• Meaning

Lipsey-“macroeconomics is the study of the determination of economic aggregate and averages, such as, total output, total employment, the general price level, the rate of economic growth”

  1. E Boulding-“macroeconomics deals not with individual quantities as such with aggregates of those quantities not with individual income but with national income not with individual prices but with price level not with individual outputs but with national output”

Mc. Connel-“macroeconomics examines the forest not the tree. It gives us a bird’s eye view of the economy”

  • Scope of macroeconomics
  • Theory of income and employment
  • Macro theory of distribution
  • Theory of international trade business fluctuations
  • Theory of money and price level
  • Theory of economic growth
  • Macroeconomic policies
  • Types of macroeconomics
  • Simple macro-statics

Kurihara-“if the objective is to show ‘a still picture’ of the economy as a whole, the micro-static model is the appropriate technique. For this technique is one of investing the relations between macro variables in the final position of equilibrium without reference to the process of adjustment implicit in that final position”

  • Comparative macro-statics
  • Macro-dynamics

Kurihara-“microeconomics enables to separate the process of trial and error into a series of continuously changing relations and indicates the cause and effect. It analysis the discrete or continuous changes of aggregates, the sequence of cause and effect events arising from some initial change and the time paths(roots) of microeconomic variables”

  • Uses of macroeconomics
  • To understand the working of the economy
  • Formulation of economic policies
  • Business decision
  • Economic planning
  • Development of microeconomic theories
  • International comparisons
  • Limitations of macroeconomics
  • It is the complicated task to find out total national income by the help of estimates of price of different good and services. Wholesale price index numbers are made to find out general price level. Those index numbers involve the problems of weighing, averaging and a number of other difficulties
  • The aggregates which are homogenous in nature can lead to accurate results. But sometimes we may have to take into account aggregates which are non-homogenous in character. Results based on these heterogeneous aggregates are not accurate and we should always avoid such problems
  • Due to imperfect knowledge of statistical techniques, some person may predict the aggregates in false way. For example, the agricultural prices decrease by 50 percent while industrial prices increase by 50 percent, the general price level remains the same because the two types of price changes neutralize each other. In such a situation one may advise the government to make no change in its policy because the general price level remains the same. But actually the government needs to implement a policy which helps the farmers who get a loss due to fall in price of their product. Thus, sometimes the aggregate results may be misleading. It requires special ability to predict the result in such a situation
  • An aggregative change may not influence all the sectors of the economy in the same manner. For example, a general rise in prices does not mean that the prices of all the commodities have increased and have increased in the same proportion. It is quite possible that the prices of a few commodities may rather decrease. Further, due to this aggregative change, some sectors may be affected more adversely than others. On the other hand, some individuals may be benefited more than others
  • Difference between microeconomics and macroeconomics
  • Study of economic units
  • Objective of study
  • Subject matter
  • Methodology
  • Components of equilibrium
Microeconomics Macroeconomics
Microeconomics studies the individual or small economic variables of the economy such as individuals consumptions, saving, investment and income Macroeconomics deals with aggregates like national income, full employment and price level
The main objective of microeconomics is to study the principles, problems and policies concerning the optimum allocation of resource The main objective of macroeconomics is to study the principles, problems and policies relating to full employment and growth of resources
The subject matter of microeconomics is to study the determination of price, consumer’s equilibrium, distribution and welfare etc. Hence it is also called price theory The subject matter of macroeconomics is to study the process of determining employment, price level, national income, trade cycle etc. Hence it is also called income and employment theory
All microeconomics concepts and laws such as law of demand, law of supply, etc. and described by setting are formulated on assumption such as full employment, constant production and income, ceteris paribus[other things being equal]. In other words, they establish relationship between cause and effect of microeconomic variables. This method of study is also known as the price equilibrium analysis Macroeconomics assumes how the factors of production[economic resources] are distributed. It explains how full employment can be achieve in market economy. The total effect of an economic factor on the economy is taken into account in macro-economic analysis. This method of study is also known as the price equilibrium analysis 
Microeconomics studies the equilibrium between the forces of market demand and market supply. Hence the basis of microeconomics is the price mechanism Macroeconomics analysis deals with the national income, output, employment etc. an such economic variables are determined at the point of equilibrium established between the forces of the whole economy[i.e. aggregate demand and aggregate supply]
The study of microeconomics is not much help to solve the important current issues and problem such as decline in national income, hyperinflation, widespread unemployment and so on Macroeconomics studies the causes, effects and possible measures for the solution of these issues and problems. Macroeconomics help to solve these problems

Table 1.1 Difference between microeconomics and macroeconomics

  • Interdependence between microeconomics and macroeconomics
  • Dependence of microeconomics on macroeconomics
  • Determination of product pricing
  • Study of factor pricing
  • Dependence of macroeconomics on microeconomics
  • Study of national income
  • Study of general price level
  • Study of total saving
  • Macroeconomic issues
  • Employment and unemployment
  • Inflection or rising general price level
  • Business cycles
  • Stagflation and deflation
  • Economic growth
  • Balance of payments and exchange rate
  • Policies instruments
  • Demand-side policies
  • supply-side policies
  • Macroeconomic indicators
  • Nominal GDP
  • Real GDP
  • GDP deflator
  • GDP at producer’s price
  • Aggregate demand and saving
  • Government finance-revenue, expenditure and fiscal deficit
  • Monetary aggregates-narrow money and broad money
  • Definition


NI=(Y1+Y2+ Y3+ Y4+ …………. Yn)

Traditional approach

Marshall-“the labor and capital of a country acting on its natural resources produce annually a certain net aggregate of commodities, materials and immaterial, including services of all kinds”

Pigou-“national income is that part of objective income of the community, including of course, income derive from abroad, which can be measured in money”

Fisher-“the national dividend or income solely of services as received by ultimate consumers, whether from their material or from their human environment”

Modern approach

Simon Kuznets-“national income is the net output of commodities and services flowing during the year from the country’s productive system to the hands of the ultimate consumers”

World bank-“gross national product measures the total domestic and foreign value added claimed by residents. It comprises gross domestic product plus net income from abroad which is the income received by residents from abroad for factor services[labor and capital] less payments made to non-residents who contributed  in the production of goods and services to the domestic economy”

Definition of National by United Nation

  • Net national product, i.e. aggregate of net value added in all branches of economic activity during a specified period, including net income from abroad
  • Sum of the distributive shares, i.e. the aggregate of National Income accrued to the factors of production[in the form of wages, profits, interest, rent etc.
  • Net national expenditure, i.e. the aggregate of expenditures on final consumption of goods and services, plus domestic and foreign investment


  • National Income is the total amount of income from all economic activities like primary[agriculture], secondary[industry] and tertiary[trade, transport, services, etc.] sectors during a year
  • It is a result of combine contribution of all economic resources like natural resources, human resources and physical resources
  • It is a flow concept, not a stock. In other words, it is a flow of final goods and services produced from all economic sectors in the country during a year
  • Generally, it is calculated as a net form. The word net refers to the depreciation which is deducted from gross value of National Income
  • Net factor income from abroad should be added to National Income
  • There is triple identity; National Output = National Income = National Expenditure[NO=NI=NE]
  • Various concept of national income
  • In terms of market price
  • Gross domestic product[GDP]



C=consumption expenditure

I=domestic investment

G=government expenditure

X=export earnings

M=import expenses

  • Net domestic product[NDP]




NFIA=net factor income from abroad

  • Gross national product[GNP]



NFIA=net factor income from abroad

  • Net national product[NNP]

NNPMP= GNPMP-Depreciation

  • In terms of factor cost
  • Gross domestic income[GDI]

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed income +Depreciation

Where the item of compensation of employees are

  • Wage and salary
  • Bonus
  • Room accommodation
  • Tour and travel facilities
  • Education and health facilities
  • Other fringe benefits
  • Gross national income[GNI]



NFIA=net factor income from abroad

  • National income[NI]

NIMP= GNIMP-Depreciation

Short note: Net National Product[NNP] or National Income[NI]

  • Only those economic values are evaluated in calculating GDP/NDP/GNP/NNP in both market price and factor cost which add productive capacity of the economy
  • Some economic values such as capital gains, secondhand sales, illegal income, transfer payments etc. are excluded from GDP/NDP/GNP/NNP in both market price and factor cost which do not add productive capacity of the economy
  • Net domestic income[NDI]




NFIA=net factor income from abroad

Items of NDI

  • Compensation of employees
  • Operation surplus

Operation surplus=Rent + Interest + Profit

  • Mixed income

Significance of depreciation

  • Conversion of gross product into net product
  • NDPMP=GNPMP-Depreciation
  • NNPMP= GNPMP-Depreciation
  • NDIMP=GNIMP-Depreciation
  • NIMP= GNIMP-Depreciation
  • Conversion of net product into gross product
  • GNPMP=NDPMP + Depreciation
  • GNPMP= NNPMP + Depreciation
  • GNIMP=NDIMP + Depreciation
  • GNIMP= NIMP + Depreciation

Significance of net factor income from abroad[NFIA]

  • Conversion of gross product into net product
  • Conversion of net product into gross product

Concept of net indirect tax

  • Conversion of factor cost into market price
  • Conversion of market price into factor cost

Private income

Private income=National Income – Income from prosperity and entrepreneurship accruing to the government – Saving of non-departmental enterprise + National debt interest + Current transfers from government + Other current transfers from rest of the world

Personal Income[PI]

PI=NI – [undistributed profit + cooperate income taxes +social security contribution – transfer payments


PI=Personal Income

NI=National Income

Disposable Income[DI]

DI=PI – direct taxes


PI=Personal Income

DI=Disposable Income


DI= C + S


DI= C + I


DI=Disposable Income





Robertson-“current saving is a function of past income. It is the difference between yesterday’s income and today’s expenditure”

Keynes-“current saving is the difference between current income and current consumption”





DI=Disposable Income



Per capita income

Per capita income=National income of the yearTotal population of the year

Real GDP vs nominal GDP, Deflator and Rate of inflation

GDP deflator=National GDPReal GDP*100

Rate of inflation=Change GDP deflatorGDP deflator for previous year*100

  • Some basic concept
  • Potential GDP/GNP and actual GDP/GNP
  • Transfer payments
  • Capital gains
  • Second-Hand sale
  • Illegal income
  • Closed economy and open economy
  • Normal residents of a country
  • Stock and Flows
  • Production process
  • Depreciation
  • Circular flow of income and expenditure

Concept of money flow and real flow

Assumption of circular flow of income and expenditure in a two-sector model

  • There are only two sectors in the economy, (a) the households and (b) the producer
  • All income is spent on consumption. There are no saving in the economy
  • There is no government
  • It is a closed economy with no export and import
  • Households are the owners of factors of production or they are the suppliers of factor services
  • Producers/firms have factor services from the households

Features of households

  • The households are the owners of all factors of production
  • Their total income consists of wages, rent, interest and profits
  • They are the consumers of all consumer goods and services
  • They save a part of their income and supply finance to the firm

Features of business firms

  • They own no resources of their own
  • They hire and use the factors of production from the households
  • They produce and sell goods and services to the households
  • They do not save, that is there is no cooperate saving

