M.L. Jhingan: Macroeconomic Theory

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1. Summarise the accelerator theory of investment and provide examples of situations when this theory will not work.
2. Critically discuss the accelerator theory of investment.
3. Explain the flexible theory of investment.
4. Explain how adjustment is made when there are lags between levels of output and capital stock in the theory of accelerator.
5. Explain the profits theory of investment.
6. Explain the “cost of funds” theory of investment.
7. How has Duesenberry integrated the accelerator principle with the profits theory of investment?
8. Explain the financial theory of investment.
9. Critically examine the neoclassical theory of investment.
10. Explain Tobin's q of theory of investment.

1. How is equilibrium level of income determined under the Keynesian system ?
2. Is it possible to have equilibrium in the level of national income without achieving full employment ?
3. "The level of employment is determined by the level of income which in turn depends upon aggregate demand." Comment.
4. Explain Keynes's under-employment equilibrium.

1. All factors of production are in perfectly elastic supply so long as there is any unemployment.
2. All unemployed factors are homogeneous, perfectly divisible and interchangeable.
3. There are constant returns to scale so that prices do not rise or fall as output increases.
4. Effective demand and quantity of money change in the same proportion so long as there are any unemployed resources.
404 (407)
the Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one through the rate of interest.
405 (408)
The Complicated Model. Keynes himself pointed out that the real world is so complicated that the simplifying assumptions upon which the reformulated quantity theory of money is based, will not hold.
406 (409)
(1) "Effective demand will not change in exact proportion to the quantity of money.
(2) Since resources are homogenous, there will be diminishing, and not constant returns as employment gradually increases.
(3) Since resources are not interchangeable, some commodities will reach a condition of inelastic supply while there are still unemployed resources available for the production of other commodities.
(4) The wage-unit will tend to rise, before full employment has been reached.
(5) The remunerations of factors entering into marginal cost will not all change in the same proportion."
407 (412)
Thus the Keynesian analysis is superior to the traditional analysis because it studies the relationship between quantity of money and prices both under unemployment and full employment situations.
408 (413)
2. Stable Demand for Money.
409 (413)
3. Nature of Money.
410 (413)
4. Effect of Money.
411 (413)
It was, therefore, wrong on the part of Keynes to argue that money had little effect on income. Money does affect national income.
412 (415)
Forms of Wealth.
413 (415)
2. Bonds
414 (415)
3. Equities
415 (415)
4. Physical goods or non-human goods
416 (415)
5. Human capital
417 (419)
Friedman has been criticised for using the broad definition of money
418 (420)
3. More Importance to Wealth Variables.
419 (420)
4. Money Supply not Exogenous.
420 (421)
6. Does not consider Time Factor.
421 (421)
7. No Positive Correlation between Money Supply and Money GNP.
422 (421)
First, Friedman uses a broader definition of money than that of Keynes in order to explain his demand for money function.
423 (421)
Second, Friedman postulates a demand for money function quite different from that of Keynes.
424 (421)
Third, there is also the difference between the monetary mechanisms
425 (422)
Fourth, there is the difference between the two approaches with regard to the motives for holding money balances. Keynes
426 (422)
Fifth, in his analysis, Friedman introduces permanent income
427 (426)
is an important determinant of the money supply.
428 (427)
central bank requires all commercial banks to hold reserves equal to a fixed percentage of both time and demand deposits. These are legal minimum or required reserves.
429 (427)
A commercial bank advances loans equal to its excess reserves which are an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operations and discount rate policy.
430 (428)
4. High-Powered Money
431 (428)
5. Other Factors
432 (429)
(a) The marginal propensity to save
433 (429)
(b) Banks may also create more or less credit
434 (429)
(c) The velocity of circulation of money also affects
435 (429)
The use of high-powered money consists of the demand of commercial banks for the legal limit or required reserves
436 (430)
High-powered money (H) (or monetary base) consists of currency held by the public (C) plus required reserves (RR) and excess reserves (ER) of commercial banks. Thus high-powered money The relation between M and H can be expressed as the ratio
437 (433)
But the monetarists give more importance to excess reserves. According to them, due to uncertainties prevailing in banking operations as in business, banks always keep excess reserves. The amount of excess reserves depends upon the interaction of two types of costs: the cost of holding excess reserves, and the cost generated by deficiency in excess reserves.
438 (435)
RBI calls M3 as broad money. M4. The fourth measure of money supply is M4 which consists of M3 plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of money supply.
439 (438)
But how does a change in money supply affect liquidity ? A
440 (439)
monetary authority that influences money supply in the economy by following "easy" or "tight" monetary policy.
441 (444)
This view is also wrong becuase it is based on arguments relating to a single bank. As pointed out by Prof Samuelson, "The banking system as a whole can do what each small bank cannot do: it can expand its loans and investments many times the new reserves of cash created for it, even though each small bank is lending out only a fraction of its deposits."
442 (446)
where 1/ RRr, the reciprocal of the percentage reserve ratio, is called the deposit (or credit) expansion multiplier.
443 (449)
2. Proper securities.
444 (449)
3. Banking habits of the People.
445 (449)
will lead to the withdrawal of cash from the credit creation stream of the banking system. This reduces the power of banks to create credit to the desired level.
446 (450)
5. Excess Reserves.
447 (450)
6. Leakages.
448 (450)
7. Cheque Clearances.
449 (450)
9. Economic Climate.
450 (450)
10. Credit Control Policy of the Central Bank.
451 (451)
We may conclude that commercial banks do not possess unlimited powers to create credit.
452 (452)
central bank is that which is the lender of the last resort.
453 (453)
The central bank can restrict or expand the supply of cash according to the requirements of the economy. Thus it provides elasticity to the monetary system. By having a monopoly of note issue, the central bank also controls the banking system by being the ultimate source of cash. Last but not the least, by entrusting the monopoly of note issue to the central bank, the government is able to earn profits from printing notes whose cost is very low as compared with their face value.
454 (454)
Thus it is the custodian of government money and wealth. As
455 (454)
Commercial banks are required by law to keep reserves equal to a certain percentage of both time and demand desposits liabilities with the central bank. It is on the basis of these reserves that the central bank transfers funds from one bank to another to facilitate the clearing of cheques.
456 (454)
manages exchange control operations by supplying foreign currencies to importers and persons visiting foreign countries on business, studies, etc. in keeping with the rules laid down by the government.
457 (456)
The most important function of the central bank is to control the credit creation power of commercial bank in order to control inflationary and deflationary pressures within the economy.
458 (458)
6. To Have Growth with Stability.
459 (458)
Quantitative Methods.
