Recent Articles

Monday, August 24, 2009

Objectives of Monetary Policy

Monday, August 24, 2009 - 0 Comments

The principal objectives of Monetary Policy are:

(a) Safeguarding of the country’s gold reserves

(b) Price stability

(c) Exchange stability

(d) Elimination of cyclical fluctuations

(e) Achievement of full employment

(f) Economic Growth of a country

(g) Balance of Payments Equilibrium.

In addition to this the other objectives are

(i) Creation working and expansion of different financial institutions.

(ii) Provision of an efficient payment mechanism.

(iii) Proper debt management.

(iv) Evaluation of rational interest rate structure.

(v) Operation of credit control measures.

(vi) Income stabilization by preventing or mitigating cyclical fluctuations.

(vii) To ensure neutrality of money.

(viii) To bring about monetary equilibrium in the economy by equalising saving and investment and demand for and supply of money.

Automatic Built In Stabilizers

One way to get around the problems of fiscal policy inflexibility and long lags that impede the use of countercyclical fiscal policies is to build automatic stabilizers into the budget. Automatic stabilizers are provisions in the budget that cause government spending to rise or taxes to fall automatically, without legislative action, when GDP fall. Similarly when GDP rises automatic stabilizers cause spending to fall or taxes to rise without any need for direct legislative action.

A good example of automatic stabilizer is unemployment insurance. In USA when the economy goes into recession and unemployment rises, more people receive unemployment benefits, which are paid automatically without further action by legislative. Thus unemployment insurance component of transfers rise during recessions, making fiscal policy automatically more expansionary.

Quantitatively, the most important automatic stabilizer is the income tax system. When economy goes into recession, people’s income fall, and they pay less income tax. This ‘automatic tax cut’ helps cushion the drop in disposable income and prevents aggregate demand from falling as far as it might otherwise. Likewise when people’s income rise during boom, the government collects more income tax revenue, which helps restrain the increase in aggregate demand? Keynesian argues that this automatic fiscal policy is a major reason for the increased stability of economy since World War II.

A side effect of automatic stabilizer is that government budget tends to increase in recession because government spending automatically rises and taxes automatically fall when GDP declines. Similarly the deficit tends to fall in boom.

Ricardian Equivalence

The alternate theory of public debt which was presented by Professor Ricardo is known as Ricardian Equivalence. According to this theory the public debt does not affect national savings and capital accumulation.

In Ricardian theory when we study the effects of fiscal policy we keep in view the behaviour of consumer who is having enough foresightedness. We see the behaviour of forward looking consumer when tax is cut, when he is aware of with this that government is not going to decrease it expenditure. In this situation so many questions rise in the mind of consumer. Whether the tax cut will increase opportunities for him, whether he will get rich, whether he will be able consume more.

Apparently nothing of this sort will rise as government has financed tax cuts with budget deficit. And in future government will have to increase tax to pay the public debt and the interest upon it. It means that tax cuts of today will be equal to imposition of taxes in future. In other words, the tax cuts yield a temporary rise in income to the consumer which will be taken back from him afterwards. As a result the consumer will not be better-off in any way. Therefore he will not bring change in his consumption.

When the consumers are having foresightedness they will easily understand it that future taxes will be equal to present tax-cuts. If government borrows by decreasing taxes it will have to repay it by imposing the taxes. This point of view is called Ricardian Equivalence. Thus Ricardian Equivalence shows that because of tax cut the debt which is raised does not influence the consumption. The savings which are made by household due to tax cuts have to be utilized by them in the payment of tax in future. The increases in private savings are offset due to fall in public savings. Thus national savings which are sum of private and public savings remain the same. As a result, the effects of tax-cut are not present here.

Relative Income Hypothesis

The relative income hypothesis was first introduced by Dorothy Brady and Rose Friedman. It stated that the consumption expenditure does not depend on absolute level of income but instead on the relative level of income. Dussenburry lent it empirical and psychological support.

According to Dussenberry there is strong tendency for the people to emulate and initiate the consumption pattern of their neighbours. This is the ‘demonstration effect’ i.e. relative income affecting consumption. The Relative Income theory tells us that the level of consumption spending is determined by the households level of current income relative to the highest level of income earned previously people are the reluctant to revert to the previous low level of consumption. This is the ‘Rachet Effect’.

The Relative Income Theory states that if the current and peak incomes grow together changes in consumption are always proportional to change in income. That is, when the current income rises proportionally with peak income, the average propensity to consume (APC) remains constant.

Disguised Unemployment

John Robinson was perhaps the first, economist who used term ‘disguised unemployment’. But she used this term for the people taking to occupation with comparatively low productivity and income instead of occupation of high productivity and large income during periods of depression in the developed and advanced countries.

