Macroeconomics Theory and Policy PDF

MACROECONOMICS THEORY AND POLICY (For Postgraduate (M.A., M.Com.) and B.A. (Hons.) Students of Economics, Commerce, Business Management and Competitive Examinations) ADVANCED ANALYSIS OF Income and Employment Determination Theories of Consumption Function and Investment Monetary Demand & Supply Money, Prices and Inflation Theories of Business Cycles and Stabilisation Policies New Classical Macroeconomics based on Rational Expectations New Keynesian Economics Relevance of Keynesian Economics for Developing Countries Government Budget Constraint, Fiscal Policy and Fiscal Deficit Open Economy Macroeconomics : Balance of Payments, Foreign Exchange Rate and International Economic Linkages Theories of Economic Growth : Harrod-Domar Model; Neoclassical Growth Theory; New Theory of Growth, and Lewis’ Model of a Labour-Surplus Economy Nature of Unemployment and Development Strategies for Labour-Surplus Developing Countries. Bhagwati Vs. Sen : Debate on Growth and Distribution Dr. H.L. AHUJA M.A. Ph.D. (DSE) Formerly, Senior Reader Department of Economics Zakir Husain Delhi College University of Delhi Delhi THOROUGHLY REVISED TWENTIETH EDITION S Chand And Company Limited (ISO 9001 Certified Company) S Chand And Company Limited (ISO 9001 Certified Company) Head Office: Block B-1, House No. D-1, Ground Floor, Mohan Co-operative Industrial Estate, New Delhi – 110 044 | Phone: 011-66672000 Registered Office: A-27, 2nd Floor, Mohan Co-operative Industrial Estate, New Delhi – 110 044 Phone: 011-49731800 www.schandpublishing.com; e-mail: [email protected] Branches Ahmedabad : Ph: 27542369, 27541965; [email protected] Bengaluru : Ph: 22354008, 22268048; [email protected] Bhopal : Ph: 4274723, 4209587; [email protected] Bhubaneshwar : Ph: 2951580; [email protected] Chennai : Ph: 23632120; [email protected] Guwahati : Ph: 2738811, 2735640; [email protected] Hyderabad : Ph: 40186018; [email protected] Jaipur : Ph: 2291317, 2291318; [email protected] Jalandhar : Ph: 4645630; [email protected] Kochi : Ph: 2576207, 2576208; [email protected] Kolkata : Ph: 23357458, 23353914; [email protected] Lucknow : Ph: 4003633; [email protected] Mumbai : Ph: 25000297; [email protected] Nagpur : Ph: 2250230; [email protected] Patna : Ph: 2260011; [email protected] Ranchi : Ph: 2361178; [email protected] Sahibabad : Ph: 2771238; [email protected] © S Chand And Company Limited, 1986 All rights reserved. No part of this publication may be reproduced or copied in any material form (including photocopying or storing it in any medium in form of graphics, electronic or mechanical means and whether or not transient or incidental to some other use of this publication) without written permission of the copyright owner. Any breach of this will entail legal action and prosecution without further notice. Jurisdiction: All disputes with respect to this publication shall be subject to the jurisdiction of the Courts, Tribunals and Forums of New Delhi, India only. First Edition 1986 Subsequent Editions and Reprints 1988, 90, 94, 96, 98, 99, 2001, 2002, 2004 (Twice), 2006, 2007, 2008 (Twice), 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 (Twice), 2018 (Twice), 2019 LPSPE 2019 LPSPE 2020 ISBN: 978-93-5283-732-8 Product Code: H5MAC41ECON10ENAT19L Dedicated to My Guru Dr. J.D. Varma with Reverence and Affection PREFACE TO THE TWENTIETH EDITION It is a matter of great pleasure for me to bring out this twentieth edition of the book. The book has been further revised in the light of UGC model Curriculum for M.A., M.Com., MBA, and B.A.(Hons.) Economics and B.Com.(Hons.) classes of Indian Universities. In the present new edition we have made the following changes: 1. In Chapter 1 among the explanation of various schools of thought regarding macro- economic theory, the emergence of New Keynesian Economics has been explained. 2. In Chapter 2, concerning National Income Accounting, the important new concept of Green GNP has been discussed. 3. Chapter 3 concerning the Classical Full-Employment Model has been extensively re- vised and Classical Dichotomy and Neutrality of money have been further elaborated and diagrammatically illustrated. 4. In Chapters 4 and 5 relating to Keynes’s theory of income and employment, the link between money market and goods market has been clearly brought out and graphi- cally illustrated. 5. Chapter 5A is now concerned only with three-sector model of income determination with Government. In this chapter the various fiscal multipliers such as Government Expenditure Multiplier, Tax Multiplier and Balanced Budget Multiplier have been explained and the numerical problems concerning them have been solved. 6. In Chapter 7 Limitations and Relevance of Keynesian Multiplier for developing coun- tries have been explained at length. 7. In Chapter 10, the comparison of Keynesian and Classical theories has been expanded especially the claim of classical economists regarding self-correction by a free market economy when lapses from full employment occur. 8. In Chapter 11, Keynes’s money-wage rigidity model has been critically examined and in this context the importance of Keynes’s effect and Pigou’s real balance effect has been clearly explained. 9. The effectiveness of fiscal and monetary policies with IS-LM model has been extensively discussed in Chapter 12 and in the next chapter inflation-unemployment trade-off as explained by the concept of Phillips curve has been critically examined. 10. In Part 3 dealing with monetary demand and supply, objectives and instruments of monetary policy of the Reserve Bank have been discussed. 11. In Part IV concerning Money, Prices and Inflation, large changes in determination of general level of prices, especially quantity theory of money and Keynes’s integration of money market with goods market, have been discussed. Besides, the explanation of Friedman’s monetarism has been extent and its critical evaluation has been made. 12. Part VI concerning the explanation of government’s budget constraint and resource mobilisation have been explained at length, especially the role of deficit budgeting has been critically examined. 13. In Part VII dealing with open economy macroeconomics we have explained the determination of national income in four-sector model and foreign trade multiplier has been incorporated. Special mention may be made of equilibrium of an open economy with current account deficit, and with import surplus which have been explained at length. 14. In the last part concerning Theories of Economic Growth, the concept of Golden Rule Level of Capital, in the New Classical Growth Theory has been explained. 15. At the end of the last part debate between two eminent Indian economists, Jagdish Bhagwati and Amartya Sen, about economic growth and distribution has been provided so that students should understand the difference in two important approaches to the subject of economic growth and distribution. It is worth noting that we have not only confined ourselves to mere Keynesian Macroeconomics but have also critically examined the post-Keynesian developments in macroeconomics such as monetarism, concepts of aggregate demand and supply with flexible prices (i.e. AD-AS model), synthesis of Classical and Keynesian theories in terms of IS-LM model, cost-push and structurallist theories of inflation, Phillips curve concept visualising trade-off between inflation and unemployment, Post-Keynesian theories of consumption, investment and demand for money, supply-side economics, problem of stagflation, Lucas’ New Classical Rational Expectations Theory and New Keynesian Macroeconomic Theory. In fact, an attempt has been made to incroporate the latest trends and tendencies in macroeconomic analysis and policy. For this purpose some chapters have been re-written and the study of new topics has been included. The new chapters have been added to cover new topics of macroeconomic theory. Since many universities have prescribed the study of the theories of economic growth in their revised syllabi, we have added the new Part VIII in this book which deals with the critical examination of Harrod-Domar Model of Growth, Neoclassical Theory of Growth, New Growth Theory, i.e., Endogenous Growth Model. Lewis Model of Development with Surplus Labour. We have also discussed the relevance of these growth theories for the developing countries like India. Besides, a comprehensive new Chapter 38 analysing International Economic Linkages and Mun- dell-Fleming Model of an Open Economy with Perfect Capital Mobility have been added. The inclusion of this chapter will enhance the understanding of the students of the impact of globalisation on the Indian economy that is currently taking place. An important feature of this book is that it has kept in view the macroeconomic environment of the developing economies, especially the Emerging Indian economy while analysing and discussing various theories and policies of macroeconomics. It has been amazing for me to note that some authors of Textbooks of Macroeconomics, following Dr. V.K.R.V. Rao’s article written in early nineteen fifties are still writing that Keynesian macroeconomic theory, especially the principles of investment multiplier and demand deficiency, are inapplicable to the developing countries like India. This is quite incorrect in the present-day context of the Indian macroeconomic environment. In the last over sixty years of economic development and structural transformation of the Indian economy, many of the concepts and theories of Keynesian macroeconomics have become relevant. Therefore, in this book we have discussed how the Keynesian theories of investment multiplier, demand constraint, investment behaviour of business class, consumption function, demand-pull inflation and Keynes’ rationale for the intervention of Government through adoption of fiscal and monetary policies to revive and stabilise the economy are relevant for developing countries like India. Besides, in the latest editions we have added chapters 45 and 46 in which we analysed the nature of unemployment and development strategies for labour-surplus developing countries. In view of the above changes made, the book will be useful not only for the Honours and Postgraduate Classes of Economics and Commerce but also of professional courses such as MBA, CA, ICWA, Honours in Journalism and Business Economics, Engineering, Banking and of Competitive Examinations such as IAS and Allied Services, IES (Indian Economic Service). I hope the present edition of the book will be of immense use for the students. Suggestions for further improvement of the book from the fellow teachers and students will be heartily welcomed. The author can be approached through e-Mail: [email protected]. 