Eco Sem-5 GKJ

Gobind Kumar Jha 9874411552
Contents
CHAPTER 1. BASIC CONCEPTS OF ECONOMICS
CHAPTER 2. NATIONAL INCOME
CHAPTER 3. DETERMINATION OF EQUILIBRIUM LEVEL OF NATIONAL INCOME
CHAPTER 4. IS AND LM MODEL
CHAPTER 5. INFLATION AND UNEMPLOYMENT
1
CHAPTER-1
BASIC CONCEPTS OF ECONOMICS
Meaning of macroeconomics:
Macroeconomics is that branch of Economics which is concerned with the economics
magnitudes relating to the economy as a whole. According to Kenneth Boulding,
“Macroeconomics deals ….not with individual income but with national income, not with
individual prices but with the price level, not with individual outputs but with national
output.”
According to Paul Sammuelson, “Macroeconomics is the study of the behaviour of the
economy as a whole. It examines the forces that affect many firms, consumers and
workers at the same time.”
Scope of Macroeconomics:
Some of the important issues analysed in Macroeconomics are the following:
1. Income and employment determination;
2. Price level;
3. Business cycles;
4. Economic growth.
Difference between Microeconomics and Macroeconomics:
Microeconomics Macroeconomics
1. It is that branch of economics which 1. It is that branch of economics
deals with the economic decision which deals with aggregates and
making of individual economic agents averages of the economy, e.g.
such as the producer, the consumer, aggregate output, national
etc. income, aggregate savings and
investment, etc.
2. In microeconomics, the economic 2. In macroeconomics, the decision
decision making units (or the making units (or the player) are
economics agents) are individual the Central Planning Authority,
consumers, individual producers etc. the Central Bank (e.g. the Reserve
Bank of India) etc.
3. It takes into account small 3. It takes into consideration the
components of the whole economic. economy of any county as a
whole.
4. It deals with the process of price 4. It deals with the general price
determination in case of individual level in any economy.
products and factors of production.
Some basic concepts:

a) Economic goods and non-economic goods: The goods which are scarce and not
available freely, can be termed as economic goods. Any individual or firm has to pay
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some price to avail economic goods. Example, the crude oil, iron ore, several
consumer goods (sold in the market), etc.
On the other hand, the goods which are available freely and not transacted in the
market, can be termed as non-economic goods. For example, natural light and air
are non-economic goods.
b) Economic and non-economic services: The services which can be availed of in
exchange of a price or money can be considered as economic services. For example,
the services provided
by the doctors, engineers, lawyers, tax consultants, etc. If some services are
provided free of any charges or price, then those services are called as non-economic
services. For example, the domestic services provided by millions of housewives in
India.
c) Consumer goods (or consumption goods): The goods which are used for
consumption purposes are called consumer goods. They are used for direct
consumption, and not for producing any other goods.
d) Intermediate goods: The goods which are used at some point in the production
process of other goods (rather than final consumption) are treated as intermediate
goods. For example, a farmer purchases high-yielding varieties of seeds, fertilizers,
diesel oil for running the pump-set or tractor etc.
Thus, intermediate goods are those goods which have not yet crossed the boundary
of production, i.e. they are not ready for a final use.
e) Capital goods: All the durable goods such as machines, building, trucks, ships,
airfields, aircraft, etc. used to produce goods and services for sale in the market, are
treated as capital goods.
f) Producer goods: The goods which are used by the producers for production
purposes, are considered as producer goods. Hence the fixed assets like the plant
machinery, and the raw materials used by producers in the production process, are
called as producer goods.
g) Final goods: When the goods are produced and sold to the consumers for final use,
then these goods are considered as final goods. Final goods cross the production
boundary and need not pass through any further stages of production.
h) Difference between intermediate and final goods:

Final goods Intermediate goods
These goods are used for final These goods are used for producing
consumption (for example, coal used at other goods (e.g. cola used in a factory)
home for cooking)
These goods have direct demand. These goods have derived demand.
These goods are included in the These goods are not included in the
calculation of national income. calculation of national income.
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These goods cross the production These goods do not cross the production
boundary. boundary.
There remains no scope for further Some value is still to be added to these
value addition to these goods. goods.
i) Stock and flows:

a) Stock: The stock refers to the level of a variable (at a particular point of time). For
example, the number of vehicles in a city, the amount of money in the saving
account (with any commercial bank) of a person, etc.
According to Richard G. Lipsey, ‘a stock variable has no time dimension.’ That is the
stock variable is not expressed in terms of per hour or per day or per week or per
month, etc.
b) Flows: A flow variable represents its quantitative changes per time period. Hence, a
flow variable must have a time dimension.
If it is stated that the income of a person is Rs. 5,000, then this is an incomplete
statement. The correct statement would be ‘an income of Rs.5000 per week (or per
month)
Difference between Stock and flows:

Stock Flow
A stock has no time dimension. A flow has a time dimension.
A stock is measured at a point of time A flow is measured per time period (say,
(say, as on 31st, March, 2010) per month, per week etc)
A stock indicates the static aspects of A flow variable indicates the dynamic
an economy. aspects of an economy.
A stock often influence a flow, e.g. A flow variable also influence a stock e.g.
higher stock of capital would lead to greater flow of saving per year would
higher flow of goods & services in an result in higher investment and greater
economy. capital stock in a country.
j) Consumption:
By consumption, we mean satisfaction of wants. It is became we have wants that we
consume various goods and services.
Consumption is defined as the satisfaction of human wants through the use of goods
and services.
k) Saving:
Saving is defined as income minus consumption. Whatever is left in the hands of an
individual after meeting consumption expenditures is the individuals savings.
l) Saving and savings:
The sum total of funds in the hands of an individual obtained by accumulating the saving
of the past years is called the savings of the individual.
m) Meaning of investment:
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Investment means an increase in the stock of capital. For a country, as a whole,

investment would imply an increase in the capital stock of the country.
Real investment:
Real investment means an increase in the real capital stock of a country, viz., an addition
to the stock of machines, factory buildings, power generating stations, railway tracks,
railway engines, bridges, etc.
Portfolio investment:
In the modern business world, portfolio investment means the purchases of shares and
debentures of a company. When any individual or an organization purchases new shares
or debentures of a joint stock company, this can be treated as an investment.
n) National product: Gross and net national product
The total of the values of goods and services produced by all the producers in an
economy in a given year, is called the gross national product (or GNP) of the country for
that year. The production process leads to wear and tear of the nation’s capital goods,
i.e. there is depreciation of the capital stock.
The amount of annual depreciation should be deducted from the GNP. What we get
after this deduction is called the Net national Product (or NNP) of the country for the
year.
Thus, NNP = GNP – Depreciation of capital.
o) Per capital Income:
Per capital income of a country for a given year is defined as the country’s national
income for that year dividend by the country’s population in that year.
𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙𝑖𝑛𝑐𝑜𝑚𝑒
Per capital income = 𝑇𝑜𝑡𝑎𝑙𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
5
CHAPTER-2
NATIONAL INCOME
Q1. Circular flow of income:

Two sector economy
In simple economy if there is two sector i.e. household and firm, then transaction between
these two sector will lead to a circular flow of income. The real flow implies the flow of
goods and services across different sector of economy and money flow implies flow of
money in the form of expenditure on various goods and services. The circular flow of
income is based on following assumption –
(a) All economic decisions are taken by Households and firms.
(b) Production takes place in firms and sold to households.
(c) Households are the suppliers of factor of production.
(d) Households spend money to purchase goods produced by a firms.
The concept of circular flow can be explained with the help of following diagram.
In the upper part of this diagram

Households supply different factors
to firm as shown by real flow (A)
and in return household received
factors income from firms as shown
by money flow (B). In factor market
households are sellers and firms are
buyers. The expenses of firms is the
income of households. In lower part
of diagram firms supply goods and
services to households as shown by
real flow (C). In return households
payments for goods and services to
firms as shown by money flow (D).
In product market households are buyer and firms are sellers. The money flows from
households to firm. In others words the expenditure of households is the income of the
firm. since the starting point and the final point are the same therefore this is called circular
flow.
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Three Sector Economy:
In our above analysis of money flow, we have ignored the existence of government for the
sake of making our circular flow model simple. This is quite unrealistic because government
absorbs a good part of the incomes earned by households. Government affects the
economy in a number of ways.Here we will concentrate on its taxing, spending and
borrowing roles. When part of income is spent on tax payment then that part of spending
by any household or a firm can not arise as income of another firm or household. So this tax
payment is considered as the Leakage or Withdrawal from the circular flow of income.
When government purchase goods and services produced by any sector ( says firm sector)
then income earned by the firm sector does not depend on expenditure made by the
household sector. So the government expenditure considered as Injection into the circular
flow of income. It should be noted that in any economy injection must be equal to
withdrawal.
On left part of diagram shows the flow of income and expenditure between household
sector and the government. Household sector pays net tax (tax –transfer payment). On the
other hand, the government also purchase goods and services from the household in form
of wages and salaries or also makes transfer payments in the form pension funds, relief,
sickness benefits, health, education etc. On the right side of the diagram shows flow of
income and expenditure between business sector and the government. Business firms pay
net taxes ( tax-subsidies) to the government. On the other hand the government provides
subsidies and purchase goods and services from the business sector.
Q2. Difficulties of Measurement of National Income:

There are some following difficulties while measuring national income –
(a) Lack of data: in India many people depends on agriculture. Farmers lack in keeping
records of their income and expenditure. Hence correct estimation is not possible.
(b) Illiteracy problem: There is still high rate of illiteracy in India. People are unable to
provide information on production cost etc.
7
(c) Illegal activities: Earning from such activities are excluded in national income
accounting. There is insufficient date about such earnings.
(d) Problem of black money: To evade taxes people hide their income. This leads to
black money. This is excluded from national income. As the volume of black money
increasing the size of error in the estimation of national income also increases.
(e) Problems of multiple counting: While measuring national income, problem of
multiple counting may arises if we take the value of each and every product
separately.
(f) Problems of non-marketed goods: In India large part of output is non-marketed.
There is barter system. It is difficult to determined imputed value of such
commodities.
(g) Personal services: some personal services are kept out in the measurement of
national income because it is difficult to calculate money value of such services.
(h) Capital gain and losses are exclude; It is something seen that commodities
produced in some previous year is sold out at higher price in current year. some
profit is reaped in this way.
Q3. Production method:

In the production method, we make a complete census of all products produced by all
members of the nation during the year and add them together to get the GNP total. Since
different goods and services have different units, they can be added only by taking their
money value.
In the census of production method, multiple counting of the same product may arise if we
take the total value of each and every product separately. To avoid this multiple counting,
two methods are available: one is the value added method and the other is the final product
method.
In the value added method, we take the value added at each stage of production and add
them up. The value added by a productive unit is the difference between the total value of
its output of the year and the value of purchasing of all raw materials. In the final product
method, all products are divided into two categories: intermediate goods and final goods.
Where as intermediate goods are those goods which is used as a input and consumed within
the same year and final goods are those goods which are finally ready to consume and there
is no any further process on that goods.
The value added method and the final product method give us the same figure of the GNP
total. Suppose in an economy wheat is produced worth Rs.1000 during a year. The entire
wheat is transformed into flour in the same year and the flour is valued at Rs.1500. suppose
also that the entire output of flour is used up in the production of bread during the same
year and bread is valued at Rs.2500. If we add up the value of wheat, the value of flour and
the value of bread we have multiple counting.
The value of wheat is included thrice while the value of flour is included twice. To avoid this,
we take either the value of bread which is the final product in this case or the values added
8
in different stages of production value added in wheat production is Rs.1000, value added in
the production of flour is Rs.500 and the value added in the production of bread is Rs.1000.
Hence, total value added is Rs.(1000+500+1000) = 2500. Again the value of output of bread
is also Rs.2500.
Precaution:
(a) The value of all goods and services which are marketed are included.
(b) The services of owner occupied house i.e. inputted rent should be included. The
service of member of family should not be included.
(c) In case of self employed professionals like doctors educated etc. the value of the
services are included.
(d) Public services such as defence, police etc should be included.
(e) Value goods produced but not yet marketed should be included.
Q4. Income method: In the census of income method we make a census of all earnings unit
of an economy. An earning unit may be an individual or a company. In national income
accounting only those earning units are considered which participates in the production
process. There are generally four factors of the Production labour, capital, land and
entrepreneurship. Labour gets wages and salaries in the form of cash and kinds, capitals get
interest, land gets rent and entrepreneurship get profit as their remuneration. Beside there
are some self employed persons who employ their own capital such as doctors advocates
CA etc. their income is called mixed income. Hence, the national income is equals to the
sum total of all wages, rents, interest and profit earned in the production process i.e.
NDPfc = COE + OS + MI
Where as compensation of employee (COE) include wages and salaries in cash or in kind.
Operating surplus (OS) consists of rent, royalty, interest and profits ( corporate tax,
dividend, undistributed profit or retained earning i.e. saving )
MI represents mixed income of self-employed.
Precautions:
(a) Transfer income should not be included.
(b) Wind gains i.e. lottery etc should not be included.
(c) Undistributed profits of the firms must be included.
(d) Illegal income should not be included.
(e) Household services rendered by the members of the family should not be included.
(f) Receipts from the sale of second hand goods should not be included.
Q5. Census of expenditure method:
The third method of measuring national is expenditure method. According to this method
National income is measured in terms of expenditure made by the consumer on final goods
and services produced in the economy during on accounting year. Thus the national income
of country is equal to sum of all Private Final Consumption Expenditure(C), Government
9
Final Consumption Expenditure(G), Gross Domestic Capital Formation(I) and Net Exports on
goods and services. Where as Private Final Consumption Expenditure shows expenditure
incurred on final goods and services by resident household and non- profit institution
serving household (Ex- churches, trade unions, political parties, charities hospitals,
universities etc.). Government Final Consumption Expenditures shows expenditure on goods
and services incurred by the government. Gross Domestic Capital Formation also consists of
two parts i.e. Gross fixed Capital Formation (e.g. expenditure on construction, machinery,
etc.) and inventories investment i.e. (change in stock of raw materials). And net exports
refers to difference between value of exports(X) and value of imports(M).Hence
GDPmp = C+I+G+(X – M)
Where, C= Private Final Consumption expenditure; I = Gross Domestic Capital Formation., G
= Government Final consumption expenditure; (X – M) = Net exports.
In this way in expenditure method national income is obtained by adding different types of
expenditure.
Precaution:
(a) Expenditure on purchase of second hand goods should be excluded.
(b) Government transfer payment should be excluded.
(c) Expenditure on share and Bond should be excluded.
(d) To avoid double counting, expenditure on all intermediate goods and services is
excluded.
(e) Imputed expenditure on own account output (i.e. owner occupying his house should
be included.)
10
CHAPTER-3
THEORY OF EQUILIBRIUM INCOME DETERMINATION
Consumption function OR propensity to consume:

