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Macroeconomics

Theory and Policy

Fifth Edition
 About the Author
Dr D N Dwivedi obtained his MCom, MA and PhD degrees
from Banaras Hindu University. He joined Ramjas College
of Delhi University as a Lecturer of Economics in 1969 and
retired as a Reader in 2004. After retirement, he joined
Maharaja Agrasen Institute of Management Studies
(MAIMS), Delhi, as Professor of Economics. After seeking
retirement from MAIMS in 2016, he worked as Guest
Faculty for two years in the Delhi School of Professional Studies and
Business Research (DSPSR), Delhi. During his academic career, Dr
Dwivedi also worked as an Economic Consultant for seven years in the
Consulting Centre for Finance and Investment (CCFI), Riyadh, Saudi
Arabia. He has submitted papers to and attended several Economic
Conferences held by the Indian Economic Association and other
organisations. He was awarded Senior Fellowship for a period of two years
(1993–95) by the Indian Council of Social Science Research, New Delhi.
Dr Dwivedi has published over fifty academic papers on various economic
issues of the country in national and international journals and in reputed
periodicals of India. He has authored several famous textbooks including
Managerial Economics, Principles of Economics, Microeconomics: Theory
and Application, International Economics, and Essentials of Managerial
Economics, a research book, Problems and Prospects of Agricultural
Taxation in India and also edited a book on Readings in Public Finance.
 Macroeconomics

Theory and Policy

Fifth Edition

D. N. Dwivedi
Former Professor of Economics
Maharaja Agrasen Institute of Management Studies
Delhi

McGraw Hill Education (India) Private Limited

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While evolving the content and organisation of fifth edition of
Macroeconomics, the prime objective of prior editions to offer a
comprehensive and authentic textbook on macroeconomics is retained. The
scope of this book is planned by taking a comprehensive review of the
syllabi of macroeconomics recommended by UGC and the Indian
universities for undergraduate and postgraduate courses. The book meets
the theoretical needs of academicians and policymakers. The extent to
which UG and PG students have perceived the book, appreciation gained by
the subject teachers and recommendations by various Indian universities,
give a strong evidence of the successful efforts laid in its evolution.
However, in dealing with a scientific subject, there is always a scope for
improving methodological approach for presenting the subject matter more
systematically. As such, there are certain significant revisionary changes
made in this edition.

What is New in the Fifth Edition?

The structural organisation of the subject matter of Macroeconomics
remains the same as adopted in previous editions. However, some crucial
additions and changes in the text are made in this edition, identified by
assessing study needs of students, and suggestions and advice provided by
the subject experts. The revisions made are highlighted below.
1. The learning objectives are listed at the beginning of each chapter to
highlight its content and scope. Accordingly, the introductory
paragraph is also revised.
2. The purview of Chapter 1 is changed substantially. The section on
“What is Economics” is eliminated as the students might understand
what economics is about. Chapter 2 of the fourth edition that dealt
 with ‘macroeconomic issues, concepts and model building’ is
shortened and merged with Chapter 1 to present a consolidated and
succinct introduction of macroeconomics.
3. Chapter 3 presents a deliberate discussion on the methods of
measuring the national income in general and in India with the
updated empirical data.
4. Chapter 7 explores the concept and measures of multiplier related to
different economic variables. In addition, “Dynamic Multiplier” is
elaborately explained with graphical illustrations.
5. Two NEW sections are added in Chapter 12: (i) Evolution of Money
– describing the origin and periodic emergence of different kinds of
medium of exchange and store of value, and (ii) Money and Near
Money – pointing out the difference between money as legal tender
and bank deposits as a medium of exchange.
6. Chapter 25 is extended with the addition of a NEW section entitled
“Is Mild Inflation Good for the Economy?”. This topic presents that
some inflation is desirable for healthy working of the economy.
7. Chapter 26 elucidates the determination of foreign exchange rate
with different theories of exchange rate determination. It also
expounds the updated data on foreign exchange rate of Indian
currency.
8. The statistical data on different and relevant aspects of Indian
economy are updated in subsequent chapters. Specifically, the
current data on India’s BOP in Chapter 27, monetary data on India’s
monetary policy in Chapter 30, and budgetary data related to India’s
budgetary policy in Chapter 31 are updated.
9. A NEW chapter, i.e., – “Chapter 32: Demonetisation and
Implementation of GST in India” is added with the analysis of the
purpose and economic effects of these policy actions taken by the
Government of India recently.
10. In Review Questions, NEW objective questions are added in many
chapters to enhance the readers’ understanding of the concepts found
in the chapter.

How this book is different from other books?

• Organisation of the Subject Matter
In this book, the subject matter of macroeconomics is organised based on
the origin and the growth of macroeconomic theories and its emergence as a
branch of economic science. Following the theoretical growth of
macroeconomics, the book is compiled in nine parts.
Part I: Introduction: It gives a detailed description about macroeconomics
along with its origin and growth, basic concepts, and macro variables. The
working system of the economy is analysed graphically, and the method of
national income accounting is narrated with India’s example.
Part II: Product Market Analysis: This part explores theoretical aspects of
macroeconomics. These include classical postulates and the Keynesian
theories of national income determination in three models – simple
economy model, closed economy model, and the open economy model.
Part III: Theories of Consumption and Investment: The theories of
consumption discussed here include the Keynesian theory, Friedman’s
theory, life-cycle theory, and Robert Hall’s random-walk theory. The
theories of investment include theories based on marginal efficiency of
capital (MEC), acceleration principle, the neo-classical theory, and Tobin’s
q-theory.
Part IV: Money Market Analysis: It contains a detailed analysis of money
market including classical postulates of money demand and the Keynesian
and the post-Keynesian theories of the money supply, money demand and
interest rate determination. The discussion on theory of money supply
includes the sources of money supply, money multiplier, and the theory of
money supply. The theory of money demand includes the Keynesian theory
and the post-Keynesian theories. This is followed by an explanation of
theory of interest rate determination.
Part V: Integration of Product and Money Markets: John Maynard Keynes
had analysed and developed his product and money-market theories in
isolation of one another whereas the two markets are interdependent and
interactive. J. R. Hicks had integrated the Keynesian theories of product and
money markets through his IS-LM model. In this part, there is an elaborate
discussion on the Hicksian IS-LM model. In a subsequent chapter, synthesis
of classical and Keynesian theories and the growth of post-Keynesian
macroeconomics developed by the other economists are discussed.
Part VI: Economic Growth and Business Cycles: This part explains the
theories of economic growth and business cycles as developed by the
economists of different generations. Having initially described the growth
factors, theories of economic growth discussed here include Harrod-Domar
model, neo-classical theory, and endogenous growth theory. The theories of
business cycle include Hawtrey’s monetary theory, Hayek’s monetary over-
investment theory, Schumpeter’s innovation theory, and Hicksian theory of
trade cycle along with evaluation of business cycle theories.
Part VII: Dynamics of Inflation and Unemployment: Two economic issues,
viz., inflation and unemployment along with their theoretical and empirical
interrelationship are discussed in this part. The discussion on inflation
includes its meaning, measurement, and desirability. It is followed by the
theories of inflation in detail which include classical, neo-classical,
Keynesian, and modern theories. This part also emphasises on the policy
measures to control inflation.
Part VIII: International Aspects of Macroeconomics: The two important
international aspects of macroeconomics discussed here are determinants of
the foreign exchange rate and assessment of balance of payments. An
adverse balance of payments of a country affects its economy adversely and
hence, it needs to be adjusted. The various theoretical approaches and
policy measures for the adjustment of balance of payments are discussed
which include the classical approach, Mundell-Fleming model, currency
devaluation, and monetary approach. These aspects of international
economics are covered in detail in three chapters.
Part IX: Macroeconomic Policies: Monetary and Fiscal Policies: In this last
part of the book, two fundamentally important macroeconomic policies,
viz., monetary and fiscal policies are described. The discussion includes
policy objectives, instruments of policy operation, and operational
mechanism of policy measures. It is known that neither monetary nor fiscal
policy works efficiently as anticipated to achieve the predetermined
objectives. The limitations and efficacies of two policy measures are
discussed elaborately. This is followed by a brief discussion on two new
policy measures, viz., demonetisation and imposition of Goods and Service
Tax (GST) implemented by the Government of India recently.
• Methodological Approach
A unique comprehensive methodology is followed in the book for the
exposition of macroeconomic theories. The aim is to make complex
theories easily understandable for students. Primarily, theories are
demonstrated verbally along with the assumptions under which they have
been formulated. Their relevance is often justified with reference to some
empirical facts derived from historical economic events faced by different
countries. Further, theories are presented graphically, which is the most
common method used for the illustration of economic theories.
Graphically presented macroeconomic theories are further strengthened
with illustrations in the form of mathematical models, specifically in
algebraic form. These theoretical models are constructed based on certain
hypothetical functions of the relevant variables of the model. The algebraic
models are converted into numerical functions to show the empirical
applications of the models. After the complete exposition of
macroeconomic theories, the text appends their limitations and logical
deficiencies as indicated by critics of next generations.