Graphical representation of circular flow in a two-sector model

Circular money flow with saving and investment

The circular flow of income and expenditure in a three-sector model

Graphical representation of circular flow in a three-sector model

Assumption of circular flow of income and expenditure in a four-sector model

  • The external sector consists only of exports and imports of goods and services, made only by the firms
  • The households expert only labour and capital

Graphical representation of circular flow in a four-sector model

  • Methods of measuring national income
  • Expenditure method[spending approach]



NNPMP= GNPMP-Depreciation


C=consumption expenditure

I=domestic investment

G=government expenditure

X=export earnings

M=import expenses

R=receipt from abroad

P=payment made to abroad

Components of expenditure method

  • Private[personal] consumption expenditure[C]
  • Gross private domestic investment or gross capital formulation[I]
  • Non-residential investment
  • Residential investment
  • Changes in business inventories
  • Depreciation
  • Government expenditure[G]
  • Net foreign investment(X-M)
  • Net factor income from abroad[NFIA] or net receipt[R-P]
Gross private domestic investment may also classified as:

I=net fixed investment + changes in inventories + depreciation

Or, I=net investment[net capital formation] + depreciation

Or, I=gross fixed investment + changes in inventories

Or, I=gross fixed capital formation + changes in inventories


Components of net factor income come earned from abroad

  • Net compensation of employees
  • Net income from property[rent and interest and income from entrepreneurship]
  • Net retained earnings of the resident companies working in foreign companies

Precaution for taking to estimating National Income by expenditure method

  • All expenditures on second-hand goods are to be excluded
  • Expenditures on financial assets, like shares and bonds within the country are excluded
  • All government expenditures on transfer payments, such as old age pension, national debt interest, unemployment allowance, etc. should be excluded
  • Expenditures on all intermediate goods and services are also excluded because otherwise there would be double counting in the National Income
  • Income method[share distributive approach

Components of income method

  • Rents
  • Compensation of employees
  • Profits
  • Mixed income of self-employed
  • Depreciation[capital consumption allowance or consumption of fixed capital]
  • Net indirect tax

Items those are included in net indirect taxes

  • Value of production for self-consumption, such as agricultural products used by the farmers for the consumption in of their families
  • Imputed rent of houses occupied by the owners of these houses

Items those are not included in net indirect taxes

  • All current transfer incomes, like pensions, unemployment relief, scholarship, etc. should be excluded from National Income because they have been received without rendering any productive services in the current year. The transfer incomes do not reflect any product of goods and services in the current year
  • Illegal incomes, like incomes of smugglers and gamblers are excluded from National Income as they are the result of illegal activities and are unaccountable
  • Cooperate profit taxes have to be excluded because they are part of cooperate profit which are already included in factor incomes and their inclusion separately would amount to double counting
  • Interest on national debt is excluded from National Income since it is treated as transfer income on the assumption that government borrowings are used for consumption purposes
  • Money income received from the sale and purchase of second-hand goods, bonds, share are excluded from National Income because they do not contribute anything to the current flow of goods and services

According to income method

  • NDPFC[domestic factor income receipt]= Rent + Interest + Profit + Compensation of employees + Mixed income
  • NDPFC= Compensation of employees + Operating surplus + Mixed income
  • GDPK= NDPK + depreciation
  • GDPMP= GDPK + net indirect tax
  • NNPK= NDPK + net factor income from abroad
  • NNPMP=NNPK + net indirect tax
  • GNPK= NNPK + depreciation
  • GNPMP= GNPK + net indirect tax
  • Product method[inventory approach]

Components of product method

  • Primary sector which includes agro-products[food crops, cash crops, animal husbandry, horticulture, etc.], fishery, forestry, mining, querying and so on
  • Secondary sector, which includes manufacturing, construction, electricity, gas, water supply and others
  • Tertiary sector, which includes banking and insurance, transport and communication, trade and commerce, health and education and other services
  • Net factor income from abroad

According to product method

  • GDPMP=total product of primary sector + total product of secondary sector + total product of tertiary sector
  • GNPMP=GDPMP + net factor income from abroad
  • NDPMP=GDPMP – depreciation
  • NNP at factor cost or NI=NNP at market price – net indirect tax

Problem of double counting

Method to avoid problem of double counting

  • Final product method
  • Value added method

Items those are included in product method

  • Own account production of fixed assets, like residential buildings, factor-buildings by households, corporate and quasi-corporate entrepreneurs and government
  • Food and other items for self-consumption
  • Imputed rent of owner-occupied houses

Items those are included in product method

  • Sale and purchase of second-hand goods are not included because these transactions have not contribute anything to the flow of goods and services in the current year
  • Capital gains obtained from sale and purchase of bonds and shares are excluded from National Income since they do not contribute directly to the flow of goods and services in the current year
  • Services of housewives are excluded from National Income because there is no way of evaluating these services
  • Expenditures on financial assets, like shares and bonds within the country are excluded
  • All government expenditures on transfer payments, such as old age pension, national debt interest, unemployment allowance, etc. should be excluded
  • Reconciliation of three methods of measuring GDP at MP
Product method Income method Expenditure method
Net value added in the primary sector at factor cost Compensation of employees Private final consumption expenditure
Net value added in the secondary sector at factor cost Rent Government final consumption and investment expenditure
Net value added in the tertiary sector at factor cost Interest Gross capital formation or private domestic investment
Depreciation or consumption of fixed capital Profits Net export of goods and services
Net indirect taxes Mixed income of self-employed
Net indirect taxes
GDP at market price GDP at market price GDP at market price

Table 2.1 Reconciliation of three methods of measuring GDP at MP

  • Difficulties in measurement of National Income
  • Conceptual difficulties
  • Inclusion of services
  • Identifying intermediate goods
  • Identifying factor incomes
  • Services of housewives and other similar services
  • Imputing unpaid services
  • Income of the foreign companies
  • Valuation of inventory changes
  • Estimation of depreciation
  • Practical difficulties
  • Lack of occupational specialization
  • Non-Monetized sector
  • Inadequate information
  • Unreported illegal income
  • Non-Availability of reliable statistical data

The number of gap in non-availability of reliable data

  • There is a dearth of agencies and statistical organizations collecting national income data
  • A large number of enumerators entrusted with the task of collecting data at the village level are semi-illiterate and untrained in the collection of data. They do not possess requisite knowledge of collecting, classifying and analyzing data
  • Thirdly, There are also major gaps of data in respect of agricultural by-products, like fruits, vegetables, timber and firewood, price data on several products like livestock, poultry products. Moreover, data in respect of consumption, saving and investment expenditures are incomplete, inadequate and deficient
  • Importance and uses of National Income

Samuelson-“by means of statistics of national income, we can chart the movements of a country from depression to prosperity, its steady long term rate of growth and development and finally, its material standard of living in comparison with other nations”

  • Since income is a flow of wealth. Changes in the National Income give some indication of economic welfare. The total figure, however, can be misleading since account must be taken of the changes in the value of money and changes in the total population. Per capita income is the best indicator of development. Other things being equal, economic per head is used to compare standards of living in different countries
  • National Income per head is used to compare standards of living in different countries
  • Economic growth is measured in terms of per capita National Income and the National Income figures[in real terms] are used to measure the rate of growth of a country
  • The National Income accounts make possible an analysis of the behavior of the different sectors of the economy. They provide the details of the changes in consumption and investment spending in the level of savings, in the output of different branches of industry, in the expenditure of public authorities and to the distribution of income among the different income groups. These details are essential in planning development of various sectors
  • Inflationary and deflationary pressures can be estimated with the help of National Income statistics. The inflationary or deflationary gaps are the inconsistencies of certain subtotals
  • National Income statistics can be used to forecast the level of business activity later dates and to find out trends in other annual data
  • The National Income figures are useful in providing a correct sense of proportion about the structure of the economy
  • In war time the study of the components of National Income is of great importance because they show the maximum production possibilities of the country
  • Above all, the National Income statistics are used for planned economic development of a country. In the absence of such data, planning will be a leap in the dark
  • Say’s Law of Market


  • There is optimum allocation of resources
  • There is perfect competition prevailing in the commodity market as well as the factor market. Thus, commodity prices are equal to average costs and factor prices are equal to marginal productivities
  • There is free-enterprise economy
  • There is no government intervention to the economic field. The government follows laissez-faire policy to facilitate economic adjustment and smooth working of the market mechanism in the capitalist economic system
  • The size of the market has no limits. Thus, there is automatic expansion of the market with an increase in output offered for sale
  • The free market economy and its working of prices mechanism provide due scope to labour supply and the rising population also stimulate capital formation. In an expanding economy, new workers and firms will be automatically absorbed into the productive channels by their own products in exchange without displacing or sub-planting the existing firms and workers
  • The circular flow of money is regular and continuous without any leakage. This implies that saving is nothing but another form of spending for capital goods. Savings are, thus, automatically invested. There is absence of hoarding. Hence, there is no break in the flow of income and expenditure. Income is automatically spent through consumption expenditure and investment expenditure
  • Since all savings are automatically invested, saving is always equal to investment. Saving investment equality is the basic condition of equilibrium in the economy. It is maintained by interest flexibility
  • The economy’s equilibrium process is perceived from the long-term point of view


  • In the long-run, free economy automatically attains equilibrium at full employment level
  • There is automatic adjustment when supply creates its own demand. Increase in supply will meet its own demand in the process of the functioning of a free capitalist economy. Hence, there is no need for the government to intervene. On the contrary, any government interference in the economic field comes in direct conflict with the self-adjusting mechanism of the Say’s Law of Market
  • Since supply creates its own demand automatically, there is no possibility of any general overproduction. The Say’s Law is denial of the possibility of a deficiency in aggregate demand
  • When there is no general overproduction, then in the long-run there can be no problem of general unemployment in the long-run and the economy tends to remain at full employment equilibrium level
  • In the expanding free enterprise economy when new workers and new firms are productively absorbed, they do not supplant the output, income and employment of the existing one and as they release additional output and income, the community becomes automatically rich with increasing size of National Income. it also means that employment of new or unused resources in productive process tends to pay its own way and confer benefits to the society at large
  • Supply creates its own demand in real items. Thus, money is just a veil. Behind the flow of money, there is a flow of goods and services which is important. Thus, changes in the supply of money has no impact on the real economy’s process of equilibrium as a full-employment level
  • A capitalist economy under the laissez-faire policy has built in flexibility. It functions automatically to optimum adjustments through freely operating market mechanism and the price system
  • Savings-investments equality is brought about by the flexibility of interest rate. Rate of interest is, thus, a strategic variable in the equilibrium process of the economy
  • Wage flexibility in a competitive labour market tends to bring about full-employment of workers. As Harve and Johnson put it, a competition and flexible prices in product and factor markets-quickly and automatically remove any disequilibrium
  • Meaning and types of unemployment

Types of unemployment

  • Cyclical unemployment
  • Frictional unemployment
  • Structural unemployment
  • Open unemployment
  • Disguised unemployment
  • Underemployment
  • Educated unemployment

Labour force and unemployment rate

Labour force=number of employed + number of unemployed

Unemployment rate=Number of employedLabour force*100

Natural rate of unemployment

  • Classical theory of employment


  • Full employment is a normal feature of a closed capitalist economy in the long-run
  • Individuals are rational human beings and are motivated by self-interest
  • The government should not interfere in the automatic working of the automatic system and should follow the policy of laissez-faire
  • Money acts as a medium of exchange. Individuals do not suffer from money illusion
  • Techniques of production and organizational structure of business do not change
  • There is existence of perfect competition in all markets[i.e. product market, labour market and money market]
  • People spend their entire income either on consumption or on investment


