Macro Economics Reading Material

HIMACHAL PRADESH NATIONAL LAW UNIVERSITY, SHIMLA
Course Contents and Reading Material: B.A./B.B.A.-LL.B. (HONS)

II SEMESTER
Macroeconomics
For Private Circulation Only- HPNLU, Shimla Page 1

Semester II
B.B.A. LL.B. Paper Code: BL 202
Credit-04
SUBJECT: E c o n o m i c s - I I (Macro Economics)
Module-1
Introduction to Macroeconomics and National Income Accounting:
(Total Lectures-17)
1.1 Basic issues studied in macroeconomics; Statics, Comparative Statics and Macro- Dynamics,
1.2 Introduction to National Income. Basic Concepts, Concepts of GDP, GNP, NDP and
NNP at market price and factor cost; Private Income, Personal Income and Disposable Personal
Income; Real versus Nominal GDP, GDP Deflator.
1.3 Rules and approaches of Measurement of GDP (Income, expenditure, product and
Value added approaches),
1.4 Difficulties of Estimating National Income.
Circular Flow of Income and expenditure in two sectors.
1.5 National Income and Economic Welfare, Environmental Concern - Green Accounting
Concept.
Module-2
Theories of Employment and Consumption Function and Investment Function
(Total Lectures- 17)
2.1 Classical assumptions, Say’s Law of Market, Classical theory of employment, output, prices
and interest, Limitations of Classical Theories.
2.2 Keynesian theory of employment: Determination of effective demand, Aggregate Demand
and Aggregate Supply, equilibrium aggregate output, Comparison and contrast between
Classical and Keynesian contribution, Relevance of Keynesian economics to developing
countries.
2.3 Short run and Long run consumption functions, APC, MPC, APS, MPS.
2.4 Fundamental Psychological Law of Consumption; Factors Influencing Consumption
Function
2.5 Investment Function, Types of Investment, Factors determining Investment, Investment
Multiplier: Its working and leakages, Importance and critique.

Module-3 Money and Supply of Money
3.1 Money, Functions, Quantity theory of money

3.2 Fisher’s equation and Cambridge equation.
3.3 Keynesian theory of money and prices.
3.4 Supply of Money; Concept of money in modern economy.
3.5 Credit creation and measures to control credit creation- quantitative andqualitative measures.

Module-4 Inflation and Trade Cycle
4.1 Inflation: Types and meaning, Cost-push and demand-pull theories of Inflation
4.2 Deflation and stagflation, Monetary and Fiscal Policies, Role of Monetary
andFiscal Policies for Stabilization.
4.3 Trade Cycles: Meaning, Types, Phases,
4.4 Theories of Trade Cycles- Hawtrey’s monetary theory,
4.5 Keynes view on trade cycle, Schumpeter’s Innovation theory.
Text Books:
1. D.D. Chaturvedi, Macro Economic Theory, International Book House Pvt Ltd,New Delhi,
2012
2. D.N. Dwivedi, Macro-Economics, Tata Mc Graw Hill, 2005
3. Rana, K.C. and K.N., Verma, Macro Economic Analysis, Vishal Publishing Company,
Jalandhar, Eighth Edition, 2006.
References:
1. Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th edition, 2010.
2. N. Gregory Mankiw. Macroeconomics, Worth Publishers, 7th edition, 2010.
3. Olivier Blanchard, Macroeconomics, Pearson Education, Inc., 5th edition, 2009.
4. Richard T. Froyen, Macroeconomics, Pearson Education Asia, 2nd edition, 2005.
5. Andrew B. Abel and Ben S. Bernanke, Macroeconomics, Pearson Education, Inc.,
7thedition, 2011.
6. Errol D‘Souza, Macroeconomics, Pearson Education, 2009.
7. Paul R. Krugman, Maurice Obstfeld and Marc Melitz, International Economics, Pearson
Education Asia, 9th edition, 2012.

9. E. Shapiro, Macro-Economic Analysis, Tata Mc Graw Hill, 2003
10. M.C. Vaish, Macro-Economic Theory, Vikas Publishing House, New Delhi, 1999
11. Mishra, S.K. and V.K. Puri Modern Macroeconomic Theory; Himalaya Publishing
House; 2003

MODULE 1
Basic issues studied in macroeconomics; Statics, Comparative Statics and
Macro-Dynamics
Until the Great Depression of 1930s, economic science was broadly limited to what is now
known as microeconomics. Macroeconomics emerged as a separate branch in 1936 with the
publication of John Maynard Keynes’ revolutionary book, The General Theory of
Employment, Interest and Money, generally referred to as The General Theory.
Economics is regarded as the oldest discipline. However, as students of economics might be

aware, it could not be defined precisely. Economists, from Adam Smith, the father of
economics2, to the early 20th century economists, have defined economics differently,
depending on their perception of this discipline. For instance, Adam Smith defined
economics, in 1776, as ‘the science of wealth’. Nearly one and half century later in 1920,
Alfred Marshall, one of the all-time-great economists, defined economics with a wider scope.
According to him, “Economics is the study of mankind in the ordinary business of life; it
examines that part of individual and social action which is most closely connected with the
attainment, and with the use of the material requisites of well-being”. John Robbins, a
contemporary economist, defined economics in 1932 more precisely. According to him;
“Economics is the science which studies human behaviour as a relationship between ends
and scarce means which have alternative uses”. Although Robbins’ definition of economics
is more precise, his definition limits the scope of economics to a part of what is known today
as microeconomics. The scope of economics goes far beyond the study of the ‘choice making
behaviour’ of the people.
Gardner Ackley: “Macroeconomics concerns the overall dimensions of economic life.

More specifically, macroeconomics concerns itself with such variables as aggregate volume
of an economy, with the extent to which its resources are employed, with size of the national
income,
with the ‘general price level”.
P. A. Samuelson and W. D. Nordhaus: “Macroeconomics is the study of the behaviour of the

economyas a whole. It examines the overall level of a nation’s output, employment, and

prices”.

“Macroeconomics is first and foremost a policy science”. Macroeconomics as a policy
science provides an analytical framework and guidelines for devising appropriate policy
measures for controlling or eliminating undesirable factors in the economy and to guide it
on the path of stable growth.
To be sure, macroeconomics is a young and imperfect science. The macroeconomist’s ability

to predict the future course of economic events is no better than the meteorologist’s ability
to predict next month’s weather. But, as you will see, macroeconomists know quite a lot
about how economieswork. This knowledge is useful both for explaining economic events
and for formulating economic policy.
Macroeconomic variables are generally grouped under (i) stock variables, and (ii) flow
variables. Another kind of variables used in macroeconomic analysis are called rates,
expressed in terms of percentage rates, e.g., percentage rate of economic growth, inflation,
savings, investment, interest, etc. A brief description of stock and flow variables is given
below.
The stock variables refer to the quantity or value of certain economic variables given at a
point of time, e.g., on 31st March or 31st December of the year. In other words, the variables
that are measured with reference to a point of time are stock variables. For example, the
water stored in a tank at a point of time is a stock variables and number of books in a library
on a particular date is a stock variable. In economics, the stock of capital in a country, the
number of persons employed, the total money supply, all at a point in time, are some
examples of macro stock variables. The flow variables, on the other hand, are the variables
that are expressed per unit of time, e.g., per hour, perweek, per month, or per year. For
example, GDP, aggregate consumption, aggregate saving, aggregate investment, aggregate
exports, aggregate imports, etc. are macro flow variables. To understand the distinction
between stock and flow variables, see the following examples. The water accumulated in a
lake is a stock variable but the quantity of water flowing in or flowing out per unit of time

(per day or per week) is a flow variable.
Similarly, the stock of foodgrains with Food Corporation of India (FCI) is a stock variable
and the supply of foodgrains per time unit is a flow variable. A fixed deposit with a bank is
a stock variable and interest earned on the deposit, e.g., monthly or annual interest income,
is a flow variable. The stock of capital in terms of plant, building, machinery, stocks, etc. is
a stock variable and the annual investment is a flow variable.

Static and dynamic analyses refer to two ways of analysing a subject matter of
macroeconomics. When an economic phenomenon is analysed under static conditions, i.e.,
under the condition of things to be given at a point of time, the analysis is called ‘static
analysis’ and when the subject is analysed under changing conditions, it is called ‘dynamic
analysis’. Macroeconomics studies aneconomic phenomenon under both static and dynamic
conditions.
Static Analysis In general sense of the term, ‘static’ means a ‘state of rest’ or ‘a state of
motionlessness’. For example, a table placed in a classroom, a book placed on the table, and
a car parked on the road is in the state of rest, i.e., the static condition. But an economy is
never in the state of rest. People in an economy are continuously engaged in economic
activities—production, exchange, consumption, etc.—with or without changing the size of
the economy. However, for the purpose of analysing an economy at a point in time,
economists assume a ‘static economy’. “Static economy does not mean an economy in which
no activity is taking place or no one is doing anything at all.No economic system is ever at
rest in anything like the mechanical sense.”A static economy means an economy or in which
normal activities go on but there is no change in the size of the economy or in the level of
national output, stock of capital, prices and employment. As Schumpeter puts it, a static
economy refers to “an economic process that merely reproduces itself.”3 When an economy
is studied under static conditions, it is called static analysis. For static analysis, a static model
is used. A model of a static economy is created by a “rigorous formulation of conditions
[assumptions] under which it is possible to make generalisations about the factors
determining economic equilibrium.” A static macro-model assumes that there is no change
in the size of the economy, no change in national output, prices and employment. In a static
economy, the basic forces of change, like stock of capital, technology, population, nature of

business organisations, and tastes and preferences of the people remain unchanged over the
reference period. The economic process in a static economy merely produces itself year after
year. Such an economy is said to be in astate of static equilibrium. According to Harrod,
“… a static equilibrium by no means implies a stateof idleness, but one in which works is
steadily going forward day by day and year after year but without increase or diminution”.
Another important feature of static analysis is that the variables used in the static model
have no past or future and all variables belong to the same point in time,i.e., past value
and predicted future value of the variables are ignored. Thus, a static model is the
construction of a timeless economy. In a static model, the values of all the interrelated
variables are simultaneously and instantaneously determined.

In other words, there is no time lag in the adjustment of the dependent variables to the
change in the independent variables. This kind of approach to the study of an economic
phenomenon is essentially a theoretical approach. The prime objective of constructing a
static model is to make a generalisation or theoretical proposition regarding the relationship
between the related variables under static conditions.
Comparative Static Analysis Comparative static analysis is a comparative study of

economic conditions of an economy at two static equilibrium positions at two different points
in time. In a comparative static analysis, “… we are comparing the equilibrium values of the
system corresponding to the two equilibrium positions with one another. This sort of
comparative analysis of two equilibrium positions may be described as comparative static
analysis …” A comparative study of this kind assumes a great significance where the
objective of the study is to predict the future course of the economy on the basis of the past
experience. A comparative analysis of the relationships between the variables at two
equilibrium positions at two different points of time is helpful in tracing the change in their
relationships. This approach has a great predictive power, especially when changes are few
and small and the economy treads smoothly from one equilibrium position to another.
Dynamic Analysis In contrast to static approach, dynamic approach is adoptedto study an
economy in motion. When a macroeconomic phenomenon is analysed under changingor
dynamic conditions, it is called dynamic analysis. Dynamic analysis is adopted to study an
economy under dynamic conditions. In a dynamic economy, the economic factors and forces
keep changing. An economy in motion raises certain issues which cannot be handled through
static and even comparative static approaches. The following are two such major issues: (i)
Does a dynamic economy, when displaced from one equilibrium, ever reach another
equilibrium position? (ii) What path is a dynamic economy likely to take to move from one
equilibrium position to another? The merit of dynamic analysis lies in its power to predict
the future course of the economy. A static analysis, by its very nature, has no power to predict
the path that a dynamic economy follows while moving from one equilibrium point to
another, nor it can be used to predict whether the economy will ever attain another
equilibrium position. Dynamic approach does this job. Economic dynamics studies the
‘factors and forces’ that set an economy in motion and lead it to a new equilibrium at a higher
or lower level. It studies the actions of, and interactions between, the factors and forces of
change. The interaction between the factors and forces of change is not instantaneous and
simultaneous. It involve a time-lag, i.e., the time that a change in an economic variable takes
to affect the other related variables, and the time that other variables take to adjust themselves
to the change. Dynamic analysis takes into account the time lag involved in the process of
adjustments. It studies the nature and the magnitude of changes and finds whether they are
oscillatory or dampening—if oscillatory, then whether divergent or convergent. If they are
convergent, the economy may reach another equilibrium. If changes are divergent, the
economy may not attain another equilibrium position—it may keep oscillating constantly.
Distinction between Economic Statics and Dynamics The distinctive features of static and
dynamic analyses can be summarised as follows. (i) Economic statics is an abstraction from
reality whereas economic dynamics is the study of the real world. (ii) All the variables in a
static analysis are undated in the sense that they are taken at a point or unit of time whereas
in dynamic analysis, all variables are dated, i.e., their movement on time scale is known. (iii)
Economic statics is a timeless analysis whereas in economic dynamics, time is used as one
of the variables because time works as a determinant of other variables. For example,
national income of a country in time t depends on its value in time t–1. (iv) In static analysis,
fundamental economic conditions are assumed to be given

and known, but in a dynamic analysis, they continue to change over time. (v) Dynamic
analysis has predictive power which static analysis does not have, though comparative statics
can be used for thepurpose.
Macroeconomics, like any theoretical branch of economics, uses a set of theoretical

formulations derived on the basis of some macroeconomic models. Macroeconomists have
devised and developed, over time, a set of ‘elegant and remarkably powerful’ models for the
purpose of analysing the behaviour and performance of the economic system as a whole.
The ‘economy as a whole’ is an extremely complex and intricate system because each and
every element and variableof the economy is interrelated, interlinked, interdependent and
interactive. To analyse such a complex system systematically and scientifically is an
extremely complex and complicated task.
However, in order to study a macroeconomic phenomenon, macroeconomists divide the

entire system under different sectors with common features and characteristics, and develop
a simplified model to study the selected macroeconomic phenomenon. This process is called
model building. A macroeconomic model, or any economic model for that matter, is an
abstraction of a macroeconomic phenomenon from the real world, with the purpose of
creating a manageablehypothetical world. The model so created is used as a basic tool of
analysis to describe, explain and derive the relationship between any two or more
macroeconomic variables.
A macroeconomic model is constructed by a systematic process as described below: (i)

Specifyingthe subject of study and segregating it from the rest of the system; (ii) Specifying
and defining the relevant macroeconomic variables; (iii) Making assumptions regarding the
behaviour of selected variables; (iv) Specifying the relationship between the selected
variables in the form of equations, if possible; and (v) Specifying the criteria for drawing
conclusions. The choice of relevant economic variables is a very important aspect of building
economic models. So is the case with macroeconomic models—the choice of relevant
macroeconomic macroeconomic variables is essential for building a purposeful
macroeconomic model. Macroeconomic variables are generally classified as: (i) Endogenous
variables, and (ii) Exogenous variables. (i) Endogenous variables refer to the variables that
are constituted in the model and their value is determined within the model. Some typical
endogenous variables used in macroeconomic models of income determination are national

income,consumption, savings, investment, market interest rate, price level, and employment.
(ii) Exogenous Variables are those that fall out of the model and their values are determined
outside the model, e.g., money supply, tax rates, government expenditure, exchange rate, etc.
However, depending on the objective of analysis, endogenous variables are converted into
exogenous variables, and exogenous variables can be endogenised. For example, let us
consider Keynes’ model of income determination. The Keynesian model of income
determination assumes that the equilibrium level of income is determined where Aggregate
Demand (AD)= Aggregate supply (AS)
Aggregate demand and aggregate supply are defined, respectively, as follows.

AD= C + I + G + X AS= C + S + T + M
where C = aggregate consumption expenditure; I = investment spending; G = government

spending; X = exports; S = savings; T = taxes and M = imports. Now, national income
equilibrium (Y) can be redefined as : Y = C + I + G + X = C + S + T + M;
This is the final form of the Keynesian model of determination of the equilibrium level of
income. What is now required is to define the macro variables and specify the relationship
among the variables. The variables and their interrelationship are specified in function form
along with the relevant assumption, as follows. (i) Aggregate consumption (C) may be the
function of many variables, like wealth, return on investment, advertisement, demonstration
effect, snob effect, age factor, etc. However, Keynes defined aggregate consumption function
as C = f(Y). This function is based on the assumption that, in the short run, consumption
depends on income only, and not on any other factor. (ii) Variables I, G, T and X are
determined exogenously, i.e., these variables are determined outside the framework of the
model. (iii) Although imports (M) of a country depend on anumber of factors, e.g., price of
domestic substitutes of imported goods, foreign price of the products, exchange rate, etc.,
the Keynesian model assumes that M is the function of income only, i.e., M = f(Y). What
one needs now is to collect data on the variables included in the model and test the validity
of the model. This is called empirical testing of the model. If the model stands the empirical
tests against income and expenditure data from several counties, the validity of the model is
established. The macroeconomic models so developed are used to make economic
generalisations, leading to the formulation of macroeconomic theories.

Introduction to National Income,
National Income
Measurement of national income is a part of the process of estimating national income. It is

also known as national income accounting. Understanding national income accounting is
important because macroeconomics is the study of economy as a whole and national income
is the single-most important macrovariable that represents ‘the economy as a whole’. The
level of national income determines the level of all other macroeconomic variables –
aggregate consumption, saving, investment, employment, and also the price level. Also, most
macroeconomic theories are based on national income and its components. Therefore, a clear
understanding of concepts and methods of measurement of national income is necessary for
the study of macroeconomics. The objective of thischapter is to discuss briefly the concepts
used in and the methods of measuring national income with example of methods used in
India. Looking back historically, available records show that the attempts to estimate national
income, especially by Gregory King, had started in the 17th century. The king had adopted
a simple method of estimating national income, i.e., by taking it as sum of individual incomes
and government income reconciling with their expenditures. Not much progress was made
in the method of estimating national income until the 1930s. The first estimate of national
income was made in the US in 1934. The modern concepts of national income and method
of ‘national income accounting’, known also as ‘social accounting’, was developed and
adopted by Simon Kuznets of Harvard University in 1941. In fact, the need and necessity
of a reasonable estimate of national income had arisen after the publication of Keynes’ The
General Theory of Employment, Interest and Money in 1936. The analytical framework
adopted by Keynes in his General Theory for macroeconomic analysis required detailed
accounting of various components of the national income, including aggregate demand and
aggregate supply, aggregate consumption expenditure (private and public), aggregate

savings and investment, total exports and imports, net balance of foreign transactions, etc.
National income accounting or the ‘social accounting’ is, in fact, a detailed accounting of
total national product resulting from different kinds of economic activities, classified under
different sectors and industries, and also the intersectoral flows of goods andservices. It also
takes into account the net effect of inflows and outflows of goods and services toand from
foreign countries.
The importance of national income accounting lies in the fact that the performance and
behaviour ofan economy are studied on the basis of the performance of its macroeconomic
variables including national income (estimated as Gross National Product or Gross Domestic
Product), aggregate consumption, aggregate savings and investment, total labour
employment, general price level, total supply of money and total demand for money, and
balance of payments (BOP). Incidentally, of these aggregates, national income is the ‘most
macro’ of all macroeconomic variables. All other macro variables are either the components
of or are the result of, national income (GDP/GNP). For instance, the level of employment
depends on the level of GDP, aggregate consumption expenditure and aggregate savings and
investment are the components of GDP, and their level depends on the level of GDP. Given
the money supply, the general level of price depends on the GDP, and so on.
The purpose of GDP is to summarize all these data with a single number representing the
dollarvalue of economic activity in a given period of time.6
National income is the most important variable from both the theoretical and the practical
points of view. At the theoretical level, a major part of macroeconomic theories seeks to
explain the determination of national income, the interrelationship and interaction between
its various components, and growth of, and fluctuation in, national income. From the
practical point of view, a country’s national income data is used for (i) measuring the
standard of living and economic welfare of its people, (ii) formulation of economic policies
for the management of the economy, and (iii) making international comparisons about the
status of the economy.

National Income Concepts
1. GNP = Market value of final goods and services (including both consumer and capital)
plusincomes earned by the national residents in foreign countries minus incomes earned
locally but accruing to foreigners
2. GDP = Market value of goods and services produced by the residents in the country plus
incomes earned locally by foreigners minus incomes received by the nationals from abroad.
3. NNP = GNP – Depreciation (or Capital Consumption)
4. PI = NNP – (Undistributed Company Profits + Surplus of Public Undertakings + Rentals

of Public Property)

5. Disposable income (Yd) = PI – Personal Taxes
Some Accounting Relationships
1. GNP at factor cost plus net indirect taxes less depreciation = GNP at market price
2. GNP (at market price) less depreciation = NNP at market price
3. NNP at market price less indirect taxes add subsidies = NNP at factor cost
4. NNP at factor cost minus domestic income accruing to non-residents = NDP at factor cost
5. NDP at factor cost – [surplus of public undertakings + profits of statutory corporations +

profit tax
+ income accruing to non-residents] + [interest on national debts + transfer payments] =
Personal income.
6. Personal income less direct taxes, fees, fines, etc. = Disposable income
Accounting of National Income
For systematic and reliable accounting of national income, it is essential to classify different
types if economic activities and sources of income as it provides conceptual clarity and
comprehensiveness in national income estimation. Therefore, the sources and types of
national income are classified under different categories. The purpose of classifying different
sources and types of economicactivities under different sectors is to make national income
accounting systematic and analysis of national income data easy and comprehensive. The
groups so formed are generally called ‘sectors’of the economy.
This is called sectoral accounting of national income. For sectoral classification of economic
activities, the activity performers of different sectors are classified on the basis of (i) nature

of economic activity, also called functional classification, and (ii) the use of the national
income. The basis of classification is chosen in accordance with the purpose and method
chosen for estimating national income. In mixed economies, economy is often classified as
(i) private sector, and (ii) public sector.
Sectoral Classification of Economy
For the purpose of estimating national income, the CSO uses the following sectoral
classification of economy.
(i) Primary sector, including agriculture and allied activities, forestry, fishing,
mining andquarrying;
(ii) Secondary sector, including manufacturing industries, and
(iii) Tertiary sector or service sector, including banking, insurance, transport and
communication, trade and commerce.

Depending on the purpose and data availability, these broad sectors of the economy are
sub- classified under their sub-categories. For the purpose of estimating national income,
the broad sectors are further divided under sub-sectors as given below.
I. Primary sector
1. Agriculture,
2. Forestry and logging,
3. Fishing,
4. Mining and Quarrying.
II. Secondary sector
1. Manufacturing,
2. Registered manufacturing,
3. Unregistered manufacturing,
4. Construction,
5. Electricity, water and gas supply.
III. Tertiary sector
A.Transport, Trade and Communication
1. Transport, storage and communication
2. Railways,

3. Other means of transport,
4. Communication,
5. Trade, hotels and restaurants.
B.Finance and Real Estate
1. Banking and insurance
2. Real estate for residential and business purposes
C. C
ommunity and Personal Services
1. Public administration and defence
2. Other services.

The GNP deflator and its application
The GNP deflator is essentially an adjustment factor used to convert nominal GNP into real
GNP. TheGNP deflator is the ratio of price index number (PIN) of a chosen year to the
price index number(PIN) of the base year. The PIN of the base year = 100. The chosen year
is the year whose real GNP is to be estimated. The method of working out GNP deflator is
given below.
The formula for converting nominal GNP of a year into real GNP may be written as follows.
(
where PINcy is the price index number of the chosen year).
Rules and approaches of Measurement of GDP
Methods of Measuring National Income
It may be noted at the outset that, given the nature of the Indian economy and the paucity of
reliable data, it is not possible to use any single method, or to estimate the national income
by using each method separately. For example, income method cannot be used for the
agricultural agricultural sector because of unavailability of reliable data, and income of
household enterprises cannot be estimated by the expenditure method. Therefore, a
combination of different methods, especially of value added method and income method, is
used for estimating national income in India.
Given the sectoral and sub-sectoral classification of the economy, let us now look at the
methods adopted by the CSO for estimating income of the different sectors.

Production method, what is also called net output method or value added method, is used
to estimate income or domestic product of the following production sectors.
1. Agricultural and allied services,
2. Forestry and logging,
3. Fishing,
4. Mining and Quarrying, and

5. Registered manufacturing.
Value Added Method: According to final goods approach, only the money value of final or
finished goods and their output should be considered by neglecting the output of
intermediate goods and raw materials, which facilitates to avoid double counting. For
example, while measuring output of textile industry only the total output of cloth should
be taken into account.
In this method the value added by each enterprise in the production goods and services is
measured. This method involves the following steps:
a) Identifying the producing enterprise and classifying them into industrial sectors according
to their activities.
b) Estimating net value added by each producing enterprise as well as each industrial sector
and adding up the net value added by all the sectors.
All the producing enterprises are broadly classified into three main sectors namely:
1) Primary sector which includes agriculture and allied activities, 2) Secondary sector which
includes manufacturing units and 3) Tertiary sector which include services like banking,
insurance, transport and communication, trade and professions. These sectors are further
divided into sub-sectors and each sub-sector is further divided into commodity group or
service-group. For calculating the net product of the inductrial sector we need to know
about gross output of the sector, the raw materials and intermediate goods and services
used by the sector and the amount of depreciation. For an individual unit, we subtract from
the value of its gross output, the value of raw material and intermediate goods and services
used by it and, from this, we subtract the amount of depreciation to get net product or value
added by each unit. Adding value added by all the units in one sub-sector, we get value
added by the sub-sector. Again adding value added or net products of all the sub-sectors
of a sector we get value- added or net product of that sector. For the economy as a whole,
we add net products contributed by each sector to get Net Domestic Product. If the
information regarding the final output and intermediate goods is available in terms of
market prices we can easily convert it in terms of factor costs by subtracting net indirect
taxes to it. If we add or subtract net income from abroad we get Net National Product at
factor cost which is nothing but National Income.
The symbolic expression of this method of measuring national income is:
Y = (P – D) + (S – T) + [(X –M) + (R – P)]

Where, Y = National Income, P = Domestic production of all productive sectors, D =
Depreciation allowance, S = Subsidies, T = Indirect Taxes, X = Exports, M = Imports, R
= Receipts from abroad, P = Payments made abroad.
Precautions: Following precautions should be taken while measuring national income of a
country through value added method.
1. Imputed rent values of self-occupied houses should be included in the value of output.
Though these payments are not made to others, their values can be easily estimated from
prevailing values in the market.
2. To avoid double counting only the value of output of final or finished goods should be
considered.
3. Value of services of housewives is not included because it is not easy to find out correctly
the value of their services.
4. Products self consumption by the producers should be estimated by guesswork.
5. Value of intermediate goods must not be counted while measuring value added because
this will amount to double counting.
6. While evaluating the output, changes in the price levels must be taken into account.
Income method is used for estimating domestic income of the following sectors.
1. Unregistered manufacturing,
2. Gas, electricity and water supply,
3. Banking and insurance,
4. Transportation, communication and storage,
5. Real estate, ownership of dwellings and business services,
6. Trade, hotels and restaurants,
7. Public administration and defence, and

8. Other services.
Income Method: Different factors of production pool their services for carrying out production
activities. These factors of production, in return, are paid for their services in the form of factor
incomes. The labour gets wages, land gets rent, capital gets interest and entrepreneur gets
profits. In other words, whatever is produced by a producing unit is distributed among the
factors of production for their services and aggregate of factor incomes of all the factors of
production of all the producing units from the subject matter of calculation of national income
by income method. This method of estimating national income has the great advantage of
indicating the distribution of national income among the different income groups such as
landlords, owner of capital, workers, entrepreneurs. Measurement of national income through
income method involves the given below steps:
1. Like the value added method, the first step in income method is also to identify the
productive enterprises and then classify them into various industrial sectors such as agriculture,
fishing, forestry, manufacturing, transport, trade and commerce, banking etc.
2. In this step the factor payments of the production units are estimated. Generally the
factor payments are divided into following categories.
a) Compensation of employees which are includes wages and salaries, both in cash and kind,
as well as employers’ contribution to social security schemes.
b) Rent
c) Interest
d) Profits –dividends, undistributed profits & corporate income tax
3. Mixed Income: It is the income which arises due to work, enterprises and property. In
this it is difficult to know the separate contribution of property and that of work e.g. the income
of the farmer, small shop-keepers.
4. Third Stage: In this stage the factor payments of all the domestic units are added. It is
also called domestic factor income. (Domestic Factor Income = Sum of factor payments by all
units in the domestic territory.)

5. Fourth Stage: Incomes paid by out by all industrial sectors we will obtain domestic
factor income which is also called net domestic product at factor cost.
6. Finally, by adding net factor income earned from abroad to domestic factor income or
Net Domestic Income at factor cost which is called national income.
Precautions : The following precautions should be consideved for calculating national inanedy
income included,
1. The income from illegal activities like theft, smuggling and gambling should not be
included in national income.
2. Windfall gains like lottery etc. should also not be included.
3. All unpaid services (like services of house wife) should not to be included and services
for payments should be included.
4. Financial transactions and sales of old property are to be excluded, and they do not add
to the real income.
5. Direct tax revenue to the government should be subtracted from the total income, as it
is only a transfer of income.
6. The income derived from new or old shares and bonds is not included in National
income.
7. The value of the production kept for self-consumption is also included in National
income.
8. Profit tax or corporation tax is the part of the profit only. So the profits before tax should
be added in national income but afterwards profits or corporate tax should not be added again.
If the profit is added after the tax payment, then however, profit tax should be added separately
in national income.
For the sake of comparison of estimates and to check their reliability, CSO estimates
national income also on the basis expenditure method.
Expenditure Method: In explaining the concept if G.N.P. we considered different
expenditures which add up the gross national product. Accordingly, we can say that national

income can be measured by adding all final expenditures made for purchases of goods and
services in a year. It should be noted here that incomes from productive activity are received
only because people spend money on goods and services produced by the income receivers.
For simple understanding of the expenditure method of estimating national income, we can
divide expenditure into four groups.
a) Personal consumption expenditure – what private individuals spend on consumer goods
and services.
b) Gross domestic private investment –what private business spend on replacement,
renewals and new investment.
c) Net foreign investment expenditure – what the foreign countries spend on the goods
and services of the national economy over and above what this economy spends on the output
of the foreign countries, i.e. export minus imports.
d) Government purchases – what the government spends on the purchases of goods and
services.
From this we deduct depreciation allowances, and then we get Net National Product at market
prices. From this, if we deduct indirect taxes and add subsidies, we get National Product at
factor cost.
* Precautions: While estimating National income through expenditure method, the
following precautions should be taken.
1. The expenditure made on second-hand goods should not be included because this does
not contribute to the current year production of goods and services.
2. Expenditure on purchase of old shares and bonds from other people and from business
enterprises should not be included while estimating G.N.P. through expenditure method. This
is because bonds and shares are more financial claims and do not represent expenditure on
currently produced goods and services.
3. Expenditure on transfer payments by government such as unemployment benefits, old
age pension should also not be included because no goods or productive services are produced
in exchange by the recipients of these payments.
4. Expenditure on intermediate goods such as fertilizers and seeds by the farmers and
wool, cotton and yarn by manufacturers of garments should also be excluded. This is because
we have to avoid double counting. Therefore, for estimating G.N.P. we have to include only
expenditure of final goods and services.
We have explained above the three alternative methods of estimating national income. The best
way to arrive at national income will be to employ all these three methods so as to permit their

cross-checking ensuring accuracy and throwing more light on details.
Methods of Measuring National Income Aggregates
Estimating national income – more appropriately gross national product (GNP) – is not the
end of the story. Once GNP of the country is estimated, it provides the basis of measuring
other national income aggregates. The process of generating macroeconomic aggregates
other than GNP is shown below in tabular form.

Circular Flow of Income and Expenditure

National Income and Economic Welfare
Social Accounting Method :
Social accounting of social accounts has assumed great importance in modern times. This is so
because economic theory is being increasingly applied for the solution of practical problem. If
study of economics is to be truthful, knowledge of social accounts is absolutely essential. Social
accounting is a term which is applied to the description of the various types of economic
activities that are taking place in the community in a certain institutional frame-work. In social
accounting, we are concerned with statistical classification of the economic activity so that we
are able to understand easily and clearly the operation of the economy as a whole. According
to Stone and Murry, “The term social accounts is used in a general sense to denote an organized
arrangement of all transactions, actual or imputed, in an economic system. In such a system
distinctions are drawn between i) forms of economic activity, namely, production, consumption
and accumulation of wealth, ii)sectors or institutional division of the economy, and iii) types
of transactions, such as sales and purchase of goods and services, gifts, taxes and other current
transfers, etc. Here is another description of the field of social accounting. The field of studies-
summed up by the words social accounting embraces, however, not only the classification of
economic activity, but also the application of the information thus assembled to the
investigation of the economic system. Social accounting is thus concerned with the analytical
as well as the statistical elements of the study of national accounts.
In the economy there are different sectors are producing different types of goods and services,
i.e. Public sector, Private sector, Co-operative sector, Capital sector and Rest of world sector.
To understand the relationship between various sectors it is necessary to understand the social
accounting method. Now a day the concepts of economics are changing, because state has
accepted the concept of welfare state, planned economic development and maximum welfare.
So social accounting method is useful for understand the social and industrial sectors income
for the measurement of national income. What is the direction of economic development?,
What type of planning is necessary for economic development? has been cleared through the
social accounting method. This method is also useful for to understand the business cycles,
industrial production, savings, and domestic capital formation. Generally, the problems of
economy are related to the national income and related factors of national income.
Number of transactions is happenings in the day-to-day in the economy. The consumable goods
are purchased by the consumers, farmers are producing the agricultural products, industrial

sector produces the industrial products, purchase of raw material, purchase of machineries,
distribution of wages, collection of tax and import and export trade etc. transactions are
continuously happenings in the economy. To understand the share of each sectors in the
national income it necessary to use a specific method. Social accounting method is useful for
calculate the sector wise share in the national income.
The measurement of national income through social income accounting method following
factors should be taking into consideration.
a) Accounting of Production
b) Accounting of Capital
c) Accounting of Household sector
d) Accounting of Government sector
e) Accounting of Rest of World sector
All above mentioned factors are interdependent. This interdependence or income and
expenditure have taken into consideration in the circular flow of national income. There are
three methods of social accounting of national income measurement. These are as follows:
A) Double Entry Account System
B) Equation Account System
C) Flow of Funds System
A) Double Entry Account System: In this method the income from various sectors is shown
on the receipts side and expenditure is shown on the liabilities side. Left side shows the
expenditure and right side shows the income. From the production sector we can understand
the income generated from the various sectors and the expenditure on the various sector. As
per this information we can get the national income data. Following schedules are shown the
accounts of house hold sector, production sector, government sector, capital sector, saving-
investment sector and rest of the world sector.

3. Equation Account Method: In this method different kinds of signs are used for the national
income accounting instead of figures. Double accounting method used the figures and Equation
method using the various signs for national income accounting; this is only difference between
both methods. With the help of following example we can explain the Equation method.

As per the above example Gross National Income = A+B+C+D+E+Y+R+L+V
3. Flow of Funds System: This method creates the relationship between flow of money and
sectoral structure in the economy. Production sector is the central point in this method. This
shows the flow of income comes from the different factors of the economy and how it spends
from the production sector. Accounting of National income can determine by the flow of
money in this method. With the following table we can explain the national income accounting.
Above table clears the relationship between production sector and other sectors income and
expenditure flow. Private consumption is the receipt side of production sector and private
consumption is the expenditure side of the household sector. In other words the expenditure
side of other sectors is the income side of the production sector. With the help of following
diagram we can explain the interdependence of income and expenditure of different sectors.

The flow of income from the different sectors of economy to production sector has shows with
the help of arrow. In the free economy there are multiple transactions of the various countries.
With assume above thing the diagram of flow of funds has prepared with consideration of
income of production sector, consumption, capital formation and import-export.
Social accounting method is also having some limitations. No method is without limitations.
Different methods are necessaries as per different objectives. This method is useful for only
monetary transactions, but in the economy there are different transactions are happening
without money. These are not considered in this method
Green Accounting:-
The term “Green Accounting” was first brought into common usage by economist and
Professor Peter Wood in the 1980’s.Green accounting is a type of accounting that attempts
to factor environmental costs into the financial results of operations. It has been argued that
gross domestic product ignores the environment and therefore policymakers need a revised
model that

incorporates green accounting. Better macroeconomic and societal indicators are needed to
reflect the contribution of biodiversity and ecosystem services to human beings. One
approach that is gaining momentum across the globe is “Green Accounting” whereby
national accounts are adjusted to include the value of nature’s goods and services.MrJairam
Ramesh , the former environment minister , advocated greening India’s National accounts
by 2015 and encouraged policy makers to recognize the trade-off between pursuing high
growth policies against the extensive impact they could have on India’s Natural capital.
The major purpose of green accounting is to help businesses understand and manage the
potential quid pro quo between traditional economics goals and environmental goals. It also
increases the important
Need of Green Accounting
Green accounting is said to only ensure weak sustainability, which should be considered as
a step toward ultimately a strong sustainability of economic growth .
Green Accounting has been classified into
Monetayr Approach
Physical Approach
They are further divided into Macro-level, Local administration level and micro level.
Practically for developing countries like India, it is a twin problem about saving
Environment andEconomic Development. As the country’s Economic condition is not very
strong, it needs to beimproved first. A study by world bank estimated that about Rs 34000
crores were lost by India due to environmental damage. Company like AT&T is
implementing Green Accounting.
Another organizationthat is already leading the way is GIST- Green Indian states Trust.
According to their results , the loss of forest ecological services (i.e., soil erosion prevention,

flood control and ground water augmentation ) over three years (2001-03) was due to
declining dense forests.
Green Life Cycle:
The life cycle of a product, process, system or facility begins with acquisition to make it
green to the decommissioning which can include toxic removal and remediation. Life cycle
is a more systematic and complete assessment of a firm’s long term costs.
Objectives Of Green Accounting:
1. Segregation and Elaboration of all Environment related Flows and Stocks of Traditional
Accounts:
The segregation of all flows and stocks of assets related to environment permits the
estimation of the total expenditure for the protection of the environment. A further objective
of this segregation isto identify that part of the gross domestic product that reflects the costs
necessary to compensate for the negative impacts of economic growth, that is, the defensive
expenditures.
2. Linkage of Physical Resource Accounts with Monetary Environmental Accounts:

Physical resource accounts cover the total stock or reserves of natural resources and changes
therein, even if those resources are not affected by the economic system. Thus natural
resource accounts provide the physical counterpart of the monetary stock and flow accounts
of SEEA. (Systemof Environmental Economic Accounting)
3. Assessment of Environmental Costs and Benefits:
The SEEA expands and complements the SNA (System of National Accounts) with regard
to costing:
(a) The use (depletion) of natural resources in production and final demand;
(b) The changes in environmental quality, resulting from pollution and other impacts of
production,consumption and natural events, on the one hand, and environmental protection,
on the other.
4. Accounting for the Maintenance of Tangible Wealth:
The SEEA extends the concept of capital to cover not only human-made but also natural
capital. Capital formation is correspondingly changed into a broader concept of capital
accumulation allowing for the use or consumption and discovery of environmental assets.
5. Elaboration and Measurement of Indicators of Environmentally Adjusted Product and

Income:
The consideration of the costs of depletion of natural resources and changes in

environmental quality permits the calculation of modified macro-economic aggregates,
notably an environmentally adjusted net domestic product (EDP)
Traditional Growth Measures:
Green Accounting is a measure of sustainable income level that can be secured without
decreasing the stock of natural assets. This requires adjustment of the system of National
Accounts (SNA) in terms of stocks of natural assets. In SNA, allowance is made for capital

consumption or man-made capital while calculating Net Domestic Product. Net Domestic
Product (NDP)= GDP- Depreciation.
SNA has three main Defects:
1. It neglects the depletion of natural capital such as farmland, forests, fishing stock, minerals,
etc.
2. Environmental Degradation mainly from Pollution
3. Defensive Expenditures which the society incurs in facing the external effects of
Environmental Degradation.
To Overcome these drawbacks of SNA, the staitstical Division of UN has developed the
system of Environmental Economic Accounting (SEEA).The SEEA focuses on :
1. Accounting for depletion of Scarce Natural Resources
2. Measuring the costs of environmental Degradation and its prevention.

Thus the computation of Green NDP has been replaces by a measure of National Product
which includes the Economic Cost of degrading natural resources which are required to
produce goods and services directly and indirectly.
SNA defines Net Domestic Product as:
NDP= Net exports(X-M) + Final Consumption (c)+ Net Capital Accumulation (I)
To arrive at Green NDP, if net capital accumulation (I) is replaced by net capital
accumulation of produced and non-produced natural assets, the identity becomes
EDP= (X-M) + C + Nap. Ec + (NAnp.ec- NAnp.n)
Where, EDP= Environmental Domestic Product(X-M) = Exports - Imports

C= Capital Accumulation
NAp.ec = Net accumulation of produced economic assets NAn.ec = Net accumulation of

non- produced economic assets NAnp.n = Net accumulation of non –produced natural assets
Module 2

Classical Assumptions, Say’s Law of Market
Classical Theory of Employment
The classical economists had not expounded any single, monolithic theory or thought which
can be referred to as classical macroeconomics. There is no coherent macroeconomic theory
or model developed by the classical economists, nor a theory of national income
determination.
Therefore, in the opinion of some economists, it is ‘somewhat inaccurate to talk about the
macroeconomic theories’ of the classical economists. This however should not mean that the
classical economists had not given any thought to the macroeconomic issue of how
aggregate output is determined in an economy. They had, in fact, made certain postulates
about the macroeconomic issues. The modern economists have, however, reinterpreted
macroeconomic thoughts of the classical economists and constructed the classical
macroeconomics by piecing together the classical thoughts related to macroeconomic issues.
The classical macroeconomics was constructed by Keynes himself in his The General
Theory. The classical macroeconomics consists broadly of the classical theories of output
and employment and the quantity theory of money.
The classical postulates In their approach to macroeconomics issues, the classical economists
had, assumed certain macro aspects of the economy to be given. They provided deductive
logic but little empirical support to their views on macroeconomic issues. Their views were
expressed by Keynes as ‘postulates of the classical economics’. The main postulates of the
classical economics as summarised by the modern economists, are described below.

1. There is always full employment
According to Hagon, “The classical economists took full employment (without inflation for
granted because they accepted the underlying theory of employment. Classical theory of
employment leads to the conclusion that [market] forces operate in the economic system
which tend to maintain full employment”. If there is unemployment at any time, then there
is a tendency towards full employment, provided there is no external or government
interference with the functioning of the economy. In the classical view, full employment
does not mean that all the resources are fully employed—there might be frictional and
voluntary unemployment in the state of full employment. .
2. The Wage Rate is Equal to Marginal Product of Labour
Classical economists believed that in case of full employment, wage rate is equal to marginal
productivity of labour. Marginal productivity of labour is measured by the addition to the
total production by employment of one additional labour.
3. The economy is always in the state of equilibrium
the classical economists postulated that an economy is always in the state of equilibrium.
They believed that full employment of resources generates incomes, on the one hand, and
goods and services, on the other. The value of goods and services is always equal to incomes
generated through the process of production. The income earners spend their entire income
on goods and services produced. This implies that the value of entire output of goods and
services is equal to total social expenditure. There is no general overproduction and there is
no general underproduction over a period of production. To put it in the Keynesian
terminology, in the classical system, the aggregate demand is always equal to aggregate
supply in the long run, and the economy remains in stable equilibrium.
The classical postulates of full employment and equilibrium of the economy are based on
the assumption that the economy works on the principles of laissez-faire. The laissez-faire
system has the following features:
(i) There is no government control or regulation of private enterprises. If there is any

government interference, its objective is to ensure free competition;
(ii) There are no monopolies and restrictive trade practices—if there are any, they are
eliminated by law;
(iii) There is complete freedom of choice for both the consumers and the producers; and
(iv) Market forces of demand and supply are fully free to take their own course
depending onthe demand and supply conditions.
4. Money does not matter
The classical economists treated money only as a medium of exchange. In their opinion, the
role of money is only to facilitate the transactions. It does not play any significant role in
determining the output and employment. The levels of output and employment are
determined by the availability of real resources, that is, labour and capital.

