obtain that determines how
additional reserve and by reducing the siie of portfolios. In terms of Figure much spending they can actually carry out.

″
 …
Tlle tra“ dond`Kcyllcdan"cost of bolTowlng eX口 an面 ∞ Of山 e mterest ngure 2 Crcdt rado面 n3Eモ pand° n of demand ●

rate's influence on spending rests on the implicate assumption that the

avaitability.of CrCilit is- u-n'afftcted *nen ferialrrg iaibi cfaaga pgig$i1g rr-
I \
rates rise either because the witlingness of lender tir supply funds has for I
some reasons declined or the demand for them has risen. Either way. relatively I - \ \
to demand. funds are now less available. When lending rates rise, those I \\ /1
borroweB no longer willing to pay the higher bonowing costs will voluntarilY 7t
drop out of the market so that if the rate adjusts rapidly there is no excess | ,/l\\
demand for eredit. But it is a mistake to conccnrate on the price effecl L/ I \'l
alone- as i[. when the ma*el is cleared at the ne\v rate. the quanlity of credil I I "J
exlended will have no eflecl on expenditure e\cePl lhrough price. When i I I
credit marLets clear. a restrictive policy uct bv simultane,rusly increasin-8 loun
rates and decreasing the availability of fi.rnds (From L0 to Lr). The etTect of o- Lo Lr LOANS
.redit rationing is to increase the quantitatiYe effrct of restrictive policy, the
atlditronul impuct on thc lltrw of frrnds :s L. - L..
Figure 3 Credit rationing: Reduction of supply
If、 vc ctlH[hc ccluilibllum changc in hc volulllc of lcnding thc availability
clfcct and dcinc thc crcdit rationing cffcct
quittbllum ou“ omc ad thc crcdi rationing(
paradoxical but uscful rcsult that credit rati(
cffo11(L。 ‐
Ll)and an availability effect(L
cven if markcts were to clcar Rcstrictivc
v money tight,cvcn if SOmcdmcs it doesn't,

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￨

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How much more depcnds tt me s10pes Ofl
￨

S supply Of ioans and on how iong thc dise

: 麟籠
帯IjEl野 讐ギ l尊i聴鸞露ll蘇-
over the relevant range : (L, - LJ < G, - Lo) where LO is the credit "蕊
; il;.';.'
鵠患 棚 憮よ
;.';J'4, ;" "ri
鰐」Ψ 織出織 i端
ttt曇
the supply schedules of loans in the
rationing outcome, and L1 and L2 the equilibrium results given Dl arrd D2 of u ."itine. Til" total excess demand resulting ftom a shift
from
respectively. Conespondingly the availability effect is greater the more elustic ^fr.."i"
pi. fl interest ceiling or lag effect (L, - Lr).for S_,- und.(L,

is demand. - L,) for "o-pri*t"ao

Sr. The remaining djstance io L3, the credit availability effect since
if t,he restriction *"." .o removed this demand would be eliminated by
o-3 - L2) <(L3 . Ll). the rise in r,-.
 167
Figure 4. An interest rate ceiling
Lo L, L2 Lt LOANS
It is a credit rationing argument that Radcliffe is making, an argument
that depends, for its policy importance, on there being a significant time lag
in adjusting lending rates to changed conditions. It is a disequilibrium
argurnent. The Keynesian cost of credit argument is the price aspect of
an equilibrium argument within which it is impossible to speak of money's
being tight or easy: it can only be dear of cheap. Shifting away from the
equilibrium model retained most of the feature of what had by then become
widely understood as the "Ke5rnesian" transmission mechanism while
providing as escape from its dismal prospect for monetary policy in a world
where interest rates were believed to have little influence.
FINANCIAL INTERMMIARMS AND VEI]0CITY
The Radcliffe proposition is that controlling the stock of money is a
waste of time. Velocity can be raised at the will of the private sector. It
is well to be clear how his is done. There are atleast three ways : by altering
payments arrangement, by changing the volume of direct lending and by
increasing the dmount of financial intermediation. The last is the most
important. The Radcliffe's terminology, a money supply policy is likely to be
frustrated because borrowers who fail to obtain a loan from one source will
srck if from another.
The Radcliffe discussion of the relevance of tlnancial intermediation is
hardly new. Its immediate precursors was the work of Gurley and Shau but
it is part of a debate with a long history, the "uniqueness cf banks"
controversy: whether banks are unique in their ability to create credit.
Radcliffe takes the position that non-bank financial intermediaries are not
168
fundamentally different from banks, thus theirs nothings to suggest the
concentration of control on the banks which traditionally characteristic
monetary policy. Sayers argues that the ease with which the non-bank
financial intermediaries enlarge their balance sheets total is a important in
financing aggregate demand as is the activity of the institutions we call
banks.
CONCLUSION
The Radcliffe model is rich but confusingly stated. The policy
recommendations were straight forward. control of the money supply they
viewed as an anachronism in the highly developed post war uK financial
system. The logical conclusion of their model is to control credit creation,
from whatever source. This was rejected on the grounds of administrative
inconvenience. The banks were to continue to receive "special attention"
because they were key lenders. However, it was advances, not deposits,
which were to be their subject of control, and that only in emergency
situations.
For day to day purpose, they recommended control through interest
rates. Now we have seen that in the case of restriction of policy of
managing the rate on government securities might be quite effective especially
ifcredit rationing plays an important role. what actually happened was
that the needs of economic policy frequently conflicted with the narrower
problem of meeting the government borrowing requirement. The bank of
England' view that expectations in the giltedeged market were usually
perverse led to a policy of stabilizing rather than more generally managing,
interest rates.
Effective macro economic policy may imply interest rate stabilization
under some circumstances, but no general case can be made. Radcliffe did
not make it. The practical result of Radcliffe was a more or less complete
abandonment of control over the money supply. But this judgement did not
follow from their theory any more than it follows from the work of Keynes.
FACTORS AFFECTING MOI\EY SUPPLY IN INDIA
Money in India is defined as currency (C) plus demand deposits (DD)
plus other deposits of the RBI (oD) which are of nature of demand deposits
- all held by the public.
ThusM=C+DD+OD-(1)
Currency constitutes a little more than half of money supply in India
and 'other deposits' of the RBI are a negligible part of the money supply.
 t7r t72
of r, the effect
. ..,.. Jteie is another approach to trade-cycle theory which does not rely Y, = C, + { + AEt+ ........................(3) ,is would predict
so strongly on internal factors. It analyses cyclical adjustment paths that where AE is autonomous expenditure. Therefore, for short-run rs but interest -
are generated by the impact.on the economic system of exogenous factors, equilibrium we must have rns from falling
such as population changes, the accumulation of new inventions, the opening y, = (I-S) Y, * V '-:.. - '-^ "- , .-
(y, - \,) + AE,...............(4)
up of new territories or changing patterns of international trade.
output and demand vary from one period to another because aggregate
KEYNESTAN TRADE. CYCLE THEORY demand depends on last period's income as we[ as on current lncome.
when last period's income differs from this period's income aggregata demand
Keynesian trade-cycle theory grew out of the 'General Theory', starting
changes from period to period. Solving equation (4) for y we obtain
in the late 1930s. Samuelson first used the muitiplier relationship together
with the key-role played by unstable investment. He expressed it in terms Yr =(r .*)., .. ... .... (s) SL
of the accelerator theory of investment to construct cumulative upward and *.
downward movements in reai ou(put. This process works as lbllcws. As Equation (5) is an example of a first-order linear difference equarion as
t:xpecii:rcl increase in output which generates a demand for additionat capital it is lag-sed just one period. using equation (5) we can derive the iime path
stock leads to an increase in invesfment. The increase in investment causes of incolr.e. 1,Ye start from a static equilibrium level of income which equals
output to rise by au amount equai to the increase in investment tirnes the AIls. (This is derived froin equation (4) by seuing y, = y,-, an<i solving fbr
jncome multiplier" 'ihe increase in income causes investment to rise further the static equilibriurn level of income). Income then diverges from its static
and so the multiplier accelerato!' process continues. The money supply is equilibrium level. In the initial period 0 income is so. Thus the initial
implicitly assumed to adjust to the quantity of output. ihere is also no divergence is Yo- AE/s. From equation (5) we therefore obtain that income rs
mention of price changes, as in the Keynesian tradition these are assumed I is
in period t adjust rapidly;
fixed prices do not adjust all adjustment is irv-nuantities and hence gives
rise to sizeable fluctuations in real output ano
Y,= (t +S\ yo credit rationing.
tment. In the typicai
\ v-sl -AE the old interest
v-s

パ一
Kevnesian manner, the supply of labour is assurneci to be perfectiy elastic"

俎一
epared to lend.

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Ｔ
／１＼
The use of the rnultiplier accelerator relationship to derive cyclical fluctuations

Ｄ
Ｖ
Ｓ

Ｖ
Ｓ
rtioned" among

¨
is now examined in more detail.

恥森
です
TTIE FIRST-ORDER MTJLTIPI,IBR - ACCELERATOR INTERACTION restores much
The simplest specification of the accelerator function for net investment
is the following first-order difference equation.
舗 to which banks
is in no way
Therefore, continuing on for Y, yo etc by substituting in to equation
it. It is whether
(5) we obtain
I = v (Y, - Y,-1) .....................(l) th T+ぐ +お <響 明 at matters.
In this version the capital srock is fully adjusted to its desired level
at the end of each period. when firms enter the current period their capital
stock is not optimal related to current output, as it was adjusted to last
・ =°
宮 (+褥 ,ntext we know

period's output. Investment (or disinvestment) therefore takes place but not =(1+S)t Yo― AE[1‐ (1+S)t] paid adjustment
credit rationing.
until the end of the period. Consumption is assumed to depend V‐ S S V― S rnd availability
proportionately on the current level of income.
=(1+g)t(Yo― AE)+AE.¨ ¨¨¨¨(7) xtent to which
c, = (I _ s) y, .........................(2) rl of borrowers
S S
Where 'S' is the marginal propensity to save. The model is solved by letermines how
essuming short-run equilibrium is achieved in each period whereby aggregate Where g= S
demand equals national output. ・

浴
 173
174

Now 'g' will be positive provided that .v, is greater than .s'.
In general there are four basic types of adjustment path that a variable
can follow. The adjustment path can converge towards equilibrium, in which
case the model is stable, or diverge from equilibrium, in which event the
model is unstable or explosive. The adjustment path is further characterised
as oscillating or monotonic. The latter path always moves in the same
direction. The four kinds of adjustment paths are shown in figure (i) and
illustrated using the general form of equation (7) in which o
=t*g
Y, = a'(Yo - AE) + AE ................(8)
“
ざ︲
when t is an even number and being negative when t is an odd number.
The adjustment path oscillates around the equilibrium value of income,
which is therefore overshot a number of times. As the oscillations gradually
die away, the cyclical path is said to be damped.
3. Explosive and monotonic if o is greater than l. As time progress
a'gets larger. whether income is continually rising and falling is determined
by whether the initiating movement was an increase or a decrease in output
respectively.
4. Explosive and Oscillating If cr is less than -1, crt again tends to

infinity as time passes. since cr is a negative number, ct is altematively

ガ ＝メ︲ガ ロＥ︼

positive and negative depending on whether t is an even or an odd number.

