Commerce Eed - Vision

By,

Gobind Kumar Jha

CA (F), L.L.B(H), M.COM,
B.COM(H)
 Gobind Kumar Jha 9874455112

Chapter – 1
Introduction
(2 Marks)
Define Macroeconomics:-
Macroeconomics may be defined as the branch of economics which deals with aggregate behaviour and total part of
the economic system. It is concerned with national income, aggregate demand, aggregate supply, international trade,
aggregate employment, money supply, total savings, etc.

Explain the scope of Macroeconomics:-

The scope of macroeconomics include:
a) Aggregate demand
b) Aggregate supply
c) Income and employment generation
d) Price level of the economy, etc.

Explain the difference between Micro and Macro Economics:-

Micro Economics Macro
Economics
i. It deals with individual behaviour in the a) It deals with aggregate and average of the
economic system. economy.
ii. In microeconomics, small part of whole b) It deals with total part of the economy.
economy is considered.
iii. It studies individual pricing. c) It studies general pricing.

Define the Economic & Non-economic Goods:-

Economic Goods are those goods which are not available for free. For every economic goods money value is paid
inthe form of price.
Non-economic Goods are those goods for which no payment is required and these are not backed with the price.

Intermediate Goods:-
These are the goods which are used by the firm for further processing, these are not in the usable state and those goods
are not yet crossed the boundary of production. Example:- Wood for furniture.

Final Goods:-
These are the products which are actually used by the final consumer. These are sold in the market at different
prices.

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Savings:-
It may be defined as the part of the income which is not spent by the individual for consumption whatever is left inthe
hand after spending is known as savings.

Consumption:-
It can be defined as the part of income which is used for daily Spending. The income has direct relation with the
consumption that mean higher the income, higher the consumption and lower the income, lower the consumption.
But even if there is no income still consumption arises.

Explain the difference between Stock and Flow Concept:-

Stock Flow
Concept Concept
a) It helps to measure at a point of time. i. It is measured for the period of time.
b) A stock indicate the static aspect. ii. It indicates dynamic concept.
c) Stock has no time dimension. iii. It has time dimension.

Define Capital Goods. Can final goods be regarded as Capital Goods?

Capital Goods refers to those goods which are made durable items used to produce goods and services. They include
machinery, tools, buildings, equipment, etc. These are treated as final asset in accounting with the name Property,
Plant and Equipment.
Final Goods are those goods which are ultimately used for consumption.
Capital Goods are not final goods because they are used to create final goods.

Define Gross Investment and Net Investment:-

Gross Investment refers to the investment in the fixed assets or capital formation. Gross investment is directly
helpful in creating capital assets.
Net Investment is the value of investment after adjusting depreciation. Net
Investment = Gross Investment – Depreciation

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Unit-2
Money & Inflation
[12 Marks]

1. What is money? What are the functions of money? *

Meaning of Money
Money is anything serving as a medium of exchange. Most definitions of money take ‘functions of money’ as
their starting point. ‘Money is that which money does.’ According to Prof. Walker, ‘Money is as money does.
This means that the term money should be used to include anything which performs the functions of
money, viz., medium of exchange, measure of value, unit of account, etc. Since general acceptability isthe
fundamental characteristic of money, therefore, money may be defined as ‘anything which isgenerally
acceptable by the people in exchange of goods and services or in repayment of debts.’
Functions of Money:
The functions of money are as follows:
1. Money as the Medium of Exchange:
Money came into use to remove the inconveniences of barter as money has separated the act of purchase
from sale. Medium of exchange is the basic or primary function of money. People exchange goods and
services through the medium of money. Money acts as a medium of exchange or as a medium of payments.
2. Money as a Unit of Account or Measure of Value:
Money serves as a unit of account or a measure of value. Money is the measuring rod, i.e., it is the units in
terms of which the values of other goods and services are measured in money terms and expressed
accordingly
3. Money as the Standard of Deferred Payments:
The use of money as the standard of deterred or delayed payments immensely simplifies borrowing and
lending operations because money generally maintains a constant value through time. Thus, money
facilitates the formation of capital markets and the work of financial intermediaries like Stock Exchange,
Investment Trust and Banks. Money is the link which connects the values of today with those of the future.
4. Money as a Store of Value:
People normally wish to keep a part of their wealth in the form of money because savings in terms of goods
is very difficult. This desire is known as liquidity preference. Clearly money is the best form of store of
value. Wheat or any other product which will command a value cannot be stored for a long period.

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2. What is money? Distinguish between ‘Narrow money’ and ‘Broad money’.

What is Narrow Money?

Narrow money is a category of money supply that includes all physical money such as coins and
currency, demand deposits and other liquid assets held by the central bank. M1 or M0 are used to
describe narrow money. Narrow money is a subset of broad money.
This category of money is considered to be the most readily available for transactions and commerce.
What is Broad Money?
The sum of M1 and time deposits is called broad money. Time deposits, though not as liquid and
instantly available as transactions settling medium as M1, are still money, since it will be available at
some point, and very often, as in the case of fixed deposits, can be converted to cash for some penalty.
Usually, time deposits are much larger than both currency in circulation and demand deposits.
While M1/M0 are used to describe narrow money, M2/M3/M4 qualify as broad money and M4
represents the largest concept of the money supply. These are often referred to as longer-term time
deposits because their activity is restricted by a specific time requirement.
Broad money is the definition of the Money Supply which includes a wide scope for the definition of
money – including both notes and coins, but also more illiquid forms of money – such as bank deposits,
treasury bills, gilts.
Differences between Narrow money & Broad Money:
Narrow Money Broad Money
The narrow money definition of the money supply Broad money is a measure of the total amount of
is a measure of the value coins and notes in money held by households and companies in the
circulation and other money equivalents that are economy. Broad money is made up mainly of
easily convertible into cash such as short term commercial bank deposits
deposits in the banking system
M1 or M0 are used to describe narrow money. M2/M3/M4 qualify as broad money and M4
Narrow money is a subset of broad money. represents the largest concept of the money
supply.
This category of money is considered to be the These are often referred to as longer-term time
most readily available for transactions and deposits because their activity is restricted by a
commerce. specific time requirement.

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3. What is meant by money supply and on what factors does it depend?

The supply of money:

The term ‘the supply of money’ is synonymous with such terms as ‘money stock’, ‘stock of money’,
‘money supply’ and ‘quantity of money’.
The supply of money at any moment is the total amount of money in the economy. There are three
alternative views regarding the definition or measures of money supply.
(a) The most common view is associated with the traditional and Keynesian thinking which stresses
the medium of exchange function of money. According to this view, money supply is defined as
currency with the public and demand deposits with commercial banks. Demand deposits are
sayings and current accounts of depositors in a commercial bank
(b) The second definition is broader and is associated with the modern quantity theorists headed by
Friedman. Professor Friedman defines the money supply at any moment of time as “literally the
number of dollars people are carrying around in their pockets, the number of dollars they have
to their credit at banks or dollars they have to their credit at banks in the form of demand
deposits, and also commercial bank time deposits.”
(c) The third definition is the broadest and is associated with Gurley and Shaw. They include in the
supply of money, M2 plus deposits of savings banks, building societies, loan associations, and
deposits of other credit and financial institutions.

Determinants of Money Supply:

There are two theories of the determination of the money supply. According to the first view, the
money supply is determined exogenously by the central bank. The second view holds that the money
supply is determined endogenously by changes in the economic activity which affects people’s desire to
hold currency relative to deposits, the rate of interest, etc.
Thus the determinants of money supply are both exogenous and endogenous which can be described
broadly as: the minimum cash reserve ratio, the level of bank reserves, and the desire of the people to
hold currency relative to deposits.
1. The Required Reserve Ratio:
The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio) is an
important determinant of the money supply. An increase in the required reserve ratio reduces the
supply of money with commercial banks and a decrease in required reserve ratio increases the money
supply.
2. The Level of Bank Reserves:
The level of bank reserves is another determinant of the money supply. Commercial bank reserves
consist of reserves on deposits with the central bank and currency in their tills or vaults. It is the central
bank of the country that influences the reserves of commercial banks in order to determine the supply
of money. The central bank requires all commercial banks to hold reserves equal to a fixed percentage
of both time and demand deposits. These are legal minimum or required reserves.
3. Public’s Desire to Hold Currency and Deposits:
People’s desire to hold currency (or cash) relative to deposits in commercial banks also determines the
money supply. If people are in the habit of keeping less in cash and more in deposits with the
commercial banks, the money supply will be large. This is because banks can create more money with

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larger deposits. On the contrary, if people do not have banking habits and prefers to keep their money
holdings in cash, credit creation by banks will be less and the money supply will be at a low level.
4. Other Factors:
The money supply is a function not only of the high-powered money determined by the monetary
authorities, but of interest rates, income and other factors. The latter factors change the proportion of
money balances that the public holds as cash. Changes in business activity can change the behaviour of
banks and the public and thus affect the money supply. Hence the money supply is not only an
exogenous controllable item but also an endogenously determined item.
High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by
the public. High-powered money is the base for the expansion of bank deposits and creation of the
money supply.

4. Discuss the different measures of supply of money.

Four Measures of Money Supply in India
The supply of money in any country refers to the stock of money held by the public at any particular point
of time. So, money supply is a stock concept.
In India, coins and one-rupee notes are issued by the Government of India, while other paper notes are
issued by the Reserve Bank of India. All notes and coins together constitute currency. Currency plus
demand deposits plus certain other deposits is called M1 in India. This is one measure of money supply.

Some of the measures of the supply of money are mentioned below:

a) M1 = Rupee notes and coins with the public (C) + demand deposits with the commercial banks
(DD) + other deposits with the Reserve Bank (OD).
b) M2 = M1 + Postal savings bank deposits.
In this measurement, the deposits of the people with savings banks are also included in the money
supply.
c) M3 = M1 + (Net) Time deposits with the commercial banks.
In this measure, which is supposed to be much broader than M1 measure of money supply, the net
time deposits or term deposits of the public with the commercial banks are also treated.
d) M4 = M3 + Total deposits with the postal savings organizations (excluding National Savings
Certificates).
In India, M1 and M2 are considered as Narrow Money, while M3 and M4 are treated as Broad
Money.
However, from the view point of liquidity of an asset, M1 is supposed to be most liquid and M4 is
supposed to be least liquid.

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5. What is high-powered money?
High Powered Money:
High powered money or powerful money refers to that currency that has been issued by the
Government and Reserve Bank of India. Some portion of this currency is kept along with the public while
rest is kept as funds in Reserve Bank.
Thus, we get the equation as:
H=C+R
Where H = High Powered Money
C = Currency with the public (Paper money + coins)
R = Government and bank deposits with RBI
High powered money is also known as secured money (RM) because banks keep with them Reserve
Fund(R) and on the bases of this Demand deposits (DD) are created. Since the bases of creation of credit
is Reserve Fund (R) and R is obtained as a part of high powered money (H) Security fund so high
powered money is termed as Base money.

Components of High Powered Money:

The High powered money refers to the total liability of the monetary authority (say, the RBI) of the
country. It consists of:
a) Currency held by the public;
b) Cash reserve with the commercial banks;
c) Required reserve of the commercial banks to be maintained with the RBI; and
d) Other deposits with the RBI: Every commercial bank has to keep certain proportion of its total
deposits with the Central Bank. This is called required reserve.
For example:
The commercial banks may have to keep 10 per cent of their total deposits as cash reserve with
the Central Bank (which is known as statutory cash reserve ratio). The rest 90 per cent can be
used by the commercial banks for credit creation as well as for meeting the regular day-to-day
demands of their depositors. This is called as free reserve.
Both these reserves are considered as assets of the commercial banks but liabilities of the Central
Bank.
This reserve money plays an important role for the creation of credit money by the banking
system or by the commercial banks as a whole in an economy.