Say’s Law of Market: The Foundation of Classical Macroeconomics
Say’s law of market is generally stated as “the supply creates its own demand” or “supply calls
forth its own demand.” The logic behind this law is that supply of goods itself generates
sufficient
income to generate a demand equal to the supply of goods. This is how supply creates its own
demand. The significance of this simple law is that it is regarded as the core of ‘classical’
macroeconomic thought. The law that ‘supply creates its own demand’ is generally attributed
to a French economist, Jeane Baptiste Say (1767-1832). Although some scholars trace the
origin
of this law to the writings of James Mill, it was J. B. Say who refined this law. The law is
therefore known as Say’s law. Say’s law is regarded as the ‘beginning of sound thinking in
macroeconomics.’ This law can be explained in the context of both a barter system and a
monetised economy.
In a barter economy, people tend to specialise in the production of goods or services which
they can produce relatively more efficiently, though they consume many other goods and
services. They acquire other goods and services they consume in exchange for their own
produce. When they offer their produce in barter for other goods, they create demand for
other goods. For example, a farmer offers his surplus produce (say, wheat) to the weaver in
exchange for cloth. Thus, the farmer creates demand for cloth. The weaver who is in need of
wheat produces surplus cloth which creates demandfor wheat. Thus, the supply of wheat
creates demand for wheat. Say’s law applies equally well to themonetized economy. In an
monetized economy, money is used as medium of exchange, that is, goods are bought and
sold with the use of money. In an monetized economy, the logic of ‘supply creates its own
demand’ works somewhat differently. Production in a market economy is meant for sale in
the market. Production of goods requires employment of factors of production—land, labour,
capital, and entrepreneurship. The employment of factors of production generates money
income inthe form of rent, wages, interest, and profits, respectively. Income earners spend
their income on goods and services they consume. By spending their money income on the
goods they produce, theycreate demand. It follows that if there is production, there is income,
and if there is income, there is demand for goods including demand for goods whose
production creates income. Thus, supply creates conditions for its own demand in a market
economy.9

Two Major Derivatives from Say’s Law: The Classical Macroeconomics
As noted above, the Say’s law of market provides the foundation of classical
macroeconomics. The classical macroeconomics is based on two main derivatives from the
Say’s law, which are described here briefly.
(i) No General Overproduction or Underproduction
Say’s law was refined and popularised in England by a group of classical economists,
especially David Ricardo. This is known as the classical reformulation of Say’s law. The
classical reformulation of Say’s law states that, in a capitalist economy, total supply
always equals total demand and that there cannot be ‘general underproduction’ or
‘general overproduction.’ In the opinion of classical economists, a capitalist economy
based on laissez-faire is always in equilibrium. Underproduction and overproduction, if
any, are only transitory and are caused by external factors. That is, there might be short-
term imbalances in the demand for and supply of some goods and services caused by
the exogeneous factor. The short-term demand-supply

imbalance is corrected and equilibrium restored in a capitalist economy by the market
forces. The process of restoration of equilibrium can be described as follows. When there
is underproduction, demand exceeds supply. Excess demand leads to rise in prices which
reduces demand, on the one hand, and encourages supply, on the other. Similarly, when
there is overproduction, prices tend to decrease. Decrease in price results in decrease in
supply, on the one hand, and increase in demand, on the other. This process of demand-
and-supply adjustmentrestores the equilibrium. Thus, in the long run, a market economy
is always in equilibrium. A simple proof of the ‘classical’ long-run equilibrium of the
economy can be described as follows.
(ii) No Unemployment Under Classical System
As mentioned earlier, classical economists postulated that, in a free enterprise economy, full
employment is a normal affair. It means that there cannot be general unemployment in a free
enterprise economy. In their opinion, full employment ensures that actual output equals the
potential output. Full employment coincides with equilibrium level of output. In classical
view, total production is always sufficient to maintain the economy at the level of full
employment in a free market economy. Unemployment, if any, is a temporary phenomenon.

Whenever there is unemployment, wages decrease. Decrease in wage rates makes
employment of labour more profitable. This results in increase in demand for labour and
unemployment disappears. However, classical economists did not rule out the existence of
voluntary and frictional unemployment in the state of full employment.
voluntary unemployment arises when:
(a) potential workers are unwilling to work at the prevailing wage rate,
(b) workers go on strike (unpaid) for higher wages,
(c) rich persons are unwilling to work, that is, the idle rich,
(d) some persons prefer leisure or idleness to better life, that is, the case of very poor,
mendicants,sadhus and sanyasins.

Frictional unemployment arises when workers remain temporarily out of job due to labour
market imperfections, immobility of labour, seasonal nature of occupation as in agricultural
activities, technological changes, natural calamities, wars, and so on. The existence of
voluntary and frictional unemployment is consistent with the classical postulate of full
employment.
Classical Theory of Employment: A Formal Model of Say’s Law
This section presents a formal model of Say’s law as constructed by the Keynesians. It is
noteworthy that classical economists had not developed any theory or model of employment.
They believed that‘available resources’ including ‘employable population,’ ‘natural wealth’
and ‘accumulated capital equipment’ determine employment. In the words of Keynes,
however, “... the pure theory of what determines the actual employment of the available
resources have seldom been examined in great detail. [But] To say that it has not been
examined at all would, of course, be absurd”. In fact, “... ithas been deemed so simple and
obvious that it has received, at the most, a bare mention”.However,Keynes had himself used
the essence of classical thoughts on employment and constructed classical theory of
employment. The classical model of employment as reconstructed by Keynesians consists
of two components: (i) Aggregate production function, and (ii) Labour supply and labour
demand functions.
These two functions are used to show the determination of output and employment. The
classical model presented below displays the determination of the real output and
employment required to produce equilibrium level of national output, and the general price
level under the condition of a given money supply.
The Aggregate Production Function The aggregate production function is central to the
classical model as it determines simultaneously the aggregate output and employment.
According to the classical economists, the national output of a country at any point of time
depends on the capitaland labour employed. As it is, the aggregate production function used
in the reconstructed classical model can be expressed as:10

where Y = aggregate real output, K = capital (fixed), and L = amount of labour
(homogeneous) required to produce Y. The classical production function (5.1) assumes (i)
the stock of capital (K) is fixed, (ii) technology of production used by the firms is given, and
(iii) population is constant. Obviously, classical production function has been constructed in
a short-run framework. The national output in the short-run is therefore the function of the
employment of labour drawn from the constant population. The model assumes also that the
use of successive units of labour is subjectto the law of diminishing returns. In other words,
marginal productivity of labour, defined as MPL = ΔY/ΔL, decreases with an increase in
employment. According to the classical view, the level of output at which MPL = 0 marks
the level of maximum possible level of employment and national output.
Figure presents the short-run aggregate production function [Y = F(, L)] under the
assumptions that capital (K) is constant and employment of labour yields diminishing
returns.

As Fig. shows, ΔY/ΔL (given by the slope of the production function) goes on decreasing as
labour employment increases. As the total production curve (marked Y = F(, L)) shows,
marginal productivity of labour (ΔY/ΔL) goes on decreasing as labour employment increases
and ΔY/ΔL tends to zero. Let us suppose that at point M, ΔY/ΔL 0. The point M, therefore,
marks the limit of employment at ON and total output at MN.
An important feature of the classical employment model is that factors operating on the
supply side of the market determine the level of employment and output. As shown above,
labour market equilibrium is determined by the demand for and supply of labour. The labour
demand curve is, however, derived from the production function based on a given technology
determinedexogenously. The labour demand curve is therefore, in a sense, a datum, i.e., a
given fact or law. According to classical theory, it is the labour supply, which is a function
of real wages, that plays a more important role in the determination of the labour market
equilibrium and employment. And, employment determines the level of output. Thus, in the
classical model, employment and output are determined solely by the factors operating on
the supply side of the labour market.
Wage Price Flexibility
According to classical theory, there is always full employment in the market but in

case of unemployment, a general cut in money wages would take the economy to full
employment level again. It is assumed that there is direct and proportional
relationship between money and real wages.
Given K and T, the production function becomes Q= f(N), this implies that output is
a function of number of workers employed. Output increases as more workers are
employed but after a point when more workers are employed the diminishing
marginal returns to labour start.
In Figure 1, curve Q= f(N), is a production function, and total output OQ1
corresponds to the full employment level Nf but when more workers are employed
NfN2 beyond full

employment level output OQ1, the increase in output Q1Q2 is less than increase in
employment NfN2 or N1N2
Labour market Equilibrium
The demand for labour can be described as a function of real wage rate. Dn=f {W/P}.
Dn= demand for labour, W= Wage Rate, P= Price level.
Real Wage rate= W/P
The demand for labour is the decreasing function of real wage rate as shown by
downward sloping demand curve Dn. By reducing real wage rate more workers can
be employed.
Supply of labour also depends upon real wage rate. It is an increasing function of real
wage rate as shown by upward sloping Sn curve. When Dn and Sn curves intersect,
full employment level Nf is determined at real wage rate W/P0. At W/P1 wage rate
ds workers will be involuntary unemployed as demand for labour is W/P1- d is less
than their supply W/P1-s. Due to competition among workers they will be ready to
accept lower wage rate W/P0. Consequently, the wage rate will fall from W/P1 to
W/P0. The supply of labour willfall and their demand will rise, the equilibrium point

E will be restored at full employment level. If the real wage rises to W//P1 , the supply
exceeds the demand for labour by sd and N1N2 workers are unemployed. It is only
when the real wage of reduced to W/P0 that unemployment disappears and level of
full employment is reached. In part (B), MPn is the marginal product of labour curve
which slopes downward as more labour is employed. Since every worker is payed
according to his marginal product, therefore full employment level Nf is reached
when wage rate falls from W/P1 to W/P0

Wage Price Flexibility
In case of unemployment, a general cut in money wages will take the economy to full
employment level. It is assumed that there exists direct and proportional relationship
between real and money wages. When money wages are reduced , they lead to
reduction in cost of production and consequently, lower prices of products. As prices
fall, the demand forproducts will increase, and sales will be pushed up. Increased
sales will necessitate the employment of more labour and ultimately full employment
will be achieved.
Demand for labour is decreasing function of real wage rate. If W is the money wage
rate, p isthe price of the product and MPn is the marginal product of labour. This
means, W= P x MPn or MPn= W/P. Since, MPn declines as employment increases,
it follows that real wage declines. In the Figure, part A, Sn is supply of labour and

Dn is demand of labour. The intersection of the two curves at E shows full level of
employment at E at real wage W/P0.

Goods Market equilibrium
The goods market is in equilibrium when total savings equal investment. At this
point, total demand equals total supply and the economy is in the state of full
employment. Whatever is not spent is automatically invested. If there is divergence
between the two, the equality is maintained through mechanism of interest rates.
According to classical theorists, both savings and investment of the interest rate.

S= f(r); I= f(r), S= I, S= saving, I= Investment, r = interest rate
According to classicists, interest is the reward for saving. Higher the rate of interest,
higher the saving, lower the investment. On the contrary, lower the rate of interest,
higher the demand for investment funds and lower the savings. If at any given period,
investment increase saving(I>S), the rates of interest will rise.Saving will increase
and investment will

decline till the two are equal at full employment level. This is because saving is
regarded as increasing function of interest rate and investment is regarded as
decreasing function of interest rate.
Assuming that interest rates are perfectly elastic, S is the saving curve and I is the
investment curve. Both intersect at E which is the full employment level, where Or
is the interest rate and S= I. If interest rate rises to Or1 which means savings are more
than investment which will lead to unemployment in the economy. Since S>I, the
investment demand for capital is less than its supply , the interest rate will fall to Or,
the investment will increase and savings will decline. Consequently, S=I, the
equilibrium will be re-established at point E.
On the contrary, with fall in interest rates from Or to Or2, investment will be more
than saving (I>S) by cd, the demand for capital will be more than its supply. The
interest rates will rise, savings will increase and investment will decline till S =I and
equilibrium is restored at full employment level E.
Money Market Equilibrium

Money market theory in the classical theory is based on quantity theory of money
which states that the general price level (P) in the economy depends upon the supply
of money(M). The equation, MV=PT, M= Supply of money, V= Velocity of
circulation of M, P= Price level, T = Volume of transaction or total output. MV=PT
implies that the total money supply is equal to the total value of output PT in the

economy. If we assume V and T to be constant, a change in supply of money (M)
causes proportional change in the price level (P). Thus, the price level is the function
of the money supply: P= f(M). MV is the money supply curve which is a rectangular
hyperbola. This is because MV= PT holds on all points of the curve. Given the output
level OQ, there would only be one price level OP consistent with the quantity of
money as shown by the point M on the MV curve. If the quantity of money increases,
the MV curve will shift to the right as M1V curve. As a result the price level would

rise from OP to OP1 given the same level output OQ. This rise in price level is exactly
proportional to rise in the quantity of money.i.e PP1=MM1
when the full employment level of output remains OQ.
In a nutshell, in classical theory, the determination of employment and output takes

place in labour, goods and money markets of the economy. The forces of demand
and supply will ultimately bring full employment in the economy.

The Collapse of the Classical microeconomics The classical macroeconomic postulates
prevailed until the Great Depression and it had prevailed because it was never put to test by
big changes in economic conditions over time.

However, the Great Depression proved that the very basic postulates of the classical
economics in general, and classical macroeconomic in particular, were fundamentally
wrong. Recall the two basic postulates of the classical economics. One of the fundamental
postulates of the classical economicsis that if there is perfect competition in both product
and labour markets, then (i) the economy is always in equilibrium, and if some external
forces create disequilibrium, market forces of demand and supply bring it soon back to the
equilibrium, and (ii) there is always full employment, and unemployment, if any, is either
frictional or voluntary, i.e., those who are unwilling to work at the prevailing wage rate would
remain unemployed. The second basic postulate of the classical economics is the Say’s law
that, ‘supply creates its own demand’. It implies that the aggregate demand is always equal
to aggregate supply and there is no demand deficiency, except for a short period of
disturbance. It is ironical that classical thoughts and theories failed to hold when classical
postulates were really put to test in the world economy. If market conditions were ever close
to the classical perception of perfect competition, it was between the First World War and
the Great Depression. Yet, the Great Depression took place. The industrial economies
suffered a long-run disequilibrium and a prolonged state of involuntary unemployment. The
intensity and duration of economic calamity brought about by the depression was
unprecedented. In the US, output had fallen by 30% and unemployment had risen to over
25%. In the UK, the rate of unemployment was lower (10%) but it had persisted over the
entire period of 1930s. Most other industrialised nations also had experienced an
unprecedented fall in their GNP and rise in unemployment. This experience invalidated the
classical postulates and Say’s law. There was supply of labour willing to work at prevailing
wage rate but there was no demand for labour. There was supply of capital but there was no
sufficient demand for capital. Until the beginning of recovery, there was supply of goods and
services, but demand lagged far behind. This was a clear case of failure of the Say’s law. The
classical theory had no answer to these global economic predicaments of the 1930s. This
marked the collapse of the classical economics. This takes us to the end of our brief
dicsussion on the classical macroeconomics with focus on the classical theory of output
(income) determination and employment and Keynes’ attack on the classical
macroeconomics.
Keynesian Theory of Employment

Keynes himself had not formulated the theory of income determination. In his General
Theory, Keynes had, in fact, formulated a general theory of employment. However,
economists of the next generation developed the Keynesian theory of income determination
by consolidating the various theories, concepts and functions used by Keynes in his own
theory of employment. Let us have glance at the basics of the Keynesian theory. In
formulating his theory of employment, Keynes had conceptualized the aggregate supply and
aggregate demand functions and also the consumption, saving and investment functions,
which constitute his basic theoretical framework. Keynes hadexpressed the aggregate supply
function as Z = f (N) and aggregate demand function as D = f (N), where Z = total revenue
of entrepreneurs; N = labour employment; and D = aggregate demand. The aggregate
demand function, i.e., D = f (N), implies that the aggregate demand depends on income
generated from the employment of labour. According to Keynes, equilibrium level of
employment is determined at the level of employment at which aggregate supply of output
is equal to aggregate demand, i.e., where Z = f (N) = D = f (N). According to the Keynesian
propositions, given the MPPL, real wage rate (w/p), stock of capital, and total expenditure
by the society, once employment is determined, national income (Y) is also determined.
Thus, national income (Y) is the function of employment (N), i.e., Y = f (N).

Given the basic Keynes’ theoretical framework, modern economists consolidated various
Keynesian theories, concepts and functions to reconstruct the Keynesian theory of income
determination. Samuelson1 reformulated Keynesian theory of income determination
systematically and presentedit mathematically. Other economists have explained Keynes’
theory of income determination more elaborately and presented it mathematically and
graphically under three models: (i) simple economymodel – a model with households and
firms, (ii) closed economy model – a model with government sector, and (iii) open economy
model – a model with foreign sector. The same approach has been adopted in this book.
Before we discuss the Keynesian theory of income determination, let us look atthe theoretical
framework, basic concepts, definitions and functions used in his theory of income
determination. The concepts and functions that are crucial to the discussion on the Keynesian
theoryof income determination are: (i) the aggregate supply function, (ii) the aggregate
demand function,
(iii) t
he aggregate consumption and saving functions, and (v) the constant investment.
According to Keynes, an increase in aggregate demand would increase the level of

employment and vice versa. Total employment of a country can be determined with the help
of total demand of the country. A decline in total effective demand would lead to
unemployment. As per Keynes theory, effective demand signifies the money spent on the
consumption of goods and services and on investment. The total expenditure is equal to the
national income which is equivalent to the nationaloutput. It can be expressed as:
Effective demand= National Income= National Output
Therefore, effective demand effects employment of a country, national income and national
output. It declines due to the mismatch of income and consumption and this decline lead to
unemployment. With the increase in national income , rate of consumption also increases but
the rate of increase in consumption is relatively low as compared to the increase in national
income. Low consumption rate leads to decline in effective demand. Therefore, the gap
between income and investment should be reduced by increasing the number of investment
opportunities. Consequently, effective demand also increases which helps in reducing
unemployment and bringing full employment condition. In fact, the effective demand refers

to total expenditure of an economy at a particular employment level. The total expenditure
is equal to the total supply price of the economy(cost of production of goods and services)
at a certain level of employment. Therefore, effective demand refers to the demand of
consumption and investment of an economy.
Determination of Aggregate Demand
Aggregate demand price and aggregate supply price are two key determinants given by
Keynes which together contribute to determine effective demand, which further helps in
estimating level of employment in the economy at a particular period of time. In an economy,
employment level depends upon number of workers that are employed, so that maximum
profit can be drawn. Therefore, the employment level of an economy is dependent upon
the decisions of the

organizations related to the hiring of the employee and placing them. The level of
employment in an economy can be determined with the help of aggregate demand price and
aggregate supply price.
Aggregate Supply Price
Aggregate Supply price refers to total amount of money that all organizations in the
economy receive from the sale of output by employing specific number of workers. In other
words, aggregatessupply price is the cost of production of goods and services at a particular
level of employment. It is the total amount of money paid by the organizations to different
factors of production of products and services at a particular level of employment. Therefore,
the organizations will not employ the factors of production until they can recover the costs
of production incurred for employing them. A certain minimum amount of price is required
for inducing employers to offer a specific amount of employment. The minimum price or
proceeds which will induce employment on a given scale, is called the aggregate supply of
that amount of employment. If an organization does not get an adequate price so that its cost
of production is covered , it employs less number of workers.Therefore, aggregate supply
price varies with the different number of workers employed.
Aggregate supply price schedule is a schedule of minimum price required to induce different
quantities of employment. Thus, higher the price required to induce different quantities of
workers, greater will be the level of employment. Therefore, the supply of aggregate supply
curve is upwardto the right.
Aggregate Demand Price
Aggregate demand price is different from demand for products of individual organizations
and industries. The demand for individual organizations or industries refers to a schedule of
quantity purchased at different levels of price of a single product, whereas aggregate
demand price is thetotal amount of money that an organization expects to receive from sale
of output produced by employing a specific number of workers. In other words, aggregate
demand price implies the total sale receipts which an organization expects to receive by

employing specific number of workers.
Aggregate demand price schedule refers to the schedule of expected earnings by selling the
product at different levels of employment. Higher the level of employment , greater the
output would be.
Consequently, the increase in the level of employment would increase the aggregate demand
price. Thus, the slope of aggregate demand price would be upward to the right, whereas
individual demand curve slopes downward. There is a thin line but appreciable difference
between aggregate supply price and aggregate demand price. In aggregate supply price, the
organizations should receive from sale of output produced by employing specific number of
workers, whereas in aggregate demand price, it is the expected sale receipts of the
organization from the sale of output produced by specific number of workers. In aggregate
supply price , it is the necessary amount which should be received by the organization
whereas in aggregate demand price, it is the amountof money which may or may not be
received.

Determination of Equilibrium level of Employment
Aggregate supply price and aggregate demand price help in determining the equilibrium
level of employment.
AD curve represents aggregate demand price, AS curve represents the aggregate supply
price.Although both the curves are moving in the same direction but they are different in
shape. They are different for different levels of employment. In the figure, on AS curve, the
organization would employ ON1 number of workers it should receive OC amount of sales
receipts. Similarly, on OD curvethe organization would employ ON1 number of workers in
expectation that they would produce OH amount of sales receipts for them. The aggregate
demand price exceeds aggregate supply price at some levels of employment. For example,
at ON1 level of employment aggregate demand price OH is greater than OC aggregate

supply price. At some level, aggregate supply price and aggregate demand price become
equal. The point at which the two curves intersect each other (E )is known as the point of
equilibrium. Initially, there is a slow movement of supply curve but later there is a steep rise
. This implies that the organization employs more number of workers initially, the cost of
production increases at a slow rate but when amount of sales receipts increase the
organization employs more workers. Organization employs ON1 number of workers when
OT amount of sales receipts are received by the organization.

However, AD curve shows rapid increase initially but after some time it gets flattened. This
means that expected sales receipts increase with increase in number of workers. In other
words, theexpectation of the organization to earn profits increase but after a certain point
there will be no further increase in sale receipts for corresponding increase in employment
level At ON2 level, the employment level keeps on increasing as the organizations want to
keep hiring more and more workers to earn higher profits. But as ON2 level is breached AD
curve is below the AS curve, which shows aggregate supply price exceeds aggregate demand
price. Hence, the organization would start incurring losses and that would reduce the
employment level.
Thus, the economy would be in equilibrium when the aggregate supply price equals
aggregate demand price. In other words, the equilibrium is attained when the amount of sales
receipt necessary and amount of sales receipts expected to be achieved by the organization
at the particularlevel of employment are equal.
Short Run and Long Run Consumption function
The consumption function is one of the most important functions used in macroeconomics
and the most important function used in the Keynesian theory of income determination. A
consumption function is a functional statement of relationship between the consumption
expenditure and its deteminants. Although consumption expenditure of households depends
on a number of factors— income, wealth, interest rate, expected future income, lifestyle of
the society, availability of consumer credit, age and sex, etc. Income is the primary
determinant of consumption and saving’. Given this dictum, the most general form of
consumption function is expressed as: where C= consumption expenditure, and Y =
disposable income. The consumption expenditure is a positive function of income, i.e.,
consumption increases with increase in income.
Short-run and long-run consumption function : Ando and Modigliani have expressed realistic
findings based on fieldwork done by then in America. They have given an explanation of short
and long-run consumption level of different age group people of low income. This function has
been estimated taking time series data for the country U.S.A. The estimate tells us that, in
America there was high level of consumption in low income group at their retirement age (after
60) on large scale. On the contrary, there was large number of middle age group youths in

America whose average propensity to consume was relatively low. It is because of increase in
income decreases the consumption in short-run period. But in long-run period, average
propensity to consume was larger i.e. 0.72 as well as constant. These observation based findings
have been shown in the figure No. 2.3.1
Figure No. 2.3.1 shows us the level of short and long-run consumption level. Ando and
Modigliani observed in America that, there was 0.6 short run consumption level where as in
long-run it was 0.72. The long run consumption level was stable and constant. This had
happened due to the increasing trend of income and consumption tendency of low and high
level income groups A.P.C.
According to Keynes, this relationship between income and consumption is based on a

“fundamental psychological law” that “men are disposed, as a rule and on average, to
increase their consumption as their income increases, but not as much as the increase in their
income”. This Keynesian view implies that ΔC/ΔY goes on decreasing in case of individual
households. The nature and extent of relationship between income and consumption in
interpreted by marginal propensity to consume. Therefore, the Keynesian consumption

theory is explained by using the concept of marginal propensity to consume.
Marginal Propensity to Consume (MPC)
The marginal propensity to consume (MPC) refers to the relationship between marginal
income and marginal consumption. The marginal propensity to consume (MPC) is expressed
symbolically as ΔC/ΔY. In the opinion of Keynes, ΔC/ΔY decreases with the increase in
income. In plain words, as income increases, people tend to consume a decreasing
proportion of the marginal income. This kind of income-consumption relationship
represents the Keynesian consumption function. The Keynesian theory of consumption
produces a curvi-linear consumption function as shown in

It is important to note here that the Keynesian consumption function is relevant for individual
household’s consumption behaviour—not for the economy as a whole or at the aggregate
level. Keynesian economists have, however, estimated empirically the consumption function
for the economy as a whole which take the form of a linear consumption function. The linear
consumption function is shown by the straight line marked by the consumption function C2
= f (Y) . The Keynesians have used a linear consumption function in reconstructing Keynes’s
theory of income determination. Let us therefore look at the linear consumption function.
The Linear Aggregate Consumption Function Although Keynes postulated a curvi-linear
consumption function, it is now a convention in the modern interpretation and analysis of
Keynesian macroeconomics to use a linear aggregate consumption function of the following
form.
In consumption function given in above equation, C = aggregate consumption expenditure;

Y = total disposable income. Intercept a is a positive constant. It denotes the level of

consumption at zero level of income. The consumption at zero level of income is called
autonomous consumption, supposed to be financed out of past savings. In Eq., the coefficient
b is a positive constant. Mathematically, it represents the slope of a linear consumption
function. It denotes a constant MPC
= ΔC/ΔY. The MPC is less than unity but greater than zero, that is, 0 < b < 1. Given the
consumption function , it can be shown that b = ΔC/ΔY. Let us suppose that the consumption
function is given as

Let us suppose that an empirically estimated linear aggregate consumption function is given
as:
The consumption function is presented graphically in Fig. As Fig shows, consumption (C)
equals Rs 200 even when Y = 0. This consumption is assumed to be financed out of past
savings. It shows also that the subsequent increases in income (ΔYs) induce additional
consumption (ΔCs) at a fixed proportion of 75%. That is, aggregate consumption increases
with the increase in aggregate income, at a constant rate of 75% of the marginal income. For
example, when aggregate income increases from Rs 200 to Rs 300, aggregate consumption
increases from Rs 250 to Rs 325.

The constant MPC = 0.75 can be worked out as follows. At Y = 300,

And, when income (Y) increases from Rs 300 to Rs 400, C increases from Rs 325 to Rs
400. In thiscase,
This shows that, in our example, the marginal propensity to consume (MPC) is constant at
75% at theaggregate level.
Average Propensity to Consume (APC)
The average propensity to consume (APC) is defined as
Given the consumption function, C = a + bY,
If consumption function is assumed to be of the form C = bY, then, It implies that if C = bY,

then APC = MPC.
Saving Function
The saving function is the counterpart of the consumption function. It states the relationship
between income and saving. Therefore, saving is also the function of disposable income.
We know that Y = C + S. Thus, consumption and saving functions are counterparts of one
another.Therefore, if one of the functions is known, the other can be easily derived. Given
the consumption

function as C = a + bY, saving function can be easily derived as follows. Since, Y = C +
S, savings (S)can be defined as
By substituting consumption function, C = a + bY, for C in Eq. (6.10), we get,
The term 1–b in function gives the marginal propensity to save (MPS), where b = MPC.
The saving function can be derived algebraically as follows. By substituting consumption

function, C
= 200 + 0.75Y for C in Eq. , we get the saving function as
The saving function is presented graphically in Fig.

As the figure shows, savings are negative till income rises to Rs 800. At income of Rs 800,
savings equal to zero. Positive saving takes place only after income rises above Rs 800.
Saving increases at the rate of 25% of the marginal income.
The Aggregate Demand Function
Now that we have explained the consumption and saving functions, we can present aggregate
demand function, assuming that investment (I) remains constant. Recall aggregate demand
(AD) andconsumption (C) functions given as

By substituting a + bY for C, we get
The Aggregate Demand Function
Recall our estimated hypothetical consumption function C = 200 + 0.75Y and assume that =
100. By substitution, the estimated aggregate demand function can be written as
The derivation of the aggregate demand function is shown in Fig. In Fig., a constant
investment is shown by a straight horizontal line I ̅ = 100. Consumption (C) being a
rising function of income is shown by an upward sloping line, C = 200 + 0.75Y. The

aggregate demand function is obtained by vertical summation of the consumption function
and the constant investment, that is, AD = C + , at different levels of income (Y).
Income Determination in Simple Economy Model
Simple economy model includes only two sectors: (i) the household sector, and (ii) the
business sector. An economy of this kind does not exist in reality. But, this hypothetical
economy provides a simple and a convenient starting point in understanding the Keynesian
theory of income determination. The determination of income and output in realistic models
will be discussed in the subsequent chapters. In order to explain the determination of
income in two-sector model, let us

look at the theoretical model and the assumptions. Assumptions The simple economy model
makes the following assumptions.
1. There are only two sectors in an economy, viz., (i) the households, and (ii) the business
firms— there is no government and no foreign trade.
2. In simple economy model, aggregate demand consists of (i) aggregate consumer demand
(C) and aggregate investment demand (I). Thus, aggregate demand (AD) = C + I and there
is no leakage or injection.
3. Since there is no government, there is no tax and no government expenditure. Even if some
form of government exists, it does not impose any tax and does not spend.
4. The two-sector economy is a closed economy—there is no foreign trade nor is there any
external inflow or outflow of money.
5. In the business sector, there is no corporate savings or retained earnings. The total profit
is distributed as dividend.
6. All prices, including factor prices, remain constant.
7. The supply of capital and technology are given. Having specified the two-sector model,
we proceed now to analyse the determination of the equilibrium level of national income.
Income and Output Determination
According to the Keynesian theory of income determination, the equilibrium level of

national income is determined at a level where aggregate demand (C + I) equals the aggregate
supply of income Y = C + S. That is, the national income equilibrium is determined where:
Keynes argued that there is no reason for the aggregate demand to be always equal to the

aggregatesupply. According to Keynes, aggregate demand depends on households’ plan to
consume and to save and invest. Aggregate supply depends on the producers’ plan to
produce goods and services.For the aggregate demand and the aggregate supply to be always
equal, the households’ plan must always coincide with producers’ plan. However, Keynes
argued that there is no reason to believe:
(i) that consumers’ consumption plan always coincides with producers’ production
plan; and
(ii) that producers’ plan to invest matches always with households’ plan to save.
Therefore, there is no reason for C + I to be always equal to C + S and national
income to be in equilibrium at all the levels of income. According to Keynes, there
is a unique level of outputand income at which the aggregate demand equals the
aggregate supply. This unique point exists where consumers’ plan matches with
producers’ plan and savers’ plan matches with firms’ plan to invest. It is here that
the equilibrium level of income and output is determined. A formal model of income
and output determination is given below. Formal Model of Income Determination
In this section, we present a formal model of income

determination in a two-sector framework. Recall the Keynesian theory of income
determination that the equilibrium level of national income is determined where
aggregate demand (C + I) equals the aggregate supply (C + S). As mentioned above,
the condition for national income equilibrium can thus be expressed as:
Since C is common to both the sides of Eq. C on both sides gets cancelled out. Thus,
the equilibrium condition for the national income can also be expressed as:
Given the Eqs., there can be two approaches to explain the Keynesian theory of
national income determination, viz., (i) Aggregate Demand and Supply (AD-AS)
approach, and (ii) Saving and Investment approach. Let us first explain the theory of
income determination by AD-AS approach.
(i) Aggregate Demand and Supply Approach
According to the AD-AS approach, national income equilibrium is determined where
Equation tells that at equilibrium level of national income,
As noted above, the aggregate consumption function, C = a + b Y and I is constant

at . By substituting a + bY for C and for I in Eq. (6.17), the equilibrium level of
national income can be expressed as:

Equation may now be solved to find the equilibrium level of national income (Y)
and consumption (C). Let us first solve Eq. for Y. As given in Eq.
Above Equation represents the ultimate form of the equilibrium condition for
nationalincome equilibrium in two-sector model.
Fundamental Psychological Law of Consumption
According to Keynes, this relationship between income and consumption is based on a

“fundamental psychological law” that “men are disposed, as a rule and on average, to increase
their consumption as their income increases, but not as much as the increase in their income”.
This Keynesian view implies that ΔC/ΔY goes on decreasing in case of individual households.
The concept of consumption function plays an important role in his employment and income
theory. Keynes wrote a book entitled 'The theory of employment, interest and money' in 1936,
According to Keynes, the functional relationship between income and consumption is known
as consumption function. We can explain this concept with the following formula.
C = f (y)
Here C = Consumption
f = functional relationship. y = Income.
According to Hansen, Keynes has given important contribution to the consumption function.
* Keynsian psychological law of consumption function : Keynes has stated psychological law
of consumption function in the following manner.
Other things being same, as income increases, consumption increases but not by as much as
the increase in income. In another words, marginal propensity to consume is less than one.

The above statement of consumption function is based on the following 3 basic assumptions.
a) Constant psychological and institutional frame work : Keynes assumes that the factors
affecting consumption function in short-run period are constant. These factors are distribution
of income, tastes and traditions of the people, prices of commodities etc. do not change during
this period.
b) This law is applicable in normal position of an economy.
c) Keynes law of consumption function becomes truth in free capitalistic economy.
Now we will consider this law in detail.
Keynes' law of consumption function describes the relationship between income and
consumption. The table No. 1 clears the psychological law of consumption function in respect
of changes in income, consumption and savings.
Table No. 1 clears that as the income increases, the consumption increases but it increases less
than increase in income. When income increases the savings also increase due to marginal
propensity to consume is less than one. The table also shows that as income increases from
crores 0 to 200 crores, Consumption increases from Rs. 40 Crores to Rs. 140 Crores and savings
also increases from Rs. 20 Crores to Rs. 60 Crores. We can explain this concept of Keynesian
psychological law of consumption function with the help of following figure No. 1.

Figure No. 1 shows us the trend of increasing level of income and consumption expenditure.
Here we observed that as per increase in income of a country, consumption expenditure

increases but with low protortion indicates that since the 'P' point as per increase in income,
consumption decreases and savings increases. Keynes says that this happens due to the
psychology of a consumer.
Important conclusions of Keynes' psychological law of consumption function:
There are 3 important findings of the Keynes' law of Consumption function.

They are as follows.
1) When the aggregate income increases aggregate consumption expenditure also increases but
by same what smaller amount. The basic cause behind it is that of increase in income, the
primary wants and expenditure an it has been fulfilled.
2) An increase in aggregate income will be divided into 2 parts i.e. consumption and savings.
When entire income is not spent on consumption, the part of that is saved.
3) As per increase in aggregate income, both consumption and savings increases. It seems that,
increase in income leads to increase in consumption as well as saving.
Importance of Keynesian Consumption Function:
Keynes' concept of consumption function is useful in macro-economic analysis.

This law is important in theory as well as in practice. Prof. A. H. Hansen has remarked that
Keynes' concept of consumption function for the formulation of macro-economic policy. Now
we will see the importance of this concept.
1) The concept of consumption function hightlights the importance of investment. Keynes says
that investment and consumption are the two important factors of theory of employment. The
total volume of employment depends upon the level of consumption expenditure and
investment. The psychological law of consumption function devotes that when in crease in
income does not enhance the consumption expenditure, there is a greater need of investment.
2) This law helps to invalidate say's law of markets, Keynes' consumption function effectively
contradicts says law of markets due to the problems arises in the equilibrium between demand
and supply. Keynes says that say's law of market is not useful now - a - days, because when
consumption expenditure does not increase as per increase in income, the problem of
overproduction and unemployment arises. The Government has to solve this critical situation
by stimulating consumption and investment.

3) Keynes' law of consumption gives us more explanation about the turning point of business
cycle. He says that MPC is always less than one. Due to this, the phases of trade cycle arises
in a economy. This law also gives us the explanation about rising the phases of boom, recession
and recovery.
4) This concept of consumption function helps to explain the process of income agreation
through additional income generated in an economy with the rising trend of savings.
5) The concept of consumption function gives the explanation about decreasing trend of
marginal efficiency in a country. Keynes says that consumption expenditure doesn't increase
as per increase in income due to MPC is less than 1. So that beyond a limit, marginal efficiency
of capital decreases due to less demand, consumption and the level of production in a economy.
This decreasing trend of MEC affects the economic development of a economy.
In this way, Keynesian law of consumption function is useful in a developing as well as
developed countries in the world.

Determination of consumption
Having obtained the equilibrium level of Y, we can work out the equilibrium level
of aggregate consumption as follows. Given the consumption function as
By substituting Eq. for Y in the consumption function, we get
Numerical Example The equilibrium level of Y and C can be determined

numerically by assuming a hypothetical consumption function and a given level of .
Let us suppose the consumption function is given as:
Given the consumption function (6.21) and I ̅ = 200, there are two methods of
finding the value of C at equilibrium level of Y. One method is to substitute the
numerical value for
a, b and I in Eq. . The second method is to first calculate equilibrium Y and find the
value ofC through Eq. By using the first method, we get

By using the second method, the value of Y can be obtained by substituting the
numerical values for C and , respectively, in Eq. (6.18). We get equilibrium level of
Y as follows.
Thus, given the consumption function as C = 100 + 0.75Y and I ̅ = 200, the
equilibrium level of national income is determined at 1200. Once the equilibrium
level of national income is determined, the equilibrium level of consumption (C) can
be obtained by substituting

1200 for Y in the consumption function . Thus,
Determination of Savings Since we have computed the equilibrium values of Y

and C, we can easily obtain the equilibrium level of saving (S) as follows.
By substituting the actual values of Y and C in Eq. , we get
The final condition of national income of equilibrium in the two-sector model may
now be presented as given below.
The theory of national income determination presented above algebraically in two-

sector model can be presented graphically also.
Graphical Presentation of Income Determination
The determination of national income in a two-sector model based on the
consumption function and the value of I is presented graphically in Fig. 6.6. The AS-
schedule represents the aggregate supply curve. It gives a hypothetical growth path
of national income on the assumption that the society spends its entire income on
consumer and capital goods, thatis, the aggregate expenditure is always equal to the
aggregate supply.

The C + I-schedule drawn on the basis of Eq. (6.22) represents the aggregate demand
(AD). The AD schedule intersects with the AS schedule at point E. The intersection
of the AD and AS schedules is also called “the Keynesian cross”—a term coined by
Samuelsson in his book Economics. The point of intersection between the AD and
AS schedules is the point of equilibrium of the national income.
The equilibrium point E determines the equilibrium level of national income at
1200 whichis the same as obtained in the numerical example [see Eq. (6.22)]. The
equilibrium level of income will remain stable so long as there is no change in the
aggregate demand, given the aggregate supply.
(ii) The saving-investment approach The equilibrium level of income can also be
determined by using saving-investment model, i.e., by using only S and I schedules.
This is called the saving-investment approach. The saving-investment approach can
be derived directly from the national income equilibrium condition based on AD-
AS approach. We know that, at equilibrium, AD = AS, i.e., where
Since C is common to both the sides of this equation, it gets cancelled out. Then, the
equilibrium equilibrium condition can be written as:

Investment (I) is assumed to remain constant at I ̅ . But saving is the function of
income, i.e., S = f(Y). So we need to derive the saving function. We know that
By substituting a + bY for C in Eq. (6.26), we get

Given the saving function, the equilibrium condition by saving-investment approach
can be expressed as:
In our example, I ̅ = 100 and, given the values of a and b in Eq. (6.21), by substitution
saving function can be written as
By substituting these values in Eq. (6.25), we get the equilibrium level of Y as:
Note that the saving-investment approach determines the same equilibrium level of
the national income (1200) as determined by the aggregate demand and aggregate
supplyapproach. The determination of national income equilibrium through saving-
investment approach is presented graphically in Fig. Income Determination:
Saving and Investment Approach

As Fig. shows, investment () is given at 200 and is shown by a horizontal straight
line. Saving function S = – 100 + (1 – 0.75)Y is shown as a rising function of income.
It can be seenin Fig. that I nd S schedules intersect at point E determining the
equilibrium level of income

at 1200, where S = I = Rs 200. The foregoing discussion takes us to the end of the
theory of income determination in two-sector model. The theory of income
determination is based on the assumption that the consumption function and
investment are given and, therefore, aggregate demand is also given. In other words,
the theory of income determination in two-sector model has been discussed under
static economic conditions. In a dynamic economy, aggregate demand keeps
changing causing change in the equilibrium level of income.
Investment Function
The level of income, output and employment depends upon the effective demand , which in
turn depends upon the expenditures on consumption goods and investment goods. Y= C+ I.
Out of the two consumption is relatively more stable, it lends increasingly important role to
investment in determining income , output and employment. According to the psychological
law given by Keynes , as the income increases the consumption also increases but by lesser
than the increase in income. This part of income which is not spent is saved. These savings
must be invested to bridge the gap between increase in income and consumption. If not
invested it may lead to decrease in economic activity, employment and hence less income
generation and increase in unsold stocks, which in turncould lead to depression and mass
unemployment. Hence, investment is very important for an economy. It means real
investment i.e investment in new machines, new factory buildings, roads , bridges and other
types of productive capital stock of the community. Financial investment e.g. investment in
existing shares, securities of firms, does not qualify as real investment as it does not lead to
increase in effective demand , income and employment in the economy. Investment is a flow
variable and its counterpart, capital is a stock variable.
Types of Investment
1) Induced Investment: it is an investment which is income elastic i.e. it changes with

change inincome. In capitalist system, investments are induced by profit motive. As
the income increases, the induced investment also increases.