The relationship between aggregate consumption expenditure (C) and national income
(Y) in an economy is considered as consumption function. If C is a function of Y i.e., if ‘C’
depends on ‘Y’ then the consumption function is expressed as
C = f(Y)
According to J.M. Keynes, there is a ‘fundamental psychological law’ that guides the
relation between ‘C’ and ‘Y’. It is generally observed that when Y rises, C also rises but
the increase in ‘C’ would be less than that of Y.
Propensity of consumption:
The propensity of consumption refers to different possible amount of consumption
expenditure which the consumers desire to spend at different possible levels of national
income.
Average Propensity to Consume (APC):
The proportion of aggregate income which is spent for consumption purposes, is called as
average propensity to consume.
𝐶
APC =
𝑌
Marginal Propensity of Consume (MPC):

The change in aggregate consumption expenditure (∆𝐶) due to a change in national income
(∆𝑌), is considered as Marginal Propensity to Consume (MPC). It implies the function of
additional national income which the people use for consumption purposes.
∆𝐶
MPC = ∆𝑌 = 𝑏(𝑠𝑎𝑦)
C = a + by
Where, a = Autonomous consumption, i.e. the minimum amount of consumption
expenditure needed for maintaining a subsistence level of living.
∆𝐶
B = MPC = ;
∆𝑌
Y = Income, and
C = Consumption expenditure
A. Propensity to save and saving function:

Saving refers to that part of income which is not consumed during any particular
accounting year. Saving function can be expressed as
S = f(Y)
The saving function shows the relationship between the level of aggregate (desired)
saving and national income in an economy during any particular accounting year.
11
It is assumed that as Y rises, ‘S’ will also rise but only a portion of the additional income
is saved. So, there remains a positive correlation between ‘S’ and ‘Y’.
Propensity to save:
The portion of income that the people desire to save at different possible levels of
income implies the propensity to save.
Average and marginal propensity to save:
The proportion of income which is saved by the individuals during any particular year
can be considered as Average Propensity to save (APS).
𝑆
APS =
𝑌
The change in aggregate desired saving (DS) due to a change in the national income (DY)
of a country is considered as Marginal Propensity Save (MPS).
∆𝑆
MPS = ∆𝑌
B. Investment function:
The function relationship between the aggregate investment and its determinants (such
as interest rate, national income) in an economy is called as investment function.
The investment which remains independent of the level of income is called autonomous
investment. The autonomous investment function can be represented as I = I0(fixed)
The investment which depends on the level of national income(Y), is called induced
investment. The induced investment function is expressed as I = I(Y) and we assumed that I
rise with an increase in the level of Y, and vice versa.
Q.1 Determination of equilibrium level of National Income:
In an Economy level of national income and determined by the forces of aggregate demand
and aggregate supply. According to Prof. Keynes, there is no fundamental difference
between determination of national income and determination of employment as national
income depends on level of employment.
In simple Keynscan model i.e. two sector closed economy, aggregate demand (AD) is the
sum of consumption demand and investment demand.
Consumption demand is demand for capital goods produce consumer goods. It is assumed
that investment demand (I) is autonomous in nature i.e. independent to level of income.
In any economy, aggregate supply has two component, i.e. consumption (C) and saving (S)
as pointed out by Prof. Keynes. Hence in two sector closed economy, aggregate supply (Y) =
C + S. AS curve will be always 450 line.
Assumption:
While determine the equilibrium level of national income we make the following
assumptions –
(a) There is no government sector.
(b) There is no foreign sector
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(c) It is also assume that total amount of investment in the economy is constant at all
level of income.
(d) Price level is also constant.
(e) Analysis in short run production function.
Equilibrium level of income:

The equilibrium level of national income is defined by the equality of aggregate demand and
aggregate supply.
Aggregate demand (Y) = C+ I
Aggregate Supply (Y) = C + S
In equilibrium AD = AS
C+I=C+S
I =S
In this diagram, aggregate demand curve is C+I which is the lateral summation of
consumption and investment demand curve. Aggregate supply is 45 line degree and it
intersect aggregate demand curve C+I at point E . Hence E is the equilibrium point which is
Defined by the intersection of aggregate demand curve and aggregate supply curve and OP
is the equilibrium level of output which is we get. Before equilibrium level of output
aggregate demand is better than aggregate supply and after the equilibrium level of income
or output aggregate supply is better than aggregate demand.
13
If aggregate demand is greater than aggregate supply

It means that buyers are planning to buy more goods and services that producer are
planning to produce. In this situation inventory is with producers will start falling. To
maintain the desired level of inventory producer will increase the production level. For this
purpose pressure will hire more workers. This will raise the employment level in the
economy and result increased in the distribution of factor income i.e. national income which
AS. This excess demand is also influenced the price level in the economy. This process will
continue till aggregate demand and aggregate supply not become equal to each other.
If aggregate supply is greater than aggregate demand.
It means that buyers are planning to buy less goods and services then producer are planning
to produce. In this situation inventory is with the producers will start Rising. To maintain the
desired level of inventory judicial be reduced the production level, for this purpose producer
will lay off the workers, this will reduce the employment level in the economy and also price
level in the economy. This process will continue till aggregate demand and aggregate supply
not become equal to each other.
Q2. Saving Investment equality approach:

In any economy entire income received (Y) is allocated on consumption and saving i.e.
Y = C+S .......... (i)
Total value of goods produced (Y) is derived from consumption goods and capital goods.
i.e. Y = C + I ............... (ii)
In other words, aggregate demand (Y) is the sum total consumption demand & Investment
demand and aggregate supply in a two sector closed economy has two components
consumption & savings as pointed out by Prof. Keynes.
From equation i & ii
C+I = C+S
I=S
Hence, actual savings and actual investment in the economy are always equal. Actually it is
an identity.
Assumption:
While determine the equilibrium level of national income we make the following
assumptions –
(a) There is no government sector.
(b) There is no foreign sector
(c) It is also assume that total amount of investment in the economy is constant at all
level of income.
(d) Price level is also constant.
(e) Analysis in short run production function.
Both, savings & Investment are different activities performed by two different groups of
individuals having their own motives.
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Savings are performed by the household & investment decisions are taken by the firms. So,
planned saving & planned investment are equal only in equilibrium as shown in the diagram.
∆𝐼
In figure, AI0 is the investment curve which is autonomous in nature ( ∆𝑌 = 0). The
equilibrium level of national income is defined by the equality of planned saving and
planned investment. Hence, E is the equilibrium point where AI0 curve intersects aS curve
i.e. planned savings = planed investment. OYe is the equilibrium level of national income
which is determined.
At higher income level OY2planned investment is less than planned saving it means
aggregate demand is less than aggregate supply. When aggregate demand is less than
aggregate supply it means that buyers planning to buy less goods and services then
producer are planning to produce. In this situation inventory with the producer will rising
which leads to reduce production level in the economy as a result employment in the
economy is also Falls and it also effect the price level in the economy. this process will
continue tell aggregate demand and aggregate supply become equal to each other.
At lower income level OY1planned investment is greater than planned saving it means that
aggregate demand is greater than aggregate supply when aggregate demand is greater than
aggregate supply it means that buyers are planning to buy more goods and services then
producer are planning to produce. in this situation inventories with the producer will start
falling. To maintain the desired level of inventory producers will increase the production
level, as a result employment level in the economy will increase and this excess demand is
also influence the price level in the economy this process will continue till aggregate
demand and aggregate supply become equal to each other.
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Q3. Paradox of thrift:

A decrease in C (consumption expenditure) leads to an increase in saving (S) with every
increase in level of income (Y). Hence, saving function (SS) is positively sloped. An increase in
thriftness in the society or in the economy leads to upward shifting of saving curve as shown
in diagram.
S, I
S1 S0
S0 = I0 F E
S1 = I1
(+) A
0 Y
B1 Y1 Y0
(-)
B0
Initial equilibrium point is E and equilibrium level of national income is OY 0 and increase in
thriftiness leads to upward shifting of saving curve from S0B0 to S1B1. Hence, at OY0 income
level, S>I
Y–C>I
Y>C+I
i.e. there will be excess supply in the economy and unintended accumulation takes place
due to fall in level employment and national output. So, income level Y decreases
continuously upto OY1, where planned saving & planned investment are again equal (I1 = S1).
However, a new equilibrium level OY1 is less than OY0. Such decrease in income due to an
increase in thriftness in the economy. So, it is called Paradox of thrift to tackle such
situation, physical & monetary measures should be taken by the government.
Q4. Investment Multiplier:

The effect of an increase in autonomous investment on equilibrium level of national income
ia shown in the Theory of investment multiplier. The theory was introduced and popularised
by Prof. J.M. Keynes. Investment multiplier represents the ratio of change in income in
response to change in investment in investment.
16
According to this theory if there is an increase in autonomous investment then national

income will increase by a multiple of that initial in autonomous investment.
In any economy, level of income increases in the multiples of an initial increase in amount of
autonomous investment i.e.
∆Y = K. ∆I
∆𝑌
K= ∆𝑌 = Change in income
∆𝐼
∆I = Change in investment
Working of Investment Multiplier:

Suppose, initial increase in autonomous investment in the economy be Rs.100 crore and
MPC = 0.8 in the first phase an increase in autonomous investment of Rs.100 crore will be
additional. Income of Rs.100 crore of people. New 80% of increased income will be
consumed i.e. Rs.80 crore as a consumption expenditure will be additional income of Rs.80
crore for the another group of people. Now again this group will consume 80% of the
increased income i.e. Rs.60 crore. This increase in consumption expenditure of Rs.64 crore
for the third group of the people. This process in the economy will be continued until the
amount becomes infinitely small. The sum of the following G.P series will be an increase in
income in the economy.
I.e. ∆Y = 100+80+64+. ∞
𝑎
[𝑆𝖺 = ]
1−𝑟
100
∆𝑌 =
1 − 0.8
100
0.2
∆𝑌 = 𝑅𝑠. 500 𝑐𝑟𝑜𝑟𝑒
Hence, an initial increase in autonomous investment of Rs.100 crore leads to an increase in
500
national income by Rs.500 crores. In such case, investment multiplier K = 100
K=
The magnitude of investment multiplier will be always greater than 1 and less than 𝖺
17
Y=E
C + I0 +∆I
F C + I0
H
b E G
450
0
Y1 Y2
Initially, E is the equilibrium point defined by the point of intersection of aggregate demand
curve (C+I0) and aggregate supply curve which is 450 line or income line OY1 is the initial
level of income. when investment is increased by ∆I amount. (C+Io) curve shift upward and
becomes (C+I+∆I). F is the new equilibrium point and OY2 is the corresponding equilibrium
level of income.
In this case,
Change in come (∆Y) = OY2 – OY1 = Y1Y2
Change in investment (∆I) = FY2 – HY2 = FH
∆𝑌
Investment multiplier (k) = ∆𝐼
𝑌1𝑌2
K=
𝐹𝐻
Limitations or leakages of investment multiplier:

Paying off debts:
The first leakage in the multiplier process occurs in the form of payment of debts by the
people, especially by businessmen. In the real world, all income received by the people as a
result of some increase in investment is not consumed. A part of the increment in income is
used for paying back the debts which the people have taken from moneylenders, banks or
other financial institutions.
The incomes used for paying back the debts do not get spent on consumer goods and
services and therefore leak away from the income stream. This reduces the size of the
multiplier. Of course, when incomes received by the moneylenders, banks or institutions are
18
again lent back to the people, they come back to the income stream and enhance the size of
multiplier. But this may or may not happen.
Holding of idle cash balances:

If the people hold apart of their increment in income as idle cash balances and do not use it
for consumption, they also constitute leakage in the multiplier process. As we have seen,
people keep part of their income for satisfying their precautionary and speculative motives,
money kept for such purposes is not consumed and therefore does not appear in the
successive rounds of consumption expenditure and therefore reduces the increments in
total income and output.
Imports:
In our above analysis of the working of the multiplier process we have taken the example of
a closed economy, that is, an economy with no foreign trade. If it is an open economy as is
usually the case, then a part of increment in income will also be spent on the imports of
consumer goods. The proportion of increments in income spent on the imports of consumer
goods will generate income in other countries and will not help in raising income and output
in the domestic economy.
Taxation:
Taxation is another important leakage in the multiplier process. The increments in income
which the people receive as a result of increase in investment are also in part used for
payment of taxes. Therefore, the money used for payment of taxes does not appear in the
successive rounds of consumption expenditure in the multiplier process, and the multiplier
is reduced to that extent.
MPC may not be constant: In this theory it is assumed that MPC remains constant for the
whole economy. But in real life situation, MPC of the lower income class remains relatively
higher than that of the higher income class.
Q5. Size of Investment Multiplier depends on MPC:

The magnitude and strength of investment multiplier depends on marginal propensity to
consume.
In eualibrium,
Y = C+I ......... (i)
Let, I = I0& C = a + CY
∆𝐶
Where, C = ∆𝑌 = MPC
Y = a + CY + I0
Y – CY = a + I0
Y(1 – C) = a + I0
19
𝑎+𝐼0
Y= = 𝑌1(𝑙𝑒𝑡)......... (ii)
1−𝐶
When, investment in economy is increased by ∆I amount then
Y = C + I + ∆I
Y = a + CY + I0 + ∆I
Y – CY = a + I0 + ∆I
Y (1 – C) = a + I0 + ∆I
= 𝑌 (𝑙𝑒𝑡) ........... (iii)
a + I0+ ∆I
Y= 2
(1−𝐶)
Change in Income,
∆Y = Y2 – Y1
a + I0+ ∆I a + I0
= −
(1−𝐶) (1−𝐶)
a + I0+ ∆I−a−I0
=
(1−𝐶)
∆𝐼
∆Y = (1−𝐶)
∆𝑌 1
=
∆𝐼 (1−𝐶)
1 1 ∆𝐶
K= [𝑘 = ] , [𝐶 = = 𝑀𝑃𝐶]
(1−𝐶) 1−𝑀𝑃𝐶 ∆𝑌
1
Hence, Size of investment, multiplier depends on MPC [K = ]
1−𝑀𝑃𝐶
1
K= [where (MPS) = 1 –MPC ]
𝑚𝑝𝑠
Investment multiplier is the reciprocal of MPS (Marginal propensity to save)
QUESTION. Derivation of saving curve from consumption curve

We know that consumption + saving is always equal to Income because income is either
consumed or saved. It implies that consumption and saving curves representing
consumption and saving functions are complementary curves. Therefore, we can derive
saving function or curve directly from consumption function or curve. This can with the help
of diagram which is given below
20
Consumption curve has been derived from point C, because at zero level of income there
exist minimum level of consumption also known as autonomous consumption indicated by
the measurement OC. As we know that with increase in income level of consumption
increases and accordingly, consumption curve CC is drawn. A 45 line degree has been
drawn indicating that at its every point, income is equal to consumption. Consumption
curve i.e. CC intersecting the 45 line degree at point A indicating C= Y i.e. break even point.
We know at zero level of income, minimum level of consumption is equal to the dissaving,
accordingly point S measuring a ( equal to minimum level of consumption) is taken. At a
break even point savings are equal to zero, therefore corresponding point A is considered
on x axis. By joining point S and A and extending it with the same slope we get our saving
curve SS.
QUESTION. Derivation of consumption curve from saving curve.

We know that consumption + saving is always equal to Income because income is either
consumed or saved. It implies that consumption and saving curves representing
consumption and saving functions are complementary curves. Therefore, we can derive
consumption function or curve directly from saving function or curve. This can be explained
with the help of diagram which is given below.
Saving curve has been started from point S, because at zero level of income there exists
dissaving indicated by the measurement OS. As we know with the increase in income, level
of saving increases and accordingly, saving curve SS is drawn. Saving curve intersecting the
x-axis at point A indicating savings are equal to zero i.e. break even point. Now, a 45 line
degree has been drawn indicating that at its every point income is equal to consumption. At
point A on saving curve saving are zero. It means at corresponding point A on 45 line degree
, income is equal to consumption. Also we know that at 0 level of income, dissaving is equal
to minimum level of consumption, hence OC point measuring “a” is taken on Y axis. By
joining point A and C and extending it with the same slope we get our consumption curve
CC.
21
Relationship between APC and APS
The sum of the Average Propensity to Consume (APC) and Average Propensity to save (APS)
is always equal to unity, i.e., APC + APS = 1. It is so because the money income can either be
spent on consumption or it can be saved. In case, we consider the ratio of consumption to
money income, we call it average propensity to consume, (APC), and the ratio of saving to
income represents average propensity to save (APS). It is for his reason that the sum of APC
and APS equals unity.
We know that
Y=C+S
Now, dividing both sides of this equation by Y, we obtain
Y/Y = C/Y + S/Y
1 = APC + APS
Or, APS = 1 – APC
When APC rises (or falls) APS falls (or rises). When APC = 1, APS must be equal to zero, and
when APC = 0, APS = 1. But since APC can never be zero, so APS can never be equal to one. It
must be less than one.
Relationship between MPC and MPS
The sum of the Marginal Propensity to Consume (MPS) and Marginal propensity to Save
(MPS) is always equal to unity, i.e. MPC + MPS = 1.
It is so because MPC shows the ratio of change inc consumption, i.e., ΔC/ ΔY, whereas MPS
shown the ratio of change in saving to change in income, i.e., ΔS/ΔY. Increased income could
again be spent either on consumption or can be saved.
We know that,
Y=C+S
22
Now, suppose, income changes to ∆ Y. As a result, both consumption and saving change to
∆C and ∆S, respectively, i.e.,
∆Y = ∆C + ∆S
Dividing both sides of this equation by ∆ Y we get
∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
Or, 1 = MPC + MPS
or, MPS = 1 – MPC
When MPC rises (falls) MPS must fall (rise) in such a manner that their sum becomes equal
to one.
23
CHAPTER-4
COMMODITY AND MONEY MARKET EQILIBRIUM
Q1. The product market equilibrium and the IS curve:
The product market is said to be in equilibrium when aggregate demand for output in an
economy is just equal to the aggregate supply of output. Aggregate demand for output is
determined by the total expenditure (Say, E) on goods and services in an during any
particular time period.
Assumptions:
∆𝐶
1) C = C(Y), where 0 < < 1
∆𝑌
Consumption expenditure (C) depends on income (Y), and C rises within increase in
Y.
∆𝑆
The saving function will be S = S(Y), where 0 < < 1
∆𝑌
2) Investment is assumed to be a function of the rate of interest (r), i.e. I = I(r), where
∆𝐼
<0
∆𝑟
There remains an inverse relationship between the desire investment and the
market rate of interest.
3) Both the tax payments (T) and Government expenditure (G) are assumed to be
autonomous in nature.
Derivation of IS curve:
IS curve represents different combination of rate of interest and levels of national income
which will keep the product market in equilibrium. With a fall in the rate of interest, the
planned investment will increase which will cause upward shift in aggregate demand
function (C + I) resulting in goods market equilibrium at a higher level of national income.
The lower the rate of interest, the higher will be the equilibrium level of national income.
Thus, the IS curve is the locus of those combinations of rate of interest and the level of
national income at which goods market is in equilibrium.
24
In panel (a) the relationship between rate of interest and planned investment is depicted by
the investment demand curve II. It will be seen from panel (a) that at rate of interest Or 0the
planned investment is equal to OI0. With OI0 as the amount of planned investment, the
aggregate demand curve is C + I0 which, as will be seen in panel (b) of Fig. 20.1 equals
aggregate output at OY0 level of national income. Therefore, in the panel (c) at the bottom
of the Fig. 20.1, against rate of interest Or0, level of income equal to OY0has been plotted.
Now, if the rate of interest falls to Or1, the planned investment by businessmen increases
from OI0 to OI1 [see panel (a)].
With this increase in planned investment, the aggregate demand curve shifts upward to the
new position C + II in panel (b), and the goods market is in equilibrium at OY 1 level of
national income. Thus, in panel (c) at the bottom of Fig. 20.1 the level of national income
OY1 is plotted against the rate of interest, Or1. With further lowering of the rate of interest
to Or2, the planned investment increases to OI2 [see panel (a)].
With this further rise in planned investment the aggregate demand curve in panel (b) shifts
upward to the new position C +I2 corresponding to which goods market is in equilibrium at
OY2 level of income. Therefore, in panel (c) the equilibrium income OY2 is shown against the
interest rate Or2.
By joining points A, B, D representing various interest-income combinations at which
goods market is in equilibrium we obtain the IS curve. It will be observed that the IS curve
is downward sloping (i.e., has a negative slope) which implies that when rate of interest
declines, the equilibrium level of national income increases.
Q2. Features of IS curve:

(a) IS curve represents various combinations of income (Y) and interest rate (r), which
keeps product market in equilibrium.
(b) IS curve is negatively sloped due inverse relationship between rate of interest and level
of income. As the decline in the rate of interest brings about an increase in the planned
investment expenditure. The increase in investment spending causes the aggregate
demand curve to shift upward and therefore leads to the increase in the equilibrium
level of national income.Thus, a lower rate of interest is associated with a higher level
of national income and vice versa. This makes the IS curve, which relates the level of
income with the rate of interest, to slope downward.
(c) Slope of IS curve depends on slope of investment function. If investment expenditure is
relatively interest elastic then IS curve will relatively flatter whereas it will be relatively
steeper if investment is interest inelastic. If investment expenditure is perfectly interest
𝑑𝑟
elastic [I`(r) = 0] then IS curve will be vertical ( 𝑑𝑦= ∞)
If investment expenditure is perfectly interest inelastic [I`(r) = ∞] then IS curve will be
𝑑𝑟
horizontal i.e. [ 𝑑𝑦 = 0]
25
(d) Slope of IS curve also depends on slope of saving function. If slope of saving function
relatively higher than IS curve will be relatively steeper. on contrary IS curve will be
flatter if slope of saving function is relatively low.
(e) The position of IS curve depends on the value of government expenditure (G) and taxes
(T). Given the value of T an increase in government expenditure (G) leads to rightward
shifting of IS curve. IS curve shifts leftward along the decrease in government
expenditure (G).
Given the value of G an increase in taxes (T) leads leftward shifts of IS curve whereas it
shifts rightward along with fall in taxes (T).
FOR LONG QUESTION

