Meaning of Production Function:

In simple words, production function refers to the functional rela

tionship between the quantity of a good produced (output) and factors
of production (inputs).

“The production function is purely a technical relation which connects

factor inputs and output.” Prof. Koutsoyiannis

ADVERTISEMENTS:

Defined production function as “the relation between a firm’s physical

production (output) and the material factors of production (inputs).”
Prof. Watson

In this way, production function reflects how much output we can

expect if we have so much of labour and so much of capital as well as
of labour etc. In other words, we can say that production function is an
indicator of the physical relationship between the inputs and output of
a firm.

The reason behind physical relationship is that money prices do not

appear in it. However, here one thing that becomes most important to
quote is that like demand function a production function is for a
definite period.

It shows the flow of inputs resulting into a flow of output during some
time. The production function of a firm depends on the state of
technology. With every development in technology the production
function of the firm undergoes a change.

The new production function brought about by developing technology

displays same inputs and more output or the same output with lesser
inputs. Sometimes a new production function of the firm may be
adverse as it takes more inputs to produce the same output.

Mathematically, such a basic relationship between inputs and outputs

may be expressed as:
Q = f( L, C, N )

Where Q = Quantity of output

L = Labour

ADVERTISEMENTS:

C = Capital

N = Land.

Hence, the level of output (Q), depends on the quantities of different

inputs (L, C, N) available to the firm. In the simplest case, where there
are only two inputs, labour (L) and capital (C) and one output (Q), the
production function becomes.

Q =f (L, C)

The Demand for Labour

 Many factors influence how many people a business is willing and able to take
on. But we start with the most obvious – the wage rate or salary

 There is an inverse relationship between the demand for labour and the wage
rate that a business needs to pay as they take on more workers

 If the wage rate is high, it is more costly to hire extra employees

 When wages are lower, labour becomes relatively cheaper than for example
using capital inputs. A fall in the wage rate might create a substitution effect and
lead to an expansion in labour demand.
The Demand for Labour

Shifts in the Demand for Labour

The number of people employed at each wage level can change and in the next
diagram we see an outward shift of the labour demand curve. The curve shifts when
there is a change in the conditions of demand in the jobs market. For example:

 A rise in the level of consumer demand for a product which means that a
business needs to take on more workers (see below on the concept of derived
demand)
 An increase in the productivity of labour which makes using labour more cost
efficient than using capital equipment
 A government employment subsidy which allows a business to employ more
workers

The labour demand curve would shift inwards during a recession when sales of goods
and services are in decline, business profits are falling and many employers cannot
afford to keep on their payrolls as many workers. The result is often labour
redundancies and an overall decline in the demand for labour at each wage rate.
Ordinarily labor demand will be an increasing function of the product's selling price p (since a
higher p makes it worthwhile to produce more output and to hire additional units of input in order to
do so), and a decreasing function of w (since more expensive labor makes it worthwhile to hire less
labor and produce less output). The rental rate of capital, r, has two conflicting effects: more
expensive capital induces the firm to substitute away from physical capital usage and into more labor
usage, contingent on any particular level of output; but the higher capital cost also induces the firm
to produce less output, requiring less usage of both inputs. Depending on which effect
predominates, labor demand could be either increasing or decreasing in r.

What is the equilibrium in the labor market?

The labor market is in equilibrium when supply equals demand; E* workers are
employed at a wage of w*. In equilibrium, all persons who are looking for work at the
going wage can find a job.

EQUILIBRIUM IN THE LABOUR MARKET

Objectives:

 Understand the concept of real wages.

 Identify labour market equilibrium.
 Understand the concepts of voluntary and involuntary
unemployment.
 Analyse the impact of a minimum wage on the labour market.
 Analuyse flexibility in the labour market.
Equilibrium in the labour market is where supply equals demand. The
wage at this point is the market wage or the market clearing wage.
No worker who wants a job at this wage rate or a lower one is without a
job. They are employed.
No firm who wishes to hire people at this wage rate (or higher) has
vacancies. The market at this point has cleared.
Any worker who is not prepared to work for this wage rate is without a
job and is voluntarily unemployed and is without work. (The area to the
right of equilibrium).
The multiplier effect
The multiplier effect refers to the increase in final income arising from any new injection of
spending.
The simple spending multiplier shows us how much economic output increases with an increase
in spending. Economists ask the question this way: how much did real GDP change when a
component of aggregate demand changed?
To understand the simple spending multiplier, you also need to understand how likely people are to
spend versus save any extra income they get, because this determines how big the multiplier effect
will be. Economists call these two other concepts the marginal propensity to consume and the
marginal propensity to save.

The formula for this simple expenditures multiplier, m, is:

1 1
m= =
(1 - MPC) MPS
Where MPC is the marginal propensity to consume and MPS is the marginal propensity to
save.

If, for example, the MPC is 0.75 (and the MPS is 0.25), then an autonomous $1 trillion
change in investment expenditures results in a change in aggregate production of $4 trillion.

While the simple expenditures multiplier can be derived from the basic two-sector
Keynesian multiplie

Other Multipliers

The simple expenditures multiplier is one of several Keynesian multipliers. Other related
multipliers exist based on (1) the autonomous shock and (2) assumptions concerning what
is induced by the changes in aggregate production and income. Four notable multipliers are
(complex) expenditures multiplier, simple tax multiplier, (complex) tax multiplier, and
balanced-budget multiplier.

 (Complex) Expenditures Multiplier: The expenditures multiplier, or complex

expenditures multiplier, is so named because it includes other induced expenditures
and components. At the very least it might include induced investment expenditures.
However, the "complete" four-sector complex multiplier is likely to include induced
government purchases, induced taxes, and induced exports, as well.

 Simple Tax Multiplier: The simple tax multiplier measures changes in aggregate
production caused by changes in taxes when consumption is the only induced
 expenditure. It differs from the simple expenditures multiplier in that aggregate
expenditures change by less than the change in taxes.

 (Complex) Tax Multiplier: The tax multiplier, or complex tax multiplier, is so named
because it also includes other induced expenditures and components, including
induced investment expenditures, induced government purchases, induced taxes,
and induced exports.

 Balanced-Budget Multiplier: The balanced-budget multiplier measures the combined

impact on aggregate production of equal changes in government purchases and
taxes. The simple balanced-budget multiplier has a value equal to one.

The Foreign Trade Multiplier in an Open Economy:

In a closed economy equilibrium level of national income is
determined at the level where intended saving equals intended
investment (S = I). Saving represents leakage or withdrawal of some
money from the income flow, while investment is the injection of some
money into the income stream.

The level of national income is in equilibrium (that is, circular flow of

income is constant) when leakage from the income stream in the form
of savings is equal to the injection of investment expenditure. In an
open economy, the role of foreign trade, that is, exports and imports of
a country are also to be considered. Imports by consumers of a country
represent the expenditure on imported goods by the residents of the
country and leads to the leakage of some income from domestic
economy.

Therefore, in addition to saving, imports are other form of leakage that

occur in an open economy. On the other hand, exports represent
expenditure by the people of foreign countries on the goods produced
in the domestic economy and are, like domestic investment, injection
into the income stream of an open economy.

Therefore, equilibrium level of national income in an open economy is

determined at the level at which total leakage, that is, savings plus
imports (S + M) equal total injection, that is, domestic investment plus
exports (I + X) into the income stream.

Thus, in an open economy, national income is in equilibrium at the

level at which

S+M=I+X

ADVERTISEMENTS:

When a change in any of the above four variables occurs, then the
change on the left side of the above equation must equal the change on
the right side if the new equilibrium is to be achieved.

Hence

ΔS + ΔM = ΔI + ΔX …(1)

Now, change in saving, ΔS = s. ΔY

Where s = marginal propensity to save and

ΔY= change in national income.

Likewise, change in imports, ΔM = m. ΔY

where m = marginal propensity to import.

Thus, foreign trade multiplier is equal to the reciprocal of marginal
propensity to save (s) plus marginal propensity to import (m). It is
evident that smaller the leaks, that is, smaller the values of marginal
propensity to save (s) and marginal propensity to import (m) the
greater the value of foreign trade multiplier. Let us given an example.
If s = 0.2 and m = 0.2, then

Graphic Representation of Foreign Trade Multiplier:

The foreign trade multiplier has been graphically illustrated in Fig.
24.2 where S + M is the saving plus import function curve and X0 is
the export curve which is constant as it has been assumed to be an
autonomous variable, that is, independent of the level of income. To
simplify our analysis we assume that there is no investment,
equilibrium level of national income will therefore be determined by
consumption (saving) and exports.
Initially, the economy is in equilibrium at level of income Y0 where S +
M=X0, investment being zero. Suppose there is autonomous increase
in exports so that export curve shifts upward from X0 to X1. It will be
seen from Fig. 24.2 that equilibrium income increases to Y1.

Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to
Y1 – Y0 which is much greater than change in exports (ΔX). The expression
ΔY/ΔX represents the foreign trade multiplier whose value depends on the slope
of saving-import function curve S+ M which is equal to the reciprocal of the sum
of marginal propensity to save and marginal propensity to import (1/s + m).

Over the years, economists came up with two basic models of the economy. There are other
variations of this, but these are the basic concepts. The first one's called the Classical Model

The Classical Model

The Classical Model was popular before the Great Depression. It says that the economy is very free-
flowing, and prices and wages freely adjust to the ups and downs of demand over time. In other
words, when times are good, wages and prices quickly go up, and when times are bad, wages and
prices freely adjust downward.
The major assumption of this model is that the economy is always at full employment, meaning that
everyone who wants to work is working and all resources are being fully used to their capacity. The
thinking goes something like this: if competition is allowed to work, the economy will automatically
gravitate toward full employment, or what economists call potential output - just like the
expressway at an average speed of 55 miles per hour. Remember what happened when traffic
slowed down because there were too many cars? After a few minutes, everything went back to
normal. Classical economists believe that the economy is self-correcting, which means that when a
recession occurs, it needs no help from anyone. So that's the Classical Model.

The Keynesian Model

A second model is called the Keynesian Model. As I said before, this model came about as a result
of the Great Depression. Economist John Maynard Keynes observed that the economy is not always
at full employment. In other words, the economy can be below or above its potential. During the
Great Depression, unemployment was widespread, many businesses failed and the
Economy was operating in much less than its potential

Stagflation occurs when there is an increase in inflation and also at the same time an
increase in unemployment and lower economic growth.

Typically stagflation will be caused by an increase in the cost of production which shifts
the SRAS curve to the left. This could be caused by a rise in oil prices.

Stagflation occurs when there is an increase in inflation and also at the same time an
increase in unemployment and lower economic growth.

Typically stagflation will be caused by an increase in the cost of production which shifts
the SRAS curve to the left. This could be caused by a rise in oil prices. Diagram of
Stagflation
The diagram shows that the stagflation causes the price level to rise from P1 to P2.
Output falls from Y1 to Y2

How to solve stagflation?

It is not easy. For example, the Central Bank could use Monetary policy to try and
reduce inflation. Higher Interest rates increase the cost of borrowing and this will reduce
aggregate demand (AD). This will be effective for reducing inflation, but, it will cause a
bigger fall in GDP. Therefore, the Central Bank may be reluctant to target inflation when
growth is already low.

Monetarist view
The monetarist view is that the primary macroeconomic objective should be to reduce
inflation. Reducing inflation may cause higher unemployment and lower economic
growth in the short-term. But, this unemployment is a ‘price worth paying’ for higher
inflation
Supply-side solutions
One solution to stagflation is to increase aggregate supply (AS) through supply-side
policies, for example, privatisation and deregulation to increase efficiency and reduce
costs of production. However, these will take a long time.

Wage control

In the 1970s, part of the stagflation was caused by rising wages (powerful trade unions).
A policy tried was wage control – government intervention to limit wage rises. In theory,
limiting wage increases can break the cycle of wage inflation and help to improve the
economic situation. In practising wage control is fairly difficult to implement and had little
impact in solving stagflation

EXCHANGE RATE
The exchange rate is defined as "the rate at which one country's currency may be converted into
another." It may fluctuate daily with the changing market forces of supply and demand of currencies
from one country to another.
 A country with a lower inflation rate than another's will see an appreciation in the value of its
currency.

. Increases in interest rates cause a country's currency to appreciate because higher interest rates
provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in
exchange rates
A deficit in current account due to spending more of its currency on importing products than it is
earning through sale of exports causes depreciation.
Government debt is public debt or national debt owned by the central government

5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices
to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its
imports prices. This results in higher revenue, which causes a higher demand for the country's
currency and an increase in its currency's value. This results in an appreciation of exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with
less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment
away from other countries with more political and economic stability.

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to
acquire foreign capita

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order
to make a profit in the near future. As a result, the value of the currency will rise due to the increase
in demand. With this increase in currency value comes a rise in the exchange rate as well.
A floating exchange rate is a regime where the currency price is set by the forex market based
on supply and demand compared with other currencies. This is in contrast to a fixed exchange
rate, in which the government entirely or predominantly determines the rate.

The Mundell-Fleming model shows how to make appropriate use of

monetary, fiscal and trade policies to achieve any desired
macroeconomic objective. The influence of these policies depends on
the exchange rate system. Under floating exchange rate system, only
monetary policy can alter national income.

The effect of expansionary fiscal policy is totally neutralised by

currency appreciation. Under fixed exchange rate system, only fiscal
policy can alter Y. The central bank loses control over money supply
since it has to be adjusted upward or downward for maintaining the
exchange rate at a predetermined level.
The Great Depression was a worldwide economic depression that lasted 10
years. Its kickoff was “Black Thursday," October 24, 1929. That's when traders
sold 12.9 million shares of stock in one day, triple the usual amount. Over the
next four days, stock prices fell 23 percent in the stock market crash of 1929.
The Great Depression had already started in August when the economy
contracted
the Great Depression caused drastic declines in output, severe unemployment,
and acute deflation in almost every country of the world
The U.S. recovery began in the spring of 1933. Output grew rapidly in the mid-
1930s: real GDP rose at an average rate of 9 percent per year between 1933
and 1937. Output had fallen so deeply in the early years of the 1930s,
however, that it remained substantially below its long-run trend path
throughout this period. In 1937–38 the United States suffered another severe
downturn, but after mid-1938 the American economy grew even more rapidly
than in the mid-1930s. The country’s output finally returned to its long-run
trend path in 1942.

Recovery in the rest of the world varied greatly. The British economy stopped
declining soon after Great Britain abandoned the gold standard in September
1931, although genuine recovery did not begin until the end of 1932. The
economies of a number of Latin American countries began to strengthen in
late 1931 and early 1932. Germany and Japan both began to recover in the
fall of 1932. Canada and many smaller European countries started to revive at
about the same time as the United States, early in 1933. On the other hand,
France, which experienced severe depression later than most countries, did
not firmly enter the recovery phase until 1938.

Unemployment Reached 25 Percent

The Great Depression started in the United States after a major fall in stock prices that began
around September 4, 1929, and became worldwide news with the stock market crash of October 29,
1929 (known as Black Tuesday). Between 1929 and 1932, worldwide gross domestic product
(GDP) fell by an estimated 15%. By comparison, worldwide GDP fell by less than 1% from 2008 to
2009 during the Great Recession.[4] Some economies started to recover by the mid-1930s. However,
in many countries, the negative effects of the Great Depression lasted until the beginning of World
War II.[5]
The Great Depression had devastating effects in countries both rich and poor. Personal income, tax
revenue, profits and prices dropped, while international trade plunged by more than 50%.
Unemployment in the U.S. rose to 25% and in some countries rose as high as 33%.[6]
A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary
authority with respect to a foreign currency or a basket of foreign currencies. By contrast,
a floating exchange rate is determined in foreignexchange markets depending on demand
and supply, and it generally fluctuates constantly.

In most countries of the world, recovery from the Great Depression began in 1933. In the
U.S.,recovery began in early 1933, but the U.S. did not return to 1929 GNP for over a decade
and still had an unemployment rate of about 15% in 1940, albeit down from the high of 25% in
1933.
Currency depreciation in the 1930s is almost universally
shows the behavior of the stock of money, both the narrow M1and broader M2 measures of it. The shaded
area shows the decreases in those money stocks in the 1937-38 depression. Those declines were one of the
reasons for that depression, just as the large declines in the money stock in 1929-33 were major factors
responsible for the Great Contraction. During the Contraction of 1929-33, the narrow measure of the money
stock — currency held by the public and demand deposits, M1 — fell 28 percent and the broader measure of
it (M1 plus time deposits at commercial banks) fell 35 percent. These declines were major factors in causing
the sharp decline that was the debacle of 1929-33.

The behavior of the unemployment rate is shown in Figure 2.[2] The dashed line shows the reported official
data, which do not count as employed those holding “temporary” relief jobs. The solid line adjusts the
official series by including those holding such temporary jobs as employed, the effect of which is to reduce
the unemployment rate (Darby 1976). Each series rises from around 3 to about 23 percent between 1929 and
1932.

Mundell-Fleming Model:
Meaning and Main Message
(With Diagram)
The Mundell–Fleming model portrays the short-run relationship between an economy's nominal
exchange rate, interest rate, and output (in contrast to the closed-economy IS-LMmodel, which
focuses only on the relationship between the interest rate and output).
The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is
an economic model first set forth (independently) by Robert Mundell and Marcus Fleming.
Meaning of the Mundell-Fleming Model:
The basic Mundell-Fleming model — like the IS-LM model — is based
on the assumption of fixed price level and shows the interaction
between the goods market and the money market.

The model explains the causes of short-run fluctuations in aggregate

income (or, what comes to the same thing, shifts in the ad curve) in an
open economy.

The basic assumption of this model is that the domestic rate of interest
(r) is equal to the world rate of interest (r*) in a small open economy
with perfect capital mobility
It may be recalled that “smallness” of a country has no relation to its
size. A small country is one which cannot alter the world rate of
interest through its own borrowing and lending activities. In contrast,
a large economy is one which has market (bargaining) power so that it
can exert influence over the world rate of interest.
For such a country, either international capital mobility is far from
perfect, or the country is so large that it can exert influence on world
capital markets.

The Open Economy IS Curve:

In the Mundell-Fleming model, the market for goods and
services is expressed by the following equation:
Y = C(Y – T) + I(r*) + G + NX(e) … (1)
I

The Open Economy LM Curve:

The equilibrium condition of the money market in the
Mundell-Fleming model is:
M = L(r*, Y) … (2)
since r = r*.

Here the supply of money equals its demand and demand for money
varies inversely with r* and the positively with Y. In this model, M
remains exogenously fixed by the central bank.
General Equilibrium:
In the Fig. 12.3, we show the general equilibrium of goods market and
the money market. The equilibrium income (Y0) and exchange rate (e0)
are determined simultaneously at point A where the IS and LM curves
intersect.

The Business Cycle

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-
wide fluctuations in production, trade, and general economic activity. From a conceptual
perspective, the business cycle is the upward and downward movements of levels of
GDP (gross domestic product) and refers to the period of expansions and contractions
in the level of economic activities (business fluctuations) around a long-term growth
trend.
Figure 1. Business Cycles: The phases of a business cycle follow a wave-like pattern over time with regard to
GDP, with expansion leading to a peak and then followed by contraction.

Business Cycle Phases

Business cycles are identified as having four distinct phases: expansion, peak,
contraction, and trough.

An expansion is characterized by increasing employment, economic growth, and

upward pressure on prices. A peak is the highest point of the business cycle, when the
economy is producing at maximum allowable output, employment is at or above full
employment, and inflationary pressures on prices are evident. Following a peak, the
economy typically enters into a correction which is characterized by
a contraction where growth slows, employment declines (unemployment increases),
and pricing pressures subside. The slowing ceases at the trough and at this point the
economy has hit a bottom from which the next phase of expansion and contraction will
emerge.

Definition of 'Real Business Cycle

Theory'
Definition: An economy witnesses a number of business cycles in its life. These
business cycles involve phases of high or even low level of economic activities. A
business cycle involves periods of economic expansion, recession, trough and
recovery. The duration of such stages may vary from case to case.

The real business cycle theory makes the fundamental assumption that an economy
witnesses all these phases of business cycle due to technology shocks. Technological
shocks include innovations, bad weather, stricter safety regulations, etc.

Description: According to the theory, monetary shocks or expectation changes have no

role to play in a business cycle.

Intro to Economic Business Cycles

Before understanding real business cycle theory, one must understand the basic
concept of business cycles.

A business cycle is the periodic up and down movements in the economy, which
are measured by fluctuations in real GDP and other macroeconomic variables.
There are sequential phases of a business cycle that demonstrate rapid growth
(known as expansions or booms) followed by periods of stagnation or decline
(known as contractions or declines).

1. Expansion (or Recovery when following a trough): categorized by an

increase in economic activity
2. Peak: The upper turning point of the business cycle when expansion turns
to contraction
3. Contraction: categorized by a decrease in economic activity
4. Trough: The lower turning point of the business cycle when contraction
leads to recovery and/or expansion

Real business cycle theory makes strong assumptions about the drivers of these
business cycle phases.

Primary Assumption of Real Business Cycle Theory

The primary concept behind real business cycle theory is that one must study
business cycles with the fundamental assumption that they are driven entirely by
technology shocks rather than by monetary shocks or changes in expectations.

That is to say that RBC theory largely accounts for business cycle fluctuations
with real (rather than nominal) shocks, which are defined as unexpected or
unpredictable events that affect the economy. Technology shocks, in particular,
are considered a result of some unanticipated technological development that
impacts productivity.

Shocks in government purchases are another kind of shock that can appear in a
pure real business cycle (RBC Theory) model.

Real Business Cycle Theory and Shocks

In addition to attributing all business cycle phases to technological shocks, real
business cycle theory considers business cycle fluctuations an efficient response
to those exogenous changes or developments in the real economic environment.

Technological Shock:
Given these assumptions, the production function of the economy is
given by

Y = Zf (K,N)

Where Y is total output, Z is the state of technology, K is

predetermined capital stock and N is labour input. The produced
output can either be consumed or invested.

Assuming that population is given and there is a fixed labour force,

output depends on technology and capital stock. So output is
determined by the production function, Y= Zf (K). The capital stock, K
depreciates at the rate S, so that the undepreciated capital stock
evolves as (1-δ) K. This capital stock is available as input for
production in the next period.

With a capital stock K, output is Y and the total resources available in

the economy in the current period are Y + (1-δ) K.

Since Y = Zf (K), the total resources can be expressed as Zf (K) + (1-δ)

K. These resources can either be consumed or accumulated as capital
to be used as investment for the next period.
A real business cycle is generated in a steady state economy when
there is a positive exogenous and permanent technological shock. This
leads to increase in productivity. As a result, the aggregate production
function shifts upward.

The improvement in technology from the initial level Z to Z1 and the

consequent upward shift of the production function from Zf(K) to
Z1f(K) is shown in Figure 1. Given the initial capital stock OK, output
increases from OY to OY1.
As a result, total resources increase from OR to OR1 and the total
resources curve shifts upward from Zf(K)+(1-δ) K to Z1f(K)+(l-δ)K.
With the increase in total resources, both current consumption and
capital accumulation also increase. There is increase in capital stock to
OK1.
With no change in technology, the increase in capital stock to K1 in the
next period leads to a further rise in output to OY2 and the increase in
total resources to OR1. In this way, the economy continues to expand
when consumption, investment and output increase gradually leading
to a new steady state.

Technological Shock:
Given these assumptions, the production function of the economy is
given by

Y = Zf (K,N)

Where Y is total output, Z is the state of technology, K is

predetermined capital stock and N is labour input. The produced
output can either be consumed or invested.

Assuming that population is given and there is a fixed labour force,

output depends on technology and capital stock. So output is
determined by the production function, Y= Zf (K). The capital stock, K
depreciates at the rate S, so that the undepreciated capital stock
evolves as (1-δ) K. This capital stock is available as input for
production in the next period.

With a capital stock K, output is Y and the total resources available in

the economy in the current period are Y + (1-δ) K.
Since Y = Zf (K), the total resources can be expressed as Zf (K) + (1-δ)
K. These resources can either be consumed or accumulated as capital
to be used as investment for the next period.

A real business cycle is generated in a steady state economy when

there is a positive exogenous and permanent technological shock. This
leads to increase in productivity. As a result, the aggregate production
function shifts upward.

The improvement in technology from the initial level Z to Z1 and the

consequent upward shift of the production function from Zf(K) to
Z1f(K) is shown in Figure 1. Given the initial capital stock OK, output
increases from OY to OY1.
As a result, total resources increase from OR to OR1 and the total
resources curve shifts upward from Zf(K)+(1-δ) K to Z1f(K)+(l-δ)K.
With the increase in total resources, both current consumption and
capital accumulation also increase. There is increase in capital stock to
OK1.
With no change in technology, the increase in capital stock to K1 in the
next period leads to a further rise in output to OY2 and the increase in
total resources to OR1. In this way, the economy continues to expand
when consumption, investment and output increase gradually leading
to a new steady state.
What is the circular flow?

The circular flow of income and spending shows connections between different sectors
of an economy

 It shows flows of goods and services and factors of production between firms and
households
 The circular flow shows how national income or Gross Domestic Product is
calculated

Businesses produce goods and services and in the process of doing so, incomes are
generated for factors of production (land, labour, capital and enterprise) – for example
wages and salaries going to people in work.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows
that some part of household income will be:

 1.Put aside for future spending, i.e. savings (S) in banks accounts and other
types of deposit
  2.Paid to the government in taxation (T) e.g. income tax and national insurance
 3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the
economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of
income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or
exports so boosting the circular flow of income leading to a multiplied expansion of
output.

1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
2. The government, i.e. government expenditure (G) e.g. on the NHS or defence
3. Overseas consumers buying UK goods and service, i.e. UK export expenditure
(X)

An economy is in equilibrium when the rate of injections = the rate of

withdrawals from the circular flow.
• To make the model more realistic let us now include government expenditure, G,
and taxation, T, in the model..
• The injections box now includes government expenditure in addition to
investment
• The withdrawals box now includes taxation. This means that the income that
households have to spend on consumer goods is no longer Y but rather Y − T
(income less tax), which is called disposable income, Yd.

• In our previous discussion it was implicitly assumed that the variables Y, PS, PC,
A and T are held fixed.
• We describe this situation by calling Q and P endogenous variables, since they
are allowed to vary and are determined within the model.
• The remaining variables are called exogenous, since they are constant and are
determined outside the model.
 • then a rise in income causes the intercept, b, to increase.
• We conclude that if one of the exogenous variables changes then the whole
demand curve moves,
• , whereas if one of the endogenous variables changes, we simply move along
the fixed curve.

by

Rajesh Goyal

What is Inflation or What is the meaning of Inflation :

In economics inflation means, a rise in general level of prices of goods and services in a
economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services. Thus, inflation results in loss of value of money. Another
popular way of looking at inflation is "toomuch money chasing too few goods". The last
definition attributes the cause of inflation to monetary growth relative to the output /
availability of goods and services in the economy.

In case the price of say only one commodity rise sharply but prices of other commodities
fall, it will not be termed as inflation. Similarly, in case due to rumors if the price of a
commodity rise during the day itself, it will not be termed as inflation.
What are different types of inflation :

Broadly speaking inflation is divided into two categoires i.e.

(a) DEMAND - PULL INFLATION: In this type of inflation prices increase results from an
excess of demand over supply for the economy as a whole. Demand inflation occurs when
supply cannot expand any more to meet demand; that is, when critical production factors are
being fully utilized, also called Demand inflation.

(b) COST - PUSH INFLATION: This type of inflation occurs when general price levels rise
owing to rising input costs. In general, there are three factors that could contribute to Cost-Push
inflation: rising wages, increases in corporate taxes, and imported inflation. [imported raw or
partly-finished goods may become expensive due to rise in international costs or as a result of
depreciation of local currency ]

Deflation generally causes stocks to decline, government bonds to increase and corporate
bonds to potentially decrease. 11. STAGFLATION A condition of slow economic growth and
relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or
inflation.

A: Inflation is a term used by economists to define broad increases in prices. ...Stagflation is a

term used by economists to define an economy that has inflation, a slow or stagnant economic
growth rate and a relatively high unemployment rate. Economic policy makers across the globe
try to avoid stagflation at all costs.

Keynes’ consumption function has the following attributes:

1. Consumption is a stable function of income, i.e., C = f(Y).

2. Consumption is assumed to vary directly with income. As income

rises, consumption rises.

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3. The rate of increase in consumption is less than the rate of increase

in income. In Keynes’ terminology, the value of the marginal
propensity to consume (MPC) is less than one (i.e., MPC < 1).
4. MPC is less than the average propensity to consume (APC) in the
short run (MPC < APC).

1. APC and MPC:

APC is the ratio of consumption to income. It is the proportion of
income that is consumed. It is worked out by dividing total
consumption expenditure (C) by total income (Y). Symbolically,

APC = C/Y

MPC measures the response of consumption spending to a change in

income. It is the ratio of change in consumption to a change in income.
It is worked out by dividing the change in consumption by the change
in income. Symbolically,

MPC = ∆C/∆Y

Suppose, national income rises from Rs. 100 crore to Rs. 200 crore. As
a result, consumption spending rises from Rs. 125 crore to Rs. 200
crore. Thus,

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In this example, MPC = 3/4 The economic meaning is that if national

income rises by four rupees, consumption spending would increase by
three rupees and the remainder one rupee would be saved. Notice that,
in this example, the value of MPC is positive but less than one (0 >
MPC < 1). Since at zero level of income consumption is positive, MPC
must always be positive. Further, since increase in consumption is less
than that of increase in income, the value of MPC must be less than
one.
The relationship between planned consumption expenditure and
income is presented in Table 3.1 in terms of a hypothetical data.

Table 3.1 tells us that when income is zero, consumption is positive (Rs. 50 crore).
But as income increases, consumption rises. Further, as the rise in consumption is
less than the rise in income APC declines. However, since the rate of increase in
consumption is less than the rate of increase in income the value of MPC is always
less than one (here 0.75). At the same time, MPC is always positive because
consumption is positive even if income is zero. Finally, the table suggests that
MPC < APC.

2. Consumption Function Equation:

The relationship between consumption spending and
income is usually explained in an equation form:
C = a + bY (a > 0; 0 < b < 1)

Here, C and Y represent consumption and income, respectively. This

equation indicates that consumption is a linear function of income
since it is the equation of a straight line. In the equation, ‘a’ stands for
autonomous consumption. This part of consumption spending is
independent of the level of income.

Its value is positive in the sense that consumption is always positive,

even if income is zero, ‘b’ is-the behavioural coefficient or the MPC.
This part of consumption is called ‘induced’ consumption. According
to Keynes, MPC is always positive, but less than one. Here ‘b’ is the
slope of the consumption function. Thus, MPC is the slope of the
consumption line.

We can prove this in the following way.

The equation of the linear consumption line

Is C= a+ bY. From this equation, one obtains

APC = C/Y =a/Y + b,

and MPC = b.

Thus, APC > MPC by the amount.

Keynes’ consumption function is a short run one and the relationship

between consumption and income is a non-proportional one in the
sense that MPC < APC.

However, a long run consumption function shows a proportional

relationship between income and consumption. Because of this
proportional relationship, MPC = APC. The long run consumption
function starts from the origin. Its functional form is, thus, C = bY
The Life-Cycle Theory of
Consumption (With Diagram)
Let us make an in-depth study of the Life-Cycle Theory of
Consumption:- 1. Explanation to the Theory of Consumption
2. The Reconciliation 3. Critics of the Life Cycle Hypothesis.

Explanation to the Theory of Consumption:

An important post-Keynesian theory of consumption has been put forward
by Modigliani and Ando which is known as life cycle theory. According to
life cycle theory, the consumption in any period is not the function of
current income of that period but of the whole lifetime expected income.
The life-cycle theory of the consumption function was developed by Franco
Modigliani, Alberto Ando and Brumberg.
An individual’s or household’s level of consumption depends not just on
current income but also, and more importantly, on long-term expected
earnings.
Individuals are assumed to plan a pattern of consumer expenditure
based on expected earnings over their lifetime.
Thus, in life cycle hypothesis the individual is assumed to plan a
pattern of consumption expenditure based on expected income in
their entire lifetime. It is further assumed that individual maintains a
more or less constant or slightly increasing level of consumption.

To see the implications of this theory for the form of the consumption
function, we first look at a simplified example.
Consider an individual of a given age who is in the labour force, has a
life expectancy of T years, and plans to remain in the labour force for
N years. Our representative consumer might, for example, be 30 with
a life expectancy of 50 (additional) years, plan to retire after 40 years,
and, therefore, have expected years in retirement equal to (T – N), or
10. We make the following assumptions about the individual’s plans.
The individual is assumed to desire a constant consumption flow
throughout life. Further, we assume that this person intends to
consume the total amount of lifetime earnings plus current assets and
plans no bequests. Finally, we assume that the interest paid on assets
is zero; current saving results in dollar-for-dollar future consumption.
These assumptions are purely to keep the example simple and are
relaxed later.

These assumptions imply that consumption in a given period will be a

constant proportion, 1/T, of expected lifetime resources

It can be seen from Equation (1) that according to the life cycle
hypothesis, consumption depends not only on current income but also
on expected future income and current asset holdings (i.e., current
wealth). In fact, the life cycle hypothesis suggests that consumption
would be quite unresponsive to changes in current income (Y,1) that
did not also change average expected future income. From equation
(1), for example, we can compute

3. Permanent Income Theory of Consumption:

But consumption, according to Friedman, depends neither on ‘absolute’
income, nor on ‘relative’ income but on ‘permanent’ income, based on
expected future income. Thus, he finds a relationship between consumption
and permanent income. His hypothesis is then described as the ‘permanent
income hypothesis’ (henceforth PIH). In PIH, the relationship between
permanent consumption and permanent income is shown.
Though Friedman’s permanent income hypothesis differs from life
cycle consumption theory
, according to Friedman, consumption is determined by long-term
expected income rather than current level of income.
It is this long-term expected income which is called by Friedman as
permanent income on the basis of which people make their
consumption plans. To make his point clear, Friedman gives an
example which is worth quoting. According to Friedman, an individual
who is paid or receives income only once a week, say on Friday, he
would not concentrate his consumption on one day with zero
consumption on all other days of the week.

He argues that an individual would prefer a smooth consumption flow

per day rather than plenty of consumption today and little con-
sumption tomorrow. Thus consumption in one day is not determined
by income received on that particular day. Instead, it is determined by
average daily income received for a period. This is on the line of life
cycle hypothesis. Thus, according to him, people plan their
consumption on the basis of expected average income over a long
period which Friedman calls permanent income.

1. Relative Income Theory of Consumption:

An American economist J.S. Duesenberry put forward the theory
of consumer behaviour which lays stress on relative income of
an individual rather than his absolute income as a determinant
of his consumption
Another important departure made by Duesenberry from
Keynes’s consumption theory is that, according to him, the
consumption of a person does not depend on his current
income but on certain previously reached income level.
This is because with the increase in incomes of all
individuals by the same proportion, the relative incomes of
the individuals would not change and therefore they would
consume the same proportion of their income. This applies
to all individuals and households. It therefore follows that
assuming that relative distribution of income remains the
same with the growth of income of a society, its average
propensity to consume (APC) would remain constant.
It is important to note that relative income theory implies
that with the increase in income of a community, the relative
distribution of income remaining the same, does not move
along the same aggregate consumption function, but its
consumption function shifts upward. Since as income
increases, movement along the same consumption function
curve implies a fall in average propensity to consume,
Duesenberry’s relative income hypothesis suggests that as
income increases consumption function curve shifts above
so that average propensity to consume remains constant.
Investment? What are the different types of
investment available?
In simple terms, Investment refers to purchase of financial assets. While Investment Goods are those
goods, which are used for further production.

The meaning of investment in the Keynesian sense is different from its ordinary sense. Ordinarily
investment means the purchase of stocks and shares, Govt, bonds, equities etc. But there are
financial investments. Keynes means investment as the real investment.

According to Stonier and huge, "By investment, we do not mean the purchase of existing paper
securities, bonds debentures, or equities but the purchase of new factories, machines and the like. In
the case of financial’ investment no new physical- asset to be used for production is created.

Spending on these cannot be called real investment. In economics expenditure on the creation of
new physical assets or capital goods such "as factories, machines, tools, houses etc. is called
investment expenditure. There expenditure leads to the creation of new physical assets that add to
the aggregate demand for goods and services.

Types of Investment:-
(1) Induced investment and Autonomous investment:
Investment which does not change with the changes in income level, is called as Autonomous or Government
Investment.
Investment which changes with the changes in the income level, is called as Induced Investment.

