Say's Law: The classical economists try to explain the economic theories on the assumption of full-employment. Full-employment means a situation in the economy where the people are willing to work and able to work.
They admitted that there could be 4% to 5% unemployment in the economy. When all the labourers are more or less employed, other factors of production will also be employed. In other words, at the time of full-employment there will be no idle resources in the country.
The classical economists developed the concept of full-employment on the basis of Say's Law. According to Mr. J. B. Say "supply creates its own demand". Whatever amount of goods is produced in the country will automatically be demanded in the country. This is because due to the increase in production, employment will increase. This will increase the income of the suppliers of factors of production. Thus, with the increase in income, demand will also increase. Hence it will be profitable for the businessmen to employ more labourers. As a result of this, all the labourers will be fully employed or occupied.
Thus Say's Law plays an important role in classical economic theories.
Keynes' Theory: Mr. J. M. Keynes did not accept the concept of full-employment. So he tried to develop a new concept of employment. According to him, employment in the economy depends on many factors. Of these factors, the most important factor is the Marginal Efficiency of Capital.
According to Mr. Keynes, employment depends on expenditure. When the expenditure is more, the effective demand will be more. This will increase the price, profit, investment, production and employment. But expenditure depends on the income. When the income is more, expenditure will be more. But the income is the sum of 1) consumption, 2) investment and 3) government expenditure.
1) Consumption: In order to satisfy the economic wants, man uses goods and services. Thus consumption depends on two factors, income and propensity to consume. Propensity to consume shows the relationship between change in income and change in consumption. When people consume more with an increase in income, propensity to consume will be more. But propensity to consume is influenced by many other factors. Some of the factors are as follows:
a) Distribution of income in the society: According to Mr. Keynes, the psychology of the people is that when people have less income, propensity to consume will be more.
b) When the desire to imitate others is more, the propensity to consume will be more.
c) If the government levies more taxes on expenditure, propensity to consume will be less.
d) If the people are economical, propensity to consume will be less.
e) If the propensity to save is more, propensity to consume will be less.
The propensity to save is again influenced by other factors, such as
i) the opportunity to save
ii) the power to save
iii) social position
iv) social guarantee
v) rate of interest, etc.
2) Investment: Investment in the economy is primarily determined by two factors
a) Marginal Efficiency of Capital
b) Rate of Interest
a) Marginal Efficiency of Capital: It shows the relationship between change in marginal investment and expected return out of that investment. When the expectation of return is more, marginal efficiency of capital will be more and vice versa.
This marginal efficiency of capital again is determined by many other factors.
i) Population: If the rate of growth of population is quite fast, effective demand will be more in the economy. Hence marginal efficiency of capital will be more.
ii) Innovation: If businessmen succeed to introduce new techniques and new machines, cost of production will be low, and so marginal efficiency of capital will be more.
iii) Taxes: If the government levies more taxes on production, cost will increase, and so marginal efficiency of capital will be less.
iv) Stock of goods: If the existing stock of finished goods is more, marginal efficiency of capital will be less.
v) Existing rate of investment: If the rate is more, marginal efficiency of capital will be more.
b) Rate of Interest: According to Mr. Keynes, rate of interest is determined by the demand for and supply of money. The demand for money depends on the desire of the people to hold money. There are basically three motives for which people want to hold money. These three motives are
i) Transactions Motive: People earn their income at the end of a certain period of time. So to meet the daily transactions during that period of time, people hold money.
ii) Precautionary Motive: In order to safeguard against the future uncertainties, people want to hold money.
iii) Speculative motive: In order to earn more money from the use of money, people want to hold money. According to Mr. Keynes, People want to hold money to buy bonds. When people expect to get more return from the purchase of bonds, they invest the money in the purchase of bonds.
3) Government Expenditure: The government can spend money either on consumption or on investment. When government spends money on consumption by giving unemployment allowances or social security, the purchasing power of the people increases. This leads to rise in demand, price, profit, investment, production and employment. Again, when the government spends money on investment, production and employment increases.
Conclusion: According to Mr. Keynes, there are many factors on which employment depends. Of these factors, consumption is not very active in the determination of employment, because in the long run consumption remains more or less constant. Government expenditure does not depend on the economic policy of the country. It generally depends on the political policy of the government. So it is outside the scope of economics. The rate of interest also remains constant. Hence it is the marginal efficiency of capital, which goes on fluctuating, actually determines employment.
Monday, December 12, 2011
Friday, September 16, 2011
Software System Development Process
Software Systems development requires an organized, step by step approach. The steps should be natural and have well-defined results. The completion of each step should provide a check-point where it can be determined whether the next step can be carried out or not.
The Conception Phase starts as someone, the user or anyone else, recognizes a problem or an opportunity, which has a data processing solution. The systems analyst and the user meet to develop information, mainly description of the problem or opportunity, goals, benefits and project scope.
The Initial information of the Conception Phase are generally recorded in a document called Project Request Form, whatever be its format. In the Conception Phase face to face discussion with the user is the best way to collect the true and exact facts.
Since users mostly can't explain their problems properly, the systems analyst must have interviewing skills. He should know what questions to ask. Thus Conception and Initiation are the preliminary phases involving a lot of queries, and interviewing those people who will be using the system. As stated earlier, one has to know what questions to ask to bring out the exact requirements. Users are not always very clever in expressing what they actually need.
Goals to be achieved and benefits to be derived from the software system must be well defined and documented. It will show whether the solution is adequate or not. A systems analyst should have a reasonably good understanding of the user's business and particularly the functional area for which the system is to be developed.
Sources from which information have been derived should be properly listed.
Benefits should be quantified in terms of money and should be listed in a sequence such that the first one is the easiest one to quantify.
A rough estimate of the project development cost is necessary against which the money values of the benefits are to be compared.
All the departments & sections as well as personnel that will be affected by the software system are recorded to determine the size of the project.
'User' is the manager, lowest in the organization, to whom all affected areas report.
Analysis and design are the two most vital phases, which can ensure a long life of the software.
Analysis part is all about understanding and ascertaining what the system is supposed to do.
In involves preparation of the Context Analysis Diagram,
Data Flow diagram, top level as well as lower level ones,
identifying external entities involved with the system, like the departments affected by the system or outside people,
processes that are required to convert raw data into processed data,
which then becomes usable, meaningful information for the user,
blowing up the processes to identify the sub-processes existing within the major (top level) processes, and identifying the data structures that are required to be updated by the various processes.
converting processed data into meaningful, understandable data, properly formatted and printed or shown on the screen,
Design part is supposed to take care of how the system should perform all that has been ascertained in the Analysis part. It involves preparing structure charts, module specifications, logic involved, checks and validations that need to be incorporated, taking care of interfaces with other systems, and exporting or importing data to or from other systems.
Building a software is a costly affair. A company cannot build it from the scratch every year, though upgradations are always done according to the changes that take place in course of time. So a long life of the software is very essential. Another very vital thing is the changeability of the software system,.... how far and how long it can undergo changes. The more flexible it is, the longer will be its life. So its development cost will automatically be spread over a long period,....seven to ten years... thereby lowering the yearly charge. Changeability totally depends on the Design part..... how the individual modules of the software are related to one another, and how far the modules are independent. The more independent a module is, the less will be chances of other modules getting affected by a change made in one particular module. More the changes a system can take, the more will be its life and the more beneficial it will be for the company using the software.
Another very vital thing is designing the database structure, and individual data file structure. There are rules and principles to do that. This also affects the changeability of the system. A poor database structure will make the system too rigid, ....life span will not be more than four years. It has to be scrapped after that period.
Then comes the Construction Phase when the actual programming work, building up the data files and the database, syntax and logical testing etc. are done. Interactions with the user are necessary, as and when required.
At the end comes the System Testing part when tests like Stress Testing, Volume testing, Data Validation Check Testing etc. are done.
This completes an overview of the system development process.
Tuesday, September 13, 2011
Economic Functions of the Government
The functions that a modern government should perform basically hover around securing freedom from want and better working conditions. The functions that a modern government is expected to perform can be categorized under the following eight heads.
1. Securing Full Employment
In any modern day economy unemployment is a serious problem. One who is unemployed has to depend upon others to satisfy his basic economic wants. He cannot afford to raise his standard of living, which always remains low. This way he remains frustrated also. Unemployment in a large scale leads to social and other kinds of disorders. A country facing large scale unemployment thus wastes a lot of its human resource, which is the most valuable of all economic resources.
There may also be under-employment and disguised unemployment. These are also equally bad as unemployment. Unemployment leads to low income, low effective demand, and low level of national income.
The government should take up more public works and make fresh investments in areas like building of roads, bridges, dams etc. This will create employment for many. Also the government can induce private investors to invest in new areas by lowering the cost of investment, primarily interest rate, and by providing better infrastructural facilities.
2. Improvement of the Standard of living
Everybody wants better food, better clothes, better housing and the like. All economic policies of the government should be directed towards the fulfillment of these wants. Endeavours by the government to create fresh income for the people will ensure improvement in the standard of living. Increasing the per capita income seems to be the objective here.
In less developed countries development of the agricultural sector is of great importance as a large number of workers engaged here have primarily a low level of income. Development of the industrial sector, transport, commerce, foreign trade also helps to improve the overall standard of living of a country.
Ensuring a sustainable level of investment seems to be the goal with scope for future growth. This will go a long way in fulfilling the desires of the people.
3. Reduction of Inequalities in Income and Wealth
Uneven distribution of income and wealth can be seen in almost every country in varying degrees. When wealth and income gets concentrated in the hands of a few, it becomes a very harmful thing for every economy and society.
Redistribution of income and wealth is absolutely necessary from time to time, and its duty lies with the government. The government can do this by revising the tax system, thereby collecting more taxes from the rich and giving tax relief to the poor. Excess tax collected from the rich can be spent by the government to provide free education, free medical facilities, low cost housing etc. to the poor. Ensuring minimum level of wages, giving foods at a subsidized price are some other measures through which the inequality can be eliminated to some extent. However, in a free economy some level of inequality will always be there.
4. Keeping the Value of Money Stable
A stable price level is always necessary for the well being of the people of a country as well as for its economy. Rising price level reduces the real income in the hands of people. They can buy less things with their income. Income does not increase at par with rises in price level. So rising level of prices affects the living standards of middle class and the poor.
When prices fall, producers start producing less to curtail the supply with an expectation that it will bring the price level up again.
Through adoption of various fiscal and monetary measures a government can keep the price level steady to a great extent, though some fluctuations will always be here. Fiscal and monetary measures help to keep the value of money stable.
5. A Stable Currency and Banking System
Money is the central element of every economy. In order for the economy to function healthily a good, stable currency system is necessary. This is connected with the banking system of a country, which handles the major portion of the currency. A government should ensure a sound banking and currency system so that the economy can function smoothly.
6. Controlling Monopolistic Practices
Monopoly is harmful for the society as well as the economy. Consumers get exploited by it as they have to pay higher prices charged by the monopolists. Monopolists can control affairs unfairly by paying lower wages to workers and thereby increasing their profit. This promotes income inequality. So it is the duty of the government to curb the growth of monopoly.
7. Better Terms and Conditions
As labourers are poor, they cannot bargain with their employers. So they somehow have to accept the terms and conditions of work laid down by the employer. Such terms and conditions may at times be unfavourble for the labourers. Here the government must step in and make laws in order to protect the interests of the labourers. There should be laws to govern the pay, the working conditions as well as the welfare and other benefits of the workers.
8. Social Security
Financial insecurity is in itself a very serious thing that affects everyone. When there is sickness, accident, death or unemployment, the poor finds it very difficult to tackle the situation. They do not have savings to fall back upon. In such situations it is the duty of the government to come to the help of the poor.
A fund is created where the worker, employer and the government contributes. When some worker falls sick, meets with an accident etc. he is provided with a certain amount out of that fund to tackle the situation. Old age benefits, pensions to widows, orphans, maternity benefits, unemployment benefits etc. can also be provided out of this fund. Thus social security eliminates certain insecurities of the poorer sections of the society. In case of social security contributions made by the government is of prime importance as contributions made by the workers and employers are highly inadequate. Governments of developing countries have fewer funds to contribute in this regard.
1. Securing Full Employment
In any modern day economy unemployment is a serious problem. One who is unemployed has to depend upon others to satisfy his basic economic wants. He cannot afford to raise his standard of living, which always remains low. This way he remains frustrated also. Unemployment in a large scale leads to social and other kinds of disorders. A country facing large scale unemployment thus wastes a lot of its human resource, which is the most valuable of all economic resources.
There may also be under-employment and disguised unemployment. These are also equally bad as unemployment. Unemployment leads to low income, low effective demand, and low level of national income.
The government should take up more public works and make fresh investments in areas like building of roads, bridges, dams etc. This will create employment for many. Also the government can induce private investors to invest in new areas by lowering the cost of investment, primarily interest rate, and by providing better infrastructural facilities.
2. Improvement of the Standard of living
Everybody wants better food, better clothes, better housing and the like. All economic policies of the government should be directed towards the fulfillment of these wants. Endeavours by the government to create fresh income for the people will ensure improvement in the standard of living. Increasing the per capita income seems to be the objective here.
In less developed countries development of the agricultural sector is of great importance as a large number of workers engaged here have primarily a low level of income. Development of the industrial sector, transport, commerce, foreign trade also helps to improve the overall standard of living of a country.
Ensuring a sustainable level of investment seems to be the goal with scope for future growth. This will go a long way in fulfilling the desires of the people.
3. Reduction of Inequalities in Income and Wealth
Uneven distribution of income and wealth can be seen in almost every country in varying degrees. When wealth and income gets concentrated in the hands of a few, it becomes a very harmful thing for every economy and society.
Redistribution of income and wealth is absolutely necessary from time to time, and its duty lies with the government. The government can do this by revising the tax system, thereby collecting more taxes from the rich and giving tax relief to the poor. Excess tax collected from the rich can be spent by the government to provide free education, free medical facilities, low cost housing etc. to the poor. Ensuring minimum level of wages, giving foods at a subsidized price are some other measures through which the inequality can be eliminated to some extent. However, in a free economy some level of inequality will always be there.
4. Keeping the Value of Money Stable
A stable price level is always necessary for the well being of the people of a country as well as for its economy. Rising price level reduces the real income in the hands of people. They can buy less things with their income. Income does not increase at par with rises in price level. So rising level of prices affects the living standards of middle class and the poor.
When prices fall, producers start producing less to curtail the supply with an expectation that it will bring the price level up again.
Through adoption of various fiscal and monetary measures a government can keep the price level steady to a great extent, though some fluctuations will always be here. Fiscal and monetary measures help to keep the value of money stable.
5. A Stable Currency and Banking System
Money is the central element of every economy. In order for the economy to function healthily a good, stable currency system is necessary. This is connected with the banking system of a country, which handles the major portion of the currency. A government should ensure a sound banking and currency system so that the economy can function smoothly.
6. Controlling Monopolistic Practices
Monopoly is harmful for the society as well as the economy. Consumers get exploited by it as they have to pay higher prices charged by the monopolists. Monopolists can control affairs unfairly by paying lower wages to workers and thereby increasing their profit. This promotes income inequality. So it is the duty of the government to curb the growth of monopoly.
7. Better Terms and Conditions
As labourers are poor, they cannot bargain with their employers. So they somehow have to accept the terms and conditions of work laid down by the employer. Such terms and conditions may at times be unfavourble for the labourers. Here the government must step in and make laws in order to protect the interests of the labourers. There should be laws to govern the pay, the working conditions as well as the welfare and other benefits of the workers.
8. Social Security
Financial insecurity is in itself a very serious thing that affects everyone. When there is sickness, accident, death or unemployment, the poor finds it very difficult to tackle the situation. They do not have savings to fall back upon. In such situations it is the duty of the government to come to the help of the poor.
A fund is created where the worker, employer and the government contributes. When some worker falls sick, meets with an accident etc. he is provided with a certain amount out of that fund to tackle the situation. Old age benefits, pensions to widows, orphans, maternity benefits, unemployment benefits etc. can also be provided out of this fund. Thus social security eliminates certain insecurities of the poorer sections of the society. In case of social security contributions made by the government is of prime importance as contributions made by the workers and employers are highly inadequate. Governments of developing countries have fewer funds to contribute in this regard.
Wednesday, June 22, 2011
Shut Down Conditions of a Firm - Short Run and Long Run
http://www.DoPartTimeJob.com/?user=1947605
----------------------------------------------------------------------------
Short Run Decision
In the short run, a profit-maximizing firm will:
increase production if marginal revenue is greater than marginal cost
decrease production if marginal revenue is less than marginal cost
The shutdown rule is that in the short run a firm should continue to operate if price is greater than average variable costs. In the short run a firm must earn sufficient revenue to cover its variable costs. When a firm shuts down operation, it does not incur any variable cost. However, the firm still has to bear its fixed costs. Because fixed cost must be paid irrespective of whether a firm operates or not, fixed costs should not be considered in deciding whether to produce or shutdown.
Total variable cost/Quantity = Average variable cost (AVC)
Total Fixed cost/Quantity = Average Fixed cost (AFC)
Average variable cost (AVC) + Average Fixed cost (AFC) = Average total cost or Average cost (ATC/AC)
1. When P > AVC, the firm is covering all variable cost plus there is additional revenue or contribution, which can be applied to fixed costs. The size of the fixed costs is not relevant in this regard as it is already spent.
a) P < AC - part of fixed cost remains uncovered. The firm will continue production.
b) P = AC - The firm is at break even earning only normal profit. It is at minimum average cost. The firm will continue production.
c) P > AC - the firm is making economic profit. The firm will continue production.
2. P = AVC - Whole fixed cost remains uncovered, but covering the whole variable cost. The firm will continue production.
3. P < AVC - The firm cannot cover even the variable expenses. This is a shut down point. The shut down point is at the minimum of the average variable cost curve.
When a firm decides to shut down, it is really a temporary suspension of production. The firm is not going out of the industry. It may again resume production if situation becomes favourable. Hence shutting down is a short-run affair. A firm that has decided to shut down operations cannot avoid its fixed costs.
Long Run Decision
Leaving the industry is a decision that can only be taken in the long run. When a firm exits, it basically winds up all its operations. The capital resources thus get free for use in another venture. In the long run, so long as the price is greater than or equal to average variable cost, the firm should not wind up its operations. If marginal revenue is equal to marginal cost, the firm should operate. If price is less than average variable cost and total revenue is less than total cost, it is advisable for the firm to leave the industry.
Also read: Perfect Competition - Short Run Equilibrium
Perfect Competition - Long Run Equilibrium
----------------------------------------------------------------------------
Short Run Decision
In the short run, a profit-maximizing firm will:
increase production if marginal revenue is greater than marginal cost
decrease production if marginal revenue is less than marginal cost
The shutdown rule is that in the short run a firm should continue to operate if price is greater than average variable costs. In the short run a firm must earn sufficient revenue to cover its variable costs. When a firm shuts down operation, it does not incur any variable cost. However, the firm still has to bear its fixed costs. Because fixed cost must be paid irrespective of whether a firm operates or not, fixed costs should not be considered in deciding whether to produce or shutdown.
Total variable cost/Quantity = Average variable cost (AVC)
Total Fixed cost/Quantity = Average Fixed cost (AFC)
Average variable cost (AVC) + Average Fixed cost (AFC) = Average total cost or Average cost (ATC/AC)
1. When P > AVC, the firm is covering all variable cost plus there is additional revenue or contribution, which can be applied to fixed costs. The size of the fixed costs is not relevant in this regard as it is already spent.
a) P < AC - part of fixed cost remains uncovered. The firm will continue production.
b) P = AC - The firm is at break even earning only normal profit. It is at minimum average cost. The firm will continue production.
c) P > AC - the firm is making economic profit. The firm will continue production.
2. P = AVC - Whole fixed cost remains uncovered, but covering the whole variable cost. The firm will continue production.
3. P < AVC - The firm cannot cover even the variable expenses. This is a shut down point. The shut down point is at the minimum of the average variable cost curve.
When a firm decides to shut down, it is really a temporary suspension of production. The firm is not going out of the industry. It may again resume production if situation becomes favourable. Hence shutting down is a short-run affair. A firm that has decided to shut down operations cannot avoid its fixed costs.
Long Run Decision
Leaving the industry is a decision that can only be taken in the long run. When a firm exits, it basically winds up all its operations. The capital resources thus get free for use in another venture. In the long run, so long as the price is greater than or equal to average variable cost, the firm should not wind up its operations. If marginal revenue is equal to marginal cost, the firm should operate. If price is less than average variable cost and total revenue is less than total cost, it is advisable for the firm to leave the industry.
Also read: Perfect Competition - Short Run Equilibrium
Perfect Competition - Long Run Equilibrium
Saturday, June 18, 2011
Perfect Competition - Long Run Equilibrium
Before reading this, read: Perfect Competition - Short Run Equilibrium
The long run is a period of time in which the quantities of all inputs are variable. The distinction between short run and long run varies from one industry to another. The plant capacity, which is considered as fixed in the short run, can also be considered as variable in the long run. It is assumed that in the long run all firms have made necessary long-term adjustments. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.
In the long run it is impossible for a perfectly competitive firm to hold on to its short run economic or supernormal profit. The firm, in the long run, earns just enough profit to cover its economic (opportunity) costs.
As there is supernormal profit in the short run, new firms enter the industry. On the other hand, less efficient firms may be forced to move out of the industry. As new firms enter into the industry, they increase the supply of the product in the market. Competition among all the firms brings down the price of the product. More and more new firms, offering products at lower prices, bring down the market price of the product further.
The market price of the product, and with it the demand, will thus keep coming down until all the firms earn only normal profits. All of the economic or supernormal profit gets wiped out or disappears. Only in perfect competition P = AR = MR. Firms thus have no eagerness to enter or exit the industry. As short run economic profit disappears, there is no incentive for other firms to enter the industry. As the firms do not incur economic loss or earn below-normal profit, there is no urge for the firms to leave the industry.
As there is only 'normal profit', revenue is equal to cost, or average revenue (AR) is equal to average cost (AC). Equilibrium occurs where the AR curve (demand curve) is tangent to the AC curve at the only possible point of tangency, the minimum point. At the equilibrium point D, the equilibrium condition P=AC=AR=MC=MR is satisfied.
Equilibrium output OB is the profit-maximizing output as MC=MR. Equilibrium price is OA. Rectangle OADB represents the total cost, which is equal to total cost.
The firm's long run supply curve is the long run marginal cost curve above the minimum long run average cost curve (AC curve).
Remember that marginal cost rises less sharply in the long run, making the long run marginal cost curve flatter than what it is in the short run.
Also read: Shut down Conditions of a firm
The long run is a period of time in which the quantities of all inputs are variable. The distinction between short run and long run varies from one industry to another. The plant capacity, which is considered as fixed in the short run, can also be considered as variable in the long run. It is assumed that in the long run all firms have made necessary long-term adjustments. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.
In the long run it is impossible for a perfectly competitive firm to hold on to its short run economic or supernormal profit. The firm, in the long run, earns just enough profit to cover its economic (opportunity) costs.
As there is supernormal profit in the short run, new firms enter the industry. On the other hand, less efficient firms may be forced to move out of the industry. As new firms enter into the industry, they increase the supply of the product in the market. Competition among all the firms brings down the price of the product. More and more new firms, offering products at lower prices, bring down the market price of the product further.
The market price of the product, and with it the demand, will thus keep coming down until all the firms earn only normal profits. All of the economic or supernormal profit gets wiped out or disappears. Only in perfect competition P = AR = MR. Firms thus have no eagerness to enter or exit the industry. As short run economic profit disappears, there is no incentive for other firms to enter the industry. As the firms do not incur economic loss or earn below-normal profit, there is no urge for the firms to leave the industry.
As there is only 'normal profit', revenue is equal to cost, or average revenue (AR) is equal to average cost (AC). Equilibrium occurs where the AR curve (demand curve) is tangent to the AC curve at the only possible point of tangency, the minimum point. At the equilibrium point D, the equilibrium condition P=AC=AR=MC=MR is satisfied.
Equilibrium output OB is the profit-maximizing output as MC=MR. Equilibrium price is OA. Rectangle OADB represents the total cost, which is equal to total cost.
The firm's long run supply curve is the long run marginal cost curve above the minimum long run average cost curve (AC curve).
Remember that marginal cost rises less sharply in the long run, making the long run marginal cost curve flatter than what it is in the short run.
Also read: Shut down Conditions of a firm
Sunday, June 12, 2011
Perfect Competition - Short Run Equilibrium
In the model of price and output determination under perfectly competitive market conditions, price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker. Perfect competition is used by economists not so much as an attainable goal, but as a pure state against which all other markets can be measured.
For a market to be perfectly competitive, the following necessary conditions must, in general, prevail.
1. There must be many firms acting independently. Each firm is small enough relative to the size of the market, so that a single firm's decision to either stop production entirely or to produce to full capacity will not have any perceptible effect on market supply to cause a change in market price.
2. Entry and exit from the market are free and frictionless for both the firms and consumers.
3. The products offered for sale are homogeneous and divisible into small units.
5. Buyers and sellers have perfect knowledge about the market conditions.
6. Price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker.
7. There is perfect knowledge among consumers about the price at which goods are being sold in the market. Sellers thus cannot manipulate the commodity price and thereby exploit the consumer.
8. There is perfect mobility of goods and factors of production among firms. Uniformity in factor prices is prevalent in the market.
If these necessary conditions prevail, the firm can lose its entire market if it sets its price above the market price. It can also expect no gain by lowering price, since it can sell all it wishes to produce at the market price. The competitive firm has no price discretion. Market price will not be affected by the independent action of a single firm. No firm is able to influence market price.
The objective of each firm is to maximize profit. Profit is the difference between revenue and cost of production. Marginal cost (MC) is the cost incurred to produce an additional unit of the product. If the per unit price of a commodity is greater than the marginal cost, the firm will be interested in producing more of the commodity. On the other hand if price falls below marginal cost, the firm will curtail its production.
Equilibrium condition will prevail at a point where profit is maximized. This happens where price is equal to marginal cost (P = MC). Also at the point of equilibrium, the marginal cost curve must be upward sloping.
Average Revenue (AR) = Total Revenue/No. of units sold.
Since the price is set by impersonal forces of supply and demand and every individual firm is a price taker, the average revenue (AR) curve is a straight line, parallel to the X-axis. Price always remains the same and is equal to AR. Marginal revenue (MR) is the price at which an additional unit may be sold. Since this can be done only at the current market price, marginal revenue is equal to average revenue (MR=AR) and the marginal revenue curve is the same as the average revenue curve (MR curve = AR curve). This is the demand curve for the firm. It is perfectly elastic as it is parallel to the X-axis.
The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. In the short run an increase in the variable input results in an increase in the marginal productivity of the variable input. When first few quantities of a variable input are added to a fixed input, marginal returns from the variable input flow in an increasing rate.
As marginal returns flow in an increasing rate and average fixed cost starts declining, the marginal cost per unit starts falling and the marginal cost curve shows a downward slope. After some time, as more and more of the variable input is combined with the fixed input, the marginal productivity of the variable input eventually starts declining.
So with diminishing returns, the marginal cost per unit starts increasing and the marginal cost curve starts showing an upward trend. This explains the U-shape of the marginal cost curve.
Short Run Equilibrium of a perfectly competitive firm
In the short run total fixed cost remains unchanged. So any change in total cost is caused by changes in the total variable cost in the short run. Marginal cost is the cause of change in total cost or total variable cost. Marginal cost is defined as additional variable cost incurred due to an additional change in output.
Similarly the average cost curve also takes an U-shape like the marginal cost curve. As production increases, both marginal cost curve and the average cost curve rises due to the Law of Diminishing Marginal Productivity. As the MC curve lies below the AC curve, while rising it cuts the AC curve at its minimum point. A perfectly competitive firm's supply curve is the portion of its marginal cost curve that lies above the minimum of the average (variable) cost curve.
In the short run, the demand curve, namely the average revenue curve, and the supply curve, namely the marginal cost curve, intersects at two places, E' and E. The profit maximizing P = MC is satisfied at both the points. If the firm continues to produce even after E', it will still be able to increase its revenue as marginal revenue or price will continue to be greater than marginal cost till the point E. So the firm continues production up to point E. Thus E is the point of profit maximization. E' is the point of loss minimization since until E' the marginal cost curve lies above the marginal revenue curve. E is the profit-maximizing point where the MC (supply) curve cuts the MR (demand) curve from below. Equilibrium output is OB and equilibrium price is OC. Rectangle OCEB shows the total revenue and rectangle OADB shows the total cost. Profit is shown by the rectangle ACED, which is basically 'economic profit'.
A few points
1. Price = Marginal cost (P=MC) shows the economic efficiency of the firm.
2. Marginal cost=Marginal revenue (MC=MR) is the standard condition for profit maximization. This gives the highest economic profit to the firm.
3. Price=Average revenue=Marginal revenue (P=AR=MR) shows that
a) a perfectly competitive firm has no market control
b) price is determined by the combined forces of demand and supply. The firm can sell any or all of its production at this going market price.
c) the firm is a price-taker.
d) the firm faces a perfectly elastic demand curve equal to market price.
Also read: Perfect Competition - Long Run Equilibrium
Shut down Conditions of a firm
For a market to be perfectly competitive, the following necessary conditions must, in general, prevail.
1. There must be many firms acting independently. Each firm is small enough relative to the size of the market, so that a single firm's decision to either stop production entirely or to produce to full capacity will not have any perceptible effect on market supply to cause a change in market price.
2. Entry and exit from the market are free and frictionless for both the firms and consumers.
3. The products offered for sale are homogeneous and divisible into small units.
5. Buyers and sellers have perfect knowledge about the market conditions.
6. Price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker.
7. There is perfect knowledge among consumers about the price at which goods are being sold in the market. Sellers thus cannot manipulate the commodity price and thereby exploit the consumer.
8. There is perfect mobility of goods and factors of production among firms. Uniformity in factor prices is prevalent in the market.
If these necessary conditions prevail, the firm can lose its entire market if it sets its price above the market price. It can also expect no gain by lowering price, since it can sell all it wishes to produce at the market price. The competitive firm has no price discretion. Market price will not be affected by the independent action of a single firm. No firm is able to influence market price.
The objective of each firm is to maximize profit. Profit is the difference between revenue and cost of production. Marginal cost (MC) is the cost incurred to produce an additional unit of the product. If the per unit price of a commodity is greater than the marginal cost, the firm will be interested in producing more of the commodity. On the other hand if price falls below marginal cost, the firm will curtail its production.
Equilibrium condition will prevail at a point where profit is maximized. This happens where price is equal to marginal cost (P = MC). Also at the point of equilibrium, the marginal cost curve must be upward sloping.
Average Revenue (AR) = Total Revenue/No. of units sold.
Since the price is set by impersonal forces of supply and demand and every individual firm is a price taker, the average revenue (AR) curve is a straight line, parallel to the X-axis. Price always remains the same and is equal to AR. Marginal revenue (MR) is the price at which an additional unit may be sold. Since this can be done only at the current market price, marginal revenue is equal to average revenue (MR=AR) and the marginal revenue curve is the same as the average revenue curve (MR curve = AR curve). This is the demand curve for the firm. It is perfectly elastic as it is parallel to the X-axis.
The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. In the short run an increase in the variable input results in an increase in the marginal productivity of the variable input. When first few quantities of a variable input are added to a fixed input, marginal returns from the variable input flow in an increasing rate.
As marginal returns flow in an increasing rate and average fixed cost starts declining, the marginal cost per unit starts falling and the marginal cost curve shows a downward slope. After some time, as more and more of the variable input is combined with the fixed input, the marginal productivity of the variable input eventually starts declining.
So with diminishing returns, the marginal cost per unit starts increasing and the marginal cost curve starts showing an upward trend. This explains the U-shape of the marginal cost curve.
Short Run Equilibrium of a perfectly competitive firm
In the short run total fixed cost remains unchanged. So any change in total cost is caused by changes in the total variable cost in the short run. Marginal cost is the cause of change in total cost or total variable cost. Marginal cost is defined as additional variable cost incurred due to an additional change in output.
Similarly the average cost curve also takes an U-shape like the marginal cost curve. As production increases, both marginal cost curve and the average cost curve rises due to the Law of Diminishing Marginal Productivity. As the MC curve lies below the AC curve, while rising it cuts the AC curve at its minimum point. A perfectly competitive firm's supply curve is the portion of its marginal cost curve that lies above the minimum of the average (variable) cost curve.
In the short run, the demand curve, namely the average revenue curve, and the supply curve, namely the marginal cost curve, intersects at two places, E' and E. The profit maximizing P = MC is satisfied at both the points. If the firm continues to produce even after E', it will still be able to increase its revenue as marginal revenue or price will continue to be greater than marginal cost till the point E. So the firm continues production up to point E. Thus E is the point of profit maximization. E' is the point of loss minimization since until E' the marginal cost curve lies above the marginal revenue curve. E is the profit-maximizing point where the MC (supply) curve cuts the MR (demand) curve from below. Equilibrium output is OB and equilibrium price is OC. Rectangle OCEB shows the total revenue and rectangle OADB shows the total cost. Profit is shown by the rectangle ACED, which is basically 'economic profit'.
A few points
1. Price = Marginal cost (P=MC) shows the economic efficiency of the firm.
2. Marginal cost=Marginal revenue (MC=MR) is the standard condition for profit maximization. This gives the highest economic profit to the firm.
3. Price=Average revenue=Marginal revenue (P=AR=MR) shows that
a) a perfectly competitive firm has no market control
b) price is determined by the combined forces of demand and supply. The firm can sell any or all of its production at this going market price.
c) the firm is a price-taker.
d) the firm faces a perfectly elastic demand curve equal to market price.
Also read: Perfect Competition - Long Run Equilibrium
Shut down Conditions of a firm
Tuesday, June 7, 2011
Opportunity Cost, Normal Profit, Economic Profit and Accounting Profit
Opportunity Cost:
Supply of economic resources is limited. Scarcity is fundamental to the study of economics. If certain resources are used somewhere, it can no longer be used anywhere else. When such limited resources are used to satisfy certain wants or needs, it means many alternative uses of those resources automatically get overlooked. All those alternatives that get overlooked can be evaluated in terms of returns or satisfaction that could have been derived out of them, had the resources in question been put into use in each of such alternatives, or had each of such alternatives been pursued. The highest valued return or satisfaction thus foregone in the pursuit of one activity is called the Opportunity cost. This is because of the mutually exclusive nature of the use of such economic resources. Doing one thing means foregoing many others. Economic wants are unlimited but resources are limited. Thus opportunity cost is the highest valued foregone or sacrificed return from an alternative use.
Put in another way, Opportunity cost is the benefits or returns a firm could have received by taking an alternative course of action.
An opportunity cost can be either explicit, usually involving a monetary payment, or implicit, which does not involve a monetary transaction. Opportunity cost is also known as economic cost. In economics, cost primarily means economic cost. It is different from the term 'cost' used by accountants, which is more financial by nature. However, all economic costs are not accounting costs and vice versa.
Opportunity cost does not consider all alternatives foregone. It is concerned only with the foregone alternative use that would have fetched the highest return or satisfaction. When a particular activity is pursued, it is assumed that it is the most beneficial and economic use of the resources that are being used to pursue that activity.
Normal Profit:
Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a commodity, or the profit that could be received by entrepreneurship in another business venture. Entrepreneurship used in the production of a certain commodity can as well be used in the production of another commodity. But both cannot be done together. Profit that could have been earned from the venture that is foregone is the opportunity cost of the venture that is undertaken. This is termed as the normal profit. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur.
Use of every resource has an opportunity cost. Like the opportunity cost of all other resources, normal profit (foregone profit) is deducted from revenue to determine the economic profit. It is however, never included as an accounting cost when accounting profit is calculated.
Thus, normal profit is the profit that could be earned in another activity elsewhere. It is the profit that could be earned in an alternative venture.
Normal profit is different from accounting profit because opportunity cost is taken into consideration.
Normal profit is the minimum level of profit needed for a firm to remain competitive in the market.
Normal Profit + economic profit = accounting profit (current activity profit)
Or, Current activity profit (accounting profit) - normal profit = economic profit
If economic profit is greater that zero, Then the current activity is better; it is giving more earning.
If economic profit is less than zero, (though accounting profit from current activity is positive), switching entrepreneurship to the other activity is advisable. That would generate more earning.
Normal profit is not deducted from revenue to calculate accounting profit. The foregone profit is the opportunity cost of entrepreneurship and is deducted from revenue to calculate economic profit.
Economic Profit:
Economic profit is the difference between the total opportunity cost of production and the total revenue received by a firm. Economic profit is what remains after all opportunity costs associated with production, including normal profit (entrepreneurial opportunity cost) is deducted from the revenue generated by the production. Opportunity costs are the alternative returns foregone by using the chosen inputs.
Economic profit acts as an indicator when the focus is turned towards efficiency. In a perfect world, no firm receives economic profit. Firms receive economic profit only when price exceeds opportunity cost of production (including entrepreneurial opportunity cost).
Economic profit = Total revenue - total (opportunity) cost (including normal profit).
A firm can stay in business without economic profit or supernormal profit or above-normal profit. It can continue producing goods and services so long as it is able to pay all opportunity costs. One critical opportunity cost is normal profit. Because accounting profit is generally the combination of normal profit and economic profit, zero economic profit does not mean zero accounting profit. A firm can continue by earning normal profit only.
Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit
Total Revenue - $100 million
Total Cost - $60 million
Entrepreneurial opportunity cost or normal profit (Profit that can be earned from alternative venture) - $30 million
Current activity profit (accounting profit) = $(100 - 60) million = $40 million
Current activity profit (accounting profit) - normal profit = economic profit
That is, $(40 - 30) million = $10 million (economic profit)
In another way,
Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit
That is, ${100 - (60+30)} million = $10 million (economic profit)
Accounting Profit:
Accounting profit is the difference between total revenue earned and the explicit accounting costs incurred to earn the revenue.
Accounting profit differs from economic profit because there is a difference between accounting cost and economic cost. Some accounting costs are not economic costs, and vice versa.
In reality, opportunity costs of all other resources associated with production tends to be equal to explicit accounting cost incurred to earn the revenue.
Supply of economic resources is limited. Scarcity is fundamental to the study of economics. If certain resources are used somewhere, it can no longer be used anywhere else. When such limited resources are used to satisfy certain wants or needs, it means many alternative uses of those resources automatically get overlooked. All those alternatives that get overlooked can be evaluated in terms of returns or satisfaction that could have been derived out of them, had the resources in question been put into use in each of such alternatives, or had each of such alternatives been pursued. The highest valued return or satisfaction thus foregone in the pursuit of one activity is called the Opportunity cost. This is because of the mutually exclusive nature of the use of such economic resources. Doing one thing means foregoing many others. Economic wants are unlimited but resources are limited. Thus opportunity cost is the highest valued foregone or sacrificed return from an alternative use.
Put in another way, Opportunity cost is the benefits or returns a firm could have received by taking an alternative course of action.
An opportunity cost can be either explicit, usually involving a monetary payment, or implicit, which does not involve a monetary transaction. Opportunity cost is also known as economic cost. In economics, cost primarily means economic cost. It is different from the term 'cost' used by accountants, which is more financial by nature. However, all economic costs are not accounting costs and vice versa.
Opportunity cost does not consider all alternatives foregone. It is concerned only with the foregone alternative use that would have fetched the highest return or satisfaction. When a particular activity is pursued, it is assumed that it is the most beneficial and economic use of the resources that are being used to pursue that activity.
Normal Profit:
Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a commodity, or the profit that could be received by entrepreneurship in another business venture. Entrepreneurship used in the production of a certain commodity can as well be used in the production of another commodity. But both cannot be done together. Profit that could have been earned from the venture that is foregone is the opportunity cost of the venture that is undertaken. This is termed as the normal profit. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur.
Use of every resource has an opportunity cost. Like the opportunity cost of all other resources, normal profit (foregone profit) is deducted from revenue to determine the economic profit. It is however, never included as an accounting cost when accounting profit is calculated.
Thus, normal profit is the profit that could be earned in another activity elsewhere. It is the profit that could be earned in an alternative venture.
Normal profit is different from accounting profit because opportunity cost is taken into consideration.
Normal profit is the minimum level of profit needed for a firm to remain competitive in the market.
Normal Profit + economic profit = accounting profit (current activity profit)
Or, Current activity profit (accounting profit) - normal profit = economic profit
If economic profit is greater that zero, Then the current activity is better; it is giving more earning.
If economic profit is less than zero, (though accounting profit from current activity is positive), switching entrepreneurship to the other activity is advisable. That would generate more earning.
Normal profit is not deducted from revenue to calculate accounting profit. The foregone profit is the opportunity cost of entrepreneurship and is deducted from revenue to calculate economic profit.
Economic Profit:
Economic profit is the difference between the total opportunity cost of production and the total revenue received by a firm. Economic profit is what remains after all opportunity costs associated with production, including normal profit (entrepreneurial opportunity cost) is deducted from the revenue generated by the production. Opportunity costs are the alternative returns foregone by using the chosen inputs.
Economic profit acts as an indicator when the focus is turned towards efficiency. In a perfect world, no firm receives economic profit. Firms receive economic profit only when price exceeds opportunity cost of production (including entrepreneurial opportunity cost).
Economic profit = Total revenue - total (opportunity) cost (including normal profit).
A firm can stay in business without economic profit or supernormal profit or above-normal profit. It can continue producing goods and services so long as it is able to pay all opportunity costs. One critical opportunity cost is normal profit. Because accounting profit is generally the combination of normal profit and economic profit, zero economic profit does not mean zero accounting profit. A firm can continue by earning normal profit only.
Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit
Total Revenue - $100 million
Total Cost - $60 million
Entrepreneurial opportunity cost or normal profit (Profit that can be earned from alternative venture) - $30 million
Current activity profit (accounting profit) = $(100 - 60) million = $40 million
Current activity profit (accounting profit) - normal profit = economic profit
That is, $(40 - 30) million = $10 million (economic profit)
In another way,
Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit
That is, ${100 - (60+30)} million = $10 million (economic profit)
Accounting Profit:
Accounting profit is the difference between total revenue earned and the explicit accounting costs incurred to earn the revenue.
Accounting profit differs from economic profit because there is a difference between accounting cost and economic cost. Some accounting costs are not economic costs, and vice versa.
In reality, opportunity costs of all other resources associated with production tends to be equal to explicit accounting cost incurred to earn the revenue.
Wednesday, May 25, 2011
Automatic Stabilizer and Discretionary Fiscal and Monetary Policy
In a stable economy relative prices and outputs must be free to vary with changes made in technology, tastes and preferences of consumers and suppliers of factors of production, namely land, labour and capital.
An automatic stabilizer is any feature of the economic system, which automatically tends to reduce the strength of recessions or inflations without any policy changes being made. Automatic adjustments in expenditures or revenues take place to bring about economic stability without deliberate government intervention.
This can be shown in the following diagram.
Taxes act in such a way that the economy is automatically stabilized. At full-employment National Income NP1, tax revenues are just adequate to cover government expenditure (E). Now if business activity falls and the economy swings down into a recession to NP2, tax collections fall as income falls, and the budget automatically moves towards a deficit. CD measures the amount of deficit at NP2. As tax collections fall, more disposable income is left in the hands of the public. Thus the downward trend is checked as demand increases, and the budget deficit is wiped off.
The tax system also acts as a restraint to upward swing. As National Income rises from NP1 to NP3, tax collections rise and this produces a budget surplus. As a result the disposable income in the hands of public is reduced. This reduces the demand and subsequently inflation. Thus the upward momentum is slowed down.
The degree of automatic stabilization depends on the tax rates. Higher the tax rates, higher will be the degree of stabilization.
Automatic stabilizers are there on the government expenditure side also. During recession unemployment, insurance, compensation and welfare expenditures automatically rise. This maintains the sufficient level of disposable income and checks recession and downward swing by increasing the aggregate demand. The opposite thing happens in case of inflation and budget surplus.
Discretionary Fiscal Policy
Automatic stabilizers can never fully stabilize the economy. So government action is necessary to make the economy stable.
The principal weapons of discretionary fiscal policy are
a) Varying public works and other expenditure programmes
b) Varying transfer expenditure programmes (welfare, subsidy, social security etc.)
c) Varying rates of tax cyclically
Discretionary variations in transfer expenditure programmes and tax rates may have greater short-run stabilizing effects.
Monetary Policy and Fiscal Policy
An important function of the modern government is the attempt to prevent chronic unemployment and stagnant growth and to wipe off the effects of demand inflation or deflation.
Monetary Policy: It is the policy of the Central Bank, which aims at changing the quantity of money or credit conditions. There are various ways like open market operations, change in discount rate etc. The main aim is to ensure that the monetary conditions are consistent with the achievement of the goods of high employment and stable prices.
Fiscal Policy: The government has the ability and responsibility to manage the aggregate demand to ensure a continued prosperity or sustained growth without unemployment and inflation. Fiscal policy is the tool by which the government can affect the aggregate demand. Fiscal policy means change in government expenditure or tax rates.
During depression the government initiates work on public investment projects for the unemployed. These investments are primarily aimed to create work for the people. But the effect of public works on the economy is felt after a certain time. There is a time lag between the launching of the project and generation of production and employment.
Therefore during a mild recession economists rely more on monetary policy than on public works programme (fiscal policy). However, fiscal measures are not to be dispensed with. They should be carried on for their own sake and over long periods of time.
Transfer expenditure programmes (welfare, subsidy, social security etc.) may also be undertaken to stabilize the economy. The government can stop giving some veteran's bonus in inflationary times to bring down the disposable income and aggregate demand and disburse them during periods of depression.
Variation of tax rates: If the economists think that the recession will be brief, a temporary tax cut may prevent income and demand from falling, or a tax rise may be used to eliminate extra demand and inflationary gap.
However there is a need for coordination between fiscal policy and monetary policy. It will not be proper on the part of a government to adopt a restrictive monetary policy when the demand is increasing as a result of an expansionary fiscal policy. An optimum mix of the two must be chosen by the government. In short, fiscal policies, along with stabilizing monetary policies, can provide a favourable and stable economic environment, giving the people a maximum opportunity for achievement.
Automatic Stabilizer Versus Discretionary Fiscal and Monetary Policy
While automatic stabilizers reduce the severity of economic fluctuations, they do not eliminate them. The objective of Discretionary Policy is to reduce the fluctuation even more. So a government should stress on two things.
1) The automatic stabilizers are the first line of defense, but are not sufficient to maintain full stability.
2) Reliance on them in preference to discretionary programme raises some philosophical and ethical questions.
In short, a built-in stabilizer acts to reduce part of any fluctuation in the economy, but does not wipe out 100 per cent of the disturbance. It leaves the rest of the disturbance as a task for fiscal and monetary discretion.
Also read: Role of Fiscal Policy and Monetary Policy
An automatic stabilizer is any feature of the economic system, which automatically tends to reduce the strength of recessions or inflations without any policy changes being made. Automatic adjustments in expenditures or revenues take place to bring about economic stability without deliberate government intervention.
This can be shown in the following diagram.
Taxes act in such a way that the economy is automatically stabilized. At full-employment National Income NP1, tax revenues are just adequate to cover government expenditure (E). Now if business activity falls and the economy swings down into a recession to NP2, tax collections fall as income falls, and the budget automatically moves towards a deficit. CD measures the amount of deficit at NP2. As tax collections fall, more disposable income is left in the hands of the public. Thus the downward trend is checked as demand increases, and the budget deficit is wiped off.
The tax system also acts as a restraint to upward swing. As National Income rises from NP1 to NP3, tax collections rise and this produces a budget surplus. As a result the disposable income in the hands of public is reduced. This reduces the demand and subsequently inflation. Thus the upward momentum is slowed down.
The degree of automatic stabilization depends on the tax rates. Higher the tax rates, higher will be the degree of stabilization.
Automatic stabilizers are there on the government expenditure side also. During recession unemployment, insurance, compensation and welfare expenditures automatically rise. This maintains the sufficient level of disposable income and checks recession and downward swing by increasing the aggregate demand. The opposite thing happens in case of inflation and budget surplus.
Discretionary Fiscal Policy
Automatic stabilizers can never fully stabilize the economy. So government action is necessary to make the economy stable.
The principal weapons of discretionary fiscal policy are
a) Varying public works and other expenditure programmes
b) Varying transfer expenditure programmes (welfare, subsidy, social security etc.)
c) Varying rates of tax cyclically
Discretionary variations in transfer expenditure programmes and tax rates may have greater short-run stabilizing effects.
Monetary Policy and Fiscal Policy
An important function of the modern government is the attempt to prevent chronic unemployment and stagnant growth and to wipe off the effects of demand inflation or deflation.
Monetary Policy: It is the policy of the Central Bank, which aims at changing the quantity of money or credit conditions. There are various ways like open market operations, change in discount rate etc. The main aim is to ensure that the monetary conditions are consistent with the achievement of the goods of high employment and stable prices.
Fiscal Policy: The government has the ability and responsibility to manage the aggregate demand to ensure a continued prosperity or sustained growth without unemployment and inflation. Fiscal policy is the tool by which the government can affect the aggregate demand. Fiscal policy means change in government expenditure or tax rates.
During depression the government initiates work on public investment projects for the unemployed. These investments are primarily aimed to create work for the people. But the effect of public works on the economy is felt after a certain time. There is a time lag between the launching of the project and generation of production and employment.
Therefore during a mild recession economists rely more on monetary policy than on public works programme (fiscal policy). However, fiscal measures are not to be dispensed with. They should be carried on for their own sake and over long periods of time.
Transfer expenditure programmes (welfare, subsidy, social security etc.) may also be undertaken to stabilize the economy. The government can stop giving some veteran's bonus in inflationary times to bring down the disposable income and aggregate demand and disburse them during periods of depression.
Variation of tax rates: If the economists think that the recession will be brief, a temporary tax cut may prevent income and demand from falling, or a tax rise may be used to eliminate extra demand and inflationary gap.
However there is a need for coordination between fiscal policy and monetary policy. It will not be proper on the part of a government to adopt a restrictive monetary policy when the demand is increasing as a result of an expansionary fiscal policy. An optimum mix of the two must be chosen by the government. In short, fiscal policies, along with stabilizing monetary policies, can provide a favourable and stable economic environment, giving the people a maximum opportunity for achievement.
Automatic Stabilizer Versus Discretionary Fiscal and Monetary Policy
While automatic stabilizers reduce the severity of economic fluctuations, they do not eliminate them. The objective of Discretionary Policy is to reduce the fluctuation even more. So a government should stress on two things.
1) The automatic stabilizers are the first line of defense, but are not sufficient to maintain full stability.
2) Reliance on them in preference to discretionary programme raises some philosophical and ethical questions.
In short, a built-in stabilizer acts to reduce part of any fluctuation in the economy, but does not wipe out 100 per cent of the disturbance. It leaves the rest of the disturbance as a task for fiscal and monetary discretion.
Also read: Role of Fiscal Policy and Monetary Policy
Monday, May 23, 2011
Theory of Consumption - Revealed Preference Analysis
Introduction: In 1960 Mr. Samuelson introduced the Revealed Preference Analysis to explain the behaviour of the consumer. The fundamental difference between the Utility Analysis, Indifference Curve Analysis and Revealed Preference Analysis is that when the first two are based on the psychology of the consumer, the revealed Preference is based on the actual behaviour of the consumer.
Assumptions: In order to explain the behaviour of the consumer with the help of Revealed preference Analysis, Mr. Samuelson made the following assumptions.
1. Utility cannot be measured.
2. The consumer always prefers more of a good to less, until his income is exhausted.
3. It is based on the Principle of Strong Ordering. This means that if the consumer is given many commodities, he can place them in order of his preference.
4. It is based on the Principle of Consistency, and the consumer acts consistently. 'Consistency in choice' means that if the consumer chooses the commodity combination P in preference to all other combinations, then he will never subsequently choose any combination from the rejected ones in a situation in which P is also available. This is the key to this approach.
5. The choice made by the consumer will reveal the preference of the consumer for the commodity. If he chooses P over Q, then this choice reveals his preference for P.
6. The consumer's preference pattern maintains transitivity. If the consumer prefers P over Q, and Q over R, Then he definitely prefers P over R.
The substitution effect is always non-positive. It can never result into a reduction in the purchase of the commodity whose price has fallen.
In order to find out the consumer's equilibrium position with the Revealed Preference Analysis, we make the following assumptions.
1. The consumer has a fixed amount of income.
2. There are only two commodities available in the market, namely A and B.
On the basis of these assumptions we can now draw the following diagram and find out the consumer's equilibrium position.
Let us assume that the price line or budget line is XY. It represents all combinations of commodities A and B available to the consumer. The consumer can choose any of the combinations of commodities A and B, lying within, or on border of the shaded triangle OXY.
We now assume that out of all the combinations available to him, the consumer chooses to consume Oa of commodity A and Ob of commodity B. This combination is represented by the point P. Thus the consumer has chosen the combination P in preference to all other combinations lying within the triangle OXY. So in future he will never choose any combination from triangle OXY in a situation where P is also available.
Now there is a fall in the price of commodity B. The price of commodity A and the income of the consumer remains constant. Given the same income, the consumer can still consume OX of commodity A by spending all his income on commodity A. Also as the price of commodity B has fallen, he can consume OZ of commodity B instead of Ob, by spending all his income on commodity B. Therefore, XZ is the new budget line.
A fall in the price of a commodity is equivalent to an increase in real income. This income effect needs to be eliminated. This is done by moving the new budget line XZ towards the origin O, keeping it parallel to its original position, until it passes through point P. So the new budget line is X'Z', where the consumer is able to purchase his original combinations of commodities A and B at P, but at the new set of prices. (new price for commodity B only; price of commodity A has not changed). The consumer can now choose any point on X'Z'.
Considering the segment X'P: All points on segment X'P were available to the consumer before the fall in the price of commodity B. All these points were within the triangle OXY and rejected by him originally in favour of the combination at point P. So, in the new situation, where P is still available, he will definitely choose P rather than a combination previously rejected. This is because the consumer moves according to the Principle of Consistency.
Considering the segment PZ': The segment PZ' represents combinations of commodities which were not previously available to the consumer. It would therefore be quite consistent for the consumer to choose some combination along the PZ' part of the new budget line. This could mean consuming more of commodity B, whose price has fallen.
This implies that the consumer either consumes same quantity of commodity B as before by remaining at point P, or more of the commodity B by choosing a point on the segment PZ'. The consumer selects the point Q. If we now restore the income effect and return to the changed budget line XZ, the consumer will move to R on the changed budget line XZ, as a result of both income effect and substitution effect, where bc (the price effect) = bs (the substitution effect) + sc (the income effect).
Conclusion: The substitution effect can never lead the consumer to buy less of a commodity whose price has fallen.
Unless the income effect is negative and of sufficient magnitude to neutralize the substitution effect, under the assumption of consistency in choice, the demand curve of a consumer for any product will slope downward to the right.
Criticism: Some economists have said that this analysis is based on the assumption of Strong Ordering. But according to the critics if the consumer is given many commodities it will not be possible for him to follow the Principle of Strong Ordering. In the case of many commodities there may be a stage where the consumer will be indifferent.
Though there are some defects in this analysis, the advocates of this analysis regard this as superior to the other two because it is based on the actual behaviour of the consumer. So according to them this is more scientific because it is based on the actual behaviour of the consumer.
Assumptions: In order to explain the behaviour of the consumer with the help of Revealed preference Analysis, Mr. Samuelson made the following assumptions.
1. Utility cannot be measured.
2. The consumer always prefers more of a good to less, until his income is exhausted.
3. It is based on the Principle of Strong Ordering. This means that if the consumer is given many commodities, he can place them in order of his preference.
4. It is based on the Principle of Consistency, and the consumer acts consistently. 'Consistency in choice' means that if the consumer chooses the commodity combination P in preference to all other combinations, then he will never subsequently choose any combination from the rejected ones in a situation in which P is also available. This is the key to this approach.
5. The choice made by the consumer will reveal the preference of the consumer for the commodity. If he chooses P over Q, then this choice reveals his preference for P.
6. The consumer's preference pattern maintains transitivity. If the consumer prefers P over Q, and Q over R, Then he definitely prefers P over R.
The substitution effect is always non-positive. It can never result into a reduction in the purchase of the commodity whose price has fallen.
In order to find out the consumer's equilibrium position with the Revealed Preference Analysis, we make the following assumptions.
1. The consumer has a fixed amount of income.
2. There are only two commodities available in the market, namely A and B.
On the basis of these assumptions we can now draw the following diagram and find out the consumer's equilibrium position.
Let us assume that the price line or budget line is XY. It represents all combinations of commodities A and B available to the consumer. The consumer can choose any of the combinations of commodities A and B, lying within, or on border of the shaded triangle OXY.
We now assume that out of all the combinations available to him, the consumer chooses to consume Oa of commodity A and Ob of commodity B. This combination is represented by the point P. Thus the consumer has chosen the combination P in preference to all other combinations lying within the triangle OXY. So in future he will never choose any combination from triangle OXY in a situation where P is also available.
Now there is a fall in the price of commodity B. The price of commodity A and the income of the consumer remains constant. Given the same income, the consumer can still consume OX of commodity A by spending all his income on commodity A. Also as the price of commodity B has fallen, he can consume OZ of commodity B instead of Ob, by spending all his income on commodity B. Therefore, XZ is the new budget line.
A fall in the price of a commodity is equivalent to an increase in real income. This income effect needs to be eliminated. This is done by moving the new budget line XZ towards the origin O, keeping it parallel to its original position, until it passes through point P. So the new budget line is X'Z', where the consumer is able to purchase his original combinations of commodities A and B at P, but at the new set of prices. (new price for commodity B only; price of commodity A has not changed). The consumer can now choose any point on X'Z'.
Considering the segment X'P: All points on segment X'P were available to the consumer before the fall in the price of commodity B. All these points were within the triangle OXY and rejected by him originally in favour of the combination at point P. So, in the new situation, where P is still available, he will definitely choose P rather than a combination previously rejected. This is because the consumer moves according to the Principle of Consistency.
Considering the segment PZ': The segment PZ' represents combinations of commodities which were not previously available to the consumer. It would therefore be quite consistent for the consumer to choose some combination along the PZ' part of the new budget line. This could mean consuming more of commodity B, whose price has fallen.
This implies that the consumer either consumes same quantity of commodity B as before by remaining at point P, or more of the commodity B by choosing a point on the segment PZ'. The consumer selects the point Q. If we now restore the income effect and return to the changed budget line XZ, the consumer will move to R on the changed budget line XZ, as a result of both income effect and substitution effect, where bc (the price effect) = bs (the substitution effect) + sc (the income effect).
Conclusion: The substitution effect can never lead the consumer to buy less of a commodity whose price has fallen.
Unless the income effect is negative and of sufficient magnitude to neutralize the substitution effect, under the assumption of consistency in choice, the demand curve of a consumer for any product will slope downward to the right.
Criticism: Some economists have said that this analysis is based on the assumption of Strong Ordering. But according to the critics if the consumer is given many commodities it will not be possible for him to follow the Principle of Strong Ordering. In the case of many commodities there may be a stage where the consumer will be indifferent.
Though there are some defects in this analysis, the advocates of this analysis regard this as superior to the other two because it is based on the actual behaviour of the consumer. So according to them this is more scientific because it is based on the actual behaviour of the consumer.
Wednesday, May 18, 2011
General Equilibrium Theory - Overview
Micro-economics is the study of the behaviour of isolated economic entities as individual consumers, firms or industries. It deals with the division of the total output among individuals, industries, products, and firms and the allocation of resources among competing users. It looks at the whole thing with a singular point of view.
Contrarily, macro-economics is the study of the behaviour of the economy as a whole, as measured by the aggregate value of such variables like the aggregate volume of output of an economy (GNP), the extent to which its resources are employed, the size of the national income, the price level (i.e. whether there is inflation, deflation or price stability), and the level of employment. It is concerned with the overall dimension of economic life. It looks at the size, shape and functioning of the whole economic system.
General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of micro-economics to analyze the behaviour of the entire economy.
In common with macro-economics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy.
In common with micro-economics, the analysis in general equilibrium theory is carried out in terms of individual decision-makers and commodities, rather than in terms of aggregates.
The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macro-economic theory. Given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macro-economics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of the individual consumers, producers and commodities making up these aggregates.
Micro-economics may be regarded as a simple form of general equilibrium theory in which the decision makers in the economy are the consumers, the producers and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (money or security). The producer, in his turn, has to take decisions on the number of units of labour to hire to produce a particular commodity, which may be used either as a consumption or as a capital item. The producer has also to determine how much units to set aside for production in future. The resulting interaction among these consumption, wealth-holding, and production decisions determine such variables as the price of a commodity, the interest rate, the number of units of labour and capital employed, the number of units of output, their distribution cost etc. within a framework of government policies, namely fiscal and monetary.
Macro-economics provides simple and straightforward answer to such questions like which goods will be produced and how, and also who will acquire them. General equilibrium theory has a much more ambitious goal - that of analyzing the operations of the economy, explicitly taking into account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers, as well as the differences in technological possibilities available to production firms. To quote J. K. Galbraith: "There is also the world of farmers, repairmen, retailer, small manufacturer, plumber, television repairmen, service station operator, medical practitioner, artist, actress, photographer..... In economics, as in anatomy, the whole is much more than the sum of the parts." The analytical framework of general equilibrium analysis is that of micro-economics.
The essential theme of general equilibrium analysis is that all markets are interrelated (commodity market, labour market, money market, capital market, stock market etc). It deals with interconnected markets and emphasizes the inter-relationship of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each commodity depends upon all prices. If the goods A and B are gross substitutes, an increase in the price of A will induce consumers as a whole to substitute B for A. The opposite would be the case if A and B were compliments. Likewise pairs of inputs may also be defined as substitutes and compliments. Furthermore, production and consumption are not independent. Consumers earn their incomes from the sale of labour, services, and other productive factors to producers. Similarly they spend their incomes on goods and services produced by the firms. Thus business firms earn their income from the expenditure made by consumers. As a consequence, equilibrium from all commodity markets and factor (land, labour and capital) markets must be determined simultaneously in order to secure a consistent set of prices.
The general equilibrium theory uses utility and production function of consumers and producers, prices of all factors of production and commodities, and quantities purchased by each consumer and producer. Consumers and producers behave in a manner to maximize their utility and profit correspondingly, and there exists a set of equilibrium prices, with which all the markets will be cleared. Existence of a competitive economy is assumed, and the general equilibrium analysis is done with a relative price concept in view. Absolute prices are nor relevant.
General equilibrium theory deals with the fundamentals of supply and demand within an economy where there are a group of markets. It considers all markets in totality. Its objective is to prove that all input and output prices are at equilibrium. It was initially done by Leon Walras, a French economist in the year 1870. The concept was revised by Gustav Cassel in 1932. It is popularly known as the Walras-Cassel Model.
Contrarily, macro-economics is the study of the behaviour of the economy as a whole, as measured by the aggregate value of such variables like the aggregate volume of output of an economy (GNP), the extent to which its resources are employed, the size of the national income, the price level (i.e. whether there is inflation, deflation or price stability), and the level of employment. It is concerned with the overall dimension of economic life. It looks at the size, shape and functioning of the whole economic system.
General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of micro-economics to analyze the behaviour of the entire economy.
In common with macro-economics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy.
In common with micro-economics, the analysis in general equilibrium theory is carried out in terms of individual decision-makers and commodities, rather than in terms of aggregates.
The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macro-economic theory. Given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macro-economics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of the individual consumers, producers and commodities making up these aggregates.
Micro-economics may be regarded as a simple form of general equilibrium theory in which the decision makers in the economy are the consumers, the producers and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (money or security). The producer, in his turn, has to take decisions on the number of units of labour to hire to produce a particular commodity, which may be used either as a consumption or as a capital item. The producer has also to determine how much units to set aside for production in future. The resulting interaction among these consumption, wealth-holding, and production decisions determine such variables as the price of a commodity, the interest rate, the number of units of labour and capital employed, the number of units of output, their distribution cost etc. within a framework of government policies, namely fiscal and monetary.
Macro-economics provides simple and straightforward answer to such questions like which goods will be produced and how, and also who will acquire them. General equilibrium theory has a much more ambitious goal - that of analyzing the operations of the economy, explicitly taking into account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers, as well as the differences in technological possibilities available to production firms. To quote J. K. Galbraith: "There is also the world of farmers, repairmen, retailer, small manufacturer, plumber, television repairmen, service station operator, medical practitioner, artist, actress, photographer..... In economics, as in anatomy, the whole is much more than the sum of the parts." The analytical framework of general equilibrium analysis is that of micro-economics.
The essential theme of general equilibrium analysis is that all markets are interrelated (commodity market, labour market, money market, capital market, stock market etc). It deals with interconnected markets and emphasizes the inter-relationship of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each commodity depends upon all prices. If the goods A and B are gross substitutes, an increase in the price of A will induce consumers as a whole to substitute B for A. The opposite would be the case if A and B were compliments. Likewise pairs of inputs may also be defined as substitutes and compliments. Furthermore, production and consumption are not independent. Consumers earn their incomes from the sale of labour, services, and other productive factors to producers. Similarly they spend their incomes on goods and services produced by the firms. Thus business firms earn their income from the expenditure made by consumers. As a consequence, equilibrium from all commodity markets and factor (land, labour and capital) markets must be determined simultaneously in order to secure a consistent set of prices.
The general equilibrium theory uses utility and production function of consumers and producers, prices of all factors of production and commodities, and quantities purchased by each consumer and producer. Consumers and producers behave in a manner to maximize their utility and profit correspondingly, and there exists a set of equilibrium prices, with which all the markets will be cleared. Existence of a competitive economy is assumed, and the general equilibrium analysis is done with a relative price concept in view. Absolute prices are nor relevant.
General equilibrium theory deals with the fundamentals of supply and demand within an economy where there are a group of markets. It considers all markets in totality. Its objective is to prove that all input and output prices are at equilibrium. It was initially done by Leon Walras, a French economist in the year 1870. The concept was revised by Gustav Cassel in 1932. It is popularly known as the Walras-Cassel Model.
Tuesday, May 17, 2011
Part IV- Shifts of IS and LM Curves
Synthesis of Monetary and Income Analysis - Part IV
Any fiscal policy change shifts the IS Curve, and any monetary policy change shifts the LM Curve.
a) Shift of the IS Curve due to changes in fiscal policy
The IS Curve shifts to the right to I'S' due to expansionary fiscal policy. Expansionary fiscal policy may be adopted through
i) Cut in taxes
ii) Increase in government expenditure
These are basically called real disturbances in the economy.
H becomes the new equilibrium position. When government spends more, there is an increase in income due to the operation of the multiplier. So the income increases to Yc from Ye. If national income increases, the demand for money also increases. This leads to an increase in the rate of interest, which now goes up to rc.
A cut or fall in taxes lead to an increase in the disposable income (Yd). Similarly this also leads to an increase in the rate of interest. Yd = Y - Tax.
The opposite thing will happen if the national income falls. The demand for money will fall. This would lead to a fall in the rate of interest.
b) Shift of the LM Curve due to changes in monetary policy
An increase in money supply or adoption of an expansionary monetary policy leads to a fall in the price of money, namely the rate of interest. This is basically called a monetary disturbance in the economy. Rate of Interest falls from re to rd. This shifts the LM Curve downward to L'M'. E' becomes the new equilibrium position. Due to a fall in the rate of interest, investment increases in the commodity market. Change in investment will increase the national income because ΔY = m(ΔI). National Income increases from Ye to Yd.
Thus, an increase in money supply leads to
a) Fall in the demand for money
b) Fall in the rate of interest
c) Rise in investment
d) Rise in the level of income
Similarly, a decrease in money supply leads to
a) Rise in the demand for money
b) Rise in the rate of interest
c) Fall in investment
d) Fall in the level of income
Any change in consumption function, investment function, government expenditure or taxes Shifts the IS Curve. Upward or downward shift depends upon whether the effect is expansionary or contractionary.
Any change in the demand for money, supply of money (or price level) Shifts the LM Curve. Again, upward or downward shift depends upon whether the effect is expansionary or contractionary.
c) There will be a number of possibilities if both the curves shift, due to simultaneous changes in monetary policy and fiscal policy.
If the IS Curve shifts to the right and the LM Curve to the left, the rate of interest increases from ro to r1, but income remains unchanged at Yo.
If both the curves shift to the right, the rate of interest remains unchanged at ro, but the level of income increases from Yo to Y1.
Various combinations of expansionary and contractionary monetary and fiscal policies may be adopted by the government to bring about the desired change in the economy.
Part IV of IV
Any fiscal policy change shifts the IS Curve, and any monetary policy change shifts the LM Curve.
a) Shift of the IS Curve due to changes in fiscal policy
The IS Curve shifts to the right to I'S' due to expansionary fiscal policy. Expansionary fiscal policy may be adopted through
i) Cut in taxes
ii) Increase in government expenditure
These are basically called real disturbances in the economy.
H becomes the new equilibrium position. When government spends more, there is an increase in income due to the operation of the multiplier. So the income increases to Yc from Ye. If national income increases, the demand for money also increases. This leads to an increase in the rate of interest, which now goes up to rc.
A cut or fall in taxes lead to an increase in the disposable income (Yd). Similarly this also leads to an increase in the rate of interest. Yd = Y - Tax.
The opposite thing will happen if the national income falls. The demand for money will fall. This would lead to a fall in the rate of interest.
b) Shift of the LM Curve due to changes in monetary policy
An increase in money supply or adoption of an expansionary monetary policy leads to a fall in the price of money, namely the rate of interest. This is basically called a monetary disturbance in the economy. Rate of Interest falls from re to rd. This shifts the LM Curve downward to L'M'. E' becomes the new equilibrium position. Due to a fall in the rate of interest, investment increases in the commodity market. Change in investment will increase the national income because ΔY = m(ΔI). National Income increases from Ye to Yd.
Thus, an increase in money supply leads to
a) Fall in the demand for money
b) Fall in the rate of interest
c) Rise in investment
d) Rise in the level of income
Similarly, a decrease in money supply leads to
a) Rise in the demand for money
b) Rise in the rate of interest
c) Fall in investment
d) Fall in the level of income
Any change in consumption function, investment function, government expenditure or taxes Shifts the IS Curve. Upward or downward shift depends upon whether the effect is expansionary or contractionary.
Any change in the demand for money, supply of money (or price level) Shifts the LM Curve. Again, upward or downward shift depends upon whether the effect is expansionary or contractionary.
c) There will be a number of possibilities if both the curves shift, due to simultaneous changes in monetary policy and fiscal policy.
If the IS Curve shifts to the right and the LM Curve to the left, the rate of interest increases from ro to r1, but income remains unchanged at Yo.
If both the curves shift to the right, the rate of interest remains unchanged at ro, but the level of income increases from Yo to Y1.
Various combinations of expansionary and contractionary monetary and fiscal policies may be adopted by the government to bring about the desired change in the economy.
Part IV of IV
Monday, May 16, 2011
Part III - Derivation of the LM-Curve and Equilibrium
Synthesis of Monetary and Income Analysis - Part III
Derivation of the LM-Curve and equilibrium
The derivation is based on the following three propositions.
1. An increase in the level of income leads to an increase in the demand for money.
2. An increase in the demand for money leads to an increase in the rate of interest.
3. Therefore, an increase in the level of income leads to an increase in the rate of interest.
The left part of the diagram shows the Demand for and Supply of money.
Ms is the supply curve for money.
Md is the demand curve for money.
E is the point of equilibrium in the money market.
Oro is the equilibrium rate of interest.
The right part of the diagram shows the relationship between level of income and the rate of interest in the money market, and the derivation of the LM_Curve.
OYo is the level of income.
Oro is the rate of interest.
Now income increases from Yo to Y1. So the demand for money will go up, and the demand curve for money, Md, will shift to the right. M'd becomes the new demand curve for money. F becomes the new equilibrium point, and the rate of interest goes up to Or1.
Now if we join the points E', F' etc. in diagram (b), we get the LM-Curve. 'L' stands for the demand for money (speculative) or liquidity preference and 'M' stands for the supply of money. The LM-Curve shows the alternative combinations of the rate of interest and the level of income for which money market is in equilibrium. In other words, at any point on the LM-Curve demand for money or liquidity preference is equal to the supply of Money.
General Equilibrium of the Commodity market and the Money market
We have shown two different equilibrium relationships between the rate of interest and the level of income, in the form of the IS-Curve and the LM-Curve. The commodity market and the money market are closely related to one another. Decisions regarding consumption and investment determine people's behaviour regarding wealth-holding between money and bond, and thus their demand for money. The rate of interest and the level of income in both the commodity market and the money market are the same.
Therefore the general (overall) equilibrium of the economy is ensured when the rate of interest and income are such that these are compatible with equilibrium in both the markets. The IS-Curve shows the equilibrium in the commodity market, and the LM-Curve shows the equilibrium in the money market. In other words, what it implies is that the values in question must lie on both the LM and the IS Curves for an overall equilibrium condition to be true. This can occur only when both the curves intersect.
Here both the IS and LM Curves are plotted on the same axes. The equilibrium level of income is given at Ye, where OYe is the equilibrium level of income, and that of interest at re, where Ore is the equilibrium rate of interest. Only at point G both the markets are at equilibrium. The diagram shows the general equilibrium of the commodity market and the money market. This is called the Synthesis of Monetary Analysis and Income Analysis, or the Synthesis of Fiscal Policy and Monetary Policy.
