Macro Economics Explained

MACRO ECONOMICS: COMPILED BY SIR KHALID AZIZ
IQRA COMMERCE NETWORK
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Macro Economics and its Importance:
Definition of Macro Economics:
Economics is traditionally divided into two main branches:
(i) Micro Economics.
(ii) Macro Economics.
Micro economics is a branch of economics that examines the functioning of individual business firms
and households. The goal of micro economics is to explain the determination of prices and quantitative
individual goods and services. Micro economics is, therefore, often called price theory. In brief, Micro
economics is the study of choices made by consumers, firms and government and how these decisions
affect the market for a particular good and services.
What is Macro Economics?
The term 'Macro' is derived from the Greek word 'Uakpo' which means large. Macro economics looks at
the economy as a whole. It examines the factors that determine national output and its growth overtime. It
studies the economic aggregates such as the overall level of prices, output and employment in the
economy.
According to R. G. D. Allen:
"The term macro economics applies to the study of relations between broad economic aggregates such
as total employment, income and production".
In the words of Edward Shapiro:
"The major task of macro economics is the explanation of what determines the economy's aggregate
output of goods and services. It deals with the functioning of the economy as a whole".
Professor K. E. Boudling is of the view that:
"Macro economics is that part of economics which studies the overall averages and aggregates of the
economic system. It does not deal with individual incomes but with the I national income, not with
individual prices but with the price level, not with individual output, but with national output".
In brief, Microeconomics looks at the individual units, household, the firm, the industry, It sees and
examines the "trees". Macro economics looks at the whole, the economic aggregates. It sees and
analyzes the 'forest'.
Importance/Issues/Scope of Macro Economics:
The importance/issues/scope, which are addressed in macro economics are in brief as under:
(i) It helps in understanding the determination of income and employment. Late J.M. Keynes laid
great stress on macro economic analysis. He, in his revolutionary book, "General Theory, Employment
interest and Money", brought drastic changes in economic thinking. He explained the forces or factors
which determine the level of aggregate employment and output in the economy.

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(ii) Determination of general level of prices. Macro economic analysis answers questions as to how the
general price level is determined and what is the importance of various factors which influence general
price level.
(iii) Economic growth. The macro economic models help us to formulate economic policies for achieving
long run economic growth with stability. The new developed growth theories explain the causes of poverty
in under developed countries and suggest remedies to overcome them.
(iv) Macro economics and business cycles. It is in terms of macro economics that causes of
fluctuations in the national income are analyzed. It has also been possible now to formulate policies for
controlling business cycles i.e., inflation and deflation.
(v) International trade. Another important subject of macro economics is to analyze the various aspects
of international trade in goods, services and balance of payment problems, the effect of exchange rate on
balance of payment etc.
(vi) Income shares from the national income. Mr. M. Kalecki and Nicholas Kelder, by making
departure from Ricardo theory, has presented a macro theory of distribution of income. According to
these economists, the relative shares of wages and profits depend upon the ratio of investment to
national income.
(vii) Unemployment. Another macro economic issue is to explain the causes of unemployment in the
economy. Stagflation is another important issue of modern economics. The Keynesian and post
Keynesian economists are putting lot of efforts in explaining the causes of cyclical unemployment and
high unemployment coupled with inflation and suggesting remedies to counteract them.
(viii) Macro economic policies. Fiscal and monetary policies affect the performance of the economy.
These two major types of macro economic policies are central in macro economic analysis of the
economy.
(9) Global economic system. In macro economic analysis, it is emphasized that a nation's economy is a
part of a global economic system. A good or weak performance of a nation's economy can affect the
performance of the world economy as a whole.
Limitations/Exceptions of Macro Economics:
The main limitations/exceptions of macro economics are as follows:
(i) The macro economies ignores the welfare of the individual. For instance, if national saving is increased
at the cost of individual welfare, it is not considered a wise policy.
(ii) The macro economics analysis regards aggregates as homogeneous but does not look into its internal
composition. For instance, if the wages of the clerks fail and the wages of the teachers rise, the average
wage may remain the same.
(iii) It is not necessary that all aggregate variable are important. For instance, national income is the total
of individual incomes. If national income in the country goes up, it is not necessary that the income of all
the individuals in the country will also rise. There is a possibility that the rise in national income may be
due to the increase in the incomes of a few rich families of the country.
(iv) The macro economic models are designed mostly to suit the developed countries of the world. The
developing countries face different economic realities, so they do not benefit much from them.

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Interdependence of Micro and Macro Economics:
The micro and macro economics are interdependent. We cannot draw any precise line of separation
between micro and macro economics. We cannot put them in water light compartments. Both these
approaches help us in analyzing the working of the economy. If we study one approach and neglect the
other, we are considered to be only half educated. We should integrate the two approaches for the
successful analysis of the working of economic system. The macro approach should be applied when
aggregate entities are involved and micro approach when individual parts of the economy are examined.
If we ignore one and lay emphasis on the other, it I may lead to wrong or inadequate conclusions. In the
words of Gardner Ackley:
"Actually, the line between macro economics and micro economics theory cannot be precisely drawn. A
true general theory of the economy would clearly embrace both. It would explain individual behavior,
individual I outputs, incomes and prices and the sums or averages of individual results I would constitute
the aggregates which macro economics is concerned".
Concepts of National Income:
There are various concepts of national income. These are explained below one by one:
(1) Gross National Product (GNP).
(2) Net National Product (NNP)/National Income.
(3) Gross Domestic Product (GDP).
(4) National Income at Factor Cost.
(5) Personal Income.
(6) Disposable Personal Income.
(1) Gross National Product (GNP):
Gross National Product at Market Price:
Definition and Explanation of GNP:
The concept of gross national product (GNP) is comprehensive. It enables us to measure and analyze
as to how much is the aggregate economic production of a country in a given period. The gross national
product of a country (GNP) is defined as:
"The total money value of all final goods and services produced by the residents of a country in one year
period".
In the words of W.C. Peterson:
"Gross national Product may be defined as the current market value of all final goods and services
produced by the economy during an income period regardless of where the output is produced".
we should remember the following aspects about GNP.

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(i) GNP is a flow concept: GNP represents a flow. It is a quantity produced per unit of time. It is the
value of final goods and services I produced in a country during a given time period.
(ii) GNP measures final output: While calculating GNP, the market value of only final goods and
services produced in a year are added up. Final goods are those goods which are purchased for final use
in I the market.
(iii) GNP is output produced by the citizens of a country: Gross national product is the final output of
goods and services produced by the citizens and businesses of a country during a given time period
which is usually a year. For example, the economic activity carried out by the USA citizens and
businesses outside the country is counted in GNP. While the income of the residents who are not USA
citizens is subtracted from GNP.
Components of Expenditures in GNP:
For measuring GNP at market price, the economists use Expenditure Approach. According to this
approach:
There are four categories of expenditures which are added together to measure gross national product
(GNP) at market price, (i) Consumption, (ii) Investment (iii) Government expenditure and (iv) Net exports.
These four types of expenditures are now explained in brief:
(i) Consumption Expenditure (C): It includes all personal expenditure incurred by the citizens of a
country on durable and non-durable goods in a period of one year.
(ii) Investment (I): It is the total expenditure incurred by firms or households on capital goods.
(iii) Govt. expenditures (G): It includes all types of expenditure incurred by Federal, Provincial, Local
Councils on the purchases of goods and services such as national defense, law and order, street lighting
etc.
(iv) Net Exports (X - M): Net exports of goods and services are value of exports minus the value of
imports.
Formula For Gross Profit:
GNP = C + I + G + (X - M)
Where:
C = consumption, I = investment, G = Govt. expenditure and X - M = Net exports
(2) Net National Product (NNP)/National Income:
Definition and Explanation of NNP:
"Net national Product or national income at market prices is the net market money value of all the final
goods and services produced in a country during a year. It is found out by subtracting the amount of
depreciation of the existing capital in a year from the market value of all final goods and services".
For a continuous flow of money payments, it is necessary that a certain amount of money should be set
aside from the gross national income for meeting the necessary expenditure of wear and tear of all capital
equipment so that there should not be any deterioration in the capital and it should remain intact. If we

