EEP-I

Lecture 2
Batch 2019-21
Classical economics and Keynesian economics
• The classical economist extended the theory of Adam Smith. Carried
by David Ricardo, Alfred Marshal, C. Pigou.
• Malthus was only classical economist who emphasis demand side
and introduced a term Effective demand(ED).
• ED further modified by J.M.Keynes
Classical economics Keynesian economics
Laissez-fair approach, market is perfect Market is imperfect and not self sustaining
Government spending is not a major market force Government policy can influence demand

Output and employment is determines by Level of output is a function of employment and

production function i.e. demand for labour and employment is determined by AD for goods and
supply of labour services

Both Demand and supply for labour are functions of Demand for labour depend so on real wage but
real wages supply for labour depends on money wage

The equilibrium of NI is determined at the level of Money market equilibrium and interest rate
full employment. determination by AD and AS of Money.

In LR economy is always in equilibrium. Neither Demand deficiency can be removed through

overproduction nor under production Government spending
 The National Income Accounts for the Great Depression in the U.S.
(1992 Prices)

Government
YEAR GDP Consumption Investment Purchase Exports Imports

1929 790.9 593.9 92.4 105.4 35.6 46.3

1930 719.7 562.1 59.8 116.2 29.4 40.3

1931 674.0 544.9 37.6 121.2 24.4 35.2

1932 584.3 496.1 9.9 117.1 19.1 29.2

1933 577.3 484.8 16.4 112.8 19.2 30.4

1934 641.1 519.0 31.5 127.3 21.4 31.1

1935 698.4 550.9 58.0 131.3 22.6 40.7

1936 790.0 606.9 75.5 152.5 23.7 40.2

1937 831.5 629.7 94.0 147.0 29.9 45.3

1938 801.2 619.5 61.3 157.8 29.6 35.2

1939 866.5 654.0 79.5 171.8 31.2 36.9

1940 941.2 688.0 111.3 174.2 35.4 37.8

Fallacy of aggregation….which states that what is true for
individual may not be true for the aggregate or that the total may not
equal the sum of the parts.

year Household 1 Household 2 Economy

Y1t C1t MPC1t Y2t C2t MPC2t YNt CNt MPCNt

2004 50000 40000 80% 90000 80000 89% 140000 120000 86%

2014 100000 70000 70% 50000 45000 90% 150000 115000 77%

Where, N= 1+2+….+n

So, if the assumption of MPC is fixed for all household Macro

functions would follow Micro function but actually it doesn’t follow
Individual consumptionAggregate consumption
function is: function is:
Cjt = aj + bjYjt ………….(1.1) Ct = A +B Yt ………….(1.2)
Cjt – consumption expenditure Ct – consumption expenditure of
household j (j=1,2,…..n) in of all households in period t
period t
aj – autonomous consumption A – autonomous consumption
of household j of all households
bj – marginal propensity to consume B- marginal propensity to
of household j consume in the country
Yjt – income of household j in period Yt – income of all households
t (national income) in period t
aj > 0, bj >0 A,B > 0
Measuring National Income of a
country
 Overview

1. Why an economy’s total income equals its

total expenditure or value added.
2. How Gross Domestic Product (GDP) is
defined and calculated.
3. Distinguish between real and nominal GDP
and see if GDP measures economic well-
being.
 Circular Flow of Income(CFI) - Simple economy

Assumptions:
1) Neither the household save from their income nor the firms save
for profits
2) Government does not play any role
3) Economy neither export nor import
Two sector model without financial market

Factor
Factorpayments
payments Expenditure
Expenditureon
on
Goods
Goods and
and
services
services
 Two sector model with financial market

Expenditure
Expenditureon on
Factor
Factor Goods
Goods and
and services
services
payments
payments Or
OrConsumption
Consumptionof of
domestic
domestic
produced
produced products
products
(C
(Cdd)) Net
Net
saving
saving(S)
(S)
 Cont..Two sector model with financial market

Expenditure
Expenditureon on
Factor
Factor Goods
Goods and
and services
services
payments
payments Or
OrConsumption
Consumptionof of
domestic
domestic
produced
produced products
products
(C
(Cdd)) Net
Net
saving
saving(S)
(S)
The CFI in two sector model with financial
market
 The inner flow
 Withdrawals
– net savings
 Injections
– investment
 Conclusion 1
National Expenditure (E)= C+I….(1)
Where C= consumption expenditure,
I= Private investment, and

