MACROECONOMICS

Chandana Ghosh
Ambar Ghosh
MACROECONOMICS
MACROECONOMICS

CHANDANA GHOSH
Assistant Professor
Economic Research Unit
Indian Statistical Institute
Kolkata

AMBAR GHOSH
Professor
Economics Department
Jadavpur University
Kolkata

New Delhi-110001
2011
`

MACROECONOMICS
Chandana Ghosh and Ambar Ghosh

© 2011 by PHI Learning Private Limited, New Delhi. All rights reserved. No part of this book
may be reproduced in any form, by mimeograph or any other means, without permission in
writing from the publisher.

ISBN-978-81-203-4306-1

The export rights of this book are vested solely with the publisher.

Published by Asoke K. Ghosh, PHI Learning Private Limited, M-97, Connaught Circus,
New Delhi-110001 and Printed by Mudrak, 30-A, Patparganj, Delhi-110091.
 To
Dr. MAHESH GOENKA
This book would never have been possible without his Midas touch
 Contents

Preface xiii

PART I SUBSTANTIVE MACROECONOMICS

1. Introduction 3–5
Reference 5

2. National Income Accounting 6–71

2.1 Introduction 6
2.2 Performance of Economic Activities and Circular Flow of Income 7
2.3 National Income Accounting (NIA) and GDP Measurement 8
2.3.1 The Value Added Method 8
2.3.2 The Income Method 11
2.3.3 The Spending/Expenditure Method of Estimating GDP and NDP 14
2.3.4 Incorporation of the Government 17
2.3.5 National Income Accounting in an Open Economy 23
2.4 Measures of Production 27
2.4.1 Gross Domestic Product (GDP) and
Net Domestic Product (NDP) 28
2.4.2 Domestic Products and National Products 30
2.5 Production and Income 32
2.6 Different Concepts of Income, Saving and Investment 33

vii
viii Contents

2.7 Balance of Payments 41

2.7.1 Saving, Investment and Current Account Balance 46
2.8 Real and Nominal GDP 48
2.9 Composition of India’s GDP 50
2.10 Employment and Unemployment in India 53
2.11 Poverty 57
2.12 Measures of Inflation 59
2.13 Conclusion: India’s Position Relative to the World 64
Problems 69
References 71

3. Aggregate Demand and Determination of GDP 72–118

3.1 Introduction 72
3.2 Simple Keynesian Model 75
3.2.1 Simple Keynesian Model (SKM) for a Closed
Economy without Government 75
3.3 Stability of Equilibrium 80
3.4 Comparative Static Exercises 82
3.4.1 Effect of an Increase in the Autonomous
Expenditure on Y and C 82
3.4.2 Mathematical Derivation of the Increase in Y and C 83
3.5 Multiplier Process at Work 85
3.6 Inflationary and Deflationary Gap 87
3.7 Relationship between GDP, Actual and Planned
Consumption and Actual and Planned Investment 89
3.8 Simple Keynesian Model for a Closed Economy
without Government in Terms of Saving and Investment 92
3.9 Stability of Equilibrium 94
3.10 An Exogenous Increase in the Autonomous Component of Saving 95
3.11 Simple Keynesian Model for a Closed Economy with Government 96
3.11.1 The Model 97
3.11.2 Comparative Static Exercise 98
3.12 SKM with Government in Terms of Saving and Investment 111
3.13 Fiscal Policy and Government’s Budget 113
3.14 Conclusion 116
Problems 116
References 118