69, Vaishali Dr. H.L. AHUJA Pitampura Delhi—110 088 Disclaimer : While the author of this book have made every effort to avoid any mistake or omission and has used his skill, expertise and knowledge to the best of has capacity to provide accurate and updated information, the author and S. Chand do not give any representation or warranty with respect to the accuracy or completeness of the contents of this publication and are selling this publication on the condition and understanding that they shall not be made liable in any manner whatsoever. S.Chand and the author expressly disclaim all and any liability/responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything and everything forming part of the contents of this publication. S. Chand shall not be responsible for any errors, omissions or damages arising out of the use of the information contained in this publication. Further, the appearance of the personal name, location, place and incidence, if any; in the illustrations used herein is purely coincidental and work of imagination. Thus the same should in no manner be termed as defamatory to any individual. CONTENTS PART I MACROECONOMICS 1. Nature and Scope of Macroeconomics 3 – 19 What is Macroeconomics—The Origin and Roots of Macroeconomics—The Major Issues and Concerns of Macroeconomics: Determination of National Income and Employment; General Price Level and Inflation; Business Cycles; Economic Growth— The Role of Government in the Macroeconomy—Post- Keynesian Developments in Macroeconomics : Monetarism; Supply-Side Economics; New Classical Macroeconomics; Rational Expectations Theory; and New Keynesian Economics —Why a Separate Study of Macroeconomics? — Importance of Macroeconomics — Questions for Review. 2. Circular Flow of Income and National Income Accounting 20 – 52 Meaning of National Income —Circular Flow of Income—National Income and National Product — Concepts of National Income: GDP, GNP, NNP, NNPFC, Personal Income and Personal Disposable Income—Measurement of National Income — Value Added Method—Expenditure Method—Income Method—Diffi- culties in the Measurement of National Income —Difficulties of Measuring National Income in Developing Countries — Nominal GNP and Real GNP —The Concept of Green GDP–Limitations of GNP as a Measure of Social Welfare—Some Numerical Problems of Calculation of National Income —Questions for Review. 3. The Classical Full-Employment Model 53 – 73 Economy in the Long Run : The Full-Employment Model—Classical Theory of Income and Employment : Introductory Analysis—Say’s Law and Classical Theory—Wage-Price Flexibility and Full-Employment—The Classical Theory of Employment and Output(Income) : A Formal Full-employment Classical Model— Determination of Income and Employment without Saving and Investment: Labour Market Equilibrium – Self -correction by a Free Market Economy—Classical Model: Determination of Income and Employment with Saving and Investment—Capital Market Equilibrium : Determination of Interest—Classical Theory of Income and Employment : Aggregate Demand, Money and Prices — Classical Aggregate Supply Curve—Classical Theory of Output and Employment : Complete Model — Neutrality of Money and Classical Dichotomy—Keynes’s Critique of Classical Theory— Price Flexibility and Unemployment—Sticky Wages and Unemploy- ment—Questions for Review Appendix to Chapter 3 : Using Classical Full -Employment Model : 74 – 77 Effect of Changes in Technology and Labour Supply Introduction — Effect of Changes in Technology : Impact on Real Wages; Impact on Output — Effect of Labour Supply on Labour, Product and Capital Markets. 4. Keynes’s Theory of Employment: An Outline 78 – 91 Keynes’s Income-Expendiutre Approach — Keynesian Theory of Employment— Principle of Effective Demand (With Fixed Price Level)—Aggregate Demand Function—Aggregate Supply Function—Determination of the Equilibrium Level of Employment—Effective Demand: Further Clarification—Equilibrium is not necessarily established at Full Employment-Underemployment Equilibrium : The (vii) Problem of Demand Deficiency — Summary of Keynes’s Theory of Employment— Keynes’s Money-Wage Rigidity Model—What Causes Depression and Cyclical Unemployment: Keynes’s View—Monetarist Explanation—Questions for Review. 5. Determination of National Income: Keynes’s Simple Two-Sector Model 92 – 115 Introduction—Aggregate Expenditure —Aggregate Output and 45° Income Line —Determination of the Equilibrium Level of National Income—Principle of Effective Demand—Underemployment Equilibrium—Determination of National Income: Saving-Investment Approach—Equilibrium Level of National Income : Al- gebraic Analysis—National Income and Employment — Anti-recessionary Policy: Shifting Aggregate Expenditure Curve Upward. Relationship between Saving and Investment : Ex-Post Savings and Ex-Post Investment are always equal—Ex-ante saving and investment are equal only in equilibrium—Concepts of Inflationary and Deflationary Gaps — Some Numerical Problems—Questions for Review. Appendix to Chapter 5 : Keynes’s Complete Macroeconomic Model : 116 – 118 Integrating Goods Market with Money Market Linking Goods Market with Money Market — Keynes’s Complete Macroeconomic Model—Policy Implications. 5A. Determination of National Income With Government : Three-Sector Models119 – 141 Introduction — Determination of National Income with Government : Three -Sector Model; Government Expenditure Multiplier — Determination of National Income with Government Expenditure and a Lump Sum Tax : Model 2; Multiplier Effect of Lump Sum Tax and the Level of National Income — Determination of National Income with Lump Sum -Tax and Transfer Payments — Government Expenditure Multiplier and Transfer Payments Multiplier — Proportional Income Tax and Shift in Consumption Function — Three-Sector Model with (Proportional Income Tax) — The Tax Multiplier — Balanced Budget Multiplier — Government Expenditure, Budget Deficit and Capital Market — Numerical Problems — Questions for Review. 5A. Concepts of Inflationary and Deflationary Gaps 142 – 148 Inflationary Gap – Is there a Self-Correcting Mechanism ? – How to Eliminate In- flationary Gap ? – Deflationary Gap – Anti-Deflationary Economic Policy : Shifting Aggregate Expenditure Curve Upward 6. Consumption Function 149 – 169 The Concept of Consumption Function: Average and Marginal Propensity to Consume —Saving Function: Average Propensity to Save and Marginal Propen- sity to Save — Keynes’s Theory of Consumption and Keynes’s Psychological Law of Consumption — Important Features of Keynes’s Consumption Function — Determinants of Propensity to Consume: Objective and Subjective Factors — Life Cycle Theory and Permanent Consumption Theories – Consumption Function Puzzle: Keynes’ Consumption Function and Kuznets’ Findings—Impor- tance of Consumption Function. 7. Post-Keynesian Theories of Consumption 170 – 181 Introduction —Relative Income Theory of Consumption: Demonstration Effect and Ratchet Effect—Life Cycle Theory of Consumption—Permanent Income Theory of Consumption—Long-Run and Short-Run Consumption Function : Conclusion. 8. Investment Demand 182 – 206 Meaning of Investment— Types of Investment : Business Fixed Investment; (viii) Residential Investment; Inventory Investment — Autonomous and Induced In- vestment Determinants of Investment: Marginal Efficiency of Capital—Business Expectations and Economic Fundamentals—Investment Demand Curve— Accelerator Theory of Investment—Neo Classical Theory of Investment: Ex- pected Output and Desired Capital Stock; Rental Cost of Capital; Capital Stock Adjustment; Fiscal and Monetary Policy and Investment – Tobin’s Theory of Investment-Impact of Inflation on Investment – Monetary and Fiscal Policy Meas- ures and Investment. 9. Theory of Multiplier 207 – 224 The Concept of Investment Multiplier—Diagrammatic Representation of Multiplier—Leakages in the Multiplier Process—Importance of the Concept of Multiplier—The Paradox of Thrift—The Keynesian Explanation of the Great Depression: The Impact of Multiplier—Limitations of the Concept of Multiplier for the Developing Countries – The Relevance of Multiplier for Developing Countries: The Modern View — Questions and Problems for Review. Appendix to Chapter 9: Static and Dynamic Mutliplier 225 – 229 Derivation of Static Multiplier—Dynamic Multiplier—Dynamic Multiplier: Continuous Injection Model—Dynamic Multiplier: Single Injection Model. 10. Aggregate Demand - Aggregate Supply Model (With Price Flexibility) 230 – 260 Aggregate Demand Curve (With Price Flexibility)—Derivation of Aggregate Demand Curve—Shift in Aggregate Demand Curve and Multiplier Effect-Multiplier with Changes in Price Level — Three Ranges of Short-Run–Aggregate Supply Curve (With Variable Prices)—Shifts in Aggregate Supply Curve — Long-Run Aggregate Supply Curve; Changes in Long-Run Aggregate Supply Curve— Derivation of Aggregate Supply Curve : The Sticky Wage Model—Changes in Short-Run Aggregate Supply Curve —Shift in Aggregate Supply and Stagfla- tion—Macroeconomic Equilibrium : AS-AD Model – Friedman’s Natural Rate Hypothesis—Economic Fluctuations : AS-AD Model. Appendix to Chapter 10 : Camparison of Keynes’s and Classical Theories 261 – 277 Introduction — Say’s Law of Markets and Full-Employment Equilibrium – Wage-Price Flexibility and Self-Correction by a Free Market Economy — Keynes’s Challenge – Keynes’s Versus Classical Theories of Aggregate Demand, Keynesian View : Unstable Aggregate Demand — The Classical and Keynes- ian Theories of Aggregate Supply — Saving-Investment Relation : Are Saving Automatically Invested? — Classical Dichotomy and Neutrality of Money — Keynes’s Theory : Money Supply Affects Real Variables (That is, Money is Non-Neutral) — Explanation of Depression : Classics vs. Keynes — Explanation of Inflation : Classics Versus Keynes. 11. Unemployment, Full Employment and Wage-Employment Relationship 278 – 294 Introduction—Meaning of Unemployment—Types of Unemployment: Fric- tional Unemployment; Structural Unemployment; Cyclical Unemployment—The Cyclical Unemployment and Labour Market Equilibrium Concept of Full Employment—Wage-Price Flexibility and Employment: Keynes’s View of Involuntary Unemployment—Wage Cut and Employment : Classical View — Keynes’s Critique of Classical View — Wage Flexibility and Employ- ment: Keynes Vs. Pigou — Insider-Outsider Model – Anti-Recessionary Policy to Remove Cyclical Unemployment — Questions for Review. (ix) PART II POST-KEYNESIAN DEVELOPMENTS IN MACROECONOMICS 12. The IS-LM Curve Model 297 – 321 The Goods Market and Money Market: Links between them—Goods Market Equilibrium: The Derivation of the IS Curve : Shift in the IS Curve—Money Market Equilibrium: The LM Curve: The Essential Features — Shift in LM Curve—In- tersection of the IS and LM Curves: The Simultaneous Equilibrium of the Goods Market and Money Market — The Critique of IS-LM Curves Model—Deriving Aggregate Demand Curve with IS-LM Model — Factors Causing a Shift in Ag- gregate Demand Curve—IS-LM Curve Model: Explaining Role of Fiscal and Monetary Policies—The Three Ranges of LM Curve—The Elasticity of LM Curve and the Relative Effectiveness of Monetary and Fiscal Policies — The Classical Case of Zero Interest — Responsiveness of Demand for Money : Full Crowding- Out of Fiscal Stimulus — The Importance of Crowding-Out Effect of Expansionary Fiscal Policy. Appendix to Chapter 12 : IS-LM Model : Algebraic Analysis 322 – 337 The Derivation of IS Curve : Algebraic Method — Numerical Problems of IS Curve: Two-Sector Model — Numerical Problems on IS Curve : Three-Sector Model (with Taxation) — Derivation of LM Curve : Algebraic Analysis — IS-LM Model : Joint Determination of Income and Interest Rate—Numerical Problems on IS-LM Model. 