Prof. Amar Oswal S.Y.B.

Com – Sem III Economics 2024-25

TOPIC NO.1
INTRODUCTION TO MACRO ECONOMICS

Introduction: The concept of Macro-economics is propounded by ‘Ragner Firsh and

made popular by Lord J.M Keynes.
Origin: The word ‘macro’ has been derived from a greek word called ‘makros’ which
means large.
Meaning: Macro Economics is the study of the overall conditions of an economy total
output, total consumption, total national income, savings and investment, aggregate
demand and aggregate supply, total employment, and so on.
Definition: Kenneth E. Boulding in his book ‘Economics Analysis’ defines “Macro
Economics deals not with individual quantities as such, but with aggregates of these
quantities; not with individual incomes but with the national incomes; not
withindividual prices but with the price level; not with individual outputs but with
the national output”.

Features of Macro Economics

1. Study of Aggregates: Macro Economics is concerned with a study of aggregates
i.e. (i) Aggregate Demand (Demand for all types of goods in a country).
(ii) Aggregate Supply (Supply of all types of goods in a country.
(iii) Total Output (Production of all goods and services in a country).
(iv) General Price Level (Overall rise or fall in the prices).
(v) National Income (Income of entire country).
2. Lumping Method: Unlike Micro Economics where slicing method is used under
Macro Economics Lumping Method is used. In a lumping method we are
concerned with object as a whole i.e. study of aggregates. For e.g. we are not
concerned with price of an individual commodity but overall price level.
3. General Equilibrium: Macro Economics is concerned with a General Equilibrium
analysis i.e. everything depends on everything else. For e.g. due to change in the
level of investment there may be change in the level of income, output,
employment and ultimately economic growth.

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4. Telescopic View: Macro Economics gives overall view of an economy it connects

various economic aggregates and shows the relationship between them.
5. Determination of Income Theory: Macro Economics determines National Income.
It studies the causes of rise and the fall in the national income.
6. Employment Theory: It studies the various factors which are responsible for
creating employment and also what are the causes of unemployment on the bases
of which appropriate policies can be made by the government.
7. Based on interdependence: It explains how various economic units are
interdependent on each other. For e.g. It explains how the level of investment
affects income, output, employment and therefore the growth of the nation.
8. Realistic approach: Macro economics takes into account the entire economy as a
whole which is more realistic as compared to Micro economics which takes into
account only one unit of an economy. In other words macro economics follows
general equilibrium whereas macro economics follows partial equilibrium.
9. Short and long run analysis: Macro economics deals with short run economic
fluctuation arises due to trade cycle and it also deals with long run increase in
growth and development of an economy (country).

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Scope / Subject matter of Macro Economics

Macro
Economics

Theory of Theory of
Theory of price Theory of
income & economic
level distribution
employment growth

1. Determination of National Income: Micro Economics studies aggregate

consumption, investment, government expenditure, net export etc. which determines
National Income of a Country. And on the basis of National income even per capita
income (PCI) is determine. It also analysis and study how National Income is
distributed between the individuals to know whether there is vide disparity of income
or it is evenly distributed. If income is unevenly distributed then government makes
appropriate policies to reduce the disparity of income.
2. Employment Level: Macro Economics studies and analysis the level of employment
in a country in different sectors of an economy and the changes in the level of
employment on account of government policy, technology, economic conditions etc.
and this enables the government to make appropriate policies to create employment
if required.
3. Price Level: Macro Economics studies general price level of goods and services in a
different sectors to know if there is inflation (over all rise in the prices) or depression
(overall fall in the prices) of the goods and services. Both the extremes are harmful to
the economy and therefore, government makes appropriate policies to control
inflation or depression.
4. Economic Growth: Economic Growth and development is also studies under macro
economics in fact on the basis of study an evaluation is done whether resources are
properly utilized or not and if not then appropriate policies are made to ensure rapid
growth and development.
5. Distribution of National Income: Macro economics studies how the national it is
distributed between different factors of production in an economy. And accordingly
policy decisions are taken by the government.

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6. Study of Business Cycle: In free market economies are subject to trade cycle i.e. Up’s
and Down’s in a economy consisting of depression, recovery, boom, recession etc.
which has a impact on production, consumption, and income. Study of this trade
cycles help the government in making appropriate policies.
7. Balance of Payment & Exchange Rate: Macro economics explains the factors which
determine balance of payment and identifies the causes of deficits (imports are more
than exports if any and accordingly corrective steps are taken.

Uses/ Importance / Significance of Macro Economics:

1) Income level: It helps in knowing & understanding the income level of people.
2) Employment level: It helps in knowing employment level of a country.
3) Price level: It helps in knowing the overall price level in an economy, whether there
is inflation on deflation.
4) Factors of production: It helps the government in knowing the income of factors of
production.
5) Functioning of economic system: It helps in understanding the functioning of
different types of economy, capitalist economy & mixed economy.
6) Framing of economic policies: It helps the government in making suitable economic
policies.
7) Solutions to problems: It provides solution to many national & international
problems.
8) Forecasting of future trend: Macro Economics provides foundation to economic
analysis to forecast future trends in interest rate, exchange rate, price level and
accordingly policies are made.
9) Political decisions: Political parties in a democracy secure votes by promising
economic benefits like employment price control, social well fare.

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Criticisms / Limitations of Macro Economics:

1) Misleading picture: Macro economics study may give misleading picture. E.g. there
may be rise in national income but that does not mean there is a majority of the rise in
the national income may be pocketed by selected number of people.
2) Homogenous factor: It is assumed that all individual economic units are homogenous
which cannot be in reality. For e.g. all the laborers cannot be same in efficiency.
3) Harmful decisions: A general policy decision taken by the government may turn out
to be harmful to individuals.
4) Complicated system: It is a very difficult & complicated system to know &
understand.
5) Lack of Reliable data: Despite of several improvements in statistical techniques it is
very difficult to acquire reliable accurate and dependable data of various economic
units.
6) Limited Application: Most of the macro economic theory are application to develop
and industrialized countries only. For E.g. theory of trade cycle is application to
industrialize economy and not to the aggregation.
7) Conflict between Micro & Macro: Macroeconomic policies are made nation as a whole
but may not be applicable to the individuals. For E.g. reduction of rate of interest
benefits the business man but adversely affects personal living on fixed deposits.

TOPIC NO. 2
CIRCULAR FLOW OF NATIONAL INCOME

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Introduction: In Modern Economy every one’s life is characterized by continue flow

of money, all the economic activities are revolved around money, money is required
to produce goods and services and money is also required to purchase goods and
services, this can be explained with the help of circular flow of national income.

A. Circular Flow of National Income with Two Sectors without Saving

The circular flow of national income explains overall economic activity in the form of
income, output and expenditure in a two sector model close economy.

We take into account:

a) Household: This is also known as consumption sector. Household supplies land,
labor, capital & enterprise to firms.
b) Firms: Firms are also known as production sector. They purchase factors of
production for the purpose of production, against which they make payments in
the form of rent for land, wages to the labour, Interest on capital and profits to the
entrepreneur.
Assumptions of Two Sector Model without Savings: -
 The economy consists of Two sectors
 Household &
 Firm
 Production takes place only in firms
 Households spend their entire income received in the form of rent, wages, interest
& profits for purchase of goods and services i.e. there is no saving.

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 Firms supply goods and services only as per demand, thus do not maintain any
inventory i.e. stock in hand.
 There are no government operations i.e. any government expenditure and taxes in
the economy.
 There is no international economic relation. There is no outflow and inflow of goods
and services (export & import), making the economy a closed one.

B. Two Sector Model with saving: -

In a Two sector model with savings, circular flow of national income takes place in a
following manner: -

a) Household supplies land, labour, capital and enterprise to the firm for which firm
pays rent, wages, interest and profit.
b) Out of income received, household spends bulk of income for purchase of goods
and services and some portion is saved and invested in bank (finance market).
c) Money received by the bank from the household is lend (given) to the firm.

C. Three Sector Model with Government:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In modern days, in every country, there is an involvement of the government in the

financial activity.

In Three sector model we have: -

a) Household: who supplies factors of production in turn they get money.
b) Firm: Firm purchases factors of production and supplies goods.
c) Government: They are also involved in various activities.
Government receives money in the form of taxes from household and firms,
Government spends money in the form of wages, salary and transfer payments
(pension) to the households and subsidies to the firms.

D. Sector Model with Foreign Trade:

In an open economy, there is foreign trade and we take into account Four sectors: -

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

a) Household: Supplies factors of production and receives the payments from the
firms and the government.
b) Firms: Firms purchases factors of production and supplies goods and services to
the household, government and also to other countries.

Importance of Circular flow of income:

 Shows smooth functioning of the economy: The concept of circular flow gives a
clear-cut picture of the economy. From it we can know whether the economy is
functioning efficiently or whether there is any disturbance in the smooth
functioning of the economy.
 Helps to know the problem of disequilibrium: With the help of circular flow we
can study the problems of disequilibrium. It can also guide us in the restoration of
equilibrium.
 Helps to find out the leakages in the circular flow: The concept of circular flow
enables us to find out the leakages in the form of saving, imports and taxes and
their efforts on income and expenditure.
 Highlights the importance of monetary and fiscal policies: The study of circular
flow highlights the importance of monetary and fiscal policies to bring about equity
between income and expenditure.
 Linked between producers and the consumers: The circular flow of establishes
linked between the producers and the consumers. Producers buy services of the
factors of production from the household (consumers). Consumer’s in-turn buys
goods and services from the producers.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

TOPIC NO. 3
MEASUREMENT OF NATIONAL INCOME

Introduction: The concept of National Income is of great significance. To analyze

economic development, every country in the world calculates National Income. It is a
common yard-stick (Barometer) to find out status of an economy.

Meaning: “National income refers to the money value of goods and services
produced in an economy during a year”.

Definition: According to Irvin Fisher, “The national dividend or income consists

solely of services as received by ultimate consumers, whether from their material
or from their human environments. Thus a piano or an overcoat made for me this
year is not a part of this year’s income, but an addition to capital. Only the services
rendered to me during this year by these things are income.”

Features of National Income:

1) National Income takes into account the total of goods and services produced during
a particular year e.g. Total Product into price.
2) National income is calculated annually i.e. it is calculated at the end of the year.
3) National income is macro concept i.e. it takes into account all the economic activities
in a country.
4) National income is expressed in terms of money.
5) While calculating National Income double counting should be avoided.
6) National income is calculated in open as well as closed economy. Closed economy
is one in which foreign trade is not allowed and open economy is one in which
foreign trade is allowed.
7) National income is a flow concept & it is concerned with the flow of money.
8) National income can be calculated at current as well as constant price.
Current price is one in which change in price level between different years is not
considered.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Constant price is one in which National income of a year a compared with any year
in the past and on that basis National income is calculated.
9) While calculating National Income only earned income is taken into account i.e.
unearned income like dowry income, pension, social security, winning of a lottery
ticket, etc. are not taken into account.
10) While calculating National income incomes earned by Indians working abroad
should also be taken into account
11) National Income is calculated by C. S. O. [Central Statistical Organisation]

Concept of National Income

Concept of National Income has three interpretations
A. Value of Goods produced (product method).
B. The total income received (income method).
C. Total expenditure incurred (expenditure method).
This implies the value of goods and services produced in an economy requires
payments to be made to the factors of production in the form of rent, wages, interest
& profit. The factors of production spend this money for purchase of goods therefore
we can say:
National Income = National Product = National Expenditure
These three measures of National Income gives triple identity to national income and
all of them lead to same conclusion.

