Unit 1
- 1. UNIT 1 CLASSICALAND KEYNESIAN APPROACHES structure 1.0 Objectives 1.I Iiltroduction 1.2 SomeCencepts 1.2.1 Aggregate Supply 1.2.2 Supply of and Demand for Labour 1.2.3 Aggregate Demand 1.2.4 Equilibrium Output andPrice 1.2.5 Measurement of Aggregate Output 1.26 Circular Flowof Income 1.3 Various Schools of Thought 1.4 CollsurnptionExpenditureandSavitig 1.4.1 Average and Marginal Propensity to Consume 1.4.3 Consumption Function 1.4.3 Saving Function 1.4.4 Determinants of Consumptionand Saving 1.5 Fixed PriceKeynesianModel 1.6 1r;vesttnent~ulti~lier 1.7 Let Us SumUp 1.8 Key Words 1.9 SomeUsefulBooks 1 .I 0 AnswersMints toCheckYourProgressExercises 1.0 OBJECTIVES Aftergoingthroughthis unityoushouldbe inapositionto explaintheconceptsofaggregatedemandandaggregatesupply; identifythe factorsinfluencingagyegatedemandandaggregatesupply; explaintheClassicalapproachtodeterminationofequilibriumoutputandprices; and explaintheKeynesianapproachtodeterminationofeqdibriumoutputandprices. 1.1 INTRODUCTION Macroeconomicsconcernswith thestudyofaggregatebehaviourinaneconomy.The need foraspecialbmchofmacmnomicsarisesbecausewhatholdsfortheindividual unit may not hold good fortheaggregate.For example,afirmmay be in apositionto increaseitsoutputlevel intheshortrunto meet the increaseddemandforitsproduct. Hut ifallf m swanttoincreasetheiroutputlevel,intheshortrunitwouldnotbepossible
- 2. TraditionalApproachesto Macroeconomics becauseof limitedavailabilityofresources(say, labour)unlessthere areunemployed~ resources in the economy.Thus the increase in demand may result in hike in pice4 withoutany increase inoutput. I Throughtheintersectionofaggregatedemandandaggregatesupplyweobtainaggregatd output and aggregateprice level for the economy.A change in aggregate demand or aggregatesupplywould influencethe levelsofoutputandprices. Economistsdifferon the mechanismandspeedwith which suchchangetakesplace in theeconomy.Inthis unit>we'willdiscusstheclassicalandKeynesianapproachesto determinationofoutput andpricesinaneconomy.However,wehgin with somebasicconceptsbeforewe deal withtheseapproaches. 1.2 SOMECONCEPTS Webeginwiththedefinitionofcertainimportantconcepts,whichwe will beusinginthis course. 1.2.1 Aggregate Supply I Aggregate supply of an economy is the amount of output produced by firms in thk economy. Withthe objective of profit maximization firms decide on the quantityof outputthey supplytothemarket.Thetotal outputproduced dependsupontwo factors: i) level of inputs,and ii)level ofteclmology.The demand for inputsby firms depends upon inputprices. We assumethat there aretwo primary factors, viz., labour (L)and capital (K)used in the production process. Ofthese two inputs, labour is supplied by householdswhilecapitalisthe stockofequipment andstructureused in productionand availableinthemarket.Machineries,buildingandvehiclesareexamplesofcapital input. Through 'investment' wecan increasethe level ofcapital inputintheeconomy.Onthe otherhand, laboursupplydependson populationgrowtll.Wewill learnmore aboutthe productionfunction,which showsatechnicalrelationshipbetween inputsandoutputin Block 2. Asthe quantityofinputused increasesthereisanincreasein output, andthereforethe quantitysupplied(Q").Aggregatesupplycurve(AS)isplotted ona graph(seeFig. 1.1) wherex-axis denotesquantityoflaboursuppliedandy-axis denotespriceofoutput(P). Recallfrommicroeconomicsthatindividualsupplycurveisupwardslopinginprices.In the caseofaggregatesupplycurve.however,thereis disagreement amongeconomists -whether itisavertical stmightlineoranincreasingcurveinprices. Usuallyitisassumad thatintheshortrunaggregatesupplyisupwardslopingwhileinthelongrunit isvertical. 1.2.2 Supply of and Demand for Labour Thequantityoflaboursupplied (L' ) byhouseholdsdependsupontheprevailingwage rate.Ifwagerate istoo lowcertainindividualsmay optoutofthe marketwhileathigher wagerateindividualsmayput inmoreworkinghours.Thusthereisa directrelationsGp between laboursupplyandwagerate.Rememberthat whenwetalk ofunemployment, wemean 'involuntary unemployment'; weexcludevoluntaryunemployment.The ' l a b force' or 'workforce' isthe sumofemployedandunemployedpersons.Unemploymdnt rate isdefined asthe percentageof labourforce that isnot employed. Thequantityoflabourdemanded (L" ) isadownwardslopingcurve ofwagerate.By interaction of the supply and demand curves of labour the equilibrium wage rate is determined.Wageratecanbe measured innominalorreal terms. Bynominal wage (w)
