1

INTRODUCTORY MICROECONOMICS
UNIT-I
PRODUCTION POSSIBILITIES CURVE
The production possibilities (PP) curve is a graphical medium of highlighting the
central problem of
'what to produce'. To decide what to produce and in what quantities, it is first
necessary to know what
is obtainable. The PP curve shows the options that are obtainable, or simply the
production
possibilities.
What is obtainable is based on the following assumptions:
1. The resources available are fixed.
2. The technology remains unchanged.
3. The resources are fully employed.
4. The resources are efficiently employed.
5. The resources are not equally efficient in production of all products. Thus if
resources are
transferred from production of one good to another, the cost increases. In other
words
marginal opportunity cost increases.
The last assumption needs explanation because it determines the shape of the
PP curve. If this
assumption changes, the shape changes.
Efficiency in production means productivity i.e. output per unit of an input. Let the
input be worker.
Suppose an economy produces only two goods X and Y. Suppose a worker is
employed in
production of X because he is best suited for it. The economy decides to reduce
production of X
and increase that of Y. The worker is transferred to Y. He is not that efficient in
production of Y as
he was in X. His productivity in Y will be low, and so cost of production high.
The implication is clear. If the resources are transferred from one use to another,
the less and less
efficient resources will be transferred leading to rise in the marginal
opportunity cost which is
technically termed as marginal rate of transformation (MRT). What is
MRT?
Marginal Rate of Transformation (MRT)
To simplify, let us assume that only two goods are produced in an economy. Let
these two goods be
guns and butter, the famous example given by Samuelson. The guns symbolize
defense goods and
butter, the civilian goods. The example, therefore, symbolizes the problem of
choice between civilian
goods and war goods. In fact it is a problem of choice before all the countries of
the world.
Suppose if all the resources are engaged in the production of guns, there will be
a maximum amount
of guns that can be produced per year. Let it be 15 units (one unit may be taken
as equal to 1000, or
one lakh and so on). At the other extreme suppose all the resources are
employed in production of
butter only. Let the maximum amount of butter that can be produced is 5 units.
These are the two
extreme possibilities. In between there are others if the resources are partly used
for the production
of guns and partly for production of butter. Given the extremes and the in-
between possibilities, a
schedule can be prepared. It can be called a production possibilities schedule.
Let the schedule be:
2
Production Possibilities Schedule
Possibilities Guns Butter MRT = Guns
(units) (units) Butter
A 15 0 -
B 14 1 1G : IB
C 12 2 2G : IB
D 9 3 3G : IB
E 5 4 4G : IB
F 0 5 5G : IB
In the table the possibility A is one extreme. The society devotes all the resources
to guns and
nothing to butter. Suppose the society wants one unit of butter. Since resources
are limited and fully
and efficiently employed, to produce one unit of butter some of the resources
engaged in production
of guns have to be transferred to the production of butter. Let the resources worth
one unit of gun are
enough to produce one unit of butter. This gives us the second possibility with
MRT = 1G/IB. Now
suppose that the society wants another unit of butter. This requires transfer of
more resources from
the production of guns. Now we require transfer of resources worth 2 units of
guns to produce one
more unit of butter. The MRT rises to 2G/IB. MRT rises because now less
efficient resources are
being transferred. In this way MRT goes on rising.
We can now define MRT in general terms. MRT is the ratio of units of one good
sacrificed to produce
one more unit of the other good.
MRT = Units of one good sacrificed____ = Guns
More units of the other good produced Butter
Or, MRT is the rate at which the quantity of output of one good is sacrificed to
produce on more unit
of the other good.
Production Possibility Curve
By converting the schedule into a diagram, we can get the PP
curve. Refer to the figure I which is based on the PP schedule.
Butter's production is shown on the x-axis and that of guns on the
y-axis.
We can measure MRT on the PP curve. For example MRT
between the possibilities C and D is equal to CG/GD. Between D
and E it is equal to DH/HE, and so on.
3
Diagrammatically, the slope of the PP curve is a measure of the MRT. Since the
slope of a concave
curve increases as we move downwards along the curve, the MRT rises as we
move downwards
along the curve.
Characteristics
A typical PP curve has two characteristics:
(1) Downward sloping from left to right
It implies that in order to produce more units of one good, some units of the other
good must
be sacrificed (because of limited resources).
(2) Concave to the origin
A concave downward sloping curve has an increasing slope. The slope is the
same as MRT.
So, concavity implies increasing MRT, an assumption on which the PP curve is
based.
Can PP curve be a straight line.
Yes, if we assume that MRT is constant, i.e. slope is constant.
When the slope is constant the curve must be a straight line. But
when is MRT constant? It is constant if we assume that all the
resources are equally efficient in production of all goods.
Note that a typical PP curve is taken to be a concave curve
because it is based on a more realistic assumption that all
resources are not equally efficient in production of all goods.
Does production take place only on the PP curve?
Yes and no, both. Yes, if the given resources are fully and
efficiently utilized. No, if the resources are underutilized or
inefficiently utilized or both. Refer to the figure 3.
On point F, and for that matter on any point on the PP curve
AB, the resources are fully and efficiently employed. On point
U, below the PP curve or any other point but below the PP
curve, the resources are either underutilized or inefficiently
utilised or both. Any point below the PP curve thus highlights
the problem of unemployment and inefficiency in the economy.
4
Can the PP curve shift?
Yes, if resources increase. More labor, more capital goods,
better technology, all mean more production of both the goods.
A PP curve is based on the assumption that resources remain
unchanged. If resources increase, the assumption is broken, and
the existing PP curve is no longer valid. With increased resources
there is a new PP curve to the right of the existing PP curve.
It can also shift, to the left if the resources decrease. It is a rare
possibility but sometimes it may happen due to fall in population,
due to destruction of capital stock caused by large scale natural
calamities, war, etc.
5
UNIT-II
CONSUMER'S EQUILIBRIUM
_ Introduction
A consumer is one who buys goods and services for satisfaction of wants.
The objective of a consumer is to get maximum satisfaction from spending his
income on various
goods and services, given prices.
We start with a simple example. Suppose a consumer wants to buy a commodity.
How much of it
should he buy? One of the approaches used for getting an answer to this
question is 'utility' analysis.
Before using this approach, we would like to familiarize ourselves with some
basic concepts used in
this approach,
_ Concepts
The term utility refers to the want satisfying power of a commodity. Commodity
will possess utility
only if it satisfies a want. Utility differs from person to person, place to place, and
time to time.
Marginal Utility is the utility derived from the last unit of a commodity purchased.
It can also be
defined as the addition to the total utility when one more unit of the commodity is
consumed.
Total Utility is the sum of the utilities of all the units consumed.
As we consume more units of a commodity, each successive unit consumed
gives lesser and lesser
satisfaction, that is marginal utility diminishes. It is termed as the Law of
Diminishing Marginal Utility.
The following utility schedule will make the Law clear.
Units of a commodity Total (utils) Utility Marginal (utils) Utility
1 4 4 (=4-0)
2 7 3 (=7-4)
3 9 2 (=9-7)
4 10 1 (=10-9)
5 10 0 (=10-10)
6 9 -1 (=9-10)
Here we observe that as more units are consumed marginal utility declines. This
is termed as the
law of diminishing marginal utility. The law states that with each
successive unit consumed the
utility from it diminishes.
Assumptions
The utility approach to consumer's equilibrium is based on certain assumptions.
6
1. Utility can be cardinally measurable, i.e. can be expressed in exact units.
2. Utility is measurable in monetary terms
3. Consumer’s income is given
4. Prices of commodities are given and remain constant.
Equilibrium
(a) One commodity case
Suppose the consumer wants to buy a good. Further suppose that price of goods
is Rs. 3 per unit.
Lel the utility be expressed in utils which are measured in rupees. We are given
the marginal utility
schedule of the consumer.
Quantity Price Marginal Utility
138
237
335
433
532
When he purchases the first unit, the utility that he gets is 8 utils. He has to pay
only
Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because he gets more than
what he gives.
Similarly, we compare the utility received from other units with the price paid. We
find that he will buy
4 units. At the 4th unit, MU equals price. If he buys the 5th unit, he is a looser
because the utility that
he gets is 2 utils and what he has to pay is Rs. 3. Therefore, the consumer will
maximize his satisfaction
by buying 4 units of this commodity. The condition for maximization of satisfaction
if only one
commodity is purchased then is:
MU = Price.
(b) Two commodities case
Suppose a consumer consumes only two goods. Let these goods be X and Y.
Given income
and prices (Px and Py), the consumer will get maximum satisfaction by spending
his income in such
a way that he gets the same utility from the last rupee spent on each good. This
is satisfied when
MUx = MUy = M.U. of a rupee spent on a good.
Px Py
We can show that in order to maximise satisfaction this condition must be
satisfied. If it is not satisfied
what difference will it make. Suppose the two ratios are:
MUx > MUy
Px Py
7
It means that per rupee MUx is higher than per rupee MUy. It further means that
by transferring one
rupee from Y to X, the consumer gains more utility than he looses. This prompts
the consumer to
transfer some expenditure from Y to X. Buying more of X reduces MUx, Px
remaining unchanged,
MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Py
remaining unchanged
it raises, per rupee MUy. The change continues till per rupee MUx becomes
equal to per rupee MUy.
In other words :
MUx = MUy = per rupee MU
Px Py
CONCEPTS OF DEMAND AND DEMAND SCHEDULE
Demand for a good is the quantity of that good which a buyer is willing to buy
at a particular price,
during a period of time.
Demand schedule is a tabular presentation showing the different quantities
of a good that buyers
of that good are willing to buy at different prices during a given period of time.
Demand schedule of a commodity
Price (Rs. per unit) Quantity demanded (in units)
50 50
40 100
30 150
20 200
10 250
This schedule indicates that more is purchased as price falls. This inverse
relationship between
price and quantity demanded, other thing remaining the same is called the law
of demand.
RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND AND
TOTAL EXPENDITURE
At this stage of learning it is sufficient to know the following about this
relationship:
1. When demand is elastic, a fall (rise) in the price of a commodity results in
increase (decrease)
in total expenditure on it. Or, when a fall (rise) in the price of a commodity results
in increase
(decrease) in total expenditure on it, its demand is elastic.
2. When elasticity is unitary, a fall (rise) in the price of the commodity does not
result in any
change in total expenditure on it, or when a fall (rise) in price results in no
change in total
expenditure then its elasticity is unitary.
3. When demand is inelastic, a fall (rise) in the price of a commodity results in a
fall (rise) in total
expenditure on it, or when a fall (rise) in the price of a commodity results in
decrease (increase)
in total expenditure on it, its demand is inelastic.
8
Unit III
PRODUCER’S BEHAVIOUR AND SUPPLY
Meaning of supply
Supply means the quantity of a commodity which a firm or an industry is willing to
produce at
a particular price, during a given time period.
Law of supply
This law states that 'other things remaining the same', an increase in the price of
a commodity
leads to an increase in its quantity supplied. Thus, more of a commodity is
supplied at higher prices
than at lower prices.
This law can be explained with the help of a supply schedule and curve.
A supply schedule is a table which shows the quantities of a commodity supplied
at various
prices during a given time period.
Supply Schedule Supply Curve
Price (Rs.) Supply (Units)
1 100
2 200
3 300
As the price increases from Re. 1 to Rs. 3, the supply also rises from 100 units to
300
units, in response to the rising price. What is the basis of the law of supply?
Other things remaining
the same, an increase in price results in higher profits for the producer. The
higher the price of the
commodity, the greater are the profits earned by the firms and the greater is the
incentive to
produce more. Similarly when the price falls, profits decline, resulting in a
decrease in quantity
supplied of the commodity. Thus the price and quantity supplied of a commodity
are directly
related, other things remaining the same.
‘Change in supply’ versus ‘change in quantity supplied’
(‘shift of supply curve’ versus ‘movement along a supply curve’)
The supply of a commodity depends on its own price and 'other factors' like input
prices,
technique of production, prices of other goods, goals of the firm, taxes on the
commodity etc.
Movement along a supply curve
The law of supply states the effect of a change in the own price of a commodity
on its supply,
other things remaining constant. The supply curve also carries the same
assumption. Thus when
other factors influencing supply do not change, and only the own price of the
commodity changes, the
9
change in supply takes place along the curve only. This is what movement along
a supply curve
means. A movement from one point to another on the same supply curve is
also referred to as
a change in quantity supplied”.
In figure 7, OQ is the quantity supplied at price OP. When the price rises
to OP1 the quantity supplied increases to OQ1. Thus there is an upward
movement along the supply curve from point A to B. It is extension of
supply.
Similarly, when the price of a commodity falls from OP to OP2, there is a
decrease in quantity supplied from OQ to OQ2 and thus a downward
movement along the supply curve from A to C. It is contraction of supply.
Movements along the supply curve are caused by a change in the own
price of the good only, other things remaining the same.
Shifts of the supply curve
When supply changes due to changes in factors other than the own price of the
commodity, it
results in a shift of the supply curve. This is also referred to as a “change in
supply”.
An ‘increase’ in supply means more of the commodity is supplied at the same
price. As a
result the supply curve shifts to the right.
In figure 8, at price OP the previous supply was OQ which
increased to OQ1. This also means that OQ units can now be supplied
at a lower price OP1 with the new supply curve S1S1.
An ‘increase’ in supply can take place due to many reasons. For
example, if the input prices fall or there is an improvement in technology,
it will enable producers to produce and sell more at the same price
resulting in a rightward shift of the supply curve.
A decrease in supply means less of the commodity is supplied at
the same price, than previously. As a result, the supply curve shifts
inwards to the left.
In figure 9, at price OP, previously OQ units were supplied which
decreased to OQ1. This also means that OQ units can now be supplied
at a higher price OP1 with the new supply curve S1S1.
10
Shifts of the supply curve of a good are caused by a change in
any one or more of the
'other factors' affecting supply, own price remaining
unchanged. For example, if the input
prices fall or there is a decrease in the prices of other related
commodities, the producers
supply more at the same price resulting in a rightward shift of
the supply curve.
