Macro Economics

Dr. Ritika Malik

Introduction

Macroeconomics is that branch of Economic Analysis

in which groups created to the whole economies,.
That is national income, Total production, total
consumption, total savings, wage-level, general cost,
and general price level are studied.
The term 'Macro' is derived from the Greek word
'Uakpo' which means large. Macro economics looks at
the economy as a whole. It examines the factors that
determine national output and its growth overtime. It
studies the economic aggregates such as the overall
level of prices, output and employment in the economy.
In short, macroeconomics is the study of national
aggregates or economy-wide aggregates. In a way it is
like study of economic forest as distinguished from
trees that comprise the forest. Main tools of its analysis
are aggregate demand and aggregate supply.
Pros and Cons
Pros
It is helpful in determining the balance of payments
along with the causes of deficit and surplus of it.
It makes the decision regarding economic and fiscal
policies and solves the issues of public finance.
Cons
 Its analysis says that the aggregates are homogeneous, but it is
not so because sometimes they are heterogeneous.
 It covers only the aggregate variables which avoid the welfare
of the individual
Definitions of Macro Economics
According to R. G. D. Allen:
"The term macro economics applies to the study of relations
between broad economic aggregates such as total employment,
income and production".
 Professor K. E. Boudling is of the view that: 
"Macro economics is that part of economics which studies the
overall averages and aggregates of the economic system. It
does not deal with individual incomes but with the national
income, not with individual prices but with the price level,
not with individual output, but with national output".
 
“Macroeconomics, then, is that part of the subject
which deals with the Great aggregates and averages of
the system rather than with particular item in it, and
attempts to define, these aggregates in a useful
manner and to examine their relations.” Professor
Bouding
Features of Macroeconomics

1. Changeability
In it, macro-units are considered as the variable
(dynamic) whereas Micro units are considered as
static.
2. Connectedness
Determination of quantity of Micro and Macro is done
by different methods. Benefits of the whole society are
kept in view during Macroeconomic analysis.
3. Study of the Whole Economy
Macroeconomics policies and problems related to the
whole economy are studied. And the effects of these
policies not seen on individual units but on the whole
society. 
Nature

DETERMINATION OF NATIONAL INCOME AND

EMPLOYMENT
DETERMINATION OF GENERAL PRICE LEVEL
ECONOMIC GROWTH AND DEVELOPMENT
DISTRIBUTION OF FACTORS OF PRODUCTION
Scope of Macroeconomics
1. Theory of Income and Employment
In it, the formulation of income and Employment level
is done and study of consumption function,
investment function, multiplier are also done.
2. Theory of General Price Level
In it, the formulation of the general price level is
studied and problems related to inflation, deflation are
a prime subject matter of Macro Economics. 
3. Theory of Development and Planning
For a fast and balanced development, developing
countries apply many economic theories.
So, the study of process and theories of economic
development and planning is also an important subject
matter of Macro Economics.
4. Theory of trade cycle
In macroeconomics study of the trade, the cycle is done.
The factor of Boom and Depression in the trade cycle,
there effects and removal of these effects are studied in
Macro Economics.
5. Theory of International Trade and Foreign
Exchange
It is also a subject matter of Macroeconomics. Under its
theory of International Trade, terms of trade,
determination of foreign exchange rates, etc. Are
studied.
6. Theory of Public Finance
In it, the study of theories, policies, and effects related to
government income, expenditure loan, etc. are done.
Study of fiscal policy is the prime subject matter of
public finance.
7. Principles of Money and Banking
In macroeconomics, theories related Money and banking,
country’s monetary and credit system, functions of the
central bank and other banks and international finance
are studied. 
8. Macro-Theory of Distribution
In macroeconomics study of Distribution of wages and
profits in national income is done. 

So it is clear that the scope of Macro Economics it’s very

wide.
Scope
Importance of Macroeconomics
1. Useful in Formulation of Economic Policies
The Macroeconomics is very useful in the formulation
of economic policies.

Related to this matter professor Boulding has

written, “Macro Economics is very important in the
view of economic policies because economic policies
of the government are related to the group of
individuals and not with individuals.
2. Helpful in Understanding the Collective and
Complex Operation of Economy
In Micro Economics knowledge of only individual units
can be done but for the collective and complex operation
of while the economy, Macroeconomics is helpful.
3. Helpful in Development of Micro Economics
It is helpful in the development of microeconomics
because the formulation of laws and theories of
microeconomics is done with the help of
macroeconomics.
4. Useful in Solving various Economic Problems
Economists take the help of macroeconomics in solving
the problem related to the whole economy, like-National
income, National Savings, and investment, consumption,
production, etc.
5. Useful in Economic Planning
At present, for the solution of economic problems and
for fast and balanced economic development.
Every nation takes help of economic planning and
determination of targets in plans is done on the basis of
Macro Analysis.
6. Analysis of trade cycle
On the basis of macroeconomics by doing the analysis
of factors Boom and Depression, important steps are
taken.
7. Analysis of monetary problems
Knowledge of determination of monetary policy of a
country, the study of its effect and cause of monetary
problems and solutions for the removal of these
problems is done only by Macro analysis.
8. Due to Micro Paradoxes, It is Essential to Study the
Whole Economy
Due to micro paradoxes, it is essential to study the whole
economy because those decisions which are applicable to
individual units it is not necessary that the same decision
will be applicable to the whole economy.
9. Analysis of Unemployment
In a country the reason for unemployment is due to a lack
of effective demand. So for the removal of unemployment
increase in effective demand is essential.
Limitations of Macroeconomics

1. Importance not given to Individual Units

It is not complete analysis because in it instead of the
individual units whole economy is studied collectively.

 2. Possibility of Wrong Predictions

Policies are framed on the basis of the whole economy
sometimes maybe dangerous for some firms and
commodities.
For example: If the general price level is fixed, then it
cannot be said that price of commodities will also
remain fixed .

3. Difficult to find out Macro Quantities

It is difficult to find out macro quantities. Index
number, defective of giving weight to index no.
Thus, it is very difficult to find correct data of total
investment total savings, total consumption, etc.
4. No Attention to Structure and Composition of
Group
Macroeconomics attention is given only towards
groups and totals not towards the structure and
composition of the group. 
Macroeconomic paradoxes
The paradox of thrift
An increase in the propensity to save will reduce
output. One or even many individuals may increase the
proportion of their income that they save and do not
spend.
However if the majority of the population of an
economy do so, overall consumption will fall, reducing
output. This may even lead to a fall in the absolute
level of savings if the economy shrinks, so that an
increase in desired saving leads to a fall in actual
saving.
The paradox of costs
 This holds that a decrease in real wages will not
increase the profits of firms and will instead lead to a
fall in employment.
One firm can achieve higher profits by reducing its
wage bill. However, if all firms attempt to do the same,
consumption will fall at the macro level, reducing
sales, and from there the rate of profits.
The paradox of public deficits
 This theory shows that an increase in the
government’s deficit can increase firm profitability. The
extent of this will vary depending on the impact of a
higher deficit on the balance of trade in an open
economy.
It also may not hold in the longer term, as a boost to
profits in the short-term may reduce the incentives
for firms to restructure or prevent weaker firms going
bust, thereby hampering structural change. But it
remains a possibility.
The paradox of profit-led demand 
This idea suggests that if overall real wages in an economy are
reduced to reduce prices, this can lead to a boost to demand via net
exports as the country becomes more competitive internationally.
However if all countries try to do the same, global consumption
will fall, reducing demand and output. It is impossible for all
countries to become more competitive against each other, since the
world economy is a closed system.
 While one country can benefit from real wage reductions, other
things being equal, the world economy as a whole cannot. A good
example of this paradox is the Eurozone since 2000, with Germany
as the economy reducing wages to increase the competitiveness of
its exports
Macroeconomics variables