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6. Explain briefly the theory of demand-pull inflation. Explain the causes of a

demand-pull inflation.
What is Demand-Pull Inflation ?
Demand-pull inflation is used by Keynesian economics to describe what happens when price levels rise
because of an imbalance in the aggregate supply and demand. When the aggregate demand in an
economy strongly outweighs the aggregate supply, prices go up. Economists describe demand-pull
inflation as a result of too many dollars chasing too few goods.
A demand-pull inflation is an inflation created by the pressure of excess demand in the market. If there
is an excess of demand over supply, price tends to increase under this pressure of excess demand. If
aggregate demand exceeds aggregate supply, there will be an upward pressure on the aggregate price
level. This type of inflation is called demand-pull inflation. If there is no change in the aggregate
demands curve or the aggregate supply curve, there will be no change in the level of equilibrium price.

Causes of Demand-Pull Inflation

There are five causes for demand-pull inflation:
(a) A growing economy: When consumers feel confident, they will spend more, take on more debt
by borrowing more. This leads to a steady increase in demand, which means higher prices.
(b) Asset inflation: a sudden rise in exports, which translates to an undervaluation of the involved
currencies
(c) Inflation expectations: forecasts and expectations of inflation, where companies increase their
prices to go with the flow of the expected rise
(d) More money in the system: demand-pull inflation is produced by an excess in monetary growth
or an expansion of the money supply. Too much money in an economic system with too few
goods makes prices increase.
(e) Increase in public spending: Spending by the Government is an important part of total
spending in any modern economy. It is a total spending that determines the total demand. Thus,
Government expenditure is an important determinant of aggregate demand. In India, the amount
of Government spending has increase by leaps and bounds. This has created inflationary pressure
on the economy.
(f) Deficit financing of Government spending: If the increase in Government spending is
financed by taxation, the problem would not have been so severe. Because, taxation would have
taken money away from the hands of the people and would have lessened the pressure of
demand in the market. In order to be able to incur the extra expenditure, the Government
resorts to deficit financing. For instance, it prints money and spends it. This adds to the pressure
of inflation.
(g) Increased velocity of circulation: The total use of money in the market is the amount of
money supply by the Government multiplied by the velocity of circulation of money. During the
boom phase of the business cycle, people spend money at a faster rate. The velocity of circulation
of money increases. This also creates inflationary pressures on the economy.
(h) Population growth: Growth of population also increases total demand in the market. If the
supply of gods and services does not keep pace with demand, the pressure of excess demand will
creates inflation.

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7. Explain the concepts of inflationary gap with the help of suitable diagram

When aggregate demand (AD) exceeds the maximum potential aggregate supply (AS) corresponding to
the full employment level in an economy, then it is called a situation of excess demand.
Hence, Excess demand = AD – AS > 0
Or, AD > AS (corresponding to full employment level)
Thus, when the desired aggregate expenditure (representing the AD) exceeds the aggregate supply at the
full employment level, there would arise a problem of excess demand in the economy. At this stage, the
available resources of the economy are fully employed and there will be no scope for any further increase
in the aggregate supply of goods and services. As a result, an excess of AD over AS would create an
upward pressure on the average prices of goods and services in the economy. Hence, an inflationary
pressure will be generated.
Inflationary gap:
An inflationary gap arises when AD exceeds AS at the full-employment level in an economy. Thus, an
excess demand situation creates an inflationary gap in the economy. If YE denotes full-employment level
of national output, (C + I)p denotes the present level of desired aggregate
expenditure in the economy and (C + I)F denotes the aggregate expenditure at the full-employment level
of output, then
Inflationary gap = (C + I)p - (C + I)F> 0
Or, (C + I)p> (C + I)F
At the full employment level of equilibrium national output, YE = (C+I)F. Hence, an inflationary gap is
created in the economy when the present desired aggregate expenditure (C + I)p, exceeds the full
employment level of output.
∴ Excess demand = ADp – ASF [where, ADp> ASF]

= (C + I)p – YF
= (C + I)p - (C + I)F
= Inflationary gap

C+I Y = C+I C+I Y = C+I

ADP (C+I)P

ADF (C+I)F
F F

E E
Excess Inflationary
demand gap
450 450
0 YF Y 0 YF Y

Fig – (a) Fig – (b)

In Fig (a), the 450 line shows the equality between AS and AD. If the present aggregate demand schedule
[or, (C+I)P] is denoted by ADP, then it is observed that at the full-employment level of national output
(YF), the ADP is greater than YF (=ADF) by an amount of EF. This gap indicates the extent of excess
demand in the economy.
In Fig (b), we observe the same thing, i.e. at the full-employment level of national output (YF), the desired
present aggregate expenditure [(C+I) P] exceeds the full-employment level of equilibrium national output
[Y = (C+I)F] by an amount of EF. This shows an inflationary gap.

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8. What is Unemployment? Explain the concept of Voluntary

and Involuntary & Frictional unemployment.
What is Unemployment?
Unemployment occurs when a person who is actively searching for employment is unable to find work.
Unemployment is often used as a measure of the health of the economy. The most frequent measure of
unemployment is the unemployment rate, which is the number of unemployed people divided by the
number of people in the labor force.
Unemployment is defined as a situation where someone of working age is not able to get a job but would
like to be in full-time employment.
Note: If a mother left work to bring up a child or if someone went into higher education, they are not
working but would not be classed as unemployed as they are not actively seeking employment.
Types of unemployment
(1) Voluntary unemployment
Voluntary unemployment is defined as a situation when workers choose not to work at the current
equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour
market. There are several reasons for the existence of voluntary unemployment including excessively
generous welfare benefits and high rates of income tax. Voluntary unemployment is likely to occur when
the equilibrium wage rate is below the wage necessary to encourage individuals to supply their labour.

(2) Involuntary unemployment

An involuntary unemployment means a situation in which all able persons who are willing to work at the
prevailing wage rate do not get work. Such people are (i) physically and mentally fit to work and are also
(ii) willing to work at the going rate but are out of Job. Thus, their unemployment is involuntary (i.e., not
voluntary) because they are rendered unemployed against their wishes.

(3) Frictional unemployment

Frictional unemployment, also called search unemployment, occurs when workers lose their current job
and are in the process of finding another one. There may be little that can be done to reduce this type of
unemployment, other than provide better information to reduce the search time. This suggests that full
employment is impossible at any one time because some workers will always be in the process of
changing jobs.

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(4) Other Concepts about Unemployment
• Seasonal Unemployment. In certain regions, unemployment may be seasonal e.g.
unemploymentrises in winter when there are no tourists.
• Disguised / Hidden unemployment. Often unemployment statistics don’t include certain
types of workers. For example, those put on incapacity benefit may not be counted as
unemployed, but, it may really be a type of structural unemployment.
• Natural Rate of Unemployment. This is the level of unemployment when the labour
market is in equilibrium. It is the difference between the labour force and those willing and
able to accept a job at going wage rate. It encompasses the different supply side
unemployment like frictional and structural unemployment.
• Under-employment. This is when people have a job, but it is part-time or temporary.
They would like to work full time, but only have a part-time income.

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Unit – 3:
National Income

1. What is national income?*

National income is the sum total of factor incomes earned by normal residents of a country during the
period of one year.
NY = ∑ 𝐧𝐧
𝐅𝐅=𝟏𝟏 FY𝐅𝐅

Where NY = National Income,

FY = Factor Income and
n = All normal residents of a country.
Rent, wages, interest and profit are the factor incomes. So, national income is the sum total of rent, wages,
interest and profit earned by normal residents of a country during an accounting year.

2. What is Value Added Method of measurement of National

Income?
In the value added method we take the values added at each stage of production and add them up. The value
added by a productive unit is the difference between the total value of its output of the year and the value of
all raw materials that have been drawn from the production of the year and have been used up. The value of
raw materials drawn from the accumulated stocks is not deducted and the value of raw materials drawn from
current production but not used up in the year is also not deducted

3. Can transfer earnings be included in National income?

Transfer payment should not be included in the national income since such payments are made without
receiving any service is return.

4. Can Capital Gain be included in National income?

Capital gains should not be included in the national income as the capital gain is earned without
rendering any productive service.

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5. What is Production Method of measurement of National

incomes?
In the production method, we make a complete census of all products produced by all members of the nation
during the year and add them together to get the GNP total. Since different goods and services have different
units, they can be added only by taking their money value.
In the census of production method, multiple counting of the same product may arise if we take the total value
of each and every product separately. To avoid this multiple counting, two methods are available: one is the
value added method and the other is the final product method.
In the value added method, we take the value added at each stage of production and add them up. The value
added by a productive unit is the difference between the total value of its output of the year and the value of
purchasing of all raw materials. In the final product method, all products are divided into two categories:
intermediate goods and final goods. Where as intermediate goods are those goods which is used as a input and
consumed within the same year and final goods are those goods which are finally ready to consume and there
is no any further process on that goods.
The value added method and the final product method give us the same figure of the GNP total. Suppose in an
economy wheat is produced worth Rs.1000 during a year. The entire
wheat is transformed into flour in the same year and the flour is valued at Rs.1500. suppose also that the entire
output of flour is used up in the production of bread during the same year
and bread is valued at Rs.2500. If we add up the value of wheat, the value of flour and the value of bread we
have multiple counting.
The value of wheat is included thrice while the value of flour is included twice. To avoid this, we take either
the value of bread which is the final product in this case or the values added in different stages of production
value added in wheat production is Rs.1000, value added in the production of flour is Rs.500 and the value
added in the production of bread is Rs.1000. Hence, total value added is Rs.(1000+500+1000) = 2500. Again
the value of output of bread is also Rs.2500.
Precaution:
(a) The value of all goods and services which are marketed are included.
(b) The services of owner occupied house i.e. inputted rent should be included. The service of member of
family should not be included.
(c) In case of self employed professionals like doctors educated etc. the value of the services are
included.
(d) Public services such as defence, police etc should be included.
(e) Value goods produced but not yet marketed should be included.

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6. What is Income Method of measurement of National

Income?
In the census of income method we make a census of all earnings unit of an economy. An earning unit may be
an individual or a company. In national income accounting only those earning units are considered which
participates in the production process. There are generally four factors of the Production labour, capital, land
and entrepreneurship. Labour gets wages and salaries in the form of cash and kinds, capitals get interest, land
gets rent and entrepreneurship get profit as their remuneration. Beside there are some self employed persons
who employ their own capital such as doctors advocates CA etc. their income is called mixed income. Hence,
the national income is equals to the sum total of all wages, rents, interest and profit earned in the production
process i.e.
NDPfc = COE + OS + MI
Where as compensation of employee (COE) include wages and salaries in cash or in kind.
Operating surplus (OS) consists of rent, royalty, interest and profits ( corporate tax, dividend, undistributed
profit or retained earning i.e. saving )
MI represents mixed income of self-employed.
Precautions:
(a) Transfer income should not be included.
(b) Wind gains i.e. lottery etc should not be included.
(c) Undistributed profits of the firms must be included.
(d) Illegal income should not be included.
(e) Household services rendered by the members of the family should not be included.
(f) Receipts from the sale of second hand goods should not be included.

