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Director : Dr. Prof.

Harsh Gandhar
Course Coordinator : Mrs. Sangeeta Malhotra
Course Leader/Prepared by : Dr. Prof. Harsh Gandhar
(Honorary)
M.A. ECONOMICS, SEMESTER – I
MACRO ECONOMICS
PAPER : I, MAECO - 102
 Introductory Letter (i)
 Syllabus (ii)
CONTENTS
L. No. Topics Author Pages
Unit -I

1 Introduction to Macro Economics Vipul Gupta 1

2 Classical Economics Vipul Gupta/ Harsh 6
Gandhar
3 Say's Law in Classical Market Poonam Gupta 22

4 Keynesian Economics Poonam Gupta / 33

Vipul Gupta

5 Classical & Keynesian Poonam Gupta / 48

Vipul Gupta

6a Wage Price Flexibility : An Introduction Vipul Gupta 61

6 Wage Price Flexibility Vipul Gupta 71

Unit -II

7 Consumption Function Vipul Gupta 85

8 Theories of Consumption Function Vipul Gupta 99

9 Consumption under Uncertainty Vipul Gupta 116

Unit -III

10 Investment in Economics Vipul Gupta 129

11 Theories of Investments Vipul Gupta 142
12 Investment Under Uncertainty Vipul Gupta 163
2

Unit -IV

13 What is Money Vipul Gupta 175

14 Supply of Money Poonam Gupta 186

15 Demand for Money-I Vipul Gupta / 201

Poonam Gupta

16 Demand for Money-II Vipul Gupta 215

Vetter: Dr. (Mrs.) Harsh Gandhar (Honorary)

E-Mail of Department : coordeco@pu.ac.in

Contact No. of Department : 0172-2534326

(i)
3

INTRODUCTORY LETTER

Dear Distance Learner

Welcome to Semester I of M.A. Economics Programme. The second core paper (or
course) of MA (Eco) Sem. I is titled Macro Economics-I. This branch of knowledge, as you
must be aware, deals with aggregates and, establishes the functional relationship between
large body of empirical economic knowledge. This study of Macro Economics is very
important for an economy as it is specialized in the functional analysis of various parameters
and variables. Hope this paper will broaden your understanding of topics and help you
understand the phenomena in daily life. Do not forget to consult ten year paper, references
given at the end of syllabus; and to attempt assignment.

Please see CDOE e-notice board regularly to check related details.

Course Leader
(Honorary)
Note :
1. Information regarding Assignments and PCP schedule is available in the Prospectus.
2. PCP attendance must not be less than 75 percent in any case. So do not miss classes and
fill google form daily.
3. Feedback is essential. So fill the form at the end of PCP.
4
(ii)

Semester I
PAPER- MAECO-102: MACRO ECONOMICS-I

Max. Marks : 100

Theory : 80 Marks
Internal Assessment : 20 Marks
Time : 3 Hours
Teaching Hours : 50
Objective:

Macroeconomics or aggregative economics analysis establishes the functional relationship

between the large aggregates. The aggregate analysis has assumed such a great
significance in recent times that a prior understanding of macroeconomic theoretical
structure is considered essential for the proper comprehension of the different issues
and policies. Macroeconomics now is not only a scientific method of analysis; but also a
body of empirical economic knowledge.
The paper entitled “Macro-Economics-I” equips the students at the postgraduate level to
understand systemic facts and latest theoretical developments for empirical analysis.
The students would be evaluated at the end of each semester through subjective type
questions/answers (both short and essay type). The scripts would be evaluated by the
examiners having adequate postgraduate teaching experience in the paper/option
concerned.

Pedagogy of the Course Work:

The course relies on a combination of lectures, solving problems, and discussing of
academic articles or real-life situations. Teacher will assign topic for assignments on
contemporary themes and issues from the syllabi. Special tutorials/contact hour for one-
to-one student-teacher interactions.

INSTRUCTIONS FOR THE PAPER-SETTER AND CANDIDATES:

1. The syllabus of this paper has been divided into four units.
2. There shall be 9 questions in all.
3. The first question, which would be compulsory, shall be short answer type (word
limit 25-30 each). It would carry 15 short questions, spread over the entire syllabus.
The candidate will be required to attempt any 10 short answer type questions. Each
short answer type question would carry 2 marks (10 × 2 = 20).
4. Rest of the paper shall contain 4 units. Each unit shall have two questions and the
candidates shall be required to attempt one question from each Unit— 4 in all. Each
question shall carry 15 marks (15 × 4 = 60).
(iii)
5

UNIT-I
(Fundamental Theories of Income and Employment Determination)
Income and Employment Determination: Integrated Classical and Keynesian Models of
Income and Employment Determination; commodity, money (including bond market of
Keynes), and labour markets.
Wage-Price Flexibility and Automatic Full Employment: Classical Versus Keynesian
Approach.

UNIT-II
(Consumption Theories)
Consumption and Consumption Function: Keynes Consumption and saving functions
under Psychological law of consumption, Consumption Puzzle: Absolute Income
hypothesis, Relative Income hypothesis, Permanent Income hypothesis and Life Cycle
Hypothesis.
Consumption under Uncertainty: Random Walk Hypothesis; Interest Rate and Saving;
Consumption and Risky Asset: Consumption CAPM.

UNIT-III
(Investment Theories)
Investment and Investment Function: Type of Investment, Role of investment using
Investment Multiplier, Classical and Keynesian Theories of Investment, Accelerator
Theory of Investment, Neo- Classical Theory of Investment, and Tobin’s-q Theory of
Investment. Effects of Uncertainty, Kinked and Fixed Adjustment Costs, Investment in
the Housing Market.

UNIT-IV
(Money Supply and Demand)
Supply of Money: Theoretical Debate and Empirical Attempts to define money;
Components of Supply of Money, Credit Creation by Commercial Banks, Money
Multiplier.
Demand for Money: Classical Quantity Theory, Keynesian Theory, Baumol and Tobin’s
Contributions. Friedman’s Restatement of Quantity Theory of Money.

CLASSICAL THEORY OF EMPLOYMENT AND OUTPUT

DETERMINATION
Structure

2.0 Objectives
2.1 Introduction
2.2 Say's Law of Markets
2.3 Wage - Price Flexibility
2.4 Unemployment and its types
2.4.1 Frictional Unemployment
2.4.2 Seasonal Unemployment
2.4.3 Cyclical Unemployment
2.4.4 Structural unemployment
2.4.5 Technological Unemployment
2.4.6 Voluntary Unemployment
2.4.7 Involuntary Unemployment
2.5 Concept of Full Employment
2.5.1 The Classical view of Full Employment
2.5.2 Classical unemployment
2.5.3 Keynesian theory of unemployment
2.6 Assumptions of Classical
2.7 Full Employment Classical View
2.8 Classical Model of Output and Employment
2.9 Classical Model without Saving and Investment
2.10 Classical Model with Saving and Investment
2.11 Keynesian view of full employment
2.12 Summary
2.13 Glossary
2.14 References
2.15 Further Readings
2.16 Model Questions
2.0 OBJECTIVES
After going through this chapter you will shall be able to :
 explain Say's Law of Markets
 discuss Wage - Price Flexibility
 describe Unemployment and its types
12

 mention Concept of Full Employment

 view on Full Employment classical View
 explain the making of Classical Model of Output and Employment
2.1 INTRODUCTION
Macroeconomics is of relatively new origin. The foundation of macroeconomics, as a
separate branch of economics, was laid by British economist, John Maynard Keynes (1883-
1946) in his revolutionary book The General Theory of Employment, Interest and Money
(1936). Macroeconomics as you all know is the study of economic aggregates. According to
Prof. P.A. Samuelson, "Macroeconomics is the study of behavior of the economy as a whole. It
examines the overall level of nation's output, employment, prices and money."
The Macroeconomics as a subject developed with the association of two broad theories
namely the Classical theory originated from the work of Pre-Keynesians and the Keynesian
theory originated from the work of J. M. Keynes and his predecessors.
The term "classical economics" was coined by Karl Marx to refer to the classic work of
eminent economists such as David Ricardo and James Mill and their predecessors
specifically in the eighteenth and nineteenth centuries. They developed theories about the
way markets and market economies work. Famous economists of this school of thought
included Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill and J.B. Say.
In the line of notion of classical economists like Adam Smith, Ricardo, Mill, Marshall
and Pigou, the classical theory implies that the economy is self-regulating and self-
sustaining. The fundamental principle of the classical theory is that the economy is self-
regulating. Classical economists observed that the economy is always capable of achieving
the natural level- of real GDP or output, which is the level of real GDP that is obtained when
the economy's resources are fully employed that is there exists a full employment in the
economy.
While many fluctuations arise from time to time that cause the economy to fall below
or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the
market system that work to bring the economy back to the natural level of real GDP. The
classical doctrine- that the economy is always at or near the natural level of real GDP- is
based on two deep rooted beliefs of Say's Law and flexibility of prices, wages, and interest
rates.
2.2 SAY'S LAW OF MARKET
John-Baptiste Say (1767-1832) is one of the most important and insightful thinkers in
the history of economic science. Prof. Say was a major proponent of Adam Smith's self-
directing economic system of competition, natural liberty, and limited government. J.B. Say
was the original supply-sider and documented that production is the source (reason) of
consumption and placed supply over demand in the hierarchy of economics. A person's
ability to demand goods and services from others proceeds from the income produced by his
own acts of production. His level of production determines his ability to demand. Demanding
products requires money which, in turn, requires a prior act of supply. The production of
goods causes income to be paid to those who produce. In other words, a person sells his
labor services or assets for money which he then uses to demand products. In the end, when
exchanges have been affected, it will be found that a person has paid for goods and services
with other goods and services. The demand for any commodity is a function of the supply of
other commodities. Thus, Say's law, or the law of market, is an economic principle of
classical economics. Say's law is based upon the fact that every production of goods also
13

creates incomes equal to the value of goods produced and these incomes are spent on
purchasing these goods. In other words, production of goods itself creates its own purchasing
power. Therefore, Say's law is expressed as - Supply creates its own demand. In other words,
the supply of goods produced creates demand for it equal to its own value with the result
that the problem of general overproduction does not arise. Say's law was generally accepted
throughout the 19th century. Say's Law of Markets, a key component of the classical school
of economics, describes the process through which supplies in general are translated into
demands in general. For Say, the balance between aggregate supply and aggregate demand is
an ex ante identity.
Self Assessment Question

Q. What do you mean by exante Saving?

Ans. ....................................................................................................................................

...................................................................................................................................
....................................................................................................................................

From this perspective, supply equals demand only because of, and to the amount of,
people's demand for other goods. Demand is supply seen from another angle. Because supply
is demand there cannot be an excess of supply over demand. The demand for products can
be said to be rooted in the production of products. Thus, according to Say's Law supply
creates its own demand, i.e., the very act of producing goods and services generates an
amount of income equal to the value of the goods produced. Say's Law can be easily
understood under barter system where people produced (supply) goods to demand other
equivalent goods. So, demand must be the same as supply. Say's Law is equally applicable in
a modern economy. The circular flow of income model suggests this sort of relationship. For
instance, the income created from producing goods would be just sufficient to demand the
goods produced.
(b) Saving-Investment Equality: There is a serious omission in Say's Law. If the
recipients of income in this simple model save a portion of their income, consumption
expenditure will fall short of total output and supply would no longer create its own demand.
Consequently there would be unsold goods, falling prices, reduction of production,
unemployment and falling incomes. However, the classical economists ruled out this
possibility because they believed that whatever is saved by households will be invested by
firms. That is, investment would occur to fill any consumption gap caused by savings
leakage. Thus, Say's Law will hold and the level of national income and employment will
remain unaffected.
(c) Saving-Investment Equality in the Money Market: The classical economists
also argued that capitalism contained a very special market - the money market - which
would ensure saving investment equality and thus would guarantee full employment.
According to them the rate of interest was determined by the demand for and supply of
capital. The demand for capital is investment and its supply is saving. The equilibrium rate of
interest is determined by the saving-investment equality. Any imbalance between saving and
investment would be corrected by the rate of interest. If saving exceeds investment, the rate
of interest will fall. This will stimulate investment and the process will continue until the
equality is restored. The converse is also true. What Say stated was that the supply of a good
14

constitutes demand for everything that is not that good. Aggregate supply thus creates its
own aggregate demand. Within the context of a free market system, the supply of each
producer makes up his demand for the supplies of other producers. Therefore, in the
aggregate, demand always equals supply and the general overproduction of goods is
meaningless and impossible. According to Say, it was possible to have a surplus or a
shortage of any specific commodity. Production can be misdirected and too much of some
products can be produced for which there is insufficient demand. He said that gluts of
production did not occur through general overproduction, but instead through
overproduction of certain goods in proportion to others which were under produced. Prof. Say
thus admits that there can be short-term gluts of a particular commodity. The market, left to
its own devices, permits such imbalances to be corrected through adjustments of prices and
costs. Any disequilibrium in the economy exists only because the internal proportions of
output differ from the proportions preferred by consumers and not because production is
excessive in the aggregate. It follows that overproduction or a glut can only take place
temporarily when too many means of production are applied to one type of product and not
enough to others. This type of disequilibrium is normally quickly remedied in a free market
economy as market incentives and rational self-interest lead to adjustments in production,
prices, marketing strategies, and so on. People have a rational self-interest in correcting their
errors. According to Prof. Say, savings is beneficial and it is used in the production of capital
goods or in additional production. When production exceeds consumption, the difference is
savings, which goes toward the production of investment goods, which are the basis for
future growth. There will be no deficiency in aggregate demand as long as savings are
reinvested in productive uses. Prof. Say argued that savings searching for profits goes quickly
into investments for production and also contended that money is a neutral mechanism
through which aggregate supply is transformed into aggregate demand. He viewed money as
an intermediate good that enables people to buy. In Say's system, money serves chiefly as a
medium of exchange and was not explicitly identified as a store of wealth. He viewed inflation
as a monetary phenomenon rather than the result of excessive employment and economic
growth. Say viewed interest rates as the price of credit. He understood that market-
determined interest rates perform the function of a market clearing price for money.
2.3 MONEY WAGES AND REAL WAGES
The amount of wages paid in money is called money wages. It is also called nominal
wages. Thus, the total amount of money earned by a person as wages during a certain period
is called money wages. The term real wages refers to wages that have been adjusted for
inflation. This term is used in contrast to nominal wages or unadjusted wages. Real wages
provide a clearer representation of an individual's wages. Thus real wages are wages in terms
of goods and services the money wages will buy.
Real Wage = Money Wage / General Price Level
2.4 TYPES OF UNEMPLOYMENT
In this section, we'll study various types of unemployment :
2.4.1 Frictional Unemployment
Frictional unemployment is the time period between jobs when a worker is searching
for, or transitioning from one job to another. It is sometimes called search unemployment
and can be voluntary based on the circumstances of the unemployed individual. Frictional
unemployment is always present in an economy, so the level of involuntary unemployment is
15

properly the unemployment rate minus the rate of frictional unemployment, which means
that increases or decreases in unemployment are normally under-represented in the simple
statistics. Frictional N unemployment exists because both jobs and workers are
heterogeneous, and a mismatch can result between the characteristics of supply and
demand. Such a mismatch can be related to skills, payment, work-time, location, seasonal
industries, attitude, taste, and a multitude of other factors. New entrants (such as
graduating students) and re-entrants (such as former homemakers) can also suffer a spell of
frictional unemployment. Workers as well as employers accept a certain level of imperfection,
risk or compromise, but usually not right away; they will invest some time and effort to find a
better match. This is in fact beneficial to the economy since it results in a better allocation of
resources. However, if the search takes too long and mismatches are too frequent, the
economy suffers, since some work will not get done. Therefore, governments will seek ways to
reduce unnecessary frictional unemployment through multiple means including providing
education, advice, training, and assistance such as daycare centers.
2.4.2 Seasonal Unemployment
Seasonal unemployment may be seen as a kind of structural unemployment, since it
is a type of unemployment that is linked to certain kinds of jobs (construction work,
migratory farm work). This type of unemployment arises because of the seasonal nature of a
particular productive activity so that people become unemployed during the slack season.
Thus, seasonal unemployment results from seasonal fluctuations in demand. Indian
agriculture is a seasonal operation so that the farmers remain unemployed during off
seasons although they are employed during harvesting and sowing seasons. Another example
for seasonal unemployment is ice-cream sellers as they remain unemployed during winter
seasons. The most-cited official unemployment measures erase this kind of unemployment
from the statistics using "seasonal adjustment" techniques.
2.4.3 Cyclical Unemployment
Cyclical unemployment arises due to cyclical fluctuations in the economy. Thus,
cyclical unemployment relates to the cyclical trends in growth and production that occur
within the business cycle. When business cycles are at their peak, cyclical unemployment
will be low because total economic output is being maximized. When economic output falls,
the business cycle is low and cyclical unemployment will rise. Economists describe cyclical
unemployment as the result of businesses not having enough demand for labor to employ all
those who are looking for work. Advanced capitalist countries have been suffering this type of
unemployment. This type of unemployment greatly increases during recession and
depression. This type of unemployment is due to the fact that the total effective demand of
the community is not sufficient to absorb the entire production of goods that can be
produced with the available stock of capital. Thus, a change in unemployment levels that can
be tied to cyclical economic changes in the market such as recession, recovery, growth and
decline are called cyclical unemployment. The reason for calling this type of unemployment
as cyclical is that it is usually linked to a country's business cycle.
2.4.4 Structural unemployment
Structural unemployment is a form of unemployment resulting from a mismatch
between demand in the labour market and the skills and locations of the workers seeking
employment. Even though the number of vacancies may be equal to, or greater than, the
number of the unemployed, the unemployed workers may lack the skills needed for the jobs;
or they may not live in the part of the country or world where the jobs are available.
16

Structural unemployment is a result of the dynamics of the labour market and the fact that
these can never be as flexible as, e.g., financial markets. Workers are "left behind" due to
costs of training and moving, plus inefficiencies in the labour markets, such as
discrimination or monopoly power. Structural unemployment is hard to separate empirically
from frictional unemployment, except to say that it lasts longer. As with frictional
unemployment, simple demand-side stimulus will not work to easily abolish this type of
unemployment. Structural unemployment may also be encouraged to rise by persistent
cyclical unemployment: if an economy suffers from long-lasting low aggregate demand, it
means that many of the unemployed become disheartened, while their skills become
obsolete. Problems with debt may lead to homelessness and a fall into the vicious circle of
poverty. This means that they may not fit the job vacancies that are created when the
economy recovers.
2.4.5 Technological Unemployment
Technological unemployment is caused by the replacement of workers by machines or
artificial intelligence technology. Thus this type of unemployment is caused by technological
changes or new methods of production in an industry or business. Modern production
process is essentially dynamic where innovations lead to the adoption of new machineries
and inventions thereby displacing existing workers leaving behind as unemployed.
2.4.6 Voluntary Unemployment
The voluntary unemployment is unemployment deliberately chosen by the person
concerned. This could be because of a desire to refrain from work, or because they are
searching for better opportunities. Thus, voluntary unemployment is unemployment that
results when labourers who are able to engage in production choose not to do so. These are
resources (especially labor) that decide to leave one job, often in search of another. The
contrast to voluntary unemployment is involuntary unemployment, in which resources are
forced out of work. In this type of unemployment a person is out of job of his own desire
doesn't work on the prevalent or prescribed wages. Either he wants higher wages or doesn't
want to work at all. It is in fact social problem leading to social disorganization.
Though there have been several definitions of voluntary and involuntary
unemployment in the economics literature, a simple distinction is often applied. Voluntary
unemployment is attributed to the individual's decisions, whereas involuntary unemployment
exists because of the socioeconomic environment (including the market structure,
government intervention, and the level of aggregate demand) in which individuals operate. In
these terms, much or most of frictional unemployment is voluntary, since it reflects
individual search behavior. Voluntary unemployment includes workers who reject low wage
jobs whereas involuntary unemployment includes workers fired due to an economic crisis,
industrial decline, company bankruptcy, or organizational restructuring.
2.4.7 Involuntary Unemployment
In this type of situation the person who is unemployed has no say in the matter. It
means that a person is separated from remunerative work and devoid of wages although he
is capable of earning his wages and is also anxious to earn them. Forms and types of
unemployment according to Hock are.
There remains considerable theoretical debate regarding the causes, consequences
and solutions for unemployment. Classical economics, neoclassical economics argue that
market mechanisms are reliable means of resolving unemployment. These theories argue
17

against interventions imposed on the labour market from the outside, such as unionization,
minimum wage laws, taxes, and other regulations that they claim discourage the hiring of
workers. Keynesian economics emphasizes the cyclical nature of unemployment and
recommends interventions it claims will reduce unemployment during recessions. This theory
focuses on recurrent supply shocks that suddenly reduce aggregate demand for goods and
services and thus reduce demand for workers. Keynesian models recommend government
interventions designed to increase demand for workers; these can include financial stimuli,
publicly funded job creation, and expansionist monetary policies.
2.5 THE CONCEPT OF FULL EMPLOYMENT
In macroeconomics, full employment is a condition where all persons willing and able
to work at the prevailing wages and working conditions are able to work. Thus, full
employment would be the situation where everyone willing to work at the going wage rate is
able to get a job. This would imply that unemployment is zero because if you are not willing
to work then you should not be counted as unemployed. To be classified as unemployed you
would need to be actively seeking work. This does not mean everyone of working age is in
employment. Some adults may leave the labour force, for example, women looking after
children.
However, full employment does not mean that everyone is employed. Some people like
children, old men and physically handicapped people are not able to work as they are not
included in the labour force of the country. Full employment will exist in spite of their not
working. The idle rich though able to work are not willing to work because they get enough
unearned incomes to live. Thus, unemployed are those who are involuntarily idle. They are
able and willing to work but the economy does not provide them jobs. Thus, full employment
is said to exist in the economy even if there is prevailing some amount of frictional and
seasonal unemployment in the economy. Thus, full employment is a state of the economy in
which all eligible people who want to work can find employment at prevailing wage rates.
However, it does not imply 100 percent employment because allowances must be made for
frictional unemployment and seasonal factors.
2.5.1 The Classical view of Full Employment
The classical economists were of the view that in a free competitive economy,
unemployment cannot exist for an indefinite period. If anyone remains jobless for a
considerable period of time, then it can be only due to the fact that he is demanding more
wages than that he is really worth for. They believed that in order to avoid this prolonged
unemployment, the worker should accept wage cuts. The classical economists, however,
admitted that in short period unemployment can exist due to various reasons. For example,
some unemployment may be caused by the introduction of machinery and other labor saving
devices in the factory or it may be due to industrial disputes which lead to temporary
unemployment among the factory workers. Some unemployment can also exist in factories
for a part a year where the work is carried out seasonally. The classical economists always
believed in the existence of full employment in the economy. To them full employment was a
normal situation and any deviation from this was regarded as something abnormal.
According to Pigou, the tendency of the economic system was to automatically provide full
employment in the labour market. Unemployment resulted from the rigidity in the wage
structure and interference in the working of free market system by trade unions. Full
employment exists when everybody who at the running rate of wages wishes to be employed.
Those who are not prepared to work at the existing wage rate are not unemployed in the
18

Pigouvian sense because they are voluntarily unemployed. There is, however, no possibility of
involuntary unemployment in the sense that people are prepared to work but they do not find
work. However, the classical view of full employment is consistent with some amount of
frictional, voluntary, seasonal or structural unemployment.
2.5.2 Classical unemployment
Classical economists suggest that the invisible hand of free markets will respond
quickly to unemployment and underutilization of resources by a fall in wages followed by a
rise in employment. Classical or real-wage unemployment occurs when real wages for a job
are set above the market-clearing level, causing the number of job-seekers to exceed the
number of vacancies. Most economists have argued that unemployment increases the more
the government intervenes into the economy to try to improve the conditions of those without
jobs. For example, minimum wage laws raise the cost of laborers with few skills to above the
market equilibrium, resulting in people who wish to work at the going rate unemployed. Laws
restricting layoffs made businesses less likely to hire in the first place, as hiring becomes
more risky, leaving many young people unemployed and unable to find work. However, this
argument is criticized for ignoring numerous external factors and overly simplifying the
relationship between wage rates and unemployment as other factors may also affect
unemployment.
2.5.3 Keynesian theory of unemployment
Keynesian unemployment, also known as deficient-demand unemployment, occurs
when there is not enough aggregate demand in the economy to provide jobs for everyone who
wants to work. Demand for most goods and services falls, less production is needed and
consequently fewer workers are needed. Wages are sticky and do not fall to meet the
equilibrium level, and mass unemployment results. With cyclical unemployment, the number
of unemployed workers exceeds the number of job vacancies, so that even if full employment
was attained and all open jobs were filled, some workers would still remain unemployed.
Keynesian economists see the lack of demand for jobs as potentially resolvable by
government intervention. They suggested government interventions through deficit spending
a measure to boost employment and demand.
2.6 CLASSICAL ASSUMPTIONS
The classical economics is based upon the following assumptions:
1. There is a state of full employment in the economy.
2. There is always perfect competition prevailing in the product and labor markets.
3. The economy is characterized by the feature of Taissez faire'i.e. it from
government intervention.
4. There exists a say's law in the market economy i.e. 'Supply always creates its
own demand'.
5. There exists a perfect wage -price flexibility in the market economy.
6. Money acts only as a medium of exchange.
2.7 FULL EMPLOYMENT (CLASSICAL VIEW)
Full employment is a condition whereby all the individuals of the economy are willing
to work at the prevailing wages; more specifically full employment is that situation in the
economy which is characterized by the absence of involuntary unemployment. The various
economists also define the situation of full employment as an acceptable level of natural
19

unemployment above 0%. Thus, there may be an existence of surplus labourforce in one
segment of labor markets while other segments may witness shortages which persist as long
as the both the segments get matched and economy reaches the full employment level. Thus,
full employment is always characterized by some part of unemployment in form of friction
like layoffs, strikes and seasonal like season changes. The involuntary part of unemployment
exists because of excess supply of labor over its demand in the market economy.
The British economist of 20th century Prof. William Beveridge stated that 3% of an
unemployment rate is always consistent with full employment. Other economists also
provided that 2% and 3% of unemployment rate is consistent with full employment
depending on the nature of the country, its circumstances and its political priorities. Lord
William Beveridgede fined "full employment as where the number of unemployed workers
equaled the number of job vacancies available. Full employment does not mean that there is
'zero unemployment', but rather that all of the people willing and able to work have jobs at
the current wage rate. Full employment is the quantity of labour employed when the labour
market is in equilibrium".
2.8 THE RELATIONSHIP BETWEEN EMPLOYMENT AND OUTPUT
The classical neutrality proposition implies that the level of real output will be
independent of the quantity of money in the economy. An important ingredient of classical
model is the short run production function which is microeconomic concept stating the
relation between inputs and outputs in the economy. The production may rise in any
economy by making changes in the factors used in the production. The production is
function of factor like labour (N), capital (K) and land (L).
Q = f (N,K,L)
Given the factors of production in an economy any fluctuations in the employment of
factors may either increase or decrease the production. However for the economic system as
a whole, the level of output in the short period varies directly with the input of labor, while
the inputs of capital and natural resources (land) remain constant.
Self Assessment Question
Q.1 Explain Classical concept of fill Employment.
……………………………………………………………………………………………………….
……………………………………………………………………………………………………….
2.9 THE CLASSICAL THEORY OF EMPLOYMENT
According to the classical theory, the determination of the Level of Employment and
Output is as follows (considering simultaneous equilibrium in three markets) :
2.9.1 Labor Market Equilibrium
The classical economists were of the view that there exists flexibility in wages and
prices in the economy which always leads to full employment situation. The stability through
full employment situation is achieved with the interaction of demand for labor and supply of
labor. The basic contention of the classical economists is that the wages are measured in real
terms. The demand for labor is downward sloping curve which means increase in labor would
decrease the real wage of labor whereas supply curve of labor is upwardly sloping implying
that with increase in labor would increase the real wage rate.
In the following figure the equilibrium wage rate (wo) is determined by the demand for
and the supply of labour. The level of employment is OLo.
20

Fig 2.1 Determination of Level of Employment

The lower panel of the diagram shows the relation between total output and the
quantity of the variable factor (labour). It shows the short-run production function which is
expressed as
Q = f(K, L),
Where, Q, is output,
K is the fixed quantity of capital and
L is the variable factor labour. Total output
Qo is produced with the employment of Lo units of labour. According to classical
economists this equilibrium level of employment is the full employment level. So the
existence of unemployed workers was a logical impossibility. Any unemployment which
existed at the equilibrium wage rate (wo) was due to frictions or restrictive practices in the
economy. The classical economists believed that aggregate demand would always be
sufficient to absorb the full capacity output Qo. In other words, they denied the possibility of
under spending or overproduction. This belief has its root in Say's Law. According to Say's
Law supply creates its own demand, i.e., the very act of producing goods and services
generates an amount of income equal to the value of the goods produced.
2.9.2 Product Market equilibrium
The classical economists stated that the capitalism as a special feature of the market
economy ensuring the equality of saving and investment which is also a cause of full
21

employment. According to them the rate of interest was determined by the demand for and
supply of capital. The demand for capital is investment and its supply is saving. The
equilibrium rate of interest is determined by the saving-investment equality. Any imbalance
between saving and investment would be corrected by the rate of interest. If saving exceeds
investment, the rate of interest will fall. This will stimulate investment and the process will
continue until the equality is restored. The converse is also true.
2.9.3 Money Market Equilibrium
The money market equilibrium is witnessed by the notion of Fisher Quantity theory of
money which states that there is equality of money velocity and price into transactions. The
notion basically put forth that velocity and transactions as constant and implies that with
the increase in money supply the prices also increases as
Where
MV = PT P = prices
M = money T = transactions
V = velocity
Self Assessment
Q. Write equation ( Fishers) of Money Supply

2.9.4 The Interaction Between three Markets

The classical theory is the theory of full employment. It outlines a model which
ensures equilibrium at full employment. The equilibrium levels of aggregate output and
employment are determined by the aggregate production function and the demand and
supply of labour. The aggregate production function postulates a positive relationship
between output and employment. A higher level of output is associated with a higher level of
employment.
Q = f(N)
Where Q denotes the level of output, N is the level of employment and represents the
fixed stock of capital and technology respectively.
The demand function of labour is derived from the aggregate production function. As
employment increases, the output also increases the marginal physical product of labour
(MPL) declines. Marginal physical product of labour curve which incidentally is the demand
curve for labour, will thus have a negative slope. Any business firm, hiring workers, will
provide employment to labour up to an extent where the real wages paid out to the workers
become equal to the marginal physical product of labour. The essential condition for profit-
maximization on the part of a firm, thus, is:
W/P = MPL
Since the demand for labour is determined by the MPL which diminishes with an
increase in output and employment and the real wage (W/P) equals the MPL, the demand for
labour is also a function of real wages DL = f (W/P). The demand function of labour varies
inversely with the real wage rates. On the supply side, it may be pointed out that work
involves strain, exertion and sacrifice of leisure. This makes additional work-load or a large
number of labour-hours quite disagreeable to the workers and is generally known as the
marginal disutility of labour. Unless this disutility of work is neutralized through the
payments of additional real wages, the workers cannot be induced to put in additional labour
input. Thus the supply of labour-hours is related positively to the real wages of the workers.
SL = g (W/P)
22

Fig 2.2 : Determinations of Employment and Output

Given the demand and supply functions of labour, it is possible to determine the
equilibrium level of employment, when the demand for labour gets equalized with the supply
of labour at the equilibrium real wage rate (W/P)0. If the real wage rate (W/P)l is higher than
this equilibrium rate, the labour supply will be in excess of the demand for labour, denoting
a state of unemployment among the workers and initiating a tendency among the workers to
bid down the wages for securing more job opportunities. The decline of real wages will reduce
the unemployment gap and there would be a tendency towards the achievement of
equilibrium at full employment (NO). If the real wage, on the other hand, is lower than the
equilibrium wage rate, say (W/P)2, the employers will like to absorb more workers. But the
workers will be reluctant to take up the jobs offered by the employers, since the disutility of
work is more in proportion to the real wages. Consequently, the employers will have to raise
real wages in order to hire more workers. The equilibrium is determined ultimately at the full
employment level N0. At (W/P)1 real wage rate, there is an unemployment gap equal to AB
which tends to be wiped out by the competition among the workers for more jobs and the
equilibrium at (W/P)0 wage rate is finally determined at N0 full employment level. At a lower
real wage rate (W/P)2, there is an over employment gap equivalent to A1 B1 which denotes a
state of excess demand for labour. This will push up the wage rate and tends it to
approximate to (W/P)0. The equilibrium level of employment NO represents a state of full
employment. It is presumed that all the persons who are willing and able to work at (W/P)0
wage rate have been absorbed, except a very small proportion of the frictionally unemployed
labour force. At (W/P)0 equilibrium real wage rate which is perfectly consistent with the
marginal product of labour, if a certain number of workers are not willing to work, it will
clearly mean that these people do not offer their services voluntarily and the level of
employment existing in the economy denotes full employment of the employable workers. In
the classical system, the unemployment and over-employment gaps tend to be automatically
23

adjusted, over time, through the adjustment mechanism manifest in the wage-flexibility. Any
lapse from full employment, assuming the price level to be unchanged would be easily
overcome in this system through the variations in wage rates.
2.10 CLASSICAL SYSTEM WITHOUT SAVING AND INVESTMENT
The classical system of full employment equilibrium involves adjustments of the
variables in labour market, goods market and money market. The goods market gives the
aggregate production function, which indicates different levels of output at different inputs of
labour, assuming the stock of capital and technique of production to be given in the short
period. The demand for and supply of labour in the labour market determine the equilibrium
level of employment, which in the classical system, always coincides with the state of full
employment. The money market explains the determination of the price level. The supply
function of money determines the price level quite independent of the levels of labour inputs
and output. The functional relationships involved in the three market classical system
without saving and investment are given below:
Q = f(N) .......................................(i)
DL = f(S/P) ................................. (ii)
SL = f(W/P) ............................... (iii)
MV = PQ .................................... (iv)
The classical system of full employment equilibrium not involving the saving and
investment has been shown in Figure 1.3

Figure 2.3 Classical Model

In part (iii) of Figure 2.3, MV is money supply function which is a rectangular
hyperbola, since the quantity theory relation MV = PQ holds all along the curve. It relates the
level of output and price. Given the level of output Q0 (which remains constant by
assumption), there can only be one relevant price level P0. Part (iv) of the figure represents
the price-wage adjustments, (W/P)0 Figure 1.3 Classical System without Saving and
24

Investment represents the equilibrium real wage line which is the locus of different money
wage rates and price levels such that the real wage rate throughout remains the same. Given
this equilibrium real wage rate and the equilibrium price PO there is only one money wage
rate WO consistent with the both. Part (i) of the figure shows the production function which
relates the level of output to the level of the labour inputs, when the stock of capital and
techniques of production are assumed to be given. The production function indicates that the
level of output Q0 corresponds with the level of employment N0. Part (ii) of the figure shows
that the demand function of labour along with labour supply function determines the
equilibrium in the labour market at N0 full employment level with the equilibrium real wage
rate at (W/P)0.
2.11 CLASSICAL SYSTEM WITH SAVING AND INVESTMENT
The classical model we have been discussing is oversimplified because it does not
recognize the processes of saving and investment. We must now recognize that the income
earned is not fully spent for consumption goods; some part of this income is withheld from
consumption, or saved. Clearly, if planned investment spending is not equal to the income
saved, Say's Law is invalidated. Another part of classical theory provides the mechanism that
presumably assures that planned saving will not exceed planned investment. This
mechanism is the rate of interest. Classical theory treated saving as a direct function of the
rate of interest and investment as an inverse function. The rate of interest will fluctuate freely
over the wider range necessary to equate saving and investment. To simplify the exposition of
the classical system, let us assume here that the curve is indeed elastic, so that investment
is relatively responsive to changes in the rate of interest. Small changes will then keep saving
and investment in balance. In other words, the classical analysis so far has been pursued on
the assumption that the community spends away its entire earnings by way of consumption
and no part of it is saved. Saving is one possible trouble spot in the otherwise harmonious
picture of classical system. Saving can make problems in Say's Law. Although, the
Classicalist recognized the existence of saving, they interpreted saving as an alternative way
of spending on capital goods. In their scheme of analysis, all saving is automatically
transformed into investment spending. In this sense, any amount of saving is unlikely to
cause any deficiency in aggregate spending. The basis of this strategic classical notion is the
equilibrating mechanism of the rate of interest, which is supposed to transform savings into
an equivalent amount of investment. The classical system postulates both saving and
investment as the functions of the rate of interest. Saving is assumed as a direct function of
the rate of interest and investment as the inverse function of it and that saving and
investment can be brought into equilibrium by the variations in the rate of interest. Thus in
the classical system we must introduce the following relations: S = f (r) (Saving function) I = f
(r) (Investment function) S = I (Equilibrium in the capital market). Another significant fact in
connection with the above relations is that saving and investment are supposed to be
relatively more interest-elastic so that the volumes of saving and investment change with very
small changes in the rate of interest. An excess of S over I can be offset through a reduction
in the rate of interest. On the opposite, a rise in the rate of interest can restore equality
between them, when investment exceeds saving. The possibility of transforming any level of
saving into equivalent volume of investment through small variations in the rate of interest is
based on the implicit assumption that there are infinite possibilities of new investment in the
economy because, otherwise, the excess of full employment saving over investment will vitiate
Say's Law and permit the economic system to degenerate into secular stagnation. The
classical full employment system with saving and investment can be studied through the
following set of equations:
25

Q = f (N).....................(i)
DL = f(S/P)................(ii)
SL = f(W/P)...............(iii)
MV = PQ...................(iv)
S = f(r).......................(v)
I = f(r).......................(vi)
S = I.........................(vii)
In addition to the four equations (i) to (iv), that we have used to analyzethe classical
system (without saving and investment), we have added a new set of equations (v) to (vii)
which incorporates saving and investment relationship with rate of interest. These two sets
have to be studied quite independently of each other, since the rate of interest and the
division of output between the output of consumption and investment goods seems to be
independent of the factors influencing the size of national output, quantity of money and the
level of wages and prices. However, the impact of S-I inequalities upon the volume of
employment needs to be investigated. Excess of Saving over Investment: If the full
employment ex-ante S exceeds the ex-ante I, it means that expenditure on consumption plus
investment goods falls short of the value of total output. Given the supply of money, the
surplus output can be cleared off the market at lower prices. The fall in price level will push
up the real wage rate assuming the money wages to be given. The increase in real wage rate
will cause an excess of the supply of labour over the demand for it. The appearance of
unemployment will lower the level of output also. The interest rate flexibility will set into
motion the process of adjustment. A fall in interest rate will reduce savings, thereby causing
an increase in consumption expenditure. The investment expenditure will also increase.
Given the supply of money, an increase in aggregate expenditure will raise the demand for
money which will push up the prices resulting in a decline in real wages and a consequent
reduction in the excess supply gap in the labour market. Thus, a reduction in the rate of
interest, initiating a tendency towards equilibrium in the capital market, sets such forces into
action which tend the labour market also towards equilibrium at full employment. Excess of
Investment over Saving, an excess of ex-ante I over S at the prevailing rate of interest will be
an excess of ex-ante expenditure over the value of current output. This will lead to an
increase in the price level. The real wage rate will go down and create a state of excess
demand in the labour market. That would ultimately be chocked off by a rise in the rate of
interest, setting a chain reaction in the money market. Thus, the interest rate flexibility
ensures a state of full employment in the economic system. It follows that classical system
has an inbuilt mechanism in wage and interest rate flexibility which tend it continuously
towards full employment whenever the economy faces certain lapses from full employment.

Self Assessment Question

Q. What is classical Model of Employment? Write all equations
Ans. ..................................................................................................................................
..................................................................................................................................
..................................................................................................................................
26

2.12 SUMMARY
As unemployment and underemployment is caused by deficiency in effective demand,
full employment can be achieved by increasing effective demand. It is possible through an
increase in investment or consumption or both. Hence, full employment can be achieved by
using fiscal policy by governments and also by the monetary measures by the central bank of
a country.
2.13 GLOSSARY
1. Full employment refers to a situation in which every able bodied person who is
willing to work at the prevailing rate of wages is, infact, employed. Alternatively,
it is a situation when there is no involuntary unemployment.
2. Classical economic theory is rooted in the concept of a laissez-faire economic
market. A laissez-faire—also known as free—market requires little to no
government intervention. It also allows individuals to act according to their own
self interest regarding economic decisions.
3. Real GDP is a measurement of economic output that accounts for the effects of
inflation or deflation. It reports the gross domestic product as if prices never
went up or down, which gives a more realistic assessment of growth. Otherwise,
it could seem like a country is producing more when it's only that prices have
gone up.
4. Nominal GDP includes both prices and growth, while real GDP is pure growth.
It's what nominal GDP would have been if there were no price changes from the
base year. As a result, nominal GDP is usually higher.
5. Saving is income not spent, or deferred consumption. Methods of saving
include putting money aside in, for example, a deposit account, a pension
account, an investment fund, or as cash. Saving also involves reducing
expenditures, such as recurring costs.
6. An investment is an asset or item that is purchased with the hope that it will
generate income or will appreciate in the future. In an economic sense, an
investment is the purchase of goods that are not consumed today but are used
in the future to create wealth.
2.14 REFERENCES
 Dernburg T.E and McDougall D.M.(1986). Macroeconomics. Pergamon Press. Oxford
 Rana K.C. and Verma K.N. (2014). Macroeconomics. Vishal Publishing Company.
Eleventh edition.
 Dwivedi, D.N. (2011). Macroeconomics. Tata McGraw Hill Publication, New York.
2.15 FURTHER READINGS
 Ackley, G. (2018). Macroeconomic theory. Pergamon Press Oxford.
 Shapiro, E. (2009). Macroeconomic analysis. Third edition edwardshapiro
macroeconomics free download pdg. pdf
 Branson, W.H.(1989). Macroeconomic Theory and Policy. Third edition. Harper collins
2.16 MODEL QUESTIONS
1. Derive demand and supply curve of labour under classical economics.
2. Critically examine the classical theory of income and employment in detail.
3. Discuss the classical theory of employment and also explain its limitations.
27

Lesson-3

SAYS LAW OF MARKETS

Structure
3.0 Objectives
3.1 Introduction
3.2 Statement of Say's Law
3.3 Assumptions of Say's Law
3.4 Working of Say's Law
3.4.1 Further Explanation
3.4.2 Impact of Saving on Employment
3.5 Modern Versions
3.6 Implications of Say's Law
3.7 Criticism of Say's Law
3.8 Summary
3.9 References
3.10 Further Readings
3.11 Model Questions
3.0 OBJECTIVES
After going through this lesson you shall be able to :
 explain say's law of market alongwith its modern version
 discuss how later economists have criticised Say's version
 describe implications of Say's law
3.1 INTRODUCTION
The previous chapter depicted the functioning of classical model very lucidly. The
Say's law & the major premise of classical tenet of full employment is discussed here in
detail, though it is very much part of the classical model. The concept, its modern versions,
basic assumptions and implications have been discussed along with the major points of
criticism levelled by Keynesian School of thought.
3.2 STATEMENT OF SAY'S LAW
Say's Law as Law of Markets was propounded by French economist J.B. Say in his
book "Traited Economic Politique in 1803. Say seems to have drawn inspiration from Adam
Smith who wrote in his famous work "Wealth of Nations" that economic systems are self
adjusting and the ship of all economies is steered dear of all troubled waters by an 'Invisible
hand' which equates demand with supply.
Similarly Say's Law also postulates that there is no overproduction in the market
stretched to logical conclusion, it would mean that these would not be any unutilised
28

resources, including those of labour. Hence these cannot be unemployment in general. In

other words, full employment is the general order.
3.3 ASSUMPTIONS OF THE SAY'S LAW
The foundations on which this law is built are several assumptions which as the
architects of law supposed, governed the actual working and running of an economy.
These assumptions or essential basis or foundations may be listed as follows:
(i) There exists free competition, Consequently, prices, wages, costs and interest
rate are free to adjust themselves to changing conditions.
(ii) There exists free market system based on price mechanism that tends to
provide a place for population and growing capital.
(iii) There is no break in the flow of income which is automatically spent partly on
consumption on investment (Saving is just another form of spending to be made
on investment goods).
(iv) The size of market is capable of expansion indefinitely.
(v) There is no international influence on the economy i.e. the economy is a closed
economy.
(vi) Savings are equal to investment and are automatically investment. The equality
between S ought about by the changes in the rate of interest.
(vii) Wages are perfectly flexible. There is no factor which interferes with the level of
wages as determined by the unobstructed forces of demand and supply in the
labour market.
3.4 WORKING OF SAY'S LAW
Say's law in a broad way, is a description of free-exchange economy, Classical
economists, chief among them Say, undoubtely, were the architects of the law and the neo
classical economists, particularly Marshall and Plgou, were the faithful inheritors of the law.
J.B. Say said "It is production which creates markets for goods, for selling and at the
same time buying, and in production process men are creating a demand for other goods."
Whenever somebody produces something, he does so in order to exchange his
produces with the products of other people so that he could have a full life. A full life needs
so many things and no single person can ever produce all these things himself. For this, he
has to exchange his own products with the products of other people. In a free-exchange
economy particular commodity that is produced is exchanged for another commodity.
Additional supply is additional demand.
Ricardo, another chief classical economist, put the idea of automatic equation,
between demand and supply lucidly. He says, "No man produces, but with a view to
consuming or selling and he never sells but with an intention to purchase some other
commodity which may be useful to him or which contributes to future production. By
producing, then, he becomes either the consumer of his own goods or the purchaser or
consumer of the goods of some other person". In clearer words of another great classical
economist, James Mill. "Consumption is coexistence with production." Supply generates its
own demand not only at the same time, but also to an equal extent. This generation-and
29

Simultaneous generation at the same time of demand by supply is explained by Say himself
with an example.
Suppose a car is manufactured. The very fact of its production generates an equal
purchasing power to buy the car. The value of the car had already been distributed as
purchasing power in the shape of wages, rent, interest and profits. These were rewards of the
factor of production which have contributed to the production of the commodity and these
constitute purchasing power which would ultimately be spent on purchasing the commodity.
The purchasing power generated by the production of supply of the car may not be spent on
purchasing the car: it may be spent on purchasing some other commodity, but, then
purchasing power generated by production of some other commodity or commodities would
be spent on purchasing the car. The not result would be that no production or supply
remains un-bought in the market. No glut or over-production is possible. Aggregate demand
can never be deficient. The total or aggregate supply of all commodities in the economy,
would be exactly equal to the demand for all the commodities in the economy.
One thing more must be clearly understood, J.B. Say does admit that in the case of a
particular commodity demand may exceed supply or vice versa. But it will be a purely
temporary disequilibrium, and the disequilibrium would be automatically removed, if no
artificial resistances are present in economy. These producers who suffer losses because of
their supply not being lifted in the market, will shift to the production of a commodity which
is not in supply. Hence the balance or the equilibrium would be resorted. It may thus be
noted that there may be disequilibrium in case of the production of a particular commodity.
But this is only temporary. As far as the general disequilibrium in the economy is concerned,
that can never happen.
3.4.1 Important Concepts and Further Explanation
The classical model of employment tries to prove that unless there is an interference
by the government or the trade unions in the free operation of market forces in the form of
pitching the prevailing wages at a level higher than the one determined by the market forces
of supply and demand for labour, there will always be a full employment in the economy.
Meaning of Full Employment : According to the classicals, full employment in an
economy means a situation where every body who wishes to be employed at a given wage
rate, gets employment. If there are some persons who want a wage higher then the prevailing
wage and would therefore prefer to remain without a job. It will not be considered, as
situation of unemployment. A voluntary unemployment, according to the classicals, is no
employment at all: It will be a situation of full employment if every body willing to work at the
giving wage rate gets the job.
The classical model is based on the analysis of equilibrium in three markets as under:
(i) The labour market: for determination of real wages and the number of workers
employed at that wage.
(ii) The product market: for determining the output produced in the economy by
the employment of workers determined by the equilibrium in the labour market.
(iii) The money market: for determining the level of prices obtained when output
determined in the product market is produced i.e. in market (ii). Besides this
the model at the end tries to determine the money value of real wages as
determined in market. (I) i.e. the money wages, In the light of prices determined
in the money market i.e.: market (iii) In other words the last part of the model
30

tries to link the money market with the labour market (I) In its attempt to show
that equilibrium in each individual market S is clicking with each other. The
model can be explained with the help of following diagram.

CLASSICAL MODEL OF EMPLOYMENT

Fig. 3.1
We start with Fig 3.1(a) It explain the equilibrium in the LABOUR MARKET. SS
and DD represents the supply and demand curve for labour respectively. Both these curves
and in terms of real wages (not money wages):- Wages on Y-axis and number of workers on
X-axis (the money wages if divided by the price level gives real wages i.e. real wages equal to
W/P where W stands for money wage and P stands for the general price level. The two curves
intersect at point E which means that the real wages which actually prevail are OR and at
this wage rate, ON workers are actually employed. Point E obviously is a point of full
employment. If we go by the definition of full employment given above. The number of
workers offering themselves for employment at the prevailing wage rate as well as the
number of workers- employed is ON, i.e. the same in fact, the classical model assumes an
upward sloping supply curve for labour (without an kink) and in such a situation an point of
equilibrium will indicate full employment.
31

According to the classicals, there will be unemployment only if the govt. through its
action or the trade unions are able to get the real wages fixed at a level higher than the rate
actually determined by the force of demand arid supply. For example, if the real wages are
artificially fixed at say OK. At this wage rate, ON, workers will offer themselves for
employment. Employers according to their demand curve, will be willing to employ only ON
workers. Thus at the wage OK2 workers equal to N1N2 will be involuntarily unemployed. The
dassicial economics say that if wages are flexible and there is no obstruction in their
downward movement, this unemployment will automatically disappear.
Fig. 3.1 (b) shows the aggregate production function i.e. the curve TT showing the
total output in the economy when a certain number .of workers is employed. In this diagram,
aggregate output (T) is shown on Y-axis and labour employed on X-axis. The output has been
shown in real terms and not in money terms. Fig. 3.1 (b) is used to show the equilibrium in
the product market. In the present case. It shows that OQ will be the aggregate output if ON 1
is the labour actually employed (as determined in Fig. 3.1(a).
After determining the aggregate output, the classical mode to study the equilibrium in
the money market. The money market equilibrium shows the level of prices when the output
as determined by the product market equilibrium in diagram (b) and the amount of money is
given.
The prices as we know, are determined either b the Fisher's equation
i.e. PT = MV or P = MV/T
(Where M is the money supply, V is the Velocity of money and T is the output
determined through Fig.3.1 (b) or by the Cambridge equation i.e.
P = M/KT
(where K is the ratio of output which people keep in the form of money). We have used
the Fisher's equation to determine the price level in Fig. 3.1 (c).
MV is the curve showing the money supply (MV) at a given point of time. We measure
on Y-axis, the aggregate output and prices on X-axis. The curve MV is a rectangular
hyperbola in shape and this needs some explanation. This explanation follows in the next
paragraph.
We know that PT=MV. where MV is assumed to be constant at a given point of time.
Now each point on the curve MV shows two features: it represents a point which shows the
product of price and output i.e. PT. Secondly, all the points on this curve show that has the
same value i.e. equal to MV. Obviously the equation of the curve will be XY-a where 'a' is
nothing else but MV (constant-given) and XY is nothing else but PT.
Now from Fig. 3.1(b), we have known that the aggregate output in equilibrium will be
OQ. Using this equilibrium amount in fig. 3.1(c), we find that the general price level will be
OP. This price level will ensure equilibrium in the money market.
All the three markets are now in equilibrium. There is still one thing missing in the
model. We do not so/far known what will be the level of money wages, in figure 6.1 (a), we
determined the real wages. The money wage should be such that after being divided by the
general price level they become equal to the real wages as derived in fig. 6.1 (a). So, for
determining money wages result obtained from fig. 3.1 (a) and fig. 3.1(c) have been used. This
is shown in fig. 3.1 (d) On Y-axis, money wages (w) are shown. On X-axis the price level has
been shown. A line (Vector) OF through the origin O has been drawn in such a manner that
32

the value of the tangent of the angle (0) made by this vector with X-axis is equal to W/P i.e.
real wages, (as determined in fig. 3.1(a).
We can now use this diagram to know the money wages if we know the price level from
diagram 3.1 (c) in the present case if price level is QP, money wages will be indicated by the
corresponding value of W on Y-axis, as indicated by the vector OF in Fig. 3.1 (d). The money
wages will be OM in this case.
3.4.2 Impact of Saving on Employment
The Classicals had anticipated one objection against their v-^model and therefore tried
to meet this objection while explaining the model itself. It was that with the use of money in
the economy, saving had become possible. Now if people saved out of their income and did
not spend it, would it not affect the total demand adversely and therefore the employment,
situation also? Unemployment might thus appear. To this, the classical replied that more
saving would reduce the rate of interest and this fall in the rate of interest would increase the
investment. According to the classicals, the rate of interest will fall so much that the total
saving is converted into investment. The classical further pointed out that the total demand
consisted of demand for consumption goods and the demand for investment goods. So,
according to them, if due to greater savings the demand for consumption goods falls the
demand for investment goods rises by the amount equal to the additional amount saved. The
total demand therefore will not fall. Similarly if the savings decline, the only effect will be a
rise in the rate of interest. The aggregates demand will not increase even if the consumption
expenditure increases due to decline in savings:- This is because the demand for investment
goods will decline by the amount, the savings have declined.
3.5 MODERN VERSION OF THE 'SAY'S LAW OF MARKETS
The Classical Model of Employment
We have a read the Say's law of markets and its functioning. Its main conclusions
were that there was "no possibility of general unemployment" in a capitalist economy and
that there is "no need for any state intervention for maintaining or ensuring full employment.
Say's law of markets, however, has been open to one serious criticism that this law
was originally couched in non-monetary terms and, in fact, because of this feature, the law
was considered completely irrelevant from the point of view of present day monetised
economics. Three important development have taken place since the Say's law was
propounded. These developments are:
(i) the economics became heavily monetised. Money became a medium of
exchange. As such change the supply for money normally started effecting the
price level. This, in turn, could affect the supply and Demand for various
commodities and ultimately the general employment situation. Conclusions of
Says law under such situation could become wrong. Say's law, as we know was
never explained originally in terms of prices of various commodities.
(ii) With the Increasing use of money it became easy for the people to save for the
future. This possibility would affect the present demand for the commodities,
which, in turn, could lead to unemployment.
(iii) There was not only the development of money market which helped the lending
and borrowing of money but also of a labour market. In this labour market,
labourers on the one hand, offered their services for employment the return for
33

wages and on other hand, there were entrepreneurs who demanded the services
of workers and offered to pay them wages for their services.
Say's law of markets did not consider the development of labour market. Rather
the law assumed as if every body was self employed and had sufficient means to employ
himself. In such a situation, a worker (if be chance, unemployed) would employ himself to
creat the supply for his producer and simultaneously a demand for some other product. This
was no longer true when people started seeking employment from others. They could remain
unemployed if the wages they demanded were higher than what the enterpreneurs offered to
them. There could thus be unemployment. It is obvious that Say's law could no longer help
one to conclude that there would always be full employment in an economy. An altogether
new explanation was required to prove that there is always full' employment in an economy.
This new explanation was put forth by A.C. Pigou in the form of a model which took
into consideration the various development : that had taken place in various
economies. This model (given by Pigou) is called classical model of full employment. Some
economists call it the monetised version of the Say's law of markets.
3.6 IMPLICATIONS OF SAY'S LAW
The logical consequences of Say's law of market are;;
(i) There is automatic adjustment between supply and demand and the
government need not interfere with the working of the economic system. The
built in flexibility of the economic system is self-correcting.
(ii) As long as there are unemployed resources of labour and capital in the
economy, It is profitable to employ them because they increase production and
pay for themselves.
(iii) There can be no general over-production or general unemployment in the
economy. This is because wage and price flexibility keeps the economy in full
employment equilibrium where total demand-total supply.
(iv) Saving is socially desirable. Any saving will ultimately result in investment. This
will result in additional productive capacity in the economy.
(v) Prosperity is indivisible. Prosperity of one will result in the prosperity of the
other. If one gets richer by producing more, he will at the same time by creating
demand for the products of other, add to the richness of others.
3.7 CRITICISM OF SAY'S LAW
It is not that all through the year from Say or Ricardo down to Pigou, nobody raised
his little finger in objection to or suspicion in Say's law. Many economists in all times raised
doubts, sometimes serious about the validity or soundness of the principle. Maithus had
pointed out the possibility of the law not coming true. The years between 1823 and 1833 saw
frequent attacks on Ricardo, a great champion of Say's Law. In America, the institutionalists,
like Velban and Mitchell were suspicious of this law. In France, Aftalion (In 1909) openly
attacked Say's law Clark of U.S.A. poohpoobed the idea of a self-adjusting economy. But in
all, these attacks were unsuccessful because "it takes a new conceptual scheme to cause the
abandonment of an old one." Facts or statement of belief alone will not destroy a theory.
Nothing less than a general theory a sufficiently comprehensive theory was required to
smash the old citadel. And the yeoman's service and Horculec task was performed by Keynes
in his "General Theory". We may note the major points of criticism of this law as under :-
34

