Macroeconomics

1 AN INTRODUCTION TO MACROECONOMY
1.1. Meaning

Lipsey-“macroeconomics is the study of the determination of economic

aggregate and averages, such as, total output, total employment, the
general price level, the rate of economic growth”

R. E Boulding-“macroeconomics deals not with individual quantities as

such with aggregates of those quantities not with individual income but
with national income not with individual prices but with price level not
with individual outputs but with national output”

Mc. Connel-“macroeconomics examines the forest not the tree. It gives

us a bird’s eye view of the economy”

1.2. Scope of macroeconomics

 Theory of income and employment
 Macro theory of distribution
 Theory of international trade business fluctuations
 Theory of money and price level
 Theory of economic growth
 Macroeconomic policies
1.3. Types of macroeconomics
 Simple macro-statics

Kurihara-“if the objective is to show ‘a still picture’ of the economy as a

whole, the micro-static model is the appropriate technique. For this
technique is one of investing the relations between macro variables in
the final position of equilibrium without reference to the process of
adjustment implicit in that final position”

 Comparative macro-statics
 Macro-dynamics

Kurihara-“microeconomics enables to separate the process of trial and

error into a series of continuously changing relations and indicates the
cause and effect. It analysis the discrete or continuous changes of
aggregates, the sequence of cause and effect events arising from some
initial change and the time paths(roots) of microeconomic variables”

1.4. Uses of macroeconomics

 To understand the working of the economy
 Formulation of economic policies
 Business decision
 Economic planning
 Development of microeconomic theories
 International comparisons
1.5. Limitations of macroeconomics
 It is the complicated task to find out total national income by the
help of estimates of price of different good and services. Wholesale
price index numbers are made to find out general price level. Those
index numbers involve the problems of weighing, averaging and a
number of other difficulties
 The aggregates which are homogenous in nature can lead to
accurate results. But sometimes we may have to take into account
aggregates which are non-homogenous in character. Results based
on these heterogeneous aggregates are not accurate and we should
always avoid such problems
 Due to imperfect knowledge of statistical techniques, some person
may predict the aggregates in false way. For example, the
agricultural prices decrease by 50 percent while industrial prices
increase by 50 percent, the general price level remains the same
because the two types of price changes neutralize each other. In
such a situation one may advise the government to make no change
in its policy because the general price level remains the same. But
actually the government needs to implement a policy which helps
the farmers who get a loss due to fall in price of their product. Thus,
sometimes the aggregate results may be misleading. It requires
special ability to predict the result in such a situation
 An aggregative change may not influence all the sectors of the
economy in the same manner. For example, a general rise in prices
does not mean that the prices of all the commodities have increased
and have increased in the same proportion. It is quite possible that
the prices of a few commodities may rather decrease. Further, due
to this aggregative change, some sectors may be affected more
adversely than others. On the other hand, some individuals may be
benefited more than others
1.6. Difference between microeconomics and macroeconomics
 Study of economic units
 Objective of study
 Subject matter
 Methodology
 Components of equilibrium

Microeconomics Macroeconomics
Microeconomics studies the Macroeconomics deals with
individual or small economic aggregates like national income,
variables of the economy such as full employment and price level
individuals consumptions, saving,
investment and income
The main objective of The main objective of
microeconomics is to study the macroeconomics is to study the
principles, problems and policies principles, problems and policies
concerning the optimum allocation relating to full employment and
of resource growth of resources
The subject matter of The subject matter of
microeconomics is to study the macroeconomics is to study the
determination of price, process of determining
consumer’s equilibrium, employment, price level, national
distribution and welfare etc. income, trade cycle etc. Hence it is
Hence it is also called price theory
also called income and
employment theory
All microeconomics concepts and Macroeconomics assumes how the
laws such as law of demand, law of factors of production[economic
supply, etc. and described by resources] are distributed. It
setting are formulated on explains how full employment can
assumption such as full be achieve in market economy.
employment, constant production The total effect of an economic
and income, ceteris paribus[other factor on the economy is taken
things being equal]. In other into account in macro-economic
words, they establish relationship analysis. This method of study is
between cause and effect of also known as the price
microeconomic variables. This equilibrium analysis
method of study is also known as
the price equilibrium analysis
Microeconomics studies the Macroeconomics analysis deals
equilibrium between the forces of with the national income, output,
market demand and market employment etc. an such
supply. Hence the basis of economic variables are
microeconomics is the price determined at the point of
mechanism equilibrium established between
the forces of the whole
economy[i.e. aggregate demand
and aggregate supply]
The study of microeconomics is Macroeconomics studies the
not much help to solve the causes, effects and possible
important current issues and measures for the solution of these
problem such as decline in issues and problems.
national income, hyperinflation, Macroeconomics help to solve
widespread unemployment and so these problems
on
Table 1.1 Difference between microeconomics and macroeconomics

1.7. Interdependence between microeconomics and

macroeconomics
1.8. Dependence of microeconomics on macroeconomics
 Determination of product pricing
 Study of factor pricing
1.9. Dependence of macroeconomics on microeconomics
 Study of national income
 Study of general price level
 Study of total saving
1.10. Macroeconomic issues
 Employment and unemployment
 Inflection or rising general price level
 Business cycles
 Stagflation and deflation
 Economic growth
 Balance of payments and exchange rate
1.11. Policies instruments
 Demand-side policies
 supply-side policies
1.12. Macroeconomic indicators
 Nominal GDP
 Real GDP
 GDP deflator
 GDP at producer’s price
 Aggregate demand and saving
 Government finance-revenue, expenditure and fiscal deficit
 Monetary aggregates-narrow money and broad money

2 NATIONAL INCOME ACCOUNTING

2.1 Definition
n

NI=∑ Y 1
i=1

NI=(Y1+Y2+ Y3+ Y4+ …………. Yn)

Traditional approach

Marshall-“the labor and capital of a country acting on its natural

resources produce annually a certain net aggregate of commodities,
materials and immaterial, including services of all kinds”

Pigou-“national income is that part of objective income of the

community, including of course, income derive from abroad, which can
be measured in money”
Fisher-“the national dividend or income solely of services as received by
ultimate consumers, whether from their material or from their human
environment”

Modern approach

Simon Kuznets-“national income is the net output of commodities and

services flowing during the year from the country’s productive system to
the hands of the ultimate consumers”

World bank-“gross national product measures the total domestic and

foreign value added claimed by residents. It comprises gross domestic
product plus net income from abroad which is the income received by
residents from abroad for factor services[labor and capital] less
payments made to non-residents who contributed in the production of
goods and services to the domestic economy”

Definition of National by United Nation

 Net national product, i.e. aggregate of net value added in all

branches of economic activity during a specified period, including
net income from abroad
 Sum of the distributive shares, i.e. the aggregate of National Income
accrued to the factors of production[in the form of wages, profits,
interest, rent etc.
 Net national expenditure, i.e. the aggregate of expenditures on final
consumption of goods and services, plus domestic and foreign
investment

Features
 National Income is the total amount of income from all economic
activities like primary[agriculture], secondary[industry] and
tertiary[trade, transport, services, etc.] sectors during a year
 It is a result of combine contribution of all economic resources like
natural resources, human resources and physical resources
 It is a flow concept, not a stock. In other words, it is a flow of final
goods and services produced from all economic sectors in the
country during a year
 Generally, it is calculated as a net form. The word net refers to the
depreciation which is deducted from gross value of National Income
 Net factor income from abroad should be added to National Income
 There is triple identity; National Output = National Income = National
Expenditure[NO=NI=NE]
2.2 Various concept of national income
 In terms of market price
 Gross domestic product[GDP]

GDPMP=C+G+I+(X-M)

Where

C=consumption expenditure

I=domestic investment

G=government expenditure

X=export earnings

M=import expenses

 Net domestic product[NDP]

NDPMP=GNPMP-Depreciation

NDPMP=NNPMP-NFIA

Where

NFIA=net factor income from abroad

 Gross national product[GNP]

GNPMP=GDPMP+NFIA

Where

NFIA=net factor income from abroad

 Net national product[NNP]

NNPMP= GNPMP-Depreciation

 In terms of factor cost

 Gross domestic income[GDI]

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed

income +Depreciation

Where the item of compensation of employees are

 Wage and salary

 Bonus
 Room accommodation
 Tour and travel facilities
 Education and health facilities
 Other fringe benefits
 Gross national income[GNI]
GNIMP=GDIMP+NFIA

Where

NFIA=net factor income from abroad

 National income[NI]

NIMP= GNIMP-Depreciation

Short note: Net National Product[NNP] or National Income[NI]

 Only those economic values are evaluated in calculating

GDP/NDP/GNP/NNP in both market price and factor cost which add
productive capacity of the economy
 Some economic values such as capital gains, secondhand sales,
illegal income, transfer payments etc. are excluded from
GDP/NDP/GNP/NNP in both market price and factor cost which do
not add productive capacity of the economy
 Net domestic income[NDI]

NDIMP=NNIMP-NFIA

NDIMP=GNIMP-Depreciation

Where

NFIA=net factor income from abroad

Items of NDI

 Compensation of employees
 Operation surplus

Operation surplus=Rent + Interest + Profit

 Mixed income

Significance of depreciation

 Conversion of gross product into net product

 NDPMP=GNPMP-Depreciation
 NNPMP= GNPMP-Depreciation
 NDIMP=GNIMP-Depreciation
 NIMP= GNIMP-Depreciation
 Conversion of net product into gross product
 GNPMP=NDPMP + Depreciation
 GNPMP= NNPMP + Depreciation
 GNIMP=NDIMP + Depreciation
 GNIMP= NIMP + Depreciation

Significance of net factor income from abroad[NFIA]

 Conversion of gross product into net product

 GDPMP=GNPMP-NFIA
 NDPMP=NNPMP-NFIA
 GDIMP=GNIMP-NFIA
 NDIMP=NNIMP-NFIA
 Conversion of net product into gross product
 GNPMP=GDPMP + NFIA
 NNPMP=NDPMP + NFIA
 GNIMP=GDIMP + NFIA
 NNIMP=NDIMP + NFIA

Concept of net indirect tax

 Conversion of factor cost into market price

 GDPMP=GDIFC+NIT
 GNPMP=GNIFC+NIT
 NNPMP=NIFC+NIT
 NDPMP=NDIFC+NIT
 Conversion of market price into factor cost
 GDIFC=GDPMP-NIT
 GNIFC=GNPMP-NIT
 NIFC=NNPMP-NIT
 NDIFC=NDPMP-NIT

Private income

Private income=National Income - Income from prosperity and

entrepreneurship accruing to the government – Saving of non-
departmental enterprise + National debt interest + Current transfers
from government + Other current transfers from rest of the world

Personal Income[PI]

PI=NI – [undistributed profit + cooperate income taxes +social security

contribution – transfer payments

Where

PI=Personal Income

NI=National Income

Disposable Income[DI]

DI=PI – direct taxes

Where
PI=Personal Income

DI=Disposable Income

Further

DI= C + S

Or

DI= C + I

Where

DI=Disposable Income

C=Consumption

S=Saving

I=Investment

Saving

Robertson-“current saving is a function of past income. It is the

difference between yesterday’s income and today’s expenditure”

Keynes-“current saving is the difference between current income and

current consumption”

S=DI-C

Or

S=Y-C

Where
DI=Disposable Income

C=Consumption

Y=Income

Per capita income

National income of the year
Per capita income= Total population of the year

Real GDP vs nominal GDP, Deflator and Rate of inflation

National GDP
GDP deflator= Real GDP *100

ChangeGDP d eflator
Rate of inflation= GDP deflator for previous year *100

2.3 Some basic concept

 Potential GDP/GNP and actual GDP/GNP
 Transfer payments
 Capital gains
 Second-Hand sale
 Illegal income
 Closed economy and open economy
 Normal residents of a country
 Stock and Flows
 Production process
 Depreciation
2.4 Circular flow of income and expenditure

Concept of money flow and real flow

Assumption of circular flow of income and expenditure in a two-

sector model
 There are only two sectors in the economy, (a) the households and
(b) the producer
 All income is spent on consumption. There are no saving in the
economy
 There is no government
 It is a closed economy with no export and import
 Households are the owners of factors of production or they are the
suppliers of factor services
 Producers/firms have factor services from the households

Features of households

 The households are the owners of all factors of production

 Their total income consists of wages, rent, interest and profits
 They are the consumers of all consumer goods and services
 They save a part of their income and supply finance to the firm

Features of business firms

 They own no resources of their own

 They hire and use the factors of production from the households
 They produce and sell goods and services to the households
 They do not save, that is there is no cooperate saving

Graphical representation of circular flow in a two-sector model

Circular money flow with saving and investment

The circular flow of income and expenditure in a three-sector model

Graphical representation of circular flow in a three-sector model

Assumption of circular flow of income and expenditure in a four-
sector model

 The external sector consists only of exports and imports of goods

and services, made only by the firms
 The households expert only labour and capital

Graphical representation of circular flow in a four-sector model

2.5 Methods of measuring national income

 Expenditure method[spending approach]

GDPMP=C+G+I+(X-M)

GNPMP=C+G+I+(X-M)+(R-P)

