UNIT 1 CLASSICAL AND KEYNESIAN

APPROACHES
structure
1.0 Objectives
1. I Iiltroduction
1.2 Some Cencepts
1.2.1 Aggregate Supply
1.2.2 Supply of and Demand for Labour
1.2.3 Aggregate Demand
1.2.4 Equilibrium Output and Price
1.2.5 Measurement of Aggregate Output
1.2 6 Circular Flow of Income
1.3 Various Schools of Thought
1.4 CollsurnptionExpenditureand Savitig
1.4.1 Average and Marginal Propensity to Consume
1.4.3 Consumption Function
1.4.3 Saving Function
1.4.4 Determinants of Consumption and Saving
1.5 Fixed Price Keynesian Model
1.6 1r;vesttnent~ u l t i ~ l i e r
1.7 Let Us Sum Up
1.8 Key Words
1.9 Some Useful Books
1 .I 0 AnswersMints to Check Your Progress Exercises

1.0 OBJECTIVES
After going through this unit you should be in a position to
explain the concepts of aggregate demand and aggregate supply;
identifythe factors influencing agyegate demand and aggregate supply;
explain the Classical approach to determination of equilibrium output and prices;
and
explain the Keynesianapproach to determination of eqdibriumoutput and prices.

1.1 INTRODUCTION
Macroeconomics concerns with the study of aggregate behaviour in an economy. The
need for a specialb m c h of macmnomics arises because what holds for the individual
unit may not hold good for the aggregate. For example, a firm may be in a position to
increase its output level in the short runto meet the increased demand for its product.
Hut if all f m s want to increasetheir output level, in the short runit would not be possible
Traditional Approaches to because of limited availability of resources (say, labour) unless there are unemployed~
Macroeconomics resources in the economy. Thus the increase in demand may result in hike in pice4
without any increase in output. I

Through the intersection of aggregate demand and aggregate supply we obtain aggregatd
output and aggregate price level for the economy. A change in aggregate demand or
aggregate supply would influencethe levels of output and prices. Economists differ on
the mechanism and speed with which such change takes place in the economy. In this
unit>we'will discuss the classical and Keynesian approachesto determination of output
and prices in an economy. However, we h g i n with some basic concepts before we deal
with these approaches.

1.2 SOME CONCEPTS

We begin with the definitionof certain important concepts, which we will be using in this
course.

1.2.1 Aggregate Supply I

Aggregate supply of an economy is the amount of output produced by firms in thk

economy. With the objective of profit maximization firms decide on the quantity of
output they supply to the market. The total output produced depends upon two factors:
i) level of inputs, and ii) level of teclmology. The demand for inputs by firms depends
upon input prices. We assume that there are two primary factors, viz., labour (L) and
capital ( K )used in the production process. Of these two inputs, labour is supplied by
households while capital is the stock ofequipment and structure used in production and
available in the market. Machineries, building and vehiclesare examples of capital input.
Through 'investment' we can increase the level of capital input in the economy. On the
other hand, labour supply depends on population growtll. We will learn more about the
production function, which shows a technical relationship between inputs and output in
Block 2.

As the quantity of input used increases there is an increase in output, and therefore the
quantity supplied (Q"). Aggregate supply curve (AS) is plotted on a graph (see Fig. 1.1)
where x-axis denotes quantity of labour supplied and y-axis denotes price of output (P).
Recall from microeconomicsthat individual supply curve is upward sloping in prices. In
the case of aggregate supply curve. however, there is disagreement among economists
-whether it is a vertical stmight line or an increasingcurve in prices. Usually it is assumad
that in the short runaggregate supply is upward sloping while in the long runit is vertical.

1.2.2 Supply of and Demand for Labour

The quantity of labour supplied (L' ) by households depends upon the prevailing wage
rate. Ifwage rate is too low certain individuals may opt out ofthe market while at higher
wage rate individuals may put in more working hours. Thus there is a direct relationsGp
between labour supply and wage rate. Remember that when we talk of unemployment,
we mean 'involuntary unemployment'; we exclude voluntary unemployment. The ' l a b
force' or 'workforce' is the sum of employed and unemployed persons. Unemploymdnt
rate is defined as the percentage of labour force that is not employed.

