Department of Distance and

Continuing Education
University of Delhi

Master of Business Administration (MBA)

Semester - II
Course Credit - 4.5
Core Course - MBAFT - 6203
 Editorial Board
Dr. Kumar Bijoy
Ms. Shalini Prakash

Content Writers
Dr. Minesh Kumar Srivastava, Dr. Sunil Kumar,
Dr. Arjun Singh Solanki, Dr. Dezy Kumari,
Dr. Meghna Aggarwal,

Academic Coordinator
Mr. Deekshant Awasthi

© Department of Distance and Continuing Education

ISBN: 978-81-19169-08-5
1st edition: 2023
e-mail: ddceprinting@col.du.ac.in
management@col.du.ac.in

Published by:
Department of Distance and Continuing Education under
the aegis of Campus of Open Learning/School of Open Learning,
University of Delhi, Delhi-110 007

Printed by:
School of Open Learning, University of Delhi
Disclaimer

DISCLAIMER

This book has been written for academic purposes only.Though every
effort has been made to avoid errors yet any unintentional errors
might have occurred . The authors ,the editors,the publisher and the
distributor are not responsible for any action taken on the basis of this
study module or its consequences thereof.

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 MBAFT-6203: ECONOMIC ENVIRONMENT OF BUSINESS

INDEX
LESSON 1: INTRODUCTION TO MACROECONOMICS ................................................... 1
1.1 Learning Objectives
1.2 Introduction
1.3 Macroeconomic Variables: Meaning and Relationships
1.4 Fiscal Policy, Budget Deficits, and Budget Surpluses
1.5 Business Cycle
1.6 National Income Accounts
1.7 Measuring Price Changes: Real vs Nominal GDP
1.8 Summary
1.9 Glossary
1.10 Answers to In-Text Questions
1.11 Self-Assessment Questions
1.12 References
1.13 Suggested Readings

LESSON 2: NATIONAL ACCOUNTS&PROBLEMS OF GDP MEASUREMENTS ....... 25

2.1 Learning Objectives
2.2 Introduction
2.3 Need of National Income Accounts
2.4 Approach to Measure Economic Activities
2.5 Measuring GDP (Group Domestic Product)
2.6 Practical Exercise to Calculate GDP
2.7 Other Important Concepts
2.8 Problems Associated with GDP Calculation in India
2.9 Green GDP
2.10 Summary
2.11 Glossary
2.12 Self-Assessment Questions
2.13 References
2.14 Suggested Readings

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LESSON 3: ECONOMIC GROWTH ....................................................................................... 50

3.1 Learning Objectives
3.2 Economic Growth
3.3 Growth around the World
3.4 A Model of Production
3.5 Solow Growth Model
3.6 Total Factor Productivity
3.7 Balanced Growth Path
3.8 Steady State Growth Path
3.9 Transition Dynamics
3.10 Lessons for Developed and Developing Countries
3.11 Summary
3.12 Glossary
3.13 Answers to In-text Questions
3.14 Self-Assessment Questions
3.15 References
3.16 Suggested Readings

LESSON 4: THE IS-LM MODEL ............................................................................................ 75

4.1 Learning Objectives
4.2 Introduction
4.3 Keynesian Framework
4.4 The interaction of goods and money market explained by IS-LM Curves
4.5 The Short-Run Equilibrium in the IS–LM model
4.6 Effect of Fiscal Policy on the IS Curve and Changes the Short-Run Equilibrium
4.7 Effect of monetary policy on LM curve and the Short-Run Equilibrium
4.8 The Interaction between Monetary and Fiscal Policy
4.9 Summary
4.10 Glossary
4.11 Answers to In-Text Questions
4.12 Self-Assessment Questions
4.13 References
4.14 Suggested Readings

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LESSON 5AD/AS FRAMEWORK ........................................................................................... 93

5.1 Learning Objectives
5.2 Introduction
5.3 Supply Side Economics
5.4 Difference between the Short Run and Long Run
5.5 The Model of Aggregate Supply and Aggregate Demand
5.6 Policy effectiveness and AD& AS
5.7 Fiscal policy
5.8 Monetary policy
5.9 Trade and Exchange rate policy
5.10 Summary
5.11 Glossary
5.12 Answers to In-Text Questions
5.13 Self-Assessment Questions
5.14 References
5.15 Suggested Readings

LESSON 6: PHILIPS CURVE , MONETARY POLICY, AND FISCAL POLICY .......... 110
6.1 Learning Objectives
6.2 Introduction
6.3 Philips Curve
6.4 Expectation Augmented Philips Curve
6.5 Fiscal Policy
6.6 Monetary Policy
6.7 Neutrality of Money
6.8 Crowding Out
6.9 Liquidity Trap
6.10 Role of the central Bank
6.11 Self-Assessment Questions
6.12 References

LESSON 7: THEORIES OF TRADE AND BALANCE OF PAYMENT ........................... 142

7.1 Learning Objectives
7.2 Introduction
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7.3 Theories of International Trade

7.4 Balance of Payment
7.5 Summary
7.6 Answers to In-text Questions
7.7 Self-Assessment Questions
7.8 References
7.9 Suggested Readings

LESSON 8: EXCHANGE RATES AND THE MUNDELL–FLEMING MODEL ............ 185

8.1 Learning Objectives
8.2 Introduction
8.3 Exchange Rates and the Foreign Exchange Market
8.4 Capital Account Convertibility
8.5 The Mundell–Fleming Model
8.6 Summary
8.7 Glossary
8.8 Answers to In-Text Questions
8.9 Self-Assessment Questions
8.10 References
8.11 Suggested Readings

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LESSON 1
INTRODUCTION TO MACROECONOMICS
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies –
Technical Campus, New Delhi
Email-Id: minesh.srivastava@gmail.com

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3 Macroeconomic Variables: Meaning and Relationships
1.3.1 Output
1.3.2 Aggregate Supply
1.3.3 Aggregate Demand
1.3.4 Unemployment
1.3.5 Inflation
1.4 Fiscal Policy, Budget Deficits, and Budget Surpluses
1.5 Business Cycle
1.6 National Income Accounts
1.7 Measuring Price Changes: Real vs Nominal GDP
1.8 Summary
1.9 Glossary
1.10 Answers to In-Text Questions
1.11 Self-Assessment Questions
1.12 References
1.13 Suggested Readings

1.1 LEARNING OBJECTIVES

After studying this chapter, you will be able to:
● Understand the subject matter of macroeconomics
● Trace the behaviour of Indian economy over the past several decades
● Define and measure the important macroeconomic variables.
● Examine the national income accounts of the economy.
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1.2 INTRODUCTION
The term macroeconomics was first coined in the year 1933 by the Norwegian economist
Ragnar Frisch. It was emerged as a major branch of economics during the Great Depression
of the 1930s. The severe economic situation during the Great Depression lent importance to
the subject matter of macroeconomics. It is the study of the behaviour of the economy as a
whole. John Maynard Keynes in his famous book, ‘The General Theory of Employment,
Interest, and Money’, developed a framework to systematically analyse the behaviour of
aggregate economic variables such as employment and output. His theories were extended
and elaborated by his followers during the two decades following World War II. Keynesian
economists faced major challenge in the late 1960s, when the world saw an increased interest
in monetarism. Monetarism is a body of theory developed during 1940s by Milton Friedman
and others. In 1970s, a new school of thought named the new classical economics came into
picture. And, during 1980s, Keynesian economics was challenged by a group of economists
called the supply-side economists. The real business cycle theory and the new Keynesian
economics were two other major schools of thought that emerged in the 1980s and 1990s.
Alfred Marshall has defined economics as the “study of mankind in the ordinary business of
life; it examines that part of individual and social action which is most closely connected with
the attainment and with the use of the material requisites of well-being.” This study material
examines the branch of economics called macroeconomics, where we study the ordinary
business of life in the aggregate. Here, we analyse the behaviour of the economy as a whole.
The key variables under macroeconomics are total output in the economy, the aggregate price
level, employment and unemployment, interest rates, wage rates, and foreign exchange rates.
We will determine the levels of these variables and assess how the variables change over
time. The subject matter of macroeconomics includes the rate of growth of output, the
inflation rate, changing unemployment in periods of expansion and recession, and
appreciation or depreciation in foreign exchange rates.
Macroeconomics is a subject that is policy-oriented. It questions, to what extent can
government policies affect output and employment? To what extent the rise in the price level
is the result of unplanned government policies? What governmental measures should be taken
to achieve the lowest possible rates of unemployment or inflation? Do the policies of the
government favour our foreign exchange rates? You will be able to analyse the effects of
various policy decisions made by the government after reading this chapter.

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1.3 MACROECONOMIC VARIABLES: MEANING AND

RELATIONSHIPS

According to estimates, India once accounted for one-fourth of the global GDP. But, when it
gained independence in 1947 it was left with mass unemployment, poverty, starvation, and
very few large industries. Even after a few decades of independence, the country was
importing wheat and other essential commodities from outside. In this section, we see the
trends of key macroeconomic variables such as output, employment, price level, etc. in the
context of Indian economy.
1.3.1 Output
Since its Independence, India has come a long from being nowhere to be one of the biggest
economies in the world. In 1947, India's GDP was approximately Rs 2.8 lakh crore which has
increased many folds to $3.17 trillion, making it the sixth-largest economy. Figure 1.1 shows
the growth rate of output of India from the period 1960–2020. The output measure in the
figure is real gross domestic product (GDP). Gross domestic product is the value of current
production of goods and services. Real means that the value of the GDP has been adjusted for
price change. The data measure growth in the quantity of goods and services produced. The
data in the figure show considerable variation in GDP growth over the past six decades.
During the 1960s and 70s, there were instances of negative growth in the GDP.
Fig 1.1: GDP Growth Trends (1960-2020)

Source: World Bank (https://www.macrotrends.net/countries/IND/india/gdp-growth-rate)

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1.3.2 Aggregate Supply

Aggregate supply refers to the quantity of goods and services produced by an economy.
Aggregate supply is a function of the price level. Just as in goods markets, higher prices bring
about a greater amount of supply in the short-run. Fig 1.2 illustrates a short-run aggregate
supply (SRAS) curve and a long-run aggregate supply (LRAS) curve. The real level of output
of goods and services (real GDP) is on the horizontal axis and the overall level of prices in
the economy is on the vertical axis.

Fig 1.2: Short-run and Long-run Aggregate Supply Curve

From the figure, first we will understand why the LRAS curve is a vertical line and why the
SRAS curve slopes upward. Then we will discuss the factors that cause the curves to shift
over time. LRAS is not affected by the price level. LRAS is the potential (full-employment)
real output of the economy. The potential output of an economy will primarily depend on
three factors. Potential output is positively related to:
1. The size of the labour force in the economy
2. The size of the economy's capital stock (productive resources).
3. The technology that the economy possesses.
The amount of labour that is readily available at any given time can change as unemployment
changes. The number of people employed and the number of hours they work will change as
people decide to enter or leave the workforce, change jobs, businesses grow or fail. When the
economy is operating at full employment, the level of real GDP on the LRAS curve
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represents the level of production. Remember that there is still some unemployment even
when there is full employment. There will always be some unemployment as people look for
the best jobs out there, employers look for the best candidates, and as the economy changes
and leaves workers from industries with declining employment without the skills needed to
work in industries that are expanding.
Along the LRAS curve, there is a natural rate of unemployment that is correlated with the
magnitude of real GDP. That level of output is referred to as full-employment GDP. As we
will see, the economy can " operate at less than full employment GDP during a recession
when cyclical unemployment is high, and (temporarily) at above full-employment GDP
during periods of rapid economic growth. The LRAS curve may shift over time as the full-
employment quantity of labour changes, as the amount of available capital in the economy
changes, or as technology improves the productivity of capital, labour, or both.
Firms will react to changes in the prices of goods and services in the short-term. The key to
understanding movements in the SRAS curve is to understand that we are allowing the prices
of final goods and services to vary while holding the wage rate and the price of other
productive resources constant in the short-run. When goods and services prices rise (fall),
businesses have an incentive to expand (reduce) production, and real GDP will increase
(decrease) above (below) the full-employment level shown by the LRAS curve. We depict
real GDP as an upward-sloping function of price level along the SRAS curve to reflect this.
Again, in the short-run, we are holding the money wage rate, other resource prices, and
potential GDP (LRAS) constant.
Next, we identify the factors that will shift the SRAS curve. We start with the elements that
also affect the LRAS curve. The SRAS and LRAS curves will both shift when the full-
employment quantity of labour changes, the amount of available capital in the economy
changes or as technology improves the productivity capital, labour, or both. There are some
factors that will shift SRAS but not affect LRAS. While constructing the SRAS curve, we
held the money wage rate and other resource prices constant. The SRAS curve will shift to
the left, showing a decline in short-run aggregate supply, if wage rates or prices of other
productive inputs rise. Businesses will reduce their output as the level of output that
maximises profits declines when they notice a rise in resource prices. The change in money
wage rates is influenced by two significant factors. One is increased unemployment, which
lowers the money wage rate because there is already an excess of labour available at the
current rate. On the other hand, there will be upward pressure on the money wage rate if the
economy is momentarily operating above full employment levels. Expectations of inflation
are the second factor that may have an impact on the money wage rate. Money wages will
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rise in response to an anticipated rise in inflation, while money wages will decline in response
to an anticipated decline in inflation.
1.3.3 Aggregate Demand
The aggregate demand curve shows the relation between the price level and the real quantity
of final goods and services (real GDP) demanded. The components of aggregate demand are:
Consumption (C). Investment (I). Government spending (G). Net exports (X-M), which is
exports minus imports.
Aggregate demand = C + I + G + (X-M)
The aggregate demand curve is downward sloping because at higher price levels,
consumption, business investment, and exports will decrease. There are two effects here to
consider. First, people's real wealth declines as the price level rises. Since they have less
accumulated wealth in real terms, individuals will spend less. This is referred to as the
‘wealth effect’. Second, interest rates will increase as the price level rises. An increase in
interest rates decreases business investment (I) as well as consumption (C) as consumers
delay or forego purchases of consumer durables such as cars, appliances and home repairs.
This is a ‘substitution effect’, as consumers substitute consumption later for consumption
now because the cost of consuming goods now instead of later (the interest rate) has
increased. This is referred to as ‘intertemporal substitution’, substitution between time
periods. So changes in the price level cause changes in (the quantity of) aggregate demand.
Among various factors that can affect aggregate demand there are three primary factors
● Expectations about future incomes, inflation, and profits.
● Fiscal and monetary policy
● World economy.
A rise in anticipated inflation will increase aggregate demand as consumers accelerate
purchases to avoid price hikes in the future. An expectation of higher incomes in the future
also will cause consumers to increase purchases in anticipation of these higher incomes. An
increase in expected profits will lead businesses to increase their investment in plants and
equipment.
Fiscal policy refers to government policy with regard to spending, taxes, and transfer
payments. An increase in spending increases the government component (G) of aggregate
demand. Consumers' spending power (or disposable income) will rise as a result of lower

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taxes or higher transfer payments (such as social security benefits or unemployment benefits),
which will increase aggregate demand through an increase in consumption (C).
Monetary policy refers to the central bank's decisions to increase or decrease the money
supply. An increase in the money supply tends to decrease interest rates and increase
consumption and investment spending, increasing aggregate demand. We will look at both
monetary and fiscal policy effects more closely in subsequent chapters. The state of the world
economy will influence a country's aggregate demand through the net exports (X)
component. Increased foreign incomes will result in greater foreign demand for the nation's
exports, which will raise X. If the country's exchange rate increases (foreign currency buys
fewer domestic currency units), its goods are relatively more expensive to foreigners, and
exports will decrease. Additionally, since imports will be relatively less expensive, there will
be greater demand for them. Net exports (exports minus imports) will tend to decline as a
result of both effects, which will also reduce aggregate demand. The opposite is true when a
country's exchange rate declines (currency depreciation), as exports rise, imports fall, net
exports rise, and aggregate demand rises.
We show long-run equilibrium at the point where the aggregate demand curve and the LRAS
curve converge in Figure 1.3. Changes in the price level of final goods and services can move
the economy to long-run macroeconomic equilibrium.

Fig 1.3: Long-Run Equilibrium Real GDP

1.3.4 Unemployment
The unemployment rate, the labour force participation rate (LFPR), and the employment-to-
population ratio are the three key labour market indicators. If a person is not working but is
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available to work, has actively looked for employment within the past four weeks, has been
laid off and is awaiting recall, or will begin a new job within the next 30 days, they are
considered to be unemployed. The unemployment rate is the percentage of people in the
labour force who are unemployed. All individuals who are either employed or actively
looking for work are considered to be part of the labour force.

Unemployment rate = x 100

During expansions, the unemployment rate falls, and during recessions, it rises. The labour-
force participation rate is the percentage of the working-age population who are either
employed or actively seeking employment.

Labour force participation rate = x 100

Changes in the number of discouraged workers—those who are available for work but neither
employed nor actively seeking employment—can cause short-term fluctuations in the labour-
force participation rate. When the economy is growing, the labour force participation rate
tends to rise; during recessions, it tends to fall. Once the expansion takes hold and they feel
their chances of finding work are better, discouraged workers who stopped looking for work
during the recession are motivated to do so again. The employment-to-population ratio is the
percentage of the working-age population who are employed.

Employment to Population Ratio = x 100

When unemployment is low (during expansions), the employment-to-population ratio tends

to increase, and when unemployment is high (during recessions), it tends to decline. The
employment indicators we’ve covered so far reflect the number of people who have jobs, but
to know how much total labour is being performed, we also need to take into account the
average amount of time that employees are working. To trace the effects of part-time work
and overtime, we calculate aggregate hours, the total number of hours worked in a year by all
employed people. Aggregate hours have shown a long-term upward trend, but they have not
grown as fast as the labour force because the average workweek (weekly hours worked per
person) has been declining over time. Both aggregate hours and the workweek tend to rise
during expansions and fall during recessions. Aggregate hours worked is an important
measure because it enables us to assess the productivity of labour, the amount of output
produced per hour worked. A labour will receive a higher wage rate for being more
productive. Money wage rates are adjusted for shifts in the general level of prices to produce
real wage rates. The value of an hour's labour is expressed in terms of goods and services
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using real wage rates. Real wage rates are calculated using total labour compensation, which
includes wages, salaries, and benefits provided by the employer, and they typically fluctuate
with labour productivity.
Types of unemployment
1. Frictional unemployment is a result of the economy's ongoing changes, which delay
the timely placement of qualified candidates with open positions. Employees spend
time and effort seeking work and employers spend time and effort seeking workers.
Unemployment resulting from this job search activity referred to as frictional
unemployment is a persistent problem as businesses grow or shrink and employees
relocate, lose their jobs, or leave to pursue other opportunities.
2. Economic (structural) changes that result in the creation of new jobs for which the
unemployed lack the necessary skills are what lead to structural unemployment.
Because the unemployed workers lack the necessary skills to fill the newly created
jobs, structural unemployment is different from frictional unemployment.
3. Cyclic Variations in the overall level of economic output are the root cause of cyclical
unemployment. Cyclical unemployment occurs when the economy is not operating at
full capacity. When there is no cyclical unemployment in the economy, there is full
employment. But keep in mind that even when the economy is at full employment,
there is still structural and frictional unemployment. In other words, even when the
economy is at "full employment," there will still be some unemployment.
The natural rate of unemployment is the total of the frictional and structural unemployment
rates. The level of output the economy can generate (theoretically) when unemployment is at
the natural rate is known as potential GDP. Cyclical unemployment rises when real GDP
declines below potential GDP. Cyclical unemployment declines as real GDP increases to and
above potential GDP.
1.3.5 Inflation
The rise in the general level of prices is known as inflation. A price index that gauges the
overall (or general) price level in relation to a base year is used to determine the rate of
inflation. The percentage rate of change in the price index over a specified period is then used
to calculate the inflation rate.
An ongoing rise in prices over time is referred to as inflation. A currency's purchasing power
is reduced by inflation. Inflation can ultimately destroy a nation's monetary system if it

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continues to grow unchecked, forcing people and businesses to use foreign currency or return
to bartering physical goods.
The economy is not experiencing inflation if there is a single jump in the price level but no
subsequent increases. Increases in the relative prices of some goods or in the cost of a single
good alone do not constitute inflation. The cost of almost all goods and services will rise if
there is inflation. We can calculate the annual inflation rate by using a numerical measure of
the price level, such as the consumer price index or the GDP deflator:

Annual Inflation Rate = x 100

The two types of inflation are demand-pull and cost-push. Demand-pull inflation results from
an increase in aggregate demand. While, cost-push inflation results from a decrease in
aggregate supply.
Demand-Pull Inflation
Increased government spending, an increase in the money supply, or any other factor that
raises aggregate demand can all lead to demand-pull inflation. Figure 1.4 illustrates the
impact of rising aggregate demand on the price level.

Fig 1.4: Demand-pull Inflation

In Figure 1.4, the economy begins at equilibrium with output at GDP1 and the price level at
P1. The aggregate demand and short-run aggregate supply curves are AD1 and SRAS1. Real

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GDP is equal to potential GDP, which is represented by the long-run aggregate supply curve
LRAS. Now imagine that the central bank expands the money supply, which increases
aggregate demand to AD2. With no initial change in aggregate supply, output increases to
GDP2 and the price level increases to P2. Real GDP exceeds potential GDP (at full
employment) as prices rise. Real GDP growth is unsustainable when it exceeds the level of
full employment. When unemployment falls below its natural rate, real wages are under
pressure to increase. Rising real wages result in a decrease in short-run aggregate supply (the
curve shifts left from SRAS1) until real GDP returns back to full-employment GDP. Demand-
pull inflation would continue until the central bank slowed the expansion of the money
supply and gave the economy the chance to achieve full employment equilibrium at a real
GDP level equal to potential GDP.

Cost-Push Inflation
Inflation can also result from an initial decrease in aggregate supply caused by an increase in
the real price of an important factor of production, such as wages or energy. The impact of a
decline in aggregate supply on output and price level is shown in Figure 1.5.

Fig 1.5: Cost-push Inflation

With no initial change in aggregate demand, the reduction from SRAS1, to SRAS2, raises the
price level to P2, and decreases output to GDP2, while SRAS1 remains unchanged. The
impact on output is the main distinction between the cost-push and demand-pull effects.

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While cost-push inflation results from a reduction in aggregate supply, it initially causes a
decline in GDP, demand-pull effects increase GDP above full employment.
The primary indicators used to measure the inflation rates in India is Consumer Price Index
(CPI) and Wholesale Price Index (WPI).

Consumer Price Index (CPI)

The retail prices of a fixed "basket" of thousands of goods and services that households buy
are measured by the consumer price index (CPI). The CPI is an explicit price index in that it
tracks changes in the weighted average of the prices of the market basket's goods and services
over time. Because it tracks the costs of goods and services that consumers directly buy, the
CPI is the price index that matters most to them. Many government pensions, including
Social Security benefits, and some wage rates are indexed to the CPI, meaning that they have
provisions for automatic increases geared to increases in the CPI.
The formula for the index is:

CPI = x 100

As measured by the CPI, the inflation rate is given by the following formula:

Inflation Rate = x 100

Calculating the inflation rate based on CPI

Ex: The CPI for all items was 202.9 in June 2021 and 194.5 in June 2020. The CPI
for all items less energy was 203.6 in June 2021 and 198.5 in June 2020. Calculate
and interpret the inflation rate based on these two measures.
Answer: (i) All items = x 100
= 4.3%.
(ii) All items ex-energy = x 100
= 2.6%
As measured by the CPI, the inflation rate for goods excluding energy was less than
the inflation rate for all items over this 12-month period. This means energy prices
must have been increasing faster than the overall price level.

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Wholesale Price Index (WPI)

The wholesale price index (WPI), which calculates the wholesale costs of about 3,000 items,
is another widely used price index. Since many raw materials and semi-finished goods are
sold at the wholesale level, changes in the WPI predict future changes in retail prices, such as
those tracked by the CPI.

1.4 FISCAL POLICY, BUDGET DEFICITS, AND BUDGET

SURPLUSES

The use of taxation and spending by the federal government to achieve macroeconomic
objectives is referred to as fiscal policy. Fiscal policies are used to stabilize the economy.
When the government receives the same amount in tax revenue as it spends during a fiscal
year, the budget is said to be balanced. A budget deficit occurs when government spending
exceeds tax revenue, and a budget surplus occurs when the opposite is true.
Taxes are raised and/or reduced by the government during inflationary periods and increased
and/or decreased by the government during recessionary periods to deal with changes in the
business cycles.
The largest component of GDP is total investment. Investment is defined as outlays for
inventory and fixed productive assets. National savings, foreign borrowing, and government
savings are the three main sources of funding for investments. The first two elements come
from private financing sources. Government savings, the third source, are equal to the
difference between government tax receipts and expenditures. Government budget deficits
(borrowing rather than saving) result in a decrease in the sources of total investment, whereas
budget surpluses (savings) increase those sources. Investment has a direct impact on real
GDP growth. Less capital is created as investment falls, which lowers the real GDP growth
rate. On the other hand, as investment increases, more capital is produced, increasing the
growth rate of real GDP.
The government's decisions regarding taxes and spending have a big impact on the markets
for investment capital. Taxes on capital gains have an impact on the amount saved and
invested, which changes real GDP growth. The incentive to save falls as taxes imposed on
capital income rise (after-tax returns on saving fall). Therefore, as taxes on capital income
rise, private savings likely will fall.
The availability of government savings is impacted by fiscal policy as well. Budget deficits
necessitate government borrowing, just as budget surpluses signify government saving
(negative saving or dissaving). Larger budget deficits reduce savings rates, which raises the
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real interest rate and causes businesses to borrow less money and invest less in physical
capital. This adverse effect of a budget deficit on private investment in capital is referred to
as the crowding out effect. The decrease in the growth rate of capital will reduce potential
GDP.

IN-TEXT QUESTIONS
The different phases of the business cycle are:
peak and trough
inflation and deflation
expansion and contraction
employment and unemployment
The unemployment rate is defined as the number of unemployed as a percentage
of the __________.
Labour force
Number of employed
Working-age population
Civilian non-institutional population.
Which of the following indicators moves inversely with the business cycle?
Aggregate hours
Unemployment rate
Labour force participation rate
Employment-to-population ratio
Which of the following would be counted as frictional unemployment?
Due to the negative growth of GOP, person X was laid off
Person X was fired from his job after he got into an argument with his foreman,
and has not sought a new job
Although there were jobs available, person X was unable to find an employer
with an opening
When the plant was modernized, person X lost her job because she did not have
the skill needed to operate the new equipment
The value of an hour's labour in terms of goods and services is called:
Productivity
The real wage rate
The nominal wage rate
Total labour compensation.

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1.5 BUSINESS CYCLE

The business cycle is characterized by fluctuations in economic activity. The two main
factors used to identify the current stage of the cycle are real GDP and the rate of
unemployment. There are two stages of the business cycle: expansion (where real GDP is
rising) and contraction or recession (real GDP is decreasing). The business cycle's peak and
trough are the transitional points between the phases. In Figure 1.6, the phases and turning
points are depicted.

Fig 1.6: Business Cycle

Short-term, or cyclical, changes in output and employment typically result from changes in
both actual and potential output. The level of output that the economy could produce at high
rates of resource utilisation is known as potential output. Such abrupt changes in output result
from variations in labour and capital utilisation rates. In the long-run, potential output
growth—which denotes growth in the quantity of factors of production (labour and capital)
that are available as well as technological advancements—becomes a significant factor in
determining output growth.

1.6 NATIONAL INCOME ACCOUNTS

In subsequent chapters, we will examine macroeconomic models. These models, which are
condensed versions of the economy, make an effort to capture key elements affecting
aggregate variables like output, employment, and price level. This chapter begins by defining
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the real-world counterparts of the variables in our models as a prelude to comprehending such
relationships. Because we build our models using these relationships, it also takes into
account the accounting relationships that exist between these variables. We start by
describing the key variables measured in the national income accounts. Nobel Prize–winning
economists Simon Kuznets and Richard Stone played pioneering roles in the development of
national income accounting. In India, economists such as V.K.R.V. Rao, R.C. Dutt, Dada
Bhai Nauroji, etc. played an important role in the study of national income accounting. In
India, national income accounts data are published by National Statistical Office (NSO),
Ministry of Statistics and Programme Implementation, Government of India.
Like the accounts of a business, national income accounts have two sides: a product side and
an income side. Production and sales are tracked on the product side. The distribution of sales
proceeds is measured on the income side. Gross domestic product (GDP) and gross national
product (GNP) are two frequently reported indicators of total production on the product side
(GNP). They differ in their treatment of international transactions. GNP includes earnings of
Indian businesses overseas and Indian residents working overseas; GDP does not.
Conversely, GDP includes earnings in India of foreign residents or foreign-owned firms;
GNP excludes those items. For example, profits earned in India by a foreign-owned firm
would be included in GDP but not in GNP. For country like India, the difference between
GNP and GDP is huge as large number of residents working overseas.
Gross Domestic Product
Gross domestic product (GDP) is defined as a measure of all currently produced final goods
and services evaluated at market prices. Before moving further we need to clarify some
aspects of above definition.
● Currently Produced: The value of only currently produced goods and services is
included in the GDP. It is a flow measure of output that only includes the goods and
services produced during the given time period, such as a quarter or an entire year.
Market transactions such as exchanges of previously produced machinery, scooters or
buildings do not enter into GDP. Other market exchanges, such as those involving
stocks and bonds, do not directly involve the current production of goods and services
and are therefore excluded from the calculation of GDP.
● Only Final Goods and Services: Only the final goods and services produced by an
economy are included in its GDP. Intermediate goods that are used to produce other
goods rather than being sold for final consumption are not counted separately in GDP.
The problem of double counting will arise if they are counted separately. For
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example, we would not count the value of metal sheets used in the manufacturing of a
car separately and then again when the car is sold.
● Evaluated at Market Prices: Market prices for goods and services are a common
yardstick for estimating GDP. This makes it possible to measure things like apples,
oranges, machines, clothes, etc. However, the calculation of GDP does not include
goods and services that are not traded on markets. For instance, the services of
housewives or the produce of kitchen gardens, as well as unreported or unlawful
transactions like prostitution, gambling, and the sale of illegal drugs. GDP is sensitive
to changes in the average price level because it measures the value of output in terms
of market prices. At different average market prices, the same physical output will
correspond to a different GDP level. In order to account for this, real GDP, in addition
to GDP calculated in terms of current market prices, is also calculated. GDP can be
broken down into four components that are, GDP = Consumption (C) + Investment (I)
+ Government Purchases (G) + Net Exports (X-M)
Or
Y = C + I + G + (X-M) ……….……… (i)
The consumption component of GDP consists of the household sector’s purchases of
currently produced goods and services. Consumption can be broken down into consumer
durable goods (e.g., automobiles, televisions), non-durable consumption goods (e.g., foods,
beverages, clothing), and consumer services (e.g., medical services, haircuts).
Three sub-components make up the investment portion of the GDP. The largest of these is
business fixed investment. Business fixed investment consists of purchases of newly
produced capital goods like plant and equipment. The second sub-component of investment is
residential construction investment, the building of single- and multifamily housing units.
The final subcomponent of investment is inventory investment, which is the change in
business inventories which may be positive or negative.
Government purchases of goods and services is the next part of GDP. This is the share of the
current output bought by the government sector, which includes the central government as
well as state and local governments. It should be noted that not all government spending is
included in GDP because not all spending reflects a demand for goods and services that are
currently being produced. Government transfer payments to individuals (e.g., Social Security
payments) and government interest payments are examples of expenditures that are not
included in GDP.

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Net Exports is the final component of GDP. Net exports are the sum of all gross exports less
all imports. Gross exports are the goods and services that are currently produced and sold to
customers abroad. They are included in GDP. Imports are purchases made by domestic
consumers of goods and services made elsewhere and are not appropriate to include in GDP.
However, the GDP totals for consumption, investment, and government spending do include
imported goods and services. To calculate the total value of goods and services produced
domestically, we must first subtract the value of imports. The (net) direct impact of
transactions in the foreign sector on GDP continues to be net exports.
National Income
Let's move on to the national accounts' income side. The total GNP rather than GDP serves as
the starting point when calculating national income. As previously stated, GNP includes
income earned by Indian residents and businesses from abroad but does not include earnings
of foreign residents and businesses from India's domestic production. In order to calculate
GNP from GDP, we first add the foreign earnings of Indian residents and businesses,
followed by the foreign earnings of Indian residents and businesses.
The total factor earnings from the current production of goods and services make up the
national income. Earnings from production factors like labour, capital, and land are referred
to as factor earnings. Although GNP and national income are sometimes used
interchangeably, there are some minor adjustments needed to convert between the two.
Depreciation is the factor that is excluded from national income. The portion of the capital
stock used up must be subtracted from final sales before national income is computed.
Depreciation represents a cost of production, not factor income. Making this subtraction gives
us net national product (NNP).
GNP – Depreciation = NNP …………. (ii)
Personal and Disposable Personal Income
The basis for some accounting definitions or identities used to build macroeconomic models
is the interrelationships between GDP, national income, personal income, and personal
disposable income. Income earned from the current production of goods and services is
measured as national income. However, it is convenient to have a measure of income
received by persons regardless of source. For instance, income has an impact on a
household’s consumption expenditures. Therefore, the relevant income concept is all income
received by persons.

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Personal income is the income received by persons from all sources. When we subtract
personal tax payments from personal income, we get disposable (after-tax) personal income.
To go from national income to personal income, we subtract elements of national income that
are not received by persons and add income of persons from sources other than current
production of goods and services. The portion of corporate profits in the national income
accounts that are not distributed as dividends to individuals is the first of the main items
subtracted from national income to calculate personal income. These portions include
corporate profits tax payments and undistributed profits (retained earnings). The
contributions made by both employees and employers to Social Security are another item
deducted from national income when calculating personal income.
Payments to individuals that are not in exchange for the current production of goods and
services are items that are added to the national income to obtain personal income. Transfer
payments come first on the list. Most of these are transfers from the government, like Social
Security payments, pensions, and payments to retired government workers. Interest payments
made by the government to people is also been added. Bonds previously issued by the
central, state, and local governments receive interest payments from the government. These
adjustments will give personal income. Personal taxes are then subtracted to obtain personal
disposable income.
YD = Y – T ………… (iii)
Where YD is personal disposable income, Y is personal income and T is the personal taxes.
Personal saving is the part of personal disposable income that is not spent. And all disposable
income goes for consumption expenditures or personal saving.
YD = C + S ……….. (iv)
Or, we can write it as
Y=C+S+T …………. (v)
If we ignore external sector for the simplification of our understanding we will have
Y=C+I+G (from eq i)
Therefore, we will have

C+I+G≡Y≡C+S+T …………… (vi)

This identity states that expenditures on GDP (C + I + G) by definition equal dispositions of

national income (C + S + T).
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1.7 MEASURING PRICE CHANGES: REAL VS NOMINAL GDP

Nominal GDP, which measures currently produced goods and services valued at current
market prices, has been the subject of our discussion up to this point. When the overall price
level and the volume of production change, GDP calculated at current market prices will also
change. For many purposes, we want a measure of GDP that varies only with the quantity of
goods produced. Such a measure would be most closely related to employment. The GDP
measure that changes only when quantities, not prices, change is termed real GDP. Real GDP
is calculated by measuring output in terms of constant prices starting from a base year.
Real GDP changes only when production changes; nominal GDP changes whenever the
quantity of goods produced changes or when the market price of those goods changes.
Therefore, the two measures' movements sharply diverge when prices are changing
dramatically.
Implicit GDP deflator gives the ratio of nominal GDP to real GDP (nominal GDP ÷ real
GDP), where the ratio is multiplied by 100. The ratio of nominal GDP to real GDP is a
measure of the value of current production in current prices (e.g., in 2022) relative to the
value of the same goods and services in prices for the base year (2011). The ratio of nominal
GDP to real GDP is simply the ratio of the current price level of goods and services relative
to the price level in the base year because the same goods and services are present at both the
top and bottom. It is a measurement of the total (or overall) level of prices, also known as the
price index.
By comparing implicit GDP deflator values across years, we can track changes in the overall
level of prices. The ratio of nominal to real GDP is termed a deflator because we can divide
nominal GDP by this ratio to correct for the effect of inflation on GDP—to deflate GDP. This
follows because

GDP deflator =

Real GDP =

The GDP deflator is an implicit price index since we first construct a quantity measure, real
GDP, and then compare the movement in GDP in current and constant rupees to measure the
price changes. We do not explicitly measure the average movement in prices. Two explicit
price indices are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

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Chain-Weighted Real GDP

When real GDP is calculated using prices from a base year, two issues occur. One issue is
that every time the base year is altered, we change the weights assigned to various sectors.
Second, changes in relative prices and consequent substitutions among the product categories
contained in GDP. For instance, since 2005, the relative price of personal computers has
decreased, and consumers' spending patterns have shifted toward computer purchases.
Computers will be overstated as a GDP component if the higher 2005 prices are used to
weight the computer component when calculating real GDP. Government agencies use the
chain-weighted measure of real GDP to address these issues. Here, the chain-weighted
measure uses the average of the prices in the current year and the year prior as weights as
opposed to using prices from a base year. In order to calculate real GDP in 2020, prices from
2019 and 2021 are weighted. In practise, the base advances annually to solve the issue
brought on by relative price-induced substitutions.

What is not comes under GDP?

The most comprehensive measure of a country’s economic affair is the GDP. Researchers
and decision-makers frequently use GDP to track both short- and long-term growth trends
in any economy. It does, however, have some expectations.
Non-market productive activities: Non-market production, such as homemaker services,
are not included in GDP because goods and services are valued at market prices.
Illegal economic activities: The GDP excludes both legal activities that are not reported
to avoid paying taxes as well as illegal economic activities like gambling and the drug
trade.
GDP does not reflect welfare: GDP does not reflect welfare or even material well-being;
it measures the production of goods and services. Leisure is not given any weight.
Additionally, some production-related welfare costs are not subtracted. For instance, we
count the production of electricity in GDP but do not deduct the economic loss from the
pollution if it results in acid rain, water pollution and dying forests. In fact, if the
government spends money to try to clean up the pollution, we count that too. GDP is a
useful indicator of economic activity in general, not of welfare.
GDP and Happiness: If it is not a welfare measure, one would not expect GDP to
measure happiness. According to studies, Ghanaians are happier than Americans are with
their lives, and Nigerians are just as happy as French people. In a society, relative income
might be more significant than absolute income. The government of Bhutan has placed
more emphasis on gross national happiness (GNH), not GDP.

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1.8 SUMMARY
Our country has emerged as the fastest growing major economy in the world and is expected
to be one of the top three economic powers in the world in the coming years. In this chapter,
we have discussed about the past performance and current trends in the key macroeconomics
variables of the Indian economy. India is anticipated to have the third-largest economy in the
world by the year 2031. The economy's long-term growth outlook is favourable due to its
young population, low dependency ratio, high savings rate, and international investments.
India is now completely self-sufficient in terms of food grains. From receiving food aid due
to famine and other issues to becoming a new exporter, India has come a long way. Crop-
yield-per-unit-area of all crops has grown since 1950 because of special emphasis on the
sector and advancements in irrigation, technology, subsidies, and agricultural credit.
India was largely isolated from international markets until 1991. There were quantitative
restrictions, export taxes, and import tariffs that applied to international trade. The FDI was
also restricted by upper-limit equity participation, apart from government approval.
Due to increased production of fast-moving consumer goods, increased foreign direct
investment (FDI), and ease of doing business, the manufacturing and industry sector has
experienced growth in recent years. Following the country's independence, domestic sector
has faced with increasing foreign competition including the threat of cheaper Chinese
imports. The country has since handled the change by flattening costs, revamping
management and new technology. The "Aatmanirbharat" campaign in India has also
revitalised MSMEs that had fallen behind because of foreign competitors.
The services sector has the largest share of India's GDP, accounting for 53 percent in 2021-
22. Nearly 25% of the workforce is employed in the services sector. The percentage of the
labour force that is unemployed is known as the unemployment rate. Due to the Covid-19
lockdown, unemployment spiked in recent years and has continued to be extremely high even
after more than two years of economic recovery.

1.9 GLOSSARY
Potential Output: is the level of output that would be reached if productive resources
(labour and capital) were being used at benchmark high levels.
Consumer Price Index (CPI): It is the measure of the retail prices of a fixed “market
basket” of several hundred goods and services purchased by households

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Wholesale Price Index (WPI): It measures the wholesale prices of approximately 3,000
items
Price Index: measures the aggregate price level relative to a chosen base year.
Personal Income: measure of income received by persons from all sources
National Income: is the sum of the earnings of all factors of production that come from
current production
Government Purchases: goods and services that are the part of current output that goes to
the government sector—the central government as well as state and local governments
Net Exports: total (gross) exports minus imports
Investment: is the part of GDP purchased by the business sector plus residential
construction
Capital Goods: capital resources such as factories and machinery used to produce other
goods
Depreciation: portion of the capital stock that wears out each year
Gross Domestic Product (GDP): measure of all currently produced final goods and services
Aggregate Demand: is the sum of the demands for current output by each buying sector of
the economy: households, businesses, the government, and foreign purchasers of exports
Trade Deficit: the excess of imports over exports
Unemployment Rate: the number of unemployed persons expressed as a percentage of the
labour force
Monetary Policy: central bank’s use of control of the money supply and interest rates to
influence the level of economic activity
Money: is whatever is commonly accepted as payment in exchange for goods and services
(and payment of debts and taxes.

1.10 ANSWERS TO IN-TEXT QUESTIONS

1. (c) The phases of the business 4. (c) One of the causes of frictional
cycle are called expansion and unemployment is that information
contraction (or recession). regarding prospective employees
and employers is costly and
2. (a) The unemployment rate is the
sometimes hard to find.
number of unemployed as a
percentage of the labour force, 5. (b) The real wage rare measures the
purchasing power of an hour's
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3. (b) The unemployment rate labour. The nominal wage rare is the
increases when GDP decreases, money value of an hour's labour.
and decreases when GDP Productivity is output per hour of
increases. The other three labour, one of the determinants of
indicators move in the same the real wage rare. Total labour
direction as the business cycle compensation is one of the measures
of the real wage rare.

