Module 4

Syllabus

Measurement of National Income – Two sector model, consumption and saving function,
theory of multiplier, basic concept of three sector and four sector model, business cycles
and economic stabilization policies

National Income

 National income is the money value of all economic activities of a nation conducted in a
given year.
 An economic activity refers to production of goods and services which can be valued at
market prices.
 It includes agricultural production, industrial production and production of services.
 Goods and services which do not have an exchange value or market value are non-
economic in nature.
 For instance, services of a housewife, house husband, services of members of family to
other members or their own selves, hobbies etc.
 The national income of a country can be defined as the total market value of all final
goods and services produced in the economy in a given year.
 National income measures market value of annual output.
 It is therefore a monetary measure of the value of goods and services.
 In order to measure the real national income or the measure the changes in physical
output of goods and services, the figure for national income is adjusted for price changes.
 Further, for the accurate calculation of national income, all goods and services produced
in a year must be counted only once.
 Generally, goods are produced at different stages before they reach the markets in their
final form.
 Hence components of goods are exchanged many times. Thus to avoid multiple counting
national income includes only the market value of final goods.
 This is how national income is defined in terms of product flow.

For example,

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 Stage 1 Stage 2 Stage 3 Stage 4 Stage 5
Value added by Value added by Value added by Value added by Final value of
farmer miller baker retailer bread
Rs. 5 Rs. 2 Rs. 5 Rs. 3 Rs. 15
Value of storing The final value
and handling by of bread
retailer
Value of baking Value of baking
Value of milling Value of milling Value of milling
wheat into flour
Value of wheat Value of wheat Value of wheat Value of wheat

 National income can also be defined in terms of money flow.

 Economic activities generate money flow in the form of payments i.e. wages, interest,
rents and profits.
 National income can thus be obtained by adding the factor incomes and adjusting it for
indirect taxes and subsidies.
 National income obtained in this manner is known as National income at factor cost.
 National income can be viewed from different angles.
 It represents total receipts and it also represents total expenditure.
 When goods and services are valued at their market prices, three identities are created,
namely: the value of receipts equal to the value of payments equal to the value of goods
and services produced and sold.
 These three identities can be put as: National Income = National Expenditure = National
product.
 To understand the concept, let us assume a two sector model of an economy consisting of
households and firms.
 Firms produce goods and services.
 In order to produce, firms require factor services: viz, land, labour, capital and enterprise.
 Factors of production are paid their prices in the form of rent, wages, interests and profits.

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  These incomes become the source of expenditure.
 Thus income flows from the firms to the households in exchange for productive services.
 The income goes back to the firms in the form of expenditure made by households on
goods and services.
 This process is also referred to as the Circular Flow of Economic Activities.
 There are thus three measures of national income of a country, namely:

1. The total value of all final goods and services produced

2. The total of all incomes received by the factor owners in a year and

3. The total of consumption expenditure, net investment expenditure and government

expenditure on goods and services.

 Thus three measures denote the three fundamental functions of an economic system or a
national economy, namely: production, distribution and expenditure. The fourth
fundamental function is that of consumption and is subsumed in expenditure.

Introduction to Circular Flow of income

In barter economy, goods were produced for our own consumption. There was no surplus. In the
modern economy where money is used as a medium of exchange, goods and services are not
produced for self-help and free services. Today, goods are produced for the market.

Production and consumption is carried out two different economic entities referred to as
households and firms in the modern economy. The households supply factor services viz. land,
labour, capital and enterprise to the firms and are paid in return the factor rewards in the form of
rent, wages, interest and profit.

On receipt of payments, households spend it on the goods and services produced by the firms. In
this way, the total income flows in the circular manner from the firms to households and from the
households back to the firms.

One may deduce from the above said statement that National Output is equal to National
Income which is equal to National Expenditure. National Output refers to the real flow of goods
and services, national income is the money value of the goods and services which is produced

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which can be mathematically expressed as the sum of factor rewards (r + i + w + r) and national
expenditure is the disposable income for the consumption of goods and services produced.

DIFFERENCE BETWEEN CLOSED ECONOMY AND OPEN ECONOMY:

 When the trade is carried out within the domestic borders of the country, it is referred to
as closed economy.
 The trade that is carried outside / across the borders is referred to as open economy.
 Closed economy does not include exports and imports wherein open economy would
include exports and imports.

