UNIT III

Recall the production function

And Recall the concept of national income
Do you see a link between the usage of resources and
the income level?
Actual Output: The output and therefore the income which is
generated in the economy at the prevailing level of
employment.

Potential Output: The level of output which the economy

would produce if all the factors were fully employed.
Potential output is a shifting-goalpost!
 Relationship between income and employment is direct
 If a portion of the workforce and/or capital remains unemployed or
underemployed, the corresponding level of income is called the
underemployment level of income or less-than-full-employment level of income.
 If there is no underemployment or unemployment of inputs, the economy
operates at the full-employment level of income.
 Full-employment level of income is the maximum beyond which a nation's
income cannot go without procuring more inputs and/or improving technology.
 A nation which operates at an underemployed level of income must design its
macro management strategy to achieve full employment.
Out of the two factors of production - labor and capital, which
should be of a greater concern?
 IMPORTANT CONCEPTS

 Labor force
 Labor force participation rate
 Working population
 Primary labor market
 Voluntarily
 Secondary labor market
unemployed
 Gig workers
 Employed
CLASSICAL VIEW

Assumptions:
Laissez Faire economy
Perfect competition in factor and product markets
Wages and Prices are flexible
Closed Economy
Money - merely a medium of exchange
CLASSICAL VIEW ON INCOME AND EMPLOYMENT

 Supply creates its own demand. So, an economy is always in

equilibrium (product markets)
 An economy always enjoys full employment (equilibrium in factor
markets)
 Money plays an insignificant role
BUT IN SHORT RUN…

Actual output may deviate from potential output

Short run fluctuations define the business cycles that are

experienced by various economies
THE GREAT DEPRESSION

World economy’s experience over 1929-1939

 Worst experience in US, Europe, relatively mild in Latin America, Asia
 Industrial production fell by more than 40%
 GDP declined by nearly 30%
 Wholesale prices fell by at-least 30%
 Unemployment touched almost 25%
 Average family income fell by 40%
 Around 11,000 banks failed; more than $1 billion in bank deposits were lost, nearly
300,000 companies went out of business
The ‘short run deviations’ created havoc in most economies
and lives
Classical view/propositions could not act as ‘the savior!’
ALTERNATE VIEW – J. M. KEYNES

If an economy is in a state of recession or depression, the way to get out

of it is to increase the level of spending by government intervention.
This is the essence of the Keynesian theory.
KEYNESIAN VIEW

Assumptions:
 All prices and wages are fixed at given levels; involuntary
unemployment prevails
View:
 Operating at less than full employment level, the supply expands to
meet demand
 Actual output = Aggregate demand
IN A TWO SECTOR ECONOMY

Aggregate expenditure/Aggregate demand

AD = C + I
CONSUMPTION DEMAND

Consumption Function: C = f (Y)

C = a + bY

Does the HH sector consume all that it earns?

ACTIVITY 3.1
Find S, APC, MPC, APS, MPS

Y C
0 20
100 100
200 180
300 260
400 340
500 420
ACTIVITY 3.2

Prove that: MPC + MPS = 1

INVESTMENT DEMAND

Investment demand means firms’ desired additions to their

physical capital and inventories

Investment demand depends upon the current guesses about

future demand for their output
PRODUCT MARKET EQUILIBRIUM (SHORT RUN)

When AD or planned aggregate spending equal the output that is actually

produced
i.e. AD = Y

If AD < Y, there is unplanned addition to stocks

If AD > Y, there is unplanned reduction in stocks
ACTIVITY 3.3

C = 8 + 0.7Y, I = 22
Find the equilibrium level of national income.

If ΔI = - 9
What is the new Y?
MULTIPLIER

It reflects how much the output changes when there is a

change in AD
Formula
Graphical presentation
WHAT IF – PEOPLE ARE KEEN ON SAVING?

Discouraging saving is tough!

Adverse impact on C means…firms may not invest as they
foresee weak demand
What will happen to Y?
The economy will settle at an underemployment equilibrium
KEYNESIAN PROPOSITION

In an underemployed economy, the government can play a

significant role in case demand is not forthcoming from the
Households or the Firms
 FISCAL POLICY

Taxation
Expenditure
Public debt
Budget
BUDGET POSSIBILITIES

 G = T (Balanced Budget)

 G < T (Surplus Budget)

 G > T (Deficit Budget)

GOVERNMENT INTERVENTION

 AD = C + I + G
 Increase in G will have a multiplied effect on Y (the same way as the
increase in I)
 ΔY = kΔG
 In recessionary times, increased G can increase AD and the
equilibrium level of output
ACTIVITY 3.4

 C = 200 + 0.5 Y I = 450 G = 200 Find the equilibrium national

income
 If ΔG = 100, find the new Y
 What is the value of k?
 How much increase in government spending is required to attain
potential output of 2500?
Why does the Government show so much interest in
lowering unemployment?
GOALS OF FISCAL POLICY

 Economic growth
 Balanced regional growth
 Encourages private investment
 Provisioning public goods
 Re-distribution of income and wealth
 Enabling consumption
TYPES OF FISCAL POLICY

 Expansionary fiscal policy

 Contractionary fiscal policy
OUTCOMES MAY/MAY NOT BE DESIRED

Crowding In
Crowding Out
WHAT ROLE IS HIGHLIGHTED BY THESE EXAMPLES?

 Registrar of Companies
 Telecom Regulatory Authority of India
 Food Safety and Standards Authority of India
 Securities and Exchange Board of India
 National Pharmaceutical Pricing Authority
 Bureau of Indian Standards
 NEED FOR REGULATORY ROLE OF THE STATE

 To check externalities

 To check asymmetric information

 To check anti-competitive practices

 To promote public interest

CLASSIFICATION OF REGULATION IN INDIA

 1947- mid1980s
 Web of controls (licensing, quota restrictions, etc.)
 Cases of direct control
 Regulations were not independent
 1985 onward
 De-licensing, abolition of restrictions, simplification of procedures
 1991
 Liberal and simplified foreign trade and capital movements
 Formation of independent regulators for specific sectors
PRESENTLY

 Domestic reforms and external liberalization is continuing

 Complexities exist
 Complete independence of regulatory bodies is desired
YET SOME OTHER FUNCTIONS PERFORMED BY THE STATE

 To provide basic infrastructure for smooth functioning of business

activities

 To create institutions that support business activities

 To formulate policies that ensure free and fair business operations

and expansion
EXAMPLES

 Federation of Indian Export Organizations

 Small Industries Development Bank of India
 Coffee Board
 Indian Rubber Manufacturers Research Association
 Gem and Jewellery Export Promotion Council
 Khadi and Village Industries Commission
 Council for Leather Exports
REVISIT


Relationship between income and employment is direct

Concepts: actual output vs. potential output; underemployment level of income vs. full-employment level
of income; Labor force vs. Working population; Voluntarily unemployed; LFPR; primary vs. secondary
market; gig economy

Classical view on income and employment

Keynesian view on income and employment

Fiscal policy: composition, goals, types; trend; Union Budget FY23

Crowding In; Crowding out

Regulatory role of State

Facilitation by State

Entrepreneurial role of State