I1I1 is the investment curve which shows induced investment at various levels of
income. Induced investment is zero at OY1 income. When income rises to OY3 , the
induced income rises to I3Y3. A fall in income to OY2 also reduces induced
investment to I2Y2.
The quantity of investment goods demanded depends on the interest rate, which measures
the cost of the funds used to finance investment. For an investment project to be profitable,
its return (the revenue from increased future production of goods and services) must exceed
its cost (the paymentsfor borrowed funds). If the interest rate rises, fewer investment projects
are profitable, and the quantity of investment goods demanded falls.
It can be further divided into Average Propensity to Invest, the marginal propensity to invest
a) Average Propensity to Invest: The average propensity to invest is the ratio of

investment to income, I/Y. In the above figure, the average propensity to invest at

OY3 level of income is I3Y3/OY3
b) Marginal Propensity to Invest: The marginal propensity to invest is the ratio of
change to invest to change in income. i.e. ∆I/∆Y
2) Autonomous Investment: This investment is independent of level of income and
thus is income inelastic. It is influenced by factors other than demand. E.g social and
political factors, growth of population, war, etc. It includes investments made on
social and

overheads, infrastructure, buildings, dams, canals, hospitals etc. made by both private
sector and public sector. Almost all kinds of public investments form part of
autonomous investments.
In the figure, autonomous investment is shown by curve I1I’. It shows that at all
levels of income , the investment OI1 remains constant. The I2I’’ indicates higher
constant rate of investment at various levels of income.
Determinants of Levels of Investment
1) Investment is made only when the expected rate of return on the investment is greater
than the interest rate at which capital is raised i.e. the cost of capital. The three factors
being considered for making investment decision are cost of the capital asset,
expected rate of return , market rate of interest. Keynes has put forward the concept
of marginal efficiency ofcapital. (MEC)
The marginal efficiency of capital can be defined as highest rate of return expected
from an additional unit of capital asset over its cost.
If the supply price of the capital asset(machinery) is Rs. 30000/- and its annual yield
in Rs. 3000/- The marginal efficiency of capital will be (3000/30000 )x 100= 10 %
John Maynard Keynes defines marginal efficiency of capital in his General Theory

as the “ rate of discount which would make present value of series of annuities given
by the returns expected from the capital asset during its life equal to its supply price”
Sp = R1/(1+i) + R2 /(1+i)2 + …+ Rn/(1+i)n
Where Sp is the supply price or the cost of the capital , R1, R2, R3 …., Rn are the
prospective yields or the series of expected annual returns from the capital asset in
1,2,…., n, i is the rate of discount which makes capital asset equal to the present value
of expected yield from it.
“I” in fact is the MEC or the rate of discount which equates two side of the equation.
If the supply price of a new asset is Rs. 1000/-, its life is two years. It is expected to
yield Rs. 550/-

in first year, Rs. 605/- in the second year. Its MEC is 10% which equates the expected
yields to the supply price of the capital asset.
Sp Rs. 1000= 550/ (110) + 605/(1.10)2 = 500 + 500=1000
If we expect Rs. 200 from machine after one year and the rate of interest is 5%, the
present value of machine is R1/ (1+i)= 200/(1.05)= Rs. 190.47/-. If Rs. 200 is
expected after two years and the rate of interest is 5%, the present value of the asset
or machine is 200/(1.05)2 = Rs 181.40/-. The present value of an asset is inversely
related to the rate of interest. The lower the interest rate higher the present value and
vice versa.
In the Figure, the rate of interest is shown along X axis, the present value of asset
is shown on vertical axis, The curve PR shows the inverse relation between the
present value and the rate of interest. If the current rate of interest is i1, the present
value of asset is P1. On the other hand higher rate of interest i2 will lead to lower
present value P2. When the present value curve PR cuts the horizontal axis at Z, the
net present value becomes zero.
MEC is the expected rate of return over cost of new capital asset. In order to decide
whetherto purchase an asset or not, its present value must be compared with the cost
of buying it.If the present value of asset is more than its cost, then the asset could be

bought. On the other hand , if the present value of asset is less than the cost of buying
it, then it is not worthwhile buying the asset.
Comparison of MEC with market rate of interest is also critical. If the MEC of
the capitalasset is higher than the market rate of interest at which it is borrowed, it
pays to purchase the capital asset and vice versa.
If the market rate of interest is equal to MEC, the firm is said to possess optimum
capital stock. If MEC is higher than the interest rate, there will be a tendency to
borrow funds and invest them in purchasing the capital asset. If MEC is lower than
the market rate of interest, no firm will take the risk of borrowing the capital and
investing it in purchasing capital stock. Any disequilibrium between MEC and rate
of interest can be removed by altering capital

stock ( i.e. MEC) or by changing rate of interest or both. Since, the stock of capital is
slow to change, the changes in rate of interest are more vital in attaining equilibrium.
This is as much valid for the entire economy as it is for a single firm.
Figure shows MEC curve of an economy sloping negatively from left to right, which
indicates that higher the MEC smaller the capital stock. As the level of capital stock
increases, the MECfalls. It is because of law of diminishing returns in production. As
a result, the marginal physical productivity of capital and marginal revenue fall.
When the capital stock is OK1 the , the MEC is Or1. As the capital increases from
OK1 to OK2 , the MEC falls from Or1 to Or2.The net investment to the capital
stock represents , the net investment in the economy. In order to reach optimum or
desired capital stock in the economy MEC must be equal to the rate of interest. If
existing capital stock is OK1 , the MEC is Or1, and the rate of interest is at Or2.
Everyone in the economy will borrow the funds and invest them in capital assets.
This isbecause the MEC at Or1 is higher than the rate of interest at Or2. This will
continue till MEC(Or1) will come down to the level of the interest rate at (Or2).

When MEC equals the rate of interest , the economy reaches the optimum stock level.
The fall in MEC is due to increase in the actual capital stock from OK1 to desired
capital stock OK2. The increase in firm’s capital stock K1K2 is the net investment of
the firm. But it is the rate of interest which determines the size of optimum capital
stock in the economy. MEC relates amount ofdesired capital stock to the rate of
interest. The negative slope of MEC curve indicates thatas the rate of interest falls
the optimum stock of capital increases.

Marginal Efficiency of Investment
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.
Like MEC, it is the rate which equates supply price of the capital asset with its
prospective yield. The investment on an asset will be made depending upon the
interest rate involved in getting funds from the market. If the rate of interest is high ,
the level of investment is low. A low rate of interest leads to an increase in investment
MEI relates investment to the rate of interest. MEIschedule shows the amount of
investment demanded at various rates of interest. It is also called investment demand
schedule or curve which has a negative slope. At Or1 rate of interest OI’ is the rate
of investment as the rate of interest fall to Or2 , the investment increases to OI’’.
The extent of increase in investment with the fall in interest rate depends upon the
elasticity of MEI curve. The less elastic the curve , lower is the increase in the
investment with the corresponding fall in the interest rates and vice versa.
Distinction between MEC and MEI

1) MEC is based on given supply price of capital, MEI is based on induced changes
in its price.
2) MEC shows return of all successive units of capital without regard to existing
stock of capital. On the other hand, MEI shows rate of return on only units of
capital over and above existing stock of capital.
3) In MEC, capital stock is taken on the horizontal axis, whereas in MEI, the amount
of investment is taken on X axis.

4) MEC determines optimum capital stock in an economy at each level of interest
rate. MEIgives net investment of the economy at each interest rate, given the
capital stock.
Investment Multiplier
The idea of multiplier was first given shape by R.F. Kahn in year 1931 in his study
titled “ the relation of home investment to Unemployment”. It referred to
employment multiplier. Keynes took the idea from Kahn and formulated it as
investment multiplier. The multiplier according to Keynes , “ establishes a precise
relationship, given the propensity to consume, between aggregate employment and
income and rate of investment. It tells us that, when there is an increment of
investment , income will increase by an amount which is K times theincrement of
investment”.
Multiplier (k) is the ratio of increase in national income (∆Y ) due to an increase in
investment (∆I).
K=∆Y/∆I
Suppose an additional investment of Rs. 5000/- crores increases the national

income ofRs.20000/-, the value of the multiplier, K= 20000/5000=4.
It means income has increased 4 times, with one time increase in investment.
Derivation of relationship between multiplier and MPC
Y= C+I
∆Y =∆C+∆I
Dividing both sides by ∆Y
∆Y/∆Y=∆C/∆Y + ∆I/∆Y
1= MPC + 1/K [∵∆Y/∆Y=1; ∆C/∆Y= MPC; ∆I/∆Y=1/K]

K= 1/1-MPC
Multiplier(K) in terms of MPS,
K= 1/1-MPC
We know that, 1-MPC=MPS
K=1/MPS

Multiplier is directly related to MPC and inversely related to MPS.
Multiplier, MPC and MPS
MPC MPS(1-MPC) Multiplier K (K= 1/1-MPC)

0 1 1
0.50 0.50 2
0.67 0.33 3
0.75 0.25 4
0.80 0.20 5
0.90 0.10 10
1 0 ..
Maximum Value of the Multiplier
The maximum value of the multiplier is infinity when the value of MPC=1,. MPC=1
indicates that the economy decides to consume its additional income. No part of
additional income is saved. It will lead to continuous increase in consumption
expenditure and the value of the multiplier will be infinity.
Minimum Value of the multiplier
The minimum value of multiplier is one when the value of MPC is zero.MPC=0
means thatthe economy decides to save the entire additional income and nothing is
spent on consumption. Therefore, there will be no further increase in income. As a
result, totalincrease in income
(∆Y) will be equal to total increase in investment (∆I) i.e. ∆Y=∆I . The value of
multiplier = 1

Working of Multiplier
The working of multiplier is based on the fact that one’s person expenditure is another
person’ s income. When an additional investment is made then the income increases
many more times than the increase in income.
Round Increase in Increase in Increase in Increase in

Investment (∆I) Income (∆Y) in Consumption Saving ( ∆
in Rs Crores Rs. Crores (∆C) in Rs. S=∆Y-∆C) in
Crores Rs. Crores
= (∆Y ) x MPC
1 100 100 90 (100 x 0.9) 10
2 90 81 (90 x0.9) 9
3 81 72.9 (81x0.9) 8.10
4 72.9 65.61(72.9x0.9) 7.29
5 65.61 59.04(65.61x0.9) 6.57
6 59.04 53.13 (59.04x0.9) 5.91
7 53.13 47.81(53.13x 0.9) 5.32

8 47.81 43.02(47.81 4.79
x0.9)
9 43.02 38.71 (43.02 x 4.31
0.9)
10 38.71 34.83 (38.71 x 3.88
0.9)
Total 100 1000 900 100

Thus, an additional investment of Rs. 100 crore leads to Rs. 1000/- crore increase in
income.Therefore, multiplier (K)= 1000/100= 10

Income is taken on X axis, and aggregate demand on the Y axis. Suppose , the initial
equilibrium is determined at point E where AD curve intersects AS curve. The
equilibrium level of income is OY. Now suppose , the investment increases by ∆I so
that new aggregate demand curve AD1 intersects aggregate supply curve AS curve
at point F. Thus, the new

equilibrium level of income is OY1. The income rises from OY to OY1 due to
increase of ∆I. It can be clearly seen that the increase in income (YY1 or ∆Y) is
greater than increase in investment ∆I. The value of multiplier is given by K= ∆Y/∆I
Leakages of Multiplier:
Given the marginal propensity to consume , the increase in income in each round
declines due to leakages in income stream and ultimately the income increase fizzles
out..
1) Saving: Saving is the most important leakage in the multiplier process. Since the
marginal propensity to consume is less than one, the whole increment on income
is not spent on consumption.
2) Strong liquidity Preference: It means the heightened desire of people to hoard
moneyas idle cash balances due to fear of the future as a precautionary measure.
It acts as a leakage out of the income stream.
3) Purchase of existing shares and securities: If part of the increased income is
spent on buying existing shares and securities of firms and not on consumer
goods, the consumer expenditure will fall and its cumulative effect on the income
will be less than before.
4) Debt Repayment: If part of income is spent on repaying the debts due to banks
instead on spending it on further consumption, a part of income will fizzle out of
the income stream.
5) Price Inflation: When increased inflation will lead to price inflation, the
multiplier effect of increased income may be dissipated on the higher prices.
6) Net Imports: If increased income is spent on the imported goods , it acts as a
leakage out of the domestic income stream.
7) Undistributed Profits: If the profits earned by the joint stock companies are not
distributed to the shareholders in form of dividends but are kept as reserves, it is
a leakage in income.
8) Taxation: Progressive taxes have the effect of lowering the disposable income
of taxpayers and reducing their consumption expenditure.Indirect taxation also
raises the prices of goods and part of income may be dissipated on the higher

prices
9) Excess Stocks of Consumption Goods: If the increased demand for
consumption is met through existing stocks of goods, there will be no further
increase on output, employment and income.
10) Public Investment Programmes: Public investment programmes may raise the
demand for labour and materials, thereby increasing cost of production which
could make some private enterprises unprofitable. Government borrowing may
raise the interest ratesand stifle the private investment. Increased governmental
sphere of activity could discourage private investment.
Importance of Multiplier:
1) Investment: Multiplier helps explain the concept of income propagation that is

when consumption is constant in the short run, the income and employment can
be varied in the long run by change in rate of investment.

2) Trade Cycle: It explains how when investment increases , the overall income
and employment in the economy increases leading to boom period. On the
contrary, when investment decreases, the income and employment reduces
leading to recessionary phase in the economy.
3) Savings- Investment Equality: If there is divergence between savings and
investment, say, investment is more than savings, it will lead to higher
employment and higher incomes, hence higher savings. Hence, the parity
between savings and investment willbe maintained.
4) Aiding Policy Making: When an economy is facing inflationary situation, the
investment can be reduced to bring the income and employment to manageable
levels. In the opposite case, when there are deflationary pressures in the economy,
investments can be stepped up to raise the income and employment in the
economy. Deficit financing can be used when there exists a situation of
depression and the cheap money policy of low interest rates fails to increase
private investment as marginal efficiency of capital is low. Increased public
expenditure through deficit budget helps in increasing income and employment
through public investment programmes.
Criticisms of Multiplier:
1) Availability of Desired Consumer Goods: Multiplier will only work when there is
availability in the market for desired consumer goods on which people could spend
their increased incomes derived from increased investments.
2) Assumes Instantaneous Relationship between Investment, Income, and
Consumption: Contrary to what Keynes proposed, there always exists time lag
between making investmentand appearance of income and its transformation into
consumption and its reappearance as income.
3) No Empirical Verification offered: Keynes based his theory entirely on the
algebraic relationship between marginal propensity to consume and increased
income. It had no empirical verification to follow it up.
4) Exclusive Emphasis on Consumption: It failed to take into account the total impact
ofincreased investment on government and private spending, instead it only focused
on the marginal propensity to consume.

5) Ignored the derived demand of Capital goods sector: It failed to see the
relationship between demand for capital is derived from demand of capital goods and
the contribution it makes to the economy.
6) Maintenance of Investment: Maintenance of investment is essential to maintain the
incomeat higher level. It is because after the injection of initial investment is made
and the multiplier has worked itself out completing the cycle, the incomes will fall
back to their original levels.

Module 3
Concept of Money and its Functions:
Money is the medium of exchange for dealing in goods and services. In absence of money,
the bartersystem (direct exchange of goods for goods) would prevail which requires “double
coincidence of demand”, it may be a cause for inconvenience. Barter system will also mean
that there is nostandard for measurement of value, absence of subdivision of commodities,
difficulty of storage.
Functions of Money:
1) Medium of Exchange: Introduction of money avoided the inconvenience of the

bartersystem.
2) Measure of Value: We can measure the value of any good by the amount of money
we payfor it. Money acts as a common measure of value.
3) Store of Value: It is more convenient to store the value in form of money especially
when aperson owns perishable commodities.
4) Standard of deferred payments: As modern economy is based on credit, the
system isfacilitated by the availability of money which acts as a standard for future
payments.
Features of Money Material:
1) General Acceptability: A reasonably durable material which conveys value will

findacceptance as money. E.g. gold, silver.
2) Portability: Since money has to be moved from place to place it should be easily
carriedwithout much expense.
3) Cognizability: Must be easily recognizable from its colour and texture. E.g. gold.
4) Durability: The material should be chemically inert and last for a long time. E.g.
metals, goldand silver.
5) Divisibility: The material must be easily divisible without losing greater part of its
value.
6) Homogeneity: All Coins must of be of similar quality.

7) Stability of Value: Commodities which are subject to volatile changes in their
supply anddemand in market are unsuitable for money.
8) Malleability: The material must be capable of being moulded without much
difficulty.
Quantity Theory of Money
Classical economists stated that general price level (P) in an economy is directly
dependent on money supply (M).
P=f (M)
If M doubles, P will double. If M halves, P will decline by same amount. This theory was
first stated in 1586 but received the approval of Irving Fisher in 1911 and later it was
given alternative theories remains same that price level varies directly and proportionally
to money supply.
Assumptions:

First assumption is of Say’s Law that supply creates its own demand. i.e. sum of values
of all goods produced is equal to sum of values of all goods bought. Thus, by definition
of demand , there cannot be deficiency of demand or under utilization of resources.
Second assumption is of full employment.
Fisher’s Quantity Theory of Money
Like price of the commodity, the value of money is determined by supply of money and
demand of money. Fisher laid emphasis on use of money as medium of exchange i.e. the
money is demanded for transaction purposes.
In a given time period, total money expenditure is equal to the total value of goods traded
in the economy. Or the national expenditure i.e. the value of money must be identically
equal to the national income or total value of goods for which the money is exchanged.
MV= ∑piqj = PT, here M= total stock of money in the economy; V = velocity of
circulation of money that is the number of times a unit of money changes its hand; Pi=
prices of individual goods; qi = quantities of individual goods transacted; ∑P = p1q1 +
p2q2……+ pnqn are the prices and output of all individual goods; P = average or general
price level or index of prices; T= total volume of goods transacted or index of physical
volume of transactions. This equation is an identity which always hold true: It tells us
that the total stock of money used for transactions must be equal to the value of goods
sold in the economy. In this equation, supply of money consists of nominal quantity of
money multiplied by the velocity of circulation. The average number of times a unit of
money changes hands is called the velocity of circulation of money.The concept that
provides the link between M and PxT is also called the velocity of money. V , is thus,
defined as total expenditure, Px T, divided by the amount of money, M , i.e. V= PxT/M
If PxT in a year is Rs.5 crore, and the quantity of money is Rs. 1 crore then V = 5. This
implies thata unit of money is spent 5 times in buying goods and services in an economy.
Thus, the supply of money or total expenditure on national income is MV. On the other
hand, total value of all transactions or money demand comprises P multiplied by T.
Fisher assumed fixity in V in short run. V is determined by 1) payment habits of the

people; 2)the nature of the banking system, 3) General factors (e.g. density of population
, rapidity of transportation). As far as T is concerned, it would remain constant due to the
assumption of full employment in Say’s Law. Therefore, if V and T are constant , an
increase in M leads to proportional increase in P. The stock of money thus determines
the price level. People hold more money than their need for transactions when money
supply increases. Holding of money isfruitless so they spend money. This additional
expenditure given the full employment raises the price level. Again, the rise in price
levels means increase in value of transactions and hence, the demand for money rises.
This process will continue until the equality between demand and supply of money is re-
established.
Fisher’s equation can be extended by adding bank deposits in the definition of money
supply. Now money supply includes bank money M’ in addition to legal tender money
M. This bank money also has stable velocity of circulation V’. Therefore, the Fisher’s
equation can be written as MV+ M’V’ =PT

Or P =( MV + M’V’)/T
Assuming V and V’ and T to be constant, an increase in M and M’ will increase the P by

an equal amount. In an economy , it may be quite difficult to measure the total number
of transaction T,so we may replace T by Y, here Y is the total income and P.Y is nominal
income or output. Now, the equation becomes P.Y = M. V . It can be called as income
version of quantity theory of money.
Cambridge’s Quantity Theory of Money
Cambridge economists Pigou, Marshall, Robertson and Keynes in early 1900 gave
alternative version of quantity theory of money known as cash balance theory of money.
According to this theory, money acts as both a medium of exchange and as a store of
wealth. Here, the words, cash balance and money balance mean the amount of money
that people want to hold rather than savings. They held that people want to hold cash to
finance transactions and unforeseen future needs. They also suggested that individual’s
demand for cash and money balances is directly proportional to his income. Therefore,
larger the income of an individual , larger will be the demand for cash or money balances.
Md= kPY, Y is the physical level of aggregate or national output, P is the average price,
and k is the proportion of national output or income that people want to hold. Let us
assume that Ms is the supply of money determined by the monetary authority. At
equilibrium the demand of money must be equal to supply of money i.e. Ms= Md
Md= kPY
M = kPY or P = M/kY
K and Y are determined independently of money supply. K being constant given by

transaction demand of money and y constant due to full employment, any increase and
decrease in money supply leads to proportional increase or decrease in price level. To be
noticed that Cambridge ‘k’ and Fisherian ‘V’ are reciprocals of each other. i.e. 1/k is the

same as ‘V’in the Fisher’s equation.
The figure gives the relationship between money supply and price level. It first
establishes the relationship between money supply and national output or national
income below full employment stage (Yf) from origin (O). The relationship between
money supply and price level after full employment stage can be established assuming
(O’) as origin. Before the attainment of full employment state (Yf) an increase in money
supply from OM1 to OM2 causes national income (shown by the steep output curve) to
rise more rapidly than the price level. By utilizingits resources urgently and fully , an
economy can increase its output level by increasing the volume of investment consequent
upon increase in money supply. Since there is limit to output expansion due to full
employment (i.e. beyond which output will not increase), an increase in money supply
from M3 to M4 will cause price level to rise from P3 to P4 proportionally. For stability
in price level money supply should grow in proportion to increases in output.

Limitations:
1) Inoperative below full employment: Quantity theory of money comes into operation
only at full employment level. Assuming constancy in V, V’, T and Y , a change in
money supply will bring about change in price level. During the period of full
employment, T or Y remains unchanged. During such a time even if money supply
rises T and Y will not change, but the price levels will rise. But in reality , full
employment of resources is a rarity. Mostly what we actually find is
underemployment or unemployment of resources. During underemployment an
increase in money supply will tend to raise output level and hence T, but not P will
rise. Therefore, quantity theory of money fails when the resources remain below the
full employment level.

2) V, T do not remain fixed: In a dynamic economy, the variables such as V, V’ , T do
not remain constant which is contrary to the assumption of this theory. In such a case,
any change in these variables can cause the price level to change even if money
supply does not change.
3) Aggregate Demand/ Expenditure and not M influences the price level: According to
Keynes the price level in an economy is not influenced by money supply. The
important determinant

of money supply is the income level and the total expenditure of the country. Keynes
held that increase in money supply is tantamount to increase in effective demand.
After attaining the stage of full employment, increase in effective demand (i.e. =
C+I+G) will raise price level but not proportionately.
4) Too much emphasis on money supply: Change in price level is caused by many
factors besides money supply. For example increase in cost of production may cause
increase in price level. E.g. increase in wage rate of employees after revision in pay
scale of employeesor increase in cost of raw materials(rise in price of petroleum
products) will surely push up the price level, whether economy stays on or below full
employment level. Quantity theory attaches too much importance on money supply.
5) Money supply influences Price level via interest rates: Although classical theory
established adirect relationship between money supply and price level but critics
have argued that relationship is not direct but an indirect one. It largely ignored the
influence of rate of interest on price level. Supply of bank money or credit money is
primarily influenced by the interest rates. It is argued that increase in money supply
affects the rates of interest which affects the total output and price level in the ultimate
analysis. Change in stock of money leads to change in interest rate which leads to
change in investment which in turn leads to change in income, employment and
output which leads to change in price levels.
Despite criticisms, quantity theory has seminal merits. Any abnormal Increase in money
supply in theeconomy has invariably led to increase in price levels i.e. causing inflationary
impact. There may not be a proportional increase but increase in inflation has followed
abrupt increased in money supply.In 1950s corroborating quantity theory of money, Milton
Friedman came up with a statement that “ inflation always and everywhere is a monetary
phenomenon”. In other words, it meant that inflationis largely caused by excessive growth
of money supply as it was laid down by the quantity theory of money.
Keynesian Theory of Money and Prices

Keynes version of quantity theory of money transformed monetary theory of prices into
monetary theory of output. He linked value theory with the monetary theory by bringing rate
of interest into the picture. He refused to believe that there exists a direct and proportional
link between quantityof money and prices. Rather he proposed that the link between the
quantity of money and prices is indirect and non – proportional. According to him, the
economics has been divided into two separate compartments of theory of value and theory
of money and prices which is essentially same as the difference between relative price level
(arising from demand and supply of goods) andabsolute price level (arising from demand
and supply of money). This happened due to failure of classical economists to integrate value
theory with monetary theory. He also criticized the classical view which regarded the money
as neutral and that it does not influence the economy’s realequilibrium relating to relative
prices. According to him the real world problem to be dealt with is

that of shifting equilibrium in economy and how money enters as a link between the present
and thefuture.
Keynes Theory of Money and Prices is based upon these assumptions:
1) All factors of production are in perfectly elastic supply so long as there is any
unemployment.
2) All unemployed factors are homogeneous, perfectly divisible and interchangeable.
3) There are constant returns to scale so that prices do not rise or fall as output increases.
4) Effective demand and quantity of money change in the same proportion so long as
there areany unemployed resources.
Keynesian chain of causation between changes in the quantity of money and in prices
is an indirect one and through rate of interest. So when the quantity of money is
increased , its first impact is on rate of interest. So when quantity of money is
increased, the first impact is on rate of interest which tends to fall. If marginal
efficiency of capital is given , the fall in rateof interest /will increase volume of
investment.. Increased investment will raise effective demand through multiplier
effect thereby increasing income, output and employment. Sincethe supply curve of
factors of production is perfectly elastic in a situation of unemployment, wage and
non – wage factors are available at constant remuneration. There being constant
returns to scale, prices do not rise with increase in output so long there is
unemployment.
Therefore, the income and employment will increase in same proportion as effective
demand and effective demand will increase in same proportion as quantity of money.
But “once full employment is reached, output stops responding to all changes in
supply of money and so in effective demand. The elasticity of supply of output in
response to changes in supply of money, which was infinite as long as there was
unemployment, falls to zero. Theentire effect of changes in the supply of money is
exerted on prices which rise in exact proportion with the increase in the effective
demand.”
Therefore, Keynes stressed on the fact that with increase in the quantity of money
prices rise only when the level of full employment is reached, not before this.
OTC is the output curve relating to quantity of money and PRC is the price curve
relating to the quantity of money Panel A shows that as the quantity of money

increases from O to M, the level of output also rises along OT portion of OTC curve.
As the quantity of money reaches OM level, full employment OQF is being produced.
But after point T , the output curve becomes vertical because any further increase in
the quantity of money cannot raise OQf. Panel B shows relationship between quantity
of money and prices. So long as there is unemployment, prices remain constant
whatever the increase in the quantity of money. Prices start rising only after full
employment level is reached.
The price level OP remains constant at the OM quantity of money corresponding to
the full level of employment level of output OQ1. But an increase in quantity of
money above OM raises prices in same proportion as the quantity of money. This is
shown by the RC portion ofthe PRC curve.

W33
The assumptions given by Keynes makes the application too simplistic which may
not be true in a dynamic economy. Realizing this fact, he gave following
complications which may qualifythe theory of money and prices given by him:
Limiting complications for Keynesian theory of money and prices:

1) Effective demand will not change in the exact proportion to the quantity of
money.
2) Since resources are homogeneous, there will be diminishing and not constant
returns asemployment gradually increases.
3) Since resources are gradually interchangeable, some commodities will reach a
condition of inelastic supply while there are still unemployed resources available
for the production of other commodities
4) The wage unit will tend to rise before full employment has been reached
5) The remunerations of factors i.e. their marginal cost will not all change in the
same proportion.
Considering above complications, Keynesian theory becomes inapplicable in its original

form. An increase in effective demand will not change in exact proportion to the quantity of
money, but it will partly spend itself in increasing output and partly in increasing the price
level. So long as there are unemployed resources the general price level will not rise much
as output increases. But sudden large increase in aggregate demand will encounter

bottlenecks when resources are still unemployed.It could happen that supply of some factors
becomes inelastic or others may be in short supply and are not interchangeable. This may
lead to increase in marginal cost and price. Price would accordingly rise above average unit
cost and profits would increase rapidly which, in turn tend to raise money wages owing to
trade union pressures. Diminishing returns may also set in. As full employment is reached
elasticity of supply of output falls to zero and prices rise in proportion to the increase in
quantity of money.

In the figure, shows aggregate supply (S) and demand curve(D). Price level is measured on
vertical axis and output is measured on X axis. According to Keynes, an increase in quantity
of money increases the demand of money for investment as a result of fall in the interest
rates. This increases output and employment in the beginning but not the price level. In the
figure , the increase in the aggregate money demand from D1 to D2 raises output from OQ1
to OQ2 level but the price level remains constant at OP. As aggregate money demand
increases from D2 to D3, output increases from OQ2 to OQ3 and the price level also rises
to OP3. This is because costs rise as bottlenecks develop due to immobility of resources.
Diminishing returns set in and less efficient labour and capital are employed. Output
increases at a slower rate than a given increase in aggregate money demand and this leads to
rise in prices. As full employment approaches , bottlenecks increase. Further, rising prices
lead to increased demand for factors, thus prices rise at an increasing rate, shown over the
range in the figure.
But when economy reaches the full employment level of output, any further increase in
aggregate demand brings about proportional increase in price level but output remains

unchanged at that level. As shown in figure when demand curve D5 shifts upward to D6 and
the price level increases from OP5 to OP6 while the level of output remains constant at OQf.
Merits of Keynesian theory over classical quantity theory of Money
Keynes rejected that there exists a direct and proportional relation between quantity of money
and prices but instead he proposed the relationship between money and prices is indirect and
non- proportional. Keynes transformed pure monetary theory of prices into monetary theory
of output and employment. He integrates monetary theory , value theory and theory of
output and

employment through rate of interest. When the quantity of money increases, the rate of
interest falls which increases the volume of investment and aggregate demand, thereby,
raising output and employment. Thus, he integrated theory of output and employment. As
output and employment increase they further raise the demand for factors of production.
Consequently, certain bottlenecks appear which raise the marginal cost including money
wage rates. Thus prices start rising. Hence, monetary theory is integrated with value theory.
Thus, Keynes theory does not keep real andmonetary sectors of economy in two separate
compartments with no doors and windows between theory of value and theory of money and
prices.
Classical quantity theory of money is based upon unrealistic assumption of full employment
of resources. Under this assumption, increase in quantity of money always leads to
proportional increase in price level. According to Keynes, full employment is an exception.
As long as there will be unemployment, output and employment will change in same
proportion as the quantity of money. Thus, Keynesian theory is better than classical theory
because it gives the relationship between money and prices both under unemployment and
full employment conditions. Keynesian theory gives detailed analysis which has important
policy implications. Classical theory believes that every increase in quantity of money leads
to inflation. According to Keynes, as long as there is unemployment the rise in prices is
gradual there is not threat of inflation. It is only after the economy reaches the full
employment level that rise in prices in inflationary with every increase in the quantity of
money. This stresses on the important point that objectives of full employment and price
stability may be inherently irreconciliable.
Criticisms of Keynes theory of money and prices:
1) Keynes analyzed the effect of money in terms of quantity of goods traded rather than
their average prices. He adopted an indirect way through changes in bond prices,
interest rates, investment i.e. effect of monetary changes on economic activity. But
in actual it is observed that the monetary impact is more direct.
2) Stable demand for money: Keynes observed that monetary changes reflect in the
demand for money. But Milton Friedman in his studies found that demand for money
is relatively stable.

3) Nature of Money: Keynes visualized only singular way where money could be
exchanged for bonds only. But in reality money could be exchanged for different
types of assets like bonds, securities, physical assets, human wealth etc..
4) Effect of money: According to Keynes, the impact of quantity of money on income
is limited.But according to Friedman, it was contraction of money which precipitated
depression. Therefore, money supply does effect national income.

Supply of Money
Money supply means total stock of money (paper notes, coins, demand deposits of bank)
in circulation which is held by the public at any particular time. Money supply is the
stock of moneyin circulation on any specific day. There are two components of money
supply:
1) Currency (Paper notes and coins)
2) Demand deposits for commercial banks
Difference between Stock of money and Supply of money
Supply of money is that part of stock of money which held by public at a particular point
of time. In other words, it means the money held by users (not producers) in spendable
form at a pointof time is termed as money supply. The stock of money held by the
government and the banking system is not included because they are the producers of
money and cash balances held by themare not in actual circulation. We can say that
money supply includes currency held by public and net demand deposits in banks.
Sources of Money Supply:
1) Government (which issues one rupee notes and coins)
2) RBI (which issues paper currency)
3) Commercial banks (which create credit on the basis of demand deposits)
Measures of Money Supply/Money Stock:

Reserve bank of India uses four alternative measures of money supply M1, M2, M3 and
M4. M1 ismost used as most of its components are regarded as most liquid assets.
1) M1= C + DD + OD
Where C= currency( i.e. paper notes and coins) held by the public DD= demand
deposits
OD= other deposits with RBI
Demand deposits are those deposits which can be withdrawn at any time by the
accountholders. Current account deposits are included in demand deposits.
Savings account deposits are not included in M1 because certain conditions are
imposed onamount of their withdrawal and number of withdrawals.

OD stands for other deposits with RBI which includes demand deposits of public
financial institutions, demand deposits of foreign central banks, and international
financial institutions like IMF, World Bank etc.
2) M2= M1 (as given above) + Savings deposits with post office savings bank and other
banks
3) M3 = M 1 + Net time deposits of banks
4) M4= M3 + Total deposits with Post Office Savings Organization (excluding NSC)
Savings deposits of post office are not part of money supply because they do not
serve as medium of exchange due to lack of cheque facility. Similarly fixed deposits
in commercial banks are not counted as money. Therefore , M1 and M2 may be
treated as narrow money and M3 and M4 is treated as broad money.
In practice, M1 is widely used as measure of money supply which is also the
aggregate monetary resource of the society. All the four measures represent different
measures of liquidity, with M1 being most liquid while M4 being least liquid.
Liquidity means ability to convert asset into money quickly without loss of value.
Credit Creation
The central bank of a country is the primary source of money supply in the economy through
circulation of currency. It ensures the availability of currency for meeting the transaction
needs of the economy and facilitating various economic activities like production,
distribution and consumption. However, for this purpose, the central bank needs to depend
upon the reserves of the commercial banks. These reserves are secondary source of money
supply in the economy. The commercial banks perform this function of increasing the money
supply by creation of credit. Money supplied by commercial banks is called credit money.
Commercial banks create loans by advancing loans and purchasing securities. They lend
money to individuals and businesses out of deposits accepted from the public. However,
commercial banks cannot use entire amount of public deposits accepted for lending purposes.
They are required to keep certain amount as reserve with the central bank for serving the
cash requirements for depositors. A bank may receive interest by permitting customers to
overdraw their accounts or by purchasing securities and paying for them through its own

cheques, thus increasing the total bank deposits.
Let us assume an isolated community having no foreign relations and only one bank where
everybody keeps an account; further no cash circulates and transactions are settled by
cheques. Bankers know that all the currency that depositors withdraw soon returns to the
bank. They also know that all depositors will not withdraw all deposits at the same time.
From the experience, they have learnt that if they keep only 20% of their total demand
deposits in cash reserves, they will have enough to meet all demands of cash. Suppose an
ordinary borrower goes to the bank for a loan of Rs. 1000/- . After being convinced of the
solvency of the borrower and safety of the loan in hishands, the bank will advance a loan of
Rs. 1000/- not by handing over cash or gold to the borrower but by opening an account in
his own name. If the borrower already has an account, he will be allowed an overdraft to the
extent of Rs.1000/-. The borrower will then draw cheques on bank while

making purchases. Those who receive the cheques on the bank while making purchases.
Those who receive the cheques deposit them in their own bank accounts. Therefore, a bank
loan of Rs. 1000/- has resulted in deposits of Rs. 1000/- . The underlying concept is that
loans are made by creating deposits. When a person deposits Rs. 1000/- with a bank, the
bank does not keep entire cash but only a certain percentage (20%) of it to meet day today
cash obligations. Thus, the bank keeps Rs. 200/- and lends another Rs. 800/- by opening a
credit account in his name. Again, keeping 20% to meet B’s obligations, the bank advances
rest Rs. 640/- to C; further keeping 20% to meet C’sobligations, the bank advances Rs. 640/-
to C; further keeping 20% to meet C’s obligations the bank advances Rs. 512/- to D and so
on, till Rs. 1000/- are completely exhausted. Thus , an original depositof Rs. 1000/ leads to
additional deposit of Rs. 800/- plus Rs. 640/- plus Rs. 512/- plus Rs. 409/-, plus Rs. 328/-
and so on. By adding up all the deposits we get total of Rs. 5000/- . It is thus clear that total
amount of credit creation is inverse of cash reserve ratio. Here , the cash reserve ratio is
assumed to be 20% or 1/2 , therefore the credit is Rs. 5000/- i.e. five times the original deposit
of Rs. 1000/-. Although we have assumed one bank yet credit creation will take place if there
are many banks.
Hence , the main limitation to credit creation is the reserve ratio of cash to credit. Therefore,
the amount of credit that a system of banking can create depends upon the reserve ratio. The
banks can multiply given amount of cash to many times of credit. If the public would demand
no cash, credit would go on expanding indefinitely. But the reserve ratio acts like a leakage
from the stream of credit creation. Thus higher the reserve ratio , smaller will be the credit
creation multiplier For example, with an original deposit of Rs. 1000/- the bank was in
position to create credit of Rs. 5000/-The credit creation multiplier will be Rs. (5000/1000)=
5 . If reserve ratio is 1/3 , it will give us 15multiplier of 3 and if the reserve ratio is 1/5, it will
give us higher multiplier of 5.
Purchase of securities: Deposits can also be created by buying securities. Banks buy
securities at stock exchange or sometimes they also buy real assets. When the bank does
so it does not paysellers in cash , rather it credits the amount of the price of the security or
assets to the accounts of the sellers.. The bank , therefore creates deposits with it. It does not
matter whether the seller of the securities or property is the customer of the purchasing bank
or not as the seller would deposit the cheques he receives in one of the banks. The purchase
of security by any banker is bound to increase the deposits either of his own bank or some

other bank, in any case, the deposits of the banking system as a whole.
Fractional Reserve Banking System
Bankers maintain that they only lend the deposits they receive or ( out of it ) and that their
ability to create deposits is the main constraint on their work. Economists on the other hand
assert that banklending itself creates deposits. They believe that bank deposits arise out of
bank lending and not thatlending is done because of the deposits. Bank deposits do not
constitute a pre condition for lending. A banking system that works to minimum ratio of
reserves i.e. cash to deposit liabilities, is also known as fractional reserve banking system.
Here , the reserves are not confined to cash alone but includes assets which are equivalent to
cash or as liquid as cash. Therefore. According to fractional reserve banking system , bank
deposits bear a given relation to the banking reserves and a change in reserve base (which
include cash plus assets of similar types which are as liquid) will lead to multiple change in
bank deposits. It is therefore essential to study the factors governing the supply of
reserves. If banks adhere to fixed reserve ratio, and if the supply of reserves is determined
without any reference to the level of bank deposits, then it is reasonable to regard reserves
can be regarded as main determining factor for the level of bank deposits.
But if supply of reserves is determined by the level of bank deposits, rather than the other
way round, we must look beyond reserves to some other explanation for changes in deposits.
Destruction of bank credit or money
Banks can destroy credit as easily as they create it. Bank credit can be destroyed by means
of reduction in bank loans and investment. The extent of destruction depends upon the
prevailing cash reserve ratio. A reduction of cash below the reserves to support demand
deposits leads to multiplecontraction of bank credit throughout the banking system. Thus, in
above example, the original reduction of Rs. 1000/ in bank A, is followed by reduction in
deposits of Rs. 800/ from bank B and Rs. 640 from bank C and so on. The process of
contraction of bank credit is the same as that of expansion- only in the reverse direction. The
credit creation multiplier effect works in the backward direction. Sometimes, the government

intervenes directly with creation or destruction of money with the commercial banks. Under
normal circumstances, the government need not intervene but in the overall interest of
economic stability, to avoid both inflation or deflation, the government may create or destroy
money. It is in this sense, the money is described as the creature of the state. The government
may intervene by creating or destroying legal tender, using printing press, monetary
management through treasury, demonetization etc. Out of various tools to create or destroy
money, the choice of any particular tool will depend upon the nature of the situation ,
objectives of monetary policy, monetary and banking convention etc.
The central bank of the country uses various methods to control credit both quantitative and
qualitative
Quantitative Methods:
Quantitative methods of credit control aim at regulating the total quantity of deposits created
by thecommercial banks. They also aim at regulating the quantity of credit rather than its
end use. They relate to volume in general and are mostly indirect in nature. Their objectives
are:
1) Controlling the volume of credit in the economy
2) Maintaining the equilibrium between savings and investment in the economy
3) Maintaining stability in exchange rates.
4) Correcting disequilibrium in the balance of payments in the country.
5) Removing shortage of money in the market or managing liquidity The important

methods are:

1) Bank Rate Policy: The bank rate is the rate at which the central bank is prepared
to rediscount the approved securities. That means the rate of interest at which the
central bank is prepared to advance loans to its member banks against approved
securities. As the central bank is only the lender of last resort, the bank rate is
usually higher than the market rate of interest. If central bank want to reduce the
creation of credit , it will raise the bank rate. As a result, the market rate and other
lending rates in the money market will go up. Borrowing will be discouraged.
The raising of the bank rate will lead to contraction of credit. Similarly, fall in
bank rate may lower the lending rate in the money market, which in turn will
stimulate the commercial and industrial activity, for which more credit will be
required from the banks. This will cause the expansion of bank credit.
2) Open Market Operations: In first case, the government sells and purchases
government securities in the money market. But in another case it may also
sell and purchase thebills and securities issued by the private concerns besides
government securities. When banks and private individuals purchase these
securities from the Central bank. They haveto make payment for these securities
to the central bank. This causes fall in cash reserves of the commercial banks
which in turn reduces their ability to create credit. Hence, the central bank is able
to exercise a check on the expansion of credit.
But if there is a deflationary situation and the commercial banks are not creating
enoughcredit for the economy as is required. Then in such a situation the central
bank will start purchasing the securities in the open market from commercial and
private individuals. With this operation, the cash will move from the central bank
to commercial banks. Withincreased cash reserves the commercial banks will be
in a position to create more credit and as a result the volume of credit will expand
in the economy.16
3) Cash Reserve Ratio: The central bank controls credit by changing cash reserve
ratio. If commercial banks have excess cash reserves on the basis of which they
are creating too much credit which is harmful for the larger interest of the
economy. So, the central bankwill raise the CRR which the commercial banks
are required to maintain with the central bank. This will force the commercial
banks to curtail the credit creation in the economy. Hence, the central bank will

be able to put an effective check on the inflationary expansion of credit in the
economy.
Similarly, when the central bank desires that the commercial banks should
increase the volume of credit in order to bring about revival in the economy. The
central bank will lower the CRR in order to increase the cash reserves of the
commercial banks. Hence , the commercial banks will be in a position to create
more credit than before. Thus, by varying cash reserve ratio , the central bank can
influence the creation of credit.
Open market operations are time consuming whereas variations in CRR produce
immediate impact on the economy. Secondly, open market operations can have
full impact when the government and corporate bond market is already well
organized and developed in the economy. Thirdly, the open market operations
will be successful wheremarginal adjustments in cash reserve are required. But
the variable cash reserve ratio

method is more effective when the commercial banks, happen to have excessive
cash reserves with them. Both these methods are complementary to each other.
Qualitative Method of Credit Control:

1) Rationing of Credit: Under this method, the central bank provides for
maximum limits on loans which a bank can provide for particular sectors.
a) Variable Portfolio ceiling: Central bank fixes maximum ceiling on
aggregate portfolios of commercial banks above which loans and
advances should not be increased.
b) Variable capital assets ratio: the central bank can fix minimum ratios
which the capital and reserves of the bank must bear to the volume of
assets or specific categories thereof of the commercial banks.
2) Direct Action: Central bank issues directives to control the credit created by
the commercial banks. It gives directives to control the lending policies of the
commercial banks, to prevent the flow of bank credit into non essential lines,
to divert bank credit into productive and essential sectors, to fix maximum
credit limit for certain purposes. The commercial banks have to abide by the
directives or face penalties from the central bank.
3) Moral Suasion: Under this method, the central bank gives advice, then
request and to commercial banks to cooperate with the central bank in
implementing its credit policies. If they do not abide by the central bank
policies, Central bank can only exercise the moral influence upon commercial
banks and it usually refrains from imposing any gross penalties on them.
4) Method of Publicity: Central banks resort to publicity channels in order
to maketheir policies successful through mobilizing public opinion in support
of these policies. In developed countries commercial banks automatically
change their credit policies in line with the central bank’s directives. But in
developing countries the commercial banks are lured by regional gains.
5) Regulation of consumer’s credit: Central bank fixes downpayment and
period over which instalments will be spread. In developed countries, large
portion of national incomes are spent on consumer durable goods like cars ,
furniture etc. it is essential to regulate expenditure on such consumer goods
in order to control inflation.