460 (458)
Limitations of Bank Rate Policy
461 (458)
2. Wages, Costs and Prices not Elastic.
462 (458)
3. Banks do not approach Central Bank.
463 (458)
4. Bills of Exchange not Used.
464 (460)
6. Power to Control Deflation Limited.
465 (460)
7. Level of Bank Rate in relation to Market Rate.
466 (460)
8. Non-Discriminatory.
467 (460)
9. Not Successful in Controlling BOP Disequilibrium.
468 (462)
Thus open market operations have a direct influence on the market rates of interest also. Limitations of Open
469 (462)
2. Cash Reserve Ratio not Stable.
470 (462)
3. Penal Bank Rate.
471 (463)
5. Pessimistic or Optimistic Attitude.
472 (463)
6. Velocity of Credit Money not Constant.
473 (466)
4. Inflexible.
474 (466)
7. Other Factors.
475 (466)
8. Depressive Effect.
476 (466)
9. Rigid.
477 (466)
10. Not for Small Changes.
478 (474)
"directives" issued from time to time to the commercial banks to follow a particular policy which the central bank wants to enforce immediately.
479 (475)
2. No Specificity.
480 (475)
3. Difficult to distinguish between Essential and Non-essential Factors.
481 (476)
5. Discriminatory.
482 (476)
6. Malallocation of Resources.
483 (476)
7. Not Successful in Unit Banking.
484 (477)
The “monetarist revolution” refers to the new and important contributions made to monetary theory and policy by Prof. Friedman and his colleagues at the University of Chicago. It was a sort of revolution against the views of Keynesians who held the view that “money does not matter.”
485 (477)
monetarist revolution “only money matters” for three reasons: one, because the quantity of money is capable of being controlled fairly accurately by deliberate policy; two, because changes in the quantity of money can produce substantial changes in the flow of income, prices and other important variables; and three, because the relationships between stock of money and other assets are relatively stable and dependable.”
486 (478)
That link is the constant velocity of money.
487 (478)
Thus there will be inflation due to inappropriate increase in money supply. That is why the monetarists regard inflation as a purely monetary phenomenon.
488 (480)
Thus the economy is usually at or near the full employment level where there is no involuntary unemployment. Friedman refers to this as the natural rate of unemployment. This view is in marked contrast to the Keynesian view that there is always underemployment equilibrium in the economy and unemployment is involuntary.
489 (481)
For example, the rational expectationists deny the possibility of any inflation-unemployment trade-off even in the short run. Economists regard the above views of the monetarists as revolutionary. 1
490 (481)
1. Money Supply Endogenous
491 (481)
2. Demand for Money not Stable
492 (481)
3. Money Supply and GNP not Positively Correlated
493 (482)
5. Real World does not Approximate to a General Equilibrium System
494 (482)
6. Economy not Inherently Stable
495 (484)
In Fisher's "Equation of Exchnage", MV = PT
496 (484)
But people also hold money for other reasons, such as to earn interest and to provide against unforeseen events.
497 (485)
The Cambridge demand equation for money is Md = kPY
498 (485)
demand for money in an economy:( 1) the transactions demand, (2) the precautionary demand, and (3) the speculative demand.
499 (486)
transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as
LT = kY
500 (490)
function of both income and interest rates which can be expressed as LT = f (Y, r).
501 (494)
But at a very low rate of interest r2, the LS curve becomes perfectly elastic. This is know as the liquidity trap when people prefer to keep money in cash rather than invest in bonds and the speculative demand for money is infinitely elastic.
502 (494)
Thus the Keynesian speculative demand for money function is highly volatile, depending upon the behaviour of interest rates.
503 (495)
balances. This is the famous Keynesian liquidity trap. In this case, changes in the quantity of money have no effects at all on prices or income. ,,At a very low rate of interest, such as r2, in Figure 5, the Ls curve becomes perfectly elastic and the speculative demand for money is infinitely elastic. This portion of the Ls curve is known as the liquidity trap.
504 (496)
Further, according to Keynes, "a long-term rate of interest of 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear."
505 (496)
First, the monetary authority cannot influence the rate of interest even by following a cheap money policy.
506 (496)
497 8937: 20150515@ Secondthe rate of interest cannot fall to zero.
507 (496)
Third, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve,
508 (496)
LT = f (Y),
509 (498)
lateral summation of LT and LS curves : L = LT + LS.
510 (503)
Baumol's inventory theoretic approach to the transactions demand for money is an improvement over the classical and Keynesian approaches.
511 (503)
1. The cash balances quantity theory of money assumed the relationship between the transactions demand and the level of income as linear and proportional. Baumol has shown that this relationship is not accurate.
512 (503)
2. Baumol's theory also has the merit of demonstrating the interest elasticity of the transactions demand for money as against the Keynesian view that it is interest inelastic.
513 (503)
3. Baumol analyses the transactions demand for real balances thereby emphasising the absence of money illusion.
514 (503)
4. Baumol's inventory theoretic approach is superior to both the classical and Keynesian approaches because it integrates the transactions demand for money with the capital-theory approach by taking assets and their interest and non-interest costs into account.
515 (503)
5. Baumol's theory removes the dichotomy between transactions and speculative demand for money of the Keynesian approach.
516 (503)
James Tobin in his famous article "Liquidity Preference as Behaviour Towards Risk," 14 formulated the risk aversion theory of liquidity preference based on portfolio selection.
517 (505)
But the majority of investors belong to the third category. They are risk averters or diversifiers.
518 (509)
First, Tobin's theory does not depend on inelasticity of expectations of future interest rates, but proceeds from the assumption that the expected value of capital gain or loss from holding interest-bearing assets is always zero.
519 (509)
Second, this theory is superior to Keynes's theory in that it explains that individuals hold diversified portfolios of bonds and money rather than either bonds or money.
520 (509)
Third, like Keynes, Tobin regards the demand for money as closely dependent on interest rates and inversely related to interest rates and his theory provides a basis for liquidity preference.
521 (509)
Fourth, Tobin is more realistic than Keynes in not discussing the perfect elasticity of demand for money (the liquidity trap) at very low rates of interest.
522 (509)
Fifth, according to David Laidler, the real importance of the portfolio theory lies in "not what it tells directly about the aggregate economy,
523 (510)
theories of interest rate such as the classical, the loanable funds, the Keynesian, and the modern
524 (510)
Keynesian liquidity preference theory that determines the interest rate by the demand for and supply of money is a stock theory. It emphasises that the rate of interest is a purely monetary phenomenon.
525 (511)
marginal productivity of capital to him. It shows that at a higher rate of interest, the demand for capital is low and it is high at a lower rate of interest. Thus the demand for capital is inversely related to the rate of interest,
526 (511)
saving involves a sacrifice, abstinence or waiting when they forgo present consumption in order
527 (512)
(2) Saving-Investment Schedules not Independent.