There are 4 main macroeconomic variables that

policymakers should try and manage: Balance of
Payments, Inflation, Economic Growth and
Unemployment.
This can be easily remembered using the following
acronym:
B: Balance of Payments
I: Inflation
G: (Economic) Growth
E: Employment
The Balance of Payments is the difference between the
total amount of goods a country exports (sells to other
countries) and the total amount of goods a
country imports (buys from other countries). This can be
simplified to X-M.
If the amount of goods that a country exports (X) is greater
than the amount of goods that a country imports (M), there
is a balance of payments surplus because X>M.
If the amount of goods that a country exports (X) is less
than the amount of goods that a country imports (M), there
is a balance of payments deficit .
Inflation is the amount that the cost of goods and services
within an economy has increased over a given time
period (usually measured over a year).
 Inflation is damaging to an economy and this means that
policymakers tend to try and keep inflation low. For example,
the Bank of England aim to set inflation at around 2%.
There are 2 types of inflation, cost-push inflation (which is
caused by the costs of production for firms increasing,
forcing them to put their sale prices up) and demand-pull
inflation (which is caused by growing demand for goods that
firms produce, allowing firms to increase prices to gain more
profit).
Economic growth is the amount that the level of
output within an economy increases over a given time
period (again usually measured over a year).
Economic growth is extremely desirable as it means
that, in general, the people within an economy are
getting richer.
Economic growth can be increased in a number of
ways, such as technological improvement, an increase
in the demand for goods and services, and an increase
in the size of the workforce (a fall in unemployment).
Unemployment is the amount of people within an economy
who are willing and able to work, but do not have a job. 
There are a number of different types of unemployment. 
Frictional unemployment (which is unemployment caused
by the search for a new job or a transition between
jobs), structural unemployment (caused by the decline of an
industry, for example type-writing or coal mining), seasonal
unemployment (caused by the time of year, for example
working on a Christmas tree farm is undesirable during
summer), and cyclical unemployment (which is caused by a
recession – a reduction in the level of output within an
economy).
Concept and measure of Development and
Underdevelopment
In economic terms, development has been understood
as achieving sustainable rates of growth of income and
to enable the nation to expand its output faster than
the population.
 This definition fails to take into consideration
problems of poverty, discrimination, unemployment
and income distribution; the assumption being that
increased output or economic growth would deal with
these issues.
In sociological terms, the term ‘development’ is used
to mean industrialization, economic growth and the
living standards associated with prosperity, such as
increased life expectancy, health-care, free education,
etc.
Those countries that have not yet achieved these
objectives are said to be ‘undeveloped’ and are often
termed ‘lessdeveloped countries’ (LDCs).
The views on development think of development as
material or social change in the material world.
However, others (Myers 1999) providing a religious
view on development consider it as a positive change
in the whole of human life materially, socially and
spiritually.
Myers calls this transformational development
Torado and Smith (2011) sum up development and
underdevelopment using 3 key questions;
What has been happening to poverty?
What has been happening to unemployment?
What has been happening with inequality?

They conclude that if the three of these have declined from

higher levels, then beyond doubt, this has been a period of
development. If one or more of these problems have been
growing worse, especially if all the three have, then that
would be a period of ‘underdevelopment.
Economics of development refers to the problems of
economic development of underdeveloped countries.
In the early days, the focus was on problems that were
statistic in nature and largely related to a Western
European framework of social and cultural institutions.
However, after the Second World War economists
started devoting attention towards analyzing the
problems of underdeveloped countries and
formulating theories and models of development and
growth.
After the Second World War, the poverty and
backwardness of some of the world countries became
extremely conspicuous.
Many reasons, including colonial exploitation,
devastation by war, war-induced inflation and the like,
could possibly be said to be responsible for such a sad
state of affairs in many countries.
It is precisely at this time that the subject of
development economics came into being to study the
problems of backwardness and underdevelopment of
these nations.
Measurement of economic development
Economic development is measured in four ways:-
1. Gross National Product (GNP)
2. GNP per capita
3. Welfare
4. Social Indicators

Gross National Product:- GNP is the total value of all final

goods and services produced within a nation in a particular year,
plus income earned by its citizens (including income of those
located abroad), minus income of non-residents located in that
country. Basically, GNP measures the value of goods and services
that the country's citizens produced regardless of their location.
GNP is one measure of the economic condition of a
country, under the assumption that a higher GNP
leads to a higher quality of living, all other things
being equal.
Closely related to GNP is Gross Domestic Product
(GDP):- which is the total market value of all final
goods and services produced in a country in a given
year, equal to total consumer, investment and
government spending, plus the value of exports, minus
the value of imports.
GNP per capita:- This relates to increase in the per capita
real income of the economy over the long period.
This indicator of economic growth emphasizes that for
economic development the rate of increase in real per capita
income should be higher than the growth rate of population.
However, several difficulties still remain:-
 i. An increase in per capita income may not raise real
standard of living of the masses.
ii. There is possibility that the masses remain poor despite an
increase in the real GNP per capita if the increased income
goes only to the few rich instead of going to the many poor.
Welfare :-Economic development is often measured
from a welfare point of view.
From this perspective, economic development is
regarded as a process whereby there is an increase in
the consumption of goods and services by individuals.
From a welfare perspective, economic development is
defined as a sustained improvement in material well-
being, which is reflected in an increasing flow of goods
and services.
Social Indicators:- Due to dissatisfaction with
GNP/GNP per capita as measures of economic
development, certain economists have tried to
measure it in terms of social indicators.
Some indicators are ‘inputs’ e.g. nutrition standards or
number of hospital beds or doctors per head of
population while others are outputs e.g. infant
mortality rates, sickness rates etc.
Social indicators are normally referred to as basic
needs of development. The direct provision of basic
needs such as health, education, food, water,
sanitation and housing affects poverty in a shorter
period and with fewer monetary resources.
Human Development

By the early 1960s :-

(i) economic growth had emerged as both a leading objective,
and indicator, of national progress in many countries 
(ii) even though GDP was never intended to be used as a
measure of wellbeing.

 In the 1970s and 80s development debate considered using

alternative focuses to go beyond GDP, including putting
greater emphasis on employment, followed by redistribution
with growth, and then whether people had their basic needs
met.
These ideas helped pave the way for the human
development approach, which is about expanding the
richness of human life, rather than simply the richness
of the economy in which human beings live.
It is an approach that is focused on creating fair
opportunities and choices for all people.
So how do these ideas come together in the human
development approach?
People: the human development approach focuses on
improving the lives people lead rather than assuming
that economic growth will lead, automatically, to
greater opportunities for all.
Income growth is an important means to
development, rather than an end in itself.
Opportunities: human development is about giving
people more freedom and opportunities to live lives
they value.
In effect this means developing people’s abilities and
giving them a chance to use them. For example,
educating a girl would build her skills, but it is of little
use if she is denied access to jobs, or does not have the
skills for the local labour market.
Foundations for human development are to live a
healthy and creative life, to be knowledgeable, and to
have access to resources needed for a decent standard
of living.
Many other aspects are important too, especially in
helping to create the right conditions for human
development, such as environmental sustainability or
equality between men and women.
Choices: human development is, fundamentally, about
more choice. It is about providing people with
opportunities, not insisting that they make use of
them.
No one can guarantee human happiness, and the
choices people make are their own concern.
The process of development – human development -
should at least create an environment for people,
individually and collectively, to develop to their full
potential and to have a reasonable chance of leading
productive and creative lives that they value.
The human development approach, developed by the
economist Mahbub Ul Haq, is anchored in Amartya
Sen’s work on human capabilities, often framed in
terms of whether people are able to “be” and “do”
desirable things in life.
Examples include
Beings: well fed, sheltered, healthy
Doings: work, education, voting, participating in
community life.
Freedom of choice is central: someone choosing to be
hungry (during a religious fast say) is quite different to
someone who is hungry because they cannot afford to
buy food.
As the international community seeks to define a new
development agenda post-2015, the human
development approach remains useful to articulating
the objectives of development and improving people’s
well-being by ensuring an equitable, sustainable and
stable planet.
Sector-wise contribution of GDP of India

Services sector is the largest sector of India. Gross Value

Added (GVA) at current prices for Services sector is
estimated at 92.26 lakh crore INR in 2018-19.
Services sector accounts for 54.40% of total India's GVA
of 169.61 lakh crore Indian rupees.
With GVA of Rs. 50.43 lakh crore, Industry sector
contributes 29.73%. While, Agriculture and allied sector
shares 15.87%.
At 2011-12 prices, composition of Agriculture & allied,
Industry, and Services sector are 14.39%, 31.46%, and
54.15%, respectively.
Share of primary (comprising agriculture, forestry,
fishing and mining & quarrying), secondary
(comprising manufacturing, electricity, gas, water
supply & other utility services, and construction) and
tertiary (services) sectors have been estimated as 18.57
per cent, 27.03 per cent and 54.40 per cent.
Sector wise Indian GDP composition in 2017 are as
follows : Agriculture (15.4%), Industry (23%) and
Services (61.5%).
With production of agriculture activity of $375.61
billion, India is 2nd larger producer of agriculture
product. India accounts for 7.39 percent of total global
agricultural output. India is way behind china which
has $991 bn GDP in agriculture sector.
 GDP of Industry sector is $560.97 billion and world
rank is 6. In Services sector, India world rank is 8 and
GDP is $1500 billion.
Contribution of Agriculture sector in Indian economy is
much higher than world's average (6.4%). Contribution of
Industry and Services sector is lower than world's average
30% for Industry sector and 63% for Services sector.
Composition of Agriculture & allied, Industry, and
Services sector was 51.81%, 14.16%, and 33.25%,
respectively at current prices in 1950-51.
Share of Agriculture & allied sector has declined at
18.20% in 2013-14. Share of Services sector has improved
to 57.03%. Share of Industry sector has also increased to
24.77%
Composition of National Income and
Occupational Structure
Some of the main features of occupational structure in India
are as follows:
1. Agriculture is Main Occupation:
In India, agriculture is the main occupation. 66.7 percent of
population is engaged in agriculture as against 71 percent in
1901.
2. Less development of industries:
17 percent of population depends on manufacturing
industries in India. In USA 32 percent, in England 42 percent
and in Japan 39 percent people are engaged in secondary
sector. It shown that India is industrially backward.
3. Unbalanced:
Indian economy is highly unbalanced. All production
activities are not equally developed. Too much
dependence on agriculture is a symptom of economic
backwardness.
4. Less Income:
Per capita income and standard of living of the people
in India is low. It is so because agriculture yields less
income than trade.
5. Small Villages:
Dominance of agriculture proves that most of the
people in India must be living in small villages and
number of people living in towns and cities must be
very small.
In India 76 percent of population lives in rural areas
and 24 percent in urban areas.
6. Backward Agriculture:
66 percent of population is engaged in agriculture. In
India, yet we import food grains from other countries.
It testifies that our agriculture is very backward.
On the other hand, in America, 2 percent of
population is engaged in agriculture which exports the
surplus of food to other countries. It shows that
agriculture sector should be developed.
7. Increase in the proportion of Agriculture
Labourers:
The proportion of agricultural labourers has been
rising during the period of planning. It shows the fact
that the number of wage earners is increasing in
agricultural sector.
8. Less development of tertiary sector:
Tertiary sector which includes services, banking,
communication, transport etc. is not much developed
in India.
 In India, 20.5 percent of population is engaged in
tertiary activities as against 66 percent in America, 56
percent in England and 49 percent in Japan.