  • Say’s Law of Market
  • Product market
  • Money market
  • Labour market
  • Production function


  • Full employment is a normal feature of a capitalist economy. In other words, the economy attain equilibrium only at full employment and general unemployment or general overproduction is not possible
  • Full employment means absence of involuntary unemployment. Even at full employment, there may exist, voluntary unemployment, frictional unemployment, seasonal unemployment, structural unemployment or technical unemployment
  • The version of Say’s Law of Market, i.e. supply creates its own demand, is the key to achieve full employment
  • Flexibility of interest rate, prices and wages ensures full employment in the economy in the capitalist economy in the long-run. They are determined in their respective markets through the equality of demand and supply functions
  • Saving is an increasing function of rate of interest or S=f(r) and dSdr>0
  • Investment is a decreasing function of rate of interest or I=f(r) and dIdr<0
  • People demand money[Md] for transactions and precautionary purposes[Ll] and demand for these purposes is a function of income[Y]. In long-run, demand for money remains constant
  • Price level varies positively and proportionately with the supply of money. Equality between demand for money and supply of money gives the market clearing condition in the money market
  • Demand for labour is a decreasing function of real wage[WP or R] or DL=f(R) and dDLdR<0
  • Supply of labour is an increasing function of real wage or SL=f(R) and dSLdR>0
  • Equality between demand for labour and supply of labour gives the market clearing condition in the labour market
  • Total output is a decreasing function of number of workers employed. It is subject to the law of diminishing marginal returns


  • Keynes considered the fundamental classical assumption of full employment equilibrium condition as unrealistic. To him, there is the possibility of equilibrium condition at under-employment as a normal phenomenon. Keynes regarded it as a rare phenomenon. Keynes in fact considered the underemployment condition of equilibrium to be more realistic
  • Keynes opposed the classical insistence on long-term equilibrium instead, he attached greater importance to short-term equilibrium
  • Classical economists rest on the Say’s Law which blindly assured that supply always creates its own demand and affirmed the impossibility of general overproduction and disequilibrium in the economy. Keynes totally disagreed with this and stressed the possibility of super exceeding demand, causing disequilibrium in the economy and pointed out that there is no automatic self-adjustment in the economy
  • Keynes strongly objected to the classical formulation of employment theory, particularly Pigou’s notion that unemployment will disappear if the workers will just accept sufficiently wages rates[i.e. a voluntary cut in money wage]. He rejected Pigou’s plea for wage flexibility as a means of promoting employment at a time of depression
  • On the practical side, Keynes pointed out that the trade unions are an integral part of the modern industrial system and they would certainly resist a wage-cut policy. Strike and labour unrest are the bad consequences of such a policy. Similarly, there is welfare legislation regarding minimum wage and unemployment insurance in a welfare state. Dilard-“therefore, it is a bad politics even if it should be considered good economics to object to labour unions and to liberal labour legislation”. Thus, in modern times, money wage cut is not a practical propositions
  • On the theoretical ground, Keynes observed that a general wage cut would reduce the purchasing power in the hands of the workers which means a cut in their consumption, i.e. effective demands in the products of industry. A decline in aggregate effective demand will obviously lead to a decrease in the level of employment. According to Keynes, thus, a general wage cut would reduce the volume of employment
  • Keynes also attacked the classical theory in regard to saving and investment. He objected to the classical idea of saving and investment equilibrium through flexible rates of interest. To him saving and investment equilibrium are obtained through changes in income rather than in the interest rate
  • For the classical economists, money is only a veil and its main function is to act as medium of exchange. Keynes, on the other hand, emphasized the store of value function of money. According to Keynes when there is unemployment of resources, an increase in the quantity of money increases output and employment and prices rise very little and that too only indirectly
  • The classical theory gives a static picture of the economy by assuming a state of full employment. It ignores the empirical facts of changing levels of employment in the real world
  • The theory is also based on the unrealistic assumption of perfect competition. Perfect competition does not exist in the real world
  • The classical theory has a little practical significance. It does not provide any solution to the problem of unemployment or trade cycles
  • Principle of Effective Demand



  • There is existence of closed economy, ignoring the effect of foreign trade
  • There is operation of the law of diminishing returns
  • Perfect competition exists in market
  • He assumes that labour has money illusion. It means that a worker feels better when his wages double when prices also double, thus, leaving his real wage unchanged
  • The government assumed to have no part play either as taxer or a spender, i.e. the fiscal operations of the government are not explicitly recognized
  • Less than full employment equilibrium is possible in short period


Aggregate demand function

Stonier and Hague-“the aggregate demand price at any level of employment is the amount of money which all the entrepreneurs in an economy taken together really do expect that they will receive if they sell the output produced by this given amount of men”

Aggregate supply function

Determinants of Level of Employment

Summary of Keynesian Theory of Employment

  • Total Employment = Total Output = Total Income. As employment increases, output and income also increase proportionately
  • Effective demand is the key determinant of volume of employment. In other words, deficiency effective demand[i.e. the gap between income and expenditure] results unemployment. Hence, effective demand has to be increased to achieve high level of employment
  • Effective demand is a point at which aggregate demand function[except receipts of entrepreneurs] and aggregate supply function[cost of entrepreneurs] are equal
  • Keynes assumed aggregate supply function as given in the short period and regarded aggregate demand as the most important element in this theory
  • Aggregate demand function is the sum of consumption expenditure and investment expenditure
  • Consumption expenditure depends upon the psychological and objective factors; however the main determinants are size of income and propensity to consume. It is fairly stable in the short-period because propensity to consume does not change quickly
  • Investment expenditure depends upon marginal efficiency of capital and the rate of interest unlike consumption expenditure, investment expenditure is highly unstable. The marginal efficiency of capital is determined by a supply price of capital asset and their prospective yields. Rate of interest is a monetary phenomenon and remains constant in short period. Hence, the main determinant of effective demand is the prospective yields
  • Original Keynesian analysis considers economic activities governed by private sector only but does not take into account government expenditure. But, in modern times, government expenditure is also a significant determinant of effective demand. Government expenditure is consider the most effective weapon to fight unemployment
  • Consumption function

Kurihara-“consumption represents amount of consumer expenditure made at a given level of income, whereas the propensity to consume is a schedule of consumption expenditure at various income levels”

  1. H. Hansen-“the consumption function shows what changes can be expected in the consumption from given change in income”
  2. G. Lipsey and R. A. Chrystal-“the term consumption function describes the relationship between private consumption and the variables that influence it. In the simpler theory consumption is primarily determined by personal disposable income”






C=a + bYd


C=total consumption expenditure

a=Y-intercept or autonomous consumption or consumption at Yd=0

b=marginal propensity to consume[MPC] or slope of consumption curve or rate of change in induce consumption with respect to change in income

Yd=disposable income

  • Psychological law of consumption function

Keynes-“the fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of expenditure, is that men are disposed as a rule and on an average to increase their consumption as their income increase but not by as much as increase in income”


  • When aggregate income increases, consumption expenditure also increases but by a smaller amount. It is because that as income increases, people are able to satisfy their wants side by side, so that the need to spend more consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, consumption expenditure varies positively with income, but not in the same proportion in which income increases[i.e. C=f(Y) or dCdY>0 and 0<dCdY[MPC]<1]
  • The increased income will be divided in some ratio between saving and expenditure[i.e. ∆Y=∆C+∆Y]. This proposition is followed from the first proposition because when the whole of increased income is not spent on consumption, the remaining is saved. Hence, consumption and saving move together
  • Increase in income always leads to an increase in both consumption and saving


  • The psychological and institutional factor[complexes] such as income distribution, price level, population growth, taste, preferences and fashion, etc. remain unchanged in the short period
  • It assumed the existence of a laissez-faire capitalist economy. The law operates only in a developed and free capitalist economy. People are free to spend their increased income in such type of economy. This law is not applicable in socialist and government regulated economy
  • It assumed the existence of normal circumstances. It implies that operation of the law is possible only under normal circumstances and not under extraordinary circumstances, like war, hyperinflation and depression or civil war etc.
  • Short-run[cyclical] and Long-run[secular] consumption function
  • Technical attributes of consumption function
  • Average propensity to consume[APC]





  • Marginal propensity to consume[MPC]



∆C=change in consumption

∆Y= change in income

Properties of MPC

  • The value of MPC is always positive and less than unity[i.e. 0<MPC<1]. It implies that consumption expenditure increases at less proportion than increase in income. It shows the technical expression of the psychological law of consumption function
  • The short run MPC is stable. It is because the psychological and institutional factors on which the propensity to consume depends do not change in the short period
  • The MPC of the poor is greater than that of the rich. Generally, poor people are unable to satisfy even their basic needs. Therefore, they tend to spend larger amounts of their increased income on consumption. But the rich people already enjoy a high standard of living and therefore, tend to spend less amount of their increased income. The amount for high MPC in underdeveloped countries like, Nepal, India, Pakistan, etc. and low in developed countries like UK, USA, Japan, etc.

