CU-BA-SEM-III-Economics-III-Second Draft-converted

BACHELOR OF ARTS SEMESTER-III ECONOMICS III BAQ207

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:- 01133002345 For: CHANDIGARH UNIVERSITY 2 Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action 3 CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENTS Unit-1 Introduction................................................................................................5 Unit-2 Determination of Income and Employment.............................................27 Unit-3 Consumption and Investment Functions..................................................49 Unit-4 Consumption and Investment Functions..................................................73 Unit-5 Theories of Money and Interest ...............................................................91 Unit – 6 Banking ...............................................................................................127 Unit- 7 Credit Creation and Credit Control.......................................................149 Unit-8 Inflation and Macro–Economic Policies................................................164 Unit-9 Measures to control inflation .................................................................189 4 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-1 INTRODUCTION Structure 1.0 Learning objectives 1.1 Introduction 1.2 Macroeconomics -meaning 1.3 Definition 1.4 Development of macroeconomics 1.5 Scope of macroeconomics 1.5.1 Theory of National Income 1.5.2 Theory of Employment 1.5.3 Theory of Money 1.5.4 Theory of general price level 1.5.5 Theory of International Trade 1.5.6 Theory of Economic Growth 1.5.7 Monetary Policy 1.5.8 Fiscal Policy 1.6 Importance of macroeconomics 1.7 Major microeconomic issues 1.8 Limitations of macroeconomics 1.9 Difference between Macroeconomics and Microeconomics 1.10 Summary 1.11 Keywords 1.12 Learning activity 1.13 Unit End Questions 1.14 References 1.0LEARNING OBJECTIVES After studying this unit, students will be able to: • Define the meaning of macroeconomics • Describe the development of macroeconomics • Identify the scope of macroeconomics

• Evaluate the importance of macroeconomics • Explain the limitations of macroeconomics 1.1 INTRODUCTION Macroeconomics is that branch of science which deals with the economy as a whole or in totality including the macro factors. The hope of macroeconomics does not involve studying the individual units of an economy. But, the economy as a whole, studies the total and average of the entire economy. Such as the national income, total employment, total saving and Investments, total demand and supply, and the general price level. The term macroeconomics came into existence in 1933 by Ragnar Frisch. However, its approach towards economic problems came in the 16th and 17th centuries. As a result, this originated with mercantilists. 1.2 MACROECONOMICS-MEANING Macroeconomics (from the Greek prefix ‘makro’- meaning \"large\" + economics) is a branch of economics dealing with the performance, structure, behaviour, and decision-making of an economy as a whole. For example, using interest rates, taxes and government spending to regulate an economy's growth and stability. Macroeconomics is the branch of economics that studies the behaviour and performance of an economy as a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate, gross domestic product and inflation. Macroeconomics analyses all aggregate indicators and the microeconomic factors that influence the economy. Government and corporations use macroeconomic models to help in formulating of economic policies and strategies. Common macroeconomics measurement includes the Gross Domestic Product (GDP), which is the total amount of goods produced in an economy. Macroeconomics develops models to explain the relationship of these actions to the overall economy and at what magnitude each factor can affect the economic environment as a whole. Macroeconomics is important for the government as it acts as regulators to determine if monetary policies and fiscal policies or a combination of both are needed to obtain stable growth in an economy. It is also important for an investor to have the ability to examine a 6 CU IDOL SELF LEARNING MATERIAL (SLM)

country’s current and future environment since this will allow them to pinpoint assets and securities that may benefit or be harmed by economic variables. Macroeconomics focuses on the larger of these variables, including government spending, inflation, rate of employment, and consumption, all of which can affect the health of various industries, companies, and securities. 1.3 DEFINITION In the words of Boulding, \"Macro economic theory is that part of economics which studies the overall averages and aggregates of the system.\" According to Shapiro, \"Macroeconomics deals with the functioning of the economy as a whole.\" According to Ackley Gardner, “Macroeconomics concerns with such variables as the aggregate volume of the output of on economy, with the extent to which its resources are employed, with the size of national income and with the general prize level.” In words of M.H. Spence – “Macroeconomics is concerned with the economy as a whole or large segment of it. in macroeconomics attention is focussed on such problems as the level of unemployment, the rate of inflation, the nation’s total output and other matters of economy wide significance.” 1.4 DEVELOPMENT OF MACROECONOMICS Macroeconomics is the study of the behaviour of the whole economy. It is concerned with the determination of the broad aggregates in the economy, in particular the national output, unemployment, inflation and the balance-of payments position. The main body of macroeconomic theory applies to a developed, capitalist economy. A capitalist economy is one where productive asset are owned either directly by individuals or by individuals through the medium of firms. These employ others to work with the productive assets in order to produce output. In such an economy, economic decisions are taken by individuals and firms acting independently of one another and co-ordinated via the market mechanism. All these decisions then interact to determine the values of variables such as output and prices. Economies that are nowadays classified as 'capitalist' all have important state sectors which in various and differing ways intervene in the operation of market fore es to redirect or suppress them. The way in which we nowadays study macroeconomics largely owes its origins to John Maynard 7 CU IDOL SELF LEARNING MATERIAL (SLM)

Keynes's The General Theory of Employment, Interest and Money Published in 1936 The General Theory was regarded by its author, and by many others since, as a revolutionary work. In it Keynes set out to challenge the mainstream neoclassical economic thought of his day, which he castigated as unable to explain or offer policy solutions for the high level of unemployment which, in Britain between 1921 and 1939, was just under 10 per cent at its lowest level and rose to 22 per cent at the depth of the depression in 1932. The main premise of neoclassical economics is that markets do work and that price signals will bring about the necessary adjustments in the economy in response to economic change. Neoclassical economics grew out of the marginalist school of the latter part of the nineteenth century which developed economic theory on the basis of maximising behaviour. These ideas were elaborated by Alfred Marshall, Leon Walras and others and provide the theoretical underpinning to modern economic theory. Keynes himself used neoclassical theory to develop investment and labour demand functions. A Macroeconomics Rosalind Levačić and Alexander Rebmann 1982 R. Levačić Introduction to Macroeconomics main policy conclusion of the neoclassical economists of that period was that government intervention to regulate the economy was unnecessary and brought about distortions. In the General Theory Keynes argued that once an economy had moved into a situation of high unemployment, the price mechanism would not work to adjust the economy back to a high level of employment. Instead, the government needed to raise the demand for output by increasing public expenditure. Once demand had increased firms would supply more output and employ more people, which in turn would increase demand still further. The General Theory is a complex book and not particularly easy to understand. As befits a c1assic work it is capable of several interpretations. In order to simplify and disseminate its ideas, a number of Keynes's disciples developed a relatively simple theoretical framework within which to present the main arguments. It is this body of theory which became known as 'Keynesian economics' and which will be outlined here and in subsequent chapters. The Keynesian model of the economy, which shows it capable of coming to rest at a high level of unemployment, has important policy implications. By managing the level of aggregate demand, raising it when unemployment is high, or reducing it if excess demand is causing inflation (defined as a situation of continually rising prices), the government can stabilise the economy, which otherwise would fluctuate between booms and long periods of depression. Many early Keynesians in fact believed that depression was a chronic state for a capitalist economy which 8 CU IDOL SELF LEARNING MATERIAL (SLM)

would persistently exhibit too low a level of demand to employ all the. work-force. The policy conclusions of Keynesian economics also have important political implications. It concludes that the government can improve the performance of a capitalist economy by managing the level of aggregate demand. This is done by fiscal policy, which involves changing the levels of taxation or of government expenditure, or by monetary policy, which affects interest rates and the supply of money and credit. These policies only require a modest amount of government intervention at a very general and aggregate level. They do not require detailed intervention at the micro level of individual markets and firms. Thus, the policy recommendations of Keynesian economics are appealing to those with social-democratic persuasions. The capitalist economy can be modified and tamed by government intervention without the loss of individual freedom inherent in very detailed state supervision of economic life. For Marxists, Keynesian economics is less attractive. Although Keynesian analysis can be viewed as a critique of the capitalist market-orientated economic systems, its policy conclusions, if correct, enable the capitalist economy to survive because its performance has been improved. 1.5 SCOPE OF MACROECONOMICS Microeconomics focuses on the way the economy performs as a whole. It then analyses how various factors of an economy are related to each other to know how these totals function. These functions include the gross domestic product (GDP), inflation, rate of unemployment, etc. The government uses macroeconomics models in the construction and evaluation of the economic, monetary, and fiscal policy. It gives numerous scales of the government budget and impact on the policy on consumers and businesses and concerns itself on important better decisions through more understanding of how to; get maximized utility. 9 CU IDOL SELF LEARNING MATERIAL (SLM)

