BCM109_Macro Economics(Draft 2)

(b) Frictional unemployment (c) Voluntary unemployment (d) Structural unemployment 5. Full employment is also defined as a situation where there is no involuntary unemployment (a) True (b) False Answers: 1. (a) 2. (d) 3. (a) 4. (b) 5. (a) 8.9 REFERENCES  Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill.  Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India.  Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press.  Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd.  Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India.  Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 151 CU IDOL SELF LEARNING MATERIAL (SLM)

152 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 9- THEORIES OF INCOME AND EMPLOYMENT Structure 9.0. Learning Objectives 9.1. Introduction 9.2. Classical theory of income and employment 9.2.1 Savings, Investment & Rate of Interest 9.2.2 The Money Market 9.2.3 Price-Wage Flexibility 9.2.4 Wage-Price Flexibility 9.2.5 How the Product Market Adjusts 9.2.6 Conclusion 9.2.7 The Classical Theory Summer Up 9.2.8 Keynes Criticism 9.3. Keynesian theory of Income and employment 9.4. Difference between classical and Keynesian approach 9.5. Summary 9.6. Key Words/Abbreviations 9.7. Learning Activity 9.8. Unit End Exercises (MCQs and Descriptive) 9.9. References 9.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe the various theories related to income & employment  Explain the Classical theory of income & employment  State the Keynesian theory of income & employment 153 CU IDOL SELF LEARNING MATERIAL (SLM)

9.1 INTRODUCTION Given the amount of capital, technology and quality of labour, a country’s national income, i.e., the total output of goods and services, can be increased by increasing employment. Therefore, the larger the national income of a country the larger the volume of employment; and the smaller the national income, the smaller the volume of employment. Thus, in the short run, the factors that would determine the economy’s level of national income would also determine its level of employment. Hence, the theory of income determination is also called the theory of employment. The credit for expounding a theory of income and employment goes to J M. Keynes, an English economist (1884-1946). In 1936, he published his epoch-making book General Theory of Employment, Interest and Money and set out his new theory in it. Prior to it, economists confined their attention to what we now call ‘price theory’ and did not analyses the economy as a whole. In fact, the earlier economists believed that normally there was full employment in the economy and, therefore, the level of national income normally corresponded to the level of full employment. Our observation of economic life, however, is quite different. The Great Depression of the early nineteen thirties was an eye-opener. There was then widespread and acute unemployment and a sharp fall in national incomes throughout the world. Obviously, there was something seriously wrong with the above belief of the earlier economists. Keynes not only proved that they were wrong but also formulated a comprehensive theory to explain how the level of income and employment in an economy is determined. In the light of his theory, he also indicated what economic policies be adopted to attain and maintain full employment and thus to raise the level of national income. Keynes thus gave a new turn to Economics this is why his theory and ideas have been given the name of New Economics, and some people go to the extent of calling it Keynesian Revolution. In an elementary book as this one, it is not proposed to attempt a detailed account of the Keynesian theory of income determination; only a preliminary idea would be given and that also only in outline. 9.2 CLASSICAL THEORY OF INCOME AND EMPLOYMENT The basic contention of classical economists was that “given flex­ible wages and prices, a competitive market economy would operate at full employment. That is, economic forces would always be generated to ensure that the demand for labor would always equal its supply”. 154 CU IDOL SELF LEARNING MATERIAL (SLM)

In the classical model the equilibrium levels of income and employment were supposed to be determined largely in the labor market. The demand curve for labour shows the relationship between the real wage (equal to the value of the marginal product of labour in a competitive economy) and the demand for labour by employers. The lower the wage rate, the more the workers will be employed. This is why it is downward sloping. The supply curve of labour is upward sloping for obvious reasons. The higher the wage rate, the greater the supply of labour. Fig. 9.1 shows the labour market situation. The equilibrium wage rate (W0) is determined by the demand for and the supply of labour. The level of employ-ment is OL0. The lower graph shows the relation between total output and the quantity of the variable factor (labour). Fig. 9.1 Classical Theory of Income and Employment The graph actually shows the short-run production function which may be ex-pressed as Q =f (KL), where Q is output, K is the fixed quantity of capital and L is the variable factor labour. Total output is OQ0 when OL0 units of labour are em-ployed. According to classical econo­mists this equilibrium level of employment is the ‘full employment’ level. So, the existence of unemployed workers was a logical impossibility. Any unemployment which existed at the equilibrium wage rate (OW0) was attributable to frictions or restrictive practices in the economy or was voluntary in nature. 155 CU IDOL SELF LEARNING MATERIAL (SLM)

The classical economists assumed flexibility of wages and prices (or of real wages). They believed that if the wage rate was flexible a competitive economy would always be able to maintain full employment. In other words, aggregate demand would be sufficient to absorb the full capacity output OQ1. In fact, “whatever the full employment level of output, the income created in producing it will necessarily lead to spending which will be sufficient to purchase the goods produced”. In other words, the classical economists denied the possibility of under-spending or overproduction. True enough, the classicists had faith in Say’s Law, named after the French economist J. B. Say (1767-1832). Say’s Law. Say’s Law is the simple notion that the supply of goods and services creates its own demand, i.e., the very act of producing goods and services generates an amount of income equal to the value of the goods produced. That is, the production of any good would automatically provide the wherewithal to take the output off the market. The essence of the Law—that supply creates its own demand—can be envisaged most easily in terms of a simple barter economy. A farmer, for example, produces or supplies wheat as a means of buying (or demanding) the shoes, shirts and other things produced by shoe-makers and craftsmen. The farmer’s supply of wheat is equivalent to his demand for other goods. This is true for other producers and for the whole economy. Demand must be the same as supply. In fact, the circular flow model of the economy and national accounting both suggest this sort of relationship. For instance, “the income generated from the production of any level of total output would, when spent, be just sufficient to provide a matching demand”. Say’s Law is equally applicable in a modern economy which uses money as a medium of exchange and store of value. Here any excess supply of money possessed by an individual implies excess demand for goods and vice versa. So, for the economy to be in equilibrium the sum of the excess supply functions must be zero. If the composition of output is in accord with the tastes and preferences of consumers, all markets would be cleared of their outputs. Thus all that businessmen need to do to sell a full- employment output is to produce that output; “Say’s Law guarantees that there will be sufficient consumption spending for its successful disposal”. 9.2.1 Saving, Investment and the Rate of Interest: There is, of course, a serious omission in Say’s Law. If the recipients of income in this simple model save a portion of their income, consumption expenditure will fall short of total output and supply would no longer create its own demand. Conse-quently, there would be unsold goods, falling prices, cutbacks in produc-tion, unemployment and falling incomes. 156 CU IDOL SELF LEARNING MATERIAL (SLM)

However, the classical economists ruled out this possibility by suggest-ing that saving would not really in a deficiency of total demand, because each and every rupee saved would be automatically invested by business firms. That is, investment would occur to fill any consumption ‘gap’ caused by saving leakage. In fact, businessmen produce not only consumption goods for sale to households but investment (capital) goods for sale to other firms (or to one another). The latter constitute a considerable portion of society’s total output. In other words, investment spending by business will add to the income-expenditure stream. This may fill any consumption gap arising from saving. Thus, if private business firms as a group intend to invest as much as households want to save, Say’s Law will hold and the levels of national income and employment will remain constant. To illustrate Say’s law consider Fig. 9.2. It shows a simplified version of the circular flow of income diagram. There are only two sectors—households and private business firms. House-holds receive income exactly equal to the value of goods and services produced. Fig. 9.2 Saving, Investment and the Rate of Interest: Part of this income is spent on consumption goods, the balance is saved. Thus consump-tion demand falls short of the total value of production (GNP) by the amount of saving, which is made up by demand for capital goods (i.e., investment demand). Thus so long as investment and saving are equal, aggregate demand (i.e., consumption demand plus investment demand) will always be equal to the total value of production. Thus, “whether or not the economy could achieve and sustain a level of spending sufficient to provide a full-employment level of output and in-come therefore would depend upon whether businesses were willing to invest enough to offset the amount households want to save”. 9.2.2 The Money Market: The classicists also argued that capitalism contained a very special market—the money mar-ket—which would ensure saving invest-ment equality and thus would guarantee full employment. According to them the rate of interest (the price paid for the use of money) was 157 CU IDOL SELF LEARNING MATERIAL (SLM)