National Income(Y)= C+S…..(2)

Where C= consumption,
S= saving

Therefore, C+I=C+S
Or, I=S
 Cont.. Three sector model

Investment
Investment(I)
(I)
Government
Government
Consumption expenditure
expenditure(G)
(G)
Consumption of of
Factor
Factor domestically
domestically
payments
payments produced
producedgoods
goods
and
andservices
services(C
(Cdd))

Net
Net
Net
Net taxes
taxes(T)
(T)
saving
saving(S)
(S)
 The CFI in three sector model
 The inner flow
 Withdrawals
– net savings
– net taxes
 Injections
– investment
– government expenditure
 Conclusion 2
National Expenditure (E)= C+I+G….(1)
Where C= consumption expenditure,
I= Private investment, and
G= Government Expenditure

National Income(Y)= C+S+T…..(2)

Where C= consumption,
S= saving
T= Tax
Therefore, I+G=S+T
Or, G-T=S-I

If G>T, government will have budget deficit. To finance the budget deficit,
government will borrow money from financial markets. Then private
investment (I) by business firm must be less than saving(S). I<S

Thus government borrow tends to decrease in private investment

 Conclusion 3
National saving= Private Saving + Public Saving

We know that,
Y= C+I+G
or, I=Y-C-G
Therefore, Y-C-G= (Y-C-T) +(T-G)

NATIONAL SAVING= PRIVATE SAVING + PUBLIC SAVING

 Four sector model

Investment
Investment(I)
(I)
Government
Government
Consumption expenditure
expenditure(G)
(G)
Consumption of of
Factor
Factor domestically
domestically BANKS GOV. ABROAD
payments
payments produced
producedgoods
goods
and
andservices
services(C
(Cdd))
Import
Import
Net
Net expenditure
Net
Net expenditure(M)
(M)
taxes (T)
taxes (T)
saving
saving(S)
(S)
 Cont…Four sector model

Export
Export
expenditure
expenditure(X)
(X)
Investment
Investment(I)
(I)
Government
Government
Consumption expenditure
expenditure(G)
(G)
Consumption of of
Factor
Factor domestically
domestically BANKS GOV. ABROAD
payments
payments produced
producedgoods
goods
and
andservices
services(C
(Cdd))
Import
Import
Net
Net expenditure
Net
Net expenditure(M)
(M)
taxes (T)
taxes (T)
saving
saving(S)
(S)
 The CFI in four sector model
 The inner flow
 Withdrawals
– net savings
– net taxes
– import expenditure
 Injections
– investment
– government expenditure
– export expenditure
 Conclusion 4
National Expenditure (E)= C+I+G +NX….(1)
Where C= consumption expenditure,
I= Private investment, and
G=Government Expenditure
NX= net export (X-M)
National Income(Y)= C+S+T…..(2)
Where C= consumption,
S= saving
T= Tax
Therefore, I+G + NX=S+T
From equation 1, NX=Y-(C+I+G)
=NDP –Aggregate Expenditure
1) If NDP>ADE ( we export the excess)
2) If NDP<ADE ( we import the shortfall)
 Conclusion 5
National Expenditure (E)= C+I+G +NX =Y….(1)
Or, Y-C-G=I+NX
or, National saving = I+N
S=I+NX
S-I =NX
NX is also known as trade balance
1) If trade balance>0, Export > import
2)If trade balance<0, Export < import
 Circular flow of income as a whole
• The circular flow of income shows leakages (withdrawals) from the
national income, which are not part of expenditure on national
product. These are: savings(s), taxes(t) imports(M)
• The circular flow of income shows injections(additions) into
expenditure on national product. These are: investment(I), government
expenditure(G), and export(X)
• Therefore, to hold the equilibrium, total planned leakages should be
equal to total planned injections i.e:
S+T+M=I+G+X

The above equation indicates that in an open economy there can

be three gaps/ imbalances:
• Investment-savings gap
• Fiscal deficit/surplus gap
• Current account(of balance of payment)deficit/surplus