PGEC S2 02

Exam Code: MAC2

Macro Economics- II

SEMESTER-II

ECONOMICS
BLOCK : 1

KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

Subject Experts
Prof. Madhurjya P. Bezbaruah, Department of Economics, Gauhati University
Prof. Nissar Ahmed Barua, Department of Economics, Gauhati University
Dr. Gautam Mazumdar, Department of Economics, Cotton University
Course Co-ordinator: Utpal Deka, KKHSOU

SLM Preparation Team

UNITS CONTRIBUTORS
1, 2 Dr. Parag Dutta, Dispur College, Guwahati
3 Dr. Bhaskar Sarmah, KKHSOU
Utpal Deka, KKHSOU
4, 7 Dr. Debojit Konwar, St. Joseph University, Nagaland
5 Dhrubajyoti Das, Research Scholar, Gauhati University
6 Priyanka Kakoti, Research Scholar, Gauhati University
Editorial Team
Content : Dr. Chandrama Goswami, Mangaldai College, Mangaldai
(Unit 1-2)
Dr. Gautam Mazumdar, Cotton University (Unit 3-7)
Language : Dr. Manab Medhi, Bodoland University
Structure, Format & Graphics : Utpal Deka, KKHSOU

March, 2020

ISBN : 978-93-89955-49-1
This Self Learning Material (SLM) of the Krishna Kanta Handiqui State Open University
is made available under a Creative Commons Attribution-Non Commercial-Share Alike 4.0
License (international): http://creativecommons.org/licenses/by-nc-sa/4.0/
Printed and published by Registrar on behalf of the Krishna Kanta Handiqui State Open University.

The University acknowledges with thanks the financial support provided by the
Distance Education Bureau, UGC, for the preparation of this study material.
Head Office : Patgaon, Rani Gate, Guwahati-781 017
City Office : Housefed Complex, Dispur, Guwahati-781 006
Website: www.kkhsou.in
 CONTENTS
Page No.

Unit 1 : Supply of Money 7-20

Money and Near Money; Inside and Outside Money; Money Multiplier
and High Powered Money.
21-33
Unit 2 : Post-Keynesian Theories of Demand for Money
Post-Keynesian Approaches to Demand for Money: Patinkin and the
Real Balance Effect; Approaches of Baumol and Tobin; Friedman
and the Modern Quantity Theory.
Unit 3 : Inflation
34-52
Demand Pull Inflation; Cost-Push Inflation; Effects of Inflation;
Inflationary Gap Analysis; Policies to control inflation; Concept of
Stagflation.
Unit 4 : Inflation and Unemployment 53-77
Philips Curve Analysis: Short Run and Long Run Philips Curve;
Samuelson and Solow: the Natural Rate of Unemployment
Hypothesis; Tobin’s Modified Philips Curve; Adaptive Expectations
and Rational Expectations.
Unit 5 : Business Cycles 78-96

Theories of Business Cycles: Schumpeter, Kaldor, Samuelson and

Hicks; Control of Business Cycles; Relative Efficiency of Monetary
and Fiscal Policies.
Unit 6 : Supply Side Economics
97--107
Failure of Keynesianism; Features of Supply Side Economics; Critical
Evaluation.
Unit 7 : Monetarism vs Keynesianism 108--136
Monetarists vs Keynesian; Policy Implications of Monetarism vs
Keynesianism; Crisis in Keynesian Economics and the Revival of
Monetarism; Reconciliation, Monetary-Fiscal Policy Mix and Growth.
COURSE INTRODUCTION

Macro Economics II is the second course of second semester of the M.A. in Economics programme
of this University. This is the second course dealing with Macro Economics as we have already studied
Macro Economics in first semester of this programme as Macro Economics I. So, this course basically
covers the topics of Macro Economics which are not covered in the first semester course and introduces
the learners with various new knowledge and ideas of Macro Economics. This course comprises of 14
units and has been divided into two blocks. Both the blocks comprise of seven units each.
BLOCK INTRODUCTION

This is the first block of the course and it comprises of seven units. The first unit of the course
discusses the supply of money. This unit will help you understand the meaning of the term supply of
money, determinants of supply of money, money and near money, inside money and outside money
and the concept of money multiplier and high-powered money. The second unit deliberates on the post-
Keynesian theories of demand for money. Important concepts discussed in the unit include Patinkin and
the real balance effect, approaches of Baumol and Tobin and Friedman’s modern quantity theory of
Money. The third unit will introduce you to the concept of inflation. In this unit we will discuss the meaning
and types of inflation, causes and effects of inflation in an economy, demand-pull and cost-push inflation,
different policies to control inflation and the concept of deflation and stagflation. The fourth unit deals
with the relation between unemployment and inflation. This unit explains about short run and long run
Philips curve, reasons of shift of Philips curve, natural rate of unemployment, shifts in Philips curve
owing to changes in adaptive and rational expectations and Tobin and Solow’s modification on Philips
curve. The fifth unit discusses about the business cycle, theories of business cycle propounded by
Schumpeter, Kaldor, Samuelson and Hicks economic policies and its applicability in different phases of
business cycle. The sixth unit will help you to acquire knowledge about the supply side economics. In
this unit we will discuss the loopholes of Keynesian Economics, the reasons for the emergence of
supply side economics and the main features of Supply Side Economics. The seventh unit deals with
the Keynesian and Monetarist view about money. This unit will help you to understand the short run and
long run effect of money supply in the economy, factors influence interest rate and price from the
approaches of Keynesianism and Monetarism and effectiveness of monetary and fiscal policy in different
economic situations.

While going through a unit, you will notice some along-side boxes, which have been included to
help you to know some of the difficult, unseen terms. Again, we have included some relevant concepts
in “LET US KNOW” along with the text. And, at the end of each section, you will get “CHECK YOUR
PROGRESS” questions. These have been designed to self-check your progress of study. It will be
better if you solve the problems put in these boxes immediately after you go through the sections of the
units and then match your answers with “ANSWERS TO CHECK YOUR PROGRESS” given at the end
of each unit.
6 Macro Economics- II
UNIT 1: SUPPLY OF MONEY
UNIT STRUCTURE

1.1 Learning Objectives

1.2 Introduction
1.3 Definition of Supply of Money
1.4 Determinants of Money Supply
1.5 Concept of Money and Near Money
1.6 Inside and Outside Money
1.7 Concept of Money Multiplier and High Powered Money
1. 8 Let Us Sum Up
1.9 Further Reading
1.10 Answers to Check Your Progress
1.11 Model Questions

1.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

z understand the meaning of the term supply of money
z know the determinants of supply of money
z explain the concept of money and near money
z understand the concepts of inside money and outside money
z know about the concept of money multiplier and high-powered
money.

1.2 INTRODUCTION

This unit is concerned with familiarizing you with supply of money,

determinant of supply of money, the concept of credit multiplier and money
multiplier.

In general, the term “supply of money” can be defined as the total

stock of currency and other liquid instrument held by the public and
circulating in an economy during a particular point of time. The term “public”
refers to the individuals and the business firms in the economy, excluding
Macro Economics- II 7
Unit 1 Supply of Money

the central government, the central bank and the commercial banks. Money
may be regarded as something, which is generally used as a means of
payment and accepted for the settlement of debt.
There are various determinants of supply of money such as monetary
base, money multiplier, reserve ratio, currency ratio, confidence in bank
money, time deposit ratio, real income, interest rate, monetary policy and
seasonal factors and public desire to hold currency etc.
Money is anything that is generally acceptable as a means of payment
in the settlement of all transactions, including debt. On the other hand,
near money assets do not have any legal status.
Inside money is money issued by private intermediaries (i.e.
commercial banks) in the form of debt (credit). Outside money is money
that is not a liability for anyone “inside” the economy.
The money multiplier is the amount of money that banks generate
from each unit of the currency reserves. The value of the money multiplier
depends on the desired currency deposit ratio and the excess deposit ratio.

1.3 DEFINITION OF SUPPLY OF MONEY

The supply of money is a stock at a particular point of time, though it

conveys the idea of a flow over time. The term ‘the supply of money’ is
synonymous with such terms as ‘stock of money’, ‘money supply’ and
‘quantity of money’. The supply of money is a policy variable determined
jointly by the monetary authority, banks and the public. However, in most of
the time the monetary authority plays the dominant role in the determination
of the supply of money. To study the mechanics of supply of money, it is
essential to understand the distinction between two types of money- ordinary
money and high powered money. All the empirical measures of money as
given by the Reserve Bank of India popularly known as M1, M2, M3 and M4
can be termed as ordinary money. On the other hand, high powered money
or powerful money refers to the currency that has been issued by the
Reserve Bank of India (RBI) and the Government of India. Some portion of
the currency is held by the public and the rest is kept as funds in Reserve
Bank. The total amount of supply of money is determined by various factors,
which are discussed in the next section of the unit.
8 Macro Economics- II
Supply of Money Unit 1

1.4 DETERMINANTS OF MONEY SUPPLY

The determinants of money supply are both exogenous and

endogenous. Money supply is determined exogenously by the central bank
and money supply is determined endogenously by changes in the economic
activity, which affects people’s desire to hold currency relative to deposits
and the rate of interest etc.

Broadly, the determinants of money supply can be classified into two

catagories such as monetary base and the money multiplier. These two
broad determinants of money supply are, in turn influenced by other factors.
We will discuss all the determinants of supply on money as follows:

z The Monetary Base: The monetary base is considered as the most

important determinant of supply of money. Money supply varies
directly in relation to the changes in the monetary base. Monetary
base refers to the supply of fund available for use either as cash or
reserve of the central bank. Monetary base changes due to the
policy of the government or is influenced by the value of money.
The current practice is to explain the determinants of the money
supply in terms of the monetary base or high-powered money. High-
powered money is the sum of commercial bank reserves and
currency (notes and coins) held by the public. High-powered money
is the base for the expansion of bank deposits and creation of the
money supply. Thus, the supply of money varies directly with
changes in the monetary base, and inversely with the currency and
reserve ratios.

z Money Multiplier: Money supply and high powered money are linked
through the money multiplier. The money multiplier is the ratio of the
stock of money to the stock of high powered money and is always
greater than one. Money multiplier has positive influence upon the
supply of money. An increase in the size of money multiplier will
increase the money supply and vice versa. A detailed discussion
regarding the money multiplier is carried out in subsequent section
of the unit.
Macro Economics- II 9
Unit 1 Supply of Money

z The Level of Bank Reserves: The level of bank reserves is another

determinant of the money supply. Commercial bank reserves consist
of reserves on deposits with the central bank and currency in their
tills or vaults. It is the central bank of the country that influences the
reserves of commercial banks in order to determine the supply of
money. The central bank requires all commercial banks to hold
reserves equal to a fixed percentage of both time and demand
deposits. These are the legal minimum or required reserves. Required
reserves (RR) are determined by the required reserve ratio (RRr)
and the level of deposits (D) of a commercial bank. For example, if
the deposit amount is Rs. 100 lakhs and the required reserve ratio is
20 percent, then the required reserves will be Rs. 20 lakhs (20% x
Rs. 100 lakhs). If the reserve ratio is reduced to 10 per cent, the
required reserves will also be reduced to Rs. 10 lakhs. Thus, the
higher the reserve ratio, the higher the required reserves to be kept
by a bank, and vice versa. But it is the excess reserves (ER) which
are important for the determination of the money supply. Excess
reserves are the difference between total reserves (TR) and required
reserves (RR): ER=TR-RR. If total reserves are Rs 100 lakhs and
required reserves are Rs 20 lakhs, then the excess reserves are Rs
80 lakhs (100 - 20 lakhs).

When required reserves are reduced to Rs 10 lakhs, the excess

reserves increase to Rs 90 lakhs. It is the excess reserves of a
commercial bank which influence the size of its deposit liabilities. A
commercial bank advances loans equal to its excess reserves which
are an important component of the money supply. To determine the
supply of money with a commercial bank, the central bank influences
its reserves by adopting open market operations and discount rate
policy. Open market operations refer to the purchase and sale of
government securities and other types of assets like bills, securities,
bonds, etc., both government and private, in the open market. When
the central bank buys or sells securities in the open market, the level
of bank reserves expands or contracts. The purchase of securities
10 Macro Economics- II
Supply of Money Unit 1

by the central bank is paid for with cheques to the holders of securities
who, in turn, deposit them in commercial banks thereby increasing
the level of bank reserves. The opposite is the case when the central
bank sells securities to the public and banks who make payments to
the central bank through cash and cheques thereby reducing the
level of bank reserves.

Bank rate policy affects the money supply by influencing the

cost and supply of bank credit to commercial banks. The bank rate in
India is the interest rate at which commercial banks borrow from the
central bank. A high bank rate means that commercial banks get
less amount by selling securities to the central bank. The commercial
banks, in turn, raise their lending rates to the public thereby making
advances dearer for them. Thus, there will be contraction of credit
and the level of commercial bank reserves. Opposite is the case
when the bank rate is lowered. It tends to expand credit and the
consequent bank reserves.

It should be noted that commercial bank reserves are affected

significantly only when open market operations and bank policy
supplement each other. Otherwise, their effectiveness as determinants
of bank reserves and consequently, of money supply is limited.

z Statutory Liquidity Ratio: Apart from this CRR, the commercial

banks also need to keep liquid in the form of cash, gold and
unencumbered approved securities which are known as Statutory
Liquidity Ratio (SLR). This SLR is by law an additional measure to
determine money supply. The raising of the SLR has the effect of
reducing the money supply with the commercial banks for the lending
purposes and the lowering of the SLR tends to increase the money
supply with banks for advances. At present (as of February, 2020),
the SLR as fixed by RBI in India is 18.25%.

z Open market operations: To determine the supply of money with a

commercial bank, the central bank influences its reserves by adopting
open market operation. These refer to the purchase and sale of
Macro Economics- II 11
Unit 1 Supply of Money

government securities and other types of assets like bills, securities,

bonds etc, both government and private, in the open market. When
the central bank buys and sells securities in the open market, the
level of bank reserves expands or contracts. The purchase of
securities by the central bank is paid for with the cheque to the holder
of securities who in turn, deposit them in the commercial banks thereby
increasing the level of bank reserves. The opposite is the case when
the central bank sells securities to the public and banks who make
payment to the central bank through cash and cheque thereby
reducing the level of bank reserves.

z Discount Rate Policy/ Bank Rate: The discount rate policy affects
the money supply by influencing the cost and supply of bank credit to
commercial banks. This is known as bank rate in India. It is the interest
rate at which commercial banks borrow from the central bank. A high
interest means that commercial banks get less amount by selling
securities to the central bank. In turn, the commercial banks raise
their lending rates to the public thereby making advances dearer for
them. Thus, there will be contraction of credit and the level of
commercial bank reserves. The opposite is the case when the bank
rate is lower. This means it tends to expand credit and consequently
the bank reserves expand.

z Public Desire to hold Currency and Deposits: People’s desire to

hold currency (or cash) relative to deposits in commercial banks also
determines the money supply. If people are in the habit of keeping
less in cash and more in deposits with the commercial banks, the
money supply will be large. This is because banks can create more
money with larger deposits. On the contrary, if people do not have
banking habits and prefers to keep their money holdings in cash,
credit creation by banks will be less and the money supply will be at
a low level.

z Time-Deposit Ratio: Time deposit ratio (t), which represents the

ratio of the time deposit to the demand deposit is a behavioural

12 Macro Economics- II
Supply of Money Unit 1

parameter having negative effect on the money multiplier (m) and

thus on the money supply. A rise in ‘t’ reduces ‘m’ and thereby the
supply of money decreases.

z Monetary Policy: Monetary policy is the single most important

determinant of money supply by definition. A change in the monetary
policy has profound impact on behaviour of the banking institutions
and people to hold money in the form of cash. The monetary policy
determines the money supply in an economy by deciding on the CRR,
SLR, Repo Rate, Reverse Repo Rate, Open Market Operations,
Selective Credit Control and so on.

1.5 CONCEPT OF MONEY AND NEAR MONEY

As mentioned in the previous section, money is anything that is

generally acceptable as a means of payment in the settlement of all
transactions, including debt. It is the commonly used medium of exchange
or means of transferring purchasing power. General acceptability as a
means of payment or as a medium of exchange is the unique feature of
money. What makes money medium of exchange is the belief held by
everyone that it will be accepted as such by all others in the economy.
Money consists of coins, currency notes and demand deposits of the banks.
Near money, on the other hand, includes the financial assets like time
deposits, bills of exchange, bonds, shares etc. Money is a legal tender and
gives the possessor liquidity in hand. It performs the medium of exchange
function. On the other hand, near money assets do not have any legal
status. They possess moneyness or liquidity but not ready liquidity like
money. They are almost perfect substitutes for money as a store of value.

The difference between money and near money can be explained in

terms of liquidity and types of functions of money and near money. Money
possesses 100 per cent liquidity; i.e., it is liquid or can be readily acceptable
as a means of payment. Near-money lacks 100 percent liquidity, i.e., it
involves time cost for its conversion into money. Another difference between
money and near money is that money serves as a unit of account or a

Macro Economics- II 13
Unit 1 Supply of Money

common measure of value. All prices are expressed in terms of money.

Near-money on the other hand, does not perform such functions. Rather,
its own value is expressed in terms of money.

1.6 INSIDE AND OUTSIDE MONEY

In this section of the unit, a discussion is carried out regarding inside

and outside money.

Inside money is an asset representing, or backed by, any form of

private credit that circulates as a medium of exchange. Inside money is also
known as indigenous money as it is created inside the private sector. It is
mainly used to identify debt that is considered an asset to the holder while
also being a liability to the issuer of the debt. In monetary economics, inside
money is money issued by private intermediaries (i.e. commercial banks) in
the form of debt (credit). This money is typically in the form of demand deposits
or other deposits, and hence is part of the money supply. The money, which
is an asset of the depositor but coincides with a liability of the bank, is inside
money. Inside money is thus a liability (equivalently a negative asset) to the
issuer, so the net amount of assets associated with inside money in an
economy is zero. Most money circulating in a modern economy is inside
money. One of the most common examples of inside money is the deposits
that customers make at banks and similar financial institutions.

Money that are backed by some asset and that are not in zero net
supply within the private sector of the economy is known as outside money.
Thus, outside money is a net asset for the private sector. Outside money is
not a liability for anyone “inside” the economy. It is held in an economy in
net positive amounts. Money that is backed by gold and assets denominated
in foreign currency or otherwise backed up by foreign debt, like foreign
cash, stocks or bonds are examples of outside money.

The distinction between inside and outside money can be explained

in case of rising or falling prices. When there is inflation or deflation, a
change in the purchasing power of money in case of inside money leads to
an equal change in the real value of both assets and liabilities of the private

14 Macro Economics- II
Supply of Money Unit 1

sector. Thus, a change in the price level does not affect the behavior of the
depositors and borrowers possessing inside money.

But in case of outside money, a change in the price level affects the
behavior of the economic units possessing outside money because the
real value of the cash held by economic unit changes. Thus, given the
nominal amounts of outside money, its real value varies inversely with the
price level, and each change in its real value leads to a wealth transfer
between the private sector and the government.

ACTIVITY 1.1

Q.1: Identify the relation between money and near

money.
..........................................................................................................
..........................................................................................................
..........................................................................................................

CHECK YOUR PROGRESS

Q.1: State whether True (T) or False (F)

(i) Money supply varies directly in relation to the
changes in the monetary base. (True/False)
..................................................................................................................
(ii) Demand deposit is an example of near money. (True/False)
..................................................................................................................

1.7 CONCEPT OF MONEY MULTIPLIER AND HIGH

POWERED MONEY

Money multiplier and high powered money are related to each other.
The current practice to define money multiplier is in terms of high powered
money. The high powered money is the sum of the commercial bank
reserves and currency held by the public. High powered money is the base
for expansion of bank deposit and creation of the value of the money
mutplier. This can be explained as follows:
Macro Economics- II 15
Unit 1 Supply of Money

The money supply consists of deposits of commercial bank (D) and

Currency (C) held by the public. Thus, the supply of money (Ms)
Ms = D + C ............................ (1)

On the otherhand, the high powered money (H) consists of currency

held by the public (C) plus required reserve ratio (RR) and the excess
reserve of the commercial bank.
HP = C + RR + ER ............................ (2)

Now, the relation between Ms and HP can be explained as a ratio of

Ms to HP.
MS DC
HP C  RR  ER .................................(3)

D C

Ms D D
Hp C RR ER (Dividing the numerator and denominator by D)
 
D D D

C
1
Ms D
or Hp C RR ER ......................... (4)
 
D D D

C RR ER
By substituting Cr for , RRr for , ERr for equation 4 becomes
D D D
Ms 1  Cr
Hp Cr  RRr  ERr ......................... (5)
Thus high powerd money and money supply are equal to
MS DC
u HP ......................... (6)
HP C  RR  ER

1  Cr
Now, Cr  RR  ER can be termed as money multiplier (m) and equation
r r

6 can be rewritten as Ms = mH ......................... (7)

Equation 7 expresses the money supply as a function of money

multiplier and high powered money.

It can be easily drawn from the above discussion that the size of the
money multiplier is determined by the currency ratio (Cr) of the public, the
required reserve ratio (RRr) and the excess reserve ratio (ERr) of the
16 Macro Economics- II
Supply of Money Unit 1

commercial bank. The lower the values of these ratios are, the higher are
the values of the multiplier. The significance of money multiplier can be
assessed from the fact that if m is fairly stable, the central bank can
manipulate the supply of money by manipulating high-powered money.

ACTIVITY 1.2

Q.1: Try to derive the relation between high-powered

money and money multiplier.
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................

CHECK YOUR PROGRESS

Q.2: State whether True (T) or False (F)

Currency ratio is an important determinent of money
multiplier (True/False)
.............................................................................................................
Q.3: What is high powered money? (Answer in about 40 words)
.............................................................................................................
.............................................................................................................
.............................................................................................................
Q.4: Mention the determinants of money supply.
(Answer in about 40 words)
.............................................................................................................
.............................................................................................................
.............................................................................................................
Q.5: Mention the relationship between monetary base and total
supply of money in an economy. (Answer in about 40 words)
.............................................................................................................
.............................................................................................................
.............................................................................................................