But the term ‘disguised unemployment’ it is used in different sense in the under developed countries. In under developed countries ‘disguised unemployment’ refers to a situation where too many people are engaged in agriculture. A common characteristic of the over-populated under developed countries is that large majority of population draw their lively hood from agriculture. In a situation of rapidly increasing naturally a large number of people gravitate to land, because sufficient employment opportunities are not available in the non-agriculture sector to absorb the growing population. The result is that more people are apparently engaged in agriculture than are warranted by the size of land. Holdings and capital available and the techniques of cultivation. If some of them are with drawn it will not reduce agricultural output and may perhaps increase it because as it is said too many cooks spoil broth. This disguised unemployment is found in the self employed agricultural population.

The term disguised unemployment is used to refer such a situation because such people are apparently employed. In fact they are unemployed or only partly employed and their unemployment is concealed.

Neutrality of Money

The issue of neutrality or non-neutrality of money has an important bearing on the question of effectiveness or other wise of monetary policy. The supporters of neutrality of money say that a change in the quantity of money may generate economic fluctuations. It is held that creation of money may generate prosperity. The classical economists regarded money as neutral and a viel. It is regarded as simply a medium of exchange and not affecting output and employment in any manner. But to Keynes it was no longer a viel money affects rate of interest and through it rate of investment and hence general economic activity in the county.

Money is regarded as neutral if a change in the quantity of money does not alter the real equilibrium of the economic system. That is the relative prices and interest rates are not affected by a change in the quantity of money.

Conditions for Neutrality:

i. Existence of only one kid of money i.e. either inside money created against private debt and constituted by claims against financial institute or out side money (backed by foreign and government securities).

ii. Absence of money illusion

iii. Absence of distribution effects.

iv. Price wage flexibility.

v. Absence of open market operations.

vi. Unitary elasticity of expectations.

Pigou Effect

When price fall as a result of a cut in money wages, the purchasing power of money with a consumer increases or there is increase in real value of money balances. People feel that they are now better off and they increase their consumption expenditure. This leads to economic expansion or increase in GNP. The way in which an increase in the real value of money balances results in the expansion of economic activity has been described as the “Pigou Effect” it is also called real balances effect.

Pigou Effect was of the opinion that shifting of consumption function upward was due to increase in the real value of money assets resulting from a fall in money wages and prices. This is the real balance effect.

When wages and prices fall the total real value of public’s holding of wealth which has fixed money value will increase though wealth in form of goods land or equities will depreciate. Thus a fall in prices will increase in real terms the wealth of consumers to the extent that its money value is fixed. Now consumption function is an increasing function of the level of wealth and income. Hence a rising real value of wealth stimulates consumption out lays at all levels of income. Thus we see that Pigou concentrates exclusively on the real value of money assets.

Innovation Theory

In the dynamic change, which give rise to profits according to the dynamic theory of profits, Joseph Schumpeter has singled out for special treatment the part played by innovations. The daring and the dynamic entrepreneurs continue to hit at one innovation or an other, keeping their business a head of others and thus make hand some profits. According to Schumpeter, the principle function of the entrepreneur is to make innovations and profits are a reward for performing this important function.

Innovation may be defined as any new measure or new policy initiated by entrepreneur comes under innovation.

Innovation may be two types.

(a) Those innovations change the production function and reduce the cost of production

(b) Those innovations which stimulate the demand for product i.e. which change the demand or utility function.

In the first type are included the introduction of new machinery, improved production techniques or processes, exploitation of new source of raw material or a new and better organisational pattern for the firm. The second type of innovation are those which are calculated to increase the demand for the product by introducing a new product or new variety of an old product, new and more effective made of advertisement, discovery of new markets etc. success of any of these innovations brings a handsome increase in profits. Profits increase because either the cost of production is lowered or the product fetches a higher price.

Saving Function

The saving function shows the relationship between the level of saving and income.

Here we show disposable income on horizontal axis, but now saving, whether negative or positive in amount is on the vertical axis.

The saving function is the mirror image of the consumption function. This saving function comes directly from following figure of consumption function. It is the vertical distance between 450 line and consumption function.

For example at point A, we see that the house hold’s saving is negative because the consumption function lies above the 450 line. This shows that dissaving directly the saving function is below the zero saving line at point A. Similarly positive saving occurs to right of point B because saving function is above the zero-saving line.

Production Function

Production function may be defined as the functional relationship between physical inputs i.e. factor of production such as land labour, capital and organization and physical out puts i.e. the quantity of goods produced.

Thus the production function expresses the relationship between the quantity of output and quantities of various inputs used in production. The physical relationship between firms physical inputs and output depends on a given stage of technological knowledge, hence it is also called economists summary of technological knowledge.

Like demand production function refers to a period of time. Accordingly, it refers to a flow if inputs resulting in a flow of out put over a period of time leaving prices aside. It shows the maximum amount of output that can be produced from a given set of outputs in the existing stage of technology. The output will change when the quantity of any output is changed or minimum quantities of various inputs required to produce given quantity.