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deduct depreciation allowance from gross national product, we get Net National Product at current market
price.
Formula For Net National Product/National Income:
NNP at Market Price = GNP at Market Price - Depreciation
Depreciation Allowance and Maintaining Capital Intact. Here a question can be asked as to what we
actually mean by depreciation allowance and maintaining capital intact; (the words which we have used in
explaining NNP).
It is known to every one of us that when production is going on, the value of capital equipments does not
remain the same. A decrease in value because of wear and tear through, use, rusting, accident or
through actions of elements, gradually take place in the building and other equipments of business. A
certain sum of money based on the value of the capital equipment and its longevity is set aside every
year from the gross annual income so that when machinery is worn out, a new capital equipment can be
set up from the sum thus accumulated. This fund which is set aside for covering the wear and tear,
deterioration and obsolescence of the machinery is named as Depreciation Allowance. We can make
this concept more clear by taking a simple example.
Example of NNP:
Suppose, a person buys a machinery for manufacturing cloth for $10000 only. He expects that this
machinery will last ten years and after that period, it will be partially or completely worn out. He sets aside
$1000 every year from the gross national income as a depreciation reserve of the capital equipment.
After the expiry of ten years, he accumulates $10000 and with that money he replaces the old capital
equipment which has lived its useful life and maintains capital intact. The sum of money, i.e., $1000 which
he annually deducts from the gross annual income, is known as depreciation allowance.
It is often pointed out by economists that the calculation of depreciation allowance every year is a difficult
task.
For example, a person expects the longevity of the capital equipment, say for ten years. There is a
possibility that machinery may last longer or it may go out of use earlier. So they say what needed is an
approximate decision regarding the' depreciation allowance. This decision should be based on high
degree of judgment and guessing about the future.
Maintaining Capital Intact. By maintaining capital intact we do not mean that capital equipments should
remain the same. It should neither increase nor decrease. This can only by possible in a static society. In
a progressive society, the total capital equipment of a country must increase every year, otherwise the
national income will be affected adversely.
In Economics, by the phrase 'maintaining capital intact' is meant to make good the physical
deterioration which has taken place in the capital equipment while creating income during a given period.
This can only be made by setting aside a certain amount of money every year from the annual gross
income so that when the income creating equipment becomes obsolete, a new capital equipment may be
created out. If the depreciation allowance is not set aside every year, the flow of income would not remain
intact. It will decline gradually and the whole country will become poor.
NNP = GNP - Depreciation

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(3) Gross Domestic Product (GDP):
Definition and Explanation of GDP:
It is a key concept in the national income. "Gross domestic product (GDP) is the total market value at
current prices of all final goods and services produced within a year by the factors of production located
within a country".
The labor and capital of a country working on its natural resources produce a certain aggregate of
commodities, material and non-material every year. In addition to this, there may be foreign firms
producing goods in the various sectors of the economy like mining, electricity, manufacturing etc.
If we add up the money value of all the final goods produced both by domestic and foreign owned factors
annually in the country and valued at market prices, it wilt be called gross domestic product (GDP). Gross
Domestic Product thus is the value of aggregate or total production of goods and services in a country in
one year. This constitutes the Gross National Product, of a country. If we make a detailed list of all such
commodities produced annually or measure the total goods produced during a year by weight or by
volume, it will not give us any clear and concise impression about our total national output. So what
generally done is that the money value of all final goods and service produced during a year at current
market prices is added up. This total current market value of all final goods and services produced in an
economy in one year period is called gross domestic product (GDP). In the words of Campbell:
"Gross Domestic Product is defined as the total value of all final goods and services produced in a
country in one year".
According to Shapiro:
"GDP is defined as a flow variable, measuring the quantity of final good and services produced" during a
year".
Problems in Measuring GDP:
The main problems or pitfalls which are to be avoided in the measurement of GDP are as under:
(i) Stress on final output. While calculating the gross domestic product (GDP), the value of only those
goods are added which have reached their final stage of production and are available for consumption.
The primary or intermediate goods are not counted in GDP. For example, table made of wood is the final
product. The wood used in making the table is a primary good. While calculating GDP, if we include the
value of wood as a separate item and the value of table separate, it will be a case of double counting and
this leads to inflated rise in GDP.
(ii) Value added method. Another way to avoid pitfall of double or multiple counting is to calculate only
the added value of a particular commodity at its every stage of production. The result in both the cases
will be the same.
Suppose, the price of book which you are reading is $10. This includes the cost of paper, printing and
binding charges, etc., While estimating the gross domestic product, there are two ways open to you.
Either you include the final price of the book at one time in gross domestic product or you add up the
added value at every stage in the process of the production of the book. But you are not to count the
value of a thing more than once.
From the following example, the reader can easily understand as to how the danger of double or multiple
counting can be avoided.

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Stage of Production Form of the Product
Price at Each Stage
($)
Value Added at Each
Process ($)
1st Jungle Wood 0.25 0.25
2nd
The price of wood after
transporting to the city
0.38 0.13
3rd Paper manufacturing 2.00 1.62
4th Printing of book 5.00 3.00
5th Binding and title, etc. 6.00 1.00
6th Sale price 10.00 4.00
$23.63 $10.00
From the above example, it is clear that if we add up the value of the product at every stage of
production, the total value of the book comes to $23.63, while in fact it is priced al $10 only.
So we come to the conclusion that while adding the value of the book to the gross national product, we
should either include the final price of the book which is $10 or we should add up the added value at each
stage in the process of production. But we are not to count the value of a particular commodity more than
once. If we do so, the gross product will be overestimated. The computation of GDP by this method is not
popular.
(iii) Non-Productive transactions are excluded from GDP. In order to measure the economic well
being of a society in a year, the non-productive transactions are excluded from the Gross Domestic
Product. There are two major types of non-productive transactions, namely: (a) Purely financial
transactions and (b) Second hand sales. Under purely financial transaction (i) all public transfer payments
which do not add to the current flow of goods such as social security payments, relief payments and (ii) all
private financial transactions such as receipt of money by a student from his father which make no
contribution in current production are all excluded from GDP. Similarly, the second hand sales are
excluded from GDP as they do not contribute to current production in a year.
(iv) Other transactions. There are a few other transactions which are not included in GDP. For example,
persons working in their own houses without any payment through the market. For example, a house wife
takes care of house and children. Since she is not paid, therefore, the value added by her is not included
in GDP.
Exclusion of output production abroad. GDP is the value of output produced by factors of production
located within a country. It excludes the output produced abroad by domestically owned factors of
production.
Distinction Between GDP and GNP:
Here it seems necessary to make a distinction between gross domestic product (GDP) and gross national
product (GNP). Gross domestic product is the total market value of all final goods and services produced
by factors of production within a nation's border during a period of one years. In other words GDP is a flow
of production produced within the country by domestically located resources in a year.