Unit 2
National Income
National income is a value of all goods and services
produced in an economy in an accounting
year(Domestic Income)
Also if we add income from abroad is also computed
in national income
Three methods to calculate national income
Product method/Output method/Value Added
method
Income method
Expenditure method
Notes
Methods of Calculating National Income

Calculating and measuring national income is

important because that’s how we can assess an
economy’s growth rate.
There are several methods of calculating national
income.
Income Method

The income method of calculating national income

focuses on the production perspective.
Now production of goods and services involves the use
of land, labour, capital, and so on. And if we consider
these factors of production, income is generated via
rent, wages and salaries, profits, and interest.
We can then calculate the national income by adding
all these types of income. Another important source of
income is mixed income. Mixed income refers to the
income generated by self-employed professionals and
sole proprietors.
According to the income method:
National Income = Rent + Wages + Interest +
Profit + Mixed-Income
The income method, however, does not consider
transfer payments, prize money (lotteries), illegal
money, profit tax, and sale of second-hand goods.
Expenditure Method

The expenditure method of calculating national

income focuses on the expenditures. Now expenditure
refers to all the purchases made by residents,
government, or business enterprises. The expenditure
method takes the following elements into
consideration:
Purchase of consumer goods and services by residents
and households (C)
Government expenditure on goods and services (G)
Business enterprises’ expenditure on capital goods and
stocks (I)
Net exports (exports-imports) (NX)
Hence, according to the expenditure method:
National Income = C + G + I + NX
However, the expenditure method excludes
expenditure on second-hand goods and purchase of
shares and bonds.
Value-Added Method

The value-added method of calculating national

income focuses on the value added to a product at
each stage of production.
To calculate the national income using this method,
we will have to first calculate the net value added at
factor cost (NVAFC). And to calculate the (NVAFC), we
will have to deduct the net indirect taxes.
Usually, this method involves dividing the economy into
various industries such as agriculture, fishing, transport,
communication, and so on.
Then by calculating the value added ((NVAFC) at each
stage, we can derive the national income. Now since this
method concentrates on the net value added by each
component, we would need to exclude or subtract the
following elements from the output of each enterprise:
Consumption of raw materials
Consumption of capital
Net indirect taxes
Now if we add the NVAFC of all enterprises of an industry,
we get the net value added at factor cost for that industry.
And by adding the NVAFC of all industries, we get the net
domestic product at factor cost, which is represented as
NDPFC.  And to this, if we add the net factor income from
abroad, we get the national income.
Hence, according to the value-added method:
National Income = (NDPFC) + Net factor income from
abroad
Classical Theory of Income and Employment
The classical economists believed in the existence of full
employment in the economy.
To them, full employment was a normal situation and any
deviation from this regarded as something abnormal.
According to Pigou, the tendency of the economic system
is to automatically provide full employment in the labor
market when the demand and supply of labor are equal.
Full Employment
Full Employment is a normal situation
According to Pigou’s : tendency of economic system is
to automatically provide full employment in the labor
market when Dn=Sn
Classical Employment theory is based on Says Law
that is Supply creates its own Demand.
When a producer produces goods and pays wages to
workers, the workers, in turn, buy those goods in the
market. Thus the very act of supplying (producing) goods
implies a demand for them. It is in this way that supply
creates its own demand.
Unemployment results from the rigidity in the wage structure
and interference in the working of free market system in the
form of trade union legislation, minimum wage legislation
etc.
Full employment exists “when everybody who at the running
rate of wages wishes to be employed.”
Those who are not prepared to work at the existing wage rate
are not unemployed because they are voluntarily unemployed.
Thus full employment is a situation where there is no
possibility of involuntary unemployment in the sense that
people are prepared to work at the current wage rate.
The basis of the classical theory is Say’s Law of Markets
which was carried forward by classical economists like
Marshall and Pigou.
They explained the determination of output and
employment divided into individual markets for labor,
goods and money. Each market involves a built-in
equilibrium mechanism to ensure full employment in the
economy.
Assumptions
1. There is the existence of full employment without
inflation.
2. There is a laissez-faire capitalist economy without
government interference.
3. It is a closed economy without foreign trade.
4. There is perfect competition in labour and product
markets.
5. Labour is homogeneous.
6. Total output of the economy is divided between
consumption and investment expenditures.
7. The quantity of money is given and money is only the
medium of exchange.
8. Wages and prices are perfectly flexible.
9. There is perfect information on the part of all market
participants.
10. Money wages and real wages are directly related and
proportional.
12. The law of diminishing returns operates in production.
13. It assumes long run.
Say’s Law of Markets:

Say’s law of markets is the core of the classical theory of

employment.
An early 19th century French Economist, J.B. Say, enunciated the
proposition that “supply creates its own demand.” Therefore,
there cannot be general overproduction and the problem of
unemployment in the economy.
If there is general overproduction in the economy, then some
labourers may be asked to leave their jobs.
The problem of unemployment arises in the economy in the short
run. In the long run, the economy will automatically tend toward
full employment when the demand and supply of goods become
equal.
Determination of Output and Employment:

In the classical theory, output and employment are

determined by the production function and the demand for
labour and the supply of labour in the economy.
Given the capital stock, technical knowledge and other
factors, a precise relation exists between total output and
amount of employment, i.e., number of workers. This is
shown in the form of the following production function:
Q=f (K, T, N)
where total output (Q) is a function (f) of capital stock (K),
technical knowledge (T), and the number of workers (N)
Keynesian theory of Income and
Employment
John Maynard Keynes was the main critic of the classical
macro economics.
He in his book 'General Theory of Employment, Interest and
Money' out-rightly rejected the Say's Law of Market that
supply creates its own demand.
He severely criticized A.C. Pigou's version that cuts in real
wages help in promoting employment in the economy.
He also opposed the idea that saving and investment can be
brought about through changes in the rate of interest. In
addition to this, the assumption of full employment in the
economy is not realistic.
So long as the economy was operating smoothly, the
classical analysis of aggregate economy met no serious
opposition.
 However, Great Depression of 1930's created problems of
increasing unemployment, reducing national income,
declining prices and failing firms increased in intensity.
The classical model miserably failed to explain and
provide a workable solution for how to escape the
depression.
 
According to Keynes:

"In the short period, level of national income and so of

employment is determined by aggregate demand and
aggregate supply in the country. The equilibrium of
national income occurs where aggregate demand is equal
to aggregate supply. This equilibrium is also called
effective demand point".
Keynesian theory of Income and
Employment
Income and Employment depends on the Effective
Demand (ED)
Effective Demand means Output (Q) , output creates
Income (Y) and Income creates Employment (N).
Theory is applicable on short run but classical theory was
based on long run.
Effective Demand consists of Aggregate Demand and
Aggregate Supply.
Aggregate supply remains constant in short run as it is not
possible to do supply in short run.
Aggregate Demand depends on overproduction and
unemployment that is why focuses on aggregate demand.
Aggregate Demand is based on Consumption and
Investment (C+I).
Consumption is a function of Y . C=f(Y) means as Income
Increases Consumption Increases , as Income Decreases
consumption decreases but increase in income will not result
in that much increase in consumption means it increases at
diminishing rate.
Investment depends on the Marginal Efficiency of
Capital (MEC) related to assets.
Investment depends on interest rate but interest rate can be
increased or decreased.
Interest is determined where demand of money is equal to
the supply of money. Equilibrium point.
Investment and employment can be increased or
decreased depends on Rate of interest, that is rate of
interest in increasing or decreasing.
Components of Aggregate Demand
There are four components of Aggregate Demand (AD);
Consumption (C), Investment (I), Government Spending
(G) and Net Exports (X-M). 
Any increase in any of the four components of aggregate
demand leads to an increase or shift in the aggregate
demand curve as seen in the diagram above.
AD = C + I + G + (X-M)
Consumption
This is made by households, and sometimes consumption accounts for
the larger portion of aggregate demand. An increase in consumption shifts
the AD curve to the right.

