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SCOPE OF ECONOMICS

OBJECTIVES OF STUDYING
ECONOMICS BEFORE A
PROFESSIONAL MANAGER
A SIMPLE DEFINITION
• IT IS A SOCIAL SCIENCE THAT STUDIES
THE APPLICATION OF SCARCE
RESOURCES TOWARDS ALTERNATIVE
MULTIPLE END-USES.
(SCARCITY OF MEANS AND MULTIPLICITY
OF ENDS DEFINITION BY LIONNEL
ROBBINS)
THE DIFFERENT ENDS CAN BE ORDERED
IN TERMS OF PRIORITIES
SCOPE OF THE SUBJECT
• THE SUBJECT STUDIES THE MANNER IN
WHICH HUMAN CIVILIZATION HAS
ANSWERED THREE BROAD QUESTIONS:-
1.WHAT TO PRODUCE(ALLOCATION OF
RESOURCES)
2.HOW TO PRODUCE(CHOICE OF
TECHNOLOGY)
3.FOR WHOM TO PRODUCE(THE
DISTRIBUTION)
THE TWIN OBJECTIVES
BEFORE A PROFESSIONAL
MANAGER
1.UNDERSTANDING THE BUSINESS
ENVIRONMENT-AN APPLICATION OF
MACROECONOMICS.
2.PRUDENT MANAGERIAL DECISION-
MAKING. THIS IS AN APPLICATION OF
MICROECONOMICS
1.UNDERSTANDING THE
BUSINESS ENVIRONMENT
• MACROECONOMICS IS THE ANALYTICAL
STUDY OF ECONOMIC AGGREGATES OF A
NATION LIKE NATIONAL INCOME, GROWTH,
INFLATION, EMPLOYMENT, PER-CAPITA
INCOME
• IT ALSO STUDIES GOVERNMENT POLICIES
IN REGARD TO TAXES, INTEREST RATES
AND EXCHANGE RATES
2.PRUDENT MANAGERIAL
DECISION-MAKING
• APPLICATIONS OF MICROECONOMICS
• MICROECONOMICS IS THE STUDY OF
THE BEHAVIOUR OF THE INDIVIDUAL
ECONOMIC UNIT-NAMELY, THE
INDIVIDUAL HOUSEHOLD/CONSUMER,
AND THE INDIVIDUAL BUSINESS FIRM.
• THIS BRANCH ALSO STUDIES THE
NATURE OF MARKETS AND THEIR
TYPES
ECONOMIC MODELS
• ECONOMISTS USE THESE AS CONCEPTUAL
TOOLS BOTH IN MACROECONOMICS AND IN
MICROECONOMICS
• THE PURPOSE IS TO SIMPLIFY A COMPLEX
REAL SITUATION AND TO BEGIN TO
UNDERSTAND IT.
• EVERY ECONOMIC THEORY IS A MODEL-IT
MAKES GENERAL ASSUMPTIONS AND
DRAWS LOGICAL CONCLUSIONS BASED ON
THEM
• A MODEL IS ALSO EMPIRICALLY TESTED
USING STATISTICAL DATA AND ANALYSIS.
PRODUCTION
POSSIBILITIES FRONTIER
WHAT IS IT?
• AN ELEMENTARY MODEL EXPLAINING THE
SCOPE OF MACROECONOMICS
• HIGHLIGHTS THE TWO BASIC OPTIONS
AVAILABLE TO A SOCIETY
• IT DEALS WITH THE USE OF THE TOTAL
RESOURCES AVAILABLE FOR EITHER
CONSUMPTION OR INVESTMENT
• IT DESCRIBES THE OUTCOME OF EACH
CHOICE
DEFINITION AND EXPLANATION
• P-P CURVE IS THE LOCUS OF ALL THE
COMBINATIONS OF THE TWO GOODS THAT ARE
ASSUMED TO BE POSSIBLE WITH THE EXISTING
RESOURCES AND TECHNOLOGY:-
