S.Y. B.COM Fundamentals of Macroeconomics Exam Paper PDF

Krishna Sir’s 1 S.Y. B.COM/Sem-4 7878203207 Unit - 1 S.Y. B.COM (SEM – IV) – FUNDAMENTALS OF MACROECONOMICS UNIT – II...

Krishna Sir’s 1 S.Y. B.COM/Sem-4 7878203207 Unit - 1 S.Y. B.COM (SEM – IV) – FUNDAMENTALS OF MACROECONOMICS UNIT – II UNIT 2 INTRODUCTION TO MACROECONOMICS What is full employment ? Does full-employment means zero unemployment ? A.1. Full employment means employment of all the labour & other productive resources. Full employment indicates that all the persons who are able & willing to work, at the prevailing wage rate are fully employed. Thus, full employment means absence of involuntary unemployment in the economy. However, full employment does not mean zero unemployment. This is because, full employment exists with voluntary unemployment and frictional unemployment. Thus, certain amount of unemployment may exist even in those countries in which there is no problem of unemployment. What are the postulates/assumptions of Classical Theory of Employment. The classical theory of employment and income was developed by classical economists (the followers of Ricardo) J. S. Mill, Marshall and Pigou. According to this theory, normally there is full employment of labour & other productive resources in the economy. So, there can not exist involuntary unemployment. Following are the main postulates of classical theory: (1) There is always full employment of labour & other resources in the economy. So, there cannot exist involuntary unemployment. However, if there is involuntary unemployment, there is always a tendency towards full-employment. (2) There are no government regulations or controls on economic activities. This means government does not interfere in the functioning of economy. (Govt. adopts Laissez Faire Policy). (3) Price mechanism operates in the economy. This means price level, wage rate & rate of interest are flexible. So, if there is unemployment, it will be removed within a short period due to working of price mechanism (Interest mechanism & wage mechanism). (4) There is perfect competition in factor market as well as in product market. (5) There is optimum allocation of resources i.e. all the resources are fully employed. (6) The size of market is capable of expansion and contraction. (7) The economy is always in equilibrium. This means, total demand is always equal to total supply. So, there cannot be general over or under-production. (8) Money is not important in determining output income and employment. It is used only as a medium of exchange. Critically examine say’s Law of Market. OR “In classical economics, general over production and involuntary unemployment is impossible” Discuss. OR “Supply creates its own demand” Discuss. A.3. According to Say’s Law of Market, “Supply creates its own demand”. This means, whatever goods are supplied in the economy will be automatically demanded. Assumption underlying Say’s Law :- Refer question no – 2. 1 Krishna Sir’s 2 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Equilibrium Product Market :- This Say’s Law of Market can be explained in barter economy as well as in money using economy. (A) Say’s Law in Barter Economy :- (1) We know that in Barter Economy, goods and services are exchanged for each other. It means goods are produced for exchange only. So, it is natural that, production and supply of one group of commodities creates demand for another group of commodities. Similarly, supply of another group of commodities creates demand for one group of commodities. In this way, supply of all the goods and services in the economy creates demand for each other. From this point of view, it was argued that “supply creates its own demand” or “aggregate supply is equal to aggregate demand”. So, there can not be general overproduction and involuntary unemployment. (2) Now, sometimes, due to wrong calculation (miscalculation) of future demand by some producers, there may be partial overproduction of some commodities. This may result into involuntary unemployment. But, due to the working of price-mechanism, the partial over- production and involuntary unemployment will be removed within a short period. So, economy will again reach at full-employment level. (B) Say’s Law in Money-using Economy :- (1) We know that, money is used as a medium of exchange. Here also the production is made for sale in the market. It means production creates supply of goods. But production requires employment of factors of production such as land, labour, capital and entrepreneurship and the owners of these factors get money income in the form of rent, wages, interest & profit. It creates income to factors of production. This income creates demand for goods, which are already supplied in the market. Now, if people spends entire income for purchase of goods & services, demand will be just equal to supply. Thus, if there isproduction, there is income. And if there is income, there is demand for the goods. In this Production of Factor income Spending Demand for goods worth worth worth goods worth Rs. 10,000 Rs. 10,000 Rs. 10,000 Rs. 10,000 way, supply creates its own demand. e.g. Thus, every additional output creates additional income and additional expenditure. This leads to sale of additional output. (If there is involuntary unemployment, due to price & wage mechanism the idle resources will be used foradditional output). Sometime, a part of income may become saving (in money terms & to that extent), & it may create deficiency in demand and involuntary unemployment. But, it was argued by classical economists that if the rate of interest is flexible, thesaving will become investment (due to the working of interest mechanism). This mean, the saving will be spent to buy investment goods. (i.e. saving will become expenditure in terms of capital expenditure. So, unsold goods will be sold out). Say’s Law and Classical Macroeconomics Say’s Law forms the foundation of classical macroeconomics, stating that supply creates its own demand, ensuring overall economic equilibrium. No General Overproduction or Underproduction Classical economists, particularly David Ricardo, refined Say’s Law to assert that a capitalist economy is always in equilibrium under laissez-faire policies. They argued that general underproduction or overproduction cannot exist because supply and demand automatically adjust in response to price changes. Short-term imbalances may occur due to external factors, but market forces restore equilibrium through adjustments in prices. When underproduction occurs, excess demand raises prices, which reduces demand while increasing supply, leading to equilibrium. When