6) Fixation of margin requirements: Central bank prescribes the margin which
commercial banks must for loans granted maintain against commodities ,
stocks and shares. The objective is to divert funds from speculative activities
to productive ones, to reduce the volume of credit, to reduce the risk and
uncertainties while financing joint stock companies.
7) Control through directives: The directives may be in form of warnings,
written orders, direct memorandums, etc . The commercial banks have to
abide by these directives or else face the penalties imposed by the central
bank.

Module 4
Inflation
Inflation is one the most pressing problems faced by economies across the world. Inflation
occurs when money supply exceeds available goods and services. It is often attributed to
budget deficit financing which is financed by additional money creation. But monetary
expansion or budget deficit may not always cause price level to rise. Hence , it is difficult to
exactly pin down the causes of inflation.
Inflation may be defined as a sustained upward trend in the general level of prices and not
the pricesof only one or two goods. Thus, inflation is the situation of rising prices but not
high prices. It is understood as the overall increase in price level due to fall in the worth of
money or reducing purchasing power of money. It can be seen as a recurring phenomenon.
For calculating inflation, large number of goods and services used by the people in the
country are taken and then average increase in the process of those goods and services is
calculated over period of time. A small rise or sudden rise in prices is not inflation since they
may reflect short term trend in the market. It is a state of disequilibrium when there is
sustained increase in the price level. The situation is termed as inflation when price level of
most goods goes up. The increase in price level may be slow or rapid. It has to be seen that
the upward trend in the prices of most goods exist and that trend is sustained. 17
Suppose the inflation rate in 2012 was 204.5 and in December , 2013 it was 214.3, the
inflation rateduring that year will be (214.3-204.5/ 204.5) x 100= 4.79%
Opposite to inflation, the deflation is the state of falling prices but not fall in prices. Deflation
is thus,opposite of deflation, i.e. rise in the value of money or purchasing power of money.
Disinflation is the slowing down of rate of inflation.
Types of Inflation:
The nature of Inflation is not uniform across the economy all the times. It is important to
know the kind of inflation in order to understand the distributional and other effects of

inflation and to recommend anti inflationary policies. Inflation may be caused by variety of
factors. The intensity andpace may vary at different times. It can also be defined in terms of
reactions of the government toward inflation.
1) Currency inflation : Inflation caused by the excess printing of currency notes.
2) Credit Inflation: Since commercial banks are profit making institutions, they may
sanction more loans and advances than what the economy needs. Such a credit
expansion may leadto rise in price level.
3) Deficit induced inflation : When expenditure of government exceeds revenue, it is
termed as deficit. To meet this gap, the government may ask central bank to print
more money.

Since introduction of this additional printed money into the economy may cause
increase in price level, this type of inflation is known as deficit induced inflation.
4) Demand pull inflation: DPI is caused when there is increase in aggregate demand
over available output, which leads to rise in price level. The aggregate demand may
rise due to increase in money supply i.e. when supply of money in an economy
exceeds that available goods and services (as argued by the classicists). It can be
defined as a situation of too much money chasing too few goods.
Increase Demand
Increased Additional
in Price Pull
Income Demand
Level Inflation
Keynesian economists hold that inflation may also be caused due to autonomous increase
in aggregate demand or spending due to increase in consumption demand, or investment
orgovernment spending or tax cut or a net increase in exports,(i.e. C + I + G+ X-M) with
no increasein money supply. This would cause prompt upward adjustment in price. DPI
is caused by monetary (Classical) factors or non-monetary factors (Keynesian).
In the figure, output is measured on X axis and price level on Y axis. In range 1, total
spending is too short of full employment level Yf. There is little or no rise in price level.
As demand rises, the output will also rise. The economy enters Range 2, where output
approaches toward full employment situation. In this region, the price level begins to
rise. Ultimately, the economy reaches full employment situation i.e. Range 3. Where
output does not rise but price level is pulled upward. This is demand pull inflation. The
reason for this type of inflation is too much spending chasing too few goods.

5) Cost Push Inflation (CPI): Increase in overall cost of production may also cause rise
in generalprice level of goods and services. i.e. due to rise in cost of raw materials
and wages etc. But many times trade unions also influence the wage rise though not
market determined, it may also cause price rise. This may also cause wage price spiral
to come into operation when firms also raise their prices in tandem with rise in wages
to keep their profits intact. Thus , there can be two variants of CPI, wage push
inflation or profit push inflation. CPI stems from leftward shift of aggregate supply
curve.
Increased
Cost of Raw increase in Cost Push
Materials price level Inflation
and Input

On the basis of Speed or Intensity:
1) Creeping or Mild Inflation: If the speed of upward movement in the prices is
slow or small, then we have creeping inflation. If a rise in price level is kept at
2% to 3%, it is considered as an aid to economic development.
2) Walking Inflation: If the rise in price level remains between 3% to 4%, it is
termed as walking inflation. It occurs when mild inflation is allowed to fan out
into walking inflation. Mostly single digit inflation is termed as moderate
inflation. Here , the people still have faith in the monetary system of the country
which could get lost when moderate inflation goes out of control and transforms
into galloping inflation.

3) Galloping and hyperinflation: Walking inflation may transform into running
inflation which further if left uncontrolled may turn into galloping or
hyperinflation. It is extreme form of inflation when the economy is in danger of
getting shattered. Inflation is in double , or triple digits e.g. 20%, 100% or 200%
etc.
4) Government’s reaction to inflation: Government’s reaction to inflationary
situation decides whether it is reined in sooner or allowed to worsen. E.g.
increase in incomeleads to increase in spending which pushes up the general
price level. If inflationary situation is countered by rationing or consumption
control through price controls, the inflation may become suppressed. Suppressed
inflation can transform into open and then hyper inflation if allowed to persist for
a long time.
Causes of Inflation:
1) Demand Pull Inflation: According to classical economists, the inflation is
caused by rightward shift in negatively sloping demand curve due to increase
in money supply. Given the full employment level, any change in money
supply brings about equiproportionate change in the price level. Therefore,
classicists argue that inflation is always and everywhere a monetary
phenomenon. Keynesians do not attribute a direct link between money supply
and the price level in the economy. According to Keynesians, the aggregate
demand may rise due to rise in consumer demand, investment demand, or
government expenditure or net exports or the combination of these four
factors of aggregate demand. Given full employment, such increase in
aggregate demand leads to upward pressure on prices. Such situation is called
DPI. Just like price of a commodity, the price level in the economy is
determined by the interaction of aggregate demand and aggregate supply.
In figure, aggregate demand curve is negatively sloping while aggregate
supply curve before full employment is positively sloping and becomes
vertical after full employment stage is reached. AD1 is the initial aggregate
demand curve that intersects aggregate supply curve AS at point E1. The price
level thus determined is OP1. As aggregate demand curve shifts to AD2, price
level rises to OP2. Thus, increase in aggregate demand at full employment
level leads to increase in price only and not the level of output. Therefore,

how much price level will rise following increase in aggregate demand
depends upon the slope of the aggregate supplycurve AS .

Causes of Demand Pull inflation:
DPI originates in the monetary sector. Monetarists believe that around the full
employment level, any increase in money supply will lead to increase in
aggregate demand and thus, increase price level i.e. cause inflation. An
increase in nominal money supply curve shifts aggregate demand curve
rightwards. This enables people to hold excess cash balances. Spending of
excess cash balances causes the price levelto rise. Price level continues to rise
until aggregate demand equals aggregate supply. According to Keynesian
argument, inflation originates in the real sector or non monetary sector by
increase in aggregate demand due to autonomous increase in business
investment, or government expenditure. Government expenditure is
inflationary if the needed money if procured by the government from
printing excess money.
There are other factors which may push aggregate demand and hence , price
level upwards. E.g. growth of population, higher export incomes may lead to
increase in purchasing power , hence, aggregate demand may go up. When
government repays public debt, it also causes increase in aggregate demand.
The hoarders of black money tend to spend upon conspicuous consumption
of goods, it may also cause inflation.

Cost Push Inflation Theory:
Aggregate supply when it moves leftwards also causes CPI. CPI is usually
associated with non monetary factors. CPI arises due to increase in cost of
production i.e. raw materials, increase in wages. Here, we assume that
productivity of workers remains unchanged (that is does not increase due to
increase in wages). Such increases in costs are passed onto customers by firms
increasing their prices of products. Rising wages lead to higher costs which
lead to higher prices and rising prices (or profits) again motivate trade unions
to demand higher wages. Hence, inflationary wage – price spiral starts. This
causes aggregate supply curve to shift leftwards.

AS1 is initially aggregate supply curve. Below the full employment stage this
AS curve is positive sloping and at full employment stage it becomes
perfectly elastic. Intersection point E1 of AD1 and AS1 curves determine
price level OP1. There is leftward shift in As curve to AS2. With no change
in aggregate demand, this causes price level to rise to OP2 and output fall to
OY2. With reduction in output , the employment in the country declines or
unemployment rises. Further shift in AS curve from AS2 to AS3 results in
higher price level OP3 and lower volume of aggregate output OY3. Thus, CPI
may arise even below full employment (Yf)stage.
Causes of Cost Push Inflation:

1) The cost push inflation is caused by rise in prices of raw materials. This
inflation can be imported also. E.g. decision by OPEC to increase the
prices of oil, causes the government to increase the domestic prices of
petrol and diesel. These raw materials are required by every sector
especially transport sector. It may resultin increase in general price level.
2) CPI may also be induced by wage push or profit push inflation. Trade

unions demand higher wages to compensate for inflationary price rise. If
money wages exceed labour productivity , the aggregate supply will shift
leftward and upward.Firms often exercise power by pushing up prices
independently of consumer demand to expand their profit margins.

3) Fiscal Policy changes: Increase in tax rates also lead to upward pressure
on cost of production. E.g. an increase in excise rate on a good of mass
consumption canbe inflationary. In this way, the government may also
cause inflation.
4) Supply shocks and production setbacks may also lead to decrease in

output: Natural disaster, gradual exhaustion of natural resources, work
stoppages, electric power cuts etc. may cause aggregate output to decline
5) Artificial Scarcity: Hoarding by traders and sellers also causes increase in

inflation.
6) Inefficiency, Corruption and mismanagement may also be the reason

behind theCPI.
It could be combination of one or more of above factors which causes CPI.
Effects of Inflation:
As buyers we want prices of goods and services to remain stable but as sellers people want
the prices to go up. But as prices keep rising some people who cannot keep up will be
amongst the suffering lot. Inflation can be anticipated or unanticipated. If it is anticipated,
people can adjust to the higher price levels and cost to society will be smaller. If people
cannot predict the inflation, people will fail to adjust completely and it will cause economic
hardships.
1) Effect on distribution of income and wealth : During inflation, some people gain
at the expense of others. Some experience rise in incomes which is more than rise in
the prices of products. Others lose as prices rise more rapidly than their incomes. This
distributes income and wealth in the economy.
2) Creditors and Debtors: Borrowers gain and lenders lose during inflation because

the debt is denominated in rupee terms. When debt is repaid after some time their
real value declines as the price level increases, hence , the creditors lose. If the
economy is chronically debt ridden, it is wise not to advance loans or to close down
business. However, the loan giving institution makes adequate safeguards against the
erosion of real value by charging higher interest rates n loans. Moreover, banks do
not pay any interest on current accounts by charges interest on loans.
3) Bonds and Debenture holders: People earning interest incomes suffer a reduction
in real incomes when prices rise. The value of one’s savings decline if the interest
rate is less than inflation rate . Also beneficiaries of life insurance policies face
decline in real value of their savings due to savings.
4) Investors: The possibility of earning higher business profits increases when price
levels are rising during inflation. Hence, shareholders stand to gain. Higher profit
will induce the owners to distribute the profit among investors or shareholders.
5) Salaried and wage earners: Fixed income earners always suffer due to inflation.
Even where trade unions negotiate wage rise , it always lag behind the price
increases. Inflation reduces

the real purchasing power of fixed income earners. On the other hand, people earning
flexible incomes may gain during inflation. The nominal incomes of such persons
may outstrip price rises.
6) Profit earners, Speculators and Black Marketers: Business men tend to gain when
they raisethe prices of their products during inflation. Speculators dealing in the
essential commodities make profits and so do black marketers. Rich may become
richer and poor maybecome poorer. The harmful redistributive effects of inflation
will be minimal when it is anticipated and they are able to plan for it in advance. E.g.
the workers will demand thewage increase by the same rate as the hike in rate of
inflation.
Anticipated inflation too may prove costly as people may start hoarding cash balances
as their expectation of future price rise becomes stronger. Holding balances is not
advisable as its real value will be reduced by rising inflation. People use their idle
cash balances to but gold, real estate, jeweler etc These investments are unproductive.
Thus, there occurs diversion of funds from productive to non productive sectors of
economy.
Effect on Production and Economic Growth
Inflationary situation gives incentive to businessmen to raise the prices of their
products so as to earn higher volume of profits. Rising price and profits encourage
firms to make larger investments. As a result, the multiplier effect of investment will
come into picture resultingin higher national output. The positive effects will be
temporary if the wages and costs of production rise very rapidly. But in case of cost
push inflation there may be a fall in output due to accompanying supply shock.
Inflationary tendencies nurtured by the people will cause further drop in output as
people will cause rise in saving propensities in people.
Inflation causes uncertainty among the business community as firms cannot
accurately estimate their costs and revenues. Investors become reluctant to invest and
undertake long term commitments, this adversely affects the economic growth. Mild
inflation may have a positive effect on the economy but it is difficult to ensure that
the prices rise only in creepy way. Hyper inflation discourages savings. A fall in
savings mean lower rate of capital formation , which hinders economic growth. Due
to excessive price rise, there is increase in unproductive investments like gold, real

estate, jewellery etc. Speculative businesses also spike during inflation creating
artificial scarcities and , hence, further rise in prices.
Due to hyperinflation, there is decline in exports become uncompetitive resulting in
wide imbalances in balance of payments accounts. It results in flight of capital to
foreign countriesand people lose faith in the monetary arrangements of the country
thereby resulting in scarcity of resources.
The real value of tax revenues also face decline during hyperinflation, as a result,
government faces shortfall in investible resources.
Therefore, the overall impact of hyperinflation is disastrous for the economy in the
long run. The similar harmful effects of were faced by Germany after First World
War (1914-18) and latin American countries in 1980’s.

Monetary Policy and its Importance
Monetary Policy involves influencing supply and demand of money through interest rates
and other policy tools, mainly formulated and implemented by the central bank of the country
e.g. In UK, Bank of England, In US, the Federal Reserve. The main objective of the monetary
policy is to maintain low inflation. Stability at optimum level of ouptut and achieve economic
growth.
Main tools of Monetary Policy:
1) Open Market Operations
2) Bank Rate
3) Cash Reserve Ratio
4) Selective Credit Controls
When economy is facing recession or involuntary cyclical unemployment , which comes

about due to fall in aggregate demand , the central bank intervenes with expansionary
monetary policyto remedy the situation.
1) Central bank will undertake open market operations and buys securities in open
market. Thecommercial banks are primary sellers of securities , this leads increase in
money reserves with banks or amount of currency with the general public. With
greater reserves, commercial banks can issue more credit to the investors and
businessmen for undertaking more investment. More private investment will shift the
aggregate demand curve to upward. Hence, the move will have an expansionary
effect.
2) The central bank will lower the bank rate or the discount rate , which is the rate of
interest charged by the central banks on the loans it grants to the commercial banks.
At lower bank rate, the commercial banks would be tempted to borrow more and
would be able to issue more credit at lower interest rate to businessmen and investors.
It will make credit cheaper and increase the availability of money supply in the
economy. The increased money supply will increase the investment demand which
will tend to raise aggregate output and income.
3) Central bank may reduce cash reserve ratio (CRR) to be kept by the commercial

banks. With lower reserve requirements, large amount of funds are available with the
banks to beadvanced to businessmen and investors. It more direct and effective way
of expanding creditand money supply in an economy by the central bank.
4) Similar to CRR , the central bank may also reduce SLR statutory liquidity ratio (the
ratio of deposits to kept by banks in specified liquid assets e.g. government
securities).
In Keynes theory, the rate of interest is determined by the demand for and supply of
money. According to him, expansion in money supply causes rates of interest to fall,
this will encourage businessmen to borrow more for investment spending. Rate of
interest is the opportunity cost for funds invested for purchasing capital goods. In the
figure, due to some measures taken by the central bank the money supply increases
from M1 to M2 and rate of interest decreases from r1 to r2. In panel (B), the
investment increases from I1 to I2. In panel(C), the increase in aggregate investment
expenditure from I1 to I2 , shifts the aggregate demand curve from C+I1+G to
C+I2+G, intersects 45° line at point E2 and thus establishes equilibrium at full
employment level Yf. Given the increase in investment how much national

income or aggregate output will increase will depend upon the size of income
multiplier which will depend upon the marginal propensity to consume. The greater
the size of multiplier , greater will be the impact of increment in investment on
expansion of output and income. However, inspite of the importance of monetary
policy in stimulating growth, there exists some weak links which affect the full
transmission of benefits of expansionary monetary policy from reaching to the lowest
level. One of the weak links is the demand for money Md, if it becomes highly elastic
, no amount of increase in money supply will cause increase in investment as people
would prefer to hold cash balances. This also because if theinvestment demand curve
is steep or inelastic, that is, investment is not sensitive to the changes in the rate of
interest will fail to cause any significant increase in investment. As a result, the
aggregate demand curve will not change much and expansionary effect on outputand
employment will not be realized. Even Keynes realized that the effect of increase in
investment on output and employment depends upon the size of the multiplier and if
there are many leakages in the multiplier process then even an increase in investment
may not bring about much change in the income and employment. Therefore,
monetary policy is not thought of as an effective instrument in bringing about
economic revival during depression. But the liquidity preference curve is not flat and
that investment demand is fairly sensitive to the changes in the rate of interest.
According to them, monetary policy is as effective tool as the fiscal policy to enable
an economy to recover itself.

Contractionary monetary policy to control inflation
When aggregate demand rises due to huge increase in consumption or investment
expenditure or due to large increase in government expenditure relative to its revenue
resulting in huge budget deficits, a demand pull inflation occurs in the economy.
In order to check demand pull inflation, countries adopt tight or restrictive monetary
policy which reduces the availability of credit and also raises its cost.
1) The central bank sells the government securities to the banks, financial ,
depository institutions and to the public. This will reduce the reserves with
commercial banks and liquid funds with general public. With less reserves with
the banks their lending capacity will be reduced. Therefore, they will have to

reduce their demand deposits by refraining from giving new loans as old loans
are paid back. As a result money supply in the economy will shrink.
2) The bank rates may also be raised which will discourage banks from taking loans
from the central bank. This will tend to reduce liquidity and they will also be
tempted to raise

their own lending rates. It will reduce the availability of credit and raise its cost.
This will help in reducing investment spending and reducing inflationary
pressures.
3) CRR is most important tool to control inflation, when it is raised, the banks in
order to meet higher reserve requirements will they will reduce their lendings and
it will have contractionary impact on the economy. Similary SLR ,may also be
raised to almost same effect in the economy.
4) Qualitative credit control is also an important tool: By raising the margin
requirements to borrow against stock of certain commodities which are prone to
inflationary pressures restricts the flow of credit into these specific areas of
economy and prevents build up of inventories and hence, controls inflation.
Working of Tight Monetary Policy
Tight monetary policy seeks to reduce money supply through contraction of credit in
the economy and also raising the cost of credit, that is the lending rates of interest.
The reduction in money supply itself raises the rates of interest. The higher interest
rate reduces investment spending which results in lowering of aggregate demand
curve. (C+ I + G). The decrease in aggregate demand tends to reduce demand pull
inflation. Let us assume the full employment level of income if Yf.
If due to large budget deficit and excessive creation of money supply , the aggregate
money supply shifts to C+I2+ G2, the inflationary gap E1H comes to exist at full
employment level. That is , the sum of consumption expenditure, private investment
spending and government expenditure exceeds the full employment level of output
by E1H. This creates demand pull inflation resulting in rise in prices. Though with
aggregate demand curve C + I2 + G2, the equilibrium reaches at point E2 and as a
result the national income increases but only in money terms , real income or output
level remaining constant at Yf. In panel (A), tightmoney policy succeeds in
reducing money supply from M2 to M1 , the rate of interest will rise from r1 to r2.
Panel (b) shows that at higher interest rate r2, the investment falls from I2to I1. This
reduction in investment expenditure shifts aggregate demand from C + I2 + G2. And
downward from C + I1 + G2 and in this way inflationary gap is closed and

equilibrium at full employment output level Yf is once again established. It is
observed from the figure that the reduction in money supply from M2 to M1 and as
a result the rise in interest rates from r1 to r2 is sufficient to reduce investment
expenditure equal to I2 to I1, which is equal to inflationary gap and in this way
macroeconomic equilibrium without any inflationary pressure is established at output
level Yf.
In this analysis, it is assumed that demand for money curve (i.e. liquidity preference
curve) isfairly steep so as to push up the rate of interest from r1 to r2 and further that
investment demand curve II in panel (b) is fairly elastic so that the rise in interest
rates from r1 to r2 is sufficient to reduce the investment from I2 to I1 or ∆I. If the
shapes of money demand curve and investment demand curve follows the real world
situation then the tight monetary policy will succeed in its objective of controlling
inflation and bringing about price stability.

Modern economists have well accepted the view that both fiscal and monetary
policies can be effective in checking inflation and promoting economic growth.
However, a group of economists led by Milton Friedman believe that changes in
money supply are key determinants in the level of economic activity and price level.
They contend that demand curve for money is quite steep and the investment demand
curve is quite elastic so that when there is change in money supply, it significantly
affects the investment demand , therefore , the equilibrium level of national income.

However, moat of monetarists do not advocate use of discretionary or expansionary
monetary policy to lift the economy out of recession or use of tight monetary policy
to check inflation boom and thereby correct the ‘ups’ and ‘downs’ of the business
cycles. Freidman observed that in fact, far from having stabilizing impact on the
economy, the expansionary monetary policy has destabilizing

impact on the economy. On the basis of his study of monetary policy history of US ,
he contends due to imprudent decisions regarding changes in money supply of the
economy, made by the monetary authorities, are responsible for lot of instability that
prevailed during the period of his study. There are two sources of monetary
mismanagement according to monetarists !) the time lag concerning effect of money
supply on national income; 2) treating interest rates as target of monetary policy for
influencing investment demand for stabilizing the economy. If expansionary
monetary policy is adopted because the various economic indicators show situation
of mild recession then, due to time lags involved , say sixto eight months, for policy
to yield results, the economic situation might change and becomes reverse during
that period and becomes one of mild inflationary. Expansionary monetary policy
which produces effect after six to eight months might actually exacerbate the
inflationary situation. Secondly, it has also been argued that the central bank cannot
simultaneously stabilize both interest rates and money supply. By controlling the
interest rates it has actually destabilized the economy. E.g. if the economy is
recovering from recession and is presently approaching full employment with
aggregate demand , outputand employment and prices , all registering a rise, the
transactions demand for money will increase. The increase in transaction demand for
money will cause rate of interest to rise. But if monetary authorities have chosen
to stabilize the interest rates, they would adopt tight monetary policy from
preventing the rates from going up. But the tight monetary policyto check the interest
rates from rising when economy is recovering from recession , willagain cause
the recessionary situation. Thus an attempt by central bank to stabilize the interest
rates will make the economy unstable. Similarly, when economy is going into
recession , it will result in lowering aggregate output and prices. This fall in aggregate
output and prices. This fall in aggregate output and prices will cause fall in
transactions demand for money. And the decrease in transactions demand will lead
to fall in interest rates. To prevent this fall in interest rate , if money supply is
increased, it will generate inflationary pressures in the economy. Thus the steps taken
to stabilize the interest rates cause more instability in the economy rather than having
an stabilizing effect.
Monetary Rule

Therefore, the monetarists are not in favour of stabilizing the interest rate they
advocate for adoption of a monetary rule that money supply should be allowed to
grow at the rate equal to the rate of growth of economic activity. If the economy is
expected to grow annually atthe rate of 3, 4% or 5%, the money supply should also
grow at that rate. The growth of output of an economy will absorb the extra money
supply created as per this rule without generating inflationary or recessionary
conditions and will thus ensure stability in the economy.
According to this rule as long as monetary supply grows at a constant level each year
be it 3%,4% or 5%, any decline into recession will be temporary. The liquidity
provided by constantly growing money supply will cause aggregate demand to
expand. Similarly, if supply of money does not rise at a more than average rate , any
inflationary increase in spending will burn itself out for lack of fuel.

Keynesian economists have criticized the monetary rule on the grounds that given
thevelocity of money (V)being unstable or variable, increase in money supply(M)
will not ensuregrowth of aggregate demand (which is equal to MV) equal to the rate
of growth of output in a year which is difficult to predict. Thus, money supply
increase may sometimes exceed the growth output and sometimes fall short of it and
sometimes cause demand pull inflation andsometimes recessionary conditions. Thus
, according to Keynesian economists, policy of monetary rule does not guarantee
economic stability and it may itself create economic instability.
Fiscal Policy and its importance
Fiscal Policy relates to the impact of government spending and tax on aggregate
demand of the economy. Expansionary fiscal policy is an attempt to increase
aggregate demand and willinvolve higher government spending and lower taxes.
Expansionary fiscal policy leads to larger budget deficit. Deflationary fiscal policy
is an attempt to reduce aggregate demandand will involve lower spending and
higher taxes. Deflationary fiscal policy will help reduce a budget deficit.
There may be times when the economy’s national output , income , employment are
far below their optimum levels. Economic activity gets sluggish and there exists lots
of idle capacity in the economy. Therefore, the unemployment in the economy
increases along withexistence of excess capital stock. On the other hand when the
economy is overheated, the inflation exists with price levels rising. In a free market
economy though there is lot of instability, autocorrecting mechanism works to restore
the stability in the economy. But any such mechanism failed to work in the Great
Depression phase, and in the post second world war era.
According to Keynes, monetary policy was unable to lift economy out of recession,
heemphasized the role of fiscal policy as a stabilizing tool in the economy. The goal
of the macroeconomic policy is to maintain economic stability at higher level of
economic activity, ouput and employment. Along with this price stability which
discourages both inflation and deflation is to be aimed. Macroeconomic policies can
play a useful role in raising the rate of savings and investment and ensure rapid
economic growth.

Discretionary fiscal policy is the important tool in controlling the economy i.e. in
times of recession the government may adopt expansionary fiscal policy, and in order
to control inflationary situation , government must adopt contractionary fiscal policy.
Fiscal Policy in times of Recession
Government adopts expansionary fiscal policy to manage demand when due to
decrease in private investment owing to reduced marginal efficiency of investment ,
there is decrease in aggregate demand. The aggregate demand curve shifts down
causing deflationary or recessionary gap. The government can either 1) Increase the
expenditure or 2) Reduce the taxes.
1) Increase in government expenditure: Government may start public works,
building roads, dams, ports, telecommunication links, irrigation works,
electrification of newareas. Government buys material and employs workers,
results in increase in income of

those supplying labour and materials. The output of these works increases further
with the increase in incomes of those employed, as Keynes mentioned the role of
multiplier with the increase in government expenditure. Those who get incomes
spend it furtheron consumer goods depending upon their marginal propensity to
consume. Therefore idle capacity is put to use thereby reducing the
unemployment. The amount of increase in expenditure depends upon the
deflationary gap and the size of the multiplier. Suppose we begin with the
economy operating at full employment or potential level of output Yf with
aggregate demand curve C + I2 + G2 intersecting 45degree line intersecting at
point E2.Now, for example, due to adverse economic events there occurs decline
in investors’ expectations in making profits out of their investments and hence,
there is overall decline in investment. With decline in investment equal to E2B,
the aggregate demand curve will shift to C+ I2 + G2 which will bring the
economy to a new position at point Ex., thereby determine the Y2 level of
employment. The fall in output will create involuntary unemployment of labour
and excess capacity. Therefore, the deflationary gap and the reverse working of
the multiplier have created unemployment in the economy and to remedy this ,
the government increases its expenditure to E1H and aggregate demand will shift
to C+I2+ G2 and thus equilibrium level of income increases to full employment
level Yf. Note that increase in national income ∆Y and output Y1Yf is not only
equal to increase in government expenditure by ∆G or E1H but a multiple of it
depending upon the marginal propensity to consume. Thus, increase in national
income is equal to ∆G (1/1-MPC) where 1/1-MPC is the value of the multiplier.

It is to be observed that increase in government expenditure without raising taxes
will fully succeed if rates of interest remain the same. With the increase in
government expenditure and resultant increase in output and employment, the
demand for money for transaction purposes is likely to increase, where money
demand curve shifts from Md1 to Md 2 as a result of increase in transactions
demand for money. Money supply remaining constant , with increase in demand
of money , the rate of interest is likely to rise. Which will adversely affect the
private investment. The decline in private

investment will tend to offset the expansionary effect of rise in government
expenditure. Therefore, if the fiscal policy of deficit budget or increase in
government expenditure is to succeed, the central bank of the country should
also pursue expansionary monetary policy and to take steps to increase the
money supply so that increase in government expenditure does not lead to rise
in rates of interest. In the figure, if the money supply increases from Ms1 to
Ms2 , the rate of interest does notrise despite of increase in demand for money.
With rate of interest remaining unchanged the private investment will not be
adversely affected and increase in government expenditure will have full impact
on raising national income andemployment.
Financing the budget deficit
Raising the taxes is not the recommended way of financing the budget deficit as
it will reduce the disposable incomes and consumers demand for goods. Hence,
the rise in taxes would offset the expansionary impact of rise in government
spending. Therefore, the budget deficit is natural corollary of implementing

expansionary fiscal policy. A way to finance budget deficit in the market is to
borrow from the public by selling interest bearing bonds to them. However, there
does exist a problem with this method, ifgovernment borrows from the money
market where it will be competing with the private businessmen who also borrow
for private investment. The government borrowing will raise the demand for
loanable funds in the free market, where if rates of interest are not administered
by the central bank, will drive up the same. And rise in therates of interest will
crowd out private investment and interest sensitive consumer spending on
durable goods. More effective way of financing the budget deficit is by way

of creating new money. The creation of new money is known as monetization of
budgetdeficit and it will have greater expansionary effect than the borrowing by
the government.
2) Reduction in Taxes is another method to tide over the recession in the

economy. Reduction in taxes increases the disposable incomes of the people and
causes increase in consumption spending by them. For example, if there is tax
reduction in the budget of amount Rs. 200 crores, assuming the marginal
propensity to consume if 0.75, it will lead to ¾ times increase in consumption
i.e. 150 crores. Thus, it can shift the consumption function upwards. If along
with reduction in taxes, the government expenditure is kept unchanged , the
aggregate demand curve will shift upward due to rise in demand function curve.
This will increase the income and output and as a result unemployment will be
reduced. It is to be observed that reduction in taxes with government expenditure
remaining constant will also result in budget deficit which may have to be
financed either by borrowing or by creating new money. But reduction in taxes
only has an indirect impact on raising consumption function. The reduction
in taxes will also have multiplier effect on the economy. The value of tax
multiplier is givenby ∆T x MPC/1-MPC, or ∆ C x MPC/1-MPC.
In case of reduction in taxes, instead of increase in government expenditure it is

the increase in consumption C , which will cause the upward shift in the demand
curve (C+I+G) and will result in through working of the multiplier , a higher
level of equilibriumnational income. Whether to reduce taxes or increase the
government expenditure depends upon the extent of role of public sector is
deemed to be important in the economy. If government is expected to play an
important role to meet the challenges posed by the failures of the free market
system, then increase in government expenditure on public works is
recommended to increase output and employment. Those who believe that the
public sector is inefficient and involves waste of scarce resources would
advocate reduction in taxes to stimulate the economy. The choice between
reduction in taxes and increase in government expenditure also depends upon
another factor, that is magnitude of effect of expenditure multiplier and tax

multiplier.It should be noted that when expenditure multiplier is 1/1-MPC, the
tax multiplier equals MPC/1-MPC, which is less than the expenditure multiplier
1/1-MPC. For exampleMPC is 0.75 or ¾, so that value of expenditure multiplier
is 4. Increase in government expenditure by Rs. 100 crores will increase the
output by Rs. 400 crores. On the other hand reduction in taxes by Rs.100 crores
will increase the national income and outputby (100 x ¾)/1-3/4 = 75/ ¼= 300
crores. The effect in reduction in taxes by equal amount as the increase in
government expenditure has a smaller impact on national income than that of
increase in government expenditure. The difference in the impact of two
methods of expanding output has implications for the size of government deficit.
If we want to increase the income by the same amount, we would need to cut
taxes by more amount than we would have increased the government expenditure
to achieve the same result because the size of the tax multiplier is less than the
size of theexpenditure multiplier. In other words, if we plan to use the reduction
in tax method to achieve expansion by given amount , the budget deficit planned
will have to be much higher. However, this is not the sole deciding factor,
reductions in taxes is greatly

welcomed by the people as it increases its disposable incomes. Further, it is
individuals or households who themselves decide how to spend their extra
disposable incomes made possible by the tax cuts while in case of increase in
government expenditure , the government decides how to spend it.
Fiscal Policy to Control Inflation
When due to large increases in consumption demand by the households or

investment expenditures by the entrepreneurs or bigger budget deficit caused by
too large an increase of government expenditure , the aggregate demand
increases beyond whatthe economy can potentially produce, by fully employing
its given resources, it gives rise to situation of excess demand which causes
inflationary pressures in the economy. The inflationary situation might also arise
when there is too large an increase in money supply in the economy. In these
circumstances the inflationary gap exists which tends tobring about rise in prices.
If immediate steps to check the increased demand , the economy will experience
a period of inflation or rising prices. The problem of inflation can be faced by
both developed and developing countries of the world. Business cycleas it
moves from recession to recovery , the economy may become overheated due to
conditions of boom and excess demand, the prices start rising rapidly. Under
such circumstances, the anti cyclical fiscal policy can cause reduction in
aggregate demand through 1) reduction in government expenditure ; 2) Increase
in taxes;
If in the beginning the government has balanced budget, then increasing taxes
while keeping government expenditure constant will yield budget surplus. The
creation of budget surplus will cause downward shift in aggregate demand and
help in relieving pressure on rising prices. If there exists a balanced budget and
the government reduces its expenditure on defence, subsidies ,transfer payments
while keeping taxes constant , it will also create budget surplus removing the
excess demand from the economy. In country like India, the main reason for
build up of inflationary pressure in the economyis the heavy budget deficit of
the government for many consecutive years resulting in excess demand

conditions in the economy. Rate of inflation can be reduced not necessarily by
planning for budget surplus but by taking steps to reduce budget deficit.It has
been estimated to reduce fiscal deficit to 3% of GDP in order to achieve price
stability in the Indian economy. In the figure the aggregate demand curve C + I
+ G1, intersects 45 degree line at point E which determines equilibrium national
income at fullemployment level at Yf. However, due to excessive government
expenditure and a largebudget deficit , the aggregate demand curve shifts upward
from C + I + G2, this will determine Y2 level of income which is greater than
full employment or potential output level Yf. Since output cannot increase
beyond Yf, income will rise only in money terms through rise in prices , real
income and output remaining the same. In other words, when the economy does
not have labour , capital and other resources sufficient to produce Y2 level of
income or output, the households, businessmen and the government is
demanding Y2 level of output. This excess demand pushes up the price level, the
nominal income increases the size of real income or output remaining constant.
It is therefore, that with increase in aggregate demand beyond the full
employment level of output to C +I + G2. Causes excess demand equal to EA
to emerge

in the economy. It is this excess demand EA relative to full employment level Yf
which causes price level to rise and thus cause inflationary pressures in the
economy.
This excess demand EA at full employment level Yf is also known as inflationary

gap. The task of fiscal policy is to reduce this inflationary gap by reducing
government expenditure or raising taxes. With equilibrium at point H and
nominal income at Y2 , if the government expenditure equal to HB which is
equal to inflationary gap AE is reduced, the aggregate demand curve will shift
downward to C +I+ G1. Which will restore the equilibrium to full employment
level Yf. The reduction in government expenditure equal to HB has led much
greater decline in output by Y2Yf. Ideally, the government should cut back on
its unproductive or non development heads such as defence, unnecessary
subsidies. It may be observed that in India the government has been reducing its
capital expenditure which is of development nature and therefore, it is not
considered as a prudent option.

Raising Taxes to Control Inflation: A hike in direct taxes like income tax,
corporate tax, wealth tax reduces the incomes of the people and forces them to
reduce their consumption demand. It is the decrease in the domestic demand
component (C) which will cause aggregate demand curve C +I+ G2 to shift
downward. Since, the magnitude of tax multiplier is smaller than the expenditure
multiplier , the tax revenue will have to beraised by a greater amount to achieve
contraction in national income by Y2Yf.
Uses of Budget Surplus:
If anti inflationary fiscal policy(reduction in government expenditure or raising

of taxes)results in budget surplus , there are two ways to put this surplus to use:
1) Reducing or retiring government debt : if government uses budget surplus to retire

public debt, it will be returning the money to the public which it has collected through
taxes. Further, this will also add to the money supply with the public. The general
public may spendpart of money so received in increasing consumption demand. Also,
retiring public debt will increase the money supply in the money market which will
tend to lower the interest rates. The low interest rates will stimulate the consumption
and investment demand which will negate the effect of anti inflationary policy.
2) Impounding Budget Surplus: Instead of retiring the public debt, the government
may decide to impound the surplus funds and keep them idle. It also means
government shall be withdrawing some income or purchasing power from income-
expenditure stream., thus , will not create inflationary pressure to offset the
deflationary impact of the budget surplus. Therefore, impounding budget surplus is
better method of using budget surplus than retiringpublic debt.
The discretionary fiscal policy involve the problem of lags in recognizing the
problem of inflation and recession and lag of taking appropriate action to tackle the
problem.
Non Discretionary Fiscal Policy
In non discretionary fiscal policy, the tax structure and expenditure pattern are so designed
that taxes and government spending vary automatically in appropriate direction with changes
in national income.

These taxes and expenditure pattern without any deliberate action on part of government
automatically raise aggregate demand in times of recession and reduce aggregate demand in
times of inflation and thereby help in ensuring economic stability. These fiscal stabilizers are
therefore called automatic stabilizers or built in stabilizers. They are:
1) Personal Income tax: Tax structure is so designed that the revenue from these taxes
varies with income. E.g. progressive tax rates.i.e. higher rates are charged from upper
income brackets. As a result, when national income increases during expansion and
inflation, increasing proportion of people’s income is paid to the government.
Therefore, by reducing their disposable incomes , these taxes cause automatic
reduction in the aggregate demand. Thus, progressive taxes are automatically
countercyclical
2) Corporate Income taxes: Like personal income tax, corporate income tax is also
higher at high levels of corporate profits.

3) Transfer Payments: e.g. unemployment compensation, welfare benefits. During
recessionary times, the government has to spend more on unemployment benefits,
welfare programmes, such as food stamps, rent subsidies, subsidies to farmers. Hike
in government expenditure tends to make recession short lived and less intense. On
the other hand, in times of boom and inflation, the national income increases and
unemployment falls, the government curtails its programme of social benefits which
result in lowering of government expenditure. The smaller spending by the
government helps in controlling inflation
4) Corporate dividend Policy: With economic fluctuations, the corporate profits also
rise and fall. However, corporations do not increase or reduce dividends in tune with
rise or fall in corporate profits. And follow fairly stable dividend policy. A stable
dividend policy cushions recession and curbs inflation by stabilizing consumption
expenditure.
Researchers have shown that one third of economic fluctuations can be removed by
automatic stabilizers and for the rest , the discretionary fiscal policy involving
deliberate and explicit changes in tax rates and amount of government expenditure
plays a vital role.
Trade Cycle
According to Keynes, a trade cycle is composed of period of good trade characterized by

rising prices and low unemployment percentages , altering with period of bad trades
characterized by falling prices and high unemployment percentages. The two indices in
this definition are unemploymentand prices.
In words of Fredric Benham, a trade cycle may be defined as a period of prosperity followed
by a period of depression. It is not surprising that the economic process should be irregular
trade being good at sometime and bad at others.
In short, a business cycle is an alternate expansion and contraction in overall business activity
as evidenced by fluctuations in measures of aggregate economic activity such as gross
product, the index of industrial production and employment and income. Sometimes , these
fluctuations may be seen in all branches of the national economy simultaneously and

sometimes it may be confined to individual sectors and industries of the economy.
Types of Trade Cycle:
1) The Minor Cycle: It is also known as short Kitchin cycle named after British
economist JosephKitchin in the year 1923. According to him, the cycle takes place
within 30 to 40 months.
2) Major Cycle: Also known as Long Jugler cycle named after French economist
Clement Jugler showed that the period of prosperity, crisis and liquidation
followed each other alwayswithin span of nine and half years.
3) The very Long Period Cycle: Also known as Kondratieff propounded by N.D
Kondratieff , the Russian economist in the year 1925. According to him the longer
wave of cycle are of more than fifty years duration.
4) Kuznets Cycle: It was given by American economics professor Simon Kuznets.
According to him the secular swing of trade cycle can last for 7 to 11 years.

5) Building Cycles: Two American economists Warren and Pearson, held that average
trade cycle occurs within the duration of 18 years and cost of such cycle has major
effect on building construction and on industrial development.
Phases of Trade Cycle:
1) Depression: During depression the level of economic activity is extremely low. Real
income, production, employment, profit, prices etc. are falling. There are idle
resources. Prices are low leading to fall in profits, interest and wages. There will be
overall pessimism leading to closing down of business.
2) Recovery: Recovery is the turning point of business cycle from depression to
prosperity. There is slow rise in income , output, employment and price. Demand for
commodities goes up. There is increase in bank loans, investments and advances.
Pessimism gives way to optimism..
3) Prosperity: it is the phase where income and employment are high. There are no idle
resources. There is no wastage of materials. There is rise in wages, prices , profits
and interest. Demand for bank loans increases. There is all round optimism. These
boom conditions cannot last because forces of expansion are very weak. There are
bottlenecks andshortages. There may be scarcity of labour, raw material and other
factors of production. Banks may stop lending. These conditions lead to recession.
4) Recession: When entrepreneurs realize their mistakes , they reduce their investment,
employment and production. Then fall in employment leads to fall in income,
employment, prices and profits. Optimism gives way to pessimism. Banks reduce
their loans and advances.Business expansion stops. This leads recession phase into
depression.