• GUNS SYMBOLIZING INVESTMENT TOWARDS
GREATER PRODUCTIVITY IN THE
FUTURE(BECAUSE THERE IS GREATER SECURITY
WITH THEM)
• BUTTER SYMBOLIZING CONSUMPTION ACTIVITY IN
THE PRESENT
• IT IS ASSUMED THAT THESE TWO PRODUCTS CAN
BE CONTINUOUSLY SUBSTITUTED FOR EACH
OTHER Contd…
DEFINITION AND EXPLANATION
• THE NATION FACES A TRADE-OFF AS SHOWN BY
THE P-P CURVE: FULL CAPACITY UTILIZATION OF
CONSUMER GOODS MANUFACTURING IN THE
PRESENT VS. ENSURING MORE CAPACITY
CREATION IN THE FUTURE(GROWTH)
• THE CHOICE IS MADE BY PRIVATE INDIVIDUAL
PLAYERS COLLECTIVELY(BEHAVIOUR OF SAVING,
CONSUMPTION, AND INVESTMENT) AS WELL AS
GOVERNMENTS(MONETARY AND FISCAL POLICIES)
• THE QUESTION BEING DISCUSSED IS: WHAT ARE
THE OUTCOMES OF CHOICES EXERCISED BY THE
NATION OF POINTS ON THE P-P CURVE?
DETAILED EXPLANATION OF
SAMUELSON’S MODEL OF THE
P-P FRONTIER
• P-P FRONTIER IS CONCAVE WITH
RESPECT TO THE ORIGIN
• GUNS AND BUTTER ARE THE ONLY
TWO GOODS BEING CONSIDERED
FOR PRODUCTION
• THE SOCIETY OR NATION CAN DIVIDE
ALL THE AVAILABLE FACTORS OF
PRODUCTION BETWEEN THESE TWO
PRODUCTS
WHAT IS THE CONCLUSION?
• MORE CONSUMPTION LEADS TO
CAPACITY UTILIZATION IN CURRENT
PERIOD WHILE MORE INVESTMENT
LEADS TO ENHANCED GROWTH OF
CAPACITY IN THE FUTURE
• GOVERNMENT POLICIES AND SOCIAL
PREFERENCES INFLUENCE THIS
CHOICE
LOGICAL POINTS-REASON FOR
CONCAVITY OF THE P-P CURVE
• INCREMENTAL OPPORTUNITY COST OF
EACH GOOD GOES ON INCREASING
• WE NEED TO GIVE UP MORE AND MORE OF
THE OTHER GOOD AS WE PERSIST WITH
THE SUBSTITUTION
• THE REASON-INITIALLY, THE MOST
SUITABLE OF THE FACTORS FOR THE
GOOD MAY BE UTILIZED( THE EFFICIENCY
IS MORE). THIS DOES NOT AFFECT THE
OUTPUT OF THE OTHER GOOD SO MUCH
AS THE LEAST DESIRABLE FACTORS MAY
BE DIVERTED
NATIONAL INCOME
ACCOUNTING
WHAT IT MEANS
• MEASUREMENT OF THE VALUE OF THE
TOTAL ECONOMIC ACTIVITY OF EVERY
KIND, PERTAINING TO A NATION, IN A
PERIOD OF TIME USUALLY AN YEAR.
• THE UNIT OF MEASUREMENT IS THE
CURRENCY OF THE NATION.
• THERE ARE DIFFERENT MEASURES OF IT
• THERE ARE ALSO DIFFERENT METHODS OF
DETERMINING THEIR VALUE.
THREE METHODS
• EXPENDITURE METHOD
• OUTPUT/ VALUE-ADDED METHOD
• INCOME METHOD
THESE METHODS ARE COMBINED BY
THE AGENCIES LIKE THE CSO TO
ARRIVE AT VARIOUS SECTORAL
TOTALS.
EIGHT DIFFERENT MEASURES
OF NATIONAL INCOME
• GROSS AND NET VALUES:-