Macro Economics- II 17
Unit 1 Supply of Money

1.8 LET US SUM UP

z Supply of money is the total stock of currency and other liquid

instruments held by the public and circulating in an economy during a
particular point of time.
z There are various determinants of supply of money such as monetary
base, the required reserve ratio and excess reserve ratio of the bank,
monetary policy, public desire to hold currency and confidence of the
people on banks etc.

z Money multiplier is an important determinant of total supply of money

in an economy.

z The value of the money multiplier is determined by the currency ratio

(Cr) of the public, the required reserve ratio (RRr) and the excess
reserve ratio (ERr) of the commercial bank.

z Money is a legal tender and gives the possessor liquidity in hand. It

performs the medium of exchange function. On the other hand, near
money assets do not have any legal status. They possess moneyness
or liquidity but not ready liquidity like money.

z Most money circulating in a modern economy is inside money. Outside

money is money that is not a liability for anyone "inside" the economy.

z The significance of money multiplier (m) can be assessed from the

fact that if the value of the money multiplier is stable, the central bank
can manipulate the supply of money by manipulating high-powered
money.

1.9 FURTHER READING

1) Gupta, S. B. (2003). Monetary Economics: Institutions, Theory and

Policy. New Delhi: S. Chand & Company Ltd.
18 Macro Economics- II
Supply of Money Unit 1

2) Jhinghan, M. L. (2012). Monetary Economics. Vrinda Publications Pvt

Ltd.

3) Mithani, D. M. (2002). A Course in Macroeconomics. Mumbai: Himalaya

Publishing House.

4) Paul, R. R. (2008). Monetary Economics. Ludhiana: Kalyani Publisher

5) Rana, K. C. & Verma, K. N. (2009). Macro Economic Analysis.New

Delhi: Vishal Publishing Co.

6) Sheth, M. L. (2002). Monetary Economics. Agra: Lakshmi Narayan

Agarwal.

1.10 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: (i) True (ii) True

Ans to Q No 2: True

Ans to Q No 3: High powered money is the determinant of money supply

that consist of i) gold stock, ii) amount of money issued by the
government i.e. coins and currency etc. and iii) the outstanding
central government credit i.e. loan securities etc. It is given by -

High powered money (H) = C + RR + ER. where C = currency,

RR= reserve ratio; and ER= excess reserve.

Ans to Q No 4: The determinants of money supply are both exogenous

and endogenous. The exogenous factors of money supply are
determined by the central bank. The endogenous factors are
determined by changes in economic activities which affect
peoples' desire to hold currency relative to deposit, the rate of
interest etc.

Ans to Q No 5: The monetary base is considered as the most important

determinant of supply of money. Money supply varies directly in
relation to the changes in the monetary base. Monetary base
refers to the supply of fund available for use either as cash or
Macro Economics- II 19
Unit 1 Supply of Money

reserve of the central bank. Monetary base changes due to the

policy of the government or is influenced by the value of money.

1.11 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: Define near money.

Q 2: What is meant by high powered money?

Q 3: Write a short note on supply of money.

Q 4: Explain how the velocity of circulation of money affects the money

supply.

B) Essay- type Questions (Answer each question in 300-500 words)

Q 1: Explain the relation between high-powered money and money

supply.

Q 2: Explain the process of derivation of money multiplier.

Q 3: Explain the relation between inside money and outside money.

Q 4: Critically discuss the narrower definition of money.

Q 5: Explain the constituents of money supply.

*** ***** ***

20 Macro Economics- II
UNIT 2: POST-KEYNESIAN THEORIES OF
DEMAND FOR MONEY
UNIT STRUCTURE

2.1 Learning Objectives

2.2 Introduction
2.3 Post-Keynesian Approaches to Demand for Money
2.4 Patinkin and the Real Balance Effect
2.5 Approaches of Baumol and Tobin
2.5.1 Baumol's Analysis
2.5.2 Tobin's Analysis
2.6 Friedman and the Modern Quantity Theory
2.7 Let Us Sum Up
2.8 Further Reading
2.9 Answers to Check Your Progress
2.10 Model Questions

2.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

z understand the post Keynesian approaches to demand for money
z know the Patinkin and the Real Balance Effect
z explain the approaches of Baumol and Tobin
z illustrate the Friedman modern quantity theory of Money.

2.2 INTRODUCTION

This unit is concerned with familiarizing you with post Keynesian

approaches of demand for money, Patinkin real balance effect, approaches
of Baumol and Tobin and Friedman modern Quantity theory of Money.
The post Keynesian theories of demand for money were first to
emphasise the fact that it was the money supply that responds to the demand
for bank money. They are of the view that central bank cannot control the
quantity of money, but only manage the interest rate by managing the
quantity of money reserves.
Macro Economics- II 21
Unit 2 Post-Keynesian Theories of Demand for Money

The real balanced effect which was introduced by Patinkin analyse

the change in real stock of money on consumption expenditure of the
consumers. It other words, it analyse the change in consumption
expenditure as a result of change in real value of the stock of money in
circulation.
William J. Baumol and James Tobin developed independently the
transaction demand for money which was somewhat different from
Keynesian approach. The theory relies on the tradeoff between the liquidity
provided by holding money (the ability to carry out transactions) and the
interest forgone by holding one’s assets in the form of non-interest-bearing
money.
Based on the works of earlier scholars including Irving Fisher, Milton
Friedman in his quantity theory of money improved the Keynesian liquidity
preference theory by treating money like any other asset.

2.3 POST-KEYNESIAN APPROACHES TO DEMAND

FOR MONEY

In general, it has been found that over the last two decades, work on
the Post Keynesian theory of demand for money has been flourishing, and
has prompted a rethinking of the complex nature of money in modern
economies. It has tried to provide a satisfactory explanation of the transaction
demand of money as provided by Keynes. A satisfactory theory of the
transaction demand for money cannot be constructed only on the non-
synchronous character of receipt and expenditure. It has also to explain
why they are not synchronous in time and why money is held in the presence
of interest-bearing and highly liquid short-term financial asset. The problem
is not merely of explaining why transaction balances are held but also of
explaining what determines the optimal amount of such balances held by
their holders, Besides, the volume of expenditure and transaction cost, the
rate of interest as the opportunity cost of holding even transaction balances
has to be considered. It has usually found that big business houses with
surplus transaction cash are known to invest it on short term basis. The
22 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

post Keynesian economist such as Baumol and Tobin has put forwards
these aspects in their portfolio balance approach. In this unit, we are going
to discuss some of the main post Keynesian approaches to demand for
money.

2.4 PATINKIN AND THE REAL BALANCE EFFECT

Patinkin’s 1956 book “Money, Interest, and Prices: An Integration of
Monetary and Value Theory” is regarded as the most important contribution
to the neo-Walrasian synthesis where he provided an explanation of the
real balance effect. Real balance effect as provided by Patinkin considers
the behavioural effects of changes in the real stock of money. The term has
been used by Patinkin in a wider sense so as to include the net wealth
effect, portfolio effect, Cambridge effect, as well as any other effect one
might think of. Patinkin used the term real balance effect to include all the
aspects of real balances. Unless the term is used in a wider sense so as to
include all the aspects of real balances, its use is likely to be misleading
and may fail to describe a generalized theory of people’s reactions to
changes in the stock of real balances. The use of the term in the wider
sense as enunciated above also helps us to resolve the paradox— that
income is the main determinant of expenditure on the micro level and wealth
is a significant determinant of income on the macro level. Earlier this
influence was taken into consideration by Pigou which is popularly known
as ‘Pigou Effect’. Compared to Pigou effect, which was used in a narrow
sense to denote the influence on consumption only, the term real balance
effect has been made more meaningful and useful by including in it all
likely influences of changes in the stock of real balances.

As discussed in the introductory section, the term ‘real balance effect’

was coined by Patinkin to denote the influence of changes in the real
stock of money on consumption expenditure. It other words, the real
balance effect analyses the change in consumption expenditure as a result
of changes in the real value of the stock of money in circulation. The real-
balance effect is one of the effects that indicate why aggregate
expenditures are inversely related to the price level. According to the real
Macro Economics- II 23
Unit 2 Post-Keynesian Theories of Demand for Money

balanced effect, a higher price level decreases the purchasing power of

money resulting in a decrease in consumption expenditures, investment
expenditures, government purchases, and net exports. A lower price level
has the opposite affect, causing an increase in the purchasing power of
money which results in an increase in consumption expenditures,
investment expenditures, government purchases, and net exports. When
the price level changes, the real-balanced effect is activated, which is
what then results in a change in aggregate expenditures and the movement
long the aggregate demand curve.

The real-balanced effect is based on the realistic presumption that

the supply of money in circulation is constant at any given time. Money is
what the four basic macroeconomic sectors use to purchase production.
How much production they are able to purchase (that is, aggregate
expenditures) depends on the amount of money in circulation relative to
the prices of the goods and services produced (that is, the price level).
When the price level changes, the purchasing power of the available money
supply also changes and so too do aggregate expenditures. A higher price
level means money can buy less production. A lower price level means
money can buy more production. The real balance effect can be explained
with the help of a hypothetical example as given below. Suppose, for
example, that consumer A has an income of Rs 100. At a price of Rs 10 of
a specific product X each, he can afford to purchase ten units of it. However,
if the price level rises, he can no longer afford to purchase five units of the
product X. At Rs 20 each, he can now afford to buy only five units of the
product. His share of aggregate expenditures on real production declines
from ten units of X to five units of X. The purchasing power of his Rs 100
of money has fallen and with it his aggregate expenditures on real
production. He has succumbed to the real-balance effect.

According to Patinkin, real balance effect can lead to equilibrium in

the money market. The real balance effect is represented diagrammatically
by using the IS and LM technique for the reason that IS curve represents
the goods market and LM curve represent the money market.
24 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

Income

Fig.1: IS LM model for real balance effect

As shown in the diagram, Patinkin was of the view that equilibrium in
the real economy can be restored even if money supply changes. As there
is an increase in money supply, the LM curve will shift rightwards and the
new equilibrium will be at point C at YF.

ACTIVITY 2.1

Trace out the factor which effect the transaction demand

for money.
..........................................................................................................
..........................................................................................................
..........................................................................................................

CHECK YOUR PROGRESS

Q.1: State whether True (T) or False (F)

(i) The term real balance effect was given by Don
Patinkin (True/False)
..................................................................................................................
(ii) Real balance effect is considered to be superior than Pigou
effect (True/False)
..................................................................................................................

Macro Economics- II 25
Unit 2 Post-Keynesian Theories of Demand for Money

2.5 APPROACHES OF BAUMOL AND TOBIN

Keynes' liquidity theory unnecessarily bifurcated aggregate demand

for money into transaction demand and speculative demand. The transaction
demand depends upon the level of income and Keynes assumed a constant
relation between money holders and income. The speculative demand is
based on portfolio approach which considers the yields of assets and
competes with money in the individual's portfolios. The combination of
demand motives with two different approaches is inconsistent. In the post
Keynesian period, William Baumol and James Tobin applied the portfolio
analysis to correct the inconsistency in Keynesian approach.

2.5.1 Baumol's Analysis

W. Baumol argues that transactions demand for money also

depends on rate of interest. According to him, holding of cash involves
two types of cost such as interest cost and non-interest cost. Baumol
developed his algebraic model of the demand for transaction balances
at the micro level. He assumes that an individual invests his money
income in interest bearing bonds and these bonds are converted for
money in equal lots of amount M each to finance his expenditure. It is
also assumed that the individual has uniform expenditures or
transactions to make over a given time period. Each conversion will
involve a brokerage fee. The total brokerage fee will be equal to the
number of conversions into money times the brokerage fee, or b(T/
M), where T represents total transactions, M,the amount of bonds
converted to money and b, the brokerage fee.
Thus, Baumol assumed that when bonds are converted into
money, the individual forgoes interest-income and the total interest
income forgone over the expenditure period is equal to the average
money holding per conversion period (M/2) multiplied by the interest
rate (i). That is, total interest income forgone will be i (M/2). Hence
total cost of holding cash balances over the expenditure period (C)
will be written as:

26 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

§ T · §M·
C b¨ ¸  i ¨ ¸
©M¹ © 2 ¹
The aim of the investor is to minimise the cost associated with money
holding which can be done by finding out the rate of change in C with
respect to M and ultimately, we will get as equation as

2bT
M
i
The above equation is the demand for money as provide by William
Baumol which states that the nominal money holdings for the cost-
minimising individuals will vary directly with the square root of planned
nominal expenditure and inversely with the square root of market
interest rate, The demand function can be expressed in terms of real
money balances (M/P), by making expenditure and the brokerage
fee real magnitudes, i.e by dividing each nominal magnitude by a
suitable price index.

2.5.2 Tobin's Analysis

Keynes' liquidity preference analysis requires an investor to put all

his wealth either in cash or in some other single asset. But, according
to Tobin, the real explanation attempts to show the reasons for which
an investor holds a variety of assets. In fact, what is needed is a theory
of portfolio balancing. The portfolio-balancing model provides a
monetary theory of the interest rate. The model, states that the portfolio
demand for financial assets and the interest rate adjusts to equilibrate
the supply and the demand for financial assets. Tobin formulated the
model in which the simultaneous desire to avert risk and to maximise
the utility from wealth will lead an individual to choose a diversified
portfolio consisting of both money and bonds. In this respect, he
introduced the concept of risk aversion. The basic idea about the risk
aversion is that given two assets with same average return, an investor
prefers that asset which has less dispersion. One has to consider two
things in this respect. There is always a risk that an asset with an unstable
yield would provide a smaller average return, if it has to be sold before

Macro Economics- II 27
Unit 2 Post-Keynesian Theories of Demand for Money

maturity. Income being subject to the law of diminishing marginal utility,

the gains of utility to the wealth-holder during periods of higher yield
would be smaller than the loss of utility during periods of low yields.
If O represents the part of funds invested in bonds, i representss
interest rate and g represents capital gains, the average value of total
return, µ will be
P O(i  Pg) ................................... (1)
If capital gains (g) is zero, then average value of total return will
depend on O and i because
P Oi ................................... (2)
If rate of interest is fixed, there will be no risk. Risk is only due to
capital gains or losses. The risk is measured by the standard deviation
of capital gains and is designated as S g . Thus, the standard deviation
of total return ( S ) is represented as
S OS g or O S / Sg ................................... (3)
Substituting (3) in (2), we get,
S
P i ................................... (4)
Sg
Equation (4) thus indicates that the average of total return
depends upon the rate of interest and the risk of capital gains and
losses on the investment in bonds.
Thus, Tobin's approach has done away with the limitation of
Keynes' theory of liquidity preference for speculative motive, namely,
individuals hold their wealth in either all money or all bonds. Thus,
Tobin's approach, according to which individuals simultaneously hold
both money and bonds but in different proportion at different rates of
interest yields a continuous liquidity preference curve.
Further, Tobin's analysis of simultaneous holding of money and
bonds is not based on the erroneous Keynes's assumption that interest
rate will move only in one direction but on a simple fact that individuals
do not know with certainty which way the interest rate will change. It
is worth mentioning that Tobin's portfolio approach, according to which
liquidity preference (i.e. demand for money) is determined by the
individual's attitude towards risk can be extended to the problem of
asset choice when there are several alternative assets, not just two,
of money and bonds.
28 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

2.6 FRIEDMAN AND THE MODERN QUANTITY THEORY

Friedman in his essay, "The Quantity Theory of Money-A Restatement"

published in 1956 beautifully restated the old quantity theory of money. In
his restatement he says that "money does matter". It is necessary to state
the major assumptions and beliefs of Friedman. First of all, Friedman says
that his quantity theory is a theory of demand for money and not a theory of
output, income or prices.
Building on the work of earlier scholars, including Irving Fisher of
Fisher Equation fame, Milton Friedman improved on Keynes's liquidity
preference theory by treating money like any other asset. He concluded
that economic agents (individuals, firms, governments) want to hold a certain
quantity of real, as opposed to nominal, money balances. If inflation erodes
the purchasing power of the unit of account, economic agents will want to
hold higher nominal balances to compensate, to keep their real money
balances constant. The level of those real balances, Friedman argued, was
a function of permanent income (the present discounted value of all expected
future income), the relative expected return on bonds and stocks versus
money, and expected inflation. Milton Friedman quantity demand function
for money can be represented as
M = f(Y, w, P, rb, re, w, u) .................................... (i)
Where, M = aggregate demand for money
Y = total flow of income
w = ratio of non-human to human wealth
P = general price level.
rb = bond yields, the market bond interest rate
re = equity yields, the market interest rate of equities
w = Ratio of non human to human wealth
u = utility determined variables which tend to influence taste and
preferences
The demand function as shown in equation (i) indicates that the
amount of money demanded changes proportionately to the changes in
the units in which prices and money income are expressed. The equation
thus expresses that if price level and money increases to O times their original
level, demand for money also increases to O times its original quantity. Thus,
we can express the demand equation as
Macro Economics- II 29
Unit 2 Post-Keynesian Theories of Demand for Money

O M = f( O Y, w,, O P, rb, re, rc, u) .................................... (ii)

now by putting O = 1/P, the equation (ii) can be expressed as
M §Y ·
f ¨ , w, rb , re , rc , u ¸ .................................... (iii)
P ©P ¹
Equation (iii) expresses demand for money as demand for real
balances, which is function of real variables, independent of monetary values,
Friedman was of the view that money is a luxury like durable consumer
goods. With a change in per capita income, people's standard of living
changes and, as a result, they may desire to hold cash balances more or
less according to the changes in the per-capita income. A comparison can
be made between Friedman and Keynes theory of demand for money.

Comparison of Friedman Vs Keynes:

First, in order to explain his demand for money function, Friedman

uses a broader definition of money than that of Keynes. Friedman treats
money as an asset or capital good capable of serving as a temporary abode
of purchasing power. On the other hand, the Keynes definition of money
consists of demand deposits and non-interest bearing debt of the
government.
Secondly, there is also the difference between the monetary
mechanisms of Keynes and Friedman as to how changes in the quantity of
money affect economic activity. Unlike Friedman, Keynes assumes that
monetary changes affect economic activity indirectly through bond prices
and interest rates.
Thirdly, differences between the two approaches can be explained
with regard to the motives for holding money balances. Keynes divides
money balances into "active" and "idle" categories. The former consist of
transactions and precautionary motives, and the latter consist of the
speculative motive for holding money. On the other hand, Friedman makes
no such division of money balances.
Fourthly, Friedman introduces a demand for money function
significantly different from that of Keynes. According to Friedman, the
demand for money on the part of wealth holders is a function of many
variables such as the yield on money, the yield on bonds, the yield on
securities, the yield on physical assets etc. In the Keynesian theory, the
30 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

demand for money as an asset is confined to just bonds where interest

rates are the relevant cost of holding money.
Fifth, Keynes does not make a distinction between permanent income
and nominal income. Friedman, on the other hand, in his analysis makes
distinction between permanent income and nominal income to explain his
theory. Permanent income is the amount a wealth holder can consume
while maintaining his wealth intact. Nominal income is measured in the
prevailing units of currency. It depends on both prices and quantities of
goods traded.

ACTIVITY 2.2

Identify the factors that affect portfolio balancing.

..........................................................................................................
..........................................................................................................
..........................................................................................................

CHECK YOUR PROGRESS

Q.2: State whether True (T) or False (F)

(i) The Quantity Theory of Money-A Restatement
was written by Milton Friedman. (True/False)
..................................................................................................................
(ii) W. Baumol argues that transactions demand for money also
depends on rate of interest. (True/False)
..................................................................................................................

2.7 LET US SUM UP

z The post Keynesian theories of demand for money were first to

emphasise the fact that it was the money supply that responds to the
demand for bank money.
z The Patinkin real balanced effect analyses the change in real stock of
money on consumption expenditure of the consumers. In other words,

Macro Economics- II 31
Unit 2 Post-Keynesian Theories of Demand for Money

it analyses the change in consumption expenditure as a result of change

in real value of the stock of money in circulation.
z Baumol-Tobin model shows that demand for money depends positively
on the income level and negatively on the interest rate. This model is
explained in terms of assets. An individual holds portfolio for monetary
assets (currency and checking account) and non-monetary assets
(stocks and bonds).
z Demand for real money balances, according to Friedman, increases
when permanent income increases and declines when the expected
returns on bonds, stocks, or goods increases versus the expected
returns on money, which includes both the interest paid on deposits
and the services banks provide to depositors.

2.8 FURTHER READING

1) Gupta, S. B. (2007). Monetary Economics: Institutions, Theory and

Policy. New Delhi: S. Chand & Company Ltd.
2) Mithani, D. M. (2002). A Course in Macroeconomics. Mumbai: Himalaya
Publishing House.
3) Paul, R. R. (2008). Monetary Economics. Ludhiana: Kalyani Publisher
4) Rana, K. C. & Verma, K. N. (2009). Macro Economic Analysis. New
Delhi: Vishal Publishing Co.
5) Sheth, M. L. (2002). Monetary Economics. Agra: Lakshmi Narayan
Agarwal.

2.9 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: (i) True (ii) True

Ans to Q No 2: (i) True (ii) True

32 Macro Economics- II
Post-Keynesian Theories of Demand for Money Unit 2

2.10 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: What is meant by transaction demand for money?

Q 2: What is meant by real balance effect?
Q 3: Explain the Baumol's Approach of the Quantity Theory of Money.
B. Long Questions (Answer each question in about 500 words)
Q 1: Discuss the real balance effect as provided by Don Patinkin.
Q 2: Make a critical analysis of the Tobin's approach towards transaction
demand for money.
Q 3: Discuss the Milton Friedman restatement of the quantity theory of
money.
*** ***** ***

Macro Economics- II 33
 UNIT 3: INFLATION
UNIT STRUCTURE

3.1 Learning Objectives

3.2 Introduction
3.3 Concept of Inflation
3.4 Demand Pull and Cost-Push Inflation
3.5 Effects of Inflation
3.6 Inflationary Gap Analysis
3.7 Policies to control inflation
3.8 Structural Inflation
3.9 Concept of Deflation and Stagflation
3.10 Let Us Sum Up
3.11 Further Reading
3.12 Answers to Check Your Progress
3.13 Model Questions

3.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

z understand the meaning and types of inflation
z discuss the causes and effects of inflation in an economy
z explain the demand-pull and cost-push inflation
z describe different policies to control inflation
z understand the concept of deflation and stagflation.

3.2 INTRODUCTION

Basically inflation is a monetary phenomenon characterized by rising

prices. However, it is to be noted that inflation is a complex phenomenon
and hence it can not be precisely defined. In this unit, we shall try to look at
some of the important definitions of inflation. We shall also discuss its various
types, causes and the important anti-inflationary measures.

34 Macro Economics- II
Inflation Unit 3

3.3 CONCEPT OF INFLATION

As we have already stated, inflation is a monetary phenomenon

characterized by rising prices. However, the phenomenon inflation is very
complex, and hence it can not be precisely defined. In this section, we shall
try to derive the meaning of inflation and discuss a few important definitions
of it.