Acknowledgement
I would like to express my deepest appreciation and gratefulness to
McGraw Hill Education for seeking opinion and suggestions of subject
experts for improving the presentation of the book. A special gratitude to
the contribution of the editorial personnel of McGraw Hill. I am also
thankful to numerous Indian and foreign students for emailing their
appreciations of the book. I express my indebtedness to reviewers for their
appreciation, comments, and suggestions for further improvement in the
exposition of subject matter of macroeconomics.
 The comments and suggestions from the subject experts, teachers and
students are always welcome.
D. N. Dwivedi
Email: dnd.dwivedi@gmail.com
About the Author
Preface

Part I Introduction
1. Introduction to Macroeconomics
2. Circular Flow Model of the Economy
3. National Income Accounting

Part II Product Market Analysis: Theory of National

Income Determination
4. The Classical Theory of Output and Employment
5. Keynesian Theory of Income Determination: Simple Economy Model
6. Change in Aggregate Demand and Investment Multiplier
7. Theory of Income Determination in Closed Economy Model: A Model
with Government Sector
8. Income Determination in Open Economy: The Four-Sector Model

Part III Theories of Consumption and Investment

9. Theories of Aggregate Consumption
10. Theory of Investment and Capital Accumulation

Part IV Money Market Analysis

 11. Money: Definition, Functions and Importance
12. The Supply of Money
13. The Classical Theory of Money Demand and Interest Determination
14. The Keynesian Theory of Money Demand and Interest
15. The Post-Keynesian Theories of Money Demand

Part V Integration of Product and Money Markets:

The IS-LM Model
16. The Is-Lm Model: The Simple Economy Model
17. The Is-Lm Model with Government Sector: The Three-Sector Model
18. The Is-Lm Model with Foreign Sector
19. Synthesis of Classical and Keynesian Approach to General
Equilibrium
20. Post-Keynesian Macroeconomics

Part VI Economic Growth and Business Cycles

21. Theories of Economic Growth
22. Business Cycle Theories and Global Recession

Part VII Dynamics of Inflation and Unemployment

23. Inflation: Meaning, Measure and Effects
24. Theories of Inflation and Control Measures
25. Inflation and Unemployment

Part VIII International Aspects of Macroeconomics

26. Foreign Exchange Rate
27. Balance of Payments: Meaning and Assessment
28. Balance of Payments: Disequilibrium and Adjustments
 Part IX Macroeconomic Policies: Monetary and
Fiscal Policies
29. Macroeconomic Policies: Meaning, Objectives and Formulation
30. Monetary Policy
31. Fiscal Policy
32. Demonetisation and Implementation of Goods and Services Tax (Gst)
Appendix: Solutions to the Numerical Questions
Glossary
Index
About the Author
Preface

Part I Introduction
1. Introduction to Macroeconomics
1.1 What is Macroeconomics
1.2 Macroeconomic Variables
1.3 Macroeconomics as a Theoretical and a Policy Science
1.4 Microeconomics vs. Macroeconomics
1.5 Origin and Growth of Macroeconomics
1.6 Some Basic Concepts and Approaches to Macroeconomic
Analysis
1.7 Macroeconomic Model Building
1.8 Importance of Macroeconomics
1.9 Limitations of Macroeconomics
Suggested Readings
Review and Objective Questions
2. Circular Flow Model of the Economy
2.1 Economy as a Circular Flow of Products and Money
2.2 Circular Flows in the Two-Sector Model
2.3 Circular Flows in Three-Sector Model: A Model with Government
Income and Expenditure
 2.4 Circular Flows in Four-Sector Model: A Model with the Foreign
Sector
Suggested Readings
Review Questions
3. National Income Accounting
3.1 Some Concepts Related to National Income
3.2 Different Kinds of Measures of National Income
3.3 Nominal and Real GNP
3.4 Methods of Measuring National Income
3.5 Measurement of National Income in India
3.6 Trends in Some Other Macro Variables in India
Suggested Readings
Review Questions

Part II Product Market Analysis: Theory of National

Income Determination
4. The Classical Theory of Output and Employment
4.1 The Classical Postulates
4.2 Say’s Law of Market: The Foundation of Classical
Macroeconomics
4.3 Classical Theory of Employment: A Formal Model of Say’s Law
4.4 Collapse of the Classical Macroeconomics
Suggested Readings
Review Questions
5. Keynesian Theory of Income Determination: Simple Economy
Model
5.1 Basic Concepts and Functions
5.2 Income Determination in Simple Economy Model
Suggested Readings
 Review and Objective Questions
6. Change in Aggregate Demand and Investment Multiplier
6.1 Change in Aggregate Demand By Change in Investment
6.2 Investment Multiplier
6.3 Simple Model of Investment Multiplier
6.4 An Alternative Method
6.5 Static and Dynamic Multiplier
6.6 Uses and Limitations of the Multiplier
6.7 Applicability of the Multiplier Theory to LDCs
6.8 Paradox of Thrift and the Multiplier
Suggested Readings
Review and Objective Questions
7. Theory of Income Determination in Closed Economy Model: A
Model with Government Sector
7.1 Income Determination with the Government Sector
7.2 Fiscal Multipliers
Suggested Readings
Review and Objective Questions
8. Income Determination in Open Economy: The Four-Sector Model
8.1 Four-Sector Model: An Overview
8.2 Export and Import Functions and Aggregate Demand
8.3 Income Determination in the Four-Sector Model
8.4 Foreign Sector Multipliers
8.5 Complete Four-Sector Model of Income Determination
Suggested Readings
Review and Objective Questions