GROSS - NET = DEPRECIATION


= CAPITAL CONSUMPTION

GROSS VALUE INCLUDES THE EFFORT BY A NATION TO


OVERCOME THE ESTIMATED WEAR AND TEAR OF THE
EXISTING STOCK OF CAPITAL.

NET MEASURE INCLUDES THE VALUE OF THE NEW


CAPITAL STOCK ADDED IN THE YEAR BUT EXCLUDES THE
ESTIMATED VALUE OF DEPRECIATION OF THE TOTAL
STOCK OF EXISTING CAPITAL. HENCE, NET INCOME
INCLUDES ONLY THE VALUE OF CAPITAL EXPENDITURES
NET OF THE VALUE OF CAPITAL LOST IN THE YEAR.
DOMESTIC AND NATIONAL
• DOMESTIC MEASURE REFERS TO ALL ECONOMIC
ACTIVITY WITHIN THE GEOGRAPHICAL TERRITORY
OF THE NATION. IT INCLUDES THE WORK OF
FOREIGNERS AND FOREIGN FIRMS.

• NATIONAL MEASURE IS ONLY BY THE CITIZENS OF


THE NATION WORKING ANYWHERE IN THE WORLD.
• HENCE, NATIONAL=DOMESTIC+NFIA
WHERE NFIA= INCOMES RECEIVED BY INDIANS FROM
ABROAD-INCOME PAID OUT BY THEM TO
FOREIGNERS.
SOME INTERESTING EXAMPLES
• IF A PROFESSOR VISITS ANOTHER
NATION FOR DELIVERING LECTURES,
HIS REMUNERATION ADDS TO THE
NATIONAL MEASURE OF HIS HOME
COUNTRY AND THE DOMESTIC
MEASURE OF THE FOREIGN
COUNTRY. Contd.
SOME INTERESTING EXAMPLES
• THE PROFITS EARNED BY FDI UNITS
IN INDIA ARE PART OF THE DOMESTIC
MEASURE OF INCOME OF INDIA AND
THE NATIONAL MEASURE OF THE
HOME COUNTRY OF THE FOREIGN
FIRM.
MARKET PRICE AND FACTOR
COST MEASURES
• MARKET PRICE MEASURE –
NET INDIRECT TAXES
= THE CORRESPONDING FACTOR
COST MEASURE
WHERE,
NET INDIRECT TAXES = INDIRECT TAXES—
SUBSIDIES
MARKET PRICE MEASURE IS INFLATED BY THE AMOUNT OF
INDIRECT TAXES LIKE SALES TAX, BUT IT IS DEFLATED OR
REDUCED BY THE VALUE OF SUBSIDIES PROVIDED BY THE
GOVERNMENT. THIS IS IN COMPARISON WITH THE FACTOR
COST MEASURE.
WHY A TOTAL OF EIGHT
• THERE ARE THREE QUALIFICATIONS
OF THE MEASUREMENT EACH
PROVIDING TWO ALTERNATIVES
• WHEN THESE QUALIFICATIONS ARE
COMBINED TOGETHER, WE HAVE A
TOTAL OF
23 = 8 DIFFERENT MEASURES.
WHAT ARE THESE, FINALLY?
• GNP AT MP AND AT FC
• NNP AT MP AND AT FC
• GDP AT MP AND AT FC
• NDP AT MP AND AT FC
CALCULATION OF NATIONAL
INCOME AGGREGATES
SOME EXAMPLES
1. Compute GDPFC from the following information

Factor incomes Rs. in ‘000


crores
a. Paid to Domestic Residents 85
b. Paid to Foreign Residents 15
Retained profits 10
Corporate profit tax 5
Depreciation 10
SOLUTION - 1
GDPFC = Incomes paid to domestic and
foreign residents + retained
profits + corporate tax
= 85+15+10+5 = 115, 000 crores
Explanation:
depreciation is not to be deducted or
added in the calculation of gross measure,
but is to be subtracted in net measure.
SOME EXAMPLES
2. In an economy the GDPFC is Rs.80,000
crores; depreciation is Rs.4,000 crores,
GNPMP is Rs.95,000 crores and indirect
taxes are Rs.5,000 crores. There are no
subsidies in the Economy. Calculate the
net factor income from abroad.
SOLUTION - 2
GDPMP = GDPFC + NET INDIRECT TAXES
= 80,000+ 5,000
= 85,000 CRORES
NFIA= GNPMP – GDPMP
= 95,000– 85, 000
= 10,000 CRORES
SOME EXAMPLES (contd.)
Production Sector Accounts of the Nation

