Macro Economics

BA320ECO-E
B.A.
SECOND YEAR SEMESTER – III
ECONOMICS
Macro Economics
(Discipline Specific Course)
“We may forego material benefits of civilization, but we

cannot forego our right and opportunity to reap the benefits
of the highest education to the fullest extent…”
Dr. B. R. Ambedkar
Dr. B. R. AMBEDKAR OPEN UNIVERSITY

HYDERABAD
2018
COURSE TEAM
Course Development Team (CBCS)
Editor Associate Editor

Prof. NTK Naik Dr. K. Krishna Reddy
Writers: Units
Prof. G. Venkata Naidu 3&4
Prof. D. Krishnamoorthy 8&9
Prof. S. Mansoor Rahman 1&2
Dr. K. Mohan Reddy 5&6
Dr. D. Swarupa Rani 7 &10
Dr. K. Krishna Reddy 11&13
Dr. Krishna Reddy Chittedi 12
Cover Design:
G. Venkat Swamy
First Published: 2018
Copyright © 2018 Dr. B. R. Ambedkar Open University, Hyderabad, Telangana.
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writing from the University.
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Printed on behalf of Dr. B. R. Ambedkar Open University, Hyderabad by the Registrar.
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P R E FA C E
The Macro Economics Analysis has become a powerful weapon is solving economic
problems of the modern economic systems. Even during the period of Physiocrates also.
Macro Economics was conceived to be an indispensable instrument to solve the economic
problems of those days. But in the period of Neo – Classicals, the study of Macro Economics
has lost its entity due to the emergence of this, used it as an indispensable means to correct
the weakness short comings that were emerged out of Macro Economics analysis during the
1930s, when the Economic depression took place.
As observed since the independence, the Indian Economy has been passing through
various challenges, like poverty, unemployment, national income, and also the problems
involved like money, banking and inflation. The planners and policy makers have recognised
the importance of Macro Economics in solving the day to day problems of the Indian Economy.
The study of Macro Economics has gained a considerable importance.
Macro Economics as a part of Economics is studied and thought in all universities. The
book is well structured and prepared by the subject experts, drawn from different universities
to suit the reading needs of the Second Year of Economics in Third Semester of B.A.
Programme offered by Dr. B.R. Ambedkar Open University. The syllabus is divided into
Five Blocks for the sake of convenient reading, each of which is again divided into a number
of units. Each block generally covers a specific area of the subject and covered into self-
instructional material to enable the learner to read and understand them without difficulty.
The syllabus comprises national income and its estimating approaches, theories of the
Classical economists and Keynes on income and employment determination; consumption,
investment and interest theories. This book has explains the meaning of money, measures of
money supply, Classical and Neo-Classical theories of money, Functions of RBI and Methods
of Credit Control, finally describes the concept of inflation and trade cycles.
The University hopes that this material will help the student to get acquainted with the
principal issues of ‘Macro Economics’ which make for its distinctiveness and signature.
Any suggestions for improvement of the book would be highly appreciated.
III
CONTENTS
Block/Unit No. Title Page No.
BLOCK - I: INTRODUCTION TO MACRO ECONOMICS 1-28
Unit-1: Meaning, Nature and Scope of Macro Economics 2-12
Unit-2: National Income Analysis 13-28
BLOCK - II: THEORIES OF INCOME AND EMPLOYMENT 29-76
Unit-3: Classical Theory of Employment 30-44
Unit-4: Keynesian Theory of Income and Employment 45-58
Unti-5: Consumption Function: APC & MPC 59-76
BLOCK - III: THEORIES OF INVESTMENT AND INTEREST RATE 77-133
Unit-6: Investment Function, Rate of Interest, Concepts of

Multiplier and Accelerator 78-106
Unit -7: Classical, Neo-Classical and Keynesian Theories of Interest 107-133
BLOCK - IV: THEORIES OF FACTOR PRICING 134-195
Unit-8: Meaning, Functions and Classification of Money 135-149
Unit-9: Measures of Money Supply with reference to India 150-166
Unit-10: Theories of Money 167-181
Unit-11: Central Banking: Functions and Credit Control 182-195
BLOCK - V: INFLATION AND TRADE CYCLESS 196-223
Unit-12: Inflation 197-210
Unit-13: Trade Cycles 211-223

• Model Question Paper 224-226
IV
BLOCK – I
INTRODUCTION TO MACRO ECONOMICS
In this block we deal with the basics of Macro Economics. We will learn the Nature
and Scope of Macro Economics and difference between Micro Economics and Macro
Economics and also the interdependency of Economic Activities in the First Unit. The concepts
of National Income, measurement of National Income, difficulties in Estimating National
Income and the Circular Flow of Income are discussed in the Second Unit.
The units included in the Block - I are:
Unit - 1: Meaning, Nature, and Scope of Macro Economics
Unit - 2: National Income Analysis
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UNIT – 1 : MEANING, NATURE, AND SCOPE OF
MACRO ECONOMICS
Contents
1.0 Objectives
1.1 Introduction
1.2 Economic Activities
1.2.1 Scope of Economic Activities
1.2.2 Types of Economic Activities
1.3 Macro Economic Analysis
1.3.1 Historical Background of Macro Economics and Keynesian Revolution
1.3.2 Meaning and Definition of Macro Economics
1.3.3 Nature and Scope of Macro Economics
1.3.4 Distinction between Micro and of Macro Economics
1.3.5 Important of Macro Economics Concepts
1.3.6 Limitations of Macro Economics
1.4 Summary
1.5 Check Your Progress – Model Answers
1.6 Model Examination Questions
1.7 Glossary
1.8 Suggested Books
1.0 OBJECTIVES
This unit explains the role of economic activities, definition and scope of Macro
Economics, differences between Micro and Macro Economics and the various concepts relating
to Macro Economics. After reading this unit, you will be able to:
• explain inter-dependency of economic activities;
• analyze the nature and scope of Macro Economics;
• discuss the differences between Micro Economics and Macro Economics;
• examine importance of Macro Economics; and
• explain the limitations Macro Economics.
1.1 INTRODUCTION
Economics is popularly known as the ‘Queen of Social Sciences’. The word economics
has been derived from the Greek word “OIKONOMICAS” with “OIKOS” meaning a household
and “NOMOS” meaning management. It is understood that the beginning was made by the
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Greek Philosopher, Aristotle who in his book “Economica” focused that the field of economics
deals with household management. The origin of economics can be traced back to the ideas of
Physiocrats who attempted to solve the problems in aggregate or collective way. This was
clearly stated by Adam smith in his famous book, “An Inquiry into the Nature and Causes of
Wealth of Nations”. However, the aggregate analysis took a back seat with the emergence of
marginal revolution, the foundation of neo-classical economists. The gravity of 1930’s Great
Depression exposed the weaknesses and shortcomings of micro analysis and underscored the
importance of aggregate or macro analysis.
1.2 ECONOMIC ACTIVITIES

Man being born in this world is influenced by biological, physical and social needs,
which keep him always busy in searching out the means to keep him satisfied. To fulfill his
requirements arising out of various needs, he involves in an activity called economic activity.
Economic activities are those activities, which are concerned with the efficient use of scarce
means that can satisfy the wants of man. By engaging themselves in the economic activity
people aim at maximizing their satisfaction from their scarce resources. After the basic needs
viz., food, shelter and clothing have been satisfied, the priorities shift towards other wants.
Human wants are unlimited, in the sense, that as soon as one want is satisfied another crops up.
Most of the means of satisfying these wants are limited, because their supply is less than
demand. These means have alternative uses; there emerge a problem of choice. Resources
being scarce in nature ought to be utilized productively within the available means to derive
maximum satisfaction. According to Prof. J. R. Hicks “The activities which involves income
earning or spending through exchange of goods and services is economic activity”.
The knowledge of economics guides us in making effective decisions. In other words, it
deals with decisions regarding the commodities and services to be produced in the economy,
how to produce them most economically and how to provide for the growth of the economy.
Economics is a very wide subject. It concerns itself not only with the behaviour of individual
consumers and individual producers of firms, but also with industries, national income and
economic growth.
1.2.1 Scope of Economic Activities

The scope of economic activity is divided into three parts:
i. Individuals: In this part two groups are important. They are consumers and producers
or firms and households.
ii. State: The state has to perform certain economic activity in terms of public revenue,
expenditure and debt. The main objective of the state is to promote economic welfare.
iii. International: Due to inequalities of resources and manpower, the purpose is to expand
the area of trade to give benefit of trade. In this part money spending on imports, money
receiving from exports is covered.
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1.2.2 Types of Economic Activities
K. E. Boulding classified economic activities in Four types. All these are interdependent:
i. Consumption of Goods and Services: This is the main economic activity. If wants are
the starting part of economic activity consumption is the end of such activity.
ii. Production of Goods and Services: Another main economic activity. Goods and services
are produced by the firms. The firm is collection of factors of production. Firms buy
productive resources from households and produce goods and services.
iii. Exchange of Goods and Services: Exchange is kind of conversion of goods and services.
Exchange takes place when goods and services are sold in the market. Firms sell goods
and services and consumers buy goods and services in the market.
iv. Distribution of Income: Distribution is concerned with the sale of services by factors
of production. Households sell factor services to firms. Firms pay prices to these factors.
So distribution is merely the pricing of services of factors of production.
From the above analysis we can draw the main objectives of economic activities are as
follows;
a) to produce larger and greater amount of output i.e., of goods and services year after year.
b) to raise the level of employment and achievement of full employment of labour and
resources to attain economic development.
c) to promote economic welfare of people by reducing inequalities in the distribution of
income and wealth.
d) to maintain economic stability and growth.
All economic activity generates income in one way or other. So its measurement can be
made by simply estimating the income generated in the economy. But the competing definitions
regarding what constitutes productive activity ‘make it difficult to measure economic activity
through income measurement‘. So, national product becomes the widely used in the
measurement of economic activity. There is one more reason for the shift from national income
to national product.
Check Your Progress.

Note: a) Space is given below for writing your answer.
b) Compare your answer with one given at the end of the unit.
1. Explain the interdependency of Economic Activities.
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1.3 MACRO ECONOMIC ANALYSIS

The terms “micro” and “macro” were first coined and used by Ragnar Frisch in 1933.
The term “micro economics” is derived from the Greek word “mikros” which means small or a
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millionth part. It is also known as “Price Theory”. The term macro economics has been
derived from the Greek word “makros” meaning large. Macro economics otherwise is called
“Income Theory”.
1.3.1 Historical Background of Macro Economics and Keynesian Revolution

In the 18th century, the Physiocrats adopted it in their Table Economies to show the
‘circulation of wealth’ (i.e., the net product) among the three classes represented by farmers,
landowners and the sterile class. Malthus, Sismondi and Marx in the 19th century dealt with
macro economic problems. Walras, Wicksell and Fisher were the modern contributors to the
development of macro economic analysis before Keynes.
The Neo-classical economists could not explain the reasons for the crisis of Great
Depression in 1930s. It was Keynes who first made a comprehensive explanation and solutions
for that situation. It is after the publication of General Theory by John Maynard Keynes in
1936, the term ‘macro economics’ became popular. Keynes virtually revolutionised economic
thinking. Even though Keynes did not use these terms explicitly but, in fact, refereed to
macroeconomics as the “the theory of output and employment as a whole” in General Theory.
Macroeconomics evolves with the evolution of the economy. Macroeconomic theories change
over time. They keep on changing because major economic events such as the Great Depression
of the 1930s.
Keynes vehemently attacked the theories of classical economists and put forth his’
General Theory’, which dealt with all levels of employment and the factors that determine it at
a time. From Keynes’ ideas emerged as ‘Keynesian economics’ it concerned with pursuing
demand-side macroeconomic policies. There is a group of economists called ‘Keynesians’
who consider it no exaggeration to say that Keynes thereby led a revolution in economics
literature. Keynesian revolution refers to a change in macroeconomic thinking, shaped by the
Great Depression and the work of Keynes leading to greater considerations of demand-side
policies.
1.3.2 Meaning and Definition of Macro Economics

Macro economics is an analysis of aggregates and averages pertaining to the entire
economy, such as national income, gross domestic product, total employment, total output,
total consumption, aggregate demand, aggregate supply, etc. It looks to the nation’s total
economic activity to determine economic policy and promote economic progress.
According to Prof Ackely “Macro economics deals with economic affairs in the large; it
concerns the overall dimensions of economic life. It looks at the total size and shape and
functioning of the ‘elephant’ of economic experience, rather than working of articulation or
dimensions of the individual parts. It studies the character of the forest, independently of the
trees which compose it.” Thus macro economics is the study of economic system as whole. It
studies the aggregates or averages covering the entire economy, such as total employment,
notional income, total production, total consumption, total savings, aggregate supply, aggregate
demand, general price level and wage level and cost structure.
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Prof. K.E. Boulding defines; “Macro economics is that part of economics which studies
the overall averages and aggregates of the economic system. It does not deal with individual
incomes but with the national income, not with individual prices but with the price level, not
with individual output, but with national output”. In simple macro economics discusses the
problems of determination of the total income of a country and causes of its fluctuations.
According to R.G.D. Allen, “The term macro economics applies to the study of relations
between broad economic aggregates such as total employment, income and production”.
In the words of Edward Shapiro, “The major task of macro economics is the explanation
of what determines the economy’s aggregate output of goods and services. It deals with the
functioning of the economy as a whole”. Macro economics examines the factors that determine
national output and its growth overtime. It studies the economic aggregates such as the overall
level of prices, output and employment in the economy.
1.3.3 Nature and Scope of Macro Economics

The scope of Macro Economics covers the theory of National Income, the theory of
employment, macro theory of distribution, theory of economic development, theory of
international trade, theory of money, the theory of business fluctuations and the theory of general
price level which deals with continuous rise in the price level is called inflation. It distorts
production. It increases inequalities in the distribution of income and wealth. The common
man is injured by inflation. Deflation is the opposite of inflation. The general price level falls
continuously, Output and employment levels are falls. Macro economics provides explanation
provides explanation for the occurrence of inflation and deflation.
The scope of Macro Economics can be understood with the help of the following aspects.
Macro-economic Theory
Theory of Theory of Theory of Theory of

Income & General Price Economic Distribution
Employment level & Growth & showing relative
Inflation Development shares of factors
of production
Theory of Theory of
Consumption Investment
Function
Theory of Fluctuation
(or Business Cycles)
Theories of Income and Employment: Macro economics deals with aggregate demand
and aggregate supply that determines the equilibrium level of income and employment in the
economy. The level of aggregate demand determines the level of income and employment.
Macro economics also deals with the problem of unemployment due to lack of aggregate demand.
Moreover, it studies the economic fluctuations and business cycles.
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Theories of General Price Level and Inflation: Macro economics studies the general
level of price in an economy. It also studies the problem of inflation and deflation.
Theories of Economic Growth and Development: Macro economics deals with
economic growth and development. It studies various factors that contribute to economic
growth and development.
Theories of Distribution: Macro economics also deals with various factors of production
and their relative share in the total production or total national income.
Theories of Business Cycles: Macro economics analyses the causes of economic
fluctuations and suggest remedial measures.
1.3.4 Distinction between Micro and Macro Economics

Prof. Ackley makes the distinction between macro economics and micro economics. He
says; “macro economics concerns itself with such variables at the aggregate volume of the
output of an economy, with the extent to which its resources are employed, with the size of the
output of an economy, with extent to which its resources are employed, with the size of the
national income, with the general price level. Micro economics on the other hand deals with
the division of total output among industries, products and firms and the allocation of resources
among competing uses. It consider problem of income distribution. Its interest is in relative
prices of particular goods and services”.
The following are distinctions between micro and macro economics.
i. Micro economics deals with an individual product, firm, household, industry, wages,
prices, etc., while Macro economics deals with aggregates like national income, national
output, price level, etc.
ii. Micro economics studies the particular market segment of the economy, whereas Macro
economics studies the whole economy that covers several market segments.
iii. While micro economics is applied to operational or internal issues, environmental and
external issues are the concern of macro economics.
iv. Micro economics stresses on individual economic units. As against this, the focus of
macro economics is on aggregate economic variables.
v. Micro economics covers issues like how the price of a particular commodity will affect
its quantity demanded and quantity supplied and vice versa while macro economics
covers major issues of an economy like unemployment, monetary / fiscal policies, poverty,
international trade, etc.
vi. Micro economics determines the price of a particular commodity along with the prices
of complementary and the substitute goods, whereas the macro economics is helpful in
maintaining the general price level.
vii. While analysing any economy, micro economics takes a bottom-up approach, whereas
the macro economics takes a top-down approach into consideration.
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In this way micro economics focuses on the allocation of limited resources among the
individuals, the macro economics examines that how the distribution of limited resources is to
be done among many people, so that it will make the best possible use of the scarce resources.
As micro economics studies about the individual units, at the same time, macro economics
studies about the aggregate variables. In this way, we can say that they are interdependent.
Micro and Macro Economics are not contradictory in nature, in fact, they are complementary.
As every coin has two aspects - micro and macro economics are also the two aspects of the
same coin, where one’s demerit is others merit and in this way they cover the whole economy.
Both micro and macro analysis thus mutual support one another. Only difference is micro
economics explains a tree in the forest whereas macro economics explains the trees in the
forest as single unit. In the words of Prof. Ackley: “Actually, the line between macro economics
and micro economics theory cannot be precisely drawn. A true 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 individual results would constitute the aggregates
which macro economics is concerned”.
1.3.5 Importance of Macro Economics

The following are the important aspects of macro economic analysis:
i. Helpful in understanding economic system as a whole: It is helpful in understanding
the functioning of a complicated economic system.
ii. It helps to understanding the Income and Employment: Macro economics explains
the forces or factors which determine the level of aggregate employment and output in
the economy.
iii. General Level of Prices: Macro economic analysis answers to questions as to how the
general price level is determined and what is the importance of various factors which
influence general price level.
iv. Accelerated Economic Growth: The macro economics help us to formulate economic
policies for achieving long run economic growth with stability.
v. Understanding Business Cycles: It is helpful to formulate policies for controlling
business cycles i.e., inflation and deflation.
vi. International Trade: Macro economics is helpful to analyze the various aspects of
international trade in goods, services and balance of payment problems, the effect of
exchange rate on balance of payment etc.
vii. Understanding the National Income: Macro economics explains the level of output,
its composition, per-capita income, standard of living of the people and so on.
viii. Understanding the General Unemployment: It explains the causes of cyclical
unemployment and high unemployment and suggests the remedies to control them.
ix. Macroeconomic Policies: Affect the performance of the economy. The two major
macroeconomic policies i.e., fiscal and monetary policies are central in macro economic
analysis of the economy.
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x. Global Economic System: In macro economic analysis, it is emphasized that a nation’s
economy is a part of a global economic system.
xi. Saving and Investment: It discusses the importance of saving and investment in the
economy.
xii. Understanding the behaviour of Individual Units: Macro economic s is imperative to
understand the behaviour of individual units in the economy.
1.3.6 Limitations of Macro-Economics

The main limitations of macro economics are as follows:
i. Ignores the Welfare of the Individual: The macro economics ignore the welfare of the
individual. For instance, if national saving is increased at the cost of individual welfare,
it is not considered a wise policy. Individual is ignored altogether.
ii. To regard Aggregates as Homogeneous: The macro economics analysis regards
aggregates as homogeneous but does not look into its internal composition. For instance,
if the wages of the teacher fall and the wages of the doctor rise, the average wage may
remain the same.
iii. Aggregate Variables: It is not necessary that all aggregate variables are important. For
instance, national income is the total of individual incomes. If national income in the
country goes up, it is not necessary that the income of all the individuals in the country
will also rise.
iv. Defects of Macro Economic Models: The macro economic models are designed mostly
to suit the developed countries of the world. The developing countries face different
economic realities, so they do not benefit much from them.
v. Statistical and Conceptual difficulties: The measurement of macroeconomic concepts
involves a number of statistical and conceptual difficulties.

2. What is the scope of Macro Economics?
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3. What is the importance of Macro Economics?
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1.4 SUMMARY
Macro economics means aggregate economic analysis generally macro analysis relates
to an economy of a country. Macro economics deals with broad economic aggregate like
employment theory, income theory, price theory, theories of money, investment, saving etc.
Macro economics describes the trends in the economy by studying the sub-aggregates of the
economy and the inter-relation between them.
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The economic activities of a nation are to be divided into sectors or markets. The
whole economy has consumers, producers, Government and external sector. Consumers supply
services like labour to produce goods and services. Producers use them to produce goods. In
turn producers pay for the services of the consumers and consumers spend their income on the
consumption of goods. The micro and macro economics are interdependent. We cannot draw
any precise line of separation between micro and macro economics. We cannot put them in
water light compartments. Both these approaches help us analyzing the working of the economy.
Knowledge of macro Economics has become the prerequisite for the efficient
functioning of the governments to implement economic policies for the growth of their
economics. Macro theorist must guard against generalizing too much for individual experience.
Generalization or aggregate tendency may not reflect the changes in all sectors of the economy
in their true nature. The Macro theorist has to be cautious about the misleading tendency of
aggregate results. In spite of its limitations, macro economics is of great practical importance
and is widely used. It provides practical solution to economic problems. It is complementary
to macro economics and the study of both is vital for proper analysis of economic problems.
1.5 CHECK YOUR PROGRESS - MODEL ANSWERS

1. All people are at work. If we look round, we see the farmer cultivating his fields, the
labour in his factory, the clerk at his office, the doctor attending to his patients, the
teacher teaching his students. They are all engaged in what is called economic activity.
They do not want money for their own sake. They need it to buy things which satisfy
their wants. So it is clear that the type of income earning and spending activities are
called economic activities and they are interdependent.
2. The scope of macro economics covers the theory of National Income, the theory of
Employment, Marco Theory of distribution, theory of economic development, theory of
International Trade, theory of Money, the theory of Business Fluctuations and the theory
of General Price Level which deals with continuous rise in the price level is called
inflation.
3. The importance of macro-economics can be understood from the following points. Macro
Economics plays a very important role in formulating economic policies. Since
Government intervention in economic affairs is indispensable in the present economic
scenario, the knowledge of aggregates is of great importance in the framing as well as
the implementation of economic policies of the nation.
1.6 MODEL EXAMINATION QUESTIONS

I. Answer the following questions in about 10 lines each.
1. What do you mean by macro economics?
2. Examine the terms households and firms sectors.
3. Explain the important macro economic variables.
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II. Answer the following questions in about 30 lines each.
1. Explain the differences between Macro and Micro Economics.
2. Write about the limitations of Macro Economics.
3. Explain Nature, Scope of Macro economics.
III. Objective type questions.

A. Multiple choice questions.
1. The object of economic activities is
a) Essentials b) Limited c) Unlimited d) None of the these
2. Macro Economics may be called
a) Price theory b) Income theory c) Welfare theory d) Global theory
3. Micro and Macro concepts were coined by
a) Ragner Frisch b) J B Say c) J S Mill d) J M Keynes
4. Great Depression happened in
a) 1930s b) 1950s c) 1920s d) 1960s
5. Who is the Classical Economist?
a) J M Keynes b) Adam smith c) J S Mill d) A.C. Pigou
Answers: 1) c 2) b 3) a 4) a and 5) b
B. Match the following.

A B
6. J M Keynes (a) Principles of Economics
7. Adam Smith (b) Wealth of Nations
8. Alfred Marshall (c) General Theory of Employment
9. David Ricardo (d) Treatise on Political Economy
10. J B Say (e) Value Theory
Answers: 6 - c, 7 -b, 8 - a, 9 – e, and 10 - d
C. Fill in the blanks.

11. Macro Economic analyses __________________
12. The aim of economic activities is to earnings of _________________
13. _______________ is called as the ‘founding father of modern economics’.
14. _______________ Great Depression hit the world.
15. _______________ is linked with Macro Economics.
Answers: 11) Whole economic system; 12) Income; 13) J M Keynes; 14) 1930s;
15) J M Keynes.
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1.7 GLOSSARY
1. Macro Economics: The science that deals with aggregates like national savings, national
income, employment etc.
2. Consumers: A set of people who use and demand goods and services.
3. Producers: A set of people who produce and supply (output) goods and services.
4. Equilibrium: Equality between the supply and demand for goods at given price.
5. Stock variable: The value of a variable at a given point of time
6. Flow variable: The value of a variable during a unit of time.
1.8 SUGGESTED BOOKS

1. Ackely, G.: Macro Economics: Theory and Policy, New York; Mac Millan, 1978.
2. Shapiro, Edward: Macro Economic Analysis, Galgotia Publications, New Delhi,
1984.
3. Ahuja, H.L: Modern Economics, S. Chand &Company Ltd; New Delhi, 2006.
4. Ahuja, H.L: Macro Economics: Theory and Policy, S. Chand & Company Ltd;
New Delhi, 2004.
5. Vaish MC: Macro Economic Theory, Vikas Publishing House Pvt. Ltd;
New Delhi, 2005.
6. Dwivedi, D.N.: Macro Economics: Theory and Policy, Tata McGraw-Hill
Publishing Company Limited, New Delhi, 2005.
7. Edward Shapiro: Macro Economic Analysis, fifth edition Galgotia Publications (P)
Ltd. New Delhi.
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UNIT – 2 : NATIONAL INCOME ANALYSIS
Contents
2.0 Objectives
2.1 Introduction
2.2 Definitions of National Income
2.3 Concepts and Components of National Income
2.3.1 Gross National Product
2.3.2 Net National Product
2.3.3 National Income at Factor cost
2.3.4 Personal Income
2.3.5 Disposable Income
2.3.6 Per capita Income
2.4 Methods of Estimating National Income
2.4.1 Output Method
2.4.2 Income Method
2.4.3 Expenditure Method
2.5 Measurement of National Income in India
2.6 Difficulties in the Estimation of National Income
2.7 Importance of National Income
2.8 Concept of Circular Flow of Income
2.8.1 Circular Flow of Income in a Two Sector Economy
2.8.2 Circular Flow of Income in a Three Sector Economy
2.8.3 Circular Flow of Income in a Four Sector Economy
2.9 Summary
2.12 Glossary
2.13 Suggested Books
2.0 OBJECTIVES
This unit explains the different concepts of national income, measurement of national
income and circular flow of income. After reading this unit, you will be able:
• to know the importance of National Income;
• to analyze the concepts and components of National Income;
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• to explain the methods of estimating National Income ;
• to examine the problems involved in the estimation of National Income; and
• to explain Circular Flow of Income.
2.1 INTRODUCTION
Modern economy is a money economy. The national income of any country is expressed
in terms of money. The total income of the country is called national income. It is one of the most
important concepts in the study of macro economics. The accounting and finding of an economy’s
national output has more importance, especially after the Keynesian revolution in Economics and
after the phenomenon of Great Depression of 1930s. In this modern era, accounting, comparing
and predicting future of an economy of a country is inevitable for policy makers.
National income is an uncertain term which is used interchangeably with national dividend,
national output and national expenditure. On this basis, national income has been defined in a
number of ways. In common parlance, national income means the total value of goods and
services produced annually in a country. In other words, the total amount of income accumulating
to a country from economic activities in a year’s time is known as national income. It includes
payments made to all resources in the form of wages, interest, rent and profits.
National income is the total money value of the entire economic activity in an economy
during a specified period of time. To explain the complexity of measurement of the value of
national income, economists explained it very systematically. For simplicity they classified all
the economic activities under four sectors, like: Individual consumers (C), Businesses /
investments (I), Government sector (G) and Foreign sector / export and import (X-M). National
income has been defined by many professionals with different views. But in theory all definitions
are giving same meaning. Generally, we compare and rank the countries according to their
economic activities.
2.2 DEFINITIONS OF NATIONAL INCOME

Alfred Marshall’s Definition: “The labour and capital of a country acting on its natural
resources produce annually a certain net aggregate of commodities, material and immaterial
including services of all kinds. This is the true net annual income or revenue of the country or
national dividend.”
In this definition, the word ‘net’ refers to deductions from the gross national income in
respect of depreciation and wearing out of machines. And to this, must be added income from
abroad.
A.C. Pigou’s Definition: “National income is that part of objective income of the
community, including of course income derived from abroad which can be measured in money.”
This definition has proved to be more practical also. It tells national income included
that income which can be measured in terms of money while calculating the national income
now-a- days; estimates are prepared in accordance with the two criteria laid down in this
definition.
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Fisher’s Definition: “The National dividend or income consists solely of services as
received by ultimate consumers, whether from their material or from the human environments.
Thus, a piano, or an overcoat made for me this year is not a part of this year’s income, but an
addition to the capital. Only the services rendered to me during this year by these things are
income.”
Fisher adopted ‘consumption’ as the criterion of national income. Fisher’s definition is
considered to be better than that of Marshall or Pigou, because Fisher’s definition provides an
adequate concept of economic welfare which is dependent on consumption and consumption
represents our standard of living.
Simon Kuznets Definition: “National income is the net output of commodities and
services flowing during the year from the country’s productive system in to the hands of the
ultimate consumers”
National income has been defined on the basis of the systems of estimating national
income in modern point of view.
National Sample Survey’s Definition: “money measures of the net aggregates of all
commodities and services accruing to the inhabitants of a community during a specific period
are national income”
National income is not a quantum. It is a heterogeneous whole. It is the expression, in
monetary terms of goods and services produced by the country during a year.
By observing the above definitions, it is clear that, the value of the goods and services
created out of the physical wealth and capital is called national income. Since a country has
business relations with other countries, income flows from other countries. This amount is
added to the domestic annual income to get the national income. Income flows from the use of
wealth or capital. In the process, income earning some capital gets depreciated. We have to
deduct this amount of depreciation from the gross national income to arrive at net national
income.
2.3 CONCEPTS AND COMPONENTS OF NATIONAL INCOME

There are some important determinants of national income, such as: (i) natural resources
available in the country (ii) level of employment of labour (iii) physical and human capital
available in the country (iv) the efficient and innovative skills of organizers and (v) the social
and economic infrastructure available in the country.
The following are the major concepts of national income accounting.
1. Gross National Product (GNP – GNI)
2. Net National Product (NNP – NNI)
3. National Income at Factor Cost (NI)
4. Personal Income (PI)
5. Disposable Income (DI)
6. Per capita Income (PCI)
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2.3.1 Gross National Product (GNP – GNI)
Gross National Product is the total measure of the flow of goods and services at market
value resulting from current production during a year in a country, including net income from
abroad. Components of GNP
1. Consumption: The total amount of goods and services purchased by the consumers to
satisfy the immediate wants of the people;©
2. Investment: Gross private domestic investment in capital goods consisting of fixed
capital formation, residential construction and inventories of finished and unfinished
goods;(I)
3. Government Expenditure: Goods and services produced by the government; and (G)
4. Net Foreign Trade: Net exports of goods and services, i.e., the difference between
value of exports and imports of goods and services, known as net income from foreign
trade. (X-M).
GNP/GNI = C +I + G +(X-M)
Where, C = Consumption; I = Investment; G = Government Expenditure;
X = Exports; M = Imports; and X- M = Net Foreign Trade.
There are certain factors that have to be taken into consideration to calculate G N P.
i. GNP is the measure of money, in which all kinds of goods and services produced in a
country during one year are measured in terms of money at current prices and then added
together. To avoid the fluctuations in prices, a particular year when prices are normal is
taken as the base year and the GNP is adjusted in accordance with the index number for
that year.
ii. In estimating GNP of the economy, the market price of only the final products should be
taken into account. Many of the products pass through a number of stages before they
are ultimately purchased by consumers. To avoid double counting only the final products
and not the intermediary goods should be taken into account.
iii. Goods and services rendered free of charge are not included in the GNP, because it is not
possible to have a correct estimate of their market price. For example, the bringing up of
a child by the mother, imparting treatment to his son by a doctor.
iv. The transactions which do not arise from the produce of current year or which do not
contribute in any way to production are not included in the GNP. The sale and purchase
of old goods and of shares, bonds and assets of existing companies are not included in
GNP because these do not make any addition to the national product, and the goods are
simply transferred.
v. The payments received under social security, e.g., unemployment, insurance allowance,
old age pension, and interest on public loans are also not included in GNP. Because the
recipients do not provide any service in lieu of them. At the same time, depreciation of
machines, plants and other capital goods is not deducted from GNP.
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vi. The profits earned or losses incurred on account of changes in capital assets as a result of
fluctuations in market prices are not included in the GNP because they are not responsible
for current production.
vii. The income earned through illegal activities is not included in the GNP.
Gross Domestic Product: When we take the sum total of value of output of goods and
services in the economy without adding net factor incomes received from abroad, the total
obtained is called Gross Domestic Product (GDP). Dernberg defines GDP at market price as
“the market value of the output of final goods and services produced in the domestic territory
of a country during an accounting year.”
GDP = C+I+G
It is clear that if net foreign income (X-M) is deducted from GNP we get GDP. In other
words by adding net foreign income to GDP we get GNP. Generally GNP is always higher than
GDP.
2.3.2 Net National Product (NNP – NNI)

In the production process of GNP, the capital goods employed are worn-out. The amount
of decline in the value of capital goods due to wear and tear is called depreciation. So, if we
deduct depreciation from GNP, we will get NNP.
NNP = GNP – Depreciation or
NNP = Personal consumption expenditure on goods and services (C) + Net domestic private
investment (I) + Government expenditure on goods and services (G) + Net exports (X-M).
So the net value of produced in a specific period is NNP or NNI at market prices.
Net Domestic Product (NDP) Net Domestic Product (NDP) is the total money value of
all the final goods and services produced within the domestic territory of a country during a
specified period excluding the amount of depreciation. So, if we deduct depreciation from
GDP, we will get NDP.
NDP = GDP – Depreciation or
NDP = Personal consumption expenditure on goods and services (C) + Net domestic
private investment (I) + Government expenditure on goods and services (G).
2.3.3 National Income at Factor Cost (NI)

National income at factor cost means the sum of all incomes earned by resource suppliers
for their contribution of land, labour, capital and entrepreneurial ability (rent, wages, interest
and profits) which go into the net production in a year. In fact national income depicts how
much it costs the society in terms of resources to produce net output. Hence, it is called
national income at factor cost. The difference between national income at factor cost and NNP
at market prices arises due to the indirect costs and subsidies which pushes the NNP at market
prices higher than NNP at factor cost.
National income at factor cost = NNP- indirect taxes + subsidies.
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2.3.4 Personal Income
Personal income is the total income received by the individuals of a country from all
sources before payment of direct taxes in the particular year. Personal income is never equal to
the national income, because the former includes the transfer payments whereas they are not
included in national income. Personal income is derived from national income by deducting
undistributed corporate profits, profit taxes, and employees’ contributions to social security
schemes. These three components are excluded from national income because they do reach
individuals.
Personal Income = National income – Social Security Contributions – Corporate Income
Taxes - Undistributed Corporate Profits + Transfer Payments.
So to arrive at personal income, we have to subtract social security contributions, corporate
income taxes and undistributed corporate profits from national income which are earned but
not received and add incomes received but not currently earned.
2.3.5 Disposable Income (DI)

This is the amount available with the private individuals to spend. To arrive at the
disposable income personal taxes (income and personal property taxes) are deducted from
personal income. It is computed using the given formula.
Disposable Income (DI) = Personal Income - Personal Taxes or
Disposable Income (DI) = Consumption Expenditure + Savings
The whole of disposable income is not spent on consumption and a part of it is saved.
Therefore, disposable income is divided into consumption expenditure and savings.
2.3.6 Per Capita Income

The average income of the people of a country in a particular year is called Per Capita
Income for that year. This concept also refers to the measurement of income at current prices
and at constant prices. In order to find out the per capita income for 2011, at current prices, the
national income of a country is divided by the population of the country in that year.
National Income
Per capita Income =
Total Population
This concept enables us to know the average income and the standard of living of the
people of the country. Unfortunately it is not very reliable, because in every country due to
unequal distribution of national income, a major portion of it goes to the richer sections of the
society and thus income received by the common man is lower than the per capita income.

1. Define National income.
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2. Explain the components of Gross National Product.
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2.4 METHODS OF ESTIMATING NATIONAL INCOME

It is learnt that the flow of national income is studied from three different angles. National
income is the summation of values of different types of goods. The persons involved in the
production of these goods will be many in number. It is difficult to correctly estimate the
production and expenditure activities of these people. The methods of estimation of national
income fall under production, income and expenditure heads. Let us now discuss in detail
about these methods of estimating national income. There are three methods of estimating
National Income. The following are:
2.4.1 Output Method

Output or Production method of estimation of national income is also called as value-
added method. In this method, the total value of final goods and services produced in a country
during a year is calculated at market prices. To find out the GNP, the data of all productive
activities, such as agricultural products, wood received from forests, minerals received from
mines, commodities produced by industries, the contributions to production made by transport,
communications, insurance companies, lawyers, doctors, teachers, etc. are collected and assessed
at market prices. Only the final goods and services are included and the intermediary goods
and services are left out.
Economy consists of primary, secondary and tertiary sectors. In other words economy
includes agricultural, industrial and service sector. To estimate national product these three
sectors are again sub-divided. For example, primary sector is divided into agricultural and
allied agricultural activities like poultry, animal husbandry, fishing, forestry and mines.
Agricultural products can be further divided into food and non-food crops. In the secondary
sector are included the large, medium and tiny industries, construction, electricity, water and
gas supplies. Tertiary sector is divided into transport, communication, banking insurance,
commerce, hotel business, public administration and services of professional people.
All the major sectors of the economy may be further sub-divided into a number of sub-
sectors, for instance, transport sector is again divided into road, rail airways and waterways.
Similarly each sector is again divided into different minor sectors. In this manner economic
activities are grouped into different categories and the value of goods and services produced by
each category is estimated according to current prices which is equal to the value of gross
national product.
In public administration different individuals produce different services. It is difficult
to estimate the value of their productive services. Traditionally, the value of production equivalent
to the reward it receives. Hence, the total of these rewards is the total income produced by
them.
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2.4.2 Income Method
In this method, the net income payments received by all citizens of a country in a particular
year are added up, i.e., net incomes that accrue to all factors of production by way of net rents,
net wages, net interest and net profits are all added together but incomes received in the form of
transfer payments are not included in it. The data pertaining to income are obtained from
different sources, for instance, from income tax department in respect of high income groups
and in case of workers from their wage bills.
National Income = Wages and Salaries + Rent + Interest + Distributed Profits +
Undistributed Profits by Corporation + Depreciation + Mixed Income + Taxes + Net
National Income.
There are some paradoxes in the computation of national income by income method in
the capitalistic form of economy; traditionally the values of goods and services exchanged in
the market are included in national income. The incomes that the persons get for themselves
are not estimated. For example, the services rendered by a house wife are not included in the
computation. When the same services are rendered by a servant for a reward we include it in
the national income.
Income method measures from the side of the payments to the factors;
Land – Rent
Labour – Wages
Capital – Interest
Organization - Profits
2.4.3 Expenditure Method

In this method, the total expenditure incurred by the society in a particular year is added
together and includes personal consumption expenditure, net domestic investment, government
expenditure on goods and services, and net foreign investment. This concept is based on the
assumption that national income equals national expenditure. The expenditure incurred on the
production of final goods and services is called national income. The total expenditure of
household sector, business entrepreneurs and of the government together is called national
income.
National Income = Expenditure of Households + Expenditure of Business Firms +
Expenditure of Government.

3. What are methods of estimating national income?
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2.5 MEASUREMENT OF NATIONAL INCOME IN INDIA
The earliest estimate of India’s national income was made by Dadabhai Naoroji in
1867–68. Since then many attempts were made, mostly by the economists and the government
authorities, to estimate India’s national income. In 1949, A National Income Committee (NIC)
was appointed with P.C. Mahalanobis as its Chairman.
The Central Statistical Organization (CSO) is established in the year 1951 and entrusted
with the task of estimating national income on yearly basis. The CSO, Department of Statistics,
Ministry of Planning, publishes national income statistics on a regular basis.
In its conventional series of national income statistics from 1950-51 to 1966-67, the
CSO had categorized the income in 13 sectors. But, in the revised series, it had adopted the
following 15 break-ups of the national economy for estimating the national income: (i)
Agriculture; (ii) Forestry and logging; (iii) Fishing; (iv) Mining and quarrying; (v) Large-scale
manufacturing; (vi) Small-scale manufacturing; (vii) Construction; (viii) Electricity, gas and
water supply; (ix) Transport and communication; (xii) Real estate and dwellings; (xiii) Public
Administration and Defense; (xiv) Other services; and (xv) External transactions.
The national income is estimated at both constant and current prices.
2.6 DIFFICULTIES IN THE ESTIMATION OF NATIONAL

INCOME
The following difficulties are observed in estimating national income:
Problem with non-monetary transactions: The first problem in National Income
accounting relates to the treatment of non-monetary transactions such as the services of
housewives to the members of the families.
Problem of double counting: Only final goods and services should be included in the
national income accounting. But in practice, it is very difficult to distinguish between final
goods and intermediate goods and services.
Problem with underground economy: The underground economy consists of illegal
activities but these incomes are not included in the national income.
Problem with tiny and petty production units: There are large numbers of petty
producers and it is difficult to include their production in national income because they do not
maintain any account.
Difficult to assess the public services: Another problem is whether the public services
like general administration, police, army services, should be included in national income or
not. It is very difficult to evaluate such services.
Problem of transfer payments: Individual get pension, unemployment allowance and
interest on public loans, but these payments create difficulty in the measurement of national
income. These earnings are a part of individual income and they are also a part of government
expenditures.
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2.7 IMPORTANCE OF NATIONAL INCOME
National income statistics are the annual accounts as for the whole country they record
the economic transactions of the economy during a financial year. These accounts are useful in
understanding the performance of the economy as whole.
i. National income data is of great importance in assessing the economy of the country. In
modern days the national income data is regarded as accounts of the economy it indicates
the potentiality of the nation.
ii. National income data form the basis of economic policies such as employment policy,
because these statistics enable us to know the direction in which the industrial output,
investment and savings, etc. change, and proper measures can be adopted to bring the
economy to the right path.
iii. For economic planning, it is essential that the data pertaining to a country’s gross income,
output, saving and consumption from different sources should be available. In the present
age of planning, the national data are of great importance.
iv. The economists propound short-run as well as long-run economic models or long-run
investment models in which the national income data are very crucial and widely used.
v. The national income data are also made use of by the research scholars and policy
makers. They make use of the various data of the country’s input, output, income, saving,
consumption, investment, employment, etc., which are obtained from social accounts.
vi. National income data is significant for a country’s per capita income which reflects the
economic welfare and standard of living of the people of the country.
vii. National income statistics enable us to know about the distribution of income in different
sectors of the country. From the data pertaining to wages, rent, interest and profits, we
learn of the disparities in the incomes of different sections of the society in the country.
2.8 CONCEPT OF CIRCULAR FLOW OF INCOME

One of the earliest ideas on the circular flow of money was explained in the work of 18th
century Irish-French economist Richard Cantillon, later the concept was developed by J M
Keynes. The modern economy is a monetary economy. In the modern economy, money is used
in the process of exchange. The households supply economic resources to the firms and receive
in return the payments in terms of money. It is clear that in the monetary economy, there will be
flows of money corresponding to the flows of economic resources and flows of goods and
services. But each money flow is in opposite direction to the real flow.
2.8.1 Circular Flow of Income in a Two Sector Economy

The concept of circular flow of income consists of six assumptions:
a) the economy consists of two sectors i.e., households and firms.
b) households spend all of their income on consumption. There is no saving.
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c) all output produced by firms is purchased by households.
d) there is no financial sector.
e) there is no government sector.
f) there is no foreign sector
Real flows of resources, goods and services have been shown in figure-2.1.
Figure-2.1: Circular Flow of Income in a Two Sector Economy

In the upper part of this figure, the resources such as land, capital and organization skills
flow from households to firms as indicated by the arrow mark. In opposite direction to this,
money flows from firms to the households as factor payments such as wages, rent, interest and
profits. In the lower part of the figure, money flows from households to firms as consumption
expenditure made by the households on the goods and services produced by the firms, while
the flow of goods and services is in opposite direction from business firms to households. Thus
we see that money flows from firms to households as factor payments and then it flows from
households to firms. Thus a circular flow of money or income is ever continuing.
2.8.2 Circular Flow of Income in a Three Sector Economy

In the above analysis of income flow, we have ignored the existence of government.
This is quite unrealistic because government absorbs a good part of the incomes earned by
households. Government affects the economy in a number of ways.
In this we concentrate on its taxing, spending and borrowing roles. Government purchases
goods and services just as households and firms do. Government expenditure takes many forms
including spending on capital goods and infrastructure (transportation, power, communication),
on defence goods, and on education and public health and so on. These add to the money flows
which are shown in figure-2.2 where a box representing Government has been drawn. It will be
seen that government purchases of goods and services from firms and households are shown as
flow of money spending on goods and services.
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Figure-2.2: Circular Flow of Income in a Three Sector Economy
Government expenditure may be financed through taxes, out of assets or by borrowing.
The money flow from households and firms to the government is labelled as tax payments in
figure-2.2. This money flow includes all the tax payments made by households less transfer
payments received from the Government. Transfer payments are treated as negative tax
payments. Another method of financing Government expenditure is borrowing from the financial
market. Government borrowing increases the demand for credit which causes rate of interest
to rise. It affects the behaviour of the firms and households.
2.8.3 Circular Flow of Income in a Four Sector Economy

Modern economy comprises a network of four sector economy these are:
a) Household Sector
b) Firms or Producing Sector
c) Government Sector
d) Foreign Sector
The money flows that are generated in an open economy is explained in this model, i.e.,
economy which have trade relations with foreign countries. The inclusion of the foreign sector
will reveal the interaction of the domestic economy with foreign countries. Foreign trade
interacts with the domestic firms and households through exports and imports of goods and
services as well as through borrowing and lending operations through financial market.
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Figure-2.3: Circular Flow of Income in a Four Sector Economy
On the other hand, purchases of foreign-made goods and services by domestic households
are called imports. Figure-2.3 explains additional money flows that occur in the open economy
when exports and imports also exist in the economy. In our analysis, we assume it is only the
firms of the domestic economy that interact with foreign countries and therefore export and
import goods and services. In the figure a flow of money spending on imports have been
shown to be occurring from the domestic firms to the foreign countries (i.e., rest of the world).
At the same time, flow of money expenditure on exports of a domestic economy has been
shown to be taking place from foreign countries to the firms of the domestic economy.
If exports are equal to the imports, then there exists a balance of trade. In fact, exports
and imports are not equal to each other. If value of exports exceeds the value of imports, trade
surplus occurs and vice versa. In the open economy there is interaction between countries not
only through exports and imports of goods and services but also through borrowing and lending
funds or what is also called financial market.

4. Explain the concept of Circular Flow of Income.
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2.9 SUMMARY
In Macro Economic analysis, National Income and National Output form the two main
indices that explain almost the structure and functioning of the economy. National Income
studies help in evolving the plans, determining the tax rates, understanding the relationship
between different sections of the economy. In order to evaluate the performance of our economic
system in terms of how rapidly it is growing how stable it is, or how it allocates its productive
sources to different end products we need some measure of output or national income. There
are six important concepts of National Income. Gross National Product (GNP),. Net National
Product (NNP), National Income at Factor Cost or National Income, Personal Income, Disposable
Income and Per capita income, these concepts explain different dimensions of national income.
Production generate incomes which are again spent on goods and services produced.
Therefore, national income can be measured by three methods; Output or Production method,
Income method and Expenditure method. In every economy there is always a circular flow of
resource services (i.e. services of land, labour capital and enterprise) from the household to
firms and the reverse movement of goods and services from the firms to the households. National
Income data is very helpful to measure economic welfare, determine standard of living of a
community, similarly to assess economic development and for comparison purpose. It is very
difficult to collect accurate statistics of National income. Due to illiteracy it is not possible to
keep regular account for petty producers. Occupational specialization is incomplete in our
economy. Lack of adequate skilled man power to collect national income statistics is another
problem. Estimation of value of inventories i.e. raw material is very difficult. Estimation of
depreciation on capital goods and avoiding double counting is too much difficult.
2.10 CHECK YOUR PROGRESS – MODEL ANSWERS

1. National income is a money measure of the value of all goods and services produced in
a year by a nation. The National Sample Survey defines national income as “money
measures of the net aggregates of all commodities and services accruing to the inhabitants
of a community during a specific period.” According to the National Income Committee
of India” A national income estimate measures the volume of commodities and services
turned out- during a given period, counted with duplication.
2. Four major components of GDP are: 1. Private Consumption Expenditure (C) 2.
Investment Expenditure (I) 3. Government Purchases of Goods and Services (G) 4. Net
Exports (X – M). Some economists have suggested an alternative approach to measure
GDP as Sum of Expenditure. Gross Domestic Product (GDP) can be measured by
taking into account all final expenditure made during a period of account in the economy.
3. There are three methods of estimating National Income. The following are: 1. Output
Method 2. Income Method and 3. Expenditure Method.
4. The modern economy is a monetary economy. In the modern economy, money is used in
the process of exchange. Thus, from the buyers’ side comes the flow of money demand.
In other words, we have expenditure- side transaction. On the sellers’ side, money
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payments go to factor owners in the form of rent, wages, etc. Firms spend money for
buying input services. Thus, we have income-side transaction from the seller’s side.
These two are adverse and reverse of the same coin. This is called circular flow of
income and expenditure.

I. Answer the following question in about 10 lines each.
1. Examine the importance of National income.
2. Write about the determinants of National income?
3. Explain the expenditure method of estimating national income.

1. Define national income and its importance in Macro Economic analysis.
2. Analyze the concepts and components of national income.
3. Briefly review about the different methods of estimating national income.
4. Examine the problems involved in the estimation of national income.
III. Objective Type Questions.

1. The net value of GDP after deducting depreciation from GDP is
a. Net national product b. Net domestic product
c. Gross national product d. Disposable income
2 The average income of the country is
a. Per capita income b. Disposable income
c. Inflation rate d. Real national income
3. National Income is calculated by
a. CSO b. Planning Commission c. RBI d. None of these
4. Among Indian Economists who had done pioneering work on national income?
a. V R K V Rao b. Dadabhai Naoroji c. Vakil d. Manmohan Desai
5. How many methods of measuring national income?
a. 1 b. 2 c. 3 d. 4
Answers: 1) b; 2) a; 3) a; 4) a; and 5) c
B. Fill in the blanks.

6. The financial year in India is ————————
7. In India National Income is calculated at ____________________
8. ______________ First chairman of Nation Income Committee.
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9. GNP – D is ___________________
10. Year of establishment of CSO _______________
Answers: 6. 1st April – 31st March 7. Factor cost 8. P C Mahalanobis 9. NNP 10. 1951
C. Match the following.

A B
11. GDP (a) C+I+G
12. GNP (b) C+I+G+(X-M)
13. NNP (c) GNP - D
14. PCI (d) GDP - D
15. NDP (e) National Income ÷ Total population
Answers: 11 - b, 12 - a, 13 - c, 14 - e, 15 – d.
2.12 GLOSSARY
• Gross domestic output: The quantity of goods and services produced in a country in
a given time period.
• Gross domestic product: The value (price X quantity) of gross domestic output in a
given time period.
• Net national product: Gross national product less depreciation.
• National income: National income less corporate profits, social insurance and transfer.
• Circular flow of Income: The concept that the aggregate value of goods and services
produced in an economy is going around in circular way, either factor payments or
expenditure on goods and services.
2.13 SUGGESTED BOOKS

1. Edward Shapiro (1984): “Macro Economic Analysis”, Galgotia Publications, New Delhi.
2. Stonier and Hague (1980): “A Text Book of Economic theory”, ELBS & Longman,
London.
3. Ahuja, H.L (2006): “Modern Economics”, S. Chand &Company Ltd; New Delhi.
4. Backerman, W. (1968): “An Introduction to National Income Analysis”, English Language
Book Society and Weldernfeld and Nicolson, London.
5. Dwivedi, D. N. (2005): “Macroeconomics: Theory and Policy”, Tata McGraw Hill, New
Delhi, 2nd Edition.
6. Ronald A. Cooper (1967): “National Income and Social Accounting”, University Library,
London.
7. Ruggles, R. and N. Ruggles (1956): “National Income Accounts and Income Analysis”,
McGraw-Hill Book Company, Inc., New York.
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BLOCK – II
THEORIES OF INCOME AND EMPLOYMENT
In this block we know clearly the origin of classism, their ideas, principles, thoughts
in different fields. In addition to that we know the some of the economist’s ideas to support
classical theory of employment. Ex: Say’s laws of the market, Pigou’s wage cut policy.
Along with these we learn nature of employment, determinant factors of employment like,
output, money, prices, savings, investment and interest rates. Also we know some of the
basic principles of Keynesian theory of employment, distinction between classism and
Keynesian versions of employment, different factors determine employment i.e. effective
demand and to know how the aggregate supply price and aggregate demand price to bring
effective demand. In addition to that the factors which help to bring employment i.e. role of
income, consumption, expenditure, saving, interest rate, investment of private and government
sectors, and also to know the role of transactionary, precautionary and speculative motives
to obtain optimum level of employment in the economy. Further this block will highlight the
consumption function, its related concepts average propensity to consume and marginal
propensity to consume, factors determining consumption function.
The units included in the Block are:
Unit - 3: Classical Theory of Employment
Unit - 4: Keynesian Theory of Income and Employment
Unit - 5: Consumption Function: APC & MPC
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UNIT – 3 : CLASSICIAL THEORY OF EMPLOYMENT
Contents
3.0 Objectives
3.1 Introduction
3.2 Assumptions of the Classical Theory
3.3 Theory of Employment
3.3.1 Concept of Full Employment
3.3.2 Say’s Law of Markets
3.3.3 Factors Determine the Level of Employment
3.4 Determination of Equilibrium Level of Employment
3.5 Wage-Price Flexibility and Full Employment
3.6 Summary
3.7 Check Your Progress - Model Answers
3.10 Glossary
3.0 OBJECTIVES
This unit explains the classical theory of employment. After go through this you will be
able to:
• explain the meaning of full employment concept in view of classical sense;
• analyze the J.B. Say’s Law of Markets;
• recognize Say’s Law of Markets serves as a corner stone for the classical theory of
employment;
• derivation of demand and supply curves of labour;
• explain how equilibrium level of employment is determined; and
• analyze wage-price changes to bring full employment in the economy.
3.1 INTRODUCTION
The science of Economics has more than two hundred years history. In 16th, and 17th
centuries economic ideas was propagated by a group of economists called Mercantilists. Their
ideas or principles were followed and practiced in all over the Europe for several years. But the
father of economics, Adam Smith, who bitterly attacked or criticized the principles or ideas of
mercantilists and he emphasized the importance of natural forces in determining wealth of
Nations. He stressed the optimizing tendencies of free market in the absence of Government.
30
Smith expresses all his ideas in his piece of monumental work. “An inquiry into the Nature and
causes of wealth of Nations”, published in 1776. This publication initiated the development of
a systematic body of economic theory over a period of 150 years. Its main contributors are
David Ricardo, Thomas Robert Malthus, Jean Baptist Say, John Stuart Mill, Alfred Marshall
and A.C. Pigou. The ideas of all these economists were starting from Adam Smith to A.C.
Pigou are called the ‘classical economics’ and all these economists are called ‘classical
economists.’ Classical theory discusses mainly the aspects of what goods are to be produced in
the economy, how the resources are to be properly allocated for the right production of various
goods, how the prices of the products and prices of factor are to be determined, how the total
product is to be distributed among the various factors of production etc. Classical theory discusses
all these aspects both at the individual level and aggregate level. The part of the classical
economics deals with the aggregates. The important components of classical macro economics
are classical theory of employment, output, money, prices, saving, investment and interest. In
this lesson we will discuss clearly classical theory of employment.
3.2 ASSUMPTIONS OF THE CLASSICAL THEORY

The classical theory of output and employment is based on the following assumptions.
1. Existence of full employment without inflation.
2. There is a closed laissez – faire capitalist economy without foreign trade.
3. Perfect competition is necessary both in labour and product markets.
4. Labour is in homogenous character.
5. Total output of the economy is divided two parts consumption expenditure and investment
expenditure.
6. Quantity of money is constant.
7. Flexibility is necessary in both wages and prices.
8. Money wages and real wages are directly related with each other and also proportional.
9. In the short run there is no change in capital stock and technological knowledge.