Relation between APC and MPC

  • APC is the ratio of absolute consumption to absolute income at a particular period of time. MPC is also termed as the ratio of the change in consumption with the change in income. MPC reflects the change in APC
  • The consumption function be linear with positive consumption expenditure at zero income level, (a) APC is falling, while MPC is constant (b) APC is always greater than MPC
  • If consumption function be linear passes through the origin, both APC and MPC are equal and constant
  • If consumption function be non-linear or curvilinear (a) both APC and MPC decline with an increase in income, but the decline in MPC is more than the decline in APC, and (b) both APC and MPC increase with a decrease in income, but APC rises at a slower rate than MPC
  • Factors affecting consumption function
  • Subjective factors
  • Psychology of human nature
  • People are motivated to build the reserve for unforeseen contingencies such as, illness, unemployment, accidents, etc.
  • People are induced to save for providing the anticipated future needs such as, education of the children, social processions, retirements, etc.
  • People are also motivated to accumulate large wealth to get higher social or political status
  • Many people think that accumulation of more wealth gives them a great psychic satisfaction. It is due to their miserly instinct habits
  • Investment leads to increase in income and wealth of people. Thus, many people wish to save from their current incomes so that they may be able to use accumulated saving for investment which will increase their future income
  • People are also motivated to save more because of securing enough through funds to carry out speculation because it is an essential part of financial market
  • Institutional arrangement
  • Business firms are induced to save a part of their income so that they can make investment in new enterprises and carry out expansion in the future
  • Managers of the business firms are also induced to save more because they want to prove themselves successful managers. By investing saved money they would be able to increase incomes of firm in future
  • Business firms also make their institution to accumulate more because of facing emergencies and contingencies successfully
  • Firms also express desire to save more because of ensuring adequate financial provision against depreciation and obsolescence and repayment of debt
  • Objective factors
  • Changes in wage level
  • Distribution in income
  • Fiscal policy
  • Social security
  • Credit facilities
  • Holding of liquid assets
  • Attitude towards thrift
  • Financial policies of companies
  • Dues berry hypothesis
  • Consumption function of people depends upon their past living standard. As income rises from the previous level, consumption function shifts upwards
  • The consumption standards of the poor have also affected by the consumption standards of the rich. This process is called demonstration effect
  • Measures to raise propensity to consume
  • Income redistribution
  • Increasing the productivity of lower-income groups. It involves the adoption of certain measures to improve employment opportunities, working conditions, public health, housing and educational facilities for the lower-income groups. These measures would help to improve the productivity and earnings of the lower-income groups, thereby increasing the capacity to spend more on consumption
  • Increasing the purchasing power of lower-income groups through such measures as reductions in the cost of living through price-cuts and subsidies
  • Transferring purchasing power from the higher-income groups to the lower-income groups through such measures as progressive taxation, death duties, capital gains taxes, etc. and the spending of revenues so collected for the benefit of the poorer classes in the form of relief and welfare expenditure or even on the provision of social services. It is, however, objected that the redistribution of National Income through heavy and steep taxation on the rich may have the effect of discouraging capital formation and private investment and the increase in the propensity to consume, thus, secured may be offset by a decline in private investment. There may be some force in this contention and extreme caution may have to be used to see that there is no adverse effect on investment as a result of income redistribution. Thus, it is more rational to invest collected revenue on development of infrastructure and poor oriented projects
  • Wage policy
  • Social securities
  • Other measures
  • Easy credit facilities[in the form of installment buying] may be provided to the consumers for the purchase of durable consumers’ goods, such as, radio sets, automobiles, etc. in the wealthy industrial community. This would help to stimulate and sustain the demand for such consumers’ goods
  • Another method suggested to raise consumption function is to facilitate the process of urbanization in the country, since the propensity to consume of the urbanities is higher that of the ruralizes. The ruralizes are generally contented with few essential goods in view of their depressed living standard
  • The proper development of the advertising industry can also help to foster the propensity to consume by bringing to the notice of the consumers, goods and services which they would otherwise never come to know of. A well-devised campaign of advertisement and publicity can prove quite helpful in stepping up the consumption function
  • Implication of consumption function
  • Invalidation Say’s Law
  • Need for state intervention
  • Crucial importance of investment
  • Existence of underemployment equilibrium
  • Declining tendency of the marginal efficiency of capital
  • Explanation of the turning points of the business cycle
  • Saving function


Robertson-“current saving is a function of past income. It is the difference between yesterday’s income and today’s expenditure”

Keynes-“current saving is the difference between current income and current consumption”





Saving function






Or, S=Y-[a+bY]

Or, S=Y-a-bY

S=-a + (1-b)Yd


S= saving

a=Y-intercept or autonomous saving or saving at Yd=0

b=marginal propensity to save[MPS] or slope of saving curve or rate of change in saving with respect to change in income

Yd=total disposable income

Derivation of saving curve

  • Technical attributes of consumption function
  • Average propensity to save[APS]






Now we have


Dividing both side by Y



  • Marginal propensity to save[MPS]



∆S=change in total saving

∆Y=change in total income

We have



∆C=change in total consumption

∆S=change in total saving

∆Y=change in total income

Now we have


Dividing both side by ∆Y



Relationship between APC and MPC, APS and MPS

  • Short-run consumption function is considered as non-proportional consumption function. Hence, APC>MPC at all levels of income, but APS<MPS
  • Since, APC+APS=1. This expression implies that if APC decreases steadily as disposable income increases APS must be increases steadily as income rises
  • If autonomous consumption is zero, all values, i.e. APC, MPC, APS and MPS remain constant, positive and less than one[i.e. 0<APC[=MPC]<1 and 0<APS[=MPS]<1]
  • Types of saving
  • Personal saving
  • Corporate saving
  • Government saving
  • Forced saving
  • Determinants of saving
  • Level of income
  • Rate of interest
  • Paradox of thrift[saving is a vice, not a virtue]
  • Investment function

Robinson-“by investment is meant an addition to capital such as occurs when a new house is built. Investment means making an addition to the stock of goods in existence”

Peterson-“investment expenditure includes expenditure for producer’s durable equipment, new construction and the change in inventories”

  • Types of investment
  • Autonomous and induce investment

Peterson-“the autonomous investment is generally associated with such factors as the introduction of new technique or products, the development of new resources or the growth of population or labour force”

Keiser-“when an increase in investment is due to the increase in the current level of income and production, it is known as induce investment”

  • Intended[planned], unintended[unplanned] and actual investment
  • Gross investment and Net investment
  • Marginal efficiency of capital[MEC] and marginal efficiency of investment[MEI]

Marginal efficiency of capital[MEC]

Dilard-“the marginal efficiency of a particular type of capital asset is the highest rate of return over cost expected from an additional or marginal unit of that type of asset”

Kurihara-“marginal efficiency of capital is the ratio between the prospective yield of additional capital goods and their supply price”

Keynes-“equal to the rate of discount which would make the percent value of series of annuities given by the returns expected from the capital asset during its life just equal to its supply price”



SP=supply price

Q1+Q2+Q3+Q4+………………… Qn=series of prospective annual returns

r=rate of discount[MEC]


Or, (1+r)n=QnSP

Or, 1+r=[QnSP]1/n

Or, r=[QnSP]1/n-1

Schedule of Managerial Efficiency of Capital

Causes for declining Managerial Efficiency of Capital

  • Due to the operation of law of diminishing returns in the productivity of capital asset, prospective annual returns declines with an increase in level of investment
  • An increase in volume of demand for capital asset leads to increase in their prices. It results increase in supply price

Properties of MEC

  • If the MEC curve is relatively interest inelastic, then a great change in the rate of interest will lead to a small change in investment
  • If the MEC curve is relatively interest elastic, then a small change in the rate of interest will lead to considerable increase in investment
  • Due to change in MEC at constant rate of interest, MEC curve shifts either rightwards[due to increase in MEC] or leftwards[due to fall in MEC]

Investment function

Keynes-“investment will be pushed to the point on the investment demand schedule where Managerial Efficiency of Capital in general equal to the market rate of interest”

Relationship between MEC and rate of interest

Role of MEC

  • If MEC=rate of interest → neutral effect, then the project is acceptable on non-profit consider
  • If MEC>rate of interest → favorable effect, then the investment project is acceptable
  • If MEC<rate of interest → unfavorable effect, then project is rejected

Marginal efficiency of investment[MEI]

Properties of MEI

  • If there is greater response in investment demand due to change in rate of interest, the investment demand curve will be highly elastic
  • If there is less response in investment demand due to change in rate of interest, the investment demand curve will be less elastic

Relationship between MEC and MEI

  • The MEC is based on a given supply price of capital. It shows the rate of return on all successive units of capital without regard to the existing stock of capital. Hence, it is a stock concept. On the other hand, MEI is based induced changes in supply price. It shows the rate of return on only visits of capital over and above the existing stock of capital. Hence, it is a flow concept
  • The MEC determines the optimal stock in an economy at each level of interest rate. The MEC determines the net investment of the economy at each interest rate
  • Factors other than the interest rate affecting inducement to invest[MEC]
  • Short-run
  • Nature of demand, price and cost
  • Business optimism and pessimism
  • Level of income
  • Liquid asset
  • Existing stock of capital goods
  • Taxation
  • Propensity
  • Long-run
  • Population growth
  • Technological advancement
  • Urbanization
  • Supply of capital equipment
  • Economic policy
  • Political climate
  • Measures to stimulate private investment
  • Lowering the rate of interest
  • Tax reduction
  • Public expenditure
  • Price policy
  • Abolition of monopoly privileges and encouragement of competition
  • Promotion of research
  • Economic planning
  • Multiplier

Keynes-“investment multiplier tell us that when there is an increment of aggregate investment, income will increase by an amount which is K times the increment of investment”

Dilard-“investment multiplier is the ratio of an increase of income to given the increment of investment”




∆Y=change in income

∆I=change in investment

As we know




C=consumption expenditure


Let’s do small change in all


Removing the main factor


Or, ∆Y=∆Y*CY+∆I  [Y*CY=∆C]

Or, ∆Y-∆Y*CY=∆I

Or, ∆Y[1-CY]=∆I

Or, ∆Y[1-MPC]=∆I  [CY=MPC]

Or, YI=11-MPC

Or, K=11-MPC  [YI=K]

Working with multiplier


  • The original propensity to consume remains constant during the process of income propagation
  • There is change in autonomous investment and that induced investment is absent
  • There is a closed economy unaffected by foreign influences
  • There are no changes in prices
  • The accelerator effect of consumption on investment is ignored
  • There is less than full employment level in the economy
  • Consumption is a function of current income
  • There are no time lags in the Multiplier process. An increase[decrease] in investment instantaneously leads to a multiple increase[decrease] in income
  • The new level of investment is maintained steadily for the consumption of the Multiplier process
  • There is net increase in investment
  • Consumer goods are available in response to effective demand for them
  • There is surplus capacity in consumer goods industries to meet the increased demand for consumer goods in response to a rise in income following increased investment
  • Other resources of production are also easily available within the economy
  • There is an industrial economy in which the Multiplier process operates


  • Saving
  • Undistributed profit
  • Taxation
  • Debt cancellation
  • Purchase old shares and securities
  • Hoarding of cash balance
  • Inflation
  • Net imports


  • Knowledge of the process of Multiplier is of great importance for evaluating the extent of different phases of trade cycle and for its accurate forecasting and control
  • The concept of Multiplier highlights special significance of public investment or government development expenditure in achieving high level of employment and growth rate
  • It also highlights the significance of deficit financing to accelerate the process of economic expansion
  • The Multiplier process helps to understand how equality between saving and investment is brought about. An increasing investment leads to increase in income. As a result of increasing income, saving also increases and becomes equal to investment
  • The concept of Multiplier is very useful tool for formulating suitable economic policies
  • The concept of Multiplier highlights the importance of investment as a major dynamic element in the process of income generation in the economy
  • Principle of Acceleration


  • Capital output ratio remains constant
  • There should be no excess capacity in the capital goods industries
  • There is permanent change in consumption demand
  • The supply of resources should be elastic so that the investment in capital goods industries can be increased easily
  • There should be elastic supply of cheap credit
  • Technology remains constant
  • There is absence of time lags


  • The assumption of a fixed technical coefficient and replacement demand is not valid at least in the case of short run changes in demand
  • The Acceleration Principle does not operate in those situations in which there exists much unused plant capacity that enables business houses to increase the output of consumer goods without needing more capital equipment. This principle normally operates in those situations where the firms are operating at full capacity
  • The Acceleration Principle assumes a constant incremental capital output ratio[V=KI]. In a dynamic world where technological changes and innovations constantly occur, the cases of fixed ICOR are extremely rare
  • Again, the theory ignores the effect of price changes which pay an important role in the determination of an investment policy
  • The Acceleration Principle studies the effect of changes in consumption expenditure upon the derived demand for investment and ignores the effect of an autonomous investment
  • According to Prof. Tinbergen, Acceleration Principle does not possess practical importance. Since it operates only in the situation of full capacity, the statistical evidence shows that this condition is rarely satisfied in practical life