- 3. -- we meanwage accountedin moneyterns. Onthe otherhand,by realwagewemean W nominalwageadjustedforpricechange (-1 .Thusifthereisanincreaseinpricelevel P (P)andnominal wageratedoesnot increasethenthereisa decreaseinreal wagerate. 1.2.3 Aggregate Demand Inmacroeconomicsweusethetermaggregatedemand(AD)toincludethetotaldemand for goods and servicesproduced in the economy. Aggregatedemand is an inverse functionin prices depictedby a downward slopingcurve. Thus, asprices increase, aggregatedemanddecreases. Aggregatedemandisviewedintermsofexpenditureorspendingongoodsandservices. Therearefourmajorcomponentsofaggregatedeniand:i)consumptionexpenditure,ii) investment,iii)gbvemmentexpenditure,andiv)netexports.Thus *< Q"=C+I+G+(X-M) ...(1.1) where Q1'is aggregatedemand, Cisconsumptionexpenditure,I isinvestment,G is governmentexpenditure,XisexportsandMisimports.Thus(X-M)indicatenetexports. In a closedeconomy,where there isno foreigntrade,Xand Mare equalto zero and thusdonot get includedin (1.1).Thebehaviouroftheseconstituentswillbe discussed later. 1.2.4 Equilibrium Output and Price It ismentionedabovethat aggregatesupplycurve(AS)isupward sloping(intheshort run)whileaggregatedemandcurve(AD)isdownwardsloping.Throughtheintersection ofaggiegatesupplyandaggregatedemandcurvesweobtainequilibriumlevelsofoutput andprices. p I Q 0, Q Fig. 1.1 :EquilibriumOutputandPrice Levels Classicaland Keynesian Approaches
- 4. Tradition*l*~~roachwo In Fig. 1.1aggregatesupplyisgivenbj the 11neAS, and aggregatedemandisgiven hy Macroeconomics the line AD, Correspondingto the equality betweenAS, and AI), we find that the equilibriumlevelofoutputis Q, and equilibriumprice level isP,. Supposethere is a downward shiftinaggregatedemandfromAD,t o m , dueto changesinthelevelsof its components.Accordingly.the equilibrium levelsofoutput and price will changeto Q, and P,. I Certainquestionsmay be shapingup ii: yourmind atthispoint. How soondoessucha change in outputleveltakeplace? What isthe impactofsucha changeonthe levellof employment? If Q,representsfull employnlentequilibrium,doesthe economyever regainitsfullemploymentoutputlevel? WhenthereisadeclineinADthe immediate impactisadownwardshiftintheoutput level.Consequently,there isariseinunemploymentinthe economywhichpushesthe wageratedownward.Thedeclineinwagerate islikelytoreducecostofproductionand hencepricc level.As aresult,theAS cuwewill shiftdownward.'Tlrewhole process. however,takes time asthe declinein nominalwage and prices is not instantaneoys. ?'herfore,intheshortixmoutputdeclinesbelow fill1employmentlevelbut inthelong itreturnstoitsfill1employmentlevel. Solongonoutputremainsbelowfullemploymdnt level,thereisathndencyforwage ratetodecline.Through adjustmentsinwagerateahd pricestheoutput levelrecoverstoitsfill1enlploymentlevel,althoughwith considerable delay. Oncefullemploymentisrealised, increase inADwill resultinpricerise.Thus fluctuationsinoutput,wagerateandprice levelareapartoftheprocess.Suchfluctuations areoftensystenlaticand calledbusiness cycles. 1.2.5 Measurement of Aggregate Output You mayhaveheardoftheconceptgrossdonlesticproduct (GDP).which ismeasured incurrentpricesor inconstantprices. Empiricallyaggregateoutput(Q)ofaneconomy isgivenby GDPatconstantprices. ThusGDYatmarketpricesrepresents P x Q . GDPcanbe measured bythree approaches:i) sumoffinaloutput(Q),ii)sum offacaor income(Y),andiii)sumoffinalexpenditure(E).All threemeasuresprovidethe m e valueofGDP.Therefore,we will useY and Qinterchangeablyto representaggregate output. Ifwe subtractnettaxes(T)fromtotal income(Y)weobtainpersonal disposableincome (Y-T), which isadeterminingfactorinconsumptionexpenditure(C). Whiledealingwithtime seriesdatawewoulduse subscript'I' torepresenttimepel f4d. Forexample C,-,istotal consumptionfor period (t-1). 1.2.6 Circular Flow of Income There are basically three economic agents in the economy: households, firnls and government.Thehouseholdsreceiveincomeby sellingtheir labourandcapitalinputsin the factor market. This income is used on three heads: i) payment of taxes to the government, ii)consumptionof goodsand services,andiii) savingthroughfinancial markets.Firmsusetherevenueobtainedbysellinggoodsandd c e sforfactorpapats. Thegovernmentreceivesrevenuefrom taxes, which isused forpurchaseof goodsand services.IfgovernmentrevenueisIc. Lhanitspurchases(thatmeansifthereisadefiail') thenthegovernmentborrowsfromthefinancialmarkets.