Part III of IV | Part IV: Shifts of IS and LM Curves
Derivation of the LM-Curve and equilibrium
The derivation is based on the following three propositions.
1. An increase in the level of income leads to an increase in the demand for money.
2. An increase in the demand for money leads to an increase in the rate of interest.
3. Therefore, an increase in the level of income leads to an increase in the rate of interest.
The left part of the diagram shows the Demand for and Supply of money.
Ms is the supply curve for money.
Md is the demand curve for money.
E is the point of equilibrium in the money market.
Oro is the equilibrium rate of interest.
The right part of the diagram shows the relationship between level of income and the rate of interest in the money market, and the derivation of the LM_Curve.
OYo is the level of income.
Oro is the rate of interest.
Now income increases from Yo to Y1. So the demand for money will go up, and the demand curve for money, Md, will shift to the right. M'd becomes the new demand curve for money. F becomes the new equilibrium point, and the rate of interest goes up to Or1.
Now if we join the points E', F' etc. in diagram (b), we get the LM-Curve. 'L' stands for the demand for money (speculative) or liquidity preference and 'M' stands for the supply of money. The LM-Curve shows the alternative combinations of the rate of interest and the level of income for which money market is in equilibrium. In other words, at any point on the LM-Curve demand for money or liquidity preference is equal to the supply of Money.
General Equilibrium of the Commodity market and the Money market
We have shown two different equilibrium relationships between the rate of interest and the level of income, in the form of the IS-Curve and the LM-Curve. The commodity market and the money market are closely related to one another. Decisions regarding consumption and investment determine people's behaviour regarding wealth-holding between money and bond, and thus their demand for money. The rate of interest and the level of income in both the commodity market and the money market are the same.
Therefore the general (overall) equilibrium of the economy is ensured when the rate of interest and income are such that these are compatible with equilibrium in both the markets. The IS-Curve shows the equilibrium in the commodity market, and the LM-Curve shows the equilibrium in the money market. In other words, what it implies is that the values in question must lie on both the LM and the IS Curves for an overall equilibrium condition to be true. This can occur only when both the curves intersect.
Here both the IS and LM Curves are plotted on the same axes. The equilibrium level of income is given at Ye, where OYe is the equilibrium level of income, and that of interest at re, where Ore is the equilibrium rate of interest. Only at point G both the markets are at equilibrium. The diagram shows the general equilibrium of the commodity market and the money market. This is called the Synthesis of Monetary Analysis and Income Analysis, or the Synthesis of Fiscal Policy and Monetary Policy.
Part III of IV | Part IV: Shifts of IS and LM Curves
Saturday, May 14, 2011
Part II - Derivation of the IS Curve
Synthesis of Monetary and Income Analysis - Part II
Derivation of the IS-Curve
The derivation is based on the following three propositions.
1. The rate of interest determines the level of investment (Autonomous). 2. The level of investment determines the level of income. 3. Therefore, the rate of interest determines the level of income.
Diagram (a) shows that lower the rate of interest, the higher the volume of investment.
Diagram (b) shows the relationship between income and investment.
We know that change in income = multiplier times change in autonomous investment
Or, ΔY = m(ΔI)
Or, m = ΔY/(ΔI)
If investment changes by a small amount, national income changes by a multiplied amount.
Corresponding to each level of investment there is a particular level of income. Here the rate of interest and the level of income move in opposite directions. Lower the rate of interest, higher is the level of investment and higher the level of national income.
The IS-Curve shows the alternative combinations of the rate of interest and the level of income, which bring about equilibrium in the commodity market. In other words, every point on the IS-Curve is a point of savings-investment equality.
Part II of IV | Part III: Derivation of the LM Curve and equilibrium
Derivation of the IS-Curve
The derivation is based on the following three propositions.
1. The rate of interest determines the level of investment (Autonomous). 2. The level of investment determines the level of income. 3. Therefore, the rate of interest determines the level of income.
Diagram (a) shows that lower the rate of interest, the higher the volume of investment.
Diagram (b) shows the relationship between income and investment.
We know that change in income = multiplier times change in autonomous investment
Or, ΔY = m(ΔI)
Or, m = ΔY/(ΔI)
If investment changes by a small amount, national income changes by a multiplied amount.
Corresponding to each level of investment there is a particular level of income. Here the rate of interest and the level of income move in opposite directions. Lower the rate of interest, higher is the level of investment and higher the level of national income.
The IS-Curve shows the alternative combinations of the rate of interest and the level of income, which bring about equilibrium in the commodity market. In other words, every point on the IS-Curve is a point of savings-investment equality.
Part II of IV | Part III: Derivation of the LM Curve and equilibrium
Friday, May 13, 2011
Synthesis of Monetary and Income Analysis - Part I
IS-LM Analysis - Commodity Market and Money Market Equilibrium
Macro Economics deals with the fundamental problems, which are concerned with determination of gross domestic output, income and employment, price level, and growth of national income. In the short-run determination of income, employment and price level are the primary concerns. Government policies, necessary to control these variables, are required to be ascertained, and put into use at the right time to accelerate or retard the economy.
Keynesian analysis is known as Income Analysis. The Monetary Analysis was done by classical economists. But this is actually a sysnthesis of Keynesian economics.
Economists Hicks and Hansen designed a model, which is popularly known as the Hicks-Hansen IS-LM Analysis. Assumptions of this analysis are as follows.
1. An economy consists of four types of markets, namely commodity market, money market, securities market and labour market.
2. There are enough resources available to produce the required quantity of goods and services, in accordance with the demand.
3. Any change in demand is reflected in a change in output.
4. Aggregate demand or expenditure consists of consumption expenditure, investment expenditure and government expenditure.
5. Aggregate supply consists of consumption goods and savings. To this we add tax collected (T), which is the income of the government.
I) Income Analysis - This is done in the commodity market. II) Monetary analysis - This is done in the money market.
Commodity market equilibrium condition
1. Consumption Function
'a' is the minimum level of consumption even at zero income. The income identity is Y = C + S (income = consumption + savings)
C = a + b*Y
Or, C = a + (ΔC / ΔY)*(Y)
Y = disposable income
2. Savings Function
s = ΔS / ΔY
3. Investment Function
Investment (I) = f(r), where 'r' is the rate of interest. Investment is inversely related to the rate of interest, as rate of interest is the cost of borrowing investment money.
This shows the equilibrium condition in the commodity market. The commodity market is said to be in equilibrium when the economy spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.
Y = E Or, C + S = C + I
C cancels out from both the sides of the equation, leaving S and I on either side, which are equal. That is, S = I (savings = investment)
Money Market Equilibrium condition
Demand function for money or Money-Demand function is Md = KPY + L(r)
where Md = demand for money
P = Price Level
Y = money income (gross national product)
PY = National Income or the money value of the goods and services produced. It is the real income.
K = proportion of money that is held for transactions purpose and precautionary purpose.
Transaction demand and precautionary demand depend upon the level of income. If the income increases, the demand for money also increases. Any increase or decrease in the rate of interest is unable to influence these two demands for money. Only speculative demand for money is influenced by the rate of interest.
"L" = Speculative demand for money or Liquidity Preference (that is, preference to keep liquid cash). 'L' is a function of the rate of interest. That is, L = f(r)
Suppose an individual is initially at point A. He is holding OMo amount of money, when the rate of interest is Oro. Money holding means the sacrifice of the current rate of interest. If the rate of interest goes up, an individual reduces his money holding, in order to earn the high rate of interest. Therefore, the rate of interest is called the opportunity cost of holding money, i.e. loss of the opportunity to earn interest at the current rate. Higher the rate of interest, higher is the opportunity cost of holding money, and consequently lower is the demand for money. People will then want to maintain their wealth in the form of bonds and securities.
Money Supply curve
Ms = C + D
C = currency in circulation in the form of notes and coins.
D = deposit or bank money
Money supply, Ms, remains fixed in the short-run, as it is controlled by the Central Bank, the central monetary authority. Equilibrium condition in the money market is established when Md = Ms (demand for money = supply of money).
Part I - of IV | Part II - Derivation of the IS Curve
Macro Economics deals with the fundamental problems, which are concerned with determination of gross domestic output, income and employment, price level, and growth of national income. In the short-run determination of income, employment and price level are the primary concerns. Government policies, necessary to control these variables, are required to be ascertained, and put into use at the right time to accelerate or retard the economy.
Keynesian analysis is known as Income Analysis. The Monetary Analysis was done by classical economists. But this is actually a sysnthesis of Keynesian economics.
Economists Hicks and Hansen designed a model, which is popularly known as the Hicks-Hansen IS-LM Analysis. Assumptions of this analysis are as follows.
1. An economy consists of four types of markets, namely commodity market, money market, securities market and labour market.
2. There are enough resources available to produce the required quantity of goods and services, in accordance with the demand.
3. Any change in demand is reflected in a change in output.
4. Aggregate demand or expenditure consists of consumption expenditure, investment expenditure and government expenditure.
5. Aggregate supply consists of consumption goods and savings. To this we add tax collected (T), which is the income of the government.
I) Income Analysis - This is done in the commodity market. II) Monetary analysis - This is done in the money market.
Commodity market equilibrium condition
1. Consumption Function
'a' is the minimum level of consumption even at zero income. The income identity is Y = C + S (income = consumption + savings)C = a + b*Y
Or, C = a + (ΔC / ΔY)*(Y)
Y = disposable income
2. Savings Function
s = ΔS / ΔY
3. Investment Function
Investment (I) = f(r), where 'r' is the rate of interest. Investment is inversely related to the rate of interest, as rate of interest is the cost of borrowing investment money.
This shows the equilibrium condition in the commodity market. The commodity market is said to be in equilibrium when the economy spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.
Y = E Or, C + S = C + I
C cancels out from both the sides of the equation, leaving S and I on either side, which are equal. That is, S = I (savings = investment)
Money Market Equilibrium condition
Demand function for money or Money-Demand function is Md = KPY + L(r)
where Md = demand for money
P = Price Level
Y = money income (gross national product)
PY = National Income or the money value of the goods and services produced. It is the real income.
K = proportion of money that is held for transactions purpose and precautionary purpose.
Transaction demand and precautionary demand depend upon the level of income. If the income increases, the demand for money also increases. Any increase or decrease in the rate of interest is unable to influence these two demands for money. Only speculative demand for money is influenced by the rate of interest.
"L" = Speculative demand for money or Liquidity Preference (that is, preference to keep liquid cash). 'L' is a function of the rate of interest. That is, L = f(r)
Suppose an individual is initially at point A. He is holding OMo amount of money, when the rate of interest is Oro. Money holding means the sacrifice of the current rate of interest. If the rate of interest goes up, an individual reduces his money holding, in order to earn the high rate of interest. Therefore, the rate of interest is called the opportunity cost of holding money, i.e. loss of the opportunity to earn interest at the current rate. Higher the rate of interest, higher is the opportunity cost of holding money, and consequently lower is the demand for money. People will then want to maintain their wealth in the form of bonds and securities.Money Supply curve
Ms = C + D
C = currency in circulation in the form of notes and coins.
D = deposit or bank money
Money supply, Ms, remains fixed in the short-run, as it is controlled by the Central Bank, the central monetary authority. Equilibrium condition in the money market is established when Md = Ms (demand for money = supply of money).
Part I - of IV | Part II - Derivation of the IS Curve
Saturday, May 7, 2011
Effects of Inflation
Effect on Production
During inflation producers try to minimize the risk. Hence a lot of production potential is sacrificed. Goods that are more durable are produced more; as compared to goods that are less durable. This alters the pattern of production.
Inflation gives rise to more speculation and hoarding, which is bad for the economy.
The basic knowledge about the market tends to lose its importance, and producers and consumers have to update themselves constantly.
Production and economic growth gets seriously retarded, as the products, at high prices, may fail to find a buyer.
Wrong anticipations and misallocation of resources lead to loss of profit and growth.
Effect on Distribution of Wealth
Inflation has its own effects on the aggregate demand, which in turn puts its effects on total production and income. Following are the several effects of inflation.
1. As demand for money increases, its price, namely the rate of interest, rises. That brings down the investment.
2. Inflation reduces the total output of the community.
3. As consumers feel insecure during periods of inflation, their desire to save increases. Thus, propensity to save rises.
4. As the value of money falls, and consequently the real value of wealth in the hands of consumers, spending made by the consumers fall.
5. As goods fetch higher prices in the domestic market, it discourages export, and to an extent encourages imports. More imports deplete the foreign exchange reserve of a country.
6. As profit expectation remains high due to high prices, it encourages investment in some way.
Redistribution of income and wealth take place during periods of inflation. Rate of growth of the economy in also reduced. During inflation people do not want to hold the money, whose value is falling. So there may be a conversion into other assets, in the form of bonds, securities or gold and silver. Wages and profits increase relatively more that rent and interest.
People belonging to the fixed income group are the major losers. Their earnings and accumulated savings diminish or get eroded. Debtors try to pay back their past debts in currencies which are of very little value.
Low-income groups suffer the most during inflation.
Effect on Employment
Inflation and unemployment are inter-related. A near full-employment situation with stability of prices is the aim. However measures to control inflation creates unemployment, whereas measures to reduce unemployment gives rise to inflation. It is like a trap. It is considered that a full-employment situation is a country's inflation threshold.
The Philips Curve merges the demand-pull and cost-push inflation and eliminates the distinction between them. It is proclaimed that the society itself chooses the best possible combination of price-level and employment. The least desired combination between the two could thus be eliminated by the society. Thus the Phillips Curve shows the trade-off between level of unemployment and wage-price increase. It is assumed that wage rise percentage is slightly more than price rise percentage. It shows that greater the unemployment, the lesser is the price rise, and vice versa. On the other hand, more the wage rise, less is the level of unemployment, and vice versa.
Social costs of involuntary unemployment are quite obvious. It cannot be ignored. Inflation can ultimately be considered as a severe form of taxation on the economy as a whole.'
Also read: Inflation and Deflation Demand-Pull Inflation Cost-Push Inflation
During inflation producers try to minimize the risk. Hence a lot of production potential is sacrificed. Goods that are more durable are produced more; as compared to goods that are less durable. This alters the pattern of production.
Inflation gives rise to more speculation and hoarding, which is bad for the economy.
The basic knowledge about the market tends to lose its importance, and producers and consumers have to update themselves constantly.
Production and economic growth gets seriously retarded, as the products, at high prices, may fail to find a buyer.
Wrong anticipations and misallocation of resources lead to loss of profit and growth.
Effect on Distribution of Wealth
Inflation has its own effects on the aggregate demand, which in turn puts its effects on total production and income. Following are the several effects of inflation.
1. As demand for money increases, its price, namely the rate of interest, rises. That brings down the investment.
2. Inflation reduces the total output of the community.
3. As consumers feel insecure during periods of inflation, their desire to save increases. Thus, propensity to save rises.
4. As the value of money falls, and consequently the real value of wealth in the hands of consumers, spending made by the consumers fall.
5. As goods fetch higher prices in the domestic market, it discourages export, and to an extent encourages imports. More imports deplete the foreign exchange reserve of a country.
6. As profit expectation remains high due to high prices, it encourages investment in some way.
Redistribution of income and wealth take place during periods of inflation. Rate of growth of the economy in also reduced. During inflation people do not want to hold the money, whose value is falling. So there may be a conversion into other assets, in the form of bonds, securities or gold and silver. Wages and profits increase relatively more that rent and interest.
People belonging to the fixed income group are the major losers. Their earnings and accumulated savings diminish or get eroded. Debtors try to pay back their past debts in currencies which are of very little value.
Low-income groups suffer the most during inflation.
Effect on Employment
Inflation and unemployment are inter-related. A near full-employment situation with stability of prices is the aim. However measures to control inflation creates unemployment, whereas measures to reduce unemployment gives rise to inflation. It is like a trap. It is considered that a full-employment situation is a country's inflation threshold.
The Philips Curve merges the demand-pull and cost-push inflation and eliminates the distinction between them. It is proclaimed that the society itself chooses the best possible combination of price-level and employment. The least desired combination between the two could thus be eliminated by the society. Thus the Phillips Curve shows the trade-off between level of unemployment and wage-price increase. It is assumed that wage rise percentage is slightly more than price rise percentage. It shows that greater the unemployment, the lesser is the price rise, and vice versa. On the other hand, more the wage rise, less is the level of unemployment, and vice versa.
Social costs of involuntary unemployment are quite obvious. It cannot be ignored. Inflation can ultimately be considered as a severe form of taxation on the economy as a whole.'
Also read: Inflation and Deflation Demand-Pull Inflation Cost-Push Inflation
Wednesday, May 4, 2011
Cost-Push Inflation
Cost-push inflation is also known as Cost Inflation. It basically arises due to a rise in wage rates, which in modern economic conditions, are affected somewhat frequently due to pressure from labour unions. Interaction between demand for and supply of labour is no longer the only factor responsible for the determination of wage rates. That way we can say that wages rates these days are somewhat 'administered'.
Normally wage rate should increase only when there is excess demand for labour. Collective bargaining, through labour unions, is often responsible for a hike in wage rate, which has no relationship with the demand for labour exceeding supply. This way when the employers are forced to increase wages, their cost of production also increases. They cannot supply the finished goods at previous prices. Unable to curtail production, for which there may not be any apparent reason, producers and left only with the option of increasing the market price of the commodity.
It is very difficult to control this type of inflation through Fiscal and monetary policies. Through restrictive monetary and fiscal policies the aggregate demand can be brought down, which will bring down the price. But that affects economic growth, as production and investment gets curtailed and unemployment is created. Basically producers' profit is caught between restrictive monetary and fiscal policies on one side, and pressure for higher wages from labour unions on the other. Ultimately an understanding between employers and unions ascertain a stable wage rate that can drive out the inflationary price rise, where unions are faced with further unemployment, and producers are faced with reduced profits, both due to curtailed production.
Mixed Demand-Cost Inflation
Inflation may arise without an increase in general aggregate demand. Under a condition of full-employment, if there is an increase for a particular class of goods in the product or commodity market, it will push up the prices of that class of goods. This will induce producers to produce more of that particular class of goods. So more labourers or workers will be employed at a higher wage rate, as there is no idle labour force in the labour market. This may induce labourers in other industries to go for a wage hike as well, though there is no extra demand for labour in those industries. This way market prices of commodities will eventually go up due to increase in cost of production.
Also read: Inflation and Deflation Demand-Pull Inflation Effects of Inflation
Normally wage rate should increase only when there is excess demand for labour. Collective bargaining, through labour unions, is often responsible for a hike in wage rate, which has no relationship with the demand for labour exceeding supply. This way when the employers are forced to increase wages, their cost of production also increases. They cannot supply the finished goods at previous prices. Unable to curtail production, for which there may not be any apparent reason, producers and left only with the option of increasing the market price of the commodity.
It is very difficult to control this type of inflation through Fiscal and monetary policies. Through restrictive monetary and fiscal policies the aggregate demand can be brought down, which will bring down the price. But that affects economic growth, as production and investment gets curtailed and unemployment is created. Basically producers' profit is caught between restrictive monetary and fiscal policies on one side, and pressure for higher wages from labour unions on the other. Ultimately an understanding between employers and unions ascertain a stable wage rate that can drive out the inflationary price rise, where unions are faced with further unemployment, and producers are faced with reduced profits, both due to curtailed production.
Mixed Demand-Cost Inflation
Inflation may arise without an increase in general aggregate demand. Under a condition of full-employment, if there is an increase for a particular class of goods in the product or commodity market, it will push up the prices of that class of goods. This will induce producers to produce more of that particular class of goods. So more labourers or workers will be employed at a higher wage rate, as there is no idle labour force in the labour market. This may induce labourers in other industries to go for a wage hike as well, though there is no extra demand for labour in those industries. This way market prices of commodities will eventually go up due to increase in cost of production.
Also read: Inflation and Deflation Demand-Pull Inflation Effects of Inflation
Monday, May 2, 2011
Demand-pull Inflation
The classical theory states that inflation or constant price rise takes place when the quantity of money in circulation increases. The price rise is directly related to the percentage increase in the quantity of money.
Under a full-employment situation, when investment demand increases, there arises a total demand for goods, which outstrips the aggregate supply that is available. Prices then start going up. Consumer demand is dependent on disposable income. Sale of goods and services at higher prices creates more money income, and hence more demand. So the excess demand never gets checked.
Some price rise would occur even with a constant money supply. This price rise would increase the transaction demand for money, which will push up the interest rates. Higher interest rates would discourage extra investment demand. This would eliminate the inflationary effect.
We can explain demand-pull inflation with the help of inflationary gap. Inflationary gap may be defined as that part of government expenditure that is not covered by taxation or borrowing from the general public, and which is covered by borrowings from banks or other financial institutions, or by creation of money by the Government. Revenue spending of the Government then overruns revenue earning.
C+I+G shows the different expenditure levels at different levels of income. Equilibrium exists at point E, where the C+I+G cuts the income line. If, under a full-employment situation, the real income cannot reach Yo, but reaches only up to Yn, it gives rise to an inflationary gap, measured by XY.
If there is insufficient aggregate demand, there will be a fall in the C+I+G schedule. This is represented by the (C+I+G)' schedule. This will give rise to a deflationary gap, measured by YZ.
A boom in investment, technological advancements, opening up of new prospective territory etc. may give rise to some demand-pull inflation. However, increase in Government Expenditure, especially for the progress of backward areas, high defence expenditure etc. may also give rise to demand-pull inflation.
The inflationary gap may be eliminated in several ways.
1. Rate of interest can be increased by keeping the money supply constant. This will reduce investment, income and consumption. Prices will come down.
2. High prices will reduce the real value of wealth. This will reduce consumption expenditure and consequently prices. This is called the Pigou Effect.
3. If redistribution of income can be done in favour of the higher income group, consumption expenditure will come down. Higher income people will spend lesser portion of this redistributed income on consumption than the lower income group. The inflationary gap may come down in this way.
4. Extra tax collections will reduce the net disposable income. This will lower the consumption. Reduction in Government subsidies or welfare expenditure will also reduce disposable income and consumption.
5. Higher prices in the domestic market may discourage exports. This will increase supply in the domestic market. As a result, prices will come down. This may happen on its own.
Also read: Inflation and Deflation Cost-Push Inflation Effects of Inflation
Under a full-employment situation, when investment demand increases, there arises a total demand for goods, which outstrips the aggregate supply that is available. Prices then start going up. Consumer demand is dependent on disposable income. Sale of goods and services at higher prices creates more money income, and hence more demand. So the excess demand never gets checked.
Some price rise would occur even with a constant money supply. This price rise would increase the transaction demand for money, which will push up the interest rates. Higher interest rates would discourage extra investment demand. This would eliminate the inflationary effect.
We can explain demand-pull inflation with the help of inflationary gap. Inflationary gap may be defined as that part of government expenditure that is not covered by taxation or borrowing from the general public, and which is covered by borrowings from banks or other financial institutions, or by creation of money by the Government. Revenue spending of the Government then overruns revenue earning.
C+I+G shows the different expenditure levels at different levels of income. Equilibrium exists at point E, where the C+I+G cuts the income line. If, under a full-employment situation, the real income cannot reach Yo, but reaches only up to Yn, it gives rise to an inflationary gap, measured by XY.
If there is insufficient aggregate demand, there will be a fall in the C+I+G schedule. This is represented by the (C+I+G)' schedule. This will give rise to a deflationary gap, measured by YZ.
A boom in investment, technological advancements, opening up of new prospective territory etc. may give rise to some demand-pull inflation. However, increase in Government Expenditure, especially for the progress of backward areas, high defence expenditure etc. may also give rise to demand-pull inflation.
The inflationary gap may be eliminated in several ways.
1. Rate of interest can be increased by keeping the money supply constant. This will reduce investment, income and consumption. Prices will come down.
2. High prices will reduce the real value of wealth. This will reduce consumption expenditure and consequently prices. This is called the Pigou Effect.
3. If redistribution of income can be done in favour of the higher income group, consumption expenditure will come down. Higher income people will spend lesser portion of this redistributed income on consumption than the lower income group. The inflationary gap may come down in this way.
4. Extra tax collections will reduce the net disposable income. This will lower the consumption. Reduction in Government subsidies or welfare expenditure will also reduce disposable income and consumption.
5. Higher prices in the domestic market may discourage exports. This will increase supply in the domestic market. As a result, prices will come down. This may happen on its own.
Also read: Inflation and Deflation Cost-Push Inflation Effects of Inflation
Subscribe to:
Posts (Atom)
LinkWithin