Because crt gets absolutely larger as time passes, equilibrium is overshot by
ever-increasing amounts. cycles of ever-increasing amplitude are said to be
anti-damped.
一●ヽ一●ｏ ﹂ｏ  口ｏ﹁●︼＞ｏ∩

since economically plausible values for s and v give a varue of cr in

equation (7) which exceeds 1, a first-order multiplier-accelerator interact cannot
“
・

by itself generate cycles. It only produces continuous upward or downward

３ 日編

movements.

SECONIX)RDER. MWIIPIJER, . ACCELERIITOR INTERACIION

Initial Deviation Given the values of 'S' and 'V' that occur, we require income to be
=Yo-AEj lagged by more than one time period if the multiplier - accelerator relationship
s is to generate cycles. A second - order multiplier accelerator interaction
contains both current income and income lagged by one and two periods.
Important assumptions of this model are: (l) consumption is a function of
0 income lagged one period (2) Because of lags, net investment makes good
Iast period's discrepalrcy between the desired and actual capital stock. That
is, current investment is related to last period's change in output and not
this period's. It is this factor that causes cyclical fluctuations.

C, = (1 - S) Y,-, .................... (9)

The four types of adjustrnent path are:-
I," = V ({-r - Y,-2) ............... (10)

Substituting equations (9) and (10) in to (3)

1.Stabte and monotonic When .s, lies between 0 and +1. o,gets
t
steadily smaller as increases so that the divergence of income from We obtain Y, = (l - S + V)Y,-, - V yuz + AE ....... (11)
equilibrium eventually becomes negligibly small.
This has the same static-equilibrium solution as equation (7), namely
2. stable and oscillating when a lies between -1 and 0. As t tends that income equals AE/s. Equation (11) is a second-order difference equation
to infinity o,t tends to zero but in doing so alternates between being positive because it has two lags.
 175
The type of adjustment path followed by output in this model depends
on the numerical values of V and S. Figure (ii) shows the various
Fig (ii) The Combinations of V
and S which give the four types
of adjustment path
B D
damped anti-damped cycles
cycles
v{l-{sF v=(l-fsy
Explosive and
monotonic
monotonic
combinations of values for V and S which will give the four types of
adjustment path cycles will occur if V and S lies with in the areas B or D.
For this particular model, for a capital-output ratio of less than 1.0 produces
convergence, while a 'V' greater than 1.0 causes divergence, irrespective of
the size of the marginal propensity to save. In general a small capital-output
ratio is required to produce anti-damped cycles.
The lagged capital-stock adjustment mechanism, linked with particular
values of 'V' and 'S' is responsible for the cyclical behaviour. When income
rises so does the desired capital stock, but the actual capital stock is not
increased until the next period.
MODIFICATIONS TO THE M[]LTIPI,IM. . ACCE,MAIOR INTMACIION
There are several irnportant features of actual trade-cycle experience
which the multiplier-accelerator mechanism considered on its own fails to
explain:
1) While the accelerator theory could explain net fixed investrnent
when it is positive it cannot explain disinvestment. When the actual capital
stock exceeds the desired stock, the rate of disinvestment is determined not
just by ttle decline in output but also by the rate at which the capital stock
t76
depreciates. It is for thisreason that the aclluierittor principle u'orks better
as an explanation of inventory investntertt than of fixed investment. The rate
of both increases and decreases in stocks is directly linked to the behaviour
of actual and anticipated sales. Therefore the accelerator principle can be
applied to the analysis of inventory cycles.
2) Positive net investment has not ceased entirely during depressions,
as occurs in the multiplier - accelerator model.
3) The cycles generated by the multiplier-accelerator interaction are
either damped or explosive. Only if V and S have particular values in a
regular cycle of constant amplitude produced. To achieve this, V must equal
I for all values of S. Such stringent requirements are unlikely to be fulfilled
in practice.
In order to provide a more satisfactory theory of the trade cycle the
multiplier - accelerator relationship has been modified and supplemented in
various ways. The relationship can be made non-linear by allowing S and
V to vary over the cycle. The theory of permanent income rationalises
procyclical movements in the MPS. The gap between the desired and actual
capital stock can be expected to get smaller as the boom proceeds. Both
factors reduce the rate at which aggregate demand grows and can thus
rationalise an upper turning-point in the cycle.
An alterative way of generating cycles is to limit the explosive path of
the multiplier - accelerator interaction by imposing floors and ceilings to the
level of real output. This is Hick's solution. The floor is set by autonomous
investment and the ceiling is determined by limitations on the quantity of
labour supplied and on the capacities of the capital-goods industries.
T.INIT. 2
TIM MOI\trEIARIST INTERPRETAflON OF TRADE CYCI,ES
The monetarist view holds that while money has no long-run effect on
real national output, in the short run monetary disturbances cAn exert powerful
independent influences on real output. The relationship between money and
income in the USA has been thoroughly documented by Friedman and
Schwartz. They single out four periods of economic stability, 1882-92, L%3'
13, Iy23-29 and 1948-60, during which real income grew at similar rates but
the rate of change of the price level varied between -t% and 2%. The
variation in the rate of change of the price level is explained by differences
in the rate of growth of the money supply. They consider that the long-
run rate of gropth of real outpgt and".the mon€y supply arc largely
independent.
 \n
Short-run monetary fluctuations are associated with simitar fluctuations
in real output. Friedman and Schwartz consider that the primary casual link
goes from monetary changes to yariations in real output. They believe that
this is particularly important in the explanation of severe contractions. Six
of the contractions are classified as severe : 1873-79, 1892-94, lW7-08, l92l-
22, 1929-33 and 1937-38. In the seyere contractions the money supply
decreased and four of them were accompanied by a banking crisis.
Since the money supply has generally continued to increase during
less severe reaessions. Friedman and Schwa(z relate fluctuations in the rate
of change of the money supply to variations in economic actiyity. From
certain evidences Friedman and Schwartz conclude that changes in the rate
of growth of the money supply cause changes in the same direction in real
output. This leads Friedman to avoid the use of discretionary monetary
policy since it is likely ln these conditions to be unsuccessful.
Another issue concerns the fiming evidence. Friedman recognizes that
the (ming of a relationship whereby variable X leads variable Y by no means
justihes the conclusion that X causes Y. Tobin and others have devised
models in which income is the casual factor but money leads income or in
which money is the prime-mover but income leads money. Friedman's
theoretical underpinning of a casual and timing relationship that goes from
money to income is not fully worked out. But the altemative possibilities,
such as an increase in output inducing a rise in the money supply several
months before the increase in output actually occus seem less plausible.
Thus Friedman concludes that money supply changes occur independently
of output and produce disturbances in output.
Cagan provides frrther detailed evidence for the USA of the cyclical
behaviour of the determinana of the money stock. He estimates that about
one-half the vadation of the money supply about its trend is accounted for
by the currency-money supply ratio, one-quarter by the reserve ratio and
one-fifth by 'high-powered' money. Since 'high-powered' money is subject
to govemment control it can vary independently of income, unless the
government chooses to allow it to vary with income. This leaves us with
the currency and reserve ratios as variables which could depend on income.
As the demand for money grows more (less) rapidly in relation to its
supply, the rate of interest is predicted to rise (fall). If a rise (fall) in the
interest rate decreases (increases) the currency or reserve ratio, the money
supply will expand (contract), given a constant 'high-powered' money base.
In this event the direction of causality if from income to the money supply
so that the latter is endogenous.
Cagan considers the eyidence to support this interesGrate mechanism
to be weak but finds other ways in which the state of business activity
t'78
influences the curency and reserve ratios. As the expansion approaches
the peak the currency ratio tends to rise. The rate of growth oI the nroney
supply falls and checks the growth of output. Once the contraction sets
in both ratios rise. Banks become more cautious about lending and wish
to strengthen their liquid assets position. The public raise their desired
currency ratio. Both these factors lower the money supply and strengthen
the forces of attraction. This process may become self generating, as the
attempt by banks and the public to make their assets port- lblios more liquid
drains banks of cash reserves. Banks then need to liquidate more assets
and the public draw out more cash, losing confidence in the bank. Monetary
factors can therefore contribute to cyclical disturbances in economic activity,
both by occurring independently and by being related to changes in national
income.
KEINESIAN Vs MONEIARIST INTERPRETAIIONS
Therc are two aspects to the Keynesian argument that money is of
little imponance in influencing the level of economic activity in the short
run. One is that the money supply should be determined endogenously by
national income. The other is that national income should be unresponsive
to changes in the money supply. This necessitates velocity changing so
that money supply changes are rendered ineffective. An increase in the
money demand, accompanied by a reduction in the rate of growth of the
money supply causes higher interest rates, which drive up velocity. This
means people are financing each pound's worth of annual income with less
money. If money is to have little influence, the changing demand for money
with respect to output that occurs over the trade cycle must be accompanied
by large pro- cyclical variations in velocity. Also, the change in interest
rates which accompanies the change in velocity should have little effect on
expenditure.
The observation that velocity rises in the upswing and falls in the
downswing therefore weakens the case for the powerful influence of money.
Friedman distinguishes between measured velocity, the usual calculation of
velocity, which is curent income divided by the stock of money and desired
velocity, which is permanent income divided by the money stock. Since
permanent income changes less over the cycle than measured income, desired
velocity will vary less than it appears to do when measured in appropriately.
Thc Keynesian emphasis on the casual role of real variables,
particularly investment, in generating trade cycles places the
responsibility for cyclical fluctuations firmly with the private sector. This
contrasts with the monetarist view that monetar.y disturbances are thc
major factor in causing cyclical fluctuations. 1he private sector is
inherently stable but is subjected to monetary shocks brought about by
the authorities.
 r79
MODULE. VII T]NIT.1
EQULIBRIT]M AND DISEQT]ILIBRIT]M ANALY$S
