MACRO ECONOMICS

UNIT – 1

Q. Explain with appropriate diagrams the classical theory of income and employment. – 8 mark [ MU 2017 ]
Or
Discuss the classical theory of income employment and output. – 8 mark [ MU 2019 ]
Ans : Classical theory of income and employment
Classical economists such as Adam Smith and Ricardo maintained that the growth of income and employment
depends on the growth of the stock of fixed capital and inventories of wage goods.
The magnitude of national income and employment depends on the aggregate
production function and the supply and demand for labour. To show this let us
assume that the economy produces one homogeneous and divisible good, say corn.
Let symbol Y stand for the output of this good.
we have the following aggregate production function
Y = F (K, N)
In the short run the stock of capital (i.e. plant and equipment) is assumed to be
fixed.
Thus, rewriting the aggregate production
Y=F ( Ḱ , N)
With a fixed capital stock as employment of labour increases, marginal product
of labour would diminish. The classical theory assumes perfect competition in both
the factor and product markets. At a lower real wage rate, more labour will be
demanded or employed by the firms and vice versa. This implies that at a higher wage
rate, more labour would be supplied and vice versa. It will be seen from Fig. 3.1 that
supply and demand for labour are in equilibrium at the real wage rate (W/P)
There is neither excess supply of labour, nor excess demand for labour. But
given the competition among workers, the excess supply of labour at wage rate
(W/P)1 would cause the wage rate to fall to the equilibrium level (W/P) 0 at which the
labour market is cleared. On the contrary, if somehow real wage rate in the labour
market is (W/P)2 the firms would demand more labour than is offered at this real
wage rate
How much output will be produced in this full employment situation can be
readily known from the aggregate production function. We depict this in Fig. 3.2
where in addition to the supply of and demand for labour, the aggregate production
function (OY) representing the relation between employment of labour (N) and total
output (K) is shown. It will be seen from the lower panel of Fig. 3.2 that, given the
stock of fixed capital and the state of technology, employment of ONF labour
produces OYF output.

Q. Show how a change in money supply does not affect

the real sector in the classical system. 4 mark [MU 2017]
Neutrality of Money .
In the classical model based on flexibility of prices and
wages, changes in money supply only affect the price level and
nominal magnitudes (i.e. money wages, nominal interest rate, while
the real variables such as levels of labour employment and output,
saving and investment, real wages, real rate of interest remain
unaffected. This independence of real variables from changes in
money supply and nominal variables is called classical dichotomy.
 Suppose to begin with, the stock of money in the economy is equal to M 0. With this, as will be seen from Panel (d) of
Figure 3.7, aggregate demand curve for output is AD 0 which with interaction with aggregate supply curve AS determines
price level P0. Given the price level P0, labour-market equilibrium determines money wage rate W 0 and real wage rate equal
to W0 / P0 and level of employment N F in Panel (a) of Fig. 3.7. The level of employment N F given the production function,
determines aggregate output YF. in Panel (b) of Fig. 3.7. Now suppose there is expansion in money supply from M 0 to M1
which causes an upward shift in the aggregate demand curve from AD 0 to AD1 [see Panel (d) of Fig. 3.7], As a result of this
upward shift in the aggregate demand curve from AD 0 to AD1 price level rises from P 0 to P1 Now, as will be seen from
Panel (a) of Fig. 3.7, with money wage rate W0 and price level equal to P1, real wage rate falls to W0/ P1
When demand for labour exceeds supply of labour. This will cause money wage rate to rise to W 1 in equal proportion
to the rise in price level so that real wage is restored to the original level (W 1/P1 = W0/P0) and labour-market equilibrium
determines the original level of employment N1.
With the same level of labour employment aggregate output (i.e. GNP) will not be affected. Thus, we see that with
the expansion in money supply, nominal wage rate and price level have risen, but real wage rate, level of employment and
output remain constant. Hence it shows that money is neutral in its effect on real variables.