PRODUCER'S EQUILIBRIUM
The primary objective of a producer is to earn maximum profits. Profit is the
difference between
total revenue and total cost. At that level of output, he is in equilibrium at which
he is earning maximum
profit, and he has no incentive to increase or decrease his output. If he produces
less than this he
does not maximize total profits. Similarly, if produces beyond this, total profits
decline. Thus the
producer is in a 'state of rest' only at the level of output at which the difference
between the total
revenue and total cost of production is maximum i.e total profits are maximum.
(NOTE : How does a producer reach equilibrium under different market
conditions is not discussed
at this stage of learning).
RELATIONSHIP BETWEEN MARGINAL COST (MC) AND
AVERAGE COST (AC)
The relationship between marginal cost and average cost is an arithmetic
relationship. To understand
this relationship let us take a numerical example.
The table A shows the marginal costs, total costs and average costs at different
levels of output.
Table A
Output Total cost Marginal cost Average cost
(Units) (Rs.) (Rs.) (Rs.)
(1) (2) (3) (4)
1 60 60 60
2 110 50 55
3 162 52 54
4 216 54 54
5 275 59 55
Column 1 shows the level of output.
Column 2 shows the total cost of producing different levels of output.
Column 3 shows the increase in total cost resulting from the production of one
more unit of output.
(It is called marginal cost. Thus MCn = TCn - TCn-1, where n and n-1 are levels of
output).
Column 4 shows the average cost at different levels of output (ACn = TCn )
n
11
This table shows that :
1. Average cost falls only when marginal cost is less than average cost. Upto the
third unit of
output, the marginal cost is less than the average cost and average cost is falling.
When 2
units are produced the marginal cost is Rs. 50 which is less than the previous
average cost
(Rs.60), now average cost falls from Rs. 60 to Rs. 55. When 3 units are
produced, the marginal
cost is Rs. 52 which is less than the average cost of 2 units (Rs. 55) so once
again the
average cost falls from Rs. 55 to Rs. 54.
2. Average cost will be constant when marginal cost is equal to average cost.
When 4 units are
produced, average cost does not change (It is Rs. 54 when 3 units are produced
and remains
Rs. 54 when 4 units are produced) because marginal cost (Rs. 54) is equal to
average cost
(Rs. 54).
3. Average cost will rise when marginal cost is greater than average cost. When 5
units are
produced average cost rises from Rs. 54 to Rs. 55, because the marginal cost
(Rs. 59) is
greater than the average cost (Rs. 54).
This relationship between marginal cost and average cost is a generalized
relationship and holds
good in case of the marginal and average values of any variable, be it revenue or
product etc.
In the box a simple proof of the relationship is given : This is for reference only
For Reference only
Suppose AC falls. Then :
TCn < TCn-1
n n-1
Multiplying both sides by n we get,
TCn < TCn-1 x n
n-1
TCn < TCn-1 x (1 + 1 )
n-1
TCn < TCn-1 + TCn-1
n-1
TCn - TCn-1 < TCn-1
n-1
Since the left hand side is MC, and the right hand side is AC, it proves that
MC < AC
Thus a fall in average cost means marginal cost is less than average cost. It can
similarly be proved
that a rise in average cost means, marginal cost is greater than average cost and
a constant average
cost means marginal cost is equal to average cost.
The relationship between marginal cost and average variable cost is similar to the
relationship between
marginal cost and average cost because marginal cost is not affected by fixed
cost.
(For proof see box which is for reference only)
12
MCn = TCn - TCn-1
= [TFCn + TVCn] - [TFCn-1 + TVCn-1]
Since TFCn and TFCn are equal
MCn = TVCn - TVCn-1
LAW OF VARIABLE PROPORTION IN TERMS OF TP AND MP
CURVES.
(i) In terms of TP
As more and more units of variable factor are employed with fixed factor, total
product initially
increases at an increasing rate then increases at decreasing rate and ultimately
starts decreasing.
13
On the TP curve in the diagram, upto point A, TP is increasing at an increasing
rate. If more than 3
units of variable factor are employed, total product still increases till 7units are
employed but this
increase is at a diminishing rate. If beyond 7 units of variable factor are employed
then TP starts
falling. These are the three respective phases of the law.
(ii) In terms of MP
MP increases upto 3 units. This is phase 1. MP falls after 3 units but is positive
upto 7 units.
This is phase 2. MP continues to fall but is negative after 7 units. This is phase 3.
Therefore, in
phase 1 the MP curve is upward sloping; downward sloping but above the X-axis
in phase 2; and
downward sloping but below the X-axis in phase 3.
(Note that TP is convex in phase 1; concave in phase 2; and downward sloping in
phase 3. This is
how we can identify the three phases.)
Returns to Scale
Introduction
This topic is a part of study of production function. A production function is an
expression of
quantitative relation between change in inputs and the resulting change in output.
It is expressed as
:
Q = f (i1, i2 ......in)
Where Q is output of a specified good and i1, i2 ….in are the inputs usable in
producing this good. To
simplify let us assume that there are only two inputs, labour (L) and capital (K),
required to produce
a good. The production function then takes the form :
Q = f (K,L)
In microeconomics, conventionally, we study two aspects of relation between
inputs and output. One
aspect is : in what manner the change takes place in output of a good, if only one
of the inputs
required in producing that good is increased, i.e. other inputs kept unchanged?
The manner of
change in output is summed up in the law of variable proportions which you have
already studied.
The second aspect is : in what manner the output of a good changes, if all the
inputs required in
producing that good are increased simultaneously and in the same proportion.
This aspect is
technically termed as returns to scale, and is the subject matter of this study. The
word 'return' refers
to the change in physical output. The word 'scale' refers to the scale of operation
expressed in terms
of quantum of inputs employed.
Meaning
Returns to scale means the manner of change in physical output caused by the
increase in all
the inputs required simultaneously and in the same proportion. Elaborating,
suppose one unit of
capital and one unit of labour (1K + 1L), produce 100 units of output. Further
suppose that both the
14
inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by
just 100%; by more
than 100%, or by less than 100%. There is no unique answer. All the three states
are possible. The
three states are respectively called Constant Returns to Scale (CRS), Increasing
Returns to Scale
(IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three
states and then explain
reasons.
Constant Returns to Scale (CRS)
Suppose 1K+1L produce 100 units of output, and 2K+2L produce 200 units of
output. It is
100 percent increase in inputs leading to just 100 percent increase in output. This
manner of change
in output is called CRS.
Increasing Returns to Scale (IRS)
Suppose 1K+1L produce 100 units of output and 2K+2L produce 250 units of
output. It is 100
percent increase in inputs in leading to 125 percent increase in output. This
manner of change in
output is called IRS.
Decreasing Returns to Scale (DRS)
Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of
output. It is
100 percent increase in inputs leading to only 80% increase in output. This
manner of change in
output is called DRS.
Which of the above states actually results depends to a great extent on the type
of technology
used. There are technologies which result in IRS from the beginning and
continue upto a large output
level. Similarly, there are technologies leading to CRS almost throughout. There
can also be
technologies leading to DRS from the very beginning.
Besides, it is also possible that a technology is such that it gives IRS in the
beginning, followed
by CRS and then DRS. For example:
Returns to Scale
Inputs %change Output %change Returns to scale
1K+1L - 100 - -
2K+2L 100% 250 125% IRS
3K+3L 50% 375 50% CRS
4K+4L 33.3% 450 20% DRS
Why do IRS arise?
There are two possible reasons:
15
1. More division of labour
Division of labour means subdividing a task into many small sequential
operations, with each
worker (or a group of workers) assigned each operation. A single worker, instead
of doing all the
operations, concentrates on only one operation and specializes. This raises
efficiency of the worker.
Returns to scale means increasing the number of workers along with other
inputs. More
workers mean more division of labour. If one task can be divided into 20 small
operations, with each
worker assigned only one operation, the worker becomes an expert in the
operation he is assigned.
Efficiency increases and so the production. In business circles, the division of
labour type production
is called assembly line production.
2. Use of specialized machines
More capital means more capital goods and bigger capital goods. Fully automatic
machines
can replace the semi-automatic or the hand operated machines. Bigger machines
can be used in
place of small machines. Bigger capital goods can be used in place of smaller
capital goods. It is
a common knowledge that a double size capital input may produce more than
double the output.
Let us take an interesting example.
Suppose a firm needs a wooden box to store goods. Suppose initially the firm
goes in for
1'x1'x1' (LxBxH) size box. Let us see the input requirement and the resulting
output. Let the wood
be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of wood
(=1'x1'). Then
the input requirement = 1'x1'x6 = 6 sq.ft.
The storing capacity of the box is measured by its volume. Then :
Output of the box : 1'x1'x1' = 1 cubic ft.
Let us now see what happens when the size of the box is increased to 2'x2'x2'.
Input requirement = 2'x2'x6 = 24 sq.ft.
Output = 2'x2'x2' = 8 c.ft.
Now compare. Input of the box rises from 6 sq.ft. to 24 sq.ft. i.e. by 300%. Output
of the box
rises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns to scale arise.
Remember that it may not go on for ever, i.e. we go on increasing the size and
continue to get
IRS. A stage may reach when IRS may give way to CRS or DRS.
Why do DRS arise?
Economists do not find any specific reason. DRS is a puzzle. Why output rises in
a smaller
proportion when all inputs are increased? The probable explanation is that the
firm finds it difficult
to manage and coordinate the activities arising out of larger scale. The difficulties
may lead to wastage,
inefficiency etc. and cause DRS.
16
EQUILIBRIUM PRICE UNDER PERFECT COMPETITION
Meaning of equilibrium
Equilibrium, in general terms. implies (a) a balance between the opposite forces
and (b) a
state of rest or a situation that has a tendency to persist. Let us take examples to
show the application
of these meanings in microeconomics.
Let us take a market situation in which buyers and sellers are negotiating to buy
and sell a
good. Both have different prices to offer. But the good will be sold only when both
agree to a common
price and a common quantity at that price. If both agree, a market equilibrium is
said to emerge.
Note that buyers and sellers have opposite interests. The buyers will like to pay
as low a price as
possible. The sellers will like to charge as high a price as possible. Agreement on
a common price
and quantity creates a balance between the two opposite interests. This
equilibrium price and quantity
has a tendency to persist.
Equilibrium price
Equilibrium price is the price at which the sellers of a good are willing to sell the
same quantity
which buyers of that good are willing to buy. We can explain this meaning with
the help of market
demand and supply schedule of a good, given below :
Price per unit Market demand Market supply Equilibrium
(Rs.) (units) (units)
1 1000 200 Excess demand
2 800 400 Excess demand
3 600 600 Market Equilibrium
4 400 800 Excess supply
5 200 1000 Excess supply
Refer to the schedule. The market equilibrium is established at a price of Rs. 3
per unit,
because at this price both the market demand and market supply are equal. This
is the price
which has a tendency to persist.
Why is not any other price an equilibrium price?
Take, for example, a price less than the equilibrium price. Suppose it is Rs. 2 per
unit. At
this price market demand is greater than market supply. It is called an excess
demand situation. But
this price cannot persist. It will change. Why?
It is because the buyers will not be able to buy all what they want to buy. The
pressure of
excess demand will push the market price up. This will have two effects. Supply
will go up because
the producers are willing to supply more at a higher price. Demand will go down
because the buyers
are willing to buy less at a higher price. In fact, this is what is required to restore
equilibrium. The
tendency of supply going up and demand going down will continue till market
supply becomes equal
17
to market supply once again and the excess demand becomes zero. This is
achieved at Rs. 3 per
unit. The equilibrium is restored.
Let us now take a price higher than the equilibrium price. Suppose it is Rs. 4 per
unit. At this
price now the market supply is greater than market demand. It is called an excess
supply situation.
Even this price cannot persist. It is because the sellers will not be able to sell all
what they want to sell.
The excess supply pressure will push the price downwards. This will have two
effects. Supply will go
down and demand will go up. The tendency will continue till market demand
becomes equal to
market supply once again, and the price settles at Rs. 3 per unit.
To sum up, the equilibrium price is the price at which market demand equals
market supply.
This price has a tendency to persist. If at a price the market demand is not equal
to market supply
there will be either excess demand or excess supply and the price will have
tendency to change until
it settles once again at a point where market demand equals market supply.
Graphic Presentation
The equilibrium is at E the intersection of supply and
demand curves representing the two schedules given above.
The equilibrium price is Rs. 3 and equilibrium quantity 600 units.
The price higher than Rs. 3, creates excess supply and ultimately
returns to Rs. 3 on account of the effects explained above. The
arrows indicate the tendencies. The price below the equilibrium
price creates excess demand and has a tendency to return to
Rs. 3 per unit on account of the effects explained above and
indicated by the arrows.
Can the equilibrium price change?
Yes, when demand or supply or both increase or decrease. 'Increase', as you
know, means
rise in demand or supply due to factors other than the own price of the good.
Similarly the term
'decrease' is defined. Graphically, it means shift of demand curve, or supply
curve or both. You are
familiar with these terms. You are expected to study the chain effects of shifts in
demand and supply
on equilibrium price and quantity.
18
UNIT IV
FEATURES OF PERFECT COMPETITION
Introduction
Perfect competition is a state of a market. Anything which facilitates contact
between buyers
and sellers constitutes a market. It may be a face to face meeting at some place
or simply verbal
negotiations through telephone, internet, etc.
Conventionally, in microeconmoics the markets are classified into these states:
perfect
competiton, monopoly, monopolistic competition and oligopoly. There are many
criteria of
classification, the number of sellers, similarity of products, availability of
information, mobility of firms
and the inputs engaged in the firm, etc. Whatever the criteria the end result is
reflected in one thing :
how much influence an individual seller, on his own, is able to exercise on the
market. Lower the
influence more the competitive nature of the market it indicates. If the influence of
an individual seller
is zero, or virtually zero, the market is said to be perfectly competitive.