determined by the de-mand for and the supply of capital. The demand for capital is investment and its supply is saving. So the rate of interest is determined by the saving-investment mechanism. The equilibrium rate of interest is one which brings about S-I equality. Any imbalance between S and I would be brought about by changes in the rate of interest (r). If S exceeds I, r will fall. This will stimulate investment. The process will continue until and unless the equality is restored. The converse is also true. See Fig. 9.3, which is self-explanatory. Fig. 9.3 the Money Market: 9.2.3 Price-Wage Flexibility: The classicists also argued that the level of output which producers can sell depends not only upon the level of aggregate demand but also upon the levels of product prices. Thus even if the interest rate fails to equate the desired S of the household sector with the desired I of private business firms, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, Rs. 100 will buy two shirts at Rs. 50, but Rs. 50 will buy the same number of shirts provided their price falls to Rs. 25. Therefore, if households somehow succeeded in saving more than what business firms were willing to invest, the resulting fall in total spending would not result in a decline in real output, real income, and the level of employment provided product prices also declined in the same proportion as aggregate expenditure. According to classical economists competition among sellers would en-sure price flexibility. A general decline in demand in product market will force competing producers to lower their prices to clear their accumulated surpluses. Thus the result of excess saving would be to lower prices. This will raise the value of money and permit non-savers to acquire more goods and services with a fixed money income. Saving would, therefore, lower prices but not output and employment. 158 CU IDOL SELF LEARNING MATERIAL (SLM)

9.2.4 Wage-Price Flexibility: But this is not perhaps the whole truth. A fall in product prices would reduce resource prices—particularly wage rates—in the process. Thus wage rates have to decline significantly to permit businesses to produce profitably at the new lower prices. The classical econo-mists thought that & decline in product demand would automatically be translated into a fall in demand for labour and other resources. The imme-diate result would be an excess supply in the labour market, i.e., unemploy-ment at the existing wage rate. The wage rate will fall. The producers who were reluctant to employ all workers at the original wage rate will now find it profitable to employ extra workers at lower wage rate. And competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process would come to a halt only when the wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate would be established. Thus, involuntary unemployment was a logical impossibility in the clas-sical model. Anyone willing to work at the market determined wage rate would be able to find jobs readily and people would have substantial choice of jobs. 9.2.5 How the Product Market Adjusts: Equilibrium in a typical market, of which there are many in the economy, is shown in part a of Fig. 9.4. The intersection of the product demand curve (DD) and the product supply curve (SS) determine the equilibrium price (P0) and equilibrium output (Q0). Fig. 9.4 Product Market A fall in aggregate demand is reflected in a leftward shift in product market demand curves throughout the economy. This is shown in part b, where the aggregate demand curve shifts to the left to D1D1. The equilib-rium price falls from P0 to P1 and the equilibrium output from 159 CU IDOL SELF LEARNING MATERIAL (SLM)

Q0 to Q1. This also occurs in other product markets. Producers now cut back output and reduce their employment of labour and the purchase of other resources. The reluctant workers are now involuntarily unemployed because they are willing to work at the yet unchanged wage rates. They will, therefore, compete for the available jobs by bidding down wages. Similarly, suppliers of raw materials will lower their prices to reduce their surpluses. The lowering of wages and resources prices causes product market supply curves to shift upward. This process continues until the initial output levels in product markets are restored and all available workers are once again fully employed. This is shown in part c, where the product market supply curve has shifted from S1S1 to the position S2S2. The initial output of Q0 is restored, but at a lower equilibrium price P2, determined by the intersection of D1D1 and S1S1. The economy is once again operating at full employment output level. Wage-price flexibility would always ensure this result. 9.2.6 Conclusion: So to sum up, however, the classical system depends upon three central propositions: (a) S and I depend on the rate of interest; (b) Wages, prices and interest rates are flexible; and (c) The economy is characterized by competitive forces in both product and resource markets. Given these conditions, there would be neither deficiency of aggregate demand nor over-production. The end result would be full employment. 9.2.7 The Classical Theory Summed Up: In truth, the classical economists maintained that the economy would operate at its full employment output level without the need for continu­ally falling wages and prices. Say’s law assumed that the unfettered forces of free markets and laissez faire capitalism would guarantee full employ-ment with price stability. If there were disturbances that caused investment or saving curves to shift, or shifts in demand and supply curves in any other market, adjustments in wages, prices and the interest rate would always return the economy to a position of full employment equilibrium. 9.2.8 Keynes’ Criticism: Keynes criticized the classical theory on three main grounds: 160 CU IDOL SELF LEARNING MATERIAL (SLM)

(a) Saving depends on national income and is not affected by changes in interest rates. Investment may, of course, be influenced by it, although it depends on future profit expectations. Thus S-I equality through adjust-ment in interest rate is ruled out. So, Say’s Law will no longer hold. (b) The labor market is far from perfect because of the existence of trade unions and government intervention in the form of imposition of minimum wage laws. Thus, wages are unlikely to be flexible. Trade unions may succeed in raising wages even when there is no excess demand for labour, rather there is excess supply. Wages are more inflexible downward than upwards. So, a fall in demand (when S exceeds I) will lead to fall in production and employment. The problem is not one of involuntary idle-ness of resources including manpower. (c) Keynes also argued that’ even if wages and prices were flexible a free enterprise economy would not always be able to achieve automatic full employment. In a depression economy monetary policy would lose its effectiveness and would be unable to influence the rate of interest and thus the volume of investment and the level of income. The interest inelasticity of investment has been a subject matter of much debate and controversy. 9.3 KEYNESIAN THEORY OF INCOME AND EMPLOYMENT In the Keynesian theory, employment depends upon effective demand. Effective demand results in output. Output creates income. Income provides employment. Since Keynes assumes all these four quantities, viz., effective demand (ED), output (Q), income (Y) and employment (N) equal to each other, he regards employment as a function of income. Effective demand is determined by two factors, the aggregate supply function and the aggregate demand function. The aggregate supply function depends on physical or technical conditions of production which do not change in the short-run. Since Keynes assumes the aggregate supply function to be stable, he concentrates his entire attention upon the aggregate demand function to fight depression and unemployment. Thus employment depends on aggregate demand which in turn is determined by consumption demand and investment demand. According to Keynes, employment can be increased by increasing consumption and/or investment. Consumption depends on income C(Y) and when income rises, consumption also rises but not as much as income. In other words, as income rises, saving rises. Consumption can be increased by raising the propensity to consume in order to increase 161 CU IDOL SELF LEARNING MATERIAL (SLM)