Theories of Trade Cycle:
Non Monetary Theories of Trade Cycle:
1) Sunspot Theory or Climatic Theory: It is associated with W.S Jevons and later o
developed by H.C Moore. According to this theory, the spot that appears on sun
influences the climatic conditions. When a spot will appear it will affect rainfall and
hence agricultural crops. When there is crop failure, it will result in depression. And
if the spot did not appear on the sun, rainfall is good leading to prosperity. Thus,
variations in climate are so regular that depression is followed by prosperity.
However, this theory has lost its relevance in the modern times because trade cycle
has become a very complex phenomenon and it cannotbe associated with climatic
conditions. This theory failed to explain the causes of cyclical fluctuations in a highly
industrialized and advanced economy.
2) Psychological Theory: Proposed by A. C Pigou, this theory held that the
psychological factor is an important determinant in the birth of trade cycles. During
the period of good trade, thebusinessmen become optimistic and it would lead to

increase in production. As the feelingof optimism spreads, the investments are
increased beyond limits and there is overproduction which results in losses. Thus,
entrepreneurs become pessimistic resulting in reduction in production and
investment. Hence, the fluctuations are due to optimism leading to prosperity and
pessimism resulting in depression. This theory is unable to explain the occurrence of
boom and starting of revival.
3) Overinvestment theory: Arthur Spiethoff and D.H Robertson gave this theory based
on Say’slaw of markets. It believes that overproduction in one sector leads to
overproduction in

other sectors. Suppose there is overproduction and excess supply in one sector that
will result in fall in price and income of the people employed in that sector. Fall in
income will lead to decline in demand of goods and services produced by the other
sectors. This will create overproduction in other sectors. Hence, overinvestment is
the cause of trade cycle. Overinvestment is due to indivisibility of investment and
excess supply of bank credit. E.g. the railway company may lay one more track to
avoid traffic congestion but it may result in excess capacity because the additional
traffic may not be sufficient to utilize fully. Overinvestment and overproduction are
encouraged by monetary factors. If the banking system places more money in the
hands of entrepreneurs, the prices will increase. The rise in prices may lead
entrepreneurs to increase their investments and thus, leading to overinvestment. This
theory has successfully combined real and monetary factors to explain business cycle
but failed to explain revival.
4) Over saving or underinvestment theory: This theory is formulated by Malthus ,
Marx and Hobson. According to this theory , the depression is due to over saving. In
the modern society, there are great inequalities of income, the rich people have high
incomes but their marginal propensity to consume is less. Hence, they save and invest
which causes increase involumes of goods and a general glut in the market. At the
same time, majority of people are poor, they have low propensity to consume.
Therefore, consumption will not increase.Increase in supply of good and decrease in
demand create under consumption and hence over production. This theory only
explains turning point from prosperity to depression, It does not say anything about
recovery. It assumes that amount saved will be automatically invested. It gives too
much emphasis on saving.
4,5 Keynes theory of trade cycle: According to Keynes, the effective demand
decides the levelof income, output and employment. In free private enterprise, the
entrepreneurs will produce as much goods as can be sold profitably. If aggregate
demand is large , the expenditure on goods and services is large , the entrepreneurs
will be able to sell profitably alarge quantity of goods and therefore they will
produce more. In order to produce morethey will employ larger amount of resources
i.e. men , materials. Hence, higher aggregate demand will result in higher income,
output and employment. On the other hand , If aggregate demand is low, smaller
amount of aggregate goods and services can be sold profitably. This means total

quantity of national output produced will be small and small amount of output can be
produced with small amount of resources. As a result, there will be unemployment
of resources both labour and capital. Hence, the changes in aggregate demand will
be bring about fluctuations in income, output and employment. Thus, fluctuations in
economic activity are due to changes in aggregate effective demand. Fall in aggregate
effective demand create the conditions of recession or depression. If aggregate
demand increases , economic expansion will take place. The aggregate demand is
composed of demand for consumption goods and demand of entrepreneurs for
investment goods. Propensity to demand more or less consume in the short run,
fluctuations in aggregate demand and hence the cause of fluctuations in economic
activity is the fluctuation in investment demand. Investment demand is very volatile
and unstable and brings about business cycles in an economy.
During expansion phase, high demand for capital goods due to large scale investment
activity leads to rise in prices of capital goods due to rising marginal cost of their
production.

Higher prices of capital goods raise the cost of investment projects and thereby reduce
the marginal efficiency of capital (expected rate of return).
Secondly, as incomes rise during expansion phase, the demand for money increases
which raises the interest rates. Higher interest rates makes potential projects
unprofitable. Thus, fall in marginal efficiency of capital on one hand and rise in
interest rate on the other cause decline in investment demand. Declining investment
trend casts shadow on prospective yield of future investment projects which is more
important factor determining marginal efficiency of capital than cost of investment
projects and rate of interests. When among businessmen pessimism sets in about
future profitability of investment projects stock prices stumble. The crash in stock
prices worsens the situation and causes investment to fall even more. Besides, fall in
prices of shares reduces the wealth of households. Wealth, accordingto Keynes is
an important factor in determining consumption. Thus, decline in stock prices
reduces autonomous consumption demand of households. With fall in both
investment and consumption demand, aggregate demand declines which results in
accumulation of unintended inventories with the firms. This induces firms to cut
production of goods. Hence, besides rise in cost of capital goods and rise in rate on
interest towards the end of expansionphase, it is fall in expected prospective yield
that reduces the marginal efficiency of capital and causes investment demand to fall.
This induces wave of pessimism among the businessmen and speculators. This
causes stock market prices to tumble and it acts like adding fuel to fire. They cause
further fall in marginal efficiency of capital. The eventual turn from expansion to
contraction is caused by sudden collapse in marginal efficiency of capital. In graph
this fall in MEC causes leftwards shift in investment demand curve from I0I0 to I1I1.
Assuming the decline in investment from Io’ to I1’. At the given rate of interest.
Decrease in investment does not automatically decrease in rate of interest to offset
fall in the marginal efficiency of capital.

Additional factor, that makes Keynes trade cycle more potent is the working of
multiplier. According to Keynes, decrease in investment expenditure reduces income
which causes decline in consumption expenditure. The reduction in consumption
expenditure further reduces the income and this process of reduction in income
continues further. The fall in income ∆Y due to further fall in investment ∆I will be
equal to ∆I x (1/1-MPC).Where 1/1- MPC is the value of the multiplier.
If marginal propensity to consume is 0.75, the multiplier will be equal to 4. The
decline in investment by 100 crores will lead to decline in income by 400 crores.
Here the multiplier works in reverse, it magnifies the effect of reduction in investment
on aggregate demand and income which further leads to depression. Thus, Keynes
theory of income multiplier plays a magnified role in causing magnified changes in
income, output and employment. In Keynes theory, wages and prices are “sticky”
downward which implies that though wages and prices do not remain constant but
when demand falls wages and prices will fall but not sufficient to restore full

employment in the economy. Since, wage price flexibility does not ensure recovery
of economy out of depression, according to Keynes marginal efficiency of capital
must rise to stimulate investment. During depression investment falls to a very low
level , fiscal stock begins to wear out and requires replacement. For some, existing
capital equipment becomes technologically obsolete and has to be abandoned. This
generatesdemand for replacement investment. A long period of time is necessary
for existing capital

to depreciate because most capital goods are durable as well as irreversible. By
durability of capital goods means they last for a long time and by irreversibility we
mean that they cannotbe used for purposes other than those for which they are meant.
Revival of Marginal efficiency of capital i.e. expected rate of profit is the cause of
lower turning point i.e. from recession to recovery. Restoration of business
confidence is the most important yet the most difficult factor to achieve. Even if the
rate of interest is reduced investment will not increase. This is because in the absence
of confidence the profitability of investment may remain so low that no practicable
reduction in the rate of interest will stimulate the investment.
The time lapse between the upper turning point and start of recovery process is
determined by two factors: 1) The time necessary for wearing out of durable capital
assets;2) Time required to absorb the excess stocks left over from the boom period;
Just as the expected rate of profit was pushed down by growing abundance of capital
during boom period, similarly stock of capital goods are depleted and there grows
scarcity of capitalgoods , and then the expected rate of profit rises, thereby , inducing
businessmen to invest more. When level of investment increases, the income also
increases by magnified amount due to multiplier effect. Therefore, the cumulative
process starts upward.
Thus, with time as depreciation of capital stock occurs without replacement and also
some existing capital equipment becomes technologically obsolete, the size of capital
stock declines. New investment must be undertaken even to produce reduced
depression level output. Thus, with scarcity of capital , marginal efficiency of capital
rises which boosts investment. When investment increases it induces further increase
in income and consumption demand through the multiplier process. Now the
multiplier effect works to magnify the effect of increase in investment on raising
aggregate demand. The mood of businessmen changes from pessimism to optimism
which drives up stock prices. All these factors work to lift the economy out of
depression and put it on the road to recovery. However, it is crucial to note that the
recovery process from depression takes a very long time and as Keynes suggested
that the government should not wait for the natural recovery to occur but intervene
as soon as possible because persistence of depression creates lots of human
sufferings. He argued for adoption of policy of fiscal expansion through budget
deficit (i.e. either increasing expenditure or reducing taxes.) to boost aggregate

demand so that economy is lifted out of depression. In Keynes theory of trade cycle
, the economy goes through self generating cycle as it passes through long phase of
expansion but eventually some forces automatically work for example , the growing
abundance of capital stock which reduces marginal efficiency of capital and
pessimism takes over businessmen.
The concept that fluctuations in investment bring about fluctuations in economic
activity is the key contribution of Keynes.
Criticisms of Keynes Theory of Trade Cycle
Keynes theory stressed upon fluctuations in investment demand, expectations of
profit of businessmen and the multiplier effect. But in reality trade cycle doesn’t stop
after reaching new state of equilibrium due to working of multiplier but it becomes
self feeding due to working of accelerator effect. According to principle of
acceleration, the changes in national income induces further changes in the rate of
investment. In above example , when the income has risen by 400 crores, people’s
spending power has risen by an equivalent amount.This will induce them to spend
more on goods and services. When the demand for goods

rises, it will be met through overworking existing plant and machinery. All this leads
to increase in profits with the result that businessmen will be induced to expand their
productive capacity and will install new plants. i.e. they will invest more than before.
Thus, rise in income leads to further induced rise in investment. The accelerator
describes this relation between increase in income and the resulting increase in
investment. According to Samuelson, the combined effect of multiplier and
accelerator principle could lead to cyclical fluctuations in the economic activity.
Schumpeter’s Innovation Theory

Joseph Schumpeter believed trade cycles to be as a result of innovation brought about
by the entrepreneurs in a competitive economy. According to him, the trade cycles
are inherentpart of process of economic growth of a capitalist society. The first stage
deals with impact of innovation which entrepreneurs in their production process.
The second stage follows asa result of the reactions of competitors to the initial
impact of the innovation. The initial stage of equilibrium is assumed as a starting
point in the economic system when all factors are fully employed. Every producer is
producing with average cost equal to price. Product prices are equal to average and
marginal costs. Profits according to Schumpeter are zero. There is no net saving and
no net investmentt. Schumpeter calls this equilibrium state , the circular flow of
economic activity which resembles like a blood flow in a body of living organism.
The circular flow of economic activity gets disturbed when an entrepreneur
successfully carries out an innovation. According to Schumpeter, the primary
function of an entrepreneur is innovation activity which yields him real profit.
An innovation may consist of:
1) The introduction of a new product;
2) Adoption of a new method of production;
3) Theopening up of new market;
4) The conquest of new source of raw materials or semi manufactured goods;
5) Re organization of production processes within a firm.
Innovations are the commercial applications of inventions by entrepreneurs. Not
only a capitalist can be an entrepreneur but rather he is an organizer who has superior
technical knowledge with which he can attract required finances through bank credit.
Introduction of innovation starts a trade cycle. As innovator entrepreneur starts

attracting resources away from other industries, money incomes increase and prices
begin to rise thereby stimulating further investment. As the innovator steps up
production the circular flow in the economy swells up and till supply exceeds
demand. The initial equilibrium is disturbed. This wave of expansionof economic
activity is known as primary wave. The secondary wave is a result of reaction of
competitors to the original innovation. The original innovation induces other
innovators following in swarm like clusters into related product lines in hopes of they
turning out to be as profitable as the original innovation. There is cumulative
expansion of economic activity. Since the purchasing power of consumers increase,
the demands for the products of non innovating industries also go up and their prices
rise are pushed up. This secondary wave of credit expansion gets superimposed on
the primary wave of expansion. Over optimism and enthusiasm lead to boom like
conditions. but as new products replace the old products, the demand for old products
goes down so their producer firms contract their output. Some of them may be forced
into liquidation. When innovators start repaying their bank loans out of their newly
earned profits , the quantity of money is reduced as a result of which profits

tend to fall and prices get reduced. In this atmosphere of uncertainty, risks increase
and the innovation spirit is sapped up as the economy moves downward into
depression. Economy does not stay in depressive phase for long as entrepreneurs
keep trying to innovate profitably further. According to Schumpeter, the deflationary
forces are offset by certain other forces in the economy which is called as “dilution
or diffusion effect”. This occurs due to bankruptcies, liquidation and shutdowns of
uncompetitive firms which enables remaining firms to expand their operations and
enter into the markets freed up by the closed firms.The decline in aggregate demand
will be less than that in income which will result in depletion of inventories and
hence, there will arise the need to replenish them. As fresh innovations take place
more and more entrepreneurs will start following, as investments willsurge a new
boom will come along22.
Hawtrey’s Pure Monetary Theory of Trade Cycle
According to Hawtrey , trade cycle is purely monetary phenomenon as general
demand is itself a monetary phenomenon. He believed that in every economic
depression monetary factors played a critical role. He made his classical quantity
theory of money as the basis of his theory of trade cycle. He believed that changes in
flow money are the main causes of changes in economic activity. The flow of money
equals consumer outlays which equals MV ,V is the income velocity of total money
in circulation,M. If the quantity of money is expanded , demand exceeds anticipated
supply. Stocks of goods in the market will be insufficient, additional orders will have
to be placed. This causes rise in output, factor incomes, costs and hence, prices. In
the opposite situation,a reduction in quantity of money causes reduction in demand
for goods which leads to fall in income, output, employment and price. Three key
monetary factors according to Hawtrey are:
1) The strategic role of merchants in determining the role of economic activity in
responseto changes in the discount rate.
2) Changes in the flow of total monetary demand.
3) The role of recall of bank reserves.
All three factors in combination can cause upswing or a downturn in economic

activity. When banks accumulate excess reserves with themselves , they
liberalize the terms ofcredit by:
1) being less strict in insisting on the security offered;

2) They may extendmaximum time period of lending;
3) by not discriminating between the purposes forwhich they lend;
4) by reducing the rate of discount of bills. This induces merchants toborrow
more than before. The merchants make profit upon the fractional mark up on
the large stock of rapidly moving goods. Therefore, even a small reduction in
discountrate and consequent changes in interest rates leads to substantial
increase in theirprofits. Easy bank credit leads to cumulative expansion. A
reduction in rate of discount of bills by the commercial banks will induce
wholesalers to keep bigger stocks. They giveheavier orders to the manufacturers
who in turn pay more to factors of production interms of wages, rents, interest
and profits. This increases income and hence, consumer’soutlay on goods and
services. Increased expenditure on goods and services reduces the stock of
merchants to sub normal level. They in turn try to secure more credit order
more stocks and push up the production of goods and services. Hence, Hawtrey
observed that increased activity means increased demand and increased demand
means

increased activity. A vicious circle is set up , a cumulative expansion of
productive activity. Process of expansion feeds upon itself. When prices rise
under pressure of demand and rising costs, dealers have further inducement to
borrow in order to meet higher investments for holding same stock. Further,
instability of velocity of circulation of money raises investment demands. This
also feeds the boom like condition.
During later stages of boom, when banks have reduced their reserves to
dangerously low level. Further extension of credit is stopped and outstanding
loans are recovered on time. This not only halts the expansion but reverses the
growth process. As the process of contraction starts the downward tendency of
prices maintains the downward trend even though the rates of interest are no
longer high. The process of contraction becomes cumulative due to restrictions
on credit. The firms in order to repay their earlier loans are forced to sell part of
their stocks. When all firms try to do so prices fall even further, since firms suffer
losses, they curtail production and lay off workers. Fallingfactor incomes reduce
consumer outlays which depress sales and causes stock to accumulate. The
downturn in prices throws economy in deep depression. As depression sets in
loans are liquidated.23 Money flows to replenish bank reserves. Soon bank
reserves rise above normal level, rate of interest may go very low. Yet falling
prices among firms detracts them from borrowing. Hawtrey called this condition
a ‘credit deadlock’. In such a situation, a central bank might want to purchase
securities from the commercial banks so as to pump more money into the system.
It strengthens the liquidity position of the banks. Therefore, bank now may try to
give liberal loans to intending borrowers. But this does not start the process of
recovery, as the new credit may be utilized by the firms to repay old debt. Thus,
liberal credit policy during depression may lead to change in composition of
assets of the banks. It often fails to encourage investments.
Hawtrey theory is based on assumptions:
1) That changes in the rate of interest are a powerful force in directing economic
system;
2) The interest rate changes mainly influences volume of inventories and not
fixed capital.

The main conclusion of Hawtrey pure monetary theory of trade cycle is that the
monetary policy during depression should try to stabilize the prices of factors of
production and not the prices of the commodities. The stability of factor income
will ensure stable consumer outlays which would stabilize the economy.

CASE STUDY 1
China is in the news every day. It is increasingly seen as one of the major economic powers
in the world. Is the attention justified? A first look at the numbers in Figure 1 suggests it
may not be. True, the population of China is enormous, more than four times that of the
United States. But its output, expressed in dollars by multiplying the number in yuans
(the Chinese currency) by the dollar–yuan exchange rate, is still only 10.4 trillion dollars,
about 60% of the United States. Output per person is about $7,600, only roughly 15%
of output per person in the United States.
So why is so much attention paid to China? There are two main reasons: To under-stand
the first, we need to go back to the number for output per person. When comparingoutput
per person in a rich country like the United States and a relatively poor country like China,
one must be careful. The reason is that many goods are cheaper in poor countries. For
example, the price of an average restaurant meal in New York City is about 20 dollars; the
price of an average restaurant meal in Beijing is about 25 yuans, or, at the current exchange
rate, about 4 dollars. Put another way, the same income (ex-pressed in dollars) buys you
much more in Beijing than in New York City. If we want to compare standards of living, we
have to correct for these differences; measures which doso are called PPP (for purchasing
power parity) measures. Using such a measure, outputper person in China is estimated to
be about $12,100, roughly one-fourth of the output per person in the United States. This
gives a more accurate picture of the standard of living in China. It is obviously still much
lower than that of the United States or other rich countries. But it is higher than suggested
by the numbers in Figure 1.
Second, and more importantly, China has been growing very rapidly for more thanthree
decades. This is shown in Table 1,which, like the previous tables for the UnitedStates and
the Euro area, gives output growth, unemployment, and inflation for the periods 1990–
2007, 2008–2009, 2010–2014, and the forecast for 2015.
The first line of the table tells the basic story. Since 1990 (indeed, since 1980, if wewere to
extend the table back by another 10 years), China has grown at close to 10% a year. This
represents a doubling of output every 7 years. Compare this number to the numbers for the
United States and for Europe we saw previously, and you understand why the weight of
the emerging economies in the world economy, China being the mainone, is increasing so
rapidly.

There are two other interesting aspects to Table 1. The first is how difficult it is tosee the
effects of the crisis in the data. Growth barely decreased during 2008 and 2009, and
unemployment barely increased. The reason is not that China is closed to the rest ofthe
world. Chinese exports slowed during the crisis. But the adverse effect on demand was nearly
fully offset by a major fiscal expansion by the Chinese government, with, in particular, a

major increase in public investment. The result was sustained growth of demandand, in
turn, of output.
Figure 1

The second is the decline in growth rates from 10% before the crisis to less than 9%after
the crisis, and to the forecast 6.8% for 2015. This raises questions both about howChina
maintained such a high growth rate for so long, and whether it is now entering aperiod
of lower growth.
A preliminary question is whether the numbers are for real. Could it be that Chinese
growth was and is still overstated? After all, China is still officially a communist
country, and government officials may have incentives to overstate the economic
performance of their sector or their province. Economists who have looked at this
carefully conclude that this is probably not the case. The statistics are not as reliable as
they are in richer countries, but there is no major bias.
Output growth is indeed very high in China. So where has growth come from? It has
come from two sources:
The first was high accumulation of capital. The investment rate (the ratio of
investment to output) in China is 48%, a very high number. For comparison, the
investment ratein the United States is only 19%. More capital means higher productivity
and higher output. The second is rapid technological progress. One of the strategies

followed by the Chinese government has been to encourage foreign firms to relocate
and producein China. As foreign firms are typically much more productive than
Chinese firms, this has increased productivity and output. Another aspect of the strategy
has been to encourage joint ventures between foreign and Chinese firms. By making Chinese
firms work with and learn from foreign firms, the productivity of the Chinese firms has
increased dramatically.
When described in this way, achieving high productivity and high output growth appears
easy and a recipe that every poor country could and should follow. In fact, things are less
obvious. China is one of a number of countries that made the transition from central planning
to a market economy. Most of the other countries, from Central Europe to Russia and the
other former Soviet republics, experienced a large decrease in output at the time of
transition. Most still have growth rates far below that of China. In many countries,
widespread corruption and poor property rights make firms unwilling to invest.
So why has China fared so much better?
Some economists believe that this is the result of a slower transition: The first Chinese
reforms took place in agriculture as early as 1980, and even today, many firms remain owned
by the state. Others argue that the fact that the communist party has remained in control
has actually helped the economic transition; tight political control has allowed for a better
protection of property rights, at least for new firms, giving them incentives to invest.
Getting the answers to these questions, and thus learning what other poor countries can take
from the Chinese experience, can clearly make a huge difference, not only for China but for
the rest of the world.
At the same time, the recent growth slowdown raises a new set of questions: Where does
the slowdown come from? Should the Chinese government try to maintain high growth or
accept the lower growth rate? Most economists and, indeed, the Chinese authorities
themselves, believe that lower growth is now desirable, that the Chinese people will be
better served if the investment rate decreases, allowing more of output to go to consumption.
Achieving the transition from investment to consumption is the major challenge facing the
Chinese authorities today.

CASE STUDY 2
Real GDP, Technological Progress, and the Price of Computers
A tough problem in computing real GDP is how to deal withchanges in quality of existing goods.
One of the most difficult cases is computers. It would clearly be absurd to assume thata personal
computer in 2015 is the same good as a personal computer produced, say 20 years ago: The

2015 version canclearly do much more than the 1995 version. But how much more? How do
we measure it? How do we take into account the improvements in internal speed, the size of
the random access memory (RAM) or of the hard disk, faster access to the Internet, and so on?
The approach used by economists to adjust for these improvements is to look at the market for
computers and howit values computers with different characteristics in a given year. Example:
Suppose the evidence from prices of different models on the market shows that people are
willing to pay 10% more for a computer with a speed of 4 GHz (4,000 megahertz) rather than
3 GHz. The first edition of this book, published in 1996, compared two computers, with speeds
of50 and 16 megahertz, respectively. This change is a good indication of technological progress.
(A further indication of thecomplexity of technological progress is that, for the past fewyears,
progress has not been made not so much by increasingthe speed of processors, but rather by using
multicore processors. We shall leave this aspect aside here, but people in charge of national
income accounts cannot; they have to take this change into account as well.) Suppose new
computers this year have a speed of 4 GHz compared to a speed of 3 GHz for new computers last
year. And suppose the dollar price of new computers this year is the same as the dollar price of new
computers last year. Then economists in charge of computing the adjusted price of computers will
conclude that new computers are in fact 10% cheaper than last year.
This approach, which treats goods as providing a collection of characteristics—for computers,
speed, memory, and so on—each with an implicit price, is called hedonic pricing (“hedone” means
“pleasure” in Greek). It is used by the Department of Commerce—which constructs real GDP—to
estimate changes in the price of complex and fast changing goods, such as automobiles and
computers. Using this approach, the Department of Commerce estimates for example, that, for a
given price, the quality of new laptops has increased on average by 18% a year since 1995. Put
another way, a typical laptop in 2015 delivers 1.18^21 = 32 times the computing services a typical
laptop delivered in 1995. (Interestingly, in light of the discussion of slowing U.S. productivity
growth, the rate of improvement of quality has decreased substantially in the recent past, down closer
to 10%.)
Not only do laptops deliver more services, they have become cheaper as well: Their dollar price has
declined by about 7% a year since 1995. Putting this together with the information in the previous
paragraph, this implies that their quality–adjusted price has fallen at an average rate of 18% + 7% =
25% per year. Put another way, a dollar spent on a laptop today buys 1.2521 = 108 times more
computing services than a dollar spent on a laptop in 1995.

CASE STUDY 3
The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the Consumption
Function
Why would consumers decrease consumption if their disposable income has not changed? Or,
in terms of equation below, why might c0 decrease—leading in turn to a decrease in demand,
output, and so on?Here is such a case. It is reasonable to assume that the relation between
consumption and disposable income is given by the simpler relation:
C = c0 + c1YD
In other words, it is reasonable to assume that the function is a linear relation. The relation
between consumption and disposable income is then characterized by two parameters, c0 and
c1:
■ The parameter c1 is called the propensity to consume. (It is also called the
Marginal propensity to consume. I will drop the word Marginal for simplicity.) It
gives the effect an additional dollar of disposable income has on consumption. If c1
is equal to 0.6, then an additional dollar of disposable income increases
consumption by
$1 * 0.6 = 60 cents.
A natural restriction on c1 is that it be positive: An increase in disposable income
is likely to lead to an increase in consumption. Another natural restriction is that c1 be less than
1: People are likely to consume only part of any increase in disposable income and save the
rest.
■ The parameter c0 has a literal interpretation. It is what people would consume if their
disposable income in the current year were equal to zero: If YD equals zero in equation, C =
c0. If we use this interpretation, a natural restriction is that, if current income were equal to
zero, consumption would still be positive: With or without income, people still need to eat!

This implies that c0 is positive. How can people have positive consumption if their income is
equal to zero? Answer: They dis-save. They consume either by selling some of their assets or
by borrowing.
■ The parameter c0 has a less literal and more frequently used interpretation. Changes in
c0 reflect changes in consumption for a given level of disposable income. Increases in c0 reflect
an increase in consumption given income, decreases in c0 a decrease. There are many reasons
why people may decide to consume more or less, given their disposable income. They may, for
example, find it easier or more difficult to borrow, or may become more or less optimistic about
the future.
One of the first reasons that come to mind is that, even iftheir current income has not changed,
they start worrying about the future and decide to save more. This is precisely what happened
at the start of the crisis, in late 2008 and early 2009. The basic facts are shown in Figure 1
below. The figure plots, from the first quarter of 2008 to the third quarter of 2009, the behavior
of three variables, disposable income, total consumption, and consumption of durables— the
part of consumption that falls on goods such as cars, computers, and so on. To make things
visually simple, all three variables are normalized to equal 1 in the first quarter of 2008.

Note two things about the figure. First, despite the fact that the crisis led to a large fall in GDP,
during that period, disposable income did not initially move much. It even increased in the
first quarter of 2008. But consumption was unchanged from the first to the second quarter of
2008 and then fell before disposable income fell. It fell by 3 percentagepoints in 2009 relative
to 2008, more than the decrease in disposable income. In terms of the Figure 1, the distance
between the line for disposable income and the line for consumption increased. Second, during
the third and especially the fourth quarters of 2008, the consumption of durables dropped
sharply. By the fourth quarter of 2008, it was down 10% relative to the first quarter, before
recovering in early 2009 and decreasing again later.
Why did consumption, and especially, consumption of durables, decrease at the end of 2008
despite relatively small changes in disposable income? A number of factors were at play, but
the main one was the psychological fallout of the financial crisis. On September 15, 2008,
Lehman Brothers, a very large bank, went bankrupt, and that, in the ensuing weeks, it appeared

that many more banks might follow suit and the financial system might collapse. For most
people, the main sign of trouble was what they read in newspapers: Even though they still had
their job and received their monthly income checks, the events reminded them of the stories of
the Great Depression and the pain that came with it. One way to see this is to look at the Google
Trends series that gives the number of searches for “Great Depression,” from January 2008 to
September 2009, and is plotted in Figure 2. The series is normalized so its average value is 1
over the two years. Note how sharply the series peaked in October 2008 and then slowly
decreased over the course of 2009, as it became clear that, while the crisis was a serious one,
policy makers were going to do whatever they could do to avoid a repeat of the Great
Depression.
If you felt that the economy might go into another Great Depression, what would you do?
Worried that you might become unemployed or that your income might decline in the future,
you would probably cut consumption, even if your disposable income had not yet changed.
And, given the uncertainty about what was going on, you might also delay the purchases you
could afford to delay; for example, the purchase of a new car or a new TV. As Figure 1 in this
box shows, this is exactly what consumers did in late 2008: Total consumption decreased, and
consumption of durables collapsed. In 2009, as the smoke slowly cleared and the worse
scenarios became increasingly unlikely, consumption of durables picked up. But by then, many
other factors were contributing to the crisis.

CASE STUDY 4
The U.S. Recession of 2001
In 1992, the U.S. economy embarked on a long expansion. For the rest of the decade, GDP
growth was positive and high. In 2000, however, the expansion came to an end. From the third
quarter of 2000 to the fourth quarter of 2001, GDP growth was either positive and close to zero
or negative. Based on data available at the time, it was thought that growth was negative
through the first three quarters of 2001. Based on revised data, shown in Figure 1, which gives
the growth rate for each quarter from 1999–1 to 2002–4, measured at annual rate, it appears
that growth was actually small but positive in the second quarter. (These data revisions happen
often, so that what we see when we look back is not always what national income statisticians
and policy makers perceived at the time.) The National Bureau of Economic Research (NBER),
an academic organization that has traditionally dated U.S. recessions and expansions,
concluded that the U.S. economy had indeed had a recession in 2001, starting in March 2001
and ending in December 2001; this period is represented by the shaded area in the figure.

What triggered the recession was a sharp decline in investment demand. Nonresidential
investment—the demand for plant and equipment by firms—decreased by 4.5% in 2001. The
cause was the end of what Alan Greenspan, the chairman of the Fed at the time, had dubbed a
period of “irrational exuberance”: During the second part of the 1990s, firms had been
extremely optimistic about the future, and the rate of investment had been very high—the
average yearly growth rate of investment from 1995 to 2000 exceeded 10%. In 2001, however,
it became clear to firms that they had been overly optimistic and had invested too much. This
led them to cut back on investment, leading to a decrease in demand and, through the multiplier,
a decrease in GDP The recession could have been much worse. But it was met by a strong

macroeconomic policy response, which certainly limited the depth and the length of the
recession.
Take monetary policy first. Starting in early 2001, the Fed, feeling that the economy was
slowing down, started decreasing the federal funds rate aggressively. (Figure 2 shows the
behavior of the federal funds rate, from 1991–1 to 2002–4.) It continued to do so throughout
the year. The funds rate, which stood at 6.5% in January, stood at less than 2% at the end of
the year.
Turn to fiscal policy. During the 2000 presidential campaign, then candidate George Bush had
run on a platform of lower taxes. The argument was that the federal budget was in surplus, and
so there was room to reduce tax rates while keeping the budget in balance. When President
Bush took office in 2001 and it became clear that the economy was slowing down, he had an
additional rationale to cut tax rates, namely the use of lower taxes to increase demand and fight
the recession. Both the 2001 and the 2002 budgets included substantial reductions in tax rates.
On the spending side, the events of September 11, 2001 also led to an increase in spending,
mostly on defense and homeland security.

Figure 3 shows the evolution of federal government revenues and spending during 1999–1 to
2002–4, both expressed as ratios to GDP. Note the dramatic decrease in revenues starting in
the third quarter of 2001. Even without decreases in tax rates, revenues would have gone down
during the recession: Lower output and lower income mechanically imply lower tax revenues.
But, because of the tax cuts, the decrease in revenues in 2001 and 2002 was much larger than
can be explained by the recession. Note also the smaller but steady increase in spending starting
around the same time. As a result, the budget surplus—the difference between revenues and
spending—went from positive up until 2000, to negative in 2001 and, much more so, in 2002.

Let us end by taking up four questions you might be asking yourself at this point:
■ Why weren’t monetary and fiscal policy used to avoid rather than just to limit the size
of the recession? The reason is that changes in policy affect demand and output only over time.
Thus, by the time it became clear that the U.S. economy was entering a recession, it was already
too late to use policy to avoid it. What the policy did was to reduce both the depth and the
length of the recession.
■ Weren’t the events of September 11, 2001, also a cause of the recession? The answer,
in short, is no, tragic as the event was. As we have seen, the recession started long before
September 11, and ended soon after. Indeed, GDP growth was positive in the last quarter of
2001. One might have expected—and, indeed, most economists expected—the events of
September 11 to have large adverse effects on output, leading, in particular, consumers and
firms to delay spending decisions until the outlook was clearer. In fact, the drop in spending
was short and limited. Decreases in the federal funds rate after September 11—and large
discounts by automobile producers in the last quarter of 2001—are believed to have been
crucial in maintaining consumer confidence and consumer spending during that period.
■ Was the monetary–fiscal mix used to fight the recession a textbook example of how
policy should be conducted? On this, economists differ. Most economists give high marks to
the Fed for strongly decreasing interest rates as soon as the economy slowed down. But most
economists are worried that the tax cuts introduced in 2001 and 2002 led to large and persistent
budget deficits long after the recession was over. They argue that the tax cuts should have been
temporary, helping the U.S. economy get out of the recession but stopping thereafter.
■ Why were monetary and fiscal policy unable to avoid
the recession of 2009? The answer, in short, is twofold. The shocks were much larger, and
much harder to react to. And the room for policy responses was more limited.

CASE STUDY 5
Deficit Reduction: Good or Bad for Investment?
You may have heard this argument in some form before: “Private saving goes either toward
financing the budget deficit or financing investment. It does not take a genius to conclude that
reducing the budget deficit leaves more saving available for investment, so investment
increases.”
This argument sounds convincing. But, as we have seen in the text, it must be wrong. If, for
example, deficit reduction is not accompanied by a decrease in the interest rate, then we know
that output decreases and by implication, so does investment—as it depends on output. So what
is going on in this case?
We can also think of the goods-market equilibrium condition as
Investment = Private saving + Public saving
I = S + T-G
In equilibrium, investment is indeed equal to private saving plus public saving. If public saving
is positive, the government is said to be running a budget surplus; if public saving is negative,
the government is said to be running a budget deficit. So it is true that given private saving, if
the government reduces its deficit—either by increasing taxes or reducing government
spending so that T-G goes up—investment must go up: Given S, T-G going up implies that I
goes up. The crucial part of this statement, however, is “given private saving.” The point is that
a fiscal contraction affects private saving as well: The contraction leads to lower output and
therefore to lower income. As consumption goes down by less than income, private saving also
goes down. It actually goes down by more than the reduction in the budget deficit, leading to
a decrease in investment. In terms of the equation: S decreases by more than T-G increases,
and so I decreases. (You may want to do the algebra and convince yourself that saving actually
goes down by more than the increase in T-G. Does this mean that deficit reduction always
decreases investment? The answer is clearly no. We saw this in Figure 5-9. If when the deficit
is reduced, the central bank also decreases the interest rate so as to keep output constant, then
investment necessarily goes up. Although output is unchanged, the lower interest rate leads to
higher investment.
The morale of this box is clear: Whether deficit reduction leads to an increase in investment is
far from automatic. It may or it may not, depending on the response of monetary policy

CASE STUDY 6
BANK RUNS
Take a healthy bank, that is, a bank with a portfolio of good loans. Suppose rumors start that
the bank is not doing well and some loans will not be repaid. Believing that the bank may fail,
people with deposits at the bank will want to close their accounts and withdraw cash. If enough
people do so, the bank will run out of funds. Given that the loans cannot easily be called back,
the bank will not be able to satisfy the demand for cash, and it will have to close.
Conclusion: Fear that a bank will close can actually cause it to close—even if all its loans were
good in the first place. The financial history of the United States up to the 1930s is full of such
bank runs. One bank fails for the right reason (because it has made bad loans). This causes
depositors at other banks to panic and withdraw money from their banks, forcing them to
close. You have probably seen It’s a Wonderful Life, a classic movie with James Stewart that
runs on TV every year around Christmas. After another bank in Stewart’s town fails, depositors
at the savings and loan he manages get scared and want to withdraw their money, too. Stewart
successfully persuades them this is not a good idea. It’s a Wonderful Life has a happy ending.
But in real life, most bank runs didn’t end well. (For another famous movie bank run, and how
it can start, watch Mary Poppins.)
What can be done to avoid bank runs?
One potential solution is called narrow banking. Narrow banking would restrict banks to
holding liquid and safe government bonds, like T-bills. Loans would have to be made by
financial intermediaries other than banks. This would likely eliminate bank runs. Some recent
changes in U.S. regulation have gone in that direction, restricting banks that rely on deposits
from engaging in some financial operations, but they stop far short of imposing narrow bank-
ing. One worry with narrow banking is that, although it might indeed eliminate runs on banks,
the problem might migrate to shadow banking and create runs there.
In practice, the problem has been tackled in two ways. First, by trying to limit bank runs in the
first place; second, if bank runs happen nevertheless, by having the central bank provide funds
to banks so they do not have to engage in fire sales.
To limit bank runs, governments in most advanced countries have put in place a system of
deposit insurance. The United States, for example, introduced federal deposit insurance in
1934. The U.S. government now insures each checkable deposit account up to a ceiling, which,
since 2008, is $250,000. As a result, there is no reason for depositors to run and withdraw their

money.
Deposit insurance leads, however, to problems of its own. Depositors, who do not have to
worry about their deposits, no longer look at the activities of the banks in which they have their
accounts. Banks may then misbehave, by making loans they wouldn’t have made in the absence

of deposit insurance. They may take too much risk, take too much leverage.
And as the crisis unfortunately showed, deposit insurance is no longer enough. First, banks rely
on other sources of funds than deposits, often borrowing overnight from other financial
institutions and investors. These other funds are not insured, and during the crisis, there was in
effect a run on many banks, and this time, not from the traditional depositors but from
wholesale funders. Second, financial institutions other than banks can be subject to the same
problem, with investors wanting their funds back quickly and with assets difficult to dispose
of or sell quickly.
So, to the extent that runs cannot be fully prevented, central banks have put in place programs
to provide funds to banks in case they face a run. In such circumstances, the central bank will
accept to lend to a bank against the value of the assets of the bank. This way, the bank does not
have to sell the assets and fire sales can be avoided. Access to such provision was traditionally
reserved for banks. But again, the recent crisis has shown that other financial institutions may
be subject to runs and may also need access.
Just like deposit insurance, such liquidity provision (as it is called) by the central bank is not a
perfect solution. In practice, central banks may face a difficult choice. Assessing which
financial institutions beyond banks can have access to such liquidity provision is delicate.
Assessing the value of the assets, and thus deciding how much can be lent to a financial
institution, can also be difficult. The central bank would not want to provide funds to an
institution that is actually insolvent; but, in the middle of a financial crisis, the difference be-
tween insolvency and illiquidity may be difficult to establish.

CASE STUDY 7
From a Housing Problem to a Financial Crisis
When housing prices started declining in the United States in 2006, most economists forecast
that this would lead to a decrease in demand and a slowdown in growth. Few economists
anticipated that it would lead to a major macroeconomic crisis. What most had not anticipated
was the effect of the decline of housing prices on the financial system, and in turn, the effect
on the economy.
Housing Prices and Subprime Mortgages
Figure 1 shows the evolution of an index of U.S. housing prices since 2000. The index is known
as the Case-Shiller index, named for the two economists who constructed it. The index is
normalized to equal 100 in January 2000. You can see the large increase in prices in the early
2000s, followed by a large decrease later. From a value of 100 in2000, the index increased
to 226 in mid-2006. It then started to decline. By the end of 2008, at the start of the
financial crisis, the index was down to 162. It reached a low of 146 in early 2012 and
started recovering thereafter. At the time of this writing, it stands at 195, still below its
2006 peak.
Was the sharp price increase from 2000 to 2006 justified? In retrospect, and given the
ensuing collapse, surely not. But at the time, when prices were increasing, economists were
not so sure. Some increase in prices was clearly justified.
■ The 2000s were a period of unusually low interest rates. Mortgage rates were low,
increasing the demand for housing and thus pushing up the price.
■ Other factors were also at work. Mortgage lenders became increasingly willing to
make loans to more risky borrowers. These mortgages, known as subprime mortgages, or
subprimes for short, had existed since the mid-1990s but became more prevalent in the
2000s. By 2006, about 20% of all U.S. mortgages were subprimes. Was it necessarily
bad? Again, at the time, this was seen by most economists as a positive development. It
allowed more poor people to buy homes, and under the assumption that housing prices
would continue to increase, so the value of the mortgage would decrease over time relative
to the price of the house, it looked safe both for lenders and for borrowers. Judging from
the past, the assumption that housing prices would not decrease also seemed reasonable.

