Prof. Amar Oswal S.Y.B.

Com – Sem III Economics 2024-25

TOPIC NO.1
INTRODUCTION TO MACRO ECONOMICS

Introduction: The concept of Macro-economics is propounded by ‘Ragner

Firsh and made popular by Lord J.M Keynes.
Origin: The word ‘macro’ has been derived from a greek word called
‘makros’ which means large.
Meaning: Macro Economics is the study of the overall conditions of an
economy total output, total consumption, total national income, savings
and investment, aggregate demand and aggregate supply, total
employment, and so on.
Definition: Kenneth E. Boulding in his book ‘Economics Analysis’
defines “Macro Economics deals not with individual quantities as
such, but with aggregates of these quantities; not with individual
incomes but with the national incomes; not withindividual prices
but with the price level; not with individual outputs but with the
national output”.

Features of Macro Economics

1. Study of Aggregates: Macro Economics is concerned with a study of
aggregates i.e. (i) Aggregate Demand (Demand for all types of goods in
a country).
(ii) Aggregate Supply (Supply of all types of goods in a country.
(iii) Total Output (Production of all goods and services in a country).
(iv) General Price Level (Overall rise or fall in the prices).
(v) National Income (Income of entire country).
2. Lumping Method: Unlike Micro Economics where slicing method is
used under Macro Economics Lumping Method is used. In a lumping
method we are concerned with object as a whole i.e. study of
aggregates. For e.g. we are not concerned with price of an individual
commodity but overall price level.
3. General Equilibrium: Macro Economics is concerned with a General
Equilibrium analysis i.e. everything depends on everything else. For

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

e.g. due to change in the level of investment there may be change in

the level of income, output, employment and ultimately economic
growth.
4. Telescopic View: Macro Economics gives overall view of an economy
it connects various economic aggregates and shows the relationship
between them.
5. Determination of Income Theory: Macro Economics determines
National Income. It studies the causes of rise and the fall in the
national income.
6. Employment Theory: It studies the various factors which are
responsible for creating employment and also what are the causes of
unemployment on the bases of which appropriate policies can be made
by the government.
7. Based on interdependence: It explains how various economic units
are interdependent on each other. For e.g. It explains how the level of
investment affects income, output, employment and therefore the
growth of the nation.
8. Realistic approach: Macro economics takes into account the entire
economy as a whole which is more realistic as compared to Micro
economics which takes into account only one unit of an economy. In
other words macro economics follows general equilibrium
whereas macro economics follows partial equilibrium.
9. Short and long run analysis: Macro economics deals with short run
economic fluctuation arises due to trade cycle and it also deals with
long run increase in growth and development of an economy (country).

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Scope / Subject matter of Macro Economics

Macro
Economics

Theory of Theory of
Theory of price Theory of
income & economic
level distribution
employment growth
1. Determination of National Income: Micro Economics studies
aggregate consumption, investment, government expenditure, net export
etc. which determines National Income of a Country. And on the basis of
National income even per capita income (PCI) is determine. It also
analysis and study how National Income is distributed between the
individuals to know whether there is vide disparity of income or it is
evenly distributed. If income is unevenly distributed then government
makes appropriate policies to reduce the disparity of income.
2. Employment Level: Macro Economics studies and analysis the level of
employment in a country in different sectors of an economy and the
changes in the level of employment on account of government policy,
technology, economic conditions etc. and this enables the government to
make appropriate policies to create employment if required.
3. Price Level: Macro Economics studies general price level of goods and
services in a different sectors to know if there is inflation (over all rise in
the prices) or depression (overall fall in the prices) of the goods and
services. Both the extremes are harmful to the economy and therefore,
government makes appropriate policies to control inflation or depression.
4. Economic Growth: Economic Growth and development is also studies
under macro economics in fact on the basis of study an evaluation is

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

done whether resources are properly utilized or not and if not then
appropriate policies are made to ensure rapid growth and development.
5. Distribution of National Income: Macro economics studies how the
national it is distributed between different factors of production in an
economy. And accordingly policy decisions are taken by the government.
6. Study of Business Cycle: In free market economies are subject to trade
cycle i.e. Up’s and Down’s in a economy consisting of depression,
recovery, boom, recession etc. which has a impact on production,
consumption, and income. Study of this trade cycles help the government
in making appropriate policies.
7. Balance of Payment & Exchange Rate: Macro economics explains the
factors which determine balance of payment and identifies the causes of
deficits (imports are more than exports if any and accordingly corrective
steps are taken.

Uses/ Importance / Significance of Macro Economics:

1) Income level: It helps in knowing & understanding the income level of
people.
2) Employment level: It helps in knowing employment level of a country.
3) Price level: It helps in knowing the overall price level in an economy,
whether there is inflation on deflation.
4) Factors of production: It helps the government in knowing the income
of factors of production.
5) Functioning of economic system: It helps in understanding the
functioning of different types of economy, capitalist economy & mixed
economy.
6) Framing of economic policies: It helps the government in making
suitable economic policies.
7) Solutions to problems: It provides solution to many national &
international problems.
8) Forecasting of future trend: Macro Economics provides
foundation to economic analysis to forecast future trends in interest rate,
exchange rate, price level and accordingly policies are made.

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

9) Political decisions: Political parties in a democracy secure votes by

promising economic benefits like employment price control, social well
fare.

Criticisms / Limitations of Macro Economics:

1) Misleading picture: Macro economics study may give misleading
picture. E.g. there may be rise in national income but that does not mean
there is a majority of the rise in the national income may be pocketed by
selected number of people.
2) Homogenous factor: It is assumed that all individual economic units are
homogenous which cannot be in reality. For e.g. all the laborers cannot be
same in efficiency.
3) Harmful decisions: A general policy decision taken by the government
may turn out to be harmful to individuals.
4) Complicated system: It is a very difficult & complicated system to know
& understand.
5) Lack of Reliable data: Despite of several improvements in statistical
techniques it is very difficult to acquire reliable accurate and dependable
data of various economic units.
6) Limited Application: Most of the macro economic theory are application
to develop and industrialized countries only. For E.g. theory of trade cycle
is application to industrialize economy and not to the aggregation.
7) Conflict between Micro & Macro: Macroeconomic policies are made
nation as a whole but may not be applicable to the individuals. For E.g.
reduction of rate of interest benefits the business man but adversely
affects personal living on fixed deposits.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

TOPIC NO. 2
CIRCULAR FLOW OF NATIONAL INCOME

Introduction: In Modern Economy every one’s life is characterized by

continue flow of money, all the economic activities are revolved around
money, money is required to produce goods and services and money is
also required to purchase goods and services, this can be explained with
the help of circular flow of national income.

A. Circular Flow of National Income with Two Sectors without

Saving
The circular flow of national income explains overall economic activity in
the form of income, output and expenditure in a two sector model close
economy.

We take into account:

a) Household: This is also known as consumption sector. Household
supplies land, labor, capital & enterprise to firms.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

b) Firms: Firms are also known as production sector. They purchase

factors of production for the purpose of production, against which they
make payments in the form of rent for land, wages to the labour,
Interest on capital and profits to the entrepreneur.
Assumptions of Two Sector Model without Savings: -
 The economy consists of Two sectors
 Household &
 Firm
 Production takes place only in firms
 Households spend their entire income received in the form of rent,
wages, interest & profits for purchase of goods and services i.e. there is
no saving.
 Firms supply goods and services only as per demand, thus do not
maintain any inventory i.e. stock in hand.
 There are no government operations i.e. any government expenditure
and taxes in the economy.
 There is no international economic relation. There is no outflow and
inflow of goods and services (export & import), making the economy a
closed one.

B. Two Sector Model with saving: -

In a Two sector model with savings, circular flow of national income takes
place in a following manner: -

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

a) Household supplies land, labour, capital and enterprise to the firm for
which firm pays rent, wages, interest and profit.
b) Out of income received, household spends bulk of income for purchase
of goods and services and some portion is saved and invested in bank
(finance market).
c) Money received by the bank from the household is lend (given) to the
firm.

C. Three Sector Model with Government:

In modern days, in every country, there is an involvement of the
government in the financial activity.

In Three sector model we have: -

a) Household: who supplies factors of production in turn they get money.
b) Firm: Firm purchases factors of production and supplies goods.
c) Government: They are also involved in various activities.
Government receives money in the form of taxes from household and
firms,
Government spends money in the form of wages, salary and transfer
payments (pension) to the households and subsidies to the firms.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

D. Sector Model with Foreign Trade:

In an open economy, there is foreign trade and we take into account Four
sectors: -

a) Household: Supplies factors of production and receives the payments

from the firms and the government.
b) Firms: Firms purchases factors of production and supplies goods and
services to the household, government and also to other countries.

Importance of Circular flow of income:

 Shows smooth functioning of the economy: The concept of circular
flow gives a clear-cut picture of the economy. From it we can know
whether the economy is functioning efficiently or whether there is any
disturbance in the smooth functioning of the economy.
 Helps to know the problem of disequilibrium: With the help of
circular flow we can study the problems of disequilibrium. It can also
guide us in the restoration of equilibrium.
 Helps to find out the leakages in the circular flow: The concept of
circular flow enables us to find out the leakages in the form of saving,
imports and taxes and their efforts on income and expenditure.
 Highlights the importance of monetary and fiscal policies: The
study of circular flow highlights the importance of monetary and fiscal
policies to bring about equity between income and expenditure.
 Linked between producers and the consumers: The circular flow
of establishes linked between the producers and the consumers.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Producers buy services of the factors of production from the household

(consumers). Consumer’s in-turn buys goods and services from the
producers.

TOPIC NO. 3
MEASUREMENT OF NATIONAL INCOME

Introduction: The concept of National Income is of great significance. To

analyze economic development, every country in the world calculates
National Income. It is a common yard-stick (Barometer) to find out status
of an economy.

Meaning: “National income refers to the money value of goods

and services produced in an economy during a year”.

Definition: According to Irvin Fisher, “The national dividend or

income consists solely of services as received by ultimate
consumers, whether from their material or from their human
environments. Thus a piano or an overcoat made for me this year
is not a part of this year’s income, but an addition to capital. Only
the services rendered to me during this year by these things are
income.”

Features of National Income:

1) National Income takes into account the total of goods and services
produced during a particular year e.g. Total Product into price.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

2) National income is calculated annually i.e. it is calculated at the end of

the year.
3) National income is macro concept i.e. it takes into account all the
economic activities in a country.
4) National income is expressed in terms of money.
5) While calculating National Income double counting should be avoided.
6) National income is calculated in open as well as closed economy. Closed
economy is one in which foreign trade is not allowed and open economy
is one in which foreign trade is allowed.
7) National income is a flow concept & it is concerned with the flow of
money.
8) National income can be calculated at current as well as constant price.
Current price is one in which change in price level between different
years is not considered.
Constant price is one in which National income of a year a compared
with any year in the past and on that basis National income is
calculated.
9) While calculating National Income only earned income is taken into
account i.e. unearned income like dowry income, pension, social
security, winning of a lottery ticket, etc. are not taken into account.
10) While calculating National income incomes earned by Indians working
abroad should also be taken into account
11) National Income is calculated by C. S. O. [Central Statistical
Organisation]

Concept of National Income

Concept of National Income has three interpretations
A. Value of Goods produced (product method).
B. The total income received (income method).
C. Total expenditure incurred (expenditure method).
This implies the value of goods and services produced in an economy
requires payments to be made to the factors of production in the form of

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

rent, wages, interest & profit. The factors of production spend this money
for purchase of goods therefore we can say:
National Income = National Product = National Expenditure
These three measures of National Income gives triple identity to national
income and all of them lead to same conclusion.