income and employment. But the propensity to consume depends upon the psychology of the people, their tastes, habits, wants and the social structure which determine the distribution of income. All these elements remain constant during the short-run. Therefore, the propensity to consume is stable. Employment thus depends on investment and it varies in the same direction as the volume of investment. Investment, in turn, depends on the rate of interest and the marginal efficiency of capital (MEC). Investment can be increased by a fall in the rate of interest and/or a rise in the MEC. The MEC depends on the supply price of capital assets and their prospective yield. It can be raised when the supply price of capital assets falls or their prospective yield increases. Since the supply price of capital assets is stable in the short- run, it is difficult to lower it. The second determinant of MEC is the prospective yield of capital assets which depends on the expectations of yields on the part of businessmen. It is again a psychological factor which cannot be depended upon to increase the MEC to raise investment. Thus there is little scope for increasing investment by raising the MEC. The other determinant of investment is the rate of interest. Investment and employment can be increased by lowering the rate of interest. The rate of interest is determined by the demand for money and the supply of money. On the demand side is the liquidity preference (LP) schedule. The higher the liquidity preference, the higher is the rate of interest that will have to be paid to cash holders to induce them to part with their liquid assets, and vice versa. People hold money (M) in cash for three motives: transactions, precautionary and speculative. The transactions and precautionary motives (M) are income elastic. Thus the amount held under these two motives (M1) is a function (L1) of the level of income (Y), i.e. M=L (Y). But the money held for speculative motive (M2) is a function of the rate of interest (r), i.e. M=L2 (r). The higher the rate of interest, the lower the demand for money, and vice versa. Since LP depends on the psychological attitude to liquidity on the part of speculators with regard to future interest rates, it is not possible to lower the liquidity preference in order to bring down the rate of interest. The other determinant of interest rate is the supply of money which is assumed to be fixed by the monetary authority during the short-run. The relation between interest rate, MEC and investment is shown in Figure 9.5, where in Panels (A) and (B) the total demand for money is measured along the horizontal axis from M onward. The transactions (and precautionary) demand is given by the L1 curve at OY1 and OY2 levels of income in Panel (A) of the figure. 162 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig. 9.5 Keynesian Theory of Income and Employment Thus at OY1 income level, the transactions demand is given by OM1 and at OY2 level of income it is OM2. In Panel (B), the L2 curve represents the speculative demand for money as a function of the rate of interest. When the rate of interest is R2, the speculative demand for money is MM2. With the fall in the rate of interest to R1, the speculative demand for money increases to MM1. Panel (C) shows investment as a function of the rate of interest and the MEC. Given the MEC, when the rate of interest is R2, the level of investment is OI1. But when the rate of interest falls to R1, investment increases to OI2. “In the Keynesian analysis, the equilibrium level of employment and income is determined at the point of equality between saving and investment. Saving is a function of income, i.e. S=f (Y). It is defined as the excess of income over consumption, S=Y-C and income is equal to consumption plus investment. Thus Y = C + I Or Y-C = I Y-C = S I=S So the equilibrium level of income is established where saving equals investment. This is shown in Panel (D) of Figure 1 where the horizontal axis from O toward the right represents 163 CU IDOL SELF LEARNING MATERIAL (SLM)

investment and saving, and OY axis represents income. S is the saving curve. The line I1E1 is the investment curve (imagine that it can be extended beyond E as in an S and I diagram) which touches the S curve at E1. Thus OY1 is the equilibrium level of employment and income. This is the level of underemployment equilibrium, according to Keynes. If OY2 is assumed to be the full employment level of income then the equality between saving and investment will take place at E2 where I2E2 investment equals Y2E2 saving. The Keynesian theory of employment and income is also explained in terms of the equality of aggregate supply (C+S) and aggregate demand (C+I). Since unemployment results from the deficiency of aggregate demand, employment and income can be increased by increasing aggregate demand. Assuming the propensity to consume to be stable during the short-run, aggregate demand can be increased by increasing investment. Once investment increases, employment and income increase. Increased income leads to a rise in the demand for consumption goods which leads to further increase in employment and income. Once set in motion, employment and income tend to rise in a cumulative manner through the multiplier process till they reach the equilibrium level. According to Keynes, the equilibrium level of employment will be one of under-employment equilibrium because when income increases consumption also increases but by less than the increase in income. This behavior of the consumption function widens the gap between income and consumption which ordinarily cannot by filled up due to the lack of required investment. The full employment income level can only be established if the volume of investment is increased to fill the income-consumption gap corresponding to full employment. The Keynesian cross model of under-employment equilibrium is explained in Figure 9.6 where income and employment are taken on the horizontal axis and consumption and investment on the vertical axis. Autonomous investment is taken as a first approximation. C+I am the aggregate demand curve plotted by adding to consumption function C an equal amount of investment at all levels of income. 164 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig .9.6 Employment and Income The 45° line is the aggregate supply curve. The economy is in equilibrium at point E where the aggregate demand curves C+I intersects the 45° line. This is the point of effective demand where the equilibrium level of income and employment OY1 is determined. This is the level of under-employment equilibrium and not of full employment. There are no automatic forces that can make the two curves cross at a full employment income level. If it happens to be a full employment level, it will be accidental. Keynes regarded the under- employment equilibrium level as a normal case and the full employment income level as a special case. Suppose OYF is the full employment income level. To reach this level, autonomous investment is increased by I1 so that the C+I curve shifts upward as C+I+I1, curve. This is the new aggregate demand curve which intersects the 45° line (the aggregate supply curve) at E1, the higher point of effective demand corresponding to the full employment income level OYF. This also reveals that to get a desired increase in employment and income of Y1YF, it is the multiplier effect of an increase in investment by I1 (=I2 in Panel C of Figure 1) which leads to an increase in employment and income by Y1YF through successive rounds of investment. 9.4 DIFFERENCE BETWEEN CLASSICAL AND KEYNESIAN APPROACH Difference # 1. Assumption of Full Employment: Classical theorists always assumed full employment of labour and other resources. To them, full employment was a normal situation and unemployment was an abnormal 165 CU IDOL SELF LEARNING MATERIAL (SLM)

situation. According to Classicals, even if there is less than full employment in the economy, there is always a tendency towards full employment. By the term full employment of the available resources, the classical economists meant that ‘there is no involuntary unemployment’. If there is unemployment in the economy, classicists felt that it was due to the existence of monopoly in industry and governmental interference with the free play of the forces of competition in the market or it may be due to the imperfections of the market owing to immobility of the factors of production. If these limitations could somehow be eliminated, full employment, according to classical economists, would always exist. Hence, the best way to ensure full employment for the Government was to pursue the policy of ‘laissez faire’ capitalism under which free competitive market forces were allowed to have full and free play. Difference # 2. Emphasis on the Study of Allocation of Resources Only: The existence of ‘full employment’ being a normal situation in the classical scheme, it followed that factors of production are always fully employed and there is no further scope for additional employment of resources in new industries. The choice, according to classicals, was not between employment and unemployment but between employment here and employment there, i.e., increase in production in one direction could be achieved only at the cost of some decrease in another direction in the economy. In other words, classicals fell there could not be any significant misallocation of resources as the price mechanism, acting as an ‘invisible hand’ would achieve the best, the most efficient allocation of resources. Since the optimum allocation of a given quantity of resources was the main subject-matter of classical economics, it was but natural that they did not discuss the problem of national output, income or employment. With their assumption of full employment, there obviously could not be any change in the real national income of the community through additional employment of resources. What could possibly be done, given, the composition and volume of the real national income, was a more efficient allocation of the given resources. As such, they remained concerned with the special case of full employment and not with the general factors that determine employment at any time. In brief, the well-known theory of value, distribution and production formed the ‘core’ of classical economics. That unemployment of resources could also persist to pose a problem did not occur to them at all. Difference # 3. Policy of ‘Laissez Faire’: 166 CU IDOL SELF LEARNING MATERIAL (SLM)

Classicals had great faith in the philosophy of laisez-faire capitalism, which meant ‘leave alone’ or ‘let alone’ in business matters. Laissez-faire capitalism would not tolerate any kind of intervention by the Government in business matters; they rather considered it a positive hindrance in the free working of the market economy. Classicals believed in Laissez-faire capitalism as it was the traditional model of study from the very’ beginning. Classicals had great faith in price mechanism, profit-motive, free and perfect competition and the self-adjusting nature of the system. They felt that if the system is allowed to work freely without any encroachments on the part of the state, it has potentialities to overcome the maladjustments in the economic system, if there are any. Difference # 4. Wage-Cut Policy as a Cure for Unemployed Resources: Classicals further believed that involuntary unemployment could be easily cured by cutting wages down through office and perfect competition which always exists in the labour market. They argued that so long as labour does not demand more than what it is ‘worth’ or more than its marginal productivity, there is no possibility of persistent unemployment in the economy. Classicals believed that employment is determined by the wage bargains between the workers and employers, therefore, wage-cuts will reduce unemployment; such a policy if pursued vigorously can restore full employment as well. Basing their reasoning on the existence of free and perfect competition in the product and labour markets, classicals argued that the unemployed workers will cut down wages leading to a fall in prices, which, in turn, will encourage demand giving a fillip to sales. As a result of all this, more will be produced as more is demanded and employment would increase because workers are employed at lower wages to increase production. Wage-cuts, thus occupied a central place in the classical scheme of reasoning for automatic functioning of the capitalist economy at full employment. Difference # 5. Assumption of Neutral Money: Classicals did not give much importance to money treating it only as a medium of exchange its role as a store of value was not considered. To them, money facilitated the transactions of goods but had no effect on income, output and employment. They considered it as a ‘veil’ which hides real things goods and services. In other words, they assumed that people have one motive for holding money, i.e. the transaction motive. Classicals completely ignored the precautionary and speculative motives for holding money. In short, they never recognized that money could also influence the level of income, output and employment. In contrast to this view, Keynes considered money on as on active force 167 CU IDOL SELF LEARNING MATERIAL (SLM)

