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1. Micro and Macro Economics
The terms ‘micro-‘ and ‘macro-‘ economics were first coined and used by Ragnar
Fiscer in 1933. Micro-economics studies the economic actions and behaviour of
individual units and small groups of individual units. In micro-economics, we are
chiefly concerned with the economic study of an individual household, individual
consumer, individual producer, individual firm, individual industry, particular
commodity, etc. Whereas, when we are analysing the problems of the economy
as a whole, it is a macro-economic study. In macro-economics, we do not study
an individual producer or consumer, but we study all the producers or consumers
in a particular economy.
Micro-Economics or Price Theory:
The term ‘micro-economics’ is derived from the Greek prefix ‘micro’, which
means small or a millionth part. Micro-economic theory is also known as ‘price
theory’. It is an analysis of the behaviour of any small decision-making unit, such
as a firm, or an industry, or a consumer, etc. For micro-economics, in contrast to
macro economic theory, the statistics of total economic activity are valueless as
far as providing clues to policy decisions. It does not give an idea of the
functioning of the economy as a whole. An individual industry may be flourishing,
whereas the economy as a whole may be suffering.
In respect of employment, micro-economics studies only the employment in a
firm or in an industry and does not concern to the aggregate employment in the
whole economy. In the circular flow of economic activity in the community,
micro-economics studies the flow of economic resources or factors of production
from the resource owners to business firms and the flow of goods and services
from the business firms to households. It studies the composition of such flows
and how the prices of goods and services in the flow are determined.
A noteworthy feature of micro-approach is that, while conducting economic
analysis on a micro basis, generally an assumption of ‘full employment’ in the
economy as a whole is made. On that assumption, the economic problem is
mainly that of resource allocation or of theory of price.
Importance of Micro-Economics: Micro-economics occupies a very important
place in the study of economic theory.
1. Functioning of free enterprise economy: It explains the functioning of a
free enterprise economy. It tells us how millions of consumers and
producers in an economy take decisions about the allocation of productive
resources among millions of goods and services.
2. Distribution of goods and services: It also explains how through market
mechanism goods and services produced in the economy are distributed.

2. 3. Determination of prices: It also explains the determination of the relative
prices of various products and productive services.
4. Efficiency in consumption and production: It explains the conditions of
efficiency both in consumption and production and departure from the
optimum.
5. Formulation of economic policies: It helps in the formulation of
economic policies calculated to promote efficiency in production and the
welfare of the masses.
Thus the role of micro-economics is both positive and normative. It not only tells
us how the economy operates but also how it should be operated to promote
general welfare. It is also applicable to various branches of economics such as
public finance, international trade, etc.
Limitations of Micro-Economics: Micro-economic analysis suffers from certain
limitations:
1. It does not give an idea of the functioning of the economy as a
whole. It fails to analyse the aggregate employment level of the
economy, aggregate demand, inflation, gross domestic product, etc.
2. It assumes the existence of ‘full employment’ in the whole economy,
which is practically impossible.
Macro-Economics or Theory of Income and Employment:
The term ‘macro-economics’ is derived from the Greek prefix ‘macro’, which
means a large part. Macro-economics is an analysis of aggregates and
averages of the entire (large) economy, such as national income, gross domestic
product, total employment, total output, total consumption, aggregate demand,
aggregate supply, etc. Macro-economics is the economic theory which looks to
the statistics of a nation's total economic activity and holds that policy change
designed to alter these total statistical aggregates is the way to determine
economic policy and promote economic progress. Individual is ignored
altogether. Sometimes, national saving is increased at the expense of individual
welfare.
It analysis the chief determinants of economic development, and the various
stages and processes of economic growth. Different macro-economic models of
economic growth have been suggested, one of which most famous is Harrod-
Domar Model. It can be applied to both developed and under-developed
economies.
Importance of Macro-Economics:
1. It is helpful in understanding the functioning of a complicated
economic system. It also studies the functioning of global economy.

3. With growth of globalisation and WTO regime, the study of macro-
economics has become more important.
2. It is very important in the formulation of useful economic policies for
the nation to remove the problems of unemployment, inflation, rising
prices and poverty.
3. Through macro-economics, the national income can be estimated and
regulated. The per capita income and the people’s living standard are
also estimated through macro-economic study. It explains the fluctuations
in national income, per capita income, output and employment.
Limitations of Macro-Economics:
1. Individual is ignored altogether. For example, in macro-economics
national saving is increased through increasing tax on consumption, which
directly affects the consumer welfare.
2. The macro-economic analysis overlooks individual differences. For
instance, the general price level may be stable, but the prices of food
grains may have gone spelling ruin to the poor. A steep rise in
manufactured articles may conceal a calamitous fall in agricultural prices,
while the average prices were steady. The agriculturists may be ruined.
While speaking of the aggregates, it is also essential to remember the
nature, composition and structure of the components.
Equilibrium
The term equilibrium has often to be used in economic analysis. In fact, Modern
Economics is sometimes called equilibrium analysis. Equilibrium means a state
of balance. When forces acting in opposite directions are exactly equal, the
object on which they are acting is said to be in a state of equilibrium.
Types of Equilibrium
Basically, there are three types of any equilibrium:
(a) Stable Equilibrium: There is stable equilibrium, when the object
concerned, after having been disturbed, tends to resume its original position.
Thus, in the case of a stable equilibrium, there is a tendency for the object to
revert to the old position.
(b) Unstable Equilibrium: On the other hand, the equilibrium is unstable
when a slight disturbance evokes further disturbance, so that the original position
is never restored. In this case, there is a tendency for the object to assume
newer and newer positions once there is departure from the original position.
(c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces
neither bring it back to the original position nor do they drive it further away from

4. it. It rests where it has been moved. Thus, in the case of a neutral equilibrium,
the object assumes once for all a new position after the original position is
disturbed.
When the word equilibrium is used to qualify the term value, then according to
Professor Schumpeter, a stable equilibrium value is an equilibrium value that if
changed by a small amount, calls into action forces that will tend to reproduce
the old value; a neutral equilibrium value is an equilibrium value that does not
know any such forces; and an unstable equilibrium value is an equilibrium value,
change in which calls forth forces which tend to move the system farther and
farther away from the equilibrium value.
In the following figure 2, the stable equilibrium is shown. When in equilibrium at
point P, the producer produces an output OM and maximises his profits. In case
the producer increases his output to OM2 or decreases it to OM1, the size of
profits is reduced. This automatically brings in forces that tend to establish
equilibrium again at P.
Figure 3 represents the case of unstable equilibrium. Initially the producer is in
equilibrium at point P, where MR = MC and he is maximising his profits. If now
he increases his output to OM1, he would be in equilibrium output at point P1,
where he will obtain higher profits, because, at this output, marginal revenue is
greater than marginal cost. Thus there is no tendency to return to the original
position at P.
Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at
all levels of output so that the producer has no tendency to return to the old
position and every time a new equilibrium point is obtained, which is as good as
the initial one.

5. Other Forms of Equilibrium
(a) Short-term and Long-term Equilibrium: Equilibrium may be short-term
equilibrium or long-term equilibrium as in case of short-term and long-term value.
In the short-term equilibrium, supply is adjusted to change in demand with the
existing equipment or means of production, there being no time available to
increase or decrease the factors of production. However, in case of long-term
equilibrium, there is ample time to change even the equipment or the factors of
production themselves, and a new factory can be erected or new machinery can
be installed.
(b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an
equilibrium position for a sector of the economy or for one or several partial
groups of the economic unit corresponding to a particular set of data. This
analysis excludes certain variables and relationship from the totality and studies
only a few selected variables at a time. In other words, this method considers

6. the changes in one or two variables keeping all others constant, i.e., ceteris
paribus (others remaining the same). The ceteris paribus is the crux of partial
equilibrium analysis.
The equilibrium of a single consumer, a single producer, a single firm and a
single industry are examples of partial equilibrium analysis. Marshall’s theory of
value is a case of partial equilibrium analysis. If the Marshallian method (i.e.,
partial equilibrium analysis) is to be effective, even in its own terms, when applied
to a hypothetical and idealised market, it necessary that the market should be
small enough so that its inter-dependence with the rest of the hypothetical
economy could be neglected without much loss of accuracy.
(i) Consumer’s Equilibrium: With the application of partial
equilibrium analysis, consumer’s equilibrium is indicated when he is getting
maximum aggregate satisfaction from a given expenditure and in a given set
of conditions relating to price and supply of the commodity.
(ii) Producer’s Equilibrium: A producer is in equilibrium when
he is able to maximise his aggregate net profit in the economic
conditions in which he is working.
(iii) Firm’s Equilibrium: A firm is said to be in long-run
equilibrium when it has attained the optimum size when is ideal from
the viewpoint of profit and utilisation of resources at its disposal.
(iv) Industry’s Equilibrium: Equilibrium of an industry shows
that there is no incentive for new firms to enter it or for the existing
firms to leave it. This will happen when the marginal firm in the
industry is making only normal profit, neither more nor less. In all these
cases; those who have incentive to change it have no opportunity and
those who have the opportunity have no incentive.
(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical
economist, in his book ‘Elements of Pure Economics’, created his theoretical and
mathematical model of General Equilibrium as a means of integrating both the
effects of demand and supply side forces in the whole economy. Walras’
Elements of Pure Economics provides a succession of models, each taking into
account more aspects of a real economy. General equilibrium theory is a branch
of theoretical microeconomics. The partial equilibrium analysis studies the
relationship between only selected few variables, keeping others unchanged.
Whereas the general equilibrium analysis enables us to study the behaviour of
economic variables taking full account of the interaction between those variables
and the rest of the economy. In partial equilibrium analysis, the determination of
the price of a good is simplified by just looking at the price of one good, and
assuming that the prices of all other goods remain constant.