Importance of National Income

Analysis of National Income is very significant for every country due to
following reasons.
1. Measurement of Economic Performance: National Income
measurement works as a yard stick of growth of an economy. Countries
are ranked on the basis of National Income.
2. Comparison of Standard of Living: Calculation of per capita income
indicates the standard of living of the people in the country and it also
helps in comparing per capita income of other countries.
3. Sectoral Contribution: There are three sectors in economy namely
primary, secondary and territory. Analysis of national income helps us
in knowing share of different sectors in a national income.
4. Ascertation of Economic Welfare: National Income helps us in
knowing whether there is improvement in the welfare or not because
some time the national income may increase but it may not improve
the welfare of the people.
5. Economic Planning: on the basis of national Income statistics
government can make short term and long term planning. Government
cannot make plan effectively without knowledge of trained in a national
income.
6. Distribution of Grant in Aid: National Income estimates help in fair
distribution of Aid by the government to the state government and
other agencies.
7. Public Sector Performance: National Income enables us to know the
relative role of public and private sector in the economy. If majority of
the activities are performed by the state then we can assume that
public sector is performing dominant role.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

8. Budgets: On the basis of National Income data government makes the

budget in which policies regarding taxation and dates are taken.

Methods of Calculating National Income:

A) Product /Output Method B) Income Method C) Expenditure

Method

1) Final Value Approach 2) Value Added Approach

A) Product / Output Method:

Under this method national income is calculated by ascertaining the total
value of goods and services produced during a year. There are two
methods of calculating national income under product method.
1. Final Value Approach Method: Under this method we find out value
of final goods and services produced in primary (Agriculture), secondary
(Manufacturing) and tertiary (Service) sector and net receipts (R –P) from
abroad which gives us gross domestic product.
After getting gross domestic product we minus depreciation we get gross
national product.
After getting gross national product we add net income received from
external trade i.e. export – import (X – M) this gives us net national
product.
Final Value Approach
Particulars Rs.
(Crore)
1. Value of goods and services from Primary sector xxxx
(Agriculture)
+ xxxx
2. Value of goods and services from Secondary sector
(Manufacturing)
+ xxxx
3. Value of goods and services from Tertiary sector

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

(Service) xxxx
+
4. Net Receipts from abroad (R –P)
Gross Domestic Product (GDP) xxxxxx
(-)
Depreciation (xxxx)
Net Domestic Product (NDP) xxxx
+
Net Exports (x – m) xxxx
Net National Product (NNP) xxxx

2. Value Added Approach: Final value approach sometimes lead to

double counting. For e.g. for a farmer cotton is a final product and for a
textile mill shirt is a final product as a result value of a cotton is taken
twice once by farmer and once by the textile mill owner to solve this
difficulty value added approach method is used.
Under this method at every stage of production added value is counted to
determine the national income. Following table makes this concept very
clear:

Value Added Method

Stage of Production Value of Input Net Value
Rs. Added
Rs.
Raw Cotton 100 100
Cotton Yarn 150 + 50
Cotton Cloth 200 + 50
Shirt 300 + 100
Final value of shirt Rs. 300

The above table shows that final value of shirt is Rs. 300/-. If we take net
value added to each stage of production we can also avoid double
counting. The same approach can be used to estimate national income

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

from primary, secondary and tertiary sectors and also for net income
contribution to national income from international trade. While
considering this approach we should exclude indirect taxes and include
subsidy.

Precautions:
1) Double counting must be avoided i.e. the value of only the final goods
must be taken that is the value of raw material or intermediate goods
should not be taken.
2) The goods meant for self-consumption by the producers must be
estimated by guess work and their value at market prices should be
included.
3) At the time of evaluating the output the changes in the price level
between different years must be taken into account.
4) The value of indirect taxes must be deducted and the value of subsidies
must be added in order to find the value of NNP at factor cost.
5) Factor incomes earned from abroad must be included in the National
Income.

Personal Income
Meaning: Personal income refers to income earned by an individual.
Classification:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Personal Income

B C
A
INCOME FROM TRANFER INCOME
EMPLOYMENT
ASSETS [Pension, Dowry]

Wages Salary Mixed Tangible Intangible

[Physical Work] [Mental Work] Income [Fees] [Rent] [Dividend]

A) Employment:
Income from employment consists of three sources:-
1) Wages: Are paid for manual work.
2) Salary: Is paid for mental work.
3) Mixed Income: Is earned by professionals like doctors and advocates in
the form of fees.
B) Ownership of Assets:
1) Tangible assets have physical existence. They can be seen, felt and
touched. Income earned from them is called rent.
2) Intangible assets are those assets on which invisible income may be
earned from them in the form of royalty, dividend etc.
C) Transfer Income:
Transfer income is also known as unearned income. This includes pension,
social security benefit, dowry, donations & inheritance.

Per Capita Income (P.C.I.)

Meaning: PCI refers to average income available at the disposal of an
individual.
It can be calculated by using the formula.

PCI =
Personal Disposable Income (P.D.I.)
Meaning: PDI refers to income which is available at the disposal of an
individual.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

It can be calculated by using the following formula.

PDI = Personal income (PI) – direct taxes (Income taxes).

National Income and Economic Welfare

Meaning of Welfare: Welfare is a state of mind which reflects human
happiness and satisfaction i.e. welfare is happy state of human mind.

Relationship between National Income and the Welfare

An increase in the National Income normally lead to more spending by the
government, for the welfare of the public leading to increase in the
economic welfare i.e. there is direct relationship between national income
and economic welfare subject to following conditions.
1. Change in the size of National Income: When national income goes
UP it leads more income to the people and hence more spending on
goods and services. Therefore there is positive impact on welfare and
vice-versa.
2. Change in the price level: National Income is market value of goods
and services produced if there is a inflation national income may be
higher but economic welfare may not increase unless there is a
increase in the output.
3. Per Capital Income: If National Income and Per Capita Income
changes at the same rate then there will not be increase in the welfare
because per capita income will remain the same.
4. Expenditure Pattern: If with a rise in the national income there is
increase in purchase of food essential items, clothing, housing,
transportation, education, then economic welfare will increase. On the
other hand if money spent on luxury items just for demonstration or
speculative purpose welfare may fall.
5. Production Pattern: If rise in the National Income leads to increase in
the production of defense or luxury goods rather than increase in the
production of welfare goods then economic welfare will fall.
6. Change in the Income Distribution: Changes in the national income
bring the changes in the income distribution. If the rich people are

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

taxed more to spent more money for the welfare of the people and by
imposing heavy duty of luxury goods and subsidizing of essential goods.

Gross Domestic Product (GDP)

GDP means money value of final goods and services produced within a
domestic territory during a given period of time. Whether produced by
countries factor (labour) or not.
In national income accounting domestic territory is a wider term than the
political territory.
Domestic territory includes:
Political frontiers (limits) including territorial waters of a country.
Ship & vessels operated between the countries (beyond our countries
geographical territory) by residents of a country (residents may be Indian
or Foreign) (Resident does not mean citizen)
For e.g. Many Indians working in USA is residing in USA but citizens of
India. Since they work for activities in the USA i.e. conduct their economic
activities in USA they are residents of USA.
Fishing, vessels, oil and natural rigs or floating platforms operating
residents of country (Indians or Foreigners who are conducting economic
activities in India) Embassies, consulates & military establishments of the
country though located in other countries.
Gross National Income (GNI) Gross Domestic Product
(GDP)
It means total money value of It means total money value of
goods & services produced goods & services produced in the
anywhere by the nations citizens domestic territory of a country
only during a given period of time during a given period of time by
anybody.
The income earned by the national The income earned by the
(our citizens) whether within or national (citizens) outside the
outside the country are included country are not Included
That part of Income earned by the All the income earned by national
foreigners is excluded. & foreign are included

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

GNI is more if our nation is having GDP will be larger than GNI if
more investments in stock, bonds, major income flows outside due
shares in other countries (i.e. R>P) to huge investments by
foreigners in India
GND=C+I+G+(X-M)+(R-P) GDP=C+I+G+(X-M)

GNI NNI
It is money value of final goods & It is money value of good &
services produced by a countries services produced in the country
by counting factories during a
given period of time
GNI= GDP+(R-P) NNI= GDP+(R-P)-(D)
R= Receipts from Abroad D= Depreciation
F= Payments Abroad
It does not give correct pictures of It gives accurate picture of an
an economy economy

DNI, GDP, MNI &MDP at Market price &Factory cost.

Market Price: The market price (i.e. price paid in the market) is distorted
by Indirect taxes like octroi, excise, VAT i.e. Increase the price and
subsidies i.e. Assistance given by the government which reduces the
price. Factor cost includes price paid to factors of production.
Therefore; Factor cost= Market Price- Indirect Taxes+ Subsidies
Market Price= Factor Cost+ Indirect Taxes- Subsidies

Gross National Income

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Meaning: Green National Income is measured as Green Gross Domestic

Product (GGDP). It is an Index (Indications/Barometer) of Economic Growth
and measurement of Effects on Environment.
This concept is known widely accepted by many Governmentsviz USA,
Norway, China and India. China is first country to report Green Gross
Domestic product report in 2004 India has also began process in 2009.
GGDP (Green Gross Domestic Product) takes into consideration impact on
environment on a country in the process of economic growth in the form
of climatic changes, loss of bio-diversity, pollution, etc.

Need for Green GDP

Conventional measurement of NI takes into account only output produced
in a country but does not evaluate (ascertain how much wealth or assets
the county has.
When goods & services due produced ina country its assets and wealth is
used in a traditional method do not ascertain how much assets and wealth
is used and weather it will be available in future or not i.e. sustainable in
the future or not.
Traditional methods of calculating NI does not give much importance to
natural resources like geology, soil, air, water, living being at the cost of
these assets are not considered or accounted partly because of these
assets cannot be easily ascertained in the terms of money like- Air
pollution and partly because of fear of come national income due to these
costs being considered.
In the process of creating wealth the government & firms do not make
adequate provision in the interest of future generation. In the process of
generating more Income today (short run) the national resources are
falling rapidly.
Conventional GDP has limited scope for indicating social wellbeing of
people the green DGGP method makes comprehensive provision for
sustainable development & social well being.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Drawbacks/Criticism
Through the concept of GDDP is very important and needs to be
incorporated while calculating NI it has some limitations.
It is difficult to calculate monitory (money) value of some of the national
capital components.
GGDP does not able to capture economic & social welfare aspects,
because it has given to much importance on natural factors only and not
on social factors.
GDDP measure only depletion of national resources but does not tell us
about their sustainability.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

TOPIC NO. 4
TRADE CYCLE
Introduction: Every economy is subject to ups and downs, which is
called trade cycle. Trade cycle consists of following phases namely
Depression, Recovery, Boom and Recession.