  • The Principle of Acceleration, along with the Principle of Multiplier, helps to understand the process of income generation more clearly and comprehensively. The concept of Multiplier provides only partial explanation of the income generation process
  • The Principle of Acceleration explains why the fluctuations in income and employment occur so violently
  • IT demonstrates that capital goods industries fluctuate more than the consumer goods industries
  • It is more useful in explaining the upper turning point of the business cycle because what is responsible for a fall in the induced investment is not any absolute fall in the demand for consumer goods but only a decline in its rate of increase
  • Harrod has used the coefficient of acceleration in the growth to show that the economic growth in an economy depends upon the size of accelerator, higher the size of accelerator, higher the growth rate and vice versa
  • Super Multiplier



Ks=super multiplier

∆Y=change in income

∆Ia=change in autonomous investment


ΔY= Ks* ΔIa

As we know




C=consumption expenditure

Ia=autonomous investment

Ip=induce private investment

Let’s do small change in all


Removing the main factor


Or, ∆Y=∆Y*CY+∆Ia+ ΔY*IpY  [Y*CY=∆C, ΔY*IpY=∆Ip]

Or, ∆Y=b∆Y+∆Ia+Y  [b= CY, v=IpY]

Or, ∆Y-b∆Y-Y=∆Ia

Or, ∆Y[1-b-V]=∆Ia

Or, YIa=11-b-V

Or, YIa=1S-V

Super multiplier effect = Multiplier effect + Acceleration effect


  • It provides a consumption analysis of the process of income generation. If shows how an initial autonomous investment leads to a cumulative rise in output and income
  • Hicks utilized the Super Multiplier to explain the dynamics of business cycle more accurately
  • It is also useful to the government for making influence the level of economic activity and National Income through government expenditure
  • Introduction
  • Determination of IS curve[equilibrium in goods market]

Main points of IS curve

  • The IS curve is the schedule of combination of the interest rate and the level of income such that the goods market is in equilibrium
  • The IS curve is negatively sloped because an increase in the interest rate reduces planned[desired] investment spending and therefore reduces aggregate demand, thereby lowering the equilibrium level of income
  • The smaller, the Multiplier and the less sensitive investment spending is to changes in the interest rate, the steeper the IS curve
  • The IS curve is shifted by changes in autonomous spending. An increase in autonomous spending, such as investment spending or government expenditure, shifts the IS curve to the right and vice versa
  • An points to the right of the IS curve, there is excess supply in the goods market at points to the left of the curve, there is excess demand for goods
  • Determination of LM curve[equilibrium in money market]

Main points of LM curve

  • The LM curve is the schedule of combination of the interest rate and the level of income such that the money market is in equilibrium
  • The LM curve is positively sloped. Given the fixed money supply, an increase in the level of income, which increases the quality of money demanded, has to be accompanied by an increase in the interest rate. This reduces the quality of money demanded and thereby maintains money market equilibrium
  • An increase in money supply shifts the LM curve to the right and vice versa
  • At all point to the right of the LM curve, there is an excess demand for money and at the point to its left, there is an excess supply of money
  • Determination of level of income

Mathematical determination of IS-LM curve

Determination of IS curve[function]:algebraic method








Ia=autonomous investment


r=rate of interest

From above




Differentiating with respect to r




Determination of LM curve[function]:algebraic method

Under Keynesian theory

Demand for money=Supply of money




  • Introduction

Harry Johnson-“inflation as a sustained rise in prices”

Crowther-“inflation is a state in which the value of money is falling i.e. the prices is rising”

Friedman, Coulborn, Kemmeerer-“inflation as a monetary phenomenon”

Coulborn-“too much money chasing too few goods”

Friedman-“inflation is always and everywhere a monetary phenomenon”

Keynes-“inflation as a phenomenon of full employment”

  • Features
  • Inflation refers to a process of rising prices and not a state of high prices. It shows a state of disequilibrium between the aggregate demand and aggregate supply at the existing prices, necessitating a rise in the general price level
  • Inflation refers to a situation of appreciable or considerable rise in prices. This implies that every type of rise in price level is not inflationary in character. A modest and gradual rise in price level, say between 1 to 2 per cent annum is essential in achieving and maintaining high level of employment and satisfactory rate of economic growth. Such a rise in price level is essential for toning up and healthy functioning of the economy and therefore, is not regarded as inflationary rise. It is only when the price rise becomes excessive and unhealthy that is regarded as inflationary in character
  • Rise in prices should not only appreciable but prolonged in order to be called as inflationary price rise. Inflation does not refer to a one-time rise in the price level but rather to persistent rise in the price level. Moreover, rise in the price level for a short period of time; say 6 months or a year is not regarded as inflationary in nature. It is only when the price level increase continues over a long period that it is regarded as inflationary in nature
  • Inflation is measured as the rate of increase in the price level as indicated by the price index. Inflation is generally measured in terms of GNP/GDP[gross national product/gross domestic product] deflator or CPI[consumer price index] or PPI[producer price index]
  • Inflation is a long-term operating dynamic economic process
  • Inflation is fostered by the action, reaction and counteraction of macroeconomic forces
  • Pure inflation start after full employment
  • Excess aggregate demand in relation to the aggregate supply of everything is the essence of inflation
  • Inflation may be demand-pull or cost-push or mixed inflation
  • Types
  • On the basis of the rate of change in price level
  • Creeping inflation
  • Waking inflation
  • Running inflation
  • Galloping inflation
  • On the basis of the government re4action[control]
  • Open inflation
  • Suppressed inflation
  • Demand-pull inflation, cost-push inflation, mixed inflation

Demand-pull inflation

Cost-push inflation

Types of cost-push inflation

  • Wage-push inflation
  • Profit-push inflation
  • Supply shock inflation

Mixed inflation

  • Causes
  • Demand rising factors
  • Increase in money supply
  • Deficit financing
  • Increase in public expenditure
  • Increase in investment expenditure
  • Increase in export demand
  • Increase in population
  • Repayment of public debt
  • Bank money
  • Cost rising[supply reducing] factors
  • Higher wage rates
  • Higher indirect taxes
  • Higher administered prices[increase in profit margin]
  • Scarcity of factor of production
  • Supply shocks
  • Hoarding
  • Inflationary gap

Lipsey-“an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base price”

Keynes-“the inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income”

  • Inflation and unemployment
  • Effect

Samuelson-“mid inflation lubricates the wheels of trade and industry”

  • Effect on production
  • Reduction in production
  • Changes in pattern of production
  • Misallocation of resources
  • Encourages speculation
  • Fall in quality of product
  • Reduction in saving
  • Hinders foreign capital
  • Effect on the distribution of income
  • Debtors and creditors
  • Profit earners
  • Wage-earners and salaried class
  • Investors
  • Pensioners and fixed income groups
  • Farmers
  • Adverse effect on saving
  • Effect on the balance of payment
  • Effect on public revenue
  • Confidence in the currency
  • Social and moral degradation
  • Political instability
  • Control
  • Monetary measures
  • Quantitative measures
  • Selective credit control measures
  • Fiscal measures
  • Public expenditure
  • Taxation
  • Public borrowing
  • Income policy
  • Direct control
  • Price control and rationing
  • Increase the availability of goods
  • Production should be increase. More specifically, production of inflation-sensitive goods need to be increased by allocating more resources, providing subsidies and removing bottlenecks impeding production of these goods
  • Direct production of essential goods may be supplemented by imports of these goods so as to reduce shortages and minimize inflationary pressures
  • Indexation
  • Computation of rate

Rate of inflation=Pt-P[t-1]P[t-1]*100

  • Producer price index
  • Un-weighted index number
  • Simple aggregative method
  • Simple average of price relative method
  • Weighted index number
  • Weighted aggregative method
  • Weighted average of price relative method
  • Consumer price index
  • Aggregate expenditure method or weighted aggregate method
  • Family budget method or method of weighted relatives
  • Meanings

Benham-“trade cycle refers to a period of prosperity followed by a period of depression”

Haberler-“the business cycle in the general sense may be define as an alternation of periods of prosperity and depression of good and bad trade”

Keynes-“a trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad trade characterized by falling prices and high unemployment percentages”

Burn and Mitchell-“business cycles are a type of fluctuation found in the aggregate economic activity of nation that organize their work mainly in business enterprises. A cycle consists of expansions occurring at output the same time in many economic activities, followed by similarly general recessions, contractions and revivals which merge into the expansion phase of next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles very from more than one year to ten or twelve years”

  • Characteristics
  • Fluctuation of aggregate economic activity
  • Allocation of expansion and contraction in economic activity
  • Co-movement
  • Self-reinforcing
  • Degree of regularity
  • Presence of crisis
  • Phases
  • Prosperity


  • A large volume of production and trade
  • A high level of employment and income
  • A high marginal efficiency of capital
  • A rising price level
  • A rising structure of interest rate
  • A large expansion of bank credit
  • A high level of real investment
  • A rise in wages and profits
  • Overall business optimism
  • Operation of the economy at full capacity
  • Recession


  • Scarcities of labor, raw materials, etc. leading to rise in costs relative to prices
  • Rise in the rate of interest due to scarcity of capital
  • Failure of consumption to rise due to rising prices


  • Increase in liquidity
  • Construction of credit supply
  • Decrease in output, employment and income
  • Decrease stage in effective demand, price level and profit

Cite Prof. Lee-“a recession, once started tends to build upon itself much as forest fire, once under way, tends to create its own draft and given internal impetus to its destructive ability”

  • Depression


  • Shrinkage in the volume of output, trade and transactions
  • Rise in the level of unemployment
  • Price deflation
  • Fall in the aggregate income of the community
  • Fall in the structure of interest rate
  • Reduction in the level of effective demand
  • Collapse of the MEC and decline in the level of investment
  • Construction of bank credit
  • Revival or recover


  • Increase in investment in capital industries
  • Increase in price level, profit and MEC
  • Improvement in financial market
  • Increase in effective demand
  • Increase in employment, output and income in the whole economy
  • Measures of economic stabilization[control of trade cycle]
  • Monetary policy
  • Fiscal policy


  • Built in flexibility or automatic stabilizers
  • Discretionary action
  • Compensatory 
  • Direct control
  • Supply of money

Approaches to the definition of money supply

  • Traditional approach
  • Monetarist approach
  • Gurley and Shaw approach
  • Radcliffe committee approach
  • Measures of money supply



C=currency held by the public

DD=net demand deposits with bank

OD=other deposits with the central bank

M2=M1+saving deposits with post offices

M3=M1+net time deposits with commercial bank

M4=M3+total deposits with post offices

  • Determinants of money supply
  • Monetary base
  • Money multiplier
  • Reserve ratio
  • Currency ratio
  • Confidence in bank money
  • Time-deposit ratio
  • Value of money
  • Real income
  • Interest rate
  • Monetary policy
  • Seasonal factors
  • Keynes concept of demand for money

Active cash balances

Transaction motive

  • Income motive
  • Business motive



Y=money income

Lt=transactions demand for money

kt=fraction of money income society desires to hold money

Precautionary motive



Y=money income

Lp= precautionary demand for money

kp=fraction of money income society desires to hold money


Idle cash balances or speculative demand for money

Total demand for money




L2=idle cash balances or speculative demand for money

Liquidity preference schedule

  • Monetary policy
  1. P. Kent-“the management of the expansion and contraction of the volume of money in circulation for the explicit propose of attainting a specific objective such as full employment”

Paul Einzig-“as the effort to reduce to a minimum the disadvantages and increase the advantages, resulting from the existence and operation of a monetary system”