Importance of National Income

Analysis of National Income is very significant for every country due to following
reasons.
1. Measurement of Economic Performance: National Income measurement works as
a yard stick of growth of an economy. Countries are ranked on the basis of National
Income.
2. Comparison of Standard of Living: Calculation of per capita income indicates the
standard of living of the people in the country and it also helps in comparing per
capita income of other countries.

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3. Sectoral Contribution: There are three sectors in economy namely primary,

secondary and territory. Analysis of national income helps us in knowing share of
different sectors in a national income.
4. Ascertation of Economic Welfare: National Income helps us in knowing whether
there is improvement in the welfare or not because some time the national income
may increase but it may not improve the welfare of the people.
5. Economic Planning: on the basis of national Income statistics government can
make short term and long term planning. Government cannot make plan effectively
without knowledge of trained in a national income.
6. Distribution of Grant in Aid: National Income estimates help in fair distribution
of Aid by the government to the state government and other agencies.
7. Public Sector Performance: National Income enables us to know the relative role
of public and private sector in the economy. If majority of the activities are
performed by the state then we can assume that public sector is performing
dominant role.
8. Budgets: On the basis of National Income data government makes the budget in
which policies regarding taxation and dates are taken.

Methods of Calculating National Income:

A) Product /Output Method B) Income Method C) Expenditure Method

1) Final Value Approach 2) Value Added Approach

A) Product / Output Method:

Under this method national income is calculated by ascertaining the total value of
goods and services produced during a year. There are two methods of calculating
national income under product method.
1. Final Value Approach Method: Under this method we find out value of final goods
and services produced in primary (Agriculture), secondary (Manufacturing) and

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

tertiary (Service) sector and net receipts (R –P) from abroad which gives us gross
domestic product.
After getting gross domestic product we minus depreciation we get gross national
product.
After getting gross national product we add net income received from external trade
i.e. export – import (X – M) this gives us net national product.
Final Value Approach
Particulars Rs. (Crore)
1. Value of goods and services from Primary sector (Agriculture) xxxx
+
2. Value of goods and services from Secondary sector xxxx
(Manufacturing)
+
3. Value of goods and services from Tertiary sector (Service) xxxx
+
4. Net Receipts from abroad (R –P) xxxx
Gross Domestic Product (GDP) xxxxxx
(-)
Depreciation (xxxx)
Net Domestic Product (NDP) xxxx
+
Net Exports (x – m) xxxx
Net National Product (NNP) xxxx

2. Value Added Approach: Final value approach sometimes lead to double counting.
For e.g. for a farmer cotton is a final product and for a textile mill shirt is a final product
as a result value of a cotton is taken twice once by farmer and once by the textile mill
owner to solve this difficulty value added approach method is used.
Under this method at every stage of production added value is counted to determine
the national income. Following table makes this concept very clear:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Value Added Method

Stage of Production Value of Input Net Value Added
Rs. Rs.
Raw Cotton 100 100
Cotton Yarn 150 + 50
Cotton Cloth 200 + 50
Shirt 300 + 100
Final value of shirt Rs. 300

The above table shows that final value of shirt is Rs. 300/-. If we take net value added
to each stage of production we can also avoid double counting. The same approach
can be used to estimate national income from primary, secondary and tertiary sectors
and also for net income contribution to national income from international trade.
While considering this approach we should exclude indirect taxes and include
subsidy.

Precautions:
1) Double counting must be avoided i.e. the value of only the final goods must be
taken that is the value of raw material or intermediate goods should not be taken.
2) The goods meant for self-consumption by the producers must be estimated by
guess work and their value at market prices should be included.
3) At the time of evaluating the output the changes in the price level between different
years must be taken into account.
4) The value of indirect taxes must be deducted and the value of subsidies must be
added in order to find the value of NNP at factor cost.
5) Factor incomes earned from abroad must be included in the National Income.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Personal Income
Meaning: Personal income refers to income earned by an individual.
Classification:

Personal Income

B C
A
INCOME FROM TRANFER INCOME
EMPLOYMENT
ASSETS [Pension, Dowry]

Wages Salary Mixed Tangible Intangible

[Physical Work] [Mental Work] Income [Fees] [Rent] [Dividend]

A) Employment:
Income from employment consists of three sources:-
1) Wages: Are paid for manual work.
2) Salary: Is paid for mental work.
3) Mixed Income: Is earned by professionals like doctors and advocates in the form
of fees.
B) Ownership of Assets:
1) Tangible assets have physical existence. They can be seen, felt and touched. Income
earned from them is called rent.
2) Intangible assets are those assets on which invisible income may be earned from
them in the form of royalty, dividend etc.
C) Transfer Income:
Transfer income is also known as unearned income. This includes pension, social
security benefit, dowry, donations & inheritance.

Per Capita Income (P.C.I.)

Meaning: PCI refers to average income available at the disposal of an individual.
It can be calculated by using the formula.
NationalIncome
PCI =
TotalPopulation

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Personal Disposable Income (P.D.I.)

Meaning: PDI refers to income which is available at the disposal of an individual.
It can be calculated by using the following formula.
PDI = Personal income (PI) – direct taxes (Income taxes).

National Income and Economic Welfare

Meaning of Welfare: Welfare is a state of mind which reflects human happiness and
satisfaction i.e. welfare is happy state of human mind.

Relationship between National Income and the Welfare

An increase in the National Income normally lead to more spending by the
government, for the welfare of the public leading to increase in the economic welfare
i.e. there is direct relationship between national income and economic welfare subject
to following conditions.
1. Change in the size of National Income: When national income goes UP it leads
more income to the people and hence more spending on goods and services.
Therefore there is positive impact on welfare and vice-versa.
2. Change in the price level: National Income is market value of goods and services
produced if there is a inflation national income may be higher but economic welfare
may not increase unless there is a increase in the output.
3. Per Capital Income: If National Income and Per Capita Income changes at the same
rate then there will not be increase in the welfare because per capita income will
remain the same.
4. Expenditure Pattern: If with a rise in the national income there is increase in
purchase of food essential items, clothing, housing, transportation, education, then
economic welfare will increase. On the other hand if money spent on luxury items
just for demonstration or speculative purpose welfare may fall.
5. Production Pattern: If rise in the National Income leads to increase in the
production of defense or luxury goods rather than increase in the production of
welfare goods then economic welfare will fall.

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6. Change in the Income Distribution: Changes in the national income bring the
changes in the income distribution. If the rich people are taxed more to spent more
money for the welfare of the people and by imposing heavy duty of luxury goods
and subsidizing of essential goods.

Gross Domestic Product (GDP)

GDP means money value of final goods and services produced within a domestic
territory during a given period of time. Whether produced by countries factor (labour)
or not.
In national income accounting domestic territory is a wider term than the political
territory.
Domestic territory includes:
Political frontiers (limits) including territorial waters of a country.
Ship & vessels operated between the countries (beyond our countries geographical
territory) by residents of a country (residents may be Indian or Foreign) (Resident does
not mean citizen)
For e.g. Many Indians working in USA is residing in USA but citizens of India. Since
they work for activities in the USA i.e. conduct their economic activities in USA they
are residents of USA.
Fishing, vessels, oil and natural rigs or floating platforms operating residents of
country (Indians or Foreigners who are conducting economic activities in India)
Embassies, consulates & military establishments of the country though located in
other countries.
Gross National Income (GNI) Gross Domestic Product (GDP)
It means total money value of goods & It means total money value of goods &
services produced anywhere by the services produced in the domestic
nations citizens only during a given territory of a country during a given
period of time period of time by anybody.
The income earned by the national (our The income earned by the national
citizens) whether within or outside the (citizens) outside the country are not
country are included Included

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That part of Income earned by the All the income earned by national &
foreigners is excluded. foreign are included
GNI is more if our nation is having more GDP will be larger than GNI if major
investments in stock, bonds, shares in income flows outside due to huge
other countries (i.e. R>P) investments by foreigners in India
GND=C+I+G+(X-M)+(R-P) GDP=C+I+G+(X-M)

GNI NNI
It is money value of final goods & It is money value of good & services
services produced by a countries produced in the country by counting
factories during a given period of time
GNI= GDP+(R-P) NNI= GDP+(R-P)-(D)
R= Receipts from Abroad D= Depreciation
F= Payments Abroad
It does not give correct pictures of an It gives accurate picture of an
economy economy

DNI, GDP, MNI &MDP at Market price &Factory cost.

Market Price: The market price (i.e. price paid in the market) is distorted by Indirect
taxes like octroi, excise, VAT i.e. Increase the price and subsidies i.e. Assistance given
by the government which reduces the price. Factor cost includes price paid to factors
of production.
Therefore; Factor cost= Market Price- Indirect Taxes+ Subsidies
Market Price= Factor Cost+ Indirect Taxes- Subsidies

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Gross National Income

Meaning: Green National Income is measured as Green Gross Domestic Product
(GGDP). It is an Index (Indications/Barometer) of Economic Growth and
measurement of Effects on Environment.
This concept is known widely accepted by many Governmentsviz USA, Norway,
China and India. China is first country to report Green Gross Domestic product report
in 2004 India has also began process in 2009.
GGDP (Green Gross Domestic Product) takes into consideration impact on
environment on a country in the process of economic growth in the form of climatic
changes, loss of bio-diversity, pollution, etc.

Need for Green GDP

Conventional measurement of NI takes into account only output produced in a
country but does not evaluate (ascertain how much wealth or assets the county has.
When goods & services due produced ina country its assets and wealth is used in a
traditional method do not ascertain how much assets and wealth is used and weather
it will be available in future or not i.e. sustainable in the future or not.
Traditional methods of calculating NI does not give much importance to natural
resources like geology, soil, air, water, living being at the cost of these assets are not
considered or accounted partly because of these assets cannot be easily ascertained in
the terms of money like- Air pollution and partly because of fear of come national
income due to these costs being considered.
In the process of creating wealth the government & firms do not make adequate
provision in the interest of future generation. In the process of generating more
Income today (short run) the national resources are falling rapidly.
Conventional GDP has limited scope for indicating social wellbeing of people the
green DGGP method makes comprehensive provision for sustainable development &
social well being.

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Drawbacks/Criticism
Through the concept of GDDP is very important and needs to be incorporated while
calculating NI it has some limitations.
It is difficult to calculate monitory (money) value of some of the national capital
components.
GGDP does not able to capture economic & social welfare aspects, because it has given
to much importance on natural factors only and not on social factors.
GDDP measure only depletion of national resources but does not tell us about their
sustainability.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

TOPIC NO. 4
TRADE CYCLE
Introduction: Every economy is subject to ups and downs, which is called trade cycle.
Trade cycle consists of following phases namely Depression, Recovery, Boom and
Recession.