13. Inflation-Unemployment Trade-off : Phillips Curve and Rational Expectations Theory 338 – 351 Inflation and Unemployment—Phillips Curve—Explanation of Phillips Curve—De- mise of Phillips Curve in the USA (1971-91)—Causes of Shifts in Phillips Curve— Natural Rate Hypothesis and Adaptive Expectations : Friedman’s View regarding Phillips Curve—Long-Run Phillips Curve and Adaptive Expectations— Long-Run Philips Curve : Rational Expectations – Relationship between Short-Run Phillips Curve and Long-Run Phillips Curve – Sacrifice Ratio and Policy of Disinflation — Sacrifice Ratio and Rational Expectations. Appendix to Chapter 13 : Derivation of Phillips Curve from Aggregate 352 – 353 Supply Curve Phillips Curve Equation – Derivation of Phillips Curve Equation — Classical Di- chotomy and Short-Run Phillips Curve. 14. Stagflation and Supply-Side Economics 354 – 365 Stagflation—Stagflation and India—Causes of Stagflation : Adverse Supply Shocks —Tax Revenue and Laffer Curve—Inflationary Expectations—End of Stagflation in the USA : 1982-88—Stagflation in India: 1991-94—Supply-Side Economics —Basic Propositions of Supply-Side Economics : Taxation and Labour Supply; Incentives to Save and Invest; The Tax Wedge—Tax Revenue and Laffer Curve —Reaganeco- nomics and Supply-Side Economics: Reduction in Taxes; Reducing the Burden of Government Regulations—A Critical Appraisal of Supply-Side Economics—The Threat of Inflation: Demand-Side Effects of Tax Cuts; Increase in Budget Deficits; Effect on the Distribution of Income— Conclusion. 15. The New Classical Economics : Rational Expectations Model 366 – 379 Introduction — The Keynesian Theory and the New Classical (Lucas) Critique — Lucas Aggregate Supply Function — Aggregate Demand Function — The New Classical (Lucas) Rational Expectations Model — Policy Implications of New Classical Approach : Ineffectiveness of Economic Policy — Unanticipated Changes — Rational Expectations, Monetary and Fiscal Policies — Rational Expectations and Business Cycles — Comparison with New Keynesian Economics — A Critical Evaluation of Rational Expectations Model — Questions for Review. (x) 16. The New Keynesian Economics 380 – 386 Introduction—Some Common Elements of New Keynesian Models—Mankiw’s New Keynesian Model — Mankiw’s New Keynesian Model in Mathematical Form—Price Adjustment and Coordination Failures. PART III MONETARY DEMAND AND SUPPLY 17. Money: Nature, Functions and Role 389 – 404 Definition of Money —Functions of Money—Importance of Money—Paper Money System or Managed Currency Standard — Role of Money in Economic Development : Money Promotes Division of Labour and Productivity —Money Promotes Invest- ment —Money and Inflationary Financing of Economic Development—Money and Forced Savings — Monetisation and Economic Growth. 18. Credit and Commercial Banking 405 – 419 Credit: Meaning and Functions—Purposes or End Uses of Credit—Origin and Evolution of Commercial Banking—Balance Sheet of a Bank: Liabilities and Asset Structure—Functions of Commercial Banks—Role of Commercial Banks in Economic Development— Credit Creation—Limitations on the Credit-Creating Power of the Banks. 19. Central Banking 420 – 429 The Principle of Central Banking — Functions of Central Bank— Methods of Credit Control—Bank Rate Policy—Limitations of Bank Rate Policy—Open Market Operations—Limitations of Open Market Operations—Selective Credit Controls—Moral Suasion. 19A. Objectives and Instruments of Monetary Policy 430 – 440 Introduction — Objectives of Monetary Policy : Price Stability or Control of In- flation; Economic Growth; Exchange Rate Stability — Instruments of Monetary Policy : Bank Rate Policy, Repo Rate in India; Limitations of Bank Rate and Repo Rate Policy — Open Market Operations; Limitations of Open Market Operations – Changes in Cash Reserve Ratio — Selective Credit Controls – Questions for Review. Appendix to Chapter 19A : Role of Monetary Policy in Economic Growth 441 – 452 Monetary Policy and Savings — Monetary Policy and Investment — Availability of Credit — Monetary Policy and Private Investment—Allocation of Investment Funds — Monetary Policy of Reserve Bank of India. 20. Supply of Money and Its Determinants 453 – 469 Introduction: Money Supply and High Powered Money— Four Concepts of Money Supply — Theory of Money Supply—Deposit Multiplier— Money Multiplier— Derivation of Money Multiplier—Factors Determining Money Supply : RBI’s Approach — Growth of Money Supply and Rate of Inflation in Recent Years — Budget Deficit and Money Supply – Money Supply and the Open Economy. 21. Demand for Money and Keynes’s Liquidity Preference Theory of Interest 470 – 487 Introduction— Demand for Money or Motives for Liquidity Preference— Trans- actions Demand for Money— Precautionary Motive— Speculative Demand for Money— Aggregate Demand for Money: Keynes’s View— Demand for Money and Keynesian Liquidity Preference Theory of Interest. (xi) 22. Post-Keynesian Theories of Demand for Money 488 – 495 Tobin’s Portfolio Approach to Demand for Money—Tobin’s Liquidity Preference Function—Baumol’s Inventory Approach to Transactions Demand for Money— Baumol’s Analysis of Transactions Demand for Money—Friedman’s Theory of Demand for Money. PART IV MONEY, PRICES AND INFLATION 23. Money and Prices: Quantity Theory of Money 499 – 509 Value of Money and Price Level—Fisher’s Transactions Approach: Quantity Theory of Money: Fisher’s Equation of Exchange—Income Version of Quan- tity Theory—Quantity Theory of Money: Cambridge Cash-Balance Approach —Critical Evaluation of the Quantity Theory of Money—Keynes’s Critique of Quantity Theory of Money—Factors Other than Money also Effects the Price Level—Conclusion. 24. Keynes’s Monetary Theory : Money, Income and Prices 510 – 520 Introduction – Integrating Money Market with Goods Market— Keynes’s Monetary Theory: The Effect of Money Supply on the Level of Economic Activity – Ineffectiveness of Monetary Policy : Keynes’s View—Keynes’s Theory of Money and Prices—Money Supply, Aggregate Demand and Price Level. Money Supply, Price Level and National Income in the Short Run and Long Run. 25. Monetarism and Friedman’s Restatement of Quantity Theory of Money 521 – 533 Restatement of Quantity Theory of Money—Demand for Money and Quantity Theory of Money—Increase in Money Supply and the Price Level: Friedman’s Analysis—Short-Run and Long-Run Impact of Monetary Expansion — Monet- arism : Its Key Propositions — A Critique of Monetarism. 25A. Monetarism and Keynesianism Compared 534 – 545 Introduction — Two Different Approaches to Aggregate Demand — Growth of Money Supply is the Prime Determinant of Growth in Nominal GNP—Differ- ences Regarding Shape of Aggregate Supply Curve—Velocity of Money : Stable or Unstable — Price-Wage Flexibility and Natural Rate of Unemployment — Role of Monetary Policy — Role of Fiscal Policy — Monetary Policy : Discretion or Rules. 26. Inflation and Hyperinflation: Causes, Effects and Cure 546 – 576 Meaning—Demand-Pull Inflation—Demand-Pull Inflation: Monetarist Version ——Money and Sustained Inflation—Inflationary Expectations — Cost-Push Inflation—Inflation in Developing Countries: Demand-Pull or Cost-Push In- flation—Structuralist Inflation—Inflation and Interest Rate : Fisher Effect — The Cost of Inflation — Effects of Inflation: Inflation Erodes Real Incomes of the People—Anticipated and Unanticipated Inflation—Effect on Distribution of Income and Wealth—Effect on Output and Growth — Measures to Control Inflation – Fiscal Policy : Reducing Fiscal Deficit – Monetary Policy: Squeezing Credit – Limitations of Monetary Policy to Control Appendix to Chapter 26 : Measurement of Inflation and Price Indices 577 – 581 WPI and CPI Measuring Inflation with Price Indices — Consumer Price Index (CPI) — Method of Constructing Consumer Price Index (CPI) — Wholesale Price Index (WPI) — GDP Deflator. (xii) PART V BUSINESS CYCLES AND MACROECONOMIC POLICY 27. Analysis of Business Cycles 585 – 605 Phases of Business Cycles— Features of Business Cycles—Theories of Business Cycles: Sun-Spot Theory; Hawtrey Theory of Business Cycles; Under–Consump- tion Theory—Keynes’s Theory of Business Cycles—Samuelson’s Model of Business Cycles: Interaction Between Multiplier and Accelerator— Hicks’ Theory of Trade Cycles. 27A. Kaldor and Goodwin’s Models of Business Cycles 606 – 614 Introduction — Kaldor’s Model of Business Cycles : Kaldor’s Investment; Function; Kaldor’s Saving Function; Determination of Level of Economic Activity — Stable and Unstable Equilibria — Explanation of Business Cycles — Goodwin’s Model of Business Cycles : Formal Framework of Goodwin’s Model; Explaining Business Cycles—Growth and Cycles— Evaluation. 27B. Monetarist and New Classical (Rational Expectations) Theories 615 – 622 of Business Cycles Friedman’s Monetarist Theory of Business Cycles : Explaining Recession; Explain- ing Expansion – Importance of Lags – Critical Evaluation – Lucas’ New Classical Theory of Business Cycles : Introduction; Rational Expectations : Explaining Recession – Rational Expectations : Explaining Expansion – Critical Evaluation. 27C. Real Business Cycle Theory 623– 626 Introduction: Real Business Cycle Theory – Real GDP and Price Level – Has Money any Role in Business Cycle Theory – Critique of Real Business Cycle Theory. 28. Economic Stabilisation: Fiscal Policy 627 – 637 Macroeconomic Policy and Stabilisation: Introduction— Goals of Macroeconomic Policy—Discretionary Fiscal Policy for Stabilisation—Financing Increases in Government Expenditure or Budget Deficit—Reduction in Taxes to Overcome Recession—Policy Option: Increase in Government Expenditure or Reduc- tion in Taxes—Fiscal Policy to Control Inflation—Disposing of Budget Surplus —Non-Discretionary Fiscal Policy: Automatic Stabilisers—Crowding-Out Effect and Effectiveness of Fiscal Policy. 29. Economic Stabilisation: Monetary Policy 638 – 647 Introduction—Tools of Monetary Policy—Expansionary Monetary Policy to Cure Recession— How Expansionary Monetary Policy Works : Keynesian View — Monetary Policy to Control Inflation—How the Tight Monetary Policy Works —Liquidity Trap and Effectiveness of Monetary Policy—Monetary Policy : Monetarist View—Monetary Role: Monetary Policy Prescription. PART VI GOVERNMENT AND THE MACROECONOMY : GOVERNMENT’S BUDGET CONSTRAINT AND FISCAL POLICY 30. Government in the Macroeconomy: Public Expenditure 651 – 661 The Concept of Functional Finance—Public Expenditure—Increasing Importance of Public Expenditure—Types of Public Expenditure—Growth of Public Ex- penditure—Effects of Public Expenditure on Production and Distribution: Public (xiii) Expenditure and Production; Public Expenditure and Distribution—Questions for Review. 31. Financing of Government Expenditure : Taxation 662 – 677 Government Budget Constraint—What is a Tax—Classification of Taxes : Direct and Indirect Taxes —Specific and Ad Valorem Taxes—Progressive and Proportional Taxes —Principles or Canons of Good Tax System—Principles of Equity in Taxation— Benefits Received Theory—Ability to Pay Theory — Conclusion — Direct Taxes Vs. Indirect Taxes—Inefficient Resource Allocation under Indirect Taxes — Ques- tions for Review. 