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7. What is Expenditure Method of measurement of National

Income?
The third method of measuring national is expenditure method. According to this method National income is
measured in terms of expenditure made by the consumer on final goods and services produced in the economy
during on accounting year. Thus the national income of country is equal to sum of all Private Final
Consumption Expenditure(C), Government Final Consumption Expenditure(G), Gross Domestic Capital
Formation(I) and Net Exports on goods and services. Where as Private Final Consumption Expenditure shows
expenditure incurred on final goods and services by resident household and non- profit institution serving
household (Ex- churches, trade unions, political parties, charities hospitals, universities etc.). Government
Final Consumption Expenditures shows expenditure on goods and services incurred by the government. Gross
Domestic Capital Formation also consists of two parts i.e. Gross fixed Capital Formation (e.g. expenditure on
construction, machinery, etc.) and inventories investment i.e. (change in stock of raw materials). And net
exports refers to difference between value of exports(X) and value of imports(M).Hence
GDPmp = C+I+G+(X – M)
Where, C= Private Final Consumption expenditure; I = Gross Domestic Capital Formation., G = Government
Final consumption expenditure; (X – M) = Net exports.
In this way in expenditure method national income is obtained by adding different types of expenditure.
Precaution:
(a) Expenditure on purchase of second hand goods should be excluded.
(b) Government transfer payment should be excluded.
(c) Expenditure on share and Bond should be excluded.
(d) To avoid double counting, expenditure on all intermediate goods and services is excluded.
(e) Imputed expenditure on own account output (i.e. owner occupying his house should be included.)

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8. What is meant by circular flow of income in a three
sector economy ?
Three Sector Economy:
In our above analysis of money flow, we have ignored the existence of government for
the sake of making our circular flow model simple. This is quite unrealistic because
government absorbs a good part of the incomes earned by households. Government
affects the economy in a number of ways. Here we will concentrate on its taxing,
spending and borrowing roles. When part of income is spent on tax payment then that
part of spending by any household or a firm can not arise as income of another firm or
household. So this tax payment is considered as the Leakage or Withdrawal from the
circular flow of income. When government purchase goods and services produced by
any sector ( says firm sector) then income earned by the firm sector does not depend on
expenditure made by the household sector. So the government expenditure considered
as Injection into the circular flow of income. It should be noted that in any economy
injection must be equal to withdrawal.

On left part of diagram shows the flow of income and expenditure between
household sector and the government. Household sector pays net tax (tax –
transfer payment). On the other hand, the government also purchase goods and
services from the household in form of wages and salaries or also makes
transfer payments in the form pension funds, relief, sickness benefits, health,
education etc. On the right side of the diagram shows flow of income and
expenditure between business sector and the government. Business firms pay
net taxes (tax-subsidies) to the government. On the other hand the government
provides subsidies and purchase goods and services from the business sector.

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Unit – 4:
Determination of Equilibrium Level of National Income
[Marks:10]

1. Keynes theory of Investment Multiplier

The effect of an increase in autonomous investment on equilibrium level of national income ia
shown in the Theory of investment multiplier. The theory was introduced and popularised by
Prof. J.M. Keynes. Investment multiplier represents the ratio of change in income in response to
change in investment in investment.
According to this theory if there is an increase in autonomous investment then national income
will increase by a multiple of that initial in autonomous investment.
In any economy, level of income increases in the multiples of an initial increase in amount of
autonomous investment i.e.
∆Y = K. ∆I
∆F
K=
∆𝐼
∆𝑌 = Change in income
∆I = Change in investment
Working of Investment Multiplier:
Suppose, initial increase in autonomous investment in the economy be Rs.100 crore and MPC =
in the first phase an increase in autonomous investment of Rs.100 crore will be
additional. Income of Rs.100 crore of people. New 80% of increased income will be
consumed i.e. Rs.80 crore as a consumption expenditure will be additional income of
Rs.80 crore for the another group of people. Now again this group will consume 80% of
the increased income i.e. Rs.60 crore. This increase in consumption expenditure of Rs.64
crore for the third group of the people. This process in the economy will be continued
until the amount becomes infinitely small. The sum of the following G.P series will be an
increase in income in the economy.
I.e. ∆Y = 100+80+64+ ∞
𝑎
�𝑆𝖺 = �
1−𝑟
100
∆𝑌 = 1 − 0.8

100
0.2
∆𝑌 = 𝑅𝑠. 500 𝑐𝑟𝑜𝑟𝑒

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Hence, an initial increase in autonomous investment of Rs.100 crore leads to an increase in
national income by Rs.500 crores. In such case, investment multiplier K = 500 = 5
100
The magnitude of investment multiplier will be always greater than 1 and less than infinity

Initially, E is the equilibrium point defined by the point of intersection of aggregate demand
curve (C+I0) and aggregate supply curve which is 450 line or income line OY1 is the initial level
of income. when investment is increased by ∆I amount. (C+Io) curve shift upward and becomes
(C+I+∆I). F is the new equilibrium point and OY2 is the corresponding equilibrium level of
income.
In this case,
Change in come (∆Y) = OY2 – OY1 = Y1Y2
Change in investment (∆I) = FY2 – HY2 = FH
Investment multiplier (k) = ∆F
∆𝐼
F1F2
K=
𝐹𝐻

Limitations of investment multiplier:

(i) MPC may not be constant: In this theory it is assumed that MPC remains constant for the whole
economy. But in real life situation, MPC of the lower income class remains relatively higher than
that of the higher income class.
(ii) Inelastic supply of complementary resources: In case of an underdeveloped country, an increase
in autonomous investment may only create an inflationary pressure within the economy due to the
inelastic supply of some complementary resources.
(iii) Existence of some leakage: Existence of some leakages in the form of, say, import payments, net
tax payments etc. would reduce the strength of investment multiplier.

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2. Size of Investment Multiplier depends on MPC:

The magnitude and strength of investment multiplier depends on marginal propensity to
consume.
In eualibrium,
Y = C+I ........ (i)
Let, I = I0 & C = a + CY
Where, C = ∆𝐶 = MPC
∆F
Y = a + CY + I0
Y – CY = a + I0
Y(1 – C) = a + I0
Y = 𝑎+𝐼0 = 𝑌1 (𝑙𝑒𝑡) .......... (ii)
1−𝐶
When, investment in economy is increased by ∆I amount then
Y = C + I + ∆I
Y = a + CY + I0 + ∆I
Y – CY = a + I0 + ∆I
Y (1 – C) = a + I0 + ∆I
= 𝑌2 (𝑙𝑒𝑡) .............. (iii)
a + I0+ ∆I
Y=
(1−𝐶)
Change in Income,
∆Y = Y2 – Y1

a + I0+ ∆I a+I
= − (1−𝐶)0
(1−𝐶)
a + I0+ ∆I−a−I 0
=
(1−𝐶)
∆Y = ∆𝐼
(1−𝐶)
∆F 1
=
∆𝐼 (1−𝐶)
∆𝐶
K= 1
�𝑘 =
1
�, �𝐶 = = 𝑀𝑃𝐶�
(1−𝐶) 1−𝑀𝑃𝐶 ∆F
Hence, Size of investment, multiplier depends on MPC [K = 1 ]
1−𝑀𝑃𝐶
1
K= [where (MPS) = 1 –MPC ]
𝑚𝑝𝑠
Investment multiplier is the reciprocal of MPS (Marginal propensity to save)

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3. Derivation of saving curve from consumption curve
We know that consumption + saving is always equal to Income because income is either
consumed or saved. It implies that consumption and saving curves representing consumption and
saving functions are complementary curves. Therefore, we can derive saving function or curve
directly from consumption function or curve. This can with the help of diagram which is given
below

Consumption curve has been derived from point C, because at zero level of income there exist
minimum level of consumption also known as autonomous consumption indicated by the
measurement OC. As we know that with increase in income level of consumption increases and
accordingly, consumption curve CC is drawn. A 45 line degree has been drawn indicating that
at its every point, income is equal to consumption. Consumption curve i.e. CC intersecting the
45 line degree at point A indicating C= Y i.e. break even point. We know at zero level of
income, minimum level of consumption is equal to the dissaving, accordingly point S
measuring a ( equal to minimum level of consumption) is taken. At a break even point savings
are equal to zero, therefore corresponding point A is considered on x axis. By joining point S
and A and extending it with the same slope we get our saving curve SS.

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4. Derivation of consumption curve from saving curve.
We know that consumption + saving is always equal to Income because income is either
consumed or saved. It implies that consumption and saving curves representing consumption and
saving functions are complementary curves. Therefore, we can derive consumption function or
curve directly from saving function or curve. This can be explained with the help of diagram
which is given below.

Saving curve has been started from point S, because at zero level of income there exists
dissaving indicated by the measurement OS. As we know with the increase in income, level of
saving increases and accordingly, saving curve SS is drawn. Saving curve intersecting the x-axis
at point A indicating savings are equal to zero i.e. break even point. Now, a 45 line degree has
been drawn indicating that at its every point income is equal to consumption. At point A on
saving curve saving are zero. It means at corresponding point A on 45 line degree , income is
equal to consumption. Also we know that at 0 level of income, dissaving is equal to minimum
level of consumption, hence OC point measuring “a” is taken on Y axis. By joining point A and
C and extending it with the same slope we get our consumption curve CC.

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5. Discuss briefly the simple Keynesian model of income
determination.
According to Keynes, there can be different sources of national income, such as government, foreign
trade, individuals, businesses and trusts.
For determining national income, Keynes had divided the different sources of income into four sectors
namely’ household sector, business sector, government sector, and foreign sector.
He prepared three models for the determination of national income, which are shown in Figure-1:

The two-sector model of economy involves households and businesses only, while three-sector model
represents households businesses, and government. On the other hand, the four-sector model contains
households, businesses, government, and foreign sector.

Determination of National Income in Two-Sector Economy:

J.M. Keynes in his famous book, 'General theory', has used two methods for the determination of
national income at a particular time:
(1) Saving Investment Method.
(2) Aggregate Demand and Aggregate Supply Method.
Both these approaches lead us to the determination of the same level of national income.
It may here be mentioned that Keynes model of income determination is relevant in the context of short
run only.

Assumptions:
Keynes assumes that in the short run:
(a) The stock of capital, technique of production, forms of business organizations, do not change.
(b) He also assumes a fair degree of competition in the market.
(c) There is also absence of government role either as a taxer or as a spender.
(d) Keynes further assumes that the economy under analysis is a closed one. There is no influence
of exports and imports on the economy.

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(A) Determination of National Income By the Equality of Saving and
InvestmentMethod:
Definition and Explanation:
This approach is based on the Keynesian definitions of saving and investment. According to Keynes,
the level of national income, in the short run, is determined at a point where planned or intended saving
is equal to planned or intended investment. Saving as defined by Keynes isthat part of income which is
not spent on consumption (S = Y - C). On the other hand, investment is the expenditure on goods and
services not meant for consumption. (I = Y - C).

According to Keynes, if at any time, the intended saving is less than intended investment, it implies
that people are spending more on consumption. The rise in consumption will reduce the stock of
goods in the market. This will give incentive to entrepreneurs to increase output. Likewise, if at
anytime intended saving is greater than intended investment, this would meanthat people are spending
lesser volume of money on consumption. As a result of this, the inventories of goods will pile up. This
will induce entrepreneurs to reduce output. The result of this will be that national income would
decrease. The national income will be in equilibrium only when intended saving is equal to intended
investment.
Example and Diagram/Curve:
The determination of national income is now explained with the help of saving and investment curve
below:

In figure (31.2), income is measured on OX axis and saving and investment on OY axis. SS is the saving
curve which shows intended saying at different levels of income. The investment curve ll’ is drawn
parallel to the X axis which shows that investment does not change.
The entrepreneurs intend to invest $50 crore only irrespective of the amount of income. Saving (SS) and
investment curves (ll’) intersect each other at point M. If the conditions stated above remain the same, the
size of equilibrium level of income is 250 crore.