Part III Theories of Consumption and Investment

9. Theories of Aggregate Consumption
9.1 Keynesian Theory of Consumption: The Absolute-Income
Hypothesis
9.2 Duesenberry’s Theory: The Relative Income Hypothesis
9.3 Friedman’s Theory of Consumption: The Permanent-Income
Hypothesis
9.4 Life-Cycle Theory of Consumption: The Life-Cycle Hypothesis
9.5 Consumption Under Uncertainty: Robert Hall’s Random-Walk
Theory
9.6 Concluding Remarks on Consumption Theories
9.7 Non-Income Factors Affecting Consumption
Suggested Readings
Review and Objective Questions
10. Theory of Investment and Capital Accumulation
10.1 Some Basic Concepts
10.2 Theory of Investment: Methods of Investment Decision
10.3 Marginal Efficiency of Investment (MEI) and Aggregate Demand
for Capital
10.4 Theory of Capital Accumulation
10.5 Income-Investment Relationship: The Accelerator Theory of
Investment
10.6 Flexible Version of the Accelerator Theory
10.7 Internal Theory of Investment
10.8 Neo-Classical Theory of Investment: The Modern Approach
10.9 Tobin’s q Theory of Investment: Stock Market and Investment
Suggested Readings
Review and Objective Questions

Part IV Money Market Analysis

11. Money: Definition, Functions and Importance
11.1 Definition of Money
11.2 Kinds of Money
11.3 Functions of Money
11.4 Significance of Money in Modern Economy
Suggested Readings
Review Questions
12. The Supply of Money
12.1 Sources of Money Supply
12.2 Deposit Creation by the Commercial Banks
12.3 Non-Banking Financial Intermediaries and Money Supply
12.4 Measures of Money Supply in India
12.5 Theory of Money Supply
12.6 Monetary Expansion and the Money Multiplier: A Simplified
Model
12.7 Monetary Expansion, Currency Drain and Deposit Multiplier
Suggested Readings
Review Questions
13. The Classical Theory of Money Demand and Interest
Determination
13.1 The Classical Quantity Theory of Money
13.2 The Cambridge Version of Quantity Theory of Money
13.3 The Classical Theory of Interest
13.4 Keynes’s Criticism of Classical Theory of Interest
Suggested Readings
Review and Objective Questions
14. The Keynesian Theory of Money Demand and Interest
14.1 Classical–Neoclassical and Keynesian Views on Holding Money
14.2 Keynesian Theory of Demand for Money
 14.3 Keynesian Theory of Interest and Money Market Equilibrium
14.4 Changes in the Money Market and the Interest Rate
14.5 Criticism of the Keynesian Theory of Interest
Suggested Readings
Review and Objective Questions
15. The Post-Keynesian Theories of Money Demand
15.1 Portfolio Theories of Demand for Money
15.2 Baumol–Tobin Approach to Transaction Demand for Money
15.3 Tobin’s Theory of Speculative Demand for Money: The Portfolio
Optimisation Approach
15.4 Friedman’s Quantity Theory of Money
Suggested Readings
Review and Objective Questions

Part V Integration of Product and Money Markets:

The IS-LM Model
16. The IS-LM Model: The Simple Economy Model
16.1 Interdependence of Product and Money Markets
16.2 IS-LM Model: An Elementary Exposition
16.3 Mathematical Version of the Is-Lm Model
16.4 Dynamics of Adjustment from Disequilibrium to Equilibrium
16.5 Effect of Shift in the IS and LM Curves on the General
Equilibrium
Suggested Readings
Review and Objective Questions
17. The IS-LM Model with Government Sector: The Three-Sector
Model
17.1 Derivation of the IS-Curve with the Government Sector
17.2 Monetary Changes and Money-Market Equilibrium
 17.3 Product and Money-Market Equilibrium in Three-Sector IS-LM
Model
17.4 Effect of Fiscal and Monetary Changes on the General
Equilibrium
17.5 Mathematical Exposition of the Three-Sector Model
Suggested Readings
Review and Objective Questions
Appendix
18. The IS-LM Model with Foreign Sector
18.1 Foreign Sector and the IS and LM Curves
18.2 Product-Market Equilibrium with Foreign Trade
18.3 Derivation of the IS Curve
18.4 Derivation of the IS Curve: An Alternative Method
18.5 Four-Sector IS-LM Model: An Overview
18.6 Determination of the General Equilibrium
18.7 IS-LM Model with the Balance of Payments
Suggested Readings
Review and Objective Questions
19. Synthesis of Classical and Keynesian Approach to General
Equilibrium
19.1 Shortcomings of the Keynesian and the Classical Theories
19.2 Determination of Aggregate Price and Output: A Preview
19.3 Derivation of the Aggregate Demand Curve
19.4 Impact of Changes in Government Policies on the AD Curve
19.5 Classical vs. Keynesian Approach to Aggregate Supply Curve
19.6 Aggregate Demand–Supply Model: The Final View
19.7 Achieving Full Employment: Policy Options Under the
Keynesian System
19.8 Supply Shocks and Policy Dilemma
 Suggested Readings
Review and Objective Questions
20. Post-Keynesian Macroeconomics
20.1 Modern Monetarism: A Counter-Revolution
20.2 Keynesian vs. Monetarist Debate: Does Money Matter
20.3 Reconciliation of the Keynesian and Monetarist Controversy
20.4 New Classical Macroeconomics: The Radicalism
20.5 Supply-Side Macroeconomics
Suggested Readings
Review Questions

Part VI Economic Growth and Business Cycles

21. Theories of Economic Growth
21.1 Meaning of Economic Growth
21.2 Factors of Economic Growth
21.3 Production Function and Growth Accounting
21.4 Theories of Economic Growth: An Overview
21.5 Harrod-Domar Model of Growth
21.6 Neo-Classical Theory of Economic Growth: Solow’s Growth
Model
21.7 Endogenous Growth Theory
Suggested Readings
Review and Objective Questions
22. Business Cycle Theories and Global Recession
22.1 What is a Business Cycle
22.2 Phases of Business Cycles
22.3 Theories of Business Cycle: An Overview
22.4 What Theory of Trade Cycle is Most Relevant
 22.5 Global Recession of 2008–09: A Recent Case of Business Cycle
22.6 Need for Controlling Business Cycles
22.7 Policy Measures to Control Business Cycle
Suggested Readings
Review and Objective Questions

Part VII Dynamics of Inflation and Unemployment

23. Inflation: Meaning, Measure and Effects
23.1 Definition of Inflation
23.2 Methods of Measuring Inflation
23.3 Types of Inflation
23.4 Inflation, Disinflation and Deflation
23.5 Inflation in India: A Long-Term View
23.6 Social and Economic Effects of Inflation
Suggested Readings
Review and Objective Questions
Appendix
24. Theories of Inflation and Control Measures
24.1 Classical and Neo-Classical Theories of Inflation
24.2 Keynesian Theory of Inflation
24.3 Monetarist View on Inflation
24.4 Modern Theories of Inflation
24.5 Interaction Between Demand-Pull and Cost-Push Inflation
24.6 Inflation in Less Developed Countries (LDCs)
24.7 Policy Measures to Control Inflation
Suggested Readings
Review and Objective Questions
25. Inflation and Unemployment
 25.1 Meaning, Measurement and Kinds of Unemployment
25.2 Inflation and the Rate of Unemployment
25.3 Modifications in Phillips Curve
25.4 What Rate of Unemployment is the Natural Rate of
Unemployment
25.5 Policy Dilemma: What is Desirable—Inflation or Unemployment
Suggested Readings
Review and Objective Questions