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Gross national product (GNP) on the other hand, is the measure of all final goods and services produced
by the citizens within their own country as well as outside the country during a period of one year. In other
words, GNP expresses the money value of flow of goods and services produced within the country and
the net income received from abroad during a period of one year. Thus when we move from GDP to
GNP, we add factor income receipts from foreigners and subtract factor income payments to foreigners.
Formula For GDP:
GDP = GNP - Net Foreign Income From Abroad
(4) National Income at Factor Cost:
Definition and Explanation:
National income can be estimated in terms of either output or total income. When national income is
measured by adding together all income payments made to the factors of production in a year, it is called
national income at factor cost. National income thus is the sum total of all income payments made to the
factors of production. In the words of J. Sloman:
"National income (Nl) or national income at factor cost is the aggregate earning of the four factors of
production (land, labor, capital and organization) which arise from the current production of goods and
services by the nations' economy".
Components of National Income at Factor Cost:
The main components of national income at factor cost are as follows:
The factor incomes are generally divided into four categories:
(i) Compensation to employees (ii) Interest (iii) rents and (iv) profits.
(i) Compensation to employees: It is the largest component of national income. It consists of wages and
salaries paid by the firms to the workers for their labor services.
(ii) Interest: Interest is the payment for the use of funds in a year. The payment is made by private
businesses to households who have lent money to them.
(iii) Rent: Rent is all income earned by individuals for the use of their real assets such as building, farms
etc.
(iv) Profit: Profit is the amount which is left after compensation to employees, rent, interest have been
paid out. The sum of compensation to .employees, interest, rent and profit is supposed to equal national
income at factor cost.
(5) Personal Income:
National income is the sum of factor income. In other words, it is the income which individuals receive for
doing productive work in the form of wages, rent, interest and profits. Personal income, on the other hand,
includes all income which is actually received by all individuals in a year. It includes income which is not
directly earned but is received by individuals.

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For example, social security payments, welfare payments are received by households but these are not
elements of national income because they are transfer payments.
In the same way, in national income accounting, individuals are attributed income which they do not
actually receive. For example, undistributed profits, employees contribution for social security corporate
income taxes etc. are elements of national income but are not received by individuals. Hence they are to
be deducted from national income to estimate the personal income.
Formula For Personal Income:
PI = Nl + Transfer Payments - Corporate retained earnings, income taxes, social security taxes
(6) Disposable Personal Income:
Disposable personal income is the amount which is actually at the disposal of households to spend as
they like. It is the amount which is left with the households after paying personal taxes such as income
tax, property tax, national insurance contributions etc.
Formula For Disposable Personal Income:
Disposable personal income = Personal Income - Personal Taxes
DPI = PI - Personal Taxes
The concept of disposable personal income is very important for studying the consumption and saving
behavior of the individuals. It is the amount which households can spend and save.
Disposable Income = Consumption + Saving
DI = C + S
Methods of Computing/Measuring National Income:
There are three methods of measuring national income of a country. They yield the
same result. These methods are:
(1) The Product Method.
(2) The Income Method.
(3) The Expenditure Method.
We now look at each of the three methods in turn.
(1) Product Method or Value Added Method:

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Goods and services are counted in gross domestic product (GDP) at their market values. The
product approach defines a nation's gross product as that market value of goods and services
currently produced within a nation during a one year period of time.
The product approach measuring national income involves adding up the value of all the final
goods and services produced in the country during the year. Here we focus on various sectors
of the economy and add up all their production during the year. The main sectors whose
production value is added up are:
(i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v) banking
(vi) administration and defense and (vii) distribution of income.
Precautions For Product Method or Value Added Method:
There are certain precautions which are to be taken to avoid miscalculation of national income
using this method. These in brief are:
(i) Problem of double counting: When we add up the value of output of various sectors, we
should be careful to avoid double counting. This pitfall can be avoided by either counting (he
final value of the output or by including the extra value that each firm adds to an item.
(ii) Value addition in particular year: While calculating national income, the values of goods
added in the particular year in question are added up. The values which had previously been
added to the stocks of raw material and goods have to be ignored. GDP thus includes only
those goods, and services that are newly produced within the current period.
(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is
necessary as there is no real increase in output.
{iv) Production for self consumption: The production of goods for self consumption should be
counted while measuring national income. In this method, the production of goods for self
consumption should be valued at the prevailing market prices.
(2) Expenditure Method:
The expenditure approach measures national income as total spending on final goods and
services produced within nation during an year. The expenditure approach to measuring
national income is to add up all expenditures made for final goods and services at current
market prices by households, firms and government during a year. Total aggregate final
expenditure on final output thus is the sum of four broad categories of expenditures:
(i) consumption (ii) investment (iii) government and (iv) Net export.
(i) Consumption expenditure (C): Consumption expenditure is the largest component of
national income. It includes expenditure on all goods and services produced and sold to the final
consumer during the year.

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(ii) Investment expenditure (I): Investment is the use of today's resources to expand
tomorrow's production or consumption. Investment expenditure is expenditure incurred
on by business firms on (a) new plants, (b) adding to the stock of inventories and (c) on
newly constructed houses.
(iii) Government expenditure (G): It is the second largest component of national
income. It includes all government expenditure on currently produced goods and
services but excludes transfer payments while computing national income.
(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.
National income calculated from the expenditure side is the sum of final consumption
expenditure, expenditure by business on plants, government spending and net exports.
NI = C + I +G + (X - M) Precautions
Precautions For Expenditure Method:
While estimating national income through expenditure method, the following precautions
should be taken:
(i) The expenditure on second hand goods should not be included as they do not
contribute to the current year's production of goods.
(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these
also do not represent expenditure on currently produced goods and services.
(iii) Expenditure on transfer payments by government such as unemployment benefit,
old age pensions, interest on public debt should also not be included because no
productive service is rendered in exchange by recipients of these payments.
(3) Income Approach:
Income approach is another alternative way of computing national income, This
method seeks to measure national income at the phase of distribution. In the production
process of an economy, the factors of production are engaged by the enterprises. They
are paid money incomes for their participation in the production. The payments received
by the factors and paid by the enterprises are wages, rent, interest and profit. National
income thus may be defined as the sum of wages, rent, interest and profit received or
occurred to the factors of production in lieu of their services in the production of goods.
Briefly, national income is the sum of all income, wages, rents, interest and profit paid to
the four factors of production. The four categories of payments are briefly described
below:
(i) Wages: It is the largest component of national income. It consists of wages and
salaries along with fringe benefits and unemployment insurance.

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(ii) Rents: Rents are the income from properly received by households.
(iii) Interest: Interest is the income private businesses pay to households who have lent
the business money.
(iv) Profits: Profits are normally divided into two categories (a) profits of incorporated
businesses and (b) profits of unincorporated businesses (sold proprietorship,
partnerships and producers cooperatives).
Precautions For Income Approach:
While estimating national income through income method, the following precautions
should be undertaken.
(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not
be included in the estimation of national income.
(ii) Illegal money earned through smuggling and gambling should not be included.
{iii) Windfall gains such as prizes won, lotteries etc. is not be included in the estimation
of national income.
(iv) Receipts from the sale of financial assets such as shares, bonds should not be
included in measuring national income as they are not related to generation of income
in the current year production of goods.
Why Three Methods of Computing/Measuring National Income are Equal:
The three approaches used for measuring national income give the same result. The
reason is the market value of goods and services produced in a given period by
definition is equal to the amount that buyers must spend to purchase them. So the
product approach which measures market value of good and services produced and the
expenditure approach which measures spending should give the same measure of
economic activity.
Now as regards the income approach, the sellers receipts must equal what the buyers
spend. The sellers receipts in turn equal the total income generated by the economic
activity. Thus, total expenditure must equal total income generated implying that the
expenditure and income approach must also produce the same result.
Difficulties/Problems in the Measurement of National
Income:

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According to Kuznets, the measurement of national income is a complicated problem and is best with the
following difficulties:
(i) Non-availability of statistical material: Some persons like electricians, plumbers, etc., do some job
in their spare time and receive income. The state finds it very difficult to know the exact amount received
from such services. This income which, should have been added to the national income is not recorded
due to {be lack of full information of statistics material.
(ii) The danger of double counting: While computing the national income, there is always the danger of
double or multiple counting. If care is not taken in estimating the income, the cost of the commodity is
likely to be counted twice or thrice and national income will be overestimated.
(iii) Non-marketed services: In estimating the national income, only those services are included for
which the payment is made. The unpaid services, or non-marketed services are excluded from the
national income.
(iv) Difficulty in assessing the depreciation allowance: The deduction of depreciation allowances,
accidental damages, repair, and replacement charges from the national income is not an easy task. It'
requires high degree of judgment to assess the depreciation allowance and other charges.
(v) Housing: A person lives in a rented house. He pays $5000 per month to the landlord. The income of
the landlord is recorded in the national income. Let us suppose that the tenant purchases the same house
from the landlord. Now the income of the owner occupant has increased by $5000. Is it not justifiable to
include this income in the national income? Should or should not this income be recorded in the national
income is still a controversial question.
(vi) Transfer earnings: While measuring the national income, it should be seen that transfer payments
should not become a part of national income. The payments made as relief allowance, pensions, etc. do
not contribute towards current production. So they should be excluded from national income.
(vii) Self-consumed production: In developing countries, a significant part of the output is not
exchanged for money in the market. It is either consumed directly by producers or bartered for other
goods This unorganized and non-monetized sector makes calculation of national income difficult.
(viii) Price level changes: National income is measured in money terms. The measuring rod of-money
itself does not remain stable. This means that national income can change without any change in output.
Problems of Measurement is Under Developed Countries:
The national income in under-developed countries like Pakistan, Afghanistan, etc., cannot be accurately
measured due to the following reasons:
(i) Self-consumed-bartered consumption: Some of the transactions of agricultural goods in the villages
are done without the use of money. The statisticians, therefore, cannot measure the exact amount of the
transactions for inclusion in the national income.
(ii) No systematic accounts maintained: Most of the producers do not keep any record of the sale of
the products in the market. This makes the task of national income still more complicated.
(iii) No occupational classification: There is no occupational specialization in the under-developed
countries. People receive income by working in various capacities. One person sometimes works as
carpenter and at another time as mason. The statisticians cannot accurately measure the income of such
persons.

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(iv) Unreliable data: The statisticians themselves do not feel the importance of figures which they collect
They also do not take much pains for getting the reliable data. The figures of national Income are,
therefore, not up-to-date in the under-developed countries.
Psychological Law of Consumption By J.M Keynes:
J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior of the community on the
basis of human psychology. He propounded a law which is known as Psychological Law of
Consumption.
Statement:
According to this law:
"The household sector spends a major part of its income on the purchase of consumer goods and
services such as food, clothing, medicines, shelter etc., for personal satisfaction. The expenditure on
consumption (C) is the largest component of aggregate expenditure. Whatever is not consumed out of
disposable income is by definition called saving (S)".
Formula:
Disposable Income = Consumption + Saving
I = C + S
Explanation:
According to Keynes, the level of consumption in a community depends upon the level of disposable
income. As income increases, consumption also increases but it increases not as fast as income i.e., it
increases at a diminishing rate. This relationship between consumption and disposable income is
calledconsumption function.
In the words of Keynes:
“Men are disposable as a rule and on the average to increases their consumption as their income
increases, but hot by as much as the increases in their income.”
Properties of Consumption Behavior of Community:
The psychological law of consumption brings out the following properties of the consumption behavior of
the community:
(i) The level of consumption is directly functionally related to the level of disposable income = C = f(y)
(ii) With the rise in the level of income, the consumption level also rises, but at a decreasing rate = ΔC <
Δy

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(iii) As the level of income increases, the households devote a part of the increase saving. Symbolically:
ΔY = ΔC + ΔS
The Keynesian consumption function is now explained with the help of schedule and a curve.
Schedule:
($ in billion)
Disposable Income
(Y)
Consumption (C) Saving (S) APC (C/Y) MPC (ΔC/ΔY)
0 50 -50
100 100 0 1.00 0.5
200 150 50 0.75 0.5
300 200 100 0.67 0.5
In the schedule, it is shown that as the nation’s disposable income increases, the aggregate consumption
at various levels of income also increases but at a decreasing rate.
The same data is now shown in graph 30.1 below:
Diagram/Graph:
Following are the observations about the functional relationship between the national disposable income
and the economy’s aggregate expenditure.
(i) At every point on the 450 line OY, a vertical line drawn to the income axis is at the same distance from
the origin as a horizontal line drawn to the consumption axis. The 450 line thus is the line along which
expenditure equals real income.

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(ii) The consumption function is represented by consumption line (C). The consumption line C is positively
sloped indicating that as the disposable income increases, the expenditure in the economy also
increases.
(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50 billion during a short
period.
(iv) At point B the consumption line (C) intersects the 450 helping line (OY) saving. At point B,
consumption equals disposable income and there is zero saving. B is called the break even point.
(v) Left to the point B, the consumption line C is above the income line Y. It indicates negative saving.
(vi) Right to the point B, the consumption line C is below the income line Y. It denotes positive savings.
Summing up, the relationship between consumption and disposable income is referred to as
consumption function. A consumption function tells how much households plan to consume at various
levels of disposable income.
Propensity to Consume:
Meaning and Definition of Propensity to Consume:
The classical economists were of the view that the supply of saving was determined by the rate of
interest prevailing in the country. According to them, the higher the rate of interest, the larger is the saving
and so less is the consumption.
Keynes disagreed with the above view. According to him interest is not the primary determinant of an
individual’s saving and consumption decisions. It is primarily the individual’s real income which
determines his, saving and consumption decisions. J.M. Keynes has developed two concepts:
(i) Average Propensity to Consume.
(ii) Marginal Propensity to Consume to Analyze the Consumption Function.
Explanation:
These two concepts are now explained in brief:
(1) Average Propensity to Consume (APC):
Average propensity to consume ( APC) may be defined as:
Definition:

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"A ratio of total consumption to total disposable income for different levels of disposable income It is
calculated by dividing the amount of consumption by disposable income for any given level of income".
Example:
For instance, when nation’s disposable income is $2,000 billion, consumption expenditure is $1,500
billion, the average propensity to consumption is 1500/2000 = 0.75.
This shows that out of the disposable income of $2,000 billion, 75% will be used for consumption
purposes. The APC declines as income increases because the proportion of income spent on
consumption decreases. The average propensity to consume spent on consumption decreases. The
average propensity to consume at any level of income is expressed in equation as C/Y. Here C stands
for consumption Y for income.
Formula:
APC = C
Y
Diagram:
In the Fig.(30.2) income is plotted on OX axis and consumption along OY. CC curve represents the
propensity to consume schedule. At point K, the average propensity to consume is equal to 0.62.
KL/OL = (C/Y) i.e., 2500/4000 or 25/40 = 0.62
APC implies a point on the curve C which indicates the ratio of income consumed. The C curve is made
up of a series such points.
(2) Marginal Propensity to Consume (MPC):

