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					INTRODUCTORY MICROECONOMICS
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KOMUNITAS BLOGGER UNIVERSITAS SRIWIJAYA



  INTRODUCTORY MICROECONOMICS UNIT-I PRODUCTION POSSIBILITIES CURVE
The production possibilities (PP) curve is a graphical medium of highlighting the central
problem of \'what to produce\'. To decide what to produce and in what quantities, it is first
necessary to know what is obtainable. The PP curve shows the options that are obtainable, or
simply the production possibilities. What is obtainable is based on the following assumptions: 1.
The resources available are fixed. 2. The technology remains unchanged. 3. The resources are
fully employed. 4. The resources are efficiently employed. 5. The resources are not equally
efficient in production of all products. Thus if resources are transferred from production of one
good to another, the cost increases. In other words marginal opportunity cost increases. The last
assumption needs explanation because it determines the shape of the PP curve. If this assumption
changes, the shape changes. Efficiency in production means productivity i.e. output per unit of
an input. Let the input be worker. Suppose an economy produces only two goods X and Y.
Suppose a worker is employed in production of X because he is best suited for it. The economy
decides to reduce production of X and increase that of Y. The worker is transferred to Y. He is
not that efficient in production of Y as he was in X. His productivity in Y will be low, and so
cost of production high. The implication is clear. If the resources are transferred from one use to
another, the less and less efficient resources will be transferred leading to rise in the marginal
opportunity cost which is technically termed as marginal rate of transformation (MRT). What is
MRT? Marginal Rate of Transformation (MRT) To simplify, let us assume that only two goods
are produced in an economy. Let these two goods be guns and butter, the famous example given
by Samuelson. The guns symbolize defense goods and butter, the civilian goods. The example,
therefore, symbolizes the problem of choice between civilian goods and war goods. In fact it is a
problem of choice before all the countries of the world. Suppose if all the resources are engaged
in the production of guns, there will be a maximum amount of guns that can be produced per
year. Let it be 15 units (one unit may be taken as equal to 1000, or one lakh and so on). At the
other extreme suppose all the resources are employed in production of butter only. Let the
maximum amount of butter that can be produced is 5 units. These are the two extreme
possibilities. In between there are others if the resources are partly used for the production of
guns and partly for production of butter. Given the extremes and the in-between possibilities, a
schedule can be prepared. It can be called a production possibilities schedule. Let the schedule
be: 2 Production Possibilities Schedule Possibilities Guns Butter MRT = Guns (units) (units)
Butter A 15 0 - B 14 1 1G : IB C 12 2 2G : IB D 9 3 3G : IB E 5 4 4G : IB F 0 5 5G : IB In the
table the possibility A is one extreme. The society devotes all the resources to guns and nothing
to butter. Suppose the society wants one unit of butter. Since resources are limited and fully and
efficiently employed, to produce one unit of butter some of the resources engaged in production
of guns have to be transferred to the production of butter. Let the resources worth one unit of gun
are enough to produce one unit of butter. This gives us the second possibility with MRT =
1G/IB. Now suppose that the society wants another unit of butter. This requires transfer of more
resources from the production of guns. Now we require transfer of resources worth 2 units of
guns to produce one more unit of butter. The MRT rises to 2G/IB. MRT rises because now less
efficient resources are being transferred. In this way MRT goes on rising. We can now define
MRT in general terms. MRT is the ratio of units of one good sacrificed to produce one more unit
of the other good. MRT = Units of one good sacrificed____ = Guns More units of the other good
produced Butter Or, MRT is the rate at which the quantity of output of one good is sacrificed to
produce on more unit of the other good. Production Possibility Curve By converting the schedule
into a diagram, we can get the PP curve. Refer to the figure I which is based on the PP schedule.
Butter\'s production is shown on the x-axis and that of guns on the y-axis. We can measure MRT
on the PP curve. For example MRT between the possibilities C and D is equal to CG/GD.
Between D and E it is equal to DH/HE, and so on. 3 Diagrammatically, the slope of the PP curve
is a measure of the MRT. Since the slope of a concave curve increases as we move downwards
along the curve, the MRT rises as we move downwards along the curve. Characteristics A
typical PP curve has two characteristics: (1) Downward sloping from left to right It implies that
in order to produce more units of one good, some units of the other good must be sacrificed
(because of limited resources). (2) Concave to the origin A concave downward sloping curve has
an increasing slope. The slope is the same as MRT. So, concavity implies increasing MRT, an
assumption on which the PP curve is based. Can PP curve be a straight line. Yes, if we assume
that MRT is constant, i.e. slope is constant. When the slope is constant the curve must be a
straight line. But when is MRT constant? It is constant if we assume that all the resources are
equally efficient in production of all goods. Note that a typical PP curve is taken to be a concave
curve because it is based on a more realistic assumption that all resources are not equally
efficient in production of all goods. Does production take place only on the PP curve? Yes and
no, both. Yes, if the given resources are fully and efficiently utilized. No, if the resources are
underutilized or inefficiently utilized or both. Refer to the figure 3. On point F, and for that
matter on any point on the PP curve AB, the resources are fully and efficiently employed. On
point U, below the PP curve or any other point but below the PP curve, the resources are either
underutilized or inefficiently utilised or both. Any point below the PP curve thus highlights the
problem of unemployment and inefficiency in the economy. 4 Can the PP curve shift? Yes, if
resources increase. More labor, more capital goods, better technology, all mean more production
of both the goods. A PP curve is based on the assumption that resources remain unchanged. If
resources increase, the assumption is broken, and the existing PP curve is no longer valid. With
increased resources there is a new PP curve to the right of the existing PP curve. It can also shift,
to the left if the resources decrease. It is a rare possibility but sometimes it may happen due to
fall in population, due to destruction of capital stock caused by large scale natural calamities,
war, etc. 5 UNIT-II CONSUMER\'S EQUILIBRIUM _ Introduction A consumer is one who
buys goods and services for satisfaction of wants. The objective of a consumer is to get
maximum satisfaction from spending his income on various goods and services, given prices.
We start with a simple example. Suppose a consumer wants to buy a commodity. How much of
it should he buy? One of the approaches used for getting an answer to this question is \'utility\'
analysis. Before using this approach, we would like to familiarize ourselves with some basic
concepts used in this approach, _ Concepts The term utility refers to the want satisfying power of
a commodity. Commodity will possess utility only if it satisfies a want. Utility differs from
person to person, place to place, and time to time. Marginal Utility is the utility derived from the
last unit of a commodity purchased. It can also be defined as the addition to the total utility when
one more unit of the commodity is consumed. Total Utility is the sum of the utilities of all the
units consumed. As we consume more units of a commodity, each successive unit consumed
gives lesser and lesser satisfaction, that is marginal utility diminishes. It is termed as the Law of
Diminishing Marginal Utility. The following utility schedule will make the Law clear. Units of a
commodity Total (utils) Utility Marginal (utils) Utility 1 4 4 (=4-0) 2 7 3 (=7-4) 3 9 2 (=9-7) 4
10 1 (=10-9) 5 10 0 (=10-10) 6 9 -1 (=9-10) Here we observe that as more units are consumed
marginal utility declines. This is termed as the law of diminishing marginal utility. The law states
that with each successive unit consumed the utility from it diminishes. Assumptions The utility
approach to consumer\'s equilibrium is based on certain assumptions. 6 1. Utility can be
cardinally measurable, i.e. can be expressed in exact units. 2. Utility is measurable in monetary
terms 3. Consumer’s income is given 4. Prices of commodities are given and remain constant.
Equilibrium (a) One commodity case Suppose the consumer wants to buy a good. Further
suppose that price of goods is Rs. 3 per unit. Lel the utility be expressed in utils which are
measured in rupees. We are given the marginal utility schedule of the consumer. Quantity Price
Marginal Utility 1 3 8 2 3 7 3 3 5 4 3 3 5 3 2 When he purchases the first unit, the utility that he
gets is 8 utils. He has to pay only Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because
he gets more than what he gives. Similarly, we compare the utility received from other units with
the price paid. We find that he will buy 4 units. At the 4th unit, MU equals price. If he buys the
5th unit, he is a looser because the utility that he gets is 2 utils and what he has to pay is Rs. 3.
Therefore, the consumer will maximize his satisfaction by buying 4 units of this commodity. The
condition for maximization of satisfaction if only one commodity is purchased then is: MU =
Price. (b) Two commodities case Suppose a consumer consumes only two goods. Let these
goods be X and Y. Given income and prices (Px and Py), the consumer will get maximum
satisfaction by spending his income in such a way that he gets the same utility from the last rupee
spent on each good. This is satisfied when MUx = MUy = M.U. of a rupee spent on a good. Px
Py We can show that in order to maximise satisfaction this condition must be satisfied. If it is not
satisfied what difference will it make. Suppose the two ratios are: MUx > MUy Px Py 7 It means
that per rupee MUx is higher than per rupee MUy. It further means that by transferring one rupee
from Y to X, the consumer gains more utility than he looses. This prompts the consumer to
transfer some expenditure from Y to X. Buying more of X reduces MUx, Px remaining
unchanged, MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Py
remaining unchanged it raises, per rupee MUy. The change continues till per rupee MUx
becomes equal to per rupee MUy. In other words : MUx = MUy = per rupee MU Px Py
CONCEPTS OF DEMAND AND DEMAND SCHEDULE Demand for a good is the quantity of
that good which a buyer is willing to buy at a particular price, during a period of time. Demand
schedule is a tabular presentation showing the different quantities of a good that buyers of that
good are willing to buy at different prices during a given period of time. Demand schedule of a
commodity Price (Rs. per unit) Quantity demanded (in units) 50 50 40 100 30 150 20 200 10 250
This schedule indicates that more is purchased as price falls. This inverse relationship between
price and quantity demanded, other thing remaining the same is called the law of demand.
RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND TOTAL
EXPENDITURE At this stage of learning it is sufficient to know the following about this
relationship: 1. When demand is elastic, a fall (rise) in the price of a commodity results in
increase (decrease) in total expenditure on it. Or, when a fall (rise) in the price of a commodity
results in increase (decrease) in total expenditure on it, its demand is elastic. 2. When elasticity is
unitary, a fall (rise) in the price of the commodity does not result in any change in total
expenditure on it, or when a fall (rise) in price results in no change in total expenditure then its
elasticity is unitary. 3. When demand is inelastic, a fall (rise) in the price of a commodity results
in a fall (rise) in total expenditure on it, or when a fall (rise) in the price of a commodity results
in decrease (increase) in total expenditure on it, its demand is inelastic. 8 Unit III PRODUCER’S
BEHAVIOUR AND SUPPLY Meaning of supply Supply means the quantity of a commodity
which a firm or an industry is willing to produce at a particular price, during a given time period.
Law of supply This law states that \'other things remaining the same\', an increase in the price of
a commodity leads to an increase in its quantity supplied. Thus, more of a commodity is supplied
at higher prices than at lower prices. This law can be explained with the help of a supply
schedule and curve. A supply schedule is a table which shows the quantities of a commodity
supplied at various prices during a given time period. Supply Schedule Supply Curve Price (Rs.)
Supply (Units) 1 100 2 200 3 300 As the price increases from Re. 1 to Rs. 3, the supply also rises
from 100 units to 300 units, in response to the rising price. What is the basis of the law of
supply? Other things remaining the same, an increase in price results in higher profits for the
producer. The higher the price of the commodity, the greater are the profits earned by the firms
and the greater is the incentive to produce more. Similarly when the price falls, profits decline,
resulting in a decrease in quantity supplied of the commodity. Thus the price and quantity
supplied of a commodity are directly related, other things remaining the same. ‘Change in
supply’ versus ‘change in quantity supplied’ (‘shift of supply curve’ versus ‘movement along a
supply curve’) The supply of a commodity depends on its own price and \'other factors\' like
input prices, technique of production, prices of other goods, goals of the firm, taxes on the
commodity etc. Movement along a supply curve The law of supply states the effect of a change
in the own price of a commodity on its supply, other things remaining constant. The supply curve
also carries the same assumption. Thus when other factors influencing supply do not change, and
only the own price of the commodity changes, the 9 change in supply takes place along the curve
only. This is what movement along a supply curve means. A movement from one point to
another on the same supply curve is also referred to as a change in quantity supplied”. In figure
7, OQ is the quantity supplied at price OP. When the price rises to OP1 the quantity supplied
increases to OQ1. Thus there is an upward movement along the supply curve from point A to B.