32. Role of Fiscal Policy and Taxation in Resource Mobilisation for Economic Growth 678 – 684 Introduction – Objectives of Fiscal Policy in Developing Countries—Role of Fis- cal Policy for Mobilisation of Resources for Economic Growth— Taxation and Mobilisation of Resources for Growth — Direct Taxes for Resource Mobilisation for Growth — Role of Indirect Taxes in Resource Mobilisation – Role of Taxation in Promoting Private Savings and Investment. 33. Government Borrowing or Debt-Financing of Budget Deficit 685 – 693 The Government Budget Constraint : Borrowing or Debt Financing of Budget Deficit : Wealth Effect — Budget Deficit and Growth of Money — Debt Financing of Budget Deficit : The View of Ricardian Equivalence – Robert Barro and Ricardian Equivalence – Debt-Financing of Budget Deficit : The Case of India. 33A. Government Budget Constraint: Money Financing of Budget Deficit 694 – 700 Government Budget Constraint—Budget Deficit and Growth of Money Supply— Money Financing of Budget Deficit – Printed Money and Inflation Tax – Inflation Tax Revenue – Evaluation of Inflation Tax Revenue – Money Financing of Budget Deficit: Case of India. Appendix to Chapter 33A. India’s Fiscal Deficit and Economic Growth 701 – 714 Introduction — Revenue Deficit—Fiscal Deficit—Primary Deficit—Monetisa- tion of Fiscal Deficit—Measures to Reduce Fiscal Deficit—Fiscal Deficit and Economic Growth – Fiscal Consolidation. PART VII OPEN ECONOMY MACROECONOMICS 34. Balance of Payments 717 – 734 Balance of Trade and Balance of Payments—Balance of Payments on Current Account—Balance of Payments on Capital Account—Distinction between Current Account and Capital Account —Determination of Balance of Payments — Does Balance of Payments always Balance— Globalisation, Capital Flows and Balance Payments—Equilibrium in the Balance of Payments—Causes of Disequilibrium in the Balance of Payments—How Disequilibrium can be Corrected ? 34A. The Monetary Approach to the Balance of Payments 735 – 743 Introduction — Monetary Approach : Automatic Adjustments – Monetary Approach : Adjustments with a Fixed Exchange Rate – Evaluation of Monetary Approach – Monetary Approach under Flexible Exchange Rate — Effect of Monetary Expansion — Exchange Rate Overshooting. 35. Foreign Exchange Rate 744– 776 Foreign Exchange and Foreign Exchange Market—Floating vs. Fixed Exchange Rate System—Appreciation and Depreciation of Currencies—Managed Float System in India – Some Important Foreign Exchange Rate Concepts—Deter- (xiv) mination of Exchange Rate—Changes in Exchange Rate—Foreign Exchange Rate and Balance of Payments—Factors Affecting Exchange Rate—Purchasing Power Parity Theory— Effects of Changes in Exchange Rate (Depreciation or Devaluation) on the Economy—Devaluation and Balance of Trade: The J-Curve Concept—Fixed Exchange Rate and Bretton Woods System —Demise of Bretton Woods System—Fixed and Flexible Exchange Rates—Currency Convertibility — Questions for Review. 36. Determination of National Income in an Open Economy and Foreign Trade Multiplier 777 – 792 Introduction – Foreign Trade and National Income in an Open Economy – The Import Function—Foreign Trade Multiplier in an Open Economy—Graphic Representa- tion of Foreign Trade Multiplier—How the Foreign Trade Multiplier Works?— The Foreign Trade Multiplier with both Exports and Imports—Open Economy Equilibrium: Exports-Imports – Open Economy Equilibrium with Import-Surplus Increase in Imports: The Reverse Working of Foreign Trade Multiplier—Trade Balance (Net Exports) and Foreign Capital Flows – Equilibrium of the Open Economy : IS – LM Curves Model without Capital Flows–Impact of Increase in Net Exports (NX) – Effect of Depreciation of Exchange Rate — Questions for Review. 37. Free Trade Versus Protection 793 – 801 Introduction—Case for Free Trade : Gain in Output and Well-being from Specialisation; Gains from Economies of Scale; Long-Run Dynamic Gains; Free Trade Promotes Competition and Prevents Monopoly; Political Gains from Free Trade — Case for Protection : Nationalism; Employment Argument; Anti-Dumping Argument; Correcting Balance of Payments —Trade Barriers : Tariffs and Import Quotas— Effects of Tariff—Effects of Quotas—Questions for Review. 38. International Linkages and Mundell-Fleming Model 802 – 816 International Linkages : Flows of Trade and Capital National Income and Trade —Saving, Investment and International Flows of Goods and Capital—Goods Market and IS Curve in the Open Economy — Macroeconomic Equilibrium in the Open Economy : IS-LM Model — The Mundell-Fleming Model — Mundell- Fleming Model of Small Open Economy with a Fixed Exchange Rate Regime — Mundell–Fleming Model of a Small Open Economy with a Variable Exchange Rate System, — Asset Markets and Exchange Rate Expectations. 38A. Globalisation, Commercial Policy and WTO 817 – 834 Introduction : Meaning of Globalisation—Case for Globalisation of Indian Economy — Dangers and Risks of Globalisation – Volatility in Exchange Rate and Economic Instability — Measures Adopted in India to Promote Globalisation — Consequences of Globalisation for India — Global Commercial Policy – Effects of Trade Agreements : Trade Creation and Trade Diversion – GATT and WTO. Deadlock in Negotiations at Geneva Regarding Trade Facilitation Agreements. Appendix to Chapter 38A. Global Financial Crisis 2007-09 835 – 846 Sub-Prime Housing Bubble – Failure of Free Market Economy – Crash in Stock Market – Adverse Effect on Flow of Credit, Investment and How Crisis Spread to Europe and other Countries – Impact of Global Financial Crisis on India : Stock Market Crash, Depreciation of Indian Rupee, Liquidity Crunch in the Banking System – Impact on Indian Economic Growth and Balance of Payments – Indian Response to the Financial Crisis — Recovery of the Indian Economy —Exports and Foreign Investment — Eurozone Crisis and its Impact. (xv) PART VIII THEORIES OF ECONOMIC GROWTH 39. Economic Growth and its Determinants 849 – 862 Meaning of Economic Growth — Meaning of Economic Development : Tra- ditional View — The Concept of Economic Development : The Modern View — Factors Determining Economic Growth : Capital Formation; Foreign; Capital; Foreign Aid and Foreign Investment—Human Capital : Education and Health; — Technological Progress and Economic Growth — Human Capital Education and Economic Growth —The Growth of Population — Capital-Output Ratio. 40. Harrod-Domar Model of Growth 863 – 874 Dual Effect of Investment : Income Effect and Capacity Effect—Domar’s Growth Model: The Condition for Equilibrium—Harrod’s Growth Model—Warranted Rate of Growth; The Condition for Equilibrium Growth Rate; The Natural Rate of Growth; The Golden Age—The Relevance of Harrod-Domar Growth Model for Developing Countries. 41. Neoclassical Theory of Growth 875 – 889 Introduction — Neoclassical Growth Theory : Production and Saving—Neoclassical Growth Theory : Fundamental Growth Equation-the Growth Process—Impact of Increase in the Saving Rate—Effect of Population Growth — Long-run Growth and Technological Change—Golden Rule Level of Capital – Conclusion: Key Results of Neoclassical Model — Sources of Economic Growth — Knowledge or Education: the Missing Factor : Economies of Scale and Economic Growth. 42. New Theory of Growth (Endogenous Growth Model) 890 – 894 Introduction — Endogenenous Growth Model — Investment in Human Capital and Learning by Doing — Policy Implications of New Growth Theory. 43. Theory of Development with Surplus Labour : Lewis Model 895 – 900 Lewis Model of Development with Surplus Labour – Profit as the Main Source of Capital Formation – A Critique of Lewis Model 44. Limitations and Relevance of Keynesian Economics to Developing 901 – 908 Countries Traditional View : Limitations and Irrelevance of Keynesian Economics : The Demand Deficiency Problem; Keynes’s Policy Prescriptions are not relevant; Keynes- ian Multiplier is Inapplicable to Developing Countries—Modern View: Relevance of Keynesian Economics in Some Important Respects for Developing Countries — Problem of Deficiency of Effective Demand—Investment Behaviour in Develop- ing Countries—Portfolio Choice by Investors—Keynes’s Consumption Function — Keynesian Multiplier and the Present-day Developing Countries—Questions for Review. 45. Nature of Unemployment in Labour Surplus Developing Countries 909 – 919 Basic Explanation : Lack of Capital Stock Relative to Labour Force–-Lack of Wage Goods and Unemployment in Developing Countries — Use of Capital-Intensive Technology— The Concept of Disguised Unemployment—Prof. Amartya Sen’s Analysis of Disguised Unemployment. 46. Development Strategies for Labour-Surplus Developing Countries 920– 931 Industrialisation-Led Strategy of Development; Wage-Goods Strategy of Develop- ment ; Employment Strategy : Using Labour-Intensive Technology; Rural Public Works for Employment Generation. 47. Sen Vs. Bhagwati: Debate on Growth and Distribution 932– 936 Bhagwati’s Approach – Evaluation of Bhagwati’s Approach – Prof. Amartya Sen on Growth, Poverty and Distribution – Evaluation. (xvi) PART I MACROECONOMICS : THEORY OF INCOME AND EMPLOYMENT  Nature and Scope of Macroeconomics  Circular Flow of Income and National Income Accounting  Classical Full Employment Model  Keynes’s Theory of Employment  Determination of National Income : Two-Sector Simple Keynesian Model  Consumption Function  Theory of Investment Multiplier  Investment Demand  Aggregate Demand - Aggregate Supply Model (with Price Flexibility)  Unemployment, Full Employment and Wage-Price Flexibility Final \\sathya\\Macroeconomic Theory & Policy This Page has been intentionally left blank Chapter 1 Nature and Scope of Macroeconomics In the first volume of this book we have studied microeconomics which is concerned with the behaviour of individual consumers, factor owners, firms and individual industries and markets. It is through their interaction that microeconomic theory explains how prices of products and factors are determined and how resources are allocated between various products. In microeconomic theory it is assumed that full employment of resources such as labour and capital prevails and analyses how they are allocated among different products. Further, it explains whether resource allocation achieved is economically efficient. In this second volume we will study macroeconomic theory and its applications to the formulation of economic policies. In this chapter we shall briefly explain what macroeconomics is about and why the British economist J.M. Keynes laid stress on macroeconomic analysis as a separate study from microeconomic analysis. Besides, we shall explain the various issues that are studied in macroeconomics. In the end we shall briefly explain the various post-Keynesian developments in macroeconomics. We shall also discuss the importance of the study of macroeconomics. What is Macroeconomics? Whereas microeconomics deals with the analysis of small individual units of an economy such as individual consumers, individual firms, individual industries and markets and explains how prices of products and factors are determined. On the basis of these prices microeconomics explains how resources are allocated among various products and how income distribution among factors is determined. On the other hand, macroeconomics is concerned with the analysis of the behaviour of the economic system in totality. Thus, macroeconomics studies how the large aggregates such as total employment, national product or national income of an economy and the general price level are determined. Macroeconomics is therefore a study of aggregates. Besides, macroeconomics explains how the productive capacity and national income of the country increase over time in the long run. Professor Gardner Ackley makes the distinction between macroeconomics and microeconomics more clearly when he says, “Macroeconomics concerns itself with such variables as the aggregate volume of the output of an economy, with the extent to which its resources are employed, with the size of the national income, with the ‘general price level’. Microeconomics, on the other hand, deals with the division of total output among industries, products and firms and the allocation of resources among competing uses. It considers problem of income distribution. Its interest is in relative prices of particular goods and services.”1 It is evident from above that the subject matter of macroeconomics is to explain what determines the level of total economic activity (that is, the size of the national income and employment) and 1. Gardner Ackley, Macroeconomic Theory, 1961, p. 4. 