CIRCULAR FLOW OF INCOME IN A CLOSED ECONOMY:

Two Sector Model (without savings)

This simple economy consists of households and firms. It is free from government and external
sector. This model is based on the following assumptions:

1. This consists of only two sectors, namely households and firms.

2. Households own factor services such as land, labour, capital and enterprise and the firms
use these services.
3. Households receive payments in the form of rent, wages, interest and profits.
4. Both households and firms have zero savings.
5. There is no foreign trade or the government sector. As there is no savings, financial
sector does not exist.
6. Supply of factor services and the state of technology are given.

Let us proceed to understand the working of this simple economic system.

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The figure is divided into two parts. The uppermost part represents the factor market in
which the households sell their factor services, namely land, labour, capital and enterprise.
Firms buy them by making payments in the form of rent, wages, interest and profit. The
exchange of factor services for factor payments facilitates flow of factors of production to the
firms and the flow of factor payments to the households, thus completing half the circular
flow.

The lower half of the figure represents goods market. The firms sell goods and services and
earn revenue. Households buy the goods and services. In this way, household income flow
back to the firms and goods and services to the household, thereby completing the circular
flow of income. Thus, the economy is in equilibrium when factor payments is equal to the
value of output and the value of output is equal to the household expenditure.

TWO SECTOR WITH SAVINGS

Savings are nothing but leakages from the circular flow of income. This savings are again
injected back into the economy in the form of investment. Actually savings reduces the level
of national income but investment restores it to the original level. Households have part of
their income in the form of bank deposits and financial investments through money and
capital markets. Firms borrow from the money and capital markets and convert these into
real investment.

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From this one may infer that when savings are made, the circular flow of income is disturbed
and when investments are made, the equilibrium is restored.

However, in reality savings and real investment are never equal in reality as they are
undertaken by two different economic units, namely households and firms. When savings are
greater than investment national income will decline and vice versa. Theoretically,
equilibrium is established when savings are equal to investments. Mathematically it can be
expressed as

Y=C+S=C+I

C is common to both the sides hence it can be stated as I = S.

THREE SECTOR MODELS (FIRMS, HOUSEHOLDS AND GOVERNMENT)

The savings and the investments are also caused by the financial market operations of the
government. The State spends on the welfare and developmental works. These expenses
made and met by the State Government are met through public revenue. Both direct and
indirect taxes collected make public revenue. Taxes are form of leakages from the circular
flow of income. Where direct taxes are concerned, both personal income tax and corporate

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tax gain importance. Households pay personal income tax and the firms pay up corporate tax
to the government. The money that is collected in the form of revenue is (ejected from the
circular flow of income is injected back) invested into the flow thereby maintaining an
equilibrium. This is possible only when the government follows a balanced budget, i.e., when
public revenue is equal to public income. However, there are surplus and deficit budgets. The
surplus budget reduces the level of national income as the leakage is not matched by the
investment, deficit budget increases the level of National Income if the deficit is made good
by monetization and not borrowing from the financial markets. Government borrowings from
the financial markets will reduce the circular flow of income and when the borrowed money
is spent, an equilibrium is established.

The above figure depicts circular flow of income in a three sector economy. When the
national flows are matched by the real flows equilibrium is established. The income received
by the household sector for their factor services is spent on the goods and services produced
by the firms and it constitute the consumption expenditure. The savings and the financial
expenditure are made by the household sector and this is matched by government

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expenditure on goods and services, subsidies and transfer payments. When the government
spends the surplus, money goes into the financial markets. When the government runs a
deficit budget, it borrows from the financial market.

CIRCULAR FLOW OF INCOME IN AN OPEN ECONOMY

When we talk about the open economy the fourth sector i.e external or foreign sector is
added. This includes exports and imports. When a country exports, it receives money from
abroad and such flows are injections into the economy. Similarly, when a country imports,
monetary flows eject out of the economy and such flows will be considered as leakages,
ejections or outflows. Hence, exports increase the level of equilibrium income and imports
decrease it. Therefore, if the circular flow of income is to be in equilibrium, exports should
be equal to imports. When net exports are positive, the equilibrium will rise and if net exports
are negative, the equilibrium income will decrease.

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 A four sector open economy will be in equilibrium when exports is equal to imports.
Savings, taxes and imports are leakages (L) and investment, government expenditure and
exports are injections (I). Symbolically, the circular flow of income in an open economy can
be stated as:

S+T+M=I+G+X

Where S + T + M = L

I+G+X=I

Whatever be the sector, when injections are equal to ejections an equilibrium is established.