that in influences total output. Difference # 6. Interest Rate as the Equilibrating Mechanism between Saving and Investment: Classicals would give the pride of place to the rate of interest as the equalizer of saving and investment at full employment of resources. The implied assumption was that both saving and investment are highly sensitive to changes in the rate of interest. The belief was firmly rooted that saving and investment can be equal only at full employment, and that ‘under employment equilibrium’ is a disequilibrium situation which would not last long in an atmosphere of wage price flexibility under the pressure of competition. 9.5 SUMMARY  Income and employment theory, a body of economic analysis concerned with the relative levels of output, employment, and prices in an economy. By defining the interrelation of these macroeconomic factors, governments try to create policies that contribute to economic stability.  Income and employment theory, a body of economic analysis concerned with the relative levels of output, employment, and prices in an economy. By defining the interrelation of these macroeconomic factors, governments try to create policies that contribute to economic stability.  Modern interest in income and employment theory was triggered by the severity of the Great Depression of the 1930s in the United States and Europe. In its failure to explain the persistent high levels of unemployment and the low levels of business productivity, the prevailing school of classical economics lacked solutions for the problems of that era.  John Maynard Keynes offered new thinking on income and employment theory with the publication of General Theory of Employment, Interest and Money (1936). Building on his theory, Keynesians have stressed the relationship between income, output, and expenditure. Since transactions are two-sided—in that one person’s income is another person’s expenditure—the relationship could be expressed in the form of a simple equation: Y = O = D, where Y is the national income (i.e., purchasing power), O is the value of the national output, and D is national expenditure. What this equation means is that effective demand is equal to income as well as to output. Since consumers can either spend or save their income, Y = C + S, where C is consumption and S is savings. 168 CU IDOL SELF LEARNING MATERIAL (SLM)

 Similarly, on the output side, production is either sold to final customers or invested in inventory or new capital equipment, (such as production plants or machinery). So O = C + I, where C represents sales to final customers and I investment. Thus, C + S = C + I and, therefore, S = I. However, while savings and investment may thus be equated from an accounting standpoint, in fact, actual planned savings and planned investment may differ in real life. Keynesians say that economic instability stems from this discrepancy between savings and investment.  A competing theory of income and employment, the monetarist approach, places the quantity of money in the controlling role. The analysis of the effects of increasing or decreasing the money supply is approximately parallel to that of the consumption- and-savings relation. The rules of thumb derived from the two theories may, in fact, be combined: an excess demand for goods or an excess supply of money (the two may be seen as aspects of the same phenomenon) will be associated with rising income; similarly, an excess supply of goods or an excess demand for money will be associated with falling income. Monetarists, such as Milton Friedman, have advocated monetary policy as the proper countercyclical tool of government.  Both the Keynesian and the monetarist theories have two notable shortcomings. First, both are demand-side theories and are therefore incapable of contributing toward the long-term considerations of economic growth. Second, both assume that people can be fooled over and over again; in reality, as they learn to anticipate government policies based on the monetarist or Keynesian models, people act in ways to offset these policies and thus negate the government actions. 9.6 KEY WORDS/ABBREVIATIONS  Interest - Payment for services which are provided by capital.  Intermediate goods - Goods which are used up during the process of production of other goods.  Inventories - The unsold goods, unused raw materials or semi-finished goods which a firm carries from a year to the next.  Private income - Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world.  Wage Payment - for the services which are rendered by labour. 9.7 LEARNING ACTIVITY 169 CU IDOL SELF LEARNING MATERIAL (SLM)

1. State the difference between classical & Keynesian approach __________________________________________________________________________________ __________________________________________________________________________________ 2. Note on Income & Employment __________________________________________________________________________________ __________________________________________________________________________________ 9.8 UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. Explain classical theory of income & employment 2. State the Keynesian theory of income & employment 3. Note on money market equilibrium 4. Note on wage-price flexibility 5. What are the Keynes criticism towards classical theory B. Multiple Choice Questions (MCQs) 1. In classical theory the equality between saving and investment is brought about by: (a) Rate of interest (b) Income (c) Consumption (d) Multiplier 2. In classical theory the level of employment is a function of: (a) Price level (b) Money wage rate (c) Quantity of money (d) Real wage rate 170 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Which of the following is not an obstacle to full employment in classical theory? (a) Excess of saving over investment (b) Liquidity trap (c) Price rigidity (d) Wage Flexibility 4. According to Keynes, employment can be increased by increasing consumption and/or investment (a) True (b) False 5. The transactions and precautionary motives (M) are income ___ (a) Elastic (b) Inelastic (c) Unitary (d) No relation Answers: 1. (a) 2. (d) 3. (d) 4. (a) 5. (a) 9.9 REFERENCES  Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill.  Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India.  Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press.  Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd.  Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India.  Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 171 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 10- INFLATION AND DEFLATION 172 Structure 10.0. Learning Objectives 10.1. Introduction 10.2. Types of inflation 10.2.1 One the Basis of Causes 10.2.2 On the Basis of Speed or Intensity 10.3. Inflationary and deflationary gap 10.3.1 Inflationary Gap 10.3.2 Deflationary Gap 10.3.3 Deflationary Gap & Equilibrium Level of Income 10.4. Causes of occurrence 10.5. Measures to control 10.5.1 Monetary Measures 10.5.2 Fiscal Measures 10.5.3 Price Control 10.6. Summary 10.7. Key Words/Abbreviations 10.8. Learning Activity 10.9. Unit End Exercises (MCQs and Descriptive) 10.10. References 10.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain the concept of inflation & deflation  Give details of the inflationary & deflationary gap CU IDOL SELF LEARNING MATERIAL (SLM)

 State the various causes of inflation & measures to control it 10.1 INTRODUCTION Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’. Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or aver­age of prices’. In other words, inflation is a state of rising prices, but not high prices. It is not high prices but rising price level that con-stitute inflation. It constitutes, thus, an over-all increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon. While measuring inflation, we take into ac-count a large number of goods and services used by the people of a country and then cal-culate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market. It is to be pointed out here that inflation is a state of disequilib-rium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sus-tained. That is why inflation is difficult to define in an unambiguous sense. Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was 223.8- 193.6/ 193.6 x 100 = 15.6 As inflation is a state of rising prices, de-flation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation. 173 CU IDOL SELF LEARNING MATERIAL (SLM)

10.2 TYPES OF INFLATION As the nature of inflation is not uniform in an economy for all the time, it is wise to distin-guish between different types of inflation. Such analysis is useful to study the distribu-tional and other effects of inflation as well as to recommend anti-inflationary policies. Infla-tion may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation. Thus, one may observe different types of inflation in the contemporary society: 10.2.1 On the Basis of Causes: (i) Currency inflation: This type of infla-tion is caused by the printing of cur-rency notes. (ii) Credit inflation: Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level. (iii) Deficit-induced inflation: The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may then be called the deficit-induced inflation. (iv) Demand-pull inflation: An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in-flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre-gate demand to money supply. If the supply of money in an economy ex-ceeds the available goods and services, DPI appears. It has been described by Coulbourne as a situation of “too much money chasing too few goods.” Keynesians hold a different argu-ment. They argue that there can be an autonomous increase in aggregate de-mand or spending, such as a rise in con-sumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup-ply. This would prompt upward adjust-ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument). DPI can be explained in terms of Fig. 10.1, where we measure output on the horizontal axis 174 CU IDOL SELF LEARNING MATERIAL (SLM)

and price level on the vertical axis. In Range 1, total spending is too short of full employment out-put, YF. There is little or no rise in the price level. As demand now rises, out-put will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ul-timately, the economy reaches full em-ployment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull in­flation. The essence of this type of in­flation is that “too much spending chas­ing too few goods.” Fig. 10.1 On the Basis of Causes: (v) Cost-push inflation: Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro-duction may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determined. Higher wage means high cost of production. Prices of commodities are thereby increased. A wage-price spiral comes into opera-tion. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two im-portant variants of CPI wage-push in-flation and profit-push inflation. Any-way, CPI stems from the leftward shift of the aggregate supply curve: 175 CU IDOL SELF LEARNING MATERIAL (SLM)