Dr. Cr.
Rs. in ‘000 Rs. in ‘000
crores crores

Wages and salaries 200 Sales to households 250


Dividends 40 Fixed investment 20
Retained profits 50 Net change in 20
inventories
Profit tax 10 Exports 50
Excise tax 20 Imports -20
320 320
Required to compute : GDPFC
SOLUTION - 3
• GDPFC = WAGES+
DIVIDENDS+RETAINED
PROFITS+PROFIT TAX
= 200+40+50+10
= 300
Explanation:
excise tax is indirect and hence is left out of
factor cost measure; profit tax is direct tax and
figures in PBT of the firm.
ALL ABOUT PRICE INDICES
INTRODUCTION
DEFINITION:
A PRICE INDEX IS A MEASURE OF THE
GENERAL LEVEL OF PRICES, IN A
GIVEN PERIOD OF TIME, IN RELATION
TO THE GENERAL LEVEL OF PRICES IN
A CHOSEN YEAR FOR COMPARISON
CALLED THE ‘BASE YEAR’.
METHODOLOGY
IN THE PRACTICAL SENSE, IT IS
DEFINED AS A WEIGHTED AVERAGE
OF ‘PRICE RELATIVES’.
A PRICE RELATIVE IS THE RATIO OF
PRICE OF A COMMODITY IN THE
CURRENT YEAR TO THE PRICE OF
THE SAME IN THE BASE YEAR.
THE BASE YEAR
THE GENERAL LEVEL OF PRICES IN A BASE
YEAR IS TAKEN AS A STANDARD FOR
MEASURING THE PRICE INDEX OF ANY
YEAR.
THE BASE YEAR MUST BE A NORMAL YEAR
FROM THE SOCIAL / ECONOMIC POINT OF
VIEW i.e. not a war period, or an year of
extreme environmental conditions, or any
national event which affected the economy
BASKET OF COMMODITIES
ANY PRICE INDEX IS BASED ON THE
SAMPLING METHOD AND NOT ON
COMPLETE ENUMERATION.
THE ENTIRE GAMUT OF GOODS AND
SERVICES ARE CATEGORIZED INTO
GROUPS ON THE BASIS OF USE e.g.,
food, clothing, shelter, fuel, transport,
entertainment, and communication etc. .
contd.
BASKET OF COMMODITIES
EACH CATEGORY FINDS A
REPRESENTATION IN THE SELECT
GROUP OF COMMODITIES i.e. BASKET
OF COMMODITIES. E.g., KEROSENE
AND LPG MIGHT REPRESENT THE
CATEGORY OF DOMESTIC FUEL. THE
BASKET OF COMMODITIES IS THUS
COMPRISED OF REPRESENTATIVE
GOODS / SERVICES.
THE WEIGHTS
THE WEIGHT OF EACH ITEM IN THE
BOC IS THE RATIO OF EXPENDITURE
INCURRED ON THE ITEM BY THE
NATION TO THE TOTAL EXPENDITURE
INCURRED ON ALL THE ITEMS IN THE
BOC. Symbolically,
piqi / Σ piqi is the weight of the
ith item in BOC of an index.
Contd….
THE WEIGHTS
LASPAYRE’S METHOD: THE BASIS FOR
DETERMINATION OF THESE WEIGHTS
IS THE CONSUMPTION BEHAVIOUR OF
THE NATION IN THE BASE YEAR.
Hence, the ith item in the BOC will have
the weight: pi0qi0 / Σ pi0qi0
contd…..
THE WEIGHTS
PASCHE’S METHOD: HERE, THE
WEIGHTS ARE DETERMINED BY THE
CONSUMPTION BEHAVIOUR OF THE
NATION DURING THE CURRENT YEAR
i.e., the ith commodity weight in the BOC
then is
pi1qi1 / Σ pi1qi1 .
FISHER’S IDEAL INDEX
IN LASPEYRE’S METHOD, THERE IS A BIAS
TOWARDS CONSUMPTION BEHAVIOUR IN
THE BASE PERIOD, AND IT DOES NOT GIVE
ADEQUATE REPRESENTATION FOR
CHANGES IN LIFESTYLES.
PASCHE’S METHOD IS ATTEMPTING TO
OVERCOME THIS, BUT UNDERPLAYS THE
PRICE CHANGES IN TRADITIONALLY
IMPORTANT ITEMS.
FISHER’S IDEAL INDEX IS THE GEOMETRIC
MEAN OF THE TWO INDICES.
THREE IMPORTANT PRICE INDICES