Meaning
Perfect competition can be defined either in terms of its characteristic features, or
in terms of
the unique end result of these characteristics. Unique in the sense that it is
specific to a perfectly
competitive market. In terms of its features, a perfectly competitive is a market
where there are
large number of buyers and sellers, the firms produce homogeneous products,
the buyers and sellers
have perfect knowledge and the firm are free to entry or make an exit in and out
of industry. In terms
of the end result of these features which is unique to this market, a perfectly
competitive market is
one in which an individual firm cannot influence the prevailing market price of the
product on its own.
Features and their implications
A perfectly competitive market has the following features:
1. Large number of sellers and buyers
Note that 'large number' is not a specifically defined number. However, it has a
specific
implication. Let us talk about the large number of sellers first. The words 'large
number' imply that
the number of sellers is large enough to render a single seller's share in total
market supply of the
product insignificant. It has a further implication. Insignificant share means that if
only one individual
firm reduces or raises its own supply, the prevailing market price remains
unaffected. The prevailing
market price is the one which was set through the interaction of market demand
and market
supply forces, for which all the sellers and all the buyers together are responsible.
One single
seller has no option but to sell what it produces at this market determined price.
This position of
an individual firm in the total market is referred to as price taker. This is a
unique feature of a
perfectly competitive market.
Similarly, the 'large number' of buyers also has the same implication. A single
buyer's
share in total market demand is so insignificant that the buyer cannot influence
the market price
on his own by changing his demand. This makes a single buyer also a price
taker.
19
To sum up, the feature 'large number' indicates ineffectiveness of a single seller
or a
single buyer in influencing the prevailing market price on its own, rendering him
simply a price
taker.
2. The products of all the firms in the industry are
homogenous
It means that the buyers treat the products of all the firms in the industry as
homogenous. The
products produced by the firms are identical, or treated as identical, or perfectly
standardized. The
buyers do not distinguish the output of one firm from that of the other.
The implication of this feature is that since the buyers treat the products as
identical they are
not ready to pay a different price for the product of any one firm. They will pay the
same price for the
products of all the firms in the industry. On the other hand, any attempt by a firm
to sell its product at
a higher price will fail.
To sum up, the 'homogenous products' feature ensures a uniform price for the
products of all
the firms in the industry.
3. Perfect knowledge about markets for outputs and
inputs.
The firms have all the knowledge about the product market and the input
markets. Buyers
also have perfect knowledge about the product market.
Let us take the product market first. The implication of perfect knowledge about
the product
market is that any attempt by any firm to charge a price higher than the prevailing
uniform price will
fail. The buyers will not pay because they have perfect knowledge. There is no
ignorance factor
operating in the market. The sellers do not charge a lower price due to ignorance.
The buyers do not
pay a higher price due to ignorance. A uniform price prevails in the market.
As regards the knowledge about the input markets, the implicit assumption is that
each firm
has an equal access to the technology and the inputs used in the technology. No
firm has any cost
advantage. Cost structure of each firm is the same. All the firms have a uniform
cost structure.
Since there is uniform price and uniform cost in case of all firms, and since profits
equals cost
less price, all the firms earn uniform profits.
4. Freedom to firms to enter or to leave the industry in
the long run
Freedom of entry means that there are no artificial barriers and natural barriers in
the way of
a new firm wishing to enter into industry. The artificial barriers may take the form
of patent rights,
legal restrictions, etc. The natural barrier may take the form of huge capital
expenditure required to
start a new firm, which the firm wishing to enter is not able to arrange.
Freedom of exit means no barriers in the way of a firm deciding to leave the
industry.
Government rules, labour laws, loss of huge fixed capital etc. do not come in the
way.
The freedom of entry and exit of firms has an important implication. This ensures
that no
firm can earn above normal profits in the long run. Each firm earns just the
normal profits, i.e.
minimum necessary to carry on business. In Microeconomics, normal profits is
treated as an
20
opportunity cost, and therefore, counted in calculation of total cost. Since profit
equals total revenue
minus total cost, normal profit means zero economic profit. Why? Let us explain.
Suppose the existing firms are earning above normal profits, i.e. positive
economic profits.
Attracted by the positive profits, the new firms enter the industry. The industry's
output, i.e. market
supply, goes up. The price comes down. New firms continue to enter and the
price continues to
fall till economic profits are reduced to zero.
Now suppose the existing firms are incurring losses. The firms start leaving. The
industry's
output starts falling, price starts going up, and all this continues till losses are
wiped out. The remaining
firms in the industry then once again earn just the normal profits.
Only zero economic profit in the long run is the basic outcome of a perfectly
competitive
market.
Average Revenue and marginal revenue curves of a
perfectly competitive firm
The forces of market supply (i.e. supply by industry) and market demand
(demand by all the
buyers) determine the market price. The firm, being a price taker, adopts this
price and is free to sell
any quantity it likes at this price. The price taker feature determines the shape of
the firms AR and
MR curves. Refer to the figure -12 b
The figure 12a shows the intersection of demand and supply curves at E
determining the
price OP. The figure 12b shows the adoption of price by the price taker firms who
are free to sell any
quantity, at this price. This makes the AR curve perfectly elastic and thus parallel
to the
X-axis. As per the average marginal relationship, when AR is constant, MR must
be equal to AR.
Therefore, AR curve is also the MR curve of the firm.

1
PART B : INTRODUCTORY MACROECONOMICS
UNIT 6 - NATIONAL INCOME AND RELATED AGGREGATES
SOME CONCEPTS
CONCEPT OF ECONOMIC TERRITORY
INTRODUCTION
National income accounting is a branch of macroeconomics of which estimation
of national
income and related aggregates is a part. National income, or for that matter any
aggregate
related to it, is a measure of the value of production activity of a country. But,
production activity
where and by whom? Is it on the territory of the country? Or, is it by those who
live in the
territory? In fact it is both. This raises further question. What is the scope of
territory? Is it simply
political frontiers? Or, is it something else? Who are those who live in the
territory? Is it simply
citizens? Or, it is something else. The answer to these questions leads us to the
concepts of (i)
economic territory and (ii) resident. The two have an important bearing on the
estimation of
national income aggregates. How? We will explain it a little later.
Definition
The first thing to note is that economic territory of a country is not simply political
frontiers
of that country. The two may have common elements, but still they are
conceptually different. Let
us first see how it is defined. According to the United Nations :
Economic territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely.
The above definition is based on the criterion “freedom of circulation of persons,
goods and
capital”. Clearly, those parts of the political frontiers of a country where the
government of that,
country does not enjoy the above “freedom” are not to be included in economic
territory of that
country. One example is embassies. Government of India does not enjoy the
above freedom in
the foreign embassies located within India. So, these are not treated as a part of
economic
territory of India. They are treated as part of the economic territories of their
respective countries.
For example the U.S. embassy in India is a part of economic territory of the
U.S.A. Similarly, the
Indian embassy in Washington is a part of economic territory of India.
Scope
Based on ‘freedom’ criterion, the scope of economic territory is defined to cover:
(i) Political frontiers including territorial waters and air space.
(ii) Embassies, consulates, military bases, etc located abroad,but excluding those
located
within the political frontiers.
(iii) Ships, aircrafts etc, operated by the residents between two or more countries
2
(iv) Fishing vessels, oil and natural gas rigs, etc operated by the residents in the
international
waters or other areas over which the country enjoys the exclusive rights or
jurisdiction.
Implication
National income and related aggregates are basically measures of production
activity.
There are two categories of national income aggregates : domestic and national,
or domestic
product and national product. Production activity of the production units located
within the economic
territory is domestic product. Gross domestic product, net domestic product are
some examples.
We will learn more about the implications after studying the concept of resident.
CONCEPT OF RESIDENT
Introduction
Note that citizen and resident are two different terms. This does not mean that a
citizen is
not a resident, and a resident not a citizen. A person can be a citizen as well as a
resident, but it is
not necessary that a citizen of a country is necessarily the resident of that
country. A person can be
a citizen of one country and at the same time a resident of another country. For
example a NRI,
Non-resident Indian. A NRI is citizen of India but a resident of the country in
which he lives.
Citizenship is basically a legal concept based on the place of birth of the person
or some
legal provisions allowing a person to become a citizen. On the other hand
residentship is basically
an economic concept based on the basic economic activities performed by a
person.
Definition
A resident is defined as follows:
A resident, whether a person or an institution, is one whose
centre of economic interest lies in the economic territory of the country
in which he lives.
The ‘centre of economic interest’ implies two things: (i) the resident lives or is
located
within the economic territory and (ii) the resident carries out the basic economic
activities of
earnings, spending and accumulation from that location
Implications
Production activity of the residents of an economic territory is national product.
GNP, NNP,
are some examples. National product includes production activities of residents
irrespective of
whether performed within the economic territory or outside it.
In comparison, domestic product inludes production activity of the production
units located
in the economic territory irrespective of whether carried out by the residents or
non-residents.
3
Relation between national product and domestic product
The concept of domestic product is based on the production units located within
economic
territory,operated both by residents and non-residents. The concept of national
product is based
on residents, and includes their contribution to production both within and outside
the economic
territory.Normally, in practical estimates, domestic product is estimated first.
National product is
then derived from the domestic product by making certain adjustments.Let us see
how?
National product is derived in the following way:
National product = Domestic product
+ residents contribution to production outside the economic
territory
- non-residents contribution to production inside the economic
territory
In practical estimates the resident’s contribution outside the economic territory is
called
“factor income received from abroad”. The non-residents’ contribution inside the
economic territory
is called “factor income paid to residents”. Therefore,
National product = Domestic product
+ Factor income received from abroad
- Factor income paid to abroad.
Factor income received from abroad’ is added to domestic product because this
contribution
of residents is in addition to their contribution to domestic product. ‘Factor income
paid to abroad’
is subtracted because this part of domestic product, does not belong to the
residents. By subtracting
factor income paid’ from “factor income received” from abroad, we get a net
figure “Net factor
income from abroad” popularly abbreviated as NFIA.
National product = Domestic product
+ Net factor income from abroad
= Domestic product + NFIA
INDUSTRIAL CLASSIFICATION
Introduction
It means grouping production units into distinct industrial groups, or sectors. This
is the
first step required to be taken in estimating national income, irrespective of the
method of
estimation. It is statistically more convenient to estimate national income
originating in a group of
similar production units rather than for each production unit separately.
4
It is now a matter of general practice to group all the production units of the
economic
territory into three broad groups : primary sector,secondary sector and tertiary
sectors. Each of
these sector can be further subdivided into smaller groups depending upon the
requirement. Let
us now explain each sector.
Primary Sector
Primary sector includes production units exploiting natural resources like land,
water, subsoil
assets,etc. Growing crops, catching fish, extracting minerals, animal husbandry,
forestry, etc.
are some examples. Primary means of first importance’. It is primary because it is
a source of
basic raw materials for the secondary sector.
Secondary Sector
Secondary sector includes production units which are engaged in transforming
one good
into another good. Such an activity is called manufacturing activity. These units
convert raw
materials into finished goods. Factories, construction, power generation, water
supply are the
examples. It is called secondary because it is dependent upon the primary sector
for raw materials.
Tertiary Sector
Tertiary sector includes production units engaged in producing services.
Transport, trade
education, hotels and restaurant, finance, government administration, etc are
some examples.This
sector finds third place because its growth is primarly dependent onthe primary
and secondary
sectors.
NATIONAL INCOME AGGREGATES
There are many aggregates in national income accounting. The basic among
these is
Gross Domestic Product at Market Price (GDPmp). By making adjustments in
GDPmp, we can
derive other aggregates like Net Doemstic product at Market Price (NDPmp) and
NDP at factor
cost (NDPfc).
Net Domestic Product
Why is GDPmp called gross? GDPmp is final products valued at market price. This
is what
buyers pay. But this is not what production units actually receive. Out of what
buyers pay the
production units have to make provision for depreciation and payment of indirect
tax like excise,
sales tax, etc. This explains why GDPmp is called ‘gross’. It is called gross
because no provision
has been made for depreciation. However, if depreciation is deducted from the
GDP, it becomes
Net Domestic Product (NDP). Therefore,
GDPmp - depreciation = NDPmp
Domestic product at Factor Cost
Why is GDPmp called ‘at market price’ ?
Out of what buyers pay, the production units have to make payments of indirect
taxes,if
5
any. Sometimes production units receive subsidy on production. This is in
addition to the market
price which production units receive from the buyers. Therefore what production
units actually
receive is not the ‘market-price’ but “market price - indirect tax + subsidies” This
is what is actually
available to production units for distribution of income among the owners of
factors of production.
Therefore,
Market price - indirect tax (I.T.) + subsidies = Factor payments (or factor costs)
By making adjustment of indirect tax and subsidies we derive GDP at factor cost
(GDPfc)
from GDPmp..
GDPmp - I.T. + subsidies = GDPfc
or GDP - net I.T. = GDPfc
Net Domestic Product at Factor Cost
If we make adjustment of both the net I.T and depreciation (also called
consumption of
fixed capital) we get one more aggregate called Net Domestic Product at Factor
Cost (NDPfc)
GDPmp - I.T. + Sub-depreciation = NDPfc.
or NDPfc+ I.T. - Sub+depreciation = GDPmp
Net National Product at Factor Cost (NNPfc) or National Income
Net factor income from abroad (NFIA) provides the link between NDP and NNP.
Therefore,
NDPfc + NFIA = NNPfc
or NNPfc - NFIA = NDPfc
Similarly,
NDPmp + NFIA = NNPmp
GDPmp + NFIA = GNPmp
Summing up
The three crucial adjustments required for deriving one aggregate from the other
are:
Gross - depreciation = Net
Market price - I.T. + Subsidies = Factor cost
Domestic + NFIA = National
METHODS OF ESTIMATION OF NATIONAL INCOME (N.I.) AND
OTHER RELATED
AGGREGATES
There are three methods of estimation of national income : production (value
added),
6
income-distribution and final expenditure methods. You are familiar with the
various steps required
to be taken in each. Let us see what aggregates are arrived through each
method.