Since the production function is concerned with physical aspects of production, it is more concern of an engineer or a technician than of an economist.

Production function can be expressed as under

X = f (a,b,c,d….)

Here X is the output of commodity per unit of time and a,b,c,d….. are the various productive resources which go into making of quantity of the commodity, f is function i.e. varying with.

Induced Investment

Investment which varies with the changes in national income is called induced investment. Changes in national income bring about changes in aggregate demand which in turn affects the volume of investment. When, for instance, national income increases, aggregate demand too increases. Investment has to be under taken to meet this increased demand. This induced investment is income elastic i.e. it increases as income increases and versa.

Induced investment is investment not only in fixed capital but also in inventories which is undertaken to enable the economy to produce a larger output in order to meet increased demand. Induced investment is made by the people as a result of changes in income level or consumption. It is also influenced by price changes, interest changes etc. which affect profit possibilities. It is under taken for the sake of profit or income and it changes with a change in income. Thus induced investment is governed by profit motive. It is sensitive to change in income i.e. it is income-elastic.

As income is shown along 0X and investment 0Y. The investment curve it has been shown as rising upwards to the right. This means that as income increases, investment also increases and as income decreases investment too decreases.

Dynamic Functions of Money

Following are the chief or dynamic functions that money has to perform.

i. Medium of Exchange:

Under barter system people felt many difficulties and inconveniences. Money has solved all these difficulties. There is no necessity for a double coincidence of wants in a medium economy. Money serves as a very convenient sells medium of exchange – under money economy a worker sells his services and a producer his goods. Both get money a general purchasing power.

ii. Store of value:

Money serves as a store of value or in other words it enables a person to keep a portion of his assets liquid. Liquid assets are those which can be used for any purpose at any time one likes. Most persons in the modern world have to keep currency notes in their pockets or at home, or they may keep current accounts with bank with draw able by cheque.

iii. Standard Measure of Value:

Under the barter economy there was no common measure of value in terms of which other value could be expressed and accounts kept. Money removes this difficulty too. In a money economy, it is easy to compare the receptive values of commodities and services. They are in proportion to their respective prices. In matters of exchange a common standard of value makes transactions easy and fair.

iv. Standard of Deferred Payments:

In the word of to day borrowing and lending are very essential. But is should be so arranged that neither the borrowers nor the lenders should suffer any undeserved loss or should make an unexpected gain. If a loan were taken in oxen and has to be repaid in that very form we can imagine the difficulty. In a loan is taken in the form of money and repaid in money, then we give back practically what we borrowed, for money has comparatively a stable value.

v. Money Transfers Value:

With the help of money it is easy for a person to shift his movable and immovable property to different place. He has supply to dispose it off and with the sale proceeds buy similar property in the place where he wants to settle down.

IS-LM Curve

The IS-LM model was developed in 1937 by Nobel laureate Sir John Hicks who intended it as a graphical representation of the ideas presented by Keynes in 1936 in his famous book ‘The General Theory of Employment’, “Interest and Money”. In his original IS-LM model Hicks assumed that the price level was fixed at least temporarily. Since Hicks, several generations of economists have worked to refine the IS-LM model, and it has been widely applied in analysis of cyclical fluctuations and macro economics policy, and in forecasting.

Because of is origins the IS-LM model is commonly identified with the Keynesian approach to business cycle analysis. Classical economists who believe that wages and prices move rapidly to clear markets, would reject Hick’s IS-LM model because of the assumption that the price level is fixed. However conventional IS-LM model may be easily adapted to allow for rapidly adjusting wages and prices. The IS-LM model as a frame work for both classical and Keynesian analysis has several practical benefits. First it avoids the need to learn two different models. Second utilizing a single frame work emphasises the large areas of agreement between the Keynesian and classical approaches. Moreover because versions of IS-LM model are so often applied in analysis of the economy and macro economics policy, studying the frame work will help one under stand macro economics problems.

Keynes Psychological Law of Consumption

Keynes produced a Law based on the analysis of consumption function. This Law is called Fundamental Law of consumption or Psychological Law of consumption. It states that aggregate consumption is a functioning aggregate disposable income.

Proposition of the Law: This law consists of three related proposition stated below.

(i) When aggregate income increases, consumption expenditure will also increase but by somewhat smaller amount. The reason is that as income increases more and more of our wants get satisfied, hence not as much is again spent on consumption as the increase in income. Consumption expenditure will no doubt increase but not to the same extent as increase in income.

(ii) The second proposition is that when income increases, the increments of income will be divided in same proposition between saving and consumption this really follows from first proposition. Since consumption spending does not increase at the same rate as the increase in income, a part of the increased is saved and only a part is consumed. That is why consumption and savings go side by side. What is not consumed is saved. Saving is thus the complement of consumption.