scope of macro Macroeco National Income economics nomic Employment theories Money Macroeco pricelevel nomic International Trade policies Monetary policy Fiscal policy Figure: 1.1 Scope of Macro Economic 1.5.1 Theory of National Income National income is the country’s total value of new goods and services produced in one year. National income is considered what happens when goods are being produced and sold. Typically, goods and services are produced in the number of stages, where the raw material is converted into a finished product and then sold to the final consumer. The theory of national income is related to identifying the balance level of national income that is the level of national income at which the purchasing power and producing plans of the economy are adjusted. It includes different topics related to the measurement of national income, including revenue, spending, and budgeting. As a macroeconomic study, it is vital for assessing the overall performance of the economy in terms of national income. At the onset of the Great Depression of the 1930s, it was essential to investigate the triggers of general overproduction and general unemployment. This led to the creation of data on national income. It helps to forecast the level of economic activity. It also helps in understanding the income distribution among various classes of citizens. 1.5.2 Theory of Employment This scope of macroeconomics assists in determining the level of unemployment. It also determines the conditions that lead to such conditions of unemployment. Hence, this affects the production supply, consumer demand, consumption, and expenditure behaviour. 10 CU IDOL SELF LEARNING MATERIAL (SLM)

The theory of employment is broadly divided into two classical theories of employment and the Keynesian theory of employment. The classical theory assumed the full employment rate. From 1929 to 1934, there was a great depression in the entire world related to the rate of unemployment, low output, low national income for about five years and that’s where it gives rise to the Keynesian theory of employment. The Classical Theory of Employment The word classical economist was first used by Karl Marx to determine his thought and his predecessors, including Adam Smith. There are two broad features of the classical theory of employment were. • Full employment of labour and other productive resources As per classical economists, labour and resources are fully employed. The general over- production and unemployment are assumed to be impossible. If there is unemployment in a country, it is assumed to be temporary abnormal. According to classical, unemployment cannot persist for a long time. The reason for unemployment can be intervention by the government or private monopoly, wrong calculation by entrepreneur or wrong decision, artificial resistance. • The flexibility of price and wages to bring full employment The second assumption of full employment theory is the flexibility of price and wages. If the general overproduction is increasing the depression and unemployment, then the prices would fall. As a result, demand would increase, the price would rise, and productivity will be stimulated, and employment tends to disappear. Similarly, unemployment could be solved by cutting down wages which would increase the demand for labour. Keynesian Theory of Employment Keynes has criticized the classical theory in his book ‘general theory of employment’. Modern economists widely accept his theory of employment. He is also known as the new economic revolutionist. Keynes has introduced new techniques and tools of economic analysis such as consumption function, the marginal efficiency of capital, effective demand, etc. In short, it is assumed that capital equipment, population, and technical knowledge remains constant. That’s why, according to Keynesian theory, the volume of employment is dependent on the level of national income and output. 11 CU IDOL SELF LEARNING MATERIAL (SLM)

1.5.3 Theory of Money Macroeconomics assesses the impact of the reserve bank in the economy, the inflow and outflow of capital, and its effects on job rates. The frequent change in the value of money caused due to inflation and deflation diversely affect the economy of a nation adversely. They can be aggravated by taking monetary, fiscal policies and direct control measures for the economy as a whole. To understand the theory of money, it is important first to know the value of money. In economics, a different economist has defined the term value of money differently. Some economists have explained it with the value of gold or silver in terms of their weight and fineness. On the other hand, some economists have explained it as the purchasing power of a nation. However, the value of money is associated with purchasing power which refers to the number of goods and services that can be bought with a unit of money. Three natures are analysed for the financial approach of a country. • Quantity Velocity Approach • Cash Balance Approach • Income-Expenditure Approach Amongst these three approaches, the quantity velocity approach and cash balanced approach are grouped in the theory of money. On the other hand, the income-expenditure approach is coming under the modern theory of money. 1.5.4 Theory of General Price Level The most significant of these is the study of commodity prices and how specific price rates fluctuate due to inflation or deflation. An index that measures the change in price of goods in an economy over time and hence the purchasing power of the currency of the country. For instance, in the U.S. it is represented by the CPI (Consumer Price Index) maintained by the U.S. Department of Labour. 1.5.5 Theory of International Trade It is an area of study that focuses on the export and import of products or services. In brief, it points out the effect on the economy through cross-border commerce and customs duty. International trade theories are simply different theories to explain international trade. Trade is the concept of exchanging goods and services between two people or entities. International trade is then the concept of this exchange between people or entities in two different countries. People or entities trade because they believe that they benefit from the exchange. They may 12 CU IDOL SELF LEARNING MATERIAL (SLM)

need or want the goods or services. While at the surface, this many sounds very simple, there is a great deal of theory, policy, and business strategy that constitutes international trade. With time, economist have established theories that explain global trade. These theories explain what exactly happen in International Trade. There are 6 economic theories under International Trade law which are classified in four:(I)Mercantile Theory of Trade (II) Classical Theory of Trade (III) Modern Theory of Trade (IV) New Theories of Trade. Both of these categories, classical and modern, consist of several international theories. 1.5.6 Theory of Economic Growth The growth of an economy also comes under the study of macroeconomics. The resources and capabilities of an economy are evaluated based on the scope of macroeconomics. It schemes the increase in the level of national income, output, and the environment level. They have a direct impact on the economic development of an economy. There are various models of economic growth stressing various causes. The principle of this theory includes the following. • The wealth of a nation is defined by the total accumulation of gold and the trade surplus of a country. • Under the classical theory, Adam Smith emphasizes the improvement in the role of return to scale. • Neoclassical theory is based on the supply factors such as labour productivity, size of the workforce, and factors input. • The rate of economic growth is strongly influenced by human capital and the rate MACROECONOMIC POLICIES The government and the reserve bank functions together while determining the macroeconomic policies, for the nation’s welfare and development. At least since the Great Depression 60 years ago there has been general agreement that Washington has a major responsibility for fostering economic prosperity and stability, as the essay on general-welfare liberalism, makes clear. The demands placed on the federal government run the gamut from controlling the business cycle (the ups and downs in employment and prices) to encouraging stable growth in the productivity of labour and capital to regulating commercial activities to ensure the public health, safety, and welfare to protecting business and labour from unfair foreign competition. Attaining these goals is clearly a tall order. More important, even though 13 CU IDOL SELF LEARNING MATERIAL (SLM)

Americans generally agree on the need for public action, they quarrel bitterly about its extent and form. Economists and politicians all have their favourite approaches. Many favour a combination of taxing and public spending, while others advocate regulating the supply of money. In practice, economic policy involves a mixture of the two, but during the past several decades each method has at one time or another been dominant. 1.5.7 Monetary Policy Monetary policy attempts to control the amount of money in circulation or the cost and availability of credit. The objective is straightforward even if difficult to put into practice. If money is readily available because, say, interest rates are low, people can afford to borrow and spend. But unless production keeps pace, there will not be enough goods and services to meet the demand this borrowing and spending creates. In the face of the excessive demand, producers and suppliers have incentives to raise their prices. As time goes by, prices spiral upward, leading to uncontrolled inflation during which dollars lose their value. The key to keeping inflation in check is to maintain stable interest rates and not let the money supply grow too rapidly. Monetary policy falls within the province of the Federal Reserve System, the nation's central bank. Like fiscal policy, monetarism has a downside. Should the government constrict the flow of cash into the economy too severely, consumers and businesses cannot afford to borrow, spending and investments decline, products sit on store shelves, factories close, and new homes, automobiles, and appliances go unsold. As the economy cools off, more and more workers are laid off and the downward plunge picks up momentum. As we saw at the outset, the Fed's decision to curb the supply of money in 1979 led the United States into its worst recession in 50 years. Nevertheless, just as Democrats traditionally favour stimulative policies, conservative Republicans tend to boost monetary policy as the best way to control inflation, which they argue is a greater evil than unemployment. 1.5.8 Fiscal Policy By manipulating government spending and taxes in order to stimulate or slow down growth, Washington affects the aggregate or total demand for goods and services. This method of economic management is called fiscal policy. 14 CU IDOL SELF LEARNING MATERIAL (SLM)