(i) The assumption of free and perfect competition does not hold true in the real
world. We have many imperfections in the market, including that of labour.
Perfect market may sometimes be there somewhere but as a rule, such markets
do not exist, in the world of mortals, the only perfect thing is imperfection.
(ii) It is wrong to assume that money has no active or independent role in an
economy. It is not just a medium of exchange. It is for instance a store of value
too. People can store money, may be for transaction, precautionary or
speculative motive. It has independent role to play in creation of employment. In
fact the General Theory of Keynes is a monetary theory.
(iii) Say's Law in its original form, was inapplicable to a monetary economy. It was
true, as Hansen points out, only in barter economy.
(iv) The law assumes that income is spent either on consumption or on investment
Or to put in a different language, ail incomes are spent either on consumption
or a part of them is saved. And this saving is spent on investment. Keynes
points out that the reasoning is contrary to the realities of life. We find that
incomes are saved and hoarded also, especially in the short period. Saving is
not always used for investment purpose. Herein comes the store-of-value
function of money which was sadly, almost criminally neglected by the
advocates of Say's law.
(v) Keynes gave a new tool of consumption function with the help of which he
refuted the classical contention that aggregate demand would always be equal
to aggregate supply. It is fallacious to think that aggregate supply is equal to
the aggregate of consumption investment. It was implied by the classical
economists that consumption and investment are determined in the same
manner. But Keynes showed that the determinants of consumption (which
depended on income) are different from the determinants of investment (which
depends on marginal efficiency of capital). The determinants of investment are
technological. Further, as explained through the concept of consumption
function, with an increase in income, consumption also increases, but the
increase in consumption is less than the increased in income, leaving a gap,
which is not automatically filled. This feads to deficiency of aggregate demand.
Aggregate supply may become greater than aggregate demand.
(vi) Say's law is not able to explain the frequent phenomenon of trade cycles. If
supply creats its own demand, why do then depression and booms come about
in a free enterprise economy at almost regular intervals? The great Depression
of thirties is probably the most glaring fact staring the classicists in the face.
There was general over-product which could not create any demand for itself
and there was wide spread unemployment. And the state of depression
continued for years.
(vii) The classical law might probably apply to individual firms or industries, but
not to the economic system as a whole. For example wage cuts in particular
firm industry to be employed. But if there is (general wage cut, then incomes
would be reduced and effective demand would be less inducement to invest will
be less and there would be a greater unemployment rather than employment,
Classical analysis through the few of markets, was essentially s partial
35

equilibrium analysis and micro analysis is not always applicable to macro-

situations.
(viii) Keynes pointed out that saving and investment are not sensitive to rate of
interest. This is, saving arid investment are not interest elastic. It is not the
interest rate that brings about equilibrium between saving and investment.
They are equated through the agency of income changes. In-many cases, would
save at any interest rate. Similarly, the people, may invest at a higher rate of
interest if Marginal Efficiency of Capital (MEC) is greater than this rate of
interest.
(ix) Keynes also lashed at the classicals for relying too much on the supposed
self-adjusting mechanisim of economic systems, and for advocating
complete non-interference by the state. Keynes was of the opinion that
distribution of income in free economies is such that the great percentage of
wealth gets concentrated in fewer hands. For such people, with every rise in
income, consumption increases less than proportionately and, thus, saving
becomes more and more. They do not invest mush either because purchasing
power or aggregate demand on the part of the many poor is very little. That is
why in very prosperous economies, there is a tendency towards secular
stagnation. And because of non-investment and over-saving this leads to
unemployment. This requires government to take up responsibility in a big way
and make investment. Unlike Classicals, Keynes realised the importance of
government investment. ,
(x) Keynes also doesn't agree with Pigou that wage cutting is the remedy for
unemployment, Firstly Si age cuts may be effective in a particular firm or
industry, out general wage cut would decrease income and falling income wilt
adversely effect aggregate effective demand. Secondly, employment depends not
on money wages, but on the effective demand in the economy and effective
demand can be maintained at a high level without touching money wages.
(xi) Prof. Haberler say that Say's law is tautological (Supply is equal to demand,
so is equal to investment and MV (Supply of Money) = PT (Demand for money).
So in this sense, the of the principle i.e. Supply = Demand is a more tautology.
(xii) Hazlitt is of the view that even if the law is true, we don't need it so directly to
solving specific economic problems.
(xiii) It is said by some defenders and apologists of Say's law that is a statement of a
tendency of economic system in the long run. But Keynes with sturdy
common sense about him was not very fond of thinking of the long run. As
he so" interestingly puts in "In the long run we are all dead". The common man
is interested in what is going to happen to him in the foreseeable future rather
than what might happen to his grandchildren in the unforeseeable future.
Self Assessment Question
Q. Mention four contributions of Say's Law.
Ans. ..................................................................................................................................
..................................................................................................................................
..................................................................................................................................
36

Conclusion
Medicine for one may be poison for another. Say's law was probably valid and, by and
large, had sound and heat logic for the age of Say and Ricardo or the age of barter economies
when production and consumption were almost or nearly simultaneous. Then came
industrial Revolution and now we have roundabout productive processes. Production is done
very much in advance by forecasting needs of consumption. Producers and consumers do not
have a dialogue, not in any case. In the short run, as probably they used to have once upon a
time in the days of barter economies. Obviously, there is bound to be, quite sometimes, a glut
in the market. We all experience such a situation during the thirties. Such phenomena of
glut cannot be explained by the above principle. In modern economies, where money plays a
big role, where industrial revolution came back, this law has no place. Hansen in his "Guide
to Keynes" says, Says law is an example of how a great principle, tossed on the sea of
controversy, is likely to point out misleading conclusion". The classical model of employment
which is the modern version of the theory is defective.
For another matter, the law perhaps still has some relevance to underdeveloped
economies, like some other ideas of the classical economists (e.g. Save more if you want
economic development and capital formation-an idea which is discarded in advanced
countries and modern economies). In such economies there are vast opportunities of
production and, consequently, of employment. With increase in production, there is bound to
take place an increase in aggregate demand. Supply in a sense here will create its own
demand. Markets of these countries have almost an unlimited scope for expansion. Markets
can be as big as the volume of goods produced. So although the law does not hold good in
modern highly monetized economies. It may be said to have some validity in
underdevelopment economies. Most of these economies present a situation for which the law
was conceived originally.
3.8 SUMMARY
In this lesson, we have studied about Say's Law, its working, implications and its
critical appraisal by economists.
3.9 REFERENCES
1. Dernburg, T. F., & Dernburg, J. D. (1969). Macroeconomic analysis: an
introduction to comparative statics and dynamics. Addison-Wesley.
2. Rana, K. C., & Verma, K. N. (2009). Macroeconomics Vishal Publishing
Company.
3. Dwivedi, D. N. (2005). Macroeconomics: theory and policy. Tata McGraw-Hill
Education. Dwivedi, D.N,; Macroeconomics
3.10 FURTHER READINGS
1. Ackley, G. (1961). Macroeconomic theory, MC Millan Library References.
2. Shapiro, E. (1978). Macroeconomic analysis (No. 339.2 S4 1978). Galgotia
Publications.
37

3.11 MODEL QUESTIONS

1. Critically analyse the working of Say's Law.
2. Write Short notes on –
(a) Modern Version of Say's Law
(b) Implications of Say's Law
38

Lesson - 4

KEYNESIAN THEORY OF INCOME AND EMPLOYMENT

Structure
4.0 Objectives
4.1 Introduction
4.2 Keynes criticism of classical theory
4.3 Principle of effective demand
4.4 Determinants of Income
4.5 Keynesian Model of Output and Employment
4.6 Keynesian two sector model
4.7 Keynesian three sector model
4.8 Importance of effective demand
4.9 Criticism of Keynesian theory
4.10 Summary
4.11 Glossary
4.12 References
4.13 Further Readings
4.14 Model Questions
4.0 OBJECTIVES
After going through this chapter you shall be able to :
 enlist Keynes criticism of classical theory
 explain Principle of effective demand
 discuss Keynesian Model of Output and Employment
 discuss Keynesian two sector model
 discuss Keynesian three sector model
 comments on importance of effective demand
4.1 INTRODUCTION
John Maynard Keynes was the main critic of the classical macroeconomics. He in his
book 'General Theory of Employment, Interest and Money' out-rightly rejected the Say's Law
of Market" supply creates its own demand'. He severely criticized A.C. Pigou's version that
cuts in real wages help in promoting employment in the economy. He also opposed the idea
that saving and investment can be brought about through changes in the rate of interest. In
addition to this, the assumption of full employment in the economy is not realistic.
So long as the economy was operating smoothly, the classical analysis of aggregate
economy met no serious opposition. However, Great Depression of 1930's created problems
39

of increasing unemployment, reducing national income, declining prices and failing firms
increased in intensity. The classical model miserably failed to explain and provide a workable
solution for how to escape the depression.
It was at that time when J. M. Keynes wrote his famous book 'General Theory'. In it
he presented an explanation of the Great Depression of 1930's and suggested measures for
the solution. He also presented his own theory of income and employment. According to
Keynes: "In the short period, level of national income and so of employment is determined by
aggregate demand and aggregate supply in the country. The equilibrium of national income
occurs where aggregate demand is equal to aggregate supply. This equilibrium is also called
effective demand point".
4.2 KEYNES'S CRITICISM OF CLASSICAL THEORY
Keynes vehemently criticized the classical theory of employment for its unrealistic
assumptions in his General Theory.
He criticised the classical theory on the following grounds :
(1) Underemployment Equilibrium:
Keynes rejected the fundamental classical assumption of full employment equilibrium
in the economy. He considered it as unrealistic. He regarded full employment as a special
situation. The general situation in a capitalist economy is one of under employment. This is
because the capitalist society does not function according to Say's law, and supply always
exceeds its demand. We find millions of workers are prepared to work at the current wage
rate, and even below it, but they do not find work. Thus the existence of involuntary
unemployment in capitalist economies (entirely ruled out by the classicists) proves that
underemployment equilibrium is a normal situation and full employment equilibrium is
abnormal and accidental.
(2) Refutation of Say's Law:
Keynes refuted Say's Law of markets that supply always created its own demand. He
maintained that all income earned by the factor owners would not be spent in buying
products which they helped to produce. A part of the earned income is saved and is not
automatically invested because saving and investment are distinct functions so when all
earned income is not spent on consumption of goods and a portion of it is saved, this result
in a deficiency of aggregate demand. This leads to general overproduction because all that is
produced is not sold and in turn, leads to general unemployment. Thus Keynes rejected Say's
Law that supply created its own demand. Instead he argued that it was demand that created
supply. When aggregate demand rises, to meet that demand, firms produce more and employ
more people.
(3) Self-adjustment not Possible:
Keynes did not agree with the classical view that the laissez-faire policy was essential
for an automatic and self-adjusting process of full employment equilibrium. He pointed out
that the capitalist system was not automatic and self-adjusting because of the non-
egalitarian structure of its society. There are two principal classes, the rich and the poor. The
rich possess much wealth but they do not spend the whole of it on consumption. The poor
lack money to purchase consumption goods. Thus there is general deficiency of aggregate
demand in relation to aggregate supply which leads to overproduction and unemployment in
the economy. This, in fact, led to the Great Depression. Had the capitalist system been
40

automatic and self-adjusting, this would not have occurred. Keynes, therefore, advocated
state intervention for adjusting supply and demand within the economy through fiscal and
monetary measures.
(4) Equality of Saving and Investment through Income Changes:
The classicists believed that saving and investment were equal at the full employment
level and in case of any divergence the equality was brought about by the mechanism of rate
of interest. Keynes held that the level of saving depended upon the level of income and not on
the rate of interest. Similarly investment is determined not only by rate of interest but by the
marginal efficiency of capital. A low rate of interest cannot increase investment if business
expectations are low. If saving exceeds investment, it means people are spending less on
consumption. As a result, demand declines. There is overproduction and fall in investment,
income, employment and output. It will lead to reduction in saving and ultimately the
equality between saving and investment will be attained at a lower level of income. Thus it is
variations in income rather than in interest rate that bring the equality between saving and
investment.
(5) Importance of Speculative Demand for Money:
The classical economists believed that money was demanded for transactions and
precautionary purposes. They did not recognize the speculative demand for money because
money held for speculative purposes related to idle balances. But Keynes did not agree with
this view. He emphasized the importance of speculative demand for money. He pointed out
that the earning of interest from assets meant for transactions and precautionary purposes
may be very small at a low rate of interest. But the speculative demand for money would be
infinitely large at a low rate of interest. Thus the rate of interest will not fall below a certain
minimum level, and the speculative demand for money would become perfectly interest
elastic. This is Keynes 'liquidity trap' which the classicists failed to analyse.
(6) Rejection of Quantity Theory of Money:
Keynes rejected the classical Quantity Theory of Money on the ground that increase in
money supply will not necessarily lead to rise in prices. It is not essential that people may
spend all extra money. They may deposit it in the bank or save. So the velocity of circulation
of money (V) may slow down and not remain constant. Thus V in the equation MV = PT may
vary. Moreover, an increase in money supply, may lead to increase in investment,
employment and output if there are idle resources in the economy and the price level (P) may
not be affected.
(7) Money not Neutral:
The classical economists regarded money as neutral. Therefore, they excluded the
theory of output, employment and interest rate from monetary theory. According to them, the
level of output and employment and the equilibrium rate of interest were determined by real
forces. Keynes criticised the classical view that monetary theory was separate from value
theory. He integrated monetary theory with value theory, and brought the theory of interest
in the domain of monetary theory by regarding the interest rate as a monetary phenomenon.
He integrated the value theory and the monetary theory through the theory of output. This he
did by forging a link between the quantity of money and the price level via the rate of interest.
For instance, when the quantity of money increases, the rate of interest falls, investment
increases, income and output increase, demand increases, factor costs and wages increase,
41

relative prices increase, and ultimately the general price level rises. Thus Keynes integrated
monetary and real sectors of the economy.
(8) Refutation of Wage-Cut:
Keynes refuted the Pigovian formulation that a cut in money wage could achieve full
employment in the economy. The greatest fallacy in Pigou's analysis was that he extended the
argument to the economy which was applicable to a particular industry .Reduction in wage
rate can increase employment in an industry by reducing costs and increasing demand. But
the adoption of such a policy for the economy leads to a reduction in employment. When
there is a general wage-cut, the income of the workers is reduced. As a result, aggregate
demand falls leading to a decline in employment. From the practical view point also Keynes
never favoured a wage cut policy. In modern times, workers have formed strong trade unions
which resist a cut in money wage. They would resort to strikes. The consequent unrest in the
economy would bring a decline in output and income. Moreover, social justice demands that
wages should not be cut if profits are left untouched.
(9) No Direct and Proportionate Relation between Money and Real Wages:
Keynes did not accept the classical view that there was a direct and proportionate
relationship between money wages and real wages. According to him, there is an inverse
relation between the two. When money wages fall, real wages rise and vice versa. Therefore, a
reduction in the money wage would not reduce the real wage, as the classicists believed,
rather it would increase it. This is because the money wage cut will reduce cost of production
and prices by more than the former. Thus the classical view that fall in real wages will
increase employment breaks down. Keynes, however, believed that employment could be
increased more easily through monetary and fiscal measures rather than by reduction in
money wage. Moreover, institutional resistances to wage and price reductions are so strong
that it is not possible to implement such a policy administratively.
(10) State Intervention Essential:
Keynes did not agree with Pigou that "frictional maladjustments alone account for
failure to utilize fully our productive power." The capitalist system is such that left to itself it
is incapable of using productive powerfully. Therefore, state intervention is necessary. The
state may directly invest to raise the level of economic activity or to supplement private
investment. It may pass legislation recognising trade unions, fixing minimum wages and
providing relief to workers through social security measures. Therefore, as observed by
Dillard, "it is bad politics even if it should be considered good economics to object to labour
unions and to liberal labour legislation." So Keynes favoured state action to utilise fully the
resources of the economy for attaining full employment.
(11) Long-Run Analysis Unrealistic:
The classicists believed in the long-run full employment equilibrium through a self-
adjusting process. Keynes had no patience to wait for the long period for he believed that "In
the long-run we are all dead". As pointed by Schumpeter, "His philosophy of life was
essentially a short-term philosophy." His analysis is confined to short-run phenomena.
Unlike the classicists, he assumes tastes, habits, techniques of production, supply of labour,
etc. to be constant during the short period and so neglects long-run influences on demand.
Assuming consumption demand to be constant, he lays emphasis on increasing investment
to remove unemployment. But the equilibrium level so reached is one of underemployment
42

rather than of full employment. Thus the classical theory of employment is unrealistic and is
incapable of solving the present day economic problems of the capitalist world.
4.3 Principle of Effective Demand
In the Keynesian theory of income and employment determination, principle of
effective demand occupies a significant place. In the capitalist economy, the level of
employment depends upon the level of aggregate effective demand. According to Keynes,
effective demand is determined by aggregate supply and aggregate demand. Only that level of
demand is effective where aggregate demand and supply are fully matched and entrepreneurs
have no tendency either to expand or contract output and employment.
Definition: 'Effective demand' represents that level of aggregate demand or total
spending (consumption expenditure and investment expenditure) which matches with
aggregate supply (national income at factor cost).
In other words, effective demand is the signification of the equilibrium between
aggregate demand (C+I) and aggregate supply (C+S). This equilibrium position (effective
demand) indicates that the entrepreneurs neither have a tendency to increase production nor
a tendency to decrease production. It implies that the national income and employment
which correspond to the effective demand are equilibrium levels of national income and
employment.
Unlike classical theory of income and employment, Keynesian theory of income and
employment emphasizes that the equilibrium level of employment would not necessarily be
full employment. It can be below or above the level of full employment.
Self Assessment Question
Q. What is effective demand?
Ans. ..................................................................................................................................
..................................................................................................................................
..................................................................................................................................

4.4 DETERMINANTS OF INCOME:

The determinants of effective demand and so of equilibrium level of national income
and employment are the aggregate demand and aggregate supply.
(1) Aggregate Demand (C+l):
Aggregate demand refers to the sum of expenditure, households, firms and the
government is undertaking on consumption and investment in an economy. The aggregate
demand price is the amount of money which the entrepreneurs expect to receive as a result
of the sale of output produced by the employment of certain number of workers. An increase
in the level of employment raises the expected proceeds and a decrease in the level of
employment lowers it.
The aggregate demand curve AD (C+I) would be positively sloping signifying that as the
level of employment increases, the level of output also increases, thereby increasing of
aggregate demand (C+l) for goods. The aggregate demand (C+l), thus, depends directly on the
level of real national income and indirectly on the level of employment.
43

(2) Aggregate Supply (C+S):

The aggregate supply refers to the flow of output produced by the employment of
workers in an economy during a short period. In other words, the aggregate supply is the
value of final output valued at factor cost. The aggregate supply price is the minimum
amount of money which the entrepreneurs must receive to cover the costs of output
produced by the employment of certain number of workers.
The aggregate supply is denoted by (OS) because a part of this is consumed (C) and
the other part is saved (S) in the form of inventories of unsold output. The aggregate supply
curve, (C+S) is positively sloped indicating that as the level of employment increases, the level
of output also increases, thereby, increasing the aggregate, supply. Thus, the aggregate
supply (C+S) depends upon the level of employment through the economy's aggregate
production function.
4.5 DETERMINANTS OF INCOME AND EMPLOYMENT:
Aggregate Supply Function
In his General Theory, Keynes relates aggregate supply function to varying levels of
employment. It is based on the assumption that labour is the only resource and the only cost
which must be covered by the sale proceeds. At any level of employment of labour, aggregate
supply price is the total amount of money which all the entrepreneurs in the economy taken
together, must expect to receive from the sale of output produced by the given number of
labours employed, if it is just worth employing them. Aggregate supply price, at given level of
employment, according to Keynes, is the expectation of proceeds which will just make it
worthwhile for the entrepreneurs to employ that number of workers. It is the minimum
proceeds which the entrepreneurs expect to recover from the sale of output. We can
represent aggregate supply faction as a schedule of various aggregate supply prices at
different levels of employment. That is, each level of employment in the economy is related to
a particular aggregate supply price and there are different aggregate supply prices for
different levels of employment as shown in the following table.
Table 2.1
Levels of employment (in lakhs Aggregate Supply Price (in
of workers) crores of Rs)
10 200
20 220
30 240
40 260
50 280
50 300
The above table 2.1 represents varying levels of aggregate supply prices at different
levels of employment. It reveals that the aggregate supply price rises with the increase in level
of employment. If the entrepreneurs are to provide employment to 20 lakh workers, they
must receive Rs 220 crores from the sale of output produced by them. If the level of
employment is 40 lakh the aggregate supply price is 260 crores which is the minimum
proceeds expected to receive to sustain such level of employment. But when the economy
44

reaches the level of full employment (50 lakh) aggregate supply price continues to increase
but there is no further increase in employment. According to Keynes, the aggregate supply
function is an increasing function of the level of employment. But when the economy reaches
full employment, aggregate supply function becomes perfectly inelastic. Aggregate supply
function is linear. But if wage rate also increases long with the expansion in employment, the
aggregate supply function follows a nonlinear path as shown below.

Fig. 4.1 Aggregate Supply

The curve of aggregate supply function starts from the point of origin and slopes
upwards to the right because as the necessary expected proceeds increase, the level of
employment also increases. But when the economy reaches full employment limit, as
indicated by Nf, the aggregate supply curve becomes vertical. Even with the increase in
aggregate supply price it is not possible to provide more employment as the economy has
attained the level of full employment.
Aggregate Demand Function
The major analytical tool employed by Keynes in the determination of income and
employment is aggregate demand function. According to Keynes, aggregate demand function
means the amount of money or proceeds that all the entrepreneurs in the economy taken
together expect to receive from the sale of output produced by the given number of workers
employed. In other words, aggregate demand price, represents the amount of expenditure
actually expected by the entrepreneurs when a given number of workers are employed to
produce goods and services. The aggregate demand schedule does not represent any
particular or actual level of demand; it is simply the possible level of demand for different
categories of goods and services. Thus, aggregate demand is an ex-ante concept.
In a two sector economic model consisting of households and business sector, the level
of aggregate demand is determined by aggregating the expected expenditures on the
consumer goods and services and in the investment goods. Thus, aggregate demand is
determined by the consumption demand and investment demand. The aggregate demand can
be expressed as D = C + I. As said above, consumption demand depends on disposable
income on the one hand, and propensity to consume on the other. According to Keynes,
investment is determined by marginal efficiency of capital (MEC) and rate of interest. While
45

rate of interest is more or less sticky, it is the changes in MEC that cause frequent changes
in inducement to invest. According to Keynes, the aggregate demand function is an
increasing function of the level of employment. Thus we can construct aggregate demand
curve showing different aggregate demand prices at different levels of employment. Aggregate
demand also rises from left to the right. This is because as the level of employment increases,
aggregate demand price also rises, as shown below.

Fig. 4.2 Aggregate Demand

Self Assessment Question

Q. What Aggregate Demand Function?
Ans. ...................................................................................................................................
...................................................................................................................................
...................................................................................................................................

Demand and Determination of Employment

As said above, aggregate supply curve shows the receipts which must be received by
the entrepreneurs so as to provide employment to given number of laborers whereas
aggregate demand curve shows proceeds which entrepreneurs actually expects to receive at
different levels of employment. These aggregate demand and aggregate supply curves
determine the level of employment in the economy. The equilibrium level of employment is
determined at the point where demand price aggregate equals the aggregate supply price. In
other words, it is the point where what the entrepreneurs expects to receive equals what they
must receive and their profits are maximized. This point is called the effective demand.
Effective demand is that aggregate demand price which becomes effective because it is equal
to aggregate supply price and thus represents short run equilibrium. So long as aggregate
46

demand price is higher than aggregate supply price, the prospects of getting additional
profits are greater when more workers are provided employment. The expected proceeds
(revenue) rise more than proceeds necessary (cost). This process will continue till the
aggregate demand price equals aggregate supply price and the point of effective demand is
reached.
It is not necessary that the equilibrium level of employment is always at full
employment. Equality between aggregate demand and aggregate supply does not necessarily
indicate the full employment level. The economy can be in equilibrium at less than full
employment or underemployment equilibrium can exist. The classical economists denied that
there would be equilibrium at less than full employment because they believed that supply
creates its own demand and therefore deficiency of aggregate demand would not be
experienced. Keynes demolished the classical thesis of full employment and point out that
deficiency of aggregate demand can cause underemployment equilibrium. The following
figure illustrates the principle of effective demand and the determination of equilibrium level
of employment.

Fig. 4.3 Determination of Employment

AD is the aggregate demand function and AS is the aggregate supply function.
Aggregate demand curve and aggregate supply curve intersects at point E. this is the effective
demand where 0N2 workers are employed. At less than 0N2 level of employment, say at 0NI,
aggregate demand curve lies above aggregate supply curve showing that it is profitable to
expand the amount of employment. However, it would not be profitable for the entrepreneurs
to increase employment below 0N2, as AD lies below AS and they incur losses. Thus, E, the
point of effective demand determines actual level of employment in the economy.
It can be noticed that the equilibrium at E represents underemployment or less than
full employment level. At equilibrium level of employment 0N2, the N2Nf persons remain
unemployed. It is important to note that N2Nf persons are involuntarily unemployed. They
are willing to work at the existing wage rates but are unable to find jobs. This unemployment
is due to deficiency of aggregate demand. It follows that, to raise the economy to the level of
full employment, requires the raising the point of effective demand by increasing the
aggregate demand. The unemployment will be removed and full employment will be reached
47

if through increase in investment demand or increase in consumption demand or both,

aggregate demand curve shifts upwards so that it intersects aggregate supply curve at point
R. With the intersection of aggregate demand and aggregate supply at point R, equilibrium
will be stabled at full employment level 0Nf.
4.6 KEYNESIAN TWO SECTOR MODEL
As said above, Keynesian theory deals with short run and Keynesian theory of income
determination can be explained by assuming only two sectors in the economy, namely
households and business firms. It is a closed economy in which there are no exports and
imports. Keynes focused on this simple two sector model for determination of income and
derived conclusions regarding policy formulations from this basic model.
Self Assessment Question
Q. What is two sector Model?
Ans. ...................................................................................................................................
...................................................................................................................................
...................................................................................................................................

In the two sector model, only consumption and investment expenditure takes place.
Thus total output of the economy is the sum of is the sum of consumption and investment
expenditures. Because there is no government in this economy, national income equals net
national product. Again, because there is no government, there can be no taxes and all
personal income becomes disposable personal income. In this economy, disposable personal
income also equals net national product. Disposable personal income must be devoted either
to personal consumption expenditures or to personal savings. Because disposable personal
income equals net national product, personal savings must then equal investment. Thus we
have the following identities.
NNP (Y) = C + I (i)
Disposable Personal income (Yd.) = C + S (ii)
Y = Yd. (iii)
Therefore S = I [Cancelling C in the identity C+S = C+I]
These are fundamental accounting identities with which we will work in the two sector
model.
Equilibrium Income and Output
The equilibrium level of income and output is determined at the point where the
aggregate demand function intersects aggregate supply function. In the two sector economy,
aggregate demand consist of consumption demand and investment demand (Y= C+I). In
drawing aggregate supply, not only stock of capital, size of population, state of technology,
average and marginal product of labour and money wages are assumed to remain constant
but also price level of output is held constant. This type of aggregate supply curve (Y - C+S)
can be shown as 45° line starting from the point of origin. The following figure depicts the
equilibrium level of income and output in the two sector model.
48

Fig. 4.4 Keynesian Income and Employment

In the figure 4.4 aggregate demand function is represented by C + I drawn by adding
consumption function (C) and investment demand (I). The 450 line represents the aggregate
supply function Y = C+S. the aggregate demand function and aggregate supply function
intersects at point E and equilibrium level income 0Y is determined. Now income cannot be
in equilibrium at levels smaller than 0Y, say at 0Y0. This is because at 0Y0, aggregate
demand exceeds aggregate supply since C+I curve lies above 45° line. This excess demand
will lead to the decline in inventories which induce firms to expand their output of goods and
services to meet the extra demand for them. Income will continue to increase till 0Y is
reached. On the contrary, at levels of income greater than the equilibrium level, say at 0Y1,
aggregate demand fall short of aggregate supply. This will cause unintended increase in
inventories of goods with the firm. The firms will respond by cutting down production. This
will lead to a fall in income until the level 0Y is reached where aggregate demand is equal to
the aggregate supply.
The equilibrium may also be defined as that level of income at which planned saving
equals planned investment. In part B of the figure, I is autonomous investment function and
S is saving function. The saving and investment function intersects at point E which
determines the equilibrium level of income 0Y. At 0Y, planned saving is equal to planned
investment. At 0Y0, planned investment by the entrepreneurs is more than planned savings
by the people. This would mean that aggregate demand is greater than aggregate supply of
49

output. This will lead to decline in inventories and firms will increase production, raising the
level of income and employment. On the other hand, at 0Y1, investment is less than savings.
It means that aggregate demand is less than aggregate supply. As a result, the entrepreneurs
will not be able to sell their entire output at given prices. The result will be that output will be
reduced which will results in reduction in income.
4.7 KEYNESIAN THREE SECTOR MODEL
In the above analysis of two sector model, we explained how equilibrium level of
income is determined by the consumption function and autonomous investment demand. We
can construct a three sector model by adding government sector to the two sector simple
economy model. Even though government influences the economy in a variety of ways,
Keynesian three sector model confines to the effects of government's expenditure (G) and
taxation (T).
Thus, GNP identity for the three sector model, we have AD = C+I+G and AS = C+S+T.
the Keynesian condition for equilibrium in a three sector model may now be written as C+S+T
= C+I+G
Expressed in terms of saving and investment, equilibrium will be found at that level of
income at which saving plus taxes equals planned investment plus government expenditure.
S+T = I+G
The determination of equilibrium level of income in a three sector model is graphically
shown below.

Fig. 4.5 Keynesian Three Sector Model

4.8 IMPORTANCE OF EFFECTIVE DEMAND

The principle of effective demand is the most important contribution of J.M. Keynes.
Its importance in macroeconomics, in brief, is as under:
(i) Determinant of employment. Effective demand determines the level of
employment in the country. As effective demand increases employment also
increases. When effective demand falls, the level of employment also decreases.
(ii) Say's Law falsified. It is with the help of the principle of effective demand that
Says Law of Market has been falsified. According to the concept of effective
demand whatever is produced in the economy is not automatically consumed. It
is partly saved. As a result, the existence of full employment is not possible.
(iii) Role of investment. The principle of effective demand explains that for
achieving full employment level, real investment must equal to the gap between
income and consumption. In other words, employment cannot expand, unless
investment expands. Therein lies the importance of the concept of effective
demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a
rich community, the gap between income and expenditure is large. If required
investment is not made to fill this gap, it will lead to deficiency of effective
demand resulting in unemployment.
4.9 CRITICISM ON KEYNESIAN THEORY
From mid-1970's onward, the Keynesian theory of employment came under sharp
criticism from the monetarists. Milton Friedman, the Chief advocate of monetarists rejected
the Keynesianism as a whole. The monetarists returned back to the old classical theory for
the explanation of the rise in general price level and stated that inflation is always and
everywhere a monetary phenomenon.
The monetarists are of the view that J. M. Keynes laid more emphasis on the
determinants of aggregate demand and to a greater extent ignored the determinants of
aggregate supply. The monetarists encouraged the supply side policy and thus favored free
enterprise economy for solving the problems of unemployment and inflation.
J. R. Hicks describes Keyne's 'General Theory' as depression economics. Further, the
'General Theory of Keynes is applicable to the developed economies. The Keynesians concepts
are not very useful for policy purposes in less developed countries.
1. Does not provide comprehensive solution of unemployment:
Keynes theory does provide solution of all types of unemployment. It deals with only
cyclical unemployment. Keynes did not attempt to solve frictional, technological
unemployment and chronic unemployment of under-developed countries. Keynes did not
elaborate how to secure fair employment. A complete theory should explain how to get both
full and fair employment.
2. Unrealistic assumption of perfect competition:
In real business world imperfect competition is found instead of perfect competition
even in capitalist economics. Therefore, it is not applicable in advanced economies.
51

3. No determinate functional relationship between effective demand and

employment:
Critics point out that there cannot be a definite functional relationship between ED
and employment. Keynes did not provide any evidence of this functional relationship. There
is no direct relationship between ED and level of employment. In fact everything depends
upon the complex interrelationship of wage rates, prices and money supply.
4. Wholly aggregative in nature:
It is highly aggregative because it deals with aggregate concepts such as aggregate
consumption, total investment and total output. These aggregate concepts may be misleading
because these do not explain the economic problems of individual economic units like firm,
industry and individual consumption. It is not the size of investment alone that determines
employment but the character of investment also affects production and employment.
5. Undue importance to inducement to invest:
Keynes theories solely rely on investment to increase employment. Critiques point out
that other determinants of employment were ignored by Keynes.
6. Criticism of consumption function:
Everybody knows that when income increase, consumption also increases. Thus,
consumption function is a truism. Prof. Hazet criticizes Keynes' consumption function on the
basis that it is purely quantitative, but consumption function has qualitative aspect as well
Prof. Hazet also points out that actual experience and empirical evidence do not support
Keynes' consumption function.
7. Keynes ignores long-run problem:
Keynes assumes that ASF is given. Thus, it is a short-run theory and provide solution
to short-run employment problem. Keynes himself said, "In future we are all dead."
8. Keynes theory is not general:
Keynes theory is not applicable anywhere and everywhere. Its application, as best, is
limited to industrially advanced countries and it has little relevance to the problems of
underdeveloped countries like India.
9. Keynes ignored accelerator effect:
Accelerator and multiplier work simultaneously. Multiplier describes the effect of
investment on consumption and the accelerator shows the effect of consumption on
investment. But Keynes ignored the accelerator effect completely.
10. Liquidity preference theory of interest is indeterminate:
This is an incomplete theory as it considers interest a purely monetary phenomenon.
But rate of interest is not determined by monetary factor alone. Real factors also affect the
rate of interest.
11. No explanation of partial equilibrium:
Keynes theory offers no solution to the problem of depression in an individual or
particular industry.
52

4.10 SUMMARY
Mere cheap monetary policy may fall to stimulate business activities during
depression. It provides no explanation of cost-push inflation. Moreover Keynesian economics
is an economics of depression. There may be weaknesses in Keynesian theory. However, it
made a notable contribution to economics theory. Its prescriptions have wider application to
solve practical economic problems. It is revolutionary theory and marks a sharp departure
from classical thinking. Keynes theory provided tools of thinking which helped and may help
to seek solutions to many economic problems.
4.11 GLOSSARY
 Effective demand (ED) in a market is the demand for a product or service which
occurs when purchasers are constrained in a different market. It contrasts with
notional demand, which is the demand that occurs when purchasers are not
constrained in any other market.
 Aggregate demand (AD) or domestic final demand (DFD) is the total demand for final
goods and services in an economy at a given time. It specifies the amounts of goods
and services that will be purchased at all possible price levels. This is the demand for
the gross domestic product of a country.
 Aggregate supply (AS) or domestic final supply (DFS) is the total supply of goods and
services that firms in a national economy plan on selling during a specific time period.
It is the total amount of goods and services that firms are willing and able to sell at a
given price level in an economy.
 Underemployment Equilibrium! If we are to mention the greatest contribution which
Keynes made to economic analysis, it is this demonstration that equilibrium of the free
enterprise, capitalist economy is not only possible at less than full employment but is
also the common situation.
4.12 REFERENCES
 Ackley, Gardner (1986). Macroeconomic theory. Pergamon Press Oxford.
 Shapiro, Edward (2009). Macroeconomic analysis. Fourth edition.
edwardshapiromacroeconomicsfreedownloadpdg.pdf
 Dernburg T.E and McDougall DM (1986). Macroeconomics. Pergamon Press Oxford.
4.13 FURTHER READINGS
 Rana K.C. and Verma K.N. (2016). Macroeconomic analysis. Vishal Publishing
Company. Eleventh Edition.
 Dwivedi D.N. (2011). Macroeconomics. Tata McGraw Hill Publication.
 Branson, WH (1989). Macroeconomic Theory and Policy. Third edition. Harper Collins.
4.14 MODEL QUESTIONS
1. Derive demand and supply curve of labour under Keynesian System.
2. Explain the Keynesian theory in detail.
3. Describe the principle of Effective Demand and Explain its components.
53

Lesson-5

CLASSICAL VERSUS KEYNESIAN-VIEWS

Structure
5.0 Objectives
5.1 Introduction
5.2 Critical Analysis of Classical Model
5.3 Difference Between Classical and Keynesian Views
5.4 Classical Arguments
5.5 Keynesian View
5.5.1 Liquidity Trap and Real Balance Effect
5.5.2 Meaning and Significance of Liquidity Trap
5.5.3 Real Balance Effect Meaning
5.6 Summary
5.7 Further Readings
5.8 Model Questions
5.0 OBJECTIVES
After going through this lesson you shall be able to –
 critically analyse the classical argument/model
 discuss the Keynesian Argument
 compare and contrast the classical and Keynesian views.
5.1 INTRODUCTION
Having read the functioning of an economy under classical and Keynesian models, this
lesson draws comparison between the two and shows how Keynesian model is an
improvement over the classical model.
5.2 CRITICISM OF CLASSICAL THEORY
The classical theory of employment and income on various grounds has been
critirised:-
(i) The automatic adjustment of the economy is not always possible.
(ii) The diminishing returns can be halted by technical progress which could not be
considered by the classical economists.
(iii) Unemployment is very much possible in a capitalist economy. This was evident
during the Great Depression of the thirties.
(iv) General overproduction or glut cannot be eliminated automatically by the
market forces. The world-wide Depression of thirties is a glaring example of this
truth.
54

(v) It is not possible to have automatic full employment in a capitalist economy.

What is more possible is unemployment or underemployment. Full employment
is conspicuous by its absence in the present day world.
(vi) Keynes has shown that due to deficiency of effective demand, supply cannot
always find its market. Thus, Say's Law of Market is not correct.
(vii) A reduction in the wage rate is not practically possible. Even if it is possible, a
wage cut will lead to reduction in effective demand. Thus, supply will exceed
demand and, hence, unemployment will increase and, not decrease.
(viii) The economy cannot always be adjusted automatically. Therefore, government
interference is sometimes necessary.
(ix) Most of the classical assumptions such as perfect competition, full employment
and so on are not realistic.
(x) Saving and investment cannot always be made equal through the rate of
interest. They can be equalised by the level of income.
(xi) The classical writers assigned a very passive role to money. In fact, money can
influence the product market.
Keynes has vehemently criticised classical economists. Let us give below the main
differences between Keynes and the classical economists.
5.3 DIFFERENCE BETWEEN CLASSICAL VIEWS AND KEYNESIAN VIEWS
Although Keynes was primarily a classical economist, still he differed on many
important points from the classical economists. The main points of difference between
Keynes and the classicists can be shown in the following chart:
Classical Views Keynesian Views
1. There is a direct relationship between 1. No such direct relationship exists. The
the money supply and the price level. relation is only indirect.
2. Saving-investment equality is brought 2. The equality between saving and
about by the rate of interest investment is brought about by the
mechanism. income level.
3. Rate of interest is a flow. 3. Rate of interest is a stock.
4. Labour supply depends on the real 4. Supply of labour depends on the money
wage rate. wage rate.
5. There is no money illusion. 5. There is money illusion.
6. The economy is at full employment 6. The economy is at underemployment
equilibrium. equilibrium.
7. The automatic adjustment works. 7. There is no such thing.
8. No speculative demand for money. 8. There is speculative demand for money.
9. Wages are flexible. 9. Wages are rigid downward.
10. Supply creates its own demand. 10. Supply is generally greater than demand
(they are not equal).
55

11. Money is a veil. 11. Money is important for dynamic activity.

12. Rate of interest is a reward for 12. Rate of interest is a reward for parting
saving. with liquidity.
13. Laissez fake. 13. No laissez faire.
14. When the wage level goes down, 14. When the wage level goes down,
employment goes up. employment goes down.
15. Saving is good. 15. Saving is bad.
16. Balanced budget. 16. Unbalanced budget.
17. Long-run. 17. Short-run.

Fig. 5.1 FULL EMPLOYMENT INCOME

Now, we have three markets viz product market, money market and labour market
correspondingly, we have three locus representing equilibrium in the three markets. We have
a level of income YF (effective demand, see Fig. (1) where money and product market in
equilibrium. Here comes a fundamental question. Will this effective demand (Y E) ensure
equilibrium in the labour market or will YF, or if YE is not equal to YF, will there be forces
strong enough to take the system to overall equilibrium to three markets?
Classical economists believed that there exist forces capable of bringing the economic
system to full employment equilibrium. While Keynesians believe that, there is no such
automatic mechanism. We will examine this issue now.
Here effective demand is just equal to full employment, income that equilibrium in the
money and product market is not consistent with the equilibrium in the labour market. Fig.
5.4 shows that effective demand is less than the full employment income. Figure 5.2 shows
that the effective demand is greater than the full employment income. The basic debate
among Keynesians and classicists is regarding Fig. 5.4 classical would argue that it YE<YF
this will generate forces to bring the system back to that presented in fig. 5.3. Keynesians
would argue that situation of fig 5.4 may continue.
5.4 THE CLASSICAL ARGUMENTS
Labour supply and demand on real wages is shown Fig. 5.2, 5.3. The interaction of
demand and supply determines equilibrium in the labour market.
56

If there is excess labour in the economy and if labour is willing to work at lower real
wage. S curve will shift to the right thus eliminating the excess supply. If there exist better
opportunities for firms D curve may shift upwards and this will also eliminate excess supply.
This is the basic classical argument.
With money prices P, you get the real wages W/P. Thus it is clear that a fail in money
wages would lead to fall in real wages if and only if the fall in money prices is less than the
fall in money wage.

Fig. 5.2 Simultaneous Equilibrium in all the markets

Fig. 5.3 Under Employment Equilibrium

For example, if money wage rate is Rs. 100/- and money price is Rs 50/- the 100 real
wages will be 100/50-2. Now suppose, there is a 10%. fall in money wages, and no fail in
money prices, then the real wage will be 90/50=9/5. This la less than 2, If the fall in money
price was 8% the real wage would be 90/46=90/46. This is less than 2. However if the fall to
money wages was also 10% then the real wage would be 90/45-2 as before. Thus ability of
fell in money wage to reduce unemployment under classical assumption will depend upon
the extent of fall in money price in response to money wages. Dernburg and Mc Dougal
summarize the arguments in this connection as follows:
A fall in W will reduce marginal coat of production. Consequently employment and
output will increase. But MPC is less than 1, so all of the output will not be bought for
consumption. The remainder must be intended investment for equilibrium to be sustained. If
intended investment is not sufficient unintended inventory accumulating will lead to price
fall. In the event of no increase in intended investment a fall in price will bring the level of
output and employment to the old level, the real wage will move to the old level.

Fig. 5.4 IS-LM curves and Full-employment - Classical view

Fig. 5.5 Shift in LM curves and Full-Employment - Keyna view

The classical economists thought that sufficient intended investment will be

forthcoming to eliminate the gap between increased output and consumption demand. As
prices fall real value of money supply will increase. Consequently, interest will fall. The
pressure on interest via real money balances will increase investment. The argument is
shown in the Figure-7.
Initially YF > YE so there is unemployment. Consequently, money wages and prices
would fall. A fall in prices will increase the real value of money. LM curve will shift to the
right to LM1 until YE = YF Then all the three equilibrium curves will be intersecting
simultaneously at the point of full employment equilibrium. Look at the new LM curve
designated as LM2.

Fig. 5.6 Over Employment Equilibrium

In the classical world where there is perfect price, wage and interest flexibility and the
market responses are of the type desirable for full employment, full employment equilibrium
follows as mathematical theorem. The model assumes that Y F is given and adjustment has to
take place, that is, my disequilibrium between Y E and YF will initiate the change in IS or LM
or both functions and these changes will continue to operate in the desired direction until Y E
equals YF.

Fig. 5.7 Equilibrium in the Labour Markets

QF : is the equilibrium quantity at full employment
59

5.5 KEYNESIAN VIEW

The task of Keynesian economics was to prove that it is not only that Y K may be less
than YF but the equilibrating forces will not strong enough to equalise Y K and YF. This could
be done either by finding errors in the logical deduction of classical theory or by questioning
the assumption of the classicists. Keynesian economics questions the assumptions of the
classical. These will be discussed in the following paragraphs through the IS - LM model.
(i) Downward Inflexibility of Wages and Money Illusion
The classical model assumed that labour supply is a function of real wages. Thus, the
supply of labour should be same if money wages are Rs.20 with price of Rs. 15 or money
wages are Rs. 40/- and prices are Rs. 10/- because the real wages remains same in both the
cases. Keynesian model questions this. It argues that workers, would prefer the second
alternative (Rs. 40 with price Rs. 10/-) due to what known as money illusion. Further, trade
unions would resist any fall in wages, even if its consequence would be increased
unemployment. Since wages will not be allowed to fall wage price flexibility is only a
theoretical solution for bringing full employment equilibrium.
(ii) Interest Inelasticity of Investment
Investment demand depends on interest as well as oat profitability of investment. If
there is a general decline in the business a low interest rate may not induce sufficient
investment demand as required fox fall employment equilibrium. The situation may become
like the one depicted in fig. 5.8.
Full employment equilibrium at a negative interest rate.
In figure 8, due to tack of Interest elasticity of investment IS curve cuts and Y F line at
a negative interest rate. Thus shift in the LM curve due to classical mechanism explained
above will not bring full employment at any positive interest rate. Since, it is not practical to
think of negative rate of interest, full employment equilibrium will not be obtained. In the
present situation the answer to the problem of full employment equilibrium lies in the action
that will shift the IS curve above and to the right.
(iii) Liquidity Trap
Sometimes it may not be possible to reduce interest rate to a sufficiently low level to
ensure full employment equilibrium. When interest is low, demand for liquidity could become
infinitely large making the LM curse horizontal to the income axis as shown in figure 5.9. The
demand for liquidity is infinite at that rate of interest.
This phenomenon was called liquidity trap by Keynes. In this situation, the classical
mechanism of shift in the LM curve would bring changes of the type shown m figure 9. As is
easily seen, wage price flexibility and changes is the quantity of money do not affect Y Z at all.
Again full employment equilibrium can be obtained only through direct shift in the IS curve.
Self Assessment Questions
Q. What is liquidity trap?
Ans. ...................................................................................................................................
....................................................................................................................................
...................................................................................................................................
(iv) The Question of Time and the Conclusion
The classical economists particularly Pigou and recently Patinkim found a theoretical
answer to the problem posed by Keynesians. They found a way in which the IS curve would
60

shift upward if only prices were flexible. Due to real balance effect the IS curve will shift
upward in case of price fall because a price fall will lead to increase in the real value of cash
balances which will push consumption expenditure (Pigou) and also investment expenditure
(Patinkin).
The arguments presented above are very simple. The Keynesian argument as
presented above does not contradict the classical theory. As Axel Beijonpufrend has apply
demonstrated the so called Keynesian argument is not exactly what Keynes tried to say.
Keynes; view was simply this: in view of the possibility of many frictions (such as wage
rigidity money illusion, gaps between exante savings and investment decisions, liquidity trap,
interest inelasticity of investments) the system may take very long time to come to the
equilibrium of the classical world. Thus, if it take 200 years for unemployment to be
automatically eliminated, it is as good as if not eliminated, in view of the dynamic real
consequences of the period of disequilibrium. Concerned with the short run Keynes
established the need for direct action.

Fig. 5.8 Liquidity Trap

5.5.1 Liquidity Trap and Real Balance Effect
"Liquidity trap" is one of the crucial concepts on which the Keynesian criticism of
classical theorem of full employment equilibrium depends. 'Real balance effect' is the basic
theoretical argument initiated by Pigou and then elaborated by Patinkin to defend the
classical theorem from the Keynesian attack based on the concept of liquidity trap. This
lessen la meant to explain the concepts of liquidity trap and real balance effect and to
critically examine the arguments built around them.
5.5.2 Meaning and Significance of Liquidity Trap
Keynes introduced the speculative demand for money in economic theory and thereby
the interest elasticity of money. Let us recapitulate this. Depending upon the background
and experience of people they will take differences in their expectations about the rate of
interest and accordingly they will take decisions. In particular consider the choice between
holding bonds or money. Remember the inverse relationship between the price of bond and
interest rate.
If bond price goes up the bond holders benefit (capital gain). If bond price fall the bond
holders lose (capital loss). If a wealth holder thinks that price of bond will fall farther, he
61

would like to postpone purchase of bond or would like to sell bond. That is he would like to
have (demand) money so that he could benefit from, market changes in the bond market.
This is what is known as speculative demand for money. When bond price is high that is
interest rate is low people would like to hold cash balances. There is a negative relationship
between speculative demand for money and the rate of interest. (See Fig 5.8)
Keynes argued that there was a "normal" rate of interest as conceived by an individual.
Whenever the interest reaches a lower limit below the normal rate the holds money rather
than bonds. Whenever, the interest rate reaches an upper limit above the normal rate he
holds bonds rather than money. Although there will be differences in expectations but there
will be some upper limit (finite) of the rate of interest when everybody would expect a fall,
everybody will hold bonds; speculative demand for money will be zero. Similarly there will be
some lower limit when everybody will except a rise in the interest rate nobody would like to
hold bonds; the speculative demand for money will be infinite.1 Keynes argued that this lower
limit of rate of interest would be well above zero when the speculative demand and therefore
the total demand would be infinite. This is the situation of liquidity trap. In what sense? The
answer follows.
The relationship between rate of interest and speculative demand for money is shown
in the diagram given in Figure 5.10
When there is deficiency of aggregate demand, if this task of demand via conscious
monetary policy could push the interest rate sufficiently down, perhaps the economy could
be saved. But infinite demand for liquidity does not let this happen. The economy is trapped.
It is in this sense that this particular situation is called liquidity trap. The significance of the
liquidity trap is that it blocks the working of interest rate mechanism to induce sufficient
effective demand. Economy remains stuck at less than lull employment equilibrium.
Remember that the rate of interest determined by the interaction of demand for money
and supply of money. This is shown in figure. 5.9

Rate of
Interest

Supply and Demand for Money

Fig. 5.9 Equilibrium Rate of Interest
You know that through appropriate monetary policy (that it playing with the quantity)
of money it is argued that the rate of interest can be changed to a desired level. But as shown

1 See Ackley
62

in the above figure, when the demand for money becomes infinitely elastic at (ro), the rate of
interest cannot be decreased no matter how much quantity of money is supplied to the
economy.
In fact wealth holders keep all their wealth in the form of money, the demand for
bonds remains zero. The self adjusting responses of the market as also the monetary
becomes blunt in view of the infinite speculative demand for money.
What effect is would have on investment demand? Even if investment demand is
elastic since the interest rate itself cannot be brought below a certain level, sufficient
investment fails only because interest rate itself becomes sticky. Figure 5.4.
In figure 5.13 with which you must be familiar full employment equilibrium could be
achieved if the C+l could be raised to the level of (C+l). Suppose this gap could be filled by
additional investment if the rate of interest, could be reduced to say 2%. But if the liquidity
trap occurs at 2.5% interest rate cannot be reduced to 2% and thereby the required
additional demand will not be forthcoming. Full employment equilibrium cannot be restored
through interest rate mechanism.

Rate of
Interest

SPECULATIVE DEMAND
FIg. 5.10 Speculative Demand
Self Assessment Question
Q. Define Speculative demand for money.
Ans. ...................................................................................................................................
...................................................................................................................................
...................................................................................................................................
Now add to the speculative demand for money the transaction and precautionary
demand for money.2 Then, the demand for money curve could look like the one shown in
figure 5.12.
It must be noted that infinite elasticity of demand for money is an extreme case. A
general argument should not be based on extreme cases. The real significance of the
argument of liquidity trap is that if speculative demand is highly interest elastic the pace of

2 Keynes though that transaction and precautionary demand for money were not interest elastic. However, later economist
like Tobin and Baumol have proved that these too could be interest elastic.
63

recovery through interest rate mechanism may be so that it is as bad as if there is no

recovery. If it 'takes 1000 years to achieve full employment equilibrium it does not have any
practical utility. Keynes believed, as all of us should, that in she long-run we would all be
dead.
5.5.3 Real Balance Effect Meaning
The Keynesian demonstration of failure of interest rate mechanism was taken as a
challenge by those who believed that automatic forces of the economy would bring the full
employment equilibrium. This led to a search for forces that would be released in the absence
of sufficient demand in order to take the economy in the direction of full employment. Real
balance effect was the major discovery. The argument is simple and is based upon the effect
of change in real value of money balances due to falling prices on the aggregate demand.

Fig. 5.11 Total Demand for Money

Fig. 5.12 Gap Between effective Demand and also full Employment
64

What are the factors which determine aggregate demand (consumption or investment).
The Keynesian model emphasized rate of interest and income as the major determinants.
This is
Ed = F(i, Y)
Where ED=Aggregate Demand
i - Interest
Y - Income
and F is the rule describing the relationship. between ED and i and Y Pigou questioned this
specification of the aggregate demand function. He argued that demand did not depend only
on I and Y it also depends upon the wealth level.3 An important component of wealth is the
stock of money. The real value of the stock of money depends upon the price level. Thus as
price declines, the real value of stock of money, called real balance. 4 As a result the
consumers and investors feel richer. This induces effective demand. This real balance effect
will continue to work so long as prices fall and economy will be pulled out of the under
employment position even if there was liquidity trap. This is illustrated in Figure-5.12.

Full Employment
Fig. 5.13 Real Balance Effect
Figure 5.12 is a reproduction of figure 5.13. But we will put a difference meaning to it
now. You have seen the possibility of the economy not being able to generate effective
demand (C+l) shown by the broken line because of the liquidity trap. But then so long as
prices are less than required for full employment real balance effect will push the effective
demand upward and may be able to bring it to the level (C+I). This will restore full
employment equilibrium. All that is required price flexibility for the real balance effect to
work. The classical theorem of full employment equilibrium is rehabilitated despite the
liquidity trap.

3 Note the difference between the Wealth and Income.

4 Suppose you have Rs. 400/- with you and the price level is 2. Then the real value of what you have is 100/- (1) Rs. 50/-
Now suppose price level falls to 1. then the real value of what you have will be 100/1 = Rs. 100/- you are twice as rich as
you were before. This feeling of richness must get expression in terms of increased consumption and or investment by
you.
65

You should be able to appreciate the point that the real balance effect argument is
based on inclusion of a new variable as an argument in the aggregate demand function. Thus
the demand function in introduced in the question (I) is replaced by the following.
Ed = P(Y1 I - M/P)
Where M is the quantity of money held by people and P is the price. Thus M/P is the
real balance. It is assumed that as M/P increased Ed will increase. As price falls M/P
increases which in turn, increases effective demand. This effectiveness of general price level
on aggregate demand is a change in the value of real balances and has come to be known as
'real balance effect'. Other names for this effect are 'Pigou Effect' and 'Wealth Effect'.

Self Assessment Question

Q. Explain real balance effect?
Ans. ...................................................................................................................................
...................................................................................................................................
...................................................................................................................................

Conclusion
It seems that Keynes did not attach much weightage to the liquidity trap argument
(see Patinkin, p. 349) but later Keynesian economists (e.g Hicks, Hansen Modogliani) were
responsible to make this argument to have a key position in Keynesian economics.
Pigou advanced the real balance effect argument in terms of consumption function.
Patinkin gave an elaborate shape to the argument in his monumental attempt to integrate
monetary and value theory. He, however, based his argument on what is called 'outside’
money. Later in a book Pesek tried to incorporate 'inside money’ also in the framework of the
real balance effect argument.
5.6 SUMMARY
In this lesson we have studied the critical appraisal of classical model by Keynes.
Keynes assumptions, his explanation of working of economy, and its differences with the
classical Model.
5.7 FURTHER READINGS
 Gardner Ackley (1978). Macro-economics Theory and Practice. ColliN MacMillan
London.
 Patinkin Don (1965). Money Interest and Prices. Harper International p. 349.
5.8 MODEL QUESTIONS
1. Compare and Contrast Classical and Keynesian arguments.
2. Explain the Keynesian Model in detail.
66

Lesson – 6a

WAGE PRICE FLEXIBILITY AND FULL EMPLOYMENT : AN

INTRODUCTION
Structure
6a.0 Objectives
6a.1 Introduction
6a.2 Pigou's Version
6a.3 Keynes Version
6a.4 Wage Flexibility and the Level of Employment
6a.4.1 Wages and Consumption
6a.4.2 Wages and investment
6a.4.3 Wages and the Rate of Interest
6a.5 Effect of change in money wage on rate of interest and employment.
6a.6 Real Balance Effects or Pigou effect or evaluation of the Real Balance Effect
6a.7 Other effect of Wage Flexibility on Income and Employment.
6a.8 Philips Curve
6a.9 Summary
6a.10 Glossary
6a.11 References
6a.12 Further Readings
6a.13 Model Questions
6a.0 OBJECTIVES
After going through this lesson, you shall be able to :
 explain the classical view on wage price flexibility
 the Keynsian view on wage price flexibility
 discuss relationship between wage change and employment, price change and
employment, interest change and employment
6a.1 INTRODUCTION
As studied in the previous lessons, in the classical theory of output, employment and
price level, prices and wages are flexible. This means that money wage will fall when
unemployment appears in the economy and the price level will fall when the market cannot
be cleared of the existing output at current prices. Given this pries-wage flexibility the
economy will tend towards full employment, The core of the classical argument is that a fall
in money wage rate leads to cost reduction under perfect competition and causes the price
level to fall, thereby increasing the sales of goods and services. This increased sale will
67

require more people to be employed in the production process. Fall in wages will also be
accompanied by raising profits. This process of falling wages and prices accompanied by
raising profits will lead to increase in employment until equilibrium is reached at full
employment level.5
Keynes disagreed with classical economists saying that wage-price flexibility does not
lead to full employment. According to him classical reasoning of wage price flexibility and full
employment is neither theoretically nor practically valid. Collective bargaining by trade
unions, minimum wage regulations and other legislations passed by the state for the
protection of labour do no allow entrepreneurs to effect an all round cut on money wages.
Keynes also argued that a fall in money wages will cause a decline in aggregate
demand and thus leave aggregate output and employment unchanged. The classicals failed
to visualize the fact that wages, are not simply an element of cost, but they also determine
the aggregate demand of the community. If wages are reduced it will reduce the amount of
goods and services purchased by the working community and thus influence the aggregate
demand.
6a.2 PIGOU'S VERSION
Now let us consider pigou's equation and the influence of wage cut on employment
Pigouvian equation is N = qv/w where N is employment, q is that part of national income
which goes to workers in the form of wages, Y is the national income, w is the average money
wage rate. According to the classical scheme of analysis, a cut m money wage rate, assuming
national income to constant, can raise the volume of employment. However, Keynes believed
that fail in wage (w) will lead to fall in aggregate demand of income (Y) in the same proportion
and thereby employment may not increase as a consequence of fall in wages unless q
changes. Decline in money wages may change because the entrepreneur may substitute
labour with other factors) Keynes, views can be represented through Fog.