528 (512)
(3) Neglects the Effects of Investment on Income.
529 (513)
But Keynes does not believe that investment depends on the rate of interest. It depends on the marginal efficiency of capital.
530 (513)
So, for each income level a separate saving curve will have to be drawn. This is all circular reasoning and offers no solution to the problem of interest. That is why Keynes characterised the classical theory of interest as indeterminate. (5) Neglects other
531 (514)
(6) Unrealistic Assumption of Full Employment.
532 (514)
(7} Neglects Monetary Factors.
533 (514)
(8) No Automatic Equality between Equilibrium and Market Rates of Interest.
534 (514)
Thus, Keynes dismisses the classical theory of interest as absolutely wrong and inadequate.
535 (516)
(2) Indeterminate Theory.
536 (517)
(4) Savings not Interest Elastic.
537 (517)
(5) Not correct to combine Real and Monetary Factors.
538 (517)
Despite these weaknesses, the loanable funds theory is better and more realistic than the classical theory on a number of counts.
539 (519)
demand for resources to invest with the readiness to abstain from consumption.
540 (519)
The rate of interest, in Keynes words, is the "premium which has to be offered to induce people to hold the wealth in some form other than hoarded money."
541 (519)
According to Keynes, there are three motives behind the desire of the people to hold liquid cash: (1) the transaction motive, (2) the precautionary motive, and (3) the speculative motive.
542 (519)
Transactions Motive. The transactions motive relates to "the need of cash for the current transactions of personal and business exchanges."
543 (519)
Precautionary Motive. The precautionary motive relates to "the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases."
544 (520)
Keynes holds that the transactions and precautionary motives are relatively interest inelastic, but are highly income elastic.
545 (520)
A bond carries a fixed rate of interest. For instance, if a bond of the value of Rs 100 carries 4% interest and the market rate of interest rises to 8%, the value of this bond falls to Rs 50 in the market. If the market rate of interest falls to 2%, the
546 (520)
the liquidity trap. At a very low rate of interest, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss.
547 (524)
(3) Falls into Methodological Fallacy.
548 (524)
Thus the Keynesian theory falls into "methodological fallacy" by assuming a definite functional relationship between the quantity of money and the rate of interest.
549 (524)
(5) Inconsistent Theory.
550 (526)
"Without saving there can be no liquidity to surrender. The rate of interest is the return for saving without liquidity."
551 (526)
(8) Wrong Notion of Liquidity Trap.
552 (526)
(9) Ignores Real Factors. The greatest fallacy in Keynes's analysis is that he ignores the influence of real factors in determining the interest rate.
553 (526)
(11) Incomplete Theory.
554 (527)
It treats the interest rate as a purely monetary phenomenon and by neglecting the real factors makes the theory narrow and unrealistic.
555 (527)
(2) The liquidity preference theory is more realistic than the loanable funds theory because it is more akin to the behaviour of interest rate in the business world.
556 (528)
Hence the classical and the loanable funds theories of interest rate are indeterminate.
557 (528)
perfectly inelastic money supply curve QM is drawn on the assumption that the supply of money is fixed by the monetary authority.
558 (528)
the Kenesian theory simply relates different income levels to various interest rates, but does not show what the rate of interest will be. Hence it is an indeterminate theory.
559 (528)
The IS Curve
560 (534)
fall. This lower limit to which the rate of interest will fall is the Keynesian liquidity trap already explained above in Keynes's theory of interest.
561 (536)
Thus with a given LM curve, when the IS curve shifts to the right income increases and along with it the rate of interest also rises. Given the IS curve, when the LM curve shifts to the right, income increases but the rate of interest falls. The Hicks-Hansen analysis is thus an integrated and determinate theory of interest in which the two determinates, the IS and LM curves, based on productivity, thrift, liquidity preference and the supply of money, all play their parts in the determination of the rate of interest.
562 (536)
2. Interest Rate not Flexible.
563 (536)
3. Investment not Interest Elastic.
564 (536)
4. Highly Artificial.
565 (536)
5. Closed Model.
566 (537)
6. Price Level Exogenous Variable.
567 (538)
The Wicksell theory is based on. the following assumptions:
1. There is full employment in the economy.
2. Investment is a decreasing function of the rate of interest.
3. Saving is an increasing function of the rate of interest.
   568 (538)
   depends on the expected profitability of new investment. All factors which affect the expected profitability of investment bring changes in the natural rate of interest.
   569 (541)
   Mrs Robinson regards the Wicksell Effect as "the key to the whole theory of capital accumulation."
   570 (545)
   3. Expectations and Uncertainty. Other
   571 (546)
   Its Assumptions
   572 (551)
   The Theory
   573 (555)
   3. Another reason of the superiority of segmented market theory over the expectations theory is that it does not explain the term structure of interest rates on the basis of the average of expected short-term interest rates.
   574 (555)
   4. As against the expectations theory, the segmented market theory does not explain a unique relation between short-term and long-term interest rates.
   575 (564)
   Don Patinkin in his monumental work Money, Interest and Prices
   576 (564)
   prices will have no effect on the demand and supply of goods.
   577 (565)
   With sufficiently large fall in wages and prices, the full employment level of output and income will be restored. Finally, even if there is the “liquidity trap”, the expansion of the money supply will increase money balances, and full employment can be restored through the operation of the real balanace effect.
   578 (568)
   The Pigou effect, also known as the wealth effect, was propounded by A.C. Pigou in 1943 to counter Keynes' argument that wage-price deflation cannot lead to automatic full employment.
   579 (575)
   Keynes was against wage-cutting and argued for increase in effective demand to remove unemployment. In this chapter, we discuss in detail the classical and Keynesian views on the relationship between wages and employment.
   580 (575)
   In a competitive economy when money wages are reduced, they lead to reduction in cost of production and consequently to the lower prices of products. When prices fall, demand for products will increase and sales will be pushed up. Increased sales will necessitate the employment of more labour and ultimately full employment will be attained.
   581 (578)
   Keynes did not accept the classical view that reduction in money wages led to full employment. He emphasised that unemployment could be removed by raising effective demand. His main objections to the classical view were as follows:
   582 (579)
   Keynes, when money wages are reduced in the economy, they will reduce money incomes of the workers who will reduce their demand for products.
   583 (579)
   Thus the main defect in the classical view was the failure to recognise the dual nature of wages as costs and incomes. The classicists only considered the cost aspect and neglected the income aspect.
   584 (579)
   3. Inverse Relation between Money and Real Wages.
   585 (579)
   This is because a fall in money wages will lead to a more than proportionate fall in prices.
   586 (579)
   relation between money wage and real wage, falls down and it is not possible to achieve full employment by reduction in money wages.
   587 (580)
   5. Cut in Real Wages via Increase in Prices.
   588 (580)
   6. Cut in Money Wages Impractical.
   589 (580)
   According to .Keynes, unemployment resulted from the lack of aggregate demand. It is demand that determines employment, and employment determines the real wage rate, not the other way round.
   590 (580)
   In order to establish this, Keynes brought out the distinction between money wages and real wages. Keynes pointed out that the relation between the two is inverse.
   591 (581)
   Keynes argued that workers are prepared to work at the current money wage rate, even if their real wage rates are lowered by increase in prices. This is because of the existence of “money illusion” in the labour market.
   592 (583)
   The main difference between the classical and Keynesian propositions about cut in real wages lies in that the classicists advocated cut in real wages through cut in money wages. They believed in the flexibility of money wages.
   593 (583)
   Keynes believed that money wages are not flexible, rather they are sticky downward.
   594 (584)
   The rich, on the other hand, have a high propensity to save and a low propensity to consume. This causes a decline in aggregate demand, income and employment. This is called Keynes's redistributive effect.
   595 (584)
   hThe owners of these fixed assets will feel themselves richer than before and their propensity to consume will be strengthened and the propensity to save weakened. This is known as the Pigou Effect which will tend to increase aggregate demand and employment.
   596 (585)
   No entrepreneur will be prepared to invest under such conditions.
   597 (586)
   Thus more money will be available for speculative motive and the rate of interest would fall.
   598 (586)
   This process of increase in investment and employment via reduction in wages and rate of interest is called the “Keynes Effect.”
   599 (586)
   The process of increase in investment and employment via reduction in money wages and interest rate is called the Keynes effect.
   600 (587)
   But Keynes did not believe that a policy of flexible wages and prices can lead to full employment. It can only lead to underemployment equilibrium.
   601 (589)
   IS curve cuts the LM2 curve in the liquidity trap.
   602 (589)
   The Keynes effect has been criticised by Hansen, Patinkin and other economists on the following grounds:
   603 (590)
   (b) Money Illusion.
   604 (590)
   (c) Price Level Expectations.
   605 (590)
   3. Investment not Insensitive to Interest Rate.
   606 (590)
   4. Adverse Effects of Wage-Price Deflation.
   607 (591)
   6. Wage-Price Deflationary Process Absurd.
   608 (592)
   Again, a gereral cut in money wages is bound to adversely affect the MEC, investment and employment in the economy.
   609 (592)
   Keynes did not favour a flexible wage policy in the form of a cut in money wages on certain practical grounds also.
   610 (592)
   Further, social justice requires that money wages of worker alone should not be cut.
   611 (1093)
   According to Keynes, "The economic system cannot be made self-adjusting along these lines."
   612 (1093)
   In other words, a policy of increasing the supply of money can lead to increase in employment by lowering the interest rate, like the policy of a cut in money wages. Such a policy is not only realistic but also involves far less social costs.
   613 (594)
   "Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter."
   614 (594)
   b,0150618
   615 (594)
   Keynes in his General Theory allayed all such fears. He did not believe like the neo-classicists that there was always full employment in the economy which resulted in hyper-inflation with increases in the quantity of money.
   616 (596)
   creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 per cent per annum is characterised as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth.
   617 (597)
   3. Running Inflation.
   618 (597)
   4. Hyperinflation.
   619 (598)
   inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices.
   620 (601)
   goods market as well as in the factor market.
   621 (603)
   takes place when aggregate demand is rising while the available supply of goods is becoming less.
   622 (603)
   “too much money chasing too few goods.”
   623 (603)
   Consequently, the amount of money spent did not affect the level of real output so that a doubling of the quantity of money would result simply in doubling the price level. Until prices had risen by this proportion, individuals and firms would have excess cash which they would spend, leading to rise in prices.
   624 (604)
   “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output.”
   625 (606)
   Keynes and his followers emphasise the incease in aggregate demand as the source of demand-pull inflation.
   626 (606)
   Thus the aggregate demand comprises consumption, investment and government expenditures. When the value of aggregate demand exceeds the value of aggregate supply at the full employment level, the inflationary gap arises.
   627 (607)
   The supply of some factors might become inelastic or others might be in short supply and non-substitutable. This would lead to increase in marginal costs and hence in prices.
   628 (613)
   Cost-push inflation is caused by wage increases enforced by unions and profit increases by employers.
   629 (613)
   The basic cause of cost-push inflation is the rise in money wages more rapidly than the productivity of labour. In advanced countries, trade unions are very powerful.
   630 (614)
   Cost-push inflation may be further aggravated by upward adjustment of wages to compensate for rise in the cost of living index.
   631 (615)
   impact on prices. Economists, therefore, do not give much importance to profit-push inflation as an explanation of cost-push
   632 (616)
   The cost-push theory has been criticised on three issues.
   633 (616)
   debate between demand-pull and cost-push inflation arises mainly from the difference between the policy recommendations on the two views. Recommendations on demand-pull inflation are related to monetary and fiscal measures which lead to a higher level of unemployment.
   634 (618)
   “The trouble is that we have no normal initial standard from which to measure, no price level which has always existed to which every one has adjusted.”
   635 (618)
   If prices increase first, it is a demand-pull inflation, and if wages increase follow, it is a cost-push inflation.
   636 (618)
   elements of both.
   637 (619)
   Suppose an inflationary process begins with excess demand with no cost-push forces at work. Excess demand will raise prices which will in due course pull up money wages. But the rise in money wages is not the result of cost-push forces. Such a mixed inflation will lead to sustained rise in prices.
   638 (621)
   The cost-push inflationary process will be self-sustaining only if every wage-push is accompanied by a corresponding increase in aggregate demand.
   639 (625)
   first the prices of agricultural goods, second, the general price level, and third, wages. Let us analyse them.
   640 (625)
   2. Wage Increases.
   641 (627)
   5. Money Supply.
   642 (628)
   The analysis is based on the assumption that both wages and prices are “administered”
   643 (629)
   Inflation is open when “markets for goods or factors of production are allowed to function freely, setting prices of goods and factors without normal interference by the authorities.”
   644 (630)
   The Phillips curve examines the relationship between the rate of unemployment and the rate of money wage changes.
   645 (633)
   b,0150620
   646 (634)
   But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation. So long as there is discrepancy between the expected rate and the actual rate of inflation,
   647 (634)
   expected rate of inflation.
   648 (634)
   Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may
   649 (634)
   imperfections.But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly
   650 (636)
   In the long-run, the economy is bound to establish at the natural unemployment rate.
   651 (636)
   There is, therefore, no trade-off between unemployment and inflation except in the short run.