Trade cycle can be explained with the help of following diagram:

A. Depression
 It is a period of very low economic activity
 People are very pessimistic
 Rate of growth is very less
 There is reduction in production & factories are closing down
 People are losing their jobs, leading to unemployment
 Prices are reducing below normal level
 Investment market is at a very low level (i.e.) share prices are falling
 Business units are incurring losses

When depression reaches the lowest level it is called trough, which is a turning point.
This stays for a very short period of time and recovery begins due to following
reasons: -
 The producers may offer jobs to the workers anticipating better future. They try to
maintain their capital stock.
 Consumers may start purchasing, expecting no further declining of prices.
Therefore demand starts growing.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

 Banks and private investors start investing in the securities and bonds from the
accumulated excess liquidity therefore prices start rising.
 Favorable monetary (easy loans) and fiscal policies (lower taxes) lead to recovery.
 It is noted that generally prices of inputs fall faster than the prices of the finish
goods and therefore there is some profit which increases after trough as a result
there is increase in investment in employment which in turn increases output,
income, demand etc. leading to stage of recovery

B. Recovery –Due to several factors economy enters phase of recovery during which
upward movement begins in output, input and employment.
People may start replacing semi-durable goods or capital goods; as a result there is
rise in demand. To fulfill this demand there is more investment and ultimately
employment.
In the beginning prices may not rise because already there is excess capacity, but
slowly capacity may be exhausted and the prices may rise.

C. Prosperity – Due to increase in output, employment, easy loans, higher profits,

better price, economy enters the stage of prosperity where people are very
optimistic.
Following are important features observed during Prosperity: -
 Bank loans are increased
 Unutilized funds are transferred to productive areas
 Share prices go up
 Money supply also increases
 People start expanding or starting new business and economy reaches a peak, but
ultimately it leads to recession due to expansion of business beyond required limits.

D. Recession – During this period, economy starts coming down as a consequence: -

 Demand reduces a bit
 Prices starts falling
 New investment stops

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 Stock prices start reducing

 Bank loans are reduced
 Employment also starts falling
 Ultimate effect of this leads to depression

Factors responsible for Trade Cycle

Introduction – Every economy in the world is subject to fluctuation due to trade cycle
(ups and downs). There are several factors, which are responsible for trade cycles but
following are important factors:
1) Monetary factors - Due to expansion and contraction of money supply (currency
and loans) trade cycles immerges. In fact it is one of the primary factors to cause
trade cycle.
2) Innovation and productivity –On account of innovation and productivity in any
one of the sector can have an impact on rest of the economy leading to trade cycle.
3) Fluctuations in investments – Due to rise or falls in investments on account of
marginal efficiency of capital (MEC) trade cycle may emerge. For eg: Due to more
expectations on capital investment, investments may fall leading to less
productions and employment.
4) Interaction of multiplier –Acceleration forces: - The multiplier and acceleration
forces are also responsible for fluctuation in economic activities.
5) Supply stocks – Due to changes in the aggregate supply the impact may fall on the
economy for e.g.: When oil prices go up it leads to inflation and low production.
6) Political factors – On account of change in the govt./ political parties, the policies
may change leading to trade cycle
7) Movement in prices and wages – Due to changes in the price of commodities, and
the wages to laborers, supply may change leading to trade cycle.
Conclusion – The above factors clearly reveal that there are many factors which are
responsible for the emergence of trade cycle.

TOPIC NO.5
SAY’S LAW OF MARKET

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Introduction: According to classical economist market forces will maintain full

employment in a long run. Consequently the output will be produced at the level of
full employment.

Say’s Law of Market

J. B. Say was a French Economist who stated the law of market in a systematic form in
the year 1803. According to him “supply creates its own demand” this statement
implies that production of goods and services will automatically generate income and
expenses will be incurred on the goods which are produced (there is enough demand).
In such situation generally there is no over production or unemployment on account
of excess supply of goods.

Assumptions of Say’s Law of Market:

1. Full Employment of labour and resources: Say assumes that there is full
employment in an economy it is a normal situation even if there is a temporary
unemployment economy will create employment again.
2. Flexibility of Wages, Price & Interest: Say has assumed that wages, prices and
interest rate are flexible, the flexibility brings equality between demand and supply
of labour, money, savings and investments.
3. Perfect Competition: He assumes that there is perfect competition in product and
factor market.
4. Direct Relationship between Money Wages and Real wages: According to Say
money wages and real wages are directly related and proportional. Therefore
change in the money wages will bring proportional change in the real wage.
5. Free Market Economy: It is assumed that there is free market economy equilibrium
is reached automatically between demand and supply government need not
interfere.

Criticism of Say’s Law:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

J. M. Keynes in his general theory has criticized Say’s law of market on following
grounds.
1. Supply does not create its demand.
2. Say’s law assumes that production creates demand for the goods on its own.
However this proposition is not applicable in modern economies were demand
does not increase as much as supply increases i.e. there is surplus production.
3. Self Adjustment not Possible: According to this theory full employment is reached
automatically in a long run. Keynes is of the opinion that there should be solution
in a short term because “in long run we all are dead and after death there is no
problem”.
4. Money is not Neutral: Say’s law of market is based on barter system and ignores
the role of money by saying that money does not affect the economic activities. On
the other hand Keynes says money is very important. Every household as well as
business man holds money.
5. Over Production is Possible: Say’s law is based on the assumption that supply will
create its own demand and therefore there cannot be over production. According
to Keynes people do not spent their entire income and therefore demand may not
be created.
6. Under Employment: According to Kayne’s there is no country in the world where
there is full employment. In a capitalist economy there are problems of under
employment.
7. State Intervention: According to Say’s law of market government will not interfere
i.e. “Laissez-faire policy” is adopted however in modern days in every country
there is interference of the government.
8. Demand Creates its Own Supply: Say’s law states that supply will create its own
demand but Kayne’s says that demand creates its own supply.

TOPIC NO. 6

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

THEORY OF EFFECTIVE DEMAND

Introduction: Lord JM Keynes brought out the importance of aggregate demand in

his book “General theory of employment, interest and money in 1936”.

Aggregate Demand: It means demand for all goods and services in an economy. It is
also called as aggregate expenditure.
JM Keynes gave more importance to aggregate demand. According to him, if
aggregate demand goes up, there is increase in output and aggregate income, which
increases employment level also.

How equilibrium level of income is reached?

According to JM Keynes, an equilibrium level of income is reached when Aggregate
Demand (AD) = Aggregate Supply (AS).
 Aggregate demand –It is also called Aggregate expenditure as when people create
demand, they spend money to buy the goods and services.
 Aggregate supply – It is also called as aggregate income as when goods are supplied,
income is received.

How equilibrium level of income is reached in 2-sector model?

In 2-sector model, there is household sector (consumption) and production sector
(firm) (i.e. C+I)

Aggregate demand (AD) consists of:

 Consumption demand i.e. demand for the goods and services created by the
consumers/household for personal use namely clothing, food etc.
 Investment demand i.e. demand for the goods and services created by firms/
production units namely, machinery tools etc.

An economy reaches an equilibrium at the point where Aggregate Demand (AD) =

Aggregate Supply (AS).

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

This fact can be explained with the help of the following diagram:

In the above diagram AD curve intercepts ‘y’ axis at point C which implies that even
when the income is zero, there is consumption expenditure i.e. money is spent on
food, clothing etc.
The aggregate supply (Aggregate income) goes up from the origin in 45degree angle
which implies that the amount spent on C + I = aggregate supply.
An equilibrium is reached at point E where ON is a national income and AD = AS
which is also called ‘Keynesian Cross’

How equilibrium is reached (income) when there are 3-sectors in an economy?

a) Household sector (consumption) C
b) Production sector (Investment) I
c) Government sector (Govt. exp.) G
The equilibrium level of national income in 3- sector economy can be explained with
the help of the following diagram.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In the above diagram AD curve intercepts at C on ‘y’ axis, which implies amount is
spent on basic needs even when income is zero. A interception on ‘y’ axis implies govt.
expenditure, also, apart from consumption expenditure.
AD 1 indicates consumption, investment and govt. expenditure. Equilibrium is
reached at point E.
When govt. is not involved with AD = AS and at point E 1 when govt. is involved and
national income is ON 1 i.e. an increase in the national income by NN 1 due to govt.
expenditure

How equilibrium national income is reached in four sector model?

In two and three sector model, we have assumed that there is no foreign trade i.e. there
is close economy. However in real world foreign trade plays important role in every
economy the form of export, import, investment, borrowings and lending etc. The net
foreign exchange earnings can be treated as NX i.e. net export – net import. The
equilibrium level of national income can be better understood with the help of the
diagram given below:

In the above diagram AD curve indicates close economy and AD, indicated an open
economy (with foreign trade). IN the close economy equilibrium is reached at a point
E where AD = AS and ON is a national economy and with foreign trade equilibrium
is reached at E1 where national income is ON, this point is called Keynesian Cross.

TOPIC NO. 7

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

CONSUMPTION FUNCTION
(Psychological Law of Consumption)

Introduction The concept of consumption function has been propounded by a well -

known British economist Lord J.M.Keynes.

Explanation
There is a direct relationship between income and consumption i.e. when income rises
consumption also rises. The consumption function can be better understood with the
help of schedule and diagram given below:
Sr. No. D.Y. C S (Y-C) APC= C MPC=C
Y Y
1 0 20 -20 -- --
2 100 100 0 100/100 = 1 80/100 = .80
3 200 180 20 180/200 = .90 80/100 = .80
4 300 260 40 260/300 = .87 80/100 = .80
5 400 340 60 340/400 = .85 80/100 = .80
6 500 420 80 420/500 = .84 80/100 = .80
Y Diagram

Consumption

O Income X

 Disposal Income (DY)

Income left with a person at his disposal after paying taxes to the government.
 C = Consumption expenditure
 S = Saving i.e. Y-C

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

 APC = Average propensity to consume. It can be calculated by using the following

formula.
 APC = C
Y
MPC = Marginal Propensity to Consume i.e. it establishes the relationship between
change in the income and resultant change in consumption. It can be calculated by
using the following formula.
𝐂
MPC = 𝐘

C = Change in consumption
Y = Change in income.
MPS = Marginal Propensity to save i.e. it establishes the relationship between changes
in income and resultant change in saving. It is created by using following formula.
𝐒
MPS = 𝐘

S = Change in savings
Y = Change in income.
In the above table it is observed that in the first stage even when income is 0, there is
a consumption of Rs. 20/- which indicates that whether a person has a source of
income or not, he will have to spend some money for his survival even by borrowing.
In the second stage, it is observed that as income and consumption both are equal i.e.
the point of equilibrium.
Third stage onwards it is observed that as income keep on rising, the consumption
also rises in the same proportion.
From forth stage onwards it is observed that savings keep on increasing because with
the increase in income, entire additional income is not consumed, only some portion
of additional consumption is consumed and some is saved. It is also observed that
APC keeps on failing which is the ratio of income and consumption.
Lastly it is observed that MPC is constant because income and consumption both are
changing in the same proportion.