Induced investment is that investment which changes with the change in income of the rate of profit.
It increases with as income increases and decreases as income decreases. Thus-induced investment
is income elastic. In capitalistic economy investments are mainly induced investment. Induced
investment is also called private investment because private individuals and motivated by the profit
expectations.

The induced investment curve slopes upward to might showing increase in investment as a result of
increase in income. Autonomous investment, on the other hand, is independent of income and is not
guided by profit motive. This investment is generally undertakes by the Govt, who is not guided by
the profit consideration. The autonomous investment curve is a horizontal straight line parallel to
the OX-axis. It indicates that the investment remains the same what ever the level of income may be.
(2) Gross Investment and Net Investment:

Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually
a year.

Gross Investment means the total amount of money spent for creation of new capital assets like Plant and Machinery,
Factory Building, etc.

Gross investment means the total expenditure on capital goods in a given period of time. Gross
investment comprises of (a) net investment (b) depreciation. Net investment means the vestment
which results in an increase in capital stock. Net vestment is the excess of gross investment over
depreciation.

(3) Planned and unplanned Investments:

Investment made with a plan in several sectors of the economy with specific objectives is called as Planned or
Intended Investment.
Investment done without any planning is called as an Unplanned or Unintended Investment.

The Investment is said to be planned or intended where investments made intentionally to achieve
certain desired goal. When investment on goods is made in expectation of a rise in prices, the
investment is called planned or intended. On other hand on account of sudden fall in demand stocks
of finished and unfinished goods accumulated with the businessmen, it is called an intended or
unplanned investment.

4. Real Investment

Investment made in new plant and equipment, construction of public utilities like schools, roads and railways, etc., is
considered as Real Investment.

3. Financial Investment

Investment made in buying financial instruments such as new shares, bonds, securities, etc. is considered as a
Financial Investment.

The Five Determinants of Demand

The five determinants of demand are:

1. The price of the good or service.

2. Prices of related goods or services. These are either complementary,
those purchased along with a particular good or service, or substitutes,
those purchased instead of a certain good or service.
3. Income of buyers.
 4. Tastes or preferences of consumers.
5. Expectations. These are usually about whether the price will go up.

For aggregate demand, the number of buyers in the market is the sixth
determinant

Main determinants of the supply of money are (a)

monetary base and (b) the money multiplier

Main determinants of the supply of money are (a) monetary base and (b) the money multiplier.
These two broad determinants of money supply are, in turn, influenced by a number of other factors.
Various factors influencing the money supply are discussed below:

1. Monetary Base:

Magnitude of the monetary base (B) is the significant determinant of the size of money supply.
Money supply varies directly in relation to the changes in the monetary base.

Monetary base refers to the supply of funds available for use either as cash or reserves of the central
bank. Monetary base changes due to the policy of the government and is also influenced by the value
of money.

2. Money Multiplier:

Money multiplier (m) has positive influence upon the money supply. An increase in the size of m will
increase the money supply and vice versa.

3. Reserve Ratio:

Reserve ratio (r) is also an important determinant of money supply. The smaller cash-reserve ratio
enables greater expansion in the credit by the banks and thus increases the money supply and vice
versa.

Reserve ratio is often broken down into its two component parts; (a) excess reserve ratio which is the
ratio of excess reserves to the total deposits of the bank (re = ER/D); (b) required reserve ratio which
is the ratio of required reserves to the total deposits of the bank (rr = RR/D). Thus r = re + rr. The
rr ratio is legally fixed by the central bank and the re ratio depends on the market rate of interest.
4. Currency Ratio:

Currency ratio (c) is a behavioural ratio representing the ratio of currency demand to the demand
deposits.The effect of the currency ratio on the money multiplier (m) cannot be clearly recognised
because enters both as a numerator and a denominator in the money multiplier expression (1 + c/r(1
+t) + c). But, as long as the r ratio is less than unity, a rise in the c ratio must reduce the multiplier.

5. Confidence in Bank Money:

General economic conditions affect the confidence of the public in bank money and, thereby,
influence the currency ratio (c) and the reserve ratio (r). During recession, confidence in bank money
is low and, as a result, c and r ratios rise. Conversely, during prosperity, c and r ratios tend to be low
when confidence in banks is high.
6. Time-Deposit Ratio:

Time-deposit ratio (t), which represents the ratio of time deposits to the demand deposits is a
behavioural parameter having negative effect on the money multiplier (m) and thus on the money
supply. A rise in t reduces m and thereby the supply of money decreases.

7. Value of Money:

The value of money (1/P) in terms of other goods and services has positive influence on the monetary
base (B) and hence on the money stock.

8. Real Income:

Real income (Y) has a positive influence on the money multiplier and hence on the money supply. A r
se in real income will tend to increase the money multiplier and thus the money supply and vice
versa.

9. Interest Rate:

Interest rate has a positive effect on the money multiplier and hence on the money supply. A rise in
the interest rate will reduce the reserve ratio (r), which raises the money multiplier (m) and hence
increases the money supply and vice versa.

10. Monetary Policy:

Monetary policy has positive or negative influence on the money multiplier and hence on the money
supply, depending upon whether reserve requirements are lowered or raised. If reserve requirements
are raised, the value of reserve ratio (r) will rise reducing the money multiplier and thus the money
supply and vice versa.

11. Seasonal Factors:

Seasonal factors have negative effect on the money multiplier, and hence on the money stock. During
holiday periods, the currency ratio (c) will tend to rise, thus, reducing the money multiplier and,
thereby, the money supply.