It is extension of supply. Similarly, when the price of a commodity falls from OP to OP2, there is
a decrease in quantity supplied from OQ to OQ2 and thus a downward movement along the
supply curve from A to C. It is contraction of supply. Movements along the supply curve are
caused by a change in the own price of the good only, other things remaining the same. Shifts of
the supply curve When supply changes due to changes in factors other than the own price of the
commodity, it results in a shift of the supply curve. This is also referred to as a “change in
supply”. An ‘increase’ in supply means more of the commodity is supplied at the same price. As
a result the supply curve shifts to the right. In figure 8, at price OP the previous supply was OQ
which increased to OQ1. This also means that OQ units can now be supplied at a lower price
OP1 with the new supply curve S1S1. An ‘increase’ in supply can take place due to many
reasons. For example, if the input prices fall or there is an improvement in technology, it will
enable producers to produce and sell more at the same price resulting in a rightward shift of the
supply curve. A decrease in supply means less of the commodity is supplied at the same price,
than previously. As a result, the supply curve shifts inwards to the left. In figure 9, at price OP,
previously OQ units were supplied which decreased to OQ1. This also means that OQ units can
now be supplied at a higher price OP1 with the new supply curve S1S1. 10 Shifts of the supply
curve of a good are caused by a change in any one or more of the \'other factors\' affecting
supply, own price remaining unchanged. For example, if the input prices fall or there is a
decrease in the prices of other related commodities, the producers supply more at the same price
resulting in a rightward shift of the supply curve. PRODUCER\'S EQUILIBRIUM The primary
objective of a producer is to earn maximum profits. Profit is the difference between total revenue
and total cost. At that level of output, he is in equilibrium at which he is earning maximum
profit, and he has no incentive to increase or decrease his output. If he produces less than this he
does not maximize total profits. Similarly, if produces beyond this, total profits decline. Thus the
producer is in a \'state of rest\' only at the level of output at which the difference between the
total revenue and total cost of production is maximum i.e total profits are maximum. (NOTE :
How does a producer reach equilibrium under different market conditions is not discussed at this
stage of learning). RELATIONSHIP BETWEEN MARGINAL COST (MC) AND AVERAGE
COST (AC) The relationship between marginal cost and average cost is an arithmetic
relationship. To understand this relationship let us take a numerical example. The table A shows
the marginal costs, total costs and average costs at different levels of output. Table A Output
Total cost Marginal cost Average cost (Units) (Rs.) (Rs.) (Rs.) (1) (2) (3) (4) 1 60 60 60 2 110 50
55 3 162 52 54 4 216 54 54 5 275 59 55 Column 1 shows the level of output. Column 2 shows
the total cost of producing different levels of output. Column 3 shows the increase in total cost
resulting from the production of one more unit of output. (It is called marginal cost. Thus MCn =
TCn - TCn-1, where n and n-1 are levels of output). Column 4 shows the average cost at
different levels of output (ACn = TCn ) n 11 This table shows that : 1. Average cost falls only
when marginal cost is less than average cost. Upto the third unit of output, the marginal cost is
less than the average cost and average cost is falling. When 2 units are produced the marginal
cost is Rs. 50 which is less than the previous average cost (Rs.60), now average cost falls from
Rs. 60 to Rs. 55. When 3 units are produced, the marginal cost is Rs. 52 which is less than the
average cost of 2 units (Rs. 55) so once again the average cost falls from Rs. 55 to Rs. 54. 2.
Average cost will be constant when marginal cost is equal to average cost. When 4 units are
produced, average cost does not change (It is Rs. 54 when 3 units are produced and remains Rs.
54 when 4 units are produced) because marginal cost (Rs. 54) is equal to average cost (Rs. 54). 3.
Average cost will rise when marginal cost is greater than average cost. When 5 units are
produced average cost rises from Rs. 54 to Rs. 55, because the marginal cost (Rs. 59) is greater
than the average cost (Rs. 54). This relationship between marginal cost and average cost is a
generalized relationship and holds good in case of the marginal and average values of any
variable, be it revenue or product etc. In the box a simple proof of the relationship is given : This
is for reference only For Reference only Suppose AC falls. Then : TCn < TCn-1 n n-1
Multiplying both sides by n we get, TCn < TCn-1 x n n-1 TCn < TCn-1 x (1 + 1 ) n-1 TCn <
TCn-1 + TCn-1 n-1 TCn - TCn-1 < TCn-1 n-1 Since the left hand side is MC, and the right hand
side is AC, it proves that MC < AC Thus a fall in average cost means marginal cost is less than
average cost. It can similarly be proved that a rise in average cost means, marginal cost is greater
than average cost and a constant average cost means marginal cost is equal to average cost. The
relationship between marginal cost and average variable cost is similar to the relationship
between marginal cost and average cost because marginal cost is not affected by fixed cost. (For
proof see box which is for reference only) 12 MCn = TCn - TCn-1 = [TFCn + TVCn] - [TFCn-1
+ TVCn-1] Since TFCn and TFCn are equal MCn = TVCn - TVCn-1 LAW OF VARIABLE
PROPORTION IN TERMS OF TP AND MP CURVES. (i) In terms of TP As more and more
units of variable factor are employed with fixed factor, total product initially increases at an
increasing rate then increases at decreasing rate and ultimately starts decreasing. 13 On the TP
curve in the diagram, upto point A, TP is increasing at an increasing rate. If more than 3 units of
variable factor are employed, total product still increases till 7units are employed but this
increase is at a diminishing rate. If beyond 7 units of variable factor are employed then TP starts
falling. These are the three respective phases of the law. (ii) In terms of MP MP increases upto 3
units. This is phase 1. MP falls after 3 units but is positive upto 7 units. This is phase 2. MP
continues to fall but is negative after 7 units. This is phase 3. Therefore, in phase 1 the MP curve
is upward sloping; downward sloping but above the X-axis in phase 2; and downward sloping
but below the X-axis in phase 3. (Note that TP is convex in phase 1; concave in phase 2; and
downward sloping in phase 3. This is how we can identify the three phases.) Returns to Scale
Introduction This topic is a part of study of production function. A production function is an
expression of quantitative relation between change in inputs and the resulting change in output. It
is expressed as : Q = f (i1, i2 ......in) Where Q is output of a specified good and i1, i2 ….in are
the inputs usable in producing this good. To simplify let us assume that there are only two inputs,
labour (L) and capital (K), required to produce a good. The production function then takes the
form : Q = f (K,L) In microeconomics, conventionally, we study two aspects of relation between
inputs and output. One aspect is : in what manner the change takes place in output of a good, if
only one of the inputs required in producing that good is increased, i.e. other inputs kept
unchanged? The manner of change in output is summed up in the law of variable proportions
which you have already studied. The second aspect is : in what manner the output of a good
changes, if all the inputs required in producing that good are increased simultaneously and in the
same proportion. This aspect is technically termed as returns to scale, and is the subject matter of
this study. The word \'return\' refers to the change in physical output. The word \'scale\' refers to
the scale of operation expressed in terms of quantum of inputs employed. Meaning Returns to
scale means the manner of change in physical output caused by the increase in all the inputs
required simultaneously and in the same proportion. Elaborating, suppose one unit of capital and
one unit of labour (1K + 1L), produce 100 units of output. Further suppose that both the 14
inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by just 100%; by
more than 100%, or by less than 100%. There is no unique answer. All the three states are
possible. The three states are respectively called Constant Returns to Scale (CRS), Increasing
Returns to Scale (IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three
states and then explain reasons. Constant Returns to Scale (CRS) Suppose 1K+1L produce 100
units of output, and 2K+2L produce 200 units of output. It is 100 percent increase in inputs
leading to just 100 percent increase in output. This manner of change in output is called CRS.
Increasing Returns to Scale (IRS) Suppose 1K+1L produce 100 units of output and 2K+2L
produce 250 units of output. It is 100 percent increase in inputs in leading to 125 percent increase
in output. This manner of change in output is called IRS. Decreasing Returns to Scale (DRS)
Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of output. It is 100
percent increase in inputs leading to only 80% increase in output. This manner of change in
output is called DRS. Which of the above states actually results depends to a great extent on the
type of technology used. There are technologies which result in IRS from the beginning and
continue upto a large output level. Similarly, there are technologies leading to CRS almost
throughout. There can also be technologies leading to DRS from the very beginning. Besides, it
is also possible that a technology is such that it gives IRS in the beginning, followed by CRS and
then DRS. For example: Returns to Scale Inputs %change Output %change Returns to scale
1K+1L - 100 - - 2K+2L 100% 250 125% IRS 3K+3L 50% 375 50% CRS 4K+4L 33.3% 450
20% DRS Why do IRS arise? There are two possible reasons: 15 1. More division of labour
Division of labour means subdividing a task into many small sequential operations, with each
worker (or a group of workers) assigned each operation. A single worker, instead of doing all the
operations, concentrates on only one operation and specializes. This raises efficiency of the
worker. Returns to scale means increasing the number of workers along with other inputs. More
workers mean more division of labour. If one task can be divided into 20 small operations, with
each worker assigned only one operation, the worker becomes an expert in the operation he is
assigned. Efficiency increases and so the production. In business circles, the division of labour
type production is called assembly line production. 2. Use of specialized machines More capital
means more capital goods and bigger capital goods. Fully automatic machines can replace the
semi-automatic or the hand operated machines. Bigger machines can be used in place of small
machines. Bigger capital goods can be used in place of smaller capital goods. It is a common
knowledge that a double size capital input may produce more than double the output. Let us take
an interesting example. Suppose a firm needs a wooden box to store goods. Suppose initially the
firm goes in for 1\'x1\'x1\' (LxBxH) size box. Let us see the input requirement and the resulting
output. Let the wood be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of
wood (=1\'x1\'). Then the input requirement = 1\'x1\'x6 = 6 sq.ft. The storing capacity of the box
is measured by its volume. Then : Output of the box : 1\'x1\'x1\' = 1 cubic ft. Let us now see
what happens when the size of the box is increased to 2\'x2\'x2\'. Input requirement = 2\'x2\'x6 =
24 sq.ft. Output = 2\'x2\'x2\' = 8 c.ft. Now compare. Input of the box rises from 6 sq.ft. to 24
sq.ft. i.e. by 300%. Output of the box rises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns
to scale arise. Remember that it may not go on for ever, i.e. we go on increasing the size and
continue to get IRS. A stage may reach when IRS may give way to CRS or DRS. Why do DRS
arise? Economists do not find any specific reason. DRS is a puzzle. Why output rises in a smaller
proportion when all inputs are increased? The probable explanation is that the firm finds it
difficult to manage and coordinate the activities arising out of larger scale. The difficulties may
lead to wastage, inefficiency etc. and cause DRS. 16 EQUILIBRIUM PRICE UNDER
PERFECT COMPETITION Meaning of equilibrium Equilibrium, in general terms. implies (a) a
balance between the opposite forces and (b) a state of rest or a situation that has a tendency to
persist. Let us take examples to show the application of these meanings in microeconomics. Let
us take a market situation in which buyers and sellers are negotiating to buy and sell a good.
Both have different prices to offer. But the good will be sold only when both agree to a common
price and a common quantity at that price. If both agree, a market equilibrium is said to emerge.
Note that buyers and sellers have opposite interests. The buyers will like to pay as low a price as
possible. The sellers will like to charge as high a price as possible. Agreement on a common
price and quantity creates a balance between the two opposite interests. This equilibrium price
and quantity has a tendency to persist. Equilibrium price Equilibrium price is the price at which
the sellers of a good are willing to sell the same quantity which buyers of that good are willing to
buy. We can explain this meaning with the help of market demand and supply schedule of a
good, given below : Price per unit Market demand Market supply Equilibrium (Rs.) (units)
(units) 1 1000 200 Excess demand 2 800 400 Excess demand 3 600 600 Market Equilibrium 4
400 800 Excess supply 5 200 1000 Excess supply Refer to the schedule. The market equilibrium
is established at a price of Rs. 3 per unit, because at this price both the market demand and
market supply are equal. This is the price which has a tendency to persist. Why is not any other
price an equilibrium price? Take, for example, a price less than the equilibrium price. Suppose it
is Rs. 2 per unit. At this price market demand is greater than market supply. It is called an excess
demand situation. But this price cannot persist. It will change. Why? It is because the buyers will
not be able to buy all what they want to buy. The pressure of excess demand will push the market
price up. This will have two effects. Supply will go up because the producers are willing to
supply more at a higher price. Demand will go down because the buyers are willing to buy less at
a higher price. In fact, this is what is required to restore equilibrium. The tendency of supply
going up and demand going down will continue till market supply becomes equal 17 to market
supply once again and the excess demand becomes zero. This is achieved at Rs. 3 per unit. The
equilibrium is restored. Let us now take a price higher than the equilibrium price. Suppose it is
Rs. 4 per unit. At this price now the market supply is greater than market demand. It is called an
excess supply situation. Even this price cannot persist. It is because the sellers will not be able to
sell all what they want to sell. The excess supply pressure will push the price downwards. This
will have two effects. Supply will go down and demand will go up. The tendency will continue
till market demand becomes equal to market supply once again, and the price settles at Rs. 3 per
unit. To sum up, the equilibrium price is the price at which market demand equals market supply.
This price has a tendency to persist. If at a price the market demand is not equal to market supply
there will be either excess demand or excess supply and the price will have tendency to change
until it settles once again at a point where market demand equals market supply. Graphic
Presentation The equilibrium is at E the intersection of supply and demand curves representing
the two schedules given above. The equilibrium price is Rs. 3 and equilibrium quantity 600 units.
The price higher than Rs. 3, creates excess supply and ultimately returns to Rs. 3 on account of
the effects explained above. The arrows indicate the tendencies. The price below the equilibrium
price creates excess demand and has a tendency to return to Rs. 3 per unit on account of the
effects explained above and indicated by the arrows. Can the equilibrium price change? Yes,
when demand or supply or both increase or decrease. \'Increase\', as you know, means rise in
demand or supply due to factors other than the own price of the good. Similarly the term
\'decrease\' is defined. Graphically, it means shift of demand curve, or supply curve or both. You
are familiar with these terms. You are expected to study the chain effects of shifts in demand and
supply on equilibrium price and quantity. 18 UNIT IV FEATURES OF PERFECT
COMPETITION Introduction Perfect competition is a state of a market. Anything which
facilitates contact between buyers and sellers constitutes a market. It may be a face to face
meeting at some place or simply verbal negotiations through telephone, internet, etc.