Factors determining Consumption Function

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

(A) Objective Factors (B) Subjective Factors

(1) Income (1) Motive of Enterprise
(2) Distribution of Income (2) Motive of Liquidity
(3) Price Level (3) Motive of Improvement
(4) Unexpected Profit/Losses (4) Motive of Precaution
(5) Debts (5) Motive of Independence
(6) Expectations
(7) Advertisement
(8) Credit Facility
(9) Rate of Interest

(A)Objective Factors
1. Income: When income level goes up, consumption is automatically increased i.e.
more one earns more one spends.
2. Distribution of income: If income is evenly distributed then consumption
expenditure is more but if there is wide disparity of income consumption
expenditure is less.
3. Price level: When the goods are available at low prices consumption expenditure
rises because people would prefer to buy more.
4. Unexpected profits/losses: If person get unexpected profits then their
consumption expenditure increase and when there are unexpected losses,
consumption expenditure falls.
5. Debts: If people are living in debts then their consumption expenditure falls
because a major portion of their income earned is spent on paying interest and
principal amount.
6. Expectations: If people are expecting a bad situation in the future their current
expenditure falls but if people are expecting bright future their consumption
expenditure rises.
7. Advertisement: When products are aggressively advertised people are tempted to
buy them. As a result consumption expenditure rises.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

8. Credit facility: When credit facilities are easily and conveniently offered, people
are tempted to buy more goods thereby consumption expenditure rises.
9. Rate of interest: If banks and other financial institutions are offering high rate of
interest the people are tempted to save more money and put in the bank and
consumption expenditure reduces.

(B) Subjective Factors:

(1) Motive of Enterprise: People save more to secure resources to undertake further
capital investment in productive units.
(2) Motive of Liquidity: People like to have liquid cash on hand to feel secured to
meet exigencies of future uncertainties.
(3) Motive of Improvement: People want to save more at present to get confidence
on a better life in old age in future.
(4) Motive of Precaution: People always prefer to save money, inorder to make
provision for any future needs and emergency.
(5) Motive of Independence: People save more money to maintain their status and
dignity with enjoyment of sense of independence.
Thus, the consumption function demand is a part of the aggregate demand
influenced by the above objective and subjective factors.

Savings Function
This is also known as propensity to save.
The amount of saving normally depends on level of income i.e. is higher the income
higher the saving can be calculated by using the formula.
Saving (s) = Income (y) –Consumption (c)

The concept of saving can be better understood with the help of following schedule
and diagram:
Stage Income (y) (crores) Consumption(c) (crores) Savings(y-c)(crores)

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

A 0 20 -20
B 100 100 NIL(0)
C 200 180 20
D 300 260 40
E 400 340 60
Following are the observations:
1. In stage A consumption is more than income than it implies people are living on
borrowed money therefore there is a negative saving
2. In stage B Income = Consumption therefore no saving
3. In stage C, D and E it is observed that income can be better understood with the
help of following diagram.
Y

o X

In the above diagram OY is the income curve drawn is 45 degree angle CC is the
consumption curve.
SS is the savings curve.
In the beginning when the income is less than ON there is Dis–Saving because
consumption is more than Income.
At OM Income = Consumption & therefore there is no saving.
When income is more than ON, income is more than consumption & therefore there
is saving.
Factors affecting Savings function:-
1. Level of income- There is direct relationship between level of income & savings.
If the level of income is more savings are bound to be more & vice-versa.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

2. Distribution of income- If income is evenly distributed among the people than

everyone spends more money & therefore savings are less on the other hand when
there is even distribution of income the savings are bound to be more because rich
people can save more money because of huge income & limitation of consumption.
3. Degree of indebtness- If people are living on borrowed money than substantial
portion of their income is taken away towards payment of interest & loan &
therefore the savings are bound to be less.
4. Precautionary motive- If people are very careful about their future requirements
than they will have tendency to spend less & therefore the savings will be more
but on the other hand if people are not bothered about their future they will spend
more & therefore the savings will be less.
5. Future plans- If people have number of future plans to be fulfilled like education,
expansion of business, etc than their present consumption will be less & savings
will be more.

DISTINGUISH BETWEEN: APC AND MPC

Points Average Propensity to Marginal Propensity to
Consume (APC) Consume (MPC)
Meaning Average Propensity to consume Marginal Propensity to
is the ratio of total consumption consume is the ratio of change
to total income. in consumption to change in
income.
Expression Symbolically, it is expressed as Symbolically, it is expressed
APC = C/Y as
MPC = C/ Y
Comparison APC is always greater than MPC is always less than APC.
MPC.
Indicator APC indicates total MPC indicates additional
consumption expenditure. consumption expenditure.
SAVINGS & CONSUMPTION
Points Savings Consumption

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Meaning Saving is that part of income It refers to the expenditure

which is not spent on current incurred by the people to
consumption. purchase goods & services to
satisfy their various wants.
Formula S = Y – C, where S= Savings, Y = C = Y – S, where S= Savings,
Income, & C = Consumption. Y = Income, & C =
Consumption.
Function Saving is a function of income but Consumption is a function of
depends on liquidity, preference income, i.e. C = f(Y).
& rate of interest.
Importance Saving encourages investment & Consumption encourages
capital formation in the economy. further production of goods
& services in the economy.

SAVINGS & INCOME

Points Savings Income
Meaning Saving is that part of income It is the amount earned or
which is not spent on current received by an individual or
consumption. a unit or a group during a
given period of time.
Formula S = Y – C, where S= Savings, Y = Y = C + S, where S= Savings,
Income, & C = Consumption. Y = Income, & C =
Consumption.
Importance Saving encourages investment & Income facilitates
capital formation in the economy. expenditure on consumption
& savings, if any.

TOPIC NO.8
INVESTEMENT FUNCTION

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Introduction: The word function indicates the relationship between two or more
economic variables, dependant and independent.
Investment function indicates the inducement of the people to invest. Investment
function can be expressed in an equation; I= f(e,I)
I= investment
F= function
E= marginal efficiency of capital
I= rate of interest

Determinants of Investment Function

According to Lord Keynes investment depends on:
1) Rate of Interest
2) Marginal efficiency of capital (MEC)

 Rate of interest: Rate of interest means the amount of money required to be paid
for borrowed interest, lower the investment and lower the rate of interest higher
the investment. In a short run, rate of interest is normally stable and therefore it is
not a very active factor to determine level of investment.
 Marginal efficiency of capital (MEC): Marginal efficiency of capital indicates that
higher the returns on investment; higher the tendency to invest. Marginal efficiency
of capital can also be called as “expected profitability”
According to Mr. Kurihara, “marginal efficiency of capital is the prospective yield of
additional capital asset and their supply price. This can be expressed in the symbolic
terms as follows:-
E=Q/p
E= marginal efficiency of capital
Q= prospective yields of capital asset
P= supply price of this asset
It is clear from the above definition that by following factor. They are as follows...
i) Supply price of an asset

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

ii) Prospective yield

iii) Rate of interest
iv) MEC schedule and level of investments
 Supply price of the Asset: It refers to the price of an asset which an
entrepreneur has to pay to acquire new brand assets. Eg. If machine is available for
Rs. 10,00,000 it is a supply price. Lord Keynes arrived at a precise definition of MEC
by relating the above two concepts of (a)supply price; (b) prospective yields.
 Prospective yields: It means the amount of money which investors are expecting
to earn from the money invested in the assets arriving its lifetime after deducting
operating expenses.
E.g. If Mr. A has invested Rs. 10,00,000 in a machinery and has expecting the total
returns of Rs. 20,00,000 after deducting operating expenses like maintenance. Life
span of the machinery is 10 years. In this case; the prospective yield per annum is Rs
20,00,000.
However, Keynes formula for calculation is reffered as series of annuities is referred
to as Q1, Qi2, Q3, Q4.....Q10. In this case ‘Q’ stands for annuity and number 1,2, 3 stands
for years.
According to Keynes annuities may vary from year to year.
 Rate of Interest: Marginal efficiency of capital depends on rate of interest. If the
rate of interest is more than MEC is less and vice-versa. In other words MEC and
rate of interest are inversely related to each other.
 MEC Schedule and level of investments: According to J.M Keynes there is inverse
relationship between MEC and level of investment because as the level of
investment increases MEC starts falling this fact can be better understood by
schedule and diagram given below:

Investment (in 1000) MEC (in %)

2 20
4 18

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

6 16
8 14
10 12
12 10

In the above scheduled diagram it is observed that as the investment raises the MEC,
keep on falling shown by negative slope of a curve.

Factors affecting MEC

Factors affecting MEC are classified under two heads;
a) Short term factors
b) Long terms factors
A) Short term factors affecting MEC are:
1) Expectationsabout demand, price and cost: The MEC will rise if the investor
expects the demand for the product to rise or the costs to fall and vice versa.
2) Changes in the propensity to consume: An increase in the propensity to consume
will raise the MEC and vice versa, because the demand for capital goods depends
partly upon the demand for consumer goods.
3) Changes in income: Sudden increases in income due to tax concessions, windfall
gains, etc. will raise the MEC and a fall in income will lower the MEC.
4) Business optimism and pessimism: business optimism will increase MEC, while
business pessimism will lower MEC. Business optimism and pessimism depend
upon political, psychological and social factors.

B) Long Term factors affecting MEC are:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

1) Increase in population
2) Development of new areas
3) Improvements in technology
4) Development of infrastructure
The above factors will lead to huge investment activates of all types in the economy.

Investment Function
Introduction: Broadly speaking investment can be classified into 2 parts:-
a) Financial investment: i.e. investment in financial documents (shares and bonds)
b) Real Investment: i.e. Investment in assets and properties (machinery, building,
tools)

Lord Keynes is concerned with Real Investment only because real investment leads to
addition of output and creation of employment.

Classification of Investment
Investment can be classified into 2 parts:
Autonomous Investment Induced Investment
1) It means investments which is made 1) It means investment which are
without any reference to income and dependent on profitability that is,
profits that is; profit is not the higher the profit, higher the
consideration. investment and lower the profit
Eg. Investment in public hospital lower the investment.
2) Autonomous investment is income 2) Induced investment is income elastic
inelastic
3) Autonomous investments is normally 3) Induced investments is normally
done by the government done by private sector

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Gross Investment Net Investment

i)Gross investment refers to total i) Net investment refers to the Gross
investments in fixed assets like factory, Investment- Depreciation.
building, machinery and also the
investments in current assets like raw
material, work in progress, etc
ii)Gross investment does not represent ii) Net investment represents the real
the real; investment because it does take investment because it provides for
into consideration depreciation depreciation
iii) Gross Investment always more than iii) Net investment is always equal or
net investment less than gross investment

TOPIC NO. 9
THEORY OF MULTIPLIER

Multiplier / Keynesian Multiplier / Investment Multiplier

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Introduction:Mr. R.F. Khan originally developed the concept of investment multiplier

in the year 1935 to explain the relationship between increase in investment and
increase in income.
Subsequently, Lord J.M. Keynes refined it.
Meaning of Multiplier:According to Lord J.M. Keynes, when initial investment is
increased, it increases consumption income and employment many fold.
The concept of investment multiplier can be expresses symbolically:
∆𝑌
K=
∆𝐼

E.g: If initial investment is increased by Rs: 100 which results in increase income by
Rs: 400 then multiplies = 4 which means that investment increases the income 4 times.
It can be calculated in the following manner:
1 1
K = 1−𝑚𝑝𝑐 or K = 𝑚𝑝𝑠

K = Multiplier, mpc = marginal propensity to consume &

Mps = marginal propensity to sale

Assumption of Multiplier
The Keynesian theory of multiplier is based on following assumption:
1. Constant marginal propensity to consume– The marginal propensity to consume
remains constant during the process of income propagation.
2. Excess Capacity– There is an excess capacity in various consumer goods
industries.
3. Existence if Unemployment– The economy operates at less than full employment
level and there exists in voluntary unemployment in the economy.
4. No time lag– There is no significant time lag involved between the receipt of
income and to its expenditure.
5. Closed Economy– The economy is a closed economy and the country has no
foreign trade activity.
6. Stable monitory and fiscal policy– The fiscal policy and monitory policies remain
stable so that they do not influence propensity to consume.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

7. Stable Economy– It is assumed that economy is stable in nature.

8. Stable price level– The price level remains stable throughout the process of income
propagation.

Concept of Multiplier can be better understood with the help of following schedule
and the diagram:
Multiplier Schedule
Increase in Induced Income Additional Additional Savings
Investment (Rs. in crores) Consumption (Rs. in crores) (20%)
(Rs. in crores) (Rs. in crores)
(80%)
1000 1000 800 200
800 640 160
640 512 128
512 410 102
Total 5000 4000 1000

Higher the mpc higher the increase in national income (income – consumption =
savings).
It is observed that with the initial increase in investments of Rs. 1000 crores there is
increase in the national income of Rs. 5000 crores which is the multiplying effect.

In the above diagram the total original expenditure curve C + I intersects in 45o angle
at point E at which national income is OY1. However when the additional investment

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

is made the new curve is C + I + ∆𝐼 which is to the right and national income is
increased to OY2 i.e. ∆𝑌 is much greater than ∆𝐼 which is multiplying effect.

Leakages in the Multiplier

The operation of certain factors reduces the process of income propagation or
multiplier effect. These factors are termed as leakages of multiplier. They are as
follows: -
1. Holding of cash balances – If people prefer to save part of their increase in income
and do not use for consumption, the multiplier effect would be reduced. The higher
the hoarding, the lower would be value of the multiplier and vice-versa.
2. Purchase of shares and security – If a part of an increased income is spent on
buying shares and government securities, like bonds. The consumption will be less
and the multiplier effect would be low.
3. Debt un-payment –If people use part of their increased income to repay old debts
instead of spending for future consumption, the value of multiplier will be reduced.
4. Net imports – When there is an excess of exports over imports, there is a net outflow
of funds to foreign countries. This outflow of flow reduces the value of multiplier
in short run.
5. Inflation – When there is a use in prices of consumption goods, it would require
additional money expenditure to consume the same amount of goods and services.
The increase in income will be lower and multiplier effect would be reduced.
6. Higher taxes and co-operate savings – The higher taxes and an increase in
cooperate savings would reduce consumption expenditure of people and value of
multiplier.

Limitations of Multiplier or Criticism of Keynes Theory of Multiplier

1. Existence of time log – Keynes assumed that there is no time gap between the
receipt of income and its expenditure in working of multiplier. According to critics,
this assumption is highly unrealistic as in reality there is an existence of time log
between receipt of income and consumption expenditure as well as between
consumption expenditure and its reappearance as income.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

2. Static phenomenon – According to critics the Keynesian theory of investment

multiplies is a static phenomenon as it is not suitable to the changing process of
dynamic world.
3. No Empirical Verification – According to Haler Keynes presentedno ethical
evidence of his multiplier theory. Keynes offered only some observation instead of
sound proof for his multiplier theory.
4. Exclusive emphasis on consumption– According to Gordon Keynes emphasized
too much on marginal propensity to consume. It would have been more realistic to
emphasize on “Marginal Propensity to spend” rather than marginal propensity to
consume.
5. Neglected effect of induced consumption on induced investment – According to
Keynes, the multiplier theory takes into account the effects of induced consumption
on income. It completely neglects the effect of induced consumption on induced
investment i.e. capital goods sector.
6. Worthless Concept – According to Professor Hazlitt, there can never be a precise
relationship between an increase in investment and increase in national income.
Hence the concept of multiplier is a myth and it is a worthless concept.

Reverse Multiplier
The multiplier operates forward or backward depending upon rise or fall in the
investments.
If investment rises the multiplier will move forward and when investment falls it will
move backwards which is called reverse multiplier.
The reverse multiplier can be understood with the help of the following diagram:

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In the above diagram original investment curve is I and equilibrium is reached at point
“E” where I & S intersect each other. (SS curve is drawn on the assumption that MPS
is same at all levels of MI and national income is “OY”.
However when investment falls as downwardly I, the new equilibrium is revealed at
point E1 and national income has fallen to OY1 the YY1 (change in NI) is greater
than II1 which indicates that small fall in investments leads to much more fall in NI.

Money Multiplier
The total money supply in an Economy is always more than currency, initially
supplied by monetary authorities.This is called as money multiplier.
𝑴
m=𝑯

M = Total money supply

H = High powered money (C+R)
m = Money multiplier

How much will be the total money supply depends on:

1) Currency deposit ratio (k)
2) Reserve ratio (h)

Currency deposit ratio (k)

The high-powered money (h) is determined by
1) The money as a currency (c)
2) The banks as reserves (r)
When the people demand more cash, less cash is available with the banks therefore,
lower is the credit creation. The ratio of preference of the people demanding deposits
is called currency deposit ratio.

Reserve Ratio (r)

The reserves held by the banks as reserve money can be divided into two parts:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

1) The required reserves (rr)

2) Excess reserves (es)

Required Reserves – The required reserves is one which commercial bank must hold
with the RBI when required reserves is reduced, commercial banks will have more
cash in hand to create loans

Acceleration
Introduction:The principle of acceleration was originally introduced by French
economist Mr. Albert & subsequently refined and developed by Hick Samuelsson &
others. This principle basically, tells us that when there is rise in the demand for
consumer goods, it leads to rise in the demand for capital goods at much higher rate.
For eg: If demand for car (consumer goods) increases by 10% may lead to increase in
demand for machinery (capital goods) by 20%.
The principle of acceleration shows the relationship between change in the demand
for consumption goods and capital goods.
Symbolically,
A = Accelerator
I = change in demand for investment/capital goods
C= change in demand for consumption goods.
The concept of acceleration can be better understood with the help of schedule given
below:

Accelerator Schedule
Duration Demand % of No. of No. of No. of Total No. Remark
for Cars change machinery machinery machinery of
in required required for required machinery
demand to meet replacement to meet required
for cars to meet

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

original new total

demand demand demand
0 1000 -- 100 -- -- 100 --
demand fo
cars is
1 1000 -- 100 10 -- 110 constant bu
for
machinery
is increased
by 10% for
replacemen
demand fo
cars has
2 1100 10% 100 10 10 120 increased b
10% but fo
machinery
is increased
by 20% for
replacemen
↑ 10% ↑ 20% 1:2

Observations:
It is observed that when the demand for the consumer goods is increased by 10%,
demand for the capital goods is increased by 20%

Assumptions of Acceleration:
1) Demand for the cars is 1000 in the first year
2) For manufacturing cars, 10% machineries are required i.e. 100 machineries are
required for manufacturing 1000 cars.

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3) Machinery has a life span of 10 years i.e. every year 10% machineries are required
to be replaced.
4) Demand for the cars is increasing only from second year.
5) It is necessary to have capital goods
6) It is assumed that factories working at a full capacity and therefore with the increase
for cars there is a increase in the demand for the machinery

Limitations:
1) It is assumed that capital output rate will remain constant but in fact it keeps
changing.
2) It is assumed that there is full utilization of capacity but in many cases there is
underutilization.
3) It is also assumed that resources are available for investment but in fact they may
not be available
4) It is also assumed that there is no time gap between production and consumption
but in fact there is always a time gap
5) It is assumed that demand is constant but in fact it keeps on fluctuating.

Distinguish between Multiplier & Accelerator.

Multiplier Accelerator
Multiplier means the no. of times the Accelerator means rise in demand for
rise in income due to rise in capital goods due to rise in demand
investments. for consumption goods.
∆𝑌 ∆𝐼
K= A = ∆𝐶
∆𝐼

Multiplier depends on investment. Accelerator depends on demand for

Higher the investment, higher will be consumption goods.
the national income but investment
again depends on MPC i.e. Higher the
MPC, higher will be the investment.

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TOPIC NO.10
LIQUIDITY PREFERENCE THEORY OF INTEREST

Introduction: Liquidity preference theory of interest was profounded by “Lord J.M.

Keynes”.
What is Interest?

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Interest is the price paid for money i.e. just like a price of a commodity is decided by
its demand, interest rate is decided by its demand for liquidity preference (D/D for
money) & supply for money.

Factors Determining Demand for Liquidity Preference/ Demand for Money

Demand for liquid cash i.e. Desire to hold liquid cash in hand or in a bank account
from which money can be withdrawn any time (saving & current account) depend on
three motives: -
1. Transaction Motives: It means desire of people to keep liquid cash in hand/ bank
for day to day unavailable expenses.
Individuals/ household keep liquid cash with them to meet day to day expenses
like food, transport, clothing etc.
Businessmen keep liquid cash with them to meet day to day expenses bill etc.
The Demand for Transaction Motive is : -
A. Interest Inelastic: i.e. irrespective of rate of interest offered by the banks on term
deposits the D/D for transaction motive remains same because expenses are
unavailable &
B. Income Elastic: i.e. money demand for transaction motive depends on higher the
income higher the money demanded for transaction motive.
2. Precautionary Motive: It refers to demand for liquid cash created by the people to
meet unexpected emergencies.
Individuals and firms keep money for precautionary and sickness etc.
The demand for precautionary motive is interest inelastic i.e. higher the income –
higher the demand for precautionary motive.
3. Speculative Motive: It refers to cash in hand/bank (savings/current account) kept
for speculation i.e. to take advantage of price fluctuation i.e. buy at lower price and
sell at higher price.
The demand for speculative motive is interest elastic i.e. if banks are paying higher
interest on term deposit people will keep less cash with them and vice-versa i.e.
there is inverse relationship between ROI and demand.

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We can express the demand for money for transaction, precautionary and
speculative motive as under:-
Md = M1 + M2
Md= total demand for money
M1 = demand for money for transaction and precautionary motive M1 f(Y).
M2 = demand for money for speculative motive M2 f(r).
Md = f (y,r).
The relationship between rate of interest (ROI) and demand for liquidity preference
(cash in hand) can be better understood with the help of diagram given below:

In the above diagram it is observed that rate of interest is reduced from OR to OR1
by the bankers and financial institutions. Demand for money (cash in hand)/
liquidity preference) has increased from OM to OM1 has denoted Md curve sloping
downwards from left to right which means there is a inverse relationship between
rate of interest and demand for liquidity preference.
Supply of Money: According to Lord J.M. Keynes money is supplied by the central
bank of the country and in a short run money supply remains constant irrespective of
rate of interest. This fact can be explained with the help of the diagram given below:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In the above diagram MS curve (money supply curve) is a vertical straight line
indicating irrespective rate of interest money supply remains constant.

Determination of Rate of Interest: Demand for liquidity preference (demand for

cash) and supply for liquidity preference (supply of cash) can be better understood
with the help diagram given below:

In the above diagram Md is a demand curve for liquidity preference and Ms is money
supply curve both the curves intersect at point E at which OR is the rate of interest.

Criticisms of Liquidity Preference Theory of Interest:

1. One Sided Theory: According to Prof. Hazitt the liquidity preference theory is one
sided because it takes into account only monitory factors affecting the rate of
interest whereas infact there are non monitory factors also which affects rate of
interest.
2. Role of productivity is neglected: According to critics the rate of interest paid by
the borrower to the lenders depends on productivity of a capital which is
completely neglected by J.M. Keynes.

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3. Element of savings ignored: According to Prof. Jacob this theory has ignored
elements of savings, according to this theory rate of interest for is for partying
(surrendering) with the liquidity but in fact rate of interest is paid saved by the
people.
4. Long Run Period is neglected: According to critics Keynes has considered only
short run factors in determining rate of interest and has fail to explain
determination of rate of interest in a long run.
5. Different rate of Interest: According to critics liquidity preference theory fail to
explain why different rate of interest exist for different types of loans.
6. Failure to explain Depressionary Situation: According to critic rate of interest
during the depression is very low while liquidity preference is very high. This is
contrast to Kenyes theory which says higher the liquidity (keeping more cash in
hand and not in bank) higher the rate of interest (bank do not have more deposits).

TOPIC NO. 11
ISLM Model

The ISLM Model is introduced by Hicks &Hansen they divided market into two parts
a) Goods/ Product Markets
b) Money Market
They explained how an economy reaches equilibrium with the help of equilibrium in
product and money market.
 The product/ goods Market equilibrium and IS curve.

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 The goods/ product market researches an equilibrium when aggregate demand =

Aggregate income.
 The aggregate demand depends on consumption investment demand
 The ROI is an important factor to determine level of investment
 When ROI (Rate of Interest) falls (), the level of investments rise () and vice-versa.
 When the level of investment rises (), there is a rise in aggregate demand.
 The level of investments decides the goods market equilibrium and the level of
investments is decided by rate of interest. Indirectly IS curve relates different levels of
equilibrium of National Income with ROI i.e. when ROI rises (), Investment falls (), and
when investment falls (), Aggregate demand also falls () and vice-versa. The result of
changes in the above factors leads to shift in the equilibrium in the goods market.

The above diagram is divided into panel ‘A’ & ‘B’.

 In panel A, ‘AD’ curve intersects at point A1 on 45 degree line and the goods market
is in equilibrium at OY, Income curve is panel B at ‘E1’ point the ROI is OI1.
However, when there is a fall () in the ROI to OI2, the AD2 curve intersects at point
E2 in panel “A” and as a result National Income goes up to OY2 by joining E1 E2.
 In panel B, we get IS curve. The IS curve slope downwards because sue to fall () in
the ROI, the investment and Aggregate demand rises (). When IS curve shifts to the
right it indicates i.e.
1) There is an increase in government spending OR
2) There is a fall in the tax rate OR
3) There is a rise in the autonomous investments.

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Money Market Equilibrium and LM Curve

The money market equilibrium is reached when demand and supply of money are
equal.
 The LM curve explains different combination of rate of interest and National Income
at which money market reaches equilibrium.
 The demand for money for transaction and precautionary motive depends on level of
income i.e. higher the income, higher the DLP (demand for liquidity preference)
 The demand for money for speculative motive depends on ROI i.e. if the ROI is more
demand for DLP is less.
Md = L (y, r)
Md = Money demand
L = Liquidity preference
Y = Real income
R = ROI

TOPIC NO. 12
PHILLIPS CURVE – UNEMPLOYMENT – STAGFLATION

Phillips Curve
Introduction: A noted British Economist, A.W. Phillips published an article in 1958,
on the basis of research of historical data from UK for about 100 years.
On the basis of data collected by him, he arrived at a conclusion that there is an Inverse
relationship between Inflation (price rise) and level of unemployment in a country.
In other words there is a trade off between the level of unemployment and inflation
i.e. for reducing level of unemployment the higher rate of inflation must be accepted
and for reducing the inflation higher rate of unemployment must be accepted.
The concept of Phillips Curve can be explained with the help of diagram, given below:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

It is observed that at point “E” the rate of inflation is 10% and rate of unemployment
is only 2% and when rate of inflation falls to 5% the level of unemployment has
increased to 5%.
However during ‘70s in USA & Britain a situation contrary to Phillips curve had a rose
i.e. there was high level of inflation and also high level of unemployment in a country.

Stagflation
Introduction:- The term stagflation is introduced by Jain Macleod, a British
parliamentarian in the year 1965.
The concept of stagflation is contrary to concept of Phillips curve because in
stagflation there is;
a) Increase in rate of Inflation and
b) Increase in level of unemployment
The concept of stagflation can be explained with the help of following diagram:

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In the above diagram “AS” is aggregate supply curve and AD is aggregate demand
curve.
At point E, ‘AS’ curve intersects ‘AD’ curve where at ‘op’ price “ON” output is
produced and economy reaches an equilibrium. Due to increase in oil prices etc. the
cost of production rises leading to upward movement of supply curve i.e. AS1. “AS1”
curve at which price “E1” on AD curve, at which price increased to “OP” and output
reduces to “ON1” this indicates.
1) Prices have gone up (inflation)
2) Output have reduced (production)
3) Due to less output even employment falls i.e. (unemployment increases).
Some of the economists are of the opinion that India faced stagflation in 1970’s and
1980’s and currently USA is heading for stagflation.

Causes of Stagflation
1) Higher prices of crude oil: Increase in the prices of crude oil is major causes of
stagflation the “OPEC” Organisation of petroleum exporting countries “have taken
steps in this regard”
2) Increase in cost of production: Due to rise in cost of wages, raw material & other
products there is increase in cost of Production.
3) Low productivity: The lower productivity (i.e. average production & Quality)
mainly due to protection to the labourer results in higher cost.
4) Social Benefits: Social benefits in the form of pension, free supply of goods, good
and services for the poor, subsidies , unemployment benefits, food security etc
creates more demand without increasing the production leading to stagflation
5) Excessive Government Regulations: Complicated & unwanted rules regulations,
procedures & formalities results in less production leading to stagflation.
6) Higher Taxes: Due to higher taxes imposed by the Govt., cost of production
increases resulting in higher prices and less demand.

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7) Benefits Finance: Due to deficit financing there is ore expenses incurred by the
Govt. Than income resulting in more demand and higher prices.
8) Policy changes: popular policy measures like farmer debt waiver, free electricity;
free educational, higher salary leads to more demand without increase in supply
leads to stagflation.

TOPIC NO.13
MONEY SUPPLY

Meaning of Money Supply:

It means total stock of domestic currency owned by the public (individuals and
business organization) in a country. In other words, money held by the govt. Central
bank & Commercial bank does not include money supply because it is not in
circulation.
Constituents of Money Supply: Constituents of money supply is classified into two
parts
Constituents of Money Supply
Traditional Measure B)
Modern Measure
(Narrow Money) (Broad Money)

1) Currency (Coins & Notes) 1) Currency (Coins & Notes)

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2) Demand Deposits 2) Demand Deposits

3) Saving Deposits with P.O
4) Time Deposits (Fixed)
5) Government Securities
6) Credit

Traditional concept of money or Narrow Money

According to traditional concept, money is means of making payments therefore it
includes only those things, which can be used for making immediate payment for
purchase of goods and services.

Traditional concept of money includes:

1) Currency – It includes coins and notes, which can be used for making immediate
payments.
2) Demand Deposits – These are those deposits which account holder can withdraw
from the bank anytime by cash or making of payments to anybody by issue of
cheques. For eg: Current account or Savings account. It should be noted that time
deposits i.e. deposits in the form of fixed deposits are not included because money
can be withdrawn only after the expiry of a particular period of time. It is also called
extraction money because it is used for day-to-day transaction. Symbolically, it can
be expressed as
M1 = C + DD
M1 = Traditional/Narrow money
C = Currency
DD = Demand deposits

M1 is very near to RBI’s concept of M1

RBI’s concept of M1 is:
M1 = C + DD + OD
OD includes other deposits of commercial banks and foreign banks with RBI; this is
very negligible and therefore can be ignored for practical reasons.

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A) Modern Concept of Money or Broad Money:

The modern concept of money is also called as new money or economist like Milton
Freidman, Edward etc. and supports broad money concept.
Broad money concept includes everything, which is in liquid form & new liquid form.

The modern concept of money can be called as M2 i.e. M1 + a + b + c + d

No. M1 M2 M3 M4
1 Notes in Notes in Notes in circulation Notes in circulation
circulation circulation
2 Circulation of Circulation of Circulation of Rupee Circulation of Rupee
Rupee Coins Rupee Coins Coins Coins
3 Circulation of Circulation of Circulation of small Circulation of small
small coins small coins coins coins
4 Cash with banks Cash with banks Cash with banks Cash with banks
5 Demand deposits Demand deposits Demand deposits Demand deposits with
with bank with bank with bank bank
6 Other deposits Other deposits Other deposits with Other deposits with RBI
with RBI with RBI RBI
7 POSB deposits POSB deposits POSB deposits
8 Time deposits with Time deposits with
bank bank
9 Total post office
deposits

It should be noted that from M1 M2 M3 M4 are arranged in order of liquidity.

It should further be noted that money supply must not include
1) Cash balance of govt. – Cash balance held by central and state govt. with central
bank (RBI)
2) Time deposits – Deposits commercial bank, which cannot be withdrawn before
maturity, they are included in money supply only when they are withdrawn.

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3) Overdraft – It is not included unless the holder uses them.

4) Cash balance reserves – Cash balance held by central and commercial bank held as
reserves to support demand deposits.
5) Monetary gold reserve – It is held by the central bank because it not in circulation.
Since the above-mentioned are not in circulation, therefore they are not money.

High Powered/ Reserve Money (H)

High Powered/Reserve money is at the base of “money supply”. High
Powered/Reserve money can be expressed as: H = C + R + OD
C = Currency i.e. (Coins & Notes)
R = Cash Reserve Ratio
OD = Other Deposits with R.B.J

High Powered/Reserve money concept defers from M, concept of money of RBJ in

“second” components.
M1 = C + DD + OD
C = Currency with public
DD = Demand Deposits
OD = Other deposits with RBJ

High Powered/Reserve money is referred as Mo also.

H (Mo) = C + R + OD

“R” is cash reserves ratio & is decided by the central monetary authority i.e. RBJ and
not the commercial banks.
DD is a creation of commercial banks. The amount of “DD” available depends on ‘R’.
If ‘R’ is more, DD will be less because more money goes to the Central Bank. The
capacity of commercial banks to create Loans/ Credit depends on “DD”. Therefore
“R” is at the base of money supply.

Velocity of Circulation of Money

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Introduction: Money supply at a given point of time (stock of money) is the static
concept, to know money supply over a period of time we should multiple stock of
money (M) with velocity of money (V).
The difference between money supply at a particular point of time and over a period
of time is well brought out by D.H. Robertson by describing them as “Money Sitting
(Stock of Money) and Money on the Wing (Velocity)”

Meaning: In simple term velocity of Money means number of times money is

circulated during a given period of time.