The quantity of labour demanded (L" ) is a downward sloping curve of wage rate. By
interaction of the supply and demand curves of labour the equilibrium wage rate is
determined. Wage rate can be measured in nominal or real terms. By nominal wage (w)
 - -

we mean wage accounted in money terns. On the other hand, by real wage we mean Classical and Keynesian
Approaches
W
nominal wage adjusted for price change (-1 .Thus if there is an increase in price level
P
(P)and nominal wage rate does not increase then there is a decrease in real wage rate.

1.2.3 Aggregate Demand

In macroeconomics we use the term aggregate demand (AD) to include the total demand
for goods and services produced in the economy. Aggregate demand is an inverse
function in prices depicted by a downward sloping curve. Thus, as prices increase,
aggregate demand decreases.

Aggregate demand is viewed in terms of expenditure or spending on goods and services.

There are four major components of aggregate deniand: i)consumption expenditure, ii)
investment, iii) gbvemment expenditure, and iv) net exports. Thus
*<

Q"=C+I+G+(X-M) ...(1. 1)

where Q1' is aggregate demand, Cis consumption expenditure, I is investment, G is

government expenditure,Xis exports and Mis imports. Thus (X-M) indicatenet exports.
In a closed economy, where there is no foreign trade, Xand Mare equal to zero and
thus do not get included in (1.1). The behaviour of these constituents will be discussed
later.

1.2.4 Equilibrium Output and Price

It is mentioned above that aggregate supply curve (AS) is upward sloping (in the short
run) while aggregatedemand curve (AD) is downward sloping. Through the intersection
of aggiegate supply and aggregatedemand curves we obtain equilibriumlevels of output
and prices.
p I

Q 0, Q
Fig. 1.1 :Equilibrium Output and Price Levels
Tradition*l*~~roachwo In Fig. 1.1 aggregate supply is given b j the 11neAS, and aggregate demand is given hy
Macroeconomics
the line AD, Corresponding to the equality between AS, and AI), we find that the
equilibrium level of output is Q, and equilibrium price level is P,. Suppose there is a
downward shift in aggregate demand fromAD, t o m , due to changes in the levels of its
components. Accordingly. the equilibrium levels ofoutput and price will change to Q,
and P,. I

Certain questions may be shaping up ii: your mind at this point. How soon does such a
change in output level take place? What is the impact of such a change on the levellof
employment? If Q, represents full employnlent equilibrium, does the economy ever
regain its full employment output level?

When there is a decline in AD the immediate impact is a downward shift in the output
level. Consequently, there is a rise in unemployment in the economy which pushes the
wage rate downward. The decline in wage rate is likely to reduce cost ofproduction and
hence pricc level. As a result, the AS cuwe will shift downward. 'Tlre whole process.
however, takes time as the decline in nominal wage and prices is not instantaneoys.
?'herfore, in the short ixm output declines below fill1employment level but in the long
it returns to its fill1employment level. So long on output remains below full employmdnt
level, there is a thndency for wage rate to decline. Through adjustments in wage rate ahd
prices the output level recovers to its fill1enlployment level, although with considerable
delay. Once full employment is realised, increase in AD will result in price rise. Thus
fluctuations in output, wage rate and price level are a partof the process. Such fluctuations
are often systenlatic and called business cycles.

1.2.5 Measurement of Aggregate Output

You may have heard of the concept gross donlesticproduct (GDP). which is measured
in current prices or in constant prices. Empirically aggregate output (Q)of an economy
is given by GDP at constant prices. Thus GDY at market prices represents P x Q .

GDP can be measured by three approaches: i) sum of final output (Q), ii) sum of facaor
income (Y), and iii) sum of final expenditure(E). All three measures provide the m e
value of GDP. Therefore, we will use Y and Q interchangeably to represent aggregate
output.

If we subtract net taxes (T) from total income (Y) we obtain personal disposable income
(Y-T), which is a determining factor in consumption expenditure (C).