7. General equilibrium is different from the aggregate or macro-economic
equilibrium. General equilibrium tries to give an understanding of the whole
economy using a bottom-top approach, starting with individual markets and
agents. Whereas, the macro-economic equilibrium analysis utilises top-bottom
approach, where the analysis starts with larger aggregates. In macro-economic
equilibrium models, like Keynesian type, the entire system is described by
relatively few, appropriately defined aggregates and functional relationships
connecting aggregate variables such as total consumption expenditure, total
investment, total employment, aggregate output and the like. In macro-economic
analysis, many important variables and relationships tend to be disappeared in
the process of aggregation.
There are two major theorems presented by Kenneth Arrow and Gerard Debreu
in the framework of general equilibrium:
(i) The first fundamental theorem is that every market equilibrium is
Pareto optimal under certain conditions, and
(ii) The second fundamental theorem is that every Pareto optimum is
supported by a price system, again under certain conditions.
Uses of General Equilibrium
1. To get an overall picture of the economy and study the problems
involving the economy as a whole or even large segments / sectors of it.
2. It shows that the quantities of demanded goods / factors are equal to the
quantities supplied. Such a condition implies that there is a full
employment of resources.
3. It also provides with an ideal datum of economic efficiency. It brings out
the fact that long-run competitive equilibrium is a standard of efficiency for
the entire economy. Only when the competitive economy obtains general
equilibrium shall its economic efficiency be at its peak and there shall be
no further gains made by any reallocation of resources.
4. General equilibrium also represents the state of optimum production of
all commodities, because there can be no over-production or under-
production under such conditions.
5. It also provides an insight into the way the multitudes of individual
decisions are integrated by the working of the price mechanism. It,
therefore, solves the fundamental problems of a free market
economy, viz., what to produce, how to produce, how much to produce,
etc. This analysis shows that such decisions with regard to innumerable
consumers and producers are co-ordinated by the price mechanism.

8. 6. The general equilibrium analysis also gives us the clue for predicting
the consequences of an economic event.
7. It also helps in the field of public policy. The formulation of a logically
consistent public policy requires a complete understanding of the various
sector markets and aspects of individual decision-making units, and the
impact of policy on the whole economy.
Limitations of General Equilibrium Analysis
1. The Walrasian general equilibrium system is essentially static. It treats
the coefficient of production as fixed. It considers the supply of resources
to be given and consistent. It also takes tastes and preferences of the
society as fixed.
2. It ignores leads and lags, for it considers everything to happen
instantaneously. It is supposed to work just in the same way as an electric
circuit does. In the real world, all economic events have links with the past
and the future.
3. Walrasian general equilibrium analysis is of little practical utility. It
involves astronomical volumes of calculations for estimating the various
quantities and practices. This makes its application practically impossible.
Even the use of computers cannot be of much help because such a
system cannot aid in collecting and recording the innumerable sets of
prices and quantities that are required to formulate these equations. The
critics further argue that even if such a solution exists, the price
mechanism may not necessarily cover it.
4. Last but not least, the general equilibrium analysis falls to the ground as
its star assumption of perfect competition is contrary to the actual
conditions prevailing in the real world.
General Disequilibrium (Keynesian Theory)
Neoclassical economics thinks in terms of a market system in which supply
equals demand in every market, so that no unemployment could ever occur. But
this is an assumption. Keynes suggests a market system in which Disequilibrium
can occur in some markets, including labour market, and in which the
disequilibrium can spread contagiously from one market to another. Keynes’
idea was that, when this spreading disequilibrium settles down, there would be a
kind of equilibrium – not supply and demand equilibrium, but often termed as
‘general disequilibrium’.
Take an example of a commodity, say cellular telephone sets, its equilibrium of
demand and supply is shown in the following figure:

9. In the above figure, MC curve is the marginal cost curve for the commodity.
Originally, the market is in equilibrium at price P1 with demand curve D1. Then,
for any reason, demand for that commodity decreases to D2, Neoclassical
economists tells us that the new equilibrium will be at price P3. But, in fact, the
prices do not drop quite that far, instead, prices drop to P2. Perhaps this is
because the businessmen do not know just how far they need to cut their prices,
and are cautious to avoid cutting too much. At a price P2, the seller can sell only
Qd amount of output. By producing Qd amount of output at price P2, the
producers are not maximising their short-run profit. We have ‘disequilibrium’ in
the sense that production is not on the marginal cost curve. At P2, the sellers
can sell Qd amount of output, but they cannot produce the same amount of
output. Here is a qualification. Producer might temporarily produce more that
Qd, in order to build up their inventories. But there is a limit to how much
inventories they want, so they will cut their production back to Qd eventually.
With a reduction of demand for cellular phones, any economist would expect a
reduction in the quantity of that commodity produced. Neoclassical economics
leads us to expect that the price would drop to P3 and output cut back to Qe. At
the same time, a certain number of workers would be laid off and would switch
their efforts into their second best alternatives, working in other industries,
perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the
production and layoffs would go even further, with output dropping to Qd. A
reduction in income does not only reduce the demand for cellular phones, but it
also reduces the demand for all other normal goods as well. This disequilibrium
will spread contagiously through many different goods markets, through the
effect of disequilibrium on income. So every other industry will face a reduction
in demand because of the reductions in productions in many other industries.
Harrod Domar Growth Model

10. As we know that one of the principal strategies of development is mobilisation of
domestic and foreign saving in order to generate sufficient investment to
accelerate economic growth. The economic mechanism by which more
investment leads to more growth can be described in terms of Harrod-Domar
growth model, often referred to as the AK model.
Every economy must save a certain proportion of the national income, if only to
replace worn-out or impaired capital goods (buildings, equipment, and materials).
However, in order to grow, new investments representing net additions to the
capital stock are necessary. If we assume that there is some direct economic
relationship between the size of the total capital stock, K, and total GNP, Y – for
example, if $3 of capital is always necessary to produce a $1 stream of GNP – it
follows that any net additions to the capital stock in the forms of new investment
will bring about corresponding increases in the follow of national output, GNP.
This relationship is known as ‘capital-output ratio’ and is represented as ‘k’. in
the above case ‘k’ is roughly 3:1.
If we further assume that the national savings ratio ‘S’ is a fixed proportion of
national output (e.g. 6%) and that total new investment is determined by the level
of total savings. We can construct the following simple model of economic
growth:
· Saving (S) is some proportion, s, of national income (Y) such that we
have the simple equation:
S = s .Y ---------------------------- (i)
· Net investment (I) is defined as the change in the capital stock, K, and
can be represented by ΔK such that:
I = ΔK ----------------------------- (ii)
But because the total capital stock, K, bears a direct relationship to total national
income or output, Y, as expressed by the capital-output ratio, k, it follows that:
K = k
Y
Or
ΔK = k
ΔY

11. Or
ΔK = k.ΔY ------------------------------- (iii)>
· Finally, because net national savings, S, must equal net investment, I,
we can write this equality as:
S = I ------------------------------- (iv)
But from equations (i), (ii) and (iii), we finally get the following equation:
I = ΔK = k. ΔY
Therefore, we can rewrite the equation (iv) as follows:
S = s.Y = k.ΔY = ΔK = I --------------- (v)
Or simply
s.Y = k.ΔY -----------------------------------(vi)
Dividing both the sides of equation (vi) first Y and then by k, we obtain the
following expression:
ΔY = s -------------------------------------- (vii)
Y k
Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of
change or rate of growth in GNP (i.e., the percentage change in GNP).
The Harrod Domar Model, more specifically says that in the absence of
government, the growth rate of national income will directly or positively related
to the savings ratio (i.e., the more an economy is able to save and invest out of a
given GNP, the greater the growth of that GNP will be. Harrod Domar Model
further states that the growth rate of national income will be inversely or
negatively related to the economic capital-output ratio (i.e., the higher k is, the
lower the rate of GNP growth will be).
The additional output can be obtained from an additional unit of investment and it
can be measured by the inverse of the capital-output ratio, k, because this
inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows
that multiplying the rate of new investment, s = I / Y, by its productivity, 1 / k,
will give the rate by which national income or GNP will increase.

12. For example, the national capital-output ratio in an under-developed country is,
let say, 3 and the aggregate saving ratio (s) is 6% of GNP, it follows that this
country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose
that the national saving rate increased from 6% to 15% through increased taxes,
foreign aids, and / or general consumption sacrifices – GNP growth can be
transferred from 2% to 5% (15% / 3).
According to Rostow and other theorists, the countries that were able to save
15% to 20% of GNP could grow at a much faster rate than those that saved less.
Moreover, this growth would then be self-sustained. The mechanisms of
economic growth and development, therefore, are simply a matter of increasing
national savings and investment.
The main obstacle or constraint on development, according to this theory, was
the relatively low level of new capital formation in most poor countries. But if a
country wanted to grow at, let say, a rate of 7% per annum and if it could not
generate savings and investment at a rate of 21% (i.e., 7% × 3) of national
income but could not only manage to save 15%, it could seek to fill this saving
gap of 6% through either foreign aid or private foreign investment.
Limitations of the model:
1. Economic growth and economic development are not the same.
Economic growth is a necessary but not sufficient condition for development
2. Harrod Domar model was formulated primarily to protect the developed
countries from chronic unemployment, and was not meant for developing
countries.
3. Practically it is difficult to stimulate the level of domestic savings
particularly in the case of LDCs where incomes are low.
4. It fails to address the nature of unemployment exists in different countries.
In developed countries, the unemployment is ‘cyclical unemployment’, which
is due to insufficient effective demand; whereas in developing countries, there
is ‘disguised unemployment’.
5. Borrowing from overseas to fill the gap caused by insufficient savings causes
debt repayment problems later.
6. The law of diminishing returns would suggest that as investment increases
the productivity of the capital will diminish and the capital to output ratio rise.
The Harrod-Domar model of economic growth cannot be rejected on the ground
of above limitations. With slight modifications and reinterpretations, it can be
made to furnish suitable guidelines even for the developing economies.

13. National Income Accounts
What is National Income Accounting?
National income accounting is a term which is applied to the description of the
various types of economic activities that are taking place in the community in a
certain institutional framework. In national income accounting, we are concerned
with statistical classification of the economic activity so that we are able to
understand easily and clearly the operation of the economy as a whole. In
national income accounting the following distinctions are drawn between:
(a) forms of economic activity, namely, production, consumption, and
accumulation of wealth;
(b) sectors or institutional division of the economy; and
(c) types of transactions, such as sales and purchases of goods and
services, gifts, taxes, and other current transfers.
In national income accounting, a transactor is supposed to keep a set of three
accounts in which transactions are recorded:
(i) In the first account, incomes and outgoings relating a productive
activity of the transactor are brought together. The difference between
the two shows the profit or gain.
(ii) The second account seeks to show how this profit and any other
income that accrues to the transactor are allocated to different uses.
The excess of income over outlay is saving.
(iii) The third account shows how this saving and any other capital funds
are used to finance the capital expenditure or to give loans to other
transactors.
Since in an economy, there are numerous transactors, therefore, they are
grouped into sectors. In a sector, accounts of a same type are consolidated.
The ‘sector accounts’ form the units in a system of national income accounting.
Comparison of National Income Accounting and Individual Income
Accounting:
(a) Double entry book-keeping: Both national income accounting system
and individual income accounting system are based on the method of
double-entry book-keeping. For example, under individual income
accounting, a cash sale is recorded as a debit in Cash Account and as a

14. credit in Sales Account. Whereas, in national income accounting, the
cash transactions are not separately presented. Cash balances are
recorded in the capital transaction account. The difference is that the
national income accounting does not record the second entry in detail.
(b) Individual vs. collective individuals: Individual income accounts or
private accounts relate to an individual businessman or a corporate firm.
Whereas, the national income accounts are closely related to all the
businessmen or corporate firms in the community.
(c) Profit and loss account: Individual income accounts are usually
presented in the form of a Profit and Loss Account or Income Statement
which shows the flow of income and its allocation during a year. The
Balance Sheet shows the stock of assets and liabilities at the end of the
year. The Profit and Loss Account of a private businessman resembles in
national income accounting to what is called the Appropriation Account.
The only difference is that in private accounting, the profit often includes
some elements of costs such as depreciation on plant and machinery and
fees paid to the directors of the company. On the other hand, in national
income accounting, these incomes are shown net. There is no
counterpart at all of a Balance Sheet in national income accounting since
there is a great difficulty in collecting such a huge bank of data accurately
and completely especially on uniform basis.
Income Statement of a Typical Firm
For the year ended on December 31, 2005
Debits Rs. Credits Rs.
To Sales Account
(50,000 units @ Rs.
25)
1,250,000
By Cost of Sales:
Wages
Rent
Interest
Profit (residual)
750,000
150,000
150,000
200,000
Total 1,250,000 Total 1,250,000
National Product Account 2004-05
(Millions of rupees)
Flow of Product Rs. Flow of Earning Rs.

15. Final Output
(500 million units @ Rs.
25)
12,500
Costs or Earnings:
Wages
Rent
Interest
Profit
7,500
1,500
1,500
2,000
Total 12,500 Total 12,500
Uses of National Income Accounting:
(a) Clear picture of the economy: The national income accounts or social
accounts give a clear picture of the economy regarding the GDP, national
income, per capita income, saving ratio, production, consumption,
disposable income, capital expenditure, etc. It gives a clear view of the
health of the economy and the way in which it functions. It also gives a
view on the living standard of the people.
(b) Promotion of efficiency and stability of the economy: To foster the
economic growth, any government has to see what she has achieved in
the past and what has to be done in the future. For this purpose, the
preparation of national income accounts is quite inevitable for the
promotion of economic efficiency and stability. It helps the government to
set the national priorities, such as education, inflation, unemployment,
defence, social development, and industrialisation, etc., in long-term and
medium-term planning. It also helps the planner to set the economic
objectives to be achieved in the near future. Thus it serves the purpose of
planning and controlling tool for public administrators.
(c) Measurement of economic welfare: Measurement of economic welfare
is another purpose of the preparation of social accounts. Through social
accounting, we can know at a glace to what extent the masses are better
off than at the time when planning started.
(d) Interrelationship of different sectors of the economy: Through the
study of national income accounts, the reader is in a position to inter-relate
different sectors of the economy. For example, through the study of
national income accounts, we can know that Pakistan’s industrial sector is
largely dependant on agriculture sector, because most of the raw
materials like cotton, silk, leather, sugarcane, milk, poultry, etc. are
supplied from agriculture.
(e) Monetary, fiscal and trade policies: The national income accounts are
very essential for the statesmen, governments, and politicians, because

16. they help them to efficiently formulate different economic policies,
including monetary policy, fiscal policy and trade policy. In the absence of
national income accounts, the economic planning would be disastrous.
Gross National Product (GNP):
GNP is the basic national income accounting measure of the total output or
aggregate supply of goods and services. It has been defined as the total value of
all final goods and services produced in a country during a year. GNP is a ‘flow’
variable, which measures the quantity of final goods and services produced
during a year. For calculating GNP accurately, all goods and services produced
in any given year must be counted once, but not more than once.
Approaches of Measuring GNP/GDP:
The primary purpose of national accounts is to provide a coherent and
comprehensive picture of the economy. To be concise, these estimates tend to
answer questions such as:
(a) What is the output of the economy, its size its composition, and its uses?
And
(b) What is the economic process by which this output is produced and
distributed? These questions are addressed below in relation to estimation
of GDP/GNP and final uses of the GNP.
The gross national product (GNP) is the market value of all final goods and
services, produced in the economy during a year. GNP is measured in Rupee
terms rather than in physical units of output. Gross domestic product (GDP) is a
better idea to visualize domestic production in the economy. GDP may be
derived in three ways or in combination of them.
(i) Production Approach: It measures the contribution to output made by
each producer. It is obtained by deducting from the total value of its output
the value of goods and services it has purchased from other producers
and used up in producing its own output, i.e.:
VA = value of output – value of intermediate consumption.
Total value added by all producers equals GDP.
(ii) Income/Cost Approach: In this approach, consideration is given to the
costs incurred by the producer within his own operation, the income paid
out to employees, indirect taxes, consumption of fixed capital, and the
operating surplus. All these add up to value added.

17. (iii) Expenditure Approach: This approach looks at the final uses of the
output for private consumption, government consumption, capital
formation and net of imports & exports. According this approach, GDP is
the sum of following four major components:
 Personal consumption expenditure on goods and services,
 Gross private domestic investment,
 Government expenditure on goods and services, and
 Net export to the rest of the world.
The concepts of expenditure approach and cost approach have been illustrated
in the following diagram of circular flow of a simplified two-sector economy:
In the above diagram, the upper loop represents the ‘expenditure’ side of the
economy. Through this loop, all the products flow from business sector to
household sector. Each year the nation consumes a wide variety of final goods
and services: goods such as bread, apples, computers, automobiles, etc.; and
services such as haircuts, health, taxis, airlines, etc. But we include only the
value of those products that are bought and consumed by the consumers. In our
‘two-sector economy’ illustration, we have excluded the investment expenditure,
government expenditure and taxes from GDP calculation.
The lower loop represents the ‘cost or revenue’ side of the economy. Through
this loop, all the costs of doing business flow. These costs include wages paid to
labour, rent paid to land, profits paid to capital, and so forth. But these business
costs are revenues that are received by households in exchange of supplying
factors of production to the business sector.

18. Precautions in Measuring GNP/GDP / Problems in National Income
Measurement / Dangers of National Income Accounts:
The federal statisticians and economists have to be very careful in measuring
GDP or preparing national income accounts. The following precautionary
measures should be taken:
(a) Reliable source of data: All the data for national accounts are collected
from different sources, including surveys, income tax returns, retail sales
statistics, and employment data. Inaccurate or incomplete data can
severely damage the integrity of the national accounts. The economists
have to be very careful in collection and selection of national income
accounting data.
(b) Difficulties of Measuring Some Services in Money Terms: National
Income of a country is always measured in money terms, but there are
some goods and services, which cannot be measured, in monetary terms.
Such goods include, the services of the housewife, housemaid and the
singing as a hobby by an individual. Exclusion of these services from the
national income, underestimate the national income account.
(c) Illegal Activities in the Economy/The Growth of “Black Economy”:
The “Black Economy” refers to that part of economic activity, which is
undeclared and therefore unrecorded for tax purposes and is therefore
deemed to be ‘illegal’. Many illegal activities in the economy generally
escape both the law and measurement in the national income. Such
illegal activities include, smuggling, drug trafficking and all parallel market
transactions. Since such activities are outlawed, income earned, through
them are not captured in the national income, thus, under estimating the
national income account.
(d) Danger of double counting: While measuring GDP, we have to
distinguish between the three forms of goods:
(i) Final product: A final product is one that is produced and sold for
consumption or investment.
(ii) Intermediate good: Intermediate goods are semi-finished goods or
goods-in-process.
(iii) Raw material: Raw materials are unfinished and unprocessed goods.
To avoid double or multiple counting, it is necessary to add the value of only
those goods which have reached their final stage of production, i.e., final goods,
and to not add the value of intermediate goods and raw materials, which are

19. already included in the value of final goods. GDP, therefore, includes bread but
not wheat, cars but not steal.
(e) Problem of Including All Inventory Change in GNP: Firms generally
record inventories at their original cost rather than at replacement costs.
When prices rise, there are gains in the book value of inventories but
when prices fall, there are losses. So, the book value of inventories
overstates or understates the actual inventories. Thus, for correct
computation of GNP, inventory evaluation is required. This is achieved
when a negative valuation of inventory is made for inventory gains and a
positive valuation is made for losses.
(f) Problem of Price Instability: Since national income is measured in
money terms, fluctuation in the general price level will render unstable the
measuring rod of money for national income. When prices are rising, the
national income figures are rising even though production might have
gone down. On the other hand, when prices are falling, GNP is declining
even though the production might have gone up. To solve this problem,
economist and statisticians have introduced the concept of real income.
(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses
accruing to property owners by increase or decrease in the market value
of their asset are not included in GNP computation because such changes
do not result from current economic activities. Such exclusions
underestimate or overestimate the GNP.
(h) Value added: ‘Value added’ is the difference between a firm’s sales and
its purchases of materials and services from other firms. In calculating
GDP earnings or value added to a firm, the statistician includes all costs
that go to factors other than businesses and excludes all payments made
to other businesses. Hence business costs in the form of wages, salaries,
interest payments, and dividends are included in value added, but
purchases of wheat or steel or electricity are excluded from value added.
The following table illustrates the concept of value addition in GDP:
Table 1
Bread Receipts, Costs, and Value Added
Rupees Per Loaf
Stages of
Production
(1) (2) (3)
Sales
Receipts
Cost of
Intermediate
Materials
Value
Added
(wages,
profit, etc.)

20. (1 – 2)
Wheat 2.00 0 2.00
Flour 5.50 2.00 3.50
Baked dough 7.25 5.50 1.75
Delivered bread 10.00 7.25 2.75
Total 24.75 14.75 10.00
(i) Non-productive transactions are excluded from GDP: The non-
productive transactions are excluded from GDP measurement. There are
two types of non-productive transactions:
(i) Purely financial transactions: Purely financial transactions are:
 All public transfer payments, which do not add to the current
flow of goods such as social security payments, relief
payments, etc.
 All private financial transactions, such as receipt of money
by a student from his father, etc.
 Buying and selling of marketable securities, which make no
contribution to current production.
(ii) Sale proceeds of second-hand goods.
Difference between GDP and GNP:
GDP is the most widely used measure of national output in Pakistan. Another
concept is widely cited, i.e., GNP. GNP is the total output produced with labour
or capital owned by Pakistani residents, while GDP is the output produced with
labour and capital located inside Pakistan. For example, some of Pakistani GDP
is produced in Honda plants that are owned by Japanese corporations. The
profits from these plants are included in Pakistani GDP but not in Pakistani GNP.
Similarly, when a Pakistani university lecturer flies to Japan to give a paid lecture
on ‘economies of under-developed countries’, that lecturer’s salary would be
included in Japanese GDP and in Pakistani GNP.
Net National Product (NNP):
Net national product (NNP) or national income at market price can be obtained
by deducting depreciation from GNP. NNP is a sounder measure of a nation’s
output than GNP, but most of the economists work with GNP. This is so because
depreciation is not easier to estimate. Whereas the gross investment can be
estimated fairly-accurately.
NNP equals the total final output produced within a nation during a year, where
output includes net investment or gross investment less depreciation. Therefore,
NNP is equals to:

21. NNP = GNP – Depreciation
It is the net market value of all the final goods and services produced in a country
during a year. It is obtained by subtracting the amount of depreciation of existing
capital from the market value of all the 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 GNP for meeting the necessary expenditure
of wear and tear, deterioration and obsolescence of the capital and ‘it should
remain intact’.
In the above definition, 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.
National Income or National Income at Factor Cost:
National income (NI) or national income at factor cost is the aggregate earnings
of all the factors of production (i.e., land, labour, capital, & organisation), which
arise from the current production of goods and services by the nation’s economy.
The major components of national income are:
(i) Compensation of employees (i.e., wages, salaries, commission,
bonus, etc.);
(ii) Proprietors income (profits of sole proprietorship, partnership, and
joint stock companies);
(iii) Net income from rentals and royalties; and
(iv) Net interest (excess of interest payments of the domestic business
system over its interest receipts and net interest received from
abroad).
National income can be calculated as follows:
National Income = NNP – Indirect Taxes + Subsidies
Personal Income:
Personal Income is the total income which is actually received by all individuals
or households during a given year in a country. Personal income is always less

22. than NI because NI is the sum total of all incomes earned, whereas, the personal
income is the current income received by persons from all sources. It should be
noted here that all the income items which are included in NI are not paid to
individuals or households as income. For instance, the earnings of corporation
include dividends, undistributed profits and corporate taxes. The individuals only
receive dividends. Corporate taxes are paid to government, and the
undistributed profits are retained by firms. There are certain income items paid
to individuals, but not included in the national income, commonly known as
‘transfer payments’. Transfer payments include old age benefits, pension,
unemployment allowance, interest on national debt, relief payments, etc.
Personal income can be measured as follows:
Personal Income = NI at Factor Cost – Contributions to Social Insurance –
Corporate Income Taxes – Retained Corporate Earnings + Transfer
Payments
Disposable Income:
Disposable income is that income which is left with the individuals after paying
taxes to the government. The individuals can spend this amount as they please.
However, they can spend in categorically two ways, i.e., either they can spend on
consumption goods, or they can save. Therefore, the disposable personal
income is equal to:
Disposable Income = Personal Income – Personal Taxes
or
Disposable Income = Consumption + Saving

23. Details of National Income Accounts:
It is very important to take a brief tour of major components or particulars of
national accounts or product accounts. In this way, we can thoroughly
understand the concept of GDP/GNP:
(a) GDP Deflator: The problem of changing prices is one of the
problems economists have to solve when they use money as their
measuring rod. Clearly, we want a measure of the nation’s output
and income that uses an invariant yardstick. This problem can be
solved by using ‘price index’, which is a measure of the average
price of a bundle of goods. The price index is used to remove
inflation from GDP or to deflate the GDP, that is why, it is also
called ‘GDP deflator’. The function of GDP deflator is to convert the
‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’. The
formula of real GDP is as follows:
Real GDP = Nominal GDP
GDP Deflator

24. or
Q = PQ
P
Nominal GDP or PQ represents the total money value of final
goods and services produced in a given year, where the values in
terms of the market prices of each year. Real GDP or Q removes
price changes from nominal GDP and calculate GDP in constant
prices. And the GDP deflator or P is defined as the price of GDP.
Example:
A country produces 100,000 litres of coconut oil during the year 2005 at a price
of Rs. 25 per litre. During the year 2006, she produces 110,000 litres of coconut
oil at a price of Rs. 27 per litre. Calculate nominal GDP, GDP deflator and real
GDP (using 2005 as base year).
Solution:
Nominal GDP:
Year
Price
P
Quantity
Q
Price × Quantity
PQ
Nominal GDP
2005 25 100,000 2,500,000
2006 27 110,000 2,970,000
Hence, during 2006, the nominal GDP grew by 18.8%.
GDP Deflator:
P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1
P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 =
1.08
Real GDP:
Year
Nominal GDP
PQ
GDP Deflator
P
Real GDP
(PQ/P)
Q
2005 2,500,000 1 2,500,000
2006 2,970,000 1.08 2,750,000

25. Hence, during 2006, the real GDP grew by 10%.
(b) Investment and Capital Formation: Investment consists of the
additions to the nation’s capital stock of buildings, equipment, and
inventories during a year. Investment involves sacrifice of current
consumption to increase future consumption. Instead of eating
more pizzas now, people build new pizza ovens to make it possible
to produce more pizza for future consumption.
To economists, investment means production of durable
capital goods. In common usage, investment often denotes
using money to buy shares from stock exchange or to open
a saving account in a bank. In economic terms, purchasing
shares or government bonds or opening bank accounts is
not an investment. The real investment is that only when
production of physical capital goods takes place.
Investment can be further categorised as:
(i) Gross investment: Gross investment includes all the
machines, factories, and houses built during a year – even
though some were bought to replace some old capital goods.
Gross investment is not adjusted for depreciation, which
measures the amount of capital that has been used up in a
year.
(ii) Net investment: Gross investment does not adjust the deaths
of capital goods; it only takes care of the births of capital.
However, the net investment takes into account the births as
well as deaths of capital goods. In other words, net investment
is adjusted for depreciation. Therefore, the net investment plays
a vital role in estimating national income:
Net Investment = Gross Investment – Depreciation
(c) Government Expenditure: Government expenditures include
buying goods like from roads to missiles, and paying wages like
those of marine colonels and street sweepers. In fact, it is the third
great category of flow of products. It involves all the expenditures
incurred on running the state. However, it does not mean that GDP
includes all the government expenditures including ‘government
transfer payments’. The government transfer payments, which
include payments to individuals that are not made in exchange for
goods and services supplied, are excluded from GDP
measurement. Such transfers payments include expenditures on

26. pensions, old-age benefits, unemployment allowances, veterans’
benefits, and disability payments. One peculiar government
transfer payment is ‘interest on national debts’. This is a return on
debt incurred to pay for past wars or government programmes and
is not a payment for current government goods and services.
Therefore, the interests are excluded from GDP calculations.
(d) Net Exports: ‘Net exports’ is the difference between exports and
imports of goods and services. Pakistan is facing negative net
export situation since her birth, except for few years. The biggest
reason is that Pakistan is a developing nation and consistently
importing capital goods and final consumption goods from
developed countries at much higher prices. Whereas, we export
raw materials and intermediate goods at lower prices, which have
less demand due to their poor quality or because of availability of
much cheaper substitute goods in the market.
Circular Flow of Income
The amount of income generated in a given economy within a period of time (national
income) can be viewed from three perspectives. These are:
 Income,
 Product, and
 Expenditure.
The above assertion implies that we can view national income as either the total sum of
all income received within a particular period (income); the total good and services
produced within a particular period (product) or total expenditure on goods and services
within a given period (expenditure). Whichever approach is used, the value we get is the
same.
The circular flow of income and product is used to show diagrammatically, the
equivalence between the income approach and the product approach in measuring gross
national product (GNP).
In analysing the circular flow of income, there are three scenarios:
1. A simple and closed economy with no government and external transactions,
i.e., two-sector economy;
2. A mixed and open economy with savings, investment and government activity,
i.e., three-sector economy; and

27. 3. A mixed and open economy with savings, investment, government activity and
external trade, i.e., four-sector economy.
1. Circular Flow of Income in a Two-Sector Economy:
According to circular flow of income in a two-sector economy, there are only two sectors
of the economy, i.e., household sector and business sector. Government does not exist at
all, therefore, there is no public expenditure, no taxes, no subsidies, no social security
contribution, etc. The economy is a closed one, having no international trade relations.
Now we will discuss each of the two sectors:
(i) Household Sector: The household sector is the sole buyer of goods and services,
and the sole supplier of factors of production, i.e., land, labour, capital and
organisation. It spends its entire income on the purchase of goods and services
produced by the business sector. Since the household sector spends the whole
income on the purchase of goods and services, therefore, there are no savings and
investments. The household sector receives income from business sector by
providing the factors of production owned by it.
(ii) Business Sector: The business sector is the sole producer and supplier of goods
and services. The business sector generates its revenue by selling goods and
services to the household sector. It hires the factors of production, i.e., land,
labour, capital and organisation, owned by the household sector. The business
sector sells the entire output to households. Therefore, there is no existence of
inventories. In a two-sector economy, production and sales are thus equal. So
long as the household sector continues spending the entire income in purchasing
the goods and services from the business sector, there will be a circular flow of
income and production. The circular flow of income and production operates at
the same level and tends to perpetuate itself. The basic identities of the two-
sector economy are as under:
Y = C
Where Y is Income
C is Consumption

28. Circular Flow of Income in a Two-Sector Economy (Saving Economy):
In a two-sector macro-economy, if there is saving by the household sector out of its
income, the goods of the business sector will remain unsold by the amount of savings.
Production will be reduced and so the income of the households will fall. In case the
savings of the households is loaned to the business sector for capital expansion, then the
gap created in income flow will be filled by investment. Through investment, the
equilibrium level between income and output is maintained at the original level. It is
illustrated in the following figure:

29. The equilibrium condition for two-sector economy with saving is as follows:
Y = C + S or Y = C + I or C + S = C + I
or
S = I
Where Y is Income
C is Consumption
S is Saving
I is Investment
When saving and investment are added to the circular flow, there are two paths by which
funds can travel on their way from households to product markets. One path is direct, via
consumption expenditures. The other is indirect, via saving, financial markets, and
investment.

30. Savings: On the average, households spend less each year than they receive in income.
The portion of household income that is not used to buy goods and services or to pay
taxes is termed ‘Saving’. Since there is no government in a two-sector economy,
therefore, there are no taxes in this economy.
The most familiar form of saving is the use of part of a household’s income to make
deposits in bank accounts or to buy stocks, bonds, or other financial instruments, rather
than to buy goods and services. However, economists take a broader view of saving.
They also consider households to be saving when they repay debts. Debt repayments are
a form of saving because they, too, are income that is not devoted to consumption or
taxes.
Investment: Whereas households, on the average, spend less each year than they receive
in income, business firms, on the average, spend more each year than they receive from
the sale of their products. They do so because, in addition to paying for the productive
resources they need to carry out production at its current level, they desire to undertake
investment. Investment includes all spending that is directed toward increasing the
economy’s stock of capital.
Financial Market: As we have seen, households tend to spend less each year than they
receive in income, whereas firms tend to spend more than they receive from the sale of
their products. The economy contains a special set of institutions whose function is to
channel the flow of funds from households, as savers, to firms, as borrowers. These are
known as ‘financial markets’. Financial markets are pictured in the center of the circular-
flow diagram in the above figure.
Banks are among the most familiar and important institutions found in financial markets.
Banks, together with insurance companies, pension funds, mutual funds, and certain other
institutions, are termed ‘financial intermediaries’, because their role is to gather funds
from savers and channel them to borrowers in the form of loans.
2. Circular Flow of Income in a Three-Sector Economy:
We have so far discussed the two-sector economy consisting of household sector and
business sectors. Under three-sector economy, the additional sector is the government.
Two-sector economy is a hypothetical economy, whereas the three-sector economy is
much more realistic. The inclusion of the government sector is very essential in
measuring national income. The government levies taxes on households and on business
sector, purchases goods and services from business sector, and attain factors of
production from household sector. The following figure illustrates three-sector economy:

31. In the above diagram, in one direction, the household sector is supplying factors of
production to the factor market. Business sector demands the factors of production from
factor market. Inputs are used by the business sector, which produces goods and services
that are purchased back by the households and the government. Personal income after
tax or disposable income that is received by households from business sector and
government sector is used to purchase goods and services and makes up consumption
expenditure (or C). The money spent in the product market is the market value of final
goods and services (or GDP). That money goes to business sector that pays it back in the
form of wages, rent, profits and interests.
Total spending on goods and services is known as ‘aggregate demand’. The total market
value of output produced and sold is also known as ‘aggregate supply’. To measure
aggregate demand in a closed economy, we simply add consumption spending (C),
investment spending (I) and government spending (G). Therefore:
Y = C + I + G
Where Y is Income,

32. C is Consumption,
I is Investment, and
G is Government Spending.
Note that government spending (G) includes its buying of labour from factor market,
buying of goods and services from product market, and transfer payments to the
household sector. Transfer payments are payments the government makes in return for
no service, for example, welfare payments, unemployment compensation, pension, etc.
The government collects its money in the form of tax, which makes up most of the
government revenue. But the government does not always balance their budgets. The
government always tends to spend more than it takes in as taxes. The federal government
almost always runs a deficit. The government deficit must be financed by borrowing in
financial markets. Usually this borrowing takes the form of sales of government bonds
and other securities to the public or to financial intermediaries. Over time, repeated
government borrowing adds to the domestic debt. The ‘debt’ is a stock that reflects the
accumulation of annual ‘deficits’, which are flows. When the public sector as a whole
runs a budget surplus, the direction of the arrow is reversed. Governments pay off old
borrowing at a faster rate than the rate at which new borrowing occurs, thereby creating a
net flow of funds into financial markets.
3. Circular Flow of Income in a Four-Sector Economy:
Two-sector economy and three-sector economy are briefly discussed in previous sections.
These are hypothetical economies. In real life, only four-sector economy exists. The
four-sector economy is composed of following sectors, i.e.:
(i) Household sector,
(ii) Business sector,
(iii) The government, and
(iv) Transaction with ‘rest of the world’ or foreign sector or external sector.
The household sector, business sector and the government sector have already been
defined in the previous sections. The foreign sector includes everyone and everything
(households, businesses, and governments) beyond the boundaries of the domestic
economy. It buys exports produced by the domestic economy and produces imports
purchased by the domestic economy, which are commonly combined into net exports
(exports minus imports). The inclusion of fourth sector, i.e., foreign sector or transaction
with ‘rest of the world’ makes the national income accounting more purposeful and
realistic. With the inclusion of this sector, the economy becomes an open economy. The
transaction with ‘rest of the world’ involves import and export of goods and services, and
new foreign investment. It is illustrated in the following figure.

33. In four-sector economy, goods and services available for the economy’s purchase include
those that are produced domestically (Y) and those that are imported (M). Thus, goods
and services available for domestic purchase is Y+M. Expenditure for the entire economy
include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus:
Y + M = C + I + G + X
Y = C + I + G + (X – M)
Where,C = Consumption expenditure

34. I = Investment spending
G = Government spending
X = Total Exports
M = Total Imports
X – M = Net Exports
Economy Leakages and Injections:
Leakages: When households engage in savings and purchase of goods and services from
abroad, we experience temporary withdrawal of funds from circulation. Therefore,
leakages in the circular flow are savings, taxes and imports
Injection: On the other hand, when we sell abroad (export) we receive income. More so
when foreigners invest in our country the level of income will also increase. These two
activities are injection into the income stream. Therefore, injections are investment,
government spending and exports.
Total Leakages = Total Injections
C + I + G + (X-M) = C + S + Net Taxes
S + Net Taxes + Imports = I + G + Exports
S = I + (G – NT) + (X – M)
One way of thinking about the circular flow of income is to imagine a water tank.
Investment, government spending and spending by foreigners is injected into the tank,
and savings, taxes and spending on imports leak out. The injections and the withdrawals
are equal to each other so the level in the tank is stable, or as economists like to say in
equilibrium.

35. If injections are greater than withdrawals or leakages then the level in the tank will rise. If
withdrawals are greater than injections then the level in the tank falls. If planned (I+G) is
equal to planned (S+T), so that injections is equal to leakages and total spending is equal
to total income and total demand is equal to total supply. Then we have a ‘stable
economy’. If leakages are higher than injections i.e., planned savings plus taxes are
greater than planned investment plus government spending (S+T > I+G), economy
contracts resulting in inventory accumulation, too little spending and drop in prices. If
injections are higher than leakages, i.e., planned investment plus government spending
are greater than planned saving plus taxes (I+G > S+T), economy expands resulting in
more goods and services produced, and higher prices.
Theory of Employment
TYPES OF UNEMPLOYMENT:
(a) Structural Unemployment: It is also known as Marxian unemployment
or long-term unemployment. It is due to slower growth of capital stock in
the country. The entire labour force cannot be absorbed in productive
employment, because there are not enough instruments of production to
employ them.
(b) Seasonal Unemployment: Seasonal unemployment arises because of
the seasonal character of a particular productive activity so that people
become unemployed during the slack season. Occupations relating to
agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.
(c) Frictional Unemployment: It arises when the labour force is temporarily
out of work because of perfect mobility on the part of the labour. In a
growing and dynamic economy, in which some industries are declining
and others are rising and in which people are free to work wherever they
wish, some volume of frictional unemployment is bound to exist. This is
so because it takes some time for the unemployed labour to learn new

36. trades or to shift to new places, where there is a demand for labour. Thus,
frictional unemployment exists when there is unsatisfied demand for
labour, but the unemployed workers are either not fit for the jobs in
question or not in the right place to meet this demand.
(d) Cyclical Unemployment: It is also known as Keynesian unemployment.
It is due to deficiency of aggregate effective demand. It occurs when
business depression occurs. During the times of depression, business
activity is at low ebb and unemployment increases. Some people are
thrown out of employment altogether and others are only partially
employed. This type of unemployment is due to the fact that the total
effective demand of the community is not sufficient to absorb the entire
productive of goods that can be produced with the available stock of
capital. When the businessmen cannot sell their goods and services, their
profit expectations are not fulfilled. So the entrepreneurs reduce their
output and some factors of production become unemployed.
(e) Disguised Unemployment: Disguised unemployment is the most
widespread type of unemployment in under-developed countries. In
under-developed countries, the stock of capital does not grow fast. The
capital stock has not been growing at a rate fast enough to keep pace with
the growth of population, the country’s capacity to offer productive
employment to the new entrants to the labour market has been severely
limited. This manifests itself generally in two ways:
(i) the prevalence of large-scale unemployment in
the urban areas; and
(ii) in the form of growing numbers engaged in
agriculture, resulting in ‘disguised unemployment’.
In disguised unemployment, there is an existence of a very backward
agricultural economy. People are engaged in production with an
extremely low or zero marginal productivity. Since the employment
opportunities in non-agricultural sector are not sufficient, therefore, most of
the workers are bound to work in agricultural sector. This gives rise to the
concept of ‘disguised unemployment’, in which people are unwillingly
engaged in occupations, where their marginal productivity is very low.
THEORIES OF EMPLOYMENT:
The theories of employment are broadly classified into two:
(a) Classical theory of employment
(b) Keynesian theory of employment.

37. The classical theory assumed the prevalence of full employment. The ‘Great
Depression’ of 1929 to 1934, engulfing the entire world in widespread
unemployment, low output and low national income, for about five years, upset
the classical theorists. This gives rise to Keynesian theory of employment.
Classical Theory of Employment:
The term ‘classical economists’ was firstly used by Karl Marx to describe
economic thought of Ricardo and his predecessors including Adam Smith.
However, by ‘classical economists’, Keynes meant the followers of David Ricardo
including John Stuart Mill, Alfred Marshal and Pigou. According to Keynes, the
term ‘classical economics’ refers to the traditional or orthodox principles of
economics, which had come to be accepted, by and large, by the well known
economists by then. Being the follower of Marshal, Keynes had himself accepted
and taught these classical principles. But he repudiated the doctrine of laissez-
faire. The two broad features of classical theory of employment were:
(a) The assumption of full employment of labour and other productive
resources, and
(b) The flexibility of prices and wages to bring about the full employment
(a) Full employment:
According to classical economists, the labour and the other resources are always
fully employed. Moreover, the general over-production and general
unemployment are assumed to be impossible. If there is any unemployment in
the country, it is assumed to be temporary or abnormal. According to classical
views of employment, the unemployment cannot be persisted for a long time, and
there is always a tendency of full employment in the country. According to
classical economists, the reasons for unemployment are:
(i) Intervention by the government or private monopoly,
(ii) Wrong calculation by entrepreneurs and inaccurate decisions,
and
(iii) Artificial resistance.
The economy is assumed to be self-adjusting and perfectly competitive
economy. It is the economy in which the relative values of goods and services
are determined by the general relations of demand and supply. The pricing
system serves as the planning mechanism.
(b) Flexibility of prices and wages:

38. The second assumption of full employment theory is the flexibility of prices and
wages. It is the flexibility of prices and wages which automatically brings about
full employment. If there is general over-production resulting in depression and
unemployment, prices would fall as a result of which demand would increase,
prices would rise and productive activity will be stimulated and unemployment
would tend to disappear. Similarly, the unemployment could be cured by cutting
down wages which would increase the demand for labour and would stimulate
activity. Thus, if the prices and wages are allowed to move freely, unemployment
would disappear and full employment level would be restored. Further, the
classical economists treated money as mere exchange medium. They ignored
its role in affecting income, output and employment.
Say’s Law:
1. Say’s Law is the foundation of classical economics. Assumption of full
employment as a normal condition of a free market economy is justified by
classical economists by a law known as ‘Say’s Law of Markets’.
2. It was the theory on the basis of which classical economists thought that
general over-production and general unemployment are not possible.
3. According to the French economist J. B. Say, supply creates its own
demand. According to him, it is production which creates market for
goods. More of production, more of creating demand for other goods.
There can be no problem of over-production.
4. Say denies the possibility of the deficiency of aggregate demand.
5. The conceived Say’s Law describes an important fact about the working of
free-exchange of economy that the main source of demand is the sum of
incomes earned by the various productive factors from the process of
production itself. A new productive process, by paying out income to its
employed factors, generates demand at the same time that it adds to
supply. It is thus production which creates market for goods, or supply
creates its own demand not only at the same time but also to an equal
extent.
6. According to Say, the aggregate supply of commodities in the economy
would be exactly equal to aggregate demand. If there is any deficiency in
the demand, it would be temporary and it would be ultimately equal to
aggregate supply. Therefore, the employment of more resources will
always be profitable and will take to the point of full employment.
7. According to Say’s Law, there will always be a sufficient rate of total
spending so as to keep all resources fully employed. Most of the income
is spent on consumer goods and a par of it is saved.

39. 8. The classical economists are of the view that all the savings are spent
automatically on investment goods. Savings and investments are
interchangeable words and are equal to each other.
9. Since saving is another form of spending, according to classical theory, all
income is spent partly for consumption and partly for investment.
10. If there is any gap between saving and investment, the rate of interest
brings about equality between the two.
Basic Assumptions of Say’s Law:
(a) Perfectly competitive market and free exchange economy.
(b) Free flow of money incomes. All the savings must be immediately
invested and all the income must be immediately spent.
(c) Savings are equal to investment and equality must bring about by
flexible interest rate.
(d) No intervention of government in market operations, i.e., a laissez faire
economy, and there is no government expenditure, taxation and
subsidies.
(e) Market size is limited by the volume of production and aggregate
demand is equal to aggregate supply.
(f) It is a closed economy.
Pigou’s Theory:
1. According to Professor Pigou, the unemployment which exists at any time
is because of the fact that changes in demand conditions are continually
taking place and that frictional resistances prevent the appropriate wage
adjustment from being made instantaneously.
2. Thus, according to classical theory, there could be small amounts of
‘frictional unemployment’ attendant on changing from one job to another
but there could not be ‘involuntary unemployment’ for a long period.
3. According to Professor Pigou, if people were unemployed, wages would
fall until all seeking employment were in fact employed.
4. Involuntary unemployment which was found at times of depression was
because of the fact that wages were kept too high by the actions of labour
unions and governments. Therefore, Professor Pigou advocated that a

40. general cut in money wages at a time of depression would increase
employment.
5. According to Pigou, perfectly elastic wage policy would abolish
fluctuations of employment and would ensure full employment.
6. The of the economy as described by the classical theory is depicted as
follows:
Suppose the consumer saves 10% of his income. The result will be firm’s
receipts fall by the same proportion. Profit will fall and the firm will tend to react
by reducing the output and hence reducing the employment and income.
Therefore, to avoid this problem the savings are channelled to firms through
banking.
Criticism of Classical Theory:

41. 1. Supply may not create its own demand when a part of the income is
saved. Aggregate demand is not always equal to aggregate supply.
2. Employment in a country cannot be increased by cutting general
wages.
3. There is no direct relationship between wages and employment.
4. Interest rate adjustments cannot solve savings-investment problem.
5. Classical economists have made the economy completely self-adjusting
and self-reliant. An economy is not so self-adjusting and government
intervention is unobvious.
6. Classical economists have made the wages and prices so much flexible.
In practical, wages and prices are not so flexible. It will create chaos
in the economy.
7. Money is not a mere medium of exchange. It has an essential role in
the economy.
8. The classical theory has failed to explain the occurrence of trade
cycles.
Keynesian Theory of Employment:
Keynes has strongly criticised the classical theory in his book ‘General Theory of
Employment, Interest and Money’. His theory of employment is widely accepted
by modern economists. Keynesian economics is also known as ‘new economics’
and ‘economic revolution’. Keynes has invented new tools and techniques of
economic analysis such as consumption function, multiplier, marginal efficiency
of capital, liquidity preference, effective demand, etc. In the short run, it is
assumed by Keynes that capital equipment, population, technical knowledge,
and labour efficiency remain constant. That is why, according to Keynesian
theory, volume of employment depends on the level of national income and
output. Increase in national income would mean increase in employment. The
larger the national income the larger the employment level and vice versa. That
is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of
income’.
Theory of Effective Demand:
According to Keynes, the level of employment in the short run depends on
aggregate effective demand for goods in the country. Greater the aggregate
effective demand, the greater will be the volume of employment and vice versa.
According to Keynes, the unemployment is the result of deficiency of effective

42. demand. Effective demand represents the total money spent on consumption
and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and
consumption. The gap can be filled up by increasing investment and hence
effective demand, in order to maintain employment at a high level.
According to Keynes, the level of employment in effective demand depends on
two factors:
(a) Aggregate supply function, and
(b) Aggregate demand function.
(a) Aggregate supply function:
1. According to Dillard, the minimum price or proceeds which will induce
employment on a given scale, is called the ‘aggregate supply price’ of
that amount of employment.
2. If the output does not fetch sufficient price so as to cover the cost, the
entrepreneurs will employ less number of workers.
3. Therefore, different numbers of workers will be employed at different
supply prices.
4. Thus, the aggregate supply price is a schedule of the minimum amount
of proceeds required to induce varying quantities of employment.
5. We can have a corresponding aggregate supply price curve or
aggregate supply function, which slopes upward to right.
(b) Aggregate demand function:
1. The essence of aggregate demand function is that the greater the
number of workers employed, the larger the output. That is, the
aggregate demand price increases as the amount of employment
increases, and vice versa.
2. The aggregate demand is different from the demand for a product. The
aggregate demand price represents the expected receipts when a given
volume of employment is offered to workers.

43. 3. The aggregate demand curve or aggregate demand function represents
a schedule of the proceeds of the output produced by different methods
of employment.
Determination of Equilibrium Level of Employment:
1. In the above diagram, AS curve shows the different total amounts which
all the entrepreneurs, taken together, must receive to induce them to
employ a certain number of men. If the entrepreneurs are convinced to
receive OC amount of money, they will employ ON1 number of labour.
2. The AD curve shows the different total amounts which all the
entrepreneurs, taken together, expect to receive at different levels of
employment. If they employed ON1 level of employment, they expect to
receive ON amount of proceeds from the total output.
3. At ON1 level of employment, the economy is not in equilibrium. Because
the total expected amount is greater than the total amount paid:
OH > OC
4. The equilibrium level of employment is ON2, as at this point the AD curve
intersects the AS curve or the AD is just equal to AS. The amount of
proceeds, i.e., OM which entrepreneurs expect to receive from providing
ON2 number of jobs is just equal to the amount i.e. OM which they must
receive if the employment of that number of workers is to be worthwhile for
the entrepreneurs.

44. 5. If the situation is such that the total amount of money expected to be
received from the sale of output exceeds the amount that is considered
necessary to receive, there will be competition among the entrepreneurs
to offer more employment and thus, the employment will increase. On the
left of N2, AD is greater than AS, i.e., the amount expected to be received
is greater than the amount considered necessary, there will be competition
amount entrepreneurs to employ more labour.
6. Beyond the N2, the AD curve lies below AS curve, which means that the
amount expected by the entrepreneurs is less that the amount they
considered necessary to receive. Therefore, the number of persons
employed will be reduced in the economy.
7. The slope of AS curve, at first rises slowly and then after a point it rises
sharply. It means that at beginning as more and more men are employed,
the cost of output rises slowly. But as the amount received by the
entrepreneurs increases they employ more and more men. As soon as
the entrepreneurs start getting OT amount, they will be prepared to
employ all of the workers.
8. The AD curve, in the beginning, rises sharply, but it flattens towards the
end. This shows that in the beginning as more men are employed, the
entrepreneurs expect to get sharply increasing amounts of money from
the sale of the output. But after employment has sufficiently increased,
the expected receipts do not rise sharply.
9. Effective demand is that aggregate demand price which becomes
‘effective’ because it is equal to aggregate supply price and thus
represents a position of short-run equilibrium.
10. Effective demand also represents the value of national output because
the value of national output is equal to the total amount of money received
by the entrepreneurs from the sale of goods and services. The money
received by the entrepreneurs from the sale of goods is equal to the
money spent by the people on these goods. Hence the equation is:
Effective demand = National income
= Value of national output
= National expenditure
= Expenditure on consumption goods +
Expenditure on investment goods

45. 11. It is not necessary that the equilibrium level of employment is always at
full employment level. Equality between AD and AS does not necessarily
indicate the full employment level. It can be in equilibrium at less that full
employment or an under-employment equilibrium.
12. Actually there is always some unemployment in the economy, even in
economically advanced countries.
13. According to Keynes, full employment is the level of employment beyond
which further increases in effective demand do not increase output and
employment.
14. At the point of intersection of AS and AD, the entrepreneurs are
maximising their profits. The profit will be reduced if volume of
employment is more or less that this point. Even if the point does not
represent full employment.
15. AD and AS will be equal at full employment only if the investment demand
is sufficient to cover the gap between the AS price and consumption
expenditure. The typical investment falls short of this gap. Hence the AD
curve and AS curve will intersect at a point less than full employment,
unless there is some external change.
16. In the above diagram, in this situation of aggregate supply (AS), ON’
number of men were seeking employment, whereas only ON number of
men could secure employment.
17. In this situation, the economy has not yet reached the full employment
level, and there are still NN’ number of workers unemployed in the
economy.

46. 18. If the favourable circumstances push the economy and the AD increases
so much that the entrepreneurs now find it worthwhile to employ ON’ men
at the equilibrium point E’, where the economy is in full employment level.
19. The situation in which the economy is in equilibrium at the level of full
employment is called the ‘optimum situation’.
20. The root cause of the under-employment equilibrium is the deficiency of
AD. This deficiency is due to the fact that there is a gap between income
and consumption. As income increases consumption increases but not
proportionately. If the investment is increased sufficiently to cover this
gap, there can be full employment. Hence the gap between income and
consumption and insufficiency of investment to this gap are responsible
for under-employment equilibrium.
Comparison between Classical and Keynes’ Theories:
(a) Equilibrium at full employment:
(i) According to classical theory, the economy can only be
in a state of equilibrium at full employment level. Any deviation from
full employment would be of short period.
(ii) Keynes’ theory is of the viewpoint that an economy can
be in equilibrium even at less than full employment level. There is a
small possibility of full employment in a country.
(b) Macro vs. Micro:
(i) The classical economic theory dealt with individual
aspects of the economy, and relates to microeconomics.
(ii) Keynes’ theory relates to macroeconomics which
studies the economy as a whole.
(c) Aggregates vs. Innumerable decisions:
(i) The classical economic theory studies the economic
system in terms of innumerable decision making units, for example,
producers’ equilibrium and consumers’ equilibrium.
(ii) Whereas, the Keynes’ theory deals with aggregates, for
example, aggregate supply and aggregate demand.
(d) Wages and employment:

47. (i) Classical economists believed that a state of full
employment could be brought about through cuts in money wages.
(ii) According Keynes, lowering wages will reduce the
aggregate income and so effective demand which in turn reduce the
level of employment in an economy.
(e) Interest:
(i) According to classical theorists, interest is the reward
for ‘waiting’ or for time preference.
(ii) According to Keynes, interest is a reward for parting
with liquidity.
(f) Rate of interest:
(i) According to classical theory, the rate of interest is
determined by the interaction of savings and investment.
(ii) According to Keynesian theory, the rate of interest is
determined at different levels of income.
(g) Statics vs. Dynamics:
(i) The classical theory is based on the conception of static
economy.
(ii) The Keynesian theory is based on the conception of
dynamic economy.
(h) Full employment theory vs. General theory:
(i) The classical theory relates only to full employment.
(ii) The Keynesian approach is a general theory which has
a very wide application at all situations, i.e., unemployment, partial
employment and near full-employment.
(i) Theory of money and prices:
(i) The classical economists had segregated the theory of
money from the theory of value and output, and dealt with them as if
they are unrelated to one another which is actually not the case.

48. (ii) Keynes’ theory is more realistic. He has integrated the
theory of money and prices with the theory of income and
employment in the country.
(j) Budgeting:
(i) Classical economists believed in orthodox finance and
balanced budgets.
(ii) According to Keynes’ a country’s budget should reflect
the financial situation, and should vary in accordance with the
requirements. Keynes has not emphasised on balanced budget,
because there are several developing countries with deficit budgets
dictated by their economic conditions and requirements.
(k) Supply of money:
(i) According to classical economists, increase in money
supply would bring about inflation and should be controlled in order to
avoid the employment less than full employment.
(ii) Whereas, the Keynes’ theory states that an appropriate
increase in money supply would increase employment and output
and does not necessarily bring inflation.
(l) General price level vs. Individual commodity prices.
(m) Level of employment in a community vs. Employment of a particular
class of labour.
Significance of Keynesian Theory:
1. Keynes has given a new approach, i.e., Macro-approach to the field of
economics. His theory has several names: theory of income and
employment, demand-side theory, consumption theory, and macro-
economic theory. In fact, he has brought about a revolution in economic
analysis, often known as ‘Keynesian Revolution’.
2. Keynes’ theory has completely demolished the idea of full-
employment and forwards the idea of under-employment equilibrium. He
states that employment level in the economy can only be increased by
increasing investment.
3. The new economic tools and techniques developed by Keynes have
enabled the today’s economists to draw correct conclusions on the

49. economic situation of a country. Such tools are consumption function,
multiplier, investment function, liquidity preference, etc.
4. Keynes has integrated the theory of money with the theory of value
and output.
5. Keynes has first time introduced a dynamic economic theory, in order
to depict more realistic situation of the economy.
6. He also states the reasons of excess or deficiency of aggregate demand
through inflationary and deflationary gap analysis.
7. Keynes’ theory is a general theory and therefore, can be applied to all
types of economic systems.
8. Keynes influenced on practical policies and criticised the policy of
surplus budget. He advocated deficit financing, if that sited the economic
situation in the country.
9. Keynes has emphasised on suitable fiscal policy as an instrument for
checking inflation and for increasing aggregate demand in a country. He
advocated extensive public work programmes as an integral part of
government programmes in all countries for expanding employment.
10. He advised several monetary controls for the central bank, which in
turn will act as the instrument of controlling cyclical fluctuations.
11. Keynesian theory has played a vital role in the economic development
of less-developed countries.
12. He rejected the theory of wage-cut as a means of promoting full-
employment.
13. Keynes’ theory has given rise to the importance of social accounting or
national income accounting.
Criticism on Keynes’ Theory:
1. According to Schumpeter, the Keynes theory is a depression theory,
which has limited applications.
2. Some socialist or communist economists had said that Keynes’ theory is
dead if communism comes. However, even the socialist countries have
strived to raise their national income by using Keynesian theory.

50. 3. Keynesian theory is not as much dynamic and it may more properly be
called comparative statics.
4. Keynesian theory has ignored microanalysis and is not helpful in the
solution of the problems of individual firms and consumers.
5. Keynes has not given any place to the accelerator principle.
6. It pays excessive attention to money in economic analysis.
Relevance of Keynes’ Theory to Less-Developed Countries (LDCs)
(Extended Criticism):
1. The Keynesian theory is primarily for fighting depression. The
assumptions on which Keynesian theory is based are:
(a) The multiplier, and
(b) Short-term analysis.
2. In the short-term analysis, Keynes assumes that capital equipment,
technology, organisation, labour and their efficiency remains
constant. He thinks that the problems relating to employment in
developed countries arises only on account of the deficiency of demand.
3. But the problem in case of LDCs is to increase capital equipment, to
improve technology and labour efficiency. Solving this problem will take
a long process; it cannot be solved in short-run.
4. The developing countries like Pakistan and India, the basic cause of
unemployment is low rate of savings and investment.
5. Most of the LDCs are agriculturists and the Keynesian approach is
industry-oriented. Therefore, increase in national income by deficit
spending will lead to increase in demand for food. This will raise the
prices of food grains. Therefore, heavy reliance on Keynesian approach
could mislead the economists, and can plunge the economy into
inflationary spiral.
6. The principle of multiplier does not much work in LDCs. Suppose
new investments are made in the country, increased investment will lead
to the establishment of new factories, workers will get employed, income
will increase, demand will increase, but it does not guarantee the increase
in the supply of goods because there is no excess capacity, and the
supply of productive factors is not elastic. Increased income will be
absorbed in high prices.

51. Determination of National Income
1. In the short run, the level of national income is determined by aggregate
demand and aggregate supply. The supply of goods and services in a
country depends on the production capacity of the community. But during
the short period the productive capacity does not change.
2. If AD increases, output will also increase and the level of national output
(i.e., national income) will rise. On the other hand, if AD decreases, the
national output or national income will also decrease. It follows that the
equilibrium level of NI is determined by AD since the aggregate capacity
remains more or less the same during the short run.
3. Thus, there are two components of effective demand:
(a) Consumption demand, and
(b) Investment demand.
4. Aggregate Demand = Consumption + Investment
i.e., AD = C + I
5. The consumption demand depends on propensity to consume and
income. At a given propensity to consume, as income increases, the
consumption demand will also increase.
6. In the above diagram the 45o line represents aggregate supply line and it
is also called ‘income line’. This income line shows two things:

52. (a) Total output or aggregate supply (C + I), and
(b) National income.
7. In the above diagram, the curve C rises upward to the right which means
that as income increases consumption also increases. The distance
between income line and consumption line represents saving. Thus, NI =
C + S or Y = C + S.
8. One noteworthy thing about propensity to consume is that it remains
stable or constant during the short period. Because the propensity to
consume depends on the tastes and needs of the people and these do not
change in the short run.
9. Since consumption is more or less stable and cannot be varied, therefore,
variation in NI depends on variation in investment.
10. Investment is the second component of AD. Investment depends on two
things:
(a) Marginal efficiency of capital, and
(b) The rate of interest
11. The rate of interest is more or less stable, hence, change in investment
depends on the marginal efficiency of capital (MEC).
12. The MEC means expectations of profit from investment. In other words,
the expected rate of profit is called MEC.
13. The MEC depends on two factors:
(a) Replacement cost of capital goods, and
(b) Profit expectations of investors.
14. If we join the investment demand with the curve C of propensity to
consume, we get AD curve C + I in which C represents consumption and I
investment. The distance between propensity to consume curve C and
AD curve C + I is equal to investment.
15. The level of NI will be determined at point at which the AD and AS curves
intersect each other. At this point AD and AS are in equilibrium.

53. 16. In the above diagram, the equilibrium level of income is OY. At this point
the AD curve and AS curve intersect each other.
17. If the income is more than OY, than total output or AS is greater than AD
(C + I), and the entire output cannot be sold out.
18. If the income is less than OY, then total output or AS is less than AD (C +
I), and the entire output will be sold out. In such a situation there is a
shortage of supply, but the output will be increased in order to cover the
shortage and the NI will also increase.
19. OY is the equilibrium level of income which is less than full employment
level, i.e., OYF. Whereas, the HF corresponds the saving.
20. The economy will be in full employment level only when investment
demand increases so as to cover this saving. But there is no guarantee
that investment demand will exactly be equal to savings.
Equality of Saving and Investment:
1. There is another way of determining the equilibrium level of NI, i.e.,
through equality of savings and investment.
2. Take the same diagram of AD and AS. At point E, the savings and
investment are equal to GE. At above the point the saving is more than
investment, and for income less than this point, the investment is more
than saving. Saving and investment are only equal at the equilibrium level
of income, and when they are not equal, the NI is not in equilibrium.
3. When at a certain level of NI intended investment by the entrepreneurs is
more than intended savings by the people, this would mean that AD is
greater than total output or AS, i.e.,
I > S or AD > AS
This would induce the firms to increase production raising the level of
income and employment.
4. Hence, when at any level of NI, investment is greater than savings, there
will be a tendency for the NI to increase.
5. On contrary, when at any level of NI, the investment demand is less than
saving, it means that AD is less than AS. As a result of a decline in
national output, the national income will also reduce.

54. 6. Saving is withdrawal of some money from the income stream. On the
other hand, investment is the injection of money into the income stream. If
the intended investment is more than intended saving, it means that more
money has been injected in the economy. This would increase the
national income.
7. But when investment is just equal to saving, it would mean that as much
money has been put into income stream as has been taken out of it. The
result would be that the NI will neither increase nor decrease, i.e., it would
be in equilibrium. The determination of NI by investment and saving is
illustrated in the following diagram:
8. In the above diagram, the investment line (II curve) has been drawn
parallel to the X-axis. This is done on the assumption that in any year, the
entrepreneurs intend to invest a certain amount of money. That is, we
assume that investment does not change with income.
9. The saving line (SS curve) shows intended saving at different levels of
income.
10. The saving line and investment line intersect each other at the equilibrium
point E, where the intended saving and the intended investment are equal
at OY level of income. Hence OY is the equilibrium level of NI.
11. In the above diagram, there is no tendency for income to increase or
decrease.

55. 12. If the income level is greater than OY, the amount of intended investment
is less than saving, as a result, the income will finally decrease.
13. If the income level is less than OY, the amount of intended investment is
greater than intended saving, as a result, the income will continue to
increase to the equilibrium level.
Inflationary Gap:
Inflationary gap arises when consumption and investment spending together are
greater than the full employment GNP level. This means that people are
demanding more goods and services than can be produced. In other words, the
implication of inflationary gap is that national income, output and employment
cannot rise further. The only consequence of increased demand is that the price
level will increase. Or we may say that there will be an inflationary gap if
scheduled investment tends to be greater than full employment saving. In a
situation like this, more goods will be demanded than the economic system can
produce. The result will be that price will begin to rise and an inflationary
situation will emerge. Thus, if full employment saving falls short of scheduled
investment at full employment (which means that peoples’ propensity to spend is
higher than the propensity to save), there will be an inflationary gap.
In the above diagram, C + I + G (consumption, investment and government
spending) line shows the total expenditure on demand in the economy. At this
level, Y is the real output, as shown by the intersection, point D, with the 45o line.
YF represents a full employment level on real output. Real income of the
economy, obviously cannot reach Y. At YF, total demand (C + I + G) exceeds
total output, leaving a gap AB, which is the inflationary gap in the Keynesian
sense.