Factors that Affect Consumption

• Consumer Confidence : If consumers are confident about their future

income, job stability, and the economy is growing and stable, spending is
likely to increase. However, any job insecurity and uncertainty over
income is likely to delay spending. An increase in consumer
confidence shifts AD to the right.
• Interest Rates
Lower interest rates tend to increase consumption because
consumers purchase larger goods on credit. If interest
rates are low, then it’s cheaper to borrow. Consumers
mostly borrow to buy houses, which is one of the biggest
purchases and lower interest rates means lower mortgage
payments so that households can spend more on other
goods. So, lower interest rates increase Aggregate
Demand.
•  Consumer Debt
If a consumer has a lot of debt, he is unlikely to buy more
since he would have to pay his debt off first. Low
consumer debt increases consumption and aggregate
demand.
• Wealth
Wealth is assets held by a household, such as property
or stocks. An increase in property is likely increase to
consumption.
Investment
Investment, second of the four components of aggregate demand,
is spending by firms on capital, not households. However, investment
is also the most volatile component of AD. An increase in investment
shifts AD to the right in the short run and helps improve the quality
and quantity of factors of production in the long run.

Factors that Affect Investment

• Interest Rates
Firms borrow from banks to make large capital intensive purchases,
and if the interest rate decreases, it becomes cheaper for firms to
invest and provides incentive for firms to take risk.
•  Business Confidence
If firms are confident about the economy and its future
growth, they are more likely to invest in capital, new
projects and buildings/machinery.
• Investment Policy
If governments provide incentives such as tax
breaks, subsidies, loans at lower interest rates then
investment can increase.
• National Income
As firms increase output, they would need to invest in
new machines. This relationship is known as The
Accelerator. The assumption behind the accelerator is that
firms will want to make a fixed capital to output ratio,
meaning that if a factory uses one machine to produce
1000 goods, and the firms needs to produce 3000 goods
more, then the firm will buy 3 more machines.
Government Spending
Government spending forms a large total of aggregate
demand, and an increase in government spending shifts
aggregate demand to the right.
This spending is categorized into transfer payments and
capital spending.
Transfer payments include pensions and unemployment
benefits and capital spending is on things like roads, schools
and hospitals.
 Governments spend to increase the consumption of health
services, education and to re-distribute income. They may
also spend to increase aggregate demand.
Net Exports
Imports are foreign goods bought by consumers
domestically, and exports are domestic goods bought
abroad.
Net exports is the difference between exports and imports,
and this component can be net imports too, if imports are
greater than exports. 
An increase in net exports shifts aggregate demand to the
right.
The exchange rate and trade policy affects net exports.
Equilibrium Income

Most simply, the formula for the equilibrium level

of income is when aggregate supply (AS) is equal to
aggregate demand (AD), where AS = AD.

Adding a little complexity, the formula becomes Y = C + I

+ G, where Y is aggregate income, C is consumption, I is
investment expenditure, and G is government expenditure.
The equilibrium level of income is when an economy or
business has an equal amount of production and market
demand.
The equilibrium level of income is the point at which a
business is able to sell all of the goods it planned to.
The company produces its product to that level, and then
sells exactly the same amount. The company's output -- its
production -- is equal to the consumer demand to buy the
product.
At the national level, gross domestic product, or GDP,
represents the business manufacturing its products. All the
businesses, consumers, investors, and government
spending in the economy represent the consumers buying
those products.
An economy is said to be at its equilibrium level of
income when aggregate supply and aggregate demand are
equal. In other words, it is when GDP is equal to total
expenditure.
Change in Equilibrium
Changes in either demand or supply cause changes in
market equilibrium. Several forces bring­ing about changes
in demand and supply are constantly working which cause
changes in market equilibrium, that is, equilibrium prices
and quantities. 
The demand may increase or decrease, the supply curves
remaining unchanged. This would cause a change in
equilibrium price and quantity.
Similarly, the increase or decrease in supply, the demand
curve remaining constant, would have an impact on
equilibrium price and quantity. Both supply and demand
for goods may change simultaneously causing a change in
market equilibrium.
Supply-demand analysis is an im­portant tool of economics
with which we can make forecasts about how prices and
quantities will change in response to changes in demand
and supply. We explain below the impact of changes in
demand and supply on equilibrium price and quantity.
Impact of Increase in Demand on Market
Equilibrium:
Increase in demand affects prices and quantities. Suppose
there is increase in income of the working class due to the
enhancement of their salaries by the Pay Commission. As
a result of this increase in income, their demand for cloth
for shirting will increase causing a shift in the entire
demand curve for cloth to the right.
This will raise the equilibrium price and quantity of cloth, the supply
curve of cloth remaining unchanged as is shown in Fig. 24.2. It is
important to understand the chain of causation which leads to the
increase in price and quantity as a result of increase in demand.

Consider Fig. 24.2, in which D0D0 and SS are the initial demand and
supply curves of cloth. The increase in income causes a shift in the entire
demand curve to the right to the new position D1D1 while the supply
curve SS remains constant. It will be observed from Fig. 24.2, that with
the shift in demand curve to D1D1 at the old price OP0 excess demand of
cloth equal to E0A has emerged. This excess demand of the good exerts
upward pressure on price.
This will result in rise in price to OP where again quantity
demanded equals quantity supplied and new market
equilibrium is attained and excess demand is eliminated. It
is worth noting that increase in demand is the most
important factor causing inflation, that is, rise in prices
and is generally described as demand-pull inflation.
Though the term inflation is used in the context of a rise in
general price level.
Impact of Decrease in Demand on Market
Equilibrium
Now, take the opposite case of the impact of decrease in
demand on market equilibrium, the supply curve remaining
the same. The decrease in demand causes a shift in the entire
demand curve to the left.
This is graphically shown in Fig. 24.3, where originally
demand curve D0D0 intersects the supply curve SS of eggs at
point E0 and determines equilibrium price equal to OP0 and
equilibrium quantity OQ0. Now, suppose that doctors advise
the people to take less eggs as it contains greater quantity of
cholesterol which increases the risk of heart disease.
Consequently, demand for eggs decreases causing a shift
in the demand curve to the left to the new position D2D2.
The new equilibrium between demand and supply is
attained at price P, and quantity Q2 which are lower than
the initial equilibrium price OP0 and quantity OQ0.
Thus, the decrease in demand leads to the fall in both
price and quantity. How does this come about? With the
decrease in demand and consequently leftward shift in the
demand curve to D2D2 supply curve remaining unchanged,
at the original price OP0.
The sellers which cannot sell the quantity which they want
to sell at the original price will make offers to sell eggs at
a lower price.
Impact of Changes in Supply on Market
Equilibrium
Now, we explain the impact of changes in supply on price and output
of commodity, the demand for the commodity remaining the same.
Let us first examine the case of increase in supply. Suppose in a year
there is good Monsoon in India yielding bumper crop of wheat.
This will increase the supply of wheat in the market causing a shift in
its supply curve to the right. The impact of increase in supply of
wheat on equilibrium price and quantity is graphically depicted in
Fig. 24.4.
Originally, demand curve DD and supply curve 55 of wheat intersect
at point E and determine equilibrium price equal to OP and
equilibrium quantity OQ exchanged between the sellers and buyers.
Now, due to good monsoon resulting in bumper crop of
wheat the supply curve of wheat shifts to the right from SS
to the new position S1S1. The new supply curve
S1S1 intersects the given demand curve DD at point E 1, at
which the new lower equilibrium price OP 1 and larger
quantity OQ1 are determined. Thus, the increase in supply
leads to the fall in price and increase in equilibrium quantity.
Improvements in technology, reduction in the prices of
factors and resources used in the pro­duction of a commodity
or lowering of excise duty on a commodity also leads to the
increase in supply of the commodity.
For example, in recent years improvements in technology in the manufac­
ture of personal computers have served to increase the supply of personal
computers causing their supply curve to shift to the right. This has resulted
in lowering the prices of personal computers.
A personal computer which was available at price above Rs. 60,000 a few
years ago are now available at about Rs. 20,000.
Similarly, in the Central Budget for 1993-94, the Finance Minister Dr.
Manmohan Singh reduced excise duties on several commodities with the
hope that producers it would pass it on to the consumers and result in
shifting their supply curve to the right and thereby causing the drop in their
prices.
At lower prices, he argued, more of these commodities would be demanded
and there­fore it would help the industries which were facing demand
recession.
Multiplier
In 1930s, economists name F. A Kahn developed the
concept of multiplier.
Later J.M. Keynes developed the multiplier that is with
regard to the investment purpose and the effect on that
income.
Two different types of multiplier are there .
F.A Khan developed Employment Multiplier.
J. M Keynes developed Income Multiplier
Multiplier is like change is something will result in how
many times change in other thing (how many multiple
times)
According to F.A. Kahn ,if in economy initial
employment changes then how many times the secondary
employment will change.
 According to J M Keynes multiplier means how many
times the change in income takes place with increase in
investment.
Like if investment is 100 thousand crore then income will
not increased to 100 thousand only but many more.