NNPMP= GNPMP-Depreciation

Where

C=consumption expenditure

I=domestic investment

G=government expenditure

X=export earnings

M=import expenses

R=receipt from abroad

P=payment made to abroad

Components of expenditure method

 Private[personal] consumption expenditure[C]

 Gross private domestic investment or gross capital formulation[I]
 Non-residential investment
 Residential investment
 Changes in business inventories
 Depreciation
 Government expenditure[G]
 Net foreign investment(X-M)
 Net factor income from abroad[NFIA] or net receipt[R-P]

Gross private domestic investment may also classified as:

I=net fixed investment + changes in inventories + depreciation
Or, I=net investment[net capital formation] + depreciation
Or, I=gross fixed investment + changes in inventories
Or, I=gross fixed capital formation + changes in inventories

Components of net factor income come earned from abroad

 Net compensation of employees

 Net income from property[rent and interest and income from
entrepreneurship]
 Net retained earnings of the resident companies working in foreign
companies

Precaution for taking to estimating National Income by expenditure

method

 All expenditures on second-hand goods are to be excluded

 Expenditures on financial assets, like shares and bonds within the
country are excluded
 All government expenditures on transfer payments, such as old age
pension, national debt interest, unemployment allowance, etc.
should be excluded
 Expenditures on all intermediate goods and services are also
excluded because otherwise there would be double counting in the
National Income
 Income method[share distributive approach

Components of income method

 Rents
 Compensation of employees
 Profits
 Mixed income of self-employed
 Depreciation[capital consumption allowance or consumption of fixed
capital]
 Net indirect tax

Items those are included in net indirect taxes

 Value of production for self-consumption, such as agricultural

products used by the farmers for the consumption in of their families
 Imputed rent of houses occupied by the owners of these houses

Items those are not included in net indirect taxes

 All current transfer incomes, like pensions, unemployment relief,

scholarship, etc. should be excluded from National Income because
they have been received without rendering any productive services
in the current year. The transfer incomes do not reflect any product
of goods and services in the current year
 Illegal incomes, like incomes of smugglers and gamblers are excluded
from National Income as they are the result of illegal activities and
are unaccountable
 Cooperate profit taxes have to be excluded because they are part of
cooperate profit which are already included in factor incomes and
their inclusion separately would amount to double counting
 Interest on national debt is excluded from National Income since it is
treated as transfer income on the assumption that government
borrowings are used for consumption purposes
 Money income received from the sale and purchase of second-hand
goods, bonds, share are excluded from National Income because
they do not contribute anything to the current flow of goods and
services

According to income method

 NDPFC[domestic factor income receipt]= Rent + Interest + Profit +

Compensation of employees + Mixed income
 NDPFC= Compensation of employees + Operating surplus + Mixed
income
 GDPK= NDPK + depreciation
 GDPMP= GDPK + net indirect tax
 NNPK= NDPK + net factor income from abroad
 NNPMP=NNPK + net indirect tax
 GNPK= NNPK + depreciation
 GNPMP= GNPK + net indirect tax
 Product method[inventory approach]

Components of product method

 Primary sector which includes agro-products[food crops, cash crops,
animal husbandry, horticulture, etc.], fishery, forestry, mining,
querying and so on
 Secondary sector, which includes manufacturing, construction,
electricity, gas, water supply and others
 Tertiary sector, which includes banking and insurance, transport and
communication, trade and commerce, health and education and
other services
 Net factor income from abroad

According to product method

 GDPMP=total product of primary sector + total product of secondary

sector + total product of tertiary sector
 GNPMP=GDPMP + net factor income from abroad
 NDPMP=GDPMP – depreciation
 NNP at factor cost or NI=NNP at market price – net indirect tax

Problem of double counting

Method to avoid problem of double counting

 Final product method

 Value added method

Items those are included in product method

 Own account production of fixed assets, like residential buildings,

factor-buildings by households, corporate and quasi-corporate
entrepreneurs and government
 Food and other items for self-consumption
 Imputed rent of owner-occupied houses
Items those are included in product method

 Sale and purchase of second-hand goods are not included because

these transactions have not contribute anything to the flow of goods
and services in the current year
 Capital gains obtained from sale and purchase of bonds and shares
are excluded from National Income since they do not contribute
directly to the flow of goods and services in the current year
 Services of housewives are excluded from National Income because
there is no way of evaluating these services
 Expenditures on financial assets, like shares and bonds within the
country are excluded
 All government expenditures on transfer payments, such as old age
pension, national debt interest, unemployment allowance, etc.
should be excluded
2.6 Reconciliation of three methods of measuring GDP at MP

Product method Income method Expenditure method

Net value added in the Compensation of Private final
primary sector at employees consumption
factor cost expenditure
Net value added in the Rent Government final
secondary sector at consumption and
factor cost investment
expenditure
Net value added in the Interest Gross capital
tertiary sector at formation or private
factor cost domestic investment
Depreciation or Profits Net export of goods
consumption of fixed and services
capital
Net indirect taxes Mixed income of self-
employed
Depreciation
Net indirect taxes
GDP at market price GDP at market price GDP at market price
Table 2.1 Reconciliation of three methods of measuring GDP at MP

2.7 Difficulties in measurement of National Income

 Conceptual difficulties
 Inclusion of services
 Identifying intermediate goods
 Identifying factor incomes
 Services of housewives and other similar services
 Imputing unpaid services
 Income of the foreign companies
 Valuation of inventory changes
 Estimation of depreciation
 Practical difficulties
 Lack of occupational specialization
 Non-Monetized sector
 Inadequate information
 Unreported illegal income
 Non-Availability of reliable statistical data

The number of gap in non-availability of reliable data

 There is a dearth of agencies and statistical organizations collecting

national income data
 A large number of enumerators entrusted with the task of collecting
data at the village level are semi-illiterate and untrained in the
 collection of data. They do not possess requisite knowledge of
collecting, classifying and analyzing data
 Thirdly, There are also major gaps of data in respect of agricultural
by-products, like fruits, vegetables, timber and firewood, price data
on several products like livestock, poultry products. Moreover, data
in respect of consumption, saving and investment expenditures are
incomplete, inadequate and deficient
2.8 Importance and uses of National Income

Samuelson-“by means of statistics of national income, we can chart the

movements of a country from depression to prosperity, its steady long
term rate of growth and development and finally, its material standard
of living in comparison with other nations”

 Since income is a flow of wealth. Changes in the National Income

give some indication of economic welfare. The total figure, however,
can be misleading since account must be taken of the changes in the
value of money and changes in the total population. Per capita
income is the best indicator of development. Other things being
equal, economic per head is used to compare standards of living in
different countries
 National Income per head is used to compare standards of living in
different countries
 Economic growth is measured in terms of per capita National Income
and the National Income figures[in real terms] are used to measure
the rate of growth of a country
 The National Income accounts make possible an analysis of the
behavior of the different sectors of the economy. They provide the
details of the changes in consumption and investment spending in
the level of savings, in the output of different branches of industry,
 in the expenditure of public authorities and to the distribution of
income among the different income groups. These details are
essential in planning development of various sectors
 Inflationary and deflationary pressures can be estimated with the
help of National Income statistics. The inflationary or deflationary
gaps are the inconsistencies of certain subtotals
 National Income statistics can be used to forecast the level of
business activity later dates and to find out trends in other annual
data
 The National Income figures are useful in providing a correct sense
of proportion about the structure of the economy
 In war time the study of the components of National Income is of
great importance because they show the maximum production
possibilities of the country
 Above all, the National Income statistics are used for planned
economic development of a country. In the absence of such data,
planning will be a leap in the dark

3 THEORIES OF EMPLOYMENT
3.1 Say’s Law of Market

Assumption

 There is optimum allocation of resources

 There is perfect competition prevailing in the commodity market as
well as the factor market. Thus, commodity prices are equal to
average costs and factor prices are equal to marginal productivities
 There is free-enterprise economy
 There is no government intervention to the economic field. The
government follows laissez-faire policy to facilitate economic
 adjustment and smooth working of the market mechanism in the
capitalist economic system
 The size of the market has no limits. Thus, there is automatic
expansion of the market with an increase in output offered for sale
 The free market economy and its working of prices mechanism
provide due scope to labour supply and the rising population also
stimulate capital formation. In an expanding economy, new workers
and firms will be automatically absorbed into the productive
channels by their own products in exchange without displacing or
sub-planting the existing firms and workers
 The circular flow of money is regular and continuous without any
leakage. This implies that saving is nothing but another form of
spending for capital goods. Savings are, thus, automatically invested.
There is absence of hoarding. Hence, there is no break in the flow of
income and expenditure. Income is automatically spent through
consumption expenditure and investment expenditure
 Since all savings are automatically invested, saving is always equal to
investment. Saving investment equality is the basic condition of
equilibrium in the economy. It is maintained by interest flexibility
 The economy’s equilibrium process is perceived from the long-term
point of view

Importance

 In the long-run, free economy automatically attains equilibrium at

full employment level
 There is automatic adjustment when supply creates its own demand.
Increase in supply will meet its own demand in the process of the
functioning of a free capitalist economy. Hence, there is no need for
 the government to intervene. On the contrary, any government
interference in the economic field comes in direct conflict with the
self-adjusting mechanism of the Say’s Law of Market
 Since supply creates its own demand automatically, there is no
possibility of any general overproduction. The Say’s Law is denial of
the possibility of a deficiency in aggregate demand
 When there is no general overproduction, then in the long-run there
can be no problem of general unemployment in the long-run and the
economy tends to remain at full employment equilibrium level
 In the expanding free enterprise economy when new workers and
new firms are productively absorbed, they do not supplant the
output, income and employment of the existing one and as they
release additional output and income, the community becomes
automatically rich with increasing size of National Income. it also
means that employment of new or unused resources in productive
process tends to pay its own way and confer benefits to the society
at large
 Supply creates its own demand in real items. Thus, money is just a
veil. Behind the flow of money, there is a flow of goods and services
which is important. Thus, changes in the supply of money has no
impact on the real economy’s process of equilibrium as a full-
employment level
 A capitalist economy under the laissez-faire policy has built in
flexibility. It functions automatically to optimum adjustments
through freely operating market mechanism and the price system
 Savings-investments equality is brought about by the flexibility of
interest rate. Rate of interest is, thus, a strategic variable in the
equilibrium process of the economy
 Wage flexibility in a competitive labour market tends to bring about
full-employment of workers. As Harve and Johnson put it, a
competition and flexible prices in product and factor markets-quickly
and automatically remove any disequilibrium
3.2 Meaning and types of unemployment

Types of unemployment

 Cyclical unemployment
 Frictional unemployment
 Structural unemployment
 Open unemployment
 Disguised unemployment
 Underemployment
 Educated unemployment

Labour force and unemployment rate

Labour force=number of employed + number of unemployed

Number of employed
Unemployment rate= Labour force *100

Natural rate of unemployment

3.3 Classical theory of employment

Assumption

 Full employment is a normal feature of a closed capitalist economy

in the long-run
 Individuals are rational human beings and are motivated by self-
interest
 The government should not interfere in the automatic working of
the automatic system and should follow the policy of laissez-faire
 Money acts as a medium of exchange. Individuals do not suffer from
money illusion
 Techniques of production and organizational structure of business
do not change
 There is existence of perfect competition in all markets[i.e. product
market, labour market and money market]
 People spend their entire income either on consumption or on
investment

Components

 Say’s Law of Market

 Product market
 Money market
 Labour market
 Production function

Summary

 Full employment is a normal feature of a capitalist economy. In other

words, the economy attain equilibrium only at full employment and
general unemployment or general overproduction is not possible
 Full employment means absence of involuntary unemployment.
Even at full employment, there may exist, voluntary unemployment,
frictional unemployment, seasonal unemployment, structural
unemployment or technical unemployment
 The version of Say’s Law of Market, i.e. supply creates its own
demand, is the key to achieve full employment
 Flexibility of interest rate, prices and wages ensures full employment
in the economy in the capitalist economy in the long-run. They are
determined in their respective markets through the equality of
demand and supply functions
dS
 Saving is an increasing function of rate of interest or S=f(r) and dr >0
dI
 Investment is a decreasing function of rate of interest or I=f(r) and dr
<0
 People demand money[Md] for transactions and precautionary
purposes[Ll] and demand for these purposes is a function of
income[Y]. In long-run, demand for money remains constant
 Price level varies positively and proportionately with the supply of
money. Equality between demand for money and supply of money
gives the market clearing condition in the money market
W
 Demand for labour is a decreasing function of real wage[ P or R] or
dDL
DL=f(R) and dR <0
 Supply of labour is an increasing function of real wage or SL=f(R) and
dSL
dR
>0
 Equality between demand for labour and supply of labour gives the
market clearing condition in the labour market
 Total output is a decreasing function of number of workers
employed. It is subject to the law of diminishing marginal returns