Velocity of Money is classified into Two Parts

1. Transaction Velocity: It means the speed at which unit of money moves around the
circle of payments from income to the payment for goods and services and back to
income again.
Annual Volume of Transaction
Transaction Velocity Ratio = 𝑆𝑡𝑜𝑐𝑘𝑜𝑓𝑀𝑜𝑛𝑒𝑦

E.g. If stock of money is Rs. 1000 crores transaction conducted are worth Rs. 10,000
crores.
Annual Volume of Transaction 10,000
Transaction velocity ratio = = = 10
𝑆𝑡𝑜𝑐𝑘𝑜𝑓𝑀𝑜𝑛𝑒𝑦 1000

Therefore, TV Ratio = 10 which means 1 unit of money is circulated 10 times in a year.

Factors Determining transaction Velocity

A number of factors influence the transaction velocity. They are:
1. Volume of Production and Trade: With a constant supply of currency and demand
deposits, their velocity would be more when economy produces more goods and
this has more transactions.
2. Institutional Arrangements: If the institutional set up comprising banks and other
financial intermediaries enable deferred payments, or other credit systems, the
velocity will be lower.

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3. Savings: If people increase their savings, less money is spent, bringing down the
velocity. Dis-savings, on the other hand increases expenditure and this transaction
velocity.
4. Change in Price Level: During inflation money circulates faster, whereas during
deflation economic activities decline and so also the velocity. A change in price level
is usually associated with cyclical phases. During the prosperity period economic
activities increases and also the price level. This necessitates a higher velocity of
money. Reverse is the situation during deflation.
5. Regularity and Certainty of Income receipts: Time interval between successive
income receipt influences velocity of money. If income is received in quick intervals,
less money is required to be held therefore money turns over faster. Long intervals
increase idle cash and reduce velocity. Certainty of income receipts infuses
confidence and encourages spending. If income receipts are not certain people
become cautions, spend carefully, keeping balance to meet uncertainty and thus
reducing velocity of money.

Income Velocity of Money

It is the “average number of times a unit of money is used for making payments for
final and services”. The concept is more popular with national income accounting
techniques.
𝐺𝑟𝑜𝑠𝑠𝑁𝑎𝑡𝑜𝑖𝑛𝑎𝑙𝑃𝑟𝑜𝑑𝑢𝑐𝑡 (𝐺𝑁𝑃)
The Income Velocity Money Ratio = 𝑀𝑜𝑛𝑒𝑦𝑆𝑡𝑜𝑐𝑘

If the GNP is Rs. 50,000 crores and money stock (M1) is Rs. 10,000 crores,
𝐺𝑟𝑜𝑠𝑠𝑁𝑎𝑡𝑜𝑖𝑛𝑎𝑙𝑃𝑟𝑜𝑑𝑢𝑐𝑡 (𝐺𝑁𝑃) 50,000
The Income Velocity Money Ratio = = 10,000 = 5
𝑀𝑜𝑛𝑒𝑦𝑆𝑡𝑜𝑐𝑘

i.e. Income Velocity of Money is 5 times in a year.

The income velocity is always lower than transaction velocity, since the former
confines itself to the final goods and services. Transaction in financial assets and sales
of existing land and building are also excluded from income velocity.

Factors Determining Income Velocity

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Growth of GNP: An increase in GNP vis a vis given quantity of money requires faster
turnover of money to purchase the larger quantity of final goods and services. A
decline of GNP with the constant quantity of money would reduce the income velocity.
Similarly an increase in quantity of money with constant GNP would bring down the
income velocity of money.
Demand for Idle Cash: Income velocity of idle cash is zero. If the demand for idle cash
increases, expenditure on final goods and services declines, bringing down the income
velocity.
Quantity of Money Supply: If the stock of money increases faster than the final goods
and services, the income velocity falls, since there are less goods and services available
to purchase.
Besides these, some factors which affect the transaction velocity also affect income
velocity of money.

TOPIC NO. 14
DEMAND FOR MONEY

Introduction: We live in a monetary economy in a monetary economy people create

demand for money
 Buying goods and services
 Holding at idle cash

We must answer two questions to understand the concept of demand for money
 Why people want (demand) money?
 Which factors decide the demand for money?

Theories of Demand for Money

A) Classical Theory of demand for money:

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 The classical theory of demand for money is profounder by economists like David
Hume, T.S. Mill and Living Fisher etc.
 According to them, money is demanded for buying goods and services.
 Money acts as a medium for exchange.
 If the volumes of transactions are more than the demand for money is also more &
vice-versa.
The demand for money is determined by three objective factors:
 The volume of transactions (Quantity)
 Price of commodity products
 The velocity of money circulation MV = PI
M – Money supply
V – Velocity
P – Price Leader
I – Transaction which means, money supply is money issued by the government x
velocity
(Number of times money is circulated during a given period of time). Total demand
for money = price x quantity of goods purchased.
From the above it is very clear that: -
 MV indicates supply of money
 PT indicates demand of money in short run
 M & T are constant
 The increase in velocity of money reduces demand for money

B) Cash Balance Theory (C.B.T)

Cash Balance Theory (CBT) relating to value of money has been presented by Neo –
classical economist like Marshall, Robertson, and Keynes. This version is also known
as Cambridge equation because all these economists belong to Cambridge school of
economics in Chicago. This theory is known as C.B.T because it gives more importance
to cash balance rather than cash transaction.
The CBT states that value of money depends upon the demand for the cash balance
(Demand for liquid cash in hand) rather than price level.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In modern days, the supply of money remains constant i.e. fixed. Demand for money
plays a very important role in determining the value of money. Thus, according to
Cash Balance Theory for money, “The Demand for money remaining equal”, the value
of money varies inversely with the supply of money i.e. if the supply increases the
demand remaining the same (equal) value of money falls. Therefore, vice - versa.

Explanation:
According to this Neo – Classical Theory, the value of money is determined by demand
and supply of money.
Cash Balance Theory by Alfred Marshall:
According to Dr. Alfred Marshall, cash balance equation is as follows: -
M =Ky
M = Stock of Money (Money Supply)
K = Refers to proportions of income which person would prefer to retain with him as
liquid cash
Y = Value of output = Price x output (P x O)

C) Keynesian Approach of demand for money

According to Lord Keynes, demand for money depends on demand for liquidity
preference i.e. demand for liquid cash by the people. According to him, people keep
liquid cash with them for three important motives –

Transaction Motive:
Transaction motive means demand of people to keep liquid cash with them to make
day-to-day unavoidable expenses.
Individuals keep liquid cash with them to meet expenses on food transport etc.
Businessmen or firms keep liquid cash with them to meet expenses like wages taxes
light bill etc.
Demand for transaction motive in interest inelastic that is irrespective of rate of interest
the demand for transaction motive remains the same.

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However the demand for liquidity motive is influenced by income. Higher the income,
higher the demand for liquidity preference and vice-versa.

Precautionary Motive:
Precautionary motive means the demand for money created by the people to meet
emergencies, which are unpredictable.
Individuals/Firms keep liquid cash to meet emergencies like accidents, sickness etc.
Demand for the precautionary motive is an interest inelastic that is irrespective of rate
of interest. The demand for precautionary motives remains the same.
However, demand for precautionary motive is directly related to income i.e. higher
the income, higher the demand and vice-versa.
Lord Keynes calls the combined demand for transactions and precautionary motives
by individuals and firms “Active Balances”. Symbolically it’s called “L1”

Speculative Motive:
Speculative motive means desire of people to keep liquid cash in hand to take
advantage of fluctuation in rates of interest and prices of shares and bonds.
Lord Keynes has observed that when the rate of interest is expected to rise the demand,
the demand of money for speculative purpose i.e. bond market starts falling as people
would like to take advantage of higher rates of interest and vice-versa.
Demand for speculative motives is inversely related to rate of interest. Lord Keynes
calls it as “Idle Balances” symbolically called “L2”
According to Keynes, the total aggregate demand for money consists of ‘L1’ & ‘L2’
L1 includes transaction and precautionary motives that depend on income.
Symbolically, L1 = f (y)
L2 includes speculative motives that are dependent on rate of interest.
Symbolically, L2 = f (r)
Therefore, according to Keynes, L1 + L2 = L
L = f (y,r)

Demand for Liquidity Preference Curve

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The total or aggregate demand for money with a given level of income (income is
assumed to be stable) depends on the rate of interest i.e. higher the ROI lower the
demand for liquidity preference i.e. demand for liquid cash.

TOPIC NO.15
INFLATION

Introduction: The word inflation is very common and is used by everybody

repeatedly. It has become a global problem. Normally, everybody suffers due to
inflation. Only the extent of suffering may differ.
Meaning: According to Gowther, inflation is a state in which value of money is falling.
According to Coulbwin, inflation means too much of money chasing too few goods.
According to J.M.Keynes, inflation means a rise in the price level after the point of full
employment is true inflation.

Demand Pull Inflation: Whenever there is a rise in a price level due to rise in demand,
it is called demand-pull inflation.

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The concept of Demand Pull Inflation can be better understood with the diagram
given below:

In the diagram above, SS is the supply curve and DD is the original demand curve.
They intersect at point E and goods are sold at OP Price. However, due to rise in the
demand, demand curve moves to the right represented by D1 D1. Supply being
constant at point E1 equilibrium is reached and goods are sold at OP1 price. In other
words, price has increased from OP to OP1 leading to inflation due to rise in the
demand.
Following are the factors causing Demand Pull Inflation:
1) Increase in money supply: Money supply is the responsibility of monetary
authority (RBI). When reserve bank of India increases money supply without
corresponding, increase in supply of goods leads to more money chasing too few
goods. As a result prices go up which is called inflation.
2) DeficitFinancing: It is a situation in which government expenditure is more than
govt. revenue. As a result of expenditure, people’s income rises resulting in more
money supply creating more demand for goods without corresponding increasing
supply as a consequence higher prices called inflation.
3) Credit Creation: Credit creation is a process of giving of loan by the commercial
and other banks. When credit creation increases it results in higher money supply,
higher demand but constant supply as a consequence is called inflation.
4) Exports: When exports are increased it automatically reduces domestic supply at
the same time people who are directly or indirectly involved in exports get higher

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income as a consequence there is more money supply more demand but less supply
as a consequence higher prices called inflation.
5) Repayment of Debts: When government pays of Public Debt, the overall money
supply in the hands of the people increases. Therefore, more demand is created.
Supply being constant as a consequence prices go up which is called inflation.
6) Black Marketing: Black marketing means changing of more than the prescribed
price by the seller from the consumers. Though unethical and illegal it may prevail
in the market. Black marketing is namely due to more demand less supply, which
results in higher prices called inflation.
7) Black Money: Black money means unaccounted money. Unaccounted money is
circulated due to activities like: tax aviation, smuggling and illegal activities.
Normally people with the black money have tendency to buy unwanted goods and
also excess quantity of goods than required which results in increase in demand for
the goods and services without corresponding increase in supply resulting in
higher prices called inflation.
8) Hoarding by consumers: Hoarding is process of accumulation of goods/buying of
goods more than normal requirements, which results in higher demand without
corresponding increase in supply resulting in higher prices called inflation.
9) Hoarding by suppliers: It means accumulation of goods by the suppliers with the
intension to create shortage of goods in the market leading to higher prices called
inflation.
10) Population: When population of a country increases, it leads to higher demand for
the goods but when there is no corresponding increase in supply of goods it leads
to higher prices called inflation.
11) Reduction in taxes: When govt. reduces the taxes, it leads to more money in the
hands of the people due to which people are tempted to buy more goods without
corresponding increase in the supply of goods resulting in higher prices called
inflation.
12) Payment of interest: When banks financial institutions and the govt. pays interest
on loans taken by them to the public, money supply in the hands of public is

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increased as a result demand goes up without corresponding increase in the supply

of goods leading to higher prices called inflation.