   652 (639)
   Conclusion. The vertical Phillips curve has been accepted by the majority of economists. They agree that at unemployment rate of about 4 per cent, the Phillips curve becomes vertical and the trade-off between unemployment and inflation disappears. It is impossible to reduce unemployment below this level because of market imperfections.
   653 (641)
   levels of unemployment. In other words, it provides a guideline to the authorities about the rate of inflation which can be tolerated with a given level of unemployment. For this purpose,
   654 (650)
   3. Increase in Public Expenditure.
   655 (650)
   4. Increase in Consumer Spending.
   656 (650)
   5. Cheap Monetary Policy.
   657 (650)
   7. Expansion of the Private Sector.
   658 (650)
   8. Black Money.
   659 (650)
   9. Repayment of Public Debt.
   660 (650)
   10. Increase in Exports.
   661 (651)
   2. Industrial Disputes.
   662 (651)
   3. Natural Calamities.
   663 (652)
   5. Increase in Exports.
   664 (652)
   6. Lop-sided Production.
   665 (652)
   7. Law of Diminishing Returns.
   666 (652)
   8. International Factors.
   667 (652)
   Monetary measures aim at reducing money incomes.
   668 (652)
   (b) Demonetisation of Currency.
   669 (653)
   (b) Increase in Taxes.
   670 (653)
   (d) Surplus Budgets.
   671 (655)
   (c) Price Control.
   672 (655)
   (d) Rationing.
   673 (655)
   Conclusion. From the various monetary, fiscal and other measures discussed above, it becomes clear that to control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-headed monster which should be fought by using all the weapons at the command of the government.
   674 (655)
   fixed income group and the flexible income group.
   675 (657)
   (2) Salaried Persons. Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.
   676 (657)
   (3) Wage Earners.
   677 (658)
   (5) Equity Holders or Investors.
   678 (658)
   (7) Agriculturists.
   679 (658)
   (8) Government.
   680 (659)
   Conclusion. Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors.
   681 (660)
   inflation adversely affects production
   682 (660)
   (2) Changes in the System of Transactions.
   683 (660)
   (3) Reduction in Production.
   684 (660)
   (4) Fall in Quality.
   685 (660)
   (5) Hoarding and Blackmarketing.
   686 (660)
   (7) Hinders Foreign Capital.
   687 (660)
   (8) Encourages Speculation.
   688 (661)
   (3) Exchange Rate.
   689 (661)
   (4) Collapse of the Monetary System.
   690 (661)
   (6) Political.
   691 (664)
   economic or social loss arising from the effects of inflation.
   692 (664)
   Individuals and business enterprises hold cash balances because they yield utility to them. At a higher rate of inflation, they find the purchasing power of the money balances diminishing.
   693 (664)
   The majority of economists also regard the redistributive effects of inflation as the cost of inflation.*
   694 (665)
   usually associated with falling activity and employment. As
   695 (666)
   deflation affects adversely the distribution of income and wealth. When
   696 (667)
   Keynes, “Inflation is unjust, deflation is inexpedient.
   697 (667)
   all the evils in a capitalist society, unemployment leading to poverty is the worst.
   698 (667)
   Inflation is unjust because it widens the gulf between the rich and the poor.
   699 (667)
   Thus it leads to inequalities of income and wealth.
   700 (667)
   creating shortages and hardships for the common man.
   701 (667)
   socially harmful. People are lured to amass wealth by unscrupulous means.
   702 (668)
   Keynes pointed out that, “it is not necessary that we weigh one evil against the other.
   703 (668)
   But deflation is a greater evil. Though it redistributes income in favour of the low income groups, yet it fails to benefit them because they are unemployed and have little income during deflation.
   704 (670)
   But the effectiveness of public expenditure primarily depends upon the public works programme, its importance in the economic system, the volume and nature of public works and their planning and timing.
   705 (670)
   b,0150621
   706 (671)
   trade characterised by falling prices and high unemployment percentages.”
   707 (671)
   (2) The Long Jugler Cycle.
   708 (672)
   (4) Building Cycles.
   709 (672)
   (5) Kuznets Cycle.
   710 (672)
   Business cycles possess the following characteristics :
   711 (672)
   2. Fluctuations are recurrent in nature.
   712 (672)
   3. They are non-periodic or irregular. In other words, the peaks and
   713 (673)
   4. They occur in such aggregate variables as output, income, employment and prices.
   714 (673)
   5. These variables move at about the same time in the same direction but at different rates.
   715 (673)
   6. The durable goods industries experience relatively wide fluctuations in output and employment but relatively small fluctuations in prices.
   716 (673)
   7. Business cycles are not seasonal fluctuations such as upswings in retail trade during Diwali or Christmas.
   717 (673)
   8. They are not secular trends such as long-run growth or decline in economic activity.
   718 (673)
   9. Upswings and downswings are cumulative in their effects.
   719 (673)
   4,Recovery
   720 (678)
   3. Over-Investment.
   721 (678)
   5. Psychological Causes.
   722 (679)
   7. Marginal Efficiency of Capital (MEC). According to Keynes, the cycle consists primarily of fluctuations in the rate of investment.
   723 (680)
   To conclude with Samuelson, business cycles are caused both by external and internal factors. The economic system responds to fluctuations in external factors according to its internal factors, and vice versa.
   724 (680)
   Thus the rich become richer and the poor poorer.
   725 (683)
   (2) Money Supply cannot Continue a Boom or Delay a Depression.
   726 (684)
   (4) Traders do not React to changes in Interest Rates.
   727 (684)
   (5) Factors other than Interest Rate More Important.
   728 (684)
   (7) Does not Explain Periodicity of Cycle.
   729 (684)
   (8) Ignores Non-Monetary Factors.
   730 (686)
   (2) Unrealistic Assumption of Equilibrium.
   731 (686)
   (3) Interest Rate not the only Determinant.
   732 (687)
   (5) Investment does not fall with Increase in Consumer Goods.
   733 (687)
   6. Incomplete Theory.
   734 (688)
   Schumpeter assigns the role of an innovator not to the capitalist but to an entrepreneur. He does not provide funds but directs their use.
   735 (689)
   Thus Schumpeter's first approximation consists of a two-phase cycle. The economy starts at the equilibrium state, rises to a peak and then starts downward into a recession and continues till the new equilibrium is reached.
   736 (690)
   (2) Innovations not the Only Cause of Cycles.
   737 (690)
   (3) Bank Credit not the Only Source of Funds.
   738 (690)
   (4) Innovation financed through Voluntary Savings does not produce a Cycle.
   739 (691)
   prices. Since full employment is an exception rather than the rule. Thus Schumpeter's theory is not a correct explanation of trade cycles.
   740 (691)
   According to Pigou, expectations originate from some real factors such as good harvests, wars, natural calamities, industrial disputes, innovations, etc. But he attributes the causes of business cycle into two categories : (a) inpulses and (b) conditions. Impulses refer to those causes which set a process in motion.
   741 (696)
   (2) Divergent Cobweb.
   742 (697)
   The analysis of the cobweb theory is based upon very restrictive assumptions which make its applicability doubtful.
   743 (698)
   2. Output not Determined by Price.
   744 (698)
   3. Divergent Cobweb Impossible.
   745 (698)
   4. Continuous Cobweb Impractical.
   746 (699)
   The Keynesian theory of the trade cycle is an integral part of his theory of income, output and employment.
   747 (699)
   mainly due to "a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system."
   748 (699)
   "the cycle consists primarily of fluctuations in the rate of investment. And
   749 (700)
   must elapse before recovery begins, depends partly upon the magnitude of the normal rate of growth of the economy and partly upon the length of life of capital goods.
   750 (700)
   Keynes's theory of the trade cycle is superior to the earlier theories because "it is more than a theory of the business cycle in the sense that it offers a general explanation of the level of employment, quite independently of the cyclical nature of changes in employment."
   751 (701)
   (3) Explanation of Crisis Wrong.
   752 (701)
   (4) Incomplete Theory.
   753 (701)
   (5) Not Based on Empirical Data.
   754 (701)
   (6) One-Sided Theory.
   755 (701)
   Yt = Gt + Ct + It ...( 1)
   where Yt is national income Y at time t which is the sum of government expenditure Gt , consumption expenditure Ct and induced investment It.
   756 (701)
   Ct = aYt– 1 ...( 2)**
   It = ß( Ct– Ct– 1)
   757 (708)
   Hicks writes in this connection: “I shall follow Keynes in assuming that there is some point at which output becomes inelastic in response to an increase in effective demand.”
   758 (709)
   The Hicksian theory of the business cycle has been severely criticised
   759 (710)
   Duesenberry, Smithies and others
   760 (710)
   2. Value of Accelerator not Constant.
   761 (710)
   3. Autonomous Investment not Continuous.
   762 (711)
   5. Distinction Between Autonomous and Induced Investment not Feasible.
   763 (711)
   6. Ceiling Fails to Explain adequately the onset of Depression. Hicks has been criticised for his explanation of the ceiling or the upper
   764 (711)
   8. Full Employment level not Independent of Output Path.
   765 (712)
   10. Mechanical Explanation of Trade Cycle.
   766 (712)
   11. Contraction Phase not Longer than Expansion Phase.
   767 (712)
   But the actual behaviour of the postwar cycles has shown that the expansionary phase of the business cycle is much longer than the contractionary phase.
   768 (712)
   Despite these apparent weaknesses of the Hicksian model, it is superior to all the earlier theories in satisfactorily explaining the turning points of the business cycle.
   769 (718)
   the weaknesses of Goodwin's model.
   770 (719)
   (i) changes in economic activity have always been accompanied by changes in the money stock; (ii) there have not been major changes in the money stock that have not been accompanied by changes in economic activity; and (iii) changes in the stock of money have been attributed to a specific variety of exogenous factors rather than to changes in economic activity.
   771 (723)
   (3) Time Lag of Peaks and Troughs not Long and Variable.
   772 (723)
   Despite these criticisms, it cannot be denied that one of the important causes of business cycles is "a dance of the dollar."
   773 (728)
   Monetary policy as a method to control business fluctuations is operated by the central bank of a country.
   774 (728)
   boom, it raises its bank rate, sells securities in the open market, raises the reserve ratio, and adopts a number of selective credit control measures such as raising margin requirements and regulating consumer credit. Thus the central bank adopts a dear money policy.
   775 (728)
   To control a recession or depression, the central bank follows an easy or cheap monetary policy by
   776 (728)
   2. Fiscal Policy
   777 (729)
   government tries to reduce unnecessary expenditure
   778 (729)
   policy of having a surplus budget when the government revenues exceed expenditures.
   779 (729)
   borrow more from the public
   780 (730)
   Policy during Depression. During a depression, the government increases public expenditure, reduces taxes and adopts a budget deficit policy.
   781 (730)
   public works as roads, canals, dams, parks, schools, hospitals and other construction works.
   782 (730)
   Therefore, all methods should be used simultaneously.
   783 (732)
   investment. Firstly, it creates income, and secondly, it augments the productive capacity of the economy by increasing its capital stock.
   784 (734)
   fundamental equation of the model:
   785 (735)
   net autonomous investment (? I/ I) must be equal to as (the MPS times the productivity of capital).
   786 (736)
   The warranted rate of growth is, according to Harrod, the rate “at which producers will be content with what they are doing.”
   787 (738)
   is less than saving and that the aggregate demand falls short of aggregate supply. The result is fall in output, employment, and income. There would thus be chronic depression.
   788 (743)
   (3) The two models also fail to consider changes in the general price level.
   789 (743)
   (4) The assumption that there are no changes in interest rates is irrelevant to the analysis.
   790 (743)
   (5) The Harrod-Domar models ignore the effect of government programmes on economic growth.
   791 (743)
   (6) It also neglects the entrepreneurial behaviour which actually determines the warranted growth rate in the economy.
   792 (743)
   Despite these limitations, “Harrod-Domar growth models are purely laissez-faire ones based on the assumption of fiscal neutrality and designed to indicate conditions of progressive equilibrium for an advanced economy.”
   793 (758)
   The Solow-Swan neoclassical growth model explains the long-run growth rate of output based on two exogenous variables: the rate of population growth and the rate of technological progress
   794 (760)
   The Romer Model.
   795 (761)
   Romer takes investment in research technology as endogenous factor in terms of the acquisition of new knowledge by rational profit maximisation firms.
   796 (763)
   ,3. Romer's Model of Technological Change
   797 (763)
   In the Romer model, new knowledge enters into the production process in three ways. First, a new design is used in the intermediate goods sector for the production of a new intermediate input. Second, in the final sector, labour, human capital and available producer durables produce the final product. Third, and a new design increases the total stock of knowledge which increases the productivity of human capital employed in the research sector.
   798 (781)
   Macroeconomic policy is achieved through certain instruments and objectives. Its two main instruments are monetary and fiscal policy and its four major objectives are full employment, price stability, economic growth, and balance of payments equilibrium.
   799 (782)
   For instance, the government may have the following policy objectives : (1) to achieve full employment at the rate of 3 per cent unemployment; (2) to achieve price stability at an annual inflation rate of 5 per cent per annum; and (3) to attain the growth rate of 5 per cent per annum for the economy. Thus the policy targets of the government are 3 per cent unemployment rate, 5 per cent inflation rate and 5 per cent growth rate per year. On the other hand, policy instruments are those exogenous variables that can be directly influenced by the government.
   800 (782)
   Full employment has been ranked among the foremost objectives of economic policy.
   801 (782)
   According to Pigou, the tendency of the economic system was to automatically provide full employment in the labour market.
   802 (783)
   However, this classical view on full employment is consistent with some amount of frictional, voluntary, seasonal or structural unemployment.
   803 (783)
   Thus the problem of full employment is one of maintaining adequate effective demand.
   804 (784)
   Thus the Keynesian concept of full employment involves three conditions: (i) reduction in the real wage rate; (ii) increase in effective demand; and (iii) inelastic supply of outut at the level of full employment.
   805 (784)
   frictional unemployment of 3% in a full employment situation for England.
   806 (785)
   Differential price changes are essential for allocating resources in the market economy.
   807 (786)
   Generally, economists believe in the possiblity of continual growth.
   808 (786)
   The economy may not grow further if there is no improvement in the quality of labour in keeping with the new technologies.
   809 (787)
   Another objective of macroeconomic policy since the 1950s has been to maintain equilibrium in the balance of payments.
   810 (788)
   What is the balance of payment target of a country ?
   811 (788)
   A deficit in the balance of payments of a country can be wiped out with restrictive monetary and fiscal policies, by reducing imports and encouraging exports, and by devaluation of the currency.
   812 (789)
   Thus unskilled workers are the worst sufferers because they are thrown out of jobs with automation.
   813 (790)
   Full Employment and Price Stability
   814 (790)
   Economists do not find any conflict between unemployment and price stability.
   815 (791)
   Price Stability and Balance of Payments
   816 (793)
   Obviously, points to the right and above the IB curve relate to inflation or over full employment, and points to the left and below the curve refer to recession or unemployment.
   817 (793)
   points above the EB curve refer to a surplus and points below the curve relate to a deficit in the balance of payments.
   818 (795)
   Tinbergen Principle which leads to the assignment problem. The solution to this problem has been suggested by Mundell which we discuss below in detail.
   819 (795)
   If there are more objectives than policy instruments it means that there are not enough tools to achieve the policy objectives. The system is undetermined.
   820 (795)
   Thus the number of policy tools must equal the number of targets for economic policy to be successful. This has come to be known as the Tinbergen Principle or the fixed targets approach.
   821 (799)
   2. Ignores Stagflation.
   822 (799)
   3. Neglects Other Factors.
   823 (799)
   4. Practical Constraints.
   824 (800)
   6. Not a True Adjustment Mechanism.
   825 (800)
   7. Debt-Servicing Requirements not Considered.
   826 (800)
   8. Retards Capital Formation.
   827 (801)
   10. Long Time Lags.
   828 (801)
   According to Keynesians, the economy is subject to many exogenous shocks from factors like changes in expectations, political events, international events such as oil crisis, war, etc.
   829 (801)
   Therefore, Keynesians argue that government should follow activist fiscal and monetary policies to stabilise the economy.
   830 (801)
   To Keynesians, stabilisation policy means “leaning against the prevailing economic wind.”
   831 (805)
   Friedman distinguishes among three basic lags: the recognition lag, the administrative lag, and the operation lag. These lags are explained as under:
   832 (805)
   Empirical evidence in the U.S. suggests that in the past the Federal Reserve Bank recognised the need for monetary action only three months after the trough in a business cycle and about six months after a boom had started. Thus the recognition lag has been longer at the peaks than at the troughs.
   833 (806)
   Countercyclical policy means “leaning against the prevailing economic winds”. It implies that the authorities follow an easy policy in a recession and a tight policy in a boom.
   834 (806)
   According to Friedman, “We seldom in fact know which way the economic wind is blowing until several months after the event.”
   835 (807)
   Friedman, therefore, calls for an end to discretion in policy. In place of the judgement of monetary and fiscal authorities, he proposes that it should follow a fixed long-run rule, that is to increase the money supply and fiscal deficit at an annual fixed percentage rate regardless of current economic conditions.
   836 (808)
   The Keynesians also do not concur with Friedman’s policy prescription to avoid the lag problems. They favour the use of monetary policy to control a boom, and supplementing monetary policy with fiscal policy to control a recession.
   837 (809)
   b,0150714
   838 (809)
   Objectives or Goals of Monetary Policy
   839 (809)
   2. Price Stability
   840 (809)
   3. Economic Growth
   841 (809)
   4. Balance of Payments
   842 (811)
   Changes in Reserve Ratios.
   843 (811)
   Selective Credit Controls.
   844 (814)
   1. Increase in the Velocity of Money.
   845 (816)
   (c) Methods to Make Better Use of Available Money Supply.
   846 (817)
   3. Threat to Credit Market.
   847 (817)
   4. Threatens Solvency of NBFIs.
   848 (817)
   5. Alter Expectations of Borrowers and Lenders. A very tight monetary policy may alter the expectations of borrowers
   849 (818)
   Keynes did not agree with the classical view that the supply of money influences the price level directly and that the economy always stays at the full employment level. Moreover, the classical analysis was related to the long-run where market forces worked the economy toward full employment.
   850 (819)
   contends that a change in the supply of money can permanently change such variables as the rate of interest, the aggregate demand, and the level of employment, output and income.
   851 (819)
   Keynes believed in the existence of unemployment equilibrium.
   852 (819)
   In a situation of unemployment, Keynes advocated cheap money policy.
   853 (820)
   the rate of interest, the lower the demand for money, and vice versa. This negative relationship between the demand for money and the rate of interest provides a link between changes in the supply of money and the level of economic activity.
   854 (820)
   He argued that at a very low interest rate, the demand for money curve becomes perfectly elastic.
   855 (820)
   This is the liquidity trap portion of the demand for money curve which is completely flat. This means that further increases in the supply of money by the monetary authority cannot reduce the rate of interest. This implies that there will be no effect on investment and income, and monetary policy does not influence economic activity.
   856 (820)
   “If we are tempted to assert that money is the drink which stimulates the system of activity, we must remind ourselves that there may be several steps between the cup and the lip.”
   857 (821)
   Recent researches have shown that Keynes was misrepresented by his followers in attributing that he was not a votary of monetary policy.
   858 (822)
   Thus the “neo-Keynesians contend that financial assets are the closest substitutes for money, and that, consequently, increases in the supply of money will have their effect eventually on the level of economic activity by bringing about increases in the output of capital goods industries.”
   859 (822)
   The monetarists led by Friedman are of the view that excess money balances will be used to purchase not only financial assets but also real assets such as houses, land, consumer durables, etc.