To see how fiscal policy works, consider a period of high unemployment and business stagnation. America has suffered through numerous such periods such as in the early 1980s and 1991 to late 1993. The national government attempts to revive industry and create jobs by injecting billions of dollars into the economy (a task some call \"pump priming\"). It does so by cutting taxes, thereby leaving individuals and businesses with more to spend; by purchasing goods and services (such as building bridges, dredging harbours, and buying airplanes); and by making direct payments to individuals (social security or unemployment insurance, for example). In theory at least, the net effect is to raise aggregate demand, the total goods and services citizens and businesses can afford to buy. A rise in demand causes industries to manufacture more products, hire additional labour, and invest in new buildings and machinery, all of which helps commerce and trade. Government spending, moreover, has a multiplier effect. The billions of dollars allocated to public projects go into the pockets of carpenters, steelworkers, bricklayers, truck drivers, and thousands of other laborers, who spend the money on food, clothing, housing, medical care, automobiles, and recreation. Workers in these industries, in turn, spend their wages on additional goods and services. Gradually the government's dollars trickle through the economy. The multiplier effect holds for all types of budget transactions, whether in the form of tax cuts, direct payments, or actual purchases. Consequently, federal pump priming increases national income by much more than the nominal or face amount of the outlays. In times of prosperity, on the other hand, demand may exceed supply. The excess causes prices to increase and, unless stopped, leads to inflation, a condition in which the value of money decreases as prices rise. When this happens, the government reverses gear by cutting spending, raising taxes, or both. The result is less money in the hands of consumers and business, and less money means lower aggregate demand, which causes prices to level off. Fiscal policy thus strives to smooth out the business cycle by manipulating the federal budget to maintain just enough demand to keep people working but not so much as to fuel inflation. In essence fiscal policy is a juggling act by adjusting spending and taxation, the government can in principle maintain high levels of employment and stable prices. In the past, Democrats, especially members from the liberal wing of the party, have advocated fiscal action to combat unemployment and sustain economic productivity and were willing to risk inflation and incur budget deficits to achieve these ends. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

Associated with the British economist John Maynard Keynes, fiscal policy is often called Keynesian theory. Although Franklin Roosevelt effectively adopted Keynesian theory in the 1930s and it has been widely accepted ever since, it has nonetheless always created deep misgivings and endless controversy. Many economists doubt that the national government can fine-tune the economy by raising or lowering taxes and expenditures. Besides being too ponderous and time-consuming, these methods involve enormous uncertainties. But before dismissing the impact of fiscal policy, consider unemployment. Unemployment as a percent of the labour force has gone up and down since the Republic's founding. But prior to World War II, when policy makers preferred to let the market correct swings in the business cycle, the variation in jobless was much greater than in the post-war period. In recent years the rate of unemployment has hover around 6 percent; at times, as in the early 1982 it reached nearly 11 percent. But the waves have been much smoother than they were in the 1900 to 1940 period, an era of bust and boom. Despite fiscal policy's apparent success, an even more potent economic policy is monetary policy. 1.6 IMPORTANCE OF MACROECONOMICS 1. Macroeconomics is a vital concept that considers the whole nation and works for the welfare of the economy. 2. It is helpful for the timing of economic fluctuations to prevent or be equipped for any financial crisis or any long – term negative situations. 3. The system of fiscal and monetary policies depends entirely on the analysis of the widely held macroeconomic conditions in the nation. 4. Macroeconomics mainly aims to help the Government and the financial bodies to prepare economic stability in the country. 5. This stream of economics gives a broader perspective of social or national issues. The ones who want to contribute to the welfare of society need to study macroeconomics. 6. It ensures or keeps a check over the proper functioning of the country’s economy and actual position. 7. The analysis of macroeconomics theories and issues helps the economists to figure out the causes and possible solutions of such macro-level problems. 8. Dealing with various economic conditions through the use of macro-economic data opens the door for growth in the country. 16 CU IDOL SELF LEARNING MATERIAL (SLM)

1.7 MAJOR MACROECONOMIC ISSUES (1) Growth and Development- Growth and development are the two important factors of macroeconomics or macroeconomics, related policies. ‘Growth and development’ have become the focus of study of macroeconomics of different countries economy in this age of globalization. The continuous growth of economics are essential and this growth (in the form of flow goods and services) should be seems in the form of increasing standard of living of common people or should be totally improvement of quality of life. Growth should be transformed in development. Its meaning is that the gaps between haves and have not should be reduced in course of time. In fact, the problem of growth and development has got much importance in recent past. Attainment of economic growth should not be done by (i) dozen fall of environment and (ii) natural resources (particularly non-renewable resources) excessive exploitation because by this future generations production potentiality may be reduced. Only in this context economist talks about ‘sustainable development’ and this is the rising problem of today’s macroeconomics. In fact, planner and politicians are cautioned that they formulated such a type of macroeconomics related policy by them confirmed consistent economic growth (in the form of continuing availability of goods and services increasing) and social justice (means in the form of equal distribution of wealth and income) and neither decay of environment not future generations production potentiality less by any types. (2) Employment -In the decade of 1930 whole world was in the grip of great depression. Economic activities had been down very slowly. The demand of goods and services had been fallen. As a result, massive fall in commercial benefit and investment cut down at large level and unemployment speeded. If, in the production filled a large percentage of active population fakes unemployment then it becomes such a problem whose solution at the whole economy level become very essential. This is an important problem of macroeconomics. In India unemployment continues a dreadful problem. Unskilled labourer at great scale suffering from rural unemployment. In urban areas too in skilled artisans founds amazing unemployment and under employment. In our country unemployment problem is so vast and long term that government has subjected to give reservation in government jobs. This reservation is trying to implement in private sector also. In fact, why will be needed reservation if all those who are ready to work on given wages, in great number jobs should be created? It can be said certainly that our country is not developing at that rate on which whole man power of country can be employed. Unemployment is not a characteristic of underdeveloped country as India. This is a 17 CU IDOL SELF LEARNING MATERIAL (SLM)

serious problem of developed country like U.K. and U.S.A. In developed and underdeveloped countries only, difference found in nature of unemployment. In underdeveloped countries its nature is of chronic and its reason is shortage in production potentialities. Just its contrary in developed countries its nature is cyclical for that reason decrease in the demand of goods and services. Rather than an important problem of macroeconomics is unemployment and it is related to all economies of world. (3) Business cycle -In economic activities always have fluctuations nature of changing occurred in this is not always steady. When economic activities go down then it is called stage of recession when it reaches to its lowest position then it is called stage of great depression. When in this being improvement then it called stage of recovery and when it reaches at its topmost position then it is called stage of boom. Recession and great depression is the stage of low profit. In this condition marginal firms are close, huge cut in quantity of investment and unemployment takes dreadful form. Just its contrary boom condition is such a condition where profit is increasing in which quantity of investment and means of production of demand increases continuously. Business cycle is not limited to a special firm or a particular commercial activity. This is a macro phenomenon which is taken in his grip all production units of country. In fact, at times it is become a global phenomenon, as great depression 1930 decade. It is a matter of to pay attention that macroeconomics’ a separate branch of study origin goes credit to 1930-decade great depression. During this period, capitalist economics of world, particularly in U.K. excessive employment has found. In U.K. economy unemployment level had reached at the rate of 25%. In such a time great economist of world Lord Keynes had propagated theory of income and employment and deficiency of aggregate demand, caused occurred problems of unemployment’s global remedy. In fact, an economy’s cyclic circulation in itself a great macroeconomics related problem whose solution is sought no only producer, but also government. Producer follows such a strategy by which recession and boom’s condition can be faked. Government is to formulate such a policy by which effect of business cycle can be minimal and economic growth’s fixed path can be made certain. (4) Inflation- Inflation is called such a condition in which at general price level (Average cost of all goods and services of economy) within a given period of time finds tendencies of continuously increasing. As a result, value of money decreases and people’s real purchase power is decreased. This is an also macroeconomics related problem, whose to understand and their solution is very necessary. Normal increment in price is helpful in economic growth. It causes increment in investment and whole level of economic activities are initiates. But 18 CU IDOL SELF LEARNING MATERIAL (SLM)