WALRASTAN EQIJTLTBRTUM ANALY$S
Walras's Law :-
The crucial feature of neo-classical economics is that when market
demands and supplies_ are in imbalance, prices will adjust to bring about
market clearing equilibrium in all marketi. The first major economist to
expound
adjustment mechanism in a general equilibrium context was
-this(1954).
kon Walras
In a walrasian economy particulai importance attaches to the idea that
each trader makes his demand and supply plans on the basis that he can
buy and sell as much of any good u. h"-*intr to at the prevailing prices
given his budget constraint. No trader plans to spend more than his income
or earn income in excess of his planned purchases. so although a trader's
excess-demand
a particular good may be positive or negativl the overall
-for
sum of excess demands for all the goods musf be equal to iero. lf the trader
has a positive demand m-l of the goods, he must have an equal
positive exges-s supply of-oyer
the m th good in order to finance his pranned net
purchase of the m-l goods.
If the sum of excess demands over all m goods equals zero for one
trader, then it must also equal zero for all traders ind hence for the economy
as a whole. This result which is a consequence of the budget constraint
is known as walras's Law. ie, walras's law states that the sum of excess
demands over all the goods in the economy must equal zero and this applies
whether or not the markets are in equilibiium.
GENIERAL EQULIBRITJM
consider a simple model with two goods A and B. There is only one
independent relative price, the price of 1 in ter*s of B, which gives
number of units of B which have to be exchanged in order to buy-one
the
unit
of
.A. The relative price of B in terms of A is- not independent tecause it
is just the reciprocal of A in terms of B. The market is cleared
at the relative
price level of A.
- If there are m goods are exchanged in a market there will be m-l
relative prices at which all markets will be cleared. The m-l relative prices
can be expressed in terms of a common standard. one good is considered
as a 'numeraire' and the relative prices of the other gooJs *" expressed
as
the numben of units of each good which exchangl for one unit of tt
numeraire. If we chose good I as numeraire, then thI price of the numerairc"
P, is fixed at one and the other m-r prices a." in number of units
"*p.eri"d
of good I.
180
The Thtonnement :-
Although there exists a set of relative prices consistent with Walrasian
equilibrium it is to be explained that how this competitive equilibrium set of
prices arrived at. walras posits the existence of a fictional auctioneer who
undertakes no trading. The auctioneer fixes a set of relative prices and find
the levels of excess demand in each market at this set of prices. If general
equilibrium is not achieved, the auctioneer tries another set of prices. prices
are raised in markets with positive excess demand and lowered in markets
with negative excess demand (or excess supply).
This is the Walrasian adjustment mechanism by which excess demands
in some markets are matched by excess supplies in other markets so that
prices rise and fdll in each type of markets in order to move it towards
market-clearing equilibrium. The auctioneer keeps on trying different sets of
relative prices in this way until he finds one set at which all markets are
cleared. The process by which auctioneer gropes towards equilibrium set of
relative prices and quantities is known as 'tatonnement' (for groping).
The simultaneous market model :-
If we admit money in to the Walrasian model we need to introduce
some consideration of time. Traders will have a demand for money balances
which is required for transaction purposes. Individual's utility now depends
not only on the amount of m goods but also on the volume of money
balances held at the end of the tradering period. It is convenient to use
money as the numeraire good so that the prices of other goods are expressed
in terms of money. If there is excess demand (supply) over all m goods
markets, there must be an equivalent excess supply of (demand for) money.
General equilibrium can only be established when all markets, including the
money market are cleared. Adding an aggregate excess demand for money
function into the model.
m
Mr=k I. p, Q*
8=l
The demand for money function is provided by the quantity theory of
money whereby the demand for money is a constant proportion, k of the
money value of transactions. The total nominal stock of money is fixed at
Mto, so we can write the excess dema'nd for money equation as
m
P, 9r-ML
g=l
' 'The'excess demldnd foi moirtiy eqiiatlon"a'long wiih m-l exdess demand
functions for
goods provides m independent equations to determine m
goods. prices in terms of money. The inclusion of an explicit sector the
 . r8l ta
mo$el to determine a unique price level so that there is only one prices Patinkin differentiate between positive and negative real balance effects.
in terms,of the numeraire money for each good or services that is consistent The real balance is positive when an increase in the quantity of money
with gelreral equilibrium. There will be one set of prices in terms of money increases the real balances too. For explaining negative real balance effect
which, given a particular money stock, make the excess demand equation for the help of the following figure js used.
money equal to zero. Given k, the nominal quantity of money determines the
absolute price level.
Let the economy is in general equilibrium. Let us assume that all
traders have their nominal money balances doubled and the auctioneer calls
out the previous equilibrium set of money prices. The money supply now
exceeds traders demand for money. Since Walaras law holds, the excess
supply of money is matched by an equivalent demand for goods. To get
back to general equilibrium the auctioneer has to double all money prices.
The nominal demand for money now rises to equal the increased nominal
money supply. Relative prices of goods are the same as in the previous
equilibrium. Hence in a competitive equilibrium set of relative prices ; a Rcal Good
change in nominal quantity of money affects the absolute price level
proportionally (i.e, money is neutral).
In this scenario, the demand for goods is affected by the quantity of
real balances held when the money market is in disequilibrium. Traders are
then undertaking portfolio adjustments. An excess supply of money balanpes
exerts a positive impact on the demand for goods, where as an excess
demand for money balances depress the demand for goods.
DON PATINKIN: TIIE REAL BAI"ANCE ETTECT t2S I50
Real Balance
Don patinkin criticized the Walrasian assumption that an increase in Fig. 7.1 The Real Balance effect
money supply rises the absolute price level without affecting the relative
prices. In his monumental work'Money, interest and prices", he disapproved There are two goods, money and commodity, both are equally preferable.
classical dichotomisation of goods and money markets and then reconciles Total wealth of consumer consists of goods and real
the two markets through the real balance effect.
balances. W=G+M
The separation of classical system into two independent sectors, the
monetary sector and the real sector is called the classical dichotomy. The
Real wealth, W7P=P*G/P+M/P
demand for and supply of goods and services is determined in the real Lct us assume that the general priccs level is 2. From thc rlgure,
sector (i.e, the commodity market), while the demand for the supply of
money determines the absolute prices level in the monetary sector (i.e the 300/2=2*10CIノ 2+100/2
money market). To Patinkin both real and monetary sector depends on the 150=100+50
real balance people held. Real balance means real purchasing power or the
stock of cash holdings of the people. He says that as the prices level The individual traded the real good and the real balance in order to
changes as a result of a change in money supply, it affects the demand for maximise satisfaction. 150〓 80+70
and supply of goods and services. This is the real balance effect. When the When the price level increases the real wealth decreases to 125, then
price level increases due to a rise in money supply real balance of the the balancing equation is 125 = 65 + 60
people reduces. and ,consequently they spend less on goods and sq.rvices.
This leads a fall in prices. Thus, the changes in absolute price level change ' rhi: ieauciion in tt"'.eli'*i;iit[ ii.'i,'r.L*riio to izsi'ii ii" n"jutiu"'
the relative prices. real balance effect.
 183 tu
DISEQLITLIBRIUM ANALYSF relatively short, but within that period traders plans are made consistent via
quantity rather than price adjustment so there is no incentive for agents to
The crucial assumption behind Walras law is that when trade takes
place it occur at market clearing or equilibrium prices. When trade is known change their plans within the time period of analysis. The economy is shown
to occur only at market clearing prices which the traders treat as given, then as moving from one short-run equilibrium to another since further adjustment
do occur which prevent the short-period equilibrium from being permanent
traders make choices on the assumption that they can buy and sell much
resting-place. The short period is often characterised as one that is not long
of any good or service as they please subject 'to budget constraint. With
enough for price adjustment to occur, hence quantities have to do the
no auctioneer to find the market clearing set of prices, there will be false
adjusting. This characterization reflects the keynesian view that quantities
trading at non-market clearing or disequilibrium prices.
adjust more rapidly than prices.
Effective demand r walrasian auctioneer ensures that trade do not occur unless the real
Once falls trading takes place at non-market clearing prices then it wage is at market clearing equilibrium. The exfieme neo.Keynesian assumption
becomes unrealistic to the traders to make plans based on the presumption is that in the absence of walrasian auctioneer the price level and the money
that they can buy and sell as much they like to. If households find that wages are fixed in short-run. False trading occurs at this prices. Let we
there is an excess supply of labour, then not all households can sell as much consider different kinds of non-marketing clearing states which can arise
labour as they would like to at the prevailing prices. In other words, they when false trading occurs.
are quantity-constrained on the labour market. Consequently, some The classical unem[loyment :
households incomes are lower than they would have chosen them to be in
Suppose that money wage rate and the price level are fixed at values
the absence of quantity constrains on their supply of labour. With lower
which yield the real wage in excess of the market clearing real wage, w. The
incomes than they would have had in the market clearing equilibrium
effect of this assumption on the demand for and the supply of the labour
households cannot purchase as many goods as they would have chosen to
is illustrated in the following figure.
by their equilibrium demand functions.
The effective demand for goods is the amount that the households can
actually purchase given the quantity constraint on their sales of labour. Output
Given the distinction between equilibrium and effective excess demands,
walrasian economics is characterised as considering only equilibrium plans,
whereas Keynesian economics is concemed with false trading in which
effective excess demands are different from equilibrium ones and it is the
former that determine the level of output and employment. F
NEO-KE"TNESIAN QUANTTTY CONSTRATNm MODETS