3 4 Macroeconomics : Theory and Policy fluctuations (i.e., ups and downs) in it in the short run. It also explains what causes the general price level to rise and determines the rate of inflation in the economy. Besides, modern macroeconomics analyses those factors which determine the increase in productive capacity and national income in the long run. The problem of increasing productive capacity and national income over time in the long run is called the problem of economic growth. Thus, what determines rate of growth of an economy is also the concern of macroeconomics. Thus, why is national income higher today than it was in 1950? Why does rate of unemployment in a free market economy go up in a period and fall in another period? Why do some countries have high rates of inflation, while others maintain price stability? What causes alternating periods of depression and boom (generally described as business cycles)? Why should government intervene in the economy and what policy should it adopt to check inflation, control business cycles, raise level of national income, reduce unemployment and restore equilibrium in the balance of payments are some of the important questions which macroeconomics seeks to answer. The Origin and Roots of Macroeconomics The Great Depression. Beginning in late 1929, capitalist economies of the world experienced a severe depression which created a lot of involuntary unemployment and also a sharp fall in their GDP. This depression was caused by drastic decline in private investment. For example, in the United States in 1929, 1.5 million workers were unemployed. After four years in 1933 this unemployment of labour rose to 13 million people out of labour force of 51 million, that is, around 25 per cent of labour force became unemployed. The similar situation prevailed in Britain and other capitalist countries. This depression spurred a great deal of controversy among economists about the causes of this depression and the policies to overcome it and restore full employment. It was at this time that a noted British economist, J.M. Keynes (1883-1946), challenged the view of classical economists who applied microeconomic models to explain depression and involuntary unemployment. By emphasising that the prevailing depression and large-scale involuntary unemployment was due to lack of aggregate effective demand resulting from a fall in private investment he laid the foundation of modern macroeconomics. In his theory he showed that a free market economy was not self-correcting and therefore there was a need for the government to intervene and take appropriate fiscal measures to restore full employment in the economy. The Classical Economists and Say’s Law of Markets Classical and neoclassical economists2 assumed that full employment of labour and other resources always prevailed in the economy and concentrated mainly upon explaining how the resources were allocated to the production of various goods and services and how the relative prices of products and factors were determined. It is mainly because of their full-employment assumption that they concentrated on the problem of determination of prices, outputs and resource employment in the individual industries. They believed that if there were departures from full employment, a free market economy would automatically work in a way that would restore full employment of resources. They argued that involuntary unemployment and underutilisation of the productive capacity could not occur in capitalist economies if market mechanism were allowed to work freely without any interference by the trade unions. Thus, according to them, even when deficiency of aggregate demand arises as it happens during the times of recession or depression, prices and wages would quickly change in such a way that employment, output and national income would not decline. The belief of classical economists that full employment of labour and capital stock will always exist was based on Say’s Law of Markets. According to Say’s Law, supply creates its own demand and, therefore, the problem of lack of demand for supply of goods and services does not arise. Factors which produce goods 2. Note that Keynes called all those economists who preceded him as classical economists. Thus, neoclassi- cal economists are included in the term classical economists as used by Keynes. Nature and Scope of Macroeconomics 5 and services for supply in the market get rewards (wages, interest and rent) for their contributions to the production of goods and services produced. Thus, incomes earned by them become expenditure made on goods and services. Therefore, the problem of deficiency of demand does not arise. They thus could not provide adequate explanation of the occurrence of huge unemployment that prevailed during depression of 1930s in the capitalist economies. What is worse, the classical economists, particularly A.C. Pigou, tried to apply the economic laws that hold good in the case of an individual industry to the case of the behaviour of the whole economic system and macroeconomic variables. Keynesian Revolution. However, the classical model was not found to be true as the depression appeared to be not self-correcting. During the Great Depression of 1930s unemployed remained at a high level for nearly 10 years. At that time, an eminent British economist, A.C. Pigou, asserted that involuntary unemployment existing at the time of depression in the 1930s was due to the obstacles put up by trade unions and government and further that this involuntary unemployment could be eliminated and employment expanded by cutting down the wages. A noted British economist, J.M. Keynes, challenged this classical viewpoint during the early nineteen thirties when severe depression took place in the capitalist countries such as Britain and the U.S.A. While the cut in wages may expand employment in an individual industry, the reduction in wages throughout the economy will result in fall in incomes of the working classes and is likely to cause decrease in the level of aggregate demand. The fall in aggregate demand will tend to lower the level of employment rather than expand it. Though there were pre-Keynesian theories of business cycles and the general price level that were “macro” in nature, but it was J.M. Keynes, an eminent British economist, who laid stress on macroeconomic analysis and put forward a general theory of income and employment in his revolutionary book, A General Theory of Employment, Interest and Money, published in 1936. Keynes’s theory made a genuine break from the classical and neo-classical economics and produced such a fundamental and drastic change in economic thinking that his macroeconomic analysis has earned the names Keynesian Revolution and New Economics. Keynes in his analysis made a frontal attack on the classical Say’s Law of Markets which was the basis of full-employment assumption of classical view that involuntary unemployment could not prevail in a free private enterprise economy. He showed how the equilibrium level of national income and employment was determined by aggregate demand and aggregate supply and further that due to lack of aggregate effective demand equilibrium level of income and employment might well be established at far less than full-employment level in a free-market capitalist economy. This causes involuntary unemployment of labour on the one hand and excess productive capacity (i.e. underutilisation of the existing capital stock) on the other. His macroeconomic model reveals how consumption function, investment function, liquidity preference function, conceived in aggregate terms, interact to determine the level of national income and employment. Further, the fall in employment in the Great Depression of 1930s and emergence of huge unemployment of labour which in some countries went up to 25 per cent of labour force gives unmistakable evidence that aggregate demand is not always large enough to ensure full employment of labour and full use of productive capacity. After Keynes, there have been significant developments in macroeconomics. Apart from what determines the level of employment of labour and use of productive capacity, modern macroeconomics is concerned with many more issues such as the problems of inflation, economic growth, business cycles, stagflation and the balance of payments and the exchange rate. The analysis of these six major issues describes the scope of macroeconomics. We shall be explaining all these six issues of macroeconomics in detail in later chapters. Here we shall explain only briefly what these problems are. THE MAJOR ISSUES AND CONCERNS OF MACROECONOMICS As explained above, Keynes in his book, Theory of Employment, Interest and Money, explained how levels of income and employment were determined in a free market economy. During the 6 Macroeconomics : Theory and Policy Second World War period, he extended his macro-theory to explain inflation. However, after Keynes, economists have further developed and extended macroeconomics. We briefly explain below the main issues of macroeconomics. The Problem of Unemployment. The first major issue in macroeconomics is to explain what determines the level of employment and national income in an economy and therefore what causes involuntary unemployment. Why is level of national income and employment very low in times of depression as in 1930s in various capitalist countries of the world. This will explain the cause of huge unemployment that emerged in these countries. As mentioned above, classical economists denied that there could be involuntary unemployment of labour and other resources for a long time. They thought that with changes in wages and prices, unemployment would be automatically removed and full employment established. But this did not appear to be so at the time of depression in the thirties and after. Keynes explained that level of employment and national income is determined by aggregate demand and aggregate supply. With aggregate supply curve remaining