Conventionally, in microeconmoics the markets are classified into these states: perfect
competiton, monopoly, monopolistic competition and oligopoly. There are many criteria of
classification, the number of sellers, similarity of products, availability of information, mobility
of firms and the inputs engaged in the firm, etc. Whatever the criteria the end result is reflected
in one thing : how much influence an individual seller, on his own, is able to exercise on the
market. Lower the influence more the competitive nature of the market it indicates. If the
influence of an individual seller is zero, or virtually zero, the market is said to be perfectly
competitive. Meaning Perfect competition can be defined either in terms of its characteristic
features, or in terms of the unique end result of these characteristics. Unique in the sense that it is
specific to a perfectly competitive market. In terms of its features, a perfectly competitive is a
market where there are large number of buyers and sellers, the firms produce homogeneous
products, the buyers and sellers have perfect knowledge and the firm are free to entry or make an
exit in and out of industry. In terms of the end result of these features which is unique to this
market, a perfectly competitive market is one in which an individual firm cannot influence the
prevailing market price of the product on its own. Features and their implications A perfectly
competitive market has the following features: 1. Large number of sellers and buyers Note that
\'large number\' is not a specifically defined number. However, it has a specific implication. Let
us talk about the large number of sellers first. The words \'large number\' imply that the number
of sellers is large enough to render a single seller\'s share in total market supply of the product
insignificant. It has a further implication. Insignificant share means that if only one individual
firm reduces or raises its own supply, the prevailing market price remains unaffected. The
prevailing market price is the one which was set through the interaction of market demand and
market supply forces, for which all the sellers and all the buyers together are responsible. One
single seller has no option but to sell what it produces at this market determined price. This
position of an individual firm in the total market is referred to as price taker. This is a unique
feature of a perfectly competitive market. Similarly, the \'large number\' of buyers also has the
same implication. A single buyer\'s share in total market demand is so insignificant that the
buyer cannot influence the market price on his own by changing his demand. This makes a single
buyer also a price taker. 19 To sum up, the feature \'large number\' indicates ineffectiveness of a
single seller or a single buyer in influencing the prevailing market price on its own, rendering
him simply a price taker. 2. The products of all the firms in the industry are homogenous It
means that the buyers treat the products of all the firms in the industry as homogenous. The
products produced by the firms are identical, or treated as identical, or perfectly standardized.
The buyers do not distinguish the output of one firm from that of the other. The implication of
this feature is that since the buyers treat the products as identical they are not ready to pay a
different price for the product of any one firm. They will pay the same price for the products of
all the firms in the industry. On the other hand, any attempt by a firm to sell its product at a
higher price will fail. To sum up, the \'homogenous products\' feature ensures a uniform price for
the products of all the firms in the industry. 3. Perfect knowledge about markets for outputs and
inputs. The firms have all the knowledge about the product market and the input markets. Buyers
also have perfect knowledge about the product market. Let us take the product market first. The
implication of perfect knowledge about the product market is that any attempt by any firm to
charge a price higher than the prevailing uniform price will fail. The buyers will not pay because
they have perfect knowledge. There is no ignorance factor operating in the market. The sellers do
not charge a lower price due to ignorance. The buyers do not pay a higher price due to ignorance.
A uniform price prevails in the market. As regards the knowledge about the input markets, the
implicit assumption is that each firm has an equal access to the technology and the inputs used in
the technology. No firm has any cost advantage. Cost structure of each firm is the same. All the
firms have a uniform cost structure. Since there is uniform price and uniform cost in case of all
firms, and since profits equals cost less price, all the firms earn uniform profits. 4. Freedom to
firms to enter or to leave the industry in the long run Freedom of entry means that there are no
artificial barriers and natural barriers in the way of a new firm wishing to enter into industry. The
artificial barriers may take the form of patent rights, legal restrictions, etc. The natural barrier
may take the form of huge capital expenditure required to start a new firm, which the firm
wishing to enter is not able to arrange. Freedom of exit means no barriers in the way of a firm
deciding to leave the industry. Government rules, labour laws, loss of huge fixed capital etc. do
not come in the way. The freedom of entry and exit of firms has an important implication. This
ensures that no firm can earn above normal profits in the long run. Each firm earns just the
normal profits, i.e. minimum necessary to carry on business. In Microeconomics, normal profits
is treated as an 20 opportunity cost, and therefore, counted in calculation of total cost. Since
profit equals total revenue minus total cost, normal profit means zero economic profit. Why? Let
us explain. Suppose the existing firms are earning above normal profits, i.e. positive economic
profits. Attracted by the positive profits, the new firms enter the industry. The industry\'s output,
i.e. market supply, goes up. The price comes down. New firms continue to enter and the price
continues to fall till economic profits are reduced to zero. Now suppose the existing firms are
incurring losses. The firms start leaving. The industry\'s output starts falling, price starts going
up, and all this continues till losses are wiped out. The remaining firms in the industry then once
again earn just the normal profits. Only zero economic profit in the long run is the basic outcome
of a perfectly competitive market. Average Revenue and marginal revenue curves of a perfectly
competitive firm The forces of market supply (i.e. supply by industry) and market demand
(demand by all the buyers) determine the market price. The firm, being a price taker, adopts this
price and is free to sell any quantity it likes at this price. The price taker feature determines the
shape of the firms AR and MR curves. Refer to the figure -12 b The figure 12a shows the
intersection of demand and supply curves at E determining the price OP. The figure 12b shows
the adoption of price by the price taker firms who are free to sell any quantity, at this price. This
makes the AR curve perfectly elastic and thus parallel to the X-axis. As per the average marginal
relationship, when AR is constant, MR must be equal to AR. Therefore, AR curve is also the MR
curve of the firm.            1 PART B : INTRODUCTORY MACROECONOMICS UNIT 6 -
NATIONAL INCOME AND RELATED AGGREGATES SOME CONCEPTS CONCEPT OF
ECONOMIC TERRITORY INTRODUCTION National income accounting is a branch of
macroeconomics of which estimation of national income and related aggregates is a part.
National income, or for that matter any aggregate related to it, is a measure of the value of
production activity of a country. But, production activity where and by whom? Is it on the
territory of the country? Or, is it by those who live in the territory? In fact it is both. This raises
further question. What is the scope of territory? Is it simply political frontiers? Or, is it
something else? Who are those who live in the territory? Is it simply citizens? Or, it is something
else. The answer to these questions leads us to the concepts of (i) economic territory and (ii)
resident. The two have an important bearing on the estimation of national income aggregates.
How? We will explain it a little later. Definition The first thing to note is that economic territory
of a country is not simply political frontiers of that country. The two may have common
elements, but still they are conceptually different. Let us first see how it is defined. According to
the United Nations : Economic territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely. The above definition is
based on the criterion “freedom of circulation of persons, goods and capital”. Clearly, those parts
of the political frontiers of a country where the government of that, country does not enjoy the
above “freedom” are not to be included in economic territory of that country. One example is
embassies. Government of India does not enjoy the above freedom in the foreign embassies
located within India. So, these are not treated as a part of economic territory of India. They are
treated as part of the economic territories of their respective countries. For example the U.S.
embassy in India is a part of economic territory of the U.S.A. Similarly, the Indian embassy in
Washington is a part of economic territory of India. Scope Based on ‘freedom’ criterion, the
scope of economic territory is defined to cover: (i) Political frontiers including territorial waters
and air space. (ii) Embassies, consulates, military bases, etc located abroad,but excluding those
located within the political frontiers. (iii) Ships, aircrafts etc, operated by the residents between
two or more countries 2 (iv) Fishing vessels, oil and natural gas rigs, etc operated by the
residents in the international waters or other areas over which the country enjoys the exclusive
rights or jurisdiction. Implication National income and related aggregates are basically measures
of production activity. There are two categories of national income aggregates : domestic and
national, or domestic product and national product. Production activity of the production units
located within the economic territory is domestic product. Gross domestic product, net domestic
product are some examples. We will learn more about the implications after studying the concept
of resident. CONCEPT OF RESIDENT Introduction Note that citizen and resident are two
different terms. This does not mean that a citizen is not a resident, and a resident not a citizen. A
person can be a citizen as well as a resident, but it is not necessary that a citizen of a country is
necessarily the resident of that country. A person can be a citizen of one country and at the same
time a resident of another country. For example a NRI, Non-resident Indian. A NRI is citizen of
India but a resident of the country in which he lives. Citizenship is basically a legal concept
based on the place of birth of the person or some legal provisions allowing a person to become a
citizen. On the other hand residentship is basically an economic concept based on the basic
economic activities performed by a person. Definition A resident is defined as follows: A
resident, whether a person or an institution, is one whose centre of economic interest lies in the
economic territory of the country in which he lives. The ‘centre of economic interest’ implies
two things: (i) the resident lives or is located within the economic territory and (ii) the resident
carries out the basic economic activities of earnings, spending and accumulation from that
location Implications Production activity of the residents of an economic territory is national
product. GNP, NNP, are some examples. National product includes production activities of
residents irrespective of whether performed within the economic territory or outside it. In
comparison, domestic product inludes production activity of the production units located in the
economic territory irrespective of whether carried out by the residents or non-residents. 3
Relation between national product and domestic product The concept of domestic product is
based on the production units located within economic territory,operated both by residents and
non-residents. The concept of national product is based on residents, and includes their
contribution to production both within and outside the economic territory.Normally, in practical
estimates, domestic product is estimated first. National product is then derived from the domestic
product by making certain adjustments.Let us see how? National product is derived in the
following way: National product = Domestic product + residents contribution to production
outside the economic territory - non-residents contribution to production inside the economic
territory In practical estimates the resident’s contribution outside the economic territory is called
“factor income received from abroad”. The non-residents’ contribution inside the economic
territory is called “factor income paid to residents”. Therefore, National product = Domestic
product + Factor income received from abroad - Factor income paid to abroad. Factor income
received from abroad’ is added to domestic product because this contribution of residents is in
addition to their contribution to domestic product. ‘Factor income paid to abroad’ is subtracted
because this part of domestic product, does not belong to the residents. By subtracting factor
income paid’ from “factor income received” from abroad, we get a net figure “Net factor income
from abroad” popularly abbreviated as NFIA. National product = Domestic product + Net factor
income from abroad = Domestic product + NFIA INDUSTRIAL CLASSIFICATION
Introduction It means grouping production units into distinct industrial groups, or sectors. This is
the first step required to be taken in estimating national income, irrespective of the method of
estimation. It is statistically more convenient to estimate national income originating in a group
of similar production units rather than for each production unit separately. 4 It is now a matter of
general practice to group all the production units of the economic territory into three broad
groups : primary sector,secondary sector and tertiary sectors. Each of these sector can be further
subdivided into smaller groups depending upon the requirement. Let us now explain each sector.
Primary Sector Primary sector includes production units exploiting natural resources like land,
water, subsoil assets,etc. Growing crops, catching fish, extracting minerals, animal husbandry,
forestry, etc. are some examples. Primary means of first importance’. It is primary because it is a
source of basic raw materials for the secondary sector. Secondary Sector Secondary sector
includes production units which are engaged in transforming one good into another good. Such
an activity is called manufacturing activity. These units convert raw materials into finished
goods. Factories, construction, power generation, water supply are the examples. It is called
secondary because it is dependent upon the primary sector for raw materials. Tertiary Sector
Tertiary sector includes production units engaged in producing services. Transport, trade
education, hotels and restaurant, finance, government administration, etc are some examples.This
sector finds third place because its growth is primarly dependent onthe primary and secondary
sectors. NATIONAL INCOME AGGREGATES There are many aggregates in national income
accounting. The basic among these is Gross Domestic Product at Market Price (GDPmp). By
making adjustments in GDPmp, we can derive other aggregates like Net Doemstic product at
Market Price (NDPmp) and NDP at factor cost (NDPfc). Net Domestic Product Why is GDPmp
called gross? GDPmp is final products valued at market price. This is what buyers pay. But this
is not what production units actually receive. Out of what buyers pay the production units have
to make provision for depreciation and payment of indirect tax like excise, sales tax, etc. This
explains why GDPmp is called ‘gross’. It is called gross because no provision has been made for
depreciation. However, if depreciation is deducted from the GDP, it becomes Net Domestic
Product (NDP). Therefore, GDPmp - depreciation = NDPmp Domestic product at Factor Cost
Why is GDPmp called ‘at market price’ ? Out of what buyers pay, the production units have to
make payments of indirect taxes,if 5 any. Sometimes production units receive subsidy on
production. This is in addition to the market price which production units receive from the
buyers. Therefore what production units actually receive is not the ‘market-price’ but “market
price - indirect tax + subsidies” This is what is actually available to production units for
distribution of income among the owners of factors of production. Therefore, Market price -
indirect tax (I.T.) + subsidies = Factor payments (or factor costs) By making adjustment of
indirect tax and subsidies we derive GDP at factor cost (GDPfc) from GDPmp.. GDPmp - I.T. +
subsidies = GDPfc or GDP - net I.T. = GDPfc Net Domestic Product at Factor Cost If we make
adjustment of both the net I.T and depreciation (also called consumption of fixed capital) we get
one more aggregate called Net Domestic Product at Factor Cost (NDPfc) GDPmp - I.T. + Sub-
depreciation = NDPfc. or NDPfc+ I.T. - Sub+depreciation = GDPmp Net National Product at
Factor Cost (NNPfc) or National Income Net factor income from abroad (NFIA) provides the
link between NDP and NNP. Therefore, NDPfc + NFIA = NNPfc or NNPfc - NFIA = NDPfc
Similarly, NDPmp + NFIA = NNPmp GDPmp + NFIA = GNPmp Summing up The three crucial
adjustments required for deriving one aggregate from the other are: Gross - depreciation = Net
Market price - I.T. + Subsidies = Factor cost Domestic + NFIA = National METHODS OF
ESTIMATION OF NATIONAL INCOME (N.I.) AND OTHER RELATED AGGREGATES
There are three methods of estimation of national income : production (value added), 6 income-
distribution and final expenditure methods. You are familiar with the various steps required to be
taken in each. Let us see what aggregates are arrived through each method. (I) Production
method (value added method) In this method we first find out Gross Value Added at Market
Price (GVAmp) in each sector and then take their sum to arrive at GDPmp Sum total of GVAmp
by all the sectors = GDPmp Then we make adjustments to arrive at national income or NNPfc
GDPmp - Consumption of fixed capital = NDPmp NDPmp - I.T. + Subsidies = NDPfc NDPfc +
NFIA = NNPfc (2) Income distribution method In this method we first estimate factor payments
by each sector. The sum of such factor payments equals Net value Added at Factor Cost
(NVAfc) by that sector. Then we take sum total of NVAfc by all the sectors to arrive at NDPfc.