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Disequilibrium:
Under the assumed conditions if there is inequality between saving and investment or disequilibrium, the
forces will operate in the economy and restore the equilibrium position.

Let us suppose, that the income has increased from the equilibrium level OL to ON ($300 crore). At this
level of income, desired saving is greater than the desired investment. When intended saving exceeds
planned or intended investment, the businessmen will not be able to dispose off all their current output.
They will slow down their productive activities. This will result in reducing the number of workers
employed in factories and a decrease in the income. This process will go on until due to a decrease in
income, people's saving is reduced to the level of investment ($50 crore). The equilibrium income is $250
crore.

In the same way, income cannot remain below this equilibrium level of $250 crore. If at any time, income
falls below the equilibrium level, then it means that people are investing more than they are willing to
save I > S. They will increase productive activities as they are making high profits. The number of
workers employed in the factories will increase. This will result in an increase in income and higher
saving. This rise in national income will go on up to a point where saving and investment are just in
balance and that will be the equilibrium level. At this point, income will have the tendency of neither to
rise nor to fall. It will be in a state of rest. It is, thus, clear that national income is determined at a point
where the intended investment is equal to intended saving.

(B) Determination of Equilibrium Level of National Income According

to Aggregate Demand and Aggregate Supply Method:
Definition and Explanation:

While determining the level of national income in a two sector economy, it is assumed that
it is an economy where there is no role of the government and of foreign trade. In other
words, it is a closed economy with no government intervention. The two sector economy
comprises of households and firms.

According to J. M. Keynes, the equilibrium level of national income is that situation in whichaggregate
demand (C+ I) is equal to aggregate supply (C + S). The aggregate demand (C+ I) refers to the total
spending in the economy.
In a two sector economy, The aggregate demand is the sum of demands for the consumer goods (c)
and investment goods by households and firms respectively. The aggregate demandcurve is positively
sloped. It indicates that as the level of national income rises, the aggregate demand (or aggregate
spending) in the economy also rises.

Aggregate supply (C + S)=Y

It is the flow of goods and services in the economy. In other words, the value of aggregate supply is equal
to the value of net national product (national income). The aggregate supplycurve (C + S) is a positively
sloped 45° helping line. It signifies that as the level of national income rises, the aggregate supply also
rises by the same proportion.

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Equilibrium Level of Income:
According to Keynesian model, the equilibrium level of national income is determined at a point where
the aggregate demand curve intersects the aggregate supply curve. The 45° helping line represents
aggregate supply. By definition, output equals income on each point of aggregate supply curve. The
determination of the level of aggregate income is explained below.

Diagram/Curve:

In the figure 31.3, income is measured along OX axis and expenditure on OY axis. The aggregate demand
curve (C + I) intersects the aggregate supply curve (45° line) at point K point. K, here is the only point
where the economy is willing to spend exactly the amount which is necessary to dispose off the entire
output. The equilibrium level of income is $250 billion. It may, however, be noted that this equilibrium
output does not mean in any way thefull employment output.

Departure From Equilibrium Level of Income:

Now a question arises that if at any time there is a departure from the equilibrium income of $250 billion,
how will the economy move towards an equilibrium level? To answer this question, we examine two
possible levels of income other than the equilibrium level.

Let us suppose first that the actual income is $300 billion rather than $250 billion. According to aggregate
demand, schedule (C + l), (the actual consumption + investment expenditure) at an income of $300
billion falls short by $30 billion (shown by bracket). This means that the goods worth $30 billion are not
sold. When the inventories pile up with the business, they would curtail this production and provide fewer
jobs. There will thus be a decline in total income which will continue till the income falls to the
equilibrium level of $250 billion.

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Now let us suppose that the level of income fails to $100 billion. According to aggregate demand
schedule represented by (C + l) curve, the expenditure at this level exceeds incomeby $50 billion (shown
by bracket). The increase in demand of consumer and investment goods will induce the businesses to
increase their output. The higher rate of production willprovide more jobs to the workers.

The level of income would rise and the upward drive continues till the income reaches theequilibrium
level of $250 billion. We, thus, conclude by saying that an economy sustains only that level of income
where the total quantity supplied and the aggregate quantity demanded are equal. At this equilibrium
national income of $250 billion, the firms have neither the tendency to increase output nor the tendency to
decrease output. Hence, $250billion is the equilibrium level of national income. The equilibrium output,
in this simpleKeynesian analysis, does not mean full employment.

6. What is Keynesian consumption function? What are its

characteristics? Show that MPC+MPS=1.
The Concept of Consumption Function:
As the demand for a good depends upon its price, similarly consumption of a community depends upon the
level of income. In other words, consumption is a function of income. The consumption function relates the
amount of consumption to the level of income. When the income of a community rises, consumption also
rises.
How much consumption rises in response to a given increase in income depends upon the marginal
propensity to consume. It should be borne in mind that the consumption function is the whole schedule
which describes the amounts of consumption at various levels of income.
The consumption function or propensity to consume refers to income consumption relationship. It is a
“functional relationship between two aggregates, i.e., total consumption and gross national income.”
Keynesian Consumption Function:
The consumption function states that aggregate real consumption expenditure of an economy is a
function of real national income. This is called the Keynesian Consumption Function.
The consumption function has two technical attributes or properties:
(i) The average propensity to consume, and
(ii) The marginal propensity to consume.
(1) The Average Propensity to Consume:
“The average propensity to consume may be defined as the ratio of consumption expenditure to any
particular level of income.” It is found by dividing consumption expenditure by income, or APC = C/Y. It is
expressed as the percentage or proportion of income consumed.
The APC declines as income increases because the proportion of income spent on consumption
decreases.
But reverse is the case with APS (average propensity to save) which increases with increase in income.
Thus the APC also tells us about the APS, APS=1-APC.

(2) The Marginal Propensity to Consume:

“The marginal propensity to consume may be de- fined as the ratio of the change in consumption to the
change in income or as the rate of change in the average propensity to consume as income changes.” It
can be found by dividing change in consumption by a change in income, or MPC = ∆C/∆Y.

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Characteristics of Keynesian consumption function
According to Keynes the consumption function must possess the following characteristics:
(a) Aggregate real consumption expenditure is a stable function of real income.
(b) The marginal propensity to consume (MPC) or the slope of the consumption function defined as
dc/dY must lie between zero and one i.e. 0 < MPC < 1.
(c) The average propensity to consume (APC) or the proportion of income spent on consumption
defined as C/Y should be decreasing as income increases. From the relation between marginal and
average we know that, when average falls, marginal is below average. Thus, when the average
propensity to consume (APC) falls, the marginal propensity to consume (MPC) must be lower than
the APC.
(d) The marginal propensity to consume (MPC) itself probably decreases or remains constant as
income increases.

These four characteristics specify the shape of the consumption function. It can be seen clearly that, if
we draw a straight line consumption function with a positive intercept with the vertical axis, and
intersecting the 45° line from above, it will satisfy all the four characteristics.
Mathematical Relationship between MPC and MPS!
The sum of MPC and MPS is equal to unity (i.e., MPC + MPS = 1).
For sake of convenience, suppose a man’s income Increases by Rs 1. If out of it, he spends 70 paise on
consumption (i.e., MPC = 0.7) and saves 30 paise (i.e., MPS = 0 3) then MPC + MPS = 0.7 + 0.3 = 1.
MPC + MPS = I as proved below.
We know that income (Y) is either spent on consumption (C) or saved (S).
Symbolically:
Y =C + S
or
∆Y = ∆C + ∆S
By dividing both sides by AY, we get:
∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
or
1 = MPC + MPS
MPC + MPS = 1.

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7. Diagrammatically represent a Keynesian linear
consumption function and show how it is affected when
MPC changes.
The consumption function, or Keynesian consumption function, is an economic formula representing the
functional relationship between total consumption and real national income.
Where C= Aggregate Consumption of the economy .
b = Marginal propensity to consume.
Y = Real income or the total output.
In Keynesian economics, we will see that this marginal propensity to consume denoted by “b” plays a vital
role in income determination and thus employment.
Consumption demand depends on income and propensity to consume. Propensity to consume depends on
various factors such as price level, interest rate, stock of wealth and several subjective factors. Since Keynes
was concerned with short-run consumption function he assumed price level, interest rate, stock of wealth
etc. constant in his theory of consumption. Thus with these factors being assumed constant in the short run,
Keynesian consumption function considers consumption as a function of income.
Thus C= f(Y)
In a specific form, Keynesian function can be written as: C = a + f(Y) Which is popularly represented by
Keynes as C= a + bY Where a and b are constants. While a is intercept term of the consumption function, b
stands for the slope of the consumption function and therefore represents marginal propensity to consume.

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The Concept of Consumption Function:
 As the demand for a good depends upon its price, similarly consumption of a community depends
upon the level of income. In other words, consumption is a function of income. The consumption
function relates the amount of consumption to the level of income. When the income of a
community rises, consumption also rises.
 How much consumption rises in response to a given increase in income depends upon the marginal
propensity to consume. It should be borne in mind that the consumption function is the whole
schedule which describes the amounts of consumption at various levels of income.
 The consumption function states that aggregate real consumption expenditure of an economy is a
function of real national income. This is called the Keynesian Consumption Function. The classical
economists used to argue that consumption was a function of the rate of interest such that as the
rate of interest increased the consumption expenditure decreased and vice versa. Keynes stated
that the rate of interest may have some influence on consumption but the real income was the
important determinant of consumption
 It should be remembered that in the consumption function consumption expenditure refers to
intended or ex-ante consumption and not actual consumption. Similarly, income refers to
anticipated income and not actual income. Therefore, the consumption function shows what
consumption expenditure would be at different levels of income. The aggregate consumption in the
economy can be found out from the consumption expenditure of different individuals purchasing
commodities.
 Thus, the aggregate consumption function states that real consumption is a function of real income
and then the consumption function can be written as C = C(Y) where C is real consumption
expenditure and Y is real national income. This is the Keynesian Consumption Function. The straight
line consumption function has a constant slope at all points. Here, we are considering a straight line
consumption function and so the MPC is constant for all income level.
 Thus, the aggregate consumption function states that real consumption is a function of real income
and then the consumption function can be written as C = C(Y) where C is real consumption
expenditure and Y is real national income or the output produced in the economy. This is the
Keynesian Consumption Function. The straight line consumption function has a constant slope at all
points. The (MPC) marginal propensity to consume decreases as income increases.
[Average Propensity to consume is the average calculation . That is how much does a society consume out of income
on an average. And the Marginal Propensity to Consume calculates how much additional change is incurred in a
society for a small increase in income]

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8. Explain the Keynesian theory of investment multiplier.
What are the limitations of the theory?
OR
Explain briefly the implication of various leakages in the
process of working of the Keynesian investment multiplier.
OR
“In the context of the simple Keynesian model, the increase in
income is a multiple of the increase in autonomous
investment” – explain.
What is an Investment Multiplier
An investment multiplier refers to the concept that any increase in public or private investment spending
has a more than proportionate positive impact on aggregate income and the general economy. The
multiplier attempts to quantify the additional effects of a policy beyond those immediately measurable. The
larger an investment's multiplier, the more efficient it is at creating and distributing wealth throughout an
economy.
What Is the Keynesian Multiplier?
The multiplier concept is central to Keynes’ theory because it tells us that an increase in investment by a
certain amount leads to an increase in income greater than the increase in investment. Thus, an investment
has a “multiplier effect” on aggregate demand. The concept of multiplier is a solution to the problem of
underemployment equilibrium.