Inflation is characterized by rising prices. Here, the phrase rising

prices is important. This is because inflation denotes a situation where
the prices are rising continuously and not for once only. Thus, a sudden
increase in the price level of the economy will not be termed as
inflation, unless it is experienced on a continuous basis. However, it is
also true that there can be inflation even without a rise in the price
level. This type of inflation may occur during a war period. On account
of many controls and rationing that exist during war time, prices will be
kept under check. But the moment controls are withdrawn, prices will
go up. So the real test of inflation is neither an increase in the amount
of money nor a rise in prices, but the appearance of abnormal profits.
Whenever businessmen and producers make huge profits, it is a sign
of inflation.

Definition of Inflation: As we have repeatedly noted, inflation is a complex,

multi-dimensional phenomenon. Many economists have tried to define it;
but often they end up highlighting on certain aspects while leaving aside
others. Therefore, it is very difficult to put forward an all acceptable definition
of inflation. Even then, we shall discuss some of the important definitions of
this term.

Crowther has defined the term in these simple words: “Inflation is a state
in which the value of money is falling, i.e, prices are rising”. So it is generally
regarded that during a period of inflation, the price level will rise. It is also
described as a situation where too much money chases too few goods
resulting in an abnormal increase of price level. Ackley has defined inflation

Macro Economics- II 35
Unit 3 Inflation

as “a persistent and appreciable rise in the general level or average of

prices”. Milton Friedman has defined it as a process of “a steady and
sustained rise in prices”.

3.4 DEMAND PULL AND COST-PUSH INFLATION

In general, based on the four types of inflation, four theories of inflation

exist: a) Demand-pull inflation, b) Cost-push inflation, c) Mixed demand-
pull cost-push inflation and d) Sectoral-demand shift theory. In this unit, we
shall basically deal with the first two theories of inflation.

Demand – Pull Inflation

This type of inflation is loosely described as “too much money chasing

too few goods”. It refers to the situation where general price level rises
because the demand for goods and services exceed the supply available
at the existing prices.

Traditionally, classical economists viewed that increase in the supply

of money is mainly responsible for inflation in the economy. Thus, according
to them, rise in the price level is proportionate to the rise in quantity of
money supply. For example, an increase in the quantity of money supply by
5% raises the price level by 5%. Keynes however, rejected such direct and
proportionate relationship between the quantity of money and level of
aggregate demand. It is to be noted here that there exists three major
approaches to the demand pull theory of inflation; viz., (a) the excess demand
analysis analysis, (b) Keynes’ inflationary gap analysis and (c) Bent Hansen’s
demand inflation theory. In this unit, we shall, however, utilise only the excess
demand analysis and Keynes’ inflationary gap analysis to explain the
demand-pull theory of inflation.

Excess Demand Analysis Approach: This approach views inflation

as the process of rising prices initiated and sustained by excess of demand
for goods and services over the level of their supply. The concept can be
explained with the help of figure 3.1.

36 Macro Economics- II
Inflation Unit 3

Figure 3.1: Demand-pull Inflation

In the above figure 3.1, the price level has been shown in the Y-axis,
while real income has been depicted on the X-axis. Here, D0, D1 and D2
are the aggregate demand curves, while AS represents the aggregate
supply function. It can be seen from the figure that as the level of real
income increases, the level of aggregate demand also rises. Thus, as
real income rises from Y0 to Y1, the level of aggregate demand rises from
D0 to D1. As a result, price level increases from P0 to P1. However, it is to
be noted that, as level of aggregate demand rises as a consequence to
the rise in the level of real income,aggregate supply rises as well. Finally,
the stage comes when aggregate supply can not increase further. This is
the stage where the economy reaches the level of full employment. As
level of full employment has been reached, the level of real income can
not increase further. Thus, at this stage, supply will also not increase further;
this will make the aggregate supply curve become parallel to the Y-axis.
The significance of this situation is that given real income, any rise in
aggregate demand further will only induce the price level to rise. This is
what is known as demand pull inflation.

Cost–push Inflation

According to the cost–push inflation approach, inflation is induced

by rising costs. This approach to inflation became popular during and
Macro Economics- II 37
Unit 3 Inflation

after the World War II. The underlying idea of this approach is that inflation
may arise even in the absence of excess demand for goods and services.
Thus, this theory propagates that even in the absence of demand-pull
situations, certain factors may push-up the cost of production and this
increased cost of production may result in inflation. The factors that may
push cost of production are basically three viz., (a) increase in wage rates
(wage push inflation); (b) increase in profits (profit-push inflation) and (c)
increase in material cost (material cost -push inflation). Now, let us discuss
each of the approaches as follows:

Wage-push approach: Before discussing the wage-push approach to

inflation in detail, let us consider some of its underlying propositions. First,
this type of inflation is experienced in industries where the sellers can
exercise great discretionary control in the formulation of pricing of products
and wage rates. Secondly, increase in the wage rate is the result of
persisting pressures of trade unions (and not for increase in their
productivity). Let us suppose, the factory owner increases the price of the
final product. This may be due to the increase in the price of inputs or
increased wage rate. This increase in price of the goods and services will
adversely affect the living standard of the labours. As a result, the labour
union will pressurise the factory owner to raise their wage rate so that
their real income remains unaffected. This will further increase the price
of the goods and services; which in turn push up the price level to another
height. Thus, the inflationary process continues and at each time, the
increase in money wage and costs (i.e., cost push) will move the price
level up. Interestingly, in such movements of the price level, the pressure
of excess demand is absent all the while.

Economists point out that such type of inflation will affect employment
adversely. The higher wage rate and subsequent rise in the price level will
ultimately reduce the level of output and employment in each stage of the
cycle. This has been explained with the help of figure 3.2.

38 Macro Economics- II
Inflation Unit 3

Figure 3.2 : Cost-push Inflation

Y

P2
P1 S2
P0
S1

D0
S0
Y2 Y1 Y0
Real Income, Aggregate Demand, Aggregate Supply

From the above figure, it can be seen that the initial level of aggregate
supply and demand are represented by the curves S0S and D0 respectively.
The output and employment level at this stage is 0Y0; and the price level is
0P0. Now, as wage increases (which are basically for the pressure of the
trade union and not because of any increase in labour productivity) from S 0
to S1, the new supply curve becomes S1S. Given the aggregate demand,
this increase in wage rate will push-up the price level to 0P1. This increase
in the price level in turn reduces the level of employment from 0Y0 to 0Y1.
Again, increased price will also have unfavourable effect on the real income
of the wage earners. Thus, the trade union will further put pressure on their
employees to increase their wage rate further (such that their real income
remains unchanged). Thus, as the wage rate is increased further, the supply
curve will further shift from S1S to S2S. This will push the price level up from
0P1 to 0P2. As a result, with the level of aggregate demand remaining the
same, the level of output and employment will further decline from 0Y1 to
0Y2. Such movements in the price level cause cost-push inflation in the
economy.

This cycle is, however, likely to discontinue for an infinite period (or in
the long-run). This is because reduction in employment (or increase in
unemployment) will affect the workers and their families as well. The children
of the workers will remain unemployed. This may restrain the trade union
Macro Economics- II 39
Unit 3 Inflation

itself from pressurizing the owner to increase their wage rate further.

Profit – Push Inflation: The explanation of profit push inflation is offered

only with respect to such prices as are administratively fixed and not
market determined.In fixing administered prices, business men are
assumed to apply a markup factor to their labour and material cost per
unit of output to earn a target rate of return. Such price fixing is common
with oligopolistic firms or firms enjoying some market power in their
respective industries. When such administered prices are pushed up
due to hiked markup, it is called profit push inflation.Once started by a
few powerful firms and inducing other firms to markup their profit
margins,their material costs may go up. The speed of such increases
have been called profit-profit spiral.

Material cost – Push Inflation: The prices of some key materials such
as crude oil, steel, basic chemicals etc. may get pushed up either due
to domestic autonomous push factors or due to autonomous international
development. Such materials are used directly or indirectly almost in
the entire economy. Therefore, increase in their prices affect significantly
the cost structure in almost all industries. Consequently, whether prices
are competitively determined or determined administratively, all prices are
revised upward. Periodic increases in the prices of basic materials then
give continual boost to the general price level through the usual spread
mechanism, which is known as material cost push inflation.The Indian
economy has suffered from such material cost push inflation from time
to time, as for example, we can talk about the experience from the first
quarter of 2007 to the 3rd quarter of the calender year of 2008.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are True

(T) or False (F)
(i) Cost-push inflation is also known as “too
much money chasing too few goods”. (T/F)
..................................................................................................................

40 Macro Economics- II
Inflation Unit 3

(ii) Crowther described inflation as “a steady and sustained rise in

prices”. (T / F)
..................................................................................................................
Q.2: What do you mean by demand-pull inflation? (Answer in about
40 words).
..................................................................................................................
..................................................................................................................
..................................................................................................................

3.5 EFFECTS OF INFLATION

Inflation is not considered bad so far as it creates additional

employment for the factors of production of the economy. The evil effects
of inflation start when it fails to do so. The major effects of inflation include
the following:

z Effects on production: So far as there are unemployed resources

in the economy, a creeping inflation may induce business to invest
more. But once creeping inflation goes out of control, then it affects
production adversely. It hampers the proper functioning of the price
mechanism, capital formation in the economy. Harmful and unlawful
practices like hoarding, speculative trading, etc., on the other hand,
go up.

z Effects on distribution: Inflation also adversely affects redistribution

of income and wealth. Due to inflation, the value of money falls. This
affects the poorer section of the society more than the richer section.
Rising prices may help businessmen, hoarders, speculators and black
marketers to earn huge profits. But, it adversely affects the fixed
income earners (salaried people) and the poor section of the people.
Thus, inflation may result in redistribution of income in favour of the
richer section of the society and thus causes serious problem in social
equity and justice.

z Debtors and creditors: During inflation, creditors (who lend money)

tend to lose while the debtors (who borrow money) tend to gain.

Macro Economics- II 41
Unit 3 Inflation

This is because inflation causes decline in the value of money. When

the creditor lends money, he charges a fixed rate of interest. But as
the value of money falls, he tends to lose. For example, let us
suppose Mr. X lends Mr. Y a sum of Rs. 1000/- on 1st of January,
2008. He charges 8 percent per annum interest on it. Mr. Y repays
the money with interest on June 30, 2009. Thus, Mr. Y pays him a
total amount of Rs.1120/- (Rs. 1000/- + interest Rs.120/-) on June
30, 2009. But at the same time, the price level rises by 10 percent
per annum. This means that to purchase a product Mr. X had to pay
Rs. 1000/- in January 2008. But for the same good, he will now
have to pay Rs. 1150/- in June 2009. Thus, he loses in terms of
purchasing power of money. But contrarily Mr. Y gains. Because,
he repays back less purchasing power to Mr X.

z Farmers: Farmers tend to gain during inflation. This is because his

receipts (i.e., prices of food grains) go up. But his payments on the
other hand, remain either constant or do not increase much. When
the farmer has to pay interest on his loan previously opted during
the cultivation period, he stands to gain (as we saw in case of Mr.
Y). Similarly, if he has to pay taxes on his income, he ultimately
pays less (as the rate of tax is already fixed at the beginning of a
financial year).

z Entrepreneurs: Entrepreneurs just like as the farmers gain from

inflation. They get higher prices for their products. This increases the
profitability of the entrepreneurs and induces them to invest more.
Again, as they often undertake loans for running/expansion of the
business activities, they tend to gain from that side as well.

z Wage earners: Wage earners are hit adversely. As the rate of inflation
rises the cost of living also rises; but contrary to this the wage rate is
not raised proportionately. Again, inflation causes rise in the prices of
different commodities at different rates. Prices of some commodities
may increase more while the prices of some commodities may
increase slightly. Even when the wage rate is increased to the cost

42 Macro Economics- II
Inflation Unit 3

of living index, this is unlikely to relieve the wage earners to the

fullest. This is because the price of a very essential commodity not
included in the cost of living index may rise very high and thus, may
adversely affect the real income of the wage earners. The real value
of past savings also declines during inflation. This also adversely
affects the wage earners. Fixed income groups such as salaried and
pensioners, are the worst sufferers during inflation.Persons who live
on pensions, interest and rent suffer during the period of rising prices
because their incomes remain constant.

3.6 INFLATIONARY GAP ANALYSIS

This theory was developed by Keynes in his book, ‘How to pay for the
war’ in 1940.It is an application of the static aggregate demand model of
his general theory to the situation of inflation.The notion of inflationary gap
can be explained with the help of conventional Keynesian cross diagram.

Fig. 3.3: Keynes’Inflationary Gap

In the figure 3.3, the 45o line represents the income expenditure
identity. The aggregate expenditure in the economy is represented by
the line C+I+G. The full employment level of output or income is indicated
by the point Yf. At this level of income ,the aggregate expenditure is
more than the value of output or aggregate supply by an amount given
Macro Economics- II 43
Unit 3 Inflation

by the distance ‘ab’.Thus ‘ab’ constitutes the excess demand that pushes
up the general price level. Keynes calls this the inflationary gap.If the
economy is placed in this situation, the excess demand will continue to
cause prices to rise, because by assumption, output cannot be increased
beyond Yf.Thus, this is a demand pull inflation as prices are pulled up
by the excess demand.

3.7 POLICIES TO CONTROL INFLATION

Since inflation has many evils, every government tries to check it.
Inflation can be checked by some or all of the following measures:

z Fiscal Measures: Following fiscal measures may be adopted for

the control of inflation:

¾ Cutting down unnecessary spending: During inflation the

government should attempt to cut down unnecessary
developmental spending. This will help in curbing the additional
flow of money to the economy.

¾ Raising tax rates: Raising of tax rates especially on luxurious

commodities, the corporate tax rates etc can help in checking
inflation. At the same time, promotion of saving through the
provision of higher interest rates on savings can also help in
controlling inflationary pressure on the economy as people
will save more and spend less. Keynes in this regard
prescribed for compulsory saving (he called it ‘deferred
payment’) to increase saving and curb the money supply in
the economy.

¾ Surplus budget: Government should present surplus budget

(means collection of more revenue than expenditure) during
inflation to present a surplus budget is an important fiscal
instrument.

¾ Public debt: Postponement of repayment of public debt is

another instrument of controlling inflation. W hen the
44 Macro Economics- II
Inflation Unit 3

government postpones payment of public debt, it reduces the

volume of liquidity available in the economy.

z Monetary Measures: The following monetary measures may be

adopted for the control of inflation:

¾ Credit control: For reducing the availability of liquidity in the

economy, the central bank of the country may undertake
various credit control measures. These include raising the
bank rate and reserve ratio, sale of government securities in
the open market among others.

¾ Issue of new currency: This is an extreme measure of

monetary control. Under this system, one new currency note
is exchanged for a number of old currency notes. The value
of bank deposits is also changed accordingly. Such measure
is adopted during hyperinflation.

z Other Measures: Other important measures for the control of

inflation include:

¾ Increase in production and productivity: Increase in

production of essential commodities as well as increasing the
productivity of the production system producing such categories
of products is one important tool of controlling inflation.
Increasing the production of essential commodities will check
the price rise of the important commodities. Again, raising the
productivity will also help in reducing the cost of production.

¾ Price control: Price control (means fixing an upper limit of

the sale price) of essential commodities is another important
tool to control inflation in the economy. This helps in easing
out the inflationary pressure of the economy and in maintaining
the living standard of the people.

¾ Wage freeze policy: Sometimes a ‘wage freeze’ is

recommended to check inflation. That is, trade unions are
requested not to ask for an increase in wages during a given
period.
Macro Economics- II 45
Unit 3 Inflation

The success of the above measures in tackling inflation

depends upon the efficiency of the government in implementing
the measures.

3.8 STRUCTURAL INFLATION

The inflationary situation associated with developing countries is

known as structural inflation, because it is associated with the very structure
of such countries. In the early 1950’s different economists like Myrdal,
Streeten and several Latin American economists contributed to the concept
of structural inflation.Inflation in developed countries is related with full
employment policies and the labour market respond to these policies.But
inflation in developing countries is associated with the developmental efforts
made by such countries in order to achieve higher order of development
and the structural rigidities and bottlenecks suffered by such countries.
Also the socio-economic structure of developing countries is quite different
from that of developed countries, which also determines the source and
character of inflation in such countries.
The important causes of structural rigidities are as follows-
z Resource Gap: Developing countries cannot raise enough resources
from taxes, borrowing, and profits of state enterprises to meet the
rapidly growing public expenditure. Therefore, they depend on deficit
financing. This results in excess supply of money year after year which
fuels inflation.
z Food bottlenecks: Due to various structural factors such as defective
land ownership and tenancy, technological backwardness and low
agricultural investment; the domestic supply of food does not keep
pace with increase in demand for food due to increase in population
and urbanization. The extreme dependence of agriculture on weather
produces acute shortage of food from time to time due to drought,
wide spread floods etc. In years of food shortage , prices of food
grains rise very fast, boosted by further speculative hoarding of food
grains by traders. Food grains, being the key wage good, with increase
in their prices tend to raise other prices as well.
46 Macro Economics- II
Inflation Unit 3

z Foreign exchange Gap: The industrial development of developing

countries requires heavy import bill. But due to low exportable surplus
and relatively poor competitive power, the export earnings of these
countries do not increase very fast. Most of the occasions developing
countries face serious shortage of foreign exchange. So, the domestic
availability of goods is short and supply cannot be easily improved
through imports. As a result of that the prices of such goods increase
and the increase spread to other goods as well.

z Infrastructural bottlenecks: Due to resource and foreign exchange

gaps, inefficiency and corruption, faulty planning and implementation,
most of the developing countries suffer from serious infrastructural
bottleneck in the fields of power and transport. This holds back the
development in other sectors creating underutilized capacity in the
economy which in turn discourages further investment. In that process,
the rate of development of the entire economy gets arrested.
Therefore, even small increase in expenditure gets converted into
excess demand process and generates inflation.

z Other structural factors: It is also said that entrepreneurs in

developing countries do not possess adequate spirit of enterprise,
adventure and innovation and they prefer safe and conventional
investment. At the same time, socially unproductive, private investment
in land, precious metals etc. take away a sizeable part of investable
resources. This behavioural pattern holds back growth and prepares
the ground for inflationary forces to operate successfully.

According to the structural approach of inflation, the above factors

and similar other structural features of a developing country best explain
inflation in that country.

3.9 CONCEPT OF DEFLATION AND STAGFLATION

Deflation: Both inflation and deflation refer to the movement of prices.

Deflation is the opposite of inflation. In loose terms, it may be described as
the phenomenon of falling prices. During deflation, since prices fall faster

Macro Economics- II 47
Unit 3 Inflation

than costs, there will be heavy losses for producers and businessmen. There
will not be profits in any branch of economic activity. So there will be a fall in
investment. This results in unemployment. Crowther defines deflation as a
‘state in which the value of money is rising, i.e., prices are falling’. Keynes
developed a theoretical model explaining the various causes of deflation.
The key elements in this model can be shown with the help of the following
tree diagram 3.4:

Figure 3.4: Causes of Deflation according to Keynes

Causes of Defation

Deficient Aggregate Demand

Less Investment Expenditure Less Consumption Expenditure

Low MEC High Rate of Interest

High Liquidity Preference Less Supply of Money

Stagflation:The term ‘stagflation’ has been coined by joining together

‘stag’ of stagnation and ‘flation’ and of ‘inflation’. The term was coined
to describe a phenomenon the world witnessed during the early 1970s,
in which two paradoxical situations: inflation, on one hand and declining
output, employment and under-utilisation of productive capacity on the
other, were found to co-exist. Thus, the term stagflation is defined as
the situation in an economy in which periods of recession and rising
unemployment is coupled with positive rates of price inflation.

The phenomenon of stagflation was first witnessed in the western

countries in the 1970s. As an economic phenomenon, stagflation emerges
when sudden shock increases the costs of supply. The stagflation of the
48 Macro Economics- II
Inflation Unit 3

early 1970s was caused by the sudden increase in the oil prices enforced
by the OPEC countries. In 1973, the OPEC countries increased the oil
prices by four times. Such sharp rise in oil prices adversely affected the oil
importing countries. For example, due to such steep rise in oil prices, the
prices of manufactured goods in USA increased sharply, as a consequence,
the rate of inflation in the US economy in 1974 increased upto 12 percent.
The result was a decline of the real GNP growth rate, which further led to
high rate of unemployment in the economy, which shot upto nearly 9 percent.
This was however, not seen only in the USA, but also in the developed
economies like UK, Germany and France, etc.

These countries started to recover from such recession in 1975 and it

took a few years to recover. However, a revolution broke out in Iran in 1979
again that led to a crisis in the world oil market. This time, OPEC doubled
its oil prices. This brought back stagflation in the developed countries.

The phenomenon of stagflation, i.e., the combination of high rate of

inflation coupled with high rate of unemployment, is not easily
comprehensible from the theoretical perspectives of Economics. In fact,
this phenomenon puzzled many who believed in the theoretical framework
of the monetarists or the Keynesian economics; as both were unable to
explain this phenomenon adequately. This led to the emergence of a new
economic thought called as the ‘supply side economics’. You would be able
to know more about these concepts later on.

CHECK YOUR PROGRESS

Q.3: State whether True (T) or False (F)

(i) Inflation affects the farmers adversely.(T/F)
............................................................................................................
(ii) Wage earners stand to gain during inflation. (T/F)
............................................................................................................
(iii) Presenting a surplus budget is an important monetary policy
to curb inflation. (T/F)
............................................................................................................

Macro Economics- II 49
Unit 3 Inflation

(iv) Deflation is a phenomenon of falling prices. (T/F)

...........................................................................................................
Q.4: How are the wage earners affected during inflation?
(Answer in about 50 words)
...........................................................................................................
...........................................................................................................
...........................................................................................................
Q.5: Why and how does a debtor stand to lose during an
inflation? (Answer in about 40 words)
...........................................................................................................
...........................................................................................................
...........................................................................................................

3.10 LET US SUM UP

z Inflation is generally described as the situation when the price level

keeps on rising. It is also described as a situation where too much
money chases too few goods, resulting in an abnormal increase of
price level.

z Based on four types of inflation, four theories of inflation exist, viz.,

Demand-pull inflation, Cost-push inflation, Mixed demand inflation
and Sectoral-demand shift theory of inflation.

z Demand – Pull Inflation is loosely described as “too much money

chasing too few goods”. It refers to the situation where the general
price level rises because the demand for goods and services
exceeds the supply available at the existing prices.

z There exists three major approaches to the demand pull theory of

inflation; viz., Keynes’ inflationary gap analysis, the excess demand
analysis and Bent Hansen’s demand inflation theory.

z According to the cost – push inflation approach, inflation is induced

by rising costs. The underlying idea of this approach is that inflation

50 Macro Economics- II
Inflation Unit 3

may arise even in the absence of excess demand for goods and
services.

z Inflation also adversely affects redistribution of income and wealth.

z During inflation creditors (who lend money) tend to lose while the
debtors (who borrow money) tend to gain.

z The inflationary situation associated with developing countries is

known as structural inflation, because it is associated with the very
structure of such countries.