Trade cycle can be explained with the help of following diagram:

A.Depression
 It is a period of very low economic activity
 People are very pessimistic
 Rate of growth is very less
 There is reduction in production & factories are closing down
 People are losing their jobs, leading to unemployment
 Prices are reducing below normal level
 Investment market is at a very low level (i.e.) share prices are falling
 Business units are incurring losses

When depression reaches the lowest level it is called trough, which is a

turning point. This stays for a very short period of time and recovery
begins due to following reasons: -
 The producers may offer jobs to the workers anticipating better future.
They try to maintain their capital stock.
 Consumers may start purchasing, expecting no further declining of
prices. Therefore demand starts growing.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

 Banks and private investors start investing in the securities and bonds
from the accumulated excess liquidity therefore prices start rising.
 Favorable monetary (easy loans) and fiscal policies (lower taxes) lead to
recovery.
 It is noted that generally prices of inputs fall faster than the prices of
the finish goods and therefore there is some profit which increases after
trough as a result there is increase in investment in employment which
in turn increases output, income, demand etc. leading to stage of
recovery

B.Recovery –Due to several factors economy enters phase of recovery

during which upward movement begins in output, input and
employment.
People may start replacing semi-durable goods or capital goods; as a
result there is rise in demand. To fulfill this demand there is more
investment and ultimately employment.
In the beginning prices may not rise because already there is excess
capacity, but slowly capacity may be exhausted and the prices may
rise.

C.Prosperity – Due to increase in output, employment, easy loans,

higher profits, better price, economy enters the stage of prosperity
where people are very optimistic.
Following are important features observed during Prosperity: -
 Bank loans are increased
 Unutilized funds are transferred to productive areas
 Share prices go up
 Money supply also increases
 People start expanding or starting new business and economy reaches
a peak, but ultimately it leads to recession due to expansion of business
beyond required limits.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

D. Recession – During this period, economy starts coming down as a

consequence: -
 Demand reduces a bit
 Prices starts falling
 New investment stops
 Stock prices start reducing
 Bank loans are reduced
 Employment also starts falling
 Ultimate effect of this leads to depression

Factors responsible for Trade Cycle

Introduction – Every economy in the world is subject to fluctuation due
to trade cycle (ups and downs). There are several factors, which are
responsible for trade cycles but following are important factors:
1) Monetary factors - Due to expansion and contraction of money supply
(currency and loans) trade cycles immerges. In fact it is one of the
primary factors to cause trade cycle.
2) Innovation and productivity –On account of innovation and
productivity in any one of the sector can have an impact on rest of the
economy leading to trade cycle.
3) Fluctuations in investments – Due to rise or falls in investments on
account of marginal efficiency of capital (MEC) trade cycle may emerge.
For eg: Due to more expectations on capital investment, investments
may fall leading to less productions and employment.
4) Interaction of multiplier –Acceleration forces: - The multiplier and
acceleration forces are also responsible for fluctuation in economic
activities.
5) Supply stocks – Due to changes in the aggregate supply the impact
may fall on the economy for e.g.: When oil prices go up it leads to
inflation and low production.
6) Political factors – On account of change in the govt./ political parties,
the policies may change leading to trade cycle

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

7) Movement in prices and wages – Due to changes in the price of

commodities, and the wages to laborers, supply may change leading to
trade cycle.
Conclusion – The above factors clearly reveal that there are many
factors which are responsible for the emergence of trade cycle.

TOPIC NO.5
SAY’S LAW OF MARKET

Introduction: According to classical economist market forces will

maintain full employment in a long run. Consequently the output will be
produced at the level of full employment.

Say’s Law of Market

J. B. Say was a French Economist who stated the law of market in a
systematic form in the year 1803. According to him “supply creates its
own demand” this statement implies that production of goods and
services will automatically generate income and expenses will be incurred
on the goods which are produced (there is enough demand). In such
situation generally there is no over production or unemployment on
account of excess supply of goods.

Assumptions of Say’s Law of Market:

1. Full Employment of labour and resources: Say assumes that there
is full employment in an economy it is a normal situation even if there is
a temporary unemployment economy will create employment again.
2. Flexibility of Wages, Price & Interest: Say has assumed that
wages, prices and interest rate are flexible, the flexibility brings
equality between demand and supply of labour, money, savings and
investments.
3. Perfect Competition: He assumes that there is perfect competition in
product and factor market.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

4. Direct Relationship between Money Wages and Real wages:

According to Say money wages and real wages are directly related and
proportional. Therefore change in the money wages will bring
proportional change in the real wage.
5. Free Market Economy: It is assumed that there is free market
economy equilibrium is reached automatically between demand and
supply government need not interfere.

Criticism of Say’s Law:

J. M. Keynes in his general theory has criticized Say’s law of market on
following grounds.
1. Supply does not create its demand.
2. Say’s law assumes that production creates demand for the goods on its
own. However this proposition is not applicable in modern economies
were demand does not increase as much as supply increases i.e. there
is surplus production.
3. Self Adjustment not Possible: According to this theory full
employment is reached automatically in a long run. Keynes is of the
opinion that there should be solution in a short term because “in long
run we all are dead and after death there is no problem”.
4. Money is not Neutral: Say’s law of market is based on barter system
and ignores the role of money by saying that money does not affect the
economic activities. On the other hand Keynes says money is very
important. Every household as well as business man holds money.
5. Over Production is Possible: Say’s law is based on the assumption
that supply will create its own demand and therefore there cannot be
over production. According to Keynes people do not spent their entire
income and therefore demand may not be created.
6. Under Employment: According to Kayne’s there is no country in the
world where there is full employment. In a capitalist economy there are
problems of under employment.

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

7. State Intervention: According to Say’s law of market government will

not interfere i.e. “Laissez-faire policy” is adopted however in modern
days in every country there is interference of the government.
8. Demand Creates its Own Supply: Say’s law states that supply will
create its own demand but Kayne’s says that demand creates its own
supply.

TOPIC NO. 6
THEORY OF EFFECTIVE DEMAND

Introduction: Lord JM Keynes brought out the importance of aggregate

demand in his book “General theory of employment, interest and money
in 1936”.

Aggregate Demand: It means demand for all goods and services in an

economy. It is also called as aggregate expenditure.
JM Keynes gave more importance to aggregate demand. According to
him, if aggregate demand goes up, there is increase in output and
aggregate income, which increases employment level also.

How equilibrium level of income is reached?

According to JM Keynes, an equilibrium level of income is reached when
Aggregate Demand (AD) = Aggregate Supply (AS).
 Aggregate demand –It is also called Aggregate expenditure as when
people create demand, they spend money to buy the goods and services.
 Aggregate supply – It is also called as aggregate income as when goods
are supplied, income is received.

How equilibrium level of income is reached in 2-sector model?

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In 2-sector model, there is household sector (consumption) and production

sector (firm) (i.e. C+I)

Aggregate demand (AD) consists of:

 Consumption demand i.e. demand for the goods and services created by
the consumers/household for personal use namely clothing, food etc.
 Investment demand i.e. demand for the goods and services created by
firms/ production units namely, machinery tools etc.

An economy reaches an equilibrium at the point where Aggregate

Demand (AD) = Aggregate Supply (AS).
This fact can be explained with the help of the following diagram:

In the above diagram AD curve intercepts ‘y’ axis at point C which implies
that even when the income is zero, there is consumption expenditure i.e.
money is spent on food, clothing etc.
The aggregate supply (Aggregate income) goes up from the origin in
45degree angle which implies that the amount spent on C + I = aggregate
supply.
An equilibrium is reached at point E where ON is a national income and AD
= AS which is also called ‘Keynesian Cross’

How equilibrium is reached (income) when there are 3-sectors in

an economy?
a) Household sector (consumption) C
b) Production sector (Investment) I
c) Government sector (Govt. exp.) G

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

The equilibrium level of national income in 3- sector economy can be

explained with the help of the following diagram.

In the above diagram AD curve intercepts at C on ‘y’ axis, which implies

amount is spent on basic needs even when income is zero. A interception
on ‘y’ axis implies govt. expenditure, also, apart from consumption
expenditure.
AD 1 indicates consumption, investment and govt. expenditure.
Equilibrium is reached at point E.
When govt. is not involved with AD = AS and at point E 1 when govt. is
involved and national income is ON 1 i.e. an increase in the national
income by NN 1 due to govt. expenditure

How equilibrium national income is reached in four sector model?

In two and three sector model, we have assumed that there is no foreign
trade i.e. there is close economy. However in real world foreign trade
plays important role in every economy the form of export, import,
investment, borrowings and lending etc. The net foreign exchange
earnings can be treated as NX i.e. net export – net import. The equilibrium
level of national income can be better understood with the help of the
diagram given below:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In the above diagram AD curve indicates close economy and AD, indicated
an open economy (with foreign trade). IN the close economy equilibrium is
reached at a point E where AD = AS and ON is a national economy and
with foreign trade equilibrium is reached at E1 where national income is
ON, this point is called Keynesian Cross.

TOPIC NO. 7
CONSUMPTION FUNCTION
(Psychological Law of Consumption)

Introduction The concept of consumption function has been propounded

by a well - known British economist Lord J.M.Keynes.

Explanation
There is a direct relationship between income and consumption i.e. when
income rises consumption also rises. The consumption function can be
better understood with the help of schedule and diagram given below:
Sr. No. D.Y. C S (Y-C) APC= C MPC=C
Y Y
1 0 20 -20 -- --
2 100 100 0 100/100 = 1 80/100 = .80
3 200 180 20 180/200 = .90 80/100 = .80
4 300 260 40 260/300 = .87 80/100 = .80
5 400 340 60 340/400 = .85 80/100 = .80
6 500 420 80 420/500 = .84 80/100 = .80
Y Diagram

Consumption

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

O Income X

 Disposal Income (DY)

Income left with a person at his disposal after paying taxes to the
government.
 C = Consumption expenditure
 S = Saving i.e. Y-C
 APC = Average propensity to consume. It can be calculated by using
the following formula.
 APC = C
Y
MPC = Marginal Propensity to Consume i.e. it establishes the relationship
between change in the income and resultant change in consumption. It
can be calculated by using the following formula.
C
MPC =
Y
C = Change in consumption
Y = Change in income.
MPS = Marginal Propensity to save i.e. it establishes the relationship
between changes in income and resultant change in saving. It is created
by using following formula.
S
MPS =
Y
S = Change in savings
Y = Change in income.
In the above table it is observed that in the first stage even when income
is 0, there is a consumption of Rs. 20/- which indicates that whether a
person has a source of income or not, he will have to spend some money
for his survival even by borrowing.
In the second stage, it is observed that as income and consumption both
are equal i.e. the point of equilibrium.
Third stage onwards it is observed that as income keep on rising, the
consumption also rises in the same proportion.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

From forth stage onwards it is observed that savings keep on increasing

because with the increase in income, entire additional income is not
consumed, only some portion of additional consumption is consumed and
some is saved. It is also observed that APC keeps on failing which is the
ratio of income and consumption.
Lastly it is observed that MPC is constant because income and
consumption both are changing in the same proportion.