Cost Push Inflation: When inflation takes place due to increase in cost, it is called Cost
Push Inflation.

In the diagram above DD and SS are original demand and supply curve respectively
and equilibrium is reached at point E at which OM quantity of goods are sold at OP
price. However due to rise in the cost supply, it is reduced denoted by S1. S1 curve
are sold at OP1 price which implies price has increased from OP to OP1.

Following are the features leading to Cost Pull Inflation:

1) Wages: when workers are paid more wages, it increases the cost of production.
When cost of production is increased it results in higher prices called inflation.
2) Material Cost: When the cost of material increases, it increases the cost of
production. When the cost of production is increased it results in higher prices
called inflation.
3) Profit margins: When sellers want more profits it leads to higher prices which is
called inflation.
4) Other factors: Other factors like earthquake, flood, drought, etc. may increase the
cost of production resulting in increase in price called inflation.

Steps to Control Inflation

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Introduction: Inflation is a very serious problem created due to disequilibrium

between demand and supply. This problem must be solved immediately otherwise it
may lead to hyper inflation due to which economy may crumble and collapse.
Steps/ measures to control inflation can be classified under 4 heads. They are as
follows:

Steps taken to Control Inflation

Monetary Measures Fiscal Measure Physical Measures

Bank Rate Reduction in ExpenditureRationing & Price Control
Cash Reserve Ratio Public Borrowing Increase in Output
Open Market operation Rise in tax
Consumer credit Overvaluation of Currency
Selective credit control Management of Debts
Marginal requirement Promotion to save
Moral sudation

Following are some of the monetary measures;

i) Bank Rate: Reserve bank of India (central bank) increases bank rate for
commercial bank when they come for rediscounting of bills (as a result)
commercial bank increases lending rate to the public. Loan as a result loans
become costly. Therefore borrowing is reduced. When is reduced, money supply
is reduced, prices are reduced and therefore inflation is controlled.
ii) Cash Reserve Ratio: It means the percentage of liquid cash of the total deposits
which commercial banks are required to keep with them in a liquid form when
central banks tell the commercial banks to keep higher percentage of liquid cash
with them their capacity to give loan is reduced which automatically reduces
money supply when money supply is reduced prices fall and with the fall in price,
inflation is controlled.

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iii) Open market operation: It means buying or selling of government securities and
bonding to public by RBI. When RBI starts selling government bonds and
securities, people start withdrawing money from commercial banks to buy these
securities. As a result, money supply in the hands of the commercial banks is
reduced. Due to this, loans are reduced. When loans are reduced, money supply
is reduced which reduces the demand as a result price is also reduced and
inflation is controlled.
iv) Consumer credit: It means loans and advances given by banks for buying of
consumer durable products viz. T.V, fridge, motorcycle, etc.
During inflation, central banking authority i.e RBI may direct commercial banks
to reduce consumer credit. When consumer credit is reduced, demand for
consumer durable products falls resulting in reduction in prices of consumer
durable which means inflation is controlled.
v) Selective Credit Control: It means reducing loans and advances on selected goods
and services which are leading to inflation. Under this method, central monetary/
banking authority i.e. RBI instructs the commercial banks to reduce or not to give
loans and advances on selected items which are leading to inflation. Eg. RBI may
instruct banks not give loans against schemes and securities.

vi) Margin Requirement: Margin requirement means the % of money which a

borrower is requeid to pay/ bring – for taking loans .foreg. If margin requirement
is 40% that means a person buying a car for Rs 4,00,000/- will have to bring Rs.
160,000/- and bank will give him loan of Rs 2,40,000/- only. During inflation
margin requirement may be raised to 50% which means banks will give loan of
Rs. 2,00,000/- only as a result, demand for cars will fall controlling the inflation.
vii) Moral Suasion: Under this method, RBI calls an informal meeting of all bankers
and expresses his view points on controlling inflation and bankers are expected
to listen to his instructions and assist him in controlling inflation. Supply is
reduced which reduces the price and ultimately inflation is controlled.
Selling of bonds↑ Withdrawal from loans ↑ Markets ↓ Price ↓ and securities
commercial banks supply.

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Fiscal Measures: It refers to steps taken by the government to control inflation by

reducing money supply in the hands of the people
i) Reaction in Public Expenditure: Public expenditure means money spent by the
government on various projects (goods and services)
During inflation, government reduces public expenditure and as a result, money
supply falls and when money supply falls demand for goods and services also
falls. As a result prices are reduced and inflation is controlled.
ii) Public Borrowings: Means borrowings of money by the government form the
public by using government bonds and securities when people purchase their
bonds and securities money supply in the hands of the public is reduced. As a
result demand falls due to which price falls and inflation is controlled.
iii) Rise in Taxation: When government increases direct and indirect taxes in the form
of income tax, sales tax, octroi tax etc. Money in the hands of the people reduces
considerably. As a result prices fall automatically which controls inflation.
iv) Over valuation of Currency: Overvaluation of currency means increase in the
value of Indian currency. As a result goods become costly for the foreigners due
to which exports are reduced and when exports are reduced, supply of goods in
home country goes up which reduces the prices and inflation is controlled.
v) Management of Debts: By managing the public debts, inflation can be controlled.
Eg. Repayment of foreign debts reduces the money supply in the domestic
country. As a result, demand falls, prices fall which controls inflation.
vi) Promotion to Save: This is a very effective and productive method of controlling
inflation. By encouraging the savings investments in productive aids increases
which increases the production when production increases, prices are reduced
and inflation is controlled.
vii) Physical Measures: Rationing and price control – Due to inflation from lower
income group and middle income groups are affected most to help them.
Government supplied basic necessities distribution system i.e. rationing. And also
puts restrictions on prices of several other commodities.

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viii)Increase in Output: Inflation takes place due to more money and less goods and
therefore government takes the inflation to increases the production but the prices
of increasing the production it should be remembered that there is cost control
also.

Effects of Inflation
Introduction: Inflation affects different people differently, when prices rise value of
money falls as a result some people gain, some people loose and some people stand
between.
People can be broadly divided into two economic groups (1) Fixed Income Group &
(2) Flexible Income Group.
Effect of Inflation on Redistribution of Income and Wealth, Production and on the
society as a whole are discuss below.
1. Effect on Redistribution of Income and Wealth: There are two ways to measure
the effect of inflation on redistribution of income and wealth on the society. First on
the basis of change in the real value of such factor income namely wages, salary,
rent, interest, dividend and profits.
Second, on the basis of the size distribution of income over time as a result of
inflation, i.e. whether the income of the rich have increased and that of the middle
and poor classes have declined with inflation. Inflation brings about shifts in the
distribution of real income from those whose money incomes are relatively
inflexible to those whose money incomes are relatively flexible.
The poor and middle classes suffer because their wages and salaries are more or
less fixed but the prices of commodities continue to rise. They become more
impoverished. On the other hand, businessmen, industrialists, traders, real estate
holders, speculators, and other with variable incomes gain during rising prices.
The latter category of persons becomes rich at the cost of the former group. There
is unjustified transfer of income and wealth from the poor to the rich. As a result,
the rich roll in wealth and indulge in conspicuous consumption, while the poor and
middle classes live in abject misery and poverty.

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The Effects of Inflation on Different groups of Society are discussed below:

1. Debtors and Creditors: During periods of rising prices, debtors gain and creditors
lose. When prices rise the value of money falls. Though debtors return the same
amount of money, but they pay less in terms of goods and services. This is because
the value of money is less than when they borrowed the money.
Thus the burden of the debt is reduced and debtors gain. On the other hand,
creditors lose. Although they get back the same amount of money which they lent,
they receive less in real terms because the value of money falls. Thus inflation
brings about a redistribution of real wealth in favour of debtors at the cost of
creditors.
2. Salaried Persons: Salaried workers such as clerks, teachers, and other white collar
persons lose when there is inflation. The reason is that their salaries are slow to
adjust when prices are rising.
3. Wage Earners: Wage earners may gain or lose depending upon the speed with
which their wages adjust to rising prices. If their union are strong, they may get
their wages linked to the cost of living index. In this way, they may be able to
protect themselves from the bad effects of inflation. But the problem is that there is
often a time lag between the raising of wages by employees and the rise in prices.
So workers lose because by the time wages are raised, the cost of living index may
have increased further. But where the unions have entered into contractual wages
for a fixed period, the workers lose when prices continue to rise during the period
of contract. On the whole, the wage earners are in the same position as the white
collar persons.
4. Fixed Income group: The recipients of transfer payments such as pensions,
unemployment insurance, social security, etc. and recipients of interest and rent
live on fixed incomes. Pensioners get fixed pensions. Similarly the rentier class
consisting of interest and rent receivers get fixed payments. The same is the case
with the holders of fixed interest bearing securities, debentures and deposits.
All such persons lose because they receive fixed payments, while the value of
money continues to fall with rising prices. Among these groups, the recipients of
transfer payments belong to the lower income group and the rentier class to the

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upper income group. Inflation redistributes income from these two groups towards
the middle income group comprising traders and businessmen.
5. Equity Holders or Investors: Persons who hold shares or stocks of companies gain
during inflation. For when prices are rising, business activities expand which
increase profits of companies. As a profits increase, dividends on equities also
increase at a faster rate than prices. But those who invest in debentures, securities,
bond, etc. which carry a fixed interest rate lose during inflation because they receive
a fixed sum while the purchasing power is falling.
6. Businessmen: Businessmen of all types, such as producers, traders and real estate
holders gain during periods of rising prices. Take producers first. When prices are
rising, the value of their inventories rise in the same proportion. So they profit more
when they sell their stored commodities. The same is the case with traders in the
short ran. But producers profit more in another way.
Their costs do not rise to the extent of the rise in the prices of their goods. This is
because prices of raw materials and other inputs and wages do not rise immediately
to the level of the price rise. The holders of real estate’s also profit during inflation
because the prices of landed property increase much faster than the general price
level.
7. Agriculture: Agriculture are of three types: landlords, peasant proprietor, and
landless agriculture workers. Landlord lose during rising prices because they get
fixed rents. But peasant proprietor who own and cultivate their farms gain. Prices
of farm products increase more than the cost of production.
For prices of inputs and land revenue do not rise to the same extent as the rise in
the prices of farm products. On the other hand, the landless agriculture workers are
hit hard by rising prices. Their wages are not raised by the farm owners because
trade unionism is absent among them. But the prices of consumer goods rise
rapidly. So landless agriculture workers are losers.
8. Government: The government as a debtors gains at the expense of households who
are its principle creditors. This is because interest rates on government bonds are
fixed and are not raised to offset expected rise in prices. The government, in turn,
levies less taxes to service and retire its debt. With inflation, even the real value of

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taxes is reduced. Thus redistribution of wealth in favour of the government accrues

as a benefit to the tax-payers.
Since the tax-payers of the government are high income groups, they are also the
creditors of the government because it is they who hold government bonds. As
creditors, the real value of their assets declines and as tax-payers, the real value of
their liabilities also declines during inflation. The extent to which they will be gainer
or losers on the whole is a very complicated calculation.

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