3.11 FURTHER READING

1) Ahuja, H.L. (2007). Macroeconomics: Theory and Policy. New Delhi:

S.Chand & Co.
2) Gupta, R. D. & Rana, A. S. (2009). Keynes and Post-Keynesian
Economics. Ludhiana: Kalyani Publisher.
3) Rana, K. C. & Verma, K. N. (2009). Macro Economic Analysis. New
Delhi: Vishal Publishing Co.
4) Shapiro, E. (1988). Macroeconomic Analysis. New Delhi: Galgotia
Publications pvt.ltd.

3.12 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: (i) False (ii) False

Ans to Q No 2: Demand – Pull Inflation is loosely described as “too
much money chasing too few goods”. It refers to the situation
where general price level rises because the demand for goods
and services exceeds the supply available at the existing
prices.
Ans to Q No 3: (i) False (ii) False (iii) True (iv) True
Ans to Q No 4: Wage earners are adversely affected during inflation.
Compared to the rate of inflation, the wage rate is not raised
Macro Economics- II 51
Unit 3 Inflation

proportionately. Even when wage rate is increased to the cost

of living index, this is unlikely to relieve the wage earners to
the fullest. The real value of past savings also declines during
inflation.
Ans to Q No 5: During inflation debtors stand to gain. This is because
by the time debtors pay back the loan amount, the value of
money declines. The rate of interest remaining the same, the
debtors transfer less purchasing power to the creditors. Thus,
the debtors gain during inflation.

3.13 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: Write a short note on inflation, deflation and stagflation.

Q 2: Briefly explain the concept of structural inflation.
Q 3: Briefly explain the various causes of inflation.
Q 4: Distinguish between the demand pull and cost-push approach
of inflation.
B. Essay-type Questions (Answer each question in about 300-500
words)
Q 1: Discuss the inflation in the framework of demand pull inflation.
Q 2: Describe the cost-push approach to inflation.
Q 3: Describe anti-inflationary measures other than fiscal measures.
Q 4: Write an essay on Policies to control inflation.

*** ***** ***

52 Macro Economics- II
UNIT 4: INFLATION AND UNEMPLOYMENT
UNIT STRUCTURE

4.1 Learning Objectives

4.2 Introduction of Philips Curve
4.2.1 Derivation of Philips Curve
4.2.2 Explanation of Philips Curve (Short Run)
4.2.3 Limitation and Policy Implication of Philips Curve
4.2.4 Causes of shift of Philips Curve
4.3 Natural Rate of Unemployment
4.4 Adaptive Expectations: Friedman’s View on Philips Curve
4.4.1 Long Run Philips Curve and Adaptive Expectations
4.4.2 Implication of Adaptive Expectation Theory
4.5 Rational Expectation Hypothesis
4.5.1 Critique and Policy Implication of Rational Expectation
Theory
4.6 Tobin’s View on Philips Curve and His Modification
4.7 Samuelson and Solow’s View on Philips Curve
4.8 Let Us Sum Up
4.9 Further Reading
4.10 Answers to Check Your Progress
4.11 Model Questions

4.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

z understand the relation between unemployment and inflation
z understand about short run and long run Philips curve
z identify the reasons of shift of Philips curve
z understand the natural rate of unemployment
z explain shifts in Philips curve owing to changes in adaptive and
rational expectations
z discuss Tobin and Solow’s modification on Philips curve.

Macro Economics- II 53
Unit 4 Inflation and Unemployment

4.2 INTRODUCTION OF PHILIPS CURVE

The early idea for the Phillips curve was proposed in 1958 by economist
A.W. Phillips. In his original paper, Phillips tracked money wage changes and
unemployment changes in Great Britain from 1861 to 1957, and found that
there was a stable, inverse relationship between money wages and
unemployment. This correlation between money wage changes and
unemployment seemed to hold good for Great Britain and for other industrial
countries. In 1960, economists Paul Samuelson and Robert Solow expanded
this work to reflect the relationship between inflation and unemployment.
Because wages are the largest components of prices, inflation (rather than
wage changes) could be inversely linked to unemployment.

4.2.1 Derivation of Philips Curve

Prof. Philips found that there existed a stable, inverse and

nonlinear relationship between the rate of change of money wage (w)
and unemployment rate (u). In other words, when unemployment is
low, wage and price level will rise; when unemployment is high, wages
will tend to fall but slowly because of downward rigidity of wage rate.
The inverse relationship between the rate of change of money wage
(or the rate of wage inflation) and the rate of unemployment became
known after his name as Philips Curve. The inverse relationship
between wage inflation and unemployment is shown in fig. 4. 1.

Fig. 4.1: Philips curve showing negative relationship between

Rate of Inflation and Unemployment
54 Macro Economics- II
Inflation and Unemployment Unit 4

On graphically fitting a curve of historical data Philips obtains a

downward sloping curve exhibiting the inverse relationship between
wage inflation and rate of unemployment. The curve is convex to the
origin which shows the percentage increase in money wages with
decrease in unemployment rate and vice-verse. In the figure, at
unemployment level 8%, inflation is 5%. If wage inflation increases to
10% unemployment decreases to 3%. The curve is not a straight line
but convex to the origin because successful reduction of
unemployment leads to progressively greater increases in wage
inflation. Similarly, to reduce wage inflation to zero high level of
unemployment is required and negative wage inflation requires very
high level of unemployment.
Philips’ basic argument was demand pull in nature. Excess
demand is backed by more employment. Excess demand in labour
market triggers off wage inflation and also determines its speed. In
the period of low unemployment, excess demand for labour exists
and labour scarcity pushes money wage upward. Similarly, in terms
of high unemployment, excess supply of labour exists and the surplus
labour drives money wages downward.

4.2.2 Explanation of Philips Curve (Short Run)

The explanations of Philips curve by Keynesian economics is

simple and illustrated in the fig. 4.2. Keynesian economics assumes
the upward sloping short run aggregate supply (SAS) curve and down
ward sloping aggregate demand (AD) curve. Keynes recognised that
the SAS curve is upward sloping in intermediate range and as the
economy approaches to near full employment the aggregate supply
curve slopes upward. According to Keynesian economists the short
run aggregate supply curve is upward sloping due to two reasons.
First, as output is increased by firms the diminishing marginal returns
to variable factors while if wage and other cost remain constant, there
is increase in marginal cost of production. The second reason is that
marginal cost goes up due to rise in the wage rate, employment and
Macro Economics- II 55
Unit 4 Inflation and Unemployment

output pressure created from aggregate demand. With the pressure

for more output, demand for labour increases and wage tends to rise.
The supply curve of labour is being upward sloping along with high
marginal cost. The equality between aggregate demand and supply
at various price level and relation between unemployment and inflation
can be explained by fig. 4.2 (panel a and b)

Fig. 4.2: Keynesian Explanation of Philips Curve

In the fig. 4.2 Panel (a) the aggregate demand (AD) and aggregate
supply (AS) curves determine the price level. The equilibrium point a,
b, c determines price opo, op1 and op2 with income level oyo, oy1 and
oy2. The increase in national income as a result of increase price
level reduces the unemployment rate in the economy. Thus the rise
in price level from opo to op1 means inflation created in the economy
result in lowering unemployment rate showing inverse relationship
between the two. Further if aggregate demand increases to AD 2 the
price level further increases to op2 and national income increases to
oy2 which will further lower the rate of unemployment. The higher the
level of AD the higher level of inflation and output and that result in
much lower rate of unemployment.
In panel (b) shows the trade off between unemployment and
inflation according to equilibrium point a, b, c of panel (a). As aggregate

56 Macro Economics- II
Inflation and Unemployment Unit 4

demand and price increases from opo to op2 unemployment decreases

from ou3 to ou1 according to the plotted Philips curve in panel (b).
Thus, down ward sloping aggregate demand curve and upward sloping
aggregate supply curve explain the downward sloping Philips curve
showing negative trade off between inflation and unemployment.

4.2.3 Limitation and Policy Implication of Philips Curve

Though, the Philips Curve suggests a stable and nonlinear trade

off between wage inflation and unemployment, the explanation has
certain limitations.
Philips Curve analysis ignores the problem of Stagflation. But
from 1967 onwards the major industrialised countries of the world
experienced both high levels of inflation and unemployment which is
known as stagflation. Theories based on the Philips Curve suggested
that this could not happen, and the curve came under a concerted
attack from the group of economist headed by Milton Friedman.
Friedman argued that the Philips Curve relationship was only a short
run phenomenon and there is no trade off between inflation and
unemployment in the long run as the economy experiences natural
rate of unemployment in the long run. Friedman Samuelson and Solow
argued that in the long run workers and employers will take inflation
in to account resulting in employment contract that increase pay at
rates near anticipated inflation. Unemployment would then begin to
rise back to its previous level, but now with higher inflation rates. This
result implies that over the long run there is no trade off between
inflation and unemployment. This implication is significant for practical
reasons because it implies that Central banks will not set
unemployment targets below the natural rates.
During the sixties the Philips Curve became an important concept
of macroeconomic analysis but the stable relationship between inflation
and unemployment could not hold good during the seventies and
eighties, especially in the United States. Therefore, experience in two
decades from 1971 to 91has promoted some economists to say that
Macro Economics- II 57
Unit 4 Inflation and Unemployment

the stable Philips Curve has disappeared. The slope of Philips Curve
appears to have declined and there has been controversy over the
usefulness of the Philips Curve in predicting inflation. In the two
decades rate of both inflation and unemployment increased i.e. a
high unemployment rate was associated with high unemployment,
which shows no trade off between the two. Fig. 4.3 shows that the
data of the United States during the seventies and eighties did not
confirm a stable Philips Curve and the Curve became disappeared.

Fig. 4. 3: Shift of Philips Curve in the United States

Apart from the limitations, the Philips Curve remains the primary frame
work for understanding and forecasting inflation used in Central bank.
Philips Curve analysis received significant attention from the policy
makers, particularly because of its explanation of the relationship
between price inflation and unemployment. Price level changes are
linked with money wage rate and inflation in such a way that Philips
Curve expressed the inverse relationship between the rate of price
inflation and the rate of unemployment. A stable Philips Curve enables
the policy makers to choose a given rate of unemployment or inflation
and enable the Govt. to maintain proper strategy or to bear the cost
for necessary action. In other words, less inflation can be possible
only at the cost of higher unemployment and lower unemployment is
possible at the cost of higher inflation.
58 Macro Economics- II
Inflation and Unemployment Unit 4

CHECK YOUR PROGRESS

Q.1: What is the relation exhibit by Philips curve

between inflation and unemployment? (Answer in
about 50 words)..
.........................................................................................................
.........................................................................................................
Q.2: What is “adverse supply shock” as explained by Keynes?
(Answer in about 50 words).
.........................................................................................................
.........................................................................................................

4.2.4 Causes of Shift of Philips Curve

There are two causes of shift of Philips curve. First, according to

Keynesians the occurrence of higher inflation rate along with the
increase in unemployment rate witnessed during the seventies and
early eighties due to price hike of petroleum products delivered to
American companies. The increase in the price of petroleum resulted
in the increase in price of all products in the market, as petroleum is
used as an energy inputs and thereby increase transportation cost
and other cost of production. The increase cost of production caused
a shift of aggregate supply curve to the leftward with high price. It is
termed as the “Adverse Supply Shock”. The adverse supply shock
raised the unit cost at each level of output as shown in fig 4.4.

Fig. 4.4: Adverse supply Shock giving rise to Stagflation and

breakdown of Philips Curve
Macro Economics- II 59
Unit 4 Inflation and Unemployment

In the fig. 4.3 Initial equilibrium point is at E. Due to adverse

supply shock the aggregate supply curve ASo shift to AS1 which
intersect the given aggregate demand curve ADo at point H. At the
new equilibrium point price increases to OP1 and decreases output to
OY1 which will cause to increases unemployment at point H.
The second reason of shift of Philips curve is the change of
adaptive expectations in the long run developed by Friedman
(explained in 4.4 and 4.4.1).

4.3 NATURAL RATE OF UNEMPLOYMENT

The natural unemployment is the rate at which the labour market and
current number of unemployment of a country is equal to the number of
jobs available. These unemployed workers are not employed for frictional
and structural reasons, though the equivalent number of jobs are available
to them. For instance, due to lack of information, lack of mobility, lack of
good utilisation of time, some workers unable to find jobs; this situation is
called frictional unemployment. On the other hand, some labour are
unemployed due to lack of training, skill, efficiency etc.in newly created job
opportunities in the growing industries; this situation is called structural
unemployment.
Thus it is this frictional and structural unemployment that constitute
the natural rate of unemployment. Full employment is said to prevail even
in the presence of natural rate of unemployment. It is generally believed
that 4 to 5 percent of unemployment represents the natural rate of
unemployment.

4.4 ADAPTIVE EXPECTATIONS: FRIEDMAN'S VIEW

ON PHILIPS CURVE

Milton Friedman provided the explanation of the occurrence of higher

rate of inflation simultaneously with higher rate of unemployment. According
to him, though there is trade off between rate of inflation and unemployment,
it is applicable only in the short run and it is not stable; and it often shifts
leftward or rightward. In the long run there is no trade off between rate of
60 Macro Economics- II
Inflation and Unemployment Unit 4

inflation and unemployment. His view is that the economy is stable in the
long run at the natural rate of unemployment. Therefore, in the long run
Philips curve is a vertical straight line. These views expounded by Friedman
and Phelps have come to be known as Friedman Phelps approach or
Acceleration hypothesis.

Friedman's explanation of shift of short run Philips curve is based on

the expectation about the future rate of inflation. People adapt their
expectations on the basis of inflation on the previous period. The adaptive
expectation according to Friedman is to change or adapt their expectations
only when the actual inflation rate turns out (exceed) from their expected
rate of inflation. Therefore, there may be trade off between rate of inflation
and unemployment in the short run but there is no trade off in the long run

Fig. 4.5: Shift of Short run Philips Curve and deriving Long run
Philips Curve
In the fig. 4.5, the economy begins with SPC1 in the short run Philips
Curve at point Ao (5% rate of inflation) corresponding to the natural rate of
unemployment 5% at point S. The nominal wage rate is determined
according to expectation such that 5% inflation will be continuing in future.
Assume that the Government adopts expansionary fiscal and monetary
policy to rise aggregate demand and cause the inflation rise to 7% given the
level of money wage rate which was fixed on the basis of 5% earlier. Philips
curve explains higher inflation and price than the expected level would raise
the profit of the firms and induced to invest more and thereby reduce
Macro Economics- II 61
Unit 4 Inflation and Unemployment

unemployment than the natural rate 5% (assume unemployment decrease

to 3.5%) and economy move to point A0 to A1in short run Philips curve SPC1.

4.4.1 Long Run Philips Curve and Adaptive Expectations

Friedman addresses the above explanation in a different way

taking into account natural rate of unemployment. He thinks that lower
rate of unemployment achieved with higher inflation is only a temporary
phenomenon. Because, when the actual rate of inflation increases
surpasses the expected rate, unemployment increases again. The
economy will not be a stable equilibrium at point A1. This is because
the workers realise that due to higher rate of inflation than the expected
rate, their real wages and income fall down. The workers will, therefore,
demand higher wage to restore their real income. Payment of higher
wage reduces the profit of the businessman. Therefore, they reduce
employment. The unemployment again increases from 3.5% to 5%
with high inflation of 7% and the economy moves from point A1 to B0.
Further at point B0 on SPC2 the actual inflation is 7%. The workers
expected that 7% inflation rate will continue further. With this
expectation, if again Government adopts expansionary policy the
economy will move to B1 on SPC2 at 9% inflation rate. The 9% inflation
rate reduces the unemployment for a short period (i.e. unemployment
reduce to 3.5%). But 9% inflation is more than expected 7% inflation;
and it will cause SPC2 shift to SPC3 to point C0 at which point the
economy experiences the natural rate of unemployment 5% at point
S in the diagram which is shown at OS level of unemployment.
By joining point A0, B0, C0 corresponding to the given natural rate
of unemployment the vertical LPC exhibits that there is no trade off
between inflation and unemployment in the long run.

The adaptive expectation theory also can be explained by the

reverse process of disinflation. Assume the economy is originally at
point C0 at 9% inflation rate and if the Govt. contract the money supply,
it will reduce the inflation rate to less than the expected 9% of inflation.
As a result profit and employment will decline as price declines more
62 Macro Economics- II
Inflation and Unemployment Unit 4

rapidly than wages. Eventually, firms and workers will adjust their
expectation and unemployment rate will be retained at the natural
rate.

4.4.2 Implication of Adaptive Expectation Theory

Adaptive expectation is an economic theory that looks at past

activity to predict future outcomes. The theory is especially concerned
with inflation rate or relationship between increase in price and
decrease is purchasing power. The effectiveness of monetary policy
can be explained with the help of Friedman Phelp's approach. The
model suggests that monetary or fiscal policy can affect employment
and output only in the short run due to error of anticipation. But in the
long run the Govt. policies will became ineffective because, firms,
businessman, consumer, workers will fully anticipate the inflation rate
and as a consequence unemployment will return back to its natural
rate.

CHECK YOUR PROGRESS

Q.3: What is Natural Rate of Unemployment?

(Answer in about 50 words)

..................................................................................................................

..................................................................................................................

..................................................................................................................

..................................................................................................................

Q. 4: Define the term Adaptive Expectation.(Answer in about 50 words)

..................................................................................................................

..................................................................................................................

..................................................................................................................

..................................................................................................................

Macro Economics- II 63
Unit 4 Inflation and Unemployment

4.5 RATIONAL EXPECTATION HYPOTHESIS

The idea of Rational Expectation was first discussed by John F. Muth

in his article, "Rational Expectations and the theory of price movements" in
1961. However, the idea was not widely used in macro economics until the
new classical revolution of the early 1970s. Later on it was popularized by
Robert Lucas (University of Chicago), Thomas Sergeant and Nail Wallace
(University of Minnesota). No doubt the theory of Rational Expectation is a
major breakthrough of macroeconomics.

According to Rational Expectation hypothesis, people have rational

expectations about economic variables. The implication of the theory is
that people make intelligent use of available information in forecasting
variables that affect their economic decisions. The forecasting variables
are unbiased and based on all available information. People use all available
information and economic theory in forecasting variables that affect
economic decisions. This implies that people understand how the economy
works and how the Govt. policies alter macroeconomic variables such as
the price level, level of employment, aggregate output etc. The theory posits
that individuals base their decisions based on three primary factors viz.

z Human rationality

z Information available to him

z Past experience.

The doctrine suggests that people's current expectations are

themselves able to influence what the future state of the economy will
become. This precept contrasts with the idea that Govt. policy influences
financial and economic decisions. Economists often use the doctrine of
rational expectation to explain anticipated inflation rate. For example if past
inflation rates were higher than expected people might consider this along
with other indicators to mean that future inflation also might exceed of their
expectations. Expectations and outcomes influence each other. There is
continual feedback flow from past outcomes to current expectations. In
current situation, the way to future unfolds from the past trends to be stable
64 Macro Economics- II
Inflation and Unemployment Unit 4

and people adjust their forecasts to confirm to stable pattern. Thus, if

individuals are expecting inflation by expansionary fiscal and monetary
policies of the Govt. then the rational expectation model can be expressed
as follows.

§ 'M ·
Pe a¨ ¸e  b(F)e
© M ¹
Where, Pe is expected rate of inflation (or price rise)

§ 'M ·
¨ ¸ is the expected rate of monetary policy
© M ¹

(F)e is the expected rate of fiscal policy

a and b are the coefficient, which indicate that the impact on the
expected money supply growth and fiscal policy will have influence on the
public expected rate of inflation.

Thus rational expectation theory involves detailed information and

clear understanding about the past, current and expected behaviour of
variables and changes in economic policies. Therefore, the theory argued
that nominal wages are quickly adjusted to any expected changes in the
price level so that there exist no Philips curve to show trade off between
rate of inflation and unemployment. The rate of inflation resulting from
increase in aggregate demand is fully corrected and anticipated by workers,
firms and businessmen and get completely and quickly incorporated into
the wage agreements resulting in higher price of product. The Fig. 4.6
shows that as price increases the level of output or real GDP (Gross
Domestic Product) remain unchanged at the natural level. The long run
aggregate supply (LRAS) curve according to the rational expectation theory
is vertical straight line at potential level of national output and the long run
Philips curve corresponds to the long run aggregate supply curve is a
vertical straight line at natural rate of unemployment as shown in figure
4.6 and 4.7.

Macro Economics- II 65
Unit 4 Inflation and Unemployment

Fig. 4.5: Inflation and National output Fig. 4.6: The long run Philips
Curve

To illustrate fig. 4.6 Yp is the level of real and potential output

corresponding to the full employment of labour (natural rate of
unemployment). LRAS is the long run aggregate supply curve at Yp level of
potential output. To begin with aggregate demand AD1 curve intersects LRAS
and SRAS curve at point A and determine price OP1. Let the Govt. adopts
expansionary monetary policy to increase output and employment and
consequently the aggregate demand curve shifts upward to the new position
AD2. According to the rational expectation theory, people (i.e. workers,
businessmen, customers, firms) will correctly anticipate with expansionary
policy and they would take promotional measures to protect themselves
against the inflation. Workers would press for higher wages and get granted,
businessman would raise the price of their product, and financial institutions
increase their rates of interest. All of these increases would take place
immediately. The expansionary monetary policy finally leads to higher
aggregate demand AD2 and will cause new equilibrium to shift at point C. At
new equilibrium point C, price will increase to OP3 while real national income,
real wage rate, real interest rate remain unchanged.

It is to mentioned that like Friedman's adaptive expectation theory in

rational expectation doctrine the economy does not move temporarily
66 Macro Economics- II
Inflation and Unemployment Unit 4

equilibrium position from position A to position B in the short run along with
short run aggregate supply curve SRAS1. When aggregate demand shift
from AD1 to AD2 short run supply curve immediately shifts from SRAS1 to
SRAS 2 such that immediate and quick adjustment takes place with
anticipated rate of inflation. Therefore, according to the rational expectation
theory long run aggregate supply LRAS curve will be a vertical straight line
at potential level of national income YP. Since, the (LRAS) curve is vertical
in the long run, the long run Philips curve (LRPC) will also be a vertical
straight line at the natural rate of unemployment UN as shown in the fig. 4.7.
The long run Philips curve shows the relationship between inflation and
unemployment when the actual inflation rate equals to anticipated (i.e.
expected) rate of inflation.

