economics for business -unit iv

7/30/2019 Economics for Business -Unit IV

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Dr.P.Madhusoodanan Pillai

MA,MS,MBA,MSc,MIB,PGDBI,MIB,MPhil,PhD

Head of the Department in Management

Gurudev Institute of Management Studies

MBA106 MANAGERIAL ECONOMICS

Unit IV

Unit IV - (University Syllabus) National Income Accounting and their implication in

business decision - Aggregate Demand and Supply - Consumption, Investments, Exports,

Imports, Liquidity preference, wages and profits, Employment Equilibrium of the KeynesianModel - solutions for income, employment and interest rate - Multiplier and Accelerator

National Income

National Income is defined as the sum of all the incomes earned by the inhabitants of a

country whether as salaries and wages, profits, interests or rents from their contribution to

production. So, a distinction is needed to evaluate income derived from productive activity andincome derived from transfers or redistribution of income. The incomes derived from all

productive activities become termed as Gross National Income (GNI). The GNI is defined as thesum of money incomes earned for the production of GNP in a country during a financial year.While Gross National Product (GNP) is the money value of all final goods and services produced

in a country during a year. There are many kinds of transfer incomes: Gifts between persons,transfer from companies to charities, grants from public authorities, interests paid to citizens to

Govt. on national debts, net property income form abroad, etc. are transfer incomes. Since theestimates of incomes are made form a large number of sources of various degrees of reliability,the sums are not always perfect. As a consequence there is a small residual error or statistical

discrepancy in calculating national income.Personal Income

Personal income is the sum of individual incomes including the incomes of nonprofit

making institutions. Naturally personal income is the sum of income earned by an individualfrom all sources of economic activities including the unearned incomes. Personal income before

tax is really the Gross Personal Income (GPI). Personal Income less tax burden is called

disposable Income (DPI).Private Income

The sum of personal incomes and undistributed incomes of Private Corporation becometermed as private income. The undistributed income is the profits of business corporationsincluding dividends to shareholders. It is the Gross Profit or revenue of Business Firms from

which the pay taxes and a part is provided as dividends and the remaining is used as grossbusiness savings. To get the estimate of total private income we must add the undistributed


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income of public corporations along with other income which accrues to other states form itsproductive activity and from the property it owners.

Domestic Income

Domestic income is the sum of the incomes arising from the productive capacity thattakes place in a country including the incomes distributed to income earners in respect of their

contribution to that activity. It provides a basis for valuing the production of a country. TheTotal is best called Net Domestic Product (N D P) at factor Cost. The N D P is expressed at

factor cost because it is considered only with factor incomes. Factor cost represents the price wehave to pay to the factor owners or the price paid to the productive factors of productions such asrents, wages, interests, profits, etc. . The sum of rewards paid to the factor owners become called

as the domestic income.Gross Domestic Product

Gross Domestic product (G D P) at factor cost refers the full cost of products including

the capital consumption allowances. In producing goods and services we need extra expensesbeyond factor cost services, at the same time, fixed assets are subject to depreciation, there needs

capital consumption allowances when we deduct net income from abroad from the net national

income at factor cost. To get the Net National Product (N N P) from domestic product we haveto deduct from it the value of that part of domestic product which is due to the activities of

foreigners and add the value of net exports (X- M). So, NNP = NDP + ( X-M).Gross National Product (G N P)

The GNP is the sum of all final goods and service produced in a country during a

financial year. If we add net income from abroad to G DP, we get GNP and it is a macroconcept. The GNP only takes into account movements of income and does not make the

corresponding adjustments for indirect taxes, subsidies and depreciation. Usually a constant priceis used is measure GNP. In the United States the techniques of GNP deflator is used to calculateGNP. The GNP deflator is the constant dollar price used to value GNP. In India, for instance,

the technique of Index Numbers is advised to measure GNP with the base year price and current

year's price.Gross National income (GNI)

Gross National Income is the sum of money incomes earned in the production ofGNP during one year as salaries and wages, rents, profits, interest, etc . In other words, the

money value of GNP at market price is called as GNI. GNI less indirect taxes equal NetNational Income (NNI).

Percapita income

Percapita income of a country usually refers to the average earnings or income of anindividual in an year. It is calculated by dividing the national income of a country by the

population the country in that year. Suppose we want to know the percapita income of India in1998, we shall divide the national income of India in 1998 by the population of India in 1998.

So, a country having high national income and less population will have higher percapitaincome.Transfer payments

Transfer payments are those income payments by the Government to the people as socialsecurity payments such as unemployment benefit, old age pension, etc..

Richard and Giovana Stone in their book National Income and Expenditure have

illustrated various concepts of GDP totals in UK and USA. Following table shows Nationalincome and other totals of income in UK and the United States in 1969..


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National Income and other totals of Income and Product

UK USA(Million) $ In Million

1969 1969

1. Personal Income.... 37698 786.0plus undistributed 1977 61.1income of companies before tax

2. Private Income..... 39675 847.1plus Government income from property 1153 3.63. National Income ..... 34907 776.6

4. Domestic Income.... 34456 767.7plus depreciation.... 3694 78.9

5. Gross domestic product at factor cost. .. 38150 846.5plus indirect taxes..... 7024 80.66. Gross domestic product.... 45174 927.1

plus income from abroad 451 4.37. Gross National Product.... 45625 931.4

In the above table various National Income and product incomes in UK and USA are

evaluated based on 1969 report .It reveals that National Income in UK has taken from the BlueBookand in USA the data have been compiled from the department of commerce.

Following is a brief description of different National Income concepts:

GNP = NDP at Factor cost+

Depreciation+ indirect taxes.

GDP = GDP at factor Cost+

Indirect Taxes.GDP at Factor Cost = NDP at factor Cost+

Depreciation.

NDP at Factor Cost = National Income- Income form abroad.

GNP = GDP at Market price + Income from abroad.

Personal Income = Undistributed income of companies before tax =Private income.

National Income = Private Income+ Government income+ Net income form abroad

National IncomeIncome form abroad = Domestic Income or NDP at factor cost.

GDP at factor cost = NDP at factor cost +Depreciation .

GDP at Market Prices. = GDP at factor cost+ Indirect taxes

GNP = GDP at Market Prices+ Income form abroad


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Calculation of National Income

In an economy there are three flows flowing at the same period: income, out put andexpenditure. Therefore, national income can be calculated as a net domestic product at factor

prices. In many countries, for practical purposes, national income is calculated according to theproduct method and income method. There are other methods such as the expenditure method,

social accounting method and combined method. Among them, expenditure method is the macromethod. Social accounting method is used in the national accounting system. Combined methodis a mixture of the product method and income method. Following is a brief description about

such practical methods of National Income Accounting which also reveals the problems behindnational income analysis Calculation of National Income

In an economy there are three flows flowing at the same period: income, out put andexpenditure. Therefore, national income can be calculated as a net domestic product at factor

prices. In many countries, for practical purposes, national income is calculated according to theproduct method and income method. There are other methods such as the expenditure method,

social accounting method and combined method. Among them, expenditure method is the macromethod. Social accounting method is used in the national accounting system. Combined methodis a mixture of the product method and income method. Following is a brief description about

such practical methods of National Income Accounting which also reveals the problems behindnational income analysis

NATIONAL ACCOUNTING IN INDIANational income accounting is a methodology of a social accounting which contains

various systems of accounting the national income at product base, income base and expenditurebase. The term social accounts denotes an organized arrangement of all transactions actual or

imputed in an economic system. In such a system, there should be clear evaluations regardingthe different forms of economic activity viz, production, consumption and accumulation ofwealth; tracing different sectors such as households; firms and Govt. and types of transactions,

viz sales and purchases of goods and services, gifts, taxes and other current transfers. Sinceevery economy is an assemblage of millions of households, thousands of firms, various

governmental agencies, there are four markets, viz, the commodity market, the labour market,the bond market and the money market. The methodologies of social accounting are : NationalAccounts Matrix, Flow of Funds Accounts, National Balance Sheet Accounts and balance of

Payments Accounts.National Accounts Matrix

The National Accounts Matrix analysis is concerned with income and producttransactions. They are designed to show income return the current productive activity, of the

economy, distinguishing the current income and outlay associated with specific funds ofeconomic activity such as production, consumption and investment. It is a statistical statement of

national output or receipts, such as Gross National Product, Net National Product, personalincome and disposable income. These accounts seek to show the sources and disposition ofincome for the domestic economys major sectors, viz households, firms and Government units.