- 5. 7 Classical and Keynesian I ' . 1 Fig. 1.2:Circular Flowof Income t Income Eb 'Thusthere isa circularflowofincomeandexpenditurefromoneeconomicagentto othersin aclosedeconomy.Ifforeigntrade isallowed,themodel presented atFig. 1.2 r I needsmodificationandexternalsectorneedstobeintroduced.Rememberthatthecircular I flowdepictedin Fig. 1.2isa simplificationofrealityevenfora closedeconomy.Here we assumethathouseholdsownlabourandcapital.Inpractice, firmsalsoowncapital, make investment,and paytaxesto thegovernment.Governmenttransfersmoney to householdsassocialsecuritymeasures. 1.3 .VARIOUSSCHOOLSOFTHOUGHT Amongeconomiststhereisnoagreementonhowadjustmentsinequilibriumlevelsof Markets for Factors of Production output,prices andemploymenttakeplace.Therearealsodifferencesinviewsoilthe sourcesofeconomicfluctuations.Basicallytherearetwoimportantschoolsofthought: classicalandKeynesian.Classical approachisatermcoinedby~oh~MayrMd~eynes to reflectthe ideaspresentedby economistspriorto him. Prominent amongclassical economists Adam Smith,DavidRicardo,ThomasMalthusandJohnStuartMill.The classicalandKeynesianeconomistsdifferon: i)therelativerolesplayedby supplyand demandindeterminationofoutput,employmentandprices, ii)theflexibilityofprices andwagerateintheeconomy,and iii)thedichotomybetweenreal sectorandmonetary scctvr. Theinainstayofclassicaleconomicshasbeenthebasicassumptionthat 'supply createsitsown demand'; oftenreferred to as 'Say's law', named afterJ. B. Say.The Keynesianeconomistsruleoutsuchapossibility,particularlyduringperiodsofrecession. ., Approaches Factor Payments w Infxt,Keynesianeconomicsevolvedontheaftermathofthe 'Great Depression' during 1929-34withthepublication of 'The GeneralTheoryofEmployment,Interestand Money' in 1936by Keynes.Aswewillnoticebelow,theclassicaleconomistsfailedto tiousehold savings +, Financial Markets Government Deficit w Firms A Ciovem~nent1Io~~scliolds 'Taxes D- Firm revenue Government I'urchases Consumption Investment Market5 foKtoods and Services
- 6. TraditionalApproachesto Macroeconomics explaintheprevailingunemploymentanddeclineinoutputduringthe'Great ~e~ressionb. In an attempito explain the downturn ~eynes'su~~estedthat the GreatDepression occurredmainly dueto inadequatedemand.InKeynesianview 'demand createsiOs ownsupply' solongasunemployrlent existsintheeconomv, I The classical economists believed in free trade and minimum intervertion by thle governmentoneconomicactivities.Theysuggesteda 'laissez-faire' (~renchfor 'leave us alone') economy where government should confine itself to law, defence and governance.Insuchaneconomy 'market forces' will determinerealvariablessuchas output,employmentandprices. Thisismadepossibleby flexibilityinpriceandwage levels. Theclassicaleconomistsbelievedthattheaggregatesupplycurveisvertical, so thatthereisnochangeinequilibriumlevelofoutputandemployment(seeFig. 1.3). For example,supposethereisadownwardshiftinaggregatedemandfromAD,toAll, duetoreducedconsemptinexpenditurebyhouseholds.Thiswillresultinexcesssupply atthe prevailingprice P,. Consequently,priceswill declineto P,whiletherewillben$ declinein outputlevel, and market getscleared. In the factormarket,wage rate will declinesothatl l l employmentismaintained.AccordingtoclassicaleconomiststhereiS a 'self-correctingmechanisrr:'bchindthe 'marketclearing model7oftheeconomy.The processofchangeinwage rateandpricesareachievedinstantaneously.Theclassic4 economists also assume dichotomy between real variables (such as output and employment)andnominalvariables(suchasmoneysupplyandprices). Thuschangesirb money supply(M) donot influenceoutputor employment.If there is adecreasein moneysupply,levelsofpricesandwageratewilldecline. Fig. 1.3:ClassicalApproach toOutputandPriceDetermination TheKeynesianapproach,however,doesnot subscribetotheverticalAS curve.Keynes pointsoutthat inthe shortrunthereareprice andwage 'rigidities' sothat prices and wagerate donot declinewhen thereisa downwardshiftinaggregatedemand.Wag$ rigiditiesarisebecauseofvariouscontractsandlabourlegislation.Duetowagerigidity, wagerate ismaintainedat ahigher level,Consequently, theoutputleveldeclinesand thereis 'recession' intheeconomy.Inthe short-runtheAS curveiseitherhorizontal ot upward sloping(in Fig. 1.1.we have presented an upward slopingAS curvesothat downwardshiftinADresultsindeclineinbothoutputandpricelevels).IntheKeynesim