inflation sometimes takes the form of galloping inflation of hyperinflation. In the condition of hyperinflation, factors of production become dear. Specially in investments’ interest rate got tendency of heavy increment. As a result of this cost of production increases much and business competitiveness is becoming less, especially in world market. When finds the tendency of decrease in demand and rise in production cost then in production process clearly occurs obstacles. In such a case economy move towards boom to recession and great depression. Common people suffer seriously due to inflation. His purchasing power decreases and towards government his rage increases. General dissatisfaction finally takes the form of social restlessness, by that reason government stability in at stake. In fact, by price control doing charity has become a part of election manifesto India like countries. As a result in mostly welfare states has given most priority on inflation controlling strategies. In this time for government prevails major policy problem is growth without inflation. (5) Budgetary Deficit and fiscal Policy -World’s economies after privatisation and globalisation in development process direct participation of government (as an investor) is becoming continuously less. But due to the extension of welfare related work, government budget related expenditure is increasing. Specially defence to face the challenge of terrorism and to maintain law and order government expenditure is continually increasing. Another cause of increasing in government expenditure is giving subsidy to farmer. This matter is to pay attention that India like country a major part of government expenditure is expensing on nondevelopment activities. It means that government expenditure is more on consumption of goods and services and less in their production. India like countries mostly government as a means of income depends on borrowings. As a result of this fiscal deficit Borrowing by government in huge quantity is continuously increasing. As much increasing in borrowing by government, the central bank of India (Reserve bank of India) issuing note subjection as much increases. As a result of this fuel add to inflation like fine whose adverse effects on country’s growth and its development. As a form of alternative, government for increasing his income, try to impose more tax. But, by government, money paid by taxpayer, expenses consumption related activities than production (that is also pleasing policy of common peoples) its causes social resentment, by that political instability occurs and for country’s whole economic activities danger increases. Budgetary deficit and fiscal policy related to that is a central problem of macroeconomics on which serious supervision is needed, so that in economy for investment a favourable environment can be made. 19 CU IDOL SELF LEARNING MATERIAL (SLM)

(6) Interest Rates and Monetary policy -Monetary policy is related to those monetary measures by which government in economy (i) rate of interest and (ii) changes in supply of money, so that growth with stability can be promoted. High rate of interest means high cost of investment which is harmful to development process. India like underdeveloped countries high rates of interest is very sensitive, because due to this whole production cost is increased and in international market their competitiveness is become less. As a result, these countries exports are affected and their import capacity is reduced; whether reality is that, for these countries economic development’s acceleration fast, capital intensive goods import is necessary. On the other hand, high interest rate is a great challenge for these economies, because it causes more inflation. These economies mostly agriculture intensive and on it season effects to a great extent, due to shortage of rain in these economies occurs much imbalance between supply and demands of food. This imbalance causes inflation. Inflation gradually takes whole economy in his grip. When general price level increases, then increase of interest rate and their adverse effects is inevitable. In above section discuss of it that government’s deficit budget and as a result of this taking borrowing by government has become a central problem of macroeconomics. Generally, in economy due to borrowing, supply of money increases that become the immediate cause of inflation whose production capacity is very low. Supply of money and rate of interest keeping in control for underdeveloped countries regarding macro- economies a great challenge because these countries become a victim of immediate inflationary factor pressure. But it means not that there is no relevancy of monetary policy is developed countries. If underdeveloped economies due to low production capacity and high aggregate demand sensitive towards inflation-factor-pressure, then developed countries also due to comparison of total supply of goods and services, recurring deficiency of aggregate demand as much sensitive towards inflation factors pressure. In inflation condition, investment initiative become very low, rather rate of interest is low. The purpose of monetary policy of such economies is to increase supply of money, so that expense on goods and services can be increased and in this way shortage of demand can be removed. Exchange rate (in international market the value of one country’s currency to other country’s currency) is another parameter of monetary policy by which all levels of economic activities is affected. Favourable exchange rate, with comparison to other countries increase in value of currency of own countries, is not a good sign. For those economies that wants to made his development process rapid by export promotion, this is certainly not right. The meaning of increasing in value of Indian currency that by one American dollar in Indian market will be 20 CU IDOL SELF LEARNING MATERIAL (SLM)

purchased less goods and services form prior. In other words, now the demand of Indian goods in international market will be necessarily less. 1.8 LIMITATIONS OF MACROECONOMICS • Considers Aggregates as Homogenous: The individual data may not be similar in structure or composition. Thus, when such single figures are compiled to get an aggregate value, it may not seem to be that useful. • Misleading: The extensive application of the macroeconomics measures seems to be irrelevant when aimed at 100% results. • Fallacy of Deductive Inferences: Macroeconomics function on aggregate values. But, the interpretation of the individual activities may not be the same as compared to the conclusion drawn on a mass level. • Conceptual and Statistical Complexities: When the individual data have different units, its aggregation becomes arduous and holds no significance. • Unnecessary Aggregate Variables: When the individual elements need to be examined separately, the aggregate values cannot be used for the purpose. • Neglects Individual Consumers: The concept of macroeconomics overlooks the importance of the individual unit or consumer since the fundamental is to make use of the aggregates. • Too Much Generalization: The conclusion derived from the aggregation of the data, is generally taken to be true for all the individuals 1.9 DIFFERENCE BETWEEN MACROECONOMICS AND MICROECONOMICS Basis of Difference Microeconomics Macroeconomics Meaning Microeconomics is the Macroeconomics is the branch of Economics that is branch of Economics that related to the study of deals with the study of the individual, household and behaviour and performance firm’s behaviour in decision of the economy in total. The making and allocation of the most important factors 21 CU IDOL SELF LEARNING MATERIAL (SLM)

resources. It comprises studied in macroeconomics markets of goods and services involve gross domestic and deals with economic product (GDP), issues. unemployment, inflation and growth rate etc. Area of study Microeconomics studies the Macroeconomics studies the Deals with particular market segment of whole economy, that covers the economy several market segments Business Application Microeconomics deals with Macroeconomics deals with various issues like demand, various issues like national supply, factor pricing, income, distribution, product pricing, economic employment, general price welfare, production, level, money, and more. consumption, and more. It is applied to internal issues. It is applied to environmental and external issues. Scope It covers several issues like It covers several issues like Significance demand, supply, factor distribution, national income, pricing, product pricing, employment, money, general economic welfare, price level, and more. production, consumption, and more. It is useful in regulating the It perpetuates firmness in the prices of a product alongside broad price level, and solves the prices of factors of the major issues of the production (labour, land, economy like deflation, entrepreneur, capital, and inflation, rising prices 22 CU IDOL SELF LEARNING MATERIAL (SLM)

more) within the economy. (reflation), unemployment, and poverty as a whole. Limitations It is based on impractical It has been scrutinised that presuppositions, i.e., in the misconception of microeconomics, it is composition’ incorporates, presumed that there is full which sometimes fails to employment in the prove accurate because it is community, which is not at feasible that what is true for all feasible. aggregate (comprehensive) may not be true for individuals as well. 1.10 SUMMARY • Macroeconomics looks down the economy as a whole, trying to determine its course and nature. • Macroeconomics derived from the Greek word makro which means large. • The term was coined by Ragnar Frisch in 1933. • Macroeconomics is also known as Theory of Income and Employment since its subject matter deals with the determination of Income and Employment. • The main body of macroeconomic theory applies to capitalist economy. • The theory of national income is related to identifying the balance level of national income that is the level of national income at which the purchasing power and producing plans of the economy are adjusted. • The classical economists assume the full employment rate. • According to Keynes, the volume of employment depends on the level of output and national income. • Monetary policy attempts to control the circulation of money and credit creation available. • Fiscal measures are frequently used in tandem with monetary policy to achieve monetary goals. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

• Macroeconomics consider economy as a whole & work for the welfare of the nation. 1.11 KEYWORDS • GDP- Gross Domestic Product • CPI- Consumer Price Index • Macro - Big • Aggregate Demand - Demanded by all sector • National Income - Income of the nation. 1.12 LEARNING ACTIVITY 1. Find out the Unemployment rate and compare it with previous years. Discuss the causes for unemployment. ___________________________________________________________________________ ____________________________________________________________________ 2. Discuss the macroeconomic problems in the nation & give your suggestions to solve those problems. ________________________________________________________________ ____________________________________________________________ 1.13UNIT END QUESTIONS A. Descriptive Questions 24 Short Questions 1. What do you mean by macroeconomics? 2. Give the definition of macroeconomics. 3. What do you mean by National Income? 4. What is price level changes? 5. What is monetary policy? 6. What is fiscal policy? Long Questions 1. What is macroeconomics & define the term macroeconomics? 2. Write the development of macroeconomics. 3. Write the scope of macroeconomics. CU IDOL SELF LEARNING MATERIAL (SLM)