It seeks to explain how GNP and GNI are traced. Since GNP is the money value of all finalgoods and services produced in a country during a financial year, GNI is sum of all incomes

earned for the production of GNP in the form of salaries and wages, profits, interests and rents.While computing National Accounts, many other transfer incomes such as, gifts betweenpersons, transfers from companies to charities, grants from public authorities, interest paid to


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citizens by Government on national debt, net property income from abroad, etc. should beincluded. To sum up, the national income is the income residents of a country from their

participation in world production. Indian Experience of National Accounts Matrix

The first estimate of national income for Indian was prepared by Dadabai Naoroji for

the period 1867-68, in his book Poverty and UnBritish Rule in India. Dr. Naoroji used thecombined application of production and income method. His estimation revealed that Indias

national income for the year 1867-68 was Rs. 340 crores and percapita income was Rs. 30. ThenF.J. Atskinson estimated Indias national income in 1875 as Rs. 574 crores and percapita income

at Rs. 30.5. In his second estimation done in 1895, the entire national income of British Indiawas Rs. 877 crores and percapita income at Rs. 39.5. In 1898 W. Digby estimated the BritishIndias national income at Rs. 428 crores and percapita income at Rs. 18.9. For the year 1901,

Lord Curzon estimated British Indias national income at Rs. 675 crores and percapita income atRs. 30. Since 1900 AD, a large number of estimations appeared based on Time-series trends.

Among those estimations Dr. Naorojis estimation become more scientific and accurate. Indiabeing an agricultural country Dadabai started with the rough estimation of the net income from

land under crops. Due to the paucity of data pertaining to agriculture, Dr. Naoraji limited himselfto the data on one or two main crops for each province and there form he derived the estimate ofaverage value of net income per acre. He then multiplied that figure by the total average of all

crops under cultivation in that province. He added to this on arbitrarily estimated value of Rs. 15crores for the value of industrial output. Basing his calculations on the Govt. sources, Dadabaiestimated the physical and calculating the income from commerce by forming rough estimate of

total transactions. The total value of goods were about Rs. 307 crores and the net value ofservices accounted to Rs. 33 crores, by adding both, he got Rs. 340 crores as the national

income.

Dr. V.K.R.V. Rao calculated the national income of India during 1931-32 as between Rs.1600 crores and Rs. 1800 crores. In other words it was Rs. 1700 crores and percapita income at

Rs. 62. In making his calculations, Dr. Rao made use of inventory method as well as incomemethod. The former method was used for the agriculture sector, for all the other sectors heemployed the income method, and calculated as average earnings by each major occupational

groups. He was careful in avoiding double counting. Then M. Mukerji has prepared to calculatethe percapita income in India, at 1948-49 price, for the second half of the 19th century. Mukerjisestimation highlights that Indias percapita income in 1857 Rs. 169, in 1876 it was Rs. 210, in

1886 it was Rs. 219, in 1896 it fell to Rs. 204 and in 1900 at again declined to Rs. 188. Based on1948-49 price level. Wadia and Joshi calculated Indias national income at Rs. 1087 crores in

1913-14 and percapita income at Rs. 171. Later, Govt. of India estimation in 1942-43 disclosedthat Indias national income was Rs. 3433 crores and percapita at Rs. 263. Adakar and Tandonestimation that Indias national income in 1944-45 was Rs. 5060 crores and percapita income at

Rs. 260.The official estimates in Indias national income began to appear from 1948-49. The

National Income Committee (NIC) was setup in 1949 with P.C. Mahalonobis as the Chairman

and Dr. Gadgil and V.K.R.V. Rao as members. The first and final reports in 1951 and 1954 bythis committee were quite comprehensive and exhaustive in presentation. In its first report of theNICs estimation, the national income of India was Rs. 8710 crores in 1948-49 and percapita

income at Rs. 255. Today, the official statistics of national income and other aggregates arebrought out annually by the Central Statistical Organization (CSO) in the form of a publication


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called National Accounts Statistics. Its estimation pointed out that Indias National Incomefor the period 1951-52 was Rs. 9970 crores and percapita income at Rs. 250. Besides CSO, the

State Statistical Bureau (SSBs) the Indian Statistical Institute (ISI) and the National Council ofApplied Economic Research (NCAER) also publish the national income statistics in India. The

Indian Association for Research in National Income and Wealth (IARNIW) brings out the

Journal and Income and Wealth.In India the production approach of national income is called as the GDP method (Gross

Domestic Product) and income approach is known as NDP (Net Domestic Product) method. The

NDP approach is used to estimate the income for electricity, gas, water supply, transport andcommunications, storage, banking and insurance, real estate, public administration and defense

other services and wholesale and retail trade, including hotels and restaurants. In order to assessthe agricultural output Random Sample crop cutting surveys are made. For Livestock there areLivestock census, for forestry the survey report of state chief conservator of forests, for fishing

there are reports from fishing departments, for assessing Mining and quarrying reports arecollected from Indian Bureau of Mines, for manufacturing there are Annual Service of Industries

for assessing Electricity gas and water supply reports are obtained from Annual Survey of

Industries of Electricity and Gas Agencies, for transport communication and storage, AnnualReports from Railways and Warehousing Corporations and obtained for trade Hotels and

Restaurants, distributive trade survey reports are collected and so on. The RBI Bulletin givesinformation regarding Banking Insurance and Real Estate and for community and personal

Services, the data of annual budget of Govt. of India and N.S.S. survey data are obtained. Inassessing NNP, the distribution of factor income varies according to the sectoral distribution ofincome, the characters of the products, the institutional setup and enterprises ownership. The

National Income Accounting system in India illustrates a unified system for studying structureand behaviour of Indian Economy over a time. Obtaining and using national income information

is essentially a collective endeavor in India, though it is subject to some unavoidabledeficiencies. From the point of view of income estimation there has been considerable

improvement in the coverage of data and the refinement of the methodology, yet there is a greatscope for further improvements in the national income estimates. Following table shows thegrowth rate of Net National Product at factor cost at current prices and at 1980-81 base prices

and also the index number of NDP on the concept that 1950-51 price index is 100. It is strictlybased on the rules and regulations of National Accounts Matrix both theoretically and practicallywith slight modifications according to the rate of inflations.

Input-output MatrixThe input-output table also known as the transactions table, inter industry table or the

Flow Matrix, shows the flows of goods and services from each branch, called sectors of theeconomy to different branches of the economy over a specified period of time during a year. It

gives a systematic description of interdependence of different sectors of the economy by way oftwo-way table consisting of several rows and columns. The rows arranged horizontally give the

distinction of the output of each sector, while the columns arranged vertically give the inputsconsumed by each sector. Though the earliest example of input-output tables are found inFrancois Quesnays Tableau Econonique and Walrasian general equilibrium analysis , the

clear input output technique was introduced by Wassily Leotief. Accordingly, the economy isdivided into many sectors capable of different subsectroal divisions. The output of one sector is

used as the inputs in all sectors and the balance for final consumption demand. Let us assume


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that there are agriculture sector (X1) Industrial sector (X2) and Tertiary sector (X3) in aneconomy, the national output could be analyzed as:

X1 = X11

+ X12

+ X13

+ F1

X2 = X21

+ X22

+ X23

+ F2

X3 = X31

+ X32

+ X33

+ F3

Xi = Xij + Fi

Where i = 1, 2, 3 and j = 1,2,3Indian Practices of Input Output Matrix

In India a beginning was made in the field of input-output tables by individual researchworkers around 1951. M. Mukherji was the first to prepare a four sectoral input output table for

the year 1949-50. T. Choudari constructed an inter-industry table for the year 1948-49consisting of 23 sectors. An inter industry unit was setup in the planning division of Indian

statistical Institute. This unit prepared a table for 1951-52, 1953-54 and 1955-56. They areknown as ISI Tables. Thereafter, the task of preparing input out tables has shifted to the planningunit. The planning unit at Delhi prepared the first input output table for the year 1960-61. Later it

prepared a larger table with 144 sectors. The CSO also brought out on input output tableconsistent with National Accounts Statistics for the year 1973-74. It presents the inter-industry

transaction at factor cost in a 60 x 60 matrix where columns represent the industries and the rowsrepresent of the group of commodities. Each row shows the distribution of the particularcommodity group, output of various industries for their intermediate consumption and then to

different final uses such as private current consumption expenditure, public current consumptionexpenditure, gross fixed capital formation, changes in stocks, exports of goods and services and

imports of goods and services.

