Macro Economics (EC 5501) Past Paper PDF

TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ❖Expansion of Say’s Law by the Quantity Theory of Money: ▪ The validity of Say’s law in a money econ...

TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ❖Expansion of Say’s Law by the Quantity Theory of Money: ▪ The validity of Say’s law in a money economy, also depends on the classical theory of money, which states that the price level is a function of the supply of money, i.e. MV = PT. as the quantity of money increases the value of money falls or decreases. This comes about because of a rise in the general price level. Here the money supply has increased and therefore money wages increase but real wages do not increase because of a rise in the general price level. As a result, equilibrium in the economy is maintained. ❖A.C. Pigou’s Version of Equilibrium of Say’s law: ▪ Pigou explained general equilibrium from the labor market equilibrium. According to him, unemployment or disequilibrium will not rise. Supposing for some reason, the demand for labour falls and there is unemployment, then according to Pigou, in a free market economy, wages will fall. This will increase the demand for labor restoring full employment. According to him, just as wages are flexible downwards, relative prices are also flexible downwards and thus a general equilibrium could be maintained. ▪ But these days we have unions and minimum wage policies of government which have rendered Pigou’s theory outdated. ❖Keynesian Criticism on classical economics: 1) The fundamental assumption of full-employment equilibrium in the economy was rejected by Keynes. He considered it as unrealistic and even if it happens as a special situation. → In reality we find under employment as a general situation. Say’s law does not operate effectively because of lack of effective demand. → SS exceed dd and there is involuntary unemployment. 2) Say’s law of market S does not operate. All income earned by the factors is not spent in buying goods and services rich they helped to produce. A part of the income is saved and it is not automatically inverted. Because savings and investments are distinct functions. So when all earned income is not spent on consumption goods and a part of it is saved, there results a deficiency of aggregate dd. This leads to over production because all that produces is not sold. So investments and employment will go down. Thus Keynes gave the principle of MPC < 1. Page | 13 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ 3) Keynes did not agree with the classical view that the “laissez faire” policy was essential for a self -adjusting process of full employment equilibrium. → He printed that the capitalist systems was not automatic and self adjusting because of the unequal (non-egalitarian) structure of its society. There are two man groups. The rich and the poor. → The rich possess much wealth but they donot spend all of it on consumption goods. Thus there is general deficiency in aggregate demand in relation to aggregate supply which leads to over production and unemployment in the economy. This infact led to the “great depression” of 1929. Had the capitalist system been automatic and self adjusting. This would not have occurred. → Therefore advocate struck state intervention for adjusting supply and demand with the economy through fiscal measures. 4) The classicals believed that savings and investments are equal to the full- employment level and in case of any divergence the equality was brought about by the mechanism of rate of interest. → Keynes held the level of savings and investments were equal at the full employment level and in case of any divergence the equality was brought about by the mechanism of rate of interest. → Similarly investment is determined not only by the volume but by the MEC also. A low rate of interest cannot increase investment if business expectations are low. → If savings exceed investments means people are spending less on consumptions. As a result demand declines. There is over production and fall in investment, income output and employment. It will lead to reduction in savings and ultimately the equality between savings and investments will be attained at a lower level of income. Thus it is variations in income rather than interest rate that losing the equally between savings and investments. 5) The classical economists believed that money was demanded for transactions and precautionately purposes. They did not recognize the speculative demand for money because money held for speculative purpose related to idle balances. Keynes did not agree with this view. He emphasized the importance of speculative demand for money. Page | 14 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ 6) AC Pigou advocated policy of general wage/price cut to achieve full employment equilibrium. But Keynes argued that a policy of wage/price cut can be applied only to industry not entire economy. → If such a policy foe whole economy is adopted then trade unions will resort to strike. Such an unrest would lead to fall in output and income so it is advertisement difficult to cut wages for whole economy Keynes did not agree that there was a direct and proportionate relationship between money wages and real wages as the classicals argued. 