- 7. I model, however, theAScurveisassumedto be verticalinthe longrunsothatoutput Classicaland Keynesian suppliedisfixed.Thuswecansaythattheclassicalmodelexplainsthelongrunwhilethe Approaches I i Keynesianmodelexplainstheshortrun. 1 In responseto the Keynesianeconomicsthe 'neoclassicaleconomists' (JohnHicks, I PaulSarnuelson,RobertSolowamongothers)attemptedtoimbibetheimportantideas of Keynesianeconomicsinaclassicalframework.Thepioneeringeffortsby SirJohn Hicks paved the way for the synthesisof classicaland Keynesian ideason real and nominal macro-variables,popdarlyknownasIS-LMmodel.Theneoclassicalgrowth 1 modelby Solowhelpedinanalysisoflongrungrowthofaneconomy. i The 'newclassicaleconomics' isatermbroadlyusedtodescribethechallengesposed totheKeynesianorthodoxy.Thisschoolofthought suggeststhateconomicfluctuations r canbeexplainedwhilemaintainjngclassicalassumptions.Someofthetopicsbased on newclassicaleconomicsthatwewill discussinlaterUnitsarerealbusinesscycletheory (Unit 14)andrationalexpectationshypothesis(unit7).Thenewclassicaleconomists (prominentareRobertBarroandRobertLucas)endorsethepriceandwageflexibility I assumedbyclassicaleconomists. The 'new Keynesianeconomics' isoftheviewthatwagesandpricesadjustslowlyto . shocks.Asaresult,fluctuationsinaggregatedemandcauseshortrun fluctuationsin outputandemployment.NewKeynesianeconomists(CmgoryMankiwamongothers) suggestthat 'menucosts', 'aggregatedemandexternalities' andcooWionfailurecause stickyprices. CheckYourProgress 1 1) Explaintheinteraction betweenhouseholdandfirmsthroughacircularflow diagram. 2) DistinguishbetweentheclassicalandKeynesianmodelsofautputandprice 1 detexminationintermsofdemandandsupplycurves.
- 8. TraditionalApproachesto Macroeconomics 1.4 CONSUMPTIONEXPENDITUREANDSAVING Forhouseholdsthepersonal disposableincome(thatis,incomeafterpayment oftaxes and addingtransfer payments)is allocatedoneitherconsumptionexpenditure(9or saving(S).Thuswe have +s = y . 1.4.1 Average and Marginal Propensity to Consume Consumptionexpenditureisthemajorheadof spendingby householdsanddepends uponpersonaldisposableincome.Itisgenerallyobservedthatforahouseholdthelevel ofconsumptionincreasesasincomelevelincreases.However,thereisaminimum level ofconsumptionrequiredforsurvival.Thus,inordertosurvive,ahouseholdhastospend aminimumamountonconsumptionevenifitsincomeleveliszero.Thehouseholdmay borrow forconsumptionexpenditureormay drawuponpast saving.Secondly.poorer householdsspendlessonconsumptionthanricherhouseholdsdo. But asapercentage ofhouseholdincome,it isobservedthatpoorerhouseholdsspendahigherpercentage oftheirincomeonconsumption. We introduce two conczpts: average propensity to consume (APC) and marginal propensitytoconsume(MPC).APC isdefinedastheratioofconsumptionexpenditure C to income(- ).For example,if afamilyhas anincomeof Rs. 8000 apd spendsRs. Y 5000 on consumption, then APC is 5000/8000 = 0.625. Marginal propensity to consume(MPC)isdefinedastheamountspentonconsumptionoutofevery additidnal AC Rupee earned.In symbolsit isgivenby -.Asanexample,MPC=0.65 fora fmily AY ifconsumptionexpenditureincreasesby &. 65PaisawhenincomeincreasesbyRs.100. 1.4.2 Consumption Function Consumptionfunctionshowstherelationshipbetweencandy. Ourconsumptionfunction shoulddepicttheabovefeatures.Ifwe ignoretaxesandsubsidiesby the government, thenconsumptionfunctionin itssimplestformisgivenby where Ct iscurrentconsumptionand Y, iscurrentincome. Theconsumptionfunction givenat(1.2)isastraightlinewithintercept C andslopec.Here C isthethreshold or minimumconsumptionwhenincomeiszero.SinceahouseholdspendsonlyapartoKits income onconsumptionthe value of c shouldbe lessthan 1.Moreover, c cannot be negative.Thusc remainsbetwen 0and 1,that is, 0 <c <1.We observethat c isthe AC MPC sincec = -.Notice animportant featureoftheconsumptionfunction,thdt is, AY the averagepropensity to consume (C, 1I;) falls as income rises. In Fig. 1.3(panel-a) we depictthe consumptionfunction.Here we draw a 45O line alongwhich whatever is earnedisconsumed,that is, C=Y When incomelevelisY,, consumptionequalsincomeastheconsumptionhction intersectsthe 45 line.71-i;s