As you can see from Figure 1, housing prices had not decreased even during the 2000–
2001 recession.
In retrospect, again, these developments were much less benign than most economists
thought. First, housing prices could go down, as became evident from 2006 on. When this
happened, many borrowers found themselves in a situation in which the mortgage they
owed now exceeded the value of their house (when the value of the mortgage exceeds
the value of the house, the mortgage is said to be underwater). Second, it became clear
that, in many cases, the mortgages were in fact much riskier than either the lender
pretended or the borrower understood. In many cases, borrowers had taken mortgages with
low initial interest rates, known as “teaser rates,” and thus low initial in terest payments,
probably not fully realizing that payments would increase sharply over time. Even if house
prices had not declined, many of these borrowers would have been unable to meet their
mortgage payments. Thus, as house prices turned around and many borrowers defaulted,
lenders found themselves faced with large losses. In mid-2008, losses on mortgages were
estimated to be around $300 billion. This is a large number, but, relative to the size of the
U.S. economy, it is not a large one. Three hundred billion dollars is only about 2% of U.S.
GDP. One might have thought that the U.S. financial system could absorb the shock and
that the adverse effect on output would be limited. This was not to be. Although the trigger
of the crisis was indeed the decline in housing prices, its effects were enormously
amplified. Even those economists who had anticipated the housing price decline did not
realize how strong the amplification mechanisms would be. To understand those, we must
return to the role of financial intermediaries.
The Role of Financial Intermediaries
In the previous section, we saw that high leverage, illiquidity of assets, and liquidity of
liabilities all increased the risk of trouble in the financial system. All three elements were
present in 2008, creating a perfect storm.
Leverage
Banks were highly levered. Why was it so? For a number of reasons: First, banks probably
underestimated the risk they were taking: Times were good, and in good times, banks, just
like people, tend to underestimate the risk of bad times. Second, the compensation and
bonus system gave incentives to managers to go for high expected returns without fully
taking the risk of bankruptcy into account. Third, although financial regulation required
banks to keep their capital ratio above some minimum, banks found new ways of avoiding
the regulation, by creating new financial structures called structured investment vehicles

(SIVs).
On the liability side, SIVs borrowed from investors, typically in the form of short- term
debt. On the asset side, SIVs held various forms of securities. To reassure the investors
that they would get repaid, SIVs typically had a guarantee from the bank that had created
them that, if needed, the bank would provide funds to the SIV. Although the first SIV was
set up by Citigroup in 1988, SIVs rapidly grew in size in the 2000s. You may ask why
banks did not simply do all these things on their own balance sheet rather than create a
separate vehicle. The main reason was to be able to increase leverage. If the banks had
done these operations themselves, the operations would have appeared on their balance
sheet and been subject to regulatory capital requirements, forcing them to hold enough
capital to limit the risk of bankruptcy. Doing these operations through an SIV did not
require banks to put capital down. For that reason, through setting up an SIV, banks could
increase leverage and increase expected profits, and they did.
When housing prices started declining and many mortgages turned out to be bad, the
securities held by SIVs dropped in value. Questions arose about the solvency of the SIVs,
and given the guarantee by banks to provide funds to the SIVs if needed, questions arose
about the solvency of the banks themselves. Then, two other factors, securitization, and
wholesale funding, came into play.
Securitization
An important financial development of the 1990s and the 2000s was the growth of
securitization. Traditionally, the financial intermediaries that made loans or issued
mortgages kept them on their own balance sheet. This had obvious drawbacks. A local
bank, with local loans and mortgages on its books, was much exposed to the local eco-
nomic situation. When, for example, oil prices had come down sharply in the mid-1980s
and Texas was in recession, many local banks went bankrupt. Had they had a more
diversified portfolio of mortgages, say mortgages from many parts of the country, these
banks might have avoided bankruptcy.
This is the idea behind securitization. Securitization is the creation of securities based on
a bundle of assets (e.g., a bundle of loans, or a bundle of mortgages). For instance, a
mortgage-based security (MBS) for short, is a title to the returns from a bundle of
mortgages, with the number of underlying mortgages often in the tens of thousands. The
advantage is that many investors, who would not want to hold individual mortgages, will
be willing to buy and hold these securities. This increase in the supply of funds from

investors is, in turn, likely to decrease the cost of borrowing.
Securitization can go further. For example, instead of issuing identical claims to the returns
on the underlying bundle of assets, one can issue different types of securities. For example,
one can issue senior securities, which have first claims on the returns from the bundle, and
junior securities, which come after and pay only if anything remains after the senior
securities have been paid. Senior securities will appeal to investors who want little risk;
junior securities will appeal to investors who are willing to take more risk. Such securities,
known as collateralized debt obligations (CDOs), were first issued in the late 1980s but,
again, grew in importance in the 1990s and 2000s.
Securitization went even further, with the creation of CDOs using previously created c
CDOs, or CDO2.
Securitization would seem like a good idea, a way of diversifying risk and getting a larger
group of investors involved in lending to households or firms. And, indeed, it is. But it
also came with two large costs, which became clear during the crisis. The first was that if
the bank sold the mortgage it had given as part of a securitization bundle and thus did not
keep it on its balance sheet, it had fewer incentives to make sure that the borrower could
repay. The second was the risk that rating agencies, those firms that assess the risk of
various securities, had largely missed. When underlying mortgages went bad, assessing
the value of the underlying bundles in the MBSs, or, even more so, of the underlying MBSs
in the CDOs, was extremely hard to do. These assets came to be known as toxic assets. It
led investors to assume the worst and be reluctant either to hold them or to continue lending
to those institutions such as SIVs that did hold them. In terms of the discussion in the
previous section, many of the assets held by banks, SIVs, and other financial
intermediaries, were illiquid. They were extremely hard to assess and thus hard to sell,
except at fire sale prices.
Wholesale Funding
Yet another development of the 1990s and 2000s was the development of other sources of
finance than checkable deposits by banks. Increasingly, they relied on borrowing from
other banks or other investors, in the form of short-term debt, to finance the purchase of
their assets, a process known as wholesale funding. SIVs, the financial entities set up by
banks, were entirely funded through such wholesale funding.
Wholesale funding again would seem like a good idea, giving banks more flexibility in the
amount of funds they could use to make loans or buy assets. But it had a cost, and that cost
again became clear during the crisis. Although holders of checkable deposits were

protected by deposit insurance and did not have to worry about the value of their deposits,
this was not the case for the other investors. Thus, when those investors worried about the
value of the assets held by the banks or the SIVs, they asked for their funds back. In terms
of the discussion in the previous section, banks and SIVs had liquid liabilities, much more
liquid than their assets.
The result of this combination of high leverage, illiquid assets, and liquid liabilities was a
major financial crisis. As housing prices declined and some mortgages went bad, high
leverage implied a sharp decline in the capital of banks and SIVs. This in turn forced them
to sell some of their assets. Because these assets were often hard to value, they had to sell
them at fire sale prices. This, in turn, decreased the value of similar assets remaining on
their balance sheet, or on the balance sheet of other financial intermediaries, leading to a
further decline in capital ratios and forcing further sales of assets and further declines in
prices. The complexity of the securities held by banks and SIVs made it difficult to assess
their solvency. Investors became reluctant to continue to lend to them, wholesale funding
came to a stop, which forced further asset sales and price declines. Even the banks became
reluctant to lend to each other. On September 15, 2008, Lehman Brothers, a major bank
with more than $600 billion in assets, declared bankruptcy, leading financial participants
to conclude that many, if not most, other banks and financial institutions were indeed at
risk. By mid-September 2008, the financial system had become paralyzed. Banks basically
stopped lending to each other or to anyone else. Quickly, what had been largely a financial
crisis turned into a macroeconomic crisis.
Macroeconomic Implications
The immediate effects of the financial crisis on the macroeconomy were twofold. First, a
large increase in the interest rates at which people and firms could borrow, if they could
borrow at all; second, a dramatic decrease in confidence.
We saw the effect on various interest rates. In late 2008, interest rates on highly rated
(AAA) bonds increased to more than 8%, interest rates on lower rated (BBB) bonds
increased to 10%. Suddenly, borrowing became extremely expensive for most firms. And
for the many firms too small to issue bonds and thus depending on bank credit, it became
nearly impossible to borrow at all.
The events of September 2008 also triggered wide anxiety among consumers and firms.
Thoughts of another Great Depression and, more generally, confusion and fear about what
was happening in the financial system, led to a large drop in confidence. The evolution of

consumer confidence and business confidence indexes for the United States are shown in
Figure 2. Both indexes are normalized to equal 100 in January 2007. Note how consumer
confidence, which had started declining in mid-2007, took a sharp turn in the fall of 2008
and reached a low of 22 in early 2009, a level far below previous historical lows. The result
of lower confidence and lower housing and stock prices was a sharp decrease in
consumption Policy Responses
The high cost of borrowing, lower stock prices, and lower confidence all combined to
decrease the demand for goods. In terms of the IS-LM model, there was a sharp adverse
shift of the IS curve, In the face of this large decrease in demand, policy makers did not
remain passive.
Financial Policies
The most urgent measures were aimed at strengthening the financial system:
■ To prevent a run by depositors, federal deposit insurance was increased from
$100,000 to $250,000 per account. Recall, however, that much of banks’ funding came
not from deposits but from the issuance of short-term debt to investors. To allow the banks
to continue to fund themselves through wholesale funding, the federal government
offered a program guaranteeing new debt issues by banks.
■ The Federal Reserve provided widespread liquidity to the financial system. We
have seen that, if investors wanted to take their funds back, the banks had to sell some of
their assets, often at fire sale prices. In many cases, this would have meant bankruptcy.
To avoid this, the Fed put in place a number of liquidity facilities to make it easier to
borrow from the Fed. It allowed not only banks, but also other financial intermediaries, to
borrow from the Fed. Finally, it increased the set of assets that financial institutions could
use as collateral when borrowing from the Fed (collateral refers to the asset a borrower
pledges when borrowing from a lender. If the borrower defaults, the asset then goes to the
lender). Together, these facilities allowed banks and financial intermediaries to pay back
investors without having to sell their assets. It also decreased the incentives of investors to
ask for their funds because these facilities decreased the risk that banks and financial
intermediaries would go bankrupt.
■ The government introduced a program, called the Troubled Asset Relief Program
(TARP), aimed at cleaning up banks. The initial goal of the $700 billion program,
introduced in October 2008, was to remove the complex assets from the balance sheet of
banks, thus decreasing uncertainty, reassuring investors, and making it easier to assess the
health of each bank. The Treasury, however, faced the same problems as private investors.

If these complex assets were going to be exchanged for, say, Treasury bills, at what price
should the exchange be done? Within a few weeks, it became clear that the task of
assessing the value of each of these assets was extremely hard and would take a long time,
and the initial goal was abandoned. The new goal became to increase the capital of banks.
This was done by the government acquiring shares and thus providing funds to most of the
largest U.S. banks. By increasing their capital ratio, and thus decreasing their leverage,
the goal of the program was to allow the banks to avoid bankruptcy and, over time, return
to normal. As of the end of September 2009, total spending under the TARP was $360
billion, of which $200 billion was spent through the purchase of shares in banks.
Fiscal and monetary policies were used aggressively as well.
Monetary Policy
Starting in the summer of 2007, the Fed began to worry about a slowdown in growth and
had started decreasing the policy rate, slowly at first, faster later as evidence of the crisis
mounted. The evolution of the federal funds rate from 2000. By December 2008, the rate
was down to zero. By then, however, monetary policy was constrained by the zero lower
bound. The policy rate could not be decreased further. The Fed then turned to what has
become known as unconventional monetary policy, buying other assets so as to directly
affect the rate faced by borrowers. Suffice it to say that, although these measures were
useful, the efficacy of monetary policy was nevertheless severely constrained by the zero
lower bound.

Fiscal Policy
When the size of the adverse shock became clear, the U.S. government turned
to fiscal policy. When the Obama administration assumed office in 2009, its
first priority was to design a fiscal program that would increase demand and
reduce the size of the recession. Such a fiscal program, called the American
Recovery and Reinvestment Act, was passed in February 2009. It called for
$780 billion in new measures, inthe form of both tax reductions and
spending increases, over 2009 and 2010. The
U.S. budget deficit increased from 1.7% of GDP in 2007 to a high of 9.0% in
2010. The increase was largely the mechanical effect of the crisis because the
decrease in output led automatically to a decrease in tax revenues and to an

increase in transfer programs such as unemployment benefits. But it was also
the result of the specific measures in the fiscal program aimed at increasing
either private or public spending. Some economists argued that the increase in
spending and the cuts in taxes should be even larger, given the seriousness of
the situation. Others however worried that deficits were becoming too large,
that it might lead to an explosion of public debt, and that they had to be
reduced. From 2011, the deficit was indeed reduced, and it is much smaller
today.
We can summarize our discussion by going back to the IS-LM model we developedin the
previous section. This is done in Figure 3. The financial crisis led to a large shift of the IS
curve to the left, from IS to IS9. In the absence of changes in policy, the equilibrium
would have moved from point A to point B. Financial and fiscal policies offset some of
the shift, so that, instead of shifting to IS9, the economy shifted to IS0. And monetary
policy led to a shift of the LM down, from LM to LM9, so the resultingequilibrium was at
point A9. At that point, the zero lower bound on the nominal policyrate implied that the
real policy rate could not be decreased further. The result wasa decrease in output from
Y to Y9. The initial shock was so large that the combina

Fiscal Policy
When the size of the adverse shock became clear, the U.S. government turned to fiscal policy.
When the Obama administration assumed office in 2009, its first priority was to design a fiscal
program that would increase demand and reduce the size of the recession. Such a fiscal
program, called the American Recovery and Reinvestment Act, was passed in February 2009.
It called for $780 billion in new measures, in the form of both tax reductions and spending
increases, over 2009 and 2010. The
U.S. budget deficit increased from 1.7% of GDP in 2007 to a high of 9.0% in 2010. The increase
was largely the mechanical effect of the crisis because the decrease in output led automatically
to a decrease in tax revenues and to an increase in transfer programs such as unemployment

benefits. But it was also the result of the specific measures in the fiscal program aimed at
increasing either private or public spending. Some economists argued that the increase in
spending and the cuts in taxes should be even larger, given the seriousness of the situation.
Others however worried that deficits were becoming too large, that it might lead to an explosion
of public debt, and that they had to be reduced. From 2011, the deficit was indeed reduced,
and it is much smaller today.
We can summarize our discussion by going back to the IS-LM model we developed in the
previous section. This is done in Figure 3. The financial crisis led to a large shift of the IS curve
to the left, from IS to IS”. In the absence of changes in policy, the equilibrium would have
moved from point A to point B. Financial and fiscal policies offset some of the shift, so that,
instead of shifting to IS”, the economy shifted to IS0. And monetary policy led to a shift of the
LM down, from LM to LM’, so the resulting equilibrium was at point A9. At that point, the
zero lower bound on the nominal policy rate implied that the real policy rate could not be
decreased further. The result was a decrease in output from Y to Y’. The initial shock was so
large that the combination of financial, fiscal, and monetary measures was just not enough
to avoid a large decrease in output, with U.S. GDP falling by 3.5% in 2009 and recovering
only slowly thereafter.

CASE STUDY 8
Henry Ford and Efficiency Wages
In 1914, Henry Ford the builder of the most popular car in the world at the time, the Model-
T—made a stunning announcement. His company would pay all qualified employees a
minimum of $5.00 a day for an eight-hour day. This was a large salary increase for most
employees, who had been earning an average $2.30 for a nine-hour day. From the point of view
of the Ford Company, this increase in pay was far from negligible; it represented about half of
the company’s profits at the time.
What Ford’s motivations were is not entirely clear. Ford himself gave too many reasons for us
to know which ones he actually believed. The reason was not that the company had a hard time
finding workers at the previous wage. But the company clearly had a hard time retaining
workers. There was a high turnover rate, as well as high dissatisfaction among workers.
Whatever the reasons behind Ford’s decision, as Table 1 shows. the results of the wage increase
were astounding, as the table shows.

The annual turnover rate (the ratio of separations to employment) plunged from a high of 370%
in 1913 to a low of 16% in 1915. (An annual turnover rate of 370% means that on average 31%
of the company’s workers left each month, so that over the course of a year the ratio of
separations to
employment was 31% : 12 = 370%.) The layoff rate collapsed from 62% to nearly 0%. The
average rate of absentee- ism (not shown in the table), which ran at close to 10% in 1913, was
down to 2.5% one year later. There is little question that higher wages were the main source of
these changes.
Did productivity at the Ford plant increase enough to offset the cost of increased wages? The
answer to this question is less clear. Productivity was much higher in 1914 than in 1913.
Estimates of the productivity increases range from 30 to 50%. Despite higher wages, profits
were also higher in 1914 than in 1913. But how much of this increase in profits was the result
of changes in workers’ behavior and how much was because of the increasing success of
Model-T cars is harder to establish. Although the effects support efficiency wage theories, it
may be that the increase in wages to five dollars a day was excessive, at least from the point of
view of profit maximization. But Henry Ford probably had other objectives as well, from
keeping the unions out—which he did—to generating publicity for himself and the company—
which he surely did.

CASE STUDY 9
What Explains European Unemployment?
What do critics have in mind when they talk about the “labor-market rigidities” afflicting
Europe? They have in mind in particular:
■ A generous system of unemployment insurance. The replacement rate—that is, the ratio
of unemployment benefits to the after-tax wage—is often high in Europe, and the duration of
benefits—the period of time for which the unemployed are entitled to receive benefits— often
runs in years.
Some unemployment insurance is clearly desirable. But generous benefits are likely to increase
unemployment in at least two ways. They decrease the incentives the unemployed have to
search for jobs. They may also increase the wage that firms have to pay. Recall our discussion
of efficiency wages in Chapter 7. The higher unemployment benefits are, the higher the wages
firms have to pay to motivate and keep workers.
■ A high degree of employment protection. By employ-
ment protection, economists have in mind the set of rules that increase the cost of layoffs for
firms. These range from high severance payments, to the need for firms to justify layoffs, to
the possibility for workers to appeal the decision and have it reversed.
The purpose of employment protection is to decrease layoffs, and thus to protect workers from
the risk of unemployment. It indeed does that. What it also does, however, is to increase the
cost of labor for firms and thus to reduce hires and make it harder for the unemployed to get
jobs. The evidence suggests that, although employment protection does not necessarily increase
unemployment, it changes its nature. The flows in and out of unemployment decrease, but the
average duration of unemployment increases. Such long durations increase the risk that the
unemployed lose skills and morale, decreasing their employability.
■ Minimum wages. Most European countries have na-
tional minimum wages. And in some countries, the ratio of the minimum wage to the median
wage can be quite high. High minimum wages clearly run the risk of limiting employment for
the least-skilled workers, thus increasing their unemployment rate.
■ Bargaining rules. In most European countries, labor con-
tracts are subject to extension agreements. A contract agreed to by a subset of firms and unions
can be automatically extended to all firms in the sector. This considerably reinforces the

bargaining power of unions because it reduces the scope for competition by nonunion- ized
firms. The stronger bargaining power on the part of the unions may result in higher un-
employment. Higher unemployment is needed to reconcile the demands of workers with the
wages paid by firms.
Do these labor-market institutions really explain high unemployment in Europe? Is the case
open and shut? Not quite. Here it is important to recall two important facts.
Fact 1: Unemployment was not always high in Europe. In the 1960s, the unemployment rate in
the four major continental European countries was lower than that in the United States, around
2 to 3%. U.S. economists would cross the ocean to study the “European unemployment
miracle”! The natural rate in these countries today is around 8 to 9%. How do we explain this
increase?
One hypothesis is that institutions were different then, and that labor-market rigidities have
only appeared in the last 40 years. This turns out not to be the case, however. It is true that, in
response to the adverse shocks of the 1970s (in particular the two recessions following the
increases in the price of oil), many European governments increased the generosity of
unemployment insurance and the degree of employment protection. But even in the 1960s,
European labor-market institutions looked nothing like U.S. labor-market institutions. Social
protection was much higher in Europe; yet unemployment was lower.
A more convincing line of explanation focuses on the interaction between institutions and
shocks. Some labor- market institutions may be benign in some environments, yet costly in
others. Take employment protection. If competition between firms is limited, the need to adjust
employment in each firm may be limited as well, and so the cost of employment protection
may be low. But if competition, either from other domestic firms or from foreign firms,
increases, the cost of employment protection may become high. Firms that cannot adjust their
labor force quickly may simply be unable to compete and go out of business.
Fact 2: Prior to the start of the current crisis started, a number of European countries actually
had low unemployment. This is shown in Figure 1, which gives the unemployment rate for
15 European countries (the 15 members of the European Union before the increase in
membership to 27) in 2006. Wechose 2006 because, in all these countries, inflation was stable,
suggesting that the unemployment rate was roughly equal to the natural rate.
As you can see, the unemployment rate was indeed high in the four large continental countries:
France, Spain, Germany, and Italy. But note how low the unemployment rate was in some of
the other countries, in particular Denmark, Ireland, and the Netherlands.

Is it the case that these low unemployment countries had low benefits, low employment
protection, and weak unions?
Things are unfortunately not so simple. Countries such as Ireland or the United Kingdom
indeed have labor-market institutions that resemble those of the United States: limited benefits,
low employment protection, and weak unions. But countries such as Denmark or the
Netherlands have a high degree of social protection (in particular high unemployment benefits)
and strong unions.
So what is one to conclude?
An emerging consensus among economists is that the devil is in the details. Generous social
protection is consistent with low unemployment. But it has to be provided efficiently. For
example, unemployment benefits can be generous, so long as the unemployed are, at the same
time, forced to take jobs if such jobs are available. Employment protection (e.g., in the form of
generous severance payments) may be consistent with low unemployment, so long as firms do
not face the prospect of long administrative or judicial uncertainty when they lay off workers.
Countries such as Denmark appear to have been more successful in achieving these goals.
Creating incentives for the unemployed to take jobs and simplifying the rules of employment
protection are on the reform agenda of many European governments. One may hope they will
lead to a decrease in the natural rate in the future.

CASE STUDY 10
Changes in the U.S. Natural Rate of Unemployment since 1990
The natural rate of unemployment appears to have decreased in the United States from around
7 to 8% in the 1980s to close to 5% today. (At the time of writing, the unemployment rate
stands at 5.5%, and inflation is stable). Researchers have offered a number of explanations.
■
Increased globalization and stronger competition between U.S. and foreign firms may have
led to a decrease in monopoly power and a decrease in the markup. Also, the fact that firms
can more easily move some of their operations abroad surely makes them stronger when
bargaining with their workers. The evidence is that unions in the U.S. economy are becoming
weaker. The unionization rate in the United States, which stood at 25% in the mid-1970s, is
around 10% today. As we saw, weaker bargaining power on the part of workers is likely to
lead to lower unemployment.
■
The nature of the labor market has changed. In 1980, employment by temporary help agencies
accounted for less than 0.5% of total U.S. employment. Today, it ac-
counts for more than 2%. This is also likely to have reduced the natural rate of unemployment.
In effect, it allows many workers to look for jobs while being employed rather than
unemployed. The increasing role of Internet-based job sites, such as Monster.com, has also
made matching of jobs and workers easier, leading to lower unemployment.
Some of the other explanations may surprise you. For example, researchers have also pointed
to:
■
The aging of the U.S. population. The proportion of young workers (workers between the ages
of 16 and 24) fell from 24% in 1980 to 14% today. This reflects the end of the baby boom,
which ended in the mid-1960s. Young workers tend to start their working life by going from
job to job and typically have a higher unemployment rate. So, a decrease in the proportion of
young workers leads to a decrease in the overall unemployment rate.

■
An increase in the incarceration rate. The proportion of the population in prison or in jail has
tripled in the last 20 years in the United States. In 1980, 0.3% of the U.S population of working
age was in prison. Today the proportion has increased to 1.0%. Because many of those in
prison would likely have been unemployed were they not incarcerated, this is likely to have
had an effect on the unemployment rate.
■
The increase in the number of workers on disability. A relaxation of eligibility criteria since
1984 has led to a steady increase in the number of workers receiving disability insurance, from
2.2% of the working age population in 1984 to 4.3% today. It is again likely that, absent
changes in the rules, some of the workers on disability insurance would have been
unemployed instead.
Will the natural rate of unemployment remain low in the future? Globalization, aging, prisons,
temporary help agencies, and the increasing role of the Internet are probably here to stay,
suggesting that the natural rate could indeed remain low. During the crisis, there was however
the worry that the large increase in actual unemployment (close to 10% in 2010) might
eventually translate into an increase in the natural unemployment rate. The mechanism through
which this may happen is known as hysteresis (in economics, hysteresis is used to mean that,
“after a shock, a variable does not return to its initial value, even when the shock has gone
away”). Workers who have been unemployed for a long time may lose their skills, or their
morale, and become, in effect, unemployable, leading to a higher natural rate. This was a
relevant concern. In 2010, the average duration of unemployment was 33 weeks, an
exceptionally high number by historical standards. Forty-three percent of the unemployed had
been unemployed for more than six months, and 28% for more than a year. When the economy
picked up, how many of them would be scarred by their unemployment experience and hard to
reemploy? The verdict is not in yet. But, given the current relatively low unemployment rate
and the absence of pressure on inflation, it looks like this worry may not have been justified, at
least at the macroeconomic level.
CASE STUDY 11
Deflation in the Great Depression

After the collapse of the stock market in 1929, the U.S. economy plunged into an economic
depression. As the first two columns of Table 1 show, the unemployment rate increased from
3.2% in 1929 to 24.9% in 1933, and output growth was strongly negative for four years in a
row. From 1933 on, the economy recovered slowly, but by 1940, the unemployment rate was
still a high 14.6%.
The Great Depression has many elements in common with the recent crisis. A large increase
in asset prices before the crash—housing prices in the recent crisis, stock market prices in the
Great Depression, and the amplification of the shock through the banking system. There are
also important differences. As you can see by comparing the output growth and
unemployment numbers in Table 1 to the numbers for the recent crisis in Chapter 1, the
decrease in output and the increase in unemployment were much larger then than they have
been in the recent crisis. In this box, we shall focus on just one aspect of the Great Depression:
the evolution of the nominal and the real interest rates and the dangers of deflation.
As you can see in the third column of the table, monetary policy decreased the nominal rate,
measured in the table by the one-year T-bill rate, although it did this slowly and did not quite
go all the way to zero. The nominal rate decreased from 5.3% in 1929 to 2.6% in 1933. At the
same time, as shown in the fourth column, the decline in output and the increase in
unemployment led to a sharp decrease in inflation. Inflation, equal to zero 1929, turned
negative in 1930, reaching -9.2% in 1931, and -10.8% in 1932. If we make the assumption that
expected deflation was equal to actual deflation in each year, we can construct a series for the
real rate. This is done in the last column of the table and gives a hint for why output continued
to decline until 1933. The real rate reached 12.3% in 1931, 14.8% in 1932, and still a high 7.8%
in 1933! It is no great surprise that, at those interest rates, both consumption and investment
demand remained very low, and the depression worsened.
In 1933, the economy seemed to be in a deflation trap, with low activity leading to more
deflation, a higher real interest rate, lower spending, and so on. Starting in 1934, however,
deflation gave way to inflation, leading to a large decrease in the real interest rate, and the
economy began to recover. Why, despite a high unemployment rate, the U.S. economy was
able to avoid further deflation remains a hotly debated issue in economics. Some point to a
change in monetary policy, a large increase in the money supply, leading to a change in
inflation expectations. Others point to the policies of the New Deal, in particular the
establishment of a minimum wage, thus limiting further wage decreases. Whatever the reason,
this was the end of the deflation trap and the beginning of a long recovery.

CASE STUDY 12
Oil Price Increases: Why Were the 2000s So Different from the 1970s?
Why is it that oil price increases were associated with stagflation in the 1970s but had little
apparent effect on the economy in the 2000s?

A first line of explanation is that shocks other than the increase in the price of oil were at work
in the 1970s but not in the 2000s. In the 1970s, not only did the price of oil increase, but so did
the price of many other raw materials. So the effect was stronger than would have been the
case, had only the price of oil increased.
In the 2000s, many economists believe that, partly because of globalization and foreign
competition, workers bargaining power weakened. If true, this implies that, although the
increase in oil prices increased the natural rate, the decrease in bargaining power of workers
decreased it, with the two effects largely offsetting each other.
Econometric studies suggest, however, that more was at work, and that, even after controlling
for the presence of these other factors, the effects of the price of oil have changed since the
1970s. Figure 1 shows the effects of a 100% increase in the price of oil on output and on the
price level, estimated using data from two different periods. The black and blue lines show the
effects of an increase in the price of oil on the consumer price index (CPI) deflator and on gross
domestic product (GDP), based on data from 1970:1 to 1986:4; the green and red lines do the
same, but based on data from 1987:1 to 2006:4 (the time scale on the horizontal axis is in
quarters). The figure suggests two main conclusions. First, in both periods, as predicted by our
model, the increase in the price of oil led to an increase in the CPI and a decrease in GDP.
Second, the effects of the increase in the price of oil on both the CPI and on GDP have become
smaller, roughly half of what they were previously.
Why have the adverse effects of the increase in the price of oil become smaller? This is still a
topic of research. But, at this stage, two hypotheses appear plausible.
The first hypothesis is that, today, U.S. workers have less bargaining power than they did in
the 1970s. Thus, as the price of oil has increased, workers have been more willing to accept a
reduction in wages, limiting the increase in the natural unemployment rate.
The second hypothesis has to do with monetary policy. As we discussed in Chapter 8, when
the price of oil increased in the 1970s, inflation expectations were not anchored. Seeing the
initial increase in inflation as a result of the increase in the price of oil, wage setters assumed
that inflation would continue to be high, and thus asked for higher nominal wages, which led
to further increases in inflation. In contrast, in the 2000s, inflation was much more anchored.
Seeing the initial increase in inflation, wage setters assumed it was a one-time increase and did
not change their expectations of future inflation as much as they would have in the 1970s. Thus,
the effect on inflation was much more muted, and the need for the Fed to control inflation
through higher policy rates and low output was much more limited.

CASE STUDY 13
Does Money Lead to Happiness?
Does money lead to happiness? Or, put more accurately, does higher income per person lead
to more happiness? The implicit assumption, when economists assess the performance of an
economy by looking at its level of income per person or at its growth rate, is that this is indeed
the case. Early examinations of data on the relation between income and self-reported measures
of happiness suggested that this assumption may not be right. They yielded what is now
known as the Easterlin paradox (so named for Richard Easterlin, who was one of the first
economists to look systematically at the evidence):
■ Looking across countries, happiness in a country appeared to be higher, the higher the
level of income per person. The relation, however, appeared to hold only in relatively poor
countries. Looking at rich countries, say the set of Organisation for Economic Co-operation
and Development (OECD) countries, there appeared to be little relation between income per
person and happiness.
■ Looking at individual countries over time, average happiness in rich countries did not
seem to increase much, if at all, with income. (There were no reliable data
for poor countries.) In other words, in rich countries, higher income per person did not appear
to increase happiness.
■ Looking across people within a given country, happiness appeared to be strongly
correlated with income.
Rich people were consistently happier than poor people. This was true in both poor and rich
countries.
The first two facts suggested that, once basic needs are satisfied, higher income per person does
not increase happiness. The third fact suggested that what was important was not the absolute
level of income but the level of income relative to others.
If this interpretation is right, it has major implications for the way we think about the world
and about economic policies. In rich countries, policies aimed at increasing income per person
might be misdirected because what matters is the distribution of income rather than its average

level. Globalization and the diffusion of information, to the extent that it makes people in poor
countries compare themselves not to rich people in the same country but to people in richer
countries, may actually decrease rather than increase happiness. So, as you can guess, these
findings have led to an intense debate and further research. As new data sets have become
available, better evidence has accumulated. The state of knowledge and the remaining
controversies are analyzed in a recent article by Betsey Stevenson and Justin Wolfers. Their
conclusions are well summarized in Figure 1.
The figure contains a lot of information. Let’s go through it step by step.
The horizontal axis measures PPP GDP per person for 131 countries. The scale is a logarithmic
scale, so a given size interval represents a given percentage increase in GDP per person. The
vertical axis measures average life satisfaction in each country. The source for this variable is
a 2006 Gallup World Poll survey, which asked about a thousand individuals in each country
the following question:
“Here is a ladder representing the ‘ladder of life.’ Let’s suppose the top of the ladder
represents the best possible life for you; and the bottom, the worst possible life for you. On
which step of the ladder do you feel you personally stand at the present time?”
The ladder went from 0 to 10. The variable measured on the vertical axis is the average of the
individual answers in each country.
Focus first on the dots representing each country, ignor- ing for the moment the lines that cross
each dot. The visual impression is clear. There is a strong relation across countries between
average income and average happiness. The index is around 4 in the poorest countries, around
8 in the richest. And, more importantly in view of the early Easterlin paradox, this relation
appears to hold both for poor and rich countries; if anything, life satisfaction appears to increase
faster, as GDP per person increases, in rich than in poor countries.
Focus now on the lines through each dot. The slope of each line reflects the estimated relation
between life satisfaction and income across individuals within each country. Note first that
all the lines slope upward. This confirms the third leg of the Easterlin paradox. In each country,
rich people are happier than poor people. Note also that the slopes of most of these lines are
roughly similar to the slope of the relation across countries. This goes against the Easterlin
paradox. Individual happiness increases with income, whether this is because the country is
getting richer or because the individual becomes relatively richer within the country.
Stevenson and Wolfers draw a strong conclusion from their findings. Although individual
happiness surely depends on much more than income, it definitely increases with income.
While the idea that there is some critical level of income beyond which income no longer

impacts well-being is intuitively appealing, it is at odds with the data. Thus, it is not a crime
for economists to focus first on levels and growth rates of GDP per person.
So, is the debate over? The answer is no. Even if we accept this interpretation of the evidence,
clearly, many other aspects of the economy matter for welfare, income distribution surely being
one of them. And not everyone is convinced by the evidence. In particular, the evidence on the
relation between happiness and income per person over time within a country is not as clear as
the evidence across countries or across individuals presented in Figure 1.
Given the importance of the question, the debate will continue for some time. One aspect which
has become clear, for example from the work of Nobel Prize winners Angus Deaton and Daniel
Kahneman is that, when thinking about “happiness,” it is important to distinguish between two
ways in which a person may assess her or his well-being. The first one is emotional well-
being—the frequency and intensity of experiences such as joy, stress, sadness, anger, and
affection that make one’s life pleasant or unpleasant. Emotional well-being appears to rise with
income because low income exacerbates the emotional pain associated with such misfortunes
as divorce, ill health, and being alone. But only up to a threshold; there is no further progress
beyond an annual income of about $75,000 (the experiment was run in 2009). The second is
life satisfaction, a person’s assessment of her or his life when they think about it. Life
satisfaction appears more closely correlated with income. Deaton and Kahneman conclude that
high income buys life satisfaction but does not necessarily buy happiness. If measures of well-
being are to be used to guide policy, their findings raise the question of whether life evaluation
or emotional well-being is better suited to these aims.

CASE STUDY 14
Capital Accumulation and Growth in France in the Aftermath of World War II
When World War II ended in 1945, France had suffered some of the heaviest losses of all
European countries. The losses in lives were large. Out of a population of 42 million, more
than 550,000 people died. Relatively speaking, though, the losses in capital were much larger.
It is estimated that the French capital stock in 1945 was about 30% below its prewar value. A
vivid picture of the destruction of capital is provided by the numbers in Table 1.
The model of growth we have just seen makes a clear prediction about what will happen to a
country that loses a large part of its capital stock. The country will experience high capital
accumulation and output growth for some time.
This prediction fares well in the case of postwar France. There is plenty of anecdotal evidence
that small increases in capital led to large increases in output. Minor repairs to a major bridge
would lead to the reopening of the bridge. Reopening the bridge would significantly shorten
the travel time between two cities, leading to much lower transport costs. The lower transport
costs would then enable a plant to get much needed inputs, increase its production, and so on.
More convincing evidence, however, comes directly from actual aggregate output numbers.
From 1946 to 1950, the annual growth rate of French real GDP was a high 9.6% per year. This
led to an increase in real GDP of about 60% over the course of 5 years.
Was all of the increase in French GDP the result of capital accumulation? The answer is no.
There were other forces at work in addition to the mechanism in our model. Much of the
remaining capital stock in 1945 was old. Investment had been low in the 1930s (a decade
dominated by the Great Depression) and nearly nonexistent during the war. A good portion of
the postwar capital accumulation was associated with the introduction of more modern capital
and the use of more modern production techniques. This was another reason for the high
growth rates of the postwar period.

CASE STUDY 15
Social Security, Saving, and Capital Accumulation in the United States
Social Security was introduced in the United States in 1935. The goal of the program was to
make sure the elderly would have enough to live on. Over time, Social Security has become
the largest government program in the United States. Benefits paid to retirees now exceed 4%
of GDP. For two-thirds of retirees, Social Security benefits account for more than 50% of their
income. There is little question that, on its own terms, the Social Security system has been a
great success and has decreased poverty among the elderly. There is also little question that it
has also led to a lower U.S. saving rate and therefore lower capital accumulation and lower
output per person in the long run.
To understand why, we must take a theoretical detour. Think of an economy in which there is
no social security system—one where workers have to save to provide for their own retirement.
Now, introduce a social security system that collects taxes from workers and distributes
benefits to the retirees. It can do so in one of two ways:
■ One way is by taxing workers, investing their contributions in financial assets, and
paying back the principal plus the interest to the workers when they retire. Such a system is
called a fully funded social security system: At any time, the system has funds equal to the
accumulated contributions of workers, from which it will be able to pay benefits to these
workers when they retire.
■ The other way is by taxing workers and redistributing the tax contributions as benefits
to the current retirees. Such a system is called a pay-as-you-go social
security system. The system pays benefits out “as it goes,” that is, as it collects them through
contributions.
From the point of view of workers, the two systems may look broadly similar. In both cases,
they pay contributions when they work and receive benefits when they retire. But there are two
major differences.
First, what retirees receive is different in each case:
■ What they receive in a fully funded system depends on the rate of return on the financial
assets held by the fund.
■ What they receive in a pay-as-you-go system depends on demographics—the ratio of
retirees to workers—

and on the evolution of the tax rate set by the system. When the population ages, and the ratio
of retirees to workers increases, then either retirees receive less, or workers have to contribute
more. This is very much the case in the United States today. The ratio of retirees to workers,
which was equal to 0.3 in 2000 is already up to 0.4 today and is forecast to increase to close to
0.5 by 2030. Under current rules, benefits will increase from 4% of GDP today to 6% in 2030.
Thus, either benefits will have to be reduced, in which case the rate of return to workers who
contributed in the past will be low, or contributions will have to be increased, in which case
this will decrease the rate of return to workers who are contributing today, or more likely, some
combination of both will have to be implemented.
Second, and leaving aside the aging issue, the two systems have different macroeconomic
implications:
■ In the fully funded system, workers save less because they anticipate receiving benefits
when they are old. But the Social Security system saves on their behalf, by investing their
contributions in financial assets. The presence of a social security system changes the compo-
sition of overall saving: Private saving goes down, and public saving goes up. But, to a first
approximation, it has no effect on total saving and therefore no effect on capital accumulation.
■ In the pay-as-you-go system, workers also save less because they again anticipate
receiving benefits when they are old. But now, the Social Security system
does not save on their behalf. The decrease in private saving is not compensated by an increase
in public saving. Total saving goes down, and so does capital accumulation.
Most actual social security systems are somewhere between pay-as-you-go and fully funded
systems. When the U.S. system was set up in 1935, the intention was to partially fund it. But
this did not happen. Rather than being invested, contributions from workers were used to pay
benefits to the retirees, and this has been the case ever since. Today, because contributions
have slightly exceeded benefits since the early 1980s, Social Security has built a social security
trust fund. But this trust fund is far smaller than the value of benefits promised to current
contributors when they retire. The U.S. system is basically a pay-as-you- go system, and this
has probably led to a lower U.S. saving rate over the last 70 years.
In this context, some economists and politicians have suggested that the United States should
shift back to a fully funded system. One of their arguments is that the U.S. saving rate is indeed
too low and that funding the Social Security system would increase it. Such a shift could be
achieved by investing, from now on, tax contributions in financial assets rather than distributing
them as benefits to retirees. Under such a shift, the Social Security system would steadily ac-
cumulate funds and would eventually become fully funded. Martin Feldstein, an economist at

Harvard and an advocate of such a shift, has concluded that it could lead to a 34% increase of
the capital stock in the long run.
How should we think about such a proposal? It would probably have been a good idea to fully
fund the system at the start. The United States would have a higher saving rate. The U.S. capital
stock would be higher, and output and consumption would also be higher. But we cannot
rewrite history. The existing system has promised benefits to retirees and these promises have
to be honored. This means that, under the proposal we just described, current workers would,
in effect, have to contribute twice; once to fund the system and finance their own retirement,
and then again to finance the benefits owed to current retirees. This would impose a
disproportion- ate cost on current workers (and this would come on top of the problems coming
from aging, which are likely to require larger contributions from workers in any case). The
practical implication is that, if it is to happen, the move to a fully funded system will have to
be slow, so that the burden of adjustment does not fall too much on one generation relative to
the others.
The debate is likely to be with us for some time. In assessing proposals from the
administration or from Congress, ask yourself how they deal with the issue we just discussed.
Take, for example, the proposal to allow workers, from now on, to make contributions to
personal accounts instead of to the Social Security system, and to be able to draw from these
accounts when they retire. By itself, this proposal would clearly increase private saving.
Workers will be saving more. But its ultimate effect on saving depends on how the benefits
already promised to current workers and retirees by the Social Security system are financed.
If, as is the case under some proposals, these benefits are financed not through additional
taxes but through debt finance, then the increase in private saving will be offset by an increase
in deficits (i.e., a decrease in public saving). The shift to personal accounts will not increase
the U.S. saving rate. If, instead, these benefits are financed through higher taxes, then the U.S.
saving rate will increase. But in that case, current workers will have both to contribute to their
personal accounts and pay the higher taxes. They will indeed pay twice.
CASE STUDY 16
Macroeconomic Performance:
An Overview
(A) Economic Growth

Historical Perspective
Economic growth is the principal yardstick of macroeconomic performance. By this standard,
the two decades since 1980- 81 have been easily the best in the last half century of India’s
economic performance (Table 1). After averaging the so-called ‘Hindu rate’ of 3.6 per cent per
year in the 30 years between 1950-51 and 1980-81, GDP growth accelerated to 5.6 per cent in
the eighties and stayed at this level in the final decade up to 2000-01. Indeed, if the crisis-
affected year of 1991-92 is omitted, as it reasonably should be, GDP growth in the past nine
years (1992-93 – 2000-01) averaged an unprecedented 6.1 per cent.1
Furthermore, the growth performance of the eighties was bedeviled by the emergence of
unsustainable fiscal deficits and increasing strains in the external accounts, which triggered the
crisis of 1991. In the last nine years, although the fiscal imbalances have waned and waxed, the
external sector has been far more manageable. Clearly, this has been a golden decade (almost)
of growth for India. The trend in decadal growth rates looks even better when we look at per
capita GDP growth, which accelerated from 0.8 per cent in the seventies to 4.0 per cent in the
last nine years. If we think of per capita GDP as a rough proxy for average living standards of
India’s population, the last two decades have shown welcome improvement.
International Perspective
India’s growth performance in the last two decades of the 20th century also looks good in
international perspective. Virmani (1999) ranks India sixth in the world growth league after
China, Korea, Thailand, Singapore and Vietnam (Table 2). This is certainly a far cry from the
conventional image of the Indian economy as a lumbering, shackled giant trailing far behind
most significant emerging market economies in the growth race. Even more heartening is
Virmani’s finding that India retains sixth position when the ranking is redone in terms of per
capita GDP growth.
The Last Decade: A Closer Look
Table 3 presents more detail on India’s growth in the most recent decade, including
performance of the major sectors which constitute GDP. Furthermore, we subdivide the nine
years following the 1991 crisis into an initial high growth period of five years (corresponding
to the Eighth Plan) and the subsequent four years up to 2000-01. Several points are worth

noting.
First, comparing performance in the last nine years to the pre-crisis decade, it is interesting that
the acceleration in GDP growth (from 5.6 to 6.1 per cent) is entirely attributable to the services
sector where growth surged to 7.8 per cent from an already high 6.7 per cent in the eighties.
Indeed, the growth of both agriculture and industry averages a little slower in the post-crisis
nine years compared to the pre- crisis decade. Second, focusing now on the post-crisis
quinquennium, the acceleration of GDP growth to 6.7 per cent from the pre-crisis decadal
average of 5.6 per cent is quite remarkable. Clearly, economic policy (including macro policy)
was getting some things right! Third, it is noteworthy that in the post-crisis quinquennium
all the major sectors (agriculture, industry, services) grew noticeably faster than in the pre-
crisis decade. Fourth, it is interesting to note that in both the pre-crisis decade and the post-
crisis quinquennium, the sectors of industry and services grew at almost identical rates.
The good news ends when we look at the average growth performance in the four most recent
years. Overall GDP growthdrops to 5.4 per cent. Much more disquieting is the collapse of
agricultural growth to 1.2 per cent (from almost four times the rate in the Eighth Plan period)
and the significant fall in industrial growth down to 4.8 per cent. Indeed, the drop in GDP
growth in these four years would have been much steeper but for the extraordinary buoyancy
of services which averaged growth of 8.1 per cent. This growth in services was much faster
than industry, a pattern which is quite different and novel compared to our past experience and,
at the very least, raises questions of sustainability.
The growing importance of services in India’s economic growth is brought out in Table 4. In
both the pre-crisis decade and the post-crisis quinquennium services accounted for a little under
half of GDP growth. For the full nine years, post-crisis, the growth-contributing role of services
was almost 60 per cent. Even more remarkably, the proportion rose to nearly 70 per cent in
the last four years. Without wishing to be labelled as a commodity-fetishist, this kind of
numbers surely raises genuine issues of both plausibility and sustainability.
Furthermore, a part of the services sector growth in the last four years was ‘spurious’ in the
sense that it simply reflected the revaluation of the value added in the subsector ‘Public
Administration and Defence’ because of higher pay scales resulting from decisions on the Fifth
Pay Commission (FPC). It is a peculiarity of national income accounting conventions that value
added in non-marketed services is estimated on the basis of cost. These Pay Commission effects
(including knock–on effects in the states) were spread mainly over three years, 1997-98, 1998-
99 and 1999-2000, when ‘real’ growth of ‘Public Administration and Defence’ soared to
14.5 per cent, 10.3 per cent and 13.2 per cent, respectively, compared to an average growth in

the previous five years of less than 4 per cent. Subtracting the trend growth from the
exceptionally high reported growth rates gives a measure of the ‘spurious’ (or Pay Commission
effected) growth in these years, which we also subtract from overall GDP growth in the relevant
years. This adjustment reduces GDP growth by 0.5 per cent in 1997-98 and 1999-2000 and by
0.4 per cent in 1998-99. The adjusted (net of Pay Commission effect) GDP growth becomes
4.3 per cent in 1997-98, 6.1 per cent in 1998-99 and 5.6 per cent in 1999- 2000. As a result of
these adjustments, the average GDP growth in the last four years 1997-98 to 2000-01 drops to
5.0 per cent, which is noticeably below the 5.6 per cent average for the pre-crisis decade and
substantially lower than the 6.7 per cent achieved in the post-crisis quinquennium.