overproduction occurs, excess supply reduces prices, which discourages production while increasing demand, again restoring equilibrium. Mathematical Proof of Classical Equilibrium The total value of production in the economy is always equal to the total cost of production, which includes wages, rent, profit, and interest. These factor incomes represent the total expenditure in the economy, which in turn equals the Krishna Sir’s 3 S.Y. B.COM/Sem-4 7878203207 Unit - 1 total value of production. Since total expenditure equals total production, total demand will always equal total supply, ensuring equilibrium. No Unemployment Under the Classical System Classical economists believed that full employment is a natural state in a free market economy, meaning general unemployment cannot exist. Full employment ensures that actual output equals potential output, and production levels are always sufficient to sustain the economy. If unemployment arises, falling wage rates make hiring more profitable for businesses, increasing labor demand and eliminating unemployment. Types of Unemployment in the Classical System Voluntary Unemployment: o Occurs when workers refuse to work at the prevailing wage rate. o Can result from strikes, wealth-induced inactivity (idle rich), or personal preference for leisure over work. Frictional Unemployment: o Temporary unemployment due to labor market imperfections and mobility issues. o Can be caused by seasonal jobs (e.g., agriculture), technological changes, natural calamities, wars, or other transitional factors. Despite the existence of voluntary and frictional unemployment, the classical theory still considers full employment to be the normal state of the economy. Q.2 Explain Classical theory of employment. Introduction The classical theory of employment is based on the ideas of economists like Adam Smith, David Ricardo, J.S. Mill, Alfred Marshall, and A.C. Pigou. It assumes that full employment is the normal condition of a free-market economy. Any deviation from full employment is considered temporary and due to external factors. The theory is fundamentally based on Say’s Law of Markets, which states that "supply creates its own demand," meaning that whatever is produced is automatically consumed, ensuring no general overproduction or underproduction. Assumptions of the Classical Theory 1. Full Employment: The economy naturally operates at full employment without inflation. 2. Laissez-Faire System: There is no government intervention in economic activities. 3. Closed Economy: The theory assumes no foreign trade (exports and imports do not exist). 4. Perfect Competition: Labor and product markets operate under perfect competition. 5. Homogeneous Labor: All workers are identical in skills and productivity. 6. Flexible Wages and Prices: Wages and prices adjust automatically to changes in supply and demand. 7. Money as a Medium of Exchange: Money only facilitates transactions and does not influence real economic factors. 8. Automatic Savings-Investment Equality: Savings are automatically converted into investments, balanced by interest rate adjustments. 9. Fixed Capital and Technology: The amount of capital stock and the level of technology are assumed to be constant. Say’s Law and Market Equilibrium Say’s Law suggests that total demand in an economy always equals total supply. If an excess of goods is produced, prices fall, leading to increased demand, restoring equilibrium. If production is too low, shortages raise prices, encouraging more production, again restoring equilibrium. Mathematical Expression of Equilibrium: Value of total production = Total Factor income = Total Expenditure Total Demand = Total supply Diagram: Say’s Law in a Market Economy 3 Krishna Sir’s 4 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Explanation of the Production Function Diagram in the Classical Theory 1. The X-axis of the diagram represents the number of workers employed (N), which signifies the level of labour input in the economy, while the Y-axis represents the total output (Q), which indicates the total quantity of goods and services produced in the economy based on the employment of labour. 2. The curve in the diagram represents the classical production function Q=f(N)Q = f(N), which establishes a direct relationship between the number of workers employed and the total output produced, assuming that other factors of production such as capital stock (K) and technological knowledge (T) remain constant. 3. In the initial stages of employment, as the number of workers employed increases from a lower level to a higher level, the total output of the economy also increases at an increasing rate due to better utilization of fixed capital and division of labor, which leads to higher productivity. 4. The vertical line at N = NF represents the full employment level, which is the point where all available workers willing to work at the prevailing wage rate are employed, and beyond this point, any further increase in employment results in diminishing marginal returns to labor. 5. The horizontal line at Q=OQ1 represents the total output level at full employment, indicating the maximum level of efficient production that can be achieved when the economy operates with all available labor resources without any surplus labor. 6. According to the classical theory of employment, when labor is increased beyond the full employment level from Nf to N2 the corresponding increase in output from Q1 to Q2 becomes smaller compared to the previous increases in production, illustrating the law of diminishing marginal returns, which states that as more labor is added while other factors remain constant, the additional output gained from each extra worker decreases. 7. The diminishing marginal returns effect implies that beyond the full employment level, employing additional workers results in inefficiencies because capital and technology remain constant, leading to overcrowding of labor and reduced per-worker productivity. 8. In the classical economic framework, this self-regulating mechanism of the labor market ensures that any short-term unemployment will be corrected by wage adjustments, and the economy will naturally return to the full employment level without the need for government intervention. 9. This diagram effectively illustrates the classical economists’ belief that unemployment in a free-market economy is only temporary and that the economy always gravitates towards full employment, where labor supply and demand are balanced through flexible wages and price adjustments. 