Factors determining Consumption Function

(A) Objective Factors (B) Subjective Factors

(1) Income (1) Motive of Enterprise
(2) Distribution of Income (2) Motive of
Liquidity
(3) Price Level (3) Motive of Improvement
(4) Unexpected Profit/Losses (4) Motive of Precaution
(5) Debts (5) Motive of
Independence
(6) Expectations
(7) Advertisement
(8) Credit Facility
(9) Rate of Interest

(A)Objective Factors
1. Income: When income level goes up, consumption is automatically
increased i.e. more one earns more one spends.
2. Distribution of income: If income is evenly distributed then
consumption expenditure is more but if there is wide disparity of
income consumption expenditure is less.
3. Price level: When the goods are available at low prices consumption
expenditure rises because people would prefer to buy more.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

4. Unexpected profits/losses: If person get unexpected profits then

their consumption expenditure increase and when there are
unexpected losses, consumption expenditure falls.
5. Debts: If people are living in debts then their consumption expenditure
falls because a major portion of their income earned is spent on paying
interest and principal amount.
6. Expectations: If people are expecting a bad situation in the future
their current expenditure falls but if people are expecting bright future
their consumption expenditure rises.
7. Advertisement: When products are aggressively advertised people
are tempted to buy them. As a result consumption expenditure rises.
8. Credit facility: When credit facilities are easily and conveniently
offered, people are tempted to buy more goods thereby consumption
expenditure rises.
9. Rate of interest: If banks and other financial institutions are offering
high rate of interest the people are tempted to save more money and
put in the bank and consumption expenditure reduces.

(B) Subjective Factors:

(1) Motive of Enterprise: People save more to secure resources to
undertake further capital investment in productive units.
(2) Motive of Liquidity: People like to have liquid cash on hand to feel
secured to meet exigencies of future uncertainties.
(3) Motive of Improvement: People want to save more at present to
get confidence on a better life in old age in future.
(4) Motive of Precaution: People always prefer to save money,
inorder to make provision for any future needs and emergency.
(5) Motive of Independence: People save more money to maintain
their status and dignity with enjoyment of sense of independence.
Thus, the consumption function demand is a part of the aggregate
demand influenced by the above objective and subjective factors.

Savings Function

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

This is also known as propensity to save.

The amount of saving normally depends on level of income i.e. is higher
the income higher the saving can be calculated by using the formula.
Saving (s) = Income (y) –Consumption (c)

The concept of saving can be better understood with the help of following
schedule and diagram:
Stage Income (y) Consumption(c) Savings(y-c)
(crores) (crores) (crores)
A 0 20 -20
B 100 100 NIL(0)
C 200 180 20
D 300 260 40
E 400 340 60
Following are the observations:
1. In stage A consumption is more than income than it implies people are
living on borrowed money therefore there is a negative saving
2. In stage B Income = Consumption therefore no saving
3. In stage C, D and E it is observed that income can be better understood
with the help of following diagram.
Y

o X

In the above diagram OY is the income curve drawn is 45 degree angle CC

is the consumption curve.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

SS is the savings curve.

In the beginning when the income is less than ON there is Dis–Saving
because consumption is more than Income.
At OM Income = Consumption & therefore there is no saving.
When income is more than ON, income is more than consumption &
therefore there is saving.
Factors affecting Savings function:-
1. Level of income- There is direct relationship between level of income
& savings. If the level of income is more savings are bound to be more
& vice-versa.
2. Distribution of income- If income is evenly distributed among the
people than everyone spends more money & therefore savings are less
on the other hand when there is even distribution of income the
savings are bound to be more because rich people can save more
money because of huge income & limitation of consumption.
3. Degree of indebtness- If people are living on borrowed money than
substantial portion of their income is taken away towards payment of
interest & loan & therefore the savings are bound to be less.
4. Precautionary motive- If people are very careful about their future
requirements than they will have tendency to spend less & therefore
the savings will be more but on the other hand if people are not
bothered about their future they will spend more & therefore the
savings will be less.
5. Future plans- If people have number of future plans to be fulfilled like
education, expansion of business, etc than their present consumption
will be less & savings will be more.

DISTINGUISH BETWEEN: APC AND MPC

Points Average Propensity to Marginal Propensity to
Consume (APC) Consume (MPC)
Meaning Average Propensity to Marginal Propensity to
consume is the ratio of total consume is the ratio of
consumption to total change in consumption to

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

income. change in income.

Expression Symbolically, it is expressed Symbolically, it is
as expressed as
APC = C/Y MPC = C/ Y
Compariso APC is always greater than MPC is always less than
n MPC. APC.
Indicator APC indicates total MPC indicates additional
consumption expenditure. consumption expenditure.
SAVINGS & CONSUMPTION
Points Savings Consumption
Meaning Saving is that part of income It refers to the
which is not spent on current expenditure incurred by
consumption. the people to purchase
goods & services to
satisfy their various
wants.
Formula S = Y – C, where S= Savings, C = Y – S, where S=
Y = Income, & C = Savings, Y = Income, & C
Consumption. = Consumption.
Function Saving is a function of Consumption is a function
income but depends on of income, i.e. C = f(Y).
liquidity, preference & rate of
interest.
Importance Saving encourages Consumption encourages
investment & capital further production of
formation in the economy. goods & services in the
economy.

SAVINGS & INCOME

Points Savings Income
Meaning Saving is that part of income It is the amount earned or
which is not spent on current received by an individual
consumption. or a unit or a group

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

during a given period of

time.
Formula S = Y – C, where S= Savings, Y = C + S, where S=
Y = Income, & C = Savings, Y = Income, & C
Consumption. = Consumption.
Importance Saving encourages Income facilitates
investment & capital expenditure on
formation in the economy. consumption & savings, if
any.

TOPIC NO.8
INVESTEMENT FUNCTION

Introduction: The word function indicates the relationship between two

or more economic variables, dependant and independent.
Investment function indicates the inducement of the people to invest.
Investment function can be expressed in an equation; I= f(e,I)
I= investment
F= function
E= marginal efficiency of capital
I= rate of interest

Determinants of Investment Function

According to Lord Keynes investment depends on:
1) Rate of Interest
2) Marginal efficiency of capital (MEC)

 Rate of interest: Rate of interest means the amount of money

required to be paid for borrowed interest, lower the investment and
lower the rate of interest higher the investment. In a short run, rate of

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

interest is normally stable and therefore it is not a very active factor to

determine level of investment.
 Marginal efficiency of capital (MEC): Marginal efficiency of capital
indicates that higher the returns on investment; higher the tendency to
invest. Marginal efficiency of capital can also be called as “expected
profitability”
According to Mr. Kurihara, “marginal efficiency of capital is the
prospective yield of additional capital asset and their supply price. This
can be expressed in the symbolic terms as follows:-
E=Q/p
E= marginal efficiency of capital
Q= prospective yields of capital asset
P= supply price of this asset
It is clear from the above definition that by following factor. They are as
follows...
i) Supply price of an asset
ii) Prospective yield
iii) Rate of interest
iv) MEC schedule and level of investments
 Supply price of the Asset: It refers to the price of an asset which
an entrepreneur has to pay to acquire new brand assets. Eg. If machine
is available for Rs. 10,00,000 it is a supply price. Lord Keynes arrived at
a precise definition of MEC by relating the above two concepts of
(a)supply price; (b) prospective yields.
 Prospective yields: It means the amount of money which investors
are expecting to earn from the money invested in the assets arriving its
lifetime after deducting operating expenses.
E.g. If Mr. A has invested Rs. 10,00,000 in a machinery and has expecting
the total returns of Rs. 20,00,000 after deducting operating expenses like
maintenance. Life span of the machinery is 10 years. In this case; the
prospective yield per annum is Rs 20,00,000.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

However, Keynes formula for calculation is reffered as series of annuities

is referred to as Q1, Qi2, Q3, Q4.....Q10. In this case ‘Q’ stands for annuity and
number 1,2, 3 stands for years.
According to Keynes annuities may vary from year to year.
 Rate of Interest: Marginal efficiency of capital depends on rate of
interest. If the rate of interest is more than MEC is less and vice-versa.
In other words MEC and rate of interest are inversely related to each
other.
 MEC Schedule and level of investments: According to J.M Keynes
there is inverse relationship between MEC and level of investment
because as the level of investment increases MEC starts falling this fact
can be better understood by schedule and diagram given below:

Investment (in MEC (in %)

1000)
2 20
4 18
6 16
8 14
10 12
12 10

In the above scheduled diagram it is observed that as the investment

raises the MEC, keep on falling shown by negative slope of a curve.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Factors affecting MEC

Factors affecting MEC are classified under two heads;
a) Short term factors
b) Long terms factors
A) Short term factors affecting MEC are:
1)Expectationsabout demand, price and cost: The MEC will rise if the
investor expects the demand for the product to rise or the costs to fall
and vice versa.
2) Changes in the propensity to consume: An increase in the
propensity to consume will raise the MEC and vice versa, because the
demand for capital goods depends partly upon the demand for
consumer goods.
3) Changes in income: Sudden increases in income due to tax
concessions, windfall gains, etc. will raise the MEC and a fall in income
will lower the MEC.
4) Business optimism and pessimism: business optimism will increase
MEC, while business pessimism will lower MEC. Business optimism and
pessimism depend upon political, psychological and social factors.

B) Long Term factors affecting MEC are:

1) Increase in population
2) Development of new areas
3) Improvements in technology
4) Development of infrastructure
The above factors will lead to huge investment activates of all types in the
economy.

Investment Function
Introduction: Broadly speaking investment can be classified into 2
parts:-
a) Financial investment: i.e. investment in financial documents (shares
and bonds)

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

b) Real Investment: i.e. Investment in assets and properties (machinery,

building, tools)

Lord Keynes is concerned with Real Investment only because real

investment leads to addition of output and creation of employment.

Classification of Investment
Investment can be classified into 2 parts:
Autonomous Investment Induced Investment
1) It means investments which is 1) It means investment which are
made without any reference to dependent on profitability that
income and profits that is; profit is, higher the profit, higher the
is not the consideration. investment and lower the profit
Eg. Investment in public hospital lower the investment.
2) Autonomous investment is 2) Induced investment is income
income inelastic elastic
3) Autonomous investments is 3) Induced investments is
normally done by the normally done by private sector
government

Gross Investment Net Investment

i)Gross investment refers to total i) Net investment refers to the
investments in fixed assets like Gross Investment- Depreciation.
factory, building, machinery and
also the investments in current
assets like raw material, work in
progress, etc
ii)Gross investment does not ii) Net investment represents the
represent the real; investment real investment because it

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

because it does take into provides for depreciation

consideration depreciation
iii) Gross Investment always more iii) Net investment is always equal
than net investment or less than gross investment

TOPIC NO. 9
THEORY OF MULTIPLIER

Multiplier / Keynesian Multiplier / Investment Multiplier

Introduction:Mr. R.F. Khan originally developed the concept of
investment multiplier in the year 1935 to explain the relationship between
increase in investment and increase in income.
Subsequently, Lord J.M. Keynes refined it.
Meaning of Multiplier:According to Lord J.M. Keynes, when initial
investment is increased, it increases consumption income and
employment many fold.
The concept of investment multiplier can be expresses symbolically:
∆Y
K=
∆I

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

E.g: If initial investment is increased by Rs: 100 which results in increase

income by Rs: 400 then multiplies = 4 which means that investment
increases the income 4 times. It can be calculated in the following
manner:
1 1
K= or K =
1−mpc mps
K = Multiplier, mpc = marginal propensity to consume &
Mps = marginal propensity to sale

Assumption of Multiplier
The Keynesian theory of multiplier is based on following assumption:
1. Constant marginal propensity to consume– The marginal
propensity to consume remains constant during the process of income
propagation.
2. Excess Capacity– There is an excess capacity in various consumer
goods industries.
3. Existence if Unemployment– The economy operates at less than full
employment level and there exists in voluntary unemployment in the
economy.
4. No time lag– There is no significant time lag involved between the
receipt of income and to its expenditure.
5. Closed Economy– The economy is a closed economy and the country
has no foreign trade activity.
6. Stable monitory and fiscal policy– The fiscal policy and monitory
policies remain stable so that they do not influence propensity to
consume.
7. Stable Economy– It is assumed that economy is stable in nature.
8. Stable price level– The price level remains stable throughout the
process of income propagation.