Growth in the Nineties:
A Capsule Story
A serious investigation of the determinants of growth in the last decade is far beyond the scope
of this paper. But we can essay a brief heuristic story.
GDP growth collapsed to 1.3 per cent in 1991-92 as the balance of payments crisis of 1991
took its toll. The stabilisation and structural reform measures of 1991-93 restored
macroeconomic stability and fuelled one of the swiftest recoveries of economic dynamism seen
anywhere in the world in recent decades [Acharya 1995, 1999]. GDP growth recovered to
nearly 6 per cent in 1993-94 and exceeded 7 per cent in each of the next three years.
Manufacturing recorded average real growth of 11.3 per cent in the four years 1993-94 to 1996-

97. Export growth in dollar terms averaged 20 per cent in the three years 1993-94 – 1995-96
and the rates of aggregate savings and investment in the economy peaked in 1995-96. Real
fixed investment rose by nearly 40 per cent between 1993-94 and 1995-96, led by a more than
50 per cent increase in industrial investment. It was, manifestly, boom time for the Indian
economy.

The year 1997 was a watershed, which rang in the end of the economic party. In particular,
three marker events occurred within a six-month period to check the momentum of growth. In
March, the instability inherent in coalition governments became manifest in the political crisis
which ended the Deve Gowda government and ushered in the Gujral version of the United
Front government. In July the Thai financial crisis raised the curtain on the Asian crisis saga,
which dominated the international economic arena for next 18 months. Finally, in September,
the Gujral government announced its decisions on the Fifth Pay Commission report,
decisions which were to prove costly for both the fiscal and economic health of the country.
Economic growth fell to 4.8 per cent in 1997-98, 4.3 per cent if the ‘Pay Commission effect’
is netted out. Agriculture recorded negative growth in value added, while the growth of
manufacturing slumped to 1.5 per cent from 9.7 per cent in the previous year.
Only services boomed at 9.8 per cent. Although industrial expansion remained subdued, GDP
growth recovered smartly in 1998-99 thanks to a strong rebound in agriculture and continued
buoyancy in services. Growth was sustained in 1999-2000 by a temporary recovery in industry.
In 2000-01, renewed industrial deceleration and virtual stagnation in agriculture pulled GDP
growth down to 4 per cent. The marker events of 1997 are by no means the only reasons for
the deceleration in India’s economic growth after 1996-97. Others included the petering out of
productivity gains from economic reforms, which clearly slowed after 1994.
Although reforms continued throughout decade, they never regained the breadth and depth of
the early 1990s. Key reforms in the financial sector, infrastructure, labour laws, trade and
industrial policy, bankruptcy provisions and privatisation remained unfinished or undone. Real
investment in industry, which had risen fast until 1995-96, plateaued thereafter for several
reasons, including the political instability associated with three general elections and a
succession of coalition governments, rising fiscal deficits after 1996-97 which kept real interest
rates high, and the loss of momentum in reforms. Third, despite good intentions, the bottlenecks
in infrastructure became worse over time, especially in power, railways and water supply,
reflecting slow progress in reforms of pricing, ownership and the regulatory framework.
Fourth, the low quality and quantity of investment in rural infrastructure combined with
distorted pricing of some key agricultural inputs and outputs to damp the growth of agriculture.
Fifth, the continuing decline in governance and financial discipline in (especially, but by no
means exclusively) the populous states of the Gangetic plain constrained growth prospects for
over 30 per cent of India’s population. Finally, aside from the Asian crisis of 1997-98, the
economic sanctions of 1998-99 and the rebound of international oil prices in the last two years
have together made the international economic environment less supportive than in the Eighth

Plan period.
Potential versus Actual Growth
The above discussion omits the important issue of the evolution of potential GDP over time
and the gaps between potential and actual GDP. Some interesting work has been done by RBI
analysts Donde and Saggar (1999) showing much lower differences between potential and
actual growth in the post-1991 period as compared to the previous four decades. Although the
study is not conclusive, it does suggest that macroeconomic policy has had greater success in
attaining the economy’s output potential in the last decade than in any previous period.
(B) Inflation
Historical Perspective
If growth is the key measure of macroeconomic performance, inflation (or rather its absence)
is the generally preferred indicator of macroeconomic stability. As Table 5 shows, the 1950s
was the best decade in the last half century as far as inflation is concerned. The seventies had
the worst record, with annual inflation averaging in double digits. This is mainly because the
decade straddled the two oil shocks of 1973-74 and 1979-80. In both the decades since 1980-
81 inflation has averaged in the 7 to 8 per cent range: the average annual rate was 7.2 per cent
in the ten years up to 1990-91 and 7.8 per cent in the 10 years since. If the crisis year of 1991-
92 is omitted, the average rate of inflation in the last nine years was 7.1 per cent.

International Comparisons
How does India’s inflation record stack up in international perspective? Table 6 provides some
answers for the last two decades. In the eighties India’s average inflation rate of 7.2 per cent
was close to the average rate for Asian Developing Countries as a group (7.1 per cent), a little
above the average rate for the ‘Advanced Economies’ (5.6 per cent) and much lower than the
average for all Developing Countries (39.0 per cent), which was driven high by Latin American
inflation (145.4 per cent). In the most recent decade, a similar pattern is repeated except for the
conspicuous difference that inflation in Advanced Economies is very low at 2.6 per cent, or
one-third the average rate for India. Two other points are noteworthy. First, although the
average inflation recorded by Asian Developing Countries is marginally higher than India’s for
the decade, the Asian group does better than India in the two most recent years. Second, Latin
American inflation has dropped to single digits in the last three years.
All of this suggests that in the closing years of the 20th century the inflation dragon had been
slayed in most parts of the world. This was both a boon to India (in helping contain price
increases of freely traded commodities) and a challenge to keep inflation low or suffer the
penalties in competitiveness and exchange rate volatility.

The Last Decade: A Closer Look
Conventionally, inflation in India is measured by the wholesale price index (WPI) for the
principal reason that its coverage is far wider and more uniform than that of the three available
consumer price indices (CPI) for selected sections of society. Of the three available CPIs, the
index for industrial workers, CPI(IW), is most commonly used when there is a special need to
focus on consumer prices. Of late [e g, Reserve Bank 2000] the concept of ‘core inflation’ has
gained some currency both in India and abroad. Alternative measures of ‘core inflation’ have
been experimented with by the RBI. For our purpose, the essence of the idea (of filtering out
temporary fluctuations because of supply shocks and administered price hikes) may be
adequately captured by looking at trends in the wholesale price index for manufactures,
WPI(MP).
In Table 7 and Figure 1 we look at the evolution of inflation during the last decade. It is also
instructive to split the decade into two five-year periods. The first noteworthy point is that
inflation was in double digits in the first half of the decade according to all three indices. Even
if the crisis year of 1991-92 is excluded, inflation averaged close to 10 per cent in the next four
years according to all three indicators. Second, the rate of inflation clearly decelerated in the
second half of the decade according to all three measures. Going by the usual measure of
inflation, the WPI, the rate was halved down to 5 per cent in the latter quinquennium. The
deceleration was even more dramatic, down to 3 per cent, in core inflation as measured by
WPI(MP). The CPI(IW) slowed the least, mainly because of the exceptional spurt in food prices
(especially onions and potatoes) in 1998-99. Third, although the WPI ratcheted up by 7 per
cent in 2000-01 because of higher oil prices, the increase in both core inflation and the CPI(IW)
remained subdued.
Inflation in the Nineties:
A Synoptic View
As with economic growth, inflation is a multi-causal phenomenon, which defies simple

explanations. A short heuristic story would run as follows.
The balance of payments crisis of 1991 and attendant severe restrictions on imports disrupted
industrial production.

Coupled with a bad year in agriculture these supply problems propelled inflation to nearly 14
per cent in 1991-92. Inflation moderated in the next two years as the stabilisation programme
took hold and confidence in macromanagement was restored. By the second half of 1993-94
the restoration of confidence and liberalisation of foreign investment policies had triggered a
temporary surge in foreign capital inflow, which added over US$ 12 billion to foreign exchange
reserves between September 1993 and October 1994. As a result, reserve money shot up by
25 per cent in 1993-94 and by over 22 per cent in 1994-95, fuelling broad money growth of
over 18 per cent in 1993-94 and 22 per cent in 1994-95 (Table 8).3 This surge in liquidity
pushed inflation back up to 12.5 per cent in 1994-95. By the following year monetary growth
had been curbed and the simultaneous boom in industry and imports ensured an easy supply
situation, resulting in moderation of inflation down to 8 per cent.
In 1996-97 aggregate demand cooled as both investment and exports levelled off after the boom
in the preceding three years. The supply situation remained easy with strong growth in
agriculture and industry. More significant for the medium-term, the cumulative impact of
import liberalisation and customs tariff reductions combined with low world inflation in
manufactures to bring down the increase in the WPI(MP) to 2.1 per cent in 1996-97. As a result,
the increase in the overall WPI dropped to 4.6 per cent in 1996-97.
From 1996-97 onwards inflation in India has remained low, powerfully influenced by the
prevalence of very low inflation in industrialised countries and (therefore) internationally
traded manufactures, combined with an increasingly open trade regime in India. Core inflation,
measured by WPI(MP), stayed around 3 per cent, except for a blip up to 4.4 per cent in 1998-
99. Since manufactures have a weight of about 64 per cent in the WPI, low increases in
WPI(MP) have translated into low inflation in the WPI. In two years there were sharp spikes
in the indices for ‘primary articles’ and ‘fuel, power, light’, which temporarily raised the rate
of WPI inflation. In 1998-99 the spike was due to the flare up in prices of a handful of
agricultural commodities, especially onions and potatoes. In 2000-01 the major increases in
petroleum prices were the main culprit.
The relatively low inflation in the second half of the decade also reflected two other factors:
mostly moderate increases in money supply and, more worryingly, the apparent slack in
autonomous investment demand.
(C) The External Sector
The external sector of India’s economy was the focal stress point of the 1991 balance of

payments crisis. Perhaps for that reason it saw the most far-reaching reforms and successful
responses to reform initiatives. As I have dealt with these issues in some detail in a separate
paper [Acharya 1999], I shall be relatively brief here.
Some Historical Antecedents
The 1991 crisis had manifold roots, including a series of high fiscal deficits, excessive
regulation of industry and trade and a weakening financial sector. Within the external sector
itself the key contributory factors included an overvalued exchange rate (aggravated by real
appreciation of the rupee in the first half of the 1980s), foreign trade and payments policies
biased against exports and growing recourse to various forms of external borrowing to finance
a series of large trade and current account deficits in the latter half of the eighties.
The extent of anti-export bias in the trade and payments regime can be gauged by the fact that
in 1985-86 merchandise exports accounted for only 4.1 per cent of GDP, while imports were
running more than 80 per cent higher at 7.6 per cent of GDP, entailing a trade deficit of 3.5 per
cent of GDP. Although an active policy of real exchange rate depreciation in the second half
of the eighties induced good export growth in the later years of the decade, it was a case of too
little too late. Moreover, the growth of exports was offset substantially by a steady decline in
net invisible earnings.
For the five-year period 1985-90, the trade deficit averaged 3 per cent of GDP, while the current
account deficit averaged
2.2 per cent of GDP (Table 9). These deficits were financed by growing recourse to various
sources of external borrowing including external assistance, commercial borrowing and
increasingly expensive NRI deposits. Foreign exchange reserves were also run down. Foreign
investment was a negligible 0.1 per cent of GDP. By 1990-91, the trade deficit of 3.0 per cent
of GDP was fully reflected in a peak current account deficit of 3.1 per cent of GDP, since
invisibles had turned marginally negative. The growing recourse to external borrowing in the
second half of the 1980s had led to a substantial deterioration in India’s external debt indicators.
The debt service ratio rose to a peak of 35 per cent in 1990-91 (Table 10). The external debt
stock to GDP ratio peaked at 39 per cent at the end of 1991-92, as did the debt to exports ratio
at 563 per cent. The proportion of short-term debt (by original maturity) in total external debt
attained its highest level in March 1991 at 10.3 per cent. As a ratio to foreign currency reserves,
short-term debt soared to a dangerous 382 per cent, signalling the heightened fragility of India’s
external finances.

External Sector Trends in the Nineties
The Gulf War of 1991 and the associated oil price hike tipped India’s fragile external finances
into a full-blown balance of payments crisis. To contain the crisis and restore economic health,
the new Congress government of June 1991 initiated a wide- ranging programme of
stabilisation and structural reform. Without going into the details of the programme, the salient
thrusts which directly relate to the external sector may be summarised [they are broadly
consistent with the recommendations in [Government of India 1993]:
– The exchange rate was devalued and the system transformed in less than 2 years from a
discretionary, basket-pegged system, to a market-determined, unified exchange rate, following
a short intermediate period of dual rates.
– The heavy anti-export bias in the trade and payments regime was also reduced
substantially by a phased reduction in the exceptionally high customs tariffs and a phased
elimination of quantitative restrictions on imports.
– Policies were initiated to encourage both direct and portfolio foreign investment.
– Short-term debt was reduced and strict controls put in place to prevent future expansion.
Medium-term borrowing from private commercial sources was made subject to annual caps
and minimum maturity requirements.
– Growth of NRI deposits was moderated through reduction of incentives.
– Foreign exchange reserves were consciously accumulated to provide greater insurance
against external sector stresses and uncertainties.
As a result of these measures and other reforms in industrial, fiscal and financial areas, the
performance of the external sector over the last decade has been generally strong. The
stabilisation measures of 1991-92 reduced sharply imports, the trade deficit and the current
account deficit.
Import growth recovered and surged in the mid-nineties, but the current account deficit
remained well below 2 per cent of GDP because of the concomitant buoyancy of exports and
the strong recovery of net invisible earnings (Table 9). This surge in net invisibles to an average
level of over 2 per cent of GDP in the last five years may be attributed in part to the strength
of the world economy, in part to the rational incentives embedded in a market-determined
exchange rate system and in part to the strong growth of software service exports.

Merchandise exports grew at about 20 per cent a year in dollar terms for three successive years
between 1993-94 and 1995-96 and then decelerated to negative growth in 1998-99 before
recovering againto record 20 per cent growth in 2000-01. Despite the sluggish performance of
exports between 1996-97 and 1998-99, the trade deficit remained below 4 per cent of GDP
thanks to the equally subdued growth of imports, especially non-oil imports. The continuing
deceleration in non-oil import growth largely reflects the slow growth of industry in recent
years.
Portfolio foreign investment responded smartly to new initiatives and climbed quickly to a peak
of $ 3.8 billion in 1994-95. Direct foreign investment rose more slowly but steadily to a peak
of $ 3.6 billion in 1997-98, before falling off significantly thereafter. Taken together, foreign
investment peaked at $ 6.2 billion 1996-97 or just 1.6 per cent of GDP, which compares quite
unfavourably with the record of a number of east Asian and Latin American countries,
including China and Brazil, where FDI has attained 5 per cent of GDP in recent years.
Comparing the latest decade to the late eighties, three sources of foreign borrowing have clearly
declined in significance: external assistance, NRI deposits and IMF financing. On the other
hand, net external commercial borrowings have fluctuated, reaching peak levels in 1998-99
and 2000-01 because of exceptional recourse to Resurgent India Bonds and India Millennium
Deposits, respectively.
Taking the constituent elements together, it is noteworthy that the capital account surplus
reached its peak in 1993-94 (at 3.5 per cent of GDP) and has been well below that level in all
subsequent years. Nevertheless, except for 1995-96, the capital account surplus has been large
enough in relation to the corresponding current account deficit in each of the last 10 years, to
ensure accretion to foreign exchange reserves. Such reserves have increased from $ 5.8 billion
in March 1991, representing 2.5 months of import cover to $ 42.3 billion 10 years later,
amounting to more than 8 months of import cover.
We noted earlier how external debt indicators clearly signalled in 1991 the fragility of India’s
external finances. Table 10 brings out the sustained and remarkable improvement in these
indicators over the decade, reflecting the success of India’s external sector policies, in general,
and prudent approach to external debt, in particular. By March 2000 the debt service ratio had
more than halved (from its peak) down to 16 per cent. The external debt to GDP ratio had fallen
to 22 per cent. The proportion of short-term debt (by original maturity) was at a comfortable
level of 4.1 per cent. Perhaps most telling, the ratio of short-term debt to foreign currency assets
had plunged from its perilous height of 382 per cent in March 1991 to a sanguine 11.5 per cent
in March 2000.

International comparisons with 14 other large external debtor developing countries for
December 1999 also show India in a very favourable light (Table 11). By each significant debt
yardstick India ranks among the best.

A critical instrument in bringing about healthy outcomes in the external sector has been
exchange rate policy. The transition from the prevailing (undisclosed) basket- pegged system
in June 1991 to an unified, market-determined system was accomplished in a phased manner
and with considerable finesse. By August 1994 India had committed to current account
convertibility under Article VIII of the IMF. Following the unification of the exchange rate in
March 1993, the authorities (especially the RBI) operated the ‘managed float’ of the rupee with
the twin objectives of fostering India’s international competitiveness while containing day to
day market volatility. Table 12 and Figure 2 present data on nominal and real export-weighted
exchange rate indices of the rupee. The profile of the 10-country REER suggests that the real
exchange rate generally prevailed a little higher than the low point of 1993-94, but not by much
(except in 1997-98 when the REER index rose 10 per cent above the 1993-94 base thanks to
virtual stability in the nominal exchange rate index over two years). Occasional bouts of modest
appreciation have usually been corrected. The instruments deployed by RBI to manage the float
have included exchange market intervention, occasional administrative measures and monetary
policy. However, these partner country REER indices fail to capture possible deterioration in
India’s competitiveness in major markets relative to a number of east Asian competitors
(notably, Thailand, Malaysia, Philippines and Indonesia) whose nominal exchange rates
underwent substantial depreciation during the east Asian crisis of 1997-98 [Krueger and
Chinnoy 2001].
If this dimension is factored in, it is quite possible that the rupee’s prevailing exchange rate
in the closing years of the decade has been somewhat overvalued from the vantage point of
India’s export competitiveness.
On the other hand, India’s exchange rate policy has achieved considerable success in damping
volatility in nominal rates, especially during periods of international currency market
turbulence and contagion that prevailed in 1997 and 1998.
(D) Fiscal Deficits, Savings and Investment
Growth, inflation and external balance are the main ultimate targets of macroeconomic policy.
These are the aggregate variables by which an economy’s macro performance is most
commonly evaluated. However, there is almost as much interest in a set of intermediate target
variables which lie at the heart of macroeconomic policy, namely fiscal deficits, savings and
investment. Each of these, especially fiscal deficits, warrant some commentary.
Fiscal Deficit

It is generally agreed (though not unanimously) that a series of large fiscal and revenue deficits
is inimical to macroeconomic performance.4 Such deficits tend to crowd out private
investment, increase inflationary potential, weaken the balance of payments, render financial
sector reform more difficult and impose a serious burden of adjustment on future generations.
The series of high fiscal deficits in the late 1980s were clearly a major cause of the 1991
economic crisis in India. Let us look at the trends since then.
This is easier said than done. Obtaining a comparable and consistent series of even the centre’s
fiscal deficit is bedevilled by changes in the treatment of small savings (intermediated through
the budget) and significant revisions in GDP data [Rao and Nath 2000]. Here we focus on the
definition of deficit net of small savings transferred to states. The GDP series with 1993-94
base is used throughout. Furthermore, we give prominence to the consolidated deficit of the
centre and states, although we present deficit data for each separately as well. We do not deploy
a public sector borrowing requirement (PSBR) concept since official Indian data are not
compiled on this basis. Nor do we attempt adjustments for extrabudgetary items such as the
Oil Pool Account deficit/surplus or con tingent liabilities of either the centre or the states. We
recognise that the fiscal deficit in recent years would be larger if such elements were factored
in.5
Tables 13, 14 and 15 present time series for fiscal, primary and revenue deficits of centre-states
consolidated, the centre (separately) and states (separately), respectively. The following trends
are noteworthy regarding the consolidated picture:
– The gross fiscal deficit increased significantly from an average of 7.2 per cent in the 5
years 1980-85 to 8.9 per cent in the next quinquennium, 1985-90, and even further to 9.4 per
cent in 1990-91.
– There was a reduction of over 2 per cent of GDP in the gross fiscal deficit in 1991-92,
brought about essentially by the central budget of that year (Table 14) and in the context of an
IMF loan programme initiated to help cope with the balance of payments crisis of 1991.

– This correction was largely negated by a very large central government fiscal slippage

(relative to budget targets) in 1993-94, timed, perhaps not coincidentally, with the end of the
IMF programme in spring 1993.
– The lost ground was quickly recovered and further consolidated in the next three years,
with the lowest consolidated fiscal deficit for the decade of 6.4 per cent of GDP recorded in
1996-97. This coincided with and was largely a result of the centre’s achieving its lowest deficit
in the decade (indeed in 20 years) of 4.1 per cent of GDP.
– This was also the year in which the consolidated primary deficit achieved a nadir of 1.3
per cent of GDP, thanks mainly to the only year of primary surplus achieved by the Centre in
the last 20 years.
– In the next three years, propelled principally by government pay increases following
the Fifth Pay Commission, the consolidated fiscal deficit rose sharply to
9.5 per cent of GDP by 1999-2000, marginally exceeding the pre-crisis level of 1990-91. In
2000-01 there was a further small increase.
– By 1999-2000 the consolidated primary deficit had tripled (relative to the 1996-97
nadir) to 3.9 per cent of GDP and the revenue deficit had risen sharply to 6.3 per cent of GDP.
– The consolidated revenue deficit in 1999-2000 at 6.3 per cent of GDP was 50 per cent
higher than the pre-crisis level of 4.2 per cent in 1990-91.
– Tables 14 and 15 and Figure 3 clearly show that while trends in the consolidated deficit
indicators were largely dominated by trends at the centre up to 1996-97, the recent deterioration
is due to adverse trends in both the centre and states but predominantly in the latter.
This is not the place for a detailed decomposition of the factors explaining the trends in deficits
over the decade. However, Tables 16 and 17 support several broad points – Revenue
receipts (tax and non-tax) did not contribute to the improvement in the Centre’s fiscal position
between 1990-91 and 1996-97. In fact, there was some decline in the ratios to GDP. There was
a particularly worrying decline in the ratio of tax revenues to GDP, which fell to its nadir in
1998-99.
– The entire improvement in the centre’s fiscal situation up to 1996-97 was due to a
reduction in the expenditure to GDP ratio from 17.3 per cent in 1990-91 down to 13.9 per cent
GDP in 1996-97, with most of the reduction being concentrated in capital expenditure.
– Similarly, the deterioration in the Centre’s fiscal position after 1996-97 is wholly
attributable to a rise in the expenditure to GDP ratio to 15.4 per cent by 1999-2000. The
difference is that this increase is almost entirely because of the rise in the share of revenue
expenditure to GDP, in large part to accommodate a higher bill for government pay and
pensions.

At the states level, there is no really significant trend in the fiscal deficit ratio until the sharp
deterioration of 1998-99 and 1999-2000. This is largely explained by the ratcheting up of
revenue expenditure, partly because of pay revisions following the Pay Commission.
Before leaving the subject of fiscal deficits, a quick glance at international comparisons of
fiscal deficits reveals that India’s deficit is emphatically on the high side. Out of 74 countries
with population more than 10 million for which the IMF has fiscal data, only seven recorded a
general government deficit higher than 7 per cent of GDP in 20006 (Table 18). India is one of
this ‘magnificent seven’. And of these seven, only two countries, Turkey and Zimbabwe, had
a higher deficit than India. The warning bells are ringing loud and clear!

Savings and Investment
As we would expect, the trends in the overall fiscal position, especially in revenue deficits, find
reflection in India’s public savings performance. Table 19 shows that public savings in the
nineties reached its peak of 2.0 per cent of GDP in 1995-96, the year when the consolidated
revenue deficit was at its lowest mark in the decade. Subsequently, as the consolidated revenue
deficit nearly doubled to 6.3 per cent of GDP in 1999-2000, an increase of 3 per cent points of
GDP, public savings fell by almost the same percentage of GDP, becoming negative 0.9 per
cent of GDP by 1999-2000.
This sharp decline in public savings between 1995-96 and 1998-99 largely explained the drop
in the ratio of gross domestic savings from its peak of 25.1 per cent of GDP in 1995-96 to 21.7
per cent in 1998-99. Table 19 shows that although public savings fell further in 2000-01, the
rise in private savings (especially household savings) brought about a modest improvement
in gross domestic savings.

Not surprisingly, the gross investment ratio mirrors the trend in the savings ratio, attaining a

peak level of 26.9 per cent ofGDP in 1995-96 and then dropping by over four per cent points
of GDP to 22.7 per cent in 1998-99. It is quite interesting how the deterioration of about 3 per
cent points of GDP in the consolidated revenue deficit between 1995-96 and 1998-99 is
reflected strongly in the worsening of aggregate savings and investment ratios over the period.
It would be hard to find more telling presumptive evidence of the adverse impact of fiscal
deficits on savings and investment. Another way to look at this is that if the fiscal deterioration
since 1995-96 had not occurred, savings and investment might well have been higher by around
3 per cent points of GDP in recent years. Indeed, the beneficial impact might well have been
greater because of the effect of lower real interest rates on the buoyancy of private, especially
corporate, investment and savings.
Real interest rates, that is interest rates net of anticipated inflation, are unobservable. However,
proxies can be constructed based on past and current inflation data. Even so, the link between
real interest rates and private investment is likely to embedded in a more complex causal story
of investment behaviour which includes financial intermediation, ‘animal spirits’ or confidence
and uncertainty. Nevertheless, Figure 4 shows some presumption of expected links between
real interest rates and private investment in India over the period 1985-86 to 1999-2000.
Further- more, the high average level of real interest rates in the second half of the nineties
suggests that the reductions in nominal interest rates did not keep pace with the sharp decline
in inflation in this period. Whether this was due more to rising fiscaldeficits or unduly slow
reductions in administered interest rates (for small savings and provident funds) is hard to say.

Macro Policy Responses to Emerging Problems
Thus far we have told the macro story in terms of usual tables and charts and with the benefit
of hindsight. In this section my aim is to convey some feel for how macroeconomic policy
was formulated as major economic challenges emerged and had to be dealt with.

BALANCE OF PAYMENTS CRISIS
Much has been written on the 1991 balance of payments crisis and the far- reaching policy
responses it triggered. Hence my treatment of this defining challenge for Indian economic
policy will be brief, especially since detailed descriptions are available in contemporary official
publications, notably the government’s Economic Surveys and the Reserve Bank’s Annual
Reports.
The deep-seated roots of the 1991 crisis in fiscal laxity, growing reliance on external
borrowing, a weakening financial sector and heavy handed regulation of trade and industry are
well known. The proximate trigger was the Gulf war in the second half of 1990-91, which
jacked up international oil prices (and India’s oil import bill) and reduced remittance inflows
from the Gulf. This happened in the context of unstable coalition politics in India in the period
between the end of the Rajiv Gandhi Congress government in late 1989 and the assumption of
power by the Narasimha Rao Congress government in June 1991. The increase in doubts about
India’s ability to manage the current account pressures triggered adverse effects in the capital
account, which compounded the external sector problem. By September 1990 net inflows of
NRI deposits had turned negative and access to external commercial borrowings was becoming
costly and difficult. By December 1990 even short-term credit was becoming expensive and
elusive. Foreign currency reserves fell sharply and dipped below $ 1 billion in January 1991.
The initial responses to the mounting external payments crisis were ‘traditional’. They included
recourse to IMF financing ($ 1.8 billion was drawn in January 1991 under the Compensatory
and Contingency Financing Facility and a First Credit Tranche arrangement) and a series of
measures to reduce imports, including high and rising cash margin requirements, a surcharge
on petroleum product prices, a surcharge on interest on bank finance for imports and a
tightening of import licensing. The severity of import compression may be gauged from the
fact that in 1991-92 non-oil imports fell by 22 per cent in dollar terms (Table 9). As the
Economic Survey (Part I, p 8) for the year observes, “Import compression had reached a stage
when it threatened widespread loss of production and employment, and verged on economic
chaos”.
Despite these harsh measures, NRI deposit outflows accelerated in the second quarter of 1991
and foreign exchange reserves continued to fall after a brief respite from IMF-financing. To
quote the Eco- nomic Survey again, “By June 1991, the balance of payments crisis had become
overwhelmingly a crisis of confidence - of confidence in the government’s ability to manage
the balance of payments…A default on payments, for the first time in our history had become
a serious possibility in June 1991.”

Faced with this prospect, the new Congress government of June 1991, with Manmohan Singh
as finance minister, acted quickly to stabilise the macroeconomic situation and initiate long
overdue structural reforms to restore economic health. In July 1991 the rupee was devalued by
18 per cent and the new Budget for 1991-92 cut the fiscal deficit by 2 per cent of GDP. The
transition to a market-determined exchange rate system was begun through the induction of a
system of tradable import entitlements called ‘Eximscrips’. Indus- trial licensing was virtually
abolished and MRTP clearances dispensed with. For the first time, foreign investment up to 51
per cent equity was automatically allowed in a wide range of industries. A programme of
disinvestment of government equity in public sector enterprises was begun. To accommodate
a revival in imports and industry, further multilateral, balance of payments financing was
secured from the IMF, World Bank and Asian Development Bank.
As noted earlier, the economy’s response to this programme of stabilisation and structural
reform was exceptionally strong. By 1993-94, GDP was growing at nearly 6 per cent,
manufacturing value added at 8.5 per cent, exports in dollar terms at 20 per cent and the boom
time of the mid- nineties was yet to come. As early as March 1993 the external sector was
looking good, with foreign exchange reserves nearly touching US $ 10 billion (about five
months of imports), export growth picking up, trade and current account deficits well under
control, net invisible flows recovering, non-resident deposit inflows bouncing back and foreign
investment on an upswing. Since most of this data became available with a lag of two or three
months (and much longer for national income), the strength of the recovery began to be ap-
parent to us in the finance ministry only in the summer of 1993 and much later as far as the real
economy was concerned.
(B) Foreign Capital Surge of 1993-947
The turnaround in the external sector was very welcome, as vindication of the economic reform
policies. But it brought with it the brand new problem of a surge in foreign capital inflows.8
For us this was a novel challenge and in responding we had to try and marry textbook
prescriptions with practical realities – and that is a marriage which is not made in heaven. Let
me give a flavour of the key issues faced, the policy choices made and the ensuing results and
lessons.
Between September 1993 and October 1994, foreign currency reserves rose by $ 12.2 billion,
or about $ 1 billion per month. Another way of looking at this is that reserve build up during
those 13 months amounted to about 4 per cent of GDP.

The surge in inflows of foreign exchange confronted policymakers with three major issues:
• Should the nominal exchange rate be permitted to appreciate in response to these flows
or should the money be taken into foreign exchange reserves?
• How could the problem of capital surge be transformed into opportunities for
liberalisation of external trade and payments?
• If reserves were going to rise sharply what could monetary authorities do to limit the
impact on inflation?
Let me make a few remarks on each of these issues. It is important to remember that in taking
decisions we were severely handicapped by ignorance about the future trajectory of capital
flows; in particular, whether the phenomenon of surge was temporary or lasting.
On the exchange rate issue, despite contrary advice from the IMF, we decided to build up
reserves and not permit the nominal rupee-dollar parity to appreciate. Several reasons informed
this key decision. First, in September 1993 the stock of foreign currency reserves (exclusive of
gold and SDRs), at $ 7.6 billion (or about three months imports), was still quite modest and
after the trauma of 1991 we certainly preferred a higher comfort level of forex reserves. Second,
at that time India was still in the early months of an export boom, which we did not want to
choke off through a significant nominal appreciation in the exchange rate. Third, an
appreciation of the nominal exchange rate would have cheapened imports, fanned domestic
protectionist sentiments and undermined the ongoing programme of trade liberalisation in the
form of customs tariffs reductions and progressive relaxation of quantitative restrictions on im-
ports. Fourth, since we were uncertain about the durability of the capital surge, we were
reluctant to ride the possible roller- coaster of a sharp nominal appreciation followed by an
equally abrupt nominal depreciation in the currency.
To moderate the monetary impact of reserve accumulation and seize opportunities for
liberalisation and strengthening of the external sector, several initiatives were undertaken.
First, imports of essential consumer goods, such as sugar, edible oils and cotton, were
liberalised from quantitative restrictions.
Second, India formally moved to current account convertibility in August 1994 by accepting
IMF’s Article VIII obligations.
Third, deliberate measures were taken to retire short-term external debt obligations.
Fourth, we phased out the category of Foreign Currency Non-Resident Deposits which
benefited from exchange guarantee by the Reserve Bank of India. Fifth, we partially liberalised
the overseas investment policy for Indian firms.
On the monetary side, the RBI under- took partial sterilisation of the foreign asset accumulation

through an increase in reserve requirements and some open market sale of government
securities by the RBI. Fuller sterilisation operations were constrained by the lack of depth in
the securities market, the sharp increase in new government securities because of major fiscal
slippage in 1993-94 and a policy choice not to throttle monetary expansion at early stages of
an investment boom.
Looking back, the results and lessons of these policy choices appear to have been reasonably
favourable:
• Foreign currency reserves did get built up from three months import cover to over six
months by March 1995. Foreign exchange reserves, inclusive of gold and SDRs, were even
more comfortable at over eight months of import cover.
• The export boom continued strong for three successive years between 1993-94 and
1995-96 at about 20 per cent annual growth in dollar terms.
• The environment for foreign capital inflows remained conducive, although the surge in
foreign exchange reserves levelled off after 1994-95 as a strong industrial recovery fuelled
high import growth and widened the current account deficit.
• Overall economic growth accelerated to over 7 per cent by 1994-95, led by an industrial
boom.
• The reduction in short-term external debt led the way for improvements in external debt
indicators.
• On the negative side, both monetary growth and inflation did accelerate in 1994-95.
But by the middle of 1995 the annual growth rate of both inflation and broad money had come
down to reasonable levels (Figure 5).
The overall lesson I would draw is that while a temporary capital surge does pose a significant
challenge, it can be handled. Perhaps the key point is to prevent temporary phenomena from
destabilising medium-term objectives of growth in exports, investment and the economy.
(C) Containing Inflation
We have already noted that the years 1993-94 to 1996-97 were boom time for the Indian
economy by the yardsticks of overall growth, manufacturing sector growth, export dynamism
and aggregate savings and investment. The first three years of this four-year period also saw a
strong revival of inflation, which posed a substantial challenge for the technocrats and
considerable political discomfort for the ruling party.

After averaging 13.7 per cent in 1991-92 and 10.1 per cent in 1992-93, the annual rate of WPI
inflation had decelerated in the last five months of 1992-93 and dropped below 7 per cent in
the initial months of 1993-94. By July the trend had reversed and inflation was rising again. By
the end of the fiscal year (March 1994) it was in double digits at 10.8 per cent. Several factors
contributed to this resurgence of inflation, including the sharp increase in reserve money fuelled
by the build up of net foreign assets, the cumulative effect of earlier increases in procurement
prices for food grains, the upward revision of administered prices of food grains, sugar and
petroleum in the final quarter of 1993-94 and the generally buoyant economic conditions. The
large fiscal slippage in 1993-94 would also have contributed to monetary growth but for adroit
management by the Reserve Bank of large sales of government securities, as a consequence of
which there was hardly any increase in net RBI credit to the central government for the year as
a whole. Inflationary pressures persisted throughout 1994-95, with growth of broad money
(M3) accelerating to 22.4 per cent. WPI inflation averaged 12.5 per cent in 1994-95, with both
manufactures and primary articles recording double digit price increases, suggesting the
dominance of macro demand factors in propelling inflation. Government policy sought to
deploy both supply and demand measures to contain price increases. In April 1994, imports of
sugar and cotton were freed from import licensing and the customs duties reduced to zero.
Edible vegetable oils were also freed from import restrictions at a duty of 65 per cent
(subsequently reduced to 30 per cent in March 1995). On the demand side a reduction of the
centre’s fiscal deficit by 1.6 per cent of GDP helped contain the accretion of fresh inflationary
pressures. Monetary policy had to contend with the competing pulls of accelerating industrial
growth and resurgent inflation. In the summer of 1994, the cash reserve ratio (CRR) was raised
by one per cent back up to 15 per cent and later in the year the CRR regime was extended to
NRI deposits. The Reserve Bank also continued with open market sales of government
securities to moderate liquidity growth. In the event these brakes on monetary growth proved
insufficient, with both reserve money and broad money growing by 22 per cent. This was
enough, despite the acceleration of real GDP growth to 7.3 per cent, to accommodate average
WPI inflation of 12.5 per cent. With the benefit of hindsight, it might have been desirable to
attempt stronger monetary countermeasures to offset the liquidity growth stemming from the
surge in net foreign assets. But that would have run the risk of choking off the strong industrial
revival which had begun in the second half of 1993-94.
In 1995-96 the sharp edge of the trade- off between growth and inflation was blunted. The
annual rate of WPI inflation slowed below double digits by June 1995, although industrial
growth continued to accelerate. In August 1995, there was unexpected turbulence in the foreign

exchange market after two and a half years of an unchanged rupee-dollar nominal parity. To
prevent panic reactions to this unfamiliar variability the Reserve Bank intervened with
substantial dollar sales. The foreign capital surge was over. Indeed 1995-96 turned out to be
the only year since 1990-91 that has seen a decline in foreign exchange reserves, a fact which
helped bring broad money growth down to 13.6 per cent in 1995-96 and supported the
deceleration of WPI inflation throughout the year. By March 1996 the annual rate of inflation
had fallen to 4.5 per cent, although the average WPI increase for the year was 8.1 per cent.
Although we did not know this at that time, generalised inflation ceased to be a significant
problem for the rest of the decade, except for the short-lived ‘onion crisis’ of mid-1998.
(D) The Industrial Slowdown
Inflation ceased to be a problem in 1996-97. But the second half of the year saw a sudden
deceleration in growth of industry and exports. Measured by the index industrial production
(IIP), growth of industrial output was comfortably in double digits in every month of 1995-96,
as was the growth of manufacturing output (which accounts for nearly 80 per cent of the weight
of this index). This buoyancy continued in the first half of 1996-97. Growth faltered in
September 1996, recovered in October and then suddenly plummeted in the last five months
of the year (Figure 6). What is worse, industrial growth remained sluggish throughout 1997-98
and 1998-99 (Table 20). Although there was some pick up in 1999-2000, it was short-lived and
ran out of steam by the end of 2000, with month-on-year-ago- month growth rates of both
manufacturing and industry collapsing to below 2 per cent by March 2001. It is quite
remarkable that after August 1996 there has been only one solitary month (November 1997) in
which either the overall IIP or the component for manufacturing has registered double digit
growth from a year ago. Moreover, except for the welcome partial recovery of 1999- 2000,
there is not one instance, since September 1996, of three successive quarters registering more
than 6 per cent growth. Although there has been no lack of hypotheses, there is no definitive,
available explanation for the sudden loss of industrial momentum which occurred in late 1996
and has continued to constrain Indian economic performance since. A popular contemporary
explanation among many industrialists was the ‘credit squeeze’ of 1995-96. However, this
mistook the unexpected and temporary tightening of liquidity in money markets, resulting from
the large dollar sales by the Reserve Bank in late 1995 in support of a suddenly wobbly rupee-
dollar exchange rate, as an expression of deflationary credit policy. As the Reserve Bank’s
Annual Report for the year was at pains to point out, monetary policy was steadily loosened
from November 1995 with successive reductions in the CRR, which added nearly Rs 13,000

crore of primary liquidity in the nine months between October 1995 and June 1996. Indeed,
during this period the total net liquidity impact of foreign exchange transactions and CRR
reductions was an injection of primary liquidity of over Rs 14,000 crore (Table 21).
Furthermore, since non- food bank credit grew by 22.5 per cent in 1995-96, it would be hard
to reconcile this with any ‘credit squeeze’ view.

We may be on firmer ground if we seek answers to the industrial slowdown puzzle in the
contemporaneous deceleration of exports and the deceleration of investment, especially
industrial investment, in 1996-97. Both these sources of demand for industrial products lost
their earlier dynamism for different reasons. Export growth in dollars declined from over 20
per cent in 1995-96 to only 5 per cent in 1996-97, partly because of the rupee’s real appreciation
between March 1993 and August 1995 and also because of a more general, Asia-wide slowing
of export growth associated with loss of market share to China’s surging exports. Real gross
fixed investment in industry showed no increase in 1996-97 or in 1997-98 (Table 22). It
declined as a ratio of GDP. The deceleration of investment may be attributable to several factors
including the over-expansion of capacities in the investment boom up to 1995-96, the slump in
the capital market for the new issues, the rise in real interest rates in 1995-96 because of the
fall in inflation and a temporary rise in nominal interest rates and the weakening of business
confidence associated with the advent of coalition governance.
The policy response to the initial industrial slowdown was mainly in the monetary arena. The
CRR reductions which had begun in November 1995 were continued throughout 1996-97.
Between April 1996 and January 1997, the CRR was reduced by 4 percentage points from 14
to 10 per cent. In April 1997 the Bank rate was reactivated by linking several interest rates to
it, including the rate at which RBI would provide refinance.
The Bank rate was reduced to 11 per cent in April 1997, 10 per cent in June and 9 per cent in
October. These reductions were partially reflected in declines in commercial bank prime
lending rates. However, real interest rates probably remained high as economic agents factored
in the persisting low inflation.
Government policy also sought to stimulate industrial investment through substantial reduction
in rates of corporate and personal income taxes in the February 1997 budget. Although this
‘dream budget’ was delightedly received by the stock markets, the euphoria was cut short by
the political crisis within the United Front government in March and April, which brought
about a change in prime ministers. Despite the easing of monetary policy, the stimulus of tax
policy and the resurgence of fiscal deficits (after September 1997) industrial investment and
production remained sluggish. Quite possibly, the slowdown in structural reforms and the rise

in political uncertainty were taking a significant toll of investment intentions. By the middle of
1997 the Asian crisis had begun and the international environment also became a source of
uncertainty and turbulence.
(E) East Asian Crisis and Contagion
In July 1997 the Thai baht depreciated massively and ushered in the east Asian financial crisis
which had worldwide re- percussions. The literature on the Asian crisis is voluminous.9 My
limited focus here is on the question: why didn’t India catch the east Asian flu and what was
the role of macro policy in achieving this outcome? The question is also relevant for other south
Asian countries since if India had succumbed to the contagion, then her immediate neighbours
may well have found it impossible to ward off serious infection. At one level, the experience
of 1997-99 has underlined the weaknesses in the international financial architecture in coping
with sudden panics in international financial markets and massive swings in cross-border flows
of mobile capital. While we should work jointly to strengthen the international financial
architecture, here the focus is limited to some of the lessons of the east Asian crisis for national
economic management. To my mind, the key lessons include:
– Avoid high levels of short-term external debt. This also assumes fairly complete
knowledge of the country’s total (including short-term) external liabilities, information on
which was found to be woefully incomplete in several east Asian countries at the time of crisis.
– Avoid sustained and substantial appreciation in the real effective exchange rate of the
country. In some east Asian countries, the combination of a fixed nominal parity with the dollar,
combined with high capital inflows, had laid the basis for the ensuing crisis.
– Avoid massive expenditure of forex reserves in support of unrealistic exchange rate
levels.
– Seek to strengthen the domestic financial sector in terms of capital adequacy, prudential
norms, disclosure requirements and a well-functioning regulatory environment.
– Consider prudential limits for exposure of the banking system to speculative markets,
such as real estate and stocks, where assets bubbles can build-up and deflate with severe
consequences for the financial system.
– Keep close watch on the size of the current account deficit in relation to growth of
current receipts through exports and invisibles.
– Tread the path towards capital account convertibility cautiously with due regard to the
strength of the domestic fiscal and financial situations.

