Semester I SY B.

Com MACRO ECONOMICS

Economics Part I: Trade cycles, Keynesian theory of Effective demand, consumption and investment functions

Trade Cycles (6)

Periodic changes in the level of economic acclivities in the long run are commonly termed as trade cycles. The level of economic activity periodically, increases and reaches a peak, shows a change in trend, decreases and bottoms out and finally, changes trend towards increase. Such cyclical changes in the level of economic activities constitute the trade cycle. Trade cycle is a neoclassical concept of macro economics which tries to explain the changes in the economic activities with respect to time. The concept of trade cycle was initially developed by Joseph Schumpeter. The different phases in the trade cycle are named in relation to the full employment level. Accordingly, there are five phases of trade cycle: 1. Inflation 2. Boom 3. Deflation 4. Recession 5. Depression, and 6. Recovery

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SY BCom: Economics Part I

1. Inflation: When the economic activity increases after full employment level, it is called inflation. During inflation, the demand pressures will be high. Increasing demand leads to increasing product prices, increasing demand for factors, higher wages and then increasing demand again. 2. Boom: Boom refers to the peak in the level of economic activity after full employment. The demand pressures will be at the peak. The price level will be very high. 3. Deflation: It is the downward trend in the economic activities after boom. At boom level the Government will take corrective measures due to which the economic activity will show a change in trend. 4. Recession: When the economic activity reduces below full employment It is called recession. The level employment will decreases, the prices will decrease and the economic activity shrinks. 5. Depression: This is the lowest level of economic activity. The markets collapse. Large scale unemployment will lead to poverty and suffering. The world experienced Great depression during 1929 and 1933. 6. Recovery: From the lowest levels of economic activity the markets recover due to positive Government policy. The economic activity will increase towards full employment. Three will be increase in the level of employment, incomes, investment and demand. The reasons for the occurrence for the trade cycle has been not yet explained satisfactorily. The Sun spot theory relates the level of economic activity with the number of sun spots. In absence of any other theory, the Sun Spot theory still holds valid.

Phillips curve is the modern concept which relates unemployment and inflation. According to Phillip, there is a trade off between inflation and unemployment; one can be reduced only at the cost of the other. If inflation
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is reduced, unemployment increases and if unemployment is reduced inflation may increase. In such case the ideal alternative is to find such a point on the curve which is closest to the origin. By selecting such a combination, both inflation and unemployment can be maintained at tolerable levels. Classical Theory of Employment Macro economic theories provide relationship between various macroeconomic variables like consumption, imports, savings, interest, invest, taxes, exports and employment. These relationships are studied with respect to employment. Hence macro-economic theories are called theories of employment.

Says Law Of Markets

The classical theory in general believes in laissez faire. Following are relationships advocated by classical theory. 1. Full employment is natural state. It is known that the objective of macro economic exercise is full employment. Thus full employment is natural tendency of every economy. 2. Unemployment or Over-employment is found in short run. In long run economies attain full employment. 3. Laissez faire indicates that there is no state interference. It is a process of full employment .It is natural & automatic. J.B. say represents classical theory of employment. He explains working through says law of markets. According to him, Supply creates its own demand Any increment in supply will correspondingly increase demand. Increase in supply is possible only when wages are increased. Increase in income leads to increase in demand. This way the demand-supply equality is maintained.

Criticisms of classical theories

1. Classical theories are long run theories: - According to Keynes theory should aim at short run problems & policies. Long run is imaginary.

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2. Classical economists believed that economies could have equilibrium only with employment. But countries have equilibrium even with unemployment. 3. Increasing the level of employment is not possible by laissez faire policy. Full employment is not automatically 4. Savings do constitute leakage in classical system .It reduces demand. 5. Unemployment can not be solved by a wage-cut policy. Strong trade union movement will resist any decrease in wages.

Theory of Effective Demand (12)

The classical economists failed to provide policy solutions to economic problems. The classical theory believed in long run & full employment equilibrium. Keynesian economics is short run economics. According to the theory equilibrium is possible even with unemployment. There is no automatic system in long run, which will grant full employment. According to Keynes employment theory, it should provide short run solutions He assigns an active role to the Govt. This is a deviation from traditional laissez faire system. Keynesian theory is called the general theory of employment The private investment can create employment to a certain level. Therefore the govt. investment can help in increasing the level of employment.

Factors Determining Effective Demand:There are two important factors determining effective demand. 1. Aggregate demand function and 2. Aggregate supply function Aggregate Demand function deals with the various amount of money the producers expect from the sale of output at different levels of employment. These are the receipts the producers expect. ADF is short run factor. So Keynes considers it for study in detail. The Effective demand is determined by ADF in the short run. ADF inturn is determined by Consumption, Investment and, Government investment or expenditure.

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Aggregate Supply function deals with the various amount of money the producers must receive from the sale of output at different levels of employment. These are costs the producers must receive. ASF on the other hand is a long run factor. Keynesian economics is short run economics, so it is kept as constant in the short run. ASF is determined by long run factors like Population, natural resources, cost structure, technology etc.

Level of Employment (000) 100 200 300 400 500

Aggregate Demand (000) 1000 1500 3500 6000 4000

Aggregate Supply (000) 800 1400 3500 6200 4500

Relationship ADF>ASF ADF>ASF ADF=ASF ADF<ASF ADF<ASF

Aggregate demand function represents receipt and Aggregate Supply Function the costs.

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At a point where ADF = ASF the effective demand is determined. In turn the level of employment is found at The level of employment can't increase above because ADF < ASF and receipt < cost. If private investments cannot increase the level of employment then, the govt. investment can increase. This is the prescription for increasing the level of employment. The economy may have equilibrium even with unemployment.

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Aggregate supply function as a long run factor is represented as a 45-degree line cut at full employment. The proportionate increases do not affect the short run factors. ADF can be studied in terms of its components. C - Consumption expenditure, I - Investment expenditure and G - Government expenditure. National Income Y= C+I+G

C + I constitute ADF determining the equilibrium at . The level of employment can be increased to the government expenditure. The increase in employment and income can be seen on X-axis. The Keynesian perception of government investment helped in generating employment during great depression (1929-33). It was adopted by the U.S. under New deal policy. The government invested in irrigation projects. Pump priming finances the activity of public expenditure. The money in circulation is increased the government investment generates employment increases incomes, demand and prices. Thereafter the private investments will take over. The fall out of Keynesian government investment is inflation. In the process of generating resources for employment; the government increases the money in circulation. This is also called as deficit financing. Deficit financing is highly inflationary.

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Hence inflation is purely post Keynesian occurrence. However government investment is found highly suitable for financing development employment and growth.

Consumption function (6)

Keynesian consumption function is an important part of ADF. It is responsible determination of private investment multiplier and accelerator. Consumption depended on the Income and in turn determines demand in the market. Consumption and income are directly related. However, C can not be zero at any level of income. The consumption is financed by income. If income is zero it is financed by negative savings i.e. borrowings. Hence, Y=C+S Where, C > zero

At zero level of income, consumption is financed by borrowings (negative savings). Therefore with the increasing income negative savings decrease after C = Y. The positive savings emerge. It can be seen from the savings function.

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SY BCom: Economics Part I

Propensity of Consumption (6)

The intensity of consumption whether aggregate or additional is called propensity of consumption. Propensity of consumption can be measured in two ways. Average propensity of consumption: APC is the ratio of consumption to Income. APC = C/Y. Marginal propensity of consumption: The MPC measures changes in consumption for changes in income. It is the measures of propensity of consume for an increment in income. MPC = C / P

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Keynesian Psychological Law of Consumption (6)

According to the law with increasing levels of income, the marginal propensity of consumption decreases i.e. countries with low income will have high MPC. It is known that MPC + MPS = 1 or 1 - MPC = MPS. In this case the low-income countries will have lower MPC and poor capital formation. The consumption function is not a linear function. The rate of consumption slows down at higher levels of income. Relationship between MPC and APC 1) At low levels of income APC < MPC. 2) When C = Y, APC = MPC. 3) At higher levels of income APC > MPC This is drawn from Keynesian law of consumption where MPC is non-linear function and APC is an aggregate measured.

Factors affecting consumption (12)

The propensity of consumption is qualitative part of consumption function. It is a intensity of consumption which finally determines consumption expenditure. There are two sets of factor determining consumption function a) Objective factor.
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b) Subjective factor

A. Objective factors
These are the external influences on the consumption pattern of the society and individual consumers may not have control over these factors. The objective factors explain the changes in consumption to a large extent. Following are the objectives factors 1) Income: Income directly influences the volume of consumption these factors alone explain the changes in consumption. According to Keynes with increasing level of income , MPC decreases. 2) Distribution of Income: Equitable distribution of income will show smaller proportion of aggregate consumption as compared with inequalities. Inequalities will have larger section with low incomes and high MPC. 3) Prices:Continuous increase in prices is called inflation. Inflation increases the value of consumption without increasing the real consumption. Inflation is universally found in all countries. 4) Public Expenditure: Rapid increase in public expenditure will increase household incomes finally lead to an increase in consumption. 5) Corporate Policy: If industries declare liberal dividends the household income will increase leading to an increase in consumption. The government determines a corporate policy. 6) Customary Standard of Consumption: Every society displaces a specific pattern of consumption. This is an external pattern and people are bound by this. 7) Demonstration Effect: Low-income countries imitate the consumption factor of high-income countries. In this process there will be large wasteful expenditure. 8) Economic development: With increasing level of consumption, income increases at the same time. According to Wagener's law with increasing development, public expenditure increases finally there is an increase in consumption. 9) Taxation: Indirect taxes are inflationary. It is added to the price and the prices increase; the government may use indirect tax for regulating
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consumption. Similarly direct taxation reduces disposable income with increasing population the aggregate consumption expenditure increases.

B Subjective Factors
These are behavioral motives of consumption. There are personal reasons for higher or lower intensity of consumption. The subjective factors can be associated with the behavior of a community. The motives of consumption offer the choice between present consumption and future consumption. Larger insecurities regarding future will reduce present consumption with huge savings. Following are subjective factors: 1. Motive of precaution: It affects the present consumption. The consumer through this motive prepares for future unknown contingency. 2. Motive of foresight: In this the consumer prepares for future known contingency. Even in this the present consumption is postponed to future. 3. Motive of pride: In case of less developed economy, the consumption has a special utility on demonstration such tendency increases consumption. 4. Motive of calculation The consumer may distribute his preference of consumption between present and future. 5. Motive of independence: The consumer may sacrifice present consumption for future propensity. In such case MPC will be high. 6. Motive of enterprise: Conservative methods of consumption may lead through larger rate of savings. e.g.:- Communities encouraging recycled technologies have low aggregate consumption. 7. Motive of Avarice: Economies with high mass consumption lead to decreases in consumption at a later stage. This is due to excess material consumption. Such countries have large rate of savings.

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Investment function

[Supply price/ Marginal efficiency of capital/ Investment function, 6marks]

Investment is an important part of aggregate demand function. Investment refers to private induced investment which is governed by rate of profit and returns. When private induced investment falls short of creating adequate employment, the government investment is added to increase levels of income and employment. Investment function depends on rate of interest (i) and marginal efficiency of capital (e). Investment, I = f ( i , e) Further Marginal efficiency of capital, e determined by supply price (p) and expected rate of returns (Q). Marginal efficiency of capital, e= f ( Q,P) Every income yielding asset has three properties: a. The assets yields returns over its life time, different each year b. The asset has a fixed life span during which it gives returns c. A price is payable for the asset before it yields returns. These are important issues in making investment decisions.