(I) Production method (value added method)
In this method we first find out Gross Value Added at Market Price (GVAmp) in
each sector
and then take their sum to arrive at GDPmp
Sum total of GVAmp
by all the sectors = GDPmp
Then we make adjustments to arrive at national income or NNPfc
GDPmp - Consumption of fixed capital = NDPmp
NDPmp - I.T. + Subsidies = NDPfc
NDPfc + NFIA = NNPfc
(2) Income distribution method
In this method we first estimate factor payments by each sector. The sum of such
factor
payments equals Net value Added at Factor Cost (NVAfc) by that sector. Then we
take sum total
of NVAfc by all the sectors to arrive at NDPfc. The components of NDPfc are:
1. Compensation of employees
2. Rent and royalty
3. Interest
4. Profits
NDPfc
System of National Accounts 1993, a joint publication of the United Nations and
the World
Bank,has elaborated the above components and recommended their use by all
the countries in
preparing national income estimates.
Compensation of employees is defined as : the total remuneration in cash
or in kind, payable by
an enterprise to an employee in return for work done by the latter during the
accounting period.
The main components of compensation of employees are :
(1) Wages and salaries
(a) in cash
(b) in kind
7
(2) Social security contributions by the employers.
Rent is defined as the amount receivable by a landlord from a tenant for the use
of land.
Royalty is defined as the amount receivable by the landlord for granting the
leasing rights of subsoil
assets.
Interest is defined as the amount payable to the owners of financial assets in
the production
unit. The production unit uses these assets for production and in turn makes
interest payment,
imputed or actual.
Profit is a residual factor payment to the owners of a production unit. The
production unit
uses profit for (i) payment of corporation tax, (ii) dividend payments and (iii)
undistributed profits/
retained earnings.
The main source of factor payments are the accounts of production units. Since
accounts
of most production units are not available to the estimators, and also since the
accounting practices
differ, it is not possible for the estimators to clearly identify the components.
Therefore, in cases
where total factors payment is estimable but not its different components, an
additional factor
payment item called ‘mixed income’ is added. Since this problem arises mainly in
case of selfemployed
people like doctors, chartered accountants, consultants, etc, this factor payment
is
popularly called “mixed income of the self employed”. In case there is such item
then,
NDPfc = Compensation of employees
+ Rent and royalty
+ Interest
+ Profit
+ Mixed income (if any)
There is another term used in factor payments. It is ‘operating surplus’. It is
defined as the
sum of rent and royalty, interest and profits. In that case then:
NDPfc = Compensation of employees
+ operating surplus
+ mixed income (if any)
Once we estimate NDPfc, we can find NNPfc, or national income, by adding NFIA.
NDPfc + NFIA = NNPfc.
(3) Final expenditure method
In this method we take the sum of final expenditures on consumption and
investment.
This sum equals GDPmp. These final expenditures are on the output produced
within the economic
territory of the country. Its main components are:
Private final Consumption expenditure (PFCE)
+ Government final consumption expenditure (GFCE)
+ Gross domestic Capital formation (GDCF)
8
+ Net exports (= Export - imports) (X-M)
= GDPmp
By making the usual adjsutments we can arrive at national income
OFCE
+ GFCE
+ GDCF
+ (X-M)
= GDPmp
- Consumption of fixed capital
= NDPmp
- indired Tax
+ Subsidies
= NDPfc
+ NFIA
= NNPfc (National income)
Note that GDCF is composed of the following:
GDCF= Net domestic fixed capital formation
+ Closing stock
- Opening stock
+ Consumption of fixed capital
Also note that. ‘Clossing stock - opening stock ‘ equals net change in stocks.
PRECAUTIONS IN MARKING
ESTIMATES OF NATIONAL INCOME
There are a large number of conceptual and statistical problem that orise in
estimating
national income of a country. To minimize error, it is necessary that certain
precautions are taken
in advance. Some of the methodwise precautions are:
(1) Value added (Production) method
(i) Avoid double counting
Value added equals value of output less intermediate cost. There is a possibility
that
instead of counting ‘value added’ one may count value of output. You can verify
by taking some
imaginary numerical example that counting only values of output will lead to
counting the same
output more thanonce. This will lead to overestimation of national income. There
are two alternative
ways of avoiding double counting: (a) count only valueadded and (b) count only
the value of final
products.
9
(ii) Do not include sale of second hand goods.
Sale of the used goods is not a production activity. The good should not treated
as fresh
production, and therefore doesn’t should not treated as fresh production, and
therefore doesn’t
qualify for inclusion in national income however, any brokerage or commission
paid to facilitate
the sale is a fresh production activity. It should be included in production but to
the extent of
brokerage or commission only.
(iii) Self-consumed output must be included.
Output produced but retained for self-consumption, rather than selling in market,
is output
and must be included in estimates. Services of owner-occupied buildings, farmer
consuming its
own produce, etc are some examples.
(2) Income distribution method
(i) Avoid transfers
National income includes only factor payments, i.e. payment for the services
rendered to
the production units by the owners of factors. Any payment for which no service
is rendered is
called a transfer, and not a production activity. Gifts, donations, characters, etc
are main examples.
Since transfers are not a production activity it must not be included in national
income.
(ii) Avoid capital gain
Capital gain refers to the income from the sale of second hand goods and
financial assets.
Income from the sale of old cars, old house, bonds, debentures, etc are some
examples. These
transactions are not production transactions. So, any income orising to the
owners of such things
is not a factor income.
(iii) Include income from self-consumed output
When a house owner lives in that house, he does not pay any rent. But infact he
pays rent
to himself. Since rent is a payment for services rendered, even though rendered
to the owner
itself, it must be counted as a factor payment.
(iv) Include free services provided by the owners of the
production units
Owners work in their own unit but do not charge salary. Owners provide finance
but do not
charge any interest. Owners do production in their own buildings but do not
charge rent. Although
they do not charge, yet the services have been performed. The imputed value of
these must be
included in national income.
(3) Final expenditure method
(i) Avoid intermediate expenditure
By definition the method includes only final expenditures, i.e. expenditure on
consumption
and investment. Like in the value added method, inclusion of intermediate
expenditure like that
on raw materials, etc, will mean double counting.
10
(ii) Do not include expenditure on second hand goods and
financial assets
Buying second hand goods is not a fresh production activity. Buying financial
assets is not
a production activity because financial assets are neither goods nor services.
Therefore they
should not be included in estimates of national income.
(iii) Include the self use of own produced final products.
For example, a house owner using the house for seef. Although explicitly he does
not
incur any expenditure, implicitly he is making payment of rent to himself. Since
the house is
producing a service, the imputed value of this service must be include in national
income.
(iv) Avoid transfer expenditures
A transfer payment is a apayment against which no services are rendered.
Therfore no
production takes place. Since no production takes place it has no place in
national income.
Charities, donations, gifts, scholarships, etc are some examples.
DISPOSABLE INCOME
Introduction
Disposable income refers to the income actually available for use as consumption
expenditure and saving. It includes both factor contrast national income includes
only factor
incomes. Broadly, therefore, if we are given national income we can find
disposable income by
making adjustments of non factor incomes.
National Disposable Income
Given GNPmp, we can derive Gross National Disposable income (GNDI) and Net
National
Disposable income (NNDI).
GNPmp
+ Net current transfers from abroad
= GNDI
- Consumption of fixed capital
= NNDI
aLTERNATIVELY,
NNDI = NNPmp
+ Net current transfers from abroad
Disposable income aggregate of the private sector
GNDI and NNDI are the disposable income aggregates of the nation. Let us now
derive
the disposable income of the private sector of the nation. As a first step, given
national income,
11
we deduct-national income accring to the government. Then as a second step we
make
adjustments of non-factor incomes in various stages to ultimately arrive at
personal disposable
income. These steps are summed up in the following table.
NDPfc
Less : Income from property and entrepreneurship accruing to the government
administrative departments
Less : Saving of non-departmental enterprises
= NDPfc accruing to the private sector
Add : Net factor income from abroad
Add : National debt interest
Add : Current transfers from the government administrative departments.
Add : Net current transfers from the rest of the world.
= Private Income
Less : Saving of private corporate sector
(net of retained earnings of foreign companies)
Less : Corporation tax
= Personal Income
Less : Direct taxes paid by households
Less : Miscellaneous receipts of government administrative departments
= Personal disposable income
of the above ‘national debt interest’ is the interest paid by government on loans
taken to
meet its administrative expenditure, a consumption expenditure, a consumption
expenditure.
Since interest on loans taken to meet consumption expenditure is not a factor
income it was not
included in NDPfc. But since it is a disposable income it is added to NDPfc to arrive
at disposable
income of which private income is a part.
Miscellaneous receipts of government administrative departments are small
compulsory
payments by the people to the government in the form of fees, fines, etc and
treated like a tax,
and therefore deducted.
12
UNIT 7 - Determination of Income and Employment
Involuntary unemployment : Involuntary unemployment occurs when
those who are able and
willing to work at the going wage rate do not get work.
Aggregate demand : Aggregated demand means the total demand for final goods
in an economy.
It also means the aggregate expenditure on final goods in an economy.
The components of aggregate demand are :
1. Demand for goods and services for private consumption also called private
final
consumption expenditure.
2. Demand for private investment
3. Demand for goods and services by the government
4. Net exports.
Since the determination of income and employment is to be studied in the context
of two
sector model, the third and fourth components of aggregate demand are not
discussed in
details. The two sectors taken are households and firms.
1. Demand for goods and services for private consumption is made by household
sector. It
is also called private final consumption expenditure and will be refered to as
consumption
expenditure. It must be kept in mind that the consumption expenditure we are
discussing
is ex-ante i.e. planned consumption expenditure.
This demand is influenced by many variables such as price of the goods or
services,
income, wealth, expected income, tastes and preferences of individuals and so
on. Keynes
formulated his fundamental Psychological Law of Consumption to lay down a
behavioural rule to
the process of consumption activity.
Keynes stated that “men are disposed, as a rule and on the average, to increase
their
consumption as their income increases, but not by as much as the increase in
their income”. This
relationship between consumption and income is called the consumption
function.
The consumption function may be represented by the following equation.
C=
–
C + bY
–
C > 0, 0 < b < I.
Where,
13
C = Consumption
–
C = Autonomous Consumption
b = Marginal Propensity to Consume
Y = Level of income
The intercept
–
C represents autonomous consumption, that is, the amount of consumption
expenditure when income is zero.
–
C is assumed to be positive, that is there is consumption even
in the absence of any income. Hence, it is not possible to think of a situation
where there is no
comsumption at all.
The slope of the consumption function is ‘b’. It measures the rate of change in
consumption
per unit change in income and is also known as the Marginal Propensity to
Consume (MPC). For
example, if b is 0.6, then a rupee change in income causes a 0.60 rupee change
in consumption.
If b is 0.45, then a rupee change in income will cause a 0.45 rupee change in
consumption.
By assumption, the MPC is positive, and its value ranges between 0 and 1. This
means
that consumption increases with income, but a rupee increase in income causes
less than a
rupee increase (of b) in consumption. For example, if b is 0.90, a rupee increase
in income
causes a 0.90, a rupee increase in consumption.
The consumption function may be plotted on a graph with the help of a numerical
example.
Figure 1 shows the graph of the hypothetical consumption function.
Consider a consumption function given by
C = 100 + 0.8 Y
Since this is an equation of a straight line, the consumption function will have a
constant
slope.
Table 1 shows the level of consumption for various levels of income.
Column (1) shows the consumption expenditure at various levels of income. The
values in
column (1) are obtained from the consumption function. Column (5) in table 1
shows how MPC is
calculated. As income increases from Rs. 600 to Rs. 700 (an increase of 100
rupees), the
consumption increases from Rs. 580 to Rs. 660 (an increase of 80rupees). The
MPC is therefore
80/100 = 0.8. The MPC at all levels of income is the same because of the
particular consumption
function we have used in our example. (Constant slope and therefore constant
MPC is a feature
of all straight line consumption functions). The information given in the Table 1
can be plotted in
a graph, as shown in Fig. 1.
14
Table 1 : Consumption, Income and Marginal Propensity to
Consume
Consumption Change in Income Change in Marginal Prpensity
C Consumption Y Y to consume (MPC)
C = (2)/(4) = C/ Y
(1) (2) (3) (4) (5)
100 - 0 - -
180 80 100 100 (80/100) = 0.8
260 80 200 100 (80/100) = 0.8
340 80 300 100 (80/100) = 0.8
420 80 400 100 (80/100) = 0.8
500 80 500 100 (80/100) = 0.8
580 80 600 100 (80/100) = 0.8
660 80 700 100 (80/100) = 0.8
740 80 800 100 (80/100) = 0.8
820 80 900 100 (80/100) = 0.8
900 80 1000 100 (80/100) = 0.8
Fig. 1 shows, the graph of the consumption function C = 100 + 0.8Y.
To understand the figure, it is helpful to look at the 45o line drawn from the origin.
Since the
vertical and horizontal axes have the same scale, the 45o line has the property
that at any point
on it, the distance up from the horizontal axis (which is consumption expenditure)
exactly equals
the distance across from the vertical axis (which is income).
Thus, at any point on the 45o line, consumption expenditure exactly equals
income. The
45o line therefore immediately tells us whether consumption spending (as per the
consumption
function) is equal to, greater than, or less than the level of income.
The consumption function crosses the 45o line at point B. This point is known as
the
breakeven point. Here households are just breaking even, because the
consumption is exactly
equal to the income. In our example, the income and consumption at the
breakeven point is Rs.
500.
At any point other than B on the consumption function, consumption is not equal
to income.
At points to the left of B, the consumption function lies above the 45o line.