10. Thus, the classical theory suggests that involuntary unemployment cannot persist in the long run, and any observed unemployment is either voluntary (workers unwilling to accept lower wages) or frictional (temporary due to job transitions or market imperfections), reinforcing the idea that full employment is the natural state of the economy. Labour Market Equilibrium: In the labour market, the demand for labour and the supply of labour determine the level of output and employment. The classical economists regard the demand for labour as the function of the real wage rate: DN =f (W/P) Where DN = demand for labour, W = wage rate and P = price level. Dividing wage rate (W) by price level (P), we get the real wage rate (W/P). The demand for labour is a decreasing function of the real wage rate, as shown by the downward sloping DN curve in Fig. 2. It is by reducing the real wage rate that more workers can be employed. The supply of labour also depends on the real wage rate: SN =f (W/P), where SN is the supply of labour. But it is an increasing function of the Krishna Sir’s 5 S.Y. B.COM/Sem-4 7878203207 Unit - 1 real wage rate, as shown by the upward sloping SN curve in Fig. 2. It is by increasing the real wage rate that more workers can be employed. When the DN and SN curves intersect at point E, the full employment level NF is determined at the equilibrium real wage rate W/P0. If the wage rate rises from WP0 to WP1 the supply of labour will be more than its demand by ds. Now at W/P1 wage rate, ds workers will be involuntary unemployed because the demand for labour (W/P1-d) is less than their supply (W/P1-s). With competition among workers for work, they will be willing to accept a lower wage rate. Consequently, the wage rate will fall from W/P 1 to W/P0. The supply of labour will fall and the demand for labour will rise and the equilibrium point E will be restored along with the full employment level Nr On the contrary, if the wage rate falls from W/P0 to WP2 the demand for labour (W/P2-d1) will be more than its supply (W/P2- s1). Competition by employers for workers will raise the wage rate from W/ P2 to W/P0 and the equilibrium point E will be restored along with the full employment level NF. Wage Price Flexibility: The classical economists believed that there was always full employment in the economy. In case of unemployment, a general cut in money wages would take the economy to the full employment level. This argument is based on the assumption that there is a direct and proportional relation between money wages and real wages. When money wages are reduced, they lead to reduction in cost of production and consequently to the lower prices of products. When prices fall, demand for products will increase and sales will be pushed up. Increased sales will necessitate the employment of more labour and ultimately full employment will be attained. Pigou explains the entire proposition in the equation: N = qY/W. In this equation, N is the number of workers employed, q is the fraction of income earned as wages, Y is the national income and W is the money wage rate. N can be increased by a reduction in W. Thus the key to full employment is a reduction in money wage. When prices fall with the reduction of money wage, real wage is also reduced in the same proportion. As explained above, the demand for labour is a decreasing function of the real wage rate. If W is the money wage rate, P is the price of the product, and MPN is the marginal product of labour, we have W=P X MPN or W/P = MPN Since MPN declines as employment increases, it follows that the level of employment increases as the real wage (W/P) declines. This is explained in Figure 3. In Panel (A), SN is the supply curve of labour and DN is the demand curve for labour. The intersection of the two curves at E shows the level of full employment NF and the real wage W/P0. If the real wage rises to W/P1, supply exceeds the demand for labour by sd and N1N2 workers are unemployed. It is only when the wage is reduced to W/P0 that unemployment disappears and the level of full employment is attained. This is shown in Panel (B), where MPN is the marginal product of labour curve which slopes downward as more labour is employed. Since every worker is paid wages equal to his marginal product, therefore the full employment level NF is reached when the wage rate falls from W/P1 to W/P0. Contrariwise, with the fall in the wage from W/P0 to W/P2, the demand for labour increases more than its supply by s1d1, the workers demand higher wage. This leads to the rise in the wage from W/P2 to W/P0 and the full employment level NF is attained. Goods Market Equilibrium: The goods market is in equilibrium when saving equals investment. At that point of time, total demand equals total supply and the economy is in a state of full employment. According to the classicists, what is not spent is automatically invested. Thus saving must equal investment. If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest. To them, both saving and investment are 5 Krishna Sir’s 6 S.Y. B.COM/Sem-4 7878203207 Unit - 1 the functions of the interest rate. S=f(r) …(1) I=f(r) …(2) S = I Where S = saving, I = investment, and r = interest rate. To the classicists, interest is a reward for saving. The higher the rate of interest, the higher the saving, and lower the investment. On the contrary, the lower the rate of interest, the higher the demand for investment funds, and lowers the saving. If at any given period, investment exceeds saving, (I > S) the rate of interest will rise. Saving will increase and investment will decline till the two are equal at the full employment level. This is because saving is regarded as an increasing function of the interest rate and investment as a decreasing function of the rate of interest. Assuming interest rates are perfectly elastic, the mechanism of the equality between saving and investment is shown in Figure 4 where S is the saving curve and I is the investment curve. Both intersect at E which is the full employment level where at Or interest rate S = I. If the interest rate rises to Or1 saving is more than investment by ha which will lead to unemployment in the economy. Money Market Equilibrium: The money market equilibrium in the classical theory is based on the Quantity Theory of Money which states that the general price level (P) in the economy depends on the supply of money (M). The equation is MV= PT, where M = supply of money, V= velocity of circulation of M, P = Price level, and T = volume of transaction or total output. The equation tells that the total money supply MV equals the total value of output PT in the economy. Assuming V and T to be constant, a change in the supply of money (M) causes a