1. Who are the prominent economists included in classical school?
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2. What are the important macro components of classical economists?
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3. What are the assumptions of classical theory of employment?
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3.3 THEORY OF EMPLOYMENT

The classical proposition is that the economy is always in the state of full employment
without inflation. Given wage-price flexibility, there are automatic forces in the economy that
tend to maintain full employment, and produce output at that level. Hence full employment is
regarded as a normal situation. Even if the economy is away from the full employment
equilibrium position, the deviation from this level is something abnormal is purely temporary
which automatically tends toward full employment in a short span of time with the help of
natural forces. Here we have to observe that the economy is always at a state of stable full
employment equilibrium, and how the forces will act automatically and bring the economy to
a state of full employment equilibrium by way of changing wage-price in the economy.
3.3.1 Concept of Full Employment

In an ordinary parlance full employment means employment of all the available resources
without leaving anything unemployed. But classical economists did not use the term “Full
employment” in this sense. According to classical “Full employment” means absence of
involuntary unemployment. Full employment is a state where all those who are willing to work
at prevailing wage rate are employed. But it does not mean that there is no unemployment in
the economy. Still certain types of unemployment like seasonal, frictional, disguised
unemployment will exist with full employment.
Voluntary unemployment means those people who are not willing to work at present
existing wages of prices. Likely people have only few months of work and remaining time they
are ideal it is called seasonal unemployment. This kind of unemployment appears in agriculture
activity. Ex: After harvest is over workers will be ideal until next sowing seasons. Likely
Disguised unemployment is also exist particularly in agriculture sector. If a farm has requires
10 labours for plantation or harvesting. Instead of that the total available number of workers or
family members may be engage in the same farm or field for sowing, weeding or harvesting,
they may partially get employment through their field, it is generally called as disguised
unemployment. This kind of unemployment exists mainly in Agricultural oriented countries.
The reason is lack of employment opportunities in other sectors like industrial or service sectors.
Frictional unemployment arises due to tremendous changes in science and technology.
When technology changes, labour, with their existing skills and knowledge is not fit to take up
their economic activities. Hence they require updating their skills, until they may acquire new
skills, they may be unemployed. This type of unemployment is called frictional unemployment.
This kind of unemployment is exist in highly industrially developed economies.
3.3.2 J.B. Say’s Law of Markets

We are already known that according to classicals the economy is always in a state of
full employment. The fundamental base for this proposition is J.B. Say’s Law of Markets.
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Say’s Law of markets is a core or corner stone or central pillar of the classical theory of
employment. Jean Baptist Say, an early 19th century French economist, who enunciated a
proposition that “supply creates its own demand.” Now we shall try to understand more clearly
what is this law, and when this law is true, how the economy attains full employment.
Generally in any economy, people participate in the productive activities they produce
goods and earn income they utilized their income to purchase goods and services. In a two sector
economy business sector productive sector, firms hire or purchase factor services. They can make
use factor services and produce goods and services and sell them to consumers. The amount
earned is distributed in the form of factor incomes. Since people participated in economic activities
to earn the income and spend it on goods and services, production good creates required demand
for them i.e. supply creates its own demand. When there is only one producing unit in the economy
it is very easy to visualize that supply creates its own demand. When there are several firms in the
economy, people purchase the goods produced by many firms. Therefore income generated in
each firm creates the demand for the goods of various other firms along with the demand for its
own product. Until income generated in all firms is sufficient to purchase goods produced by
other firms in the economy. Then supply equals to demand. In such a situation there cannot be
general over production because supply of goods will not exceed demand as a whole.
When supply creates its own demand, there is no scarcity or deficiency of demand in the
economy. Producers sell their entire product to earn profits, for maximizing profits producers
will continuously increase the employment until all the available resources are exhausted. That
is the state of full employment in the classical sense. The state of full employment is base on
Say’s Law of Markets. In such a situation there cannot be general over production of general
unemployment. In fact this Law serves as a corner stone of entire classical theory of employment.
Say’s Law of Market is truly applicable in a barter economy, when people receive their
income in terms of goods they produce. In the money economy, people receive their income in
terms of money for rendering their services. Even the existence of money does not alter the
basic Say’s Law. According to Say the main source of demand is the flow of factor income
generated from the process of production itself. When producers obtain the various inputs to be
used in the production process, they generate the necessary income accruing to the factor owner
in the form of rent, wages and interest. This in turn demands for the goods produced. This
reasoning is based on the assumption that all income earned by the factor – owners in spent in
buying commodities which they help to produce.
General behavior of the people is that they save a part of their money income, what is not
spent is automatically invested. Thus saving must equal investment. If there is any divergence
between saving and investment, the equality is maintained through the mechanism of rate of
interest. According to classists, people divert a part of their income from spending stream in
order to meet their future needs. Generally it is called as saving. In other words, saving means
the postponement of present consumption.
According to classists, interest is a reward for saving. The higher the rate of interest,
higher the saving and vice versa. The relationship between saving and interest rate is called the
classical saving function. In mathematical notation it can be written as S = f (r), where ‘S’ is
33
saving, ‘r’ is the interest rate and ‘f’ is a function. The curve show its relationship is called as
saving curve, it generally moves an upward sloping curve.
Saving yield a return only when it is used in a proper investment. For making investment,
firms borrow the funds on same interest rate. The level of borrow depends on the returns on
investment and rate of interest. Given rate of return on investment, it is the rate of interest that
determines the level of investment in any economy. Higher interest rate higher saving. On the
contrary, the lower the rate of interest, higher the demand for investment funds. The relationship
between investment and rate of interest is shown as I = f (r), where ‘I’ is investment, ‘r’ is a rate
of interest and ‘f’ is a function. The curve representing this relationship is called investment
demand curve it is a down word sloping curve from left to the right.
At any given period investment exceeds saving, rate of interest will rise, saving will
increase and investment will decline till the two are equal at full employment level. Saving is
regarded as an increasing function of the interest rate and investment as a decreasing function
of rate of interest.
The Mechanism of equality Y I1
between saving and investment is I S
Rate of interest (r)
shown in figure 3.1. In the figure, the E1

r1
rate of interest is measured on Y axis E
r
and saving and investment is
measured on X axis. I, I is the I1
investment demand curve, SS is the I
saving curve. The two curves
intersect at point E, where the rate of O A C X
interest is Or and both saving and Saving (s) = Investment (I)
investment are equal to OA. If there
Figure – 3.1: Equilibrium of Capital Market
is an increase in investment, the
investment curve shifts to the right as I1 I1 curve and at the interest rate ‘Or1’ investment ‘OC’
is greater than ‘OA’ saving. SS curve remain at its original level, when there is any increase in
investment. To maintain equality between saving and investment, the rate of interest will rise.
This is shown to rise to ‘Or1’in figure 3.1. At this interest rate, saving curve SS intersects the
investment curve I1 I1 at E1 consequently, both saving and investment equal at OC. Hence, in a
money economy saving is always equal to investment, and J.B. Say’s Law of Market is proved
to be true.

4. Discuss classical views of full employment?
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5. Explain Say’s laws of markets.
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3.3.3 Factors Determine the Level of Employment
As per the classical version, the actual level of employment in any economy is determined
in the labour market by the interaction of two forces namely demand for labour and supply of
labour. Now we will try to understand how these two forces will interact in the labour market
and bring the equilibrium level of employment.
1. Demand Function of Labour

The basis for the demand function of labour is the aggregate production function. Now it
is necessary to study what is aggregate production function. The aggregate production function
is depending upon the marginal productivity of labour, which in turn determines equilibrium
level of productivity.
Aggregate Production Function

We are all aware that in the process of production all the firms use various inputs and
produce output. The level of output generally depends upon the size of inputs used. The physical
or technological relationship between the output produced and the inputs employed is called
the production function. Either it can be at the firm level, industry level and aggregate level.
The production function at aggregate level is called the aggregate production function. It
is defined as the relationship between aggregate amount of output produced and the aggregate
amount of inputs employed. If the output is produced by using only two inputs say labour and
capital, then the mathematical notation aggregate production function can be written as
Y = f (L, K)
Where Y is the aggregate amount of output produced.
L is the aggregate amount of labour employed.
K is the aggregate amount of capital employed. and
If we assume that the stock of capital is given to be K , then the aggregate output varies
with only the labour employment and the
Y
aggregate production function becomes Y
= f K (L).
Stage II
Output (y)
The above relationship is such that

as the employment of labour increases,
initially the output also increases at an
increasing rate, after some state it increase
Stage III
at a decreasing rate and finally it Stage I
continuously declines, if labour is X
O
continuously employed. This relationship Labour (L)
can be shown in figure 3.2. Figure – 3.2: The Total Product Curve
When we observe the production
curve an intelligent producer always will opt only I & II stages. At I stage his expected returns
are very high at this stage he will employ more labour continuously, the production level enter
35
into II stage it is an optimum stage to him.
Y
The third stage is not advisable. Therefore
the relevant part of the total product is
shown in the figure 3.3.
Output (y)
Marginal Product Curve of Labour
The level of product is associated
with the marginal productive curve of
labour and additional unit of input used.
Thus the marginal productivity of labour O X
Labour (L)
(MPL) is the output produced by an
additional unit of labour. Symbolically it Figure – 3.3: Relevant Part of Total
can be expressed as MPL =DY/DL. Product Curve
Where DL is the change in labour

employment and DY is the corresponding Y
change in output. In the third stage in figure Marginal productivity of

3.2 level of production, MPL continuously Labour (MPL)
declines with the increase in employment of
labour. The marginal productivity curve shown
the relationship between MPL and labour
employment it is always pass in downward MPL
sloping, this can be shown in figure 3.4. O X
Labour (L)
The marginal productivity curve of
Figure – 3.4: Marginal Productivity
Labour shows the output produced by an
Curve of Labour
additional unit of labour at different levels of
employment. This curve can also serve as demand curve for labour. Now we shall examine
how this curve can serve as a demand curve of labour.
Labour Demand Curve

Generally all firms try to maximisation of their profits. To achieve this objective they
will always compare the marginal productivity of labour with their price or wage. Until the
marginal physical productivity of labour (MPPL) is greater than the real wage (W/P) it is a
profitable position to a firm, they employ additional unit of labour. This state will continue
until MPPL is equal to real wage level. If the size of employment is increased continuously
beyond that stage, MPPL will be less than real wage, no rational producer will to that. Thus the
firm’s demand that amount of labour whose MPPL is equal to real wage. If the MPPL is less
than the real wage the producer will stop production. In the figure 3.4 marginal productivity
curve shows MPL at various level of employment. In the figure 3.5, real wage (W/P) is measured
on Y axis and Demand for labour on X axis. With the help of marginal physical productivity
labour and real wage we will draw MPPL curve.
36
In the figure 3.5, when the Y
real wage is (W/P)1. The demand
for labour L1, when the real wage
Real wage (W/P)

is increases (W/P)2 level, Demand
for labour will decrease L2. This (W/P)2
clearly shows that when the
marginal physical productivity of (W/P)1
labour is less than the real wage
MPPL
demand for labour will decrease
from L1 to L2. It is clear from
O L2 L1 X
figure 3.5 demand for labour
Demand for Labour (DL )
depends on the real wage. To
express relationship between the Figure – 3.5: Demand Curve for Labour
demand for labour and real wage is called demand function for labour. It can be expressed in
mathematical notation is DL = DL (W/P) .
Where DL is the demand for labo-ur and W/P is the real wage i.e. wage is divided by
price level it reflect the real wage level. If the wage level is not increase in proportion with
money wage real wage is decreased and demand for labour will decrease. It means price of
labour becomes very cheap. The relationship between wage and price is called demand curve
of labour.
Supply Function of Labour

In any economy labour services are supplied by labourers. When the labourers sell their
services, in turn they receive remuneration in the form of wages, which gives them utility.
Whenever supply of labour sacrifice leisure, it causes disutility. Hence it causes both utility
and disutility to the labourers. Any attempt is made to increase the utility by increasing the
incomes through the supply of more services will automatically led to increase the disutility
through the sacrifice of leisure. According to classical labours will always try to maximize
their utility in supplying labour services. Based on this type of behavior of the labourers we can
draw the labour supply curve.
In general the available time is fixed (24 hours) for every individual. He allocates his
time between work (income = work X real wage) and leisure in such a way that he maximize
his satisfaction. At a given real wage, his income increases only with the decline in leisure
time. We already know that income gives satisfaction and sacrifice of leisure gives dissatisfaction.
Hence there is a trade-off between income and leisure. It is possible to find various levels of
Income and leisure, which gives the same level of satisfaction, an individual can be indifferent
to choose one among them. We plot several points on the graph by various combinations of
income and leisure, it form a curve. It is known as ‘Indifference curve.’ With the help of
indifference curves we can measure various combinations of income and leisure, individual
choose maximum utility. To find out such a combination there is a need of line like the budget
constraint used in the theory of consumer behavior. Here the line showing the income position
of individual at various levels of leisure (24 hours work) serves as a budget constraint. This line
37
is given by Y = (W/P) (24-L), where Y is
the level of income, L is the hours of leisure
y
and (W/P) is the real wage. It is also called
Y = (W/P)o N
as income leisure constraint line.
Income (y)
The figure 3.6 clearly shows that U5
U4
the allocation of time between Income
U3
(work) and leisure time, given real wage. U2
In the diagram income is measured on Y U1
axis, and leisure time L is measured on
O N
X-axis. Since the total time available is
fixed, (24 hours), the hours of work is - Leisure (L) →←Work (N) - X
always equal to total time minus leisure Figure – 3.6: Income Leisure Trade-off
i.e. N = 24-L. Hours of work is measured with the help of indifference curves U1, U2, U3 and the
line Y = (W/P). N is the income leisure constraint line.
In the figure 3.6 the higher indifference curves shows the higher levels of both Income
and leisure, and give higher level of satisfaction. Hence individual is always tried to be on the
highest indifference curve. At a given income leisure constraint line, whose position is fixed by
the real wage (W/P). The individual can reach at U3 and he allocates his time between work
and leisure in such a way that he receives an income of OY and takes a leisure of ON. With
combination of OY and NO, given the real wage (W/P.)0.
The level of income – leisure constraint line depends on the real wage; it changes with
the real wage. Increase in real wage leads to a right ward rotation in the income leisure constraint
line as shown in the figure 3.7. The income – leisure combinations will also change with
change in real wage. The number of hours an individual will work per day depends on the real
wage. The relationship between the number of hours and individual works and real wage is
called an individual’s supply function of labour. The curve representing this function is called
an individual’s supply curve of labour. It can be shown in the figure 3.7.
Y
Y3 C
U3
Income (y)
B
Y2 U2
(W/P)o = 6 U1
A
Y1
(W/P)o = 4
16 14 12 (W/P)o = 2
O X
- Leisure (L) → ←Work (N)
Figure – 3.7: Income Leisure Trade off
38
When the real wage Rs.2/- per hour, individual choose a combination of income (work)
and leisure represented by point A. At this wage Rs.2/- individual choose 12 hours per day.
When the real wage increase from Rs.2/- to
4/-, individual choose a different Y
combination of work and leisure. At this
wage he chooses 14 hours work 8 hours
Real wage (W/P)

leisure per day. Again when the real wage
increases from Rs.4/- to Rs.6/- individual
choose his combination at point C. At this
point he will work 16 hours and take 6 hours
leisure. Various combinations of work and
leisure at various points A, B and C at
O X
various wage level integrate and derive a Hours of work (N)
new curve, it is known as supply curve of Figure – 3.8: Supply Curve of Labour
labour. This can be shown in figure 3.8.
From the figure 3.8 it is clear that an individual labour supply increases only with the
increase in real wage level. The relationship between real wage and work is called as an individual
supply function of labour. In mathematical notation it can be written as SL = SL (W/P.)
SL is the supply curve of labour and W/P is the real wage of workers when real wage
increases aggregate supply of labour is also increases upto a certain level and then it decline.
The curve representing this relationship is called as an aggregate supply curve of labour.
3.4 DETERMINATION OF EQUILIBRIUM LEVEL OF

EMPLOYMENT
According to classical theory
of employment, demand for labour Y
and supply of labour continuously SL
Real wage (W/P)
(W/P)2
interact in the labour market and
bring equilibrium level of
(W/P)0
employment. At this level demand
for labour is equal to the supply of (W/P)1
labour. Now we shall examine
graphically the demand and supply DL
O N2 N4 N0 N1 N3 X
of labour interact in the market and
obtain equilibrium level of Employment (N)
employment. This can be shown in Figure – 3.9: Equilibrium Level of Employment
the figure 3.9.
In the figure 3.9, DD is the Demand curve of labour SS is the supply curve of labour. DD
and SS intersect at point E and determine ON0 employment at W/P0 real wage this is the
equilibrium level of employment.
39
According to classical full employment in the economy is a natural phenomenon. At this
stage that are willing to work at this wage rate will find employment.
To have a clear understanding the concept of full employment, to take disequilibrium
position and examine the process of change. At any wage rate lower than (W/P)0, say at W/P1,
the demand for labour (ON1) is greater than supply of labour ON2. This position automatically
raises wage level from W/P1 to W/P0 level. Once this stage is reached, there is no further
tendency for the firms to increase the money wages because at that stage demand for labour is
equal to supply of labour. On the other hand if the real wage level above W/P0. at this stage
supply of labour (ON3) is greater than the demand for labour (ON4) because wage level is high
level i.e. W/P2. It creates a fear and uncertainty among the labourers, whether they can find
employment or not. This unemployment threat induces the labourers to offer the labour at
lower wage rate. At this stage wages take a downward trend and it will continue until the real
wages down upto W/P0. Once this stage is reached there is no further tendency for the labourers,
to reduce the wage because the demand for labour is exactly equal to the supply of labour. At
this equilibrium level of employment is called as full employment.
3.5 WAGE – PRICE FLEXIBILITY AND FULL EMPLOYMENT

Through changes in wages and prices, economy is adjusted from a disequilibrium position
to equilibrium position. Therefore, wage-price flexibility and perfect knowledge of the market
for both labourers and (firms) entrepreneurs is a essential conditions for the attainment of full
employment. If the labour market is not perfect, labourers form as a union, they will always try
to push the money wages upwards and they will never allow them to fall down by exercising
their union power. So that wages are flexible upwards and rigid downwards. In any economy
the labour supply is excess, the money wages are rigid, the result is unemployment in the
economy. It can observe in the above diagram 3.8. When the real wage (W/P)2 the supply of
labour is ON3 and the demand for labour is ON4. Therefore, N4 N3 is unemployment of the
workers who are not ready to offer their labour services at a lower real wage. This will continue
unemployment in the economy. The classical economists always attribute the existence of
unemployment in the economy, if it exists, to the rigidity of the money wages. To solve this
problem of unemployment in the economy classical suggested wage-price flexibility is the
only solution.

6. What is aggregate production function?
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7. Explain marginal productivity of labour in equation form.
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8. Discuss the classical equilibrium level of employment.
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9. How wage-price flexibility brought full employment.
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3.6 SUMMARY
Classical economists always believe in perfectly competitive markets, which bring full
employment in any economy. Full employment means absence of involuntary unemployment.
This notion is based on J.B. Say’s Law of Markets, which states that supply creates its own
demand. Equilibrium level of employment is determined by demand and supply of labour in
the market. The demand curve of labour is the marginal productivity curve of labour and it is
derived from the, aggregate production function. In the functional form it is given by DLDL
(W/P), and ∆DL/∆(W/P)<0. The supply curve of labour is derived in the functional form by
SL = SL (W/P) and ∆SL/∆(W/P)>0. Until labour market is perfectly competitive, money wages
and prices are freely flexible, adjustments in the money wages and prices will continuously
take place until demand for labour is equal to supply of labour. Attainment of full employment
in the economy is automatic with the force of Natural forces. According to classists in any
situation if unemployment prevail, it is only due to the rigidity of money wages. Hence they
had given a better solution only wage-price flexibility for solving the problem of unemployment
in the economy.

1. The prominent economists included in classical school are David Ricardo, Thomas Robert
Malthus, Jean Baptist Say, John Stuart Mill, Alfred Marshall and A.C. Pigou. The ideas
of all these economists start from Adam Smith to A.C. Pigou is called the ‘classical
economics’ and all these economists are called ‘classical economists.
2. The important macroeconomic components of classical theory of employment are output.
Money, prices, saving, investment and interest.
3. The classical theory of output and employment is based on the following assumptions. i)
Existence of full employment without inflation. ii) There is a closed laissez – faire
capitalist economy without foreign trade. iii) Perfect competition is necessary both in
labour and product markets. iv) Labour is in homogenous character. v) Total output of
the economy is divided two parts consumption expenditure and investment expenditure.
vi) Quantity of money is constant. vii) Flexibility is necessary in both wages and prices.
viii) Money wages and real wages are directly related with each other and also
proportional. ix) In the short run there is no change in capital stock and technological
knowledge.
41
4. According to classical view “Full employment” means absence of involuntary
unemployment. Full employment is a state where all those who are willing to work at
prevailing wage rate are employed.
5. J.B. Say’s Law of Markets. Say’s Law of markets is a core or corner stone or central
pillar of the classical theory of employment. Jean Baptist Say, an early 19th century
French economist, who enunciated a proposition that “supply creates its own demand.”
6. The aggregate production function explains, the physical or technological relationship
between the output produced and the inputs employed is called the production function.
Either it can be at the firm level, industry level and aggregate level.
7. The marginal productivity of labour (MPL) is the output, produced by an additional unit
of labour employed. Symbolically it can be expressed as MPL = Y/DL.
8. According to classical theory of employment, demand for labour and supply of labour
continuously interact in the labour market and bring equilibrium level of employment.
At this level demand for labour is equal to the supply of labour.
9. Wage-price flexibility and perfect knowledge of the market for both labourers and (firms)
entrepreneurs is a essential conditions for the attainment of full employment. If the labour
market is not perfect, labourers form as a union, they will always try to push the money
wages upwards and they will never allow them to fall down by exercising their union
power. So that wages are flexible upwards and rigid downwards through this full
employment attain in the market.

1. Explain J.B. Say’s Law of Market.
2. Discuss the important assumptions of classical theory.
3. Explain production functions.

1. Explain classical theory of employment.
2. Point out the classical theory of interest rate determination.
3. Write classical theory of employment and income determination.
4. Discuss classical theory of employment and income.

1. The first economist who criticized mercantilists’ economic ideas?
a) Adam Smith b) Marshall c) Pigou d) Keynes
2. Among these Economists who is not a Classical Economist?
a) David Ricardo b) Thomas Robert Malthus c) Marshall d) J.M. Keynes
42
3. If MPPL is less than real wage, the producers will
a) Increase the production b) Stop the production
c) Decrease the production d) None of the above
4. According to Classicals the employment in labour market is determined by
a) Demand for labour b) Supply of labour c) a & b d) None of the above
5. Interest is a reward for
a) Investment b) Saving c) Capital d) None
Answers: 1. a; 2. d; 3. b; 4. c; and 5. b

6. Production function ( ) (a) DL = DL(W/P)
7. J.B. Say ( ) (b) Adam Smith
8. Wealth of Nations written by ( ) (c) French Economist
9. Supply creates its own demand ( ) (d) Y= f(L,K)
10. Demand function of labour ( ) (e) J.B. Say
Answers: 6. d; 7. c; 8. b; 9. e; and 10. a

11. Classical economists always believes in ______________ competition.
12. Wealth of nations published by Adam Smith in the year of ________________
13. According to the classists full employment is possible through _____________forces.
14. The concept of supply creates its own demand developed by ______________
15. According to classists full-employment is attained ____________ flexibility.
Answers: 11. Perfect 12. 1776 13. Automatic or Natural 14.J.B.Say 15. Wage-price
3.9 GLOSSARY
1. Laissez-faire economy: Literally, leave today. A policy of complete non-intervention
by government in the economy, leaving all decisions to the market. If there was no
market failure then laissez-faire would ensure the attaining economic efficiency.
2. Perfect competition: An idealized market situation in which all information is known
to all market situation in which all information is known to all market participants, and
both buyers and sellers are so numerous that each is a price-taken, able to buy or sell any
desired quantity without affecting the market price.
3. Full employment: A situation where the labour market has reached a state of equilibrium,
so that those in the active labour force who are willing and able to work at going wage
rates are able to find work and the only remaining unemployment is frictional
unemployment.
43
4. Savings: Savings is a flow and refers to the excess of income over consumption in a
given period.
5. Savings Function: It shows relationship between savings and rate of interest.
6. Savings curve: The curve representing the savings functions.
7. Say’s law: Typically summarized as the proposition that ‘supply creates its own demand.’
The argument behind say’s law is that the supplier of a product will spend the income
received, thus the supply creates its own demand.
8. Investment: The process of adding stocks of real productive assets. This may mean
acquiring fixed assets, such as buildings, plant, or equipment, or adding to stock and
work in progress.
9. Investment Demand Function: It shows relationship between investment and rate of
interest.
10. Investment Demand curve: The curve representing investment demand function.
11. Aggregate production function: The technical or physical relationship between
aggregate output and inputs.
12. In voluntary unemployment: Unemployment caused by imperfect matching in the labour
market between people who want jobs and employers who offers jobs.
13. Marginal product: The extra output that results from a small increase in an input.
14. Marginal product curve of labour: The curve representing the relationship between
marginal product of labour and labour employment.

1. Stonier and Hague : A Text Book of Economic Theory.
2. Edward Shapiro : Macro Economic Analysis.
3. H.L. Ahuja : Macro Economics Theory and policy.
4. M.L. Jinghan : Macro Economics.
5. M.C. Vaish : Macro Economic Theory.
44
UNIT – 4 : KEYNESIAN THEORY OF INCOME AND
EPLOYMENT
Contents
4.0 Objectives
4.1 Introduction
4.2 Keynes Theory of Employment
4.2.1 Aggregate Demand Price
4.2.2 Aggregate Demand Curve or Function
4.2.3 Aggregate Supply Price
4.2.4 Aggregate Supply Curve or Function
4.2.5 Effective Demand
4.2.6 Determination of Equilibrium Level of Employment
4.2.7 Outlines of the Keynes Model of Employment
4.3 Keynesian Theory of Income determination in a Two Sector Economy
4.3.1 National Income Accounting Identities and the Equilibrium Conditions for
determination of Income.
4.3.2 Consumption Expenditure and Related Concepts
4.3.3 Saving Function
4.3.4 Determination of Equilibrium level of Income
4.4 Summary
4.7 Glossary
4.8 Suggested Books
4.0 OBEJECTIVES
The intention of this unit is explain the ideas of J.M. Keynes and his disciples on
determination of employment and income. After go through this unit you will be able to:
• know the Keynes concepts of aggregate demand, supply and finally effective demand;
• understand the Keynes theory of employment;
• recognize how Keynes ideas are modified by his disciples in the determination of income;
• understand Keynes consumption function and its related concepts; and
• discuss income determination in two sector economy.
45
4.1 INTRODUCTION
Keynesian contribution to macroeconomics can be traced in his “General theory of
employment, interest and money” (1936). His work, popularly known as General theory brought
a revolution in the thinking of economists, administrators and statesmen all over the world.
Keynesian revolution is a comprehensive analysis of aggregate economic variables like income,
employment, money etc. According to Keynes the level of employment and income are
determined by the real factors and monetary factors together. Keynesian analysis is aimed at
reviving the economies from the effects of depression. In the long run we are all dead and
buried hence Keynesian analysis is a short-run analysis. Further, his theory relates to the aggregate
and comparative static analysis.
Generally, all nations aim at attaining full employment. It is known that employment
provides livelihood to factor inputs like labour. Factor inputs produce output and increase the
incomes of producers and consumers (workers). As a result, the demand for goods and services
is generated. However, there are differences in the views of classical economics and Keynes on
some of these issues.
Keynes rejected the classical view that every economy will have natural capacity to
move towards full employment level. Keynes said employment cannot increase on its own and
on the other hand governmental interference is necessary to increase the level of national
employment. J.B. Say’s law of markets ‘supply creates its own demand,’ was discarded by
Keynes. He said that during depression an increase the demand would cause an increase in
supply. Further pigou’s version of wage cut resulting in more and more employment is also not
true. On the other hand, wage cut may further lead to a decline in the level of employment. The
classical view that savings investment equality determines the interest rate is discarded by
Keynes who held the view that the equilibrium between savings and investment is possible by
changes in income. In this unit, we shall discuss the outlines of Keynes theory of employment,
income in two sector economy.
4.2 KEYNESIAN THEORY OF EMPLOYMENT

Keynes theory of employment is based on the following concepts viz. Aggregate Demand
(AD) and Aggregate Supply. (AS) It is a fact that income and employment are related to one
another. If income changes employment also changes in the same direction. At the Firm’s level,
the level of employment depends upon the decisions of the firm. Every firm wants to maximize
its profits. At the national level employment depends upon the decision of all producers. Here
also their decisions are governed by profit and with the primary objective of profits they estimate
their aggregate demand and aggregate supply.
4.2.1 Aggregate Demand / Price

Aggregate demand price for the output of any given amount of employment is the total
sum of money or proceeds, which is expected from the sale of output produced when the
amount of labour is employed. Aggregate demand price is the amount of money which the
entrepreneurs expect to get by selling the output produced by the number of men employed. In
46
another way, it refers to the expected revenue from the sale of output produced at a particular
level of employment. Different aggregate demand prices related to different levels of employment
in the economy.
4.2.2 Aggregate Demand Curve or Function

Aggregate demand function is a
Y
statement showing the various aggregate
AD
demand prices at different levels of
employment. In mathematical farm, it can be
demand price
Aggregate
express as D = D (N) where D is the aggregate
demand price and N is the employment. When
employment increases aggregate demand price
is also increases. The curve showing the
relationship between these two is called as the
aggregate demand curve. It move generally an O X
upward sloping curve as shown in figure 4.1. Employment (N)
4.2.3 Aggregate Supply Price Figure – 4.1: Aggregate demand curve
When an entrepreneur gives employment to certain amount of labour, it requires certain

quantities of cooperate factors like land, capital, raw material etc., which will be paid
remuneration along with labour. In brief aggregate supply price refers to the proceeds necessary
from the sale of output at a particular level of employment. In other words producers must
receive at least the cost of production by the sale of output. Thus each level of employment in
the economy is related to a particular aggregate supply price and there are different aggregate
supply prices for different levels of employment. So, aggregate supply price is the cost of
production.

1. Discuss aggregate demand price.
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
2. Explain aggregate demand function in mathematical equation.
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
3. Discuss aggregate supply price.
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
47
4.2.4 Aggregate Supply Curve or Function
Aggregate supply function is the
Y AS
relationship between the aggregate supply
price and level of employment. Symbolically
it can be written as S = S(N) where S is the
supply price
Aggregate
aggregate supply price and N is the level of
employment. The nature of this relationship is
such that the aggregate supply price increases
with the increase in the level of employment.
The curve representing this relationship is
X
O Employment (N)
called the aggregate supply curve. It is an
upward sloping curve as shown in diagram 4.2. Figure – 4.2: Aggregate supply curve
As per the estimates of all producers in
the nation, by the employment of some amount of workers (N), If aggregate Demand price is
more than Aggregate supply price (Revenue exceeding the cost of production), they employ
more and more number of workers. This process continues up to a level of employment N+N1
workers where their profits (Revenue > cost) disappear. On the other hand, if aggregate
supply price is more than the Aggregate Demand price (cost exceeding revenue) they reduce
the number of workers employed. This process continues up to the level where their losses
(cost > revenue) are wiped out.
Thus, adjustment in the level of employment goes on until the Aggregate demand price
is equal to Aggregate supply price (Revenue = cost).
Aggregate demand price > Aggregate supply price ! Employment increases.
Aggregate supply price > Aggregate demand price ! Employment decreases.
Aggregate Demand price = Aggregate supply price ! Employment is stable.
4.2.5 Determination of Effective Demand

The level of employment is determined at the point where the aggregate demand price
equals the aggregate supply price. It is the point where what the entrepreneurs expect to receive
equals what they must receive and their profits
are maximized. This point is called the effective
Y
demand and here the entrepreneurs earn normal ASP
profits. The proceeds expected (revenue) rise E
ADP & ASP
more than the proceeds necessary (costs). This ADP

process will continue till the aggregate demand
price equals the aggregate supply price and the
point of effective demand is reached. This point
determines the level of employment and output
in the economy. This situation can be shown in O X
diagram 4.3. Employment (N)
Figure – 4.3: Effective Demand
48
4.2.6 Determination of the Equilibrium Level of Employment
According to Keynes the level of employment in the economy is determined by effective
demand. Effective demand (ED) which in turn is determined by AS and AD functions. Figure
4.4 shows that the X-axis measures the level of employment in the economy and Y axis measures,
Aggregate demand price and supply prices. The two curves intersect (AD/AS) each other at
point E. This is effective demand where ON workers are employed. At this point the
entrepreneurs’ expectations of profits are maximized. At any point other than this, the
entrepreneurs will either incur losses or earn subnormal profits. At ON1 level of employment
the proceeds expected (revenue) are more than the proceeds necessary (costs) i.e. RN1 > CN1.
This indicates that it is profitable for
Y Effective Demand AS
the entrepreneurs to provide
Aggregate Demand Price &

C1
Aggregate supply price

increasing employment to workers till
ON level is reached where the E
proceeds expected and necessary R
R1 AD
equal at point E. It would not be,
profitable for the entrepreneurs to
increase employment beyond this to C
NF level because the proceeds
necessary (costs) exceed the proceeds
O X
expected (revenue) C1NF > R1NF and N1 N NF
they incur losses. Thus E, the point Employment (N)
of effective demand determines the Figure – 4.4: Determination of Equilibrium
actual level of employment in the level of employment
economy which is of underemployment equilibrium.
Of the two determinants of effective demand, Keynes regards the aggregate supply function
to be given, because it depends on the changes in technology, availability of raw materials, machines,
etc. which do not change in the short run. It is, therefore, the aggregate demand function which
plays a vital role in determining the level of employment in the economy. According to Keynes,
the aggregate demand function depends
Y AS
on the consumption function and
investment function. The cause of AD1
Aggregate Demand Price &
E1
Aggregate supply price
unemployment may be a fall in either

consumption expenditure or investment
expenditure, both. The level of
employment can be raised by increasing E
either consumption expenditure or AD
investment expenditure, or both. Thus, it
is the aggregate demand function which
is the “effective” element in the principle
of effective demand. Prof. Dillard regards X
O N NF
this as the core of the principle of effective
demand. Employment (N)
Figure – 4.5: Determination of Equilibrium
level of employment 49
It follows that to raise the economy to the level of full employment requires the raising
of the point of effective demand by increasing the aggregate demand. This is shown in below
figure 4.5. Where E is the point of effective demand which determines ON levels of employment.
If ONF is the level of full employment for the economy, it requires the raising of the point of
effective demand. This is possible by raising the aggregate demand curve AD1 where it intersects
aggregate supply curve AS at E1. This is the new point of effective demand which provides an
optimum level of employment ONF to the economy. If the AD function is raised beyond this
point the economy will experience is inflation because all the existing resources are fully
employed and their supply cannot be increased during the short run, it clearly shown in the
vertical portion of the AS curve in the figure 4.5. As per the diagram economy is always at a
state of under employment equilibrium i.e. equilibrium less than full employment level.

4. Explain aggregate supply function in symbolic form.
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
5. How the effective demand is determined?
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
6. Elucidate the Equilibrium Level of Employment according to Keynes.
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
4.2.7 Outline of the Keynes Model of Employment
To have a clear understanding of underemployment equilibrium, to study the entire model
developed by Keynes. Keynes underemployment equilibrium can be shown through a chart.
Employment
Effective Demand
Aggregate Demand Aggregate Supply
Consumption Demand Investment Demand
Income Propensity Rate of Interest Marginal Efficiency

Consume of Capital
Money supply Liquidity Cost of Business

Preference capital expectation
Transactions Precautionary Speculative

Motive motive demand
for money
Level of Income Psychological

Character
50
4.3 KEYNESIAN THEORY OF INCOME DETERMINATION IN
A TWO SECTOR ECONOMY
Keyes explained that income and employment are related to one another and are influenced
by each other by changing in the same time. Again these two are dependent on effective demand.
In other words an increase in effective demand results in an i.e. increase in income and
employment. The functional relationship between them is
Y= f (E) where Y is income.
E = f (Y) where E is employment.
E & Y = f (ED) where E.D. is effective demand.
Effective demand means real demand or the demand that can be established.
Effective Demand = Total Expenditure.
Total Expenditure = Total Income.
Total Income = Total production.
In the analysis National income, last year income expenditure and production are equal
to one another.
Gross National Product = Gross National income = Gross National Expenditure
GNP = GNY = GNE
Somehow, if the total expenditure increased, the effective demand increases and the
income and employment also rise. The crucial issue is to increase the total expenditure. In the
National income analysis of a closed, two sector economy namely household sectors and business
sector, the amount spent by households on consumer goods and services is called consumer
expenditure (c). The amount spent by the firms an investment is called investment expenditure
(i). Generally households will not spend all their income on consumer goods and services.
They save a part of their income. It is called savings (S). If the aggregate income is y, aggregate
consumption expenditure is C, then aggregate savings S = Y – C.
4.3.1 National Income Accounting Identities and Equilibrium Conditions for

Determination of Income
In a two sector economy National income accounting identifies as follows.
C+S = GNP = C+I.
If S and I are measured in net terms i.e., saving is net saving (gross saving – depreciation)
and investment is net investment (gross investment – depreciation), the above identity becomes
C+S = NNP = C+I
Since there is no government in the economy, there are no indirect taxes and government
subsidies. Then the national product (NNP) becomes National income (y). In the absence of
government there are no corporate profit taxes and government transfer payments. If we assume
that there are no undistributed corporate profits and social insurance contributions then NI
becomes the personal disposable income ‘yd’. Then the above stated identity becomes
51
C+S = Y = Yd = C+I
From this identity we have the following equilibrium conditions for estimating the income
in the economy
Y = C+S
Or
S=I
One of these conditions can be used for estimating the aggregate income in the economy.
The variables involved in the equilibrium conditions are, aggregate income, consumption
expenditure, savings and investment expenditure. Before going to discuss the determination of
income, we examine the behavior of these variables.
4.3.2 Consumption Expenditure and Related Concepts

The expenditure incurred on the consumption goods that satisfy human wants directly
and quickly is called consumption expenditure. This expenditure is determined by two variables
namely (a) income and (b) propensity to consume. The relationship between these two variables
can be analyzed in the form of consumption function.
Consumption function: C.f (income level + propensity to consume).
a) Income level: In the short run the income level does not change. In other words, it
remain stable. Hence, its effect on consumption expenditure remains stable.
b) Propensity to consumption: This is the crucial factor that determines the consumption
expenditure. Propensity to consume explains the relationship between income and
consumption. Change in income leads to a change in consumption. This change in
consumption expenditure may be (i) Average propensity consumption (ii) Marginal
propensity consumption.
i. Average propensity to consume (APC): APC is the ratio of total consumption
expenditure to total income, on an average. APC can be estimated by dividing the total
consumption expenditure by total income. APC = c/yd.
ii. Marginal propensity to consume (MPC): MPC is the ratio of additional consumption
expenditure to additional income in a given period. MPC can be estimated by dividing
the additional consumption expenditure by additional income. MPC = DC/DYd.
Since income = Consumption + Savings or Investment.
What is not consumed is saved and available for investment.
If we assume that income = 1
4.3.3 Saving Function

Average propensity to save = 1 – Average propensity t consume.
APS = 1 – APC. Or APS = S/Yd
Similarly,
Marginal propensity to save = 1 – Marginal propensity to consume.
52
MPS = 1 – MPC. Or MPS = “S/”Yd
In reality consumption expenditure is influenced by not only income but also by several
other factors. Keynes also explained that consumption expenditure depends upon the size of
the family, affection on family members, tastes and preferences, future expectations, Government
policy etc. The details relating to the relationship between consumption and income in the next
chapters.
4.3.4 Determination of Equilibrium Level of Income

We are already discussed the conditions for estimating the equilibrium level of income
in an economy constituting of two sectors y = C+I or S = I. Therefore the level of income at
which y = C+I or S=I is the equilibrium level of income. It can be determined by using either y
= C+I or S=I. We shall discuss the determination of income both geometrically and algebraically
using the two equilibrium conditions.
We know that consumption expenditure depends on the real disposable income and
consumption function is C = c/y and O < ∆c/∆y < 1. We did not discuss the determinants of
investment and investment function. We can observe in the outline of the Keynes model presented
in the chart, it can be visualized that investment expenditure depends on marginal efficiency of
capital and the rate of interest. If we incorporate their theory into the income determination
here, income will determine. Therefore we assume that investment is given [I = I0]. In other
words investment is assumed to be autonomous. The aggregate spending at various levels of
income can be arrived at by adding the investment expenditure to the consumption expenditure
and aggregate spending curve can e drawn in below figure 4.6. In below figure income is
measures an X-axis and aggregate spending (C+I) is measured on y axis, the 450 line represents
the equality between income and aggregate
spending. This line together with the
Y
aggregate spending curve determines the
equilibrium level of income. In the figure y = C+I
Aggregate spending
aggregate income y, which is also equal to c/

y is measured on x axis and consumption E
C+I 1
expenditure and aggregate spending are
I }
measured on y – axis. The line c/y is the C = c(y d )
consumption curve. The line C+I is the
aggregate spending curve and the 450 line
45 0
representing y = C+I. This line intersects with O X
y
aggregate spending line at point E. The
income at this level is y. Therefore y is the
Aggregate Income
level of income at which y = C+I. Hence y is Figure – 4.6: Determination of
the equilibrium level of income in the equilibrium level of income
economy.
Geometrically equilibrium level of income can be estimated S = I. We know that savings
depend on real disposable income and saving function in the form of S = S(yd) and O < ∆ S/∆yd
< 1. The saving curve is an upward slope with a negative y intercept when S is measured on Y
53
= axis and yd is measured on X – axis. Investment
Y
Saving and Investment

expenditure is measured to be I. Then investment
curve is a line parallel to x-axis if investment is S = S(Yd )
measured on y axis and income is measured on
y axis. The intersection of the saving curve and
investment curve determines the equilibrium
level of income it can be show in below figure I = I0
4.7. The equilibrium level of income is y. E
We will discuss equilibrium level of
O X
Income in terms of algebraically. For that Income (Y)
consumption and saving function are to be
Figure – 4.7: Determination
expressed by algebraic equations. Let us assume
of equilibrium level of income
that
I = I0 (investment function)
And Y = C+I (Equilibrium position)
C = CO+Cyd (Consumption function)
Substituting the consumption equation and investment equation in the equilibrium
condition we get
Y = CO+Cyd+IO
∴ Y = CO+CY+IO (Since y = yd)
∴ Y –CY = CO+IO
(I-c) y = CO+IO
∴ Y = [CO+IO] / I-C
Thus [CO+I O]/I-C is the equilibrium level of Income corresponding to the given
consumption and investment function.
To have a more clear idea about the determination of Income, consider the following
functions.
C = 20+3/4 yd (consumption function)
I = 20 (Investment function)
Y = C+I (Equilibrium condition)
Equilibrium level of Income y = 20+3/4 Yd + 20
= 20+3/4 Y+20 (since Yd=Y)
∴ Y - ¾ Y = 40
∴ 1-3/4 Y = 40
Y = 40
Y = 40 x 40 = 160
54
∴ The equilibrium level of Income is 160.
Instead of the consumption function, if the savings function is given, the equilibrium
condition S = I is to be used. Suppose the saving and Investment functions are given by
S = S0+SYd
and I = I0
In order to find the equilibrium level of Income, substituting the above two equations in
S = I we have
S0 + Syd = I0
SYd = I0 = S0
Yd = [I0-S0-]/S.
Since Y = Yd
Y = [I0-S0]/S
Hence the equilibrium level of income is [I0=S0]/S
To have a more clear idea about the determination of Income, consider the following
functions.
S = -20+1/4 Yd
I = 20
and S=I
Substituting the saving and Investment equations in the equilibrium condition, we have
-20+1/4 yd = 20
¼ Yd = 20+20 = 40
Yd = 40x4 = 160
Therefore the equilibrium level of income is 160.

7. What is propensity consumption?
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
8. What is average propensity to consume (APC)?
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
9. What is marginal propensity to consume (MPC)?
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
55
10. What is saving function?
..……………………………………… ………………………………………………
..……………………………………… ………………………………………………
4.4 SUMMARY
According to classical economists the level of employment is determined by natural
forces or automatic forces. But Keynes clearly said that employment in the economy is
determined by the effective demand. Increase in effective demand leads to increase in
employment. Effective demand is the aggregate demand, which is equal to aggregate supply.
Thus the level of effective demand is determined by aggregate demand and aggregate supply. It
is the aggregate demand that plays a key role and aggregate supply plays only a passive role. In
an economy consisting of households and firms, aggregate demand is the sum of consumption
expenditure and investment expenditure. Therefore level of employment in any economy
increases only with the increase in consumption expenditure or increase in investment
expenditure or both. The nature of the economy is such that generally there is a deficiency of
demand. This deficiency of the demand will not allow the economy to attain full employment.
Hence the economy is always in a state of underemployment equilibrium. Generally this position
is called the optimum level of employment. This optimum level of employment is known as
Keynesian theory of employment.

1. Aggregate demand price is the amount of money which the entrepreneurs expect to get
by selling the output produced by the number of men employed.
2. In mathematical farm aggregate demand function, can be express in the form of D = D
(N) where D is the aggregate demand price and N is the employment.
3. In brief aggregate supply price refers to the proceeds necessary from the sale of output at
a particular level of employment.
4. Symbolically aggregate supply can be written as S = S(N) where S is the aggregate
supply price and N is the level of employment.
5. It is the point where what the entrepreneurs expect to receive equals what they must receive
and their profits are maximized. This process will continue till the aggregate demand price
equals the aggregate supply price and the point of effective demand is reached.
6. According to Keynes the level of employment in the economy is determined by effective
demand. Effective demand (ED) which in turn is determined by AS and AD functions.
7. Propensity to consume explains the relationship between income and consumption.
Change in income leads to a change in consumption.
8. The APC is the ratio of total consumption expenditure to total income, on an average.
APC can be estimated by dividing the total consumption expenditure by total income.
APC = c/y.
9. The MPC is the ratio of additional consumption expenditure to additional income in a
given period. MPC can be estimated by dividing the additional consumption expenditure
by additional income. MPC = DC/DY.
56
10. Aggregate saving function is a result of difference between aggregate income and
consumption expenditure.
Average Propensity to Save = 1 - Average Propensity to Consume. APS = 1 – APC

1. Explain the principles of effective demand.
2. Determination of effective demand.
3. Explain the conditions which require Equilibrium level of Employment.
4. Briefly explain the role of consumption in Keynesian theory of employment.
5. What are the properties of consumption function?
1. Discuss Keynesian Theory of Employment.
2. Examine how Keynesian theory of employment is refinement over classical theory.
3. Critically evaluate the Keynesian theory of employment. To what extent it is relevant to
Indian economy?
1. General theory of Employment, Interest and Money was published in
a) 1776 b) 1836 c) 1936 d) 1966
2. According to Keynes the level of employment and income determined by
a) Real Factors b) Monitory Factors c) a & b d) None of these
3. According to Keynes equilibrium between saving and investment through
a) Saving b) Income c) Investment d) Interest
4. According to Keynes employment is determined by
a) Aggregate Demand b) Aggregate Supply c) Effective Demand d) None
5. Effective Demand is determined by
a) Aggregate Demand b) Aggregate Supply c) Aggregate Investment d) A & B
Answers: 1. c; 2. c; 3. b; 4. c; and 5. d

A B
6. ASP > ADP ( ) a) S= S(N)
7. Aggregate Demand is ( ) b) Total Expenditure
8. APS ( ) c) Expected revenue
9. Aggregate Supply function ( ) d) 1 – APC
10. Effective Demand ( ) e) Employment decreases
Answers: 6- e, 7-c, 8-d, 9-a, and 10-b.
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11. The concept of liquidity preference is related to _____________
12. According to Keynes Level of employment can be raised through _____________
13. According to Classists saving and invest equality determines _______________
14. Keynes rejected the classical view that every economy will have _________ capacity/
forces.
15. Keynesian aim at reviving the economies from the effect of ______________
Answers: 11. Keynes; 12. Expenditure; 13. Interest rate;
14. Natural / Automatic; and 15. Depression.
4.7 GLOSSARY
1. Aggregate demand price: The sum of money or proceeds expected by the producers by
selling the output at a given level of employment.
2. Aggregate demand curve: The curve which showing the relationship between aggregate
demand price and level of employment.
3. Aggregate supply price: Proceeds that producer must receive by selling the output at a
given level of employment.
4. Aggregate supply curve: The curve which showing the relationship between aggregate
supply price and employment.
5. Effective demand: Ex ante spending, that is plans to purchase, by people with the means
to pay. Effective demand is contrasted with national demand, the demand that would
exist if all markets were in equilibrium.
6. Aggregate consumption expenditure: Total amount spent by the households on consumer
goods and services.
7. Aggregate investment expenditure: Total amount spent by the business firm’s investment
goods.
8. Average propensity to consume: The part of the income that is spent on consumer goods
and services.
9. Marginal propensity to save: Change in savings for a unit change in real disposable
income.
4.8 SUGGESTED BOOKS

1. Edward Shapiro : Macro Economic Analysis.
2. Stonier and Hague : A Text Book of Economic theory.
3. H.L. Ahuja : Macro economics theory and policy.
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UNIT – 5 : CONSUMPTION FUNCTION: APC & MPC
Contents
5.0 Objectives
5.1 Introduction
5.2 The Concept of Consumption Function
5.3 Shifts in Consumption Function
5.4 Average and Marginal Propensity to Consume
5.4.1 Average Propensity to Consume (APC)
5.4.2 Marginal Propensity to Consume (MPC)
5.4.3 Tabular Presentation of APC and MPC
5.4.4 Diagrammatic Presentation of APC and MPC
5.5 The Concept of Saving Function
5.5.1 Average Propensity to Save (APS)
5.5.2 Marginal Propensity to Save (MPS)
5.6 Linear and Non-Linear Consumption Function
5.7 Determinants of Consumption
5.7.1 Subjective Factors
5.7.2 Objective Factors
5.8 Keynesian Psychological Law of Consumption
5.8.1 Assumptions of the Law
5.8.2 Propositions of the Law
5.9 Post-Keynesian Theories of Consumption
5.10 Summary
5.13 Glossary
5.0 OBJECTIVES
This unit explains about the consumption function, its meaning and determinants. After
reading this unit, you will be exposed to:
• meaning, concept of consumption function and the saving function;
• shifts in consumption function;
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• concepts of Average and Marginal propensity to consume & Average and Marginal
propensity to save and the significance of MPC;
• determinants of Consumption;
• Keynesian psychological law of consumption;
• Post-Keynesian Theories of Consumption; and
• significance of consumption function.
5.1 INTRODUCTION
The theory of income and employment determination examines how the level of national
income is determined. Given the aggregate supply, the level of income and employment is
determined by the level of aggregate demand. The aggregate demand consists of consumption
demand and investment demand. This unit analyses the consumption demand and the factors
on which it depends and how it changes over a period of time. Consumption demand depends
upon the level of income and the propensity to consume.
5.2 THE CONCEPT OF CONSUMPTION FUNCTION

Consumption function is one of the important tools of Keynesian economics. The
consumption function refers to income consumption relationship. Consumption is a function
of disposable income. Consumption function is a “functional relationship between total
consumption and gross national income”. Symbolically, this can be expressed as C=f(Y),
where C is consumption, Y is income, and f is the functional relationship. This relationship is
based on the assumption of “ceteris paribus”. Consumption function is a schedule of the
various amounts of consumption expenditure corresponding to different levels of income.
Assume that consumption is a linear function of disposable income. An imaginary consumption
schedule is given in the following table-5.1.
Table-5.1: Consumption Schedule
Table-5.1 shows that consumption is an increasing
(in Crores)
function of income because consumption expenditure
increases with an increase in income. While looking at Income Consumption
the Table, it can be said that when income is zero during (Y) C = f (Y)
the depression, people spend out of their past savings 0 10
on consume because they must eat in order to live. When 30 35
income is generated in the economy to the extent of Rs. 60 60
30 crores, it is not sufficient to meet the consumption 90 85
expenditure of the community, so that the consumption 120 110
expenditure of Rs. 35 crores (Rs. 5 crores are dis-saved). 150 135
When both consumption expenditure and income equal 180 160
of Rs. 60 crores, it is the basic consumption level. After
this, income is shown to increase by Rs. 30 crores and consumption by Rs. 25 crores. The
above schedule of consumption function reveals an important fact that when income increases,
consumption also increases but not as much as the income. It is to be noted that consumption
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function be distinguished from the “amount of consumption”.
Consumption demand depends on income and propensity to consume. Propensity to
consume depends on several factors like price level, interest rate, stock of wealth etc. Keynes
was concerned with short-run consumption function, assumed price level, interest rate, stock
of wealth etc. constant in his theory of consumption. Therefore, the Keynesian consumption
function considers consumption as a function of income. Hence, it can be written as: C = f(Y).
Where, C0+C1Y are constants. C0 is intercept term of the consumption function, C1 stands
for the slope of the consumption function and therefore represents marginal propensity to
consume.
The figure -5.1 shows about the consumption function diagrammatically.
Figure 5.1 shows about the
Keynesian consumption function. CC’ Y
represents the consumption function. 0X
0′
–axis represents national income and
consumption expenditure is shown on
Consumption
0Y-axis. A line 00' makes 450 angle with C′

the X-axis every point on it is equidistant
from both the X-axis, and Y-axis. Thus, C
if consumption function curve coincides Consumption
with 450 line 00', indicating that with the Function
increase in income, consumption would 45 0 C= C0 +C1 Y
also increase by the same amount. But, 0 X
in actual practice, consumption increases Income
less than the increase in income. Figure – 5.1: Consumption Function
It is clear from the figure 5.1 that the consumption curve CC'’ deviate from the 450 line 001.
At lower levels of income, the consumption function curve CC' lies above the 00' line, indicating
that at these lower levels of income consumption is greater than the income. As income increases,
consumption also increases and at the income level of 0Y0', consumption is equal to income.
Beyond this income level, with the increase in income, consumption also increases but less than
the increase in income and therefore, consumption function curve CC' lies below the 450 line 00'
beyond Y0. Beyond the level of income 0Y0, the gap between consumption and income is widening.
The difference between consumption and income represents savings. Hence, it can be said that
with the increase in income, saving gap also widens.

1. Define consumption function.
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5.3 SHIFTS IN CONSUMPTION FUNCTION
If the consumption function of a
community changes, the whole consumption
O'
Y C'
function curve changes or shifts. If
propensity to consume increases, at various C''
Consumption
levels of income more is consumed than C'
Demand
before. As a result, the whole consumption
function curve shifts upward as shown in C''
figure-5.2 by upper curve C’C’ and vice-
versa. The downward shift is shown in the
figure -5.2 by the downward curve C”C”, X
O
which signifies the fact that at various levels National Income
of income, less is consumed than before. Figure – 5.2
5.4 AVERAGE AND MARGINAL PROPENSITY TO CONSUME

The propensity to consume is of two concepts.viz; average propensity to consume (APC)
and marginal propensity to consume (MPC). It can be said that consumption changes as income
changes. The consumption changes in response to a given change in income depend upon the
average and marginal propensity to consume.
5.4.1 Average Propensity to Consume (APC)

Average propensity to consume may be defined as the ratio of the amount of consumption
to total income. It is found by dividing consumption expenditure by income. Symbolically, it
can be written as follows:
APC= C/Y
Where, APC=Average Propensity to Consume; C = amount of consumption; and
Y = level of income.
5.4.2 Marginal Propensity to Consume (MPC)

“The marginal propensity to consume may be defined as the ratio of the change in
consumption to the change in income or as the rate of change in the average propensity to
consume as income changes”. It can be obtained by dividing the change in consumption by a
change in income. Symbolically, this can be written as follows:
MPC= ∆C/∆Y
Where,
MPC = Marginal Propensity to Consume;
ÄC = Change in Consumption; and
ÄY = Change in income.
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5.4.3 Tabular Presentation of APC and MPC
The concepts of APC and MPC are explained with the help of the Table-5.2.
Table-5.2: APC &MPC; APS &MPS

Income (Y) Consumption(C) APC=C/Y MPC= ∆C/ ∆Y APS=S/Y MPS=∆ ∆Y
∆S/∆
(1-APC) (1-MPC)
(1) (2) (3) (4) (5) (6)
120 120 120/120=1 - 0 -
180 170 170/180=0.92 50/60=0.83 0.08 0.17
240 220 220/240=0.91 50/60=0.83 0.09 0.17
300 270 270/300=0.90 50/60=0.83 0.10 0.17
360 320 320/360=0.88 50/60=0.83 0.12 0.17
While looking at the table-5.2, it can be said that the MPC is constant at all levels of
income as shown in column 4 of table-5.2. It is 0.83 because the ratio of change in consumption
to change in income is ÄC/ÄY=50/60. From the Table-5.2, it can be seen that at the level of
income Rs. 120 crores, consumption expenditure is equal to Rs. 120 crores. Therefore, APC is
here equal to 120/120=1. Like-wise, when the income rises to Rs. 240 crores, consumption
rises to Rs. 220.
5.4.4 Diagrammatic Presentation of APC & MPC

The diagrammatic presentation of APC and MPC has shown in the following figures:
Y Y
C
N
C''
C
R ∆C
C' R
Consumption
C' Q
∆Y
O X O Y X
Y Y''
(A) (B)
Income
Figure-5.3
Diagrammatically, the average propensity to consume is any one point on the C curve. In
figure 5.3 panel (A), point R measures the APC of the C curve which OC’/OY’. The flattening
of the C curve to the right shows declining of APC. The marginal propensity to consume is
measured by the slope of the C curve. This is shown in figure-5.3 panel (B) by NQ/RQ, where
NQ is the change in consumption (∆C) and RQ is the change in income (∆Y) or C’C”/Y’Y”.
63
2. Define APC.
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3. State the concept of MPC.
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5.5 THE CONCEPT OF SAVING FUNCTION

Saving can be defined as the part of income which is not consumed because disposable
income either consumed or saved. Therefore, it can be said that:
Y=C+S
Where, Y = Disposable income; C = Consumption; and S = Saving.
Like consumption, saving is also a function of income. Hence, saving function can be
written as follows:
S= f(Y)
Saving function is a counter part of consumption. Therefore, given a particular
consumption, we can derive the corresponding saving function. Let us take the Keynesian
consumption, namely, C=C0+C1Y. We can derive saving function corresponding to it.
Since
Y=C+S
S=Y-C
5.5.1 Average Propensity to Save (APS)

It explains about the relationship between income and saving. APS is the proportion of
disposable income that is saved i.e. not consumed. Mathematically:
APS= Savings/Disposable Income=S/Y
The relationship between APC and APS is as follows:
APC+APS=1 or APS=1-APC
5.5.2 Marginal Propensity to Save (MPS)

The marginal propensity to save is the additional disposable income that is devoted to
saving. Therefore, it can be defined as the change in savings induced by a change in the disposable
income. Symbolically, it can be written as follows:
MPC= ∆S/∆Y
As the additional income either consumed or saved, the sum of marginal propensity to
consume and marginal propensity to save is equal to one.
MPC+MPS=1 or MPS=1-MPC
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The relationship between APC and APS; and MPC and MPS can be visualized in
Table-5.2.

4. Define the concept of saving.
..........................................................................................................................................
..........................................................................................................................................
5. State the concept of APS.
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6. What do you mean by MPS?
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5.6 LINEAR AND NON-LINEAR CONSUMPTION FUNCTION

Consumption function may be linear and non-linear. A consumption is said to be a
linear if the marginal propensity to consume is constant, positive and less than average propensity
to consume. In this case, the average propensity to consume also keeps declining. The linear
consumption function is as follows:
C= C0+C1Y
When both average propensity to consume and the marginal propensity to consume are
declining and the marginal propensity to consume is less than the average propensity to consume,
the consumption function is called non-linear.
The non-linearity can be seen from the table- 6.3 that when the level of income increases
from Rs. 500 crores to 550 crores, consumption increases from 475 crores to 520 crores, that,
is by Rs. 45 crores. Therefore marginal propensity to consume is 0.9 and when income rises
from 700 crores to RS. 750 crores, consumption increases by Rs. 25 crores from Rs. 625 crores
to 650 crores.
Table-5.3: Non-Linear Consumption Function: APC and MPC

Income Consumption Average Propensity to Marginal Propensity to
(Rs. in crores) (Rs. in crores) Consume (C/Y) Consume (∆∆C/∆
∆Y)
500 475 475/500=0.95 -
550 520 520/550=0.94 45/50=0.9
600 560 560/600=0.93 40/50=0.8
650 595 595/650=0.91 35/50=0.7
700 625 625/700=0.89 30/50=0.6
750 650 650/750=086 25/50=0.5
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Therefore, marginal propensity to Y Y= C+ S
consume has declined from 0.9 to 0.5. Z
When with the increase in income, B
Consumption Demand
C
marginal propensity to consume declines, A
then the curve of consumption function
is not a straight line but has a shape as
shown in Fig. 5.4. C
In this case of non-linear
consumption function average propensity
to consume will also decline. At any point
on the propensity to consume curve CC 45 0
one can find out average propensity to O Y1 Y2 X
consume by joining that point with the National Income
point of origin by a straight line whose
Figure – 5.4: Non-Linear Consumption
slope will measure the average propensity
Function: Declining APC
to consume.
In Fig. 5.4, if we have to find out average propensity to consume at point A on the
consumption function curve CC, we connect point A with the origin by a straight line. Now, the
slope of the line OA i.e., AY1\OY1 will measure the average propensity to consume. Similarly,
at point B of the given consumption function CC, the average propensity to consume will be
given by the slope of the line OB which is equal to BY2/OY2. A glance at the Figure-6.4 shows
that the slope of the line OB is smaller than the slope of the line OA. Therefore, average
propensity to consume at point B or at income level OY2 is less than that at point A or income
level OA.

7. Distinguish between the linear and non-linear consumption function.
..........................................................................................................................................
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5.7 DETERMINANTS OF CONSUMPTION

Keynes broadly classified the factors determining the consumption in to two groups.
They are: i) Subjective factors; and ii) Objective factors.
5.7.1 Subjective Factors

The subjective factors are endogenous to the economic system. They include
psychological characteristics of human nature, social practices and institutions, and social
arrangements.
The subjective factors are included those factors which induce people to save some part
of their income. Firstly, people save owing to meet the unforeseen contingencies, such as illness,
unemployment, accidents etc.
66
Secondly, people are induced to save because they want to provide for the expected
future needs such as education of the children, marriages of their children etc.
Thirdly, people wish to save from their current incomes so that they may be able to use
accumulated savings for investment which will increase their future income. Investments will
bring them more income in the form of more profits and interest.
Fourthly, people are prompted to save so that they can accumulate large wealth which
will increase their social status.
Fifthly, many individuals save for speculative purposes and other business projectly.
Besides, several people prompted to save for the sake of leaving a good fortune for their heirs
and children.
Finally, many people save due to their miserly instinct and habits. The accumulation of
more wealth gives them a great psychic satisfaction.
The subjective factors are also influenced by the behavior of business corporations
and governments. Keynes lists four motives for accumulation on their part: i. Enterprise –
many business firms desire to save to make investment in new enterprises and to expand in
the future; ii. Liquidity –business firms are also induced to save to meet emergencies and
difficulties successfully; iii. Successful Management- for the successful management of
the business, business firms save; iv. Financial Produce- business firms desire to save for
making up the depreciation in plant and machinery. Firms also want to save because they
have to repay their debts.
The aforesaid subjective factors increase the propensity to save and in turn reduce the
propensity to consume. These subjective factors play a crucial role while determining the shape
and level of the consumption function. To Keynes some subjective factors raise the propensity
to consume. People have a natural instinct to imitate others’ consumption habits generally lead
to increase consumption expenditure. To Duesenberry, people in lower and middle income
ranges imitate the consumption standards of the higher income groups and this increases their
propensity to consume.
5.7.2 Objective Factors

Keynes mentioned the following objective factors which influence the consumption
function. They are:
i. Changes in the General Price Level: This is an important factor which influences the
consumption. If the general price level increases, the consumption function shifts
downward due to the decline of the monetary value of the money balances and financial
assets held by the public, which is conversely true.
ii. Fiscal Policy: Fiscal policy of the government; especially taxation policy affects the
propensity to consume. By levying excise duties, sales tax, the government can cut down
the consumption and thereby increase savings of the community. If the government reduces
taxes, consumption of the people increases and this raises the propensity to consume.
67
iii. Rate of Interest: It affects the propensity to consume and save as well. In the classical
economic theory, consumption was regarded as a negative function of the rate of interest.
Other things being equal, real consumption was inversely related to the rate of interest.
However, this relationship is not infallible. Depending upon the nature of household’s
preference map, consumption may either be independent of interest rate or may be
positively related to it.
iv. Stock of Wealth: This is also another important factor that determines propensity to
consume. Wealth includes not only “real assets” such as land, houses and automobiles
but also “financial assets” such as cash balances, saving by fixed deposits with banks,
stocks and bonds possessed by households. In general, it is held that the greater the
wealth which people have accumulated, the weaker is the incentive to save further. The
other things remaining the same, the increase in wealth generally causes an upward shift
in the consumption function and decreases in wealth causes a downward shift in the
consumption function.
v. Credit Conditions and Consumer Indebtedness: The availability of easy credit leads
to an increase in consumption and shifts the consumption function upward. On the other
hand, tightening of credit produces an opposite effect, that is, causes a downward shift in
the consumption function. Similarly, the level of consumer indebtedness also greatly
affects the propensity to consume of the people. The greater the degree of indebtedness
of households in the economy, the higher will be the consumption function curve and
vice-versa.
vi. Income Distribution: Distribution of income in a society also determines the level of
consumption function. If national income is more unequally distributed, the lower will
be the propensity to consume. This is due to the fact that the propensity to consume of
the rich is relatively less as compared to that of the poor.
vii. Windfall Gains & Losses: Windfall gains and losses also affect the propensity to
consume. If the prices of the shares go up, the shareholders begin to think themselves
better-off and this raises their consumption. If the prices of the shares go down, the
shareholders have to suffer sudden losses and they begin to think themselves relatively
poor than before and this induces them to reduce their consumption.
viii. Change in Expectations: It also influences the propensity to consume. If people expect
prices to go up, then they will try to spend more on goods to meet the needs of the
immediate future and this raises the consumption function in the current period. On the
other hand, if people expect the prices to fall they reduce their current consumption so
that they should spend more when the prices actually fall.
ix. Money Illusion: Though there is no change in the real income, the aggregate real
consumption spending will also be affected if consumers are subject to money illusion.
The phenomenon of money illusion occurs when despite equi-proportional change in
the prices of goods and services and their money income which keeps their real income
unchanged consumers make a change in their real consumption.
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It is worth noting that propensity to consume does not generally change in the short-run,
because it depends more on psychological and institutional factors which change only in the
long-run. “The institutional factors which determine the distribution of income in the
society are important forces determining the consumption function”. The institutional
factors do not change in the short-run. Hence, Keynes was of the view that consumption function
remains stable in the short-run.

8. State the two broad determinants of consumption.
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9. State the objective factors which influence the consumption function.
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5.8 KEYNESIAN PSYCHOLOGICAL LAW OF CONSUMPTION

Keynes put forward a “psychological law of consumption”, which forms the basis of
the consumption function. Keynesian law states that “Men are disposed as a rule and on the
average, to increase their consumption, as their income increases, but not as much as the
increase in their income”. Therefore, marginal propensity to consume is less than one and
greater than zero i.e. 0<MPC<1.
5.9.1 Assumptions of the Law

This law is based on the assumptions mentioned hereunder. They are:
i. It assumes a constant psychological and institutional complex. Such complexes are income
distribution, tastes, habits, social customs, price movements, population growth etc.
ii. It assumes the existence of normal conditions in the economy. In the case of abnormal
circumstances like war, revolution a hyper inflation, the law will not operate.
iii. It assumes the existence of laissez-faire capitalist economy. This law is inoperative in
socialist or State controlled and regulated economies.
5.8.2 Propositions of the Law

This law has three related propositions. They are:
i. When income increases, consumption expenditure also increases but by a smaller amount.
ii. The increased income will be divided in some proportion between consumption
expenditure and saving as it is due to the fact that when the whole of increased income is
not spent on consumption, the remaining is saved. Therefore, it can be said that both
consumption and saving move together.
iii. Increase in income always leads to an increase in both consumption and saving.
69
10. State the Keynesian Psychological law of consumption.
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11. State the assumptions of the Psychological law of consumption.
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5.9 POST-KEYNESIAN THEORIES OF CONSUMPTION

The Post-Keynesian empirical studies made on the income-consumption relationship
reveals the fact that the short-run consumption function has a smaller slope relatively to the
slope of the long-run consumption function. In this regard, different hypotheses have been
developed by the economists in order to explain the apparent contradiction between the short-
run non-proportional and the long-run proportional consumption- income relationship. As per
the various studies, while the long-run consumption- income ratio (C/Y=APC) has been constant,
the short-run consumption- income ratio (C/Y) decreases as income increases. Thus, the
consumption function takes two different forms on the basis of the short or long period. The
short-run consumption function takes the form of equation C=C0+C1Y, while the long-run
consumption function takes the form of equation C=C1Y. In this regard, J.S.Duesenberry, Milton
Fried man put forward the theories of consumer behaviour popularly known as Relative Income
Hypothesis and Permanent Income Hypothesis respectively. Besides, Franco Modigliani,
Richard E. Brumberg and Albert Ando have put forward the theory of consumer behaviour
popularly known as Life -Cycle Hypothesis.
According to Duesenberry’s relative income hypothesis, consumption of an individual
is not the function of his absolute income but of his relative position in the income distribution
in a society. For instance, if the incomes of all individuals in a society increase by the same
percentage, then his relative income would remain the same, though his absolute income would
have increased. Thus, to Duesenberry, an individual’s average propensity to consume (APC)
will remain the same despite the increase in his absolute income. Duesenberry stated that the
non-proportionality short-run consumption function during the course of business cycle.
According to the Life Cycle Theory, the consumption in any period is not the function
of current income of that period but of the whole life time expected income. To this theory, an
individual is assumed to plan a pattern of consumption expenditure based on expected income
in their entire life time. To this theory, a typical individual in his early years of life spends on
consumption either by borrowing from others or spending the assets bequeathed from his parents.
It is in his main working years of his life time that he consumes less than the income he earns
and therefore makes net positive savings. He invests these savings in assets, that is, accumulates
wealth which he consumes in the future years. In his life time after retirement he again dissaves,
that is, consumes more than his income in these later years of his life but is able to maintain or
even slightly increase his consumption in the life time after retirement. Thus, to the life cycle
70
theory, age is a crucial variable in determining relationship of consumption to the measure income
and perhaps the relationship between consumption and wealth. The concept of life-cycle
consumption explains the non-proportional relationship between consumption and income which
has been observed over the short period in the cross-sectional consumption studies. The life-cycle
hypothesis states that the average propensity to consume (APC) will be falling with higher levels
of family income and vice-versa. The APC is highest at the beginning of the life-cycle.
Friedman’s Permanent Income Hypothesis is similar to Life Cycle Hypothesis and it
also differs. Like the life cycle approach, permanent income hypothesis explains the riddle
about the relationship between consumption and income, that is, whereas in the long-run time
series data, consumption –income ratio (i.e. APC) is constant, in the short run it declines with
the increase in income. Friedman’s hypothesis is quite consistent with the constancy of APC
in the long-run and its variation in the short-run. To put it differently, the permanent income
hypothesis states that the ratio of permanent consumption to permanent income is constant
regardless of the level of permanent income. Since permanent consumption is proportional to
permanent income, the long-run aggregate APC equals the long-run aggregate MPC.

12. State the Post-Keynesian theories of consumption.
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5.10 SUMMARY
This unit explained the consumption demand and the factors on which it depends and
how it changes over a period of time. Consumption demand depends upon the level of income
and the propensity to consume. The consumption function refers to income consumption
relationship. Consumption is a function of disposable income. The propensity to consume is of
two types –APC and MPC. APC can be defined as the ratio of the amount of consumption to
total income i.e. APC =C/Y. The marginal propensity to consume can be defined as the ratio of
the change to the change in income i.e. MPC= ∆C/∆Y. The value of MPC is assumed to be
positive but less than one i.e. 0<MPC<1. In this unit, we also introduced the concept of saving
function. Saving can be defined as the difference between disposable income and consumption.
The propensity to save is of two types- APS and MPS. APS is the proportion of disposable
income that is saved i.e. APS=S/Y. APC+APS=1. MPS is the change in savings resulting from
a change in the disposable income i.e. MPS= ∆S/∆Y. MPC+MPS=1. According to Keynes both
the subjective and objective factors determine the level of consumption. The subjective factors
like unforeseen contingencies, expected future needs, speculation, accumulation of large wealth,
business projects, good fortune for their heirs and children are analysed. The objective factors
like changes in the general price level, fiscal policy, rate of interest, stock of wealth, credit
conditions and consumer indebtedness, income distribution, windfall gains and losses, change
in expectations, money illusion etc. are also explained. Besides, the present had also dealt with
the Keynesian psychological law of consumption. The Post-Keynesian empirical studies made
on the income-consumption relationship reveals the fact that the short-run consumption function
71
has a smaller slope relatively to the slope of the long-run consumption function. In this regard,
different hypotheses have been developed by the economists in order to explain the apparent
contradiction between the short-run non-proportional and the long-run proportional consumption-
income relationship. As per the various studies, while the long-run consumption- income ratio
(C/Y=APC) has been constant, the short-run consumption- income ratio (C/Y) decreases as
income increases. Thus, the consumption function takes two different forms on the basis of the
short or long period. The short-run consumption function takes the form of equation C=C0+C1Y,
while the long-run consumption function takes the form of equation C=C1Y. In this regard,
J.S.Duesenberry, Milton Friedman put forward the theories of consumer behaviour popularly
known as Relative Income Hypothesis and Permanent Income Hypothesis respectively.
Besides, Franco Modigliani, Richard E. Brumberg and Albert Ando have put forward the theory
of consumer behaviour popularly known as Life-Cycle Hypothesis. And finally, this unit had
also devoted to examine the significance of consumption function in macro economic analysis.

1. Consumption function is a “functional relationship between total consumption and
gross national income”. Symbolically, this can be expressed as C=f(Y), where C is
consumption, Y is income, and f is the functional relationship. This relationship is based
on the assumption of “ceteris paribus”.
2. Average propensity to consume can be defined as the ratio of the amount of consumption
to total income. Symbolically, it can be written as follows:
APC= C/Y
Where, APC = Average Propensity to Consume; C = amount of consumption; and
Y = level of income
3. The marginal propensity to consume can be defined as the ratio of the change in
consumption to the change in income or as the rate of change in the average propensity
to consume as income changes.
4. Saving can be defined as the part of income which is not consumed because disposable
income either consumed or saved. Therefore, it can be said that:
Y=C+S
S=Y- C
Where, Y= Disposable income; C= Consumption; and S= Saving
5. It explains about the relationship between income and saving. APS is the proportion of
disposable income that is saved i.e. not consumed. Mathematically:
APS= Savings/Disposable Income=S/Y
The relationship between APC and APS is as follows:
APC+APS=1 or APS=1-APC
72
6. It can be defined as the change in savings induced by a change in the disposable income.
Symbolically, it can be written as follows:
MPC= ÄS/ ÄY
7. Consumption function may be linear and non-linear. A consumption is said to be a
linear if the marginal propensity to consume is constant, positive and less than average
propensity to consume. In this case, the average propensity to consume also keeps
declining. The linear consumption function is as follows:
C= C0+C1Y
When both average propensity to consume and the marginal propensity to consume are
declining and the marginal propensity to consume is less than the average propensity to
consume, the consumption function is called non-linear.
8. The two broad determinants of consumption are subjective factors; and objective factors.
Keynes examines the role of these factors in chapter-8 and 9 of “The general Theory of
Employment, Interest and Money”.
9. Keynes mentioned the objective factors which influence the consumption function are:
i) changes in the general price level; ii) Fiscal Policy; iii) Rate of Interest; iv) Stock of
Wealth; v) Credit Conditions and Consumer Indebtedness; vi) Income Distribution; vii)
Windfall Gains & Losses; viii) Change in Expectations; and ix) Money Illusion.
10. Keynesian psychological law states that “Men are disposed as a rule and on the average,
to increase their consumption, as their income increases, but not as much as the
increase in their income”. Therefore, marginal propensity to consume is less than one
and greater than zero i.e. 0<MPC<1.
11. Keynesian psychological law is based on the assumptions mentioned hereunder. They
are: i) It assumes a constant psychological and institutional complex. Such complexes
are income distribution, tastes, habits, social customs, price movements, population growth
etc; ii) It assumes the existence of normal conditions in the economy. In the case of
abnormal circumstances like war, revolution a hyper inflation, the law will not operate;
and iii) It assumes the existence of laissez-faire capitalist economy. This law is inoperative
in socialist or State controlled and regulated economies.
12. The Post-Keynesian empirical studies made on the income-consumption relationship
reveals the fact that the short-run consumption function has a smaller slope relatively to
the slope of the long-run consumption function. In this regard, different hypotheses have
been developed by the economists in order to explain the apparent contradiction between
the short-run non-proportional and the long-run proportional consumption- income
relationship. In this regard, J.S.Duesenberry, Milton Fried man put forward the theories
of consumer behaviour popularly known as Relative Income Hypothesis and Permanent
Income Hypothesis respectively. Besides, Franco Modigliani, Richard E. Brumberg
and Albert Ando have put forward the theory of consumer behaviour popularly known as
Life -Cycle Hypothesis.
73
1. Examine the relationship between APC and APS.
2. Examine the relationship between APS and MPS.
3. Discuss the significance of Consumption Function.
4. Describe the significance of MPC.

1. Elucidate the Keynesian Theory of consumption.
2. Define the consumption function and analyse the determining factors of consumption
function.

1. According to Keynes, the consumption expenditure is affected by:
(a) Real income (b) Disposable income (c) Absolute income (d) All the above
2. In case of a short-run linear consumption function, as income increases the:
(a) APC falls (b) MPC remains constant (c) Both of them (d) None of the above
3. In case of non-linear consumption function when income rises, the:
(a) MPC remains constant (b) MPC falls (c) MPC rises (d) None of the above
4. According to Keynes’ psychological law of consumption, as aggregate income increase,
the:
(a) Saving gap rises (b) Saving gap decreases
(c) Saving gap remains same (d) None of the above
5. Keynes’ consumption income hypothesis relates absolute consumption to:
(a) Current absolute income (b) Current relative income
(c) Previous income (d) Past income
6. Cyclical consumption is:
(a) Proportional (b) Non-proportional (c) Both of them (d) None of the above
Answers: 1. d; 2. c; 3. b; 4. a; 5. a; and 6. b.

1. The __________ consists of consumption demand and investment demand and investment
demand.
2. Consumption functions refers to ___________ relationship.
3. __________ is an increasing function of income.
74
4. _____________ can be defined as the ratio of the amount of consumption to total income.
5. _____________ can be defined as the ratio of the change in consumption to total income.
6. The value of MPC is assumed to be ____________ but less than ____________
7. The higher the MPC, the ___________ the multiplier.
8. _____________ is the proportion of disposable income that is saved.
9. _____________ is the additional disposable income that is devoted to saving.
10. Marginal propensity to consume is _____________ one and ______________ zero.
Answers: 1. Aggregate; 2. Income and consumption; 3. Consumption; 4. Average
propensity to consume; 5. Marginal propensity to consume; 6. Positive; Unity; 7. Higher; 8.
Average propensity to save; 9. Marginal propensity to save; and 10. Less than and greater than

A B
i. APC (a) 1/1-MPC
ii. MPC (b) S/Y
iii. APS (c) ∆S/∆Y
iv. MPS (d) C/Y
v. Multiplier (e) ∆C/∆Y
vi. Duesenberry (f) s= f(y)
vii. Permanent income hypothesis (g) Relative income hypothesis
viii. Modigliani, Brumberg and Ando (h) c= f(y)
ix. Keynes (i) Life cycle hypothesis
x. Consumption function (j) Milton Fried man
xi. Saving function (k) Psychological law of consumption
Answers: i). d; ii). e; iii). b; iv). c; v). a; vi). g; vii). j. viii). i. ix). k. x). h; and xi). f.
5.13 GLOSSARY
1. Consumption Function: It is a schedule of the various amounts of consumption
expenditure corresponding to different levels of income.
2. Average Propensity to Consume: It is the ratio of consumption to disposable income
i.e. APC =C/Y .
3. Marginal Propensity to Consume: It is the ratio of change in consumption to change in
disposable income i.e. MPC= ÄC/ÄY.
4. Saving: It can be defined as the difference between disposable income and consumption.
5. Average Propensity to Save: APS is the proportion of disposable income that is saved
i.e. APS=S/Y .
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6. Marginal Propensity to Save: MPS is the change in savings induced by a change in the
disposable income.
7. Consumption: Consumption refers to the amount consumed at a specific level of income.
The consumption depends on the level of income.
8. Absolute Income Hypothesis: It states the relationship between absolute income and
absolute consumption of the household. To this hypothesis, consumption is a function of
absolute income of the household.
9. Relative Income Hypothesis: It states that the consumption of a household is a function
of household’s relative income. To Duesenberry, an individual’s average propensity to
consume (APC) will remain the same despite the increase in his absolute income.
10. Life Cycle Hypothesis: It states that the consumption in any period is not the function
of current income of that period but of the whole life time expected income. To this
theory, a typical individual’s average income is lower at the young and old ages than
during the middle age.
11. Permanent Income Hypothesis: It states that the ratio of permanent consumption to
permanent income is constant regardless of the level of permanent income. This hypothesis
is quite consistent with the constancy of APC in the long-run and its variation in the
short-run.

1. Ackely, G: Macro Economics: Theory and Policy, New York; Mac millan, 1978.
2. Shapiro, Edward: Macro Economic Analysis, Galgotia Publications, New Delhi, 1984.
4. Ahuja, H.L: Macro Economics: Theory and Policy, S. Chand &Company Ltd; New
Delhi, 2004.
5. V. Vaish MC: Macro Economic Theory, Vikas Publishing House Pvt.Ltd; New Delhi,
2005.
6. Dwivedi, D.N: Macro Economics: Theory and Policy, Tata Mc Graw-Hill Publishing
Company Limited, New Delhi, 2005.
7. Dewett, K.K: Modern Economic Theory, S. Chand &Company Ltd; New Delhi, 2005.
8. Jhingan, M.L: Macro Economic Theory, Konark Publishers, Pvt. Ltd; New Delhi, 1987.
76
BLOCK – III
THEORIES OF INVESTMENT AND INTEREST RATE
This block covers the meaning of Investment and Capital; types, functions, determinants
of investment, marginal efficiency of capital and investment, the concept of Multiplier,
Accelerator and Super-Multiplier. It also discuss about the Classical, Neo-Classical and
Keynesian theories of Interest, determination of the Rate of Interest and limitations, Keynes
Liquidity Preference Theory of Interest and concept of IS – LM Curves.
Unit - 6: Investment Function, Rate of Interest, Concepts of Multiplier and
Accelerator
Unit -7: Classical, Neo-Classical and Keynesian Theories of Interest
77
UNIT – 6 : INVESTMENT FUNCTION, RATE OF
INTEREST, CONCEPTS OF MULTIPLIER,
AND ACCELERATOR
Contents
6.0 Objectives
6.1 Introduction
6.2 Meaning of Investment and Capital
6.3 Types of Investment
6.3.1 Gross Investment and Net Investment
6.3.2 Private Investment and Public Investment
6.3.3 Financial Investment and Real Investment
6.3.4 Induced Investment and Autonomous Investment
6.4 Investment Function
6.5 Determinants of Investment
6.6 Marginal Efficiency of Capital
6.6.1 Rate of Interest and Investment Demand curve
6.6.2 Profit Expectations and Shift in Investment Demand curve
6.7 Factors Affecting the Investment Demand
6.8 Marginal Efficiency of Investment
6.9 Relationship between the MEC and the MEI
6.10 The Concept of Multiplier
6.10.1 Assumptions of the Multiplier
6.10.2 Algebraic Derivation
6.10.3 Diagrammatic Presentation
6.10.4 Leakages of Multiplier
6.10.5 Importance of the Concept of Multiplier
6.11 The Principle of Acceleration
6.11.1 Assumptions of the Acceleration Principle
6.11.2 Operation of the Acceleration Principle
6.11.3 Diagrammatic Presentation of the Acceleration principle
6.11.4 A Critique
6.12 Interaction between Multiplier - Accelerator
6.13 The Concept of Super-Multiplier
78
6.13.2 Simple Numerical Example
6.14 Summary
6.17 Glossary
6.0. OBJECTIVES
This unit analyses the investment function, rate of interest and marginal efficiency of
capital. After reading the unit, you will be exposed to:
• Meaning of investment and capital and types of investment.
• Investment function and the determinants of investment.
• Marginal efficiency of capital, marginal efficiency of investment and the relationship
between MEC and MEI
• Factors affecting the investment demand.
• The concepts of multiplier, acceleration, super-multiplier. and
• The multiplier- accelerator interaction
6.1 INTRODUCTION
The aggregate demand consists of two components-consumption demand and investment
demand. In the fifth unit we learnt the consumption function and its various determining
factors. This unit examines the factors which determine the investment demand. Investment
demand plays a crucial role in the determination of income and employment. A higher levels of
investment, a higher the level of income and employment.
The concept of simple investment multiplier constitutes an important pillar of the whole
edifice of the Keynesian theory of income and employment. The concept of accelerator which
was not taken into account by Keynes has become popular after Keynes to analyse the theories
of trade cycles and economic growth. The acceleration and multiplier principles have been
combined into a single model to show their interaction provides a satisfactory theory of trade
cycles. The combined effect of the multiplier and the accelerator is also called the “leverage
effect” had also been taken up in this unit.
6.2 MEANING OF INVESTMENT AND CAPITAL

In general investment means to buy shares, bonds, debentures, stocks and securities
from the market. But this is not the real investment because this represents the transfer of
existing assets. Therefore, it can be called as financial investment. To Keynes, investment
refers to the new addition to the stock of physical capital such as plants, machines, trucks,
79
construction of public works like dams, roads, buildings and so on that creates income and
employment. Thus, it can be said that real investment means the addition to the stock of
physical capital.
Capital refers to real assets like factories, plants, equipment, and inventories of finished
and semi-finished goods. The amount of capital available in an economy is the stock of capital.
Hence, capital is a stock concept. Capital and investment are related to each other through net
investment. In fact, investment is a flow variable and capital is a stock variable.

1. Define the concept of investment.
.........................................................................................................................................
.........................................................................................................................................
2. What do you mean by capital?
.........................................................................................................................................
.........................................................................................................................................
6.3 TYPES OF INVESTMENT

Investment may be of different types, which have mentioned here under:
6.3.1 Gross Investment and Net Investment

Gross investment is the total amount spent on new capital assets in a year. Symbolically,
it can be said that:
Ig = I net +R
Where, Ig = Gross investment; I net = Net investment; and
R = Replacement investment or depreciation.
Net investment is gross investment minus depreciation and obsolescence charges ( or
replacement investment). This is the net addition to the existing capital stock of the economy.
Symbolically, this can be written as follows:
I net = Ig – R
If gross investment equals deprecation, net investment is zero which implies that there
is no addition to the economy’s capital stock. If gross investment is less than depreciation, net
investment is negative and the capital stock decreases. If gross investment is greater than
depreciation, net investment is positive and the capital stock rises.
6.3.2 Private Investment and Public Investment

Investment made by individuals, non-governmental institutions and agencies is called as
private investment, whereas investment made by the government is called as public investment.
80
Private investment is a highly volatile element. The volume of investment in a private enterprise
depends on two factors – the marginal efficiency of capital and rate of interest. Governmental
action is necessary not only to stabilise but also to encourage private investment to expand
employment opportunities.
6.3.3 Financial Investment and Real Investment:

Buying of existing shares and bonds by an individual is called as financial investment.
Keynes does not mean financial investment but to real investment. Financial investment does
not affect aggregate spending and does not provide additional employment. Keynes refers to
real investment which is a net addition to the existing capital equipment like new plants, machines
etc. It leads to increase in level of income and production by increasing the production and
purchase of capital goods.
6.3.4 Autonomous Investment and Induced Investment

Post – Keynesian economists had been made the distinction between autonomous
investment and induced investment. Autonomous Investment refers to the investment which
does not depend upon changes in the income level. It is income inelastic. It is influenced by
exogenous factors like innovations, inventions, Y
growth of population and labour force, researches,
social and legal institutions, weather changes, war,
Investment
revolution etc. Most of the investment undertaken

by government in various development projects Ia I'a
to accelerate economic growth of the country is
of the autonomous nature. The autonomous
investment is shown in figure-6.1
The autonomous investment curve Ia a is O X
parallel to horizontal axis, which indicates that at Income
all levels of income the amount of investment Figure-6.1. Autonomous Investment
remains constant at Ia. Induced Investment is that
investment affected by the changes in the level of Y
income. Factors like prices, wages and interest
changes affect profits, influence induced investment.
Induced investment is depicted in figure – 6.2.
I‘d
Investment
In figure-6.2, it can be seen that with the

increase in income, induced investment is increasing.
It increases or decreases with the rise or fall in income Id
as shown in figure-6.2. Therefore, it can be said
that it is income elastic. Induced investment divided
into two – the average propensity to invest and the O X
marginal propensity to invest. The average Income
propensity to invest is the ratio of investment to
Figure-6.2. Induced Investment
income, i.e. , I/Y, whereas the marginal propensity
81
to invest is the ratio of change in investment to the change in income i.e., I/ Y.

3. State the different types of investment.
........................................................................................................................................
........................................................................................................................................
4. Distinguish between Gross Investment and Net Investment.
........................................................................................................................................
........................................................................................................................................
5. Make a distinction between autonomous investment and induced investment.
........................................................................................................................................
........................................................................................................................................
5 (a) Define the concepts of API and MPI.
........................................................................................................................................
........................................................................................................................................
6.4 INVESTMENT FUNCTION

A firm invests in capital goods that produce goods and services yielding additional income
to the investor. As a matter of fact, the level of investment depends on the magnitude of
expected income flow of capital goods, price of capital good and the market rate of interest that
affects the profitability of investment. The functional relationship between these factors and
investment can be called as the investment function. Symbolically, it can be written as:
I = f(1/e, Pc, r)
Where, I = Investment; 1/e = Expected income flow from capital good;
Pc = Price of capital good; and r = Market rate of interest.
6.5 DETERMINANTS OF INVESTMENT

Investment demand depends upon two factors. They are
i. Expected rate of profits. To Keynes, this is nothing but the Marginal Efficiency of Capital
(MEC); and
ii. The rate of interest.
Of the two determinants, marginal efficiency of capital or expected rate of profit is of
comparatively greater importance than the rate of interest. This is due to the fact that the rate
of interest does not change much in the short run; it is more or less sticky. But changes in the
expectations of profits greatly affected the marginal efficiency of capital. Consequently, changes
in marginal efficiency of capital, investment demand is greatly affected which causes aggregate
demand to fluctuate very much. The changes in the marginal efficiency of capital play a crucial
role in causing changes in the investment level and economic activity.
82
6. State the concept of investment function.
........................................................................................................................................
........................................................................................................................................
7. What are the determinants of investment?
........................................................................................................................................
........................................................................................................................................
6.6 MARGINAL EFFICIENCY OF CAPITAL (MEC)

The rate of profit expected from an extra unit of a capital asset is known as marginal
efficiency of capital. To Kurihara, it is the ratio between the prospective yield of additional
capital goods and their supply price. The prospective yield (Y) is the aggregate net return
from an asset during its life time, while the supply price (P) is the cost of producing this asset.
According to Keynes, marginal efficiency of capital is equal to the rate of discount which
would make the present value of the series of annuities given by the returns expected
from the capital asset during its life just equal to its supply price. Therefore, it can be said
that Supply Price = Discounted Prospective Yields. Symbolically, it can be written as follows:
R1 R2 R3 Rn
C= + + + ......
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )
n
Where, C = Supply price or Replacement Cost; R1, R2, R3 ...Rn = the annual prospective
yields from the capital asset and r = rate of discount or marginal efficiency of capital.
If the supply price of a new capital asset is Rs. 1000 and its life is two years, it is
expected to yield Rs. 550 in the first year and Rs. 605 in the second year. Marginal efficiency
of capital is here equal to 10 percent. By substituting these values in the above equation, we
obtain the following:
550 605
100 = + = 500 + 500
(1.10) (1.10)2
The term R1/(1+r) is the present value (PV) of the capital asset. Present value is the
value now of payments to be received in the future. It depends on the rate of interest at
which is discounted. The present value of a capital asset is inversely related to the rate of
interest. The lower the rate of interest, the higher is the present value, and vice-versa.

6. State the concept of investment function.
83
........................................................................................................................................
........................................................................................................................................
7. What are the determinants of investment?
........................................................................................................................................
........................................................................................................................................
8. Define the concept of MEC.
........................................................................................................................................
........................................................................................................................................
6.6.1 Rate of Interest and Investment Demand Curve

Diminishing marginal efficiency of capital represents a curve which slopes downward.
This can be seen in figure-6.3.
Y
I
MEC & Rate of Interest
MEC
r1
r2
r3
I
0 I1 I2 X
I3
Investment
Figgure-6.3: Investment Demand curve
In figure – 6.3 investment in capital assets is shown on X – axis and the marginal efficiency
of capital and the rate of interest is shown on Y – axis. From the figure – 6.3, it can be seen that
when investment in capital asset is OI1, then marginal efficiency of capital is r1. When the
investment is increased to OI2, marginal efficiency of capital falls to r2. Similarly, when
investment rises to OI3, MEC further dominants to r3. Therefore, it can be said that inducement
to invest depends on the MEC and the rate of interest. Further, the figure – 6.3 shows that if the
rate of interest is r1, then I1 investment will be undertaken. Since at OI1 level of investment
MEC is equal to the rate of interest r1. If the rate of interest falls to r2, investment in capital
assets will rise to OI2 since at OI2 level of investment the new rate of interest r2 is equal to the
MEC. Thus, the MEC curve shows the demand for investment and it represents the investment
demand curve. This investment demand curve shows how much investment will be undertaken
by the entrepreneurs at various rates of interest. If the investment demand curve is less elastic,
then investment demand will not increase much with the fall in the rate of interest. But if the
84
investment demand curve is very much elastic, then the changes in the rate of interest bring
about large changes in investment demand.
6.6.2 Profit Expectations and Shift in Investment Demand Curve

If the expectations of profit change, the MEC curve will shift. If profit expectations fall,
the MEC curve will shift downward to left which is shown in figure – 6.4 from II to. If the
profit expectations increase, the MEC curve will shift upward to the right as shown in figure –
6.4 from II to. The downward shift in MEC curve shows that at the given rate of interest, less
investment will be undertaken than before, whereas an upward shift in MEC curve indicates
more investment will be undertaken at the given rate of interest than before.
Y
I I'
I ''
I'
I
I ''
X
0 I '' I I'
Figure-6.4. Shifts in Investment Demand curve due to changes in MEC
In figure-6.4, the initial investment demand curve is shown by I I, at the rate of interest
r then the demand for investment is OI. Due to downward shift in MEC curve to , investment
demand falls to O at the given interest rate r and further due to upward shift in MEC curve to
, investment demand rises to O at the given rate of interest r.
From the preceding analysis, it can be said that rate of interest, along with the marginal
efficiency of investment, determines the volume of investment. Of the two determinants of the
rate of investment, marginal efficiency of investment is more volatile than the rate of interest.
The rate of interest is usually sticky in the short-run, while marginal efficiency of investment
can fluctuate from one extreme to another. If there is a divergence between the two, usually the
marginal efficiency of investment will adjust to the rate of interest.
6.7 FACTORS AFFECTING THE INVESTMENT DEMAND

The investment demand depends on the rate of interest and MEC. There are several
factors other than rate of interest which affect the investment and brings about change in
investment demand.
They are as follows:
85
1. Element of Uncertainty: To Keynes, the MEC is more volatile than the rate of interest.
This is because the prospective yield of capital assets depends upon the business
expectations. These business expectations are very uncertain. Expectations may change
quickly and drastically in response to the general mood of the business community,
rumours, news of technical developments, political events, etc. Keynes believed that it
was irrational swings of optimism and pessimism of the business class that were
more important during force in the stock market that determines investment.
2. Inventions and Innovations: Advances in technology and introduction of new products
and processes have been important determinants of investment. These tend to raise the
inducement to invest. If these lead to more efficient methods of production which reduce
costs, the MEC of new capital assets will rise. The absence of these will mean low
inducement to invest. For instance, the introduction of mobile cellular telephones boosted
investment in telecommunication by business class.
3. Availability of Credit: It also determines investment in the economy.
4. Expected Demand for Products: Expected net return on investment by a business firms
depends to a large extent on the demand for its product it anticipates. For the economy
as a whole, the marginal efficiency of investment depends on the consumption expenditure
of households on the products produced in the economy.
5. Liquid Assets: The amount of liquid assets with the investors also influences the
inducement to invest. If they possess large liquid assets, the inducement to invest is
high, which is conversely true.
6. Growth of Population: Growing population means growing market for all types of
goods in the economy. To meet the demand of an increasing population in all brackets
investment will increase in all types of consumer goods industries. On the other hand, a
declining population results in a shrinking market for goods there by lowering the
inducement to invest.
7. State Policy: The economic policies of the government have an important influence on
the inducement to invest in the country. If the State levies heavy progressive taxes on
corporations, the inducement to invest is low, and vice versa. Heavy indirect taxation
tends to raise the prices of commodities and adversely affects their demand there by
lowering the inducement to invest, and vice versa. If the State follows the policy of
nationalisation of industries, the private enterprise would be discouraged to invest. On
the other hand, if the State encourages private enterprise by providing credit, power and
other facilities, inducement to invest will be high.
8. Political Climate: Political conditions also affect the inducement to invest. If there is
political instability in the country, the inducement to invest may be affected adversely.
Whereas, a stable government creates confidence in the business community where by
the inducement to invest is raised. By the same token, the danger of a revolution or war
with some other country has an adverse effect on the inducement to invest, whereas
peace and prosperity tend to raise it.
86
6.8 THE MARGINAL EFFICIENCY OF INVESTMENT (MEI)
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 MEC, it is the rate which equals the
supply price of a capital asset to its prospective yield. The investment on asset will be made
depending upon the interest rate involved in getting funds from the market. If the rate of
interest is high, investment is at a low level. A low rate of interest leads to an increase in
investment. Therefore, the MEI relates the investment to the rate of interest.
6.9 RELATIONSHIP BETWEEN THE MEC AND MEI

Prof. A.P. Lerner pointed out as early as in 1946 that Keynes erred not only descriptively
but also analytically by failure to distinguish between the marginal efficiency of capital (MEC)
and the marginal efficiency of investment (MEI). Leaner, Gardner Ackley and some other
economists have clearly defined the distinguished between the two concepts.
The MEC is based on a given supply price for capital, and the MEI on induced changes
in this price. The MEC shows the rate of return on all successive units of capital without
regard to the existing stock of capital. On the other hand, the MEI shows the rate of return on
only units of capital over and above the existing stock of capital.
The MEC determines the optimum capital stock in an economy at each level of interest
rate. The MEI determines the net investment of the economy at each interest rate, given the
capital stock. The net investment is the addition to the existing capital stock whereby the
actual capital stock increases. Therefore, investment will continue to be made in the economy
till the optimum capital stock is reached. The amount of investment to be made to attain the
optimum capital stock in the economy will depend upon the law of production under which the
capital goods industry is operating.

9. State the factors affecting the investment demand.
........................................................................................................................................
........................................................................................................................................
10. What do you mean by Marginal Efficiency of Investment (MEI).
........................................................................................................................................
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6.10 THE CONCEPT OF MULTIPLIER

The concept of simple multiplier constitutes an important pillar of the whole edifice of
the Keynesian theory of income and employment. Keynes has discussed the investment
multiplier in his magnum opus “The General Theory of Employment, Interact and Money”.
Keynes’ discussion of investment multiplier is based on R.F.Khan’s work who discussed the
concept of employment multiplier in his well-known article “The Relation of Home Investment
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to Unemployment”, published in “The Economic Journal” in June 1931. Keynes took the idea
from Khan and formulated the “Investment Multiplier”. The multiplier, according to Keynes,
“establishes a precise relationship, given the propensity to consume, between aggregate
employment and income and the rate of investment”. The multiplier is the ratio of increment
in income to the increment in investment. Symbolically, it can be written as follows:
K=∆Y/∆I
Where, ∆I = increment in investment; ∆Y=increment in income; and K = multiplier.
The value of the multiplier is determined by the marginal propensity to consume. The
higher the marginal propensity to consume, the higher is the value of the multiplier, and vice-
versa. The multiplier is the reciprocal of one minus marginal propensity to consume. It is
known that saving is equal to income minus consumption, one minus marginal propensity to
consume will be equal to marginal propensity to save, i.e. 1-MPC=MPS. Therefore, multiplier
is equal to the 1/1-MPC=1/MPS.
6.10.1 Assumptions of the Multiplier

The Keynesian theory of multiplier operates under certain assumptions which limit the
operation of the multiplier process. They are:
i. The marginal propensity to consume remains constant throughout as the income
increases in various rounds of consumption expenditure.
ii. There is a net increase in investment
iii. There is no any time-lag between the increase in investment and the demand resultant
increment in income.
iv. Excess capacity exists in the consumer goods industries so that when the demand for
consumer goods increases, more amounts of them can be produced to meet this demand.
v. There is a closed economy unaffected by foreign influences.
vi. There are no changes in prices.
vii. The accelerator effect of consumption on investment is ignored.
viii. There is less than full employment level in the economy.

The multiplier can be derived algebraically as follows:
If we consider two sector economy, the equilibrium level income can be written as follows:
Y=C+I………..(i)
In the Keynesian model, change in investment is autonomous, where as changes in
consumption are function of changes in income. Therefore, the consumption function can be
written as follows:
C=C0+C1Y……(ii)
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Where, Y= Real Disposable Income; C0= The constant; and C1= MPC.
Substituting equation - ii in to equation –i:
Y=C0+C1Y+I
Y-C1Y=C0+I
Y(1-C)=C0+I
Y=1/1-C1(C0+I) or Y=C0+I/1-C1….(iii)
An alternative approach to the determination of the multiplier is in terms of saving and
investment. Saving (s) can be defined as the disposable income minus consumption.
S=Y-C……………(i)
C=C0+C1Y………(ii)
S=Y-(C0+C1Y)
S=-C0+Y-C1Y
S=-C0 +Y(1-C)…..(iii)
We can express the equilibrium requirement as:
S=I……………..(iv)
Substituting equation –(iii) in equation –iv, then:
- C0+Y(1-C1)=I
Y(1-C1)=C0+I
∴ Y=1/1-C1(C0+I) or Y=C0+I/1-C1…..(v)
If private investment I, increased to the extent of ∆I which causes for the increase in
income Y to ∆Y
Y=C0+C1Y+I
I=I+ ∆I
Y=Y+ ∆Y
∴ Y+ ∆Y= C0+ C1(Y+ ∆Y)+ I+ ∆I
Y+ ∆Y= C0+ C1Y+ C1∆Y+ I+ ∆I
Y- C1Y+ ∆Y- C1∆Y= C0+ I+ ∆I
Y(1- C1)+ ∆Y((1-C1)=C0+I+ ∆I
Dividing the above equation both sides by 1-C1, then:
Y+ ∆Y=C0+I/1- C1+ ∆I/1- C1.............(vi)
Subtracting equation –vi from equation –v
Y+ ∆Y-Y= [C0+I/1- C1+ ∆I/1- C1] - [ C0+I/1-C1]
∴ ∆Y= ∆I/1- C1
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By dividing the above equation both sides by ∆I:
∆Y/∆I=1/1- C1=1/1-MPC=K
The value of multiplier ∆Y/∆I=K will remain constant as long as marginal propensity to
consume remains the same.
6.10.3 Diagrammatic Presentation
C+I 1
C+I 0
C
∆Y
C1
C0
CA
C0
45 0
YA Y0 Y1 Y
O Yp
S&I
S
1-C1 ∆ Y
SB
∆Y
S1 ,I 1 I1
S1 ,I 0 I0
O
Y Y1 YB YP Y
Figure-6.5: Keynes’ Income Multiplier

The upper panel of figure-6.5 represents the model graphically. In the figure-6.4 income
(Y) is measured horizontally, consumption (C) and investment (I) vertically. We are concerned
only with levels of Y up to and including Yp, the potential output. The consumption function is
the straight line labelled C, the vertical intercept of which is, C0 and the slo0pe C1. It shows
what consumers will spent (measured vertically) for every income level (measured horizontally).
90
The lines C+I0, and C+I1, above and parallel to line C, show the total expenditures (C+I) that
would be forthcoming at each level of income, given each of two possible levels of investment
I0 and I1 (the lower panel of figure-6.5). The vertical distances between these lines and the
consumption function, equal (exogenous) investment, which is the same regardless of income.
The C+I lines as representing aggregate demand.
The “solution” to the model is obviously found where C+I (measured vertically) equals
Y(measured horizontally). Graphically, this can be located with the aid of a 450 diagonal line
through the origin, which connects all points in the quadrant at which vertical and horizontal
measurements are equal. The solution or “equilibrium” given this consumption function and
the particular investment level I0 is found at Y=Y0 and C=C0. Y can be at no other level
because, if it were, aggregate demand (C+I) would either exceed or fall short of output. For
instance, if Y were somehow established at YA, aggregate demand (CA+I0) would exceed
production, the resulting increase of production, and thus of disposable income, would further
raise the consumption component of aggregate demand, but by less than the rise in income.
Still, aggregate demand would necessarily exceed production until output (income) reached
the equilibrium level, Y0. If I now should rise to I1, the aggregate demand function would shift
upward as shown, and equilibrium income (output) would rise to Y1.
An alternative formulation of this model, in terms of saving and investment has shown
in the lower panel of the figure -6.5. Graphically, the model in this appears as in the lower panel
of the figure-6.5, where S is the saving function (Corresponding to the consumption function in
the upper panel), and I0 and I1, two different levels of autonomous investment (the same levels
used in the upper panel). Given I0, S and I are equal only at Y0; given I1, S and I are equal only
at Y1. Thus, Y0 and Y1 are the equilibrium values for Y, given I0 and I1 respectively. If with
I=I0, output were somehow established at YB, Saving (SB) would exceed investment (I0). The
sum of consumption spending (YB-SB) together with investment spending (I0) would thus fall
short of output (YB). Such a deficiency of aggregate demand would necessarily lead to a drop
of production, which could only terminate when Y reached Y0 where total purchases would
equal production.
Since 1-C1 is the Marginal propensity to save (MPS), we can say that, in this simplest of
models, the multiplier is the reciprocal of the MPS.
6.10.4 Leakages of Multiplier

Leakages are the potential diversions from the income stream which tends to weaken the
multiplier effect of new investment. The leakages reduce the size of the multiplier in the real
world. The operation of the simple multiplier is thwarted by many leakages which are mentioned
here under:
i. Saving: savings is the most important leakage of the multiplier process. Higher MPS
lower the multiplier and vice versa. Thus, it can be said that saving constitutes leakage
from the income-expenditure circular flow stream.
ii. Inflation: Inflation also causes leakage in the multiplier because increased money
spending fails to increase real consumption. This leakage results from the fact of additional
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money spending being absorbed in increasing the prices rather than increasing the output
and real income. The real investment and income multiplier becomes non-operative at
full employment income.
iii. Strong Liquidity Preference: If people prefer to hoard the increased income in the
form of idle cash balances to satisfy a strong liquidity preference for the transaction,
precautionary and speculative motives, that will act as a leakage out of the income stream.
As income increases people will hoard money in inactive bank deposits and the multiplier
process is checked.
iv. Imports: The working of the multiplier process is relating to the closed economy i.e. an
economy with no foreign trade. If it is open economy, a part of increment in income will
also be spent on the imports of consumer goods. The proportion of increments in income
spent on the imports of consumer goods will generate income in other countries and will
not help in raising income and output in the domestic economy. Thus, imports constitute
another important leakage in the multiplier process.
v. Taxation: Taxation is another important leakage in the multiplier process. Progressive
taxes have the effect of lowering the disposable income of the tax payers and reducing
their consumption expenditure. Therefore, increased taxation reduces the income stream
and lowers the size of the multiplier.
vi. Paying off debts: The leakage in the multiplier process occurs in the form of payment
of debts by the people, especially by business man. If a part of increased income is used
to repay debts to banks, money-lenders or other financial institutions, instead of spending
it for further consumption, that part of the income peters out of the income stream.
vii. Purchase of existing wealth: If a part of the increment in income is used in buying land,
building, second hand consumer durables and purchase of shares and bonds from the
shareholders, and so on, the consumption expenditure will fall and its cumulative effect
on income will be less than before.
viii. Undistributed profits: If profits accruing to joint stock companies are not distributed to
the share holders in the form of dividend and kept in the reserve fund, it acts as a leakage
from the income stream.
The aforesaid leakages reduce the multiplier effect of the investment. If these leakages
are eliminated, the functioning of multiplier would be positive.
6.10.5 Importance of the Concept of Multiplier

Multiplier is one of the most important concepts developed by J.M.Keynes to explain
the determination of income and employment in an economy. Its importance lies in the following:
i. The theory of multiplier has been used to explain the movements of trade cycles or
fluctuations in the economy.
ii. The concept of multiplier has also a great practical importance in the field of fiscal
policy to be pursued by the government to get out of the depression and achieve the state
of full employment in the economy.
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iii. The multiplier theory highlights the importance of investment in income and employment
theory. A fall in investment leads to a cumulative decline in income and employment by
the multiplier process and vice-versa
iv. The concept of multiplier highlights the importance of deficit budgeting.

11. Define the concept of Multiplier.
........................................................................................................................................
........................................................................................................................................
12. State any three assumptions of multiplier.
........................................................................................................................................
........................................................................................................................................
13. Bring out the leakages of multiplier.
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6.11 THE PRINCIPLE OF ACCELERATION

The origin of the acceleration is traceable in the writings of Aftalion, Bickerdike, Hawtrey
and Frisch. The study of acceleration principle is found in J.M.Clark’s well-known article
entitled “Business Acceleration and the Law of Demand” published in “The Journal of
Political Economy” in March 1917. After Clark, significant contributions to the acceleration
principle were made by Lundberg, Samuelson, Harrod, Bennion, Hicks, Baumol, Goodwin and
others. The acceleration principle says that “when income or consumption increases,
investment will increase by a multiple amount”. To Kurihara, “the accelerator co-efficient
is the ratio between induced investment and an initial change in consumption expenditure”.
Symbolically, it can be written as follows:
β =∆I/∆C or ∆I= β∆C
Where, β = the accelerator co-efficient; ∆I = net change in investment; and ∆C = net
change in consumption expenditure.
The principle states that demand for capital goods varies directly with the change in the
level of output. The extent of change in the demand for capital goods depends on the capital-
output ratio and the change in the level of output. Since the change in aggregate output depends
on the change in aggregate expenditure or aggregate demand which itself equals the change in
the level of equilibrium income, we might say that total investment in the economy in any
given time period depends on the change in the aggregate demand which in equilibrium equals
the increase in national income plus the replacement investment which is often assumed constant.
Thus, the gross investment in the economy during any given time period “t” will be equal to the
increase in national income during that time, period times the capital-output ratio (K/0) plus
the replacement of capital consumed in the process of production.
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Designating the “capital-output ratio” or capital co-efficient by γ aggregate income of
time periods t and t-1 by Yt and Yt-1 respectively and replacement investment by R, the gross
investment (Ig) in any given time period “t” will be:
Ig = γ (Yt-Yt-1)+R…(i)
= γ ∆y+R…….(ii)
The average capital-output ratio γ =K/0 is called “the accelerator or relation”.
The rigid acceleration principle in its naive form, however, assumes a given fixed
relationship between capital and output. It states that the net induced investment in any given
time period “t” is entirely a function of the growth of final output in that time period, i.e.
(Inet)t = γ (Yt-Yt-1)…iii
= γ ∆Yt…………iv
or
(Inet)t = ∆Kt = γ ∆Yt…………v
According to equations (iv and v), the net investment in the economy in any given time
period “t” is accelerator times the change in the aggregate output or income in that time period.
Put it differently, the accelerator states that if the aggregate output stayed at a high level
but ceased growing, than the net investment would eventually become zero. This has been
shown in figure-6.6, where so
long as the aggregate output Y
shown by the aggregate output Inet
curve OO is increasing over time,
Aggregate output(o)
the net investment shown by the

Net Investment &
curve Inet Inet is positive. It is, O

however, decreasing because the
aggregate output per time period
is growing at a diminishing rate.
The negative slope of the Inet
curve reflects the diminishing
slope (growth) of the aggregate
Inet
curve. When the slope of the X
aggregate curve becomes zero, O
Time period
the net investment also becomes
Figure-6.6
zero.
6.11.1 Assumptions of the Acceleration Principle

The simple acceleration principle is based on several assumptions. They are as follows:
i. This principle assumes a constant capital-output ratio.
ii. There is no excess or idle capacity in plants.
iii. The increased demand is permanent.
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iv. The capital goods are perfectly divisible in any required size.
v. This principle assumes that resources are easily available.
vi. There is elastic supply of credit and capital.
vii. It assumes that an increase in output immediately leads to a rise in net investment.
6.11.2 Operation of the Accelerator

The working of the acceleration principle is explained with the help of an hypothetical
example as given in the following table-6.1.
Table -6.1: Operation of the Acceleration Principle

Time period Output Required Replacement Net Gross
(1) (2) capital Investment (R) Investment Investment
(3) (4) (5) (6=4+5)
t 50 200 20 0 20
t+1 50 200 20 0 20
t+2 55 220 20 20 40
t+3 66 264 20 44 64
t+4 72 288 20 24 44
t+5 74 296 20 8 28
t+6 72 288 20 -8 12
t+7 67 268 20 -20 0
t+8 66 264 20 -4 16
t+9 64 256 20 -8 12
The table-6.1 traces changes in total output, capital stock, net investment and gross
investment over ten time periods. Assuming the value of the acceleration γ=4, the required
capital stock in each period is 4 times the corresponding output of that period, as shown in
column-3. The replacement investment is assumed to be equal to 10 per cent of the capital
stock in period t, shown as 20 in each time period. Net investment in column-5 equals γ times
the change in output between one period and the preceding period. For instance, net investment
in period t+3= γ(Yt+3-Yt+2)=4(66-55)=4(11)=44. It means that given the accelerator of 4, the
increase of 11 in the demand for final output leads to an increase of 44 in the demand for capital
goods (machines). Accordingly the total demand for capital goods (machines) rises to 64 made
up of 20 of replacement and 44 of net investment. The Table reveals that net investment depends
on the change in total output, given the value of the accelerator. So long as the demand for final
goods (output) rises net investment is positive. But when it falls net investment is negative. In
the Tble-6.1, total output (Col.2) increases at an increasing rate from period t+1 to t+3 and so
does net investment (Col.5). Then it increases at a diminishing rate from period t+4 to t+5 and
net investment declines, from period t+6 to t+9, total output falls, and net investment becomes
negative.
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6.11.3 Diagrammatic Presentation of the Acceleration Principle
The acceleration principle is shown diagrammatically in figure-6.7 where in the upper
portion, total output curve Y increases at an increasing rate up to t+3 period, then at a decreasing
rate up to period t+6. After this it starts diminishing. The curve In, in the lower part of the figure,
shows that the rising output leads to increased net investment up to t+3 period because output is
increasing at an increasing rate. But when output increases at decreasing rate between t+4 and t+5
periods, net investment declines. When output starts declining in period t+6, net investment
becomes negative. The curve Ig represents gross investment of economy. Its behavior is similar to
the net investment curve. But there is one difference that gross investment is not negative and
once it becomes zero in period t+7, the curve Ig again starts rising. This is because despite net
investment being negative, the replacement investment is taking place at a uniform rate.
Output
Q
O t+1 t+1 t+3 t+4 t+5 t+6 t+7 t+8 t+9
Net &
Gross
Investment
O
Ig
t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9
Time I net
Figigure-6.6
6.11.4 A Critique
This has been criticised on several grounds as follows:
i. The assumption of constant capital-output ratio has been vehemently-criticised. It is
argued that empirical studies do not lend support to the assumption of fixed accelerator.
But this does not remain constant in the modern dynamic world. In our age of rapid
scientific advancement, technology has been fast changing over time.
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ii. The accelerator theory ignores the role of expectations in the investment decisions of
the firms. Entrepreneurs will not increase their plant capacity even if the demand for
their products has increased unless they expect the increase in the demand to be permanent.
According to Tinbergen, the acceleration principle cannot accurately depict the formation
of investment decisions. David McCord Wright has rejected the acceleration principle
as an important factor in investment decisions.
iii. “Full-Capacity”, which is a pre-requisite for the operation of the acceleration principle
is absent in the early stages of the cyclical up-swing. Consequently, the operation of the
accelerator is asymmetrical as between the cyclical up-swing and down-swing. Tinbergen
has also criticised the acceleration principle as being useless in practice. Since full-
capacity is a pre-requisite for the operation of the acceleration principle, according to
Tinbergen, statistical evidence shows that this condition is very rarely, if ever, met with
in practice.
iv. The acceleration principle ignores the technical factors in investment.
Despite all the criticisms, the acceleration principle, together with other factors, helps in
explaining the critical oscillations which are observed in the investment activity in the economy.
On account of these limitations, various attempts have been made to modify the simple
acceleration theory in a number ways. Goodwin and Chennery have suggested a “stock-
adjustment version” of the acceleration principle.

14. Define the acceleration principle.
........................................................................................................................................
........................................................................................................................................
15. State any three assumptions of acceleration.
........................................................................................................................................
........................................................................................................................................
16. State any two important criticisms leveled against the acceleration principle.
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6.12 INTERACTION BETWEEN MULTIPLIER-

ACCELERATOR
The acceleration and multiplier principles have been combined into a single model to
show their interaction. This follows from the fact that an increase in the autonomous investment
increases output and income which in turn increases consumption. The induced consumption
increases the induced investment via the acceleration principle. The chain causation between
the multiplier and the accelerator is roughly of the following structure:
∆IA→∆y→∆c→∆ey→∆y→∆c→∆ey
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Economists like Samuelson, Hicks and Duesenberry have shown how accelerator
combined with multiplier provides an adequate and satisfactory theory of trade cycles that
occur in the capitalist economics. However, any desired result can be obtained by choosing the
appropriate values for the accelerator (β) and the marginal propensity to consume (C1).
6.13 THE CONCEPT OF SUPER-MULTIPLIER

Hicks has combined the multiplier and accelerator mathematically in order to measure
the total effect of initial investment on income, and given it the name of the “super-multiplier”.
The combined effect of the multiplier and the accelerator is also called the “leverage effect”
which may lead the economy to very high or low level of income propagation.
The super-multiplier is worked out by combining both induced consumption i.e.
MPC=∆c/∆y and induced investment i.e. MPI=∆c/∆y. Hicks divides the investment component
into autonomous investment and induced investment so that investment I=IA+ey, where IA is
the autonomous investment and ey is the induced investment.

The super-multiplier can be derived in the following manner:
Y=C+I→(i)
∵ C=C0+C1y
I= IA+ey
Substituting the values of C and I in the equation ….(i), then it gives the following:
Y= C0+C1y+ IA+ey……(ii)
Transferring the terms C1y and ey on left-hand side of the above education, we get:
Y C1y- ey= C0+ IA…….(iii)
Taking “Y” as a common:
Y(1- C1-e)= C0+ IA……….(iv)
then:
Y= C0+ IA/1- C1-e……..(v)
If IA increases to ÄIA, then Y should also increase to the extent of ∆y, then the equation
–(ii) can be written as follows:
Y+ ∆y= C0+ C1(Y+ ∆y)+ IA+ ∆IA+e(Y+ ∆y)……….(vi)
Y+ ∆y= C0+ C1Y+ C1∆y+ IA+ ∆IA+ ey+ e∆y………(vii)
Transferring the terms C1Y+ C1∆y+ ey+ e∆y to the left-hand side, we get:
Y+ ∆y- C1Y- C1Äy- ey-e∆y= C0+ IA+ ∆IA.............(viii)
Re-arranging the terms in the above equation, we get:
Y- C1y- ey+∆y- C1Äy- e∆y= C0+ IA+ ∆IA.............(ix)
Y (1- C1-e)+ ∆y(1- C1-e)= C0+ IA+ IA.............(x)
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Dividing both sides by 1- C1-e , then:
Y (1- C1-e)+ ∆y(1- C1-e)/ 1- C1-e = C0+ IA+ IA/1- C1-e……….(xi)
Y (1- C1-e)/ 1- C1-e+ Äy(1- C1-e)/ 1- C1-e = C0+ IA/1- C1-e+ ∆IA/1- C1….(xii)
∴ Y+∆y= C0+ IA/1- C1-e+ ∆IA/1- C1-e……….(xiii)
Subtracting equation –v from equation –xiii, then:
Y+∆y-y = [C0+ IA/1- C1-e+ ∆IA/1- C1-e ] - [C0+ IA/1- C1-e ]
∴ y = ∆IA/1- C1-e……….(xiv)
Dividing both sides by ∆IA gives the super multiplier i.e. k’
∆y/∆IA= ∆IA/1- C1-e/∆IA
∴ ∆y/∆IA= 1/1- C1-e=K’………(xv)
∴ C1=MPC
e= MPI
∆y/∆IA= 1/1- MPC- MPI= K’
(or)
K’= 1/1- MPC- MPI……(xvi)
Where, O< C1+e<1.
MPE=MPC+MPI should be less than one. Marginal Propensity to Expenditure requires
that the MPI (e) should be less than the marginal propensity to save (1- C1).
6.13.2 Simple Numerical Example

Let us explain this with the simple numerical example as follows: suppose MPC =0.8
and MPI=0.1, then the multiplier (K) and the super –multiplier (K’) are:
K= 1/1- MPC=1/1-0.8=1/0.2=5
K’= 1/1- MPC- MPI=1/1-0.8-0.1=1/1-0.9=1/0.1=10
Thus, it can be said that the inclusion of induced investment in the model raises the value
of the investment multiplier from 5 to 10. So long as the MPI is positive, the super-multiplier
will be greater than the simple-multiplier.
6.14 SUMMARY
Investment refers to the new addition to the stock of physical capital. Capital refers to
real assets like factories, plants, etc. Capital and investment are related to each other through
net investment. In fact, investment is a flow variable, capital is a stock variable. Investment
may be of different types like gross investment and net investment, private investment and
public investment, financial investment and real investment, induced investment and autonomous
investment. Induced investment is divided into two – the average propensity to invest and the
marginal propensity to invest. The level of investment depends on the magnitude of the three
factors like expected income, flow of capital goods, price of capital goods and the market rate
99
of interest. The functional relationship between these factors and investment can be called as
the investment function.
Investment demand depends upon the two factors such as expected rate of profits and
the rate of interest. Of the two determinants, marginal efficiency of capital or expected rate of
profit is of comparatively greater importance than the rate of interest. The changes in the
marginal efficiency of capital play a crucial role in causing changes in the investment level and
economic activity.
The rate of profit expected from an extra unit of a capital asset is known as marginal
efficiency of capital. To Keynes marginal efficiency of capital is equal to the rate of discount
which would make the present value of the series of annuities given by the returns expected
from the capital asset during its life just equal to its supply price. Hence, it can be said that
Supply Price = Discounted Prospective Yields. This rate of discount is said to be the marginal
efficiency of capital. There is an inverse relationship between the discount rate and present
value of capital asset. It implies that higher the discount rate lower is the present value and
lower the discount rate higher is the present value.
The investment demand depends on the rate of interest and MEC. Apart from the rate
of interest, there are several other factors like element of uncertainty, inventions and innovations,
availability of credit, expected demand for products, liquid assets, growth of population, State
policy, political climate etc. which affect the investment and bring about change in investment
demand.
The marginal efficiency of investment is the rate of return expected from a given
investment on a capital asset after covering all its costs, except the rate of interest. The MEC
is based on a given supply price for capital, and the MEI on induced changes in this price. The
MEC determines the optimum capital stock in an economy at each level of interest rate. The
MEI determines the net investment of the economy at each interest rate, given the capital stock.
Both the concepts of multiplier and accelerator had acquired lot of significance in macro
economic analysis, especially in the theory of income determination and the theory of trade
cycles. Keyne's investment multiplier is based on R.F. Khan's employment multiplier. The
multiplier is the ratio of increment in income to the increment in investment. Symbolically, it
can be expressed as K=∆y/∆I=1/1-MPC. Since 1-MPC=MPS, then K=1/MPS. The acceleration
co-efficient is the ratio between induced investment and an initial change in consumption
expenditure. Symbolically, it can be expressed as β= ∆I/∆C. The acceleration principle states
that demand for capital goods varies directly with the change in the level of output. Economists
like Samuelson, Hicks and Duesenberry have shown how accelerator combined with multiplier
provides an adequate and satisfactory theory of trade cycles that occur in the capitalist economies.
Both the acceleration and multiplier principles have been combined into a single model to
show their interaction. Hicks has combined the multiplier and accelerator mathematically to
measure the total effect of initial investment on income, and given it the name of the “super-
multiplier”. Symbolically, the super-multiplier can be expressed as K’= 1/1- MPC- MPI.
100
1. Investment refers to the new addition to the stock of physical capital such as plants,
machines, trucks, construction of public works like dams, roads, buildings and so on that
creates income and employment. Thus, it can be said that real investment means the
addition to the stock of physical capital.
2. Capital refers to real assets like factories, plants, equipment, and inventories of finished
and semi-finished goods. The amount of capital available in an economy is the stock of
capital. Hence, capital is a stock concept. Capital and investment are related to each
other through net investment. In fact, investment is a flow variable and capital is a stock
variable.
3. The different types of investment are gross investment and net investment; private
investment; autonomous investment and induced investment.
4. Gross investment is the total amount spent on new capital assets in a year. Symbolically,
it can be said that:
Ig = I net +R
Where, Ig = Gross investment; I net = Net investment; and
R = Replacement investment or depreciation.
Net investment is gross investment minus depreciation and obsolescence charges ( or
replacement investment). This is the net addition to the existing capital stock of the
economy. Symbolically, this can be written as follows:
I net = Ig – R
5. Autonomous Investment refers to the investment which does not depend upon changes
in the income level. It is income inelastic. It is influenced by exogenous factors like
innovations, inventions, growth of population and labour force, researches, social and
legal institutions, weather changes, war, revolution etc.
5 (a). The average propensity to invest is the ratio of investment to income, i.e., ∆ I/Y, whereas
the marginal propensity to invest is the ratio of change in investment to the change in
income i.e., ∆ I/Y.
6. The functional relationship between these factors and investment can be called as the
investment function. Symbolically, it can be written as:
I = f(1/e, Pc, r)
Where, I = Investment; 1/e = Expected income flow from capital good;
Pc = Price of capital good; and r = Market rate of interest.
7. Investment demand depends upon two factors. They are
i. Expected rate of profits. To Keynes, this is nothing but the Marginal Efficiency of
Capital (MEC); and ii. the rate of interest.
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Of the two determinants, marginal efficiency of capital or expected rate of profit is of
comparatively greater importance than the rate of interest. This is due to the fact that the
rate of interest does not change much in the short run; it is more or less sticky.
8. Marginal efficiency of capital is equal to the rate of discount which would make the
present value of the series of annuities given by the returns expected from the capital
asset during its life just equal to its supply price. Therefore, it can be said that Supply
Price = Discounted Prospective Yields. Symbolically, it can be written as follows:
R1 R2 R3 Rn
C= + + + ......
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r )
n
Where,
C = Supply price or Replacement Cost.
R1, R2, R3 ...Rn = the annual prospective yields from the capital asset.
r = rate of discount or marginal efficiency of capital
9. The factors affecting the investment are: i) element of uncertainly; ii) Inventions and
Innovations; iii) Availability of Credit; iv) Expected Demand for Products v) Liquid
Assets; vi) Growth of Population; vii) State policy viii) Political Climate.
10. 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 MEC, it is the rate which equals
the supply price of a capital asset to its prospective yield.
11. The multiplier, according to Keynes, “establishes a precise relationship, given the
propensity to consume, between aggregate employment and income and the rate of
investment”. The multiplier is the ratio of increment in income to the increment in
investment. Symbolically, it can be written as follows:
K=∆Y/∆I
Where, ∆I = increment in investment; ∆Y=increment in income; K = multiplier.
12. The Keynesian theory of multiplier operates under certain assumptions which limit the
operation of the multiplier process. They are:
i. The marginal propensity to consume remains constant throughout as the income
increases in various rounds of consumption expenditure.
ii. There is no any time-lag between the increase in investment and the demand resultant
increment in income.
iii. Excess capacity exists in the consumer goods industries so that when the demand for
consumer goods increases, more amounts of them can be produced to meet this demand.
13. Leakages are the potential diversions from the income stream which tends to weaken the
multiplier effect of new investment. The leakages reduce the size of the multiplier in the
real world. The operation of the simple multiplier is thwarted by many leakages which
are; i) Saving; ii) Inflation; iii) Strong Liquidity Preference; iv) Imports; v) Taxation;
vi) Paying off debts; vii) Purchase of existing wealth; viii) Undistributed profits.
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14. The acceleration principle says that “when income or consumption increases,
investment will increase by a multiple amount”. To Kurihara, “the accelerator co-
efficient is the ratio between induced investment and an initial change in
consumption expenditure”. Symbolically, it can be written as follows:
β =∆I/∆C or ∆I= β∆C
Where, β=the accelerator co-efficient; ∆I =net change in investment; and ∆C =net change
in consumption expenditure.
15. The simple acceleration principle is based on several assumptions. The three important
assumptions are: i. This principle assumes a constant capital-output ratio. ii. There is no
excess or idle capacity in plants. iii. The increased demand is permanent.
16. This has been criticised on several grounds and among them the two important criticisms
levelled against the acceleration principle are: i) The assumption of constant capital-
output ratio has been vehemently-criticised. It is argued that empirical studies do not
lend support to the assumption of fixed accelerator. But this does not remain constant in
the modern dynamic world. In our age of rapid scientific advancement, technology has
been fast changing over time; and ii) The acceleration principle ignores the technical
factors in investment.

1. Examine the marginal efficiency of capital.
2. Explain the marginal efficiency of investment.
3. Distinguish between MEC and MEI.
4. Analyse the determinants of investment.
5. Define the “Multiplier” and distinguish it from the “Super-Multiplier”.
6. Write a detailed note on the Acceleration Principle.

1. Elucidate the different types of investment.
2. Define investment and state the different types of investment.
3. Examine the relationship between MEC and rate of interest.
4. Discus the factors that affect the Investment Demand.
5. Why is the MEC expressed as a rate of discount? How does this concept help in explaining
the investment behaviour.
6. Discuss the concept of investment multiplier and its role in the theory of income and
employment.
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A. Multiple Choice Questions.
1. The net investment is positive, when:
(a) Ig = In (b) Ig<In (c) Ig>In (d) Ig ‘“ In
2. Induced investment depends upon:
(a) Demand (b) Supply (c) Income and Profits (d) None of the above
3. MEC is the sum of:
(a) Discounted prospective yields (b) Current and previous yields
(c) Yields in a series of time periods (d) None of the above.
4. Marginal Efficiency of Investment is a:
(a) Flow concept (b) Stock concept (c) Both of them (d) None of the above
5. As stock of capital increases, the MEC:
(a) Increases (b) Falls (c) Remains constant (d) None of the above.
6. The accelerator relates the net induced investment to:
(a) Change in output (b) Change in autonomous investment
(c) Change in savings (d) All the above
7. The concept of employment multiplier was given by:
(a) Keynes (b) Kurihara (c) Khan (d) Samuelson
8. The impact of increase in government expenditure upon income is:
(a) Expansionary (b) Neutral (c) Equal (d) None of the above.
9. The investment multiplier relates a change in income to a change in:
(a) Induced investment (b) Autonomous investment
(c) Foreign investment (d) All of the above
10. The size of investment multiplier is related to MPC:
(a) Directly (b) Investment (c) Neither of the two
(d) No relationship between investment multiplier and MPC
11. If MPC = 0.6, Then K is equal to:
(a) Zero (b) Unity (c) More than unity (d) Less than unity
Answers: 1. c; 2. c; 3. a; 4. a; 5. b; 6. a; 7. c; 8. a; 9. b; 10. a; and 11. c.

1. ___________ is a stock concept
2. Investment is a flow concept
3. Net investment is ________________ minus depreciation and obsolescence charges.
104
4. Buying of existing shares and bonds by an __________ is called as financial investment.
5. Autonomous investment is income ________
6. Investment demand depends upon the expected rate of profits and __________
7. Diminishing marginal efficiency of capital curve slopes _______________
8. Net addition to the existing capital equipment like new plants, machines, etc. are called
____
9. 1/1-MPC =_________
10. 1-MPC = _________
11. The acceleration principle ignores the ___________ factors in investment.
Answers: 1. capital; 2. flow; 3. gross investment 4. individual; 5.inelastic; 6. the rate of
investment; 7. downward; 8. real investment; 9. Multiplier; 10. MPS; 11. technical

A B
(i). Investment (a) Ig –R
(ii) Capital (b) Flow concept
(iii) Ig (c) Stock concept
(iv) Inet (d) Inet+R
(v) Autonomous investment (e) Profit
(vi) Induced investment (f) Income inelastic
(vii) Investment multiplier (g) Eisner
(viii) Employment multiplier (h) Hicks
(ix) Profit theory of investment (i) Keynes
(x) The concept of super-multiplier (j) Khan
Answers: i. b; ii. c; iii. d; iv. a; v. f; vi. e; vii. i; viii. j; ix. g; x. h
6.17 LOSSARY
1. Gross Investment: It is the total amount spent on new capital assets in a year
2. Net Investment: It is gross investment minus depreciation and obsolescence charges.
This is the net addition to the existing capital stock of the economy.
3. Private Investment: Investment made by individuals, non-governmental institutions
and agencies.
4. Public Investment: Investment made by the Government.
5. Financial Investment: Buying of existing shares, bonds securities etc. by an individual.
6. Real Investment: Net addition to the existing capital equipment like new plants,
machines, etc.
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7. Autonomous Investment: Investment which does not depend upon changes in the income
level. Most of the investment undertaken by government is of the autonomous nature.
8. Induced Investment: Investment affected by the changes in the level of income.
9. Investment Function: The functional relationship between the expected income flow
of capital goods, price of capital goods, the market rate of Interest and the Investment.
10. Expected Yield: The total net returns expected from the capital asset over its life period.
11. Supply Price: The present value of future income from the capital asset over its life
period or the discounted future yield of the asset.
12. Marginal Efficiency of Capital: The rate of profit from on extra unit of a capital asset
13. Marginal Efficiency of investment: The rate of return expected from a given Investment
on a capital asset after covering all its costs, expect the rate of interest.
14. Average Propensity to Invest: It is the ratio of investment to income i.e. I/Y.
15. Marginal Propensity to Invest: It is the ratio of change in investment to the change in
income i.e., ∆I/∆Y.
16. Multiplier: The multiplier is the ratio of increment in income to the increment in
investment. Symbolically, it can be written as K=∆Y/∆I.
17. Acceleration: The accelerator co-efficient is the ratio between induced investment and
an initial change in consumption expenditure. Symbolically, it can be written as: β= ∆I/
∆C, where β is the acceleration co-efficient.
18. Super-multiplier: super-multiplier measures the total effect of initial investment on
income. The concept of super-multiplier is worked out by combining both induced
consumption i.e. MPC= ∆C/∆Y and induced investment i.e. MPI= ∆I/∆Y. Symbolically,
it can be written as: K’= 1/1- MPC- MPI.
6.19 SUGGESTED READINGS

1. Ackely, G.: Macro Economics: Theory and Policy, New York; Mac millan, 1978.
2. Shapiro, Edward: Macro Economic Analysis, Galgotia Publications, New Delhi, 1984.
Delhi, 2004.
5. V. Vaish MC: Macro Economic Theory, Vikas Publishing House Pvt.Ltd; New Delhi,
2005.
6. Dwivedi, D.N.: Macro Economics: Theory and Policy, Tata McGraw-Hill Publishing
7. Dewett, K.K. Modern Economic Theory, S. Chand &Company Ltd; New Delhi, 2005.
8. Jhingan, M.L. Macro Economic Theory, Konark Publishers, Pvt. Ltd; New Delhi, 1987.
106
UNIT – 7 : CLASSICAL, NEO-CLASSICAL AND
KEYNESIAN THEORIES OF INTEREST
Contents
7.0 Objectives
7.1 Introduction
7.2 Gross Interest Rate and Net Interest Rate
7.3 Theories of Interest
7.3.1 Classical Theory of Interest
7.3.2 Abstinence or Waiting Theory
7.3.3 Fisher’s Time Preference Theory
7.3.4 Austrian or Agio Theory
7.4 Determination of the Rate of Interest
7.4.1 Classical or Real Theory of Interest
7.4.2 Demand for Savings
7.4.3 Supply of Savings
7.4.4 Equilibrium between Demand for Supply of Savings
7.4.5 Critical Appraisal
7.4.6 Loanable Funds Theory of Interest
7.4.7 Supply of Loanable Funds
7.4.8 Demand for Loanable Funds
7.4.8 Equilibrium between Demand for and Supply of Loanable Funds
7.5 Criticism
7.6 Keynes Liquidity Preference Theory of Interest
7.6.1 Introduction
7.6.2 Supply of Money
7.6.3 Demand for Money
7.7 Determination of the Rate of Interest
7.8 Criticism
7.9 Superiority of the Keynesian Interest Theory
7.10 The Modern Theory of Interest
7.10.1 Introduction
7.10.2 The Modern Theory of Interest
7.11 IS – LM Curves
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7.12 Simultaneous Determination of Interest Rate and Income
7.13 Limitations
7.14 Summary
7.15 Check your progress - Model Questions
7.17 Glossary
7.0 OBJECTIVES
This unit explains the Classical and Neo-Classical theories of Interest. After reading
this unit, you will be able to:
• describe the concepts of Gross Interest and Net Interest;
• analyze the various theories of Interest i.e., Classical, Neo-Classical and Keynesian
theories;
• understand the Equilibrium between Demand for and Supply of Savings; and
• explain how superiority of the Keynesian Interest theory to Classical theory.
7.1 INTRODUCTION
The term Interest, has been defined and interpreted in various forms. To the economists
in broader sense interest is nothing but the rate of return on the capital invested. Some classical
economists have distinguished it between the natural or real rate of interest and the market
rate of interest. The market rate of interest is the rate at which funds can be borrowed in the
market, whereas the natural rate of interest is the rate of return on capital investment. If the
natural rate of interest is higher than the market rate, the situation is viewed as being favourable
for a higher level of investment. Higher investment will result in a decline in the natural rate of
interest. When the natural rate of interest becomes equal to the -market rate of interest equilibrium
is established.
Just as rent is a payment made for the use of land, similarly interest is a payment for the
use of capital. To Marshall, interest is the price paid for the use of capital in any market. Just
as wage is the price of the service of labour, similarly, interest is the price of capital. It is
expressed as a percentage return on capital invested after allowing for risks of investment.
Samuelson defines interest as the market rate of interest is that percentage return per year
which has to be earned on the value of any capital asset (such as a machine, a hotel, building,
plant, a patent right) in any competitive market where there are no risks or where all risk
factors have already been taken care of by effecting special premium payments so as to protect
against risk. In this unit, an attempt is being made to discuss all these divergent views pertaining
to the nature of interest and determination of its rate. This unit is concerned with the discussion
on real rate of interest.
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There are two concepts of interest which are related to each other. The first concept of
interest refers to the rate of return earned on capital as a factor of production. The second
concept of interest refers to the price which is paid by the borrowers to the lenders for the use
of their saving funds. This concept of interest is of crucial importance. Thus, interest in essence
is defined as the price paid for the use of borrowed funds.
Here it is worth to make a distinction between the real rate of interest and the nominal
rate of interest. The real rate of interest is the nominal rate of interest corrected for inflation in
the economy. Therefore, it can be said that :
Real Rate of Interest = Nominal Rate of Interest – Rate of Inflation
7.2 GROSS INTEREST AND NET INTEREST

The price or amount charged by the lender of money to the borrower is the gross interest.
It includes net interest, payments to cover the risks, payments on accounts on account of the
troubles and inconveniences to which the lender is put and other types of allowances. Net
interest is thus equal to :
Net Interest = Gross Interest – Insurance against risks + Reward for Management +
Payment for inconvenience
Therefore, gross interest may be very high, while the net interest may be very low. The
net rate of interest will be the same for all because the force of competition will fix one single
rate for the whole economy. But the rates of gross interest will differ from place to place and
person to person.

1. What are the two concepts of Interest.
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
2. What are Gross Interest and Net Interest.
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
7.3 THEORIES OF INTEREST

The theory of interest fundamentally deals with two aspects : (i). How interest arises?
And (ii). How the rate of interest is determined. Some of the theories analyse only one of these
aspects, while the others explain both. For instance the Productivity Theory, Abstinence or
Waiting Theory, Agio Theory and Fisher’s Time Preference Theory are all classical theories
which explain only why interest arises or why interest is paid. On the other hand, the Classical
Theory, the Loanable Funds Theory and Liquidity Preference Theory explain both how interest
109
arises as well as how the rate of interest is determined. Neo-classical economists such as Wicksell,
Ohlin, Haberler, Robertson, Viner had developed the Neo-Classical Theory of Interest or
Loanable Funds Theory. These writers have considered the Interplay of monetary and non-
monetary forces in the determination of the rate of interest. The Loanable funds theory is partly
a monetary theory of interest. To Keynes interest is purely a monetary phenomenon. It is
determined by the demand for money (i.e. liquidity preferences) and the supply of money. To
him, interest is a price not for the sacrifice of waiting or time preferences but for parting with
liquidity.
Infact, all these theories are nothing but demand and supply theories. In the classical
theory, rate of interest is determined by the demand for savings to make investment and the
supply of savings. Whereas Loanable funds theory seeks to explain the determination of the
rate of interest through the equilibrium between demand for and supply of loanable funds. In
addition to savings, loanable funds consist of funds obtained from other sources as well.
Keynesian theory of interest analyses the determination of interest through the equilibrium
between demand for and supply of money.
7.3.1 Classical Theory of Interest

Classic economics were of the view that interest as the marginal productivity of capital.
Since physical capital has to be purchased with monetary funds, rate of interest becomes the
rate of return over money invested in physical capital. Classical theory examines the of the
determination of the rate of interest through interaction of the demand for savings to the real
theory of interest as this theory analyses the determination of the rate of the interest by real
forces such as thriftiness, time preference and productivity of capital. Classical economists
differ as regards the interests. Some of them emphasized on the forces governing the supply of
savings. They considered interest as a price for abstinence or waiting or time preference. Fisher
and Bohm-Bawerk analysed the interest from the angle of both demand side and supply side
factors as determinants of interest. Some others like J.B.Clark and F.H. Knight were of the
view that marginal productivity of capital is a force which operates on the demand side of
savings that determines the rate of interest. Some of the theories formulated by the classical
writers are being examined here under:
7.3.2 Abstinence or Waiting Theory

Nasau Senior was of the view that interest as a reward to the sacrifice of abstinence.
This theory approaches the problem from the supply side of saving. To him, saving was an act
of abstaining from consumption. Since to abstain from consuming was painful, it was necessary
to reward people for this act. This reward was in the form of the interest paid to those who
consumed their incomes, or part of their incomes.
This idea was criticised by the many economists particular by Karl Marx. To him, the
rich people who are the prime source of savings are able to save without making any real
sacrifice of abstinence. They save due to something being left over after getting indulged meeting
their consumption need. To overcome this criticism Marshall substituted the word waiting for
abstinence. As per Marshall, when a person saves money and lends it to others, he does not
110
abstain from consumption for all time; he merely postpones present consumption to a future
date. Meanwhile, he has to wait. But since most people do not like to wait, an inducement is
necessary to encourage this postponement of consumption. Interest is this inducement. Thus to
this view, interest is a price paid for waiting.
7.3.3 Fisher’s Time Preference Theory

An eminent American economist Irving Fisher emphasises the fact of time preference
as the central point in the theory./ along with the time preference, he also considered the role of
marginal productivity of capital with the term rate of return over cost as a factor that also
determines interest.
Rate of interest arises because people prefer present satisfaction to future satisfaction.
They are thus impatient to spend their incomes now. The degree of impatience depends on the
size of the income, the distribution of income over time, the degree of certainty regarding
enjoyment in the future and the temperament and the character of the individual. Therefore,
people with larger incomes are likely to have their present wants more fully satisfied and will
thus discount the future at a lower rate than the poorer people.
As regards distribution of income overtime, three kinds of situations are possible. The
income may be uniform throughout one’s life, or increase with age or decrease with age. If it is
uniform, the degree of impatience to spend in the present will be determined by the size of the
income and the temperament of the individual. If the income increases with age, it means the
future is well provided for, and the degree of impatience to spend money in the present will be
greater. If the income decreases with age, the converse of it will be true.
By the same yardstick, based on the assumption of ceteris paribus, if an individual is
sure of enjoyment of income in the future, the impatience to spend money in the present will be
less which imply that the degree of time preference will be smaller.
Finally, the character of the individual will also affect his time preference. A man of
fore thought will discount the future at a lower rate compared with a spend thrift. The rate of
time preference is also influenced by expectation of life. If a man expects to live long, his
preference for purchasing power in the present will be comparatively low.
Fisher regarded productivity of capital as the rate of return over cost, which determines
the interest. He viewed several uses of capital and different expected income streams. The
greater the expected income from an investment, the higher will be the rate of interest. Further,
Fisher also introduced risk and uncertainty in this theory of interest.
7.3.4 Austrian or Agio Theory

This theory is also known as psychological theory of interest. This was first advanced
by John Rae in 1834. This theory was given its final shape by Bohm-Bawerk, an Austrian
economist. This theory became popular later among some American economists, like Fisher
with slight modifications.
According to this theory, interest arises because people prefer present goods to future
goods. Hence, there is an agio or premium on present goods. The present gratification is attached
111
greater importance than the future satisfaction. When viewed from the present angle it undergoes
a future satisfaction. When viewed from the present angle it undergoes a discount. Thus, interest
is the discount which must be paid to induce people to lend money or postpone present
satisfaction to a future date. Bohm-Bawerk gave three reasons for the emergence of interest.
They are:
i. The future is less clearly perceived than the present. It is uncertain.
ii. Present wants are felt more keenly than the future wants.
iii. Present goods possess a technical superiority over future goods.
Besides, there is another reason that is one may hope to improve his economic position
in future as a result of which the marginal utility of his income will decline. Therefore, he
prefers to use his income at the present when the marginal utility of his income is high.
However, these reasons may not apply to all, at any rate and to the same extent.

3. What is Abstinence or Waiting theory.
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
7.4 DETERMINATION OF THE RATE OF INTEREST

Among the theories of interest, the classical or real theory, loanable funds or neo-
classical theory and Keynesian or liquidity preference theory are the important theories which
analyse the determination of the rate of interest through the equilibrium between the forces of
demand and supply. But one can find the differences among the theories of interest. As per the
classical theory of interest, rate of interest is determined by demand for saving to invest and
supply of savings. Loanable funds theory examines the determination of the rate interest through
the equilibrium between demand for loanable funds and supply of loanable funds. Keynesian
theory of interest states that the rate of interest is determined by the demand for money to hold
and the supply of money.
7.4.1 Classical or Real Theory of Interest

The classical theory of interest is also known as the real theory of interest, which explains
the determination of the rate of interest by real factors like productivity and thrift i.e. productivity
of capital goods and saving of goods. According to the classical theory, rate of interest is
determined by the supply of savings and demand for savings to invest.
7.4.2 Demand for Savings

The demand for savings comes from the entrepreneurs or firms which desire to invest
in capital goods. Capital goods are demanded because they can be used to produce further
goods which can be sold to earn more income. Hence, capital goods have revenue productivity
like all other factors. For any given type of capital asset, e.g., a machine, it is possible to draw
a marginal revenue productivity curve showing the addition made to total revenue by an
112
additional unit of a machine at various levels of the stock of that machine.
Like other factors of production, capital has marginal revenue productivity. But the
marginal revenue productivity of capital is a more complex concept than other factors, because
capital has a life of many years. Hence, capital asset continues to yield returns for many years.
But the future is very much uncertain. Therefore, the entrepreneurs have to take in to consider
the uncertainties of the future and estimate the prospective yield or income from a capital asset
after making allowance for maintenance and operating costs, which is the net expected return.
The more capital assets of a given kind an entrepreneur has the less revenue or income, he will
expect to earn by purchasing one more machine of the same kind. Therefore, the marginal
revenue productivity curve of capital slopes downwards to the right as shown in the figure 7.1.
The way in which the demand for capital goods rises as the rate of interest falls is shown
in the figure, where MRP is the marginal revenue productivity curve.
Y
r
Net return on capital
Rate of Interest /
r'
MRP
0 M M' X
Amount of capital
Figure-7.1: Marginal Revenue Productivity Curve
Net rate of return on capital and the rate of interest are shown on Y-axis, whereas amount
of capital is shown on X-axis. At Or rate of interest OM amount of capital is demanded. If the
rate of interest falls from Or to Or the amount of capital demanded will increase from OM to
OM since at OM the falling net rate of return equals the new interest rate Or. Thus, it is clear
from the above analysis that the marginal revenue productivity curve of capital shows the
demand for capital which slopes downwards to the right. This is true of individual firms, of
individual industries and of the community as a whole.
7.4.3 Supply of Savings

According to this theory, the money which is to be used for purchasing capital goods is
made available by those who save from their current income. By postponing consumption of a
part of their income, they release resources for the production of capital goods. This theory
assumes that savings are interest elastic. The higher the rate of interest, the more the savings
113
Y
which people will be induced to make.
Besides, at higher rate of interest, savings S
would be forthcoming from those persons
whose rates of time preference are more r
Rate of Interest
strongly weighed in favour of present
satisfaction. Therefore, the supply curve of r'
savings slopes upward to the right as shown
in figure 7.2. S
In the figure, X-axis represents the
supply of savings and Y-axis shows the rate
of interest. SS is the saving curve. At Or rate 0 X
N' N
of interest, ON is the supply of savings and at Savings
a lower rate, Or’ the supply of savings is ON’. Figure-7.2: The Supply Curve of Savings
7.4.4 Equilibrium between Demand for and Supply of Savings
As per the classical theory, the rate of interest is determined by the interaction of the
forces of demand for capital (or investment) and the supply of savings. The rate of interest at
which the demand for capital (or demand for savings to invest in capital goods) and the supply
of savings are in equilibrium will be the interest rate determined in the market.
The rate of interest is determined by the inter-section of the investment demand curve
and the supply of savings curve- the curves showing the relation of investment and savings to
the rate of interest is shown in figure - 7.3. On Y-
axis rate of interest is shown, whereas savings and
investment are shown on X-axis. SS is the supply
curve of savings and I I is the demand curve of
savings to invest in capital goods (I I is also called
demand curve for investment or simply investment.
Demand curve). Investment demand curve I I and
the supply of savings curve SS intersect at point E
and thereby determine Or as the equilibrium rate
of interest. If any change in the demand for 0 N X
investment and supply of savings comes about, the Savings and Investment
curves will shift accordingly, and, therefore, the Figure-7.3: Determination of
equilibrium rate of interest will also change. Rate of Interest
The classical theory of the rate of interest has three important features.
i) Firstly, it is a purely flow theory i.e., the variables which determine the rate of interest
namely the saving supply and investment demand are the flow quantities which are
distinct from stock quantities.
ii) Secondly, both savings and investment are real variables which are distinct from monetary
variables. In the classical theory, the rate of interest is not determined by the quantity of
money in circulation. Consequently, it is invariant with respect to changes in the money
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supply because any change in the money supply is neutralized by an equi proportionate
change in the prices leaving the quantity of real money in the economy unchanged.
Consequently, the demand and supply curves of money intersect remain at the same rate
of interest.
iii) Thirdly, if the equilibrium between saving and investment is disturbed due to the shift in
any one of the functions. It is re-established exclusively through changes in the rate of
interest without affecting any other variable. In other words, the theory is relevant only
to the equilibrium of economy’s real sector, while the monetary sector of the economy is
left out of the purview of the economy.
7.4.5 Critical Appraisal

The classical theory of interest has been criticised on several grounds. J. M. Keynes
vehemently criticised the classical theory and propounded a new theory of interest called liquidity
preference theory. The following are some of the criticisms levelled against the classical theory
of interest.
i. Classical theory of interest has been criticised for its assumption of full employment of
resources which is said to be unrealistic. Dillard aptly says that within the frame work of
a system of theory built on the assumption of full-employment, the notion of interest as
reward for waiting or abstinence is highly plausible. It is based on the premise that
resources are typically fully employed which lacks the plausibility in the contemporary
world.
ii. By assuming full employment, the classical theory has neglected the changes in the
income level. By neglecting the changes in the income level, the classical theory is led
into error of viewing the rate of interest as the factor which brings equality of savings
and investment. To Keynes equality between savings and investment is brought about
not by changes in the rate of interest but by changes in the level of income. To Dillard,
the difference between the traditional theory of interest and Keynes’ monetary theory of
interest is a fundamental aspect of the difference between the economics of full employment
and the economics of less than full-employment.
iii. As per the classical theory of interest, more investment (production of capital goods)
can take place only by curtailing consumption. Greater the reduction of consumption
more is the savings and, therefore, more investment. But a decrease in the demand for
consumer goods is likely to lessen the incentive to produce capital goods and therefore,
will affect investment adversely.
iv. The classical theory views savings out of current income as the only source of supply of
saving. In reality savings from current income are one of the many sources of savings.
Thus, the theory ignores the bank money, hoarded savings.etc.
v. According to the classical theory, the investment demand schedule can change or shift
without causing a change or shift in the savings curve schedule. For instance, to classical
theory, if investment demand schedule or curve II shifts downwards, then the new
equilibrium rate of interest will be determined where this new investment demand curve
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cuts the old savings curve which has remained unchanged. But this is wrong. From the
Keynesian economics, one can say that a fall in investment leads to decrease in income
and out of the reduced income, less is saved and therefore savings curve also changes.
Thus, it can be said that the classical theory ignores the effect of changes in investment
on savings.
vi. The classical theory of interest is criticised on the grounds that it considered only the
real as distinct from the monetary and only the flow as distinct from the stock variable.
As a result both the monetary and stock variables are left out in the interest rate
determination.
vii. The classical theory is also faulty since it completely ignores the consideration of the
asset, demand for money and regards money as being demanded exclusively for transaction
purpose.
viii. Finally, the classical theory, as pointed out by Keynes, is indeterminate. Position of the
savings curve varies with the level of income. There will be different savings schedules
for different levels of income. As income rises, the savings curve will shift to the right
and as income falls the savings curve will shift to the left. Thus, we cannot know the
position of the savings curve unless we know the level of income, and if we do not know
the position of the savings curve, we cannot know the rate of interest. Hence, the classical
theory, offers no determinate solution to the problem of interest rate determination and is
indeterminate.
Some of the short-comings of the classical theory of interest were removed by the loanable
funds theory.
7.4.6 Loanable Funds Theory of Interest

Loanbale funds theory is also called as the neo-classical theory. To this theory, interest
is the price paid for the use of loanable funds. This theory asserts that rate of interest is
determined by the equilibrium between demand and supply of loanable funds in the credit
market. This theory was first formulated by Swedish economist Knut-Wicksell and later on
developed by Bertil Ohlin, Dennis Robertson, A. C. Pigou, Gunnar Myrdal, Eric Lindahl,
Jacob Viner, etc.
According to this theory, real forces, such as thriftiness, waiting, time-preference and
productivity of capital alone do not determine the rate of interest. Monetary forces such as
hoarding and dishoarding of money, money created by banks, monetary loans for consumption
purposes also play an important role in the determination of the rate of interest. Therefore, it
can be said that the propounders of the loanbale funds theory were of the view that both monetary
and non-monetary forces play a vital role in the determination of the rate of interest. As per this
theory, rate of interest is determined by demand for and supply of loanable funds.
7.4.7 Supply of Loanbale Funds

The supply of loanable funds is derived from the four basic sources, namely, i. Savings,
ii. Dishoarding, iii. Bank Credit, and iv. Disinvestment.
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i. Savings: Savings by individuals or households constitute the most important source of
loanable funds. In the loanable funds theory, savings are looked at in either of these two
ways, firstly, as ex-ante savings, i.e., savings planned by individuals at the beginning of
a period in the hope of expected incomes and anticipated expenditures on consumption;
or secondly in the Robertsonian sense saving is the difference between the income of the
preceding period and the consumption of the present period. In either case, the amount
saved varies at various rates of interest. Savings by individuals and households primarily
depend upon the size of their incomes. But given the level of income, savings vary at
various rates of interest. More savings will be forthcoming at higher rates of interest,
and vice versa.
Like individuals, businesses also save. Apart of the earnings of a business concern is
consumed as declared dividends; the undistributed part constitutes business or corporate
savings. Such savings depend partly upon the current rate of interest. A high rate of
interest is likely to encourage business savings as a substitute for borrowings from the
loan market.
But these business savings are often demanded for investment purposes by the firms
themselves. Therefore, they do not enter, the market for loanable funds.
ii. Dishoarding: This is another source of loanable funds. Individuals may dishoard money
from the hoarded stock of the previous period. Thus, cash balances, lying idle in a previous
period, become active balances in the present period and are available as loanable funds.
At higher rate of interest, more will be dishoarded. At very low rates of interest, there is
a greater tendency to hold on to money.
iii. Bank Credit: The banking system provides a third source of loanable funds. Banks, by
creating credit money, can advance loans to the businessmen. Banks can also reduce the
amount of money by contracting their lending. The new money created by the banks in a
period adds greatly to the supply of loan funds. The supply curve of funds provided by
banks is to some degree interest-elastic, i.e., it varies with various rates of interest.
Generally speaking, the banks will lend more money at higher rates of interest than at
lower ones, other things remaining the same.
iv. Disinvestment: Disinvestment is the opposite of investment and takes place when, due
to the structural changes or bad venture, the existing stock of machines and other
equipment is allowed to wear out without being replaced or when the inventories are
drawn below the level of the previous period. When this happens, apart of the revenue
from the sale of the products, instead of going into capital replacement, flows into the
market for loanable funds. Disinvestment is encouraged somewhat by a high rate of
interest on loanable funds. When the rate is high, some of the current capital may not
produce a marginal revenue product to match this rate of interest. The firm may decide
to let this capital run down and to put the depreciation funds in the loan market. Thus,
disinvestment adds to the supply of loanable funds. In figure - 10.4 DI is the disinvestment
curve and slopes upwards to the right.
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By the lateral summation of the four curves, savings (S), dishoarding (DH), disinvestment
(DI), and bank credit (BM), we get the total supply curve of loanable funds which slopes
upward to the right showing that a greater amount of loanable funds will be available at higher
rates of interest, and vice versa.
7.4.8 Demand for Loanable Funds

The demand for loanable funds comes mainly from three fields: (i) investment, (ii)
consumption and (iii) hoarding.
The bulk of demand for loanable funds comes from business firms which borrow money
for purchasing or making new capital goods, including the building up inventories. Demand
for loanable funds for investment purposes by business firms is the most ‘important constituent
of total demand for loanable funds. The price of the loanable funds required to purchase the
capital goods is obviously the rate of interest. It will pay businessmen to demand loanable
funds up to the point at which the expected net rate of return on the capital goads equals the rate
of interest. Businessmen will find it profitable to purchase larger amounts of capital goods,
when the rate of interest (i.e., the price of the loanable funds) declines.
Thus, the demand for loanable funds for investment purposes is interest-elastic and slopes
downwards to the right. The demand for loanable funds for investment purposes is represented
by curve I in Fig-7.4.
The second big demand for loanable funds comes from individuals or households who
want to borrow for consumption purposes. Individuals or households demand loanable funds
when they wish to make purchases in excess of their current incomes and cash resources.
Generally, the loans for consumption are demanded for buying durable goods like automobiles,
refrigerators, radios, television sets, etc. Lower rates of interest will encourage some increase
in consumer borrowing. Demand for loanable funds for consumption purposes is shown by the
curve ‘C’ in Fig - 7.4, which is interest-elastic and slopes downward to the right.
Lastly, the demand for loanable funds may come from those who want to hoard money,
i.e., to satisfy the liquidity preference. Hoarding signifies the people’s desires to hold their
savings as idle cash balances. An important point to be noted here is that the one who supplies
the loanable funds is the same person who demands the loanable funds for hoarding. A saver
who hoards his savings can be said to be supplying loanable funds and also demanding them to
satisfy his liquidity preference.
Demand for hoarding is shown by curve H in Fig-7.4. The demand for hoarding money
is interest elastic and slopes downwards to the right. At higher rates of interest, people will
hoard or hold less money, because much of the money will be lent to take advantage of the
higher interest rates. Similarly, at lower rates of interest, people will hoard more money, because
the loss incurred by hoarding in this case is not very much.
7.4.9 Equilibrium between Demand for and Supply of Loanable Funds

The rate of interest will be determined by the equilibrium between the total demand for
loanable funds and the total supply of loanable funds as shown in Fig-7.4.
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In this figure, LS is the total supply curve
DH DI S BM
of loanable funds, which has been derived by the
LS
lateral summation of the savings curve S,
Interest
dishoarding curve DH, Bank credit curve BM and
disinvestment curve DI. Total demand curve for R E
loanable funds is LD which has been found out
by the lateral addition of curves I, C and H, which LD
show respectively the demand for loanable funds H C I
for investment purpose, consumption purpose and O N X
for hoarding. The curve LD of total demand for Loanable Funds
loanable funds and curve LS of the total supply Figure 7.4: Demand and Supply
of loanable funds inter-sect each other at the rate Equilibrium
of interest Or (=NE). At this rate, the loanable
funds lent or supplied are equal to the loanable funds borrowed or demanded. Hence, Or is the
equilibrium rate of interest which will tend to settle in the loan market.
7.5 CRITICISM
Most of the criticisms made against the classical theory are also valid in the case of the
loanable funds theory. In fact, there is not much difference in the classical and loanable funds
theories. The difference lies only in the meaning of saving. In the classical theory, savings is in
fact the same thing as the loanable funds of the loanable funds theory. In classical theory, savings
mean savings out of the income of the previous period. In the loanable funds theory, loanable
funds consist of savings out of the income of the previous period plus borrowed bank deposits
plus activated idle balances. In classical language, savings out of current income may well exceed
the savings of loanable funds theory, because current income is increased by bank loans or the
injection of idle balances. Thus, the supply schedule of savings of classical theory amounts to the
same thing as the supply schedule of loanable funds of the loanable funds theory.
Further, the loanable funds theory like the classical theory is indeterminate. According
to this theory, the rate of interest is determined by the inter-section of the demand curve for
loanable fund with the supply curve. Now the supply of loanable funds is composed of savings
plus bank credit and dishoarding. But since the savings part of the supply curve varies with the
level of income, it follows that the total supply of loanable funds will also vary with income.
Thus, this theory is also indeterminate.

4. Who had developed the Loanable Funds theory or Neo – Classical theory of Interest?
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
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7.6 KEYNES’ LIQUIDITY PREFERENCE THEORY OF
INTEREST
7.6.1 Introduction
Keynes, in his book ‘The General Theory of Employment, Interest and Money’ gave a
new view on the aspect of interest rate. Keynes defines the rate of interest as the reward for
parting with liquidity for the specified period. It is price which brings in to equilibrium the
desire to hold wealth in the form of cash with the available quantity of cash. With a given
income one has to decide how much to consume and how much to save. The consumption
depends on the propensity to consume. Given the propensity to consume, the individual will
save a certain proportion of his given income. How much of his resources he holds in the form
of ready money and how much he will part with depend upon, what Keynes calls, “liquidity
preference”. Liquidity preference means the demand for money to hold or the desire of the
public to hold cash. According to Keynes, the rate of interest is determined by the demand for
and the supply of money. This theory is known as the monetary theory of interest.
7.6.2 Supply of Money

The supply of money is the total quantity of money available for all purposes at any time
in the country. Though the supply of money is a function of the rate of interest to a certain
degree, it will be fixed usually by the monetary authorities. The supply curve of money is taken
as perfectly inelastic. The total supply of money consists of coins, notes and bank deposits.
7.6.3 Demand for money

For explaining the demand for money Keynes coined a new term ‘liquidity preference’
and by this his theory of interest is known as the liquidity preference theory of interest. Liquidity
preference is nothing but the desire to hold cash. According to Keynes, “the rate of interest is
the premium which has to be offered to induce people to hold the wealth in some form other
than hoarded money”. The higher the liquidity preference, the higher will be the rate of interest
which has to be paid to the cash holders to induce them to part with their liquid assets. The
lower the liquidity preference, the lower will be the rate of interest that will be paid to the cash
holders. People will get interest if they lend their money. But normally people will prefer to
have liquid resources. According to Keynes, there are three motives behind the desire of the
people to have liquid cash. They are: 1. The transactions motive, 2. The precautionary motive
and 3. The speculative motive.
1. Transactions Motive: The transactions motive relates to the demand for money for the
current transactions of personal. and business exchanges. Individuals hold cash to bridge
the gap between the receipt of income and expenditure. It is called the ‘income motive’
Similarly, the businessmen and the entrepreneurs hold _cash to bridge the gap between
the time of incurring business costs and that of the receipt of the sale proceeds. If the
time between the incurring of expenditure and receipt of income is small, less cash will
be held by the people for current transactions and vice versa. The amount of money held
under this transactions motive will depend upon the level of income and the business
turnover. The larger the income and the turnover, the larger will be the cash they hold.
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2. Precautionary Motive: The precautionary motive relates to the desire to provide for
any unforeseen contingencies requiring sudden expenditures and for unforeseen
opportunities of advantageous purchases. Individuals hold some cash to provide for illness,
accidents, unemployment and other unforeseen contingencies. Businessmen keep cash
to overcome unfavourable conditions or to gain from unexpected deals. The amount of
money held under this motive will depend on the level of income, nature of business
activity, opportunities for unexpected profitable deals, availability of cash and the cost
of holding liquid assets.
According to Keynes, the transaction and precautionary motives are relatively interest
inelastic, but are highly income elastic. The amount of money held under these two
motives (M1) is a function of (f1) the level of income (y) and is expressed as M1 = fl (y).
3. Speculative Motive: Speculative motive relates to the desire to hold resources in liquid
form which can be invested at an opportune moment in interest bearing bonds or securities.
Money held under the speculative motive serves as a store of value. Bond prices and the
rate of interest are inversely related to each other. A bond carries a fixed rate of interest.
One can gain by buying bonds when they are cheaper when the rate of interest is high
and sell them when they are dearer when the rate of interest falls. The higher the rate of
interest, the lower the speculative demand for money and the lower the rate of interest,
the higher the speculative demand for money. The speculative demand for money is a
decreasing function of the rate of interest. Keynes expressed the speculative demand for
money (M2) is the function of (f2) the rate of interest (r) i.e., M, = f2(r). It is explained in
figure 7.5.
The speculative demand for money is measured on, x axis and the rate of interest is
measured on y axis. The Liquidity Preference Curve (LPC) is a downward sloping towards the
right. When the market rate of interest is OR the speculative demand for money is OQ. If the
rate of interest increases to OR, the speculative demand for money decreases to 0Q, . When the
market rate of interest falls to OR2 the speculative demand for money increases to 0Q2. With
the further fall in the rate of interest to OR3, money held under speculative motive increases to
0Q3. The liquidity preference curve
LPC becomes perfectly elastic at a
very low rate of interest, which is
horizontal line beyond point E3. This
perfectly elastic portion of LPC
indicates the situation of absolute
liquidity preference of the people. At
a very low rate of interest people will
hold with them as inactive balances
any amount of money they have.
This portion of LPC with absolute X
liquidity preference is called ‘
liquidity trap’. At a very low rate of Demand for money (Speculative)
Figure 7.5
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interest, people prefer to keep money in cash rather than invest in bonds because purchasing
bonds means incurring a definite loss.
If the total liquid money is denoted by M, the transactions and precautionary motives by
M1 and the speculative motive by M2 then M M1 + M2. Since M1 = f1 (y) and M2 = f2(r), the total
liquidity preference function is M = f(y, r). M1 is completely interest inelastic unless the interest
rate is very high and M2 is interest elastic. M1 is circulating or active money and M2 is idle or
passive money.
7.7 DETERMINATION OF THE RATE OF INTEREST

According to Keynes, the demand for money, i.e.,
the liquidity preference and supply of money determine
the rate of interest. In fact, the liquidity preference for
speculative motive along with quantity of money
available determines the rate of interest. The rate interest
is determined by the equilibrium between the liquidity
preference for speculative motive (demand for money)
and the supply of money. In figure 7.6 the vertical line
QM represents the supply of money and the curve L
represents the total demand for money. Both are
intersecting at E where the equilibrium rate of interest
OR is established as the demand for money and supply
of money are being equal i.e., OM. If there is any
deviation from this equilibrium position, an adjustment
takes place via the rate of interest, and the equilibrium
will be reestablished at E only. Figure-7.6
At E1 the rate of interest is OR1
and the supply of money OM is more
than the demand for money OM/. Hence,
the rate of interest will decrease from
OR1 to the equilibrium rate of interest
OR. Similarity, at E2 the rate of interest
is OR2 and the demand for money 0M2
is more than the supply of money OM.
As a result, the rate of interest OR2 will
increase to the equilibrium rate OR.
If the supply of money is
increased by the monetary authorities,
but the liquidity preference curve L
remains the same, interest rate will fall.
This is shown in figure - 7.7. Given the
L curve, when the supply of money
Figure-7.7
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curve is QM and the rate of interest is OR. If money supply increases from QM to Q1M1 and
Q2M2, the rate of interest decreases from OR to OR1 and to OR2. Any further increase in the
supply of money is not showing effect on the rate of interest as the liquidity preference curve L
is perfectly elastic at OR2 interest rate. When the supply of money increases to Q3M3, the rate
of interest is stationary at OR2 corresponding to the equilibrium point E3
Given the demand for money, if the supply of money decreases from 0M1 to OM then the
equilibrium shifts from Ei to E and the rate of interest increases from OR., to OR. Thus, given
the liquidity preference, there is an inverse relationship between the changes in the supply of
money and changes in the rate of interest.
The act of increase in the quantity of money may cause a change in the expectations of
the public and thereby cause an upward shift in liquidity preference curve for speculative
motive. A shift in liquidity preference schedule or curve can also be due to many other factors
which affect the expectations and might take
place independently of changes in the quantity
of money supplied by the central bank. Shifts in
the liquidity function may be either downward
or upward.
Figure 7.8 shows that, given the supply of
money, if the demand for money increases and
the liquidity preference curve shifts upward, the
rate of interest increases. Initially the supply of
money curve QM and the demand for money
curve L are intersecting at E point. At this
equilibrium point the equilibrium rate of interest
is OR. When the demand for money is increasing,
the L curve shifts upward as L1 and QM line and
L1 curve both intersect at El which is the new Figure-7.8
equilibrium point. This determines OR1 interest
rate. This rate of interest OR1 is higher than OR interest rate at the equilibrium point E. When
the liquidity preference for speculative motive rises from L to L1, the amount of money hoarded
does not change, it remains OM as before.
If with the increase in the liquidity preference, the supply of money also increases in the
same proportion to Q IMI, then there is no change in the rate of interest OR except that the new
equilibrium point is at E2.
Keynes advised that the monetary authorities should increase the money supply and
reduce the rate of interest in order to increase the investment, aggregate demand and the
employment level.
7.8 CRITICISMS
The Keynesian theory of interest has been criticized by Hansen, Robertson, Knight,
Hazlitt, Hutt and others on the following aspects.
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1. The theory says that the demand for money is mainly associated with liquidity preference
for the speculative motive. Persons will hold more money by selling bonds when the rate
of interest falls and hold less cash but more bonds when the interest rate increases.
Robertson does not regard bonds as the only alternative to money. This view of Keynes
is lacking comprehensiveness.
2. Keynes holds that money held for speculative purpose only is fruitful as it brings interest
and money as a store of wealth is barren. But W.H. Hutt pointed that, money is as
productive as all other assets and the demand for money assets is a demand for productive
resources.
3. According to Knight and Hazlitt facts are contrary to the Keynes’ theory. According to
the Keynesian theory, the rate of interest should be highest at the bottom of depression
because the liquidity preference is the strongest at that time due to falling prices. But the
short term interest rates are the lowest in a depression because investment opportunities
are closed temporarily. Similarly, according to the theory, short term interest rates should
be lowest during the peak of the boom because people would be investing their money
rather than keep it in cash form. The liquidity preference being the lowest, a very small
reward is required to part with their cash. But, the rate of interest is the highest at the
peak of a boom.
4. Keynes regards the interest as reward for parting with liquidity and not a return for
saving or waiting. Saving is necessary for funds to be invested at interest. Jacob Viner
said that, “Without savings there can be no liquidity to surrender. The rate of interest is
the return for saving without liquidity”. The rate of interest is related to saving which is
neglected by Keynes in the determination of interest.
5. Liquidity is not necessary for interest. In Hazlitt’s words, “If a man is holding his funds
in the form of time deposits or short term treasury bills, he is being paid interest on them:
therefore he is getting interest and liquidity too”. So interest is not the reward for parting
with liquidity.
6. Keynes’ notion of the ‘Liquidity Trap’ is wrong. The liquidity preference schedule may
be perfectly inelastic rather than being elastic at the low interest rate. During a depression
all expectations are pessimistic. Friedman said that even in depression there was no
liquidity trap.
7. Keynes regards the interest rate as a purely monetary phenomenon and he has ignored
the influence of real factors like productivity of capital and thriftiness or saving in
determination of the rate of interest.
8. Keynes’ criticism of the classical and loanable fund theories equally applies to his interest
theory. Like the classical and loanable funds theories, Keynes’ theory of interest is also
indeterminate. Given the total money supply, we cannot know the liquidity preference
without knowing the level of income. The supply and demand for money schedules
cannot give the rate of interest without knowing the income level as in the classical case
where the demand and supply schedules for saving offer no solution until the income is
known.
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9. According to Hicks, Somers, Lerner, Hansen and others, the rate of interest, along with
the level of income is determined by four factors: the investment demand function
(Marginal efficiency of capital —MEC), the saving function, the liquidity preference
function and the quantity of money function. All these are found in the Keynesian analysis.
But he took only the liquidity preference and the quantity of money and ignored the
investment and saving functions.
10. Keynes says that the demand for money is inversely dependant on the interest rate and
the equilibrium rate of interest is inversely dependent on the amount of money. It is a
confusion. The former relation is true in the case of an individual and the latter relation
is true in the case of market.
11. Keynes assumed a definite functional relationship between the quantity of money and
the rate of interest. A change in the quantity of money leads to a change in the price of
the good in the same proportion. But, there is no functional relationship between the
price level and rate of interest. Hence, no monetary change has any direct or permanent
effect on the interest rate.
Thus, the Keynesian interest theory can be viewed as being narrow and unrealistic on
the above score.
7.9 SUPERIORITY OF THE KEYNESIAN INTEREST THEORY

Keynesian theory is considered to be superior than the loanable funds theory due to the
following.
1. Keynesian theory is about stock or quantity of money at a point of time. The loanable
funds theory is about certain flows or quantities of money per time period. Economists
prefer the stock approach to the rate of interest.
2. It is more realistic than the loanable funds theory. It explains clearly the various motives
for holding money and the relation between business expectations and the interest rate.
3. All the variables in the loanable funds theory like saving, investment, hoarding,
dishoarding are in terms of the partial equilibrium analysis. In the Keynes’ theory the
demand for and supply of money are the part of general determinate system.
4. Saving and investment do not have much importance in the loanable funds theory and
the interest rate can be fixed by hoardings plus dissaving and bank credit plus dishoarding.
In the Keynesian theory savings are interest inelastic and investment depends on the
money supply.
Conclusion
Keynes defines the interest rate as the reward for parting with liquidity and according to
him the interest rate will be determined by the demand for and the supply of money. Keynes
used a new term ‘liquidity preference’ for the demand for money to hold cash. Due to the
transaction, precautionary and speculative motives people prefer to have liquid cash. The
transaction and precautionary motives are interest inelastic and the speculative motive alone is
interest elastic. It is inversely dependent on the rate of interest. Given the liquidity preference,
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if the supply of money increases interest rate falls and vice versa. Similarly, given the supply of
money, if the demand for money increases the rate of interest increases. Hansen, Robertson,
Knight, Hazlitt, Hutt and others have criticized the Keynesian theory of interest on various
grounds. However, the Keynesian theory is superior to the loanable funds theory. Keynes took
only monetary factors and ignored the real factors. Integration of these monetary and real
factors is required for the improvement of the theory of interest.
7.10 THE MODERN THEORY OF INTEREST

7.10.1 Introduction
The classical theory of interest explained the interest rate in terms of real factors real
saving and real investment. It did not include monetary factors to explain the interest rate. The
neo — classical theory of interest explained the interest rate not only in terms of real factors
but also on the basis of monetary factors. Keynes explained the interest rate in terms of demand
for and supply of money i.e., liquidity preference and constant money supply. Keynes regards
interest as a purely monetary phenomenon and ignored the real factors. As pointed out by the
Swedish economist Knut Wicksell, the truth is that real and monetary factors have to be
recognized fora complete theory of interest. All these theories are not providing a satisfactory
explanation of the rate of interest. As a result the modem theory of interest has been developed.
7.10.2 The Modern Theory of Interest

J.R.Hicks, A.H. Hansen and Lender have taken the important elements particularly from
the classical and the Keynesian theories and synthesized them into the modem theory of interest.
It is also called “Neo-Keynesian theory of interest”. This theory has combined the four elements
— Saving, investment, liquidity preference and money supply — into a well integrated theory.
The loanable funds theory also attempted to integrate these four elements. But the attempt did
not succeed. The modern theory has considered both the real and the monetary factors. In the
classical theory of interest, the rate of interest equalizes saving and investment. In the Keynes’
theory of interest, the rate of interest brings an equilibrium between the liquidity preference
and the supply of money.
If the four variables saving, investment, liquidity preference and the supply of money
are integrated along with income, we get a satisfactory explanation of the interest rate. The
modem theory has developed two curves, the IS curve and the LM curve. The IS curve shows
the equilibrium in the real sector and the LM curve shows the equilibrium in the monetary
sector. With the help of IS and LM curves simultaneous determination of interest rate and level
of income can be seen.
7.11 IS - LM CURVES
The IS curve explains the relationship between saving and investment schedules. This
curve shows the equality of saving and investment at different combinations of the levels of
income and the interest rates. In figure 7.9 (A), the saving curve S in relation to income is
drawn in a fixed position. Because, the influence of interest on saving is assumed to be negligible.
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The saving curve is showing that saving increases with increase in income. Investment depends
on the rate of interest and the level of income. Given the level of interest rates, the level of
investment increases with the level of income. At a 7% interest rate 12 is the investment curve.
If the interest rate is reduced to 6% the investment curve shifts upward to 13. The investment
has to be raised to reduce the marginal efficiency of capital for equality with the lower interest
rate. 13 investment curve shows more investment at every level of income. Similarly, when the
interest rate is increased to 8%, the investment curve shifts downward to I. The reduction in the
investment is necessary to raise the marginal efficiency of capital for equality with the higher
interest rate.
In figure 7.9 (B), IS curve will
be drawn by marking the level of
income at various interest rates. Each
point on the IS curve represents a level
of income and interest rate at which
saving and investment are equal. If the
interest rate is 8%, the curve S
intersects the II curve at E 1 which
determines Oyi income which is equal,
to Rs.10 crores and its corresponding
point on IS is A. At interest rate 7%,
the S curve intersects 12 curve at E2 to
determine 0y2 income (Rs 20crores).
In figure 7.9(B), point B relates to 7%
interest rate and Rs 20 crores income
level. The point C relates to the
equilibrium of S and 13 at 6% interest
rate. IS line or curve is obtained by
connecting the points A, B and C with
a line or curve. The IS curve slopes
downward from left to right because
as the level of income increases,
savings will increase, rate of interest
falls and investment increases. The
position of the IS curve depends on the
position of the saving and investment
curves.
Figure - 7.9
The LM curve shows all the combinations of interest rates and levels of income where
the demand for money and the supply of money are equal. The LM curve is derived from the
liquidity preference schedules and the schedule of money supply. In figure 7.10 (A) liquidity
preference curves L1Y1, L2Y,, and L3Y3 are drawn at income levels of Rs 10 crores, Rs.20
crores and Rs.30 crores respectively. These curves together with the perfectly inelastic money
supply curve MQ will provide the LM curve. At the income ,level Yi(Rs.10crores), the demand
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for money (L1Y1) equals the money supply (MQ) at interest rate OR1. At the Y2(Rs.20crores)
income level, the L2Y, and the MQ curves equal at OR2 interest rate. At the Y3 (Rs.30crores)
income level, the L3Y3 and MQ curves equal at OR3 interest rate. The income of Rs 10 crores
creates a demand for money represented by the curve Li Y 1. L1Y1 and MQ curves are intersecting
at E1 point in figure A. Similarly, L2Y, and MQ curves are intersecting at E, and L3Y3 and MQ
curves are intersecting at E3. Point A in figure B can be determined by drawing a line to the
right from point E1 to meet the line drawn upward from Y1. In the same way points B and C
have to be determined. Now by connecting these A, B and C points with a line, we get the LM
curve. This curve relates various income levels to various interest rates. The LM curve slopes
upward from left to right because given the money supply, as the income level increases the
liquidity preference increases and consequently the rate of interest also increases. Similarly,
when the income level decreases, the liquidity preference decreases and consequently the rate
of interest also diminishes.
Figure - 7.10
7.12 SIMULTANEOUS DETERMINATION OF INTEREST RATE

AND INCOME
With the help of IS and LM curves we can see the simultaneous determination of interest
and income in figure 7.11. IS and LM curves relate to the income levels and interest rates. It is
only their intersection determines the rate of interest and the level of income. The IS and LM
curves intersect at E point and OR interest rate is determined corresponding to the income level
OY. The income level and the interest rate lead to the simultaneous equilibrium in the real
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market (investment and saving)
Y
and the money market (demand for
and supply of money).
If there is any deviation
R1
from this equilibrium position E,
certain forces will act and react in
Interest rate
such a way that the equilibrium R
will be restored. Level OY1 the
interest rate in the real market is
Y1B and it is YIA in the money R2
market. When the interest rate in
the real market is more than the
interest rate in the money market
(Y1B > Y1A), the businessmen will
borrow from the money market at Y1 X
Y Y2
a lower interest rate and invest
Income
these borrowed funds in the capital
Figure - 7.11
market at a higher interest rate. As
a result income will increase to OY via the investment multiplier and the equilibrium interest
rate OR will be reached. If the income level is 0Y2 the interest rate in the real market is less than
the interest rate in the money market (Y2C < Y2D). Now the businessmen will repay in the
money market and will not invest in the capital market. Hence, investment decreases and income
will fall to OY via the investment multiplier and the equilibrium interest rate OR will be reached.
It is observed that no other interest rate barring OR can bring simultaneous equilibrium
in both the markets i.e., real and money markets. At any rate of interest other than this particular
rate, economy’s one or the other sector will be disequilibrium. Consequently, the rate of interest
will not be a stable equilibrium interest rate. At OR1 interest rate, investment and saving are in
equilibrium at OY, level of income, but the demand for and supply of money are in equilibrium
at 0Y2 level of income. It is not possible to have two levels of income simultaneously.
Shifts in the IS and LM curves will bring changes in the equilibrium, rate of interest and
income level accordingly.
7.13 LIMITATIONS
The Hicks - Hansen theory of interest is a useful integration of the classical and Keynes’
theories. Relative effectiveness of monetary and fiscal policies in different economic situations
can be explained through IS —LM curves diagram. The chief merits of the modern theory of
rate of interest that it is free from all the criticisms which were valid in the case of the classical
and the liquidity preference theories. The theory also shows that the rate of interest is determined
by the stocks and flows and these mutual interaction in the system of general equilibrium
involving the simultaneous equality between investment, saving, demand for money and supply
of money However, this analysis is significant only if (i) the rate of interest is free to move
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rather than being maintained at a certain level by central bank actions and (ii) the interest rate
does exercise some influence on the volume of investment.
The analysis does not introduce the possibility of variations in the general price level. It
is criticized by Donpatinkin and Milton Friedman as being too simplified to be of any practical
use. In their opinion, division of the economy into only real and monetary sectors is an
oversimplified version. They have suggested a general equilibrium approach to the determination
of interest rate and income. In their opinion, rate of interest is only one of the prices which acts
and reacts to the changes in the prices of all the goods and services. They have suggested an
integrated approach not only to the determination of income and the interest rate but to other
prices as well.

5. How many reasons given by Bohm – Bawerk to emergency of interest? What are they?
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
6. What are the important features of the Classical theory of rate of interest?
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
7. State about IS-LM Curves.
...…………………………………………….…………………………………………
...…………………………………………….…………………………………………
7.14 SUMMARY
J.R Hicks and A.H.Hansen have taken real factors and monetary factors from the classical,
Neo classical and Keynesian theories and synthesized them in to the IS-LM analysis. IS curve
shows the equilibrium between investment and saving in the real market and the curve LM
shows the equilibrium between the liquidity preference and supply of money IS-LM analysis
explains the simultaneous determination of equilibrium in real and money markets, interest rate
and the level of income. If there is any deviation from the equilibrium position, certain forces will
act and react in such a way that the equilibrium will be reestablished. This IS — LM analysis has
been criticized by Don patinkin and Milton Friedman as being too simple and they have suggested
a general equilibrium approach to the determination of interest rate and income level.

1. There are two concepts of interest which are related to each other. The first concept of
interest refers to the rate of return earned on capital as a factor of production. The second
concept of interest refers to the price which is paid by the borrowers to the lenders for
the use of their saving funds. This concept of interest is of crucial importance. Thus,
interest in essence is defined as the price paid for the use of borrowed funds.
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2. The price or amount charged by the lender of money to the borrower is the gross interest.
It includes net interest, payments to cover the risks, payments on accounts on account of
the troubles and inconveniences to which the lender is put and other types of allowances.
Net interest is thus equal to :
Net Interest = Gross Interest – Insurance against risks + Reward for Management +
Payment for inconvenience
3. Nasau Senior was of the view that interest as a reward to the sacrifice of abstinence.
This theory approaches the problem from the supply side of saving. To him, saving was
an act of abstaining from consumption. Since to abstain from consuming was painful, it
was necessary to reward people for this act. This reward was in the form of the interest
paid to those who consumed their incomes, or part of their incomes.
4. Loanable Funds theory or Neo – Classical theory of Interest was first formulated by
Swedish economist Knut-Wicksell and later on developed by Bertil Ohlin, Dennis
Robertson, A.C.Pigou, Gunnar Myrdal, Eric Lindahl, Jacob Viner, etc.
5. Bohm-Bawerk gave three reasons for the emergence of interest. They are: i) The future
is less clearly perceived than the present. It is uncertain; ii) Present wants are felt more
keenly than the future wants; and iii) Present goods possess a technical superiority over
future goods.
6. The classical theory of the rate of interest has three important features. Firstly, it is a
purely flow theory ii) Secondly, both savings and investment are real variables which
are distinct from monetary variables. iii) Thirdly, if the equilibrium between saving and
investment is disturbed due to the shift in any one of the functions.
7. The IS curve explains the relationship between saving and investment schedules. The
LM curve shows all the combinations of interest rates and levels of income where the
demand for money and the supply of money are equal.

1. Analyse the Abstinence Theory of Interest.
2. Examine the Fisher’s Time Preference Theory of Interest.
3. Briefly explain the motives for demand for money.
4. What is liquidity trap?

1. Critically examine the classical theory of rate of interest.
2. Critically examine the liquidity Preference theory of interest.
3. Discuss the modern theory of interest.
4. Explain IS-LM curves.
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III. Objective Type Questions.
1. The Real Rate of Interest =
a ) Nominal Rate of Interest b) Rate of Inflation
c) Nominal Rate of Interest -- Rate of Inflation d) None
2. Neo-Classical Economists are
a) Knut Wicksell b) Ohlin c) Robertson d) Above all
3. According to Fisher and Bohm-Bawerk the factors determinants of Interest
a) demand side factors b) supply side factors c) saving factors d) Both a & b
4. Austrian or Agio theory was first advanced by John Rae in the year of
a) 1834 d) 1734 c) 1934 d) 1804
5. IS Curve shows the equilibrium between
a) Liquidity preference and supply of money b) Investment and Saving
c) Both of the above d) None of the above
Answers: 1) c 2) d 3) d 4) a and 5) b

1. Loanable Funds Theory is also called as ————————————————
2. Bohn-Bawerk developed—————————————————————— Theory
3. J.M. Keynes published book ———————————————————————
4. The Classical Theory of Interest criticized by ———————————————
5. Knut Wicksell is a —————————————— Econimist
Answers: 1. The Neo-Classical Theory 2. Austrian or Agio Theory 3. The General Theory of
Employment, Interest and Money 4. J.M. Keynes and 5. Swedish Economist.

A B
1. Abstinence or Waiting theory (a) J.M. Keynes
2. Austrian Agio theory (b) An American Economist
3. Liquidity Preference theory (c) Nasau Senior
4. Modern theory of Interest (d) Bohm-Bawerk
5. Irving Fisher (e) J.R.Hicks, A.H.Hansen
Answers: 1- c, 2- d, 3- a, 4- e, and 5- b
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7.17 GLOSSARY
1. Interest: It is the price paid for the use of capital in any market.
2. Market Rate of Interest: It is the rate at which funds can be borrowed in the market.
3. Natural Rate of Interest: It is the rate of return on capital investment.
4. Real Rate of Interest: It is the nominal rate of interest corrected for inflation in the
economy.
5. Classical Theory of Interest: As per the classical theory, rate of interest is determined
by the supply of savings and demand for savings to invest.
6. Loanable Funds Theory of Interest: This theory is also called as the Neo-classical
Theory. This theory asserts that the rate of interest is determined by the equilibrium
between demand and supply of loanable funds in the credit market.
7. Liquidity preference: Liquidity preference means the demand for money to hold or the
desire of the public to hold cash. This concept was used by J.M. Keynes.
8. Transactions motive: The transactions motive relates to the demand for money for the
current transactions of personal and business exchanges. It is income elastic and interest
inelastic.
9. Precautionary motive: The precautionary motive relates to the desire to hold cash to
meet the sudden and unforeseen expenditures. It is income elastic and interest inelastic.
10. Speculative motive: The speculative motive relates to the desire to hold resources in
liquid form which will be invested. It is interest elastic.
11. Liquidity Trap: The liquidity preference curve becomes perfectly elastic at a very low
rate of interest. This indicates the situation of absolute liquidity preference of the people.
12. IS curve: It shows the equality of investment and saving at different combinations of the
income levels and the interest rates.
13. LM Curve: The LM curve shows all the combinations of interest rates and income
levels where the demand for money and the supply of money are equal.

1. Ackley G : Macro Economic Theory
2. Shapiro E : Macro Economic Analysis
3. M.L. Jhingan : Macro Economics
4. R.D. Gupta : Keynes and Post Keynesian Economics
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BLOCK – IV
THEORIES OF FACTOR PRICING
This block explains the Meaning, Functions and Classification of Money and its
Aggregates, determinants of Money Supply in India. It also tries to explain the various
Theories of Money i.e., Classical and Neo-Classical - Fisher's and Cambridge, versions of
Quantity theory of Money. In this last part of this block, it discusses in detail the Central
Bank's Functions and Credit Control.
Unit - 8: Meaning, Functions and Classification of Money
Unit - 9: Measures of Money Supply with reference to India
Unit - 10: Theories of Money
Unit - 11: Central Banking: Functions and Credit Control
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UNIT – 8 : MEANING, FUNCTIONS AND
CLASSIFICATION OF MONEY
Contents
8.0 Objectives
8.1 Introduction
8.2 Definition of Money
8.2.1 Functional Definition
8.2.2 Legal Definition
8.2.3 General Acceptability Definition
8.3 Evolution of Money
8.4 Classification of Money
8.4.1 Metallic Money
8.4.2 Legal Tender Money
8.4.3 Paper Money
8.4.4 Bank Money
8.5 Functions of Money
8.5.1 Primary Functions
8.5.2 Secondary Functions
8.5.3 Contingent Functions
8.6 Summary
8.9 Glossary
8.0 OBJECTIVES
After reading through this unit, you will be able to:
• understand the evolution of the concept of money;
• define the concept of Money in different’ forms;
• classify the money in different ways; and
• know the different functions of Money.
8.1 INTRODUCTION
In Modern economies, whether they are capitalist or socialist or mixed economies are all
135
called money economies. Money plays an important role in influencing the real variables such
as employment and production in the economy. The real variables in turn influence the quantum
and volume of circulation of money in the economy. In monetary economies, the consumers
use money as an instrument for carrying out their day-to-day economic activities. Before the
introduction of money in the economic activities, people used to get their goods and services
through “Barter System”. Under the barter system, the goods are exchanged for goods. People
used to give away the goods and services that are in excess of their requirement in exchange for
the goods and services that they need. This type of exchange system still exists in Indian
villages in nascent form. There are certain disadvantages in this system. The wants of both the
parties who exchange the goods and services should coincide. That is, the person who wants to
sell a good should have interest to get the good that the other person is prepared to give.
Otherwise, the exchange of the goods and services cannot take place. The value of the goods
and services they exchange should be determined accurately. If there is no general or common
measure to ascertain the values of the goods, they cannot carry out the transaction. Similarly,
the goods and services that they exchange should be perfectly divisible according to the needs
of the individual. If they are not indivisible, they cannot perform the exchange. For example,
a live hen cannot be exchanged for a live goat. The barter system would work well when the
number of goods and services in the economy and the wants of the people are limited. If they
are unlimited, and if they need to go to far-off places to get the goods, the system cannot work
well. In view of all these limitations of the Barter system, a common measure of value viz.,
‘Money’ had to be introduced in the economy. In this lesson, we shall learn the meaning and
definition of money, evolution of money focusing on different types of money that they existed
in the world in different periods of time as well as different approaches to the definition of
money as proposed by various schools of thought and Reserve Bank of India. We shall also
discuss various functions that the money is expected to perform in an economy in a detailed
manner.
8.2 DEFINITION OF MONEY

Everyone knows about money and its uses in his/her varied daily activities. But precise
definition of money is not possible. Several economists defined Money in different ways
emphasizing a particular function or particular form of money. To get a comprehensive view of
the concept of money, let see various definitions offered by the economists.
8.2.1 Functional Definition

The functional definition of money emphasizes different functions that the money is
expected to perform. Gustav Cassel emphasized the ‘common measure’ function of money.
According to him “An article that has the function of common measure for the valuation of
other goods is called Money”. Francis A Walker defined money in a very broad sense.
According to him “Money is that Money does”. According to Karl Helfferich, the normal
purpose of money is “facilitation of economic intercourse (or the transfer of values) between
economic individuals”. Thus above definitions emphasize the measure of value and medium
of exchange functions of money.
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8.2.2 Legal Definition
Generally certain things are recognized by the “State” as currency for two purposes viz.,
to make it generally acceptable i) in carrying out the transactions; and ii) to clarify the legal
position of debtor and creditor in discharging credit obligations in monetary terms. Hawtrey
has defined money purely in legal terms. He defines money as “the means established by law
(or by custom having the force of law) for the payment of debts”. The government can bestow
legal tender powers to any type of currency. Legal tender money is that money which a creditor
has no right to refuse it, if offered by a debtor in the fulfillment of a general monetary obligation
payable in monetary terms. Critics argue that granting of legal tender powers is not a significant
factor in making money generally acceptable. They cite the German experience during the
hyper inflation of 1922-23, when non-legal tender money such as privately issued paper and
foreign currencies were preferred in lieu of domestic legal tender currency viz., Mark. Thus
general acceptability is a more significant factor than their legal recognition. Hence, economists
define money in terms of General Acceptability aspect.
8.2.3 General Acceptability Definition

Many economists defined money in terms of its general acceptability. According to
them anything which is generally acceptable in payment of debt and is commonly used as a
medium of exchange or standard of value can be regarded as money. In the words of E. R. A.
Seligman, “a thing that possesses general acceptability” is called money. According to
Marshall “Money included all those things which are (at any given time or place) generally
current without doubt or special enquiry as a means of purchasing commodities or services,
and of defraying expenses”. D. H. Robertson defines money as “anything which is widely
accepted in payment for goods or in discharge of other kinds of business obligations”. In the
opinion of G.D. H. Cole, “Money is anything that is habitually or widely used as a means of
payment, and is generally acceptable in the settlement of debts”. Crowther defines money as
“anything that is generally acceptable as a means of exchange (i.e., as a means of settling
debts) and that at the same time acts as a measure and a store of value”. Thus all the definitions
listed above insisted on one common condition viz., ‘General Acceptability’ as the most important
characteristic of money.

1. Define Money in one sentence.
..........................................................................................................................................
..........................................................................................................................................
2. Give Functional Definition of Money.
..........................................................................................................................................
..........................................................................................................................................
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3. Give Hawtrey’s legal definition of money.
..........................................................................................................................................
..........................................................................................................................................
4. Do you think that General Acceptability is sine quo non for money?
..........................................................................................................................................
..........................................................................................................................................
8.3 EVOLUTION OF MONEY

In the primitive societies animals such as cows, goats and sheep were recognized as
money and transactions were carried out in terms of these animals. The concept of Go-Dhan
(Cattle wealth) in the ancient Indian civilization existed and it is referred to in Arth –Veda. In
the fourth century B. C., the Roman State had officially recognized cows and sheep as money
to collect fines and taxes. Later a large number of commodities from axes to yarn have been
adopted as money. The particular commodity chosen as money depended upon various factors
such as location of the community, climatic conditions, cultural and economic standards of the
society concern etc. For example, people living in seashores adopted shells and dried fish as
money, people living in cold regions such as those in Alaska and Siberia preferred skins and
furs as medium of exchange, African people used ivory and Tiger jaws as money, people living
in delta regions used rice, tea, tobacco as money. Prof. Paul Einzig has recorded some 172
commodities in the list of primary money.
Animal and commodity money suffered from several drawbacks. They are
i) lack of uniformity and standardization;
ii) inefficient store of value;
iii) lack of easy transferability; and
iv) indivisibility.
In view of all these drawbacks of the commodity money, in the course of time, metallic
money has been introduced.
With the growth of economic civilization from the pastoral to commercial stage of society,
precious metals such as gold, silver, copper, bronze, aluminum etc., were used as a medium of
exchange. Gradually, these metals were used to mint coins and hence the coinage system has
been developed in the economies. According to the noted historian, Toynbee, the coinage
system is believed to have come into existence around 700 B. C., in a Green city viz., Lylia.
Imperfections in the size and shape of the coins were removed with the undertaking of the
minting activity by the state.
Metallic money has the following drawbacks:

i) On account of their bulkiness, a large sum of money in terms of coins is not easily
portable;
ii) It is unsafe to carry and it can be stolen easily; and
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iii) Rapid transactions are not possible with coins.
The next stage in the evolution of money is the introduction of paper money. During the
17th and 18th centuries, merchants used to issue receipts against metallic money as that was
found to be unsafe and inconvenient to carry to distant places. With the shortage of metals, the
state authorities introduced paper money called paper currency as a representative of proper
money. These currencies were convertible in to the metals such as gold and silver which acted
as a backup for the issue of the paper currencies. In the course of time these, however, became
inconvertible ‘Fiat Money’ recognized by the government as medium of exchange without any
reserves to serve as the backup for the currencies issued to the public. Most of the world’s
paper money is fiat money because fiat money is not linked to physical reserves. It has the
risks of becoming worthless due to hyper inflation. If people lose faith in a nation’s paper
currency, the money will no longer hold any value.
The following are the major advantages of paper money.
i) Paper money is economical and it is cheaper than any metal;
ii) It is very convenient to carry paper money from place to place;
iii) It is also easy to store paper currency;
iv) It is very easy to count paper notes than metallic coins; and
v) Supply of paper money is easily adjustable as per needs of the economy.
The following are the major disadvantages of paper money.
i) Firstly, there is a danger of over issues of currency notes at the discretion of the
government. The over issue of the paper currencies leads to rising prices and falling
value of money;
ii) If the people lose confidence on the government for one reason or other, the paper money
lacks general acceptability;
iii) Durability of paper money is much lesser than the metallic money;
iv) Unless the currency is an internationally acceptable key currency like Dollar, the
circulation of the paper currency would be limited to the domestic economy only; and
v) Lastly, the possibility of printing fake currency by the unscrupulous persons is very high
which may lead to undesirable consequences in the economy.
With the development of modern banking system, along with the paper money, bank
money in the form of Cheques, Drafts, Travelers Cheques have been introduced against the
Demand (Current) or Savings deposits of the individuals and business organizations concern.
Even though they cannot be considered as legal tender money, a large number of business
transactions are being conducted in modern times through bank cheques, bills of exchange and
other business instruments. Hence, these possess the most important characteristic of money
viz., General Acceptability.
Sir Thomas Gresham (1519-79), a leading English business man and financial adviser to
Queen Elizabeth I stated that ‘Bad Money Drives out Good Money out of Circulation’. This
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is known as Gresham’s Law after him. When both “bad money” and “good money” are in
circulation, people will use the “bad money” when making transactions and the “good money”
will be hoarded. The natural human tendency is to retain the better coins or notes and pass on
into circulation the comparatively old and worn out coins or notes. Similarly, when new 50
rupees and 200 rupees notes were released, people stored 200 rupees notes and new 50 rupees
currency notes and used old 50 rupees notes for doing transactions.

5. Which State recognized Cows and Sheep as money in ancient days?
..........................................................................................................................................
..........................................................................................................................................
6. List out the drawbacks of Commodity Money.
..........................................................................................................................................
..........................................................................................................................................
7. When did the coinage system begin in the world?
..........................................................................................................................................
..........................................................................................................................................
8. What is Fiat money?
..........................................................................................................................................
..........................................................................................................................................
8.4 CLASSIFICATION OF MONEY

Money can be classified on the basis of its physical form, legal recognition or its nature.
On the basis of Physical form, money can be classified as animal money, commodity money,
metallic money, paper money and plastic money. On the basis of legal recognition, money can
be classified as Limited legal tender money and Unlimited legal tender money. On the basis of
its nature, money can be classified as Deposit money or Credit money. We have already discussed
about animal and commodity money in the last section on the evolution of money. Let us now
discuss other types of money in detail.
8.4.1 Metallic Money

Metallic money refers to coins that are made out of various metals such as gold, silver,
bronze and aluminum. The size, shape, weight, value and fineness of coins are generally
determined by the State. Minting of the coins is the prerogative of the government and the
place where the coins are minted is called Mint. Metallic coins are classified into ‘Standard or
Full-bodied coins’ and ‘Token Coins’. A Standard coin is that coin whose face value is equal (or
almost equal) to its intrinsic value, i.e., the value of the metal used in its minting. Standard or
full bodied coins were used under Gold or Silver standards. The British Sovereign before 1914
and the Indian Rupee between 1835 and 1893 were the best examples for the standard or full-
bodied coins. On the other hand, in the case of token coins, the face value is greater than its
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intrinsic or its metal value. All coins in domestic circulation in the modern economies are token
coins. It should be noted that the money that has intrinsic value in a precious metal like Gold,
silver, and any other precious metal can also be considered commodity money.
8.4.2 Legal Tender Money

Legal Tender money is that money which is officially designated by the government as
an adequate instrument for the discharge of obligations denominated in domestic money. It
increases its general acceptability and provides legal guarantee. Depending upon the degree or
extent to which money pieces of different denominations in circulation is legally acceptable;
legal tender money is further classified as Limited Legal Tender and Unlimited Legal Tender
money. Limited legal tender money is accepted as legal tender only up to a certain limit. For
example, in India 10, 20, and 25 paise coins were legal tender only up to a sum of Rs. 25/-. It
means, up to rupees twenty-five a person cannot refuse a payment through these small coins.
So 10, 20, 25 paise coins are examples of limited legal tender. Unlimited legal tender money is
that money which has to be accepted as a means of payment up to any amount without any
limit. For example, in our country, 50-paise coins, One rupee coin and Currency notes of all
denominations are unlimited legal tender.
8.4.3 Paper Money

Paper money is the money or currency issued by the State Treasury or the Central Bank of
the country. We have already learned about the features of paper currency, its major advantages
and disadvantages. The disadvantages of paper currency could be overcome and controlled by a
proper checks and balances. Hence, in modern economies, paper money is in wide circulation.
In India, all currencies except one rupee notes are issued by the Reserve Bank of India and the one
rupee notes are issued by the Ministry of Finance, Government of India.
8.4.4 Bank Money or Optional Money

As noted already, the development of modern banking activities paved the way for the
introduction of another important type of money viz., Bank money. The Bank money is also
known as Deposit Money or Credit Money or Optional Money. The Bank money is mostly in the
form of Cheques. These cheques are issued to the customers by the banks against their deposits
in the banks or on the basis of credit authorized to them by the banks. Hence, these are called as
Bank Money or Deposit Money or Credit Money. The cheques are ordinarily accepted by the
people in final payments even though there is no legal sanction behind them. Apart from cheques,
other credit instruments like drafts, bills of exchange, promissory notes etc., are also accepted in
lieu of currency notes and hence these are called Optional Money. Bank money today constitutes
a major segment of money supply in advanced as well as in developing countries.

9. What is optional money?
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10. Give examples for unlimited and limited legal tender money.
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8.5 FUNCTIONS OF MONEY

Money has been used for different purposes in an economy. These purposes are called
functions of money. Economists identified three types of major functions of money. They are
i) Essential or Primary Functions; ii) Secondary or Derived Functions; and iii) Contingency
Functions as shown in the chart below:
8.5.1 Primary Functions

Essential of Primary Functions are also known as the Original or Fundamental or Basic
Functions of money. These functions are very essential for the basic operations of the economies
and hence these called primary functions. Generally, economists have defined two types of
primary functions of money. They are as follows: (i) Medium of exchange; and (ii) Measure
of value.
i) Medium of Exchange: Right from the invention of money, it has been performing an
important function as medium of exchange as everyone in the society is willing to accept
it in exchange for goods and services. Producers sell their goods to the wholesalers in
exchange of money. Wholesalers sell the same goods to the consumers in exchange of
money. In the same way, all sections of society sell their goods and services in exchange
of money and with that they buy goods and services which they need. Money, working
as medium of exchange, has eliminated several inconveniences which were faced in
barter transactions. It simplified exchange compared to barter and now there is no need
for a double coincidence of wants. However, money can operate as medium of exchange
only when it is generally accepted in that role. Bank money can be treated as money
only if it is accepted by the seller of the goods and services. Money has given considerable
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amount of freedom to the buyers and sellers of goods with regard to the quantities and
qualities of the goods they desire to buy and sell, the time and place of their transactions
and the parties with whom they choose to deal. Money functioning as a medium of
exchange has, thus, perfected the price mechanism. The factors of production that get
their remuneration in terms of money rather than in kind would have greater freedom
and wider choice for their disposal in the market.
ii) Unit of Account: Money measures the value of various goods and services produced in
an economy. The value expressed in terms of money is called ‘price’. In other words,
money works as unit of value or standard of value or common denominator of value. In
barter economy it was very difficult to decide as to how much volume of goods should
be given in exchange for a given quantity of another good or other goods. Money, by
performing the function of common measure of value, has saved the society from this
difficulty. Money is divisible. So it can be used to measure and compare the values of
different goods. Now the value of various goods and services are expressed in terms of
money such as Rs. 250 per metre of cotton cloth, Rs. 60/- per kilogram of onion etc. In
this way, money works as common measure of value by expressing exchange value of all
goods and services in terms of money in the market. By working as a unit of value,
money has facilitated modern business and trade. The pricing mechanism and the efficient
allocation of resources have been made possible with the common value function of
money. Money performs the twin functions of medium of exchange and measure of
value almost simultaneously.
8.5.2 Secondary Functions

Apart from the four primary or essential functions of money discussed above, there are
other important functions that money has to perform. These are as follows: (i) Standard of
deferred payments; (ii) Store of value; and (iii) Transfer of Value.
i) Standard of Deferred Payments: Money, besides facilitating the current transactions,
also facilitates the future or deferred payments. When the future payments are settled
using money, both creditors and debtors do not stand to lose. The modern economic
setup is based on credit. In recent years the significance of credit has increased so much
that it will not be improper to call it as the foundation stone of modem economic progress.
In such a credit economy, money plays an important role in the settlement of credit. It
should, however, be noted that money can be a satisfactory standard of deferred payments
only if it maintains stability in its value through time. If the value of money changes due
to changes in the price level, it causes serious difficulties in the relationship between
debtors and creditors. When the value of money increases (fall in the general price
level), it puts an unjust burden on the debtor. This is because he has to return more
purchasing power than he has originally acquired. Similarly, when the value of money
falls (rise in the general price level), it puts an unjust burden on the creditor. This is
because the debtor returns less purchasing power than that he originally acquired.
ii) Store of Value: Money acts as a convenient instrument to store the value or the surplus
purchasing power over the time. Under barter system, the consumers have to store the
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commodities for their exchange in future. Sometimes, the commodities may be perishable
and hence cannot be stored for longer duration. The discovery of money has removed
this difficulty. With the help of money, people can store surplus pur-chasing power and
can use it whenever they want to use it. Saving in money form is not only secure but its
possibility of being destroyed is very less. According to Milton Friedman, money is one
of the important forms of holding wealth. It confers power on its holder to claim real
goods and services in future. It is the most liquid form of the asset and the holder of
money is empowered to spend it at his will. In fact the function of money as an asset is
the direct result of the most important property of money namely its liquidity. It was
Keynes who first fully realised the liquid store value of money function and regarded
money as a link between the present and the future. However, if money shrinks in its
purchasing power or its exchange value over a period of time, as it happens during
inflationary periods, people may lose confidence in cash balances as an efficient store of
value. Nevertheless, money as a means of storing the value or surplus purchasing power
can be limited to the immediate future period, if not to a farfetched future period during
which there may be uncertainty over the value of the money. The two primary functions
and two secondary functions have been summed up in a couplet which says that ‘Money
is a matter of functions four, a medium, a measure, a standard and a store’.
iii) Transfer of Value: Money also functions as a means of transferring value. Through money,
value can be easily and quickly transferred from one place to another because money is
acceptable everywhere and to all. Since money embodies value in its most general form, to
transfer money is to transfer generic value from one place and person to another place and
person. It does not involve any difficulty. For example, it is much easier to transfer one
lakh rupees through bank draft from person in Chandigarh to a person in Hyderabad than
remitting the same value in terms of a commodity such as Wheat.
8.5.3 Contingent Functions

Besides performing the primary and secondary functions, money also performs some
more functions which David Kinley termed as ‘Contingent’ functions. They are i) Basis of
Credit System; ii) Distribution of Social (National) Income; iii) Imparting a General Form to
Capital; and iv) Maximization of Satisfaction. Let us discuss these functions briefly.
i) Basis of Credit: In present days, the credit money like cheque, draft, bill of exchange,
promissory notes are in wide use. Business people settle their credit obligations and get
payments through these instruments only. These credit instruments are issued to business
people and individuals on the basis of cash deposits held by the banks. Hence, money is
a basis of credit.
ii) Distribution of Social (National) Income: Total output of the country is jointly produced
by a number of people as workers, land owners, capitalists, and entrepreneurs. This, in
turn, will have to be distributed among them. Money helps in the distribution of this
national product or National income that is expressed in monetary terms through the
system of payment of wage, rent, interest and profit. These are measured in terms of
money more efficiently.
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iii) General Form of Capital: Money as ‘the embodiment of generic value’ imparts mobility
and liquidity to capital. It also imparts uniformity to different types of wealth. Money
works as a general form of capital. In the present times, almost all wealth or capital are
kept in the form of money. This increases the liquidity and mobility of capital. Hence,
capital can be used in a useful way. Since money gives liquid form to wealth, many
people prefer to store their wealth in the form of money rather than in non-money form.
iv) Maximization of Satisfaction: Money helps consumers and producers to maximize
their benefits. A consumer maximizes his satisfaction by equating the prices of each
commodity (expressed in terms of money) with its marginal utility. The utility derived
out of the consumption of different goods by the consumers is measured in terms of
money. Similarly, a producer maximizes his profit by equating the marginal productivity
of a factor unit to its price (expressed in terms of money). The profits of business
concerns are also measured in terms of money.

1. What are the primary functions of money?
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2. List out the secondary functions of money.
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3. Enumerate the contingent functions of money.
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8.6 SUMMARY
In this unit, an attempt is made to understand the concept of money. We discussed the
difficulties of barter system where goods are exchanged for goods. We have seen that to overcome
the difficulties of the barter system money has been introduced. We have discussed several
definitions of money and we have seen that ‘General Acceptability’ is the most important
requirement of money. We have traced the evolution of money starting from the primitive
societies where animals and agricultural commodities were used as medium of exchange to the
modern age where cheques and drafts are accepted as money. Over the years, precious metals
like gold and silver and paper currencies were introduced as money. We have also discussed
how money is classified and we have learnt about several concepts of money like fiat money,
legal tender money, metallic money, paper money and bank money. Economists belonging to
different schools of thought have given different approaches to money particularly the
components that are to be included within the purview of money, near money and money
substitutes. The Reserve Bank of India originally has given a four-fold classification of money
such as M1, M2, M3 and M4 and recently, on the recommendations of the Working Group has
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made certain changes in the first three components and dropped the fourth component. Finally,
we have thoroughly discussed three major types of functions of money viz., Primary Functions,
Secondary Functions and Contingent Functions. The primary or the basic functions of money
such as medium of exchange and measure of value, Secondary Functions such as Standard of
Deferred payments, Store of Value and Transfer of Value are very important in all types of
economics to ensure efficient allocation of resources. The Contingent Functions such as
providing Basis to Credit, Distribution of Social (National) Income among the agents of
production, proving General Form to Capital and Maximization of Satisfaction of consumers
and producers are very important in all the economies particularly in the capitalist economies.

1. Generally money is acceptable in payment of debt and is commonly used as a medium of
exchange or standard of value can be regarded as money.
2. The money is measure of value and medium of exchange.
3. Hawtrey has defined money purely in legal terms. He defines money as “the means
established by law (or by custom having the force of law) for the payment of debts”.
4. Money is generally acceptable in payment of debt and is commonly used as a medium of
exchange or standard of value can be regarded as money.
5. Roman State had officially recognized cows and sheep as money to collect fines and
taxes.
6. Commodity money suffered from several drawbacks. They are: i. Lack of uniformity
and standardization; ii. Inefficient store of value; iii. Lack of easy transferability; and iv.
Indivisibility.
7. The coinage system is believed to have come into existence around 700 B. C., in a Green
city viz., Lylia.
8. ‘Fiat Money’ recognized by the government as medium of exchange without any reserves
to serve as the backup for the currencies issued to the public. Most of the world’s paper
money is fiat money because fiat money is not linked to physical reserves. It has the
risks of becoming worthless due to hyper inflation.
9. The Bank money is also known as Deposit Money or Credit Money or Optional Money.
The Bank money is mostly in the form of Cheques. These cheques are issued to the
customers by the banks against their deposits in the banks or on the basis of credit
authorized to them by the banks.
10. In India 10, 20, and 25 paise coins were legal tender only up to a sum of Rs. 25/-. It
means, up to rupees twenty-five a person cannot refuse a payment through these small
coins. So 10, 20, 25 paise coins are examples of limited legal tender. Unlimited legal
tender money is that money which has to be accepted as a means of payment up to any
amount without any limit. For example, in our country, 50-paise coins, One rupee coin
and Currency notes of all denominations are unlimited legal tender.
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11. Primary functions of money are i. Medium of exchange; and ii. Measure of value.
12. Secondary functions of money are i. Standard of deferred payments; ii Store of value;
and iii Transfer of Value.
13. Contingent functions of money are i. Basis of Credit System; ii. Distribution of Social
(National) Income; iii. Imparting a General Form to Capital; and iv. Maximization of
Satisfaction.

1. Trace the evolution of money.
2. What is money and discuss its classifications.
3. Discuss different approaches to Money.
4. Examine the functions of money in detail.

1. What are the drawbacks of the barter system?
2. What are different forms of money in the modern economy?
3. Give a brief account of RBI classification of money.
4. Distinguish between Inside Money and Outside Money

1. Who defined money as “Money is what money does” ?
a) Gustav Cassel b) Francis A Walker c) Karl Helfferich d) Hawtrey
2. Which of the following is the primary function of the money?
a) Standard of deferred payments b) Store of value
c) Transfer of Value d) Measure of value
3. Which of the following is not the Secondary function of the money?
c) Transfer of Value d) Medium of Exchange
4. Which of the following is the contingent function of money?
a) Standard of deferred payments b) Distribution of Social income
c) Transfer of Value d) Medium of Exchange
5. Metallic money refers to coins that are made out of
a)gold, b) silver, c) aluminum d) All the above
Answers: 1. b; 2. d; 3. d; 4. b; and 5. d
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6. The most important characteristic of money is its ________________
7. The money that has no intrinsic value and is not backed by reserves is called
_______________
8. If the face value of a coin/currency is greater than its intrinsic or its metal value, such a
coin/currency is called__________
9. If the face value of a coin is equal to its intrinsic value, it is known as _____________
10. In the fourth century B. C., ___________which had officially recognized cows and sheep
as money to collect fines and taxes?
Answers: 6. General Acceptability; 7. Fiat Money; 8. Token Money; 9. Standard Coin;
and 10. The Roman State.
C. Match the following with list one with list two.

1. List – 1 List – 2
a) Token Money 1) 200 Rupee note
b) Standard Money 2) 20 paise coin
c) Limited Legal Tender Money 3) Gold Sovereign
d) Unlimited Legal Tender Money 4) 100 rupee coin
Answers: a) 4; b) 3; c) 2; and d) 1
2. List – 1 List - 2
a) Absence of double coincidence of wants 1) Standard of Deferred Payments
b) Value expressed in terms of money 2) Medium of Exchange
c) Savings in terms of Currency 3) Measure of Value
d) Payments of loans 4) Store of Value
Answers: a) 2; b) 3; c) 4; and d) 1
8.9 GLOSSARY
1. Commodity Money: Under Barter system certain prominent commodities were used as
unit of account to carry out the transactions and hence these are called commodity money.
2. Metallic Money: If metals like gold, silver, copper and aluminum are used in making of
coins, such coins are called Metallic Money.
3. Paper Money: The currency notes issued by the State Treasury or the Central Bank of a
country are called paper Money.
4. Bank Money or Credit Money: The Bank demand deposits or savings deposits which
could be withdrawn by Cheques are called Bank money or credit money.
5. Limited Legal Tender Money: If a particular type of money is accepted legally only up
to a certain limit, such money is called Limited Legal Tender Money.
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6. Unlimited Legal Tender Money: If a particular type of money is accepted legally without
any limit, such money is called Unlimited Legal Tender Money.
7. Fiat Money: The Currency that a government has declared to be legal tender, despite
the fact that it has no intrinsic value and is not backed by reserves is called Fiat Money.
8. Token Money: If the face value of a coin/currency is greater than its intrinsic or its
metal value, such a coin/currency is called Token money.
9. Standard Coin: A Standard coin is that coin whose face value is equal (or almost equal)
to its intrinsic value, i.e., the value of the metal used in its minting.
10. High Powered Money or Base Money or Reserve Money: in a country is defined as
the portion of the commercial banks’ reserves that are maintained in accounts with their
central bank plus the total currency circulating in the public (which included the currency,
also known as vault cash that is physically held in the banks’ vaults).
8.6 SUGGESTED BOOKS

1. Mithani, D. M. (2002). Money, Banking, International Trade and Public Finance,
Mumbai: Himalaya Publishing House.
2. Sethi, T. T. (1981). Monetary Economics, New Delhi: S. Chand & Company Ltd.
3. Setti, M. L. Macroeconomics, Agra: Lakshmi Narayin Agarwal.
4. Sundaram, K. P. M. Money, Banking and International Trade, New Delhi: Sultan &
Chand Company Ltd.
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UNIT – 9: MEASURES OF MONEY SUPPLY WITH
SPECIAL REFERENCE TO INDIA
Contents
9.0 Objectives
9.1 Introduction
9.2 The Indian Currency System
9.3 The Concept of Money Supply
9.4 Monetary Aggregates in India
9.4.1 M1 or First Type Money
9.4.2 M2 or Second Type Money
9.4.3 M3 or Third Type Money
9.4.4 M4 or Fourth Type Money
9.5 New Monetary and Liquidity Aggregates in India
9.6 Reserve Money or Base Money or High Powered Money
9.7 Money Multiplier
9.8 Determinants of Money Supply in India
9.8.1 Net Bank Credit to the Governments
9.8.2 Quantum of Bank Credit to the Business Sector
9.8.3 Size of Net Foreign Exchange Reserves
9.8.4 Governments’ Obligation towards Token Currency
9.8.5 The size of Non-monetary Obligations of the Banking Sector
9.9 Other Determinants of Money Supply in India
9.9.1 The Nature of the Reserve System
9.9.2 People’s Preferences in the Social System
9.9.3 Cash Reserve Ratio
9.9.4 Growth Rate of Economy
9.10 Summary
9.13 Glossary
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9.0 OBJECTIVES
The aim of this unit is to explain you how money evolved, how people transacted
business before the invention of money, Monetary Aggregates and Determinants of Money
Supply in India . After reading this unit, you will be able:
• to know the concept of measures of money supply;
• to analyse the measures of money supply being in practice in India such as M1, M2, M3
and M4 ;
• to understand the changes in the concept of money supply that have been introduced in
India in recent years;
• to get an idea about the new liquidity aggregates that have been introduced in India and
their significance; and
• to analyse the determinants of money supply in a country particularly in India.
9.1 INTRODUCTION
In the last unit, we have discussed the concept of money, its origin and evolution,
classification of money into different types and functions of money. The discussion enabled
us to understand the concept of money in general and various functions that the money is
expected to perform in a modern economy. We know that Reserve Bank of India is our Central
Bank since 1935. Like any other central bank, Reserve Bank of India also performs several
functions. The most important function of Reserve Bank is monopoly power of issue of currency.
We will discuss about this function in detail in this chapter. Secondly, Reserve Bank of India
controls the credit system in the economy created by the commercial banking system though its
two types of instruments viz., quantitative instruments like bank rate, open market operation,
variable reserve ratios and qualitative instruments like moral suasion, regulation of hire purchase
system etc. Thirdly, Reserve Bank of India is considered to be the bankers’ bank and the lender
of the last resort. This is because all commercial banks in the country ultimately borrow from
the reserve bank of India. Fourthly, RBI supervises and regulates the entire banking system in
the country. Fifthly, Reserve Bank of India also serves as the banker to the Central as well as
the state governments in India and performs several functions on behalf of government of
India. Sixthly, Reserve Bank of India regulates India’s foreign exchange reserves and the
external value of the rupee. Seventhly, it acts as the clearing house for the clearance of all
inter-bank credit instruments of the banking system in India. Lastly, Reserve Bank of India
collects and provides comprehensive data base on several banking, economics, financial and
international trade and payments aspects. Apart from these, major functions, RBI also performs
many promotional functions like provision of Rural and Agricultural Finance through specialized
bank called National Bank for Agriculture and Rural Development (NABARD), Industrial
Development through Development Financial institutions like Industrial Development Bank
of India, Industrial Finance Corporation etc. In this unit, we shall discuss in detail the essential
of Indian monetary system and the measures of money being used in India particularly the
measures of money employed by the Reserve Bank of India.
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9.2 THE INDIAN CURRENCY SYSTEM
The Reserve Bank of India has got the monopoly power of issuing currency notes. The
current monetary system in India can be termed as “Inconvertible paper Currency Standard”,
wherein it is not possible to convert the money printed in papers and metals into Gold or Silver.
This conversion facility was available in India when the Gold Standard was in practice before
the First World War. But Indian money can be converted into foreign money to get access to
foreign purchasing power. The basic unit of the Indian currency is Rupee. It is in the form of
coins or currency. The current monetary system in India is called the ‘Decimal System’ wherein
there are 100 paise per rupee. It is in practice since January 1957. In the traditional Indian
system, there were coins of 8 anas (1/2 rupee), 4 anas (1/4 rupee), 2 anas (12 paise), one ana
(six Paise), 1/2 ana (three paise) in circulation. Indian Currency (Amendment) Act of 1955
replaced the earlier system by the New Decimal system since January 1957. Between 1957
and 1964, there were coins and currencies belonging to both the systems. But since 1964 only
the new Decimal system has been in practice in India.
9.3 THE CONCEPT OF MONEY SUPPLY

The stock of money with the public and business organizations in a country is known as
“Money Supply”. The money that is used by the general public and the business organizations
to carry out their day to day transactions and to settle their debts constitutes the money supply.
This implies that the money with the government treasury and with the banking system will not
come under the purview of money supply. The stock of money supply is in two major forms.
They are:
i. The coins and currencies issued by the reserve bank of India which is in circulation with
the public. and
ii. The public money in the form of Demand Deposits with the banking system.
This Concept of money supply is known as ‘Narrow Money’. Let us discuss in detail the
different measures of money employed by the Reserve Bank of India.
9.4 MONETARY AGGREGATES IN INDIA

Reserve Bank of India adopts four types of money stock measures or monetary aggregates
in India. They are termed as M1, M2, M3, and M4. Let us discuss these measures in detail.
M1 is also known as Narrow money. It consists of three major components. They are
i. The coins and currency with the public denoted as “C”.
ii. The demand deposits with the commercial and cooperative banks denoted as “DD”.
iii. The other deposits with the Reserve Bank of India denoted as “OD”.
In short, M1 = C + DD + OD.
The concept of M1 is called “Narrow Money”, and this concept of money supply was
employed by the classical economists in their discussions.
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The following components are found in the second type of money denoted as M2.
i) M1 .
ii) The Saving Deposits with the post offices.
In short, M2 = M1 + SD of PO.
The third type of money M3 comprises the following components:
i) M1 .
ii) The fixed or term deposits (TD) with the commercial and cooperative banks.
In short, M3 = M1 + TD.
This concept of money is known as ‘Broad Money’ and this is the most important
component of money.
The following components are included in the fourth type of money called M4.
i) M1
ii) All types of deposits with the post offices (AD of PO).
In short, M4 = M1 + AD of PO
Let us discuss these components in detail below.
9.4.1 M1 or First Type Money

As stated already, the first type of money M1 includes coins and currencies in circulation
but does not include the coins and currencies with the banking system. Since currencies are the
Legal Tender Money, everyone accepts these in all types of transactions and in the settlement
of debts. It is also called ‘Common Money’ or ‘Ordinary Money’.
Thus, M1 = C + DD + OD.
The quantum of Coins and Currencies and the Demand Deposits with the banking system
as on 31st March 2018 is furnished in Table 9.1.
Table -9.1: Quantity of Narrow Money (M1) in India in during 2005-06 to 2017-18.
(in Billions)
S. No. Details 2005-06 2010-11 2015-16 2017-18
I Currency with the Public 4121.24 9118.36 15972.54 17597.12
(49.87) (55.66) (61.37) (53.86)
II Demand Deposits 4074.23 7228.56 9898.34 14837.12
(49.30) (44.12) (38.03) (45.41)
III Other Deposits with the RBI 68.43 36.53 154.51 239.07
(0.83) (0.22) (0.59) (0.73)
Narrow money or Money 8263.9 16383.5 26025.4 32673.3
Supply with Public or (100.00) (100.00) (100.00) (100.00)
M1(I + II+III)
Source: www.http://rbi.org
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As could be observed from Table -9.1, the currency with public was Rs.4,121.24 billion
in the year 2005-06 and the same increased in absolute terms to Rs. 17,597.12 billion by 31st
March 2018. In relative terms also, the share of the component ‘currency with the public’
increased from 49.87 per cent to 53.86 per cent during the same period. The deposit money of
the public rose from Rs.4,074.23 billion to Rs.14,837.12 billion in absolute terms during the
period March 2006 to March 2018. However, in relative terms, the share of this component
declined from 49.30 per cent to 45.41 per cent during the same period. In short, the narrow
money or the money supply with the public increased from Rs.8,263.89 billion to Rs.32,673.31
billion between March 2006 and March 2018 registering nearly a 4 times increase during the
period under consideration.
9.4.2 M2 or Second Type Money

As noted already, the second type of money M2 consists of M1 and the saving deposits of
the public with the post offices. Post offices also collect deposits particularly, savings deposits
and recurring deposits from the public in rural areas. When these saving deposits are added to
the first component M1, we get M2. The savings deposits of the post offices constitute very
insignificant proportion particularly in recent years. The Reserve Bank of India is not updating
the savings deposits component of post offices in recent years. Hence, M2 component has
become meaningless and has not been reported in RBI data bank in recent years.
9.4.3 M3 or the Third Type Money

Among the original four measures of money supply proposed by the Reserve Bank of
India, M3 component is a very important component. As noted already, when the time deposits of
the banking system is added to M1, we get M3. M3 is also called ‘Broad Money’. There has been
a phenomenal growth in M3 in recent years mainly because of rapid rise in the fixed deposits of
the banks. This is because, of late the banks have liberalized the terms and conditions of fixed
deposits. Fixed deposits can be converted in to cash at any time with some loss of interest.
Moreover, one can get loans by pledging the fixed deposit certificates in a relatively easy manner.
In view of these facilities, fixed deposits are considered to be as good as demand deposits.
The Radcliff Committee which has examined the British Monetary system distinguished
between ‘Money’ and ‘Liquidity’. The Committee expressed the opinion that the spending
behaviour of the public depends not only on the quantum of money that they have in hand, but
also on the amount of the liquidity that they are able to access. Viewed from this angle, all the
near money substitutes also influence the spending behaviour of the public. The time deposits
of the banks, the savings deposits of the public with the post offices etc., come under the
category of near money assets. Therefore, the time deposits of the public with the banks are
considered to be liquid assets. When the time deposits of the public are added to M1 or the
narrow money, we get the broad money, M3. The quantum of broad money in circulation in
India since 1991 to 2014 is furnished in Table 9.2.
As it is shown in table 9.2, the quantum of Broad Money in circulation in India as on
March 2006 was Rs. 27,194.94 billion and the same rose to Rs.1,39,625.86 billion at the end of
March 2018. In other words, during 13 years, the quantum of broad money in circulation has
risen by more than 4 times. There has also been a considerable change in the structure of broad
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money over the years. While in the year 2005-06, the narrow money constituted 30.39 per
cent and the time deposits of the public with the banking system accounted for 69.61 per
cent, the relative share of the former decelerated to 23.40 per cent and the relative share of
the latter increased to 76.60 per cent at the end of March 2018. This clearly indicates the
increase in the relative share of near money components particularly the time deposits created
by the banking system in recent years which constituted more than three-fourths of the total
broad money in India.
Table -9.2: Quantity of M3 in India in during 2005-06 to 2017-18 (in Billions)

S. No. Details 2005-06 2010-11 2015-16 2017-18
I Narrow money or Money 8263.9 16383.5 26025.4 32673.3
Supply with Public or M1 (30.39) (25.19) (22.40) (23.40)
II Time Deposits of the Public 18931.04 48657.71 90150.77 106952.55
Banking System (69.61) (74.81) (77.60) (76.60)
Quantity of M3 (I + II) 27,194.94 65,041.21 1,16,176.17 1,39,625.86
(100.0) (100.0) (100.0) (100.0)
9.4.4 M4 or the Fourth Type Money

The fourth type of measure of money introduced by the Reserve Bank of India is M4.
When all types of deposits, viz., savings, recurring and time deposits of the public with the post
offices excluding National Savings Certificates (NSC) are added to M3, we get the fourth type
of measure of money, M4. Post offices play a major role in the village economy in the mobilization
of latent savings in rural areas where the penetration of the banking system is relatively very
less. The share of total deposits of the post offices is highly insignificant. Moreover, in recent
years, the data on the total deposits of the post offices seemed to have not been updated by the
Reserve Bank of India. In view of the insignificance of the M4 component, in the revised
measures of money introduced by the Reserve Bank of India, this component has altogether
been abolished.

b) Compare your answer with the one given at the end of the unit.
1. What are the two major forms of the stock of money supply?
.........................................................................................................................................
.........................................................................................................................................
2. What are the monetary aggregates in India?
.........................................................................................................................................
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9.5 NEW MONETARY AND LIQUIDITY AGGREGATES IN
INDIA
The Reserve bank of India has appointed Working Group to assess the existing measures
of money in India and to suggest suitable alternative measures of money supply. The Working
Group suggested removing the post office savings deposits component of money supply in M2.
The Group also suggested to drop the concept of M4 and to include the total deposits component
of post offices included in M4 in the new liquidity aggregates introduced by the Group. Table
9.3 presents the revised monetary measures, new liquidity aggregates introduced along with
the original money supply measures.
It could be observed from the table that there is no change in the concept of M1. In M2,
instead of post office saving deposits, the time deposit portion of savings deposits kept with the
banking system and term deposits maturing within one year are included. Similarly, in the
revised M3, instead of all time deposits of banks which are added to M1, time deposits over one
year maturity and call/term borrowings of banks are included. The concept of M4 has been
omitted in the revised money aggregates.
Apart from the three revised monetary aggregates, the Reserve Bank introduced three
new Liquidity aggregates viz., L1, L2 and L3. The concept of L1 consists of the revised M3 and
all deposits of the public with the post offices excluding the national saving certificates (NSCs).
With the view to brining in the activities of term lending institutions within the purview of
money, the term deposits with the term lending institutions and the term borrowings of Financial
institutions, as well as the certificates of the deposits issued by the Financial institutions are
added to the new M3 to get the new liquidity aggregate L2. Lastly, the public deposits of the
Non-banking Financial Institutions are added to the L2 to get the new L3
Table-9.3: New Monetary and Liquidity Aggregates in India

Original Measures Revised Money Supply New Liquidity Resources
Measures
M1 = C + DD + OD M1 = C + DD + OD L1 = New Revised M3
C = Coins & Currency C = Coins & Currency + all deposits with post office
DD = Demand Deposits DD = Demand Deposits savings banks
OD = Other Deposits OD = Other Deposits (excluding NSCs)
with RBI with RBI (Unchanged)
M2 = M1 + SD of PO M2 = M1 L2 = New M3
SD of PD = Savings + Time Deposits portion of + term deposits with term
Deposits with the savings deposits with banks lending institutions
post offices + CDs issued by banks + term borrowings of FIs
+ Term deposits maturing + CDs issues by FIs.
within one year
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M3 = M1 + TDs of Bs M3 = M2 L3 = L2 + Public deposits
TD of Bs = Time Deposits + Time Deposits over of NBFCs
of Banks one year maturity
+ Call/term borrowings
of banks
M4 = M1 + ADs of PO
Ads of PO = all M4 = Abolished ———
Deposits of the POs
Note: CDs: Certificate of Deposits, NBFCs. : Non-bank Financial Companies, FIs :
Financial Institutions, SD: Saving deposits, Ads: All Deposits, Pos: Post Offices.
Thus, the revised money measures consist of only bank deposits and bank borrowings
and the liquidity resources include apart from these, the term deposits and term borrowings of
the financial institutions, certificates of deposits issued by the financial institutions as well as
public deposits with the Non-banking financial institutions. The broadening of these concepts
enables the Reserve Bank of India to exercise more controls over the term lending institutions
and non-banking financial institutions more effectively than earlier. This is also expected to
strengthen the working of monetary policy in India with more vigour and effectiveness.
9.6 RESERVE MONEY OR BASE MONEY OR HIGH

POWERED MONEY
Apart from the three measures of money aggregates viz., M1, M2 and M3 and the three
liquidity resources viz., L1, L2 and L3, the Reserve Bank of India has introduced one more
concept of money viz., Reserve Money or Base Money or High Powered Money denoted by
M0. One of the important determinants of money supply in the country is the Reserve Money or
the High powered money. Since the Reserve Bank is one of the organs of the government, the
money that is issued by the Reserve Bank and kept with the public or with the banking system
is called the Reserve Money. More preciously, the Reserve Money (M0) is defined as
M0 = Currency in Circulation + Cash Reserves with RBI + Other deposits with RBI.
In symbols, these can be stated as follows:
M0 = C + CR + OD
The first component of M0 is the currency in circulation with the public denoted as “C”.
It consists of coins and currency notes held by the general public excluding the amount held by
banks as cash on hand.
The second component of M0 is Cash Reserves (CR). It consists of two parts. The first
part is the currency notes kept in banks by the banks themselves for day to day transactions.
The second part is the bankers’ deposits kept with the Reserve Bank of India as per the norms
prevailing at any particular point of time.
The third component of the Reserve Money is the other deposits of the public (OD)
particularly those of the privileged few persons such as former governors and Deputy Governors
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of the Reserve Bank of India. These are also considered to be equal to money.
In short, the money that is issued by the government or the organ of the government viz.,
the Reserve Bank of India and is kept with the public or with the banking system in the country
is known as Base Money or the Reserve Money or the High Powered Money. Let us consider
the two components of High Powered Money and M1 and make comparisons between the two
concepts, M0 = C + CR + OD and M1 = C + DD + OD
In both the concepts, the first and third components viz., C and OD are the same. While
CR is present in the Reserve Money, DD is present in M1. The CR component indicates the
proportion of their total deposits that the commercial banks have to keep with the Reserve
Bank as per the norms existing at any particular time. On the other hand, DD indicates the total
deposits amount that the ‘n’ banks in the country have mobilized from the public. There is a
close relation between CR and DD. The Cash Reserves of the banks (CR) forms the basis for
the multiple expansions of bank deposits.
Let us explain this relation with a simple example. Let us assume that the current cash
reserve ratio (CR) for the banking system is 20 per cent or one-fifth. Let us also assume that a
bank receives a primary demand deposit of Rs.1000/-. Given that the CR is 20 per cent, the
bank has to keep Rs.200 as the cash reserves with the Reserve Bank and the remaining amount
of Rs.800 is lent out as loan. The person who has taken the loan creates a demand deposit of
Rs.800 in his name which can be withdrawn through cheque. The bank which has got the
demand deposit of Rs.800/- keeps 20 per cent of Rs.800/- (Rs.160/-) as cash reserves with the
RBI and the remaining amount of Rs.640/- is lent out to other person. The second person who
has got the loan of Rs.640/-, creates demand deposit with the bank in his name and withdraws
through cheque. The bank which has got the derived demand deposit of Rs.640/- keeps 20 per
cent of it (Rs.128/-) as reserves with the Reserve Bank, and lends out the remaining amount of
Rs. 512/- as loan. This process of deposit becoming the loan and the loan becoming the deposit
continues until the initial primary deposit of Rs.1,000/- becomes 5 times or Rs.5,000/-. Since
the cash reserve ratio is 20 per cent or 1/5 the initial deposit of Rs.1,000/- has multiplied into
Rs.5,000/- or five times the original deposit. If the cash reserve ratio is 10 per cent or 1/10, the
initial deposit of Rs.1,000/- will multiply itself by 10 times and will become Rs.10,000/-. Thus
in the equation for the Reserve Money M0 = C + CR + OD, the component CR is the basis for
the multiple expansion of demand deposits with the banking system. Higher the reserve ratio
lower is quantum of creation of derived deposits and lower the reserve ratio, higher is the
quantum of creation of derived deposits. By making suitable changes in the reserve ratio, the
Reserve Bank of India can bring about desired changes in the quantity of money supply in the
country because, demand deposits are one of the important components of Narrow money.
It should, however, be noted that if CR is so important component in the determination
of quantity of money supply in the country, why should the other components of M0 such as C
and OD appear in the concept of Reserve Money, M0. This is because the other components of
currency with the public and the other deposits are also potential enough to enter the banking
system and can become demand deposits at any time and there by the reserve money. The
Reserve Bank need not use its authority to convert them into deposits and subsequently, the
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reserve money. Hence, all the three components are called the Reserve money or High powered
money. Table 9.4 provides the trends in the growth of Reserve money in India in recent years.
Table-9.4: Trends in the Growth of Components of

Reserve Money (Rupees in Billions)
Year Currency Other Cash Reserves of the banks
with the Deposits Cash Banks’ Cash Total Cash Reserve
Public with the reserves Reserves Reserves Money
(C) RBI with the with the (CR) (RM)
( OD ) banks RBI
1 2 3 4 5 6 7=2+3+6
2005-06 4,121.24 68.43 174.54 1355.11 1529.65 5,719.32
2010-11 9,118.36 36.53 378.23 4235.09 4613.32 13,768.21
2015-16 15,972.54 154.51 662.09 5018.26 5680.35 21,807.40
2017-18 17,597.12 239.07 696.35 5655.25 6351.6 24,187.79
It could be seen from the table that in the year 2005-06, the currency with the public
was Rs.4,121.24 billion. The other deposits of the public held with Reserve Bank by the former
Governors and Deputy Governors of RBI amounted to Rs.68.43 billion. The total cash reserves
of the banking system was Rs.1,529.65 billion. As a result, the total Reserve money or the high
powered money in the country aggregated to Rs.5,719.32 billion as detailed below:
RM = C + OD + CR
= Rs.4,121.24 + Rs.68.43 + Rs.1,529.65 billion
= Rs.5,719.32 billion
Over the years, all the components of the reserve money particularly the bank deposits
have shown an increasing trend. As could be seen from the table in the year 2017-18, the value
of Reserve money soared to Rs.24,187.79 billion.
RM = C + OD + CR
= Rs. 17,597.12 + Rs. 239.07 + Rs. 6351.6 billion
= Rs.24,187.79 billion
The average annual growth rate of Reserve Money during the period 1981-91 was 16 per
cent. But during the 13 year period from 2005-18, the growth of Reserve Money skyrocketed
to around 25 per cent. During the decade 1980- the budgetary deficit of the government was
made good by printing new currency. Hence, the monetized deficit was responsible for the
growth or reserve money during this period. But during the period 2005-18, the growth of
Reserve Money could be attributed to growth of deposit money of the banking system as detailed
above. Another important reason for the growth of Reserve Money was the rapid surge in the
net foreign exchange reserves mainly on account of increased inflow of Foreign Direct and
Portfolio investments during the era of globalization. The foreign exchange reserves which
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amounted to US $ 5834 million in the year 1990-91, increased enormously to US $ 400.12
billion as on August 2018. The growth of net RBI credit to the Central government is yet
another reason for the growth of reserve money. The Reserve Money, M0 increased by 27.27
per cent during 2017-18 as compared to the negative growth of by -12.9 per cent during 2016-
17. The main driver of increase in reserve money during 2017-18 was net RBI credit to the
centre. It could also be attributed partially to a decrease in operations under the liquidity
adjustment facility (LAF) following the cap on LAF borrowing and build-up in government
balance with the Reserve Bank.
9.7 MONEY MULTIPLIER

As noted already the money supply in a country is determined by several factors. One
among them is reserve money or the High powered money. The concept of ‘Money Multiplier’
provides the relation between the High powered money and the money supply measures in the
country. The following mathematical equation preciously explains the relationship between
Reserve money and the money supply.
M = m x RM or m = M/RM.
Here, M = Money Supply measure either M1 or M3.
RM = Reserve Money or High Powered Money or Base Money
m = Money Multiplier.
The value of money multiplier indicates the ratio between the appropriate money supply
measure and the reserve money. In other words, the money supply in the country increases by
money multiplier times the quantum of reserve money in the country. The money multiplier
values are generally computed for two measures of money supply viz., M1 or M3.
The Narrow Money Multiplier is given by
m1 = M1/ RM
The Broad Money Multiplier is given by
m3 = M3/ RM
Table 9.5 incorporates values of money multipliers in India for selected years.
Table-9.5: Values of Narrow and Broad Money Multipliers in India in selected years
Year M1 M3 RM
(Rs. In billions) (Rs. In billions) (Rs. In billions) m1 = M1/ RM m3 = M3/ RM
2005-06 8263.9 27,194.94 5,719.32 1.44 4.75
2010-11 16383.5 65,041.21 13,768.21 1.19 4.72
2015-16 26025.4 1,16,176.17 21,807.40 1.19 5.33
2017-18 32673.3 1,39,625.86 24,187.79 1.35 5.77
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As could be observed from the table, in the year 2005-06, the Narrow Money Multiplier
was 1.44 and the Broad money Multiplier was 4.75. Though the narrow money multiplier
declined to 1.19 in the year 2010-11 and 2015-16, it again started to increase to reach the
maximum level of 1.35 in the year 2017-18. Along with the Narrow Money Multiplier, the
value of Broad Money Multiplier also began to increase over the years. After a short-lived fall
to 4.72 in the year 2010-11, the Broad Money multiplier again increased to 5.33 in the year
2015-16 and further to 5.77 in the year 2017-18. There was an increase in monetary deepening
as well, as measured by the ratio of M3 to gross domestic product (GDP) which increased from
78.2 per cent in 2012-13 to 79.2 per cent in 2013-14 and further to 93.00 per cent in the year
2017-18. This consistent improvement could be attributed to the spread of banking services in
the country and development of the financial sector.

3. Define Reserve Money.
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..........................................................................................................................................
4. State about the concept of Money Multiplier.
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9.8 DETERMINANTS OF MONEY SUPPLY IN INDIA

According to Reserve Bank of India, the stock of money supply in the country is
determined by five major factors. They are,
i. Net Bank Credit to the Governments;
ii. Banks Credit to the Business Sector;
iii. Net Foreign Asset Reserves of the Banking Sector;
iv. Government’s Liability to the Currency holdings of the public; and
v. The non-monetary liabilities of the Banking sector, except the Time Deposits.
Let us discuss these determinants briefly.
9.8.1 Net Bank Credit to the Governments

The banks credit to government can be classified into two categories.
a) The Credit extended by the Reserve Bank to the Central and State Governments; and
b) The Credit provided by other banks to Central and State Governments.
Generally, the central government meets its expenditure obligations through direct and
indirect taxes collected from the public and business. When these resources are not sufficient
to meet the committed expenditure, the Central government borrows money from the Reserve
Bank. When the Central government borrows money from the Reserve Bank, the money supply
in the country expands. This is because the Reserve Bank has to print new currency to the
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extent the Central bank borrowed money from the Reserve Bank. Apart from the Reserve Bank,
other banks also extend credit to the Central and State governments.
9.8.2 Quantum of Bank Credit to the Business Sector

The private production and commercial sectors are called Business Sector. It is the
prime responsibility of the banking sector to provide short-term and long-term credit to the
business sector to meet their fixed capital or working capital requirements. When the commercial
banks extend loans to the business sector, it does not provide currency notes but instead creates
demand or current account deposits in their names. These could be withdrawn through cheques
only. These cheques again come to the banking sector in the form of additional demand deposits.
This process of loans becoming deposits and deposits becoming loans is called Credit Creation.
We have already explained this process of multiple creation of credit or money earlier. This
results in the multiple expansion of deposit money or narrow money in the economic system.
9.8.3 Size of Net Foreign Exchange Reserves

Another important determinant of money supply in the country is the size and growth of
foreign exchange reserves in the country. The exporters deposit the foreign exchange earned
through exports with their banks or sell to the Reserve Bank through the authorized dealers in
foreign exchange market and get Indian rupees in exchange for them. Hence, the supply of
domestic currency should be increased in accordance with the growth of foreign exchange
reserves in the country. Similarly, when the residents of our country import foreign goods, the
importers purchase the foreign currencies by returning the domestic currency that is rupees. As
a result, the money supply in the country has to be decreased to an extent of purchase of foreign
currency. Therefore, in increasing domestic money supply, the net increase in the foreign
exchange reserves are taken in to account. India’s foreign exchange reserves have increased in
leaps and bounds since the introduction new economic policy in India in the form of
liberalization, privatization and globalization in 1991. As on 31st August 2018, India’s foreign
exchange reserves aggregated to US $400.12 billion from about One billion US dollars in the
year 1991.
9.8.4 Governments’ Obligation towards Token Currency

As we have learned already, the government of India prints one rupee notes and mints
all coins. As the size of this component of money supply increases, the government’s
responsibility to meets its obligations to the public increases. This is because, the current
currency system is known as token money system. There is no back up of assets equivalent to
the money issued in the economy because the present governments follow the policy of minimum
reserve system so as to get flexibility to print money in tune with the increasing needs of the
economy. Therefore, the government would expand the money supply to an extent of meetings
its currency obligations without any hassle.
9.8.5 The size of Non-monetary Obligations of the Banking Sector

The Reserve bank of India and other commercial banks have got certain non-monetary
obligations. For example, the paid up capital of the Reserve Bank, the reserves that it maintains,
the pension and provident fund payments to be made to the employees of the Reserve Bank
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could be considered as the obligations of the Reserve Bank of India. Similarly, the paid up
capital, reserves, bills of exchange to be paid by other commercial banks could be treated as the
obligations of the banking sector. These obligations have to be deducted from the total money
supply. Higher the quantum of these obligations, lower will be the money supply and vice
versa in the country.
9.9 OTHER DETERMINANTS OF MONEY SUPPLY IN INDIA

Apart from the above determinants, the following factors also influence the supply of
money in a country. Let us discuss these determinants of money supply briefly.
9.9.1 The Nature of the Reserve System

We have already learned that the government of India and the Reserve Bank of India has
the monopoly power of note issue. However, they cannot issue coins and currencies as per their
whims and fancies. There is some system which has to be followed in the issue of coins and
currencies. In the beginning, the Reserve Bank of India followed the Proportional Reserve
System wherein gold and foreign exchange reserves were kept as back up in proportion to the
quantum of coins and currencies issued in the economy. Since, it was not flexible enough to
increase the money supply in accordance with the growth needs of the Indian economy, an
alternative system known as Minimum Reserve System was introduced. Under this system,
Rs. 200 crores worth of gold and foreign exchange reserves should be maintained out of which
not less than Rs.115 crores worth of assets should be in the form of gold. The remaining
portion could be in the form of foreign security assets.
9.9.2 People’s Preferences in the Society

The preferences of the people in the society as to how much of their total income
should be kept in the form of cash and how much should be kept in the form of bank deposits
also determine the stock of money supply in the economy. Though currency is a component of
High power Money, bank deposits will have greater influence than cash in the determination of
money supply and its growth. This is because, given the cash reserve ratio, banks have the
capacity to multiply the deposit money many times the initial deposits.
9.9.3 Cash Reserve Ratio

As just stated, the capacity of the banks to create credit in the economy depends upon
the prevailing cash reserve ratio. Higher the reserve ratio, lower is the capacity of the banks to
create credit and lower the reserve ratio, higher is the capacity of the banks to create credit or
deposit money in the economy and hence the money supply in the economy will expand.
9.9.4 Growth Rate of Economy

Lastly, the most important determinant of money supply in the economy is the rate of
economic growth achieved by the economy. If the growth rate of output and consequently, the
growth rate of the economy are high, the growth of money supply will also be high. This is
because money is needed to transact the increased output in the economy brought about by the
growth of the economy. It should, however, be noted that money is not needed to the full value
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of the growth of output in the economy because depending upon the velocity of money, a
monetary unit will circulate four or five times per day and do the transactions to that extent.
Hence, money supply will be increased only by a fraction of the value of the increased output.
This is clearly explained in the Old Quantity Theory of Money formulated by Irving Fisher in
the form of the equation, MV = PT or M = PT/V. Modern economists are of the opinion that
fluctuations in the economy emanate from the fluctuations in the money supply. Hence, they
plead for ‘Controlled Expansion’ duly following a monetary rule.

5. What are the determinants of the stock of money supply in India?
..........................................................................................................................................
..........................................................................................................................................
9.10 SUMMARY
In this unit, we have clearly discussed the Indian monetary system particularly the money
stock measures employed by the Reserve Bank of India. Originally, the Reserve Bank of India
has employed four money stock measures viz., M1, M2, M3 and M4. While M1 is called Narrow
Money, M3 is called Broad Money. In recent years, on the recommendations of the RBI Working
Group, the RBI has revised the money stock measures particularly M2, and M3, and completely
dropped M4. Apart from these the RBI has also introduced three Liquidity aggregates with a
view to bring about even term lending institutions within the purview of RBI’s monetary control.
We have also seen the growth of these money stock measures since 1980 to 2013-14. Another
important aspect discussed in this unit is the concept of Reserve Money or High Powered
Money or the base Money, denoted by M0. It is the basis for multiple expansion of money
supply in the country called “Money Multiplier”. Taking India’s data on M1, M3, and M0, we
have computed the values of money multipliers for various years in India. Finally, we have
discussed the determinants of money supply in general and in India in particular.

1. The stock of money supply is in two major forms. They are: i) The coins and currencies
issued by the reserve bank of India which is in circulation with the public; and ii) The
public money in the form of Demand Deposits with the banking system.
2. The monetary aggregates in India are termed as M1, M2, M3, and M4.
3. The Reserve Money (M0) is defined as
M0 = Currency in Circulation + Cash Reserves with RBI + Other deposits with RBI.
In symbols, these can be stated as follows:
M0 = C + CR + OD
4. Money Multiplier provides the relation between the High powered money and the money
supply measures in the country. The value of money multiplier indicates the ratio between
the appropriate money supply measure and the reserve money.
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5. According to Reserve Bank of India, the stock of money supply in the country is
determined by five major factors. They are, i. Net Bank Credit to the Governments; ii.
Banks Credit to the Business Sector; iii. Net Foreign Asset Reserves of the Banking
Sector; iv. Government’s Liability to the Currency holdings of the public; and iv. The
non-monetary liabilities of the Banking sector, except the Time Deposits.

1. Discuss the original and revised money stock measures employed in India.
2. Elucidate trends in the movement of monetary aggregates in India in recent years.
3. What is money Multiplier? Clearly explain the process of money multiplier in India. .
4. Examine the determinants of money supply in India.

1. Explain the concept of Narrow money
2. What is Broad money? Explain its significance.
3. State the concept of High Powered Money.
4. Briefly explain about new liquidity aggregates introduced in India.

1. Which of the following is called ‘Narrow Money’?
a)M1 b) M2 c) M3 d) M4
2. Which of the following is called ‘Broad Money’?
a)M1 b) M2 c) M3 d) M4
3. Which measure of the money supply has been omitted by RBI in recent years?
a)M1, b) M2, c) M3, d) M4
Answers: 1) a 2) c and 3) d

1. The Decimal System was introduced in India in the year ___________
2. The theory of money Supply explained by ____________
3. The Committee which distinguished between Money and Liquidity was
_______________
4. The Component which is found in narrow money, M1 but not in the Reserve Money M0
is_____________
5. The Component which is found in the Reserve Money, M0 but not in the narrow money,
M1 is____________
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Answers: 1) 1957 2) Fisher 3) Radcliff Committee 4) DD and 5) CR

a) Money Multiplier 1) CC+CR=OD
b) High Powered Money 2) M/RM
c) Narrow Money 3) M1+ TD
d) Broad Money 4) CC+DD+OD
Answers: a) 2 b) 1 c) 4 and d) 3
a) Demand Deposits 1) M4
b) Post office Savings Deposits 2) M3
c) Time Deposits of Banks 3) M2
d) All Deposits of Post Offices 4) M1
Answers: a) 4 b) 3 c) 2 and d) 1
9.13 GLOSSARY
1. M1 or Narrow Money: M1 is defined as currency with the public, Demand Deposits of
the public with the commercial banks and other Deposits with RBI.
2. New M2: M2 is defined as M1 + time liability portion of savings deposits with banks +
Certificates of Deposits (CDs) issued by banks + Term deposits maturing within a year.
3. New M3 or Broad Money: M2 + Term deposits over one year maturity + call/term
borrowings of banks.
4. High Powered Money or Reserve Money, M0 : High Powered Money or Base Money
or Reserve Money in a country is defined as the portion of the commercial banks’ reserves
that are maintained in accounts with their central bank plus the total currency circulating
in the public (which included the currency, also known as vault cash that is physically
held in the banks’ vaults) or M0 = CC + CR + OD.
5. Money Multiplier: The ratio between a money stock measure and the Reserve money is
called Money multiplier. In symbols, m = M/RM.

1. Mithani, D. M. (2002). Money, Banking, International Trade and Public Finance,
Mumbai: Himalaya Publishing House.
2. Sethi, T. T. (1981). Monetary Economics, New Delhi: S. Chand & Company Ltd.
3. Setti, M. L. Macroeconomics, Agra: Lakshmi Narayin Agarwal.
4. Gaurav Datt and Ashwani Mahajan, (2013), Datt & Sundharam Indian Economy, Delhi:
166 S. Chand.
UNIT – 10 : THEORIES OF MONEY
Contents
10.0 Objectives
10.1 Introduction
10.2 The Cash-Transactions Approach
10.3 Fisher’s Quantity Theory of Money
10.4 Assumptions
10.5 Conclusion of Fisher’s Quantity Theory
10.6 Criticism of Quantity Theory of Money
10.7 The Cambridge Cash Balance Approach
10.8 The Cambridge Equations
10.8.1 Marshallian Cash-Balance Equation
10.8.2 Pigue’s Equation
10.8.3 Robertson’s Equation
10.9 Criticism of the Cash-Balance Approach
10.10 Keyne’s Real-Balance Equation
10.11 Summary
10.14 Glossary
10.0 OBJECTIVES
In this unit we know clearly about the theories of money, Fisher’s and Cambridge, versions
of quantity theory of money. After reading this unit you will be able to:
• explain the relationship between quantity of money and price level;
• understand how the transactions affect the quantity of money in classical theory of cash
transactions approach; and
• determine how the cash balances affect the quantity of money in the Neo classical theory
of i.e. Cambridge theory (cash balances approach).
10.1 INTRODUCTION
Money is one of the most intelligent creations of man. It plays a dominant role in all the
fields of economic activities. Why do people need money? People need money because money
performs important functions of medium of exchange and a store of value in the society. On the
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basis of these two functions of money the quantity theory of money was framed. The occurrence
of wide movements in the general price level has attracted attention of the economists first
began to while on the economic matters. These price movements have been largely attributed
to the monetary and non monetary factors. According to monetary explanation, changes the
general price level in the economy are caused by changes in the quantity of money in circulation.
According to the other explanation, changes in prices are caused by non- monetary factors such
as war, famine etc. The first explanation of changes in the general price level has been labeled
as the quantity theory of money.
The quantity theory of money is the oldest and has been the most influential theory
purport us to explain the determination of the value of money at any one time and the variations
of this value over periods of time.
This theory’s essence is the classical monetary thoughts, which proclaim the idea of a
unique functional relationship believes money and prices.
The money is exchangeable for all goods and services. The value of a unit of money
should be capable of expression in terms of the quantity of goods and services it will buy. The
value of money varies inversely with the number of units of money and directly with number of
units of goods and services in existence.
The Italian writer, Bernardo Davanzati was the originator of the idea of the Quantity
Theory of Money. But the theme of the quantity theory as an explanation for the changes in the
value of money, however received wider acceptance in the classical thinking through David
Hume’s book on Political Discourses, published in 1752. Hume mentioned that: “Prices are
proportional to the plenty of money supply.” J.S. Mill, noted classical economists, for instance,
writes: “the value of money, other things being the same, varies inversely with as its quantity;
every increase in quantity lowers the value and every diminution in it raises the value exactly
in an equivalent ratio.”
In short, the quantity theory implies that the quantity of money brings about a directly
proportionate change in the price level and hence an inversely proportionate change in the
value of money. Thus, it emphasizes a functional relationship between the quantity of money
and the value of money. There are two refined approaches to the traditional quantity theory.
They are:
1. The cash-transactions approach, - the classical approach: and
2. The cash – balance approach – the neoclassical approach.
10.2 THE CASH – TRANSACTIONS APPROACH: THE

CLASSICAL FISHERIAN VERSION
Prof. Irving Fisher, in his book The Purchasing Power of Money (1911), tried to provide
a formalistic expression to the direct relationship between the quantity of money supply and
the general level of prices, through the equation of exchange. Fisher held that the general price
level varies directly with the quantity of money (or money supply). Thus, when the money
supply is doubled, the prices will also be doubled. And, if the money supply halved, the prices
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will also be halved. This he proves with the help of equation of exchange as follows:
Equation of Exchange
It is a monetary equilibrium identity put forward by Fisher as under:
MV=PT
Where, M represents the total quantity of money; V is the velocity of circulation of
money, i.e., the average number of times each unit of money is spent for the purchase of goods
and services during a given period; P represents the general price level (or the average price per
unit of T); and T refers to the total volume of transactions (of goods and services traded) for
which money is made.
Thus, the product MV gives the aggregate effective supply of money (or total of money
expenditure) during a given period and PT is the money value of all the things bought during a
given period. It gives the demand for money.
Hence, MV=PT connotes that under monetary equilibrium, the supply of money equals
the demand for money.
The equation of exchange is also referred to as the cash transactions equation.

1. What are the approaches to the traditional quantity theory?
........................................................................................................................................
........................................................................................................................................
2. What factors determined the price level?
........................................................................................................................................
........................................................................................................................................
10.3 FISHER’S QUANTITY THEORY OF MONEY

Based on the equation of exchange: MV=PT, Fisher infers
MV
P= which implies that the quantity of money (M) determines the price level (P)
T
and the latter varies directly in proportion to the changes in the stock of money, assuming T and
V to be constant.
In this equation of exchange, however, only primary money or currency money is
conceived. But in the modern economy, money includes not only notes and coins, but also
demand deposits of banks or credit money. Consequently, Fisher has extended the equation of
exchange to include bank deposits also. He denotes M' for demand deposits in the bank or bank
money, and V' for the velocity of circulation of bank money. Thus, the extended form of the
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equation of exchange is written as,
MV + M ' V '
P= . It is easy to see from this equation that the price level is determined
T
by the following factors:
i. The quantity of money in circulation (M);
ii. The velocity of circulation of money (V);
iii. The volume of bank money (M');
iv. The velocity of circulation of bank money (V'); and
v. The volume of trade or transactions, i.e., the amount of goods bought by money (T).
The equation further denotes that the price level (P) is directly related to M, V, M', and V'
and it is inversely related to T.
The proportion declared fundamental to the quantity theory runs thus the price level
varies in proportion to the quantity of money.
Thus, the fundamental thesis which Prof. Fisher seeks to establish in the equation of
exchange is that the price level or the value of money is a function of the quantity of money
only. He regarded this equation as an important tool of analysis, including the correlation between
the generally price level and the quantity of money.
Example: Fisher’s quantity of money can be explained with the help of an example.
Suppose M = Rs. 1000, M' = 500,V=3, V' = 2, T= 4000 goods.
MV + M ' V '
P=
T
P=
(100 × 3) + ( 500 × 2 )
= Rs.1 per good.
4000
Value of money (1/P) = 1
If the Supply of Money is Doubled
P=
( 2000 × 3) + (1000 × 2 )
= Rs.2 per good.
4000
Value of money (1/P) = 1/2
Thus, when money supply is doubled from Rs. 4000 to 8000, the price level is doubled,
and the value of money is halved i.e., from 1 to 1/2.
The effects of a change in money supply on the price level and the value of money are
graphically shown in figure 10.1-A and B respectively.
In Figure 10.1-A, when the money supply is doubled from OM2 to OM4, the price level
is also doubled from OP2 to OP4 . When the money supply is decreased from OM2 to OM, the
price level is decreased from OP2 to OP. The price curve, P= f(M), is a 45o line showing a direct
proportional relationship between the money supply and the price level.
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In figure 10.1-B, when the money supply is doubled
from OM2 to OM4 , the value of money is halved from
O1/P2 to O1/P4 and when the money supply is halved from
OM2 to OM, the value of money is doubled from O1/P2 to
O1/P. The value of money curve, 1/P= f(M), is a rectangular
hyperbola curve showing an inverse proportional
relationship between the money supply and the value of
money (1/P).
10.4 ASSUMPTIONS
1. The price level P is supposed to be passive i.e., it is
only the dependent variable. In other words, it is
determined by the other elements in the equation
and it does not influence other elements.
2. Fisher assumed that V the velocity of money remains
constant. Figure-10.1: Change in money
3. He assumed that T, transactions in a given period supply and the value of money.
are independent (does not depend on M, V and P in
the equation). It is believed that transactions ultimately depends on aggregate real output
and it will not change in short period.
4. The theory also assumes that full employment exists in the economy.
5. In a nutshell, P being a passive factor and V and T are constant, Quantity of money
influences the general price level thus, greater the quantity of money (M), higher the
level of prices (P).
10.5 CONCLUSION OF FISHER’S QUANTITY THEORY

Given the demand for money, changes in money supply lead to proportional changes in
the price level. Since money is only a medium of exchange, changes in the money supply
change absolute (nominal), and not relative (real) prices and thus leave the real variables such
as employment and output unaltered. Money is neutral. The monetary authorities, by changing
the supply of money, can influence and control the price level but not the level of economic
activity of the country.
10.6 CRITICISM OF QUANTITY THEORY OF MONEY

The quantity theory of money as developed by Fisher has been criticized on the following
grounds:
1. Interdependence of Variables: The various variables in transactions equation are not
independent as assumed by the quantity theorists:
i. M influences V. As money supply increases, the prices will increase. Fearing further rise
in prices in future, people increase their purchases of goods and services. Thus, velocity
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of money (V) increases with the increase in the money supply (M).
ii. M influences V. when money supply (M) increases, the velocity of credit money (V)
also increases. As prices increase because of an increase in money supply, the use of
credit money also increases. This increases the velocity of credit money (V).
iii. P influences T. Fisher assumes price level (P) as a passive factor having no effect on trade
(T). But, in reality, rising prices increase profits and thus promote business and trade.
iv. According to the quantity theory of money, changes in money supply (M) influences
changes in the price level (P), i.e., money is the cause and price is the effect. But, critics
maintain that a change in the price level occurs independently and this later on influences
money supply.
v. T influences V. If there is an increase in the volume of trade (T) may lead to an increase
in the money supply (M), without altering the prices.
2. Unrealistic Assumption of Long Period: The quantity of money has been criticized on
the ground that it provides a long-term analysis of value of money. It throws no light on
the short-run fluctuations in the value of money. Keynes has aptly remarked that “in the
long-run we are all dead.” Actual problems are short-run problems. Thus, quantity theory
has no practical value.
3. Unrealistic Assumption of full Employment: Keynes’ fundamental criticism of the
quantity theory of the money was based upon its unrealistic assumption of full
employment. Full employment is a rare phenomenon in the actual world. In a modern
capitalist economy, less-than-full employment, and not full employment, is a normal
feature. According to Keynes, as long as there is unemployment, every increase in money
supply leads to a proportionate increase in output, thus leaving the price level unaffected.
4. Static Theory: The quantity theory assumes that the values of V, V and T remain constant.
The assumption of constancy of these factors makes the theory a static theory and renders
it inapplicable in the dynamic world.
5. Simple Truism: The equation of exchange (MV=PT) is a mere truism and proves nothing.
It is simply a factual statement which reveals that the amount of money paid in exchange
for goods and services (MV) is equal to the market value of goods and services received
(PT). Or in other words, the total money expenditure made by the buyers of the
commodities is equal to the money receipts of the sellers of the commodities. The equation
does not tell anything about the casual relationship between money and prices; it does
not indicate which is the cause and which is the effect.
6. Technically Inconsistent: Prof. Halm considers the equation of exchange as technically
inconsistent. M in the equation is a stock concept; it refers to the stock of money at a
point of time. V, on the other hand, is a flow concept; it refers to velocity of circulation
of money over a period of time. M and V are non-comparable factors and cannot be
multiplied together. Hence the left-hand side of the equation MV=PT is inconsistent.
7. Fails to Explain Trade Cycles: The quantity theory does not explain the cyclical
fluctuations in prices. It does not tell why during depression the prices fall even with the
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increase in the quantity of money, and during the boom period the prices continue to rise
at a faster rate in spite of the adoption of tight money and credit policy. The proper
explanation for the decline in prices during depression is the fall in the velocity of money,
and for the rise in prices during boom period is the increase in the velocity of money.
Thus, the quantity theory of money fails to explain the trade cycles. Crowther has
remarked, “The quantity theory is at best, an imperfect guide to the causes of the cycle.”
8. Ignores Other Determinants of the Price Level: The quantity theory maintains that
price level is determined by the factors included in the equation of exchange, i.e., by M, V
and T, and unrealistically establishes a direct and proportionate relationship between the
quantity of money and the price level. It ignores the importance of many other determinants
of prices, such as income, investment, saving, consumption, population, etc.
9. Fails to integrate Monetary Theory with Price Theory: The classical quantity theory
falsely separates the theory of value from the theory of the general price level. Since
money is considered neutral, changes in money supply are believed to affect the absolute
prices, but not relative prices. In classical view, the absolute prices are determined in the
real sector. Keynes criticizes this view and maintains that money place an active role and
both the theory of money and the theory of value are essential parts of the general theory of
output, employment and money. He integrated the two theories through the rate of interest.
10. Money as a Store of Value Ignored: The quantity theory of money considers money
only as a medium of exchange and completely ignores its importance as a store of value.
Keynes recognized the store of value function of money and laid emphasis on the demand
for money for speculative purpose as against the classical emphasis on the transactions
and precautionary demand for money.
11. No Discussion of the Velocity of Money: The quantity theory of money does not discuss
the concept of velocity of circulation of money, nor does it throw light on the factors
influencing it. It regards the velocity of money to be constant and thus ignores the
variations in the velocity of money which are bound to occur in the long period.
12. One-Sided Theory: Fisher’s transactions approach is one-sided. It takes into
consideration only the supply of money and its effects and assumes the demand for
money to be constant. It ignores the role of demand for money in causing changes in the
value of money.
13. No Direct and Proportionate Relation between M and P: Keynes criticized the classical
quantity theory of money on the ground that there is no direct and proportionate
relationship between the quantity of money (M) and the price level (P). a change in the
quantity of money influences prices indirectly through its effects on the rate of interest.,
investment and output. The effect on prices is also not predictable and proportionate. It
all depends upon the nature of the liquidity preference function, the investment function
and the consumption function. The quantity theory does not explain the process of
causation between M and P.
14. A Redundant Theory: The critics regard the quantity theory as redundant and
unnecessary. In fact, there is no need of a separate theory of money. Like all other
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commodities, the value of money is also determined by the forces of demand and supply
of money. Thus, the general theory of value which explains value determination of a
commodity can also be extended for explanation of the value of money.
15. Why does the value of money fluctuate? Prof. Crowther has criticized the quantity
theory of money on the ground that it explains only ‘how it works’ of the fluctuations in
the value of money and does not explain ‘why it works’ of these fluctuations. As he says,
“The quantity theory can explain the ‘how it works’ of fluctuations in the value of money…
but it cannot the ‘why it works’, except in the long period”.
10.7 THE CAMBRIDGE CASH-BALANCE APPROACH

During almost the same period when Fisher was developing his equation of exchange in
America. Marshall, Pigou, Robertson, Keynes, at the Cambridge University popularized the
classical Cambridge cash-balance approach to the quantity theory of money. While Fisher’s
transactions approach emphasized the medium of exchange function of money, the cash-balance
approach was based on the store of value function of money.
According to the cash-balance approach, the value of money is determined by the demand
for and supply of money. This new approach, however, considers the demand for money and
supply of money at a particular moment of time, rather than over a period of time as considered
by the transactions approach. Since, the supply of money at a particular moment is fixed, it is
the demand for money which largely accounts for the changes in the price level. In this sense,
the cash-balance approach is also called the demand theory of money.
The Cambridge economists viewed the term ‘demand for money’ in a different manner.
The demand for money arises not because of transactions (as assumed in Fisher’s approach),
but because of its being a store of value. The real demand for money comes from those who
want to hold it for various motives and not from those who want to exchange it for goods and
services. This is the same thing as to say that the real demand for houses comes from those who
want to live in them and not from those who simply want to construct and sell them. Thus, in
the Cambridge approach, the demand for money implies demand for cash balances.
Cash balance is that proportion of the real income which people desire to hold in the
form of money. The total demand for money of the economy is a certain proportion of its
annual real national income which the community wants to hold in the form of money. In the
words of Marshall, “In every state of society, there is some fraction of their income which
people find it worthwhile to keep it in the form of currency; it may be a fifth or a twentieth”.
When people increase their demand for money, it implies a fall in the demand for goods and
services, because they can have larger cash balances only by cutting down their expenditure on
goods and services. A fall in the demand for goods and services will reduce the price level and,
consequently, the value of money will rise. Conversely, an increase in the demand for money
will raise the price level and, hence, will reduce the value of money.
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10.8 THE CAMBRIDGE EQUATIONS
The Cambridge economists explained their cash-balance approach to the quantity theory
of money by formulating equations known as Cambridge equations.
10.8.1 Marshallian Cash-Balance Equation

Marshallian cash-balance equation is expressed as follows:
M = KPY
Where, M is the quantity of money (currency plus demand deposits); P is the price level;
Y is aggregate real income; and K is the proportion the real income which people desire to hold
in money form.
Thus, using this equation, the value of money (1/P) is found out by dividing the total
amount of goods which the people want to hold out of the total income (KY) by the amount of
cash held by the public (M). Thus,
1 KY
=
P M
Similarly, the price level can be found out by dividing the money supply (M) by the
amount of goods which the community wants to hold (KY). Thus
M
P=
KY
1
For example, if M is Rs. 1000, Y is 10000 units, K is ½ or .5, then the value of money
P
KY .5 × 1000 units
will be = = 5 = 5 units of goods per
M Rs.1000
M Rs.1000
Rupee and the price level (P) will be =
KY .5 × 10000 units = Rs. 1/5 per unit.
The cash-balance approach also implies that the price level (P) is directly proportional
to the money supply (M). It is indirectly proportional to the aggregate real income (Y) and the
proportion of the real income which individuals choose to keep in the form of money (K). M
and Y are constant, P falls with the increase in K and rises with the decrease in K. similarly, K
and Y remaining unchanged, if M increases, P rises and if M decreases, P falls.
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Y Q1 Q2 Q3
D
Value of Money
P1
∆P
P2
P3
D = f(CK, RP)
∆M
X
O M1 M2 M3
Demand and Supply of Money
10.2 - Figure
In the figure 10.2, DD1 is the demand curve of money. It slopes negatively, because the
purchasing power of money units is less interms of goods and services if people choose to hold
more money in cash. In other words if people desire to hold and spend more money for purchase
of goods and services, the price level an creases and then the value of money decreases.
Q1 M1, Q2 M2, Q3 M3 are supply curves of money. These are vertically parallel to the 'Y'
axis. It implies that the money supply will be determined by the monetary policies of the
government / RBI.
Where the demand and supply curves money are equal (interseet), money supply is OM1
and the value of money is OP1. If supply of money increased to OM2 or Q2M2, the purchasing
power of money decreases from OP1 to OP2. The change between the supply of money and
value of money are proportionately two-fold equal. Further, if supply of money increase
three-fold to OM3 or Q3 M3, the value of money also decreas three-fold to OP3.
10.8.2 Pigou’s Equation

Pigou’s cash-balance equation is
KR
P=
M
Where, P is the price level and 1/P is the purchasing power; R is the total real income or
the real resources; K is the proportion of real income held by the people in the form of money
; and M is the total money supply.
Since money is held by the community not merely in the form of cash but also in the
form of bank deposits, Pigou extended his equation by dividing cash into two parts, i.e., cash
with the public and deposits with the banks. Thus, he modified his equation as:
KR
P= { c + h (1- c) }
M
Where, c is the proportion of cash which people keep with them; (1 – c) is the proportion
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of bank balances held by the people; and h is the proportion of cash reserves to deposits held by
the banks.
In this equation, K, c, h are all positive constants being less than one but more than zero,
i.e., 0 < K < 1 ; 0 < c <1 ; and 0 < h < 1. By assuming k, R, c and h as constants, the equation
gives a rectangular hyperbola curve implying unitary elastic demand for money in terms of
price level at all points of the curve.
Pigou has given his equation in the form of purchasing power (1/P). According to him,
K was more important than M in explaining changes in the purchasing power of money. This
means that the value of money depends upon the demand for money to hold cash balances.
Moreover, assuming K and R (and also c and h in the modified equation) to be constant, there
is direct and proportional relationship between money supply (M) and price level (P).
10.8.3 Robertson’s Equation

Robertson’s cash-balance equation is similar to that of Pigou but with a slight difference
that in place of Pigou’s real resources (R), he includes total transactions (T). Robertson’s equation
is as follows:
M = KPT
Where, P is the price level; M is the money supply; T is the total amount of goods and
services to be purchased during a year; and K is the proportion of T which people wish to hold
in the form of cash.
The equation clearly shows that P changes directly with M and inversely with K and T.
Pigou’s equation is generally preferred to that of Pigou because it is easily comparable with
Fisher’s equation.
10.9 CRITICISM OF THE CASH-BALANCE APPROACH

Despite its superiority, the Cambridge approach also suffers from a number of drawbacks
as discussed below:
1. Simple Truism. Like the transaction equation, PT = MV, the Cambridge equation, M=KPY,
is also simple truism. It merely establishes proportionate relationship between the quantity
of money and the price level, assuming all other factors to be constant.
2. Unitary Elastic Demand. The cash-balance approach is based on the assumption that
demands for money has uniform unitary elasticity. It means that an increase in the desire
for holding cash balance (K) leads to equi-proportionate fall in the price level. This is
possible in a static society when stock of money and the volume of goods and services
remain constant, not in dynamic conditions.
3. Speculative Motive Ignored. The cash-balance theory has not properly analysed various
motives for holding money. For example, it ignored the speculative demand for money
which turned out to be an important determinant of money holding in Keynesian analysis.
In fact, it is the speculative motive which causes violent changes in the demand for money.
4. Investment Goods Ignored. A serious drawback in the Cambridge approach, particularly
177
that given by Pigou and Keynes, is that it explains the value of money in terms of
consumption goods and ignores the investment goods altogether. This is a narrow view
of the purchasing power of money.
5. Role of Rate of Interest Ignored. The theory neglects the role of rate of interest in
explaining the changes in the price level. In fact, rate of interest has a definite influence
on demand for money and, in turn, on the price level and a realistic monetary theory can
hardly ignore its importance.
6. Real Factors Ignored. The theory, while explaining the changes in price level ignored the
importance of real factors like, income, saving, investment, etc., on prices. These factors
have determining influence on the price level of the economy.
7. Real-Balance Effect Ignored. Like Fisher’s approach the Cambridge economists also
assumed neutrality of money and a dichotomy between the money and the commodity
markets, and thus maintained that absolute prices are determined in the money market
independently of the determination of relative prices in the commodity market. Thus, it
ignored the real-balance effect which implies that an individual’s wealth is influenced
by the changes in the price level and changes in wealth further influences the expenditure
on goods and services.
8. Narrow View of K. the theory presents a narrow approach by making real income as the
sole determinant of K. it has overlooked the importance of other factors., such as, price
level, banking and business habits of the people, business integration, etc., which may
influence the value of K.
9. Two-way Relationship between K and P. the theory maintains that the value of money or
the price level (P) is determined by K. but it has been pointed out that K not only influences
P but is also influenced by it. During rising prices (P), the proportion of money which
people wish to hold (K) declines and vice versa.
10. K and T Assumed Constant. Cambridge version, like Fisherian version, assumes K and
T as given which is possible only in a static situation and not in dynamic conditions.
11. No Explanation of Trade Cycles. The Cambridge approach like the transaction approach,
provides no explanation for the trade cycles, i.e., why prosperity leads to depression and
depression leads to prosperity.
12. Lacks Quantitative Analysis. The Cambridge approach does not provide an adequate
monetary theory which can be used to explain how much prices and output will change
as a result of a given change in the supply of money.
The cash-balance approach was not without its faults. But it had the merit of analyzing
the demand for money as a store of value.
10.10 KEYNE’S REAL-BALANCE EQUATION

Keynes gives his real-balance quantity equation as an improvement over the other
Cambridge equations. According to him, the demand for money is with reference only to
consumer goods. In other words, people hold money to buy or to represent only goods and
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services. Keyne’s equation is as follows:
n
N = pk or P=
k
Where, n is the cash held by the general public; p is the price level of consumer goods;
and k is the real balance or the proportion of consumer goods over which cash (n) is kept.
Assuming k to be constant, there is a direct and proportionate relationship between n and p.
In order to consider bank deposits, Keynes extended the equation as follows:
n
P=
k + rk '
Where,
r is the cash-reserve ratio of the banks;
k' is the real balance held in the form of bank money.
Again, assuming k, k' and r to be constant, the same conclusion emerges, i.e., there is
direct and proportionate relationship between n and p.

3. What are the assumptions of Fisher’s quantity theory?
........................................................................................................................................
........................................................................................................................................
4. Explain about the Robertson’s cash-balance equation.
........................................................................................................................................
........................................................................................................................................
10.11 SUMMARY
Cash transaction apprach and cash balances approach are two important forms of quantity
theory of money. Cash transactions theory gave importance to medium exchange function of
money and the cash - balance approach has given to the store of value of money. Cash balances
apprach has considered real income (in the form of goods and services) as a major component
is determination of value of money. Though combridge economists putforth different cash
balance equations there are very marginal differences between them. Not only that, cash
transcation and cash balance theories are presented in different forms with few commonalities.
Keynes under the influence of cambridge equations proposed real balances quantity equation.
He included the concept of interest in determination of price level. Miton Friedman, one of the
famous modern economists laid stressed on importance of money in determination of both
overall economic activity and general price level.
179
1. There are two refined approaches to the traditional quantity theory: i) The cash-
transactions approach, - the classical approach; and ii) The cash – balance approach –
the neoclassical approach.
2. The price level is determined by these factors:( i) The quantity of money in circulation
(M); (ii) The velocity of circulation of money (V); (iii) The volume of bank money
(M'); (iv) The velocity of circulation of bank money (V'); and (v) The volume of trade
or transactions, that is, the amount of goods bought by money (T).
3. Assumptions: i) the price level P is supposed to be passive i.e., it is only the dependent
variable. In other words, it is determined by the other elements in the equation and it
does not influence other elements. ii) Fisher assumed that V the velocity of money remains
constant iii) He assumed that T, transactions in a given period are independent (does not
depend on M, V and P in the equation). It is believed that transactions ultimately depends
on aggregate real output and it will not change in short period. iv) The theory also assumes
that full employment exists in the economy. V) In a nutshell, P being a passive factor and
V and T are constant, Quantity of money influences the general price level thus, greater
the quantity of money (M), higher the level of prices (P).
4. Robertson’s cash-balance equation is similar to that of Pigou but with a slight difference
that in place of Pigou’s real resources (R), he includes total transactions (T). Robertson’s
equation is as follows : M = KPT . Where, P is the price level; M is the money supply;
T is the total amount of goods and services to be purchased during a year ; and K is the
proportion of T which people wish to hold in the form of cash.

1. Write about the Robertson’s cash-balance equation.
2. Briefly discuss the Keyne’s equation on money.
3. Explain the Pigou’s cash balance equation.

1. Graphically present and explain the Fisher version of Cash transaction theory.
2. Examine the different equations given by Cambridge economists in brief.

1. According to the cash-balance approach, the value of money is determined by
a) The demand for and supply of money b) Supply of money
c) Demand d) None of the above
2. According to cash transaction theory, when supply of money (M) increases, the value of
money (1/P) ___
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a) Neutral b) Increases c) Decreases d) Will be in Equilibrium
Answers: 1) a and 2) c

1. Fisher’s theory is known as___________________
2. Real cash-balance quantity equation is given by ____________________
3. Robertson is one among ______________ economists.
4. While cash transaction theory gave importance to the function of medium of exchange,
the cash-balance theory has given importance to ___________function of money.
5. Money supply and value of money have ___________relationship.
Answers: 1. Cash Transactions; 2. Keynes; 3. Cambridge; 4. Store of Value; and 5) Inverse.

1. Fisher Equation ( ) (a) M = KPT
n
2. Marshall’s Equation ( ) (b) N = pk (or) P =
k
MV
3. Pigou’s Equation ( ) (c) MV = PT (or) P =
T
M
4. Robertson’s Equation ( ) (d) M = KPY or P =
KY
KR
5. Keyne’s Equation ( ) (e) P=
M
Answers: 1- c, 2- d, 3- e, 4- a, and 5- b
10.14 GLOSSARY
1. Real Stock Money: it is the real amount of money damanded i.e., Md/p.
2. General Price Level: This concept indicates the average price of all goods and services.
The changes in it are noted by an index number of prices.
3. Demand and Cash Balances: Holding apart of income in the form of cash balance for
future transactions and contingences.

1. M.C.Vaish : Macro Economic Theory
2. Edward Shapiro : Macro Economic Analysis
3. D.M. Mithani : Macro Economics
4. H.L. Ahuja : Macro Economics Theory and Policy
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UNlT – 11 : CENTRAL BANKING: FUNCTIONS AND
CREDIT CONTORL
Contents
11.0 Objectives
11.1 Introduction
11.2 Need for Establishing Central Bank (RBI)
11.3 Central Bank and Commercial Banks
11.4 Objectives of the Central Bank
11.4.1 Central Bank in Developed Countries
11.4.2 Central Bank in Developing Countries
11.4.3 Central Bank as a Promoter of Economic Development
11.5 Functions of RBI
11.5.1 Monopoly of Note Issue
11.5.2 Banker to the Government
11.5.3 Banker’s Bank
11.5.4 Custodian of Foreign Exchange Reserves
11.5.5 Controller of Credit
11.5.6 Lender of Last Resort
11.5.7 Clearing House
11.6 Instruments of Credit Control
11.6.1 Quantitative or General Methods
11.6.2 Qualitative or Selective Methods
11.7 Summary
11.10 Glossary
11.0 OBJECTIVES
The purpose of this unit is to analyse the circumstance that led to the establishment of
the Reserve Bank of India and to examine its various functions and credit controlling methods.
After reading this unit, you will be able to:
• discuss the necessity of the Reserve Bank of India;
• similarities and dissimilarities between Reserve Bank of India and commercial banks;
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• explain the objectives and functions of the Reserve Bank of India; and
• know the credit control methods of Reserve Bank of India.
11.1 INTRODUCTION
A major landmark in the evolution of central banking in India was the amalgamation of
the three presidency Banks of Bombay, Bengal and Madras to form the Imperial Bank of India
in 1921. Though it performed two important central banking functions, it was the banker to the
Government and to some extent, the bankers’ bank; it was not a central bank. The other central
banking functions were performed by the Government only. Because of this unsatisfactory
arrangement, demands were made for a full-fledged Central Bank.
11.2 NEED FOR ESTABLISHING CENTRAL BANK (RBI)

The object of establishing the Reserve Bank was to regulated the issue of Bank notes
and keeping of reserve with a view to securing monetary stability in British India and generally
to operate the currency and credit system of the country to its advantage.
Secondly, the White Paper on Indian Constitutional Reforms made a condition that the
Reserve Bank should be established if the responsibility at the center were to be transferred
from British to the Indians.
Thirdly, the inadequacy of the Imperial Bank of India in controlling the money market
was patent, because of the lack of confidence of other joint-stock banks on the Imperial Bank.
Banks were naturally reluctant to approach the Imperial Bank for any help. Under these
circumstances it was decided to establish a Reserve Bank with the object of discharging purely
central banking functions and thereby making a fresh start in the field of Indian central banking.
Fourthly, central bank was found necessary to remove the structural instability of the
banking system. Without a Central Bank, each commercial bank as to maintain enough cash
reserves to ensure its own liquidity position.
Lastly, a Central Bank was found necessary in order to follow an appropriate credit
policy. Since the Central Bank has the sole authority to issue notes, it can exercise control over
the basis for the creation of credit. As a bankers’ bank a Central Bank has control over the cash
reserves of commercial banks and hence can influence their power to create credit. Further, a
central bank is armed with various weapons of credit control through which it can control the
credit situation in the country.
It is for achieving all the above objectives that the Reserve Bank of India was brought
into existence from April 1, 1935. In view of the need for close co-ordination between the
monetary and credit policies of the Reserve Bank and the financial policies of the Government,
it was decided to nationalize the Reserve Bank immediately after attainment of independence.
Consequently, the Reserve Bank of India was nationalized from 1st January 1949 the Reserve
Bank began to function as a state-owned organization. The nationalization of the Reserve
Bank was in keeping with the contemporary worldwide tendency towards state-ownership of
the Central banks. The Central Office of Reserve Bank is situated in Mumbai.
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1. What is the major objective in establishing the RBI ?
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2. When was the Reserve Bank of India brought into existence?
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11.3 CENTRAL BANK AND COMMERCIAL BANKS

Basically, a central bank is different from commercial banks in view of both objectives
and functions. In certain respects, there are similarities between central bank and commercial
banks. Both central bank and commercial banks are monetary or financial institutions dealing
with money. The central bank as also commercial banks creates money in the economy. Further,
both these institutions deal with foreign exchange. The central bank as also commercial banks,
particularly public sector banks, undertakes many financial transactions of the government.
There are certain dissimilarities between the central bank and commercial banks. The
central bank in all the countries is generally owned by the state where as the commercial banks
is owned either by the state or by the private sector. Second, the central bank has the monopoly
power of issuing currency notes, but the commercial banks do not have such power. However,
the commercial banks can create credit or demand deposits and issue cheques to the public.
These cheques are legal tender money. The central bank does not operate with profit motive, as
its primary objective is the promotion of economic development of the nation. On the other
hand, the commercial banks operate with profit motive, following sound business principles.
Fourth, the central bank acts as the custodian of the foreign exchange reserves to maintain
stability in the exchange rate and ensure equilibrium in the balance of payments in the country.
The commercial banks, on the other hand, undertake foreign exchange transactions only. Fifth,
the central bank does not directly deal with the public, while the commercial banks directly
deal with the public. The central bank is authorized to supervise and regulate the activities of
the commercial banks and the commercial banks have to follow the directions given by the
central bank from time to time in the interests of the country’s economic progress. Further, the
central bank acts as a lender of the last resort and as a clearing house for all the commercial
banks in the country.
A healthy coordination between the central bank and commercial banks is necessary for
stability and development of sound monetary system of a country. Both these institutions have
to play a vital role in the growth of money and capital markets and also for the promotion of
economic development.
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11.4 OBJECTIVES OF THE CENTRAL BANK
The objectives of the central bank vary between countries and change from time to time.
The objectives of central banks in advanced countries differ from those in developing countries.
The following objectives are explained below.
11.4.1 Central Bank in Developed Countries

In advanced countries central banks aim at preventing cyclical fluctuations and
maintaining stability as also the rate of growth already achieved. In those countries money and
credit markets are well-developed and well-coordinated. Hence sub-markets can quickly respond
to changes in monetary and credit policies of the central bank.. For example, a fall in the rate of
interest in one sub-market say, commercial banks will automatically lead to fall in the rate of
interest in other sub-markets like co-operative and regional banks.
Further, in advanced countries as the bill market is well developed the policies of the
central bank will be more effective. The commercial banks discount the bills of exchange in
business transactions and the central bank in turn rediscounts the eligible bills of exchange at
the bank rate or discount rate. In accordance with the general economic conditions of the country,
the central bank can manipulate the bank rate and exercise control over the entire economy.
Apart from this, the other credit control methods, such as, variable reserve ratio and open
market operations, pursued by the central bank in its monetary policies would work more
effectively in these countries.
11.4.2 Central Bank in Developing Countries

The central bank in a developing country aims at undertaking the responsibility of meeting
the monetary requirements in the wake of rapid economic development. The banking sector
has to play a vital role in helping the process of industrialization as also agricultural development.
This requires monetization of erstwhile non-monetized and semi-monetized segments of the
economy. Further, the state has to undertake the task of initiating and developing public sector
enterprises and provide encouragement to private sector. Under these conditions, the central
bank as the banker to the government and as an apex institution in the money market has to play
an important role in meeting the needs of the growing economy.
The central bank under these circumstances aims at facilitating the development of well-
knit, effective, and efficient money and capital markets. A strong and dynamic banking structure
is necessary to cater to the short-term and long-term needs of agricultural and industrial sectors.
In this context, the central bank has to play a positive and dynamic role in the development of
financial institutions both commercial and development banks.
11.4.3 Central Bank as a Promoter of Economic Development

In modern times, central bank is considered as an agent for promoting economic
development of a country, particularly developing country like India. It is regarded as an
institution responsible for the maintenance of stability – both internal and external and assisting
the growth the economy. It helps and assists the development of sound banking system to cater
to the needs of agriculture, industry, and trade.
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In this context, the important task of the central bank is the development of organized
money and capital markets to assist investment activities for capital formation.
In developing countries like India, the central bank, besides providing credit and
maintaining stability, undertakes the responsibility of spreading the banking facilities, providing
cheaper credit to priority sectors like agriculture, cottage, and small-scale industries and
protecting the government securities market.
11.5 FUNCTIONS OF THE RESERVE BANK OF INDIA

The Reserve bank performs all the functions of a Central Bank. Its main function is to
regulate the monetary mechanism comprising of the currency, banking, and credit systems of
the country. The Bank is given complete monopoly right for the issue of notes and has wide
powers over the other commercial banks. Another important functions of the bank is to conduct
the banking and financial operations of the Government. The Bank is also responsible for
maintaining the external value of the rupee.
11.5.1 Monopoly Power of Note Issue

One of the most important functions of central banks is the monopoly power of note
issue. In almost all countries central banks enjoy exclusive privilege of issuing currency. No
other bank in the country is authorized to issue notes. Infect, until the beginning of the 20th
century Central banks were known as banks of note issue. In the opinion of Vera Smith, it is the
essence of the Central Bank’s definition. The central banks enjoy much privilege and public
confidence due to monopoly power of note issue. The following reasons are important for
entrusting the task of note issue to a Central Bank. They are:
i) to ensure uniformity in the circulation of currency.
ii) to have control over undue expansion of credit by commercial banks.
iii) to give distinct prestige associated with note issue to central bank.
iv) to have a share in the monopoly profits of note issue.
v) to avoid political interference and pecuniary needs in the matter of issue of notes. and
vi) to ensure sound monetary policy.
There are several methods of note issue. Under gold standard, the volume of currency
was backed by 100 percent gold reserves. This system was proved to be too expensive. Later
proportional reserve System was introduced. Under this system, the bank was required to keep
a certain percent of assets (say 40%) in the form of gold coins, gold bullion and foreign securities.
This system also placed rigid limitations on the Central Bank. Hence, another system known
as minimum reserve system has been in vogue in several countries. Under this system, a minimum
amount of gold, silver and foreign exchange will be kept as backing.
11.5.2 Banker to the Government

A Central Bank acts a banker, agent and adviser to the government. As a banker to the
government, it carries out the banking accounts of the government departments, institutions
and enterprises. It performs government’s transactions involving purchases or sales of foreign
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currency, accepts deposits of the government, makes disbursements and transfers of funds for
the governments from one account to another or from one place to another. It makes ways and
means (short-term) advances to governments in normal conditions and extraordinary advances
during depression, war or other emergency circumstances.
As fiscal agent to government, it collects cheques, drafts on behalf of the government
and credits them to government accounts. The central bank maintains the income and expenditure
accounts of the government for the entire country free of charge.
The Central Bank also undertakes the administration and management of the national
debt, including floating debt. It undertakes the issue and redemption of treasury bills, bonds,
and receipts. Further, as an Agent of government, it receives taxes and other payments on
government account. It also administers the Foreign exchange control policy of the government.
It represents the government at the specialised financial institutions in the country as well as at
international financial institutions and conferences.
As an advisor to the government, the Central Bank gives advice to the government on
important matters of economic policy such as deficit financing, devaluation of currency, trade
policy, foreign exchange policy etc. Government gets expert advice from Central Bank on
budget preparations and fiscal matters. But the responsibility of monetary management
(monetary policy) is entrusted to the Central Bank.
In the words of De Kock, the Central Bank operates as the government’s banker, not only
because it is more convenient and economical to the government but also because of the intimate
connection between public finance and monetary affairs.
11.5.3 Banker’s Bank

Central Bank of a country acts as a banker to all the commercial banks. All commercial
banks are required to keep a certain proportion of their deposits in the form of cash reserves.
This proportion is fixed from time to time either by law or by custom. In many countries, the
banks are required to maintain certain proportion of their reserves in government or government
approved securities. This is known as Statutory Liquidity Ratio. The Central bank discounts
Bills of commercial banks, making available to them the credit based on these ultimate reserves.
The centralization of cash reserves in the central bank is the source of great strength, power
and prestige to the banking system of the country. When all the reserves of the commercial
banks are pooled together in the Central Bank, they can be used for meeting any crisis situation.
The reserves can be used by the central banks to clear inter-bank claims through the clearing
house. During a slack season commercial banks may keep more reserves with the central bank
while in busy season the commercial banks may withdraw their surplus cash reserves to meet
the claims of the customers. Thus a central bank acts as a custodian of the cash reserves of
other banks, safeguarding and protecting the interests of the nation is general and customers in
particular. This may also help to divert excess reserves from the regions of surplus to the region
of deficit. The centralized cash reserves can help to achieve a more elastic credit structure than
if the same amount were scattered among the individual banks. Moreover, the commercial
banks can conduct larger volume of business even with relatively smaller reserves if central
bank helps them in need of the hour.
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11.5.4 Custodian of Foreign Exchange Reserves
In all countries central banks maintain gold and foreign exchange reserves. As noted
already, the central bank is required by law to maintain minimum reserves against its note
issue. These reserves help to settle deficit in balance of payments and to maintain stability in
the external value of the currency or foreign exchange rates. It should be noted that under the
system of fixed exchange rates there would be greater possibility to have either deficit or
surplus in balance payments. Only when these deficits or surplus are cleared by depleting
foreign exchange reserves, the external value of the currency can be maintained at the required
level. It is the responsibility of the Central Bank to maintain stable exchange rates of the currency.
Central banks also maintain stable internal value of the currency. It should be noted that
when the money supply is increased in excess of increase in real output, there would be inflation
in the economy and as result the internal value of the currency falls. Similarly, when the money
supply is not increased in tune with the increase in the real output, there will be depression and
hence real value of the currency will increase. In order to avoid such extreme situations, the
Central Bank of the country adopts the policy of “Controlled expansion” and there by helps to
maintain stable internal value of the currency.
11.5.5 Controller of Credit

Control of credit is considered to be the most important function of the central bank.
According to De Kock. “It is the function which embraces the most important questions of
central bank policy and one through which practically all the other functions are united and
made to serve a common purpose”. The central bank issues currency in circulation and the
commercial banks create credit many times more than the initial deposits that serve as equally
good as currency. An effective monetary management requires a centralized control over both
currency and credit. Hence, the central banks exercise control over excessive expansion of
credit by the commercial banks. In modern times credit play an important role in the settlement
of business transactions. Changes in the volume of credit may bring about changes in the value
of money as well as in value of employment and income. This may bring about disturbances
and maladjustment in the parts of the economic structure. A central bank being a bank of note
issue and supervisor of banking activities in an economy can legitimately control the process of
credit creation in the economy. A central bank uses two types of credit control measures viz.,
i) quantitative credit control methods and ii) qualitative credit control methods. You will know
about these methods in the next section.
11.5.6 Lender of Last Resort

Bagehot coined the term ‘lender of the last resort’ in his book “Lombard Street” published
in 1873. After the publication of this book, the responsibilities of Bank of England as the lender
of last resort unequivocally recognised. After this, central banks recognised the function of
“the lender of last resort” as one of the integral part of the central banking.
As a lender of last resort, central banks provide short-term credit to commercial banks
mostly by rediscounting their eligible bills. The central banks generally impose stringent
conditions and charge higher rates of interest in order to see that such facilities are not misutilised.
According to De Kock rediscounting of Bills of Exchange increases the elasticity and liquidity
of the entire credit structure and it should be seen that it is not abused.
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11.5.7 Clearing House
As a central bank keeps cash reserves of all commercial banks, it can easily discharge
the function of acting as a clearing house or settlement bank for other banks in the country.
Bank of England pioneered in the discharge of the function of clearing house. Soon central
banks of other countries followed suit. Shaw, an authority on central banking, opined that
clearing function is a mere matter of mechanism or book keeping. Other writers like Kisch and
Eikin. Jauncey and Will consider clearing as an important function of central bank. As all
banks maintain their accounts with central bank, the claims against one another are easily
settled by simple adjustments in the respective accounts. This system provides economy in the
use of money in banking operations, and strengthens the banking system.

3. What are the functions of RBI?
.........................................................................................................................................
..........................................................................................................................................
4. What are the reasons for entrusting the task of note issue to a Central Bank?
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11.6 INSTRUMENTS OF CREDIT CONTROL

The important functions of a central bank are control of credit that is created by the
commercial banks in the country. Excessive creation of credit may result in inflationary
tendencies in the economic growth. Secondly there may be also speculative activities in the
country that may discourage investments in socially and economically productive activities.
Thirdly, there is a need to reduce inequalities in the income and wealth of the people so that
there will not be wide gap between the rich and the poor. Lastly, control of credit is also
necessary to mitigate the harmful effects of trade cycles.
Central Bank of a country has broadly two types of instruments to control credit. The
following flow chart states the credit control methods.
Methods of Credit Control
Quantitative or General Methods Qualitative or Selective Methods
1. Bank Rate 1. Regulation of Consumer Credit

2. Open Market Operations 2. Margin Requirment
3. Variable Cash Reserve Ratio 3. Rationing of Credit
4. Moral Suasion
5. Publicity
6. Direct Action
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11.6.1 Quantitative or General Methods
The quantitative methods of credit control aim at regulating the cost and availability of
credit in the country. The quantitative methods of credit control include i) bank rate ii) open
market operations, and iii) variable reserve ratios.
i. Bank Rate: Bank rate is the rate at which the central bank of a country rediscounts
eligible bills and securities or advances loans against the approved securities to commercial
banks. When the cash balances of commercial banks fall below the minimum level, the
commercial banks have no other option but to approach the central bank the bank rate
determines the lending and borrowing rates of the commercial banks. Whenever bank
rate is raised, the lending and borrowing rate of the commercial banks are automatically
raised. Whenever bank rate is reduced the borrowing and lending rates are instantaneously
reduced. Thus, accordingly the cost of borrowing by the public increases or falls. During
periods of inflation, rank rate is raised and during days of recession and unemployment
bank rate is revised downwards.
The bank rate policy is based on the following assumptions:
I There is a close relationship between bank rate and the market rates in the economy.
2. The bills market and the money (short-term credit) market are well developed.
3. Commercial banks do not have any prejudice to discount their bills.
4. The economy is highly flexible and it quickly responds to any changes in the interest
rates.
5. Commercial banks do not keep excess reserves’ so as to avoid or nullify the actions
taken by the Central bank.
But these assumptions are rarely met in the real world. The bank may be very successful
in developed countries where most of the assumptions are fulfilled. However, in underdeveloped
countries, these conditions are not found and hence the bank rate may not work successfully in
these countries.
ii. Open Market Operations: Open market operations’ is another quantitative instrument
available at the disposal of central bank to influence the volume of money supply in the
country. Open market operations refer to the buying and selling of government and
other approved securities by the central bank in the money and capital market.
The mechanism of working of open market operations is very simple.
In inflationary period: During periods of inflation and boom, there will be excess
liquidity with the public and financial institutions. In order to mob up the excess liquidity, the
central bank sells the government and other approved securities Buyers of these securities pay
the central bank by drawing on their cash deposits in the banks. The reduction in cash reserves
forces banks to reduce their advances and loans to the public this checks the inflationary
tendencies in the economy.
During the periods of depression, the central bank performs the exactly opposite
operations. It buys the approved bills and securities and it issues cheques on it. The individuals
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who receive these cheques deposit them in their respective accounts in the banks. The banks
realize the proceeds of the cheques and thereby their reserve position improves. They are now
in a position to advance more loans to revive the economic activities in the country and thereby
employment, income, and output in the economy rise.
Limitations of Open Market Operations

1. In the theory of open market operations, it is assumed that public and banking system
possess or willing to possess the needed approved securities. However, if as in
underdeveloped countries, people do not have the habit of buying and selling government
or approved securities, the method may not work properly.
2. In many underdeveloped countries, both money and capital market instruments do not
exist under such circumstances. Open Market Operations will not be successful.
3. If commercial banks have excess cash reserves, open market sales of securities by the
central bank may not be effective.
4. During the periods of boom, there will be general optimism about the future among the
businesspersons. Under such circumstances even if central bank reduces the reserves of
the commercial banks through open market operations, the banks may to be ready to
lend even at the reduced reserve levels.
iii. Variable Reserve Ratio: Another powerful and direct method of credit control is variable
reserve e ratio. In all countries, the commercial banks are required to keep a certain
proportion of their deposits in the form of cash reserves with the central bank. This ratio
varies from 3 percent to 15 percent in different countries. When the central bank wants
to control credit creation by the commercial banks, the former will simply raise the cash
reserve ratio say from 3 percent to 8 percent. Thus directly affects the amount of liquidity
available with the commercial banks. Similarly, when the central bank wants to expand
credit, it will simply reduce the reserve requirements of the commercial banks.
The variable reserve ratios are not free from limitations. Like the other two methods,
variable reserve ratios also cannot prevent banks from lending especially during the periods of
boom and prosperity. Secondly, during this period, there will be more inflow of gold and
foreign exchange, which may counteract the shortages in domestic liquidity. Thirdly, frequent
use of variable reserve ratio may create uncertainty and adversely affect the business prospects.
In view of these, Harry Johnson opined that this method should be used very sparingly especially
to control credit expansion.
11.6.2 Qualitative or Selective Methods

Besides above quantitative credit control methods that affect the total cost and volume
of credit in a country, there are certain qualitative credit control methods that affect credit
flows to sectors These methods are also known as selective credit control methods. These
include:
1. Regulation of Consumer Credit: Under this method consumers are given credit in a
little quantity and this period is fixed for 18 months; consequently credit creation expanded
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within the limit. This method was originally adopted by the U.S.A. as a protective and
defensive measure, there after it has been used and adopted by various other countries.
2. Margin Requirement: Another important selective credit control method in the hands
of the central bank is the margin requirements. Margin refers to the difference between
the value of the securities (value of the projects) and the loan amount. The commercial
banks do not generally lend loans to full value of the securities pledged or the value of
the projects proposed. The loan amount will be a certain proportion of value say 80
percent of total value of the securities pledged or project cost. The remaining proportion
is to be borne by the borrower. In case the central bank wants to contract credit, it will
raise the margin requirement say from 20 percent to 40 percent. In that case, the borrowers
may be reluctant to borrow from the banks. Similarly, if the central bank wants to expand
credit, it will lower the margin requirement say from 20 percent to 10 percent. This may
give impetus for the borrowers to borrow from the banking system. The central bank
may stop advancing of loans to commercial banks against any particular type of sensitive
collateral such as foreign securities, sensitive commodities such as wheat, rice etc., which
are highly susceptible for hoarding. In order to control speculative and black marketing
in sensitive commodities with the help of bank credit, the central bank regulates the
margin requirement.
3. Rationing of Credit: Credit rationing .by central banks may take several forms. A
central bank may put ceiling on rediscounting facility extended to commercial banks.
The commercial bank in turn may put ceiling on the total amount of loan sanctioned to a
particular sensitive sector or number of times it can extend loans to that particular sector.
4. Moral Suasion: The central bank may also persuade commercial banks to exercise
restraint on the advancement or credit particularly during periods of inflation. It may
issue circulars or use its moral influence to urge commercial banks not to advance credit
to sensitive activities that may lead to speculative activities. The Bank of England and
Reserve Bank of India exercised this method with a high degree of success.
5. Publicity: The central bank of a country may disclose its policy through monthly or
quarterly reports, circulars publicize through Radio, TV and Newspapers. The information
relating to recognition or de-recognition of scheduled commercial banks, non-banking
financial institutions is generally issued through newspapers so that public would be
more cautious about fake financial institutions.
6. Direct Action: Under this method if the Commercial Banks do not follow the policy of
the Central Bank, then the Central Bank has the only recourse to direct action. This
method can be used to enforce both quantitatively and qualitatively credit controls by
the Central Banks. This method is not used in isolation; it is used as a supplement to
other methods of credit control.
Direct action may take the form either of a refusal on the part of the Central Bank to re-
discount for banks whose credit policy is regarded as being inconsistent with the maintenance
of sound credit conditions. Even then the Commercial Banks do not fall in line, the Central
Bank has the constitutional power to order for their closure.
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This method can be successful only when the Central Bank is powerful enough and has
cordial relations with the Commercial Banks. Mostly such circumstances are rare when the
Central Bank is forced to resist to such measures.

5. What are the Qualitative Credit Control Methods?
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11.7 SUMMARY
It is clear from the above that apart from the traditional central banking functions, the
RBI performs certain non-monetary functions like the promotion of sound banking in India.
While the monetary functions like control of credit, issue of notes etc., are significant as they
regulate the volume of money and credit in the country, the non-monetary functions are equally
important to the context of India’s economic backwardness.

1. The object of establishing the Reserve Bank was to regulated the issue of Bank notes
and keeping of reserve with a view to securing monetary stability in British India and
generally to operate the currency and credit system of the country to its advantage.
2. the Reserve Bank of India was brought into existence from April 1, 1935.
3. RBI performs the following functions: i) Monopoly Power of Note Issue; ii) Banker to
the Government; iii) Banker’s Bank; iv) Custodian of Foreign Exchange Reserves; v)
Controller of Credit; vi) Lender of Last Resort; and vii) Clearing House.
4. The reasons for entrusting the task of note issue to a Central Banks are I) to ensure
uniformity in the circulation of currency; ii) to have control over undue expansion of
credit by commercial banks; iii) to give distinct prestige associated with note issue to
central bank; iv) to have a share in the monopoly profits of note issue; v) to avoid political
interference and pecuniary needs in the matter of issue of notes; and vi) to ensure sound
monetary policy.
5. The Qualitative Credit Control Methods are i) Regulation of consumer credit; ii)
Margin requirement; iii) Rationing of credit; iv) Moral suasion; v) Publicity; and vi)
Direct action.

1. What the need is for established the RBI?
2. Explain any two Quantitative Credit Control methods of RBI.
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1. Analyze the major functions of RBI.
2. Discuss the Credit Control methods of RBI.

1. Reserve Bank of India was nationalized from
(a) 1st Feb, 1949 (b) 1st July 1949 (c) 1st January, 1949 (d) 1st June, 1949
2. Reserve Bank of India’s head office located in
(a)Delhi (b) Mumbai (c) Kolkata (d) Chennai
3. Which one of the following is a qualitative credit control measure of RBI?
(a) Bank Rate (b) Open Market Operations (c) Variable Reserve Ratio (d) Direct action
Answers: 1. c; 2. b; and 3. d.

4. The ___________ of a country acts as a banker to all the commercial banks.
5. Bank of Bombay was a _______________ bank.
6. The bank rate determines the _________________rates of the commercial banks.
Answers: 4. Central Bank; 5. Imperial; and 6. Lending and Borrowing.
11.10 GLOSSARY
• Central Bank: An apex bank in a country that is entrusted with the responsibility of
controlling the nation’s money supply and credit as well as supervising the banking
system in the country is known as Central Bank.
• Commercial Bank: Commercial Banks are a type of financial institutions that act as
intermediaries between savers and investors. They accept deposits from the public and
advance loans to those who need them.
• Monopoly of Note Issue: A Central bank’s exclusive privilege of issuing currency in
the country is known as monopoly power of note issue.
• Banker’s to Bank: A Central bank which is entrusted with the function of supervising
the activities of all the commercial banks in the country is known as banker’s bank.
• Banker to Government: A central bank, which acts as the banker, agent and advisor to
the Government knows government, as banker.
• Custodian of Foreign Exchange: A central bank is entrusted with the responsibility of
maintaining the foreign exchange reserves of a country. Hence, it is known as the custodian
of foreign exchange reserves.
• Clearinghouse: The transactions of different commercial banks in the country are cleared
through the Central bank as it maintains the cash reserves of all commercial banks. Thus
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a central bank acts as the Clearinghouse.
• Lender of Last Resort: A Central bank of a country comes to the rescue of commercial
banks when The latter do not have any other source of finance. Hence, a central bank is
known as lender of last resort.
• Statutory Liquidity Ratio: The part of deposits of a commercial bank, which is invested
in government or government-approved securities, is known as Statutory Liquidity Ratio.
• Primary Deposits: The deposits of the public in the form of cash, cheques, bills etc.,
that are deposited in a bank for that first time are known as primary deposits.
• Secondary Deposits: The additional deposits that are created from out of primary deposits
are known as Secondary Deposits.
• Cash Drain: The rate at which the public converts the demand deposits into currency as
the level of deposits increase is known as cash drain.

1. R.S Sayers: Moderen Banking.
2. K.P.M. Sundaram: Money, Banking, Trade and Finance.
3. S.K. Basu: Current Banking Theory and Practice.
4. Setti, M. L. Macroeconomics.
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BLOCK – V
INFLATION AND TRADE CYCLESS
Stability in prices is an important condition for the efficient and stable economic life
in an economy. Fluctuations in prices create an uncertain and unfavourable atmosphere which
is not conductive to development activity. We will know these conditions from this block.
This block explains the concept, classifications, causes and measures to control the Inflation.
It also explains features, causes, effects, theories and measures to control the Trade Cycles.
Unit - 12: Inflation
Unit - 13: Trade Cycles
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UNIT – 12: INFLATION
Contents
12.0 Objectives
12.1 Introduction
12.2 Definitions of Inflation
12.3 Classification of Inflation
12.3.1 Based on the Rate of Increase in the Price Level
12.3.2 Influence Money Supply and Demand for Goods and Services
12.3.3 Criterion of Time
12.3.4 Coverage or Scope Point of View
12.3.5 Governments Reactions to the Prevalence of Inflation
12.4 Indicators of Measure of Inflation
12.5 Types and Effects of Inflation
12.5.1 Types of Inflation
12.5.2 The Effects of Inflation
12.6 Causes of Inflation in India
12.7 Measures to Control Inflation
12.8 Important Concepts on the Literature of Inflation
12.9 Summary
12.12 Glossary
12.0 OBJECTIVES
The purpose of this unit is to detailed explanation of the inflation. After reading this
unit, you will be able to:
• explain the meaning and types of inflation.
• analyse the causes of inflation.
• discuss the measures to control inflation. and
• identify the important concepts pertaining to inflation.
12.1 INTRODUCTION
Inflation is a term which frightens every one and which has common feature across the
countries. There are various schools of thought in economics on inflation but there is a consensus
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among economists that inflation is a sustained rise in the general level of prices over time.
General level essentially means that price increases are not limited to only a few goods and
services but pertain to a broader set - usually defined as a “basket” of goods and services. The
inflation rate is the rate at which the price level increases.
For Example: The cost of 1 Kg Rice is Rs. 35 in the month of September, 2018. After
one month i.e. in the month of October, 2018 the cost of 1Kg Rice is Rs.55. Due to increase of
price 35 to 55, the purchasing power of money has declined and same amount of good is
available at higher price. This will have negative impact on consumer consumption. In other
words, inflation refers to a unit of currency depreciating in value so that it takes more currency
units to buy the same amount of goods and services as it did in past. A Rupee today doesn’t buy
as much as it did twenty five years ago. The cost of almost everything has gone up. The rate of
inflation, the percentage change in the overall level of prices - varies greatly over time and
across countries.
12.2 DEFINITIONS OF INFLATION

Different economists defined inflation in different ways as it appears to each one of
them. Some important definitions are:
According to John Maynard Keynes, “inflation is the result of the excess of aggregate
demand over the available aggregate supply and true inflation starts only after full employment.”
According to Paul Samuelson, “inflation occurs when the general level of prices and
costs is rising.”
According to Arthur Cecil Pigou, “inflation exists when income is expanding more than
in proportion to the income earning activities.”
According to Crowther, “inflation is a state in which the value money is falling i.e.,
prices are rising.”
The essence of all the definitions is the rise in price level or fall in the value of money. It
also should be noted here that this rise in price level is not a temporary phenomenon, but is
continuous and sustained over a long period.
12.3 CLASSIFICATION OF INFLATION

There are various types of Inflation. Which are discussed as under:
12.3.1 Based on the Rate of Increase in the Price Level

(a) Creeping Inflation: When prices are gently rising, it is referred as creeping inflation.
According to R.P Kent, Creeping inflation means rise in price level by not more than
three percent annum.
(b) Walking Inflation: Means the rise in price level more than three percent but less than
ten percent per annum. This walking inflation gives a cautionary signal for the occurrence
of running inflation.
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(c) Running Inflation: A rapid acceleration in the rate of rising prices is called Running
inflation. It occurs when the prices rise by more than ten percent per annum.
(d) Galloping Inflation: refers to unmanageable high inflation rates that run into two or
three digits inflation rates like thirty percent or four hundred percent per annum.
(e) Hyper Inflation: According to Cagan (1956.) and is “beginning in the month the rise in
price exceeds fifty percent and as ending in the month before the monthly rise in prices
drops below that amount and stays below for at least a year.” This corresponds to thirteen
hundred percent. It refers to a situation where the prices rise at an alarming high rate.
The paper currency becomes so utterly worthless during hyperinflation. Hyperinflations
typically begin when governments finance large budget deficits by printing money. When
prices change frequently by large amounts, it is hard for customers to shop around for
the best price. Highly volatile and rapidly rising prices can alter behavior in many ways.
12.3.2 According to the Factors which Influence Money Supply and Demand for
Goods and Services
Basically, inflation occurs when the aggregate quantity of goods demanded at any
particular price level is rising more quickly than the aggregate quantity of goods supplied at
that price level.
(a) Excessive Inflation: Excessive inflation is the price due to access of money supply in
relation to the availability of real goods and services
(b) Cost Inflation: When prices rise due to increase in factor production prices. It occurs
when money incomes of factors expand more than real production.
(c) Deficit Inflation: When government spends too much money on various investment
projects/social welfare schemes and which will cause deficit inflation. The production
of consumption goods fails to keep pace with the increased expenditure.
(d) Export Boom Inflation: When a country exporting more goods and services it may
experience an increased demand and if the supply is short in domestic market, the demand
for goods and services rise rapidly resulting in inflation in domestic country.
(e) Import Price Hike - Inflation: If a country imports goods from abroad and the prices of
these goods increase in abroad the prices of products in domestic country using these
goods will increase.
(f) Credit Inflation: It arises due to excessive bank credit or the money supply in the economy.
12.3.3 Under the Criterion of Time

(a) War Time Inflation: is the situation when prices rise during the war. This will occur due
to war expenditure and the diversion of goods and services for military consumption
from civilian consumption.
(b) Post War Inflation: Immediately after the war the prices rise due to increase in disposal
income of the community as a result of withdrawal of war taxes or due to repayment of
public debt.
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(c) Peace Time Inflation: It occurs in the normal period due to increased government outlays
on capital projects having a long gestation period.
12.3.4 Coverage or Scope Point of View

(a) Comprehensive Inflation: It means increase in the price of every commodity throughout
the economy.
(b) Sporadic Inflation: It means rise in prices of specific goods due to fall in supply of those
goods.
12.3.5 According to Governments Reactions to the Prevalence of Inflation

(a) Inflation is Open: When prices rise without interruption. Free market mechanism is
allowed to play its role. The government does not attempt to control the inflation.
(b) Repressed Inflation: The government proposes controls.
(c) Profit Inflation: Originated by Keynes is considered by Prof. Brahmananda as a unique
category of inflation. It means prices rise due to excess investment over savings in the
economy.
12.4 INDICATORS OF MEASURES OF INFLATION

The different Price Indices and the GDP Deflator are as follows.
(1) Consumer Price Index (CPI): CPI is measure of the average change over time in the
prices paid by consumers for a market basket of consumer goods and services. Urban
inflation is measured with the help of CPI.
(2) Wholesale Price Index (WPI): WPI measures the average change in the prices of
commodities for bulk sale at the level of early stage of transactions. WPI in India is
published by the Office of Economic Adviser, Ministry of Commerce and Industry,
Government of India. The various commodities taken into consideration for computing
the WPI can be categorized into primary article, fuel and power, and manufactured goods.
While general inflation is measured in terms of WPI.
WPI reflects the change in average prices for bulk sale of commodities of the first stage
of transaction while CPI reflects the average change in prices of retail level paid by the
consumers. The weights of the WPI are based on production values whereas the weights
of the CPI basket are based on the average household expenditure taken from the
consumers expenditure survey conducted in the base year.
(3) Producer Price Index (PPI): Measures average Changes in input and output prices
from domestic producers perspective.
(4) GDP Deflator: Measures the price of output relative to its price in the base year. It
reflects what’s happening to the overall level of prices in the economy. Unlike the price
indices, for GDP deflator is not based on a fixed basket of goods and services- the “basket”
in each year is the set of all goods that were produced domestically.
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1. What is Inflation?
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..........................................................................................................................................
2. What is Running Inflation?
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12.5 TYPES AND EFFECTS OF INFLATION

Inflation is one of the major concerns among the economists across the globe. It makes
an impact on almost all spheres of economic activities. The origin of mainstream economics is
centrally focused with analysing trend, nature, determinants, types and effects of inflation.
Although various schools of economic thoughts differ in their views from the context of building
theories, the types and effects of it on various stakeholders is common to all.
12.5.1 Types of Inflation

As per the Robert J. Gordon, there are mainly three kinds of inflation from the point of
view of the causes of inflation.
1. Demand pull inflation
2. Cost-push inflation
3. Built in inflation
1. Demand - Pull Inflation: According to many economists, inflation takes place because
of the greater demand shock in the economy. As demand for goods and services increases
rapidly mainly because of the socio-political, economic or financial repercussions, then
prices of all goods and services start
rising at a rapid rate. Demand-pull Y D2
inflation is an inflation that results from S''
D1
an initial increase in aggregate demand.
Price level
Demand pull inflation is also caused by

D
increased government and private S' D2
spending than reflects in hike in D1
aggregate demand in the economy.
According to economists, the moderate S D
demand pull inflation is good for the O X
Aggregate output
economy as it accelerate economic
growth by enhancing economic Figure 12.1 Demand Pull Inflation
activities.
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In the following figure-12.1, the demand pull inflation is explained. On OX-axis aggregate
output and on OY- axis the price level are shown SS is the supply curve. DD curves are demand
curves.
The supply curve between S1 slope upwards i.e., when there is under full employment,
the price rise causes increase in production also but the increase in supply may not be
proportionate to the increase in demand and therefore prices rise. Between S1 S11 it is vertical it
means even if there is price rise supply will not increase, may be due to full employment level.
Then every increase in demand leads to increase in prices.
2. Cost - Push Inflation or Supply-Shock Inflation: The cost-push inflation is another
kind of inflation that is also called supply shock inflation. This kind of inflation takes place in
the economy when aggregate supply drops down drastically. This is mainly because of the
increases prices of the factors of production. It is mainly caused by an increase in wages and an
increase in the profit margins. Regarding the profit motivated price rise it occurs due to
monopolies in the product market. The monopolies may be induced to raise the prices in order
to fetch high profits. Then there is profit push
D'' S
in raising the prices. The increased cost of Y
production pressurizes the producers to hike the D'
price of the products in order to survive in the D D''
market. Trends in international commodity P''
F
prices and the effects of changes in indirect P' D'
P S2 S1
taxes on prices also contribute for cost push D
inflation. However, natural disaster may also S
cause the cost-push inflation that result in the
X
disaster prone regions. In the following figure- O Real output
12.2 the cost push inflation is explained. Figure 12.2: Cost Push Inflation
On OX- axis the inverse in real output and on OY-axis increase in price level are shown.
1
SS is the supply curve. The SF portion of the supply curve is slopping upwards indicating the
increase in real output with every increase in prices. But FS1 portion of the curve is vertical line
indicating the constant level of real output at OY level which may be explained as full
employment level. Then as cost of production increase due to wage increase or profit motivated.
A part of the supply curve, shifts upwards i.e., S to S1 and from S1 to S2. As a result new
equilibrium price occur i.e., P1and P11. It reflects the rise in prices from OP to OP1 and OP11
given the constant demand at DD. If however, the government or monetary authority is committed
to maintain full employment there will be more public spreading or more credit expansion
causing the price level to rise much more such as from P to P1 and P11.
3. Built in Inflation or Anticipated Inflation: Built-in inflation is also reflected as
hangover inflation It involves workers trying to keep their wages up with prices and then
employers passing higher costs on to consumers as higher prices as part of a “vicious circle.”
Built-in inflation is the persistence of inflation in the current period that was originated in the
past periods. It continues to prevail in the current period because for the reflection of the
economics conditions that got affected by the inflation in the past periods.
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In a simpler way it can be understood as follows. Inflation took place in the past period
either because of demand or supply shocks. That effect on macro economic conditions persists
and continues for a longer time period. That kind of inflation is generally termed as build in
inflation.
12.5.2 The Effects of Inflation

Inflation affects various section of the society in various ways. But inflation does not
make everyone poorer. Its effects among various stakeholders have been explained as under:
(1) Effects on Producers: Although the mild inflation is necessary and also good for the
business community. A little hike in price level asserts the optimistic attitude among the
producers by increasing profitability. The unutilized resources get utilized at a rapid rate
because for their increasing investment on production. But once, the inflation takes form
of hyper-inflation, it causes destructive effects on producers the aggregate demand for
the product comes down and the producers face greater loss. The producer tries to seek
profits by manipulating market rather than going for efficient process.
(2) Debtors and Creditors: The debtors borrow funds from the creditors during their needy
times; they repay the loans it at a future date with interest. Due to increased inflation,
they pay lesser amount in real terms to the creditors. Thus, the creditors suffer loss and
the debtor’s gains, if the inflation takes place during the repayment of loans.
(3) Farmers: The farmers generally are profitable during the inflation. They receive higher
sales revenue due to increased price level. The cost of production (generally interest and
taxes) remains constant or they do not rise much. The farmers are also looked as the
debtors and the government as creditors. When the inflation takes place, they pay less to
the government for land revenues. Hence the farmers gains during the inflationary
situations.
(4) Middle Class and Salaried Persons: The middle class and salaried persons are the
worst sufferers from the inflation. As their source of income is limited and to run their
households with the fixed amount of income, higher price level worsens their affordability.
Some of the lower middle class cannot even fulfil their basic requirements during inflation.
(5) Government: A democratic and well seeing government incur higher costs during the
inflationary pressures. The government spends more on budgetary actions for price-stability,
it spends on project works and team member to check and assess the inflationary pressures.
If the inflation is demand pull than it raises the tax rate to stop the higher aggregate demand.
(6) Wage Earners: The wage earners are also negatively sufferers from the hyperinflation.
Although the wage rate rises when inflation takes place it does not go in the same direction.
In other words, wage rate does not rise as much as the rise in inflation rate. As a result of
which they cannot meet their day to day cost of living. It is also agreed that there exists
a time between the rise in inflation and the rise in wage. The repercussion (negative) of
inflation is again more on unorganized labourers like labourers in agriculture than the
organized labourers. The organized labourers can bargain for higher wages through their
trade union and succeed at an easy effort.
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3. State about the Cost - Push Inflation.
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4. Which sections of the society affected by the Inflation?
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12.6 CAUSES FOR INFLATION IN INDIA

The causes can be classified into Monetary and Non-Monetary factors.
Among the monetary factors, the significant are:
i) Over expansion of money supply
ii) Expansion of bank credit
iii) Deficit Financing
iv) Increase in Public Expenditure
v) Huge investment on infrastructure and long gestation projects
vi) Black money
Among the non-monetary the important are:
i) Population growth
ii) National calamities
iii) Hoarding and Speculative activities
iv) Industrial Import Content
v) Underutilisation of production capacity
12.7 MEASURES TO CONTROL INFLATION

The measures to control inflation consists of those controlling excess demand and those
which promote production to fill the gap in supply of goods and services this is so since price
rise is due to pulls in demand or push in the costs. To control demand there are monetary
measures, Fiscal measure and other measures.
1) Monetary Measures
Aim at reducing the money supply and the consequential fall in demand. The weapons
under monetary measures are (a) Bank Rate (b) Open Market Operations and (c) Variable
Reserve Ratio. The other measures are (d) demonstration and (c) issue of new currency.
a) Bank Rate : Is the rate of interest changed by the Central Bank on the loans taken by
commerical banks. At the time of inflation, it rises the bank rate which ultimately leads
to rise in the interest rate charged by the commerical banks on the loan to business men.
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As a result, the loans already taken will be repaid and the new loans are restricted. Thus
the money circulation is cut down, the demand for goods fall, prices fall.
b) Open Market Operations: Means the central bank purchasing and selling bonds. At
the time of inflation the central bank prefers to sell bonds, so that the excess money
available with the public goes to central bank and as a result the money circulation,
demand for goods and prices of goods are lowered.
c) Variable Reserve Ratio: It is the ratio that Commercial Banks have to keep out of their
deposits in central bank. During the inflation the Central bank increase the ratio that is to
be kept in it. Then the scope of giving loans by the commerical banks is restricted and
money circulations falls, demand falls, prices fall.
d) Demonetisation: Of currency of higher demoninations. Such a measure is usually adopted
when there is abundance of black money in the country. But this measures reflect the
inability of the government to control inflation by their measures. So generally this is
not used frequently.
e) The extreme monetary measure issue of new currency in place of old currency. Under
this system one new note is exchanged for a number of notes of the old currency. The
value of bank deposits is also fixed accordingly. Such a measure is adopted when there is
an excessive issue of notes and there hyper inflation in the country. This measure is
inequitable as it hurts the small depositors the most.
2) Fiscal Measures
Relate to budgetary changes from time to time with regard to the public revenue or
public expenditure. The principal fiscal measures are (a) Taxes (b) Reduction in public
expenditure (c) cutting down personal consumption expenditure (d) promoting savings and (e)
avoiding deficit financing.
a) Taxes: Personal income tax, estate duty, gift tax which are direct in nature reduce the
disposable income in the public. Then the demand for goods fall and price fall.
b) Reduction in Public Expenditure: Causes restricted flow of incomes to the public. At
low levels of income the demand for goods is low and prices may continue at low level.
c) Domestic Personal Consumption: Can be cut down by improving heavy indirect taxes
like excise, sales taxes. These taxes, when imposed discourage unnecessary consumption
and demand for goods. In this connection, it is necessary that increase in this taxes
should not be so high that they discourage saving, investment and production.
d) Promoting Saving: Savings in the public may be promoted by proper incentives for
savings in personal income tax, corporate tax. If necessary the government may adopt
the policy of forced savings like compulsory deposits schemes etc. It can also float public
loans on condition of repayment after some time. All these restrict the money supply
and demand for goods and services.
e) Now a days in developing economics government adopt the policy of deficit financing
to fill the gap between the proposed development expenditure and the public revenue.
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The deficit financing itself may not be inflationary, but when it is spent on long gestation
projects and on building the infrastructure facilities it leads to inflation. Therefore, it
would be proper to avoid deficit financing at the time of inflation.
12.8 IMPORTANT CONCEPTS ON THE LITERATURE OF

INFLATION
There are some important concepts in the economic literature connected with inflation.
They are: 1) Inflationary gap; 2) Phillips curve; 3) Stagflation; 4) Deflation and 5) Inflation tax.
(1) Inflationary Gap: This is an important concept explained by Keynes in his pamphlet
“How to pay for the war” in 1940. Keynes defined the inflationary gap as an excess of
public expenditure over the available output at pre-inflation or base prices. It implies
that inflation occurs mainly because of excess of expenditure over income at the full
employment level. The larger aggregate expenditure, the larger the gap and the more
rapid rise in inflation. The concept of inflationary gap is used by Keynes just only to
show the main determinants that cause the rise of prices.
(2) Phillips Curve: The technique of Phillips curve is used to explain the relationship between
the rate of unemployment and the rate of money wages. A.W. Phillips explained this
based on the empirical evidence in U.K. According to him there is inverse relationship
between the two, i.e., when the unemployment is low the rate of increase in money wage
rate is high. The reasons are:
a) When the demand for labour is high and there are very few unemployed the employer
prefer to pay higher wage rates,
b) In a period of rising business activity when unemployment falls with increasing demand
for labour, the employees with bid up wages.
c) The change in cost of living as indicated by the rate of change of retail prices. If increase
in demand for labour and employment is followed by proportionate increase in labour
productivity the prices will not rise. If the rate of increase in money wage rates is higher
than the growth rate of labour productivity, prices will rise.
(3) Stagflation: Stagflation is a situation in which the economy experiences stagnation or
unemployment along with a high rate of inflation. It is otherwise called as inflationary
recession. The concept is coined in 1970 combining stagnation “Stag” plus inflation
(“flation”).
The cause for stagflation is restriction in the aggregate supply. When aggregate supply is
reduced there is a fall in output and employment and the price level rises. A reduction in
aggregate supply may be due to a restriction in labour supply. The restriction in labour
supply in turn may be by a rise in money wages on account of strong unions or by a rise
in the legal minimum wage rate, or by increases tax rate which reduce work effort on the
part of workers. When wage rise, firms are forced to reduce production or employment.
Consequently there is a fall in real income and consumer expenditure. Since the decline
in consumption will be less than the fall in real income, there will be excess demand in
commodity market which will push up the prices.
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Another reason for fall in aggregate supply is the increase in indirect taxes by central,
state and local governments. When indirect taxes are increased they raise costs or price
and reduce output and employment. Moreover, when the government increases taxes, it
leads to the transfer of real purchasing power from the people to the government. As
result aggregate demand falls and output and employment adversely affected. If however,
the government increases its expenditure equal to the increase in tax revenue it would
raise the price level further due to increase in additional demand.
The measures to come out stagflation are: 1. To keep the minimum wages constant, 2. To
follow tax bases income policies, 3. Limiting the increase in money wages with
productivity increase, and 4. To reduce personal and business taxes because they lend to
reduce labour costs and raise demand labour.
4. Deflation: During the deflation period the prices of goods and services in the economy
steadily decreases. The price level falls persistently if aggregate demand increases at a
persistently slower rate than aggregate supply. Deflation is different from fluctuations in
the prices. A onetime fall in the price level is not deflation. Deflation is marked by long-
term trend of falling prices for goods and services. During the period of deflation, the
real value of money increases. In other words, Purchasing power of money is increased.
However, deflation can be bad for the economy. Lower prices mean lower profits for
business. In this situation, firms reduce the workforces and it has impact on aggregate
demand for goods and services. As more and more people lose their jobs, the
unemployment rate rises.
Deflation, likes inflation produces both winners and losers - but in the opposite direction.
Due to the falling price level, a Rupee in the future has a higher real value than a Rupee
today. Therefore, lenders, who are owed money, gain under deflation because the real
value of borrowers’ payments increases. Borrowers lose because the real burden of their
debt rises.
5. Inflation Tax: When the government raises revenue by printing money, it is said to levy
an inflation tax. The inflation tax is not exactly like other taxes, however, because no
one receives a bill from the government for this tax. Instead, the inflation tax is more
subtle. When the government prints money, the price level rises, and the Rupee in your
wallet are less valuable. Thus, the inflation tax is like a tax on everyone who holds
money.

5. What are the monetary causes for inflation in India?
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6. Briefly explain about Phillips Curve.
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12.9 SUMMARY
This unit explained a view the problem of the multi-faceted problems of inflation and
discussed its various aspects. Inflation means increased prices. However, not every rise in price
may constitute inflation. Sustained increase in prices over time is called inflation. It is a situation
is which general level of prices or average price level rises or value of money falls. It is not
proper to define it is too much chasing too few goods because without reference to money,
inflation can be analysed. In addition, you were explained demand-pull and cost pull inflation.
The root cause of inflation is the structure of economy and pattern of investment. Wrong pattern
of investment is the root cause of inflation.
Inflation is measured as a rate per period. It is measured both in terms of WPI and CPI.
While general inflation is measured in terms of WPI. Urban inflation is measured with the help
of CPI. In the short period, during periods of inflation debtors lose and creditors gain. Inflation
redistributes wealth and income from poor to rich. As inflation is a multi-faceted phenomenon,
it cannot be controlled easily. A multi-pronged attack is needed. It can be tackled through
demand or supply management. Fiscal and monetary tools are used to reduce inflationary
pressures. The best solution to inflation is raising production and productivity, which is possible
in the long run.

1. The rise in price level or fall in the value of money. It should be noted that this rise in
price level is not a temporary phenomenon, but is continuous and sustained over a long
period.
2. A rapid acceleration in the rate of rising prices is called Running inflation. It occurs
when the prices rise by more than ten percent per annum.
3. The cost-push inflation is another kind of inflation that is also called supply shock inflation.
This kind of inflation takes place in the economy when aggregate supply drops down
drastically. This is mainly because of the increases prices of the factors of production. It
is mainly caused by an increase in wages and an increase in the profit margins.
4. Inflation affects various section of the society in various ways. However, inflation does
not make everyone poorer. Its effects among various stakeholders, they are: i. Effects on
Producers; ii. Debtors and Creditors; iii. Farmers; iv. Middle Class and Salaried Persons;
v. Government; and Wage Earners.
5. The monetary causes for inflation in India are: i. Over expansion of money supply; ii.
Expansion of bank credit; iii. Deficit Financing; iv. Increase in Public Expenditure; v.
Huge investment on infrastructure and long gestation projects; and vi. Black money.
6. The technique of Phillips curve is used to explain the relationship between the rate of
unemployment and the rate of money wages. A.W. Phillips explained this based on the
empirical evidence in U.K. According to him there is inverse relationship between the
two, i.e., when the unemployment is low the rate of increase in money wage rate is high.
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1. Define the concept of Inflation.
2. What are the Indicators of measure of Inflation?
3. Explain the concept of Stagflation.

1. Explain the economic benefits and challenges of inflation.
2. What are the causes for inflation in India?
3. Discuss the various types of Inflation.

1. “Inflation occurs when the general level of prices and costs is rising.” this definition
given by -
a) Adam Smith b) Paul Samuelson c) A.C. Pigou d) J.M. Keynes
2. When government spends too much money on various investment projects/social welfare
Schemes and which will cause -
a) Cost Push Inflation b) Hyper Inflation c) Reflation d) Deficit Inflation
3. The Phillips curve shows the relationship between inflation and what?
a) The balance of trade b) The rate of growth in an economy
c) The rate of price increases d) Unemployment
Answers: 1. b; 2. d; and 3. d

1. Inflation is a ______________ in the general level of prices over time.
2. Inflationary Gap is an important concept explained by _________________
4. Hyperinflation refers to the situation, where the __________________are too sharp.
4. During the Inflation times, the repayment of loans the creditor’s ____________
Answers: 1. Rise 2. Keynes and 3. Suffer loss

A B
1. Cost - Push Inflation a) Inflation tax
2. Increase in Public Expenditure b) A tax on everyone who holds money
3. Monetary factor c) Supply shock inflation
Answers: 1) c; 2) a; and 3) b
209
12.12 GLOSSARY
1. Consumer Price Index (CPI): It is a price index that tracks the prices of a specified
basket of consumer goods and services, providing a measure of inflation.
2. Cost Push Inflation: Cost push inflation occurs when the increasing cost of production
pushes up the general price level.
3. Cost of Living Index: It measures the cost to maintain a constant standard of living.
4. Deflation: Deflation refers to a situation, where there is decline in general price levels.
5. Demand Pull Inflation: Inflation caused by increase in aggregate demand, not matched
by aggregate supply of goods, resulting in rise of general price level.
6. Galloping or Hyper Inflation: It is a stage of inflation, which starts after the level of
full employment is reached. Here price level rises very rapidly within a short period.
7. GDP Deflator: It a price index that shows how much of the change in the GDP from a
base year is reliant on changes in the price level.
8. Hyperinflation: Hyperinflation is a situation where the price increases are too sharp.
9. Inflation: Inflation states, in which the value of money is falling, i.e., prices are rising.
10. Monetary inflation: It is a type of inflation, which is caused by a too rapid increase in
the money supply and by nothing else.
11. Reflation: Reflation is a type of controlled inflation deliberately undertaken to relieve a
depression.
12. Running inflation: It is a type of inflation in which the price increase is about 8 to 10
percent per annum.
13. Stagflation: Stagflation refers to economic condition where economic growth is very
slow or stagnant and prices are rising.
14. Tax Inflation: It is a type of inflation in which sellers charge high price to the consumers
due to rise in indirect taxes,
15. Walking inflation: Walking inflation is a marked increase in the rate of inflation as
compared to creeping inflation.
16. Wholesale Price Index (WPI): WPI is the index that is used to measure the change in
the average price level of goods traded in wholesale market.

1. Ahuja, H.L: Modern Economics, S. Chand & Company Ltd; New Delhi, 2006.
2. Ahuja, H.L: Macro Economics: Theory and Policy, S. Chand & Company Ltd; New
Delhi, 2004.
3. V. Vaish MC: Macro Economic Theory, Vikas Publishing House Pvt. Ltd; New Delhi,
2005.
5. Dewett, K.K. Modern Economic Theory, S. Chand & Company Ltd; New Delhi, 2005.
210
UNIT – 13 : TRADE CYCLES
Contents
13.0 Objectives
13.1 Introduction
13.2 Meaning and Definitions of Trade Cycles
13.3 Nature and Features of Trade Cycles
13.4 Phases of Trade Cycles
13.5 Theories of Trade Cycles
13.5.1 Classical Theories
13.5.2 Modern Theories
13.6 Causes of Trade Cycles
13.7 Effects of Trade Cycles
13.8 Measures Required to Control Trade Cycles
13.9 Summary
13.12 Glossary
13.0 OBJECTIVES
The purpose of this unit is to explain nature, features, phases, theories, causes and effects
of Trade Cycles. After reading this unit, you will be able to:
• understand the concept of Trade Cycles;
• explain the nature and features of Trade Cycles;
• describe the causes and phases of Trade Cycles;
• know the effects of Trade Cycles; and
• suggest the measures to solve trade cycle problems.
13.1 INTRODUCTION
Economic development of any country is not going smoothly without fluctuations. Every
time changes are taken place in Investment, Production, Prices and Employment levels. Changes
in economic activities are common to each economy. However, in Capitalistic economies level
of economic activities is not constant. Fluctuations in economic activities are important feature
in these economies. For each country, economic development is common and in the similar
way changes in economic activities are also common. We can observe changes in production,
wages, profits, interest rates, bank deposits, exports and imports in each country’s economy.
211
13.2 MEANING AND DEFINITION OF TRADE CYCLES
In a country’s economic activities, sometimes optimistic changes and other times
pessimistic changes may takes place. This type of optimistic and pessimistic changes in economic
activities can be called as Trade Cycles. It means regular fluctuations in economic activities of
a nation are termed as Trade Cycles. These regular fluctuations arise one after the other and
influences economic development of a nation.
Definitions:
Trade Cycles are defined by different economists in different ways.
“Trade Cycles are regular fluctuations in income, output and employment.” - R.A. Gordon
“A trade cycle may be defined as a period of prosperity followed by a period of depression.
The economic process should be irregular and trade being good at some time and bad at others.”
Benhaam
“A trade cycles is composed of good trade characterized by rising prices and low
unemployment percentages, altering with periods of bad trade characterized by falling prices
and high unemployment percentages.” - Keynes
13.3 NATURE AND FEATURES OF TRADE CYCLES

Trade cycles are irregular, non- periodic fluctuations in the macro economy, especially
seen by changes in the unemployment rate, the inflation rate, and growth rate of real GDP. This
means that the overall economy expands and grows for a while. How long? It could be a
couple of years. It might be up to a decade. No one knows for sure. But then it contracts and
declines for a while. How long? It could be six months. It might be a few years. No one knows
when the economy expands and contracts. It grows in spurts, it stops, and it declines. Things
are good, then bad. Unfortunately, no one knows how long the good times will last before they
turn bad. This is the non-periodic, irregular nature of trade cycles. The economy might expand
for a year or it might expand for a decade before it contracts. While the term “cycle” is used to
indicate these fluctuations, trade cycles are not cyclical or periodic in the same way as other
noted cycles, such as the daily cycle of sunrise and sunset, the lunar cycle of full moon and new
moon, or the seasonal cycle of spring, summer, fall, and winter.
The Trade Cycles have the following features:
i. Trade Cycles are related to entire economic system. It means fluctuations in economic
activities are not limited to a particular sector. These are spread over to all the sectors of
the economy.
ii. Changes in production, income, employment and prices.
iii. Economic system fluctuates between economic prosperity and depression.
iv. Trade Cycles can spread from economic system of a country to economic system of
another country.
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v. Fluctuations in business are not limited to one time, after sometime they may come
again and again.
vi. Trade Cycles are cumulative. Ex., if economic prosperity starts, it develops speedily
without under the control of policy makers.
vii. Any two Trade Cycles are not one and the same. Each Trade Cycle prosperity and
depression stages are not symmetry. Different Trade Cycles shows different effect in
various sectors.
viii. Economic crisis arises due to Trade Cycles. Speedy changes from top to bottom lead to
economic crisis.
ix. The changes in prices, production, employment and income levels result into changes in
currency and its circulation.
x. Changes in the prices of agricultural products are more than the changes in the prices of
industrial products.

1. What is meaning of Trade Cycles?
..........................................................................................................................................
..........................................................................................................................................
2. State two features of Trade Cycles.
..........................................................................................................................................
..........................................................................................................................................
13.4 PHASES OF TRADE CYCLES

The following are the phases of Trade Cycles: 1. Economic depression or slump; 2.
Recovery; 3. Prosperity or Boom; and 4. Recession.
1. Economic Depression or Slump: This stage is dangerous in Trade Cycles. Economic
activities are very low level in this stage. It means economic activities are below to
normal level. Production and employment is very low level and prices of products and
wage rates decrease more. Prices are less than wage rates. So, producers incur losses.
Even though real wages are more but money wages decrease. This stage is bad to producers
and employees. Bank credit is in low level and banks pressurize to their customers to
repay the loans. Unemployment increases consequently wage rates also decrease.
Decreases in prices of agricultural products are more than the decrease in the prices of
industrial products. Wholesale prices decreases more than retail prices. Unexpected
changes in prices lead to great changes in production and exchange of goods. Income of
shareholders decreases speedily. So, bank deposits decrease. In this stage, construction
industry incurs more losses. This stage helps to redistribution of Nation Income. Thus,
213
in this stage people in all sectors and industries are in depression and problems.
2. Recovery: This stage will come soon after depression in Trade Cycles. In this stage,
economic activities are slowly improved. All types of economic activities are increased
systematically in this stage. Situation is not bad as in the depression. Production and
employment level slowly increases. Increased unemployment in the depression will
decreases in this stage. Increase in production and employment levels leads to increase
in income of all sectors of the people. In the first stage of the recovery, prices are
constant. Later on, prices start rising and producers get more profits. Wages will also
increase. But, this increase is less than the increases in prices. Since profits are more
investors are interested to invest more in industries. This results in increase in bank
credits. Velocity of circulation in money increases. Hence, economic activities increase.
Construction industry also starts getting strengthened. In this stage, people in all sectors
will come out of depression. Recovery happens slowly because; we cannot say perfectly
how much time it will take to complete this stage.
3. Prosperity or Boom: Economic activities which were started in recovery stage reach
maximum point in this stage. This stage is welcomed by all and economic activities
reach optimum stage. All factors of production are fully utilized. We can see more
increase in production, prices, profits and investments. In this stage, full employment
can be achieved. Construction industry starts prospering. Share market can give more
profits to investors. Due to increase in interest rates, financial institutions create more
credit. In this stage, all people are happy. But, this prosperity stage is not permanent.
Hence, this happiness may not a permanent one.
4. Recession: Happiness in all sectors people during prosperity stage cannot stay for a
longer time. After some time it leads to Recession. After reaching a peak level, the
economic activities are being constant they create so many problems. Producers and
business men regret themselves for the mistakes because expectations of these people
during the prosperity will get reversed, economic activities start falling. Due to increase
in the prices, purchasing power of the employees decreases. There is high increase in
production but demand is less. As a result, they have to sell the goods at lower prices.
Profits decrease and confidence of business people will also decrease. So, the firms
which are started with high expectations have to be closed. It results in decrease in
production and employment. Construction industry will be in trouble. Hence,
unemployment increases more. Due to un-employment, income and expenditure decreases.
Share market becomes dull. Credit facilities are reduced by banks. During prosperity all
people will have over optimism, but in this stage they change into over pessimism. People
in all sectors are in fear. Once economic activities are in recession, if controlling measures
are not taken, it leads to economic depression.
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The phases of Trade Cycles are shown here under.
Phases of Trade Cycles
Economic depression
Recession Recovery
Prosperity
The Structure of Phases of Trade Cycles are shown here under.

Y
Economic
Depression Turning Point
Real
Productio
n
O X
Recovery Prosperity Recession Time
Turning
point
Characteristics of various Phases of Trade Cycles
Characteristics Depression Recovery Prosperity Recession
1. Employment Less Slow increase More Suddenly decreases
2. Industrial Less Slow More (but Falls
Production increase obstacles will
appear in the
later stages)
3. Wage rates Less Increase More (but less Decreases (but these
(but less than than prices) are less than prices)
prices)
4. Prices Less Slowly More (It is very Decreases speedily
increase high in later
stages)
5. Bank loans Less Spread More Decreases more
6. Bank More Slowly Less Suddenly
Reserves decrease increases
7. Bank Meager Slowly More Suddenly decrease
Clearings increase
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8. Discount Less Sufficiently Increases More
Rates
9. Cost of Less Slowly More (more in Decrease
Production increase later stages)
10. Profits Positive Increase More Sometimes missing
(but decreases)
11. Business More less Less Suddenly increase
Failure
12. Speculation Very less Slowly It spreads Less
increase all over
13. Business Less Slowly More (more & Suddenly decrease
Inventories increase more in later
stages)
14. Construction Approximately (Except More (more & Suddenly decrease
of Buildings nothing Government more later
slowly stages)
increase
works)
15. Concept Pessimism Carefully guess Optimistic Reverse

3. What are the phases of Trade Cycles?
..........................................................................................................................................
..........................................................................................................................................
13.5 THEORIES OF TRADE CYCLES

To know how Trade Cycles occur, we have to understand different theories of Trade
Cycles propounded by various economists. The following are the important theories of Trade
Cycles.
Theories of Trade Cycles are mainly classified into two types: They are 1. Classical
Theories; and 2. Modern Theories.
13.5.1 Classical Theories

The classical theories classified into four types. The following are 1. Climatic Theory;
2. Psychological Theory; 3. Over-production Theory; 4. Under Consumption Theory; and 5.
Innovation Theory.
1. Climatic Theory: This theory is the oldest theory in the theories of Trade Cycles. This
theory was propounded by Sir Willium Harchel and Willium Stanly Jevons. According
to their argument, sun spots arise in the sun lead to changes in climatic conditions and
fluctuations in agricultural production. When climatic conditions are favorable then
216
agricultural production increases there by income of the formers increase. When climatic
conditions are not favorable then agricultural output falls. It results economic depression.
Changes in climatic conditions shows its effect on agricultural sector and there by Trade
Cycles arises this type of their argument is not correct, because Trade Cycles are more in
industrially developed countries.
2. Psychological Theory: This theory was propounded by Sir Willium Beveridge, A.C.
Pigou and Jhon Lescur. According to their argument, Psychology of business men is
the cause for arise of Trade Cycles. It means that over optimism and over pessimism
among the business people is the cause for Trade Cycles. When business people are
optimistic then they felt that in future they may get more profits. Hence, they invest
more. When business people are pessimistic they feel that in future they may incur losses,
and then they invest less. Hence, Economic depression occurs. This type of optimism
and pessimism spreads to other business people also. Though this theory is true to some
extent, this theory does not give complete picture.
3. Over Production Theory: According to this theory, over production is the cause for the
Trade Cycles. Competition among the producers leads to over production. This results
fall in prices. But the cost of production does not fall. This is because every producer
wants to have grip over the market. After some time, to get minimum cost of production
if producers increase prices of their goods, demand for those goods decreases, because
consumers postpone their purchases. This results in incurring losses to producers and
business people. Due to this producers and business people will become bankrupt. There
by business firms are forced to close and it leads to economic depression. Thus,
competition psychology among the producers leads to over production there by cause
for Trade Cycles. This theory does not explain why Trade Cycles occur. We cannot say
competition is only the cause for Trade Cycles.
4. Under Consumption Theory: This theory was propounded by Duggulas and Hobben..
According to this theory inequality in the incomes of the people is the cause for Trade
Cycles. Income is the source to savings. Rich people are having more income. So, they
can save more. These savings become investment and results in increased production
and that leads to the economic welfare or prosperity. Poor people have less income their
little income is enough for consumption expenditure. So, there are no savings, if no
savings then no investment. Hence, production falls. It leads to economic crisis. When
incomes of the people are low disequilibrium arises between demand and supply of
goods and that leads to economic depression conditions. According to this theory, savings
and investments of people are only the cause for occurring Trade Cycles. It ignores
other causes. To convert savings into investment, rate of interest and profits play an
important role.
5. Innovation Theory: This theory was propounded by Joseph A Schumpeter. According
to him innovation is the cause for cyclical fluctuations in capitalistic economies.
Innovation means using new techniques of production and using new raw materials.
Innovators are investing more to increase production by using new methods. This situation
217
starts with big entrepreneur and then it spreads to small entrepreneurs also. Over
investment leads to over production and goods in the market are more than the demand
for them. Hence, prices fall there by entrepreneurs are incur losses. This leads to economic
crisis. This theory explains innovation is only the cause for Trade Cycles. It ignores
other factors.
13.5.2 Modern Theories

Modern theories are classified into two types. The following are 1. Keynisian Theory;
and 2. Hawtrey’s Theory.
1. Keynisian Theory: According to Keynes, changes in interest rates, marginal efficiency
of capital and changes in investments are the causes for Trade Cycles. In an economy,
total money supply and liquidity preference of people determine the rate of interest.
Marginal efficiency of capital depends on price of capital assets and expected profits on
them, rate of Interest and marginal efficiency of capital determine investment. During
economic depression businessmen becomes optimistic and they felt that we can get profits
in future so they invest more. At this stage even marginal efficiency of capital is also
high. Due to more investments, all factors of production get employment and there by
their level of Income increase. While increasing the level of income marginal consumption
behavior decrease, after reaching peak level of the economic activities marginal efficiency
of capital start falling. Then business people become pessimistic and they reduce the
investment or they stop the investment as economic depression starts. Keynes theory
has given much importance to investment multiplier. This theory explains psychological
theory in a new dimension.
2. Hawtrey’s Theory: According Hawtrey, changes in money supply is the cause for Trade
Cycles. He states that changes in quantity of money determine the purchasing power of
the people. When purchasing power decreases, then demands for goods are decreases,
and it leads to Business Cycles. While decreases in the consumers expenditure quantity
of money and velocity of money circulation falls and that leads to economic depression
and on the contrary when consumers expenditure increases quantity of money and velocity
of money circulation rises, that leads to economic prosperity. In modern economy deposit
money play an important role. The fluctuations in the deposit money is also cause for
crating Trade Cycles because a rise in deposit money leads to economic prosperity and
decrease in deposit money leads to economic depression. Hawtrey argues that Trade
Cycles occurs in monetary economics only. But, this argument is not corrects because all
economies in the world are working with money. So, in each economic system Trade
Cycles arise due to many other causes in addition to changes in quantity of money. This
theory ignores Non-monetary issues. Hence, this theory is incomplete one.
13.6 CAUSES OF TRADE CYCLES

There are so many causes for the Trade Cycles. The following are some of the important
causes for Trade Cycles:
218
1. Due to changes in money, purchasing power also changes Trade Cycles arise.
2. Every country wants to achieve economic development. Technical changes which can
influence economic development in the short run is one of the causes for arise of Trade
Cycles.
3. Interest rates of banks also cause for arising Trade Cycles. Due to fluctuations in the rate
of interest of banks, over production and under production causes for expansion and
depression.
4. The capital changes in capital goods due to changes in marginal efficiency may lead to
Trade Cycles.
5. Psychology of business men which will be in between optimism and pessimism may
lead to create Trade Cycles. When Business men expect that more profits will come
then they invest more and produce more goods. But after some time, when consumption
is less than production then they may incur losses. It means that economic activities are
shifted from prosperity to recession.
6. Increase or decrease in agricultural production due to changes in climatic conditions
may lead to Trade Cycles.

4. State any two causes for the Trade Cycles.
..........................................................................................................................................
..........................................................................................................................................
13.7 EFFECTS OF TRADE CYCLES

Effects of Cyclical fluctuations on Business Firms
How Business firms are affected by cyclical fluctuations depend on the nature of business
performed by them. In business expansion period, demand for products business is increases.
Then prices of goods are more than their cost of production which leads increase in profits. So,
producers and business men feel happy. This stage may be called as expansion.
This optimistic situation continues up to sometime only. After that price of raw materials,
wages, rents, rate of interests collected by banks etc., increase there by cost of production
increases. But prices of goods do not increased that much. So, producers and Business people
are in troubles, and then dis-equilibrium arises between production and demand. This leads to
not only reducing the profits to the business men but also they incur losses also. Hence, this
situation is starting stage of recession.
In an economy expansion and recession is common. Small firms and big firms are
mixed in the business. During economic depression there is a danger that small firms may be
closed. But, big firms try to adjust to the fluctuations. Cyclical fluctuations are not in our
control. So, business firms have to adjust themselves according to the situations.
219
13.8 MEASURES REQUIRED TO CONTROL TRADE CYCLES
There are two methods to solve the problems arising out of Business Cycles. They are 1.
Preventive measures; and 2. Relief measures.
1. Preventive Measures: we can prevent the economy from economic crisis when economic
activities are in peak level in an economy by imposing controls on purchases, by safe
guarding assets and removal of irrational expansion of credit.
2. Relief Measures: Businessmen and producers can come out of economic crisis by way
of reducing cost of production, increase of quality of goods and increase of demand for
goods in the market.
In an economy, stabilization of prices by control of Trade Cycles is necessary. The central
bank tries with its credit control methods to stabilize business activities in the economy. But,
these activities failed to encourage economic activities and to control the situations of great
depression which came into existence throughout the world during the period of 1929 to 1934.
We can achieve economic stability by controlling of Trade Cycles through Fiscal Policy.
Fiscal policy means policy of public expenditure and taxation policy. Government can save
the economy by controlling Trade Cycles through by following deficit budget during economic
depression and by introducing surplus budget during economic prosperity; thereby we can
achieve economic stability and price stabilization. Tax rate are low during economic depression
when compared to in the periods of economic prosperity.
By following direct action like control on investments, industrial licensing policy, foreign
exchange control, rationing policy the government tries to achieve economic stability there by
stabilization of prices and control.
13.9 SUMMARY
Trade Cycles are regular fluctuations in income, output and employment. Trade cycles
are irregular, non- periodic fluctuations in the macro economy, especially seen by changes in
the unemployment rate, the inflation rate, and growth rate of real GDP.
Trade Cycles are related to entire economic system. They can spread from economic
system of a country to economic system of another country. Fluctuations in business are not
limited to one time, after sometime they may come again and again. Economic crisis arises due
to Trade Cycles. Speedy change from top to bottom leads to economic crisis. Due to changes
in money, purchasing power also changes Trade Cycles arise. Every country wants to achieve
economic development. Technical changes which can influence economic development in the
short run is one of the causes for arise of Trade Cycles. Interest rates of banks also cause for
arising Trade Cycles. Due to the fluctuations in the rate of interest of banks, over production
and under production causes for expansion and depression. The capital changes in capital
goods due to changes in marginal efficiency may lead to Trade Cycles. Psychology of business
men which will be in between optimism and pessimism may lead to create Trade Cycles. When
Business men expect that more profits will come then they invest more and produce more
goods. But after some time, when consumption is less than production then they may incur
220
losses. It means that economic activities are shifted from prosperity to recession. Increase or
decrease in agricultural production due to changes in climatic conditions may lead to Trade
Cycles.
How Business firms are affected by cyclical fluctuations depend on the nature of business
performed by them. In business expansion, demand for products of business increases. Then
prices of goods are more than their cost of production which leads increase in profits. So,
producers and business men feel happy. This stage may be called as expansion. This optimistic
situation continues up to sometime only. After that price of raw materials, wages, rents, rate of
interests collected by banks etc., increase there by cost of production increases. But prices of
goods do not increased that much. So, producers and Business people are in troubles, and then
dis-equilibrium arises between production and demand. This leads to not only reducing the
profits to the business men but also they incur losses also. Hence, this situation is starting stage
of recession.

1. Optimistic and pessimistic changes in economic activities can be called as Trade Cycles.
It means regular fluctuations in economic activities of a nation are termed as Trade
Cycles. These regular fluctuations arise one after the other and influences Economic
development of a nation.
2. The features of Trade Cycles are i) Changes in Production, Income, Employment and
Prices. ii) Economic System fluctuates between economic prosperity and depression.
3. The following are the phases of Trade Cycles: 1. Economic depression or slump; 2.
Recovery; 3. Prosperity or Boom; and 4. Recession.
4. The following are some of the important causes for Trade Cycles: i) The capital changes
in capital goods due to changes in marginal efficiency may lead to Trade Cycles. ii) Due
to changes in money, purchasing power also changes Trade Cycles arise.

1. State the nature of Trade Cycles.
2. What are the causes of the Trade Cycles?
3. Explain the features of different stages of Trade Cycles.
4. In an economy how price stabilization is possible?

1. Define Trade Cycles and explain their features.
2. Describe the different phases of Trade Cycles.
221
1. The low point in the business cycle is referred to as the
(a) Expansion (b) Boom (c) Trough (d) Peak
2. When aggregate economic activity is increasing, the economy is said to be in
(a) an expansion (b) a contraction (c) a peak (d) a turning point
Answers: 1. c; and 2. a
B. Fill in the Blanks.

1. A rising aggregate price level is referred to as ———————
2. ________________of banks also cause for arising Trade Cycles.
Answers: 3. Inflation; and 4. Interest rates
C. Match the Following.

A B
1. Optimistic and pessimistic changes a) Recession is common
2. Depression or Slump b) Trade Cycles
3. An economy expansion c) Economic activities very low
Answers: 1. b; 2. c; and 3. a
13.12 GLOSSARY
1. Boom: Boom refers to the peak in the level of economic activity after full employment.
The demand pressures will be at the peak. The price level will be very high.
2. Contraction: A contraction, or decline, in the business phase marks the end of the
expansion or prosperity phase.
3. Depression: This is the lowest level of economic activity. In this time the markets collapse.
Large scale unemployment will lead to poverty and suffering. The world experienced
Great depression during 1929 and 1933.
4. Expansion: The expansion or growth stage of the business cycle is marked by a strong
economy. During this phase, people are making money and the demand for goods and
services begins to increase.
5. Prosperity: The prosperity stage typically follows the expansion stage. As the economy
continues to operate at full, or near to full, capacity, and prices for goods and services
increase, workers tend to ask for raises. Consequently, wages also tend to rise during
periods of prosperity. The cost associated with higher wages also translates into additional
inflation as higher wages means a higher cost to produce goods and services.
6. Trade Cycles: Regular fluctuations in economic activities of a nation are termed as
Trade Cycles.
222
7. Recession: When the economic activity reduces below full employment. It is called
recession. The level employment will decreases, the prices will decrease and the economic
activity shrinks.
8. Recovery: From the lowest levels of economic activity the markets recover due to positive
Government policy. The economic activity will increase towards full employment. There
will be increase in the level of employment, incomes, investment and demand.

Delhi, 2004.
3. V. Vaish MC: Macro Economic Theory, Vikas Publishing House Pvt. Ltd; New Delhi,
2005.
5. Dewett, K.K. Modern Economic Theory, S. Chand &Company Ltd; New Delhi, 2005.
223
DR. B.R. AMBEDKAR OPEN UNIVERSITY
FACULTY OF SOCIAL SCIENCES
B. A. II YEAR - SEMESTER - 3
MODEL EXAMINATION QUESTION PAPER
Subject: ECONOMICS
Course - 2: Macro Economics
Time: 3 Hours
[Max. Marks: 100]
[Min. Marks: 40]
SECTION – A
[Marks: 5 x 4 = 20]
Instructions to the Candidates:

a) Answer any Five of the following questions in about 10 lines each.
b) Each question carries Four marks.
1. Explain Production Function.

2. Explain the conditions which require Equilibrium level of Employment.
3. Examine the relationship between APC and APS.
4. Define the "Multiplier" and distinguish it from the "Super-Multiplier".
5. What are the causes of the Trade Cycles?
6. What is Money? and discuss its classifications.
7. State the concept of High Powered Money.
8. What are the Indicators of measure of Inflation?
9. Explain the expenditure method of estimating national income.
10. What is Liquidity Trap?
SECTION – B
[Marks: 5 x 12 = 60]
a) Answer all the following questions in about 30 lines each.
b) Each question carries 12 marks.
11. (a) Explain Classical theory of employment.

Or
(b) "Keynesian Economics does represent a genuine break with classical
economics". Discuss.
12. (a) Elucidate the Keynesian Theory of Consumption.

Or
(b) Discuss the concept of Investment Multiplier and its role in the theory of
income and employment.
224
13. (a) Define Trade Cycles and explain their features.
Or
(b) What are the different forms of money in the modern economy?
14. (a) Examine the determinants of money supply in India.

Or
(b) Discuss the various types of Inflation.
15. (a) Discuss the Qualitative Credit Control methods of RBI

Or
(b) Discuss the modern theory of interest.
SECTION – C
[Marks: 20 x 1 = 20]
a) Answer all of the following questions.
b) Each question carries One mark.
A. Multiple Choice Questions. Choose the Correct Answer.

16. Interest is a reward for
a) Investment b) Saving c) Capital d) None
17. According to Keynes employment is determined by
a) Aggregate Demand b) Aggregate Supply
c) Effective Demand d) None
18. When aggregate economic activity is increasing, the economy is said to be in
a) an expansion b) a contraction c) a peak d) a turning point
19. In case of a short-run linear consumption function, as income increases the:
a) APC falls b) MPC remains constant
c) Both of them d) None of the above
20. Marginal Efficiency of Investment is a:
a) Flow concept b) Stock concept c) Both of them d) None of the above
21. Which of the following is the primary function of the money?
c) Transfer of Value d) Measure of value
22. Which of the following is called 'Broad Money'?
a) M1 b) M2 c) M3 d) M4
225
23. The Phillips curve shows the relationship between inflation and what?
a) The balance of trade b) The rate of growth in an economy
c) The rate of price increases d) Unemployment
24. Which one of the following is a qualitative credit control measure of RBI?
a) Bank Rate b) Open Market Operations
c) Variable Reserve Ratio d) Direct action
25. According to the cash-balance approach, the value of money is determined by
a) The demand for and supply of money b) Demand
c) Supply of money d) All of these
25a. The net value of GDP after deducting depreciation from GDP is
a) Net national product b) Net domestic product
c) Gross national product d) Disposable income
B. Fill in the Blanks:
26. Classical economists always believe in ______________ competition.
27. The concept of liquidity preference is related to ________________
28. ________________of banks also cause for arising Trade Cycles.
29. The higher the MPC, the _____________ the multiplier.
30. Net investment is ____________ minus depreciation and obsolescence charges.
C. Match the Following:

A B
A B
31. Supply creates its own demand (a) Expected revenue
32. Aggregate Demand is (b) Trade Cycles
33. Consumption function (c) J.B. Say
34. Optimistic and pessimistic changes (d) Keynes
35. Investment multiplier (e) c= f(y)
Answers: 31 __, 32 __, 33 __, 34 __, 35 __.
226

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BA320ECO-E

“We may forego material benefits of civilization, but we

Dr. B. R. AMBEDKAR OPEN UNIVERSITY

Editor Associate Editor

First Published: 2018

Copyright © 2018 Dr. B. R. Ambedkar Open University, Hyderabad, Telangana.

This text forms part of Dr. B. R. Ambedkar Open University Programme.

Block/Unit No. Title Page No.

BLOCK - I: INTRODUCTION TO MACRO ECONOMICS 1-28

Unit-1: Meaning, Nature and Scope of Macro Economics 2-12

Unit-2: National Income Analysis 13-28

BLOCK - II: THEORIES OF INCOME AND EMPLOYMENT 29-76

Unit-3: Classical Theory of Employment 30-44

Unit-4: Keynesian Theory of Income and Employment 45-58

Unti-5: Consumption Function: APC & MPC 59-76

BLOCK - III: THEORIES OF INVESTMENT AND INTEREST RATE 77-133

Unit-6: Investment Function, Rate of Interest, Concepts of

Unit -7: Classical, Neo-Classical and Keynesian Theories of Interest 107-133

BLOCK - IV: THEORIES OF FACTOR PRICING 134-195

Unit-8: Meaning, Functions and Classification of Money 135-149

Unit-9: Measures of Money Supply with reference to India 150-166

Unit-10: Theories of Money 167-181

Unit-11: Central Banking: Functions and Credit Control 182-195

BLOCK - V: INFLATION AND TRADE CYCLESS 196-223

Unit-12: Inflation 197-210

Unit-13: Trade Cycles 211-223

1.2 ECONOMIC ACTIVITIES

1.2.1 Scope of Economic Activities

Check Your Progress.

1.3 MACRO ECONOMIC ANALYSIS

1.3.1 Historical Background of Macro Economics and Keynesian Revolution

1.3.2 Meaning and Definition of Macro Economics

1.3.3 Nature and Scope of Macro Economics

Theory of Theory of Theory of Theory of

1.3.4 Distinction between Micro and Macro Economics

1.3.5 Importance of Macro Economics

1.3.6 Limitations of Macro-Economics

Check Your Progress.

1.5 CHECK YOUR PROGRESS - MODEL ANSWERS

1.6 MODEL EXAMINATION QUESTIONS

III. Objective type questions.

B. Match the following.

C. Fill in the blanks.

1.8 SUGGESTED BOOKS

2.2 DEFINITIONS OF NATIONAL INCOME

2.3 CONCEPTS AND COMPONENTS OF NATIONAL INCOME

2.3.2 Net National Product (NNP – NNI)

2.3.3 National Income at Factor Cost (NI)

2.3.5 Disposable Income (DI)

2.3.6 Per Capita Income

Check Your Progress.

2.4 METHODS OF ESTIMATING NATIONAL INCOME

2.4.1 Output Method

2.4.3 Expenditure Method

Check Your Progress.

2.6 DIFFICULTIES IN THE ESTIMATION OF NATIONAL

2.8 CONCEPT OF CIRCULAR FLOW OF INCOME

2.8.1 Circular Flow of Income in a Two Sector Economy

Figure-2.1: Circular Flow of Income in a Two Sector Economy

2.8.2 Circular Flow of Income in a Three Sector Economy

2.8.3 Circular Flow of Income in a Four Sector Economy

Check Your Progress.

2.10 CHECK YOUR PROGRESS – MODEL ANSWERS

2.11 MODEL EXAMINATION QUESTIONS