1.CPI: MIN. OF LABOUR COMPUTES THEM,


AND IS BASED ON RETAIL PRICES OF FINAL
GOODS AND SERVICES. IT USES
LASPEYRE’S METHOD. IT IS INTENDED TO
MEASURE THE CHANGING BURDEN OF
PRICES ON DIFFERENT COMMUNITIES. IT IS
A SENSITIVE MEASURE POLITICALLY
SPEAKING.
WPI
UNLIKE CPI, IT INCLUDES ALSO
REPRESENTATIVE ITEMS FROM THE
INTERMEDIATE GOODS FROM THE
MANUFACTURING SECTOR, BUT EXCLUDES
ALL SERVICES. IT IS BASED ON THE
LASPEYRE’S METHOD. IT IS COMPUTED BY
THE OFFICE OF THE ECONOMIC ADVISER
TO PM. IT IS A MORE COMPREHENSIVE
MEASURE FOR GAUGING INDUSTRIAL
ENVIRONMENT.
NATIONAL INCOME DEFLATOR
IT USES PASCHE’S METHOD. IT IS USED IN
COMPARING THE NATIONAL INCOME FROM
DIFFERENT YEARS. IT REPRESENTS ALL
FINAL GOODS AND SERVICES INCLUDING
INVESTMENT GOODS.
IN THIS, THE WEIGHTS KEEP CHANGING
FROM YEAR TO YEAR WITH CHANGE IN
RELATIVE PREFERENCES OF THE NATION
WITH REFERENCE TO SPENDING.
EXAMPLES OF WEIGHTS
• PRIMARY ARTICLES(FOOD ETC.) HAVE
A WEIGHT OF 22.O2%
• MANUFACTURED PRODUCTS HAVE
63.75%
• INDUSTRIAL INPUTS- FUEL, POWER,
LIGHT AND LUBRICANTS HAVE 14.23%
IN WPI OF INDIA.
AND FINALLY,
PRICE INDICES ARE AFFECTED BY
TWO PARAMETERS- THE BASKET OF
COMMODITIES, AND THE WEIGHTS.

THESE ARE DECIDED BY THE


SPECIFIC PURPOSE THE INDEX IS TO
SERVE.
SOME EXAMPLES
Item q1 q2 p1 p2
Rice 30 25 3 5
Milk 20 30 4 6
Matches 1 2 5 6.50
Cloth 5 3 15 25
Power 100 150 .30 .40
THE BASIC KEYNESIAN
EQUILIBRIUM INCOME
DETERMINATION MODEL
INTRODUCTION
• EXPLAINING THE RELATIONSHIP BETWEEN
NATIONAL INCOME, CONSUMPTION
EXPENDITURES, INVESTMENT,
GOVERNMENT EXPENSES, AND NET
EXPORTS.
• ASSUMPTION: THE PRICES DO NOT
CHANGE. AT ANY GIVEN PRICE-LEVEL,
INCOME GETS DETERMINED BY OTHER
VARIABLES. SECONDLY, A-S CURVE IS
PERFECTLY ELASTIC AT THE POINT OF
ANALYSIS.
THE COMPONENTS OF
AGGREGATE DEMAND
Ex-ante value of national income (AD) is in terms
of anticipated or planned expenditures in the
economy in a period of time. It is the aggregate
demand composed of four parts:-
1. Consumption spending: It is defined as the
demand existing in the economy in a given
period of time created by various consumption
activities in the economy e.g. visits to
restaurants, purchase of more consumer
durables and non-durables etc. . Contd…….
THE COMPONENTS OF
AGGREGATE DEMAND

2. Investment demand: This part of AD is


owing to investment activities that put
money into the system in the form of factor
incomes in the current period e.g.
infrastructure projects, roads, machines,
power plants, airports etc. . The benefits of
these in terms of more consumable goods
and services are felt in later periods.
contd….
THE COMPONENTS OF
AGGREGATE DEMAND