While dealing with time series data we would use subscript 'I' to represent time pel f 4d.
-,
For example C, is total consumption for period (t-1).

1.2.6 Circular Flow of Income

There are basically three economic agents in the economy: households, firnls and
government. The households receive income by sellingtheir labour and capital inputs in
the factor market. This income is used on three heads: i) payment of taxes to the
government, ii) consumption of goods and services, and iii) saving through financial
markets. Firms use the revenue obtained by selling goodsand d c e s for factor p a p a t s .
The government receives revenue from taxes, which is used for purchase of goods and
services.If government revenue is Ic. Lhan its purchases (that means ifthere is a defiail')
then the government borrows from the financial markets.
 t
Income
7
Markets for Factors of
Production
., Classical and Keynesian
Approaches
Factor Payments

tiousehold savings
+, Financial
Markets

Government Deficit
w w

1 Io~~scliolds 'Taxes Ciovem~nent Firms

D-
A

Government
I'urchases
Investment

Firm revenue
Consumption Market5 foKtoods and
Services
I ' . 1
Fig. 1.2: Circular Flow of Income

Eb 'Thus there is a circular flow of income and expenditure from one economic agent to
others in a closed economy. If foreign trade is allowed, the model presented at Fig. 1.2
r
I needs modification and external sector needs to be introduced.Rememberthat the circular
I flow depicted in Fig. 1.2 is a simplification of reality even for a closed economy. Here
we assume that households own labour and capital. In practice, firms also own capital,
make investment, and pay taxes to the government. Government transfers money to
households as social security measures.

1.3 .VARIOUSSCHOOLS OF THOUGHT

Among economists there is no agreement on how adjustments in equilibrium levels of
output, prices and employment take place. There are also differences in views oil the
sources of economic fluctuations. Basically there are two important schools of thought:
classical and Keynesian. Classical approach is a term coined by ~ o h ~ M a y r M~ de y n e s
to reflect the ideas presented by economists prior to him. Prominent among classical
economists Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill. The
classical and Keynesian economists differ on: i) the relative roles played by supply and
demand in determinationof output, employment and prices, ii) the flexibility of prices
and wage rate in the economy, and iii) the dichotomy between real sector and monetary
scctvr. The inainstay of classical economics has been the basic assumption that 'supply
creates its own demand'; often referred to as 'Say's law', named after J. B. Say. The
Keynesian economistsrule out such a possibility, particularly during periodsof recession.

In fxt, Keynesian economics evolved on the aftermath of the 'Great Depression' during
1929-34 with the publication of 'The General Theory of Employment, Interest and
Money' in 1936by Keynes. As we will notice below, the classical economists failed to
TraditionalApproaches to explain the prevailing unemployment and decline in output during the 'Great ~e~ressionb.
Macroeconomics In an attempi to explain the down turn ~ e y n e s ' s u ~ ~ e sthat
t e dthe Great Depression
occurred mainly due to inadequate demand. In Keynesian view 'demand creates iOs
own supply' so long as unemploy rlent exists in the economv,
I
The classical economists believed in free trade and minimum intervertion by thle
government on economic activities. They suggested a 'laissez-faire' (~renchfor 'leave
us alone') economy where government should confine itself to law, defence and
governance. In such an economy 'market forces' will determine real variables such as
output, employment and prices. This is made possible by flexibility in price and wage
levels. The classical economists believed that the aggregate supply curve is vertical, so
that there is no change in equilibrium level of output and employment (see Fig. 1.3).

For example, supposethere is a downward shift in aggregate demand from AD, to All,
due to reduced consemptin expenditure by households. This will result in excess supply
at the prevailing price P,. Consequently,prices will decline to P, while there will be n$
decline in output level, and market gets cleared. In the factor market, wage rate will
decline sothat l l l employment is maintained. According to classical economiststhere iS
a 'self-correcting mechanisrr:'bchind the 'marketclearing model7of the economy. The
process of change in wage rate and prices are achieved instantaneously. The classic4
economists also assume dichotomy between real variables (such as output and
employment) and nominal variables (such as money supply and prices). Thus changes irb
money supply (M) do not influence output or employment. If there is a decrease in
money supply, levels of prices and wage rate will decline.