  1. J. Shapiro-“monetary policy is the exercise of the central bank’s control over the money supply as an instrument for achieving the objectives of economic policy”
  • Instruments
  • Quantitative control
  • Bank rate policy
  • Open market operations
  • Changes in cash reserve ratios
  • Selective credit control
  • Regulation of consumer credit
  • Regulation of margin requirements
  • Credit rationing
  • Direct action
  • Moral suasion
  • Publicity
  • Types
  • Restrictive monetary policy
  • Expansionary monetary policy
  • Objectives
  • Neutrality of money
  • Exchange rate stability and BOP equilibrium
  • To correct disequilibrium
  • Full employment
  • Economic growth with stability
  • Significance in developing countries
  • To correct inflationary pressures
  • To correct BOP disequilibrium
  • Formulation of effective interest rate policy
  • To develop banking and financial system
  • Price stability
  • Debt management
  • Fiscal policy

Arthur Smithies-“a policy under which government uses its expenditure and revenue programs to produce desirable effects and avid undesirable effects on the national production and employment”

Musgrave-“fiscal policy is concerned with those aspects of economic policy which arise in the operation of public budget”

Learner-“the principle of judging fiscal measures by the way they work or function in the economy, we may call functional finance”

  • Instruments
  • Budget

P.E Taylor-“the budget is the master financial plan of a government6. It brings together estimates of anticipated revenues and proposed expenditures for the budget period and from these estimates and activities to be undertaken and the means of their financing can be inferred”

Types of budget policy

  • Balanced budget policy
  • Deficit budget policy
  • Surplus budget policy
  • Public expenditure


  • Current expenditure and capital expenditure
  • Direct expenditure and transfer expenditure
  • Productive and unproductive expenditure
  • Public revenue

Dalton-“a direct tax is really paid by the person on whom it is legally imposed. The indirect tax is imposed upon one person but paid partly or wholly by other”

  • Public debt
  1. E. Taylor-“the debt is the firm of promises by the treasury to pay to the holders of these promises a principal sum and in most instances interest on that principal. Borrowing is restored in order to provide funds for financing current deficit”

Internal and external public debt

Dalton-“a loan is internal, if subscribed by persons or institutions within the area controlled by public authority which rises the loan; external if subscribed by persons or institutions outside the area”

  • Methods
  • Built in flexibility
  • Discretionary fiscal policy

The government makes deliberate change in:

  • The level and pattern of taxation
  • The size and pattern of its expenditure
  • The size and composition of public debt

Government makes following type of deliberate change in direct and indirect taxes

  • Imposition of new taxes or abolition of old taxes
  • Imposition of taxes on new tax bases
  • Increasing or decreasing the tax rates

The deliberate changes in the government spending include changes in:

  • The size of the government expenditure
  • The composition of government expenditure
  • The method of financing government expenditure
  • Transfer payments
  • Overall budgetary surplus and deficit
  • The method of deficit financing
  • Compensatory fiscal policy
  • Objectives
  • Optimum allocation of resources
  • Full employment
  • Price stability
  • Equitable distribution of income and wealth
  • Economic growth


  • Raising the saving ratio to income by curtailing consumption
  • Mobilizing them for raising the rate of productive investment
  • Encouraging the flow of spending into productive way
  • Role in developing countries
  • Mobilization of resources
  • Capital formation
  • Saving and investment are the two components of capital formulation. The government may resort to voluntary and forced saving to collect enough resources for investment; the fiscal policy should be formulated in such a manner as to increase the rate of investment both in public as well as private sectors. This requires large amounts of financial resources, which can be obtained by rising the incremental saving ratio[MPS]. Incremental saving ratio can be increased by number of methods which may include direct physical controls, increase in the rates of exiting taxes, imposition of new taxes, public borrowing, deficit financing, etc.
  • Special incentives like tax relief and subsidies can be given in the entrepreneurs to set up industries in the backward regions. This will promote development of backward regions
  • Public expenditure policy can be effectively used in promoting economic development. The government may develop socio-economic overheads or infrastructures and established capital goods and key industries. It may stimulate development by providing education, training and research facilities
  • Minimize the inequalities of income and wealth
  • The tax system should be made progressive. Heavy direct taxes should be imposed on the rich and the poor should be exempted from taxes
  • Items of luxuries and those items which are consumed by the rich section of the society should be taxed heavily. Items of daily necessities, which are largely consumed by the poor, should be subjected to low taxes
  • The government most spends more on those activities which benefit the low income groups. For example, expenditure on social activities like education, public health should be increased and these services should be provided free of cost or at lower cost to the poor. Similarly, expenditure on social security scheme like pensions, unemployment relief, sickness benefits may be increased. These expenditure will increase the efficiency and skill of the people and thereby reduce inequalities
  • The government should undertake investment in setting up industries in the backward regions. This will remove regional disparities
  • Increase employment opportunities
  • Public expenditure on economic and social overheads should be incurred to generate employment and increase productive efficiency of the economy in the long run
  • The government can impose heavy taxes on the rich people and the proceeds of these taxes may be distributed among the poor or may in invested on such projects which help to raise living standard of the poor
  • Public debt policy can be used to control private consumption expenditure and to raise small savings for financing the development expenditure. The government for this purpose can issue debentures, bonds, etc. with attractive rates of interest to encourage people to purchase these titles
  • The government may resort to compulsory savings by the public
  • In the rural areas, efforts should be made to encourage for establishing industries by providing technical trainings, subsidized, finance, tax rebates, etc.
  • Counteract inflation
  • Excess purchasing power should be withdrawn through taxes, compulsory saving and public borrowings
  • Progressive direct tax, commodity tax, etc. should be imposed
  • Market imperfections and structural rigidities should be removing. Moreover, for the fiscal policy to be effective, it must be supplemented by anti-inflationary monetary measures
  • To correct disequilibrium in BOP
  • Inflation of heavy import duty, especially on the import of consumer goods
  • Subsidization of exports
  • Tax subsidy in imported raw materials and machineries which are used in export oriented industries
  • Special fiscal package to establish import substituted industries and key industries
  • Deficit financing


  • Borrowing from Central Bank
  • Withdrawal of its cash balances from the Central Bank
  • Issuing of new currency, i.e. printing of more notes and putting into circulation


  • The deficit financing is a method of meeting financial needs of the government during crises period such as war because the government tends to resort to acquire a quick command over resources to meet the growing war expenses
  • Prof. J M Keynes advocated it is an instrument of economic development, level of output and employment
  • It is advocated for the mobilization of surplus, idle and unutilized resources for promoting rapid economic growth in underdeveloped economies as well as developing economies
  • It is advocated as essential to mobilize resources for financing the plans
  • To raise the level of effective demand and simulate private investment
  • To divert undesirable and unproductive source into desirable and productive channels of the economy
  • To accelerate economy with high employment and economic growth


  • Deficit financing and war expenditure
  • Deficit financing and depression
  • Deficit financing and price level
  • Deficit financing and employment
  • Deficit financing and distribution of income
  • Deficit financing and economic growth
  • Debt management

Prof. Abbot-“public debt management is concerned with the decisions of forms of public debt, in terms of which new bonds are sold, maturing debts are redeemed or refunded, the proportion in which different forms of public debt should be issued, the pattern of maturities of debt and its ownership, etc.”


  • Public debt management must sub serve the economic policy of the government. During the period of depression it should help to raise the purchasing power and effective demand in the economy and vice versa in inflation
  • In the time of war and for economic development. It should provide sufficient funds to meet the requirement of the economy
  • It should be undertaken in such a way that it must be the most beneficial for the activities of government
  • It should not have any adverse effect on the economic condition of the country
  • It should also be undertaken in such a way as to strengthen the money market

Principles of debt management by Prof. Philip E. Taylor

  • The policies pursued must be able to extract from the public without undue coercion
  • The extraction of loanable funds from the market and its repayment when debt is retired should not frustrate the smooth growth of the economy
  • It should be so placed as to minimize the need to enter the market when it is inconvenient to do so

Summary of principles of debt management

  • Minimum interest cost of servicing public debt
  • Satisfaction of the investors
  • Funding of short term debt into long term debt
  • Public debt must be in coordination with fiscal and monetary
  • Proper adjustment of maturity
  • Economic development, economic growth and economic welfare

Economic development

Meier and Baldwin-“economic development is a process whereby an economy’s real national income increases over a long period of time. And, if the rate of development is greater than the rate of population growth. Then per capita real income will increase”

Laibenstein-“development implies the environment of an economy’s power to produce goods and services per capita, for such environment is the prerequisite to rising levels of living”

UNO-“development concerns not only men’s material needs, but also the improvement of social conditions of his life. Development is, therefore, not only economic growth but growth plus change-social, cultural and institutional as well as economic”

Todaro-“economic development was redefined in terms of the reduction or elimination of poverty, inequality and unemployment within the context of growing economy”

Three core values of economic development

  • Life-Sustenance: The ability to provide basic need
  • Self-Esteem: To be a person
  • Freedom from servitude: To be able to choose

The three objectives of economic development

  • To increase the availability and wide the distribution of basic life sustaining goods such as food, shelter, cloth, education, health and protection
  • To raise levels of living including, in addition to higher incomes, the provision of more jobs, better education and greater attention to cultural and humanistic values, all of which will serve not only to enhance material well-being but also to generate greater individual and national self-esteem
  • To expand the range of economic and social choices available to individuals and rations by freeing them from servitude and dependence not only in relation to other people and nation-states but also to the forces of ignorance and human misery

Economic growth

Kuznets-“economic growth as a long term rise in capacity to supply increasingly diverse economic goods to its population, this growing capacity based on advancing technology and the institutional and ideological adjustment that it demands”

Principle components of economic growth

  • The sustained rise in national output is a manifestation of economic growth and the ability to provide a wide range of goods is a sign of economic maturity
  • Advancing technology provides the basis or precondition for continuous economic growth- a necessary but not sufficient condition
  • To realize the potential for growth inherent in new technological, institutional, attitudinal and ideological adjustment must be made

Kuznet: Characteristics of economic growth

  • High rates of growth per capita output and population
  • High rates of increase in total factor productivity
  • High rates of structural transformation of the economy
  • High rates of social and ideological transformation
  • The propensity of economically developed countries to reach out the rest of the world for markets and raw materials
  • The limited speed of this economic growth to only one third of the world’s population

Economic welfare

Pigou-“economic welfare as that part of social welfare which can be directly or indirectly measured in money”

Meier-“per capita real income is only a partial index of economic welfare because the question of economic welfare also involves a judgment about the desirability of income distribution”

Determinants of economic welfare

  • National Income
  • Leisure
  • Non-market transaction
  • Distribution of income
  • Composition of output
  • Quality of life
  • Determinants of economic growth

Natural resource

  • The composition and the quality of natural resources determine the relative importance of different economic activities. For example, quality of land can influence the level of agricultural productivity in the early stages of economic development and this can determine the importance of natural resources
  • Natural resources are likely to exert major influence on the speed of development, the pace of agricultural advance and the price of industrialization. Countries like the United States have been able to achieve a high rate of economic growth because of rich availability of natural resources