unchanged in the short run, it is the deficiency of aggregate demand that causes underemployment equilibrium with the appearance of involuntary unemployment. According to him, it is the changes in private investment that causes fluctuations in aggregate demand and is, therefore, responsible for the problems of cyclical unemployment. We will explain Keynes’s theory of employment and income and its various aspects in detail in the subsequent chapters. Recession and Determination of National Income (or GNP). National income is the value of all final goods and services produced in a country in a year. Level of national income or what is called Gross National Product (GNP) shows the performance of the economy in a year and determines the overall living standards of the people of a country. The higher the per capita national income, the greater the amounts of goods and services available for consumption per individual on an average. Recession in the economy not only results in involuntary unemployed but also falls in the actual level of national income below the potential level. Given the technology used for production, the magnitude of employment goes hand-in-hand with the change in size of national income. The fluctuations in economic activity primarily manifest themselves in changes in national income and employment. In a free market economy, the changes in aggregate demand cause divergence of national income from the level of potential GNP in the short run. It is important to note that in a developing country such as India it is not a mere level of aggregate demand that determines national income. In it the supply-side factors such as availability of physical capital, human capital (skills and education of people), material resources, the technology used for production in agriculture and industries play a more important role in the determination of national income. Problem of Inflation. Another macroeconomic issue is to explain the problem of inflation. Inflation has been a major problem faced by both the developed and developing countries in the last fifty years. Classical economists thought that it was the quantity of money in the economy that determined the general price level in the economy and, according to them, rate of inflation depended on the growth of money supply in the economy. Keynes criticised the `Quantity Theory of Money’ and showed that expansion in money supply did not always lead to inflation or rise in price level. Keynes who before the Second World War explained that involuntary unemployment and depression were due to the deficiency of aggregate demand, during the war period when prices rose very high he explained in a booklet, How to Pay for War, that just as unemployment and depression were caused by the deficiency of aggregate demand, inflation was due to the excessive aggregate demand. Thus, Keynes put forward what is now called demand-pull theory of inflation. After Keynes, theory of inflation has been further developed and many theories of inflation depending upon various causes have been put forward. Cost-push and structuralist theories of inflation have been put forward. To analyse the problem of inflation is an important issue of macroeconomics. Nature and Scope of Macroeconomics 7 Business Cycles. Throughout history market economies have experienced what are called business cycles. Business cycles refer to fluctuations in output and employment with alternating periods of boom and recession. In boom periods both output and employment are at high levels, whereas in recession periods both output and employment fall and as a consequence large unemployment come to exist in the economy. When these recessions are extremely severe, they are called depressions. What are the causes of these business cycles or ups and downs in market economies is an important macroeconomic issue which has been highly controversial. The objective of macroeconomic policy is to achieve economic stability with equilibrium at full employment level of output and income. We shall discuss various theories of business cycles and also monetary and fiscal policies to control business cycles and achieve economic stability. Stagflation. How to control business cycles and achieve economic stability has been a very difficult problem for the economies to solve. But during the decade of 1970s and in some later times in the subsequent decades market economies have experienced a still more intricate problem which has been described as stagflation. While in business cycles, recession or depression is accompanied by high unemployment and falling prices, in the seventies recession or stagnation was accompanied by not only high unemployment but also rapid inflation. Since in that period high unemployment and recession (or stagnation) co-existed with high inflation, this problem was given the name stagflation. This stagflation could not be explained with the Keynesian theory which focuses on the demand side. Therefore, a new economic thought which is called Supply-side Economics emerged which explained stagflation by laying stress on the supply side of economic activity. It may be noted that in the context of developing countries such as India, the term ‘stagflation’ is used in the sense of slowdown in economic growth along with high rate of inflation in the economy. Stagflation is an important issue of modern macroeconomics. Stagflation along with supply-side economics will be explained at length in a later chapter. Economic Growth. Another important issue in macroeconomics is to explain what determines economic growth in a country. Economic growth means sustained increase in national income (GNP) or per capita income over a sufficiently long period of time. Given the availability of natural resources, economic growth of a country depends on the growth of physical capital, human capital and progress in technology. The growth of all these factors requires saving and investment. The growth rate can therefore the stepped up by raising the rates of saving and investment. However, the expansion in these factors determines the increase in productive capacity. To ensure full use of the rising productive capacity aggregate to demand for output must be increasing sufficiently. Theory of economic growth or what is simply called growth economics which has been recently developed a good deal is an important branch of macroeconomics. The problem of growth is a long- run problem and Keynes did not deal with it. In fact, Keynes is said to have once remarked that “in the long run we are all dead”. From this remark of Keynes it should not be understood that he thought long run to be quite unimportant. By this remark he simply emphasized the importance of short- run problem of fluctuations in the level of economic acitivity (involuntary cyclical unemployment, depression). It was Harrod3 and Domar4 who extended the Keynesian analysis to the long-run problem of growth with stability. They laid stress on the dual role of investment—one of income-generating, which Keynes considered, and the second of capacity-creating which Keynes ignored because of his preoccupation with the short run. In view of the fact that an investment adds to the productive capacity (i.e., capital stock), then if growth with stability (i.e., without stagnation or inflation) is to be achieved, income or demand must be increasing at a rate large enough to ensure the full utilisation of the increasing capacity. Thus, macroeconomic models of Harrod and Domar have explained the rate of growth of income that must take place if the steady growth of the economy is to be achieved. These 3. R.F. Harrod, Towards a Dynamic Economics (1948). 4. E.D. Domar, “Expansion and Employment”, American Economic Review (March 1947). 8 Macroeconomics : Theory and Policy days growth economics has been further developed and extended a good deal and new theories of growth have been put forward by Solow, Meade, Kaldor and Joan Robinson and recently by Romer. It is important to note that in the context of developing countries, economic growth has been distinguished from economic development. Economic development is a more inclusive concept than economic growth. Economic development is generally understood to mean that apart from increase in national income or per capita income poverty, unemployment and inequality must also be declining in the growth process. Besides, according to Amartya Sen, winner of Nobel Prize in economics, freedom to improve the quality of life of the poor, their freedom from undernourishment, freedom from illiteracy, freedom from illness are essential requirements of economic development. It is the building up capabilities of the poor and enlargement of the opportunities to gain freedom in these respects that Amartya Sen calls development5. The macroeconomics for developing countries must therefore concern itself with not only economic growth but also economic development. Since the above growth theories apply particularly to the present-day developed economies, special theories which explain the causes of underdevelopment and poverty in less developed countries (LDCs) and which also suggest strategies for initiating and accelerating growth in them have also been propounded. These special growth theories relating to less developed countries (LDCs) are generally known as Economics of Development. We shall discuss some theories of development such as balanced growth theory of Nurkse, unbalanced growth theory of Hirschman, ‘theory of economic development with unlimited supplies of labour’ of Arthur Lewis in this book. Balance of Payments and Exchange Rate. Balance of payments is the record of economic transactions of the residents of a country with the rest of the world during a period. The aim to prepare such a record is to present an account of all receipts on account of goods exported, services rendered and capital received by the residents of a country and the payments made for goods imported, services received and capital transferred to other countries by residents of a country. There may be deficit or surplus in balance of payments. Both create problems for an economy. An important effect is that the transactions in balance of payment are influenced by the exchange rate. The exchange rate is the rate at which a country’s currency is exchanged for foreign currencies. The instability in exchange rate has been a major problem in recent years which has given rise to serious balance of payments problems. During the 12 years period (1901-2002), Indian rupee depreciated to a large extent in terms of US dollar giving rise to serious problems. During the two years 1997 and 1998, currencies of many South-East Asian countries and Japan rapidly depreciated in terms of US dollar. This creates the situation of economic crisis which needs to be overcome. In view of greater integration of the Indian economy with the world economy our foreign exchange rate has become greatly volatile as it is now freely determined by demand for and supply of it and of other currencies such as US dollar, Euro etc. For example, from May 2013, India’s demand for US dollars increased due to large deficit on our current account balance on the one hand and outflow of capital (mainly US dollars) started