Example investment increased to 3 hundred thousand

crore then it is increased in multiples of 3. Here the
multiplier is 3 that is 3 times increase in national income
will take place.
Derivation
From notes
Assumptions
MPC remains stable or constant
Net increase in investment : No further effect in later
period as it will effect value of multiplier that is why it is
constant.
No time lag between initial increase in the investment and
final ultimate multiplier effect in the increment in the
income.
Excess capacity in the economy that is demand increases
that is excess production that is why adequate supply will
be there.
Graphs
Notes
Keynes Psychological law of consumption
Keynes put forward a psychological law of consumption,
according to which, as income increases consumption
increases but not by as much as the increase in income.
While Keynes recognized that many subjective and
objective factors including interest rate and wealth
influenced the level of consumption expenditure, he
emphasized that it is the current level of income on which
the consumption spending of an individual and the society
depends.
Keynes makes three points:
First, he suggests that consumption expenditure depends mainly
on absolute income of the current period, that is, consumption is
a positive function of the absolute level of current income. The
more income in a period one has, the more is likely to be his
consumption expenditure in that period.
Secondly, Keynes points out that consumption expenditure does
not have a proportional relationship with income. According to
him, as the income increases, a smaller proportion of income is
consumed. The proportion of consumption to income is called
average propensity to consume (APC). Thus, Keynes argues that
average propensity to consume (APC) falls as income increases.
The Keynes’ consumption function can be expressed in the
following form:
C = a + bYd
where C is consumption expenditure and Y d is the real disposable
income which equals gross national income minus taxes, a and b are
constants, where a is the intercept term, that is, the amount of
consumption expenditure at zero level of income. Thus, a is
autonomous consumption.
The parameter b is the marginal propensity to consume (MPC)
which measures the increase in consumption spending in response
to per unit increase in disposable income. Thus
MPC = ∆C/∆Y
APC and MPC
Consumption function denotes the functional relation
between consumption and income.
Whereas the MPC refers to the marginal increase in
consumption (∆C) as a result of marginal increase in
income (∆Y), APC means the ratio of total consumption to
total income (C/Y).
Where: C = consumption Y = income
So, if an economy has total household consumption of 1
trillion dollars and a total household income of 1.03
trillion, we can determine the average propensity to
consume in that economy as follows:
APC = C/Y
APC = 1,00,000,000,000 / 1,030,000,000,000
APC = .97 or 97%
Business Cycle
A economy experiences fluctua­tions in the level of economic
activity. And fluctuations in economic activity mean
fluctuations in macroeconomic variables.
At times, consumption, investment, employment, output, etc.,
rise and at other times these macroeconomic variables fall.
Such fluctua­tions in macroeconomic variables are known as
business cycles. A capitalistic economy exhibits alternating
periods of prosperity or boom and depression. Such
movements are similar to wave-like movements or see saw
movements. Thus, the cyclical fluctuations are rather regular
and steady but not random.
Since GNP is the comprehensive measure of the overall
economic activity, we refer to business cycles as the short
term cyclical movements in GNP. In the words of
Keynes : “A trade cycle is composed of periods of good
trade characterized by rising prices and low
unemployment percentages, alternating with periods of
bad trade characterized by falling prices and high
unemployment percentages.”
In brief, a business cycle is the periodic but irregular up-
and-down movements in economic activity.
Characteristics of Business Cycle
It exhibits a wave-like movement having regularity and
recognized patterns. That is to say, it is repetitive in
character.
Almost all sectors of the economy are affected by the
cyclical movements. Most of the sectors move together in
the same direction. During prosperity, most of the sectors
or industries experience an increase in output and during
recession they experience a fall in output
Not all the industries are affected uniformly. Some are hit
badly during depression while others are not affected
seriously.
Investment goods industries fluctuate more than the consumer
goods industries. Further, industries producing consumer
durable goods generally experience greater fluctuations than
sectors producing non­durable goods.
Profits tend to be highly variable and pro-cyclical. Usually,
profits decline in recession and rise in boom. On the other hand,
wages are more or less sticky though they tend to rise during
boom.
Trade cycles are ‘international’ in character in the sense that
fluctuations in one country get transmitted to other countries.
This is because, in this age of globalization, dependence of one
country on other countries is great.
Every cycle has four distinct phases: (a) depression, (b)
revival, (c) prosperity or boom, and (d) recession.
Periodicity of a trade cycle is not uniform, though
fluctuations are something in the range of five to ten years
from peak to peak.
Phases of Business Cycle
A typical business cycle has two phase’s ex­pansion phase
or upswing or peak and con­traction phase or downswing.
The upswing or expansion phase exhibits a more rapid
growth of GNP than the long run trend growth rate.
In the contraction phase, GNP declines.
A trade cycle has four phases:
(i) Depression,
(ii) Revival,
(iii) Boom, and
(iv) Recession.
Depression
The depression is the bottom of a cycle where eco­nomic
activity remains at a highly low level.
Income, employment, output, price level, etc. go down.
A depression is generally characterized by high
unemployment of labor and capital and a low level of
consumer demand in relation to the economy’s capacity to
pro­duce.
This deficiency in demand forces firms to cut back
production and lay-off workers.
Thus, there develops a substantial amount of unused
productive capacity in the economy.
Even by lowering down the interest rates, fi­nancial
institutions do not find enough bor­rowers. Profits may
even become negative.
Firms become hesitant in making fresh invest­ments.
Recovery
During depression some machines wear out completely
and ultimately become useless. For their survival,
businessmen replace old and worn-out machinery.
Thus, spending starts. This gives an optimistic signal to
the economy.
 Industries begin to rise and expectations tend to become
more favourable. Investment becomes no longer risky.
Additional and fresh investment leads to a rise in
production.
Increased production leads to an increase in demand for
inputs. Employment of more labor and capital causes GNP
to rise.
Further, low interest rates charged by banks in the early
years of recovery phase act as an incentive to producers to
borrow money. Thus, investment rises.
The recovery phase, however, gets gradually cumulative
and income, employment, profit, price, etc., start
increasing.
Prosperity
Once the forces of revival get strengthened the level of
economic activity tends to reach the highest point—the
peak.
A peak is the top .of a cycle. The peak is characterized by
an all-round optimism in the economy—income,
employment, output, and price level tend to rise.
Meanwhile, a rise in aggregate demand and cost leads to a
rise in both investment and price level. But once the
economy reaches the level of full employment, additional
investment will not cause GNP to rise.
On the other hand, demand, price level, and cost of
production will rise.
 During prosperity, existing capacity of plants is
overutilised.
Labor and raw material shortages develop. Scarcity of
resources leads to rising cost. Aggregate demand now
outstrips aggregate supply. Businessmen now come to
learn that they have overstepped the limit.. This ultimately
slows down the economic expansion and paves the way
for contraction.
Recession
Like depression, prosperity or peak, can never be long-
lasting. Actually speaking, the bubble of prosperity
gradually dies down.
A recession begins when the economy reaches a peak of
activity and ends when the economy reaches its
depression.
A recession is a significant decline in economic activity
spread across the economy lasting more then a few
months, normally visible in production, employment, real
income and other indications.
During this phase, the demand of firms and households
for goods and services start to fall. No new industries are
set up.
Sometimes, existing industries are wound up. Unsold
goods pile up because of low household demand. Profits
of business firms dwindle.
Output and employment levels are reduced. Eventually,
this contracting economy hits the slump again. A recession
that is deep and long-lasting is called a depression and,
thus, the whole process restarts.
Inflation
Inflation and unemployment are the two most talked-about
words in the contemporary society.
Inflation exists when money supply exceeds available goods
and services.
Inflation may be defined as ‘a sustained upward trend in the
general level of prices’ and not the price of only one or two
goods.
G. Ackley defined inflation as ‘a persistent and appreciable
rise in the general level or aver­age of prices’. In other
words, inflation is a state of rising prices, but not high
prices.
It is not high prices but rising price level that con­stitute
inflation.
It constitutes, thus, an over­all increase in price level. It
can, thus, be viewed as the devaluing of the worth of
money.
 In other words, inflation reduces the purchasing power of
money. A unit of money now buys less. Inflation can also
be seen as a recurring phenomenon.
While measuring inflation, we take into ac­count a large
number of goods and services used by the people of a
country and then cal­culate average increase in the prices
of those goods and services over a period of time.
A small rise in prices or a sudden rise in prices is not
inflation since they may reflect the short term workings of
the market.
It is to be pointed out here that inflation is a state of
disequilib­rium when there occurs a sustained rise in price
level. It is inflation if the prices of most goods go up.
Let’s measure inflation rate. Suppose, in December 2007,
the consumer price index was 193.6 and, in December
2008, it was 223.8. Thus, the inflation rate during the last
one year was
223.8- 193.6/ 193.6 x 100 = 15.6
Causes of Inflation