7) Keynes did not argue with Pigou “frictional maladjustments alone _________ for failure to utilize fully over productive power” the capitalist system is such that itself it is incapable of using productive power fully. The state may directly insert to raise the level of economic activity or to supplement private investment. It may pass legislation recognizing trade unions fixing minimum wages and providing relief to workers through social security measures, so Keynes favored stage action to utilize fully the resources of the economy for attaining full employment. 8) Classicals advocated a long run full employment equilibrium through self adjusting mechanism of market force. But Keynes believed that in that “we are all dead” so he advocated the S.R. equilibrium. 9) Classicals regarded money as neutral therefore excluded the theory of output employment and interest rate from the monetary theory. According to them level of output, employment and equilibrium rate of interest were determined by real forces of market. But Keynes integrated value theory and monetary theory. ___________ ___________ ___________ III. Keynes Psychological law of consumption: ▪ The law is based on fundamental psychological behavior (both from a prior knowledge and facts of human experience) that as income increases consumption increases but not in the same proportion as the increase in income. ▪ The law is based on 3 propositions; 1) When aggregate income increases, consumption expenditure also increases but less than proportionately. As a person’s income increases, more of Page | 15 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ his/her wants are satisfied and hence lesser amount is spent out of subsequent increase in income. 2) The increase in income is bifurcated into spending and saving. 3) With the increase in income, consumption as well as saving increases i.e. an increase in income is unlikely to lead either to less spending or less saving than before. [The law as called, propensity to consume and subsequent writers called it law of consumption.] ___________ ___________ ___________ IV. Consumption Function: ▪ Keynesian consumption function is based on 3 assumptions: 1) Propensity to consume will remain stable owing to the constancy of the existing psychological and institutional complexities. 2) No extraordinary circumstances such as war, inflation etc 3) There exists a wealthy capitalistic economy and therefore there are no government restrictions on consumption. ▪ Consumption depends upon disposable/net income, i.e. income after taxes nd other liabilities are deducted. Expenditures/Spendings are of two types: 1) Consumption expenditure 2) Investment expenditure Consumption function shows the expenditure that consumers wish to make at every level of disposable income. The consumption function is C = f(y) expresses that consumption depends on disposable income and shows the schedule of corresponding levels of consumption at various levels of income. [According to Dernburg and MC Dougall: “the schedule that relates consumption to disposal income is called the propensity to consume”. According to R.G. Lipsey “Consumption function is nothing more than a statement of the relation between consumption, expenditure and income.] Y C=Y D ----------------- B ------------- C Page | 16 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ - ------------ -------------- 0 X A C Income ▪ In the above figure the 45° line shows that C is exactly equal to Y i.e. every increase in the disposable income is spent in the same proportion. Income Consumption Savings APC APS MPC MPS 0 60 -60 - - - - 100 150 -50 1.5 -0.5 0.90 0.10 200 220 -20 1.1 -0.1 0.70 0.0 250 250 0 1 0 0.60 0.40 350 300 50 0.89 0.11 0.50 0.50 450 345 105 0.77 0.23 0.45 0.55 Y C=Y E Investment A 45° Savings X Y Dis - saving A Income B C - Consumption curve starts from A. the distance OA shows when income is zero there is still some consumption. - This consumption need is met by dissaving. - As income increases, the dis – savings reduce i.e. needs of people are met from income and they don’t have to spend much from past savings. - Income and consumption are equal at point E or OY level of income. - After this point as income increases consumption increases less than proportionately. Page | 17 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ - Thus savings arise and savings are spent on investment. The portion of dis-savings shows that on the consumption curve, MPC ≥ 1 and the portion of savings show, MPC < 1 for the consumption function. ___________ ___________ ___________ V. Marginal propensity to consume and save: ▪ MPC is the ratio of incremental change in consumption as a result of a given change in income. ▪ According to Keynes, MP is always < 1 after a certain income level is reached or in the rich capitalist economies. Δ𝐶 𝑑𝐶 ∴ 𝑀𝑃𝐶 = or Y = Disposable income and C = consumption. Δ𝑌 𝑑𝑌 ∆𝐶 + ∆𝑆 = ∆𝑌 ▪ If we divide by the change in income, then we weill have Δ𝐶 Δ𝑆 Δ𝑌 + + i.e. MPC + MPS = 1 Δ𝑌 Δ𝑌 Δ𝑌 ▪ Thus we can conclude that as income increases, the MPC tends to decline and MPS tends to increase. ▪ Irrespective of its shape, when the consumption function lies below the 45° line MPC > 1. Y L S2 C C1 C2 S1 C1 B Page | 18 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ C1 45° X 0 Y1 Y2 Δ𝐶 ▪ In the above figure the 45° line consumption = income or Δ𝑌 = 1 ∴ it is known as the unit (MPC) line. ▪ CC’ is a consumption function or a propensity to consume curve – it moves upwards to the right showing that the consumption increases as income increases. ▪ But from C to B the curve is linear (a straight line) meaning there may be that the consumption increases at the same rate as the increase in the income. ▪ At income Y1 consumption and income are equal (OY1 = OC1). As the income increases to Y2 consumption also increases to C2 but the amount of consumption OC2 is smaller than income OY2 by S1S2. 