4.5.1 Critique and Policy implication of Rational

Expectation theory

The rational expectation theory is not free from critique and policy
implications, some of such critique and policy implications are
mentioned below:

The most important critique of rational expectation doctrine is

ineffectiveness of fiscal and monetary policies in reducing
unemployment. The basic idea is that a predictable attempt to stimulate
the economy would be known in advance, and it would have no effect
on the economy which is represented as a policy ineffectiveness of
the Government.

To ignore the role of capital and money in economic decisions is

the weak point of rational expectation theory because, the theory is
not concerned about the capital accumulation, inventories, taxes and
money behaviour in economic activities. Thus it is essentially a
classical type of model in which there is sharp division between real
and monetary phenomenon.

To be rational, expectation should be unbiased. People's

expectation should be based on all possible relevant information. But

Macro Economics- II 67
Unit 4 Inflation and Unemployment

expectations are not directly observable. In reality, it is not possible to

have unbiased expectations especially when information is costly.

The theory of rational expectation gained its importance in recent

years. Many economists have viewed on the basis of this expectation
concept that people can set their expectations about the accuracy of
inflation forecasts or change in the government policy correctly. Rational
expectation hypothesis claims that government policies are effective in
the short run because people cannot form their expectations correctly.
But people can correctly anticipate about the government's policy
change in the long run and hence it is ineffective in the long run. Thus
the theory succeeds in putting serious question in front of policy makers.
The rational expectation theory threw a challenge to the Philips curve
analysis of the short run trade off between inflation and unemployment
that Philips curve analysis is partial succeed in solving two main
problems of inflation and unemployment in the economy only in the
short run but ineffective in the long run.

CHECK YOUR PROGRESS

Q.5: What is the Rational Expectation? (Answer

in about 50 words).

........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................
Q.6: What is the shape of long run aggregate supply and Philips
curve according to Rational Expectation hypothesis? (Answer in about
50 words).
........................................................................................................
........................................................................................................
........................................................................................................
........................................................................................................

68 Macro Economics- II
Inflation and Unemployment Unit 4

4.6 TOBIN'S VIEW ABOUT PHILIPS CURVE AND HIS

MODIFICATION

In 1971, Jams Tobin, in his Presidential address in "American

Economic Association" compromised between negative sloping and vertical
Philips curves by different shape. Tobin believes that there is a limit in
Philips curve. Because, as economy expands employment grows and the
curve becomes more fragile and vanishes until it becomes vertical at some
critical rate of unemployment. Thus Tobin Philips curve is of kinked shape
of which one part is like normal Philips curve and the rest is vertical as
shown in fig. 4.8.

Fig. 4.8: Tobin modified Philips curve

In fig. 4.8 Uc is the critical rate of unemployment at which the Philips
curve became vertical and there is no trade off between unemployment
and inflation. According to Tobin the vertical portion of the curve is not
due to increase demand for more wages but due to the imperfections in
the labour market. The critical rate of unemployment is the rate at which
there is no possibility of more employment in the economy because of
imperfections in labour market. These imperfections emerge due to job
seekers have wrong skill, wrong age, wrong sex, or may be the wrong
place etc. On the other hand, the downward portion is like the normal
properties in Philips curve.

Macro Economics- II 69
Unit 4 Inflation and Unemployment

For Tobin, there is a wage change floor in excess supply situation.

In the range of relatively high unemployment to the right of critical rate of
unemployment, the inflation increases the involuntary unemployment and
wage floor market gradually diminishes. When all sectors of labour market
are above the wage floor the level of critically low rate of unemployment
Uc is reached.

4.7 SAMUELSON AND SOLOW'S VIEW ON PHILIPS

CURVE

Paul Samuelson and Robert Solow extended the Philips curve to

the trade off between unemployment and level of price (Inflation). Thus
the Philips curve suggests that unemployment can be reduced by having
more inflation and vice versa.

Samuelson Solow Philips curve provided economic rationale for

expansionary Government policies in 1960s that the unemployment rate
could be lowered with small rise in inflation. Their contribution played an
important role in the great inflation that occurred in the United States during
1960 and 1970.

Samuelson and Solow in their research paper published in 1960 in

'American Economic Review and Proceedings' presented the result of
Philips type of relationship (hand drew curve) for United States. The notion
of Samuelson Solow Philips curve was first advanced as a policy tool with
attractive option of pursuing expansionary and fiscal policy which rise
inflation and lower unemployment. Like Philips curve trade off between
nominal wage and unemployment, Samuelson Solow estimated their curve
trade off between inflation and unemployment by using 25 years of data
from 1934 to 1958. This relationship, which looks like that of what Philips
curve reported for 1861 to 1913 and 1948 to 1957 periods, is downward
sloping and nonlinear. Samuelson and Solow called it the Philips curve.

70 Macro Economics- II
Inflation and Unemployment Unit 4

Fig. 4. 9: Samuelson Solow Philips Curve (1934 - 1958)

Samuelson and Solow interpreted their statistical Philips curve as a
structural relationship that had the potential of offering menu of exploitable
trade off between inflation and unemployment. However they warned that
the trade off may not be sustainable i.e.the Philips curve might shift. This
message seemed to quickly lost when in 1961 Samuelson incorporated
the Philips curve in to the 5th edition of his Economics text introducing the
notion of an inflation-unemployment trade off and again as reported by
Leeson, (1997) in an interview in mid-1960s Samuelson and Solow
themselves seemed to downplay the possibility of an unstable Philips curve.
At the same time they argued that an unemployment rate of about 4% is
a reasonable and prudent full employment target for stabilization policy.

Thomas E. Hall and William R. Hart (Miami University) in their

working paper (2010) presented that Samuelson and Solow Philips curve
was neither statistical nor structural. Samuelson Solow provided no
empirical estimates of the Philips curve in their celebrated 1960 paper.
Instead they simply hand-drew a line they believed fit the data for the 25
years period from 1934 - 1958. By using same data of the period 1934 -

Macro Economics- II 71
Unit 4 Inflation and Unemployment

1958 Thomas E. Hall and William R. Hart estimated Philips curve and
and it turned out that the new curve bore small resemblance to their hand-
drawn curve and provided little support for a menu of lower unemployment
and higher inflation trade off.

Like Tobin, in the long run, Solow does not believe that the Philips
curve is vertical at all rates of inflation. According to him the curve is
vertical at positive rate of inflation and it is horizontal at negative rate of
inflation (at the time of deflation) as shown in fig. 4.10.

Fig. 4. 10: Solow's modified Philips curve

In the fig. 4.10 on the basis of Philips curve LPC wage rate is starkly
downward even in the face of heavy unemployment or at the time of deflation.
But at a particular level of unemployment when the demand for labour
increases and wage rises in the face of expected inflation the Philips curve
became vertical at minimum level of unemployment (which unemployment
level is mentioned as critical by Tobin and as natural unemployment by
Friedman) and there is no trade off between unemployment and inflation.

The vertical Philips curve has been accepted by the majority of

economist. They agree that at unemployment rate about 4% the Philips
curve becomes vertical and the trade off between unemployment and
inflation disappears. It is impossible to reduce unemployment below this
level because of market imperfections.

72 Macro Economics- II
Inflation and Unemployment Unit 4

CHECK YOUR PROGRESS

Q.7: State the view of Tobin about Philips Curve.

(Answer in about 50 words).

.........................................................................................................
.........................................................................................................
.........................................................................................................
.........................................................................................................
Q.8: What is meant by critical rate of unemployment? (Answer in
about 50 words).
.........................................................................................................
.........................................................................................................
.........................................................................................................
.........................................................................................................
Q.9: Mention is Solow's view about Philips Curve. (Answer in about
50 words).
.........................................................................................................
.........................................................................................................
.........................................................................................................
.........................................................................................................

4.8 LET US SUM UP

z The Philips Curve states that there is an inverse relationship between

inflation and unemployment. Higher inflation is associated with lower
unemployment and vice verse.

z A stable Philips Curve enables the policy makers to choose a given

rate of unemployment or inflation and enables the Govt. to maintain
proper strategy or to bear the cost for necessary action. In other words,
less inflation can be possible only at the cost of higher unemployment
and for lower unemployment is possible at the cost of higher inflation.

Macro Economics- II 73
Unit 4 Inflation and Unemployment

z Philips curve in the light of consumer and workers expectations in

explaining the relationship between inflation and unemployment may
not hold good in the long run.

z Stagflation occurs when an economy experiences stagnant economic

growth, high unemployment and high price inflation. This scenario
directly contradicts the theory behind the Philips curve.

z The increase in cost of production caused a shift of aggregate supply

curve to the left with increase in price. It is called the "Adverse Supply
Shock". The adverse supply shock raised the unit cost at each level
of output and are responsible for the shift of Philips curve.

z The natural unemployment is the rate at which the labour market and
current number of unemployment of a country is equal to the number
of jobs available. It is generally believed that 4 to 5 percent of
unemployment represents the natural rate of unemployment.

z The adaptive expectation hypothesis proposes that people adjust their

future behaviour and expectations based on recent past experience
and behaviour.

z The effectiveness of monetary or fiscal policy can be explained with

the help adaptive expectation approach. The model suggests that
monetary or fiscal policy can affect employment and output only in
the short run due to error of anticipation. But in the long run the Govt.
policies will became ineffective because of anticipation of inflation
and as a consequence unemployment will return back to its natural
rate.

z The rational expectation theory involves detailed information and clear

understanding about the past, current and expected behaviour of
variables and changes in economic policies.

z Then rational expectation doctrine suggests that the economy does

not move temporarily equilibrium position in the short run along with
short run aggregate supply curve as explained in adaptive expectation
hypothesis. According to rational expectation hypothesis, when
aggregate demand shifts upward in the short run supply curve
74 Macro Economics- II
Inflation and Unemployment Unit 4

immediately shifts upward such that immediate and quick adjustment

takes place in the economy with anticipated rate of inflation.

z The long run Philips curve shows the relationship between inflation
and unemployment when the actual inflation rate equals the
anticipated (i.e. expected) rate of inflation.

z Tobin's view on Philips curve is that as economy expands employment

grows and the Philips curve becomes more fragile and vanishes until
it becomes vertical at some critical rate of unemployment. Thus Tobin
Philips curve is of kinked shape of which one part is like normal Philips
curve and the other part is vertical.

z Like Tobin, Robert Solow does not believe that the Philips curve is
vertical at all rates of inflation. According to him the curve is vertical at
positive rate of inflation and it is horizontal at negative rate of inflation.

4.9 FURTHER READING

1) Ahuja, H.L. (2015). Macro Economic Theory and Policy. New Delhi : S.
Chand & Company Ltd.
2) Chopra, P. N. (2011). Advanced Economic Theory Micro and Macro.
New Delhi: Kalyani Publishers. 12th Edition.
3) Seth, M. L. (2010). Macro Economics. Laxami Narayan Agarwal
Educational Publishers (LNA).
4) http://www. investopedia.com
5) http://www. investopedia.com
6) http//en.m.wikipedia.org
7) http://www. investopedia.com
8) http//www. Economicshelp.org>blog
9) http://www.fsb.miamioh.edu/fsb/ecopapers/docs/hallte-2010-08-
paper.pdf
10) https://www.economics.ox.ac.uk/department-of-economics-discussion-
paper-series/economists-on-samuelson-and-solow-on-the-phillips-
curve
Macro Economics- II 75
Unit 4 Inflation and Unemployment

4.10 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: Prof. Philips found that there existed a stable, inverse and
nonlinear relationship between inflation and unemployment. The
Philips curve is convex to the origin which shows increase in
inflation with decrease in unemployment rate and vice verse.
Ans to Q No 2: The adverse "supply shock" is a situation of shift of aggregate
supply curve to the left with high price due to increase in cost of
production. The adverse supply shock raised the unit cost at
each level of output and result in the occurrence of higher inflation
along with higher unemployment.
Ans to Q No 3: The natural unemployment is the rate at which the labour
market and current number of unemployment of a country is equal
to the number of jobs available. These unemployed workers are
not employed for frictional and structural reasons. It is generally
believed that 4 to 5 percent of unemployment represents the
natural rate of unemployment.
Ans to Q No 4: The adaptive expectation is the expectations on the basis
of inflation on the previous period. The adaptive expectation
according to Friedman is to change or adapt their expectations
only when the actual inflation rate exceeds their expected rate of
inflation.
Ans to Q No 5: The rational expectation is the anticipation about the future
state of the economy. The implication of rational expectation is
that people make intelligent use of all available information that
affects their economic decisions from past to present and from
present to future.
Ans to Q No 6: The long run aggregate supply (LRAS) curve according to
the rational expectation theory is vertical straight line at potential
level of national output and the long run Philips curve
corresponding to the long run aggregate supply curve is a vertical
straight line at natural rate of unemployment.
76 Macro Economics- II
Inflation and Unemployment Unit 4

Ans to Q No 7: According to Tobin, as economy expands employment

grows and the Philips curve becomes more fragile and vanishes
until it becomes vertical at some critical rate of unemployment.
Thus Tobin Philips curve is of kinked shape of which one part is
like normal Philips curve and the other part is vertical.
Ans to Q No 8: The critical rate of unemployment is the rate at which there
is no possibility of more employment in the economy because of
imperfections in labour market. These imperfections emerge
because job seekers have wrong skill, wrong age, wrong sex, or
may be the wrong place etc.
Ans to Q No 9: Robert Solow believes that the Philips curve is vertical at all
rates of inflation. According to him the curve is vertical at positive
rate of inflation and it is horizontal at negative rate of inflation.

4.11 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: What is meant by Philips curve? What kind of trade off between

unemployment and inflation rate does it imply?
Q 2: Write a note on natural rate of unemployment.
Q 3: Define short run and long run Philips curve.
Q 4: What modifications are made by Tobin on the Philips curve?
Q 5: Write a note on Solow's view on the Philips curve.
B. Long Questions (Answer each question in about 300-500 words)
Q 1: Explain the improvements of Philip curve by Friedman, Tobin and Solow.
Q 2: What is meant by adaptive expectation? Explain how Friedman
proves that short run Philips curve is downward sloping while in the
long run Philips curve is vertical.
Q 3: What is meant by rational expectation? Explain briefly the rational
expectation hypothesis.
Q 4: What is meant by rational and adaptive expectation? Explain how
the rational expectation hypothesis differs from adaptive expectation
hypothesis.
*** ***** ***
Macro Economics- II 77
 UNIT 5: BUSINESS CYCLE
UNIT STRUCTURE

5.1 Learning objectives

5.2 Introduction
5.3 Theories of Business Cycle
5.3.1 Schumpeter's Theory of Business Cycle
5.3.2 Kaldor's Model of Business Cycle
5.3.3 Samuelson's Model of Business Cycle
5.3.4 Hicks' Theory of Business Cycle
5.4 Control of Business Cycles
5.5 Relative Efficiency of Monetary and Fiscal Policies
5.6 Let us Sum Up
5.7 Further Reading
5.8 Answers to Check Your Progress
5.9 Model Questions

5.1 LEARNING OBJECTIVES

After reading this unit the learner will be able to

z understand about business cycle
z explain the theories of business cycle propounded by
Schumpeter, Kaldor, Samuelson, and Hicks
z know about economic policies and its applicability in different
phases of business cycle.

5.2 INTRODUCTION

The business cycle is also known as economic cycle or trade cycle

which shows the upward and downward movement of economic activity
that an economy experiences over a long period of time. The fluctuations
or the upward and downward movement of the economic activities are
usually measured in terms of the growth rate of real gross domestic product.
A typical Business Cycle is characterised by five different stages or phases-
78 Macro Economics- II
Business Cycle Unit 5

---- depression, recovery, prosperity, boom and recession. All these five
stages have different characteristics or features. Some stages are favourable
for the economy while some are not. By using the monetary and fiscal
policies it is possible for the economy to attain a favourable economic stage.
Various economists had provided different theories of business cycle. So
this unit mainly tries to cover the theories of business cycle and steps which
are taken for controlling it.

5.3 THEORIES OF BUSINESS CYCLE

Out of the all business cycle theories some theories are remarkable.
Following are the important theories developed by economists from time to
time to explain the phenomenon of the business cycle.

5.3.1 Schumpeter's Theory of Business Cycle

The name of Joseph Schumpeter is associated with the

innovations theory of trade cycle. According to him, innovations are
the cause of cyclical fluctuations. But the question here is what
innovation he refers to. Innovation should not be confused with
inventions. An invention is an act of bringing ideas together in a novel
way to create something that did not exist before. On the other hand,
innovations simply indicate the commercial application of new
techniques of production, new materials and new methods of
organisation and management. Schumpeter assigns the role of
innovator to an entrepreneur who has revolutionary attitudes and
capacity to take new factor combinations, new methods or techniques,
new products, new ideas for innovating the business activity.

Initially when a few innovators begin investment in the risky new

ideas, the cyclical upswing process starts gradually in the economy,
assuming full employment situation. Once the initiative is taken by a
few leaders and becomes successful and profitable then the other
entrepreneurs follow it in an increasing number and the path gets
progressively smoothened for successors by an accumulation of
Macro Economics- II 79
Unit 5 Business Cycle

experience and removals of obstacles. The innovating entrepreneur

is financed by the expansion of bank credit. Such 'swarm like cluster'
appearance of the entrepreneur raises the demand for existing
productive resources which raises their prices and money income
and helps to create a cumulative expansion throughout the economy.
With the increase in the purchasing power of consumers, the demand
for the consumer goods increases in relation to supply. Consequently,
price and profit of the industries increase and so they expand their
industries by borrowing more from the banks.Such over optimistic
and speculative thought leads to credit inflation or boom situation.
After a period of gestation, when the new products flow into the
market, disequilibrium exists in the economy as it displaces the
previous products. The demand for previously produced goods are
decreased and as a result prices of the products fall. So the firms
contract their output and some are even forced to run into liquidation.
In such unfair economic situation if repayment of loan is made then it
causes deflationary effects. The quantity of money is decreased and
prices tend to fall. Profits decline whereas uncertainty and risk
increases in the economy. The strong wish for innovation is reduced
and eventually comes to an end. As a result depression occurs and
the process of re-adjustment begins to achieve a new point of
neighbourhood of equilibrium. This is the recovery process. Once the
equilibrium is restored the economy is set for a new wave of innovation
and a repetition of the same trade cycle.
Thus, in Schumpeter's trade cycle theory the innovative
entrepreneur plays a very important role to bring upswing stage in the
economy through innovation and the bank credit helps them to fulfil
their desires; once the upswing ends, the downswing begins and
reached full-fledged depression situation. After that, recovery process
starts to achieve a new point of neighbourhood of equilibrium.
The main weaknesses of Schumpeter's theory are - a) It is based
on unrealistic assumption of full employment of resources to begin
with (b) Schumpeter gives too much importance to bank credit although
80 Macro Economics- II
Business Cycle Unit 5

it has limiting role in the long run when the need for capital funds is
much higher (c) Innovation is also not the only cause of cyclical
fluctuation as natural financial reasons also cause fluctuations in the
economy.

CHECK YOUR PROGRESS

Q.1: Mention the various stages of Business Cycle.

(Answer in about 20 words)

.........................................................................................................
.........................................................................................................
Q.2: What is the inherent meaning of Innovation according to
Schumpeter? (Answer in about 20 words)
.........................................................................................................
.........................................................................................................

5.3.2 Kaldor's Model of Business Cycle

Nicholas Kaldor's model of business cycle is based on Keynes

saving-investment analysis and makes both the saving and investment
dependent on the level of output and stock of capital. Symbolically,
dl dS
I = I (Y, K), ! 0 and S = S (Y, K), !0 ;
dY dY
where I is investment, S is saving, Y is income and K is capital stock.

Kaldor believes that both the saving as well as the investment

functions are non-linear in nature. A non-linear investment function
conforms more closely with the investment behaviour during the course
dl
of business cycle. The is very low at low levels of income. During
dY
the mid range of income, the entrepreneurs like to increase the volume
dl
of investment and at relatively high levels of income the value of
dY
dS
reduces. Similarly, in case of saving function, the tends to increase
dY
at an increasing rate at very high levels of income. During the mid
range of income, saving will increase at some normal rate and at very
low levels of income savings will greatly be depleted and may even
Macro Economics- II 81
Unit 5 Business Cycle

dS
be negative so that when expansion starts, is expected to be
dY
relatively large.

Now, equilibrium national income requires the equality of saving

and investment. Equating Kaldors' saving and investment functions,
logically there are three possible equilibrium points exist, which is
shown below in the diagram.

S
B
I

O Income
Yo Y1 Y2

Fig. 5.1: Possible equilibrium points

In the above Fig. 5.1, points A and B are the stable positions of
equilibrium while C represents an unstable position. If Y<Yo or Y1 < Y
< Y2 , then I > S which causes the level of Y to rise. If Y >Y2 or Yo <Y<
Y1, then S > I, which decreases the income level. If income is Y1 then
a slight fall in income will initiate the process of contraction until Yo is
reached. Similarly if a slight disturbance causes income to rise above
Y1, a process of expansion will be initiated that will come to be
terminated at Y2 stable equilibrium position.

But Kaldor asserts that both these two positions (i.e.; A and B)
are stable only in the short period; not in the long period. To start with,
let us assume that the economy is enjoying high employment and
output at point B (equilibrium point). Here, both the saving and
investment are high. As the capital accumulates, the rate of profit
declines and the investment schedule shifts downward. And the point
B coincides with the point C, as shown in the fig. 5.2.
82 Macro Economics- II
Business Cycle Unit 5

Fig.5.2: Capital accumulation, Fig.5.3: Capital

unstable equilibrium and depletion, unstable
depression equilibrium and boom

At the point C-B in figure 5.2, the equilibrium is unstable. So the

economy moves to the point A, where the output and employment
are low i.e.; depression.

At point A, income is low. As capital stock starts depleting, the

investment schedule shifts up. After a while, points A and C coincide
(shown in Fig. 5.3). With further depletion of capital, the economy
will experiences a strong boom and reach point B. Thus, from this
analysis it is found that the forces of saving and investment not only
arrest depression but lead the system onwards through expansion.
This model is an endogenous self-generating model of cyclical
fluctuations.
The main weakness of this model are - (a) it overlooks the working
of the accelerator or the multiplier-accelerator interaction, (b) it
ignores the impact of monetary forces on business variations, (c) it
does not involve the impact of business expectations upon economic
cycles.

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Unit 5 Business Cycle

CHECK YOUR PROGRESS

Q.3: State the nature of investment and saving

function used in Kaldor’s model. (Answer in about
40 words)
.........................................................................................................
.........................................................................................................
.........................................................................................................
.........................................................................................................