Flow of Funds Accounts

They provide information on the creation of bank credit purchase of securities and other

changes in the assets and liabilities of the different sectors of the economy. Flow of fundsaccounts are broader in scope than national income and product accounts because they embrace

not only income and product transactions but also purely financial transactions, such as thepurchase and sale of various kinds of securities and the expansion and construction of bank

credit. This system was developed by Morris. A. Copeland of Units States as part of a projectsponsored by the National Bureau of the Federal Reserve System. According to the flow of fundssystem, the economy is divided into consumer sector, Farm business sector, Non farm business

sector, Corporate business sector, Central Government, State and local Governments,Commercial banks, Savings institutions, Insurance Companies, other financial Sector and the

Rest of the world. For, each sector, a flow of funds statement is prepared showing but financialand non financial flows from its transactions. These flows are generally associated with means of

payment, purchase and sales, transfer of gifts, and borrowing and lending of funds. Each sectorsstatement can be subdivided into a Current transactions account and a Capital transactionaccount.

Indian Experience of Flow of Funds Accounts

The RBI has adopted a slightly different structure for presenting flow of funds data.There are six sectors, viz, Banking, other financial institutions, Private Corporate Business,

Government, Rest of the world, and Household. The accounts for household sector are divided


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as a residual. The sector wise presentation of flow of funds data for the year 1976-77 is stated inthe following table where the main instruments identified in the accounts are currency and

deposits, Investment and bank securities, Corporate Securities, bank securities, foreign securitiesand securities of other financial institutions, loans and advances, small savings, life fund,

Provident fund, foreign Claims, Trade debts versus credits, etc. Thus the nature of flow of funds

accounts suggest that their major uses will be in financial analysis, which is stated below.

National Balance Sheet Accounts (NBS)

It shows the assets and liabilities of different sectors of the economy. They are closelyrelated to flow of funds statements, except that they deal with stocks rather than flows. They areconcerned with both tangible and intangible assets of the economy and the liabilities. The

earliest attempt to construct the national balance sheet account was made by Dickinson andEakin in 1936. It was more popular in U.S.A. and U.K. This method evaluates the different

assets and liabilities of the economy based on the farm sector, corporate business, householdsand govt. sectors.

Indian Experiences of NBSIn India the NBS system was introduced by Uma Datta and Vinod Prakash in 1957, and

then it was elaborated by M. Mukerji and Sastry in 1959. M.S. Joshi used such method in1966, and he identified four sectors, viz, financial intermediaries, business enterprises, govt. andhouseholds.

Growth Rate of GNP in Various Sectors of the Economy

The estimation of CSO reveals that India gained satisfactory growth in the primary,

secondary, tertiary, banking, personal service and public administration sectors. Since Indiapossesses the basic features of an agricultural economy, she sustained forward momentum in the

tertiary sector under the planning era. Following table shows the percentage growth share ofdifferent sector in net domestic product.

Interstate Variations in Percapita Income in India

Indias percapita net national product at current prices wasRs. 237.5 in 1950-51 which increased by Rs. 326.3 in 1960-61,

Rs. 672.1 in 1970-71, Rs. 1630.1 in 1980-81 and Rs. 6928.8 in 1993-94. The estimation of CSOreveal that over the 43 years from 1950-51 to 1994-95, Indias percapita income rose by 102.5 %with 1.65% annual growth. Following table shows the growth rate of percapita income based on

1980-81 base price level in certain important leading states in India.

Indias Percapita Income and International Comparison

It is very difficult to make an international comparison of different net national percapitaoutput because there is no common currency in between nations. However, for analysis U.S.Dollar could be taken as world currency for a comparative study. For that the percapita income

of different nations should be converted into U.S. Dollar during a time based on their rate ofexchange. Following table shows the levels of percapita income and its annual average growth in

selected nations,


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GNP percapita and Average Annual growth rate inse lected countries

Countries GNP per capita in Average annual growth

U.S. Dollars 1992 in percentage (1980-1992)

Developed Countries

Japan 28190 3..6U.S.A. 23240 1.7

Germany 23030 2.4France 22260 1.7

Italy 20460 2.2U.K. 17790 2.4Less developed nations

Mexico 3470 -0.2Brazil 2770 3.2

Thailand 1840 6.0Philippines 770 -1.0

Indonesia 670 4.0China 470 7.6Nigeria 320 -0.4

India 310 3.1Bangladesh 220 1.8Ethiopia 110 -1.2

Table 1.8 Source: The World Bank world development report 1994.

From the above table, it is clear that Indias growth ra te of per

Micro Foundation of Macro EconomicsMicro Economics and Macro Economics are two approaches to economic analysis. Micro Economics

is the microscopic study of individual economic units such as households, particular firms etc. relating to there

economic problems and solutions. It enquires how the resources of one firm is allocated to other firms and how

prices of different goods are determined based on the national pricing policies. According to Garder Ackley

Micro Economics deals with the div ision of total output among competing groups. It considered the problems

of income distribution. Its interest is in relative prices of particular goods and services . He called micro

economics as price and value theory because it explains the micro-price mechanism in an economy through

which the price system is operated. A price system is a system of economic association in which price

mechanism operates. Price mechanism discloses how each individual behaves in an economy in his capacity as

a producer, consumer and resource owner and how much he performs to the national economy, and how much

he shares.

Macro economics is the study of the relations between broad economic aggregates such as total

income, total employment, total investment, aggregate demand and aggregate supply, general price level etc

for maintaining economic growth and economic stability. It is popularly called as the theory of income,

employment, prices and money. According to Garder Ackley,Macro economics deals with economic affairs

in the large. It concerns the over all dimensions of economic life, to use a metaphor, it studies the character of

the forest independently to the trees which compose it. The theoretical concept and policies involved in macro

economic analysis are generally wide aggregates or averages such as total income or total employment. It


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confronts an aggregation of general economic problems and their solutions. It enquires how an economy

maintains economic growth and economic stability.

The Neo-classicals where the pioneers in deriving micro economic analysis from the classical

conception of general equilibrium analysis. Alfred Marshall, the head of the neo-c lassical school synthesized

many of the ideas ofW.S. Jevons and Leon Walras. Marshalls analysis was concerned with the microscopic

behaviour of individuals in economic affairs to attain material welfare. He stated that economics is on the oneside a study of wealth but on the other and more important side, it is the study of man. Marshalls definition

highlights that Economics is the study of mankind in the ordinary business of life, it examines that part of

individual and social action which is most closely connected with the attainment and with the use of material

requisites of well being. He made all economic theories into an engine of social betterment. He was followed

by Irving Fischer, A.C. Pigou, Robertson, Heyek and others. The school became known as the Neo-classical

School was victorious over the traditional classical school with separate micro economic philosophy.