Inflation is mainly caused by excess demand/ or decline in

aggregate supply or output.
Former leads to a rightward shift of the aggregate demand
curve while the latter causes aggregate supply curve to
shift left­ward. Former is called demand-pull inflation
(DPI), and the latter is called cost-push infla­tion (CPI)..
(i) Demand-Pull Inflation Theory

According to Keynesians, aggregate demand may rise due to

a rise in consumer demand or investment demand or govern­
ment expenditure or net exports or the com­bination of these
four components of aggregate demand. Given full
employment, such in­crease in aggregate demand leads to an
up­ward pressure in prices. Such a situation is called DPI.
This can be explained graphically.
Just like the price of a commodity, the level of prices is determined by the
interaction of aggregate demand and aggregate supply. In Fig. 4.3,
aggregate demand curve is negative sloping while aggregate supply curve
before the full employment stage is positive sloping and becomes vertical
after the full employ­ment stage is reached. AD1 is the initial aggregate
demand curve that intersects the aggregate supply curve AS at point E 1.

The price level, thus, determined is OP 1. As ag­gregate demand curve shifts

to AD2, price level rises to OP2. Thus, an increase in aggre­gate demand at
the full employment stage leads to an increase in price level only, rather
than the level of output. However, how much price level will rise following
an increase in aggregate demand depends on the slope of the AS curve.
 
(ii) Cost-Push Inflation Theory:
In addition to aggregate demand, aggregate supply also
generates inflationary process. As inflation is caused by a
leftward shift of the aggregate supply, we call it CPI.
CPI is usu­ally associated with non-monetary factors. CPI
arises due to the increase in cost of produc­tion. Cost of
production may rise due to a rise in cost of raw materials or
increase in wages.
Such increases in costs are passed on to consumers by
firms by rais­ing the prices of the products. Rising wages
lead to rising costs.
Rising costs lead to rising prices. And, rising prices again
prompt trade unions to demand higher wages. Thus, an
inflationary wage-price spiral starts. This causes aggregate
supply curve to shift leftward.
This can be demonstrated graphically where AS 1 is the initial
aggregate supply curve. Below the full employment stage this AS
curve is positive sloping and at full em­ployment stage it becomes
perfectly inelastic.
Intersection points (E1) of AD1 and AS1 curves determine the price
level (OP1). Now there is a leftward shift of aggregate supply curve
to AS2. With no change in aggregate demand, this causes price level
to rise to OP2 and output to fall to OY2. With the reduction in
output, employment in the economy de­clines or unemployment
rises. Further shift in AS curve to AS3 results in a higher price level
(OP3) and a lower volume of aggregate out­put (OY3). Thus, CPI
may arise even below the full employment (Y F) stage.
Controls of Inflation
Inflation is considered to be a complex situation for an
economy. If inflation goes beyond a moderate rate, it can
create disastrous situations for an economy; therefore is
should be under control.
It is not easy to control inflation by using a particular
measure or instrument.
The main aim of every measure is to reduce the inflow of
cash in the economy or reduce the liquidity in the market.
The different measures used for controlling inflation are
shown in Figure-5:
1. Monetary Measures:
The government of a country takes several measures and formulates
policies to control economic activities. Monetary policy is one of the
most commonly used measures taken by the government to control
inflation.
In monetary policy, the central bank increases rate of interest on
borrowings for commercial banks. As a result, commercial banks
increase their rate of interests on credit for the public. In such a situation,
individuals prefer to save money instead of investing in new ventures.
This would reduce money supply in the market, which, in turn, controls
inflation. Apart from this, the central bank reduces the credit creation
capacity of commercial banks to control inflation.
2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal measures
to control inflation. The two main components of fiscal policy are
government revenue and government expenditure.
In fiscal policy, the government controls inflation either by reducing
private spending or by decreasing government expenditure, or by using
both.
It reduces private spending by increasing taxes on private businesses.
When private spending is more, the government reduces its
expenditure to control inflation. However, in present scenario, reducing
government expenditure is not possible because there may be certain
on-going projects for social welfare that cannot be postponed.
Besides this, the government expenditures are essential for
other areas, such as defense, health, education, and law and
order. In such a case, reducing private spending is more
preferable rather than decreasing government expenditure.
When the government reduces private spending by
increasing taxes, individuals decrease their total
expenditure.
3. Price Control:
Another method for ceasing inflation is preventing any further rise
in the prices of goods and services. In this method, inflation is
suppressed by price control, but cannot be controlled for the long
term. In such a case, the basic inflationary pressure in the economy
is not exhibited in the form of rise in prices for a short time. Such
inflation is termed as suppressed inflation.
The historical evidences have shown that price control alone
cannot control inflation, but only reduces the extent of inflation.
For example, at the time of wars, the government of different
countries imposed price controls to prevent any further rise in the
prices. However, prices remain at peak in different economies.
Deflation
Many people accept inflation as a fact of life. However, under
certain economic situations, the opposite phenomenon actually
takes place, and is known as “deflation.”
Deflation is the reduction of prices of goods, and although
deflation may seem like a good thing when you’re standing at
the checkout counter, it’s not. Rather, deflation is an indication
that economic conditions are deteriorating. Deflation is usually
associated with significant unemployment , which is only
corrected after wages drop considerably. Furthermore,
businesses’ profits drop significantly during periods of deflation,
making it more difficult to raise additional capital to expand and
develop new technologies.
“Deflation” is often confused with “disinflation.” While
deflation represents a decrease in the prices of goods and
services throughout the economy, disinflation represents a
situation where inflation increases at a slower rate.
 However, disinflation does not usually precede a period
of deflation. In fact, deflation is a rare phenomenon that
does not occur in the course of a normal economic cycle,
and therefore, investors must recognize it as a sign that
something is severely wrong with the state of the
economy.
Causes
Deflation can be caused by a number of factors, all of
which stem from a shift in the supply-demand curve.
Remember, the prices of all goods and services are
heavily affected by a change in the supply and demand,
which means that if demand drops in relation to supply,
prices will have to drop accordingly. 
Also, a change in the supply and demand of a nation’s
currency plays an instrumental role in setting the prices of
the country’s goods and services.
Change in Structure of Capital Markets : When many
different companies are selling the same goods or
services, they will typically lower their prices as a means
to compete. Often, the capital structure of the economy
will change and companies will have easier access to debt
and equity markets, which they can use to fund new
businesses or improve productivity.
Increased Productivity: Innovative solutions and new
processes help increase efficiency, which ultimately leads
to lower prices. Although some innovations only affect the
productivity of certain industries, others may have a
profound effect on the entire economy.
Decrease in Currency Supply: As the currency supply decreases,
prices will decrease so that people can afford goods. How can
currency supplies decrease? One common reason is through central
banking systems.
Deflationary Spiral: Once deflation has shown its ugly head, it can
be very difficult to get the economy under control for a number of
reasons. First of all, when consumers start cutting spending, business
profits decrease. Unfortunately, this means that businesses have to
reduce wages and cut their own purchases. In turn, this short-circuits
spending in other sectors, as other businesses and wage-earners have
less money to spend. As horrible as these sounds, it continues to get
worse and the cycle can be very difficult to break.
Role of Government in controlling Inflation
The steps are:
 1. Monetary Policy 
2. Fiscal Policy
 3. Automatic Stabilizers
 4. Another Built-In-Stabilizer in the U.S.A is
Unemployment Insurance 
5. Direct Controls.
Step1. Monetary Policy:
Monetary inflation:
By leading to higher prices, higher profits and an optimistic.
Outlook strengthens the upswings of the cycle.
Monetary deflation:
On the ‘contrary, by leading to lower prices, lower profits and
pessimistic outlook re-in-forces the down swing of the cycle.
Some steps should be taken to check and control the
monetary factors which aggravate business fluctuations
caused by the business cycle. For this, the government may
evolve a suitable monetary policy to deal with the situation.
So far as money supply is concerned it’s under expansion
could be checked by insisting upon a proper and adequate
cover against note-issue. As regards bank credit, the
Central Bank of the country could utilize the various
weapons of control, such as bank rate, open market
operations, reserve ratios, moral suasion etc., to control it.
Step2. Fiscal Policy:
Monetary policy taken alone may not suffice to check cyclical
business fluctuations. It is therefore suggested that monetary policy
should be properly integrated with a suitable fiscal policy to achieve
the desired results.
Government activity of late has expanded so much that the
government is now in a position to exercise a very great influence on
the total volume of output in a country.
It is therefore suggested that the government should regulate its
activities in such a manner as to off-set the cyclical fluctuations in
private business activity. The three main instruments of fiscal policy-
taxation, spending and borrowing can be used by the Government to
achieve this purpose.
Step3. Automatic Stabilizers:
In this case the economists have suggested the
introduction of a number of automatic stabilizers or (built
in stabilizers) to deal with the business cycle. An
automatic stabilizer or (built-in-stabilizer) is an economic
stock-absorber that helps smooth the cyclical business
fluctuations of its own accord, without requiring
deliberate action on the part of the government.
For example:
Such device in U.S.A. is the federal progressive income-tax.
This tax is so devised that people in higher income brackets are
taxed at a progressively higher rate than those in the lower
income brackets.
Such a progressive type of income-tax trends automatically to
offset cyclical fluctuations because in an up saving when
incomes are rising people would pay more taxes to the
government and thus their expenditure would be checked and in
a down swing when incomes are declining and tax percentage is
low people would pay less taxes to the Government leaving
more funds for them to spend.
Step 4 Another Built-In-Stabilizer in the U.S.A is Unemployment Insurance:
During the period of prosperity the employers pay taxes to the government
at enhanced rates but the Government does not pay unemployment
allowances to the unemployment persons because there is hardly any
unemployment worth the name at such a time. Money therefore accumulates
with the Government.
On the other-hand during the period of depression the Government lowers
the taxes but pays out unemployment allowances to the unemployed persons
thereby making available more money to the people, which automatically
tend to offset the reduction in the circuit flow.
Thus consumers buying power is strengthened and recessionary pressures
are tempered. In combination, these built in stabilizers have played a key
role in the prompt reversal of U.S. recessions since the Second World War.
Step5. Direct Controls:
This method is to ensure proper allocation of resources for
the purpose of price stability. They are in the form of
rationing, price and wage controls, export duties, exchange
control, monopoly control etc. They are more effective in
overcoming shortages arising from inflationary pressures.
Their point of success mainly depends upon the existence
of an efficient and honest administration. They are mostly
used in emergencies like war, crop failures and in hyper
inflation.
In the end it can be said that there is no single method
which can control cyclical fluctuations. Therefore, it can
be suggested that all methods be used simultaneously.
Because monetary policy is easy to apply but it is less
effective.
Next, the fiscal measures are effective and better than
monetary method but it is difficult to control and operate.
Therefore, it can be a point to study that the right remedy
for the trade cycles has not been found as yet. Therefore,
its permanent remedy cannot exist.
 