Criticism

 Keynes considered the fundamental classical assumption of full

employment equilibrium condition as unrealistic. To him, there is the
possibility of equilibrium condition at under-employment as a
normal phenomenon. Keynes regarded it as a rare phenomenon.
 Keynes in fact considered the underemployment condition of
equilibrium to be more realistic
 Keynes opposed the classical insistence on long-term equilibrium
instead, he attached greater importance to short-term equilibrium
 Classical economists rest on the Say’s Law which blindly assured that
supply always creates its own demand and affirmed the impossibility
of general overproduction and disequilibrium in the economy.
Keynes totally disagreed with this and stressed the possibility of
super exceeding demand, causing disequilibrium in the economy and
pointed out that there is no automatic self-adjustment in the
economy
 Keynes strongly objected to the classical formulation of employment
theory, particularly Pigou’s notion that unemployment will disappear
if the workers will just accept sufficiently wages rates[i.e. a voluntary
cut in money wage]. He rejected Pigou’s plea for wage flexibility as a
means of promoting employment at a time of depression
 On the practical side, Keynes pointed out that the trade unions are
an integral part of the modern industrial system and they would
certainly resist a wage-cut policy. Strike and labour unrest are the
bad consequences of such a policy. Similarly, there is welfare
legislation regarding minimum wage and unemployment insurance
in a welfare state. Dilard-“therefore, it is a bad politics even if it
should be considered good economics to object to labour unions and
to liberal labour legislation”. Thus, in modern times, money wage cut
is not a practical propositions
 On the theoretical ground, Keynes observed that a general wage cut
would reduce the purchasing power in the hands of the workers
which means a cut in their consumption, i.e. effective demands in
 the products of industry. A decline in aggregate effective demand
will obviously lead to a decrease in the level of employment.
According to Keynes, thus, a general wage cut would reduce the
volume of employment
 Keynes also attacked the classical theory in regard to saving and
investment. He objected to the classical idea of saving and
investment equilibrium through flexible rates of interest. To him
saving and investment equilibrium are obtained through changes in
income rather than in the interest rate
 For the classical economists, money is only a veil and its main
function is to act as medium of exchange. Keynes, on the other hand,
emphasized the store of value function of money. According to
Keynes when there is unemployment of resources, an increase in the
quantity of money increases output and employment and prices rise
very little and that too only indirectly
 The classical theory gives a static picture of the economy by
assuming a state of full employment. It ignores the empirical facts of
changing levels of employment in the real world
 The theory is also based on the unrealistic assumption of perfect
competition. Perfect competition does not exist in the real world
 The classical theory has a little practical significance. It does not
provide any solution to the problem of unemployment or trade
cycles
3.4 Principle of Effective Demand

Meaning

Assumption
 There is existence of closed economy, ignoring the effect of foreign
trade
 There is operation of the law of diminishing returns
 Perfect competition exists in market
 He assumes that labour has money illusion. It means that a worker
feels better when his wages double when prices also double, thus,
leaving his real wage unchanged
 The government assumed to have no part play either as taxer or a
spender, i.e. the fiscal operations of the government are not
explicitly recognized
 Less than full employment equilibrium is possible in short period

Determinants

Aggregate demand function

Stonier and Hague-“the aggregate demand price at any level of

employment is the amount of money which all the entrepreneurs in an
economy taken together really do expect that they will receive if they
sell the output produced by this given amount of men”

Aggregate supply function

Determinants of Level of Employment

Summary of Keynesian Theory of Employment

 Total Employment = Total Output = Total Income. As employment

increases, output and income also increase proportionately
 Effective demand is the key determinant of volume of employment.
In other words, deficiency effective demand[i.e. the gap between
 income and expenditure] results unemployment. Hence, effective
demand has to be increased to achieve high level of employment
 Effective demand is a point at which aggregate demand
function[except receipts of entrepreneurs] and aggregate supply
function[cost of entrepreneurs] are equal
 Keynes assumed aggregate supply function as given in the short
period and regarded aggregate demand as the most important
element in this theory
 Aggregate demand function is the sum of consumption expenditure
and investment expenditure
 Consumption expenditure depends upon the psychological and
objective factors; however the main determinants are size of income
and propensity to consume. It is fairly stable in the short-period
because propensity to consume does not change quickly
 Investment expenditure depends upon marginal efficiency of capital
and the rate of interest unlike consumption expenditure, investment
expenditure is highly unstable. The marginal efficiency of capital is
determined by a supply price of capital asset and their prospective
yields. Rate of interest is a monetary phenomenon and remains
constant in short period. Hence, the main determinant of effective
demand is the prospective yields
 Original Keynesian analysis considers economic activities governed
by private sector only but does not take into account government
expenditure. But, in modern times, government expenditure is also a
significant determinant of effective demand. Government
expenditure is consider the most effective weapon to fight
unemployment

4 COMPONENTS OF MACROECONOMICS
4.1 Consumption function

Kurihara-“consumption represents amount of consumer expenditure

made at a given level of income, whereas the propensity to consume is
a schedule of consumption expenditure at various income levels”

A. H. Hansen-“the consumption function shows what changes can be

expected in the consumption from given change in income”

R. G. Lipsey and R. A. Chrystal-“the term consumption function describes

the relationship between private consumption and the variables that
influence it. In the simpler theory consumption is primarily determined
by personal disposable income”

C=f(Y)

Where

C=consumption

f=function

Y=income

C=a + bYd

Where

C=total consumption expenditure

a=Y-intercept or autonomous consumption or consumption at Yd=0

b=marginal propensity to consume[MPC] or slope of consumption

curve or rate of change in induce consumption with respect to change
in income
Yd=disposable income

4.2 Psychological law of consumption function

Keynes-“the fundamental psychological law upon which we are entitled

to depend with great confidence both a prior from our knowledge of
human nature and from the detailed facts of expenditure, is that men
are disposed as a rule and on an average to increase their consumption
as their income increase but not by as much as increase in income”

Propositions

 When aggregate income increases, consumption expenditure also

increases but by a smaller amount. It is because that as income
increases, people are able to satisfy their wants side by side, so that
the need to spend more consumer goods diminishes. It does not
mean that the consumption expenditure falls with the increase in
income. In fact, consumption expenditure varies positively with
income, but not in the same proportion in which income
dC dC
increases[i.e. C=f(Y) or dY >0 and 0< dY [MPC]<1]
 The increased income will be divided in some ratio between saving
and expenditure[i.e. ∆Y=∆C+∆Y]. This proposition is followed from
the first proposition because when the whole of increased income is
not spent on consumption, the remaining is saved. Hence,
consumption and saving move together
 Increase in income always leads to an increase in both consumption
and saving

Assumption
 The psychological and institutional factor[complexes] such as income
distribution, price level, population growth, taste, preferences and
fashion, etc. remain unchanged in the short period
 It assumed the existence of a laissez-faire capitalist economy. The
law operates only in a developed and free capitalist economy.
People are free to spend their increased income in such type of
economy. This law is not applicable in socialist and government
regulated economy
 It assumed the existence of normal circumstances. It implies that
operation of the law is possible only under normal circumstances
and not under extraordinary circumstances, like war, hyperinflation
and depression or civil war etc.
4.3 Short-run[cyclical] and Long-run[secular] consumption function
4.4 Technical attributes of consumption function
 Average propensity to consume[APC]
C
APC= Y

Where

C=consumption

Y=income

 Marginal propensity to consume[MPC]

ΔC
MPC= Δ Y

Where

∆C=change in consumption

∆Y= change in income

Properties of MPC

 The value of MPC is always positive and less than unity[i.e.

0<MPC<1]. It implies that consumption expenditure increases at less
proportion than increase in income. It shows the technical
expression of the psychological law of consumption function
 The short run MPC is stable. It is because the psychological and
institutional factors on which the propensity to consume depends do
not change in the short period
 The MPC of the poor is greater than that of the rich. Generally, poor
people are unable to satisfy even their basic needs. Therefore, they
tend to spend larger amounts of their increased income on
consumption. But the rich people already enjoy a high standard of
living and therefore, tend to spend less amount of their increased
income. The amount for high MPC in underdeveloped countries like,
Nepal, India, Pakistan, etc. and low in developed countries like UK,
USA, Japan, etc.

Relation between APC and MPC

 APC is the ratio of absolute consumption to absolute income at a

particular period of time. MPC is also termed as the ratio of the
change in consumption with the change in income. MPC reflects the
change in APC
 The consumption function be linear with positive consumption
expenditure at zero income level, (a) APC is falling, while MPC is
constant (b) APC is always greater than MPC
 If consumption function be linear passes through the origin, both
APC and MPC are equal and constant
 If consumption function be non-linear or curvilinear (a) both APC and
MPC decline with an increase in income, but the decline in MPC is
more than the decline in APC, and (b) both APC and MPC increase
with a decrease in income, but APC rises at a slower rate than MPC
4.5 Factors affecting consumption function
 Subjective factors
 Psychology of human nature
 People are motivated to build the reserve for unforeseen
contingencies such as, illness, unemployment, accidents, etc.
 People are induced to save for providing the anticipated future
needs such as, education of the children, social processions,
retirements, etc.
 People are also motivated to accumulate large wealth to get higher
social or political status
 Many people think that accumulation of more wealth gives them a
great psychic satisfaction. It is due to their miserly instinct habits
 Investment leads to increase in income and wealth of people. Thus,
many people wish to save from their current incomes so that they
may be able to use accumulated saving for investment which will
increase their future income
 People are also motivated to save more because of securing enough
through funds to carry out speculation because it is an essential part
of financial market
 Institutional arrangement
 Business firms are induced to save a part of their income so that they
can make investment in new enterprises and carry out expansion in
the future
 Managers of the business firms are also induced to save more
because they want to prove themselves successful managers. By
investing saved money they would be able to increase incomes of
firm in future
 Business firms also make their institution to accumulate more
because of facing emergencies and contingencies successfully
 Firms also express desire to save more because of ensuring adequate
financial provision against depreciation and obsolescence and
repayment of debt
 Objective factors
 Changes in wage level
 Distribution in income
 Fiscal policy
 Social security
 Credit facilities
 Holding of liquid assets
 Attitude towards thrift
 Financial policies of companies
 Dues berry hypothesis
 Consumption function of people depends upon their past living
standard. As income rises from the previous level, consumption
function shifts upwards
 The consumption standards of the poor have also affected by the
consumption standards of the rich. This process is called
demonstration effect
4.6 Measures to raise propensity to consume
 Income redistribution
 Increasing the productivity of lower-income groups. It involves the
adoption of certain measures to improve employment opportunities,
working conditions, public health, housing and educational facilities
for the lower-income groups. These measures would help to improve
the productivity and earnings of the lower-income groups, thereby
increasing the capacity to spend more on consumption
 Increasing the purchasing power of lower-income groups through
such measures as reductions in the cost of living through price-cuts
and subsidies
 Transferring purchasing power from the higher-income groups to the
lower-income groups through such measures as progressive
taxation, death duties, capital gains taxes, etc. and the spending of
revenues so collected for the benefit of the poorer classes in the
form of relief and welfare expenditure or even on the provision of
social services. It is, however, objected that the redistribution of
National Income through heavy and steep taxation on the rich may
have the effect of discouraging capital formation and private
investment and the increase in the propensity to consume, thus,
secured may be offset by a decline in private investment. There may
be some force in this contention and extreme caution may have to
be used to see that there is no adverse effect on investment as a
result of income redistribution. Thus, it is more rational to invest
collected revenue on development of infrastructure and poor
oriented projects
 Wage policy
 Social securities
 Other measures
 Easy credit facilities[in the form of installment buying] may be
provided to the consumers for the purchase of durable consumers’
goods, such as, radio sets, automobiles, etc. in the wealthy industrial
community. This would help to stimulate and sustain the demand for
such consumers’ goods
 Another method suggested to raise consumption function is to
facilitate the process of urbanization in the country, since the
propensity to consume of the urbanities is higher that of the
ruralizes. The ruralizes are generally contented with few essential
goods in view of their depressed living standard
 The proper development of the advertising industry can also help to
foster the propensity to consume by bringing to the notice of the
consumers, goods and services which they would otherwise never
come to know of. A well-devised campaign of advertisement and
publicity can prove quite helpful in stepping up the consumption
function
4.7 Implication of consumption function
 Invalidation Say’s Law
 Need for state intervention
 Crucial importance of investment
 Existence of underemployment equilibrium
 Declining tendency of the marginal efficiency of capital
 Explanation of the turning points of the business cycle
4.8 Saving function

Saving

Robertson-“current saving is a function of past income. It is the

difference between yesterday’s income and today’s expenditure”
Keynes-“current saving is the difference between current income and
current consumption”

S=Y-C

Where

C=Consumption

Y=Income

Saving function

S=f(Y)

Where

S=saving

f=function

Y=income

Or, S=Y-[a+bY]

Or, S=Y-a-bY

S=-a + (1-b)Yd

Where

S= saving

a=Y-intercept or autonomous saving or saving at Yd=0

b=marginal propensity to save[MPS] or slope of saving curve or rate of

change in saving with respect to change in income
Yd=total disposable income

Derivation of saving curve

4.9 Technical attributes of consumption function

 Average propensity to save[APS]

C+S=Y

Where

C=consumption

S=saving

Y=income

Now we have

C+S=Y

Dividing both side by Y

C S Y
+ =
Y Y Y

APC+APS=1

 Marginal propensity to save[MPS]