Therefore consumption
expenditure is greater than income. For example, at an income level of Rs. 200,
the consumption
15
is Rs. 260. The household must find funds to meet this consumption expenditure.
The shortage
in income will make them to sell the assets acquired in the past, or to resort to
borrowing so that
Rs. 60 could be raised for consumption. This act on the part of the household to
liquidate their
own assets or to go in for a loan is referred to as the process of dissaving.
Dissaving is in order
to help the households to finance the consumption over and above the level of
income.
Fig. 1 : The Consumption Function C = 100 + 0.8 Y
At any point to the right of B, the consumption function lies below the 45o
line;therefore
consumption expenditure is less than the level of income. The part of income,
which is not
consumed, is saved. This must be so, because income is either consumed or
save, there is no
other use to which it can be put. Savings can be measured in the graph as the
vertical distance
between the consumption function and the 45o line. For example, at an income
level of Rs. 900.
consumption is Rs. 820. Therefore, the amount of savings is the diference
between the two, that
is, Rs. 80.
To sum up: when the consumption functiuon lies above the 45o line, consumption
is greater
than income at each level of income. This means that there is dissaving, Where
the two lines
intersect, the level of consumption is exactly equal to the level of income, When
the consumption
function lies below the 45o line, the level of consumption is less than the level of
income. This
means that there is positive saving. The amount of dissaving or saving is always
measured by
the vertical distance between the consumption function and the 45o line.
16
Consumption and Savings
We shall now look into the relationship between consumption and saving. We
may obtain
the savings function from this relationship.
The equation below says that income that is not spent on consumption is saved,
that is
S=Y-C
This equation tells us that by definition, saving is equal to income minus
consumption.
The consumption function, along with the above equation, implies a savings
function. The
savings function relates the level of saving to the level of income. Substituting the
consumption
function into the above equation we can get the saving function.
S=Y-C
=Y-(
–
C + bY) (Since C =
–
C + bY)
=Y-
–
C - bY
S=-
–
C + (1 - b)Y
This is the savings function. The intercept term
–
C is the amount of savings done when
there is zero level of income. It is already shown that
–
C is positive. Therefore
–
C savings is negative.
Thus, there is negative savings
–
C at zero level of income. Since negative savings is nothing but
dissaving, this means that at zero level of income, there is a dissaving of amount
–
C. Note that the
amount of autonomous consumption is exactly equal to the amount of dissaving
at zero level of
income. This is because of the fact that Y = C + S (whether S is positive or
negative).
The slope of the savings function is (1 - b). The slope of the savings function
gives the
increase in savings per unit increase in income. This is known as the Marginal
Propensity to
Save (MPS) Since b is less than one it follows that (1 - b) and therefore MPS is
positive. Therefore,
savings is an increasing function of income.Suppose the MPC, that is, b is 0.8,
then the MPS, tha
is (1 - b) is 0.2. This means that for every one rupee increase in income, savings
increase by 0.2
rupee.
Note that MPS = 1 - b = 1 - MPC. This means that the part of the increase in
income, which
is not consumed, is saved, This is because income is either consumed or saved.
Therefore, it is
always the case that MPC + MPS = 1.
Using the numerical example of the consumption function we had earlier given,
we can
derive the corresponding savings function.
S=
–
C + (1 - b) Y
= - 100 + (1 - 0.8)Y
S = -100 + 0.2Y
17
Table 2 : Consumption - Saving Relationship
Y Change C Change MPC Saving Change MPS C+S MPC+
in Y in C C/ Y S in S S/ Y MPS
YCS
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
0 - 100 - - -100 - - 0 -
100 100 180 80 0.8 -80 20 0.2 100 1
200 100 260 80 0.8 -60 20 0.2 200 1
300 100 340 80 0.8 -40 20 0.2 300 1
400 100 420 80 0.8 -20 20 0.2 400 1
500 100 500 80 0.8 0 20 0.2 500 1
600 100 580 80 0.8 20 20 0.2 600 1
700 100 660 80 0.8 40 20 0.2 700 1
800 100 740 80 0.8 60 20 0.2 800 1
900 100 820 80 0.8 80 20 0.2 900 1
1000 100 900 80 0.8 100 20 0.2 100 1
Table 2 shows the levels of consumption and savings for various levels of
income.
Note that (a) consumption plus saving everywhere equals income, and (b) MPC +
MPS = 1.
Columns (1) to (5) are repeated from Table 1. Column (6) shows the level of
savings at different
levels of income. The values in this column are obtained from the savings
function. Column (8) in
table 2 shows how MPS is calculated. As income increases from Rs. 600 to Rs.
700 (an increase
of Rs. 100), the savings rises from Rs. 20 to Rs. 40 (an increase of Rs. 20). The
MPS is therefore
(20/100) = 0.2.
The MPS is the same at all levels of income because of the particular savings
function
(a linear curve with constant slope) we used in our example (constant slope and
therefore constant
MPS is a feature of all straight line savings functions).
Column (9) of the table shows the sum of consumption expenditure and savings
at
every level of income. Note that column (9) is identical to column (1). This is
because income is
either consumed or saved, there is no other use to which it can be put. Thus, the
sum of
consumption expenditure and saving must be identically equal to income.
Column (10) of the table shows the sum of the MPC and MPS. Note that the sum
of
MPC and MPS is equal to one. This means that the part of the increase in
income, which is not
consumed, is saved. This is because income is either consumed or saved.
The information given in table 2, can be plotted in a graph, as shown in Fig. 2
18
The information given in table 2 can be plotted in a graph, as shown in Fig 2.
Fig 2 : The consumption Function and its associated Savings Function
Part A of Fig 2 shows the consumption function, Part B shows the savings
function.
This is the counterpart of the consumption shown in part A. In part A, the amount
of saving at any
level of income is the vertical distance between the consumption function and the
45o line. The
saving function shown in part B can therefore be directly derived from part A.
When income is 500, we see in part A that consumption is 500 and saving equals
0.
This is depicted in part B by the intersection of the savings function with the
horizontal axis at
point B, which corresponds to an income level of 500. When income is 200,
consumption is 260
and saving is -60 (dissaving is 60); the savings function lies 60 below the
horizontal axis at an
income level of 200.
When income is 900, consumption is 820 and saving is 80; the saving function
lies 80
above the horizontal axis at an income level of 900.
In general, to the left of points B in part A, the consumption function lies above
the 45o
line (consumption is more than income). Hence to the left of point B in part B,
savings is negative
and the savings function lies below the horizontal axis.
19
To the right of point B in part A, the consumption function lies below the 45o line
(consumption is less than income). Hence to the right of point B in part B,
savings is positive and
the savings function lies above the horizontal axis.
Average Propensities to Consume and Save
From the consumption function, we can find out the value of the consumption
income ratio
C/Y, at every level of income. At any particular level of income. the ratio of
consumption to income
is called the Average Propensity to Consume (APC). The APC gives the average
consumption -
income relationship at different levels of income.
Similarly, from the savings function, we can find out the average savings - income
ratio. At
any particular level of income, the Average Propensity to Save (APS) is the ratio
of savings to
income.
We have
APC = C/Y and APS = S/Y
Now, the sum of the APC and APS is always equal to one. This is because
income is either
consumed or saved. The proof of this statement is as follows; From the
relationship between
income, consumption and saving,
We have
Y=C+S
Dividing both sides of the equation by Y we have
Y/Y = C/Y + S/Y
Thus, I = APC + APS
Using the earlier examples of consumption function and savings function we can
calculate
the values of APC and APS for every level of income. This is done in Table 3.
Table 3 Average Propensities to Consume and Save
Y C APC S APS APC+APS
(2)/(1) (4)/(1)
(1) (2) (3) (4) (5) (6)
0 100 - -100 - -
100 180 1.8 -80 -0.8 1
200 260 1.3 -60 -0.3 1
300 340 1.13 -40 -0.13 1
400 420 1.05 -20 -0.05 1
500 500 1 0 0 1
600 580 0.97 20 0.03 1
700 660 0.94 40 0.06 1
800 740 0.92 60 0.08 1
900 820 0.91 80 0.09 1
1000 900 0.90 100 0.10 1
Note : Figures in table are rounded upto two decimal points
20
Column (3) shows how APC is calculated. At a particular income level, the APC
is the corresponding
level of consumption divided by that level of income. Similarly: APS is calculated
in column (5). At
a particular income level, the APS is the corresponding level of saving divided by
that level of
income. Column (6) shows the sum of APC and APS. As expected, at every level
of income, the
sum of APC and APS is equal to one. This is because income is either
consumed or saved.
Therefore the proportion of income that is not consumed must be saved.
As we can see from the above table. APC is continuously declining as income
increases;
and APS is continuously increasing as income increases. This means that as
income increases,
the proportion of income saved increases and the proportion of income
consumed decreases.
2. Demand for Private Investment
Demand for private investment refers to the planned or ex-ante investment
expenditure
by the firms. It includes addition to the stock of physical capital and change in
inventory. For
simplicity sake it is assumed in our study that the investment expenditure is
autonomous. This
means investment decisions are not influenced by any of its determinants,
including output.
Aggregate Supply : It is total quantity of goods and services produced in the
economic teritory of
a country. It refers to the planned aggregate output in the economy. It is assumed
that in the short
run the prices of goods do not change and the elasticity of supply is infinite. At
the given price
level, output can be increased till all resources are fully employed. So how much
will be the
aggregate output will primarily depend upon how much is the aggregate demand
in the economy.
The level of output income and employment in an economy move together in the
same
direction till full employment is reached. Increase in output means, increase in
level of employment
and increase in level of income. Decrease in output means less employment and
lower level of
income.
Determination of Equilibrium Level of Output, Income &
Employment
We shall confine our analysis of the determination of the equilibrium level of
output to an
economy with only two sectors, households and firms. Hence, the only
components of aggregate
demand will be consumption demand and investment demand.
Consumption plus Investment Approach
We may show output determination using the consumption plus investment (C+I)
approach.
This is illustrated in Fig. 3, which shows total spending or aggregate demand
plotted against
output or income. The line CC is the consumption function, showing the desired
(planned level)
of consumption corresponding to each level of income. We now add desired
(planned) investment
(which is at fixed level I) to the consumption function. This gives the level of total
desired spending
or aggregate demand, represented by the C+Io curve. At every point, the (C+Io)
curve lies above
the CC curve by an amount equal to Io.
The 45o line will enable us to identify the equilibrium. At any point on the 45o line,
the
aggregate demand(measured vertically) equals the total level of output
(measured
horizontally).
The economy is in equilibrium when aggregate demand, represented by the C+Io
curve is
equal to the total output.
21
Fig. 3 : Output Determination by Consumption plus Investment approach
The aggregate demand or (C + Io) curve shows the desired level of expenditure
by consumers
and firms corresponding to each level of output. The economy is in equilibrium at
the point where
the C + Io curve interseets the 45o line - point E in Fig. 3. At point E, the economy
is in equilibrium
because the level of desired spending on consumption and investment exactly
equals the level
of total output. The level of output corresponding to point E, is the level of output
OM. Thus, OM
is the equilibrium level of output.
The Adjustment Mechanism
Equilibrium occurs when planned spending equals planned output. When
planned spending
is not equal to planned output, then output will tend to adjust up or down until the
two are equal
again.
Consider the case when the economy is at a level of output greater than the
equilibrium
level OM in Figure 3. At any such greater level of output, the C + Io line lies below
the 45o line that
is planned spending is less than planned output. This means that consumers and
firms together
would be buying less goods than firms were producing. This would lead to an
unplanned undersired
increase in inventories of unsold goods (representing goods neither sold to
households for
consumption nor bought by firms for investment) Firms would then respond to
this unplanned
inventory increase by decreasing employment and hence output. This process of
decrease in
output will continue until the economy is back at output level OM, where again
aggregate demand
equals planned ouput and there is no further tendency to change.
Consider another case when the economy is at a level of output less than the
equilibrium
level OM. At any such lower level of output, the C + Io line lies above the 45o line,
that is, planned
spending is more than planned output. This means that consumers and firms
together would be
22
buying more goods than firms were producing. This would lead to an unplanned,
undesired
decrease in inventories. Firms would then respond to this unplanned inventory
decrease by
increasing employment and hence output. This process of increase in output will
continue until
the economy is back at output level OM, where again aggregate demand equals
planned output
and there is no further tendency to change.
Fig. 4 : The Consumption Function and the corresponding Savings Function
Output Determination Using the Savings Function and the
Investment Schedule
Saving Function
Figure 4 shows the consumption function and the corresponding savings
function, is it not
similar to Fig. 2? Recall that each point on the consumption function shows
desired or planned
consumption at that level of income. Each point on the savings function shows
the desired or
planned savings at that income level.
The two functions are closely related, since income always equals consumption
plus saving.
Therefore these can be called complementary curves.
23
Investment Schedule
For simplicity we shall assume that firms plan to invest exactly the same amount
every
year, regardless of the level of output.
If we plot on a graph the level of investment demand at every level of output (and
therefore
income), we will have the investment schedule. Figure 5 shows the investment
schedule.
Since firms plan to invest the same amount Io regardless of the level of output, the
investment
schedule will be a horizontal line. This is because every point on the investment
schedule lies at
the same height above the horizontal axis, That is, the level of investment
demand is the same at
every level of output.
Fig. 5 : The Investment Schedule
Equilibrium Output
By examining the interaction of savings and investment, we can find the
equilibrium level
of output. Fig 6. combines the savings function of Fig. 4 and the investment
schedule of Fig. 5.
We see the savings function and the investment schedule intersect at point E.
This point
corresponds to a level of output OM, which is the equilibrium level of output.
This intersection of the savings function and the investment schedule gives the
equilibrium
towards which output will gravitate.
Meaning of the Equilibrium
Point E is the point of intersection of the savings function and the investment
schedule.
Thus, only at point E will planned savings of households equal planned
investment of firms.
When planned savings and planned investment are not equal, output will tend to
adjust up or
down till they are equal again.