While developing his theory of “investment multiplier”, Keynes borrowed the concept from R. F. Kahn’s
“employment multiplier.” A change in autonomous investment expenditure brings about a change in
income. However, the change in income is greater than or a multiple of the change in investment. Suppose,
an investment of Rs. 2,000 crore causes an increase in income by Rs. 6,000 crore, then the value of the
multiplier would be 3. Thus, the multiplier is the change in income consequent upon a change in investment.
Or the multiplier is the ratio of change in income (∆Y) to a planned change in investment (∆I). Let the
investment multiplier be denoted by KI. Multiplier is the number by which the change in investment has to
be multiplied to obtain the resulting change in income.
Thus, ∆Y = KI. ∆l
Or KI = ∆Y/∆I
Multiplier Process:
Why does income rise in a multiplied form following a rise in investment? From the circular flow of income,
we know that business firms earn when households spend, and households earn when firms spend on hiring
input services rendered. Thus, total income equals total expenditure.
However, a part of this total income is spent on consumption and the rest is saved. This induced
consumption of one individual becomes the income of another individual which again results in an increase
in consumption. This again creates income and the process goes on.

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Thus, an initial autonomous investment expenditure leads to an increase in income via consumption
expenditure. However, the process of income generation must stop when the last consumption spending
fails to generate fresh income. Anyway, at the end, the total increase in income will be more than the initial
volume of investment. However, how much income will rise in response to an increase in investment
depends on the value of MPC or its complementary term, MPS.

Fig. 3.15 illustrates the graphical exposition of the multiplier process in an alternative way. To be in
equilibrium, leakage (here, saving only) must equal injection (here, investment only). Further, investment is
assumed to be autonomous, represented by the line I1. SS’— the saving schedule— cuts the I1 line at E1.
Corresponding to this equilibrium point, equilibrium level of income, thus, determined is OY 1 An increase in
investment by an amount AI causes the investment line to shift up to l1 Equilibrium point shifts to E2 and
income rises from OY1to OY2 Anyway, the increase in income (AY) is bigger than the increase in investment
(A 1). The multiplier is now in action and the economy recovers from the ‘Great Depression’.
Limitations:
(a) Firstly,Keynes assumed that consumption depends on income and MPC of the economy does not
change. But, experience and evidence suggest that consumption depends on other factors including
income. Keynes ignored other determinants of consumption function.
(b) Secondly, the multiplier analysis describes the effect of an increase in autonomous investment on
national income. But it neglects the effect of consumption on investment. Changes in consumption
result in a change in investment spending. This sort of investment is called induced investment.
Multiplier analysis neglects this aspect. If induced investment is taken into account the value of
multiplier will be larger than the simple multiplier presented by Keynes.
(c) Thirdly, multiplier analysis comes to a halt if the economy remains at the full employment level since
output or income cannot increase beyond this level even if investment spending increases. Only at the
underemployment situation does multiplier work.
(d) Fourthly, Keynesian multiplier is an instantaneous multiplier in the sense that as soon as investment
takes place income tends to rise. This is also called ‘static multiplier’ as there is no lag between income
and investment expenditure. However, in reality, there exists a time lag between incomes received and

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consumption spending. Greater the time lag, lower will be the value of the multiplier because now
change in income is not instantaneous.
(e) Finally, leakages or withdrawals result in a smaller value of multiplier. In other words, due to the
presence of leakages, process of income generation slows down. For instance, if people decide to save
more from their incomes the value of the multiplier will be weaker.

9. Determination of Equilibrium Level of Income

In an Economy level of national income and determined by the forces of aggregate demand and aggregate
supply. According to Prof. Keynes, there is no fundamental difference between determination of national
income and determination of employment as national income depends on level of employment.
In simple Keynscan model i.e. two sector closed economy, aggregate demand (AD) is the sum of
consumption demand and investment demand.
Consumption demand is demand for capital goods produce consumer goods. It is assumed that investment
demand (I) is autonomous in nature i.e. independent to level of income.
In any economy, aggregate supply has two component, i.e. consumption (C) and saving (S) as pointed out
by Prof. Keynes. Hence in two sector closed economy, aggregate supply (Y) = C + S. AS curve will be
always 450 line.
Assumption:
While determine the equilibrium level of national income we make the following assumptions –
(a) There is no government sector.
(b) There is no foreign sector
(c) It is also assume that total amount of investment in the economy is constant at all level of income.
(d) Price level is also constant.
(e) Analysis in short run production function.

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Equilibrium level of income:

The equilibrium level of national income is defined by the equality of aggregate demand and aggregate
supply.
Aggregate demand (Y) = C+ I
Aggregate Supply (Y) = C + S
In equilibrium AD = AS
C+I=C+S
I =S
In this diagram, aggregate demand curve is C+I which is the lateral summation of consumption and
investment demand curve. Aggregate supply is 45 line degree and it intersect aggregate demand curve
C+I at point E . Hence E is the equilibrium point which is Defined by the intersection of aggregate
demand curve and aggregate supply curve and OP is the equilibrium level of output which is we get.
Before equilibrium level of output aggregate demand is better than aggregate supply and after the
equilibrium level of income or output aggregate supply is better than aggregate demand.
If aggregate demand is greater than aggregate supply
It means that buyers are planning to buy more goods and services that producer are planning to produce.
In this situation inventory is with producers will start falling. To maintain the desired level of inventory
producer will increase the production level. For this purpose pressure will hire more workers. This will
raise the employment level in the economy and result increased in the distribution of factor income i.e.
national income which AS. This excess demand is also influenced the price level in the economy. This
process will continue till aggregate demand and aggregate supply not become equal to each other.
If aggregate supply is greater than aggregate demand.
It means that buyers are planning to buy less goods and services then producer are planning to produce. In
this situation inventory is with the producers will start Rising. To maintain the desired level of inventory
judicial be reduced the production level, for this purpose producer will lay off the workers, this will
reduce the employment level in the economy and also price level in the economy. This process will
continue till aggregate demand and aggregate supply not become equal to each other.

10. Saving Investment equality approach:

In any economy entire income received (Y) is allocated on consumption and saving i.e.
Y = C+S .......... (i)
Total value of goods produced (Y) is derived from consumption goods and capital goods.
i.e. Y = C + I .............. (ii)
In other words, aggregate demand (Y) is the sum total consumption demand & Investment demand and
aggregate supply in a two sector closed economy has two components consumption & savings as pointed
out by Prof. Keynes.
From equation i & ii
C+I = C+S
I=S
Hence, actual savings and actual investment in the economy are always equal. Actually it is an identity.

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Assumption:
While determine the equilibrium level of national income we make the following assumptions –
(a) There is no government sector.
(b) There is no foreign sector
(c) It is also assume that total amount of investment in the economy is constant at all level of income.
(d) Price level is also constant.
(e) Analysis in short run production function.
Both, savings & Investment are different activities performed by two different groups of individuals
having their own motives.
Savings are performed by the household & investment decisions are taken by the firms. So, planned
saving & planned investment are equal only in equilibrium as shown in the diagram.

∆𝐼
In figure, AI0 is the investment curve which is autonomous in nature � = 0�. The equilibrium level of
∆F
national income is defined by the equality of planned saving and planned investment. Hence, E is the
equilibrium point where AI0 curve intersects aS curve i.e. planned savings = planed investment. OYe is
the equilibrium level of national income which is determined.
At higher income level OY2planned investment is less than planned saving it means aggregate demand is
less than aggregate supply. When aggregate demand is less than aggregate supply it means that buyers
planning to buy less goods and services then producer are planning to produce. In this situation inventory
with the producer will rising which leads to reduce production level in the economy as a result
employment in the economy is also Falls and it also effect the price level in the economy. this process
will continue tell aggregate demand and aggregate supply become equal to each other.
At lower income level OY1planned investment is greater than planned saving it means that aggregate
demand is greater than aggregate supply when aggregate demand is greater than aggregate supply it
means that buyers are planning to buy more goods and services then producer are planning to produce. in
this situation inventories with the producer will start falling. To maintain the desired level of inventory
producers will increase the production level, as a result employment level in the economy will increase
and this excess demand is also influence the price level in the economy this process will continue till
aggregate demand and aggregate supply become equal to each other.\

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11. Paradox of thrift:
A decrease in C (consumption expenditure) leads to an increase in saving (S) with every increase
in level of income (Y). Hence, saving function (SS) is positively sloped. An increase in
thriftiness in the society or in the economy leads to upward shifting of saving curve as shown in
diagram.

Initial equilibrium point is E and equilibrium level of national income is OY 0 and increase in
thriftiness leads to upward shifting of saving curve from S 0B0 to S1B1. Hence, at OY0 income
level, S>I
Y–C>I
Y>C+I
i.e. there will be excess supply in the economy and unintended accumulation takes place due to
fall in level employment and national output. So, income level Y decreases continuously upto
OY1, where planned saving & planned investment are again equal (I1 = S1). However, a new
equilibrium level OY1 is less than OY0. Such decrease in income due to an increase in thriftiness
in the economy. So, it is called Paradox of thrift to tackle such situation, physical & monetary
measures should be taken by the government.

12. Derive the government expenditure multiplier in the

context of national income determination.
GOVERNMENT EXPENDITURE MULTIPLIER:
Like private investment, an increase in government spending results in an increase in national income.
Thus, its effect on national income is expansionary. There is a limit to private investment. Thus, to stimulate
income the gap has to be filled up by government expenditure.
However, the increase in income is greater than the increase in government spending. The impact of a change
in income following a change in government spending is called government expenditure multiplier, symbo-
lised by kG. The government expenditure multiplier is, thus, the ratio of change in income (∆Y) to a change
in government spending (∆G). Thus,
KG = ∆Y/∆G and ∆Y = KG. ∆G
In other words, an autonomous increase in government spending generates a multiple expansion of income.
How much income would expand depends on the value of MPC or its reciprocal, MPS. The formula for KG is

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the same as the simple investment multiplier, represented by KI.
The impact of a change in government spending is illustrated graphically in Fig. 3.19 where C + 1 + G1 is the
initial aggregate demand schedule. E1 is the initial equilibrium point and the corresponding level of income is,
thus, OY1If the government plans to spend more, aggregate demand schedule would then shift to C + I + g2.
As this line cuts the 45° line at E2, the new equilibrium level of income, thus, rises to OY2— an amount larger
than the initial one. It is clear from Fig. 3.19 that the increase in income (∆Y) is larger than the increase in
government spending (∆G).

The reason behind this expansionary effect of government spending on income is that the increase in public
expenditure constitutes an increase in income, thereby triggering successive increases in consumption, which also
constitutes increase in income. However, greater the MPC, greater will be the increase in income.