- 9. levelofincomeiscalled'breakeven income', andontheavexage,afamilyhavingincome Y,consumeswhateverhearns.WhenincomeislessthanY,, consumptionlevelofthe household ismorethanits income.Ontheotherhand,when income ismorethanY,, consumptionis less than income. For example, in Fig. 1.3 (a) when income is Y, consumption isC,. Noticethatwhen incomeexceedsY,, wehave C <y . / 45' line function Fig. 1.4(a): ConsumptionFunction S Fig. 1.4(b): SavingFunction 1.4.3 Saving Function Aswen~tedearlier,incomeisthesumofconsumptionandsaving.Thusinthesimplified modelthatwe discussedabove,thatpart ofincomewhich isnotconsumedissaved.In Fig. 1.3(panel-b)wehavepresentedthesavingfunction.NoticethatwhenincomeisY, k Classicaland Keynesian Approaches
- 10. IradfiionaIAp~roachrn(0 thereisnosaving,asaonsumptionisequalto income.WhenincomeislessthanY,dere Macroeconomics isdis-saving,thatis, thehouseholdisexpectedtoborrowor drawuponpast savingin ordertofinanceitscurrentconsumptionexpenditure.Ontheotherhand, whenincodeis morethanY, apartofincomeischannelbedtowardssaving.Accordingly,inFig. 1.3(b) savingfunctionintersectsx-axiswhenincomeisY,.Sincetheconsumptionhctio isa straightline,thesavingfunctionalsoisanupwardslopingstraightlinewithslopes,w1'ch iscalledthemarginalpropensity to save(MPS).Theintercepttirm isnegativesihce savingisnegativewhenincomeiszero.Moreover,MPSispositiveandremain b e ~ n zaoa .one.Inequationformthesavingfunctionisgivenby RememberthatMPC andMPS addupto unity, that is, c +s = 1 . 1.4.4 Determinants of Consumption and Saving Acrucialissuebeforeahouseholdistodecideonhowmuchtoallucatetowardscurtent consumptionoutof itscurrentincome.Apartfromthe levelof incomeanotherfmor influencingthelevelofsavingistherateofinterest,thatis,highertheinterestratehi$her isthesaving. We know that when we save money (in the form of bank deposits or in bonds) we receive interest. Thuswhen we look beyond the currentperiod we expecta flowof incomeoverdifferenttimeperiods.Thusexpectedhtureincomeplaysanimportanttole inourdecisiononconsumptionandsavinginthecurrentperiodaswellasinfuturetime periods.Basedupon+hesimpleframeworkdiscussedabovethere quiteafew&er- temporalconsumptionmodels,whichwewill discussinBlock4. Asecondissueisthedetermbtionofaggregateconsumptionandsavingfortheeconomy asawhole. Whatwehaveexplainedaboveisthebehaviourofhouseholds.Itistruethat allhouseholdshavedifferentincomelevelsandMPC,whichposecertainmmplexiriies. Itisusually seenthat youngadultshavealowMPCl ~ l y d u eto lesserresponsibilikies comparedto oldpeople. Economicmodelsthat stressthepresenceofoldandyo~lng householdsarerefemd to as 'overlappinggenerationsmodel'. You may have observedthat savingrate varies acrosseconomiesandoverfima. In India, forexarnple,saving rate wasaround 10percentofGDPdwing 1950swhileit is around25 percentofGDPatpresent. Therehasbeenathree-foldincreaseinperabita ihcomqduring1950-51and2004-2005.However, higherpercapitaincomedoesnot translateintohighersavingratealways.Weobservethatamongdevelopedeconorrhies savingrateisnotuniform. Forexample,savingrateismuchhigherinJapan(about30 percent)comparedtotheUnited States(about 14percent).Thustheremay becertain otherfactorsapartfromincome, which influenceconsumptionandsavihgdecision. However,incrosscountryanalysisweseethatthereisapcitiveandstrongconelafion between saving rate and per capitaincome. Thus we can saythat the consumptiion function at aggregate level would also depict the same features as the household consumptionfunction Herewefirstestablishedarelationshipbetweenconsumptionandsavingof individual households and based upon that attempted to explain the behaviour of aggregate consumptionandaggregatesaving.Inotherwards,weprojectedthebehaviourofmacm