The success ofNeo-classicalism is with their Marginalist Revolution in price mechanism, especiallywith regard to individual micro economic units. Accordingly, the price of a commodity is based on marginalutility and price of a factor of produc tion is related to marginal produc tivity. The higher the marginal utility,the greater will be the market price of a commodity. Similarly, the higher the marginal productivity, the greater

becomes the factor prices. Marginal productivity is the change in total output resulting from the employment ofone more or one less unit of a factor, other factors remaining constant. The Neo-classical traced separatesolutions to individual economic problems. In a private enterprise economy, each and every economic unit isseparate. So that, individual taste, habits, preferences etc changed from time to time and from place to place.As micro economics studies resource allocation, it finds solutions of scarce resources also. For instance, in aprivate enterprise economy, there are millions of house holds, thousands of firms and various Governmental

bodies. Since every householder is independent, he faces the problems of resource allocation that: How muchis spend on food? How much for clothing? How much for entertainment? How much for education of

children? How much for personal savings? and so on. It is the methodology of resource allocation in macroeconomics which tries to answer those questions. In fact, resource allocation is a technique in which theavailable resources are systematically allocated for varying wants to get minimum satisfaction or individualbenefits. Like the householder every firm has to face the problems of resource allocation. Before enteringproduction, the individual firms have to face such problems as: What commodities are produced? How theyare produced? For whom goods are produced? How much of goods are produced? Who gets the benefit of

production? At the same time, there are local Govts. , State Governments and Central Govts. Recently, thepolicy of local self Govt. has been accepted by many countries. For instance, a municipality or a panchayath

authority faces the problems of resource allocation such as:How much of revenue is used for drinking water?How much for street lighting? How much for local roads? How much for public health? How much for

elementary education? and so on. Those problems are of micro economic in character but they are having amacro outlook.

In 1929 the depression began which upset both classical and Neo-classical philosophies on account ofthe emergence of unemployment problems. The victory of the neo-classical school over former economicdoctrines became shadowed. The situation became worse in 1930s. The sudden instability in capitalism hadbeen enquired by Gunner Myrdal in Sweden, Micheal Kaleky in Poland and John Maynad Keynes in

England. The movement became known as Keynesian Revolution because Keynes beautifully narrated thecauses and solutions of depression with the publication of his General Theory of Employment, Interest And

Money, in 1936. He recommended a macro approach even though Ragnar Frisch introduced the term macroin 1933. Keynes is called as the father of macro economics, for he formulated a refreshed and logical analysiswhich clearly expressed that unemployment arises due to the deficiency in effective demand and not thesituation of high wage rate or over production. He recommended to boost up effective demand to solve thedepression through consumption function and the multiplier actions. Keynes stated the need of Governmentintervention while criticising the classical concept ofLassez-faire. He formulated theories on macro economiccontrol in a free market economy with the active participation of Government as the regulatory and coordinator


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agency over millions of households and thousands of firms. Keynesian economics is worth with macroeconomic policies. But the continuous boom in 1950s and the resultant inflation in 1960s compelled the Neo-Keynesians to integrate neo-classical micro economic philosophy and Keynesian macro economic outlook.

The Neo-Keynesians began to integrate micro and micro economics not only for individualsatisfaction but also to aggregate economic welfare. In the Neo-Keynesians theory the circulation of money

exerts a more modest influence. One of the main weakness of Keynesian theory was the negligence of time-lag. In fact, Keynes avoided the significance of time-lag in his multiplier and consumption function, but the

Neo-Keynesians have attempted to modify it with in the time limit. For that, they used the tool of Neo-classical equilibrium analysis of supply and demand. They believed that certain mechanisms attained in thegeneral balance between supply and demand. There are disturbances of equilibrium originating in the relationbetween consumption, investment, taxes and national income. The Neo-Keynesians have been interested toformulate theories of growth.

Unemployment is common in many countries where actual growth is far below thanpotential growth.

A national employment policy becomes effective when entirely different micro foundations co-operated. For

instance, the NREP, RLEGP and JRY Schemes of the Government of India are the living examples.

e) Useful in generating Growth

Maintenance of full employment GNP is a potential need in every country which necessitates closeco-operation between different micro foundations. The macro policies such as monetary policy, fiscal policy,The micro foundations of macro economics explains the integration between micro and macro economic tools

in generalising economic problems and solutions. Ours economy is an assemblage of three sectors viz,household, firms and government, as well as four transactors, viz, the commodity market, the labour market,the bond market and the money market. Millions of households and thousands of firms are the microfoundations on which macro economic policies have been implemented. In the micro foundations of macroeconomics, every house holder has dual role; first as a productive agent in the form of rendering factorservices and secondly, as a consumer. He enters to the various markets and a join as a link in the chain ofmacro economics. Similarly, a firm has also dual role in the national economy. First as a producer of goodsand services and second, as a seller of finished goods, for which the firms created income and receive businessreceipts. Finally, a Govt. has dual role to perform either as a co-ordinator or through the regulatory agency.

Government collects taxes and make spending for the common benefit. Therefore, every economy necessitiesnational economic policies. They are implemented upon the micro foundations. In the United States, for

instance, the Federal government implements national economic policies in co-operating the private microeconomic foundations. Since a firm evaluates how much of goods are produced, it is according to the needs ofconsumers that production is being made. There, the government should enquire whether goods are producedaccording to the needs of consumers or not. In facing the problems of how to produce, the government advicewhether the micro foundations choose a capital intensive or labour intensive technology or a mixture of both.The lessens of great depression highlight that the main weakness of classical mechanism was absence ofgovernment intervention. If a government was functioned as a regulatory agency, it could have to avoid thedepression through price supporting policies and resist a positive inflation through price ceiling policies. Therefore, macro economics should function for the well-being of thousands of micro economic units. The need ofmicro foundations of macro economics could be analyses form the following points.

a) To understand the working of the economyEvery economy functions with millions of households, thousands of firms and different governmental

agencies. When government introduces economic policies, say, a price policy or incomes policy, it should be

executed on millions of households and thousands of firms, there micro economics and macro economics

should integrate upon one another.

b) To provide tools for economic policies

In order to make economic policies a lot of micro economic variables have been integrated into a

macro outlook. Functional relationships, behavioural patterns, etc need micro foundations of macro economics.


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c) Helpful in the efficient employment of resources

The resource mobilisation and allocation are the part of national planning policies, which become

effective with the co-ordination between different sectors, units and agencies. The success of planning properly

depends upon public co-operation and integration of micro variables.

d) Useful in National Employment Policy

incomes policy, price policy and employment policy are of no use when micro economics is not co-ordianated

with macro economics.

f) To resist business Cycle

A trade cycle or business cycle is a wave like movements of boom, prosperity, recession, depression

and recovery. A recession and the dangerous depression should be avoided with proper price policies with the

necessity micro-macro integrations.

g) Usefull in public economics

In the theory of public revenue, public expenditure and public debt, micro-macro interactions are

essential. Any change in fiscal measures are sensitive to the micro markets and consumer demands. As taxes

are raised, disposible income is declined, consumption is contracted, aggregate demand becomes lower which

lead to deficency in effective demand. At the same time, a tax cut generates more income and high aggregatedemand.

h) For understanding the behaviour of Individual Units

Micro-macro integrations disclose how the three transactors entered into four markets and make the

economy into a system of aggregate equilibrium with saving and investment equality, equality in taxes and

Govt. expenditures, equality in exports and imports and there by equilibrium between the aggregate demand

function and aggregate supply function.

i) To examine economic welfare

The Pareto criterion, Edgeworth criterion, compensatingcriterion andNew Social Welfare Functions

including the contributions of Samuelson and Prof. Arrow disclose that micro-macro integrations are essential

to the individual welfare and social welfare function.

Micro foundations are essential for model building in economics. There, the old deductive and

inductive reasoning are integrated with thepositive and normative frame work of the national economy. It was

Jan Tnbergin, the Dutch economist, contributed much about the use and application ofquantification in

model building. TheNeo-Keynesian equations are concerned with model building which intermingles the

different micro economic variables with national macro economic frame work.

Views of Levacic and Bermann on Micro Foundations

The post war work of both Keynesian and neoclassical economists have been increasingly influenced

by the desire to build aggregate macro economic relationships upon macro economic foundations. Macro

economic theory investigates individual behaviour, taking as fixed those variables that the individual cannot

alter by him or himself. The behaviour of individuals is depicted as rational in that they attempt to maximise

their own utility subject to constraints. By proceeding in this way, macro economic models, which determine alimited number of variables, such as the price and output of a particular product are constructed. This method

of analysis is known as partial equilibrium analysis. Since all other variables in the economy are assumed to

be unaffected by changes in the few variables being analysed. Micro theory is thus concerned with a single

market or a set of closely related markets which are assumed not to influence the rest of the economy.