Steepness of the IS curve depends on:
(1) The elasticity of the investment demand curve, and
(2) The size of the multiplier.
The elasticity of investment demand signifies the degree of responsiveness of investment

spending to the changes in the rate of interest. Suppose the investment demand is highly
elastic or responsive to the changes in the rate of interest, then a given fall in the rate of
interest will cause a large increase in investment demand which in turn will produce a large
upward shift in the aggregate demand curve.
A large upward shift in the aggregate demand curve will bring about a large expansion in the
level of national income. Thus when investment demand is more elastic to the changes in
the rate of interest, the investment demand curve will be relatively flat (or less steep).
Similarly, when investment demand is not very sensitive or elastic to the changes in the
rate of interest, the IS curve will be relatively more steep. The steepness of the IS curve
also depends on the magnitude of the multiplier. The value of multiplier depends on the
marginal propensity to consume (mpc). It may be noted that the higher the marginal
propensity to consume, the aggregate demand curve (C + I) will be more steep and the
magnitude of multiplier will be large.
In case of a higher marginal propensity to consume (mpc) and therefore a higher value of
multiplier, a given increment in investment demand caused by a given fall in the rate of
interest will help to bring about a greater increase in equilibrium level of income. Thus, the
higher the value of multiplier, the greater will be the rise in equilibrium income produced by
a given fall in the rate of interest and this makes the IS curve flatter.
On the other hand, the smaller the value of multiplier due to lower marginal propensity to
consume, the smaller will be the increase in equilibrium level of income following a given
26
increment in investment caused by a given fall in the rate of interest. Thus, in case of
smaller size of multiplier the IS curve will be more steeper.
Shift in IS Curve:
It is important to understand what determines the position of the IS curve and what causes
shifts in it. It is the level of autonomous expenditure which determines the position of the
IS curve and changes in the autonomous expenditure cause a shift in it. By autonomous
expenditure we mean the expenditure, be it investment expenditure, the Government
spending or consumption expenditure, which does not depend on the level of income and
The government expenditure is an important type of autonomous expenditure. Note that
the Government expenditure, which is determined by several factors as well as by the
policies of the Government, does not depend on the level of income and the rate of
interest.
Similarly, some consumption expenditure has to be made if individuals have to survive even
by borrowing from others or by spending their savings made in the past year. Such
consumption expenditure is a sort of autonomous expenditure and changes in it do not
depend on the changes in income and rate of interest. Further, autonomous changes in
investment can also occur.
In the goods market equilibrium of the simple Keynesian model the investment expenditure
is treated as autonomous or independent of the level of income and therefore does not vary
as the level of income increases. However, in the complete Keynesian model, the
investment spending is thought to be determined by the rate of interest along with marginal
efficiency of investment.
Following this complete Keynesian model, in the derivation of the IS curve we consider the
level of investment and changes in it as determined by the rate of interest along with
marginal efficiency of capital. However, there can be changes in investment spending
autonomous or independent of the changes in rate of interest and the level of income.
For instance, growing population requires more investment in house construction, school
buildings, roads, etc., which does not depend on changes in level of income or rate of
interest. Further, autonomous changes in investment spending can also take place when
new innovations come about, that is, when there is progress in technology and new
machines, equipment, tools etc., have to be built embodying the new technology.
Besides, Government expenditure is also of autonomous type as it does not depend on

income and rate of interest in the economy. As is well known, government increases its
27
expenditure for the purpose of promoting social welfare and accelerating economic growth.
Increase in Government expenditure will cause a rightward shift in the IS curve.
Q3. The money market equilibrium and the LM curve:

The money market is said to be in equilibrium when the aggregate demand for money is
equal to the supply of money within the economy.
The demand for money is the demand to hold a stock of money balance. The real value of
𝑀
money is the nominal value of money divided by the price index ( ). Thus, real demand for
𝑃
money is termed as demand for real balances. The demand for money is a demand for the
real balances because people hold money primarily because if functions as a median of
exchange and as a store of value.
Keynes considered three motives for holding money viz, the transaction demand, the
precautionary demand and the speculative demand for money.
The transaction demand refers to people’s desire to hold money to meet the day to day
transactions expenditure. It is assumed that this transaction demand for money in an
economy is an increasing function of national income. The specific form of this transaction
demand for money is –
M1 = k.Y, where K>0
[or, M1 = L1(Y)]
Keynes believed that money is also held to guard against unforeseen emergencies in future.
Money held for this motive, is termed as the precautionary demand for money. Keynes
believed that the precautionary demand for money depends positively on income.
The final motive for holding money that Keynes considered was the speculative motive.
Money demanded to enjoy any windfall gain through the changes in the prices of bond and
securities, is called the speculative demand for money. Thus, as r increases the bond-price
falls and the speculators purchase more of bonds leading to a fall in their speculative
demand for money M2 or the speculative balance.
When r falls and Bp rises, the speculators would sell more bonds and their speculative
balance or the speculative demand for money increase. The speculative demand function
can be stated as follows
28
M2 = L2(r)
The total demand for money (Md) will be Md = L1(Y) + L2(r) = L(Y, r)
The total supply of money (Md) or the supply of real balance is assumed to remain fixed and
determined by the monetary authority of the country.
̅
𝑀
Thus, Ms = is exogenously given
𝑃
The money market is said to be in equilibrium when
Ms = Md
̅
𝑀
Or, = L1 (Y) + L2 (r) ........ (2)
𝑃
Now, different combinations of Y and r, as shown in equation (2), which keep the money
market in equilibrium, give rise to the LM curve.
Part (a) shows that due to increases in income (from Y0 to Y1 to Y2) causes shift of the
demand curve for money from Md(Y0) to Md(Y1), then to Md (Y2). In order to restore
equilibrium in the money market, the rate of interest has to rise from r0 to r1 and r2 as
income increases from Y0 to Y1 and to Y2.
In part (b) we derive the LM curve by connecting points like E, E’ and E” showing
combinations of income (Y) and the interest rate r that equilibrate the money market.
Points E, E’ and E” showing equilibrium combinations such as (r0, Y0), (r1, Y1,) and (r2, Y2) in
part (b) correspond to the same points in part (a). Part (a) shows that as income increases,
higher interest rates are required for money market equilibrium.
This is why the LM curve is upward sloping from left to right. In part (a), when the money
market is in equilibrium at point E, demand for money equals to supply of money at the
equilibrium interest rate r0. This corresponds to point E on the LM curve in part (b), showing
money market equilibrium, with Y = Y0 and r = r0.
In part (a), as income increases from Y0 to Y1, and to Y2 the demand for money increases and
the demand curve for money shifts upward parallely. As a result the rate of interest rises
from r0 to r, and from r1 to r2 as shown by points E’ and E”. These three points of money
market equilibrium in part (a) correspond with points E, E’ and E” which lie on the LM curve
showing three combinations of Y and r, viz., Y0 and r0, Y1 and r1 and Y2 and r2.
29
Thus we see that the LM curve is a locus of points showing alternative combinations of Y
and r that bring about money market equilibrium. The LM curve is upward sloping from left
to right because as the level of income rises higher interest rates are required to reachieve
money market equilibrium.
Q4. Features of LM curve:

(a) LM curve represents various combination of income Y and interest r which keep
money market in equilibrium.
(b) LM curve is generally positively sloped.
(c) The slope of the LM curve depends on the interest elasticity of demand for money. If
demand for money is interest elastic than LM curve will be flatter whereas it will be
steeper, if demand for money is interest inelastic.
(d) LM curve shifts to the right with an increase in quantity of money M and vice-versa.
(e) LM curve shifts left with an increase in price level and vice-versa.
(f) LM curve shifts left with an increase in transaction demand for money M 1 and vice-
versa.
For long questions
Factors Determining the Slope of the LM Curve:
The steepness or flatness of the LM curve depends on interest elasticity of demand
for money. If the demand for money is interest inelastic the LM curve will be fairly
steep. If it is fairly elastic, the LM curve will be relatively flat.
The higher the value of c1, the steeper the LM curve. The reason is that the higher the
value of c1, the larger the increase in money demand per unit increase in income, and
hence, the larger is the upward adjustment in the interest rate required to restore
money market equilibrium. The higher is c1, the steeper will be the LM curve.
If money demand is highly interest elastic (c2 is large), a relatively small increase in
the interest rate will offset the increase in transactions demand for money caused by
a rise in income from Y0 to Y1 and to Y2 if c1 (which shows the increase in M per unit
increase in income) remains constant.
In fig. (a) the interest elasticity of demand for money is low (in absolute value). This
is why the demand curve for money is relatively steep. In this case, the LM curve is
also (a) Low Interest Elasticity of Money Demand relatively steep. In Fig. 9.14(b) we
show an almost opposite type of situation.
Since the demand for money is higher interest elastic (i.e., responsive to interest rate
changes), the demand curve for money is relatively flat. In such a situation the LM
curve is also relatively flat.
30
Shifts in the LM Curve:

Another important thing to know about the IS-LM curve model is that what brings
about shifts in the LM curve or, in other words, what determines the position of the
LM curve. As seen above, a LM curve is drawn by keeping the stock or money supply
fixed.
Therefore, when the money supply increases, given the money demand function, it
will lower the rate of interest at the given level of income. This is because with
income fixed, the rate of interest must fall so that demands for money for speculative
and transactions motive rises to become equal to the greater money supply. This will
cause the LM curve to shift outward to the right.
31
ii. Shifts in the Money Demand Curve:

If the demand for money increases (falls) the LM curve shifts to the left (right).
Suppose due to some reason, such as people’s loss of confidence in bonds the
demand for money increases at the same level of income and the same rate of
interest.As a result, the demand curve for money shifts upward and to the right from
M0d (Y0) to M1d (Y0) in Fig. As a result, the equilibrium rate of interest rises for the
same level of income (Y0) in part (a). Consequently the LM curve shifts upward and
to the left from LM0 to LM1 in part (b).
Q3. Determination of Equilibrium level of Income and interest rate:

OR
General equilibrium for product and money market.
IS curve represents different combinations of Y and r for which product market in of

equilibrium.
LM curve represents various combination of Y and r which keep money market in
equilibrium.
For the overall equilibrium of the economy it is essential that both product market and
money market should be in equilibrium at the same time.
By solving above two equations the value of Y and r which satisfy both equations is called
equilibrium level of income (Ye) and rate of interest (re). In other words the equilibrium level
of income and rate of interest is defined by the point of intersection of IS & LM curve as
shown below
figure, E is the equilibrium point, where IS curve intersects LM curve. OY eis the equilibrium
level of income & ore is the equilibrium rate of interest.
At (Ye, re) both product & money market will be in equilibrium At the same time which is
essential for overall equilibrium of the economy.
Q5. Balanced Budget Multiplier:

A one unit increase in government expenditure matched by an equal one unit increase in tax
increases the equilibrium level of national income by one unit. This interesting result is
known as Balanced Budget multiplier (MMB) and can be explained with the help of
following model –
We have already considered the independent effects of government spending and taxes on
national income. Now we will consider the combined effects of government spending and
taxes on national income in the light of balanced budget.
Balanced budget means change in government expenditure is exactly matched by a change

in taxes. If government expenditure and tax receipts increase by the same amount, will
national income or output increase or remain the same?
Classical economists believed that a balanced budget is neutral in the sense that the levels
of output or income remain unchanged. However, Keynes and his followers argued that, in
reality, its effect on income will not be zero or neutral. In other words, we can find out the
expansionary effect on national income of a balanced budget. The expansionary effect of a
balanced budget is called the balanced budget multiplier (henceforth BBM) or unit
multiplier. Here an increase in government spending matched by an increase in taxes results
in a net increase in income by the same amount. This is the essence of BBM.
Let us assume an MPC of 0.75. If government expenditure increases by Rs. 20 crore
national income would increase to Rs. 80 crore.
This can be obtained by using the formula for government spending multiplier, KG:
Now, an increase in taxes by the same amount (i.e. Rs. 20 crore) would lead to a reduction
in aggregate output of Rs. 60 crores.
Applying the formula for tax multiplier, KT, we obtain:
33
As a result, the net increase in national income (Rs. 80 – Rs. 60 crore) becomes Rs. 20 crore.
Thus, the BBM, defined as the net increase in income (Rs. 20 crore) caused by an increase in
government spending (Rs. 20 crore), and increase in taxes (Rs. 20 crore) will have a value of
1. This result is known as the balanced budget theorem or unit multiplier theorem which
must have a value of one, no matter whatever the value of MPC.
Balanced Budget multiplier (BBM) =
𝛿𝑌𝑒 𝛿𝑌𝑒
+
𝛿𝐺0 𝛿𝑇0
1 𝑏
= −
(1−𝑏) (1−𝑏)
1−𝑏
=
(1−𝑏)
=1
Hence, Balanced Budget multiplier is unity.
Q6. Fiscal policy and its tools

Fiscal policy
Fiscal policy means the set of policies that deal with the revenue expenditure process of the
Government. Any policy that affects either the revenue or the expenditure of the
Government falls under the category of fiscal policy.
Tools of fiscal policies:
The fiscal policy refers to the budgetary policy of the government of any country. The
principal tools of fiscal policy are Government expenditure (G) and taxes (T) imposed by the
Government.
Q7. Monetary policy and its tools.
Monetary policy
By ‘Monetary policy’ we mean any policy which affects the quantity of money in circulation
in the economy or the cost of the use of money i.e., the rate of interest.
Tools of monetary policy:
There are various instruments or tools at the disposal of the monetary authorities. These
are broadly of two types: quantitative and qualitative. Changing the supply of notes and
coins in circulation is the most obvious method of changing the supply of money. This can
be described as a quantitative method because it directly changes the quantity of money.
The control of bank credit is the most vital part of the monetary policy of any country.
There are three methods of quantitative credit control:
34
a) Changes in the bank are;

b) Open market operations; and
c) Variable reserve ratio.
There are two methods of qualitative credit control:
a) Selective credit control; and
b) Moral suasion.
Q8. Effectiveness of the fiscal policy: IS – LM framework:
The impact of the fiscal policy and its effectiveness in raising the national income can be analysed
under the IS – LM framework. If there is an increase in Government expenditure (G), there will be a
rightward shift in the IS curve. The IS curve would be steeper when investment is relatively interest-
inelastic.
Fig – a Fig – b Fig – c