Part VIII International Aspects of Macroeconomics

26. Foreign Exchange Rate
26.1 Meaning and Measure of Foreign Exchange Rate
26.2 Foreign Exchange Market
26.3 Market Theory of Exchange Rate Determination
26.4 Purchasing Power Parity Theory
26.5 Monetary Approach to Exchange Rate Determination
26.6 Portfolio Balance Approach to Exchange Rate Determination
26.7 Fixed Exchange Rate and its Determination
26.8 Controversy on Fixed vs. Flexible Exchange Rate
Suggested Readings
Review and Objective Questions
27. Balance of Payments: Meaning and Assessment
27.1 Balance of Payments: Meaning and Purpose
27.2 The Balance of Payments Accounts
27.3 BOP Accounting System in India
27.4 Assessment of Balance of Payments
27.5 Causes and Kinds of BOP Disequilibrium
Suggested Readings
 Review Questions
28. Balance of Payments: Disequilibrium and Adjustments
28.1 The Classical Approach: The Automatic Adjustment Approach
28.2 BOP Adjustment by Policy Measures: Mundell-Fleming Model
28.3 Mundell-Fleming Model: The Expenditure Changing Policies
28.4 The Expenditure Switching Policy: Devaluation
28.5 Monetary Approach to BOP Adjustments
Suggested Readings
Review and Objective Questions

Part IX Macroeconomic Policies: Monetary and

Fiscal Policies
29. Macroeconomic Policies: Meaning, Objectives and Formulation
29.1 Macroeconomic Policy: Meaning and Scope
29.2 The Need for and Advent of Macroeconomic Policies
29.3 Objectives of Macroeconomic Policies
29.4 Objectives of India’s Macroeconomic Policy
29.5 Formulation of the Macroeconomic Policy
Suggested Readings
Review Questions
30. Monetary Policy
30.1 Meaning and Scope of Monetary Policy
30.2 Instruments of Monetary Policy
30.3 Transmission Mechanism of Monetary Policy: The Portfolio
Adjustment
30.4 Limitations and Effectiveness of Monetary Policy
30.5 Monetary Policy of India
Suggested Readings
 Review and Objective Questions
Appendix
31. Fiscal Policy
31.1 Meaning and Scope of Fiscal Policy
31.2 Fiscal Instruments and Target Variables
31.3 Kinds of Fiscal Policy
31.4 Fiscal Policy and Macroeconomic Goals
31.5 Limitations of Fiscal Policy
31.6 Crowding-Out and Crowding-In Controversy
31.7 Fiscal Policy of India
Suggested Readings
Review and Objective Questions
Appendix
32. Demonetisation and Implementation of Goods and Services Tax
(GST)
32.1 Demonetisation
32.2 Goods and Services Tax (GST)
Review Questions
Appendix
Appendix: Solutions to the Numerical Questions
Glossary
Index
Part I

Introduction
The objective of Part I of the book is to introduce macroeconomics and
to lay down the method of theoretical foundation and basic framework
for the study of macroeconomics. Part I of the book contains three
chapters. Chapter 1 contains a detailed discussion on the introduction
of macroeconomics as a branch of economic science, its origin and
growth, the scope of its subject matter, its comparison with
microeconomics, the macro-variables and analytical concepts used in
macroeconomic analysis, method of building analytical models, and
importance and limitations of macroeconomic theories. Chapter 2
explains the working of the economy and presents graphically the
circular flow of macro-variables, especially products and money. In
Chapter 3, national income accounting has been discussed in detail.
 C O
The objective of this chapter is to introduce macroeconomics and to
discuss analytical framework along the following aspects:
• Introduction of macroeconomics as a branch of economics
• A brief account of macroeconomic variables
• Macroeconomics as theoretical and policy science
• Comparison of macroeconomics with microeconomics
• Taking a view of origin and growth of macroeconomics
• The basic concepts and approaches to macroeconomic analysis
• A brief description of model building in macroeconomics
• Importance and limitations of macroeconomics

INTRODUCTION
As is widely known, modern economics has two major branches: (i)
microeconomics and (ii) macroeconomics1. Although economics as a
social science was founded by Adam Smith, the ‘Father of Economics’2, in
his book The Wealth of Nations in 1776, the subject matter of economics
remained confined until 1930s to what is now known as microeconomics.
The economic thoughts and theories propounded by the classical
economists from the days of Adam Smith down to the neo-classical
economists until the Great Depression (1929-1934) was confined to what is
known as microeconomics. Therefore, until the early 1930s, the scope of
economics remained limited to microeconomics. It was in 1936 that John
Maynard Keynes laid the foundation of macroeconomics as a new branch of
economics by writing his revolutionary book The General Theory of
Employment, Interest and Money (1936). The subsequent growth of
literature on the interpretation and elaboration of Keynesian thoughts and
theories and the empirical verification and evaluation of his thoughts and
theories over a period of three decades, culminated in the emergence of
macroeconomics. The subject matter and the scope of macroeconomics
continued to expand further with the counter-criticism of Keynesian
theories and methodology and formulation of new macroeconomic theories,
which led to the foundation of post-Keynesian macroeconomics. The prime
objective of this book is to present a comprehensive and authentic
elaboration of the Keynesian and post-Keynesian macroeconomics.

1.1 WHAT IS MACROECONOMICS

Macroeconomics is essentially the study of the performance and the
behaviour of the economy as whole. It may be noted at the outset that
defining economics has been a difficult proposition. So is the case with
macroeconomics. Nevertheless, some economists have attempted to define
macroeconomics according to their own perception of its subject matter. Let
us take a view of some relatively comprehensive definitions of
macroeconomics offered by some famous economists as it would give
broad view of what macroeconomics is about.
Gardner Ackley: “Macroeconomics is the study of forces or factors that
determine the levels of aggregate production, employment and prices in the
economy, and their rate of change over time”3.
Kenneth E Boulding: “Macroeconomics is the study of the nature,
relationships and behaviour of aggregates of economic quantities....
Macroeconomics ... deals not with individual quantities as such, but with
aggregates of these quantities … not with individual incomes, but with the
national income, not with individual prices, but with the price levels, not
with individual output, but with the national output”4.
J. M. Culbertson: “Macroeconomic theory is the theory of income,
employment, prices and money”5.
P. A. Samuelson and W. D. Nordhaus: “Macroeconomics is the study of
the behaviour of the economy as a whole. It examines the overall level of a
nation’s output, employment, and prices”6.
Although these definitions are fairly comprehensive, they do not reveal
the exact nature and scope of modern macroeconomics, nor do they fully
capture its subject matter. Since “macroeconomics is [still] a young and
imperfect science” (Mankiw, Macroeconomics, 2003, p. 3), it is difficult to
define it precisely. However, the definitions quoted above do give an idea of
the central theme of theoretical macroeconomics, and this is what matters in
economics. The central theme that emerges from the above definitions may
be stated as follows: Macroeconomics is essentially the study of the
behaviour and performance of the economy as a whole. It examines the
relationship and interaction between the ‘factors and forces’ that determine
the level and growth of national output and employment, general price
level, and the balance of payments of the economy. This definition too
should be treated only as a working definition of macroeconomics.
In order to comprehend the subject matter of macroeconomics, let us look
at the basic questions that macroeconomics seeks to answer.
• What determines the levels of economic activities, total output, the
general price level, and the overall employment in a country?
• How is the equilibrium level of national income determined?
• What causes fluctuations in the national output and employment?
• What determines the general level of prices in a country?
• What determines the level of foreign trade and trade balance?
• What causes disequilibrium in the balance of payments of a country?
• How do the monetary and fiscal policies of the government affect
the economy?
 • What kind of economic policies can restrain economic recession and
steer the economy on the path of growth?
These are some major theoretical questions that macroeconomics seeks to
answer.