proportional change in the price level (P). Thus the price level is a function of the money supply: P = f (M). The relation between quantity of money, total output and price level is depicted in Figure 5 where the price level is taken on the horizontal axis and the total output on the vertical axis. MV is the /money supply curve which is a rectangular hyperbola. This is because the equation MV = PT holds on all points of this curve. Given the output level OQ, there would be only one price level OP consistent with the quantity of money, as shown by point M on the MV curve. If the quantity of money increases, the MV curve will shift to the right as M 1V curve. As a result, the price level would rise from OP to OP1 given the same level of output OQ. This rise in the price level is exactly proportional to the rise in the quantity of money, i.e., PP 1 = MM1 when the full employment level of output remains OQ. Q.3. Explain Keynes objections to Classical Theory of employment. OR Explain the criticisms to Krishna Sir’s 7 S.Y. B.COM/Sem-4 7878203207 Unit - 1 classical theory of employment. A.6. Following are the main points of criticisms to classical theory of employment : (1) Assumption of Full Employment :- According to Keynes the assumption of full- employment is not realist / correct. In fact, in capitalist economy, full employment is a rare situation and unemployment is a normal situation. (2) Say’s Law of Market :- Keynes did not agree with Say’s Law of Market. This is because when a part of income is saved and not spent, it may create deficiency in demand and involuntary unemployment. (3) Say’s Law of Market is not applicable in money using Economy :- According to Keynes, Say’s Law of Market is not fully applicable (valid) in money using economy. This is because, saving and investment may not be always equal, due to following reasons :- (a) Saving and investment are done by different group of people. (Saving is done by general public, but investment is done by investors / entrepreneurs) (b) The motives behind saving and investment are different, & Due to above reasons, saving and investment may not be always equal. So, it is possible that, if saving is greater than investment, it may create a deficiency in demand & involuntary unemployment. (4) Saving is not interest-elastic :- According to classical economists, savings of people directly depends upon the rate of interest. But, according to Keynes, savings of people mainly depends upon the level of income & not on the rate of interest. (This means, even if rate of interest is higher, their saving will be lower if their income is low). Thus, saving is not interest-elastic. (5) Investment is not Interest-elastic :- According to classical economists, investment depends upon the rate of interest. But, according to Keynes, investment depends upon the Marginal Efficiency of Capital (expected rate of return on investment) in relation to rate of interest. (6) Wage-Price Flexibility :- According to Keynes, wages and prices are not flexible. (7) Wage-cut not a solution to Unemployment :- (a) Effect on Effective Demand :- It is argued by Pigou that wage-cut removes unemployment. But, Keynes does not agree with this idea. He argued that, if there is a wage-cut in a particular industry, it may increase employment. But, if there is a wage-cut, in all the industries, income and purchasing power of people will fall. So, demand will fall. This will create deficiency in demand and involuntary unemployment. Thus, instead of expanding employment opportunities, a wage-cut will increase unemployment. (b) Difficult to reduce money-wage :- Further, wage-cut may be strongly opposed by trade unions. So, the wage-mechanism may fail to remove unemployment or may fail to guarantee full-employment. (8) Money as a Medium of Exchange :- According to classical theory, money acts only as a medium of exchange. But, according to Keynes, money also acts as a store of value and it is demanded for speculative purpose also. (9) Role of Monetary and Fiscal Measures :- According to Keynes, employment can be increased more easily by monetary and fiscal measures rather by reduction in money wage. (10) Wage-Price Flexibility and Full-Employment :- According to classical economists, if there is increase in savings of people, consumption expenditure will fall. This will create deficiency in demand. Due to this, price will fall and demand will again rise. So, the unsold goods will be sold out. Thus, there will not be a problem of deficiency in demand and general unemployment. This is ensured by price flexibility. (Thus, even if savings rises, output, income and employment will not fall). When there is deficiency in demand, prices will fall. So, production will become less profitable. Now, to maintain their profit, they will reduce wage-rate. So, demand for labour will increase. Thus, due to wage flexibility, employment will increase and the country will achieve full-employment situation. 7 Krishna Sir’s 8 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Consumption Function 1. Explain the concept of consumption function and propensity to consume. When consumption function is linear and non−linear ? Ans : (I) Consumption Function [ Oct. ‘2013 ] ➔ The concept of “consumption function” has been popularized by Keynes. ➔ Consumption expenditure depends upon a number of factors like income, rate of interest, expected future prices, past savings, etc. ➔ Out of all above these factors, income is the main factor, which decides consumption expenditure. ➔ Taking this, we can say that, ➔ Consumption function is a mathematical expression, ➔ Which shows a relationship Between income & consumption expenditure ➔ It can be expressed as follow : C = f (y) Where, C = consumption expenditure of people, Y = Income, and F = Shows functional relationship ➔ Consumption function shows that the consumption expenditure of people directly depends upon their income. ➔ According to Keynes, there is a direct and positive relationship Between income & consumption ➔ So, when income increases, the consumption expenditure increases. (II) Attributes / Features / Concept of Consumption Function [ April ‘2011 ] : ➔ To explain the relationship Between income Keynes has & introduced following two concepts Consumption expenditure (A) Average Propensity to consume [APC] (B) Marginal Propensity to consume [MPC] ➔ Now, let us explain these concepts − (A) Average Propensity to Consume [ APC ] : Krishna Sir’s 9 S.Y. B.COM/Sem-4 7878203207 Unit - 1 ➔ It is the ratio of Total Consumption Expenditure to a given level of total income. ➔ It shows a fraction (part) of income which becomes consumption expenditure ➔ APC can be calculated by following formula − Total Consumption Expenditur e APC = Total Income C = Y ➔ Suppose, consumption expenditure is Rs. 1600, when income is Rs.2,000 ➔ In this case, C 1600 APC = = = 0.8 Y 2000 (B) Marginal Propensity to Consume / MPC [ Oct.’2012 ] : ➔ MPC is the ratio of additional consumption expenditure (to) additional income ➔ It shows, a fraction / part of additional income, ➔ Which becomes consumption expenditure. ➔ MPC can be calculated by following formula − Change in Consumption Expenditur e MPC = Change in Income C = Y Where, ∆ = Change C = consumptions expenditure Y = Income ➔ Suppose, When income increases from Rs.10,000 to Rs. 12,000, consumption expenditure increases from Rs. 8000 to Rs.9,600. ➔ In this case, C MPC = [ ∆C = NC 9600 (−) OC 8000 = 1600 ] Y 1600 = [ ∆Y = NI 12000 (−) OI 10,000 = 2,000 ] 2000 16 = 20 = 0.8 [ This means 80% of additional income is spent by people] Features / Attributes of MPC [ Nov. ‘2011, March ‘2012 ] ➔ Following are the main features of MPC (a) MPC is always positive [ MPC > 0 ] (b) MPC is always less than one [ MPC < 1 ] (c) MPC is a falling / diminishing function of income. ➔ Let us discuss each feature of MPC in detail. (a) MPC is always Positive / [MPC > 0 ] : ➔ According to Keynes, there is a positive relationship 9 Krishna Sir’s 10 S.Y. B.COM/Sem-4 7878203207 Unit - 1 between income & consumption ➔ So, when income increases, consumption expenditure also increase, vice versa. ➔ So, additional consumption expenditure is always positive. ➔ So, MPC is always positive [ MPC > 0 ] (b) MPC is always less than one / [ MPC < 1 ] : ➔ When income increases, a part of additional income becomes consumption expenditure and the remaining part becomes savings. ➔ So, additional consumption expenditure (∆C) is always less than additional income (∆Y)  ∆C < ∆Y C   1 Y  MPC < 1 (c) MPC is a diminishing function of Income : ➔ When income increases, the additional consumption expenditure is falling. ➔ So, MPC is falling, ➔ So, MPC is a diminishing function of income. (III) Non−Linear Consumption Function and Consumption Curve : ➔ According to Keynes, consumption function is non−linear. ➔ In case of non −linear consumption function, ➔ Consumption curve is upward sloping with diminishing slope ➔ That is, it is concave to X−axis ➔ This can be explained with the help of following example and diagram. Incom ∆Y ∆ MPC=∆C/∆ S ∆ MPS=∆S/∆ eY C C Y S Y 0 −− 50 −− --- (- −− (−) 50 100 10 130 80 0.8 )5 20 (−) 30 0 0 200 20 70 0.7 30 0 10 0 (- 300 60 0.6 40 40 0 )3 26 0 10 0 0 0 40 Y Consumption Expenditure [C=Y] & Saving P C a S O X M S Income Krishna Sir’s 11 S.Y. B.COM/Sem-4 7878203207 Unit - 1 ➔ This diagram shows that, (a) X−axis measures income, and (b) Y−axis measures consumption expenditure and income. (c) The consumption curve starts from point a on y−axis. ➔ This shows that when income is zero, ➔ Consumption expenditure is positive [Oa] ➔ This consumption expenditure is called autonomous consumption, ➔ Which does not depend upon income ➔ It is financed out of past savings (or) borrowings. (d) The consumption curve is upward sloping because with increase in income. ➔ Consumption expenditure also increases (e) According to Keynes psychological law of consumption ➔ With increase in income, the additional consumption expenditure is falling, ➔ So, MPC is falling, [ slope of consumption curve is falling ] ➔ Because of this reason, ➔ Consumption curve is upward sloping with diminishing slope ➔ That is, it is concave to X−axis. Q.2 Explain the concept and process of investment multiplier, prove that investment multiplier (K) is reciprocal of MPS [ OR ] What is propensity to consume? Explain the relationship between the propensity to consume and investment multiplier ? Ans : (I) CONCEPT OF INVESTMENT MULTIPLIER : ➔ The concept of investment multiplier has been developed by Keynes. ➔ Investment multiplier explains the effect of change in autonomous investment on income. ➔ Normally when there is increase in investment by certain amount ➔ It results into increase in income by certain amount in times. ➔ This number of times by which income increases because of increase in investment is known as investment multiplier. ➔ So, investment multiplier is a numerical figure showing the number of times by which income increases because of change in investment. ➔ Investment multiplier can be measured by following formula : Y Investment Multiplier (K) = I ➔ For e.g. Additional income of Rs. 5,000, additional investment is Rs.1,000 Y K = I Where, Y = Additional Income I = Additional Investment 11 Krishna Sir’s 12 S.Y. B.COM/Sem-4 7878203207 Unit - 1 K = Investment Multiplier 5,000 = 1,000 K = 5 times (II) ASSUMPTIONS OF MULTIPLIER : ➔ The working of investment multiplier is based on following assumptions : 1. There is change in autonomous investment and not in induced investment. 2. The MPC is constant. 3. Consumption is a function of current income 4. There are no time gap in the multiplier process, that is an increase or decrease in investment instantly leads to increase or decrease in income 5. The new level of investment is maintained steadily for the completion of multiplier process. 6. There is net increase in investment 7. Consumer goods are available in response to effective demand for them. 8. Other resources of production are also easily available within the economy. 9. There is industralised economy in which multiplier process works. 10. There is a closed economy unaffected by foreign trade/influences 11. There is no changes in prices. 12. The accelerator effect of consumption on investment is ignored. 13. There is less than full employment level in the economy. (III) DERIVATION OF THE FORMULA OF INVESTMENT MULTIPLIER: ➔ We know that, Y K = I ➔ Now, according to Keynes theory of income determination at equilibrium level of income, saving is equal to investment [ S = I ] ➔ If we replace investment (I) by saving (S) in the above formula we will get K Y  = 1 S S  1/ K = Y 1  = MPS K 1 K =........(1) MPS 1 K =........