5.3.3 Samuelsons' Model of Business Cycle

Samuelson developed a three sector closed economy model

where he shows how the interaction between multiplier and accelerator
causes cyclical fluctuations in economic activities. Mathematically,
this can be represented as-

Yt = Gt + Ct + It ....................... (1)
Ct = DYt-1 ....................... (2)
lt E(C t – C t 1 ) ....................... (3)

Here Y t is National income or output, Gt is Autonomous

government expenditure, Ct is induced consumption expenditure, It is
induced private investment, D is marginal propensity to consume, E
is the accelerator and 't' represents the time period.
Now, lt E( D Yt 1 – D Yt  2 ) .................. (4)
Since Ct is the f(Yt-1), Ct-1 is the f(Yt-2)
Putting the value of equation (2) and (4) in equation (1)
Yt G t  D Yt  E( D Yt 1  D Yt  2 )

G t  D Yt 1  DE Yt 1 – DE Yt  2 )

G t  Y t  1 (1  E ) D  D E Y t  2

With different values of D and E , various super multiplier effectss

can be noted and these values will cause different types of fluctuations.
Samuelson has described the different types of fluctuations in four
different regions, given the different magnitude of D and E . Figure
84 Macro Economics- II
Business Cycle Unit 5

5.4 depicts the four regions of movements which the economy passes
-- Region-A, Region-B, Region-C and Region- D.

Fig. 5.4: Regions of economic fluctuations

In the diagram, the horizontal axis represents E and the
vertical axis represents D . Region A is relevant when D is 0.5
and E is 0. The growth in income is simply due to the multiplier
effect. Region B is relevant when D is 0.5 and E is equal to 1. It
shows the situation when constant continual autonomous spending
dampens the fluctuations of national income. Region C is relevant
when D is 0.6 and E is 2. This region represents the explosive or
ever increasing fluctuations situation due to a constant level of
autonomous spending. If D is 0.8 and E is 4 then Region D is
relevant. Here, a constant level of spending causes an ever
increasing national income approaching a compound interest rate
of growth. Even a single dose of investment likewise will make the
system move into infinity at a compound interest rate of growth.
This model provides a simple and logical explanation of the
essential mechanism of the business cycle. So it has a great appeal
for the economists.
Macro Economics- II 85
Unit 5 Business Cycle

This model is criticised because it rests upon crude and

mechanical concepts of multiplier and accelerator and also because
of the assumed constant values of D and E , which is not true in
actual reality. This model fails to state the periodicity of business
cycle and do not prescribe the ceiling and floor limits of the
fluctuations. Samuelson also assumed closed economy. He did not
analyse the cyclical variations in an open economy.

CHECK YOUR PROGRESS

Q.4: Under what background has Samuelson’s

model been criticised? (Answer in about 30 words)

.........................................................................................................
.........................................................................................................
.........................................................................................................

5.3.4 Hicks' Theory of Business Cycle

The business cycle model of Hicks is regarded as the modified

version of Samuelsons' business cycle model. According to Hicks'
model, the autonomous investment (through the multiplier) and
induced investment (through the accelerator) cause cyclical
fluctuations in business activity. Suppose due to spurt of autonomous
investment the equilibrium situation of an economy is suddenly
disturbed.Then the income and output will expand to the degree
indicated by the multiplier. Such expansion will result in induced
investment via the accelerator which further increases the income
(multiplier) and further induce investment (accelerator) and so on. In
this upswing stage, the income and output rises faster than the
equilibrium rate. This process of rising income and output will continues
till it reaches the Upper limit or Ceiling determined by full employment.
As it hit the ceiling, their expansionist force is bound to be checked.
As a result, the mechanism of multiplier-accelerator works in reverse
86 Macro Economics- II
Business Cycle Unit 5

order which reduces income, output, investment etc. The output may
plunge downward below the equilibrium level to a greater extent than
it rose above it on account of the reverse working of the multiplier and
accelerator.

Hicks' theory can be explained with the help of fig. 5.5

Fig. 5.5: Fluctuation of business activity in between

ceiling and floor line
In the diagram, Y-axis represents the national income and
investment and X-axis represents time. AA line indicates that the
autonomous investment grows annually at a rate given by the slope
of AA. LL line is the floor-line. The line EE shows the equilibrium time
path of national income determined by investment and accelerator.
FF line represents the full employment ceiling or maximum output
line at any period of time. The economy starts from E and moves
along the path EE. Let the economy reach the point P0 along the EE
path. At this point, suppose there is outburst of investment which
pushes the economy above the EE path after the point Po. This
increase in income will cause further increase in income due to
Macro Economics- II 87
Unit 5 Business Cycle

combined effect of multiplier and accelerator. As a result the economy

moves along the time path P0P1 and inevitably stops at P1 because
P1 is located on the FF line which is the full employment ceiling.
From the P1 of FF line, the economy creeps along the FF line at the
same rate at which the autonomous investment increases and reaches
P2. Since the national income has now ceased to grow at a rapid
rate, therefore, the national income moves downward to EE from P2.
The fall in national income will not stop on touching the line EE, but
will continue moving downwards, till it reaches the point Q1. But it will
not slip down beyond Q1, because the floor has now been reached.
The economy may creep along the LL from Q1 to Q2. Once again
there is a growth in the national income and the economy moves in
the upward direction towards Q3 and the full employment ceiling. In
this way, the multiplier and accelerator cause fluctuations in the
economy. In brief this is Hicks' theory of business cycle.

CHECK YOUR PROGRESS

Q.5: What is meant by Autonomous Investment?

(Answer in about 20 words)

.........................................................................................................
.........................................................................................................

5.4 CONTROL OF BUSINESS CYCLES

To control the business cycles, the following steps can be undertaken-

z Monetary Policy: The monetary authority (i.e., Central bank) has the
power to influence upon the supply, cost and availability of money to
ensure a more efficient operation of the economic system. For
realisation of this the authority deliberately used the monetary
instruments like bank rate, open market operations, reserve
requirements and quantitative credit control method. In the upswing
state of the trade cycle, generally the higher prices, higher profits and
an optimistic outlook among the agent are the basic features; while in
88 Macro Economics- II
Business Cycle Unit 5

the downswing stage of the trade cycle lower prices, lower profits and
pessimistic outlook are the basic characteristics. Thus, some steps
should be taken to check and control such situation. So far as money
supply is concerned in the upswing stage, it is needed to check the
undue expansion of money (like issue of new notes) in proper and
adequate way. And, for curbing the excess supply of credit, the central
bank uses both the quantitative and qualitative monetary instruments.
The Central bank favours to raise the rate of interest by modifying its
bank rate and sale the government securities in the open market
operation to reduce the availability of money in the economy. On the
contrary, in the downswing stage the monetary instruments are used
to adequately expand the credits. Thus, monetary policy has an
important part to play in curbing cyclical business fluctuations and
contributing to economic stability.
z Fiscal Policy: Needless to say, the role of government has been
increasing in today's globalised society. For achieving the higher levels
of growth and economic stability, the government has started
employing the various fiscal instruments, namely, taxation, government
spending and borrowing. Keynes and his followers have recommended
compensatory fiscal policy to bring stability in the business activity.
If the business activity shows signs of slacking down, the government
should at once enforce the three instruments of fiscal policy to check
down-trend and ensure stability in the economy. The government does
not impose any new taxes on the people; even the existing taxes
should be substantially reduced for encouraging the people to spend
and buying additional goods. The government also increases its
expenditure by taking various public works programme. In this way
government tries to offset the deflationary effect on the economy.
Public borrowing policy is also used to fight depression and
unemployment. On the other hand, if the economy recovers and retains
a position towards prosperity then the government should follow
exactly the opposite policy. That is, government should raise the tax
rate and also impose new taxes, favour to reduce the government
expenditure programmes etc.
Macro Economics- II 89
Unit 5 Business Cycle

z Automatic Stabilizers: An automatic stabilizer or built in stabilizers

is an economic shock-absorber that helps smoothing the cyclical
business fluctuations on its own accord, without requiring deliberate
action on the part of the government. The personal income tax,
unemployment insurance benefits, agricultural price support etc. are
some examples of automatic stabilizers. Suppose income level
declines, then taxes fall and consumption expenditures increase
automatically. On the opposite, if income expands, then the tax level
increases and the consumption expenditures decline automatically.

CHECK YOUR PROGRESS

Q.6: Mention two instruments of monetary policy.

(Answer in about 20 words)

.........................................................................................................
.........................................................................................................

5.5 RELATIVE EFFICIENCY OF MONETARY AND

FISCAL POLICIES

Although both the policies are useful and helps to fight economic
cycles to establish stabilization in the economy, but in relative sense their
efficiency level is different in different economic situations.

z Monetary Policy: There has been widespread belief among the

academicians and the policy framers that the monetary policy during
depression is almost ineffective and helpless. It fails to pull the
economy out of depression by lowering the rate of interest or injecting
cash and often liquid asset.
During the period of depression, it is necessary to invest in more
productive and risky asset to expand the economic activities but due
to prevalence of uncertainty and general panic situation in the
economy, the firms and individuals are not interested to invest in risky
assets; instead they prefer less and more liquid asset.

90 Macro Economics- II
Business Cycle Unit 5

But the effectiveness of monetary policy is much greater in the

inflationary situation. By adapting the anti-inflationary monetary policy
(the reduction of money supply and increase in the rate of interest) it
is possible to control the Aggregate Demand, which is a major factor
of inflation.
A combination of light money and credit measures may keep the
system in equilibrium at full employment without inflation. This is shown
in Fig.5.6

1 0

Fig. 5.6: Effectiveness of monetary policy

In the diagram (Fig: 5.6), OX and OY represents income and
rate of interest respectively. When the LM0 and IS intersect each other,
the original equilibrium income OY0 exceeds full employment income
OYf.
Y0 Yf is the inflationary gap. A contractionary money supply shifts
LM function to LM1 so that equilibrium gets determined at full
employment income OYf and interest rate increases from r0 to r1. In
this way full employment situation is established.
Fiscal policy: It refers to the use of government spending and tax
policies to influence the economic conditions. During recession or
depression, the government must adopt a deficit budget policy by
Macro Economics- II 91
Unit 5 Business Cycle

reducing the rate of tax or by increasing the government expenditure.

Such an increase in government expenditure as well as reduction in
tax rate helps to increase the aggregate demand in the economy. As
a result deflationary gap vanishes and the economy achieves the full
employment equilibrium position.

Fig.5.7: Effectiveness of fiscal policy in Deflation

Suppose the equilibrium level of the economy decreases from
the full employment equilibrium point E2 to E1 due to reduction of
investment level. Now if the government intends to overcome this
situation then the level of government expenditure must have to
increase an equal amount of deflationary gap (E1B). As a result AD1
curve shifts upward to position AD2 and the equilibrium level of income
will increase to the full employment income YF and the economy will
be out of depression.
On the other hand, in the inflationary situation it is needed to
increase the tax rates along with the reduction in government
expenditure to wipe out inflationary pressure completely.

92 Macro Economics- II
Business Cycle Unit 5

National Income

Fig.5.8: Effectiveness of fiscal policy in Inflation

In figure: 5.8, at point E1 full employment equilibrium level is
attained. If due to increase in consumption and investment
expenditure, the AD1 curve shifts to AD2, then AE2 amount of
inflationary gap arises. By reducing the government expenditure or
by increasing the tax rate, it is possible to decrease the aggregate
demand curve from AD2 to AD1. As a result the economy is restored
at the full employment level OYF.

CHECK YOUR PROGRESS

Q.7: What is meant by inflationary gap? (Answer

in about 20 words)

.........................................................................................................
.........................................................................................................

5.6 LET US SUM UP

z The business cycle shows the upward and downward movement of

economic activity that an economy experiences over a long period of
time.
Macro Economics- II 93
Unit 5 Business Cycle

z A typical Business Cycle has five different stages or phases–depression,

recovery, prosperity, boom and recession.

z Schumpeter shows the upswing and downswing of economic activity

in terms of innovations.

z Nicholas Kaldor's model of business cycle is based on Keynes saving-

investment analysis and believes that both the saving as well as the
investment functions are non-linear in nature.

z Samuelson developed a three sector closed economy model where

he shows how the interaction between multiplier and accelerator causes
cyclical fluctuations in economic activities.

z Hicks believes that the autonomous investment and induced investment

cause cyclical fluctuations in business activity.

z The monetary authority (eg. RBI) adopts monetary policy by using

monetary instruments like bank rate, open market operations, direct
control, etc. On the other hand, the government of a country uses the
fiscal policy and used taxation, government spending and borrowing
as fiscal instruments.

z Both monetary and fiscal policy along with automatic stabilizer helps
to maintain business stability of an economy.

5.7 FURTHER READING

1) Gupta, K. R.; Mandal, R. K and Gupta, A. (2008). Macro Economics.

5th Revised and Enlarged Edition.
2) Mankiw, N.G. (2012). Macroeconomic. New York: Worth Publisher. 8th
Edition.

3) Rana, K.C. & Verma, K. N. (2009). Macroeconomic Analysis. New

Delhi: Vishal Publishing Co.

94 Macro Economics- II
Business Cycle Unit 5

5.8 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: A typical Business Cycle is characterised by five different

stages or phases- depression, recovery, prosperity, boom and
recession.
Ans to Q No 2: By innovation, Schumpeter means the introduction of
something new that changes the existing methods of production.
Ans to Q No 3: Kaldor in his model asserted that both the saving as well as
the investment functions are non-linear in nature. A non-linear
investment function conforms more closely with the investment
behaviour during the course of business cycle.
Ans to Q No 4: Samuelson's model is criticised because it rests upon
crude and mechanical concepts of multiplier and accelerator and
also because it assumed constant values of D and E, which is
not true in actual reality.
Ans to Q No 5: If investment does not depend either on income/output or
the rate of interest, then such investment is called Autonomous
Investment.
Ans to Q No 6: The two instruments of monetary policy are bank rate and
open market operations.
Ans to Q No 7: According to Keynes, the excess Aggregate Demand over
Aggregate Supply after the full employment is regarded as
inflationary gap.

5.9 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: What are the main objectives of economic policy?

Q 2: Why do Hicks use ceiling line and floor line in his model?
Q 3: State two differences between Monetary and Fiscal policy.
Macro Economics- II 95
Unit 5 Business Cycle Business Cycle

Q 4: How can business cycles be controlled?

B. Long Questions (Answer each question in about 300-500 words)
Q 1: Write a short note on the Schumpeter's theory of innovation.
Q 2: Explain Kaldor's model of Business Cycle with diagram.
Q 3: Discuss Samuelson's theory of Business Cycle.
Q 4: Hicks's model is regarded as modified version of Samuelson's
business cycle model. Discuss.
Q 5: How is fiscal policy helpful to curb inflationary situation? Explain
with diagram.
*** ***** ***

96 Macro Economics- II
UNIT 6: SUPPLY SIDE ECONOMICS
UNIT STRUCTURE

6.1 Learning objectives

6.2 Introduction
6.3 Failure of Keynesianism
6.4 Features of Supply Side Economics
6.5 Critical Evaluation
6.6 Let Us Sum Up
6.7 Further Reading
6.8 Answers to Check Your Progress
6.9 Model Questions

6.1 LEARNING OBJECTIVES

After going through this unit you will be able to-

z know the loopholes of Keynesian Economics
z understand the reasons behind the emergence of Supply Side
Economics
z explain the main features of Supply Side Economics.

6.2 INTRODUCTION

John Maynard Keynes’ General Theory marks a turning point in

intellectual history. In less than a decade since its publication, the numerous
converts to Keynesianism attained dominance in both the academic and
political realms. Their hold on these positions has, since the 1970’s,
weakened under the combined force of theoretical criticisms and practical
failures.

After the failure of demand-side economics due to the economic

problems, alternative economic theories and policies appeared in the late
1970’s and 1980’s. Mainly, monetarism, rational expectations theory, public
choice economics, Neo-Austrian economics and supply-side economics
criticized the Keynesian economics and suggested new remedies to the
Macro Economics- II 97
Unit 6 Supply Side Economics

economic problems. Supply-side economics made a critique of the Keynes’

Law, which means that “demand creates its own supply.” In contrast, it
defended the idea of “supply creates its own demand”, popularly known as
Say’s Law. The present unit highlights this economic theory which focused
on the effects of fiscal policy on incentives and relative prices in order to
provide high GNP and government revenues.

6.3 FAILURE OF KEYNESIANISM

Critics have been arguing that the Keynesian theory is doomed in

practice because the idea of ‘giving spending money to some people’ in the
form of government jobs or directly as transfer payments and welfare and
then borrowing the necessary funds from savers is like a zero-sum exercise,
resulting in no addition to aggregate demand.

According to Prof. Schlesinger, “Overall demand is of course to some

extent affected by relations on the supply side; Keynes’ treatment of demand
was thus over simple in that it neglected the possibility that the relative
prices prevailing in the different sectors determine in-part the total amount
of outlays.”

Professor Don Patinkin believes that Keynes’ treatment of the

aggregate supply function has some inherent defects. The aggregate supply
is considered as stable during the short run. Moreover, the representation
of the aggregate supply curve by the 45 degree line in the Keynesian cross
diagram conveys the meaning that “demand creates its own supply.”

Conversely, it implies that the aggregate supply is ruled by aggregate

demand. According to Patinkin, “this line of reasoning is yet another facility
by product of the usual Keynesian neglect of the supply side of the
commodity market.”

Another condemnation of the Keynesian economics is that it is

appropriate to the short run. Keynes therefore assumed a given stock of
capital tool; active practice, choices and behavior of the people, organization,
and dimension of populace etc. But all these aspects vary during the short
run. This makes Keynes’ study imaginary.
98 Macro Economics- II
Supply Side Economics Unit 6

Monetarists claim that monetary policy is the real driver of the business
cycle. Monetarists like Milton Friedman blame the Depression on high-
interest rates. They believe expansion of the money supply will end
recessions and boost growth.
Socialists criticize Keynesianism because it doesn’t go far enough.
They believe that the government should take a more active role to protect
the common welfare. This means owning of some factors of production.
Most socialist government owns the nation’s energy, health care, and
education services.
Even more critical are communists. They believe that the people, as
represented by the government, should own everything. The government
completely controls the economy.
Austrians are more critical of government intervention. They argue
that government intervention only prevents the private sector dealing with
the disequilibrium.
In the 1950s and 60s, Keynesian demand management was in vogue,
as governments appeared to have a choice between unemployment and
inflation. However in the 1970s, there was a period of stagflation (higher
inflation and higher unemployment). It appeared to the critics of Keynesian
demand management that policies to boost demand were only aggravating
inflation and not reducing unemployment in the long-term. To monetarist
critics, such as Milton Friedman, the better policy was to target low inflation
and accept that there may be a temporary period of unemployment.
Friedman and other ‘supply-side economists’ tended to focus on supply-
side reforms to increase market efficiency and reduce imperfections in labour
markets (such as minimum wages and labour markets). A number of
economists including Arthur Laffer, Paul Craig Roberts, Norman Ture,
Michael Evans, Alan Reynolds, George Gilder, Robert Mundell, Jude
Wanniski, etc.contributed to this theory.
Supply-side economists say that increasing business growth, not
consumer demand, will boost the economy. They agree the government
has a role to play, but fiscal policy should target companies. They rely on
tax cuts and deregulation.
Macro Economics- II 99
Unit 6 Supply Side Economics

CHECK YOUR PROGRESS

Q.1: Name some economists who had contributed

to the Supply-Side Economics. (Answer in about
30 words)
.........................................................................................................
.........................................................................................................
.........................................................................................................

6.4 FEATURES OF SUPPLY-SIDE ECONOMICS

Supply-side economics (SSEs) is a relatively new term which came

into use in the mid-1970s as a result of the failure of Keynesian demand-
side policies in the US economy which led to stagflation. Supply-side
economics is based on two propositions- first, full faith in the validity of
Say’s Law of Markets and secondly, a believe that tax rates are the prime
determinant of incentives, which in turn, are the prime determinant of
production.
Supply-side economists insist on the validity of Say’s Law because it
will be possible to explain how the economy works by approaching it from
the viewpoint of aggregate supply rather than aggregate demand.
When we talk of supply-side economics, it means impacting the
aggregate supply curve by modernization, rationalization, skill formation,
liberal depreciation, reorganization and cost reduction. Modern supply-side
economics lays emphasis on providing all types of economic incentives to
raise aggregate supply in the economy. The essential argument of supply-
side theory is that adding to supply unlike adding to demand is not a zero-
sum task.
The most common theme of Supply-side economics is the
responsiveness of work, productivity, saving, investment and enterprise to
after-tax rewards. High tax rates are opposed because they discourage
economic activity; divert resources to tax- shelter industries and tax-exempt
goods; drives economic activity underground; induces tax evasion and
encourages smuggling and fraud; and causes the disintegration of the moral
100 Macro Economics- II
Supply Side Economics Unit 6

values of the nation. Supply-siders argued that high tax rates collect tiny
revenues; Laffer’s Curve graphically shows that a 100 percent tax rate will
collect no revenue and it is illustrated in the Fig. 6.1 below:

Fig. 6.1: Laffer’s Curve

According to economist Arthur Laffer, there is a close relationship
between tax rates, revenues and productivity. When the tax rate is 100
percent, all revenue cease; people will not work for nothing. On the other
hand, if the tax is zero, there is no government. At the left hand side of the
scale, the government imposes no taxes on income and so gets no revenues.
Moving right along the scale, as the tax rate increases, so do the revenues.
Thus, Laffer Curve is a graphical representation of the disincentives created
by high tax rates which is an essential element of the theory of Supply-side
Economics.
The government’s role is limited to liberalising markets, reducing taxes
and freeing the labour market. The main objectives of supply-side policies
are to keep inflation at a low level, achieve and maintain full employment
and attain faster economic growth. Supply-side economists suggest the
following policy measures in order to achieve these objectives.

z Tax-induced Change in Aggregate Supply: An important feature of

Supply-side economics is the issue of incentives and tax cuts. Supply-
Macro Economics- II 101
Unit 6 Supply Side Economics

siders treat incentives as the main engine of growth as it energies the

economic system. To assess the likely effects of tax reductions, they
distinguish between income and substitution effects of a cut in the
marginal rate of income tax.
The substitution effect of a wage cut induces people to work
more and have less leisure, and the income effect causes people to
work less and enjoy more leisure. It is only when the substitution
effect of a tax cut is larger than the income effect that there will be an
incentive to work more, thereby leading to reduction in unemployment.

Thus supply-side tax cuts by raising work, effort, saving and

investment, increase the supplies of labour and capital and shift the
aggregate supply curve to the right. The effect of a supply-side tax
cut is illustrated in Fig. 6.2 where AS is the aggregate supply curve
and AD is the given demand curve.