Population growth: Human resources

  • An increase in population means an increase in supply of the basic factor of production-labour has always been the greatest productive asset of a country. Labour, in cooperation with other factors of production like tools, machine land and natural resources, helps in producing goods and services. Therefore, an increasing population and labour supply almost invariably leads to increase in total output. In the past, population growth and increase in labour force has been the major source of increase in total output all over the world
  • Population growth leads to expansion of markets. Larger population means more demand for various consumer goods like food, cloth, etc. An expansion of markets promotes high level of investment. This will stimulate business activity and increase the level of employment. Furthermore, it may provide the needed incentive for production on large scale, resulting in economies of scale and lowering the cost of production
  • Growth of population is beneficial in case of underdeveloped countries. These countries are not able to use their agricultural land effectively due to less number of labors. Thus, population growth in these countries will enable them to use their land effectively and thereby increase the agricultural output. Similarly, a larger population will facilitate economic growth by enabling these economies to exploit the utilized resources
  • Growth of population has positive effect on technological development. Growth of human resource means larger pool of talents from which to draw people for working in various areas of science. It also would mean an increase in the number of creative minds. This will promote technological progress

Capital formation

  • Generation of saving
  • Ability to save
  • Willingness to save
  • Facilities to save
  • Mobilization of saving
  • Investment

Significance of capital formation in economic growth

  • Formation of sound infrastructures
  • Use of roundabout methods of production
  • Maximum utilization of natural resources
  • Proper use of human capital formation
  • Improvement in technology
  • High rate of economic growth
  • Agricultural and industrial development
  • Increase in National Income
  • Increase in economic welfare

Technological progress

  • Technological progress enabled the modern economies to produce most of the commodities at a low cost of production. This means either of the two things, viz, [i] producing more output with the same amount of land, labor and capital, [ii] producing same quantity of output using fewer amounts of inputs like land, labor and capital. Thus technological progress has increased the efficiency of inputs in the formed of increased productivity of land and labour, etc.
  • Technological progress has brought forth a food of new products, which could not have been demand of in the past. Computers, televisions, CDs, cameras, movies, motor cars, aeroplane-all these are the product of technological progress

Values and institutions

  • Privatization

Types and modalities

  • Divestiture: sale of shares or assets by open tender
  • Break up: selling or spinning of section of large public enterprise
  • Liquidation: legally chose down the public enterprise
  • Marginalization: freezing or gradual reduction of the operations of a public enterprise
  • Privatization of management: through contract, leasing, confessional agreement etc.


  • To liberalize the economy
  • To enable more integration into the international economy
  • To increase efficiency and competitiveness
  • To develop national capital markets
  • To develop a strong private sector as the engine of growth
  • To attract private capital for infrastructure development
  • To repay state debts or reduce borrowing
  • To redirect subsidies to other areas of state spending


  • Raising revenue for the government
  • Increased competition
  • Increased efficiency
  • Wider share ownership
  • Cost push inflation may be reduce


  • Long term loss of revenue
  • Competition in product markets may not be increase
  • Loss of potential revenue from the sale of privatized concerns
  • Private sector firms may not act in the public interest
  • Loss of government control over the economy
  • Economic liberation

In Nepal,

  • Reduce budget deficit
  • Increase in competition
  • Efficient use and allocation of resource
  • The resource mobilization by the government in other sectors
  • Increase in production
  • Globalization

World Bank-“globalization is trades flows, investment flows and financial flows and extend to flows of technology, information and services across national boundaries”


  • Economic interdependence between countries in the world
  • Free movement of product across border
  • Free flow of capital, labour, management and technology across borders internationally


  • Economic globalization
  • Political globalization
  • Environmental globalization
  • Cultural globalization


  • Most of developing countries like Nepal are suffered from the problems of unemployment and underemployment. MNCs as the main agent of globalization create local employment and career opportunities. They also help in professionalization of management and development of human resource
  • Globalization through reduction in tariff and non-tariff barrier helps to increase the scope of market for the product
  • Globalization creates the environment for the smooth flow of international capital mobility and technology at a low cost. Globalization promotes the foreign direct investment and helps to solve the problem of resource gap, trade gap, revenue-expenditure gap and debt burden in developing countries
  • An efficient allocation of resource in different line of productions can be achieved through competition. Globalization is the precondition for fostering competition around the globe, which helps for better utilization of resources
  • Consumer through globalization get benefit by way of qualitative and modern products produced in global business environment at a cheap price
  • Globalization helps to transfer the foreign capital, technology and management which help to accelerate the rate of growth


  • It may lead to promote social evils such as child sex abuse, prostitution, women trafficking and international terrorism. This strikes hard at traditional social and cultural value systems of developing countries
  • Industries based on labour, intensive technique in developing countries suffer adversely due to cheap imports from developing countries
  • Globalization promotes the use of modern technology which ultimately displaces traditional art and culture, small scale industries, etc.
  • Globalization may tend to result capital flight from developing countries to developed countries
  • Global corporations possess considerable economic power which adversely impacts on national sovereignty
  • Damage to environment results due to fast exploitation of natural resources to cater to the high consumption needs in the developed countries
  • Global competition proves a threat to domestic industry and agriculture in developing countries. Global corporations tend to capture domestic market and kill domestic industries
  • Foreign direct investment


  • Increase in resources
  • Risk-taking
  • Know-how
  • High standard
  • Marketing facilities


  • Limited areas
  • Increased dependence
  • Remittance of large amounts
  • Obsolete machinery and technology
  • Political interference
  • Foreign employment

History of international labour migration in the Nepalese context

Role of foreign employment[remittance]



  • Consider the following data for national accounts to compute NNPMP by both income and expenditure method[BIM 2016]
Description Rs in billion
Indirect business taxes 36,000
Imports 26,000
Government investment 36,000
Net fixed investment 1,08,000
Payment to rest of the world 16,000
Exports 14,400
Wages and salaries 4,40,000
Proprietor’s income 60,000
Government consumption 60,000
Receipts from rest of the world 8,000
Consumption 5,29,600
Change in stock -4,000
Subsidy 16,000
Rent 18,000
Interest 30,000
Mixed income 20,000
Employee’s contribution to social security 30,000
Cooperate income 1,00,000
Consumption of fixed capital 32,000




  • Consider the following data for national accounts to compute NNPMP by both income and expenditure method[BIM 2015]
Description Rs in billion
Indirect business taxes 2,700
Imports 1,500
Government investment 2,250
Net fixed capital formation 8,100
Net receipt -600
Exports 1,080
Wages and salaries 33,000
Proprietor’s income 4,500
Government consumption 4,500
Personal consumption expenditure 39,720
Change in inventories -300
Government subsidies 1,200
Rental income 1,350
Business interest payments 2,250
Dividend 2,700
Mixed income of self employed 1,500
Social security contribution by employer 2,250
Cooperate profit 7,500
Direct taxes 1,395
Current transfer 12,000
Undistributed profit 3,000
Depreciation 2,400
Social security contribution 10,200



  1. Consider the following data[BIM 2012]
Description Rs in million
Rental income

Business interest payments

Corporate profits

Capital consumption allowance

Indirect business taxes

Corporate dividends

Social security contributions

Transfer payments

Personal taxes


Net fixed investment

Net exports

Changes in inventories

Government expenditure

Compensation of Employees

Proprietor’s income


















  • Compute GDPMP by income and expenditure method.
  • Compute personal income and disposable income.



  • Consider the following data and compute NI and personal income[BIM 2013]
Description Rs in million
Compensation of employee 11,000
Rental income 400
Business interest payments 600
Proprietor’s income 4,000
Employer’s contribution to social security 2,000
Mixed income 1,500
Cooperate dividend 1,000
Transfer payment 7,000
Cooperate profit 8,000
Social security contribution 2,500



GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed income +Depreciation






NIMP= GNIMP-Depreciation



Personal Income=NI – [undistributed profit + cooperate income taxes +social security contribution – transfer payments]




  • Find IS curve, LM curve and equilibrium rate of interest and income from the function C=100+0.8Y, S=-100+0.2Y, I=120-500r [r=rate of interest], Ms=120 and Md=0.2Y-500r





I=120-500r [r=rate of interest]



For IS curve





For LM curve

Md= Ms




From above










  • Find IS curve, LM curve and equilibrium rate of interest and income from the function C=80+0.8Yd, T=60+0.2Y, I=200-1000r [r=rate of interest], Ms=476, Ml=0.4Y, Msp=300-2000r and G=160





I=200-1000r [r=rate of interest]





For IS curve in 3-sector economy









For LM curve

Md= Ms





From above









  • Calculate GNP deflator and rate of inflation from the table below
Year Nominal GNP Real GNP
2000-01 470269 208481
2001-02 542691 209621
2002-03 618961 220489
2003-04 719548 233805
2004-05 843294 249903



GDP deflator=Nominal GNPReal GNP*100%











Again for rate of inflation

Rate of inflation=current years GDP deflator-previous years GDP deflatorprevious years GDP deflator*100%

Rate of inflation for 2001-02=258.89-225.57225.57*100%


Rate of inflation for 2002-03=280.72-258.89258.89*100%


Rate of inflation for 2003-04=307.76-280.72280.72*100%


Rate of inflation for 2004-05=337.45-307.76307.76*100%


  • Find IS curve, LM curve and equilibrium rate of interest and income from the function C=200+0.75Yd, T=200, I=200-250r [r=rate of interest], Ms=550, Md=0.5Y-1000r and G=250





I=200-250r [r=rate of interest]




For IS curve in 3-sector economy









For LM curve

Md= Ms




From above









  • Find national income by expenditure method
Items Rs in million
Net factor income from abroad -5
Subsidies 10
Indirect taxes 60
Private final consumption expenditure 400
Consumption of fixed capital[depreciation] 30
Government final consumption expenditure 50
Gross fixed capital formation 310
Net export -5
Change in stock 50



GDPMP=C+ gross capital formation +G+I+(X-M)








=GNPMP-[indirect tax-subsidies]




NNPFC= GNPFC-Depreciation



  • Calculate GNPMP, NNPMP, NDPMP, GNPFC, NNPFC and NDPFC from the following data
Items Rs in Crores
Wages and salaries 800
Mixed income of self employed 160
Operating surplus 600
Undistributed profit[retained earnings] 150
Gross fixed capital formation 330
Change in stock 25
Net capital formation 300
Employer’s contribution to social security schemes 100
Export 30
Imports 60
Private final consumption expenditure 100
Government final consumption expenditure 450
Net indirect tax 60
Compensation of employees paid by the government 75
Net factor income from abroad -20




=C+G+[I+ change in stock]+(export-import)








Depreciation=Gross investment-Net investment



NNPMP= GNPMP-Depreciation




=GNPMP-[indirect tax-subsidies]



NIFC= GNIFC-Depreciation



  • Calculate GNPFC, NNPFC and NI from the following data
Items Rs in Crores
Gross domestic capital formation 1000
Depreciation of fixed capital 450
Government final consumption expenditure 500
Private final consumption expenditure 2650
Net change in stock 130
Net indirect tax 450
Net export -70
Net factor income from abroad -50













NNPMP= GNPMP-Depreciation



NIFC= GNIFC-Depreciation




  • Calculate NI from the following data
Items Rs in Thousands
Gross fixed capital formation 300
Private final consumption expenditure 900
Net export -50
Subsidies 50
Government final consumption expenditure 150
Indirect tax 250
Change in stock 50
Consumption of fixed capital 50
Net factor income from abroad 50