( 2) [ MPS = 1 − MPC ] 1 − MPC ➔ The above formula shows that, ➔ Investment multiplier [K] directly depends upon MPC & inversely [ oppositely ] depends upon MPS Krishna Sir’s 13 S.Y. B.COM/Sem-4 7878203207 Unit - 1 (IV) RELATIONSHIP BETWEEN MPS, MPC & K : ➔ Now let us refer following table − MPC MPS K 1.0 0  0.9 0.1 10 0.8 0.2 5 0.5 0.5 2 0.1 0.9 1.1 0 1 1    ➔ This table shows that, (a) Higher the MPC, higher the value of K and vice versa. So, K directly depends upon MPC. (b) Higher the MPS, lower the value of K and vice versa. So, K inversely depends upon MPS (c) K is reciprocal to MPS, For e.g. if MPS = 1/5, then investment multiplier will be equal to 5 at the same way. If MPS = 1/3, K=3 If MPS = 1/2, K=2 (V) Process (or) Working of Investment Multiplier [ OR ] Process of Income Propagation [ March ‘2012, Oct.’2013 ]  Multiplier has two effect : (a) Primary Effect : ➔ When increase in investment becomes income of factors of production. ➔ It is primary effect. (b) Secondary Effect : ➔ When consumption expenditure by one person becomes income of another person, ➔ It is secondary effect, ➔ Now, let us explain the process of investment multiplier with the help of following example − ➔ Suppose, (i) The economy is in equilibrium and investment increases by Rs.1,000 (ii) MPC = 0.9 ( 9/10) (iii) MPC remains constant at all level of income. ➔ Now, let us find out the amount of creation of additional income [ Amount in Rs. ] Stage I Y C = (  Y. MPC) I Rs. 1,000 1,000 900 II −− 900 810 III −− 810 729 IV −− 729 −− 13 Krishna Sir’s 14 S.Y. B.COM/Sem-4 7878203207 Unit - 1 TOTAL −− 10,000 −− ➔ So, an initial investment of Rs. 1,000 results into additional income of Rs.10,000 ➔ This can be calculated following formula : ➔ K=1/MPS ➔ K=1/1-MPC ➔ K=1/1-0.9 ➔ K=1/0.1 ➔ K=10 ➔ K=  Y/  I  Y=  I (x) K = 1000 (X) 10 = RS 10,000/-  Assuming that MPC remain constant, income will increase in following manner : (a) First Stage : ➔ When investment increases by Rs.1,000 ➔ This amount becomes income for those persons, who supply factors of production, ➔ So, in the first stage, there is creation of additional income by Rs. 1,000 ➔ This is the primary effect of investment multiplier (b) Second Stage : ➔ Now, people who earned income will spend a part of income. ➔ In this example MPC is 0.9. ➔ So, there is consumption expenses of Rs. 900 out of income of Rs. 1,000 ➔ This amount becomes income of another person ➔ So, there is income generation of Rs. 900 in the second stage. (c) Third Stage : ➔ Again out of income of Rs. 900, ➔ There is consumption of Rs. 810. ➔ So, this amount become income in the next stage. ➔ In this way, if the process of spending and responding remains continuous till the end of the process ➔ There will be income generation of Rs.10,000 (VI) DIAGRAMMATIC PRESENTATION OF INVESTMENT MULTIPLIER : ➔ Let us explain the working of investment multiplier with the help of following diagram. ➔ According to Keynes theory of income determination, ➔ It is the equality of [ C + I ] and Y (or) ➔ Saving and Investment, which decides equilibrium level of income ➔ So, condition for equilibrium level of income is C (+) I = Y (OR) S = I (A) Aggregate Spending Approach : ➔ This diagram, shows that, Krishna Sir’s 15 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Y Y [ AS ] [ C + S ] C+I+  I E’ C+I E A’  I A  Y X O Y Y’ Income (a) X−axis measures income and (b) Y−axis measures total expenditure [ consumption & investment ] (c) In this figure C + I = Y at OY level of income, (d) So, OY is original equilibrium level of income (e) Now, suppose investment rises by AA’. (f) So, aggregate demand curve [ C + I ] shifts in upward direction (g) Now, C + I = Y at OY’ level of income. (B) Saving, Investment Approach : Y S Saving & Investment Q’ A’ I’ [ I + I ] } I Q A I Y S X O Y Y’ Income ➔ This diagram shows that, (a) X−axis measures income, and (b) Y−axis measures saving and investment (c) In the original situation, S = I at point Q, at OY level of income (d) So, equilibrium level of income is OY. (e) Now, suppose investment increases by AA’. So, investment curve are equal to point Q’, at OY’ level of income. (f) So, now the equilibrium level of income is OY’. ➔ So when investment increases by AA’, income increases by YY’ ➔ Here, increase in income is greater than increase in investment ➔ This shows the working of investment multiplier ➔ So, increase investment by AA’ results into increase in income by YY’ ➔ Here, increase in income is greater than increase in investment ➔ This shows the working of investment multiplier. Leakages of multiplier. 15 Krishna Sir’s 16 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Leakages are factors that reduce the effectiveness of the multiplier by diverting income away from consumption. Saving is the most significant leakage because not all additional income is spent on consumption. A higher marginal propensity to save (MPS) leads to a smaller multiplier effect. When people hoard money instead of spending, it weakens the income stream and reduces the multiplier impact. If income is used to buy old stocks and securities, it does not contribute to new consumption or production. Debt repayment acts as a leakage because money is not used for further spending. Inflation absorbs increased income, making goods more expensive and reducing real consumption. Spending on imports takes money out of the domestic economy, limiting the multiplier effect. If businesses retain profits instead of distributing them, the money does not enter the consumption cycle. High taxes lower disposable income, leading to reduced spending and a weaker multiplier. If demand is met from existing stocks rather than new production, the economy does not experience growth. Public investment can sometimes discourage private investment due to higher costs, interest rates, or fear of government control. Criticism of the Multiplier Some economists argue that the multiplier is just a mathematical formula without real-world significance. The theory assumes instantaneous income and consumption changes, which is unrealistic due to time lags. The acceleration effect, where investment responds to consumption changes, is ignored. The assumption that the marginal propensity to consume (MPC) remains constant is unrealistic in a dynamic economy. The relationship between income and consumption is complex, not simply linear as Keynes suggested. Some economists dismiss the multiplier as a "useless theoretical concept" with little practical value. Despite these criticisms, the multiplier principle is still useful for economic policy and investment planning. Importance of multiplier The multiplier concept is a significant contribution of Keynes to income and employment theory. It highlights the importance of investment in determining income and employment levels. A rise in investment leads to a cumulative increase in income and employment, while a decline causes a downturn. The multiplier effect explains the phases of the trade cycle, including booms and recessions. It helps maintain saving-investment equilibrium by ensuring savings increase along with rising income. Governments use the multiplier principle to design policies that stimulate economic growth and control unemployment. By adjusting investment levels, the