10.2.2 On the Basis of Speed or Intensity: (i) Creeping or Mild Inflation: If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is con-sidered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger. (ii) Walking Inflation: If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’. Often, one-digit inflation rate is called ‘moder­ate inflation’ which is not only predict­able, but also keep people’s faith on the monetary system of the country. Peoples’ confidence gets lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation. (iii) Galloping and Hyperinflation: Walking inflation may be converted into running inflation. Running inflation is danger-ous. If it is not controlled, it may ulti-mately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shattered. “Inflation in the double- or triple- digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”. (iv) Government’s Reaction to Inflation: In-flationary situation may be open or suppressed. Because of anti-infla-tionary policies pursued by the govern-ment, inflation may not be an embar-rassing one. For instance, increase in income leads to an increase in con-sumption spending which pulls the price level up. If the consumption spending is countered by the govern-ment via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the sup-pressed inflation becomes open infla-tion. Open inflation may then result in hyperinflation. 10.3 INFLATIONARY AND DEFLATIONARY GAP 176 CU IDOL SELF LEARNING MATERIAL (SLM)

10.3.1 Inflationary Gap: Inflationary gap is the amount by which the actual aggregate demand exceeds ‘aggregate supply at level of full employment’. For instance, in Fig. 10.2, BE is shown as inflationary gap. It is a measure of the excess of aggregate demand over level of output at full employment. Inflationary gap causes a rise in price level which is called inflation. Fig. 10.2 Inflationary Gap: 10.3.2 Deflationary Gap: Deflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at level of full employment’. For instance, in Fig. 10.3, EB is shown as deflationary gap. It is a measure of amount of deficiency of aggregate demand. Deflationary gap causes a decline in output, income and employment along with persistent fall in prices. Fig. 10.3 Deflationary Gap 10.3.3 Deflationary gap and equilibrium level of income: Remember, equilibrium level of income indicates mere equality between aggregate demand and aggregate supply regardless of whether the equilibrium is at full employment or under- employment of resources. In case, it is full employment equilibrium where all resources are employed to their full limit, deflationary gap cannot exist at equilibrium level of income. But if it is an under-employment 177 CU IDOL SELF LEARNING MATERIAL (SLM)

equilibrium where all resources are not fully employed, i.e., some resources are under-employed, then deflationary gap can exist at the equilibrium level of income. 10.4 CAUSES OF OCCURRENCE Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift left-ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla-tion (CPI). Before describing the factors, that lead to a rise in aggregate demand and a de­cline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation. (i) Demand-Pull Inflation Theory: There are two theoretical approaches to the DPI—one is classical and other is the Keynesian. According to classical economists or mon-etarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classi-cists maintained that a change in money supply brings about an equi-proportionate change in price level. That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and price level causing an upward shift in aggregate demand. According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or govern-ment expenditure or net exports or the com-bination of these four components of aggregate demand. Given full employment, such in-crease in aggregate demand leads to an up-ward pressure in prices. Such a situation is called DPI. This can be explained graphically. 178 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig. 10.4 Demand-Pull Inflation Theory: Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. 10.4, aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employ-ment stage is reached. AD1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E1. The price level, thus, determined is OP1. As ag-gregate demand curve shifts to AD2, price level rises to OP2. Thus, an increase in aggre-gate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve. (ii) Causes of Demand-Pull Inflation: DPI originates in the monetary sector. Mon­etarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will in-crease aggregate demand and will, thus, cause inflation. An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash bal-ances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply. Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government 179 CU IDOL SELF LEARNING MATERIAL (SLM)

expendi-ture. Government expenditure is inflationary if the needed money is procured by the gov-ernment by printing additional money. In brief, increase in aggregate demand i.e., in-crease in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply gen-erated by the printing of additional money (classical argument) which drives prices up-ward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenom-enon. There are other reasons that may push ag-gregate demand and, hence, price level up-wards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate de-mand may also go up if government repays public debt. Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors. (iii)Cost-Push Inflation Theory: In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usu-ally associated with non-monetary factors. CPI arises due to the increase in cost of produc-tion. Cost of production may rise due to a rise in cost of raw materials or increase in wages. However, wage increase may lead to an in-crease in productivity of workers. If this hap-pens, then the AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change in spite of an increase in wages. Such increases in costs are passed on to consumers by firms by rais-ing the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward. 180 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig. 10.5 Cost-Push Inflation Theory: This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full em-ployment stage it becomes perfectly inelastic. Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this causes price level to rise to OP2 and output to fall to OY2. With the reduction in output, employment in the economy de-clines or unemployment rises. Further shift in AS curve to AS3 results in a higher price level (OP3) and a lower volume of aggregate out-put (OY3). Thus, CPI may arise even below the full employment (YF) stage. (iv)Causes of Cost-Push Inflation: It is the cost factors that pull the prices up-ward. One of the important causes of price rise is the rise in price of raw materials. For in-stance, by an administrative order the govern-ment may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres-sure on cost of production. Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC com-pels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, espe-cially the transport sector. As a result, trans-port costs go up resulting in higher general price level. Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compen-sation against inflationary price rise. If in-crease in 181 CU IDOL SELF LEARNING MATERIAL (SLM)

money wages exceed labour produc-tivity, aggregate supply will shift upward and leftward. Firms often exercise power by push-ing prices up independently of consumer de-mand to expand their profit margins. Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall in-crease in excise tax of mass consumption goods is definitely inflationary. That is why govern-ment is then accused of causing inflation. Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop-pages, electric power cuts, etc., may cause ag-gregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation. Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise. 10.5 MEASURES TO CONTROL 10.5.1 Monetary Measures: The government of a country takes several measures and formulates policies to control economic activities. Monetary policy is one of the most commonly used measures taken by the government to control inflation. In monetary policy, the central bank increases rate of interest on borrowings for commercial banks. As a result, commercial banks increase their rate of interests on credit for the public. In such a situation, individuals prefer to save money instead of investing in new ventures. This would reduce money supply in the market, which, in turn, controls inflation. Apart from this, the central bank reduces the credit creation capacity of commercial banks to control inflation. The monetary policy of a country involves the following: (a) Rise in Bank Rate: Refers to one of the most widely used measure taken by the central bank to control inflation. The bank rate is the rate at which the commercial bank gets a rediscount on loans and advances by the central bank. The increase in the bank rate results in the rise of rate of interest on loans for the public. This leads to the reduction in total spending of individuals. The main reasons for reduction in total expenditure of individuals are as follows; 182 CU IDOL SELF LEARNING MATERIAL (SLM)