ΔS
MS= Δ Y

Where

∆S=change in total saving

∆Y=change in total income

We have
∆C+∆S=∆Y

Where

∆C=change in total consumption

∆S=change in total saving

∆Y=change in total income

Now we have

∆C+∆S=∆Y

Dividing both side by ∆Y

∆C ∆S ∆Y
+ =
∆Y ∆Y ∆Y

MPC+MPS=1

Relationship between APC and MPC, APS and MPS

 Short-run consumption function is considered as non-proportional

consumption function. Hence, APC>MPC at all levels of income, but
APS<MPS
 Since, APC+APS=1. This expression implies that if APC decreases
steadily as disposable income increases APS must be increases
steadily as income rises
 If autonomous consumption is zero, all values, i.e. APC, MPC, APS
and MPS remain constant, positive and less than one[i.e.
0<APC[=MPC]<1 and 0<APS[=MPS]<1]
4.10 Types of saving
 Personal saving
 Corporate saving
 Government saving
 Forced saving
4.11 Determinants of saving
 Level of income
 Rate of interest
4.12 Paradox of thrift[saving is a vice, not a virtue]
4.13 Investment function

Robinson-“by investment is meant an addition to capital such as occurs

when a new house is built. Investment means making an addition to the
stock of goods in existence”

Peterson-“investment expenditure includes expenditure for producer’s

durable equipment, new construction and the change in inventories”

4.14 Types of investment

 Autonomous and induce investment

Peterson-“the autonomous investment is generally associated with such

factors as the introduction of new technique or products, the
development of new resources or the growth of population or labour
force”

Keiser-“when an increase in investment is due to the increase in the

current level of income and production, it is known as induce
investment”

 Intended[planned], unintended[unplanned] and actual investment

 Gross investment and Net investment
4.15 Marginal efficiency of capital[MEC] and marginal efficiency of
investment[MEI]
Marginal efficiency of capital[MEC]

Dilard-“the marginal efficiency of a particular type of capital asset is the

highest rate of return over cost expected from an additional or marginal
unit of that type of asset”

Kurihara-“marginal efficiency of capital is the ratio between the

prospective yield of additional capital goods and their supply price”

Keynes-“equal to the rate of discount which would make the percent

value of series of annuities given by the returns expected from the
capital asset during its life just equal to its supply price”
Q1 Q2 Q3 Q4 Qn
SP= (1+r ) + (1+r )2 + (1+r )3 + (1+r )4 … … … … … (1+ r)n

Where

SP=supply price

Q1+Q2+Q3+Q4+………………… Qn=series of prospective annual returns

r=rate of discount[MEC]
Qn
SP= (1+r )n

Qn
Or, (1+r )n= S P
Qn
Or, 1+r=[ S P ¿1/n
Qn
Or, r=[ S P ¿1/n-1

Schedule of Managerial Efficiency of Capital

Causes for declining Managerial Efficiency of Capital

 Due to the operation of law of diminishing returns in the productivity
of capital asset, prospective annual returns declines with an increase
in level of investment
 An increase in volume of demand for capital asset leads to increase
in their prices. It results increase in supply price

Properties of MEC

 If the MEC curve is relatively interest inelastic, then a great change in

the rate of interest will lead to a small change in investment
 If the MEC curve is relatively interest elastic, then a small change in
the rate of interest will lead to considerable increase in investment
 Due to change in MEC at constant rate of interest, MEC curve shifts
either rightwards[due to increase in MEC] or leftwards[due to fall in
MEC]

Investment function

Keynes-“investment will be pushed to the point on the investment

demand schedule where Managerial Efficiency of Capital in general
equal to the market rate of interest”

Relationship between MEC and rate of interest

Role of MEC

 If MEC=rate of interest → neutral effect, then the project is

acceptable on non-profit consider
 If MEC>rate of interest → favorable effect, then the investment
project is acceptable
 If MEC<rate of interest → unfavorable effect, then project is rejected

Marginal efficiency of investment[MEI]

Properties of MEI

 If there is greater response in investment demand due to change in

rate of interest, the investment demand curve will be highly elastic
 If there is less response in investment demand due to change in rate
of interest, the investment demand curve will be less elastic

Relationship between MEC and MEI

 The MEC is based on a given supply price of capital. It shows the rate
of return on all successive units of capital without regard to the
existing stock of capital. Hence, it is a stock concept. On the other
hand, MEI is based induced changes in supply price. It shows the rate
of return on only visits of capital over and above the existing stock of
capital. Hence, it is a flow concept
 The MEC determines the optimal stock in an economy at each level
of interest rate. The MEC determines the net investment of the
economy at each interest rate
4.16 Factors other than the interest rate affecting inducement to
invest[MEC]
 Short-run
 Nature of demand, price and cost
 Business optimism and pessimism
 Level of income
 Liquid asset
 Existing stock of capital goods
 Taxation
 Propensity
 Long-run
 Population growth
 Technological advancement
 Urbanization
 Supply of capital equipment
 Economic policy
 Political climate
4.17 Measures to stimulate private investment
 Lowering the rate of interest
 Tax reduction
 Public expenditure
 Price policy
 Abolition of monopoly privileges and encouragement of competition
 Promotion of research
 Economic planning
4.18 Multiplier

Keynes-“investment multiplier tell us that when there is an increment of

aggregate investment, income will increase by an amount which is K
times the increment of investment”

Dilard-“investment multiplier is the ratio of an increase of income to

given the increment of investment”
ΔY
K= Δ I

Where

K=multiplier

∆Y=change in income

∆I=change in investment
As we know

Y=C+I

Where

Y=income

C=consumption expenditure

I=investment

Let’s do small change in all

Y+∆Y=C+∆C+I+∆I

Removing the main factor

∆Y=∆C+∆I
ΔC ΔC
Or, ∆Y=∆Y* ΔY +∆I [ Δ Y* Δ Y =∆C]
ΔC
Or, ∆Y-∆Y* Δ Y =∆I
ΔC
Or, ∆Y[1- Δ Y ¿=∆I
ΔC
Or, ∆Y[1-MPC]=∆I [ Δ Y =MPC]
ΔY 1
Or, =
Δ I 1−MPC

1 ΔY
Or, K= 1−MPC [ Δ I =K]

Working with multiplier

Assumption
 The original propensity to consume remains constant during the
process of income propagation
 There is change in autonomous investment and that induced
investment is absent
 There is a closed economy unaffected by foreign influences
 There are no changes in prices
 The accelerator effect of consumption on investment is ignored
 There is less than full employment level in the economy
 Consumption is a function of current income
 There are no time lags in the Multiplier process. An
increase[decrease] in investment instantaneously leads to a multiple
increase[decrease] in income
 The new level of investment is maintained steadily for the
consumption of the Multiplier process
 There is net increase in investment
 Consumer goods are available in response to effective demand for
them
 There is surplus capacity in consumer goods industries to meet the
increased demand for consumer goods in response to a rise in
income following increased investment
 Other resources of production are also easily available within the
economy
 There is an industrial economy in which the Multiplier process
operates

Leakages

 Saving
 Undistributed profit
 Taxation
 Debt cancellation
 Purchase old shares and securities
 Hoarding of cash balance
 Inflation
 Net imports

Importance[uses]

 Knowledge of the process of Multiplier is of great importance for

evaluating the extent of different phases of trade cycle and for its
accurate forecasting and control
 The concept of Multiplier highlights special significance of public
investment or government development expenditure in achieving
high level of employment and growth rate
 It also highlights the significance of deficit financing to accelerate the
process of economic expansion
 The Multiplier process helps to understand how equality between
saving and investment is brought about. An increasing investment
leads to increase in income. As a result of increasing income, saving
also increases and becomes equal to investment
 The concept of Multiplier is very useful tool for formulating suitable
economic policies
 The concept of Multiplier highlights the importance of investment as
a major dynamic element in the process of income generation in the
economy
4.19 Principle of Acceleration

Assumption
 Capital output ratio remains constant
 There should be no excess capacity in the capital goods industries
 There is permanent change in consumption demand
 The supply of resources should be elastic so that the investment in
capital goods industries can be increased easily
 There should be elastic supply of cheap credit
 Technology remains constant
 There is absence of time lags

Criticism

 The assumption of a fixed technical coefficient and replacement

demand is not valid at least in the case of short run changes in
demand
 The Acceleration Principle does not operate in those situations in
which there exists much unused plant capacity that enables business
houses to increase the output of consumer goods without needing
more capital equipment. This principle normally operates in those
situations where the firms are operating at full capacity
 The Acceleration Principle assumes a constant incremental capital
ΔK
output ratio[V= Δ I ]. In a dynamic world where technological
changes and innovations constantly occur, the cases of fixed ICOR
are extremely rare
 Again, the theory ignores the effect of price changes which pay an
important role in the determination of an investment policy
 The Acceleration Principle studies the effect of changes in
consumption expenditure upon the derived demand for investment
and ignores the effect of an autonomous investment
 According to Prof. Tinbergen, Acceleration Principle does not possess
practical importance. Since it operates only in the situation of full
capacity, the statistical evidence shows that this condition is rarely
satisfied in practical life

Importance

 The Principle of Acceleration, along with the Principle of Multiplier,

helps to understand the process of income generation more clearly
and comprehensively. The concept of Multiplier provides only partial
explanation of the income generation process
 The Principle of Acceleration explains why the fluctuations in income
and employment occur so violently
 IT demonstrates that capital goods industries fluctuate more than
the consumer goods industries
 It is more useful in explaining the upper turning point of the business
cycle because what is responsible for a fall in the induced investment
is not any absolute fall in the demand for consumer goods but only a
decline in its rate of increase
 Harrod has used the coefficient of acceleration in the growth to
show that the economic growth in an economy depends upon the
size of accelerator, higher the size of accelerator, higher the growth
rate and vice versa
4.20 Super Multiplier
ΔY
Ks= Δ Ia

Where

Ks=super multiplier
∆Y=change in income

∆Ia=change in autonomous investment

Or
ΔY =¿ Ks* ΔI a

As we know

Y=C+Ia+Ip

Where

Y=income

C=consumption expenditure

Ia=autonomous investment

Ip=induce private investment

Let’s do small change in all

Y+∆Y=C+∆C+Ia+∆Ia+Ip+Ip

Removing the main factor

∆Y=∆C+∆Ia+∆Ip
ΔC Δ Ip ΔC ΔI p
Or, ∆Y=∆Y* ΔY +∆Ia+ ΔY* Δ Y [ ΔY* Δ Y =∆C, ΔY* ΔY =∆Ip]

ΔC ΔI p
Or, ∆Y=b∆Y+∆Ia+VΔY [b= Δ Y , v= ΔY ]

Or, ∆Y-b∆Y-VΔY=∆Ia

Or, ∆Y[1-b-V ]=∆Ia

 ΔY 1
Or, =
Δ Ia 1−b−V

ΔY 1
Or, =
Δ Ia S−V

Super multiplier effect = Multiplier effect + Acceleration effect

Significance

 It provides a consumption analysis of the process of income

generation. If shows how an initial autonomous investment leads to
a cumulative rise in output and income
 Hicks utilized the Super Multiplier to explain the dynamics of
business cycle more accurately
 It is also useful to the government for making influence the level of
economic activity and National Income through government
expenditure

5 THE IS-LM MODEL[HISKS-HANSEN THEORY OF

INCOME DETERMINATION
5.1 Introduction
5.2 Determination of IS curve[equilibrium in goods market]

Main points of IS curve

 The IS curve is the schedule of combination of the interest rate and

the level of income such that the goods market is in equilibrium
 The IS curve is negatively sloped because an increase in the interest
rate reduces planned[desired] investment spending and therefore
reduces aggregate demand, thereby lowering the equilibrium level
of income
 The smaller, the Multiplier and the less sensitive investment
spending is to changes in the interest rate, the steeper the IS curve
 The IS curve is shifted by changes in autonomous spending. An
increase in autonomous spending, such as investment spending or
government expenditure, shifts the IS curve to the right and vice
versa
 An points to the right of the IS curve, there is excess supply in the
goods market at points to the left of the curve, there is excess
demand for goods
5.3 Determination of LM curve[equilibrium in money market]

Main points of LM curve

 The LM curve is the schedule of combination of the interest rate and

the level of income such that the money market is in equilibrium
 The LM curve is positively sloped. Given the fixed money supply, an
increase in the level of income, which increases the quality of money
demanded, has to be accompanied by an increase in the interest
rate. This reduces the quality of money demanded and thereby
maintains money market equilibrium
 An increase in money supply shifts the LM curve to the right and vice
versa
 At all point to the right of the LM curve, there is an excess demand
for money and at the point to its left, there is an excess supply of
money
5.4 Determination of level of income

Mathematical determination of IS-LM curve

Determination of IS curve[function]:algebraic method

AD=Y=C+I

AS=Y=C+S

I=S

C=a+bY

S=-a+(1-b)Y

I=Ia-ir

Where

Ia=autonomous investment

i=MPI

r=rate of interest

From above
S=I

-a+(1-b)Y=Ia-ir

(1-b)Y=a+Ia-ir
a+ Ia ir
Y= 1−b - 1−b

Differentiating with respect to r

a+ Ia ir
∂Y ∂[ ] ∂[ ]
∂r = 1−b - 1−b
∂r ∂r

0+0 1
= 1−b - 1−b
1
=- 1−b
Determination of LM curve[function]:algebraic method

Under Keynesian theory

Demand for money=Supply of money

Md=Ms

L=M

6 INFLATION
6.1 Introduction

Harry Johnson-“inflation as a sustained rise in prices”