- 11. variablesonthebasisofmicrovariables. Thissortofresearch strategviscalled'micro- Classicaland Keynesian foundation' ofmacroeconon~icanalysis. Approaches Weassumedaboveintheconsumption(andsaving)functionthatconsumptiondepends uponthelevelofincome.However,therearecertainotherdeterminantsofconsumption. Theredistributionofincomeinfavouroflow-incomehouseholdswillresultinanincrease in MPCwhilethe oppositewill happenifthereis growinginequalityinthe economy. Second,theavailabilityofcreditwitheasealsoin-s consumption. Third,expectations regardingpriceandincomechangesalsoaffectconsumptionexpenditurebyhouseholds. lfpeopleexpectpricestodeclineincomingdaysaeypostponegpurchaseswhichresults inadownwardshiftinaggregatedemandcurve,anddeclineinequilibriumoutput.Fourth, aspointedoutbyFisherindividualsfacea 'money illusion' ifpricesandincomechange in the sameproportion-thereal incomeofpeopledoesnotchangebut theymaynot perceivethepriceriseandincreaseconsumptionasincomeincreases.FiRh,whenprices fall,there isanincreaseinreal valueoffixedincomeyieldingassets(suchasbonds), whichmayincreaseconsumption. 1.5 FIXEDPRICEKEYNESIANMODEL Theclassicaleconomistssuggestedthatthereshouldbefketmdeintheemnomybased onmarketrr~echanismandlittleinterventionbythegovernment,asitwouldbeineffective. Keynes,however,advocatedinterventionbythegovernmentinmacroeconomicvariables inordertocorrectthedisequilibriumintheeconomy. Forequilibriumtoberealisedthereshouldbeequalitybetweenaggregatedemandand aggregatesupply.Aswehaveseenearlier,aggregatesupplyisthetotaloutputproduced in theeconomywhile aggregatedemandisthe sumofconsumption,investmentand governmentexpenditure.Keynesianmodelassumesthatthereispricerigiditysothat adjustmenttakesplacethroughchangesmoutputlevel. 1 inFig. 1.4we depicttheadjustmentprocessintheemnomywhenpriceysfixed.Onthe / x -axiswemeasureaggregatesupply(levelofoutput)whileaggregatedemand(C+I+G) / ismeasuredanthey-axis. InFig. 1.4wehavedrawna45OlineonwhichAS=AD. We / assumethatinvestment(I)andgovernmentexpenditure(G)areexogenousvariablesin : the sensethat their levelsdonotdependupon thelevelofoutputorincome. &the aggregatedemandh t i o nwillbea p d e lshiftintheconsumptionfunction,thediffance 1 betweenthetwoindicatingthesumofinvestmentandgovernmentexpenditure(I*). InFig. 1.4weobservethatequilibriumlevelofoutputisY asthelineindicating(C+I+G) t'crossesthe45Olineatthis levelofoutput. Weknowtha the slopeoftheconsumption I functionisequaltoMPC. SupposethereisadecreaseintheMPCfromcto c'(implies 1 anincreaseintheprbpensityto save).ItimpliesthatforoneRupeeincreaseinincome, 1 aloweramountwillbespentoncons~~ption-andmorewillbedevotedtosaving.InFig. t, 1-4suchadeclineinMPCwillresultin adownwardrotationoftheconsumptionfunction i fromC to C' (seethe dottedline). Accordingly,(C'+I+G) will alsorotatedownward t andthenewequilibriumoutputlevelwillbeYLNoticethatanincreaseinthepropensity 1 to saveisresultinginadeclineinoutput. I I Weobservethat aggregatedemandchangesifthereis changeinC, I orG Therefore, increaseinbusiness investmentor governmentexpenditurewill increaseaggregate demand,andthusequilibriumoutputwill incxme. Similarly,adeclinein investmentor i , government expenditure will dampenaggregate demand and result in a decline in
