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The money supply is all the currency and other liquid instruments in a country’s economy on the date measured. The money supply roughly includes both cash and deposits that can be used almost as easily as cash.

In macroeconomics, the money supply (or money stock) is the total value of money available in an economy at a point of time. There are several ways to define “money”, but standard measures usually include currency in circulation and demand deposits (depositors’ easily accessed assets on the books of financial institutions). The central bank of each country may use a definition of what constitutes money for its purposes.

Governments issue paper currency and coin through some combination of their central banks and treasuries. Bank regulators influence money supply available to the public through the requirements placed on banks to hold reserves, how to extend credit and other regulation.

Money supply data is recorded and published, usually by the government or the central bank of the country. Public and private sector analysts monitor changes in the money supply because of the belief that such changes affect the price levels of securities, inflation, the exchange rates, and the business cycle.

The relationship between money and prices has historically been associated with the quantity theory of money. There is strong empirical evidence of a direct relationship between the growth of the money supply and long-term price inflation, at least for rapid increases in the amount of money in the economy. For example, a country such as Zimbabwe which saw extremely rapid increases in its money supply also saw extremely rapid increases in prices (hyperinflation). This is one reason for the reliance on monetary policy as a means of controlling inflation.

The nature of this causal chain is the subject of some debate. Some heterodox economists argue that the money supply is endogenous (determined by the workings of the economy, not by the central bank) and that the sources of inflation must be found in the distributional structure of the economy.

In addition, those economists seeing the central bank’s control over the money supply as feeble say that there are two weak links between the growth of the money supply and the inflation rate. First, in the aftermath of a recession, when many resources are underutilized, an increase in the money supply can cause a sustained increase in real production instead of inflation. Second, if the velocity of money (i.e., the ratio between nominal GDP and money supply) changes, an increase in the money supply could have either no effect, an exaggerated effect, or an unpredictable effect on the growth of nominal GDP.

• Central bank money: Obligations of a central bank, including currency and central bank depository accounts
• Commercial bank money: Obligations of commercial banks, including checking accounts and savings accounts.

Effect of Money Supply on the Economy

An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production. The increased business activity raises the demand for labor. The opposite can occur if the money supply falls or when its growth rate declines.

Change in the money supply has long been considered to be a key factor in driving macroeconomic performance and business cycles. Macroeconomic schools of thought that focus heavily on the role of money supply include Irving Fisher’s Quantity Theory of Money, Monetarism, and Austrian Business Cycle Theory.

Historically, measuring the money supply has shown that relationships exist between it and inflation and price levels. However, since 2000, these relationships have become unstable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are one of a wide array of economic data that economists and the Federal Reserve collects and reviews.

There are several definitions of the supply of money. M1 is narrowest and most commonly used. It includes all currency (notes and coins) in circulation, all checkable deposits held at banks (bank money), and all traveler’s checks. A somewhat broader measure of the supply of money is M2, which includes all of M1 plus savings and time deposits held at banks. An even broader measure of the money supply is M3, which includes all of M2 plus large denomination, long‐term time deposits, for example, certificates of deposit (CDs) in amounts over $100,000. Most discussions of the money supply, however, are in terms of the M1 definition of the money supply.

The various types of money in the money supply are generally classified as Ms, such as M0, M1, M2 and M3, according to the type and size of the account in which the instrument is kept. Not all of the classifications are widely used, and each country may use different classifications. The money supply reflects the different types of liquidity each type of money has in the economy. It is broken up into different categories of liquidity or spendability.

M0 and M1, for example, are also called narrow money and include coins and notes that are in circulation and other money equivalents that can be converted easily to cash. M2 includes M1 and, in addition, short-term time deposits in banks and certain money market funds.1 M3 includes M2 in addition to long-term deposits. However, M3 is no longer included in the reporting by the Federal Reserve.3 MZM, or money zero maturity, is a measure that includes financial assets with zero maturity and that are immediately redeemable at par. The Federal Reserve relies heavily on MZM data because its velocity is a proven indicator of inflation.4

Money supply data is collected, recorded, and published periodically, typically by the country’s government or central bank.

Banking business. In order to understand the factors that determine the supply of money, one must first understand the role of the banking sector in the money‐creation process. Banks perform two crucial functions. First, they receive funds from depositors and, in return, provide these depositors with a checkable source of funds or with interest payments. Second, they use the funds that they receive from depositors to make loans to borrowers; that is, they serve as intermediaries in the borrowing and lending process.

When banks receive deposits, they do not keep all of these deposits on hand because they know that depositors will not demand all of these deposits at once. Instead, banks keep only a fraction of the deposits that they receive. The deposits that banks keep on hand are known as the banks’ reserves. When depositors withdraw deposits, they are paid out of the banks’ reserves. The reserve requirement is the fraction of deposits set aside for withdrawal purposes. The reserve requirement is determined by the nation’s banking authority, a government agency known as the central bank. Deposits that banks are not required to set aside as reserves can be lent to borrowers, in the form of loans. Banks earn profits by borrowing funds from depositors at zero or low rates of interest and using these funds to make loans at higher rates of interest.

A balance sheet for a typical bank is given in Table. The balance sheet summarizes the bank’s assets and liabilities. Assets are valuable items that the bank owns and consist primarily of the bank’s reserves and loans. Liabilities are valuable items that the bank owes to others and consist primarily of the bank’s deposit liabilities to its depositors. In Table, the bank’s assets (reserves and loans) total $1 million. The bank’s liabilities (deposits) total $1 million. A banking firm’s assets must always equal its liabilities.

Assets		Liabilities
Reserves	$100,000	Deposits	$1,000,000
Loans	90,000

You can infer from Table that the reserve requirement in this example is 10%.

Money multiplier. The amount by which bank deposits expand in response to an increase in excess reserves is found through the use of the money multiplier, which is given by the formula

Money Multiplier = 1 / Reserve Requirement

Determinants of Money Supply

1. The Level of Bank Reserves:

The level of bank reserves is another determinant of the money supply. Commercial bank reserves consist of reserves on deposits with the central bank and currency in their tills or vaults. It is the central bank of the country that influences the reserves of commercial banks in order to determine the supply of money. The central bank requires all commercial banks to hold reserves equal to a fixed percentage of both time and demand deposits. These are legal minimum or required reserves.

Required reserves (RR) are determined by the required reserve ratio (RRr) and the level of deposits (D) of a commercial bank: RR-RRr’ D. If deposits amount of Rs 90 lakhs and required reserve ratio is 25 percent, then the required reserves will be 25% x 90=Rs 22.5 lakhs. If the reserve ratio is reduced to 25 per cent, the required reserves will also be reduced to Rs 22.5 lakhs.

Thus the higher the reserve ratio, the higher the required reserves to be kept by a bank, and vice versa. But it is the excess reserves (ER) which are important for the determination of the money supply. Excess reserves are the difference between total reserves (TR) and required reserves (RR): ER=TR-RR. If total reserves are Rs 90 lakhs and required reserves are Rs 25 lakhs, then the excess reserves are Rs 65 lakhs (Rs 90-25 lakhs).

When required reserves are reduced to Rs 8 lakhs, the excess reserves increase to Rs 72 lakhs. It is the excess reserves of a commercial bank which influence the size of its deposit liabilities. A commercial bank advances loans equal to its excess reserves which are an important component of the money supply. To determine the supply of money with a commercial bank, the central bank influences its reserves by adopting open market operations and discount rate policy.

Open market operations refer to the purchase and sale of government securities and other types of assets like bills, securities, bonds, etc., both government and private in the open market. When the central bank buys or sells securities in the open market, the level of bank reserves expands or contracts.

The purchase of securities by the central bank is paid for with cheques to the holders of securities who, in turn, deposit them in commercial banks thereby increasing the level of bank reserves. The opposite is the case when the central bank sells securities to the public and banks who make payments to the central bank through cash and cheques thereby reducing the level of bank reserves.

The discount rate policy affects the money supply by influencing the cost and supply of bank credit to commercial banks. The discount rate, known as the bank rate in India, is the interest rate at which commercial banks borrow from the central bank. A high discount rate means that commercial banks get less amount by selling securities to the central bank. The commercial banks, in turn, raise their lending rates to the public thereby making advances dearer for them. Thus there will be contraction of credit and the level of commercial bank reserves. Opposite is the case when the bank rate is lowered. It tends to expand credit and the consequent bank reserves.

It should be noted that commercial bank reserves are affected significantly only when open market operations and discount rate policy supplement each other. Otherwise, their effectiveness as determinants of bank reserves and consequently of money supply is limited.

2. The Required Reserve Ratio:

The required reserve ratio (or the minimum cash reserve ratio or the reserve deposit ratio) is an important determinant of the money supply. An increase in the required reserve ratio reduces the supply of money with commercial banks and a decrease in required reserve ratio increases the money supply.

The RR1 is the ratio of cash to current and time deposit liabilities which is determined by law. Every commercial bank is required to keep a certain percentage of these liabilities in the form of deposits with the central bank of the country. But notes or cash held by commercial banks in their tills are not included in the minimum required reserve ratio.

But the short-term assets along with the cash are regarded as the liquid assets of a commercial bank. In India the statutory liquidity ratio (SLR) has been fixed by law as an additional measure to determine the money supply. The SLR is called secondary reserve ratio in other countries while the required reserve ratio is referred to as the primary ratio. The raising of the SLR has the effect of reducing the money supply with commercial banks for lending purposes, and the lowering of the SLR tends in increase the money supply with banks for advances.

3. Public’s Desire to Hold Currency and Deposits:

People’s desire to hold currency (or cash) relative to deposits in commercial banks also determines the money supply. If people are in the habit of keeping less in cash and more in deposits with the commercial banks, the money supply will be large. This is because banks can create more money with larger deposits. On the contrary, if people do not have banking habits and prefers to keep their money holdings in cash, credit creation by banks will be less and the money supply will be at a low level.

4. High Powered Money and the Money Multiplier:

The current practice is to explain the determinants of the money supply in terms of the monetary base or high-powered money. High-powered money is the sum of commercial bank reserves and currency (notes and coins) held by the public. High-powered money is the base for the expansion of bank deposits and creation of the money supply. The supply of money varies directly with changes in the monetary base, and inversely with the currency and reserve ratios.

5. Other Factors:

The money supply is a function not only of the high-powered money determined by the monetary authorities, but of interest rates, income and other factors. The latter factors change the proportion of money balances that the public holds as cash. Changes in business activity can change the behaviour of banks and the public and thus affect the money supply. Hence the money supply is not only an exogenous controllable item but also an endogenously determined item.

The Quantity Theory of Money seeks to explain the factors that determine the general price level in an economy. According to this theory, the supply of money directly determines the price level.

The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.

In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double. The theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, and was influentially restated by philosophers John Locke, David Hume, Jean Bodin, and by economists Milton Friedman and Anna Schwartz in A Monetary History of the United States published in 1963.

The theory was challenged by Keynesian economics, but updated and reinvigorated by the monetarist school of economics. Critics of the theory argue that money velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between money supply and price level does not hold. In mainstream macroeconomic theory, changes in the money supply play no role in determining the inflation rate as it is measured by the CPI, although some outspoken critics such as Peter Schiff believe that an expansion of the money supply necessarily begets an increase in prices in a non-zero number of asset classes. In models where the expansion of the money supply does not impact inflation, inflation is determined by the monetary policy reaction function.

Alternative theories include the real bills doctrine and the more recent fiscal theory of the price level.

Exchange Equation

To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:

M*V = P*Q

Where:

M: Refers to the money supply

V: Refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP

P: Refers to the prevailing price level

Q: Refers to the quantity of goods and services produced in the economy

Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.

The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.

Demand for Money

The Exchange Equation can also be remodeled into the Demand for Money equation as follows:

Md = (P*Q)/V

Where:

Md: Refers to the demand for money

P: Refers to the price level in the economy

Q: Refers to the quantity of goods and services offered in the economy

V: Refers to the Velocity of Money

In the formula, the numerator term (P x Q) refers to the nominal GDP of a country. Moreover, the equation provides another take on the monetarist theory as it relates GDP to the demand for money (contrary to Keynesian economists, who believe that interest rates drive inflation).

The value of money, as revealed by the money market, is variable. A change in money demand or a change in the money supply will yield a change in the value of money and in the price level. Notice that the change in the value of money and the change in the price level are of the same magnitude but in opposite directions. An increase in the money supply is depicted. Notice that the new intersection of the money supply curve and the money demand curve is at a lower value of money but a higher price level. This happens because more money is in circulation, so each bill becomes worth less. It takes more bills to purchase goods and services, and thus the price level increases accordingly.

The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases. In the SparkNote on inflation we learned that inflation is defined as an increase in the price level. Based on this definition, the quantity theory of money also states that growth in the money supply is the primary cause of inflation.

Limitations:

This theory has been criticised on several grounds:

(i) Inoperative below Full Employment:

It is alleged that the quantity theory of money comes into its own only during period of full employment of resources. Assuming con­stancy in V, V’, T, Y, etc., a change in money supply will bring about a change in price level. During the period of full employment, T or Y remains unchanged. During such a time, even if money supply rises, T or Y will not change.

On the other hand, price level will rise. But, in reality, full employment of resources is a rare possibility. What we find in reality is unem­ployment or underemployment of resources. During underemployment an increase in money supply will tend to raise output level and, hence, T, but not P. So, quantity theory of money breaks down when resources remain at full employment.

(ii) V, T, etc., do not Remain Fixed:

Secondly, in a dynamic economy V, V’, T, the ratio of M to M’ never remain constant. In such an economy, a change in any of the variables may cause a change in price level, even if money supply does not change. In this sense, these are not independent variables, although the authors of this theory assumed quantity of money as independent of other elements of the equation.

(iii) It is Identity, That is, Always True:

Thirdly, Fisher’s equation is an identity. MV and PT are always equal. In fact, the quantity theory of money is a hypothesis and not an identity which is always true.

(iv) Aggregate Demand/Expenditure, and not M, Influences Price Level:

Fourthly, Keynes argued that price level in an economy is not influenced by money supply. The im­portant determinant of money supply is the income level and the total expenditure of the country. According to Keynes, an increase in money supply is tantamount to an increase in effective demand.

After attaining the stage of full employment, an increase in effective de­mand which is the sum of consumption ex­penditure, investment expenditure and gov­ernment expenditure (i.e., C + I + G) will raise the price level, but not proportionately.

(v) Too much Emphasis on Money Supply:

Fifthly, change in price level is caused by vari­ous factors, besides money supply. For exam­ple, an increase in cost of production has an important bearing on the price level. For in­stance, an increase in wage rate following a revision in the pay scale of employees or an increase in the price of raw materials (say, hike in the price of petroleum products) will definitely push the price level up, whether the economy stays on or below the full employ­ment level. The quantity theory attaches too much importance on money supply.

(vi) M Influences P via Interest Rate:

Sixthly, the classical theory establishes a direct and proportional relationship between money supply and price level. Critics say that the relationship is not a direct one. Fisher ignored the influence of the rate of interest on the price level. Supply of bank money or credit money is influenced largely by the interest rate.

It is argued that the increase in money supply first affects the rate of interest which influences total output and price level in the ultimate analysis.

The casual relationship is: Change in the stock of money → change in interest rate change in investment → change in in­come, employment and output → change in general prices.

Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available. Higher prices are then the result, as costs of production increases due to a decreased aggregate supply. It stands in contrast to demand-pull inflation. Both accounts of inflation have at various times been put forward with oftentimes inconclusive evidence as to which explanation is superior.

Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials. Cost-push inflation is determined by supply-side factors, such as higher wages and higher oil prices.

Cost-push inflation is different to demand-pull inflation which occurs when aggregate demand grows faster than aggregate supply.

Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary.

A situation that has been often cited of this was the oil crisis of the 1970s, which some economists see as a major cause of the inflation experienced in the Western world in that decade. It is argued that this inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC.

Since, petroleum is so important to industrialized economies, a large increase in its price can lead to the increase in the price of most products, raising the price level. Some economists argue that such a change in the price level can raise the inflation rate over longer periods, due to adaptive expectations and the price/wage spiral, so that a supply shock can have persistent effects.

Causes

• Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices and higher transport costs. All firms would see some rise in costs. As the most important commodity, higher oil prices often lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
• Imported Inflation. A devaluation will increase the domestic price of imports. Therefore, after a devaluation, we often get an increase in inflation due to rising cost of imports.
• Higher Wages. Wages are one of the main costs facing firms. Rising wages will push up prices as firms have to pay higher costs (higher wages may also cause rising demand)
• Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price increase will be a temporary increase.
• Profit-push inflation. If firms gain increased monopoly power, they are in a position to push up prices to make more profit
• Higher Food Prices. In western economies, food is a smaller % of overall spending, but in developing countries, it plays a bigger role.

Policies to Reduce Cost-Push Inflation

Policies to reduce cost-push inflation are essentially the same as policies to reduce demand-pull inflation.

The government could pursue deflationary fiscal policy (higher taxes, lower spending) or monetary authorities could increase interest rates. This would increase the cost of borrowing and reduce consumer spending and investment.

The problem with using higher interest rates is that although it will reduce inflation it could lead to a big fall in GDP.

For example, in early 2008, we had a high period of inflation (5%) due to rising oil and food prices. Central banks kept interest rates high, but this pushed the economy into recession. Arguably, interest rates should have been lower and less importance attached to reducing cost-push inflation.

In 2010, we might see a period of cost-push inflation, but, the Central Bank may need to adopt a certain flexibility in inflation targeting. There is no point in rigidly sticking to an inflation target if the inflation is caused by temporary factors.

The long-term solution to cost-push inflation could be better supply-side policies which help to increase productivity and shift the AS curve to the right. But, these policies would take a long time to have an effect.

Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as “too much money chasing too few goods. “More accurately, it should be described as involving “too much money spent chasing too few goods,” since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at a full employment level. It is the opposite of cost-push inflation.

Causes of demand-pull inflation

• There is a quick increase in consumption and investment along with extremely confident firms.
• There is a sudden increase in exports due to huge under-valuation of the currency.
• There is a lot of government spending.
• The expectation that inflation will rise often leads to a rise in inflation. Workers and firms will increase their prices to ‘catch up’ to inflation.
• There is excessive monetary growth, when there is too much money in the system chasing too few goods. The ‘price’ of a good will thus increase.
• There is a rise in population.
• A depreciation of the exchange rate which makes exports more competitive in overseas markets leading to an injection of fresh demand into the circular flow and a rise in national and demand for factor resources – there may also be a positive multiplier effect on the level of demand and output arising from the initial boost to export sales.
• Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or indirect taxation or higher government spending and borrowing. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased borrowing feeds through directly into extra demand in the circular flow.
• Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand, for example in raising demand for loans or in causing rise in house price inflation.
• Faster economic growth in other countries, Providing a boost to UK exports overseas.
• Improved business confidence which prompts firms to raise prices and achieve better profit margins

Demand-pull inflation means:

• Excess demand and ‘too much money chasing too few goods.’
• The economy is at (or ver close to) full employment/full capacity.
• The economy will be growing at a rate faster than the long-run trend rate.
• A falling unemployment rate.

How demand-pull inflation occurs

If aggregate demand is rising at 4%, but productive capacity is only rising at 2.5%; firms will see demand outstripping supply. Therefore, they respond by increasing prices.

Also, as firms produce more, they employ more workers, creating a rise in employment and fall in unemployment. This increased demand for workers puts upward pressure on wages, leading to wage-push inflation. Higher wages increase the disposable income of workers leading to a rise in consumer spending.

The Liquidity Preference Theory says that the demand for money is not to borrow money but the desire to remain liquid. In other words, the interest rate is the ‘price’ for money.

John Maynard Keynes created the Liquidity Preference Theory in to explain the role of the interest rate by the supply and demand for money. According to Keynes, the demand for money is split up into three types; Transactionary, Precautionary and Speculative.

He also said that money is the most liquid asset and the more quickly an asset can be converted into cash, the more liquid it is.

In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936) to explain determination of the interest rate by the supply and demand for money. The demand for money as an asset was theorized to depend on the interest foregone by not holding bonds (here, the term “bonds” can be understood to also represent stocks and other less liquid assets in general, as well as government bonds). Interest rates, he argues, cannot be a reward for saving as such because, if a person hoards his savings in cash, keeping it under his mattress say, he will receive no interest, although he has nevertheless refrained from consuming all his current income. Instead of a reward for saving, interest, in the Keynesian analysis, is a reward for parting with liquidity. According to Keynes, money is the most liquid asset. Liquidity is an attribute to an asset. The more quickly an asset is converted into money the more liquid it is said to be.

According to Keynes, demand for liquidity is determined by three motives:

• The transactions motive: people prefer to have liquidity to assure basic transactions, for their income is not constantly available. The amount of liquidity demanded is determined by the level of income: the higher the income, the more money demanded for carrying out increased spending.
• The precautionary motive: people prefer to have liquidity in the case of social unexpected problems that need unusual costs. The amount of money demanded for this purpose increases as income increases.
• Speculative motive: people retain liquidity to speculate that bond prices will fall. When the interest rate decreases people demand more money to hold until the interest rate increases, which would drive down the price of an existing bond to keep its yield in line with the interest rate. Thus, the lower the interest rate, the more money demanded (and vice versa).

The Transactions Demand for Money:

The transactions demand for money arises from the medium of exchange function of money in making regular payments for goods and services. According to Keynes, it relates to “the need of cash for the current transactions of personal and business exchange.” It is further divided into income and business motives.

The income motive is meant “to bridge the interval between the receipt of income and its disbursement.” Similarly, the business motive is meant “to bridge the interval between the time of incurring business costs and that of the receipt of the sale proceeds.”

If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions, and vice versa. There will, however, be changes in the transactions demand for money depending upon the expectations of income recipients and businessmen. They depend upon the level of income, the interest rate, the business turnover, the normal period between the receipt and disbursement of income, etc.

Given these factors, the transactions demand for money is a direct proportional and positive function of the level of income, and is expressed as L=kY

where LT is the transactions demand for money, k is the proportion of income which is kept for transactions purposes, and Y is the income.

The Precautionary Demand for Money:

The precautionary motive relates to “the desire to provide for contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous purchases.” Both individuals and businessmen keep cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies.

Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to gain from unexpected deals. Therefore, “money held under the precautionary motive is rather like water kept in reserve in a water tank.” The precautionary demand for money depends upon the level of income, business activities, opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank reserves, etc.

Keynes held that the precautionary demand for money, like transactions demand, was a function of the level of income. But the post-Keynesian economists believe that like transactions demand, it is inversely related to high interest rates.

The transactions and precautionary demand for money will be unstable, particularly if the economy is not at full employment level and transactions are, therefore, less than the maximum, and are liable to fluctuate up or down. Since precautionary demand, like transactions demand is a function of income and interest rates, the demand for money for these two purposes is expressed in the single equation LT = f (Y,r).

The Speculative Demand for Money:

The speculative (or asset or liquidity preference) demand for money is “for securing profit from knowing better than the market what the future will bring forth”. Individuals and businessmen having funds, after keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an opportune moment in interest-bearing bonds or securities.

Liquidity Trap:

Keynes visualised conditions in which the speculative demand for money would be highly or even totally elastic so that changes in the quantity of money would be fully absorbed into speculative balances. This is the famous Keynesian liquidity trap. In this case, changes in the quantity of money have no effects at all on prices or income.

According to Keynes, this is likely to happen when the market interest rate is very low so that yields on bonds, equities and other securities will also below.

At a very low rate of interest, such as r2, in Figure 5, the Ls curve becomes perfectly elastic and the speculative demand for money is infinitely elastic. This portion of the Ls curve is known as the liquidity trap. At such a low rate, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will mean a definite loss. People will not buy bonds so long as the interest rate remains at the low level and they will be waiting for the rate of interest to return to the “normal” level and bond prices to fall.

According to Keynes, as the rate of interest approaches zero, the risk of loss in holding bonds becomes greater. “When the price of bonds has been bid up so high that the rate of interest is, say, only 2 per cent or less, a very small decline in the price of bonds will wipe out the yield entirely and a slightly further decline would result in loss of the part of the principal.” Thus, the lower the interest rate, the smaller the earnings from bonds. Therefore, the greater the demand for cash holdings. Consequently, the Ls curve will become perfectly elastic.

Further, according to Keynes, “a long-term rate of interest of 2 per cent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.” This makes the Ls curve “virtually absolute in the sense that almost everybody prefers cash to holding a debt which yields so low a rate of interest.”

Prof. Modigliani believes that an infinitely elastic Ls curve is possible in a period of great uncertainty when price reductions are anticipated and the tendency to invest in bonds decreases, or if there prevails “a real scarcity of investment outlets that are profitable at rates of interest higher than the institutional minimum.”

The phenomenon of liquidity trap possesses certain important implications:

First, the monetary authority cannot influence the rate of interest even by following a cheap money policy. An increase in the quantity of money cannot lead to a further decline in the rate of interest in a liquidity trap situation.

Second, the rate of interest cannot fall to zero.

Third, the policy of a general wage cut cannot be efficacious in the face of a perfectly elastic liquidity preference curve, such as Ls in Figure 5. No doubt, a policy of general wage cut would lower wages and prices, and thus release money from transactions to speculative purpose, the rate of interest would remain unaffected because people would hold money due to the prevalent uncertainty in the money market.

Last, if new money is created, it instantly goes into speculative balances and is put into bank vaults or cash boxes instead of being invested. Thus there is no effect on income. Income can change without any change in the quantity of money. Thus, monetary changes have a weak effect on economic activity under conditions of absolute liquidity preference.

The Total Demand for Money:

According to Keynes, money held for transactions and precautionary purposes is primarily a function of the level of income, LT =f (Y), and the speculative demand for money is a function of the rate of interest, Ls = f (r). Thus the total demand for money is a function of both income and the interest rate:

LT+Ls =f (Y)+f (r)

or L =f(Y)+f (r)

or L =f(Y,r)

where L represents the total demand for money. Thus the total demand for money can be derived by the lateral summation of the demand function for transactions and precautionary purposes and the demand function for speculative purposes, as illustrated in Figure 6 (A), (B) and (C). Panel (A) of the Figure shows OT, the transactions and precautionary demand for money at Y level of income and different rates of interest. Panel (B) shows the speculative demand for money at various rates of interest.

It is an inverse function of the rate of interest. For instance, at r. rate of interest it is OS and as the rate of interest falls to r2, the Ls curve becomes perfectly elastic. Panel (C) shows the total demand curve for money L which is a lateral summation of LT and Ls curves: L=LT+LS. For example, at r rate of interest, the total demand for money is OD which is the sum of transactions and precautionary demand OT plus the speculative demand TD, OD=OT+TD, where TD = OS. At r2 interest rate, the total demand for money curve also becomes perfectly elastic, showing the position of liquidity trap.

Criticisms

In Man, Economy, and State (1962), Murray Rothbard argues that the liquidity preference theory of interest suffers from a fallacy of mutual determination. Keynes alleges that the rate of interest is determined by liquidity preference. In practice, however, Keynes treats the rate of interest as determining liquidity preference. Rothbard states “The Keynesians therefore treat the rate of interest, not as they believe they do as determine by liquidity preference but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system.”

Criticism emanates also from post-Keynesian economists, such as circuitist Alain Parguez, professor of economics, University of Besançon, who “reject[s] the keynesian liquidity preference theory … but only because it lacks sensible empirical foundations in a true monetary economy”.

The national income and national product accounts of a country describe the economic performance or production performance of a country.

The most frequently cited summary measures of an economy’s performance are the gross national product (GNP) or gross domestic product (GDP). However, there is a subtle distinction between GNP and GDP since both move closely together. Anyway, the distinction between the two will be presented in due time.

• It shows flows of goods and services and factors of production between firms and households
• The circular flow shows how national income or Gross Domestic Product is calculated

Businesses produce goods and services and in the process of doing so, incomes are generated for factors of production (land, labour, capital and enterprise) for example wages and salaries going to people in work.

The national product is the value of final goods and services produced in a country. Since all the value produced must belong to someone in the form of a claim on the value, national product is equal to national income. Each transaction in an economy involves a buyer and a seller. Households spend money for buying goods and services produced.

Thus, from the buyer’s side comes the flow of money demand. In other words, we have expenditure side transaction. On the seller’s side, money payments go to factor owners in the form of rent, wages, etc. Firms spend money for buying input services. Thus, we have income- side transaction from the seller’s side. These two are obverse and reverse of the same coin. This is called circular flow of income and expenditure.

Firms and households.

Firms make production decision. Households are consuming units which absorb output produced in the business firms. Again, firms coordinate and employ different factor units which are owned by households.

In Fig. 8.1, goods and services flow from firms to households via the product market in return for the money payment for these goods and services by firms.

Arrowhead indicates such goods flow and money flow between firms and households. It is clear that the flow of monetary payment on goods and services by buyers must be identical to the money value of all goods and services that firms produce and sell to the households.

But wherefrom do the households get money? The diagram answers this question. Households supply factor inputs to firms via the factor market. In return, households receive money from firms in the form of rent, wages, etc. These income payments to households on hiring input services must be identical to the firms’ income.

This is the essence of the circular flow of income in a two-sector economy where there is no governmental activity and the economy is a closed one.

Adding these, we have:

Y = C + I

Where, Y denotes national incomes, C private consumption spending and I private investment spending.

In a three-sector (closed) economy, the government intervenes. It spends not only for the benefits of the general people and firms but also imposes taxes on them to finance its spending. If we add government activities (levying of taxes, T, and incurring expenditures, G), we have

Y = C + I + G

The relationship between households, firms and the government have been presented in a circular way in Fig. 8.2:

A four-sector economy is called an open economy in the sense that the country gets money by sending its goods outside, i.e., exports (X), and spends money by buying foreign-made goods and services, i.e., imports (M).

In other words, in an open economy, there occurs a trading relationship between nations. The circular flow model in a four-sector open economy has been shown in Fig. 8.3. Adding (X – M) in the above equation, we get

Y = C + I + G + (X – M)

 

The only difference in the circular flow of income between a closed economy and an open economy is that, in a four-sector economy, households purchase foreign-made goods and services (i.e., imports). Likewise, people of other countries purchase goods and services not produced domestically (i.e., exports).

Imports constitute leakage from the circular flow while exports constitute injection in the circular flow. For simplicity’s sake, we have not shown in the diagram that firms and governments also sell export goods and purchase import goods.

Note that (I + G + X) constitute injections into the circular flow of income while(S + T + M) constitute withdrawals or leakages from the circular flow of income. Injections increase national income and leakages decrease national income.

The national product or national income measures the overall economic performance of a nation. To measure the national product, we add up the value of all final goods and services produced in a country in a year. Thus, we focus on firms or sellers which receive payment for the production. This is the product method of calculating national income.

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

• Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
• Paid to the government in taxation (T) e.g. income tax and national insurance
• Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

• Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
• The government, i.e. government expenditure (G) e.g. on the NHS or defence
• Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

Closed economy Models

A closed economy is a country that does not import or export. A closed economy sees itself as self-sufficient and claims it does not want to trade internationally. In fact, it believes it does not need to trade.

A closed economy is a type of economy where the import and export of goods and services don’t happen, which implies that the economy is self-sufficient and has no trading activity from outside economics. The sole purpose of such an economy is to meet all the domestic consumers’ needs within the country’s border.

In a completely closed economy, there are no imports or exports. The country claims that it produces everything its citizens need. We also refer to this type economy as isolationist or an autarky.

A closed economy is the opposite of an open economy or a free-market economy. Open economies trade with other nations; they import and export goods and services. Hence, we also call them trading nations.

Maintaining a closed economy is more difficult today than two hundred years ago.

Certain raw materials are vital for the production of many products. For example, without oil, a country would not be able to function today. Many countries, such as Japan, need to import nearly all their raw materials.

Y = Cd + Id + Gd + X

Were,

Y: National income

Cd: Total domestic consumption

Id: Total investment in domestic goods and services

Gd: Government purchases of domestic goods and services

X: Exports of domestic goods and services

Importance of Closed Economy

With globalization and international trade, it is impossible to establish and maintain a closed economy. The open economy has no restrictions on imports. An open economy carries the risk of depending too much on imports. The domestic players will not be able to compete with international players. To tackle this the governments, use quotas, tariffs, and subsidies.

Resource availability across the globe varies and is never constant. Thus, depending on this availability, an international player will find out the best place to procure a particular resource and come up with the best price. Domestic players who have constraints to globalize will not be able to produce the same product at a price at par or discount compared to an international player. Thus domestic players will not be able to compete with the foreign players and the government uses the above options to provide support to domestic players and also reduce dependency on imports.

Advantages

• It is isolated from neighbors, so there is no fear of coercion or interference.
• Transit costs will be usually very less in the closed economy.
• Taxes on goods and products will be less and controlled by the government, less burden for consumers.
• Domestic players need not compete with the outside players and price competition is less.
• The self-sufficient economy will create proper demand for domestic products and agricultural products and producers will be compensated appropriately.
• Price fluctuations and volatility are easily controllable.

Limitations

• The economy will not grow if they are short of resources like oil, gas, and coal.
• The consumer will not get the best price for commodities compared to global prices.
• In case of emergencies, the economy will be hit severely as most of its production is only domestic.
• They must be able to meet all of its domestic demand internally, which is a difficult task to accomplish.
• They will have restrictions on goods and services to be sold and thus the opportunity for the consumers in such markets is more.
• Isolated economies can be looked down upon by the developing nations and globally such an economy can expect a limited aid when the need comes.

Reasons for Closed Economy

There are a few reasons a country might choose to have a closed economy or other factors that will facilitate the maintenance and building of a closed economy. It is assumed that the economy is self-sufficient and doesn’t require any import outside domestic borders to meet all of its demands from consumers.

• Isolation: An economy might be physically isolated from its trading partners (consider an island or a country surrounded by mountains). The natural boundaries of a country will factor this reason and lead the economy towards a closed one.
• Transit Cost: Due to physical isolation the transportation cost of goods will be highest leading to high transit costs. It doesn’t make sense in trade if the price of goods is increased due to the high overheads of transport and thus the economy tends to close in such cases.
• Government Decree: Governments might close down borders for taxes, regulations purposes. Thus, they will decree the trade with other economies. Violations will be punished. The government will try to support its domestic producers and tax international players to generate revenue.
• Cultural Preferences: Citizens might prefer to contact and trade only with citizens, this will lead to another barrier and facilitate a closed economy. For example, when McDonald’s came to India, people opposed the outlets claiming they use beef in their dishes and it was against culture.

Open economy Models

An open economy is a type of economy where not only domestic actors but also entities in other countries engage in trade of products (goods and services). Trade can take the form of managerial exchange, technology transfers, and all kinds of goods and services. (However, certain exceptions exist that cannot be exchanged; the railway services of a country, for example, cannot be traded with another country to avail the service.)

It contrasts with a closed economy in which international trade and finance cannot take place.

The act of selling goods or services to a foreign country is called exporting. The act of buying goods or services from a foreign country is called importing. Exporting and importing are collectively called international trade.

There are a number of economic advantages for citizens of a country with an open economy. A primary advantage is that the citizen consumers have a much larger variety of goods and services from which to choose. Additionally, consumers have an opportunity to invest their savings outside the country. There are also economic disadvantages of an open economy. Open economies are interdependent on others and this exposes them to certain unavoidable risks.

If a country has an open economy, that country’s spending in any given year need not equal its output of goods and services. A country can spend more money than it produces by borrowing from abroad, or it can spend less than it produces and lend the difference to foreigners. As of 2014 there is no totally-closed economy.

he basic model

In a closed economy, all output is sold domestically, and expenditure is divided into three components: consumption, investment, and government purchases.

Y = C + I + G

where Y is the national income, C is the total consumption, I is the total investment and G is the total government expenditure. In an open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy’s output Y into four components: Cd, consumption of domestic goods and services, Id, investment in domestic goods and services, Gd, government purchases of domestic goods and services, X, exports of domestic goods and services. The division of expenditure into these components is expressed in the identity

Y = Cd + Id + Gd + X.

The sum of the first three terms, Cd + I d + Gd, is domestic spending on domestic goods and services. The fourth term, X, is foreign spending on domestic goods and services (the value of exports).

Advantages

Lower Costs

Open economies are able to get cheaper imports and can sell exports at higher prices. In other words, both importers and exporters of open countries [and therefore, their consumers] benefit from price differentials.

Economic Growth

It is claimed that an open economy, with given productive resources, can have a higher GDP. Alternatively, for producing a given GDP, it spends a smaller quantity of productive resources.

This happens due to its enhanced access to improved and better technology which provides an upward thrust to economic development.

Global Prosperity and Flow of Productive Resources

Traditional economic thinking dealing with international economic transactions assumed that there was near absence of mobility (flow) of capital and other factors of production between countries.

Over time, however, the realities of international trade have belied this theory. Currently, enormous volumes of a variety of capital funds are circulating between world economies.

In addition, international flows of other inputs (raw materials and intermediate products, technology, institutional set ups, work ethos and, to some extent, even labour) have increased in varying degrees.

Some models of entrepreneurial and institutional set ups have gained the status of international standardisation. All this has also added to the overall global prosperity, as countries increasingly yearn, learn and earn together.

Superiority of Trade over Isolation

Some countries have been able to experience a rapid export-led economic growth. In contrast, it is difficult to find instances of widespread successful import substitution. Successful import substitution has been possible only in respect of a few specified industries.

Improved Availability of Goods and Services

International trade in goods and services enables each country to concentrate on the production of those goods in which it has a comparative cost advantage, and import those in which it has a comparative cost disadvantage. That way, it can add to the volume, variety and quality of goods and services that go into determining its GDP.

Impetus to Innovation

Open economies provide an incentive for research and adoption of innovations. This is because open economies have ‘lie benefit of a wider scope for their profitable application over bigger markets and recovery of huge research costs. However, being an open economy also has its drawbacks.

Disadvantages

1. Footloose Funds:

Currently, large amounts of “footloose” (that is, short term and/or speculative type) funds are moving around the world in search of places where they can be “parked” (that is, invested temporarily) within acceptable levels of safety and return.

Therefore, any change in one or both of these determining factors can lead to a large scale international movement of these funds.

2. Risk Exposure:

Open economies are interdependent. And this exposes them to certain unavoidable risks. Disturbances like trade cycles, and fluctuations in income, prices and employment etc., originating in one economy, spread to other economies also.

These disturbances may even gather strength in the process of dispersal. Consequently, all open economies, including the one from where a disturbance originates, are likely to suffer in varying degrees. Expectedly, the damage inflicted on the interdependent open economies is influenced by the following factors.

Size of the Economy:

More precisely, it is the proportion contributed by the originating economy in international economic transactions and the nature of these transactions.

By way of examples of this phenomenon, we can consider countries which have a large share in short-term capital flows or in energy sources like petroleum products, etc. and countries whose currencies are used as foreign exchange reserves, such as the US and the UK.

Intensity of the Initial Disturbance:

Other things being equal, a disturbance of higher initial intensity is likely to cause a correspondingly greater damage to the interconnected open economies.

Degree of Integration:

This factor is self-explanatory. Economies with greater restrictions on international economic transactions tend to suffer less when a disturbance originates in some other country.

When a number of South East Asian economies suffered heavily on account of a severe financial crisis in 1997-98, India could escape this disaster.

This was because Indian rupee was not freely convertible on capital account and short term capital funds could not leave the country on a large scale.

3. Indebtedness:

Large scale increase in international capital flows has resulted in problems like heavy indebtedness of certain countries and their inability to repay their debts. Starting with 1970s banks and other financial institutions, in search for better returns extended huge loans to some countries.

Their borrowers, however, could not use these loans for increasing their export earnings out of which to service them. Some of them could not “absorb” these loans productively for promoting their economic growth. This resulted in frequent bankruptcies of the borrowing governments and associated financial crises.

4. Import Dependence:

Certain varieties of imports can expose a country to undue political, economic and cultural risk. Examples are imports necessary for defence, health care, energy needs, food needs, and the like.

5. Growth Bringing Poverty:

There are instances where an expansion in international trade of a country has resulted in what is termed “immiserising growth”.

It happens when international trade adds to the productive capacity of a country, but its terms of trade deteriorate so much that there is a net decline in its economic welfare.

In addition, it is also possible that while there is an overall increase in economic welfare of the country, some sections happen to be net losers.

6. Constraints on Resource Use:

It is possible that a country is forced to adopt certain production technologies which do not let it make an optimum use of its factor-endowment.

Alternatively, it may have to face restrictions on its exports. Such a state of affairs may be thrust upon a country which has a weak bargaining strength or which is facing balance of payments difficulties.

For example, the USA and several other industrially advanced countries (with abundant capital resources) are interested in weakening competition from imported goods from labour-surplus countries like India.

They are insisting that imports should be totally banned (or at least severely restricted) if they are produced by “exploited” or “sweat” labour (that is, by labour which is paid at rates lower than those in rich countries like the USA) or by child labour.

The flaws in this logic are quite easy to see. Wage rates are expected to be lower in a labour-surplus economy. And it is this fact which makes its labour-intensive products competitive.

Similarly, it is a fact that child labour is extensively used in India in the manufacture of carpets and other handicrafts.

It is also admitted that it would be better if these children, instead of working, were attending schools. But that happy situation can be attained only if our economy grows and income levels of the parents rise. Till then, if these children are prevented from taking up jobs, their families would become still poorer.

7. Problems of Foreign Exchange:

These days, currencies are on “paper standard”.’ And historically, some leading currencies of the world (the most prominent being the US dollar) are being held as “foreign exchange reserves” by countries of the world for financing their trade and other international economic transactions.

Moreover, a rapid expansion in these transactions has added to the need for ever-increasing volumes of foreign exchange reserves.

The gross national income (GNI), previously known as gross national product (GNP), is the total domestic and foreign output claimed by residents of a country, consisting of gross domestic product (GDP), plus factor incomes earned by foreign residents, minus income earned in the domestic economy by non-residents.

GNI is the total amount of money earned by a nation’s people and businesses. It is used to measure and track a nation’s wealth from year to year. The number includes the nation’s gross domestic product plus the income it receives from overseas sources.

GNI is an alternative to gross domestic product (GDP) as a means of measuring and tracking a nation’s wealth and is considered a more accurate indicator for some nations.

Gross national product (GNP) is the market value of all the goods and services produced in one year by labor and property supplied by the citizens of a country. Unlike gross domestic product (GDP), which defines production based on the geographical location of production, GNP indicates allocated production based on location of ownership. In fact it calculates income by the location of ownership and residence, and so its name is also the less ambiguous gross national income.

GNP is an economic statistic that is equal to GDP plus any income earned by residents from overseas investments minus income earned within the domestic economy by overseas residents.

GNP does not distinguish between qualitative improvements in the state of the technical arts (e.g., increasing computer processing speeds), and quantitative increases in goods (e.g., number of computers produced), and considers both to be forms of “economic growth”.

The term gross national income (GNI) has gradually replaced the Gross national product (GNP) in international statistics. While being conceptually identical, the precise calculation method has evolved at the same time as the name change.

Criticism of gross national product

The gross national product (GNP) measures the welfare of a nation’s economy through the aggregate of products and services produced in that nation. Although GNP is a proficient measurement of the magnitude of the economy, many economists, environmentalists and citizens have been arguing the validity of the GNP in respect to measuring welfare.

Joseph Stiglitz, Nobel Prize–winning economist, states that this standard measurement for any national economy has become deficient as a measure of long-term economic health in our recently resource-driven and globalizing world. Critics suggest that GNP often includes the environment on the wrong side of the balance sheet because if someone first pollutes and then another person cleans the pollution, both activities add to GNP making environmental degradation frequently look good for the economy.

Critics of mainstream economics complain that GNP compiles spending that makes us worse off, spending that allows us to stay in the same place, and spending that makes us better off all in a single measure, giving a nation no clue if they are making progress or not.

Manfred Max-Neef, Chilean economist, explains that politicians feel that it is irrelevant whether the spending is productive, unproductive, or destructive. In this sense, it is common to see political policies that call to depredate a natural resource in order to increase the GNP. To take into account the environmental depredation and resource depletion, there is a call to shift away from the traditional GNP and construct an assessment of national product that takes into account environmental effects.

Need

Many people are calling for a green national product that would indicate if activities benefit or harm the economy and well-being. This green national product would revolve around the social and economic issues on which many green movements have focused: care for the earth and all that sustain it. This new national product would differ from the traditional GNP by addressing both the sustainability and well-being of the planet and its inhabitants. It is essential that this system takes into account natural capital, which is currently hidden from our traditional measurement.

Green GNP

Is an economic and environmental accounting framework which measures the national wealth by accounting for exhaustion of natural resources and degradation of environment and investment in environment support.

The goal of Green GDP is one of the dreams of every economist. An economist who could actually come up with a serious theory of Green GDP would go down in history as the one of the greatest economists ever!

That’s because in the big picture, “externalities” costs or benefits which are not born by the person performing the economic action which causes them are very important in determining the wealth of a society. But economists are very limited in their ability to study them.

Externalities include things like the cost imposed on society by potentially harmful emissions into the common spaces.

But Green GDP is cheap ideological political propaganda masquerading as economic science.

As economics, it is pure rubbish. It manufactures silly economic cost estimates with absolutely no scientific basis, based purely on continually changing “narratives”, invented by activists, and kept alive (as people eventually discover that their predictions are all falsified by reality) by

(a) Altering the public record of what they were saying

(b) Emotionalist propaganda to appeal to those who lack the intellectual curiosity to find out the facts. All this solely to support the authoritarian political agenda of its promoters.

In economics, the consumption function describes a relationship between consumption and disposable income. The concept is believed to have been introduced into macroeconomics by John Maynard Keynes in 1936, who used it to develop the notion of a government spending multiplier.

The Keynesian consumption function expresses the level of consumer spending depending on three factors.

• Yd = disposable income (income after government intervention – e.g. benefits, and taxes)
• a = autonomous consumption (consumption when income is zero. e.g. even with no income, you may borrow to be able to buy food)
• b = marginal propensity to consume (the % of extra income that is spent). Also known as induced consumption.

Consumption function formula

    C = a + b Yd

This suggests consumption is primarily determined by the level of disposable income (Yd). Higher Yd leads to higher consumer spending.

This model suggests that as income rises, consumer spending will rise. However, spending will increase at a lower rate than income.

• At low incomes, people will spend a high proportion of their income. The average propensity to consume could be one or greater than one. This means people spend everything they have. When you have low income, you don’t have the luxury of being able to save. You need to spend everything you have on essentials.
• However, as incomes rise, people can afford the luxury of saving a higher proportion of their income. Therefore, as incomes rise, spending increases at a lower rate than disposable income. People with high incomes have a lower average propensity to spend.

Limitations of consumption function

• Life cycle factors, Students more likely to borrow and spend during university days.
• Behavioural factors, People may be influenced by general optimism.

importance of the concept of propensity to consume is that we derive the theory of multiplier from it which has great practical importance in the formulation of macro-economic policy, especially of public works in times of depression. The magnitude of multiplier is equal to the reciprocal of one minus marginal propensity to consume (K = 1/1-MPC) where K stands for multiplier and MPC for marginal propensity to consume. According to this concept of multiplier, when investment increases, in­come, output and employment increase by a multiple amount, depending upon the size of the multiplier.

Income increases manifold than the original investment because of the nature of consumption function. When some investment in some projects is undertaken, it leads to the increase in income of those employed in the projects but the process does not stop here.

The increases in income are further spent on consumption and this leads to further increase in income and so the chain of increases in income and consumption continues and the ultimate increase in income and employment is multiple of the original increment in investment.

If the marginal propensity to consume were equal to zero, then all increments in income brought about by additional investment would have been saved and therefore multiplier process would not have worked. Since the marginal propensity to consume is greater than zero, the increase in net investment has a multiplier effect on income, output and employment. Thus, the effect of investment on income depends on the size of the multiplier which depends on the value of the marginal propensity to consume. The greater the marginal propensity to consume, the greater the size of the multiplier.

(4) From the concept of consumption function, we can also explain why there is a tendency for the marginal efficiency of capital to decline. The declining tendency of the marginal effi­ciency of capital is due to the nature of the consumption function. Two features of consumption function are important. First, the marginal propensity to consume is less than one which implies that as income increases, consumption increases less than this. Secondly, consumption function is stable in the short run i.e., it does not shift much in the short run.

As we know that the level of investment is a crucial factor in the determination of income and employment, fluctuations in the levels of income and employment depend primarily on the fluctuations in investment. The investment demand in the short run is determined by the rate of interest on the one hand and marginal efficiency of capital on the other. Since the rate of interest is relatively sticky, it is the marginal efficiency of capital which greatly affects the level of investment in the short run.

Marginal efficiency of capital is nothing but the expected rate of profit on investment in the future. Thus, the marginal efficiency of capital is determined by the expectations of the entrepreneurs regarding the earning of profits from capital assets in the future.

Now, the most, important fact that affects the entrepreneurs expectations regarding profit prospects and thereby the marginal efficiency of capital is the level of future consumption demand for goods and services. Their estimate of future consumption demand depends on, among others, on the population growth. If population growth of a country is expected to fall as was estimated in the early thirties when Keynes wrote his book (General Theory of Employment, Interest and Money), this would adversely affect future consumption demand which in turn would adversely affect investment in the long run, Besides, according to Keynes, average propensity to consume (APC) falls as income of a community increases overtime.

This also adversely affects inducement to invest. If there does not occur capital-using technological change, this will result in decline in investment opportunities in the long run, causing secular stagnation. Thus, we see that in the Keynesian scheme of things level of investment depends upon the level of consumption demand in the long run.

Since marginal propensity to consume is less than one and also the consumption function is stable when income increases, consumption does not increase proportionately. As a result, the aggregate demand becomes deficient and the marginal efficiency of capital declines. The decline in the marginal efficiency of capital adversely affects investment which stops rising. As a result, the growth process stops and economic recession occurs.

In this way, Keynes himself and later important Keynesian economist, Prof. A.H. Hansen developed the theory of secular stagnation for the mature capitalist economies. This secular stagnation theory is based upon the assertion that investment opportunities in a capitalist economy will be exhausted soon due to the absence of the possibilities of increasing consumption demand. The meagre possibilities of increasing investment in the mature capitalist economies, according to them, were partly due to the constancy of consumption function and declining average propensity to consume which caused the marginal efficiency of capital to decline.

Theory of secular stagnation has not been found true by empirical evidence in the last over seventy years of growth in the capitalist developed countries. However, the fact that current consumption is influenced by changes in rate of interest, stock of wealth and price level and further that it is the changes current consumption level that determine short-run business expectations about future yields from investment which cause fluctuations in investment.

Together with the working of multiplier fluctuations in investment cause business cycles in a free market economy. This shows the great importance of Keynes’s consumption function and the factors that determine it.

Investment function

The investment function is a summary of the variables that influence the levels of aggregate investments.

The level of income, output and employment in an economy depends upon effective demand, which in turn, depends upon expenditures on consumption goods and investment goods (Y = C + I).

Consumption depends upon the propensity to consume, which, we have learnt, in more or less stable in the short period and is less than unity. Greater reliance, therefore, has to be placed on the other constituent (investment) of income.

The reason for investment being inversely related to the Interest rate is simply because the interest rate is a measure of the opportunity cost of those resources. If the resources instead of financing the investment could be invested in financial assets, there is an opportunity cost of (1+r), where r is the interest rate. This implies higher investment spending with a lower interest rate. When GDP increases, the output and the capacity utilization increases. This results in an increase of capital investment. At last, a higher Tobins q is represented when the market puts a high value of the installed capital and buys stocks in the firm for a higher price. The firm can then raise more resources per share issued and increase their investments.

Out of the two components (consumption and investment) of income, consumption being stable, fluctuations in effective demand (income) are to be traced through fluctuations in investment. Investment, thus, comes to play a strategic role in determining the level of income, output and employment at a time.

We can establish the importance of investment in another way also. In order to maintain an equilibrium level of income (Y = C + I), consumption expenditures plus investment expenditures must equal the total income (Y); but according to Psychological Law of Consumption given by Keynes, as income increases consumption also increases but by less than the increment in income. This means that a part of the increment in income is not spent but saved.

The savings must be invested to bridge the gap between an increase in income and consumption. If this gap is not plugged by an increase in investment expenditures, the result would be an unintended increase in the stocks of goods (inventories), which in turn, would lead to depression and mass unemployment. Hence, investment rules the roost. In Keynesian economics investment means real investment i.e., investment in the building of new machines, new factory buildings, roads, bridges and other forms of productive capital stock of the community, including increase in inventories.

Types of Investment:

1. Induced Investment:

Real investment may be induced. Induced investment is profit or income motivated. Factors like prices, wages and interest changes which affect profits influence induced investment. Similarly demand also influences it. When income increases, consumption de­mand also increases and to meet this, investment increases. In the ultimate analysis, induced investment is a function of in­come i.e., I = f(Y). It is income elastic. It increases or de­creases with the rise or fall in income, as shown in Figure 1.

Induced Investment

is the investment curve which shows induced invest­ment at various levels of income. Induced investment is zero at OY1 income. When income rises to OY3 induced investment is I3Yy A fall in income to OY2 also reduces induced investment to I2Y2.

Induced investment may be further divided into (i) the average propensity to invest, and (ii) the marginal propensity to invest:

(i) The average propensity to invest is the ratio of investment to income, I/Y. If the income is Rs. 40 crores and investment is Rs. 4 crores, I/Y = 4/40 = 0.1. In terms of the above figure, the average propensity to invest at OY3 income level is I3Y3/ OY3

(ii) The marginal propensity to invest is the ratio of change in investment to the change in income, i.e., clip_image004I/clip_image004[1]Y. If the change in investment, I=Rs 2 crores and the change in income, Y = Rs 10 crores, I/∆Y = 2/10=0.2

2. Autonomous Investment:

Autonomous investment is independent of the level of income and is thus income inelastic. It is influenced by exogenous factors like innovations, inventions, growth of population and labour force, researches, social and legal institutions, weather changes, war, revolution, etc. But it is not influenced by changes in demand. Rather, it influ­ences the demand. Investment in economic and social overheads whether made by the government or the private enterprise is au­tonomous.

Such investment includes expenditure on building, dams, roads, canals, schools, hospitals, etc. Since investment on these projects is generally associated with public policy, autonomous in­vestment is regarded as public investment. In the long-run, private investment of all types may be autonomous because it is influenced by exogenous factors. Diagrammatically, autonomous investment is shown as a curve parallel to the horizontal axis as I1I’ curve in Figure 2. It indicates that at all levels of income, the amount of investment OI1 remains constant.

Autonomous Investment

The upward shift of the curve to I2I” indicates an increased steady flow of investment at a constant rate OI2 at various levels of income. However, for purposes of income determination, the autonomous investment curve is superimposed on the С curve in a 45° line diagram.

3. Determinants of the Level of Investment:

The decision to invest in a new capital asset depends on whether the expected rate of return on the new investment is equal to or greater or less than the rate of interest to be paid on the funds needed to purchase this asset. It is only when the expected rate of return is higher than the interest rate that investment will be made in acquiring new capital assets.

In reality, there are three factors that are taken into consideration while making any investment decision. They are the cost of the capital asset, the expected rate of return from it during its lifetime, and the market rate of interest. Keynes sums up these factors in his concept of the marginal efficiency of capital (MEC).

The Keynesian Multiplier is an economic theory that asserts that an increase in private consumption expenditure, investment expenditure, or net government spending (gross government spending government tax revenue) raises the total Gross Domestic Product (GDP) by more than the amount of the increase. Therefore, if private consumption expenditure increases by 10 units, the total GDP will increase by more than 10 units.

Components of the Keynesian Theory

The three main components of the Keynesian Theory are:

• Aggregate demand is influenced by the decisions in the private and public sector. The level of demand by the private sector could exert an effect on macroeconomic conditions. For example, a decrease in aggregate spending can bring the economy into a recession. However, the negative impact of private decision-making can be mitigated through government intervention with a fiscal or monetary stimulus.
• Prices such as wages are often slow to respond to changes in demand and supply. It is why there are many instances of a shortage or an excess in the supply of labor.
• A change in aggregate demand causes the greatest impact on the output and employment in the economy. Keynesian economic theory says that spending by consumers and the government, investment, and exports will increase the level of output. Even a change in one the components will cause total output to change.

Calculating the Keynesian Multiplier

The value of the multiplier depends on the marginal propensity to consume and the marginal propensity to save.

1. Marginal Propensity to Save

The change in total savings as a result of a change in total income is known as the marginal propensity to save. When an individual’s income increases, the marginal propensity to save (MPS) measures the proportion of income the person saves rather than spend on goods and services. It is calculated as MPS = ΔS / ΔY.

2. Marginal Propensity to Consume

The change in total consumption as a result of a change in total income is known as the marginal propensity to consume. The marginal propensity to consume (MPC) measures how consumer spending changes with a change in income. Using the figures above, the MPC is ΔC / ΔY = 300/600 = 0.5.

Leakages in the Multiplier Process:

We have seen above that as a result of increase in investment, the level of income increases by a multiple of it. In our above analysis, saving is a leakage in the multiplier process. Had there been no saving and as a result marginal propensity to consume were equal to 1, the multiplier would have been equal to infinity.

In that case as a result of some initial increase in investment, income would go on rising indefinitely. Since marginal propensity to consume is actually less than one, some saving does take place. Therefore, multiplier in actual practice is less than infinity.

But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. Therefore, the increase in income as a result of some increase in investment will be less than warranted by the size of the multiplier measured by the given marginal propensity to consume. We explain below the various leakages that occur in the income stream and reduce the size of multiplier in the real world.

Paying off debts:

The first leakage in the multiplier process occurs in the form of payment of debts by the people, especially by businessmen. In the real world, all income received by the people as a result of some increase in investment is not consumed. A part of the increment in income is used for paying back the debts which the people have taken from moneylenders, banks or other financial institutions.

The incomes used for paying back the debts do not get spent on consumer goods and services and therefore leak away from the income stream. This reduces the size of the multiplier. Of course, when incomes received by the moneylenders, banks or institutions are again lent back to the people, they come back to the income stream and enhance the size of multiplier. But this may or may not happen.

Holding of idle cash balances:

If the people hold apart of their increment in income as idle cash balances and do not use it for consumption, they also constitute leakage in the multiplier process. As we have seen, people keep part of their income for satisfying their precautionary and speculative motives, money kept for such purposes is not consumed and therefore does not appear in the successive rounds of consumption expenditure and therefore reduces the increments in total income and output.

Imports:

In our above analysis of the working of the multiplier process we have taken the example of a closed economy, that is, an economy with no foreign trade. If it is an open economy as is usually the case, then a part of increment in income will also be spent on the imports of consumer goods. The proportion of increments in income spent on the imports of consumer goods will generate income in other countries and will not help in raising income and output in the domestic economy.

Increase in Prices:

Price inflation constitutes another important leakage in the working of the multiplier process in real terms. The multiplier works in real terms only when as a result of increase in money income and aggregate demand, output of consumer goods is also increased.

When output of consumer goods cannot be easily increased, a part of the increases in the money income and aggregate demand raises prices of the goods rather than their output. Therefore, the multiplier is reduced to the extent of price inflation. In developing countries like India the extra incomes and demand are mostly spent on food-grains whose output cannot be increased so easily.

Therefore, the increments in demand raise the prices of goods to a greater extent than the increase in their output. Besides, in developing countries like India, there is not much excess capacity in many consumer goods industries, especially in agriculture and other wage-goods industries.

Therefore, when income and demand increase as a result of increase in investment, it generally raises the prices of these goods rather than their output and therefore weakens the working of the multiplier in real terms. Thus, it was often asserted in the past that Keynesian theory of multiplier was not very much relevant to the conditions of developing countries like India. However, we shall discuss later that this old view about the working of Keynes’ multiplier is not fully correct.

The above various leakages reduce the multiplier effect of the investment undertaken. If these leakages are plugged, the effect of change in investment on income and employment would be greater.

Multiplier with Changes in Price Level:

In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price. How much national income or GNP increases as a result of any autonomous expenditure such as government expenditure, investment expenditure, net exports is determined by a shift in aggregate demand curve by the size of simple Keynesian multiplier when price level is fixed.

This implies a horizontal short-run supply curve. However, as studied above, short-run aggregate supply curve slopes upward as the firms are willing to supply additional output in the short run only at a higher price level. With short-run aggregate supply curve sloping upward, a rightward shift in aggregate demand curve raises new equilibrium GNP level not equal to the horizontal shift in the aggregate demand curve but less than it.

Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level. This is because a part of expansionary effect of GNP of the increase in autonomous government expenditure is offset by rise in the price level.

The multiplier effect in case of upward sloping curve is shown in Fig. 10.3. To begin with, in the top panel of Fig. 10.3 aggregate expenditure curve AE₀ intersects 45° line at point Sand determines Y₀ equilibrium level of GNP. In the panel at the bottom of Fig. 10.3 the corresponding aggregate demand curve AD₀ and the short-run aggregate supply curve SAS intersect at B’ at the above determined GNP level K₀. Now suppose autonomous investment expenditure (which is independent of changes in price level) increases by AI.

As a result, aggregate expenditure curve AE shifts upward to AE₁ and determines new equilibrium GNP level equal to Y₂. In the lower panel (b), due to the upward shift in aggregate expenditure curve, aggregate demand curve shifts rightward from AD to AD₁The horizontal shift in the aggregate demand curve at a given price level is determined by the increase in aggregate expenditure multiplied by the simple Keynesian multiplier at the given fixed price level (B’H or ∆Y = ∆I 1/1- MPC) But given the upward sloping short-run aggregate supply curve SAS with new aggregate demand curve AD₁, price level does not remain fixed. As will be seen from the lower panel (b) of Fig. 10.3, the aggregate demand curve AD₁ intersects the short-run aggregate supply curve SAS at point R’ and as a result price level rises to P₁.

Now, with this rise in price level to P₁, aggregate expenditure curve in the upper panel (a) will not remain unaffected but will shift downward. This fall in aggregate expenditure curve is due to the adverse effects on wealth or real balances, interest rate and net exports. Much of wealth is held in the form of bank deposits, bonds and shares of companies and other assets.

With the rise in price level, real value or purchasing power of wealth possessed by the people declines. This induces them to spend less. As a result, consumption expenditure declines due to this wealth effect. Secondly, the rise in price level reduces the supply of real money balances (M^s/P) that causes a shift in money supply curve to the left.

Given the demand function for money (M^d), the decline in the real money supply will cause rate of interest to rise. Now, the rise in interest will induce private investment expenditure to decline. Lastly, rise in price level in the domestic economy will adversely affect exports of a country causing net exports to fall.

Thus, as a result of negative effects of rise in price level on real wealth, private investment and net exports, in the upper panel (a) of Fig. 10.3 aggregate expenditure curve shifts downward to AE₁ (dotted) so that it determines GNP level Y₁ at which aggregate expenditure curve AE₁ intersects 45° line. This also corresponds to the intersection of aggregate demand curve AD₁ and short-run aggregate supply curve SAS point R’ in the lower panel (b) of Q 1. Fig. 10.3.

Thus with the upward sloping short-run aggregate supply curve SAS, the effect of increase in autonomous investment expenditure (or for that matter increase in any other autonomous expenditure such as Government expenditure, net exports, autonomous consumption) on the GNP level can be visualized to occur in two stages.

First, increase in investment expenditure shifts aggregate expenditure curve AE upward in the upper panel (a) of Fig. 10.3 and correspondingly aggregate demand curve in the lower panel (b) shifts to the right to AD₁ and brings about increase in GNP level from Y₀ to Y₂with the given fixed price level P_r In the second stage due to the upward sloping short-run aggregate supply curve SAS, the rightward shift in the aggregate demand curve causes price level to rise from P₀ to P_t and causes decrease in GNP from Y₂to Y₁

However, as shall be seen from Fig. 10.3, when price level effect is taken into account, the increase in investment expenditure has still a multiplier effect on real GDP but this effect is smaller than it would be if price level remained fixed. It may be further noted that steeper the slope of the short- run supply curve, the greater is the increase in the price level and smaller is the effect on real GNP.

Importance of the Concept of Multiplier:

Multiplier is one of the most important concepts developed by J.M. Keynes to explain the determination of income and employment in an economy. The theory of multiplier has been used to explain the cumulative upward and downward swings of the trade cycles that occur in a free-enterprise capitalist economy. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment.

As a result, economy experiences rapid upward movement. On the other hand, when due to some reasons, especially due to the adverse change in the expectations of the business class, investment falls, then backward working of the multiplier causes a multiple and cumulative fall in income, output and employment and as a result the economy rapidly moves on downswing of the trade cycle. Thus, Keynesian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy.

The theory of multiplier has also a great practical importance in the field of fiscal policy to be pursued by the Government to get out of the depression and achieve the state of full employment. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes.

But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. But the importance of public works is enhanced when it is realised that the total effect on income, output and employment as a result of some initial investment has a multiplier effect. Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment.

The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. The multiple increase in income and demand will also encourage the increase in private investment.

Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored. If the multiplier had not worked, the income and demand would have risen as a result of some public investment but not as much as they rise with the multiplier effect.

Inspired by the Keynesian theory of multiplier, expansionary fiscal policy of increase in Government expenditure and reduction in income tax have been adopted by President John Kennedy and President George W. Bush in the United States of America to remove involuntary unemployment and depression. This had a great success in removing unemployment and depression and therefore, Keynesian theory of multiplier was vindicated and as a result people’s belief in it increased.