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SY BCom: Economics Part I

Given , Or

Marginal efficiency of capital, e= f ( Q,P) P =

Q E Supply price is the sum of discounted annual returns. The discount rate is the marginal efficiency of capital This is true when the asset has a life span of one year. If the asset has a life span of n years, the supply price,

Where Q1, Q2, Qn are expected returns over n years, are discounts over n years. is discounted annual return

And e is the marginal efficiency of capital Marginal efficiency of capital is that rate of discount which when applied to annual returns sums up to supply price. Accordingly the demand price is computed a for the purpose of evaluating the investment decisions. The demand price,

Where Q1, Q2, Qn are expected returns over n years, are discounts over n years.

is discounted annual return

And r is the rate of interest

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Marginal Efficiency of capital (6/ 12)

Marginal efficiency of capital is that rate of discount which when applied to annual returns sums up to supply price. Investment function depends on rate of interest (i) and marginal efficiency of capital (e). Investment, I = f ( i , e) Further Marginal efficiency of capital, e determined by supply price (p) and expected rate of returns (annual returns) (Q). Marginal efficiency of capital, e= f (Q,P) There is a negative relationship between MEC and the volume of investment. This negative relationship is due to three reasons: 1. Keeping all other factors constant, when the volume of investment increases, law of diminishing returns operates and the productivity of increasing factor decrease. 2. When, the production increases, the product prices may decrease causing a decline in the rates of returns and marginal efficiency of capital. 3. When, the demand for other factors increases the factor prices may increase causing increase in cost of production and decrease in marginal efficiency of capital.

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With increasing levels of investment, MEC can be kept constant. This is possible only by shifting the MEC curve. Shift in the MEC curve means a change in the production function and change in the level of technology.

Factors determining Marginal efficiency of capital (6)

Marginal efficiency of capital depends on two sets of factors: a. Short run factors, and b. Long run factors

a. Short run factors

Short run factors are important in determining marginal efficiency of capital as well as investment. Following are the long run factors affecting marginal efficiency of capital: 1. Marginal propensity of consumption Increasing level of marginal propensity of consumption increases marginal efficiency of capital. The intensity of consumption encourages marginal efficiency of capital. 2. Income Higher levels of income yield larger marginal efficiency of capital. Increasing income will also increase conspicuous consumption. 3. Price level During periods of inflation marginal efficiency of capital will be high. Price levels with more money supply will increase capacity to pay. 4. Interest rate Higher interest rates discourage marginal efficiency of capital. Higher cost of capital increases cost of production thus reducing chances of increasing marginal efficiency of capital 5. Consumption expenditure Higher consumption expenditure increases the marginal efficiency of capital. Increasing consumption expenditure can be due to reasons like income, price levels, demonstration effect or price illusion. 6. Government Policy Government policy of taxation, controls on out put will reduce the possibility of increasing marginal efficiency of capital. 7. Business cycles Business cycles mainly deal with mood in business environment. There can be business optimism or business pessimism. During

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periods of business optimism the marginal efficiency of capital will be high similarly, during periods of business pessimism, marginal efficiency of capital will be low. 8. Rational expectations A rational expectation is a post Keynesian concept, concerned with business environment and business. It is regarding the business adapting to changing policy, market, consumer expectation and management of business with rational risk management.

b. Long run factors

Long run factors do not fall under the study of Keynes, because, Keynesian economics is short run economics. Yet, these are the factors which are effective in the ling run. Following are the long run factors affecting marginal efficiency of capital: 1. Population Though population changes even in the short run. The effect of population can be seen only in the ling run, by way of changes in the pattern of demand and labor force. 2. Technology Technology helps in the ling run in reducing costs and making production function efficient. 3. Alternative sources of raw material and energy Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical. 4. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. In the long run, mass consumption increase.
SY BCom Economics Part II follows

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