- 12. TraditionalApproachesto Macroeconomics Fig. 1.5:Fixed-PriceKeynesianModel Wepointed outaboveinSub-section 1.2.1thataggregatedemandisseenintheconteAt ofaggregatespendinginthe economy.Duetothecircularflowof incomewhenode economicagentspendscertainamount(sayoneRupee), it causesan increaseinthe incomeofanothereconomicagentbythesameamount(byoneRupee).Basedonthiis simplelogicKahndevelopedthetheoryofmultiplier,oftenknownas'investmentmuhiplief.' Letusexplainthemultipliereffectthmughahypotheticalexample.Supposethegovernmerit issuesabondofRs. 100inthemarketsothatgovernmentexpenditurecanbei n c d by Rs. 100.Asaresult, a sequenceofeventswilltakeplace. 1) Theadditionalexpenditurebythegovernmentwillincreasetheincomeofhouseholdk byRs. 100.Outofthisincreasedincomethehouseholdconsumesanamounte q d to 1OOxcandsavestheresidual (ifMPC=0.65, thenthehouseholdwillspendRs. 65and saveRs. 35). 4- 2) Supposethehouseholdgettingthe incomeofRs. 100,spendsRs.65onpurchase ofbread.Consequently,theincomeofthebred-seller will increaseby Rs.65. 3) Whenthe incomeofthe bread-sellerincreasesby Rs. 65, shewill saveRs. 22.75 and spendRs. 42.25 (sinceMPC =0465). 4) ThespendingofRs.42.25bythebread-seller wdl increasetheincomeofanotha personbyRs.42.25.Thesequencewillcontinuefbrtherwiththeamountspentor earned&dung M e rinsubsequentrounds. RecallthattheinitialspendingbythegovernmentisRs. 100.But ithasarippleeffect& the economy, generating income of Rs. 100+Rs. 65 + Rs. 42.25 + ... .Thus, the increaseinaggregatedemandduetoaspendingofRs. 100bythegovernmentwouldbf muchmorethan Rs. 100. I
- 13. How much the whole sequencewould add-upto? If c is the marginalpropensityto Classicaland Keynesian consumethenthe seriesisaddsupto Approaches 1 s In(1.4)abovetheterm -iscalledthe'investmentmultiplier'sincem a t edemand 1-c 1 increasesbyamultipleof -foraninitialspemhgbythegovernment.Inourexample 1-c above when government expenditureincreased by Rs.100and MPC = 0.65, the 1 increaseinaggregatedemandwouldbe Rs.100x =Rs.285.71. 1-0.65 Wedrawa fewinferencesfromtheabove. 1) Governmentspendinghasthebeneficialeffectofboostingupaggregatedemand byahigheramountthantheinitialspending. x 2) An increaseinMPC will result in an increase in the value of themultiplier. Conversely,decreaseinMPSwouldresultinahighermultipliervalue. 3) Weassumedthatgovernmentspendmgisfinancedbyborrowingh mthemarket 1 Ifit istax financedthenthemultiplierwillbe 1,not -sinceincreaseintax 1-c willhavethemultipliereffectintheoppositedirection.Consequentlyaggregate demandwill increaseanamountequaltotheinitialspendingbythegovernment. It iscalled 'balanced budget multiplier' andisequalto 1. 4) It isassumedthat householdsspendaccordingtotheirMPCanddonot hoard themoney. KeynesprojectedtheGreatDepressionasaconsequenceofdemanddeficiency.There wasdeclineinincomebecauseofinaxmeinunemployment.Declineinincomegaverise to decreaseinconsumptiondemand.Inadequatedemandreiultedinexcesssupplyin themarketandinventoriesgot piledup, which discouragedW e rproduction.With curtailmentinproductiontherewasfiatherunemploymentandfurtherdeclineinincome. Secondly,peopleexpectedpricestodeclinefiathersothattheypostponedtheirpurchases whichreducedaggregatedemandfurther.Therewasanoverallgloomyperiodoffalling output, income and prices, and rising unemployment. Keynes suggested that the governmentshbvidincreaseitsspendingsothat peopleget employment,whichwill generateincomeanddemand. Intheaboveanalysisweobservethatgovernmentexpenditureisanexogenousvariable sothatitslevelcanbeincreased.Therecanbesimilarmultipliereffectsiftheexportof thecountrygoesup.Also,Slimscouldincreasetheirinvestment,amultipliereffectwill takeplace. CheckYourProgress2 1) Explaintheimportantfeaturesofconsumptionfunction. ,
- 14. TraditionalApproachesto Macroeconomics ........................................................................................................................... I; 2) IntheKeynesianmodel,whatisaggregatedemand?Howdoesachangein aggregate 1 demandaffectoutput? 3) Withanexampleexplaintheconceptofinvestmentmultiplier. ........................................................................................................................... ............................................................................................................................ ........................................................................................................................... ........................................................................................................................... 