Real output or GDP is measured along the horizontal axis and

the price level on the vertical axis. AS and AD curves intersect at
point T and determine OP price and OQ real output of the economy.
Suppose there is a tax cut both on persons and firms. This increases
work effort and saving on the part of workers and investment by firms.

AS AS1

P T
C
P1
AD

O Q Q1
Real output
Fig. 6.2: The effect of a supply-side tax cut
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Supply Side Economics Unit 6

As a result, supplies of labour and capital increase which shift

the aggregate supply curve AS to the right as AS1. Now the AS1 curve
cuts the AD curve at point C. As a result, the price level falls to OP1
and the real output increases to QQ 1 as a result of a tax cut.
Similarly, reduction in corporate tax rates, by giving incentives to
the corporate sector in the form of increasing tax credit for larger
investment and providing higher depreciation allowance, encourage
investment. Higher investment leads to the production of more goods
and services per unit of labour and capital.
z Increasing Growth Rate: According to supply-side economists, tax
cuts increase the disposable income of the people who raise additional
demand for goods and services. On the other hand, the faster growth
in productivity leads to the production of additional goods and services
to match the additional demand.
This leads to balanced growth in the economy without shortages.
When the economy is moving towards balanced growth, the rate of
inflation is low. This, in turn, leads to an increase in the real disposable
income of the people which raises consumption, output and
employment.
Low inflation leads to increase in net exports which strengthens
country’s foreign exchange reserves and BOP Current Account. The
increase in productivity increases the production of more goods for
export, thereby further strengthening the country’s foreign earning.
Thus supply-side economists advocate reduction -in tax rates in order
to increase the incentives to work, save and invest and to get more
tax revenue by the government. Increase in investment leads to an
increase in the economy’s capital stock, to increase in productivity, to
larger output, low inflation, high level of employment and high growth
rate of the economy.
These policy prescriptions shift the aggregate supply curve of
the economy to the right. This is illustrated in Fig. 6.3 where AS is the
aggregate supply curve and AD is the given aggregate demand curve.
They intersect at point E which is the initial equilibrium point of the
economy with OP price level and OQ real output.
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Unit 6 Supply Side Economics

Real output
Fig. 6.3 : Shifting of aggregate supply curve of the economy
Suppose the supply-side policies increase the total supply of
factors like labour and capital due to tax policies, incentives, etc. They
increase real output and shift the AS curve to the right as AS1. The
new equilibrium is at where the AS1 curve cuts the AD curve. Now
real output increases to OQ1 and the price level falls to OP1 thereby
increasing the growth rate of the economy.

CHECK YOUR PROGRESS

Q.2: What is meant by Laffer curve? (Answer in

about 20 words)

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Q.3: What is meant by supply- side economics? (Answer in about
30 words)
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6.5 CRITICAL EVALUATION

The above prescriptions of supply-side economics have been criticized

by economists on the following grounds:

z Laffer Curve Controversial: The Laffer curve is an interesting but a

controversial concept. No one knows with certainty either the location
of the optimum point or the exact shape of this curve. The curve may
peak at 40% or 90% tax rate, or it may peak in-between these rates.

z Tax Cuts not Dependable: Tax changes have both income and
substitution effects. The Supply-side Economics assume that the
substitution effects will dominate over income effects. But there is
absolutely no ground for such an assumption. The effect of tax cut on
savings, investment, output, a tax revenues, will very likely vary
between countries and over time within a given country for various
reasons including cultural factors, level of current tax rates, inflation
and the investment climate.

z No Trickle down Effects and Rise in Income Inequalities: Tobin

asserts that, “The only sure results of supply-side policies are
redistributions of income, wealth, and power- from government to
private enterprises, from workers to capitalists, from poor to rich.”
Supply Side Economists are not averse to this result. They assert
that such redistribution will, in the long-run, benefit the immediate
losers as well as the beneficiaries. This is the famous ‘trickle down’
theory. Hans Singer argued that automatic ‘trickle down’ is most
unlikely because there is unequal access to the opportunities of
producing or obtaining the income incremental GNP. Richer groups
have privileged access, and so the larger slice goes to them, creating
sharper inequalities.

z Weak as a Theory of Underdevelopment: From the angle of

underdevelopment, the most objectionable parts of the SSE arguments
are (i) neutral role of government; (ii) small size for the public sector;
and (iii) support for the maintenance of the existing inequalities.
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z Supply-side Policies fail to bring Social Justice: Supply-side

economists emphasize that reduction in social spending, subsidies,
grants and budget deficit with reduction in taxes. But such a policy
has actually led to huge budget deficits in the United States. Further,
the policy of reducing social spending, subsidies and grants adversely
affects the poor and unemployed and fails to bring social justice.

6.6 LET US SUM UP

z Monetarism, rational expectations theory, public choice economics,

Neo-austrian economics and supply-side economics criticized the
Keynesian economics and suggested new remedies to the economic
problems.
z Friedman and other ‘supply-side economists’ tended to focus on supply-
side reforms to increase market efficiency and reduce imperfections in
labour markets.
z The most common theme of Supply-side economics is the
responsiveness of work, productivity, saving, investment and enterprise
to after-tax rewards.
z An important feature of Supply-side Economics is the issue of incentives
and tax cuts.
z The Laffer curve is an interesting but a controversial concept.

6.7 FURTHER READING

1) Gupta, K.R., Mandal, R.K. & Gupta, A. (2008). Macro Economics. New
Delhi: Atlantic Publishers & Distribution (P) Ltd. 5th Revised & Enlarged
Edition.
2) Keleher, R.E. (1982). Historical Origins of Supply - Side Economics.
Economic Review, Federal Reserve Bank of Atlanta.
3) Paul, R.R. (2007). History of Economic Thought. New Delhi: Kalyani
Publishers.
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Supply Side Economics Unit 6

6.8 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: The economists who had contributed to Supply-Side

Economics include Arthur Laffer, Paul Craig Roberts, Norman
Ture, Michael Evans, Alan Reynolds, George Gilder, Robert
Mundell, Jude Wanniski, etc.
Ans to Q No 2: Laffer Curve is a graphical representation of the disincentives
created by high tax rates.
Ans to Q No 3: Supply-side economics means manipulating the aggregate
supply curve by modernization, rationalization, skill formation,
liberal depreciation, reorganization and cost manipulation.

6.9 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: Mention the two propositions on which supply-side economics is

based.
Q 2: State the main features of supply side economics.
Q 3: According to economist Arthur Laffer, there is a close relationship
between tax rates, revenues and productivity. Explain the statement.
B. Long Questions (Answer each question in about 300-500 words)
Q 1: Discuss the reasons for the failure of Keynesianism.
Q 2: Explain the Laffer Curve with suitable diagram.
Q 3: Explain the criticisms against supply-side economics.

*** ***** ***

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 UNIT 7: MONETARISM VS KEYNESIANISM
UNIT STRUCTURE

7.1 Learning Objectives

7.2 Monetarism Vs Keynesianism
7.3 The Monetarist View
7.3.1 Increase Money Supply and Price: Monetarist View
7.4 The Keynesian View
7.4.1 Effect of Money Supply: Keynesian View
7.4.2 Ineffectiveness of Monetary Policy: Keynesian View
7.4.3 Money Supply and Price: Keynesian View
7.5 Policy Implication of Monetarism and Keynesianism
7.5.1 Keynesianism
7.5.2 Monetarism
7.6 Policy Differences of Keynesianism and Monetarism
7.6.1 Policy of Keynesianism
7.6.2 Policy of Monetarism
7.7 Crisis in Keynesian Economics and Revival of Monetarism
7.8 Fiscal and Monetary Policy Mix and Growth
7.9 Let Us Sum Up
7.10 Further Reading
7.11 Answer to Check Your Progress
7.12 Model Questions

7.1 LEARNING OBJECTIVES

After going through this unit, you will be able to learn-

z understand about Keynesian and Monetarist view about money
z understand about short run and long run effect of money supply
in the economy
z identify the factors influencing interest rate and price from the
approaches of Keynesianism and Monetarism
z enable to understand the effectiveness of monetary policy at
liquidity trap
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Monetarism Vs Keynesianism Unit 7

z enable to understand crowding out effect of government

expenditure
z enable to understand effectiveness of fiscal and monetary policy
in different economic situations i.e. inflation and deflation
z understand the differences and policy mix of fiscal and monetary
policy.

7.2 MONETARISM VS KEYNESIANISM

The two most prominent theories of macro economics to emerge

during the 20th century are the Keynesianism (1883 – 1946) and the
Monetarism (1912 – 2006). Keynesian thoughts trace back to the early part
of the century as a response to panic of 1914 and First World War and the
Monetarist theory arose in the later decades by Milton Friedman following
the great depression and Second World War. Each theory attempts to explain
the fundamental derives of the economic cycle and to prescribe the best
policies to restore growth during recession and depression. While both
theories aim to achieve the same goal, each of them focus on fundamentally
different economic phenomenon. Monetarism relates to the money matters
of a country and hold that monetary policy is a more potent instrument than
fiscal policy in economic stabilisation. The key focuses of Monetarism are
Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), money supply,
exchange rate or the function of Central bank etc. On the other hand,
Keynesianism believes that “money does not matter” for economic
stabilisation. The fiscal policies i.e. government intervention, investment,
taxes, policies etc. are more powerful tools than monetary policy.

7.3 THE MONETARIST VIEW

Monetarism is an economic theory that says that money supply is the

most important instrument of economic growth. As money supply increases
in the economy people’s demand increases, producer produce more and
create job opportunities. The monetarist emphasises on the role of money
in explaining the short term changes in national income. They warn that the

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increasing money supply only provides temporary boost to economic growth

and job creation but in the long run it increases inflation as demand outstrips
supply. Monetarism argues that the role of money has been neglected by
Keynes. They hold that all recession and depression are caused by severe
contraction of money and credit and booms influenced by excessive supply
of money. Friedman and monetarist economist focus on keeping inflation low
and stable by controlling the money supply. The greatest danger of an
economy is felt when the money supply falls too low or rise too high for a
given economic environment. When the inflation is too high the money supply
should be decreased such that with less money circulating supply and demand
principle bring inflation back down to lower level. In the opposite scenario of
liquidity crisis monetarist think that the monetary base should be expanded
to prevent damaging deflationary spiral. As a result in both cases, interest
rate will move to appropriate level to either encourage or discourage borrowing,
keeping aggregate demand and aggregate supply in balance.
According to monetarists money supply is the determinant of the level
of output and prices in the short run and the level of price in the long run. In
the long run the level of output is not influenced by supply of money. It is
dependent on real factors such as technology quantity and quality of
productive resources etc. The money supply is the only determinate factor
of price level and output in the short run. But in the long run the affect of
money supply is directly related to price level, because in the long run, the
economy is near full employment and an increase in money supply tend to
increase price level. Thus changes in money supply affect national income
directly. The monetarist holds that the rate of interest has no part in
determining the demand for money. The demand for money is the transaction
demand for money which is direct function of the level of income. They
believe that money supply is also not determined by rate of interest. The in-
sensitiveness of demand and supply of money to rate of interest is based
on the quantity theory of money. The simplest equation of quantity theory
of money is PT=MV (P = Price level, M = Quantity of money, V = Velocity of
circulation of money, T = Number of physical transactions). Taking PT =Y
(Y = National income) the equation becomes MV = Y; if V remain constant
income changes with changes in quantity of money.
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Monetarism Vs Keynesianism Unit 7

The concept of demand for money to hold as put forward by Friedman

can be written as

Md = KPy

Where Md = Demand for money or cash balances to hold.

K = Proportion of national income, people desired to hold in the form

of money or cash balances.

Py = National income which is obtained by multiplying price (P) with

real income (y).

Monetarists believe that demand for money holding depends on the

real rate of interest, inflationary expectation and frequency of payments.
The higher the rates of interest the lesser is the amount of money people
want to hold. Similarly, with inflationary pressure they would spend more
money and increase the frequency of payments and velocity of money and
vice verse. Given frequency of payments, interest rates people desire to
hold money (Md) in cash balances of nominal income can be explain in fig.
7.1.

Fig. 7.1: Determination of Nominal income and Money Demand

In the fig. 7.1 the money demand curve Md is drawn from the origin
and it explains the amount of money people want to hold for transaction
purpose at various nominal income level. The Md curve being an upward
sloping straight line implies that public demand for money is a constant
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Unit 7 Monetarism Vs Keynesianism

function of K = 1/V (K = Portion of nominal income held in the form of real

cash balances i.e. Md = KPy). The vertical MS is the money supply curve,
and it shows that given amount of money supply OM is fixed in the economy.
The demand and supply of money are in equilibrium by intersection of MS
and Md curves at point E (Md = Ms = KPy) which determine equilibrium level
of nominal income equal to PoYo . At P1Y1 level of income money supply is
more (Ms > KPy) and people start to spend their excess money till income
increases to equilibrium level PoYo. On the other hand, when income level is
P2Y2 there is shortage of money supply (Ms < KPy) and people start reducing
their spending such that income decreases to equilibrium level.

Friedman holds that the demand for money is a stable function of

income and money is the good substitutes for all types of asset i.e. bond,
securities, and all types of durable goods. Therefore, people want to hold
certain fixed amount of their income. If central bank increases money supply
it affects interest rate in three different ways.

z Liquidity effect: When money supply increases it will cause short

run reduction of interest rate and people sell their securities and their
holding of money increases. People therefore expend their excess
money balances to financial asset or consumer durable goods.

z Output effect: When people starts spending their excess money

balances due to liquidity effect production, income and employment
increases in the economy.This will tend to increase interest rate and
price.

z Price expectation effect: When interest rate and price rise due to
output effect the interest rate in the economy further tends to increase
because of expected inflation or expectation of higher price in future.
The money lender charge higher interest rate to cover expectation of
price hike.

Thus the liquidity effect in the short run tend to downward pressure to
interest rate on the one hand but the output and price expectation effect
bring upward pressure to rise interest rate on the other hand. The combined
effect will pressure an increased interest rate in the economy. These will in
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turn discourage investment and reduce output and employment. The

combined effect of liquidity, output and price expectation can be explained
by fig. 7.2.

Money demand and supply

Fig. 7.2: Effect of Money Supply and Interest Rate
In fig. 7.2 demand and supply of money measured in OX axis and
interest rate is measured on OY axis. The Md1 money demand curve and
M1 money supply curve intersect each other at point E indicate equilibrium
level of interest rate OR. If the Central bank increases money supply the M1
curve shift to M2 and new equilibrium is reached at point E1. The new
equilibrium tends to decrease interest rate to OR2. At this point people start
spend their excess money due to liquidity effect which will tend to increase
price income, output and employment in the economy.As a result the demand
of money curve shifts to Md2 from Md1. The new Md2 curve intersects M2
money supply curve at point E2 and reach new equilibrium and take interest
rate to a higher at OR1.

7.3.1 Increase Money Supply and Price: Monetarist View

According to monetarist an increase in money supply in the

economy affect price level and national income. Consider the equation
of monetary equilibrium
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Unit 7 Monetarism Vs Keynesianism

Md = Ms = KPy

Ms = KPy

P = Ms/Ky

Now if K and Y remain constant price is directly proportional to

money supply. This is the view point of old quantity theory of money
which believes that velocity of money (V), in other words K = 1/V, and
real income are constant. Monetarists stress that K and V are stable;
the real GNP will change if the economy is working below the full
employment level. The increase in money supply (constant K or V)
leads to increase in output or income more than the rise in the price
level (P). But in the long run aggregate supply curve is vertical straight
line at full employment level of output and at this situation an increase
in money supply will cause rise of price level and inflation in the
economy. Fig. 7.3 explains monetarist view about the relation between
money supply and price level.

Fig. 7.3: Money Supply and level of price

In the diagram 7.3 in panel (a) let supply of money increases
from OM1 to OM2 causes increase nominal income from P1Y1 to P2Y2.
Thus people will be induced to spend the excess money supply and
thereby raise aggregate demand for goods and services and tend to
shift AD1 to AD2 and result increase in price level from OP1 to OP2
with increases real national income from OY1 to OY2 in panel (b).

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Monetarism Vs Keynesianism Unit 7

But in the long run at full employment level of output the aggregate
supply curve is a vertical straight line and real income becomes
constant. At full employment level of output any further increase in
money supply will cause a rise in aggregate demand and thereby
increase price level and thus brings about a rise in nominal income.

CHECK YOUR PROGRESS

Q.1: What are the key focuses of monetarism?

(Answer in about 50 words)..

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Q.2:What is liquidity, output and price expectation effect as explained
by monetarism? (Answer in about 50 words).
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7.4 THE KEYNESIAN VIEW

The Keynesian economy is a demand side economy that believes

that the economy is best controlled by manipulating the demand for goods
and services. However, the economists of Keynesianism do not completely
disregard the role of money supply in affecting gross domestic product
(GDP). Keynesianism emphasises the role of fiscal policy to stabilise the
economy and suggests that raising of the government expenditure in
recession will help in quicker economic recovery. Keynes holds opposite
views of the monetarists about the demand and supply of money and
aggregate expenditure. But demand and supply of money is monetary
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Unit 7 Monetarism Vs Keynesianism

phenomena and highly interest elastic while aggregate expenditure is not.

People want to hold a certain portion of their income and wealth in liquid
form so that it can be ready to use as a means of payment of buying goods
and services. The demand for money, also called liquidity preference, is
desire to hold cash. There are three motives to hold cash i.e. transaction,
precautionary and speculative demand for money. Money held for transaction
and precautionary motives is increasing function of income and represented
by (M1). Money held for speculative motive is decreasing function of rate of
interest and represented by (M2).

Thus,Md = M1 + M2 (Md = Money demand)

M1 = L1(Y)...................(1)

M2 = L2 (r)...................(2)

Where L1, L2 represent demand function, Y = Income, r = Interest rate.

Since Md = L1(Y) + L2 (r)

To the Keynesians it is the expectation about changes in bond prices

or in the market rate of interest which determines the speculative demand
for money. The speculative demand for money is decreasing function of
rate of interest. The higher the rate of interest the lower the speculative
demand for money and vice verse. But at very low rate of interest speculative
demand for money is perfectly elastic and people want to keep money in
cash rather than invest in bonds asset.

In order to explain the relation between demand for money and interest
rate Keynes assumes two asset economies.

z Money is the form of currency and demand deposit in the banks which
earn no interest.

z Long term bonds where rate of interest and bond prices are inversely
related. When rate of interest goes up the price of bond and securities
decreases and vice verse. The demand for money by the people
depends upon how they decide to balance their portfolio between
money and bonds. This decision is influenced by two factors. The
higher the level of income people hold the more money remains in
their portfolio balance and the higher the rate of interest the lower the
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Monetarism Vs Keynesianism Unit 7

demand for money for speculative motives. Because higher interest

rate means higher opportunity cost for holding money.

7.4.1 Effect of Money Supply - Keynesian View

Keynes believes in the existence of an economy below full

employment equilibrium. This implies that an increase in money supply
can bring about increase in level of output. The ultimate influence of
money supply on the price level depends upon its influences on
aggregate demand and the elasticity of supply of aggregate output.
Thus if the rate of interest is reduced as a result of increase in money
supply, the rate of investment increases and thereby increases income
with activation of multiplier. If this happens there will be an increase in
aggregate expenditure and aggregate demand and as a result real
national income (aggregate output) increases. The relation between
increase in money supply and rate of interest and effect on investment
can be explained in fig. 7.4 and 7.5

Fig. 7.4: Increase in money Supply and rate of Interest

Rate of interest according to Keynes is a purely monetary
phenomenon. Demand for money to hold depends on the level of
income and rate of interest. At the lower rate of interest demand for
money is high and vice verse. Therefore, money demand curve (MD)
slopes downward as shown in fig. 7.4. The rate of interest Oi0 is
determined according to point E0 at the initial stage by equality between
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Unit 7 Monetarism Vs Keynesianism

demand and supply of money. The OM1 money supply is fixed by

monetary authority.Therefore MS1curve is vertical. Now if central bank
increases money supply by purchasing government securities from
the market money supply curve will shift to MS2 and new equilibrium
will be reached at point E1 and rate of interest will decrease to Oi1.
Decrease of interest rate to Oi1 encourages investment demand in
the market and as a result investment increases from OIo to OI1 as
shown in fig. 7.5.

Fig.7.5: Rate of Interest and Investment

The second phase of change of rate of interest as a result of
changes of money supply affects on investment of the economy.
According to Keynes, investment of an economy depends on the rate
of interest on one hand and marginal efficiency of investment (MEI)
on the other hand. The marginal efficiency of investment depends on
the expectations of entrepreneurs. It is worth mentioning that the
increase in investment as a result of change in the rate of interest
depends on the responsiveness (that is elasticity) of investment
demand to the change in the rate of interest. The higher the elasticity
of investment expenditure to the changes in the rate of interest, the
greater will be the increase in investment for a given fall in the rate of
interest.
The third phase of effect of money supply on the national income
and price level with impact of increase in investment and aggregate
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Monetarism Vs Keynesianism Unit 7

demand. The aggregate demand (AD) is determined by the sum of

private consumption expenditure (C), private investment expenditure
(I), government expenditure on goods and services (G) and Net
exports (NX).

Thus AD = C + I + G + NX

When, the rate of interest is reduced money supply increases

causing investment to increase and thereby increase in national
income in the economy which can be explained by fig. 7.6.

Fig.7.6: Aggregate Demand and National Income

In the fig. 7.6 the investment demand curve C + I 1 + G + Xn (AD)
and aggregate supply curve OZ intersect each other and determine
equilibrium at point at E where OY1 national income is determined. If
government adopts expansionary monetary policy interest rate will
decrease and aggregate demand curve (AD) will shift upward to C +
I2 + G + Xn. The new aggregate demand curve equates with aggregate
supply curve at point H and tends to increase income to OY2.

Finally, the effect of increase in investment and aggregate

demand on real national income (GNP) depends on the size of the
multiplier. The size of multiplier depends on the marginal propensity
to consume (MPC) of the community. The higher the MPC the higher
the size of multiplier (Multiplier (K) = 1/1 – MPC) and the higher the
level of income as a result of given investment.

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Unit 7 Monetarism Vs Keynesianism

7.4.2 Ineffectiveness of Monetary Policy: Keynesian View

It is to be noted that Keynesians were not very optimistic about

the success of expansionary monetary policy in lifting the economy
out of depression. They point out that there is chain causation in the
process of increase in money supply leading to the rise in aggregate
demand. When the economy is in great depression the rate of interest
already prevails at low level.Therefore interest rate is not expected to
fall further. According to Keynes the demand for money is perfectly
elastic at very low rate of interest and gets liquidity trap. In this situation
expansionary monetary policy becomes ineffective because there is
no possibility of further fall in the rate of interest to encourage
investment. The ineffectiveness of monetary policy can be explained
in fig. 7.7.