Q. Critically examine Fisher’s quantity theory of money. [ MU 2017 ] – 12 marks

MV
Ans : Fisher’s theory can be best explained with the help of a famous equation i.e. MV = PT or P =
T
The value of money or price level is also determined by the demand and the supply of money. Supply of the money
consists of a quantity of money in existence (M). It is multiplied by the number of times this money changes hands which is
the velocity of money (V). V is the transaction velocity of the money in Fisher’s equation. That means that the average
number of times a unit of money turns over or changes hands to effectuate transactions during a period of time.
Therefore, MV refers to the total volume of the money in circulation during a period of time. Since the money is only
to be used for transaction purposes; the total supply of money also forms the total value of money expenditure in all the
transactions in an economy during a period of time.
#Criticisms of the Theory:
The Fisherian quantity theory has been subjected to severe criticisms by economists.
1. Truism:
According to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of exchange is a simple truism
because it states that the total quantity of money (MV+M’V’) paid for goods and services must equal their value (PT). But
it cannot be accepted today that a certain percentage change in the quantity of money leads to the same percentage change
in the price level.
2. Other things not equal:
The direct and proportionate relation between quantity of money and price level in Fisher’s equation is based on the
assumption that “other things remain unchanged”. But in real life, V, V and T are not constant. Moreover, they are not
independent of M, M’ and P. Rather, all elements in Fisher’s equation are interrelated and interdependent. For instance, a
change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change in the quantity of money. Similarly, a
change in P may cause a change in M. Rise in the price level may necessitate the issue of more money. Moreover, the
volume of transactions T is also affected by changes in P. When prices rise or fall, the volume of business transactions also
rises or falls. Further, the assumptions that the proportion M’ to M is constant, has not been borne out by facts. Not only
this, M and M’ are not independent of T. An increase in the volume of business transactions requires an increase in the
supply of money (M and M’).
3. Constants Relate to Different Time:
Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and V to a period of time.
The former is a static concept and the latter a dynamic. It is therefore, technically inconsistent to multiply two non-
comparable factors.
4. Fails to Measure Value of Money:
Fisher’s equation does not measure the purchasing power of money but only cash transactions, that is, the volume of
business transactions of all kinds or what Fisher calls the volume of trade in the community during a year. But the
purchasing power of money (or value of money) relates to transactions for the purchase of goods and services for
consumption. Thus the quantity theory fails to measure the value of money.
5. Weak Theory:
 According to Crowther, the quantity theory is weak in many respects. First, it cannot explain ’why’ there are
fluctuations in the price level in the short run. Second, it gives undue importance to the price level as if changes in prices
were the most critical and important phenomenon of the economic system. Third, it places a misleading emphasis on the
quantity of money as the principal cause of changes in the price level during the trade cycle.
Prices may not rise despite increase in the quantity of money during depression; and they may not decline with
reduction in the quantity of money during boom. Further, low prices during depression are not caused by shortage of
quantity of money, and high prices during prosperity are not caused by abundance of quantity of money. Thus, “the
quantity theory is at best an imperfect guide to the causes of the trade cycle in the short period” according to Crowther.
7. Unrealistic Assumptions:
Keynes in his General Theory severely criticised the Fisherian quantity theory of money for its unrealistic
assumptions. First, the quantity theory of money for its unrealistic assumptions. First, the quantity theory of money is
unrealistic because it analyses the relation between M and P in the long run. Thus it neglects the short run factors which
influence this relationship. Second, Fisher’s equation holds good under the assumption of full employment. But Keynes
regards full employment as a special situation. The general situation is one of the under-employment equilibrium. Third,
Keynes does not believe that the relationship between the quantity of money and the price level is direct and proportional.
8. V not Constant:
Further, Keynes pointed out that when there is underemployment equilibrium, the velocity of circulation of money V
is highly unstable and would change with changes in the stock of money or money income. Thus it was unrealistic for
Fisher to assume V to be constant and independent of M.
9. Neglects Store of Value Function:
Another weakness of the quantity theory of money is that it concentrates on the supply of money and assumes the
demand for money to be constant. In order words, it neglects the store-of-value function of money and considers only the
medium-of-exchange function of money. Thus the theory is one-sided.

Q. On what grounds has it been criticized by lord kaynes ? [ MU 2019 ] 4 marks

Ans :
1. Attack on Money Wage Cut Policy:
Keynes objected to the classical formulation of employment theory, particularly, Pigou’s notion that unemployment
will disappear if the workers will just accept sufficiently low wage rates (i.e., a voluntary cut in money wage). He rejected
Pigou s plea for wage flexibility as a means of promoting employment at a time of depression.
2. Keynes’ attack on Interest Rate to be strategic variable:
Keynes also attacked the classical theory in regard to saving and investment. He objected to the classical idea of
saving and investment equilibrium through flexible rates of interest. To him saving and investment equilibrium are
obtained through changes in income rather than in the interest rate.
3. Keynes’ Attack on Laissez-faire Policy:
Keynes strongly attacked the classicists for their unrealistic approach to the problems of contemporary capitalist
economic system. Pigou’s plea for a return to free perfect competition to solve the problem of unemployment seemed
‘obsolete’ in the changed conditions of the modern world.
4. Undue Importance to the Long Period:
Keynes opposed the classical insistence on long-term equilibrium; instead, he
attached greater importance to short-term equilibrium. To him, “in the long run, we are
all dead.” So, it is no use to say that in the long run everything will be all right.
Q. Explain briefly the classical view with regard to the relationship between
wage price flexibility and full employment. – 5 Mark [MU 2017]
Ans :
N = q.Y/W
In this equation, N is the number of workers employed, q is the fraction of income
earned as wages and salaries, Y is the full employment national income and W is the
average money wage rate. If Y is a given, N can be increased only by a reduction in W.
Thus, the key to full employment is a reduction in the real wage.
 This is explained in the adjoining Figure 3.3. In panel (A), S is the supply curve of labour and D is the demand curve
for labour. If the intersection of the two curves at E shows the point of full employment N f then it is the real wage W/P at
which full employment is secured. If the real wage is maintained at a higher level such as W/P 1 supply exceeds the demand
for labour by sd and we find that N0Nf labour is unemployed.
It is only when the wage is reduced to the level W/P that the unemployment disappears and the level of full
employment is attained. This is shown in panel (B) of the figure where MP 1 is the marginal product of labour curve which
slopes downward as more labour is employed. Since every worker is paid wages equal to his marginal product, the full
employment level AY is reached when the wage rate falls from W/P 1 to W/P level.
When there is a cut in the money wage, the real wage is also reduced to the same extent which reduces
unemployment and ultimately brings full employment in the economy.
Q. State Says Law of Markets . 3 marks [MU 2017]
Ans : It is a classical economic theory that says that the income generated by past production and sale of goods is the
source of spending that creates demand to purchase current production. Modern economists have developed varying views
and alternative versions of Say's Law. Say's Law of Markets is theory from classical economics arguing that the ability to
purchase something depends on the ability to produce and thereby generate income.
Say reasoned that to have the means to buy, a buyer must first have produced something to sell. Thus, the source of
demand is production, not money itself.
Say's Law implies that production is the key to economic growth and prosperity and the government policy should
encourage (but not control) production rather than promoting consumption.
Q. Explain, With the help of Diagram, how the Classical theory of income and employment maintains a
dichotomy of the real and monetary sector of an economy. 12 marks [MU 2019]
Q. How does wages – price flexibility ensure full employment in the classical model ? 5 marks [MU 2019]
Q. What does quantity theory of money state ? 3 Marks [MU 2019]