in large quantity. This outflow of capital from India from May 2013 started occurring as a result of the announcement by the US Federal Reserve System to unwind its unconventional policy of quantitative easing through which it was pumping US dollars in the market by buying bonds from the market, keeping rate of interest near zero. Thus, due to increase in demand for US dollar due large deficit on current account on the one hand and outflow of capital (US dollars) from India due to unwinding of quantitative policy by the US Federal Reserve Indian rupee started depreciating sharply so much so that its value fell to ` 68.85 to a US dollar on August 28, 2013. RBI took several steps (including sale of US dollars in the market from its foreign exchange reserves) to arrest the fall in the value of rupee. As a result of these steps rupee gained again and its value remained in the range of ` 63 to ` 61.5 to a US dollar from Oct. 2013 to March 2014. From April 2014 as a result of hope of a stable government at the Centre in April-May 2014 elections, there has been inflow of capital on a large scale 5. Amartya Sen, Development as Freedom, Oxford University Press, 2000. Nature and Scope of Macroeconomics 9 with the revival of investor confidence. Due to these inflows of capital on the one hand and drastic reduction in current account deficit for the year 2013-14, the Indian rupee has appreciated and its value at present (July 2014) is hovering around ` 59 to a US dollar. Both interrelated problems of balance of payments and instability of foreign exchange rate will be analysed in a separate part of this book. THE ROLE OF GOVERNMENT IN THE MACROECONOMY In modern macroeconomics, the intervention by the government to influence economic activity is well recognised. It is now widely believed that instability is inherent in a free-market economy and further that there is no any self-correcting mechanism to ensure stability at full employment level and sustained economic growth. There are three types of economic policy that are used by the government to influence the working of macroeconomy: 1. Fiscal Policy 2. Monetary Policy 3. Supply-Side Policies We will discuss these three policy instruments in detail in the subsequent chapters. However, we briefly explain them below and indicate what they are concerned with. Fiscal Policy. An important way the government affects the economy is through the adoption of appropriate fiscal policy. The fiscal policy refers to taxation and expenditure decisions of the government. Before Keynes it was believed that the government budget should preferabily be balanced, that is, revenue collected through taxes should be equal to the expenditure made by the government. Keynes showed that balanced budget is not good under all circumstances. He advocated that at times of depression, deficit budget should be made to get the economy out of it and to eliminate involuntary unemployment. In case of deficit budget the government expenditure exceeds revenue collected through taxes. The budget deficit arises when the government increases its expenditure without raising taxes or it arises when taxes are reduced without cutting back an expenditure. Therefore, the policy of budget deficit represents expansionary fiscal policy. The budget deficit raises aggregate demand and leads to the increase in national income and employment. To meet the budget deficit, the government borrows from the banks and the public and pays interest to them. This raises debt burden of the government. The borrowing by the government increases the demand for loanable funds and leads to rise in rate of interest. The higher interest rate discourages private investment. It is therefore claimed that government borrowing to finance budget deficit crowds out some private investment so that net effect of budget deficit on expansion in output and employment is small. We will explain in detail in a subsequent chapter how far this crowding-out effect is significant. However, to avoid borrowing and rise in public debt, the alternative way to finance the budget deficit is printing of money by the government. The danger of financing budget deficit through printing of money is that it may lead to inflation in the economy. The implications of different ways of financing budget deficit will be discussed in detail in a later chapter. On the contrary, when there is high inflation in the economy the government can check it by reducing its expenditure or raising taxes and in this way make a surplus budget. This will tend to reduce aggregate demand which will help in controlling inflation. Thus fiscal policy is an important instrument used by the government to change the level of aggregate demand and thereby affect income, employment and prices. Monetary Policy Monetary policy is another important instrument which the government (or Central Bank of the country) uses to achieve the objectives of price stability, full employment and economic growth. 10 Macroeconomics : Theory and Policy Monetary policy refers to the policies regarding growth of money supply, availability of credit and interest or cost of credit. Monetary policy is an important tool of controlling inflation in the economy. It is generally believed that large expansion in money supply causes rise in price level. To check inflation tight monetary policy is adopted wherein rate of interest is raised and availability of credit is reduced. When interest rate rises, businessmen and households find it more costly to borrow. This discourages demand for credit and leads to the contraction of money supply in the economy. Besides, to discourage the creation of excess credit by the banks for investment and consumption purposes, cash reserve ratio is raised or Government bonds and securities are sold to the banks and the public. The decrease in credit for investment and consumption will cause decline in aggregate demand which will exert downward pressure on prices. On the contrary to get the economy out of recession expansionary monetary policy is adopted. The increase in money supply lowers the rate of interest. The credit from banks becomes cheaper which encourages investment. At lower interest rate households also tend to borrow more for consumption. As a result, aggregate demand in the economy increases which raises levels of output and employment. However, it may be noted that Keynes was not optimistic about the efficacy of monetary policy to tackle the problem of depression and unemployment. He argued that demand for money at the time of depression is highly interest-elastic and therefore expansion in money supply will not lead to lowering of interest rate significantly. Besides, according to him, investment demand is not much interest-elastic so that even smaller interest rate will not stimulate investment. In a developing country such as India the right monetary policy can play a useful role for achieving the objectives of higher economic growth with price stability. For example, in India the Reserve Bank of India ensures that while genuine demand for credit for investment by firms must be met, the excessive growth in money supply and credit be avoided. The Reserve Bank of India has been often adjusting its monetary policy to suit the changing economic situation. Supply-Side Policies Many economists doubt the efficacy of fiscal and monetary policies to eliminate the fluctuations in the economic activity through demand management (that is, influencing the level of aggregate demand). A school of economic thought known as supply-side economics argues that focus of government policy should shift from demand management to stimulation of aggregate supply of output. For example, in the seventies when the USA and Britain experienced the problem of stagflation, some economists suggested that instead of demand management the government should reduce taxes to increase the incentives to work, save and invest more. More labour supply and more investment will increase the supply of goods and services. As a result, price level will fall and at the same time output will rise. The policies to reduce inflation through expansion in supply of output are generally described as supply-side policies. Besides, for promotion of growth, especially in developing countries, the government adopts appropriate fiscal and monetary policies. It is generally believed that higher economic growth in the developing countries will lead to the reduction in poverty and unemployment. To raise the rate of saving and investment the government must take appropriate fiscal and monetary measures. Recently, it has been found that policy of moderate taxes generates more revenue through greater tax compliance and at the same time it provides incentives to save and invest more. In developing countries in order to speed up economic growth the government should increase its expenditure on infrastructure such as irrigation projects, roads and highways, power, telecommunication, ports etc. Besides, as has been emphasised by Amartya Sen, for accelerating growth and removal of poverty the government must invest more in social sector consisting of education, health, literacy. It is important to note that a developing country cannot rely on private sector investment alone which is governed and guided by profit motive. Therefore, to supplement the private sector investment the government Nature and Scope of Macroeconomics 11 itself should directly undertake investment especially in infrastructure projects to promote and accelerate economic growth. POST-KEYNESIAN DEVELOPMENTS IN MACROECONOMICS There have been significant developments of macroeconomic ideas in the post-Keynesian era. These developments came about as a critique of Keynesian macroeconomics. We briefly explain below the following three main developments in macroeconomics after Keynes: (1) Monetarism (2) Supply-Side Economics (3) New Classical Economics based on Rational Expectations (4) New Keynesian Economics Monetarism American economist Milton Friedman, a Nobel Laureate in economics, criticised Keynes’s macroeconomics and put forward a new view or idea. Milton Friedman along with Anna Schwartz published an important work, A Monetary History of the United States, in which they argued that monetary policy is the prime engine in causing fluctuations in economic activity by bringing about changes in aggregate demand. Milton Friedman made a sharp criticism of Keynes’s view that monetary policy was quite ineffective instrument in bringing about economic stability. In fact, he asserted that monetary policy caused or contributed to almost all recessions he studied. He stressed that even the Great Depression of 1930s was primarily caused by the tight monetary policy adopted at that time. He further argued that the Great Depression of the 1930s did not show the failure of free-market system, but the failure of Government’s interventionist policy, especially monetary policy of the Central Bank which landed the U.S. economy into depression. According to Friedman, it is the excessive contraction of money supply by the Federal Reserve Bank System (which is the Central Bank of the U.S.A.) that caused depression in the U.S. economy. There are differences between the monetarists