(i) Making the borrowing of money costlier: Refers to the fact that with the rise in the bank rate by the central bank increases the interest rate on loans and advances by commercial banks. This makes the borrowing of money expensive for general public. Consequently, individuals postpone their investment plans and wait for fall in interest rates in future. The reduction in investments results in the decreases in the total spending and helps in controlling inflation. (ii) Creating adverse situations for businesses: Implies that increase in bank rate has a psychological impact on some of the businesspersons. They consider this situation adverse for carrying out their business activities. Therefore, they reduce their spending and investment. (iii) Increasing the propensity to save: Refers to one of the most important reason for reduction in total expenditure of individuals. It is a well-known fact that individuals generally prefer to save money in inflationary conditions. As a result, the total expenditure of individuals on consumption and investment decreases. (b) Direct Control on Credit Creation: Constitutes the major part of monetary policy. The central bank directly reduces the credit control capacity of commercial banks by using the following methods: (i) Performing Open Market Operations (OMO): Refers to one of the important methods used by the central bank to reduce the credit creation capacity of commercial banks. The central bank issues government securities to commercial banks and certain private businesses. In this way, the cash with commercial banks would be spent on purchasing government securities. As a result, commercial bank would reduce credit supply for the general public. (ii) Changing Reserve Ratios: Involves increase or decrease in reserve ratios by the central bank to reduce the credit creation capacity of commercial banks. For example, when the central bank needs to reduce the credit creation capacity of commercial banks, it increases Cash Reserve Ratio (CRR). As a result, commercial banks need to keep a large amount of cash as reserve from their total 183 CU IDOL SELF LEARNING MATERIAL (SLM)

deposits with the central bank. This would further reduce the lending capacity of commercial banks. Consequently, the investment by individuals in an economy would also reduce. 10.5.2 Fiscal Measures: Apart from monetary policy, the government also uses fiscal measures to control inflation. The two main components of fiscal policy are government revenue and government expenditure. In fiscal policy, the government controls inflation either by reducing private spending or by decreasing government expenditure, or by using both. It reduces private spending by increasing taxes on private businesses. When private spending is more, the government reduces its expenditure to control inflation. However, in present scenario, reducing government expenditure is not possible because there may be certain on- going projects for social welfare that cannot be postponed. Besides this, the government expenditures are essential for other areas, such as defense, health, education, and law and order. In such a case, reducing private spending is more preferable rather than decreasing government expenditure. When the government reduces private spending by increasing taxes, individuals decrease their total expenditure. For example, if direct taxes on profits increase, the total disposable income would reduce. As a result, the total spending of individuals decreases, which, in turn, reduces money supply in the market. Therefore, at the time of inflation, the government reduces its expenditure and increases taxes for dropping private spending. 10.5.3 Price Control: Another method for ceasing inflation is preventing any further rise in the prices of goods and services. In this method, inflation is suppressed by price control, but cannot be controlled for the long term. In such a case, the basic inflationary pressure in the economy is not exhibited in the form of rise in prices for a short time. Such inflation is termed as suppressed inflation. The historical evidences have shown that price control alone cannot control inflation, but only reduces the extent of inflation. For example, at the time of wars, the government of different countries imposed price controls to prevent any further rise in the prices. However, prices remain at peak in different economies. This was because of the reason that inflation was persistent in different economies, which caused sharp rise in prices. Therefore, it can be said inflation cannot be ceased unless its cause is determined. 10.6 SUMMARY  We may conclude our discussion in this way Equilibrium level of national income is 184 CU IDOL SELF LEARNING MATERIAL (SLM)

determined by the equality between aggregate demand and aggregate supply (or between savings and investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate demand and aggregate supply are in equilibrium at such a point where all the resources of the economy are fully employed. Every economy aspires for it.  But in real world situation, aggregate demand either exceeds or falls short of the level of full employment supply. Excess demand results in inflation without an increase in output and employment whereas deficient demand leads to unemployment and fall in output, income and prices.  Both the situations bring harmful effects on the economy and, therefore, require to be checked by adopting fiscal, monetary and other measures. All these measures should be integrated and used as complementary to each other, rather counter to each other. Therefore, all efforts should be made to achieve and stay at the equilibrium level of income ensuring full employment of all the available resources.  The \"general\" money price increase/decrease that many refer to as inflation/deflation amounts to a myth. Without the influence of a change in the supply of money, price movements of individual goods tend to offset each other. My model did not reflect this fully, but in real markets, when the dollar price of one product rises (declines), the dollar prices of one or more other products declines (rises). The likelihood that all production will rise or fall simultaneously remains very small.  For a generalized increase or decrease in money prices to occur requires the influence of a change in the one common denominator: money.  Money only has value as a medium of indirect exchange. Increasing its quantity adds nothing to economic welfare. So, even the moderate inflation, advocated by some, has no economic benefit. And decreasing the quantity of money subtracts nothing from the economy. The quantity of money, however, does influence dollar prices, which have a vital role conveying economic information.  Dollar prices provide vital signals for effective, efficient, and adaptable decisions by market actors. Any disruption of those signals by artificial changes in the quantity of money (inflation or deflation) causes rational decisions to produce flawed results. 10.7 KEY WORDS/ABBREVIATIONS  Price level - an index that traces the relative changes in the price of an individual good (or a market basket of goods) over time. 185 CU IDOL SELF LEARNING MATERIAL (SLM)

 Monetary - relating to or involving money  Adjustable-rate mortgage (ARM) - a loan used to purchase a home in which the interest rate varies with market interest rates  Base year - arbitrary year whose value as an index number is defined as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year—for example, 100; so, if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year  Core inflation index - a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices 10.8 LEARNING ACTIVITY 1. If the CPI is 93 in 2014 and 97 in 2015, calculate the rate of inflation from 2014 to 2015. __________________________________________________________________________________ __________________________________________________________________________________ 2. Note on inflationary & deflationary gap __________________________________________________________________________________ __________________________________________________________________________________ 10.9 UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. Explain the ways to control inflation 2. Note on demand pull inflation 3. Note on cost push inflation 4. Note on inflation 5. State the types of inflation B. Multiple Choice Questions (MCQs) 1. When prices are falling continuously, the phenomenon is called: (a) Inflation 186 CU IDOL SELF LEARNING MATERIAL (SLM)

(b) Stagflation 187 (c) Deflation (d) Reflation 2. Cause of Inflation in India is / are: (a) Deficit financing (b) Erratic agriculture growth (c) Inadequate rise in industrial production (d) All of these 3. Which is the most effective quantitative method to control inflation in the economy? (a) Bank rate policy (b) Selective credit control (c) Cash reserve ratio (d) Both (a) and (b) 4. Inflation is measured on the basis of: (a) Wholesale price index (b) Consumer price index (c) Marshall’s index (d) All of these 5. When price increases due to increase in factor prices it is ______. (a) Demand pull inflation (b) Cost pull inflation (c) Stagflation (d) None of these Answers: CU IDOL SELF LEARNING MATERIAL (SLM)

1. (c) 2. (d) 3. (c) 4. (b) 5. (b) 10.10 REFERENCES  Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill.  Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India.  Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press.  Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd.  Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India.  Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 188 CU IDOL SELF LEARNING MATERIAL (SLM)

189 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 11- GOVERNMENT BUDGET Structure 11.0. Learning Objectives 11.1. Introduction 11.2. Objectives and components 11.2.1 Objectives 11.2.2 Components of Budget 11.3. Classification of receipts:- revenue receipts and capital receipts 11.3.1 Revenue Receipts 11.3.2 Capital Receipts 11.3.3 Difference between revenue & capital receipts 11.4. Classification of expenditure – revenue expenditure and capital expenditure 11.4.1 Revenue expenditure 11.4.2 Capital expenditure 11.4.3 Comparison between Revenue Expenditure & Capital Expenditure 11.5. Measures of government deficit - revenue deficit, fiscal deficit, primary deficit their meaning 11.5.1 Revenue Deficit 11.5.2 Fiscal Deficit 11.5.3 Primary Deficit 11.6. Fiscal policy and its types 11.6.1 Expansionary Fiscal Policy 11.6.2 Contractionary Fiscal Policy 11.7. Summary 11.8. Key Words/Abbreviations 11.9. Learning Activity 11.10. Unit End Exercises (MCQs and Descriptive) 190 CU IDOL SELF LEARNING MATERIAL (SLM)