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Definition:
The concept of marginal propensity to consume is very important is macro economics. J.M.
Keyneshas defined marginal propensity to consume (MPC):
"As the relationship between a change in consumption (ΔC) that resulted from a change in disposable
income (ΔY)".
Formula:
It is found out by dividing change in consumption to a given change in disposable Income.
MPC = Change in Consumption = ΔC
Change in Income ΔY
Example:
Thus we make this concept clear by taking an example, let us suppose the disposable income rises from
$2000 billion to $3000 billion ( by $1000 billion) and the consumption expenditure increases from $1500
billion to $2000 billion (by $500 billion). The marginal propensity to consume is:
ΔC/ΔY = 500/1000 = 1/2 = 0.5
All the concepts of consumption function are now explained whit help of schedule and a diagram.
Schedule For Propensity to Consume:
($ in billion)
Disposal Income (Y) Consumption
Expenditure (C)
Average Propensity to
Consume (APC = C/Y)
Marginal Propensity to
Consume (MPC =
ΔC/ΔY)
A 1000 1100 1.1 800/1000 = 0.9
B 2000 2000 1.0 600/1000 = 0.6
C 3000 2600 0.86 500/1000 = 0.5
D 4000 3100 0.77 300/1000 = 0.3
E 5000 3400 0.68 200/1000 = 0.2
F 6000 3600 0.6 100/1000 = 0.1
G 7000 3700 0.53
The reader can easily understand from the above schedule that with the increase in the disposable
income, the propensity to consume decreases and conversely with a fall in income, the propensity to

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consume and the marginal propensity to consume increases. The consumption schedule can also be
explained with the help of a curve which is given below:
Diagram For Propensity to Consume:
In the figure (30.3), disposable income is measured along the horizontal axis OX and consumption along
the vertical axis OY. Let us now draw 450 helping line from O to ON. If we take any point on the
450helping line, income will be exactly equal to expenditure. The curve AG represents the income
consumption schedule, indicating the propensity to consumer at various levels of income. Point A which is
above 450 helping line, shows us that the expenditure is greater than its income.
This deficit in income can be converted either by borrowing or from the sale of assets. At point B,
consumption expenditures exactly equal to disposable income and there is neither saving nor dis-saving.
This point is known is as break even point.
From B onward up to G, the curve lies below the 450 helping line. This shows that the consumption
expenditure is less than the disposable income. Net saving is measured by the distance from the
propensity to consume curve up to 450 helping line.
For example, when the income is $5,000 billion, the expenditure is $3400 billion and saving $1,600 billion.
Marginal propensity to consume curve can also be illustrated from the very same figure. At point B,
income is $2,000 billion and is equal to expenditure, i.e., $2,000. When income increases from $2,000
billion to $3,000 billion, consumption increases only by $600 billion.
Now we move from point B towards right up by $1,000 billion. BM line shows as the increases in income.
Then we go vertically until we reach point K. MK line indicates addition made to the total consumption. It
is equal to $600 billion. So the marginal propensity to consume will be equal to $600/$1000 = $6.
Determinants/Factors of the Consumption Function:

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There are a number of determinants/factors both subjective and objective which determine the position
of consumption function. The factors or causes of shifts in consumption function are as fallows:
(1) Subjective Factors:
(i) Psychological Characteristics of Human Nature: The subjective factors affecting propensity to
consume are internal to the economic system. The subjective factors include characteristics of human
nature, social practices which lead households to refrain or activate to appending out of their income.
For example, religious belief of the people towards spending, their foresight attitude towards life, level of
education, etc. etc., directly affect propensity to consume or determine the slope and position of the
consumptions curve. The subjective factors do not undergo a material change over a short period of time.
These remain constant in the short run.
(2) Objective Factors:
The objective factors are external to economic system. The undergo rapid changes and bring market in
the consumption function. The main objective factors are as under:
(i) Real Income: Real income is the basic factor which determines community’s propensity to consume.
When real income of the community increases, consumption expenditure also increases but by a smaller
amount. The consumption function shifts upward.
(ii) Distribution of wealth: If there is unequal distribution of wealth in a country, the consumption function
will also be unequal. People with low income group have high propensity to consume and rich people low
propensity to consume. An equal distribution of wealth raises the propensity to consume.
(iii) Expectation Change in Price: If people expect prices are going to rise in near future, they hasten to
spend large sum out of a given income just after the promulgation of first Martial Law in our country. So
we can say that when prices are expected to be high in future, the propensity to consume increases or
the consumption function shifts upward. When they are expected to be low, the propensity to consume
decreases or the consumption function shifts downward.
(iv) Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to
consume. If the nature of taxes is such that they directly affect the poor people and reduce their income,
then the propensity to consume is high and if rich persons are not taxed at a progressive rate and they
accumulate more wealth, then the propensity to consume is low.
(v) Change in the Rate of Interest: A change in the rate of interest exercises influence on the propensity
to consume. When the interest rate is raised, it generally induces people to decrease expenditure and
save more for lending purposes. On the other hand, when the interest rate is reduced, it usually
encourages expenditure as lending then becomes less attractive. So we conclude that an increase in the
rate of interest generally reduces propensity to consume or shifts the consumption function downward
and a fall in the rate of interest usually helps to the increase of propensity to consume or shifts the
consumption function upward.
(vi) Availability of Goods: Propensity to consume is also affected by the availability of consumption
goods. If the goods are available in abundance, then the propensity to consume increases. If they are
scarce and are priced very high, then the propensity to consume will decline.

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(vii) Credit Facilities: cheap credit facilities are available in the country, the consumption function will
move upward.
(viii) Higher Living Standard: If the real income of the people increases in the country and people adopt
the use of new produce like television, washing machines, refrigerators, care, etc., etc., the consumption
function is high.
(ix) Stock of Liquid Assets: If the consumer have greater amounts of liquid assets; there will be more
desire for the households to spend out of disposable income. The consumption function shifts upward
and vice versa.
(x) Consumer Indebtedness: In case the consumer are heavily indebted and they pay bigger monthly
installments to replay the dept, then propensity to consume is low or the consumption function shifts
downward and vice versa.
(xi) Windfall Gains: If there are unexpected gains due to stock market boom in the economy, it tends to
shift the consumption function upward. They are windfall gains. The unexpected losses in the stock
market lead to the downward shifting of the consumption curve.
(xii) Demographic Factors: The consumption function is also influenced by demographic factors like
size of family, occupations, place of residence etc. Persons living in cities, for instance, spend more than
those living in rural areas.
(xiii) Attitude Towards Saving: If a community is consumption oriented, there will be less saving in the
country. The consumption function shifts upward. In case, people save more and spend less, then the
consumption function will shift downward.
(ix) Demonstration Effect: If people are easily influenced by advertisements on radio and television and
seeing pattern of living of the rich neighbors, the level of total consumption will go up.
Concept of Propensity to Save/Saving Function:
Definition:
The propensity to save schedule which for the sake of brevity is called the propensity to save or saving
function shows relation between saving and disposable income at varying levels of income S = F(Y).
The propensity to save schedule comes from subtracting consumption from income at each level of
income. Since saving represents the difference between the 45o guideline and the consumption function,
it may be positive or negative. The propensity to save schedule can easily be derived from the propensity
to consume schedule, in our example given earlier, (Click here to read full example), the propensity to
consume, is as follows:
Income ($ in
billion)
50 100 140 200 300
Expenditure ($
in billion)
50 70 100 140 200