If we accept these as some of the major lessons of the east Asian crisis for developing countries,
it is noteworthy that Indian policy appears to have internalised some of these prudential lessons
before the onset of the east Asian financial conflagration in mid-1997. These lessons were
drawn largely from India’s own external sector crisis in 1991, some of which were reinforced
by the Mexican peso crisis of 1994-95. Let me list some India-specific points:
– Short-term external debt was, as we have seen, under tight control and at very modest
levels.
– The market determined exchange rate system had been managed in a moderately
flexible manner in the 4 years preceding mid-1997. This practice continued during the period
of maximum stress (from the East Asian flu) from August 1997 to December 1998. The rupee-
dollar parity depreciated by 16 per cent during this period.
– There was some use of foreign currency reserves, which reduced holdings from
$ 26.4 billion in August 1997 to $ 23.9 billion in June 1998. However, by December 1998 the
reserves level had recovered to $ 27 billion.
– A series of financial sector reforms were undertaken in the period 1992 to 1997 which
had helped to strengthen the financial sector.
– Prudential limits on exposure of financial intermediaries to stocks and real estates were
quite stiff and helped to reduce systemic risks.
– Although export growth had already slowed in 1996-97, the current account deficit
remained well within manageable limits.
– While foreign direct and portfolio investors in India and external lenders enjoyed
complete convertibility, resident firms and individuals were subject to strict capital controls. In
June 1997, an official expert committee (Tarapore Committee) came out with a report
recommending a phased implementation of capital account convertibility. Its timing, virtually
coincident with the onset of the east Asian crisis, meant that the recommendations would be
treated with more than the normal dose of official caution!

Despite these very favourable circumstances, India did not remain completely immune from
the gales of financial turbulence roaring through Asian markets. Between August 1997 and
January 1998, the foreign exchange market was subject to repeated bouts of speculative
pressure. In both spot and forward markets, there were persistent excess demand conditions
and considerable volatility. To give just one indicator of persistent pressure, outstanding
forward sales of foreign currencies by the Reserve Bank surged from negligible levels in early
August 1997 to over $ 3 billion by January 1998. Despite such massive intervention in the
forward market, the six-month forward premium rose from 3.6 per cent in July 1997 to 14.6
per cent in February 1998, before declining thereafter.
To cope with this spillover of east Asian contagion (to some extent compounded by domestic
political uncertainty) monetary authorities deployed a range of measures, which included:
– Substantial intervention by RBI in both spot and forward exchange markets to curb
excessive volatility. Basically, the RBI conducted dollar sales and swap operations in these
markets to put brakes on the depreciation of the rupee. The operation was fraught with
substantial uncertainty and tension and required the ‘hands on’ engagement of the RBI
governor in daily operational decisions.
– Exchange rate flexibility to the tune of 8 per cent depreciation between July 1997 and
February 1998, with respect to the US dollar. Such flexibility was essential to the success of
the overall effort to contain the risks of destabilisation. But it was not easy to achieve in the
background of considerable discomfort at political levels with nominal exchange rate
depreciation.
– A phased tightening of monetary policy from November 1997, culminating in a mid-
January 1998 package which raised the Bank rate and the fixed repo rate by 2 per cent,
increased reserve requirements (CRR) and raised the interest surcharge on bank credit for
imports.
These measures had a salutary effect. By March 1998 foreign currency reserves had climbed
back to $ 26 billion, the six month forward rate had dropped below 10 per cent, and RBI’s
outstanding forward sales of foreign currencies had been rolled back below $ 1.8 billion. With
calm restored in forex markets, the Reserve Bank quickly loosened the monetary policy reins,
reducing the Bank rate and the CRR to pre- January levels of 9 per cent and 10 per cent
respectively and phasing down the short-term fixed repo rate to 5 per cent by mid-June.
(F) Pay Commission and Resurgence of Fiscal Pressure

The Fifth Pay Commission (FPC) had presented its report in 1996. Negotiations between
central government employee unions/associations and the government dragged on for many
months. The main decisions were finally taken by the United Front (Gujral) government in
September 1997 and entailed pay increases in excess of those recommended by the FPC for the
overwhelming majority of government employees. A normally sober observer commented,
‘There is hardly any parallel to this fiscal profligacy in the last 50 years since independence’
[Godbole 1997]. The budgetary implications for the central government were very substantial
and only became fully apparent by 1999-2000 as the follow-up decisions for various employee
categories and payment of arrears were finalised and the pension implications became clearer.
As in the past, state governments also felt obliged to follow suit and it took a little time for the
wage and pension increases to be reflected in budgetary data.

Table 23 presents available time series on employee compensation and pension payments at
central and state (including union territories) level. The sharp increases in all the relevant
aggregates after 1996-97 are readily apparent. However, it would not be correct to attribute the
entire increase to decisions on the FPC Report, since the data show modest upward trends in
the years leading up to 1996-97. It is virtually impossible to isolate the FPC-related increases
in the absolute numbers post 1996- 97. But if we focus on the trends as ratios of current price
GDP, the stability in the ratios up to 1996-97 and sizeable increases thereafter become obvious
(Table 24). Given the earlier stability, it is a reasonable approximation to attribute the increases
in the ratios between 1996-97 and 1999-2000 to FPC effects.
Thus the 40 per cent plus increase in the ratio of employee compensation to GDP from 1.6 per
cent in 1996-97 to 2.3 per cent in 1999-2000 for the centre accounts for well over half the
deterioration in the revenue deficit from 2.4 to 3.5 per cent of GDP over this period and for a
little under half of the widening in the fiscal deficit from 4.1 to 5.4 per cent of GDP. While,
quite obviously, many other things were going on during this period in the centre’s fiscal trends,
the FPC effects were clearly crucial.
At the state level too, the ratio of employee compensation to GDP stays virtu ally unchanged
at 3.8 per cent of GDP between 1993-94 and 1996-97 and then rises to 4.7 per cent in 1999-
2000, a sizeable increase of 0.9 per cent of GDP. However, since other factors were also
weakening state finances during this period, this increase constitutes ‘only’ about half of the
worsening in the state’s revenue deficit and over 40 per cent of the widening in the fiscal deficit
over these three years. Taking both levels of government together, Table 24 shows a large
increase in the employee compensation ratio from 5.4 per cent of GDP in 1996-97 to 6.9 per
cent in 1999-2000. This increase of 1.5 per cent points of GDP accounts for over half of the
worsening in the consolidated revenue deficit and for almost half the increase in the
consolidated fiscal deficit over these three years. Whatever else may have been happening, the
FPC effects constitute the single largest adverse shock to India’s public finances in the last
decade, with corresponding negative consequences for aggregate savings and investment in the
economy.
Given the magnitude of the fiscal shock, attempts to make offsetting policy corrections were
surprisingly modest at both central and state levels. At the centre, the government raised the
special duty on customs (imposed in the previous budget) from 2 to 5 per cent, increased the
foreign travel tax and sought to reduce by 5 per cent expenditure on items other than plan,
defence, interest, salaries and transfers to states. The disinvestment target for the year was also
raised. In the event, the quantitative yield from these temporary measures proved modest and

did not prevent slippage in the fiscal deficit target for the year. The relative inaction at all
governmental levels may have been due partly to the temporally extended unwinding of the
budgetary implications, spread as they were over different governments at the centre and
(some) states, and partly to serious underestimation of the implications for major components
like pensions. The inevitability of the pay and pension increases, once the basic decisions had
been made in 1997, may have also played a role. We have dwelt on the resurgence of fiscal
pressure in recent years, with the consolidated fiscal deficit climbing back to exceed the pre-
crisis height of 9.4 per cent of GDP by 1999-2000 and the consolidated revenue deficit scaling
new peaks above 6 per cent of GDP. One interesting issue these disturbing new trends have
posed is: why hasn’t this marked deterioration in the fiscal balance triggered pressure on the
external accounts in the way that happened in the late 1980s? Despite the widening of the fiscal
deficit, the current account deficit in the balance of payments has remained at or below one per
cent of GDP in the last three years. What explains this lack of correlation between the two
deficits?
The answer to this apparent conundrum may lie with the anaemic behaviour of investment in
relation to savings. While high revenue deficits and low public savings have pulled down the
rate of aggregate savings in the economy, aggregate investment has also fallen substantially
from its peak in 1995-96. Compared to 1990-91, both public and private investment were
significantly lower in 1999- 2000 and 2000-01 as proportions of GDP, entailing a relatively
small excess of domestic investment over domestic savings (equal, in ex post accounting, to
the size of the current account deficits). The uncomfortable obverse of this explanation is that
if investment rates recover (or domestic savings fall further) we could well see a resurgence
in external account deficits.
(G) Economic Sanctions, Onions and Oil Prices
As we saw earlier, an orthodox monetary squeeze in January 1998 had successfully restored a
semblance of normalcy to the turbulent forex market by March. But the Asian crisis had not
gone away. It continued to cloud the international economic environment throughout 1998 and
posed further challenges to Indian macroeconomic management.
The somewhat delicate situation in the forex market was complicated further when the new
BJP-centered coalition government of March 1998 conducted nuclear tests in May, provoking
economic sanctions by several industrial countries, especially the United States. The main
economic content of these sanctions was the cessation of fresh commitments of loans and

credits from the World Bank and the Asian Development Bank and a number of bi- lateral
donors. Since it usually takes more than a year for commitments to translate into disbursements,
the direct, short-term impact of these measures on flows of external assistance was negligible.
But the sanctions triggered a downgrade of India by some international credit agencies and
worsened an already difficult climate for private capital flows, leading to significant net
outflows by foreign institutional investors (FII) in the summer of 1998. Despite a reversal of
trends later in the year, net foreign portfolio investment turned negative in 1998-99 for the first
and only year in the nineties (Table 9). Flows of direct investment also dropped by more than
a billion dollars from their 1997-98 peak of $ 3.6 billion. As a result, total foreign investment
in India slumped to $ 2.4 billion, less than half of the $ 5.4 billion received in the previous year.
The reversal of FII inflows and the downgrade in credit ratings heightened uncertainty and
reignited pressures on the rupee. The Reserve Bank countered with a combination of dollar
sales and allowing limited market-driven depreciation of the rupee-dollar parity. Between May
and July, the RBI sold $ 2.5 billion to support the rupee. Despite market intervention of this
magnitude the rupee’s exchange rate slipped from 39.7 per dollar at the beginning of May to
42.4 in mid-June. There- after, the forex market stabilised for a couple of months. In mid-
August the contagion from the Asian crisis swept Russia into a severe financial crisis. This
event renewed speculative pressure on the rupee. As in January, the RBI responded with its
third line of defence – monetary tightening. The CRR was raised by one per cent to 11 per cent
and the short-term fixed repo rate was hiked from 5 to 8 per cent. In order to focus the tightening
of liquidity at the short end of the market and minimise any hardening of rates and credit
availability in longer-term funds (against a back- drop of sluggish industrial investment), the
Bank rate was left unchanged.
As in January, the monetary squeeze calmed the forex market. Matters were greatly helped by
the successful fruition of the government’s Resurgent India Bond (RIB) initiative, announced
in its June budget. Recognising the emerging confidence problem in external finance, the
government had authorised the scheme of five-year RIBs floated by the State Bank of India
and subscribed by NRIs. The dollar interest rate of 7.75 per cent was fairly competitive with
quasi-sovereign offerings by other emerging market economies with comparable credit ratings.
To protect SBI finances from exchange risk, the bulk of it was borne by the government and
RBI. The RIB initiative was successful. It raised $ 4.2 billion at a crucial time when access to
regular international market channels had become expensive and confidence in India’s external
finances was at some risk. The successful RIB flotation in August/September quickly raised
foreign exchange reserves to above April levels and restored substantially confidence in India’s

ability to manage her external finances in a difficult situation.
The first half of 1998-99 was a testing time for macro managers. Against a background of
unrelenting pressure on external finances, there was an unexpected flare up in food prices,
especially onions and potatoes, in the period May to November 1998. In September onion
prices were 400 per cent higher than a year ago and potatoes prices were up 250 per cent! Prices
of some pulses and edible oils also rose. By November 1998 the CPI(IW) had risen by an
unprecedented 20 per cent (from a year ago) and the food component of the index was 25 per
cent higher. The political discomfort from this sudden spike in vegetable prices was very
considerable and spawned various administrative efforts to counter the unexpected supply
shortfalls in commodities in which the government did not normally command any capacity to
manage supply. Partly thanks to these efforts but mainly because of market induced restoration
of normalcy in supply/demand balances, the surge in food prices subsided quickly. By March
1999 the food component of the CPI(IW) showed only 7 per cent annual inflation. Indeed, the
annual inflation rate as per the WPI barely exceeded 7 per cent in the worst months of July and
November 1998 before subsiding to 5 per cent by March 1999.
The very sharp increase in consumer prices and the modest rise in the WPI posed a difficult
conundrum for monetary policy in the autumn of 1998. While the price trends called for a
further tightening of monetary policy, the continuing slack in industrial production and
investment pointed towards easing of credit conditions. The RBI correctly diagnosed the supply
shock driven price rise as temporary and largely self-correcting and therefore refrained from
tightening monetary policy further. The deceleration of inflation by March 1999 vindicated this
judgement and permitted reduction of the Bank rate to 10 per cent and the fixed repo rate to 6
per cent. The CRR was backed down to 10 per cent in early May.
Looking back, it is clear that the broadly successful management of external sector pressures
in 1997-1998 and 1998-99 was greatly aided by the largely fortuitous coincidence of low
international prices for oil. Oil prices declined throughout 1997 and 1998 from a previous peak
above $ 20 per barrel in late 1996 to a little over $ 10 per barrel at the end of 1998. As a result,
India’s oil import bill declined from over
$ 10 billion in 1996-97 to $ 8.2 billion in 1997-98 and $ 6.4 billion in 1998-99. The extra
leeway of nearly $ 4 billion in 1998-99 was probably crucial to the successful management of
the problems of contagion, sanctions and confidence during the year.
This good fortune changed in 1999. For a variety of largely unpredicted reasons oil prices
rebounded vigorously in 1999 and continued to surge upwards throughout 2000, rising above
$ 30 per barrel in the latter half of the year. The implications for India’s oil import bill were

equally dramatic. Oil imports rose above $ 10 billion in 1999-2000 and to nearly $ 16 billion
in 2000-01. Compared to 1998-99 India was paying $ 800 million per month extra in 2000-01
for its oil imports. As these payments mounted inexorably, foreign exchange reserves dropped
from $ 38 billion at the beginning of the fiscal year to $ 35 billion in October and the rupee
depreciated from Rs. 43.3 per dollar to Rs 46.4 per dollar. The problem of waning confidence
feeding speculative pressures again surfaced in the summer of 2000 . Faced by this rising oil
import bill the government followed a three-pronged strategy to deal with the problem. First,
to prevent oil import payment pressures from being transmitted into a large, additional fiscal
problem via Oil Pool Account deficits, the administered prices of petroleum products were
revised upwards in three tranches within a twelve-month period: in October 1999, in March
2000 and in September 2000. On two of these occasions the government courageously broke a
long-standing taboo and raised the price of kerosene. Second, recognising that increases in
domestic prices of oil were unlikely to bring about the necessary adjustment in the trade deficit
(essentially because of the low price- inelasticity of oil demand), and that the adjustment would
have to come from other imports and exports, the authorities did not resist unduly the market-
driven depreciation of the exchange rate that occurred between April and November. Third,
since adjustment takes time, the government mobilised exceptional balance of payments
financing to generate the necessary ‘breathing space’ and tackle the emerging confidence
problem. The means deployed was the India Millennium Deposit (IMD) scheme, which closely
paralleled the earlier RIB venture. Launched in late October and closing in early November,
the IMD scheme mobilised $ 5.5 billion of five-year funds at 8.5 per cent interest in dollars.
Although deemed unduly expensive by some observers, these resources certainly solved the
confidence problem and helped take foreign exchange reserves to a new peak of $ 42.4 billion
by the end of 2000-01. Aside from expense, the IMD issue may have been ‘too successful’ in
the sense that it prevented the rupee from depreciating enough to facilitate the economy’s
adjustment to higher oil prices (and to the lifting of the final tranches of quantitative restrictions
on imports that occurred in 2000 and 2001).
IV
Institutional Reforms in Macroeconomic Policy
(A) Fiscal Policy
Perhaps the most significant advance in the methodology of fiscal policy in India that occurred
during the decade was in the institutionalisation of the concept of ‘fiscal deficit’. In retrospect,
it is quite remarkable that a dozen years ago the concept of ‘fiscal deficit’ was notable by its

absence from official government documents such as Budgets and Economic Surveys. The
concept first appears in the 1989-90 Survey, published in February 1990, which stated (p 75):
The central government budget deficit as conventionally defined has fluctuated around 2 per
cent of GDP in recent years... The conventional budgetary deficit does not indicate the full
measure of overall deficit and the government’s draft on domestic savings and dependence on
external savings. A fuller measure of the overall deficit, which is commonly used
internationally, is the difference between government expenditure and net lending on the one
hand and current revenue and grants on the other. Measured thus, the overall deficit of the
central government increased from 6.1 per cent of GDP in 1980-81 to 8.2 per cent in 1988-89
(RE).
The rest, as they say, is history. Within a year or two, tables on fiscal deficit and attendant
concepts had become routine in Budgets and Surveys, the fiscal deficit had become the focus
of the macro dimension of fiscal policy in all relevant contexts and had firmly supplanted the
earlier, more limited concept of budget deficit. This transition was probably accelerated by the
IMF programmes of the early 1990s which naturally focused heavily on fiscal consolidation.
A second important change in the conduct of fiscal policy was in the shift of central
government borrowings to market interest rates. Before 1991, the increases in government
borrowing programmes were accommodated through hikes in the statutory liquidity ratio
(SLR) imposed on commercial banks. By 1990 the SLR had risen steeply to 39 per cent. This
captive market facilitated placement of government securities at sub-market rates and imposed
a corresponding tax on financial intermediation by the banks. From 1992- 93 government
borrowing shifted to market interest rates (usually determined by auction of government paper)
and the SLR was progressively reduced. While this change did not help the fiscal accounts, it
was an important component of financial sector reform. Government borrowing at market rates
was also an essential prerequisite for the development of a healthy secondary market in
government securities, which, in turn, was a necessary pre- condition for the evolution of
monetary policy.
In 1994 the central government under- took a major initiative to curb its hitherto unrestricted
access to the Reserve Bank to finance its deficits. Before 1994 the government could
unilaterally access RBI financing through the device of ‘ad hoc’ Treasury bills. What is more,
throughout the eighties the government routinely used this route to meet its requirements for
funds and such monetisation of the deficit became the principal propellant for the expansion of
reserve money. On average, changes in net RBI credit to the central government accounted for
93 per cent of the variations in reserve money [Rangarajan 1995]. Recognising that such

automatic monetisation of the deficit undermined severely the scope for discretionary monetary
policy, the government formalised an agreement with the RBI in September 1994 to phase out
‘ad hoc’ Treasury Bills over a three-year period. The phase out duly occurred and at the end of
the three years a new system of ways and means advances was instituted, which placed clear
limitations on the government’s automatic access to RBI financing. Knowledgeable observers
have judged this delinking of budget deficits from their monetisation as a landmark event in
India’s fiscal/monetary institutional history.
Earlier, we assessed the enormous fiscal shock from the decisions taken on the Fifth Pay
Commission . One unexpected consequence has been the institutionalisation of greater central
government involvement in the fiscal reforms of states. Against a background of extreme
pressure on state finances the National Development Council met in February 1999 and
mandated the union finance minister and a representative group of state chief ministers and
finance ministers to evolve a medium-term strategy to address the fiscal problem of states. This
led to advance financial assistance to states (over and beyond assistance through the normal
channels of centre- state financial relations such as tax devolution and central assistance for
state plans) in support of agreed programmes of medium-term fiscal reform.12 This innovation
of conditional central assistance for state fiscal reforms was later supported by the
recommendations of the Eleventh Finance Commission.
Finally, in December 2000 the Fiscal Responsibility and Budget Management (FRBM) Bill
was introduced in parliament. The bill is based on the work of an expert committee and draws
on the international experience with fiscal responsibility legislation. If enacted in its present
form, it would have profound implications for the conduct of India’s fiscal policy. Amongst its
major features are:
– Reduction of the centre’s revenue deficit to nil by March 2006;
– Reduction of the fiscal deficit to 2 per cent of GDP by March 2006;
– Reduction of the ratio of central government liabilities to GDP to 50 per cent by March
2011;
– Quarterly review of fiscal trends (in relation to budget) placed before parliament;
– Proportionate cuts in expenditure when there is shortfall of revenue or excess of
expenditure over budget targets.
Basically, the FRBM is an effort to institutionalise the medium-term process of fiscal
consolidation through a legislative mandate. It will be interesting to see if it receives
parliament’s approval in its present form.
Looking ahead, a remarkable new document has charted the desirable course of reform in

institutions and procedures for fiscal policy. This is the (Ahluwalia) Report of the Advisory
Group on Fiscal Transparency [Reserve Bank 2001b].
(B) Monetary Policy
The reforms in the institutional framework and operational procedures for monetary policy in
the nineties were even more far-reaching than in the case of fiscal policy. Prior to 1991, the
unrelenting series of high fiscal deficits, the system of administered interest rates and
automatic magnetisation of budget deficits (through ‘ad hocs’) had placed monetary and
financial policy in an unsustainable bind. The foremost authority of the period noted
[Rangarajan 1994:
Until the overall reform process was initiated in 1991, the basic goal of monetary policy was
to neutralise the impact of the fiscal deficits. Monetary management took the form of
compensatory increases in the cash reserve ratio (CRR) for banks, controls on growth of
commercial credit (mainly to the enterprises sector) and adjustments of administered interest
rates.
Basically, banks were obliged to fund most of the large fiscal deficits at sub- market rates to
meet the high and rising SLRs imposed, while the remainder was necessarily accommodated
by the RBI through the medium of ‘ad hoc’ Treasury bills, which the government could (and
did) issue at will. The deleterious results of this system included an unsustainably high tax on
financial intermediation (pre- emption through reserve requirements cumulated to 63.5 per cent
of new bank deposits by 1991!), suppression of the allocative role of interest rates in money
and credit markets, stunted development of these markets and severe constraints on
discretionary monetary policy.
Against this background, the key themes in the reform of the institutional framework and
operational procedures for monetary policy have been:
– Phased reduction in the reserve requirement ratios of CRR and SLR;
– Phased liberalisation of interest rates;
– Elimination of direct credit controls;
– Development of money and financial markets, beginning with those for government
securities and bills;
– Restraints on automatic monetisation of budget deficits;
– Activation of open market operations (OMO) by RBI to influence liquidity;
– Policy focus on interlinkages across various segments of financial markets;

– Restoration of the Bank Rate as a signalling instrument for monetary policy
These broad themes have been pursued with considerable success throughout the decade. Here
I will confine my remarks to a few salient features.
The shift of new central government borrowing to market interest rates (through auctions) from
April 1992 was a crucial prerequisite for the development of government securities markets,
without which RBI could not conduct open market operations. This shift was successful in
placing all primary issues in the market without significant devolvement on RBI, despite a
substantial reduction in the SLR. The demand for government paper was obviously interest-
elastic. Demand may also have been buttressed by the zero-risk rating of government paper in
the new Basle-type capital adequacy norms that were being phased in for banks as part of a
broader effort to strengthen prudential and supervisory norms in the financial sector. The need
for undertaking OMO arose very soon with the surge in foreign capital inflow in 1993-94, when
RBI sold more than Rs 9,000 crore of government securities in the secondary market to
moderate this liquidity surge. Thus, within two years of moving away from the ‘ancient
regime’, RBI was conducting successful OMO policy in the secondary market for government
securities.
To buttress OMO operations for liquidity management RBI also developed repos (repurchase
agreements) between RBI and commercial banks. The first such auction of repos, collateralised
by central government securities, occurred in December 1992. Repos have focused on the
short- end of the market with periods ranging from overnight to 14 days. Normally, repos mop
up liquidity. Over time ‘reverse repos’ have also evolved to allow the RBI to inject short-term
liquidity into the market. The use of OMO and repos developed over the course of the decade
with the RBI expressing a clear preference for these ‘indirect’ instruments of monetary
management over ‘direct’ changes in reserve requirements (CRR). The stated medium- term
policy on the CRR was to reduce it, since it was viewed as a tax on financial intermediation.
Thus, in 1996-97 the CRR was reduced by 4 per cent points from 14 to 10 per cent; but to
moderate the resulting expansion in liquidity, OMO was deployed to mop up more than Rs
10,000 crore. On occasion, such as January 1998 and Au- gust 1998, the RBI has felt compelled
to temporarily increase the CRR to deal with special contingencies.13 But the general
preference has been for a secular decline in the CRR, currently ruling at 7.5 per cent compared
to 15 per cent plus 10 per cent incremental CRR in 1991.
As OMO and repos have come to the fore as preferred instruments of monetary control, so has
the once dormant Bank Rate. By 1997 interest rates had been substantially liberalised. In April
1997 the Bank Rate was reactivated as a signalling rate, with several key rates, including the

RBI general refinance rate, linked to it. In 1998 and 1999 the Bank Rate was effectively
deployed to signal the stance of monetary policy and influence prime lending rates of banks.
By the spring of 1999 monetary policy had evolved to establish an informal corridor for short-
term interest rates, with the fixed repo rate providing the floor and the Bank Rate the ceiling
[Reddy 1999].
By April 1999 the RBI’s general refinance window had been replaced by a collateralised
lending facility (CLF) in the context of the new interim liquidity adjustment facility (ILAF).
Access to the CLF, at the Bank Rate, was limited by a transparent, quantitative formula.
Beyond that there was further access to an additional CLF at 2 per cent above the Bank Rate.
The LAF operations have evolved further with repo and reverse repo auctions setting a ‘de
facto’ corridor for money market rates. Together with outright OMO in government securities
and Treasury bills the RBI now marshals an effective array of instruments to influence liquidity
and short-term interest rates. As Reddy (2001) observes:
With the announcement of the second phase of LAF, the RBI has moved gradually from a
system of segmented refinance to a more interlinking or interspersing system of liquidity
adjustment at market-related rates.
This evolution in the transmission mechanisms for monetary policy has been facilitated greatly
by the abolition of ‘ad hoc’ Treasury Bills and the institution of the new system of limited ways
and means advances (WMA) since 1997. But progress has been hampered by the series of large
and growing fiscal deficits since 1997-98. Although the abolition of ‘ad hocs’ has cut the
automatic link between deficits and monetisation, the problem has not gone away. As the
manager of government debt, the RBI too often faces the unpalatable choice between seeing
interest rates rise uncomfortably in primary auctions of government securities and
accommodating government debts on its books through the medium of private placement.
Indeed, this latter mechanism goes against the spirit of the WMA accord, although it does leave
the timing and extent of monetisation to the discretion of RBI. Basically, reforms in operational
procedures cannot, in themselves, control the leviathan!
The nineties have also witnessed some evolution in the ultimate objectives of monetary policy.
Until at least the middle of the decade official pronouncements continued to emphasise the
hallowed twin objectives of growth and price stability. Following the subsequent turbulence in
forex markets and RBI’s preoccupation with restoring or maintaining orderly conditions in
these markets, a third objective appears to have joined the pantheon. By early 1999, the RBI’s
articulate deputy governor was explicitly stating [Reddy 1999], “Apart from these two
important goals, there has been a conscious attempt on the part of the Reserve Bank in recent

years to maintain orderly conditions in the foreign exchange market . . . ”
This expansion in the set of ultimate objectives of monetary policy was accompanied by a
similar increase in complexity in the case of intermediate targets. From the time of the
Chakravarty Committee Report [Reserve Bank 1985] to 1997-98 the annual growth in broad
money (M3) had held sway as the sole, explicit intermediate target of monetary policy. With
the liberalisation of financial markets in the nineties and the growing importance of external
economic transactions, matters have changed. Based on substantial technical work [e g,
Reserve Bank 1998], the RBI announced in 1998-99 in favour of a “multiple indicator
approach”, which would encompass interest rates, exchange rate and other variables. In
practice M3 appears to continue as the single most important intermediate target. But it has
clearly lost its exclusivity.
The conceptualisation and practice of monetary policy has clearly undergone a sea change
during the nineties. Key institutional reforms have been carried out. New institutions and
operational procedures have been established and strengthened. The array of instruments of
monetary policy has been effectively broadened. The complexity of market interactions has
been recognised. Overall, monetary policy at the end of the decade was a far more sophisticated
operation than at its beginning. But some of the old problems and dilemmas remain. In
particular, the efficacy of monetary policy continues to be constrained by an excessively loose
fiscal policy as well as an insufficiently responsive financial system.
(C) Exchange Rate Policy
The transition to a market-determined exchange rate was the key institutional reform which
was crucial for the success of both macroeconomic management and structural reforms in the
first half of the nineties. We have already described how India moved to a unified, market-
determined rate by March 1993 and to full current account convertibility by August 1994.
After the initial 30 months of stability in the nominal rupee-dollar parity up to August 1995
(roughly coterminous with the period of large capital account sur- pluses), the nominal rate has
varied in line with underlying conditions in the forex market, as modified by occasional bouts
of RBI intervention to counter unusual speculative pressures.
During these past half a dozen years there has been little change in the institutional framework
for India’s exchange rate policy. However, there has been a great deal of on-the-job learning
by RBI of the nitty-gritty of monitoring the forex market and its linkages with the domestic
money market and of the arduous activity of central bank intervention in spot and forward forex

markets. Also, RBI has, in recent years, evolved a doctrine or view to support its brand of
managed floating [Reserve Bank 2001]. This view, based on the experiences of east Asia,
Russia, Mexico and Brazil (and more recently Turkey and Argentina), perceives high real
economic costs from ‘contagion’ effects in currency markets and places a premium on damping
volatility. In RBI’s view [Reserve Bank 2001a, p 10], “India’s exchange rate policy of focusing
on managing volatility with no fixed target while allowing the underlying demand and sup-
ply conditions to determine the exchange rate movements over a period in an orderly way has
stood the test of time.”
The dilemmas of a managed float in today’s world are real and I have discussed them elsewhere
[Acharya 1999]. Part of the problem stems from the ‘thinness’ of the forex markets, both spot
and forward. But such ‘thinness’ itself is partly a result of a cautious approach to currency
convertibility. With capital account convertibility (for residents) still very distant in India, it is
not surprising to find somewhat shallow forex markets which are potentially vulnerable to
swings in expectations and herd mentality. At the same time, the east Asian crisis has driven
home the downside risks of capital account convertibility in the absence of a really strong,
well-regulated financial sector. The only viable medium-term solution is to acquire the
requisite strength in the financial sector and cautiously tread the path towards full capital
account convertibility.
One recent important institutional reform in this area has been the modernization of the legal
framework brought about by the passage of the Foreign Exchange Management Act (FEMA)
in December 1999. Its provisions came into effect in June 2000 and supplanted the earlier
Foreign Exchange Regulation Act (FERA). FEMA takes current account convertibility as a
base and allows for progressive liberalisation of the capital account. It is more transparent than
FERA and, unlike FERA, is a civil law. Nor does it embody the FERA’s fearsome presumption
of mens rea, which placed the burden of proving innocence on the citizen.
In a longer perspective the key ‘institutional’ advance in this area has perhaps been in the
mindset of policy-makers. Before the nineties ‘foreign exchange shortage’ was the foundation
on which a rickety structure of bad economic policy was built. The typical response to an
exchange shortage or reserve loss was to further tighten import controls. The nineties have
changed all that. Foreign exchange is seen to have a price, the exchange rate, which plays a
pervasive allocative function in the economy. Faced by temporary pressures in forex markets
policy-makers now respond with a sensible mix of rate flexibility, market intervention and
monetary policy. To a significant (though, by no means complete) extent the exchange rate has
been ‘depoliticised’.

(D) Men and Institutions
Institutions and procedures do not alone make economic policy. Conception, implementation
and articulation of policy also requires people. Part of India’s apparent success with
macroeconomic performance and institutional reforms in the nineties may be attributed to the
people who manned the levers of economic policy. It was an unusually talented and cohesive
team. To begin with, India was blessed by a succession of three very able ministers, starting
with the remarkable Manmohan Singh. Singh had earlier held every serious economic
manager position (including Governor, RBI, Deputy Chairman, Planning Commission,
Secretary for Economic Affairs and Chief Economic Adviser) and knew the Indian economy
inside out. He quickly assembled half a dozen or so top officials in the ministry of finance
(MoF) and RBI, who shouldered the day-to-day responsibilities of economic management, not
only during his five-year tenure from 1991 to 1996 but also for much of the remaining years of
the decade.
This core group of econocrats at MoF and RBI provided exceptional continuity to economic
management in the nineties. Apart from their individual talents, there were several other factors
which amplified the policy effectiveness of these officials. First, they were experienced; almost
all of them had served earlier in macro policy positions a rung or two below the level they
attained in the nineties. Second, they remained at the top for unusually long tenures, partly
because they had entered public service laterally at relatively young ages and partly thanks to
the raising of the retirement age in 1997. Both factors contributed to continuity. Third, the
group displayed unusually strong rapport and teamwork. Most had worked as colleagues in the
eighties. Some were close friends of many years. All had mutual respect. The density of
informal professional interaction was exceptional and enhanced the conduct of economic
management. Fourth, these officials held similar views on the paradigm and priorities of Indian
economic policy. The disagreements were minor, the common ground enormous. Last, these
men commanded substantial credibility and respect as professionals both at home and in
international economic and financial circles.
By the middle of 2001 this core team had largely dispersed from the MoF/RBI citadels of
macroeconomic policy (with the exception of Jalan and Reddy at the RBI) and it is a matter of
some interest whether a similar, cohesive and enduring group could be rebuilt soon to deal with
ongoing challenges of macroeconomic policy.
V

Macroeconomic Challenges Ahead
The nineties have ended but macroeconomic challenges continue. In this concluding section
I discuss briefly some of the main problems that confront macroeconomic policy today and
are likely to pose continuing challenges in the years ahead.
First and foremost is the enduring problem of the fiscal deficit. As we saw earlier, with a
consolidated general government deficit of around 10 per cent of GDP India has the dubious
privilege of being in the top three countries in worldwide fiscal deficit rankings. The ratio of
central and state government debt to GDP also stands impressively high at about 70 per cent.
Our own economic history and that of many other countries point to the unsustainability of
such high ratios and to the enormous economic toll they exact. Furthermore, the problem of
debt sustainability is likely to become more pressing if the present slowdown in economic
growth continues. The sooner there is significant and enduring progress in fiscal consolidation
the better it will be for overall macroeconomic performance, the health of the financial sector
and the economy’s capacity for coping with unforeseen external or internal shocks. The best
medium-term hope in this regard is the Fiscal Responsibility and Budget Management Bill
tabled in parliament in December 2000. Much will depend on its legislative fortunes. In the
short run there is no substitute for determined efforts at expenditure containment, better cost
recovery and revenue mobilisation at all levels of government. In any case, even if the FRBM
Bill is enacted in its present form, meeting its targets will require the same set of coordinated
and comprehensive policies for fiscal consolidation.
Second, recent months have brought home the high economic costs that can emanate from a
weak and inefficient financial sector. It is a drag on overall economic performance, generates
periodic and large claims (through bail-outs of foundering financial institutions) on an already
weak fiscal, weakens significantly the competitiveness of Indian firms and can profoundly
cloud the climate for business investment. Prescriptions for necessary financial sector reform
have been around for a long time, for example the ‘second’ Narasimham Committee report on
banking sector reforms [Government of India 1998] and the report on restructuring weak public
sector banks brought out by the RBI [Reserve Bank 1999]. The challenge is to move forward
with implementing the key prescriptions in the face of political and administrative opposition.
Indeed, in some areas the time may have come to go further than some of the recommendations
in these reports.
Third, the challenge of a sluggish industrial economy continues. To a substantial extent, real
progress with fiscal consolidation and financial sector reform will enhance the climate for
industrial investment and improve the availability and terms of financing. This will certainly

help the industrial sector. But some of the solutions to the problem lie outside the realm of
macro policy. For example, successful reform of rigid labour laws, small-scale reservation
policy and ill-functioning infrastructure sectors is crucial for improving industrial
productivity and investment. Unless these problems are seriously tackled the best macro
policy will only have limited impact on boosting industrial growth. Nor does the oft-touted
solution of ‘pump priming’ have much credibility when fiscal deficits are already so
dangerously high. And sector-specific tax sops (often advocated by industry associations)
could set back seriously the genuine progress achieved in tax reform without accomplishing
any lasting favourable impact on overall industrial growth. In- deed, a continuing challenge for
economic policy will be to avoid inappropriate and ill-conceived solutions to the very real
problem of growth slowdown.
In the external sector some disquieting signs have emerged in recent years. Export growth in
dollars has slowed to average below 10 per cent in the last five years and the outlook for 2001-
2002 and beyond is clouded by the slowing world economy and our weakening international
competitiveness. Foreign investment has fallen substantially from the peak level of 1996- 97.
The future debt service profile has to navigate the redemption humps of RIBs and IMDs. Until
now these weaknesses have been outweighed by the continued buoyancy of inward remittances
and software exports and the sluggishness of non- oil import growth. But the tide could turn,
especially if exports of both goods and services are hurt seriously by the global slowdown
which began in the second half of 2000. In the short run this will pose a challenge for
appropriately flexible exchange rate management. In the medium term, there is no alternative
to improving the underlying productivity and competitiveness of the economy through the
wide range of structural reforms indicated earlier.
Policy will also have to contend with tensions between the priorities for stabilisation on the one
hand and structural reform on the other. An important example of this is in tax policy. To
enhance our competitiveness and reduce the policy bias against exports it is important to reduce
our still exceptionally high customs tariffs. But with customs revenue still accounting for about
30 per cent of the central government’s gross tax revenues, reductions in customs tariffs will
have to be carefully managed to avoid missing fiscal deficit targets. The solution to this
dilemma is to increase the proportion of tax revenues coming from direct taxes and domestic
commodity/service taxes, notably central excise. It is relatively simple to state the necessary
direction of change, much harder to carry it out in practical policy.
In the decades ahead, there is likely to be growing need to coordinate the central government’s
budget policy with that of the states. Already we have seen the rising share of state deficits in

consolidated deficits of the centre and states. This has had serious implications for the
management of overall fiscal policy. Coming to grips with this problem will necessarily require
changes in the existing pattern of inter-government fiscal relationships – a difficult task in the
best of circumstances. The recent injection of some conditionality in central financial assistance
to states (linked to medium-term fiscal reform at the state level) may have to be strengthened.
The key objective has to be the reversal of the recent deterioration in the states’ fiscal positions.
Without such improvement both macroeconomic stability and development momentum will
remain exposed to substantial risks.
Finally, there is urgent need to recapture the growth momentum of the mid-nineties, not only
in industry but in all sectors of the economy. Most of the policy initiatives necessary to achieve
this overarching objective are of a sectoral or structural nature. They entail reforms in
agriculture, health and education, infrastructure, energy sector, industrial policy, labour laws,
public enterprises and the financial sector. Some of the reforms have already been announced
and await implementation. Others have been identified but not yet decided upon.17 At the level
of macro policy, the key elements for restoring the growth momentum are successful fiscal
consolidation, the evolution of a more flexible, market- responsive exchange rate policy and a
supportive monetary policy. Without a decisive and sustained resurrection of the economy’s
growth momentum, the prospects for rapid increase in gainful employment and quick reduction
of India’s poverty will become distant.

Bibliography:
1. D.N Dwivedi, Macroeconomics Theory and Policy, ( 4th Edition, McGraw Hill
Education IndiaPrivate Limited, 2015)
2. N. Gregory Mankiw, Macroeconomics, 4, (7th Edition, Worth Publishers, 2009)
3. Olivier Blanchard, Macroeconomics, 271, (7th edition, Pearson, 2017)
4. G. C. Harcourt, Kahn and Keynes and the making of "The General Theory",
https://www.jstor.org/stable/24231844?seq=1#page_scan_tab_contents
5. Dr. Rajshree R, Need of Green Accounting,
http://www.iosrjournals.org/iosr- jbm/papers/Conf.17037-2017/Volume-4/7.%2039-
43.pdf,( 4/9/2019 10:04 AM)
6. Acharya, S., 2002. Macroeconomic management in the nineties. Economic and
Political Weekly, pp.1515-1538.

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HIMACHAL PRADESH NATIONAL LAW UNIVERSITY, SHIMLA

Course Contents and Reading Material: B.A./B.B.A.-LL.B. (HONS)

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B.B.A. LL.B. Paper Code: BL 202

SUBJECT: E c o n o m i c s - I I (Macro Economics)

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3.1 Money, Functions, Quantity theory of money

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Economics is regarded as the oldest discipline. However, as students of economics might be

Gardner Ackley: “Macroeconomics concerns the overall dimensions of economic life.

P. A. Samuelson and W. D. Nordhaus: “Macroeconomics is the study of the behaviour of the

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To be sure, macroeconomics is a young and imperfect science. The macroeconomist’s ability

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Comparative Static Analysis Comparative static analysis is a comparative study of

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Macroeconomics, like any theoretical branch of economics, uses a set of theoretical

However, in order to study a macroeconomic phenomenon, macroeconomists divide the

A macroeconomic model is constructed by a systematic process as described below: (i)

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Aggregate demand and aggregate supply are defined, respectively, as follows.

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where C = aggregate consumption expenditure; I = investment spending; G = government

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Measurement of national income is a part of the process of estimating national income. It is

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3. NNP = GNP – Depreciation (or Capital Consumption)

4. PI = NNP – (Undistributed Company Profits + Surplus of Public Undertakings + Rentals

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Some Accounting Relationships

2. GNP (at market price) less depreciation = NNP at market price

5. NDP at factor cost – [surplus of public undertakings + profits of statutory corporations +

Accounting of National Income

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Sectoral Classification of Economy

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2. Forestry and logging,

4. Mining and Quarrying.

II. Secondary sector

5. Electricity, water and gas supply.

III. Tertiary sector

A.Transport, Trade and Communication

1. Transport, storage and communication

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5. Trade, hotels and restaurants.

B.Finance and Real Estate

1. Banking and insurance

2. Real estate for residential and business purposes

1. Public administration and defence

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Rules and approaches of Measurement of GDP

Methods of Measuring National Income

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1. Agricultural and allied services,

2. Forestry and logging,

4. Mining and Quarrying, and

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