𝐶1𝐶2 Δ𝑆 ▪ The MPC at income level Y2 is = 𝑌1𝑌2 Δ𝑌 ▪ MPC is thus the slope of the consumption function. The portion of income that is not consumed is saved (s1S2). Savings are thus positive and increase as income increases. ❖Average Propensity to Consume (APC) 𝐶 ▪ APC is the ratio of absolute consumption to absolute income and is expressed as 𝑌 [proportion of aggregate consumption expenditure to aggregate income] ▪ According to Kurhara “The APC is the ratio of consumption expenditure to any particular level of income.” ▪ In other words it is the proportion of a given income which is spent for consumption purpose. [Professor Hansen has estimated APC in the United States in normal times to be at 88%] ▪ The APC curve is drawn below: Y C P 𝐶 60 APC = 𝑌 Page | 19 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ❖Relationship Between Average Propensity to Consume (APC) & Marginal Propensity to Consume(MPC): ▪ Let us consider the case of two linear consumption functions, OB and CD. ▪ For the consumption function OB, APC = MPC, and both remain constant at all the levels of income. ▪ For the consumption function CD, as it is a linear one the MPC remains constant while the APC keeps on falling. ▪ At point A, the APC of the consumption function OB and CD is the same. ▪ In the interval between CA, i.e. for lower levels of income, the APC of CD > APC of OB, while for points after A, i.e. at greater levels of income, the APC of CD < the APC of OB. CONSUMPTION Y B D A C X 0 INCOME Page | 21 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ Page | 22 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ❖ Factors affecting Propensity to Consume/ CF The psychological law of consumption depends upon several factors. Though we Assume the propensity to consume to be constant during the given time, it is not very rigid. Consumption or propensity to consume may depend upon the following factors- I. Price variables: 1. Price expectations— If consumers expect rise in price of certain commodities, they are likely to rush and buy them, sometimes exceeding their current income. This raises MPC above the given level and vice versa in case where they expect fall in prices. Likewise if the consumers expect their incomes to rise in the near future, they increase consumption beyond the MPC. 2. General price level/Inflation— When the general price level changes, real income changes. If this change in real income is none proportional to increase in price level than consumption function will change. If real income changes proportionately to change in price level than consumption may not change much. 3. Relative Prices— Change in general price level is not equally distributed overall goods. If general price changes impacts relative prices of goods of mass consumption or strategic goods than consumption function will change significantly. II. Monetary variable 1. Interest value— Interest rate impacts consumption but this impact is discussed differently in different schools of thought. Besides, the impact of interest rates on consumption will depend upon choices between present consumption and saving or saving for future to enhance future consumption. Classicals opined that high rate of interest in the present times will reduce present consumption and increase savings. The neo-Keynesians believed people save to provide for oldage or for future generations. They can do this by accumulating smaller saving rather than drastically reducing current consumption. 2. Credit- the terms of credit and availability of credit is easy, people tend to increase their consumption beyond the determined MPC and vice-versa. Page | 23 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ III. Stock variables 1. Stock of consumer durables- if the stock of consumer durables with the consumers has increase in the current period than in the immediate short run consumers will reduce their consumption of durable goods. 2. Wealth- Amount of wealth in a society impacts consumption. There are differing views regarding this impact. Pigou’s argument is that, as wealth increases, its marginal utility decreases and therefore the society will increase current consumption rather than further accumulating wealth. As wealth increases, people may want to increase MPC savings/invest rather than increase consumption. Hence MPC will fall and MPS will rise. Here the impact of MPC wealth is like that of increased income. IV. Social, Psychological and Philosophical variables According to Keynes some of the motives for consumption depends on the underlying notions of propensity to consume, such as capacity of enjoyment, short sightedness, generosity, miscalculations, ostentations, extravagance. The motives of savings are said to be precaution, calculation, independence, enterprise, pride, etc. All their subjective motivations exists as they have some influence on consumption whether measurable or not. V. Long run Variables Page | 24 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ VI. Other Factors 1. Liquid assets- if people have more liquid assets they have a tendency to increase their current consumption. 