Macro economics considers the interaction of all the individual decision units in the economy and

must, therefore, involve in general equilibrium analysis. In micro theory we examine the consumption andsaving behaviour of a household in relation to the rate of interest which is externally given to that household.At the macro level we took at how households savings plans and their demands for financial assets interact


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with the investment and financing plans of firms to determine the level of interest rates in the economy. Theessential feature of macro economics is that it analysis the interdependencies between variables and therepercussions of a change in one variable upon other variables together with the feedback effects on thatvariable. A macro model solves for general equilibrium when all its interrelated markets are in equilibrium. One approach to macro economic analysis is to work with all the micro equations of the

economy and to determine the prices of commodities and factors of production and the quantities

of commodities produced by solving the model for general equilibrium. As each commodity,factors of production and household is represented by its own behavioral equations, such modelsare difficult to handle. The alternative and more widely used approach in macro analysis is tosuppress the individual behavioral relationships and to work with broad aggregates. A common

procedure is to derive behavioral relationships at the individual, micro level and to generalize tothe aggregate level. For instance, hypothesizes that a households consumption will vary directly

with its disposable income and then one extends this hypothesis to a relationship betweenaggregate consumption and national disposable income.

Positive and Normative Economics

Economics as a social science is concerned with predicting or determining the impact of changes in

economic variables on the actions of human beings. Scientific economics commonly referred to as positive

economics, attempts to determine what economics is, where as normative economics tells what economics

would be. Positive economic statements postulate a relationship that is potentially verifiable or refutable. We

can statistically investigate the relationship between the supply of money and the general price level. We can

analyses the facts to determine the correctness of a statement about positive economics. Normative economics

involves the advocacy of specific policy alternatives, because it uses ethical judgements as well as knowledge

of positive economics. Normative economic statements concern what ought to be given the philosophical

views of the economic policy. Value judgements may be the source of disagreement about normative

economic matters. Two persons may differ on a policy matter because one is a socialist and the other a

librarian, one a liberal and the other a conservative or one a traditional and the other a radical. They may agree

as to the expected outcome of altering an economic variable but disagree as to whether that outcome is good or

bad. Suppose, the construction of a national high way needs $ 10 million and it needs five years to complete,

positive economics describes all the present level problems in constructing the highway, while normative

economics tells the after effect of commissioning highway that it would results 15% increase in national

income and more employment opportunities. Therefore, the highway construction programme has more

normative meaning than that of positive economics. In contrast with positive economic statements normative

economic statements cannot be tested and proved false. The government should increase defence expenditures.

Business firm should not maximise profits. Trade unions should not increase wages more rap idly than the

cost of living. These normative statements cannot be scientifically tested, since their validity rests on value

judgements. Positive economics does not tell as which policy is best. The purpose of positive economics is to

increase our knowledge of all policy alternatives, thereby eliminating our source of disagreement about policy

matter. The knowledge that we gain from positives economics also serves to reduce a potential source ofdisappointment with policy matters. Sometimes what one thinks will happen if a policy is instituted may be a

very unlikely result in the real world.

Our normative economic views can sometimes influence our attitude towards positive economicanalysis. When we agree with the objectives of a policy, it is easy to overlook its potential liabilities. Desiredobjectives though are not the same as workable solutions. The actual effects of policy alternatives often differdramatically from the objectives of their proponents. Positive economics will help use to evaluate moreaccurately whether or not a positive alternative will, in fact, accomplish a desired objective. The task of theprofessional economist is to expand our knowledge that how the real world operates. If we do not fully


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understand the implication including the secondary effects of alternatives polices, we will not be able to chooseintelligently among the alternatives. If it is not always easy to isolate the impact of a change in an economicvariable or policy. Thus positive economics tells what economics is and normative economics explain whateconomics would be. Every macroeconomist should keep that normative ideology before executing

macroeconomic polices. Perhaps positive economics is risky and problematic when economic ideologies arehaving much normative senses. For instance, the construction of a new bridge. If it costs $ 500 million and

necessitates 10 years to complete, positive economics points out all of the problems behind its construction butthe normative economics reveals that the national output would rise by the 10% when it is properly constructedor commissioned for the public, which helps the extension of new variety of markets. So that, all types ofpublic works programmes and highway planning have more normative meaning than that of positiveeconomics.

Marco economic variables

A variable is a quantity that may vary over a range. It is a measurable magnitude or quantity which

varies and in whose variations we have an interest, with because of its direct importance or because of its

effects on other variable. These variables belong to a system as its integrate parts when they are called

endogenous variables, and some times they may be external to the system, when they are described as

exogenous. Variables explained within the structure of a model are called endogenous variables. Variableswhich are based on outside the model are taken from outside the system are exogenous variables. Macro

variables are of three main types such as stock, flows and ratio.

A stock variable has no time dimension. The weight of an automobile is a stock variable. A stock

variable refers to a quantity measured at any given point. Money is a stock. Aggregate income is a stock . The

balance sheet or stock statement shows the assets and liabilities of a business firm at a point of time. Though

the magnitude of the stock has no time dimension, a stock is measured at some point in time.

A flow variable, on the other hand, has a time dimension. The speed of automobile is a flow. A flow

variable is a quantity which can be measured only over any given period of time. Traffic is a flow. Income is a

flow while wealth is a stock. The profit and loss statement are flow statements which show the receipts and

expenditures incurred over a period of time. The macro flow concepts include the national income, output,

conception, saving, wages, interests, profits etc. while the macro flow concept include total money supply,total bank deposit, wealth, inventories, capital stock, debt etc.

A ratio variable is one which express relationships between two flows or two stocks and flows at a

certain point of time . Price is a ratio variable - a ratio between a flow of cash and a flow of goods. Liquidity is

a ratio variable between stocks. The savings ratio is a flow ratio since both saving and income are flow

variables. Velocity of money indicates a relationship between a flow of money transactions and a stock of

money.

Various economic problems in macro theory involve the relationship between flows and stocks.

Stocks change through flows. For example, stock of capital goods increases through an excess of new

construction and manufacture over wearing or depreciation.

Functional relationship and parameters

Functional relationship establishes a unique relation among two or more variables. Consumption is a

function of income. Consumptions in this case is a dependent variable where as income in an independent

variable. Consumption could rise or fall with income. The responsiveness in one variable to change in another

variable is a important features in macroeconomics. Economists now talk of functional relationship among

their variables instead of vague terms like tendencies or causes. The existence of a functional relationship


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among two or more variables that the value or the magnitudes of the variables are some how uniquely related.

The Marshallain demand curve, for example, deals with single relation between two variables which proves

extremely valuable variable in the analysis of price changes. Hence quantity demanded is a function of price

and may be symbolically expressed us D= f(P), where D is the quantity demand, f is the function and p is

the price level. But in an economy several goods are demanded at different prices based on income and the

changes in the price of one commodity may affect the demand of the other commodity.. Then, the macrodemand relationship becomes: D= f (P1,p2... ..Pn, Y), where P1, P2 .....Pn are the prices of different goods and

Y is the income. For convenience price are taken and the other variables are put in the vessel of Ceteris paribus

assumption.

Similarly, the Keynesian effective demand analysis is based on a functional relationship between aggregate

demand function (ADF) and aggregate supply function (ASF). The A.D.F relates any given level of

employment to the expected proceeds form that volume of employment and one investment. The former

necessitates a study of the consumption and the latter of the investment demand func tion (Y= C+I).

A constant variable is called a parameter. In static analysis, certain parameters such as taxes, income

etc is assumed as constant. As the demand function is based on two simple variables such as the price and

quantity we hold the values of the other variables as constant (parameters) by using the phrase ceteris

paribus. The ordinary demand curve shifts when one of the other variables change, viz, consumers income,taste, habits, fashions, customs, preferences, close substitutes. These are all parameters in the demand

functions. In fact, an important parameter of the ordinary demand curve is consumers taste. The functional

relationship in the demand analysis becomes:

D = f(P1,P

2.......Pn, K,Y), whereD is the demand,f is the function, P

1,P

2 are the prices of the different

commodities, K is the constant and Y is income. Here, prices are independent factor and all others are the

dependent factors, so that, they are all parameters.