Concept of Multiplier can be better understood with the help of following

schedule and the diagram:
Multiplier Schedule

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Increase in Induced Additional Additional Savings

Investment Income (Rs. Consumption (Rs. in crores)
(Rs. in in crores) (Rs. in crores) (20%)
crores) (80%)
1000 1000 800 200
800 640 160
640 512 128
512 410 102
Total 5000 4000 1000

Higher the mpc higher the increase in national income (income –

consumption = savings).
It is observed that with the initial increase in investments of Rs. 1000
crores there is increase in the national income of Rs. 5000 crores which is
the multiplying effect.

In the above diagram the total original expenditure curve C + I intersects

in 45o angle at point E at which national income is OY1. However when
the additional investment is made the new curve is C + I + ∆ I which is to
the right and national income is increased to OY2 i.e. ∆ Y is much greater
than ∆ I which is multiplying effect.

Leakages in the Multiplier

The operation of certain factors reduces the process of income
propagation or multiplier effect. These factors are termed as leakages of
multiplier. They are as follows: -

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

1. Holding of cash balances – If people prefer to save part of their

increase in income and do not use for consumption, the multiplier effect
would be reduced. The higher the hoarding, the lower would be value of
the multiplier and vice-versa.
2. Purchase of shares and security – If a part of an increased income
is spent on buying shares and government securities, like bonds. The
consumption will be less and the multiplier effect would be low.
3. Debt un-payment –If people use part of their increased income to
repay old debts instead of spending for future consumption, the value
of multiplier will be reduced.
4. Net imports – When there is an excess of exports over imports, there
is a net outflow of funds to foreign countries. This outflow of flow
reduces the value of multiplier in short run.
5. Inflation – When there is a use in prices of consumption goods, it
would require additional money expenditure to consume the same
amount of goods and services. The increase in income will be lower and
multiplier effect would be reduced.
6. Higher taxes and co-operate savings – The higher taxes and an
increase in cooperate savings would reduce consumption expenditure
of people and value of multiplier.

Limitations of Multiplier or Criticism of Keynes Theory of

Multiplier
1. Existence of time log – Keynes assumed that there is no time gap
between the receipt of income and its expenditure in working of
multiplier. According to critics, this assumption is highly unrealistic as in
reality there is an existence of time log between receipt of income and
consumption expenditure as well as between consumption expenditure
and its reappearance as income.
2. Static phenomenon – According to critics the Keynesian theory of
investment multiplies is a static phenomenon as it is not suitable to the
changing process of dynamic world.

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

3. No Empirical Verification – According to Haler Keynes presentedno

ethical evidence of his multiplier theory. Keynes offered only some
observation instead of sound proof for his multiplier theory.
4. Exclusive emphasis on consumption– According to Gordon Keynes
emphasized too much on marginal propensity to consume. It would
have been more realistic to emphasize on “Marginal Propensity to
spend” rather than marginal propensity to consume.
5. Neglected effect of induced consumption on induced
investment – According to Keynes, the multiplier theory takes into
account the effects of induced consumption on income. It completely
neglects the effect of induced consumption on induced investment i.e.
capital goods sector.
6. Worthless Concept – According to Professor Hazlitt, there can never
be a precise relationship between an increase in investment and
increase in national income. Hence the concept of multiplier is a myth
and it is a worthless concept.

Reverse Multiplier
The multiplier operates forward or backward depending upon rise or fall in
the investments.
If investment rises the multiplier will move forward and when investment
falls it will move backwards which is called reverse multiplier.
The reverse multiplier can be understood with the help of the following
diagram:

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 Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

In the above diagram original investment curve is I and equilibrium is

reached at point “E” where I & S intersect each other. (SS curve is drawn
on the assumption that MPS is same at all levels of MI and national income
is “OY”.
However when investment falls as downwardly I, the new equilibrium is
revealed at point E1 and national income has fallen to OY1 the YY1
(change in NI) is greater than II1 which indicates that small fall in
investments leads to much more fall in NI.

Money Multiplier
The total money supply in an Economy is always more than currency,
initially supplied by monetary authorities.This is called as money
multiplier.
M
m=
H
M = Total money supply
H = High powered money (C+R)
m = Money multiplier

How much will be the total money supply depends on:

1) Currency deposit ratio (k)
2) Reserve ratio (h)

Currency deposit ratio (k)

The high-powered money (h) is determined by
1) The money as a currency (c)
2) The banks as reserves (r)
When the people demand more cash, less cash is available with the banks
therefore, lower is the credit creation. The ratio of preference of the
people demanding deposits is called currency deposit ratio.

Reserve Ratio (r)

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The reserves held by the banks as reserve money can be divided into two
parts:
1) The required reserves (rr)
2) Excess reserves (es)

Required Reserves – The required reserves is one which commercial

bank must hold with the RBI when required reserves is reduced,
commercial banks will have more cash in hand to create loans

Acceleration
Introduction:The principle of acceleration was originally introduced by
French economist Mr. Albert & subsequently refined and developed by
Hick Samuelsson & others. This principle basically, tells us that when there
is rise in the demand for consumer goods, it leads to rise in the demand
for capital goods at much higher rate.
For eg: If demand for car (consumer goods) increases by 10% may lead to
increase in demand for machinery (capital goods) by 20%.
The principle of acceleration shows the relationship between change in the
demand for consumption goods and capital goods.
Symbolically,
A = Accelerator
I = change in demand for investment/capital goods
C= change in demand for consumption goods.
The concept of acceleration can be better understood with the help of
schedule given below:

Accelerator Schedule
Durati Dema % of No. of No. of No. of Total Remark
on nd for chang machin machine machin No. of
Cars e in ery ry ery machin
dema require required require ery

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

nd for d to for d to require

cars meet replace meet d to
original ment new meet
deman deman total
d d deman
d
0 1000 -- 100 -- -- 100 --
demand
for cars is
1 1000 -- 100 10 -- 110 constant
but for
machiner
y it is
increased
by 10%
for
replacem
ent
demand
for cars
2 1100 10% 100 10 10 120 has
increased
by 10%
but for
machiner
y it is
increased
by 20%
for
replacem
ent
↑ 10% ↑ 20% 1:2

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Observations:
It is observed that when the demand for the consumer goods is increased
by 10%, demand for the capital goods is increased by 20%

Assumptions of Acceleration:
1) Demand for the cars is 1000 in the first year
2) For manufacturing cars, 10% machineries are required i.e. 100
machineries are required for manufacturing 1000 cars.
3) Machinery has a life span of 10 years i.e. every year 10% machineries
are required to be replaced.
4) Demand for the cars is increasing only from second year.
5) It is necessary to have capital goods
6) It is assumed that factories working at a full capacity and therefore with
the increase for cars there is a increase in the demand for the
machinery

Limitations:
1)It is assumed that capital output rate will remain constant but in fact it
keeps changing.
2)It is assumed that there is full utilization of capacity but in many cases
there is underutilization.
3)It is also assumed that resources are available for investment but in fact
they may not be available
4)It is also assumed that there is no time gap between production and
consumption but in fact there is always a time gap
5)It is assumed that demand is constant but in fact it keeps on fluctuating.

Distinguish between Multiplier & Accelerator.

Multiplier Accelerator
Multiplier means the no. of times Accelerator means rise in
the rise in income due to rise in demand for capital goods due to
investments. rise in demand for consumption

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

goods.
∆Y ∆I
K= A=
∆I ∆C

Multiplier depends on Accelerator depends on demand

investment. Higher the for consumption goods.
investment, higher will be the
national income but investment
again depends on MPC i.e. Higher
the MPC, higher will be the
investment.

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TOPIC NO.10
LIQUIDITY PREFERENCE THEORY OF INTEREST

Introduction: Liquidity preference theory of interest was profounded by

“Lord J.M. Keynes”.
What is Interest?
Interest is the price paid for money i.e. just like a price of a commodity is
decided by its demand, interest rate is decided by its demand for liquidity
preference (D/D for money) & supply for money.

Factors Determining Demand for Liquidity Preference/ Demand

for Money
Demand for liquid cash i.e. Desire to hold liquid cash in hand or in a bank
account from which money can be withdrawn any time (saving & current
account) depend on three motives: -
1. Transaction Motives: It means desire of people to keep liquid cash in
hand/ bank for day to day unavailable expenses.
Individuals/ household keep liquid cash with them to meet day to day
expenses like food, transport, clothing etc.
Businessmen keep liquid cash with them to meet day to day expenses
bill etc.
The Demand for Transaction Motive is : -
A.Interest Inelastic: i.e. irrespective of rate of interest offered by the
banks on term deposits the D/D for transaction motive remains same
because expenses are unavailable &
B.Income Elastic: i.e. money demand for transaction motive depends on
higher the income higher the money demanded for transaction motive.
2. Precautionary Motive: It refers to demand for liquid cash created by
the people to meet unexpected emergencies.
Individuals and firms keep money for precautionary and sickness etc.
The demand for precautionary motive is interest inelastic i.e. higher the
income – higher the demand for precautionary motive.

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3. Speculative Motive: It refers to cash in hand/bank (savings/current

account) kept for speculation i.e. to take advantage of price fluctuation
i.e. buy at lower price and sell at higher price.
The demand for speculative motive is interest elastic i.e. if banks are
paying higher interest on term deposit people will keep less cash with
them and vice-versa i.e. there is inverse relationship between ROI and
demand.
We can express the demand for money for transaction, precautionary
and speculative motive as under:-
Md = M 1 + M 2
Md= total demand for money
M1 = demand for money for transaction and precautionary motive M 1
f(Y).
M2 = demand for money for speculative motive M2 f(r).
Md = f (y,r).
The relationship between rate of interest (ROI) and demand for liquidity
preference (cash in hand) can be better understood with the help of
diagram given below:

In the above diagram it is observed that rate of interest is reduced from

OR to OR1 by the bankers and financial institutions. Demand for money
(cash in hand)/ liquidity preference) has increased from OM to OM1 has
denoted Md curve sloping downwards from left to right which means

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

there is a inverse relationship between rate of interest and demand for

liquidity preference.
Supply of Money: According to Lord J.M. Keynes money is supplied by
the central bank of the country and in a short run money supply remains
constant irrespective of rate of interest. This fact can be explained with
the help of the diagram given below:

In the above diagram MS curve (money supply curve) is a vertical straight

line indicating irrespective rate of interest money supply remains
constant.