(iii) The third proposition included in Keynes Psychological Law is that as income increases both consumption spending and savings will go up. An increment of income is unlikely to lead either to less spending or less savings than before. It will seldom happen that a person may decrease his consumption or his savings when he has got more income. He will spend a little more than before and also save more than before.

Philips Curve

Professor Phillips, formerly of London School of Economists, urged that there was a close link between the level of unemployment and the rate of wage increase. Phillips curve shows this relationship. IT may also be considered a relationship between inflation and unemployment, because when there is inflation money wages invariably go up under trade union pressure.

Rate of unemployment is shown along the x-axis and the rate of wage increase along the Y-axis both in percentage. From this figure which represents a hypothetical economy we find that when wage rise by 2% per annum, unemployment goes up by 4%. Thus we may say that as wages rise unemployment rises more than proportionately. But the curve also shows that when unemployment has reached a very high level, say 5%, wages do not raise at all, which means that in the case of wide spread unemployment the workers are keener to get employment than to fight for higher wages.


The situation where higher level of unemployment is attached with higher level of inflation is known as stagflation. Keynesian says that this situation emerges because of increase in costs of production or because of supply shocks. Because of costs push inflation when costs of production increased (due to increase in price of oil or shortage of raw material), the AS curve shifted to left side. The reduced supply of goods will have the effect of increasing the price level as well as reducing the level of output and employment. Accordingly, the economy may experience the situation of stagflation.

The basic equilibrium of economy takes place at E1, where AD = AS1 accordingly OY1 is the level of income and employment while the level of prices is OP1. Because of increase in costs of production, AS curve has shifted to the left side as AS0. The new equilibrium takes place at E0 where AD=AS0. Hence OY0 is the level of output and the price level is OP2. It is obvious that along with increased price level, the level of output has declined which would result in unemployment. The difference between P2 and P1 shows inflation while difference between Y1 and Y0 represents unemployment.

Inflationary Gap and Deflationary Gap

(i) Inflationary Gap: Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP level. This means that people are demanding more goods and services than can be produced. In other words the implication of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased for goods and services on the part of people will be to raise the price level. Or we may say that there will be inflationary gap if scheduled investment tends to be greater than full employment saving. In a situation like this ore goods will be demanded than the economic system can produce. The result will be that the prices will begin to rise and an inflationary situation will emerge. Thus if full employment saving falls short of scheduled investment at full employment there will be an inflationary gap.

The inflationary gap can be explained with the help of above diagram. C.I.G stand for the consumption, investment and Government expenditure respectively, C+I+G line shows the total expenditure on demand in economy. At the level Yx is the total real output, as shown by intersection point D with the 45° line. YFx represents a full employment limit on real output YFx. Real income of the economy obviously cannot reach Yx- at YFx total demand (C+I+G) exceeds total output, leaving a gap AB which is the inflationary gap in the Keynesian sense.

(ii) Deflationary Gap: As we have drawn above the diagram in order to explain the inflationary gap, in the same way we can explain the deflationary gap with the help of diagram given as under.

Deflationary gap would come into existence if total aggregate demand is insufficient to create full employment Yx is the total output at full employment. Let us assume that the total demand is (C+I+G) which cuts the 45° line at B, with real output Yx. AB then is the deflationary gap.

Liquidity Preference

One of the functions of money is that it serves as a liquid asset. Since money is generally accepted as a medium of exchange and as a store of value, hence it is most liquid of all assets. Whenever people want liquidity, they hold their wealth in the form of money. In fact people can hold their wealth in the form of real asset like houses, shops, factories, etc claims of money like bonds or debentures and money. Holding of wealth in the form of real asset or goods and in the form of claims of money yield income to its possessor. But holding of wealth in form of money does not give any income and still people like to hold money or prefer liquidity. There are many motives for holding money or liquidity preference. But all the motives are not equally important for all classes of people. Keynes has given three main motives for holding money or liquidity preference. They are discussed as under.


The transaction motive relates to demand for money for current payments. People like to hold some cash in order to meet their expenses in the interval between the receipt of income and its expenditure. Business men also want to hold some cash for current payments. For instance they have to buy raw material at regular interval and have to pay for the repair of the machinery and plants etc. from time to time. Money held by the people under this motive depends upon the level of income and business activity.


Besides holding money for meeting the current needs, people would like to keep some money with them to meet certain unforeseen expenditures and contingencies such as danger of unemployment, sickness, accident etc. Money held under this motive will depend on the financial position and the nature of individual. The quantity of money held to satisfy the precautionary motive will vary widely with individuals and business according to their degree of financial conservatism, the nature of their enterprise, their access to the credit market and the stage of development of organised markets for quick conversion of earning assets such as stock and bonds into cash.