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The propensity to save schedule can easily be derived by subtracting the amount of consumption from
the corresponding amount of income. The saving schedule thus is as follows:
Income ($ in
billion)
50 100 140 200 300
Save ($ in
billion)
0 30 40 60 100
Concepts of Propensity to Save:
There are two concepts of propensity to save:
(1) Average Propensity to Save (APS).
(2) Marginal Propensity to Save (MPS).
(1) Average Propensity to Save (APS):
Definition:
Average propensity to save is the percentage of income saved at a given level of income (APS).
The average propensity to save at any point can be found by dividing saving by income.
For instance, If the disposable income is $100 billion and expenditure $80 billion on consumption goods,
then the saving win be equal to $20 billion. The average propensity at save will be = 0.2. The average
propensity to save can also be found by subtracting average propensity to consume from 1. In the above
example, the average propensity to consume is:
80/1000 = 0.8
So the average propensity save will be 1 - 8 = 2
(2) Marginal Propensity to Save (MPS):
Definition:
Marginal propensity to save is the ratio of change in saving to change in income. The MPS measures
the change in saving generated by a change in income.
Formula:
MPS = Change in Saving

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Change in Income
MPS = ΔS
ΔY
It is also found out by subtracting marginal propensity to consume from 1. Thus:
MPS = 1 - MPC
Schedule For APS and MPS:
($ in billion)
Disposable
Income (Y)
Consumption
Expenditure (C)
Net Saving (S) Average
Propensity to
Save (1 (1
- PC = PS)
Marginal
Propensity to
Save (1
- MPC = MPS)
A 1000 1100 $100 1 -1 = 1 1 - 9 = 0.1
B 2000 2000 $000 1 - 1 = 0 1 - 6 = 0.4
C 3000 2600 $400 1 - 0.86 = 0.14 1 - 5 = 0.5
D 4000 3100 $900 1 - 0.77 = 0.23 1 - 3 = 0.7
E 5000 3400 $1600 1 - 0.68 = 0.32 1 - 2 = 0.8
F 6000 3600 $2400 1 - 0.6 = 0.4 1 - 1 = 0.9
G 7000 3700 $3300 1 - 0.53 = 0.47
It is quite clear from the above saving schedule that as the income increases, the average propensity to
save and marginal propensity to save also increases and as income decreases, the average propensity to
save and the marginal propensity to save also decreases.
Diagram:

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In figure (30.4) disposable income is measured along the X axis and saving along the Y axis. At point A,
the consumption expenditure $1,100 billion against the disposable income of $1,000 billion. The
expenditure is more than the disposable income. There is dis-saving of $100 billion. The excess
expenditure of $100 billion is met either out of accumulated saving or by borrowing. When income
increases to $2,000 billion, the expenditure also increases to $2,000 billion.
At point B, consumption is exactly equal to expenditure. B is the break even point where C =Y. From B
onward up to G point, saving goes or increasing with the increase in disposable income. AG thus is the
saving curve which has risen with the rise in income.
It may here be noted saving as used by Keynes in consumption function is "real saving" and ‘income
is"real disposable income". The saving function like the consumption function remain stable in the short
period.
Concept of Investment:
Definition:
Investment is an important component of national income. It plays an important role in the determination
of equilibrium level of national income and corresponding level of employment. When the term investment
is used in economics, it refers to the:
"Expenditure incurred by individuals an businesses on the purchase of new plant and machinery, the
building of the houses, factories, schools, construction of roads etc. It is, in other words the acquisition of
new physical capital".
Investment Expenditures:
Investment, in brief, includes the following kinds of expenditures:
(i) Stock or Inventories:

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The inventories expenditures incurred by businesses on the purchase of new raw material, semi
finished gods and on stock of unsold goods (inventories) are counted as investment.
(ii) Fixed Capital:
The expenditure made on new plants and machinery vehicles, houses facilities, etc., are also included in
investment. In the words of J.M. Keynes:
"Investment means real investment which refers to increase in the real capital stock of the economy".
Types of Investment:
There are two types of investment (1) Induced investment and (2) Autonomous investment.
There two are now explained brief:
(1) Induced Investment:
Investment in the economy is influenced by the income or output of the economy. The large the national
income, the higher is the investment. Induced investment is the change in investment which is induced by
the change in the national income. The investment function signifies that as the real national income
rises, the level of inducement investment also rises and as the real national falls. The level of investment
also down.
Diagram:
In figure (30.5), it is shown that investment curve I/ is positively sloped. It indicates that as the level of
national income rises from OY1 to OY2, the level of induced investment also rises from OI1 to OI2.
Shift in the Investment Curve: The induced investment is the increasing function of profit. If firm expect
profit, they are induced to invest. The profit expectation of firms depend upon aggregate demand for
goods and services in the economy. The level of aggregate demand itself depends upon the level of
national income. The higher the level of national income, the higher thus is the level of induced
investment.
(2) Autonomous Investment:

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The investment which is not influenced by changes in national income is autonomous investment. In
other words an autonomous investment is independent of the level national income.
As regards the size of autonomous investment, it is influenced by many basic factors such as increase in
population. Manpower, level of technology, the role of interest, the expectations of future economic
growth and the role of capacity utilization etc.
Diagram:
In figure (30.6) it is shown that autonomous investment curve Ia is a horizontal straight line. For example,
when national income is OY1 the autonomous investment is $10 billion. If national income increases to
OY2 the autonomous investment remains $10 billion and so on.
In case, there is an introduction of new technologies, or the rate of interest falls or if the businessmen
expect the sales to grow more, the producer choose to operate to full capacity, the autonomous
investment is influenced. The autonomous investment curve shifts upward from $10 billion to $15 billion.
Concept of Marginal Efficiency of Capital (MEC):
Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations output
depends on its stock capital. An increase in the stock of capital increases output. The question is how
much increase in investment raises output? Well, this depends on the productivity of new capital i.e. on
the marginal efficiency of capital. Marginal efficiency of capital is the rate return expected to be obtainable
on a new capital asset over its life time.
J.M. Keynes defines marginal efficiency of capital as the:
“The rate of discount which makes the present value of the prospective yield from the capital asset equal
to its supply price”.
A businessman while investment in a new capital asset, examines the expected rate of net return (profit)
on it during its lifetime against the supply price of capital asset (cost of capital asset) if the expected rate
of profit is greater than the replacement cost of the asset, the businessman will invest the money in the
project.
Example:

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For example, if a businessman spends $10,000 on the purchase of a new griding machine. We assume
further that this new capital asset continues to produce goods over a long period of time. The net return
(excluding meeting all expenses except the interest cost) of the griding machine expected to be $1000
per annum. The marginal efficiency of capital will be 10%.
(1000/10000) Χ (100/1) = 10%
Schedule:
According to J.M. Keynes, the behavior of investment in respect of new investment depends upon the
various stock of capital available in the economy at a particular period of time. As the stock of capital
increases in the economy, the marginal efficiency of capital goes on diminishing. The MEC curve is
negatively sloped as a shown in the figure 30.7.
Investment ($ in billion) Marginal Efficiency of Capital
20 10%
25 9%
40 7%
70 5%
100 2%
Diagram/Curve:
In the above table, it is shown when stock of capital is equal to $20 billion, the marginal efficiency of
capital is 10% while at a capital stock of $100 billion, it declines to 2%. This investment demand schedule
when depicted graphically in figure 30.7 gives us the investment demand curve which goes on sloping
downward from left to right.