1.2 MACROECONOMIC VARIABLES

As mentioned above, macroeconomics is the study of the behaviour of the
economy as a whole. The behaviour of the economy as a whole is studied
on the basis of the behaviour of the aggregate variables, i.e.,
macroeconomic variables. Macroeconomic variables are, in general,
interrelated and interdependent. Macroeconomics provides the framework
for analysing the nature and extent of relationship and interactions between
the aggregate variables, which leads to the formulation of macroeconomic
theories. It is, therefore, important to have a view of macroeconomic
variables. For analytical purpose, macroeconomic variables can be
classified under two categories: (i) Goods market macro variables, and (ii)
Money market macro variables. The two kinds of macro variables are listed
in Table 1.1.

Table 1.1 Macroeconomic Variables

Among the macro variables of the goods market, gross domestic product
(GDP) is the most important macro variable as all the other macro variables
of the goods market, except employment, are the components of GDP. All
the goods-market variables are flow variables in the sense that they are
subject to change over time with change in their determinants. Also, all
goods-market macro variables are interrelated and interdependent. The
interrelationship and interdependence of the macro variables will be
discussed ahead along with the theory of income determination.
In case of macro variables of the money market, aggregate money supply
and aggregate money demand are the two most important macro variables.
The aggregate money supply is determined autonomously by the central
bank of the country and, in the analysis of money market, it is treated to be
a stock variable. But, money demand is treated as a flow variable. Money
demand consists of transaction plus speculative demands for money. The
variable ‘interest rate’ is determined by aggregate money supply and money
demand.
Beside, the macro variables of the goods and money market are also
interrelated and interdependent. Their interrelationship and interdependence
are elaborately discussed and presented graphically and in functional form
in Chapter 17. It may be noted here that the analysis of the interaction
between macro variables of goods and money market makes a very
important contribution to macroeconomics, known as IS-LM model. The
interaction between the goods market and money market variables
determines the level of the ultimate target variables: (i) economic growth,
(ii) general price level, and (iii) balance of payments.

1.3 MACROECONOMICS AS A
THEORETICAL AND A POLICY
SCIENCE
As Samuelson and Nordhaus have pointed out, “…macroeconomics is still
an area of great controversy among economists and politicians alike” (op.
cit., p. 381). While some economists consider macroeconomics basically as
a theoretical science, some others consider it as a purely policy science.
This kind of controversy on the nature of macroeconomics raises a
question: Is macroeconomics a theoretical science or a policy science?
Macroeconomics, however, has both theoretical and policy orientations. Let
us now look at theoretical and policy orientations of macroeconomics.
Macroeconomics as a Theoretical Science
Macroeconomics as a theoretical science uses theoretical models to explain
the behaviour and the determination of the equilibrium level of
macroeconomic variables (national output, employment, money supply and
demand, general price level and balance of payments, etc.) and analyses the
nature of relationship between them in a logical way and in an orderly
manner. The most important aspect of macroeconomic theories is that they
provide framework and analytical tools to analyse the macroeconomic
phenomena. Macroeconomic theories that offer theoretical explanation of
the determination of national income, aggregate level of consumption,
saving and investment, employment and growth rate, behaviour of the
general price level, determination of product-and-money market
equilibrium, exchange rate and balance of payments constitute the main
body of theoretical macroeconomics. Macroeconomic theories, though not
perfect, do provide a great deal of understanding of, and insight into, the
working of the economy, and in identifying the factors and forces that cause
adverse or desirable effects on the economy. A clear understanding of
macroeconomic dynamics is a necessary condition for the formulation of
appropriate macroeconomic policies to achieve predetermined goals.

Macroeconomics as a Policy Science

As regards its policy orientation, macroeconomics provides a sound
theoretical framework for investigating the causes and effects of economic
problems—unemployment, inflation, recession and depression, stagflation,
etc.—and provides guidelines for devising appropriate policy measures to
find solution to the problem. Also, macroeconomics analyses the working
and effectiveness of macroeconomic policies, especially the monetary and
fiscal policies, on the economy. The knowledge of working and efficacy of
these policies are extremely useful in devising appropriate policy measures
for controlling and regulating the economy to achieve the desired goals. It
is, perhaps, for this reason that Dornbusch, et al., hold the view that
“Macroeconomics is an applied science”. But they add (in the very next
paragraph), “Macroeconomics is very much about tying together facts and
theories”7. It means that there are macroeconomic ‘theories’ which can be
‘tied’ together with ‘facts’ to make macroeconomic studies. However, the
policy aspect of macroeconomic studies has assumed such a great
importance in modern times that in the opinion of some economists,
“Macroeconomics is first and foremost a policy science”8.
Macroeconomics as a policy science provides an analytical framework and
guidelines for devising appropriate policy measures for controlling or
eliminating undesirable factors in the economy and to guide it on the path
of stable growth.

Conclusion
It may be concluded at the end that macroeconomics has both theoretical
and policy orientations. In fact, the origin of macroeconomics can be related
to the search for means and measures to solve such economic problems as
the Great Depression and unemployment. But, for finding out an
appropriate feasible solution to such economic problems, it is indispensable
to develop analytical frameworks and economic models to understand the
working of the economy, and interaction and interdependence of the macro
variables. Any random choice and application of policy measures to solve
big economic problems can do more harm than good to the economy.
Building analytical framework and models represents the theoretical nature
of macroeconomics. However, macroeconomic theories are not abstract
theories: they have been developed on the basis of facts of economic life.
Therefore, macroeconomic theories, though imperfect, have a good deal of
application in policy formulation. In case of macroeconomics, theories and
policies go together.

1.4 MICROECONOMICS VS.

MACROECONOMICS
Before we proceed, let us have a glance at how the economists distinguish
between microeconomics and macroeconomics to help us in
comprehending the subject matter of the two branches of modern
economics.

1.4.1 Units of Study

The first distinction between the two branches of economics is made on the
basis of the unit of study. As mentioned above, microeconomics studies the
economic behaviour of individual decision-making units (individuals as
consumers and producers); how the price of an individual product is
determined in the market; and how the price of a factor determined.
Microeconomics analyses how an individual household decides on what to
consume, how much of it to consume, and how to allocate its total
consumption expenditure on various goods and services so that its total
utility is maximised. Similarly, microeconomics analyses how individual
firms take decision on what to produce and how to price its product so that
its total profit is maximised, given its resources. Also, microeconomics
analyses the working of markets for individual goods and services and
explains how prices of individual goods and services are determined in the
market.
In simple words, microeconomics takes a microscopic view of the
economic system and studies how the system works at the micro level.
According to Lerner, “Microeconomics consists of looking at the economy
through a microscope, as it were, to see how the millions of cells in the
body economic—the individuals or households as consumers, and the
individuals or firms as producers—play their part in the working of the
whole economic organism”9.
In contrast, the unit of study in macroeconomics is the economy as a
whole. Macroeconomics is concerned with the nature, relationships, and the
behaviour of national economic aggregates such as national income, total
consumption expenditure, savings and investment, total employment, and
the general price level. As Boulding has put it, “Macroeconomics… deals
not with individual quantities as such, but aggregate of these quantities—
not with individual incomes, but with the national income, not with
individual prices, but with the [general] price level, not with individual
output, but with the national output”10. In brief, macroeconomics studies
the working and performance of the economy as a whole.
1.4.2 Basic Assumptions of Microeconomics and
Macroeconomics
Another factor that distinguishes the two branches of economics is the basic
assumption on which the microeconomic and macroeconomic studies are
based. Microeconomics assumes all the macro variables to be given. That
is, it assumes the level of total production (national income), consumption,
saving and investment, employment, and the general price level, etc., to
remain constant. In contrast, macroeconomics assumes economic decisions
of households and firms, prices of individual products to be given and
studies the behaviour of the macro variables. Briefly speaking, what
microeconomics treats as constants, macroeconomics treats them as
variables and what macroeconomics treats as constants, microeconomics
treats them as variables.