Determination of Rate of Interest: Demand for liquidity preference

(demand for cash) and supply for liquidity preference (supply of cash) can
be better understood with the help diagram given below:

In the above diagram Md is a demand curve for liquidity preference and

Ms is money supply curve both the curves intersect at point E at which OR
is the rate of interest.

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Criticisms of Liquidity Preference Theory of Interest:

1. One Sided Theory: According to Prof. Hazitt the liquidity preference
theory is one sided because it takes into account only monitory factors
affecting the rate of interest whereas infact there are non monitory
factors also which affects rate of interest.
2. Role of productivity is neglected: According to critics the rate of
interest paid by the borrower to the lenders depends on productivity of
a capital which is completely neglected by J.M. Keynes.
3. Element of savings ignored: According to Prof. Jacob this theory has
ignored elements of savings, according to this theory rate of interest for
is for partying (surrendering) with the liquidity but in fact rate of
interest is paid saved by the people.
4. Long Run Period is neglected: According to critics Keynes has
considered only short run factors in determining rate of interest and has
fail to explain determination of rate of interest in a long run.
5. Different rate of Interest: According to critics liquidity preference
theory fail to explain why different rate of interest exist for different
types of loans.
6. Failure to explain Depressionary Situation: According to critic rate
of interest during the depression is very low while liquidity preference is
very high. This is contrast to Kenyes theory which says higher the
liquidity (keeping more cash in hand and not in bank) higher the rate of
interest (bank do not have more deposits).

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TOPIC NO. 11
ISLM Model

The ISLM Model is introduced by Hicks &Hansen they divided market

into two parts
a) Goods/ Product Markets
b) Money Market
They explained how an economy reaches equilibrium with the help of
equilibrium in product and money market.
 The product/ goods Market equilibrium and IS curve.
 The goods/ product market researches an equilibrium when aggregate
demand = Aggregate income.
 The aggregate demand depends on consumption investment demand
 The ROI is an important factor to determine level of investment
 When ROI (Rate of Interest) falls (), the level of investments rise () and
vice-versa.
 When the level of investment rises (), there is a rise in aggregate demand.
 The level of investments decides the goods market equilibrium and the
level of investments is decided by rate of interest. Indirectly IS curve
relates different levels of equilibrium of National Income with ROI i.e. when
ROI rises (), Investment falls (), and when investment falls (), Aggregate
demand also falls () and vice-versa. The result of changes in the above
factors leads to shift in the equilibrium in the goods market.

The above diagram is divided into panel ‘A’ & ‘B’.

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 In panel A, ‘AD’ curve intersects at point A1 on 45 degree line and the

goods market is in equilibrium at OY, Income curve is panel B at ‘E1’
point the ROI is OI1. However, when there is a fall () in the ROI to OI2,
the AD2 curve intersects at point E2 in panel “A” and as a result
National Income goes up to OY2 by joining E1 E2.
 In panel B, we get IS curve. The IS curve slope downwards because sue
to fall () in the ROI, the investment and Aggregate demand rises ().
When IS curve shifts to the right it indicates i.e.
1) There is an increase in government spending OR
2) There is a fall in the tax rate OR
3) There is a rise in the autonomous investments.

Money Market Equilibrium and LM Curve

The money market equilibrium is reached when demand and supply of
money are equal.
 The LM curve explains different combination of rate of interest and
National Income at which money market reaches equilibrium.
 The demand for money for transaction and precautionary motive depends
on level of income i.e. higher the income, higher the DLP (demand for
liquidity preference)
 The demand for money for speculative motive depends on ROI i.e. if the
ROI is more demand for DLP is less.
Md = L (y, r)
Md = Money demand
L = Liquidity preference
Y = Real income
R = ROI

TOPIC NO. 12
PHILLIPS CURVE – UNEMPLOYMENT – STAGFLATION

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Phillips Curve
Introduction: A noted British Economist, A.W. Phillips published an article
in 1958, on the basis of research of historical data from UK for about 100
years.
On the basis of data collected by him, he arrived at a conclusion that
there is an Inverse relationship between Inflation (price rise) and level of
unemployment in a country.
In other words there is a trade off between the level of unemployment and
inflation i.e. for reducing level of unemployment the higher rate of
inflation must be accepted and for reducing the inflation higher rate of
unemployment must be accepted.
The concept of Phillips Curve can be explained with the help of diagram,
given below:

It is observed that at point “E” the rate of inflation is 10% and rate of
unemployment is only 2% and when rate of inflation falls to 5% the level
of unemployment has increased to 5%.
However during ‘70s in USA & Britain a situation contrary to Phillips curve
had a rose i.e. there was high level of inflation and also high level of
unemployment in a country.

Stagflation

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

Introduction:- The term stagflation is introduced by Jain Macleod, a

British parliamentarian in the year 1965.
The concept of stagflation is contrary to concept of Phillips curve because
in stagflation there is;
a) Increase in rate of Inflation and
b) Increase in level of unemployment
The concept of stagflation can be explained with the help of following
diagram:

In the above diagram “AS” is aggregate supply curve and AD is aggregate

demand curve.
At point E, ‘AS’ curve intersects ‘AD’ curve where at ‘op’ price “ON”
output is produced and economy reaches an equilibrium. Due to increase
in oil prices etc. the cost of production rises leading to upward movement
of supply curve i.e. AS1. “AS1” curve at which price “E 1” on AD curve, at
which price increased to “OP” and output reduces to “ON 1” this indicates.
1) Prices have gone up (inflation)
2) Output have reduced (production)
3) Due to less output even employment falls i.e. (unemployment
increases).
Some of the economists are of the opinion that India faced stagflation in
1970’s and 1980’s and currently USA is heading for stagflation.

Causes of Stagflation

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1) Higher prices of crude oil: Increase in the prices of crude oil is major
causes of stagflation the “OPEC” Organisation of petroleum exporting
countries “have taken steps in this regard”
2) Increase in cost of production: Due to rise in cost of wages, raw
material & other products there is increase in cost of Production.
3) Low productivity: The lower productivity (i.e. average production &
Quality) mainly due to protection to the labourer results in higher cost.
4) Social Benefits: Social benefits in the form of pension, free supply of
goods, good and services for the poor, subsidies , unemployment
benefits, food security etc creates more demand without increasing the
production leading to stagflation
5) Excessive Government Regulations: Complicated & unwanted rules
regulations, procedures & formalities results in less production leading
to stagflation.
6) Higher Taxes: Due to higher taxes imposed by the Govt., cost of
production increases resulting in higher prices and less demand.
7) Benefits Finance: Due to deficit financing there is ore expenses
incurred by the Govt. Than income resulting in more demand and
higher prices.
8) Policy changes: popular policy measures like farmer debt waiver, free
electricity; free educational, higher salary leads to more demand
without increase in supply leads to stagflation.

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TOPIC NO.13
MONEY SUPPLY

Meaning of Money Supply:

It means total stock of domestic currency owned by the public (individuals
and business organization) in a country. In other words, money held by the
govt. Central bank & Commercial bank does not include money supply
because it is not in circulation.
Constituents of Money Supply: Constituents of money supply is
classified into two parts
Constituents of Money Supply
Traditional Measure B)
Modern Measure
(Narrow Money)
(Broad Money)

1) Currency (Coins & Notes) 1) Currency (Coins

& Notes)
2) Demand Deposits 2) Demand Deposits
3) Saving Deposits with
P.O
4) Time Deposits
(Fixed)
5) Government Securities
6) Credit

Traditional concept of money or Narrow Money

According to traditional concept, money is means of making payments
therefore it includes only those things, which can be used for making
immediate payment for purchase of goods and services.

Traditional concept of money includes:

1) Currency – It includes coins and notes, which can be used for making
immediate payments.

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2) Demand Deposits – These are those deposits which account holder

can withdraw from the bank anytime by cash or making of payments to
anybody by issue of cheques. For eg: Current account or Savings
account. It should be noted that time deposits i.e. deposits in the form of
fixed deposits are not included because money can be withdrawn only
after the expiry of a particular period of time. It is also called extraction
money because it is used for day-to-day transaction. Symbolically, it can
be expressed as
M1 = C + DD
M1 = Traditional/Narrow money
C = Currency
DD = Demand deposits

M1 is very near to RBI’s concept of M1

RBI’s concept of M1 is:
M1 = C + DD + OD
OD includes other deposits of commercial banks and foreign banks with
RBI; this is very negligible and therefore can be ignored for practical
reasons.

A) Modern Concept of Money or Broad Money:

The modern concept of money is also called as new money or economist
like Milton Freidman, Edward etc. and supports broad money concept.
Broad money concept includes everything, which is in liquid form & new
liquid form.

The modern concept of money can be called as M2 i.e. M1 + a + b

+c+d
No. M1 M2 M3 M4
1 Notes in Notes in Notes in circulation Notes in circulation
circulation circulation
2 Circulation of Circulation of Circulation of Circulation of Rupee
Rupee Coins Rupee Coins Rupee Coins Coins

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3 Circulation of Circulation of Circulation of small Circulation of small

small coins small coins coins coins
4 Cash with banks Cash with Cash with banks Cash with banks
banks
5 Demand Demand Demand deposits Demand deposits
deposits with deposits with with bank with bank
bank bank
6 Other deposits Other deposits Other deposits Other deposits with
with RBI with RBI with RBI RBI
7 POSB deposits POSB deposits POSB deposits
8 Time deposits with Time deposits with
bank bank
9 Total post office
deposits

It should be noted that from M 1 M2 M3 M4 are arranged in order of

liquidity.
It should further be noted that money supply must not include
1) Cash balance of govt. – Cash balance held by central and state govt.
with central bank (RBI)
2) Time deposits – Deposits commercial bank, which cannot be
withdrawn before maturity, they are included in money supply only when
they are withdrawn.
3) Overdraft – It is not included unless the holder uses them.
4) Cash balance reserves – Cash balance held by central and
commercial bank held as reserves to support demand deposits.
5) Monetary gold reserve – It is held by the central bank because it not
in circulation.
Since the above-mentioned are not in circulation, therefore they are not
money.

High Powered/ Reserve Money (H)

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High Powered/Reserve money is at the base of “money supply”. High

Powered/Reserve money can be expressed as: H = C + R + OD
C = Currency i.e. (Coins & Notes)
R = Cash Reserve Ratio
OD = Other Deposits with R.B.J

High Powered/Reserve money concept defers from M, concept of money of

RBJ in “second” components.
M1 = C + DD + OD
C = Currency with public
DD = Demand Deposits
OD = Other deposits with RBJ

High Powered/Reserve money is referred as Mo also.

H (Mo) = C + R + OD

“R” is cash reserves ratio & is decided by the central monetary authority
i.e. RBJ and not the commercial banks.
DD is a creation of commercial banks. The amount of “DD” available
depends on ‘R’. If ‘R’ is more, DD will be less because more money goes to
the Central Bank. The capacity of commercial banks to create Loans/
Credit depends on “DD”. Therefore “R” is at the base of money supply.

Velocity of Circulation of Money

Introduction: Money supply at a given point of time (stock of money) is
the static concept, to know money supply over a period of time we should
multiple stock of money (M) with velocity of money (V).
The difference between money supply at a particular point of time and
over a period of time is well brought out by D.H. Robertson by describing
them as “Money Sitting (Stock of Money) and Money on the Wing
(Velocity)”

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Meaning: In simple term velocity of Money means number of times

money is circulated during a given period of time.