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Relative Role of MEC and the Rate of Interest:
The MEC and the rate of interest are the two important factors which affect the volume of new
investment in a country. An investor while making a new investment, weighs the MEC of new investment
against the prevailing rate of interest. As long as the MEC is higher than the rate of interest, the
investment will be made till the MEC and the rate of interest are equalized.
For example, if the rate of interest 7%, the induced investment will continue to be made till the MEC and
the rate of interest are equalized. At 7% rate of interest, the new investment will be $40 billion. In case,
the rate of interest comes down to 2%, the new investment in capital assets will be $100 billion.
Summing up, if investment is to be increased in the country, either the rate of interest should go down or
MEC should increase.
Factors on Which Marginal Efficiency of Capital
Depends:
According to. J .M. Keynes, the volume of new investment depends on the following two factors:
(1) Marginal Efficiency of Capital (MEC).
(2) Market Rate of Interest.
The producer's decision as to whether or not, he should undertake a given investment project is arrived at
by comparing marginal efficiency of capital (MEC) with the market rate of interest (or the cost of funds).
Meaning of Marginal Efficiency of Capital:
The marginal efficiency of capital is the expected annual rate of return on an additional unit of a capital
good. It is also described as the rate of return expected to be received on money if it were invested in a
newly produced asset. According to J.M. Keynes:
"The marginal efficiency of capital is the rate of discount which makes the present value of the
prospective yield from the capital asset equal to its supply price. The marginal efficiency of capital will
progressively diminish as investment in the asset increases. The marginal efficiency of capital (MEC)
curve is, therefore negatively sloped".
Factors Affecting MEC:
The marginal efficiency of capital is influenced by short run as well as long run factors. These factors are
now discussed in brief:
Short Run Factors:
(i) Demand for the product. It the market for a particular good is expected to grow and its costs are likely
to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in demand of goods
and a rise in cost, the will decline.

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(ii) Liquid assets. If the entrepreneurs are holding large volume of working capital, they can take
advantage of the investment opportunities that come in their way. The MEC will be high and vice versa.
(iii) Sudden changes in income. The MEC is also influenced by sudden changes in income of the
entrepreneurs. If the business community gets windfall profits, or there are tax concession etc., the MEC
will be high and hence investment in the country will go up. On the other hand, MEC falls with the
decrease in income.
(iv) Current rate of investment. Another factor which influences MEC is the current date of investment in
a particular industry. If in a particular industry, much investment has already taken place and the rate of
investment currently going on in that industry is also very large, then the marginal efficiency of capital will
be low.
(v) Wave of optimism and pessimism. The marginal efficiency of capital is also affected by waves of
optimism and pessimism in the business circle. If businessmen are optimistic about future, the MEC will
be overestimated. During periods of pessimism the MEC is under estimated.
Long Run Factors:
The long run factors which influence the marginal efficiency capital are as under:
(i) Rate of growth of population. Marginal efficiency of capital is also influenced by the rate of growth of
population. If population is growing at a rapid speed, it is usually believed that at the demand of various
classes of goods will increase. So a rapid rise in the growth of population will increase the marginal
efficiency of capital and a slowing down in its rate of growth will discourage investment and thus reduce
marginal efficiency of capital.
(ii) Technological development. If investment and technological development take place in the
industry, the prospects of increase in the net yield brightens up. For example, the development of
automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc.
So we can say that inventions and technological improvements encourage investment in various projects
and increase marginal efficiency of capital.
(iii) The quantity of capital goods of relevant types already in existence. If the quantity of any
particular of goods is available in abundance in the market and the consumers can partially or full meet
the demand, then it will not be advantageous to invest money in that particular project. So in such cases,
the marginal efficiency of capital will be low.
(iv) Rate of taxes. Marginal efficiency of capital is directly influenced by the rate of taxes levied by the
government on various commodities, When taxes are levied, the cost of commodities is increased and
the revenue is lowered.
When profits are reduced, marginal efficiency of capital will naturally be affected. It will be low.
Keynes Theory of Income Determination:

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It has been the practical experience of every country of the world that economic progress has never run
an even course. There have been wide fluctuations in the national income from time to time. The earlier
economists were of the view that if at any time there was a period of prosperity, it is then generally
followed by period of depression. When an economy is in the grip of depression, it automatically recovers
and soon grows into a boom. It was believed that economy normally operates at the level of the
employment.
J.M. Keynes in his book, "General Theory of Employment Interest and Money" has contradicted this view
point of the earlier economists. He is of the opinion that if an economy operates at a level of equilibrium, it
is not necessary that there should be a high level of employment in a country. It is just possible that there
may be millions of persons unemployed. So according to Keynes, if any country wishes to achieve high
level of employment, it can only do so through the changes in the magnitude of investment.
Determination of Equilibrium for National Income in a
Two Sector Economy:
Methods For the Determination of National Income/Keynes Model of
Income Determination:
J.M. Keynes in his famous book, 'General theory', has used two methods for the determination of
national income at a particular time:
(1) Saving Investment Method.
(2) Aggregate Demand and Aggregate Supply Method.
Both these approaches lead us to the determination of the same level of national income.
It may here be mentioned that Keynes model of income determination is relevant in the context of
short run only.
Assumptions:
Keynes assumes that in the short run:
(i) The stock of capital, technique of production, forms of business organizations, do not change.
(ii) He also assumes a fair degree of competition in the market.
(iii) There is also absence of government role either as a taxer or as a spender.
(iv) Keynes further assumes that the economy under analysis is a closed one. There is no influence of
exports and imports on the economy.
(1) Determination of National Income By the Equality of Saving and
Investment Method:

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This approach is based on the Keynesian definitions of saving and investment. According to Keynes, the
level of national income, in the short run, is determined at a point where planned or intended saving is
equal to planned or intended investment. Saving as defined by Keynes is that part of income which is not
spent on consumption (S = Y - C). On the other hand, investment is the expenditure on goods and
services not meant for consumption. (I = Y - C).
According to Keynes, if at any time, the intended saving is less than intended investment, it implies that
people are spending more on consumption. The rise in consumption will reduce the stock of goods in the
market. This will give incentive to entrepreneurs to increase output. Likewise, if at anytime intended
saving is greater than intended investment, this would mean that people are spending lesser volume of
money on consumption. As a result of this, the inventories of goods will pile up. This will induce
entrepreneurs to reduce output. The result of this will be that national income would decrease. The
national income will be in equilibrium only when intended saving is equal to intended investment.
Example and Diagram/Curve:
The determination of national income is now explained with the help of saving and investment curve
below:
In figure (31.2), income is measured on OX axis and saving and investment on OY axis. SS is the saving
curve which shows intended saying at different levels of income. The investment curve ll/ is drawn parallel
to the X axis which shows that investment does not change.
The entrepreneurs intend to invest $50 crore only irrespective of the amount of income. Saving (SS) and
investment curves (ll/) intersect each other at point M. If the conditions stated above remain the same, the
size of equilibrium level of income is 250 crore.
Disequilibrium:
Under the assumed conditions if there is inequality between saving and investment or disequilibrium, the
forces will operate in the economy and restore the equilibrium position.
Let us suppose, that the income has increased from the equilibrium level OL to ON ($300 crore). At this
level of income, desired saving is greater than the desired investment. When intended saving exceeds
planned or intended investment, the businessmen will not be able to dispose off all their current output.
They will slow down their productive activities. This will result in reducing the number of workers
employed in factories and a decrease in the income. This process will go on until due to a decrease in