state can regulate inflation and prevent recessions. Deficit financing, supported by the multiplier effect, helps governments boost demand during economic downturns. Public investment in infrastructure and welfare projects plays a crucial role in stabilizing the economy. The timing of investment policies is essential—higher investment is beneficial when people have a higher tendency to consume. Q.3 Explain how the equilibrium income is determined in a model having three sectors [ June ‘2013 ] GOVERNMENT EXPENDITURE MULITIPLIER Krishna Sir’s 17 S.Y. B.COM/Sem-4 7878203207 Unit - 1 [ OR ] Explain theory of income determination in three sector model. What is the effect of government sector on the level of income. Ans : (I) INCOME DETERMINATION IN THREE SECTOR MODEL : ➔ Three sector model includes Household, Business and Sector Government ➔ The government makes expenditures on, ➔ (i) Purchase of goods & From the business sector services & ➔ (ii) Purchase of factor services from the household sector. ➔ Moreover, one hand, ➔ (i) The government collect taxes from people & ➔ (ii) spends the same amount for different purposes ➔ In three sector model, ➔ Equilibrium level of income is decided at that level, ➔ At which aggregate demand (AD) is equal to aggregate supply (AS) (A) Aggregate Demand : ➔ In three sector model, ➔ aggregate demand ➔ includes Consumptions Goods (H) Investment expenditure (I) government expenditure (G).  Aggregate Demand = C + I + G (B) Aggregate Supply : ➔ In three sector model, ➔ (i) part of income of people becomes consumption expenditure & ➔ (ii) a part of income is used to pay taxes (T) to the government. ➔ So, aggregate supply includes consumption expenditure (C), Savings (S) & taxes (T)  Aggregate Supply = Y = C + S + T (II) Condition for Equilibrium level of Income : ➔ At equilibrium level of income : Aggregate Demand = Aggregate Supply 17  Krishna Sir’s 18 S.Y. B.COM/Sem-4 7878203207 Unit - 1 C+I+G=Y …….. (1)  C+I+G=C+S+T ➔ Now, it is assumed by Keynes that at equilibrium level, ➔ Government Expenditure = Taxes  C+I=C+S  I=S  S=I ….. ….. (2) ➔ So, equilibrium level of income is determined at that level at which C + I + G = Y (OR) This can be explained with the help of following diagram S = I ➔ Diagram for Aggregate Demand and Aggregate Supply in three sector model. Figure - 1 Figure - 2 Y Y AS(Y) & Government Expenditure Consumption & Investment Saving & Investment C+I+G E’ C+I S B E F’ B I+G A F A I X X O Y Y’ O Y Income S Income (I) Figure - 1 ➔ This diagram shows that – (a) X−axis measures income (b) Y−axis measures total expenditure of economy (C + I + G). (c) In the given figure, aggregate demand (C + I + G) is equal to aggregate supply (Y) at OY’ level of income. (d) So, OY’ is equilibrium level of income. Q.4 The Budget Multiplier explains the impact of government expenditure on national income. Discuss [ April ‘2011, Nov. ‘2011, March ‘2012, Jan. ‘2013, June ‘2013, Jan.’2014 ] [ OR ] “Balanced Budget Multiplier is always equal to one” Explain. [ OR ] Write a short note on Balanced Budget Multiplier. [ OR ] Explain the concept of balanced budget multiplier [Government Multiplier] Ans : ➔ Balance budget multiplier explains the effect of balanced budget policy on the level of income. Krishna Sir’s 19 S.Y. B.COM/Sem-4 7878203207 Unit - 1 ➔ When govt. adopts / accepts balanced budget policy, ➔ govt. expenditure (G) is equal to taxes (T)  Govt. expenditure = Taxes  G = T  ∆G = ∆T ➔ On one hand, Govt. expenditure results into increase in income of people & their subsequent consumption expenditure. ➔ Now, let us explain the effect of both on the level of income. (I) How to Get/ Derive the Formula of Balance Budget Multiplier (BBM) : ➔ To explain BBM, let us find out the formula of Govt. Expenditure Multiplier (GM) & Tax Multiplier (TM) (a) Government Expenditure Multiplier (GM) : ➔ We know that − Y GM = G ➔ Now, because of Government expenditure ∆Y = ∆G x Multiplier 1  ∆Y = ∆G x 1 − MPC Y 1  = G 1 − MPC 1  GM = (Where C = MPC) 1− C (b) Tax Multiplier (TM) : ➔ We know that − Y TM = T ➔ Now, because of taxation :  ∆Y = (∆T x − MPC) x TM 1  ∆Y = ∆T x − MPC x 1 − MPC Y 1  = − MPC x T 1 − MPC − MPC  TM = 1 − MPC −C = [ where C = MPC ] 1−C −C  TM = ……………(2) 1−C (II) Formula of Balanced Budget Multiplier (BBM) : ➔ When we add value of GM with TM, ➔ we will get value of BBM. 19 Krishna Sir’s 20 S.Y. B.COM/Sem-4 7878203207 Unit - 1  BBM = G M + TM 1 −C = + 1− C 1−C 1− C = 1− C  BBM = 1 ➔ So, when ∆G = ∆T, balanced budget multiplier is always equal to one ➔ So, increase in national income is exactly equal to the amount of government expenditure. (III) Diagrammatic Presentation : ➔ The effect of BBM on NI can be explained by following diagram − Y Y C+I+G E1 Total Spending C + I + G’ E2 C+I D G E A Y O Y Y2 Y1 X Income ➔ In the given diagram, (a) X−axis measures income & Y−axis measures total spending. (b) In the starting stage, aggregate demand curve [ C + I ], & ➔ It intersects [cuts] aggregate supply curve at point E, at OY level of income. ➔ So, the original equilibrium level of income is OY. (c) Now, when govt. expenditure is added, ➔ the aggregate demand curve shifts upward. ➔ So, now the aggregate demand curve is C + I + G. ➔ It intersects aggregate supply curve at point E1. ➔ So, equilibrium level of income increases from OY to OY1 (by YY1). (d) If govt. expenditure is financed by taxation, ➔ the disposable income of people & ➔ their consumption expenditure will fall. ➔ So, aggregate demand curve shifts downward. ➔ Now, aggregate demand curve is C + I + G’. ➔ It intersects the income curve at point E2. ➔ So, equilibrium level of income is OY2. ➔ So, because of taxation, equilibrium level of income falls from OY1 to OY2. (e) So, because of balanced budget multiplier, ➔ there is net increase in income by YY2, ➔ which is exactly equal to govt. expenditure (AD). ➔ So, Krishna Sir’s 21 S.Y. B.COM/Sem-4 7878203207 Unit - 1 ∆Y = ∆G Y  = 1 G  BBM = 1 ➔ This shows that BBM is always equal to one. Limitations of the Balanced Budget Multiplier The balanced budget multiplier only considers government spending on goods and services while excluding transfer payments, even though transfer payments offset the negative tax multiplier. It assumes a uniform marginal propensity to consume (MPC) for both taxpayers and those receiving government payments, which is unrealistic. The model ignores the effects of government spending and taxation on investment, which can influence economic activity depending on whether taxes are imposed on businesses or fixed-income groups. Critical Appraisal of the Balanced Budget Multiplier As an expansionary tool, the balanced budget