1.4.3 Machlup’s View on Micro-Macro Distinction

Machlup has given a very important view on micro-macro distinction
of economics. According to him, it is difficult to draw a sharp line between
microeconomics and macroeconomics or to put the two branches of
economics in watertight compartments. Fritz Machlup has examined four
criteria proposed by various authors for making a distinction between
microeconomics and macroeconomics, viz., (i) how one looks at the
economy, (ii) whose actions are analysed, (iii) what is being aggregated,
and (iv) what role is given to the price relationships. He has concluded that
‘there is no agreement on the meaning and scope of the concepts of micro
and macro theory’11. Some authors are also of the opinion that the division
of economics between micro and macro economics “often contributes more
to fuzzy confusion than to rigorous understanding”. The confusion might
arise because there is a large area of economic issues and studies that
overlap with the boundaries of the two branches. For instance, study of a
particular industry, say, IT industry, is generally treated as a micro study.
But if the scope of the study is extended to capture its effect on
employment, GDP, balance of payments, etc., it enters the area of
macroeconomics. Similarly, a study of change in banks’ prime lending rate
(PLR) and its effect on banks’ loans and advances can be treated as a
microeconomic study. However, if the scope of the study is enlarged to
cover the effect of changes in the PLR on the overall financial market and
its repercussions on the aggregate investment, the study enters the area of
macroeconomics.

1.4.4 Microeconomics and Macroeconomics as

Two Separate Branches of Economics
As mentioned above, some economists do not agree on the division of
economic science between micro and macroeconomics. Notwithstanding
the disagreement of some economists on the division of economics between
micro and macroeconomics, there are certain issues like economic growth,
unemployment, inflation, stagflation, etc., often faced by most economies,
which cannot be analysed and tackled simply by analysing individual
markets and individual products, or even by analysing a segment of the
economy. Microeconomics and macroeconomics are, in fact, recognised by
most economists as the two major branches of economic studies for both
analytical and practical purposes. Boulding12 has justified macroeconomics
as a separate branch of economics on the basis of ‘macroeconomics
paradoxes’ or more appropriately, micro-macro paradoxes. The micro-
macro paradoxes refer to paradoxical facts that are true in case of individual
economic units and quantities but are not true in case of economic
aggregates and for the economy as a whole.

Micro-Macro Paradoxes
Boulding13 has pointed out the following three important Micro-Macro
Paradoxes:
1. An important paradox pertains to cash holding. If all the individuals
decide to hold a larger amount of cash, the total individual cash
holding increases which decreases the level of transactions. But the
stock of money remains the same for the overall transactions in the
economy as a whole.
 2. The second paradox is related to saving and investment. If an
individual saves and invests more, his or her income increases. But
this is not true for the economy as a whole. The reason is if all the
individuals with given incomes decide to save more and more, the
consumption expenditure will decrease by the same amount.
Decrease in consumption expenditure reduces the aggregate demand
for consumer goods. This reduces the prospect for investment. The
aggregate investment may even decrease which will reduce the level
of aggregate income.
3. The third paradox pertains to profit and wages. At micro level, one
tends to accept the proposition that the distribution of national
income between wage incomes and profits depends on the relative
bargaining power of the labour and the employers. According to
Boulding, however, it depends on “a combination of other factors,
the most important of which are decisions of management to invest,
i.e., to accumulate real assets, and the complex of the decision of the
whole society about liquidity preference”. Boulding concludes, “It is
these paradoxes, more than any other factor, which justify the
separate study of the system as a whole, not merely as an inventory
or list of particular items”.

1.5 ORIGIN AND GROWTH OF

MACROECONOMICS
As already mentioned, the foundation of macroeconomics, as a separate
branch of economics, was laid down by a British economist, John Maynard
Keynes (1883–1946) in his revolutionary book The General Theory of
Employment, Interest and Money (1936). This should, however, not mean
that the economists of the pre-Keynesian era had not given thought to the
macroeconomic problems of the economy. Keynes has himself pointed out
that the use of macro approach to certain economic phenomena can be
traced back to the writings of the 16th century economists called
‘mercantilists’ and those of the later era. The economists of the 16th and
17th century, called ‘mercantilists’ were the first to use macro approach to
the economic problems of those days. According to Keynes, the
mercantilism made “a contribution to statecraft, which is concerned with
the economic system as a whole and with securing optimum employment of
the system’s entire resources …”14. The 18th century economists, called
‘physiocrats’ analysed the ‘circular flows of wealth’ in an economy in an
aggregative framework. Quesnay’s Tableau Economique (1758) is regarded
as one of the most remarkable macro models of the early days. The circular
flow model was later developed and used by Walras, Wicksell, Bohm
Bawerk and Schumpeter to analyse the flow of national income and
expenditure. During the 18th century, Malthus contributed greatly to
aggregative economic analysis in so far he pointed out the deficiency in the
Say’s law and showed that aggregated demand might fall short of the full
employment level and this may result in stagnation in demand for capital
and subsequent stagnation in demand for labour. In the 19th century, Karl
Marx used macro approach to economic analysis of the society. However,
pre-classical macroeconomic views and thoughts were not strong enough to
lay the foundation of macroeconomics.
In this section, we describe briefly the origin and growth of
macroeconomics as a separate branch of economic science. The origin and
growth of macroeconomics is reviewed here in three stages of its
development: (i) classical macroeconomics, (ii) ‘Keynesian Revolution’
and macroeconomics, and (iii) post-Keynesian developments in
macroeconomics.

1.5.1 Classical Macroeconomics

The ‘classical views’15 refer to the views and thoughts of the classical
economists. The classical economists are referred to the economists from
Adam Smith, the founder of economics, to those of the 18th and 19th
centuries. The views, thoughts and theories formulated by the classical
economists, mainly by David Ricardo, John Stuart Mill, Robert Malthus,
Alfred Marshall, and Arthur Cecil Pigou are regarded as the classical
economics.
The classical economists had not developed any coherent macroeconomic
theory. The macroeconomic views of the classical economists, as envisaged
by the economists of the post-Keynesian era are treated as the classical
macroeconomic postulates. The classical postulates can be stated as
follows.
According to the classical economists, if market forces—demand and
supply—are allowed to work freely, the following macroeconomic features
continue to exist.
1. There will always be full employment in the long run, and
unemployment, if ever, will be a short-run phenomenon.
2. The equilibrium level of national income is determined at the level
of full employment and national income is equal to the total cost of
production.
3. The economy is always in equilibrium in the long run and there is
neither overproduction nor underproduction in the long run.