Money

Money is often defined in terms of the three functions or

services that it provides. Money serves as a medium of
exchange, as a store of value, and as a unit of
account. Medium of exchange. Money's most important
function is as a medium of exchange to facilitate
transactions.
Functions of Money
1. A Medium of Exchange:
The only alter­native to using money is to go back to the
barter system. However, as a system of ex­change the
barter system would be highly impracticable today.
For example, if the baker who supplied the green-grocer
with bread had to take payment in onions and carrots, he
may either not like these foodstuff or he may have
sufficient stocks of them.
The use of money as a medium of exchange overcomes
the drawbacks of barter.
Thus, money provides the most efficient means of
satisfying wants. Each consumer has a different set of
wants. Money enables him (her) to decide which wants to
satisfy, rank the wants in order of urgency and capa­city
(income) and act accordingly.
2. A Measure of Value:
Under the barter system, it is very difficult to measure the value
of goods. For example, a horse may be valued as worth five cows
or 100 quintals of wheat, or a Maruti car may be equivalent to 10
two- wheelers. Thus one of the disadvantages of the barter
system is that any commodity or service has a series of exchange
values.
Money is the measuring rod of everything. By acting as a
common denominator it permits everything to be priced, that is,
valued in terms of money. Thus, people are enabled to com­pare
different prices and thus see the relative values of different goods
and services.
3. A Store of Value :
A major disadvantage of using commodities — such as
wheat or salt or even animals like horses or cows — as
money is that after a time they deteriorate and lose
economic value. 
Thus money is used as a store of purchasing power. It can
be held over a period of time and used to finance future
payments. More­over, when people save money, they get the
assurance that the money saved will have value when they
wish to spend it in the future.
4. The Basis of Credit:
Money facilitates loans. Borrowers can use money to
obtain goods and services when they are needed most. A
newly married couple, for example, would need a lot of
money to completely furnish a house at once. They are not
required to wait for, say ten years, so as to be able to save
enough money to buy costly items like cars, refrigerators,
T.V. sets, etc.
The Determinants of Money Supply

Main determinants of the supply of money are

monetary base and (b) the money multiplier.

These two broad determinants of money supply are, in turn,

influenced by a number of other factors. Various factors
influencing the money supply are discussed below:
1. Monetary Base:
Magnitude of the monetary base (B) is the significant
determinant of the size of money supply. Money supply
varies directly in relation to the changes in the monetary
base.
Monetary base refers to the supply of funds available for
use either as cash or reserves of the central bank.
Monetary base changes due to the policy of the
government and is also influenced by the value of money.
2. Money Multiplier:
Money multiplier (m) has positive influence upon the
money supply. An increase in the size of m will increase
the money supply and vice versa.
3. Reserve Ratio:
Reserve ratio (r) is also an important determinant of
money supply. The smaller cash-reserve ratio enables
greater expansion in the credit by the banks and thus
increases the money supply and vice versa.
Reserve ratio is often broken down into its two component
parts; (a) excess reserve ratio which is the ratio of excess
reserves to the total deposits of the bank (re = ER/D); (b)
required reserve ratio which is the ratio of required
reserves to the total deposits of the bank (rr = RR/D). Thus
r = re + rr. The rr ratio is legally fixed by the central bank
and the re ratio depends on the market rate of interest.
4. Confidence in Bank Money:
General economic conditions affect the confidence of the
public in bank money and, thereby, influence the currency
ratio (c) and the reserve ratio (r). During recession,
confidence in bank money is low and, as a result, c and r
ratios rise. Conversely, during prosperity, c and r ratios
tend to be low when confidence in banks is high.
5. Time-Deposit Ratio:
Time-deposit ratio (t), which represents the ratio of time
deposits to the demand deposits is a behavioural
parameter having negative effect on the money multiplier
(m) and thus on the money supply. A rise in t reduces m
and thereby the supply of money decreases.
6. Value of Money:
The value of money (1/P) in terms of other goods and
services has positive influence on the monetary base (B)
and hence on the money stock.
7. Real Income:
Real income (Y) has a positive influence on the money
multiplier and hence on the money supply. A rise in real
income will tend to increase the money multiplier and
thus the money supply and vice versa.
8. Interest Rate:
Interest rate has a positive effect on the money multiplier and hence on
the money supply. A rise in the interest rate will reduce the reserve ratio
(r), which raises the money multiplier (m) and hence increases the
money supply and vice versa.

9. Monetary Policy:

Monetary policy has positive or negative influence on the money
multiplier and hence on the money supply, depending upon whether
reserve requirements are lowered or raised. If reserve requirements are
raised, the value of reserve ratio (r) will rise reducing the money
multiplier and thus the money supply and vice versa.
10. Seasonal Factors:
Seasonal factors have negative effect on the money
multiplier, and hence on the money stock. During holiday
periods, the currency ratio (c) will tend to rise, thus,
reducing the money multiplier and, thereby, the money
supply.
Quantity Theory of Money
The quantity theory of money states that there is a direct
relationship between the quantity of money in an economy
and the level of prices of goods and services sold.
According to QTM, if the amount of money in an
economy doubles, price levels also double,
causing inflation (the percentage rate at which the level of
prices is rising in an economy).
The consumer, therefore, pays twice as much for the same
amount of the good or service.
MV = PT (the Fisher Equation)

Each variable denotes the following:

M = Money Supply
V = Velocity of Circulation (the number of times money
changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services
It is built on the principle of "equation of exchange":
Amount of Money x Velocity of Circulation = Total
Spending
Thus, if an economy has US$3, and those $3 were spent
five times in a month, total spending for the month would
be $15.
QTM Assumptions