11.11. References 11.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Outline the components of budget  Explain the concept of government deficits  Explain the receipts & expenditure classification of the government budget  State the fiscal policy & its types 11.1 INTRODUCTION Government has several policies to implement in the overall task of performing its functions to meet the objectives of social & economic growth. For implementing these policies, it has to spend huge amount of funds on defense, administration, and development, welfare projects & various other relief operations. It is therefore necessary to find out all possible sources of getting funds so that sufficient revenue can be generated to meet the mounting expenditure. The term budget is derived from the French word \"Budgette\" which means a \"leather bag\" or a \"wallet\". It is a statement of the financial plan of the government. It shows the income & expenditure of the government during a financial year, which runs generally from 1stApril to 31st March. Budget is most important information document of the government. One part of the government's budget is similar to company's annual report. This part presents the overall picture of the financial performance of the government. The second part of the budget presents government's financial plans for the period up to its next budget. So, every citizen of a nation from the common man to the politician is eager to know about the budget as they would like to get an idea of the: -  Financial performance of the government over the past one year.  To know about the financial programmers & policies of the government for the next one year.  To know how their standard of living will be affected by the financial policies of the government in the next one year. 191 CU IDOL SELF LEARNING MATERIAL (SLM)

11.2 OBJECTIVES AND COMPONENTS 11.2.1 Objectives Government prepares the budget for fulfilling certain objectives. These objectives are the direct outcome of government’s economic, social and political policies. The various objectives of government budget are: 1. Reallocation of Resources: Through the budgetary policy, Government aims to reallocate resources in accordance with the economic (profit maximization) and social (public welfare) priorities of the country. Government can influence allocation of resources through: (i) Tax concessions or subsidies: To encourage investment, government can give tax concession, subsidies etc. to the producers. For example, Government discourages the production of harmful consumption goods (like liquor, cigarettes etc.) through heavy taxes and encourages the use of ‘Khaki products’ by providing subsidies. (ii) Directly producing goods and services: If private sector does not take interest, government can directly undertake the production. 2. Reducing inequalities in income and wealth: Economic inequality is an inherent part of every economic system. Government aims to reduce such inequalities of income and wealth, through its budgetary policy. Government aims to influence distribution of income by imposing taxes on the rich and spending more on the welfare of the poor. It will reduce income of the rich and raise standard of living of the poor, thus reducing inequalities in the distribution of income. 3. Economic Stability: Government budget is used to prevent business fluctuations of inflation or deflation to achieve the objective of economic stability. The government aims to control the different phases of business fluctuations through its budgetary policy. Policies of surplus budget during inflation and deficit budget during deflation helps to maintain stability of prices in the economy. 4. Management of Public Enterprises: There are large numbers of public sector industries (especially natural monopolies), which 192 CU IDOL SELF LEARNING MATERIAL (SLM)

are established and managed for social welfare of the public. Budget is prepared with the objective of making various provisions for managing such enterprises and providing those financial help. 5. Economic Growth: The growth rate of a country depends on rate of saving and investment. For this purpose, budgetary policy aims to mobilize sufficient resources for investment in the public sector. Therefore, the government makes various provisions in the budget to raise overall rate of savings and investments in the economy. 6. Reducing regional disparities: The government budget aims to reduce regional disparities through its taxation and expenditure policy for encouraging setting up of production units in economically backward regions. 11.2.2 Components of budget Table 11.1 Components of budget 11.3 CLASSIFICATION OF RECEIPTS: - REVENUE RECEIPTS AND CAPITAL RECEIPTS Government receipts are divided into two groups—Revenue Receipts and Capital Receipts. All Government receipts which either create liability or reduce assets are treated as capital receipts whereas receipts which neither create liability nor reduce assets of Government are called revenue receipts. 193 CU IDOL SELF LEARNING MATERIAL (SLM)

11.3.1 Revenue Receipts: Government receipts which neither (i) create liabilities nor (ii) reduce assets are called revenue receipts. These are proceeds of taxes, interest and dividend on government investment, chess and other receipts for services rendered by the government. These are current income receipts of the government from all sources. Government revenue is the means for government expenditure. In the same way as production is means for consumption. 11.3.2 Capital Receipts: Government receipts which either (i) create liabilities (e.g. borrowing) or (ii) reduce assets (e.g. disinvestment) are called capital receipts. Thus when govt. raises funds either by incurring a liability or by disposing off its assets, it is called a capital receipt. (A) Two examples of Capital Receipts which create liability are Borrowing and raising of funds from Public Provident Fund and Small savings deposits. How? (i) Borrowings are treated capital receipts because they create liability of returning loans, (ii) Similarly, funds raised from PPF, small saving deposits In post offices and banks are treated capital receipts because they Increase liability of the government to repay these amounts to PPF (Public Provident Fund) holders and small savings depositors. (B) Two examples of Capital Receipts which reduce assets are Disinvestment and Recovery of Loans. (D2006, 12C) How? (i) Disinvestment by government means selling a part or whole of its shares of public sector undertakings (e.g., HMT, LIC, and FCI). Funds raised from disinvestment reduce government assets (ii) Recovery of loan is also capital receipt as It reduces government assets. For Instance, If UP government, which has taken loan of Rs 100 crore from Central government, repays Rs 20 crore, value of Central government assets of Rs 100 crore is now reduced to Rs 80 crore because of partial recovery of loan. 11.3.3 Difference between revenue and capital receipts: The main difference between revenue receipts and capital receipts is that in the case of revenue receipts, government is under no future obligation to return the amount, i.e., they are non-redeemable. But In case of capital receipts which are borrowings, government is under obligation to return the amount along with Interest. Debt is creating and Non-debt creating capital receipts: Capital receipts may be debt creating or non-debt creating. Examples of debt creating receipts are—Net borrowing by government at home, loans received from foreign governments, borrowing from RBI. Examples of non-debt capital receipts are—Recovery of loans, 194 CU IDOL SELF LEARNING MATERIAL (SLM)

proceeds from sale of public enterprises (i.e., disinvestment), etc. These do not give rise to debt. 11.4 CLASSIFICATION OF EXPENDITURE – REVENUE EXPENDITURE AND CAPITAL EXPENDITURE An expenditure that neither creates assets nor reduces a liability is categorized as revenue expenditure. If it creates an asset or reduces a liability, it is categorized as capital expenditure. This is the basis of classification between revenue expenditure and capital expenditure. 11.4.1 Revenue Expenditure: Simply put, an expenditure which neither creates assets nor reduces liability is called Revenue Expenditure, e.g., salaries of employees, interest payment on past debt, subsidies, pension, etc. These are financed out of revenue receipts. Broadly, any expenditure which does not lead to any creation of assets or reduction in liability is treated as revenue expenditure. Generally, expenditure incurred on normal running of the government departments and maintenance of services is treated as revenue expenditure. Examples of revenue expenditure are salaries of government employees, interest payment on loans taken by the government, pensions, subsidies, grants, rural development, education and health services, etc. It is a short period expenditure and recurring in nature which is incurred every year (as against capital expenditure which is long period expenditure and non-recurring in nature). The purpose of such expenditure is not to build up any capital asset, but to ensure normal functioning of government machinery. Traditionally, all grants given to state governments are treated as revenue expenditure even though some of the grants may before creation of assets. 11.4.2 Capital Expenditure: An expenditure which either creates an asset (e.g., school building) or reduces liability (e.g., repayment of loan) is called capital expenditure. (A) Capital expenditure which leads to creation of assets are (a) expenditure on purchase of land, buildings, machinery, (b) investment in shares, loans by Central government to state government, foreign governments and government companies, cash in hand and (c) acquisition of valuables. Such expenditures are incurred on long period development programmers, real capital assets and financial assets. This type of expenditure adds to the capital stock of the economy and raises its capacity to produce more in future. (B) Repayment of loan is also capital expenditure because it reduces liability. These 195 CU IDOL SELF LEARNING MATERIAL (SLM)

expenditures are met out of capital receipts of the government including capital transfers from rest of the world. 11.4.3 Comparison between Revenue Expenditure and Capital Expenditure Revenue Expenditure Capital Expenditure 1. It is incurred for normal 1. It is incurred for acquisition of running of government capital assets. departments and maintenance. 2. It does not result in creation of 2. It results in creation of assets. assets. 3. It is recurring in nature and 2. It is non-recurring in nature. incurred regularly. 4. It is short period expenditure. 4. It is generally a long period expenditure. 5. For example, expenditure on 5. For example, construction of a medicines and salaries of doctors hospital building is capital expenditure. for rendering services is Table 11.2 Comparison between Revenue Expenditure and Capital Expenditure 11.5 MEASURES OF GOVERNMENT DEFICIT - REVENUE DEFICIT, FISCAL DEFICIT, PRIMARY DEFICIT THEIR MEANING There can be different types of deficit in a budget depending upon the types of receipts and expenditure we take into consideration. Accordingly, there are three concepts of deficit, namely (i) Revenue deficit (ii) Fiscal deficit and (iii)Primary deficit. Although budget deficit and revenue deficit are old ones but fiscal deficit and primary deficit are of recent origin. 196 CU IDOL SELF LEARNING MATERIAL (SLM)