3. Government spending: Governments


either raise tax revenues or resort to
deficit financing to incur expenditures on
various social and economic activities like
educational institutions, hospitals, law and
order, subsidized transport etc. . This puts
purchasing power into the hands of
residents in the form of factor incomes.
contd…..
THE COMPONENTS OF
AGGREGATE DEMAND
4. Net exports: This is the domestic demand resulting from the
surplus of exports from the nation over the value of her
imports. The balance therefore is the purchasing power
chasing domestic output. Therefore,
AD= C+I+G+(X—M)
This is the identity describing the components of national
income from the demand side or the ex-ante viewpoint.
AUTONOMOUS AND INDUCED
PARTS OF AGGREGATE
DEMAND
Keynesian analysis is based on a
distinction made between these two parts
of AD:-
a. Induced part- it is that part which arguably
depends upon the level of actual national
output (ex-post). Generally, it is a part of
the consumption spending demand (C)
figuring in the identity of AD.
AUTONOMOUS AND INDUCED
PARTS OF AGGREGATE
DEMAND
Consumption Function: This is a
mathematical relationship between
planned Consumption expenditures(C)
and the actual national output in the ex-
post sense i.e. the supply of final goods
and services during the same period(Y).
It is assumed that the consumption
function is a linear relationship. Contd….
AUTONOMOUS AND INDUCED
PARTS OF AGGREGATE
DEMAND
Mathematically, C= a + b. Y
Y is the ex-post variable value of national output.
It signifies national income that has actually
materialized as aggregate supply in the current
period and not the planned or anticipated value
of AD of which C is a part.
a is the autonomous part of the consumption
function (intercept on the y-axis). b is the
coefficient of Y called as the Marginal Propensity
to Consume (MPC). Contd….
AUTONOMOUS AND INDUCED
PARTS OF AGGREGATE
DEMAND
Hence, the AD identity is modified as
AD = a + bY + I + G + X—M
The autonomous part of AD is a+I+G+(X-M)
denoted by A;
The induced part is bY. The autonomous part
is independent of the value of national output
of the current period.It is assumed to be
determined by other conditions like
government decisions, and the businesses
AUTONOMOUS AND INDUCED
PARTS OF AGGREGATE
DEMAND
It is the induced part bY that is crucial for
the determination of equilibrium national
output. The AD identity becomes
AD = A + bY where
A= a+I+G+X-M and b= MPC
A= autonomous part and
bY= induced part
EQUILIBRIUM INCOME
DETERMINATION
The important argument involved is:-
At equilibrium, AD should exactly match AS in the
economy. Otherwise, the market forces in the
commodities and factors markets will set into motion the
process of either increasing or decreasing the
equilibrium level of income. When prices are constant,
and the economy is operating on an elastic part of the
AS curve, there is a shift in the AD curve rightward or
leftward because of any change in the parameters of AD.
This causes an expansion or contraction of the
equilibrium level of Y, the national output on the same
AS curve.
THE FINAL FORM
Mathematically, A + bY = Y or
Y = A/ (1-b)
Conclusion: Any increase or decrease in the
autonomous part of the AD impacts the
equilibrium level of national income a
multiplier times. The multiplier is equal to
1/ (1-b) = 1/MPS
MODIFYING THE BASIC FORM
• A / (1-b) TAKES AN ALTERED FORM
WHEN PROVISIONS ARE MADE FOR A
DIRECT TAX LEVIED THUS:-
IF A CONSTANT DIRECT TAX OF t% IS
LEVIED ON THE INCOME MEASURED AS
THE VALUE OF OUTPUT OF GOODS AND
SERVICES(Y), THE VALUE OF
AGGREGATE DEMAND GETS MODIFIED
LIKE THIS:
MODIFYING……..contd…
CONSUMPTION SPENDING AS PER THE
CONSUMPTION FUNCTION BECOMES
NOW
C= a + bY(1-t/100).
ACCORDINGLY, AT EQUILIBRIUM,
AS=AD
Y= a + b(1-t%)Y +I+ G+X-M, and so,
Y= A / (1-b(1-t%))
IF COMPONENTS OF A ARE
ALTERED……..
IF THE AUTONOMOUS PART OF
AGGREGATE DEMAND A IS MODIFIED
FOR PRACTICAL ANALYSIS AS PER
SOME ASSUMPTIONS:-
i. Part of the investment spending is
assumed to be induced by output Y thus,
I=c+dY
A ALTERED……..
THEN, AS=AD BECOMES
Y= a+b(1-t%)Y+c+dY+G+X-M
TAKING ALL THE Y TERMS TOGETHER
AND SOLVING FOR Y,
Y= (a+c+G+X-M) / (1-b(1-t%)-d).
FURTHER, IF M=mY,
Y=(a+c+G+X) / (1-b(1-t%)-d+m)
THE ALTERED FORM
IF GOVERNMENT TRANSFERS MONEY
AS UNEMPLOYMENT ALLOWANCE etc.,
THEN THE DISPOSABLE INCOME ON
WHICH THE CONSUMPTION FUNCTION
ACTS IS INCREASED BY THE
TRANSFER AMOUNT = J.
CONSUMPTION EXPENDITURE C=
a+b(1-t%)Y+bJ
SO, FINALLY…….
WHEN THIS IS INCORPORATED INTO
THE FINAL FORM WE HAVE,
Y= (a+c+G+bJ+X) / (1-b(1-t%)-d+m).