Gross investment= Gross fixed capital formation + change in stock










NNPMP= GNPMP-Depreciation




=NNPMP-[indirect tax-subsidies]




  • Calculate GNPMP, GNPFC and NI from the following data
Items Rs in Million
Exports 70
Imports 130
Private final consumption expenditure 3,000
Operating surplus 2,200
Government expenditure 1,100
Wages and salary 1,800
Net indirect tax 20
Mixed income of self-employed 320
Undistributed profit 300
Gross capital formation 700
Change in stock 50
Net capital formation 600
Employee’s contribution to social security schemes 300
Net factor income from abroad -60













Depreciation=Gross investment-Net investment



NNPFC= GNPFC-Depreciation



  • Calculate DDI, GNI and NI by income and expenditure method.
Items Rs in Million
Mixed income 400
Compensation of employees 500
Private final consumption expenditure 900
Net factor income from abroad -20
Net indirect tax 500
Consumption of fixed capital 120
Net domestic capital formation 280
Net export -30
Profit 350
Rent 100
Interest 150
Government final consumption expenditure 450



Income method

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed income +Depreciation






NNPFC= GNPFC-Depreciation



Expenditure method

Gross investment= Net fixed capital formation + Consumption of fixed capital



















Appendix A


Macroeconomics is concerned with the economic activities

New classical macroeconomics

New-classicist claimed that people are rational expectation behavior. It means, people are rational behavior and they do not make systematic error. According to the rational expectation hypothesis, expectations are made on the basis of all available relevant information and variables

New Keynesian economics

In fact, the new Keynesian school is characterized by what has been called dizzying diversity of approaches

Static analysis of macroeconomics

Static means in a state of rest. It shows a stable equilibrium condition. Static economy studies the economic conditions at equilibrium position

Comparative macro static analysis

It is comparison between two or more than two static equilibrium condition of an economy at different time period

Circular flow

The flow of goods and services from business sectors to household sector and raw material and factor of production from household sector to business sectors is called circular flow

Circular flow of income and expenditure

Under two-sector economy, household sector consists of factor of production; land labour capital and entrepreneurship. Incomes of factor of production are land for rent, labour for wages, capital for interest and organization for profit. Similarly, business sector or business firms have not their own resources

National income

National income refers to the sum of income earned by all individuals of a nation in a particular period of time

Gross domestic product at market price

Gross domestic product is the total market value of all final goods and services produced within the domestic territory of a country during a year

Net domestic product at market price

NDPMP is the residual part of GDP at MP after deducting depreciation

Gross domestic product at factor cost

Gross domestic product at factor cost is the sum of income earned by factors of production in the forms of rent, wages, interest and profit

Net domestic product at factor cost

NDPFC is income earned by factors of production after deduction of depreciation

Gross national product at market price

GNPMP is the final value of goods and services produce by the nation during a year plus net factor income from abroad

Gross national product at factor cost

GNPMP is the sum of income earned by factors of production plus net factor income from abroad

Net national product at market price

NNPMP is the residual part of gross national product after deduction of depreciation

Personal income

Personal income can be define as the sum of all kinds of income received by the individuals from all possible sources

Per capita income

Per capita income is the national income divided by total population by country within a particular year

Product approach

Product method measures national income at the phase of production in the circular flow.  This method is also called a value added method

Final product approach

Final product method is to excludes all those goods and services which are intermediate in the phase of production[such as wheat and floor in the making of bread] and to include only final goods and services in the consumption of the gross national product

Value added approach

Value added approach, instead of taking the market value of final product, the value added or created at different stages of production is counted for estimating national income


Unemployment is a situation in which an individual person is ready to work mentally and physically at existing market wage rate but not get any job

Keynesian theory of employment

The theory of effective demand was develop by J. M. Keynes in the book general theory of employment, interest and money

Effective demand

In ordinary parlance, demand means desire. It becomes effective when income is spent in buying consumption goods and investment goods

Aggregate demand price

The aggregate demand price for the output of any given amount of employment is the total sum of money or proceeds, which is expected from the sale of the output produced when that amount of labor is employed

Aggregate supply price

The aggregate supply price refers to the proceeds necessary from the sale of output at the particular level of employment. Thus each level of employment in the economy is related to a particular aggregate supply price and there are different aggregate supply prices in different levels of employment

Paradox of thrift

Paradox of thrift is the situation where increase in saving ultimately reduce the productive capacity, employment, income and saving itself. The classical economist regarded the saving as a social virtue

Simple multiplier

The multiplier is expressed as a ratio of the change in overall equilibrium output[income] to the given change in autonomous expenditure
IS Curve

IS Curve is the locus of various combination rate of interest and level income which gives goods market equilibrium

LM Curve

LM Curve is the locus of various combination rate of interest and level of income which gives money market equilibrium


Inflation is the continuous, persistent and appreciable rise in the general price level of goods and services

Consumer price index[CPI]

Consumer price index is measure of the overall cost of goods and service purchase by a consumer. It is a way of finding the cost of living

Wholesale price index[WPI]

Wholesale price index is an index which is used to measure the average price changes of goods and services between times at the level of wholesale price of big sales

GDP deflator

GDP deflator is a price index which measures the changes in the overall price of all newly produce final goods and services

Demand pull inflation

Demand pull inflation is caused by a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output

Cost push inflation

Cost push inflation develops because the higher the cost of factor of production decreases in aggregate supply[the amount of total production] in the economy

Phillips curve

Inverse relationship between the rate of change money wages and the rate of unemployment becomes known as Phillips curve


Deflation is an economic theory, which deals with the general reduction in the price levels or in the prices of a type of good or asset


Stagflation refers to a situation where a high rate of inflation occurs simultaneously with a high rate of unemployment

Business cycle

The world economic history is essentially history of business cycles or economics ups and downs, booms and slumps, prosperity and depression. Business cycle or trade cycle is inevitable in the cabalistic economy

Business cycle refers to the phenomenon of cyclical fluctuations in the aggregate output, employment, income, price level, profit, bank credit, etc.

Recovery phase

Recovery is a situation when depression has lasted for some time and the revival phase or lower turning point starts. The trough is the turning point from which the economy began to recover

Prosperity phase

Prosperity phase is an idle condition for an economy. In this phase, demand, output, employment and income are at a high level

Recession phase

Recession refers to the downfall from the peak which is of a short duration. In fact the seed of the recession is shown during the phase of prosperity

Depression phase

Depression is the most critical phase of business cycle. During this phase, all economic activities are far below the normal rate of growth

Monitory policy

Monitory policy refer to the policy measures undertaken by the central banks to influence the availability, cost and use of money and credit with the help of monitory measures to achieve specific goals such as increase in output, employment, income and price stability, etc.

Fiscal policy

Fiscal policy refer to the government’s expenditures and revenue program to produce desirable effects and avoid undesirable effects on national income, product and employment

Money supply

Money supply is exogenously determined by central monetary authority. Money supply is total money circulated of an economy

Transaction demand for money

Demand for money which is used by day-to-day transaction of goods and services is called transaction demand for money

Precautionary demand for money

People holds certain cash for minimize risk and uncertainty factor. For examples: sudden in price of the product, unpredictable events like fire, theft, sickness, loss the job

Speculative demand for money

The desire to hold idle cash balances for speculative purpose arises from the desire to take advantages of change in the money market

Liquidity trap

At low rate of interest all money are speculated by people which creates problem liquidity in the market and known as liquidity trap

Capital market

Capital markets are the market mean for long-term securities issued by the government or a corporation. Capital markets, typically involve financial assets have life span of greater than one year

Monetary policy

Any conscious action undertaken by central monetary authority

Bank rate of policy

Bank rate is the rate at which central bank lends money to the commercial bank and rediscounts the bills of exchange presented by the commercial banks

Exchange rate

The rate at which one currency is exchanged the currency of another country is called exchange rate


Privatization is management by private sector with total absence of government intervention. Such institutions generate their own funds through higher fees, user charges and full use of resources


Liberalization means the process of shifting the economy from government control to market economy


Globalization is a process of integration among the world through international trade, investment and information technology

Economic inequality

Economic inequality is the state of affairs in which assets, wealth or incomes are distributed unequally among individuals in a group, among groups in a population or among countries

Appendix B


  • Two sector economy


  • There are only two sectors in an economy: household and business sectors
  • No government and no foreign trade
  • There is no government intervention so no tax rate
  • All prices remain constant
  • Supply of capital and technology are given
  • Only autonomous investment
  • Marginal propensity to consume remains constant
  • All income should be spent
  • All factors of productions taken from household to business sectors
  • All goods and services are taken from business to foreign sector

Simple multiplier



Y= a+bY+I




Differentiate with respect to I





Super multiplier


I=eY[because private investment increase with income level of people where as e is constant term]


Y= a+bY+I+Ia

Y= a+bY+eY+Ia




Differentiate with respect to I





  • Three sector economy


  • Three sector economy: household, business and government sectors
  • Government intervention
  • Perfect competitive market
  • Well managed financial market
  • Imposition of taxation
  • Provides subsidies both household sector and business sector
  • Household sector pay direct tax to government sector
  • Business sector pay both direct and indirect tax
  • The economy is closed

Government expenditure multiplier


Yd=Y-T [disposable income]








Differentiate with respect to G




Tax multiplier


Yd=Y-T [disposable income]








Differentiate with respect to T




Balanced budget multiplier


Yd=Y-T [disposable income]





Small change in all






∆Y-b∆Y=∆G-b∆G [∆T=∆G]



It is unit multiplier

  • Four sector economy


  • Four sector includes household, business, government and foreign sector
  • Open economy
  • No restriction of export and import
  • Competitive both internal and external markets
  • Minimum government intervention
  • Well managed financial market

Export multiplier


Yd=Y-T [disposable income]











Differentiating with respect to M




Import multiplier


Yd=Y-T [disposable income]











Differentiating with respect to X





Appendix C





NNPMP= GNPMP-Depreciation

GDIMP=Rent + Interest + Profit + Compensation of employees + Mixed income +Depreciation


NIMP= GNIMP-Depreciation



Operation surplus=Rent + Interest + Profit

Conversion of gross product into net product





Conversion of net product into gross product





Concept of net indirect tax

Conversion of factor cost into market price





Conversion of market price into factor cost





Private income=National Income – Income from prosperity and entrepreneurship accruing to the government – Saving of non-departmental enterprise + National debt interest + Current transfers from government + Other current transfers from rest of the world

Personal Income=NI – [undistributed profit + cooperate income taxes +social security contribution – transfer payments]

DI=PI – direct taxes




GDP deflator=National GDPReal GDP*100

Rate of inflation=Change GDP deflatorGDP deflator for previous year*100

NDPFC[domestic factor income receipt]= Rent + Interest + Profit + Compensation of employees + Mixed income

NDPFC= Compensation of employees + Operating surplus + Mixed income

GDPK= NDPK + depreciation

GDPMP= GDPK + net indirect tax

NNPK= NDPK + net factor income from abroad

NNPMP=NNPK + net indirect tax

GNPK= NNPK + depreciation

GNPMP= GNPK + net indirect tax

Labour force=number of employed + number of unemployed

Unemployment rate=Number of employedLabour force*100



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