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ECONOMICS NOTES FOR M.COM. SEMESTER - II

MODULE 2: KEYNESIAN THEORY AND PHILLIPS CURVE

1. The starting point of the theory of effective demand is the concept of aggregate demand
and aggregate supply. Elaborate.

Or

1. What do you understand by the “theory of effective demand”?

Or

1. Define effective demand. How is it achieved?

Keynes used the term ‘effective demand’ to denote the total demand for goods and services at
various levels of employment. In Keynes’s words, “The point of Aggregate Demand function,
where it is intersected by the Aggregate Supply function, will be called the effective demand.”
Thus according to Keynes, the level of employment is determined by effective demand which, in
turn, is determined by aggregate demand price and aggregate supply price.

Aggregate Demand Price: “The 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 the output
produced when that amount of labour is employed.” Thus the 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 other words, it refers to the expected revenue from the sale of
output produced at a particular level of employment.

AD curve first rises quite steeply, but this rapidity tends to slacken at higher levels of
employment. This shape of AD curve implies that expected receipts increase rapidly in the initial
stages of rise in employment.
But gradually this increase slows down when employment reaches higher levels. It follows from
the fact that with income and employment at low levels, the community will be too poor to save
much of its earnings.
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ADP
1
0.9
AGGREGATE DEMAND PRICE

0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

LEVEL OF INCOME/OUTPUT

Aggregate Supply Price: When an entrepreneur gives employment to certain amount of labour,
it requires certain quantities of co-operant factors like land, capital, raw materials, etc. which will
be paid remuneration along with labour. Thus each level of employment involves certain money
costs of production including normal profits which the entrepreneur must cover. “At any given
level of employment of labour aggregate supply price is the total amount of money which all the
entrepreneurs in the economy, taken together, must expect to receive from the sale of the output
produced by that given number of men, if it is to be just worth employing them.” In brief, the
aggregate supply price refers to the proceeds necessary from the sale of output at a particular
level of employment.
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The shape of AS curve depends upon the relationship between employment and marginal
productivity. The AS curve rises slowly to begin with implying that employment would increase
fairly rapidly at first as amount received from selling output of the economy rose from zero.
This is because the cost of production would not initially rise rapidly. Later on, AS curves rises
progressively as employment increases because at higher levels of employment cost of
production rises more rapidly.
At full employment level (i.e., after point F), AS curve becomes a vertical straight line,
indicating that no increase in receipts would increase employment further.
Determination of effective demand:

Effective demand is a point on the graph achieved by the intersection of aggr

aggregate
egate demand price
curve and aggregate supply price curve. This is shown in the diagram below.
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However, since the point of effective demand is obtained before acieveing the level of full
employment, it is alsoi referred
d to as underfull employment effective demand. In order to attain
effective demand at the level of full emoloument, aggregate demand can be easily altered in
contrast to aggregate supply. An increase in aggregate demand will result in upward shift of the
AD
D curve and thus full employment effective demand cab be acheieved.
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Q2. What do you mean by inflationary gap?

An inflationary gap is a concept in macroeconomics that measures the difference between the
prevailing GDP in the economy and the potential GDP i.e. the GDP when the economy operates
at full employment. This gap is considered inflationary only if the current GDP is greater than
the potential GDP. It occurs either due to an increase in aggregate demand or a reduction in
aggregate supply.

If aggregate demand exceeds the aggregate value of output at the full employment level, there
will exist an inflationary gap in the economy. Aggregate demand or aggregate expenditure is
composed of consumption expenditure (C), investment expenditure (I), government expenditure
(G) and the trade balance or the value of exports minus the value of imports (X – M).

Let us denote aggregate value of output at the full employment by Yf. This inflationary gap is
given by C + I + G + (X – M) > Yf. The consequence of such gap is price rise. Prices continue to
rise so long as this gap persists. Inflationary gap thus describes disequilibrium situation.

For Example, All economies go through trade cycles and experience inflationary gaps in the
process. The economy in the United States was booming in 2006. The economic boom led to a
lowering of unemployment rates, an increase in wages and also an increase in disposable
income.

While this increased the demand and wages, less money was left for production and thus there
was a gap in demand and output. Hence, the increase in purchasing power caused an inflationary
gap.

Inflationary gap = Real or Actual GDP- Potential GDP

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In Fig. above,, aggregate expenditure is measured on the vertical axis aand

nd national income or
aggregate output is measured on the horizontal axis. Let us assume that Yf is the full
employment level of national income. If C + I + G + (X – M) is the aggregate demand (AD)
curve that cuts the 45° line at point A then an equilibriu
equilibriumm income is determinded at Yf. There
will not be any price rise since aggregate demand equals aggregate supply. Now if the AD
curve shifts up to AD’, equilibrium output will not increase since output cannot be increased
beyond the full employment level. In other words, because of full employment, output cannot
increase to Y*. Thus at Yf level of full employment output, there occurs an inflationary gap to
the extent of AB. The vertical distance between the aggregate demand and the 45° line at the
full employment
ment level of national income is termed the inflationary gap. Or at full
employment, there is an excess demand of AB that pulls up prices. We weigh aggregate
demand (i.e., C + I + G + X-M)
M) and aggregate supply. Since the former exceeds the latter, an
inflationary gap emerges.
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Q3. What are the determinants of effective demand?

(a) Meaning ● Aggregated demand means the total demand for final goods and
services in an economy.

It is the total (final) expenditure of all the units of the economy, i.e.,
households, firms, government, and the rest of the world.

(b) Following are the various components of aggregate demand:

Components of AD = C + I + G + (X – M)
aggregate demand

(a) Private ● It comprises a household’s expenditure on the consumption of

(Household goods and services.
consumption
● These goods can be durable, semi-durable, or non-durable.
expenditure) (C))
● Consumption of households depends upon their disposable
income and Propensity to consume.

 Propensity to consume, in economics, the proportion of total

income or of an increase in income that consumers tend to
spend on goods and services rather than to save.

(b) Investment ● It refers to the expenditure incurred by firms on the purchase of

expenditure (I)) capital goods like machines, plants, equipment, etc., to increase the
production capacity.

● Investment decision depends upon the relative values of MEI

(Rate of return/Marginal efficiency of investment) and rate of
interest.

 The marginal efficiency of capital is the percentage of profit

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expected from a given investment on a capital asset.

(c) Government ● It refers to expenditure incurred by the government on the

expenditure (G)) purchase of consumer goods and capital goods to satisfy the
collective wants of the society. Example: public parks, public
hospitals, roads, etc.

● Government expenditure depends upon the priorities of the

government and not on profit or returns.

(d) Net exports ● It is the difference between exports and imports.

(X – M) ● It reflects the net demand for a domestic product by the rest of the
world.

● Net exports depend upon many things like foreign trade policy,
foreign exchange rate, comparative prices, quality, etc.
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Income

Propensity to
Consume

Rate of
Return

Marginal
Efficiency of
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Q4. How are inflation and unemployment related?

or

Q4. Explain the Short run Phillips curve in detail. How does the Phillips Curve change in
the long run?

A. W. Phillips, in his research paper published in 1958, indicated a negative statistical rela-
tionship between the rate of change of money wage and the unemployment rate.

It was also shown that a similar negative relationship holds for rate of change of prices (i.e.,
inflation) and the unemployment level. In other words, there is a tradeoff between wage
inflation and unemployment.

This relation is usually generalized in the Phillips curve. Phillips first examined this negative
relationship using data from the UK during the period 1861-1957.

The Phillips curve, drawn in Fig. 4.5, shows that as the unemployment level rises, the rate of
inflation falls. Zero rate of inflation can only be achieved with a high positive rate of un-
employment of, say 5 p.c., or near full employment situation can be attained only at the cost
of high rate of inflation. Thus, there exists a trade-off between inflation and unemployment;
the higher the inflation rate, the lower is the unemployment level.

The following diagram shows the working of Short run Phillips curve.
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This Phillips curve relation poses a di

dilemma
lemma to the policymakers. If the objective of price
stability is to be attained, the country must accept a high unemployment rate, or if the country
designs to reduce unemployment,
ment, it will have to sacrifice the objective of price stability.
Therefore, it is rightly said that Phillips curve is a trade off between rate of inflation and
unemployment.

The long-run
run Phillips curve is a vertical line at the natural rate of unemploymen
unemployment,
t, so inflation and
unemployment are unrelated in the long run.

The Phillips curve shows the trade

trade-off
off between inflation and unemployment, but how accurate is
this relationship in the long run? According to economists, there can be no trade-off
trade between
inflation
lation and unemployment in the long run. Decreases in unemployment can lead to increases in
inflation, but only in the short run. In the long run, inflation and unemployment are unrelated.
Graphically, this means the Phillips curve is vertical at the natur
natural
al rate of unemployment, or the
hypothetical unemployment rate if aggregate production is in the long
long-run
run level. Attempts to
change unemployment rates only serve to move the economy up and down this vertical line. The
natural rate of unemployment theory, aalso known as the non-accelerating
accelerating inflation rate of
unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund
Phelps. According to NAIRU theory, expansionary economic policies will create only temporary
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decreases in unemployment ass the economy will adjust to the natural rate. Moreover, when
unemployment is below the natural rate, inflation will accelerate. When unemployment is above
the natural rate, inflation will decelerate. When the unemployment rate is equal to the natural
rate, inflation is stable, or non-accelerating.
accelerating.

The same is represented with the help of the following graph.