QTM adds assumptions to the logic of the equation of

exchange.
In its most basic form, the theory assumes that V (velocity
of circulation) and T (volume of transactions) are constant
in the short term. These assumptions, however, have been
criticized, particularly the assumption that V is constant.
The arguments point out that the velocity of circulation
depends on consumer and business spending impulses,
which cannot be constant.
The theory also assumes that the quantity of money, which
is determined by outside forces, is the main influence of
economic activity in a society. A change in money
supply results in changes in price levels and/or a change in
supply of goods and services. It is primarily these changes
in money stock that cause a change in spending. And the
velocity of circulation depends not on the amount of
money available or on the current price level but
on changes in price levels.
Finally, the number of transactions (T) is determined by
labor, capital, natural resources (i.e. the factors of
production), knowledge and organization. The theory
assumes an economy in equilibrium and at full
employment.
Functions of Central Bank
Eight major functions of central bank in an economy
are as follows:

(1) Bank of Issue, (2) Banker, Agent and Advisor to

Government, (3) Custodian of Cash Reserves, (4)
Custodian of Foreign Balances,
(5) Lender of Last Resort, (6) Clearing House, (7)
Controller of Credit, and (8) Protection of Depositor’s
Interest.
Functions of Central Bank
Function 1 # Bank of Issue:
Central bank now-a-days has the monopoly of note-issue
in every country. The currency notes printed and issued by
the central bank are declared unlimited legal tender
throughout the country.
Function 2 # Banker, Agent and Adviser to the
Government:
Central bank, everywhere, performs the functions of
banker, agent and adviser to the government.
As banker to the government, it makes and receives
payments on behalf of the government. It advances short-
term loans to the government to tide over difficulties.
Function 3 # Custodian of Cash Reserves:
All commercial banks in a country keep a part of their
cash balances as deposits with the central bank, may be on
account of convention or legal compulsion. They draw
during busy seasons and pay back during slack seasons.
Part of these balances is used for clearing purposes. Other
member banks look to it for guidance, help and direction
in time of need.
Function 4 # Custodian of Foreign Balances:
Under the gold standard or when the country is on the gold
standard, the management of that standard, with a view to
securing stability of exchange rate, is left to the central bank.
After World War I, central banks have been keeping gold and
foreign currencies as reserve note-issue and also to meet adverse
balance of payment, if any, with other countries. It is the
function of the central bank to maintain the exchange rate fixed
by the government and manage exchange control and other
restrictions imposed by the state. Thus, it becomes a custodian
of nation’s reserves of international currency or foreign
balances.
Function 5 # Lender of Last Resort:
Central bank is the lender of last resort, for it can give
cash to the member banks to strengthen their cash reserves
position by rediscounting first class bills in case there is a
crisis or panic which develops into ‘run’ on banks or when
there is a seasonal strain. Member banks can also take
advances on approved short-term securities from the
central bank to add to their cash resources at the shortest
time.
Function 6 # Clearing House:
Central bank also acts as a clearing house for the
settlement of accounts of commercial banks. A clearing
house is an organisation where mutual claims of banks on
one another are offset, and a settlement is made by the
payment of the difference. Central bank being a bankers’
bank keeps the cash balances of commercial banks and as
such it becomes easier for the member banks to adjust or
settle their claims against one another through the central
bank.
Function 7 # Controller of Credit:
The control or adjustment of credit of commercial banks
by the central bank is accepted as its most important
function. Commercial banks create lot of credit which
sometimes results in inflation.
The expansion or contraction of currency and credit may
be said to be the most important causes of business
fluctuations. The need for credit control is obvious. It
mainly arises from the fact that money and credit play an
important role in determining the level of incomes, output
and employment.
Function 8 # Protection of Depositors Interests:
The central bank has to supervise the functioning of
commercial banks so as to protect the interest of the
depositors and ensure development of banking on sound
lines.
The business of banking has, therefore, been recognized
as a public service necessitating legislative safeguards to
prevent bank failures.
Monetary Policy
Monetary policy is the process by which the monetary
authority of a country, typically the central bank
or currency board, controls either the cost of very short-
term borrowing or the monetary base, often targeting
an inflation rate or interest rate to ensure price
stability and general trust in the currency.
Further goals of a monetary policy are usually to
contribute to the stability of gross domestic product, to
achieve and maintain low unemployment, and to maintain
predictable exchange rates with other currencies.
Monetary economics provides insight into how to craft an
optimal monetary policy. In developed countries,
monetary policy has generally been formed separately
from fiscal policy, which refers to taxation, government
spending, and associated borrowing.
Monetary policy is referred to as being either
expansionary or contractionary.
Expansionary policy occurs when a monetary authority
uses its tools to stimulate the economy. An expansionary
policy maintains short-term interest rates at a lower than
usual rate or increases the total supply of money in the
economy more rapidly than usual. It is traditionally used
to try to combat unemployment in a recession by
lowering interest rates in the hope that less expensive
credit will entice businesses into expanding.
This increases aggregate demand (the overall demand for
all goods and services in an economy), which boosts
short-term growth as measured by gross domestic
product (GDP) growth.
Expansionary monetary policy usually diminishes the
value of the currency relative to other currencies.
The opposite of expansionary monetary policy is
contractionary monetary policy, which maintains short-
term interest rates higher than usual or which slows the
rate of growth in the money supply or even shrinks it. This
slows short-term economic growth and lessens inflation.
Contractionary monetary policy can lead to increased
unemployment and depressed borrowing and spending by
consumers and businesses, which can eventually result in
an economic recession if implemented too vigorously.
Cash Reserve Ratio ( CRR )

Cash Reserve Ratio (CRR) is the share of a bank’s total

deposit that is mandated by the Reserve Bank of India
(RBI) to be maintained with the latter in the form liquid
cash.
Objectives of Cash Reserve Ratio

In order to determine the base rate,  the Cash Reserve

Ratio acts as one of the reference rates.
Base rate means the minimum lending rate which is
determined by the Reserve Bank of India (RBI) and no
bank is allowed to lend funds below this rate.
This rate is fixed to ensure transparency with respect to
borrowing and lending in the credit market.
The Base Rate also helps the banks to cut down on
their cost of lending so as to be able to extend
affordable loans.
Apart from this, there are two main objectives of Cash
Reserve Ratio:
1. Cash Reserve Ratio ensures that a part of the bank’s
deposit is with the Central Bank and is hence, safe
2. Another objective of CRR is to keep inflation under
control. During high inflation in the economy, RBI raises
the CRR to lower the bank’s loanable funds.
How does Cash Reserve Ratio work?

When the RBI decides to increase the Cash Reserve Ratio,

the amount of money that is available with the banks
reduces. This is the RBI’s way of controlling the excess
supply of money. 
The cash balance that is to be maintained by scheduled
banks with the RBI should not be less than 4% of the total
NDTL, which is the Net Demand and Time Liabilities.
This is done on a fortnightly basis.
NDTL refers to the total demand and time liabilities
(deposits) that is held by the banks. It includes deposits of
the general public and the balances held by the bank with
other banks. 
Demand deposits consist of all liabilities which the bank
needs to pay on demand like current deposits, demand
drafts, balances in overdue fixed deposits and demand
liabilities portion of savings bank deposits.
Time deposits consist of deposits that need to be repaid on
maturity and where the depositor can’t withdraw money
immediately; instead, he is required to wait for a certain
time period to access the funds. It includes fixed deposits,
time liabilities portion of savings bank deposits and staff
security deposits. The liabilities of a bank include call
money market borrowings, certificate of deposits and
investment in deposits other banks.
In short, higher the Cash Reserve Ratio, lesser is the
amount of money available to banks for lending and
investing.
Statutory Liquidity Ratio ( SLR )

The Reserve Bank of India mandates every bank should

have a specific liquid reserve in the form of cash or gold.
It is called Statutory Liquidity Ratio ( SLR ).
How does Statutory Liquidity Ratio work?

Every bank must have a minimum portion of their Net

Demand and Time Liabilities (NDTL) in the form of cash,
gold or other liquid assets by the day’s end.
The ratio of these liquid assets to the demand and time
liabilities is called as the Statutory Liquidity Ratio.
The Reserve Bank of India has the authority to increase
this ratio up to 40%. The increase in this ratio constricts
the ability of the bank to inject money into the economy.
In India, the Reserve Bank of India is responsible for
regulating the supply of money and stability of prices to
run the economy.
Statutory Liquidity Ratio is one of its many monetary
policies for the same. SLR (among other tools) is
instrumental in ensuring the solvency of the banks and
money flow in the economy.
Objectives of Statutory Liquidity Ratio

a. To curtail the commercial banks from over

liquidating:
This can happen in the absence of SLR, when the Cash
Reserve Ratio goes up and the bank is in dire need of
funds. RBI employs SLR regulation to have control over
the bank credit. It helps to ensure that there is solvency in
commercial banks and assures that banks invest in
government securities.
b. To increase or decrease the flow of bank credit:
The Reserve Bank of India raises SLR to control the bank
credit during the time of inflation. Similarly, it decreases
the SLR during the time of recession to increase the bank
credit.