The components of NDPfc are: 1. Compensation of employees 2. Rent and royalty 3. Interest 4.
Profits NDPfc System of National Accounts 1993, a joint publication of the United Nations and
the World Bank,has elaborated the above components and recommended their use by all the
countries in preparing national income estimates. Compensation of employees is defined as : the
total remuneration in cash or in kind, payable by an enterprise to an employee in return for work
done by the latter during the accounting period. The main components of compensation of
employees are : (1) Wages and salaries (a) in cash (b) in kind 7 (2) Social security contributions
by the employers. Rent is defined as the amount receivable by a landlord from a tenant for the
use of land. Royalty is defined as the amount receivable by the landlord for granting the leasing
rights of subsoil assets. Interest is defined as the amount payable to the owners of financial assets
in the production unit. The production unit uses these assets for production and in turn makes
interest payment, imputed or actual. Profit is a residual factor payment to the owners of a
production unit. The production unit uses profit for (i) payment of corporation tax, (ii) dividend
payments and (iii) undistributed profits/ retained earnings. The main source of factor payments
are the accounts of production units. Since accounts of most production units are not available to
the estimators, and also since the accounting practices differ, it is not possible for the estimators
to clearly identify the components. Therefore, in cases where total factors payment is estimable
but not its different components, an additional factor payment item called ‘mixed income’ is
added. Since this problem arises mainly in case of selfemployed people like doctors, chartered
accountants, consultants, etc, this factor payment is popularly called “mixed income of the self
employed”. In case there is such item then, NDPfc = Compensation of employees + Rent and
royalty + Interest + Profit + Mixed income (if any) There is another term used in factor
payments. It is ‘operating surplus’. It is defined as the sum of rent and royalty, interest and
profits. In that case then: NDPfc = Compensation of employees + operating surplus + mixed
income (if any) Once we estimate NDPfc, we can find NNPfc, or national income, by adding
NFIA. NDPfc + NFIA = NNPfc. (3) Final expenditure method In this method we take the sum of
final expenditures on consumption and investment. This sum equals GDPmp. These final
expenditures are on the output produced within the economic territory of the country. Its main
components are: Private final Consumption expenditure (PFCE) + Government final
consumption expenditure (GFCE) + Gross domestic Capital formation (GDCF) 8 + Net exports
(= Export - imports) (X-M) = GDPmp By making the usual adjsutments we can arrive at national
income OFCE + GFCE + GDCF + (X-M) = GDPmp - Consumption of fixed capital = NDPmp -
indired Tax + Subsidies = NDPfc + NFIA = NNPfc (National income) Note that GDCF is
composed of the following: GDCF= Net domestic fixed capital formation + Closing stock -
Opening stock + Consumption of fixed capital Also note that. ‘Clossing stock - opening stock ‘
equals net change in stocks. PRECAUTIONS IN MARKING ESTIMATES OF NATIONAL
INCOME There are a large number of conceptual and statistical problem that orise in estimating
national income of a country. To minimize error, it is necessary that certain precautions are taken
in advance. Some of the methodwise precautions are: (1) Value added (Production) method (i)
Avoid double counting Value added equals value of output less intermediate cost. There is a
possibility that instead of counting ‘value added’ one may count value of output. You can verify
by taking some imaginary numerical example that counting only values of output will lead to
counting the same output more thanonce. This will lead to overestimation of national income.
There are two alternative ways of avoiding double counting: (a) count only valueadded and (b)
count only the value of final products. 9 (ii) Do not include sale of second hand goods. Sale of
the used goods is not a production activity. The good should not treated as fresh production, and
therefore doesn’t should not treated as fresh production, and therefore doesn’t qualify for
inclusion in national income however, any brokerage or commission paid to facilitate the sale is
a fresh production activity. It should be included in production but to the extent of brokerage or
commission only. (iii) Self-consumed output must be included. Output produced but retained for
self-consumption, rather than selling in market, is output and must be included in estimates.
Services of owner-occupied buildings, farmer consuming its own produce, etc are some
examples. (2) Income distribution method (i) Avoid transfers National income includes only
factor payments, i.e. payment for the services rendered to the production units by the owners of
factors. Any payment for which no service is rendered is called a transfer, and not a production
activity. Gifts, donations, characters, etc are main examples. Since transfers are not a production
activity it must not be included in national income. (ii) Avoid capital gain Capital gain refers to
the income from the sale of second hand goods and financial assets. Income from the sale of old
cars, old house, bonds, debentures, etc are some examples. These transactions are not production
transactions. So, any income orising to the owners of such things is not a factor income. (iii)
Include income from self-consumed output When a house owner lives in that house, he does not
pay any rent. But infact he pays rent to himself. Since rent is a payment for services rendered,
even though rendered to the owner itself, it must be counted as a factor payment. (iv) Include
free services provided by the owners of the production units Owners work in their own unit but
do not charge salary. Owners provide finance but do not charge any interest. Owners do
production in their own buildings but do not charge rent. Although they do not charge, yet the
services have been performed. The imputed value of these must be included in national income.
(3) Final expenditure method (i) Avoid intermediate expenditure By definition the method
includes only final expenditures, i.e. expenditure on consumption and investment. Like in the
value added method, inclusion of intermediate expenditure like that on raw materials, etc, will
mean double counting. 10 (ii) Do not include expenditure on second hand goods and financial
assets Buying second hand goods is not a fresh production activity. Buying financial assets is not
a production activity because financial assets are neither goods nor services. Therefore they
should not be included in estimates of national income. (iii) Include the self use of own produced
final products. For example, a house owner using the house for seef. Although explicitly he does
not incur any expenditure, implicitly he is making payment of rent to himself. Since the house is
producing a service, the imputed value of this service must be include in national income. (iv)
Avoid transfer expenditures A transfer payment is a apayment against which no services are
rendered. Therfore no production takes place. Since no production takes place it has no place in
national income. Charities, donations, gifts, scholarships, etc are some examples. DISPOSABLE
INCOME Introduction Disposable income refers to the income actually available for use as
consumption expenditure and saving. It includes both factor contrast national income includes
only factor incomes. Broadly, therefore, if we are given national income we can find disposable
income by making adjustments of non factor incomes. National Disposable Income Given
GNPmp, we can derive Gross National Disposable income (GNDI) and Net National Disposable
income (NNDI). GNPmp + Net current transfers from abroad = GNDI - Consumption of fixed
capital = NNDI aLTERNATIVELY, NNDI = NNPmp + Net current transfers from abroad
Disposable income aggregate of the private sector GNDI and NNDI are the disposable income
aggregates of the nation. Let us now derive the disposable income of the private sector of the
nation. As a first step, given national income, 11 we deduct-national income accring to the
government. Then as a second step we make adjustments of non-factor incomes in various stages
to ultimately arrive at personal disposable income. These steps are summed up in the following
table. NDPfc Less : Income from property and entrepreneurship accruing to the government
administrative departments Less : Saving of non-departmental enterprises = NDPfc accruing to
the private sector Add : Net factor income from abroad Add : National debt interest Add :
Current transfers from the government administrative departments. Add : Net current transfers
from the rest of the world. = Private Income Less : Saving of private corporate sector (net of
retained earnings of foreign companies) Less : Corporation tax = Personal Income Less : Direct
taxes paid by households Less : Miscellaneous receipts of government administrative
departments = Personal disposable income of the above ‘national debt interest’ is the interest
paid by government on loans taken to meet its administrative expenditure, a consumption
expenditure, a consumption expenditure. Since interest on loans taken to meet consumption
expenditure is not a factor income it was not included in NDPfc. But since it is a disposable
income it is added to NDPfc to arrive at disposable income of which private income is a part.
Miscellaneous receipts of government administrative departments are small compulsory
payments by the people to the government in the form of fees, fines, etc and treated like a tax,
and therefore deducted. 12 UNIT 7 - Determination of Income and Employment Involuntary
unemployment : Involuntary unemployment occurs when those who are able and willing to work
at the going wage rate do not get work. Aggregate demand : Aggregated demand means the total
demand for final goods in an economy. It also means the aggregate expenditure on final goods in
an economy. The components of aggregate demand are : 1. Demand for goods and services for
private consumption also called private final consumption expenditure. 2. Demand for private
investment 3. Demand for goods and services by the government 4. Net exports. Since the
determination of income and employment is to be studied in the context of two sector model, the
third and fourth components of aggregate demand are not discussed in details. The two sectors
taken are households and firms. 1. Demand for goods and services for private consumption is
made by household sector. It is also called private final consumption expenditure and will be
refered to as consumption expenditure. It must be kept in mind that the consumption expenditure
we are discussing is ex-ante i.e. planned consumption expenditure. This demand is influenced by
many variables such as price of the goods or services, income, wealth, expected income, tastes
and preferences of individuals and so on. Keynes formulated his fundamental Psychological Law
of Consumption to lay down a behavioural rule to the process of consumption activity. Keynes
stated that “men are disposed, as a rule and on the average, to increase their consumption as their
income increases, but not by as much as the increase in their income”. This relationship between
consumption and income is called the consumption function. The consumption function may be
represented by the following equation. C = – C + bY – C > 0, 0 < b < I. Where, 13 C =
Consumption – C = Autonomous Consumption b = Marginal Propensity to Consume Y = Level
of income The intercept – C represents autonomous consumption, that is, the amount of
consumption expenditure when income is zero. – C is assumed to be positive, that is there is
consumption even in the absence of any income. Hence, it is not possible to think of a situation
where there is no comsumption at all. The slope of the consumption function is ‘b’. It measures
the rate of change in consumption per unit change in income and is also known as the Marginal
Propensity to Consume (MPC). For example, if b is 0.6, then a rupee change in income causes a
0.60 rupee change in consumption. If b is 0.45, then a rupee change in income will cause a 0.45
rupee change in consumption. By assumption, the MPC is positive, and its value ranges between
0 and 1. This means that consumption increases with income, but a rupee increase in income
causes less than a rupee increase (of b) in consumption. For example, if b is 0.90, a rupee
increase in income causes a 0.90, a rupee increase in consumption. The consumption function
may be plotted on a graph with the help of a numerical example. Figure 1 shows the graph of the
hypothetical consumption function. Consider a consumption function given by C = 100 + 0.8 Y
Since this is an equation of a straight line, the consumption function will have a constant slope.
Table 1 shows the level of consumption for various levels of income. Column (1) shows the
consumption expenditure at various levels of income. The values in column (1) are obtained
from the consumption function. Column (5) in table 1 shows how MPC is calculated. As income
increases from Rs. 600 to Rs. 700 (an increase of 100 rupees), the consumption increases from
Rs. 580 to Rs. 660 (an increase of 80rupees). The MPC is therefore 80/100 = 0.8. The MPC at all
levels of income is the same because of the particular consumption function we have used in our
example. (Constant slope and therefore constant MPC is a feature of all straight line
consumption functions). The information given in the Table 1 can be plotted in a graph, as
shown in Fig. 1. 14 Table 1 : Consumption, Income and Marginal Propensity to Consume
Consumption Change in Income Change in Marginal Prpensity C Consumption Y Y to consume
(MPC) C = (2)/(4) = C/ Y (1) (2) (3) (4) (5) 100 - 0 - - 180 80 100 100 (80/100) = 0.8 260 80 200
100 (80/100) = 0.8 340 80 300 100 (80/100) = 0.8 420 80 400 100 (80/100) = 0.8 500 80 500
100 (80/100) = 0.8 580 80 600 100 (80/100) = 0.8 660 80 700 100 (80/100) = 0.8 740 80 800
100 (80/100) = 0.8 820 80 900 100 (80/100) = 0.8 900 80 1000 100 (80/100) = 0.8 Fig. 1 shows,
the graph of the consumption function C = 100 + 0.8Y. To understand the figure, it is helpful to
look at the 45o line drawn from the origin. Since the vertical and horizontal axes have the same
scale, the 45o line has the property that at any point on it, the distance up from the horizontal
axis (which is consumption expenditure) exactly equals the distance across from the vertical axis
(which is income). Thus, at any point on the 45o line, consumption expenditure exactly equals
income. The 45o line therefore immediately tells us whether consumption spending (as per the
consumption function) is equal to, greater than, or less than the level of income. The
consumption function crosses the 45o line at point B. This point is known as the breakeven point.
Here households are just breaking even, because the consumption is exactly equal to the income.