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income, people's saving is reduced to the level of investment ($50 crore). The equilibrium income is $250
crore.
In the same way, income cannot remain below this equilibrium level of $250 crore. If at any time, income
falls below the equilibrium level, then it means that people are investing more than they are willing to save
I > S. They will increase productive activities as they are making high profits. The number of workers
employed in the factories will increase. This will result in an increase in income and higher saving. This
rise in national income will go on up to a point where saving and investment are just in balance and that
will be the equilibrium level. At this point, income will have the tendency of neither to rise nor to fall. It will
be in a state of rest. It is, thus, clear that national income is determined at a point where the intended
investment is equal to intended saving.
(2) Determination of Equilibrium Level of National Income According to
Aggregate Demand and Aggregate Supply Method:
While determining the level of national income in a two sector economy, it is assumed that it is an
economy where there is no role of the government and of foreign trade. In other words, it is a closed
economy with no government intervention. The two sector economy comprises of households and firms.
According to J. M. Keynes, the equilibrium level of national income is that situation in which aggregate
demand (C+ I) is equal to aggregate supply (C + S). The aggregate demand (C+ I) refers to the total
spending in the economy. In a two sector economy, The aggregate demand is the sum of demands for
the consumer goods (c) and investment goods by households and firms respectively. The aggregate
demand curve is positively sloped. It indicates that as the level of national income rises, the aggregate
demand (or aggregate spending) in the economy also rises.
Aggregate supply (C + S):
It is the flow of goods and services in the economy. In other words, the value of aggregate supply is equal
to the value of net national product (national income). The aggregate supply curve (C + S) is a positively
sloped 45° helping line. It signifies that as the level of national income rises, the aggregate supply also
rises by the same proportion.
Equilibrium Level of Income:
According to Keynesian model, the equilibrium level of national income is determined at a point where the
aggregate demand curve intersects the aggregate supply curve. The 45° helping line represents
aggregate supply. By definition, output equals income on each point of aggregate supply curve. The
determination of the level of aggregate income is explained below.
Diagram/Curve:

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In the figure 31.3, income is measured along OX axis and expenditure on OY axis. The aggregate
demand curve (C + I) intersects the aggregate supply curve (45° line) at point K point. K, here is the only
point where the economy is willing to spend exactly the amount which is necessary to dispose off the
entire output. The equilibrium level of income is $250 billion. It may, however, be noted that this
equilibrium output does not mean in any way the full employment output.
Departure From Equilibrium Level of Income:
Now a question arises that if at any time there is a departure from the equilibrium income of $250 billion,
how will the economy move towards an equilibrium level? To answer this question, we examine two
possible levels of income other than the equilibrium level.
Let us suppose first that the actual income is $300 billion rather than $250 billion. According to aggregate
demand, schedule (C + l), (the actual consumption + investment expenditure) at an income of $300 billion
falls short by $30 billion (shown by bracket). This means that the goods worth $30 billion are not sold.
When the inventories pile up with the business, they would curtail this production and provide fewer jobs.
There will thus be a decline in total income which will continue till the income falls to the equilibrium level
of $250 billion.
Now let us suppose that the level of income fails to $100 billion. According to aggregate demand
schedule represented by (C + l) curve, the expenditure at this level exceeds income by $50 billion (shown
by bracket). The increase in demand of consumer and investment goods will induce the businesses to
increase their output. The higher rate of production will provide more jobs to the workers.
The level of income would rise and the upward drive continues till the income reaches the equilibrium
level of $250 billion. We, thus, conclude by saying that an economy sustains only that level of income
where the total quantity supplied and the aggregate quantity demanded are equal. At this equilibrium
national income of $250 billion, the firms have neither the tendency to increase output nor the tendency to
decrease output. Hence, $250 billion is the equilibrium level of national income. The equilibrium output, in
this simple Keynesian analysis, does not mean full employment.
Inflationary and Deflationary Gaps:

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J. M. Keynes in his famous book 'General Theory' put forward an analysis of unemployment and inflation.
The Keynesian theory assumes that a maximum level of national output can be obtained at any particular
time in the economy. According to him the maximum level of national income is generally referred to as
full employment level of national income. If the equilibrium level of national income coincides with the full
employment, there will be no deficiency of aggregate demand and hence no dis-equilibrium
unemployment (seasonal, frictional unemployment can exist at this level).
Now if the equilibrium level of income as determined by the AD (aggregate demand) and AS (aggregate
supply) is not equal to the level of full employment, then two situations can arise. Either this equilibrium
level will be below the full employment level or above the lull employment level. In case, the equilibrium
income is below the potential income, it indicates the presence of recessionary gap. If it is above the full
employment income, it shows the presence of inflationary gap. Both the situations of deflationary and
inflationary gaps are situations of disequilibrium in the economy. These gaps are now explained with the
help of graphs.
Deflationary Gap/Recessionary Gap:
Deflationary gap is also called re-cessionary gap. When there is an insufficient demand for goods and
services in the economy, the equilibrium will occur at the lower level of full employment income and to the
left of full employment line. In other words, re-cessionary gap occurs when the aggregate demand is not
sufficient to create conditions of full employment.
The deflationary gap thus is the difference of amount by which aggregate expenditure falls short of the
level needed to generate equilibrium national income at full employment without inflation.
Example and Diagram/Figure:
The deflationary gap is illustrated in figure below:
In this diagram 31.4, the national income is measured on OX axis and aggregate expenditure on OY axis.
Let us assume initially that the aggregate expenditure curves AE° interests the 45 degree line at point E/to
the left of full employment line or potential income.
The economy is operating at equilibrium income level of $150 billion which is below potential income of
$250 billion. There is a deficiency of $100 billion in aggregate expenditures. This shortfall of national
expenditure ($100 billion) below the potential income or the full employment level of national income is
called Re-cessionary Gap.

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Fighting Recession:
When the economy is operating below its potential income, the government recognizes the re-cessionary
gap in aggregate income. It increases its expenditures to stimulate the economy. The multiplier process
takes over. The increase in government expenditure shifts the AE/ curve from AE° to AE1 increasing
aggregate income to the full employment income level. Such government action is expansionary fiscal
policy.
Deflationary gap thus represents the difference between the actual aggregate demand and the
aggregate demand which is required to establish the equilibrium at full employment level of Income.
Inflationary Gap:
An inflationary gap is just the opposite of deflationary gap. It is said to exist when equilibrium income
exceeds full employment income. It is created due to the effective demand being in excess of the full
employment level. It is the difference between equilibrium income and full employment income (potential
income) when equilibrium income exceeds the full employment income. Here people are trying to buy
more goods and services than can be produced when all resources are fully employed. There is too much
money chasing too few goods. The result is that the excess demand pulls up prices and there is inflation.
The excess demand for goods and services is being met in money terms but not real, terms.
Example and Diagram/Figure:
An inflationary gap is explained with the help of figure below:
In this figure 31.5 aggregate expenditure curve AE° intersects the aggregate production curve (45 degree
helping line) at point E/ to the right of potential line or full employment line (FE).
The equilibrium level of income is $200 billion whereas the potential income is $100 billion. When the
equilibrium income exceeds potential income, there is said to be inflationary gap which in the diagram is
$100 billion. The excess expenditure of $100 billion causes upward pressure on prices when there is no
additional output produced.

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Fighting Inflation:
Whenever there is an inflationary gap in the economy, the government adopts deflationary fiscal policy of
lowering government expenditure or raising taxes. It also adopts deflationary monetary policy for reducing
the amount of money in the economy.
Summing Up:
(i) When equilibrium income is below its potential income level, the difference is called deflationary gap.
The government can increase its expenditure to stimulate the economy.
(ii) When equilibrium income exceeds the potential income, the difference is called an inflationary gap.
To prevent inflation. Keynes believes that the government should exercise contractionary fiscal policy,
cutting government expenditure, raising taxes etc.

Macro Economics Explained

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Macro Economics Explained