Neo-Keynesian quantity constrained models show the implications for

output and employment of trading in non- market clearing places. Though
they share with the post- Keynesian approach in rejecting the Walrasian Excees Supply
theory, do not reject the other features of neo-classical methodologies. The
crucial distinction between neo-Keynessian and neo-classical models is that
the former do not presume that markets clear in equilibrium whereas the later 0 L I-s LabourUnits
do. The neo-Keynesian models solve for temporary or short-run equilibrium
in which markets are not necessarily cleared. The period of analysis is Figure 7.2 The labour market: Classical Unemployment
 185 185

A real wage higher than w provides the real wage line DE. DE has a is due to insufficient level of effective demand for goods. This unemployment
steeper slope. A real wage now equals the marginal product of labour at is called involuntary unemployment. B
point o, and firms demand for labour is now DL. At the higher real wage
households indifference curve is tangent to the real wage line at point B.
Households supply of labour is Lr. There is an excess supply of labour of (0
LrL. units. The unemployment which arises when the real wage rate is Output
greater than the market clearing real wage is termed classical unemployment
by new-Keynesian writers.
The repressed inflation : vedemand
We now assume that the money wage rate and the price level are fixed
at values which make the real wage less than that required for market
clearing equilibrium.

Output

Real wagerate

一
 Ｇ ・
w2
We

wl

ヽ Ir Lubou.
With a real wage lower than w, the real wage line is now GH and has
a less steeper slope. Again households indifference curve and the production
function are tangent to the real wage line at different points T and 6
respectively. Firms' demand is OL, units where as households are only
willing to supply OL, labour now for the real wage below w. There is an
excess demand for labour of LJ-, units.
By assumption, the money wage cannot rise even though there is
excess labour demand ; hence this case is termed repressed inflation.
Involuntary unemployment
The neo-keynesians proved that unemployment can occur when the
real wage rate is at or below the market clearing level. The unemployment
I-u, Iat Labour
+ Excess Supply
Figure 7.4 The labour Markefi Keynesian Unemployment
Let the money wage rate and the price level are fixed and are consistent
with the market clearing real wage rate, we. The real wage line is given as
AB. However, the effective demand for national output is assumed to be
only OY.r. If the firms produced the level output OY" at which marginal
product of labour equalled the real wage rate, they could not sell all of it
because of insufficient effective demand. Firms are, therefore, constrained to
produce OY* output and hence their effective demand for labour is OLuo.
 187
At the real wage level wc,fronl the second figure, houscholds supply
of labour is OLc unitt but as they are rationed they can only se■ OLED uniも
There is,therefore,an excess supply of labour of LED It units.Firms are
off the market clearing labour function and houscholds are off the market
clearing supply of laboun Therefore,there is no unique relationship between
the real wage and employmcnt. Given the effective demand constraint C)YED'
the level of cmployment of OLD is consistent with any rcal wage rate
between wl and w2・ When f1111ls are quantity― constraincd to produce OY
level of output at the real wage ratc we'the ttarginal product of labour is
greater than the rcal wage(at the point K in flgureJ.ThiS means that firms
would be willing to expend output and employ morc of labour at the c対 sting
real wage rate if the effective demand for output were high∝ Thus,we gct
the result for nco― Keynesian modcls that involuntary unemployment can
exist without the real wage rate bcing too high(i.e,above its market cicaring
levcl).The real wage rate can be at or below the market clearing one but
a lack of effective demand gives rise to involuntary unemployment.
FEXED・ PRICE… CO∬ 硼 RAttЧ L■ J MODEL
The model consists of three markets ; the goods markets, the labour
market and the money market.We assume that money market attuStS quickly
so that is cicared in each slort― run period of analysis.This leaves us with
two markcts, the goods market and the labour market, which may remain
uncleared.Houscholds are sellers of labour and buyers of goods ;flrms are
seHcrs of goods and buycrs of labour. When a market cxpcriences excess
supply then seners are rationed;when it has excess demand the buyers are
rationed:￨
HousOhOlds arc rationed seners when there is excess supply of labour
and rationcd buycrs when their is excess demand for goods. Firlns are
rationed seHcrs when there is excess supply of goods and rationod buyers
when therc is excess,demand for labour. When it is out of market cleaHng
equilibriunl, therc are two possibilities in each market.
1. When there is exccss supply9 the actual quantity sold is equal to
the amount dclnanded.
Ⅲ ｀
2 面し
1'I漢 1'Lttessど こ
品hど ふざ腱tL『 hII品 t'′ 慧
品 t・ ヽ歯 お
the amount sellers wish to supply.
188
Thus, the short side of the market determines the quantity actually
. traded contrary to market clearing equilibrium where demand and supply are
equal.
The households have to take a dual decision on the amount of labour
supplied and the amount of output demanded which are interrelated. If the
households are rationed in labour market, then the amount of output they
effectively demand is constrained by the amount of labour they can sell.
Altematively, if households are rationed in goods markets, then this may
affect their supply of labour decision.
Firm's dual decision involves the amount of labour to be employed and
amount of output to be supplied. If firms are rationed sellers in goods
market, the firms' demand for labour is constrained by the effective demand
for output in goods market. Similarly, if the firms are rationed buyers in
labour market, then amount of output they can supply is constrained by the
effective supply of labour in the labour market.
The dual decision hypotheses means that a quantity constraint in one
market affects demand or supply in another market. That is, the specification
of effective functions for the supply of labour and output and the demand
for labour and output will vary according to whether or not firms and
households are rationed sellers or buyers.
Keynesian unemployment exists when firms are rationed sellers in the
goods market and households are rationed sellers in labour market. Output
is limited by effective demand so that the real wage rate is less than the
marginal product of labour.
If the households are rationed sellers in the labour market and firms
are not rationed in the goods market, firms are producing the level of output
for which the marginal product of labour equals the real wage. This excess
supply of labour is the classical unemployment.
Repressed inflation is characterised by rationed buyers in both markets.
Firms' output is restricted by the labour supply: Thus, the marginal product
of labour exceeds the real wage.
POLICY IMPLICATIONS IN QUANTITY.CONSTRAINED MODELS
' Neo-Keynesian model are used to denionstrate the validity'of 'Keynesian
policies for reducing unemployment. In this situation, where there is no
 189 190

taxation, fiscal policy consists of changing the level of government

expenditure. The government can also conduct monetary policy by directly
giving money to households or taking it away from them. Both monetary
and fiscal policy changes shift the effective demand schedule, which now

０一”﹄０∞”た′、０“〇口︼Ｃ一Ｏｍ“”〓ｏ ﹄Ｏ ハ
includes government demand as well as household consumption. The only
difference between a monetary and fiscal expansion concerns the allocation
of goods between government and households. If the government increases
money supply, then the households can spend more. If government
expenditure increases, the government purchases more goods. The
government's third policy instrument is the prices and incomes policy by
which the government can arbitarily change the price level and money wage
rate.
To maintain the fixed price assumption we need to analysed the effects
of monetary and fiscal policy under a fixed exchange rate regime. Given a

〓““
fixed exchange rate, the government cannot alter the price level. Hence, real
wages can only fall if there is a cut in money wages. By manipulating the
exchange rate the government can alter the price level in a neo-Keynesian
open economy model. This gives the government an additional policy
instrument. o 1 2 3 4 5
Unemployment eercentage)
The policy conclusions of neo-Keynesian models seem sensitive to the
Fig。 7.5 The phillips Curve
effects of expectations held regarding quantities. For instance, a fall in
excess of labour can make the households more optimistic about future The coexistencc of positive unemployment with rising wage rates can
employment prospects and hence cause them to increase current conzumption. be explained by the existence of frictional unemployment.Even if the labour
The same conditions can cause firms to become more optimistic about sails market is in equilibrium some frictional unemployment will exist.Ъ is would
and this increases the demand for labour. Such behaviour could generate bc the level of unemployment at which thc Phillips curve cuts the horizontal
instability and gives quantity constrained models more of a 'boot straps' axis. Any reduction in unemployment below this implies excess demand for
element than is present in models which only contain price expectations. labour and results in五 sing money wages evcn though unemployment is stin
positive.
I.]MT 2
IIM PHILLPS CI.]RVE h the economy as a wholc some markets will experience cxcess supply,
others cxcess demand. When wc averages over an thcse markets then a
A statistical relationship between unemployment and inflation was first
positive average rate of unemployment duc to thc excess supply market can
introduced by Phillips in 1958. Phillips conducted a study of the relationship
be accompamed by a五 sing average money wage rate because wages in the
between the annual rate of change in money wages and the annual
cxdess demand markets Hse more rapidly than they decline in the excess
percentage rate of inflation using the U.K.- Data for 186l to 1957.It was
supply markets.Thc higher the general level of aggregate demand the lower
observed by him that the rate of change in money wages is inversely and
the average rate of unemployment and consequently the faster is the inoreasc
non- linearly related to the percentage rate of unemployment. The relationship
in average money wage rate.
established by Philips takes the following graphical form.
 191
tvz

TIIE NATT]RAL RATE OF UNENIPLOYMEIYT IIYFO'IIIESIS change in unemployment. This argument is explained in the figure given
The breakdown of empirical phillips relationship in 1960's coincided below which assumes 0= 1.
with new theorerical works notably by Friedman and phelps which denied
the existence of a permanent trade-off between inflation and unemployment.
Long - run Phillips Curve
The fundamental microeconomic relationship between the level tf
labour demand and the rate of change of real wages is the following."*""r,

∽ｏ““た′ヽｏ目〇︺‘ 僣“Ｏ∞Ｃ“〓０︶ ︺０ 〇一““

W/IV = f Pr;
where -*/w is the rate of change of real wages which is assumed to
be a function of unemployment, u. By definition the actual rate of change
in real wages equal to the rate of change in money wages minus the rate
of inflation, F/p.
i.e, ilw = il/w --dp

∞
０
When the workers and employers set money wa-ge rate, each party is
really concemed with the real wage rate which dependJ on the expected rate
of inflation. Therefore, the relation becomes
w7w=W7w-EG/p)
where E(p / p) is the expected rate of inflation.
If the workers are rational they fulry adjust the increase in money
wages for the expected increase in prices to obtain the resulting change in
real wage rate. If the workers do not take into account the inilation they Fig. 7.6 The expectations - argumented phillips Curve
expect to occur when estimating the real income from their money income, we start with an economy which has stable price level and constant
they are said to have money illusion. Money illusion would causl one not real and money wages. Assume that there is no growth in labour productivity.
resnonry his future real income even though he is correctly anticipating
19 O The short run Philips curve for a zero rate of expected inflation is pcr. Since
the rate of inflation that will occur. Therefore a coefficient o is subsequently
the price level is stable the unemployment level is U*. This level is defined
attaehed to the price expectations to account for the behaviour of
money as the rate of unemployment which is consistent with labour equilibrium and
illusion. cr = 1 if the emproyees are rational and adjust fully their money
wages to compensate for expected inflation. at which the price level could be stable.
The government usually chooses to keep the economy at point A of
Wrw=P6Y +E(B/p)
short-run Phillips curve PCo by expansionary policies which increase the
fr/w=f(u)+E(F/p) money supply. The rate of inflation now rises to 5vo and the level of
a = I if the workers completely adjust their money wage to compensate unemployment falls to u*. As expectations adjust towards the actual rate of
for expected inflation and 0 < = cr ( = l if they partiy adJust their money inflation, workers realise that real wages are lower than they had anticipated
wage. and therefore require a more rapid increase in money wage rate. The supply
of labour schedule shifts up until it regains its initial long-run position once
Friedman argued that the phillips curve therefore would shift in such
expected and actual inflation are equal. As the supply of labour shifts back
a way that in the long-run a higher rate of inflation would result in no
to its original position, the short-run phillips curve also shifts outwards
 I%,
r93

becduse the expected rate of inflation is rising. When expectations are fully
adjusted to the new higher rate of inflation the short-ruo Phillips curve in
. the figure has shifted up kl PC, which is its position when the expected rate
of inflation is 5 percent. The economy is now at point B in tigure.
Unemployment is back to its natural rate but there is now a 5 per ccni rate
ol inl]ation. The idea that thers is no way in which the rate of uncmploymcnt
can be pcrmanently held at a ditTerent ievel to the natural rate of
unemployment is known as natural rate hypothesis.
TIIE NEW MICROF{ONOMICS OF LABOUR MARKET - 'TIIE SEARCH
11iF0RY'
Since the neoclassical theory predicts that the long-run equilibrium
level of real output is invariant with respect to inflation, the apparent short-
run trade-off between output and inflation need to be rationalized. This has
resulted in a re-working of the neoclassical choice theory, what is known as
the 'new micro€conomics'. The major innovation of the new microeconomics
is that the assumption of complet€ information is dropped. The other
essentially neo-classical features are retained.
l. Economic agents maximise utility over time.
2 All exchanges which are perceived as mutually benehcial to economic
agents are conducted.
In other words, markets clear, though the market clearing equilibrium is
only temporary if expectation tum out to be wrong.
The crucial idea for explaining the existence of a short-run negatiyely
slopped Phillips curve is that the workers ssrch for jobs. It is presumed that
a job search is morc effective when a person is unemploycd since more time
can be devoted to do it. An unemployed worker has a reservatjon real wage
in mind below which the will not accept emplo)rment. When a worker first
start searching for a job his reservation real wage is based on his previous
money wage and his expectations about the future changes in the price
level. As he searches he gradually revises his reservation real wage in the
Ifmoney wages are rising bat actual inflation exceeds the expected
rate, unemployed workers will take less time to find a job olfer which pay
them morc than their reservation wages. The duration of unemployment falls
and so does the number of unemployed. While it is unanlicipated, inflation
rcsults in a higher level of real e)utput. As actual reseryation wage rate
comes k) he expecled. the workers revise their reservation money u/age
upwards, search takes longer and unemployment rises towards its natural
rate. Search theory thcrefore provides a microeconomic foundation for the
natural rate hypothesis.
A (ru(iJl fulure ol thrs approach is that markets clear:tll time. Economic
agents base their buying and selling plans on their expectations about the
future. Market prices adjust to reconcile the demands and supplies that are
conditioned by this expectations. When expectations turn out to be wrong,
agents revise their plans and prices adjust accordingly. The 'new
microeconomics' can theiefore analyses dynamic changes in the economy
by means of markets which are always in market clearing equitibrium.
ADAPTIVE EXPECTATIONS
To derive a short-lun trade off between inflation and unemployment we
have assumed that the expectations of inflation are based on Past rates of
inflation. Whenever inflation accelerates expectations of inflation lag behind
the actual rate. The adaptive expectations hypothesis assumes that the
expected rates of inflation is revised in the light of the past erors in
anticipating inflation. It can be expressed algeb,raically as follows.
E(dp/p), - E(d1p),., = L (dp/p), - E(dp/p),.,
Where E(dp/p) is the rate of inflation expected at time t to rule in the
next period t+l and 1 is the adjustment parameter which lies between 0 and
l. Thus we have.
E(dp/p), = E(d/p),,, + I (dp/p), - E(d1p),.,
i.e,
E(dp/p), = (l-1.) E(dp/p),., + I (dp/p),