Velocity of Money is classified into Two Parts

1. Transaction Velocity: It means the speed at which unit of money
moves around the circle of payments from income to the payment for
goods and services and back to income again.
Annual Volume of Transaction
Transaction Velocity Ratio =
StockofMoney
E.g. If stock of money is Rs. 1000 crores transaction conducted are worth
Rs. 10,000 crores.
Annual Volume of Transaction 10,000
Transaction velocity ratio = = =10
StockofMoney 1000

Therefore, TV Ratio = 10 which means 1 unit of money is circulated 10

times in a year.

Factors Determining transaction Velocity

A number of factors influence the transaction velocity. They are:
1. Volume of Production and Trade: With a constant supply of currency
and demand deposits, their velocity would be more when economy
produces more goods and this has more transactions.
2. Institutional Arrangements: If the institutional set up comprising
banks and other financial intermediaries enable deferred payments, or
other credit systems, the velocity will be lower.
3. Savings: If people increase their savings, less money is spent, bringing
down the velocity. Dis-savings, on the other hand increases expenditure
and this transaction velocity.
4. Change in Price Level: During inflation money circulates faster,
whereas during deflation economic activities decline and so also the
velocity. A change in price level is usually associated with cyclical
phases. During the prosperity period economic activities increases and
also the price level. This necessitates a higher velocity of money.
Reverse is the situation during deflation.

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5. Regularity and Certainty of Income receipts: Time interval

between successive income receipt influences velocity of money. If
income is received in quick intervals, less money is required to be held
therefore money turns over faster. Long intervals increase idle cash and
reduce velocity. Certainty of income receipts infuses confidence and
encourages spending. If income receipts are not certain people become
cautions, spend carefully, keeping balance to meet uncertainty and thus
reducing velocity of money.

Income Velocity of Money

It is the “average number of times a unit of money is used for making
payments for final and services”. The concept is more popular with
national income accounting techniques.
GrossNatoinalProduct (GNP )
The Income Velocity Money Ratio =
MoneyStock

If the GNP is Rs. 50,000 crores and money stock (M 1) is Rs. 10,000 crores,
GrossNatoinalProduct (GNP ) 50,000
The Income Velocity Money Ratio = = =5
MoneyStock 10,000
i.e. Income Velocity of Money is 5 times in a year.
The income velocity is always lower than transaction velocity, since the
former confines itself to the final goods and services. Transaction in
financial assets and sales of existing land and building are also excluded
from income velocity.

Factors Determining Income Velocity

Growth of GNP: An increase in GNP vis a vis given quantity of money
requires faster turnover of money to purchase the larger quantity of final
goods and services. A decline of GNP with the constant quantity of money
would reduce the income velocity. Similarly an increase in quantity of
money with constant GNP would bring down the income velocity of money.
Demand for Idle Cash: Income velocity of idle cash is zero. If the
demand for idle cash increases, expenditure on final goods and services
declines, bringing down the income velocity.

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Quantity of Money Supply: If the stock of money increases faster than

the final goods and services, the income velocity falls, since there are less
goods and services available to purchase.
Besides these, some factors which affect the transaction velocity also
affect income velocity of money.

TOPIC NO. 14
DEMAND FOR MONEY

Introduction: We live in a monetary economy in a monetary economy

people create demand for money
 Buying goods and services
 Holding at idle cash

We must answer two questions to understand the concept of

demand for money
 Why people want (demand) money?
 Which factors decide the demand for money?

Theories of Demand for Money

A) Classical Theory of demand for money:
 The classical theory of demand for money is profounder by economists like
David Hume, T.S. Mill and Living Fisher etc.
 According to them, money is demanded for buying goods and services.
 Money acts as a medium for exchange.
 If the volumes of transactions are more than the demand for money is also
more & vice-versa.
The demand for money is determined by three objective factors:
 The volume of transactions (Quantity)
 Price of commodity products
 The velocity of money circulation MV = PI

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M – Money supply
V – Velocity
P – Price Leader
I – Transaction which means, money supply is money issued by the
government x velocity
(Number of times money is circulated during a given period of time). Total
demand for money = price x quantity of goods purchased.
From the above it is very clear that: -
 MV indicates supply of money
 PT indicates demand of money in short run
 M & T are constant
 The increase in velocity of money reduces demand for money

B) Cash Balance Theory (C.B.T)

Cash Balance Theory (CBT) relating to value of money has been presented
by Neo – classical economist like Marshall, Robertson, and Keynes. This
version is also known as Cambridge equation because all these economists
belong to Cambridge school of economics in Chicago. This theory is known
as C.B.T because it gives more importance to cash balance rather than
cash transaction.
The CBT states that value of money depends upon the demand for the
cash balance (Demand for liquid cash in hand) rather than price level.
In modern days, the supply of money remains constant i.e. fixed. Demand
for money plays a very important role in determining the value of money.
Thus, according to Cash Balance Theory for money, “The Demand for
money remaining equal”, the value of money varies inversely with the
supply of money i.e. if the supply increases the demand remaining the
same (equal) value of money falls. Therefore, vice - versa.

Explanation:
According to this Neo – Classical Theory, the value of money is determined
by demand and supply of money.
Cash Balance Theory by Alfred Marshall:

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Prof. Amar Oswal S.Y.B.Com – Sem III Economics 2024-25

According to Dr. Alfred Marshall, cash balance equation is as follows: -

M =Ky
M = Stock of Money (Money Supply)
K = Refers to proportions of income which person would prefer to retain
with him as liquid cash
Y = Value of output = Price x output (P x O)

C) Keynesian Approach of demand for money

According to Lord Keynes, demand for money depends on demand for
liquidity preference i.e. demand for liquid cash by the people. According to
him, people keep liquid cash with them for three important motives –

Transaction Motive:
Transaction motive means demand of people to keep liquid cash with
them to make day-to-day unavoidable expenses.
Individuals keep liquid cash with them to meet expenses on food transport
etc.
Businessmen or firms keep liquid cash with them to meet expenses like
wages taxes light bill etc.
Demand for transaction motive in interest inelastic that is irrespective of
rate of interest the demand for transaction motive remains the same.
However the demand for liquidity motive is influenced by income. Higher
the income, higher the demand for liquidity preference and vice-versa.

Precautionary Motive:
Precautionary motive means the demand for money created by the people
to meet emergencies, which are unpredictable.
Individuals/Firms keep liquid cash to meet emergencies like accidents,
sickness etc.
Demand for the precautionary motive is an interest inelastic that is
irrespective of rate of interest. The demand for precautionary motives
remains the same.

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However, demand for precautionary motive is directly related to income

i.e. higher the income, higher the demand and vice-versa.
Lord Keynes calls the combined demand for transactions and
precautionary motives by individuals and firms “Active Balances”.
Symbolically it’s called “L1”

Speculative Motive:
Speculative motive means desire of people to keep liquid cash in hand to
take advantage of fluctuation in rates of interest and prices of shares and
bonds.
Lord Keynes has observed that when the rate of interest is expected to
rise the demand, the demand of money for speculative purpose i.e. bond
market starts falling as people would like to take advantage of higher
rates of interest and vice-versa.
Demand for speculative motives is inversely related to rate of interest.
Lord Keynes calls it as “Idle Balances” symbolically called “L2”
According to Keynes, the total aggregate demand for money consists of
‘L1’ & ‘L2’
L1 includes transaction and precautionary motives that depend on income.
Symbolically, L1 = f (y)
L2 includes speculative motives that are dependent on rate of interest.
Symbolically, L2 = f (r)
Therefore, according to Keynes, L1 + L2 = L
L = f (y,r)

Demand for Liquidity Preference Curve

The total or aggregate demand for money with a given level of income
(income is assumed to be stable) depends on the rate of interest i.e.
higher the ROI lower the demand for liquidity preference i.e. demand for
liquid cash.

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TOPIC NO.15
INFLATION

Introduction: The word inflation is very common and is used by

everybody repeatedly. It has become a global problem. Normally,
everybody suffers due to inflation. Only the extent of suffering may differ.
Meaning: According to Gowther, inflation is a state in which value of
money is falling.
According to Coulbwin, inflation means too much of money chasing too
few goods.
According to J.M.Keynes, inflation means a rise in the price level after the
point of full employment is true inflation.

Demand Pull Inflation: Whenever there is a rise in a price level due to

rise in demand, it is called demand-pull inflation.
The concept of Demand Pull Inflation can be better understood with the
diagram given below:

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In the diagram above, SS is the supply curve and DD is the original

demand curve. They intersect at point E and goods are sold at OP Price.
However, due to rise in the demand, demand curve moves to the right
represented by D1 D1. Supply being constant at point E1 equilibrium is
reached and goods are sold at OP1 price. In other words, price has
increased from OP to OP1 leading to inflation due to rise in the demand.
Following are the factors causing Demand Pull Inflation:
1)Increase in money supply: Money supply is the responsibility of
monetary authority (RBI). When reserve bank of India increases money
supply without corresponding, increase in supply of goods leads to
more money chasing too few goods. As a result prices go up which is
called inflation.
2)DeficitFinancing: It is a situation in which government expenditure is
more than govt. revenue. As a result of expenditure, people’s income
rises resulting in more money supply creating more demand for goods
without corresponding increasing supply as a consequence higher
prices called inflation.
3)Credit Creation: Credit creation is a process of giving of loan by the
commercial and other banks. When credit creation increases it results
in higher money supply, higher demand but constant supply as a
consequence is called inflation.
4)Exports: When exports are increased it automatically reduces
domestic supply at the same time people who are directly or indirectly
involved in exports get higher income as a consequence there is more
money supply more demand but less supply as a consequence higher
prices called inflation.
5)Repayment of Debts: When government pays of Public Debt, the
overall money supply in the hands of the people increases. Therefore,

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more demand is created. Supply being constant as a consequence

prices go up which is called inflation.
6)Black Marketing: Black marketing means changing of more than the
prescribed price by the seller from the consumers. Though unethical
and illegal it may prevail in the market. Black marketing is namely due
to more demand less supply, which results in higher prices called
inflation.
7)Black Money: Black money means unaccounted money. Unaccounted
money is circulated due to activities like: tax aviation, smuggling and
illegal activities. Normally people with the black money have tendency
to buy unwanted goods and also excess quantity of goods than required
which results in increase in demand for the goods and services without
corresponding increase in supply resulting in higher prices called
inflation.
8)Hoarding by consumers: Hoarding is process of accumulation of
goods/buying of goods more than normal requirements, which results in
higher demand without corresponding increase in supply resulting in
higher prices called inflation.
9)Hoarding by suppliers: It means accumulation of goods by the
suppliers with the intension to create shortage of goods in the market
leading to higher prices called inflation.
10) Population: When population of a country increases, it leads to
higher demand for the goods but when there is no corresponding
increase in supply of goods it leads to higher prices called inflation.
11) Reduction in taxes: When govt. reduces the taxes, it leads to
more money in the hands of the people due to which people are
tempted to buy more goods without corresponding increase in the
supply of goods resulting in higher prices called inflation.
12) Payment of interest: When banks financial institutions and the
govt. pays interest on loans taken by them to the public, money supply
in the hands of public is increased as a result demand goes up without
corresponding increase in the supply of goods leading to higher prices
called inflation.

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Cost Push Inflation: When inflation takes place due to increase in cost,
it is called Cost Push Inflation.

In the diagram above DD and SS are original demand and supply curve
respectively and equilibrium is reached at point E at which OM quantity of
goods are sold at OP price. However due to rise in the cost supply, it is
reduced denoted by S1. S1 curve are sold at OP1 price which implies price
has increased from OP to OP1.

Following are the features leading to Cost Pull Inflation:

1)Wages: when workers are paid more wages, it increases the cost of
production. When cost of production is increased it results in higher
prices called inflation.
2)Material Cost: When the cost of material increases, it increases the
cost of production. When the cost of production is increased it results in
higher prices called inflation.
3)Profit margins: When sellers want more profits it leads to higher
prices which is called inflation.
4)Other factors: Other factors like earthquake, flood, drought, etc. may
increase the cost of production resulting in increase in price called
inflation.

Steps to Control Inflation

Introduction: Inflation is a very serious problem created due to
disequilibrium between demand and supply. This problem must be solved

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immediately otherwise it may lead to hyper inflation due to which

economy may crumble and collapse.
Steps/ measures to control inflation can be classified under 4 heads. They
are as follows:

Steps taken to Control Inflation

Monetary Measures Fiscal Measure Physical Measures

Bank Rate Reduction in ExpenditureRationing & Price
Control
Cash Reserve Ratio Public Borrowing Increase in
Output
Open Market operation Rise in tax
Consumer credit Overvaluation of Currency
Selective credit control Management of Debts
Marginal requirement Promotion to save
Moral sudation

Following are some of the monetary measures;

i) Bank Rate: Reserve bank of India (central bank) increases bank rate
for commercial bank when they come for rediscounting of bills (as a
result) commercial bank increases lending rate to the public. Loan as a
result loans become costly. Therefore borrowing is reduced. When is
reduced, money supply is reduced, prices are reduced and therefore
inflation is controlled.
ii) Cash Reserve Ratio: It means the percentage of liquid cash of the
total deposits which commercial banks are required to keep with them
in a liquid form when central banks tell the commercial banks to keep
higher percentage of liquid cash with them their capacity to give loan
is reduced which automatically reduces money supply when money

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supply is reduced prices fall and with the fall in price, inflation is
controlled.
iii) Open market operation: It means buying or selling of government
securities and bonding to public by RBI. When RBI starts selling
government bonds and securities, people start withdrawing money
from commercial banks to buy these securities. As a result, money
supply in the hands of the commercial banks is reduced. Due to this,
loans are reduced. When loans are reduced, money supply is reduced
which reduces the demand as a result price is also reduced and
inflation is controlled.
iv) Consumer credit: It means loans and advances given by banks for
buying of consumer durable products viz. T.V, fridge, motorcycle, etc.
During inflation, central banking authority i.e RBI may direct
commercial banks to reduce consumer credit. When consumer credit is
reduced, demand for consumer durable products falls resulting in
reduction in prices of consumer durable which means inflation is
controlled.
v) Selective Credit Control: It means reducing loans and advances on
selected goods and services which are leading to inflation. Under this
method, central monetary/ banking authority i.e. RBI instructs the
commercial banks to reduce or not to give loans and advances on
selected items which are leading to inflation. Eg. RBI may instruct
banks not give loans against schemes and securities.

vi) Margin Requirement: Margin requirement means the % of money

which a borrower is requeid to pay/ bring – for taking loans .foreg. If
margin requirement is 40% that means a person buying a car for Rs
4,00,000/- will have to bring Rs. 160,000/- and bank will give him loan
of Rs 2,40,000/- only. During inflation margin requirement may be
raised to 50% which means banks will give loan of Rs. 2,00,000/- only
as a result, demand for cars will fall controlling the inflation.
vii) Moral Suasion: Under this method, RBI calls an informal meeting of
all bankers and expresses his view points on controlling inflation and

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bankers are expected to listen to his instructions and assist him in

controlling inflation. Supply is reduced which reduces the price and
ultimately inflation is controlled.
Selling of bonds↑ Withdrawal from loans ↑ Markets ↓ Price ↓ and
securities commercial banks supply.

Fiscal Measures: It refers to steps taken by the government to control

inflation by reducing money supply in the hands of the people
i) Reaction in Public Expenditure: Public expenditure means money
spent by the government on various projects (goods and services)
During inflation, government reduces public expenditure and as a
result, money supply falls and when money supply falls demand for
goods and services also falls. As a result prices are reduced and
inflation is controlled.
ii) Public Borrowings: Means borrowings of money by the government
form the public by using government bonds and securities when
people purchase their bonds and securities money supply in the hands
of the public is reduced. As a result demand falls due to which price
falls and inflation is controlled.
iii) Rise in Taxation: When government increases direct and indirect
taxes in the form of income tax, sales tax, octroi tax etc. Money in the
hands of the people reduces considerably. As a result prices fall
automatically which controls inflation.
iv) Over valuation of Currency: Overvaluation of currency means
increase in the value of Indian currency. As a result goods become
costly for the foreigners due to which exports are reduced and when
exports are reduced, supply of goods in home country goes up which
reduces the prices and inflation is controlled.
v) Management of Debts: By managing the public debts, inflation can
be controlled.
Eg. Repayment of foreign debts reduces the money supply in the
domestic country. As a result, demand falls, prices fall which controls
inflation.

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vi) Promotion to Save: This is a very effective and productive method of

controlling inflation. By encouraging the savings investments in
productive aids increases which increases the production when
production increases, prices are reduced and inflation is controlled.
vii) Physical Measures: Rationing and price control – Due to inflation
from lower income group and middle income groups are affected most
to help them. Government supplied basic necessities distribution
system i.e. rationing. And also puts restrictions on prices of several
other commodities.
viii) Increase in Output: Inflation takes place due to more money and
less goods and therefore government takes the inflation to increases
the production but the prices of increasing the production it should be
remembered that there is cost control also.

Effects of Inflation
Introduction: Inflation affects different people differently, when prices
rise value of money falls as a result some people gain, some people loose
and some people stand between.
People can be broadly divided into two economic groups (1) Fixed Income
Group & (2) Flexible Income Group.
Effect of Inflation on Redistribution of Income and Wealth, Production and
on the society as a whole are discuss below.
1. Effect on Redistribution of Income and Wealth: There are two
ways to measure the effect of inflation on redistribution of income and
wealth on the society. First on the basis of change in the real value of
such factor income namely wages, salary, rent, interest, dividend and
profits.
Second, on the basis of the size distribution of income over time as a
result of inflation, i.e. whether the income of the rich have increased
and that of the middle and poor classes have declined with inflation.
Inflation brings about shifts in the distribution of real income from those
whose money incomes are relatively inflexible to those whose money
incomes are relatively flexible.

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The poor and middle classes suffer because their wages and salaries
are more or less fixed but the prices of commodities continue to rise.
They become more impoverished. On the other hand, businessmen,
industrialists, traders, real estate holders, speculators, and other with
variable incomes gain during rising prices.
The latter category of persons becomes rich at the cost of the former
group. There is unjustified transfer of income and wealth from the poor
to the rich. As a result, the rich roll in wealth and indulge in conspicuous
consumption, while the poor and middle classes live in abject misery
and poverty.

The Effects of Inflation on Different groups of Society are

discussed below:
1. Debtors and Creditors: During periods of rising prices, debtors gain
and creditors lose. When prices rise the value of money falls. Though
debtors return the same amount of money, but they pay less in terms
of goods and services. This is because the value of money is less than
when they borrowed the money.
Thus the burden of the debt is reduced and debtors gain. On the other
hand, creditors lose. Although they get back the same amount of
money which they lent, they receive less in real terms because the
value of money falls. Thus inflation brings about a redistribution of real
wealth in favour of debtors at the cost of creditors.
2. Salaried Persons: Salaried workers such as clerks, teachers, and
other white collar persons lose when there is inflation. The reason is
that their salaries are slow to adjust when prices are rising.
3. Wage Earners: Wage earners may gain or lose depending upon the
speed with which their wages adjust to rising prices. If their union are
strong, they may get their wages linked to the cost of living index. In
this way, they may be able to protect themselves from the bad effects
of inflation. But the problem is that there is often a time lag between
the raising of wages by employees and the rise in prices.

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So workers lose because by the time wages are raised, the cost of living
index may have increased further. But where the unions have entered
into contractual wages for a fixed period, the workers lose when prices
continue to rise during the period of contract. On the whole, the wage
earners are in the same position as the white collar persons.
4. Fixed Income group: The recipients of transfer payments such as
pensions, unemployment insurance, social security, etc. and recipients
of interest and rent live on fixed incomes. Pensioners get fixed
pensions. Similarly the rentier class consisting of interest and rent
receivers get fixed payments. The same is the case with the holders of
fixed interest bearing securities, debentures and deposits.
All such persons lose because they receive fixed payments, while the
value of money continues to fall with rising prices. Among these groups,
the recipients of transfer payments belong to the lower income group
and the rentier class to the upper income group. Inflation redistributes
income from these two groups towards the middle income group
comprising traders and businessmen.
5. Equity Holders or Investors: Persons who hold shares or stocks of
companies gain during inflation. For when prices are rising, business
activities expand which increase profits of companies. As a profits
increase, dividends on equities also increase at a faster rate than
prices. But those who invest in debentures, securities, bond, etc. which
carry a fixed interest rate lose during inflation because they receive a
fixed sum while the purchasing power is falling.
6. Businessmen: Businessmen of all types, such as producers, traders
and real estate holders gain during periods of rising prices. Take
producers first. When prices are rising, the value of their inventories
rise in the same proportion. So they profit more when they sell their
stored commodities. The same is the case with traders in the short ran.
But producers profit more in another way.
Their costs do not rise to the extent of the rise in the prices of their
goods. This is because prices of raw materials and other inputs and
wages do not rise immediately to the level of the price rise. The holders

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of real estate’s also profit during inflation because the prices of landed
property increase much faster than the general price level.
7. Agriculture: Agriculture are of three types: landlords, peasant
proprietor, and landless agriculture workers. Landlord lose during rising
prices because they get fixed rents. But peasant proprietor who own
and cultivate their farms gain. Prices of farm products increase more
than the cost of production.
For prices of inputs and land revenue do not rise to the same extent as
the rise in the prices of farm products. On the other hand, the landless
agriculture workers are hit hard by rising prices. Their wages are not
raised by the farm owners because trade unionism is absent among
them. But the prices of consumer goods rise rapidly. So landless
agriculture workers are losers.
8. Government: The government as a debtors gains at the expense of
households who are its principle creditors. This is because interest rates
on government bonds are fixed and are not raised to offset expected
rise in prices. The government, in turn, levies less taxes to service and
retire its debt. With inflation, even the real value of taxes is reduced.
Thus redistribution of wealth in favour of the government accrues as a
benefit to the tax-payers.
Since the tax-payers of the government are high income groups, they
are also the creditors of the government because it is they who hold
government bonds. As creditors, the real value of their assets declines
and as tax-payers, the real value of their liabilities also declines during
inflation. The extent to which they will be gainer or losers on the whole
is a very complicated calculation.

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