Crowther-“inflation is a state in which the value of money is falling i.e.

the prices is rising”

Friedman, Coulborn, Kemmeerer-“inflation as a monetary

phenomenon”

Coulborn-“too much money chasing too few goods”

Friedman-“inflation is always and everywhere a monetary

phenomenon”

Keynes-“inflation as a phenomenon of full employment”

6.2 Features
 Inflation refers to a process of rising prices and not a state of high
prices. It shows a state of disequilibrium between the aggregate
demand and aggregate supply at the existing prices, necessitating a
rise in the general price level
 Inflation refers to a situation of appreciable or considerable rise in
prices. This implies that every type of rise in price level is not
inflationary in character. A modest and gradual rise in price level, say
between 1 to 2 per cent annum is essential in achieving and
maintaining high level of employment and satisfactory rate of
economic growth. Such a rise in price level is essential for toning up
and healthy functioning of the economy and therefore, is not
regarded as inflationary rise. It is only when the price rise becomes
excessive and unhealthy that is regarded as inflationary in character
 Rise in prices should not only appreciable but prolonged in order to
be called as inflationary price rise. Inflation does not refer to a one-
time rise in the price level but rather to persistent rise in the price
level. Moreover, rise in the price level for a short period of time; say
6 months or a year is not regarded as inflationary in nature. It is only
when the price level increase continues over a long period that it is
regarded as inflationary in nature
 Inflation is measured as the rate of increase in the price level as
indicated by the price index. Inflation is generally measured in terms
of GNP/GDP[gross national product/gross domestic product] deflator
or CPI[consumer price index] or PPI[producer price index]
 Inflation is a long-term operating dynamic economic process
 Inflation is fostered by the action, reaction and counteraction of
macroeconomic forces
 Pure inflation start after full employment
 Excess aggregate demand in relation to the aggregate supply of
everything is the essence of inflation
 Inflation may be demand-pull or cost-push or mixed inflation
6.3 Types
 On the basis of the rate of change in price level
 Creeping inflation
 Waking inflation
 Running inflation
 Galloping inflation
 On the basis of the government re4action[control]
 Open inflation
 Suppressed inflation
6.4 Demand-pull inflation, cost-push inflation, mixed inflation

Demand-pull inflation

Cost-push inflation

Types of cost-push inflation

 Wage-push inflation
 Profit-push inflation
 Supply shock inflation

Mixed inflation

6.5 Causes
 Demand rising factors
 Increase in money supply
 Deficit financing
 Increase in public expenditure
 Increase in investment expenditure
 Increase in export demand
 Increase in population
 Repayment of public debt
 Bank money
 Cost rising[supply reducing] factors
 Higher wage rates
 Higher indirect taxes
 Higher administered prices[increase in profit margin]
 Scarcity of factor of production
 Supply shocks
 Hoarding
6.6 Inflationary gap

Lipsey-“an inflationary gap as an excess of planned expenditure over

the available output at pre-inflation or base price”

Keynes-“the inflationary gap is the amount by which aggregate

expenditure would exceed aggregate output at the full employment
level of income”

6.7 Inflation and unemployment

6.8 Effect

Samuelson-“mid inflation lubricates the wheels of trade and industry”

 Effect on production
 Reduction in production
 Changes in pattern of production
 Misallocation of resources
 Encourages speculation
 Fall in quality of product
 Reduction in saving
 Hinders foreign capital
 Effect on the distribution of income
 Debtors and creditors
 Profit earners
 Wage-earners and salaried class
 Investors
 Pensioners and fixed income groups
 Farmers
 Adverse effect on saving
 Effect on the balance of payment
 Effect on public revenue
 Confidence in the currency
 Social and moral degradation
 Political instability
6.9 Control
 Monetary measures
 Quantitative measures
 Selective credit control measures
 Fiscal measures
 Public expenditure
 Taxation
 Public borrowing
 Income policy
 Direct control
 Price control and rationing
 Increase the availability of goods
 Production should be increase. More specifically, production of
inflation-sensitive goods need to be increased by allocating more
resources, providing subsidies and removing bottlenecks impeding
production of these goods
 Direct production of essential goods may be supplemented by
imports of these goods so as to reduce shortages and minimize
inflationary pressures
 Indexation
6.10 Computation of rate
Pt −P[t−1]
Rate of inflation= P [t−1] *100

 Producer price index

 Un-weighted index number
 Simple aggregative method
 Simple average of price relative method
 Weighted index number
 Weighted aggregative method
 Weighted average of price relative method
 Consumer price index
 Aggregate expenditure method or weighted aggregate method
 Family budget method or method of weighted relatives

7 TRADE CYCLES OR BUSINESS CYCLES

7.1 Meanings

Benham-“trade cycle refers to a period of prosperity followed by a

period of depression”

Haberler-“the business cycle in the general sense may be define as an

alternation of periods of prosperity and depression of good and bad
trade”

Keynes-“a trade cycle is composed of periods of good trade

characterized by rising prices and low unemployment percentages,
altering with periods of bad trade characterized by falling prices and
high unemployment percentages”

Burn and Mitchell-“business cycles are a type of fluctuation found in the

aggregate economic activity of nation that organize their work mainly
in business enterprises. A cycle consists of expansions occurring at
output the same time in many economic activities, followed by similarly
general recessions, contractions and revivals which merge into the
expansion phase of next cycle; this sequence of changes is recurrent but
not periodic; in duration business cycles very from more than one year
to ten or twelve years”

7.2 Characteristics
 Fluctuation of aggregate economic activity
 Allocation of expansion and contraction in economic activity
 Co-movement
 Self-reinforcing
 Degree of regularity
 Presence of crisis
7.3 Phases
 Prosperity

Characteristics

 A large volume of production and trade

 A high level of employment and income
 A high marginal efficiency of capital
 A rising price level
 A rising structure of interest rate
 A large expansion of bank credit
 A high level of real investment
 A rise in wages and profits
 Overall business optimism
 Operation of the economy at full capacity
 Recession

Factors

 Scarcities of labor, raw materials, etc. leading to rise in costs relative

to prices
 Rise in the rate of interest due to scarcity of capital
 Failure of consumption to rise due to rising prices

Characteristics

 Increase in liquidity
 Construction of credit supply
 Decrease in output, employment and income
 Decrease stage in effective demand, price level and profit

Cite Prof. Lee-“a recession, once started tends to build upon itself much
as forest fire, once under way, tends to create its own draft and given
internal impetus to its destructive ability”

 Depression

Characteristics

 Shrinkage in the volume of output, trade and transactions

 Rise in the level of unemployment
 Price deflation
 Fall in the aggregate income of the community
 Fall in the structure of interest rate
 Reduction in the level of effective demand
 Collapse of the MEC and decline in the level of investment
 Construction of bank credit
 Revival or recover

Characteristics

 Increase in investment in capital industries

 Increase in price level, profit and MEC
 Improvement in financial market
 Increase in effective demand
 Increase in employment, output and income in the whole economy
7.4 Measures of economic stabilization[control of trade cycle]
 Monetary policy
 Fiscal policy

Methods

 Built in flexibility or automatic stabilizers

 Discretionary action
 Compensatory
 Direct control

8 MICROECONOMIC POLICIES
8.1. Supply of money

Approaches to the definition of money supply

 Traditional approach
 Monetarist approach
 Gurley and Shaw approach
 Radcliffe committee approach
8.1.1 Measures of money supply

M1=C+DD+OD

Where

C=currency held by the public

DD=net demand deposits with bank

OD=other deposits with the central bank

M2=M1+saving deposits with post offices

M3=M1+net time deposits with commercial bank

M4=M3+total deposits with post offices

8.1.2 Determinants of money supply

 Monetary base
 Money multiplier
 Reserve ratio
 Currency ratio
 Confidence in bank money
 Time-deposit ratio
 Value of money
 Real income
 Interest rate
 Monetary policy
 Seasonal factors
8.2. Keynes concept of demand for money

Active cash balances

Transaction motive

 Income motive
 Business motive

Lt=kt[Y]

Where

Y=money income

Lt=transactions demand for money

kt=fraction of money income society desires to hold money

Precautionary motive

Lp=kp[Y]

Where

Y=money income

Lp= precautionary demand for money

kp=fraction of money income society desires to hold money

L1=Lt+Lp=kt[Y]+kp[Y]=k[Y]

Idle cash balances or speculative demand for money

Total demand for money

L=L1+L2=k[Y]

Where

L1=Lt+Lp=kt[Y]+kp[Y]=k[Y]
L2=idle cash balances or speculative demand for money

Liquidity preference schedule

8.3. Monetary policy

R. P. Kent-“the management of the expansion and contraction of the

volume of money in circulation for the explicit propose of attainting a
specific objective such as full employment”

Paul Einzig-“as the effort to reduce to a minimum the disadvantages

and increase the advantages, resulting from the existence and
operation of a monetary system”

A. J. Shapiro-“monetary policy is the exercise of the central bank’s

control over the money supply as an instrument for achieving the
objectives of economic policy”

8.3.1 Instruments
 Quantitative control
 Bank rate policy
 Open market operations
 Changes in cash reserve ratios
 Selective credit control
 Regulation of consumer credit
 Regulation of margin requirements
 Credit rationing
 Direct action
 Moral suasion
 Publicity
8.3.2 Types
 Restrictive monetary policy
 Expansionary monetary policy
8.3.3 Objectives
 Neutrality of money
 Exchange rate stability and BOP equilibrium
 To correct disequilibrium
 Full employment
 Economic growth with stability
8.3.4 Significance in developing countries
 To correct inflationary pressures
 To correct BOP disequilibrium
 Formulation of effective interest rate policy
 To develop banking and financial system
 Price stability
 Debt management
8.4. Fiscal policy

Arthur Smithies-“a policy under which government uses its expenditure

and revenue programs to produce desirable effects and avid undesirable
effects on the national production and employment”

Musgrave-“fiscal policy is concerned with those aspects of economic

policy which arise in the operation of public budget”

Learner-“the principle of judging fiscal measures by the way they work

or function in the economy, we may call functional finance”

8.4.1 Instruments
 Budget

P.E Taylor-“the budget is the master financial plan of a government6. It

brings together estimates of anticipated revenues and proposed
expenditures for the budget period and from these estimates and
activities to be undertaken and the means of their financing can be
inferred”

Types of budget policy

 Balanced budget policy

 Deficit budget policy
 Surplus budget policy
 Public expenditure

Classification

 Current expenditure and capital expenditure

 Direct expenditure and transfer expenditure
 Productive and unproductive expenditure
 Public revenue

Dalton-“a direct tax is really paid by the person on whom it is legally

imposed. The indirect tax is imposed upon one person but paid partly or
wholly by other”

 Public debt

P. E. Taylor-“the debt is the firm of promises by the treasury to pay to

the holders of these promises a principal sum and in most instances
interest on that principal. Borrowing is restored in order to provide
funds for financing current deficit”

Internal and external public debt

Dalton-“a loan is internal, if subscribed by persons or institutions within
the area controlled by public authority which rises the loan; external if
subscribed by persons or institutions outside the area”

8.4.2 Methods
 Built in flexibility
 Discretionary fiscal policy

The government makes deliberate change in:

 The level and pattern of taxation

 The size and pattern of its expenditure
 The size and composition of public debt

Government makes following type of deliberate change in direct and

indirect taxes

 Imposition of new taxes or abolition of old taxes

 Imposition of taxes on new tax bases
 Increasing or decreasing the tax rates

The deliberate changes in the government spending include changes

in:

 The size of the government expenditure

 The composition of government expenditure
 The method of financing government expenditure
 Transfer payments
 Overall budgetary surplus and deficit
 The method of deficit financing
 Compensatory fiscal policy
8.4.3 Objectives
 Optimum allocation of resources
 Full employment
 Price stability
 Equitable distribution of income and wealth
 Economic growth