The main features of the four-sector economy are as follows:

1. By the introduction of the foreign sector, the scope widened further. The money flows to
households or firms when they buy goods and services from a foreign country, also known as
imports.
2. The money flows back to households when foreign countries give them employment. For firms,
money flows back when foreign countries purchase their goods and services, also called exports.
3. If the value of imports is equal to the value of exports, it is called balanced trade. If imports are
greater than exports, it is referred to as a trade deficit. If exports are greater than imports then it
is called a trade surplus.
4. However, in the diagram, for the sake of simplicity, the trade relation (for goods and services) is
shown only between firms and foreign markets.
5. In 2019, it was reported the United States had a trade balance deficit of around USD 922.78
billion.
6. Thus, it can be said that the foreign players are investing in the US market, or the US firms are
relying on the foreign market to fulfil their production needs and vice-versa.
Importance of the Circular Flow

 The concept of the circular flow gives a clear-cut picture of the economy.
 From this one can understand whether the economy is working efficiently or whether is
any disturbance to its smooth functioning.
 It also helps the government in formulating policy measures.

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1. Study of Problems of Disequilibrium

 It is with the help of circular flow that the problems of disequilibrium and the restoration
of equilibrium can be studied.
2. Effects of leakages and injections

 The role of leakages enables us to study their effects on the national economy.
 For example, imports are a leakage out of the circular flow of income because they are
payments made to a foreign country.
 To stop this leakage, government should adopt appropriate measures so as to increase
exports and decrease imports.
3. Link between producers and consumers

 The circular flow establishes a link between producers and consumers.

 It is though income that producers buy the services of the factors of production with
which the latter, in turn, purchase goods from the producers.
4. Creates a Network of Markets

 As a corollary to the above point, the linking of producers and consumers through the
circular flow of income and expenditure has created a network of markets for different
goods and services where problems relating to their sale and purchase are automatically
solved.
5. Inflationary and Deflationary tendencies

 Leakages or injections in the circular flow disturb the smooth functioning of the
economy.
 For example, saving is a leakage out of the expenditure stream.
 If saving increases, this depresses the circular flow of income.
 This tends to reduce employment, income and prices, thereby leading to a deflationary
process in the economy.
 On the other hand, consumption tends to increase employment, income, output and prices
that lead to inflationary tendencies.
6. Basis of the multiplier

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  If leakages exceed injections in the circular flow, the total income becomes less than the
total output.
 This leads to a cumulative decline in employment, income, output and prices over time.
 On the other hand, if injections into the circular flow exceed leakages, the income is
increased in the economy.
 This leads to a cumulative rise in employment, income, output and prices over a period of
time.
 In fact, the basis of the Keynesian multiplier is the cumulative movements in the circular
flow of income.
7. Importance of monetary policy

 The study of circular flow also highlights the importance of monetary policy to bring
about the equality of saving and investment in the economy.
 Equality between saving and investment comes through the credit or capital market.
 The credit market itself is controlled by the government through monetary policy.
 When saving exceeds investment or investment exceeds saving, money and credit
policies help to stimulate or retard investment spending.
 This is how a fall or rise in prices is also controlled.
8. Importance of fiscal policy

 The circular flow of income and expenditure points toward the importance of fiscal
policy.
 For national income to be in equilibrium desired saving plus taxes (S + T) must equal
desired investment plus government spending (I + G).
 S + T represent leakages from the spending stream which must be offset by injections of I
+ G into the income stream.
 If S + T exceed I + G, government should adopt such fiscal measures as reduction in
taxes and spending more itself.
 On the contrary, if I + G exceed S + T, the government should adjust its revenue and
expenditure by encouraging saving and tax revenue.
 Thus, the circular flow of income and expenditure tells us about the importance of
compensatory fiscal policy.