Fig. 1.3: ClassicalApproach to Output and Price Determination

The Keynesian approach, however, does not subscribe to the vertical AS curve. Keynes
points out that in the short run there are price and wage 'rigidities' so that prices and
wage rate do not decline when there is a downward shift in aggregate demand. Wag$
rigidities arise because of various contractsand labour legislation. Due to wage rigidity,
wage rate is maintained at a higher level, Consequently, the output level declines and
there is 'recession' in the economy. In the short-runthe AS curve is either horizontal ot
upward sloping (in Fig. 1.1. we have presented an upward slopingAS curve so that
downward shiftin AD results in decline in both output and price levels). In the Keynesim
I model, however, the AS curve is assumed to be vertical in the long run so that output Classical and Keynesian
supplied is fixed. Thus we can say that the classical model explainsthe long runwhile the Approaches
I Keynesian model explainsthe short run.
i
1 In response to the Keynesian economics the 'neoclassical economists' (John Hicks,
I Paul Sarnuelson, Robert Solowamong others) attempted to imbibe the important ideas
of Keynesian economicsin a classical framework. The pioneering efforts by Sir John
Hicks paved the way for the synthesis of classical and Keynesian ideas on real and
nominal macro-variables, popdarly known as IS-LM model. The neoclassical growth
1 model by Solow helped in analysis of long rungrowth of an economy.

i The 'new classical economics' is a term broadly used to describethe challengesposed

to the Keynesian orthodoxy. This school of thought suggeststhat economicfluctuations
r
can be explained while maintainjng classical assumptions. Some of the topics based on
new classical economicsthat we will discuss in later Units are real business cycle theory
(Unit 14)and rational expectations hypothesis (unit 7). The new classical economists
(prominent are Robert Barro and Robert Lucas) endorse the price and wage flexibility
I assumed by classical economists.

The 'new Keynesian economics' is of the view that wages and prices adjust slowly to
. shocks. As a result, fluctuations in aggregate demand cause short run fluctuationsin
output and employment.New Keynesian economists (Cmgory Mankiw among others)
suggest that 'menu costs', 'aggregate demand externalities' and c o o W i o n failure cause
sticky prices.

Check Your Progress 1

1 ) Explain the interaction between household and firms through a circular flow
diagram.

2) Distinguish between the classical and Keynesian models of autput and price
1 detexmination in terms of demand and supply curves.
TraditionalApproaches to
Macroeconomics 1.4 CONSUMPTION EXPENDITUREAND SAVING
For households the personal disposable income (that is, income after payment of taxes
and adding transfer payments) is allocated on either consumption expenditure (9
or
saving (S). Thus we have + s = y .

1.4.1 Average and Marginal Propensity to Consume

Consumption expenditure is the major head of spending by households and depends
upon personal disposable income. It is generally observed that for a household the level
of consumption increases as income level increases. However, there is a minimum level
of consumption required for survival. Thus, in order to survive, a household has to spend
a minimum amount on consumption even if its income level is zero. The household may
borrow for consumption expenditureor may draw upon past saving. Secondly. poorer
households spend less on consumption than richer households do. But as a percentage
of household income, it is observed that poorer households spend a higher percentage
of their income on consumption.

We introduce two conczpts: average propensity to consume (APC) and marginal

propensity to consume (MPC). APC is defined as the ratio of consumption expenditure
C
to income (- ). For example, if a family has an income of Rs. 8000 apd spends Rs.
Y
5000 on consumption, then APC is 5000/8000 = 0.625. Marginal propensity to
consume (MPC) is defined as the amount spent on consumption out of every additidnal
AC
Rupee earned. In symbols it is given by -.As an example, MPC = 0.65 for a fmily
AY
if consumption expenditure increases by &. 65 Paisa when income increases by Rs. 100.