THE MULTIPLIER= 1/ (1-b(1-t%)-d+m)


AUTONOMOUS PART OF AGGREGATE
DEMAND= a+c+G+bJ+X.
CONCLUSION
FROM THE MODIFIED MULTIPLIER, b
THE ORIGINAL SLOPE OF THE AD
CURVE HAS BEEN MODIFIED TO
b(1-t%)+d-m.
EACH COMPONENT OF THE
AUTONOMOUS PART OF
AD=a+d+G+X+bJ IS ANALYZED USING
VARIOUS KEYNESIAN MACRO TERMS.
THE BALANCED BUDGET
• This is the case when governments levy a
tax T exactly equal to the government
spending G
• What is the impact of G on equilibrium Y
i.e. when AD = Y ?
• What is the net change in equilibrium Y
i.e. rise in it owing to G minus reduction in
it owing to T?
Contd.
• Eqm. Y rises by 1/(1-b)* G due to G
adding to the autonomous component.
• Disposable income is reduced by an
amount T = G; so, the consumption is
reduced by b*T; autonomous part of AD
which appears in the numerator of the
income model is reduced by same
amount.
Contd.
• Hence, reduction in eqm. Y because of T
is b/(1-b) * T
• So, the net increase in eqm. Y is
1/(1-b) * G less b/(1-b) * T
But, G here is equal to T; so, this value is
1/(1-b) * G minus b/ (1-b) * G
And this is 1 * G
Implication
• Whenever the government balances a rise in
government spending by an equal amount of
new taxes, the equilibrium national income Y
rises exactly by the amount of rise in G.
• This is how in a less than full employment
equilibrium government balanced budget policy
helps to raise the nation to full employment level
(in bridging the output gap)
SOME IMPORTANT POINTS
• THE MULTIPLIER 1/(1-b) OR
VARIATIONS OF IT CAN ALSO BE
VISUALIZED AS SUM OF AN
ARITHMETIC SERIES OF CHANGES IN
AGGREGATE CONSUMPTION AS A
RESULT OF AN INITIAL CHANGE IN
INVESTMENT.
CONTD.
• SUCCESSIVELY, CONSUMPTION
SPENDING INCREASES THROUGH
REPEATED APPLICATIONS OF THE MPC
ON SUCCESSIVE INCREASES IN
CONSUMPTION AND EQUILIBRIUM
INCOME.
• THE END RESULT IS AN ARITHMETIC
SERIES THE SUM OF WHICH IS
(1N_ bN )/(1-b); as N tends to infinity, 1/(1-b)
Contd.
• Looking at 1/[1-b(1-t)] as the value of the
multiplier, we can infer that it moves directly
as b and inversely as t.
• Imposition of a tax t is a dampener to the
magnitude of the multiplier; it reduces the
volatility of the equilibrium national income
as a result of changes in autonomous
demand. Hence, it is called as a built-in
stabilizer.
Contd.
• Increases in the numerator of the result
shifts AD curve and thus changes the
equilibrium income.
• Changes in b(1-t) + d- m alters the slope
of AD and therefore changes the
equilibrium Y. d is the income sensitivity of
investment. M is the income sensitivity of
imports.
Budget Surplus
• BS = T – G – J
Increases in G will reduce BS but lead to
higher T due to higher equilibrium Y. The net
effect is
∆ BS = ∆ T - ∆ G; ∆T=t* ∆Y
= t*∆G/(1-b(1-t)) - ∆ G
= - (1-b)(1-t)/(1-b(1-t)) * ∆ G This