and Keynesians in respect of two important issues. First issue relates to the relationship between money supply and inflation. The second relates to the role of Government in the economy. Monetarists led by Friedman believe that inflation is always and everywhere a monetary phenomenon. According to them, inflation is caused by the rapid expansion of money supply in the economy. Friedman and his followers restated the classical quantity theory of money and made improvements in it but retained its essence that it is the greater increase in money supply relative to growth of output that causes inflation. In order to control inflation, they suggest a constant growth rate of money supply in the economy. An important feature of monetarism is that to achieve economic stabilisation it is opposed to the adoption of activist role by the Government. As against this, Keynesian economists emphasise that active role should be played by the Government to control business cycles and achieve economic stability. Like classical economists, monetarists also believe that a free-market economy is inherently stable and if the economy departs from the state of full employment, full-employment equilibrium is restored through automatic adjustments in it. Therefore, they even argue that Government or its central bank should not adopt active discretionary monetary policy, rather it should pursue a policy of stable rate of growth of money supply. In sharp contrast to the monetarists’ view, Keynes and his followers advocate the adoption of activist role by the Government. In this respect Keynesian economists lays stress on the adoption of 12 Macroeconomics : Theory and Policy discretionary fiscal and monetary policies.6 Besides, Keynesian economists believe that expansion in money supply does not always cause inflation in the economy. According to them, whether or not increase in money supply will lead to inflation depends on the possibility of expansion in output. When the economy is in the grip of depression, the increase in money supply is likely to lead to the large expansion in output of goods which will prevent the rise in prices. Similarly, monetarists are opposed to the fiscal policy of budget deficits and public debt. They argue for reducing taxes and lowering public expenditure so that the role of Government in the economy is restricted. Supply-Side Economics In the 1970s and early eighties the problem of stagflation appeared in which high inflation was accompanied by high rate of unemployment. This problem of stagflation demonstrated that Keynes’s theory which focused on fluctuations in aggregate demand as responsible for either high unemployment or high inflation could not explain the problem of stagflation in which both high unemployment and high inflation occurred together. The failure of Keynesian economics to deal with stagflation led some economists to believe that problem was on the supply side of economic activity. The problem looked quite strange and Keynesian policies were incapable of solving it. Following Keynesian policy, if expansionary fiscal and monetary measures were taken to raise aggregate demand to remove stagnation or high unemployment, it accelerated inflation further. On the other hand, if steps were taken to lower aggregate demand to lower the inflation rate, it would have further increased the already high unemployment rate. Supply-side economists pointed out that it was supply-shocks, delivered among others by reduction in oil supplies and increase in oil prices, that caused the problem of stagflation. As a result of contraction in supply due to the adverse supply shocks, given the aggregate demand curve, price level and inflation rate could rise on the one hand and aggregate output could fall giving rise to more unemployment on the other. Advocates of supply-side economics argued that for the expansion in aggregate supply and thereby increase in employment opportunities, incentives to work, save and invest more were required to be promoted. According to them, more work or labour, and higher investment will lead to the increase in aggregate supply. The increase in aggregate supply, given the aggregate demand curve, will lead to the increase in employment on the one hand and reduction of inflation on the other. According to them, high rates of income tax serve as disincentives to work, save and invest more. Therefore, to encourage more saving, work and investment, they advocated for the reduction in the then prevailing high rates of income tax. As a result of more work and investment, aggregate supply will increase which will not only cause employment to rise and unemployment to decrease but also lower the rate of inflation. Besides, in the opinion of the supply-side economists the reduction in tax rates will increase income and output to such an extent that even with lower rates of taxes, the Government revenue will increase which would tend to reduce Government’s budget deficit. In this respect, the concept of Laffer curve has been put forward, according to which when rate of a tax is increased from zero upward, , Government’s revenue from it initially rises, but after a point further hike in the rate of a tax brings about decrease in revenue for the Government. Therefore, they are of the view that higher rates of personal taxes are responsible for low tax-revenue. Therefore, they assert that with lowering of tax rates, not only national income and employment will increase through greater labour supply and investment but this will also reduce Government’s budget deficit by increasing tax revenue. We will critically examine in detail the supply-side economics in a separate chapter. 6. Keynes himself advocated for the adoption of only discretionary fiscal policy to cure depression and control inflation but his followers generally called ‘New Keynesians’ emphasise both fiscal and monetary policies to attain economic stability. Nature and Scope of Macroeconomics 13 New Classical Macroeconomics : Rational Expectations Theory Recently, a new macroeconomic theory has been put forward which is also opposed to Keynesian macroeconomic theory and policy which focused on aggregate demand for goods and services. According to this new classical macroeconomic theory, consumers, workers and producers behave rationally to promote their interests and welfare. On the basis of their rational expectations, based on all the available information, they make quick adjustments in their behaviour. Therefore, according to the supporters of rational expectations theory, involuntary unemployment cannot prevail. They argue that producers and consumers collect all the necessary information about economic situation and policies and determine their behaviour according to the rational expectations formed on the basis of all available information collected. According to them, people do not make any mistakes in establishing correct relationship between economic events and Government’s policies on the one hand, and the results that follow from them on the other. In other words, they always make correct predictions from the Government’s policies and changes in the economic environment. For example, when Government makes a deficit budget they will expect that rates of interest will rise. Therefore, they will attempt to take loans now when the rates of interest are lower so as to save themselves from paying higher interest rates in the future. Unfortunately, because of this behaviour the interest rates rise immediately rather than in future. A significant difference between the Keynesian theory and rational expectations theory may be noted here. In the Keynesian theory deficit in Government budget leads to increase in aggregate demand and will therefore promote private investment. On the other hand, according to rational expectations theory, budget deficit will cause rate of interest to rise which will discourage private investment. Thus, according to rational expectations theory, increase in aggregate demand as a result of budget deficit is offset by decrease in private investment so that national output, income and employment remain unaffected. Similarly, according to rational expectations theory, if central bank of a country increases the money supply, consumers, producers and workers will expect rationally that price level will rise. On the basis of these rational expectations, workers would get their wages raised, landlords will raise their rent, lenders and bankers will increase the rate of interest, and producers will raise their profit margins. As a result of these adjustments by various persons, the effect of expansion in money supply on these persons will get cancelled. According to the rational expectations theorists, since the con- sumers, workers and producers themselves make adjustments to save them from the adverse effects of economic events and policies there is no need for the Government to intervene in the economy through adoption of proper macroeconomic policy. Thus, like Friedman and other monetarists, supporters of rational expectations theory are opposed to the activist role by the Government. According to them, it is very difficult to implement an activist policy successfully. They are of the view that market is usually in full-employment equilibrium and people make self-adjustments in their behaviour to protect and promote their interests. The Government cannot achieve any success in improving economic situation through its activist policy. As compared to the Government, individuals themselves are in a better position to take corrective measures to safeguard their interests. New Keynesian Economics New classical economics based on rational expectations put forward by Lucas and Robert Barro criticised the traditional Keynesian model by expressing doubts on the validity of its assumption of price stickiness (i.e., failure of prices to adjust quickly as a result of changes in demand or supply conditions) by pointing out that it was not based on the firm foundations of microeconomics based on rational and profit-maximising principles. In response to the critique of Lucas that the original Keynesian explanation of determination of aggregate output and employment level and fluctuations in them was not based on rationality assumption of microeconomics, a number of Keynesian economists explained short-run price stickiness with the help of microeconomics and still keeping the conclusions 14 Macroeconomics : Theory and Policy of traditional Keynesian economics intact. That is why they are called new Keynesians and the models they propounded are called New Keynesian Economics. Now, the question arises how do these new Keynesian economists explain price stickiness with microeconomic theory. There are mainly two reasons given by new Keynesian economists for short-run stickiness of prices: (1) First, according to them, imperfect competition (monopolistic competition and oligopoly) prevails in the real world product markets and prices are set by the firms working in these markets. while Keynes’s original model was based on perfect competition. Second, the other reason for not changing prices by the firms is due to the menu costs that they have to incur

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