Employment
Fig. 6a.1 Pigou Version

5 In case question is asked on wage price flexibility and full employment first of all give classical version in detail. Classical
version on wage price flexibility is in detail in the earlier lesson.
68

In Fig. 6a.1 employment is measured on the horizontal x-axis and wage-rate is

measured on the vertical y-axis. In fig. 6a.1, DL1, is the demand function for labour. It shows
the functional relationship between employment and wage rate. At Y 1 income level and OW1
wage rate, employment is ON. In case wage fall to OW2 and income level remains Y1 according
to classicals, the level of employment will increase. But a fall a wages will lead to a
proportionate drop in the income level from Y1 to Y2. This will neutralize the effect of wage cut
on employment. Given the new demand function (Y2) the level of employment will remain
unchanged at ON even though wages have fallen from OW1 to OW2. Thus a decline in
aggregate demand in proportion to the wage decline will leave the volume of unemployment
unchanged.
6a.3 KEYNES VERSION
However, Keynes, also believed that a reduction of money wages is capable of raising
output and employment for single firm but this may not be true for the economy as a whole.
According to Prof. Dillard, "classical economic theory is primarily the theory for a particular
industry and such is not designed to answer the important question of the effect of wage cut
on employment because it lacks a theory of effective demand Keynes general theory on the
other hand, is specifically designed to come to grips with this problem. The answer arrived at,
thus, is that there is clearly no direct tendency for a cut in money wage rates to increase
employment.
6a.4 WAGE FLEXIBILITY AND THE LEVEL EMPLOYMENT
Keynes also recognised the fact that wage cuts have a favourable effect on employment
in certain circumstances, while wage cuts may have an unfavourable effect on employment in
certain other circumstances. It will depend upon the effect of wage cut on effective demand
through change in consumption investment and rate of interest. Now we shall study the
effect of wage cut on these variables.
6a.4.1 Wages and Consumption
Consumption is the most important constituent of effective demand. The classicals
believed, that wage reduction would stimulate consumption. According to them wage cuts
will reduce the cost of production, which in turn will reduce prices. Lower prices will increase
consumption. However, Keynes did not agree to this view point. In case fall in wages and
prices are once for all this may have a favourable effect on consumption. In case a further fall
in wages and prices is expected the effect on consumption will certainly not be favourable.
Workers will continue to postpone consumption in view of a further fall in price.
Moreover, the Keynes suggests that wage cuts will redistribute income in favour of the
capitalist and rich classes, whose marginal propensity to consume is low. This will affect
consumption unfavourably and the propensity to consume will fall.
However Prof. Pigou believed that a fall in prices, due to cut in real wages, would raise
the real value of case balances such as bends and securities. Thus appreciation of the value
of the monetary assets with the public is likely to increase their consumption. This is
precisely called the Pigou effect of real balance effect. However, some writers do not agree
with Pigou.
6a.4.2Wages and Investment
A reduction in wages can increase effective demand if it leads to increase in
investment. A once for all cut in wages may lead to higher investment as lower wage means
69

lower cost to the entrepreneur. However, if the entrepreneurs expect a further fall in wages
the investment climate is likely to be unfavourably affected. The entrepreneurs will continue
to expect a further fall in wages and may not invest till the wages have reached the minimum
level. Meanwhile, entrepreneurs will make sales out of existing inventories. Thus a rigid
money wage policy may have a favourable effect upon investment than a policy in which
wages sag slowly to lower and lower level.6
Moreover, in democratic countries even once for all simultaneous reduction in wages
may also not be possible. A cut in money wages may, strongly be resented by the trade
unions. A cut is money wages may, strongly be possible in those areas where trade unions do
not exist. But this will be a piece meal attempt and may not have a general effect. Even if
stronger union accept a wage reduction, along with non-union sector they will expect a rise
in wages in the near future. This will affect unfavourably the marginal efficiency of capital of
the entrepreneurs.
6a.4.3Wages and the Rate of Interest
A cut in wages can reduce the rate of interest which in turn can favourably influence
the rate of investment. A cut in wages will reduce the demand for transaction motive.
Consequently, more money will be made available for speculative purposes. This shift in the
speculative demand curve will reduce the rate of interest. The lowering of the rate of interest
accompanied by an elastic investment demand curve will raise the level of investment. The
reduction of the rate of interest in this way is called the 'the Keynes effect'. However, this
analysis will not work if (i) The investment demand schedule is highly inelastic i.e.
investment is not responsive to change in the rate of interest. (ii) The liquidity preferences
schedule, becomes perfectly elastic. In such, a case any increase in the amount kept for
speculative motive will not lower the rate of interest. Whole of the addition to the speculative
motive shall be kept by the people with the hope that the rate of interest will rise higher.
Thus the fall in wages in such a case will have little effect upon the rate of interest.
However, even if fall in wages can lead to reduction in the rate of interest and have a
favourable effect on investment it will be a socially dangerous device. Central bank would
prefer to reduce the rate of interest by increasing the money supply instead of having
reduction in the rate of interest via wage cut. A cut in real wages may create a political and
social unrest in the economy which may badly affect the business expectations. Therefore, it
is very difficult to find out the effect of wage cut on interest rate. However, we shall try to
make the position more clear through the following three diagrams.
6a.5 EFFECT OF CHANGE IN MONEY-WAGE ON RATE OF INTEREST AND
EMPLOYMENT
Now we want to know the effect of change in the money wages on employment. A
decrease in money wage leads to reduction in the transactions demand, lowers prices and
also lower rate of interest and stimulates investment and thus increase employment. On the
other hand, an increase in the money-wage would decrease employment to the extent that a
higher transaction demand, associated with a higher price level, would lead to higher rate of
interest and reduce investment.
Keynes, thus explained the relation between money wage and full employment. In his
view, money-wage level is determined by institutional and historical factors, subject to the
state of the economy to a certain extent. He assumed that the level of money wages at any

6 Dillard D. "Economics of John Mcynard Keynee, (1966), P. 213

point of time is determined by this level in the past and some change may occur due to
institutional factors like change in minimum wage laws, trade union pressure or public
opinion. In addition, the state of employment in the economy also has considerable influence.
For example, as an economy reaches full employment. trade unions becomes stronger
and the resistance of employers to wage increases tends to decline, further as full
employment is reached some employers face a shortage of labour and will not be able to
employ the desired number at the existing wage rate will, therefore offer wages even without
any pressure from the trade union. Hence the money-wage rises as full-employment is
approached.
On the other hand, when unemployment it widespread, trade unions will press leas
hard for higher money-wage. It is quite possible that the employers are able to employ labour
at lower wages to reduce costs and strengthen their competitive position. In fact, it is quite
possible that workers may be competing with each other for the available jobs. Hence, money
wage rate tends to fail in the state of unemployment. But at any particular moment, money
wages, are mere or less autonomously determined and except for the effect on the price level,
insignificantly affects other variables as speculation stabilizes the interest-rate and thus
investment demand. Hence, the economic system can be said to be in equilibrium even at
less than full employment level.
Here, the concept of money wage is different from that of classical flexible wage
concept. They assumed that truly flexible wage level will fall continuously without any limit
during the state of unemployment in the economy. They felt that wage level will be stable
only when all workers seeking Jobs can get them too i.e. at full employment. While Keynes
assumes money wage level to be stable even at less than full employment where the upward
and downward pressures on wages balances out each other at lower levels of employment,
wages may fall but only at a limited rate depending upon the extent of unemployment.

Income
Fig. 6a.2
We can also study the interest rate effect of wage price flexibility through IS and LM
curves in Fig. 6a.2
71

On x-axis we measures the level of income and on y-axis we measure the rate of
interest K in the initial equilibrium point. Here ISO 0 and LM0 function intersect the
equilibrium level of income Y0 and the equilibrium level of interest r0 is determined. But Y0
level of income is not the full employment level of income. Y F is the full employment level. YF-
Y0 is the unemployment level. Let us assume that wage and price decline is once for all. It
means that MEC will be unaffected and the schedule of IS0 curve does not shift to the right.
Wage cut means small transaction balance and more of speculative balances. This will
push down. The LM curve and will reduce the rate of interest. LM curve shifts from LM0 to
LM2. Rate of interest declines to r1 which is the minimum limit set by the liquidity trap.
Consequently the income level rises, from Y0 to Y1. Still the unemployment level is YE-Y1. It is
because of the liquidity trap that rate of interest cannot fall beyond r1.
Thus the flatter the speculative demand schedule and steeper the investment schedule
the greater is the fall in wages and prices required for equilibrium i.e. full-employment. As
such a great fall may be quite possible to achieve in a period of time. According to Keynes
wage flexibility is not a practicable solution to unemployment problem. Besides, falling wages
and prices tend to create an expectation of further fall in wages and prices thereby leading
businessmen to postpone their investment expenditure decisions as well the public to
postpone consumption and thus further accentuate the problem.
Hence, Keynes denied the classical presumption that wage cutting, even if it were
feasible, would increase the aggregate effective demand, Keynes main message, as Don
Patinkin has very aptly described, was to show that the automatic adjustment process of the
markets is too unreliable to serve as a practical basis of full-employment policy.
Keynes argued against general wage-cutting as a remedy against unemployment. He
felt that a policy of wage cut in a single industry might help increase the demand for the
product of that industry but it is not true for the economy as a whole. On the contrary,
aggregate effective demand might decrease following general wage-cut and unemployment
may, as a result, increase.
6a.6 REAL BALANCE EFFECT OR PIGOU EFFECT
In the early forties, during a controversy between Pigou and Keynes, Pigou advanced
the Real Balance Effect or the 'Pigou Effect' in defending the classical position relating to the
effect of general wage cuts in reducing unemployment.7 He argued that cuts in wages and
prices would ultimately restore full employment because a decline in the price level would
cause the consumption function to shift up.
The Keynesian argument that the liquidity trap would not allow wage price flexibility to
achieve full employment was challenged by Pigou. A.C Pigou said that though the liquidity
trap might check the way to increase employment via the path of change in interest rate and
employment, but fall in wages and prices will restore full employment by raising the
consumption function. The mechanism by, which the consumption will shift up, as given by
Pigou is as follows.
When the aggregate demand la less than the full employment level and wages and
prices are flexible, the fall in wages and prices will increase the total (wages) value of the
public's holding of wealth. Now the wealth in the form of goods, land or equities depreciates

7 We have studied the real balance effect. Now we shall study it with the help of IS and LM curves.
72

in value as prices fall and their real value will act increase. But then wealth which has a fixed
money value e.g. money itself and public debt undergoes a value change when prices change.
A fall in the prices level will therefore, increase in real terms) the wealth of consumers to the
extent that its money value is fixed. If consumption is an increasing function of the wealth
and income then it means that a rising (real) value of wealth stimulates consumption outlay
at all levels of income. Hence, prices, will fall till consumption stimulated is sufficient to
increase the aggregate demand upto the full-employment level.
The operation of the Pigou effect is illustrated in the figure-6a.3 given below.
Fig. 6a.3 shows that the initial equilibrium is Y0 income and r0 rate of interest. Here
IS0 and LM0 curves intersect each other. However Y0 is not the. full employment level of
income. There exists voluntary, unemployment of Y 1 - Y0. As we have seen earlier (Fig, 6a.3)
decline in wage and prices (via Increased speculative balances) will shift the LM function from
LM0 to LM2. Pigou effect will also shift the IS function from IS 0 to IS1 This is because of the
real balance effect consumption will rise and saving will reduce.

Fig. 6a.3 Wages, Rate of Interest and Full Employment

Thus the intersection of IS1 and LM2, via real balance effect of Pigou effect can enable
the economy to achieve equilibrium at full employment level of income Y F.
Evaluation of the Real Balance Effect
To the extent equilibrium in the economy can be raised through the Pigou effect. Pigou
can be said to have succeeded in defending the classical position of possibility of full
employment through wage price flexibility. But economists concede no such victory to Pigou
and the effect has been criticized on various grounds. Pigou himself felt that on social
grounds no government will allow extreme drastic cuts in money wage necessary for the
Pigou effect to be effective. He described certain aspects of his argument as 'academic
73

exercises, of some slight use for clarifying thought, but with very little change of ever being
posed on the chess board of actual life".
Pigou effect does not tell us the magnitude of deflation needed to eliminate any given
size of unemployment. It only speaks about the direction of the effect of an increase in the
real value of liquid assets. In fact the Pigou effect is too weak, to be of any practical
importance.
Pigou effect is based upon the assumption that saving function is inversely, related to
the size of real cash balances. But it may be pointed out that the shift in the saving function
may stop at a point where it still intersects the investment function at a negative rate of
interest. This may be because consumer's response to spending may be weaker after a
certain level of prices. Thus full employment in Pigou's case can be possible at a negative rate
of interest. We are aware that the rate of interest cannot be negative.
Moreover, fall in prices due to wage cuts may have a favourable effect on creditors but
unfavourable effect on debtors. Creditor's spending may increase but debtors' spending may
decline. Stimulating effect of creditors may be off set by the discouraging effect of debtors.
According to Patinkin "Hence from this point of view the net effect of price reduction to likely
to be in the neighbourhood of zero.
Even empirical evidence shows that the Pigou effect is not substantial. According to
Hansen only a small proportion of the lower income groups holds any appreciable amount of
assets (he has quoted the finding of consumer survey institute published periodically in the
Federal Reserve Bulletin) name of the capital assets are kept by wealthy community. In their
case reduction in prices have little effect on consumer spending. Pigou effect is insignificant.
Sten, in his analysis of Swedish Saving Survey, could not find any significant correlation
between wealth and saving. T. Mayer study shows that the effect is too weak to have any
practical significance.
Moreover a downward movement in prices may have an unfavourable effect on
investment. Debt burden may increase. Government may levy more taxes to neutralize this
debt burden. This increased amount of taxation may have negative effect on investment.
Moreover, we have already seen that the uncertainty about any further fall in wages and
prices may lead to postponement of business decision to invest further. This again may affect
investment unfavourably. This unfavourable effect on investment may lead to more
unemployment instead of reducing it.
Self Assessment Question
Q. What do you mean by evaluation of real balance effect?
Ans. ..................................................................................................................................
..................................................................................................................................
....................................................................................................................................
6a.7 OTHER EFFECTS OF WAGE FLEXIBILITY ON INCOME AND EMPLOYMENT
Wage flexibility has certain other effects on the level of income and employment.
(a) A fall in wages and prices relative to levels prevailing abroad will make the
purchase of home-made goods cheaper. This will boost up exports and cut
imports, thereby increasing aggregate demand and thus employment.
74

(b) Money wage cut leads to redistribution of income from workers to

entrepreneurs. As high income groups are likely to have tower MPC than the
low income groups aggregate consumption declines and will thus reduce the
level of income and employment.
(c) Keynes believed labour to be subject to money illusion i.e. the workers were far
mere conscious of changes in money wages rather than of change in the price
level. So they tend to regard money and wage increments as real wage
increment. Even if prices went up in the same proportion. In other words,
constant money wage coupled with rising price-level would not be noticed by
the workers and therefore the supply of labour will not be affected. That is the
level of income and employment will remain the same. Such a money illusion
effect is exhibited by consumers and business executives as well. Thus money-
illusion acts as a stabilising factor, on employment. But there are cases where
this is not true.
Thus Keynesian analysts argues that although wage-reduction can have no direct
effect on demand, they should probably have some favourable indirect effects except in
limiting cases. But Keynes himself rejected general wage cuts as a policy measure for
increasing employment. In addition unemployment in the Keynesian model is not inherent.
He suggests, that the, position of consumption and investment functions may be such as to
yield less than full employment, full employment, or even a level of demand more than
sufficient. Keynes argued that if the demand for final gods resources exceeds the supply
when all workers are employed there will be a bidding up of the both prices and wages.
6a.8 PHILLIPS CURVE
The latest development in the relationship between wages and employment levels has
been the Phillips curve. A. W. Phillips derived and empirical relationship which suggested
that when unemployment is low wages tend to rise rapidly and vice-versa. The details of this
curve are explained in the lesson on Inflation.
Phillips curve shows that increases in wages increase marginal cost of productivity,
does not change and thus lead to higher prices. Hence, it suggests that there is a trade off
between unemployment and inflation. Stable prices can be attained only at the expense of
considerable unemployment.
The validity of the trade of implications of the Phillips curve is controversial and hence
we have it as it stands.
6a.9 SUMMARY
In short this lesson explains the relationship between wage-price flexibility and full
employment. We have seen that Keynes criticized flexible wages argument of classical
economists. We have also shown that worker are subject to money illusion and money wages
being rigid downwards, wage-cuts would not increase employment
6a.10 GLOSSARY
 Wage rate : the amount of base wage paid to a worker per unit of time (as per
hour or day) or per unit of output if on piecework.
 Wage flexibility : the extent to which wages and salaries can rise or fall due to
rising or falling profits. That is, a company or economy has wage if, when times
75

are good, it provides employers raises but has the ability to impose cuts when
the times are difficult.
 Real balance : In economics, the Pigou effect is the simulation of output and
employment causes by increasing consumption due to a rise in real balances of
wealth, particulary during deflation.
 Keynes effect : is the effect that changes in the price level have upon goods
market spending. Via changes in interest rate. This implies that insufficient
demand in product market cannot exist forever, because insufficient demand
will cause lower prill level, resulting in increased demand.
6a.11 REFERENCES
 Ackley G (2015). Macro Economic Theory Chap. XIV. pages 372-390.
 Dernburg T.F. and D.M. Mcdougall D.M. (2017). Macro Economics. Chapter 10. pp.
183-210.
 Patinkin Don (1948). Price Flexibility and Full-Employment, in American Economic
Review. Vol. 38 (Sept. 1948). pp. 543-64.
 Philips A.W. (1956). The Relation Between Unemployment and the Rate of Change in
Money Wage in the United Kingdom 1862-1957. Economica, Vol. 25 (1958), pp. 283-
299.
 Rana K.C. and Verma K. N. (2016). Macro Economic Analysis. pp. 549-57.
6a.12 FURTHER READINGS
 Brooman, F.S. (1970) Macro Economics. Ch. 4
 Ackley, Gardner (1961). Macroeconomics. Macmillan Library Reference. Ch. 4
 Peterson, W.C. (2002). Income, Employment and Growth. Ch. 7.
6a.13 MODEL QUESTIONS
1. Can automatic, price flexibility ensure full employment equilibrium? Give your
argument.
2. Compare and contrast classical and Keynesian approach on wage price
flexibility and automatic full employment.
76

Lesson - 6

WAGE-PRICE FLEXIBILITY
Structure
6.0 Objective
6.1 Introduction
6.2 Full employment and wage cut
6.3 Flexible interest rates, wages, and prices
6.4 Wage Flexibility
6.5 Essentially a Static Analysis
6.6 Introduction to real balances
6.7 Keynesian position on wage price flexibility
6.8 Summary
6.9 Glossary
6.10 References
6.11 Further Readings
6.12 Model Questions
6.0 OBJECTIVE
After going through this chapter you will come to know:
 discuss wage-price flexibility and full -employment
 explain flexibility of interest rates, wages, and prices
 discuss wage Flexibility
 describe essentially a Static Analysis
 discuss importance of real balances
 explain Keynesian position differs from its classical counterpart
6.1 INTRODUCTION
In the previous lesson we studied the classical economists generally assumed full-
employment. The cornerstone of classical automatic full employment was their deep faith in
the downward flexibility of money wages and prices. According to them, unemployment is
caused by wages being too high. Hence, the remedy for unemployment lies is lowering the
wage rates. In the lesson we shall discuss the wage price interest flexibility.
6.2 FULL EMPLOYMENT AND WAGE CUT
According to the Classicals, the basic determinant of the volume of employment is the
level of wages. In a free market, the free working of the market forces of demand and supply
for labour determines market wage rate which avoids the possibility of unemployment. If
there is unemployment, the market wage rate would fall till the supply of labour is equal to
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the demand for labour and full employment is restored. Thus, the classical economists
believed that there was always full employment in the economy and in case of
unemployment, a general cut in money wages will result in full employment in the economy.
The idea that a general cut in money wages will lead the economy to full
employment was mainly suggested by Prof.A.C.Pigou. According to him, in a competitive
economy, when money wages are reduced, the cost of production will be lowered. This would
lower the prices of products. When prices fall, demand increases and sales will increase and
increased sales will increase employment resulting in full employment. The classical belief
was based on the assumption that changes in money wages are related directly and
proportionately to real wages. So when money wage rate is reduced, the real wage is also
reduced to the same extent. Consequently, unemployment is reduced and full employment
prevails.
Classical economists assumed the labor market was similar to the goods market in
that price would adjust to ensure that quantity demanded equaled quantity supplied. When
demand would increase, the price of labor (the wage rate) would also increase. This would
increase quantity supplied (the number of workers or hours worked) and quantity demanded
of labor. Conversely, a decrease in the demand for labor would depress wages and the units
of labor supplied would decrease. The demand for labour by firms decreases at higher wage
rates whereas households the supply of labour will increases at higher wage rates.
In other words, at higher wage rates, people that were formerly not in the labour force will be
lured into working by higher wages. Conversely, at low wage rates, more people will choose
not to participate in the labor force. In the classical view of the labor market, all
unemployment is voluntary. When the economy goes into a recession and the demand for
labour falls, the wage rate will decline and people will opt out of the labor force.
6.2 WAGE-PRICE FLEXIBILITY AND FULL -EMPLOYMENT
The Classical economists proved the validity of full employment. According to
them, the amount of production which the business firms can supply does not depend only
on aggregate demand or expenditure but also on the prices of products. If the rate of interest
temporarily fails to bring about equality between saving and investment and as a result
deficiency of aggregate expenditure arises, even then the problem of general over-production
and unemployment will not arise. This is because they thought that the deficiency in
aggregate expenditure would be made up by changes in the price level. When due to the
increase in the savings of the people, the expenditure of the people declines; it will then affect
the prices of products. As a result of fall in aggregate expenditure or demand, the prices of
products would decline and at reduced prices their quantity demanded will increase and as a
result all the quantity produced of goods will be sold out at lower prices.
In this way, they expressed the view that in spite of the decline in aggregate
expenditure caused by the increase in savings, the real output, income and employment will
not fall provided the fall in prices of products is proportionate to the decline in aggregate
expenditure. They believed that a free-market capitalist economy actually works in that way.
Owing to the intense competition between the sellers of products as a consequence of
the fall in expenditure, the prices will decline. This is because when aggregate expenditure on
goods or demand for them declines, the various sellers and producers reduce the prices of
their products so as to avoid the excessive accumulation of stocks of goods with them.
Hence, according to the classical logic, increased saving will bring down the prices of
products and not the amount of production and employment.
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But now a question arises to what extent the sellers or producers will tolerate the
decline in prices. However, to make their business profitable they will have to reduce the
prices of the factors of production such as labour. With a fall in wages of labour, all workers
will get employment. If some workers do not want to work at reduced wages, they will not get
any job or employment and therefore will remain unemployed. But, according to classical
economists, those workers who do not want to work at lower wages and thus remain
unemployed are only voluntarily unemployed. This voluntary unemployment is not real
unemployment. According to the classical thought, it is involuntary unemployment
which is not possible in a free-market capitalist economy. All those workers who want to
work at the wage rate determined by market forces will get employment.
The classical economists also proved the validity of the assumption of full-
employment with another fundamental logic. According to them, the amount of
production which the business firms can supply does not depend only on aggregate demand
or expenditure but also on the prices of products. If the rate of interest temporarily fails to
bring about equality between saving and investment and as a result deficiency of aggregate
expenditure arises, even then the problem of general over-production and unemployment will
not arise. This is because they thought that the deficiency in aggregate expenditure would be
made up by changes in the price level. When due to the increase in the savings of the people,
the expenditure of the people declines; it will then affect the prices of products. As a result of
fall in aggregate expenditure or demand, the prices of products would decline and at reduced
prices their quantity demanded will increase and as a result all the quantity produced of
goods will be sold out at lower prices. In this way, they expressed the view that in spite of
the decline in aggregate expenditure caused by the increase in savings, the real output,
income and employment will not fall provided the fall in prices of products is
proportionate to the decline in aggregate expenditure.
Classical economists thought that a free-market capitalist economy actually works in
that way. Owing to the intense competition between the sellers of products as a consequence
of the fall in expenditure, the prices will decline. This is because when aggregate expenditure
on goods or demand for them declines, the various sellers and producers reduce the prices of
their products so as to avoid the excessive accumulation of stocks of goods with them.
Hence, according to the classical logic, increased saving will bring down the prices of
products and not the amount of production and employment.
Now a question arises to what extent the sellers or producers will tolerate the decline
in prices. However, to make their business profitable they will have to reduce the prices of
the factors of production such as labour. With a fall in wages of labour, all workers will
get employment. If some workers do not want to work at reduce3d wages, they will not get
any job or employment and therefore will remain unemployed. But, according to classical
economists, those workers who do not want to work at lower wages and thus remain
unemployed are only voluntarily unemployed. This voluntary unemployment is not real
unemployment. According to the classical thought, it is involuntary unemployment which is
not possible in a free-market capitalist economy. All those workers who want to work at the
wage rate determined by market forces will get employment.
Conclusion: During the period 1929-33 when there was a great depression in
capitalist economies, a renowned neoclassical economist Pigou suggested a cut in wage
rates in order to remove huge and widespread unemployment prevailing at that time.
According to him, the cause of depression or unemployment was that the Government and
trade unions of workers were preventing the free working of the capitalist economies and
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were artificially keeping the wage rates at high levels. He expressed the view that if the wage
rates were cut down, the demand for labour would increase so that all would get
employment. It was at this time that J.M. Keynes challenged the classical theory and put
forward a new theory of income and employment. He brought about a fundamental
change in economic thought regarding the determination of income and employment in a
developed capitalist economy. Therefore, it is often said that Keynes brought about a
revolution in our economic theory.
6.3 FLEXIBLE INTEREST RATES, WAGES, AND PRICES IN CLASSICAL MODEL
Classical economists believe that under these circumstances, the interest rate will fall,
causing investors to demand more of the available savings. Hence, an increase in savings will
lead to an increase in investment expenditures through a reduction of the interest rate, and
the economy will always return to the natural level of real GDP. The flexibility of the interest
rate as well as other prices is the self-adjusting mechanism of the classical theory that
ensures that real GDP is always at its natural level. The flexibility of the interest rate keeps
the money market, or the market for loanable funds, in equilibrium all the time and thus
prevents real GDP from falling below its natural level. Similarly, flexibility of the wage rate
keeps the labor market or the market for workers, in equilibrium all the time. If the supply of
workers exceeds firms' demand for workers, then wages paid to workers will fall so as to
ensure that the work force is fully employed. Classical economists believe that any
unemployment that occurs in the labor market or in other resource markets should be
considered voluntary unemployment. Voluntarily unemployed workers are unemployed
because they refuse to accept lower wages. If they would only accept lower wages, firms
would be eager to employ them. Thus, the Classical School believed that real factors of
production combined with free markets would increase the wealth of a nation.
According to classical, there are two types of variables in the Classical Model. These
are endogenous (within the system – capital, labour, wage and price) and exogenous (outside
the system – technology, population growth). In the Classical system the exogenous variables
affect supply rather than demand. Thus if there is technological change then the MPN will
change; if population increases or decreases the supply of labour will change. The Classical
system does not consider demand to be a question. In effect, Say‘s Law is assumed to hold:
supply creates its own demand, and, accordingly, there is never a lack of aggregate demand.
So far we have considered only the real wage rate (W/P) as playing a role. The question arises
as to what effect changes in the money wage and money price will have on output. If money P
or W change then the real wage will change. If the real wage changes there will also changes
in the demand and supply of labour. Given the money wage, a firm will choose the quantity
of labour where:
W = MPN x P or,
the money wage equals the MPN times the Price of goods and services. If P increases then
demand for labour will shift to the right, i.e. real wage falls; if P falls demand for labour will
shift to the left. In fact the demand for labour is a function only of the real wage. A
proportionate increase in W and P will thus result in the same demand for labour. Thus if
firms compete by raising money wages to attract workers other firms that do not increase the
money wage will lose workers and eventually exit the industry. However, to pay the higher
money wage firms must increase prices which decrease the real wages until equilibrium is re-
established with a higher money wage, higher money prices but the same level of out as at
the beginning of the process. In fact the aggregate supply curve under the Classical model is
vertical. No matter the price level, money wages will adjust to maintain the real wage and the
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real level of output. Thus, according to the classical, output is determined purely by supply
factors and demand plays no role. Similarly factors like the quantity of money, level of
government spending, and demand for investment goods are all demand and factors that
play no role in determining output in the classical model. Taxes that affect supply-side
factors will, however, affect output. However, factors affecting the classical equilibrium
include changes in technology, reduction of the price of raw materials as well as growth of
the capital stock. Thus, the Classical model is thus characterized by the supply-determined
nature of real output and employment.
The aggregate supply curve is vertical because of assumptions made about the labour
market: (i) perfectly flexible wages and prices; and, implicitly, (ii) perfect information, and, of
course, perfectly competitive industries.
Keynes’s main attack against the postulates of the classical economists centersaround
the relationship between price flexibility and full employment. Keynes challenged the
classical belief that price flexibility can be relied upon to generate automatic full employment.
The defenders of the classical school, on the other hand, still insist upon this automaticity as
a fundamental tenet.
6.4 WAGE FLEXIBILITY: CLASSICALS vs. KEYNESIAN ECONOMICS
The importance of wage flexibility arises from the fact that, in most macroeconomic
models, we find an inverse relationship between wages and employment. Unemployment is
thus associated with wages in excess of full-employment level and the persistence of
unemployment then depends on how quickly wages adjust in the face of unemployment. It is
often argued that if wages were very (if not completely) flexible, unemployment would be
eliminated quickly and automatically by wage cuts, and that, consequently, any persistence
of unemployment must be attributable to wage rigidity. No doubt wage inflexibility plays a
crucial role in explaining unemployment in both classical and Keynesian models. But the
mechanism through which it does so is quite different in the two cases. Classical
unemployment occurs when the real wage exceeds the marginal product of labour at full
employment. So, it is not profitable for firms to employ the whole labour force.
It can only be reduced by cuts in real wages, which makes it profitable for firms to
employ some more workers at the margin. Keynesian unemployment is caused by a
deficiency of aggregate demand. But aggregate demand is largely determined in nominal
terms so that a cut in money wages, and, hence, in prices, tends to raise real aggregate
demand. Thus, it is the inflexibility, or downward rigidity, of money wages which is the
crucial assumption in explaining why unemployment persists in the Keynesian system (even
when the economy is in equilibrium, i.e., a situation of underemployment equilibrium in
Keynesian terminology).The effectiveness of money wage flexibility in reducing unemployment
depends on the interaction of wage-setting and price-setting behavior. As Keynes stressed in
the General Theory (1936), if a change in money wages leads to an equi-proportionate change
in prices, as the behavior of competitive market might lead one to expect, it will leave the real
wage unchanged. Thus, in the Keynesian system, the wage bargaining (which is generally
conducted in money terms) has no direct effect on the real wage. If the price level is fixed, a
fall in money wages will reduce real wages but, because there is no fall in prices, there is no
stimulus to aggregate demand, and, hence, a fall in money wages will not help remove
Keynesian unemployment. We may now discuss in detail the relation between the price
flexibility and full employment in the classical and Keynesian models against this backdrop.
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Self Assessment Question

Q.1 What is Wage price Flexibility
……………………………………………………………………………………………………….
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6.5 STATIC KEYNESIANANALYSIS:
The static Keynesian model rules out the possibility of automatic full employment.
There is no guarantee that the desired savings will automatically be equal to investment. This
point is illustrated in Fig. 6.1. Here, desired real savings (S) and investment (I) are assumed
to depend only on the level of real income (Y). There are three possible investment
schedules—I1, I2, I3. Here, Y0 is the full employment level of income. If the investment desires
of the businesses are represented by the curve I1, desired savings at full employment exceed
desired investment by EE’.
This will lead to unemployment, which will cause the level of income to fall to Y 1 at
which desired savings are equal to desired investment. Conversely, if I3 is the investment
schedule, a situation of overfull employment or demand-pull inflation will arise. Businesses
desire to invest more at full-employment than is possible with the current level of savings.
Only if the investment schedule happened to be I2, the economy would reach full
employment level, with desired investment equal to desired savings. Since, in Keynes’s
model, investment decisions are independent of savings decisions, there is no reason to
expect the investment schedule to coincide with I2. Hence there is assurance that automatic
full employment will result. While defending the classicists, Don Patinkin argues that desired
savings and investment depend on the rate of interest as well as the level of income; and
that, granted flexibility, variations in the interest rate serve as an automatic mechanism for
ensuring full employment.

Fig 6.1 Saving Investment Function

Patinkin defended the classicists by the interpretation of the savings and investment
functions (representing what households and businesses desire to) are written as:
S = f (r, Y)
I = g (r, Y)Where r is the rate of interest.
In Fig. 6.2, we have drawn a whole family of curves relating savings and investment to the
rate of interest—one pair for each level—and real income. In Fig. 2, these pairs of curves are
drawn for full-employment income, Y0, as also for less than full-employment income Y1.
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Since it is assumed that for a given rate of interest people will save and invest more at
a higher level of income, the investment curve corresponding to Y = Y 0 lies above that
corresponding to Y = Y1. The same is true for the two saving curves. These are also consistent
with the assumption that, at a certain level of real income, people desire to save more and
invest less when the rate of interest increases. This is essentially a classical argument.

Fig 6.2 Saving Investment Function for full employment, less than full employment
We now consider the pair of curves, which correspond to the full employment income
Y0. If in Fig. 6.2, the rate of interest were r1, then households would be desirous of saving
more at full employment than businesses would plan to invest. If the interest rate continued
to fall, savings would fall and investment would increase. The process would continue until
finally desired full employment savings and investment would be equated at the level S 0 =
I0.In a like manner, if, at full employment desired investment exceeds desired savings, a rise
in the interest rate will prevent inflation. This is why variations in the rate of interest serve
automatically to prevent any discrepancy between desired full-employment investment and
savings, and, thus, to ensure full employment.
This point may also be illustrated in terms of Fig. 6.1. Let us assume, for analytical
convenience, that desired investment depends on the rate of interest as well as the level of
real income, while desired savings depend only on the latter. Then a fall in the rate of interest
will raise the investment curve from, say, I1 to I2.That is, at any level of income, businesses
can be encouraged to invest more by a reduction in the rate of interest. In a like manner, a
rise in the rate of interest will shift the investment curve downward from, say, I 3 to I2. Thus,
at full employment, desired savings will be equal to desired investment.
Keynes challenged this classical argument on the basis that it greatly exaggerates
the importance of the interest rate. Empirical studies give ample support to the hypothesis
that variations in the rate of interest have little effect on the amount of desired investment.
(Even the classical economists accept the hypothesis that savings are insensitive to the interest
rate.) Oscar Lange has interpreted this insensitivity as a reflection of the presence of
widespread uncertainty.
In Fig. 6.3, we show the possible effect of this insensitivity on the ability of the system
automatically to generate full employment. Although the savings functions are the same as in
Fig. 6.2, the investment functions are now represented in Fig. 6.3 as being much less
interest-sensitive than those in Fig. 6.2.
In such a situation, interest rate changes could never ensure full employment. For, in
an economy in which there are virtually no costs of storing money, the interest rate can never
be negative. But from Fig. 3 we see that the only way the interest rate can equate desired full
employment savings and investment is by assuming the negative value r2.
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Hence, the possibility of the existence of full employment national income Y 0 is ruled
out. For whatever (positive) rate of interest may prevail, the amount people want to save at
full employment exceeds what businesses want to invest. Instead, there will exist some less
than full employment income (say) Y1 for which desired savings and investment can be
brought into equality at a positive rate of interest, say, r3 in Fig. 3.

Fig 6.3 Impossibility of the existence of full employment National Income

Once again we find that automatic full employment is not the only logical possibility.
As Don Patinkin has rightly commented “whether the system will generate full employment
depends on intersection of savings and investment functions at a positive rate of interest.”
But there is no automatic mechanism to assure that the savings and investment functions
will have the proper slopes and positions to bring about such an intersection.
6.6 INTRODUCTION ON REAL BALANCES
G. Haberler and A.C. Pigou have introduced a new variable the real value of cash
balances held by individuals in the economy. Thus, Pigou’s saving function is:
S = h(r, Y, M1/P)
Where M1 is a fixed amount of money in the economy, and P is the wholesale price
level.
Pigou’s argument is simple and straightforward: If people refused to save anything at
negative or zero rates of interest, then the desired savings schedule would intersect the
desired investment schedule at a positive rate of interest whatever may be the level of
income, i.e., whether it is high or low (see Fig.6.3).
The extent to which an individual wishes to save out of current income for reasons
other than the desire of future income is inversely related to the real value of his cash
balances. At this point the only reason he will continue to save out of current income is
anticipated future interest payments. This implies that, if the real value of cash balances is
sufficiently large, the savings function becomes zero at positive rate of interest, regardless of
the income level. This argument is presented in Fig. 6.4. As evident from figure 6.4 as argued
by Pigou argues by increasing the real value of cash balances, the full employment savings
curve shifts to the right until it is in such a position that no savings are desired except at
possible interest rates. This is shown by the savings curve S*, which intersects the horizontal
axis at a positive rate of interest. This means that even if the rate of interest is positive,
saving is zero. The full employment savings curve S* intersects the full employment
investment curve I at the positive rate of interest r4. Thus, by changing the real value of cash
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balances, it is always possible to equate desired full employment savings with investment at
a positive rate of interest.

Fig 6.4 Real balance effect and Full Employment

Pigou’s assumption of flexible wage and price levels and a constant stock of money in
circulation ensure that real cash balances automatically change in the most desirable
way. If, for instance, full employment saving exceeds investment, national income begins to
fall and there is unemployment. If workers react to this by accepting lower money wages,
then the price level will also start falling. Consequently, the real value of the constant stock
of money increases correspondingly. Thus, with a fall in price level, the full employment
saving function continuously shifts to the right until it intersects the full employment
investment function at a positive rate of interest. This is the automatic mechanism on
which Haberler and Pigou rely to ensure full employment This mechanism will operate
regardless of the interest-elasticities of the savings and investment functions—
provided they are not both identically zero. The Haberler-Pigou analysis makes the
following prediction: There always exists a sufficiently low price level such that, if
expected to continue indefinitely, it will generate full employment.’

Self-Assessment Questions

1. How is the flexibility of wages and prices discussed in the classical and Keynesian
mechanism?
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2. Discuss the Pigou analysis of the wage price flexibility.
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6.7 DIFFERENCES
The Keynesian position differs from its classical counterpart on three
points:
1. Even if there were no problem of uncertainty and adverse anticipations, a policy
of price flexibility would still not assure the generation of full employment.
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2. In a static model, price flexibility would always ensure full employment. But in
a dynamic world of uncertainty and adverse anticipations, even if we were to
allow an infinite adjustment period, there is no certainty that full employment
will always be attained. That is, the economy may remain indefinitely in a
position of underemployment disequilibrium.
3. This is the Keynesian position, closest to the ‘classicists’, which states that,
even with uncertainty, full employment would ultimately be ensured by a policy
of price flexibility. But the long time period that might be necessary for the
adjustment makes the policy impractical.
Thus the reduction in money-wages will have no lasting tendency to increase
employment except by virtue of its repercussions either on the propensity to consume for the
community as a whole, or on the schedule of marginal efficiencies of capital, or on the rate of
interest. There is no method of analysing the effect of a reduction in money-wages, except by
following up its possible effects on these three factors.
The most important repercussions on these factors are likely, in practice, to be the
following:
(1) A reduction of money-wages will somewhat reduce prices. It will, therefore, involve
some redistribution of real income (a) from wage-earners to other factors entering into
marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs
to rentiers to whom a certain income fixed in terms of money has been guaranteed. What will
be the effect of this redistribution on the propensity to consume for the community as a
whole? The transfer from wage-earners to other factors is likely to diminish the propensity to
consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But
if rentiers represent on the whole the richer section of the community and those who’s
standard of life is least flexible, then the effect of this also will be unfavourable. What the net
result will be on a balance of considerations, we can only guess. Probably it is more likely to
be adverse than favourable.
(2) If we are dealing with an unclosed system, and the reduction of money-wages is a
reduction relatively to money-wages abroad when both are reduced to a common unit, it is
evident that the change will be favourable to investment, since it will tend to increase the
balance of trade. This assumes, of course, that the advantage is not offset by a change in
tariffs, quotas, etc. The greater strength of the traditional belief in the efficacy of a reduction
in money-wages as a means of increasing employment in Great Britain, as compared with the
United States, is probably attributable to the latter being, comparatively with ourselves, a
closed system.
(3) In the case of an unclosed system, a reduction of money-wages, though it increases
the favourable balance of trade, is likely to worsen the terms of trade. Thus there will be a
reduction in real incomes, except in the case of the newly employed, which may tend to
increase the propensity to consume.
(4) If the reduction of money-wages is expected to be a reduction relatively to money-
wages in the future, the change will be favourable to investment, because as we have seen
above, it will increase the marginal efficiency of capital; whilst for the same reason it may be
favourable to consumption. If, on the other hand, the reduction leads to the expectation, or
even to the serious possibility, of a further wage-reduction in prospect, it will have precisely
the opposite effect. For it will diminish the marginal efficiency of capital and will lead to the
postponement both of investment and of consumption.
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(5) The reduction in the wages-bill, accompanied by some reduction in prices and in
money-incomes generally, will diminish the need for cash for income and business purposes;
and it will therefore reduce pro tanto the schedule of liquidity-preference for the community
as a whole. Cet. par. this will reduce the rate of interest and thus prove favourable to
investment. In this case, however, the effect of expectation concerning the future will be of an
opposite tendency to those just considered under (4). For, if wages and prices are expected to
rise again later on, the favourable reaction will be much less pronounced in the case of long-
term loans than in that of short-term loans. If, moreover, the reduction in wages disturbs
political confidence by causing popular discontent, the increase in Liquidity preference due to
this cause may more than offset the release of cash from the active circulation.
(6) Since a special reduction of money-wages is always advantageous to an individual
entrepreneur or industry, a general reduction (though its actual effects are different) may
also produce an optimistic tone in the minds of entrepreneurs, which may break through a
vicious circle of unduly pessimistic estimates of the marginal efficiency of capital and set
things moving again on a more normal basis of expectation. On the other hand, if the
workers make the same mistake as their employers about the effects of a general reduction,
labour troubles may offset this favourable factor; apart from which, since there is, as a rule,
no means of securing a simultaneous and equal reduction of money-wages in all industries,
it is in the interest of all workers to resist a reduction in their own particular case. In fact, a
movement by employers to revise money-wage bargains downward will be much more
strongly resisted than a gradual and automatic lowering of real wages as a result of rising
prices.
(7) On the other hand, the depressing influence on entrepreneurs of their greater burden
of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall
of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily
indebted may soon reach the point of insolvency, with severely adverse effects on investment.
Moreover the effect of the lower price-level on the real burden of the National Debt and hence
on taxation is likely to prove very adverse to business confidence.This is not a complete
catalogue of all the possible reactions of wage reductions in the complex real world. But the
above cover, I think, those which are usually the most important.If, therefore, we restrict our
argument to the case of a closed system, and assume that there is nothing to be hoped, but if
anything the contrary, from the repercussions of the new distribution of real incomes on the
community's propensity to spend, it follows that we must base any hopes of favourable
results to employment from a reduction in money-wages mainly on an improvement in
investment due either to an increased marginal efficiency of capital under (4) or a decreased
rate of interest under (5). Let us consider these two possibilities in further detail.
The contingency, which is favourable to an increase in the marginal efficiency of
capital, is that in which money-wages are believed to have touched bottom, so that further
changes are expected to be in the upward direction. The most unfavourable contingency is
that in which money-wages are slowly sagging downwards and each reduction in wages
serves to diminish confidence in the prospective maintenance of wages. When we enter on a
period of weakening effective demand, a sudden large reduction of money-wages to a level so
low that no one believes in its indefinite continuance would be the event most favourable to a
strengthening of effective demand. But this could only be accomplished by administrative
decree and is scarcely practical politics under a system of free wage-bargaining. On the other
hand, it would be much better that wages should be rigidly fixed and deemed incapable of
material changes, than that depressions should be accompanied by a gradual downward
tendency of money-wages, a further moderate wage reduction being expected to signalize
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each increase of, say, 1 per cent. in the amount of unemployment. For example, the effect of
an expectation that wages are going to sag by, say, 2 per cent in the coming year will be
roughly equivalent to the effect of a rise of 2 per cent in the amount of interest payable for
the same period. The same observations apply mutatis mutandis to the case of a boom.
It follows that with the actual practices and institutions of the contemporary world it is
more expedient to aim at a rigid money-wage policy than at a flexible policy responding by
easy stages to changes in the amount of unemployment; -- so far, that is to say, as the
marginal efficiency of capital is concerned. But is this conclusion upset when we turn to the
rate of interest? It is, therefore, on the effect of a falling wage- and price-level on the demand
for money that those who believe in the self-adjusting quality of the economic system must
rest the weight of their argument; though I am not aware that they have done so. If the
quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to
hope in this direction. But if the quantity of money is virtually fixed, it is evident that its
quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in
money-wages; and that its quantity in proportion to incomes generally can be largely
increased, the limit to this increase depending on the proportion of wage-cost to marginal
prime cost and on the response of other elements of marginal prime cost to the falling wage-
unit.

Self-Assessment Questions
1. How the flexibility of wages and prices discussed in the classical and Keynesian
mechanism different from classicals?
………………………………………………………………………………………………………………………………………………………
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2. Discuss the importance of real balance effect.
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We can, therefore, theoretically at least, produce precisely the same effects on the rate
of interest by reducing wages, whilst leaving the quantity of money unchanged, that we can
produce by increasing the quantity of money whilst leaving the level of wages unchanged. It
follows that wage reductions, as a method of securing full employment, are also subject to
the same limitations as the method of increasing the quantity of money. The same reasons as
those mentioned above, which limit the efficacy of increases in the quantity of money as a
means of increasing investment to the optimum figure, apply mutatis mutandis to wage
reductions. Just as a moderate increase in the quantity of money may exert an inadequate
influence over the long-term rate of interest, whilst an immoderate increase may offset its
other advantages by its disturbing effect on confidence; so a moderate reduction in money-
wages may prove inadequate, whilst an immoderate reduction might shatter confidence even
if it were practicable. There is, therefore, no ground for the belief that a flexible wage policy is
capable of maintaining a state of continuous full employment; -- any more than for the belief
than an open-market monetary policy is capable, unaided, of achieving this result. The
economic system cannot be made self-adjusting along these lines. If, indeed, labour were
always in a position to take action (and were to do so), whenever there was less than full
employment, to reduce its money demands by concerted action to whatever point was
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required to make money so abundant relatively to the wage-unit that the rate of interest
would fall to a level compatible with full employment, we should, in effect, have monetary
management by the Trade Unions, aimed at full employment, instead of by the banking
system. Nevertheless while a flexible wage policy and a flexible money policy come,
analytically, to the same thing, inasmuch as they are alternative means of changing the
quantity of money in terms of wage-units, in other respects there is, of course, a world of
difference between them. Let me briefly recall to the reader's mind the three outstanding
considerations.
(i) Except in a socialised community where wage-policy is settled by decree, there is no
means of securing uniform wage reductions for every class of labour. The result can
only be brought about by a series of gradual, irregular changes, justifiable on no
criterion of social justice or economic expediency, and probably completed only after
wasteful and disastrous struggles, where those in the weakest bargaining position will
suffer relatively to the rest. A change in the quantity of money, on the other hand, is
already within the power of most governments by open-market policy or analogous
measures. Having regard to human nature and our institutions, it can only be a
foolish person who would prefer a flexible wage policy to a flexible money policy,
unless he can point to advantages from the former which are not obtainable from the
latter. Moreover, other things being equal, a method which it is comparatively easy to
apply should be deemed preferable to a method which is probably so difficult as to be
impracticable.
(ii) If money-wages are inflexible, such changes in prices as occur (i.e. apart from
"administered" or monopoly prices which are determined by other considerations
besides marginal cost) will mainly correspond to the diminishing marginal productivity
of the existing equipment as the output from it is increased. Thus the greatest
practicable fairness will be maintained between labour and the factors whose
remuneration is contractually fixed in terms of money, in particular the rentier class
and persons with fixed salaries on the permanent establishment of a firm, an
institution or the State. If important classes are to have their remuneration fixed in
terms of money in any case, social justice and social expediency are best served if the
remunerations of all factors are somewhat inflexible in terms of money. Having regard
to the large groups of incomes which are comparatively inflexible in terms of money, it
can only be an unjust person who would prefer a flexible wage policy to a flexible
money policy, unless he can point to advantages from the former which are not
obtainable from the latter.
(iii) The method of increasing the quantity of money in terms of wage-units by decreasing
the wage-unit increases proportionately the burden of debt; whereas the method of
producing the same result by increasing the quantity of money whilst leaving the wage
unit unchanged has the opposite effect. Having regard to the excessive burden of
many types of debt, it can only be an inexperienced person who would prefer the
former. If a sagging rate of interest has to be brought about by a sagging wage-level,
there is, for the reasons given above, a double drag on the marginal efficiency of
capital and a double reason for putting off investment and thus postponing recovery.
6.8 SUMMARY
In summary, Classical economics: a) stressed the role of real as opposed to monetary
factors in determining real outcomes like output and employment. Money was considered
strictly a medium of exchange not a causal factor in economic growth; and, b) stressed the
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role of the self-adjusting marketplace to ensure output and employment. Government had no
role in ensuring adequate demand or employment other than essential infrastructure, e.g.
roads, canals and competitive markets. Keynes’s main attack against the postulates of the
classical economists centreson the relationship between price flexibility and full employment.
Keynes challenged the classical belief that price flexibility can be relied upon to generate
automatic full employment. The defenders of the classical school, on the other hand, still
insist upon this automaticity as a fundamental tenet.
6.9 GLOSSARY
 Classical economic theory is rooted in the concept of a laissez-faire economic
market. A laissez-faire--also known as free--market requires little to no government
intervention. It also allows individuals to act according to their own self-interest
regarding economic decisions.
 Saving is income not spent, or deferred consumption. Methods of saving include
putting money aside in, for example, a deposit account, a pension account, an
investment fund, or as cash. Saving also involves reducing expenditures, such as
recurring costs.
 An investment is an asset or item that is purchased with the hope that it will generate
income or will appreciate in the future. In an economic sense, an investment is the
purchase of goods that are not consumed today but are used in the future to create
wealth.
 Effective demand (ED) in a market is the demand for a product or service which
occurs when purchasers are constrained in a different market. It contrasts with
notional demand, which is the demand that occurs when purchasers are not
constrained in any other market.
6.10 REFERENCES
 Dernburg, T. F., & Dernburg, J. D. (1969). Macroeconomic analysis: an introduction to
comparative statics and dynamics. Addison-Wesley.
 Rana, K. C., & Verma, K. N. (2009). Macroeconomics Vishal Publishing Company.
 Dwivedi, D. N. (2005). Macroeconomics: theory and policy. Tata McGraw-Hill
Education.
6.11 FURTHER READINGS
 Ackley, G. (1961). Macroeconomic theory, MC Millan Library References.
 Shapiro, E. (1978). Macroeconomic analysis (No. 339.2 S4 1978). Galgotia Publications
6.12 MODEL QUESTIONS
1. Explain in detail the wage price flexibility in the classical context.
2. Explain in detail the wage price flexibility in the Keynesian context.
3. Explain the difference between the flexibility of wages in prices in the two school
of thought in Economics.
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Lesson-7

CONSUMPTION FUNCTION
Structure

7.0 Objectives
7.1 Introduction
7.2 John Maynard Keynes and the Consumption Function
7.3 Keynes’s Conjectures
7.4 The Early Empirical Successes
7.5 Secular Stagnation, Simon Kuznets, and the Consumption Puzzle
7.6 Irving Fisher and Intertemporal Choice
7.7 The Intertemporal Budget Constraint
7.8 Consumer Preferences
7.9 Optimization
7.10 How Changes in Income Affect Consumption
7.11 How Changes in the Real Interest Rate Affect Consumption
7.12 Constraints on Borrowing
7.13 Summary
7.14 Glossary
7.15 References
7.16 Further Readings
7.17 Model Questions

7.0 OBJECTIVES

After going through the lesson you shall be able to –

 explain the concept of the Consumption Function as given by Keynes
 discuss the Secular Stagnation, Simon Kuznets, and the Consumption Puzzle
 describe the Intertemporal Choice
 analyse the concept of Consumer Preferences.