   860 (824)
   Broadly speaking, liquidity means moneyness. Liquidity is characterised by the ease of converting an asset into money at little cost. A liquid asset is one which is easily spendable, marketable (transferable) and has capital certainty.
   861 (825)
   Thus it held the view that “changes in rates of interest only very exceptionally have direct effects on the level of demand.”
   862 (830)
   Though the ultimate aim of fiscal policy is the long-run stabilisation of the economy, yet it can be achieved by moderating short-run economic fluctuations. In this context, Otto Eckstein defines fiscal policy as "changes in taxes and expenditures which aim at short-run goals of full employment and price-level stability."
   863 (831)
   fiscal policy has two approaches: (1) built-in stabilisers; and (2) discretionary fiscal policy.
   864 (831)
   changes in the budget are automatic and hence this technique is also known as one of automatic stabilisation. The various automatic stabilisers are corporate profits tax, income tax, excise taxes, old age, survivors and unemployment insurance and unemployment relief payments.
   865 (832)
   Built-in stabilisers have certain advantages as a fiscal device. They are: 1. The built-in stabilisers serve as a cushion for private purchasing power when it falls and lessen the hardships on the people during deflationary period. 2. They prevent national income and consumption spending from falling at a low level. 3. There are automatic budgetary changes in this device and the delay in taking administrative decisions is avoided. 4. Automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures. 5. They integrate short-run and long-run fiscal policies.
   866 (833)
   This policy has the following limitations: 1. The discretionary fiscal policy depends upon proper timing and accurate forecasting.
   867 (835)
   Deficit budgeting is an important method of overcoming depression
   868 (835)
   Budget deficit may also be secured by reduction in taxes and without government spending.
   869 (841)
   But the total expenditure remains unchanged and fiscal policy has no expansionary effect on national income.
   870 (846)
   Monetarism refers to the followers of Milton Friedman who hold that " only money matters", and as such monetary policy is a more potent instrument than fiscal policy in economic stabilisation. On the other hand, Keynesianism refers to the followers of Keynes who believe that "money does not matter,"
   871 (848)
   Friedman's historical findings show a " stable money demand function" which implies that the demand for money is a stable function of peoples' income.
   872 (849)
   The Keynesian View The Keynesians hold just the opposite views to monetarists about the demand for and supply of money and the aggregate expenditure. Both the demand for and supply of money are highly interest elastic while the aggregate expenditure is not.
   873 (851)
   Thus so long as there is unemployment, output will change in the same proportion as the quantity of money, and there will be no change in prices; and when there is full employment , prices will change in the same proportion as the quantity of money.
   874 (851)
   According to the monetarists, monetary policy has a greater influence on economic activity than fiscal policy, and fiscal policy is important only in making changes in the money supply. On the other hand, the Keynesians emphasise the importance of both fiscal and monetary policy
   875 (912)
   From the late 1960s to 1970s, a new phenomenon appeared in the form of both high unemployment and inflation, known as stagflation. This phenomenon of stagflation posed a serious challenge to economists and policy makers because the Keynesian theory was silent about it. Out of this crisis emerged a new macroeconomic theory which is called the Rational Expectations Hypothesis (Ratex).
   876 (914)
   Muth pointed out that certain expectations are rational in the sense that expectations and events differ only by a random forecast error.
   877 (917)
   The Ratex hypothesis assumes that people have all the relevant information of the economic variables. Any discrepancy between the actual rate of inflation and the expected rate is only in the nature of a random crror.
   878 (919)
   Thus for expansionary fiscal and monetary policies to have an impact on unemployment in the short-run, the government must be able to fool the people . But it is unlikely to happen all the time. If the government continues to persist with such policies, they become ineffective because people cannot be fooled for long and they anticipate their effects on production and unemployment.
   879 (924)
   Thus supply-side economists advocate reduction in tax rates in order to increase the incentives to work, save and invest and to get more tax revenue by the government. Increase
   880 (929)
   The Keynesians advocate demand management policies both fiscal and monetary to stabilise the economy. They favour active interventionist fiscal and monetary policies. They do not regard the two policies as competitive but complementary to each other.
   881 (929)
   In contrast , monetarist hold that the economy is basically stable and when disturbed by some change in basic conditions will quickly revert to its long- run growth path.
   882 (930)
   The new classical macroeconomics is based on the following principles or hypotheses: (1) Markets Continuously Clear (2) Rational Expectations (3) Aggregate Supply Hypothesis
   883 (934)
   This behaviour of workers to substitute current leisure for future leisure and vice versa is known as intertemporal substitution.
   884 (952)
   1. New classical economists argued that Keynesian economics was theoretically inadequate because it was not based on microeconomic foundations. According to them, macroeconomic models should be based on firm microeconomic foundations.
   885 (953)
   But in new Keynesian models, wages and prices fail to adjust rapidly enough to clear markets within a short time so as to keep the quantity demanded of labour equal to its quantity supplied. But this is an unemployment equilibrium.
   886 (969)
   Blanchard comments that new Keynesian economics has led to the construction of "too many monsters with few interesting results."
   887 (971)
   "Far from being a set of facts looking for a theory, the new Keynesian paradigm suffers from too many unrelated theoretical explanations." Robert Gordon. In the light of this statement,
   888 (971)
   b,0150726
   889 (972)
   But in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance sheet.
   890 (995)
   Given these assumptions, when a country devalues its currency, the domestic prices of its imports are raised and the foreign prices of its exports are reduced. Thus devaluation helps to improve BOP deficit of a country by increasing its exports and reducing its imports.
   891 (995)
   Marshall-Lerner condition states: when the sum of price elasticities of demand for exports and imports in absolute terms is greater than unity, devaluation will improve the country’s balance of payments, i.e. ex + em > 1 where ex is the demand elasticity of exports and Em is the demand elasticity for imports.
   892 (1032)
   Jan Tinbergen 6 was the first economist to lay down that the number of policy instruments must be equal to the number of objectives. If there are more objectives than policy instruments it means that there are not enough tools to achieve the policy objectives.
   893 (1033)
   Robert Mundell by the Principle of Effective Market Classification.
   894 (1042)
   commercial controls which operate on the goods side of transactions by preventing people from buying certain goods or forcing them to buy others, or providing financial incentives like tariff subsidies, etc. for certain kinds of sales or purchases.
   895 (1042)
   But direct controls involve large social costs. They lead to welfare losses when people are prevented from using foreign exchange and import goods.They also involve large administrative costs.
   896 (1056)
   59. No Free Trade.
   897 (1056)
   Such trade restrictions are tariff, import quotas, customs duties and various exchange control devices which tend to reduce the volume of imports. These, in turn, cause wide deviations between the actual exchange rate and the exchange rate set by the purchasing power parity.
   Pagetop