In our example, the income and consumption at the breakeven point is Rs. 500. At any point
other than B on the consumption function, consumption is not equal to income. At points to the
left of B, the consumption function lies above the 45o line. Therefore consumption expenditure
is greater than income. For example, at an income level of Rs. 200, the consumption 15 is Rs.
260. The household must find funds to meet this consumption expenditure. The shortage in
income will make them to sell the assets acquired in the past, or to resort to borrowing so that Rs.
60 could be raised for consumption. This act on the part of the household to liquidate their own
assets or to go in for a loan is referred to as the process of dissaving. Dissaving is in order to help
the households to finance the consumption over and above the level of income. Fig. 1 : The
Consumption Function C = 100 + 0.8 Y At any point to the right of B, the consumption function
lies below the 45o line;therefore consumption expenditure is less than the level of income. The
part of income, which is not consumed, is saved. This must be so, because income is either
consumed or save, there is no other use to which it can be put. Savings can be measured in the
graph as the vertical distance between the consumption function and the 45o line. For example,
at an income level of Rs. 900. consumption is Rs. 820. Therefore, the amount of savings is the
diference between the two, that is, Rs. 80. To sum up: when the consumption functiuon lies
above the 45o line, consumption is greater than income at each level of income. This means that
there is dissaving, Where the two lines intersect, the level of consumption is exactly equal to the
level of income, When the consumption function lies below the 45o line, the level of
consumption is less than the level of income. This means that there is positive saving. The
amount of dissaving or saving is always measured by the vertical distance between the
consumption function and the 45o line. 16 Consumption and Savings We shall now look into the
relationship between consumption and saving. We may obtain the savings function from this
relationship. The equation below says that income that is not spent on consumption is saved, that
is S = Y - C This equation tells us that by definition, saving is equal to income minus
consumption. The consumption function, along with the above equation, implies a savings
function. The savings function relates the level of saving to the level of income. Substituting the
consumption function into the above equation we can get the saving function. S = Y - C = Y - ( –
C + bY) (Since C = – C + bY) = Y - – C - bY S = - – C + (1 - b)Y This is the savings function.
The intercept term – C is the amount of savings done when there is zero level of income. It is
already shown that – C is positive. Therefore – C savings is negative. Thus, there is negative
savings – C at zero level of income. Since negative savings is nothing but dissaving, this means
that at zero level of income, there is a dissaving of amount – C. Note that the amount of
autonomous consumption is exactly equal to the amount of dissaving at zero level of income.
This is because of the fact that Y = C + S (whether S is positive or negative). The slope of the
savings function is (1 - b). The slope of the savings function gives the increase in savings per
unit increase in income. This is known as the Marginal Propensity to Save (MPS) Since b is less
than one it follows that (1 - b) and therefore MPS is positive. Therefore, savings is an increasing
function of income.Suppose the MPC, that is, b is 0.8, then the MPS, tha is (1 - b) is 0.2. This
means that for every one rupee increase in income, savings increase by 0.2 rupee. Note that MPS
= 1 - b = 1 - MPC. This means that the part of the increase in income, which is not consumed, is
saved, This is because income is either consumed or saved. Therefore, it is always the case that
MPC + MPS = 1. Using the numerical example of the consumption function we had earlier
given, we can derive the corresponding savings function. S = – C + (1 - b) Y = - 100 + (1 - 0.8)Y
S = -100 + 0.2Y 17 Table 2 : Consumption - Saving Relationship Y Change C Change MPC
Saving Change MPS C+S MPC+ in Y in C C/ Y S in S S/ Y MPS Y C S (1) (2) (3) (4) (5) (6) (7)
(8) (9) (10) 0 - 100 - - -100 - - 0 - 100 100 180 80 0.8 -80 20 0.2 100 1 200 100 260 80 0.8 -60 20
0.2 200 1 300 100 340 80 0.8 -40 20 0.2 300 1 400 100 420 80 0.8 -20 20 0.2 400 1 500 100 500
80 0.8 0 20 0.2 500 1 600 100 580 80 0.8 20 20 0.2 600 1 700 100 660 80 0.8 40 20 0.2 700 1
800 100 740 80 0.8 60 20 0.2 800 1 900 100 820 80 0.8 80 20 0.2 900 1 1000 100 900 80 0.8 100
20 0.2 100 1 Table 2 shows the levels of consumption and savings for various levels of income.
Note that (a) consumption plus saving everywhere equals income, and (b) MPC + MPS = 1.
Columns (1) to (5) are repeated from Table 1. Column (6) shows the level of savings at different
levels of income. The values in this column are obtained from the savings function. Column (8)
in table 2 shows how MPS is calculated. As income increases from Rs. 600 to Rs. 700 (an
increase of Rs. 100), the savings rises from Rs. 20 to Rs. 40 (an increase of Rs. 20). The MPS is
therefore (20/100) = 0.2. The MPS is the same at all levels of income because of the particular
savings function (a linear curve with constant slope) we used in our example (constant slope and
therefore constant MPS is a feature of all straight line savings functions). Column (9) of the table
shows the sum of consumption expenditure and savings at every level of income. Note that
column (9) is identical to column (1). This is because income is either consumed or saved, there
is no other use to which it can be put. Thus, the sum of consumption expenditure and saving
must be identically equal to income. Column (10) of the table shows the sum of the MPC and
MPS. Note that the sum of MPC and MPS is equal to one. This means that the part of the
increase in income, which is not consumed, is saved. This is because income is either consumed
or saved. The information given in table 2, can be plotted in a graph, as shown in Fig. 2 18 The
information given in table 2 can be plotted in a graph, as shown in Fig 2. Fig 2 : The
consumption Function and its associated Savings Function Part A of Fig 2 shows the
consumption function, Part B shows the savings function. This is the counterpart of the
consumption shown in part A. In part A, the amount of saving at any level of income is the
vertical distance between the consumption function and the 45o line. The saving function shown
in part B can therefore be directly derived from part A. When income is 500, we see in part A
that consumption is 500 and saving equals 0. This is depicted in part B by the intersection of the
savings function with the horizontal axis at point B, which corresponds to an income level of
500. When income is 200, consumption is 260 and saving is -60 (dissaving is 60); the savings
function lies 60 below the horizontal axis at an income level of 200. When income is 900,
consumption is 820 and saving is 80; the saving function lies 80 above the horizontal axis at an
income level of 900. In general, to the left of points B in part A, the consumption function lies
above the 45o line (consumption is more than income). Hence to the left of point B in part B,
savings is negative and the savings function lies below the horizontal axis. 19 To the right of
point B in part A, the consumption function lies below the 45o line (consumption is less than
income). Hence to the right of point B in part B, savings is positive and the savings function lies
above the horizontal axis. Average Propensities to Consume and Save From the consumption
function, we can find out the value of the consumption income ratio C/Y, at every level of
income. At any particular level of income. the ratio of consumption to income is called the
Average Propensity to Consume (APC). The APC gives the average consumption - income
relationship at different levels of income. Similarly, from the savings function, we can find out
the average savings - income ratio. At any particular level of income, the Average Propensity to
Save (APS) is the ratio of savings to income. We have APC = C/Y and APS = S/Y Now, the sum
of the APC and APS is always equal to one. This is because income is either consumed or saved.
The proof of this statement is as follows; From the relationship between income, consumption
and saving, We have Y = C + S Dividing both sides of the equation by Y we have Y/Y = C/Y +
S/Y Thus, I = APC + APS Using the earlier examples of consumption function and savings
function we can calculate the values of APC and APS for every level of income. This is done in
Table 3. Table 3 Average Propensities to Consume and Save Y C APC S APS APC+APS (2)/(1)
(4)/(1) (1) (2) (3) (4) (5) (6) 0 100 - -100 - - 100 180 1.8 -80 -0.8 1 200 260 1.3 -60 -0.3 1 300
340 1.13 -40 -0.13 1 400 420 1.05 -20 -0.05 1 500 500 1 0 0 1 600 580 0.97 20 0.03 1 700 660
0.94 40 0.06 1 800 740 0.92 60 0.08 1 900 820 0.91 80 0.09 1 1000 900 0.90 100 0.10 1 Note :
Figures in table are rounded upto two decimal points 20 Column (3) shows how APC is
calculated. At a particular income level, the APC is the corresponding level of consumption
divided by that level of income. Similarly: APS is calculated in column (5). At a particular
income level, the APS is the corresponding level of saving divided by that level of income.
Column (6) shows the sum of APC and APS. As expected, at every level of income, the sum of
APC and APS is equal to one. This is because income is either consumed or saved. Therefore the
proportion of income that is not consumed must be saved. As we can see from the above table.
APC is continuously declining as income increases; and APS is continuously increasing as
income increases. This means that as income increases, the proportion of income saved increases
and the proportion of income consumed decreases. 2. Demand for Private Investment Demand
for private investment refers to the planned or ex-ante investment expenditure by the firms. It
includes addition to the stock of physical capital and change in inventory. For simplicity sake it
is assumed in our study that the investment expenditure is autonomous. This means investment
decisions are not influenced by any of its determinants, including output. Aggregate Supply : It is
total quantity of goods and services produced in the economic teritory of a country. It refers to
the planned aggregate output in the economy. It is assumed that in the short run the prices of
goods do not change and the elasticity of supply is infinite. At the given price level, output can
be increased till all resources are fully employed. So how much will be the aggregate output will
primarily depend upon how much is the aggregate demand in the economy. The level of output
income and employment in an economy move together in the same direction till full employment
is reached. Increase in output means, increase in level of employment and increase in level of
income. Decrease in output means less employment and lower level of income. Determination of
Equilibrium Level of Output, Income & Employment We shall confine our analysis of the
determination of the equilibrium level of output to an economy with only two sectors,
households and firms. Hence, the only components of aggregate demand will be consumption
demand and investment demand. Consumption plus Investment Approach We may show output
determination using the consumption plus investment (C+I) approach. This is illustrated in Fig.
3, which shows total spending or aggregate demand plotted against output or income. The line
CC is the consumption function, showing the desired (planned level) of consumption
corresponding to each level of income. We now add desired (planned) investment (which is at
fixed level I) to the consumption function. This gives the level of total desired spending or
aggregate demand, represented by the C+Io curve. At every point, the (C+Io) curve lies above
the CC curve by an amount equal to Io. The 45o line will enable us to identify the equilibrium.
At any point on the 45o line, the aggregate demand(measured vertically) equals the total level of
output (measured horizontally). The economy is in equilibrium when aggregate demand,
represented by the C+Io curve is equal to the total output. 21 Fig. 3 : Output Determination by
Consumption plus Investment approach The aggregate demand or (C + Io) curve shows the
desired level of expenditure by consumers and firms corresponding to each level of output. The
economy is in equilibrium at the point where the C + Io curve interseets the 45o line - point E in
Fig. 3. At point E, the economy is in equilibrium because the level of desired spending on
consumption and investment exactly equals the level of total output. The level of output
corresponding to point E, is the level of output OM. Thus, OM is the equilibrium level of output.
The Adjustment Mechanism Equilibrium occurs when planned spending equals planned output.
When planned spending is not equal to planned output, then output will tend to adjust up or
down until the two are equal again. Consider the case when the economy is at a level of output
greater than the equilibrium level OM in Figure 3. At any such greater level of output, the C + Io
line lies below the 45o line that is planned spending is less than planned output. This means that
consumers and firms together would be buying less goods than firms were producing. This
would lead to an unplanned undersired increase in inventories of unsold goods (representing
goods neither sold to households for consumption nor bought by firms for investment) Firms
would then respond to this unplanned inventory increase by decreasing employment and hence
output. This process of decrease in output will continue until the economy is back at output level
OM, where again aggregate demand equals planned ouput and there is no further tendency to
change. Consider another case when the economy is at a level of output less than the equilibrium
level OM. At any such lower level of output, the C + Io line lies above the 45o line, that is,
planned spending is more than planned output. This means that consumers and firms together
would be 22 buying more goods than firms were producing. This would lead to an unplanned,
undesired decrease in inventories. Firms would then respond to this unplanned inventory
decrease by increasing employment and hence output. This process of increase in output will
continue until the economy is back at output level OM, where again aggregate demand equals
planned output and there is no further tendency to change. Fig. 4 : The Consumption Function
and the corresponding Savings Function Output Determination Using the Savings Function and
the Investment Schedule Saving Function Figure 4 shows the consumption function and the
corresponding savings function, is it not similar to Fig. 2? Recall that each point on the
consumption function shows desired or planned consumption at that level of income. Each point
on the savings function shows the desired or planned savings at that income level. The two
functions are closely related, since income always equals consumption plus saving. Therefore
these can be called complementary curves. 23 Investment Schedule For simplicity we shall
assume that firms plan to invest exactly the same amount every year, regardless of the level of
output. If we plot on a graph the level of investment demand at every level of output (and
therefore income), we will have the investment schedule. Figure 5 shows the investment
schedule. Since firms plan to invest the same amount Io regardless of the level of output, the
investment schedule will be a horizontal line. This is because every point on the investment
schedule lies at the same height above the horizontal axis, That is, the level of investment
demand is the same at every level of output. Fig. 5 : The Investment Schedule Equilibrium
Output By examining the interaction of savings and investment, we can find the equilibrium
level of output. Fig 6. combines the savings function of Fig. 4 and the investment schedule of
Fig. 5. We see the savings function and the investment schedule intersect at point E. This point
corresponds to a level of output OM, which is the equilibrium level of output. This intersection
of the savings function and the investment schedule gives the equilibrium towards which output
will gravitate. Meaning of the Equilibrium Point E is the point of intersection of the savings
function and the investment schedule. Thus, only at point E will planned savings of households
equal planned investment of firms. When planned savings and planned investment are not equal,
output will tend to adjust up or down till they are equal again. 0 Q* Output Io B M Investment
Schedule Investment (I) 24 The savings function and the investment schedule of Fig. 6 represent
planned levels of savings and invesment respectiviely. Thus, at output level OM, firms plan to
invest an amount equal to ME. Also, households plan to save an amount equal to ME. However,
in general, there is no necessity for acutal saving (or investment) to be equal to planned saving
(or invesment). This may be due to mistakes, incorrect forecasting of events, or for a variety of
other reasons. In any case, actual savings or investment might be different from planned savings
or investment. Fig. 6 : Intersection of the Savings Function and the investment schedule We will
look at the mechanism of how output adjusts until planned savings and planned investment are
equal, under three separate cases. The first case is where the economy is at a level of output
equal to OM. At this level of output, planned savings of household equals planned investment of
firms. Since the plans of households and firms are satisfied, they will be content to continue
doing exactly what they had been doing till then. Thus output, employment and income will
remain the same. In this case, it is righly called an equilibrium. The second case is where the
economy is at a level of output greater than OM. At the corresponding level of income, the
savings function lies above the investment schedule, Therefore, at this level of income
households are saving more, that is, they are refraining from consuming by an amount greater
than firms are investing. The effect of this will be to cause an undesired, unplanned build-up of
inventories of unsold goods. The effect of an undesired. unplanned inventory build-up is to
increase the actual level of investment to a level greater than the planned level of investment.