Identities versus Behaviours

Identity implies a simple mathematical and abstract truism. In fact, all that the identity means equality

between amounts purchased and sold. The identity between saving and investment is precisely the same nature.

For instance, personal saving is equal to the difference between personal disposable income and personal

expenditure income. This is accounting relationship. Identity equations MV PTandI Shardly tell anything

fruitful. When we see the identity sign, we will know that a definition is being offered and it is not a statement

about the behaviour.

A behaviour equation essentially runs in terms of functional relationship between variables. They arestatement about behaviour - embodying actual rather than complicated hypothesis. The demand schedule isstatement about market behaviour. When we say that the demand is equal to the supply, it is nothing. But ifone says that demand and supply in the schedule senses are equal, it is identity and such statement ispurposeful. So that, it involves and actual relationships and such point of intersections become observablepoints against the other, which are called virtual points. They represents the desired relationship of thevariables. The behaviour equations are statements or propositions about the economic behaviour which could

be tested by the empirical investigations.

Lags

Modern production is based on process which occupies time. For example, if there is an increasing

income, it is not necessary that consumption will go up simultaneously. It may take it some time for

consumption to increase. Thus, the gap or the time involved between the increasing consumption and

increasing income is called lag or time lag in macro economic. These lags included consumptionexpenditure

lags, wage -price lags, production lags, administrative lags etc. They occupy significant role in the theory of


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income, output and employment. In Keynesian theory the lagging adjustmentthat the economic system makes

in respond to the introduction of a disturbance is open skipped over or Keynes ignored the influence of lags.

However, the post Keynesian took account of the influences of lags on their theoretical tools like consumption

and investment function, liquidity preference, multiplieretc. For example, Prof. Robertsons analysis involves

expenditure lags where the consumption today (Ct) is a function of yesterdays income (Yt-1). In Kenynesbasic income expenditure equations. (Yt = C

t+ I

t) all the variables belong to current time period and no time

lag is involved. But according to Prof. Robertsons there is an expenditure lag between income and

consumptions, ie, consumption of today (Ct) depends on yesterdays income (Yt -1),ie (Ct =f (Yt-1).

Thus, Keynes equations (Yt=Ct + It)

if expressed in Robertsons view becomes:

Yt = C(Yt-1) + It

Statics, Comparative Statics and Dynamics

Statics analysis deal with equilibrium condition showing what is rather than how. It gives the position

of an economic model of point in time. When disequilibrium exists statistic analysis can indicate the

magnitude of variables, which also explain why such disequilibrium exists. As pointed out by Prof. P.A.Samuelson, economic static concern itself with the simultaneous and instantaneous or timeless determination

of economic variables by mutually interdependent relations. Joan Robinsons imperfect competitions andChamberlains monopolistic competitions are exercise in economic statics. A macro static analysis explainsthe static equilibrium position of the economy. Prof. Kurihara viewed that it shows a still picture of theeconomy. It neither develops nor decays. Such a position of the economy may be shown by the equation.

Yt = Ct + It

Comparative Static analysis compares two different equilibrium position in which there are two

different values for one variable. Once an equilibrium is disturbed, it may tend to regain the early equilibrium.

It analyses what happens between the two equilibrium positions. It enables us to ascertain the direction of

magnitude of changes in variables when data fluctuate from one another. Comparative analysis concentrate

only one the equilibrium position. It does not concern itself with the time it take for an equilibrium position tobe achieve. It is inadequate for the system when it changes from time to time. In fact, comparative static

bridges the gap between the equilibrium positions in one instance to the other.

By dynamic theory we mean a theory that explains how one situation grows out of the forgoing.When the system is in equilibrium and the moments of the system are away from any possible equilibrium

because of continuous changes in variables, dynamic analysis is the most suitable method. The study of tradecycle is done with dynamic analysis. Dynamic models involving relationship which hold over time orinvolving lags, habituation and accumulation. Prof. Harroddefines dynamics as the study on an economy inwhich rates of output are changing. It can be classified in to the period analysis and rate of change analysis. Inthe period analysis, time is split up into different periods and is able to study the events each period in relationto the previous period. In the case of rates of change analysis the race of certain variables are taken it invalidatethe change of other variables. These represent

CONSUMPTION FUNCTION

The Definition of Consumption

The term consumption should be reserved for the using up of the services yielded by a

good, while the act of purchasing it is consumer expenditure. So consumption is the uses ofgoods and services for maximum satisfactions. It is related to the disposable income. Goods


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which yield their services over a relatively short period are referred to as non-durables where asgoods which yield services to households over a number of years are known as consumer

durables. Consumer expenditure is the purchase of consumer non-durables and services and ofnew consumer durables. Expenditure on consumer durables forms part of aggregate demand for

currently produced output, where as the services yielded by the existing stock of durables do not.

The expectation of obtaining such services is a determinant of expenditure on consumerdurables. The distinction between consumption and consumer expenditure is an extremely

important one. Their actual numerical values will different in a non-stationary economy and thedeterminants of expenditure on durables will be differentiated from those which determine the

rate of using durable goods. A consumer durable is really an investment good since it ispurchased in order to obtain a flow of future services. In principles, the purchase of any goodwhich is expected to yield services at some future date is an act of investment. In official

statistics the term investment is reserved for the purchase of a capital good when it is done by afirm with the intention of selling future services or goods produced by the capital good on a

market. Such purchases are normally classified as consumer expenditure on durables and so areincluded as part of total consumer expenditure even though they are essentially acts of

investment. When examining the determinants of the desire to purchase both capital andconsumer goods, one must necessarily analyses the relevant decisions-units behaviour overtime. The present value of the expected future services of the good has to be compared with the

purchase price of the good, both in deciding whether the good is worth buying in decidingwhether it is worth replacing. Thus the existing stock of goods and the type and time profile ofthe services they are expected to yield will affect current purchase of the good. Households may

allocate their current periods income to current or

The Absolute Income Hypothesis

The aggregate consumption function is a core element in the Keynesian theory of income

determination. In the General Theory Keynes gave primary importance to disposable national

income as the chief determinant of aggregate consumption. He also made a prior assumptionabout the form of the relationship between consumption and income. For a household, andhence for the economy as a whole, consumption as a proportion of income tends to decline asincome rises. The basic form of the early Keynesians consumption function is that current

consumption depends on current income:

Ct = a + bYt

The hypothesis that consumption is a function of current income, whether the relationship

is linear or non-linear, is known as the absolute income hypothesis. In the above equation, it is

stated that there is a linear consumption function since b, the marginal propensity to consume(MPC) is constant. A further feature of this consumption function is that is non-proportional:the average propensity to consume (APC) = C/Y = a/Y + b declines as Y increases. A linear

non-proportional consumption function, C = a + bY, is explained in the following figure, where,if the MPC falls as income rises, then the consumption function is non-linear, as shown by thegraph ofC = f(y) in following figure.


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Y E

C = f(y) = C= a+byY=C+I E1

Yt Income (Y)

In the above Figure it is clear that the line C= a+by denotes linear non-proportional

consumption function. The line C=f (y) shows known linear consumption function. For instance,

the consumption function was one of the first economic relationships to be estimated in the1940s by the then recently developed techniques of econometrics. As with most economic

relationships two types of data, cross-section and time series data, are available for testing theconsumption function. Cross-section data are provided by sampling households to obtain

information for a particular time period on their consumption expenditure, disposable incomeand other relevant explanatory variables such as family composition by age and sex, and socialclass. Such budget studies have shown that the average propensity to consume

American economists at the end of the Second World War attempted to forecast post-war

consumption, and concluded that unless a high level of government expenditure continuedaggregate demand would be insufficient to maintain full employment. In the event of Americanpost-war, consumption was considerably greater than had been predicted by many economists

and it appeared that the whole pre-war consumption function must have shifted upwards.