light of job offers received. The individual will only accept a job offe.r if the Sinilrly,
present value of he real income stream expected from the job exceeds the
E(dp/p),., = (l- )") E(dp/p), ! + i"(dp/p),_,
prcsent value of expected income derived ftom continued search. The latte,
depends on how income the worker expects to forgo by refusing the job E(dp′ pλ 2=(lλ )E(dP/p、 3+ λ
(dp● た2

offer and on how much income he expects to gel by waiting for a better job ヽ
offer. 十 一

c uP/6108r'08v1fl m/sDE-7
 ・ 195 . 196

E(dp/p)t_n=(1‐ λ)E(dp/p)..1 +λ (dp/p)t ll 叩 ♪―(卜 わ Щ p=0-わ に出 )‐ 0■)● p/p、 1

Substituting for E(dp/p).1,E(dpノ p)t2'CtC・ ,we get )(dMp♪ ―

1.e.,【 U♪ =(1‐ λ (1‐ わ (d的 日)+(1‐ わЦ
Ц.1)
n
E(dpノ p)t=(1-λ lE(dp/p)..1 +λ Σ When(d出 )= (dp4,.1)
)n・ (1-λ )i(dP/p).1
1=1
as n… … >0.Hcnce
>0,(1- λ )n_― ― 【Ч)=(1-わ い、 1)

E(dp/p)t= Σ (1-λ )n(dP/p)tn Therefore,叩 ♪=(1-め 【

i=1
Ц直)
1t is observable from the equation that the current cxpected ratc of
as n tends to inflnity(1-わ tendS to zero.Hcnce sゝ tendS tO Zero. ■

inflation depcnds on the past histOry of inflation. Wc have This is the natural rate of unemployment and will be established under
adapttve expectations.Therefore no long‐ nm trade― off exis、 lmder adaptive
(dwノ w)=(U)+α E(dP/p)
cxpectations.Differentiating with respect to time,we get
When ∝=1, (dW/W)=f(U)+E(dp/p)
fO♪ (du/dt)=(1-λ )d(dpわ )dt
Lct us assume that the prices are set in temls of a rlxed mark― up over
labour costs, so that i.e,f(U)is negative as Phillips curve is downward sloping.
p = (l+m)w
where nl is the rate Of mark― up over wage in the economy as a whole. Given F (U)< o, 0 く く l and (du/dO く O d(dprp)/dt >o i.e,
Taking logarithms on both sides, uncmployment nlust fall in the short‐ n川 l aS inflation“ cOlerates.11五 s offers
the possibility of permanently lowering the unemployment by continuously
log p=log(1+m)+10g w accelerating inflation. This hypothesis is known as the acceleration
I》 ifferentiating with respect to tiine, we get hypoは
dp/p*1/dt=dw/w*1/dt RAT10NAL EXPUATIONS
ic; dP/p〓 dw/w Adaptive expcctation model is severely criticized becausc of the
aS,umption that people base this expectations on the values of lagged
therefOre, (dp/pt)=f(Ц )+E(dp/pp variables and fail to learn about their past erors. Therefore, when the
Substituting for E(dp/pt) expectations are adapt市 c there is a systcmatic error over successive periods
and they are senally corelated.
【U♪ =(dp/pt)
λ
夢ト If econonlic agents are rational they wim make use of an the available
infomation when forming expectations and notjust rely on past vィ lues of
By using Koyck transforlnation,ic;by taking one lag of the cquation, the relevant variable. Expectations which are conditioned on an availablc
we get infol..lations are caHed rational expectations.When expectations are fomed
rationany the erors between actual and expocted rate of illnation are random
f(U:.)=(dp/p)t.‐ (dP/p)t_n_1 .… .(7.2.1) and arc scriany uncOrrelated. So the cxpected mean error is zero. Then
multiplying bOth sides by(1-λ ),
(dp/pt)=ρ (dPIp)+Ct
(1-λ )【 Utl)=(1-λ )(dp/p)t_li(1-わ 叶l ep/p)t_...… 。
(7.2.2) where et is a randonl error with zero mean.
Σ
i=1 For instance if the increase of inflation is due to increase in money
supply such that
subtracting equation(7.2.1)frOnl(7.2.2)we get
(dP/pt)=p (dト ウヽ4t)+ ヽ
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， ＾
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 一口ｏ日 、０一。日 Ｏｃ﹁︼  ¨Ｃｏ日 、ｏ一。日 ０口●
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ＯＬ‘   一
一● ● ●● Ｃ ¨  ＣＯｏゝ 一ｏつ   ﹂摯ｏ ︲ｏＯ “﹄一  目 ●﹄  ´﹄Ｏ ｒ ∽  ｄ   ●ｏ＞。   一０●   ∽一  ＯＬｏ〓二 働〓¨
。   。‘こ ０   ００●ｏ∞﹄●∽●﹄ ｏ工い   一〓“う ０〓一  ︺Ｏ   ∽︻。● 〓０∽  ﹄ｏ〓︺Ｏ ，
一Ｃ● Ｏ● ｏＬ  ﹂Ｏ   〇一“一●一∽● ヽ
ＣＣ¨∽ョ︻０●００ ｏ‘一 ︵ Ｖ︶ の０“● ︻ ︵Ｅ︵輌ｏ﹁ｏ〓﹁ ∽Ｃ〇 一Ｃ一９００ＸＯ 一 “●０ 一“︼ 摯Ｏ ＣＯ“●０〓α″一 ” ｏ´い
¨目。日 付 場 ０¨目９ 場 ∽¨
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 t9
i,3 U.,- U,= - 0 (dp/p,) - s(dp/p,)
Where U^,= National rate of unemployment
U,= Actual rate of unemployment
dp/p = Actual rate of inflation
E(dp/p) = Expected rate of inflation
This means that the actual unemployment rate lies below the natural
rate by an amount which depends on the difference between actual and
expected inflation. one best example of such rationalization is Lucas
intertemporal substitution model.
LUCAS' INTMTEIVIFORAL SI,JBSTITUIION MODEL
The basic premise of Lucas approach is that one should model the
behaviour of the rational agents whose decision depend on rhe relative
prices only. For example, household utility has the usual specification that
it depends positively on present and future consumption and leisure. Agents
decisions are therefore crucially dependent upon expectation about future.
Expectations about future wages and prices are govemed by normal values
or the long-run equilibrium wages and prices, since actual wages and prices
are assumed to move towards their normal values. Because of this reasoning
normal and expected values are used interchangeably.
If the current real wage exceeds its normal and expected value, then
households regard the current real wage as being temporarily above the
future real wage. This gives the househoid an incentive to work more in the
current period and less in future. Becausc the model pressures this type of
behaviour it is known as the intertemporal substitution model.
The model explains fluctuations in unemployment in terms of the
voluntary choices of household to vary their supply of labour over time in
response to perceived temporary changes in the real wage. The model does
not take account of any job search because the unemployment is regarded
as the withdrawal from active labou' force. A simplified version of Lucas'
labour supply function is
L,{E(L) = h [q/E(w,)l
Where \ is the labour hours supplied in the current period, E(L,) is the
normal long-run labour supply, W, is the rea! wage in current perirod and
E(W,) is the normal, expected real wage.
m
Thus, when households perceive the current real wage rate to be
greater than its expected level, they will increase their supply of labour
relative to its long-run normal quantity. Hence, the actual rate of unemployment
U, kill fall below the natural rate of unemployment Uf Similarly, when the
real wage is thought to be less than its normal expected level, households
rvill reduce the supply of labour and the actual rate of unemployment will
rise rbove the natural rate. As the ratio q / q" has an inverse relationship
with the ratio L, I E(L), we can see that
U,/ U., = h [W,/ E(WJ]
Similarly, the supply decision of a firm depends on its perception of
the current price of its products relative to its future price. If the firm
perceives a future increase in the demand for its products, this will mean a
rise in the product price relative to its marginal cost at the permanent, then
the future relative price will be perceived as higher than the curent relative
price and the firm will wish to invest in additional productive capacity.
However, if the rise in price is considered to be only temporary, the frm will
not engage in any additional investment.
Typically, part of any change in wage and price will be regarded as
temporary and part as pefinanent, so inducing increased supply from both
households and firms. The difficult agents have in distinguishing tempcrary
from permanent ch.urges is a crucial feature of new classical models as it is
vital to generating fluctuations in output and employment. Agents cannot
distinguish temporary from permanent price and wage changes because they
Iack complete information.
IN@MPT,ETE INFORI\,IAIION
Since the economy consists of a very large number of markets, an
individual agent cannot in practice observe all prices in all markets. He has
incomplete information and only observes a few prices which are of immediate
relevance to him. Consider the case of a particular good which is traded
in a number of separate markets. Each trader is limited to ffansaction in first
one market, market Z. A trader in market Z knows the current price of the
good in market Z but not in other markets.
In ordcr to decide whether the current price of the good in market Z
is high or low relative to the future price, the trader compares the current
price in Z, P (Zt) with its normal or expected value E(P(Z),). It is assumed
that the price in market Z is the average price of the good in all markets
plus some random component *L (Z), , which applies only to market Z the
 m XD

random error f41n, (2,) captures the effect of stochastic real stocks an aggregate demand function. Nominal aggregatedemand is defined as
which shift the demand and supply function for the good in market Z. Thus. usual as real output times price level. A portfolio adjustment equation which
determines the desired holding of goods, interest bearing assets and money
P (2.) = P" + l(2) is added. The aggregate demand side of the model doesn't differ significantly
from that in the Keynesian Neoclassical synthesis.
Where P (Zr) = observed current price in market Z
The following aggregate demand and supply diagram explains the new
P" = -ean price of the good over all markets
classical model.
*L (Z), a random normally distributed error term with zero mean and
=
constant variance.
Since P is the average price of the good over all market, the mean error
term E (*L @) is zero so that over all markets the random shocks cancel
out on average.