Speculative motive relates to the demand of money to take advantage of the fluctuation in the rate of interest. The demand for holding money for the first two motives is limited and is not affected much by the rate of interest. Thus the demand for holding money or bonds etc for the speculative motive is greatly influenced by the change in the rate of interest. When the rate of interest is low but is expected to rise in the future, an individual will hold more money or bonds etc in the hope of taking advantage of the rise in the rate of interest. The opposite will happen if the rate of interest is high but is expected to fall in near future. It is here that liquidity preference is connected with the rate of interest People’s choice to hold their wealth in the form of money or bonds etc will depend upon the present rate of interest and their anticipation regarding the future rate of interest. When the rate of interest is very low people will prefer to keep their wealth in the form of money rather than in bonds and securities. It is so because they know that income from bonds etc will be low and keep with them more cash or money. Further they anticipate rise in the rate of interest and hence they prefer to hold money to take advantage of higher interest rates rather than bonds and securities. On the other hand a higher rate of interest will include people to keep their wealth in the form of bonds and securities because income from them would be quite handsome. Thus speculative motive for holding money refers to speculation in future prices of money claims i.e. bonds, shares etc.

Besides the above three main motives, there are some other motives for holding money also these motives for holding money are deflationary motive, convenience motive, and business expansion motive. Holding money for speculation in future prices of goods and services is called deflationary motive. Business motive refers to the holding money for future transaction. Holding money for sake of convenience is called convenience motive.

Effective Demand

Keynes measured employment in terms of national output or income. According to him greater the output greater shall be the employment and lesser the output lesser shall be the employment. But national output in turn depends upon effective demand

Effective demand = National Income/Output = Employment

By effective demand we do not mean mere desire but desire backed by ability and willingness to buy both consumer goods and capital goods. Hence effective demand refers to the “sum total of spending goods”. Thus according to Keynes effective demand is the sole determinant of employment in an economy. Effective demand is determined by the forces of aggregate demand function and aggregate supply function. Aggregate demand function implies a schedule of different amounts of money which entrepreneurs in an economy expect from the sale of their output and different levels of employment. Aggregate supply function is schedule of various amounts of money which represents the cost of the various outputs at different employment levels. So long as the cost is less than receipts the producers will go on producing the goods and employment will be increasing till receipts become equal costs. In case the cost exceed the receipts, the production shall be stopped and employment and employment within economy will decrease.

On Y-axis different amounts receipts from sale or expenditure by the community is represented and on X-axis volumes of employment are depicted. Curve AD represents the Aggregate demand function and curve AS represents the Aggregate Supply function at corresponding employment level. Curve AD indicates how much money the producers expect to get when they employ various amounts of workers and curve AS shows how much money the producers must get or represents the cost of various output different levels of employment. For example when OP1 men are employed, producers expect to receive OM1 (or P1H1) from the sale of their output. But supply price at this level i.e. OP1 men is OM2 or P1K1. In the initial stages AD curve shows steeper rise than the AS curve. But in the latter positions of curve AD shows a positive slope (rise up). It is because of the fact when production is less, there is a keen competition among the consumers to possess goods so that they may offer prices higher than the cost. But as scale of production increases costs rise and ‘offer prices’ of consumers fall. When employment level is OP1 the producers supply price P1K1 or M3 but they expect to get P1H1 or M1 and there by gain to the extent of K1H1 or M2M1. The competition among producers will encourage employment. At the output level OP the amount expected by producers and the must amount for producers are equal i.e. PH or (OM) = PH (or OM); hence H is the point of equilibrium employment. The employment will not increase to level of OP2 because at the point OP2 the must amount is P2H2 (or OM3) and the amount expected is P2K2. It means producers will suffer loss to the tune of K2H2, if any producer produced beyond point P. Hence OP is the ideal employment size.

First at the point K and the second at point K the equilibrium levels are shown. It implies that though there is OP size of labour force in the country but only OP amount of labour force is employed. Labour force to the extent of PP¢ is unemployment is point K and not point K1 i.e. at less than the full employment. Here by unemployment we mean only involuntary unemployment and not frictional, structure or voluntary unemployment.

Keynes holds that equilibrium at point K will be less than full employment. Keynes assumes that in short period aggregate supply function is constant because teachings of production cannot change under short period before achieving full employment.

We have said that employment is governed by effective demand so unemployment is due to lack of sufficient effective demand must be increased. During deflation expenditure on consumers goods as well as on producer’s goods must be increased to increase employment and during the inflation consumption and investment must be curtailed.