2. Hypothesis- two things affect consumption according to this hypothesis ❑ The past standard of living- if current income falls, consumption declines but less than proportionally to the falling income because people find it difficult to lower their standard of living suddenly. Hence at lower income MPC is relatively higher. ❑ Relative income- consumption is not determined by the absolute amount of income but by the income/standard of living comparisions with others. If income of a family is lower, their consumption will be higher despite their lower income because their peer groups enjoy a higher standard of living and in some societies such demonstration effects are very high. Infact in certain societies MPC is higher not owing to increase in incomes but because of demonstration effects. 3. Selling efforts- if a society increases its expenditures on advertisement then consumers may be attracted to consume more i.e. consumption may rise irrespective of income price or MPS. 4. Fiscal policy- if government increases public expenditure and reduces taxes, people will have more disposable income and MPC may rise, and vise-versa. VII. Implications Next page Page | 25 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ___________ ___________ ___________ Page | 26 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ VI. Effective Demand & underemployment equilibrium: ▪ In the Keynesian theory employment depends upon effective demand. ▪ Effective demand results in output. Output creates income. Income provides employment. Since Keynes assumes all the quantities viz, effective demand (ED), output (O), income (Y) and employment (N) proportionately equal to one another regards employment as a function of income. ▪ According to Keynes effective demand manifests itself in the spending of income and it is judged from the total expenditure in the economy. ▪ That is, from the total income earned the economy spends/incurs consists of: a) Consumption expenditure b) Investment expenditure ▪ Thus at every level f income, there is a corresponding expenditure/demand. ▪ But every demand/expenditure is not effective only that demand is effective which is matched by the supply. Y = C + I where, Y = income & C + I = expenditure [Keynes did not consider government expenditure and he assumed a closed economy so he did not consider (X-M) component of income or expenditure] Therefore he did not consider Y = C + I + G + (X-M). ▪ “Thus out of the various levels off aggregate demand function (ADF), the one which is brought in equilibrium by the aggregate supply function (ASF) is called the effective demand” – Keynes. According to Stonier and Hague: “It is that demand price which becomes effective it is equal to aggregate supply price and represents a position of short run equilibrium” ▪ Aggregate demand function (ADF): Aggregate demand = the total receipts which the entrepreneur expect to obtain. Aggregate demand function relates to the different levels of output/employment. - Receipts may also be termed here as demand price. At every different level of employment there will be corresponding demand price Page | 27 Pinky Desai  TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ Y Receipts/demand price ADF R’ R 0 X N N’ Employment ❖ Aggregate Supply function (ASF) ▪ Aggregate supply price refers to the total amount of money which all the entrepreneurs in the economy, taken together, must expect to receive from the sale of output produced by the given people employed by them in order to recover the cost of employment and of production. ▪ If producer donot receive a supply price that recovers such costs of employment and production then they will not be willing to employ. ▪ Thus each level of employment is the economy is related to a particular aggregate supply price. [in other words aggregate supply price refers t the proceeds necessary from the sale of output at a particular level of employment or to make the producer employ and supply. Y ASF Cost Aggregate supply price R’ R 0 N N’ F X Employment Page | 28 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ Determiation of effective demand Level of employment (N) Aggregate supply prize (Z) Aggregate demand price (D) (in lakhs) (Rs crores) (Rs crores) OLD NEW 20 215 230 235 25 230 240 245 30 245 250 255 35 260 260 265 40 275 270 275 40 290 280 285 40 305 290 295 ▪ In the above table, level of equilibrium employment is determined at a point where aggregate demand price = the aggregate supply price. (ASP) ▪ This is the effective demand and entrepreneur get normal profits. ▪ If aggregate demand price is higher than the aggregate supply price, the prospects of getting additional profits are greater when more workers are employed therefore entrepreneurs