1.11 SELF-ASSESSMENT QUESTIONS

1. What is inflation rate? Explain how inflation rate is calculated.
2. Define unemployment. And also explain the different types of unemployment.
3. Define the term gross domestic product. Explain which transactions in the economy
are included in GDP.
4. What are the factors that determines the cyclical behaviour of output and
employment?
5. Explain some of the major limitations of the GDP concept.
6. Define the terms personal income and personal disposable income. Explain how do
these income measures differ from national income?
7. Explain the differences among the GDP deflator, the CPI, and the PPI.
8. Define potential output. Explain why is potential output difficult to measure?

1.12 REFERENCES
Kuznets, Simon (1941) National Income and its Composition, 1919–38. New York: National
Bureau of Economic Research.

1.13 SUGGESTED READINGS

Barro, R. J. (1997). Macroeconomics. MIT Press.
Froyen, R. T. (2013). Macroeconomics: Theories and Policies. Global Edition. Pearson.

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LESSON 2
NATIONAL ACCOUNTS & PROBLEMS OF GDP MEASUREMENTS

Dr. Sunil Kumar

Assistant Professor
Department of Finance and Business Economics
South Campus, University of Delhi
Email-Id: sunil.kumar@south.du.ac.in

STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Need of National Income Accounts
2.4 Approach to Measure Economic Activities
2.5 Measuring GDP (Group Domestic Product)
2.6 Practical Exercise to Calculate GDP
2.7 Other Important Concepts
2.8 Problems Associated with GDP Calculation in India
2.9 Green GDP
2.10 Summary
2.11 Glossary
2.12 Self-Assessment Questions
2.13 References
2.14 Suggested Readings

2.1 LEARNING OBJECTIVES

After studying this material, you will be able to:
● Understand the logical structure of an economy
● Understand how to measure economic activities of an economy
● Appreciate the contribution of different sectors in the economic growth of an
economy
● Perceive the problems involved in measuring economic activities and limitation of
national income accounting
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● Differentiate between real and nominal economic indicators of an economy

● Converse about other important economic indicators which are not covered under
national income accounting

2.2 INTRODUCTION
Precise measurement is an important component of a scientific study. To have a fair idea of
how the economy works, we should have an accurate measure of macro-economic variables.
Good measures, helps policy makers to develop policies, which are best for an economy;
National Income Accounting is one such measure. In 1930’s, Simon Kuznets a Noble Prize
winner calculated the size of the US national income for the first time.
The focus of this chapter is on national income accounts, which is widely used by the
researchers, economists and policy makers to judge the robustness of an economy. The
national income accounts is a conceptual framework, which measures economic activities. It
uses the double-entry bookkeeping principle of business accounting.

2.3 NEED OF NATIONAL INCOME ACCOUNTS

National income accounts help to evaluate the performance of an economy, which further
helps in economic planning. The major determinants of economic welfare are distribution of
national income, per capita income and economic growth; all these factors are evaluated
through national income accounts.
National income data combined with financial and monetary data helps to make policies on
inflation. National income accounting help us to know the sector specific share in the
national income, which further provides the information about the structural changes taking
place in the economy. Through National Income Accounting, we can forecast the impact of
various economic policies on production and employment of an economy.

2.4 APPROACH TO MEASURE ECONOMIC ACTIVITIES

Almost every country maintains a national income account because it provides a
comprehensive measure of an economy's output, revenues and expenses. The national income
account is based on the amount of economic activities that occurs over a given period, these
economic activities can be measured by
1. The final product of an economy, excluding the intermediate produce [Product or
Value Added Approach]

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2. The income earned by the factor of production [Income Approach]

3. The total amount of spending done in an economy [Expenditure Approach]
Every approach shows different perspectives for a given economy. If there is no misreporting
and incomplete data, then all the three approaches will give the same measures of an
economy in a given year.
Figure 2.1: Circular flow of two sectors [Household and Firms]

Spending
A
B
Goods and Services

Firms Households

Factor Payments C

Factor Services

The arrows in the upper half of the above figure shows the flow of goods and services
provided by the firms to the households and the expenditure done by the households on the
purchase of these goods and services. The arrows in the lower half of the figure shows the
flow of factor services rendered by the households to the firms and the payment of these
factor services by the firms to the households.
We can analyse from the figure, that the same amount of money representing the aggregate
value of goods and services, is moving in a circular way. Therefore, to estimate the aggregate
value of goods and services during a year, we can measure it through arrow A, B, or C.
Arrow A (from Households to Firms) shows the aggregate spending; it represents the
Expenditure Method
Arrow B (from Firms to Households) shows the aggregate value of goods and services; it
represents the Product or Value-Added Method
Arrow C (from Firms to Households) shows the total factor income; it represents the Income
Method
The monetary units of all the three methods are same for a specific year.
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Illustration 2.1: Showing equivalence between the three approaches

Suppose there are only two firms in an economy, Apple Co that produces apples and sell
them in an open market. The other firm, Juice Co purchases some portion of the total apples
produce from the open market, process it to make apple juice and then sell them to the public.
Table 2.1: Representing the transitions of the each firm
Apple Co Juice Co
Transaction Amount Transaction Amount
(Rs.) (Rs.)
Wages paid to 30,000 Wages Paid to Employees 20,000
Employees
Total Revenue Received (70,000) Apple Purchase from Apple Co 50,000
1. Apple sold to the 20,000 Revenue Received by selling juice 80,000
public in public
2. Apple sold to Juice 50,000
Co

6. Product Approach: It measures the value added of final goods and services, it does not
include the value of intermediate goods and services (Reason: to avoid double counting).
Hence,
Value added of final goods = Value added of total output-Value added of intermediate
(Inputs used in production, purchased from other firms)
For Apple Co:
Value added of Apple = Rs. 70,000
For Juice Co:
Value added of Juice = Rs. 80,000*-Rs. 50,000=Rs. 30,000
Total Value added of final goods = Value added of apple +Value added of juice
= Rs. (70,000+30,000)
= Rs. 100,000
(*Note: Rs. 80,000 includes Rs. 50,000)
7. Income Approach: It measures the economic activity by adding all the factor payments.
For Apple Co:
Entrepreneur Net profit = Revenue –Cost (Wage)

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= Rs. 70,000-Rs. 30,000

= Rs. 40,000
Wage of the employees = Rs. 30,000
For Juice Co:
Entrepreneur Net profit = Revenue–Cost (Wage+ Amount of Input)
= Rs. 80,000-Rs. 20,000-Rs. 50,000
= Rs. 10,000
Wage of the employees = Rs. 20,000
Income of all the factors = Entrepreneur Profits + Wages
= Rs. (40,000+10,000) +Rs. (30,000+20,000)
= Rs. (50,000+50,000)
= Rs. 100,000
8. Expenditure Approach: This approach measures the value of economic activities by
adding all the spending done on final goods and services.
For Apple Co:
Expenditure done on Apples by the households = Rs. 20,000
For Juice Co:
Expenditure done on Juice by the households = Rs. 80,000
Total Expenditure done by the Economy = Expenditure on Apple + Expenditure
on Juice
= Rs. 20,000+Rs. 80,000
= Rs. 100,000
It is not coincidence that the results of all the three approaches are same. We should not have
any doubt that the market value of the final goods or services must be equal to the money
spend on their purchase i.e., in case of Juice Co the market value of juice Rs. 80,000 must be
equal to the willingness to pay for it. This indicates that Product and Expenditure Approach
will give the same results.

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We can observe that, what the seller is receiving must be equal to what is spent by the buyer.
Seller receipts reflect the income of an economy; it includes all the factor payments. The total
expenditure in an economy is equal to this income generated, thus, income and expenditure
approach gives the same results.
Therefore, we have
Total production = Total Expenditure (i)
Total Income = Total Expenditure (ii)
from (i) and (ii)
Total production = Total Income=Total Expenditure (iii)
Equation (iii) is the fundamental identity of the national income accounting.

2.5 MEASURING GDP (GROSS DOMESTIC PRODUCT)

GDP is the broadest measure of the aggregate economic activities. It can be calculated using
all the three approaches and all of them will give the same value.
● Product or Value Added Approach: Under the product approach, GDP is defined as
“Total market value of all the final goods and services produced within a specified period
by factors of production located within the geographical boundary of a country”. In this
definition, we need to understand the concept of market value, final goods and services,
value added and specified period.
● Market value: Market value of the goods and services are calculated by multiplying the
quantity of goods and services by their respective market price (price at which they are
sold in the market). For example: suppose economy produced 20 smart phones and 1000
pencils, if we add these two quantities this does not make any sense, as the market price
of a smart phone is quite higher than the pencils. Therefore, we multiply their quantities
with their respective market price, suppose the smart phone is sold at Rs. 10,000 each and
pencil at Rs. 10 each. Market value =Rs. (20 × 10, 000) + Rs. (10 × 1,000) =
Rs. 2,10,000.
● Final goods & services: Goods and services produced for final consumption are known as
final goods and services. Intermediate goods and services are those, which are used in the
process of making final goods and services. As discussed earlier, to avoid double
counting in the calculation of the GDP, we do not consider intermediate production.

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● Value added: It is the difference between the value of the goods or services when it
leaves the stage of production and the value when they entered into that stage of
production. In calculating GDP, we can either use the value added at each stage of
production or the value added of the final good or service [it is shown in the following
table with an arrow]
Table 2.2: Value added in the production of barrels of petrol (in $)
Stage of Value of Sales Value Added
Production
● Oil drilling 5 5
● Refining 5.6 0.6
● Shipping 6.6 1.0
● Retail Sale 7 0.4
Total Value added 7
● Specified period: The period for which GDP is calculated is one year. This one year
usually the financial year, in case of India it starts from 1st April of the year to 31st March
of next year. GDP figures are released yearly and quarterly.
To calculate the GDP, the economy is segregated into three major sectors
(i) Primary Sector (includes agriculture, fishing and other allied activities)
(ii) Secondary Sector (includes manufacturing industries)
(iii)Tertiary Sector (includes services)
GDP is calculated by adding the gross value added from these there sector

Where

 Expenditure Approach: It calculates the GDP of an economy by summing the expenditure

on final goods and services produced within the territories of the country in the specified
period. In an open economy, there are four major groups: households, firms, government

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and the rest of the world. Expenditure done by these groups summed to calculate GDP.
These expenditures are:
1. Personal Consumption Expenditures or Consumption (C): The major portions of
GDP constitute of consumption done by the households (Consumers) on the goods
and services. The three main categories where the consumer spends its income
are:
i. Durables: Goods, which can be used for a longer period of time. Example:
car, smart phones, laptops, etc. [Note: House is not included under this
head].
ii. Non-Durables: Good, which have a shorter life span. Examples: food,
clothes etc.
iii. Services: These are non-physical that are opposite to goods, which we can
touch and handle. Payment for services is the intangible part of an
economy. Example: Doctor fee, lawyer fee etc.
2. Gross Domestic Investment or Investment (I): In economics, fixed investment
means purchase of new capital, such as house, plant, equipment etc., and
inventory investment means a change in the firm’s inventory holdings1.
The fixed investment can be segregated as:
a. Business Fixed Investment or Non-Residential Investment: Expenditure done
by the firms on business structures, like, warehouse, factories, office buildings
and on equipment, like, machinery, vehicles, computer, furniture. We also
include computer software in this category.
b. Residential Investment: These are spending on the construction of new houses
and apartments2.
c. Change in the Inventories: It refers to the change in the amount of inventory
during the specified period3.

1
Economic investment is different from financial investment, which purchase of bonds, stocks or mutual funds.
2
New houses and apartments are treated as capital goods, because they provide services, like shelter, for a long
period.
3
To run the business smoothly firms produce more, some of the produce they are not able to sale within the
same year. Value the unsold stock is known as the change in inventories.
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3. Government Expenditure on goods and services (G): The expenditure done by

central, state or local government on the purchase of final goods and services is
known as government expenditure. Example-goods: school buildings, roads,
defence equipment etc.; services: salaries of teachers, member of parliament,
person working in defence etc.
Not all the government purchases are part of G. Government often provides social
security, medical facilities, pension etc., all such payments are known as transfer
payments. These payments are one way and nothing is purchased in exchange
with them, in the current period.
4. Net Exports (NE): It is the gap between exports and imports of a country in a
specified period. If domestically produced goods or services are sold in the
foreign markets, then it is known as exports. If foreign produced goods or services
are purchased by the domestic country, then it is known as imports. So, NE=X-M,
where X=Exports and M=Imports.

9. Income Approach: This approach looks into the GDP as to who receives the income. The
key component, which is calculated using this method, is National Income. In National
Income calculation we include 8 types of Income, these are
a. Compensation to Employees: It includes the income of the employees, such as,
wages, salaries, benefits given to employees (private pension funds, social
insurance). The share of this component is the largest.
b. Proprietors’ Income: Proprietor means the owner of a business that does not have
a separate identity from its owner, better known as unincorporated business. The
profit of such kind of business comes under this head.
c. Rental Income: An income earned by a person by renting its land or structures.
Royalty given to the authors and artists also comes under this category.
d. Corporate Profits: Income of the corporates, which is calculated after subtracting
wages, interest, rents and other costs from the corporate revenue. It's the second
major component of the national income of a country.
e. Net Interest: It is a difference between the interest received by the individual from
businesses and foreign sources and interest paid by them.

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f. Tax on Production and Imports: These are the taxes, which are paid by the
businesses on the production and imports, such as sales tax, excise tax, custom
duties. We also minus the subsidies given by the government to these businesses.
Therefore, Net Indirect Taxes=taxes-subsidies, it is an income of the government.
Factor Cost and Market Price
Factor cost is the total cost incurred on using factor inputs in the production of
goods and services.
Market price is the price at which goods and services are sold in the market.
Market price =Factor Cost +Taxes-Subsidies =Factor Cost + (Net Indirect Taxes)
Example: Suppose there is only one business firm in the economy, it is producing
wheat. This business firm produced 4 quintals of wheat in the specified year and
sold this in the market for Rs. 1000 per quintal. This firm spends Rs. 5000 on
labour and paid taxes Rs. 4000, it also received a subsidy of Rs. 3000. Then

g. Net Business Transfer Payment: These are payments done by business to others
(individuals or government or foreigner) not for wages or taxes or payment
against any services. In fact, such payment is for charity, for insurance, legal
settlements etc.
h. Surplus of Government owned enterprises: The current surplus of the enterprises,
which are owned by the government, such as water, electricity, sewer etc.
If we add all these 8 components, we get National Income. GDP and National Income
are quite different; however, we can find one from another. To calculate GDP out of
National Income, we need to address three more components, these are-
(i) Data Measurement Errors: These are the statistical discrepancies, caused during
data collection. If the data is accurately collected, then the data measurement will
be 0. The discrepancy occurs due to the fact that, data is compiled from different
sources to measure the production and income separately. If we add this statistical
discrepancy in the National Income, we get the Net National Product.
(ii) Depreciation or Consumption Fixed Capital: The decline in the value of goods due
to use, wear and tear, obsolescence, during the specified period of calculating the

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value of economic activities. To convert the gross value into net value, we
subtract the depreciation from the gross value. Example: GDP-
Depreciation=NDP, GNP-Depreciation=NNP.
(iii)Net Factor Income from abroad (NFIA): defined as “difference between the
aggregate amount of earnings of the country’s citizens and companies situated
abroad and aggregate amount of earnings of foreign citizens and overseas
companies earn in the domestic country”.
GDP and GNP
GNP (Gross National Product) is quite different from GDP. GDP is the market
value of all the final goods and services produced in a specified period within the
boundary of a country. GDP focuses on the final production within the territories
of a country, whether a citizen does the production or a non-citizen it does not
matter. GNP is the market value of all the final goods and services produced in a
specified period by the country’s citizen. GNP focuses on the final production
done by the citizen of that country, it does not matter whether the production took
place within or outside the boundary of the country.
Distinguishing GDP and GNP is quite tricky. Consider an Apple Inc plant in
Gujarat, India; this is an American based company producing smart phones. Most
of the workers in the plant are Indians. All the output produced by this plant is a
part of the India’s GDP, however, only a part of it is included in India’s GNP.
The wages paid to the Indian workers are the part of the Indian GNP, while the
profits of the plant are not. Any profit from the plant come under the US GNP,
because the owner of the company is American. The profits however will not be
the part of US GDP, reason being production took place outside the US
territories.
We can find the GNP from GDP and vice versa, using the following formulas:

In the above Apple Inc plant case,

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IN-TEXT QUESTIONS
Which one is not an approach to calculate the economic activities of an economy
Income Approach
Expenditure Approach
Value-Added Approach
Double-Book Keeping Approach
What is the other name for Value-Added Approach
Value Sum Approach Product Approach
Price Added Approach Price Sum Approach
Value added Approach and Expenditure approach directly calculates
Royalty comes under which head
Compensation to Employees
Proprietors’ Income
Rental Income
Corporate Profit
“In personal consumption expenditure we do not consider, goods with shorter life
span”, this statement is
True False
Can’t Say Statement is incomplete

IN-TEXT QUESTIONS
In the value added approach we include the value of
Final Goods Final Services
Intermediate Goods Intermediate Services
Both (i) and (ii) Only (ii)
Both (i) and (iii) Both (ii) and (iv)
Which one is true
Only (i) Both (i) and (iii)
Both (ii) and (iii) All

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2.6 PRACTICAL EXERCISE

a) Value Added Method

Table 2.3 (a): Calculating and using Product Method

Items (Rs. 000’)

Sales 600
Change in stock -20
Depreciation 40
Purchase of intermediate products 300

Now
Table 2.3 (b): Calculating ,

Items (Rs. 000’)

Tax 100
Subsidy 20

Now,
Table 2.3 (c): Calculating , , and

Items (Rs. 000’)

NFIA 100

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b) Expenditure Method
Table 2.4 (a): Calculating using Expenditure Method

Items (Rs. 000’)

Personal Consumption expenditure 1800
Gross Domestic Investment 500
Government Expenditure 800
Export 100
Import 160

Now,
Table 2.4 (b): Calculating , and

Items (Rs. 000’)

Net Indirect tax 140
NFIA 100
Depreciation 200

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c) Income Method
Table 2.5 (a): Calculating using Income Method

Items (Rs. 000’)

Compensation to employees 1600
Mixed income of self-employed (proprietor’s Income) 1800
Rent and Royalty 700
Profit 1200
Interest 900
Net indirect tax 500
Social security contribution by employer 300

Now,
Table 2.5 (b): Calculating , ,

Items (Rs. 000’)

Depreciation 500
NFIA 1500
Net Indirect 200
Tax

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2.7 OTHER IMPORTANT CONCEPTS

a) Private and Government Sector Income: Sometime it important to know the income
received by private and government sector.
The income received by the private sector is known as private disposable income. It is
deducted by subtracting the taxes paid to the government (by household and firms)
from the sum of income incurred through private sector activities and the payment
received by a private sector from the government.
Private Disposable Income = Y+NFIA+TP+INT-T
Where
Y = Gross domestic product (GOP)
NFIA = Net factor Income from abroad
TR = Transfer payments from the government
INT = Interest payments on the government's debt
T = Taxes paid to the government
Net government income is the part of the GDP which does not belong to the private
sector. It is calculated by subtracting the sum of transfer payments from government
to private sector and interest payment on government debt from, government revenue
from taxes.
Net Government Income = T-TP-INT
If we are adding private disposable income and net government income, we get
Y+NFIA = Gross National Product.

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b) Savings: Savings are an integral part of an Income; if we subtract consumption from

the income, we get savings. Savings are segregated into private savings and
government savings.
Private savings = Private Disposable Income –Consumption
= (Y+NFIA+TP+INT-T) -C
Government Savings = Net Government Income-Government Expenditure
= (T-TP-INT)-G
Total Saving of an Economy
National Savings = Private Savings + Government Savings
= (Y+NFIA+TP+INT-T)-C + (T-TP-INT)-G
= Y+NFIA-C-G
Further, using the expenditure method: Y=C+I+C+NX
National Savings = (C+I+G+NX) +NFIA-C-G
= I+NX+NFIA
If we rearrange this
National Savings = I + (NX+NFIA)
= I+CA
Where: Current Account Balance (CA) =NX+NFIA
If we subtract government savings from both sides, we get,
National Savings –Government Savings= I+CA-Government Savings
Private Saving = I+CA+ (-Government Savings)
Where: Negative government savings mean the government is running under a deficit.
c) Real Vs. Nominal GDP:
When the economic variables calculated at the current prices, they are known as
nominal variables. The GDP, which we have discussed, is calculated at the current
price. It is good to calculate the GDP at the current price; however, we face
difficulties if we use it for comparison. Thus, it is advisable to first convert the GDP
at current price into GDP at Real Price (Base Price) and then compare.
Suppose there is an economy producing only two goods, phones and computer, we are
comparing the GDP of this economy for two years, year 1 and year 2
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Table 2.6: Detail of an economy

Year Item Quantity (Q) Price/Unit (P) (Rs.)
Phone 2000 100
1
Computer 1000 200
Phone 2200 110
2
Computer 1500 250

GDP at Current Price

Table 2.7: Calculating Nominal GDP
Year Item Q P GVA=QXP Total (Rs.)
Phone 2,000 100 2,00,000
1 4,00,000
Computer 1,000 200 2,00,00
Phone 2,200 110 2,42,000
2 6,17,000
Computer 1,500 250 3,75,000
Increase 2,17,000
Growth 54.2%

By seeing the above result, we can easily predict that the economy has grown by
about 54.25% from year 1 to the year 2, but we fail to tell whether this growth is due
to the increase in the price or quantity. We can address this problem by choosing a
base year (constant price) for both the year and then calculate the Real GDP. Let the
base year be year 1;
Table 2.8: Calculating Real GDP
Year Item Q P GVA=QXP Total (Rs.)
1 Phone 2,000 100 2,00,000
4,00,000
(Base year) Computer 1,000 200 2,00,00
Phone 2,200 100 2,20,000
(Base Year Price)
2 5,20,000
Computer 1,500 200 3,00,000
(Base Year Price)
Increase 1,20,000
Growth 30%
Real GDP growth is only 30%, which reflects that the growth in GDP is only due to
the increase in the quantity, keeping the price effect constant. We can convert the
Nominal GDP into Real GDP and vice versa.

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Suppose for Computer:

Gross Value Added (real) = GVA (nominal) /GDP deflator
= GVA (nominal) /(current price/base price)
= 3,75,000/(250/200)
= 3,75,000/1.25
= Rs. 300,000
Therefore, by using the GDP deflator we can convert the nominal GDP into real GDP
and vice versa. We have done this exercise for a single good; however, in an economy
we are consuming many goods or a basket of goods. We consider the current price
and the base price of this basket of goods to calculate the GDP deflator.
GDP deflator data is published quarterly. CPI (consumer price Index) which is
published monthly is also used as the GDP deflator. The GDP deflator is often useful
in knowing the inflation rate in an economy.

IN-TEXT QUESTIONS
GDP when calculated at current price is called as
Green GDP Real GDP
Nominal GDP None
Real GDP can be converted into nominal GDP by using
Current price Nominal price
GDP Deflator CPI
Both (i) and (iii) Both (ii) and (iii)
Both (iii) and (iv) Only (iii)
Real GDP equals to Nominal GDP, if
Current Price> Base Price Current Price<Base Price
Current Price=Base Price None
National Savings are equal to
I+CA I+NX+NFIA
Y+NFIA-C-G
Only (i) Both (i) and (iii)
Both (ii) and (iii) All
Private Disposable Income is equal to
Y-NFIA+TP+INT-T Y+NFIA-TP+INT-T
Y+NFIA+TP-INT-T Y+NFIA+TP+INT-T
Only (i) Only (ii)
Only (iii) Only (iv)

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2.8 PROBLEMS ASSOCIATED WITH GDP CALCULATION IN

INDIA
United Nations developed SNA (System of National Account), it contains all the
recommendation, which are agreed internationally to measure the economic activities of an
economy. India also follows this standard measure of calculating GDP. In India, NAS
(National Accounts Statistics) is compiled by CSO (Central Statistical Office) under Ministry
of Statistics and Programme Implementation. The various problems, which are, faced while
measuring India’s GDP, are:
a) Informal Market: India has a huge informal market. The data, which is used for the
calculation of GDP, is gathered only from the formal market. Informal market is
completely ignored. Therefore, GDP calculated only considering formal sector is
underestimated.
b) Non-market goods and services: These are those goods and services, which are not
sold under the formal market system. Example,
(i) Service rendered by homemaking and child care.
(ii) Underground economy: All the illegal activities and illegal goods sold, such as
drugs, prostitution, gambling.
(iii)Benefits of clean air and water.
(iv) Value of services provided by government, such as defence, public education,
buildings and maintenance of roads and bridges.
c) Difficult to identify the good: Sometimes it is difficult to identify a good as final or
intermediate.
d) Inadequate and unreliable data.
e) Production for self-consumption.
f) Lack of proper occupational classification.
g) GDP does not account externalities.

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IN-TEXT QUESTIONS
Who compiles national accounts for India?
UPSC NAS
MSME CSO
GDP does not include
Value of non-traded goods
Value of goods and services from formal market
Value of goods and services from informal market
Externalities
Only (iv) (i), (iii) and (iv)
Both (i) and (iv) Only (ii)

2.9 GREEN GDP

The usual measure of GDP is only the indicator of economic growth; it fails to tell anything
about the sustainability and wealth of an economy. These limitations are well taken care with
the concept called Green GDP.
Green GDP is an indicator of economic growth, simultaneously considering the
environmental factors. It attributes the triple planetary crisis that is loss due to climate
change, the loss of our nature and biodiversity and loss due to pollution. Green GDP is
measured by deleting the net natural capital consumption from the GDP. The natural capital
consumption includes resource depletion, environmental degradation and incentives to
protect environment.
Some criticise the way Green GDP is calculated, they point out that it is difficult to quantify
those goods and services, which are not traded such as ecosystem. The proponents of Green
GDP argue that it may be difficult to quantify or put value to non-traded goods and service,
still it is a preferable alternative to GDP.

IN-TEXT QUESTIONS
________________ is measured by deleting the net natural capital consumption from the GDP
Real GDP Nominal GDP
Green GDP None
Triple planetary crisis is refer to
Loss due to climate change Loss of our nature and biodiversity
Loss due to pollution All

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2.10 SUMMARY
The broadest measure of economic activities of an economy is GDP. GDP of any economy is
estimated using three approaches i.e. product, expenditure and income approach. All the three
approaches give the same value of the GDP. In product approach, we sum the value added of
all the final goods and services produced within the domestic territory of an economy during
the specified year. In expenditure approach, we add all the spending done by the different
sectors of an economy in the specified period. Income approach sums up all the earnings of
the different factors of production in the specified period. There are certain problems
associated with measuring of GDP.
The other important concepts, which help the policy makers, are private and government
sector income, national saving, real and nominal GDP. Green GDP is another important
concept, which incorporates the net natural capital consumption for measuring GDP.

2.11 GLOSSARY
B

Business Fixed Investment: Expenditure done by the firms on business structures, like,
warehouse, factories, office buildings and on equipment.
C
Corporate Profits: Income of the corporates, calculated after subtracting wages, interest,
rents and other costs from the corporate revenue.
Compensation to Employees: Income of the employees
D
Depreciation: The decline in the value of goods due to use, wear and tear, obsolescence,
during the specified period of calculating the value of economic activities.
Durables: Goods, which can be used for a longer period of time.
E
Expenditure Approach: This approach measures the value of economic activities by adding
all the spending done on the final production of goods and services.
F
Factor cost: It is the total cost incurred in using factor inputs in the production of goods and
services

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Final Good and Services: Goods and services produced for final consumption are known as
final goods and services.
G
Government Expenditure: The expenditure done by central, state or local government on
the purchase of final goods and services
Gross Domestic Investment: In economics, fixed investment means purchase of new capital,
such as house, plant, equipment etc. and inventory investment means a change in the firm’s
inventory holdings.
Gross Domestic Product (GDP): GDP is the broadest measure of the aggregate economic
activities.
I

Income Approach: It measures the economic activity by adding all the factor payments.
Intermediate goods and services: Goods and services used in the process of making final
goods and services.
M

Market price: Price at which goods and services are sold in the market.
Market Value: Market value of the goods and services are calculated by multiplying the
quantity of goods and services by their respect market price (price at which they are sold in
the market).
N

National Income Accounts: The national income accounts is a conceptual framework, which
measures economic activities.
Net Exports: It is the gap between exports and imports of a country in a specified period.
Net Factor Income from abroad: It is defined as “difference between the aggregate amount
of earnings of the country’s citizens and companies situated abroad and aggregate amount of
earnings of foreign citizens and overseas companies earn in the domestic country”
Net Interest: It is a difference between the interest received by the individual from
businesses and foreign sources and interest paid by them
Non-Durables: Goods which have a shorter life span.

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Personal Consumption Expenditures: The major portions of GDP constitute of

consumption done by the households (consumers) on the goods and services.
Product Approach: It measures the value added of final goods and services, it does not
include the value of intermediate goods and services
Proprietors’ Income: Proprietor means the owner of a business, that does not have a
separate identity from its owner, better known as unincorporated business. The profit such
business is called as proprietors’ income.
R
Rental Income: An income earned by a person by renting its land or structures
Residential Investment: These are spending on the construction of new houses and
apartments.
S
Services: Services are non-physical that are opposite to goods, which we can touch and
handle.
V
Value Added: Is the difference between the value of the goods or services when it leaves the
stage of production and the value when they entered into that stage of production.

2.12 SELF-ASSESSMENT QUESTIONS

1. Three approaches of measuring economic activities in an economy, gives the same
result”, Justify.
2. What are the components of total spending in an economy? Why we take net exports
instead of exports?
3. To know the economic growth of an economy, which one is more appropriate Real
GDP or Nominal GDP? Why?
4. Why services like house making and childcare, income from gambling and other
illegal activities not included in the GDP?

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2.13 REFERENCES
United Nation. (1953). A System of National Accounts and Supporting Tables. New York:
UN, Department of External Affairs, Statistical Office.
United Nations. (2003). National Accouts: A Practical Introduction. New York: United
Nations.
United Nations. (2023). National Accounts Statistics:Analysis of Main Aggregates, 2021.
Department of Economic and Social Affairs, Statistics Division. New york: United
Nations.

2.14 SUGGESTED READINGS

Abel, B. A., Bernanke, S. B., & Croushore, D. Macroeconomics (Latest ed.). Pearson
Education, Inc.
Case, E. K., Fair, C. R., & Oster, M. S. . Principles of Macroeconomics. (Latest, Ed.) Pearson
Education,Inc.
Parker, D., & Nellis, G. J. . Principles of Macroeconomics. (Latest, Ed.) Pearson Education
limited.

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LESSON 3
ECONOMIC GROWTH
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies –
Technical Campus, New Delhi
Email-Id: minesh.srivastava@gmail.com

STRUCTURE
3.1 Learning Objectives
3.2 Economic Growth
3.3 Growth around the World
3.4 A Model of Production
3.4.1 Growth Paradigms
3.5 Solow Growth Model
3.5.1 Assumptions
3.5.2 The Solow Model
3.5.3 Golden Path
3.6 Total Factor Productivity
3.7 Balanced Growth Path
3.7.1 Views of Ragnar Nurkse
3.7.2 Views of Rosenstein Rodan
3.7.3 Views of W. A. Lewis
3.8 Steady State Growth Path
3.9 Transition Dynamics
3.10 Lessons for Developed and Developing Countries
3.11 Summary
3.12 Glossary
3.13 Answers to In-text Questions
3.14 Self-Assessment Questions
3.15 References
3.16 Suggested Readings

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3.1 LEARNING OBJECTIVES

After studying this chapter, you will be able to:
d) Understand the meaning and importance of economic growth and trend of economic
growth around the globe.
e) Explain the role of savings, investments, capital and labour in determining the steady
state growth path for an economy.
f) Describe the process of balanced growth and role of government policies in achieving
sustainable growth.

3.2 ECONOMIC GROWTH

Economic growth is generally measured as a rise in annual per capita real GDP over a long
period of time. This indicates three things firstly, economic growth means increase in per
capita GDP not the aggregate GDP. Per capita real GDP can be calculated as

Per capita Real GDP =

Secondly, economic growth is about increase in real income not the nominal income. This
means it considers the changes in price level.

Real GDP =

And thirdly, economic growth is about long-run rise in income. A short-run rise or temporary
fluctuation in per capita income due to any reason cannot be considered as economic growth
until and unless it sustains for a longer duration. Economic growth is also represented by an
outward shift in the Production Possibility Curve (PPC) and rightward shift in the long-run
aggregate supply curve. The reason for this shift could be technical progress and increase in
availability of resources.

3.3 GROWTH AROUND THE WORLD

Economic growth involves a process of transformation and every economy goes through a
series of phases of growth. The phases can be different for modern and industrialized
economy from a poor and under-developed economy. According to Colin Clark, each phase
of growth is dominated by different sectors (i.e., primary, secondary and tertiary) of an

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economy. Similarly, W. W. Rostow’s growth model begins from a traditional society and
reaches to maturity stage. In between it passes though to a ‘transitional’ and ‘take-off’ phases.
As the economy proceeds to maturity stage, the share of primary sector (agriculture) goes on
decreasing and the share of secondary and tertiary sectors in the GDP increases.
Economists like David Romer and David Weil have used inter-country growth
regressions in order to explore different growth paths across economies. This gave rise to a
whole new range of theoretical and empirical explorations of the determinants of growth. It
was an extensive exercise that uses sophisticated statistical tools and covers much more
countries of the world.
Comparative growth rates show an uneven growth path for group of countries. The
reason for such uneven growth during the period of 1900-50 is partly due to two major wars
and the great depression. However, post-war period have shown an phenomenal recovery of
Germany, Japan and Italy have puzzled the economist all around the world. New theories
were developed such as the Solow Model to explain such remarkable growth. It was argued
that ‘late starters’ can achieve a high rate of growth because they can adopt
advanced technologies invented by the early starters.
The period of 1950-60 saw a big push for planning and import-substitution, but it
faded away by the 1970s, specially during ‘1973 oil crisis’. It was the period of high
unemployment and stagnant growth around the world. By 1980s, a sign of convergence
started to appear among group of economies. Economists in the western world favoured a set
of policies famously known as the “Washington Consensus”. It was a liberal economic policy
which promoted the idea of privatization, openness, flow of investment, tax reforms etc.
Table 2.1: Rules of Good Behaviour for Promoting Economic Growth

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During 1980 to 2000 the real per-capita income grew at an impressive rate of around 2.3
percent per annum in the developing economies. That means the incomes doubled at every 30
years. Countries in the East and Southeast Asia such as China, South Korea, Thailand,
Malaysia, etc shown a tremendous growth rate of 4.4 per cent per annum during this period.
This also resulted in substantial improvements in social indicators in these countries such as
literacy, infant mortality, life expectation, etc.
It is worth noting that two major economies of Asia i.e., China and India achieve almost a
double digit growth rate after 1990s, despite the ‘Asian financial crisis’ of 1997–98. It is also
said that the coming decade is of India which is showing its potential of becoming a global
power. On the other hand, the growth rate of economies in Latin America and Sub-Saharan
Africa collapsed during this period. Hence the unevenness of growth path is still continues
both geographically and temporally.

3.4 A MODEL OF PRODUCTION

Economists believed that a ‘production function’ can explain why some economies grow
rapidly than others. A production function is a mathematical equation showing a relationship
between inputs (labour, capital, etc.) and outputs (automobiles, furniture’s, clothes, etc.).
Growth in the output means growth in income or GDP. Hence, it is important to study the
role of inputs in the production function.
1. Role of Labour: Economists have attributed the role of population, specially working
population in the economic growth of an economy. Government all around the world
are putting efforts to improve the quality of labours by spending on health and
education. It is believed that the more time a worker spend on his formal education
and skill development the more productive he becomes. It help them to earn more and
spend more, hence raising his income and standard of living.
2. Role of Capital: Same argument applies to the role of capital in the growth of an
economy. The quality of capital stock measured in terms of efficiency and
effectiveness decides the pace of growth. Technological improvement also called as
‘production of knowledge’ brings a significant change in the way things being carried
out. It not only increases the returns to scale but also contributes in the growth of an
economy.
3. Role of the entrepreneur: Unlike classical and Keynesian economics, modern
growth theories gave more importance to the role played by entrepreneurs in the
economic growth. Modern growth economists, Joseph A. Schumpeter stressed on the

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role of the entrepreneurs, or businessmen. Their performance and risk taking abilities
determines the speed of economic growth. For example, in western countries such as
the USA, Canada and major European countries that adopted liberal economic
policies have seen a significant pace of growth because of their entrepreneurs. These
entrepreneurs brings investments and innovation in their businesses which increases
their outputs and incomes.
2.4.1 Growth Paradigms
The base of modem growth theory were laid in the late 1950s. Tinbergen in 1959 attempted
to explain the significant growth in output in Western European countries, and the United
States. He developed a model using Cobb-Douglas production function along with capital
and labor supply functions. Followed by Robert Solow (1956) and their neo-classical growth
models that stressed on a type of production functions that operates in perfect competition
and gives diminishing marginal returns to each input. This was followed by endogenous
growth models in which technological progress were endogenously determined. So, lets have
a look at different growth theories based on their production in briefly.
1. Neo-classical Growth Model: The growth path is depicted by two equations:
A production function equation that is linear and expresses the current flow of output
as a function of the current stock of capital and labour.
Y = A Kα L1-α
Another equation that shows how investments (savings) and depreciations affects
capital accumulation.
K = sY - δK
2. AK Model: It was the first wave of endogenous growth theory. This theory does not
differentiate explicitly between capital accumulation and technological advancements.
They just merged together the physical and human capital. The AK model is the neo-
classical model without diminishing returns to scale. The production function used
here is linear homogenous in the stock of capital.
Y = AK
This model presents a ‘one size fits all’ view of growth
3. Product Variety Model of Romer (1990): The second wave of endogenous growth
models that consists of ‘innovation based growth model’. Innovation results in

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increasing productivity by creating new but not necessarily improved varieties of

products. This model gives importance to technology spill overs (Horizontal
Innovation).
4. Schumpeterian Model: Innovation based theory focusses on quality improvement.
Hence, involves the force of ‘creative destruction’.
Yit = A1-α Kα
Where A represents ‘efficiency parameter’ attached to the most recent technology
used in the industry i at time t.
Each intermediate product is manufactured and sold by the most recent innovator.
Hence, faster growth rate implies a higher rate of firm’s turnover (Vertical
Innovation).
5. Kremer’s O-Ring Theory: This model explains why advanced economies
manufacture more complicated products, have large firms and much higher worker
productivity than poor countries. It predicts that under-development is a coordination
failure because despite their potential benefits, required investments do not occur and
the country becomes trapped in a low level of equilibrium.

3.5 SOLOW GROWTH MODEL

Robert Solow was an American economist who won the prestigious Nobel Prize in 1987 for
his work on the theory of economic growth famously known as the ‘Solow Model’. It is an
exogenous growth model which focuses on long-run economic growth. Solow observed that
during the Second World War, Germany and Japan suffered heavy economic losses. Yet,
following the war both the countries grew quickly. In fact, they grew much faster than the US
and Britain. Even in the past few decades, the GDP growth in China has been very high
reaching to almost double digits. In contrast, advanced economies like the US, Canada or
Britain growing around 2% per year.
Earlier, it was thought that to achieve high growth rate is to have good institutions like,
property rights, honest government, political stability, a dependable judiciary and competitive
and open markets. The advanced economies have it all, plus they have got more human and
physical capital. But they are growing slower than India, China or Bangladesh.
The Solow model of economic growth answered this questions. It gives a clear picture of the
dynamics of growth. It also help us to understand the difference between two types of growth

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that is a) Catching up growth and b) Cutting edge growth. Where catching up growth is much
faster than the cutting edge growth.
The simple Solow growth model explains the process of economic growth using few key
variables and some basic mathematics. But before that we must keep in mind some basic
assumptions of this model.
2.5.1 Assumption
The model focuses on long-run economic growth
1. There exist full employment in the economy. That is all capital and labour are fully
utilized in production process.
2. There is a constant returns to scale i.e., output will increase at a same proportion as an
increase in capital and labour.
3. Capital accumulation can be decomposed into capital deepening and capital widening.
4. Capital widening refers to the capital accumulation required to keep k (capital per
labour) constant as L grows. Capital deepening is the capital accumulation that
permits k to grow.
5. The labour force L (population) grows at a constant rate n.
6. Increase in savings and investments in the short-run, increases the national income
and output. In contrast, higher saving and investment have no effect on the rate of
growth in the long-run.
Based on above assumption, lets understand the Solow model in detail.
2.5.2 The Solow Model
An important part of this model is its linear homogeneous production function,
Y = A Kα L1-α
also known as the Cobb-Douglas Production function. Where, Y is the output/GDP, K is the
Physical capital like factories and machineries, L is the labour or human capital. Last but
certainly not the least is A (ideas). “A” represents all of our knowledge about how to produce
goods by using capital and labour. Everything from how to ship huge quantities of goods
from one place to another with ease to how to keep diseases from spreading to how to
millions of calculations in a fraction of a second. A is ideas, and better ideas mean that we
can produce more output from the same inputs.

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The coefficient α is the capital share (the share of income that capital receives). Therefore,
output per labour is given through the following equation: y = Akα where y = Y/L (output per
labour and k = K/L (capital per labour)

α
y= = = =A =
So the production function represents human capital, physical capital and ideas being used
together to produce output.
● Physical Capital and Diminishing Returns: In order to determine the impact of change
in capital on output firstly, we will hold labour and ideas constant and focus on K. Here,
the output is a function of the quantity of capital Y = F(K). That means increasing K will
increase output. For example, a farmer can grow more crops with the help of a tractor
than with just a shovel.

Fig. 2.2: Output per worker and Capital per worker

Fig. 2.2, depicts a positive relationship between capital and output, as capital increases
the output also goes up. But another property of this kind of production function is that
while more capital gives more output, it should do so at a diminishing rate. Extending our
example, when the farmer allocates his tractors, the first tractor will be allocated to the

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most productive work and the subsequent tractors will be allocated to less and less
productive works.
We can represent both these properties in a production function using . That
means 1 unit of capital will give 1 unit of output, 4 units of capital will give 2 units of
output and so on. The marginal productivity of capital measures how much additional
output is produced with each additional unit of capital. The production function above
showing diminishing marginal productivity of capital indicating that the marginal product
of first unit of capital is very high but it goes on decreasing as the capital increases.
After the Second World War, Germany and Japan didn’t left with much resources, so that
the marginal productivity of the first units of capital was very high. This can be
understood as, the first road between two metropolitans, or the first tractor on a farm or
the first new steel factory gives a lot of additional output. Solow model says that capitals
are very productive when it is less. So, capital can boost growth but because of
diminishing returns, the same additions to the capital stock may get you less and less
output.
● Depreciation: Physical capital goes through Capital rusts or Depreciation. Roads got
potholes, tools wear out, and trucks break down and need to be repaired. In this model, it
was assumed that depreciation increases at a constant rate as the capital stock increases.
● Savings and Investments: Capital accumulation depends on savings and investments.
What we produce is either consumed or saved. What we saved becomes investment.
Suppose we invest a constant fraction of our income (Investment = 0.3 * Y). This can be
shown as an investment curve in our graph (fig 2.3). It will mimic the shape of the output
line, since investment is just a constant fraction of output.
Capital accumulation is represented by an equation
K’= K(1- δ) + I

Where, K is the Present capital stock, K’ is the future capital stock, δ is the rate of capital
depreciation and I is the level of capital investment.

= sy - δ k

Above equation shows that the change in k over time is equals to the investment (saving)
per worker minus depreciation per worker. Any positive change in k will increase output
per worker. Growth will stop at a point where dk/dt = 0.
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Fig. 2.3: Impact of Depreciation on Capital per Worker

The fig 2.4 below shows the steady state growth path for an economy. At this point the
economy grows at a constant rate. Solow model, implies that economies converge to steady
state output per worker (keeping technology constant). It also implies that, if economies have
same steady states, poor economies grow faster and ‘converge’. We call this classical
convergence or ‘convergence to steady state’ in Solow model.

Fig. 2.4: Steady State Capital per Worker and Output per Worker

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What happens if savings increased?

Now lets see the impact of increase in savings on the steady state growth path. The Solow
model argued that, the saving rate s increases the economic growth rate in the short-run, but it
has no effect on the rate of growth in the long-run. Please note that a higher saving rate does
raise the steady-state k* (capital/labour ratio). Hence the steady-state output per worker also
increases (fig 2.5). To achieve long-term growth, investment should increase at such a rate
that so that the steady-state k* (capital labour ratio) is maintained. Fig 2.5 depicts that raising
saving increases k* and y* to k1* and y1* respectively, but no permanent ‘growth effect’.

Fig. 2.5: Impact of Increase in Savings on Steady State

What if labour force grows?

According to Solow model, rise in population reduces the steady state output per worker.
In the fig. 2.6, as the population rises at a constant rate n, the capital-widening term (nk)
rises. Consequently, the steady-state capital/labour ratio k* falls, resulting a fall in the
steady-state output per worker. This rise in population also results in the increase in real
interest rate and decrease in the real wage rate. In the fig. 2.6 we can see that rise in
population shifts the capital depreciation δK line upwards to (δ + n)K and reduces the
steady state k* and y*.

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Fig. 2.6: Impact of Increase in Population on Steady State

2.5.3 Golden Path
The ‘golden path’ is the ‘optimal’ saving rate (s) that maximises per capita consumption. Fig.
2.7 depicts the golden path with k** is the steady state capital per worker.

Fig. 2.7: Golden Path

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Bangladesh’s Economy: A Lesson for India

Bangladesh ranked 24th out of 53 countries in Bloomberg’s COVID-19

resilience ranking for its economic performance during the pandemic. A brief
history of the economic journey of the country is given below.

From ‘basket case’ to ‘Asian Tiger’

Henry Kissinger once labelled Bangladesh a ‘basket case’ due to its higher rate
of poverty and hunger. Today, the nation has steadily risen to reach a new
heights and now being projected as a future ‘Asian tiger’.

In 2019, the country was the world’s seventh fastest growing nation, with a GDP
growth that almost touched the double digit. Even during the Covid lockdowns
in FY’20, the country managed a 5.24% growth rate in the GDP. And, in FY’21,
the country surpasses India in average per capita income that stood at $2,227,
higher than India’s $1,947.

Prudent economic governance

With macro-economic stability as its cornerstone, Bangladesh’s economy has

increased by more than 270 times since its independence. The country has
become the world’s second-largest textile exporter after China due to its
traditional labour-intensive light manufacturing industry. Bangladesh has
managed to achieve macro-economic stability because of its cottage, micro,
small, and medium sized enterprises (CMSMEs). They create 10 million direct
employment and contribute 25% to Bangladesh’s GDP.

Lesson for India

India can take lessons on macro-economic stability and fiscal policies from
Bangladesh's success story. India’s micro and small industries are suffering from
inadequate capital. The export-oriented industries are also massively suffering.
A prudent and supportive policies like Bangladesh can be a solution for Indian
textiles, garments, leather and gem cutting industries.

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IN-TEXT QUESTIONS
1. People in Least Developed Countries are poor because
a. of slow population growth
b. of exploitation by multinational companies
c. of dependence on foreign aid
d. of a variety of development traps
2. The Solow growth model is an example of ________________ growth theory
(exogenous/ endogenous).
3. Economic growth is measured as a rise in per capita real national income in
short-run (True/False).
4. According to Solow model, an increase in saving rate increases the economic
growth in the _____________(short-run/long-run).

3.6 TOTAL FACTOR PRODUCTIVITY

Productivity measures the ratio of inputs used i.e., (labour and capital) to produce outputs.
One can measure the productivity of individual inputs such as labour or capital productivity.
Another option is to measure the combined productivity of inputs also called total factor
productivity (TFP). TFP is measured as the ratio of the total output by weighted average of
the inputs. It is calculated to find out the growth in real output in excess of the growth in
inputs. TFP also measures the efficiency of a firm. TFP helps businesses to wisely design
their manufacturing policies, introduce advanced technologies and invest in training and
development of human resources. TFP is known by different names such as;
● Catch-all Term: The production function in the Solow Model (Y = A Kα L1-α)
consist of an exogenous component ‘A’ that captures technological growth and
improvement in productivity that is not related to any other factors of production.
● Economists later named it as ‘Solow Residual’,
● Solow’s surprise: The Solow model concluded that investment in capital cannot
sustain long-run growth in GDP per worker. It need technological advancement
(growth in A) to avoid diminishing returns to capital. In the Fig. 2.22, we can see that
a rise in ‘A’ shifts the output per worker upwards.

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Fig. 2.8: Impact of Change in Total factor Productivity on Output

TFP is the reason why Japan has achieved higher growth rate in the post-war period.
Similarly, the slowdown of growth rate of the USA from 1973 to 1990s can be attributed to
poor TFP. It can be said that the rate of economic growth depend on the growth rate of inputs
and the increase in TFP. Changes in Solow Residual/TFP comes out of several factors:
 New ways of constructing buildings
 Newly invented machineries
 New source of power/energy
 Changes in work organizations
 Efficiency of government regulations
 Degree of monopoly in the economy
 Literacy and skills of work force

3.7 BALANCED GROWTH PATH

Raganar Nurkse pioneered the balanced growth theory which states that in order to bring an
economy out of the vicious circle of poverty the government needs to make huge investments
in a number of industries simultaneously. This will not only increase the market size and

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productivity of the firms but also act as an incentive for the private sector to invest. Various
economist have contributed in the development of balanced growth theory which can be
explained with the views of:
● Ragnar Nurkse
● Rosenstein Rodan
● W. A. Lewis

2.7.1 Views of Ragnar Nurkse

Prof. Nurkse was the main propounded of the theory balanced growth. According to him,
vicious circle of poverty is the major obstacle in the growth path of a poor economy. He
explained that the vicious circle of poverty operates both on the supply and demand side.
(a) Supply Side
In the fig. 2.34, we can see that how vicious circle of poverty affects the supply side of
capital formation. The per capita income of the people is very low in any underdeveloped
economy due to which the level of saving is also low. Since savings is the main source of
investment, low savings results in low investment and hence low capital formation. This
causes low productivity and in turn low productivity means low income of people. By this
way a vicious circle operates in supply side.

Low Low Income

Productivity

Low Capital Low

Formation Savings

Low
Investment

Fig. 2.9: Vicious Circle of Poverty: Supply Side

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(b) Demand Side

The Vicious circle of poverty also operates in the demand side affecting capital formation in
under-developed countries. Low income of people in poor economies results in low buying
power. Lower demand means lower income for industries to invest lower their capital
formation. This leads to low productivity and hence lower income for people.

Low Low Income

Productivity

Low Capital Low

Formation Demand

Low
Investment

Fig. 2.10: Vicious circle of poverty: Demand Side

A balance between demand and supply side is required to maintain to break the vicious circle
of poverty. This can be done only when there is high rate of capital formation in the
underdeveloped economies. Nurkse suggested various ways through which the vicious circle
of poverty can be broken. These are:
How to Break Vicious Circle of Poverty?
(i) Complementary Demand: Investment in one industry or one sector is not
sufficient to break the vicious circle of poverty. It needs simultaneous investment in
several industries. This will enlarge the market size and create demand for various
products simultaneously. This will raise the income level of people associated with
these industries and they will act as mutual customers for each others product.
Hence demand and supply both will go up breaking the vicious circle of poverty.
(ii) Government Intervention: According to Nurkse, the private sector in any under-
developed economy is not self sufficient to bring such a huge level of investment.
So, the government must participate in economic activities and inject Huge funds in
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the market through investments. This will act as a motivating factor for private
sector and will bring positive change in the market.
(iii) External Economies: The strategy of simultaneous investment in various industries
also leads to external economies by setting up of new industries and expansion of
the existing ones. This will increase the supply of products in the market causing a
fall in price. Lower prices means higher demand and stimuli for industries to invest
more resulting higher capital formation.
2.7.2 Views of Rosenstein Rodan
Rosenstein Rodan is another economist who propounded this theory in the year 1943 but
without using the term ‘balanced growth’. He argued that the Social Marginal Product (SMP)
of an investment is different from its Private Marginal Product (PMP). If different firms
operates their businesses according to their SMP, the economy will grow much faster than if
it operated according to their PMP. Since, the SMP is greater than PMP for any firm because
of the complementarity of different industries this results in profitable investment for the
society.
He took the example of a shoe factory. He stated that, if a large shoe factory is setup in a
suitable location where 20,000 unemployed people get work. Now if the labours spend their
entire incomes on shoes, it would enlarge the shoe market. On the other hand, if series of
different firms are setup, people will spend their income on different commodities. He called
this ‘planned industrialization’.
2.7.3 Views of W. A. Lewis
W.A. Lewis has favoured the theory of balanced growth on the basis of the following two
arguments:
Firstly, in the absence of balanced growth, prices in one sector may be higher than the other
sector resulting unfavourable terms of trade in the domestic market. This will cause heavy
losses for the industries and hinders the investment activity. Since, balanced growth ensures
equality in comparative prices in all the sectors this will create a favourable terms of trade
and all the sectors will grow simultaneously.
Secondly, he argued that when an economy grows, then several bottlenecks starts to appear in
different sectors. For example, increase in per capita income of people due to economic
growth results in increase in the demand of high income-elastic goods. A lower production of
such goods in this case will increase its prices. Balanced growth ensure that the production of
such goods increases with increase in income of people.
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According to Lewis, “All sectors of the economy should be developed simultaneously so that
balance is maintained between industries and agriculture, production for domestic
consumption and production for exports”.

ACTIVITY
With the help of World Bank/ International Monetary Fund annual data and
international rankings try to comprehend the recent economic growth trends
among major countries around the globe. You will find that some poor countries
have shown a dramatic rise in their GDP growth rate on the other hand majority
of countries have experiencing a decline or stagnant growth.

3.8 STEADY STATE GROWTH PATH

The term steady state growth is similar to the long-run equilibrium in static theory of
economics. Steady state is a condition when all the variables, output, labour, capital,
investments, savings, technological advancement, either grow at constant exponential rate, or
are constant.
Different economists have interpreted steady state differently. Starting with Harrod, an
economy is growing at a steady state when Gw = Gn (where, Gw: Warranted rate of growth
and Gn: Natural rate of growth). He called it ‘Razor’s Edge Growth Path. Similar theory
propounded by Domar who called this growth as ‘Knife Edge Growth Path’. Joan Robinson
named steady state growth as ‘Golden Age’ of accumulation. According to him, steady state
is a ‘mythical state of growth not likely to obtain in any actual economy.’
According to Meade, when the growth rate of total income and per capita income are constant
along with constant population growth and no change in technology, an economy achieves
steady state growth. On the other hand, Robert Solow in his model determines steady state
with the help of expanding labour force and technological advancements.
Hence, it can be said that at a steady state birth rates is equals to the death rate meaning
constant population. The output growth, per capita consumption and rate of depreciation all
are constant indicating constant growth of real per capita income.

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3.9 TRANSITION DYNAMICS

The Solow model stressed that long-run steady state growth is not depend on the saving rate
and are determined entirely by exogenous elements. The model also predicts that a poor
economy grows faster and tends to converge with rich countries if it satisfies some
conditions. This can be explain with the help of a diagram below.

Fig. 2.11: Dynamics of the Solow model.

We can see that the growth rate of capital per labour (k) is given by the vertical distance
between the saving curve (s · f (k)/k), and the effective horizontal depreciation line (n + δ).
The growth rate of an economy is positive when k < k∗, and k moves toward k∗ (k∗ indicating
steady state level of k). Similarly, the growth rate of an economy is negative when k > k∗.
It can be noted here that, the growth rate of k is approaching toward k* from an initially low
level of capital per labour. Hence, proving that a poor country can grow faster and converge
to a rich country in a long-run.

3.10 LESSONS FOR DEVELOPED AND DEVELOPING COUNTRIES

History have told us that, no economy can achieve a rapid growth rate without sound
economic policies, property rights, market-oriented approach, money and fiscal governance.

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Various economic models have been developed to explain the movement of an economy
from lower level of economic growth to higher one. Government policies, investment,
entrepreneurship, foreign trade along with other factors are singled out as critical. For
examples, ‘two-track’ reform policy of China, setting up of ‘export processing zones’ in
Mauritius and South Korea’s system of ‘financial restraint’.
Taiwan and South Korea adopted export subsidization scheme to reduce their unfavourable
balance of trade. Similarly, Singapore gave generous tax rebates to attract foreign
investments. Botswana raises the level of government spending per GDP to bring
macroeconomic stability. Chile provided significant financial, technological, organizational,
and marketing assistance to its infant agro-industries.
As economic policies changes, an economy would move from positive to negative growth
rates and back again. According to a study by World Bank (2001), sound economic policy
can accelerate the growth rate and cut the poverty rates in half in developing economies.
Similar study by the International Monetary Fund (2000), suggest that “where sound
macroeconomic policies have been sustained, they have raised growth and reduced poverty”.
In most countries, growth depend upon favourable balance of trade. This has helped Germany
and Japan to recover fast from second world war devastations. This has also helped China,
South Korea and more recently Bangladesh to achieve high growth rate.
Resource reallocation could also be a source of growth. Economists believes that high growth
rate can also be achieved by shifting resources from low productivity sectors to high
productivity ones. For example, shifting labour from low productive agricultural sector to
high productive manufacturing and service sectors.
New knowledge through innovations and R&D opens up new possibilities for growth.
Physical and human capital accumulation cannot sustain growth in the long-run in the
absence of technological advancement. Technological progress is nothing but the ‘production
of knowledge’ through education, R&D and innovation.
So, government should adopt policies that encourage innovations and promote investment on
R&D. Along with that ‘easy money’ policies and tax incentives also works in favour of
developing economies to achieve rapid growth.

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IN-TEXT QUESTIONS
5. A balanced growth strategy relies on coordinated increases in investment in
several industries at once in order to create inter-locking markets for outputs.
(True/False)
6. Creative Destruction is an essential aspect of ______________ Model.
(Schumpeterian/ Neo-classical/ AK)
7. Match the followings:
i. Razor’s Edge Growth Path a. Robinson
ii. Golden Path b. Harrod
iii. Knife Edge Growth Path c. Domar
i-a, ii-b, iii-c
i-b, ii-c, iii-a
i-c, ii-b, iii-a
i-b, ii-a, iii-c

3.11 SUMMARY
Economic growth is the ability of a country to produce more. This increases its real GDP. But
it should be kept in mind that such increase in production in short-run is not considered as
growth. Economists all around the world have developed models that depicts the stages of
growth through which an economy passes. Some models give importance to savings and
investments in the growth process, some believes on technological advancement and some
put weight on favourable balance of trade.
The exogenous growth model suggested by Robert Solow argued that an economy moves in a
steady-state growth path as a result of constant change in the growth rate of population (n)
and technological advancement (A). Steady state is a situation when the output, capital,
labour, savings, investments, technology all grows at a constant rate. This model also predicts
that economies with same population growth rate, savings rate and depreciation rate will
converge in the long-run and along this convergence path, a poor economy grows faster than
rich country.
Another source of growth as suggested by Schumpeter is innovation that leads to creative
destruction. According to him, entrepreneurs plays a significant role in bringing innovation in
the production process that raises the productivity of labours and level of production. Prof.
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Nurkse has favoured simultaneous investment in large number of industries in order to break
the vicious circle of poverty and bring balanced growth in the economy. His model is also
supported by other economists such as Rodan and Lewis.
Solow surprise or Total Factor Productivity is the increase in total output due to change in
intangible factors such as technological advancement, level of education, research and
development, etc. It is measured as the ratio of total output to the weighted average of total
inputs. Various factors can affect the total factor productivity such as technological
innovations, new source of power/energy, better health and education, etc.
Hence, in order to achieve a high rate of economic growth, it is important for an economy to
focus on all these variables along with sound economic policies.

3.12 GLOSSARY
Capital deepening: is the process of increasing the amount of capital per labour.
Capital widening: is the process of equipping of new workers with capital, as the population
grows.
Exogenous Growth Model: Where the long-term growth rates are determined by variables
not explained by the model itself. The neo-classical models are example of exogenous growth
model.
Horizontal Innovation: It causes productivity growth through technological progress
reflected in an expansion of the number of varieties of products that is by creating new but
not necessarily improved varieties of products which means a series of opening up of new
industries.
Vertical Innovation: It causes productivity growth through technological progress reflected
in quality improvement for an array of existing kind of products, which means continues
quality enhancement within an established industry.

3.13 ANSWERS TO IN-TEXT QUESTIONS

1. D. 5. True
2. Exogenous 6. Schumpeterian model
3. False. It is measured in long-run. 7. D.
4. Short-run

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3.14 SELF-ASSESSMENT QUESTIONS

1. What is economic growth? What are the major determinants of it?

2. Discuss the importance of savings and investments in economic growth.
3. Explain the Solow model of economic growth and also write its shortcomings.
4. What do you understand by the term Vicious Circle of Poverty? How it can be turned
into virtuous circle of prosperity?
5. Why innovation is important for economic growth?
6. Briefly discuss the views of different economists on Steady state growth path? Why it is
important for an economy to maintain this growth path?
7. Write a short note on: a) Capital Deepening b) Capital Widening.
8. Explain how endogenous growth models are different from exogenous growth models.

3.15 REFERENCES

Friedman, B. M. (2006). Moral consequences of economic growth: the John R. Commons

lecture, 2006. The American Economist, 50(2), 3-8.
International Monetary Fund (2000). Policies for Faster Growth and Poverty Reduction in
Sub-Saharan Africa and the Role of the IMF. Issues Brief. Washington, DC
Mankiw, N.G., Romer, D., Weil, D.N. (1992). Contribution to the empirics of economic
growth. Quarterly Journal of Economics 107, 407–437
Murphy, K.M., Shleifer, A., Vishny, R.W. (1989). Industrialization and the big push. Journal
of Political Economy 97 (5), 1003–1026.
Romer, P. (1986). Increasing returns and long-run growth. Journal of Political Economy 94,
1002–1037.
Rosenstein-Rodan, P. (1943). Problems of industrialization of Eastern and Southeastern
Europe. Economic Journal 53 (210–211), 202–211
The Wire. (2021, July 18). Bangladesh’s Economy: What Did It Do Differently To Ride Out
the Pandemic? Retrieved from thewire.in: https://thewire.in/south-asia/bangladesh-economy-
pandemic-gdp
World Bank (2002). World Development Indicators. World Bank, Washington, DC
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3.16 SUGGESTED READINGS

Aghion, P., & Durlauf, S. (Eds.). (2005). Handbook of economic growth. Elsevier.
Barro, R. J., & Sala-i-Martin, X. (2004). Economic Growth (2nd ed.). Cambridge: The MIT
Press.

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LESSON 4
THE IS-LM MODEL
Dr. Arjun Singh Solanki
Professor
Meerut Institute of Technology, Meerut
Email-Id: ar21mp@yahoo.com

STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Keynesian Framework
4.4 The interaction of goods and money market explained by IS-LM Curves
4.5 The Short-Run Equilibrium in the IS–LM model
4.6 Effect of Fiscal Policy on the IS Curve and Changes the Short-Run Equilibrium
4.7 Effect of monetary policy on LM curve and the Short-Run Equilibrium
4.8 The Interaction between Monetary and Fiscal Policy
4.9 Summary
4.10 Glossary
4.11 Answers to In-Text Questions
4.12 Self-Assessment Questions
4.13 References
4.14 Suggested Readings

4.1 LEARNING OBJECTIVES

1. To develop a deep understanding of the basic macroeconomic concepts for analyzing
the crucial economic policies.
2. To understand the problem of Inflation, unemployment and low income in the
economy.
3. To understand the theoretical rationale behind policies framed at the country as well as
corporate level.
4. To provide the learners sound knowledge of International trade and the existing
complexities.

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4.2 INTRODUCTION
It has always been important for students to study and understand the complexities of
maintaining an economy in a stable equilibrium position. In this lesson the students will
understand the Keynesian theory on which the explanation of the advanced models like IS-
LM depend. Here we discuss the concept of short-run equilibrium in the money market and
goods and services market. We also discuss about the monetary and fiscal policy effect on the
short-run equilibrium level of income.

4.3 KEYNESIAN FRAMEWORK

Keynes in his The General Theory of Employment, Interest, and Money, presented a unique
way to analyze the economy. He emphasised the importance of aggregate demand (AD) to
bring back the economy to normalcy from the shocks of slump. Thus he suggested that an
increase in aggregate demand helps to raise income as well as employment in the economy.
The Keynesian Cross
The General Theory of Employment is mainly consists of two important ideas. First, the total
expenditure in an economy and second, its effect on output, employment and inflation. This
theory believes that the spending plans of government, business & household largely
determine the total income of an economy. And the Keynesian cross simply depicts how the
level of income in the economy is established. It is considered one of the important
components for understanding the IS–LM model.
Let’s understand here the major assumption of Keynesian model which says that prices are
constant in short run and market demand is met by the firms without increase in the level of
prices. The aggregate supply curve is perfectly elastic at the given price level. This
assumption indicates that since prices are somewhat static, shifts in any expenditure such as
investment, consumption or government expenditures cause change in output. Hence, if
government spending exceeds, for example, and all other spending plans do not change, then
output will increase.
Now let’s learn about Aggregate demand. It is defined by planned total expenditure (PE) on
goods and services by firms, households and the government. It simply means the sum total
of goods demanded in an economy.
Here we can explain the aggregate demand or planned expenditure as the sum of –

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AD = PE = C + I + G + NX…….. (1)
Here, C means the consumption expenditure on goods and services by households, I indicate
the planned investment on new capital goods such as plant, machinery, houses, etc. G stands
for the government expenditure on goods and services, NX (X –M) stands for net exports. It
shows the difference between the amount of goods exported (X) and the amount of goods
imported (M). It gives the net expenditure on domestic goods by the foreigners.
Aggregate expenditure (AE) is defined as the total planned spending on domestic goods and
services. It simply determines what is to be produced in the economy.
It is given by:
AE = Y... (2)
Now in order to understand the model of IS-LM we need to know the major components of
aggregate demand or planned expenditure. Here we discuss each component one by one-
Consumption function
The consumption refers to the expenditure done by a consumer in purchasing, using and
eating of consumable goods. Generally, the demand for consumable goods is not stagnant but
increases with multiple reasons especially if income and families expand. And with
increasing income, the level of consumption also increases. Thus, the consumption function
depicts that the consumption is an increasing function of income.
Here we explain equation for understanding Consumption Function -
C = Ca+ c Y…. (3)
Ca = this is the independent consumption which does not rely on the income level and is
constant.
C = It represents the marginal propensity to consume; it reflects the consumption increase by
per unit increase in income.
Consumption and Saving
Savings (S) are portion of income which is left after spending on consumption in a closed
economy (without government and foreign trade).
We can explain it as follows-
Y = C + I and C + S…. (4)
So
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S = Y – C…. (5)
The equation clearly shows that the remaining amount after spending on consumption is
called savings. The savings in an economy are also an increasing function of income.
Investment
The term investment refers to the goods bought for consumption in future. Investment can be
divided into two investments -fixed investment and inventory investment. The fixed
investment means purchasing of the new houses, plants and equipment whereas Inventory
investments refer to the difference between production and sales in a given year.
In the closed economy at the equilibrium level of income, savings are equal to investment. It
is clear from the equation 4.
If we put the equation together we get-
C + I = C + S…. (6)
We get-
S = I…. (7)
So here we can say that the remaining income after spending on consumption is saved and it
is automatically getting invested.
Government
We know that Government (G) can directly participate and influence the level of economic
activity through its different policy instruments.
Here we discuss the two important policy instruments of government --
 Government expenditure on goods and services for example, building roads, dams
and providing free jab to public during times of Corona.
 Increase and decrease in taxes and transfer payments also affects the real income of
the households.
The government basically increases or decreases its spending as per the requirement of
economy in times of recession or inflation and affects the aggregate demand in the economy.
Net exports
As we know, today we are the integral part of globalization where most economies have
opened their doors for exchange of various essential products and facilities. They not only

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import and export goods and services but also borrow and lend in world financial markets. As
we know trade is extremely important for many countries and international trade is crucial for
analyzing the development in economy as it paves the way for formulating economic
policies.
Net exports are the difference between the amount of goods exported (X) and the amount of
goods imported (M), and reflect the state-trade surplus and trade deficit. The positive net
export number shows trade surplus whereas negative number posits trade deficit.
NX =Y – (C + I + G)
The above equation shows that the domestic expenditure does not need to be equal to the
output of goods and services in an open economy. If output exceeds domestic expenditure,
the surplus amount of output will be exported and net exports become positive. If output falls
short of domestic expenditure, we import the deficit amount of output from abroad and out
net exports become negative.
Therefore, the Government makes its domestic policies in such a way that it provides a
conducive environment for the exports and imports and the exchange rate, which ultimately
affects the aggregate Demand in the economy.
The Economy in Equilibrium
The economy is said to be in a state of equilibrium when whatever output is produced in the
economy will be sold out and there will be no surplus or deficit of inventories exist. At this
point of equilibrium, all the stakeholders in the economy are in balance, which suggests that
at this point of equilibrium planned expenditure is equal to the actual expenditure in the
economy.
The equilibrium condition in the economy can be expressed as follows-
Actual Expenditure = Planned Expenditure = Y
Any divergence of the economy from the equilibrium point will not be a stable position and
adjustments and readjustments will take place until the equilibrium will not be achieved by
the economy.
Inventories play a crucial role in the establishment of equilibrium in the economy, for
instance, if the economy is below the point of equilibrium, at this point planned inventories
are greater than the actual inventories and this forced the firms to increase the production and
it leads to increase in income until the point of equilibrium is achieved. On the other hand, if
the economy is above the point of equilibrium, at this point actual expenditure is greater than
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the planned expenditure, this forced the firms to cut down production and it leads to a
decrease in the level of income until the equilibrium is achieved.
The below mentioned Keynesian cross explain how the level of income (Y) is determined for
a given level of planned expenditures in an economy.

Figure 4.1 illustrates the Keynesian cross where e is the equilibrium point where income or
the actual expenditure is equal to the planned expenditure in the economy, so any point below
or above leads to the disequilibrium in the economy. If the economy is below point e then
there is more planned expenditure then the actual which leads to decrease in firms unplanned
inventories and this motivates them to produce more which leads to increase in income and
again the economy attains equilibrium at e, Similarly if the economy is above the point e,
here the actual expenditure is more than the planned expenditure which leads to the
accumulation of unplanned inventories of firm, so they are induced to cut down the
production and income decreases and again the economy reaches the equilibrium point e.

4.4 THE INTERACTION OF GOODS AND MONEY MARKET

EXPLAINED BY6 IS-LM CURVES

The goods market and the IS curve

After studying the Keynesian cross it is the time to study the economy as a whole, here for
simplicity we divide the whole economy in to goods market and the money market. The
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goods market is explained by the IS curve, IS curve shows the combination of interest rate
and the level of income at which the goods market is in equilibrium. It shows the points
where the actual expenditure is equal to the planned expenditures in the goods market.
The derivation of IS curve can be explained by the below mentioned figure.

With the help of the Keynesian cross, the IS curve is derived in Figure 4.2 (a). As per
Keynesian cross, the point of equilibrium explains the equality between actual expenditure
and planned expenditure. Here in the figure initially the economy is in balance at e1 with Y1
level of income. Any increase or decrease in interest rate will affect the planned investment in
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the economy and accordingly the planned expenditure curve will shift. As we can see in the
figure increase in interest rate from r1 to r2 will shift the planned expenditure curve
downward and accordingly the new equilibrium will be established at e2 with a lower income
level. This decrease in income is equal to the multiplier times the decrease in planned
investment expenditure. If we extend the equilibrium points in part-b of the figure to show
the combination of interest rate and the level of income we will get the IS curve.
The IS curve summarises the equilibrium points in the goods market at which the interest rate
and the level of income are equal.

The IS Curve and its relationship with the Interest Rate and Investment
In an economy, planned investment is negatively related to the interest rate. It can be
expressed as follows-
I = I (r)
The above mentioned investment demand function shows a negative relationship between
investment demand and the interest rate. Higher interest rates increases the cost of borrowing
to businessmen so at higher interest rates they decrease their planned investment and keep
their money invested in bonds and fixed deposits. On the other hand decrease in interest rate
will increase the planned investment in the economy; a lower interest rate induces individuals
to liquidate their fixed investments and make a more planned investment in the economy.
This negative relationship between the interest rate and the planned investment is one of the
reason for the negative slope of IS curve.
Effects of fiscal policy changes on IS curve
In any economy the objective of government is to achieve higher employment and income
level with stability in price level. The government can achieve these objectives by raising or
controlling the aggregate demand in the economy. We have studied the components of
aggregate demand from Keynesian cross.
When an economy faces recession or inflation in economic activities, it is the responsibility
of government to use its fiscal policy tools to bring back the economy at the point of
equilibrium. Since the fiscal policy is more effective in raising or controlling aggregate
demand in the goods market, so we draw an IS curve for a given fiscal policy and will discuss
the effect of its tools on this curve.
We see the effect of following fiscal policy changes on IS curve -

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 First we increase or decrease the government expenditure (G) and keep the tax rates
(T) fixed
 We increase or decrease the Tax rates and keep the government expenditure fixed.
Keeping the other factors constant if the government increases its expenditure, this will raise
the aggregate demand by increasing consumption and investment demand in the economy.
Due to increase in government expenditure the IS curve shifts upward and the economy will
reach to a new equilibrium point at e2 with higher level of income Y2, as illustrated in figure
4.2 (b).
On the other hand, if the government increases the tax rates while keeping the other factors
fixed, it leads to a decrease in the disposable income of individuals, so accordingly the
consumption and investment demand in the economy decrease, and the aggregated demand in
the economy is reduced from the previous level. This increase in tax rate shifts the IS curve
downward with a lower level of income than the previous level.

Figure 4.2 (b) illustrates the effect of increase in government expenditure on the level of
income in the economy.

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In starting the economy is in equilibrium at Y1 level of income, increase in government

expenditure leads to shift in planned expenditure curve upwards and income increase from Y1
to Y2 level, correspondingly in panel- b the IS curve shifts rightward.
The Money Market and the LM Curve
In the money market, the demand for real money balance and the supply of real money
balance determine the interest rate. Since the supply of money is exogenously determined by
the central bank of a country, so we assume it is constant. Therefore it is the demand for real
money balance which plays a crucial role in determining the rate of interest in the money
market.
So to understand the derivation of the LM curve we should first understand the demand for
money explained by the liquidity preference theory given by Keynes.
The Theory of demand for money
The demand for money is also called the liquidity preference theory. The demand for money
is a demand for real money balances, people hold money for what money is able to buy. The
higher is the price level people need more nominal money balance to complete the same
transaction.
As per liquidity preference theory, people demand money for three reasons. First, people
demand money for complete day-to-day transactions and it depends on their level of income.
An increase and decrease in income will affect the transaction demand.
Second is the demand for precautionary motives. People hold money to deal with any kind of
emergency situation. It depends on the level of income. Higher-income leads to an increase in
money demand for precautionary purposes.
The third and most important factor determining a demand for money is the speculative
motive. People hold money to earn a return on investment. An increase in interest rate will
reduce this return and a decrease in interest rate will increase the return on investment.
Therefore the demand for precautionary motive is negatively related to the rate of interest.
The demand for real money balances is explained by below mentioned equation as follows-.
(M/P) d = L(r)
Here the left side of the equation shows the supply for real money balances (M/P) d and the
right side of the equation shows the quantity of money demanded depends on the interest rate.
Here we should know that the interest rate is the cost of holding money, so individuals hold
more money at the lower interest rates and hold less money when interest rates are higher.
This is the reason the demand curve for money is of negative slope.
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Equilibrium in the money market

In the money market, the demand for money and the supply of money jointly determine the
equilibrium interest rates. In figure-4.3 the equilibrium is illustrated with the help of the
downward slope of the money demand curve and the vertical money supply curve. Here in
the short run when the price level is given and the money supply is constant, it is the demand
for money which determines the equilibrium interest rate. Any increase or decrease in money
demand will change the equilibrium in the money market.
In the money market if there is any disequilibrium due to an increase or decrease in money
demand or money supply it will change the interest rate and the level of income. Given the
supply of money increases in money demand will increase the interest rate and the level of
income increases, and a decrease in money demand will reduce the interest rate in the money
market and the level of income decreases. The upward slope of the LM curve shows the
direct relationship between the interest rate and the level of income in the money market as
explained by the figure-4.3.
Income, Money Demand, and the LM Curve
After studying the demand for money, it is time to derive the LM curve. The demand for
money theory explains that the interest rate in the money market is determined by the demand
for money and the supply of money at the given price level.
This relationship between demand for money balance, interest rate and the level of income
can be explained by the following equation-
(M/P) d = L(r, Y)
From the above equation, we can see that the demand for money balances depends on the
level of income and the interest rate in the money market. Given the price level, the money
demand, interest rate, and level of income are directly related. It can be explained by the
below mentioned figure.

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Figure 4.3 illustrates the equilibrium in the money market. In panel-b of the figure demand
for money balance curve and the supply of money curve intersect and the equilibrium interest
rate r1 is determined. So if there is any increase in income from Y1 to Y2 demand for real
money balance shifts rightward and the new equilibrium is established with a higher interest
rate and a higher level of income. If we extend the equilibrium points as shown in panel-b of
the figure we will get an upward sloping LM curve. The LM curve shows the combination of
interest rate and the level of income at which money market will be in equilibrium.
Monetary Policy change and the LM Curve
The LM curve illustrates the equilibrium combination of interest rate and the level of income
in the money market. If the central bank increase or decrease money supply the LM curves
shits upward or downward accordingly.
We can see how the LM curve shifts due to contractionary monetary policy adopted by
central bank. Let the central bank decrease the money supply, it leads to decrease in supply of
real money balances from M1/P to M2/P. keeping the level of income constant, this decrease
in supply of real money balances raises the rate of interest, which maintains the equilibrium
in the money market. So the decrease in money supply shifts the LM curve upward as shown
in below mentioned figure-4.4. In case of increase in money supply will shift the LM curve
downward.

Here In figure 4.4 the effect of contractionary monetary policy is shown on the LM curve. In
panel-a with the given level of income decrease in money supply leads to a new equilibrium
in money market with a higher interest rate r2. Correspondingly in panel-b the LM curve shift
upward.
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4.5 THE SHORT-RUN EQUILIBRIUM IN THE IS-LM MODEL

As per the above discussion of the goods market and money market and the deriving the
equilibrium in both the markets separately, now we establish the simultaneous equilibrium of
both the markets in the economy. The IS curve shows the equilibrium points in the goods
market and the LM curve shows the equilibrium points in the money market. The equilibrium
will be established at the point where the IS and LM curve intersects and the equilibrium
interest rate and the level of income is determined.
The IS and LM curve equations can be written as follows-
Y = C (Y-T) + I (r) + G……………IS
M/P = L (r, Y)………………………LM
The LM curve illustrates the equilibrium combination of interest rate and the level of income
in the money market and IS curve represents the equilibrium in the goods market at which the
interest rate and the level of income are in equilibrium.

Figure 4.3 explains the joint equilibrium of goods and money market with equilibrium
interest rate and the level of income is determined by the intersection of LS and LM curves.

4.6 EFFECT OF FISCAL POLICY ON THE IS CURVE AND

CHANGES THE SHORT-RUN
After establishing the simultaneous equilibrium in the goods and money market, now we
study the effect of fiscal policy changes on the goods market represented by the IS curve.

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We had studied from the Keynesian cross that the changes in fiscal policy affect the planned
expenditure and accordingly IS curve shifts. Here we try to see how the shift in IS curve
influences the level of income and interest rate at the given level of prices in the short run.
Effect of Government expenditure
Now we see the effect of government spending on the equilibrium level of income in the
economy. Let the government increase its expenditure, this increase will increase the planned
expenditure in the economy so the production level in the economy increases and accordingly
the level of income will rise to a higher level. This increase in the level of income will push
the demand for real money balances and so the interest rate increase. This increase in interest
rate offsets the expected increase in investment and the level of income will increase less than
the increase in the Keynesian cross.
Effect of changes in Taxes
Now we see the effect of changes in tax rates on the IS-LM model. If the government
increases the tax rates on income, it will reduce the disposable income of individuals and
households, and accordingly, the production level was cut down by the firms. This increase in
tax rate affects both the level of income and the interest rate, so the fall in income is less than
the fall in the Keynesian cross.

4.7 EFFECT OF MONETARY POLICY ON LM CURVE AND THE

SHORT-RUN EQUILIBRIUM

We have studied earlier in the liquidity preference theory that the rate of interest is
determined by the demand for real money balances and the supply of money.
The money market equilibrium is represented by the LM curve, it summarises the interest
rate with the given level of income at the given price level.
So let us consider that the central bank increases the money supply in the economy, which
leads to a shifting in the LM curve downward at a lower interest rate. People have more
money than they want to hold on to the prevailing interest rate, so they started depositing it
into banks or interest-bearing assets. The interest rate is keep on falling until the people are
willing to keep all the extra money supplied by the central bank, this brings the money
market to equilibrium. The decrease in interest rate also affects the goods market by
stimulating the planned expenditure, production, and level of income.

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4.8 THE INTERACTION BETWEEN MONETARY AND FISCAL POLICY

Now it is the time to understand the complexity of an economy where all things work
interdependently. Whenever government applies one of the policy instruments, its efficacy
depends on the support extended by other institutions in the economy.
We try to understand what will happen if government increase the tax rate. The effectiveness
of this instrument as per IS-LM theory depends upon the support provided by the central
bank.
Here we assume three policy responses of central bank-
First, the central keeps the money supply unchanged,
Second, the central bank reduces the money supply to maintain the same level of income,
Third, the central bank increases the money supply to maintain the same level of income.
It is important to understand that the increase in tax rates reduces the disposable income of
individuals in the economy, so it leads to decrease in aggregate demand, if other factors like
money supply are not increased correspondingly. On the other hand if the money supply is
increased then the decrease in disposable income due to increase in tax rate is compensated
and there is no decrease in aggregate demand in the economy.
So it is important to note that the effectiveness of fiscal policy depends on the response of
central bank towards the money supply. Generally, while analyzing a change in one policy,
we assume the other policy effects as neutral.

4.9 SUMMARY
 The equilibrium in the economy as per Keynesian cross will take place at the point
where the aggregate demand or planned expenditure equals the actual output or actual
expenditures
 The IS and LM curve shows the goods market and the money market respectively.
They jointly determine the equilibrium in the economy, the intersection of both curves
determines the equilibrium interest rate and the level of income in the economy.
 The changes in the money supply affect the LM curve, any increase in money supply
will shift the LM curve downward, and a decrease in money supply will shift the LM
curve upward.

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 The IS curve represents the equilibrium in the goods market and any change in the
fiscal policy will shift the IS curve. Any increase in government expenditure will shift
the IS curve upward and a decrease in government expenditure will shift it downward.

4.10 GLOSSARY
Aggregate demand is the sum of the demands for current output by each of the sectors of the
economy: households, businesses, the government, and foreign purchasers of exports.
The aggregate demand curve measures the demand for total output at each value of the
aggregate price level.
The aggregate supply function is the macroeconomic analogy to the individual market
supply function, which shows the output forthcoming at each level of product price. The
aggregate supply function shows the total output firms will supply at each value of the
aggregate price level.
Automatic stabilizers are changes in taxes and government transfer payments that occur
when the level of income changes.
The autonomous expenditure multiplier gives the change in equilibrium output per unit
change in autonomous expenditures (e.g., government spending).
Autonomous expenditures are expenditures that are largely determined by factors other than
current income.
The average propensity to consume (APC) is the ratio of consumption to income.
The average propensity to save (APS) is the ratio of saving to income.
Consumption is the household sector’s demand for output for current use. Consumption
expenditures consist of purchases of durable goods (e.g., autos and televisions), nondurable
goods (e.g., food and newspapers), and services (e.g., haircuts and taxi rides).
The consumption function is the Keynesian relationship between income and consumption.
Liquidity preference is a Keynesian term for the demand for money relative to bonds.
The life cycle hypothesis about consumption asserts that saving and consumption decisions
of households reflect a plan for an optimal consumption pattern over their lifetime, subject to
the constraint of their resources.
The liquidity trap is a situation at a very low interest rate where the speculative demand for
money schedule becomes nearly horizontal.
Liquidity preference is a Keynesian term for the demand for money relative to bonds.

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The liquidity trap is a situation at a very low interest rate where the speculative demand for
money schedule becomes nearly horizontal.
Monetary policy is the central bank’s use of control of the money supply and interest rates to
influence the level of economic activity.
Money is whatever is commonly accepted as payment in exchange for goods and services
(and payment of debts and taxes).
The money market is a set of markets for low-risk liquid assets with maturities of less than
one year.
The money multiplier gives the increase in the money supply per unit increase in the
monetary base.

4.11 ANSWERS TO IN-TEXT QUESTIONS

1. Use the Keynesian cross to predict the impact on equilibrium GDP of
a. An increase in government purchases.
b. An increase in taxes.
c. Equal-sized increases in both government
d. Purchases and taxes.
2. In the Keynesian cross, assume that the consumption function is given by
C = 200 + 0.75 (Y- T).
Planned investment is 100; government purchases and taxes are both 100.
a. Graph planned expenditure as a function of income.
b. What is the equilibrium level of income?
c. If government purchases increase to 125, what is the new equilibrium income?
d. What level of government purchases is needed to achieve an income of 1,600?
3. Consider the impact of an increase in thriftiness in the Keynesian cross. Suppose the
consumption function is
C = Ca + c(Y -T),
Where Ca is a parameter called autonomous consumption and c is the marginal
propensity to consume.
a. What happens to equilibrium income when the society becomes more thrifty, as
represented by a decline in Ca?

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b. What happens to equilibrium saving?

c. Why do you suppose this result is called the paradox of thrift?
d. Does this paradox arise in the classical model? Why or why not?

4.12 SELF-ASSESSMENT QUESTIONS

1. Use the Keynesian cross to explain why fiscal policy has a multiplied effect on
national income.
2. Use the theory of liquidity preference to explain why an increase in the money supply
lowers the interest rate. What does this explanation assume about the price level?
3. What is liquidity trap? Discuss the measures taken by government to counter this trap
and the economy will reach normalcy.

4.13 REFERENCES
● N. Gregory Mankiw (2005), Macroeconomics, Worth Publisher, 41, Madison Avenue,
New York.
● McConnel, C. R. & H. C. Gupta (1984), Introduction to Macro Economics, Tata
McGra-Hill Publishing company Ltd., New Delhi.
● Ahuja H.L. (2008), Macroeconomics Theory & Policy, S. Chand & Company Ltd.,
Ram Nagar, New Delhi.
● Dwivedi D.N. (2007), Macroeconomics Theory & Policy, Tata McGraw-Hill
Publication Company Ltd., Delhi.

4.14 SUGGESTED READINGS

Mankiw, N. G. (2012). Principles of Macroeconomics (6th ed.). Cengage India.
Moorthy, V. (2017). Applied Macroeconomics: Employment, Growth and Inflation. I K
International Publishing House Pvt. Ltd.
Moss, D. A. (2015). A Concise Guide to Macroeconomics: What Managers, Executives, and
Students Need to Know (2nd ed.). Harvard Business School Press.
Roy, S. (2017). Macroeconomic Policy Environment: An Analytical Guide for Managers
(2nd ed.). McGraw Hill Education.

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LESSON 5
AD/AS FRAMEWORK
Dr. Arjun Singh Solanki
Professor
Meerut Institute of Technology, Meerut
Email-Id: ar21mp@yahoo.com

SUGGESTED READINGS
5.1 Learning Objectives
5.2 Introduction
5.3 Supply Side Economics
5.4 Difference between the Short Run and Long Run
5.5 The Model of Aggregate Supply and Aggregate Demand
5.6 Policy effectiveness and AD& AS
5.7 Fiscal policy
5.8 Monetary policy
5.9 Trade and Exchange rate policy
5.10 Summary
5.11 Glossary
5.12 Answers to In-Text Questions
5.13 Self-Assessment Questions
5.14 References
5.15 Suggested Readings

5.1 LEARNING OBJECTIVES

 To understand the theoretical rationale behind formulating policies at the national as

well as corporate level.
 To understand the fluctuations in macroeconomic indicators by using more logical
assumptions.
 To understand the concept of Supply Side Economics in solving the complex
economic problems of the country.
 To understand the role and significance of fiscal and monetary policies in controlling
aggregate demand in the economy.
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5.2 INTRODUCTION
After studying the short-run analysis of aggregate demand of the economy in lesson 4, now
we will try to study the long-run effects of policy changes on the level of income in the
economy. Here we also explain an alternative approach to solving economic problems of an
economy. It deals with the aggregate supply in the economy and recently become very
popular among policy makers.

5.3 SUPPLY SIDE ECONOMICS

As we know that the decade of 1930 is known for great depression in history. The Keynesian
theory also came into light during this worldwide economic crisis. The whole world
witnessed the negative sides of this economic downfall. The large number of labour force
fell short of employment and a huge loss of production was registered in the face of
unemployment. The entire economy was trampled and massive decline in income was seen
for many years.
After the Second World War, it has also been noticed that inflation was the major issue
addressed by the policymakers instead of unemployment. Then, Keynesian theorists came up
with their ideas and explained it in term of excess aggregate demand and called it inflation
which is caused by an increase in demand side factors. Keynesian followers also posit that to
make the economy stabilized in short run, it is essential to manage the aggregate demand.
They also suggested that the economy should use fiscal and monetary policies in order to
raise the aggregate demand and boost the economy towards growth by minimizing the
imprints of depression or recession and unemployment.
They believed that such measures will help the economy grow and reduce the unemployment.
Apart from this, they also suggested the ways to avoid the state of inflation from an economy
by adopting contractionary fiscal and monetary policy policies hence reducing the aggregate
demand.
Supply-side economics means that the economy will grow by controlling the supply of goods
and services. It simply believes that taxes should be reduced in order to generate
employment, to speed up businesses and encourage entrepreneurial activities.
Supply side economics is considered as one of the applications of micro economic theory in
the analysis of problems concerning economic aggregates – so-called "macroeconomics."

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There are few renowned economists like Adam Smith, J. B. Say, Milton Friedman and Gary
Becker who gave its conceptual explanations in their works.
The few Key Takeaway from Supply Side Economics are-
1. It emphasises on an increases in the supply of goods for economic growth.
2. It suggests to encourage production by reducing the tax as well as regulation and lower
the interest rate.
3. It is considered as an alternative to Keynesian aggregate demand-side policy.
4. It also does not accept the view that decreasing the level or rate of increase in nominal
aggregate demand necessarily results in a drop in employment and output. It stresses
that limiting the growth in nominal demand accelerates the growth in employment,
output, and real income.
Benefits of Supply Side Economics-
1. It bolsters and inspires for national economic growth and prosperity.
2. It motivates and creates multiple job opportunities in the economy.
3. It aims to incentivize firms, businesses and companies with tax cuts.
4. It focuses upon to cut taxes as an excellent method to stimulate the economy. The
reason behind tax deduction is to augment the amount of spending money an
individual or firms can use in purchasing goods and services.
5. It encourages using government projects or incentives to strengthen the economy.
Here are some examples to understand the Supply Side-Economics –
1. Purposefully encouraging free trade agreements to ensure business endeavours and
investments.
2. Allowing relaxation in tax rates.
3. Allowing relaxation in selling government land for private businesses.
4. Allowing Private Set –ups to involve, participate and contribute their expertise in
government newly organized projects and programmes to increase labour force as well
as growth in economy.
We have learned that the concept of supply-side economics is to be found in its applications
to the public economic policy issues of contemporary society. It is, therefore, to a great
extent, an integral part of macroeconomic policies in the interest of more better functioning
of the private market system, significant growth in the stock of capital, sound progress in the
productivity of labour, and sharp increase in aggregate output.

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5.4 DIFFERENCE BETWEEN THE SHORT RUN AND LONG RUN

In microeconomic theory the short run is the time period, when a firm is not able to increase
the production by increasing its fixed factors and can increase its production only by
increasing the variable factors. On the other hand, in the long run, production can be
increased by increasing all factors in any proportion.
Here in macro economics the short run and long run difference depend on the variation in
prices.
As per classical theory in long run, the economy is working at the full employment level and
the prices are flexible. But the change in price level does not affect the level of employment,
output, and level of income in the economy. So the aggregate supply curve, in the long run, is
assumed perfectly inelastic at the given level of income.
On the other hand, the Keynesian theory has explained the theory of employment in the short
run where prices are assumed constant and the firms are willing to supply an infinite amount
of output at the existing price level. It is due to unemployed resources in the economy, so the
cost of firms does not increase and they will not increase the prices. So the aggregate supply
curve in the short run is assumed perfectly elastic at the given price level.

5.4 THE MODEL OF AGGREGATE SUPPLY AND AGGREGATE

DEMAND
The aggregate demand and aggregate supply model explain the determination of the
equilibrium level of income and the price level in the economy.
The interaction of aggregate demand and aggregate supply curves determines the equilibrium
in the economy with a given level of income and prices. Here we see how the change in price
level affects the equilibrium level of income and the level of prices in the economy.
In this model first we drive the aggregate demand curve by using the IS-LM model and then
we study the factors affecting aggregate demand curve.
Aggregate Supply
Aggregate supply refers to the total quantity of production firms will produce and sell—in
other words it is the real GDP. In another words, it is the total supply of output that
businesses can sell in the economy—at a particular price and period.

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Here we understand that the rise and fall in aggregate demand causes change in aggregate
supply. For example, the rise in demand results in expansion of supply whereas the fall in
demand causes decrease in supply. This concept is further divided into short-run supply and
long-run supply. In the short run, supply is driven by price whereas in the long run,
firms increase production.
Now we learn the formula for estimating the aggregate supply which is as follow-
AS=C+S
Here, AS means the Aggregate Supply, C means the Consumption Expenditure, and S means
Savings.
Aggregate Supply Curve
The aggregate supply curve shows the number of goods or services produced in relation to
price changes. Moreover, the aggregate supply, in the short run is found horizontal which
means it is perfectly elastic. And aggregate supply curve in the long run, is found vertical
which means it is perfectly inelastic.
This horizontal curve is based on the assumption that since there are unemployed resources in
the economy so firms can produce as much as they want at the existing cost and there is no
price increase in the short run, this horizontal shape indicates that the firms are willing to
supply whatever amount of goods are demanded at the existing price level.
On the other hand the vertical supply curve in the long run shows that there is no change in
the supply of goods whatever the price level. The vertical supply curve is based on the
assumption that in the economy there is always full employment of labour and that’s why the
output is at its corresponding level and there is no scope for further increase in production
with the existing technology.

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Here in figure 5.1 we can see the shape of aggregate supply curve in short run in panel-a,
and in the long run in panel-b. In panel-a supply curve is perfectly elastic at the given price
level in the short run. It is clear from the horizontal slope of supply curve that the firm is
willing to supply as much as required by the economy at the given price level . On the other
hand in panel- b the aggregate supply curve is perfectly inelastic in the long run at the given
level of income. It shows that there is no effect on the change in the price level on the level of
income in the economy in the long run.
From the above discussion, it is clear that two extremes of supply curves were assumed one is
vertical in the long run and horizontal in the short run. Considering both the extreme time
horizons, we assume an intermediate supply curve of an upward slope, showing a positive
relationship between the price level and the level of income in the economy.
Factors affecting short run Aggregate supply curve
1. Changes in wage rate
2. Prices of inputs
3. Change in labour
4. Corporate taxes and subsidies
Factors affecting long run Aggregate supply curve
1. Changes in technology
2. Change in stock of capital
3. Increase in labour force
Aggregate Demand
Aggregate demand refers to the amount of total spending on domestic goods and services
and measures the total level of demand in an economy. It counts demand for each product
produced in the economy. It also includes the foreign demands for the domestic products but
does not include the domestic market for foreign products.
Here we have the following key takeaways of Aggregate Demand-
 Aggregate demand estimates the total consumer demand for goods and services
produced.
 The variation in aggregate demand causes changes in economy’s macroeconomic
indicators.

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 The increase in aggregate demand shows rise and growth in economy. With the
growing economy, the industry expands and opportunities of employment generate.
On the other hand, the decrease in aggregate demand weakens the economy, shrinks
the industry and rate of production and the cuts the level of labour employed in
production.
 Aggregate demand consists of foreign demand for domestic products. The economists
consider aggregate demand as a benchmark for determining the country’ position in
international trade and export.
 It helps to understand why government increases its spending during financial crisis.
Since government spending bolsters demand and increased demand boost up
production, consequently level of employment also increases over the long term..
Aggregate Demand Curve
The aggregate demand curve depicts the relationship between the price level and the level of
income at which the goods and services market and the money market are simultaneously in
equilibrium.
Aggregate demand in the economy is the sum of the consumption demand (C), investment
demand (I), government spending (G), and net exports (NX). It can be explained as follows-
AD=C+I+G+NX…….(1)
The position of the aggregate demand curve depends upon the above factors any increase in
these factors will shift the aggregate demand curve upwards and a decrease will shift
downwards. The confidence of consumers and investors also affects the position of the
aggregate demand curve in the economy.
The supply of real money balances (M/P) also affects aggregate demand in the economy, any
increase in the supply of real money balances will shift the aggregate demand curve upward,
and a decrease will shift it downward.
Derivation of Aggregate Demand Curve
The aggregate demand curve describes a relationship between the price level and the level of
national income.
To understand the determinants of aggregate demand more fully, we now use the IS–LM
model with variable price level. To derive the aggregate demand curve, first, we use the IS–
LM model to show why national income falls as the price level rises—that is, why the

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aggregate demand curve is downward sloping. Second, we examine what causes the
aggregate demand curve to shift.
From the below mentioned figures we can see the shift in Aggregate demand curves by
expansionary fiscal and expansionary monetary policy.
The aggregate demand curve shows the set of equilibrium points in goods and money market
simultaneously and shows how the change in price level changes the level of income in the
economy.

Here in Fig-5.2 we have presented the derivation of Aggregate demand curve with the help
of IS and LM curves.
In panel-a, as we can see what happened to the IS-LM curves when price level changes. For
instance if price rises from P1 to P2, it leads to decrease in money supply. This Decrease in
money supply leads to increase in the interest rates from r1 to r2 and the LM curve shifts to the
left or upward. This upward shift in LM curve will leads to a new equilibrium with higher
interest rate and lower level of income from Y1 to Y2.
Corresponding to panel-a we can see in panel-b where the AD curve is of downward slope
and the economy moves along with the AD curve due to change in price level. So AD curve
shows what happened to the income level if price level varies.

Reasons of downward slope of aggregate demand curve

Real balance effect- real balances are the purchasing power of money balances held by the
public in an economy. An increase in price level offsets the purchasing power of real money
balances held by the public. This reduction in purchasing power feels them poorer, and they
decrease their spending on consumption and the aggregate demand in the economy fell.
On the other hand, if the price level in the economy decreases, it leads to an increase in the
purchasing power of real money balances held by the public, now they feel richer due to the
increase in purchasing power, and the demand for consumption increases, and this increase in
consumption spending by the public leads to increase in aggregate demand.

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The effect of change in price level on the real balances due to which consumption in the
economy gets affected and accordingly the aggregate demand curve becomes downward
slope.
The rate of interest effect- It is the effect of change in the price level on the interest rate due
to which investment demand in the economy gets affected and accordingly the aggregate
demand in the economy gets affected.
Let the price level in the economy rise, due to the rise in price level people needs more
money to complete their transactions. This increase in demand for money at the given money
supply leads to an increase in interest rates in the economy. As we know the negative
relationship between investment and the interest rate, this increase in interest rate leads to a
decrease in investment demand, and accordingly the aggregate demand in the economy
contracts.
On the other hand if the price level decreases, this leads to more money available for the
existing transactions. So at the existing supply of money people reduce their demand for
money and the interest rates comes down, this reduction in interest rate leads to increase in
investment demand and accordingly the aggregate demand in the economy extends.
Foreign Trade effect- A change in price level affects the demand for exports and imports of
goods in the economy are called the foreign trade effect. A rise in the level of prices makes
the imported goods cheaper than the domestically produced goods and goods exported
become dearer, so this leads to an increase in imports and a decrease in exports which makes
the net export negative and leads to a contraction in aggregate demand in the economy. On
the other hand decrease in the price level leads to an increase in exports and a decrease in
imports and accordingly the aggregate demand leads to an extension.
Exchange rate effect- An increase in price level affects the exchange rate in terms of
appreciation and depreciation. Appreciation affects the net exports adversely, and
depreciation affects the net exports positively.
Here we are seeing the effect of an increase in price level on the capital outflow and capital
inflow in the country which affects the balance of payment. Any increase in the price level
leads to an increase in the interest rate and the exchange appreciates, inducing the foreign
capital to come in order to earn a higher rate of return on investment. Contrary if the price
level decreases it leads to a decrease in the interest rate and the exchange rate depreciates,
and the capital moves out of the country to earn more return somewhere else, this leads to an
adverse balance of payment, and contracts the aggregate demand assuming net exports
constant.
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Factors affecting aggregate demand

The aggregate demand curve summarizes the results from the IS–LM model, events that shift
the IS curve or the LM curve (for a given price level) cause the aggregate demand curve to
shift. For example, an increase in the money supply raises income in the IS–LM model for
any given price level; it thus shifts the aggregate demand curve to the right, Similarly, an
increase in government purchases or a decrease in taxes raises income in the IS–LM model
for a given price level; it also shifts the aggregate demand curve to the right. Conversely, a
decrease in the money supply, a decrease in government purchases, or an increase in taxes
lowers income in the IS–LM model and shifts the aggregate demand curve to the left.
Anything that changes income in the IS–LM model other than a change in the price level
causes a shift in the aggregate demand curve. The factors shifting aggregate demand include
not only monetary and fiscal policy but also shocks to the goods market (the IS curve) and
shocks to the money market (the LM curve).
The aggregate demand and aggregate supply are also get affected by the supply and demand
shocks in the economy. Shocks are the disturbances that change the position of the aggregate
demand and aggregate supply curves in the economy. These shocks are exogenous variable
that affects the economic activities in the economy. For example, if the government
announces anything for the people of the country which is going to increase their income, it
leads to an increase in their consumption spending, and the aggregate demand curve shifts
rightward. On the other hand, if any policy change affects the cost of production in the
economy, it accordingly affects the aggregate supply curve in the economy. An increase in
the cost of production or disturbance in production shifts the aggregate supply curve leftward.

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From figure 5.3 (a) we see with the given price level if there is an increase in money supply
the LM curve shifts rightward or downward and so the AD curve shift rightward at a higher
level of income with the same price level.

From figure 5.3 (b) we can see due to expansionary fiscal policy the IS curve shifts towards
right or upward and the new equilibrium will be at higher level of income with higher interest
rate at the given price level, corresponding to this new equilibrium point AD curve also shifts
towards right with the same price level new equilibrium will be at higher level of income
from Y to Y1.

5.6 POLICY EFFECTIVENESS AND AD&AS

The objective of any government is to achieve full employment, stability in the price level,
and faster economic growth, so the government has to design its macroeconomic policies in
such a manner that the above-stated objectives will be achieved. Here it is important to
understand that the economy will not work at the full employment level as stated by the
classical school, and it is also not possible to increase output or employment without an
increase in the price level as explained by Keynes in his theory.
The economy does not always work at equilibrium; there are often economic fluctuations that
occur in output, employment, and price level. At times the economy finds itself in the grip of
recession when levels of national output, income, and employment are far below their
potential level. On the other side, the economy faces the problem of hyperinflation, where
prices are increasing at a rapid rate, both economic conditions have their negative effects on
the economy, and they should be contained by the appropriate macroeconomic policies.

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So it is critical to see the efficacy of policies in achieving the objectives. So here we present
some polices which are used by the government to achieve the objectives of any economy-

5.7 FISCAL POLICY

Fiscal policy is the use of government spending and taxation to influence the aggregate
demand in the economy. In actual practice government interventions in the form of fiscal
policy are required to achieve the potential output, income, and employment objectives.
In a developing economy like India government use this policy to affect the aggregate
demand in the economy in times of Inflation and recession. As per the requirements
government increase and decreases it’s spending and affects the aggregate demand.
Government purchases and government transfer payments act like increases in autonomous
spending in their effects on equilibrium level of income.
The policy effectiveness depends upon so many other factors as well. Government also raises
and lowers taxes and affects the disposable income of households and the aggregate demand.
Government as per requirement make surplus and deficit budget and influences the aggregate
demand in the economy. It use expansionary and contractionary policy as per the objective is
to curtail or expand the aggregate demand accordingly.
Stabilizing the economy at a higher level of employment and national output is not the only
objective of a macroeconomic policy. Ensuring price stability is its other goal. Both inflation
and deflation have bad effects on the economy. It is therefore desirable to achieve price
stability.
Fiscal policy is an important instrument to stabilise the economy, which is to overcome
recession and control inflation in the economy. The fiscal policy generally aims at managing
aggregate demand for goods and services in the economy. At the time of recession, the
government increases its expenditure or cuts down taxes, or adopts a combination of both. To
counter recession government adopts an expansionary fiscal policy, which raises government
expenditure and cuts down taxes as well. The adoption of such kind of fiscal policy will lead
to a government budget deficit.
On the other hand, to control inflation government reduces its expenditure or increases taxes
to adopt a combination of both; it will lead to a government budget surplus.

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5.8 MONETARY POLICY

Monetary policy is an important instrument of macroeconomic policy by which
macroeconomic objectives can be achieved. In India, the Reserve bank of India works on
behalf of the government and acts as per the objectives decided by the government. Like
fiscal policy, monetary policy is also used to achieve a full employment level of output,
maintain price stability, and faster economic growth in an economy.
The monetary policy is a policy formulated by the central bank, i.e., RBI (Reserve Bank of
India) and relates to the monetary matters of the country. The policy involves measures taken
to regulate the supply of money, availability, and cost of credit in the economy.
Monetary policy affects the demand and supply of economy, first by affecting the interest
rates and then by affecting the aggregate demand. In order to squeeze or expand the aggregate
demand central bank use expansionary and contractionary monetary policy.
Monetary policy is used to maintain the equilibrium between the money demand and money
supply in the economy. In the case of disequilibrium between money demand and money
supply, it results in inflationary or deflationary tendencies in the economy. More specifically,
in times of recession monetary policy used its tools in such a manner that an adequate amount
of credit should be available to the household and business sector. On the other hand, in times
of inflation monetary policy is used to contract the money supply or increase the interest rate
by which the excess credit will be squeezed out from the economy. It uses different
instruments like open market operations and interest rate to curtail and increase money
demand and money supply and accordingly the aggregate demand is managed in the
economy.
It is important to note that the monetary policy has certain limitations in increasing the supply
of money to achieve the expansion in economic activity. Keynes himself has stated that in
times of depression, monetary policy will be ineffective in the recovery of the economy and
therefore he laid stress on the adoption of fiscal policy to overcome depression.

5.9 TRADE AND EXCHANGE RATE POLICY

In an open economy, international transactions play a crucial role in augmenting the level of
income in the economy. The degree of openness of an economy depends upon the amount of
international transactions like capital flows, transfer payments, imports and exports reported
in a year in the balance of payment. More open is the economy more is the complexities of
managing it.

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Trade policies, broadly defined, are policies designed to influence directly the amount of
goods and services exported or imported. Most often, trade policies take the form of
protecting domestic industries from foreign competition—either by placing a tax on foreign
imports (a tariff) or restricting the amount of goods and services that can be imported (a
quota).
In large or small open economies policies affect the trade and the exchange rates through the
interest rate. In both large and small open economies, policies that raise saving or lower
investment lead to trade surpluses, increase trade surplus affects the aggregate demand.
Similarly, policies that lower saving or raise investment lead to trade deficits. In economies, a
protectionist or liberalized trade policies causes the exchange rate to appreciate and affects
the level of aggregate demand in the economy.

5.10 SUMMARY
1. Supply-side economics gives a new perspective to policymakers to deal with the
problem of high inflation and unemployment. Using fiscal policy tools like a reduction
in the tax rate of firms leads to improvement in productivity and efficiency and affects
the aggregate supply in the economy.
2. The model of AD-AS with variable price levels gives the complete picture of the
economy. It integrates both the goods and money market at the given price level with
the given level of income. It explains the effect of changes in price level on
consumption demand, investment demand, and net exports in the economy.
3. Fiscal policy is an effective tool of government to manage the aggregate demand in the
economy in times of recession and hyperinflation. By using fiscal policy tools like
government expenditure, tax rates, and public borrowing, the government raises the
aggregate demand in the goods market in times of recession. It is more effective in
raising the aggregate demand in the economy.
4. Monetary policy is managed and controlled by the central bank. It balances the
aggregate demand in the economy by managing the equilibrium in money demand and
money supply in the money market. By affecting the interest rate and availability of
credit in the economy central bank influences the aggregate demand in the economy in
times of inflation and recession. Monetary policy is more effective in controlling money
inflation in the economy.

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5.11 GLOSSARY
Aggregate demand curve: The negative relationship between the price level and the
aggregate quantity of output demanded that arises from the interaction between the goods
market and the money market.
Aggregate-demand externality: The macroeconomic impact of one firm’s price adjustment
on the demand for all other firms’ products.
Aggregate supply curve: The relationship between the price level and the aggregate quantity
of output firms produce.
Fiscal policy: The government’s choice regarding levels of spending and taxation.
Flexible prices: Prices that adjust quickly to equilibrate supply and demand.
Government purchases: Goods and services bought by the government.
Gross domestic product (GDP): The total income earned domestically, including the
income earned by foreign-owned factors of production; the total expenditure on domestically
produced goods and services.
Gross national product (GNP): The total income of all residents of a nation, including the
income from factors of production used abroad; the total expenditure on the nation’s output
of goods and services.
Inventory investment: The change in the quantity of goods that firms hold in storage,
including materials and supplies, work in process, and finished goods.
Investment: Goods purchased by individuals and firms to add to their stock of capital.
IS curve: The negative relationship between the interest rate and the level of income that
arises in the market for goods and services.
IS–LM model: A model of aggregate demand that shows what determines aggregate income
for a given price level by analyzing the interaction between the goods market and the money
market.
Shock: An exogenous change in an economic relationship, such as the aggregate demand or
aggregate supply curve.
Supply shocks: Exogenous events that shift the aggregate supply curve.

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5.12 ANSWERS TO IN-TEXT QUESTIONS

1. The demand for money is most 3. Stagflation occurs when the economy
dependent upon? experiences.
A. The level of prices 1. Rising prices and rising outputs
B. The interest rate 2. Rising prices and falling outputs
C. The availability of banking outlets 3. Falling prices and rising outputs
D. The availability of credit card 4. Falling prices and falling outputs

2. Which of the following is NOT a 5. Which event shifts the short-run

reason why the aggregate demand aggregate supply curve to the right?
curves slope downward? 1. A decrease in money supply
1. The exchange rate effect 2. A decrease in oil prices
2. The wealth effect 3. An increase in government spending
3. The classical monetary neutrality on military equipment
effect 4. None of the above
4. The interest rate effect.

5.13 SELF-ASSESSMENT QUESTIONS

1. Explain the relevance of IS-LM model in developing the model of AD-AS?
2. Explain the roles of monetary and fiscal policy in causing and ending hyperinflations.
3. What is the impact of an increase in taxes on the interest rate, income, consumption,
and investment?

5.14 REFERENCES
1. Gupta S.G. (2001), Macroeconomics Theory & Applications, Tata McGraw-Hill
Publication Company Ltd., Delhi.
2. Ahuja H.L. (2008), Macroeconomics Theory & Policy, S. Chand & Company Ltd.,
Ram Nagar, New Delhi.
3. Dwivedi D.N. (2007), Macroeconomics Theory & Policy, Tata McGraw-Hill
Publication Company Ltd., Delhi.
4. Gupta S.G. (2001), Macroeconomics Theory & Applications, Tata McGraw-Hill
Publication Company Ltd., Delhi.

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5. N. Gregory Mankiw (2005), Macroeconomics, Worth Publisher, 41, Madison

Avenue, New York.
6. Mc Connel, C. R. & H. C. Gupta (1984), Introduction to Macro Economics, Tata
McGra-Hill Publishing company Ltd., New Delhi.

5.15 SUGGESTED READINGS

1. Blanchard, O. (2017). Macroeconomics (6th ed.). Pearson Education.
2. Dornbusch, R., S. Fischer &Startz, R. (2017). Macroeconomics (11th ed.). McGraw
Hill Education.
3. D’Souza E. (2012). Macroeconomics (2nd ed.). Pearson Education.
4. Farnham, P. G. (2014). Economics for Managers (3rd ed.). Pearson Education.
5. Jones, C. (2017). Macroeconomics. W. W. Norton & Company.

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LESSON 6
PHILIPS CURVE, MONETARY POLICY, AND FISCAL POLICY
Dr. Dezy Kumari
Assistant Professor
FMS, University of Delhi
Email Id:dezypu@gmail.com

STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Philips Curve
6.3.1 Lipsey’s analysis of Philips Curve
6.4 Expectation Augmented Philips Curve
6.4.1 Criticism of Philip’s Curve
6.5 Fiscal Policy
6.5.1 Mechanics of Fiscal Policy
6.5.2 Flexibility of the Fiscal Policy
6.5.3 Limitation of the Fiscal Policy
6.5.4 Fiscal Policy and Economic Growth
6.6 Monetary Policy
6.6.1 Objectives of Monetary Policy
6.6.2 Monetary Policy during Inflation
6.6.3 Role of Monetary Policy in developing Economy
6.6.4 Assessment of the role of Monetary Policy
6.6.5 Monetary Policy in India
6.7 Neutrality of Money
6.8 Crowding Out
6.9 Liquidity Trap
6.10 Role of the central Bank
6.10.1 Functions of the central Bank
6.10.2 Credit Control
6.11 Self-Assessment Questions
6.11.1 Short Questions
6.12.2 Long questions
6.12 References
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6.1 LEARNING OBJECTIVES

 Concept of Philips Curve
 Fiscal Policy and Monetary Policy
 Neutrality of Money
 Crowding Out
 Role of central bank in India

6.2 INTRODUCTION
This unit will contain an Concept of Philip’s Curve, Fiscal policy, Monetary policy and role
of central bank in India. The reader will understand that implications of Philips’ curve in the
situation of stagflation, the major role of monetary and fiscal policy, role of central bank in
India and efficacy of credit control. Money plays an important role in the functioning of
economy. Money is an instrument of satisfying human wants. If it not possess this quality, it
would have no value.

6.3 PHILIP’S CURVE

Keynes and Robinson foresaw a possibility of attaining simultaneously the dual objective of
full employment and price stability without the help of either price control or wage control.
This means that during recession or depression when the economy is having a good deal of
excess capacity and large scale-employment of labour and idle capital stock, the aggregate
supply curve is perfectly elastic. When full employment level of output is reached, aggregate
supply curve becomes perfectly inelastic. With this shape of aggregate supply curve becomes
perfectly inelastic. With this shape of aggregate supply curve assumed in the simple
Keynesian model, increase in aggregate demand before the level of full employment, causes
increase in the level of real national output and employment with price level remaining
unchanged. That is, no cost has to be incurred in the form of rise in the price level (i.e.
inflation rate) for raising the level of output and reducing unemployment. However, the
experience of many countries with countries with strong producer pressure group shows that
a fall in the level of unemployment increases pressure on prices and when the price level is
stable, unemployment crosses the level which is considered ‘Socially tolerable’ by countries
committed, in principle, to achieve full employment.
Philip’s curve has been substantiated by research into the relationship between money wage-
rates and the level of unemployment in UK, between 1861 and 1957 carried out by Prof.
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A.W. Philips. The research made by Prof. Philips appears to support the hypothesis that the
rate of change of money wage-rate can be explained by the level of unemployment and the
rate of change of employment. The relation between the rate of change of money-wage rates
and unemployment is likely to be curvilinear and not linear. Philips has used this curve to
determine that for the UK a rate of 5.5 percent unemployment is needed if wages are to be
held steady and a rate of 2.5 percent employment is needed if prices are to be held steady.
This means that wages would rise by the same percentage as increase in productivity which is
estimated to be 2 percent per year. In other words, wages will rise when employment is low
and wages will fall but slowly because of the downward rigidity of wage rates, when
unemployment is high. This inverse relationship between the nature of change of money
wages and the rate of employment has come to be known as Philip’s Curve.

It appears that Philip’s main argument was demand – pull in nature. The level of
unemployment reflects the excess demand because excess its demand in the labour market
causes wage inflation and also determines an upward rise in wages. Similarly, during periods
of high unemployment the excess supply of labour causes wages to move downwards.
6.3.1 Lipsey’s Analysis of Philip’s curve:
The statistical relationship established by Philips in the wage inflation and employment has
been further analysed by Prof. Lipsey. In this connection, he has pointed out two behavioural
relationships: i) a positive relation between the rate of change in the money wages –rates and
the magnitude of excess demand for labour; and ii)an inverse non-linear relation between
excess demand for labour and unemployment. These two relationships are found in single
micro labour market.
Lipsey assumes that wages inflation is the increasing function of the proportionate excess
demand for labour. He further maintains that the relation between excess demand for labour
and the rate of employment is negative and non-linear which implies that the greater the
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excess demand, the lower will be the level of unemployment and the lower the excess
demand is zero, the labour market will be in equilibrium, but this the excess demand for
labour by only the excess of number of vacancies over the number of unemployed persons.
Thus, excess demand for labour can be zero only when the unemployment rate is positive.
The unemployment compatible with zero excess demand is called frictional unemployment,
which arises because of the lack of instantaneous matching of vacancies with unemployed
workers.
The non-linear relationship means that while the unemployment rate will fall below frictional
level because of the positive excess demand for labour, it can never fall below zero, however
high level of excess demand may be.
Policy Implications of Philips Curve
Philips curve analysis aroused considerable interest among the policy makers particularly
because of the implications of its relationship with price inflation. Changes in the price level
were first related to the changes in the money wage rate and that is why Philips curve
expressed the inverse relationship between the rate of price inflation and the rate of
unemployment. The policy makers, therefore interpreted Philips curve as a relation between
price inflation and unemployment. Thus, Philips Curve enables the policy makers to choose a
given rate of inflation. It mean that inflation can be reduced only at the cost of higher
unemployment or it can be increase only at the cost of lower employment.

ACTIVITY
What is Philips Curve? What are its policy implication?

6.4 EXPECTATION AGUMENTED PHILIP’S CURVE

Another important explanation of occurrence of a higher rate of inflation simultaneously with
a higher rate of unemployment was provided by Friedman. He challenged the concept of a
stable downward sloping Philips-curve. According to him, though there is a trade off between
rate of inflation and unemployment in the short run, that is, there exists a short run downward
sloping Philips Curve, but it is not stable and it often shifts both leftward or rightward. He
argued that there is no long run stable trade off between rates of unemployment and inflation.
According to Friedman’s natural rate hypothesis though there is trade off between inflation
and unemployment in the short run, the economy is stable in the long run at the natural rate of
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unemployment and therefore the long run Philips curve is a vertical straight line. He argues
that misguided Keynesian expansionary fiscal and monetary policies based on the wrong
assumption that a stable Philips Curve exist only result in increasing inflation.
Short-Run Philips Curve and Adaptive Expectations
Another important thing to understand from Friedman’s explanation of shift in the long-run
Philips curve is that expectations about the future rate of inflation play an important role in it.
Friedman put forward a theory of adaptive expectations according to which people from their
expectations on the basis of previous period rate of inflation, and change or adapt their
expectations only when the actual inflation turns out to be different from their expected rate.
According to this Friedman’s theory of adaptive expectations, there may be a trade off
between rates of inflation and unemployment in the short run, but there is no such trade off in
the long run.
The view of Friedman and his follower illustrated in figure below. To begin with SPC1 is the
short run Philips Curve and the economy is at point AO, on its corresponding to the natural
rate of unemployment equal to 5 percent of labour force. The location of this point AO on the
short run Philips curve depends on the level of aggregate demand. Further, we assume that
the economy has been experiencing a rate of inflation equal to 5%. The other assumption we
make that the economy has been experiencing a rate of inflation equal to 5% rate of inflation
will continue in the future.

Now suppose for some reasons the government adopts expansionary fiscal and monetary
policies to raise aggregate demand. The consequent increase in aggregate demand will cause

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the rate of inflation to rise, say to7 percent. Given the level of money wage rate which was
fixed on the basis of inflation would continue to occur, the higher price level then expected
would raise the profits of the firms which will induce the firms to increase their output and
employ more labour. As a result of the increase in aggregate demand resulting in a higher rate
of inflation and more output and employment, the economy will move to point A1 on the
short-run Philips curve SPC1 in figure, where unemployment has decreased to 3.5 percent
while inflation rate has risen to 7 %. It may be noted from figure that in moving from point
AO to A1, on SPC1 the economy accepts a higher rate of inflation as the cost of achieving a
lower rate of unemployment.
Long-Run Philips Curve and Adaptive Expectations
This brings us to the concept of long run Philips Curve, which Friedman and other natural
rate theorists have put forward. According to them, the economy will not remain in a stable
equilibrium position at A1.This is because the workers will realise that due to the higher rate
of inflation than the expected one, their real wages and incomes have fallen. The workers will
therefore demand higher nominal wages to restore their real income. But as nominal wages
rise to compensate for the higher rate of inflation than expected, profits of business firms will
fall to their earlier levels. Their reduction in their profit implies that the original motivation
that prompted them to expand output and increase employment resulting in lower
unemployment rate will no longer be there. Consequently, they will reduce employment till
the unemployment rate rises to the natural level of 5%. That is, with the increase in nominal
wages in the economy will move from A1 to BO, at a higher inflation rate of 7%. It may be
noted that the higher level of aggregate demand which generated inflation rate of 7% and
caused the economy to shift from AO to A1 still persists.
Further, at point BO, and with the actual rate of inflation equal to 7 percent, the workers will
now expects this 7 percent inflation rate to continue in future. As a result, the short run
Philips curve SPC shifts upward from SPC1 to SPC2. It therefore follows, according to
Friedman and other natural rate theorists, the movement along a Philips Curve SPC is only a
temporary or short run phenomenon. In the long when nominal wages are fully adjusted to
the changes in the inflation rate and consequently unemployment rate comes back to its
natural level, a new short-run Philips Curve is formed at the higher expected rate of inflation.
However, the above process of reduction in unemployment rate and then its returning to the
natural level may continue further. The government may misjudge the situation and think that
7 percent of inflation is not too high and adopt expansionary fiscal and monetary policies to
increase aggregate demand and thereby to expand the level of employment. With the new

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increase in aggregate demand, the price level will rise further with nominal wages lagging
behind in the short run. As a result, profits of business firms will rise further with nominal
wages lagging behind in the short run. As a result, profits of business firms will increase and
they will expand output and employment causing the reduction in rate of unemployment and
rise in the inflation rate. With this, the economy will move from BO to B1 along their short-
run Philips Curve SPC2. After sometime, the workers will recognise the fall in their real
wages and press for higher normal wages to compensate for the higher normal wages to
compensate for the higher rate of inflation than expected. When this higher normal wages are
granted, the business profits which will cause the level of employment to fall and
unemployment rate of return to the natural rate of 5%. That is in the above figure the
economy moves from point B1 to CO. The new short run Philips Curve will now shift to SPC3
passing through point CO. The process may be repeated again with the result that while in the
short run, the unemployment rate falls below the natural rate and in the long run it returns to
its natural rate. But throughout this process the inflation rate continuously goes on rising. On
Joining Points such as AO, BO, CO Corresponding to the given natural rate of unemployment
we get a vertical long run Philips Curve LPC in figure. Thus, in the adaptive expectations
theory of the natural rate hypothesis while the short run Philips Curve is downward sloping
indicating the trade off between inflation and unemployment rate in the short run, the long
run Philips curve is a vertical straight line showing that no trade off exists between inflation
and unemployment in the long run.
It is important to remember that adaptive expectations theory has also been applied to explain
the reverse process of disinflation, that is, fall in the rate of inflation as well as inflation itself.
Suppose in above figure the economy is originally at point CO with 9% rate of inflation.
Now, if a decline in aggregate demand occurs, say as a result of contraction of money supply
by the central bank of a country. This will reduce inflation rate below the 9 percent expected
rate. As a result, profits of business firms will decline because the prices will be falling more
rapidly than wages. The decline in profits will cause the firms to reduce employment and
consequently unemployment will rise. Eventually, firms and workers will adjust their
expectations and the unemployment rate will return to the natural rate. The process will be
repeated and the economy in the long run will slide down along the vertical long-run Philips
curve showing falling rate of inflation at the given natural rate of unemployment.
6.4.1 Criticism of Philips Curve
I. The explanation provided by Prof. Philips has not been accepted by all the
economists. According to some economists changes in the price level are at least as

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important in determining changes in the wage-rates as unemployment, which have

been ignored by Prof. Philips.
II. The ‘money illusion’ among workers as suggested by the Keynes is largely absent in
today’s bargaining because wage earners would make every effort to retain their share
of national income if this has been eroded by rise in prices.
III. Prof. H.G. Johnson has raised doubts about the applicability of the Philips curve to the
formulation of economic Policy. In this connection he says, “On the one hand the
curve represents only a statistical description of the mechanics of adjustment in the
labour resting on the simple model of economic dynamics with little general and well
tested monetary and the and value theory behind it. On the other hand, it describes the
behaviour of the labour market in a combination of periods of economic fluctuation
and varying rate of inflation, conditions which presumably influence the behaviour of
the labour market itself, so that it may reasonably be doubted whether the curve
would continue to hold its shape if an attempt were made by economic policy to pin
the economy down to a point on it’’.
IV. According to Milton Friedman relationship between the volume of employment and
the rate of change in money prices is fallacious, because it implies a relationship
between real and nominal magnitudes.
V. The Philips curve has virtually no practical value because it is unstable and not
permanent. Relationship between inflation rate and unemployment rate as observed
by Prof. Philips curve is neither stable through time within a country nor across the
countries.
VI. The powerful role played by trade unions in the determination of wage rates in the
labour market and thus in influencing the wages has also been ignored.
VII. Wages and Prices are influenced by each other. Wage first influence prices through
the increase in the cost of production and then prices influence wages through their
effect on cost of living. The Philips curve only consider the effects of wages on the
price and ignores the effect of prices on wages.
VIII. The Philips Curve analysis is based on the assumption that inflation is an internal
phenomenon of a country but in fact inflation now is an international phenomenon.

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IX. The Philips Curve analysis fails to provide an explanation of the existence of
stagflation, that is, existence of high rate of inflation with high rate of unemployment,
found in all the highly industrialised countries of the world.

6.5 FISCAL POLICY

In the economic sphere, the deliberate use of fiscal policy to attain and maintain a high level
of employment and a stable price level, began during the thirties, largely as a result of the
apparent ineffectiveness of monetary policy as an instrument of stopping the severe
unemployment caused by the great depression and the ‘new economics’ of Keynes with its
emphasis on aggregate demand and the growing importance of government expenditures and
taxes to influence the level of output and employment, and to change the system of income
distribution. From its modest beginnings fiscal policy has now become a major instrument to
achieve economic stability.
For a discussion of fiscal policy we shall treat the aggregate demand comprising personal
consumption, domestic investment and government expenditures for final product and an
aggregate flow of income which is allocated not only to consumption expenditures and
private savings but also, in part, to taxes. The government incurs certain expenditures on the
purchase of goods and services and thus adds to the private spending. In any period, by
increasing this expenditure, the government can raise the level of aggregate demand and by
decreasing it, can bring down the level of aggregate demand and by decreasing it, can bring
down the level of aggregate demand. In the former case, it can divert less amount and in the
latter case it can divert a greater amount from the stream of private expenditures through its
net tax collections. The effect of government spending and taxation upon aggregate demand
depends upon how much it adds by its expenditures to the spending stream and how much it
withdraws through its tax collections.
Rules for Fiscal Policy
The following may be described as the rules for fiscal policy:
1. During a period of falling employment or growing unemployment the government
should obviously be interested in raising the level of aggregate demand to the level of
full employment, either by: a) an increase in government expenditure on the purchase
of goods and services, or by b) an increase in government transfer payments, or by
c) a balanced budget expansion

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2. If inflation caused by excess demand is the problem, the government for slashing the
excess demand should reduce the level of aggregate demand by a) an increase in
taxes, or by b) a reduction in government expenditure on goods and services, or by
c) a reduction in transfer payments or by d) a combination of these
3. If the level of employment and output reached is quite high, the government must try
to attain the rate of economic growth necessary to realise the objectives of continued
full employment and price stability.
6.5.1 Mechanics of Fiscal Policy
How does the government select the most effective alternative? The mechanics of fiscal
policy can be explained with the help of three models. Assuming that there are two sectors in
the economy, viz. households and businesses, we shall examine in the first model the effects
of tax receipts (T) and government purchases (G) and assume government transfer payments
to be zero. In the second model, government transfer payments are added. Both these models
assume that tax receipts are independent of the level of income, i.e. autonomous . In the third
model, the breakdown of government expenditures into purchase of goods and services and
transfer payments is retained, but tax receipts are recognised as being partly dependent on the
level of income and partly upon the level of government expenditures. These models simply
assume certain amounts of government spending and taxation, and indicate their
expansionary and contractionary effects. This will just explain the pure mechanics of the
relationship between government spending, taxation and the level of income.
First Fiscal Model
In a three sector economy─ households, business houses and government─ the fundamental
equation of income and output would be:
C+S+T = Y= C+I+G
Where Y is the net national income or product and S and I are net private saving and net
private domestic investment respectively. Thus, in terms of saving and investment
respectively. Thus in terms of saving and investment the identity can be expressed as
S+ (T – G) = I
Where (T - G) represent public saving. The equilibrium between saving and investment will
be found at the level of income and output at which planned saving plus taxes are equal to
planned investment plus government purchases:
S+T = I+G
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Any increase in G will raise the equilibrium level of income. The new equilibrium level of
income must be that at which the amount of income stream diverted from consumption into
planned saving and tax payment is just equal to the amount added to the income stream in the
form of investment and government expenditure.
Second Fiscal Model
In this model, we shall examine the essential difference the effects upon income of changes in
government transfer payments. Net tax receipts are equal to gross tax receipts minus
government transfer payments and interest on debt, or Tg – R. Expressing this as T = Tg-R
underscores the fact that R is really negative taxes, in effect an amount of gross tax receipts
which is returned to individuals through government transfer and interest payments.
Substituting Tg – R for T, the fundamental identity for net national product now becomes:
C + S + Tg – R = Y = C+ I + G
The effect upon Y of an equal increase in R or in G will be less in the case of the change in R
than in the case of G, as long as the MPC, or c is less than 1. That is,

Where ∆G equals ∆R
The reason for this difference is that all of any increase in G is an addition to aggregate
demand whereas only part of any increase in R becomes an addition to aggregate demand.
∆G affects aggregate demand directly, but ∆R affects it indirectly through the disposable
income. Assuming that there is no change in tax receipts, ∆R directly increases disposable
income by the full amount of ∆R. T he consumption function indicates, however, that not all
of any increase in disposable income will be devoted to consumer spending; some portion of
it will be devoted to personal saving. In other words, at the first step, some portion of
government transfer payments will fail to appear as demand for goods and services, but at the
first step all government purchase appear as demand for goods and services. Thus in the case
of government purchases the full increase in government spending is subject to the ordinary
multiplier, but in the case of government transfers only a part which is not diverted to saving
is subject to ordinary multiplier. These amounts may be designated as ∆G and c∆R.
Third Fiscal Model
In the previous model we have analysed the effect of a change in anyone element on Y for a
given value of c, assuming other elements remaining constant. In practice, a change in

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anyone element is bound to effect upon the level of income. The response of consumption
spending to a change in income is already included in the previous model. In the third model
we would include the response of investment spending, the response of government spending,
at least the response of transfer expenditure, but to avoid complications, we will continue to
treat these as completely autonomous. To bring this model closer to reality we can make one
modification, that is, to allow for the fact that any change in income will affect tax receipts ─
since a major part of the receipts come from personal and corporate taxes. Now, assuming
that tax receipts vary with changes in income, we may roughly treat tax receipts as a linear
function of income. Hence the tax function will be─
Tg = Ta + ty
This function is of the same type as consumption function and the investment function, t
stands for the MPT or the marginal propensity to tax. It indicates the marginal rate of tax
∆Tg/∆Y or the fraction of any change in income that will be diverted from income receivers
to government with a given tax structure and tax rates. It is comparable to the single rate in a
proportional income tax.
6.5.2 Flexibility of the Fiscal policy
The changes in the level of economic activity in the economy occur so quickly and with such
suddenness that fiscal tools not being flexible cannot be geared immediatelyto meet the
situation. That's why it has been suggested that a built -in flexibility should be introduced in
the fiscal system. Built-in flexibility implies that change in tax collections and government
spending occur automatically (i.e without any decision or action), promptly and in the right
direction (meaning that decreases in aggregate demand requires additional government
expenditure and reduced tax receipts and increases in aggregate demand requires the opposite
Steps) to stabilize the aggregate demand.
Under the built-in flexibility system the tax rates would be so fixed that in the upward swing
of the trade cycle, every increase in the national income, yields from taxes would
automatically go up at a rate faster then the increase in the national income without any
change in the rate of tax, while the government expenditure on relief, unemployment benefits
etc would fall down automatically. Owing to the operation of these two forces the budget will
automatically show a surplus and thus the upswing will be automatically put under check.
The process will be reversed in the downswing phage of the cycle.
This system is good in a number of ways: first it works without changes in the tax rates and
so it does not require any elaborate and cucumber some legislative procedure. Second, it does
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not need any forecasting before initiating the action and hence the chances of mistakes are
minimized. Third, the climate is free from uncertainties and is favourable to private
investment. Lastly, it is the best method of coordinating short-run and the long-run fiscal
policies.
Effects of discretionary change initiated by the government
In the foregoing analysis it has been stated that built-in flexibility provides appropriately
timed helpful fiscal response to cyclical fluctuations, while flexibility formula provides a
greater scope for the fiscal policy to be effective. The formula device implies discretionary
action. We now examine as to how far the fiscal measures, even with discretionary action,
can, in practice be successful in stabilizing the situation. The government can take three
measures: first change the structure of taxation, second change the level of government
purchases of goods and services and transfer payments and third change the level of
taxation
i) Changes in the structure of taxation: If the government wishes to influence the
level of consumption and investment in the private sector without changing the level
of its revenue and expenditure, it can achieve its objective to some extent by
introducing certain changes in the tax structure. For example, the government may
provide largest relief in the Income-tax at lower income levels and the loss in revenue
may be made up by making the tax more progressive at higher income levels; it may
reduce the burden of indirect taxes and shift it to direct taxes. In times of inflation the
government may find it very difficult to implement the opposite of these measures.
But a relief in Income tax or excise duty might encourage personal savings and
measures which might encourage the retention rather than the distribution of profits
might encourage corporate savings. For encouraging private investment, the
government may allow liberal depreciation deductions at the time of assessment of tax
liability. But such changes have there limitations, for example higher rates of income
or Corporation tax might adversely affect effort and initiative; the government may
also face enormous difficulty in the choice of the tax policies which are best designed
for stabilization purposes. Besides the government may also face difficulty in
reconciling these policies with the objective of economic justice because many people
might object to these policies on the basis that these gives rise to unfair distribution of
the tax burden among different income classes for different types of income.
ii) Changes in the level of government purchases: During inflation the government
can reduce the inflationary pressure by reducing government purchases. In practice,

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the government’s freedom of action in this direction is rather limited. A major portion
of the total government purchases is for meeting the requirements of National defence
which is dictated by needs of maintaining security rather than those of stabilization
and hence drastic changes in its volume cannot be made. In advanced countries, the
percentage of defence expenditure in the total budget is still higher and there is no
room for any cutback. In developing countries the items of expenditure are such that
expenditure cannot be reduced. Moreover, most of the expenditure is incurred on
meeting the requirements of social and economic development.
During recession an increase in government spending will have a multiplier effect,
there is no reduction in private expenditure to the same extent. The more its spending
is concentrated on the poorer sections of the community, where the propensity to
consume is higher, the greater will be the multiplier. Direct expenditure by the
government on goods and services has direct as well as induced effects. Since the
major part of expanded purchases has to be for public works such as roads, dams,
hospitals, schools, public buildings etc; the government has a direct control over it
and it can exercise a decision influence over it. Such investment spending may be
increased or decreased as the situation demands. Thus unlike reduction in taxation
where there is no certainty that the increase in disposable income will actually be a
spent public investment achieves actual spending.
iii) Changes in the level of taxation: Because of their limitations, public spending
programmes are not likely to be sufficiently flexible to combat successfully the
cyclical fluctuations. The government however has another device at its disposal viz.,
the budgetary policy. Through this policy, the government can influence private
consumption by changing the amount of personal disposable income of the people by
changing the level of taxation in its annual budgets. Budgetary policy is essentially a
means for adjusting the relationship between taxation and government expenditure.
Taxation implies and appropriation by the government of a part of private incomes.
The amount so appropriated is retained in the circular flow of income only when it is
spent by the government. If government taxation is less than its expenditure, the
aggregate demand will increase and income will expand. If taxation is more than the
government expenditure the aggregate demand will decline and income will contract.
To put it in another way, if aggregate demand is less than the necessary to maintain
full employment, the government through budget deficits stimulates spending out of
borrowing which, if continued from year to year, will have a multiplier effect and
increase the size of the national income. Conversely, during inflation, the government
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by increasing taxation and keeping its expenditure constant, or by reducing its

expenditure and keeping taxation constant or by some combination of both can
accumulate a budget surplus and thus increase public savings to balance the
deficiency in private savings. The main merit of adjusting aggregate demand on the
revenue side is that it enables the national product to be divided between private and
public usage according to their relative priorities. There are certain tasks which the
government can do better then the private enterprise: defence, justice, health, roads
etc and government must decide as to what proportion of the National Product should
be spend on them. How much is to be spent by the government would be given
priority and will not change according to the variations in the level of private
spending for maintianing aggregate demand at full employment level. Similarly,
policy of taxation can policy of taxation can be also used for or adjusting private
demand in such a way sufficient resources are released for the requirements of the
public sector. If there is full employment it and private demand is so high as not to
leave sufficient resources for the public sector, taxation must be increased. If, on the
other hand whatever resources left after government has met its expenditure are
inadequate for meeting the private demand, then taxation must be reduced to allow
more purchasing power to the people. In this way, full employment can be achieved
without complete control of resources. Once the essential claims of the public sector
on the economy have been met, the rest of the national product can be distributed
according to the private enterprise system.
6.5.3 Limitations of the Fiscal Policy
The limitations of fiscal policies are as follows:
I. The success of fiscal policy largely depends on fairly accurate forecasting of the
course of trade cycles, which is an extremely difficult task.
II. Even if we are able to know the future course of trade cycles, it is very difficult to
know which with exactitude the impact of various combinations of the various
instruments of fiscal policy on the different variables. Furthermore, there are
administrative delays in taking decisions, especially when legislative approval is
needed for changing the rates and the structure of Taxation or for undertaking any
Public Work project. Again, there is lot of uncertainty due to the time lag between the
implementation of official measures and there full impact on the level of income,
output and employment.

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III. Increase in public investment may cause a decline in private investment because of a
rise in the prices of factors due to the keen, competition from the government. The
fiscal policy may not be effective in combating serious depression and hyper-
inflation, because of the psychology of private investors.
IV. A vigorous fiscal policy to combat depression may cause a vast increase in public
debt which may make the debt management extremely difficult.
V. Fiscal policy for achieving full employment may be made ineffective by rising wages
which may also adversely affect the employment emanating from the spending of
those who receive funds from the government. Again, if the monopolists, instead of
increasing their output, increase the price of their products, no additional secondary
employment will be created in the monopoly industries and thus the achievement of
full employment would become impossible.
VI. Fiscal measures may be effective only in curing unemployment resulting from a
deficiency of demand and not from any other causes. Public spending may not exceed
succeed in curing unemployment caused by structural changes, Wage rise and
Monopoly restrictions.
VII. A fiscal policy for curing unemployment may create balance of payment difficulties,
because the additional incomes may be spent on the purchase of imported goods.
Increase in imports and decrease in exports may also partly neutralize the effect of
increased public spending.
VIII. Increase in government spending on public works projects during deflation and a
decrease in the same may clash with other social and economic objectives.
6.5.4 Fiscal Policy and Economic Development
Fiscal policy can help countries in accelerating the pace of economic development by
affecting the reallocation of resources between different sectors and industries and regions
in accordance with the objectives of the economic plan, by changing the distribution of
income on a more equitable basis, by increasing the rate of capital formation and by
controlling inflation. Fiscal policy can affect the distribution of resources between different
sectors and industries through the instruments of government spending and taxation.
Government spending in a particular sector of the economy tends to divert resources from
other sectors to that sector. Taxation of a sector or industry produces the opposite effect. It
is the pattern of government revenues and expenditures which act as a Lever for mobilizing

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resources among different industries and occupations and helps the reallocation of
resources according to the goal in view.
The taxation policy through various exemptions, concessions and discriminating rates can
influence the pattern and level of private investment and distribution of property and wealth
and subsidies, grants etc; can induce investment in the sectors and industries which the
government wants to develop. Through this very tools the government can make the
distribution of income more rational and equitable. For example, government spending on
health and education may enhance the occupational and geographical mobility of the
workers; land and property taxes may change the distribution of ownership inland and
property; an element of progression in the tax structure can ensure a more rational
distribution or government spending on items which benefit the poorer and backward
sections of the community can reduce the gap between the rich and the poor. However,
from the point of view of economic development the rate of capital formation and effects of
inflation are more important. In fact it is the rate of capital formation that determines the
rate of economic development of a country. Capital formation can take place either through
investment spending in the private sector─ financed other by saving or by creation of credit
or by foreign Investments; or through investment spending in the public sector─ financed
by taxation revenues, borrowing or deficit spending. Since the level of savings in
developing countries is very low, the scope of private investment is very much limited; the
flow of capital on a larger scale from other countries also doesn't have a bright chance; and
so the only major source of capital formation is that of public investment through taxation
and borrowing.
Taxation: Taxation is the only effective financial instrument for reducing private
consumption and investment and transferring resources to the government for economic
development. In the early stages of economic development a country needs use investment
on building up the economic and social overheads viz., transportation and Communications,
electrification, irrigation works, education and Health Services etc. Such projects don't
yield any direct return and are not at all attractive to private enterprise; and have therefore
to be undertaken by the state. It is also not advisable to undertake them with borrowed
funds and this are to be financed through taxation. True that taxation didn't play a very
critical role crucial role in the development of the existing developed countries of the
world. But the situation in those countries was entirely different. Firstly, in those countries
most of the development took place through private initiative. Secondly, they had the
resources for developing the scientific and Technical know how. Thirdly the inequalities in
the distribution of income where not so large. Fourthly, the per capita income was not as
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low as in the underdeveloped countries. And so going to the conditions prevailing in these
countries, state participation is considered as essential for their economic development. Not
only that since establishment of a classless society has been fixed as the goal, the extension
of the public sector is very important.
The taxation potential of developed countries is quite low because of the low level of
income the structure of the economy political setup and inequalities in the distribution of
incomes but taxation if used gradually and wisely can prove very effective in removing all
these deficiencies and in raising the taxes on potential of this countries unequal distribution
of income is not only socially undesirable but economically very harmful for the growth of
the economy the expenditure by the rich on luxury goods which are imported from abroad
is not only and productive and wasteful but also depletes the foreign exchange resources
which can be profitably utilised for the import of equipment technical no technical 9 how
and raw materials required for the economic development of the country hence taxation of
higher incomes will not only lead to the raising of resources for economic development but
also help in the profitable use of foreign exchange and in reducing the inequality in the
distribution of incomes reduction of inequalities will not motive motivate the poor classes
to sacrifice some of their essential needs and thus contribute to the cause of national
development it must however be noted that reduction of inequalities does not imply the
reduction of functional inequalities those arising from intelligence hard work skill
education etc but the reduction of inequalities which arise from inheritance functional
inequalities are necessary for the economic growth of a country and must be preserved to
the extent necessary for the development of the country taxation of personal incomes is an
important source of revenue in many developed countries but in underdeveloped countries
it can only be used for strengthening equity because most of the people life on the verge of
subsistence and can't be taxed a large part of income does not come through commercial
channels and is directly consumed by the producers majority of the people are illiterate and
cannot maintain proper accounts for assessment purposes agriculture being the predominant
occupation of vast number of people cannot be brought within the fall of the tax integrity
efficiency and administrative competence are far below the mark so far as the effect on
incentives is concerned there would be no adverse effect on incentives of a high rate of
personal income taxation if consumption of luxury goods is very high if there is voting or
flight of capital or if capital is invested in speculative Enterprises otherwise the savings
would be discouraged investment and the rate of capital formation will decline so in the
light of the foregoing analysis it can be concluded that the taxes and masonry can be gear in
the interest of economic development of a country it has the necessary potential provided

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that the physical authorities act causes Li and with foresight gorging the effect of each
major and making necessary changes in the tax structure and implementing with
promptness scale and efficiency but the greatest difficulty with many underdeveloped
countries is that the prevailing conditions do not allow the use of the tax policy for
mobilizing resources for economic development because of the existence of a large non-
monetary sector the difficulty of bringing the rural population in the Income-Tax net lack of
integrity and efficiency in the administrative staff lack of consonance and responsibility
among the taxpayer etc.

6.6 MONETARY POLICY

Paul Einzig defines monetary policy, “as including all monetary decisions and measures
irrespective of whether their aims are monetary or non-monetary, and all non-monetary
decisions and measures that aim at affecting the monetary system.” Monetary Policy in its
narrow sense, refers to the credit control of a central bank; in its broad sense, it means all
those monetary and not monetary measures which influence the cost and supply of money.
Monetary policy as an instrument of economic stabilization, has been used by various
countries to manage their economies, especially since the nationalisation of Central banks.
Such a policy involves influencing the level and composition of aggregate demand by
manipulating rates of interest and the volume of credit. The traditional instrument of
monetary policy is bank rate, supplemented by open market operations and selective credit
control, where necessary. Since the end of the last World War, certain other methods of credit
control have been developed and attempts have been made to make monetary policy more
effective and more selective in its impact on the economy.
In fact, monetary policy has a positive role to play in bringing about non-monetary reforms as
an instrument to implement the economic policy of the state. Such a role has been only
recognised by the governments of the various countries after the world war-ii. This is due to:
I. The persistence of world-wide inflationary trends
II. The inability of the governments to check such trends and to bring about stabilisation
through non-monetary measures.
III. The belief that the extent to which fiscal measures can be effectively used is limited
by international and domestic political consideration and for successful fight against

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inflation available instruments of monetary technique must be put in active

operations.
It may be pointed out that before the Great depression of the 1930’s, monetary policy was
considered to be as the most effective instrument of economic stabilisation but during the
depression it lost its prestige and fiscal policy occupied its place. It was only after the
outbreak of the world war II, owing to worldwide inflation that the monetary policy regained
its lost prestige. These days, the governments have been making uses of both monetary and
fiscal policies in economic management.
Understanding Monetary Policy

Money Supply • Currency board

• Liquidity Management

Inflation • Fluctuations
• Instruments of Credit Control
• Buying and Selling or Government bonds

Macro Economic Goals • Rate of Interest

•Employment level
• Foreign Exchange Rate

6.6.1 Objectives of Monetary Policy

 Ensuring Price Stability
 To Promote economic growth
 Stability of Exchange rate
 Macroeconomic Goals of the economy.
 Full Employment.
 Credit Control
 Creation and expansion of financial institution Control of Inflation
 Restrictions of Inventories

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6.6.3 Role of Monetary Policy in developing economy

The chief objective of the monetary policy in developing economies should be, obviously, to
raise the rate of capital formation and economic growth. This can be done by adopting a
policy of cheap money and to stimulate investment by lowering the rate of interests, directing
investment into desired channels through selective credit control and by undertaking public
investment on a large scale. In view of scarcity and shyness of capital, some economists have
suggested a policy of high rates of interest for such economies. In their opinion, high rate of
interest would channelise the scarce capital only to the most productive and uses would
eliminate wasteful uses of resources. It would stimulate savings and check inflation. It is true
that a policy of high interest rates may be successful in doing all this but it may not be
desirable to desirable to generally restrict investment just for keeping inflation under check.
In fact, a mild dose of inflation helps in raising the level of investment. But, if the inflationary
pressure continues mounting up, then the monetary authority would be required to use both
direct and indirect methods of credit control. Of these measures, the open market operations
cannot be of much help because in such economies the bill market is generally small and
undeveloped. The central bank does not have a complete control over the commercial banks
and therefore they maintain an elastic cash deposit ratio. The commercial banks are also not
encouraged to invest in government securities because of their low rate of interest, and they
prefer to keep their reserves in liquid form. The commercial banks generally also do not
borrow from the central bank.
Similarly, the bank rate policy can also not be effective because of:
I. Lack of bills of discount
II. The small and undeveloped bill market
III. A large non-monetised sector
IV. The existence of indigenous bankers, beyond the control of central bank
V. Habit of the commercial banks to maintain large cash reserve
VI. A large unorganised money market
The monetary policy can create a favourable climate both for saving and investment in such
economies. The shape of investment would, however, depend on the policy of credit
institutions and the forms of credit institutions and the forms of credit control that are
adopted. In most developing countries, the commercial banks provide only short-term credit
which is chiefly used for carrying inventories, purchasing land and real estate and for
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financing the production of export crops. The government will have to make guarantees or
provide rediscount facilities, if the commercial banks are to be induced to advance medium
and long term loans. Selective credit controls can also influence pattern of investment and
production. The commercial banks can differentiate between different sectors and industries
in matters of cost and amount of credit, the duration, the amount of collateral, etc. If the
central bank has adequate control on the commercial banks, selective control could be
exercised to indirectly influence the behaviour of banks by having different rediscount rates
for different types of loans or by making exception in regard to reserve requirements on a
selective basis.
6.6.4 Monetary Policy in India
There is no formal structure of coordination between fiscal policymakers and monetary
policymakers. However, in the six member Monetary Policy Committee, three members are
nominated by the government, which does facilitate coordination between the government
and RBI. Hence, both policies are supplementary in nature. On the other side, the MPC
framework can hamper independence of RBI in the true sense, where the RBI functions as an
agent of the government. There is a correlation between central-bank independence and
macroeconomic equilibrium. Moreover, independent central banks strongly promote stability
and sustainability in the macroeconomic framework (Mankiw, 2006). There is a specific
inflation target of 4% (plus or minus 2%); no such specific target exists for output, growth or
unemployment (Sivramkrishna, 2016). As per Article 112 of the Constitution of India, the
fiscal policy is an annual financial statement of the government's receipts and expenditures
prepared by the Ministry of Finance after consulting with other ministries and the Niti Aayog.
Moreover, the fiscal policymakers ensure that they take care of concerns of essential
stakeholders from the agriculture sector, industry and services sector before finalizing the
budget. The policymakers aim to meet expectations and requirements of the stakeholders on
the basis of the economic situation. Based on Article 266 of the Constitution of India, all
revenues are received, loans raised and receipts from recoveries of loans granted by the
government from the consolidated fund of India. All expenditures of the Government are
incurred from the consolidated fund of India. Article 267 of the Constitution authorizes the
Contingency Fund to be used by the Government to meet urgent unforeseen expenditures.
The money in provident funds, small savings, or special funds are part of the public account.
In India, under the aegis of the Finance Ministry, the department of economic affairs prepares
the fiscal policy. The Reserve Bank of India is responsible for the monetary policy (Surbhi,
2015). In short, the fiscal policy is concerned with public revenue and public expenditure

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while the monetary policy is concerned with a change in the money supply and change in the
rate of interest. There is the possibility of political influence in fiscal policy due to the nature
of the task and election pressures (Mankiw, 2014). Moreover, the politician's primary goal is
to develop confidence in their policies in voters' minds so that they are re-elected. A fiscal
stimulus package before an election helps to increase aggregate demand, leading to higher
economic growth and lower unemployment (Blanchard, 2006).
During a recessionary period, the fundamental problem is inadequate effective aggregate
demand. The first line of monetary policy against economic downturns is increasing the
money supply; the central bank reduces interest rates. This decrease in the rate of interest will
decrease the cost of borrowing to finance investment projects, such as new factories and new
housing. It will lead to increase in investments, finally increase aggregate demand and
facilitates increase in production and employment. Fiscal policy can mitigate this
recessionary pressure. The government may reduce tax rates; it increases disposable income,
which increases overall consumption, finally increases the aggregate demand (Mankiw,
2014). Both the fiscal and monetary policies increase aggregate output through multiplier
effects based on value of marginal propensity to consume. It further induces consumption,
which accordingly increases aggregate demand.

6.7 NEUTRALITY OF MONEY

Certain economists like Wicksteed, Koopmans, Hayek, Robertson, etc, advocate that the
objective of monetary policy should be to keep the money neutral, i.e, to ensure that the
quantity of money in circulation does not affect the prices. These economists believe that
business fluctuations occur because of the changes in the quantity of money in circulation and
if the disturbances caused by monetary change could be controlled or eliminated, then instead
of vigorous fluctuations, only smooth adjustments to changes in technology, consumer’s
preferences. Or act of God will take place in the economy. A neutral money policy thus,
implies two things: first, the monetary authority will have to be given authority to counter
balance changes in the velocity of circulation of money caused by hoarding and dishoarding
of people. Second, unless basic changes in the structure of the economy, viz., population,
technology etc are compensated by changes in the quantity or velocity of circulation of
money, there would be such disturbances as would be quite contrary to the neutral money
theory. It should also be noted that changes in prices may even occur when money remains
neutral, owing to the changes in the volume of transactions and improved productivity of the
factors of production.

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This theory has, therefore, been criticised on a number of points:

I. It is based on wrong premises, i.e. it carries with it all the assumptions on which the
quantity theory of money is based.
II. It is not easy to implement this policy because it is not possible to keep the supply of
money constant in actual practice without which money cannot act in a neutral
fashion.
III. Even after keeping the money supply constant at a particular level, it is not sure that
the price level would be stable because other factors like technological improvements
may cause changes in the level of output, which would certainly lead to a decline in
the price level owing to a decline the production cost.
IV. The policy appears to be self-contradictory, because on the one hand that protagonists
of this policy advocate that the state should not interfere in the economic affairs, on
the other hand for maintaining a constant supply of money they expect monetary
authority to make frequent adjustments with the fundamental changes in the economy.

6.8 CROWDING OUT

The crowding out effect refers to a phenomenon where increased government deficits can
lead to a rise in interest rates. This, in turn, can cause activity in the private sector to
diminish. The crowding out effect is an economic situation that happens when both the
government and the private sector are competing for access to the same funds or other
resources.
When the economy isn't able to meet the demand of both groups, the government tends to be
able to claim resources first. This causes private industry to be unable to obtain all the money
or raw materials that it wishes to make use of. Oftentimes, interest rates increase significantly
when the government consumes more from the private sector. This rise in rates, in turn, can
cause a slowdown in economic activity. This is primarily a situation that occurs when
governments and private industry compete for access to the same funds. Crowding out can
happen in theory at any point. However, in practice, it tends to be a problem when the
government puts much more strain on an economy's lending or industrial capacity than usual.
Examples of this can occur during:
 Wartime
 Inflationary periods
 When the government runs large budget deficits

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How ‘Crowding Out’ Works

Like with other goods, money itself is an economic market which reacts to the forces of
supply and demand. Crowding out happens when both private individuals and companies and
the government demand additional funding, and the supply of loans is not sufficient to meet
that demand. When there is an inadequate supply of capital, this forces interest rates to
increase to create a new market equilibrium.
Traditionally, fixed income investors are more eager to lend to the government than private
enterprises because the government has the power of taxation to pay its bills. This makes
government credit a safer risk than lending in the private sector. In other words, when both
the government and a private company want to take out a loan, the government generally is
able to obtain financing first.
When the government consumes more of the economy's private lending capacity, however, it
leaves fewer loans available to everyone else in the marketplace. Private companies that
would have borrowed funds to expand their factories, build new stores, or hire more
employees instead may have to forgo those plans because the cost of capital becomes too
high and these proposed projects no longer meet a company's hurdle rate.
Types of Crowding Out
The classical economics textbook example of the crowding out phenomenon is in interest
rates and the demand for money. However, there can be other types of crowding out as well.
Here are a few primary cases.
I Financial Crowding Out
Financial crowding out is the most common form. This is where the government's demand for
additional borrowed funds causes interest rates to go up, and thus stifles private sector
investment.
II Resource Crowding Out
Resource crowding out can happen when the government buys up a large portion of the
supply of a given good, and thus makes it difficult for the private sector to meet its
production schedules. This often happens during wartime when the government prioritizes
the construction of armaments and other military equipment. This could cause a deficit of
goods such as iron ore, steel, copper, and so on in the broader economy.

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III Infrastructure Crowding Out

A tension can occur in market-based economies where both the government and the private
sector provide certain infrastructure services. Suppose that the government invests more in
building transportation-related assets such as ports, railroads, postal services and the like.
This can discourage private companies from providing these services since it can be
challenging to compete against a government-run provider which has less of a profit motive
when managing its operations.

6.9 LIQUIDITY TRAP

Liquidity trap’s idea was discovered originally by J.M. Keynes and Hicks (1937), as it was
said to occur during the great recession of the 1930’s for the first time. Since the 1970’s
central banks in the developed world was interested in fighting inflation rather to stimulate
the economy by increasing money supply, as they follow Milton Friedman (1969, pp. 1-50)
rule. In the 1990’s and 2000’s the main central bank’s objective was to ensure the credible
monetary policy with inflation target (Svensson, 2010) clearly stated. As economic agents
used the same forecasting models as the central banks that time, they were able to predict
monetary policy more accurate. This in turn led to decrease in economic aggregates volatility
such as: output, inflation etc., which Bernanke (2004) called this period ‘The Great
Moderation’. Woodford (2003, p.268) shows the path of learning dynamics by economic
agents, when the Taylor rule is satisfied much more in recent decade than in previous periods.
In the late 1990’s B. Bernanke, L. Svensson, M. Woodford and P. Krugman (Krugman, 2010)
researched the Japan’s lost decade. Th outcome clearly shows that Japan’s economy has been
caught into the liquidity trap since mid-1990. Krugman (1998) argue that if liquidity trap has
occurred in Japan, it can occur elsewhere anytime now.
Crisis 2008- and the quantitative easing policy in the United States, which was targeted not
only to restore liquidity on the financial markets but also to lower right-tail of yield-curve,
might cause elements of the liquidity trap. The aim of this paper so, is to find if some aspects
of liquidity trap are visible in the United States. The literature review shows two approaches
to assessing liquidity trap. The standard Keynesian view augmented by rational expectation
and the monetary, which focus on monetary aggregates cointegration. If evolutions of
monetary aggregates become irrelevant to prices and output, economy may be caught into
liquidity trap. The paper is organized as follows: the two sections provide literature survey on
Keynesian and monetary approach to liquidity trap. The third one asses some cointegration
evidence and the fourth conclude.

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Liquidity trap: Keynesian approach

Liquidity trap was originally discovered by J.M. Keynes (1936) and Hicks (1937). Th is
phenomena is due to nominal interest rate positive only. When it is no possible to make lower
nominal interest rate than zero, further monetary stimulation of aggregate demand is
ineffective. Additionally LL curve is sloped upward since an increase of income and further it
goes into perfect inelastic (Hicks, 1937). The model has got into standard macroeconomic
textbook and was not developed much until famous Krugman’s paper (1998). According to
Krugman (1998), the lack of economists’ interest in this fi led was due to the lack of faith that
liquidity trap will ever happen. Krugman (1998) sheds new light on liquidity trap, which was
proposed by standard IS-LM model. Krugman’s model combines interest rate, consumption,
money supply and expectations: * * 1 () P y i DP y ρ + = (1) Where: i – interest rate, D –
discount factor, P* - future price level, P – current price level, y*/y - the relation between
future output (expected) and current output, ρ – relative risk aversion. The relation (1) can be
viewed as a model, which assumes sticky or flexible futures prices. The risk aversion
coefficient comes from agent’s utility function, as they are to decide whether they won’t to
buy bonds at interest rate i or spend money on consumption (which drives output). Therefore
if future prices remains fixed (P*), any raise in current prices (P) will produce future
deflation, as higher P means lower i and i cannot be negative. If nominal interest rate was
negative, agents would hold money instead of bonds. When interest rate is close to zero
bonds and money become perfect substitutes and further increase in money supply will not
change neither output nor price level. The Krugman’s (1998) model incorporated financial
intermediation in the above. The evidence for financial intermediation to liquidity trap is also
visible in the evolution of monetary aggregates. In Japan for example monetary base in years
1994-97 rose by 25.6 per cent, while bank credit rose only by .9 per cent (Krugman 1998,
table 7). Similar data provided Friedman and Schwartz (1963, table A-1). Between 1930 and
1933 in the United States currency held by public rose by ca. 46 per cent, while commercial
bank total deposits fall by ca. 41 per cent1. As it was associated with banking crisis that had
begun in the early 1930. Krugman’s (1998) provides a way to escape the liquidity trap. This
is a credible overshoot of inflation target by central bank. In other words central bank should
set agent’s expectations of the future price level to rise.
In the Keynesian approach liquidity trap condition can be seen through market friction in the
financial intermediation sector. Bernanke and Gertler (1995) introduce the term ‘external
finance premium’. The premium comes from the ‘lemons problem’ directly. Financial
intermediation assesses the borrowers’ creditworthiness, which cost is incorporated to the
‘external finance premium’. The level of an average ‘premium’ is varying over the business
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cycle. Usually during the economic downturn ‘premium’ raises, which in turn makes the
interest rate that entrepreneurs and consumers faces higher; even though central bank’s short-
term interest rate is very low. The raise in cost of ‘lemons’ in some circumstances can sharply
decrease the transaction volume, as suggested by Akerlof (1970). Kacperczyk and Schnabl
(2010) shows that financial market in the United States was blocked by the problem of
‘lemons’. Liquidity trap in that sense should occur, when financial sector is reluctant to lend
money to private sector in spite of high banks reserves. This condition is somehow similar to
the mentioned above problem of natural interest rate, as the ‘premium’ raises the nominal
interest rate. Martens and Raven (2011) evidence shows, that credit channel in the United
States depressed the expectations and hence caused the liquidity trap recession recently.

6.10 ROLE OF THE CENTRAL BANK

The variation in circumstances surrounding the origins of central banks means that their roles
and functions have not all evolved in the same way (Box 1). Some started life as special
purpose government banks constructed to bring some order to the issuance of banknotes.
Some were established to act as funding conduits for the government. Some were large
commercial banks, whose dominance was subsequently boosted by the granting of monopoly
rights to issue banknotes. The majority were, however, created in the 20th century (Box 1,
Figure 1) specifically as central banks – public policy agencies for central banking functions.
The bundle of functions that constitutes a central bank is not fully defined beyond the basic
point that a central bank is the agency that conducts monetary policy and provides the means
of settlement. Nor can the definition always be inferred from the functions allocated to
central banks established in the 20th century, since the bundle of functions often differed
substantially from country to country. This chapter explores the global diversity of functions
assigned and objectives specified, noting implications for the array of governance practices
observed. Some common themes are worth noting at the outset.
First, in the past few decades, a more focused concept of the role and responsibilities of the
central bank seems to have emerged. Objectives have become better identified and used more
actively as a means to shape the performance of the central bank. However, objectives for
some functions – including the important financial stability function – remain to be spelled
out clearly, limiting the completeness of governance arrangements. Second, difficult trade-
offs often must be made between multiple objectives in relation to specific functions and
between objectives for different functions. Those trade-offs complicate the related
governance structures as well as the performance of the tasks. But just as a clear picture of
the archetypical central bank seemed to be emerging, events moved the image out of focus.
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The current financial crisis has brought various unsettled issues to the fore (including
incomplete objectives and trade-offs) and has thus renewed some uncertainties about the
future shape of central bank functions and objectives.
6.10.1 Functions of the central Bank
Functions of RBI (The India's Central Bank) Reserve Bank of India being an apex court of
the centre enjoys enormous power and functions under banking system in India. It has
monopoly over the issue of bank-notes and monetary system of the country. These power and
functions as to issue of bank notes and currency system are governed by the Reserve Bank of
India Act, 1934. Besides it the Banking Regulation Act, 1949 also empowers certain power
and Function of the Reserve Bank. Main Functions of RBI Main functions are those functions
which every central bank of each nation performs all over the world. Basically, these
functions are in line with the objectives with which the bank is set up. It includes
fundamental functions of the Central Bank. They comprise the following tasks.
1. Issue of Currency Notes: The RBI has the sole right or authority or monopoly of
issuing currency notes except one rupee note and coins of smaller denomination. These
currency notes are legal tender issued by the RBI. Currently it is in denominations of
Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and
withdraw but even to exchange these currency notes for other denominations. It issues
these notes against the security of gold bullion, foreign securities, rupee coins,
exchange bills and promissory notes and government of India bonds.
2. Banker to other Banks: The RBI being an apex monitory institution has obligatory
powers to guide, help and direct other commercial banks in the country. The RBI can
control the volumes of banks reserves and allow other banks to create credit in that
proportion. Every commercial bank has to maintain a part of their reserves with its
parent's viz. the RBI. Similarly, in need or in urgency these banks approach the RBI
for fund. Thus, it is called as the lender of the last resort.
3. Banker to the Government: The RBI being the apex monitory body has to work as an
agent of the central and state governments. It performs various banking function such
as to accept deposits, taxes and make payments on behalf of the government. It works
as a representative of the government even at the international level. It maintains
government accounts, provides financial advice to the government. It manages
government public debts and maintains foreign exchange reserves on behalf of the
government. It provides overdraft facility to the government when it faces financial
crunch.
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4. Exchange Rate Management: It is an essential function of the RBI. In order to

maintain stability in the external value of rupee, it has to prepare domestic policies in
that direction. Also, it needs to prepare and implement the foreign exchange rate policy
which will help in attaining the exchange rate stability. In order to maintain the
exchange rate stability, it has to bring demand and supply of the foreign currency (U.S
Dollar) close to each other.
5. Credit Control Function: Commercial bank in the country creates credit according to
the demand in the economy. But if this credit creation is unchecked or unregulated
then it leads the economy into inflationary cycles. On the other credit creation is below
the required limit then it harms the growth of the economy. As a central bank of the
nation the RBI has to look for growth with price stability. Thus, it regulates the credit
creation capacity of commercial banks by using various credit control tools.
6. Supervisory Function: The RBI has been endowed with vast powers for supervising
the banking system in the country. It has powers to issue license for setting up new
banks, to open new branches, to decide minimum reserves, to inspect functioning of
commercial banks in India and abroad, and to guide and direct the commercial banks
in India. It can have periodical inspections an audit of the commercial banks in India.

6.10.2 Credit Control

The Reserve Bank of India has a credit policy which aims at pursuing higher growth with
price stability. Higher economic growth means to produce more quantity of goods and
services in different sectors of an economy; Price stability however does not mean no change
in the general price level but to control the inflation. The credit policy aims at increasing
finance for the agriculture and industrial activities. When credit policy is implemented, the
role of other commercial banks is very important. Commercial banks flow of credit to
different sectors of the economy depends on the actual cost of credit and arability of funds in
the economy.
Method of credit Control:

 The lowering or raising of their discount and interest rates with a view to lowering or
raising money rates generally and encouraging the expansion or contraction of credit.
 The buying or selling of securities or bills of exchange in the open market with a view
to putting additional funds into the market or withdrawing funds there from and thus
expanding or contracting credit.

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 The rationing of credit as an alternative or an addition to raising discount and interest

rates.
 The lowering or raising of the minimum cash reserve requirements to be maintained
by the commercial banks as an additional means of enabling the central bank to
expand or contract their capacity to create credit.
 The imposition of minimum secondary reserve requirements to be maintained by the
commercial banks in the form of government securities and other specified assets, in
order to restrict their capacity to extend credit for general business purpose.
 The regulations of terms and conditions under which credit repayable in instalments
may be granted for purchasing or carrying consumers’ durable goods, as a mean of
exercising some direct control over the volume of outstanding consumer credit.

6.11 SELF ASSESSMENT QUESTIONS

1. Examine the factors which cause shifts in the short run in Philips Curve?
2. How does Philips Curve explain the trade off between unemployment and inflation?
Discuss its policy implication
3. What do you mean by neutrality of money? How did the classical economist establish
it?
4. Explain the concept of neutrality of money?
5. What are the Principal Objectives of Monetary Policy? Is there any conflict between
these objectives?
6. Discuss the main objectives of monetary Policy?
7. Explain how fiscal policies measures can be effectively used by underdeveloped
countries for their economic development
8. Distinguish between monetary and fiscal policy, and discuss their relative advantages
as means of controlling inflation.
9. What are the role and functions of central Bank?

6.12 REFERENCES
RBI (2013). Fiscal-Monetary Co-ordination: Theory and International Experiences, Accessed
July 07, 2020. https://m.rbi.org.in/Scripts/PublicationsView.aspx?id=14938.

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Surbhi S. (2015). “Difference Between Fiscal Policy and Monetary Policy.” Accessed
December 11, 2017. https://keydifferences.com/difference-between-fiscal-policy-and-
monetary-policy.html.
Cecchetti, S.G.(1986). ‘’Testing short-run neutrality’’, Journal of Monetary Economics 17,
May, 409–23.
Brock, W.A. (1974). ‘’Money and growth: the case of long run perfect
foresight’’, International Economic Review 15, October, 750–77.

6.13 SUGGESTED READINGS

As per APA style (APA Manual 6th Edition to be referred)

Kurozumi, T. (2008). ‘‘Optimal Sustainable Monetary Policy.’’ Journal of Monetary
Economics 55: 1277– 1289.
Laidler, D.E.W. (1985). ‘’The Demand for Money: Theories, Evidence, and Problems’’, 3d
ed. New York: Harper and Row.
Linde´, J. (2005). ‘‘Estimating New-Keynesian Phillips Curves: A Full Information
Maximum Likelihood Approach.’’ Journal of Monetary Economics 52(6): 1135–1149.

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LESSON 7

THEORIES OF TRADE AND BALANCE OF PAYMENT

Dr. Meghna Aggarwal
Assistant Professor
Deen Dayal Upadhyaya College
University of Delhi
Email Id: drmeghna@ddu.du.ac.in

STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 Theories of International Trade
7.3.1 Mercantilism
7.3.2 New Trade Theory
7.3.3 Theory of Absolute Advantage
7.3.4 Theory of Comparative Advantage
7. 3.5 Modern Theory of International Trade
7.3.6 Imitation Gap Theory
7.3.7 Product Life Cycle Theory
7.3.8 Theory of National Competitive Advantage
7.4 Balance of Payment
7.4.1 Sub-Section 1
7.4.2 Sub-Section 2
7.5 Summary
7.6 Answers to In-text Questions
7.7 Self-Assessment Questions
7.8 References
7.9 Suggested Readings

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7.1 LEARNING OBJECTIVES

After reading the lesson, the learners are expected to understand
● Mercantilism
● New Trade Theory
● Theory of Absolute Advantage / Absolute Differences in Cost
● Theory of Comparative Advantage / Comparative Differences in Cost
● Modern Theory of International Trade / Heckscher Ohlin (H.O.) Theory
● Superiority of H.O. Theory over the Classical Theory / Difference between H.O.
Theory and the Classical Theory
● The Leontief Paradox
● Product Life Cycle Theory
● Theory of National Competitive Advantage
● Meaning of Balance of Payments (BOP)
● Balance of Trade
● Balance of Trade and Balance of Payments
● Components of Balance of Payments
● Difference Between Current Account and Capital Account
● Autonomous and Accommodating Items of Balance of Payments (BOP)
● Equilibrium and Disequilibrium in the Balance of Payment
● Measures to Control Disequilibrium in Balance of Payment

7.2 INTRODUCTION
The countries today are globally linked with each other through trade in goods and services
and the movement of factors of production. This helps the countries to make optimum use of
their resources through specialization, in turn, making the industries and workers more
productive. These outcomes further help in lowering the cost of production of a number of
products which translates into higher living standards. Without international trade, most
nations would be unable to provide the basic amenities to their citizens at current levels. In
short, not only nations, companies and citizens benefit from international trade, modern life
would be nearly impossible without it.
There are multiple motives for international expansion, some strategic in nature, some
reactive. These include the ability to increase sales and profits, serve customers better, access
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lower cost or superior production factors, optimize sourcing activities, develop economies of
scale, confront competitors more effectively, develop rewarding relationships with foreign
partners, and gain access to new ideas for creating or improving products and services.

7.3 THEORIES OF INTERNATIONAL TRADE

The goods and services that are traded between nations vary greatly. Rarely do countries
adopt the export and import trade patterns of other countries; instead, they develop their own
product portfolios and patterns of trade. Furthermore, the susceptibility of different countries
to the changes in exogenous factors varies significantly. This chapter aims to discuss various
theories of international trade in order to provide a conceptual understanding of the
fundamental principles of international trade and the shifts in trade patterns. Trade is essential
for the very survival of nations with scarce resources, like Singapore or Hong Kong
(currently a province of China), or nations with unbalanced resources, like those in the
Caribbean and West Asia. However, engaging in trade requires a logical foundation for
nations with diversified resources, like India, the US, China, and the UK. A nation's trade
patterns are a dynamic phenomenon rather than a static occurrence. Furthermore, a country's
trade partners and product profile do alter over time. The undisputed leader in diamond
polishing and trade, the Belgian city of Antwerp, had previously seen a shift in the diamond
industry to India and other Asian nations. A few fundamental questions must also be
addressed by managers of international businesses such as Why do countries trade with one
another? Is trading a zero-sum game or a profitable endeavour for both parties? Why do trade
patterns differ so greatly between nations? Can government policies influence trade?
Theories of international trade provide the reason for most of these queries.
Trade theories offer an insight into the potential product portfolio and trade patterns. They
also make it easier to comprehend the fundamental factors that have influenced a nation's
development as a source of supplies or a market for particular goods. These fundamental
economic theories also have varying degrees of influence on the guiding principles of
national regulatory frameworks and those of international organizations.
7.3.1 Mercantilism
According to the mercantilism theory, a country's wealth is determined by the quantity of its
accumulated wealth. Between the sixteenth and the nineteenth centuries, European colonial
powers encouraged international trade to enhance their holdings of goods, which was then
invested to create a potent army and infrastructure. The colonial powers mainly carried out
international trade for the benefit of their native countries, which viewed their colonies as

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resources to be exploited. The first ship of the East India Company arrived at the port of Surat
in 1608 to carry out trade with India and take advantage of its rich resources of spices, cotton,
finest muslin cloth, etc. Other European nations-such as Germany, France, Portugal, Spain,
Italy-and the East Asian nation of Japan also actively set up colonies to exploit the natural
and human resources. Governmental interventions that actively promoted colonial expansion
and the maintenance of trade surpluses were used to implement mercantilism. Imports were
restricted by national governments through tariffs and import quotas and encouraged exports
by subsidizing production. The colonies provided relatively cheap sources for basic
necessities like unprocessed cotton, grains, spices, herbs and medicinal plants, tea, coffee,
and fruits, which were used both as consumer goods and as industrial raw materials. Thus, the
mercantilism policy significantly aided and benefited the colonial powers' ability to amass
wealth.
During this period, gold and silver were the most important sources of wealth. A country
could earn gold and silver by exporting goods whereas importing goods would result in an
outflow of gold and silver. The main principle of mercantilism was to maintain a trade
surplus by maximizing exports and minimizing or restraining imports. By doing so, a country
would accumulate gold and silver and consequently will increase its national prosperity.
In accordance with this principle, the mercantilist doctrine recommended intervention of the
government to achieve a trade surplus. The mercantilist saw no benefit in a large volume of
trade. Rather, they recommended policies to maximize exports and minimize imports. To
achieve this, imports were restricted by non-tariff barriers like tariffs and quota and exports
were subsidized.
In 1752, a classical economist David Hume drew attention to the basic discrepancy in the
mercantilist doctrine. According to him, if England had a balance of trade surplus with
France, it would result in an increased inflow of gold and silver. Consequently, there’ll be an
increased domestic money supply resulting in inflation in England. France would have the
opposite effect due to the outflow of gold and silver. There’ll be a contraction of money
supply in France thereby causing the prices to fall. This change in relative prices between
France and England would encourage the French to buy fewer English goods that have
become relatively expensive and the English to buy more French goods that have become
relatively cheaper. This would cause the balance of trade position of England to decline and
that of France to improve until the English surplus was eliminated. Hence, in the long run no
country could continue to have a surplus on the balance of trade according to Hume unlike
what the mercantilists had anticipated.

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Criticism
1. It considered trade as a zero-sum game (a situation in which gain or loss by one country
is exactly balanced by loss or gain by another country). It was left to Adam Smith and
David Ricardo to prove that trade is a positive-sum game (a win-win situation where no
one wins at someone else’s expense).
2. The importing firms, especially those that import raw materials and parts used in the
manufacture of finished goods, suffer due to mercantilism.
3. It harms the consumers because restricting imports limits the choice of goods the
consumers can buy.
4. Import restrictions results in product shortages that may lead to higher prices i.e.
inflation. When taken to an extreme, mercantilism may invite beggar-thy-neighbour
policies (an international trade policy that benefits the country that enacted it, while
harming its neighbours or trade partners.

IN-TEXT QUESTIONS

Complete the following:

The main principle of Mercantilism was to __________________________.
The theory of Mercantilism was contradicted by ________________________.
The theory considered trade as a ____________________game.

7.3.2 The New Trade Theory

The New Trade theory, as propounded by Prof. Paul Krugman, is a collection of economic
models in international trade which focuses on the role of increasing returns to scale and
network effects which were developed in the late 1970s and early 1980s. The new trade
theorists relaxed the assumption of constant returns to scale and suggested that using
protectionist measures to build up a huge industrial base in certain industries will then allow
those sectors to dominate the world market. What was new in new trade theory was the use
of mathematical economics to model the increasing returns to scale and especially the use of
the network effect to argue that the formation of important industries was part dependent in
a way which industrial planning and judicious tariffs might control.

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The model also showed how past dependent industrial concentrations can sometimes lead to
monopolistic competition or even situations of oligopoly. Thus, it explains why countries
can export and import designer clothes. This means that capital-intensive countries often
dominate the most profitable industries. Being the first to develop these industries, these
countries gain the first mover advantage.
The New Trade Theory suggests that the government has an important role in promoting
new industries and supporting the growth of key industries in a developing economy to be
able to achieve economies of scale. However, government intervention might be
controversial, as stated by many economists, as it may encourage inefficiency in the long
run if it has poor information about the new industries it is likely to support.
Thus, the New Trade Theory recognizes that economies of scale are a key factor in
influencing the development of trade. It also suggests that free trade and laissez-faire
government intervention may be much less desirable for developing economies who find
themselves unable to compete with established multi-nationals.

IN-TEXT QUESTIONS

Fill in the blanks

The focus of the New Trade Theory is on ______________ and ___________.
The increasing rate of return was modelled through ________________in this theory.

7.3.3 Theory of Absolute Advantage

In 1776, Adam Smith questioned the mercantilists’ assumptions by stating that the real
wealth of a country consists of the goods and services available to its citizens rather than its
holdings of gold. He emphasized on the virtue of free trade that are the results of division
and specialization of labour at the national and international level. However, at the
international level, the division of labour requires the existence of absolute differences in
cost. Absolute difference in cost arises when one country produces a commodity at a lower
cost than the other country and the other country produces some other commodity at a lower
cost in comparison to the first country. Thus, according to this theory, every country should
specialize in the production of that commodity which it can produce more cheaply than
others (i.e. enjoys absolute advantage) and exchange it for those commodities which cost
less in other countries (i.e. in which it has absolute disadvantage).

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To illustrate, let there be two countries A and B producing a commodity each, X and Y
respectively, at an absolute lower cost of production than the other. The absolute difference
in cost is illustrated in Table 1.
Table 1: Absolute Difference in Cost
Country Commodity X (in Commodity Y (in
units) units)
A 10 5
B 5 10
The table shows that country A can produce 10 units of commodity X (10X) or 5 units of
commodity Y (5Y) with one unit of labour and country B can produce 5 units of commodity
X (5X) or 10 units of commodity Y (10Y) with one unit of labour. Thus, country A has an
absolute advantage in the production of commodity X (10X > 5X) and country B has an
absolute advantage in the production of commodity Y (10Y > 5Y). Both the countries will
benefit from trade if country A specializes in the production of commodity X and country B
specializes in the production of commodity Y as shown in Table 2.

Table 2: Gains from Trade

Production Production Gains from

before after trade (2
trade (1) trade (2) – 1)
Commodity X Y X Y X Y
Country
A 10 5 20 — + -
1 5
0
B 5 1 — 20 - +
0 5 1
0
Total 15 1 20 20 + +
production 5 5 5
By applying one unit of labour on the production of each commodity, both the countries can
produce only 15 units each of the two commodities. If country A were to specialize in the
production of commodity X, its total production will be 20 units of X by using both units of
labour. Similarly, if country B were to specialize in the production of commodity Y alone, its
total production will be 20 units of commodity Y by using both units of labour. The
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combined gain from trade to both the countries will be 5 units each of commodity X and Y
respectively.

The PPC of country A is YA XA and that of country B is YBXB. PPC of country A shows that
it can produce either OXA of commodity X or OYA of commodity Y. Similarly, the PPC of
country B shows that it can produce either OXB of commodity X or OYB of commodity Y.
The diagram also reveals that country A has an absolute advantage in production of
commodity X (OXA> OXB) whereas country B has an absolute advantage in the production
of commodity Y (OYB> OYA).
Criticism
Adam Smith’s analysis of the basis of international trade is unrealistic. This is because a
number of developing and underdeveloped countries have trade relations with other countries
even though they do not possess absolute advantage in the production of any commodity.

IN-TEXT QUESTIONS
The theory was propounded by __________________.
When one country produces a commodity at a lower cost than the other country and
the other country produces some other commodity at a lower cost in comparison to the
first country, it gives rise to ______________________.

7.3.4 Theory of Comparative Advantage

According to David Ricardo, the trade relation between two countries is determined by the
comparative differences in costs and not by the absolute differences. The costs differ in
countries because of geographical division of labour and specialization in production causing
a country to produce one commodity at a lower cost than the other. In this way, each country
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specializes in the production of that commodity in which its comparative cost of production
is the least. Thus, when a country enters into trade with some other country, it will export
those commodities in which its comparative cost of production is less and will import those
commodities in which its comparative cost of production is high. According to Ricardo, this
is the basis of international trade.
Statement of the Theory
“Each country will specialize in the production of those commodities in which it has the
greatest comparative advantage or the least comparative disadvantage”.
7.3.4.1 Assumptions of the Theory
The theory of comparative advantage is based on the following assumptions:
1. There are only two countries, say India and Bangladesh producing the same two
commodities, say rice and wheat.
2. Both countries have similar tastes and preferences.
3. Labour is the only factor of production and all its units are homogeneous.
4. There is no change in supply of labour.
5. Labour cost (the number of units of labour employed to produce each commodity)
determines the prices of the two commodities.
6. Commodities are produced under the law of constant costs.
7. Technological knowledge remains the same.
8. There is barter system of trade.
9. There is full employment of factors of production in both the countries.
10. Factors of production are perfectly mobile within countries but perfectly immobile
between countries.
11. Trade is free between two countries.
12. There are no transportation costs.
13. The international market is perfect; therefore, the exchange ratio is the same for the
two commodities.
1.3.4.2 Explanation of the Theory
Given these assumptions, Ricardo shows that trade is possible between two countries when
one country has an absolute advantage in the production of both commodities, but a
comparative advantage in the production of one commodity than in the other. This is
illustrated with an example of trade between India and Bangladesh as shown in Table 3.
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Table 3: Man-years of Labour Required for Producing One Unit

Country Rice Wheat
Bangladesh 120 100
India 80 90
The table shows that the production of a unit of rice in Bangladesh needs 120 men for a year
while a unit of wheat requires 100 men for a year. On the other hand, the production of a unit
of rice in India requires 80 men for a year and 90 men for a year for the production of wheat.
Thus, Bangladesh uses more labour than India in producing both rice and wheat. In other
words, Indian labour is more efficient in producing both the commodities. Thus, India
possesses an absolute advantage in the production of both rice and wheat. But India would
benefit more by producing rice and exporting it to Bangladesh because it possesses greater
comparative advantage in it. This is because the cost of production of rice (80/120 men) is
less than the cost of producing wheat (90/100 men). On the other hand, Bangladesh should
specialize in the production of wheat in which it has least comparative disadvantage. This is
because the cost of producing wheat in Bangladesh is less (100/90 men) as compared with
rice (120/80 men). Thus, trade is beneficial for both the countries.
The comparative advantage theory can also be illustrated with the help of production
possibility curve.
IN is the production possibility curve of India and BG that of Bangladesh. India enjoys an
absolute advantage in the production of both rice and wheat over Bangladesh. It produces
ON of rice and OI of wheat as against OG of rice and OB of wheat produced by Bangladesh.

Figure 2: Comparative Difference in Cost with the help of PPC

The slope of BR (parallel to IN) shows that India has a greater comparative advantage in the
production of rice because if it gives up resources required to produce OB of wheat, it can
produce OR of rice which is greater than OG of rice produced by Bangladesh. On the other
hand, Bangladesh has the least comparative disadvantage in the production of OB amount of
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wheat. Thus, India will export OR of rice to Bangladesh in exchange for OB of wheat from
it.
1.3.4.3 Gains from Trade
Ricardo does not discuss the actual ratio at which rice and cloth would exchange and how
much the two countries gain from trade. The domestic trade ratios before trade in the two
countries for rice and wheat are shown in Table 4.
Table 4: Domestic Exchange Ratios

Bangladesh India
Rice 120 : 100 Wheat (6/5) Rice 80 : 90 Wheat (8/9)
1 : 1.2 1 : 0.89
Wheat 100 : 120 Rice (5/6) Wheat 90 : 80 Rice (9/8)
1 : 0.83 1 : 1.13

The cost of production of one unit of rice in Bangladesh is 120 men and that of producing
one unit of wheat is 100 men. It shows that the cost of producing rice is more as against
wheat because one unit of rice can be exchanged for 1.2 units of wheat. On the other hand,
the cost of producing one unit of rice in India is 80 men and that of producing one unit of
wheat is 90 men. Thus, the cost of producing wheat is more than that of rice because one unit
of rice can be exchanged for 0.89 units of wheat.
Let’s assume trade begins between the two countries. Bangladesh will gain if it imports one
unit of rice from India in exchange for less than 1.2 units of wheat. India will also gain if it
imports one unit of wheat from Bangladesh in exchange for more than 0.89 units of rice.
Table 4 also shows that the domestic exchange ratio in Bangladesh is one unit of wheat =
0.83 units of rice and in India one unit of rice = 0.89 units of wheat. Assuming the exchange
ratio between two countries to be 1 unit of wheat = 1 unit of rice, Bangladesh would gain
0.17 (1 – 0.83) units of rice by exporting one unit of wheat to India. Similarly, the gain to
India by exporting one unit of rice to Bangladesh will be 0.11 (1 – 0.89) unit of wheat. Thus,
trade is beneficial for both countries.
The gains from trade and their distribution are shown in Fig. 3 where the line P1R2 depicts
the domestic exchange ratio 1 unit of wheat = 0.83 units of rice of Bangladesh and the line
P2R1 that of India at the domestic exchange ratio 1 unit of rice = 0.89 units of wheat.

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Figure 3: Gains from Trade

The line P1R1 shows the exchange rate of trade of 1 unit of wheat = 1 unit of rice between the
two countries. At this exchange rate Bangladesh gains R2R1 (0.17 units) of rice while India
gains P2P1 (0.11 units) of wheat.
Summing up, both India and Bangladesh specialize in the production of one commodity
based on the comparative costs and accordingly reallocate their factors of production. Each
country exports that commodity in which it has comparative advantage and imports that
commodity in which it has comparative disadvantage. Both gain through trade and can
increase the consumption of the two commodities.
1.3.4.4 Criticism
The principle of comparative advantage has been the very basis of international trade for
centuries but it is not free from few defects. In particular, Bertin Ohlin and Frank D.
Graham have criticized this theory several times. Some of the important criticisms are:
1. Unrealistic Assumption of Labour Cost: It is assumed that this theory considers
only labour cost and ignores non-labour costs in calculating the cost of production.
This is highly unrealistic because the basis of national and international transactions
is money cost and not labours cost. Further, the assumption of homogeneous labour
is also unrealistic because labour is heterogeneous of different kinds, skilled and
unskilled or specialized and general.
2. No Similar Tastes: The assumption of the two countries having similar tastes and
preferences is unrealistic because preferences differ with different income standards

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in a country. Economic growth and development of trade relations also brings about
a change in the tastes and preferences of people.
3. Assumption of Constant Costs: The theory assumes that commodities are produced
under the law of constant costs which is unrealistic. Factually, there are either
increasing or diminishing costs. The comparative advantage is increased if the costs
are reduced due to large scale production whereas the comparative advantage is
reduced if an increased output is the result of an increased cost of production.
4. Transport Costs Ignored: Ricardo ignores transport costs in determining
comparative advantage in trade. This is again an unrealistic assumption as transport
costs play an important role in determining the pattern of world trade. For instance,
the gain from international trade can be reduced or nullified due to high
transportation cost.
5. Immobile Factors of Production Internationally: Another unrealistic assumption of
this theory is that factors are perfectly mobile nationally and perfectly immobile
internationally. However, within a country, factors are not freely mobile from one
industry to another or from one region to another. The greater the degree of
specialization in an industry, the less is the factor mobility from one industry to
another. Thus, factor mobility influences costs and hence the pattern of international
trade.
6. Unrealistic Two-Country, Two Commodity Model: Ricardo’s doctrine of
comparative advantage is based on trade between two countries trading two
commodities. However, in reality, international trade takes place between many
countries trading in many commodities.
7. Unrealistic Assumption of Free Trade: Another drawback of this theory is that it
assumes free trade among countries. This is not realistic. World trade is not free.
The countries impose restrictions in the form of tariff and non-tariff barriers on the
movement of goods to and from other countries.
8. Neglects the Role of Technology: Technological innovations in international trade
are ignored by this theory which is unrealistic. Much is gained from innovations,
research and development. For instance, technological changes help in increasing
the supply of goods both nationally and internationally.
9. One-Sided Theory: Since the theory considers only the supply side of international
trade and ignores the demand side, it is considered to be a one-sided theory.

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10. An Incomplete Theory: The theory is considered incomplete as it simply explains

how two countries gain from trade but fails to explain how the gains from trade are
distributed between the two countries.
Despite these weaknesses, the theory of comparative advantage is considered to be the basis
of international trade. In the words of Prof. Samuelson, “Yet for all its oversimplifications,
the theory of comparative advantage has in it a most important glimpse of truth. Political
economy has found few more principles. A nation that neglects comparative advantage may
have to pay a heavy price in terms of living standards and potential rates of growth.”

IN-TEXT QUESTIONS
8. The theory of Comparative Advantage was given by ___________
9. The difference in costs is due to ________________ and
________________.
10. The theory considers only the __________side of international trade.

7.3.5 Modern Theory of International Trade

In his famous book ‘Inter-regional and International Trade (1933)’, Bertin Ohlin criticized
the classical theory of international trade and formulated the General Equilibrium or Factor
Endowment or Factor Theory of international trade. The Hecksher Ohlin theory of
international trade is therefore the difference in prices of commodities based on relative
factor endowments and factor prices as some commodities can be bought more cheaply
from the other regions than in the same region where production is possible only at high
prices.
7.3.5.1 Assumptions of the Theory
The following assumptions hold good for the H.O. theory:
1. It is a two X two X two model i.e. two countries, say A and B, two commodities,
say X and Y, and two factors of production, say labour and capital.
2. Both commodity and factor markets are perfectly competitive markets.
3. Resources are fully employed.
4. Technology is given and constant.
5. There are quantitative differences in factor endowments in different countries, but
qualitatively they are homogeneous.

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6. Production functions of the two commodities have different factor intensities (i.e.
capital intensive and labour intensive) that are non-reversible.
7. Factors are perfectly mobile within the country and perfectly immobile between
countries.
8. There are no transportation costs.
9. There is free trade between countries.
10. Each commodity in each country is produced under the law of constant cost.
11. Tastes and preferences of consumers and their demand patterns are identical in both
the countries.
12. Neither country specializes in the production of one commodity. In other words,
there is incomplete specialization.
13. Production functions are different for different commodities, but are the same for
each commodity in both countries. It means that the production function of
commodity X is different from commodity Y but the technique of production of
commodity X and commodity Y respectively in both the countries is the same.
7.3.5.2 Explanation to the Theory
Given these assumptions, Heckscher and Ohlin contend that the immediate cause of
international trade is the difference in relative commodity prices caused by differences in
relative demand and supply of factors (factor prices) as a result of differences in factor
endowments between two countries. Fundamentally, the relative scarcity of factors (shortage
of supply in relation to demand) is essential for trade between two countries. Commodities
which use large quantities of scarce factors are imported because their prices are high while
commodities which use abundant factors are exported because their prices are low.
H.O. theory is explained in terms of two definitions:
1. Factor abundance (or scarcity) in terms of price criterion: In this criterion, richness
in factor endowments is explained by Heckscher Ohlin in terms of factor prices.
Given the two countries A and B producing two commodities X and Y by employing
labour and capital as factors of production, country A is abundant in capital if
(PC/PL)A ˂ (PC/PL)B where PC and PL refer to prices of capital and labour respectively
and the subscripts A and B denote the two countries. In other words, country A is
abundant in capital if capital is relatively cheap in it whereas country B is abundant in
labour if labour is relatively cheap in it. Thus, country A will produce and export the
capital intensive good and import labour intensive good and country B will produce
and export labour intensive good and import capital intensive good. In other words,
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the capital abundant country will export the relatively cheap capital-intensive
commodity and the labour abundant country will export the relatively cheap labour-
intensive commodity.
2. Factor abundance in physical terms: Another way to explain the H.O. theory is in
physical terms of factor abundance. According to this criterion, a country is relatively
capital abundant if it is endowed with a higher proportion of capital and labour than
the other country. If country A is relatively capital abundant and country B is
relatively labour abundant, then measured in physical amounts CA/LA> CB/LB, where
CA and LA are the total amounts of capital and labour respectively in country A and
CB and LB are the total amounts of capital and labour respectively in country B.
Both the countries specialize and gain from trade for two reasons: first, their factor price rates
are equal and second, tastes and preferences for the two commodities are similar in both
countries.
But the above analysis of physical terms does not show that the capital abundant country will
export the capital intensive commodity and the labour abundant country will export the
labour intensive commodity.
7.3.5.3 Criticism
H.O. Theory has been criticized on the following grounds:
1. Two-by two-by-two Model: Ohlin has been criticized for presenting two-by-two-by-
two model based on oversimplified assumptions. But, he has demonstrated in the
mathematical appendix to his book that the model can be extended to many
countries, many commodities and many factors.
2. Non-homogeneous Factors: The theory assumes that the factors of production in
the two countries are homogeneous and factor endowment ratios can be calculated
by measuring them. In reality, however, no two factors are homogeneous
qualitatively between as well as within the country.
3. Non-homogeneous Production Techniques: The H.O. model assumes
homogeneous production techniques for each commodity in the two countries. But,
the technique of production is different in the two countries for the same
commodity.
4. Distinct Tastes and Demand Patterns: The assumption of similar tastes and demand
patterns of consumption in both countries is unrealistic. Innovations, diversifications

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and accessibility of products bring about a change in the tastes and demand patterns
of consumers.
5. No Constant Returns: It is unrealistic to assume constant returns to scale as the
advantages of economies of scale are obtained by a country having rich factor
endowments through lesser production and exports. Thus, there are increasing
returns to scale rather than constant returns.
6. Transport Cost Ignored: The theory ignores transport costs in trade between two
countries. But, in reality, when transport costs, loading and unloading charges and
other port charges that affect the price of produced commodities in the two countries
are included, they lead to price differentials for the same commodity in the two
countries.
7. Unrealistic Assumption of Full Employment and Perfect Competition: The theory
assumes full employment and perfect competition to exist in both the countries
which is not true. Factually, due to the existence of differentiated products, perfect
competition does not exist and each country strives to achieve full employment.
8. Leontief Paradox has made the Theory Questionable: Leontief’s empirical study
of Ohlin’s theorem, known as Leontief Paradox, has led to paradoxical results that
the United States exports labour-intensive goods and imports capital-intensive
goods, even though it is a capital- rich country.
9. Partial Equilibrium Analysis: Prof. Haberler regards Ohlin’s theory as, by and
large, a partial equilibrium analysis. He criticized him for his failure to develop a
comprehensive general equilibrium concept.
10. Vague and Conditional Theory: As pointed out by Haberler, “With many factors of
production, some of which are qualitatively incommensurable as between different
countries, and with dissimilar production functions in different countries, no
sweeping a priori generalization concerning the composition of trade are possible”.
Despite these criticisms, Ohlin’s theory is definitely an improvement over the classical
theory of trade as it attempts to address the basis of international trade in the general
equilibrium setting.

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7.3.5.4 Superiority of H-O Theory over Classical Theory

Heckscher- Ohlin Theory Classical Theory

The merit of H.O. theory lies in According to Samuelson, the Ricardian
explaining the causes of differences in theory could not explain the causes of
comparative advantage satisfactorily. differences in comparative advantage.
H.O. theory is scientific and focuses on The classical theory demonstrates the
the basis of international trade. It thus gains from trade between the two
relates to the positive theory. countries. Thus, it is related to the
welfare theory.
1 The classical theory regards different
According to Haberler , the H.O. theory
countries as space less markets.
is a location theory which highlights the
importance of the space factor in
international trade.
The H.O. theorem is explicitly based on The classical theory is based on
the assumption of production functions differences in the production of the
of the two countries. trading countries.
The H.O. model leads to complete The trade between two countries may or
specialization in the production of one may not lead to specialization in the
commodity by one country and that of classical theory.
the other commodity by the second
country when they enter into trade with
each other.
In the H.O. theory, trade will not cease In the classical theory, differences in
in future even if the labour becomes comparative costs between two countries
equally efficient in the two countries are due to differences in efficiency of
because the basis of trade is differences labour. Overtime, if labour in both
in factor endowments and factor prices. countries becomes equally efficient in
both countries, there’ll be no trade
between them.

7.3.5.5 The Leontief Paradox

The first comprehensive attempt to verify the Heckscher-Ohlin model was made by Wassily
Leontief in1953. The Heckscher-Ohlin theory states that relatively capital-abundant country
will export relatively capital-intensive goods and it will import relatively labour-intensive
goods i.e. the goods in whose production relatively large amounts of relatively scarce factor
labour are required. Leontief in his study reached the paradoxical conclusion that the United
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States which possesses a relatively large amount of capital and a relatively small amount of
labour in relation to the rest of the world, exported labour- intensive goods and imported
capital-intensive goods. This result has come to be known as Leontief Paradox.
To test the Heckscher-Ohlin prediction, Leontief used the 1947 input-output table of the US
economy. He aggregated 200 groups of industries into 50 sectors of which 38 traded their
products directly on the international market. He took two factors, labour and capital and
estimated their requirements for production of one million dollars worth of United States
export and import competing commodities.
His results showed that in the US import-competing industries were relatively more capital-
intensive than the export industries. Given the proposition that the US is relatively capital
abundant, it exports labour-intensive goods. This is just contrary to the Heckscher-Ohlin
theorem. Thus, it is called the Leontief Paradox.
7.3.5.5.1 Criticism
Leontief has been criticized by a majority of economists on methodological and statistical
grounds. Some points of criticism are as follows:
1. 1947, an unconventional year: Swerling did not consider 1947 as a conventional
year for testing the Heckscher-Ohlin theorem because by that year the
disorganization of production had not been corrected. Moreover, the United States
was the only major industrial economy that was saved from the destruction of the
war. Thus, Leontief study was basically a description of US trade in 1947.
2. Low Capital-Labour Ratio Industries: Swerling criticized Leontief for including
certain industries with low capital-labour ratios like fisheries, agriculture and
services like transport, wholesale trade etc. that biased his results. In response to this
criticism, Leontief reworked his study by taking a much wider range of studies but
the results obtained were similar to the original study.
3. Consumption Patterns: The impact of consumption patterns on the US exports and
imports is not considered by Leontief Paradox. The consumption pattern may be
biased either towards labour-intensive or capital-intensive commodities with an
increase in the per capita income. Brown’s study showed that the US consumption
patterns had bias towards labour-intensive commodities rather than capital-intensive
commodities. This contradicts the Leontief Paradox.

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4. Capital Durability: Buchanan criticized Leontief for using “investment-

requirements coefficients” as capital coefficients in his study. Therefore, he failed to
take into account the difference in the durability of capital in various industries.
5. Tariffs Not Considered: Travis argued that the pattern of trade was often distorted
by tariffs and thus reflected relative factor endowments of a country. In his study,
Leontief ignored the impact of US and foreign tariffs which would have otherwise
affected his results.
6. Natural Resources Overlooked: Buchanan criticized Leontief for neglecting the
role of natural resources which were very important in determining trade patterns.
7. Human Capital Ignored: Leontief, in his study, only considered physical capital
and ignored the value of human capital. Kenen found in his study that Leontief
Paradox was reversed when human capital was added to Leontief’s physical capital.
8. Unbalanced Trade: When the trade is unbalanced, Leontief Paradox fails as per
Lerner. He found no evidence of exports being labour-intensive when he examined
US trade in 1947. He only concluded that US had a trade surplus.
9. Factor Intensity Reversals: Leontief’s results led to the presence of factor intensity
reversals whereby a capital abundant country will export its labour-intensive goods.
Leontief has been criticized for taking only one country (the US) in his study. If he
had taken a second capital- abundant country, the results would have been different.
Despite the criticisms leveled against his study, Leontief retested his results by using the
average composition of US exports and imports in 1951. He increased the group of
industries into 192 sectors. However, the results again confirmed the Leontief Paradox
though the capital intensity over US exports reduced considerably. So, the Leontief Paradox
continues to persist in the US.

IN-TEXT QUESTIONS
The General Equilibrium was formulated by ________________and ____________.
The H-O Theory was verified empirically by ______________ and the results attained
are popularly known as __________________.
The theory is explained on the basis of _________ and _____________ criterion.

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7.3.6 Imitation gap Theory

Michael V. Posner in an article in 1961 analyzed the effect of technology on trade. The merit
of the theory is that it paves the way for the development of the product cycle theory. The
comparative cost theory developed by Ricardo and the factor endowment theory as given by
Heckscher-Ohlin are based on the assumption of constant technology in all trading countries.
The imitation gap or technological gap theory relaxes this assumption. It assumes that the
same technology is not always available in all countries and there is a delay in the
transmission or diffusion of technology from one country to another.
The theory simply states that technological innovation and the introduction of a new product
leads to the imitation gap and the demand gap in the other country. The extent to which trade
will take place between the two countries depends on the net effect of the imitation gap and
the demand gap.
Consider countries X and Y. Suppose that a new product appears in country X due to the
successful efforts of research and research team. The innovating firm and nation get a
monopoly through patents and copyrights which turn other nations into importers of this
product as long as the monopoly status remains.
The theory implicitly assumes that this new product will not be produced immediately by
firms in country Y. Incorporating a time dimension. the imitation lag is defined as the length
of the time (e.g., 24 months) that elapses between the product introduction in country X and
the appearance of the version produced by firms in country Y. The imitation lag includes a
learning period during which the firms in country Y must acquire technology and knowhow
in order to produce the product.
In addition, it takes time to purchase inputs, install equipment, process the inputs, bring the
finished product to market and so on. In this theory, a second adjustment is the demand lag,
which is the length of time between the products appearance in country X and its acceptance
by consumers in country Y as a good substitute for the products they are currently
consuming. This lag may arise from loyalty to the existing brand, inertia and delays in
information flows. This demand lag can also be expressed in a number of months, say 6
moths.
A key point in this theory is the comparison of the length of the imitation lag with the length
of the demand lag. For instance, if the imitation lag is 20 months, the net lag is 14 months.,
that is 20 months less 6 months (demand lag). During this 14-month period, country X will
export the product to country Y.

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The central point in imitation gap analysis is that once the foreign firms acquire this
technology, they may become more competitive than the innovator. because of certain
favourable factors (e.g., cheap labour). When it happens, the innovating country may turn
into an importer of the very product it has introduced.
Firms in the developed countries, however, strive to stay ahead through frequent innovations
which make the earlier products obsolete. Posner's imitation gap analysis is portrayed in
Figure.

Figure 4: Imitation Gap

Posner's theory is explained in Figure 4 where time is plotted on the horizontal axis and
the trade balance of the innovating country A against the imitating country B is taken on
the vertical axis. Up to point t1, there is no trade between the two countries, in say good
X. At t1, A innovates the new product. The demand lag in B will determine the amount of
exports of A and thus the slope of t1B. The imitation lag will determine how long country
B will import the commodity from A and the extent of A's exports. If there is no imitation
of the commodity in B, country A will continue to export it till exports reach the
maximum level B at time t3. The period from t1 to t3is the demand lag. If producers in B
start producing the new product by time t3, the exports of A will decline and may even
stop at time t4 as shown by the downward arrow from B to t4. In this situation, the
imitation lag t3t4 is shorter than the demand lag. If the imitation lag is longer and
producers in B are unable to adopt the innovation of the new commodity till time t5,
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country A will continue to export it to its maximum level B1. As B starts producing this
commodity, the imitation lag becomes shorter and exports from A continue to decline
until they fully stop at time t6 when the commodity is fully imitated in country B. If
producers in B introduce an innovation in the commodity so that it is better than A's
commodity, B will penetrate A's market. In this case, A will start importing it from B, as
shown by the downward arrow from t6 to A.
7.3.7 Product Life Cycle Theory
In a 1966 article, Raymond Vernon sought to explain international trade based on the
evolutionary process that occurs in the development and diffusion of products to markets
around the world. In his International Product Life Cycle (IPLC) Theory, Vernon points
out that each product and its manufacturing technologies go through a continuum or cycle
of evolution that consists of introduction, growth, maturity and decline. The location of
production will shift to serve markets according to the stage of cycle a product is therein.
Introduction: Historically, a new product originated in an advanced economy, such as
the US or Germany, in the Introductory stage. This is because such countries have
abundant capital and research and development facilities that prove advantageous to
produce new products or to produce old products in new ways. Advanced economies also
have abundant, affluent (high income) consumers who are willing to try new products,
which are often expensive. During the introduction stage, production of the new product
takes place in the inventing country so that the producer can obtain rapid market feedback
and save upon the transportation cost, since most sales are domestic. Any export sales are
mainly to advanced countries having high income consumers and who are willing to
spend on novelties. Since, production process is not standardized in this stage, it remains
labour-intensive.
Growth: Overtime, the market grows and enters the growth phase. The sales growth
attracts competitors to the market, particularly in other developed countries, who
establish a manufacturing unit in their own country and develop unique product
variations for the consumers of their country. However, the cost of production may still
be high because of start-up problems.
Growth in sales provides an incentive to companies to develop labour-saving technology
but this incentive is partly offset because competitors produce differentiated products to
suit the needs of their country. Thus, the production process still remains labour-intensive
though less than the introductory stage. In other words, the capital intensity is relatively
more than the introductory stage. The original producing country will increase its exports,
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especially to developing countries, but will lose certain key export markets in which local
production is initiated.
Maturity: As the product enters the maturity stage, the production process gets more
standardized and price becomes an important competitive strategy. The demand in
developing countries increases on account of reduced per-unit cost of production due to
capital-intensive production. The innovating country no longer commands a production
advantage. Since the innovator may earn only a narrow profit margin, the innovating
country shifts its production base to developing countries where they can employ less
skilled labour efficiently at a lower cost for capital-intensive production. Foreign
production thus, displaces the exports from the innovating country.
Decline: Once the production process is standardized, mass production becomes the
dominant activity and can be accomplished using cheaper inputs and low-cost labour.
Production shifts to low- income countries where competitors enjoy low-cost advantages
and can economically serve export markets worldwide. The innovator country eventually
becomes a net importer.

Figure 5: PLC model of international trade – innovating country

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Figure 6: PLC model of international trade – imitating country

Source: Shenkar and Luo for both
1.3.7.1 Criticism
• The PLC theory holds that the location of production facilities that serve world markets
shifts as products move through their life cycle. Many industrial products like steel, coal
etc. or basic foodstuff like salt, sugar etc. fall outside the purview of life-cycle.
• The movement of the product from one stage to another is not certain.
• The present stage in which the product is cannot be known with certainty.
• Certain products have extremely short life cycle because of rapid innovation. Shifting
production of such products from one country to another doesn’t reduce their cost.
Hence, there’s no benefit of shifting.
• The new products are introduced simultaneously in all parts of the world due to
shortened life- cycle, integration of the world economy and globalization. Thus, no
leads and lags exist between markets.
• Luxury products for which cost is of little concern to the consumers aren’t covered by
the PLC theory.
• The production location of products requiring technical expertise to move into their
next generation of models usually does not shift. This seems to explain the US
dominance of medical equipment production and German dominance in rotary printing
presses.

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• It’s difficult to predict in advance the life of the product.

• The companies today develop products for worldwide market segments and so
introduce the new products at home and abroad simultaneously. In so doing, they
choose an initial production location (that may or may not be in the innovating country)
that will minimize costs for serving markets worldwide.
The theory was empirically satisfactory during 1950s to 1970s but the recommendations of
the theory are either unclear or not fit in today’s world. In context of shifting to low-cost
countries, i.e. the comparative advantage, one of the economists comments, “In essence, it is
the Ricardian story once again.”

IN-TEXT QUESTIONS
The cycle of evolution consists of ___________, _________, ____________, and
___________ stages.
As per the PLC theory, the innovator country eventually becomes a net____________.

7.3.8 Theory of National Competitive Advantage

Schumpeter emphasized many decades ago, “Competition is profoundly dynamic in
character. The nature of economic competition is not equilibrium but a perpetual state of
change. Improvement and innovation in an industry are never-ending processes. Today’s
advantages are soon superseded or nullified”. Michael Porter, in his book, “Competitive
Advantage of Nations (1990)” explained why a nation provides an environment in which
firms improve and innovate and continue to do so faster and in the proper directions
compared to their international rivals and why some nations’ firms achieve technological
superiority, produce more differentiated or higher quality products or products which are
more attuned to customer needs than others.
Why does a nation achieve international success in a particular industry? The answer lies in
four broad attributes of a nation that shape the environment in which local firms compete that
promote or impede the creation of competitive advantage. These determinants are: (1) Factor
Conditions; (2) Demand Conditions; (3) Related and Supporting Industries; and (4) Firm’s
Strategy, Structure and Rivalry. The Porter’s model also points out two additional
determinants that influence the four main determinants. These are governmental policy and
the role of chance events.

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1. Factor Conditions: The factors most important to competitive advantage in industries

in advanced economies are not inherited but are created within a nation. To understand
the role of factors in competitive advantage, it is necessary to distinguish between
types of factors. The first demarcation is between advanced and basic factors.
Advanced factors of production are skilled labour, knowledge, capital and
infrastructure. Basic factors such as unskilled labour and raw material can be obtained
by any company and do not generate competitive advantage. The second distinction is
between specialized and generalized factors. Specialized factors involve narrowly
skilled personnel, infrastructure with specific properties, knowledge bases in particular
fields and other factors with relevance to a limited range or even to just a single
industry; for e.g. a port specialized in handling bulk chemicals or a pool of venture
capital seeking to fund software companies etc.
2. Demand Conditions: The second broad determinant of national competitive
advantage is demand conditions. The main factor is home demand conditions which
have influence in nearly every industry. The composition of home demand shapes how
firms perceive, interpret and respond to buyer needs. Nations gain competitive
advantage in industries where the home demand gives local firms a clearer or earlier
picture of buyer needs than foreign rivals. It is not merely the size of the market that is
important but it is the intensity and sophistication of the demand that is significant for
competitive advantage. If consumers are sophisticated, they will make demands for
sophisticated products and that in turn will help the production of sophisticated
products. Gradually, the country will achieve competitive advantage in such
production. As significant as early home market penetration so is early or abrupt
saturation. Early saturation forces companies to continue innovating and upgrading as
well as finding international markets for their products. In consumer electronic
products, saturation in the Japanese home market is rapid and product life cycles are
extremely short. This is because buyers have homogeneous tastes combined with
sophistication and status consciousness. This combination gives them competitive
advantage in comparison with foreign rivals.
3. Related and Supporting Industries: The third broad determinant is related and
supporting industries. The presence of internationally competitive supplier industries
in a nation creates advantages in subsequent industries. It gives efficient, early, rapid
and sometimes preferential access to the most cost-effective inputs. The benefit of
home-based suppliers may be found in the process of innovation and upgrading. Firms
gain quick access to information, to new ideas and insights and to supplier
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innovations. The presence in a nation of competitive industries, that are related, often
leads to new competitive industries. Related industries are those in which firms can
co-ordinate or share activities in the value chain when competing. An example is
pharmaceutical firms who use the same university when testing new drugs.
4. Firm Strategy, Structure and Rivalry: The fourth and last broad determinant is firm
strategy, structure and rivalry. Many aspects of a nation, too numerous to generalize,
influence the ways in which firms are organized and managed. Some of the most
important aspects are attitudes towards authority norms of interpersonal interaction,
attitudes of workers towards management and vice-versa, social norms of
individualistic or group behavior and professional standards. These in turn grow out of
the educational system, social and religious history, family structures and many other
unique national conditions. Sharp differences exist within and among nations in the
goals that the firms seek to achieve as well as the motivations of the employees and
managers. Domestic rivalry creates particularly visible pressure on each other to
improve vigorous local competition. It not only sharpens advantages at home but
pressures domestic firms to sell abroad in order to grow.
These four main determinants are influenced by the governmental policy through various
regulatory and de-regulatory measures. Policies implemented without consideration of how
they influence the entire system of determinants are as likely to undermine national
advantage as enhance them.
Government affects factor conditions in many ways. Among the most important roles of
government is creating and upgrading factors. The government procurement can be a positive
force for upgrading national competitive advantage if they provide early demand for
advanced new sophisticated products or services from local firms. The government must
support the related and supporting industries in the same way as the industries that have the
advantage. Government has an important role in the nurturing and reinforcing clusters.
Government’s policy has numerous ways of influencing how firms are created, organized,
how they manage their goals and how they compete. Sustaining and enhancing competitive
advantage requires that nation’s firms take a global approach to strategy. Government policy
should seek to avoid currency restrictions, restrictions on foreign investments and restrictions
on the inflow and outflow of skilled personnel that impede internationalization.
Few roles of the government are more important to the upgrading of an economy than
ensuring vigorous domestic rivalry and this requires strong antitrust policies because a
dominant domestic competitor rarely results in international competitive advantage.
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The last determinant that influences the four main determinants is chance events. Chance
events are developments outside the control of firms (and usually the nation’s government)
such as pure inventions, breakthroughs in basic technologies, wars, external political
developments and major shifts in foreign demand. They create discontinuities that can
unfreeze or reshape industry structure and provide opportunity for one nation’s firms to
supplant another’s. Chance has played an important role in shifting competitive advantage in
many industries. A shift that changed competitive advantage was the oil shock in the 1970s.
The oil shock ultimately helped upgrade Japanese industry. Because Japan was especially
vulnerable to energy costs and therefore, took aggressive steps towards energy conservation.
In a nutshell, the Porter’s Diamond must be seen as a system wherein the effect of one
determinant often depends on the state of other determinants.
7.3.8.1 Criticism
The Theory of Competitive Advantage suffers from the following criticisms/limitations-
1. Porter feels that sizeable domestic demand must be present for attaining competitive
advantage but there are industries that have flourished only because of demand from
foreign consumers. For eg. Nestle; a major share of its earnings comes from foreign
sales.
2. Where domestic suppliers of inputs are not available, the backward linkage will be
meaningless as the determinant related and supporting industries doesn’t exist in that
nation.
3. Availability of national resources, according to Porter, is not the only condition for
attaining competitive advantage. There must be other factors also. But, a study has
shown that some Canadian industries emerged on the global map only on the basis of
such natural resource availability.
Nevertheless, these limitations do not undermine the significance of Porter’s national
competitive advantage theory, especially in advanced industries located in advanced
countries.

IN-TEXT QUESTIONS
16. All determinants of the theory are influenced by ___________ and
_________________.
17. The four broad attributes of a nation that shape the environment are ___________,
________, __________, and __________.

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7.4 BALANCE OF PAYMENT

In the words of Kindleberger, “The balance of payments of a country is a systematic record

of all economic transactions between the residents of the reporting country and the
residents of foreign countries during a given period of time.”In other words, it is a statement
of account recording all international receipts and payments of a country with the rest of the
world. Thus, the balance of payments of a country serves as an important index that reflects
the true economic position of a country.
The economic transactions of a country with the rest of the world can be broadly classified
as:
1. Visible items which include the export and import of all types of physical goods
(made of matter/material) which are recorded at the ports (i.e. can be seen crossing
the borders).
2. Invisible items which include the export and import of all types of services, like
those rendered by shipping, banking and insurance companies, payment ports of
interest etc., which are not recorded at the (i.e. cannot be seen crossing the borders)
3. Capital transfers that involve the transfer of assets. Such transfers are concerned
with capital receipts and payments of a country with the other countries.
Thus, “the balance of payments shows the country’s trading position, changes in its net
position as foreign lender or borrower, and changes in its official reserve holding.”
7.4.1 Balance of Trade
The balance of trade (positive or negative) is the difference between the value of exports and
imports of goods i.e. visible items only. Thus,
Balance of Trade = Export of visible items – Import of visible items
During a given period of time, the balance of trade is said to be balanced if the difference
between the value of exports and the value of imports of visible items is zero. In other words,
the country is said to have a balance of trade if the value of exports is exactly equal to the
value of imports. But, it is not necessary that the country will always have a balanced balance
of trade. If the value of exports exceeds the value of imports during a given time period, the
country is said to have an export surplus or a favourable balance of trade. On the other hand,
if the value of imports exceeds the value of exports, the country is said to have an import
surplus (export deficit) or unfavourable (adverse) balance of trade.
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1.4.2 Balance of Trade and Balance of Payments

The terms balance of trade and balance of payments, though related to each other, do not
have the same meaning. Table 1, summarizes the difference between the balance of trade
(BOT) and the balance of payments (BOP).
Table 1: Difference between the Balance of Trade and Balance of Payments
Balance of Trade (BOT) Balance of Payments (BOP)
1. Balance of Trade is defined as the Balance of payment is defined as ‘a
difference between the exports and systematic record of all economic
imports of goods (visible items.) transactions between the residents of the
reporting country and the residents of
foreign countries during a given period
of time.’
2. BOT = Net Earnings on Exports – Net BOP = Current Account Balance +
payments made for imports. Capital Account Balance + Errors &
Omissions (- Balancing item)
3. BOT is favourable if exports exceed BOP will be favourable if the country is
the imports of goods and unfavourable able to pay off all past loans in her
if imports exceed the exports of capital account from the surplus in the
goods. current account. However, BOP is said
to be unfavourable if the country
borrows from the foreigners to offset its
current deficit.
4. The main factors that affect BOT are: The main factors that affect BOP are:
(i) Cost of production (i) All factors affecting BOT
(ii) Availability of raw materials (ii) Economic policy of the
(iii) Exchange rate government
(iv) Domestic price of goods (iii) Conditions of foreign lenders.
5 In the accounting sense, BOT may be In the accounting sense, BOP always
favourable, unfavourable or in balances i.e. receipts are always equal to
equilibrium. payments.
6. It is not an indicator of the economic It gives a true picture of the economy’s
performance of a country. economic performance.
7. BOT is a narrow concept BOP is a more comprehensive term.

8. BOT is a part of the current account of BOP comprises of three accounts of

the BOP which BOT is only one part of the
current account.

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7.4.3 Components of Balance of Payment

Broadly, the balance of payment (BOP) account includes: (i) current account (ii) capital
account and (iii) official settlements account as shown in Table 2.
Table 2: Components of Balance of payments (BOP) Account

Credits (+) (Receipts) Debits (–) (Payments)

I. Current Account
1. Export of goods 5. Import of goods
2. Export of services 6. Import of services
3. Income received (Interest, 7. Income paid (Interest, profit and dividends
profit and dividends paid)
received) 8. Unilateral
4. Unilateral receipts payments (Transfer
(Transfer payments received) payments made)
II. Capital Account
9. Foreign investment 12. Investment abroad
10. Short term borrowings 13. Short-term lending
11. Medium and long term 14. Medium and long-term lending
borrowing
III. Official Settlement Account
15. Increase in foreign official 16. Increase in official reserve of gold and
holdings foreign currencies.
IV. Errors and Omissions
7.4.3.1 Current Account
The current account of the balance of payments includes all transactions relating to trade
(imports and exports) in goods, services, income and current transfer and thus constitutes an
important segment of balance of payments.
Components of Current Account
In the current account, the merchandise exports and imports are the most important items. For
the purpose of compilation of balance of payments, exports are valued on the basis of ‘free on
board’ (f.o.b.)whereas imports are valued on the basis of ‘cost, insurance and freight’ (c.i.f.).
The difference between the exports and imports of a country is its balance of visible trade or
merchandise trade or simply balance of trade. If visible exports exceed the visible imports,
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the balance of trade is favourable whereas it is unfavourable if the visible imports exceed the
visible exports.
It is, however, the invisible items of the current account, namely services, income and
transfer payments, that reflect the true position of the balance of payments account. While
service transactions include costs of travel, transportation, insurance, communications,
royalties, financial and computer services, and other business services that are becoming
increasingly important, income and transfers include receipts and payments of interests and
dividends on investments and gifts, donations, grants etc, respectively.
The net value of these visible and invisible trade balances is the balance of the current
account that may be favourable or unfavourable.
Current Account Deficit/Surplus
A nation's current account balance may be either a deficit or a surplus, depending on
whether its total receipts from other countries are less than or greater than its total payments
to other countries. A current account deficit occurs when a country sends more money
abroad than it receives from abroad. If the nation receives more money from abroad than it
sends, it has a current account surplus.
7.4.3.2 Capital Account
The capital account of the balance of payments shows an international flow of loans and
investments between residents of a country and the rest of the world. In other words, the
capital account represents a change in the asset and liability status of the residents of a
country or its government. In short, capital account transactions record long term as well as
short term capital receipts and payments.
Components of Capital Account
The main components of capital account as classified by the Reserve Bank of India are as
follows:
1. Loans/Borrowings
(i) Commercial Borrowings: Commercial borrowings include borrowings by the
government and the private sector from the world money market at the market rate of
interest without considerations of any concession.
(ii) External Assistance: External assistance includes borrowings by the country from the
foreign countries under concessional rate of interest. Thus, borrowings as external
assistance involve a lower rate of interest as compared to the interest rate prevailing
in the open market.
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2. Foreign Investment
(i) Foreign Direct Investment (FDI):Foreign Direct Investment refers to the purchase of
assets in the world market by acquiring control over them. For e.g., purchase of a
firm or setting up a plant by RELIANCE INDUSTRIES in the rest of the world.
(ii) Portfolio Investment: when the residents (industry/firm) of a country purchase shares
in the foreign companies or bonds issued by foreign government over which they
have no control is referred to as portfolio investment. For e.g., the Reliance
Industries buys shares in foreign companies.
3. Banking Capital

Banking capital refers to the capital transactions in the form of foreign exchange
transactions and investment in foreign currency and securities by the foreign branches of
Indian commercial banks. It also includes deposits made by non-residents and changes in
gold and foreign exchange reserves with the RBI.
4. Other Capital

All movement of capital not included above are recorded under this head.
Thus, capital account in the balance of payments shows international lending and borrowing
of long-term as well as short term capital.
7.4.3.3 Official Settlement Account
The official settlement account is in fact a part of the capital account. The official settlement
account measures the change in nation’s liquid and non-liquid liabilities to foreign official
holders and the change in a nation’s official reserve assets during the year.
The official reserve assets of a country include its gold stock, holdings of its convertible
foreign currencies and SDR’s and its net position in the IMF.
7.4.3.4 Errors and Omissions
Imperfect compilation procedures and different data sources may lead to imbalances in the
balance of payment account. This imbalance is termed as ‘net error and omissions’ and is
explicitly identified in the BOP statement. In simple terms, net errors and omissions is the
difference between the current balance and the capital balance.
7.4.5 Difference between Current and Capital Account
The following differences between the current account and the capital account of the balance
of payments account have been enumerated below:

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Current Capital Account

Account
1. Payment for currently produced goods and Payment of debts and claims is recorded
services is recorded in the current account. in the capital account.
Interest earned or paid on claims, gifts and
donations are also included.
2. The level of national income is directly affected The capital account influences the
by the current account of the balance of payment. volume of assets held by the country. It,
In other words, receipts and payments in the however, does not affect the level of
current account cause a respective increase and national income directly.
decrease in the flow of income in the economy.

7.4.6 Autonomous and Accomodating Items of Balance of Payments (BOP)

In the words of Sodersten and Reeds, “transactions are said to be autonomous if their value
is determined independently of the balance of payments.” Thus, all those items of BOP
accounts are termed as autonomous items or ‘above the line’ items that are :
(a) related to such transactions that are undertaken for profit motive

(b) independent of BOP considerations-positive/negative or favorable/unfavorable, and

(c) not meant to establish BOP identity.

Since all transactions in the current account and capital account are autonomous items,
their balance determines the deficit or surplus of balance of payments. If the autonomous
payments exceed the autonomous receipts, the balance of payment is said to be in deficit and
vice-versa.
Accomodating items, also known as compensatory items are short-term capital flows,
such as drawings from SDR, borrowings from IMF or central banks of other countries etc.,
which have to be made to correct the disequilibrium in the autonomous items of balance of
payment. According to Sodersten and Reed, “Accomodating items are determined by the net
consequences of the autonomous items.” Thus accommodating items often referred to as
‘below the line of items’, are meant to bring about equality between the payment and
receipts of foreign exchange by compensating the surplus or deficit in the autonomous
items. In the accounting sense, therefore, the balance of payments always balances i.e. it is
always in equilibrium theoretically. Table 3 summarizes the relationship between the
autonomous and accommodating items.

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Table 3: Relationship between Autonomous and Accomodating Items.

Trade balance a
Transfer payment balance b Autonomous items
Current account balance c = (a + b)
Long-term capital balance d
Basic balance e = (c + d) Accomodating items
Short term private non-liquid capital balance f
Allocation of SDR’s g
Errors and omissions h
Net liquid Balance i = (e+f+g+h)
Short term private liquid capital balance J
Official Settlements Balance k = (i + j)
Sodersten and Reed thus point out that “essentially the distinction between autonomous and
accommodating items lies in the motives underlying a transaction, which are almost
impossible to determine”.
7.4.7 Equilibrium and Disequilibrium in the Balance of Payment
Factually, when we speak about the equilibrium and disequilibrium in the balance of
payment, we refer to only the basic balance i.e. we only consider the autonomous items and
exclude the accomodating items. If there is neither a deficit nor a surplus in the overall
balance of payment, when accomodating items are excluded, the balance of payment of a
country is said to be in equilibrium. On the contrary, the balance of payment is said to be in
disequilibrium if there is either a deficit or surplus.
Disequilibrium in the balance of payments is undesirable and harmful for the country
concerned. However, a deficit balance of payment creates more difficulties for the economy
than the surplus balance of payment as the burden of bringing about adjustments in it falls
more heavily on the countries having a deficit.
7.4.8 Measures to Control Disequilibrium in Balance of Payment
The disequilibrium in the balance of payments can be corrected (controlled) by adopting the
measures as discussed below.
7.4.8.1 Automatic Measures
The equilibrium in the balance of payments of an economy can be restored automatically
after some time period. For e.g., under the gold standard, the disequilibrium in the balance of
payments of the concerned country was automatically corrected through the outflow and
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inflow of gold. Similarly, under the paper standard, the disequilibrium in the balance of
payment is automatically corrected through the fluctuations in the exchange rate. For e.g., in
a situation of an adverse balance of payment, the demand for foreign exchange becomes
more than its supply. As a result, the exchange value of the currency goes down.
Consequently, the exports are encouraged and the imports are discouraged. The opposite
happens in a favorable balance of payments situation.
However, the automatic measures were not very effective in the short run as well as in
dealing with a serious disequilibrium in the balance of payments. Thus, deliberate measures
had to be undertaken by the concerned country in order to bring about an improvement in its
balance of payments.
7.4.8.2 Deliberate Measures
In order to improve the disequilibrium in the balance of payment situation, the concerned
country has to resort to certain deliberate measures that can be classified as follows—
1. Trade Measures
The trade policy measures refer to the measures adopted by the economy to promote exports
and reduce imports in order to improve the balance of payments.
(a) Export Promotion – Exports can be pushed up by the government by:

(i) Reducing or completely abolishing the export duties. The goods become
cheaper in foreign countries thereby encouraging exports.
(ii) Giving subsidies and cash assistance to the exporters. This helps in cutting
down their production costs on one hand and improving their competitive
position in the international market on the other.
(iii) Providing incentives to the exporters in the form of tax exemption on
exportable goods.
(b) Import Control – The deficit in the balance of payment can be kept in check by
reducing imports. The imports can be cut down by:
(i) Imposing new import duties or tariffs and increasing the existing import duties.
The price of the imported goods rises. They become more expensive in the
domestic economy and as a consequence the demand for imported goods will
decline. This helps in reversing the deficit in the balance of payment.

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(ii) Adopting the import quota system. The volume of imports are restricted by
quotas by applying quantitative restrictions i.e. the imports of the country
cannot exceed the quota fixed by the government. If, however, the importers
import more than the fixed quota, they have to pay a penal rate of import duty.
(iii) Prohibiting the imports of certain commodities, which are considered non-
essential from the national perspective.
2. Monetary Measures
The disequilibrium in the balance of payments is dealt with by the government by adopting
the following monetary measures that are used individually or jointly:
(i) Money Contraction – Currency contraction leads to an automatic fall in the prices
of goods and services. As a result, imports are discouraged and exports are
encouraged. Consequently, the disequilibrium in the balance of payments is
reduced. However, certain economists do not favour currency contraction as a
method to improve balance of payments. This is because a fall in prices of goods
and services may cause the producers to incur heavy financial losses due to which
they may be compelled to close down their business. Thus, utmost care must be
taken while using this method to remove the disequilibrium in the balance of
payment.
(ii) Devaluation – When the value of domestic currency in terms of foreign currency is
deliberately reduced by the government in order to improve its balance of payments,
it is referred to as devaluation. It means that the exports are encouraged because
foreigners pay less for the devalued currency and imports are discouraged because
the residents of the country whose currency has been devalued pay more for foreign
currencies. Let’s explain this with an example. Suppose, a commodity is worth $5 in
the U.S.A. If the exchange rate is $1 = `60, the price of the commodity in terms of
Indian currency (`) is `300 (5 × 60 = 300). Now, if the Indian government devalues
its currency such that the exchange rate increase from $1 = `60 to $1= `70, the price
of the same commodity in terms of Indian currency will be `350 (5 × 70 = 350).
Thus while the domestic price of imported goods increases; the exports get an
additional `10 (`70 instead of `60) in domestic currency for every dollar earned by
them. Therefore, they can afford to reduce the price of their exports in order to
increase their sales.
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(iii) Exchange Controls – Exchange controls is yet another method to bring about
equilibrium in the balance of payments. Under this method, the exporters are
required to surrender their foreign exchange earnings to the central bank in
exchange for domestic currency. The foreign exchange so surrendered to the central
bank is then rationed out among licensed importers. Thus, imports are kept within
limit. Similarly, all importers buy foreign exchange from the central bank to make
payments for imports. In such a case, the central bank may provide foreign
exchange for the imports of only essential goods. Thus, the volume of imports is
restricted by utilizing the exchange control system.
3. Miscellaneous Measures
Apart from the monetary and trade measures as discussed above, the following other
measures are undertaken to improve the balance of payments.
• Foreign Loans: Deficit in the balance of payments can be corrected by government
borrowings from foreign banks, foreign governments or international financial
institutions like the IMF, the World Bank etc. Since the repayment of these loans is
spread over a long period, this helps the government to remove the deficit in the
balance of payments by utilizing the time spread in improving the foreign exchange
position.
• Foreign Investment: The government tries to attract foreigners to make investment in
the country by offering them various incentives and concession, for example raising
the domestic rate of interest and/or offering tax concessions to foreign investors etc.
Consequently, there is more capital inflow in the economy from abroad that helps the
government to reduce the deficit in the balance of payments.
• Tourism Development: In order to earn foreign exchange, the government attracts
foreign tourists to visit the country in increasing numbers by offering them various
facilities like good hotels, transport facility, concessional travel etc. This helps in
increasing the foreign exchange earnings of the country which is utilized by the
government to reduce the balance of payments deficit.
• Foreign Remittances: The government encourages foreign remittance by giving
various incentives to people working abroad. This helps in more inflow of foreign
exchange which in turn helps in reducing the deficit in the balance of payment.
• Import Substitution: Production of substitutes of imported goods is encouraged by
the government by providing various incentives and concessions to the domestic
industries. This helps the government in saving foreign exchange by replacing
imported goods with their substitutes.
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IN-TEXT QUESTIONS
18. BOP is a ________________recording all international receipts and payments of
a country with the rest of the world.
19. The difference between the exports and imports of visible items is known as
___________________.
20. When the value of domestic currency in terms of foreign currency is deliberately
reduced by the government, it is referred to as______________.

7.5 SUMMARY
This chapter discusses various theories of international trade so as to develop a conceptual
understanding of the fundamental principles underlying international trade. Early trade was
based on the theory of mercantilism that measured the wealth of a nation by the size of its
accumulated treasures of gold and silver. In order to accumulate such financial wealth, the
theory suggested a nation should encourage exports and discourage imports. Since one
country's gain was dependent upon another's loss, trade was considered to be a zero- sum
game. However, the later theories of specialization promulgated that trade enhances the
overall global wealth by way of enhancing world production. The theory of absolute
advantage emphasizes that a country should produce and export those goods that it can
produce more efficiently than others. The theory of comparative advantage advocates that
even if a country does not have an absolute advantage in the production of any goods, it
should produce those goods that it can produce more efficiently than others.
As per the Heckscher-Ohlin factor endowment theory, a nation will export the commodity
whose production requires an intensive use of the nation's relatively abundant and cheap
factors and will import the commodity whose production requires the intensive use of the
nation' scarce and expensive factors. However, the Leontief paradox does not support the
factor endowment theory and finds that the US exports more labor-intensive commodities
and imports more capital-intensive products. Posner's Imitation gap theory simply states that
technological innovation and the introduction of a new product leads to the imitation gap and
the demand gap in the other country. The extent to which trade will take place between the
two countries depends on the net effect of the imitation gap and the demand gap. The new
trade theory brings in the concept of economies of scale leading to increase in returns,
enabling countries to specialize the production of such goods. The shifting patterns of
markets as well as manufacturing bases are aptly explained by the theory of international
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product life cycle. The theory of competitive advantage emphasizes upon environmental
factors, such as factor conditions, demand conditions, related and supporting industries, firm
strategy, structure, and rivalry as determinants of national competitiveness. The trade theories
also provideguiding principles for the regulatory framework and trade promotion strategies to
a varying extent to national governments and international organizations.
A country's balance of payment is the summary of all economic transactions of a country that
have taken place between the country's residents and the residents of other countries during
the specified period. The constraints in the growth of India's exports, as summarized in the
chapter, include India's adoption of the import substitution rather than export promotion
strategy, overprotection to Indian industry from external competition, high import tariffs and
other barriers, inadequate infrastructure, and complexity of trade procedures.

7.6 ANSWERS TO IN-TEXT QUESTIONS

1. Trade Surplus 11. Eli Hecksher; Bertin Ohlin

2. David Hume 12. Wassily Leontief; Leontief Paradox
3. Zero sum game 13. Price; physical
4. Increasing returns to scale; network 14. Introduction; growth; maturity; decline
effects 15. Importer
5. Mathematical economics 16. Government policy; chance events
6. Adam Smith 17. Factor conditions; demand conditions;
7. Absolute difference in costs related and supporting industries; firm’s
8. David Ricardo strategy, structure, and rivalry
9.Geographical division of labour; 18. Statement of account
specialization in production 19. Balance of trade
10. Supply 20. Devaluation

7.7 SELF-ASSESSMENT QUESTIONS

1. Analyze the product life cycle theory of international trade in detail. What criticisms
are levelled against it?
2. What are the main differences between the factor proportions and product life cycle
theories of international trade?

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3. Explain Porter’s theory of national competitive advantage as a theory of international

trade.
4. How is the factor proportion theory superior to the classical theory of international
trade?
5. Critically examine the Leontief Paradox.
6. What are the assumptions and criticisms of Ricardo’s theory of international trade?
7. Explain the absolute and comparative advantage theory of international trade.
8. What are the main sources of national competitive advantage? What are the sources of
competitive advantage that explain the success of a product that you think is very
successful in your country?
9. Critically examine the Heckscher-Ohlin theory of international trade.
10. What is the balance of payment account? What are its different components?
11. (a) The balance of payment account is a cash flow statement that records the flow of
foreign exchange from all international transactions over a period of time.’ Discuss.
(c) List the constituents of the current account and capital and financial account of the
balance of payment accounts.
12. Discuss the various components of Balance of Payment Account.
13. “Balance of Payments always balances.” Elucidate. How do you explain
disequilibrium in balance of payments?
14. What are the causes of an adverse balance of payments? Give suggestions to remove
an unfavourable balance of payments.
15. Distinguish between:
• Balance of Current Account and Balance of Capital Account
• Autonomous and Accommodating Transactions
• Deficit and Disequilibrium in Balance of Payments.

7.8 REFERENCES
A.J. Brown, Prof. Leontief and the Pattern of World Trade, Yorkshire Bulletin of Economic
and Social Research, November,1957.
B.C. Swerling, Capital Shortage and Labour Surplus in the United States, RES Vol. 36,
August, 1954.
B.J. Coher, Balance of Payments Policy, 1969.
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Charles P. Kindleberger, International Economics, 1978, p.17.

M.L. Jhingan, Macroeconomic Theory, 11th edition
N.S.Buchanan, Lines on the Leontief Paradox, Economic Internazionale, November, 1955.
P.O.Kenen, Nature, Capital and Trade, JPE, October, 1956.
P.O.Kenen, Nature, Capital and Trade, JPE, October, 1956.
Raymond Vernon, International Investment and International Trade in the Product Cycke,
Quarterly Journal of Economics 80 (May 1966), pp. 190-207.
Raymond Vernon, International Investment and International Trade in the Product Cycle,
Quarterly Journal of Economics 80 (May 1966), pp. 190-207.
W.P.Travis, The Theory of Trade and Protection, 1964.
W.W.Leontief, Factor Proportions and the Structure of American Trade; Further Theoretical
and Empirical Analysis, RES, November, 1956.

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LESSON 8
EXCHANGE RATES AND THE MUNDELL–
FLEMING MODEL
Dr. Minesh Kumar Srivastava
Assistant Professor
School of Business Studies
Vivekananda Institute of Professional Studies –
Technical Campus, New Delhi
Email-Id: minesh.srivastava@gmail.com

STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Exchange Rates and the Foreign Exchange Market
8.3.1 Demand and Supply in the Foreign Exchange Market
8.3.2 Exchange Rate Determination: Flexible Exchange Rates
8.3.3 Exchange Rate Determination: Fixed Exchange Rates
8.3.4 Pegging the Exchange Rate
8.3.5 Current Exchange Rate System
8.4 Capital Account Convertibility
8.5 The Mundell–Fleming Model
8.5.1 Imperfect Capital Mobility
8.5.2 Perfect Capital Mobility
8.6 Summary
8.7 Glossary
8.8 Answers to In-Text Questions
8.9 Self-Assessment Questions
8.10 References
8.11 Suggested Readings

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8.1 LEARNING OBJECTIVES

After reading this chapter, you will be able to:

 Understand the meaning of exchange rates and how it is determined.
 Differentiate between various types of exchange rate regimes.
 Understand the concept of capital account convertibility
 Determine the equilibrium level in money market and goods market with the help of
Mundell-Fleming model.

8.2 INTRODUCTION
Over the past three decades, financial markets in India and other countries have become
much more interconnected. Greater capital flows and a stronger correlation between asset
returns across nations are two effects of financial market integration. The Indian economy has
opened up significantly, proving that the globalisation you read about is indeed a reality.
Other chapters emphasise the connections between the Indian economy and the economies of
other countries through examples and perspectives. These relationships take centre stage
because in this chapter we explicitly discuss the macroeconomics of open economies. This
chapter examines how exchange rates are set, the current global monetary system, as well as
how our domestic economy and global economy interact. We start by describing the various
exchange rate systems used to determine exchange rates in currency markets. Then
the current global monetary system's actual exchange rate arrangements are examined. After
that a comparison of pegged and flexible exchange rate systems is made. Finally, the risks
posed by some rising trade imbalances are assessed.

The main topic of discussion of this chapter is exchange rates. The price of one currency in
relation to the other is known as the exchange rate between two currencies. On 1st March
2023, the price of an American dollar was ₹ 81.72 ($1 = 81.72 rupees), and the price of a
euro was ₹ 86.90. When Indian residents want to buy foreign goods or assets, as well as when
foreign residents want to buy Indian goods and assets, exchanges between the Indian rupee
and other currencies take place. In this chapter we will examine how exchange rates are set
between India and other nations.

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8.3 EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET

Demand for foreign exchange is the term used to describe the demand for foreign currencies
by domestic residents. The market where different national currencies are exchanged is
known as the foreign exchange market. For instance, this market is where Indian citizens sell
their rupees in order to buy foreign exchange (foreign currencies). To understand how the
balance of payments accounts and transactions in the foreign exchange market are related, we
must first acknowledge that all foreign purchases made by Indian residents as well as all
foreign transfer payments (also known as foreign exchange debits, which is a general term for
an aggregate of foreign currencies in the balance of payments accounts) also represent
demands for foreign currencies, or demands for foreign exchange.
The European exporter will demand payment in Euro even though the Indian resident
purchasing the European car does so in rupees. Therefore, on the foreign exchange market,
rupees must be converted into Euro. Take another example, in order to purchase a share of
stock on the London Stock Exchange, an Indian rupee must first be converted into British
pounds by the broker. The overall foreign spending by Indian citizens indicates a demand for
foreign currency. When viewed from the perspective of the rupee, we can say that the total
foreign expenditure of Indian residents represents an equal supply of rupees in the foreign
exchange market. On the other hand, all of the foreign income earned by residents of India
reflect equal earnings of foreign exchange. For instance, Indian exporters will demand
payment in rupees, and foreign buyers must exchange their money for rupees in order to
purchase our goods. The total credits in the balance of payments accounts then equal the
supply of foreign currency, or the demand for rupees, which is the same thing.
8.3.1 Demand and Supply in the Foreign Exchange Market
The foreign exchange market is where exchange rates between different national currencies
are decided. To understand this process, we make the following assumptions. At first, we do
not include central bank official reserve transactions. We assume that central banks do not
intervene in the foreign exchange market. This assumption will be relaxed later in this
section. For the sake of simplicity, we also assume that there are only two nations: "Europe"
and "India," with euro and rupee as their official currency.
In this straightforward scenario, the exchange rate is the relative price of the two currencies,
which we express as the price of the euro in terms of rupees. For example, if the price of the
euro is 100 rupees, then 1 euro trades for 100 rupees; at 125 rupees, the exchange rate (price
of the euro) is higher, and 1 euro equals 125 rupees, (0.80 euro = 100 rupees). It's crucial to
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keep in mind that when the exchange rate is expressed in this way, a higher exchange rate
denotes an increase in the price of foreign currency (or foreign exchange). When the
exchange rate rises, we refer it as an appreciation of foreign currency or the depreciation of
rupee.
Alternately, a drop in the exchange rate indicates a decrease in the price of foreign
exchange (the price of the euro). The rupee has appreciated while the euro has depreciated.
Figure 8.1 displays the foreign exchange supply and demand schedules plotted against the
exchange rate (π). Foreign expenditures such as Imports, purchases of foreign assets, and
transfers made by Indian citizens abroad are all considered demands for foreign currency.
Figure 8.1 depicts a downward sloping demand curve (Dfe), indicating a fall in the demand
for foreign exchange as the price of foreign exchange (price of euros) rises. The reason is that
rising foreign exchange rates will make foreign goods more expensive in rupees. As a result,
imports will decrease and the demand for foreign exchange will decrease.

Fig 8.1: Demand and Supply in the Foreign Exchange Market

Keep in mind that we are holding all prices except the exchange rate, constant. Let's say
you're thinking about spending 200 euros on a handbag made in France. The handbag will
cost ₹ 20,000 if the exchange rate, or the price of the euro in terms of rupees, is 100 (200
euros = ₹ 20,000 at a 100 euro to rupee exchange rate). The price of the handbag will increase
to ₹ 25,000 if the exchange rate increases to 125 (200 euros = ₹ 25,000 at 0.08 euro to the
rupee). The cost of imported goods in rupees increases as the exchange rate rises. Now take
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into account the demand for foreign exchange for transfers to foreign countries and the
purchase of foreign assets. We do not find a clear correlation between the volume of
international transfers and the exchange rate. It is unclear how the change in the exchange
rate will affect international aid initiatives, or gifts to foreign nationals. When buying foreign
assets, an increase in the exchange rate will increase the price of foreign stocks or bonds in
rupees, just like it does when buying imported goods. However, a proportional increase in the
interest or dividend payment on the foreign bond or stock, again expressed in rupees, will
also follow a rise in the exchange rate. For instance, at an exchange rate of 100 (1 euro = 100
rupees), a French bond that costs 800 euros and pays 80 euros in interest a year would cost
80,000 rupees and pay 8000 rupees in interest a year.
The bond will cost ₹1,00,000 and have an annual interest payment of ₹ 10,000 at a
conversion rate of 125 (0.80 euro = 100 rupees). In either scenario, the bond generates an
annual return of 10%. As a result, we would not necessarily anticipate that a change in the
exchange rate would have any impact on the demand for foreign assets. Only the fact that
imports decrease as the exchange rate increases contribute to the downward slope of the
demand for foreign exchange.
Figure 8.1 depicts the supply schedule for foreign exchange with a positive slope indicating
the supply of foreign exchange rises as the exchange rate rises. As the exchange rate (price of
euros) rises, exports from India to Europe become more affordable. Once more, we are
maintaining the fixed rates of all other prices, including the rupee value of Indian exports. For
instance, Europeans would pay 5 euros per bushel for Indian wheat that sells for 500 rupees
per bushel at an exchange rate of 100 but only 4 euros at an exchange rate of 125. As the
exchange rate rises, there should be an increase in the demand for Indian exports. Observe,
however, that at the higher exchange rate, a given rupee volume of exports earns less foreign
currency (fewer euros). For instance, if the exchange rate increased by 10% and the volume
of exports in rupees increased as a result, foreign exchange earnings would remain
unchanged. India would sell 10% more but make 10% less in euros on average. The foreign
demand for our exports must be more than unit elastic, which means that a 1 percent increase
in the exchange rate (which results in a 1 percent decline in the price of the export good to
Europeans) must result in an increase in demand of more than 1 percent, in order for the
supply of foreign exchange to increase as the exchange rate rises. If this requirement is
satisfied, the volume of our exports in rupees will increase more than proportionately to the
increase in the exchange rate, and the earnings of euros (the supply of foreign exchange) will
rise as the exchange rate increases. In Fig 8.1, we have made this assumption.

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8.3.2 Exchange Rate Determination: Flexible Exchange Rates

We have not yet included central bank intervention (official reserve transactions). Only
autonomous transactions in the balance of payments accounts are included in the supply and
demand schedules in Figure 8.1. Let's keep making this assumption and examine how, in the
absence of intervention, the exchange rate is set. In this situation, we would anticipate a
change in the exchange rate to clear the market and balance the supply and demand of foreign
currency. This equilibrium exchange rate is shown as π0 in Figure 8.1. A flexible exchange
rate system, or floating rate system as it is sometimes referred to, is one that determines
exchange rates without the involvement of a central bank.

Fig 8.2: Effect of Increase in the Demand for Imports

A set of international laws governing the determination of exchange rates is known as an
exchange rate system or regime. The central banks have an especially easy set of rules to
follow in a totally flexible or floating rate system because they have no control over the level
of the exchange rate. The market determines the exchange rate. We investigate the impact of
a shock that increases the demand for foreign exchange in order to better comprehend the
operation of a flexible exchange rate system. Let's say that Indian consumers become more
interested in imported goods. Assume, for instance, that rising gas prices lead to a switch
from SUVs to small, foreign cars that are more fuel-efficient. The result of this increase in
import demand would be a shift to the right in the foreign exchange market's demand
schedule, such as from Dfe0 to Dfe1, as shown in Figure 8.2. India has a higher demand for
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imports at a given exchange rate, which causes a higher demand for foreign currency. There
is currently an excess demand for foreign currency at the initial equilibrium exchange rate π0,
(shown as XDfe in Figure 8.2). The exchange rate must increase to the new equilibrium value
of π1. Because the price of imported goods in rupees increases along with the exchange rate,
the increase in the exchange rate will result in a decrease in the amount of imports that are
demanded. Additionally, since Indian exports are now less expensive to foreign buyers due to
the increase in the exchange rate, the demand for exports will grow. The supply and demand
for foreign exchange are once again equal at the new equilibrium with the higher exchange
rate (π1). The rise in import demand causes the rupee to lose value.
India's exchange rate system hasn't always been completely flexible. Central banks, including
the RBI, have intervened in the foreign exchange market to affect the values of their
currencies to varying degrees during this time. The characteristics of the current global
monetary system are covered later. Before we get started, it is helpful to look at how the
foreign exchange market functions under the system of fixed, or pegged, exchange rates,
which is the complete opposite of a completely flexible rate system.
8.3.3 Exchange Rate Determination: Fixed Exchange Rates
An international monetary system is a set of regulations governing the setting of exchange
rates and deciding which assets will serve as official reserve assets. The Bretton Woods
system, established after World War II, is an example of a fixed exchange rate system. Near
the end of the war, negotiations took place to create the international monetary agreements
that made up this system (at Bretton Woods, New Hampshire). To run the Bretton Woods
system, the IMF was established. The United States was required to set a parity, or par value,
for its currency in terms of gold in accordance with IMF regulations. Due to the dollar's link
to gold, other countries would set their currency parities in terms of dollars, which also fixed
the value of these other currencies in terms of gold.
The United States consented to uphold the fixed exchange rate (originally $35 per ounce)
between the dollar and gold. After a period of post-war adjustment, other nations agreed to
maintain convertibility with the dollar and other currencies but not with gold. The other
nations agreed to keep their currency values versus the dollar within a 1% range on either
side of parity. Given that the US held roughly two-thirds of the world's official gold reserves
at the time, the US's differential obligation to other IMF members regarding convertibility
into gold seemed reasonable.

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8.3.4 Pegging the Exchange Rate

We look at how a nation can "peg," or fix, the level of its exchange rate in order to
understand how a system of fixed exchange rates operates. In order to accomplish this, we go
back to our two-country example and assume that India wants to fix its exchange rate in
relation to the euro, which we are using to represent the currencies of the rest of the world.
We ignore the 1% margin that was just mentioned and assume that the RBI wants to set the
rupee's exact par value, such as at a conversion rate of 100 rupees to 1 euro. Figure 83 shows
how the foreign exchange market functions under this fixed exchange rate system.
Assuming a flexible rate system, we assume that the official fixed exchange rate of 100 is
below the equilibrium rate of 125 (0.80 euro = 100 rupees) shown in Figure 8.3. In such a
case, the rupee would be considered to be overvalued and the euro to be undervalued at the
fixed exchange rate. According to this terminology, if the exchange rate were set by the
market, it would have to increase for the market to be cleared if the price of the euro was
compared to the rupee. What stops this from occurring? Just to refresh your memory, the
demand and supply schedules we created for the foreign exchange market only measure
autonomous transactions; they do not account for accommodating transactions carried out by
central banks to finance payments imbalances.