Measures

 Raising the saving ratio to income by curtailing consumption

 Mobilizing them for raising the rate of productive investment
 Encouraging the flow of spending into productive way
8.4.4 Role in developing countries
 Mobilization of resources
 Capital formation
 Saving and investment are the two components of capital
formulation. The government may resort to voluntary and forced
saving to collect enough resources for investment; the fiscal policy
should be formulated in such a manner as to increase the rate of
investment both in public as well as private sectors. This requires
large amounts of financial resources, which can be obtained by rising
the incremental saving ratio[MPS]. Incremental saving ratio can be
increased by number of methods which may include direct physical
controls, increase in the rates of exiting taxes, imposition of new
taxes, public borrowing, deficit financing, etc.
 Special incentives like tax relief and subsidies can be given in the
entrepreneurs to set up industries in the backward regions. This will
promote development of backward regions
 Public expenditure policy can be effectively used in promoting
economic development. The government may develop socio-
 economic overheads or infrastructures and established capital goods
and key industries. It may stimulate development by providing
education, training and research facilities
 Minimize the inequalities of income and wealth
 The tax system should be made progressive. Heavy direct taxes
should be imposed on the rich and the poor should be exempted
from taxes
 Items of luxuries and those items which are consumed by the rich
section of the society should be taxed heavily. Items of daily
necessities, which are largely consumed by the poor, should be
subjected to low taxes
 The government most spends more on those activities which benefit
the low income groups. For example, expenditure on social activities
like education, public health should be increased and these services
should be provided free of cost or at lower cost to the poor.
Similarly, expenditure on social security scheme like pensions,
unemployment relief, sickness benefits may be increased. These
expenditure will increase the efficiency and skill of the people and
thereby reduce inequalities
 The government should undertake investment in setting up
industries in the backward regions. This will remove regional
disparities
 Increase employment opportunities
 Public expenditure on economic and social overheads should be
incurred to generate employment and increase productive efficiency
of the economy in the long run
 The government can impose heavy taxes on the rich people and the
proceeds of these taxes may be distributed among the poor or may
 in invested on such projects which help to raise living standard of the
poor
 Public debt policy can be used to control private consumption
expenditure and to raise small savings for financing the development
expenditure. The government for this purpose can issue debentures,
bonds, etc. with attractive rates of interest to encourage people to
purchase these titles
 The government may resort to compulsory savings by the public
 In the rural areas, efforts should be made to encourage for
establishing industries by providing technical trainings, subsidized,
finance, tax rebates, etc.
 Counteract inflation
 Excess purchasing power should be withdrawn through taxes,
compulsory saving and public borrowings
 Progressive direct tax, commodity tax, etc. should be imposed
 Market imperfections and structural rigidities should be removing.
Moreover, for the fiscal policy to be effective, it must be
supplemented by anti-inflationary monetary measures
 To correct disequilibrium in BOP
 Inflation of heavy import duty, especially on the import of consumer
goods
 Subsidization of exports
 Tax subsidy in imported raw materials and machineries which are
used in export oriented industries
 Special fiscal package to establish import substituted industries and
key industries
8.5. Deficit financing

Purpose
 Borrowing from Central Bank
 Withdrawal of its cash balances from the Central Bank
 Issuing of new currency, i.e. printing of more notes and putting into
circulation

Objectives

 The deficit financing is a method of meeting financial needs of the

government during crises period such as war because the
government tends to resort to acquire a quick command over
resources to meet the growing war expenses
 Prof. J M Keynes advocated it is an instrument of economic
development, level of output and employment
 It is advocated for the mobilization of surplus, idle and unutilized
resources for promoting rapid economic growth in underdeveloped
economies as well as developing economies
 It is advocated as essential to mobilize resources for financing the
plans
 To raise the level of effective demand and simulate private
investment
 To divert undesirable and unproductive source into desirable and
productive channels of the economy
 To accelerate economy with high employment and economic growth

Role

 Deficit financing and war expenditure

 Deficit financing and depression
 Deficit financing and price level
 Deficit financing and employment
 Deficit financing and distribution of income
 Deficit financing and economic growth
8.6. Debt management

Prof. Abbot-“public debt management is concerned with the decisions

of forms of public debt, in terms of which new bonds are sold, maturing
debts are redeemed or refunded, the proportion in which different
forms of public debt should be issued, the pattern of maturities of debt
and its ownership, etc.”

Objective

 Public debt management must sub serve the economic policy of the
government. During the period of depression it should help to raise
the purchasing power and effective demand in the economy and vice
versa in inflation
 In the time of war and for economic development. It should provide
sufficient funds to meet the requirement of the economy
 It should be undertaken in such a way that it must be the most
beneficial for the activities of government
 It should not have any adverse effect on the economic condition of
the country
 It should also be undertaken in such a way as to strengthen the
money market

Principles of debt management by Prof. Philip E. Taylor

 The policies pursued must be able to extract from the public without
undue coercion
 The extraction of loanable funds from the market and its repayment
when debt is retired should not frustrate the smooth growth of the
economy
 It should be so placed as to minimize the need to enter the market
when it is inconvenient to do so

Summary of principles of debt management

 Minimum interest cost of servicing public debt

 Satisfaction of the investors
 Funding of short term debt into long term debt
 Public debt must be in coordination with fiscal and monetary
 Proper adjustment of maturity

9 MACROECONOMIC ISSUES:NEPALESE PERSPECTIVE

9.1 Economic development, economic growth and economic welfare

Economic development

Meier and Baldwin-“economic development is a process whereby an

economy’s real national income increases over a long period of time.
And, if the rate of development is greater than the rate of population
growth. Then per capita real income will increase”

Laibenstein-“development implies the environment of an economy’s

power to produce goods and services per capita, for such environment is
the prerequisite to rising levels of living”

UNO-“development concerns not only men’s material needs, but also

the improvement of social conditions of his life. Development is,
therefore, not only economic growth but growth plus change-social,
cultural and institutional as well as economic”
Todaro-“economic development was redefined in terms of the reduction
or elimination of poverty, inequality and unemployment within the
context of growing economy”

Three core values of economic development

 Life-Sustenance: The ability to provide basic need

 Self-Esteem: To be a person
 Freedom from servitude: To be able to choose

The three objectives of economic development

 To increase the availability and wide the distribution of basic life

sustaining goods such as food, shelter, cloth, education, health and
protection
 To raise levels of living including, in addition to higher incomes, the
provision of more jobs, better education and greater attention to
cultural and humanistic values, all of which will serve not only to
enhance material well-being but also to generate greater individual
and national self-esteem
 To expand the range of economic and social choices available to
individuals and rations by freeing them from servitude and
dependence not only in relation to other people and nation-states
but also to the forces of ignorance and human misery

Economic growth

Kuznets-“economic growth as a long term rise in capacity to supply

increasingly diverse economic goods to its population, this growing
capacity based on advancing technology and the institutional and
ideological adjustment that it demands”
Principle components of economic growth

 The sustained rise in national output is a manifestation of economic

growth and the ability to provide a wide range of goods is a sign of
economic maturity
 Advancing technology provides the basis or precondition for
continuous economic growth- a necessary but not sufficient
condition
 To realize the potential for growth inherent in new technological,
institutional, attitudinal and ideological adjustment must be made

Kuznet: Characteristics of economic growth

 High rates of growth per capita output and population

 High rates of increase in total factor productivity
 High rates of structural transformation of the economy
 High rates of social and ideological transformation
 The propensity of economically developed countries to reach out the
rest of the world for markets and raw materials
 The limited speed of this economic growth to only one third of the
world’s population

Economic welfare

Pigou-“economic welfare as that part of social welfare which can be

directly or indirectly measured in money”

Meier-“per capita real income is only a partial index of economic

welfare because the question of economic welfare also involves a
judgment about the desirability of income distribution”

Determinants of economic welfare

 National Income
 Leisure
 Non-market transaction
 Distribution of income
 Composition of output
 Quality of life
9.2 Determinants of economic growth

Natural resource

 The composition and the quality of natural resources determine the

relative importance of different economic activities. For example,
quality of land can influence the level of agricultural productivity in
the early stages of economic development and this can determine
the importance of natural resources
 Natural resources are likely to exert major influence on the speed of
development, the pace of agricultural advance and the price of
industrialization. Countries like the United States have been able to
achieve a high rate of economic growth because of rich availability of
natural resources

Population growth: Human resources

 An increase in population means an increase in supply of the basic

factor of production-labour has always been the greatest productive
asset of a country. Labour, in cooperation with other factors of
production like tools, machine land and natural resources, helps in
producing goods and services. Therefore, an increasing population
and labour supply almost invariably leads to increase in total output.
 In the past, population growth and increase in labour force has been
the major source of increase in total output all over the world
 Population growth leads to expansion of markets. Larger population
means more demand for various consumer goods like food, cloth,
etc. An expansion of markets promotes high level of investment. This
will stimulate business activity and increase the level of employment.
Furthermore, it may provide the needed incentive for production on
large scale, resulting in economies of scale and lowering the cost of
production
 Growth of population is beneficial in case of underdeveloped
countries. These countries are not able to use their agricultural land
effectively due to less number of labors. Thus, population growth in
these countries will enable them to use their land effectively and
thereby increase the agricultural output. Similarly, a larger
population will facilitate economic growth by enabling these
economies to exploit the utilized resources
 Growth of population has positive effect on technological
development. Growth of human resource means larger pool of
talents from which to draw people for working in various areas of
science. It also would mean an increase in the number of creative
minds. This will promote technological progress

Capital formation

 Generation of saving
 Ability to save
 Willingness to save
 Facilities to save
 Mobilization of saving
 Investment

Significance of capital formation in economic growth

 Formation of sound infrastructures

 Use of roundabout methods of production
 Maximum utilization of natural resources
 Proper use of human capital formation
 Improvement in technology
 High rate of economic growth
 Agricultural and industrial development
 Increase in National Income
 Increase in economic welfare

Technological progress

 Technological progress enabled the modern economies to produce

most of the commodities at a low cost of production. This means
either of the two things, viz, [i] producing more output with the
same amount of land, labor and capital, [ii] producing same quantity
of output using fewer amounts of inputs like land, labor and capital.
Thus technological progress has increased the efficiency of inputs in
the formed of increased productivity of land and labour, etc.
 Technological progress has brought forth a food of new products,
which could not have been demand of in the past. Computers,
televisions, CDs, cameras, movies, motor cars, aeroplane-all these
are the product of technological progress

Values and institutions

9.3 Privatization
Types and modalities

 Divestiture: sale of shares or assets by open tender

 Break up: selling or spinning of section of large public enterprise
 Liquidation: legally chose down the public enterprise
 Marginalization: freezing or gradual reduction of the operations of a
public enterprise
 Privatization of management: through contract, leasing, confessional
agreement etc.

Objectives

 To liberalize the economy

 To enable more integration into the international economy
 To increase efficiency and competitiveness
 To develop national capital markets
 To develop a strong private sector as the engine of growth
 To attract private capital for infrastructure development
 To repay state debts or reduce borrowing
 To redirect subsidies to other areas of state spending

Arguments

 Raising revenue for the government

 Increased competition
 Increased efficiency
 Wider share ownership
 Cost push inflation may be reduce

Dis-argument

 Long term loss of revenue

 Competition in product markets may not be increase
 Loss of potential revenue from the sale of privatized concerns
 Private sector firms may not act in the public interest
 Loss of government control over the economy
9.4 Economic liberation

In Nepal,

 Reduce budget deficit

 Increase in competition
 Efficient use and allocation of resource
 The resource mobilization by the government in other sectors
 Increase in production
9.5 Globalization

World Bank-“globalization is trades flows, investment flows and

financial flows and extend to flows of technology, information and
services across national boundaries”

Process

 Economic interdependence between countries in the world

 Free movement of product across border
 Free flow of capital, labour, management and technology across
borders internationally

Forms

 Economic globalization
 Political globalization
 Environmental globalization
 Cultural globalization
Advantages

 Most of developing countries like Nepal are suffered from the

problems of unemployment and underemployment. MNCs as the
main agent of globalization create local employment and career
opportunities. They also help in professionalization of management
and development of human resource
 Globalization through reduction in tariff and non-tariff barrier helps
to increase the scope of market for the product
 Globalization creates the environment for the smooth flow of
international capital mobility and technology at a low cost.
Globalization promotes the foreign direct investment and helps to
solve the problem of resource gap, trade gap, revenue-expenditure
gap and debt burden in developing countries
 An efficient allocation of resource in different line of productions can
be achieved through competition. Globalization is the precondition
for fostering competition around the globe, which helps for better
utilization of resources
 Consumer through globalization get benefit by way of qualitative
and modern products produced in global business environment at a
cheap price
 Globalization helps to transfer the foreign capital, technology and
management which help to accelerate the rate of growth

Disadvantages

 It may lead to promote social evils such as child sex abuse,

prostitution, women trafficking and international terrorism. This
strikes hard at traditional social and cultural value systems of
developing countries
 Industries based on labour, intensive technique in developing
countries suffer adversely due to cheap imports from developing
countries
 Globalization promotes the use of modern technology which
ultimately displaces traditional art and culture, small scale industries,
etc.
 Globalization may tend to result capital flight from developing
countries to developed countries
 Global corporations possess considerable economic power which
adversely impacts on national sovereignty
 Damage to environment results due to fast exploitation of natural
resources to cater to the high consumption needs in the developed
countries
 Global competition proves a threat to domestic industry and
agriculture in developing countries. Global corporations tend to
capture domestic market and kill domestic industries
9.6 Foreign direct investment

Significance

 Increase in resources
 Risk-taking
 Know-how
 High standard
 Marketing facilities

Dis-argument

 Limited areas
 Increased dependence
 Remittance of large amounts
 Obsolete machinery and technology
 Political interference
9.7 Foreign employment

History of international labour migration in the Nepalese context

Role of foreign employment[remittance]

Numerical

1. Consider the following data for national accounts to compute

NNPMP by both income and expenditure method[BIM 2016]

Description Rs in billion
Indirect business taxes 36,000
Imports 26,000
Government investment 36,000
Net fixed investment 1,08,000
Payment to rest of the world 16,000
Exports 14,400
Wages and salaries 4,40,000
Proprietor’s income 60,000
Government consumption 60,000
Receipts from rest of the world 8,000
Consumption 5,29,600
Change in stock -4,000
Subsidy 16,000
Rent 18,000
Interest 30,000
Mixed income 20,000
Employee’s contribution to social security 30,000
Cooperate income 1,00,000
Consumption of fixed capital 32,000