multiplier is often inefficient and inadequate. Large government spending can shift resources from the private sector to the public sector, negatively affecting private businesses. The need for higher taxes to balance the budget can reduce investment, making the policy self- defeating. The classical approach to balanced budgets—requiring equal government income and expenditure annually—can destabilize the economy rather than stabilize it. During inflation, if the government increases spending or reduces taxes, it may worsen inflation instead of controlling it. During depression, reducing government expenditure or raising taxes to balance the budget could worsen economic downturns. The balanced budget theorem is seen as superior to classical budget balancing because it acknowledges the risks of rigid fiscal policies. Q.5 Write a short note on trade / foreign trade multiplier. [ Nov. ‘2011, June ‘2013, Jan. ‘2014 ] [ OR ] Explain the concept of foreign trade multiplier. Ans : (I) FOREIGN TRADE MULTIPLIER (KF) : (a) Foreign Trade Multiplier shows that, ➔ Effect of foreign trade [ that is, effects of exports and imports) on the national income of a country. ➔ It works just like investment multiplier as explained by Keynes. (b) Foreign trade multiplier shows the number of times, ➔ by which NI changes as a result of increase in exports or imports. (c) When there is increase in exports of a country, 21 Krishna Sir’s 22 S.Y. B.COM/Sem-4 7878203207 Unit - 1 ➔ its national income increases / rises. ➔ But, when there is increase in imports, ➔ its national income falls / decrease. ➔ This is because, just like saving and taxes, ➔ imports are a type / form of withdrawals from the circular flow of income. (d) Now how much will be the effect of foreign trade on national income that depends upon − (i) Marginal Propensity to Save (MPS) and (ii) Marginal Propensity to Import (MPM) ➔ So, lower the value of these two factors, ➔ higher will be the value of the foreign trade multiplier and ➔ greater will be the increase in income. ➔ Here, it should be remembered that − S (1) MPS = Y M (2) MPM = Y (II) DERIVATION OF FORMULA OF FOREIGN TRADE MULTIPLIER (Kf) : ➔ We know that Y  Kf = X ➔ Now, in open economy, ➔ at equilibrium level of income :  Y=C+I+G+X−M ➔ Now, suppose, there is no government sector  Y = C + I + X − M (where, X = export & M = imports)  Y−C=I+X−M S − I + X − M (Y − C = S)  S+M=I+X Now, suppose I is constant, then X=S+M  ∆X = ∆S + ∆M, ➔ If we divide both sides by ∆Y, we will get, X S M = + Y Y Y 1 S M 5 1  = + ( = ) Y Y Y 4 4 X 5 1 Y  = MPS + MPM ( = Kf ) Kf X 1  Kf = MPS + MPM 1  Kf = 1 − MPC + MPM Krishna Sir’s 23 S.Y. B.COM/Sem-4 7878203207 Unit - 1 1  Kf = (b = MPC & m = MPM) (main formula of KF) 1− b + m ➔ This formula shows that, ➔ The value of foreign trade multiplier inversely / appositely depends upon the value of MPS and MPM. ➔ So, lower the value of MPS and MPM, higher the value of Kf and additional income. ∆Y = Kf x ∆X  1  = 1 − (b − m)  x X   (III) CONCLUSIONS : (a) Kf inversely / oppositely depends upon MPS and MPM. ➔ So, lower the value of MPS and MPM, ➔ higher the value of Kf and additional income. (b) When MPM = 0 (no imports), ➔ it increases the value of Kf and additional income. (c) When MPM is positive, ➔ it reduces / decrease the value of Kf and additional income. Q.6 Distinguish / Difference between budget multiplier and trade multiplier [ Jan. ‘2013 ] [ OR ] Distinguish / difference between Investment Multiplier, Balance Budget Multiplier and Foreign Trade Multiplier. Ans : No. Investment Balance Budget Foreign Trade Multiplier Multiplier Multiplier (1) It explains the It explains the effect It explains the effect of effect of change in of balanced budget foreign trade (export & autonomous policy on the level of import) on the level of investment on the income. income. level of income (2) It can be measured It can be measured by It can be measured by by following formula : following formula : following formula : K = BBM = GM + TM 1 Kf = 1 1 MPS + MPM = 1 −C MPS 1 − MPC = + 1 − C 1− C Kf = 1 1− b + m 1- C = =1 Where, b = MPC 1 - C m = marginal propensity Where C = MPC to import (3) K directly depends BBm depends upon Kf inversely depends 23 Krishna Sir’s 24 S.Y. B.COM/Sem-4 7878203207 Unit - 1 upon MPC and Govt. expenditure, upon MPS and MPM inversely depends taxation and value of upon MPS multiplier Q.7 Explain Tax multiplier. Tax multipliers explain how changes in tax rates affect national income. When the government increases taxes or imposes new ones, people’s disposable income decreases, reducing their marginal propensity to consume (MPC). This results in a fall in national income due to the multiplier effect. Conversely, a reduction in taxes raises national income through the positive multiplier effect. The tax multiplier (Kₜ) is given by the formula: −𝑐 𝑘𝑡 = 1−𝑐 If c = 2/3 then , −𝑐 −2/3 𝑘𝑡 = = = −2 1 − 𝑐 1 − 2/3 This means that an increase in taxes reduces income by twice the tax increase. Types of Taxes and Their Effects: Lump-Sum Tax Multiplier: o Before imposing a lump-sum tax, the consumption function is at C, and income is at OY. o When a lump-sum tax (AG) is levied, disposable income falls, shifting the consumption function downward from C to C₁. o The total expenditure curve (C + I + G) also shifts downward to C + I + G - T. o The new equilibrium at E₁ leads to a reduction in national income from OY to OY₁. Proportional Income Tax Multiplier: o When the government imposes a proportional tax on income, disposable income decreases, reducing consumption. o The consumption function (C) shifts downward to C₁. o The total expenditure curve (C + I + G) also moves downward to C + I + G - T, cutting the 45-degree line at a new equilibrium E₁. o As a result, national income falls from OY to OY₁. Krishna Sir’s 25 S.Y. B.COM/Sem-4 7878203207 Unit - 1 Practical Examples Q.1 a) if Marginal Propensity to consume is 0.6, what will be the value of Keynesian Multiplier (K) b) If change in investment is Rs. 150, find the change in income. Q. 2. If marginal propensity to consume is 0.9 and change in investment is Rs. 100, what will be the value of change in income in the economy? Q 3. If Marginal Propensity to Save is equal to 0.6 and change in Income is equal to Rs. 1500, what will be the value of change in Investment? Q-4 Find the change in income (AY) from the following data:∆I = Rs ,10000, Marginal Propensity to save (MPS) is 0.25 Q5. Change in Investment is Rs. 3750 Cr. and the change in income is Rs. 10,400 Cr. find the value of Marginal Propensity to Save (MPS). Q.6. Value of MPC are given below Find value of K. MPC 0 0.1 0.2 0.3 0.4 0.9 1.0 K 25