0
Q* Output
Io
BM
Investment
Schedule
Investment
(I)
24
The savings function and the investment schedule of Fig. 6 represent planned
levels of
savings and invesment respectiviely. Thus, at output level OM, firms plan to
invest an amount
equal to ME. Also, households plan to save an amount equal to ME. However, in
general, there
is no necessity for acutal saving (or investment) to be equal to planned saving (or
invesment).
This may be due to mistakes, incorrect forecasting of events, or for a variety of
other reasons. In
any case, actual savings or investment might be different from planned savings
or investment.
Fig. 6 : Intersection of the Savings Function and the investment schedule
We will look at the mechanism of how output adjusts until planned savings and
planned
investment are equal, under three separate cases.
The first case is where the economy is at a level of output equal to OM. At this
level of
output, planned savings of household equals planned investment of firms. Since
the plans of
households and firms are satisfied, they will be content to continue doing exactly
what they had
been doing till then. Thus output, employment and income will remain the same.
In this case, it is
righly called an equilibrium.
The second case is where the economy is at a level of output greater than OM.
At the
corresponding level of income, the savings function lies above the investment
schedule, Therefore,
at this level of income households are saving more, that is, they are refraining
from consuming by
an amount greater than firms are investing. The effect of this will be to cause an
undesired,
unplanned build-up of inventories of unsold goods. The effect of an undesired.
unplanned inventory
build-up is to increase the actual level of investment to a level greater than the
planned level of
investment. Since firms’ plans have not materialized, they will act in order to
correct the situation.
In order to reduce the unsold inventories to the desired level firms will cut back
production and
reduce employment. The effect of this will be to reduce output until the economy
returns to
equilibrium at output level OM, where planned savings equals planned
Investment,equals actual
investment, and there is therefore no further tendency to change.
The third case is where the economy is at a level of output less than OM. At the
corresponding level of income, the savings function lies below the investment
schedule. Therefore,
at this level of income households are saving an amount less than firms plan to
invest. Households
25
are thus, refraining from consuming by an amount less than firms plan to invest.
The effect of this
will be to cause an unplanned, undesired reduction in inventories of unsold
goods. Thus, the
acutal level of investment will be less than the planned level of investment. Again,
since firms’
plans have not materialised, they will act in order to correct the situation. In order
to increase
inventories to the desired, planned level firms will increase production and
increase employment.
The effect of this will be to increase output till the economy returns to output level
OM, where
planned savings equals planned investment, planned investment equals actual
investment, and
there is thus no further tendency to change.
All three cases lead to the same inference. The only equilibrium level of output is
OM,
where planned saving equals planned investment. At any other level of output,
the discrepancy
between planned saving and planned investment will cause firms to change their
production and
employment levels, thereby returning the economy to the equilibrium output and
employment.
In equilibrium planned expenditure and planned output must
be equal
A numerical example will show why the equilibrium level of output occurs when
planned
spending and planned output are equal. Table 4 shows an example using a
consumption function
and the associated savings function.
The consumption function is
C = 1000 + 0.67Y
The associated savings function is
S = - 1000 + 0.33Y
Column (2) represents the level of planned consumption at various levels of
income. The
values in column (2) are derived from the consumption function used above.
Column (3) represents
the levels of planned saving at various levels of income. The values in column (3)
are derived
from the savings function used above. Column (5) is a reproduction of column
(1). Column (6)
shows the level of aggregate demand at various levels of income - it is the sum of
consumption
demand in column (2) and investment demand in column (4). It shows what firms
actually managed
to sell.
Table 4 : Determination of Output (All Figures in Rs. Crores)
Output and Planned Planned Planned Output and Aggregate Tendency
Income Consum- Saving Invest- Income Demand of Output
ption (3)=(1)-(2) ment (5) = (1) (6)=(2)+(4) to
(1) (2) (3) (4) (5) (6) (7)
4200 3800 400 200 4200> 4000 Decrease
3900 3600 300 200 3900> 3800 Decrease
3600 3400 200 200 3600= 3600 Equilibrium
3300 3200 100 200 3300< 3400 Increase
3000 3000 0 200 3000< 3200 Increase
2700 2800 -100 200 2700< 3000 Increase
26
The level of income at which consumption is exactly equal to income (that is, all
income is
consumed), and therefore, savings is exactly equal zero is known as the break-
even level of
income. In our example, the breakeven level of income is Rs. 3000 crores.
Now, each change of income of Rs. 300 crores causes a change of Rs. 100
crores in
saving, and a change of Rs. 200 crores in consumption. Thus MPS is a constant
and is equal to
1/3 and MPC is a constant and is equal to 2/3.
Investment is assumed to be exogenous. Firms plan to invest a constant amount
of Rs.
200 crores as shown in column (4). That is, at each level of income, firms plan to
purchase Rs.
200 crores of investment goods.
Consider the top row of the Table 4. If firms are producing Rs. 4200 crores of
output, then
the planned spending or aggregate demand is only R.s 4000 crores. In this
situation, there will be
an unplanned accumulation of inventories to the tune of Rs. 4200 crores - Rs.
4000 crores = Rs.
200 crores. Firms will respond to this unplanned inventory build-up by scaling
down their operations
and thus output will decrease.
The opposite case is represented by the bottom row of Table 4. Here, firms are
producing
Rs. 2700 crores of output but aggregate demand is Rs. 3000 crores. In this
situation, there will be
an unplanned decrease in inventories to the tune of Rs. 3000 crores - Rs. 2700
crores = Rs. 300
crores. Firms will respond to this unplanned inventory decrease by expanding
their operations,
thus causing an increase in output.
Thus, when firms as a whole are temporarily producing more than they can sell,
they will
contract their operations, causing output to fall. When they are temporarily selling
more than their
current production, they will expand their operations, causing output to rise.
Only when the level of output in column (5) is equal to aggregate demand in
column (6)
will output be in equilibrium. Firms sales will be just enough to justify continuing
their current level
of aggregate output. Thus, aggregate output will neither expand nor contract, and
will be in
equilibrium. The equilibrium level output in our example is Rs. 3600 crores.
The Multiplier
A change in the investment spending will affect output and therefore
employment. It is
logical that an increase in fixed business investment will increase the level of
output and
employment through increase in productive capacity. Conversely, a decrease in
investment will
decrease the level of output and employment.
The operation of the multiplier ensures that a change in investment causes a
change in
output by an amplified amount, which is a multiple of the change in investment.
The multiplier is the number by which the change in investment must be
multiplied in order
to determine the resulting change in output.
For example, if an increase in investment of Rs. 100 crores causes an increase in
output
27
of Rs. 300 crores, then the multiplier is 3. If, instead the resulting increase in
output is Rs. 400
crores, then the multiplier is 4.
We may derive an expression for the multiplier as follows:
At equilibrium, we have
Y=C+I
I.e., income equals the sum of consumption plus investment.
We can use the consumption function to substitute C with the expression
–
C+bY, to give
Y=
–
C + bY + I
so Y - bY =
–
C+I
or, Y (I-b) =
–
C+I
or, Y = 1 (
–
C + I)
(1-b)
Since b is nothing but the MPC, we have
Y=1
(
–
(1-MPC) C + I)
To find out the effect of a change in investment on income, we differentiate the
equation to
obtain.
Y=1I
(I - MPC)
So, (Change in income) = (Multiplier) (Change in Investment)
The multiplier is equal to I/(1-MPC). It is the number by which the change in
investment
must be multiplied in order to determine the resulting change in output.
As we can see. the size of the multiplier depends on value of the MPC.
Since O < MPC < 1, the multiplier will be greater than 1. Hence, a change in
investment
will cause a multiple change in output.
The actual size of the multiplier depends on the value of MPC. For example if
MPC is
2/3 then the multiplier is 3. If MPC be at 4/5, the multiplier is 5.
A numerical example will enable us to see the operation of the multiplier. Let the
MPC be
at 4/5. Suppose there is an increase in investment of Rs. 1000. which results in
the construction
28
of a new building. Then, the builder, the architect and the labourers together will
get an increase
in income of Rs. 1000. Since the MPC is 4/5, they will together spend 800 (4/5 of
Rs. 1000) on
new consumption goods. The producers of those consumption goods will thus
have an increase
of Rs. 800 in their incomes. Since their MPC is also 4/5, they will in turn spend
Rs. 640 (4/5 of Rs.
800. or 4/5 of 4/5 of Rs. 1000). This will cause an increase in income of other
people by Rs 640.
This process will go on with each new round of spending (and therefore increase
in investment)
being 4/5 of the previous round.
Thus, an endless chain of secondary consumption spending is set in motion by
the primary
investment of Rs. 1000. However. not only is the chain of secondary consumption
spending
endless, it is also ever-diminishing. Eventually, the sum of the secondary
consumption expenditures
will be a finite amount.
We can calculate the total increase in consumption plus investment spending and
therefore
the total increase in income as follows:
Rs. 1000 = 1 X Rs. 1000
++
Rs. 800 4/5 X Rs. 100
++
Rs. 640 (4/5)2 X Rs. 1000
++
Rs. 512 (4/5)2 X Rs. 1000
++
Rs. 409.6 (4/5)2 X Rs. 1000
++
::
Rs. 5000 [1/{1-(4/5)}] x Rs. 1000
Multiplier
We have said that the chain of secondary consumption spending is an endless
everdiminishing
chain, whose sum is a finite amount.
We may find the sum of the total increase in spending by using the formula for
the sum of
an infinite geometric progression.
The sum of the total increase in spending and the total increase in income is:
Y = 1 x Rs. 1000 + (4/5) x Rs. 1000 + (4/5)2 X Rs. 1000 + (4/5)3 X Rs. 1000
+ ...............
Y = Rs. 1000 [ 1 + (4/5) + (4/5)2 + (4/5)3 + ...]
The term in square brackets is of the form of the sum of an infinte geometric
pregression,
whose first term is 1 and where constant multiplier ‘r’ is 4/5.
29
The formula for the sum of such an infinite geometric progression is 1/(1-r). In our
case.
r = 4/5, therefore the sum of the geometric progression is
1 / [1 - (4/5) ] = 5
Replacing the term in the square brackets by 5, we have
Y = Rs. 1000 x 5
Y = Rs. 5000
We can see that with an MPC of 4/5, the multiplier is 5.
We may also express multiplier in terms of the marginal propensity to save, that
is MPS
Multiplier = 1 .
1 - MPC
Since MPS = 1 - MPC, we have
Multiplier = 1 .
MPS
i.e., if MPS were 1/x, then the multiplier would be x.
In our example, the MPS is 1/5. Let the investment expenditure increase by Rs.
1000
crores. Planned saving will have to rise till it equals the new and higher level of
investment, in
order to ‘bring output to a new equilibrium. The only way that saving can rise is
for income to
rise.With an MPS of 1/5 and an increase in investment of Rs. 1000 crores,
income must rise by
Rs. 5000 crores to bring forth Rs. 1000 crores of additional saving to match the
new investment.
Hence, at equilibrium, Rs. 1000 crores of additional investment induces Rs. 5000
crores of
additional income, in line with our multiplier arithmetic.
Problems of Excess and Deficient Demand and Measures to
Correct Them
Thus far, we have studied the determination of output,income and employment in
the
Keynesian framework. The equilibrium level of output, income and employment
was determined
solely by the level of aggregate demand. The economy will be in full-employment
equilibrium if
the aggregate demand is for an amount of output that is equal to the full-
employment level of
output. If the aggregate demand is for an amount of output less than the full
employment level of
output, then it is known as deficient demand. If the aggregate demand for a level
of output is
more than full-employment level of output, then it is known as excess demand.
We will take up
the problems of and remedies for excess and deficient demand individually.
Problem of Deficient Demand
If aggregate demand is for a level of output less than the full-employment level,
then a
situation of deficient demand exists. Deficient demand gives rise to a ‘deflationary
gap’, which
causes the economy’s income, output and employment to decline, thus pushing
the economy
into an under-employment equilibrium. Figure 7, depicts the situation of deficient
demand.
30
Fig. 7 : Deficient Demand
The Y-axis measures consumption demand, investment demand, and their sum
the
aggregate demand. The X-axis measures the level of output and income. OQ’ is
the full employment
level of output and income. (C+1)o and (C+1)1 are two parallel aggregate demand
curves, differing
only by the amount of investment expenditure.
For the economy to be at a full-employment equilibrium, the aggregate demand
should be
for a level of output equal to the full-employment level of output OQ’. In other
words, aggregate
demand should be equal to Q’F. The economy will then be in a full employment
equilibrium,
corresponding to the point F on the aggregate demand curve (C+1)1 and the
economy will produce
full-employment level of output OQ’.
Supose,however, that the aggregate demand is for a level of output Q’G, Q’G is
less than QF.
Then aggregate demand is for a level of output which is less than the full-
employment level. This
level of aggregate demand corresponds to point G on the aggregate demand
curve (C+1)o. This
results in a situation of deficient demand. The resulting deflationary gap created
due to deficient
demand is represented in Figure 7 by FG.
The deflationary gap is the difference between the level of aggregate demand
required to
establish the full-employment equilibrium and the actual level of aggregate
demand. The
deflationary gap is a measure of the amount of deficiency of aggregate demand.
The deflationary gap will set in motion forces that will cause a decline in the
economy’s output,
income and employment. At point G, the aggregate demand curve (C+1)o lies
below the 45o line.
As a result, the aggregate demand Q’G is less than the level of output OQ’. Firms
will experience
an unplanned build-up of inventories of unsold goods. They will respond by
reducing employment
and cutting back production. This will reduce the economy’s output income and
employment,
until a new equilibrium is reached at point E. This is an equilibrium because the
aggregate demand
EM is equal to output OM (since point E lies on the 45o line).
It will be noted that point E is an under-employment equilibrium. The equilibrium
levels of
output, income and employment corresponding to point E are less than the full
employment
31
levels of output, income and employment corresponding to point F. Thus, the
deficient demand
caused deflationary gap and has pushed the economy into an under-employment
equilibrium.