Since firms’ plans have not materialized, they will act in order to correct the situation. In order to
reduce the unsold inventories to the desired level firms will cut back production and reduce
employment. The effect of this will be to reduce output until the economy returns to equilibrium
at output level OM, where planned savings equals planned Investment,equals actual investment,
and there is therefore no further tendency to change. The third case is where the economy is at a
level of output less than OM. At the corresponding level of income, the savings function lies
below the investment schedule. Therefore, at this level of income households are saving an
amount less than firms plan to invest. Households 25 are thus, refraining from consuming by an
amount less than firms plan to invest. The effect of this will be to cause an unplanned, undesired
reduction in inventories of unsold goods. Thus, the acutal level of investment will be less than
the planned level of investment. Again, since firms’ plans have not materialised, they will act in
order to correct the situation. In order to increase inventories to the desired, planned level firms
will increase production and increase employment. The effect of this will be to increase output
till the economy returns to output level OM, where planned savings equals planned investment,
planned investment equals actual investment, and there is thus no further tendency to change. All
three cases lead to the same inference. The only equilibrium level of output is OM, where
planned saving equals planned investment. At any other level of output, the discrepancy between
planned saving and planned investment will cause firms to change their production and
employment levels, thereby returning the economy to the equilibrium output and employment. In
equilibrium planned expenditure and planned output must be equal A numerical example will
show why the equilibrium level of output occurs when planned spending and planned output are
equal. Table 4 shows an example using a consumption function and the associated savings
function. The consumption function is C = 1000 + 0.67Y The associated savings function is S = -
1000 + 0.33Y Column (2) represents the level of planned consumption at various levels of
income. The values in column (2) are derived from the consumption function used above.
Column (3) represents the levels of planned saving at various levels of income. The values in
column (3) are derived from the savings function used above. Column (5) is a reproduction of
column (1). Column (6) shows the level of aggregate demand at various levels of income - it is
the sum of consumption demand in column (2) and investment demand in column (4). It shows
what firms actually managed to sell. Table 4 : Determination of Output (All Figures in Rs.
Crores) Output and Planned Planned Planned Output and Aggregate Tendency Income Consum-
Saving Invest- Income Demand of Output ption (3)=(1)-(2) ment (5) = (1) (6)=(2)+(4) to (1) (2)
(3) (4) (5) (6) (7) 4200 3800 400 200 4200> 4000 Decrease 3900 3600 300 200 3900> 3800
Decrease 3600 3400 200 200 3600= 3600 Equilibrium 3300 3200 100 200 3300< 3400 Increase
3000 3000 0 200 3000< 3200 Increase 2700 2800 -100 200 2700< 3000 Increase 26 The level of
income at which consumption is exactly equal to income (that is, all income is consumed), and
therefore, savings is exactly equal zero is known as the break-even level of income. In our
example, the breakeven level of income is Rs. 3000 crores. Now, each change of income of Rs.
300 crores causes a change of Rs. 100 crores in saving, and a change of Rs. 200 crores in
consumption. Thus MPS is a constant and is equal to 1/3 and MPC is a constant and is equal to
2/3. Investment is assumed to be exogenous. Firms plan to invest a constant amount of Rs. 200
crores as shown in column (4). That is, at each level of income, firms plan to purchase Rs. 200
crores of investment goods. Consider the top row of the Table 4. If firms are producing Rs. 4200
crores of output, then the planned spending or aggregate demand is only R.s 4000 crores. In this
situation, there will be an unplanned accumulation of inventories to the tune of Rs. 4200 crores -
Rs. 4000 crores = Rs. 200 crores. Firms will respond to this unplanned inventory build-up by
scaling down their operations and thus output will decrease. The opposite case is represented by
the bottom row of Table 4. Here, firms are producing Rs. 2700 crores of output but aggregate
demand is Rs. 3000 crores. In this situation, there will be an unplanned decrease in inventories to
the tune of Rs. 3000 crores - Rs. 2700 crores = Rs. 300 crores. Firms will respond to this
unplanned inventory decrease by expanding their operations, thus causing an increase in output.
Thus, when firms as a whole are temporarily producing more than they can sell, they will
contract their operations, causing output to fall. When they are temporarily selling more than
their current production, they will expand their operations, causing output to rise. Only when the
level of output in column (5) is equal to aggregate demand in column (6) will output be in
equilibrium. Firms sales will be just enough to justify continuing their current level of aggregate
output. Thus, aggregate output will neither expand nor contract, and will be in equilibrium. The
equilibrium level output in our example is Rs. 3600 crores. The Multiplier A change in the
investment spending will affect output and therefore employment. It is logical that an increase in
fixed business investment will increase the level of output and employment through increase in
productive capacity. Conversely, a decrease in investment will decrease the level of output and
employment. The operation of the multiplier ensures that a change in investment causes a change
in output by an amplified amount, which is a multiple of the change in investment. The
multiplier is the number by which the change in investment must be multiplied in order to
determine the resulting change in output. For example, if an increase in investment of Rs. 100
crores causes an increase in output 27 of Rs. 300 crores, then the multiplier is 3. If, instead the
resulting increase in output is Rs. 400 crores, then the multiplier is 4. We may derive an
expression for the multiplier as follows: At equilibrium, we have Y = C + I I.e., income equals
the sum of consumption plus investment. We can use the consumption function to substitute C
with the expression – C+bY, to give Y = – C + bY + I so Y - bY = – C + I or, Y (I-b) = – C + I
or, Y = 1 ( – C + I) (1-b) Since b is nothing but the MPC, we have Y = 1 ( – (1-MPC) C + I) To
find out the effect of a change in investment on income, we differentiate the equation to obtain.
Y = 1 I (I - MPC) So, (Change in income) = (Multiplier) (Change in Investment) The multiplier
is equal to I/(1-MPC). It is the number by which the change in investment must be multiplied in
order to determine the resulting change in output. As we can see. the size of the multiplier
depends on value of the MPC. Since O < MPC < 1, the multiplier will be greater than 1. Hence, a
change in investment will cause a multiple change in output. The actual size of the multiplier
depends on the value of MPC. For example if MPC is 2/3 then the multiplier is 3. If MPC be at
4/5, the multiplier is 5. A numerical example will enable us to see the operation of the multiplier.
Let the MPC be at 4/5. Suppose there is an increase in investment of Rs. 1000. which results in
the construction 28 of a new building. Then, the builder, the architect and the labourers together
will get an increase in income of Rs. 1000. Since the MPC is 4/5, they will together spend 800
(4/5 of Rs. 1000) on new consumption goods. The producers of those consumption goods will
thus have an increase of Rs. 800 in their incomes. Since their MPC is also 4/5, they will in turn
spend Rs. 640 (4/5 of Rs. 800. or 4/5 of 4/5 of Rs. 1000). This will cause an increase in income
of other people by Rs 640. This process will go on with each new round of spending (and
therefore increase in investment) being 4/5 of the previous round. Thus, an endless chain of
secondary consumption spending is set in motion by the primary investment of Rs. 1000.
However. not only is the chain of secondary consumption spending endless, it is also ever-
diminishing. Eventually, the sum of the secondary consumption expenditures will be a finite
amount. We can calculate the total increase in consumption plus investment spending and
therefore the total increase in income as follows: Rs. 1000 = 1 X Rs. 1000 + + Rs. 800 4/5 X Rs.
100 + + Rs. 640 (4/5)2 X Rs. 1000 + + Rs. 512 (4/5)2 X Rs. 1000 + + Rs. 409.6 (4/5)2 X Rs.
1000 + + : : Rs. 5000 [1/{1-(4/5)}] x Rs. 1000 Multiplier We have said that the chain of
secondary consumption spending is an endless everdiminishing chain, whose sum is a finite
amount. We may find the sum of the total increase in spending by using the formula for the sum
of an infinite geometric progression. The sum of the total increase in spending and the total
increase in income is: Y = 1 x Rs. 1000 + (4/5) x Rs. 1000 + (4/5)2 X Rs. 1000 + (4/5)3 X Rs.
1000 + ............... Y = Rs. 1000 [ 1 + (4/5) + (4/5)2 + (4/5)3 + ...] The term in square brackets is
of the form of the sum of an infinte geometric pregression, whose first term is 1 and where
constant multiplier ‘r’ is 4/5. 29 The formula for the sum of such an infinite geometric
progression is 1/(1-r). In our case. r = 4/5, therefore the sum of the geometric progression is 1 / [1
- (4/5) ] = 5 Replacing the term in the square brackets by 5, we have Y = Rs. 1000 x 5 Y = Rs.
5000 We can see that with an MPC of 4/5, the multiplier is 5. We may also express multiplier in
terms of the marginal propensity to save, that is MPS Multiplier = 1 . 1 - MPC Since MPS = 1 -
MPC, we have Multiplier = 1 . MPS i.e., if MPS were 1/x, then the multiplier would be x. In our
example, the MPS is 1/5. Let the investment expenditure increase by Rs. 1000 crores. Planned
saving will have to rise till it equals the new and higher level of investment, in order to ‘bring
output to a new equilibrium. The only way that saving can rise is for income to rise.With an MPS
of 1/5 and an increase in investment of Rs. 1000 crores, income must rise by Rs. 5000 crores to
bring forth Rs. 1000 crores of additional saving to match the new investment. Hence, at
equilibrium, Rs. 1000 crores of additional investment induces Rs. 5000 crores of additional
income, in line with our multiplier arithmetic. Problems of Excess and Deficient Demand and
Measures to Correct Them Thus far, we have studied the determination of output,income and
employment in the Keynesian framework. The equilibrium level of output, income and
employment was determined solely by the level of aggregate demand. The economy will be in
full-employment equilibrium if the aggregate demand is for an amount of output that is equal to
the full-employment level of output. If the aggregate demand is for an amount of output less than
the full employment level of output, then it is known as deficient demand. If the aggregate
demand for a level of output is more than full-employment level of output, then it is known as
excess demand. We will take up the problems of and remedies for excess and deficient demand
individually. Problem of Deficient Demand If aggregate demand is for a level of output less than
the full-employment level, then a situation of deficient demand exists. Deficient demand gives
rise to a ‘deflationary gap’, which causes the economy’s income, output and employment to
decline, thus pushing the economy into an under-employment equilibrium. Figure 7, depicts the
situation of deficient demand. 30 Fig. 7 : Deficient Demand The Y-axis measures consumption
demand, investment demand, and their sum the aggregate demand. The X-axis measures the
level of output and income. OQ’ is the full employment level of output and income. (C+1)o and
(C+1)1 are two parallel aggregate demand curves, differing only by the amount of investment
expenditure. For the economy to be at a full-employment equilibrium, the aggregate demand
should be for a level of output equal to the full-employment level of output OQ’. In other words,
aggregate demand should be equal to Q’F. The economy will then be in a full employment
equilibrium, corresponding to the point F on the aggregate demand curve (C+1)1 and the
economy will produce full-employment level of output OQ’. Supose,however, that the aggregate
demand is for a level of output Q’G, Q’G is less than QF. Then aggregate demand is for a level
of output which is less than the full-employment level. This level of aggregate demand
corresponds to point G on the aggregate demand curve (C+1)o. This results in a situation of
deficient demand. The resulting deflationary gap created due to deficient demand is represented
in Figure 7 by FG. The deflationary gap is the difference between the level of aggregate demand
required to establish the full-employment equilibrium and the actual level of aggregate demand.
The deflationary gap is a measure of the amount of deficiency of aggregate demand. The
deflationary gap will set in motion forces that will cause a decline in the economy’s output,
income and employment. At point G, the aggregate demand curve (C+1)o lies below the 45o
line. As a result, the aggregate demand Q’G is less than the level of output OQ’. Firms will
experience an unplanned build-up of inventories of unsold goods. They will respond by reducing
employment and cutting back production. This will reduce the economy’s output income and
employment, until a new equilibrium is reached at point E. This is an equilibrium because the
aggregate demand EM is equal to output OM (since point E lies on the 45o line). It will be noted
that point E is an under-employment equilibrium. The equilibrium levels of output, income and
employment corresponding to point E are less than the full employment 31 levels of output,
income and employment corresponding to point F. Thus, the deficient demand caused
deflationary gap and has pushed the economy into an under-employment equilibrium. Problem
of Excess Demand If aggregate demand is for a level of output more than the full employment
level, then a suituation of excess demand exists. Excess demand gives rise to an inflationary gap;
which causes a rise in the price level or inflation. Figure 8 depicts the situation of excess
demand. Fig. 8 : Excess Demand The X-axis measures the level of output and income. The Y-
axis measures consumption demand, investment demand, and their sum, the aggregate demand.