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13. Tax multiplier
We know that a tax increase results in a decline in income. In other words, it is contractionary in effect. An
increase in tax (∆T) leads to a decrease in income (∆Y). The ratio of ∆Y/∆T, called the tax multiplier, is
designated by KT Thus,
KT = ∆Y/∆T, and ∆Y = KT. ∆T
Again, how much national income would decline following an increase in tax receipt depends on the value of
MPC. The formula for KT is

Thus, tax multiplier is negative and, in absolute terms, one less than government spending multiplier. If MPC
= 3/4 then the value of KT = (-3/4)/(1-3/4)= -3, an increase in taxes of Rs. 20 crore results in a decline of
income of Rs. 60 crore. That is to
-60 = (-3/4)/(1-3/4)
In contrast, with an MPC = 3/4, the value of KG = 4. Assume an increase in government expenditure of Rs. 20
crore. Applying the formula for KG, we obtain

Thus, KT is negative and its value is one short of K, or KG.

14. Balanced Budget multiplier

A one unit increase in government expenditure matched by an equal one unit increase in tax increases the
equilibrium level of national income by one unit. This interesting result is known as Balanced Budget
multiplier (MMB) and can be explained with the help of following model –
We have already considered the independent effects of government spending and taxes on national income.
Now we will consider the combined effects of government spending and taxes on national income in the light
of balanced budget.
Balanced budget means change in government expenditure is exactly matched by a change in taxes. If
government expenditure and tax receipts increase by the same amount, will national income or output increase
or remain the same?

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Classical economists believed that a balanced budget is neutral in the sense that the levels of output or income
remain unchanged. However, Keynes and his followers argued that, in reality, its effect on income will not be
zero or neutral. In other words, we can find out the expansionary effect on national income of a balanced
budget. The expansionary effect of a balanced budget is called the balanced budget multiplier (henceforth
BBM) or unit multiplier. Here an increase in government spending matched by an increase in taxes results in a
net increase in income by the same amount. This is the essence of BBM.
Let us assume an MPC of 0.75. If government expenditure increases by Rs. 20 crore national income would
increase to Rs. 80 crore.
This can be obtained by using the formula for government spending multiplier, KG:

Now, an increase in taxes by the same amount (i.e. Rs. 20 crore) would lead to a reduction in aggregate output of Rs.
60 crores.
Applying the formula for tax multiplier, KT, we obtain:

As a result, the net increase in national income (Rs. 80 – Rs. 60 crore) becomes Rs. 20 crore. Thus, the BBM,
defined as the net increase in income (Rs. 20 crore) caused by an increase in government spending (Rs. 20 crore),
and increase in taxes (Rs. 20 crore) will have a value of 1. This result is known as the balanced budget theorem or
unit multiplier theorem which must have a value of one, no matter whatever the value of MPC.
Balanced Budget multiplier (BBM) =
𝛿𝛿F𝑒 𝛿𝛿F𝑒
+
𝛿𝛿𝐺0 𝛿𝛿𝑇0

1 𝑏
= −
(1−𝑏) (1−𝑏)
1−𝑏
=
(1−𝑏)

=1
Hence, Balanced Budget multiplier is unity.

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Unit – 5 [10 Marks]:
Money Market &Commodity Market

1. Derive the curve indicating everywhere upon itself, equilibrium in the

commodity market [2013]
Equilibrium In Commodity Market
Equilibrium in the commodity market is attained when the aggregate demand for goods equal the
aggregate supply or investment (I) equals savings (S).
If aggregate demand in the economy exceeds the aggregate supply or investment exceeds savings (i.e., I
>S), the level of output, employment and income will have a tendency to expand. Conversely, if the
aggregate demand for goods falls short of the aggregate supply or the investment is less than saving (i.e.,
I < S), the level of output, employment and income will show a tendency to decline.
According to the classical system, the equilibrium in the commodity market is attained by the equality
between saving and investment through adjustment in the rate of interest.
If SS is the saving curve and II is the investment curve. Equilibrium in the commodity market is attained
at point E, where at Or0 is rate of interest, saving and investment are equal to OM0.

In case the market rate of interest (r1) is higher than the equilibrium rate of interest (r 0), then savings (1L)
exceed investment (r1K.). Excessive savings cause a decline in the rate of interest which comes down to
Or0. Conversely, if the market rate of interest (Or 2) is less than the equilibrium rate of interest (Or 0 ), then
investment (r2R) exceeds savings (r2 p). Excessive demand for investment causes an increase in the rate of
interest which rises to OrO.

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2. Discuss Liquidity Preference theory of demand for money.
OR
Discuss the Keynesian theory of demand for money.
Keynes’ Theory of Demand for Money:
In his well-known book, Keynes propounded a theory of demand for money which occupies an important
place in his monetary theory.
It is also worth noting that for demand for money to hold Keynes used the term what he called liquidity
preference. How much of his income or resources will a person hold in the form of ready money (cash or
non-interest-paying bank deposits) and how much will he part with or lend depends upon what Keynes
calls his “liquidity preference.” Liquidity preference means the demand for money to hold or the desire of
the public to hold cash.
Demand for Money or Motives for Liquidity Preference: Keynes’s Theory:
Liquidity preference of a particular individual depends upon several considerations. The question is: Why
should the people hold their resources liquid or in the form of ready money when he can get interest by
lending money or buying bonds?
The desire for liquidity arises because of three motives:
(a) The transactions motive,
(b) The precautionary motive, and
(c) The speculative motive.
(A) The Transactions Demand for Money:
The transactions motive relates to the demand for money or the need for money balances for the
current transactions of individuals and business firms. Individuals hold cash in order “to bridge the
interval between the receipt of income and its expenditure”.
The businessmen and the entrepreneurs also have to keep a proportion of their resources in money
form in order to meet daily needs of various kinds. They need money all the time in order to pay for
raw materials and transport, to pay wages and salaries and to meet all other current expenses incurred
by any business firm.
(B) Precautionary Demand for Money:
Precautionary motive for holding money refers to the desire of the people to hold cash balances for
unforeseen contingencies. People hold a certain amount of money to provide for the danger of
unemployment, sickness, accidents, and the other uncertain perils. The amount of money demanded
for this motive will depend on the psychology of the individual and the conditions in which he lives.
(C) Speculative Demand for Money:
The speculative motive of the people relates to the desire to hold one’s resources in liquid form in
order to take advantage of market movements regarding the future changes in the rate of interest (or
bond prices). The notion of holding money for speculative motive was a new and revolutionary
Keynesian idea.
Money held under the speculative motive serves as a store of value as money held under the
precautionary motive does. But it is a store of money meant for a different purpose. The cash held
under this motive is used to make speculative gains by dealing in bonds whose prices fluctuate.

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3. What is the IS-LM Model?
What is the IS-LM Model?
The IS-LM model, which stands for "investment savings, liquidity money," is a Keynesian
macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable
funds market (LM).
Characteristics of the IS-LM Graph
The IS-LM graph consists of two curves, IS and LM. Gross domestic product (GDP), or (Y), is placed on
the horizontal axis, increasing to the right. The interest rate, or (i or R), makes up the vertical axis. The IS
curve depicts the set of all levels of interest rates and output (GDP) at which total investment (I) equals
total saving (S). At lower interest rates investment is higher, which translates into more total output
(GDP) so the IS curve slopes downward and to the right. The LM curve depicts the set of all levels of
income (GDP) and interest rates at which money supply equals money (liquidity) demand. The LM curve
slopes upward because higher levels of income (GDP) induce increased demand to hold money balances
for transactions, which requires a higher interest rate to keep money supply and liquidity demand in
equilibrium.
The intersection of the IS and LM curves shows the equilibrium point of interest rates and output when
money markets and the real economy are in balance. Multiple scenarios or points in time may be
represented by adding additional IS and LM curves. In some versions of the graph, curves display limited
convexity or concavity. Shifts in the position and shape of the IS and LM curves, representing changing
preferences for liquidity, investment, and consumption, alter the equilibrium levels of income and interest
rates.

4. The product market equilibrium and the IS curve:

The product market is said to be in equilibrium when aggregate demand for output in an economy is just equal to the
aggregate supply of output. Aggregate demand for output is determined by the total expenditure (Say, E) on goods
and services in an during any particular time period.
Y ≡ C + I + G + (X – M)
If X = m or, if (X – M) ≅ 0 then this identity is expressed as
Y≡C+I+G
From the supply side, the basic identity of the national income accounting is:
Y ≡ C + S + T + Rf
Now, if Rf ≅ 0 then we get Y ≡ C + S + T
∴C+S+T≡Y≡C+I+G
Or, S + T ≡ I + G
Assumptions:
1) C = C(Y), where 0 < ∆𝐶 < 1
∆F
Consumption expenditure (C) depends on income (Y), and C rises within increase in Y.
The saving function will be S = S(Y), where 0 < ∆𝑆 < 1
∆F
2) Investment is assumed to be a function of the rate of interest (r), i.e. I = I(r), where ∆𝐼 < 0
∆𝑟
There remains an inverse relationship between the desire investment and the market rate of
interest.
3) Both the tax payments (T) and Government expenditure (G) are assumed to be autonomous in
nature.

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5. Explain diagrammatically how the LM curve shifts with a change in

money supply.
Shifts in the LM Curve:
Another important thing to know about the IS-LM curve model is that what brings about
shifts in the LM curve or, in other words, what determines the position of the LM curve. As
seen above, a LM curve is drawn by keeping the stock or money supply fixed.
Therefore, when the money supply increases, given the money demand function, it will
lower the rate of interest at the given level of income. This is because with income fixed, the
rate of interest must fall so that demands for money for speculative and transactions motive
rises to become equal to the greater money supply. This will cause the LM curve to shift
outward to the right.
The other factor which causes a shift in the LM curve is the change in liquidity preference
(money demand function) for a given level of income. If the liquidity preference function for
a given level of income shifts upward, this, given the stock of money, will lead to the rise in
the rate of interest for a given level of income. This will bring about a shift in the LM curve
to the left.
It therefore follows from above that increase in the money demand function causes the LM
curve to shift to the left. Similarly, on the contrary, if the money demand function for a given
level of income declines, it will lower the rate of interest for a given level of income and will
therefore shift the LM curve to the right.
Effect of Changes in Supply of Money on the Rate of Interest and Income Level:
Let us first consider what will happen if the supply of money is increased by the action of the
Central Bank. Given the liquidity preference schedule, with the increase in the supply of
money, more money will be available for speculative motive at a given level of income
which will cause the interest rate to fall. As a result, the LM curve will shift to the right.

With this rightward shift in the LM curve, in the new equilibrium position, rate of interest
will be lower and the level of income greater than before. This is shown in Fig. 24.4 where
with a given supply of money, LM and IS curves intersect at point E.

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With the increase in the supply of money, LM curve shifts to the right to the position LM’,
and with IS schedule remaining unchanged, new equilibrium is at point G corresponding to
which rate of interest is lower and level of income greater than at E. Now, suppose that
instead of increasing the supply of money, Central Bank of the country takes steps to reduce
the supply of money.
With the reduction in the supply of money, less money will be available for speculative
motive at each level of income and, as a result, the LM curve will shift to the left of E, and
the IS curve remaining un-changed, in the new equilibrium position (as shown by point T in
Fig. 24.4) the rate of interest will be higher and the level of income smaller than before.

6. Discuss, with the help of the IS-LM model, the determination of

equilibrium income and interest rate.

We have two curves, IS and LM, which relate income and the rate of interest. Neither of
them can by itself tell us either the rate of interest or the level of income. We know what the
level of income will be, given the rate of interest, but we cannot say what the rate of interest
will be unless we know the level of income. But by combining the IS and LM curves, we can
determine simultaneously both the rate of interest and income.