In forming and expectation of the normal price of the good in market

Z the nader has to decide how much weight to place on { and how much
to put on the observed current price in market 7, P(Z), The trader has to
decide how much of any given change in the observed current price is due
to,
(a) A general change in price level which affects all market for the good
(d* to. a change in {)
O) A real change in relative price of the good in market Z (in the random
disturbance term, (Z))
In forming an expectation of the current general price level individual
have two sets of information. One is the history of the general price level
and its determinants. Individuals are assumed to know what the general
price level was in previous periods. The other piece of information is the
current prices of a few goods in which the individual regularly hades. If the Figure 7.7 ADruSTMENT IN A NEW CLASSICAL MODEL
current general price level of the good a trader supplies rises he incorrectly
attributed it to a rise in relative price. Trader therefore increases the supply. Let as assume that the market is in long run equilibrium aggregate
demand in Do, output is at its permanent level Yo and the price level Po.
Once the trader realizes that the rise in the price of his product is due Let the government increases aggregated demand to D,. The short run
to a rise in general price level supply falls back to its permanent level. The supply function when the expected price level is Po is SRASo. At first the
rise in output is only temporary and so there is no longer run trade off
price level rises to P,. The traders expecting the general price level to be
between output and the inflation.
Pothink relative prices have risen and expands output along SRA,So to Yl.
A COMPLETE NEW CLASSICAL MODEL As traders adjust their expectations about general price level so the short-
In a new classical model aggregate supply consists of a permanent run supply function shifts upto left (to SRASr) Output has returned to its
component and cyclical conlponent which depends on the divergence between previous level as long run aggregated supply is invariant with respect to
actual and expected prices. A new classical model is completed by adding price level.
 VB
IMPLICATIONS OENEW CI-ASSICAL MACROECONOMICS
The new classiial economics has a number of important implication
which need lo be broughl ()ut.
1. The natural rate hypothesis: The new classical approach restates the
natural rate hypothesis in a stronger form. Output response positively and
temporarily to an increase in the current price the good if the increase
-of
is not regarded as completely due to rise in- leneral price level lf the
increase in individual price is attributed entirely! to a rise in general price
level than there will be temporary increases in iupply. An acceleration in
the rate of inflation will not cause any rise in output if the faster rate of
inflation is perceived straight away so that actual and expected rate of
inflation rise to by same amount.
2. The impotency of systematic monetary policy: The argument underlying
the strong lbrm oI natural rate hypothesis leads to the conclusion that
gove.nmcnt cannot reduce unemployment by operating a systenlatic monetary
policy. If the Govemment operates a poiicy feed back rule, it will determine
the appropriate change in money suppiy as specific fesponses to the
divergence in output from trend. For instance, lhe following feed back rules
rclatcs the current money supply to the stock ney in the previous
period time the diyergence of output from trend.
i.e.
M, = M,, +P(Y,-Y,.,)
Given that, the private sector knows the past values of money stock and
output divergence, it can corectly predict what the current periods money
supply must be. As a systematic policy cannot cause a divergence between
actual and expected rates of inflation, it cannot increase the level of output
and employment.
3. The Significance of variance in price l€v€l: The size of the impact on
real output of a rise in price depends on how much of the rise in individual
price is attributed by traders to an increases in the general price level rather
than to a rise in relative price. A high average inflating rate is likely
associated with a large variance in general price level. The new classical
economists therefore predict that mor€ a country tries to secure output in
excess of the permanent level so permits higher and higher inflation rates,
the smaller becomes the ffade off between further inflation and output.
4. The importance of structural policy parameters: The new cla--;:al
approach highlights the significance of the structural paramLi ::r ior
n4
determining the efect of macroeconomic policy. According to keyncsian
analysis, shuctural parametem are invariant with respect to policy measure.
l.he new classical economists argue that ttrc structural Parameters vary with
policy changes and hence invalidate the whole set of econometric models.
It completely undermine the keynesian case for govemment macroeconomic
policy, since it is deduced that the government macroeconomic policy,
cannot improve the stability of the economy. The best govemment can do
is not to make the economy mor€ unstable by its actions.
The new classical macroeconomics is a significant development because
it undermine the theoretical basis of keynesian economic policy. The new
classical supply function is the crucial element in refutation of keynesian
analysis. The assumption of rational expectations is an important aspect of
the new classical approach, but without the new classical supply function
it would not oyertum the keynesian policy conclusions. The introduction
of rational expectations has exposed an important weakness in keynesian
policy analysis. That is, that it is derived from models which assume that
the structural parametem are variant with respect to policy change. This
cannot be the case if the expectations are formed rationally. The new
classical economics also has its theoretical weak spots. The role of incomplete
information on money in equilibrium business cycles and the market clerning
assumption are generally questioned.
LTNIT - 4
ST'PPLY SIDE ECONOMICS
INTRODUCIION
Usually new economic ideas or suggested changes meet with
considerable resistance, generate controversy and are subject to close scrutiny
and debate. Society has progressed through the agdcultual reYolution and
the industrial revolution and perhaps is on the threshold of a third wave of
economic revolution. In the socio-economic potitical realism, we have moved
away from rugged individualism and self reliance to more govemment financed
income security and expanded federal entitlement programs. Supply side
economics is one of the newest concepts to be integrated into political
policy. Suppty side economics is one of the newest conc€pts to be. integrated
into political policy. Supply side economics can be defined as a study of
policies designed to stimulate economic growth and to promote price stability
.through various measures that effects the supply bf goods and services.
These measures included lower taxation, increased savings, greatfl investment
and stronger work motiYation.
 ffi
Roors oF SLIPPLY SIDE ECONOMICS - TrrE cr-A,ssICAL DocrRrNE
According to classical and. services, demand was always adequate to
match the supply of goods and services. This belief was basei on say,s law
of markets. According to say, goods, and services are only superficially
bought for rnoney. Actually, they are bought with other gooas und services.
According to say' is not the money that generates demand but supply or
production. In short, say's law is based on the premise that the production
of a given level of output generates sufficieni income to purchase that
amount of output, and thatsavings are directly or indirectly diverted to
investments.
In a barter economy, Say's law is varid since supply does create the
demand. Even in a monetary economy, if goods proaucei were exchanged
for money and all the money was used to pu."h"r" goods and services,
supply and demand to equal. All income generated through production
would find its way back to purchase the goods produced.
According to classical the supply and demand will always be equar
and any amount and services can be moved off the market. prlvided they
are right kinds and amount of goods. Therefore, the economy will
automatically move upto a
full employment level.
The classical theory is based on certain assumptions that tend to be
idealistic.
1. FULL EMPLOYMENT: one of the important classical assumptions is
that the only point at which the economy can be in equilibrium is that
of full employment.
2. DPENDITLIRES EQUAL INCOME: since the classicals hold that the
primary purpose of money is its use as medium of exchange, they
maintain that all income will be spent. Any decrease in consumption
will be offset by an increases in investment.
3. SUPPLY CREATES DEMAND: The classical theory assumes that the
production which creates supply also creates an equivalent amount
of
monetary power (demand) and it is assumed that all the income will
be
spent. Thus, supply creates its own demand.
According to the classicals suppry and demand will always be'equar
and any amount of goods can be moved off the market, provided they
are
in right kinds and quantities. Therefore, the economy will automatically move
upto a full employment equiribrium lever. what the classical proposed for
ffi
economic growth are the policies aimed to regulate supply of goods and
services rather than aggregate demand or money income.
SOMEDEF'IMIIONS
Prof. Arthur. B. Laffer refers to the supply side economics as the New
economics of individual incentives. According to him supply side
eronomics" is a recognition that the people change their behaviour when
marginal incentives changes". Michael Evans defines supply side economics
as "the model that stress on supply side centring on the stimulation of
productivity". According to him, Keynesian economics could not deal with
the current economic problems because it concentrates only on the demand
side of the economy. Prof. Martin Feldstien says that supply side economics
emphasize the need for new tax incentives to encourage people to save and
business to invest in new and more efficient factories and machinery.
According to Norman B Tune the supply side theory is based on the
principles developed by the classical economics. supply side economics is
short-hand for a way of analysis the effects of government policies and
actions on the economy. It is applicable to public policy problems particularly
tax and fiscal policies. According to him, supply side economics holds that
government spending and tax policies influence the economic behaviour of
household and businesses by changing the relative costs they confront. Dr.
Panal craig Roberts states that "the essence of supply side economics is
to regard tax rates changes as relative price changes affecting the supply
and structure of labour, savings, investment and visible economic activities".
Supply Side Policies
Recognizing supply an important elements of economic analysis supply
side economists put forward some major policy initiatives of national interest.
1. Large and sustained personal and corporate tax cuts to induce more
work and capital investment.
2 Keeping monetary growth in line with long-run growth potential of the
economy.
3. . A slow down in the government spending and a .cducti,-rn of nations's
tax burden relative to the GNP, thereby facing more flnancial resources
to private investment.
The above proposition are based on the following assumptions.
Resource mobilization can be influenced by supply promc-rting policies. The
supply of resources will be influenced by the tax system. The supply of
 ?fr7
output depends on the supply of inputs or tesources. The supply of
resource and total output, therefore, so affected by a public policy.
SUPPLY SIDE TAX POLICY
Suppty side economists challenge Keynesian policies as being one
riimensional insofar as they concentrate on changing effective demand and
ignttre supply. Supply side economists emphasis on policies stimulation
supply so as to expand output. The supply side tax policies are based on
the following assumptions.
l. A reduction in tax rates increases the incentive of individuals to save
by raising the rate of returns on assets held by individuals this higher
savings leads to lower interest rates and higher investment.
2. Corporate tax rate cuts or similar measure such as increasing investment
tax credit improve investment directly by increasing the average after
tax rate of return.
3. Higher investment leads to an increase in productivity which means
that more goods and services can be produced per tnit of ipput.
4. The transfer of resources from the public to the private sector increase
the overall growth rate in productivity since the productivity gains in
the public sector are small or nonexistent.
5. The faster $owth in productivity provides the needed capacity to
produce additional goods and services demanded because of the tax
cut, leading to balanced growth without bottlenecks or shortages.
ヽ ﹁ １ ■ ■ハロ，
6. Lower inflation leads to an increase in real disposable income and
hence rising consumption and" employment
7. Lower tax rates improve work efforts, resulting in an increase in the
quality and quantity of the work. This in turn raises productive capacity
still further, thereby contributing to the slow down in the rate of
inflation.
8. The lower rate of inflation causes an increase in net export which
strengthens the values of domestic currency. Thls leads to further
reduction in the rate of inflation because imported goods decline rather
than advance in prices.
SOME SI,]PPLY SIDE PROFOSMONS
Michael K Evas criticised the developing model that ignored supply
side of the economy. He blamed the sad state of'US economy at the 1980
m
period on demand side policy designers. Evas challenges Keynesian policy
as being one-sided insofar as they ignore supply. He also challenges the
Keyneisan model tenet that a redistribution of income via taxation in favour
of lower income groups will rise spending, output and employment because
poor people spend a larger share of their income than do rich people' He
that ttris could cause a decline in saving and investment and have
"tui*i
an adverse effect on production employment and income. This possibilities
is left out of the Keynesian model.
The supply siders also challenge the Keynesian assumption that
spending stimulates demand and saving retard demand. Savings can be
useful in providing funds for investment. Moreover, supply side economist
claim thai personal saving are affected by after - tax returns earned on
savings. ThLy also reject the keynesian finding that government spending
will iesult in larger increase in demand and output than an equivalent
reduction in taxes. The Keynesian reasoning holds that with govemment
spending the entire money goes for additional demand. If taxes are cut,
howevei some of tax remission may be channelled into savings, which do
not contribute to increased demand. Thus, according to keynesian policy
the effect of tax cut on the economy is less than that resulting from an
equivalent increased in government spending.
According to Eavans, supply side analysis shows exactly the opposite
result which he enumerates as follows.
A reduction in tax rates increases the incentive of individuals to save
by raising the rate of returns on assets held by individuals. This higher
savings tiads to lower rates and higher investments. Higher investment
leads to an increase in productivity, which means that more goods and
services can be produced per unit of input. The faster growth in productivity
provides the needed capacity to produce additional goods and services
demands because of tax cut, thus leading to balanced growth without
bottlenecks or shortages. The tax measufe provide a strong incentive to
economic activity.
TIIE L{trtr'ER. CI]RVE
Aconcepfrequentlyassociatedwithsupplysideeconomicsisthe
laffer curve regarding the relationship between tax rates and tax revenue'
This relationship was put forward by Prof. Arthur B Laffer and is based on
the assumption that people will work more when their after-tax wages rise
and peopli will invest more when their after - tax profit or rate of rchrm on
investment rises. This, in turn, will result in a great€r tax revenue.
 M 2t0