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9. Importance of trade policies

 Similarly, imports are leakages in the circular flow of money because they are payments
made to a foreign country.
 To stop it, the government adopts such measures as to increase exports and decrease
imports.
 Thus the circular flow points toward the importance of adopting export promotion and
import control policies.
10. Basis of flow of funds accounts

 The circular flow helps in calculating national income on the basis of the flow of funds
accounts.
 The flow of funds accounts are concerned with all transactions in the economy that are
accomplished by money transfers.
 They show the financial transactions among different sectors of the economy, and the
link between saving and investment, and lending and borrowing by them.
 To conclude, the circular flow of income possesses much theoretical and practical
significance in an economy.
Consumption function
The term consumption function refers to an economic formula that represents the functional
relationship between total consumption and gross national income (GNI). The consumption
function was introduced by British economist John Maynard Keynes, who argued the function
could be used to track and predict total aggregate consumption expenditures. It is a valuable
tool that can be used by economists and other leaders to understand the economic cycle and help
them make key decisions about investments as well as monetary and fiscal policy.
The consumption function is an economic formula introduced by John Maynard Keynes, who
tracked the connection between income and spending. Also called the Keynesian consumption
function, it tracks the proportion of income used to purchase goods and services. Put simply, it
can be used to estimate and predict spending in the future.
The classic consumption function suggests consumer spending is wholly determined by income
and the changes in income. If true, aggregate savings should increase proportionally as the gross

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domestic product (GDP) grows over time. The idea is to create a mathematical relationship
between disposable income and consumer spending, but only on aggregate levels.
Based in part on Keynes' Psychological Law of Consumption, the stability of the consumption
function is a cornerstone of Keynesian macroeconomic theory. This is especially true when it is
contrasted with the volatility of an investment. Most post-Keynesians admit the consumption
function is not stable in the long run since consumption patterns change as income rises.
Calculating the Consumption Function
The consumption function is represented as:
C = A + MD
where:
C=consumer spending
A=autonomous consumption
M=marginal propensity to consume
D=real disposable income
Assumptions and Implications
Much of the Keynesian doctrine centers around the frequency with which a given population
spends or saves new income. The multiplier, the consumption function, and the marginal
propensity to consume are each crucial to Keynes’ focus on spending and aggregate demand.
The consumption function is assumed stable and static where all expenditures are passively
determined by the level of national income. The same is not true of savings or government
spending, both of which Keynes referred to as investments.
For the model to be valid, the consumption function and independent investment must remain
constant long enough for gross national income to reach equilibrium. At equilibrium, the
expectations of businesses and consumers match up. One potential problem is that the
consumption function cannot handle changes in the distribution of income and wealth. When
these change, so too might autonomous consumption and the marginal propensity to consume.
Other Versions

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Over time, other economists have made adjustments to the Keynesian consumption function.
Variables such as employment uncertainty, borrowing limits, or even life expectancy can be
incorporated to modify the older, cruder function.
For example, many standard models stem from the so-called life cycle theory of consumer
behavior as pioneered by Franco Modigliani. His model made adjustments based on how
income and liquid cash balances affect an individual's marginal propensity to consume. This
hypothesis stipulated that poorer individuals likely spend new income at a higher rate than
wealthy individuals.
Milton Friedman offered his own simple version of the consumption function, which he called
the “permanent income hypothesis.” Notably, the Friedman model distinguished between
permanent and temporary income. It also extended Modigliani’s use of life expectancy to
infinity.
More sophisticated functions may even substitute disposable income, which takes into account
taxes, transfers, and other sources of income. Still, most empirical tests fail to match up with the
consumption function’s predictions. Statistics show frequent and sometimes dramatic
adjustments in the consumption function.
Saving Function
The functional relationship between saving and national income is known as Saving Function.
It shows the savings of households during a given period of time at a given income level. In
alternate terms, the savings function shows different savings levels at different income levels
in an economy. Saving function is also known as Propensity to Save and is represented by S =
f(Y); where S = Saving, Y = National Income, and f = Functional Relationship.

Let’s understand the concept of Saving Function with the help of the following saving schedule
and saving curve.

Saving Schedule:

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 Saving (S)
Income (Y) Consumption (C) (₹
(₹ Crores) (₹ Crores) Crores)

0 80 -80

100 140 -40

200 200 0

300 260 40

400 320 80

500 380 120

600 440 160

The above schedule shows saving at different income levels.

In the above graph, X-axis represents National Income and Y-axis represents Saving.

Observation:
1. Starting Point: The saving curve (SS) starts from point S on Y-axis and not from point O,
which means that at zero income level, there is a negative saving equal to the amount of
autonomous consumption.
2. Slope of Saving Curve: The slope of the saving curve SS is positive, which means that there
is a positive relationship between saving and income.
3. Break-even Point; i.e., S = 0: The saving curve SS crosses the X-axis at point R, which is the
break-even point. This point is known as the break-even point because here, saving is zero, or
consumption is equal to income. In the above example, break-even point occurs at ₹200 Crores
income level.
4. Positive Saving: After the break-even point; i.e., after S = 0, saving is positive.

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The saving curve will have a negative intercept on Y-axis which is of the same magnitude as the
positive intercept of consumption curve on Y-axis. It is because if at zero income level,
consumption is positive, then it means that there is dissaving of the same magnitude.

Types of Propensities to Save

The two types of Propensities to Save are Average Propensity to Save (APS) and Marginal
Propensity to Save (MPS).
1. Average Propensity to Save (APS):
It is the ratio of saving to the corresponding income level. The formula to determine Average
Propensity to Save (APS) is:

Average Propensity to Save can never be one or more than one; however, it can be zero. The
point at which the APS is equal to zero is known as the break-even point. Also, the average
propensity to save increases with the increase in income because the income proportion saved
keeps on increasing.

2. Marginal Propensity to Save (MPS):

It is the ratio of the change in saving to the change in total income. The formula to determine
Marginal Propensity to Save (MPS) is:

Marginal Propensity to save varies between 0 and 1. If the whole additional income is saved then
MPS will be equal to one, and if the whole additional income is consumed then MPS will be
equal to zero.

Equation of Saving Function

The equation of linear consumption function can be used to derive the equation of Saving
Function.

As we know,

S = Y – C …………………..(1)

and C=(\bar{c})+b(Y) …………………..(2)

By putting the value of (1) in (2), the equation of Saving Function will be:

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Where,

S = Saving

= Negative saving at zero income level

1 – b = MPS

Y = National Income

As the above equation is a straight line with intercept (-\bar{c}) and slope ‘1 – b’, it is a case of
the linear saving function. The equation of the saving function can be used to prepare the saving
curve by calculating saving expenditure at different income levels, if the value of (-\bar{c}) and
(1-b); i.e., MPS is given. For example, If the value of (-\bar{c}) and 1 – b are 30 Crores and
0.20 respectively, then the Saving Expenditure at income level will be 200 Crores, then savings
will be
S = -30 + 0.20(200)

= – 30 + 40 = 10 Crores.

Theory of Multiplier

 The theory of multiplier is one of the path breaking contributions by J. M. Keynes.

 Multiplier explains the relationship between investment and income.
 According to J. M. Keynes an increase in investment will lead to multiple increase in
aggregate income.

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  Multiplier is defined as the relationship between an initial increase in investment and the
final increase in aggregate income.
 In simple words, it is the ratio of change in income to the change in investment.
 Change in investment leads to change in income via consumption expenditure.
∆Y
 Symbolically it can be expressed as Multiplier = .
∆I
 Suppose ∆ I = Rs. 5 crores and ∆ Y = Rs. 20 crores then multiplier value is 4.
 It implies that an increase in investment will lead to increase in income by 4 times.
 Thus change in income will be more than the change in investment.
 J. M. Keynes developed this theory in 1929.
 Keynesian multiplier is known as investment multiplier or income multiplier.
 R. F. Khan gave another version in 1931 which came to be known as employment
multiplier.
 Employment multiplier explains the relationship between primary increase in primary
employment to the total employment.
 It explains how employment of one person leads to the number of people indirectly
employed.
 While investment multiplier of Keynes is represented by k, employment multiplier of R.
F. Khan is denoted by k’.

Multiplier and MPC

 The value of multiplier depends upon marginal propensity to consume (MPC).

 MPC refers to the change in consumption due to change in income.
∆C
 It is expressed as MPC = .
∆Y
 It is a direct relationship between MPC and multiplier.
 Higher the MPC, higher will be the value of multiplier and vice versa.
 The following formula is used to calculate the value of k.
1 1
 k= . It can also be expressed as k = as MPC + MPS = 1. ∴ MPS = 1 –
1−MPC MPS
MPC.

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 1 1 1
 Suppose MPC = , then k = = = 5/4 = 1.25
5 1−1/5 4 /5
 If investment increases by Rs. 10 crores then increase in income will be ∆ Y =∆ I x k
= 12.5 crores.
 Thus multiplier is reciprocal of marginal propensity to save which nothing but the change
in savings is due to change in income.
 When MPC increases, value of multiplier also rises.
 When MPC = 0, it implies that there is no change in consumption due to the change in
income.
 The additional income here is not causing any change in consumption. Hence k = 1 and
therefore aggregate income will increase only by the initial increase in investment.
 On the other hand when MPC = 1, it implies that the entire increase in income is used for
consumption.
 Therefore, multiplier value will be infinity and the change in income will also be infinity.
 MPC = 0 or MPC = 1 are extreme cases.
 In reality MPC varies between 0 and 1 and multiplier value varies between 1 and ∞ .

Assumptions of multiplier

The theory of multiplier assumes the following conditions:

a. The economy is a closed economy i.e. there is no foreign trade.

b. There is no government intervention.

c. Full employment does not exist.

d. MPC remains constant throughout the process of income generation or propagation.

e. There is no change in monetary and fiscal policy.

f. Excess capacity exists in the consumer goods industry.

g. Increase in investment and increase in income are instantaneous.

Working of multiplier

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  The process of income propagation due to multiplier effect can be explained with the help
of an example.
 Let us assume that the initial investment increases by Rs. 4000 crores in the transport
sector and MPC = ¾. The value of multiplier and increase in aggregate income can be
calculated as follows:
MPC = ¾. Therefore, MPS = ¼. k = 1/MPS = 1/1/4 =4.
 ∆ Y =∆ I x k = 4000 x 4 = Rs. 16, 000 crores.
 Thus an initial increase in investment of Rs. 4000 crores will increase aggregate income
by Rs. 16, 000 crores.
 This is because when investment is increased in one sector, it increases the income of the
people in this sector as well as people in other sectors.
 Moreover, one man’s income is another man’s expenditure.
 This results in more demand for goods and services, increase in consumption expenditure
and finally the multiplier effect takes place.
 In the above example, when investment increases by Rs. 4000 crores, people employed in
this sector get an income of Rs. 4000 crores.
 Out of this they will spend 3/4th on consumption (MPC is given as ¾).
 Therefore in the first round increase in consumption is Rs. 3000 crores (3/4 x 4000).
 This consumption expenditure of people in this sector becomes income for another group.
 They will spend ¾ of this income of Rs. 3000 crores i.e. Rs. 2, 250 crores on
consumption.
 In the next round this consumption expenditure will become income for another group of
people and they will spend 3/4th on consumption.
 This process will continue and the final increase in income will be Rs. 16, 000 crores.

Diagrammatic representation

The theory of multiplier can be explained with the help of a graph:

A
C + I’
Consumption and E’ C+I
Investment M2 E
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 M1

M 45°

O Y1 Y2

Income

 In the above graph, the 45° line OA is the income line.

 The C curve represents the consumption curve.
 C + I indicate investment and consumption.
 This curve C + I intersects the 45° line at point E. E is the equilibrium point and the
equilibrium level of income is OY1.
 When investment increases, the C + I curve shifts upwards.
 It intersects the 45° line at point E’. The new equilibrium point is E’ and the equilibrium
level of income is OY2.
 The increase in investment is M1 M2 and the increase in income is Y1 Y2. It is obvious
from the figure that Y1Y2 > M1M2. Thus a small change in investment brings about a
larger change in income due to multiplier effect.

Reverse Multiplier

 Reverse multiplier explains how a small reduction in investment will lead to a larger fall
in income.
 When investment is reduced in one sector or industry, the people employed in the
industry would be affected.
 Their income and consumption expenditure will fall.
 This would affect other sectors and finally the aggregate income will decline much more
than the fall in investment.

Leakages of Multiplier

 Certain factors reduce the value of MPC and multiplier. They are called as leakages.
They are as follows:

a. Debt cancellation/repayment

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If people use a part of their increased income for repayment of debt, then MPC will be low and
multiplier value will be low.

b. Inflation

The increase in income may be enough to buy the same quantity of goods or less due to rise in
prices. Hence there is no real increase in consumption.

c. Taxation

If tax rates are increased consumption will fall, reducing MPC and multiplier.

d. Imports

Imports drain away the money from the domestic economy. Imports do not add to the income
stream of the economy.

e. Liquidity preference

If people have high liquidity preference, spending will be less reducing the value of MPC.

f. Purchase of old securities

If the rise in income is used for buying old securities, then consumption will be less reducing
multiplier value.

 All the leakages have to be plugged if multiplier has to be effective. Lesser the leakages
greater would be the increase in income due to increase in investment.

Criticisms/limitations of multiplier

Keynesian theory of multiplier is not free from criticisms. The following are the major ones:

a. Assumptions like closed economy, constant MPC, absence of government intervention etc. are
considered unrealistic.

b. When investment increases, income will increase. This will lead to more demand for goods
and services. If supply is not increased, inflation will set in.

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c. If there is a net decline in investment, then multiplier will not work.

d. Leakages like imports, taxation, debt repayment etc. affect the working of multiplier.

e. Once the economy attains full employment, increase in investment will result in inflation
rather than increase in income.

f. It is a static theory and not suitable for dynamic economies.

g. Multiplier focuses only on autonomous investment. Exclusion of induced investment is a

major limitation according to the critics.

Conclusion

 Despite all the criticisms, the multiplier theory has a special place of significance in
macroeconomics. It helps to analyse trade cycles and highlights the importance of
government intervention when private investments fall. Multiplier theory is used by
modern economists to support the ever increasing public expenditure of welfare states in
the present era. It has also paved the way for further developments in macroeconomics.

Business cycles

 Trade cycles or business cycles refer to the ups and downs in business.
 Business is always characterized by fluctuations rather than stability.
 Trade cycles indicate the progress attained by a country during a given period of time.
 It also indicates the uncertainties involved in business and their effects on the economy.
 Trade cycles occur regularly in a capitalist economy, they are recurring in nature.
 The fluctuations manifest themselves in terms of changes in income, employment,
savings, prices and investment.
 These fluctuations in the various economic indicators are called business cycles or trade
cycles.
 Trade cycles follow a wave-like movement to indicate that prosperity will be followed by
depression and depression followed by prosperity.
 The various phases of trade cycle are nothing but the upswing and downswing.
 The term trade cycle is defined by many economists.

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  According to J. M. Keynes, “A trade cycle is composed of periods of good trade,
characterized by rising prices, low unemployment altering with periods of bad trade
characterized by falling prices and high unemployment.”
 Trade cycles or business cycles are wave like movement in the economic activities of a
country. The fluctuations in variables like income, output, prices etc. reflect the wavelike
movement.

Features/characteristics of business cycles

Business cycles exhibit certain specific features. They are as follows:

a. Business cycles are recurrent in nature but not periodical.

b. It refers to wave like fluctuations in economic activities.

c. The various economic variables like output, employment, income, prices etc. move in the
same direction. Either they rise or fall together.

d. Prosperity and depression follow each other alternately.

e. Both prosperity and depression have the seeds of their own destruction.

f. During the uptrend or downtrend, prices, output, employment etc. change. Along with these
changes, money supply, velocity of circulation etc. also changes.

g. Due to globalization in the recent times trade cycle in one country gets transmitted to other
countries very easily. While prosperity helps rich countries, recession or depression affects the
poor or developing countries very severely.

h. Business cycles are recurrent in nature. At the same time no two business cycles are the same.
Some may be steeper than others and each one is influenced by different socio-economic factors.

Phases of trade cycles

Trade cycles are ups and downs in business. A trade cycle consists of upward and downward
phases. The phases are classified as:

a. depression

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b. recovery

c. prosperity and

d. recession.

They following diagram depicts the four phases of a trade cycle.

 In the diagram the horizontal line indicates steady growth of the economy.
 The upward phase starts from recovery, reaches peak through prosperity.
 The downward phase consists of recession, depression and trough.
 Trade cycles are always measured from point to point, that is from peak or from
trough to trough.
 The various phases of trade cycle can be explained as follows:

a. Depression

 During depression, economic activities are at a low level.

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  It is characterized by low level of investment, low production, high level of
unemployment, declining profits and continuous fall in income and savings.
 All sectors of the economy suffer from inflation.
 Business pessimism prevails in the economy. When the economic activities reach the
rock bottom it is referred to as trough.
 It is a very painful stage as all the sections of the economy are affected severely.

b. Recovery

 Depression phase does not continue forever.

 Gradually a revival starts in economic activities. Positive signals to revive the economy
appear during this phase.
 Demand starts increasing leading to an increase in investment, production, employment
etc.
 Recovery starts due to public welfare programmes and investments undertaken by the
government.
 In due course of time the private sector joins in the recovery process.
 Increased investment leads to more production, more employment, more income and
further increase in demand for goods and services.
 The combined effects of multiplier and accelerator provide momentum to the
expansionary phase.
 At this stage, recovery turns into prosperity.

c. Prosperity

 During this stage demand for goods and services will be more than supply.
 Profits tend to rise at a faster rate compared to the increase in cost of production.
 Capacity utilization will be very high and the level of investment will continue to rise.
 When the trade cycle reaches its highest point, it is known as boom or peak.
 This upward trend will reach saturation after some point of time.
 Stagnating demand, shortage of skilled labour, infrastructural constraints etc. will lead to
recession.

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  Hence it is said that the seeds of recession are sown during the peak period.

d. Recession

 It refers to the downward trend.

 If national income of the economy declines in two quarters in succession it is said to be
recession.
 A fall in demand will lead to fall in investment, employment, output, profits etc.
 Unemploymnet starts increasing at a faster rate during recession times.
 When recession becomes severe it is termed as depression.

Conclusion

 Thus trade cycle is a wave like movement resulting in fluctuations in the various
economic parameters like employment, income etc. Government intervention at the right
time helps the economy to revive and be on the path of progress.

Impact of business cycles on economic growth and development

 Business cycles impact the growth and development of an economy in various ways.
 Due to globalization in the present era, trade cycles anywhere in the world will affect
other countries.
 The classic example is the financial crisis in USA in 2008 and the recession that
followed.
 Along with USA, other countries were also affected. During the recovery and boom
period, trade cycles have a positive impact on the growth and development of the
economy as follows:

a. During recovery, due to the increase in public investment i.e. government’s investment,
economic activities get a boost and they start increasing.

b. Production, employment and national income start rising.

c. As the growth process gets accelerated, resource mobilization and utilization becomes better.

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d. A well performing economy becomes an attractive destination for foreign investors. Flow of
foreign capital adds to the resources of the economy.

 When the economy reaches the boom or prosperity period the level of income, output and
employment is quite high. Profits, investment, saving etc. remain at a high level.
However after a certain point saturation sets in leading to the downswing. Hence it is said
that the seeds of recession are sown during prosperity. Both recession and depression are
painful. The effects of downswing are:

a. Decline in investment resulting in low production, employment and income.

b. Saving and capital formation gets affected.

c. Flow of foreign capital declines.

d. Overall pessimism prevails in the economy.

e. Unemployment, inequality and poverty tend to increase affecting social harmony.

f. Trade and investment flows with other countries also get affected.

Thus trade cycles affect the growth and development of the economy significantly.

Role of government in various phases (Economic stabilization policies)

The role of government was not given much significance till the Great Depression of 1930’s.
During the Great Depression the market could not revive the economy. The government had to
interfere. From that time onwards the role of government in controlling trade cycles has become
imperative. Modern governments use both monetary and fiscal measures to control trade cycles.

1. Monetary measures

 Monetary measures influence money supply, credit creation and rate of interest.
 During inflation the central bank will use a dear money policy. (Dear money policy refers
to a monetary policy by the central bank where the central bank sets high interest rates so
that credit is not easily available to the general public in order to decrease the rate of
inflation in the economy by curbing demand.)

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  Under this credit creation by banks will be controlled by using quantitative and
qualitative methods.
 The weapons used are bank rate (In case of inflation, the bank rate is increased due to
which the cash left with commercial banks decreases with its credit creation capacity and
in case of deflation the bank rate is decreased due to which commercial banks are able to
create more credit.) CRR (Cash reserve ratio or CRR is a part of the RBI's monetary
policy, which helps eliminate liquidity risk and regulate money supply in the economy.),
open market operation (Open market operation (OMO) is a term that refers to the
purchase and sale of securities in the open market by the Federal Reserve), variation in
margin requirements (Variation margin is dependent on multiple factors, such as the type
of asset, prevailing market conditions, and expected price movements. When a broker
needs its investor to contribute additional funds to its trading account in order to fulfill
the minimum criteria of margin amount, a margin call is made.) etc.
 During recession and depression period an easy monetary policy is followed to increase
credit supply to revive the economy.

2. Fiscal measures

 Fiscal measures deal with government’s revenue, expenditure, and public debt. During
prosperity time the government will impose more taxes, spend less and mobilize public
debt.
 On the contrary, during recession time the government’s expenditure will be more.
 Taxes will be reduced and repayment of public debt will be done.
 Government has to play a very active role during recession and depression.
 During these times private investment will be low due to low profits.
 Hence public investment has a crucial role to play in reviving the economy.

Conclusion

In the present era, all governments adopt a combination of fiscal and monetary measures to
control trade cycles effectively.

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