1.4.2 Consumption Function

Consumption function showsthe relationship between c andy. Our consumption function
should depict the above features. If we ignore taxes and subsidies by the government,
then consumption function in its simplest form is given by

where Ct is current consumption and Y, is current income. The consumption function

given at (1.2) is a straight line with intercept C and slope c. Here C is the threshold or
minimum consumption when income is zero. Since a household spends only apart oKits
income on consumption the value of c should be less than 1. Moreover, c cannot be
negative. Thus c remains betwen 0 and 1, that is, 0 < c < 1. We observe that c is the
AC
MPC since c = -.Notice an important feature of the consumption function, thdt is,
AY
the average propensity to consume (C, 1 I ; ) falls as income rises.

In Fig. 1.3 (panel-a) we depict the consumption function. Here we draw a 45O line
along which whatever is earned is consumed, that is, C = Y When income level is Y,,
consumption equals income as the consumption h c t i o n intersects the 45 line. 71-i;s
 level of income is called 'breakeven income', and on the avexage, a family having income Classical and Keynesian
Y, consumes whatever h earns. When income is less than Y,, consumptionlevel of the Approaches
household is more than its income. On the other hand, when income is more thanY ,,
consumption is less than income. For example, in Fig. 1.3 (a) when income is Y,
consumption is C,. Notice that when income exceeds Y,, we have C < y .
45' line

/
function

Fig. 1.4 (a): Consumption Function

S

Fig. 1.4 (b): Saving Function

1.4.3 Saving Function

As we n ~ t e earlier,
d income is the sum of consumptionand saving. Thus in the simplified
model that we discussed above, that part of income which is not consumed is saved. In
Fig. 1.3 (panel-b) we have presented the saving function. Notice that when income is Y,

k
I radfiionaIAp~roachrn(0 there is no saving, asaonsumption is equal to income. When income is less than Y, dere
Macroeconomics is dis-saving, that is, the household is expected to borrow or draw upon past saving in
order to financeits current consumption expenditure.On the other hand, when incode is
more than Y, a part of income is channelbed towards saving.Accordingly, in Fig. 1.3 (b)
saving function intersects x-axis when income is Y, . Sincethe consumption h c t i o is a
1
straight line, the saving function also is an upward slopingstraight line with slopes, w 'ch
is called the marginal propensity to save (MPS). The intercept tirm is negative sihce
saving is negative when income is zero. Moreover, MPS is positive and remain b e ~ n
zaoa .one. In equation form the saving function is given by

Remember that MPC and M P S add up to unity, that is, c + s =1.

1.4.4 Determinants of Consumption and Saving

A crucial issue before a household is to decide on how much to allucate towards curtent
consumption out of its current income. Apart from the level of income another fmor
influencing the level of saving is the rate of interest, that is, higher the interest rate hi$her
is the saving.

We know that when we save money (in the form of bank deposits or in bonds) we
receive interest. Thus when we look beyond the current period we expect a flow of
income over different time periods. Thus expected htureincome plays an important tole
in our decision on consumptionand saving in the current period as well as in future time
periods. Based upon +hesimple frameworkdiscussed above there quite a few &er-
temporal consumptionmodels, which we will discuss in Block 4.

A second issue is the determbtion of aggregate consumption and saving for the economy
as a whole. What we have explained above is the behaviour of households. It is true that
allhouseholds have different income levels and MPC, which pose certain mmplexiriies.
It is usually seen that young adultshave a low MPC l ~ l y d utoe lesser responsibilikies
compared to old people. Economic models that stress the presence of old and yo~lng
households are refemd to as 'overlapping generationsmodel'.

You may have observed that saving rate varies across economies and over fima. In
India, forexarnple,saving rate was around 10per cent of GDP dwing 1950swhile it is
around 25 percent of GDP at present. There has been a three-fold increase in per abita
ihcomqduring 1950-51 and 2004-2005. However, higher per capita income doesnot
translate into higher saving rate always. We observe that among developed econorrhies
saving rate is not uniform. For example, saving rate is much higher in Japan (about 30
per cent) compared to the United States (about 14percent). Thus there may be certain
other factors apart from income, which influence consumption and savihg decision.
However, in crosscountry analysis we see that there is a pcitive and strongconelafion
between saving rate and per capita income. Thus we can say that the consumptiion
function at aggregate level would also depict the same features as the household
consumption function