Fig. 7.7: Ineffectiveness of Monetary Policy

In fig. 7.7 the money demand curve Md is horizontal at very low
rate of interest OI (Liquidity trap) and there is no possibility of further
fall in the rate of interest. Now if the government increases its money
supply there will be no impact on further investment, income,
employment or any economic activities in the economy as the
economy is operating in the range of liquidity trap. Thus under these
circumstances Keynes and his followers concluded that expansionary
monetary policy cannot help the economy to recover from
depression.
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7.4.3 Money Supply and Price: Keynesian View

Keynes considers an economy in depression and that the

economy is operating less than full employment. In such a situation
aggregate demand increased by any economic policy (either fiscal or
monetary) increases national output without affecting price till up to
the economy reaches full employment and after that any further
increase in aggregate demand leads to increase in price. The relation
between expansionary money supply and price can be explained by
fig. 7.8.

Fig.7.8: Money Supply Aggregate Demand and Price

In the fig. 7.8 AS is aggregate supply curve which shows the
various levels of aggregate supply at which producers in the economy
are willing to produce and sale in the market at various levels of prices.
As the economy is in the state of depression there are lots of unused
resources. Initially the aggregate demand is AD1which intersects AS
curve at E1; as result OP price and OY1 income is determined. Now, if
expansion of money supply succeeds in rising aggregate demand to
AD2 and intersect AS curve at E2, there will be no change in price but
increase in income to OY2as there is unused resources in the economy.
But after reaching full employment of resources at point E3 and income
level YF any further increase of AD curve will increase price. In the fig
7.08 it is observed that the shift of aggregate demand from AD3 to
AD4 increases price from OP to OP1. Thus when full employment is
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Unit 7 Monetarism Vs Keynesianism

prevailed an increase in aggregate demand brought about by increase

in money supply leads only to higher price but not to higher output.

CHECK YOUR PROGRESS

Q.3: What is the relation explained by Keynes

between interest rate and bond prices? (Answer in
about 50 words)..
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Q.4: What is Keynesian view about money supply? (Answer in about
50 words)..
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7.5 POLICY IMPLICATION OF MONETARISM AND

KEYNESIANISM

7.5.1 Keynesianism

¾ In depression all the economic activities are at low level and

money market is in the grip of liquidity trap. The Government
intervention can stimulate aggregate demand and real output
can be increased through government spending. Therefore,
Keynesians advocate for fiscal policy in a recession.
¾ Keynesians reject the crowding out effect presented by
Monetarists. Keynesians said that if there is a sharp rise in private
sector saving (and fall in spending), government spending can
offset this decline in private sector spending.
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¾ Paradox of thrift is the key element in Keynesian theory. It is the

idea of a ‘glut’ of savings. Keynes argued that in a time of
recession, people respond to the threat of unemployment by
increasing saving and reducing their spending. This is a rational
choice, but it contributes to an even bigger decline in AD and
GDP. This is why government intervention may be needed.
¾ In recession there is a degree of wage rigidity. The wages might
be sticky downward as unions resist nominal wage cuts, and this
can lead to real wage unemployment.
¾ In a recession, when an economy has spare capacity, increasing
aggregate demand (AD) will have an impact on real output and
only minimal or no effect on the price level.
¾ Keynesians believe there is often a multiplier effect. This means
an initial investment in the circular flow can lead to a bigger
increase in real GDP based on marginal propensity to consume
(MPC).
¾ Keynesians are more likely to stress the importance of reducing
unemployment rather than inflation.
¾ Keynesians reject real business cycle theories (an idea that the
government can have no influence over the economic cycle)

7.5.2 Monetarism

¾ Monetarists are more critical of the ability of fiscal policy to

stimulate economic growth.

¾ Monetarists/classical economists believe wages are more flexible

and likely to adjust downwards to prevent real wage
unemployment.
¾ Monetarists stress the importance of controlling the money supply
to keep inflation low.
¾ Monetarists more likely place emphasis on reducing inflation than
keeping the unemployment level low.
¾ Monetarists stress on the role of the natural rate of unemployment.
(Supply side unemployment)
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Unit 7 Monetarism Vs Keynesianism

7.6 POLICY DIFFERENCES OF KEYNESIANISM AND

MONETARISM

7.6.1 Policy of Keynesianism

According to Keynesians monetary policy relatively less effective

as aggregate expenditure is relatively inelastic to interest rate. To
illustrate it, let Govt. consider expansionary monetary policy by
purchase of securities from open market. As a result price of bond
and securities increases and rate of interest decrease. People will
therefore demand more money as money demand is highly interest
elastic and people want to hold cash at low rate of interest. Therefore,
according to Keynes the monetary policy is less effective than fiscal
policy. The expansionary fiscal policy tends to shift aggregate
expenditure curve to right and lead to further increase in income,
output and employment. Increase in Govt. expenditure further
increases demand for money for transaction purpose and it tends to
increase rate of interest. The effect of expansionary fiscal policy can
be explained in fig. 7.9.

Fig. 7.9: Effect of expansionary Fiscal Policy

In the fig. 7.9 due to expansionary fiscal policy the aggregate
expenditure EC curve shifts to EC1 in panel (B) which tends to increase
money demand from OQ to OQ1 as money demand curve MD shifts to
MD1 and interest rate increases from OR to OR1in panel (A). With this
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Monetarism Vs Keynesianism Unit 7

increase in interest rate and with high income, people demanded more
money for transaction purpose and sell their securities and borrowed
more money from financial institutions. But this small increase in rate
of interest (RR1) has very small effect in reducing private investment
equal to EE2 in panel (B) because aggregate expenditure is relatively
interest inelastic in Keynesian system. Thus the expansionary fiscal
policy resulted in a net increase in aggregate expenditure EE2.
Keynesians therefore regard fiscal policy as more effective than
monetary policy.

7.6.2 Policy of Monetarism

According to monetarists, money supply has a direct influence

on aggregate expenditure and thus on income. Let the Govt. adopt
expansionary monetary policy by purchasing securities in the open
market. It will increase the price of securities and lower the rate of
interest and people sale their securities and hold more money. With
this excess money balances people start spending on financial asset,
durable consumer goods, equipment etc. and this will tend to increase
aggregate expenditure and income. According to monetarism demand
for money is relatively insensitive to rate of interest but aggregate
expenditure is highly sensitive to any change of interest rate.
Monetarist explanation about fiscal policy is that an increase in
aggregate expenditure leads to expansion of the economy and shifts
the aggregate expenditure upward. This will again lead to higher
demand for money for transaction purpose and tend to increase the
rate of interest. As demand for money is relatively less interest elastic
a very high interest rate is required to equate demand and supply of
money. But such large increase in rate of interest affects private
investment resulting in crowd out from the market and finally, according
to monetarist expansionary fiscal policy has less affect on aggregate
expenditure in the economy. Fig. 7.10 shows the crowding out effect
of fiscal policy.

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Unit 7 Monetarism Vs Keynesianism

Fig. 7.10: Crowding out Effect of Fiscal Policy

In fig. 7.10 an increase in Govt. expenditure leads to expansion in the
economy which shifts expenditure curve EC to EC1 in panel (B) and
national income also rises. This will lead higher demand for money in
the market such that MD curve shifts to MD1 and tends to increase rate
of interest from OR to OR1in panel (A). But monetarist view is that
with higher rate of interest OR1 private investment will be discouraged
or aggregate expenditure will be equal to E2E1 (in panel B). Therefore,
expansionary fiscal policy has a small effect equal to EE2 in the
economy.
Monetarist views that money supply has direct influence on
aggregate expenditure and income can be explained in fig. 7.11.

Fig. 7.11: Effect of expansionary Monetary Policy

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Monetarism Vs Keynesianism Unit 7

Fig. 7.11 shows the direct influence of money supply on aggregate

expenditure in the economy as demand and supply of money are
interest inelastic. The initial equilibrium is at point E at OR interest
rate with equality between demand and supply of money in panel (A).
The expansionary monetary policy tends to shift money supply curve
to Ms1which tends to decrease rate of interest to OR1.But, aggregate
expenditure is insensitive to rate of interest; so that aggregate
expenditure increases from OE to OE1 in panel (B).

7.7 CRISIS IN KEYNESIAN ECONOMICS AND REVIVAL

OF MONETARISM

In the 1970s, when the managed exchange rate broke down, inflation
rose and world economy stagnated, Keynesian demand management no
longer seemed to work and Keynes’ critics started to attract more attention.
The economic ideas from Keynesian economics has been challenged by
new school of thought called monetarists led by its leader Milton Friedman
of Chicago University. A debate continues to exist between one group which
provides major stress on fiscal policy as the primary engine of growth and
economic stabilizer and a second group which feels that money and therefore
monetary policy is the most important primary factor in growth of economic
activity. This group gives a special emphasis on rate of interest and
emphasizes that a change in money supply will affect cost and availability
of credit. In this process of restoring equilibrium the excess balances due
to money supply will be converted into real goods and services either directly
or through financial institutions. The pressure of more demand for goods
and services will stimulate output that has risen in proportion to the increase
money supply.

The superiority of monetary policy over Keynesian model has not

been demonstrated. However, monetary factors are not unimportant. There
is no reason to reject the view that changes in the money supply will affect
income either directly or indirectly. Advocates of monetary approach have
not yet shown that the changes in money supply have a reliable and

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Unit 7 Monetarism Vs Keynesianism

predictable effect on expenditure and income. But it is obvious that one

cannot deny that money supply and other financial factors are unimportant
in determination of economic activity; rather it is to be understood that interest
rate and supply of credit may have a considerable impact on economic
activity. Prof. Friedman himself regards that there are considerable time
lags of uncertain length between money supply and variable affected by
such changes including price level.But it can be correctly predicted what
effect a particular monetary action will have on price level and when it will
have that effect. Friedman, therefore, advocated a monetary rule for
increasing money supply between 3 to 5 per cent a year for smooth growth
of economy while ignoring other types of disturbing economic events.
However, the Keynesian economics has the following shortcomings.
z The monetarist viewed that in fiscal policy Govt. should play an active
stabilising role not by varying taxes and expenditure but also taking
such actions which will influence both private spending for consumption
and investment paving the way for stabilisation. Given the stable
demand function for money, the monetarist have strong belief that
only such nominal variables as GNP and price are affected by money
supply.Apart from that money alone controlled by Central bank became
the appropriate policy instrument for affecting economic activity or to
influence the fiscal measures i.e. changes in taxes or public
expenditure in the economy.
z Monetarists argue that expansionary fiscal policy (higher budget deficit)
is likely to cause crowding out i.e. higher government expenditure
reduces private sector expenditure and higher government borrowing
pushes up interest rate. Higher interest rate discourages private sector
investment.
z Resources crowd out. If the government borrows to finance higher
investment from the private sector tend to reduce fewer resources of
private sector to investment.
z A problem of fiscal expansion is that it often comes to effect too late
and there is time lag between investment and production of final output.
Therefore, it causes inflation.

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Monetarism Vs Keynesianism Unit 7

z Expansionary fiscal policy may lead to special interest groups pushing

for spending which is not really helpful and then prove difficult to reduce
when the recession is over. In contrast with fiscal policy monetary
policy is set by Central bank and special interest or political influences
get reduced.

z The monetary policy is quicker to implement. Interest rates can be

set every month. A decision of government expenditure may take
time to decide in which sector to spend money.

z From the break down of Philips curve trade off in the 1950s and 1960s
and the period of stagflation in the 1970s (higher inflation and higher
unemployment) it appeared to critics of Keynesian demand
management that the policies to boost demand were only aggravating
inflation and not reducing unemployment in the long term. The
monetarist (Prof. Friedman) criticised the demand management
policies and advocated supply side economics that tend to focus on
supply side reforms to increase market efficiency and reduce
imperfections in labour markets (such as minimum wage).

7.8 FISCAL AND MONETARY POLICY MIX AND

GROWTH

The two important tools of macroeconomic policy are fiscal and

monetary policy. According to Keynes, monetary policy was ineffective to
lift the economy out of depression. However, in view of modern economists
both fiscal and monetary policies play a useful role in stabilising the economy.
The policy mix is the combination of fiscal and monetary policy. These two
channels influence growth and employment generally determined by
government and the Central bank respectively. The policy mix aims at
maximizing growth and minimizing unemployment and inflation. The
monetary policy is typically carried out to control interest rates and money
supply to balance the outcomes for inflation and unemployment. The
government influences labour markets, public investment and spending
and discretionary fiscal policy.

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Unit 7 Monetarism Vs Keynesianism

The neo-Keynesian or post Keynesians like Walter Heller, Arther Okun,

Samuelson etc. do not take extreme position and feel that both fiscal and
monetary policies are important determinants of the level of output. In the
current state of controversy few economists are labeled as being completely
in the monetarist or the fiscals camps. The debate of two approaches is a
sham dispute and question of choosing one is cost ignoring or the other is
not. From economic situations one monetary policy is extremely helpful in
the long run during inflation and the other fiscal policy is very helpful in the
short run during depression.

Hence a judicious mix of the two - more monetarism and less

Keynesianism during inflation and more Keynesianism and less monetarism
during deflation - may help economic growth with stability in advanced
capitalist countries. However, neither Keynesianism nor monetarism nor a
mixture of the two is capable of initiating development process in developing
countries because these policies emphasise on the regulation of supply
and demand for monetary factors whereas, the real problem in developing
countries is the generation and regulation of supply and demand for real
physical factors in planned way.
The theoretical view point about the money supply on output and
prices leads to divergent view. Monetarists believe that monetary policy
can play a much more important role in stabilising the economy than
Keynesian view. While Keynesian agrees that money also matters but
monetary policy alone will be quite ineffective in lifting the economy out of
depression. Keynesian argues that during depression money demand curve
is quite flat so that expansion of money supply does not reduce market
interest rate as it depends primarily on business expectation of profit making.
This suggests that a slight fall in interest rate due to money supply will not
lead much increase in investment and thereby aggregate demand. Hence
expansionary monetary policy will be ineffective in curing recession. On the
other hand monetary believes that demand for money is relatively insensitive
to interest rate (money demand curve is steep).So small expansion of money
supply causes a large reduction in interest rate. Besides monetarist believes
that investment is very sensitive (investment demand curve is flat) to interest
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Monetarism Vs Keynesianism Unit 7

rate so that a fall in interest rate causes a large increase in investment

demand with a significant effect on output and employment. Therefore,
monetarist argues monetary policy is very effective for economic stabilisation.
In contrast with monetarism, Keynesians strongly debate about the
role of fiscal policy in stabilising the economy. According to them, in
Keynesian model C +I + G + (X – M) = Y, investment spending is direct
component of aggregate demand. Increase in government expenditure
therefore directly influences aggregate demand in which multiplier effect
pushes up the level of national income output and employment. In regard
of fiscal measure taxation has also a significant effect on consumption and
investment. Thus lower tax boosts up consumption and investment and
hence aggregate demand. According to Keynesians, during inflation fiscal
policy also plays an important role. At the time of inflationary pressure the
government can reduce expenditure or increase tax rate to stabilise the
economy.
Monetarist argues the fiscal policy has significant effect on aggregate
demand and therefore does not serve as an important tool of stabilisation.
They believe that fiscal policy is weak because of crowding out effect of
government expenditure. With government expenditure pushing up market
interest rate, high interest rate crowd out private investment from the market.
Therefore, fiscal policy has less effect on investment and aggregate demand
and consequently output and employment will remain unaffected.

It is being evident that neither monetary policy nor fiscal policy acting
alone can deliver the desired goals. There the general conclusion is that
one policy can be more effective than others in particular situations. The
monetary policy is more effective in inflation and fiscal policy in deflation.
However, in practical view point the policy makers have to take resort to
both measures simultaneously or combination of appropriate mix of the
policies to achieved the desired goals. As a result of Friedman’s challenge
to Keynesian thinking about fiscal and monetary policies, a vigorous debate
between monetarist and Keynesians took place.But ultimately both fiscal
and monetary policies are the important tools of economic stabilisation in
macro economics.
Macro Economics- II 131
Unit 7 Monetarism Vs Keynesianism

CHECK YOUR PROGRESS

Q.5: What is the main ground on which the

monetarists criticised Keynes? (Answer in about
50 words)..
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................
Q.6: Why does Keynes argue that monetary policy is ineffective to
cure recession? (Answer in about 50 words).
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................
..........................................................................................................

7.9 LET US SUM UP

z The key focuses of monetarism are Cash Reserve Ratio (CRR),

Statutory Liquidity Ratio (SLR), money supply, exchange rate or the
function of Central bank.
z According to monetarists, money supply is the only determinant factor
of price level and output in the short run. But in the long run the affect
of money supply is directly related with price level.
z Monetarist believes that demand for money holding depends on the
real rate of interest, inflationary expectation and frequency of payments.
The higher the rates of interest the lesser the amount of money people
want to hold.
z Friedman holds that the demand for money is a stable function of
income and money is the substitutes of all types of asset i.e. bond,
securities, and all types of durable goods. Therefore, people want to
hold certain fixed amount of their income.
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Monetarism Vs Keynesianism Unit 7

z Monetarist argues that expansionary fiscal policy is likely to cause

crowding out i.e. higher government expenditure reduces private sector
expenditure and higher government borrowing pushes up interest rate.
Higher interest rate discourages private sector investment.

z Keynesianism believes that “money does not matter” for economic

stabilisation. The fiscal policies i.e. government intervention, investment,
taxes, policies etc. are more powerful tool for economic stabilisation.

z The Keynesian economy is demand side economy which believes that

the economy is best controlled by manipulating the demand for goods
and services.

z Keynesianism believes that demand and supply of money is monetary

phenomena and highly interest elastic while aggregate expenditure is
not. People want to hold a certain portion of their income in liquid form
and the demand for money also called liquidity preference.

z According to Keynes, investment of an economy depends on the rate

of interest in one hand and marginal efficiency of investment (MEI) on
the other.

z According to Keynes the demand for money is perfectly elastic at very

low rate of interest and get liquidity trap. In this situation expansionary
monetary policy became ineffective because there is no possibility of
further fall in the rate of interest to encourage investment.

7.10 FURTHER READING

1) Ahuja, H.L. (2017). Macro Economic Theory and Policy. New Delhi: S.
Chand Publishing and Company Ltd.

2) Jhingan, M.L. (1997). Macro Economic Theory. Delhi: Vrinda

Publications (P) Ltd.

3) ‘A Monetary Explanation of the Great Stagflation of the 1970s’, NBER,

February, 2000. “Monetarism”, Econlib. “Milton Friedman,” Econlib.

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Unit 7 Monetarism Vs Keynesianism

4) https://www.investopedia.com/ask/answers/012615/what-difference-
between-keynesian-economics-and-monetarist-economics.asp

5) https://www.economicshelp.org/blog/1113/concepts/keynesianism-vs-
monetarism/

6) http://www.economicsdiscussion.net/articles/monetarism-versus-
keynesianism-explained/8421

7) https://www.fool.com/knowledge-center/differences-between-
monetarist-theory-and-keynesia.aspx

8) https://www.britannica.com/topic/Bitter-Face-Off-Between-Keynesian-
Economics-and-Monetarism-The-1905030

9) https://www.investopedia.com/ask/answers/100314/whats-difference-
between-monetary-policy-and-fiscal-policy.asp.

10) https://www.economicshelp.org/blog/1850/economics/difference-
between-monetary-and-fiscal-policy.

7.11 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: Monetarism relates to money matter of a country and holds

that monetary policy is a more potent instrument than fiscal policy
in economic stabilisation. The key focuses of monetarism are
Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR),
money supply, exchange rate or the function of Central bank.

Ans to Q No 2: When money supply increases it will cause short run

reduction of interest rate and people sell their securities and their
holding of money increases. This situation is called Liquidity effect.
When people start to spend their excess money balances due to
liquidity effect production, income and employment increases in
the economy, it is called output effect. The price expectation effect
is the expectation of increase interest rate and price due to liquidity
and output effect.

Ans to Q No 3: According to Keynes, rate of interest and bond prices are

134 Macro Economics- II
Monetarism Vs Keynesianism Unit 7

inversely related. When rate of interest goes up bond and

securities prices decrease and vice verse. The demand for money
by the people depends upon how they decide to balance their
portfolio between money and bonds. This decision is influenced
by two factors. The higher the level of income,the higher the
money people hold in their portfolio balance and the higher the
rate of interest, the lower the demand for money for speculative
motives.

Ans to Q No 4: Keynes believes in the existence of an economy below full

employment equilibrium. This implies that an increase in money
supply can bring about increase in level of output. The ultimate
influence of money supply on the price level depends upon its
influences on aggregate demand and the elasticity of supply of
aggregate output. Thus if the rate of interest is reduced as a
result of increase in money supply the rate of investment
increases and thereby increases income and output with
activation of multiplier.

Ans to Q No 5: Monetarist argues expansionary fiscal policy (higher budget

deficit) is likely to cause crowding out i.e. higher government
expenditure reduces private sector expenditure and higher
government borrowing pushes up interest rate. Higher interest
rate discourages private sector investment. At the same time
higher interest rate crowds out resources. If the government
borrows to finance higher investment from the private sector tend
to reduce fewer resources of private sector to investment.

Ans to Q No 6: Keynesian argue that during depression money demand

curve is quite flat and economy is in liquidity trap so that expansion
of money supply does not reduce market interest rate as it
depends primarily on business expectation of profit making. This
suggests that a slight fall in interest rate due to money supply
will not lead much increase in investment and thereby aggregate
demand. Hence expansionary monetary policy will be ineffective
in curing recession.
Macro Economics- II 135
Unit 7 Monetarism Vs Keynesianism

7.12 MODEL QUESTIONS

A) Short Questions (Answer each question in about 150 words)

Q 1: What is meant by monetarism?

Q 2: Briefly explain the policy differences of Keynesianism and
Monetarism.
Q 3: Briefly explain the Monetarist View on increase Money Supply and
Price.
Q 4: Briefly explain fiscal and monetary policy of economic stabilisation.
B. Long Questions (Answer each question in about 300-500 words)
Q 1: Compare monetarism with Keynesian theory of income price and
output.
Q 2: Explain how Keynesians approach of money supply to economic
activity differ from monetarist approach.
Q 3: Explain the main criticism of Keynesian Economics and revival of
Monetarism and appropriate policy mix as a tool of economic
stabilisation.
Q 4: Out of the fiscal and monetary policy of economic stabilisation, which
policy is more effective to cure recession and depression of an
economy? Give reasons.

*** ***** ***

136 Macro Economics- II

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