Collapse of Classical Macroeconomics

The macroeconomic postulates of classical economists prevailed until 1929
– the year in which the Great Depression of 1930s had started. The Great
Depression exposed the ‘inadequacy of the theoretical foundation of the
classical laissez-faire doctrine’. It proved the classical postulates to be
theoretically untenable. In fact, the Great Depression had taken place in the
US in 1929 when the US economy was working on the principles of the
laissez faire system. Yet the US stock market collapsed on 29 October 1929,
which caused the devastation of the US economy. The devastation of the
US economy had a widespread disastrous impact on the international
economy causing the Great Depression of 1930s. During the period of
Great Depression (1929–1939), there was large-scale unemployment in
almost all free market industrial economies and their national income had
declined to an unprecedented level. In the US, for example, unemployment
had increased from about 3 per cent in 1929 to 25 per cent in 1933;
production of goods and services had declined by 30 per cent; price level
had fallen by 30 per cent; and business investment had dropped to almost
nil16. Most industrial countries, e.g., the Great Britain, France and
Germany, had experienced the similar devastation of their economy. The
classical economics could neither offer an explanation to the causes and
consequences of the Great Depression nor provide any market solution to
the economic problems faced by these countries. This marked the collapse
of the classical macroeconomics.

1.5.2 Keynesian Revolution and Emergence of

Macroeconomics
The collapse of classical economics created a big gap between classical
economics and economic realities of the day. The need of the time was to
have a fresh look at the working of the economic system and to devise the
appropriate policy measures to revive the depressed economies. It was John
Maynard Keynes – an erstwhile neo-classical economist17 – who revealed
the limitations and inadequacy of the classical economics in dealing with
economic problems at the national level in his book The General Theory of
Employment, Interest and Money (1936). Keynes proved that classical
economics was not theoretically sound enough to explain the working of the
economy as a whole, to predict the consequence of the economic changes,
and to provide solution to economic problems arising at the country level.
Having pointed out the deficiencies and inadequacies of the classical
economics, Keynes constructed his own macroeconomic theories related to
national income, employment, and money market. Keynesian theories mark
the foundation of macroeconomics. Keynesian contribution to economic
science is treated as Keynesian Revolution.
The central theme of the Keynesian macroeconomics may be summarised
as follows:
• The level of output and employment in the economy is determined
by the aggregate demand for goods and services, given the resources
of the country.
• Money market equilibrium and interest rate are determined by the
aggregate demand for money, given the money supply.
• The unemployment in any country is caused by lack of aggregate
demand and the economic fluctuations are caused by demand
deficiency.
 • The demand deficiency can be removed through compensatory
government spending.
Keynesian economics stresses the role of demand management by the
government for the stable growth of the economy. “Perhaps the most
fundamental achievement of the Keynesian revolution was the reorientation
of the way economists view the influence of government activity on the
private economy”18. Contrary to the classical view that government
spending ‘crowds out’ private investment, Keynesian economics stresses
the favourable macroeconomic effects of the government spending19 on
national income and employment through its multiplier effect. The
dominance of Keynesian thought banished the classical view at least for
sometime.
The period between the late 1930s and the mid-1960s is called the “period
of Keynesian Revolution” or the “Keynesian Era”. During this period, most
economists were Keynesian and most governments, especially in the
developed countries, had adopted Keynesian policies. The Keynesian
thoughts had pervaded also the underdeveloped countries as most less
developed countries struggling to emerge out of their ‘low-equilibrium trap’
adopted Keynesian approach to initiate the process of economic
development. In fact, India’s Development Plans are largely based on the
Keynesian theory of growth and employment. So all-pervasive was the
Keynesian economics until the 1960s!
However, the real economic world has neither conformed to any particular
economic thought or principle, nor complied with any idea or ideology.
Economic system goes through a continuous process of evolution. It passes
from one system to another, rendering prevailing thoughts, theories and
laws redundant and forcing economists to examine the relevance of existing
theories and to find new explanation to emerging economic conditions. This
is what happened with Keynesian revolution also as it gave way to new
kinds of revolutionary thoughts and theories encapsulated as post-
Keynesian macroeconomics as discussed below.
1.5.3 Post-Keynesian Developments in
Macroeconomics
The Keynesian economics started showing signs of its failures in the early
1970s. Keynesian economics, especially Keynesian fiscal measures, failed
to provide solution to economic problems of low growth, high
unemployment and high rate of inflation faced by most developed
countries, especially by the US. It could offer neither a reasonable
explanation nor an effective solution to the problem of “stagflation” faced
by the US in the early 1970s. The inefficacy of the Keynesian policy
measures lead to the growth of a new school of macroeconomic thoughts,
called “monetarists”. Monetarism was subsequently followed by the
emergence of some other schools of macroeconomic thoughts. The post-
Keynesian developments in macroeconomics include the following kinds of
macroeconomic thoughts and theories:
1. Monetarism: A Counter Revolution
2. Neo-classical Macroeconomics
3. Supply-side Economics
4. Neo-Keynesianism
Let us have a brief look at the origin and central theme of these areas of
macroeconomics.

Monetarism: A Counter-Revolution
As mentioned above, the Keynesian economics started showing the signs of
its failure during the 1970s as it failed to provide solution to economic
problems of those days. This raised the doubt about the relevance and
applicability of Keynesian economics to the problems of growth and
stability. A group of economists, called “monetarists”, led by Milton
Friedman claimed that Keynesian theory had failed to predict national
output, price level, rate of employment and unemployment, and interest
rate. The monetarists came out with a new revolutionary thought.
According to the monetarists, the role of money is central to the growth and
stability of national output, not the role of aggregate demand for real output,
as Keynesians believe. In the opinion of the monetarists, money supply is
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the lake to the merciful goodness of that Providence who is "the God of the
fatherless and the widow."

Meanwhile the little vessel was battling with the angry waves in a place
where there was a narrow passage, some fifty yards broad, between two
dangerous shelving sandbanks, well known to the master of the Katharine
and his crew. The sandbanks themselves, as it happened, lay partly under
the lee of one of the little islands which stud the coast near Lachta; and the
current was bearing strong upon the bank upon the leeward. At this moment
the Katharine shipped a large quantity of water; as ill-luck would have it,
the tiller broke, and before the boat's head could be righted she had drifted
upon the edge of the bar of sand, and there she stuck fast. The little bark
would have been overwhelmed by the breakers but for the shelter afforded
by the corner of the island and the shifting of the wind a point or two round
to the north; indeed she was fast filling with water, in spite of the efforts of
the passengers to keep her afloat by bailing. To add to the general confusion
on board, it now turned out that several of the passengers, who had been
drinking at the village inn before starting from Lachta, were fairly
intoxicated, and the rest were sinking down bewildered into the apathy of
despair, so that only Stephen and two of the boatmen had their wits about
them. But though they strove with all their might, they were unable to move
the boat from off the sandbank. At this moment, when the waves were
breaking over the little Katharine, and had already swept off into deep
water one or two hapless passengers, who had lost all heart and courage, a
sail was seen approaching.

It was rather a large vessel, with a gallant crew of some twenty men,
who had been inspecting a portion of the coast. They had seen the perilous
position of old Paul and his boat, and had borne down to his assistance, for
in spite of the terrible raging of the wind and waves the captain could not
see the poor fellows swept away one by one and drowned without at least
making an effort to save them.