By combining the LM and IS curves in a general model in the Fig. 22.5 we get an
understanding of the manner in which the money market and the goods market are linked
together. IS and LM curves intersect at a point where income is OY np and the rate of interest
is O1.

These are equilibrium levels with respect to income and the rate of interest. There are any
number of levels of both income and the rate of interest, i.e., that are compatible with
equilibrium of either S and I alone, or L and M considered alone, but there is only one
unique rate of interest (the interest) and only one unique level of income (the income) that is
consistent with equilibrium in both the monetary and goods sectors.

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The actual level of both income and interest that is consistent with equilibrium in the two
sectors depends on the shape and the level assumed for the LM and IS curves. At the point of
intersection of these curves, the output level (Ynp) and the rate of interest (Oi), are such that
(S + T) and (I + G) are in equilibrium and the demand for money (L) and the supply of
money (M) are also in equilibrium.

7. Define IS curve. Derive and explain the IS curve.

'IS' curve.
The IS curve represents all combinations of income (Y) and the real interest rate (r) such that the market
for goods and services is in equilibrium. That is, every point on the IS curve is an income/real interest rate
pair (Y,r) such that the demand for goods is equal to the supply of goods (where it is implicitly assumed
that whatever is demanded is supplied) or, equivalently, desired national saving is equal to desired
investment.

Derivation of the IS Curve:

Various combinations of interest rates and the levels of income which keep product market in
equilibrium, represent the IS schedule.
The product market equilibrium can be expressed as S(Y) + T = I(r) + G
In the north-west quadrant of Fig. the horizontal summation of I(r) and G schedules results in the I(r) + G
curve. It is negative sloped implying the inverse correlation between the desired investment and the rate
of interest.

In the south east quadrant represents saving function s(y)+t is positively slope as saving is positively
associated with level of income.. In the north west quadrant represents investment function I(r)+G is
negatively sloped due to existence of inverse relationship between investment and interest rate. In the
south west quadrant 45 degree line represents the equality of withdrawal and injection which is essential
for equilibrium of product market.

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At Y0 income level withdrawal are W0. Now for equilibrium of product market injection should be J0
such that W0=J0 which is essential for product market equilibrium.. Injection will be J0 only at interest
rate is r0. Hence for combination (Y0,r0) product market will be in equilibrium.
At higher income Y1 withdrawal is increased up to W1 . For the equilibrium of production injection
should be J0 which is possible if rate of interest is r1 . Now for the combination (Y1, r1) product market
will in equilibrium.. At lower income level Y2 product market will be in equilibrium for the combination
Y2,r2.
The locus of these equilibrium points (Y0,r0,Y1,r1, Y2,r2) provides Is curve which is negatively sloped..
Features of IS curve:
(a) IS curve represents various combinations of income (Y) and interest rate (r), which keeps
product market in equilibrium.
(b) IS curve is negatively sloped.
For product market equilibrium,
�= S(Y) + T
I (r) + G �
An increase in income leads to an increase in saving (withdrawal) in such case
[S(Y) + T�] > [ I (r) + �G��]
Now, for product market equilibrium, investment (injections) should increase which is
possible along with decrease in interest rate (r).
Hence, an increase in income given the value of G & T, is associated with a decrease in
interest rate (r). So, IS curve is negative sloped.
By total differentiation of equation (i)
I`(r). dr = S`(Y).dy [G & T are constant, dG = dT = 0]

𝑆`(𝑌)
𝐼`(𝑟)
∴ 𝑆`(𝑌) > 0 𝑎𝑛𝑑 𝐼`(𝑟) < 0
𝑑𝑟
∴ <0
𝑑𝑦
Hence, slope of IS curve (𝑑𝑟) is negative.
𝑑𝑦
(c) Slope of IS curve depends on slope of investment function. If investment expenditure is
relatively interest elastic then IS curve will relatively flatter whereas it will be relatively
steeper if investment is interest inelastic. If investment expenditure is perfectly interest elastic
[I`(r) = 0] then IS curve will be vertical (𝑑𝑟= ∞)
𝑑𝑦
If investment expenditure is perfectly interest inelastic [I`(r) = ∞] then IS curve will be
horizontal i.e. [𝑑𝑟 = 0]
𝑑𝑦
(d) Slope of IS curve also depends on slope of saving function. If slope of saving function
relatively higher than IS curve will be relatively steeper. on contrary IS curve will be flatter if
slope of saving function is relatively low.

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(e) The position of IS curve depends on the value of government expenditure (G) and taxes (T).
Given the value of T an increase in government expenditure (G) leads to rightward shifting of
IS curve. IS curve shifts leftward along the decrease in government expenditure (G).
Given the value of G an increase in taxes (T) leads leftward shifts of IS curve whereas it
shifts rightward along with fall in taxes (T).

8. Define LM curve. Derive and explain the LM curve

LM curve.
The LM curve, "L" denotes Liquidity and "M" denotes money, is a graph of combinations of
real income (Y), and the real interest rate (r), such that the money market is in equilibrium
(i.e. real money supply = real money demand).
In macroeconomics, the LM curve is the liquidity preference and money supply curve, and it
shows the relationship between real output and interest rates.
Derivation of the LM Curve:
The money market is said to be in equilibrium when the aggregate demand for money is equal to the
supply of money within the economy.
The demand for money is the demand to hold a stock of money balance. The real value of money is the
nominal value of money divided by the price index (𝑀). Thus, real demand for money is termed as
𝑃

demand for real balances. The demand for money is a demand for the real balances because people hold
money primarily because if functions as a median of exchange and as a store of value.
Keynes considered three motives for holding money viz, the transaction demand, the precautionary
demand and the speculative demand for money.
The transaction demand refers to people’s desire to hold money to meet the day to day transactions
expenditure. It is assumed that this transaction demand for money in an economy is an increasing function
of national income. The specific form of this transaction demand for money is –
M1 = k.Y, where K>0
[or, M1 = L1(Y)]
Keynes believed that money is also held to guard against unforeseen emergencies in future. Money held
for this motive, is termed as the precautionary demand for money. Keynes believed that the precautionary
demand for money depends positively on income.
The final motive for holding money that Keynes considered was the speculative motive. Money
demanded to enjoy any windfall gain through the changes in the prices of bond and securities, is called
the speculative demand for money.Thus, as r increases the bond-price falls and the speculators purchase
more of bonds leading to a fall in their speculative demand for money M2 or the speculative balance.
When r falls and Bp rises, the speculators would sell more bonds and their speculative balance or the
speculative demand for money increase. The speculative demand function can be stated as follows
M2 = L2(r)

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The total demand for money (Md) will be Md = L1(Y) + L2(r) = L(Y, r)
The total supply of money (Md) or the supply of real balance is assumed to remain fixed and determined
by the monetary authority of the country.
�
Thus, Ms = 𝑀 is exogenously given
𝑃

The money market is said to be in equilibrium when

Ms = Md
�
Or, 𝑀 = L (Y) + L (r) ........... (2)
1 2
𝑃

Now, different combinations of Y and r, as shown in equation (2), which keep the money market in
equilibrium, give rise to the LM curve.

In the south east quadrants demand for active balances M1 is positively sloped. In the north west
quadrants speculative demand for money M2 is negatively sloped. In south west quadrants
money supply curve m/p × m/p makes an angle of 45 degree with each axis and having an equal
intersect because of its geometrical nature M1+M2 =m/p which is essential for the equilibrium of
money market.

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At Y0 income level demand for active balances(M1) is a0. Now for the equilibrium of money
market speculative demand for money (M2) should be b0 which is possible if rate of interest is
r0. Now for the combination (Y0, r0) money market will be in equilibrium. At higher income
level Y1 demand for active balances (M1) increase up to a1 . Now for money market equilibrium
M2 should be reduce up to b1 which is possible at higher interest rate r1. Hence for the
combination ( Y1, r1) money market will be again in equilibrium. Similarly at lower income
level Y2 money market will be again in equilibrium for the combination ( Y2,r2).
The locus of these equilibrium points ( Y0,r0,Y1,r1,Y2,r2) provide LM curve which is positively
sloped.

9. Money Market Equilibrium in an Economy

Equilibrium in the Market for Money
The money market is the interaction among institutions through which money is supplied to individuals,
firms, and other institutions that demand money. Money market equilibrium occurs at the interest rate at
which the quantity of money demanded is equal to the quantity of money supplied. Figure 1 shows
"Money Market Equilibrium" combines demand and supply curves for money to illustrate equilibrium in
the market for money. With a stock of money (M), the equilibrium interest rate is r.

Figure 1
The market for money is in equilibrium if the quantity of money demanded is equal to the
quantity of money supplied. Here, equilibrium occurs at interest rate r.

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10. Features of LM curve:

(a) LM curve represents various combination of income Y and interest r which keep money
market in equilibrium.

(b) LM curve is generally positively sloped.

For money market equilibrium.
�
�and P are given. ... (i)]
L (Y) + L (r) = 𝑀, [Where 𝑀
1 2
𝑃
An increase in income Y leads to an increase in the transaction demand for money (M 1). Given the
money supply for money market equilibrium speculative demand for money (M 2) should be reduce
which is possible with an increase in interest rate r. Here, r and Y vary in same direction. So, slope of
LM curve is positive.
By total differentiation of equation (i)
�
L` (Y). dY + L` (r).dr = 0 [Since m = constant, ∵ dm = 0 & m = 𝑀 ]
1 2
𝑃
L`2(r).dr = - L`1(Y).dy
𝑑𝑟
, 𝑑𝑌 = (-) 𝐿′1 (y)
𝐿′2 (r)
Since, L`1(Y)> 0 & L`2(r) < 0, r min< r < r max
𝑑𝑟
> 0
𝑑F
Hence, LM curve is positively sloped.

(c) The slope of the LM curve depends on the interest elasticity of demand for money. If demand for
money is interest elastic than LM curve will be flatter whereas it will be steeper, if demand for money
is interest inelastic.

(d) LM curve shifts to the right with an increase in quantity of money M and vice-versa.

(e) LM curve shifts left with an increase in price level and vice-versa.

(f) LM curve shifts left with an increase in transaction demand for money M1 and vice-versa.

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11. If autonomous investment increases, how is the IS curve affected?

Discuss its overall impact on equilibrium income and rate of interest.

Shift in IS Curve:
It is important to understand what determines the position of the IS curve and what causes
shifts in it. It is the level of autonomous expenditure which determines the position of the IS
curve and changes in the autonomous expenditure cause a shift in it. By autonomous
expenditure we mean the expenditure, be it investment expenditure, the Government
spending or consumption expenditure which does not depend on the level of income and the
rate of interest.
The government expenditure is an important type of autonomous expenditure. Note that the
Government expenditure which is determined by several factors as well as by the policies of
the Government does not depend on the level of income and the rate of interest.
Similarly, some consumption expenditure has to be made if individuals have to survive even
by borrowing from others or by spending their savings made in the past year. Such
consumption expenditure is a sort of autonomous expenditure and changes in it do not
depend on the changes in income and rate of interest. Further, autonomous changes in
investment can also occur.
In the goods market equilibrium of the simple Keynesian model the investment expenditure
is treated as autonomous or independent of the level of income and therefore does not vary as
the level of income increases. However, in the complete Keynesian model, the investment
spending is thought to be determined by the rate of interest along with marginal efficiency of
investment.
Following this complete Keynesian model, in the derivation of the IS curve we consider the
level of investment and changes in it as determined by the rate of interest along with
marginal efficiency of capital. However, there can be changes in investment spending
autonomous or independent of the changes in rate of interest and the level of income.
For instance, growing population requires more investment in house construction, school
buildings, roads, etc., which does not depend on changes in level of income or rate of
interest. Further, autonomous changes in investment spending can also take place when new
innovations come about, that is, when there is progress in technology and new machines,

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equipment, tools etc., have to be built embodying the new technology.
Besides, Government expenditure is also of autonomous type as it does not depend on
income and rate of interest in the economy. As is well- known government increases its
expenditure for the purpose of promoting social welfare and accelerating economic growth.
Increase in Government expenditure will cause a rightward shift in the IS curve.