will employ more until the point of effective demand is reached. ▪ For eg. In the above table when employment is 30 lakhs, ADF > ADS. If aggregate supply price > aggregate demand price like at the employment of 40 lakhs in the above table entrepreneurs will receive less than what they expect to receive at the given employment of 40 lakhs. Therefore they will have a tendency to reduce employment until effective demand level is reached. ▪ Thus in the above table effective demand is achieved at employment of 35 lakhs where ADP = ASP. Page | 29 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ This can be seen in the following figure: Y ASF E RD R1 X R2 0 N1 Y ND NF Employment ▪ In the above figure ADF = ASF at point E where the effective employment is N D and receipts is RD. ▪ If the employee employs only ONi labor then ADF > ASF or the actual receipts (R 1) > then the required/expected receipts (R2), therefore firms make super normal profits and therefore there will have a tendency to employment. ▪ At ONF, ADF < ASF or demand price < supply price so entrepreneurs receive less than expected and they have a tendency to reduce employment till effective demand is attained. Y Possibility of underemployment ASF ADF2 ADF1 0 X ND NF Employment ▪ In the above figure the effective demand equilibrium is point E and employment is OND. But this is not the full-employment equilibrium. To get full employment equilibrium, aggregate demand must increase. Page | 30 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ Therefore in the above figure if ADF increases from ADF1 to ADF2 only then full employment level ONF can be attained. ▪ In other words effective demand equilibrium is not always the full employment equilibrium. ▪ According to Keynes, MCP < 1 therefore aggregate demand will fall short of aggregate supply and therefore full employment cannot be attained. ▪ Thus to increase the aggregate demand and the aggregate demand price, government must intervene and with such intervention full employment can be attained. ❖The analysis of underemployment equilibrium with the help of 45° line and C + I curve. ▪ The keynesian theory of employment and income is thus also explained in terms of the equality of aggregate supply and aggregate demand. ▪ Since unemployment results from the deficiency of aggregate demand, employment and income can be increased by increasing aggregate demand. ▪ Assuming the MPC to be stable during the SR, aggregate demand can be increased by increasing investments. ▪ Once the investment increases, employment and income increases. ▪ Increased income leads to further increase in employment and income. ▪ Once set in motion, employment and income tend to rise in cumulative manner through the multiplier process till they reach the equilibrium level. ▪ According to keynes the equilibrium level of employment will be the under employment equilibrium because when income increases consumption also increases but less than the increase in income (because MPC < 1). ▪ This behaviour of the consumption function widens the gap between income and consumption which ordinally cannot be filled up due to the lack of required investment. ▪ The full employment income level can only be established if the volume of investment I increased to fill the income - consumption gap corresponding to full employment. Page | 31 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ Y (Y = C + I) E1 C + I + I1 C +I E2 C 45° 0 X Y1 YF ▪ C + I is the aggregate demand curve plotted by adding to the consumption function C , an equal amount of investment at all level of income. ▪ The 45° line is the aggregate supply curve. ▪ It shows that the increased income is spent on expenditure (C + I) in same proportion as increase in income. ▪ The economy is in equilibrium at point E where the aggregate demand curve C+ I intersects the 45° line. ▪ This is the point of effective demand where the equilibrium level of the income and employment OY is determined. ▪ This is the level of under employment and not of full employment. ▪ Suppose OYF is the full employment income level. To reach this level, autonomous investment is increased by I, so that C+I curve shifts upwards to C+ I + I curve. ▪ This is the new aggregate demand curve which intersects 45° line at E1. ▪ This is the higher point of effective demand corresponding to the full employment income level OYF. ▪ This also implies that to get a derived increase in employment and income of Y1Yf it is the multiplier effect of an increase in investment by I, which leads to an increase in employment by Y 1YF through successive rounds of consumption. _____ _____ _____ Page | 32 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ VII. Concept of Multiplier and Accelerator: ❖ Investment Multiplier: ▪ Multiplier refers to the effects of changes in investment outlays on aggregate income and employment through induced consumption expenditures. Since multiplier shows relation between initial increment in investment and resulting increase in income and employment, the multiplier concept is very important for the general theory of employment. ▪ The concept was first introduced by R.F.Kahn who stated the effect of change in investment on change in employment and Keynes extended the concept to explain