Here we first established a relationship between consumption and saving of individual

households and based upon that attempted to explain the behaviour of aggregate
consumption and aggregate saving. In other wards, we projected the behaviour of macm
 variables on the basis of micro variables. This sort of research strategv is called 'micro- Classical and Keynesian
foundation' of macroeconon~icanalysis. Approaches

We assumed above in the consumption (and saving) function that consumption depends
upon the level of income. However, there are certain other determinants of consumption.
The redistribution of income in favour of low-income households will result in an increase
in MPC while the opposite will happen if there is growing inequality in the economy.
Second, the availability of credit withease also in-s consumption. Third, expectations
regarding price and income changes also affect consumption expenditure by households.
lf people expect prices to decline in coming days a e y postponegpurchaseswhich results
in a downward shift in aggregate demand curve, and decline in equilibriumoutput. Fourth,
as pointed out by Fisher individualsface a 'money illusion' if prices and income change
in the same proportion -the real income of people does not change but they may not
perceive the price rise and increase consumption as income increases. FiRh, when prices
fall, there is an increase in real value of fixed income yielding assets (such as bonds),
which may increase consumption.

1.5 FIXED PRICE KEYNESIAN MODEL

The classical economists suggested that there should be fke tmde in the emnomy based
on market rr~echanismand little intervention by the government, as it would be ineffective.
Keynes, however, advocated intervention by the government in macroeconomic variables
in order to correct the disequilibrium in the economy.

For equilibriumto be realised there should be equality between aggregate demand and
aggregate supply. As we have seen earlier, aggregate supply is the total output produced
in the economy while aggregate demand is the sum of consumption, investment and
government expenditure. Keynesian model assumes that there is price rigidity so that
adjustment takes place through changes moutput level.

1 in Fig. 1.4 we depict the adjustment process in the emnomy when priceys fixed. On the
/ x -axiswe measure aggregate supply (level of output) while aggregate demand (C+I+G)
/ is measured an the y-axis. In Fig. 1.4 we have drawn a 45O line on which AS =AD. We
/: assume that investment (I)and government expenditure (G) are exogenous variables in
the sense that their levels do not depend upon the level of output or income. &the
aggregatedemand h t i o n will be a p d e l shift in theconsumptionfunction, thediffance
1 between the two indicating the sum of investment and governmentexpenditure (I*).

In Fig. 1.4we observethatequilibrium level of output is Y as the lineindicating(C+I+G)

t'
crosses the 45O line at this level of output. We know tha the slope of the consumption
I function is equal to MPC. Suppose there is a decrease in the MPC from c to c '(implies
11 an increase in the prbpensity to save). It implies that for one Rupee increase in income,
a lower amount will be spent on cons~~ption-and more will be devoted to saving. In Fig.
t, 1-4such a decline in MPC will result in a downward rotation of the consumptionfunction
from C to C' (see the dotted line). Accordingly, (C'+I+G) will also rotate downward
i
t and the new equilibrium output level will be YLNotice thatan increase in the propensity
1 to save is resulting in a decline in output.
I I

We observe that aggregate demand changes if there is change in C, I or G Therefore,

increase in business investment or government expenditure will increase aggregate
demand, and thus equilibrium output will incxme. Similarly, a decline in investment or
i
, government expenditure will dampen aggregate demand and result in a decline in
TraditionalApproaches to
Macroeconomics

Fig. 1.5: Fixed-Price Keynesian Model

We pointed out above in Sub-section 1.2.1 that aggregatedemand is seen in the conteAt
of aggregate spending in the economy. Due to the circular flow of income when ode
economic agent spends certain amount (say one Rupee), it causes an increase in the
income of another economic agent by the same amount (by one Rupee). Based on thiis
simplelogic Kahn developedthetheory of multiplier, often known as 'investmentmuhiplief.'