According to Laffer, there are two extremes of tax rates that produce
no tax revenue, a zero rates and tNTo tate. At one extreme people would
pay no taxes. At the other extreme, IOOVo tax rates people would hale no
incentive, thereby paying no taxes.
Point of max, tax revenue
According to Tyler Cowen, the most serious drawback of the Laffer
, curve is that it may be used for the purpose of maximizing government
revenue. He suggests a curve replacing government revenue on the horizontal
axis of the laffer curve with private sector productivity. The new curve
representing the trade-off between the rate of taxation and productivity will
show that productivity is at its maximum when the tax rate is zero.

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Supply siders challenge the slope and the shape of productivity curve

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contenting that maximum productivity would not be associated with a zero

、
tax rate, since it would mean the lack of some basic tax supported essentials

、
such as road, water ways, law enforcement, primary education and other
A BCDE public goods and services. Thus, Robert Keleher taking into consideration
Tax Rates the existence of these public goods and services, financed through taxation,
Fig. 7.8 The Latter curve presents a tax rate- output graph as follows.

一●ａ一●︵︶ ０一“∞Ｏ﹄““く
Somewhere between the two extremes is a tax rate that will maximise
tax revenue. This is shown in the figure above. The Laffer curve rests on
highly uncertain condition. In order for a tax cut to have a positive effect
on revenue, the initial tax rate must be higher than the optimum rate that
maximizes tax revenue.

In figure, it must be to the right of point C Thus, if taxes are reduced

from point E to point D or C, total revenue will increase. If the existing
tax rate is at or below the optimum rate, a cirt in the tax rate will reduce total
revenue. A cut in tle tax rate from the point B to A for example would
reduce total tax revenue. Also the amount of tax cut must be just the right X Tax Rates
amount if revenue is to be maximised. Fig. 7.10 Tax rates and Aggregate Output
 zLl
This relationship indicates zero output when the tax rates is either zero
or 100 percent. Maximum aggregate output occurs at point which corresponds
to some optimum tax rate, X
In a study conducted by Don Fullerton measured where the economy
was no the Laffer curve by analyzing the relationship between tax rates and
tax revenue. According to him, the US economy is not operating in the
prohibitive range of the laffer curve where higher tax rates reduce work
activity thereby lowering the tax revenue substantially.
TIIE CURRET{T FOLICY Sf,ilTT.IS OF SUPPLY SIDE ECONOMICS
Many of the measures advocated by supply siders such as lower
taxation, less government expenditure have been implemented as a matter of
policy on a few previous occasion in the past. There are many examples in
the realm of political economy in which famous economic policy makers were
strong advocates of supply side economic policies. Some of the measure
such as tax cuts, tax credit and accelerated depreciation, recommended by
supply siders to increase productivity and output were favoured by
Keynesian economists as means of increasing investment and effective
demanil.
Supply side measure were prominent among US economic policy duing
'80' s. Tax cuts of 3O% over a three year perid, reduction in federal
spending less government regulation and favouring accelerated depreciations,
tax credits were implemented for stimulating savings, invest and productivity.
carter Administration in 1980 in its Economic Report of the president cited
the need for improving the structural performance of the economy by
providing supply sides incentives and encouraging investment and shading
excess government regulations.
In the l98l Economic Report it is stated that tax reductions which
induce savings and investment will contribute to faster productivity and
help of reduce inflation. The report concluded the following regarding tax
reduction and fiscal policy.
l. Specific investment - oriented tax reduction are likely to increase savings
investment and productivity by a much more significant degree than
cut in personal income tax.
z P.roduct'ivity oriented, tax reductions yield improvements,in the inflation
rate that are helpful and significant, but still relatively modest in the
context of a lO% underlying inflation rate.
212
3. The supply response, while a critically important feature of any tax
reduction, will be substantially less than the demand response
particularly in the short run.
4. Since reductions is both business and personal taxes will increase
demand faster than supply they must be designed and carried out in
way that consistent with the demand restraint to reduce inflation.
Although, tax measures focused on increasing supply can make a
significant contribution toward reducing inflation, there is a continuing need
for careful and prudent fiscal policies to restrain demand.
The Reagan supply. side package
In 1981 Reagan Administration adopted an Economic Recovery
prograrnme which included the following measures.
l. A reduction of $ 5.5 billion in the current 1981 budget
Z A $ 49.9 billion cut in federal expenditure for fiscal 1982 $ 79.7 billion
in 1983 and $ 126.8 billion by 1986.
3. An across - the - board l0 percent annual penonal income tax reduction
for three years from 1981.
4. A reduction over a three year period in the maximum marginal tax rates
on invesfrnent income from 70 perc€nt to make it equal to the maximum
on wage and salary income.
5. An increase in the income level at which the maximum tax rates rates
take effect.
6 Accelerated depreciation via a version of the Capital cost recovery
Act.
7. A continuation and increase in the use of tax credit for new investrnent.
With this programme Reagan recommended that the Federal Reserve
keep the growth in money supply at a more stable rate in line with the ギ
growth in real output.
The supply side economic recovery programme was designed to
encourage savings, stimulate investment, generate productivity accelerate
real economic growth, lower interest rates and reduce both unemployment
and inflation. The U S administration were forecasting l.l%o i*.in real GNP
for t98l and 4.2% in 1982,S.V:Vo in 1983 and a real growth rate of 4.5% for
1984..At.the same tirne.they..projected.a drop;i6. tl16.rate of inflation..from
ll.L% in 1981 to 83% in 1982 and to 5.5% by 1984. During the period
unemployment was expected to fall from 7.8Vo in 1981 to 6.49oby 1984.
 213
DIODllLE中 Ⅷ
DIACROECONODIIC POIICY
Ⅳ【acroeconomic Policy refers to the instrument by which a govemment
tries to regulat or modify dle cconomic affairs Of a country in kceping with
certain`ゎ jeCt市 es. An act市 iSt macrOeconomic policy lnvolves setting
monetary and flscal variables in cach tilne period at the valucs which arc
thought neccssary to achieve the govemment's obi∝ t市 CS・ A basic premise
of Keynesian economics is that the private sector is inherently unstablc. It
is suttcct tO frequent disturbances in thё components of aggregate demand.
Stabilisation policies holds thc rcal national output and unemployment closer
to its market clearing equilib五 um time path.
Activist stabilisation poHcy can take two foll.s: it can bc cither a
discretionary policy or a fcedback policyo E)iscretionary policy reSponse
::淵 sF:。 諸 乳 淵 記 電 F:富 魔 [含 h肝 咄 驚 『 』 富 iげ :淵
should take and this formula would remain unchanged for a co五 siderable
time span. :
The main o切 ∝ t市 es Of macroeconomib pOlicy are fun employment,
stable price level and satisfactory economic growth.
TARGEr ANDINSrRUMurAL VARIABM
Target variables are deflned as those variables for which the gOve_ent
scek desrablc values. Thё targets are set with a vie■ to maximising sOcial
welfare. Policy makers are represented as an cH無 ぉ united group who can
detemine unique values for the targct variables with a well― deflned criteFia
of social welfare or public interest. In order to achieve the desired valucs‐
of the target variables the deteminants of the target varilb10s must take on
appropriate values. Instrumental variables are those variables that the
government can manlpulate to achicve its∝ onomic obiCCayes.Insmmental
vaHables are necessaril,as the govemment must be able to detemine their
values indepcndently of the othcr variables in the economy. The example
for instrumental variables are the money supply, tax FateS,ctc.¨ : there can be a portfollo attusment involving a movement out of l■ oney
D10NErARY POLECY
Monetary policy is the excrcise of the central bahks control over the
money supply as an instrument for achie宙 ng the ottect市 es Of the
to輸 面 いi Mttta●・と /61i"わ r曲
攣モぬぜおむ tttrも 宙ひacFlい 品 読F6f
such o可 ∝dveS as fuH employment,staЫ c prices and∝ onomiё ttrOWth
214
in■ ucncingthe level of aggregate demand and thereby the level of money
income.The Ccntral Bank's influencing on the level of agε tta“・ demand
and money income stems fЮ m its ability to control thO・ inohじ ソヽupply.
硼 ROLE OF MONErARY POLICY‐ ¶EE KEWNEttAN VIEW
Though the transmission process by which a change in money supply
causes a change in thc level of income is explained in the carly Keynesian
平Odel・ It iS better explained in the theory of po■ folio attuStments.
As far as the individual is c6nccmed hc can hold his wealth partly as
assets and partly as money. Their portfolios contain a particular amount of
moncy and flnancial asscts and there is a balance between these two. If
a disequilibriunl is created lby an increasc in the mOney in their portfolio's
the individual may substitute other flnancial assets for excess money
balances. This is becausc of the expected yields on various real assets.
This constitutes an increase in the demand for rcal assets. Increased
demand for existing stock of real assets win mean higher pricc for them and
this will stilnulate the production of more such goods.
Although it appears to be● e mmo important component,the increased
demand for real assets is not limited to purchase of capital goods used in
business operation or to ownership clalins on such goods. Thus,an increasc
in supply of money will bHng about a seHes of substitutions in portfollos,
which when completed will mcan an incrcase in holdings of assets as
consumable durable goods as wen as the real assets and rlnancial assets.
ThiS attustmCnt will stimulate the prOduction of more capital goods and
ralse the levcl of income.
皿 MONErARISTS'VIEW
Although, monetarists trace the effect of changes in money supply
山Юugh a portfolio attustment process,thcy differ on the effcct of a change
in intcrest rates. Friedman and others do not accept the Keynesian
propoSition that changes in interest rates are a prerequisite to changes in
the dcmand for goods and services. Fonowing an increase in money supply9
directly into goods. They argue that end results necd not be a change in
interest ratcs but a change in percapita inc6me or in Output.An increase
in money supply can lead directly to spending for real asscts. Monetarists
do not accept the Keynesian vicw that spending can bc affected only
indiFCdy:避 chtttrates,or yioldttOn・ 面 面 К 晟 」困師 聰 ′ 山 ∝ 蝸E,prospective
prorltability of acquiring rcal assets alter the prospective profltability of
 215
acquiring real assets and thereby affect the rate of spending for various
kinds .of real :assets.
Eventhough, monetarists reject Keynesian explanation, they failed to
explained, systematically, how a change in money supply can directly affect
income level. The monetarist conclusion of a direct relation is one of the
most self- evident positions in economics. As they explain, because an
increase in the amount of money means that the public as a whole now has
nrore money than before, such an increase must be on the public will raise
its total spending above what it was before. An increase in money supply
from one period to next creates additional disposable income. There is an
unquestioned direct relationship between change in disposable income and
the level of demand, so there must be similar relationship between the
change in money supply and the level of demand.
REGTJI,A^TING TTIE MONET SUPPLY
Although monetarists argue that the money supply shows a relatively
close relationship between the level of income and output, a possible
alternative guide variable is the amount of reserves held by the commercial
banking system. As changes in this variable are.almost completely under
Central Bank's control they reflect changes in government policy.
The instruments of monetary policy are of two types, one quantitative,
general or indirect and the other qualitative, selective or direct. The first
category includes the bank ratio variation, open market operations etc... The
selective credit control aims at controlling specific types of credit. They
include changing marginal requirements and regulation of consumer credit.
1. Bank rate policy: It is the minimum lending rate of the Central Bank
at which its rediscounts, first class bills of exchange and government
securities hold by the commercial banks. When the Central Bank finds
that inflationary pressures are emerging within the economy, it rises the
' bank rate.
2. Open market operations: It is the most important instrument of the
monetary policy. It is the purchase of and sales of government
securities so called the open market operations.
3. Changes in Reserve ratio: This weapon was suggested by Keynes.
Every bank is required by law to keep a certain percentage of its total
deposits in the form of reserve funds in the Central Bank. When
prices are rising the Central Bank rises the Reserve ratio.
216
4. -selective credit control: They usually take the form of changing the
margin requirements to control special activities within the economy.
TIIE LAG IN TIIE IMPACT OF MONEIARY FOLICY
Monetary policy can be used counter cyclically only if the monetary
authorities know the length of lag between the execution of polity and the
impact of that policy on aggregate demand and income. If the lag may vary
from a few months to a few years, the fact that there is no way to predict
the length of lag in a particular case, rneins that an effective monetary
policy is beyond reach. The monetarists differ in the judgement that whether
or not an effective monetary policy is possible.
Although every one recognises that some lag exists and the lags will
not be always be the same length, many economists agree that the lag is
neither so long nor so variable to neutralise the effect of a policy. But
Friedman points out that these uncertainties rules out any possibility of a
counter cyclical monetary policy. In his view, there is not question that
increases or decreasing the growth rate of money supply will have definite
effects in the short-run on the level of real economic activity, the issue is
the inability of Central Bank to use monetary policy to obtain stabilizing
rather than destabilizing effects.
FISCAL FOLICY
Fiscal policy refers to the deliberate use of federal govemment spending
and taxing as possible means of attaining and maintaining full employment,
a stable price level and a satisfactory rate of growth. Activist fiscal policy
began during the 1930's largely as a result of the apparent ineffectiveness
of monetary policy in overcoming the severe unemployment of the Great
Depression. From the relatively modest beginnings, fiscal policy has become
a major means by which the government attempts to achieve high employment
and to prevent inflation.
Fiscal policy was succeeded with deliberate use of government spending
and taxing as possible means of attaining and maintaining full employment,
a stable price level and a satisfactory rate of growth' The ultimate aim of
the fiscal policy is the long-run stabilisation of the economy. Fiscal policy
through the variations in government expenditure and taxation profoundly
affects the national income, employment, output and price.
l. Budgetary policy: The budget is the principal instrument of fiscal
policy. Fiscal theorists argue that during depression govemment should
follow a budget deficit and surplus budget during boom.
 217