investment multiplier showing effect of change in investment on change in investment on change in income. ▪ ·Multiplier is thus the ratio of the change in income to change in investment. Δ𝑌 K (multiplier) = or ∆Y = K. ∆I Δ𝐼 ▪ If investment increases by Rs.5crores and National income rises by 20crores the Δ𝑌 20 multiplier would be: = =4 Δ𝐼 5 ▪ Value of the multiplier depends upon the value of MPC. [MPC is nothing but the ratio of ∆ in consumption to in Y]. ❖ Multiplier and MPC: Page | 33 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ Value of the multiplier thus depends upon MPC. Keynes assumes that when the real Y of community increases or decreases its consumption will increase or decrease but not in the same proportion. Therefore the MPC is less than utility or 1. i.e. MPC < 1. ▪ The larger the value of MPC greater is the value of multiplier and vice versa. ▪ Theoretically multiplier have values from one to infinity when MPC is 0, K = 1 and when MPC is 1, K = infinity ∞ ▪ In actual practice however and at the same time MPC never falls to 0. Therefore K is never 1 or infinity. According to Keynes MPC falls in the 1 9 range to therefore multiplier will be somewhere around 1.5 to 10. 3 10 ▪ Keynes estimates the actual value of K to be equal to 3 considering the variation of different phases of trade cycles. ❖Process of income generation via Multiplier ▪ The actual expansion of the income because of the initial change in the investment depends upon the value of multiplier. ▪ Let us suppose that an additional investment of Rs.8crores is made in 1 construction of roads and MPC in economy be equal to 2 a. Primary generation of income: When an additional investment of Rs.8crore is made in construction of roads the engineer, supervisor, contractors, suppliers, workers etc. get an income of Rs.8crore. b. Secondary generation of income: In the round people engaged in construction activity going to spend Rs.4crore and 1 save Rs.4crore (MPC = ). 2 ▪ Thus there will be an income of Rs.4crore for the other people once again since MPC = ½ this people will spend Rs.2crore and save Rs.2crore. Thus Rs.2crore becomes the income for some other group of people. ▪ Thus primary generation of income = Rs.8crores. 1 1 Secondary generation of income = Rs.4crore + Rs.2crore + Rs.1crore + crore + 2 4 1 1 crore + crore + crore.................. = 16crore. 8 16 ▪ The stream of income generation can be expressed in the form of geometric progression as: Page | 34 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ Diagrammatic representation of Multiplier: Page | 35 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ The consumption curve CC is drawn at an MPC of 0.5 or ½. ▪ The MPC is 0.5 at all the levels of Y. C=1 is the total expenditure curve. The 45° line from the origin indicates the Y line. Equilibrium is determined at point E and the total amount of Y generated in the economy is OM. Now if the government decides to make an additional investment of Rs. 8crores the C + I curve shifts to C + I + ∆I ▪ The point determines the Y level OM to ON is equal to Rs. 16crores because the MPC is 0.5 and the value of the multiplier will be 2. Here, Y = income Page | 36 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ round round out Y (Y = income) rounds Conclusion: if the effect and leakages are ruled or leakages can be plugged then an increase in investment will have a greater multiplier effect on Y consumption and expenditure. Page | 37 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ Haberler emphasizing Conclusion: inspite of all the criticisms the concept of multiplier is very useful, is very understanding fluctuations and is very raising investments and consumptions. ❖Effects of Multiplier on Developing and Developed Economy: Page | 38 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ The multiplier theory has been criticized on several grounds. Flow over the concept is useful for developing and developed economies. 1. Public Investments: it can be directed to those where the leakages are minimum so that effect of certain increase in investment on employment and income is significant. Eg.: if the new investment is directed to industries where unemployment is high or wages from a considerable proportion of total budget than the employment and wages would rise with an initial increase in investments because of the multiplier effect. 2. The concept of multiplier helps to know the impact on the change in investment, on change in income and employment in developing and developed countries. 3. The multiplier assumes a sufficient increase in the net investment and a high degree of elasticity in production i.e. the investment should bring about a considerable production so as to raise output and employment. But in developing countries there are problems- a. Sufficient large amount of investments are very difficult to make. b. The production elasticity of investment is very low as a result multiplier effect is likely to be lower for the developing countries. 