In 1946 Prof. Simon Kuznets published long-run time-series data for the USA whichshowed that the long-run APC had not fallen as national income had increased, but was on thewhole quite stable, and maintained a long-run average of around 0.84-0.89, only rising to above

0.89 when national income fell in the decade 1029-38. From Kuznetss data, it is obtained along-run consumption function such that the long-run APC and MPC are both constant and equal

to k. This type of consumption function is known as a proportional to one another and can beexplained as

C =kY

So although the early empirical work showed that budget study data and short-run time-

series data supported the absolute income hypothesis and Keyness presumption that the APCfalls as income rises, the long-run data conflicted with these conclusions. Empirical studies show

that the long-run MPC is considerably higher than the short-run MPC. In addition, long-runconsumption functions are much more stable than short-run consumption-income relationships.An examination of the UK time-series data for consumption and disposable income reveals quite


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clearly the erratic nature of the quarterly consumption-income relationship in contrast to themuch more stable long-term relationship. Consumption has a distinct quarterly behavioral

pattern: consumption is lowest in the first quarter of the year and rises steadily in each quarter,reaching its highest level of the year in the last quarter. Income, however, does not display such a

quarterly pattern. Hence the APC rises form a relatively low level in the first quarter of the year to

a higher level in the last quarter.

The Permanent Income Hypothesis The permanent income hypothesis (PIH) of Milton Friedman is based explicitly on the theory ofintertemporal choice on the assumption that consumers take account of future income and futureconsumption possibilities when planning current consumption, changes in current income, whichFriedman terms measured income, will only affect current consumption by way of resulting changes inwealth. In a world of certainty, permanent income is the return on the households human and non-humanwealth. The households wealth is the present value of the future flow of income, which is expected bythe household to be variable from year to year.

.

Friedman assumes that consumption, defined to mean the act of consuming the services

of goods, is planned on the basis of permanent income and that the relationship between the twovariables is proportional. The model becomes:

C = Kyp

The coefficient of proportionality, k, which is the true underlying MPC and APC, assumedto depend on those factors which affect the households saving decision. These factors are

household preferences, the nature of the uncertainties facing the household, the rate of interestand the ratio of human to non-human wealth. Human wealth is the present value of future income

that people expect to earn by using their personal skills and labour. Non-human wealth is the

present value of income obtained from financial and capital assets. The particular uncertaintiesattached to labour income make it more difficult to borrow using human rather than non-human

wealth as security. It is therefore assumed that zero correlations hold between yp and y

T and C.

The last assumption means any positive transitory income is not spend on consumption but is

saved. Saving is defined to include investment in consumer durables as well as in financial assetsand capital goods. Thus, consumption refers purely to the using up of goods by enjoying their

services. These assumptions mean that any changes in measured income will only affect currentconsumption if they cause the household to alter its estimate of permanent income.

The Life - Cycle Hypothesis

The life-cycle hypothesis (LCH) developed by Ando, Brumberg and Modigliani is, like

permanent income hypothesis, which is based on household utility maximizing behaviour. Giventhat the household has a known life span and intends to leave non legacies and also givencertainty, the motivate for saving is to rearrange lifetime consumption in relation to the expectedfuture income stream. The LCH stresses the accumulation of non-human wealth as the means of

achieving this aim. Uncertainty provides an additional, related motive of saving, that ofprotecting consumption plans from the effects of unexpected falls in real income. The typical

time profile of a lifetime income stream is one that rises in the early working years, reaches aplateau in middle years and is followed by a sudden decline upon retirement. To even out the


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time profile of life time consumption a typical household will dissave or save very little whenyoung, save in the middle years and dissave upon retirement.

It is assumed that the households current consumption is proportional to its total resources,the factor of proportionality depending on the interest rate used to discount future income, tastes

and age of household. Total resources are subdivided into current income, y1, the present value offuture income from human sources, yE, and accumulated assets, A

t-1, brought forward from the

previous period. Total resources are the same as Friedmans present value of all future incomeexpected from human and non-human sources of wealth. The difference between the LCH and PIH

is one of the emphases, in that the LCH is concerned explicitly with the role of asset accumulationand the effect of age on household consumption. The LCH is similar to the PIH, in that it assumesthat any change in total resources, due to any of the three components, will cause a proportional

change in planned consumption in all future periods. The APC for a given age group is thereforededuced to be the same for all levels of income, to fall with middle age group and rise again

upon retirement. The middle years are a period when income is relatively high, consumerdurables have been acquired and there is a need to accumulate assets with which to finance

consumption upon retirement.The result of a change in current income on consumption depends on the effect of that

change upon the households total resources. If the change is regarded as only temporary, it willhave very little effect on current consumption. If the change is considered permanent it will

cause expectations of income to be revised in the same direction. The younger is the household,the more its current consumption will be affected by a change in current income regarded as

permanent. Since there is a longer period over which the changed level of expected income willbe discounted and hence a larger impact on total resources. The consumption function for eachage group is assumed to be:

CTt= kT(VTt )

Where Vtis the total resources at time tand Tindicates the age group to which

the function applies.

Consumption Theory and Policy Implications

The application of Keynesian demand-management policies requires a reasonable

knowledge of the determinants of short-run consumption. The short-run MPC is relatively small

and the relationship between current consumption and current income, even on an annual basis,is quite erratic, while the quantitative effect of determinants other than income is still an

unresolved issue. There is still disagreement concerning the channels through whichmacroeconomic policy affects consumption expenditure. The traditional Keynesian view is that

disposable income is the predominant channel in this transmission mechanism, while changes inthe money supply and interest rates have very little influence. This leaves direct and indirect taxchanges as the principal means by which the government can regulate consumption. However,

the PIH suggests the influence for fiscal policy since tax changes can only affect consumption if


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they alter permanent income. Thus temporary tax changes will have no impact on consumptionbecause they only affect transitory income. If expectations are formed rationally, then any tax

changes which we can anticipate by households have already been taken account of in theirestimates of permanent income. As these will not be revised when the anticipated tax changes

occur, then only unanticipated tax changes, which are regarded as permanent, will affect

consumption. However, the PIH does predict that a change in transitory income will be entirelyabsorbed house hold saving, which includes purchases of consumer durables. This enables tax

changes to affect a sub-component of aggregate consumption expenditure. Opponents of the PIHmaintain that households cannot borrow extensively on the expectation of uncertain future

income. They, therefore face a banking liquidity constraint which enforces a reasonable closecorrespondence between current consumption and current income. The PI-LC hypotheses givemonetary policy a greater role in determining aggregate consumption than does the traditional

Keynesian approach with its emphasis on current disposable income. The difference arisesbecause the PI-LC hypotheses treat consumption as determined by wealth or its permanent income

equivalent. The monetarist view of the transmission mechanism is that monetary policy affectsaggregate demand by causing portfolio adjustment. Any change in either total private-sector net

wealth or in its composition will result in portfolio disequilibrium. Asset-holders will adjust backto equilibrium by shifting between the various types of financial and real assets. The governmentcan increase the total amount of private-sector wealth by increasing the stock of government can

increase the total amount of private-sector wealth by increasing the stock of government bondsor money. Wealth will also increase if the ratio of money to bonds is increased, causing interestrates to fall. This, in turn, will increase the present value of future expected human income and

raise the prices of financial assets, including equity. Therefore, total wealth and permanentincome will rise. In the monetarist transmission mechanism the effect of a change in the stock of

money is thus both more direct, because consumption depends on wealth, and more pervasivebecause portfolio adjustment occurs across the whole range of financial assets and goods. Incontrast the traditional Keynesian transmission mechanism is indirect as it is restricted to

interest-rate changes only the consumption component of aggregate demand is regarded asunresponsive to interest-rate changes. Keynesians, especially in Britain, considered that

monetary policy only affects consumption by changing the availability of credit, whereas its costhas little effect. However, these differences should not be exaggerated, particularly with respectto post-1960 developments. Keynesian economists such as James Tobin have been in the

forefront of developing a general equilibrium portfolio approach to financial analysis, and morerecent Keynesian econometric models, particularly the US ones, do now incorporate a relatively

comprehensive monetary transmission mechanism.In macro economic analysis, in order to study the consumption function, it is essential to

evaluate the basic consumption function model. For instance in a Keynesian model the absolute

income -consumption function and important ingredients because it is simple wage of obtain amultiplier process

The Simple Keynesian model

The Simple Keynesian model is purely a one sector model which is based on the

assumption that involuntary unemployment is the result of deficiency in effective demand, soany addition in aggregate demand or aggregate supply is the solution of the unemployment.