Each of them is analyzed below: Fig. 11.3 Measures of Budgetary Deficit Budgetary deficit is the excess of total expenditure (both revenue and capital) over total receipts (both revenue and capital). Following are three types (measures) of deficit: 1. Revenue deficit = Total revenue expenditure – Total revenue receipts. 2. Fiscal deficit = Total expenditure – Total receipts excluding borrowings. 3. Primary deficit = Fiscal deficit-Interest payments. 11.5.1 Revenue Deficit: Revenue deficit is excess of total revenue expenditure of the government over its total revenue receipts. It is related to only revenue expenditure and revenue receipts of the government. Alternatively, the shortfall of total revenue receipts compared to total revenue expenditure is defined as revenue deficit. Revenue deficit signifies that government’s own earning is insufficient to meet normal functioning of government departments and provision of services. Revenue deficit results in borrowing. Simply put, when government spends more than what it collects by way of revenue, it incurs revenue deficit. Mind, revenue deficit includes only such transactions which affect current income and expenditure of the government. Put in symbols: Revenue deficit = Total Revenue expenditure – Total Revenue receipts For instance, revenue deficit in government budget estimates for the year 2012-13 is Rs 3,50,424 crore (= Revenue expenditure Rs 12,86,109 crore – Revenue receipts ^ 9,35,685 crore) vide summary of the budget in Section 9.18. It reflects government’s failure to meet its revenue expenditure fully from its revenue receipts. The deficit is to be met from capital receipts, i.e., through borrowing and sale of its assets. Given the same level of fiscal deficit, a higher revenue deficit is worse than lower one because it implies a higher repayment burden in future not matched by benefits via investment. 197 CU IDOL SELF LEARNING MATERIAL (SLM)

Remedial measures: A high revenue deficit warns the government either to curtail its expenditure or increase its tax and non-tax receipts. Thus, main remedies are: (i) Government should raise rate of taxes especially on rich people and any new taxes where possible, (ii) Government should try to reduce its expenditure and avoid unnecessary expenditure. Implications: Simply put, revenue deficit means spending beyond the means. This results in borrowing. Loans are paid back with interest. This increases revenue expenditure leading to greater revenue deficit. Main implications are: (i) Reduction of assets: Revenue deficit indicates dissaving on government account because government has to make up the uncovered gap by drawing upon capital receipts either through borrowing or through sale of its assets (disinvestment). (ii) Inflationary situation: Since borrowed funds from capital account are used to meet generally consumption expenditure of the government, it leads to inflationary situation in the economy with all its ills. Thus, revenue deficit may result either in increasing government liabilities or in reduction of government assets. Remember, revenue deficit implies a repa3Tnent burden in future without the benefit arising from investment. (iii)More revenue deficit: Large borrowings to meet revenue deficit will increase debt burden due to repayment liability and interest payments. This may lead to larger and larger revenue deficits in future. 11.5.2 Fiscal Deficit: Fiscal deficit is defined as excess of total budget expenditure over total budget receipts excluding borrowings during a fiscal year. In simple words, it is amount of borrowing the government has to resort to meet its expenses. A large deficit means a large amount of borrowing. Fiscal deficit is a measure of how much the government needs to borrow from the market to meet its expenditure when its resources are inadequate. In the form of an equation: 198 CU IDOL SELF LEARNING MATERIAL (SLM)

Fiscal deficit = Total expenditure – Total receipts excluding borrowings = Borrowing If we add borrowing in total receipts, fiscal deficit is zero. Clearly, fiscal deficit gives borrowing requirements of the government. Let it be noted that safe limit of fiscal deficit is considered to be 5% of GDR Again, borrowing includes not only accumulated debt i.e. amount of loan but also interest on debt, i.e., interest on loan. If we deduct interest payment on debt from borrowing, the balance is called primary deficit. Fiscal deficit = Total Expenditure – Revenue receipts – Capital receipts excluding borrowing A little reflection will show that fiscal deficit is, in fact, equal to borrowings. Thus, fiscal deficit gives the borrowing requirement of the government. Can there be fiscal deficit without a Revenue deficit? Yes, it is possible (i) when revenue budget is balanced but capital budget shows a deficit or (ii) when revenue budget is in surplus but deficit in capital budget is greater than the surplus of revenue budget. Importance: Fiscal deficit shows the borrowing requirements of the government during the budget year. Greater fiscal deficit implies greater borrowing by the government. The extent of fiscal deficit indicates the amount of expenditure for which the government has to borrow money. For example, fiscal deficit in government budget estimates for 2012-13 is Rs 5, 13,590 crore (= 14, 90,925 – (9, 35,685 + 11,650 + 30,000) vide summary of budget in Section 9.18. It means about 18% of expenditure is to be met by borrowing. Implications: (i) Debt traps: Fiscal deficit is financed by borrowing. And borrowing creates problem of not only (a) payment of interest but also of (b) repayment of loans. As the government borrowing increases, its liability in future to repay loan amount along with interest thereon also increases. Payment of interest increases revenue expenditure leading to higher revenue deficit. Ultimately, government may be compelled to borrow to finance even interest payment leading to emergence of a vicious circle and debt trap. (ii) Wasteful expenditure: High fiscal deficit generally leads to wasteful and unnecessary expenditure by the government. It can create inflationary pressure in the economy. (iii)Inflationary pressure: As government borrows from RBI which meets this demand by printing of more currency notes (called deficit financing), it results in circulation of more money. This may cause 199 CU IDOL SELF LEARNING MATERIAL (SLM)

inflationary pressure in the economy. (iv)Partial use: The entire amount of fiscal deficit, i.e., borrowing is not available for growth and development of economy because a part of it is used for interest payment. Only primary deficit (fiscal deficit-interest payment) is available for financing expenditure. (v) Retards future growth: Borrowing is in fact financial burden on future generation to pay loan and interest amount which retards growth of economy. How is fiscal deficit met? (by borrowing). Since fiscal deficit is the excess of govt. total expenditure over its total receipts excluding borrowings, therefore borrowing is the only way to finance fiscal deficit. It should be noted that safe level of fiscal deficit is considered to be 5% of GDR. (i) Borrowing from domestic sources: Fiscal deficit can be met by borrowing from domestic sources, e.g., public and commercial banks. It also includes tapping of money deposits in provident fund and small saving schemes. Borrowing from public to deal with deficit is considered better than deficit financing because it does not increase the money supply which is regarded as the main cause of rising prices. (ii) Borrowing from external sources: For instance, borrowing from World Bank, IMF and Foreign Banks (iii)Deficit financing (printing of new currency notes): Another measure to meet fiscal deficit is by borrowing from Reserve Bank of India. Government issues treasury bills which RBI buys in return for cash from the government. This cash is created by RBI by printing new currency notes against government securities. Thus, it is an easy way to raise funds but it carries with it adverse effects also. Its implication is that money supply increases in the economy creating inflationary trends and other ills that result from deficit financing. Therefore, deficit financing, if at all it is unavoidable, should be kept within safe limits. Is fiscal deficit advantageous? It depends upon its use. Fiscal deficit is advantageous to an economy if it creates new capital assets which increase productive capacity and generate future income stream. On the contrary, it is detrimental for the economy if it is used just to cover revenue deficit. 200 CU IDOL SELF LEARNING MATERIAL (SLM)