4. Financial Sector, Money Supply and Interest Rates 119–162

4.1 Introduction 119
4.2 Financial Markets 120
4.2.1 Money Market 120
4.2.2 Market for Foreign Exchange 121
 Contents ix

4.3 Pricing of Securities 123

4.3.1 Pricing of Treasury Bills 123
4.3.2 Pricing of Certificate of Deposits (CDs) 125
4.3.3 Pricing of Bonds 125
4.3.4 Comparison of Different Types of Securities 127
4.4 Financial Institutions in India 129
4.4.1 The Reserve Bank of India 131
4.4.2 Commercial Banks 133
4.4.3 Cooperative Banks 134
4.4.4 Specialized or Development Financial Institutions 135
4.4.5 Insurance Companies 135
4.4.6 Unit Trusts and Mutual Funds 136
4.4.7 Non-Bank Financial Companies (NBFCs) 136
4.5 Money Supply 137
4.5.1 Regulation of Money Supply 146
4.6 Term Structure of Interest Rates 146
4.6.1 Unbiased Expectations Theory 146
4.6.2 Liquidity Preference Theory 150
4.6.3 Market Segmentation Theory 151
4.6.4 Preferred Habitat Theory 152
4.7 Monetary Policy and the Term Structure of Interest Rates 152
4.7.1 Liquidity Adjustment Facility (LAF), Open Market
Operation (OMO) and Monetary Stabilization Scheme (MSS) 155
4.8 Conclusion 161
Reference 162

5. IS-LM Model 163–204

5.1 Introduction 163
5.2 The Model 163
5.2.1 The Commodity Market 163
5.2.2 The Money Market or the Financial Sector 170
5.2.3 Equilibrium in the IS-LM Model 177
5.3 Fiscal Policy 179
5.3.1 Increase in Government Expenditure by
dG Financed by Internal Market Borrowing 179
5.3.2 Mathematical Derivation of the Result 181
5.3.3 The Multiplier or the Adjustment Process 183
5.3.4 Note on Crowding-out Effect 184
5.3.5 Efficiency of Fiscal Policy 184
5.3.6 Built-in Stabilizers 186
5.4 Monetary Policy 186
5.4.1 The Multiplier and the Adjustment Process 189
x Contents

5.5 Inter-Linkage between the Real and the Financial

Sectors in the IS-LM Model 191
5.5.1 LM Schedule in the Liquidity Trap 192
5.5.2 The Classical Zone of the LM 193
5.6 Short-Run Economic Fluctuations and the IS-LM Model 195
5.6.1 Money and Economic Fluctuations 196
5.7 Comparison of Fiscal and Monetary Policy 197
5.7.1 Monetary and Fiscal Policy Mix 197
5.8 Conclusion 202
Problems 203
References 204

6. Classical Theory 205–229

6.1 Introduction 205
6.2 Say’s Law: Markets for Goods and Credit 206
6.3 Aggregate Supply: Aggregate Production and Labour Market 207
6.3.1 Supply of Labour 211
6.3.2 Equilibrium in the Labour Market 216
6.4 Money Market 218
6.4.1 Neutrality of Money 220
6.5 Problems with the Classical Theory 221
6.6 Conclusion 229
References 229

7. Complete Keynesian Model 230–259

7.1 Introduction 230
7.2 Complete Keynesian Model: Aggregate Demand 230
7.2.1 Shifts in AD 233
7.3 Complete Keynesian Model: Aggregate Supply 234
7.3.1 Supply Price of Labour 239
7.4 Equilibrium in the Complete Keynesian Model 242
7.4.1 Equilibrium with Involuntary Unemployment 243
7.5 Working of the CKM: Comparative Static Exercises 245
7.5.1 Effect of an Increase in Government Consumption
Financed by Internal Borrowing 245
7.5.2 Effect of an Increase in Money Supply 252
7.6 Conclusion 256
Reference 259

8. The Real Sector and the Financial Sector 260–266

8.1 Introduction 260
 Contents xi

8.2 The Model 261

8.2.1 The Financial Sector 261
8.2.2 The Real Sector 262
8.3 Interaction between the Real and the Financial Sectors 263
8.4 Conclusion: Evaluation of the Model 265
Reference 266

9. Consumption Function 267–286

9.1 Introduction 267
9.2 Keynesian Consumption Function 268
9.3 Discrepancy between the Short-Run and Long-Run
Consumption–Income Relationship 269
9.3.1 Fisher’s Model of Intertemporal Choice 270
9.4 Life Cycle Hypothesis of Consumption 274
9.4.1 Implication of the LCH for the Keynesian Multiplier 277
9.4.2 Evaluation of LCH 277
9.5 Permanent Income Hypothesis 278
9.5.1 Cross Section Budget Studies and the Permanent
Income Hypothesis (PIH) 281
9.5.2 Evaluation of PIH 284
9.6 Conclusion 285
References 286