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There is no monetary sector in contrast to quantity theory of model, which assumes exogenouslyfixed price level. The major conclusion of the model is that it can solve for an equilibrium value

of national output which is less than the maximum amount firms would wish to supply at theexisting price level. In this situation firms would produce more at current prices if only aggregate

demand were higher. Apart from an exogenous price level, the model makes a number of

simplifying assumptions. It assumes that both the stock of capital and the labour force, whichwhen fully utilized determine the maximum level of real output the economy can produce, are

constant, an underlying behavioral assumption of the model is that firms act as profitmaximisers. If demand for their output exceeds supply, firms increase production, providing

there are spare resources to put to work. Conversely, if supply exceeds demand, firms reduceoutput. The Simple Keynesian model is a shot-run model and determines the value of realnational output for a particular period of time, such as a year. The model solves for the static

equilibrium level of real output, this being the value of real output that has no tendency to changeonce it has been established. This requires that the supply of real national output, y, equals the

quantity of national output which people wish to buy, E. The condition for static equilibrium inour model is:

y = E, where E is the desired aggregate demand. We then define aggregate demand asbeing composed of real consumption expenditure, C, and real investment expenditure, I. This is

another example of a definitional relationship is:

E C + I

A further behavioral assumption is made, that real consumption varies directly with real

national income. The behavioral relationship is:

C = a+ by, where a is a constant, b =dC/dy and is known as the marginal propensity to

consume (MPC). The MPC is the change in consumption that results from a change in income(MPC = C/ Y). Another simplifying assumption is that investment is exogenous or

autonomous. This is indicated as I = I0. Consumption and income are endogenous variables as

they are determined in the model. To solve the model in order to find the static equilibrium

values for consumption and real income we substitute the earlier equations into:

y = a + by +I0

and solving this for y gives

and 1/(1-b) is known as a multiplier.

By substituting the above equation, we obtain:

C=a + AE/(1-b)

An alternative to the algebraic exposition done above can be simplified into a geometricmodel, which is given in the following figure.


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Y E

Y=C+I E1 Y C+I1

E0 Y C+I0

Y = C+I+ I

Y0 Y1 Income (Y)

In the above figure, the equilibrium condition is given by the 450

line along which y = E.Aggregate demand is given by the

E0

C0

+ I0schedule,

The slope of which depends on the marginal propensity to consume. The dotted lines crossat the equilibrium level of national output, yE

0 . Because prices are assumed fixed there is nothing

in the model to ensure that the equilibrium level of output is the same maximum amount ofoutput firms would be willing to produce at these prices. The latter level of output is known asKeynesian analysis as the full employment level of national output The crucial distinctive

characteristic of a Keynesian model is that it can solve of an equilibrium level of output at whichthe capital stock and labour force are not fully employed. If the level of aggregate demand is

increased by the shift from E0 to E1, the equilibrium level of output will rise from yE0 to yE1because output in perfectly elastic supply at current, fixed prices.

The Financial Sector

It is assumed in the IS-LM model that there are only two financial assets: money and bonds.Money has a zero rate of return since the price level is constant and no rate of interest is paid on money.By definition, money is any commodity which is generally accepted as a medium of exchange, and, inmodern economics, it consists of notes and coin in circulation with the public plus bank deposits whichare transferable by cheque. As well as being a medium of exchange, money can be a store of value.

Money is defined to be a perfectly liquid asset since a nominal quantity of money, can always beexchanged for the same nominal quantity without fear of loss and without incurring transactions costs.The liquidity of an asset is a concept which embraces the time, the transactions costs and the risk of lossassociated with turning an asset into money.

A bond is an imperfectly liquid asset since in order to convert it into cash it has to be soldon a market at the risk of making a capital loss if the selling price is less than the price at which

the bond was originally bought. The alternative of waiting till the bond matures and the principalis repaid involves time, which is included in the concept of illiquidity. Hence a financial asset is


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regarded as more illiquid, the longer its time to maturity. The price of a bond on a market is thepresent value of the income stream to which the bond is a claim.

The current interest rate is the yield on bonds, which is defined to be that rate of interest

which, used as a discount rate, makes the present value of the future income from a bond equal toits market price.

Thus, if bond prices rise, the yield or current interest rate falls. As the IS-LMmodel contains

only one interest bearing financial asset, there is only a single rate of interest to be considered. In

an economy with a number of financial assets, differing in marketability, riskiness and date tomaturity, there exists a whole range of interest rates which is known as the interest-rate structure.There is a tendency for interest rates to move in line with one another so that reducing the

number of interest rates is a simplification.

The demand for money (Liquidity Preference)

The demand for money is the demand to hold a stock of money balances. LiquidityPreference is the desire to hold liquid money for transactionary, precautionary and speculativemotives. It can be expressed either in nominal or in real terms. The nominal value of money, M,is the actual number of currency units, in existence. The real value of money, M/P, is its nominal

value deflated by an index of the price level. The quantity of nominal money required tofinance transactions is presumed to depend on the nominal value of national income and can be

generally expressed as: MD = (y) = (Y) Note that the functional notation replaces theconstant coefficient k, or constant velocity assumption, in the quantity theory of money.

The supply of money

The supply of money is the total quantity of coins, currencies, bank money, deposits in postoffices and the money derived from the use of credit instruments. It is expressed as Ms0/P and isconstant during one year period.

If we wish to depict the demand function for money on a two-dimensional diagram, weneed to hold all except one determinant constant. The following Figure shows the demand formoney as a function of the rate of interest.


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D1

D0 Ms0/P

Interest rate i1

i0

D1 =(Y)

D0 =(Y)

y0

Quantity of real money balances

In the above figure each demand for money schedule holds income, as well as theexogenous variables which determine it. Demand schedule D0D

ois plotted for a level of real

national income which is constant at y0. The supply of money, MS

O/p, is given by the vertical

line, as it is assumed exogenous and hence unaffected by the interest rate. If the level of outputis y

0, the interest rate must i

ofor the demand and supply of money to be equal. At a higher level

of output y1, the transactions demand for money is greater, and hence a higher interest rate, i

1, is

required to make the asset demand for money lower so as to still equate the money stock withdemand for money. In the above it is explained that how LM function is derived from real

income. Here, the level of real income is measured in horizontal axis and interest rate on thevertical axis. Y

0income is a function of i

0interest rate and y

1income is also the function of i

1

interest rate.

Policy analysis in a Keynesian model

Fiscal and monetary policy will be examined in the context of a Keynesian model withidle resources. This means that an expansion of aggregate demand will cause an increase in realoutput.

Fiscal policy

Fiscal policy is government attempt to varying taxation at govt. expenditure to managegovernment budget. An expansionary fiscal policy caused by either an increase in government

expenditure or by a reduction in taxation will shift the IS schedule upwards to the right. It isexplained in the following figure.


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LM

Interest rate i1

i0

IS1

IS

y y1Real Income

In the above Figure, it is assumed that a pure fiscal policy, resulting form governmentsbudget deficit is financed by bond sales to the public. The assumption of an unchanged money

supply allows us to assume that the LMcurve does not shift as it would if the money supply wereincreased in order to finance the fiscal deficit. The increased government spending, or increasedprivate spending due to a tax cut, stimulates output, which increases national income from y

0to

y1. At a higher level of income the demand for money would exceed the unchanged money

supply if the rate of interest remained unaltered. At a rate of interest of i1

and an income level of

y1

the demand for money is once more equal to the supply of money. The increase in the interest

rate following a fiscal expansion will be greater and more interest-inelastic is the demand formoney, since a larger change in the interest rate is required to persuade people to hold a given

money stock at a higher level of income.

.The change in the rate of interest required maintaining monetary equilibrium when output

changes are greater; the more interest-inelastic is the demand for money. This means that theslope of the LM function is steeper; the more interest-inelastic is the demand for money. Sincethe increase in the rate of interest following a given expansionary fiscal policy is greater, themore interest-inelastic is the demand for money, the resulting increase in real output is smaller.

Monetary Policy

A standard method

economics for business -unit iv

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