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I MACRO ECONOMICS 1. Basic Macroeconomics Income And 1 M.A.PART - I ECONOMIC PAPER - I MACRO ECONOMICS 1. Basic Macroeconomics Income and spending – The consumption function – Savings and investment – The Keynesian Multiplier – The budget – Balanced budget : theorem and multipliers. Money, interest and income – The IS-LM model – adjustment towards equilibrium – Monetary policy, the transmission mechanism and the liquidity trap – Basic elements of growth theory : Neoclassical and endogenous. 2. Behavioural foundations of Macroeconomics Consumption and savings – Consumption under certainty : The life-cycle and permanent income hypotheses – Consumption under uncertainty : The random walk approach – Interest rate and savings. – Money stock determination - The money multiplier – instruments of monetary control – Money stock and interest rate targeting. 3. Dynamic macroeconomics The dynamic aggregate supply curve – The long-run supply curve – short and long run Phillips curves – Strategies to reduce inflation, money, deficit and inflation – The Fisher equation – Deficits and money growth – The inflation tax, interest rates, deficit and debt – The instability of debt financing – Structuralist models of inflation and growth. 4. Open Economy Macroeconomics The balance of payments and exchange rates – The current account and market equilibrium – The Mundell-Fleming models : Fixed and flexible exchange rates. – The automatic adjustment process – Expenditure switching / reducing policies – Exchange rate changes and trade adjustments : Empirical issues – the monetary approach to the balance of payments – The Polak- IMF model – Flexible exchange rates. Money and prices – exchange rate overshooting – Interest differentials and 2 exchange rate expectations – Exchange rate fluctuations and policy intervention. 5. The New Macroeconomics Rational expectations – anticipated and unanticipated shocks – Policy irrelevance : The Lucas Critique. Real business cycle theory – Propagation mechanism – The persistence of output fluctuations – The random walk of GDP : Nelson and Plosser. Microeconomic foundations of incomplete nominal adjustment – New Keynesian models of price stickiness : The Mankiw model – Co-ordination failure models. – The efficiency-wage model- Implicit contracts-Insider – outsider models – Hysteresis 6. Macroeconomic Policy Issues Specification of monetary policy – Guidelines for fiscal adjustment. Fiscal policy rules – Exchange rate policies – Debt management policies – Policy coordination problems. Some macroeconomic policy issues. Targets, indicators and instruments – Activist policy. Lags in the effects of policy – Expectations, uncertainty and policy – Gradualism versus shock therapy. The role of credibility – Rules versus discretion – The dynamic inconsistency problem. The political economy of stabilization and adjustment. 3 1 Module 1 BASIC MACROECONOMICS Unit Structure 1.0 Objectives 1.1 Introduction of consumption function 1.2 The concept of consumption function 1.3 Properties or technical attributes of consumption function 1.4 Introduction of savings and investment 1.5 Meaning of saving and saving function or propensity to save 1.6 Technical attributes of propensity to save 1.7 Meaning and importance of investment 1.8 Determinants of investment 1.9 The Keynesian multiplier 1.10 Questions 1.0 OBJECTIVES After having studied this unit, you should be able To Understand the fundamentals of Macro Economics To Know the nature of Income and Spending To understand the most basic model of aggregate demand, spending determines - output and income, but output and income also determine spending. In particular, consumption depends on income, but increased consumption increases aggregate demand and therefore output. Increases in autonomous spending increase output more than one for one. In other words, there is a multiplier effect. The size of the multiplier depends on the marginal propensity to consume and on tax rates. Increases in government spending increase aggregate demand and therefore tax collections. But tax collections rise by less than the increase in government spending, so increased government spend increases the budget deficit 4 1.1 INTRODUCTION OF CONSUMPTION FUNCTION The world famous modern economist Lord J. M. Keynes wrote a well known book ―General theory of employment, interest and money‖ in 1936. Keynes theory of income and employment states that the volume of employment in the economy depends upon the level of effective demand. The level of effective demand is determined by the aggregate demand function and aggregate supply function. In a two sector mode, Keynes made use of two components of aggregate demand viz. consumption expenditure and investment expenditure. Consumption expenditure is an important constituent of aggregate demand in an economy. Keynes was not interested in the factors determining aggregate supply, since he was concerned with short run and existing productive capacity. 1.2 THE CONCEPT OF CONSUMPTION FUNCTION As demand of a commodity depends upon its price [DD=f (P)]. Similarly the consumption of a commodity depends upon the level of income. The consumption function or propensity to consume refers to an empirical income consumption relationship. It is a functional relationship indicating how consumption varies as income varies. Consumption function is a simple relation between income (Y) and consumption (C). Symbolically C = f (Y) …3.1 Where, C: Consumption f: Functional relationship Y: Income In the functional relation, consumption is dependent variable and income is independent variable. Hence consumption is dependent on income. Apart from income there are many other subjective and objective factors which can influence consumption. But income is an important factor. Thus the consumption function is based on Ceteris Paribus assumption. The functional relationship between income and consumption can take different forms. The simplest form of consumption function would be 5 Figure 1.1 C = bY Where, C : Consumption b : Marginal propensity to consume Y : Income The consumption function expressed above shows that consumption is a constant proportion of income. This consumption function is shown graphically in Figure 1.1 In figure 3.1 income is measured on X-axis and consumption is measured on Y-axis. The 45 line (i.e. C=Y) shows that consumption is equal to income. The curve C = bY…….is the consumption function curve (if b =34or 0.75). The consumption function curve C = bY indicates that if income is zero consumption will be zero. But in practice this is not true. However at zero income, consumption is positive (because it is function is sometime expressed in the following form. C = a + bY Where, C : Consumption a : autonomous consumption b : Marginal propensity to consume Y : Income In fact consumption function is a schedule of various amounts of consumption expenditure corresponding to different level of income. The schedule of consumption function is illustrated in the following table: 6 Table 1.1 Schedule of Consumption function (Rs. crores) Income (Y) = Consumption (C) + Savings (S) 00 20 -20 70 80 -10 140 140 00 210 200 10 280 260 20 350 320 30 420 380 40 Table : 1.1 shows that consumption is an increasing function of income. When income is zero (00) people spend out of their past saving or borrowed income on consumption because they must eat in order to live. When income increases in the economy to the extent of Rs. 70 crores, but it is not enough to meet the consumption expenditure of Rs. 80 crores (negative saving). When both income and consumption expenditure are equal Rs. 140 cores, it is basic consumption level, where saving is zero. After this income is shown to increase by Rs. 70 crores and consumption by Rs. 60 crores i.e. saving by 10 crores. This implies a stable or constant consumption function during the short run as assumed by Keynes. Fig. 3.2 explains the above schedule diagrammatically. In the diagram, income is measured on X-axis and consumption is measured on Y-axis. 45 line i.e. Y = C line I the unity line where at all levels, consumption and income are equal. The C= a + bY curve is linear consumption function curve which is based on the assumption that in the short run consumption changes by the equal amount. C = a +bY curve slopes upward from left to right which indicated that consumption is an increasing function of income. It also indicated that at zero level of income consumption is positive to the extent of OA. At point B consumption function curve intersect to unity line where consumption is OC and income is OY. In the figure point B is the Break Even Point where consumption is equal to income (C = Y). Before the break even point consumption is greater than (C < Y). Above the break even point saving becomes positive and below the break even point saving becomes negative. 7 Figure 1.2 The concept of consumption function given by Lord J. M. Keynes is not a linear consumption function form as explained in figure 3.1, but it is in the form of non-linear (curve-linear) consumption function. To explain the concept of consumption function Keynes most probably never used any statistical information. When he wrote general theory, no time series data was available pertaining to national income or national expenditure for any country. Hence his law of consumption function is mainly based on general observation and deductive reasoning to discover relationship between income and consumption. Keynesian, theory of consumption has been empirically tested in the recent decades by the number of economists. The empirical proof of
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