OQ’ is the full employment level of output and income. (C+I)o and (C+I)1 are two parallel
aggregate demand curves, differing only by the amount of investment expenditure. The economy
will be in a full-employment equilibrium at point F on the aggregate demand curve (C+I)o and
the economy will produce full-employment level of output OQ’. Uptil point Q’ increases in
nominal income and output correspond to increases in real income and output (since prices are
constant). Beyond point Q’ increases in nominal income and output do not correspond to any
change in real income and output. This is because real income and output cannot increase beyond
the full employment level, as all resources are already fully employed. The increases in nominal
income and output are merely due to increases in the price level. Suppose that the aggregate
demand is for a level of output Q’G. which is greater than the full-employment level of output.
This level of aggregate demand corresponds to point G on the aggregate demand curve (C+I)1.
This is a situation of excess demand. The resulting inflationary gap, created due to the excess
demand is represented in Figure 8 by FG. The inflationary gap is the amount by which the actual
aggregate demand exceeds the level of aggregate demand required to establish the full-
employment equilibrium. The inflationary gap is a measure of the amount of the excess of
aggregate demand. 32 The inflationary gap is so called because it sets in motion forces that will
cause inflation or a rise in the price level. At point G, the aggregate demand curve (C+I)1. lies
above the 45o line. As a result, the aggregate demand Q’G is greater than the level of output
OQ’. The effect of this will be to create demand pull inflation (an aggregate demand induced rise
in the price level). The rise in price level, given the constant real output, will cause an increase in
the nominal output until a new equilibrium is reached at point E. This is an equilibrium because
the aggregate demand ME is equal to the output OM (since point E lies on the 45o line). It will
be noted that the real output and real income is the same at the new equilibrium E.
Correspondingly, the equilibrium level of employment also is the same. All that has happend is
that nominal output and income have increased due to an increase in the price level. Thus the
excess demand caused an inflationary gap. which caused inflation, and therefore, the price level
to rise. In other words, the economy remains at a full-employment equilibrium, although at a
higher price level. In a three sector ecomony where the three sectors are house-holds, firms and
government, aggregate demand is equal to the sum of consumption, investment and government
expenditure. Figure 9 shows the effect of G on aggregate demand. For simplicity, we consider
government expenditure to be a constant amount. The new aggregate demand curve C+1+G lies
parallel above the old aggregate demand curve C+1. This is because, at every level of output the
vertical distance between the C+1 curve and the C+I+G curve is the constant amount of
government expenditure. Fig. 9 : Aggregate demand including government expenditure Thus, the
inclusion of government expenditure in aggregate demand causes a parallel upward shift by an
amount G in the aggregate demand curve. We are now in a position to return to the measures that
can be taken to remedy the problems of excess and deficient demand. In the following
discussion, aggregate demand will be taken to mean the sum of consumption investment and
government expenditure, since we are now considering a three sector economy. This
modification to the definition of aggregate demand does not however change the nature of or
definition of excess and deficient demand. We will first consider the remedy to the problem of
deficient demand. Income & Output 0 X Y C+I Aggregate Demand 45o C+I+G G 33 Remedy
for Deficient Demand As we have seen earlier, if aggregate demand is for a level of output less
than the full employment level of output, then a situation of deficient demand exists. Figure 10
depicts the situation of deficient demand in the context of the three sector economy. Fig. 10 :
Deficient Demand in a Three Sector Economy In order to remedy the problem of deficient
demand, the aggregate demand has to be increased by an amount equal to the deflationary gap.
This will move the economy to the full employment equilibrium at point F. The aggregate
demand may be increased by taking recourse to fiscal policy, monetary policy or both. Fiscal
Policy Measures We shall first consider the fiscal policy measures to increase aggregate demand.
This may be done by either increasing the level of government expenditure or by reducing the
amount of taxes. We will consider only increase in government expenditure. If the government
expenditure is increased by an amount equal to the deflationary gap, it will restore the economy
to the fullemployment equilibrium. The increase in government expenditure is shown in figure
11. Fig 11. Increase in government expenditure as a remedy for deficient demand 34 The new
level of aggregate demand is C+I+G1 corresponding to a higher level of government expenditure
G1. This level of aggregate demand is sufficient to keep the economy at the full employment
equilibrium, thus increase in government expenditure by an amount FG will eliminate the
problem of deficient demand. Monetary Policy Measures The problem of deficient demand can
also be solved by taking resort to monetary policy measures. The aim of the monetary policy
measure is to cause an increase in the investment expenditure by firms. This may be done in a
two step manner. The first step is to increase the availability of credit. This may be done by
reducing the reserve ratios, thus giving commercial banks greater ability to create credit, The
next step is to lower the interest rate by increasing the supply of money. The purpose of this step
is to ensure the off take of the increased credit by firms. There is an inverse relationship between
the rate of interest and the level of investment demand. If the economy’s Central Bank lower the
interest rate, then there would be an increase in investment demand. This increase in investment
demand would cause an increase in aggregate demand. Thus, by sufficiently lowering the interest
rate, the Central Bank may increase investment demand and therefore aggregate demand, until
the economy is restored to a full-employment equilibrium. Remedy for Excess Demand As we
have seen earlier, if aggregate demand is for a level of output greater than the full employment
level of output, then a situation of excess demand exists. In order to remedy the problem of
excess demand, the aggregate demand has to be reduced by an amount equal to the inflationary
gap. This will keep the economy at full employment equilibrium but will lower the price level
and thus combat the inflation. The aggregate demand may be reduced by taking recourse to fiscal
policy or to monetary policy. Reduce Government Expenditure Reduction in government
expenditure will reduce aggregate demand and remove the inflationary gap. This can also be
shown by a diagram in the same way as was done in a two sector model. The C+I+G curve will
shift downward showing fall in Government expenditure. The fall in government expenditure
should be equal to the inflationary gap. Monetary Policy Measures The monetary policy measure
to combat the problem of excess demand will operate through a reduction in the investment
demand by firms. There is an inverse relationship between the rate of interest and the level of
investment demand. If the economy’s Central Bank were to increase the interest rate, then there
would be a decrease in investment demand. This decrease in investment demand would cause a
decrease in aggregate demand. Thus, by sufficiently raising the interest rate, the Central Bank
may decrease investment demand and therefore, aggregate demand, until the inflationary gap is
eliminated, and the price level reduced. 35 UNIT 8 EVOLUTION OF MONEY Money is
anything which can serve as a medium of exchange. Historically, all sorts of things like animals,
agricultural produce, metals have been used as a medium of exchange. Today, it is prominently
paper money, i.e. the currency notes. Although today paper money is prominent, yet instances of
agricultural produce, metals, etc. can be found here and there, particularly in villages. In many
Indian villages ‘food for work’ is still a practice. This shows that many mediums of exchange
existed side by side but only one medium or the other found a prominent place. Since many
mediums of exchange existed simultaneously we can talk of evolution of money in terms of the
prominence of the mediums. Upto first half of the 18th century, the mediums of exchange were
goods with increasing use of metals, particularly gold and silver. The paper money was
introducad in the organised manner for the first time around 1750’s. So from around 1750’s till
1930’s gold and silver were prominently used but at the same time there was increasing use of
paper money. Why did gold and silver found prominence during this phase? There were many
reasons. First, gold and silver were widely accepted in monetary transactions, like buying and
selling, borrowing and lending, for storing wealth, etc. Second they were in limited supply.
Third, they are durable nearly non-perishable. Fourth, gold and silver can easily be divided into
monetary units. From 1930’s onwards most countries are now using paper currency as a
prominent, and nearly exclusive, medium of exchange. Why so? It is mainly because of
phenomenal rise in the volume of transactions needing more and more of money. But why gold
and silver were found wanting? The main reason was their limited supply. The world’s
production of gold and silver was not enough to match the requirements of increasing volume of
internal and external trade. Even if supply was sufficient, inconvenience in handling large
transactions, lack of safety during transportation of metals, etc. came in the way of using gold
and silver as a prominent medium. Note that today paper currency is in prominence as a medium
of exchange, people still prefer to hold gold and silver. They hold not because it can be used as a
medium of exchange, but because it is durable and easily convertible into paper currency for use
as a medium of exchange. BANKING Commercial Banks Banking is defined as the accepting,
for the purpose of lending or investment of deposits, money from the public, repayable on
demand or otherwise and withdrawable by cheque, draft,order or otherwise. Thus the two
essential functions of banks are to accept chequable deposits from the public and lending. 36
Acceptance of chequable deposits is a necessary, but not sufficient condition for Financial
Institution (FI) to be a bank. For example, post office savings banks are not banks in this sense of
the term even though they accept deposits from the public. This is because they do not perform
the other essential function of lending. Similarly, lending alone does not make FI a bank. For
example, many FIs like LIC, UTI, and IFC, etc, lend to others but they are not banks in this sense
of the term, as they do not accept chequable deposits. The main functions that commercial banks
perfom are : 1. Acceptance of Deposits The bank accepts three types of deposits from the public.
_ Current Account Deposits : Deposits in current accounts are payable on demand. They can be
drawn upon by cheque without any restriction. These accounts are usually maintained by
businesses and are used for making business payments. No interest is paid on these deposits.
However, the banks offer various services to the account holders for a nominal charge, the most
important being the cheque facility. Banks keep regular accounts of all transactions made in a
particular account and submit statements of the same to the account-holder at regular intervals. _
Fixed/Term Deposits : These are deposits for a fixed term (period of time) varying from a few
days to a few years. They are not payable on demand and do not enjoy chequing facilities. The
moneys deposited in such accounts become payable only on the maturity of the fixed period for
which the deposit was initially made. A variant of fixed deposits are recurring deposits. In these
accounts, a depositor makes a regular deposit of an agreed sum over an agreed period e.g. Rs.
100 per month for 5 years. Interest is paid on the deposits in these accounts. _ Savings Accounts
Deposits : These deposits combine the features of both current account deposits and fixed
deposits. They are payable on demand and also withdrawable by cheque, but with certain
restrictions on the number of cheques issued in a period of time. Interest is paid on the deposits
in these accounts but the interest paid on savings account deposits is less than that of the fixed
deposits. In monetary analysis deposits are classified into two types : demand deposits and time
deposits. Demand deposits are payable on demand either through cheque or otherwise. Only
demand deposits may serve as a medium of exchange, because their ownership can be
transferred from person to person through cheques. All other deposits that are not payable on
demand are called time deposits. All current account deposits are demand deposits and all terms
deposits are time deposits. The classification of savings deposits is not as straight forward
because they combine features of both demand and time deposits. The Reserve Bank of India
distinguishes between the demand liability position of savings deposits (which are included
under demand deposits) and the time 37 liability portion of savings deposits). The rule to decide
which part of the savings deposits came under which category was : the average of the monthly
minimum balances in the savings accounts on which interest is being paid shall be regarded as a
time liability and the excess over the said amount shall be regarded as a demand liability. 2.
Giving Loans The deposits received by the bank are not allowed to lie idle by the bank. After
keeping a certain portion of the deposits as reserves, the bank gives the balance to borrowers in
the form of loans and advances. The different types of loans and advances made by banks are as
follows : _ Cash Credit - In this arrangement an eligible borrower is first sanctioned a credit limit
upto which he may borrow from the bank. This credit limit is determined by the bank’s
estimation of the borrower’s creditworthiness. However, actual utilisation of credit by the
customer depends upon his withdrawing power. The withdrawing power depends on the value of
the borrower’s current assets, which comprise mainly of stocks of goods-raw materials,
semimanufactured or finished goods, and bills receivable (dues) from others. The borrower has
to submit a stock statement of his assets to the bank showing evidence of on-going trade and
production activity and acting as a legal document in possession of the bank, to be used in case
of default. The borrower has to pay interest on the ‘drawn’ or utilised portion of the credit only. _
Demand Loans - A demand loan is one that can be recalled on demand. It has no stated maturity.
The entire loan amount is paid in lump sum by crediting it to the loan account of the borrower.
Thus, the entire loan amount becomes chargeable to interest. Security brokers and others whose
credit needs fluctuate day to day usually take these loans. The security against these loans may
be personal, financial assets or goods. _ Short-term Loans - Short-term loans may be given as
personal loans, loans to finance working capital or as priority sector advances. These loans are
secured loans, i.e. they are loans made against some security. The whole amount of the term loan
sanctioned is paid in lump sum by crediting it to the loan account of the borrower. Thus, the
entire loan amount becomes chargeable to interest. The repayment is made as scheduled. either
in one instalment at the end of the loan period, or in a number of instalments over the period of
the loan. In addition, commercial banks extend the following facilities when they are demanded
by their customers. 3. Overdrafts An overdraft is an advance given by allowing a customer to
overdraw his current account upto an agreed limit. The security for overdrafts is usually financial
assets of the account holder such as shares, debntures, life insurance policies etc. Overdraft is a
termporary facility and the rate of interest charged on the amount of credit used is lower than that
on cash credit because the risk involved and service cost of such credit is less - it is easier to
liquify financial assets than physical assets. 38 4. Discounting Bills of Exchange A bill of
exchange is a document acknowledging an amount of money owed in consideration for goods
received. For example, if A buys goods from B, he may not pay B immediately. He may give B a
bill of exchange, stating the amount of money owed and the time when the debt has to be settled,
If B wants money immediately, he will present the bill of exchange to the bank for discounting.