Answer

2. Consider the following data for national accounts to compute

NNPMP by both income and expenditure method[BIM 2015]

Description Rs in billion
Indirect business taxes 2,700
Imports 1,500
Government investment 2,250
Net fixed capital formation 8,100
Net receipt -600
Exports 1,080
Wages and salaries 33,000
Proprietor’s income 4,500
Government consumption 4,500
Personal consumption expenditure 39,720
Change in inventories -300
Government subsidies 1,200
Rental income 1,350
Business interest payments 2,250
Dividend 2,700
Mixed income of self employed 1,500
Social security contribution by employer 2,250
Cooperate profit 7,500
Direct taxes 1,395
Current transfer 12,000
Undistributed profit 3,000
 Depreciation 2,400
Social security contribution 10,200

Answer

3. Consider the following data[BIM 2012]

Description Rs in million
Rental income 528
Business interest payments 1,364
Corporate profits 4,118
Capital consumption allowance 1,416
Indirect business taxes 1,478
Corporate dividends 918,
Social security contributions 2,000
Transfer payments 6,364
Personal taxes 826
Consumption 23,886
Net fixed investment 3,342
Net exports -984
Changes in inventories -6
Government expenditure 1,514
Compensation of Employees 18,372
Proprietor’s income 1,892

i. Compute GDPMP by income and expenditure method.

ii. Compute personal income and disposable income.
Answer
4. Consider the following data and compute NI and personal
income[BIM 2013]

Description Rs in million
Compensation of employee 11,000
Rental income 400
Business interest payments 600
Proprietor’s income 4,000
Employer’s contribution to social security 2,000
Mixed income 1,500
Cooperate dividend 1,000
Transfer payment 7,000
Cooperate profit 8,000
Social security contribution 2,500

Answer

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed

income +Depreciation

=400+600+8000+11000+1500+0

=21500

GNIMP=GDIMP+NFIA

=21500+0

=21500

NIMP= GNIMP-Depreciation

=21500-0

=21500
Personal Income=NI – [undistributed profit + cooperate income taxes
+social security contribution – transfer payments]

=21500-[0+0+2500-0]

=21500-2500

=19000

5. Find IS curve, LM curve and equilibrium rate of interest and income

from the function C=100+0.8Y, S=-100+0.2Y, I=120-500r [r=rate of
interest], Ms=120 and Md=0.2Y-500r

Answer

Given

C=100+0.8Y

S=-100+0.2Y

I=120-500r [r=rate of interest]

Ms=120

Md=0.2Y-500r

For IS curve

I=S

120-500r=-100+0.2Y

0.2Y=220-500r

Y=1100-2500r

For LM curve
Md= Ms

0.2Y-500r=120

0.2Y=500r+120

Y=2500r+600

From above

1100-2500r=2500r+600

5000r=1100-600

5000r=500

r=0.1

Now

Y=1100-2500r

=1100-2500*0.1

=1100-250

=850

6. Find IS curve, LM curve and equilibrium rate of interest and income

from the function C=80+0.8Yd, T=60+0.2Y, I=200-1000r [r=rate of
interest], Ms=476, Ml=0.4Y, Msp=300-2000r and G=160

Answer

Given

C=80+0.8Yd
T=60+0.2Y

I=200-1000r [r=rate of interest]

Ms=476

Ml=0.4Y

Msp=300-2000r

G=160

For IS curve in 3-sector economy

Y=C+I+G

Y=80+0.8Yd+200-1000r+160

Y=440+0.8[Y-T]-1000r

Y=440+0.8[Y-60-0.2Y]-1000r

Y=440+0.8[0.8Y-60]-1000r

Y=440+0.64Y-48-1000r

0.36Y=392-1000r

Y=1088.88-2777.78r

For LM curve

Md= Ms

Mi+Msp=Ms

0.4Y+300-2000r=476

0.4Y=176+2000r
Y=440+5000r

From above

1088.88-2777.78r=440+5000r

7777.78r=648.88

r=0.0834

Now

Y=440+5000r

=440+5000*0.0834

=440+417

=857

7. Calculate GNP deflator and rate of inflation from the table below

Year Nominal GNP Real GNP

2000-01 470269 208481
2001-02 542691 209621
2002-03 618961 220489
2003-04 719548 233805
2004-05 843294 249903

Answer
Nominal GNP
GDP deflator= Real GNP *100%

470269
2000-01= 208481 *100%

=225.57%
 542691
2001-02= 209621 *100%

=258.89%
618961
2002-03= 220489 *100%

=280.72%
719548
2003-04= 233805 *100%

=307.76%
843294
2004-05= 249903 *100%

=337.45%

Again for rate of inflation

current year ' s GDP deflator− previous year ' s GDP deflator
Rate of inflation= previous year ' s GDP deflator
*100%

258.89−225.57
Rate of inflation for 2001-02= 225.57 *100%

=14.77%
280.72−258.89
Rate of inflation for 2002-03= 258.89 *100%

=8.43%
307.76−280.72
Rate of inflation for 2003-04= 280.72 *100%

=9.63%
337.45−307.76
Rate of inflation for 2004-05= 307.76 *100%
=9.65%

8. Find IS curve, LM curve and equilibrium rate of interest and income

from the function C=200+0.75Yd, T=200, I=200-250r [r=rate of
interest], Ms=550, Md=0.5Y-1000r and G=250

Answer[ex6]

Given

C=200+0.75Yd

T=200

I=200-250r [r=rate of interest]

Ms=450

Md=0.5Y-1000r

G=250

For IS curve in 3-sector economy

Y=C+I+G

Y=200+0.75Yd+200-250r+250

Y=650+0.75[Y-T]-250r

Y=650+0.75[Y-200]-250r

Y=650+0.75Y-150-250r

Y=500+0.75Y-250r

0.25Y=500-250r
Y=2000-1000r

For LM curve

Md= Ms

0.5Y-1000r=450

0.5Y=550+1000r

Y=1100+2000r

From above

2000-1000r=1100+2000r

3000r=900

r=0.3

Now

Y=2000-1000r

=2000-1000*0.3

=2000-300

=2300

9. Find national income by expenditure method

Items Rs in million
Net factor income from abroad -5
Subsidies 10
Indirect taxes 60
Private final consumption expenditure 400
Consumption of fixed capital[depreciation] 30
Government final consumption expenditure 50
Gross fixed capital formation 310
Net export -5
Change in stock 50

Answer

GDPMP=C+ gross capital formation +G+I+(X-M)

=400+310+50+50-5

=810-5

=805

GNPMP=GDPMP+NFIA

=805-5

=800

GNPFC=GNPMP-NIT

=GNPMP-[indirect tax-subsidies]

=800-[60-10]

=800-50

=750

NNPFC= GNPFC-Depreciation

=750-30

=720
10. Calculate GNPMP, NNPMP, NDPMP, GNPFC, NNPFC and NDPFC from
the following data

Items Rs in Crores
Wages and salaries 800
Mixed income of self employed 160
Operating surplus 600
Undistributed profit[retained earnings] 150
Gross fixed capital formation 330
Change in stock 25
Net capital formation 300
Employer’s contribution to social security schemes 100
Export 30
Imports 60
Private final consumption expenditure 100
Government final consumption expenditure 450
Net indirect tax 60
Compensation of employees paid by the government 75
Net factor income from abroad -20

Answer

GDPMP=C+G+I+(X-M)

=C+G+[I+ change in stock]+(export-import)

=100+450+(330+25)+(30-60)

=550+355-30

=905-30

=875
GNPMP=GDPMP+NFIA

=875-20

=855

Depreciation=Gross investment-Net investment

=330-300

=30

NNPMP= GNPMP-Depreciation

=855-30

=825

GNPFC=GNPMP-NIT

=GNPMP-[indirect tax-subsidies]

=855-60

=795

NIFC= GNIFC-Depreciation

=795-30

=765

11. Calculate GNPFC, NNPFC and NI from the following data

Items Rs in Crores
Gross domestic capital formation 1000
Depreciation of fixed capital 450
Government final consumption expenditure 500
Private final consumption expenditure 2650
Net change in stock 130
Net indirect tax 450
Net export -70
Net factor income from abroad -50

Answer

GDPMP=C+G+I+(X-M)

=2650+500-1000-70

=4150-70

=4080

GNPMP=GDPMP+NFIA

=4080-50

=4030

GNPFC=GNPMP-NIT

=4030-470

=3560

NNPMP= GNPMP-Depreciation

=4030-450

=3580

NIFC= GNIFC-Depreciation

=3560-450
=3110

12. Calculate NI from the following data

Items Rs in Thousands
Gross fixed capital formation 300
Private final consumption expenditure 900
Net export -50
Subsidies 50
Government final consumption expenditure 150
Indirect tax 250
Change in stock 50
Consumption of fixed capital 50
Net factor income from abroad 50

Answer

Gross investment= Gross fixed capital formation + change in stock

=300+50

=350

GDPMP=C+G+I+(X-M)

=900+350+150-50

=1400-50

=1350

GNPMP=GDPMP+NFIA

=1350+50
=1400

NNPMP= GNPMP-Depreciation

=1400-50

=1350

NNPFC=NNPMP-NIT

=NNPMP-[indirect tax-subsidies]

=1350-[250-50]

=1350-200

=1150

13. Calculate GNPMP, GNPFC and NI from the following data

Items Rs in Million
Exports 70
Imports 130
Private final consumption expenditure 3,000
Operating surplus 2,200
Government expenditure 1,100
Wages and salary 1,800
Net indirect tax 20
Mixed income of self-employed 320
Undistributed profit 300
Gross capital formation 700
Change in stock 50
Net capital formation 600
Employee’s contribution to social security schemes 300
Net factor income from abroad -60
Answer

GDPMP=C+G+I+(X-M)

=3000+700+1100+(70-130)

=4800-60

=4740

GNPMP=GDPMP+NFIA

=4740-60

=4680

GNPFC=GNPMP-NIT

=4680-20

=4660

Depreciation=Gross investment-Net investment

=700-600

=100

NNPFC= GNPFC-Depreciation

=4660-100

=4560

14. Calculate DDI, GNI and NI by income and expenditure method.

Items Rs in Million
Mixed income 400
Compensation of employees 500
Private final consumption expenditure 900
Net factor income from abroad -20
Net indirect tax 500
Consumption of fixed capital 120
Net domestic capital formation 280
Net export -30
Profit 350
Rent 100
Interest 150
Government final consumption expenditure 450

Answer

Income method

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed

income +Depreciation

=100+150+350+500+400+120

=1620

GNPFC=GDPFC+NFIA

=1620-20

=1600

NNPFC= GNPFC-Depreciation

=1600-120

=1480

Expenditure method
Gross investment= Net fixed capital formation + Consumption of fixed
capital

=280+120

=400

GDPMP=C+G+I+(X-M)

=900+450+400-30

=1720

GNPMP=GDPMP+NFIA

=1720-20

=1700

GDIFC=GDPMP-NIT

=1720-500

=1220

GNPMP=GDPMP+NFIA

=1700-120

=1580

NIFC=NNPMP-NIT

=1580-480

=1100

15.
Appendix A
Macroeconomics

Macroeconomics is concerned with the economic activities

New classical macroeconomics

New-classicist claimed that people are rational expectation behavior. It

means, people are rational behavior and they do not make systematic
error. According to the rational expectation hypothesis, expectations
are made on the basis of all available relevant information and
variables

New Keynesian economics

In fact, the new Keynesian school is characterized by what has been

called dizzying diversity of approaches

Static analysis of macroeconomics

Static means in a state of rest. It shows a stable equilibrium condition.