7.1 INTRODUCTION
In last two semester of the course we studied the concepts of micro economics but now
we will be studying the basic concepts of macroeconomics wherein here we shall study one
main component of aggregate demand i.e. consumption demand. Here we will consider the
influence of variation in consumption expenditure on the level of employment. We will
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discuss the various theories of consumer function. The available statistical evidence suggests
a close relationship between the level at aggregate consumption expenditure and the level of
disposable income. In other words the consumption expenditure of the community is
principally determined by the community’s level of disposable income. Consumption function
indicates s the proportion of the aggregate income that shall be spent on consumption at the
various levels of income. in the words of Hansen. "lt is a functional relationship indicating
how consumption varies as income varies'.
7.2 JOHN MAYNARD KEYNES AND THE CONSUMPTION FUNCTION
How do households decide how much of their income to consume todayand how much
to save for the future? This is a microeconomic question because it addresses the behavior of
individual decision makers. Yet it answer has important macroeconomic consequences.
Keynes put forward a psychological law of consumption, according to which, as income
increases consumption increases but not by as much as the increase in income. In other
words, marginal propensity to consume is less than one. While Keynes recognized that many
subjective and objective factors including interest rate and wealth influenced the level of
consumption expenditure, he emphasized that it is the current level of income on which the
consumption spending of an individual and the society depends.
The evidence shows that the households’ consumption decisions affect the way the
economy as a whole behaves both in the long run and in the short run. The consumption
decision is crucial for long-run analysis because of its role in economic growth. The Solow
growth model of growth depicts the saving rate is a key determinant of the steady-state
capital stock and thus of the level of economic well-being. The saving rate measures how
much of its income the present generation is not consuming but is instead putting aside for
its own future and for future generations. The consumption decision is crucial for short-run
analysis because of its role in determining aggregate demand. Consumption is two-thirds of
GDP, so fluctuations in consumption are a key element of booms and recessions. The IS–LM
model shows that changes in consumers’ spending plans can be a source of shocks to the
economy and that the marginal propensity to consume is a determinant of the fiscal-policy
multipliers. The consumption function relates consumption to disposable income:
C = C(Y − T).
This approximation allowed us to develop simple models for long-run and short-run
analysis, but it is too simple to provide a complete explanation of consumer behavior. In this
chapter we will examine the consumption function in greater detail and develop a more
thorough explanation of what determines aggregate consumption. Since macroeconomics
began as a field of study, many economists have written about the theory of consumer
behavior and suggested alternative ways of interpreting the data on consumption and
income. This chapter presents the views of six prominent economists to show the diverse
approaches to explaining consumption.
We begin our study of consumption with John Maynard Keynes’s General Theory,
which was published in 1936. Keynes made the consumption function central to his theory
of economic fluctuations, and it has played a key role in macroeconomic analysis ever since.
Let’s consider what Keynes thought about the consumption function and then see what
puzzles arose when his ideas were confronted with the data.
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7.3 KEYNES’S CONJECTURES

Today, economists who study consumption rely on sophisticated techniques of data
analysis. With the help of computers, they analyze aggregate data on the behavior of the
overall economy from the national income accounts and detailed data on the behavior of
individual households from surveys. Because Keynes wrote in the 1930s, however, he had
neither the advantage of these data nor the computers necessary to analyze such large data
sets. Instead of relying on statistical analysis, Keynes made conjectures about the
consumption function based on introspection and casual observation. First and most
important, Keynes conjectured that the marginal propensity to consume—the amount
consumed out of an additional dollar of income—is between zero and one. He wrote that the
“fundamental psychological law, upon which we are entitled to depend with great confidence,
is that men are disposed, as a rule and on the average, to increase their consumption as
their income increases, but not by as much as the increase in their income.’’
That is, when a person earns an extra dollar, he typically spends some of it and saves
some of it. As we saw in Chapter 10 when we developed the Keynesian cross, the marginal
propensity to consume was crucial to Keynes’s policy recommendations for how to reduce
widespread unemployment. The power of fiscal policy to influence the economy—as
expressed by the fiscal-policy multipliers—arises from the feedback between income and
consumption. Second, Keynes posited that the ratio of consumption to income, called the
average propensity to consume, falls as income rises. He believed that saving was a luxury,
so he expected the rich to save a higher proportion of their income than the poor. Although
not essential for Keynes’s own analysis, the postulate that the average propensity to consume
falls as income rises became a central part of early Keynesian economics. Third, Keynes
thought that income is the primary determinant of consumption and that the interest rate
does not have an important role. This conjecture stood in stark contrast to the beliefs of the
classical economists who preceded him. The classical economists held that a higher interest
rate encourages saving and discourages consumption. Keynes admitted that the interest rate
could influence consumption as a matter of theory. Yet he wrote that “the main conclusion
suggested by experience, I think, is that the short-period influence of the rate of interest on
individual spending out of a given income is secondary and relatively unimportant.’’
On the basis of these three conjectures, the Keynesian consumption functionis often
written as
C = C− + cY, C− > 0, 0 <c < 1,
Where, C is consumption, Y is disposable income, C− is a constant, and c is the
marginal propensity to consume. This consumption function, shown in Figure1-1, is graphed
as a straight line. C− determines the intercept on the vertical axis and c determines the slope.
Notice that this consumption function exhibits the three properties that Keynes
posited. It satisfies Keynes’s first property because the marginal propensity to consume c is
between zero and one, so that higher income leads to higher consumption and also to higher
saving. This consumption function satisfies Keynes’s second property because the average
propensity to consume APC is
APC = C/Y = C−/Y + c.
As Y rises, C−/Y falls, and so the average propensity to consume C/Y falls. And finally,
this consumption function satisfies Keynes’s third property because the interest rate is not
included in this equation as a determinant of consumption.
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Income

Figure 7.1
This figure 7.1 graphs a consumption function with the three properties that Keynes
conjectured. First, the marginal propensity to consume c is between zero and one. Second,
the average propensity to consume falls as income rises. Third, consumption is determined
by current income. The marginal propensity to consume, MPC, is the slope of the
consumption function. The average propensity to consume, APC = C/Y, equals the slope of a
line drawn from the origin to a point on the consumption function.
7.4 THE EARLY EMPIRICAL SUCCESSES
Soon after Keynes proposed the consumption function, economists began collecting
and examining data to test his conjectures. The earliest studies indicated that the Keynesian
consumption function was a good approximation of how consumers behave. In some of these
studies, researchers surveyed households and collected data on consumption and income.
They found that households with higher income consumed more, which confirms that the
marginal propensity to consume is greater than zero. They also found that households with
higher income saved more, which confirms that the marginal propensity to consume is less
than one. In addition, these researchers found that higher-income households saved a larger
fraction of their income, which confirms that the average propensity to consume falls as
income rises. Thus, these data verified Keynes’s conjectures about the marginal and average
propensities to consume. In other studies, researchers examined aggregate data on
consumption and income for the period between the two world wars. These data also
supported the Keynesian consumption function. In years when income was unusually low,
such as during the depths of the Great Depression, both consumption and saving were low,
indicating that the marginal propensity to consume is between zero and one. In addition,
during those years of low income, the ratio of consumption to income was high, confirming
Keynes’s second conjecture. Finally, because the correlation between income and
consumption was so strong, no other variable appeared to be important for explaining
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consumption. Thus, the data also confirmed Keynes’s third conjecture that income is the
primary determinant of how much people choose to consume.
7.5 SECULAR STAGNATION, SIMON KUZNETS, AND THE CONSUMPTION
PUZZLE
Although the Keynesian consumption function met with early successes, two
anomalies soon arose. Both concern Keynes’s conjecture that the average propensity to
consume falls as income rises. The first anomaly became apparent after some economists
made a dire—and, it turned out, erroneous—prediction during World War II. On the basis of
the Keynesian consumption function, these economists reasoned that as incomes in the
economy grew over time, households would consume a smaller and smaller fraction of their
incomes. They feared that there might not be enough profitable investment projects to absorb
all this saving. If so, the low consumption would lead to an inadequate demand for goods and
services, resulting in a depression once the wartime demand from the government ceased. In
other words, on the basis of the Keynesian consumption function, these economists predicted
that the economy would experience what they called secular stagnation—a long depression of
indefinite duration—unless the government used fiscal policy to expand aggregate demand.
Fortunately for the economy, but unfortunately for the Keynesian consumption
function, the end of World War II did not throw the country into another depression.
Although incomes were much higher after the war than before, the sehigher incomes did not
lead to large increases in the rate of saving. Keynes’s conjecture that the average propensity
to consume would fall as income rose appeared not to hold. The second anomaly arose when
economist Simon Kuznets constructed new aggregate data on consumption and income
dating back to 1869. Kuznets assembled these data in the 1940s and would later receive the
Nobel Prize for this work. He discovered that the ratio of consumption to income was
remarkably stable from decade to decade, despite large increases in income over the period
he studied. Again, Keynes’s conjecture that the average propensity to consume would fall as
income rose appeared not to hold. The failure of the secular-stagnation hypothesis and the
findings of Kuznets both indicated that the average propensity to consume is fairly constant
over long periods of time. This fact presented a puzzle that motivated much of the
subsequent research on consumption. Economists wanted to know why some studies
confirmed Keynes’s conjectures and others refuted them. That is, why did Keynes’s
conjectures hold up well in the studies of household data and in the studies of short time-
series but fail when long time-series were examined?
Figure 7.2 illustrates the puzzle. The evidence suggested that there were two
consumption functions. For the household data and for the short time-series, the Keynesian
consumption function appeared to work well. Yet for the long time-series, the consumption
function appeared to exhibit a constant average propensity to consume. In Figure 7.2, these
two relationships between consumption and income are called the short-run and long-run
consumption functions.
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Fig 7.2
The Consumption Puzzle Studies of household data and short time-series found a
relationship between consumption and income similar to the one Keynes conjectured. In the
figure, this relationship is called the short-run consumption function. But studies of
longtime-series found that the average propensity to consume did not vary systematically
with income. This relationship is called the long-run consumption function. Notice that the
short-run consumption function has a falling average propensity to consume, whereas the
long-run consumption function has a constant average propensity to consume.
Economists needed to explain how these two consumption functions could be
consistent with each other. In the 1950s, Franco Modigliani and Milton Friedman each
proposed explanations of these seemingly contradictory findings. Both economists later won
Nobel Prizes, in part because of their work on consumption. But before we see how
Modigliani and Friedman tried to solve the consumption puzzle, we must discuss Irving
Fisher’s contribution to consumption theory. Both Modigliani’s life-cycle hypothesis and
Friedman’s permanent-income hypothesis rely on the theory of consumer behavior proposed
much earlier by Irving Fisher.
7.6 IRVING FISHER ANDINTERTEMPORAL CHOICE
The consumption function introduced by Keynes relates current consumption to
current income. This relationship, however, is incomplete at best. When people decide how
much to consume and how much to save, they consider both the present and the future. The
more consumption they enjoy today, the less they will be able to enjoy tomorrow. In making
this tradeoff, households must look ahead to the income they expect to receive in the future
and to the consumption of goods and services they hope to be able to afford. The economist
Irving Fisher developed the model with which economists analyze how rational, forward-
looking consumers make intertemporal choices— that is, choices involving different periods
of time. Fisher’s model illuminates the constraints consumers face, the preferences they
have, and how these constraints and preferences together determine their choices about
consumption and saving.
7.7 THE INTERTEMPORAL BUDGET CONSTRAINT
Most people would prefer to increase the quantity or quality of the goods and services
they consume—to wear nicer clothes, eat at better restaurants, or see more movies. The
reason people consume less than they desire is that their consumption is constrained by
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their income. In other words, consumers face a limit on how much they can spend, called a
budget constraint. When they are deciding how much to consume today versus how much to
save for the future, they face an intertemporal budget constraint, which measures the total
resources available for consumption today and in the future. Our first step in developing
Fisher’s model is to examine this constraint in some detail. To keep things simple, we
examine the decision facing a consumer who lives for two periods. Period one represents the
consumer’s youth, and period two represents the consumer’s old age. The consumer earns
income Y1 and consumes C1 in period one, and earns income Y2 and consumes C2 in period
two. (All variables are real—that is, adjusted for inflation.) Because the consumer has the
opportunity to borrow and save, consumption in any single period can be either greater or
less than income in that period. Consider how the consumer’s income in the two periods
constrains consumption in the two periods. In the first period, saving equals income minus
consumption. That is,
S = Y1 − C1,
where S is saving.
In the second period, consumption equals the accumulated saving, including the
interest earned on that saving, plus second-period income. That is,
C2 = (1 + r)S + Y2,
where r is the real interest rate.
For example, if the real interest rate is 5 percent, then for every $1 of saving in period
one, the consumer enjoys an extra $1.05 of consumption in period two. Because there is no
third period, the consumer does not save in the second period. Note that the variable S can
represent either saving or borrowing and that these equations hold in both cases. If first-
period consumption is less than first-period income, the consumer is saving, and S is greater
than zero. If first-period consumption exceeds first-period income, the consumer is
borrowing, and S is less than zero. For simplicity, we assume that the interest rate for
borrowing is the same as the interest rate for saving. To derive the consumer’s budget
constraint, combine the two preceding equations. Substitute the first equation for S into the
second equation to obtain
C2 = (1 + r)(Y1 − C1) + Y2.
To make the equation easier to interpret, we must rearrange terms. To place all the
consumption terms together, bring (1 + r)C1 from the right-hand side to the left-hand side of
the equation to obtain (1 + r)C1 + C2 = (1 + r)Y1 + Y2.
Now divide both sides by 1 + r to obtain
C1+ =Y1 + .
This equation relates consumption in the two periods to income in the two periods. It
is the standard way of expressing the consumer’s intertemporal budget constraint. The
consumer’s budget constraint is easily interpreted. If the interest rate is zero, the budget
constraint shows that total consumption in the two periods equals total income in the two
periods. In the usual case in which the interest rate is greater than zero, future consumption
and future income are discounted by a factor 1 + r. This discounting arises from the interest
earned on savings. In essence, because the consumer earns interest on current income that
is saved, future income is worth less than current income. Similarly, because future
consumption is paid for out of savings that have earned interest, future consumption costs
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less than current consumption. The factor 1/(1 + r) is the price of second- period
consumption measured in terms of first-period consumption: it is the amount of first-period
consumption that the consumer must forgo to obtain 1 unit of second-period consumption.
Figure 7.3 graphs the consumer’s budget constraint. Three points are markedon this figure.

Fig. 7.3
The Consumer’s Budget Constraint
This figure 7.3 shows the combinations of first-period and second-period consumption
the consumer can choose. If he chooses points between A and B, he consumes less than his
income in the first period and saves the rest for the second period. If he chooses points
between A and C, he consumes more than his income in the first period and borrows to make
up the difference.
At point A, the consumer consumes exactly his income in each period (C1 = Y1 and C2
= Y2), so there is neither saving nor borrowing between the two periods. At point B, the
consumer consumes nothing in the first period (C1 = 0) and saves all income, so second-
period consumption C2 is (1 + r)Y1 +Y2. At point C, the consumer plans to consume nothing
in the second period (C2 = 0) and borrows as much as possible against second-period
income, so first-period consumption C1 is Y1 + Y2/(1 + r). These are only three of the many
combinations of first- and second-period consumption that the consumer can afford: all the
points on the line from B to C are available to the consumer.
7.8 CONSUMER PREFERENCES
The consumer’s preferences regarding consumption in the two periods can be
represented by indifference curves. An indifference curve shows the combinations of first-
period and second-period consumption that make the consumer equally happy.
Figure 1-4 shows two of the consumer’s many indifference curves.
The consumer is indifferent among combinations W, X, and Y, because they are all on
the same curve. Not surprisingly, if the consumer’s first-period consumption is reduced, say
from point W to point X, second-period consumption must increase to keep him equally
happy. If first-period consumption is reduced again, from point X to point Y, the amount of
extra second-period consumption he requires for compensation is greater. The slope at any
point on the indifference curve shows how much second period consumption the consumer
requires in order to be compensated for a 1-unit reduction in first-period consumption. This
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slope is the marginal rate of substitution between first-period consumption and second-
period consumption. It tells us the rate at which the consumer is willing to substitute
second- period consumption for first-period consumption.
Notice that the indifference curves in Figure 7.4 are not straight lines; as a result, the
marginal rate of substitution depends on the levels of consumption in the two periods. When
first-period consumption is high and second-period consumption is low, as at point W, the
marginal rate of substitution is low: the consumer requires only a little extra second-period
consumption to give up1 unit of first-period consumption. When first-period consumption is
low and second-period consumption is high, as at point Y, the marginal rate of substitution
is high: the consumer requires much additional second-period consumption to give up 1 unit
of first-period consumption. The consumer is equally happy at all points on a given
indifference curve, but he prefers some indifference curves to others. Because he prefers
more consumption to less, he prefers higher indifference curves to lower ones. In Figure 1-4,
the consumer prefers any of the points on curve IC2 to any of the points on curve IC1. The
set of indifference curves gives a complete ranking of the consumer’s preferences. It tells us
that the consumer prefers point Z to point W, but that should be obvious because point Z
has more consumption in both periods. Yet
Compare point Z and point Y: point Z has more consumption in period one and less in
period two. Which is preferred, Z or Y? Because Z is on a higher indifference curve than Y, we
know that the consumer prefers point Z to point Y. Hence, we can use the set of indifference
curves to rank any combinations of first-period and second-period consumption.

Fig. 7.4
The Consumer’s Preferences
Indifference curves represent the consumer’s preferences over first-period and second period
consumption. An indifference gives the combinations of consumption in the two periods that
make the consumer equally happy. This figure shows two of many indifference curves. Higher
indifference curves such as IC2are preferred to lower curves such as IC1. The consumer is
equally happy at points W, X, and Y, but prefers point Z to points W, X, or Y.
7.9 OPTIMIZATION
Having discussed the consumer’s budget constraint and preferences, we can consider
the decision about how much to consume in each period of time. The consumer would like to
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end up with the best possible combination of consumption in the two periods—that is, on the
highest possible indifference curve. But the budget constraint requires that the consumer
also end up on or below the budget line, because the budget line measures the total
resources available to him.
Figure 7.5 shows that many indifference curves cross the budget line. The highest
indifference curve that the consumer can obtain without violating budget constraint is the
indifference curve that just barely touches the budget line, which is curve IC3 in the figure.
The point at which the curve and line touch—point O, for “optimum”—is the best
combination of consumption in the two periods that the consumer can afford. Notice that, at
the optimum, the slope of the indifference curve equals the slope of the budget line. The
indifference curve is tangent to the budget line. The slope of the indifference curve is the
marginal rate of substitution MRS, and the slope of the budget line is 1 plus the real interest
rate. We conclude that at point O MRS = 1 + r.
The consumer chooses consumption in the two periods such that the marginal rate of
substitution equals 1 plus the real interest rate.

Fig. 7.5
7.10 HOW CHANGES IN INCOME AFFECT CONSUMPTION
Now that we have seen how the consumer makes the consumption decision, let’s
examine how consumption responds to an increase in income. An increase in either Y1 or Y2
shifts the budget constraint outward, as in Figure 7.6. The higher budget constraint allows
the consumer to choose a better combination of first and second-period consumption—that
is, the consumer can now reach a higher indifference curve.
In Figure 7.6, the consumer responds to the shift in his budget constraint by choosing
more consumption in both periods. Although it is not implied by the logic of the model alone,
this situation is the most usual. If a consumer wants more of a good when his or her income
rises, economists call it a normal good. The indifference curves in Figure 1-6 are drawn
under the assumption that consumption in period one and consumption in period two are
both normal goods. The key conclusion from Figure 7.6 is that regardless of whether the
increase in income occurs in the first period or the second period, the consumer spreads it
over consumption in both periods. This behavior is sometimes called consumption smoothing.
Because the consumer can borrow and lend between periods, the timing of the income is
irrelevant to how much is consumed today(except that future income is discounted by the
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interest rate). The lesson of this analysis is that consumption depends on the present value
of current and future income, which can be written as
Present Value of Income = Y1 + 1 + r.

Fig. 7.6
Notice that this conclusion is quite different from that reached by Keynes. Keynes posited
that a person’s current consumption depends largely on his current income. Fisher’s model
says, instead, that consumption is based on the income the consumer expects over his entire
lifetime.
7.11 HOW CHANGES IN THE REAL INTEREST RATE AFFECT CONSUMPTION
Let’s now use Fisher’s model to consider how a change in the real interest rate alters
the consumer’s choices. There are two cases to consider: the case in which the consumer is
initially saving and the case in which he is initially borrowing. Here we discuss the saving
case; Problem 1 at the end of the chapter asks you to analyze the borrowing case.
Figure 7.7 shows that an increase in the real interest rate rotates the consumer’s
budget line around the point (Y1, Y2) and, thereby, alters the amount of consumption he
chooses in both periods. Here, the consumer moves from point A to point B. You can see that
for the indifference curves drawn in this figure, first-period consumption falls and second-
period consumption rises.
Economists decompose the impact of an increase in the real interest rate on
consumption into two effects: an income effect and a substitution effect.
Textbooks in microeconomics discuss these effects in detail. We summarize them
briefly here. The income effect is the change in consumption that results from the movement
to a higher indifference curve. Because the consumer is a saver rather than a borrower (as
indicated by the fact that first-period consumption is less than first-period income), the
increase in the interest rate makes him better off (as reflected by the movement to a higher
indifference curve). If consumption in period one and consumption in period two are both
normal goods, the consumer will want to spread this improvement in his welfare over both
periods.
This income effect tends to make the consumer want more consumption in both
periods. The substitution effect is the change in consumption that results from the change in
the relative price of consumption in the two periods. In particular, budget constraint is the
indifference curve that just barely touches the budget line, which is curve IC3 in the figure.
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The point at which the curve and line touch—point O, for “optimum”—is the best
combination of consumption in the two periods that the consumer can afford. Notice that, at
the optimum, the slope of the indifference curve equals the slope of the budget line. The
indifference curve is tangent to the budget line.
The slope of the indifference curve is the marginal rate of substitution MRS, and the
slope of the budget line is 1 plus the real interest rate. We conclude that at point OMRS = 1 +
r. The consumer chooses consumption in the two periods such that the marginal rate of
substitution equals 1 plus the real interest rate.

Fig. 7.7
7.12 CONSTRAINTS ON BORROWING
Fisher’s model assumes that the consumer can borrow as well as save. The ability to
borrow allows current consumption to exceed current income. In essence, when the
consumer borrows, he consumes some of his future income today. Yet for many people such
borrowing is impossible. For example, a student wishing to enjoy spring break in Florida
would probably be unable to finance this vacation with a bank loan. Let’s examine how
Fisher’s analysis changes if the consumer cannot borrow. Consumption from exceeding
current income. A constraint on borrowing can therefore be expressed as
C1 ≤ Y1.
This inequality states that consumption in period one must be less than or equal to
income in period one. This additional constraint on the consumer is called a borrowing
constraint or, sometimes, a liquidity constraint. A Borrowing Constraint If the consumer
cannot borrow, he faces the additional constraint that first-period consumption cannot
exceed first-period income. The shaded area represents the combinations of first-period and
second-period consumption the consumer can choose. Figure 7.8 shows how this borrowing
constraint restricts the consumer’s set of choices. The consumer’s choice must satisfy both
the inter temporal budget constraint and the borrowing constraint. The shaded area
represents the combinations of first-period consumption and second-period consumption
that satisfy both constraints.
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Fig. 7.8
7.13 SUMMARY
Keynes conjectured that the marginal propensity to consume is between zero and one,
that the average propensity to consume falls as income rises, and that current income is the
primary determinant of consumption. Studies of household data and short time-series
confirmed Keynes’s conjectures. Yet studies of long time-series found no tendency for the
average propensity to consume to fall as income rises over time. Recent work on
consumption builds on Irving Fisher’s model of the consumer. In this model, the consumer
faces an inter temporal budget constraint and chooses consumption for the present and the
future to achieve the highest level of lifetime satisfaction. As long as the consumer can save
and borrow, consumption depends on the consumer’s lifetime resources.
7.14 GLOSSARY
 Average propensity to consume (APC): The ratio of consumption to income (C/Y ).
 Consumption: Goods and services purchased by consumers.
 Consumption function: A relationship showing the determinants of consumption; for
example, a relationship between consumption and disposable income, C = F(YT).
 Income effect: The change in consumption of a good resulting from a movement to a
higher or lower indifference curve, holding the relative price constant. (Cf. substitution
effect.)
7.15 REFERENCES
 Dernburg T.E and McDougall D.M. (1986) Macroeconomics. Pergamon Press Oxford
 N. Gregory Mankiw (2010). Macroeconomics. 7th Edition. Worth Publications
 Rana K.C. and Verma K.N. (2011). Macroeconomics. Vishal Publishing Co.
 Dwivedi, D.N. (2011). Macroeconomics. Tata Mcgraw Hill Publication.
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 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference

 Shapiro, E. (2009). Macroeconomic analysis. Fourth edition. Galgotia Publications Pvt.
Ltd. (First Edition 1978)
7.15 FURTHER READINGS
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition, Harper
Collins.
 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference
 Shapiro, E. (2009). Macroeconomic analysis. Fourth edition. Galgotia Publications Pvt.
Ltd. (First Edition 1978)
7.17 MODEL QUESTIONS
1. What were Keynes’s three conjectures about the consumption function?
2. Describe the evidence that was consistent with Keynes’s conjectures and the
evidence that was inconsistent with them.
3. Use Fisher’s model of consumption to analyze an increase in second-period
income. Compare the case in which the consumer faces a binding borrowing
constraint and the case in which he does not.
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Lesson-8

THE THEORIES OF CONSUMPTION FUNCTION

Structure

8.1 Objectives
8.2 Introduction
8.3 Absolute Income Hypothesis
8.4 Relative Income Hypothesis
8.4.1 The Hypothesis
8.4.2 Implications
8.4.3 Demonstration Effect
8.4.4 Ratchet Effect
8.5 Life-Cycle Hypothesis
8.5.1The Hypothesis
8.5.2 Implications
8.6 Permanent-Income Hypothesis
8.6.1 The Hypothesis
8.6.2 Implications
8.7 Random-Walk Hypothesis
8.7.1 The Hypothesis
8.7.2Implications
8.8 Summary
8.9 Glossary
8.10 References
8.11 Further Readings
8.12 Model Questions

8.1 OBJECTIVES

After going through the chapter you shall be able to –

 Explain the concept of Absolute Income Hypothesis
 Discuss the concept of Relative Income Hypothesis
 Describe the concept of Life-Cycle Hypothesis
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 Explain the concept of Permanent-Income Hypothesis

 Discuss the concept of Random-Walk Hypothesis

8.2 INTRODUCTION

By studyining the basics of consumption in tha last lesson we know that when we eat
food, wear clothing, or go to a movie, we are consuming some of the output of the economy.
So all forms of consumption together make up about two-thirds of GDP. Because we studied
that consumption is so large, macroeconomists have devoted much energy to studying how
households decide how much to consume. Households receive income from their labor and
their ownership of capital, pay taxes to the government, and then decide how much of their
after-tax income to consume and how much to save. Households divide their disposable
income between consumption and saving. We assume that the level of consumption depends
directly on the level of disposable income. A higher level of disposable income leads to greater
consumption. Thus, the relationship between consumption and disposable income is called
the consumption function. Keynes gave 3 conjectures about consumption function. First
that Marginal proprnsity to consume is between 0 and 1. Second Keynes said that average
propensity to consume i.e the ratio of consumption to income falls as income rises and third
income was the primary determinant of consumption and interest rate doesn’t have that an
important role. When studies were conducted on the basis of these 3 conjuctures
reasearchers found that Keynes theory did hold but only for short run. In long run Keynes 2
conjectures that APC falls as income rises and income was the primary determinant for
consumption didn’t hold. When Simon Kuznets assembled the data on consumption and
income dating back to 1869, Kuznets analysis indicated that the APC is fairly constant over
long period of time. This fact presented a PUZZLE that motivated much research in
consumption.
Economists wanted to know why some studies supported or confirmed Keynes’s
conjectures and other refuted them. To solve this puzzle two economists Franco Modigliani
and Milton Friedman have two Hypothesis “Life cycle Hypothesis” and “Permanent Income
Hypothesis” respectively to solve consumption puzzle.
The different types of hypothesis being studied from this type of consumption function
are:
8.3 ABSOLUTE INCOME HYPOTHESIS:
Keynes’ consumption function has come to be known as the ‘absolute income
hypothesis’ or theory. His statement of the relationship between income and consumption
was based on the ‘fundamental psychological law’. He said that consumption is a stable
function of current income (to be more specific, current disposable income—income after tax
payment). Because of the operation of the ‘psychological law’, his consumption function is
such that 0 < MPC < 1 and MPC < APC. Thus, a non- proportional relationship (i.e., APC >
MPC) between consumption and income exists in the Keynesian absolute income hypothesis.
His consumption function may be rewritten here with the form
C = a + bY, where a > 0 and 0 < b < 1.
It may be added that all the characteristics of Keynes’ consumption function are based
not on any empirical observation, but on ‘fundamental psychological law’, i.e., experience and
intuition.
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(i) Consumption Function in the Light of Empirical Observations:

Meanwhile, attempts were made by the empirically-oriented economists in the late 1930s and
early 1940s for testing the conclusions made in the Keynesian consumption function.
(ii) Short Run Budget Data and Cyclical Data:
Let us consider first the budget studies data or cross-sectional data of a cross section
of the population and then time-series data. The first set of evidence came from budget
studies for the years 1935-36 and 1941-42. These budget studies seemed consistent with the
Keynes’ own conclusion on consumption-income relationship. The time-series data of the
USA for the years 1929-44 also gave reasonably good support to the Keynesian theoretical
consumption function.
Since the time period covered is not long enough, this empirical consumption function
derived from the time- series data for 1929-44 may be called ‘cyclical’ consumption function.
Anyway, we may conclude now that these two sets of data that generated consumption
function consistent with the Keynesian consumption equation,
C = a + bY.
Further,
0 < b < 1 and AMC < APC.
(iii) Long Run Time-Series Data:
However, Simon Kuznets (the 1971 Nobel prize winner in Economics) considered a
long period covering 1869 to 1929. His data may be described as the long run or secular
time-series data. This data indicated no long run change in consumption despite a very large
increase in income during the said period. Thus, the long run historical data that generated
long run or secular consumption function were inconsistent with the Keynesian consumption
function.
From Kuznets’ data what is obtained is that:
(a) There is no autonomous consumption, i.e., ‘a’ term of the consumption function and
(b) A proportional long run consumption function in which APC and MPC are not
different. In other words, the long run consumption function equation is
C = bY
As a = 0, the long run consumption function is one in which APC does not change over
time and MPC = APC at all levels of income as contrasted to the short run non-proportional
(MPC < APC) consumption-income relationship. Being proportional, the long run
consumption function starts form the origin while a non-proportional short run consumption
function starts from point above the origin. Keynes, in fact, was concerned with the long run
situation.
But what is baffling and puzzling to us that the empirical studies suggest two different
consumption functions a non-proportional cross-section function and a proportional long
run time-series function.
8.4 RELATIVE INCOME HYPOTHESIS:
Studies in consumption then were directed to resolve the apparent conflict and
inconsistencies between Keynes’ absolute income hypothesis and observations made by
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Simon Kuznets. Former hypothesis says that in the short run MPC < APC, while Kuznets’
observations say that MPC = APC in the long run. One of the earliest attempts to offer a reso-
lution of the conflict between short run and long run consumption functions was the ‘relative
income hypothesis’ (henceforth R1H) S. Duesenberry in 1949. Duesenberry believed that the
basic consumption function was long run and proportional. This means that average fraction
of income consumed does not change in the long run, but there may be variation between
consumption and income within short run cycles.

Self Assessment Question

Q. What is the crux of Relative Income Hypothesis?
Ans. ....................................................................................................................................
...................................................................................................................................
....................................................................................................................................

8.4.1 The Hypotheses

Duesenberry’s RIH is based on two hypotheses first is the relative income hypothesis
and second is the past peak income hypothesis. Duesenberry’s first hypothesis says that
consumption depends not on the ‘absolute’ level of income but on the ‘relative’ income—
income relative to the income of the society in which an individual lives. It is the relative
position in the income distribution among families influences consumption decisions of
individuals. A households consumption is determined by the income and expenditure pattern
of his neighbours. There is a tendency on the part of the people to imitate or emulate the
consumption standards maintained by their neighbours. Specifically, people with relatively
low incomes attempt to ‘keep up with the Joneses’—they consume more and save less. This
imitative or emulative nature of consumption has been described by Duesenberry as the
“demonstration effect.”
The outcome of this hypothesis is that the individuals’ APC depends on his relative
position in income distribution. Families with relatively high incomes experience lower APCs
and families with relatively low incomes experience high APCs. If, on the other hand, income
distribution is relatively constant (i.e., keeping each families relative position unchanged
while incomes of all families rise). Duesenberry then argues that APC will not change. Thus,
in the aggregate we get a proportional relationship between aggregate income and aggregate
consumption. Note MPC = APC. Hence the R1H says that there is no apparent conflict
between the results of cross-sectional budget studies and the long run aggregate time-series
data. In terms of the second hypothesis short run cyclical behaviour of the Duesenberry’s
aggregate consumption function can be explained. Duesenberry hypothesised that the
present consumption of the families is influenced not just by current incomes but also by the
levels of past peak incomes, i.e., C = f(Yri, Ypi), where Yri is the relative income and Ypi is the
peak income.
This hypothesis says that consumption spending of families is largely motivated by the
habitual behavioural pattern. It current incomes rise, households tend to consume more but
slowly. This is because of the relatively low habitual consumption patterns and people adjust
their consumption standards established by the previous peak income slowly to their present
rising income levels.
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On other hand, if current incomes decline these households do not immediately

reduce their consumption as they find if difficult to reduce their consumption established by
the previous peak income. Thus, during depression consumption rises as a fraction of
income and during prosperity consumption does increase slowly as a fraction of income. This
hypothesis thus generates a non-proportional consumption function.
8.4.2 Implications
Duesenberry’s explanation of short run and long run consumption function and then,
finally, reconciliation between these two types of consumption function can now be demon-
strated in terms of Fig. 8.1. Cyclical rise and fall in income levels produce a non-proportional
consumption-income relationship, labelled as CSR. In the long run as such fluctuations of
income levels are get smoothened, one gets a proportional consumption-income relationship,
labelled as CLR.

Fig 8.1
As national income rises consumption grows along the long run consumption, C LR.
Note that at income OY0 aggregate consumption is OC0. As income increases to OY1, con-
sumption rises to OC1. This means a constant APC consequent upon a steady growth of na-
tional income.
Now, let us assume that recession occur leading to a fall in income level to OY 0 from
the previously attained peak income of OY1. Duesenberry’s second hypothesis now comes
into operation: households will maintain the previous consumption level what they enjoyed at
the past peak income level. That means, they hesitate in reducing their consumption
standards along the CLR. Consumption will not decline to OC0, but to OC’1 (> OC0) at income
OY0. At this income level, APC will be higher than what it was at OY 1 and the MPC will be
lower.
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If income raises consequent upon economic recovery, consumption rises along

CSR since people try to maintain their habitual or accustomed consumption standards
influenced by previous peak income. Once OY1level of income is reached consumption would
then move along CLR. Thus, the short run consumption is subject to what Duesenberry called
‘the ratchet effect’. It ratchets up following an increase in income levels, but it does not fall
back downward in response to income declines.
8.4.3 Demonstration Effect:
By emphasising relative income as a determinant of consumption, the relative income
hypothesis suggests that individuals or households try to imitate or copy the consumption
levels of their neighbours or other families in a particular community. This is called demon-
stration effect or Duesenberry effect. Two things follows from this. First, the average
propensity to consume does not fall. This is because if incomes of all families increase in the
same proportion, distribution of relative incomes would remain unchanged and therefore the
proportion of consumption expenditure to income which depends on relative income will
remain constant. Secondly, a family with a given income would devote more of his income to
consumption if it is living in a community in which that income is regarded as relatively low
because of the working of demonstration effect. On the other hand, a family will spend a
lower proportion of its income if it is living in a community in which that income is
considered as relatively high because demonstration effect will not be present in this case.
For example, the recent studies of household expenditure made in India reveal that the
families with a given income, say Rs. 5000 per month spend a larger proportion of their
income on consumption if they live in urban areas as compared to their counterparts in rural
areas. The higher propensity to consume of families living in urban areas is due to the
working of demonstration effect where families with relatively higher income reside whose
higher consumption standards tempt others in lower income brackets to consume more.

Self Assessment Question

Q. Define Demonstration Effect.
Ans. ....................................................................................................................................
...................................................................................................................................
....................................................................................................................................

8.4.4 Ratchet Effect:

The other significant part of Duesenberry’s relative income hypothesis is that it
suggests that when income of individuals or households falls, their consumption expenditure
does not fall much. This is often called a ratchet effect. This is because, according to
Duesenberry, the people try to maintain their consumption at the highest level attained
earlier. This is partly due to the demonstration effect explained above. People do not want to
show to their neighbours that they no longer afford to maintain their high standard of living.
Further, this is also partly due to the fact that they become accustomed to their previous
higher level of consumption and it is quite hard and difficult to reduce their consumption
expenditure when their income has fallen. They maintain their earlier consumption level by
reducing their savings. Therefore, the fall in their income, as during the period of recession or
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depression, does not result in decrease in consumption expenditure very much as one would
conclude from family budget studies.
This is illustrated in Figure 8.2 where on the X-axis we measure disposable income
and on the Y- axis the consumption and savings. Starting with disposable income of zero, we
assume that there is steady growth of disposable income till it reaches Y 1 . The linear
consumption function CLR is the long- run consumption function. It will be seen from the
figure that at Y1level of disposable income, the consumption expenditure equals Y 1C1 . Now
suppose with initial income level Y1 there is recession in the economy with the result that
disposable income falls to the level Y0.
According to Duesenberry, consumption would not fall greatly to the level Y 0C0 as the
long-run consumption function curve CLR would suggest. In their bid to maintain their
consumption level previously reached people would now save less and reduce their
consumption level only slightly to Y0C’0 whereas point C’0 is on the short- run consumption
function curve CSR.
Since Y0C'0> Y0C0, the average propensity to consume at income level Y0is greater at
C’0than at C1 at income level Y1 (A ray drawn from the origin to the point C’0 will have greater
slope than that of OC1). When the economy recovers from recession and disposable income
increases, the economy would move along the short-run consumption function curve CSR till
the consumption level C1 is reached at income level Y1. Beyond this, with the growth of
income the consumption will increase along the long-run consumption function curve CLR.

Fig 8.2
Aggregate consumption function of the community: From the analysis of demonstration
and ratchet effects it follows that Duesenberry’s relative income hypothesis provides an
explanation for why aggregate consumption function of the community may be flatter than
the family budget studies would suggest. Duesenberry emphasizes that it is relative income
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rather than absolute income which determines consumption expenditure of households.

When income of the community increases, relative income remaining constant, the
proportion of consumption expenditure to income will not increase much because relative
incomes of the households remain the same (Note that this implies that saving ratio will not
rise much). Due to demonstration effect every household will increase its expenditure in the
same proportion as the increase in income. On the other hand, if the income of the
community decreases, the consumption expenditure would not decline much due to the
ratchet effect according to which people try to maintain their previously attained higher level
of consumption.

Self Assessment Question

Q. What is Ratchet Effect?
Ans. ....................................................................................................................................
...................................................................................................................................
....................................................................................................................................

This makes the consumption function of the community flatter than suggested by the
cross-sectional family budget studies. Further, it also follows from the Duesenberry relative
income hypothesis that short-run aggregate consumption function of the community is linear
rather than curved. As stated above, if, in the short run, the level of income increases, the
proportion of consumption expenditure to income is not likely to increase much due to the
operation of demonstration effect and with the fall in income the proportion of consumption
to income is not likely to decline much due to the ratchet effect. This makes the short-run
aggregate consumption function of the community linear. It is worth noting that
Duesenberry’s theory assumes that relative distribution of income does not change much.
This is in accord with the facts of the real world situation where changes in income
distribution do not take place in the short run. Thus Duesenberry’s theory provides a
convincing explanation in terms of demonstration and ratchet effects why aggregate
consumption function is linear rather than nonlinear.
8.5 THE LIFE-CYCLE HYPOTHESIS
In a series of papers written in the 1950s, Franco Modigliani and his collaborators
Albert Ando and Richard Brumberg used Fisher’s model of consumer behavior to study the
consumption function. One of their goals was to solve the consumption puzzle—that is, to
explain the apparently conflicting pieces of evidence that came to light when Keynes’s
consumption function was confronted with the data. According to Fisher’s model,
consumption depends on a person’s lifetime income. Modigliani emphasized that income
varies systematically over people’s lives and that saving allows consumers to move income
from those times in life when income is high to those times when it is low. This interpretation
of consumer behavior formed the basis for his life-cyclehypothesis.
8.5.1 The Hypothesis
One important reason that income varies over a person’s life is retirement. Most plan
to stop working at about age 65, and they expect their incomes to fall when they retire. Yet
they do not want a large drop in their standard of living, as measured by their consumption.
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To maintain their level of consumption after retirement, people must save during their
working years. Let’s see what this motive for saving implies for the consumption function.
Consider a consumer who expects to live another T years, has wealth of W, and expects to
earn income Y until she retires R years from now. What level of consumption will the
consumer choose if she wishes to maintain a smooth level of consumption over her life? The
consumer’s lifetime resources are composed of initial wealth W and lifetime earnings of R × Y.
(For simplicity, we are assuming an interest rate of zero; if the interest rate were greater than
zero, we would need to take account of interest earned on savings as well.) The consumer can
divide up her lifetime resources among her T remaining years of life. We assume that she
wishes to achieve the smoothest possible path of consumption over her lifetime. Therefore,
she divides this total of W + RY equally among the T years and each year consumes C = (W +
RY )/T.
We can write this person’s consumption function as
C = (1/T)W + (R/T)Y.
For example, if the consumer expects to live for 50 more years and work for 30 of
them, then T = 50 and R = 30, so her consumption function is C = 0.02W + 0.6Y.
This equation says that consumption depends on both income and wealth. An extra $1
of income per year raises consumption by $0.60 per year, and an extra $1 of wealth raises
consumption by $0.02 per year. If every individual in the economy plans consumption like
this, then the aggregate consumption function is much the same as the individual one. In
particular, aggregate consumption depends on both wealth and income. That is, the
economy’s consumption function is
C = aW + bY,
Where, the parameter a is the marginal propensity to consume out of wealth, and the
parameter b is the marginal propensity to consume out of income.
8.5.2 Implications
Figure 8.5 graphs the relationship between consumption and income predicted by the
life-cycle model. For any given level of wealth W, the model yields a conventional
consumption function similar to the one shown Keynesian consumption function. Notice,
however, that the intercept of the consumption function, which shows what would happen to
consumption if income ever fell to zero, is not a fixed value, as it is in Keynesian
consumption function. Instead, the intercept here is aW and, thus, depends on the level of
wealth.
This life-cycle model of consumer behavior can solve the consumption puzzle.
According to the life-cycle consumption function, the average propensity to consume is:
C/Y = a(W/Y) + b.
Because wealth does not vary proportionately with income from person to person or
from year to year, we should find that high income corresponds to a low average propensity
to consume when looking at data across individuals or over short periods of time. But over
long periods of time, wealth and income grow together, resulting in a constant ratio W/Y and
thus a constant average propensity to consume.
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Fig 8.3
The Life-Cycle Consumption Function The life-cycle model says that consumption
depends on wealth as well as income. As a result, the intercept of the consumption function
aW depends on wealth.
To make the same point somewhat differently, consider how the consumption function
changes over time. As Figure 8.3 shows, for any given level of wealth, the life-cycle
consumption function looks like the one Keynes suggested. But this function holds only in
the short run when wealth is constant. In the long run, as wealth increases, the consumption
function shifts upward, as in Figure 8.4. This upward shift prevents the average propensity
to consume from falling as income increases. In this way, Modigliani resolved the
consumption puzzle posed by Simon Kuznets’s data.
The life-cycle model makes many other predictions as well. Most important, it predicts
that saving varies over a person’s lifetime. If a person begins adulthood with no wealth, she
will accumulate wealth during her working years and then run down her wealth during her
retirement age.

.
Fig 8.4
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How Changes in Wealth Shift the Consumption Function If consumption depends

on wealth, then an increase in wealth shifts the consumption function upward. Thus, the
short-run consumption function(which holds wealth constant)will not continue to hold in the
long run (as wealth rises over time).
Note : Try Q.1 in the Model Questions at Page 115.
The Consumption and Saving of the Elderly
Many economists have studied the consumption and saving of the elderly. Their
findings present a problem for the life-cycle model. It appears that the elderly do not dissave
as much as the model predicts. In other words, the elderly do not run down their wealth as
quickly as one would expect if they were trying to smooth their consumption over their
remaining years of life. There are two chief explanations for why the elderly do not dissave to
the extent that the model predicts. Each suggests a direction for further research on
consumption. The first explanation is that the elderly are concerned about unpredictable
expenses. Additional saving that arises from uncertainty is called precautionary saving. One
reason for precautionary saving by the elderly is the possibility of living longer than expected
and thus having to provide for a longer than average span of retirement. Another reason is
the possibility of illness and large medical bills. The elderly may respond to this uncertainty
by saving more in order to be better prepared for these contingencies.
The precautionary-saving explanation is not completely persuasive, because the
elderly can largely insure against these risks. To protect against uncertainty regarding life
span, they can buy annuities from insurance companies. For a fixed fee, annuities offer a
stream of income that lasts as long as the recipient lives. Uncertainty about medical
expenses should be largely eliminated by Medicare, the government’s health insurance plan
for the elderly, and by private insurance plans. The second explanation for the failure of the
elderly to dissave is that they may want to leave bequests to their children. Economists have
proposed various theories of the parent–child relationship and the bequest motive. Overall,
research on the elderly suggests that the simplest life-cycle model cannot fully explain
consumer behavior. There is no doubt that providing for retirement is an important motive
for saving, but other motives, such as precautionary saving and bequests, appear important
as well.

Fig 8.5
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Figure 8.5 illustrates the consumer’s income, consumption, and wealth over her adult
life. According to the life-cycle hypothesis, because people want to smooth consumption over
their lives, the young who are working save, while the old who are retired dissave.
Consumption, Income, and Wealth Over the Life Cycle If the consumersmooths
consumption over her life (as indicated by the horizontal consumption line), she will save and
accumulate wealth during her working years and then dissave and run down her wealth
during retirement.
Note : Try Q.3 and Q.4 in Section 8.12 at P. 113.
8.6 PERMANENT INCOME HYPOTHESIS
In a book published in 1957, Milton Friedman proposed the permanent-income
hypothesis to explain consumer behavior. Friedman’s permanent-income hypothesis
complements Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the
consumer to argue that consumption should not depend on currentincome alone. But unlike
the life-cycle hypothesis, which emphasizes that income follows a regular pattern over a
person’s lifetime, the permanent-income hypothesis emphasizes that people experience
random and temporary changes in their incomes from year to year.
8.6.1 The Hypothesis
Friedman suggested that we view current income Y as the sum of two components,
permanent income YP and transitory income Y T. That is,
Y = YP + Y T.
Permanent income is the part of income that people expect to persist into the future.
Transitory income is the part of income that people do not expect to persist. Put differently,
permanent income is average income, and transitory income is the random deviation from
that average. To see how we might separate income into these two parts, consider these
examples:
■ Maria, who has a law degree, earned more this year than John, who is a high-
school dropout. Maria’s higher income resulted from higher permanent income,
because her education will continue to provide her a higher salary.
■ Sue, a Florida orange grower, earned less than usual this year because a freeze
destroyed her crop. Bill, a California orange grower, earned more than usual
because the freeze in Florida drove up the price of oranges. Bill’s higher income
resulted from higher transitory income, because he is no more likely than Sue
to have good weather next year. These examples show that different forms of
income have different degrees of persistence. A good education provides a
permanently higher income, whereas good weather provides only transitorily
higher income. Although one can imagine intermediate cases, it is useful to
keep things simple by supposing that there are only two kinds of income:
permanent and transitory. Friedman reasoned that consumption should depend
primarily on permanent income, because consumers use saving and borrowing
to smooth consumption in response to transitory changes in income. For
example, if a person received a permanent raise of $10,000 per year, his
consumption would rise by about as much. Yet if a person won $10,000 in a
lottery, he would not consume it all in one year. Instead, he would spread the
extra consumption over the rest of his life. Assuming an interest rate of zero
and a remaining life span of 50 years, consumption would rise by only $200 per
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year in response to the $10,000 prize. Thus, consumers spend their permanent
income, but they save rather than spend most of their transitory income.
Friedman concluded that we should view the consumption function as
approximately
C = aYP,
Where, a is a constant that measures the fraction of permanent income consumed.
The permanent-income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income.
8.6.2 Implications
The permanent-income hypothesis solves the consumption puzzle by suggesting that
the standard Keynesian consumption function uses the wrong variable. According to the
permanent-income hypothesis, consumption depends on permanent income YP; yet many
studies of the consumption function try to relate consumption to current income Y. Friedman
argued that this errors-in-variables problem explains the seemingly contradictory findings.
Let’s see what Friedman’s hypothesis implies for the average propensity to consume.
Divide both sides of his consumption function by Y to obtain
APC = C/Y = aYP/Y.
According to the permanent-income hypothesis, the average propensity to consume
depends on the ratio of permanent income to current income. When current income
temporarily rises above permanent income, the average propensity to consume temporarily
falls; when current income temporarily falls below permanent income, the average propensity
to consume temporarily rises.
Now consider the studies of household data. Friedman reasoned that these data reflect
a combination of permanent and transitory income. Households with high permanent income
have proportionately higher consumption. If all variation in current income came from the
permanent component, the average propensity to consume would be the same in all
households. But some of the variation in income comes from the transitory component, and
households with high transitory income do not have higher consumption. Therefore,
researchers find that high-income households have, on average, lower average propensities to
consume. Similarly, consider the studies of time-series data. Friedman reasoned that year-to-
year fluctuations in income are dominated by transitory income. Therefore, years of high
income should be years of low average propensities to consume. But over long periods of
time—say, from decade to decade—the variation in income comes from the permanent
component. Hence, in long time-series, one should observe a constant average propensity to
consume, as in fact Kuznets found.
The permanent-income hypothesis can help us interpret how the economy responds to
changes in fiscal policy. According to the IS–LM model tax cuts stimulate consumption and
raise aggregate demand, and tax increases depress consumption and reduce aggregate
demand. The permanent- income hypothesis, however, predicts that consumption responds
only to changes in permanent income. Therefore, transitory changes in taxes will have only a
negligible effect on consumption and aggregate demand. If a change in taxes is to have a
large effect on aggregate demand, it must be permanent. Two changes in fiscal policy—the
tax cut of 1964 and the tax surcharge of1968—illustrate this principle. The tax cut of 1964
was popular. It was announced as being a major and permanent reduction in tax rates. This
policy change had the intended effect of stimulating the economy. The tax surcharge of 1968
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arose in a very different political climate. It became law because the economic advisers of
President Lyndon Johnson believed that the increase in government spending from the
Vietnam War had excessively stimulated aggregate demand. To offset this effect, they
recommended a tax increase. But Johnson, aware that the war was already unpopular,
feared the political repercussions of higher taxes. He finally agreed to a temporary tax
surcharge—in essence, a one-year increase in taxes. The tax surcharge did not have the
desired effect of reducing aggregate demand. Unemployment continued to fall, and inflation
continued to rise. This is precisely what the permanent-income hypothesis would lead us to
predict: the tax increase affected only transitory income, so consumption behavior and
aggregate demand were not greatly affected. The lesson to be learned from these episodes is
that a full analysis of tax policy must go beyond the simple Keynesian consumption function;
it must take into account the distinction between permanent and transitory income. If
consumers expect a tax change to be temporary, it will have a smaller impact on
consumption and aggregate demand.
Note : Answer Q.1 in Section 8.12 at Page 115.
8.7 THE RANDOM-WALK HYPOTHESIS
The permanent-income hypothesis is based on Fisher’s model of intertemporal choice.
It builds on the idea that forward-looking consumers base their consumption decisions not
only on their current income but also on the income they expect to receive in the future.
Thus, the permanent-income hypothesis highlights that consumption depends on people’s
expectations. Recent research on consumption has combined this view of the consumer with
the assumption of rational expectations. The rational-expectations assumption states that
people use all available information to make optimal forecasts about the future. This
assumption can have profound implications for the costs of stopping inflation. It can also
have profound implications for the study of consumer behavior.
8.7.1 The Hypothesis
The economist Robert Hall was the first to derive the implications of rational
expectations for consumption. He showed that if the permanent-income hypothesis is
correct, and if consumers have rational expectations, then changes in consumption over time
should be unpredictable. When changes in a variable are unpredictable, the variable is said
to follow a random walk. According to Hall, the combination of the permanent-income
hypothesis and rational expectations implies that consumption follows a random walk. Hall
reasoned as follows. According to the permanent-income hypothesis, consumers face
fluctuating income and try their best to smooth their consumption over time. At any moment,
consumers choose consumption based on their current expectations of their lifetime
incomes. Over time, they change their consumption because they receive news that causes
them to revise their expectations.
For example, a person getting an unexpected promotion increases consumption,
whereas a person getting an unexpected demotion decreases consumption. In other words,
changes in consumption reflect “surprises” about lifetime income. If consumers are optimally
using all available information, then they should be surprised only by events that were
entirely unpredictable. Therefore, changes in their consumption should be unpredictable as
well.
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8.7.2 Implications
The rational-expectations approach to consumption has implications not only for
forecasting but also for the analysis of economic policies. If consumers obey the permanent-
income hypothesis and have rational expectations, then only unexpected policy changes
influence consumption. These policy changes take effect when they change expectations.
For example, suppose that today Congress passes a tax increase to be effective next
year. In this case, consumers receive the news about their lifetime incomes when Congress
passes the law (or even earlier if the law’s passage was predictable). The arrival of this news
causes consumers to revise their expectations and reduce their consumption. The following
year, when the tax hike goes into effect, consumption is unchanged because no news has
arrived.
Hence, if consumers have rational expectations, policymakers influence the economy
not only through their actions but also through the public’s expectation of their actions.
Expectations, however, cannot be observed directly. Therefore, it is often hard to know how
and when changes in fiscal policy alter aggregate demand.
Do Predictable Changes in Income Lead to Predictable Changes in Consumption?
Of the many facts about consumer behavior, one is impossible to dispute: income and
consumption fluctuate together over the business cycle. When the economy goes into a
recession, both income and consumption fall, and when the economy booms, both income
and consumption rise rapidly. By itself, this fact doesn’t say much about the rational-
expectations version of the permanent-income hypothesis. Most short-run fluctuations are
unpredictable.
Thus, when the economy goes into a recession, the typical consumer is receiving bad
news about his lifetime income, so consumption naturally falls. And when the economy
booms, the typical consumer is receiving good news, so consumption rises. This behavior
does not necessarily violate the random-walk theory that changes in consumption are
impossible to forecast.
Yet suppose we could identify some predictable changes in income. According to the
random-walk theory, these changes in income should not cause consumers to revise their
spending plans. If consumers expected income to rise or fall, they should have adjusted their
consumption already in response to that information. Thus, predictable changes in income
should not lead to predictable changes in consumption.
Data on consumption and income, however, appear not to satisfy this implication of
the random-walk theory. When income is expected to fall by $1, consumption will on average
fall at the same time by about $0.50. In other words, predictable changes in income lead to
predictable changes in consumption that is roughly half as large.
Why is this so? One possible explanation of this behavior is that some consumers may
fail to have rational expectations. Instead, they may base their expectations of future income
excessively on current income. Thus, when income rises or falls (even predictably), they act
as if they received news about their lifetime resources and change their consumption
accordingly. Another possible explanation is that some consumers are borrowing-constrained
and, therefore, base their consumption on current income alone. Regardless of which
explanation is correct, Keynes’s original consumption function starts to look more attractive.
That is, current income has a larger role in determining consumer spending than the
random-walk hypothesis suggests.
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8.8 SUMMARY
The empirical studies suggest two different consumption functions a non-proportional
cross-section function and a proportional long run time-series function. Duesenberry be-
lieved that the basic consumption function was long run and proportional. This means that
average fraction of income consumed does not change in the long run, but there may be
variation between consumption and income within short run cycles. Modigliani’s life-cycle
hypothesis emphasizes that income varies somewhat predictably over a person’s life and that
consumers use saving and borrowing to smooth their consumption over their lifetimes.
According to this hypothesis, consumption depends on both income and wealth. Friedman’s
permanent-income hypothesis emphasizes that individuals experience both permanent and
transitory fluctuations in their income. Because consumers can save and borrow, and
because they want to smooth their consumption, consumption does not respond much to
transitory income. Instead, consumption depends primarily on permanent income. Hall’s
random-walk hypothesis combines the permanent-income hypothesis with the assumption
that consumers have rational expectations about future income. It implies that changes in
consumption are unpredictable, because consumers change their consumption only when
they receive news about their lifetime resources.
8.9 GLOSSARY
 Adaptive Expectations: An approach that assumes that people form their expectation
of a variable based on recently observed values of the variable. (Cf. rational
expectations.)
 Intertemporal budget constraint: The budget constraint applying to expenditure and
income in more than one period of time. (Cf. budget constraint.)
 Life-cycle Hypothesis: The theory of consumption that emphasizes the role of saving
and borrowing as transferring resources from those times in life when income is high
to those times in life when income is low, such as from working years to retirement.
 Permanent Income Hypothesis: The theory of consumption according to which
people choose consumption based on their permanent income, and use saving and
borrowing to smooth consumption in response to transitory variations in income.
 Transitory income: Income that people do not expect to persist into the future;
current incomeminus normal income. (Cf. permanent income.)
8.10 REFERENCES
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics. Pergamon Press Oxford
 N. Gregory Mankiw (2010). Macroeconomics. 7th Edition. Worth Publications
 Rana K.C. and Verma K.N. (2011). Macroeconomics. Vishal Publishing Co.
 Dwivedi, D.N. (2011). Macroeconomics, Tata Mcgraw Hill Publication 2011
 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference 1986
8.11 FURTHER READINGS
 Shapiro, E. (2009). Macroeconomic analysis. Fourth edition, Galgotia Publications Pvt.
Ltd. (First Edition 1998)
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 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
8.12 MODEL QUESTIONS
1. How do the life-cycle and permanent-income hypotheses resolve the seemingly
contradictory pieces of evidence regarding consumption behavior?
2. Explain why changes in consumption are unpredictable if consumers obey the
permanent income hypothesis and have rational expectations.
3. Give an example in which someone might exhibit time-inconsistent preferences.
One study found that the elderly who do not have children dissave at about the
same rate as the elderly who do have children.
4. What might this finding imply about the reason the elderly do not dissave as
much as the life-cycle model predicts?
5. Explain whether borrowing constraints increase or decrease the potency of
fiscal policy to influence aggregate demand in each of the following two cases.
a. A temporary tax cut.
b. An announced future tax cut.
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Lesson – 9

CONSUMPTION UNDER UNCERTAINTY

Structure
9.0 Objectives
9.1 Introduction
9.2 Consumption under Uncertainty: The Modern Approach
9.3 The Life Cycle Permanent Income Hypothesis
9.4 Consumption and CAPM
9.5 What Is The Capital Asset Pricing Model?
9.5.1 Limitations the CAPM
9.6 The CAPM and the Efficient Frontier
9.6.1 The Logic of the CAPM
9.7 Consumption Capital Asset Pricing Model (CCAPM): A Cursory Glance
9.8 CCAPM and CAPM: A Comparison
9.9 Summary
9.10 Glossary
9.11 References
9.12 Further Readings
9.13 Model Questions
9.0 OBJECTIVES
After going through the chapter you shall be able to –
 explain Consumption under Uncertainty
 discuss Consumption and CAPM
 describe the Capital Asset Pricing Model
 make and draw Comparison between CCAPM and CAPM
9.1 1INTRODUCTION
In the previous lesson we have discussed the theories of consumption behavior which
is more or less predictable. This lesson goes a step forward and explains the model pertaining
to pricing of capital assets under uncertain circumstances. The lesson focuses on Capital
Asset Pricing Model, its limitations and significance.
Background
The lesson details that when the people become more uncertain regarding the
future, a possible reaction of them is to save more, as a matter of prudence. This, in turn
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improves the current account of balance of payment of the country as in the case of open
economies or into downward pressures in the interest rate, in the case of closed
economies. Actually, one of the possible explanations for the recent decline in world
interest rates is that people are becoming more uncertain regarding the future and
therefore want to save more. Since the world as a whole cannot be a saver, this exerts a
downward pressure on real interest rates. The idea if precautionary savings fits well in
the Keynesian doctrine of “animal spirits”. Animal spirit is a term used by the famous
British economist, John Maynard Keynes, to describe how people arrive at financial
decisions, including buying and selling securities, in times of economic stress or uncertainty.
But is this reasoning supported at the theoretical level? Why should increase
uncertainty come along with a higher saving rate? Is this a general case? Or it depends?
To answer these questions, in this handout we reassess the second period model of
consumption, extending it to the case of uncertainty. So far, we have assumed that
consumers know their future incomes before decisions regarding consumption in period
1 are taken. That is, we have assumed that consumers can plan their borrowing or
lending, knowing exactly how much will be available for consumption in period 2. Now,
we assume that consumption decisions regarding the current period are taken before
future income is known.
Self- Assessment Questions
1. What is animal spirit as according to Keynes and how it is important in uncertain
world?
…………………………………………………………………………………………………………..
…………………………………………………………………………………………………………..
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9.2 CONSUMPTION UNDER UNCERTAINTY: THE MODERNAPPROACH

To begin with a synoptic and relevant portion of Life Cycle Permanent Income
Hypothesis (LC-PIH) is being discussed in brief. If permanent income were known exactly,
then according to the LC-PIH, consumption pattern is predictable and would more or less
never change.
The modern version of the LC-PIH emphasizes the link between income uncertainty
and changes in consumption and takes a more formal approach to consumer maximization.
According to this newer version, changes in consumption arise from surprise changes in
income. Absent income surprises, consumption this period should be the same as
consumption last period. The modern approach to the LC-PIH begins by formally stating the
lifetime utility maximization problem of a representative consumer. In a particular period, a
consumer enjoys utility from consumption in that period, u(Ct). Lifetime utility is the sum of
period-by-period utilities, and the lifetime budget constraint equates the sum of period-by-
period consumption with lifetime resources:
Lifetime utility function for the time period T broken down into smaller period t,
t+1…..up to T, is mathematically expressed as
UL=u(Ct) + u(Ct+1) + … + u(CT)
subject to constraint
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Ct + Ct+1 + … +CT= wealth + YLt + YLt+1 + … +YLT

The constraint here expresses the fact that life time consumption cannot exceed the
sum total of wealth of person and income earned over life time
Consumers choose consumption each period to maximize life time utility subject to
total lifetime consumption equaling lifetime resources. The optimal choice is the consumption
path that equates the marginal utility of consumption across periods,
MU(Ct+1)=MU(Ct), and soon.
Why? Consider the alternative : If marginal utility were alittle higher in period t than in period
t+1, life time utility could be increased by shifting consumption into t from t+1 because the
gain from the former would out weight he gain from the latter. (By definition, marginal utility
is the increase in utility from a small increase in consumption. )Now add considerations of
uncertainty. The consumer cannot actually implement an equate-marginal-utilities rule
because future marginal utility, MU(Ct+1), is uncertain at time t. The consumer can equate
marginal utility today with their best guess of marginal utility at time t + 1, so the modified
rule is to equate today’s marginal utility with the expected value of tomorrow’s marginal
utility, E[MU(Ct+1)] = MU(Ct).
Marginal utility functions aren’t observable, but in this simple case the functions will
be equal only if their arguments are equal, so the rule can be rewritten as
E(Ct+1)=Ct.
Expected values are n’ to b servable either, but in the late 1970s Robert Hall realized
that rational expectations theory could be applied to the problem—and in so doing in the
revolutionized macro econometrics. Observed consumption can be written as expected
consumption plus a surprise, Ct+1=E(Ct+1)+ surprise. According to rational expectations
theory, the surprise is truly random and unpredictable.
Combining this rational expectations formula with the equate - expected-consumption
rule,
E(Ct+1)=Ct, leads to
Hall’s famous random-walk model : Ct+1 = Ct + c
Random-walk model was given by famous economist Robert E. Hall, is an
improvement over the previous periods.
Random walk theory believes it's impossible to outperform the market without
assuming additional risk. It considers technical analysis undependable because chartists
only buy or sell a security after an established trend has developed. Likewise, the theory finds
fundamental analysis undependable due to the often-poor quality of information collected
and its ability to be misinterpreted. Critics of the theory contend that stocks do maintain
price trends over time – in other words, that it is possible to outperform the market by
carefully selecting entry and exit points for equity investments.
The model Ct+1 = Ct + c states that consumption tomorrow should equal
consumption today plus a truly random error c i.e.
c = Ct+1 — Ct
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This is a significant implication of the LC-PIH which plots one period’s consumption
against the previous periods. The model appears to work nearly perfectly.
In the crux of the Random walk theory suggests that changes in stock prices have the
same distribution and are independent of each other. It infers that the past movement or
trend of a stock price or market cannot be used to predict its future movement. Random walk
theory believes it's impossible to outperform the market without assuming additional risk. It
also considers technical analysis undependable because it results in chartists only buying or
selling a security after a move has occurred. The theory considers fundamental analysis
undependable due to the often-poor quality of information collected and its ability to be
misinterpreted.
9.3 THE LIFE CYCLE-PERMANENT INCOME HYPOTHESIS: THE TRADITIONAL
MODEL STRIKES BACK
Based on the perception of rational consumer behavior, the life cycle-permanent income
hypothesis is an attractive concept for economists. However, the past studies suggest that
both the traditional rule-of-thumb consumption function and the life cycle-permanent
income hypothesis explained consumption behavior. The actual behavior of consumption
exhibits both excess sensitivity and excess smoothness. The former means that consumption
responds too strongly predictable changes in income; the latter, that it responds too little to
surprise changes in income. John Campbell and Greg Mankiw have developed a viewpoint of
combining the LIFE CYCLE-PERMANENT INCOME HYPOTHESIS and the traditional
consumption function in order to test for excess sensitivity. According to the life cycle-
permanent income hypothesis, the change in consumption equals the surprise element, c,
so ACLC-PIH = c.
According to the traditional theory, consumption (C) is sum total of autonomous
−
consumption c , and product of MPC and disposable income i.e. YD
−
C = c + cYD,
So, AC = cAYD.
Where C = Consumption,
AC (half of consumption or average consumption)
YD= Disposable Income
If h percent of the population behaves in accordance with the traditional model and
the remaining (1 — h) follow the LC-PIH, the total change in consumption is
AC = hCtrad + (1 — h)ACLC-PIH = hcAYD + (1 — h)c
Empirically estimating this equation yields
AC = AYD suggesting that half of consumption behavior is explained by current income
rather than permanent income.
9.4 CONSUMPTION AND CAPM
The behavior of share prices, and the relationship between risk and return in financial
markets, has long been of interest. Bachelier was the first to study the fluctuations in the
prices of stocks and shares and their probability distributions. However, it was only with the
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Capital Asset Pricing Model (CAPM) developed by Sharpe (1964) that one of the important
problems of modern financial economics was formalized as the quantification of the trade-off
between risk and expected return. Proponents of the CAPM took Beta (β), as a measure of
systematic risk relative to the market portfolio, argued that it is the sole determinant of
return.
Any additional variability caused by events peculiar to the individual asset can be
“diversified away” because capital markets do not reward risks borne unnecessarily. To date
numerous versions, extensions and improvements upon the model have been observed in
the empirical literature. They include the old CAPM model (fraught with numerous
weaknesses as a result of simplistic assumptions upon which it is based), the Inter-temporal
Capital Asset Pricing Model (ICAPM) and the Consumption Capital Asset Pricing Model (C-
CAPM) to name only a few. Many attempts have been made to view which of them better
reflects/determines asset prices in numerous developed and emerging markets. Analysts
have used different related approaches and more tools and related models are being evolved
in the literature to deal with this aspect of asset pricing. All the attempts are to see if any one
particular model or method could prove to be the most appropriate model for pricing assets
and portfolio’s in the capital markets. In this regard, the Consumption Capital Asset Pricing
Model (CCAPM), a newer variant of the CAPM has attracted latter day analysts and has been
adjudged a possible tool of the future in both developed and developing economies.
Self- Assessment Questions
1. What is the difference between consumption CAPM and CAPM?
………………………………………………………………………………………………………………
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2. Explain in detail LIFE CYCLE-PERMANENT INCOME HYPOTHESIS.
………………………………………………………………………………………………………………
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9.5 WHAT IS THE CAPITAL ASSET PRICING MODEL?

An Overview
The capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner
(1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990).
Four decades later, the CAPM is still widely used in applications, such as estimating the cost
of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece
of MBA investment courses. Indeed, it is often the only asset pricing model taught in these
courses (Fama and French, 2004). The attraction of the CAPM is that it offers powerful and
intuitively pleasing predictions about how to measure risk and the relationship between
expected return and risk. The CAPM’s empirical problems may reflect theoretical failings, the
result of many simplifying assumptions. But they may also be caused by difficulties in
implementing valid tests of the model. For example, the CAPM says that the risk of a stock
should be measured relative to a comprehensive “market portfolio” that in principle can
include not just traded financial assets, but also consumer durables, real estate and human
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capital. Even if we take a narrow view of the model and limit its purview to traded and
financial assets, is it legitimate to limit further the market portfolio to common stocks (a
typical choice), or should the market be expanded to include bonds, and other financial
assets, perhaps around the world?
Indeed, CAPM has been one of the most challenging topics in financial economics. The
reason is that the model provides the means for a firm to calculate the return that its
investors demand. This model was the first successful attempt to show how to assess the risk
of the cash flows of a potential investment project, to estimate the project’s cost of capital and
the expected rate of return that investors will demand if they are to invest in the project. The
model was developed to explain the differences in the risk premium across assets. According
to the theory these differences are due to differences in the riskiness of the returns on the
assets. The model states that the correct measure of the riskiness of an asset is its beta and
that the risk premium per unit of riskiness is the same across all assets. Given the risk free
rate and the beta of an asset, the CAPM predicts the expected risk premium for an asset
(Michailidis et al, 2006).
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout
finance for pricing risky securities and generating expected returns for assets given the risk
of those assets and cost of capital.
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm - Rf)
Where;
ERi = Expected return of investment
Rf = Risk-free rate
βi = Beta of the investment
ERm = Expected return of market
(ERm - Rf) = Market risk premium
Investors expect to be compensated for risk and the time value of money. The risk-free
rate in the CAPM formula accounts for the time value of money. The other components of the
CAPM formula account for the investor taking on additional risk. The beta of a potential
investment is a measure of how much risk the investment will add to a portfolio that looks
like the market. If a stock is riskier than the market, it will have a beta greater than one. If a
stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then added to the
product of the stock’s beta and the market risk premium. The result should give an investor
the required return or discount rate they can use to find the value of an asset. The goal of the
CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value
of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share today
that pays a 3% annual dividend. The stock has a beta compared to the market of 1.3, which
means it is riskier than a market portfolio. Also, assume that the risk-free rate is 3% and this
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investor expects the market to rise in value by 8% per year. The expected return of the stock
based on the CAPM formula is 9.5%.
9.5% = 3 % + 1.3(8% - 3%)
The expected return of the CAPM formula is used to discount the expected dividends
and capital appreciation of the stock over the expected holding period. If the discounted value
of those future cash flows is equal to $100 then the CAPM formula indicates the stock is
fairly valued relative to risk.
9.5.1 LIMITATIONS THE CAPM
There are several assumptions behind the CAPM formula that have been shown not to
hold in reality. Despite these issues, the CAPM formula is still widely used because it is
simple and allows for easy comparisons of investment alternatives.
1. Including beta in the formula assumes that risk can be measured by a stock’s price
volatility. However, price movements in both directions are not equally risky. The look-
back period to determine a stock’s volatility is not standard because stock returns
(and risk) are not normally distributed.
2. The CAPM also assumes that the risk-free rate will remain constant over the
discounting period. Assume in the previous example that the interest rate on U.S.
Treasury bonds rose to 5% or 6% during the 10-year holding period. An increase in
the risk-free rate also increases the cost of the capital used in the investment and
could make the stock look overvalued.
3. The market portfolio that is used to find the market risk premium is only a theoretical
value and is not an asset that can be purchased or invested in as an alternative to the
stock. Most of the time, investors will use a major stock index, like the S&P 500, to
substitute for the market, which is an imperfect comparison.
4. The most serious critique of the CAPM is the assumption that future cash flows can be
estimated for the discounting process. If an investor could estimate the future return
of a stock with a high level of accuracy, the CAPM would not be necessary.
Self- Assessment Questions
1. Explain in brief CAPM model ?
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2. Discuss any two limitations of CAPM model.
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9.6 THE CAPM AND THE EFFICIENT FRONTIER
Using the CAPM to build a portfolio is supposed to help an investor manage their risk.
If an investor were able to use the CAPM to perfectly optimize a portfolio’s return relative to
risk, it would exist on a curve called the efficient frontier, as shown on the following graph.
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Fig 9.1 Expected Return and Risk

The graph as in Fig 9.1shows how greater expected returns (y-axis) require greater
expected risk (x-axis). Modern Portfolio Theory suggests that starting with the risk-free rate,
the expected return of a portfolio increases as the risk increases. Any portfolio that fits on the
Capital Market Line (CML) is better than any possible portfolio to the right of that line, but at
some point, a theoretical portfolio can be constructed on the CML with the best return for the
amount of risk being taken. The CML and efficient frontier may be difficult to define, but it
illustrates an important concept for investors: there is a trade-off between increased return
and increased risk. Because it isn’t possible to perfectly build a portfolio that fits on the CML,
it is more common for investors to take on too much risk as they seek additional return.

Fig. 9.1 (A)

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In the following chart, you can see two portfolios that have been constructed to fit
along the efficient frontier. Portfolio A is expected to return 8% per year and has a 10%
standard deviation or risk level. Portfolio B is expected to return 10% per year but has a 16%
standard deviation. The risk of portfolio B rose faster than its expected returns.
The efficient frontier assumes the same things as the CAPM and can only be
calculated in theory. If a portfolio existed on the efficient frontier it would be providing the
maximal return for its level of risk. However, it is impossible to know whether a portfolio
exists on the efficient frontier or not because future returns cannot be predicted.
This trade-off between risk and return applies to the CAPM and the efficient frontier
graph can be rearranged to illustrate the trade-off for individual assets. In the following
chart, you can see that the CML is now called the Security Market Line (SML). Instead of
expected risk on the x-axis, the stock’s beta is used. As you can see in the illustration, as
beta increases from one to two, the expected return is also rising.

Expected Risk
Fig. 9.1 (B)
The CAPM and SML make a connection between a stock’s beta and its expected risk. A
higher beta means more risk but a portfolio of high beta stocks could exist somewhere on the
CML where the trade-off is acceptable, if not the theoretical ideal. The value of these two
models is diminished by assumptions about beta and market participants that aren’t true in
the real markets. For example, beta does not account for the relative riskiness of a stock that
is more volatile than the market with a high frequency of downside shocks compared to
another stock with an equally high beta that does not experience the same kind of price
movements to the downside.
Practical Value of the CAPM
1. Considering the critiques of the CAPM and the assumptions behind its use in
portfolio construction, it might be difficult to see how it could be useful.
However, using the CAPM as a tool to evaluate the reasonableness of future
expectations or to conduct comparisons can still have some value.
2. Imagine an advisor who has proposed adding a stock to a portfolio with a $100
share price. The advisor uses the CAPM to justify the price with a discount rate
of 13%. The advisor’s investment manager can take this information and
compare it to the company’s past performance and its peers to see if a 13%
return is a reasonable expectation.
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3. Assume in this example that the peer group’s performance over the last few
years was a little better than 10% while this stock had consistently
underperformed with 9% returns. The investment manager shouldn’t take the
advisor’s recommendation without some justification for the increased expected
return.
4. An investor can also use the concepts from the CAPM and efficient frontier to
evaluate their portfolio or individual stock performance compared to the rest of
the market. For example, assume that an investor’s portfolio has returned 10%
per year for the last three years with a standard deviation of returns (risk) of
10%. However, the market averages have returned 10% for the last three years
with a risk of 8%.
5. The investor could use this observation to reevaluate how their portfolio is
constructed and which holdings may not be on the SML. This could explain why
the investor’s portfolio is to the right of the CML. If the holdings that are either
dragging on returns or have increased the portfolio’s risk disproportionately can
be identified, the investor can make changes to improve returns.
9.6.1 THE LOGIC OF THE CAPM
The CAPM builds on the model of portfolio choice developed by Harry Markowitz
(1959). In Markowitz’s model, an investor selects a portfolio at time t-1 that produces a
stochastic return at t. The model assumes investors are risk averse and, when choosing
among portfolios, they care only about the mean and variance of their one-period investment
return. As a result, investors choose “mean-variance-efficient” portfolios, in the sense that
the portfolios minimize the variance of portfolio return, given expected return, and maximize
expected return, given variance, thus, the Markowitz approach is often called a “mean-
variance model”. The portfolio model provides an algebraic condition on asset weights in
mean-variance-efficient portfolios. The CAPM turns this algebraic statement into a testable
prediction about the relation between risk and expected return by identifying a portfolio that
must be efficient if asset prices are to clear the market of all assets. Sharpe (1964) and
Lintner (1965) add two key assumptions to the Markowitz model to identify a portfolio that
must be mean-variance-efficient. The first assumption is complete agreement; given market
clearing asset prices at t-1, investors agree on the joint distribution of asset returns from t-1
to t and this distribution is the true one–that is, it is the distribution from which the returns
we use to test the model are drawn. The second assumption is that there is borrowing and
lending at a risk-free rate, which is the same for all investors and does not depend on the
amount borrowed or lent (Fama and French, 2004).
9.7 CONSUMPTION CAPITAL ASSET PRICING MODEL (CCAPM): A CURSORY
GLANCE
Overview In the last section we saw that CAPM identifies the risk of any security as the
covariance between the security's rate of return and the rate of return on the market.
According to the CAPM, the uncertainty associated with the return on the market portfolio is
the sole source of risk in the economy but CAPM has no theoretical structure that allows us
to readily identify what it is that causes the market portfolio to be risky. Macroeconomics
does have such a theoretical structure. It tells us, for example, how the profits of firms are
related to such things as overall economic activity (GDP) and the government's conduct of
monetary and fiscal policies. Macroeconomics provides us with models that enable us to not
only identify various sources of aggregate uncertainty but to also understand the
mechanisms by which these affect security returns and prices. The asset pricing model that
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is embedded in stochastic models of macroeconomics is called the Consumption Based Asset

Pricing Model (CCAPM). The name derives from the fact that the equations that describe the
behaviour of asset prices and returns in the CCAPM devolve from the consumption/saving
and asset choice decisions of households. In the CCAPM the economy is assumed to be
populated by a large number of households that are identical in all respects, including
preferences and endowments. This assumption permits decision making to be analyzed by
examining the behaviour of a single, representative household. No matter what the
macroeconomic setting is, one consequence of the CCAPM assumption that all households
are identical is that households will never exchange assets with one another. For instance it
will never be the case that one household will borrow from another. Why? All households are
identical; if one wishes to borrow, all will wish to borrow and there will be no household that
wishes to lend. If there are any assets that exist in positive net supply, these must come from
outside the household sector (e.g. from governments, businesses, or the rest of world).
9.8 CCAPM AND CAPM: A COMPARISON
Breeden (1979) and Lucas (1978) provided the foundation of the Consumption Capital
Asset Pricing Model (CCAPM) leading to the award of a Nobel Laureate in economics to one of
them. Their model is an extension of the traditional capital asset pricing model CAPM. It is
best used as a theoretical model, but it can help to make sense of variation in financial asset
returns over time and in some cases, its results can be relevant than those achieved through
the CAPM model. While the CAPM relies on the market portfolio return in order to
understand and predict future asset prices, the CCAPM relies on the aggregate consumption.
In the CAPM, risky assets create uncertainty in an investor’s wealth, which is determined by
the market which creates uncertainty in consumption. What an investor will spend becomes
uncertain because his or her wealth is uncertain as a result of a decision to invest in risky
assets (Igbinovia and Uwubanmwen, 2012). The CCAPM prices assets with respect to
changes in aggregate consumption between two points in time. In contrast, the available data
on aggregate consumption provide total expenditure on goods and services over a period of
time. These differences between consumption in theory and its measured counterpart
suggest the first two problems. First, goods and services need not be consumed in the same
period that they are purchased. Second measured aggregate consumption is closer to an
integral of consumption over a period of time than to “Spot” consumption (at a point in time).
The “Spot” consumption is also known as instantaneous consumption. The second problem
creates a “summation bias”. In a more succinct term, the CCAPM is based on the notion that
the aggregate capital consumption and return on all assets tend to follow an optimal path of
normal distribution. On the other hand, the capital asset pricing model (CAPM) is a market
oriented capital asset pricing model. The CAPM model by Sharpe (1964) used the beta
coefficient to ascertain the riskiness of stock. A beta coefficient equal to one indicates that a
particular stock or capital asset has the same amount of systematic risk with the entire
portfolio of securities. Hence there would be no need to adjust the portfolio. If all securities in
the portfolio have unitary beta coefficients, equilibrium is attained and security prices are
rational with little tendency to fluctuate. On the other hand, a beta coefficient greater than
unity indicates that the security in question has become riskier, while a coefficient less than
unity imply that the security has become safer. These cases are deviations from equilibrium
position, which imply that security prices would also be out of equilibrium values.
According to Sharpe(1964), this price behavior could also be viewed from the
perspective of expected returns on the security and the covariance of such security. If the
covariance is zero, it implies that the price of security reflects the expected returns on it,
which is an equilibrium situation that makes price stable. A negative covariance depresses
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the price below the fundamental value, while a positive covariance would raise it above its
fundamental value. The movement of security price above and below the fundamental value
creates speculative transactions that tend to redirect the price towards equilibrium level.
Thus, if the fundamental value (returns) is higher security price would rise, but it would fall if
the value becomes lower. Thus, while the capital asset pricing model CAPM is market
oriented, the consumption oriented capital asset pricing model is consumption. The CAPM
uses the principles of Modern Portfolio Theory to determine if a security is fairly valued. It
relies on assumptions about investor behaviors, risk and return distributions, and market
fundamentals that don’t match reality. However, the underlying concepts of CAPM and the
associated efficient frontier can help investors understand the relationship between expected
risk and reward as they make better decisions about adding securities to a portfolio.
9.9 SUMMARY
The life-cycle–permanent-income hypothesis (LC-PIH) predicts that the marginal
propensity to consume out of permanent income is large and that the marginal propensity to
consume out of transitory income is very small. Modern theories of consumption assume that
individuals want to maintain relatively smooth consumption profiles over their lifetimes.
Their consumption behavior is geared to their long- term consumption opportunities—
permanent income or lifetime income plus wealth. With such a view, current income is only
one of the determinants of consumption spending. Wealth and expected income play a role
too.
Observed consumption is much smoother than the simple Keynesian consumption
function predicts. Current consumption can be very accurately predicted from last period’s
consumption. Both these observations accord well with the LC-PIH.
The LC-PIH is a very attractive theory, but it does not give a complete explanation of
consumption behavior. Empirical evidence shows that the traditional consumption function
appears to also play a role. The life-cycle hypothesis suggests that the propensities of an
individual to consume out of disposable income and out of wealth depend on the person’s
age. It implies that saving is high (low) when income is high (low) relative to lifetime average
income. It also suggests that aggregate saving depends on the growth rate of the economy
and on such variables as the age distribution of the population.
The rate of consumption, and thus of saving, could in principle be affected by the
interest rate. But the evidence, for the most part, shows little effect of interest rates on
saving.
The U.S. saving rate is very low by international standards. Most private saving in the
United States is done by the business sector.
9.10 GLOSSARY
 CAPM identifies the risk of any security as the covariance between the security's rate
of return and the rate of return on the market.
 The life-cycle–permanent-income hypothesis (LC-PIH) predicts that the marginal
propensity to consume out of permanent income is large and that the marginal
propensity to consume out of transitory income is very small
 Thelife-cyclehypothesissuggeststhatthepropensitiesofanindividualtoconsume out of
disposable income and out of wealth depend on the person’s age.
 The Barro-Ricardo equivalence proposition notes that debt represents future taxes. It
asserts that debt-financed tax cuts will not have any effect on consumption or
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aggregate demand.
9.11 REFERENCES
 Dernburg, T. F., & Dernburg, J. D. (1969). Macroeconomic analysis: an introduction to
comparative statics and dynamics. Addison-Wesley.
 Rana, K. C., & Verma, K. N. (2009). Macroeconomic analysis.
 Dwivedi, D. N. (2005). Macroeconomics: theory and policy. Tata McGraw-Hill
Education.
9.12 FURTHER READINGS
 Ackley, G. (1961). Macroeconomic theory. Macmillan Library Reference.
 Shapiro, E. (1978). Macroeconomic analysis (No. 339.2 S4 1978).
 Branson, W. H. (1979). Macroeconomic theory and policy (No. 04; HB171. 5, B73
1979.).
 Olsson, O. (2013). Essentials of advanced macroeconomic theory. Routledge.
9.13 MODEL QUESTIONS
1. The text implies that the ratio of consumption to accumulated saving declines
over time until retirement. Why? What assumption about consumption behavior
leads to this result?
2. Explain why successful gamblers (and thieves) might be expected to live very
well even in years when they don’t do well a tall.
3. What are the similarities between the life-cycle and the Permanent Income
Hypotheses? Do they differ in their approaches to explaining why the long-run
MPC is greater than the short- run MPC?
4. What is a random walk? How is Hall’s random-walk model of consumption
related to the life-cycle and permanent-income hypotheses?
5. What are the problems of excess sensitivity and excess smoothness? Does their
existence disprove or invalidate the LC-PIH? Explain.
6. What are assumption(s) regarding consumers’ knowledge and behavior in the
life-cycle and permanent-income hypothesis? Do we need to change in order for
it to explain the presence of precautionary, or buffer-stock, saving? Do these
assumptions, in your opinion, bring the model closer to or farther from the
world as you know it?
7. Explain in detail the capital asset pricing model.
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Lesson-10

INVESTMENT FUNCTION
Structure
10.0 Objectives
10.1 Introduction
10.2 Meaning of Investment
10.3 Capital And Investment
10.4 Types Of Investment
10.4.1 Gross Investment
10.4.2 Net Investment
10.4.3 Induced Investment
10.4.4 Autonomous Investment
10.5 Determinants Of The Level Of Investment
10.5.1 Marginal Efficiency Of Capital
10.5.2 Marginal Efficiency Of Investment
10.5.3 Distinction Between MEC and MEI
10.6 Other Determinants Of Investment Demand
10.6.1 Expectations
10.6.2 Level Of Economic Activity
10.6.3 Stock Of Capital
10.6.4 Capacity Utilization
10.6.5 Cost Of Capital Goods
10.6.6 Other Factor Cost
10.6.7 Technological Change
10.6.8 Public Policy
10.7 Summary
10.8 Glossary
10.9 References
10.10 Further Readings
10.11 Model Questions
10.0 OBJECTIVES
After going through the chapter you shall be able to –
 Explain the Meaning of Investment
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 Discuss the Types Of Investment

 Describe the Determinants Of The Level Of Investment
10.1 INTODUCTION
It is useful to make the meaning of investment clear now because we have already
studied the basics and applications of consumption function. When a person buys shares,
bonds or debentures of a public limited company from the market, it is generally said that he
has made investment. But this is not the real investment which determines income and
employment in the country and with which we are here concerned. Buying of existing shares
and bonds by an individual is merely a financial investment. When one individual purchases
the shares or bonds, some other one would sell them. Thus, the purchase and sale of the
shares merely represents the change in the ownership of assets which already exists rather
the creation of new capital assets. It is the new addition to the stock of physical capital such
as plant, machines, trucks, new factories and so on that creates income and employment.
Therefore, by real investment we mean the addition to the stock of physical capital.
10.2 MEANING OF INVESTMENT
In economics, investment means the new expenditure incurred on addition of capital
goods such as machines, buildings, equipment, tools, etc. The addition to the stock of
physical capital i.e., net investment raises the level of aggregate demand which brings about
addition to the level of income and employment in the economy. Keynes and many other
economists also include the increase in the inventories of consumer goods in the capital of
the country and therefore in the investment.
10.3 CAPITAL AND INVESTMENT
In ordinary parlance, investment means to buy shares, stocks, bonds and securities
which already exist in stock market. But this is not real investment because it is simply a
transfer of existing assets. Hence this is called financial investment which does not affect
aggregate spending. In Keynesian terminology, investment refers to real investment which
adds to capital equipment. It leads to increase in the levels of income and production by
increasing the production and purchase of capital goods. Investment thus includes new plant
and equipment, construction of public works like dams, roads, buildings, etc., net foreign
investment, inventories and stocks and shares of new companies. In the words of Joan
Robinson, “By investment is meant an addition to capital, such as occurs when a new house
is built or a new factory is built. Investment means making an addition to the stock of goods
in existence.”
Capital, on the other hand, refers to real assets like factories, plants, equipment, and
inventories of finished and semi-finished goods. It is any previously produced input that can
be used in the production process to produce other goods. The amount of capital available in
an economy is the stock of capital. Thus capital is a stock concept. To be more precise,
investment is the production or acquisition of real capital assets during any period of time.
To illustrate, suppose the capital assets of a firm on 31 March 2004 are Rs 100 crores and it
invests at the rate of Rs 10 crores during the year 2004-05. At the end of the next year (31
March 2005), its total capital will be Rs 110 crores.
Symbolically, let I be investment and К be capital in year t, then It = Kt– Kt- 1.
Capital and investment are related to each other through net investment. Gross
investment is the total amount spent on new capital assets in a year. But some capital stock
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wears out every year and is used up for depreciation and obsolescence. Net investment is
gross investment minus depreciation and obsolescence charges for replacement investment.
This is the net addition to the existing capital stock of the economy. If gross investment
equals depreciation, net investment is zero and there is no addition to the economy’s capital
stock. If gross investment is less than depreciation, there is disinvestment in the economy
and the capital stock decreases. Thus for an increase in the real capital stock of the
economy, gross investment must exceed depreciation, i.e., there should be net investment.
10.4 TYPES OF INVESTMENT:
10.4.1 Gross Investment
The total addition made to the capital stock of economy in a given period is termed as
Gross Investment. Capital stock consists of fixed assets and unsold stock. So, gross
investment is the expenditure on purchase of fixed assets and unsold stock during the
accounting year. However, gross investment does not indicate the actual change in
economy’s stock of productive assets for a given year. During the production process, some
amount of fixed capital is used up. This loss of fixed capital is known as depreciation. By
subtracting depreciation from gross investment, we get Net Investment.
10.4.2 Net Investment:
The actual addition made to the capital stock of economy in a given period is termed
as Net Investment.
Net Investment = Gross Investment – Depreciation
Let us now understand the meaning of depreciation.
Depreciation (Consumption of Fixed Capital):
Depreciation refers to a fall in the value of fixed assets due to normal wear and tear,
passage of time or expected obsolescence (change in technology). The concept of depreciation
is very important to differentiate between Gross value and the Net value, ‘Gross’ is inclusive
of depreciation, whereas, ‘net’ excludes it.

Gross Value = Net Value + Depreciation

Depreciation is also known as: (i) Current Replacement Cost; (ii) Replacement cost of Fixed
Capital; (iii) Capital Consumption Allowance.
Depreciation of assets is mainly due to 3 reasons:
(i) Normal wear and tear:
Continuous use of fixed assets in production process decreases their productive
capacity and value.
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(ii) Passage of time:

Value of fixed assets also decreases with the passage of time, even if they are not being
put to use in the business. Natural factors like rain, winds, weather, etc. contribute to fall in
their value.
(iii) Expected obsolescence:
Value of fixed assets also decreases due to expected obsolescence (i.e. loss in value
due to change in technology or change in demand for goods and services).
10.4.3 Induced Investment:
Real investment may be induced. Induced investment is profit or income motivated.
Factors like prices, wages and interest changes which affect profits influence induced
investment. Similarly demand also influences it. When income increases, consumption de-
mand also increases and to meet this, investment increases. In the ultimate analysis,
induced investment is a function of income i.e., I = f(Y). It is income elastic. It increases or de-
creases with the rise or fall in income, as shown in Figure 10.1.

Fig. 10.1
I1 I1is the investment curve which shows induced investment at various levels of
income. Induced investment is zero at OY1 income. When income rises to OY3 induced
investment is I3Yy A fall in income to OY2 also reduces induced investment to I2Y2.
Induced investment may be further divided into (i) the average propensity to invest,
and (ii) the marginal propensity to invest:
(i) The average propensity to invest is the ratio of investment to income, I/Y. If the
income is Rs. 40 crores and investment is Rs. 4 crores, I/Y = 4/40 = 0.1. In terms of the
above figure, the average propensity to invest at OY3 income level is I3Y3/ OY3
(ii) The marginal propensity to invest is the ratio of change in investment to the change in
income, i.e., I/ Y. If the change in investment, I=Rs 2 crores and the change in
income, Y = Rs 10 crores, then I/∆Y = 2/10=0.2 In Figure 1, I/ Y =I3a/Y2Y3
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10.4.4 Autonomous Investment:

Autonomous investment is independent of the level of income and is thus income
inelastic. It is influenced by exogenous factors like innovations, inventions, growth of
population and labour force, researches, social and legal institutions, weather changes, war,
revolution, etc. But it is not influenced by changes in demand. Rather, it influences the
demand. Investment in economic and social overheads whether made by the government or
the private enterprise is autonomous.
Such investment includes expenditure on building, dams, roads, canals, schools,
hospitals, etc. Since investment on these projects is generally associated with public policy,
autonomous investment is regarded as public investment. In the long-run, private
investment of all types may be autonomous because it is influenced by exogenous factors.
Diagrammatically, autonomous investment is shown as a curve parallel to the horizontal axis
as I1I’ curve in Figure 10.2. It indicates that at all levels of income, the amount of investment
OI1remains constant.

Fig. 10.2
The upward shift of the curve to I2I” indicates an increased steady flow of investment
at a constant rate OI2 at various levels of income. However, for purposes of income
determination, the autonomous investment curve is superimposed on the С curve in a 45°
line diagram.
10.5 DETERMINANTS OF THE LEVEL OF INVESTMENT:
The decision to invest in a new capital asset depends on whether the expected rate of
return on the new investment is equal to or greater or less than the rate of interest to be paid
on the funds needed to purchase this asset. It is only when the expected rate of return is
higher than the interest rate that investment will be made in acquiring new capital assets. In
reality, there are three factors that are taken into consideration while making any investment
decision. They are the cost of the capital asset, the expected rate of return from it during its
lifetime, and the market rate of interest. Keynes sums up these factors in his concept of the
marginal efficiency of capital (MEC).
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10.5.1 MARGINAL EFFICIENCY OF CAPITAL:

The marginal efficiency of capital is the highest rafQfYet+e te of return expected from
an additional unit of a capital asset over its cost. In the words of Kurihara, “It is the ratio
between the prospective yield to additional capital goods and their supply price.” The
prospective yield is the aggregate net return from an asset during its life time, while the
supply price is the cost of producing this asset.
If the supply price of a capital asset is Rs. 20,000 and its annual yield is Rs. 2,000, the
marginal efficiency of this asset is 2000/20000 × 100/1 = 10 per cent. Thus the marginal
efficiency of capital is the percentage of profit expected from a given investment on a capital
asset.
Keynes relates the prospective yield of a capital asset to its supply price and defines
the MEC as “equal to the rate of discount which would make the present value of the series
of annuities given by the returns expected from the capital assets during its life just equal to
its supply price.”
Symbolically, this can be expressed as:
SP =R1/ (1+i) + R2 (1+i)2 + Rn/(1+i)n
Where Sp is the supply price or the cost of the capital asset, R1 R2… and Rn are the
prospective yields or the series of expected annual returns from the capital asset in the years,
1, 2… and n, i is the rate of discount which makes the capital asset exactly equal to the
present value of the expected yield from it.
This i is the MEC or the rate of discount which equates the two sides of the equation.
If the supply price of a new capital asset is Rs 1,000 and its life is two years, it is expected to
yield Rs 550 in the first year and Rs 605 in the second year. Its MEC is 10 per cent which
equates the supply price to the expected yields of this capital asset.
Thus
(Sp) Rs 1000 = 550/(1.10) + (605)/(1.10)2 = Rs. 500 + 500
In equation (1), the term R1/(1+i) is the present value (PV) of the capital asset. The
present value is “the value of payments to be received in the future.” It depends on the rate of
interest at which it is discounted.
Suppose we expect to receive Rs 100 from a machine in a year’s time and the rate of
interest is 5 per cent. The present value of this machine is
R1 / (1+ i) =100/(1.05) = Rs 95.24
If we expect Rs 100 from the machine after two years then its present value is100/
(1.05)2 = Rs 90.70. The present value of a capital asset is inversely related to the rate of
interest. The lower the rate of interest, the higher is the present value, and vice versa. For
instance, if the rate of interest is 5 per cent, PV of an asset of Rs 100 for one year will be Rs
95.24; at 7 per cent interest rate, it will be Rs 93.45; and at 10 per cent interest rate, it will
be Rs 90.91.
The relation between the present value and the rate of interest is shown in Figure 3,
where the rate of interest is taken on the horizontal axis while the present value of the project
on the vertical axis. The curve PR shows the inverse relation between the present value and
the rate of interest. If the current rate of interest is ii the present value of the project is P1 On
the other hand, a higher rate of interest (i2) will lead to a lower present value (P2) when the
present value curve (PR) cuts the horizontal axis at point (Z), the net present value becomes
zero.
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Fig. 10.3
As a matter of fact, the MEC is the expected rate of return over cost of a new capital
asset. In order to find out whether it is worthwhile to purchase a capital asset it is essential
to compare the present value of the capital asset with its cost or supply price. If the present
value of a capital asset exceeds its cost of buying, it pays to buy it. On the contrary, if its
present value is less than its cost, it is not worthwhile investing in this capital asset. The
same results can be had by comparing the MEC with the market rate of interest. If the MEL
of a capital asset is higher than the market rate of interest at which it is borrowed, it pays to
purchase the capital asset, and vice versa. If the market interest rate equals the MEC of the
capital asset, the firm is said to possess the optimum capital stock. If the MEC is higher than
the rate of interest, there will be a tendency to borrow funds in order to invest in new capital
assets. If the MEC is lower than the rate of interest, no firm will borrow to invest in capital
assets. Thus the equilibrium condition for a firm to hold the optimum capital stock is where
the MEC equals the interest rate.
Any disequilibrium between the MEC and the rate of interest can be removed by
changing the capital stock, and hence the MEC or by changing the rate of interest or both.
Since the stock of capital changes slowly, therefore, changes in the rate of interest are more
important for bringing equilibrium. The above arguments which have been applied to a firm
are equally applicable to the economy. Figure 4 shows the MEC curve of an economy. It has a
negative slope (from left to right downward) which indicates that the higher the MEC, the
smaller the capital stock. Or, as the capital stock increases, the MEC falls. This is because of
the operation of the law of diminishing returns in production.

Fig. 10.4
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As a result, the marginal physical productivity of capital and the marginal revenue fall.
In the figure, when the capital stock is OK1, the MEC is Or1. As the capital increases from
OK1to ОK2 the MEC falls from Or1 to Or2 .The net addition to the capital stock
K1K2 represents the net investment in the economy.
Further, to reach the optimum (desired) capital stock in the economy, the MEC must
equal the rate of interest. If, as shown in the figure, the existing capital stock is OK1 the MEC
is Or2and the rate of interest is at Or1 Everyone in the economy will borrow funds and invest
in capital assets.
This is because MEC (Or1) is higher than the rate of interest (at Or2). This will continue
till the MEC (Or1) comes down to the level of the interest rate (at Or2). When the MEC equals
the rate of interest, the economy reaches the level of optimum capital stock. The fall in the
MEC is due to the increase in the actual capital stock from OK 2 to the optimum (desired)
capital stock OK2.
The increase in the firm’s capital stock by K1K2 is the net investment of the firm. But it
is the rate of interest which determines the size of the optimum capital stock in the economy.
And it is the MEC which relates the amount of desired capital stock to the rate of interest.
Thus the negative slope of the MEC curve indicates that as the rate of interest falls the
optimum stock of capital increases.
10.5.2 THE MARGINAL EFFICIENCY OF INVESTMENT (MEI)
The marginal efficiency of investment is the rate of return expected from a given
investment on a capital asset after covering all its costs, except the rate of interest. Like the
MEC, it is the rate which equates the supply price of a capital asset to its prospective yield.
The investment on an asset will be made depending upon the interest rate involved in getting
funds from the market. If the rate of interest is high, investment is at a low level. A low rate of
interest leads to an increase in investment. Thus the MEI relates the investment to the rate of
interest. The MEI schedule shows the amount of investment demanded at various rates of
interest. That is why, it is also called the investment demand schedule or curve which has a
negative slope, as shown in Fig. 10.5(A). At Or1 rate of interest, investment is OF. As the rate
of interest falls to Or2, investment increases to ОI”.

Fig. 10.5
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To what extent the fall in the interest rate will increase investment depends upon the
elasticity of the investment demand curve or the MEI curve. The less elastic is the MEI curve,
the lower is the increase in investment as a result of fall in the rate of interest, and vice
versa. In Figure 10.5 the vertical axis measures the interest rate and the MEI and the
horizontal axis measures the amount of investment. The MEI and MEI’ are the investment
demand curves. The MEI curve in Panel (A) is less elastic to investment which increases by
I’I’’. This is less than the increase in investment I1I”2 shown in Panel (B) where the MEI’ curve
is elastic. Thus given the shape and position of the MEI curve, a fall in the interest rate will
increase the volume of investment.

Fig. 10.6
On the other hand, given the rate of interest, the higher the MEI, the larger shall be
the volume of investment. The higher marginal efficiency of investment implies that the MEI
curve shifts to the right. When the existing capital assets wear out, they are replaced by new
ones and level of investment increases. But the amount of induced investment depends on
the existing level of total purchasing. So more induced investment occurs when the total
purchasing is higher. The higher total purchasing tends to shift the MEI to the right
indicating that more inducement to investment takes place at a given level of interest rate.
This is explained in Figure 10.6, where MEI1 and МЕI2 curves indicate two different levels of
total purchasing in the economy. Let us suppose that the MEI, curve indicates that at Rs 200
crores of total purchasing, OI1 (Rs 20 crores) investment occurs at Or1 interest rate. If total
purchasing rises to Rs 500 crores, the MEI1 curve shifts to the right as МЕI2 and the level of
induced investment increases to OI2 (Rs 50 crores) at the same interest rate Or1.
10.5.3 DISTINCTION BETWEEN MEC AND MEI
Keynes did not distinguish between the marginal efficiency of capital (MEC) and the
marginal efficiency of investment (MEI).
But modern economists have made clear distinctions between the two concepts as
follows:
(i) The MEC is based on a given supply price for capital, and the MEI on induced changes
in this price.
(ii) The MEC shows the rate of return on all successive units of capital without regard to
the existing stock of capital. On the other hand, the MEI shows the rate of return on
only units of capital over and above the existing stock of capital.
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(iii) In the MEC, the capital stock is taken on the horizontal axis of a diagram, while in the
MEI the amount of investment is taken horizontally on the X-axis.
(iv) The MEC is a ‘stock’ concept, and the MEI is a ‘flow’ concept.
(v) The MEC determines the optimum capital stock in an economy at each level of interest
rate. The MEI determines the net investment of the economy at each interest rate,
given the capital stock.
10.6 OTHER DETERMINANTS OF INVESTMENT DEMAND
Perhaps the most important characteristic of the investment demand curve is not its
negative slope, but rather the fact that it shifts often. Although investment certainly responds
to changes in interest rates, changes in other factors appear to play a more important role in
driving investment choices. This section examines eight additional determinants of
investment demand: expectations, the level of economic activity, the stock of capital, capacity
utilization, the cost of capital goods, other factor costs, technological change, and public
policy. A change in any of these can shift the investment demand curve.
10.6.1 Expectations
A change in the capital stock changes future production capacity. Therefore, plans to
change the capital stock depend crucially on expectations. A firm considers likely future
sales; a student weighs prospects in different occupations and their required educational and
training levels. As expectations change in a way that increases the expected return from
investment, the investment demand curve shifts to the right. Similarly, expectations of
reduced profitability shift the investment demand curve to the left.
10.6.2 The Level of Economic Activity
Firms need capital to produce goods and services. An increase in the level of
production is likely to boost demand for capital and thus lead to greater investment.
Therefore, an increase in GDP is likely to shift the investment demand curve to the right.
To the extent that an increase in GDP boosts investment, the multiplier effect of an
initial change in one or more components of aggregate demand will be enhanced. We have
already seen that the increase in production that occurs with an initial increase in aggregate
demand will increase household incomes, which will increase consumption, thus producing a
further increase in aggregate demand. If the increase also induces firms to increase their
investment, this multiplier effect will be even stronger.
10.6.3 The Stock of Capital
The quantity of capital already in use affects the level of investment in two ways. First,
because most investment replaces capital that has depreciated, a greater capital stock is
likely to lead to more investment; there will be more capital to replace. But second, a greater
capital stock can tend to reduce investment. That is because investment occurs to adjust the
stock of capital to its desired level. Given that desired level, the amount of investment needed
to reach it will be lower when the current capital stock is higher. Suppose, for example, that
real estate analysts expect that 100,000 homes will be needed in a particular community by
2010. That will create a boom in construction—and thus in investment—if the current
number of houses is 50,000. But it will create hardly a ripple if there are now 99,980 homes.
How will these conflicting effects of a larger capital stock sort themselves out? Because most
investment occurs to replace existing capital, a larger capital stock is likely to increase
investment. But that larger capital stock will certainly act to reduce net investment. The
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more capital already in place, the less new capital will be required to reach a given level of
capital that may be desired.
10.6.4 Capacity Utilization
The capacity utilization rate measures the percentage of the capital stock in use.
Because capital generally requires downtime for maintenance and repairs, the measured
capacity utilization rate typically falls below 100%. For example, the average manufacturing
capacity utilization rate was 79.7% for the period from 1972 to 2007. In November 2008 it
stood at 72.3. If a large percentage of the current capital stock is being utilized, firms are
more likely to increase investment than they would if a large percentage of the capital stock
were sitting idle. During recessions, the capacity utilization rate tends to fall. The fact that
firms have more idle capacity then depresses investment even further. During expansions, as
the capacity utilization rate rises, firms wanting to produce more often must increase
investment to do so.
10.6.5 The Cost of Capital Goods
The demand curve for investment shows the quantity of investment at each interest
rate, all other things unchanged. A change in a variable held constant in drawing this curve
shifts the curve. One of those variables is the cost of capital goods themselves. If, for
example, the construction cost of new buildings rises, then the quantity of investment at any
interest rate is likely to fall. The investment demand curve thus shifts to the left. The
$10,000 cost of the solar energy system in the example given earlier certainly affects a
decision to purchase it. We saw that buying the system makes sense at interest rates below
10% and does not make sense at interest rates above 10%. If the system costs $5,000, then
the interest return on the investment would be 20% (the annual saving of $1,000 divided by
the $5,000 initial cost), and the investment would be undertaken at any interest rate below
20%.
10.6.6 Other Factor Costs
Firms have a range of choices concerning how particular goods can be produced. A
factory, for example, might use a sophisticated capital facility and relatively few workers, or it
might use more workers and relatively less capital. The choice to use capital will be affected
by the cost of the capital goods and the interest rate, but it will also be affected by the cost of
labor. As labor costs rise, the demand for capital is likely to increase. Our solar energy
collector example suggests that energy costs influence the demand for capital as well. The
assumption that the system would save $1,000 per year in energy costs must have been
based on the prices of fuel oil, natural gas, and electricity. If these prices were higher, the
savings from the solar energy system would be greater, increasing the demand for this form
of capital.
10.6.7 Technological Change
The implementation of new technology often requires new capital. Changes in
technology can thus increase the demand for capital. Advances in computer technology have
encouraged massive investments in computers. The development of fiber-optic technology for
transmitting signals has stimulated huge investments by telephone and cable television
companies.
10.6.8 Public Policy
Public policy can have significant effects on the demand for capital. Such policies
typically seek to affect the cost of capital to firms. The Kennedy administration introduced
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two such strategies in the early 1960s. One strategy, accelerated depreciation, allowed firms
to depreciate capital assets over a very short period of time. They could report artificially high
production costs in the first years of an asset’s life and thus report lower profits and pay
lower taxes. Accelerated depreciation did not change the actual rate at which assets
depreciated, of course, but it cut tax payments during the early years of the assets’ use and
thus reduced the cost of holding capital. The second strategy was the investment tax credit,
which permitted a firm to reduce its tax liability by a percentage of its investment during a
period. A firm acquiring new capital could subtract a fraction of its cost—10% under the
Kennedy administration’s plan—from the taxes it owed the government. In effect, the
government “paid” 10% of the cost of any new capital; the investment tax credit thus reduced
the cost of capital for firms. Though less direct, a third strategy for stimulating investment
would be a reduction in taxes on corporate profits (called the corporate income tax). Greater
after-tax profits mean that firms can retain a greater portion of any return on an investment.
A fourth measure to encourage greater capital accumulation is a capital gains tax rate that
allows gains on assets held during a certain period to be taxed at a different rate than other
income. When an asset such as a building is sold for more than its purchase price, the seller
of the asset is said to have realized a capital gain. Such a gain could be taxed as income
under the personal income tax. Alternatively, it could be taxed at a lower rate reserved
exclusively for such gains. A lower capital gains tax rate makes assets subject to the tax
more attractive. It thus increases the demand for capital. Congress reduced the capital gains
tax rate from 28% to 20% in 1996 and reduced the required holding period in 1998. The Jobs
and Growth Tax Relief Reconciliation Act of 2003 reduced the capital gains tax further to
15% and also reduced the tax rate on dividends from 38% to 15%. A proposal to eliminate
capital gains taxation for smaller firms was considered but dropped before the stimulus bill
of 2009 was enacted. Accelerated depreciation, the investment tax credit, and lower taxes on
corporate profits and capital gains all increase the demand for private physical capital. Public
policy can also affect the demands for other forms of capital. The federal government
subsidizes state and local government production of transportation, education, and many
other facilities to encourage greater investment in public sector capital. For example, the
federal government pays 90% of the cost of investment by local government in new buses for
public transportation.
10.7 SUMMARY
Investment thus means the new expenditure incurred on addition of capital goods
such as machines, buildings, equipment, tools, etc. The addition to the stock of physical
capital i.e., net investment raises the level of aggregate demand which brings about addition
to the level of income and employment in the economy. This is the net addition to the existing
capital stock of the economy. If gross investment equals depreciation, net investment is zero
and there is no addition to the economy’s capital stock. If gross investment is less than
depreciation, there is disinvestment in the economy and the capital stock decreases. In
reality, there are three factors that are taken into consideration while making any
investment decision. They are the cost of the capital asset, the expected rate of return
from it during its lifetime, and the market rate of interest. Keynes sums up these
factors in his concept of the marginal efficiency of capital (MEC).
10.8 GLOSSARY
 Interest rate: The market price at which resources are transferred between the
present and the future; the return to saving and the cost of borrowing.
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 Inventory investment: The change in the quantity of goods that firms hold in
storage, including materials and supplies, work in process, and finished goods.
 Investment: Goods purchased by individuals and firms to add to their stock of
capital.
 Investment tax credit: A provision of the corporate income tax that reduces a firm’s
tax when it buys new capital goods.
 Liquidity constraint: A restriction on the amount a person can borrow from a
financial institution, which limits the person’s ability to spend his future income
today; also called a borrowing constraint.
10.9 REFERENCES
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics. Pergamon Press Oxford.
 N. Gregory Mankiw (2010). Macroeconomics. 7th Edition. Worth Publications.
 Rana and Verma. Macroeconomics. Vishal Publishing Co. (2011)
 Dwivedi, D.N. (2011). Macroeconomics. Tata Mcgraw Hill Publication.
 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference
10.10 FURTHER READINGS
 Shapiro, E. (1978). Macroeconomic analysis. (2009 Fourth edition). Galgotia
Publications Pvt. Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
10.10 MODEL QUESTIONS
1. Explain the meaning of investment and how it is different from capital?
2. Explain the main determinants of investment in economics.
3. Explain the main differences between MEC and MEI.
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Lesson- 11

THEORIES OF INVESTMENT
Structure
11.0 Objectives
11.1 Introduction
11.2 The Accelerator Theory of Investment
11.3 The Flexible Accelerator Theory or Lags in Investment
11.3.1 Koyck’s Approach
11.4 The Profits Theory of Investment
11.5 Duesenberry’s Accelerator Theory of Investment
11.6 The Financial Theory of Investment
11.7 Jorgensons’ Neoclassical Theory of Investment
11.8 Tobin’s Q Theory of Investment
11.9 Summary
11.10 Glossary
11.11 References
11.12 Further Readings
11.13 Model Questions

11.0 OBJECTIVES

After going through the chapter you shall be able to –

Describe the Accelerator Theory of Investment
 Converse with the Flexible Accelerator Theory or Lags in Investment
 Explain the Duesenberry’s Accelerator Theory of Investment
 Deliberate about the Financial Theory of Investment
 Describe the Jorgensons’ Neoclassical Theory of Investment
 Discuss the Tobin’s Q Theory of Investment
11.1 INTRODUCTION
As we have studied in the last lesson that Investment is one of the most volatile and
strategic variable in all macro-economic models. Here we shall study the theories of
investment in detail, their meaning and their calculation. As we know Investment is a vital
factor in economic growth and has attracted analytical attention because of its volatility. As
we all know aggregate demand is the sum of investment demand and consumption demand
that’s why sizeable variation in investment can produce magnified changes in the aggregate
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demand. Thus it is important to study the various investment functions in oder to predict the
various investment policy actions in the economy.
11.2 THE ACCELERATOR THEORY OF INVESTMENT:
The accelerator principle states that an increase in the rate of output of a firm will
require a proportionate increase in its capital stock. The capital stock refers to the desired or
optimum capital stock, K. Assuming that capital-output ratio is some fixed constant, v, the
optimum capital stock is a constant proportion of output so that in any period t,
Kt =vYt
Where Kt is the optimal capital stock in period t, v (the accelerator) is a positive
constant, and Y is output in period t. Any change in output will lead to a change in the
capital stock. Thus
Kt – Kt-1 = v (Yt – Yt-1)
and Int = v (Yt – Yt-1) [Int=Kt– Kt-1 = v∆Yt
Where ∆Yt = Yt – Yt-1, and Int is net investment. This equation represents the naive
accelerator.
In the above equation, the level of net investment is proportional to change in output.
If the level of output remains constant (∆Y = 0), net investment would be zero. For net
investment to be a positive constant, output must increase. This is illustrated in Figure 1
where in the upper portion, the total output curve Y increases at an increasing rate up to t +
4 periods, then at a decreasing rate up to period t + 6. After this, it starts diminishing. The
curve In in the lower part of the figure, shows that the rising output leads to increased net
investment up to t + 4 period because output is increasing at an increasing rate.
But when output increases at a decreasing rate between t + 4 and t + 6 periods, net
investment declines. When output starts declining in period t + 7, net investment becomes
negative. The above explanation is based on the assumption that there is symmetrical
reaction for increases and decreases of output.

Fig. 11.1
149

In the simple acceleration principle, the proportionality of the optimum capital stock to
output is based on the assumption of fixed technical coefficients of production. This is
illustrated in Figure 11.2 where Y and Y1 are the two isoquants. The firm produces T output
with K optimal capital stock. If it wants to produce Y1 output, it must increase its optimal
capital stock to K1. The ray OR shows constant returns to scale. It follows that if the firm
wants to double its output, it must increase its optimal capital stock by two-fold. Eckaus has
shown that under the assumption of constant returns to scale, if the factor-price ratios
remain constant, the simple accelerator would be constant. Suppose the firm’s production
involves the use of only two factors, capital and labour whose factor-price ratios are constant.

Fig. 11.2
In Figure 11.3, Y, Y1 and Y2 are the firms’ isoquants and C, C1 and C2 are the isocost
lines which are parallel to each other, thereby showing constant costs. If the firm decides to
increase its output from Y to Y1, it will have to increase the units of labour from L to L1 and of
capital from K to K1 and so on. The line OR joining the points of tangency e, e 1 and e2 is the
firms’ expansion path which shows investment to be proportional to the change in output
when capital is optimally adjusted between the iosquants and isocosts.

Fig. 11.3
11.3 THE FLEXIBLE ACCELERATOR THEORY OR LAGS IN INVESTMENT:
The flexible accelerator theory removes one of the major weaknesses of the simple
acceleration principle that the capital stock is optimally adjusted without any time lag. In the
flexible accelerator, there are lags in the adjustment process between the level of output and
the level of capital stock. This theory is also known as the capital stock adjustment model.
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The theory of flexible accelerator has been developed in various forms by Chenery, Goodwin,
Koyck and Junankar. But the most accepted approach is by Koyck. Junankar has discussed
the lags in the adjustment between output and capital stock. He explains them at the firm
level and extends them to the aggregate level. Suppose there is an increase in the demand for
output. To meet it, first the firm will use its inventories and then utilise its capital stock more
intensively. If the increase in the demand for output is large and persists for some time, the
firm would increase its demand for capital stock. This is the decision-making lag. There may
be the administrative lag of ordering the capital. As capital is not easily available and in
abundance in the financial capital market, there is the financial lag in raising finance to buy
capital. Finally, there is the delivery lag between the ordering of capital and its delivery.
Assuming “that different firms have different decision and delivery lags then in aggregate the
effect of an increase in demand on the capital stock is distributed over time. This implies that
the capital stock at time t is dependent on all the previous levels of output, i.e.
Kt = f ( Yt, Yt-1……., Yt-n).
This is illustrated in Figure 4 where initially in period t 0, there is a fixed relation
between the capital stock and the level of output. When the demand for output increases, the
capital stock increases gradually after the decision and delivery lags, as shown by the K
curve, depending on the previous levels of output. The increase in output is shown by the
curve T. The dotted line K is the optimal capital stock which equals the actual capital stock K
in period t.

Fig. 11.4
11.3.1 Koyck’s Approach
Koyck’s approach to the flexible accelerator assumes that the actual capital stock
depends on all past output levels with weights declining geometrically. Accordingly,
Kt = v (1 - ) (Yt + Yt-1 + 2Yt-2 +…….nYt-n) ……..(1)
where 0<<1. If there is no change in income and it is equal to Y the expected volume
of output also remains unchanged, then
K = v (1-) (Y + Y + 2Y +……nY)
= v (1-) Y (1++2 +…….+n) …..(2)
where (1++2+……+n) = 1/(1-) are the weights in geometric series and equation (2)
becomes
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K = v Y (1-) x 1/(1 - )
or K=vY
If equation (1) is valid, then Kt-1 is also true. Therefore, we can rewrite equation (1) as
Krt = v(1-) (Yi-1 + 2Yi-2 + 3Yi-3 + ……..+ n Yint)
Multiplying by  we have
Kt1 = v (1 - ) (Yt2 + 2Yt2 + 3Yt2 + 3Yt2 +…….+ n+1 Ytn1) ……..(3)
Subtracting equation (3) from equation (1), we get
Kt - Kt l = v (1 - ) (Yt + n+1 Ytnl).
Since the term n+1 tends to zero, the above equation becomes
Ki -  Ki-t = (1 - ) vYt
or Kt = (1 - )vYt + Ki-t …….(4)
This process of rewriting equation (1) as equation (4) is called the koyek transformation.
Net investment is the change in the stock of capital, Kt – Ktr Therefore, subtract Kit from both
sides of the equation to get the expression net investment.
Kt – Kt-1 = (1 - ) vYt +  Ki2 – Kt-2
Im = (1 - ) vYt + Kt2 (-1)
or Im = (1 - ) vYt – (1 - ) Kt-2 ……..(5)
The net investment (Kt – Kt-1) is called the distributed lag accelerator which is inversely
related to the capital stock of the previous period and is positively related to the output level.
To convert net investment to gross investment, add depreciation (D t) to both sides of
equation (5),
Im + Dt = Ig = (I - ) vYt –(1-)Kt-1 + Dt ……..(6)
Depreciation is assumed to be proportional to last year's capital stock and is estimated by
Dtm Kt-1. By adding this to equation (6), gross investment (1gt) is
Igt = (1 - ) vYt – (1-) Krt + Kit
= (1-)vYt –[(1-) + ]Kit
= (1-)vYt – (1-)Kit ……..(7)
This equation represents the flexible accelerator or the stock adjustment principle.
This suggests that “net investment is some fraction of the difference between planned capital
stock and actual capital stock in the previous period…The coefficient (1 – λ) tells us how
rapidly the adjustment takes place. If λ= 0 [i.e. (1 – λ) = 1] then adjustment takes place in the
unit period”. To conclude, the flexible accelerator is a very important contribution to the
theory of investment which solves the problem of lags in investment demand. It not only
incorporates the effects of lags but also of depreciation and excess capacity in the capital
stock adjustment.
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It’s Comparison with Naive Accelerator:

Since the flexible accelerator and naive accelerator are both accelerators, their long-
run response of investment to a change in output will be similar. Let us consider a situation
where output (Y) is rising at a decreasing rate and ultimately stops rising at a high level. In
the case of the flexible accelerator, net investment will increase during several periods before
the negative effect of the increased capital stock outweighs the positive effect of further
increases in output and ultimately net investment will become zero.
This is shown in Figure 11.5. On the other hand, in the case of the naive accelerator,
net investment will be decreasing continuously and will also become zero, as shown in Figure
6. In both the accelerators, gross investment will be equal to depreciation.

Fig. 11.5
11.4 The Profits Theory of Investment:
The profits theory regards profits, in particular undistributed profits, as a source of
internal funds for financing investment. Investment depends on profits and profits, in turn,
depend on income. In this theory, profits relate to the level of current profits and of the
recent past. If total income and total profits are high, the retained earnings of firms are also
high, and vice versa, Retained earnings are of great importance for small and large firms
when the capital market is imperfect because it is cheaper to use them. Thus if profits are
high, the retained earnings are also high. The cost of capital is low and the optimal capital
stock is large. That is why firms prefer to reinvest their extra profit for making investments
instead of keeping them in banks in order to buy securities or to give dividends to
shareholders. Contrariwise, when their profits fall, they cut their investment projects. This is
the liquidity version of the profits theory.

Fig. 11.6
153

Another version is that the optimal capital stock is a function of expected profits. If the
aggregate profits in the economy and business profits are rising, they may lead to the
expectation of their continued increase in the future. Thus expected profits are some function
of actual profits in the past,

Kt = f( t-1)

Where K is the optimal capital stock and f ( t-1) is some function of past actual profits.
Edward Shapiro has developed the profits theory of investment in which total profits
vary directly with the income level. For each level of profits, there is an optimal capital stock.
The optimal capital stock varies directly with the level of profits. The interest rate and the
level of profits, in turn, determine the optimal capital stock. For any particular level of profits,
the higher the interest rate, the smaller will be the optimal capital stock, and vice versa. This
version of the profits theory is explained in terms of Figure 11.7.

Fig. 11.7
The curve Z in Panel (A) shows that total profits vary directly with income. When the
income is Y1, profits are P1 and with increase in income to Y2 profits rise to P2. Panel (B)
shows that the interest rate and the profits level determine the capital stock. At P 2 profits
levels and r6% interest rate, the actual capital stock is K2 and at the lower profits level P and
interest rate r6%, the actual capital stock declines to K1. In Panel (C), the MEC curve is
drawn for each level of profits, given the actual capital stock and the rate of interest. As such,
the curve MEC1 relates the profits level P1 to the optimal capital stock K1 when r6% is the
interest rate. The higher curve MEC2 relates the profit level P2 to the higher optimal capital
stock K2, given the same rate of interest r 6%.
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Suppose that the level of profits is P1, the market interest rate is r6% and the actual
capital stock is K1. With this combination of the variables, the optimal capital stock in Panel
(C) is K so that the actual capital stock, K1 = K1 the optimal capital stock. As a result, net
investment is zero. But there is still I1 replacement investment at r6%, as indicated by
MEI1 curve in Panel (D). The combination of I2 investment and Y1 income level establishes
point A on the investment curve I in Panel (E) of the figure. Now begin with P 2 level of profits
and Y2 income level in Panel (A) so that at r6% interest rate in Panel (C), the optimal capital
stock is K2. Assuming again that the actual capital stock is K1, the optimal capital stock is
greater than the actual, K2 > K1 at this profit-income combination.
Here the MEC2 is higher than r6% interest rate by RM. As a result, the MEI 1 curve
shifts upward to MEI2 in Panel (D). Since K2 >K1 net investment is positive. This is shown by
I1 – I2in Panel (D). So when profits increase to P2 with the rise in income to Y2, the optimal
capital stock K2 being greater than the actual capital stock K1 at r6% interest rate,
investment increases from I3 to I4 in Panel (E) which is equal to net investment I1I2 in Panel
(D). The combination of I4 and Y2, establishes point B on the upward sloping I curve. To sum
up, in the profits theory of investment, the level of aggregate profits varies with the level of
national income, and the optimal capital stock varies with the level of aggregate profits. If at a
particular level of profits, the optimal capital stock exceeds the actual capital stock, there is
increase in investment to meet the demand for capital. But the relationships between
investment and profits and between aggregate profits and income are not proportional.
The theory is based on the assumption that profits are related to the level of current
profits and of the recent past. But there is no possibility that the firm’s current profit of this
year or of the next few years can measure the profits of the next year or of the next few years.
A rise in current profits may be the result of unexpected changes of a temporary nature.
Such temporary profits do not induce investment.
11.5 Duesenberry’s Accelerator Theory of Investment:
J.S. Duesenberry in his book Business Cycles and Economic Growth presents an
extension of the simple accelerator and integrates the profits theory and the acceleration
theory of investment.
Duesenberry has based his theory on the following propositions:
(1) Gross investment starts exceeding depreciation when capital stock grows.
(2) Investment exceeds savings when income grows.
(3) The growth rate of income and the growth rate of capital stock are determined entirely
by the ratio of capital stock to income. He regards investment as a function of income
(Y), capital stock (K), profits () and capital consumption allowances (R). All these are
independent variables and can be represented as
I = f(Y t-1, Kt-1, t-1, Rt)
Where t refers to the current period and (t-1) to the previous period. According to
Duesenberry, profits depend positively on national income and negatively on capital stock.
=aY- bK
Taking account of lags, this becomes
1=aYt-1– b Kt-1
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Where t refers to profits during period t, Yt-1 and Kt-1 are income and capital stock of
the previous period respectively and a and b are constants. Capital consumption allowances
are expressed as
R, = kKt-1
The above equation shows that capital consumption allowances are a fraction (k) of
capital stock (K t-1). Duesenberry’s investment function is a modified version of the accelerator
principle,
I t = αYt-1 + βK t-1…. (1)
where investment in period t is a function of income (X) and capital stock (K) of the
previous period (t—1). The parameter (a) represents the effect of changes in income on
investment, while the parameter ((3) represents the influence of capital stock on investment
working through both the marginal efficiency of investment and profits. Since the
determinants of investment also affect consumption, the consumption function can be
written as,
Ct = f (Yt-1 – t-1 – R t-1+ dt)
Where dt stands for dividend payments in period t. Since  = f (Y, K), R = kY and d=f (∏),
these independent variables can be subsumed under Y and K. Thus
Ct = a Y t-1 + bKt-1 …. (2)
The parameter, a, in equation (2) is MPC and it also reflects increase in profits. This
increase is reduced by the effect of profits on dividends and the effect of changes in dividends
on consumption. The influence of changes in capital stock on consumption is reflected by the
parameter b. This influence results from the influence of capital stock on profits through the
influence of profits on dividends on consumption. The capital stock is represented by the
following equation which is an identity,
Kt = (1-k) Kt-1 + 1t
It is derived as under :
Kt = Kt-1 + (1t – Rt)
Rt = kKt-1
Kt = Kt-1 + It =kKt-1
Kt = (1 - k) Kt-1 + 1t [ 1t = Yt-1 + Kt1]
The capital stock equation can be written as
Kt = (1 – k) Kt-1 + Yt-1 + Kt-1
= [(1 – k) K1-t + Kt-1] + Yt-1
= K1-t [(1 – k) + + Yt-1
or ki-t = Kt-2 [(1 – k) + ] + Yi-2, …….(3)
The national income identity can be written as
Yt = It + Ct [From equations (1) and (2)]
= Yt-1 + Kt-1 + aYt-1 + bKt-1
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= [aYt-1 + aYt-1] + [Kt-1 + bKt-1]

= ( + a) Yt-1+ ( + b) Kt-1 …….(4)
By substituting the value of K1-t in equation (4), we get
Yt = ( + a) Yt-1 + ( + b) {Kt-2 [(I – k)  + Yt-2 )
= ( + a) Yt-1 + ( + b) {aYt-2 + [(I – k) + ] Kt-2 } …….(5)
Again, the national income equation (4) can be written as
Yt-1 = (a + a) Yt-2 + ( + b) Kt-2
or ( + b) Kt-2 = Yi-t (a + a)Yt2
Having obtained the value of Kt-2 substitute it in equation (5),
Yt = (a + a) Yi-t + a( + b) Yt-2 + [(1 – k) + ] (Yi-1 – {a + a) Yi-2}
By taking common factors, we have
Yt = [(a + a) Yt-1 + (1 – k + ) Yt-1] + [a( + b) Yt-2 – (a + a) (1 – k + ) Yt-2
= [(a + a) + (l – k + ) Yt-1] + [a( + b) - (a + a) (1 – k + ) Yt-2 …….(6)
This is a generalized version of a multiplier-accelerator process.
Next Dusenberry compares his formulation with a simple multiplier-accelerator process. In a
simple model of the multiplier-accelerator, investment equation takes the following form.
It = a Yi-t = Kt-1
where in his model, the investment equation is in this form
It = a Yr-1 + Kt-1
where the value of parameter  = - 1 and investment is regarded as net investment so that
k = 0. Depreciation is not considered. The influence of changes in capital stock on
consumption is also neglected so that b = 0.
Substituting all these values in equation (6), we obtain the simple form of the equation
for the multiplier-accelerator process. Thus
a( - b) = a(-1)
Yt = [(a + a) + (1 – 0 – 1)] Yt-1 + [a(-1 + 0) – (a + a) (1 – 0 – 1)Yt-2
Or Yt = (a + a) Yt-1 + a(-1) Yt-2 …….(7)
The a (MPC) in equation (7) will be much smaller than MPC out of disposable income
because it reflects the influence of changes in income on profits and business savings.
Simultaneously, the a in the above equation will be much less than the average capital-
output ratio which is the accelerator in simple multiplier- accelerator models. An increase,
say, $100 in income, with capital stock constant, will increase the rate of business
investment by an amount which is not much larger than the increase in business savings
resulting from $100 increase in income. It will be only, say, $25. Thus an increase in income
will have a smaller immediate effect on expenditure than would occur in a simple multiplier-
accelerator model. On the other hand, the negative effect of an increase in capital stock, with
income constant, will be much smaller than in the simple multiplier-accelerator model. If
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there is an increase in business capital stock of say, $100, income being constant, it will
reduce profits by a very small amount and will have correspondingly a small effect on
business investment.
But a part of the decline in business investment will be offset by a reduction in
business saving. Such changes will reduce the effect on an increase in income on
expenditure for some time because investment will decline slowly, as capital accumulates,
provided there is no further increase in income. The system will therefore, be much more
stable than a simple multiplier-accelerator system.
11.6 THE FINANCIAL THEORY OF INVESTMENT:
The financial theory of investment has been developed by James Duesenberry. It is
also known as the cost of capital theory of investment. The accelerator theories ignore the
role of cost of capital in investment decision by the firm. They assume that the market rate of
interest represents the cost of capital to the firm which does not change with the amount of
investment it makes. It means that unlimited funds are available to the firm at the market
rate of interest. In other words, the supply of funds to the firm is very elastic. In reality, an
unlimited supply of funds is not available to the firm in any time period at the market rate of
interest. As more and more funds are required by it for investment spending, the cost of
funds (rate of interest) rises. To finance investment spending, the firm may borrow in the
market at whatever interest rate funds are available.
Sources of Funds:
Actually, there are three sources of funds available to the firm for investment which
are grouped under internal funds and external funds.
These are:
(1 Retained earnings which include undistributed profits after taxes and
depreciation allowances are internal funds.
(2) Borrowing from banks or through the bond market; and borrowing through
equity financing or by issuing new stock (shares) in the stock market are the
sources of external funds.
1. Retained Earnings:
Retained earnings are the cheapest source of funds because the cost of using these
funds is very low in the short run. There is no risk involved in spending these retained
earnings or to repay debt. In fact, the cost of using these funds is the opportunity cost which
is the return that the firm could obtain to repay debt or to buy the shares of other
companies. The opportunity cost of internal funds will be less than the cost of external funds.
When the firm lends these funds to other borrowers, it usually earns the market rate of
interest. If it borrows funds from banks or through the bond market, it has to pay a higher
interest rate. This difference in interest rate is the opportunity cost to the firm.
2. Borrowed Funds:
When the firm needs funds more than the retained earnings, it borrows from the
banks or through the bond market. The cost of borrowed funds (rate of interest) rises with
the amount of borrowing. As the ratio of debt service to earnings from investment of funds
rises, the marginal cost of borrowed funds rises. This is because the opportunity cost (risk) of
not repaying debt increases.
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3. Equity Issue:
A third source is equity financing by issuing new shares in the stock market. The
imputed cost of equity funds is more costly than the opportunity cost of retained earnings or
borrowed funds. Duesenberry points out that “the yield cost of equity finance is usually of
the order of 7 to 10 percent for large firms. To this must be added floatation costs plus any
reduction in the value of existing shares resulting from the issue. The differential is further
increased by the differential tax treatment of bond and equity finance.”
Cost of Funds:
The cost of capital to the firm will vary according to its source and how much funds it
requires. Keeping these considerations in view, we construct the marginal cost of funds curve
MCF in Figure 11.8 which shows the various sources of funds. The cost of funds is measured
on the vertical axis and the amount of investment funds on the horizontal axis.

Fig. 11.8
Region A of the MCF curve shows financing done by the firm from retained profits (RP)
and depreciation (D). In this region, the MCF curve is perfectly elastic which means the true
cost of funds to the firm is equal to the market rate of interest. The opportunity cost of funds
is the interest forgone which the firm could earn by investing its funds elsewhere. No risk
factor is involved in this region. Region B represents funds borrowed by the firm from banks
or through the bond market. The upward slope of the MCF curve shows that the market rate
of interest for borrowed funds rises as their amount increases. But the sharp rise in the cost
of borrowing is not only due to a rise in the market rate of interest but also due to the
imputed risk of increased debt servicing by the firm. Region C represents equity financing.
No imputed risk is involved in it because the firm is not required to pay dividends. The
gradual upward slope of MCF curve is due to the fact that as the firm issues more and more
of its stock, its market price will fall and the yield will rise. The cost of funds may vary from
firm to firm and consequently the shape and position of the MCF curve will differ from one
firm to another. But in general, it will be like the MCF curve of Figure 8. If we aggregate MCF
curves of different firms there will be a smooth S-shaped MCF1 curve, as in Figure 11.9. This
curve shifts upward from MCF1 to MCF2 when the cost of funds (interest rate) rises from
R1 to R2 and shifts downward from MCF2 to MCF1 with the fall in the cost of funds from R2 to
R1.
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Fig. 11.9

The amount of investment funds is determined by the intersection of ME1 and MCF
curves. The main determinants of the MEI curve are the rate of investment, output (income),
level of capital stock and its age and rate of technical change. The determinants of MCF are
retained earnings (profits minus dividends), depreciation, debt position of firms and market
interest rate. It is the shifts of the MEI and MFC curves that determine the level of
investment funds. Suppose the MEI and MCF curves interest at point E in Figure 11.10
which determines OI investment at the interest rate (the cost of funds) OR. If the MCF curve
shifts to the right to MCF1 with the increase in retained earnings (profits) of the firm, the MEI
curve will cut the MCF1 curve at E1.

Fig. 11.10

The cost of funds will fall from OR to OR1 but investment funds will rise to OI1 from
OI. On the other hand, if the MEI curve shifts to the right to MEI1 with the increase in income
and capital stock, it will cut the MCF1 curve at point E2. There will be increase in both the
cost of funds to OR2 and in the investment funds to OI2.
The above explanation is related to the short-run behaviour of MEI and MCF curves.
But the same factors that determine the position and shifts of these curves have different
effects over the business cycle.
Since the MEI curve depends primarily on output, it shifts backward to the left to
MEI1 when output (income) decreases in a recession, as shown in Figure 11.11. Both MEI
and MEI1 curves intersect the MCF curve in its perfectly elastic region. In a recession,
retained profits decline but depreciation allowances remain with firms.
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Fig. 11.11
So the elastic portion of the MCF curve becomes shorter. Meyer and Kuh found that
firms generally spend more of their retained earnings in recessions and a low interest rate
does not have any effect on investment. But when recovery starts, the MEI1 curve shifts
outward to the right to MEI.
As a result, there is an increase in investment spending of the firm out of its retained
earnings in the perfectly elastic portion of the MCF curve. Thus during a recession, monetary
policy or the market rate of interest plays no role in determining the cost of capital of a firm.
On the other hand, during a boom when output increases, the MEI curve shifts
outward to the right to MEI1 and intersects the MCF curve in its elastic rising region, as
shown in Figure 12. In the upswing leading to boom, firms borrow funds on interest for
investment spending. Thus monetary policy or interest rate is an important determinant of
investment only in boom years.

Fig. 11.12
Its Criticisms:
The financial theory of investment has been criticised on the following grounds:
1. The results of studies by Meyer and Kuh on investment behaviour of firms show that
when demand is expanding rapidly, capacity expansion is the most important
determinant of business investment during boom periods. In terms of our Figure 8, the
MEI curve intersects the MCF curve in region B. In recessions and early years of
recovery, the MEI curve shifts back to region A, and the level of retained earnings
provides the best explanation of investment spending.
2. Meyer and Kuh found that firms take a longer view while making investment spending,
whereas Duesenberry explains a short-run model of investment. Their results indicate
that firms primarily invest in capacity expansion during a boom period and their
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overall level of investment will not fall as much as indicated by Duesenberry’s short-
run model when the interest rate rises. On the other hand, firms generally spend most
of their retained earnings on technological improvements to reduce costs and on
advertisement to increase their market share.
3. Empirical evidence in the theory of investment by Kuh and Meyer shows that
monetary policy is the least effective of all the macroeconomic policy instruments. In
the analysis represented in Figure 10, we have seen that the market rate of interest
plays only a small role in the financial theory of investment. Critics point out that the
main effect of rising interest rates would be to increase the steepness (or reduce the
elasticity) of region B of the MCF curve. This would stop investment when retained
earnings of firms had been exhausted. On the other hand, declining interest rates
would flatten (increase the elasticity) region B of the MCF curve. This would have no
effect in a recession if firms finance their investment spending from retained earnings.
Thus monetary policy would be more effective in controlling a boom than in
stimulating investment in recession.
4. This theory neglects the role of fiscal policy in investment which is more effective than
monetary policy. A reduction in corporate taxes in a recession can increase investment
by firms. On the other hand, an increase in corporate taxes can reduce investment
and shift the MCF curve to the left. Changes in depreciation allowances can also help
in manipulating investment in recessions and booms. Investment spending is also
influenced by the level and changes in aggregate demand. Besides taxes, expenditure
policy and other government measures also affect aggregate demand and the MEI
curve which in turn influence the level of investment.
11.7 JORGENSONS’ NEOCLASSICAL THEORY OF INVESTMENT:
Jorgenson has developed a neoclassical theory of investment. His theory of investment
behaviour is based on the determination of the optimal capital stock. His investment
equation has been derived from the profit maximisation theory of the firm.
It’s Assumptions:
Jorgenson’s theory is based on the following assumptions:
1. The firm operates under perfect competition.
2. There is no uncertainty.
3. There are no adjustment costs.
4. There is full employment in the economy where prices of labour and capital are
perfectly flexible.
5. There is a perfect financial market which means the firm can borrow or lend at
a given rate of interest.
6. The production function relates output to the input of labour and capital.
7. Labour and capital are homogeneous inputs producing a homogeneous output.
8. Inputs are employed upto a point at which their MPPs are equal to their real
unit costs.
9. There are diminishing returns to scale.
10. There is the existence of “putty-putty” capital which means that even after
investment is made, it is instantly adapted without any costs to a different
technology.
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11. The capital stock is fully utilised.

12. Changes in current prices always produce ceteris paribus proportional changes
in future prices.
13. The price of capital goods equals the discounted value of the rental charges.
14. The firm maximises the present value of its current and future profits with
perfect foresight in relation to all future values.
Jorgenson develops his theory of investment on the assumption that the firm
maximises its present value. In order to explain the present value of the firm, he takes a
production process with a single output (Q), a single variable input labour (L), and a single
capital input (I-investment in durable goods), and p, w, and q representing their
corresponding prices. The flow of net receipts (R) at time t is given by
R (t) =p (t) Q (t) – w (t) L (t) – q(t) I(t) ….(1)
Where Q is output and p is its price; L is the flow of labour services and w the wage
rate; I is investment and q is the price of capital goods. The present value is defined as the
integral of discounted net receipts which is represented as
W= ∫o∞ e-r t R (t)dt … (2)
Where W is the present value (net worth); e is the exponential used for continuous
discounting; and r is the constant rate of interest.
The present value is maximised subject to two constraints. First, the rate of change of
the flow of capital services is proportional to the flow of net investment. The constant of
proportionality may be interpreted as the time rate of utilisation of capital stock that is the
number of units of capital service per unit of capital stock. Net investment is equal to total
investment less replacement investment where replacement investment is proportional to
capital stock.
This constraint takes the form:
K (t) = I (t)-δ K(t) ….(3)
Where K (t) is the time rate of change of the flow of capital services at time (t) while δ is
the rate of depreciation attached to capital stock. This constraint holds at each point of time
so that K, K and I are functions of time. To simplify the analysis, Duesenberry uses K in
place of K (t), I in place of I(t), and so on.
Second, the levels of output and the levels of labour and capital services are
constrained by a production function:
F (Q, L, K) = 0 …..(4)
The marginal productivity of labour is equal to the real wage:
∂Q/∂L = w/p…….. (5)
Similarly, the marginal productivity of capital is equal to its real user cost:
∂K/∂L = w/p…….. (6)
Where c = q(r + δ)-q … (7)
In the above equation, q is the average price of capital assets, r is the rate of discount,
δ is the rate of depreciation of capital goods and q is the rate of appreciation of capital assets
or time derivative of q. Therefore, the crucial determinant of the optimal capital stock is c, the
user cost of capital. Since most firms own rather than rent their capital assets, therefore c is
basically an implicit or shadow price constructed in order to permit parallel analytical
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treatment of capital and labour inputs. Equations (5) and (6) are called “myopic decision
criteria” because the firm is engaged in a dynamic optimisation process and simply equates
the MP of labour with the ratio of its price and MP of capital with the ratio of user cost of
capital. There are two reasons for the myopic decision in the case of capital assets. First, it is
due to the assumption of no adjustment costs so that the firm does not gain by delaying the
acquisition of capital. Second, it is the result of the assumption that capital is homogeneous
and it can be bought and sold or rented in a perfectly competitive market. The myopic
decision is illustrated in Figure 11.13 where in the upper portion the two alternative time
paths of output prices, P1 and P2, are shown and in the lower portion are shown the optimal
capital stocks, in Panel (A), the output prices are identical up to time t 0, and then their time
paths diverge when P1 is always lower than P2. With the myopic decision, the optimal capital
stock is identical up to t0 for both time path of output prices. But after that, for the time path
of P1 price, the optimal capital stock K1 moves at a constant rate, while for P2 time path of
output price, the optimal capital stock K2increases as the former rises. Thus in the
Jorgenson model, there are no inter-temporal trade-offs.
Assuming that there are no adjustment costs, no uncertainty and perfect competition
exists, as Jorgenson does, the firm will always be adjusted to the optimal capital stock so
that K=K. Therefore, the question of adjustment to a discrete change in the interest rate does
not rise. Instead, Jorgenson treats this problem as one of comparing two optimal paths of
capital accumulation under two different interest rates.

Fig. 11.13
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For this, he takes the demand for investment goods as given by the following equation:
I = K + δ…… (8)
Where I stands for gross demand for investment goods, K the rate of change in capital
stock, 8 the rate of depreciation and K the fixed level of capital assets which is expressed as
K =f (w, c, p)……….. (9)
The condition of equation (9) implies that with w and p fixed, c must remain
unchanged. From the expression for c in equation (7), this, in turn, implies that holding the
price of investment goods constant, the rate of change of price of investment goods must vary
as the interest rate varies so as to leave c unchanged. Formally, this condition can be
represented by
∂c/∂r = 0
Where r is the interest rate.
This condition implies that the own-interest rate on investment goods (r-q/q) must be
left unchanged by variations in the interest rate. Jorgenson assumes that all changes in the
interest rate are exactly compensated by changes in the price of investment goods so as to
leave the own-interest rate on investment goods unchanged. This condition implies that
∂2q/∂t ∂r = q
He further assumes that changes in the time path of interest rate leave the time path
of forward or discounted prices of capital goods unchanged. This condition implies that
∂2q/∂t ∂r = c
Combining these two conditions, we obtain
∂I/∂r = ∂k/∂c x c < 0

Fig. 11.14
It implies that the demand for investment goods in two alternative situations is a
decreasing function of the interest rate. This is illustrated in Figure 14 where in Panel (A),
c1 is the path of user cost of capital before a rise in the interest rate at t 0 time, and c2 is the
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path after the change in interest rate. But c is constant at time t 0. Assuming other price p
and w as given, K1 is the path of optimal capital when the interest rate is unchanged, and
K2 is the path after the rise in interest rate. Thus at time t0, a rise in the interest rate lowers
the demand for investment goods. This is obtained by comparing two alternative and
continuous paths of optimal capital accumulation.
Jorgenson concludes that the demand for investment goods depends on the interest
rate by comparing two alternative and continuous paths of capital accumulation depending
on a time path of the interest rate.
It’s Criticisms:
Jorgenson’s neoclassical theory of investment has been criticised on the following
grounds:
1. Jorgenson derives his investment function from such assumptions which do not
clarify how the actual capital stock adjusts to the optimal capital stock.
2. Jorgenson’s theory is based on the assumption of full employment in the economy
where prices of labour and capital are perfectly flexible so that producers and
consumers can anticipate changes in demand, supplies and prices of goods, But this
is not a reality because there are long time lags for orders to be executed for capital
goods which often lead to the fall in investment demand and the consequent idle
capacity and labour unemployment in both consumer and capital goods industries.
3. Jorgenson’s analysis is based on expected quantities and prices that are perfectly
foreseen. But foresight is never perfect. Moreover, Jorgenson does not provide any
mechanism for the formation of these expectations, except assuming that changes in
current prices produce proportional changes in future prices. Further, he does not tell
us anything about the expected future quantities to be sold.
4. The classical production function assumed by Jorgenson connects current investment
with future outputs, and perfect foresight provides the exact current investment which
produces the expected quantities of goods. Again, foresight is never perfect and
current investment of capital may not be fully utilised in the future. Rather, there may
be capital shortage in the future.
5. Jorgenson’s definition of user cost is vague. It does not imply that future values of c
(uses costs) will be identical. Consequently, a rise in the interest rate raises future
user costs thereby lowering the future optimal path of capital accumulation than it
otherwise would have been.
6. Jorgenson does not give a very clear economic account of his mathematical results.
7. Jorgenson labels his model as the neoclassical theory of investment but it seems to
bear little relationship with the classical theory of investment.
11.8 TOBIN’S Q THEORY OF INVESTMENT:
Nobel laureate economist James Tobin has proposed the q theory of investment which
links a firm’s investment decisions to fluctuations in the stock market. When a firm finances
its capital for investment by issuing shares in the stock market, its share prices reflect the
investment decisions of the firm.
Firm’s investment decisions depend on the following ratio, called Tobin’s q:
q = Market Value of Capital Stock/Replacement Cost of Capital
The market value of firm’s capital stock in the numerator is the value of its capital as
determined by the stock market. The replacement cost of firm’s capital in the denominator is
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the actual cost of existing capital stock if it is purchased at today’s price. Thus Tobin’s q
theory explains net investment by relating the market value of firm’s financial assets (the
market value of its shares) to the replacement cost of its real capital (shares). According to
Tobin, net investment would depend on whether q is greater than (q>1) or less than 1 (q<1). If
q>1, the market value of the firm’s shares in the stock market is more than the replacement
cost of its real capital, machinery etc. The firm can buy more capital and issue additional
shares in the stock market. In this way, by selling new shares, the firm can earn profit and
finance new investment. Conversely, if q<1, the market value of its shares is less than its
replacement cost and the firm will not replace capital (machinery) as it wears out. Let us
explain it with the help of an example. Suppose a firm raises finance for investment by
issuing 10 lakh shares in the stock market at Rs 10 per share. Currently, their market value
is Rs 20 per share. If the replacement cost of the firm’s real capital is Rs 2 crores then the q
ratio is 1.00 (= Rs 2 crores market value / Rs 2 crores replacement cost). Suppose the market
value rises to Rs 40 per share. Now the q ratio is 2 (=Rs 40/ Rs20). Now the market value of
its shares gives Rs 2 crores (=Rs 4 crores-Rs 2 crores) as profit to the firm. The firm raises its
capital stock by issuing 5 lakh additional shares at Rs 40 per share. Rs 2 crores collected
through the sale of 5 lakh shares are utilised for financing new investment by the firm.
Panels (A) and (B) of Fig. 11.15 illustrate how an increase in Tobin’s q induces a rise in
the firm’s new investment. It shows that an increase in the demand for shares raises their
market value which raises the value of q and investment. The demand for capital is shown by
the demand curve D in Panel (A). The relative value of q is taken as unity, as the market
value and replacement cost of capital stock are assumed equal. The initial equilibrium is
determined by the interaction of demand for capital and the available supply of capital stock
OK at point E, which is fixed in the short run. The demand for capital depends mainly on two
factors. First, the level of wealth of the people. The higher is the level of wealth, the more
shares people wish to have in their wealth portfolio. Second, the real return on other assets
such as government bonds or real estate. A fall in the real interest rate on government bonds
would induce people to invest in shares than in other forms of wealth. This would increase
the demand for capital and raise the market value of capital above its replacement cost. This
means rise in the value of Tobin’s q above unity. This is shown as the rightward shift of the
demand curve to D1. The new equilibrium is established at E1 in the long run when the
replacement cost rises and equals the market value of capital. The rise in the value of q to
q1induces an increase in new investment to OI, as shown in Panel (B) of the figure.

Fig. 11.15
Tobin’s q theory of investment has important implications. Tobin’s q ratio provides an
incentive to invest for firms on the basis of the stock market. It not only reflects the current
profitability of capital but also its expected future profitability. Investment is expected to be
higher in the future when the value of q is larger than 1. Tobin’s q theory of investment
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induces firms to undertake net investment even when q is less than 1 in the present. They
may adopt such economic policies which bring future profitability by raising the market
value of their shares.
11.9 SUMMARY
In short, these studies suggest that the internal funds theory does not perform as well
as the accelerator and neoclassical theories at all levels of aggregation. The evidence,
however, is conflicting with regard to the relative performance of the accelerator and
neoclassical models, with the evidence favoring the accelerator theory at the aggregate level
and the neoclassical model at other levels of aggregation.
11.10 GLOSSARY
 Inventory investment: The change in the quantity of goods that firms hold in
storage, including materials and supplies, work in process, and finished goods.
 Investment: Goods purchased by individuals and firms to add to their stock of
capital.
 Investment tax credit: A provision of the corporate income tax that reduces a firm’s
tax when it buys new capital goods.
 Life-cycle hypothesis: The theory of consumption that emphasizes the role of saving
and borrowing as transferring resources from those times in life when income is high
to those times in life when income is low, such as from working years to retirement.
11.11 REFERENCES
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics, Pergamon Press Oxford.
 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference.
 Shapiro, E. (1978). Macroeconomic analysis (2009 Fourth edition). Galgotia
Publications Pvt. Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins. 1989.
 Mankiw N. Gregory (2010). Macroeconomics. 7th Edition. Worth Publications.
11.12 FURTHER READINGS
 Rana K.C and Verma K.N. (2009). Macroeconomics. Vishal Publishing House.
 Dwivedi, D.N. (2005). Macroeconomics. Tata Mcgraw Hill Publication.
11.13 MODEL QUESTIONS
1. Explain the difference between accelerator and flexible accelerator theory of
investment.
2. Explain the tobin q theory of investment in detail.
3. Expalin the jorgenson theory of investment.
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Lesson - 12

INVESTMENT UNDER UNCERTAINTY

Structure
12.0 Objectives
12.1 Introduction
12.2 Investment and the Cost of Capital
12.2.1 The demand for capital
12.2.2 The User Cost of Capital
12.3 Model with Adjustment Costs
12.3.1 Marginal and Average 'q'
12.3.2 The Dynamics of the Model
12.3.3 The Steady State
12.4 Using the model to explore the effect of shocks
12.4.1 An unexpected permanent increase in demand
12.4.2 An anticipated permanent increase in demand
12.4.3 Anticipated Temporary Increase in demand
12.4.4 Effect of Interest rate movements
12.4.5 Effect of taxes
12.5 Investment in a model with Uncertainty
12.5.1 The model in discrete time with quadratic adjustment costs
12.5.2 Discrete time and non-convex adjustment costs
12.5.3 Non-convex adjustment costs
12.6 Investment in Housing Market
12.6.1 The Effect of Interest Rate Changes and Tax Benefits:
12.7 Summary
12.8 Glossary
12.9 References
12.10 Further Readings
12.11 Model Questions
12.0 OBJECTIVES
After going through the chapter you shall be able to –
 explain Investment and the Cost of Capital in detail
 elaborate on the concept of cost of capital
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 describe using the model to explore the effect of shocks

 discuss the effect of Interest rate movements and taxes
 explain adjustment cost of Investment model with Uncertainty
 describe Investment in Housing Market
12.1 INTRODUCTION
As we have gone through in the previous lesson Economics defines investment as the
act of incurring an immediate cost in the expectation of future rewards. Firms that construct
plants and install equipment, merchants who lay in a stock of goods for sale, and persons
who spend time on vocational education are all investors in this sense. Most investment
decisions share three important characteristics in its varying degrees. In this lesson we shall
concentrate on investment decisions under uncertainity. We shall concentrate on adjustment
cost f capital its dynamic nature also, Tobin’s q (average and marginal both)and investment
in housing market.
First, the investment is partially or completely irreversible. In other words, the initial cost of
investment is at least partially sunk that is the cost can never be recovered as it is incurred
in other words you cannot recover it all should you change your mind.
Second, there is uncertainty over the future rewards from the investment. The best can be
done is to assess the probabilities of the alternative outcomes that can mean greater or
smaller profit (or loss) for your venture.
Third, you have little freedom about the timing of your investment. You can postpone action
to get more information (but never, of course, complete certainty) about the future.
These three characteristics interact to determine the optimal decisions of investors. The
orthodox or ancient theory of investment has not recognized the important qualitative and
quantitative implications of the interaction between irreversibility, uncertainty, and the
choice of timing. For example, compared to the predictions of earlier models, real world
investment seems much less sensitive to interest rate changes and tax policy changes and
much more sensitive to volatility and uncertainty over the economic environment. We discuss
how the new view resolves these problems, and in the process offers some guidance for
designing more effective public policies concerning investment.
The option insight also helps explain why the actual investment behavior of firms
differs from the received wisdom taught in business schools. Firms invest in projects that are
expected to yield a return in excess of a required, or "hurdle," rate. Observers of business
practice find that such hurdle rates are typically three or four times the cost of capital. In
other words, firms do not invest until price rises substantially above long-run average cost.
Investment is important for macroeconomics as:
 Investment determines the stock of capital. It increases the productive capacity
of the economy, and therefore future standard of living
 Volatility of investment is high at business cycle frequencies. Therefore,
investment matters a lot for business cycle fluctuations.
12.2 Investment and the Cost of Capital
12.2.1 The demand for capital
The demand for capital is calculated by optimizing profits as denoted rK the rate of
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capital. Suppose we can write the firm’s profits, after we optimize over other inputs (such as
labor, intermediates, material set c...) as Π(K,X) where X denotes various other shifters of
profits (such as cost of other input set c...) The firm maximizes profits, taking X as given, i.e.:
Max Π (K,X)
Where,
rK =the rate of capital
Π(K,X)= where X denotes various other shifters of profits (such as cost of other inputs
etc...).
The first order condition for the demand of capital is:
ΠK(K, X) = rK
If the profit function exhibits diminishing returns to capital, and the usual Inada
conditions, then the schedule ΠK (.) is decreasing in K and there is a unique K that
solves the above equation.
12.2.2 The User Cost of Capital
Jorgenson (1963) compares the per-period value of an incremental unit of capital (its
marginal product) and an "equivalent per-period rental cost" or "user cost" that can be
computed from the purchase price, the interest and depreciation rates, and applicable taxes.
The firm's desired stock of capital is found by equating the marginal product and the user
cost. The actual stock is assumed to adjust to the ideal, either as an ad hoc lag process, or as
the optimal response to an explicit cost of adjustment. The other formulation, of James Tobin
(1969), compared the capitalized value of the marginal investment to its purchase cost. The
value can be observed directly if the ownership of the investment can be traded in a
secondary market; otherwise it is an imputed value computed as the expected present value
of the stream of profits it would yield. The ratio of this to the purchase price (replacement
cost) of the unit, called Tobin's q, governs the investment decision. Investment should be
undertaken or expanded if q exceeds 1; it should not be undertaken, and existing capital
should be reduced, if q < 1.The optimal rate of expansion or contraction is found by equating
the marginal cost of adjustment to its benefit, which depends on the difference between q
and Tax rules can alter this somewhat, but the basic principle is similar. As defined in the
Jorgenson theory of Investment whole of the capital is not rented. Thus, how should
within k of the rental rate rK in a world where firms own capital? This is the concept of the
user cost of capital as we attempted ode scribe earlier. The user cost of capital is the form of
capital in the investment which has the following features increases with the interest rate,
increases with the depreciation rate of capital, decreases with the increase in the price of
capital goods Thus the user cost model is helpful to evaluate the effect of tax policies [see
Hall and Jorgenson (1967)]. But it is not very helpful to evaluate the dynamics of investment
for two reasons:
first, the model determines the stock of capital. Therefore, any change in e.g. the
user cost of capital would require an in finite investment rate as the stock of
capital would ‘jump’ to its new level.
second, because the model does allow capital to ‘jump’, it means that decisions
about the capital stock becomes tatic : they are determined by the current cost of
capital, and are not forward looking
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What is needed is something that slows down the adjustment of the capital stock in
response to changes in the environment. The adjustment costs can be internal (e.g. firms face
direct costs of adjusting their capital stock) or external (e.g. firms do not face the costs of
adjusting their stock of capital, but face a higher price of capital goods).
12.3 MODEL WITH ADJUSTMENT COSTS
In the benchmark model, there was a clear consumption/saving decision. But there was no
investment decision. More specifically from the point of view of firms, there was a demand for
capital (capital services) every period :
Zt FK Kt, Nt) =rt + δ
Where,
Zt = output
FK, Kt = capital
Nt= labour
Rt= rate of interest
δ= depreciation
The demand for capital was such as to equal to the marginal product of capital to the
interest rate plus the discount rate. From the point of view of the economy (general
equilibrium), the capital stock at t was given from past decisions, and so the same equation
determined the equilibrium one –period interest rate at t.
In other words, the interest rate was always equal to the marginal product of capital.
In fact, the interest rate appears often to differ from the marginal product of capital. This
suggests that firms face costs of adjusting their capital.
Lets introduce adjustment costs in the benchmark model and we shall get well-defined
consumption and investment demands, which depend on current and expected future
interest rates, profit, wages. See the role of the term structure of interest rates—the set
of inter temporal prices, which clears the goods market (investment plus consumption equal
production), in present and in the future. In the forward looking version of the IS relation,
in which aggregate demand depends on current and expected income and interest rates. In
the open economy version, get a rich theory of the current account, with a role for factors
affecting investment or/and saving.
The optimization problem Consider the following modification of the benchmark
optimization problem (i.e. leaving aside the labor/leisure choice):
∞ max E[βiU (Ct+i) |Ωt] = 0 subject to:
Ct+i=G (Kt+i, Nt+I , It + I ,Zt+I ) Nt+I ≡ 1 Kt+i+1 = (1−δ) Kt+I + It+I
The change from the benchmark is the presence of a net output function: Gives net
output, given inputs Kt and Nt, and investment It.
12.3.1 Marginal and Average q (Reference Tobin q theory)
The Tobin q theory of investment states specifically the importance of q in the
investment as because represents the increase (at the margin) in the firm’s value from
investing one more unit of capital. In practice, marginal q is difficult to measure. An easier
measure is Tobin’s average q, denoted Q and defined as the ratio of the market value of the
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firm to the replacement cost of its capital, that is:

V(Kt)
Q =
t
pK,tKt
In general, average and marginal q may be quite different. However, Hayashi (1982)
shows that the two are equal when:
1. ΠKK = 0, as obtains when there are constant returns to scale and factor
markets are competitive.
2. C(I, K) is homogenous of degree 0 in I, K, i.e. C(µI, µK) = C(I, K). This is
satisfied if C(I,K) = D(I/K).
3. V is the PDV of cash flows (i.e. no bubbles, fads, etc...)
4. There are not axes
With taxes, the relationship between average and marginal q is:

A0Q = q 0
+pKK

∞
Where A = u0−∞ 
0
0 D(v − s)e dv
−rv

Σ Where,
Is pKs ds = present discounted value of current
Is pKs ds is the present discounted value of current and future tax deductions
attributable to past investments. It is not a decision variable (since it comes from
investments before t=0,)but its till affects the value of the firm.
The analysis shows the limits of using average Q instead of marginal q:
1. if the firm has market power (so that ΠKK<0)
2. if V is different from the PDV of cash flows: the market does not value firms at
their fundamental value. In that case, the firm can either:
• ignore the market signals and invest based on the fundamental value;
• if V is high, the market is the right place to fund investment (issue shares).
12.3.2 The Dynamics of the Model
To simplify the economic interpretations in a more general sense (without any impact
on the economic interpretation), let’s assume that:
(a) the interest rate is constant and equal tor;
(b) the price of capital goods is constant and equal to 1,so that qt = λt;
(c) the adjustment costs are homogenous in investment and capital:
C(I,K)=D(I/K);
Where, K = capital
t= time period
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δ= depreciation
Ψ= constant of capital accumulation
Φ=constant of capital
The model can be summarized by the following equations:
K̇t =It−δKt=(φ (qt )−δ)Kt
q˙t = (r+δ)qt−ΠK (Kt,Xt)−Ψ(qt)
where Ψ(qt ) = It CK (It , Kt )=(It /Kt )2 D J (It / Kt ) = φ (qt )2 D J (φ (qt )).
Observe that φ(1) =0 and Ψ (1)= ΨJ (1)=0.
The first equation is the capital accumulation equation, where we substituted the
fact that It = φ(qt) Kt ; the second equation is the law of motion of qt =λt from the Maximum
Principle. One of the variables, capital, is ‘pre-determined’ by historical conditions and
cannot jump. The other, Tobin’s q, is a ‘jump’ variable.
This system of two equations can be represented in a phase diagram. Let’s analyze the
two loci corresponding to K̇= 0 and q̇ =0.
Steady state capital stock.
Since φJ (q)>0, φ(1) = 0 and δ > 0, this implies that q̄ >1. Observe that the value of q is
such that I = δ K, as expected in steady state. To establish the dynamics of K, observe that an
increase in q above the K̇= 0 schedule increases φ (q) so that K̇> 0.
The second locus is given by (assuming that the variables X are constant too)
ΠK (K, X) = (r + δ)q− Ψ(q)
Where,
ΠK= profits
K=capital
X= output
r =rate of interest
δ= depreciation
q= tob in
Ψ= constant of capital accumulation
This equation yields a relationship between K and q along which them a rginal value of
capital is constant. For q close to 1, we have ΨJ (q) close to 0 and therefore the slope of that
schedule is downward sloping. To establish the dynamics, observe that an increase in K
increases q˙ since ΠKK<0.
12.3.3 The Steady State
Considering the “ profit maximization” as discussed unde “ the cost of capital” , The
steady state is characterized by the following conditions:
φ(q¯) = δ
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ΠK(K̄,X)=r+δ−Ψ(q̄)=r+δ−δ 2 D J (δ)
Where,
ΠK= profits
K=capital
X= output
r =rate of interest
δ= depreciation
q= tobin
Ψ= constant of capital accumulation
The last term on the last equation represents the additional benefit that arises from
investing in capital, i.e the dilution of adjustment costs. This term disappears in the case
where CK=0.
The first equation indicates that Tobin’s q steady state value exceeds unity because of
depreciation. (You can check that q¯ = 1 if δ = 0). This implies that the marginal value of
capital exceeds its replacement value.
12.4 Using the model to explore the effect of shocks
First a general observation on what we mean by shock shere. The model was derived
under the assumption that all the parameters are either constant or that their fluctuations
are known ahead of time (e.g. Xt). We now consider what happens if there is a sudden change
in this environment.
If it seems abitbizarre to you that we’re allowing a change in the model that firm shave
never anticipated, it’s because it is ! There are ways to finesse this (for instance by assuming
that these type so f shocks are both infrequent and small so that it is optimal for firms to
discard them when solving for their optimal investment policy. But if we follow the logic to its
end, it means that the model cannot be used to tell us really about the real world where (a)
business cycle fluctuation s are not that infrequent and (b) are not necessarily that small.
Nevertheless, these ‘phase diagram’ are stock-full of economic intuition, so it is
interesting to see what happens nonetheless. What this means is that these are not useful
models to conduct any serious calibration and real world counter factual s. But they will tell
you a lot about the forces that drive firm’s responses to changes in their environment.
Partly as a result of the ‘perfect foresight’ model’s reliance on totally unanticipated
shocks that will never happen again but just happened the literature has moved to models
that encompass the stochastic structure of the environment in which firms operate. In these
environments, firms know that changes may occur. They have rational expectations about
these changes, in the sense that the type of shocks that can occur are in the support of their
beliefs about just such changes. In this sort of environment, firms adjust their behavior to
take the associated risks in to account. We will see models of that kind in the next class when
we look at what happens if there are non-convex adjustment costs of capital. In these models,
we can trace how the economy responds to a particular realization of a shock. Although the
possibility of a shock is rationally anticipated by economic actors, they are still surprised by
its realization, just like the fact that you know a recession may happen at any time does not
mean that you would not be surprised if one happened tomorrow.
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12.4.1 An unexpected permanent increase in demand

Consider the effect of a permanent unexpected increase in demand. This can be
represented by a change in one of the shifters X in the profit function. Assume that for a
given level of capital and production, the increased demand increases marginal profits. The
resulting increase in ΠK shifts the q˙ schedule to the right(why?).
At t = 0 (when the shock occurs), the economy is not on the new saddle - path.
This requires an immediate jump in q : because profits are going to be higher in the
future, the value of installed capital increases. This triggers an increase in investment and,
overtime, an increase in capital.
Notice that while investment jumps, it remains finite and K itself does not jump.
Finally, the increase in investment is highest immediately after the shock. Gradually, q
returns to its steady state value, and as it does, so does investment. This is what is called an
accelerator theory of investment: it responds to changes in output, not the level of output
perse.
12.4.2 An anticipated permanent increase in demand
In that case, for the same reasons as before, there cannot be a jump at T. So the
economy cannot remain in steady state. It must be on the path that leads to the news
add lepa that T. This means that investment must jump at t = 0 and investment must
increase. This shows that investment will respond to expectation so f higher demand at
some point in the future : news or beliefs about future high demand times can be
sufficient to trigger a boom in investment, even if current profitability remain sun
changed.
12.4.3 Anticipated Temporary Increase in demand
In that case, the increase occurs at t1 > 0 and ends at T. The dynamics are easy to
characterize: there is a limited investment boom, followed by a reduction in investment and
are turn to the original equilibrium.
12.4.4 Effect of Interest rate movements

A permanent decrease in interest rates leaves the K̇ schedule unchanged d and shifts the
q̇ = 0 schedule to the right (and steep ensit). The shift is similar to a permanent increase in
output. Note that however, that it is the entire path of future interest rates that matters for
investment. In other words, it is more likely to be along term interest rate than a short term
one.
12.4.5 Effect of taxes
With an investment tax credit, the equilibrium consists in replacing pK = 1 with pK
(1−τ)= (1−τ). From this, it follows that an increase in τ lowers the K̇= 0 schedule. If CK(.) = 0,
then this is the only effect and q drops : the value of installed capital is ‘diluted’ by the
additional investment, so the value of the marginal projects declines. In the more general
case where CK= 0, the q˙ = 0 curve also shifts. It is likely to shift to the right, i.e. there are
more after tax profits.
So both a permanent and temporary investment tax credit can boost investment and
therefore aggregate demand. Consider the case where CK = 0 (or where the K in CK refers to
aggregate capital and therefore is not taken into account by the firm when investing). The q˙ =
0 schedule shifts down. The new steady state value would be q=q¯(1τ). The tax credit
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stimulates investment, which lowers the profitability of firms and therefore lowers q. Now
observe that with a temporary investment tax credit q does not fall as much. There-fore,
investment is higher than if the tax credit was permanent. Why? because a temporary tax
credit creates a strong incentives to firms to invest while the credit is in place. We even have
an investment boom as the credit is about to expire (i.e. as the tax credit is about to expire,
notice that the optimal path turns up: q increases and so does I).
12.5 INVESTMENT IN A MODEL WITHUNCERTAINTY
Until now, we assumed that there was no uncertainty and we characterized the optimal
investment policy. But uncertainty is a powerful force that firms are facing and we need to
model it if we want to understand the drivers of investment dynamics.
There are two ways to proceed here. One would be to revert to a discrete time set-up
and use the tools from dynamic programming that we used when we looked at the
consumption problem under uncertainty and precautionary saving. I will start with that
approach. The other approach would be to introduce as to chastic dimension in the
continuous time model
12.5.1 The model in discrete time with quadratic adjustment costs
Consider the model with constant returns to scale adjustment costs of section 3,
but cast in discrete time. The firm starts at the beginning of period t with a capital stock
Kt−1 inherited from the period t 1 . We assume that there is no depreciation and that the
firm can produce immediately with newly installed capital. This means that if the firm
chooses to invest It, it earns profits Π(Kt, θt) in period t, where Kt= Kt−1 + It. θt is a random
variable, such as productivity, or the price of the domestic good, or of inputs... It is
observed at the beginning g of period t before investment decisions. We assume θt follows
a Markov process, so that knowing θt is the only relevant piece of information for
forecasting θs for s > t. The firm discounts profits at the constant gross interest R = 1 + r.
We also simplify slightly the problem by assuming that the price of investment goods is
constant pKt =1.
12.5.2 Discrete time and non-convex adjustment costs
We now consider what happens when the adjustment costs, instead of being quadratic
(i.e. smooth around 0) are non-convex. This is relevant for a number of reasons:
 Empirically, investment at the microeconomic level appears to be quite lumpy and
irreversible. A landmark study by Doms and Dunne (1998) at the Census, found that
investment at the plant level is both infrequent and ‘spiky’. Doms and Dunne look at a
sample of 12000 manufacturing plants over the period 1972-1989. They find that on
average, the largest investment episode accounts for 25% of the overall investment over
the entire period, and represents 50% of investment for more than half the
establishments (see figures 4 and5).
 This ‘lumpiness’ would not matter much if it was randomly distributed over plants and
time, so that a model of aggregate investment with smooth adjustment costs could still
account for the empirical evidence. But this does not appear to be the case: Doms and
Dunne find that 18% of investment is accounted for by top projects: there is
granularity in the data and the structure of investment at the micro economic level
seems to matter.
 We know that the q theory does not perform very well when it comes to explaining
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aggregate investment dynamics. Some of this is probably due to financial frictions, but
some of it is most certainly due to the importance of heterogeneity.
12.5.3 Non-convex adjustment costs
We now consider the effect of change in non-convex adjustment costs of firms. Instead
of postulating an adjustment cost function C(I,K) that is smooth, we assume that the firm
potentially faces both fixed and flow variable costs. More specifically, let’s assume that the
firm faces the following costs:
a. Fixed Costs : Assume that the firm has to pay a fixed cost ClKt∗ if it adjusts
upwards at time t and Cu Kt∗if it adjusts capital down wards.
b. Variable costs: Assume that the firm has to pay a flow cost c lIt if investment is
positive (It>0) and a flow cost −cu It if investment is negative (It<0).
c. no cost if no adjustment
The overall adjustment cost function is then:
C(η, K ∗ ) = K ∗ (Cl+ clη)1{η>0} + (Cl− cuη)1{η<0}
where η =I/K ∗ . Where,
ΠK= profits
Cl= fixed capital
X= output
cuη= variable capital
r =rate of interest
δ= depreciation
let us discuss the consequences of these costs.
First, as the fixed costs Cu, Cl will in duce arrange of inaction : it makes more sense to
bunch( or group) all the investment and pay the fixed cost less frequently. This is true even
with uncertainty.
Similar is the case of variable costs cu and cl. Suppose that there are no fixed costs,
but strictly positive variable costs. The firm may be cautious about investing one extra unit
because it is possible that tomorrow the desired capital will decrease, forcing the firm to d is
invest. In that case, capital i sun changed, but the firm ends up paying cu+cl>0.
The up shot is that both types of costs in presence of uncertainty will induce the
firm to delay investing over a certain range. Intuitively, this range will be close to the desired
capital, i.e. Z=1. Over that range, since K will not adjust, Z will be moving as a result
to shocks to K∗ .
12.6 INVESTMENT IN HOUSING MARKET
Investment in housing is much riskier than having a fixed deposit in a bank. The
reason is that prices of houses and flats rise most of the time, but at times such prices
remain constant or even fall, as in a period of recession. No doubt a bank provides most of
the funds needed for the purchase of a house. But the house-owner bears the risk, since he
(she) is responsible for paying back the loan, regardless of the market price of the house.
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12.6.1 The Effect of Interest Rate Changes and Tax Benefits:

The demand for houses and flats depends to a large extent on real interest rate. For
most people, who buy houses by taking loans, the interest rate is the cost of the loan. Some
people do not borrow funds to buy houses. For them also the rate of interest affects the
decision to buy or construct houses. The reason is that the interest rate is the opportunity
cost of holding their wealth in housing (a real asset) rather than in financial assets such as
bonds or bank deposits. A fall in the interest rate, therefore, raises the demand for houses,
the prices of houses and the volume of residential investment per period. This point is
illustrated in Fig. below

Fig 12.1
One attractive aspect of investment in housing is that interest on mortgage is tax-
deductible. This is why even if the rate of interest rises people buy houses. Investment in
residential housing is a tax- favoured form of investment enjoyed by most people in India. An
investor can deduct the interest payments on his mortgage, and wealth tax such as
municipal corporation tax when he considers his income for tax purposes. In addition, the
capital gain from owning the house is not taxed until the same is sold. Even then the capital
gain (up to Rs. 5 lakhs for a married couple) from selling their house is not taxed at all. If
these tax advantages of home ownership were ever withdrawn, housing prices would fall
sharply in the short-run (during which supply is compiled inelastic). This point is illustrated
in Fig. below. Removing tax preferences for housing will shift the demand curve for housing
down and thus will lead to a fall in the price of housing in the short run.

Fig 12.2
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12.7 Summary
Investment in housing is much riskier than having a fixed deposit in a bank. The
reason is that prices of houses and flats rise most of the time, but at times such prices
remain constant or even fall, as in a period of recession. No doubt a bank provides most of
the funds needed for the purchase of a house. But the house-owner bears the risk, since he
(she) is responsible for paying back the loan, regardless of the market price of the house.
12.8 GLOSSARY
 Pigou effect: The increase in consumer spending that results when a fall in the price
level raises real money balances and, thereby, consumers’ wealth.
 Real interest rate: The return to saving and the cost of borrowing after adjustment
for inflation. (Cf. nominal interest rate.)
 Real money balances: The quantity of money expressed in terms of the quantity of
goods and services it can buy; the quantity of money divided by the price level (M/P).
 Tax multiplier: The change in aggregate income resulting from a one-dollar change in
taxes.
12.9 REFERENCES
 Dernburg, T. F., & Dernburg, J. D. (1969). Macroeconomic analysis: an introduction to
comparative statics and dynamics. Addison-Wesley.
 Rana, K. C., & Verma, K. N. (2009). Macroeconomic analysis. Vishal Publishing Co.
Delhi.
 Dwivedi, D.N. (2005). Macroeconomics: Theory and Policy. Tata McGraw-Hill Education.
 Olsson, O. (2013). Essentials of advanced macroeconomic theory. Routledge.
12.10 FURTHER READINGS
 Ackley, G. (1961). Macroeconomic theory, MacMillan Library Reference.
 Shapiro, E. (1978). Macroeconomic analysis (No. 339.2 S4 1978). Fourth Edition, 2009.
 Branson, W. H. (1979). Macroeconomic theory and policy (No. 04; HB171. 5, B73.
12.11 MODEL QUESTIONS
1. Explain in detail the investment in the housing market.
2. Explain the concept on adjustment cost mechanism.
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Lesson- 13

MONEY
Structure
13.0 Objectives
13.1 Introduction
13.2 Stages in the evolution of money
13.2.1 Commodity Money

13.2.2 Metallic money

13.2.3 Paper Money

13.2.4 Credit Money

13.2.5 Near Money

13.3 The Functions of Money
13.3.1 Primary Functions of Money
13.3.2 Secondary Functions
13.3.3 Contingent Functions
13.4 The Types of Money
13.4.1 CASE STUDY Money in a POW Camp
13.4.2 CASE STUDY Money and Social Conventions on the Island of Yap
13.4.3 Limited and Unlimited Legal Tender
13.4.4 Standard Money
13.4.5 Token Money
13.4.6 Bank Money
13.5 How the Quantity of Money Is Controlled
13.6 How the Quantity of Money Is Measured
13.7 How Do Credit Cards and Debit Cards Fit Into the Monetary System?
13.8 Summary
13.9 Glossary
13.10 References
13.11 Further Readings
13.12 Model Questions
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13.0 OBJECTIVES
After going through the chapter you shall be able to–
 Explain the Stages in the evolution of money
 Describe the Functions of Money
 Converse about the Types of Money
13.1 INTRODUCTION
We all know that economics deals with the scarce resources and its management.
Thus there arise the importance of money in the management of scarce resources. We in the
world of today are pretty familiar with notes and coins but how these coins and notes are
important to the common man will be studied in this lesson wherein the economics concept
of money will tell us the importance of money and it functions.
Definition Of Money
The word ‘money’ is derived from the Latin word ‘Moneta’ which was the surname of
the Roman Goddess of Juno in whose temple at Rome, money was coined. The origin of
money is lost in antiquity. Even the primitive man had some sort of money. The type of
money in every age depended on the nature of its livelihood. In a hunting society, the skins of
wild animals were used as money. The pastoral society used livestock, whereas the
agricultural society used grains and foodstuffs as money. The Greeks used coins as money.
When we say that a person has a lot of money, we usually mean that he or she is wealthy. By
contrast, economists use the term “money” in a more specialized way. To an economist,
money does not refer to all wealth but only to one type of it: money is the stock of assets that
can be readily used to make transactions. Roughly speaking, the dollars in the hands of the
public make up the nation’s stock of money.
To give a precise definition of money is a difficult task. Various authors have given
different definition of money. According to Crowther, “Money can be defined as anything that
is generally acceptable as a means of exchange and that at the same time acts as a measure
and a store of value”. Professor D H Robertson defines money as “anything which is widely
accepted in payment for goods or in discharge of other kinds of business obligations. From
the above two definitions of money two important things about money can be noted. Firstly,
money has been defined in terms of the functions it performs. That is why some economists
defined money as “money is what money does”. It implies that money is anything which
performs the functions of money. Secondly, an essential requirement of any kind of money is
that it must be generally acceptable to every member of the society. Money has a value for ‘A’
only when he thinks that ‘B’ will accept it in exchange for the goods. And money is useful for
‘B’ only when he is confident that ‘C’ will accept it in settlement of debts. But the general
acceptability is not the physical quality possessed by the good. General acceptability is a
social phenomenon and is conferred upon a good when the society by law or convention
adopts it as a medium of exchange.
13.2 STAGES IN THE EVOLUTION OF MONEY
The evolution of money has passed through the following five stages depending upon
the progress of human civilization at different times and places.
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13.2.1 Commodity Money

Various types of commodities have been used as money from the beginning of human
civilization. Stones, spears, skins, bows and arrows, and axes were used as money in the
hunting society. The pastoral society used cattle as money. The agricultural society used
grains as money. The Romans used cattle and salt as money at different times. The
Mongolians used squirrel skins as money. Precious stones, tobacco, tea shells, fishhooks and
many other commodities served as money depending upon time, place and economic
standard of the society.
The use of commodities as money had the following defects.
 All the commodities were not uniform in quality, such as cattle, grains, etc. Thus lack
of standardization made pricing difficult.
 It is difficult to store and prevent loss of value in the case of perishable commodities.
 Supplies of such commodities were uncertain.
 They lacked in portability and hence were difficult to transfer from one place to
another.
 There was the problem of indivisibility in the case of such commodities as cattle.
13.2.2. Metallic money
With the spread of civilization and trade relations by land and sea, metallic money
took the place of commodity money. Many nations started using silver, gold, copper, tin, etc.
as money .But metal was an inconvenient thing to accept, weigh, divide and assess in
quality. Accordingly, metal was made into coins of predetermined weight. This innovation is
attributed to King Midas of Lydia in the eighth century B C. But gold coins were used in India
many centuries earlier than in Lydia. Thus coins came to be accepted as convenient method
of exchange. As the price of gold began to rise, gold coins were melted in order to earn more
by selling them as metal. This led governments to mix copper or silver in gold coins since
their intrinsic value might be more than their face value. As gold became dearer and scarce,
silver coins were used, first in their pure form and later on mixed with alloy or some other
metal. But metallic money had the following limitations.
(i) It was not possible to change its supply according to the requirements of the nation
both for internal and external use.
(ii) Being heavy, it was not possible to carry large sums of money in the form of coins from
one place to another by merchants.
(iii) It was unsafe and inconvenient to carry precious metals for trade purposes over long
distances.
(iv) Metallic money was very expensive because the use of coins led to their debasement
and their minting and exchange at the mint cost a lot to the government.
13.2.3. Paper Money
The development of paper money started with goldsmiths who kept strong safes to
store their gold. As goldsmiths were thought to be honest merchants, people started keeping
their gold with them for safe custody. In return, the goldsmiths gave the depositors a receipt
promising to return the gold on demand. These receipts of the goldsmiths were given to the
sellers of commodities by the buyers. Thus receipts of the goldsmith were a substitute for
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money. Such paper money was backed by gold and was convertible on demand into gold.
This ultimately led to the development of bank notes. The bank notes are issued by the
central bank of the country. As the demand for gold and silver increased with the rise in their
prices, the convertibility of bank notes into gold and silver was gradually given up during the
beginning and after the First World War in all the countries of the world. Since then the bank
money has ceased to be representative money and is simply ‘fiat money’ which is
inconvertible and is accepted as money because it is backed by law.
13.2.4. Credit money
Another stage in the evolution of money in the modern world is the use of the cheque as
money. The cheque is like a bank note in that it performs the same function. It is a means of
transferring money or obligations from one person to another. But a cheque is different from
a bank note. A cheque is made for a specific sum, and it expires with a single transaction.
Acheque is not money. It is simply a written order to transfer money. However, large
transactions are made through cheques these days and bank notes are used only for small
transactions.
13.2.5. Near money
The final stage in the evolution of money has been the use of bills of exchange,
treasury bills, bonds, debentures, savings certificates, etc. They are known as ‘near money’.
They are close substitutes for money and are liquid assets. Thus, in the final stage of its
evolution money became intangible. It’s ownership in now transferable simply by book entry.
13.3 FUNCTIONS OF MONEY
The major functions of money can be classified into three. They are:
The primary functions, secondary functions and contingent functions.
13.3.I. Primary functions of money
The primary functions of money are;
 Medium of exchange and
 Measure of value
13.3.1.1. Medium of exchange
The most important function of money is that it serves as a medium of exchange. In
the barter economy commodities were exchanged for commodities. But it had experienced
many difficulties with regard to the exchange of goods and services. To undertake exchange,
barter economy required ‘double coincidence of wants’. Money has removed this problem.
Now a person A can sell his goods to B for money and then he can use that money to buy the
goods he wants from others who have these goods. As long as money is generally acceptable,
there will be no difficulty in the process of exchange. By serving a very convenient medium of
exchange money has made possible the complex division of labour or specialization in the
modern economic organization.
13.3.1.2. Measure of value
Another important function of money is that the money serves as a common measure
of value or a unit of account. Under barter system there was no common measure of value
and the value of different goods were measured and compared with each other. Money has
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solved this difficulty and serves as a yardstick for measuring the value of goods and services.
As the value of all goods and services are measured in terms of money, their relative values
can be easily compared.
13.3.2. Secondary functions
The secondary functions of money are;
13.3.2.1. Standard of deferred payments
Another important function of money is that it serves as a standard for deferred
payments. Deferred payments are those payments which are to be made in future. If a loan is
taken today, it would be paid back after a period of time. The amount of loan is measured in
terms of money and it is paid back in money. A large amount of credit transactions involving
huge future payments are made daily. Money performs this function of standard of deferred
payments because its value remains more or less stable. When the price changes the value of
money also changes. For instance, when the prices are falling, value of money will rise. As a
result, the creditors will gain in real terms and the debtors will lose. Conversely, when the
prices are rising (or, value of money is falling)creditors will be the losers. Thus if the money is
to serve as a fair and correct standard of deferred payments, its value must remain stable.
Thus when there is severe inflation or deflation, money ceases to serve as a standard of
deferred payments.
13.3.2.2 Store of value
Money acts as a store of value. Money being the most liquid of all assets is a
convenient form in which to store wealth. Thus money is used to store wealth without
causing deterioration or wastage. In the past gold was popular as a money material. Gold
could be kept safely without deterioration. Of course, there are other assets like houses,
factories, bonds, shares, etc., in which wealth can be stored. But money performs as a
different thing to store the value. Money being the most liquid of all assets has the advantage
that an individual or a firm can buy with it any thing at any time. But this is not the case
with other assets. Other assets like buildings, shares, etc., have to be sold first and converted
into money and only then they can be used to buy other things. Money would perform the
store of value function properly if it remains stable in value. In short, money has removed the
difficulties of barter system, namely, lack of double coincidence of wants, lack of division and
lack of measure and store of value and lack of a standard of deferred payment. It has
facilitated trade and has made possible the complex division of labour and specialization of
the modern economic system.
13.3.3 Contingent functions
The important contingent functions of money are;
13.3.3.1 Basis of credit
It is with the development of money market the credit market began to flourish.
13.3.3.2 Distribution of national income
Being a common measure of value, money serves as the best medium to distribute the
national income among the four factors of production.
13.3.3.3 Transfer of value
Money helps to transfer value from one place to another.
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13.3.3.4 Medium of compensations

Accidents and carelessness cause damage to the property and life. Compensation can
be paid to such damages in terms of money.
13.3.3.5 Liquidity
Liquidity means the ready purchasing power or convertibility of money in to any
commodity. Money is the most liquid form of all assets.
13.3.3.6 Money guide in production and consumption.
Utility of goods and services can be expressed in terms of money. Similarly, marginal
productivity is measured in terms of prices of goods and factors. Thus money becomes the
base of measurement and which directs the production and consumption.
13.3.3.7 Guarantor of solvency
Solvency refers to the ability to pay off debt. Persons and firms have to be solvent
while doing the business. The deposits of money serves as the best guarantor of solvency.
13.4 TYPES OF MONEY
Money takes many forms. These pieces of green paper with small portraits of famous
Americans would have little value if they were not widely accepted as money. Money that has
no intrinsic value is called fiat money because it is established as money by government
decree, or fiat. Fiat money is the norm in most economies today, but most societies in the
past have used a commodity with some intrinsic value for money. This type of money is
called commodity money. The most widespread example is gold. When people use gold as
money (or use paper money that is redeemable for gold), the economy is said to be on a gold
standard. Gold is a form of commodity money because it can be used forvarious purposes—
jewelry, dental fillings, and soon—as well as for transactions. The gold standard was common
throughout the world during the late nineteenth century.
Money in a POW Camp
An unusual form of commodity money developed in some Nazi prisoner of war(POW)
camps during World War II. The Red Cross supplied the prisoners with various goods—food,
clothing, cigarettes, and so on. Yet these rations were allocated without close attention to
personal preferences, so the allocations were often inefficient. One prisoner may have
preferred chocolate, while another may have preferred cheese, and a third may have wanted
a new shirt. The differing tastes and endowments of the prisoners led them to trade with one
another. Barter proved to be an inconvenient way to allocate these resources, however,
because it required the double coincidence of wants. In other words, a barter system was not
the easiest way to ensure that each prisoner received the good she valued most. Even the
limited economy of the POW camp needed some form of money to facilitate transactions.
Eventually, cigarettes became the established “currency’’ in which prices were quoted
and with which trades were made. A shirt, for example, cost about 80 cigarettes. Services
were also quoted in cigarettes: some prisoners offered to do other prisoners’ laundry for 2
cigarettes per garment. Even nonsmokers were happy to accept cigarettes in exchange,
knowing they could trade the cigarettes in the future for some good they did enjoy. Within
the POW camp the cigarette became the store of value, the unit of account, and the medium
of exchange.
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13.4.1 Fiat Money

It is not surprising that in any society, no matter how primitive, some form of
commodity money arises to facilitate exchange: people are willing to accept a commodity
currency such as gold because it has intrinsic value. The development of fiat money,
however, is more perplexing. What would make people begin to value something that is
intrinsically useless? To understand how the evolution from commodity money to fiat money
takes place, imagine an economy in which people carry around bags of gold. When a
purchase is made, the buyer measures out the appropriate amount of gold. If the seller is
convinced that the weight and purity of the gold are right, the buyer and seller make the
exchange. The government might first get involved in the monetary system to help people
reduce transaction costs. Using raw gold as money is costly because it takes time to verify
the purity of the gold and to measure the correct quantity. To reduce these costs, the
government can mint gold coins of known purity and weight. The coins are easier to use than
gold bullion because their values are widely recognized. The next step is for the government
to accept gold from the public in exchange for gold certificates—pieces of paper that can be
redeemed for a certain quantity of gold. If people believe the government’s promise to redeem
the paper bills for gold, the bills are just as valuable as the gold itself. In addition, because
the bills are lighter than gold (and gold coins), they are easier to use in transactions.
Eventually, no one carries gold around at all, and these gold-backed government bills become
the monetary standard. Finally, the gold backing becomes irrelevant. If no one ever bothers
to redeem the bills for gold, no one cares if the option is abandoned. As long as everyone
continues to accept the paper bills in exchange, they will have value and serve as money.
Thus, the system of commodity money evolves into a system of fiat money. Notice that in the
end the use of money in exchange is a social convention: everyone values fiat money because
they expect everyone else to value it.
13.4.2 Money and Social Conventions on the Island of Yap
The economy of Yap, a small island in the Pacific, once had a type of money that was
something between commodity and fiat money. The traditional medium of exchange in Yap
was fei, stone wheels up to 12 feet in diameter. These stones had holes in the center so that
they could be carried on poles and used for exchange. Large stone wheels are not a
convenient form of money. The stones were heavy, so it took substantial effort for a new
owner to take his fei home after completing atransaction. Although the monetary system
facilitated exchange, it did so at great cost. Eventually, it became common practice for the
new owner of the fei not to bother to take physical possession of the stone. Instead, the new
owner accepted a claim to the fei without moving it. In future bargains, he traded this claim
for goods that he wanted. Having physical possession of the stone became less important
than having legal claim to it. This practice was put to a test when a valuable stone was lost at
sea during a storm. Because the owner lost his money by accident rather than through
negligence, everyone agreed that his claim to the fei remained valid. Even generations later,
when no one alive had ever seen this stone, the claim to this fei was still valued in exchange.
Money of account
Money of account is the monetary unit in terms of which the accounts of a country are
kept and transactions settled, ie., in which general purchasing power, debts and prices are
expressed. The rupee is, for instance, our money of account. Sterling is the money of account
if Great Britain and mark that of Germany. Money of account need not, however, be actually
circulating in the country. During 1922-24 the mark in Germany depreciated in such an
extent that it ceased to be the money of account.
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13.4.3 Limited and unlimited legal tender

Money which has legal sanction is called legal tender money. So its acceptance is
compulsory. It is an offence to refuse to accept payment in legal tender money. Thus a legal
tender currency is one in terms of which debts can be legally paid. A currency is unlimited
legal tender when debts upon any amount can be paid through it. It is limited legal tender
when payments only up to a given limit can be made by means of it. For example, rupee coins
and rupee notes are unlimited legal tender in India. Any amount of transaction can be made
by using them. But coins of lower amounts like 25 or50 paisa are only limited legal tender
(up to Rs.25/-). One can refuse to receive beyond this amount. When a coin is worn out and
become light beyond a certain limit, then it ceases to be a legal tender. When one rupee and
half-rupee coins are more than 20% below the standard weight they are no longer legal
tender.
13.4.4 Standard money
Standard money is one in which the value of goods as well as all other forms of money
are measured. In India prices of all goods are measured in terms of rupees. Moreover, the
other forms of money such as half-rupee notes, one rupee notes, two rupee notes, five rupee
notes etc. are expressed in terms of rupees. Thus rupee is the standard money of India.
Standard money is always made the unlimited legal tender money. In old days the standard
money was a full-bodied money. That is its face value is equal to its intrinsic value (metal
value). But now a days in almost all countries of the world, even the standard money is only
a token money. That is, the real worth of the material contained in it is very much less than
the face value written in it.
13.4.5 Token money
Token money is a form of money in which the metallic value of which is much less
than its real value(or face value). Rupees and all other coins in India are all token money.
13.4.6 Bank money
Demand deposits of banks are usually called bank money. Bank deposits are created
when somebody deposits money with them. Banks also creates deposits when they advance
loans to the businessmen and traders. These demand deposits are the important constituent
of the money supply in the country. It is important to note that bank deposits are generally
divided into two categories: demand deposits and time deposits. Demand deposits are those
deposits which are payable on demand through cheques and without any serving prior notice
to the banks. On the other hand, time deposits are those deposits which have a fixed term of
maturity and are not with draw able on demand and also cheques cannot be drawn on them.
Clearly, it is only demand deposits which serve as a medium of exchange, for they can be
transferred from one person to another through drawing a cheque on them as and when
desired by them. However, since time or fixed deposits can be withdrawn by forgoing some
interest and can be used for making payments, they are included in the concept of broad
money, generally called M3.
13.4.7 Inside money is a term that refers to any debt that is used as money. It is a liability
to the issuer. The net amount of inside money in an economy is zero. At the same time, most
money circulating in a modern economy is inside money.
13.4.8 Outside money is a term that refers to money that is not a liability for anyone
"inside" the economy. It is held in an economy in net positive amounts. Examples are gold or
assets denominated in foreign currency or otherwise backed up by foreign debt, like foreign
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cash, stocks or bonds. Typically, the private economy is considered as the "inside", so
government issued money is also "outside money."
13.5 HOW THE QUANTITY OF MONEY IS CONTROLLED
The quantity of money available in an economy is called the money supply. In a
system of commodity money, the money supply is simply the quantity of that commodity. In
an economy that uses fiat money, such as most economies today, the government controls
the supply of money: legal restrictions give the government a monopoly on the printing of
money. Just as the level of taxation and the level of government purchases are policy
instruments of the government, so is the quantity of money. The government’s control over
the money supply is called monetary policy. In the United States and many other countries,
monetary policy is delegated to a partially independent institution called the central bank.
The central bank of the United States is the Federal Reserve—often called the Fed. If you
look at a U.S. dollar bill, you will see that it is called a Federal Reserve Note. Decisions over
monetary policy are made by the Fed’s Federal Open Market Committee. This committee is
made up of members of the Federal Reserve Board, who are appointed by the president and
confirmed by Congress, together with the presidents of the regional Federal Reserve Banks.
The Federal Open Market Committee meets about every six weeks to discuss and set
monetary policy. The primary way in which the Fed controls the supply of money is through
open-market operations—the purchase and sale of government bonds. When the Fed wants
to increase the money supply, it uses some of the dollars it has to buy government bonds
from the public. Because these dollars leave the Fed and enter into the hands of the public,
the purchase increases the quantity of money in circulation. Conversely, when the Fed wants
to decrease the money supply, it sells some government bonds from its own portfolio. This
open-market sale of bonds takes some dollars out of the hands of the public and, thus,
decreases the quantity of money in circulation.
13.6 HOW THE QUANTITY OF MONEY IS MEASURE
One goal of this chapter is to determine how the money supply affects the economy; we
turn to that topic in the next section. As a background for that analysis, let’s first discuss
how economists measure the quantity of money. Because money is the stock of assets used
for transactions, the quantity of money is the quantity of those assets. In simple economies,
this quantity is easy to measure. In the POW camp, the quantity of money was the number of
cigarettes in the camp. But how can we measure the quantity of money in more complex
economies? The answer is not obvious, because no single asset is used for all transactions.
People can use various assets, such as cash in their wallets or deposits in their checking
accounts, to make transactions, although some assets are more convenient than others.
The most obvious asset to include in the quantity of money is currency, the sum of
outstanding paper money and coins. Most day-to-day transactions use currency as the
medium of exchange. A second type of asset used for transactions is demand deposits, the
funds people hold in their checking accounts. If most sellers accept personal checks, assets
in a checking account are almost as convenient as currency. In both cases, the assets are in
a form ready to facilitate a transaction. Demand deposits are therefore added to currency
when measuring the quantity of money. Once we admit the logic of including demand
deposits in the measured money stock, many other assets become candidates for inclusion.
Funds in savings accounts, for example, can be easily transferred into checking accounts;
these assets are almost as convenient for transactions. Money market mutual funds allow
investors to write checks against their accounts, although restrictions sometimes apply with
regard to the size of the check or the number of checks written. Because these assets can be
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easily used for transactions, they should arguably be included in the quantity of money.
Because it is hard to judge which assets should be included in the money stock, more than
one measure is available.
Table 13-1 presents the three measures
Amount in October 2008
Symbol Assets Included (billions of dollars)
C Currency $ 794
M1 Currency plus demand deposits, traveler’s 1465
checks, and other checkable deposits
M2 M1 plus retail money market mutual 7855
fund balances, saving deposits (including
money market deposit accounts), and small
time deposits
TABLE 13-1
13.7 HOW DO CREDIT CARDS AND DEBIT CARDS FITINTO THE MONETARY
SYSTEM?
Many people use credit or debit cards to make purchases. Because money is the medium
of exchange, one might naturally wonder how these cards fit into the measurement and
analysis of money. Let’s start with credit cards. One might guess that credit cards are part of
the economy’s stock of money, but in fact measures of the quantity of money do not take
credit cards into account. This is because credit cards are not really a method of payment
but a method of deferring payment. When you buy an item with a credit card, the bank that
issued the card pays the store what it is due. Later, you repay the bank. When the time
comes to pay your credit card bill, you will likely do so by writing a check against your
checking account. The balance in this checking account is part of the economy’s stock of
money. The story is different with debit cards, which automatically withdraw funds from a
bank account to pay for items bought. Rather than allowing users to postpone payment for
their purchases, a debit card allows users immediate access to deposits in their bank
accounts. Using a debit card is similar to writing a check. The account balances that lie
behind debit cards are included in measures of the quantity of money. Even though credit
cards are not a form of money, they are still important for analyzing the monetary system.
Because people with credit cards can pay many of their bills all at once at the end of the
month, rather than sporadically as they make purchases, they may hold less money on
average than people without credit cards.
13.8 SUMMARY
Thus, the increased popularity of credit cards may reduce the amount of money that
people choose to hold. In other words, credit cards are not part of the supply of money, but
they may affect the demand for money of the money stock that the Federal Reserve calculates
for the U.S. economy, together with a list of which assets are included in each measure. From
the smallest to the largest, they are designated C, M1, and M2. The Fed used to calculate
another, even more extensive measure called M3 but discontinued it in March2006. The most
common measures for studying the effects of money on the economy are M1 and M2.
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13.9 GLOSSARY
 Commodity money: Money that is intrinsically useful and would be valued even if it
did not serve as money. (Cf. fiat money, money.)
 Token money is a form of money in which the metallic value of which is much less
than its real value (or face value). Rupees and all other coins in India are all token
money.
 Near money The final stage in the evolution of money has been the use of bills of
exchange, treasury bills, bonds, debentures, savings certificates, etc.
 Inside money is a term that refers to any debt that is used as money. It is a liability to
the issuer.
 Outside money is a term that refers to money that is not a liability for anyone "inside"
the economy.
13.10 REFERENCES
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics. Pergamon Press Oxford
 N. Gregory Mankiw (2010). Macroeconomics. 7th Edition. Worth Publications.
 Ackley, G. (1986). Macroeconomic Theory. Macmillan Library Reference.
 Shapiro, E. (2009). Macroeconomic Analysis. Fourth edition, Galgotia Publications Pvt.
Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
13.11 Further Readings
 Shapiro, E. (2009). Macroeconomic Analysis. Fourth edition, Galgotia Publications Pvt.
Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
13.12 MODEL QUESTIONS
1. Describe the functions of money.
2. What is fiat money? What is commodity money?
3. Who controls the money supply and how?
4. Write the quantity equation and explain it.
5. What does the assumption of constant velocity imply?
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Lesson- 14

SUPPLY OF MONEY & INSTRUMENTS OF MONETARY

CONTROL
Structure

14.0 Objectives
14.1 Introduction and Concept of Money Supply
14.2 Constituents of Money Supply
14.3 RBI‘s approach to Money Supply
14.4 Determinants of Money Supply
14.5 Instruments of Monetary Control
14.6 Summary
14.7 Glossary
14.8 References
14.9 Further References
14.10 Model Questions

14.0 OBJECTIVES

After going through the chapter you shall be able to –

 Converse with the concept of money supply
 Explain the various constituents of money supply
 Dicuss the RBI‘s approach to money supply
 Describe the factors determining supply of money
 Analyse the instruments to control the money supply in an economy

14.1 INTRODUCTION

Money supply is a stock concept. As we have studied that Money is anything which is
generally accepted as a medium of exchange. The supply of money depends on a number of
factors. In this chapter, we will discuss the theory of money supply function. We are aware d
the fact that money supply includes all money in the economy. Money supply may include-
demand deposits, time deposits and different types of liquid assets. Banks deposits
constitute nearly 80 percent of total supply advanced countries. The stock of money is to be
in a spendable form.
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Concept of Money Supply

Money supply refers to the amount of money which is in circulation in an
economy at any given time. It is the total stock of money held by the people consisting
of individuals, firms, State and its constituent bodies except the State treasury,
Central Bank and Commercial Banks. The cash balances held by the Federal and
federating governments with the Central Bank and in treasuries are not considered as part of
money supply because they are created through the administrative and non-commercial
operations of the government. Further money supply refers to the disposable stock of money.
Therefore money supply is stock of money in circulation. Money supply can be looked at from
two points of views, namely, money supply as a stock and money supply as a flow. Thus at a
given point of time, the total stock of money and the total supply of money is different. Money
supply viewed at a point of point is the stock of money held by the people on a given day
whereas money supply viewed overtime is viewed as a flow. Units of money are spent and re-
spent several times during a given period. The average number of times a unit of money
circulates amongst the people in a given year is known as Velocity of Circulation of
Money. The flow of money is measured by multiplying the stock of money with the coefficient
of velocity of circulation of money.
14.2 CONSTITUENTS OF MONEY SUPPLY.
There are two approaches to the constituents of money supply. They are the
traditional and the modern approaches.
1. Traditional Approach. According to the traditional approach, the money supply
consists of currency money consisting of coins and notes and bank money consisting of
checkable demand deposits with commercial banks. The currency money is considered high
powered money because of the legal backing of the State. The Central Bank of a country
issues currency notes and coins because it has the monopoly of note and coin issue. The
supply of money in a country depends upon the system of note issue adopted by the country.
For instance, India adopted the Minimum Reserve System in 1957. Under this system, the
Reserve Bank of India has to maintain a minimum reserve of Rs.200 Crores consisting of gold
and foreign securities. Out of this, the value of gold should not be less than Rs.115 Crores.
With this reserve, the Reserve Bank of India has the power to issue unlimited amount of
currency in the country.
Checkable demand deposits of commercial banks are used in the settlement of debt.
Payments made through checks change the volume of demand deposits by creating derivative
deposits. The creation of demand deposits is determined by the credit creation activities of
the commercial banks. Bank money is considered as secondary money whereas cash money
is known as high powered money. Thus according to the traditional approach, the total
supply of money is the sum of high powered money and secondary money or currency and
bank money. The ratio of bank money to currency money depends upon the extent of
monetization, banking habits and banking development in a country. In advanced countries,
ratio of bank money to currency money is high whereas in poor countries the ratio of
currency money to bank money is high.
2. The Modern Approach.
According to the modern approach, money supply includes currency money and near
money. Money supply therefore consists of coins, currency notes, demand deposits of
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commercial banks, time deposits of commercial banks, financial assets, treasury bills and
commercial bills of exchange, bonds and equities.
14.3 RESERVE BANK OF INDIA’S APPROACH TO THE MEASUREMENT OF
MONEY SUPPLY
According to the Reserve Bank of India since its inception in 1935, money supply in
the narrow sense of the term was the sum of currency with the people and demand deposits
with the commercial banking system. Narrow money was denoted by the RBI by M1. In 1964-
65, the concept of broad money or aggregate monetary resources was introduced. Broad
money was considered equal to M1 + Time deposits with commercial banks. In March, 1970
the RBI accepted the report of the Second Working Group on Money Supply. This report was
published in the year 1977 and it gave a broad definition of money supply. Accordingly, four
measures of money supply were brought into effect. These four measures are as follows:
1. M1 = Currency with the public + Demand deposits with the commercial Banks + Other
deposits with the RBI.
2. M2 = M1 + Post Office Savings Bank Deposits.
3. M3 = M1 + Time deposits with the commercial banks.
4. M4 = M3 + Total Post Office Deposits (excluding NSCs).
The Reserve Bank of India gives importance to narrow money (M1) and broad money
(M3). Narrow money excludes time deposits because they are not liquid and are income
earning assets while broad money includes time deposits because some liquidity is involved
in it as these assets earns interest income in future. Since time deposits have become
convertible in recent times, they have become more liquid than what they were before. The
M2 and M4 measures of money supply include post office savings and other deposits with the
post offices. The third working group on money supply recommended the following
measures of monetary aggregates through their report submitted in 1998:
1. M0 = Currency in circulation + Bankers‘ deposits with the RBI + Other deposits with
the RBI. (M0 is compiled on weekly basis).
2. M1 = Currency with the public + Demand deposits with the banking System + Other
deposits with the RBI = Currency with the public + Current deposits with the banking
system + Demand liabilities Portion of Savings Deposits with the banking system +
other Deposits with the RBI.
3. M2 = M1 + Time liabilities portion of saving deposits with the banking System +
Certificates of deposits issued by the banks + Term Deposits [excluding FCNR (B)
deposits] with a contractual maturity of up to and including one year with the banking
system = Currency with the public + current deposits with the banking System +
Savings deposits with the banking system + Certificates Of Deposits issued by the
banks + Term deposits [excluding FCNR (B) deposits] with a contractual maturity up
to and Including one year with the banking system + other deposits with the RBI.
4. M3 = M2 + Term deposits [excluding FCNR (B) deposits] with a Contractual maturity of
over one year with the banking system + Call borrowings from Non- depository
financial corporations by the banking system. (M1, M2 & M3 are compiled every
fortnight). In addition to the monetary measures stated above, the following liquidity
aggregates to be compiled on monthly basis were also recommended by the working
group: 1. L1 = M3 + All deposits with the Post Office Savings Banks (excluding
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National Savings Certificates). 2. L2 = L1 + Term deposits with Term lending

institutions and refinancing Institutions (FIs) + Term borrowing by FIs + Certificates of
Deposits issued by FIs. 3. L3 = L2 + Public deposits of Non-banking Financial
Companies. (L3 is compiled on quarterly basis).
14.4 DETERMINANTS OF MONEY SUPPLY
Currency in circulation and demand deposits are the main constituents of money
supply. While the demand deposits are created by the commercial banks, currency is issued
by the Central Bank and the Government. The supply of money is determined by the
following factors:
1. High Powered Money (H). High powered money (H) consists of currency notes and coins
issued by the Government and the Central Bank. A part of the currency issued is held by the
public and another part is held by the banks as reserves. A part of the currency reserves of
the banks is held by them in their own cash vaults and a part is deposited in the Central
bank. The high powered money can therefore be obtained as sum of currency held by the
public and the part held by the banks as reserves. Thus, H = Cp + R, where H is the amount
of high powered money, Cp is the currency held by the public and R = Cash reserves of
currency with the banks. The central bank of the country and the Government are the
creators of high powered money (H). Commercial Banks are producers of demand deposits
which are used like currency money. In order to produce demand deposits or credit, banks
have to keep with themselves cash reserves of currency which is denoted by R in the
equation above. Since these cash reserves with the banks serve as a basis for the multiple-
creation of demand deposits which constitute as important part of money supply, it imparts
high power to the currency issued by the Central bank and the Government. The relationship
between money supply and the high powered money is determined by the money multiplier.
The money multiplier (m) is the ratio of total money supply (M) to the stock of high powered
money that is m = M/H. The size of money multiplier depends on the preference of the public
to hold currency relative to deposits (the ratio of currency to deposits which is denoted by K)
and banks‘ desired cash reserves ratio to deposits which is denoted by ‗r‘. Thus if there is
increase in currency held by the public which is a part of the high powered money with
demand deposits remaining unchanged there will be a direct increase in the money supply in
the economy. If currency reserves held by the banks increase, this will not change the money
supply immediately but will set in motion a process of multiple creation of demand deposits
of the public in the banks. The amount of high powered money is fixed by the Central Bank.
Thus changes in high powered money are the result of decision of the Central Bank and the
Government who own and controls it.
2. Money Multiplier. Money multiplier is the degree to which money supply is expanded
as a result of the increase in high powered money. Thus m = M/H or M = H.m. Thus moneys
supply is determined by the size of money multiplier (m) and the amount of high powered
money (H). The size of the money multiplier is determined by the currency reserve ratio ‗r‘ of
the banks (which determines deposit multiplier) and currency deposit ratio of the public (k)
which together determines the size of money multiplier.
Money Multiplier
In order to explain the determinants of money supply in an economy we shall use Mi
concept of money supply which is the most fundamental concept of money supply. We shall
denote it simply by M rather than M1. As seen above this concept of money supply is
composed of currency held by the public (Cp) and demand deposits with the banks (D). Thus
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M =CP + D.....(i)
Where
M = Total money supply with the public
Cp = Currency with the public
D = Demand deposits held by the public
The two important determinants of money supply is the amounts of high-powered
money which is also called Reserve Money by the Reserve Bank of India and (b) the size of
money multiplier. We explain below the role of these two factors in the determination of
money supply in the economy.
High-Powered Money (H):
The high-powered money which we denote by H consists of the currency (notes and
coins) issued by the Government and the Reserve Bank of India. A part of the currency
issued is held by the public, which we designate as Cp and a part is held by the banks as
reserves which we designate as R.A part of these currency reserves of the banks is held by
them in their own cash vaults and a part is deposited in the Reserve Bank of India in the
Reserve Accounts which banks hold with RBI. Accordingly, the high-powered money can be
obtained as sum of currency held by the public and the part held by the banks as reserves.
Thus
H =Cp + R ...(2)
Where
H = the amount of high-powered money
Cp = Currency held by the public R
D = Cash Reserves of currency with the banks.
It is worth noting that Reserve Bank of India and Government are producers of the
high-powered money and the commercial banks do not have any role in producing this high-
powered money (H). However, commercial banks are producers of demand deposits which are
also used as money like currency. But for producing demand deposits or credit, banks have
to keep with themselves cash reserves of currency which have been denoted by R in equation
(2) above. Since these cash reserves with the banks serve as a basis for the multiple creations
of demand deposits which constitute an important part of total money supply in the
economy, it provides high poweredness to the currency issued by Reserve Bank and
Government.
A glance at equations (1) and (2) above will reveal that the difference in the two
equations, one describing the total money supply and the other high-powered money is that
whereas in the former, demand deposits (D) are added to the currency held by the public, in
the later it is cash reserves (R) of the banks that are added to the currency held by the
public. In fact, it is against these cash reserves (R) that banks are able to create a multiple
expansion of credit or demand deposits due to which there is large expansion in money
supply in the economy.
The theory of determination of money supply is based on the supply of and demand for
high-powered money. Some economists therefore call it The H Theory of Money Supply.
However, it is more popularly called 'Money-multiplier Theory of Money Supply' because it
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explains the determination of money supply as a certain multiple of the high-powered money.
How the high-powered money (H) is related to the total money supply is graphically depicted
in Fig. 14.1. The base of this figure shows the supply of high-powered money (H), while the
top of the figure shows the total stock of money supply. It will be seen that the total stock of
money supply (that is, the top) is determined by a multiple of the high-powered money (H).
Money Supply = C p – DD
Currency (Cp ) Demand Deposits (DD)

Currency with Cash

the public Reserves
(Cp ) (R)

High Powered Money (H) = C p + R

Fig. 14.1 The High Powered Money and the Stock of total Money-Supply
It will be further seen that whereas currency held by the public (C p) uses the same
amount of high-powered money, that is, there is one-to-one relationship between currency
held by the public and the money supply. In sharp contrast to this, bank deposits (D) are a
multiple of the cash reserves (R) of the banks which are part of the supply of high-powered
money.
That is, one rupee of high-powered money kept as bank reserves gives rise to much
more amount of demand deposits. Thus, the relationship between money supply and the
high-powered money is determined by the money multiplier. The money multiplier which we
denote by m is the ratio of total money supply {M) to the stock of high-powered money, that
is, m = M/H. The size of money multiplier depends on the preference of the public to hold
currency relative to deposits, (that is, ratio of currency to deposits which we denote by K) and
banks' desired cash reserves ratio to deposits which we call r. We explain below the precise
multiplier relationship between high- powered money and the total stock of money supply. It
follows from above that if there is increase in currency held by the public which is a part of
the high powered money with demand deposits remaining unchanged, there will be a direct
increase in the money supply in the economy because this constitutes a part of the money
supply. If instead currency reserves held by the banks increase, this will not change the
money supply immediately but will set in motion a process of multiple creation of demand
deposits of the public in the banks. Although banks use these currency reserves held by the
public which constitutes a part of the high- powered money to give more loans to the
businessmen and thus create demand deposits, they do not affect either the amount of
currency or the composition of high-powered money. The amount of high-powered money is
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fixed by RBI by its past actions. Thus, changes in high-powered money are the result of
decisions of Reserve Bank of India or the Government which own and control it.
Money Multiplier:
As stated above, money multiplier is the degree to which money supply is expanded as a)
result of the increase in high-powered money. Thus
m = M/H
Rearranging we have, M = H.m.... (3)
Thus money supply is determined by the size of money multiplier (m) and the amount
of high-powered money (H). If we know the value of money multiplier we can predict how
much money will change when there is a change in the amount of high-powered money. As
mentioned above, change in the high-powered money is decided and controlled by Reserve
Bank of India, the money multiplier determines the extent to which decision by RBI regarding
the change in high-powered money will bring about change in the total money supply in the
economy.
Size of Money Multiplier:
Now, an important question is what determines the size of money multiplier. It is the
cash or currency reserve ratio r of the banks (which determines deposit multiplier) and
currency-deposit ratio of the public (which we denote by k) which together determines size of
money multiplier. We derive below the expression for the size of multiplier.
From equation (1) above, we know that total money supply (M) consists of currency
with the public (Cp) and demand deposits with the banks. Thus
M = CP + D ... (1)
The public hold the amount of currency in a certain ratio of demand deposits with the
banks. Let this currency-deposit ratio be devoted by k.
CP= kD
Substituting kD for Cp in equation (1) we have
M = kD + D = (k+l)D
Now take equation which defines high powered money (H) as
H - CP+ R ...(3)
Where R represents cash or currency reserves which banks keep as a certain ratio of
their deposits and is called cash-reserve ratio and is denoted by r. Thus
R = rD
Now substituting rD for R and kD for Cp in equation (3) we have
H = kD + rD
H = (k + r) D ...(4)
Now money multiplier is ratio of total money supply to the high powered money,
therefore we divide equation (1) by equation (4), to get the value of multiplier, which we
denote by m. Thus
M=CP + D ...(1)
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The public hold the amount of currency in a certain ratio of demand deposits with the
banks. Let this currency-deposit ratio be devoted by k,
Cp =kD
Substituting kD for Cp in equation (1) we have
M = kD + D = (k+ 1) D ...(2)
Now take equation which defines high powered money (H) as
H = CP+R ... (3)
where R represents cash or currency reserves which banks keep as a certain ratio of
their deposits and is called cash-reserve ratio and is denoted by r. Thus
R = rD
Now substituting rD for R and kD for Cp in equation (3) we have
H = kD + rD
H = (k + r)D ... (4)
Now money multiplier is ratio of total money supply to the high powered money,
therefore we divide equation (1) by equation (4), to get the value of multiplier, which we
denote by m. Thus
m = M/H = (k+1) D/(k+r)D = k+l/k+1
or, Money multiplier (m) = M/H = 1+k/r+k
or
M = H 1+k/r+k ....(4) Where
r = Cash or Currency-reserve ratio of the banks
k = Currency-deposit ratio of the public. From above it follows that money supply is
determined by the following:
1. H, that is, the amount of high powered money.
2. r, that is, cash reserve ratio of banks (i.e., ratio of currency reserves to deposits
of the banks). This cash reserve ratio of banks determines the magnitude of
deposit multiplier.
3. k, that is, currency deposit ratio of the public.
From the equation (4) expressing the determinants of money supply, it follows that
money supply will increase:
1. When the supply of high-powered money (i.e., reserve money) H increases;
2. When the currency-deposit ratio (k)3 of the public decreases; and
3. When the cash or currency reserves-deposit ratio of the banks (r) falls.
Size of the Multiplier. The money supply (M) consists of currency with the public (Cp) and
demand deposits with the banks. Thus:
M = Cp + D ……………………………………………………………………………………(1)
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The public hold the amount of currency in a certain ratio of demand deposits with the
banks which is denoted by ‗k‘. Therefore, Cp = kD Substituting kD for Cp in equation (1), we
get:
M = kD + D = (k + 1)D …… ………………………………………………………………….(2)
The equation of high powered money (H) is:
H = Cp + R ……. ……………………………………………………………………………...(3)
Where R represents cash or currency reserves which banks keep as a certain ratio of
their deposits and is called cash reserve ratio and is denoted by r. Thus R = rD Substituting
rD for R and kD for Cp in equation (3), we get:
H = kD + rD or H = (k + r)D …… …………………………………………………………….(4)
The money multiplier is a ratio of total money supply to the high powered money.
Therefore, equation (1) will be divided by equation (4) to get the value of multiplier
which is denoted by m. Thus, Or, money multiplier Or Where r= cash reserve ratio of the
banks. k = currency deposit ratio of the public. Money supply is therefore determined by the
following:
1. H or the amount of high powered money.
2. r or the cash reserve ratio of banks (i.e. ratio of currency reserves to deposits of
the banks). The CRR determines the magnitude of deposit multiplier.
3. k or the currency deposit ratio of the public.
A change in money supply will take place:
1. When the supply of high powered money (i.e. reserve money) H changes.
2. When the currency deposit ratio (k) of the public changes, and
3. When the cash or currency reserves deposit ratio of the banks (r) changes.
Cash Reserve Ratio and the Deposit Multiplier.
Changes in cash reserves with the banks bring about changes in demand deposits.
The ratio of change in total deposits to a change in reserves is called the deposit multiplier
which depends on CRR. The value of deposit multiplier is the reciprocal of CRR, dm = 1/r,
where dm stands for deposit multiplier. If CRR is 5 per cent of deposits, then dm = 1/0.05 =
20. The deposit multiplier of 20 reveals that for every Rs.100 increase in cash reserves with
the banks, there will be expansion in demand deposits of the banks by Rs.2000 assuming
that no leakage of cash to the public takes place during the process of deposit expansion by
the banks.
Currency Deposit Ratio and Multiplier.
With the increase in reserves of the banks, demand deposits and money supply do not
increase to the full extent of deposit multiplier because the public does not hold all its money
balances in the form of demand deposits with the banks. As a result of increase in cash
reserves, banks start increasing demand deposits, the people may also like to have some
more currency with them as money balances. During the process of creation of demand
deposits by banks, some currency is leaked out from the banks to the people. This drainage
of currency to the people in the real world reduces the magnitude of expansion of demand
deposit and therefore the size of money multiplier. Assuming the CRR is 10 per cent and
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cash of Rs.100 is deposited in bank ‗A‘. bank ‗A‘ will lend out Rs. 90 and therefore create
demand deposits of Rs.90 and the process will continue as the borrowers use these deposits
for payment through checks of others who deposit them in another bank B. However, if
borrower of bank A withdraw Rs.10 in cash from the bank and issue checks of the remaining
borrowed amount of Rs.80, then bank B will have only Rs.80 as new deposits instead of
Rs.90. With this new deposit of Rs.80, bank B will create 120 demand deposits of Rs.72 and
will lend out Rs.72 and keep Rs.8 as reserves with it (80 x 10/100 = 8). The leakage of
currency may occur during all the subsequent stages of deposit expansion in the banking
system. The greater the leakage of currency, the lower will be the money multiplier. Thus the
currency deposit ratio which is denoted by ‗k‘ is an important determinant of the actual
value of the money multiplier. When there is a decrease in the currency reserves with the
banks, there will be multiplier contraction in demand deposits with the banks and vice versa.
Excess Reserves The ratio ‗r‘ in the deposit multiplier is the required cash reserve ratio fixed
by the Central Bank. However, banks may keep excess reserves. Excess reserves depend on
the extent of liquidity and profitability of making investment and the rate of interest on loans
advanced to business firms. Therefore the desired reserve ratio is greater than the statutory
minimum required reserve ratio. The holding of excess reserves by the banks will therefore
reduce the value of deposit multiplier.
14.5 INSTRUMENTS OF MONETARY CONTROL
The instruments of monetary control available at the disposal of the Central Bank can
be classified into general or quantitative instruments and selective or qualitative
instruments. The general instruments are macro-economic in impact and are used to control
the volume of credit so as to control the inflationary and deflationary pressures caused by
business cycles. The general instruments consist of the bank rate policy, open market
operations and cash reserve ratio. The selective instruments of monetary policy are used to
regulate the use of credit and hence they are sectoral in impact. Selective instruments
therefore do not affect the entire economy. Selective instruments are used with an objective
to divert the flow of credit to their desirable and productive uses. The selective instruments
consist of margin requirements, regulation of consumer credit, use of directives, credit
rationing, moral suasion and publicity and direct action.
Quantitative or General Instruments of Monetary Control
1. Bank Rate or the Discount Rate Policy. Bank rate or the discount rate is the interest
rate charged on borrowings made by the commercial banks from the Central Bank. The
Central Bank provides financial assistance to the commercial banks by discounting eligible
bills, loans and approved securities. The objective of the bank rate policy is to influence the
cost and availability of credit to the commercial banks and the borrowers at large in turn.
The cost of credit is determined by the discount rate or the interest rate charged and the
availability of the credit is determined by the legal requirements of making the bills eligible
and the duration of the loan. When the Central Bank changes the bank rate, the interest
rates in the economy also changes. Changes in the bank rate can therefore make credit
cheaper or dearer and also influence the demand for and supply of credit. A rise in bank rate
will result in a rise in the deposit and lending rates of banks and vice versa. A fall in the
bank rate signals an expansionary monetary policy whereas a rise in the bank rate signals
contractionary monetary policy. The efficacy of the bank rate policy of the Central Bank is
influenced by factors such as the development of the money market, liquidity of the banks,
business cycles, development of the bill market and the elasticity of the economic system. If
the money market where short term loans are made available is not well organized or well
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developed and consist of different rates of interest, he bank rate policy will not be effective in
influencing the varied interest rates and hence realize the objective of making a change in the
bank rate. Similarly, if the commercial banks do not approach the Central Bank for
rediscounting facility on account of surplus liquid funds, the bank rate will fail to influence
the market interest rates. Further, in order to obtain the rediscounting facility, the
commercial banks must have sufficient quantity of eligible bills and securities. In the
absence of well developed bill market, the bank rate policy will not have the desired effect on
the money market interest rates. In the prosperity and recessionary phases of business
cycles, investment demand is interest inelastic and hence changes in the bank rate will fail to
influence investment demand. During the prosperity phase when the prices are gradually
rising, profitability of investment also rises. Thus as long as the rate of return on investment
is sufficiently greater than the market interest rates, investment demand will continue to
rise. Similarly, during a recession, when prices are falling even if the bank rate falls leading
to fall in the market interest rates, investment demand will not pick up because of the poor
prospects of making profits. Finally, changes in the bank rate must influence interest rates,
prices, costs and trade. The economic system should be sufficiently elastic and respond to
the changes in the bank rate. Systemic rigidities will not create the desired impact.
2. Open Market Operations. Open market operations refer to buying and selling of
government securities in the open market. By doing so, the Central Bank can increase or
decrease bank reserves. When the Central Bank sells government securities in the open
market, the bank reserves fall to the extent of the sale multiplied by the reverse credit
multiplier and vice versa. The open market operation is an important instrument of
stabilization in the general price level in the hands of the Central Bank. The Central Bank
decides on its monetary policy options given the macro-economic conditions. In an
inflationary situation, with a view to control prices, the Central Bank will decide to sell
government securities i.e., treasury bills which are short term government securities and
long term bonds. By doing so, the Central Bank will reduce the bank reserves and thereby
money supply will also be reduced. As a result, the interest rates in the money market will
firm up, reducing investment demand. Reduction in investment demand will reduce
employment, output and incomes thus reducing the level of aggregate demand in the
economy. A reduction in the aggregate demand will help controlling the price rise. Selling
government securities through the open market operation indicates a tight or dear monetary
policy. A cheap monetary policy will operate exactly in the opposite direction when the
Central Bank starts buying government securities in a recessionary situation.
Let us see, how exactly open market transactions in government securities takes place
when the Central Bank decides on a tight monetary policy. The Central Bank sells
government bonds or securities to dealers in the open market. The dealers in turn, resell
them to commercial banks, corporates, financial institutions and individuals. The purchases
generally buy government securities by drawing a check in favor of the Central Bank. For
instance, if the Reserve Bank of India sells Rs.10 million worth of treasury bills to Ms.
Kareena, she will draw a check on State Bank of India where she has a bank account in favor
of the Reserve Bank of India. The Reserve Bank of India in turn will present the check at the
State Bank of India and when the State Bank of India pays the check, it will reduce its
balance with the Reserve Bank of India by Rs.10 million. By the end of the day, the State
Bank of India and the entire commercial banking system will lose Rs.10 million worth of
reserves at the Reserve Bank of India. Assuming a cash reserve ratio of ten per cent, the
Rs.10 million sale of government bonds will reduce money supply in the economy by Rs.100
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million; the reverse credit multiplier being ten. This is how the money supply contracts to the
extent of the sale multiplied by the reverse credit multiplier.
The success of Open Market Operation depends upon a number of factors such as
development of the securities 123 market, the rediscounting window available at the Central
bank, risk-bearing ability of the Central bank, balance of payments, flow of capital,
speculative activities etc. Nonetheless, open market operations are known to be more effective
in controlling credit.
3. Cash Reserve Ratio.
The Cash Reserve Ratio or the legal reserve requirements are an important part of the
mechanism by which the Central bank controls the supply of bank money. The commercial
banks are required to maintain a certain minimum amount of non-interest bearing reserves
out of its deposits with the Central bank. The cash reserve requirements are fixed by law
land the Central bank has the statutory powers to change the reserve requirements. In India,
the Reserve Bank of India Amendment Act, 1962 fixed reserve requirements at three per cent
for all the liabilities of the Commercial banks. The Amendment Act also gave powers to the
Reserve bank of India to determine reserve requirements in the range of three per cent and
15 per cent. The Central Bank maintains a higher reserve ratio in order to control money
supply and facilitate the smooth conduct of Open market Operations. The reserve
requirements above the level that banks desire and thereby control the short term interest
rates more effectively.
The Central bank can change cash reserve requirements in order to change the
quantity of money supply. Under inflationary conditions, the Central bank may follow a dear
money policy and may raise the reserve requirements within the given range of three per cent
to fifteen per cent. Let6 us see with an example how changes in the reserve requirements
brings about changes in the credit creating capacity of the commercial banks. Assume that
the total deposits with the commercial banks are equal to Rs.1000 billion and the Cash
Reserve Ratio is five per cent. The commercial banks will have to maintain Rs.50 billion
worth reserves with the Central Bank. The excess reserves with the commercial banks being
Rs.950 billion, the banking system will be able to create credit twenty times its excess
reserves i.e. Rs.950 × 100 ÷ 5 = Rs.19 Trillion. Pursuing a tight or dear monetary policy, if
the Central bank decides to raise the reserve requirements to ten per cent, then the excess
reserves will be Rs.900 billion and the banking system will be able to create only ten times its
excess reserves i.e. Rs.9000 billion. Thus when the reserve requirements are raised, the
credit creating capacity is reduced and vice-versa. However, in reality, the increase and
decrease in reserve requirements is never made on a scale as stated above because such
large changes will lead to steep fall or rise in the interest rates. For instance, a steep hike in
the Cash Reserve Ratio will lead to very high interest rates, credit rationing, huge decline in
investment and large reduction in national income and employment. Changes in the reserve
requirements are made incrementally or marginally and in a phased manner i.e. if the
current reserve requirement is 10 per cent, with tight monetary policy, the reserve
requirement may be raised to 11 per cent and thereafter with a gap, it may be raised by one
more percentage point to 12 per cent. Similarly, a cheap monetary policy would entail a
marginal and phased reduction in the Cash Reserve Ratio.
Selective or Qualitative Instruments of Monetary Policy.
The selective instruments of monetary control are invoked to influence the use and
volume of credit available for particular purposes in specific sectors of the economy. Selective
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instruments are used to discriminate between various uses of credit in the various sectors so
that the available credit in the various sectors is put it its most desirable land productive
use. Margin requirements, consumer credit regulation, directives, credit rationing, moral
suasion and direct action are the different selective or qualitative or specific instruments of
monetary policy. These instruments are as follows.
1. Margin Requirements. Margin requirement determines the loan value of a collateral
security offered by the borrower. The loan value of a security is the difference between the
market value and the margin requirement. For instance, if the market value of 10 grams of
gold is Rs.12000 and the margin requirement is 25 per cent then the loan value of 10 grams
of gold as a collateral security would be Rs.9000. Equity shares, bonds, precious metals and
other financial land real assets are accepted by commercial land co-operative banks as
collaterals for granting loans. The Central Bank which is the apex monetary authority in a
country has the power to determine margin requirements. Increase or decrease in the margin
requirements changes the loan value of a security. Margin requirements are fixed differently
for various types of securities. For instance in India margin requirements for equity shares is
50 per cent of the market value and for commodities it various between 20 per cent and 75
per cent. Margin requirements therefore directly influence the demand for credit without
affecting the supply of loans or the rate of interest. It is a very instrument used to control
speculative activities both in the commodity market as well as money and the capital
markets. For instance, the Reserve Bank of India has greatly used the instrument of margin
requirement to check the hoarding of essential commodities and their price rise.
2. Regulation of Consumer Credit. A number of consumer durable goods such as
television sets, washing machines, refrigerators, computers, furniture, cars etc are available
on credit repayable in equated monthly installments. Consumer credit is regulated by the
Central Bank by determining the maximum period of payment i.e. the maximum equated
monthly installments and the minimum down payment. In order to check consumer credit,
the Central bank may increase the minimum down payment and reduce the maximum period
of payment by reducing the number of equated monthly installment. By doing so, the Central
bank not only increases the size of the initial payment which is known as the minimum down
payment but also the size of the installment. Such an action by the Central bank reduces the
demand for consumer credit and thus regulates it.
3. Issue of Directives. The Central bank may direct the Commercial Banks orally or by a
written order to control the direction and volume of credit so that the credit policy followed by
the commercial banks is in harmony with the monetary policy objectives of the Central bank.
However, issue of directives may not be effective and hence more direct instruments of
monetary policy are put into effect along with the directives.
4. Credit Rationing. Credit rationing is a qualitative instrument used to control and regulate
the purpose for which credit is offered by the commercial banks. Credit rationing is carried
out in two forms, namely; the variable portfolio ceiling and the variable capital assets ratio.
The variable portfolio ceiling refers to a ceiling imposed by the Central bank on the total
portfolios of the commercial banks. The ceiling is imposed to ensure that loans and advances
do not exceed the given ceiling. Since the Central bank has the right to change the ceiling, it
is called variable portfolio ceiling. Similarly, the Central Bank may also decide the capital
assets ratio of commercial banks. These measures restrict the loans and advances made to
different categories of borrowers in the economy.
5. Moral Suasion and Publicity. Moral suasion refers to formal persuasion and request
made by the Central Bank to the commercial banks. As opposed to directives, it is an appeal
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made by the Central Bank to the moral consciousness of the commercial banks to operate
according to the objectives of the monetary policy. For instance, the Central bank may
request the commercial banks to desist from financing speculative activities. It is a
psychological instrument of monetary policy. The Central bank may also exert moral
pressure on the commercial banks by going public on the unhealthy banking practices. The
Reserve bank of India had used moral suasion for the first time in September, 1949 by
requesting the commercial banks to exercise restraint in giving advances for speculative
purposes.
6. Direct Action. Direct action is a qualitative as well as a quantitative instrument of
monetary policy. The Central Bank may stop rediscounting facility to those commercial
banks whose credit policy is at divergence with its monetary policy. It may refuse to give
more credit to banks where borrowings are in excess of their capital and reserves. It may
charge a higher rate of interest for the credit demanded by commercial banks beyond a
certain limit.
14.6 SUMMARY
1. Money supply refers to the amount of money which is in circulation in an
economy at any given time. It is the total stock of money held by the people
consisting of individuals, firms, State and its constituent bodies except the
State treasury, Central Bank and Commercial Banks.
2. There are two approaches to the constituents of money supply. They are the
traditional and the modern approaches.
3. The third working group of RBI on money supply recommended the M0, M1, M2
and M3 measures of monetary aggregates.
4. In addition to the monetary measures stated above, the following liquidity
aggregates to be compiled on monthly basis were also recommended by the
working group as L1, L2 and L3.
5. The instruments of monetary control available at the disposal of the Central
Bank can be classified into general or quantitative instruments and selective or
qualitative instruments. The general instruments consist of the bank rate
policy, open market operations and cash reserve ratio. The selective
instruments consist of margin requirements, regulation of consumer credit, use
of directives, credit rationing, moral suasion and publicity and direct action.
14.7 GLOSSARY
 Cash Reserve Ratio or the legal reserve requirements are an important part of the
mechanism by which the Central bank controls the supply of bank money
 Currency: The sum of outstanding paper money and coins.
 Selective instruments of monetary control are invoked to influence the use and
volume of credit available for particular purposes in specific sectors of the economy
14.8 REFERENCES
 N. Gregory Mankiw (2010). Macroeconomics. 7th Edition. Worth Publications
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics, Pergamon Press Oxford
 Ackley, G. (1986). Macroeconomic, Macmillan Library Reference.
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 Shapiro, E. (1978). Macroeconomic analysis. Fourth edition 2009. Galgotia

Publications Pvt. Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
14.9 FURTHER READINGS
 Shapiro, E. (1978). Macroeconomic analysis. Fourth edition 2009. Galgotia
Publications Pvt. Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy. Third edition. Harper
Collins.
14.10 MODEL QUESTIONS
1. What is money supply and explain the constituents of money supply.
2. Explain the RBI‘s approach to the measurement of money supply in India.
3. Explain the determinants of money supply.
4. Explain the instruments of monetary control.
5. Explain the quantitative instruments of monetary control.
6. Explain the qualitative or selective instruments of monetary control.
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Lesson - 15

DEMAND FOR MONEY -I

Structure
15.0 Objectives
15.1 Introduction
15.2 Classical Approach
15.3 Neo Classical Approach
15.3.1 Keynes’s version of quantity theory of money
15.3.2 The transmission mechanism process
15.4 Keynesian Approach
15.5 Friedman’s Approach to Demand For Money
15.6 Tobin‘s Portfolio Approach to Demand for Money
15.7 Baumol‘s Inventory Approach to Transactions Demand for Money
15.8 Summary
15.9 Glossary
15.10 References
15.11 Further Readings
15.12 Model Questions
15.0 OBJECTIVES
After going through the chapter you shall be able to –
 discuss classical approach to demand for money
 confer about Neo classical approach to demand for money
 consider Keynesian approach to demand for money
 deliberate about Tobin‘s portfolio approach to demand for money
 describe Baumol‘s Inventory approach to demand for money
 explain the Friedman‘s approach to demand for money
15.1 INTRODUCTION
We mostly come across the question as to why do people demand money? One reason
people demand money is because in an economy, persons as well as firms sell goods and
services (Including factor services) in the market for money and use money in turn to buy the
goods and services offered by others. Functionally, this amounts to the use of money as a
medium of exchange. You will come to know after going through the lesson that in the
Keynesian Theory, money becomes much more than a medium of exchange, much more than
a device for mediating transactions in the market place. People also demand money for
speculative purposes and as a security against unforeseen circumstances. The breakdown of
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the demand for money into transactions, precautionary and speculative demand play a vital
part in this theory advanced by Keynes to explain the interest rate. Thus, there are three
principal approaches to the demand for money, namely the Classical Approach, the
Keynesian Approach and the Post-Keynesian or Modern Approach. We shall now discuss
each approach in turn beginning with the classical explanation of the demand for money.
15.2 CLASSICAL APPROACH TO DEMAND FOR MONEY
The classical approach to demand for money is known in the name of Prof. Irving Fisher‘s
Cash Transaction approach. Prof. Irving Fisher‘s famous cash transaction equation is stated
below:
MV = PT
Where;
M = Stock of money
V = Velocity of circulation
P = Price level
T = Volume of transactions
By manipulating the equation MV = PT, the money demand function can be derived as stated
below:
Md = PT/V
Here, Md = Demand for money.
The demand for money is the product of the volume of transactions overtime and the
average price level divided by the average velocity of circulation of money. The money demand
equation can be restated as follows:
Md = 1/V PT
Assuming the values of P as Rs.10 per unit of transaction, T as 400,000 Units and V
as 8 and substituting these values in the above equations, the demand for money can be
obtained as follows
Md = 10 × 400,000/ 8 = Rs.500000.
Assuming that T and V remains constant in the short period, proportionate change in
the demand for money will be equal to proportionate change in the price level i.e. demand for
money will directly change with the change in price level. According to Irving Fisher, in the
short period, changes in the price level are directly related to the changes in money supply.
He defines money supply as
Ms = PT and Md = PT, it can be said that
Md = Ms.
Thus according to Fisher, the demand for money is always equal to the supply of
money. In the Fisherian equation, the demand for money is a proportion of the total value of
transactions i.e. 1/V = K or M = KPT.
In this equation, K = is the proportion of total value of transactions held by the people
in the form of money. It is the inverse of velocity ‗V‘. Assuming that the velocity of circulation
of money is 5 then the demand for money is 1/5 or 20 per cent of PT. If PT = Rs.40 lakhs,
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demand for money would be Rs.8 lakhs and if PT increases by 50 per cent to Rs.60 lakhs,
demand for money would be Rs.12 lakhs. Fig. 1 shows the Fisherian demand for money
function. The slope of the Md curve measures K or 1/V. Since K is assumed to be constant,
the money demand curve is a linear positively sloping straight line. It indicates a direct
proportionate relationship between demand for money and PT.
15.3 CAMBRIDGE APPROACH OR THE NEO-CLASSICAL APPROACH TO
DEMAND FOR MONEY.
The Cambridge approach or the Cash balance approach to the demand for money was
put forward by the Cambridge economists Marshall and Pigou. Both Marshall and Pigou are
considered neo-classical economists. These economists emphasized the store of value
function of money as against the medium of exchange function of money emphasized by
Fisher. According to the neo-classical economists, demand for money is the amount of money
people want to hold or the cash balances held by the people. The total demand for money is
the sum of individuals desire to hold cash balances in the community. The amount of cash
balances held by the people in any given period of time is determined by the following factors:
1. Current price level and expected changes.
2. Current interest rate and expected changes.
3. Wealth owned by individuals.
The neo-classical economists believed that these factors remain constant in the short
run. The neo-classical money-demand function can be stated as follows :
Md = KPY
Where; Md = Demand for money.
K = Proportion of national income held in the form of cash balances by
the people.
PY = Nominal national income.
15.3.1 Keynes’s version of quantity theory of money
Keynes’ great merit lies in removing the old fallacy that prices are directly determined
by the quantity of money. His theory of money and prices brings forth the truth that prices
are determined primarily by the cost of production. Keynes does not agree with the old
analysis which establishes a direct causal relationship between the quantity of money and
the level of prices. He believes that changes in the quantity of money do not affect the price
level (value of money) directly but indirectly through other elements like the rate of interest,
the level of investment, income, output and employment. The initial impact of the changes in
the total quantity of money falls on the rate of interest rather than on prices. As the quantity
of money is increased (other things remaining the same), the rate of interest is lowered
because the quantity of money available to satisfy speculative motive increases. A lowering of
the rate of interest (marginal efficiency of capital remaining the same) will raise investment,
which in turn, will result in an increase of income, output, employment and prices. The
prices rise on account of various factors like the rise in labour costs, bottlenecks in
production, etc. Thus, in Keynes’ version the level of prices is affected indirectly as a result of
the effects of the changes in the quantity of money on the rate of interest and hence
investment. It is on account of this reason that Keynes analysis is, at times, spoken of as the
‘contra-quantity theory of causation’ because it takes rise in prices as a cause of the increase
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in the quantity of money instead of taking the increase in the quantity of money as a cause of
the rise in prices.
15.3.2 The transmission mechanism process that follows in Keynes is like this:
Increases in the quantity of money → result in a fall in the rate of interest → which
encourages investment → which in turn, raises income, output and employment → it results
in raising the cost of production → this results in raising prices. The traditional theory
ignored the influence of the quantity of money on the rate of interest, and thereby on output
and goes directly from increase in the quantity of money to increase in the level of prices.
Therein lay the fault of its analysis. Keynes, thus, removed the classical dichotomy in the
traditional money-price relationship by rejecting the direct relationship between M and P. He
asserted that the relationship between M and P is indirect and that the theories of money
and prices can be integrated through the theory of aggregate demand or the theory of output.
The missing link between the real and monetary theories, according to Keynes, is the rate of
interest. The mechanism of the rate of interest will work as shown above, which will increase
investment and through multiplier ultimate income. The increase in aggregate demand for
commodities and a higher push given to wages and costs will raise firstly the relative prices
and then the general price level. The process of integration between M and P and the extent
by which P will change, as a result of a given change in M, can be shown through a general
theoretical model based on money supply (M), general price level (P), the aggregate demand
(D), the level of income or output (Y or O), the level of employment (N) and the level of money
wages (W). These relationships can be expressed through elasticity coefficients. The ratio of a
proportionate change in P to the proportionate change in M is shown by the elasticity of price
level (e). The change in aggregate demand (D) to a given change in M is the elasticity of
aggregate demand (ed). The change in Y or O in response to a change in AD may be expressed
as elasticity of income or output (e y or eo). The change in price level, as a result of a given
change in AD, is denoted by elasticity of price (e p). The response of Y or O to an increase in
employment (N) is shown by the elasticity of returns (e r) and the response of money wages as
a result of an increase in employment is the elasticity of money wages (e w).
In the classical version of the quantity theory of money, which is based on the
assumption of full employment and where money is only a medium of exchange, the elasticity
of price level (e) and ed remain equal to unity. The elasticity of output (e 0) is zero and as a
consequence the elasticity of price (e p) must be equal to unity. Since e 0 + ep = 1 (unity), the
price level, in this case rises in exact proportion to the quantity of money. In Keynes’ version,
e = 0, prior to full employment and e = 1, or unity, once the full employment level is attained.
In the former case (less than full employment) e d – unity and er will also be equal to unity on
the presumption that production is governed by the law of constant returns, but e r is
determined by ew. Before full employment money wages are assumed to be constant,
therefore, ew will be equal to zero. Assuming other factor prices also as constant, e r will be
equal to unity. If er is unity, then, e0 will also be unity. If elasticity of output (e 0) is equal to
unity, then ep, must be equal to zero. Thus, the reformulated quantity theory of money
suggests that the price level will remain constant so long as there are unemployed resources
in the economy. Keynes, however, does not subscribe to the view that the price level will be
constant before full employment, though the rise in price level may be less than
proportionate. Because there is a possibility of money wages rising before full employment,
ew is greater than zero; ew > 0 brings, in turn, the operation of the law of diminishing returns,
so that er < 1 (unity) and, therefore, eo will also be less than unity. The elasticity of aggregate
demand (ed) is equal to the sum of eo and ev (ed = eo + ep). This shows that the determination
of the magnitude of ed is very complex matter depending upon a number of variables like LP,
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MEC etc. Since a part of the money is likely to be held by speculators as idle balances, e<i is
likely to be less than unity; e p will be greater than zero because ew > 0 and er < unity. Thus, it
is clear that the price level will start rising even before the full employment level is attained.
Keynes’ analysis also shows that there is no direct or proportionate relation between M and
P, in his analysis, the monetary and the real factors in the economy stand fully integrated.
15.4 KEYNESIAN APPROACH TO DEMAND FOR MONEY
Keynes put forward his theory of demand for money in his famous work ―The General
Theory of Employment, Interest and Money (1936). According to Keynes, people hold cash
balances on account of three reasons or motives. These are the transaction motive, the
precautionary motive and the speculative motive. Accordingly the demand for money can be
separated into three parts namely transaction demand, precautionary demand and
speculative demand for money. The total demand for money or cash balances can be divided
into two namely; active and idle cash balances.
Active Cash Balances.
Demand for active cash balances is divided into transaction and precautionary
demand for money. The transaction demand for money arises due to the fact that money is
a medium of exchange. Further receipts and payments do not take place simultaneously.
There is always a time gap between two successive receipts and payments are an ongoing
affair in the routine course. Hence people need to hold cash balances to pay for their regular
transactions. According to Keynes, transaction motive for holding money is the need of cash
for the current transactions of personal and business expenditure. Therefore, households
and firms hold money on account of the transaction motive. Their respective transactions
motives can be referred to as income and business motives. The income motive refers to the
transaction motive of households. Families hold cash balances to execute routine
transactions. Household demand for money depends upon the following factors:
1. The Level of Income. Transaction demand for money by the households is directly
related to the level of income, i.e. higher the level of income, higher will be the
transaction demand for money and vice versa.
2. The Price Level. Higher the price level, higher will be the transaction demand for
money and vice versa. When prices rise, more money will be required to purchase the
same quantity of goods and services and hence the transaction demand for money
would rise when prices rise.
3. The Spending Habits. If the people in a society are thrifty, they would require less
money for transactions purposes. However, if large number of persons in a society is
spendthrift, they would require more money for transaction purposes.
4. The Time Interval. If the time interval between two successive income receipts is big,
then the people will hold larger cash balances under transaction motive and vice
versa.
Similarly, firms need cash balances to pay for raw materials, transport, wages and
salaries and other payments. Cash balance held by firms to satisfy these requirements is the
money held under business motive. The quantum of money held under business motive is
directly related to the turnover of firms i.e. larger the turnover, larger will be the amount of
money held under business motive. Transactions demand for money is therefore the sum of
money held under income motive and business motive. It is income determined and remains
stable in the short run because income change takes place only in the long run. Transactions
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demand for money is an increasing function of income. Symbolically, the transactions

demand for money function can be stated as follows:-
Lt = f (Y)
Where; Lt = Liquidity preference under transactions motive.
Y = Level of national income.
People also hold cash balances to provide for unforeseen requirements. The amount of
cash balances held by people to provide for unforeseen requirements is referred to as
precautionary demand for money or money held under precautionary motive.
Sickness, unemployment, death, accidents etc are some of the unforeseen events
which may take place in the lives of people. The precautionary demand for money depends
upon uncertainty of future receipts. It is directly related to income and relatively stable. The
precautionary demand for money is interest inelastic and changes in response to changes in
uncertainty. Symbolically, the precautionary demand for money can be stated as follows:
Lp = f (Y),
where; Lp = Liquidity preference under precautionary motive. The transaction and
precautionary demand for money cannot be easily separated in practice and since both the
money demand functions are income determined and also interest inelastic, they are
collectively known as active balances. Symbolically, the demand for active balances can be
stated as follows:
L1 = Lt + Lp
Both transaction and precautionary demand for money is income determined, we can
restate the money demand function for active balances as follows:
L1 = f (Y).
The demand for active balances is graphically depicted in Fig. 15.2 below. You will
notice that at income level OY1, OM1 is the demand for active cash balances. When income
level rises to OY2, the demand for active cash balances also rises to OM2. The demand for
active cash balances is proportionate to changes in income.

Fig. 15.1
Idle Cash Balances (Speculative Demand for Money).
The cash balances held by people for speculative purposes are known as demand for
idle cash balances. The speculative motive for holding cash balances originates from
uncertainty about the future rate of interest. Speculative demand for money arises because
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of the store of value function of money. The speculator holds cash balances in order to make
speculative gains from investment in securities. According to Keynes, investors make capital
gains by speculating in securities or bonds. The speculative demand for money depends upon
the rate of interest. The demand for speculative cash balances is inversely related to the rate
of interest. When people expect the prices of income yielding assets such as bonds to fall, the
speculative demand for money rises and vice versa. Symbolically, the speculative demand for
money can be stated as follows
L2 = f (i)
Where L2 = Speculative demand for money.
i = Rate of interest.
The opposite relationship between rate of interest and speculative demand for money
is shown in Fig.15.3 below.

Fig. 15.2
You will notice that the speculative demand for money is inversely related to the rate
of interest. When the rate of interest falls, the speculative demand for money rises and vice
versa. Speculative demand for money is therefore highly interest elastic. However, at a very
low interest rate, the speculative demand for money becomes perfectly elastic i.e., the entire
income is held in the form of idle cash balances. This is due to the fact that bond prices and
interest rates move in opposite directions. When the interest rate rises, the bond or security
prices fall and vice versa. The speculative demand for money is also income determining and
not income determined as in the case of transaction and precautionary demand for money.
When the interest rate is expected to rise, people prefer to hold cash balances at the current
interest rate so that they can take advantage of a rise in interest rate in the future. When
speculative demand for money is rising, it indicates a greater preference for liquidity.
The Concept of Liquidity Trap At a very low rate of interest, the speculative demand for
money is perfectly elastic i.e., the entire income is held by people in the form of cash
balances for speculative purposes. In the situation of liquidity trap, percentage change in the
demand for money in response to a percentage change in the rate of interest is equal to
infinity. Symbolically, the liquidity trap situation can be stated as follows: M i M i You will
notice that the L2 curve in Fig.7.2 shows the liquidity preference under the speculative
motive at different rates of interest. At a very high interest rate of 20%, the speculative
demand for money is very low and vice versa. However, when the interest rate is only 2%, the
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speculative demand for money becomes perfectly elastic. At this point, any increase in money
supply or income will be held by the people in the form of idle cash balances. In the diagram,
the liquidity trap situation is shown by highlighting the horizontal segment of the liquidity
preference curve. The liquidity trap situation arises because at very low rate of interest, the
opportunity cost of holding cash balances is negligible and that in future the opportunity cost
of holding cash balances is expected to rise.
Aggregate Demand for Money.
The aggregate or total demand for money is the sum of transaction, precautionary and
speculative demands for money. Symbolically, the aggregate demand for money can be stated
as follows:
L = L1+L2
Where; L = Aggregate demand for money.
The functional relationship between aggregate demand for money and the determining
variables nominal level of aggregate income and the rate of interest can be stated as follows:
L = f (Y, i)
The liquidity preference schedule of a community can be obtained by superimposing
the L1 curves at each level of income on the L2 curves. The liquidity preference schedule of a
community is shown in Fig.4 below. In Fig.4, Panel (A) shows the schedule of active balances
(the sum of transaction and precautionary demand for money) held by people at different
levels of income. The demand for active balances is perfectly inelastic to changes in interest
rate in the short run and changes proportionately to the changes in the level of income.
Accordingly, L1 (Y1) shows the demand for active cash balances at Y1 level of income and so
on and so forth. The L1 curves are vertically sloping because they are interest-inelastic. In
Panel (B), the L2 curves demand for idle cash balances or speculative demand for money. You
will recall that speculative demand for money is interest-elastic and inversely related to the
rate of interest. Hence the L2 curve is downward sloping. However, at a very low rate of
interest, it becomes horizontal indicating that the entire income is held in the form of idle
cash balances. In Panel (C), the liquidity preference curve indicating total demand for money
is shown. It is the result of super-imposition of the L1 curves on the L2 curves. Accordingly,
the curves L(Y1), L(Y2) and L(Y3) are obtained and they represent the liquidity preference
schedules of the community at various levels of interest rates and national income.

Fig. 15.3
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15.5 FRIEDMAN’S APPROACH TO DEMAND FOR MONEY

Milton Friedman restated the quantity theory of money and prices and put forward his
new money demand function. According to Friedman, the money demand function is the
most stable function. Money is an asset in which a part of the wealth can be kept by wealth
holders. For firms, money is a capital good which when combined with other factors of
production leads to the production of goods and services. According to Friedman, people hold
money because it has the power to purchase goods and services. Demand for money is
demand for capital assets because money also provides services and returns. The return on
monetary wealth is the quantity of goods and services that can be purchased at a given price
level. Bonds are also monetary assets in which people can hold their wealth and obtain
annualized fixed interest income. The returns on bonds is the sum of the coupon rate of
interest and the anticipated capital gains or losses due to expected change in the market
rates of interest. The public may also hold wealth in the form of equity shares and obtain
returns in the form of dividend and capital gains or losses. Friedman considered that wealth
can be held by people in the form of capital and durable consumer goods. But these goods
provide returns in kind and not in cash along with returns in the form of expected rate of
change in their prices per unit of time. Milton Friedman‘s nominal money demand function
can be stated as follows: Md = f (W, h, rm, rb, re, P, P, U) P
The demand for real money balances can be obtained by dividing nominal money
demand by the price level and this can be stated as follows:
Md = f (W, h, rm, rb, re, P, P/P, U)
Where;
Md = Nominal money demand,
Md = Demand for real money balances.
W = Wealth of the individual.
h = Proportion of human wealth to the total wealth held by the people.
rm = Interest income from money holdings.
rb = Interest rate on bonds.
re = Rate of return on equity shares.
P = Price level.
P/P = Change in the price level, and
U = Institutional factors.
According to Milton Friedman, the following factors determine the demand for money:
1. Wealth (W). Wealth is the major factor determining the demand for money. Both
human and non-human wealth is included in the concept of wealth by Friedman. Bonds,
equity shares and money are examples of non-human wealth and human capital is a form of
human wealth. Human wealth refers to the value of an individual‘s present and future
earnings and it represents the non-liquid component of wealth and hence the proportion of
human wealth to non-human wealth is included in the money demand function as an
independent variable. The demand for money is a direct function of individual‘s total wealth
and total wealth sets the upper limit of holding money by an individual. Since human wealth
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is non-liquid in nature, the demand for money will rise with the rise in proportion of human
wealth to non-human wealth.
2. Rates of Return ( rm, rb, re ). These three rates of return determine the demand for
money. The rate of interest on money held in the form of savings and fixed deposits is
denoted by (rb). The demand for money is a direct function of the rate of interest on money
given the other rates of interest i.e., higher the rate of interest on money, higher will be the
demand for money. The opportunity cost of holding money is the interest forgone by not
holding other assets such as bonds and equities. When the rates of return on bonds and
equities rise, the opportunity cost of holding money will rise and the demand for money
holdings will fall. Thus the demand for money is inversely related to the rate of interest on
bonds, equities and other non-monetary assets.
3. Price Level (P). Higher the price level, higher will be the demand for nominal money
balances and vice versa. If income (Y) is used as a proxy for wealth (W), then nominal money
income is given by Y/P which becomes an important determinant of money. Here ‗Y‘ stands
for real income and ‘P‘ stands for price level.
4. The Expected rate of Inflation (P/P)
Higher the rate of inflation, lower will be the demand for money holdings because inflation
reduces the value of money balances in terms of purchasing power. If the rate of inflation is
greater than the nominal rate of interest, the return on money holdings will be negative.
Hence, when people expect a higher rate of inflation, they will convert money holdings into
goods or other assets which are not affected by inflation.
5. Institutional Factors (U). Pattern of wage payments and bill payments are some of
the institutional factors which affect the demand for money. Further, if people expect an
impending recession or war, the demand for money balances will increase. Instability in
capital markets will also raise the demand for money. Political instability also influences the
demand for money. All these factors have been accounted for as institutional factors and
included in the variable `U’ by Friedman in his money demand function.
15.6 TOBIN’S PORTFOLIO APPROACH TO DEMAND FOR MONEY
James Tobin, an American economist in his work ―Liquidity Preference as Behavior
Towards Risk, Review of Economic Studies Vol.25 (1958) explained that rational behavior of
individuals is that they should keep a portfolio of assets which consists of both bonds and
money. He assumes that people prefer more wealth to less. An investor needs to decide as to
what proportion of his portfolio of financial assets he should keep in the form of liquid money
or non-interest bearing assets and interest bearing assets. The portfolio of individuals may
also include risk prone assets such as shares. Given the risk profile of various assets,
investors may diversify their portfolio by holding a balanced combination of safe and risk
prone assets. Investors show risk aversion i.e. they prefer less risk to more risk at a given
rate of return. According to Tobin, investors are uncertain about the future rate of interest. If
an investor chooses to hold a greater proportion of risk prone assets such as bonds in his
portfolio, he will be a earning a high average return but will bear a higher degree of risk.
According to Tobin, a risk averse- investor will not opt for risk laden portfolio consisting of
only bonds. In contrast, an investor who holds only safe and risk free assets such as liquid
money and bank demand deposits, he will be taking zero risk but will also receive very low or
no return and hence there will be no growth in his wealth. Thus, investors prefer a diversified
portfolio of money, bonds and shares with the proportion of each component determined by
the investor‘s risk profile.
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Tobin’s Liquidity Preference Function.

Tobin obtained his liquidity preference function by showing the relationship between
the rate of interest and demand for money. Tobin argued that with the increase in the rate of
interest, wealth holders will be attracted to hold a greater fraction of their wealth in bonds
and thus reduce their holding of money. Thus at a higher rate of interest, the demand for
holding liquid money will be less and investors will be holding more bonds in their portfolio.
In contrast, at a lower rate of interest, investors will hold more liquid money and less of
bonds in their portfolio. The demand function for money as an asset slopes downwards as
shown in the following figure where the demand for money is depicted on the horizontal axis.
This downward sloping liquidity preference function curve shows that the asset demand for
money in the portfolio increases as the rate of interest on bonds falls. Tobin derives the
aggregate liquidity preference curve by determining the effects of changes in interest rate on
the asset demand for money in the portfolio of investors. Tobins‘s liquidity preference theory
has been found to be true by empirical studies conducted to measure interest elasticity of the
demand for money. Empirical studies show that aggregate liquidity preference curve is
negatively sloped which means that most of the people in the economy have liquidity
preference function similar to the one shown in the following figure 15.4.

Fig. 15.4
15.7 BAUMOL’S INVENTORY APPROACH TO TRANSACTIONS DEMAND FOR
MONEY.
According to Baumol, the transaction demand for money is similar to the inventory
management of goods and materials by business firms. As businessmen keep inventories of
goods and materials to facilitate transactions in the context of changes in demand for them,
individuals also hold inventory of money because this facilitates transactions of goods and
services. However, there is a cost involved in holding inventories of goods and hence there is
a need for keeping optimal inventory of goods to reduce cost. In the same manner,
individuals have to keep optimum inventory of money for transaction purposes because they
incur cost when they hold inventories of money for transaction purposes. The interest income
foregone is the cost of holding money for transactions purposes. Baumol says that
transaction demand for money is not interest elastic.
Saving deposits in banks are relatively free from risk and yield some interest. However,
people hold money i.e. currency and demand deposits for convenience and for effecting their
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transactions. People hold money for transaction purposes to bridge the gap between the
receipt of income and its spending. As interest rate on saving deposits goes up people will
tend to shift a part of their money holdings to the interest bearing saving deposits.
According to Baumol, the cost which people incur when they hold money is the opportunity
cost of money which is the interest income lost by not putting money in saving deposits.
Transaction Demand for Money
Baumol analyses the transactions demand for money of a person who receives income
at a fixed interval and spends it gradually at a steady rate. It is assumed that the person is
paid Rs.24000/- salary check on the first day of each month. Assuming, the person
liquidates the check on the first day itself and gradually spends it daily throughout the
month at the rate of Rs.800/- per day, he will be exhausting his salary by the end of the
month. The average money holding in the given month will be Rs.12000/- (Rs.24000/2). In
the first fortnight, the person will have more than Rs.12000/- and in the second fortnight he
will have less than Rs.12000/-. The average holding of money equal to Rs.12000/- is shown
by the dotted line. This is not prudent management of money because the person is losing
interest on his money holdings. Instead of withdrawing his entire salary on the first day of
the month, if he withdraws only half of it i.e. Rs.12000/- and deposits the remaining amount
of Rs.12000/- in saving account bearing five per cent interest (see Fig), it will be seen that his
money holdings of Rs.12000/- will be zero at the end of the fortnight or on the 15th day of
the month. Now he can withdraw Rs.12000/- on 16th of each month and spend it gradually
at a steady rate of Rs.800/- per day for the next 15 days of the month. This is prudent
management of funds as the person will be earning interest on Rs.12000/- for 15 days in
each month. Average money holding in this scheme of money management is Rs.6000/-
(Rs.12000/2). In the same manner, if the person decides to withdraw Rs.8000/- or 1/3rd of
his salary on the first day of each month and deposits Rs.16000/- in the saving deposits. His
Rs.8000/- will be reduced to zero on the 10th day and on the 11th of the month, he can
withdraw another Rs.8000/- to spend till the 20th day and on the 21st day he can once
again withdraw another Rs.8000/- to spend till the end of the month. In this new scheme of
money management, he will be holding Rs.8000/2 = Rs.4000/- and will be investing
remaining funds in saving deposits and earn more interest on them.
Now the question is as to which scheme of money management will be adopted by the
individual. According to Baumol, the optimal amount of money holding is determined by 110
minimizing the cost of interest income foregone and the opportunity cost of withdrawing
money frequently (broker‘s fee). It follows that a higher broker‘s fee will raise the money
holdings as it will discourage the individuals to make more visits to the bank. Conversely, a
higher interest rate will induce them to reduce their money holdings for transaction purposes
as they will be induced to keep more funds in saving deposits to earn higher interest income.
Thus, at a higher rate of interest transactions demand for money holdings will be less.
Baumol‘s theory of transaction demand for money is definitely an improvement over the
Keynesian theory which states that transaction demand for money is interest inelastic.
Therefore, the transaction demand for money curve slopes downwards as shown in Figure. At
higher interest rates, bonds, savings and fixed deposits are more attractive relative to money
holdings for transaction purposes and individuals will be holding less money. Conversely,
when the rate of interest is low, opportunity cost of money holding will be less and the
transaction demand for money would be more. Further, the transactions demand for money
varies directly with the income (Y) of the individuals. At a given rate of interest, the
transaction demand for money would be a direct function of the level of income and an
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inverse function of the rate of interest. In Fig.6 the three transactions demand curves for
money MD1, MD2 and MD3 for the three different levels of income Y1, Y2 and Y3 are shown.
The optimum money holding for transactions will increase less than proportionately to the
increase in income. Thus transaction demand for money according to Baumol and Tobin is a
function of both rate of interest and the level of income. The transactions demand for money
can be stated as: MT = f (r, Y), where MT stands for transaction demand for money, r stand
for rate of interest and Y stands for the level of income.

Fig. 15.5
15.8 SUMMARY
1. The classical approach to demand for money is known in the name of Prof.
Irving Fisher‘s Cash Transaction approach. Prof. Irving Fisher‘s famous cash
transaction equation is stated as MV = PT.
2. The Cambridge approach or the Cash balance approach to the demand for
money was put forward by the Cambridge neo classical economists Marshall
and Pigou. According to the neo-classical economists, the total demand for
money is the sum of individuals desire to hold cash balances in the community.
3. According to Keynes, people hold cash balances on account of three reasons or
motives. Accordingly the demand for money can be separated into three parts
namely transaction demand, precautionary demand and speculative demand for
money. The total demand for money or cash balances can be divided into two
namely; active and idle cash balances.
4. According to Friedman, people hold money because it has the power to
purchase goods and services. Demand for money is demand for capital assets
because money also provides services and returns.
5. Tobin obtained his liquidity preference function by showing the relationship
between the rate of interest and demand for money.
6. According to Baumol, the transaction demand for money is similar to the
inventory management of goods and materials by business firms.
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15.9 GLOSSARY
 Transaction demand for money arises due to the fact that money is a medium of
exchange.
 Active Balances are the transaction and precautionary demand for money cannot be
easily separated in practice and since both the money demand functions are income
determined and also interest inelastic
 Portfolio of individuals may also include risk prone assets such as shares
15.10 REFERENCES
 Dernburg T.E and McDougall D.M. (1986). Macroeconomics. Pergamon Press Oxford.
 Rana K.C. and Verma K.N. (2009). Macroeconomics. Vishal Publishing Co. Delhi.
 N. Gregory Mankiw (2010). Macroeconomics, 7th Edition, Worth Publications.
 Dwivedi, D.N. (2011); Macroeconomics. Tata Mcgraw Hill Publication.
 Ackley, G. (1986). Macroeconomic. Macmillan Library Reference.
15.11 FURTHER READINGS
 Shapiro, E. (2009). Macroeconomic Analysis, Third edition, Galgotia Publications Pvt.
Ltd.
 Branson, W.H. (1989). Macroeconomic Theory and Policy, Third edition, Harper
Collins.
15.12 MODEL QUESTIONS
1. Explain the classical approach or the Fisher‘s approach to Demand for Money.
2. Explain the Cambridge approach or the neo-classical approach to demand for money.
3. Explain the Keynesian approach to demand for money.
4. Explain Tobin‘s approach to demand for money.
5. Explain Baumol‘s approach to transaction demand for money.
6. Explain Friedman‘s approach to demand for money.
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Lesson - 16

DEMAND FOR MONEY - II

Structure
16.0 Objective
16.1 Introduction
16.2 Friedman’s Restatement of Quantity Theory
16.2.1 Special Features
16.2.2 Criticism of Friedman’s Restatement
16.3 An Expository Money Demand Model
16.4 Summary
16.5 Glossary
16.6 References
16.7 Further Readings
16.8 Model Questions
16.0 OBJECTIVE
After going through the chapter you shall be able to -
 Explain the concept of Demand for money in the modern era.
 Discuss the detail Friedman's restatement of Quantity theory of money.
16.1 INTRODUCTION
In the previous lesson we discussed the concept of demand for money and how
different economist from time to time stated different theories on demand for money. The
quantity theory of money which specified a proportionate relationship between money and
prices fell in dispute after great depression of 1930's and later on revised and restated by the
monetarists at Chicago school.
16.2 FRIEDMAN’S RESTATEMENT OF THE QUANTITY THEORY
It is only in the late 1950’s that the theory underwent a revival and re-emerged into
professional respectability principally because of the works of neo-quantity theorists led by
Milton Friedman. At Chicago Milton Friedman edited a book entitled Studies in the Quantity
Theory of Money in 1956 wherein he contributed an article, the Quantity Theory of Money – A
Restatement which heralded the re-emergence of the quantity theory. Frank Knight and
Jacob Viner taught and developed a more subtle and relevant - version, one in which the
quantity theory was converted and integrated with general price theory and became a flexible
and sensitive tool for interpreting movements in aggregate economic activity and for
developing relevant policy prescriptions.
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Friedman points out that the approach of Chicago economists is a theoretical one. The
essence of it lies in its insistence that money does matter and that any interpretation of short
term movements in economic activity is seriously at fault and is often misleading, if it
overlooks monetary changes and its repercussions and if it fails to explain why people are
willing to hold a particular nominal quantity of money is existence.
Friedman assets that the quantity theory, in the first instance, is a theory of the
demand for money. It is not a theory of output, or a money income, or of price level. The
demand for money may be from the ultimate wealth owning units in the economy. For them
money is one kind of asset, one way of holding wealth and it is identical with the demand for
a consumption service. And like the theory of consumer choice, the demand for money
depends upon the following set of factors :
(a) The total wealth to be held in various forms;
(b) The price of and return on one form of wealth and its alternative forms;
(c) The tastes and preference of the wealth-owning units.
From the broadest and most general point of view, total wealth includes all source of
“income” or consumable services. One such source is the productive capacity of human
beings, and accordingly this is one form in which wealth can be held. From this point of view,
the rate of interest expresses the relation between the stock which is wealth and the flow
which is income, so if Y be the total of income and r “the” interest rate, total wealth is
W = Y/r
Income in this broadest sense should not be identified with income as it is ordinarily
measured. The latter is generally a “gross” stream and respect to human beings. Since no
deduction is made for the expense of maintaining human productive capacity intact in
addition, it is affected by transitory elements that make it depart more or less widely from the
theoretical concept of the stable level of consumption of services that could be maintained
definitely.
Wealth can be held in numerous forms and the ultimate wealth owing unit is to be
regarded as dividing his wealth among them, so as to maximize “utility”, subject to whatever
restrictions effect the possibility of converting one form of wealth into another. As usual, this
implies that he will seek an apportionment of his wealth such that the rate of which he can
substitute one form of wealth for another is equal to the rate at which he is just willing to do
so.
To describe fully the alternative combination of form of wealth that are available to an
individual, we must take account not only of their market prices-which except for human
wealth can be done simply by expressing then in units worth $ 1.00 - but also of the form
and size of income streams they yield.
It will suffice to bring out the major Issues that these considerations raise to consider
five different forms in which wealth can be held :
1. Money (M), interpreted as clearing or commodity units that are generally
accepted in payment of debts at a fixed nominal value.
2. Bonds (B) interpreted as claims to time streams of payments that are fixed in
nominal units.
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3. Equities interpreted as claims to stated pro-rata shares of the returns of

enterprises.
4. Physical non-human gas (G); and
5. Human Capital [H], Consider now the yield of each.
1. Money (M) : Money may yield a return in the form of money, for example, interest
on demand deposits. It will simply matter, however and entail no essential loss of generality,
to suppose that money yields return solely in kind, in the usual form of convenience,
security, etc. The magnitude of their return in “real” terms per nominal unit of money clearly
depends on the volume of goods that unit corresponds to, or on the general price level, which
we may designate by P. Since we have decided to take $ 100 worth as the unit for each form
of wealth, this will be equally true for other forms of wealth as well, so P is a variable
affecting the “real” yield of each. A rise in the general level of prices involves depreciation in
money and represents a capital loss in real terms which must be deducted from the nominal
yield. On the contrary, a fall in general price level, causes an appreciation in money and the
capital gains result which should be included in the nominal yield of money.
2. Bonds (B) : If we take the “standard” bond to be a claim to a perpetual income
stream of constant nominal amount then the return to a holder of the bond can take two
forms.
One, the annual sum he received the “coupon”, the other, any change in the price of
the bond over time, return which may of course be +ve or -ve. If the price is expected to
remain constant, the $ 100 worth of bond yields rb per year, where tb is simply the “coupon”
sum divided by the market price of the bond, so “is the price of a bond promising to pay $
100 per year. We shall call rb the market bond interest rate the price is expected to change,
then the yield cannot be calculated so simply, since it must take account the return in the
form of expected appreciation or depreciation of the bond, and it cannot, like rb, be
calculated directly from market prices (so long, at least, as the “standard” bond is the only
one traded in).
The nominal income stream purchased for $ 1.00 at time zero then consists of
 1 
rb O   rb O  d  
 b t  
r 
…………. (1)
rb 10 drb t 
rb 10 
rb t  dt
…………. (2)
Where t stands for time
For simplicity, we can approximate this function by its value at time zero, which is
1dr
rb  b
rbdt
This sum, together with P already introduced, defines the real return from holding $
100 of wealth in the form of bonds.
3. Equities (E) : Analogously to our treatment of bonds, we may take the “standard”
unit of equity to be a claim to a perpetual Income stream of constant “real” amount; that to
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be a standard bond with a purchasing power escalator clause, so that it promises a perpetual
income stream equal in nominal units to a constant number times a price index, which we
may, for convenience, take to be the same price index P introduced in (1). The nominal return
to the holder of the equity can then be regarded as talking three forms; the constant nominal
amount he would receive per year in the absence of any change in P, the increment or
decrement to this nominal amount to adjust for change in P, and any change in the nominal
price of the equity over time, which may of course rise from changes either interest rates or
in price levels. Let r be the market interest rate on equalities defined analogously to r b
namely as the ratio of the “coupon” sum at any time to the price of the equity so I/r b is the
price of an equity promising to pay $ 1.00 per year if the price level does not change, or to
pay.
P t 
1
P O 

If the price level varies according to pet. If r0 (t) is defined analogously, the price of the
bonds selling for ‘re(O) at time 0 will be

P(t)
P(O)re(t) …………. (3)

at time t where the ratio of prices is required to adjust for and change in the price
level. The nominal stream purchased for $ 1.00 at time zero then consists of

 P t  
 
 re  t  
P t  re O  d
re O  
P O  P O 
…………. (4)
P t  re O  1dP  t 
re O  
P O  re  t  P O  dt
…………. (5)
Once again, we can approximate this function by its value at line zero, which is

1dP1re
re
Pat redt
4. Physical Non human Goods (G) : Physical goods held by ultimate wealth owning
units are similar to equities except that the annual stream they yield is in kind rather than in
money. In terms of nominal units, this return, like that, from equities, depends on the
behaviour of prices. In addition, like equities, physical goods must be regarded as yielding a
nominal return in the form of appreciation or depreciation in money value. If we suppose the
price level P introduced earlier, to apply equally to the value 0 those physical goods, then, at
time zero.
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1dP
Pat ... (6)
is the size of this nominal return per $ 1.00 of physical goods. Together with P, it
defines the “real” return from holding $ 1.00 in the form of physical goods.
5. Human Capital (H) : Since there is only a limited market in human capital, at least
in modern non-slave societies, we cannot very well define in, market prices the terms of
substitution of human capital 0, other forms of capital and so cannot define at any time the
physical unit of capital corresponding to $ 1.00 of human capital. There are some
possibilities of substituting non-human capital for human capital in an individuals wealth
holdings, as for example, when he enters into a contract to render personal services for a
specified period in return for a definitely specified number of periodic payment, the number
not depending on his being physically capable of rendering the services. But, the main shift
between human capital and other forms must take place through direct investment and
disinvestments in the human agent, and we may as well treat this as if it were the only way.
With respect to this form of capital, therefore, the restriction of obstacles affecting the
alternative composition of wealth available to the individual cannot be expressed in terms of
market prices of rates of return. At any point of time-there is some division between human
and non-human wealth in his portfolio of assets; he may be able to change this overtime, but
we shall treat it as given at a point of them. Let w be the ratio of non human to human
wealth, or equivalently if income from non-human wealth to income from human wealth,
which means that it is closely allied to what is usually defined as the ratio of wealth to
income. This is then the variable that needs to be taken into account so far as human wealth
is concerned.
The tastes and preferences of wealth-owning units for the service streams arising from
different forms of wealth must in general simply be taken for granted as determining the form
of the demand function. In order to give the theory empirical content, it will generally have to
be supposed the tastes are constant over significant stretches of space and time. However
explicit allowance can be made for some changes in tastes in so far as such changes are
linked with objective circumstances. Let w stand for any such variable that can be expected
to affect tastes and preferences (for “utility” determining variables).
Combining 4, 5 and 6 along the lines suggested by 3 yields the following as the
demand function for money :
1b  4 1dp
M ƒ p, rb  , re 
rbdt Pdt

dre 1dp y
 w  , ; 
dt Pdt r
A number of observations are in order about this function,
1. Even if we suppose prices and rates of interest are unchanged, the function
contains three rates of interest two for specific types of assets r b and re and one intended to
apply to all types of assets r. This general rate r is to be interpreted as something of a
weighted average of the two special rates plus the rates applicable to human wealth and to
physical goods. Since the latter two cannot be observed directly, it is perhaps best to regard
them as varying in some systematic way with rb and re. On this assumption we can drop r as
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an additional explicit variable, treating its influence as fully taken into account by the
inclusion of rb and re.

2. If there were no differences of opinion about price movement and interest rate
movements and bonds and equities were equivalent except that the former are expressed in
nominal units, then
1drb 1dp 1dre
rb  re  
rbdt Pdt redt ... (8)
Or, if we suppose rates of interest either stable or changing at the same percentage
rate
1dp
rb  re 
Pdt ... (9)
i.e. the “money” interest rate equals the “real” rate plus the percentage rate of change
of prices. In application the rate of change of prices must be interpreted as an “expected” rate
of change and differences of opinion cannot be reflected, some cannot suppose (9) to hold;
indeed, one of the most consistent features of inflation seems to be that it does not.
If the range of assets were to be widened to include promises to pay specified sums for
a finite number of time units “short-term” securities as well as “Consoles” - the rates of
change of rb and rO would be reflected in the difference between long and short rates of
interest. Since at some stage it will be desirable to introduce securities of different time
duration we may simplify the present exposition by restricting it to the case in which and r b
and re taken to be stable over time. Since the rate of change of prices is required separately
in any vent, this means that we can replace the various variables introduced to designate the
nominal return on bonds and equities simply by rb and re.

4. Y can be interpreted as including the return to all forms of wealth including money
and physical capital goods owned and held directly by ultimate wealth-owing units, and so
V/r can be interpreted as an estimate of total wealth, only if Y is regarded as including some
imputed income from the stock of money and directly owned physical capital goods. For
monetary analysis, the simplest procedure is to regard Y as referring to the return to all
forms of wealth other than the money held directly by ultimate wealth owning units, and so
Y/r as referring to total remaining wealth.
A more fundamental point is that, as in all demand analyses resting on maximization
of a utility function denied in terms of “real” magnitudes, this demand equation must be
considered independent in any essential way of the nominal units used to measure money
variables. If the unit in which prices and money income are expressed change, the amount of
money demand should change proportionately. More technically eq. (7) must be regarded as
homogeneous of the first degree in P and Y, so that
 1dp 
ƒ  , rb , re , w , 
 Pdt  ... (10)
 1 dp 
Y  P, rb , re , w , 
=  P dt 
226

where the variables within the parentheses have been written in simpler form in
accordance with commitments (1) and (3).
This characteristic of the functions enables us to rewrite in two alternative ways.
(i) Let l = 1/P, Eq. (7) can then be written
M  1dp P 
 ƒ  rb , re , w, 
P  P dt Y  ... (11)
In this form the equation expresses the demand for real balances as function of “real”
variables independent of nominal monetary values.
(ii) Let l = 1/y, Eq. (7) can then be written
1

 1 dP Y 
V  rb , re , w, 
 P dt P  ... (12)
or
 1dp Y 
Y  V  rb , re w, 
 p dt P  ... (13)
In this form the equation is in the usual quantity theory form, where v is income
velocity.
These equations are solely for money held directly by ultimate wealth-owning units. As
noted, money is also held by business enterprises as a productive resource. The counterpart
to this business assets in the balance sheet of an ultimate wealth-owning units is a claim
other than money. For example, an individual may buy bonds from a corporation and the
corporations use the proceeds to finance the money holdings which it needs for its
operations.
The amount of money the business enterprises hold depends, on the cost of the
productive services, the costs of substitute productive services and the value product yielded
by the productive service : Per unit of money held, the cost depends on how the
corresponding capital is raised-whether by raising additional capital in the form of bonds or
equities, by substituting cash for real capital goods etc. These ways of financing money
holdings are much the same as the alternative forms in which the ultimate wealth owning
units can hold its human wealth, so that the variables rbreP and (I f P) (dp f dt) introduced
into (7) can be taken to represent the cost to business enterprise of holding money.
Substitutes for money as a productive service are numerous and varied, including all
ways of economising on money holdings by using other resources to synchronize more closely
payments and receipts, reduce payment periods, extend use of book credit, establish cleaning
arrangements and so on in infinite variety.
The value of product yielded by the productive services of money per unit of output
deperious on production conditions: the production function. It is likely to be especially
dependent on features of production conditions affecting the smoothness and regularity of
operations as well as on these determining the - size and scope of enterprises, degree of
vertical integration, etc. These factors can be taken into account by interpreting m as
227

including variable affecting not only the tastes of wealth owners but also the relevant
technological conditions of production. Given the amount of money demanded per unit of
output, the total amount demanded is proportional to total output, which can be represented
by Y.
The upshot of these considerations is the demand for money on the part of the
business enterprises can be regarded as expressed by a function of the same kind as eq. (7).
With the same variables on the R.H.S. and like (7), since the analysis is based on
maximization of returns by enterprises, only “real” quantities matter, so it must be
homogenous of the first degree in Y and P. In consequence, we can interpret (7) and its
variations (11) and (13) as describing the demand for money on the part of the business
enterprises as well as on the part of an ultimate wealth-owning unit, provided only that we
broaden our interpretation of m.
Strictly speaking the eqns. (7); (11) and (13) are for an individual wealth-owning unit
or business enterprise. If we aggregate (7) for all wealth owning units and business
enterprises in the society, the results, in principle, depend on the distribution of the units by
the several variables. This raises a serious problem about P, rb and re for these can be taken
as the same for all or about m for this is an unspecified portmanteau variable to be filled in
as the occasion demands. We have been interpreting (1/p) (dp/dt) as the expected rate of
price rise, so there is no reason why this variable should be the same for all, and w and y
clearly differ substantially among units. As approximation is to neglect these difficulties and
take (7) and the associated (11) and (13) as applying to the aggregate demand for money,
which (1/P) (dip) (d/t) interpreted as some kind of an average expected rate of change of
prices was the ratio of total income from non-human wealth to income from human wealth
and y as aggregate income. This is the procedure that has generally been followed.
The model does not use the distinction between ‘active balance’ and ‘idle balances’ or
the closely alien distinction between ‘transactions balances’ and ‘speculative balances’; that
is so widely used in the literature. The distinction between money holdings of ultimate
wealth-owners and of business enterprises is related to this distinction but only distantly so.
Each of these categories of money holders can be said to demand “money partly” from
“transaction” motives, partly from “speculative” or “asset” motives, but dollars of money are
not distinguished accordingly as they are said to be held for one or the other purpose.
Rather, each S is, as it were, regarded as rendering a variety of services and the holder of
money as altering his money holding unit the value to him of the addition to the total flow of
services produced by adding a S to his money stock is equal to the reduction in the flow of
services produced by substracting a S from each of the other forms in which he holds assets.
Nothing has been said about “banks” or producers of money. This is because their
main role is in connection with the supply of money than the demand for it. More specifically,
money supply may be in introduced exogenously as a policy variable. In that case the given
supply of money (M) in conjunction with the demand function for money or its reciprocal the
 1dp Y 
velocity of money function V  rb , re w , ,  will determine the money income (Y) as stated in
 Pdp P 
eq. (13). It does not specify the determinants of interest rate structure and real income and
the path of adjustment in the price level.
But if following the classical model, interest rates are assumed to be determined by
real factors of thrift and productivity and the real income also to be determined by the factors
228

such as the quantity and quality it productive resources and technology, the eq. (13) will
determine the unique equilibrium level of money income.
When the real income is known independently, the equilibrium level of money income
will also yield the equilibrium level of prices. Friedman made an overstatement in the
beginning of his “Restatement of a Quantity Theory” which should be obvious from his own
emphasis, towards the end of this very restatement. He suggests that one aspect in which a
modern ‘quantity theorist’ differs from other theorists is that the former, “not only regards
the demand function for money as stable; he also considers it as paying a vital role in
determining that he regards as of great importance for the analysis of the economy as a
whole, such as the eve I of money income of prices.”
16.2.1 Special Features of Friedman’s Approach
Having explained the main ideas contained in Friedman’s model of the determination of the
demand for money, we are now in a position to highlight the special features of this approach.
Firstly, as it was observed earlier also, the modern quantity theorist make a valid
distinction between demand for money and the “demand junction” for money or alternatively,
between velocity of money and “velocity function”.
Secondly, this believe that the demand function for money or the velocity-of-money
function as such is highly stable; much more stable that the key function of the alternative
Keynesian approach namely, the consumption function.
Thirdly, the stability of the money demand function does not imply that the real
quantity of money demanded per unit of output Le, the value of Marshallian constant k of
Fisher’s constant I/v does not fluctuate, over short periods while the velocity in function is
stable the velocity of money as such may fluctuate, even rise violently in times of hyper
flanations.
Fourthly, the modern quantity theorists like Friedman believe that it is sufficient to
include in the money demand function only a limited number of variables which are empirically
important. Friedman’s argument on this score is that “to expand the number of variables
regarded as significant is to empty the hypothesis of its empirical content”.
Fifthly, the modern quantity theorist regards the money demand function not only
stable, but also of vital importance in determining the variables which are vitally important the
analysis of the economy as a whole e.g. the level of money income and the level of prices.
Sixthly, he also believes that the Money demand function and the money supply
function are independent of each other. In other words, he believes that there are important
variables which determine the supply of money but which do not influence the demand for
money. Otherwise, Friedman’s money demand function which is intended to predict the
consequences of changes in the supply of money will fail to do the job assigned to it.
16.2.2 Criticism of Friedman’s Restatement
Friedman’s Restatement of the Quantity Theory, like his other hypothesis such as the
Permanent Income Hypothesis, provides a highly formalised model of the determination of the
demand for money. It has a dazzling fineness about it, but few win accept it as also equally
illuminating. It suffers from a number of gaps and inadequacies some of which we shall
consider here.
229

In the first place it is pointed out that, Friedman’s derivation of the money demand
function takes explicit not of a set demand for money only the transaction demand for money
has not been adequately analysed. This tantamounts to ignoring the function of money as a
means of payment. It provides no analysis of the cost of transactions and how these costs
could be relevant in the determination of the demand for money and for the alternative forms
of assets.
Similarly, there is no analysis of the relevance of different holding periods of wealth for
the structure of the portfolios of the assets of the wealth holders which certainly impinges
upon the problem of determination of demand for money. As Miles Flaming has put it, “the
nature of the services provided by money balances is not required into closely” has made
Friedman’s analysis rather too abstract.
Secondly, Friedman’s arguments implies the assumption that the different forms of
assets considered by him are close substitutes of one another. But the basis of this
assumption is not spelt out. How the transactions cost, different holding periods for wealth,
and desire for risk avoidance are likely to affect the degree of substitute substitutability
between different forms of assets, how the affected substitutability will influence the demand
for money and alternative assets are matters which have been left outside the analysis.
This has also resulted in Friedman’s selection of a very small number of variables in
his money demand function. This can hardly be justified, by the plea that they are the only
empirically significant variables and the inclusion of more variable would have made the
money demand function empirically meaningless.
The foregoing point of criticism necessarily leads to the examination of Friedman’s
contention that the demand for money can be explained in terms of a small number of
variables. What is the criterion on the basis of which some variables may be retained while
other may be dropped out of the argument of function? Obviously, it should depend on the
degree of responsiveness of the dependent variable to a small change in the particular
independent variable, all other things remaining the same. In the context, of the money
demand function, this criterion implies that the meaningfulness of an independent variable,
such of rb or re or some other variable, depends on the coefficient of elasticity of money
demand with respect to that variable. If this coefficient too small to be significant, it can be
reasonably dropped out of the argument of the function.
But, if this coefficient is significantly large, the variable should be retained. But
Friedman’s Restatement of the Quantity Theory of Money nowhere provided such an
argument for retaining some variables and dropping others.
Thirdly, one particular variable in Friedman’s money demand function is the expected
1dp
rate of change in prices P dt . But Friedman has thrown no light on how these expectations
are formed. Infact, expectations are generally the most troublesome element in economic
analysis.
Fourthly, Friedman’s model has been stated in a static form. It takes no notice of the
time lags involved and implications for the demand for money. If we assume that
expectations with respect to the difficult variables Friedman’s model are determined by their
past values the time path of these values will determine the expectations from period to
period which, in turn, will determine the demand for money. In that case, all the variables
will interact with one another which will determine their values from period to period. In
230

other words, the nature of the time lags will determine that values of the variables from
period to period.
Time lags and the formation of expectations are not the only important lags. Time lags
in the adjustment of the values and structure of assets in the wealth holders portfolios to the
desired levels and structure are also important in the determination of the demand of money.
As aptly observed by Miles Fleming, “Time lags, the size of the elasticities with respect to
independent variables and the degree of the variability in the latter must all be taken into
account in judging and assertion that the quantity demanded of money can be explained
terms of a small number of variables.” But Friedman’s model does not take note of these
factors.
Fifthly, Friedman’s assertion that his money demand function and the monetary
multiplier based on it are much more stable than the Keynesian consumption function and
the Keynesian multiplier based thereon has not been borne out by all the empirical
investigations made into this Problem. In the pioneering empirical study made by Friedman
and Meieslman “The Relative Stability of Monetary Velocity and the Investment Multiplier in
the United States, 1899-1958”, it was held that U.S. data lent support to Friedman’s thesis.
But Ando and Modigliani (“The Relative Stability of Monetary Velocity and the investment
Multiplier”) reached a different conclusion because they obtained an explanation of consumer
expenditure based on the Keynesian multiplier which was better than that of Friedman and
Meiselxnan in terms of the Monetary Multiplier. The empirical study of Barrey and Water
(“The Stability of Keynesian and Monetary Multipliers in the United Kingdom”) did not
produce a very conclusive result.
Sixthly, one important implication of Friedman’s model is that there is a very regular
and strong relation between the supply of money and the money income and prices. “ A
further implication of this is that the level of money and the prices can be controlled by
controlling money supply. Although the studies made by Friedman and his followers such as
Cagan and Selden are purported to bear out the first proposition state above, there are other
studies also which challenge this proposition.
Seventhly, Friedman’s definition of money is too broad. It includes even time deposits.
If time deposits are excluded from money income, elasticity demand of money will be near
unity rather than being more than unity.
M.L. Burstein has observed in his book on Money that impressive “simple”
uniformities relating money supply to money income and prices would appear “if only the
parameters of the system other than the money stock would stay out and that, if we account
for the influence of relatively few other variables, neo-quantity theory can be formulated
supporting monetary control if not the classical formulation.” He goes on to elaborate the
point in the footnote. “I might assert with strong confidence that a 3-4 percent reduction in
the money supply will cause prices to fall 2 percent over the next six months.”
On the second implied proposition of Friedman’s theory that control of supply of money
is the only effective method of controlling the level of money income and of prices the “liquidity”
school of monetary economics are represented by R.S. Sayers and the authors of the Radcliffe
Reports is highly sceptical. According to them the growth of non-banking financial
intermediaries and near moneys has completely changed the situation. In view of this, RS
Sayers has observed : There is no hard and fast line between what is money when we worry
ourselves about changes in the supply of moneys our concern is in fact with the shifting
liquidity position of the economy. It is idle to say that one can somewhere find an ultimate
231

form of money and consider that as the grand regulator of the economic situation, a regulator
that can be made to behave properly by legislator’s orders” (of R.S. Sayer Central banking
after Bagehot (1957, pp. 5-9).
16.3 An Expository Money Demand Model
An expository money demand model consists both of Keynes and Tobin/Baumol
approaches. It provides us a general equilibrium model of the economy that is flexible and at
the same time not too complicated. It is better than even Friedman’s model since it is
formulated in term of interest and measured income. It also explicitly includes the
transaction and speculative measure for holding money while in Friedman’s model we do not
make such distinctions.
Fig. 1 (a) depicts the transactions demand for money as derived from the Keynes
Baumol approach. Here the transaction demand curve is interest elastic Fig. 1 (b) shows the
+speculative demand curve Keynes-Tobin approach.

Fig. 16.1

In the first diagram, the curve is T1, T2, T3 and T4. In the second diagram, the curve is Ds. In
the third diagram, the curve is TD1, TD2, TD3 and TD4.
Fig. 16.1 (c) shows the total demand for money. It is the horizontal summation
of the speculative demand curve and each of transaction demand curve. Each curve in 1 (c)
represent total money demand curve at a different panel of income. The vertical demand
curve becomes horizontal at 1 (c) interest. At this rate of interest the economy falls into the
liquidity trap zone.
16.4 SUMMARY
We have seen that unlike traditional quantity theorists, Friedman stressed upon the
demand for money rather than the supply of money in his reformulation. Further he
recognized that economic activity can be significantly affected by the variations in money
supply. It is an important milestone in the field of monetary theory.
16.5 GLOSSARY
 Equity: Value of shares issued by companies.
 Bonds: A bond also known as fixed income security is a debt instrument for the
purpose of raising capital. They are essentially loan agreements.
 Demand Function: It is the velocity junction of money.
232

16.6 REFERENCES
 Rana K.C. and Verma K.N. (2009). Macroeconomics. Vishal Publishing Co. Delhi.
 Shapiro. E. (2009). Macroeconomics Analysis. Fourth Edition. Galgotia Publications
Pvt. Ltd.
16.7 FURTHER READING
 Branson, W.H. (1989). Macroeconomics Theory and Policy. Third Edition. Harper
Collins.
16.8 MODEL QUESTIONS
1. Explain the Friedman's restatement of Quantity theory of money.
2. Explain the various determinants of Quantity theory of money as restated by Milton
Friedman.
233
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