4. An initial investment is able to raise employment where there is a large proportion of open involuntary unemployment. In developed countries there is not much open unemployment. Initial government doesnot increase employment much. Such investment gives increased income but after time their growth rates as there is a slope of further employment. Also in developing countries it is an incidence of under employment which is higher than open unemployment i.e. there are people who are so to say employed insignificantly. ❖ Acceleration: Page | 39 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ The term acceleration principle was introduced by J.M.clark in 1917. It was further developed by Hicks, Samuelson and Harrod in relation to business cycles. ▪ The principle of acceleration explains the process by which an increase (or decrease) in the demand for consumption goods leads to an increase (or decrease) in investment on capital goods. ▪ This relationship comes from the fact that the demand for capital goods is derived from the demand for consumer goods. ▪ According to , "The accelerator coefficient is the ratio between induced investment and an initial change in consumption expenditure." ▪ Symbolically, 𝚫𝑰 β= or ∆I = β∆C [samuelson also gave similar equation] 𝚫𝑪 where β is the acceleration coefficient, ∆I is the net change in investment and ∆C is the net change in consumption expenditure. This version of acceleration principle was modified and broadly interpreted by Hicks as: the ratio of included investment → ∆I or changes in output it calls for → ∆Y the capital output ratio. ▪ In an economy, the required stock of capital depends on the change in demand for output. This change equals V times the change in output. Thus where ∆I = V∆Y, where V is the accelerator. ▪ Now, if an entrepreneur wishes to increase his output by Rs. 1lakh-for which she requires an investment of Rs. 4lakhs –then the accelerator = 4 𝚫𝑰 𝟒 i.e. V= = =4 𝚫𝒀 𝟏 ▪ Higher the value of accelerator higher is the investment required to produce a given output. ▪ Now, Gross investment is the economy = replacement investment + net new investment. ▪ Assuming replacement investment as constant, gross investment will vary with the level of investment corresponding to each level of output. ▪ Therefore I.S.Brooman gave the following equation: Igt = V(Yt – Yt-1) + R Page | 40 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ = V ∆Yt + R Igt = gross investment in time t V = accelerator Yt = national output in period t Yt-1 = national output from period t-1 ∆Y = change in national output from t-1 to t R = replacement investment Now if R is deducted from both the sides of equation, Igt – R = Int [Int = net investment] And V(Yt – Yt-1) + R - R = V(∆Yt) Thus, the equation is now, Int = V∆Y, which is similar to that given by Hicks i.e. ∆I = V∆Y. If Yt > Yt-1 then net investment is positive during period t. If Yt < Yt-1 then net investment is negative in period t or there is disinvestment in period t. Sometimes equation, Int = β (Ct – Ct-1) Int = β ∆C Period in Total output Required Replacement Net Gross Years (Y) Capital Investment Investment Investment (1) (2) (3) (R) (Int) (Igt) (4) (5) (6) t 100 400 40 00 40 t+1 100 400 40 00 40 t+2 105 420 40 20 60 t+3 115 460 40 40 80 t+4 130 520 40 60 100 t+5 140 560 40 40 80 t+6 145 580 40 20 60 t+7 140 560 40 -20 20 t+8 130 520 40 -40 00 t+9 125 500 40 -20 20 ▪ In the above table accelerator is assumed to be 4, i.e. V = 4. ▪ Therefore the required capital stock in column (3) is 4 times the output in column (2). ▪ A replacement investment is 10% of the capital stock in period t that is equal to 40 and it remains the same in each period. Net investment equals V times the change in output between the given period and the proceeding period. Page | 41 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ▪ For eg: in period (t+3) net investment = V (Yt+3 - Yt+2) = 4 (115 - 105) = 4 (10) =40 ▪ When output is rising or demand for goods is rising, the required capital rises with a positive net investment. ▪ When demand for final goods or output falls, net investment is negative or required capital also falls. ▪ This is shown in the figure below: ▪ The net investment is proportional to change in level of output or income in that period. When the output stops growing, net investment eventually becomes zero. ▪ In the figure as long as the aggregate output shown by the aggregate output curve 0 is increasing overtime, net investment is positive. ▪ If output increases at an increasing rate, investment is increasing and positive. ▪ If output increases at a diminishing rate, investment is decreasing and positive. ▪ When slope of aggregate output curve becomes 0, net investment becomes 0. ▪ When aggregate output starts falling, net investment becomes 0. Page | 42 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ Page | 43 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ (10) The acceleration principle is weak in that it neglects the role of technological factors in investment. Technological changes may be either capital saving or labor saving. They mey, therefore reduce or increase the volume of investment. Futher as apointed out by professor Knox, Page | 44 Pinky Desai TYBA B Macro Economics [EC 5501] Chapter 2 _______________________________________________________________________________________________ ____________________ ❑ Topic Inflationary and Deflationary Gap is left as such I did not had the notes to type… THANK YOU! Page | 45 Pinky Desai