Fig (a) to (c) show that the IS curve has shifted in the rightward direction from IS0 to IS1. This has
happened, say, due to an increase in the Government expenditure. This rise in G has directly increased
the aggregate demand and has caused an increase in Y. this rise in Y leads to an increase in the
transaction demand for money in the money market. However, given the supply of money, the money
market equilibrium requires a fall in the speculative demand for money, and hence, an increase in the
interest rate. Thus, given the LM curve, a rightward shift in the IS curve has led to an increase in the
equilibrium values of both Y and r as shown in Fig (a) to (c). The Fiscal policy becomes most
effective in raising the Y when the IS curve is vertical. [Shown in Fig (c)]
The expansionary fiscal policy is more effective in raising the equilibrium level of Y when the IS
curve is relatively steeper as shown in Fig (a). It is less effective when the IS curve is relatively flatter
[Fig (b)] implying higher interest elasticity of investment.
The effectiveness of the fiscal policy also depends upon the slope of the LM curve. The Slope of the
LM curve depends most crucially on the interest-elasticity of money-demand.
Fig – d Fig – e Fig – f
35
LM becomes relatively flatter when the speculative demand for money is relatively interest-elastic in
nature. It would be steeper as the money demand becomes relatively interest-inelastic. The LM curve
becomes vertical when the demand for money is completely interest-inelastic. The expansionary fiscal
policy, which cause a rightward shift in the IS curve, leads to an increase in Y. When the LM curve is
relatively flat [as shown in Fig – (d)], implying high interest-elasticity of money demand, the
expansionary fiscal policy becomes more effective in raising the equilibrium level of income.
When the LM curve is relatively steep [as shown in Fig (e)] which implies relatively interest-inelastic
money-demand, the expansionary fiscal policy is less effective. It is important to note in this
connection that the fall in the private investment expenditure associated with an increase in the
interest rate caused by fiscal expansion, is called the crowing out effect. This crowing out effect is
maximum when the money demand is completely interest inelastic and the LM curve is vertical [as
shown in Fig (f)]. In this case, the expansionary fiscal policy is completely ineffective in raising the
output level.
Q9. Effectiveness of the monetary policy: IS – LM framework:

Monetary authority of a country can influence the aggregate level of output through its
monetary policy
instruments. It can
raise the stock of
money which leads
to an excess supply
of money in the
economy. Now,
given the level of
income, the transaction demand for money would remain unchanged. Fig – a Fig – b Fig – c
Hence, to restore money market equilibrium, the speculative demand should rise and this
requires a fall in the interest rate. It leads an increase in the investment expenditure, and
hence, the output level.
Thus, increase in aggregate expenditure can create excess demand condition in the
economy and leads to higher level of output. Thus, with an increase in the stock of money,
the LM curve shifts in the rightward direction, and this result in higher level of equilibrium
output and a lower level of equilibrium interest rate.
The effectiveness of the monetary policy in raising the national output depends upon the
slope of the IS curve. A relatively steep IS curve reflects low interest elasticity of investment
demand. Monetary policy affects national income by lowering the interest rate, and
stimulating the investment expenditure. If investment expenditure is relatively interest-
inelastic, the effectiveness of the monetary policy would be limited. In Fig (a), the IS curve is
relatively steep, and as the LM curve shifts in the rightward direction from LM0 to LM1 due
to an increase in authority, national output increases by a small amount (Y 0Y1). Thus, the
monetary policy is not very effective in raising national output in this situation. In Fig (b), the
IS curve is relatively flat, implying greater interest-elasticity of demand; and in that case, the
monetary policy is more effective in raising the output level. If the IS schedule is vertical,
36
implying complete interest-inelasticity of investment expenditure, the monetary policy

becomes completely ineffective in raising the national output [as shown in Fig (c)]
Fig – d Fig – e Fig – f
The effectiveness of the Monetary policy also depends on the slope of the LM schedule. If
interest elasticity of money demand is relatively high then the LM curve becomes relatively
flat. If the money demand is relatively interest-elastic, then a small drop in the interest rate
can raise the demand for money to the required level so that equilibrium is restored in the
money market. This small drop in the interest rate would mean a little increase in the
investment expenditure. So, income will also rise by a small amount [as shown in Fig (d)]
Monetary policy would be more effective when the LM curve is relatively steep, implying
relative interest-inelasticity of money demand [as shown in Fig (e)]. The monetary policy is
most effective when the LM curve is vertical as shown in Fig (f).
Government expenditure multiplier

Like private investment, an increase in government spending results in an increase in
national income. Thus, its effect on national income is expansionary. There is a limit to
private investment. Thus, to stimulate income the gap has to be filled up by government
expenditure. However, the increase in income is greater than the increase in government
spending. The impact of a change in income following a change in government spending is
called government expenditure multiplier.
Definition. Thus government expenditure multiplier is the ratio of change in income due to
change in government spending. In the other words, an autonomous increase in
government spending generates a multiple expansion of income. How much income would
be expend depend upon the value of MPC.
37
CHAPTER-5
MONEY AND INFLATION
Q1. Measures of money supply:
The supply of money in any country refers to the stock of money held by the public at any
particular point of time. So, money supply is a stock concept.
In India, coins and one-rupee notes are issued by the Government of India, while other
paper notes are issued by the Reserve Bank of India. All notes and coins together constitute
currency. Currency plus demand deposits plus certain other deposits is called M 1 in India.
This is one measure of money supply.
Some of the measures of the supply of money are mentioned below:
a) M1 = Rupee notes and coins with the public (C) + demand deposits with the
commercial banks (DD) + other deposits with the Reserve Bank (OD).
b) M2 = M1 + Postal savings bank deposits.
In this measurement, the deposits of the people with savings banks are also included
in the money supply.
c) M3 = M1 + (Net) Time deposits with the commercial banks.
In this measure, which is supposed to be much broader than M 1 measure of money
supply, the net time deposits or term deposits of the public with the commercial
banks are also treated.
d) M4 = M3 + Total deposits with the postal savings organizations (excluding National
Savings Certificates).
In India, M1 and M2 are considered as Narrow Money, while M3 and M4 are treated
as Broad Money.
However, from the view point of liquidity of an asset, M 1 is supposed to be most
liquid and M4 is supposed to be least liquid.
Q2. The concept of High-powered money:

High powered money or powerful money refers to that currency that has been issued by the
Government and Reserve Bank of India. Some portion of this currency is kept along with the
public while rest is kept as funds in Reserve Bank.Thus, we get the equation as:
H=C+R
Where H = High Powered Money
C = Currency with the public (Paper money + coins)
R = Government and bank deposits with RBI
38
Thus the sum total of money deposited with the public and the funds of banks is termed as
powerful money. It is mainly created by the central bank. Since funds of commercial banks
play an important role in the creation of credit, so it is very important to study about funds.
Reserve Fund is of two types:
(i) Statutory Reserve Funds of banks which is with the central bank (RR), and
(ii) Extra Reserve Fund(ER).
Thus H = C + RR + ER
High powered money is also known as secured money (RM) because banks keep with them
Reserve Fund(R) and on the bases of this Demand deposits (DD) are created. Since the bases
of creation of credit is Reserve Fund (R) and R is obtained as a part of high powered money
(H) Security fund so high powered money is termed as Base money.
Components of High Powered Money:

The following are the important components which determine high power money:
1. Currency with the public
2. Other Deposits with RBI
3. Cash with Banks
4. Banker’s Deposits with RBI.
High powered Money (H) includes currency with Public (C), important reserves of
Commercial banks and other reserve (ER).
Thus we get the equation:

H = C + RR + ER
For example:
The commercial banks may have to keep 10 per cent of their total deposits as cash reserve
with the Central Bank (which is known as statutory cash reserve ratio). The rest 90 per cent
can be used by the commercial banks for credit creation as well as for meeting the regular
day-to-day demands of their depositors. This is called as free reserve.
Both these reserves are considered as assets of the commercial banks but liabilities of the
Central Bank.
This reserve money plays an important role for the creation of credit money by the banking
system or by the commercial banks as a whole in an economy.
39
Sources of High Powered Money:

The following are the sources of High Powered Money:
(1) Claims of Reserve Bank of India:
Reserve Bank also provides loans to the government. This loan is in the form of investment
in government securities by the Reserve Bank. After deducting the deposits of government
from quantity of loan of Reserve Bank quantity of net bank credit to government is
calculated. It is also a source of High Powered Money.
(2) Net Foreign Exchange Assets of Reserve Bank:

It is the work of Reserve Bank to make arrangement for foreign exchange funds. When,
Reserve Bank purchases foreign securities by paying the money of the country, then the
quantity of foreign exchange increases which increases high powered money. On the
contrary, when Reserve Bank sells foreign securities, then the quantity of foreign exchange
with the central bank of the country decreases. It results decrease in high powered money.
(3) Government’s Currency Liabilities to the Public:

Finance Ministry of the Indian Government is responsible for printing one rupee note and
also for coinage. This function is done through the government for completing money
related responsibilities towards the public. Thus with the increase in these liabilities,
quantity of supply of money will increase and the quantity of High Powered money will also
increase.
(4) Net Non-Monetary Liabilities of Reserve Bank:

The non-monetary liability of Reserve Bank is in the form of capital introduced in national
fund and statutory fund. Its main items are-Paid-up Capital, Reserve Fund, Provided Fund
and pension fund of the employees of Reserve Bank of India.
Non-monetary liabilities of Reserve Bank are inversely proportional to high Powered Money
i.e. with the increase in non-monetary liabilities, there will be a decrease in the quantity of
new high powered money.
Importance of High Powered Money:

The following are the importance of High Powered Money:
(1) Base Money:
Deposit of Public in a bank and expansion of credit is the base of supply of money. That is
why some economists considered it as base money.
40
(2) Source of Changes:
The direction in which change in the high power money takes place is powered to the
direction of change in the supply of money. Thus from this point of view High Powered
Money is also important.
(3) Money Multiplier:

What will be money multiplier (M) is declared in economy on the bases of High Powered
Money because supply of money is far more than high power money.
(4) Monetary Control:

A Special attention is paid by the central bank of any country on High Powered Money at the
time of monetary control. Because, it is a big part of total supply of money in a country.
Q3. Concept of money multiplier.

The money multiplier refers to how an initial deposits can lead greater increase in the total
money supply. For example if the commercial bank gain deposits of Rs. 1 million and this
leads to a final money supply of Rs 10 million. The money multiplier is 10.
The banking system can make multiple expansion of deposits. The process of credit creation
or money multiplier is based on following assumption.
(a) There are several commercial bank is the country.
(b) Each bank maintains a reserve ratio of 10%.
(c) The demand for cash by the non-bank public is fully satisfied.
(d) Each bank tries to give loans equal to its excess reserves.
(e) There is sufficient demand for loans.
(f) The ratio of interest charged by the banks while granting the loan remains the same.
(g) Let us suppose that bank A has an excess reserve of Rs.100. On the basic of excess
reserve of Rs.100. bank A creates derivative deposit of Rs.100 in the process of giving
loans. Let us suppose that the entire amount of Rs.100 is deposited with Bank B as
primary deposit. Bank B will keep Rs.10 as reserve and Rs.90 will be the excess
reserve of Bank B. Bank B will give loan by creating derivative deposit of Rs.90. Let us
suppose that the borrowers of Bank B withdraw Rs.90 from their deposit accounts.
This process will continue indefinitely and the total amount of deposit created by the
banking system as a whole on the basic of initial excess reserve of Bank A is given by
the sum of the G.P. services.
Bank A Bank B Bank C
100 + 90 + 81 +. ........... upto infinity
𝑎
𝑆∞ =
1−𝑟
100 100
= = = 1000
1−0.9 0.1
41
Where as ,
𝑎
a = 1st term; r = common ratio; i.e. r = 2
𝑎1
Thus it is seen that on the basis of excess reserve of Rs.100 of Bank A, all the banks taken
together can create deposit upto Rs.1000. Here the multiplier is equal to 10 and it is equal
to the reciprocal of the reserve ratio.
Q.4 Quantity Theory of Money.
The Quantity Theory of Money shows the relationship between the supply of money and
the price level in an economy. It also indicates the reason of money demand in an economy.
A. Cash Transaction Version:
American economist Prof. Irving Fisher in this article “The Purchasing Power of Money
(1911)”, has explained the Cash Transaction Version. This theory shows that changes in the
quantity of money is responsible for any change in the value of money. The purchasing
power of money implies the value of money. If the price level rises consequent upon an
increase in the supply of money, then the purchasing power of money (or the value of
money) will fall and vice versa.
Assumptions:
a) Money is demanded only for transaction purposes;
b) There exists full employment in the economy;
c) During any particular time period, the velocity of money circulation remains constant
in an economy.
d) Aggregate supply of goods in an economy is equal to the aggregate demand for such
goods;
e) The monetary authority of the country determines the quantum of money (M) in
circulation.
Explanation:
The price level is determined by the quantity of money in the country. Suppose that
in a country the quantity of goods and services sold and purchased in a year is T. If P
is the price level, PT will be the total value of transactions. Notice that this is
expressed in money terms.
∴ PT = Total money value of transactions = Total demand for money.
If M is the supply of money by the Government and if V is the velocity of circulation
of money, then money of quantity M will finance transactions worth rupees in a
year.
∴ MV = Value of total payments for transactions = Total supply of money
Since it is also assumed that aggregate demand for goods is equal to the aggregate supply of
goods in an economy, so the quantity of goods produced in an economy during any year
must be sold. As a consequence, demand for money must be equal to the supply of money.
PT = MV
This is called Fisher’s Equation of Exchange.In this theory, it is assumed that T and V
remain constant. So, if there is an increase in M, P will be also rise in the same
42
proportion. Similarly, if there is a fall in the supply of money, price will also fall in the
same proportion.
B. The Cash Balance Version: The Cambridge Version:

Economists connected with the University of Cambridge, England (for instance, Marshal and
Pigou) presented the same theory of money. It is assumed that people always keep a certain
proportion (say, k) of total money income with them as cash balance. Suppose that the total
output of the country in a year is Y. then the total money income of the country will be PY if
the price level is P.Let Md = Total demand for money in an economy. ∴ Md = kPY
If the total supply of money in the economy is denoted by M, then this supply must be equal
to the aggregate demand for money, i.e. Ms = Md = kPY or M = kPY
This equation is known as the ‘Cambridge equation’. The conclusion of this theory is similar
to that of Fisher. If there is full employment in the economy, output Y will be a known
constant; k also is a constant. Hence, M and P will again move in the same direction and at
the same proportion.
C. Comparison:
Fisher’s version and the Cambridge version of the quantity theory are not exactly the same.
There is a small difference. The total transaction in the market in a year, T may not be
exactly the same as total output of the year, Y.
If we ignore this small difference between T and Y (i.e. if T = Y) then a comparison of the two
equations MV = PT and M = kPY shows that
1 1
k = or V =
𝑉 𝑘
∴ M = kPY
1
= PT
𝑉
Or, MV = PT
1
Thus, the Cambridge k and Fisher’s V are the reciprocal of each other. Hence, can be taken
𝑘
to be the velocity of circulation of money. Therefore, V is called the ‘transactions velocity’
1
and is called the ‘income velocity’ of money.
𝑘
Criticism of the Quantity Theory of Money:
a) If there is unemployment, the T of Fisher’s equation of the Y of the Cambridge
equation will not be a known constant.
b) From the equation it is not clear what economic mechanism is there behind the
equi-proportional changes in M and P.
c) T and V cannot also be assumed to be constant is a dynamic society.
d) Demand for money can also arise due to speculative purpose.
e) Keynes has opined that the price level in the economy also depends upon the
aggregate consumption expenditure (C) and investment expenditure (I).
f) Price level may also increase due to the fall in the marginal productivity of labour.
43
Q5. Keynesian Theory of demand for money.

In this book ‘The General Theory of Employment, Interest and Money’ (1936), John Maynard
Keynes has explained the correct of demand for money. He stated that interest rate is a
monetary phenomenon and equilibrium rate of interest is determined through the
interactions of demand for and supply of
money. He assumed that the supply of money is determined by the monetary authority of
the country and this supply remains independent of any variation in the interest rate.
The novelty of the liquidity preference theory lies on the demand side. ‘Liquidity’ here
means liquid money. Liquidity preference means preference for liquid money.
Demand for money:
According to Keynes, the demand for money depends on three factors. Three types of
motives which people have in demanding money.
a) Transactions motive: People need to retain some liquid funds in hand in order to
finance their day-to-day purchases of commodities and services. Transaction
demand for money which is a function of money income.
b) Precautionary motive: People also like to retain some liquid funds in hand in order
to meet unforeseen emergencies. This is called the precautionary motive behind
demand for money. The precautionary demand for money also depends on the level
of income (Y).
c) Speculative motive: People also want to buy bonds in the bond market. They need
money for this purpose. The motive of keeping money in hand for buying bonds is
called the speculative motive. The speculative motive often induces people not to
keep money in hand but to convert it into bonds. The speculative demand for
money has a relation to the rate of interest.
At a very low interest rate, demand for money becomes infinite. The speculators do
not want to buy bonds since that may causes a capital loss.
This situation is called as the liquidity trap. The speculative demand function can be
expressed as follows:
𝑑𝑀
M = L (r), where 2< 0 i.e.,
2 2
𝑑𝑟
The speculative demand for money (M2) declines with an increase in the rate of interest and
vice versa.
Question- Difference between narrow money and broad money

Narrow money: narrow money is a category of money supply that includes all physical
money such as coins and currency, demand deposit and other liquid assets held by Central
Bank. M1 or m0 are used to describe narrow money. Narrow money is a subset of broad
money. This category of money is considered to be the most readily available for transaction
and commerce. “the narrow money definition of money supply is a measure of valuable
coin and notes in circulation and other Mani equivalent that are easily convertible into
cash such a short term deposit in the banking system”.
44
Broad money: broad money is a measure of total amount of money held by household and
company in the economy. Broad money is made up of commercial Bank deposit. The sum of
M1 and time deposit is called broad money. In other words, M2, M3, M4 qualify as broad
money and M4 represent the largest concept of money supply. These are often referred to
as long term time deposit because their activity is restricted by specific time
requirement.“In economics, broad money is a measure of the amount of money, or money
supply, in a national economy including both highly liquid "narrow money" and less liquid
forms.
Question. Determinates of money supply
There are two theories of the determination of the money supply. According to the first
view, the money supply is determined exogenously by the central bank. The second view
holds that the money supply is determined endogenously by changes in the economic
activity which affects people’s desire to hold currency relative to deposits, the rate of
interest, etc.
Thus the determinants of money supply are both exogenous and endogenous which can be
described broadly as: the minimum cash reserve ratio, the level of bank reserves, and the
desire of the people to hold currency relative to deposits. The last two determinants
together are called the monetary base or the high powered money.
1. The Required Reserve Ratio:

The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio)
is an important determinant of the money supply. An increase in the required reserve ratio
reduces the supply of money with commercial banks and a decrease in required reserve
ratio increases the money supply.
2. The Level of Bank Reserves:

The level of bank reserves is another determinant of the money supply. Commercial bank
reserves consist of reserves on deposits with the central bank and currency in their tills or
vaults. It is the central bank of the country that influences the reserves of commercial banks
in order to determine the supply of money. The central bank requires all commercial banks
to hold reserves equal to a fixed percentage of both time and demand deposits. These are
legal minimum or required reserves.
45
3. Public’s Desire to Hold Currency and Deposits:

People’s desire to hold currency (or cash) relative to deposits in commercial banks also
determines the money supply. If people are in the habit of keeping less in cash and more in
deposits with the commercial banks, the money supply will be large. This is because banks
can create more money with larger deposits. On the contrary, if people do not have banking
habits and prefers to keep their money holdings in cash, credit creation by banks will be less
and the money supply will be at a low level.
4. Other Factors:
The money supply is a function not only of the high-powered money determined by the
monetary authorities, but of interest rates, income and other factors. The latter factors
change the proportion of money balances that the public holds as cash. Changes in business
activity can change the behaviour of banks and the public and thus affect the money supply.
Hence the money supply is not only an exogenous controllable item but also an
endogenously determined item.
Conclusion:
We have discussed above the factors which determine money supply through the creation
of bank credit. But money supply and bank credit are indirectly related to each other. When
the money supply increases, a part of it is saved in banks depending upon the depositors’
propensity to save. These savings become deposits of commercial banks who, in turn, lend
after meeting the statutory reserve requirements. Thus with every increase in the money
supply, the bank credit goes up. But it may not happen in exactly the same proportion due
to the following factors:
(a) The marginal propensity to save does not remain constant. It varies from time to time
depending on changes in income levels, prices, and subjective factors.
(b) Banks may also create more or less credit due to the operation of leakages in the credit
creation process.
(c) The velocity of circulation of money also affects the money supply. If the velocity of
money circulation increases, the bank credit may nor fall even after a decrease in the money
supply.
46
Q6. Inflation and its types.

Inflation is defined as a sustained increase in the aggregate price level. Inflation means a
rising price level. Money a high level of prices is not called inflation because prices may be
stable at that high level. Whenever, there is a rise in the price level, there is an inflation,
irrespective of the level of prices before or after the rise.
If should be noted that inflation means a rise in the aggregate price level.
Types of inflation:
a) Creeping inflation: When the price level increases at a very slow rate, say at the rate
of only 2-2-5 per cent per annum, it is called creeping inflation.
b) Walking inflation: If the general price level of the economy increases at the rate of
about 5-6 per cent per annum, it is called walking inflation.
c) Running inflation: When the price level rises a bit faster and the rate of growth of
the price level is about 10 per cent per annum, it is called running inflation. At this
stage, the inflation rate just becomes double digited.
d) Hyper-inflation (or, Galloping inflation): At this stage, the prices rise ten or even a
hundred fold in a single month! Hence, if the general price level increases at the rate
of, say, 200 per cent or more per month, it will be treated as hyper inflation.
Demand-pull inflation:
A demand-pull inflation is an inflation created by the pressure of excess demand in the market. If
there is an excess of demand over supply, price tends to increase under this pressure of excess
demand. If aggregate demand exceeds aggregate supply, there will be an upward pressure on the
aggregate price level. This type of inflation is called demand-pull inflation. If there is no change in the
aggregate demands curve or the aggregate supply curve, there will be no change in the level of
equilibrium price.
Cost-push inflation:
If there is an increase in the costs of production of commodities, due to rise in the prices of inputs
used in the production process. It is shown that a rise in the average and marginal costs of production
leads to a leftward shift of the supply curve of a commodity. Thus, the suppliers are ready to supply
same quantity at a higher price than before. As a result, the aggregate output of goods and services in
the economy will fall and the aggregate price level will rise. Since this type of inflation is caused by a
rise in costs of production, it is called cost-push inflation.
The difference between the demand-pull and the cost-push inflation can be shown with the help of a
simple diagram. In case of demand-pull inflation, excess demand in the product market causes
rightward shift in the demand curve. So, given the supply curve, it leads to an upward pressure in the
equilibrium price of the product
Q7. Causes of inflation:

Demand-pull factors:
a) Increase in public spending:Spending by the Government is an important part of
total spending in any modern economy. It is a total spending that determines the
total demand.Thus, Government expenditure is an important determinant of
aggregate demand. In India, the amount of Government spending has increase by
leaps and bounds. This has created inflationary pressure on the economy.
47
b) Deficit financing of Government spending:If the increase in Government spending is

financed by taxation, the problem would not have been so severe. Because, taxation
would have taken money away from the hands of the people and would have
lessened the pressure of demand in the market. In order to be able to incur the extra
expenditure, the Governmentresorts to deficit financing. For instance, it prints
money and spends it. This adds to the pressure of inflation.
c) Increased velocity of circulation: The total use of money in the market is the amount
of money supply by the Government multiplied by the velocity of circulation of
money. During the boom phase of the business cycle, people spend money at a
faster rate. The velocity of circulation of money increases. This also creates
inflationary pressures on the economy.
d) Population growth:Growth of population also increases total demand in the market.
If the supply of gods and services does not keep pace with demand, the pressure of
excess demand will creates inflation.
e) Tax reduction:In democratic societies, Governments sometimes reduce taxes in
order to gain popularity among the votes. This happens, particularly, in election year.
Since this leaves more in people’s hands, this leads to inflation.
Supply side factors or cost-push factors:

a) Hoarding: Excess demand is sometimes artificially created by hoarders. They
stockpile commodities and do not release them to the market. Naturally, this leads
to excess demand and inflation.
b) Genuine shortages:Sometimes, of course, the shortages are not artificial but
genuine. If, for some reason, the factors of production are in short supply,
production will be affected. Since supply will be less than demand, prices will rise.
c) Exports: Sometimes, exports create shortages in the domestic economy. Suppose
that the total output of commodity is not sufficient to meet both domestic and
foreign demand. It can be either exported or consumed domestically. Under these
circumstances, exports will create inflation in the domestic economy.
d) Trade union pressure and rise in wage costs:Sometimes, trade unions contribute to
inflationary pressures. By demanding an increase in the wage rate, they increase the
cost of production. This creates cost-push inflation.
e) Imposition of indirect taxes:If the Government imposes indirect taxes then
producers or sellers raise the product prices to keep their profits unchanged. This
leads to inflation.
f) Price rise in the international market: If the price of some commodities or factors of
production, which are imported, rise in the world market then it would lead to
higher cost of production and hence, inflation in the domestic market.
48
Q8. Effects of inflation on different groups in a society:

Favourable impacts:
a) Higher profits: Profit incomes of the producers are generally pushed up by inflation,
because they can sell their products at higher prices.
b) Higher investment: The entrepreneurs and investors get added incentives to invest
in productive activities during inflation, since they can earn higher profits from such
investments.
c) Higher production: If productive investment grows during inflation, it would lead to
higher production of various goods and services in the economy.
d) Higher employment and income: Increase in the output of different goods during
inflation would also mean increasing demand for various factors of production. So, it
is expected that employment and income opportunities will also increase during
inflation.
e) Possibility of higher income for the shareholders: During inflationary periods, if the
companies earn higher profit, they can declare dividends for their shareholders.
Hence, the dividend income of the shareholders may also rise during inflation.
f) Gain for the borrower: Inflation means a decrease in the value or purchasing power
of money. If the rate of interest to be paid by the borrower is less than the inflation
rate, the borrower will gain.
Unfavourable consequences:
a) Fall in the real income of fixed-income groups: Real income means purchasing
power of money income. Given the money income of the fixed income groups, the
real income will fall during inflation. Hence, inflation affects worker’s, salaried
people and pension earners adversely.
b) Inequality in the distribution of income: The profit incomes of businessmen and
entrepreneurs increase during inflation, while the real income of the common
salaried people declines. So, inequality in the distribution of income becomes acute
during inflation.
c) Upsets the planning process: Inflationary pressure may also upset the entire
planning process in an economy. When prices of goods, materials, and factor
services increases continuously, then more money has to be spent for the
completion of any investment project taken up during any planning period.
d) Increase in speculative investment: If the price level rises at a fast rate, speculative
investment may increase in the economy for earning quick profits.
e) Harmful impact on capital accumulation: If the price rise becomes chronic, people
prefer goods to money. They also prefer immediate consumption to consumption in
future. So, their desire to save reduced. At the same time, their ability to save also
becomes less because, with
49
their given money income, they have to spend more for purchasing the same
quantity of goods and services. As a result, it creates a harmful impact on capital
accumulation.
f) Lenders will lose: Lenders will lose during inflation. Because they are actually
receiving an amount having lower value than before.
Q9. Measures to control inflation:

A. Monetary measures: If the supply of money in the economy can be decreased,
prices are expected to fall. The quantity of money and the price level change in the
same direction. Hence, if the quantity of money decreases, the price level will fall. If
we can reduce the rate of lending by banks, then we can reduce the total supply of
money significantly. The Central Bank of a country can reduce the lending of
commercial banks in different ways.
Quantitative credit control:
a) Bank rate: The bank rate is that discount rate at which the Central Bank of
any country rediscounts any bill of exchange submitted by any commercial
bank to take loans from the Central Bank.
b) Open market operations: This indicates the purchase and sale of
Government securities or treasury bills by the Central Bank. At the time of
inflation, the Central Bank sells Government securities in the open market to
pump out some amount of money from circulation. However, the open
market sale has been pursued by the RBI to check continuous expansion of
liquidity with the banking sector.
The success of this policy instrument depends on an organized bill / security
market.
c) Cash reserve requirements: Every commercial bank has to keep a certain
minimum cash reserve with the Central Bank. The RBI increases this cash
reserve requirement during inflation. With a rise in the cash reserve
requirements, the amount of loanable funds with the commercial banks
declines. Thus, the process of credit creation by the commercial banks is
checked.
d) Statutory Liquidity Ratio (SLR): In addition to the CRR, the commercial banks
are often required to maintain a given portion of their total liquid assets with
the Central Bank. This is known as SLR. The SLR is raised for combating the
inflationary pressure.
B. Fiscal policy: An inflationary gap arises when aggregate demand exceeds the
maximum potential supply in an economy. To overcome this situation, the following
types of fiscal measures can be undertaken:
a) A decrease in the Government expenditure; or.
b) A decrease in the Government transfer and subsidy payments.
c) An increase in taxes imposed by the Government; or
50
d) A combination of all these measures.

These are regarded as contractionary fiscal policies. These contractionary fiscal policies
reduce the employment and income opportunities within the economy. For instance an
increase in the tax rate reduces the disposable income of the consumers. Hence, these
policies restrict the growing demand for goods and services within the economy, and help in
contracting the inflationary pressure.
Q10. Problem of excess demand or inflationary gap.

When aggregate demand (AD) exceeds the maximum potential aggregate supply (AS)
corresponding to the full employment level in an economy, then it is called a situation of
excess demand.
Hence, Excess demand = AD – AS > 0
Or, AD > AS (corresponding to full employment level)
Thus, when the desired aggregate expenditure (representing the AD) exceeds the aggregate
supply at the full employment level, there would arise a problem of excess demand in the
economy. At this stage, the available resources of the economy are fully employed and
there will be no scope for any further increase in the aggregate supply of goods and
services. As a result, an excess of AD over AS would create an upward pressure on the
average prices of goods and services in the economy. Hence, an inflationary pressure will be
generated.
Inflationary gap:
An inflationary gap arises when AD exceeds AS at the full-employment level in an economy.
Thus, an excess demand situation creates an inflationary gap in the economy. If YE denotes
full-employment level of national output, (C + I)p denotes the present level of desired
aggregateexpenditure in the economy and (C + I)F denotes the aggregate expenditure at the
full-employment level of output, then
Inflationary gap = (C + I)p - (C + I)F> 0
Or, (C + I)p> (C + I)F
At the full employment level of equilibrium national output, YE = (C+I)F. Hence, an
inflationary gap is created in the economy when the present desired aggregate expenditure
(C + I)p, exceeds the full employment level of output.
∴ Excess demand = ADp – ASF [where, ADp> ASF]
= (C + I)p – YF
= (C + I)p - (C + I)F
= Inflationary gap
In Fig. 11.5, aggregate expenditure is measured on the vertical axis and national
income or aggregate output is measured on the horizontal axis.
51
Let us assume that Yf is the full employment level of national income. If C + I + G +

(X – M) is the aggregate demand (AD) curve that cuts the 45° line at point A then an
equilibrium income is determinded at Yf. There will not be any price rise since
aggregate demand equals aggregate supply. Now if the AD curve shifts up to AD’,
equilibrium output will not increase since output cannot be increased beyond the full
employment level.
In other words, because of full employment, output cannot increase to Y*. Thus at Y f level of
full employment output, there occurs an inflationary gap to the extent of AB. The vertical
distance between the aggregate demand and the 45° line at the full employment level of
national income is termed the inflationary gap. Or at full employment, there is an excess
demand of AB that pulls up prices.
Q11. Causes of excess demand or inflationary gap:

The basic reasons for the emergence of an excess demand situation or an inflationary gap in
the economy are as follows:
a) An increase in the aggregate desired expenditure: If there is an increase in the
aggregate desired private consumption expenditure (C) at each level of real national
income, then aggregate demand will increase in the economy. This may happen due
to a fall in the saving propensity of the people.
b) An increase in the aggregate desired private investment expenditure: If the
aggregate desired private investment expenditure (I) rises at each level of real
national income, then also the aggregate demand for goods and services will rise in
the economy. This may happen due to a better business prospects in an economy.
c) An increase in net export earnings: An increase in net export earnings would mean
an increment in the value of an excess of export income over import payments of
the country during any particular year. This means an additional demand for
domestic goods and services in the overseas market.
d) An increase in government expenditure: If there is an increase in government
expenditure at each level of real national income during any particular year, this
52
would also lead to a rise in the aggregate demand for goods and services in the
economy.
e) A reduction in taxes rates: If the rates of direct taxes are reduced by the
government, then the disposable income of the people will increase in the country.
As a result, consumption expenditure will rise and, therefore, aggregate demand will
rise.
Q12, The consequences of excess demand situation

The excess demand situation in an economy leads to the following consequences:
a) An increase in the general price level: An excess demand situation implies an excess
demand for goods and services over and above the full capacity output in an
economy. Hence, this leads to an upward pressure upon the general price level in
the economy. Thus, an inflationary condition emerges in the economy.
b) An increase in input prices: An excess demand for different goods and services would
also mean an increase in the average price of some of these goods which are used as
inputs for producing other gods. Hence, the cost of production will increase and this
would further stimulate the inflationary pressure.
Q13. The problem of deficient demand or a deflationary gap:

If the aggregate demand (AD) falls short of the maximum potential aggregate supply (AS)
corresponding to the full-employment level, it is considered as a situation of deflationary
demand.
∴ Deficient demand = AD – AS < 0
Or, AD < AS (corresponding to full-employment level)
Alternatively, deficient demand = AS – AD > 0
Or, AS > AD (at full-employment level of output)
Deflationary gap:
An excess supply situation in an economy leads to a continuous fall in the price level,
aggregate output and employment in an economy. This is considered as economic deflation
in any country. Thus, if the aggregate desired expenditure or the aggregate demand
becomes less than the aggregate supply available at the full employment level of output,
there arises a deflationary gap.
∴ Deflationary gap = (C+I)F – (C+I)P> 0
Or, YF = (C+I)F> (C+I)P
Hence, a deflationary gap refers to a short fall in the present aggregate desired expenditure
[(C+I)P] in relation to the aggregate expenditure required to maintain the full employment
level of output [(C+I)F]
∴ Deficient demand = ASF – ADP (where ADP< ASF)
= YF – (C+I)P
= (C+I)F – (C+I)P
= Deflationary gap.
53
In Fig 8.17, the 450 line indicates the equality between AS and AD. At the full employment
level of national output M, present aggregate demand becomes less than the aggregate
desired expenditure required to maintain that full employment level of output by an
amount of EB. This gap of EF shows the deflationary gap.
Q14. Causes of deficient demand or a deflationary gap:

a) A fall in the aggregate desired private consumption expenditure: If there is a fall in
the aggregate desired private consumption expenditure (C) at each of national
output, then it would lead to a fall in the aggregate demand in an economy. In fact,
the people may be inclined to save more and consume less at each level of national
output.
b) A fall in the aggregate desired private investment expenditure: If there is a fall in
the aggregate desired private investment expenditure (I) in an economy at each level
of national output, then aggregate demand will fall. This may happen due to bleak
business prospects in an economy.
c) A fall in net export earnings: When import payments of a country are deducted
from its export earnings, we get the net export earnings of the economy. A fall in this
export earnings at each level of national output would imply a net fall in the
overseas demand for the goods and services of the concerned country. This results in
a fall in the aggregate demand in this economy.
d) A fall in government expenditure: If there is a decline in government expenditure, at
each level of national output, then also the aggregate demand for goods and services
will decline in the economy.
e) An increase in tax rate: If the government rises the rates of direct taxes in a
economy, then the disposable income of the income earners will fall. This leads to a
fall in the consumption expenditure in the economy at each level of national output.
Hence. Aggregate demand will fall.
Q15. The consequences of deficient demand situation:

A piling up of the stock of inventories: If the aggregate demand is not sufficient to generate
a market for the maximum potential supply at the full employment level, then the unsold
54
stock will rise with the business firms. So, there will be unintended inventory accumulation
with the producers in an economy.
a) A fall in the level of output and employment: Since a deficient demand situation
leads to a piling up of the stock of inventories with the producers, they will reduce
their production. So, the demand for the factors of production will fall. As a result,
the employment opportunities will also fall in the economy.
b) A fall in the general price level: A deficient demand situation also means an excess
supply condition in the economy. This creates a downward pressure upon the
general price level in an economy. In fact, there will arise a competition among the
sellers to clear their stock even at a reduced price.
Unemployment
Unemployment may be defined as “a situation in which the person is capable of working
both physically and mentally at the existing wage rate, but does not get a job to work”
In other words unemployment means only involuntary unemployment wherein a
person who is willing to work at the existing wage rate does not get a job.
Types of Unemployment in India:

1. Open Unemployment:
Open unemployment is a situation where in a large section of the labour force does not get
a job that may yield them regular income. This type of unemployment can be seen and
counted in terms of the number of unemployed persons. The labour force expands at a
faster rate than the growth rate of economy. Therefore all people do not get jobs.
2. Disguised Unemployment:
It is a situation in which more people are doing work than actually required. Even if some
are withdrawn, production does not suffer. In other words it refers to a situation of
employment with surplus manpower in which some workers have zero marginal
productivity.So their removal will not affect the volume of total production. Overcrowding
in agriculture due to rapid growth of population and lack of alternative job opportunities
may be cited as the main reasons for disguised unemployment in India.
3. Seasonal Unemployment:
It is unemployment that occurs during certain seasons of the year. In some industries and
occupations like agriculture, holiday resorts, ice factories etc., production activities take
place only in some seasons. So they offer employment for only a certain period of time in a
year. People engaged in such type of activities may remain unemployed during the off-
season.
55
4. Cyclical Unemployment:
It is caused by trade cycles at regular intervals. Generally capitalist economies are subject to
trade cycles. The down swing in business activities results in unemployment. Cyclical
unemployment is normally a shot-run phenomenon.
5. Educated Unemployment:
Among the educated people, apart from open unemployment, many are underemployed
because their qualification does not match the job. Faulty education system, mass output,
preference for white collar jobs, lack of employable skills and dwindling formal salaried jobs
are mainly responsible for unemployment among educated youths in India. Educated
unemployment may be either open or underemployment.
6. Technological Unemployment:
It is the result of certain changes in the techniques of production which may not warrant
much labour. Modern technology being capital intensive requires less labourers and
contributes to this kind of unemployment.
7. Structural Unemployment:
This type of unemployment arises due to drastic changes in the economic structure of a
country. These changes may affect either the supply of a factor or demand for a factor of
production. Structural employment is a natural outcome of economic development and
technological advancement and innovation that are taking place rapidly all over the world in
every sphere.
8. Underemployment:
It is a situation in which people employed contribute less than their capacity to production.
In this type of unemployment people are not gainfully employed. They may be employed
either on part-time basis, or undertake a job for which lesser qualification is required. For
example a Post Graduate may work as a clerk for which only S.S.L.C. is enough.
9. Casual Unemployment:
When a person is employed on a day-to-day basis, casual unemployment may occur due to
short-term contracts, shortage of raw materials, fall in demand, change of ownership etc.
10. Chronic Unemployment:

If unemployment continues to be a long term feature of a country, it is called chronic
unemployment. Rapid growth of population and inadequate level of economic development
on account of vicious circle of poverty are the main causes for chronic unemployment.
56
11. Frictional Unemployment:

Frictional unemployment is caused due to improper adjustment between supply of labour
and demand for labour. This type of unemployment is due to immobility of labour, lack of
correct and timely information, seasonal nature of work. etc.
MEASURING NATIONAL INCOME:

SOME RELATED CONCEPTS
Q1. Calculate the NDPfc and national income by income and output methods on the basis
of the following statistical information:
Rs (in Crore)
a) Value of output 2400
b) Value of intermediate consumption 1200
c) Subsidies 30
d) Indirect taxes 180
e) Factor income earned abroad 30
f) Factor income paid abroad 60
g) Rent 120
h) Interest 15
i) Profits 45
j) Wages and salaries 330
k) Consumption of fixed capital 150
l) Mixed income of self employed 360
m) Employer’s contribution to social schemes 30
Q2. Estimate the national income with the help of income and expenditure methods on
the basis of the following information:
Rs. (in Crore)
a) Government final consumption expenditure 350
b) Private final consumption expenditure 650
c) Export earnings 100
d) Import payments 150
e) Net domestic capital formation 250
f) Wages and salaries 800
g) Operating surplus 200
h) Contribution of employees towards social security 100
i) Net factor income earned abroad (–)50
j) Net indirect taxes 100
Q3. Calculate national income using income and expenditure method on the basis of the
following data:
Rs. (in Crore)
57
a) Private final consumption expenditure 61000

b) Government final consumption expenditure 17000
c) Operating surplus 20000
d) Compensation of employees 34000
e) Mixed income of self-employed 38000
f) Net export income (–)10800
g) Net Factor income earned abroad (–)10300
h) Consumption of fixed capital 14000
i) Net addition to stocks 23000

j) Gross fixed capital formation 33000
k) Net indirect taxes 17200
Q4. Calculate GNPmp following (i) income method and (ii) expenditure method on the basis
of following data:
Rs. (in Crore)
a) Net exports 10
b) Private final consumption expenditure 400
c) Rent 20
d) Interest 30
e) Undistributed profit 5
f) Dividend 45
g) Corporate tax 10
h) Net domestic capital formation 50
i) Government final consumption expenditure 100
j) Consumption of fixed capital 10
k) Compensation of employees 400
l) Net indirect taxes 50
m) Net factor income from abroad (–)10
Q5. Calculate national income (NI) by output method and income method on the basis of
following data:
Rs. (in Crore)
a) Value of output 800
b) Value of intermediate consumption 400
c) Indirect taxes 60
d) Subsidies 10
e) Factor income received from abroad 10
f) Factor income paid abroad 20
58
g) Mixed income of self-employed 120

h) Interest and profit 20
i) Rent & Royalty 40
j) Wages & salaries 110
k) Consumption of fixed capital 50
l) Employer’s contribution to social security scheme 10
Q6. Calculate GNPfc by (i) Income method and (ii) Expenditure method based on the
following information:
Rs. (in Crore)
a) Operating surplus 600
b) Mixed income of self-employed 160
c) Wages & salaries 800
d) Undistributed profits 150
e) Gross capital formation 330
f) Change in stock 25
g) Net capital formation 300
h) Employer’s contribution to social security schemes 100
i) Exports 30
j) Imports 60
k) Net factor income from abroad (–)20
l) Private final consumption expenditure 1000
m) Government final consumption expenditure 450
n) Net indirect taxes 60
o) Compensation of employees paid by Government 75
Q7. Calculate GNP (at factor cost) (i) income method and (ii) expenditure method:
Rs. (in Crore)
a) Net domestic capital formation 5000
b) Compensation of employees 1850
c) Consumption of fixed capital 100
d) Government final consumption expenditure 1100
e) Private final consumption expenditure 2600
f) Rent 400
g) Dividend 200
h) Interest 500
i) Net exports (–)100
59
j) Profits 1100
k) Net factor income from abroad (–)50
l) Net indirect taxes 250
Q8. Calculate (i) GNP mp and (ii) GDP mpon the basis of following information:
Rs. (in Crore)
a) Personal final consumption expenditure 55000
b) Gross domestic fixed capital formation 5000
c) Government final consumption expenditure 6000
d) Decrease in inventories 600
e) Subsidies 500
f) Exports of goods and services 900
g) Imports of goods and services 1000
h) Depreciation of capital 2000
i) Net factor income from abroad (–)500

j) Net indirect taxes 2000
Q9. Calculate national income by output method and income method on the basis of
following information:
Rs. (in Crore)
a) Value of output of the primary sector 2000
b) Value of output of secondary & tertiary sectors 800
c) Raw materials purchased by the primary sector 1000
d) Raw materials purchased by the secondary & tertiary sectors 600

e) Depreciation allowance 110
f) Indirect taxes 200
g) Subsidy payments 40
h) Factor income received from the rest of the world 20
i) Factor income paid to the rest of the world 30
j) Mixed income of self-employed 400
k) Compensation of employees 340
l) Operating surplus 190
THEORY OF EQUILIBRIUM INCOME DETERMINATION
Q1. If the consumption function is C = Rs 100 + 0.8Y, where Y denotes national income;
and the autonomous investment is I = Rs 50; find equilibrium level of national income.
60
Calculate savings at equilibrium. If Y = Rs 800, what would be the inventory

accumulation?
Q2. If the savings function is S = (–) Rs 50 + 0.2Y, where Y denotes the national income, and
the autonomous investment is I = Rs 50, calculate the equilibrium level of national
income.
Q3. Let the consumption function be expressed as C = Rs 40 + 0.8Y d, where Yd denotes

disposable income. If autonomous investment is I = Rs 60, government expenditure is
G = Rs 10, and the amount of direct tax is T = Rs 10, calculate the equilibrium level of
national income.
Q4. If the consumption function is C = Rs 40 + 0.8Yd, where Yd denotes disposable income;

the autonomous investment is I = Rs 60 and, the government expenditure is G = Rs 10,
determine the equilibrium level of national income.
Q5. Let us consider the following consumption function: C = Rs 25 + 0.5Yd, where Yd

denotes the disposable income. Now, if the autonomous investment I = Rs 100;
government expenditure is G = Rs 75 and the amount of direct tax is T = 0.5Y, calculate
the equilibrium level of national income. If autonomous investment declines by an
amount Rs 40, what would be its impact on equilibrium income?
Q6. In an economy, with every increase in income, 70 percent of the increased income is
spent on consumption. Suppose a fresh investment of Rs 300 crore takes place in the
economy. Calculate the following:
a) Change in income (∆Y), and
b) Change in savings (∆S)
Q7. In an economy, autonomous investment increases by Rs 120 crore. The value of

investment multiplier is 4. Calculate the MPC.
Q8. In an economy, the saving function is S = – 50 + 0.5Y (where S = saving and Y = national
income), and the aggregate autonomous investment (I) is Rs 7000 crore. Calculate the
equilibrium level of Y.
Q9. In an economy, with every increase in national income, 15 percent of the increased
income is saved. Suppose a fresh investment of Rs 200 crore takes place in the
61
economy. Calculate (a) the change in national income (∆Y), and (b) change in
consumption expenditure (∆C).
COMMODITY AND MONEY MARKET EQUILIBRIUM
Q1. If the consumption function is given by C = Rs 40 + 0.8Y and the investment function is
I = Rs 70 – 200r, find the IS equation, and the equilibrium level of income (Y) when the
rate of interest (r) is 10 per cent.
Q2. If the transaction demand (M1) and the speculation demand for money (M2) are
expressed by the functions M1 = 0.25Y and M2 = Rs 40 – 500r respectively; and if the
money supply function is given by Ms = Rs 200 then derive the LM equation. If the rate
of interest (r) is 8 percent, determine the equilibrium value of income (Y).
Q3. Let the consumption function (C), investment function (I), transaction demand for
money (M1) function, speculative demand for money (M2) function and the money-
supply (Ms) function be represented as C = Rs 150 + 0.50Y, I = Rs 200 – 400r, M1 =
0.25Y, M2 = Rs50 – 100r and Ms = Rs180 respectively. Determine the IS and LM
function, and the equilibrium values of income (Y) and rate of interest (r) which keep
both the product and money markets in equilibrium.
Q4. Consider the following equations for the product market:
C = Rs 100 + 0.8Y; I = Rs150 – 600r, and consider the following equations for the
money market;
Ms = Rs 200; M1 = 0.2Y;
M2 = Rs 50 – 400r.
Determine the (i) IS and LM functions, (ii) the equilibrium values of r and Y which keep
both the markets in equilibrium, (iii) if the government sector is added, and if G = Rs 10
and T = 0, what would be its impact on the IS function, and the equilibrium values of Y
and r?
Q5. If the consumption function is given by C = 50 + 0.5Y and the investment functions is I
= 80 – 150r, find the IS equation and the equilibrium level of income when r = 15%
Q6. If the transaction demand for money (M1) = 0.5Y, speculative demand for money (M2)
= 50 – 800r, and if the money supply (Ms) function is Ms = 400, then determine the LM
function. Also determine the equilibrium level of income when the rate of interest (r) =
10%
Q7. If the consumption function is given by C = Rs50 + 0.5Y, and the investment function is
I = Rs100 – 50r, find the IS function, and the equilibrium level of income (Y), when the
interest rate (r) is 10%
62
Q8. Consider the following functions relations:

a) The consumption function C = Rs100 + 0.8Y
b) The investment function I = Rs250 – 100r;
c) The transaction demand for money function M1 = 0.3Y
d) The speculative demand for money function M2 = Rs 40 – 100r and
e) The money supply function Ms = Rs 500.
Derive the IS and LM functions and calculate the equilibrium values of national income (Y)
and the rate of interest (r) which keep both product and money markets in equilibrium.
63

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Gobind Kumar Jha 9874411552

CHAPTER 3. DETERMINATION OF EQUILIBRIUM LEVEL OF NATIONAL INCOME

CHAPTER 4. IS AND LM MODEL

CHAPTER 5. INFLATION AND UNEMPLOYMENT

Difference between Microeconomics and Macroeconomics:

Some basic concepts:

h) Difference between intermediate and final goods:

i) Stock and flows:

Difference between Stock and flows:

Investment means an increase in the stock of capital. For a country, as a whole,

Q1. Circular flow of income:

In the upper part of this diagram

Three Sector Economy:

Q2. Difficulties of Measurement of National Income:

Q3. Production method:

Q5. Census of expenditure method:

Consumption function OR propensity to consume:

Marginal Propensity of Consume (MPC):

A. Propensity to save and saving function:

Equilibrium level of income:

If aggregate demand is greater than aggregate supply

Q2. Saving Investment equality approach:

Q3. Paradox of thrift:

Q4. Investment Multiplier:

According to this theory if there is an increase in autonomous investment then national

Working of Investment Multiplier:

Limitations or leakages of investment multiplier:

Holding of idle cash balances:

Q5. Size of Investment Multiplier depends on MPC:

QUESTION. Derivation of saving curve from consumption curve

QUESTION. Derivation of consumption curve from saving curve.

Relationship between APC and APS

spent on consumption or it can be saved. In case, we consider the ratio of consumption to

and APS equals unity.

Now, dividing both sides of this equation by Y, we obtain

Y/Y = C/Y + S/Y

Or, APS = 1 – APC

Relationship between MPC and MPS

Dividing both sides of this equation by ∆ Y we get

∆Y/∆Y = ∆C/∆Y + ∆S/∆Y

Or, 1 = MPC + MPS

or, MPS = 1 – MPC

Q2. Features of IS curve:

FOR LONG QUESTION

(2) The size of the multiplier.

The elasticity of investment demand signifies the degree of responsiveness of investment

Besides, Government expenditure is also of autonomous type as it does not depend on

Q3. The money market equilibrium and the LM curve:

Q4. Features of LM curve:

Shifts in the LM Curve:

ii. Shifts in the Money Demand Curve:

Q3. Determination of Equilibrium level of Income and interest rate:

IS curve represents different combinations of Y and r for which product market in of

Q5. Balanced Budget Multiplier:

Balanced budget means change in government expenditure is exactly matched by a change

Q6. Fiscal policy and its tools

a) Changes in the bank are;

Fig – a Fig – b Fig – c

Fig – d Fig – e Fig – f

Q9. Effectiveness of the monetary policy: IS – LM framework: