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Thursday, August 27, 2009

Economic Integration

Thursday, August 27, 2009 - 0 Comments

Economic Integration refers to decision or process where by two or more countries combine into a larger economic region by removing discontinuities and discriminations existing along national frontiers.

The Economic Integration is classified into:

1. Free Trade Area

2. Customs Union

3. Common Market

4. Economic Union

1. Free Trade Area:

In such type of economic integration the countries forming free trade area remove tarrif walls amongst each other. However each country has right to impose tarrif against non-member countries imports. In this respect the example of “European Free Trade Area (EFTA) is given which comprised of Austria, Denmark, Norway, Sweden and Switzerland. The EFTA was formed in 1960.

2. Custom Union:

Under this type of economic integration the member countries not only remove the trade barriers amongst each other but they also have to impose a common external tarrif against non-member countries. The best example of custom union was “Zollverein” which came into being in 1837 and it was consisted of all “German States”. The regional formation of European Union (EU) was also a customs union which was formed in 1958.

3. Common Market:

This type of economic integration has following properties:

1. The trade restrictions amongs member countries are removed.

2. The external tarrif against non-member countries is levied at uniform rate.

3. The capital and labour are mobile between the member countries without any restrictions.

The status of European Community (EC) was like a “Common Market” in 1970. It was given the name of “European Common Market” (ECM) at that time and it had 12 members like Belgium, France, Luxemburg, Holland, Germany, Italy, Ireland, Denmark, Britain, Spain, Portugal and Greece. But now Austria Finland have also joined.

4. Economic Union:

This is such a type of economic integration where in addition to above properties of common market the stress is laid upon uniformity or policies regarding currency credit, government expenditure and taxation. The best example of economic union was “Benelux” whose members were Belgium, Netherland and Luxemburg. Such economic union has nowadays been merged into EC. The EC has also assumed the form of economic union. Its present name is European Union (EU) which is having a common currency by name Euro. Again the members of EU have to unify their economic policies. The economic union is an extreme type of integration, it is not practically possible because it will have the effect of surrendering economic and political independence of member countries. All the above types of economic integration are temporary one. However the Customs Union is a representative of economic integration.

Inducement to Investment

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

Induced investment is investment not only in fixed capital but also in investment which is undertaken to enable the economy to produce a larger output in order to meet the 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 investments is governed by profit motive. It is sensitive to changes in income i.e. it is income-elastic.

Income is shown a long OX and investment along OY. The investment curve II 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.


Broadly speaking, inducement to invest depends on two factors which are

(a) The marginal efficiency of capital and

(b) The rate of interest.

Suppose a man borrows money to invest. He will have to pay interest on the loan. But he expects profit from this investment. He must compare the rate of interest which be has to pay and the rate of profit that he expects to obtain. Obviously the rate of return or profit must at least be equal to the rate of interest, otherwise no investment will continue to be made. So long as the expected rate of profit exceeds the rate of interest, investment will continue to be made. The yield expected from a new unit of capital is called Keynes marginal efficiency of capital. This marginal efficiency of capital must never fall below the current rate of interest, if investment is to be worth while.

Hence the inducement to invest depends on the marginal efficiency of capital on the one hand and the rate of interest on the other. Of these two determinants of inducement to invest viz the marginal efficiency of capital and the rate of interest which is of great importance. The rate of interest does not quickly change, it is more or less sticky or constant. Hence the inducement to invest, by and large depends on the marginal efficiency of capital. If the business expectations are good or if the marginal efficiency of capital is high, more investment will be made in spite of high rate of interest. On the contrary depression or bleak prospects of profits will discourage investment, even if the prevailing rate of interest is low. Thus fluctuations in the marginal efficiency of capita.

There some other factors that affect investment. For instance if a fimr has already excess capacity and can easly handle increased future demand, it will not go in for further investment to increase its capital equipments.

Technological progress also affects current level of investment. For example a new invention may rander the present capital stock of a frim obsolete and adversely affect its ability to compete. In this case further investment will be called for.

Modern Theory of Wages and Employment

The modern economist by and large agree with Keynesian analysis. But there are some differences which lay foundation of modern theory of wages and employment. These differences are discussed below.

According to Keynes a decline in the real wage is condition for increase in employment. Since organisation, equipment and technique do not change in the short run, an increase in aggregate demand would lead to increased output and rise in marginal cost and prices. Rise in prices means a fall in real wages even when money wages remain constant.

But modern economists do not agree that an increase in employment resulting from increase in effective demand would necessarily lower real wage. They put forward the following arguments in support of this view.

(i) It is pointed out that in fixing prices of their products the producers usually follow “fuel cost” pricing policy rather than fixing them on the basis of marginal cost. When prices are fixed on full cost basis, costs will fall as output expands upto a point at which rising marginal cost rises above total unit cost. Till this point is reached, it is possible to expand output at prices lower than those obtaining before the expansion of output marted.

(ii) Keynes has assumed that in the short sum there is no change in organisation equipment and technique so that marginal costs must rise. But we know that improvement in these respects are continually being made which check the tendency of the marginal costs to rise.

(iii) The modern economists believe that the marginal cost curve remain flat over considerable range of output, where as Keynes believe that the marginal cost curve rises upward even with a small increase in out put. It follows therefore that in the view of modern economists it is not necessary for the cost and prices to rise as output expands and the real wage need not fall. Improvements in techniques may even result in the fall of the marginal cost. Hence real wages may even rise instead of falling. The modern economists do not, therefore subscribe to the view that there is an inverse relationship between wage rates and employment. They are more optimistic in thinking that there are possibilities of expanding employment through raising aggregate demand. This is because according to modern theory, prices need to rise less as employment and output expand then what Keynes had believed.

Barring the points mentioned above, the modern economists subscribe to Keynesian analysis of relationship between wages and employment.

Classicist’s Statement

The classical economists held the view that the economic system automatically adjusted itself at the level of full employment through wage-price flexibility. According to this view, there was a strong tendency towards full employment via wage adjustments. For example, if during depression, money wages were reduced all around, it would be possible not only to reduce unemployment but eventually to create a situation of full employment. A cut in money wages will lower marginal production costs and as a result, lead to increase in output and employment. The output will increase, because reduction in production costs will enable the producers to lower prices and stimulate demand. Unemployment if any will be temporary phase.

Keynes severely eroticised the classical view. He made a comprehensive analysis of he problem and pointed out serious flaws in the classical argument. The main flow is that classical economists have ignored the demand aspect. They hold the reduction in wages will leave the aggregate effective demand unaffected. There is no doubt that reduction in wages will lead to increase in output. But, unless the increased output is purchased and consumed, investment will be discouraged and output and employment reduced.

The classical economists simply saw that when wages in a particular industry were reduced, profits there increased resulting in larger output and employment. Cut in wages in a particular industry or by particular firm does not reduce the demand for the products of that industry. This is so because their particular labour is a small fraction of the total labour force. Their purchasing power may be reduced by a cut in their wages, but the purchasing power of the rest of the labour is not reduced. Hence the demand for goods will not be reduced. On the contrary the cheapening of the goods produced by them will increase demand for them. Their output will increase and so employment in that particular will increase. But what is true of a particular industry cannot be true of the economic system as a whole. If there is a great wage cut i.e. cutting of wages in all industries, then the incomes and so the purchasing power of all workers will decrease. Reduction in aggregate effective demand will result in reduction of output and curtail the volume of employment. It is to be remembered that so far as the economy is concerned wages are not only cost but also source of demand.

It is not necessary that a cut in money wage may lead to a reduction in real wage. If prices fall to that same extent as wages fall, real wages remain the same. Real wages will be reduced only when prices do not fall to the same extent as fall in wages. It is reduction in real wages which is going to provide incentive to the producers to invest and increase output and employment.

Thus the fatal flaw in the classical analysis is that it suffers from the lack of a theory of effective demand and it arises from the classical economists attempt to apply to the economy as a whole, the logic of a theory designed to apply to a particular industry. They ignored the fact that on all around reduction in wages or general or over all cut in wages would reduced effective demand or aggregate demand which will reduce employment rather than increase it.

Classical and Keynesian View on Wages and Employment


The classical economists held the view that the economic system automatically adjusted itself at the level of full employment through wage price flexibility. According to this view, there was a strong tendency towards full employment via wage adjustment. For example, if during depression, money wages were reduced all sound, it would be possible not only to reduce unemployment but eventually to create a situation of full employment.

A cut in money wages will lower marginal production costs and as a result, lead to increase output and employment. The output (and hence employment) will increase because reduction in production costs will enable the producers to lower prices and stimulate demand. Unemployment, if any will be temporary phase.

It will appear that the classical remedy for unemployment is to cut down the money wages all round. The process of bidding down the wages should continue till the employers find it worth while to employ all people seeking jobs. According to this view unemployment exists because wages are kept at a higher level than that some employers consider worthwhile. So long as there is some involuntary unemployment, wages and prices must continue to fall. This will lead to increase in investment output and income, until unemployment is eliminated.


We shall now briefly summarise the Keynesian view on wages and employment as under.

(i) In the first place, Keynes agreed with the classical economists that other things being equal, employment varied inversely with the level of real wages. That is, when real wages rose, the volume of employment was curtailed, and vice versa. In other words, the demand for labour depends on the real wage rates. It increases when the real wages rate falls and decreases when the real wages go up.

(ii) Keynes did not agree that a cut in money wages for the economy as a whole will necessarily cut the real wages. On the other hand, a reduction in the money wages reduced proportionately the total out lay, demand and prices so that the real wages remained the same unless real wages are reduced, employment can not increase. There is no doubt that an individual firm can, by cutting money wages, reduce costs and thus increase sales and employment. But when a general wage cut is affected through the economy, demand schedule will register a fall throughout, because all workers find their purchasing power reduced.

(iii) Keynes believed that while keeping the money wages constant, aggregate demand must be raised to increase employment. He said that it was possible to keep the money wages stable under a system of collective bargaining and the aggregate demand can be raised by fiscal and monetary measure.

(iv) Keynes further believed that a rise in aggregate demand, while the money wages are kept constant, would normally lead to a reduction in real wages. And a reduction in real wages would stimulate investment and increase employment. He agreed that since organisation, equipment and technique do not change in the short run; an increase in aggregate demand would result in increased output and a rise in marginal cost and prices. Rise in prices would mean a cut in real wages. It is increase in employment which reduces real wages and not the other way round.

(v) According to Keynes wage-earners do not mind a small rise in prices and do not agitate for a corresponding rise in money wages. But they vigorously resist a cut in money wages. Hence a better and more practical method of increasing employment is to raise aggregate demand and not cut money wages. For instance, the wages earners are offended at a cut in money wages but they can not blame the employer for a reduction in real wages. A cut in money wages also increase the burden of their debt. The wage earners are not satisfied even if the prices fall in proportion to the cut in money wages, because they fear that the prices may again rise to their old level. Thus according to Keynes, it is neither wise nor feasible to cut money wages the wage earners oppose cut in money wages even when the prices are falling. Thus, in modern times of strong trade unions it is impossible to cut money wages.

(vi) In order to explain why a general cut in money wages would not increase employment, Keynes analyses the effect of cut in money wages on the main determinants of income and employment viz marginal efficiency of capital consumption function and the rate of interest. He shows that all these factors are adversely affected by cut in money wages. Hence we can not hope to increase employment by cutting money wages, unless other factors are favourable.

Keynes comes to the conclusion that a cut in money wages neither remedy for unemployment nor a suitable prescription for increasing employment.

Concepts of Accelerator, its Utility and Limitations

The accelerator is the numerical value of the relation between an increase in income and the resulting increase in investment. In other words, the acceleration principle simply tells us that if owing to increase in people’s incomes, the demand for consumption goods increases, the derived demand for the factors of production, producer’s goods in particular, say machines to make the consumption goods will increase. But the point to be noted is that investment in the making of machines will even increase faster than the demand for the product.

Let us be clear about the concept of the Accelerator. When income increases people’s spending power increases; their consumption increases and consequently demand for consumer goods increase. In order to meet this enhanced demand, investment must increase to raise the productive capacity of the community. Initially, however, the increased demand will be met by over working the existing plants and machinery. All this leads to increase in profits which will induce entrepreneurs to expand their plants by increasing their investments. Thus a rise in income leads to a further induced investment thus acceleration in economy take place.


The following assumptions of the principle of accelerator which make it unrealistic

(i) We have assumed that there is no excess capacity existing in consumer goods industries. In other words we have assumed that no machine is lying idle and shift working is not possible. If there had been excess capacity and shift working was possible the supply of goods could be increased with the existing equipment and accelerator would not come into play.

In the capital goods industries, we have assumed the existence of surplus capacity. If there was no excess capacity in the machine making industry, increased demand for machines could not lead to increase in the supply of machines. Actually the things are not rigid as supposed.

(ii) The second assumption is the flexibility of output. It is assumed that machine making industry is capable of increasing its output for the time being at least. The supply can be increased by reducing stocks of the finished machines, by working extra shifts, and so on. But stocks can be reduced below zero and working double shifts or adoption of other experiments is found to be expensive. Only when the demand has increased permanently, will the entrepreneur find it worth while to increase investment for installing additional machines.

(iii) The size of the accelerator does not remain constant over time. Its value will be affected by the business man’s calculations regarding the profitability of installing new plants to make more machines on the basis of their probable working life. It also assumes that the demand for machines will remain stable in future, although the increase in demand has suddenly cropped up. The entrepreneur will have to make so may complicated calculations like the future demand for final product made by machines, about the future demand for machines themselves, about the cost and availability of machines, about the interest rates and so on. This indeed is too much for an average entrepreneur.


In spite of these limitations and difficulties, the concept of the accelerator has proved a very useful tool of economic analysis. There is no doubt that it has restricted application but it does not mean that it has no place in any realistic discussion of the factors affecting income and employment, some economists have made use of the acceleration principle in formal mathematical models to bring out how an economy would react if there was sudden increase in demand for goods.

Limitations and Leakages of Multiplier


On theoretical plane, the multiplier principle seems to be very attractive, but in actual practice things may not materialise as desired. Its working is subject to several limitations.

(i) Efficiency of Production: If the production system of the country can not cope with increased demand for consumption goods and make them readily available, the incomes generated will not be spend as visualised. As a result the marginal propensity to consume may decline.

(ii) Regular Investment: The value of the multiplier will also depend on regularly repeated investments. A steadily increasing investment is essential to maintain the tempo of economic activity.

(iii) Multiplier Period: Successive doses of investment must be ignored be injected at suitable intervals if the multiplier effect is not be lost.

(iv) Full employment ceiling: As soon as full employment of the idle resources is achieved, further beneficial effect of multiplier will practically cease.


The following are the principal leakages of the multiplier.

(i) Paying off Debts: It generally happens that a person has to pay a debt to a bank or to another person. A part of this income goes out in repaying such debts and is not utilized either in consumption or in productive activity. Income used to pay off debts disappears from the income stream. If, however, the creditor uses this amount in buying consumer goods or in some productive activity, then this sum will generate some income, otherwise not.

(ii) Idle Cash Balances: It is well known that people keep with them ready cash which is neither used productivity nor in purchasing consumer goods. Keynes has mentioned three motives for holding ready cash for liquidity preferences viz transaction motive, precautionary motive and speculative motive. This means that the respent part of income goes on decreasing. In this way, a part of the initial expenditure leaks out of the income stream. The cash may be kept in current account for saving account. But it is kept away from the expenditure all right, it would have otherwise added, to the future income.

(iii) Purchase of old Stocks and Securities: If a part of the increased income is used in buying old stock and securities instead of consumer goods, the consumption expenditure will fall and its cumulative effect on income will be less than before.

(iv) Price Inflation: When increased income investment leads to price inflation the multiplier effect on increased income may be dissipated on higher price.

(v) Net Imports: If increased income is spent on the purchase of imported goods it acts as leakage out of the domestic income stream. Such expenditure fails to affect the consumption of domestic goods.

(vi) Undistributed Profits: If undistributed profit of joint stock companies not distributed to share holders in the form of dividend but are kept in reserved fund it is a leakage from income stream and the multiplier process will be arrested.

Multiplier, its Concepts and Importance


On OX axis income and OY axis investment and saving is shown. I is investment curve S is saving curve. II and SS curve intersect the investment and saving curve at point A. It shows that when income is 300 thousand and the aggregate saving and the aggregate investment is equal, if investment increases 3 to 4 thousand. Then saving and investment curve intersect at point “B”. An increase of one thousand investment increases 3 thousand national income. It is essential to explain here such diagram can also be used for negative effect.


1. No change in autonomous investment.

2. Induced investment is absent.

3. MPC remains constant.

4. Consumption is a function of current income.

5. No time legs in the multiplier process.

6. The new level of investment is maintained steadily for the completion of multiplier process.

7. There is net increase in investment.

8. Consumer goods are available in response to effective demand for them.

9. There is less than full employment level in the economy.

10. The accelerator effect of consumption on investment is ignored.

11. There are no changes in price.

12. There is closed economy.

13. Economy unaffected by the foreign influence.

14. There is an industrial economy in which the multiplier process operates.

15. Other resources of production are also easily available within the economy.


So far we have discussed the multiplier from the theoretical point of view. Now let us see its practical importance. These days governments actively interfere in the economic activity of the community. Therefore, it is essential to realise the importance of the multiplier in connection with investment, if there is depression and unemployment in the country, the people would like the government to undertake public works so that some employment should be provided to the unemployed. But if it is realised that an investment of Rs one crore will create employment worth many times, the importance of government investment will become clear. That is the multiplier principle has added to the importance of public investment when a country is engulfed in depression, the entrepreneurs are discouraged from investment, because in such a situation profit expectations are very low. Therefore if depression is to be lifted and the level of national income and employment is to be raised, it becomes necessary to increase public investment. If during such times, the government undertakes investment, the demand for consumer goods and hence the level of income and employment will increase manifold on account of the working of the multiplier. The operation of the multiplier rapidly removes depression through government investment and the economy moves towards full employment.

It is worth noting that when, owing to government investment to remove depression and unemployment the demand for goods and level of income and employment rises, the private entrepreneurs too are encouraged to invest. This happens because as the demand for goods increases and income rises owing to government investment, the profit expectations of the entrepreneurs go up and as a result the marginal efficiency of capital rises. Hence when government makes investment in public works to fight depression and unemployment, private investment is also encouraged on account of the operation of the multiplier. Depression is quickly lifted on account of investment both by the government and private entrepreneurs. If the multiplier did not operate, the increase in income and employment would not have been so much as when it operates. Influenced by Keynesian principle of the multiplier, the US government under took large-scale investment in public works to remove the great depression of 1929-34. This met with great success and depression was lifted.

Role of Wealth in the Determination of Aggregate Consumption

Wealth is an important factor which affects the consumption is wealth. As we know that the wealth of any entity, such as household or an entire nation, equals its assets minus its liabilities.

To see how consumption and saving respond to an increase in wealth, suppose that while cleaning out her attic Prudence finds a stock certificate for so shares of stock in a pharmaceutical company. Prudence’s grand mother bought this stock for Prudence when she was born, and Prudence did not know about it. She immediately calls her broker and learns that the stock is now worth $3000. This unexpected $3000 increase in Prudence’s wealth has the same effect on her available resources as the $3000 increase in current income that he has. As in case involving an increase in her current income Prudence will use her current income. Prudence will use her increase in wealth to increase her current consumption by an amount smaller than $3000 so that she can use some of the additional $3000 to increase her future consumption. Because Prudence’s current income is not affected by finding the stock certificate, the increase in her current consumption is matched by a decrease in current saving of the same size. In this way an increase in wealth increases current consumption and reduces current saving. The same line of reasoning leads to conclusion that a decrease in wealth replaces current consumption and increase saving.

The ups and downs in the stock market are an important source of changes in wealth and the effects on consumption of change in the stock market are explored in the following Application.

On October 19, 1987 stock prices took their biggest one-day plunge. The standard and Poor’s index of 500 stocks dropped 20% that day, after having fallen by 16% from the market’s peak in August of he same year. Although estimates differ, apparently $1 trillion of financial wealth (equal in value to nearly three nonths of GDP) was eliminated by decline in stock prices on that single day.

According to economic theory, how should a stock market crash affect consumer’s spendings? There are two possible channels. First, the crash reduced household’s wealth, which should have reduced consumption. According to economic theory, however the decline in consumption should have been much smaller than the $1 trillion decline in wealth, because consumer would spread the effects of their loses over a long period of time by reducing planned future consumption as well as current consumption. We can get a quick estimate of the effect of $1 trillion drop in stock values on current consumption by supposing that consumers spread their reduction in consumption over twenty five years. Also for simplicity we assume that the real interest rate is zero. Hence in response to $1 trillion loss in wealth consumers would plan to reduce their consumption in each of the next twenty five years by 1/25 of $1 trillion or $40 billion per year.

Second, a crash could affect consumption by leading consumer’s to expect bad economic times and declining income in future. As discussed above a reduction in expected future income tends to reduce current consumption and increasing current savings. Surveys of consumer’s attitudes found significant declines in consumer confidence about the future in the months following the crash.

We have seen that a precipitous decline in the stock market can cause consumption to fall below the level it would have attained otherwise. But does the relationship between the stock market and consumption hold when the stock market rises sharply? The US experienced a consumption boom in 1990’s with consumption increasing from 66.1% GDP in 1989 to 69.3% GDP in the second quarter of 1999.

Was this consumption boom caused by the stock market boom in 1990’s? Our theory predicts that a large increase in wealth, such as the one that resulted from the boom in stock prices should increase consumption.

Jo na than Parker of the University of Wisconsin who examined the behaviour of consumption and savings in US during 1980’s and 1990’s pointed out that the consumption boom began before the 1990’s boom in the stock market. The ratio of consumption to GDP increased from 62.3% in 1979 to 66.1% in 1989, an ever larger increase than that seen during the 1990’s. Real stock prices doubled during the 1980’s but this increase was substantially smaller than the tripling of real stock prices in the 1990’s. Parker concluded that no more than one fifth of the increase in ratio of consumption to GDP during that period resulted from the increased wealth associated with the stock market boom. Thus, while Parker found some evidences consistent with our theory’s prediction that an increase in wealth will cause an increase in consumption.

Subjective and Objective Factors Affecting Consumption

When we say that propensity to consume is stable, it does not mean the consumption expenditure remains constant. Consumption expenditure does no doubt vary as income varies. But consumption changes according to a set pattern. The amount of consumption changes as income changes, but the schedule remains the same. This is what we mean by saying that propensity to consume remains stable. But there are certain factors which do bring about a change even in this propensity to consume in the long run. These factors are of two types which are discussed below.

Subjective Factors:

Such factors are concerned with one’s own psychology. As a result there may be more saving or more consumption etc. They are as:

1. Motive of Foresight: The society where people have greater regarding their expected expenditures like education and marriage of children etc, the level of savings will be higher.

2. Motive of Unforeseen Needs: The society where people anticipate about their unforeseen and unexpected needs like disease, accidents and unemployment, the level of saving will be higher.

3. Motive of Improvement: The society where people wish to improve their living standard as to have more luxuries like automobiles and electrical appliances the saving proportion will be higher discouraging consumption.

4. Motive of Calculation: The society where people are desirous to earn interest they will make greater savings. Hence consumption will be lower.

5. Motive of Business: The society where people are desirous to improve their business they will make savings reducing their consumption.

6. Motive of Pride: The society where people wish to enjoy pride after their death among their heirs they will make greater savings. As a result the savings will rise and consumption will fall.

7. Motive of Miserliness: The society where the number of miser is more, savings will be more and consumption will be less.

8. Ostentation: The society where people believe in ostentation and demonstration in the level of consumption will be higher and savings will be lower.

9. Generosity: The society where people are more generous and extravagant they will make more consumption. Hence consumption will be higher.

10. Rejoicy: The society where people believe in rejoicing i.e. drinking and eating etc they will diver major share of their income to consumption accordingly, consumption will be higher and savings will be lower.


They consist of those factors which are not concerned with person, rather they are linked with the society or economy whenever they change they may influence consumption or savings. They are listed below.

1. Distribution of Income: A part from the size of national income, consumption behaviour of the economy will also be influenced by pattern of income distribution. It will be generally observed that the average and marginal propensities to consume of the poor people are greater than those of the rich. If for example, you give an additional 10 rupee note to a poor man, the assumption is that of this additional income, he will spend a greater proportion than will be the case if the same amount were given to a rich man. This is because the poor man has a lot of unsatisfied wants and he is likely to seize every opportunity that comes his way to satisfy them. On the other hand, the rich have already a high standard of living and relatively less urgent want remain to be satisfied so that in their case an addition to their incomes is more likely to be saved than spent on consumption.

Consumption is the typically the function of poor and saving typically the function of rich. Therefore, given the national income, a more equal distribution of incomes will make for higher marginal propensity to consume and therefore will raise the value of multiplier.

2. Fiscal Policy: Fiscal policy of the government will also influence the consumption behaviour of an economy. A reduction is taxation will leave more post-tax incomes with people and this will stimulate higher expenditure on consumption; an increase in taxes will depress consumption of the two types of taxes i.e. direct tax and indirect tax, the latter will have more immediate effect on consumption than the former particularly when direct taxes are progressive in their incidence. Commodity taxes penalise consumer expenditure directly by raising the prices of commodities while taxes on income reduce commonly indirectly, by reducing the post tax income of the individual.

Hence structure of fiscal system has an important influence on the consumption behaviour of the economy, changes in the fiscal policy are liable to bring abut shift in the consumption income curve. Modern trends towards welfare state financed by progressive taxation tend to shift upward the consumption function.

3. Substantial changes in Rate of Interest: The rate of interest influences the savings as well as consumption decisions of people. When a person saves he has to forego the current consumption. A person will do so if he gets something in form of interest so that with such interest income he could have consumption in future. A consumer will go on preferring future consumption over present consumption as long as MU of future consumption is greater or least equal to MU of present consumption. It means that savings of a consumer depend upon rate of interest and savings. Greater the rate of interest more will be savings, because in such situations, the consumer will prefer future consumption over present consumption. As a result saving curve rises upward.

4. Price Expectations: If at any time the level of consumer goods prices goes on to increase, but the incomes of the people are not increasing, the consumer will have to allocate greater share of their current income on consumer goods. It so happens that consumer expects that in future rise in prices will be more. On the other hand if the prices are falling the consumers anticipate that in future prices will fall more than present one. All this shows that changes in real consumption did not occur due to present prices, rather due to expected changes in prices. While due to business pessimism the consumption expenditure will fall. Thus all those so as economic changes which affect consumer’s expectations particularly regarding prices will affect real consumption expenditure.

5. Wind fall Gains and Losses: The wind fall losses and gains out of changes in capital values affect the saving bracket mostly and not the spending sections. Hence their influence on consumption function is not so well marked.

6. Liquidity Preference: If people prefer to keep their income in liquid form consumption is reduced correspondingly.


All the above mentioned factors will affect the consumption function in one direction or other. However all of them are relatively unchanging in the normal short run and therefore cannot explain changes in total consumption during a short run period. Income is the only variable which will change considerably in the short run and affect consumption. Thus it may be assumed that consumption varies only with level of income. Or in other words, the aggregate real income is the ultimate independent variable influencing the propensity to consume.

Keynes concludes that in these words “Most period changes in consumption largely depend on changes in the state at which real income is being earned and not on changes in propensity to consume but of given income.

Concept of Propensity

Consumption function or propensity to consume establishes a relationship between consumption and income. As consumption means the amount spent on consumption at a given level of income, but consumption function or propensity to consume means the whole of the scheduled showing consumption expenditure at various levels of income. It tells us in short, how consumption function increases as income increases. The consumption function or propensity to consume therefore indicates a functional relationship between two aggregates viz total consumption expenditure and the gross national income. It is a schedule that expresses relationship between consumption and disposable income. In the words of J. M Keynes “Men on average as a rule have a behaviour that when their incomes increase, they increase their consumption, but not as much as their incomes increase”.

In this regard Keynes propounded a Law based on the analysis of consumption function. This Law consists of three related propositions.

(i) When aggregate income increases, consumption expenditure will also increase but by some what 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 not doubt increase but not to the same extent as increase in income.

(ii) The second proposition is that when income increases, the increment of income will be divided in same proportion between saving and consumption. This really follows from the first proportion. Since consumption spending does not increase at the same rate as the increase in income, apart of the increase 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 Law is that as income increases both consumption spending and saving 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.


Consumption function is not to be considered merely a subject of study and analysis. It has a great theoretical and practical importance. All countries want to remove unemployment from their midst raise their national income and enjoy prosperity for this purpose a policy of planned economic development is essential.

Consumption function underlines the crucial importance of investment. Because propensity to consume is stable, employment can be created only by increasing investment consumption function tells us that that people spend proportionately less than the increase in their income. Therefore, it becomes necessary to fill the gap between income and consumption by increasing investment, other wise it will not by profitable to increase output and employment we also know that consumption is more or less stable. Hence it is instability of investment which is responsible for fluctuations in income and employment in a country. It is therefore clear that investment plays a vital role in increasing income and employment in a country. If propensity of consumption could also increase, income and employment could be increased even without increasing investment. But since consumption function is stable, investment is the crucial and initiating determinant of the levels of income and employment.

Consumption function explains the turning points of business cycle. The trade cycle takes the downward course because the marginal propensity to consume is less than unity i.e. the people does not spend proportionately more as their income increases. Similarly the consumption function explains the upturn of the business cycle. This is due to the fact that since consumption is stable, people are unable to cut down their consumption expenditure to the full extent of a decrease in their income. It shows the danger of permanent over-saving gap and thus explains the decline in the marginal efficiency of capital.

Thus consumption function occupies a very important place in the theory of employment.

Theoretical Reasons of Unemployment

Practically we see that unemployment has assumed the form of a big issue in the economy. Accordingly we see why unemployment is rising in the free market economies or why forces of demand and supply fail to bring full employment. The economists present following reasons in this regard.


The economy which is under going changes may suffer from some frictional unemployment. For example if in an economy the demand for Personal Computers increases, the demand for type writers may go down. The labour that will get unemployed from type writer producing firms may be given the name of frictional unemployed, as they will have to remain unemployed for some time before they get new job. Again the localities while oil is extracted here the demand for labour may go up when the demand for oil increases. Again the demand for labour producing cosmetics may go down in localities where they are produced if the demand for cosmetics decreases. Such all is given the name of sectoral shift. Therefore when such like changes occur the frictional unemployment may rise.

2. Real Wage Rigidity:

As we know that if real wages are made inflexible in classical model i.e. they are not allowed to fall, then economics may suffer from unemployment. The same has been made a basis by Keynesian that in real life wages are rigid down ward. As a result the demand for and supply of labour are not equalized and economy faces unemployment. The unemployment rises due to rigid wages and rationing of employment is given the name of ‘wait employment’. Here the labour are not unemployed because they are in search of job which suits them rather they are unemployed because supply of labour is more than demand for labour. Therefore they are waiting for availability of jobs.

Now question arises why wage rigidity and unemployment rise. This is due to reason though there is excess supply of labour in the economy, yet the firms do not decrease the wages. Now the question rises why firms do not decrease the wags. Three reasons are advanced in this regard: (1) The minimum wage laws (2) The monopolistic powers of trade unions and (3) The efficiency wages.

(i) Minimum Wages Laws: The government so often in order to protect the minimum life standard of labourers set the minimum wage levels i.e. it is stipulated that no firm will give wages lower than certain minimum level. Hence it is being observed that the wages for semi-skilled and inexperienced labourers are determined more than the equilibrium wages. But such situation leads to reduce the demand for labour which results in unemployment.

(ii) Trade Unions and Collective Bargaining: The labourers who are the members of the unions their wages are set as a result of contracts between the union leaders and management of the firms in addition to demand and supply. It has been observed that the wages determined through collective bargaining are higher than equilibrium wages. This gives the firm power to employ the labour as much they like. Accordingly the firms normally reduce the demand for labour. This increases the quantity of labour that is prey to wait unemployment. Moreover unions also influence the wages of those firms which lack unions. As the firms do not like that the labourers could establish unions. Therefore the wages remain above the equilibrium wages. The unions not only pressurize for higher wages but they also stress upon reducing working hours and improvement of working conditions. Again so many firms will like to please employ workers by giving them higher wages so that they could not engage in union formation.

In this connection the experts also consider the insider and outsider model. According to them the workers who are employed in the firms are given the name of Insiders, while who are unemployed and are out of the firms are outsiders. The outsiders desire that the firms should decrease wages so that more job opportunities could be created. But Insiders are desirous to keep the wages higher. Moreover it has been observed that the firms negotiate with those workers who are employed not with those who are unemployed. It is because of the reasons that it is not possible for the firms to displace those workers who they have trained or educated. In this way insiders are superior to outsiders. The insiders may threat the employers that they may reduce their interest for work. In this way when their productivity suffers, the total output of the firm may decrease. Accordingly the firms are bound to make agreement with insiders, to pay them higher wages despite the economy is having unemployment and they are prepared to work even on lower wages.

Thus according to insider-outsider model, the wages will not decrease despite unemployment. As a result the economy will not attain full employment rapidly once it experiences depression.


According to efficiency wage theories that firm works more efficiently this pays more wages to its workers. In other words “Sometimes it is in the interest of firms that they should pay higher wages to workers, than equilibrium competitive wages though it may lead to increase the wait unemployment.

Inflation and its Types

According to professor Crother “Inflation is a state in which the value of money falls and price level persistently rises.” Professor Ackly Garden defines inflation as “Inflation is a persistent and appreciable rise in general level of average prices.” According to Professor Pigou “Inflation takes place when price level expands more in proportion to output.” Thus we conclude that Inflation is a phenomenon where by general price level rises persistently.


If in an economy, price rises due to increase in costs of production, it is given the name of cost Push Inflation. The important feature of this type of inflation is that on one side the price level rises, while on the other side the level of output and employment decreases. In other words the inflation and unemployment go side by side in such type of inflation. It s said that whenever the inflation is accompanied by unemployment, it is accorded as stagflation. In other words the combination of rising price level and rising unemployment is given name of stagflation or slumplation. Cost Push Inflation occurs for reasons discussed as under.

(a) Trade union and Cost Push Inflation (Wage Push Inflation): Nowadays the trade unions are very strong. They are well informed about rise in price level, wages agreement, and change in fiscal and monetary policies. As a result they will never let their real wages to fall. More often, they force to increase their monetary wages more than increase in price level of country. The greater increase in price level of country. The greater increase in monetary wages put a burden on the cost of production of the firms. Consequent the role of competitive forces in the economy are washed out. Hence on the one side cost of production increase which leads to increased price level. While on the other side due to the decrease in aggregate supply the level of output and employment decrease. This results in unemployment in the economy. It may also happen that labour class is preferring leisure over work as a result, the labour market is tightened. Hence the wages start rising. This situation would generate inflation.

(b) Cost Push Inflation due to Supply Shock and Monopolistic Practices: Nowadays in real life we are unable to find perfect competition. Like imperfections in labour market, we also find market imperfections in goods market. It is being observed that big corporations or businesses that have monopoly over certain strategic raw material, technology and goods reduce the supply of goods in order to raise their profits. As it happened during 1973 when OPEC not only increased the price of crude oil but the production of oil was also cut during period of October 1973 to March 1974. When this oil carted increased the price the demand for oil in US and Europe greatly decreased. More over those automobiles and machinery which used oil excessively, their demand fell. Accordingly the demand for labour decreased as the wages and prices are rigid downward, the reduction in demand for labour did not decrease the monetary wages of labour. Thus because rise in costs of production price level rises, while because of decrease in demand for goods (and then demand for labour) and because of rise in costs of production, the aggregate supply is reduced. Hence unemployment along with increase in price level is result of this inflation.


This represents a situation where the basic factor at work is the increase in demand for resources wither from the government or the entrepreneurs or the households. The result is that the pressure of demand is such that it can not be met by currently available supply of output. If for example in a situation of full employment, the government expenditure or private investment goes up this is bound to generate an inflationary pressure in the economy.

Demand pull inflation can be of two types.

(a) Perishable goods:

QS Is supply of goods which is perfectly inelastic curve. This is because the supply of goods is fixed in market period. It is the demand factor which plays an important role in determining the price level. Initially “dd” is the demand curve and equilibrium is at point “a” and the price is at “OP”. As the demand increase from “dd” to “d1d1” and further to “d2d2” the equilibrium is at point b and c. This brings an increase in price “OP” to OP1 and OP2.

This is due to the demand forces pulling the prices upward.

(b) Non-Perishable goods:

The SS curve is supply curve which is initially price elastic till the stocks are more and later it becomes perfectly inelastic due to non-availability of more stocks. Initially the “dd” is demand curve and the equilibrium is at point “a” which determines the price OP and quantity “OQ”. As the demand increases from “dd” to “d1d1” the equilibrium is achieved at point “b” which gives OP1 price and OQ1 quantity. Further increase in demand to d2d2 the price will increase to OP2 but the quantity supplied will be OQ1 only. The increase in price is due to demand pull.

Fundamental Differences between Keynes and Classical Economists

The main points of contrast between the Keynesian and Classical theories of Income and Employment are discussed in brief as under.


The classical economists explained unemployment using traditional partial equilibrium supply and demand analysis. According to them unemployment results when there is an excess supply of labour at a particular higher wage level. By accepting lower wage, the unemployed workers will go back to their jobs and the equilibrium between demand for labour and supply of labour will be established in the labour market in the long period. This equilibrium in the economy is always associated with full employment level. According to classical economists unemployment results when the wage level of workers is above the equilibrium wage level and as a result there of, the quantity of labour supplied is higher than quantity of labour demanded. The difference between the two (supply and demand) is unemployment.

J. M Keynes and his followers, however reject the fundamental classical theory of full employment equilibrium in the economy, they consider it as unrealistic. According to them full employment is a rare phenomenon in the capitalistic economy. The unemployment occurs they say when the aggregate demand function intersects the aggregate supply function at a point of less than full employment level. Keynes suggested that in the short period, the government can raise aggregate demand in the economy through public investment programmes to reduce unemployment.


Say’s Law “Supply creates its own demand” is central to the classic vision of the economy. According to say the production of goods and services generates expenditure sufficient to ensure that they are sold in the market. There is no deficiency of demand for goods and hence no need to unemploy workers. According to him full employment is a normal condition of market economy.

J. M Keynes has strongly refuted. Say’s Law of Market with the help of effective demand. Effective demand is the level of aggregate demand which is equal to aggregate supply. Whenever there is efficiency in aggregate demand a part of the goods produced remain unsold in the market which lead to general over production of goods and services in the market. When all the goods produced in the market are not sold, the firms lay off workers. The deficiency in demand for goods creates unemployment in the economy.

3. Equality between saving and investment:

Classical economists are of the view that saving and investment are equal at the full employment level. If at any time flow of savings is greater than flow of investment, then the rate of interest declines in the money market this leads to an increase in investment. The process continues till the flow of investment equals the flow of saving. Thus according to the classical economists, the quality between saving and investment is brought about through mechanism of rate of interest.

J.M.Keynes is however of the view that equality between saving and investment is brought about through changes income rather than the changes in interest rate.

4. Money and prices

The classical economists are of the opinion that price level varies in response to changes in the quantity of money. The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. J.M.Keynes has rejected the simple quantity theory of money. According to him if there is recession in the economy and the resources are lying idle and unutilized an increased spending of money lead to substantial increase in real output and employment without affectively price level.

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