10. Investment Function: Keynesian Theory of

Investment in Fixed Capital 287–290
10.1 Introduction 287
10.2 Investment in Fixed Capital 287
10.3 Conclusion: Volatility of Investment 289
Reference 290

11. Demand for Money 291–305

11.1 Introduction 291
11.2 Demand for Money: Definition and Sources 291
11.3 Transaction Demand for Money 292
11.4 Baumol’s Theory of Transaction Demand for Money 293
11.5 Precautionary Demand for Money 296
11.6 Speculative Demand for Money 296
11.7 Keynesian Theory of Speculative Demand for Money 297
11.8 Tobin’s Reformulation of the Keynesian
Theory of Speculative Demand for Money 298
11.9 Conclusion 303
References 305
xii Contents

PART II MACROECONOMICS GONE ASTRAY

12. New Classical and New Keynesian Theories 309–368

12.1 Introduction 309
12.2 Stagflation and Demise of the Keynesian Orthodoxy 310
12.3 The Phillips Curve 313
12.3.1 Oil Shock and Phillips Curve 317
12.4 New Classical Theory 318
12.4.1 Expectation Augmented Phillips Curve 319
12.4.2 Expectation Augmented Phillips Curve, Aggregate
Supply and Natural Rate Hypothesis 322
12.5 New Classical Theory and Rational Expectations 338
12.5.1 Simple Formal Model of Rational Expectations 341
12.5.2 Evaluation of the New Classical Rational Expectation Theory 346
12.6 Theory of Real Business Cycle 349
12.7 New Keynesian Theory 350
12.7.1 Nominal Rigidities and Economic Fluctuations 350
12.7.2 Real Rigidities 358
12.7.3 Rigidities in Interest Rates and Credit Rationing 362
12.8 Conclusion 367
References 368

13. Modern Theories of Growth: A Critique 369–418

13.1 Introduction 369
13.2 Harrod–Domar Model 375
13.3 Neoclassical Theory of Growth 382
13.3.1 Transitional Dynamics 387
13.3.2 Central Result of Solow Model 388
13.3.3 Effect of Increase in s 388
13.3.4 Evaluation of the Central Results of the Solow Model 391
13.3.5 Golden Rule of Capital Accumulation 395
13.3.6 Dynamic Efficiency in a Market Economy 398
13.3.7 Unconditional and Conditional Convergence 402
13.4 Endogenous Growth Theory 403
13.4.1 Human Capital Formation and Growth 404
13.4.2 Investment in R&D and Growth 412
13.5 Empirical Results and Concluding Remarks 415
References 417

Index 419–421
 Preface

We grew up in a crisis-ridden period of large-scale unemployment precipitated by the food crisis

of the mid 1960s and reinforced by the oil shocks of the 1970s. Unemployment and poverty
were the twin evils that haunted us and we wanted desperately to know what exactly caused
them and what could be done to remove them. We learnt that economics is the subject that holds
key to these questions. So we chose to study economics. Little did we know then how much
poison economics could contain and spew.
In our childish innocence we thought that economics as a science objectively and relentlessly
pursued the truth. We did not know then economics is an instrument of class war; it doggedly
pursues not the truth but the class interests. It seeks to present a distorted make-believe world
that favours the interest of the dominant class, which sets up a detailed apparatus to establish
the distorted reality as the true economic reality. Since in today’s world only one class dominates
and competition among different classes is conspicuous by its absence, economics today is
highly distorted and untrue. We write this book to substantiate these claims in the context of
macroeconomics. The book is written in the hope of showing economics in its true light to the
hapless innocent students who are swayed by the kind of emotion that moved us into studying
economics more than three decades ago.

Chandana Ghosh
Ambar Ghosh

xiii
Part I
Substantive Macroeconomics
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