2 Compensatory ,iscat policy: Its aim is continually compensatirrg the

eronomy against chronic inflation and deflation through tax and
expenditure.
鰈勲 挙
ざ翼『袖補藤麟
鱗
INSTRI'MEIYIS OF FISCAL FOLICY
∞rate b、 ■ fOllows
Fiscal policy calls for variations in government purchases' transfer that he ttζ ｀
群 F￡ 暇ぽ』if品 電]ミぶ
payments and taxes order to change the existing levels of income and a濃
e:絆
output.
by a][ltttT醐席 ‖ 」
1ぷ品 翠盟 鯛
Govenrment puNhas€s employment throughout the year

One way of reducing demand side inflationary pressures is to reduce ie,FEBS=t Yt― G― R
the level of government purchases, thereby releasing resources to me€t
priYate demands.
Thansfer palments 絲 鸞 ￨
%縣 螺 測 輔
Transfer payments by the federal govemment would appear more output levol
effective than purchases because they can be more quickly expanded or FEBS― ABS = t Yt― tY
contracted as conditions require.
= t(■ ―η
Thx€s '
The ttBS differs from the ABS only lf Y!differs from Y
The variations in taxes can be used to eff€ct changes in aggregate
supply as well as in sggregate demand. Taxes will raise peoples incentive
to work, encourage an increas€ in saving and thus increasc the investment'
When the economy faces deficient aggregate demands and recession,
appopriate fiscal policy may, of course, be to cut tax rates.
FIILL EVIPIJOYMEhIT BLTIrcET SURII.US
The federal government's budget Programme for each year-fixe's bcth
planned expenditure and tax rates. However, the government cannot frx but progra― e itscl■

can only estimate the size of the deficit or surplus because the actual size FLEXIBILrrY OF I・ ISCAL POLICY
will depend in part on the level of economic actiYity. Given the possibility
of economic activity may Yary over a sizable range, an unchanged programrne
of planned govemment expenditure is accordingly gonsistent with a whole
range of possible surPluses or deficis. The Full Emptoyment Budget Surplus
gives a measure of the stimulus or restmint exerted by a particular fiscal
programme. Any adjustment in the fiscat to vary the restraint or stimulus
exerted by that programme calls for changes in the level and composition
of govemment purchases, transfer Payments or taxes. We have the actual
budget surplus/deficit (ABS).
ABS=T"-G-R
 2t9
m
Built in flexibitity
policy is of two rypes. The first type of policy is that in which the labour
Built in flexibirity is achieved when changes in tax coilections and unions are persuaded to adopt a co-operative attitude over wage bargaining
government spending vary automatica[y, promptt,
in the right direction to and to accept no,,ns- set by the government. The second iype.poriciei
produ_ce a stabilizing effect on ugg."guti demand. 'means
This that no attempt to reduce or destroy the power of trade unions in wage bargaining.
specific action to be taken^ ana tnJinanges in govern."ri
and The following are the major instuments of income policy.
"^p*Jiture
tax collections do not lag far behind ttre ctranges in aggregate
demand. The
1. WAGE AND NON.WAGE INCOME FOLICIES
and reduced tax colrection, whereas the increases in algregate
demand call Prices cannot be stabilised unless wages are kept within the limits of
for increase in tax collection and reduction in governm?"JErp"nr"r.
aggregate demand and income rise automatic-increase in
wt", increase in productivity. For keeping labour costs stable, the government
ta* receipts and may adopt voluntary policies.
decrease in transfer payments lead to contraction. wt
ug!.Liui" a".rna
and income fall decrease in tax receipts and increase "n
il
;;:1:;';aymenrs 2. PRICE FOLICr
Iead to expansion.
The government may adopt a price poricy whereby prices should be
Formuh flexibility kept unchanged whenever possible. .

Formula flexibility relies on changes in selected indices

unemployment rate or the consumer pri-ce index as an indicatoi
such as the 3. PRICE CONIROL
or a neea
for specific,changes in income tax rates, transfer payments, Price controls are limited to essential goods and services. under the
etc. Formula
.exlDurry arso work automatic-ally in response to realised of price control prices are allowed to increase acconding to unavoidable
changes in the systern
economic situations. It differs from built-in flexibility in costs.
such a way?at uuilt- changes
in flexibility is obtained within the existing tax and ransfer p"y-"k
whereas the formula flexibility, once actlvated,
,t u"n r", 4. TAX BASE) INCOME FOLICT
changes trie struciure itserr.
INCOME FOLICY These policies are different for different individuals and firrrs. The firm
which keeps wages down to the target rates are rewarded with a reduction
lngoT"-policy emerged after the Second World War as an atrempt to in business income tax. Individuars who k€,pt wage increases below the
control inflation in advanced countries. Monetary and fiscal poricies
can target rates are rewarded with a tax reduction.
reduce the inflationary pressures, but at the cost
ofincreasin! un!*proy-"rt
among the labour force. These policies fail to take
into acJount th" i.pu"t Stndy Materiols Prepared by:
of existing economic structures and institutions on demand- pull
and cost-
push. inflation. Fconomists advocate, therefore,
an income poti"y *t i"t i, ,1. lt{s. Vimala
considered as effective as changing institution or
thei*t u"turi.. Dept. of Economics, J.M. Centre,
The rationale of income policy is inherent in the argument that there Aranattukara, Trichur
is^a stable relationship between the price of a good
and th-e unit labour cost Chapter : Modules I, II and VI
of producing it. consequently, if money wage rates rise no faster than the
productivity of labour, unit labour cost will nbr Z ll{s. Savitho
rise and therefore
will not rise. To slow the inflation rate accordingly requires tt the prices
in money wage rate be cut back uiin"."ur" Dept. of Economics, J.M. Centre,
it is no greater-tii"n it gro*th rate of Aranattukara, Trichur
labour productivity. "
INSTRUMENTS OF INCOME FOLICY Chapter : Modules III, IV and V

- Gardner G Ackly defines income policy as "a deliberate

and organised
3. Mr. Surcsh Kumar. M.S.
and continuous government effort to pi^uui" business
to avoid or delay increase-which they might have otherwise
*ortrolni
ott Dept. of Economics, J.M. Centre,
"r,
made in prices. . Aranattukara,Trichur
wages' rents, dividends or in any other form
of money income". The income Chapter : Modules MI and VItr
ヽ ■ ●一
●生 ¨
ニ