Problem of Excess Demand
If aggregate demand is for a level of output more than the full employment level,
then a
suituation of excess demand exists. Excess demand gives rise to an inflationary
gap; which
causes a rise in the price level or inflation. Figure 8 depicts the situation of
excess demand.
Fig. 8 : Excess Demand
The X-axis measures the level of output and income. The Y-axis measures
consumption demand,
investment demand, and their sum, the aggregate demand. OQ’ is the full
employment level of
output and income. (C+I)o and (C+I)1 are two parallel aggregate demand curves,
differing only by
the amount of investment expenditure.
The economy will be in a full-employment equilibrium at point F on the aggregate
demand
curve (C+I)o and the economy will produce full-employment level of output OQ’.
Uptil point Q’ increases in nominal income and output correspond to increases in
real
income and output (since prices are constant). Beyond point Q’ increases in
nominal income and
output do not correspond to any change in real income and output. This is
because real income
and output cannot increase beyond the full employment level, as all resources
are already fully
employed. The increases in nominal income and output are merely due to
increases in the price
level.
Suppose that the aggregate demand is for a level of output Q’G. which is greater
than the
full-employment level of output. This level of aggregate demand corresponds to
point G on the
aggregate demand curve (C+I)1. This is a situation of excess demand. The
resulting inflationary
gap, created due to the excess demand is represented in Figure 8 by FG.
The inflationary gap is the amount by which the actual aggregate demand
exceeds the
level of aggregate demand required to establish the full-employment equilibrium.
The inflationary
gap is a measure of the amount of the excess of aggregate demand.
32
The inflationary gap is so called because it sets in motion forces that will cause
inflation or
a rise in the price level. At point G, the aggregate demand curve (C+I)1. lies
above the 45o line. As
a result, the aggregate demand Q’G is greater than the level of output OQ’. The
effect of this will
be to create demand pull inflation (an aggregate demand induced rise in the price
level). The rise
in price level, given the constant real output, will cause an increase in the nominal
output until a
new equilibrium is reached at point E. This is an equilibrium because the
aggregate demand ME
is equal to the output OM (since point E lies on the 45o line).
It will be noted that the real output and real income is the same at the new
equilibrium E.
Correspondingly, the equilibrium level of employment also is the same. All that
has happend is
that nominal output and income have increased due to an increase in the price
level. Thus the
excess demand caused an inflationary gap. which caused inflation, and
therefore, the price level
to rise. In other words, the economy remains at a full-employment equilibrium,
although at a
higher price level.
In a three sector ecomony where the three sectors are house-holds, firms and
government,
aggregate demand is equal to the sum of consumption, investment and
government expenditure.
Figure 9 shows the effect of G on aggregate demand. For simplicity, we consider
government
expenditure to be a constant amount. The new aggregate demand curve C+1+G
lies parallel
above the old aggregate demand curve C+1. This is because, at every level of
output the vertical
distance between the C+1 curve and the C+I+G curve is the constant amount of
government
expenditure.
Fig. 9 : Aggregate demand including government expenditure
Thus, the inclusion of government expenditure in aggregate demand causes a
parallel
upward shift by an amount G in the aggregate demand curve.
We are now in a position to return to the measures that can be taken to remedy
the
problems of excess and deficient demand. In the following discussion, aggregate
demand will be
taken to mean the sum of consumption investment and government expenditure,
since we are
now considering a three sector economy. This modification to the definition of
aggregate demand
does not however change the nature of or definition of excess and deficient
demand.
We will first consider the remedy to the problem of deficient demand.
Income & Output
0
X
Y
C+I
Aggregate
Demand
45o
C+I+G
G
33
Remedy for Deficient Demand
As we have seen earlier, if aggregate demand is for a level of output less than the
full
employment level of output, then a situation of deficient demand exists. Figure 10
depicts the
situation of deficient demand in the context of the three sector economy.
Fig. 10 : Deficient Demand in a Three Sector Economy
In order to remedy the problem of deficient demand, the aggregate demand has
to be
increased by an amount equal to the deflationary gap. This will move the
economy to the full
employment equilibrium at point F.
The aggregate demand may be increased by taking recourse to fiscal policy,
monetary
policy or both.
Fiscal Policy Measures
We shall first consider the fiscal policy measures to increase aggregate demand.
This
may be done by either increasing the level of government expenditure or by
reducing the amount
of taxes. We will consider only increase in government expenditure. If the
government expenditure
is increased by an amount equal to the deflationary gap, it will restore the
economy to the fullemployment
equilibrium. The increase in government expenditure is shown in figure 11.
Fig 11. Increase in government expenditure as a remedy for deficient demand
34
The new level of aggregate demand is C+I+G1 corresponding to a higher level of
government
expenditure G1. This level of aggregate demand is sufficient to keep the economy
at the full
employment equilibrium, thus increase in government expenditure by an amount
FG will eliminate
the problem of deficient demand.
Monetary Policy Measures
The problem of deficient demand can also be solved by taking resort to monetary
policy
measures. The aim of the monetary policy measure is to cause an increase in the
investment
expenditure by firms. This may be done in a two step manner. The first step is to
increase the
availability of credit. This may be done by reducing the reserve ratios, thus giving
commercial
banks greater ability to create credit, The next step is to lower the interest rate by
increasing the
supply of money. The purpose of this step is to ensure the off take of the
increased credit by
firms. There is an inverse relationship between the rate of interest and the level of
investment
demand. If the economy’s Central Bank lower the interest rate, then there would
be an increase
in investment demand.
This increase in investment demand would cause an increase in aggregate
demand. Thus,
by sufficiently lowering the interest rate, the Central Bank may increase
investment demand and
therefore aggregate demand, until the economy is restored to a full-employment
equilibrium.
Remedy for Excess Demand
As we have seen earlier, if aggregate demand is for a level of output greater than
the full
employment level of output, then a situation of excess demand exists.
In order to remedy the problem of excess demand, the aggregate demand has to
be
reduced by an amount equal to the inflationary gap. This will keep the economy
at full employment
equilibrium but will lower the price level and thus combat the inflation. The
aggregate demand
may be reduced by taking recourse to fiscal policy or to monetary policy.
Reduce Government Expenditure
Reduction in government expenditure will reduce aggregate demand and remove
the inflationary
gap. This can also be shown by a diagram in the same way as was done in a two
sector model.
The C+I+G curve will shift downward showing fall in Government expenditure.
The fall in
government expenditure should be equal to the inflationary gap.
Monetary Policy Measures
The monetary policy measure to combat the problem of excess demand will
operate through
a reduction in the investment demand by firms. There is an inverse relationship
between the rate
of interest and the level of investment demand. If the economy’s Central Bank
were to increase
the interest rate, then there would be a decrease in investment demand.
This decrease in investment demand would cause a decrease in aggregate
demand.
Thus, by sufficiently raising the interest rate, the Central Bank may decrease
investment demand
and therefore, aggregate demand, until the inflationary gap is eliminated, and the
price level
reduced.
35
UNIT 8
EVOLUTION OF MONEY
Money is anything which can serve as a medium of exchange. Historically, all
sorts of
things like animals, agricultural produce, metals have been used as a medium of
exchange.
Today, it is prominently paper money, i.e. the currency notes. Although today
paper money is
prominent, yet instances of agricultural produce, metals, etc. can be found here
and there,
particularly in villages. In many Indian villages ‘food for work’ is still a practice.
This shows that
many mediums of exchange existed side by side but only one medium or the
other found a
prominent place.
Since many mediums of exchange existed simultaneously we can talk of
evolution of
money in terms of the prominence of the mediums. Upto first half of the 18th
century, the mediums
of exchange were goods with increasing use of metals, particularly gold and
silver. The paper
money was introducad in the organised manner for the first time around 1750’s.
So from around
1750’s till 1930’s gold and silver were prominently used but at the same time
there was increasing
use of paper money. Why did gold and silver found prominence during this
phase?
There were many reasons. First, gold and silver were widely accepted in
monetary
transactions, like buying and selling, borrowing and lending, for storing wealth,
etc. Second they
were in limited supply. Third, they are durable nearly non-perishable. Fourth, gold
and silver can
easily be divided into monetary units.
From 1930’s onwards most countries are now using paper currency as a
prominent, and
nearly exclusive, medium of exchange. Why so? It is mainly because of
phenomenal rise in the
volume of transactions needing more and more of money. But why gold and silver
were found
wanting? The main reason was their limited supply.
The world’s production of gold and silver was not enough to match the
requirements of
increasing volume of internal and external trade. Even if supply was sufficient,
inconvenience in
handling large transactions, lack of safety during transportation of metals, etc.
came in the way of
using gold and silver as a prominent medium.
Note that today paper currency is in prominence as a medium of exchange,
people still
prefer to hold gold and silver. They hold not because it can be used as a medium
of exchange,
but because it is durable and easily convertible into paper currency for use as a
medium of
exchange.
BANKING
Commercial Banks
Banking is defined as the accepting, for the purpose of lending or investment of
deposits,
money from the public, repayable on demand or otherwise and withdrawable by
cheque, draft,order
or otherwise.
Thus the two essential functions of banks are to accept chequable deposits from
the
public and lending.
36
Acceptance of chequable deposits is a necessary, but not sufficient condition for
Financial
Institution (FI) to be a bank. For example, post office savings banks are not banks
in this sense of
the term even though they accept deposits from the public. This is because they
do not perform
the other essential function of lending.
Similarly, lending alone does not make FI a bank. For example, many FIs like
LIC, UTI,
and IFC, etc, lend to others but they are not banks in this sense of the term, as
they do not accept
chequable deposits.
The main functions that commercial banks perfom are :
1. Acceptance of Deposits
The bank accepts three types of deposits from the public.
_ Current Account Deposits : Deposits in current accounts are payable on
demand. They
can be drawn upon by cheque without any restriction. These accounts are
usually
maintained by businesses and are used for making business payments. No
interest is
paid on these deposits. However, the banks offer various services to the account
holders
for a nominal charge, the most important being the cheque facility. Banks keep
regular
accounts of all transactions made in a particular account and submit statements
of the
same to the account-holder at regular intervals.
_ Fixed/Term Deposits : These are deposits for a fixed term (period of time)
varying from a
few days to a few years. They are not payable on demand and do not enjoy
chequing
facilities. The moneys deposited in such accounts become payable only on the
maturity of
the fixed period for which the deposit was initially made.
A variant of fixed deposits are recurring deposits. In these accounts, a depositor
makes a
regular deposit of an agreed sum over an agreed period e.g. Rs. 100 per month
for 5
years. Interest is paid on the deposits in these accounts.
_ Savings Accounts Deposits : These deposits combine the features of both
current account
deposits and fixed deposits. They are payable on demand and also withdrawable
by cheque,
but with certain restrictions on the number of cheques issued in a period of time.
Interest
is paid on the deposits in these accounts but the interest paid on savings account
deposits
is less than that of the fixed deposits.
In monetary analysis deposits are classified into two types : demand deposits
and time
deposits. Demand deposits are payable on demand either through cheque or
otherwise. Only
demand deposits may serve as a medium of exchange, because their ownership
can be transferred
from person to person through cheques. All other deposits that are not payable
on demand are
called time deposits.
All current account deposits are demand deposits and all terms deposits are time
deposits.
The classification of savings deposits is not as straight forward because they
combine features
of both demand and time deposits. The Reserve Bank of India distinguishes
between the demand
liability position of savings deposits (which are included under demand deposits)
and the time
37
liability portion of savings deposits). The rule to decide which part of the savings
deposits came
under which category was : the average of the monthly minimum balances in the
savings accounts
on which interest is being paid shall be regarded as a time liability and the excess
over the said
amount shall be regarded as a demand liability.
2. Giving Loans
The deposits received by the bank are not allowed to lie idle by the bank. After
keeping a
certain portion of the deposits as reserves, the bank gives the balance to
borrowers in the form of
loans and advances. The different types of loans and advances made by banks
are as follows :
_ Cash Credit - In this arrangement an eligible borrower is first sanctioned a credit
limit upto
which he may borrow from the bank. This credit limit is determined by the bank’s
estimation
of the borrower’s creditworthiness. However, actual utilisation of credit by the
customer
depends upon his withdrawing power. The withdrawing power depends on the
value of the
borrower’s current assets, which comprise mainly of stocks of goods-raw
materials, semimanufactured
or finished goods, and bills receivable (dues) from others. The borrower
has to submit a stock statement of his assets to the bank showing evidence of
on-going
trade and production activity and acting as a legal document in possession of the
bank, to
be used in case of default. The borrower has to pay interest on the ‘drawn’ or
utilised
portion of the credit only.
_ Demand Loans - A demand loan is one that can be recalled on demand. It has
no stated
maturity. The entire loan amount is paid in lump sum by crediting it to the loan
account of
the borrower. Thus, the entire loan amount becomes chargeable to interest.
Security brokers
and others whose credit needs fluctuate day to day usually take these loans. The
security
against these loans may be personal, financial assets or goods.
_ Short-term Loans - Short-term loans may be given as personal loans, loans to
finance
working capital or as priority sector advances. These loans are secured loans,
i.e. they are
loans made against some security. The whole amount of the term loan
sanctioned is paid
in lump sum by crediting it to the loan account of the borrower. Thus, the entire
loan
amount becomes chargeable to interest. The repayment is made as scheduled.
either in
one instalment at the end of the loan period, or in a number of instalments over
the period
of the loan.
In addition, commercial banks extend the following facilities when they are
demanded by
their customers.
3. Overdrafts
An overdraft is an advance given by allowing a customer to overdraw his current
account
upto an agreed limit. The security for overdrafts is usually financial assets of the
account holder
such as shares, debntures, life insurance policies etc. Overdraft is a termporary
facility and the
rate of interest charged on the amount of credit used is lower than that on cash
credit because
the risk involved and service cost of such credit is less - it is easier to liquify
financial assets than
physical assets.