4. What are macroeconomic policies & discuss them. 25 5. Write the importance of macroeconomics? B. Multiple choice questions 1. ______ deals with study of economy as a whole a. Microeconomics b. Economics c. Macroeconomics d. Theory of Income 2. Macroeconomics is derived from the Greek word_____ a. Makro b. Micro c. Monetary d. Mickro 3. Macroeconomics is also known as________ a. Theory of International Trade b. Theory of Income & Employment c. Theory of rent d. Theory of Money 4. The term “Macroeconomics” was coined by_____ a. Ragnar Frisch b. J.M.Keynes c. Adam smith d. Alfred Marshall 5. The classical economist assumes the ____ employment rate. a. Moderate b. Full CU IDOL SELF LEARNING MATERIAL (SLM)

c. Nil d. Half Answers 1-c, 2-a, 3-b, 4-a, 5-b 1.14 REFERENCES Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. • Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. • Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites • Economictimes.indiatimes.com • Theinvestorsbook.com 26 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-2 DETERMINATION OF INCOME AND 27 EMPLOYMENT Structure 2.0 Learning objectives 2.1 Introduction 2.2 National Income 2.2.1 Definition of National Income 2.2.2 Concepts of National Income 2.2.3 Measurement of National Income 2.2.4 Components of National disposable income 2.3 Classical Theory of Employment 2.4 Say’s law of market 2.4.1 Assumptions of Say’s law 2.5 Criticism of Classical Theory 2.6 Keynesian Theory of Income Determination 2.7 Aggregate Demand 2.8 Aggregate Supply 2.9 Determination of Income 2.10 Summary 2.11 Keywords/Abbreviations 2.12 Learning Activity 2.13Unit End Questions 2.14 References 2.0 LEARNING OBJECTIVES After studying this unit, students will be able to: CU IDOL SELF LEARNING MATERIAL (SLM)

• Analyse The classical theory of employment. • Describe The Keynesian theory of income determination. • Practicality of The Say’s law of market. • Identify The principle of effective demand. • Examine The term Aggregate Supply 2.1 INTRODUCTION Adam smith (1730-90), Thomas Malthus (1766-1834), David Ricardo (1772-1823), and Jean- Baptist say (1767-1832) were the most prominent classical economists. Their thinking on the macro economic issues (such as income and employment) has mostly been shaped by their time and circumstances of 18th and 19th centuries. But their ideas have also influenced the thinking of subsequent generations. As a macroeconomic study, it is vital for assessing the overall performance of the economy in terms of national income. At the onset of the Great Depression of the 1930s, it was essential to investigate the triggers of general overproduction and general unemployment. This led to the creation of data on national income. It helps to forecast the level of economic activity. It also helps in understanding the income distribution among various classes of citizens. 2.2 NATIONAL INCOME A person will be considered to live in country, when he does not live outside the country, for one year, but student who go abroad for study or patient who for treatment, whom these terms and condition do not apply. If any person, suppose any Indian lives in foreign for more than one year then he will not be considered normal dissident of India, rather he will be considered NRI – Non-Resident Indian. 2.2.1 Definitions of National Income According to Marshall: “The labour and capital of a country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the country or national dividend.” In this definition, the word ‘net’ refers to deductions from the gross national income in respect of depreciation and wearing out of machines. And to this, must be added income from abroad. 28 CU IDOL SELF LEARNING MATERIAL (SLM)

A.C. Pigou has in his definition of national income included that income which can be measured in terms of money. In the words of Pigou, “National income is that part of objective income of the community, including of course income derived from abroad which can be measured in money.” Fisher adopted ‘consumption’ as the criterion of national income whereas Marshall and Pigou regarded it to be production. According to Fisher, “The National dividend or income consists solely of services as received by ultimate consumers, whether from their material or from the human environments. Thus, a piano, or an overcoat made for me this year is not a part of this year’s income, but an addition to the capital. Only the services rendered to me during this year by these things are income.” From the modern point of view, Simon Kuznets has defined national income as “the net output of commodities and services flowing during the year from the country’s productive system in the hands of the ultimate consumers.” On the other hand, in one of the reports of United Nations, national income has been defined on the basis of the systems of estimating national income, as net national product, as addition to the shares of different factors, and as net national expenditure in a country in a year’s time. In practice, while estimating national income, any of these three definitions may be adopted, because the same national income would be derived, if different items were correctly included in the estimate. 2.2.2 Concepts of National Income Whereas, in one of the reports of United Nations, national income has been defined on the basis of the systems of estimating national income as net national product (NNP). There are various concepts pertaining to national income are as follows: Gross Domestic Product (GDP) Gross domestic product relates to the product of the factors of production employed within the political boundaries i.e., within domestic territory. It is defined as a measure of the total flow of goods and services produced by an economy over a specified time period, usually a year. All value of intermediate products is excluded. So only the market value of final products is included to define GDP. Gross National Product (GNP) 29 CU IDOL SELF LEARNING MATERIAL (SLM)

Gross national product is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad. GNP= GDP + Net income from abroad(X-M), where X= Export, M= Import. If the value of (X-M) is negative then, GDP > GNP Net National Product (NNP) Net national product is considered a true measure of national product or income. It is defined as GNP minus depreciation or capital consumption allowance or wear and tear. NNP = GNP – Depreciation Unlike GDP, GNP, net national product (NNP) may also be categorized as: NNPmp (Net national product at market price): Net national product at market prices is net value of final goods and services evaluated at market prices in the course of one year in a country NNPfc (Net national product at factor cost): Net national product at factor cost is the net output evaluated at factor prices. It includes income earn by factors of production through participation in the production process such as wages and salaries, rents profits etc. NNP at factor cost is also called National Income. NNPmp = NNPfc – S + (IT+ GS) or, NNPmp = NNPfc – subsidies + (indirect tax+ surpluses from government enterprises) NNPfc = NNPmp + S - (IT+ GS) or, NNPfc = NNPmp + subsidies - (indirect tax+ surpluses from government enterprises) Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes exceed government subsidies. However, NNP at market prices can be less than NNP at factor cost when government subsidies exceed indirect taxes. Some other concepts of national income Private income: Private income is income obtained by private individuals from any source, produce or otherwise and retained income of corporations. It can be obtained from NNP at factor cost by making certain additions and deductions. Private Income = National income (NNP at factor cost) +Transfer Payments + Interest on Public Debt – Social Security – Profits and Surpluses of Public Undertakings. 30 CU IDOL SELF LEARNING MATERIAL (SLM)

Personal Income: Personal income is the total income received by the individuals of a country from all sources before direct taxes in one year. Personal income is never equal to the national income because the former includes the transfer payments whereas they are not included in national income. Personal income is derived from national income by deducting undistributed corporate profits, profit taxes, and employee’s contributions to social security schemes. Personal income is differs than private income actually it is less than private income because it excludes undistributed corporate profits. Personal Income = National Income – Undistributed Corporate Profits – Profit Taxes – Social Security Contributions + Transfer Payments + Interest on Public Debt. Disposable Income: Disposable income or personal disposable income means the actual income which can be spent on consumption by individuals and families. Disposable Income = National Income – Business Savings – Indirect taxes plus Subsidies – Direct Taxes on persons – Direct Taxes on Business – Social Security Payments + Transfer Payments + Net Income from Abroad (X-M). Real Income: Real Income is the income expressed in terms of a general level of prices of a particular year taken as base year. National income in terms of money at current prices does not indicate the real state of the economy. So, the concept of real income has been propounded to rectify such illusions. This is also known as National Income at constant prices. Real NNP = NNP for the Current Year Multiply with Base Year Index (100) Divided by Current Year Index. Per Capita Income: The average income of the people of a country in a particular year is called Per Capita Income for that year. Per Capita Income for 2011 = National Income for 2011 divided by Population in 2011 This concept enables us to know the average income and the standard of living of the people. But it is not very reliable due to unequal distribution of national income exist in every country. 31 CU IDOL SELF LEARNING MATERIAL (SLM)