Static economy studies the economic conditions at equilibrium position

Comparative macro static analysis

It is comparison between two or more than two static equilibrium

condition of an economy at different time period

Circular flow
The flow of goods and services from business sectors to household
sector and raw material and factor of production from household
sector to business sectors is called circular flow

Circular flow of income and expenditure

Under two-sector economy, household sector consists of factor of

production; land labour capital and entrepreneurship. Incomes of
factor of production are land for rent, labour for wages, capital for
interest and organization for profit. Similarly, business sector or
business firms have not their own resources

National income

National income refers to the sum of income earned by all individuals

of a nation in a particular period of time

Gross domestic product at market price

Gross domestic product is the total market value of all final goods and
services produced within the domestic territory of a country during a
year

Net domestic product at market price

NDPMP is the residual part of GDP at MP after deducting depreciation

Gross domestic product at factor cost

Gross domestic product at factor cost is the sum of income earned by

factors of production in the forms of rent, wages, interest and profit

Net domestic product at factor cost

NDPFC is income earned by factors of production after deduction of
depreciation

Gross national product at market price

GNPMP is the final value of goods and services produce by the nation
during a year plus net factor income from abroad

Gross national product at factor cost

GNPMP is the sum of income earned by factors of production plus net

factor income from abroad

Net national product at market price

NNPMP is the residual part of gross national product after deduction of

depreciation

Personal income

Personal income can be define as the sum of all kinds of income

received by the individuals from all possible sources

Per capita income

Per capita income is the national income divided by total population by

country within a particular year

Product approach

Product method measures national income at the phase of production

in the circular flow. This method is also called a value added method

Final product approach

Final product method is to excludes all those goods and services which
are intermediate in the phase of production[such as wheat and floor in
the making of bread] and to include only final goods and services in the
consumption of the gross national product

Value added approach

Value added approach, instead of taking the market value of final

product, the value added or created at different stages of production is
counted for estimating national income

Unemployment

Unemployment is a situation in which an individual person is ready to

work mentally and physically at existing market wage rate but not get
any job

Keynesian theory of employment

The theory of effective demand was develop by J. M. Keynes in the

book general theory of employment, interest and money

Effective demand

In ordinary parlance, demand means desire. It becomes effective when

income is spent in buying consumption goods and investment goods

Aggregate demand price

The aggregate demand price for the output of any given amount of
employment is the total sum of money or proceeds, which is expected
from the sale of the output produced when that amount of labor is
employed

Aggregate supply price

The aggregate supply price refers to the proceeds necessary from the
sale of output at the particular level of employment. Thus each level of
employment in the economy is related to a particular aggregate supply
price and there are different aggregate supply prices in different levels
of employment

Paradox of thrift

Paradox of thrift is the situation where increase in saving ultimately

reduce the productive capacity, employment, income and saving itself.
The classical economist regarded the saving as a social virtue

Simple multiplier

The multiplier is expressed as a ratio of the change in overall

equilibrium output[income] to the given change in autonomous
expenditure
IS Curve

IS Curve is the locus of various combination rate of interest and level

income which gives goods market equilibrium

LM Curve

LM Curve is the locus of various combination rate of interest and level

of income which gives money market equilibrium

Inflation

Inflation is the continuous, persistent and appreciable rise in the

general price level of goods and services

Consumer price index[CPI]

Consumer price index is measure of the overall cost of goods and
service purchase by a consumer. It is a way of finding the cost of living

Wholesale price index[WPI]

Wholesale price index is an index which is used to measure the average

price changes of goods and services between times at the level of
wholesale price of big sales

GDP deflator

GDP deflator is a price index which measures the changes in the overall
price of all newly produce final goods and services

Demand pull inflation

Demand pull inflation is caused by a situation whereby the pressure of

aggregate demand for goods and services exceeds the available supply
of output

Cost push inflation

Cost push inflation develops because the higher the cost of factor of
production decreases in aggregate supply[the amount of total
production] in the economy

Phillips curve

Inverse relationship between the rate of change money wages and the
rate of unemployment becomes known as Phillips curve

Deflation

Deflation is an economic theory, which deals with the general reduction

in the price levels or in the prices of a type of good or asset
Stagflation

Stagflation refers to a situation where a high rate of inflation occurs

simultaneously with a high rate of unemployment

Business cycle

The world economic history is essentially history of business cycles or

economics ups and downs, booms and slumps, prosperity and
depression. Business cycle or trade cycle is inevitable in the cabalistic
economy

Business cycle refers to the phenomenon of cyclical fluctuations in the

aggregate output, employment, income, price level, profit, bank credit,
etc.

Recovery phase

Recovery is a situation when depression has lasted for some time and
the revival phase or lower turning point starts. The trough is the turning
point from which the economy began to recover

Prosperity phase

Prosperity phase is an idle condition for an economy. In this phase,

demand, output, employment and income are at a high level

Recession phase

Recession refers to the downfall from the peak which is of a short

duration. In fact the seed of the recession is shown during the phase of
prosperity

Depression phase
Depression is the most critical phase of business cycle. During this
phase, all economic activities are far below the normal rate of growth

Monitory policy

Monitory policy refer to the policy measures undertaken by the central

banks to influence the availability, cost and use of money and credit
with the help of monitory measures to achieve specific goals such as
increase in output, employment, income and price stability, etc.

Fiscal policy

Fiscal policy refer to the government’s expenditures and revenue

program to produce desirable effects and avoid undesirable effects on
national income, product and employment

Money supply

Money supply is exogenously determined by central monetary

authority. Money supply is total money circulated of an economy

Transaction demand for money

Demand for money which is used by day-to-day transaction of goods

and services is called transaction demand for money

Precautionary demand for money

People holds certain cash for minimize risk and uncertainty factor. For
examples: sudden in price of the product, unpredictable events like fire,
theft, sickness, loss the job

Speculative demand for money

The desire to hold idle cash balances for speculative purpose arises
from the desire to take advantages of change in the money market

Liquidity trap

At low rate of interest all money are speculated by people which

creates problem liquidity in the market and known as liquidity trap

Capital market

Capital markets are the market mean for long-term securities issued by
the government or a corporation. Capital markets, typically involve
financial assets have life span of greater than one year

Monetary policy

Any conscious action undertaken by central monetary authority

Bank rate of policy

Bank rate is the rate at which central bank lends money to the
commercial bank and rediscounts the bills of exchange presented by
the commercial banks

Exchange rate

The rate at which one currency is exchanged the currency of another

country is called exchange rate

Privatization

Privatization is management by private sector with total absence of

government intervention. Such institutions generate their own funds
through higher fees, user charges and full use of resources

Liberalization
Liberalization means the process of shifting the economy from
government control to market economy

Globalization

Globalization is a process of integration among the world through

international trade, investment and information technology

Economic inequality

Economic inequality is the state of affairs in which assets, wealth or

incomes are distributed unequally among individuals in a group, among
groups in a population or among countries

Appendix B

 Two sector economy

Assumptions

 There are only two sectors in an economy: household and business

sectors
 No government and no foreign trade
 There is no government intervention so no tax rate
 All prices remain constant
 Supply of capital and technology are given
 Only autonomous investment
 Marginal propensity to consume remains constant
 All income should be spent
 All factors of productions taken from household to business sectors
 All goods and services are taken from business to foreign sector
Simple multiplier

C=a+bY

Y=C+I

Y= a+bY+I

Y-bY=a+I

Y[1-b]=a+I
a+ I
Y= 1−b

Differentiate with respect to I

a+ I
∂Y ∂[ ]
∂I = 1−b
∂I

∂Y a+0
=
∂ I 1−b

∂Y a
=
∂ I 1−b

∆Y a
=
∆ I 1−b

Super multiplier

C=a+By

I=eY[because private investment increase with income level of people

where as e is constant term]

Y=C+I+Ia

Y= a+bY+I+Ia
Y= a+bY+eY+Ia

Y-bY-eY-=a+Ia

Y[1-b-e]=a+Ia
a+ I a
Y= 1−b−e

Differentiate with respect to I

a+ I a
∂Y ∂[ ]
∂I = 1−b−e
∂I

∂Y 0+1
=
∂ I 1−b−e

∂Y 1
=
∂ I 1−b−e

∆Y 1
=
∆ I 1−b−e

 Three sector economy

Assumption

 Three sector economy: household, business and government sectors

 Government intervention
 Perfect competitive market
 Well managed financial market
 Imposition of taxation
 Provides subsidies both household sector and business sector
 Household sector pay direct tax to government sector
 Business sector pay both direct and indirect tax
 The economy is closed
Government expenditure multiplier

C=a+bY

Yd=Y-T [disposable income]

Y=C+I+G

Y=a+bYd+I+G

Y=a+b[Y-T]+I+G

Y=a+bY-bT+I+G

Y-bY=a-bT+I+G

Y[1-b]=a-bT+I+G
a−bT + I +G
Y= 1−b

Differentiate with respect to G

a−bT + I+ G
∂ Y ∂[ ]
∂G =
1−b
∂G

∂ Y 0−0+0+1
∂G
= 1−b
∂Y 1
=
∂G 1−b

∆Y 1
=
∆ G 1−b

Tax multiplier

C=a+bY

Yd=Y-T [disposable income]

Y=C+I+G

Y=a+bYd+I+G

Y=a+b[Y-T]+I+G

Y=a+bY-bT+I+G

Y-bY=a-bT+I+G

Y[1-b]=a-bT+I+G
a−bT + I +G
Y= 1−b

Differentiate with respect to T

a−bT + I + G
∂Y ∂[ ]
∂T =
1−b
∂G

∂Y 0−1+0+ 0
∂T
= 1−b
∂Y −1
=
∂ T 1−b

∆ Y −1
=
∆ T 1−b

Balanced budget multiplier

C=a+bYd

Yd=Y-T [disposable income]

Y=C+I+G

Y=a+bYd+I+G

Y=a+b[Y-T]+I+G
Y=a+bY-bT+I+G

Small change in all

∆Y=∆a+∆bY-b∆T+∆I+∆G

∆Y=0+∆bY-b∆T+0+∆G

∆Y=b∆Y-b∆T+∆G

∆Y-b∆Y=-b∆T+∆G

∆Y-b∆Y=∆G-b∆T

∆Y-b∆Y=∆G-b∆G [∆T=∆G]

∆Y[1-b]=∆G[1-b]
∆ Y 1−b
=
∆ G 1−b
∆Y
∆G
=1

It is unit multiplier

 Four sector economy

Assumption

 Four sector includes household, business, government and foreign

sector
 Open economy
 No restriction of export and import
 Competitive both internal and external markets
 Minimum government intervention
 Well managed financial market
Export multiplier

C=a+bYd

Yd=Y-T [disposable income]

M=Ma+MY

Y=C+I+G+[X-M]

Y=a+bYd+I+G+[X-M]

Y=a+b[Y-T]+I+G+[X-M]

Y=a+bY-bT+I+G+[X-M]

Y=a+bY-bT+I+G+[X-Ma-mY]

Y=a+bY-bT+I+G+X-Ma-mY

Y-bY+mY=a-bT+I+G+X-Ma

Y[1-b+m]=a-bT+I+G+X-Ma
a−bT + I +G+ X −M a
Y= 1−b+ m

Differentiating with respect to M

a−bT + I + G+ X−M a
∂ Y ∂[ ]
∂M =
1−b+m
∂M

∂ Y 0−0+0+0+ 0−1
∂M
= 1−b+m
∂Y −1
=
∂ M 1−b+ m

∆Y −1
=
∆ M 1−b+ m
Import multiplier

C=a+bYd

Yd=Y-T [disposable income]

M=Ma+MY

Y=C+I+G+[X-M]

Y=a+bYd+I+G+[X-M]

Y=a+b[Y-T]+I+G+[X-M]

Y=a+bY-bT+I+G+[X-M]

Y=a+bY-bT+I+G+[X-Ma-mY]

Y=a+bY-bT+I+G+X-Ma-mY

Y-bY+mY=a-bT+I+G+X-Ma

Y[1-b+m]=a-bT+I+G+X-Ma
a−bT + I +G+ X −M a
Y= 1−b+ m

Differentiating with respect to X

a−bT + I+ G+ X−M a
∂Y ∂[ ]
∂X=
1−b+m
∂X

∂Y 0−0+0+0+1−0
∂X
= 1−b+m
∂Y 1
=
∂ X 1−b+ m

∆Y 1
=
∆ X 1−b+ m
Appendix C
GDPMP=C+G+I+(X-M)

NDPMP=GNPMP-Depreciation

NDPMP=NNPMP-NFIA

GNPMP=GDPMP+NFIA

NNPMP= GNPMP-Depreciation

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed

income +Depreciation

GNIMP=GDIMP+NFIA

NIMP= GNIMP-Depreciation

NDIMP=NNIMP-NFIA

NDIMP=GNIMP-Depreciation

Operation surplus=Rent + Interest + Profit

Conversion of gross product into net product

GDPMP=GNPMP-NFIA

NDPMP=NNPMP-NFIA

GDIMP=GNIMP-NFIA

NDIMP=NNIMP-NFIA

Conversion of net product into gross product

GNPMP=GDPMP + NFIA

NNPMP=NDPMP + NFIA

GNIMP=GDIMP + NFIA

NNIMP=NDIMP + NFIA

Concept of net indirect tax

Conversion of factor cost into market price

GDPMP=GDIFC+NIT

GNPMP=GNIFC+NIT

NNPMP=NIFC+NIT

NDPMP=NDIFC+NIT

Conversion of market price into factor cost

GDIFC=GDPMP-NIT

GNIFC=GNPMP-NIT

NIFC=NNPMP-NIT

NDIFC=NDPMP-NIT

Private income=National Income - Income from prosperity and

entrepreneurship accruing to the government – Saving of non-
departmental enterprise + National debt interest + Current transfers
from government + Other current transfers from rest of the world

Personal Income=NI – [undistributed profit + cooperate income taxes

+social security contribution – transfer payments]
DI=PI – direct taxes

Y=C+S

C=a+bY

S=-a+(1-b)Y
National GDP
GDP deflator= Real GDP *100

Change GDP deflator

Rate of inflation= GDP deflator for previous year *100

NDPFC[domestic factor income receipt]= Rent + Interest + Profit +

Compensation of employees + Mixed income

NDPFC= Compensation of employees + Operating surplus + Mixed

income

GDPK= NDPK + depreciation

GDPMP= GDPK + net indirect tax

NNPK= NDPK + net factor income from abroad

NNPMP=NNPK + net indirect tax

GNPK= NNPK + depreciation

GNPMP= GNPK + net indirect tax

Labour force=number of employed + number of unemployed

Number of employed
Unemployment rate= Labour force *100
Qn
r=[ S P ¿1/n-1