Fig 8.3: Foreign Exchange Market with a Fixed Exchange Rate

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To fix the exchange rate at a value that is not in equilibrium, like the 100 rupees in Figure
8.3, such central bank intervention is necessary. India must be prepared to buy and sell rupees
at that exchange rate in order to maintain the rate at 100. The exchange rate cannot drop
below that level because no one would sell elsewhere for less if the RBI agreed to buy
1 euro for 100 rupees. In a similar manner, the exchange rate is unable to increase above 100
due to the central bank's willingness to sell euros at that level. With the exchange rate below
the equilibrium rate in the scenario shown in Figure 8.3, there is an excess demand for
foreign exchange (euros), denoted in the figure as XDfe. The RBI can supply foreign
exchange, i.e., exchange euros for rupees on the foreign exchange market, to prevent the
exchange rate from rising. As an alternative, the European Central Bank might step in. To
meet the excess demand for euros and keep the price of the euro at the set exchange rate, this
bank would supply euros (sell euros and buy rupees).
8.3.5 Current Exchange Rate System
In 1971, the Bretton Woods system broke down. For major industrialised nations, the current
global exchange rate determination system is best described as a managed float (or in the case
of the countries in the euro area, for a group of countries). Although some allow for varying
degrees of exchange rate flexibility, developing countries frequently have fixed exchange rate
systems. A managed or "dirty" float combines elements of a fixed rate system and a flexible
exchange rate system (the managed part). The exchange rate is permitted to fluctuate for a
nation with a managed float in response to market forces. The central bank can, however, step
in to stop any unfavourable or disruptive changes in the exchange rate. We will now examine
the issue of how central banks have decided to intervene in the foreign exchange markets and
how an undesirable or disruptive movement in the exchange rate has been defined in practise.
There is also discussion of the causes of the Bretton Woods system's failure.
Exchange Rate Arrangements
The exchange rate policies of the nations that are IMF members are compiled in Table 8.1.
As was just mentioned, there is no single system for determining exchange rates. Some
nations set their exchange rates within a narrow range of 1% or less, either to a single
currency or to a basket of currencies. This is the 42-nation group that the table's "fixed peg
arrangements" label refers to. Pegged arrangements within bands are another group that
adheres to a fixed exchange rate policy, albeit with a larger band. Between fixed and flexible
rates, the currency category known as "crawling pegs" modifies the value of its currency in
relation to a central rate in response to a number of economic indicators (such as domestic
versus foreign inflation rates). The group labelled "participate in an exchange rate

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mechanism" comprises the European nations that have adopted a common currency, the euro,
but float as a group relative to other currencies. More information about this exchange rate
setup is provided later in the chapter. The 77 countries listed next in the table all have
managed floats but have floating rate systems. The last group, dubbed "other," uses a
different system for determining exchange rates. Among the nations with floating exchange
rates are the United States, Canada, the United Kingdom, and Japan.
Table 8.1: Exchange Rate Arrangement of IMF Member Countries
Exchange Rate Arrangements No. of Countries
Fixed peg arrangements 42
Pegged arrangements within bands 14
Crawling pegs 5
Participate in an exchange rate mechanism 17
Managed floating and float independently 77
Other 34
Source: IMF, International Financial Statistics

How much managing? How much floating?

To prevent disruptive changes in their exchange rates, central banks intervene in the foreign
exchange markets in a managed float. Their exchange rates float otherwise. The degree to
which industrialised nations intervened in the foreign exchange market varied significantly
during the post-1973 era. The American central bank frequently intervened in the foreign
exchange market in the 1970s. For instance, the U.S. government organised a significant
support programme for the dollar's price in November 1978. The Reagan administration
declared in 1981 that central bank intervention would only take place when it was absolutely
necessary to stop chaos in the foreign exchange market brought on by crisis situations. U.S.
intervention in the foreign exchange market significantly decreased after this change in how
one should define a disruptive movement in the exchange rate. The current exchange rate
system prevents the price of the dollar from floating freely even in the absence of U.S. central
bank intervention because other central banks buy or sell dollars to affect the value of their
currencies relative to the dollar. For instance, European central banks sold dollars from their
reserve holdings in 1981 and 1984 to halt the rise in the price of the dollar, which would have
resulted in a decline in the value of their respective currencies (a rise in their exchange rate

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relative to the dollar). Then, with the signing of the Plaza Accord in September 1985,
coordinated intervention by the central banks of the major industrialised nations to devalue
the dollar began (raising the U.S. exchange rate). For reasons that will be discussed later,
these central banks reversed course in 1987 and once more intervened jointly to support the
dollar. The main currency market interventions in recent years have involved Asian central
banks buying dollars. To keep the value of its currency pegged, the Bank of China amassed
enormous reserves. To prevent (or at least limit) the appreciation of the Japanese yen, the
Bank of Japan has also purchased a significant amount of dollars. To increase their stock of
reserves, other Asian central banks have spent hundreds of billions of dollars on purchases.
Advantages of Alternative Exchange Rate Regimes
Each nation, or group of nations, selects an exchange rate regime within the current
framework for determining exchange rates. The selection of the degree of exchange rate
flexibility is a crucial component of this choice. A nation makes a decision along a spectrum
that, at one end, calls for total exchange rate flexibility and, at the other, a rigid peg. Other
considerations when choosing an exchange rate regime include the quantity and kind of
reserve assets to hold, as well as the currency to use as the basis for any currency pegs.
However, the exchange rate regime's choice of degree of flexibility is crucial. Economists
and central bankers have long disagreed about the relative advantages of pegged (fixed)
versus flexible exchange rates. We examine the main justifications offered for and against
each system in this section.
Advantages of Exchange Rate Flexibility
We start with the justifications put forth for exchange rate flexibility. One benefit of more
exchange rate flexibility is that it would free policymakers from worrying about balance of
payments deficits, allowing them to focus on domestic objectives. Potential conflicts between
internal balance (domestic goals) and external balance would be eliminated (balance of
payments equilibrium). Secondly, exchange rates that are flexible would protect the domestic
economy from shocks to the global economy.
Policy Independence and Exchange Rate Flexibility
According to our earlier analysis, a country's central bank would lose official reserve assets if
it intervened in the foreign exchange market to finance a balance of payments deficit. The
central bank would eventually run out of reserves as a result of ongoing deficits. The central
bank would need to implement measures to close the balance of payments deficit before
reserves ran out. Here is where there may be a conflict between domestic objectives and the

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balance of payments. We look at the relationship between the major balance of payments
items and the level of domestic economic activity to better understand the nature of the
conflict.
The Trade Balance and the Level of Economic Activity
Figure 8.4 shows the domestic national income on the horizontal axis, along with imports (Z)
and exports (X) on the vertical axis. The import schedule is drawn sloping upward because
the demand for imports depends positively on income. Because income has a positive impact
on consumption, this relationship follows. Consumption of both domestic and imported
goods rises as income rises. Additionally, as domestic national income rises, the need for
imported inputs will grow (e.g., imported crude oil). The export schedule, however, is
horizontal. The foreign demand for imports includes the demand for Indian exports. Foreign
income determines the demand for imports from abroad. India views foreign income and
consequently the need for exports as exogenous factors.
The relative price levels in the two countries as well as the level of the exchange rate are
additional factors that affect both Indian demand for imports as well as foreign demand for
Indian exports. These factors determine the relative costs of the goods produced by the two
countries for the citizens. For the time being, we will assume that both price levels and the
exchange rate are constant. Exports and imports will be equal if income is at YTB = 0, as
shown in Figure 8.4. (where TB, the trade balance, equals zero). With this level of income,
import demand equals exogenous export level. However, there is no reason to believe that the
equilibrium level of income will be YTB = 0. The overall economy's aggregate demand and
supply, not just that of the international sector, will determine equilibrium income.
Assume, for instance, that the equilibrium income in Figure 8.4 is at Y0, above YTB = 0. At
Y0, there is a trade deficit because imports are higher than exports. In earlier chapters, we
have seen how, at least according to the Keynesian perspective, aggregate demand
management can influence equilibrium income. These policies could then be used to raise
equilibrium income to the point where exports and imports are equal, or YTB = 0. This would
be a position of external balance for the economy, which in a fixed exchange rate system
means balance of payments equilibrium, if the other current account items and the financial
account were in balance (official reserve transactions deficit equals zero). In Figure 8.4, the
decision-maker could, for instance, use a stringent fiscal strategy like a tax hike to lower
income from Y0 to YTB = 0.

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Fig 8.4: Trade Balance and the Level of Economic Activity

Politicians, however, also have domestic objectives. Achieving internal balance requires the
use of policies for aggregate demand management in the Keynesian framework in order to
pursue goals for unemployment and inflation. The issue is that there is no evidence to support
the notion that the level of income that results in external balance is also the level that is best
for achieving domestic objectives. Assume, for instance, that Y0 in Figure 8.4 represents the
ideal level in terms of domestic goals. Internal balance would be upset and an unfavourably
high unemployment rate would result from using a restrictive fiscal policy to reduce income
to YTB = 0. However, if income is kept at Y0, there will be a trade deficit and no external
balance in the economy.
Capital Flows and the Level of Economic Activity
Expected rates of return on assets in each country serve as the main determinants of capital
flows between countries. With a fixed exchange rate system, asset returns are not affected by
anticipated exchange rate movements (except at times when there is speculation that the
official exchange rate is to change). The different countries' interest rates will serve as
indicators of the relative rates of return. If we assume that other countries rates of return are
constant, the amount of capital entering a given nation will positively depend on the level of
that nation's interest rate (r); that is,
F = F(r) (8.1)

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where F is the net inflow of capital (a negative value of F represents a net outflow or deficit
on the financial account). Therefore, how the interest rate changes in response to changes in
economic activity will determine how those changes affect the balance on the financial
account. Start by taking into account the rises in economic activity brought on by
expansionary monetary policies. By lowering the interest rate, an expansionary monetary
policy will increase aggregate demand. The balance on the financial account will suffer as a
result of the lower interest rate. As foreign assets become comparatively more appealing,
foreign investment in India will decrease while Indian investment abroad will rise. As we saw
in the section before, increases in income for any reason lead to an increase in imports while
maintaining export levels, which worsens the trade balance. The trade balance and the
financial account will worsen if the increased income is the result of an expansionary
monetary policy. What if, on the other hand, the rise in economic activity was the result of an
expansionary fiscal strategy? With a fixed money supply, the interest rate will rise as income
rises due to an increase in the demand for money. In this instance, an increase in interest rates
coincides with an increase in income. As a result, the increase in interest rates will encourage
a capital inflow even though the trade balance is getting worse. The relative strength of these
two effects of the fiscal policy-induced expansion—the favourable effect on the financial
account or the unfavourable effect on the trade balance—determines whether the overall
effect on the balance of payments is favourable or unfavourable.
As a result, we discover that in a fixed exchange rate system, there may be conflicts between
domestic objectives, like a low unemployment rate, and the objective of external balance, as
determined by the balance of payments equilibrium. With regard to monetary policy, the
conflict is particularly severe because expansive policy actions have negative effects on both
the trade balance and the financial account. The price level serves as a final link between the
balance of payments and economic activity. Expansive aggregate demand policies, whether
monetary or fiscal, will raise prices unless the economy is still far from reaching full
employment. With a fixed exchange rate, an increase in domestic prices will result in higher
imports and lower exports for a constant level of foreign prices. Indian citizens will generally
find foreign goods to be less expensive, while foreign consumers will find Indian exports to
be more expensive. The direct negative impact that an economic expansion has on the trade
balance for both monetary and fiscal policies is reinforced by this price effect on the balance
of trade.
Exchange Rate Flexibility and Insulation from Foreign Shocks
The ability of flexible exchange rates to protect an economy from certain shocks is cited by
proponents. Consider a nation that is initially in a state of macroeconomic equilibrium with
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an optimal level of unemployment, an optimal price level, and equilibrium in the balance of
payments to understand the justification for this assertion. Now imagine that there is a global
recession and that foreign income decreases. Because foreign income determines the demand
for this country's exports (import demand), it will decline along with the global recession.
This decrease in export demand will be reflected in the foreign exchange market as a leftward
shift in the foreign exchange supply schedule. The foreign recession will cause the supply
schedule to change from Sfe0 to Sfe1, as shown in Figure 8.5.

Fig 8.5: Insulation of the Domestic Economy in a Flexible Exchange Rate System
The nation would experience a balance of payments deficit equal to distance AB in Figure 8.5
under a fixed exchange rate system. Additionally, the recession abroad will have
contractionary effects on the domestic economy; aggregate demand will fall, and income will
decline because export demand is a portion of aggregate demand (the foreign demand for
domestic output). A system with flexible exchange rates will see an increase in the exchange
rate as a result of the excess demand for foreign currency (equal to the balance of payments
deficit AB) brought on by the international recession. With the higher exchange rate π1, point
C will represent the new equilibrium. The deficit in the balance of payments will be
eliminated by the increase in the exchange rate. Take note of yet another feature of the
transition to a new equilibrium. As we proceed to point C, the rise in the exchange rate boosts
export demand while reducing import demand. The increase in exports brought on by the
increase in the exchange rate will cause the aggregate demand to increase. The decline in

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imports brought on by the increase in the exchange rate will also have an expansionary effect;
domestic aggregate demand will rise as people start purchasing domestic goods instead of
imports. In the flexible exchange rate scenario, we can observe that changing the exchange
rate counteracts the contractionary impact of a foreign recession on the domestic economy. In
this way, a system of flexible exchange rates protects an economy from external shocks.

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8.4 CAPITAL ACCOUNT CONVERTIBILITY

The current account and capital account make up the balance of payments account, which is a
statement of all transactions between a nation and the outside world. The capital account is
made up of the cross-border movement of capital through investments and loans, whereas the
current account primarily deals with the import and export of goods and services. The ability
of a country's currency to be converted into any other foreign currency (such as the US dollar,
British pound, or Euro) and back again is referred to as capital account convertibility. It is the
ability to exchange domestic financial assets for foreign financial assets at market exchange
rates. Unrestricted capital movement would eventually result from full capital account
convertibility. Due to the unfavourable current account situation—India had a sizable current
account deficit—the Indian rupee was not granted full capital account convertibility. The
government wanted to make sure that imports of essential goods and commodities could be
made with foreign currency at a lower cost.
India approached the full convertibility of the rupee for capital accounts with caution in light
of the Mexican crisis. The ensuing East Asian financial crisis supported the partial
convertibility of capital accounts. In the past, partial capital account convertibility was
allowed in certain circumstances. Complete capital account convertibility can encourage
capital inflows into the nation, but if circumstances worsen, there is a sizable risk of capital
outflows from the home nation. This may result in greater exchange rate volatility and even a
crisis akin to the one that hit East Asia. This year, as the government and RBI work to permit
more foreign participation in domestic bond markets, the process of capital account
convertibility is likely to advance.
Evolution of capital account convertibility
India's path to opening its economy was set in motion by the recommendations of the
Narasimham Committee in 1991. The nation had switched to a market-determined exchange
rate and full current account convertibility within five years. Current account and, to some
extent, capital account transactions were further liberalised with the passage of the Foreign
Exchange Management Act, 1999. Foreign direct investment (FDI) is largely unrestricted in
India, where it has contributed nearly 50% of all FDI inflows since 1991 over the past five
years. The highest amount ever invested by FPIs was 10.8 billion dollars in the IPOs of
Indian companies in 2021. Progress on this front has been slow over the three decades since
liberalisation started, and the capital account is currently only partially open.

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Importance
The irregular inflows and outflows of domestic and foreign capital can cause excessive
currency appreciation or depreciation and have an adverse effect on the stability of the money
supply and the financial system. Following the 1997 currency crisis in East Asian nations,
India was praised for its caution in opening up its capital account. According to the S. S.
Tarapore committee's report on fuller capital account convertibility, which was published in
2006, even nations with sound fiscal positions have experienced currency crises and sharp
declines in exchange rates. According to the report, excessive exchange rate appreciation
makes exporting industries unprofitable and makes imports much more competitive,
worsening the current account deficit. The Indian government has made numerous efforts to
achieve complete convertibility of the capital account. Increased foreign portfolio investment
limits in the Indian debt markets, for instance.
● Launching the Fully Accessible Route (FAR), which allows NRIs to invest without
restrictions in certain government securities.
● Relaxing end-user restrictions to ease the external commercial borrowing framework.
● Permitting inward FDI in the majority of sectors.
● Permitting FDI from Indian-incorporated businesses that is a multiple of their net worth.

Fig 8.6: Effect of an Expansionary Monetary Policy: Flexible Exchange Rates

Flexible Exchange Rates

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8.5 THE MUNDELL-FLEMING MODEL

All economies are open to some extent, as they are engage in trade and capital flows with
other nations. We examine monetary and fiscal policy in an open economy model in this
section. How are the outcomes of policy changes different in an open economy versus a
closed economy? Depending on whether exchange rates are fixed or flexible, how do they
differ? In the earlier discussed system of fixed exchange rates, we take into consideration any
conflicts that might occur between internal and external balance. We provide examples to
show why when exchange rates are flexible, those conflicts do not occur. There are various
macroeconomic frameworks for open economies. The Mundell-Fleming model, referred to as
the workhorse model for open economy macroeconomics.
The IS-LM model has an open economy version called the Mundell-Fleming model. The two
equations in the closed economy IS LM model are as follows:
M = L(Y, r) (8.2)
S(Y) + T = I(r) + G (8.3)

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The money market equilibrium is represented by equation (8.2) and the goods market
equilibrium is represented by equation (8.3) (IS schedule). While maintaining a constant level
of aggregate prices, the model simultaneously determines the nominal interest rate (r) and the
amount of real income (Y). What adjustments are necessary to analyse an open economy?
The LM schedule won't be changed when an open economy is taken into account. Equation
(8.2) states that in order for there to be an equilibrium, the real money supply—which we
assume is under the control of the domestic policy maker—must equal the real demand for
money. The policy maker has control over the nominal money supply, but since prices are
assumed to be fixed at a certain level, changes in the nominal money supply also affect the
real money supply. The goods market equilibrium condition for a closed economy serves as
the basis for the equation (8.3):

C+S+T≡Y=C+I+G (8.4)

which, when C is subtracted from both sides, reduces to

S+T=I+G (8.5)
If we add imports (Z) and exports (X) to the model, equation (8.4) is replaced by

C+S+T≡Y=C+I+G+X-Z (8.6)

and the IS equation becomes

S+T=I+G+X-Z (8.7)
where net exports (X-Z) is the contribution of the foreign sector to total demand. The open
economy IS equation can be written as follows if we move imports to the left-hand side and
identify the variables that each component of the equation depends on.
S(Y) + T + Z(Y,π) = I(r) + G + X(Yf, π) (8.8)
Investment and saving are the same to those in the closed economy model. Income has a
positive impact on imports. The exchange rate (π) has a negative impact on imports.
Therefore, a rise in the exchange rate will increase the cost of goods from abroad while
decreasing imports. Indian exports are actually imports for other nations, and it is positively
depends on foreign income (Yf) and the exchange rate. The reason for the relationship is that
an increase in the exchange rate reduces the cost of rupees measured in terms of the foreign
currency and lowers the price of Indian goods for foreign residents.
As depicted in Figure 8.7, it is possible to show that the open economy IS schedule is
downward sloping. Low investment levels will be the result of high interest rates. To satisfy
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equation (8.8), income must be low at these high interest rates in order for imports and saving
rates to be low. Alternatively, at low interest rate levels, which lead to high levels of
investment, the equilibrium of the goods market necessitates high imports and saving; as a
result, Y must be high. We hold four variables constant when constructing the open economy
IS schedule in Figure 8.7: taxes, government spending, foreign income, and the exchange
rate. These factors cause the schedule to change. The schedule is shifted to the right by
expansionary shocks like an increase in government spending, a reduction in taxes, a rise in
foreign income, or a rise in the exchange rate. The increased demand for our exports makes
an increase in foreign income expansionary.

Fig 8.7: Open Economy IS− LM Model

The increased demand for our exports makes an increase in foreign income expansionary. In
addition to increasing exports and decreasing imports for a given level of income, an increase
in the exchange rate causes a shift in demand from imported to domestic goods. For the same
reason, an autonomous decline in import demand is expansionary. The IS schedule is shifts to
the left when these variables change in the opposite direction. In fig 8.7, our open economy
model includes a balance of payments equilibrium schedule, the BP schedule in addition to
the IS and LM schedules. All interest rate-income combinations that lead to balance of
payments equilibrium at a specific exchange rate are plotted on this schedule. Equilibrium in
the balance of payments signifies that there is no balance in the official reserve transaction.
The BP schedule equation can be expressed as
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X(Yf, π) – Z(Y, π) + F(r - rf) = 0 (8.9)

In equation (8.9), the first two terms together make up the trade balance (net exports). The net
capital inflow, or the surplus or deficit in the financial account in the balance of payments, is
the third item. The difference between the domestic interest rate and the foreign interest rate
(r − rf) determines positively the net capital inflow. Increased demand for Indian financial
assets (such as bonds) at the expense of foreign assets results from an increase in the interest
rate differential between India and other countries. As a result, net capital inflow rises. The
opposite happens when the foreign interest rate increases. The assumption is that the foreign
interest rate is exogenous. Figure 8.7 illustrates the BP schedule is positively sloped. While
export demand remains constant as income rises, import demand does. A higher interest rate
will result in an increase in capital inflow, which is necessary to maintain balance of
payments equilibrium. Now take into account factors that impact the BP schedule. The
schedule will move horizontally to the right as π increases. A higher level of income will be
needed for balance of payments equilibrium for a given level of interest rate, which fixes the
capital flow, at a higher exchange rate. For this reason, a higher level of income that will
stimulate import demand is required for balance of payments equilibrium. The higher
exchange rate promotes exports and discourages imports. The BP schedule will also move to
the right in response to an exogenous increase in export demand (caused by an increase in Yf)
or a decrease in import demand. If exports increase, for instance, at a specific interest rate
that fixes the capital flow once more, a higher level of income and consequently of imports is
needed to re-establish the balance of payments. The BP schedule is moved to the right. The
BP schedule would also move to the right in response to a decline in the foreign interest rate
because, for a given domestic interest rate (r), the decline in the foreign interest rate results in
an increase in capital inflow. Imports and consequently income must increase for the balance
of payments to be in equilibrium.
There is one thing to note about the BP schedule before we look at the effects of various
policy changes. If capital mobility is imperfect, the BP schedule will be upward sloping.
Domestic and foreign assets (such as bonds) are substitutes in this situation, but they are not
perfect ones. Investors would move to equalise interest rates across nations if domestic and
foreign assets could perfectly substitute one another, or in a situation known as perfect capital
mobility. Investors would shift to an asset with a temporarily higher interest rate if it existed
until the rate of the other asset was lowered to make it equal. Perfect capital mobility implies
that r = rf in the context of our model. This equality implies a horizontal BP schedule. Interest
rates do not necessarily need to be equal if the assets are imperfect substitutes. Foreign assets
may not be a perfect substitute for Indian assets due to factors such as differential risk on
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international assets, exchange rate risks, transaction costs, and a lack of knowledge about the
characteristics of foreign assets.
8.5.1 Imperfect Capital Mobility
In this section, we assume that these factors are enough to make domestic and foreign assets
less than perfect substitutes. We start with the scenario of fixed exchange rates to examine
monetary and fiscal policy under the assumption of imperfect capital mobility.
Policy under Fixed Exchange Rates
Monetary Policy
Think about what would happen if the money supply increased from M0 to M1. In Figure 8.8,
the LM schedule moves to the right, from LM (M0) to LM (M1) as a result of the increase in
the money supply (M1). With a decrease in interest rates from r0 to r1 and an increase in
income from Y0 to Y1, the equilibrium shifts from E0 to E1. What happened to the payment
balance? First, keep in mind that every point below the BP schedule represents a deficit in the
balance of payments, while every point above the schedule represents a surplus. A deficit in
the balance of payments results when we move from an equilibrium point on the BP schedule
to points below the schedule, such as by raising income or lowering the interest rate, or both.
As a result, after the increase in the money supply, we move from point E0 to point E1, and
the balance of payments also moves into deficit.

Fig 8.8: Monetary Policy with a Fixed Exchange Rate

The expansionary monetary policy boosts income, encourages imports, and drives down
interest rates, which results in a capital flight (F declines). Potential conflicts between the
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objectives of domestic policy and the external balance are raised by the fact that, starting
from a point of equilibrium, an expansionary monetary policy results in a deficit in the
balance of payments. Moving to point E1 and income level Y1 may be preferable on domestic
grounds if the level of income, Y0, at point E0 in Figure 8.8 is low in comparison to full
employment. Due to the limited foreign exchange reserves, there will be a balance of
payments deficit at point E1, which cannot continue indefinitely.
Fiscal Policy
Figure 8.9 shows the results of increasing government spending from G0 to G1 in the case of
fixed exchange rates. Government spending growth causes the equilibrium point to shift from
E0 to E1, moving the IS schedule to the right from IS (G0) to IS (G1). The interest rate
increases from r0 to r1, and income increases from Y0 to Y1. Figure 8.9 illustrates the new
equilibrium point, where we are above the BP schedule and the balance of payments is in
surplus. The BP schedule in Figure 8.9 is flatter than the LM schedule, which is how we
arrive at this conclusion. s shown in Figure 8.10, an expansionary fiscal policy action would
result in a balance of payments deficit if the BP schedule were steeper than the LM schedule.
The BP schedule will become more steep as capital flows become less sensitive to interest
rates. The rise in interest rate needed to maintain balance of payments equilibrium as we
move to a higher income (and therefore import) level will be greater the smaller the increase
in capital inflow for a given increase in the interest rate (given the fixed value of rf); this
means that the BP schedule will be steeper. The BP schedule will also become more steep the
higher the marginal propensity to import.

Fig 8.9: Fiscal Policy with a Fixed Exchange Rate

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A given increase in income will result in a greater increase in imports if the marginal
propensity to import is higher. A larger compensatory increase in capital inflow and, as a
result, a larger increase in interest rate will be needed for the balance of payments to return to
equilibrium. Income rises as a result of the expansive fiscal policy action shown in Figures
8.9 and 8.10. A worsening trade balance results from increased income, which also raises
interest rates and improves the financial account. A steeper BP schedule will have a larger
negative impact on imports and the trade balance and a smaller positive impact on capital
flows.

Fig 8.10: Fiscal Policy with a Fixed Exchange Rate: An Alternative Outcome
Therefore, the steeper the BP schedule, the more likely it becomes that an expansionary fiscal
policy action will result in a balance of payments deficit. Finally, take note that whether an
expansionary fiscal policy action results in a balance of payments surplus or deficit depends
on the slope of the BP schedule in relation to the slope of the LM schedule. Given the slope
of the BP schedule, the likelihood that the LM schedule will be steeper than the BP
schedule—a condition necessary for a surplus to result from an expansionary fiscal policy
action—increases as the LM schedule gets steeper. This conclusion is reached because, other
factors being equal, the steeper the LM schedule, the greater the increase in interest rate

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(which results in the favourable capital inflow), and the lesser increase in income (which
produces the unfavourable effect on the trade balance).
Policy under Flexible Exchange Rates
Monetary Policy
Now let's consider the scenario in which there is no central bank intervention and the
exchange rate is completely flexible. In the foreign exchange market, the exchange rate is
adjusts according to supply and demand. Consider first the same monetary policy measure
that was previously examined, namely an increase in the amount of money from M0 to M1.
Figure 8.11 shows the results of this expansionary monetary policy action in the scenario of a
flexible exchange rate. Prior to a change in the exchange rate, the expansion of the money
supply has the immediate effect of advancing the economy from point E0 to point E1. The
interest rate falls from r0 to r1. Income increases from Y0 to Y1, and we move to a point below
the BP schedule where a balance of payments deficit is beginning to emerge. To clear the
foreign exchange market in a flexible exchange rate system, the exchange rate will increase
from π0 to π1). This adjustment was previously depicted in Figure 8.6. The BP schedule will
move to the right as the exchange rate increases; in Figure 8.11, the schedule moves from BP
(π0) to BP (π1).

Fig 8.11: Monetary Policy with a Flexible Exchange Rate

Due to the fact that exports increase and imports decrease as the exchange rate rises, IS
schedule also moves to the right, from IS (π0) to IS (π1). With the interest rate at r2 and the

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income at Y2, the new equilibrium is depicted at point E2. Following an expansionary
monetary policy, the exchange rate adjustment adjusts the balance of payments and resolves
any potential inconsistency between internal and external balance. It is important to note that
the income increase brought on by the expansionary monetary policy action is higher in the
flexible rate case than it is in the fixed rate case. Income would only increase to Y1 in Figure
8.11 or Figure 8.8 with a fixed exchange rate. A flexible exchange rate would allow the
increase in the exchange rate to further boost income by boosting exports and lowering
import demand (for a given income level). Therefore, monetary policy is a more effective
stabilisation tool in a regime of flexible exchange rates than in a regime of fixed rates.
Fiscal Policy
The effects of an increase in government spending from G0 to G1 with a flexible exchange
rate are shown in Figure 8.12. The initial effect—again, the result prior to the exchange rate
adjustment is a change in the IS schedule from IS (G0, π0) to IS (G1, π0) which causes the
economy to move from E0 to E1. Income increases as the interest rate increases (from r0 to
r1) (from Y0 to Y1). With the slopes of the BP and LM schedules depicted in Figure 8.12 (the
BP schedule being flatter than the LM schedule), this expansionary policy action leads to a
small balance of payments surplus. For the foreign exchange market to clear in this scenario,
the exchange rate must decrease from π0 to π1. In Figure 8.12, the BP schedule will move to
the left as the exchange rate declines, from BP (π0) to BP (π1). Because the decline in the
exchange rate will cause exports to decline and imports to increase, the IS schedule will also
move left, from IS (G1, π0) to IS (G1, π1).

Fig 8.12: Fiscal Policy with a Flexible Exchange Rate

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The expansionary impact of the fiscal policy action will be partially offset by the exchange
rate adjustment. The new equilibrium point will be at Y2, which is higher than Y0 but lower
than Y1, the level that would have been reached if the exchange rate had been fixed.
However, unlike monetary policy, there is no clear correlation between the effectiveness of
fiscal policy and the type of exchange rate regime. A balance of payments deficit will result
from an expansionary fiscal policy for a specific exchange rate if the BP schedule is steeper
than the LM schedule, as shown in Figure 8.10. The exchange rate must increase in the
flexible exchange rate regime due to an incipient balance of payments deficit in order to bring
the foreign exchange market back into equilibrium. The shift to the right in the BP and IS
schedules will reinforce the initial expansionary impact of the rise in government spending.
In contrast to the fixed exchange rate case, the expansionary fiscal policy action would have a
greater impact on income in this scenario. Though this alternate result is theoretically
possible, most economists believe the result shown in Figure 8.12 is more likely. They think
adopting an expansionary fiscal strategy will result in lower exchange rates (raise the value of
the domestic currency). This assumption is supported by the idea that there is a significant
amount of global capital mobility, which makes the BP schedule relatively flat and likely to
be flatter than the LM schedule (see Figure 8.12).
8.5.2 Perfect Capital Mobility
We have assumed up to this point that while domestic and foreign assets can be substituted,
they are not a perfect substitute. In this section, we examine monetary and fiscal policy for
the scenario of perfect capital mobility, where assets are perfect substitutes. Capital can move
freely between nations in this case, asset risk differences between nations are insignificant,
and transaction costs are negligible.
In the Mundell–Fleming model, the assumption of perfect capital mobility means that the BP
equation (8.9) is replaced with the condition
r = rf (8.10)
The BP schedule is horizontal due to the assumption of perfect capital mobility. A balance of
payments equilibrium can only exist when the domestic interest rate is equal to the
exogenously determined foreign (world) interest rate because massive capital flows result
from any interest-rate differential. Prior to examining the effects of policy in the scenario of
perfect capital mobility, take into account the assumption that the domestic interest rate must,
in an ideal situation, equilibrate with the exogenously determined foreign rate. Although we
also assumed that the foreign interest rate was exogenous, imperfect capital mobility could

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result in a difference between the domestic interest rate and the foreign interest rate. Two
possibilities exist in that situation.
One is that we are thinking about a small nation whose actions have no bearing on the global
economy. In addition to being assumed to be exogenous, an expansionary monetary policy
that lowers the domestic interest rate has no impact on the global interest rate or income in
other nations. Another possibility is that the nation is large, like India, but that we were just
ignoring the impact of its actions on other economies and, consequently, ignoring potential
repercussive effects. These were thought to be of secondary importance. Only the first
assumption is reasonable in the perfect capital mobility. Due to capital mobility and the
domestic country's small size, which prevents it from having an impact on global financial
market conditions, the domestic interest rate must adjust to reflect global rates. We would
need to model the impact of Indian policies on the global interest rate in order to consider
India as the perfect capital mobility case. To think that the interest rate in India is entirely
unaffected by the interest rate in the rest of the world is unrealistic.
Policy Effects under Fixed Exchange Rates
Monetary Policy
We will see that perfect capital mobility renders fixed exchange rates completely ineffective
for monetary policy. We need to think more about the connection between money supply and
foreign exchange market intervention in order to fully comprehend this result. Previously, we
found that an expansionary monetary policy produced a balance of payments deficit when
there was a fixed exchange rate. With this context in mind, think about what an expansionary
monetary policy would do in the scenario of perfect capital mobility. Assume, in keeping
with the previous discussion, that a small nation like New Zealand expands its money supply.
Figure 8.13 shows how the increased money supply causes the LM schedule to move from
LM (M0) to LM (M1). For a brief period, the interest rate in New Zealand moves from r0 to r1.
The interest rate in New Zealand is currently lower than the foreign (global) interest rate. In
the scenario of perfect capital mobility, there will be a significant capital outflow when the
domestic interest rate is lower than the foreign interest rate. The sale of New Zealand assets
by investors will result in the sale of New Zealand currency. Through sterilised intervention
in the foreign exchange market, the central bank of New Zealand is unable to return the
situation to equilibrium in this instance. As long as New Zealand's interest rate is lower than
the foreign rate, the massive capital outflow will continue.

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Fig 8.13: Monetary Policy with a Fixed Exchange Rate

Sterilized intervention would simply mean that the central bank of New Zealand would
quickly run out of foreign reserve assets. The central bank must allow its intervention to
reduce the money supply through the method described at the beginning of this section in
order to restore equilibrium. Until the LM schedule shifts back to the original position, LM,
the money supply will decline (M0). The New Zealand interest rate will be brought back to
parity with the foreign interest rate at this point (E0). The money supply will stop declining as
a result of the capital outflow. The money supply and income will also have returned to their
initial levels at this point. The monetary policy change will have had no effect at all.
Fiscal Policy
Regarding fiscal policy, the situation is quite different. The ideal capital mobility case is
shown in Figure 8.14 to show how an increase in government spending would affect the
economy. The shift of the IS schedule to the right from IS (G0) to IS (G1) is a direct result of
the increased spending (G1). Spending growth causes a huge capital inflow by raising the
domestic interest rate above the foreign interest rate. The domestic central bank must step in
and, in this instance, purchase foreign exchange using New Zealand dollars. The money
supply in New Zealand will increase as a result of this action. To change the LM schedule to
LM (M1) and bring back parity between domestic and foreign interest rates at point E1, the
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New Zealand central bank will need to continue purchasing foreign currency. The
expansionary impact of the rise in government spending is strengthened by this endogenous
increase in the money supply. The output increases to Y1 rather than Y'1.

Fig 8.14: Fiscal Policy with a Fixed Exchange Rate

This expansionary fiscal policy is extremely effective in a fixed exchange rate system with
perfect capital mobility because there is no increase in the domestic interest rate and
consequently no crowding out of private-sector spending.
Policy Effects under Flexible Exchange Rates
The situation is reversed in a flexible exchange rate system. Here, we discover that monetary
policy works effectively while fiscal policy completely fails.
Monetary Policy
Once again, we take into account a rise in the money supply from M0 to M1. Figure 8.15
demonstrates how this increased money supply causes the LM schedule to change from LM
(M0) to LM (M1). Similar to the fixed exchange rate scenario, the expansion of the money
supply causes the New Zealand interest rate to temporarily drop below the foreign interest
rate, which results in a significant outflow of capital. However, in a flexible exchange rate

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system, the New Zealand central bank does not intervene in the foreign exchange market as a
result. Instead, the New Zealand exchange rate increases and the value of the New Zealand
dollar decreases as investors sell New Zealand assets and as a result, sell New Zealand
dollars. This increase in the exchange rate causes a shift to the right in the IS schedule as well
as an increase in New Zealand exports and a decrease in New Zealand imports. New Zealand
dollars continue to be sold up until the exchange rate sufficiently increases from π0 to π1 and
shifting the IS schedule from IS (π0) to IS (π1).

Fig 8.15: Monetary Policy with a Flexible Exchange Rate

The New Zealand interest rate has now (E1) been brought back into parity with the foreign
interest rate. Revenue has increased to Y1. Perfect capital mobility and flexible exchange
rates make monetary policy very effective. Income increases by the full amount of the LM
schedule's horizontal shift. Notice that the interest rate, which is now fixed at the foreign
exchange rate, is no longer the mechanism by which monetary policy is implemented.
Instead, it is accomplished through net exports and the exchange rate.
Fiscal Policy
Figure 8.16 shows the results of an increase in government spending under conditions of
perfect capital mobility and flexible exchange rates. Increased government spending causes
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the IS schedule to shift from IS (G0, π0) to IS (G1, π0). As a result, the domestic interest rate
increases above the foreign interest rate, moving towards r1 in the figure. With a flexible
exchange rate, this movement results in a significant inflow of capital, which lowers the
exchange rate (the domestic currency to appreciate). As a result, imports increase while
exports decline. This shifts the IS schedule to the left. Only when the IS schedule has
completely shifted back to IS (G0, π0) = IS (G1, π1) and the domestic interest rate is once
again equal to the foreign interest rate the equilibrium restored. The pressure on the exchange
rate to fall and the capital inflow both stop at this point. At this point, income has also
returned to its starting point. This makes the fiscal policy completely ineffective.

Fig 8.16: Fiscal Policy with a Flexible Exchange Rate

8.6 SUMMARY
This chapter has dealt with the determination of exchange rates and the related issue of how
the global monetary system is set up. The ideal level of flexibility in exchange rate
determination is a key question in the field. The majority of the major currencies experienced
a managed float after the Bretton Woods system broke down. Throughout the period of
floating exchange rates, the US dollar's value has been quite irregular. There have been calls
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for changes to the international monetary system during times of sharply fluctuating currency
values in order to provide more stability of exchange rates.
In order to achieve greater exchange rate stability, national macroeconomic policies would
probably need to be better coordinated. Effective international policy coordination is
hampered by a number of factors, not the least of which are the divergent political ideologies
and industrial configurations of the major world economies. Freeing nations from the need to
coordinate policies, floating exchange rates come at the expense of extremely volatile
exchange rates. Growing current account imbalances among the major economies of the
world have recently prompted calls for better policy coordination.
In this chapter, we have also examined within an open economy version of the IS-LM model,
monetary and fiscal policy for both cases of imperfect and perfect capital mobility. Between
the two cases, there are clear differences. The following results are particularly striking when
perfect capital mobility is assumed: If the exchange rate is fixed, neither fiscal nor monetary
policy will have any effect. If the exchange rate is flexible, neither will have any effect.
Though there are some quantitative differences, our findings are more in line with the closed
economy IS-LM model when capital mobility is imperfect.
One study came to the conclusion that the world capital markets were probably "two-thirds or
three-fourths of the way but no further than that" towards perfect capital mobility based on
the situation in the middle of the 1980s. Over the past 40 years, capital markets have
advanced further in that direction. A preference for the model with imperfect capital mobility
but a comparatively flat BP schedule may result from this trend. However, it is challenging to
make a generalisation that applies to all nations. Government controls on capital movements
exist in some countries, though their prevalence is declining. These controls severely limit
capital mobility. The assumption of perfect capital mobility is preferable for other nations
whose capital markets are closely integrated with those of a large neighbour, such as Canada
and Austria.

8.7 GLOSSARY

Balance of Payments: The balance of payments accounts keep track of all economic
exchanges of goods and assets between the home country and foreign residents.
BP schedule: The BP schedule displays the combinations of r and Y that, at a specific
exchange rate, will balance supply and demand in the foreign exchange market.

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Bretton Woods System: It was a pegged exchange rate system set up at the end of World
War II.
Capital Account Convertibility: This refers to the freedom to carry out investment
transactions free from restrictions, i.e., there are no limits on the amount of rupees an Indian
resident may convert into foreign currency in order to purchase any foreign asset.
Exchange Rate: It is the value of a nation's currency in relation to other currencies.
Exchange Rate System: It is a set of rules for determining exchange rates between
currencies.
Financial Account: It keeps track of foreign residents' purchases of Indian assets (capital
inflows) and Indian residents' purchases of foreign assets (capital outflows).
Foreign Exchange: It is a general term to refer to an aggregate of foreign currencies.
LM Schedule: It displays combinations of r and Y that represent money market equilibrium.
IS Schedule: It displays combinations of r and Y that represent equilibrium in the goods
market.
Sterilization: A central bank may use sterilisation as a form of monetary action to reduce the
impact of capital inflows and outflows on the money supply.

8.8 ANSWERS TO IN-TEXT QUESTIONS

1. True 4. False. It is determined by both the supply

and demand in the foreign exchange market
2. (d) All of the above
3. It is both a Forward market and a Spot 5. Accommodating transactions
market.

8.9 SELF-ASSESSMENT QUESTIONS

● Define balance of payments accounts. Describe the various items that are listed in the
balance of payments accounts.
● Describe how a fixed exchange rate system determines a country's exchange rate.
● Describe the Bretton Woods system, which was established at the end of World War II
and remained in place until 1973.
● Explain how, in a fixed exchange rate system, the trade balance and the level of
economic activity are related.
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● Explain the connections between balance of payments equilibrium and both

expansionary monetary and fiscal policies within a fixed exchange rate system, taking
into account the impact on the trade balance and the financial account.
● "The adoption of a flexible exchange rate regime would liberate monetary and fiscal
policy for use in achieving domestic goals of full employment and price stability."
Comment.
● What are some of the relative benefits and drawbacks of fixed exchange rates in
comparison to flexible exchange rates?
● Analyse the effects of the following policy actions for both the fixed and flexible
exchange rate cases in the Mundell-Fleming model under the assumption of imperfect
capital mobility: a. A decrease in the amount of money. b. A reduction in public
spending.
● Explain why, even with perfect capital mobility, fixed exchange rates render monetary
policy completely ineffective.
● What does it mean to sterilise the effects of interventions in the foreign exchange
market? Describe how sterilisation functions when capital mobility is insufficient.

8.10 REFERENCES
Mundell, Robert (1963), Capital Mobility and Stabilization Policy Under Fixed and Flexible
Exchange Rates. Canadian Journal of Economics and Political Science, pp. 475-485.
Fleming, Marcus (1962), Domestic Financial Policies Under Fixed and Under Floating
Exchange Rates. International Monetary Fund Staff Papers, pp. 369-379.

8.11 SUGGESTED READINGS

Froyen, R. P. (2011): Macroeconomics-theories and policies (8th Edition). Pearson.
Dornbusch and Fischer (2010): Macroeconomics (9th Edition). Tata McGraw Hill.
Gregory Mankiw (2010). Macroeconomics (7th Edition). Worth Publishers.

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