2.2.3 Measurement of National Income Gross Domestic Product (GDP), Net National Product (NNP), Gross National Product (GNP), personal income, and disposable income are the important metrics determined by national income accounting. Product Approach In product approach, national income is measured as a flow of goods and services. Value of money for all final goods and services is produced in an economy during a year. Final goods are those goods which are directly consumed and not used in further production process. In our economy product approach benefits various sectors like forestry, agriculture, mining etc to estimate gross and net value. With the help of this method national income is estimated at production level. At production level national income is the value of final goods and services produced in a country within the domestic territory plus net factor income from rest of the world. In this method following steps are involved: Firstly, all the producing enterprises in an economy are broadly classified into three industrial sectors according to their activities. These are: Primary sector: Primary sector consists of those producing units which are carried out by using natural resources. It includes productive activities like agriculture, forestry, fishing mining etc. Secondary sector: This sector includes those producing units which transform inputs into output for example: transformation of wood into a chair. It includes sub sectors like construction, manufacturing, electricity, gas and water supply. Tertiary sector: Producing units of this sector produce services of all kinds such as banking, trade, transport etc. This is also known as service sector. This sector includes transportation, communication, banking services etc. Secondly: Net value added of each producing unit of the economy is estimated from their gross value of output which is calculated by multiplying total volume of goods produced with their prices. After deducting the sum of value of intermediate goods (IG), depreciation and net indirect taxes (NIT) from value of output we get net value added at FC of the producing units. or Net value added at FC = Gross value of output - IC - Dep - NIT By adding up net value added at FC of all the producing units of a sector we get net value added at FC of that particular sector. The sum total of net value added at FC of all the three sectors in the domestic territory of a country gives us Net Domestic Product at Factor Cost. Thirdly: Net National Product at factor cost is obtained by adding net factor income from ROW to net domestic product at factor cost. If net factor income from ROW is negative, NDP at FC will be greater than net national product at 32 CU IDOL SELF LEARNING MATERIAL (SLM)

factor cost (National Income), and if it is positive national income will be greater than NDP at FC. Precautions -The following precautions are necessary while estimating national income by production method (i) Production for self-consumption: That output which is produced for self-consumption and whose value can be estimated, must be included in the estimates of production because it is a part of production of current year. (ii) Sale of second-hand goods: The sale of second-hand goods should not be included in national income because the value of these goods had already been included earlier. (iii) Commission paid to the broker for sale and purchase second hand goods should be included because it is payment made for the services provided in the current year. (iv) Value of intermediate goods should not be included because it leads to double counting. (v) Services of house wife should not be included because it is very difficult to evaluate them. Income Approach In income approach, national income is measured as a flow of factor incomes. Income received by basic factors like labour, capital, land and entrepreneurship are summed up. This approach is also called as income distributed approach. Income method is used for measuring national income at distribution level. According to this method, national income is estimated by adding incomes earned by all the factors of production for their factor services during a year. If includes the following steps: (i) Firstly: Classify the production units into primary, secondary and tertiary sector. The classification is same as in value added method (ii) Secondly: Estimate the following factor incomes paid out by the production units in each industrial sector. (i) Compensation of employed (ii) Rent (iii) Interest (iv) Profit (v) Mixed income of self- employed the sum total of the above factor incomes paid out is the same as net value added at factor cost by the industrial sectors. Thirdly: Take the sum of factor payments by all the industrial sectors to arrive at the net domestic product at factor cost. Lastly: Add net factor income from abroad to the net domestic product at factor cost to arrive at net national, product at factor cost Precautions- The following are some of the main precautions which must be taken while estimating national income by the income distribution method (a) While estimating compensation of employees all benefits accruing to the employees whether in cash or in kind must be included. (b) In estimating interest, the interest on only those loans should be included 33 CU IDOL SELF LEARNING MATERIAL (SLM)

which are taken for production, the interest on loans taken to meet consumption expenditure is not included in national income as it is treated as transfer payment. (c) Gifts, donations, charities, taxes, fines, income from lotteries etc., are not factor incomes but transfer incomes. These should not be included in estimating national income. (d) Income from sale of second hand goods should not be included as it is not the income received from the goods produced in the current year. Expenditure Approach This method is known as the final product method. In this method, national income is measured as a flow of expenditure incurred by the society in a particular year. The expenditures are classified as personal consumption expenditure, net domestic investment, government expenditure on goods and services and net foreign investment. These three approaches to the measurement of national income yield identical results. They provide three alternative methods of measuring essentially the same magnitude. National income can also be measured at disposition phase with the help of expenditure method. It estimates national income by measuring final expenditure on gross domestic product at market price. Expenditure incurred on final goods is final expenditure. Final goods are those goods which are demanded for final consumption and investment. The demand for final consumption and investment is made by all the four sectors of the economy, namely, households, firms and the government and rest of the world. The main steps involved in measuring national income by this method are: Firstly: Estimate the following expenditure incurred on the final products of all the sectors of the economy. (i) Private final consumption expenditure. (ii) Government final consumption expenditure. (iii) Gross Investment (iv) Net exports (exports - imports). The sum total of all the above expenditures on final products of all the sectors of the economy gives us gross domestic product at market price. Secondly: Deduct consumption of fixed capital (Depreciation) and net indirect taxes from gross domestic product at market price to get net domestic product at factor cost. NDPFC = GDPmp - consumption of fixed capital - Net indirect tax (indirect taxes - subsidies) Thirdly: Add net factor income from abroad to the net domestic product at factor cost to obtain net national product at factor cost which is the national income. NNPFC = NDPfc + net factor income from abroad (National Income) Precautions- The main precautions required to be taken in estimating national income by expenditure method are: (i) Expenditure on intermediate products should not he included to 34 CU IDOL SELF LEARNING MATERIAL (SLM)

avoid the problem of double counting. (ii) Expenditure on gifts, donations, taxes, scholarships etc. should not be included in National Income as these are transfer payments. (iii) Expenditure incurred on purchase of second-hand goods should not be included as the expenditure on these goods has already been included when bought for the first time. (iv) Expenditure on purchase of bonds and shares should not be included as these are financial transactions. 2.2.4 Components of National Disposable Income National disposable income is estimated by following types: National disposable income = Net domestic product at factor cost (or domestic income) + net indirect tax + net factor income from abroad + receipts net current transfers from rest of the world. Difference between Personal Disposable Income and National Disposable Income (i) Personal disposable income relationship is only a nation’s residents and households’ disposable income, whereas national disposable income relationship is whole country’s disposable income. (ii) For estimation of national disposable income, net domestic product at factor cost, net indirect tax, net factor income accruing from abroad, and net current transfer accruing from rest of the world is added. On the other hand, in personal disposable income, a country’s domestic consumption and domestic savings are added. 2.3 CLASSICAL THEORY OF EMPLOYMENT The term ‘classical economists’ was firstly used by Karl Marx to describe economic thought of Ricardo and his predecessors including Adam Smith. However, by ‘classical economists’, Keynes meant the followers of David Ricardo including John Stuart Mill, Alfred Marshal and Pigou. According to Keynes, the term ‘classical economics refers to the traditional or orthodox principles of economics, which had come to be accepted, by and large, by the well-known economists by then. Being the follower of Marshal, Keynes had himself accepted and taught these classical principles. But he repudiated the doctrine of laissez-faire. The two broad features of classical theory of employment were: (a) The assumption of full employment of labour and other productive resources, and (b) The flexibility of prices and wages to bring about the full employment (a) Full employment: 35 CU IDOL SELF LEARNING MATERIAL (SLM)