Classical Theory of Employment

The classical theory of employment assumes that there is always full employment of labour and other resources. In fact full employment is considered to be normal. Even if at any time, there is not actual full employment, the classical theory asserts that there is always a tendency towards full employment. The free play of economic forces itself brings about the fuller utilization of economic resources including labour. Any interference with the free play of market forces, says the theory, shall fall to bring about full employment. The classics therefore advocate that the government should keep its hands off the economic field if there is to be full employment of labour and other resources. The assumption that there is always full employment of resources is justified in classical economics by Say’s Law of Market. This law is in fact the core of Classical Economics theory. According to J. B Say “Supply creates its own demand” in say’s words “It is production which creates market for goods, for selling is at the same time buying and more of production more of creating demand for other goods. Every production finds a buyer. In other words, every supply of output creates an equivalent demand for output, so that there can never be a problem of general over production. Say’s Law thus denies the possibility of the deficiency of aggregate demand.

Say’s Law so conceived describes an important fact about the working of the free exchange economy that the main source of demand is the sum of incomes earned by various productive factors from the process of production itself. The employment hither to unutilised labour and other resources pays its own way, because it enlarges the market demand for goods by an amount equivalent to the income created and the value of output produced. A new productive process by paying out income to its employed factors generates demand at the same time that it adds to supply. It is thus production which creates market for goods.

In brief Say’s Law of market is denial of the possibility of general over production, that is, a denial of the possibility of a deficiency of aggregate demand. Therefore employment of more resources will always be profitable and will take place to the point of full employment, subject to the limitation that the contributors of resources are willing to accept rewards no greater than their physical productivity justifies. There can be no general unemployment, according to this view if workers will accept what they are worth.


Keynes in his General Theory made a vigorous attack on the classical theory of employment. As explained above, according to Say’s Law every supply of output creates an equivalent demand for output, so that there can never be a problem of general over production and hence general unemployment. Now it is true that supply does create demand for goods and services because various factors of production earn their incomes in the process of production by helping to create additional supply of output. When factor of production are employed, for instance, to produce cloth they get their reward in the form of wages, rents interest and profits.

But from this it does not follow that entire supply of national output will always is demanded by them. The incomes of the factors of production are necessarily equal to the value added in the productive process, but it does not mean that the entire income will be automatically spent on goods and services created in a given time period. A part of incomes will be saved so that this part of income is not available to create demand for goods and services. Saving this cause or break or leakage in the income stream and obstructs the income expenditure flow. Unless investors are willing to invest to an equivalent extent of intended saving, the total effective demand, which consists of demand for consumers goods and producer’s goods will not be sufficient to absorb to entire available supply of out put. And if it happens like this, there will be overproduction and producers will not be able to sell their entire out put, their profits will fall and they will reduce their production and this will create unemployment. Thus supply does not necessarily create its own demand. In a given time period consumers are planning to spend a given part of their income and save the rest. Similarly entrepreneur are planning to invest in factories, machines etc to a given extent. The total effective demand is the sum of consumption and investment demands. Savers are saving for reasons different from the investors and in a free enterprise economy there is no mechanism to ensure that what savers are planning to save is just equal to what investors are planning to invest. If the planned investment expenditure is not enough to fill up the gap of savings, them the present level of income and employment will not be maintained and therefore there will be a fall in income and employment. Hence the basic weakness of Say’s Law arises because of lack of any agency to ensure the intended savings are just equal to intended investment, and since savings and investments are undertaken by different persons and for different reasons, a discrepancy between the two is bound to arrive and when it arises the necessary mechanism to correct it is through changes in volume of employment and income.

Thus according to Keynes there is no in inherent reason to believe that investment expenditure plus consumption expenditure would always be equal to the cost of any given output, there is thus no assurance that demand would equal any given supply savings are determined primarily by income. But investment demand depends mainly, in the short run, on marginal efficiency of capital and rate of interest and in the long run on factors like changes in technology and population growth. Therefore investment demand so determined will not necessarily fill the savings gap between the income and consumption at the level of full employment and thus unemployment will be the result.

In sharp contrast to the classical view that full employment equilibrium in the normal situation. Keynes in his general theory firmly held the view that in a free private enterprise economy there are more chances for the equilibrium to be established at less than full employment level. Further Keynes strongly opposed the Pigovian view that unemployment would disappear if a general cut in money wages was applied. A general cut in wages according to Keynes will fail to bring about increase in employment, because it will mainly cause a reduction in aggregate demand. No doubt the costs in all industries would be reduced as a result of a general wage cut but that in it would not increase demand for the products, because the purchasing power in the hands of workers would have been reduced by cutting down their wages. A general wage cut by bringing about decline in aggregate demand may actually decrease the volume of employment and thus deepen the depression. Besides worker’s organisations are too strong to permit general wage-cuts. Thus Pigovian theory has no relevance as a guide to policy. Hence the classical theory of employment must be rejected both on theoretical and practical grounds.

The fundamental fallacy in Say’s Law is that partial equilibrium analysis which could apply to particular industry has been extended to the economy as a whole. Lowering of wages rate in a particular industry may increase employment there without decreasing demand. But if wages are reduced all round, it will reduce income and so effective demand and the volume of employment.

The difference between the Pigovian and Keynesian views is fundamental. While Pigou is of the view that employment depends upon the level of money wages and can be increased by lowering wages, Keynes contends that the volume of employment is determined by the level of aggregate demand which may be adversely affected by the cuts in money wages. In Keynes view even if wages rates were perfectly flexible unemployment could still exists if the aggregate demand was deficient. Hence it is wrong to assert, as the classical economists did, that wage adjustment ensures full employment and interest rate adjustment tends to solve the saving investment problem.

By summing up the main points of criticism are as under

(i) Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to aggregate supply.

(ii) Suplyment in the economy as a whole can not be increased by means of a general wage-cut, though it may be possible in a particular industry. It is wrong to apply micro economic principle to macro-economic activities or situations.

(iii) The classical economists looked at wages only from the employers point of view i.e. the cost aspect and ignored the income aspect of wages. There is no direct relationship between wages and employment, nor is the unemployment due to wage rigidities or artificial resistances.

(iv) Interest rate adjustment cannot solve saving-investment problem. Saving and investment are not interest-elastic.

(v) The economic system is not so self-adjusting as it is supposed, hence government interest in the economic sphere becomes necessary. Wages and prices are not so flexible as was supposed.

(vi) Assumption of free and perfect competition is not realistic.

(vii) It is wrong to suppose that money is a mere medium of exchange and has no role in affecting output and employment.

(viii) Say’s Law cannot explain the occurrence of trade cycle.

(ix) The classical theory does not explain how the level of employment is determined. It evades the problem by assuming full employment.

Phases of the Business Cycle

The phases of the business cycle are discussed as under:

1. Depression

We might start at a point when business is at the lowest ebb and the economy is engulfed in depression. The lucky ones, who are employed, get distressingly low wages. The purchasing power of money is high but that of man is low. The general purchasing power of the community being very low, the productive activity both in production of consumer’s goods and producer’s goods, especially the latter, is at a very low level. Business settles down at a new equilibrium at a low level of prices, costs and profits. This new adjustment or equilibrium may last for a number of years.

2. Recovery

But the things are not going to continue to be in a depressed stage forever. After the depression has lasted for some time, rays of hope appear on the business horizon. Pessimism give place to optimism. The depression contains with in itself the germs of recovery. After the depression has lasted for some time, the situation is found favourable for a business venture. Wages are low even for efficient workers, sufficient number of whom is now available. Money is cheap and so are other materials and factors of production. Prices may by low but costs too are low. This induces an entrepreneur, who may have sufficient financial backing, to take the risk. He orders repairs, renewals and replacements and perhaps a new plant. Constructional and allied industries receive orders and re-employ workers who spend their newly-acquired purchasing power on consumer’s goods. This stimulated further investment and production in several other industries. Thus business turns the corner.

3. Boom

Recovery once started gathers momentum. The slander stream of recovery, when it has started flowing is strengthened by numerous tributaries on its way. The revival of investment in one industry leads to a revival in an other. The wages paid to workers in one industry create demand for goods produced by another. With the general revival of demand, prices show an upward trend. The businessmen’s income takes a forward jump while wages, interest and other costs lag behind. Profit margins are thus widened. Optimism grows and spreads far and wide. The banks know that profits are being made and they do not mind in giving advances. Credit expands; businessmen borrow and plunge deeper into business so long as the expected rate of profit exceeds the prevailing rate of interest. Exceptional business prosperity turns their head, and they indulge in overtrading. Every body is feverishly busy in making money. This phase of the trade cycle is known as boom and it may, like the depression last for a number of years.


But just as depression created the conditions of recovery, similarly the boom conditions generate their own checks. All the idle factors have been employed and further demand must raise their prices, but the quality available now is inferior. Less efficiency workers have to be taken on higher wages. Rate of interest rises and so also of the necessary materials. The costs have after all started the upward swing. They overtake prices ultimately and the profit margins are first narrowed and then begin to disappear. The boom conditions are almost at the end. The bankers feel uneasy over their advances. They throw sinister hints that the loans may be recalled. The out look is no longer optimistic.


Then starts the downward course fearing that the era of profits has come to a close, businessmen stop ordering further equipment and materials. The prudent businessman wants to get out altogether and cuts down his establishment ruthlessly. The Government applies the axe mercilessly. The bankers insist on repayment. The ‘bottle necks’ appear, stocks accumulate. Desire for liquidity increases all around. This accentuates the depression just as the recovery is self-reinforcing; the forces of depression are also self accumulating. Every body is shifting for himself. A scramble for liquidity ensues. Some firms are forced into bankruptcy. The failure of one firm creates difficulties for those with whom it has business connections. Gloom spreads. There is general distress. This phase of trade cycle is known as crisis.

The crisis is the period of utmost suffering for a businessman. But they recover in a course of time from stunning blow. Their commitments are liquidated some how and business enters into the stage of what has already been described as depression or slump or a state of stagnation. Lord over stone describes the course of trade cycle thus “state of quiescence – next improvement – growing confidence – prosperity – excitement – over trading – convulsion – pressure – distress – ending again in quiescence”.

In Mitchell’s terminology we can depict the phases of a business cycle. Viz expansion (upward movement) recession, contraction (downward course) and recovery.

“Monetary Policy Can Back a Boom, but it Cannot Deal with Recession.”

Monetary policy embraces banking and credit policy relating to loans and interest rates as well as the monetary standard and public debt and its management. It influences the volume of credit base and through it the volume of bank credit and thus the general level of prices and economic activity. We know the usual methods through which monetary policy works. By way of recapitulation the important ones among such methods are manipulation of bank rate and open market operations. When boom conditions are developing bank rate is raised and thus credit is contracted with the consequent brake upon the undue expansions of business activity. In a depression, a policy of cheap money may be adopted to stimulate business investment and thus assist recovery.

The bank credit policy involves two types of controls the quantitative and qualitative. The quantitative control is aimed at general toghening or easing of credit system as the situation may demand. It is exercised by influencing the reserves of banks. The qualitative control seeks to regulate particular types of credit. It’s object to stimulate, restrict or stabilize bank advances for specific business schemes.

Obviously monetary policy has much to command itself and was therefore rightly regarded, till three decades back as the best anticyclical instrument. But there are limitations of the policy relating to the bank rate and open market operations. Its resources will depend on how far certain assumptions are true. For example, how far the various members of the banking system are prepared to accept the lead given by the central banks, how far the banks can make their borrowers use their credits for purposes for which such credits have actually been created; further, how far monetary causes are responsible for the economic fluctuations, and still further and most important whether the business community will adjust their investment exactly in accordance with the altered rates of interest.

Thus since these assumptions are only partially true, it is understandable that monetary management can claim only limited efficacy. The most serious limitation of monetary policy is in period of depression when the business community is so completely in the grip of pessimism that even a substantantial reduction of the interest rates does not make them embark upon expansion of production and new investment. The horse may be taken to water, but it may refuse to drink. The monetary authority can only encourage business enterprises. The above discussed points reveal that can back a boom, but it cannot deal with recession.

Role of Acceleration Principle in Trade Cycle

As we know that the accelerator is the numerical value of relation between an increase in income and the resulting increase in investment.

When an initial investment of Rs.100 leads to a rise in income by Rs.400, people’s spending power also rises by an equivalent amount. This will induce them to spend more on goods and services. When the demand for goods rises, initially this will be met by over working the existing plant and machinery. All this leads to an increase in profits with the result that businessmen will be induced to expand their productive capacity, they will install new plants i.e. they will invest more than before. Thus a rise in income leads to a further induced increase in investment.

An example will make the working of the accelerator clear. Suppose that we are living in a world where the only commodity produces is cloth. Further, suppose that to produce cloth work Rs.100, we require one machinery worth Rs.300 which means that the value of accelerator is 3 i.e. if demand rises by Rs.100, additional investment worth Rs.300 takes place. If the existing level demand for cloth remains constant, let us say at Rs.500, then to produce this much of cloth we need five machines worth 1500 rupees. At the end of one year, let us suppose that one machine becomes useless as a result of wear and tear, so that at the end of one year, gross investment of Rs.300 must take place to replace the old machine in order that the stock of capital is capable of producing out put worth Rs.500.

In the third period, demand rises to Rs.800 to produce output worth Rs.800, we need 8 machines point our previous stock consisted of only 5 machines. Thus if we are to produce out put worth 800 rupees. In addition, since at the end of one period one old machine has become useless, even to maintain previous stock of 5 machines, we need to install one new machine in place of the old one. Thus net investment will be 900 rupees and replacement investment 300 rupees so that our gross investment rises 300 rupees in period 2 to 1200 rupees in period 3. A 60% rise in demand gives rise to 400% increase in gross investment. Here we have a glimpse of the powerful destabilizing role of accelerator.

In the fourth period demand rises from 800 rupees to 1000 rupees (25%) but total gross investment is only 900 rupees which is 25% less than the third period. In the fifth period even though demand remains constant at 1000 rupees gross statement fall to 300 rupees which is 33.3% of the fourth period while net investment falls to zero. Thus in order to keep the economy prosperous mere standing sills running at a slow pace is not good. We must run and run faster and faster in order to ward off the danger of a depression. This is because of the extremely destabilising role of the accelerator.

In the acceleration principle, we find a powerful explanation of the destabilising forces working in the economy during a trade cycle. If the accelerator is only force at work, then we will have too much of instability in the economy more then is actually found. In real life, we find that there limits to instability both in the upward and in the down ward directions so that the trade cycle must have a peak as well as bottom.

© 2013 Notes for Pakistan. All rights reserved.
Designed by SpicyTricks