The vessel neared the sandbank; but how may she approach close
enough to rescue the unfortunate fellows on board the Katharine? A boat is
lowered from the vessel, and four as gallant Russian sailors as ever
ploughed the fresh waters of Ladoga or the Baltic have rowed up to the
spot; but the strength of two of the crew, added to the exertions of Stephen
and the boatmen of the Katharine, are not sufficient to move the boat from
the firm grasp with which the sand held her keel. They were, therefore,
beginning to relax their efforts, when a second boat, with a crew of six
stout-hearted fellows, neared the bank, and by vigorous efforts reached the
spot in time to reinforce their comrades. Without the loss of a moment, one
of the crew, a fine tall muscular Russian, some six feet five inches high,
stripped off his outer garments, leaped into the sea, and after swimming a
few sharp strokes gained a footing on the sand. This was heavy work
indeed, as the sand was not hard and firm, but mixed with mud and slime;
but the giant strength of the new arrival turned the scale, and after a few
short and sharp heaves the Katharine moved once more. In a few moments
she was afloat again, and taken in tow by the other boat.

And where was Stephen all this time? Worn out with fatigue and cold,
for he had been immersed some two hours in the chilly waves, and standing
in deep water and nearly exhausted by their violence, he had lost his footing
on the slippery bank, and having got in a moment beyond his depth was
vainly attempting to keep his head above water by swimming in his
drenched and dripping clothes, the weight of which in a few minutes more
would have carried him down.

"Oh! Steenie, Steenie!" cried the old boatman, Paul, with a loud voice of
agony, which would make itself heard even above the roaring of the angry
wind and waves; "can none of you save my poor Stephen, the bravest lad
that ever trod a deck! He's gone now; and but for his help this day my boat
would have been lost."

"He's not lost yet!" cried the tall seaman; and, plunging into the waves,
he caught him by the hair of the head just as he was sinking a third time; the
next wave would have carried him fairly down, and his life would have
been gone beyond recall.

It was but the work of a moment for the strong, tall stranger to swim
with the lad towards the boat, which was hovering near; and in another
second the gallant crew had lifted him in over the gunwale and laid him at
the bottom of the boat. As soon as he showed signs of life, and began to
open his eyes, a flask of brandy was applied to his mouth, and he soon
revived. The tall man, too, got in, and leaving two of his crew to help old
Paul to tow the Katharine ashore, he gave the signal to his men, and they
pulled off with all their might in the direction of Lachta. Though the waves
were still running high, yet, fortunately, the wind was astern; so the sharp,
quick strokes of the crew soon brought the boat to a landing-place from
which, a few hours before, poor Stephen had departed in such high spirits,
and with such confidence in Paul's seamanship and the ability of the
Katharine to make the passage.

As soon as the boat came to the sheltered nook where the steps of the
landing-place led up from the sea, Stephen was put ashore, and partly led
and partly carried he reached the cottage of his mother. At the sight of her
son the poor widow burst into a flood of tears, and began to give way to an
agony of joy and grief. A warm bath was soon prepared for her son; and
after the application of some gentle restoratives poor Stephen was able to sit
up and thank his kind preserver, the tall stranger, who, with his two men
behind him, just now lifted up the latch of the cottage-door and had entered
the room.

"Gracious Heaven!" exclaimed the grateful mother; "why, sir, you are in
wet clothes too! Sit down, sir, by the fire, and accept of my humble fare,
while I go and find some of my Steenie's clothes for you to put on, and I dry
those dripping garments."

The tall stranger sat down, and, as the widow left the room, gave his two
followers a hint not to make known to the boy or his mother who he was. In
a few minutes the stranger had retired, and assumed a plain old suit
belonging to the young man whose life he had saved, and was engaged in
eating some hot bacon which the widow had just placed on the table before
him, with many protestations of her eternal gratitude to the saviour of her
son.

"May the King of Heaven, who never turns a deaf ear to the widow's
prayer, mercifully reward you for saving my Steenie's life! It is not many a
sailor, or merchant either, that would have done as you did to-day. Heaven
speed you; and may you never forget that the poor widow of Lachta is
praying for you night and morning, that the Almighty may increase your
store, whenever you are sailing over the stormy sea, or the lakes of Onega
and Ladoga."

The tall stranger was about to rise and depart, when suddenly the door
opened, and a naval officer entered with a crowd of attendants. It was the
captain and mate of the barque which Paul and Steenie had seen in the
offing, and which had sent her boats to the rescue of the Katharine.

"My noble master, may it please your majesty," he said, falling on one
knee, "the Royal Peter has come safe, and she has towed the Katharine too
into the little port of Lachta."

The poor widow fell down upon her knees in astonishment, and faltered
forth her apologies for not having recognized his majesty, and for having
treated him with such apparent disrespect.

"Nay, nay, my good woman," said the czar, smiling, "how could you
know the emperor thus disguised in mud and dirt. But you will know him
henceforth. I shall keep your son's clothes in remembrance of this day; and
when your boy 'Steenie,' as you call him, wakes up from the sound sleep
into which he has fallen, tell him that he will always find a true friend in
Peter Alexovitch."

Our readers when they learn that the foregoing story is founded upon a
plain historical fact—as they will find upon reading for themselves the
"Life of Peter the Great,"—will be grieved to hear that the noble conduct of
the emperor on this occasion cost him his life. He had for a long time
suffered under a chronic internal disease, which none of the court
physicians could effectually combat; and in the month of November, 1724,
in which our story is laid, having gone, contrary to the advice of his
physicians, to inspect the works on Lake Ladoga, his exposure to the wet
and cold, in rescuing the poor ferryman and his crew in the manner related,
affected him so seriously that he never afterwards recovered. The emperor
went home to his palace at St. Petersburg without loss of time, but his
malady increased in spite of all the remedies which the medical skill of
Russia could furnish; and gradually he sank under the disease, till death put
an end to his sufferings towards the close of the following January.

Such was the end of Peter I. of Russia, deservedly named the "Great;"
though he was the strangest compound of contradictions, perhaps, that the
world has ever seen. In him the most ludicrous undertakings were mingled
with the grandest political schemes. Benevolence and humanity were as
conspicuous in his character as a total disregard of human life. He was at
once kind-hearted and severe, even to the extent of ferocity. Without
education himself he promoted arts, sciences, and literature. "He gave,"
says one of his biographers, "a polish to his people, and yet he was himself
a savage; he taught them the art of war, of which, however, he was himself
ignorant; from the sight of a small boat on the river Moskwa he created a
powerful fleet, and made himself an expert and active shipwright, sailor,
pilot, and commander; he changed the manners, customs, and laws of the
Russians, and lives in their memory, not merely as the founder of their
empire, but as the father of his country."

Yes; the memory of Peter the Great to this day is dear among all classes
of the Russians, from the noblest of the Boyards down to the meanest
peasant. But if among the towns and villages of his vast empire there be one
in which his name is cherished with especial honour, it is that little fishing
town of Lachta; and in proof of our assertion we may add, that the cottage
in which "Steenie" and his mother lived and died is still familiarly known to
every traveller in those parts as "Peter's House."
 *** END OF THE PROJECT GUTENBERG EBOOK SASHA THE
SERF, AND OTHER STORIES OF RUSSIAN LIFE ***

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