According to classical economists, the labour and the other resources are always fully employed. Moreover, the general over-production and general unemployment are assumed to be impossible. If there is any unemployment in the country, it is assumed to be temporary or abnormal. According to classical views of employment, the unemployment cannot be persisted for a long time, and there is always a tendency of full employment in the country. According to classical economists, the reasons for unemployment are: (i) Intervention by the government or private monopoly, (ii) Wrong calculation by entrepreneurs and inaccurate decisions, and (iii) Artificial resistance. The economy is assumed to be self-adjusting and perfectly competitive economy. It is the economy in which the relative values of goods and services are determined by the general relations of demand and supply. The pricing system serves as the planning mechanism. (b) Flexibility of prices and wages: The second assumption of full employment theory is the flexibility of prices and wages. It is the flexibility of prices and wages which automatically brings about full employment. If there is general over-production resulting in depression and unemployment, prices would fall as a result of which demand would increase, prices would rise and productive activity will be stimulated and unemployment would tend to disappear. Similarly, the unemployment could be cured by cutting down wages which would increase the demand for labour and would stimulate activity. Thus, if the prices and wages are allowed to move freely, unemployment would disappear and full employment level would be restored. Further, the classical economists treated money as mere exchange medium. They ignored its role in affecting income, output and employment. 2.4 SAY’S LAW OF MARKET 1. Say’s Law is the foundation of classical economics. Assumption of full employment as a normal condition of a free-market economy is justified by classical economists by a law known as ‘Say’s Law of Markets’. 2. It was the theory on the basis of which classical economists thought that general over- production and general unemployment are not possible. 36 CU IDOL SELF LEARNING MATERIAL (SLM)

3. French economist J. B. Say in his book, “Treatise on Political Economy” (1803) “supply creates its own demand”. According to him, it is production which creates market for goods. This means more of production, more of creating demand for other goods. There can be no problem of over-production. 4. Say denies the possibility of the deficiency of aggregate demand. 5. The conceived Say’s Law describes an important fact about the working of free- exchange of economy that the main source of demand is the sum of incomes earned by the various productive factors from the process of production itself. A new productive process, by paying out income to its employed factors, generates demand at the same time that it adds to supply. It is thus production which creates market for goods, or supply creates its own demand not only at the same time but also to an equal extent. 6. According to Say, the aggregate supply of commodities in the economy would be exactly equal to aggregate demand. If there is any deficiency in the demand, it would be temporary and it would be ultimately equal to aggregate supply. Therefore, the employment of more resources will always be profitable and will take to the point of full employment. 7. According to Say’s Law, there will always be a sufficient rate of total spending so as to keep all resources fully employed. Most of the income is spent on consumer goods and a part of it is saved. 8. The classical economists are of the view that all the savings are spent automatically on investment goods. Savings and investments are interchangeable words and are equal to each other. 9. Since saving is another form of spending, according to classical theory, all income is spent partly for consumption and partly for investment. 10. If there is any gap between saving and investment, the rate of interest brings about equality between the two. 2.4.1 Assumptions of Say’s Law • Perfectly competitive market and free exchange economy (barter system). • Free flow of money incomes. All the savings must be immediately invested and all the income must be immediately spent. • Savings are equal to investment and equality must bring about by flexible interest rate. 37 CU IDOL SELF LEARNING MATERIAL (SLM)

• No intervention of government in market operations, i.e., a laissez faire economy, and there is no government expenditure, taxation and subsidies. • Market size is limited by the volume of production and aggregate demand is equal to aggregate supply. • It is a closed economy.i.e.no relationship with other economies. Fig 2.1 Say’s law of market Source: www.economicshelp.org Implications if Say’s Law isn’t true If Say’s law doesn’t hold true, it may be necessary for government intervention to break the cycle of falling aggregate demand by utilising the hoarded savings. For example, expansionary fiscal policy or printing money to create demand. Austrian Economics and Say’s Law Austrian economists hold that in the absence of distorting government behaviour, Say’s law should hold true. However, if the government cause credit booms and busts through artificially changing interest rates, this can cause disequilibrium. 38 CU IDOL SELF LEARNING MATERIAL (SLM)

The essential aspects of Say’s law can be summarised as: 1. The economy is self-adjusting 2. There is no general over- production or Unemployment is possible. 3. All idle resources are fully employed. 4. There is no interdependence between nations. 5. The wage rate is flexible in the economy. 6. The rate of interest is flexible in the economy. 7. Money is simply a veil. 8. It helps in International Trade. 9. There is no government interference in the economy. 2.5 CRITICISM OF CLASSICAL THEORY ▪ Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to aggregate supply. ▪ Employment in a country cannot be increased by cutting general wages. ▪ There is no direct relationship between wages and employment. ▪ Interest rate adjustments cannot solve savings-investment problem. ▪ Classical economists have made the economy completely self-adjusting and self- reliant. A capital economy is not so self-adjusting and government intervention is unobvious. ▪ Classical economists have made the wages and prices so much flexible. In practical, wages and prices are not so flexible. It will create chaos in the economy. ▪ Money is not a mere medium of exchange. It has dominant role in the economy. ▪ The classical theory has failed to explain the occurrence of trade cycles. ▪ All incomes earned are not meant always meant for consumption. ▪ It suffers from fallacy of aggregation. Say’s law has no validity and no use. However, the classical theory relied on say’s law to assure that there would always be full employment as a result of equality between aggregate demand and aggregate supply. In short, the aggregate demand should not be deficient. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

2.6 KEYNESIAN THEORY OF INCOME DETERMINATION Keynes is considered to be the greatest economist of the 20th century. He wrote several books. However, his 'The General Theory of Employment, Interest and Money' (1936) won him everlasting fame in economics. The book revolutionized macroeconomic thought. Keynesian economics is called the Keynesian revolution. The central problem in macroeconomics is the determination of income and employment of a nation as a whole. That is why modern economists also call macroeconomics as the theory of income determination. Keynes brings out all the important aspects of income and employment determination and Keynesian economics itself can be called macroeconomics. He attacked the classical economics and effectively rejected the Say's Law, the very foundation of the classical theory. He believed that in the short run, the level of income of an economy depends on the level of employment. The higher the level of employment, higher will be the level of income. According to Keynes, the level of employment in the short run depends on aggregate effective demand for goods in the country. Greater the aggregate effective demand, the greater will be the volume of employment and vice versa. According to Keynes, the unemployment is the result of deficiency of effective demand. Effective demand represents the total money spent on consumption and investment. The equation is: Effective demand = National Income (Y) = National Output (O)= Employment A perusal of the basic ideas of Keynes can be clearly understood from the brief summary in the flow chart. Total income depends on total employment which depends on effective demand which in turn depends on consumption expenditure and investment expenditure. Consumption depends on income and propensity to consume. Investment depends upon the marginal efficiency of capital and the rate of interest. 40 CU IDOL SELF LEARNING MATERIAL (SLM)

effective demand =output= Employemnt Aggregate Aggregate demand supply function function consumption Investment function function Size of Propensity Marginal Rate of income to consume efficiency Interest of capital (MPC) Supply Prospective Liquidity Supply of price of yield from preference Money in capital capital of the the public economy transaction Precautionary speculative motive motive motive Figure 2.2: Flowchart on Keynesian Theory 2.7 AGGREGATE DEMAND Aggregate demand refers to the sum of expenditure, households, firms and the government is undertaking on consumption and investment in an economy. The aggregate demand price is the amount of money which the entrepreneurs expect to receive as a result of the sale of output produced by the employment of certain number of workers. An increase in the level of employment raises the expected proceeds and a decrease in the level of employment lowers it. AD refers to the effective demand that is equal to the actual expenditure. Aggregate effective demand refers to the aggregate expenditure of an economy in a specific time frame. AD 41 CU IDOL SELF LEARNING MATERIAL (SLM)

involves two concepts, namely, AD for consumer goods or consumption (C) and aggregate demand for capital goods or investment (I). The total expenditure of an economy can be divided in to four categories of spending. They are consumption expenditure (C), investment expenditure (I), government expenditure (G) and net expenditure on trade or net exports that is, exports minus imports, (X-M). The aggregate demand is the sum total of all such spending. Hence the aggregate demand function is represented as AD = C+ I + G + (X-M) ........... (1) This function shows that the aggregate demand is equal to the sum of expenditure respectively on consumption (C), Investment (I), Government spending (G) and net exports (X-M). Thus, an aggregate demand is the total value of all planned expenditure of all buyers in the economy. It is the total demand for goods and services in the economy (Y) in a specific time period. Moreover, the aggregate demand is known as the amount of commodities people want to buy. In the economy, as one man's expenditure is another man's income, the total expenditure of the economy must be equivalent to the total income. That is Total income(Y) = Total expenditure (AD). Since Y = AD, equation (1) can be written as Y = AD = C+ I + G + (X-M) or Y = C+ I + G + (X-M) Keynes gives all attention to the ADF. This aspect was neglected by economists for over 100 years. Assuming that ASF is constant, the main basis of Keynesian theory is that employment depends on aggregate demand which itself depends on two factors: 1. Propensity to consume (Consumption function) 2. Inducement to invest (Investment function). 42 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 2.3 Aggregate demand curve Source: wikieducator.org In figure 2.3 show the aggregate demand tells the table of produced things on different level of employment and receives by services. The expenditure on total production is increase with the increment in the level of employment and reduced with the decrement of level of employment. In figure 2.3 the level of employment is increase with OL1 and reached to OL2, when anticipated expenditure (AD) on production is increased. It functions relation can show as AD=f (N). Total demand function increases with decrement rate, because person less spent his that income, which is increase in production and employment. So, the shield was short of agreed demand. 2.8 AGGREGATE SUPPLY The total value of goods and services produced and supplied at a particular point of time is called Aggregate supply. It comprises consumer goods as well as producer goods. When goods and services produced at a particular point of time is multiplied by the respective prices of goods and services, it provides the total value of the national output. The national output is the aggregate supply in the form of money value. The Keynesian Aggregate Supply curve is drawn based on an assumption that total income is equal to total expenditure. 43 CU IDOL SELF LEARNING MATERIAL (SLM)