Here due to increase in government expenditure the IS curve will shift to the right from
IS0 to IS1.
As investment is a component of AD, increase in investment at a given interest rate i1 will
lead to shift in AD curve.
AD curve shifts parallel upwards to AD2
Y = AD at point E2 at same interest rate → i1
... Income level increases to Y2
Point E2 corresponds to a point on the new IS curve (IS1)
Thus, due to increase in A, the IS curve shifts to the right.

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12. Monetary policy and its tools.

Monetary policy
By ‘Monetary policy’ we mean any policy which affects the quantity of money in circulation in the
economy or the cost of the use of money i.e., the rate of interest..
Monetary policy consists of the process of drafting, announcing, and implementing the plan of actions
taken by the central bank, currency board, or other competent monetary authority of a country that
controls the quantity of money in an economy and the channels by which new money is supplied.
Monetary policy consists of management of money supply and interest rates, aimed at achieving
macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. These are
achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating
foreign exchange rates, and changing the amount of money banks are required to maintain as reserves.
Tools of monetary policy:
There are various instruments or tools at the disposal of the monetary authorities. These are broadly of
two types: quantitative and qualitative. Changing the supply of notes and coins in circulation is the most
obvious method of changing the supply of money. This can be described as a quantitative method because
it directly changes the quantity of money. The control of bank credit is the most vital part of the monetary
policy of any country.
There are three methods of quantitative credit control:
a) Changes in the bank are;
b) Open market operations; and
c) Variable reserve ratio.
There are two methods of qualitative credit control:
a) Selective credit control; and
b) Moral suasion.

13. Fiscal policy and its tools

Fiscal policy
Fiscal policy means the set of policies that deal with the revenue expenditure process of the Government.
Any policy that affects either the revenue or the expenditure of the Government falls under the category
of fiscal policy.
Tools of fiscal policies:
The fiscal policy refers to the budgetary policy of the government of any country. The principal tools of
fiscal policy are Government expenditure (G) and taxes (T) imposed by the Government.

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14. Discuss, with the help of the IS-LM model, the effectiveness of fiscal
policy in increasing national income.
The impact of the fiscal policy and its effectiveness in raising the national income can be analysed under
the IS – LM framework. If there is an increase in Government expenditure (G), there will be a rightward
shift in the IS curve. The IS curve would be steeper when investment is relatively interest-inelastic.

Fig – a Fig – b Fig – c

Fig (a) to (c) show that the IS curve has shifted in the rightward direction from IS 0 to IS1. This has
happened, say, due to an increase in the Government expenditure. This rise in G has directly increased the
aggregate demand and has caused an increase in Y. this rise in Y leads to an increase in the transaction
demand for money in the money market. However, given the supply of money, the money market
equilibrium requires a fall in the speculative demand for money, and hence, an increase in the interest
rate. Thus, given the LM curve, a rightward shift in the IS curve has led to an increase in the equilibrium
values of both Y and r as shown in Fig (a) to (c). The Fiscal policy becomes most effective in raising the
Y when the IS curve is vertical. [Shown in Fig (c)]
The expansionary fiscal policy is more effective in raising the equilibrium level of Y when the IS curve is
relatively steeper as shown in Fig (a). It is less effective when the IS curve is relatively flatter [Fig (b)]
implying higher interest elasticity of investment.
The effectiveness of the fiscal policy also depends upon the slope of the LM curve. The Slope of the LM
curve depends most crucially on the interest-elasticity of money-demand.

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Fig – d Fig – e Fig – f

LM becomes relatively flatter when the speculative demand for money is relatively interest-elastic in
nature. It would be steeper as the money demand becomes relatively interest-inelastic. The LM curve
becomes vertical when the demand for money is completely interest-inelastic. The expansionary fiscal
policy, which cause a rightward shift in the IS curve, leads to an increase in Y. When the LM curve is
relatively flat [as shown in Fig – (d)], implying high interest-elasticity of money demand, the
expansionary fiscal policy becomes more effective in raising the equilibrium level of income.

When the LM curve is relatively steep [as shown in Fig (e)] which implies relatively interest-inelastic
money-demand, the expansionary fiscal policy is less effective. It is important to note in this connection
that the fall in the private investment expenditure associated with an increase in the interest rate caused by
fiscal expansion, is called the crowing out effect. This crowing out effect is maximum when the money
demand is completely interest inelastic and the LM curve is vertical [as shown in Fig (f)]. In this case, the
expansionary fiscal policy is completely ineffective in raising the output level.

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15. Discuss, with the help of the IS-LM model, the effectiveness of
Monetary Policy in increasing national income.
Monetary authority of a country can influence the aggregate level of output through its monetary policy
instruments. It can raise the stock of money which leads to an excess supply of money in the economy.
Now, given the level of income, the transaction demand for money would remain unchanged.
Hence, to restore money market equilibrium, the speculative demand should rise and this requires a fall in
the interest rate. It leads an increase in the investment expenditure, and hence, the output level.

Fig – a Fig – b Fig – c

Thus, increase in aggregate expenditure can create excess demand condition in the economy and leads to
higher level of output. Thus, with an increase in the stock of money, the LM curve shifts in the rightward
direction, and this result in higher level of equilibrium output and a lower level of equilibrium interest
rate.
The effectiveness of the monetary policy in raising the national output depends upon the slope of the IS
curve. A relatively steep IS curve reflects low interest elasticity of investment demand. Monetary policy
affects national income by lowering the interest rate, and stimulating the investment expenditure. If
investment expenditure is relatively interest-inelastic, the effectiveness of the monetary policy would be
limited. In Fig (a), the IS curve is relatively steep, and as the LM curve shifts in the rightward direction
from LM0 to LM1 due to an increase in authority, national output increases by a small amount (Y0Y1).
Thus, the monetary policy is not very effective in raising national output in this situation. In Fig (b), the
IS curve is relatively flat, implying greater interest-elasticity of demand; and in that case, the monetary
policy is more effective in raising the output level. If the IS schedule is vertical, implying complete
interest-inelasticity of investment expenditure, the monetary policy becomes completely ineffective in
raising the national output [as shown in Fig (c)].

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Fig – d Fig – e Fig – f

The effectiveness of the Monetary policy also depends on the slope of the LM schedule. If interest
elasticity of money demand is relatively high then the LM curve becomes relatively flat. If the money
demand is relatively interest-elastic, then a small drop in the interest rate can raise the demand for money
to the required level so that equilibrium is restored in the money market. This small drop in the interest
rate would mean a little increase in the investment expenditure. So, income will also rise by a small
amount [as shown in Fig (d)]
Monetary policy would be more effective when the LM curve is relatively steep, implying relative
interest-inelasticity of money demand [as shown in Fig (e)]. The monetary policy is most effective when
the LM curve is vertical as shown in Fig (f).

16. Examine how far fiscal policy is more effective than monetary policy in
combatting a recessionary situation.
Fiscal policy
Fiscal policy determines the way in which the central government earns money through taxation and
how it spends money. To assist the economy, a government will cut tax rates while increasing its own
spending; to cool down an overheating economy, it will raise taxes and cut back on spending.
Monetary policy
Monetary policy involves the management of the money supply and interest rates by central banks. To
stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to
borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can
implement a tight monetary policy by raising interest rates and removing money from circulation.

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How far fiscal policy is more effective than monetary policy
The aims of fiscal and monetary policy are similar. They could both be used to:
 Maintain positive economic growth
 Aim for full employment
 Keep inflation low
The principal aim of fiscal and monetary policy is to reduce cyclical fluctuations in the economic cycle. In
recent years, governments have often relied on monetary policy to target low inflation. However, in
recessions, there are strong arguments for also using fiscal policy to achieve economic recovery.
(a) Fiscal policy involves changing government spending and taxation. It involves a shift in the
government's budget position. e.g. Expansionary fiscal policy involves tax cuts, higher
government spending and a bigger budget deficit. Government spending is a component of AD.
(b) Expansionary fiscal policy can directly create jobs and economic activity by injecting demand
into the economy. Keynes argued expansionary fiscal policy is necessary in a recession because
of the excess private sector saving which arises due to the paradox of thrift. Expansionary fiscal
policy enables unused savings to be used and idle resources to be put into work.
(c) In a deep recession and liquidity trap, fiscal policy may be more effective than monetary policy
because the government can pay for new investment schemes, creating jobs directly – rather
than relying on monetary policy to indirectly encourage business to invest.
(d) Government spending directly creates demand in the economy and can provide a kick-start to
get the economy out of recession. Thus in a deep recession, relying on monetary policy alone,
may be insufficient to restore equilibrium in the economy.
(e) In a liquidity trap, expansionary fiscal policy will not cause crowding out because the
government is making use of surplus saving to inject demand into the economy.
(f) In a deep recession, expansionary fiscal policy may be important for confidence – if monetary
policy has proved to be a failure.

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12. Differentiate Demand Pull Inflation & Cost-push Inflation

From theoretical point of view differences between demand-pull inflation and cost-push inflation arestated
below –
DEMAND-PULL INFLATION DEMAND-PUSH INFLATION
(a) Considering aggregate supply of the (a) Increasing tendency in general price level due
commodities in the economy unchanged, to increase in cost of production (especially
Increase in aggregate demand in the economy wage cost) of the firms as a whole results in
creates excess demand that leads to a rising cost-push inflation.
price tendency generally called demand-pull
inflation.
(b) In case of demand-pull inflation producers are (b) But due to increase in cost of production,
encouraged to increase their production. In producers are highly discouraged to conduct
such a situation demand for the factors are their production process as usually due to low
increased which leads to increase in factor profitability. It leads to a reduction in total
prices. production and hence total supply of
commodities also reduced.

(c) Under demand-pull inflation existence of full (c) But in case of cost-push inflation existence of
employment of resources is an important full employment is not an important condition.
criterion.
(d) Under demand-pull inflation, it is assumed that (d) On the other hand, under cost-push inflation
cost of production remained unchanged. aggregate demand for the commodities in the
economy assumed to be fixed.
(e) Diagrammatically demand-pull inflation can be (e) On the other hand, cost-push inflation can be
explained with the help of rightward shift in the explained with the help of leftward shift in
aggregate demand curve keeping aggregate aggregate supply curve with unchanged
supply curve unchanged. aggregate demand schedule.
(f) Under demand-pull inflation excess demand for (f) On the other hand, in case of cost-push
commodities pulls up the price level from inflation higher cost of production pushes the
above. Due to this it is termed as demand-pull general price level up. Due to this such an
inflation. inflationary situation is termed as the cost-push
inflation.
(g) Demand-pull inflation may lead to galloping (g) On the other hand, cost-push inflation may lead
inflationary situation if not checked at the to economic stagflation in the economy if not
initial stage. properly controlled.
(h) In case of demand-pull inflation both fiscal and (h) But, in case of cost-push inflation neither fiscal
monetary measures are effective to check nor monetary measures but the other measures
inflationary pressure. are effective to check inflationary pressure.

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