38
4. Discounting Bills of Exchange
A bill of exchange is a document acknowledging an amount of money owed in
consideration
for goods received. For example, if A buys goods from B, he may not pay B
immediately. He may
give B a bill of exchange, stating the amount of money owed and the time when
the debt has to
be settled, If B wants money immediately, he will present the bill of exchange to
the bank for
discounting. The bank will deduct a commission and pay the present value of the
bill to B. Upon
maturity of the bill; the bank will secure payment from A.
5. Investment of funds
The banks invest their surplus funds in three types of securities - Government
securities,
other approved securities, and other securities.
Government securities are securities of both the central an state governments
such as
treasury bills, national savings certificates etc.
Other approved securities are securities approved under the provisions of the
Banking
Regulation Act, 1949. These include securities of state associated bodies like
electricity boards,
housing boards, debentures of Land Development Banks, units of UTI, shares of
Regional Rural
Banks etc.
Part of the banks investment in government securities and other approved
securities are
mandatory under the provisions of the Statutory Liquidity Ratio requirement of the
RBI. However,
banks hold excess investments in these securities because banks can borrow
against these
securities from RBI and others, or sell these securities in the open market to
meet their need for
cash. Banks hold them even though the return from them is lower than that on
loans and advances
because they are more liquid.
6. Agency Functions of the Bank
The bank performs certain agency functions for its customers in return for a
commission.
The agency services provided by the banks are :
(i) Transfer of fund - the bank provides facility for cheap and easy remittance of
funds from
place to place via instruments such as the demand drafts, mail transfers,
telegraphic
transfers etc.
(ii) Collection of fund - the bank undertakes to collect funds on behalf of its
customers through
instruments such as cheques, demand drafts, bills, hundies, etc.
(iii) Purchase and sale of shares and securities on behalf of customers
(iv) Collection of dividends and interest on share and debentures on behalf of
customers.
(v) Payment of bills and insurance premia as per customer’s directions.
(vi) Acting as executors and trustees of wills.
39
(vii) Provision of income tax consultancy and acceptance of income tax payments
of customers.
(viii) Acting as correspondent, agent or representative of customers as well as
securing
documentation for air and sea passage.
7. Miscellaneous Functions
(i) Purchase and sale of foreign exchange.
(ii) Issuance of travellers’ cheques and gift cheques.
(iii) Safe custody of valuable goods in lockers.
(iv) Underwriting activities (agreeing to partly or fully purchase the whole or the
unsold portion
respectively of new issue of securities) and private placement of securities
(selling securities
not through the open market, but privately to selected entities).
Fig. 7.1 : Schematic Classification of Commercial Banks
As is evident from the above list, banks provide a wide range of services to their
customers.
Under the present economic liberalisation, commercial banks are urged to
assume certain
roles which are usually outside the purview of typical commercial banking such
as development
banking, insurance in addition to commercial banking practices.
Figure 7.1 gives a schematic classification of commercial banks.
40
The Central Bank
The central bank is the apex institution of a country’s monetary system. The
design and
the control of the country’s monetary policy is its main responsibility. India’s
central bank is the
Reserve Bank of India.
The Central Bank performs the following functions :
1. Currency Authority
The Central Bank is the sole authority for the issue of currency in the country. All
the
currency issued by the Central Bank is its monetary liability. This means that the
Central Bank is
obliged to back the currency with assets of equal value. These assets usually
consist of gold
coin, gold bullion, foreign securities, and the domestic government’s local
currency securities.
The country’s Central Government is usually authorized to borow money from the
Central
Bank. Government does this, by selling local currency securities to the Central
Bank. The effect
of this is to increase the supply of money in the economy. When the Central Bank
acquires these
securities, it issues currency. This authority of the government gives it flexibility to
monetize its
debt. Monetizing the government’s debt (called public debt) is the process of
converting its debt
(whether existing or new), which is a non-monetary liability, into Central BanK
currency, which is
a monetary liability.
Putting and withdrawing currency into and from circulation is also the job of its
banking
department. For example, when the government incurs a deficit in its budget, it
borrows from the
Central Bank. This is done by selling treasury bills to the Central Bank, the latter
paying for the
bills by drawing down its stock of currency or printing currency against equal
transfer of the said
securities. The government spends the new currency and puts it into circulation.
2. Banker to the Government
The Central Bank acts as a banker to the government - both Central as well as
State
governments. It carries out all the banking business of the government, and the
government
keeps its cash balances on current account with the Central Bank.
As the banker to the government, the Central Bank accepts receipts and makes
payments
for the government, and carries out exchange, remittance and other banking
operations. The
Central Bank also provides short-term credit to the government, so that the
government can
meet any shortfalls in receipts over disbursements. The government borrows
money by selling
treasury bills to the Central Bank. The government carries on short term
borrowing by selling adhoc
treatury bills to the Central Bank.
As the government’s banker, the Central Bank also has the responsibility of
managing the
public debt. This means that the Central Bank has to manage all new issues of
government
loans.
The Central Bank also advises the government on banking and financial matters.
41
3. Bankers’ Bank and Supervisor
As the banker to banks, the Central Bank holds a part of the cash reserves of
banks, lends
them short-term funds and provides them with centralised clearing and
remittance facilities. The
banks are required to deposit a stipulated ratio of their net total liabilities (the
CRR) with the
Central Bank. The purpose of this stipulaton is to use these reserves as an
instrument of monetary
and credit control. In addition to this the bank holds excess reserves with the
Central Bank to
meet any clearing drains due to settlement with other banks or net withdrawals by
their account
holders. The pool of funds with the Central Bank serves as a source from which it
can make
advances to banks temporarily in need of funds, acting in its capacity as lender of
last resort.
The Central Bank supervises, regulates and controls the commercial banks. The
regulation
of banks may be related to their licensing, branch expansion, liquidity of assets,
management,
amalgamation(merging of banks) and liquidation (the winding up of banks). The
control is exercised
by periodic inspection of banks and the returns filled by them.
4. Controller of Money Supply and Credit
The Central Bank controls the money supply and credit in the best interests of
the economy.
The bank does this by taking recourse to various instruments. Generally they are
categorised as
quantitative and qualitative instruments. Let us first detail with the instruments of
quantitative
control. i.e. those that affect only the quantity of the particular variable :
1. Bank Rate Policy : The bank rate is the rate at which the central bank lends
funds as a
‘lender of last resort’ to banks, against approved securities or eligible bills of
exchange.
The effect of a change in the bank rate is to change the cost of securing funds
from the
central bank. An increase in the bank rate increases the costs of borrowing from
the
central bank. This will reduce the ability of banks to create credit. A rise in the
bank rate will
then cause the banks to increase the rates at which they lend. This will then
discourage
businessmen and others from taking loans, thus reducing the volume of credit. A
decrease
in the bank rate will have the opposite effect. In actual practice however, the
effectiveness
of bank rate policy will depend on (a) the degree of banks’ dependence on
borrower
reserves (positive relationship). (b) the sensitivity of banks’ demand for borrowed
funds to
the differential between the banks lending rate and their borrowing rate (positive
relationship), (c) the extent to which other rates of interest in the market change
and (d)
the state of supply and demand of funds from other sources.
2. Open Market Operations : OMO is the buying and selling of government
securities by the
Central Bank from / to the public and banks. It does not matter whether the
securities are
bought or sold to the public or banks because ultimately the amounts will be
deposited in
or transferred from some bank. The sale of government securities to banks will
have the
effect of reducing their reserves. When the bank gives the Central Bank a cheque
for the
securities, the Central Bank collects the amounts by reducing the bank’s reserves
by the
particular amount. This directly reduces the bank’s ability to give credit and
therefore
decrease the money supply in the economy. When the Central Bank buys
securities from
the banks it gives the banks a cheque drawn on itself in payment for the
securities. When
42
the cheque clears, the Central Bank increases the reserves of the bank by the
particular
amount. This directly increases the bank’s ability to give credit and thus increase
the
money supply. Successful conduct of OMO as a tool of monetary policy requires
first that
a well functioning securities market exists. If banks regularly and routinely resort
to keeping
excess reserves then the utility of such a policy will be doubtful.
3. Varying Reserve Requirements : Banks are obliged to maintain reserves with
the Central
Bank on two accounts. One is the Cash Reserve Ratio or CRR and the other is
the SLR or
Statutory Liquidity Ratio. Under CRR the banks are required to deposit with the
Central
Bank a percentage of their net demand and time liabilities. Varying the CRR is a
tool of
monetary and credit control. An increase in the CRR has the effect of reducing
the banks
excess reserves and thus curtails their ability to give credit.
The SLR requires the banks to maintain a specified percentage of their net total
demand
and time liabilities in the form of designated liquid assets which may be (a)
excess reserves (b)
unencumbered (are not acting as security for loans from Central Bank)
government and other
approved securities (securities whose repayment is guaranteed by the
government) and (c) current
account balances with other banks. Varying the SLR affects the freedom of
banks to sell
government securities or borrow against them from the Central Bank. This affects
their freedom
to increase the quantum of credit and therefore the money supply. Increasing the
SLR reduces
the ability of banks to give credit and vice versa.
We now deal with instruments of qualitative credit control, which deal with the
allocation of
credit between alternative uses.
1. Imposing margin requirement on secured loans : A margin is the difference
between the
amount of the loan and market value of the security offered by the borrower
against the
loan. If the margin imposed by the Central Bank is 40%, then the bank is allowed
to give a
loan only up to 60% of the value of the security. By altering the margin
requirements, the
Central Bank can alter the amount of loans made against securities by the banks.
The
advantages of this instrument are manifold. High margin requirements
discourage
speculative activities with bank credit and therefore divert resources from
unproductive
speculative activities to productive investments. By reducing speculative
activities, there
is reduction in the fluctuation of prices.
2. Moral Suasion : This is a combination of persuasion and pressure that the
Central Bank
applies on the other banks in order to get them to fall in line with its policy. This is
exercised
through discussions, letters, speeches and hints to banks. The Central Bank
frequently
announces its policy position and urges the banks to fall in line. Moral suasion
can be
used both for quantitative as well as qualitative credit control.
3. Selective Credit Controls (SCCs) : These can be applied in both a positive as
well as a
negative manner. Application in a positive manner would mean using measures
to channel
credit to particular sectors, usually the priority sectors. Application in a negative
manner
would mean using measures to restrict the flow of credit to particular sectors.
43
UNIT 9
Capital receipts and revenue receipts
Capital receipts are receipts that either create a liability (for example -
borrowings) or reduce
asset (for example disinvestment of PSU).
Revenue receipts are receipts that neither create any liability nor reduce any
asset. Tax revenue
or non tax revenue are revenue receipts as they neither create any liability nor
reduce any asset.
Capital expenditure and Revenue expenditure
Any expenditure by the government that either creates an asset (for example
construction of
school building etc) or reduces a liability (for example repayment of loan) is
categorised as capital
expenditure
Any expenditure by the government that neither creates an asset nor reduces a
liability is
catagorised as revenue expenditure, (for example interest payment, subsidies,
grants given to
states even if some of these may be for creation of assets).
Developmental and Non-developmental expenditure
Expenditure of the government on essential general services like defence,
administration etc, is
treated as non-developmental expenditure. Expenditure of the government on
agricultural,
industrial development, on economic and social infrastructure, scientific research
etc, is treated
as developmental expenditure.
Balanced Budget : It is a budget in which estimated receipts equal estimated
expenditure
Surplus Budget : It is a budget in which estimated receipts exceed estimated
expenditure,
Deficit Budget: It is a budget in which estimated receipts fall short of estimated
expenditure,
Note : Estimated receipts are net of borrowings.
Implications of fiscal deficit.
The extent of fiscal deficit is an indication of how far the government is liviing
beyond its means.
Fiscal deficit is the amount of borrowings the government has to resort to meet its
expenses. A
large fiscal deficit means large amount of borrowings. This creates a large
burden of interest
payment and repayment of loans in the future. A large fiscal deficit may also be
inflationary.
44
UNIT 10
Merits and demerits of fixed and flexible foreign exchange
rates.
Merits of fixed exchange rate:
1. It ensures stability in exchange rate. The exporters and importers have not to
operate
under uncertainty about the exchange rate. Thus it promotes foreign trade.
2. It promotes capital movements. Fixed exchange rate system attracts foreign
capital because
a stable currency does not involve any uncertainties about exchange rate that
may cause
capital loss,
3. Stable exchange rate prevents capital outflow
4. It prevents speculation in foreign exchange market
5. It forces the government to keep inflation in check. In case of fixed exchange
rate
system,inflation causes balance of payments deficit resulting in depletion of
foreign
exchange reserves.
Demerits of fixed exchange rate:
1. It contradicts the objective of having free markets
2. Under this system, countries with deficits in balance of payment run down this
stock of
gold and foreign currencies. This can create serious problem for them. They may
be
forced to devalue their currency. On the other hand countries with surplus in
balance of
payments will face the problem of inflation.
3. There may be undervaluation or overvaluation of currency. If the fixed
exchange rate is at
a level which is lower then the market level i.e. at which demand for foreign
currency far
exceeds its supply, its will result in deficit in balance of payment. If it is higher
than the
market level i.e. at which the supply exceeds demand then it may create
inflationary pressure
because of balance of payments surplus. It is difficult to fix a rate that may prove
to be
equilibrium rate
Merits of flexible exchange rate system
1. It eliminates the problem of overvaluation or undervaluation of currencies,
Deficit or surplus
in balance of payments is automatically corrected under this system.
2. It frees the government from problem of balance of payments.
3. There is no need for the government to hold any reserves.
4. It enhances the efficiency in the economy by achieving optimum resource
allocation.
45
Demerits of flexible exchange rate system
1. It creates situations of instablility and uncertainty. Wide fluctuations in
exchange rate are
possible. This hampers foreign trade and capital movements between countries.
2. It encourages speculation which may lead to larger uncertainties and
fluctuations.
3. The uncertainty caused by currency fluctuations can discourage international
trade and
investment.