In other words, the total income earned is fully spent on different types of goods and services. This is purely depending on factors of production i.e., available technology, available resources (material& labour), efficiency of labour etc. most of these factors change only in long run and remain constant in the short run. As the aggregate supply curve represents equality of total income and output, 45-degree line is drawn i.e. C+S curve. This line divides the quadrant into two-equal halves with equal distance from the two axes. Every point on the line indicates equal amount of income, output and expenditure. The C+S curve is called as AE curve i.e. Aggregate Expenditure curve. According to Keynes, Aggregate Income = Consumption + Savings. Fig 2.4 Aggregate supply curve Source: www.economicshelp.org 2.9 DETERMINATION OF INCOME According to Keynes, the equilibrium levels of national income and employment are determined by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). The equilibrium level of income determined by the equality of AD and AS does not necessarily indicate the full employment level. The equilibrium position between aggregate 44 CU IDOL SELF LEARNING MATERIAL (SLM)

demand and aggregate supply can be below or above the level of full employment as is shown in the curve below. Figure 2.5: Real income vs Aggregate supply and demand Source: economicsconcepts.in In the above figure, Horizontal axis OX measures National Income and Vertical axis OY measures Aggregate demand and Aggregate supply. The Aggregate demand is the combination of C+I curve. E1& E2 are the effective demand. The Equilibrium of National Income occurs at the point of intersection of Aggregate demand and Aggregate supply. In other words, the point at which Aggregate demand intersects with 45-degree line. E1 is the point at which the aggregate demand curve(C+I) intersects at the aggregate supply curve(C+S). The national income OY1 is said to be equilibrium at the point E1. At OY1 generation of income, the equilibrium does not correspond to full employment & therefore it is said that there is underemployment of Income. The components of Aggregate demand(C+I+G) are raised to OY2 level of income, that shifts the entire AD line upward. Now, the equilibrium also raises to the point E2. At OY2, the equilibrium denotes full employment position of the economy. Thus, government spending can help to achieve full employment. In case the equilibrium level of national income is above the level of full employment, this means that the output has increased in money terms only. The value of the output is just the same to the national income at full employment level. 45 CU IDOL SELF LEARNING MATERIAL (SLM)

2.10 SUMMARY • The classical economists believed that the productive capacity of a country decides how much to be produced. • The two broad features of classical theory were (a) assumption of full employment (b) flexibility of prices and wages. • The confidence that market makes it possible to sell everything that is produced is based upon Say’s law. • According to J.B. Say, “supply create its own demand”. • Say’s analysis is carried on its terms of barter. • Keynes launched a vigorous attack on the Say’s law & made it as unacceptable. • Keynesian economics is called the Keynesian revolution. • According to Keynesian Theory, Effective demand= output= Income= Employment. • Aggregate Demand function is represented as AD= C+I+G+ (X-M) • Aggregate Supply is the total value of all commodities that the firms intend to produce. 2.11 KEYWORDS • AD- Aggregate Demand • AS- Aggregate Supply • Y- National Income • O- Output • C- Consumption • I- Investment • S- Savings 2.12 LEARNING ACTIVITY 1. Discuss the effect of Great Depression of 1930. ___________________________________________________________________________ ___________________________________________________________________________ 2.13 UNIT END QUESTIONS A. Descriptive Questions 46 CU IDOL SELF LEARNING MATERIAL (SLM)

Short Questions 47 1. Write the assumptions of Say’s law of market 2. Write any 2 criticisms of classical theory of employment. 3. What is aggregate demand? 4. What are the factors on which aggregate demand depends? 5. What is aggregate supply? Long Questions 1. What are the features of classical theory of employment? 2. What are the criticisms of classical theory of employment? 3. Draw the flow chart of depict the essence of Keynes Theory. 4. Write a note on Aggregate demand and Aggregate supply. 5. Explain the theory of determination of National Income with diagram. B. Multiple Choice Questions 1. The central problem in economics is_____ a. Income and employment b. Price and output c. Interest and money d. None of these 2. _____ wrote the book “Treatise on Political Economy” a. Adam smith b. Alfred Marshall c. J.B. Say d. J.M. Keynes 3. To explain the simple theory of income determination, Keynes used a. Consumption and Investment b. Aggregate demand and Aggregate supply c. Production and expenditure d. All of these 4. ______= Consumption + Savings CU IDOL SELF LEARNING MATERIAL (SLM)

a. Aggregate expenditure b. Aggregate demand c. Aggregate supply d. Equilibrium 5. The worldwide depression of 1930s was also caused by a_____ a. Deflation b. Poverty c. Inflation d. Fall in investment Answers 1-a, 2-c, 3-b, 4-b, 5-d 2.14 REFERENCE Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. • Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. • Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites • Economictimes.indiatimes.com • Theinvestorsbook.com 48 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-3 CONSUMPTION AND INVESTMENT FUNCTIONS Structure 3.0 Learning objectives 3.1 Introduction 3.2Consumption function 3.3 Absolute Income hypothesis 3.3.1 criticisms 3.4 Relative Income hypothesis 3.4.1 criticisms 3.5 Permanent and life cycle hypothesis 3.5.1 Concepts of Transitory Income, Transitory Expenditure and Transitory Purchase 3.5.2 Equations of Permanent Income Hypothesis 3.5.3 Criticisms 3.6 Life cycle hypothesis 3.6.1 Postulates of Life Cycle Hypothesis 3.6.2 Criticisms 3.7 Average Propensity to consume 3.8 Marginal Propensity to consume 3.9 Saving function 3.10 Other determinants of consumption 3.11 Summary 3.12 Keywords 3.13 Learning Activity 3.14Unit End Questions 3.15 References 49 CU IDOL SELF LEARNING MATERIAL (SLM)

3.0 LEARNING OBJECTIVE After studying this unit, students will be able to: • The concept of consumption function. • The meaning of Average Propensity to consume. • The meaning of Marginal Propensity to consume. • The concept of Saving functions. • The other determinants of consumption 3.1 INTRODUCTION Consumption, in economics, the use of goods and services by households. Consumption is distinct from consumption expenditure, which is the purchase of goods and services for use by households. Consumption differs from consumption expenditure primarily because durable goods, such as automobiles, generate an expenditure mainly in the period when they are purchased, but they generate “consumption services” (for example, an automobile provides transportation services) until they are replaced or scrapped. Aggregate demand consists of two parts—consumption demand and investment demand. In this chapter we will able to learn the consumption demand and the factors on which it depends and how it changes over a period of time. Consumption demand depends upon the level of income and the propensity to consume 3.2 CONSUMPTION FUNCTION People of household spend most of their incomes on commodities. Some spend their money fully and some others spend a portion and keep the rest for saving. A function is the link between two or more variables. Consumption function, in economics, the relationship between consumer spending and the various factors determining it. At the household or family level, these factors may include income, wealth, expectations about the level and riskiness of future income or wealth, interest rates, age, education, and family size. The consumption function is also influenced by the consumer’s preferences (e.g., patience, or the willingness to delay gratification), by the consumer’s attitude toward risk, and by whether the consumer wishes to leave a bequest . The characteristics of consumption functions are important for many questions in both macroeconomics and microeconomics. 50 CU IDOL SELF LEARNING MATERIAL (SLM)