coefficient is always negative. Net effect of
increased G is reduced BS.
Contd.
• Increase in tax-rate t diminishes equilibrium
Y but applies a higher t’ on the new income.
The net effect on tax collection T is
t’A/(1-b(1-t’)) - t A/ (1-b(1-t))
= A * (1-b)(t’-t)/ (1-b(1-t’))(1-b(1-t)). The
rational expression is always positive. Thus,
BS always increases with t rise.
THE ACCELERATOR
CONCEPT
• This is a later addition to Keynesian
macroeconomic literature.
• It is a measure of how much of additional
capital is required for each unit increment in
equilibrium income Y. This is applied in a
time series context i.e. change in
autonomous investment I as a ratio of the
corresponding change in Y over the
previous period.
EXTENDING THE SIMPLE
MODEL-IS-LM MODEL
• THIS INCLUDES THE MARKETS FOR
ASSETS
• ASSETS MARKETS RELATE TO
DEMAND AND SUPPLY FOR DIFFERENT
CATEGORIES OF PRODUCTIVE ASSETS
i.e. CASH, T-BILLS,FOREX, GOLD,
BONDS, SHARES, AND OTHERS LIKE
HOMES, FACTORY SHEDS, etc.
Contd.
• ALL ASSETS ARE COMPETING
CHANNELS FOR HOLDING WEALTH
• ALL ASSETS ARE HELD WITH THE
FUTURE IN VIEW.
• AN ASSET PORTFOLIO IS DECIDED BY
CONSIDERATIONS OF LIQUIDITY AND
RETURNS ON INVESTMENT(ROI).
CONTD.
• THE ASSETS MARKETS ARE
INTERCONNECTED.
• EXAMPLE: RBI ALTERS MONEY
MARKET INTEREST RATES AND
PRICES OF EXISTING LONG
DURATION BONDS IS INVERSELY
AFFECTED.
3 BROAD TYPES OF
FINANCIAL MARKETS
• MONEY MARKETS- THESE ARE
INSTRUMENTS THAT MATURE WITHIN
AN YEAR.
• CAPITAL MARKETS- BOND AND
EQUITY
• FOREX MARKETS
2 BROAD CATEGORIES OF
ASSETS
• THE LIQUID ASSETS: PEOPLE HOLD CASH
AND SAVINGS DEPOSITS TO FACILITATE
TRANSACTIONS AND THESE ARE
REFERRED TO AS MONEY. THESE DO NOT
PAY ANY ATTRACTIVE RETURNS.
• THE ILLIQUID ASSETS: THEY HOLD
PROSPECTS FOR HIGH RETURNS AND
CAPITAL GAINS. BONDS AND SHARES ARE
SUCH ASSETS.
IMPORTANCE OF MONEY
• THE LIQUID ASSETS ARE MONEY
• THE MONEY MARKETS ARE DIRECTLY
UNDER THE CONTROL OF THE CENTRAL
BANK
• THE INTEREST RATES IN THE MONEY
MARKETS i.e. REPO RATES AND THE
REVERSE REPO RATES ARE VERY
IMPORTANT POLICY INSTRUMENTS
CONTD.
• THROUGH THESE POLICY
INSTRUMENTS, THE GOVERNMENTS
TRY CONTROL THE ENTIRE ECONOMY
• WHAT HAPPENS IN THE MONEY
MARKETS IS A DRIVER TO CHANGES
IN ALL THE OTHER ASSET MARKETS.
• MONEY MOVES IN AND OUT OF
DIFFFERENT ASSET MARKETS
IS-LM FRAMEWORK
• HICKS INVENTED THIS SOON AFTER KEYNES
PUBLISHED THE GENERAL THEORY
• THE ASSUMPTION OF CONSTANCY OF PRICES
IS STILL IN PLACE.
• SO, WE ARE ON THE HORIZONTAL PORTION
OF A SUPPLY CURVE
• THE INTEREST RATES AND ASSETS MARKETS
ARE NOW INCLUDED
THE APPROACH
• BY EXTENDING THE SIMPLE
KEYNESIAN MODEL, A RELATIONSHIP
IS EXPLAINED BETWEEN THE
INTEREST RATE AND THE
EQUILIBRIUM LEVELS OF NATIONAL
INCOME Y THAT CAN PREVAIL. ALL
OTHER VARIABLES BESIDES
INTEREST AND INCOME ARE
ASSUMED TO BE CONSTANT.