1.7 LETUS SUMUP Inthisunit wediscussedsomebasic conceptssuchasaggregatedemand, aggregate supplyandcircularflowofincome.Wealsoprovidedabriefideaondifferentschoolsof maclroeconomicthought. Theclassicaleconomistsassumedflexibilityinpriceandwagesothatthepossibilityof unemploymentintheeconomywasruledout.Theeconomyadjustedtodemandshocks throughchangesiiprice level sothateconomicfluctuationswerenotthere.Therewas noneedforgovernmeritinterventionintheclassicalmodelassupplywasinelasticatfull emplomentlevel.However,theGreatDepressiondemolishedtheclassicalbeliefs,as ' therewas&despread unemploymentassociatedwithdecliningpricesandoutput. Keynesianeconomicssuggestedthatdeficiencyinaggregatedemandcouldtriggera 1 recessionandtheremedyistoincreaseaggregatedemand.Keynesadvocatedincreased governmentspendingsothataggregatedemandwouldincreasesimultaneouslygiving 1 incomeandemplomenttopeople.Wediscussedconsumptionandsavingfunctions1 andinvestmentmultiplier,whichareimportantconceptsinKeynesianeconomics. 1.8 KEYWORDS - C ~ v e r a ~ ePropensityto Consume Theratioofconsumptiontoincome(- ). Y ,
- 15. ClassicalDichotomy ClassicalModel Keynesian Model MarginalPropensitytoConsume Menu Costs Multiplier Model New ClassicalEconomics New Keynesian Economics Openeconomy Thetheoreticalseparationofrealandnominal Classicalard Keynesian Approaches variablesintheeconomy.Itassumesthatmoney is neutral and doeanotinflue- output and employmentlevels. AmodeloftheeconorJlyderivedEromideasof thepre-Keynesianeconomists.It isbased on the:assumptionthatpricesandwagesadjustto clearmarketsandthat monetary policy does not influen&realvariablessuchasoutputand employment. A model based on the ideas contained in Keynes' General Theory. It assumes that demand creates its own supply so long as unemploymentexistsandthatpricesandwages donotadjustinstantaneouslytoclearmarkets. Theincreaseinconsumptionresultingfioma one-Rupeeincreaseinincome.It isgivenby AC When a firm wants to change prices of prodhcts, certain additional costs are to be incurred.Forexample,restaurantsreprinttheii menucards,shopsprinttheirpricecatalogues andtaxisadjusttheirmeters.l[hesecostsmay besmallbuttheytaketimeanddeterfirmsh m c mpricesfiquently. Theincreaseinoutputduetoaunit increasein certainexogenousvariable(suchasinvestment, governmentspendingandnetexports). A simplifiedrepresentationofrealitytoshow theinteractionamongvariables.Itispresented throughdiagramsorequations. Theschoolofthoughtprojectingtheviewthat economicfluctuation&be explainedwhile maintainingclassicalassumptions. n?e~ h o o lofthoughwhichsaysthatecamqk fhtwtioncanbeexplainedonlybyadmitting stickypricesandwagerate. Aneconomythat allowsfreetradewithother economies.it is-fiom'cbsedmmy' whereforeigntmcleisnotallowed.Indworld no economyisaclosedone.
- 16. TraditionalApproachesto I 1.9 SOMEUSEFULBOOKS i Macroeconomics I Mankiw,N. G, 2000,Macroeconomics,FourthEdition,Macmillan,New Delhi. Samuelson,P. A. and W. D. Nordhaus, 2005, Ecpnomics, EighteenthEdition,Tata McGrawHill,Delhi. - - 1.10 ANSWERSIHINTSTOCHECK YOUR PROGRESSEXERCISES CheckYourProgress1 1) SeeSub-section1.2.6andfmdouttheflowsofgoods,inputsandmoneybetween householdsandf mthroughvariousmarkets.DrawadiagramsimilartoFig. 1.2 andexplaintheflows. 2) ThedifferencebetweenclassicalandKeynesianmodelscanbe explainedinterms of i)therelativeimportanceofsupplyanddemand,ii)flexibilityinprice andwage levels,andiii)thetimeperiodunderconsideration(short-runorlong-run).Elaborate thesepoints. CheckYourProgress2 1) ExplainthebehaviourofAPCandMPC. Showtheconsumptionfunctioninterms ofadiagram.GothroughSub-section 1.4.2. 2) Explainthe componentsof aggregatedemand,viz., C,I and G Drawadiagram similartoFig. 1.4.~ x ~ l a i nthethan@in-gate demandanditsimpactonoutput. 3) GothroughSection 1.6.TakenumericalvalueforMPC andlevelofinvestment. Explaintheprocessofincreaseinincomeatvariousrounds.