The bank will deduct a commission and pay the present value of the bill to B. Upon maturity of
the bill; the bank will secure payment from A. 5. Investment of funds The banks invest their
surplus funds in three types of securities - Government securities, other approved securities, and
other securities. Government securities are securities of both the central an state governments
such as treasury bills, national savings certificates etc. Other approved securities are securities
approved under the provisions of the Banking Regulation Act, 1949. These include securities of
state associated bodies like electricity boards, housing boards, debentures of Land Development
Banks, units of UTI, shares of Regional Rural Banks etc. Part of the banks investment in
government securities and other approved securities are mandatory under the provisions of the
Statutory Liquidity Ratio requirement of the RBI. However, banks hold excess investments in
these securities because banks can borrow against these securities from RBI and others, or sell
these securities in the open market to meet their need for cash. Banks hold them even though the
return from them is lower than that on loans and advances because they are more liquid. 6.
Agency Functions of the Bank The bank performs certain agency functions for its customers in
return for a commission. The agency services provided by the banks are : (i) Transfer of fund -
the bank provides facility for cheap and easy remittance of funds from place to place via
instruments such as the demand drafts, mail transfers, telegraphic transfers etc. (ii) Collection of
fund - the bank undertakes to collect funds on behalf of its customers through instruments such
as cheques, demand drafts, bills, hundies, etc. (iii) Purchase and sale of shares and securities on
behalf of customers (iv) Collection of dividends and interest on share and debentures on behalf
of customers. (v) Payment of bills and insurance premia as per customer’s directions. (vi) Acting
as executors and trustees of wills. 39 (vii) Provision of income tax consultancy and acceptance of
income tax payments of customers. (viii) Acting as correspondent, agent or representative of
customers as well as securing documentation for air and sea passage. 7. Miscellaneous Functions
(i) Purchase and sale of foreign exchange. (ii) Issuance of travellers’ cheques and gift cheques.
(iii) Safe custody of valuable goods in lockers. (iv) Underwriting activities (agreeing to partly or
fully purchase the whole or the unsold portion respectively of new issue of securities) and private
placement of securities (selling securities not through the open market, but privately to selected
entities). Fig. 7.1 : Schematic Classification of Commercial Banks As is evident from the above
list, banks provide a wide range of services to their customers. Under the present economic
liberalisation, commercial banks are urged to assume certain roles which are usually outside the
purview of typical commercial banking such as development banking, insurance in addition to
commercial banking practices. Figure 7.1 gives a schematic classification of commercial banks.
40 The Central Bank The central bank is the apex institution of a country’s monetary system.
The design and the control of the country’s monetary policy is its main responsibility. India’s
central bank is the Reserve Bank of India. The Central Bank performs the following functions :
1. Currency Authority The Central Bank is the sole authority for the issue of currency in the
country. All the currency issued by the Central Bank is its monetary liability. This means that the
Central Bank is obliged to back the currency with assets of equal value. These assets usually
consist of gold coin, gold bullion, foreign securities, and the domestic government’s local
currency securities. The country’s Central Government is usually authorized to borow money
from the Central Bank. Government does this, by selling local currency securities to the Central
Bank. The effect of this is to increase the supply of money in the economy. When the Central
Bank acquires these securities, it issues currency. This authority of the government gives it
flexibility to monetize its debt. Monetizing the government’s debt (called public debt) is the
process of converting its debt (whether existing or new), which is a non-monetary liability, into
Central BanK currency, which is a monetary liability. Putting and withdrawing currency into and
from circulation is also the job of its banking department. For example, when the government
incurs a deficit in its budget, it borrows from the Central Bank. This is done by selling treasury
bills to the Central Bank, the latter paying for the bills by drawing down its stock of currency or
printing currency against equal transfer of the said securities. The government spends the new
currency and puts it into circulation. 2. Banker to the Government The Central Bank acts as a
banker to the government - both Central as well as State governments. It carries out all the
banking business of the government, and the government keeps its cash balances on current
account with the Central Bank. As the banker to the government, the Central Bank accepts
receipts and makes payments for the government, and carries out exchange, remittance and other
banking operations. The Central Bank also provides short-term credit to the government, so that
the government can meet any shortfalls in receipts over disbursements. The government borrows
money by selling treasury bills to the Central Bank. The government carries on short term
borrowing by selling adhoc treatury bills to the Central Bank. As the government’s banker, the
Central Bank also has the responsibility of managing the public debt. This means that the Central
Bank has to manage all new issues of government loans. The Central Bank also advises the
government on banking and financial matters. 41 3. Bankers’ Bank and Supervisor As the banker
to banks, the Central Bank holds a part of the cash reserves of banks, lends them short-term
funds and provides them with centralised clearing and remittance facilities. The banks are
required to deposit a stipulated ratio of their net total liabilities (the CRR) with the Central Bank.
The purpose of this stipulaton is to use these reserves as an instrument of monetary and credit
control. In addition to this the bank holds excess reserves with the Central Bank to meet any
clearing drains due to settlement with other banks or net withdrawals by their account holders.
The pool of funds with the Central Bank serves as a source from which it can make advances to
banks temporarily in need of funds, acting in its capacity as lender of last resort. The Central
Bank supervises, regulates and controls the commercial banks. The regulation of banks may be
related to their licensing, branch expansion, liquidity of assets, management,
amalgamation(merging of banks) and liquidation (the winding up of banks). The control is
exercised by periodic inspection of banks and the returns filled by them. 4. Controller of Money
Supply and Credit The Central Bank controls the money supply and credit in the best interests of
the economy. The bank does this by taking recourse to various instruments. Generally they are
categorised as quantitative and qualitative instruments. Let us first detail with the instruments of
quantitative control. i.e. those that affect only the quantity of the particular variable : 1. Bank
Rate Policy : The bank rate is the rate at which the central bank lends funds as a ‘lender of last
resort’ to banks, against approved securities or eligible bills of exchange. The effect of a change
in the bank rate is to change the cost of securing funds from the central bank. An increase in the
bank rate increases the costs of borrowing from the central bank. This will reduce the ability of
banks to create credit. A rise in the bank rate will then cause the banks to increase the rates at
which they lend. This will then discourage businessmen and others from taking loans, thus
reducing the volume of credit. A decrease in the bank rate will have the opposite effect. In actual
practice however, the effectiveness of bank rate policy will depend on (a) the degree of banks’
dependence on borrower reserves (positive relationship). (b) the sensitivity of banks’ demand for
borrowed funds to the differential between the banks lending rate and their borrowing rate
(positive relationship), (c) the extent to which other rates of interest in the market change and (d)
the state of supply and demand of funds from other sources. 2. Open Market Operations : OMO
is the buying and selling of government securities by the Central Bank from / to the public and
banks. It does not matter whether the securities are bought or sold to the public or banks because
ultimately the amounts will be deposited in or transferred from some bank. The sale of
government securities to banks will have the effect of reducing their reserves. When the bank
gives the Central Bank a cheque for the securities, the Central Bank collects the amounts by
reducing the bank’s reserves by the particular amount. This directly reduces the bank’s ability to
give credit and therefore decrease the money supply in the economy. When the Central Bank
buys securities from the banks it gives the banks a cheque drawn on itself in payment for the
securities. When 42 the cheque clears, the Central Bank increases the reserves of the bank by the
particular amount. This directly increases the bank’s ability to give credit and thus increase the
money supply. Successful conduct of OMO as a tool of monetary policy requires first that a well
functioning securities market exists. If banks regularly and routinely resort to keeping excess
reserves then the utility of such a policy will be doubtful. 3. Varying Reserve Requirements :
Banks are obliged to maintain reserves with the Central Bank on two accounts. One is the Cash
Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio. Under CRR the
banks are required to deposit with the Central Bank a percentage of their net demand and time
liabilities. Varying the CRR is a tool of monetary and credit control. An increase in the CRR has
the effect of reducing the banks excess reserves and thus curtails their ability to give credit. The
SLR requires the banks to maintain a specified percentage of their net total demand and time
liabilities in the form of designated liquid assets which may be (a) excess reserves (b)
unencumbered (are not acting as security for loans from Central Bank) government and other
approved securities (securities whose repayment is guaranteed by the government) and (c)
current account balances with other banks. Varying the SLR affects the freedom of banks to sell
government securities or borrow against them from the Central Bank. This affects their freedom
to increase the quantum of credit and therefore the money supply. Increasing the SLR reduces
the ability of banks to give credit and vice versa. We now deal with instruments of qualitative
credit control, which deal with the allocation of credit between alternative uses. 1. Imposing
margin requirement on secured loans : A margin is the difference between the amount of the loan
and market value of the security offered by the borrower against the loan. If the margin imposed
by the Central Bank is 40%, then the bank is allowed to give a loan only up to 60% of the value
of the security. By altering the margin requirements, the Central Bank can alter the amount of
loans made against securities by the banks. The advantages of this instrument are manifold. High
margin requirements discourage speculative activities with bank credit and therefore divert
resources from unproductive speculative activities to productive investments. By reducing
speculative activities, there is reduction in the fluctuation of prices. 2. Moral Suasion : This is a
combination of persuasion and pressure that the Central Bank applies on the other banks in order
to get them to fall in line with its policy. This is exercised through discussions, letters, speeches
and hints to banks. The Central Bank frequently announces its policy position and urges the
banks to fall in line. Moral suasion can be used both for quantitative as well as qualitative credit
control. 3. Selective Credit Controls (SCCs) : These can be applied in both a positive as well as a
negative manner. Application in a positive manner would mean using measures to channel credit
to particular sectors, usually the priority sectors. Application in a negative manner would mean
using measures to restrict the flow of credit to particular sectors. 43 UNIT 9 Capital receipts and
revenue receipts Capital receipts are receipts that either create a liability (for example -
borrowings) or reduce asset (for example disinvestment of PSU). Revenue receipts are receipts
that neither create any liability nor reduce any asset. Tax revenue or non tax revenue are revenue
receipts as they neither create any liability nor reduce any asset. Capital expenditure and
Revenue expenditure Any expenditure by the government that either creates an asset (for
example construction of school building etc) or reduces a liability (for example repayment of
loan) is categorised as capital expenditure Any expenditure by the government that neither
creates an asset nor reduces a liability is catagorised as revenue expenditure, (for example
interest payment, subsidies, grants given to states even if some of these may be for creation of
assets). Developmental and Non-developmental expenditure Expenditure of the government on
essential general services like defence, administration etc, is treated as non-developmental
expenditure. Expenditure of the government on agricultural, industrial development, on
economic and social infrastructure, scientific research etc, is treated as developmental
expenditure. Balanced Budget : It is a budget in which estimated receipts equal estimated
expenditure Surplus Budget : It is a budget in which estimated receipts exceed estimated
expenditure, Deficit Budget: It is a budget in which estimated receipts fall short of estimated
expenditure, Note : Estimated receipts are net of borrowings. Implications of fiscal deficit. The
extent of fiscal deficit is an indication of how far the government is liviing beyond its means.
Fiscal deficit is the amount of borrowings the government has to resort to meet its expenses. A
large fiscal deficit means large amount of borrowings. This creates a large burden of interest
payment and repayment of loans in the future. A large fiscal deficit may also be inflationary. 44
UNIT 10 Merits and demerits of fixed and flexible foreign exchange rates. Merits of fixed
exchange rate: 1. It ensures stability in exchange rate. The exporters and importers have not to
operate under uncertainty about the exchange rate. Thus it promotes foreign trade. 2. It promotes
capital movements. Fixed exchange rate system attracts foreign capital because a stable currency
does not involve any uncertainties about exchange rate that may cause capital loss, 3. Stable
exchange rate prevents capital outflow 4. It prevents speculation in foreign exchange market 5. It
forces the government to keep inflation in check. In case of fixed exchange rate system,inflation
causes balance of payments deficit resulting in depletion of foreign exchange reserves. Demerits
of fixed exchange rate: 1. It contradicts the objective of having free markets 2. Under this
system, countries with deficits in balance of payment run down this stock of gold and foreign
currencies. This can create serious problem for them. They may be forced to devalue their
currency. On the other hand countries with surplus in balance of payments will face the problem
of inflation. 3. There may be undervaluation or overvaluation of currency. If the fixed exchange
rate is at a level which is lower then the market level i.e. at which demand for foreign currency
far exceeds its supply, its will result in deficit in balance of payment. If it is higher than the
market level i.e. at which the supply exceeds demand then it may create inflationary pressure
because of balance of payments surplus. It is difficult to fix a rate that may prove to be
equilibrium rate Merits of flexible exchange rate system 1. It eliminates the problem of
overvaluation or undervaluation of currencies, Deficit or surplus in balance of payments is
automatically corrected under this system. 2. It frees the government from problem of balance of
payments. 3. There is no need for the government to hold any reserves. 4. It enhances the
efficiency in the economy by achieving optimum resource allocation. 45 Demerits of flexible
exchange rate system 1. It creates situations of instablility and uncertainty. Wide fluctuations in
exchange rate are possible. This hampers foreign trade and capital movements between
countries. 2. It encourages speculation which may lead to larger uncertainties and fluctuations. 3.
The uncertainty caused by currency fluctuations can discourage international trade and
investment. DOWNLOAD

				
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