Let us explainthemultiplier effect thmugha hypothetical example. Supposethe governmerit

issues abond of Rs. 100in the market so that government expenditurecan be i n c d
by Rs. 100.As a result, a sequence of events will take place.
1) The additionalexpenditureby the government will increasethe income of householdk
by Rs. 100. Out of this increased income the household consumes an amount e q d
to 1OOx c and saves the residual (if MPC = 0.65, then the household will spend Rs.
65 and save Rs. 35). 4-

2) Suppose the household getting the income of Rs. 100, spends Rs. 65 on purchase
of bread. Consequently, the income of the bred-seller will increase by Rs. 65.
3) When the income of the bread-seller increases by Rs. 65, she will save Rs. 22.75
and spend Rs. 42.25 (since MPC = 0465).
4) The spending of Rs.42.25 by the bread-seller wdl increase the income of anotha
person by Rs. 42.25. The sequence will continue fbrther with the amount spent or
earned & d u n g M e r in subsequentrounds.
Recall that the initial spending by the government is Rs. 100.But it has a ripple effect &
the economy, generating income of Rs. 100 + Rs. 65 + Rs. 42.25 + ... . Thus, the
increase in aggregatedemand due to a spending of Rs. 100by the governmentwould bf
much more than Rs. 100. I
How much the whole sequence would add-upto? If c is the marginal propensity to Classical and Keynesian
consume then the series is adds up to Approaches

s
1
In (1.4) abovethe term -is called the 'investment multiplier' since m a t e demand
1-c
1
increases by a multiple of -for an initial spemhg by the government. In our example
1-c
above when government expenditure increased by Rs. 100 and MPC = 0.65, the
1
increase in aggregate demand would be Rs.100x =Rs.285.71.
1- 0.65
We draw a few inferences from the above.
1) Government spending has the beneficial effect ofboosting up aggregatedemand
by a higher amount than the initial spending.
x
2) An increase in MPC will result in an increase in the value of the multiplier.
Conversely, decrease in MPS would result in a higher multiplier value.
3) We assumed thatgovernment spendmg is financedby borrowing h m the market
1
If it is tax financed then the multiplier will be 1,not - since increase in tax
1-c
will have the multiplier effect in the opposite direction. Consequentlyaggregate
demand will increase an amount equal to the initial spendingby the government.
It is called 'balanced budget multiplier' and is equal to 1.
4) It is assumed that households spend according to their MPC and do not hoard
the money.
Keynes projected the Great Depression as a consequence of demand deficiency. There
was decline in income becauseof inaxme in unemployment. Decline in income gave rise
to decrease in consumption demand. Inadequate demand reiulted in excess supply in
the market and inventories got piled up, which discouraged W e r production. With
curtailment in production there was fiather unemployment and furtherdecline in income.
Secondly,people expected prices to decline fiather so thatthey postponed their purchases
which reduced aggregate demand further. There was an overall gloomy period of falling
output, income and prices, and rising unemployment. Keynes suggested that the
government shbvidincrease its spending so that people get employment, which will
generate income and demand.

In the above analysis we observe thatgovernment expenditureis an exogenous variable

so that its level can be increased. There can be similar multiplier effects ifthe export of
the country goes up. Also, Slimscould increase their investment, a multiplier effect will
take place.

Check Your Progress 2

1) Explain the important features of consumption function. ,
TraditionalApproaches to
Macroeconomics ........................................................................................................................... I
;

2) In the Keynesianmodel, what is aggregate demand? How does a change in aggregate 1

demand affect output?

3) With an example explain the concept of investment multiplier.

...........................................................................................................................
............................................................................................................................
...........................................................................................................................
...........................................................................................................................

1.7 LET US SUM UP

In this unit we discussed some basic concepts such as aggregate demand, aggregate
supply and circular flow of income. We also provided a brief idea on different schoolsof
maclroeconomicthought.

The classical economists assumed flexibility in price and wage so that the possibility of
unemployment in the economy was ruled out. The economy adjusted to demand shocks
through changes ii price level so that economic fluctuationswere not there. There was
no need for governmerit intervention in the classical model as supply was inelastic at full
emploment level. However, the Great Depression demolished the classical beliefs, as '
there was &despread unemployment associated with decliningprices and output.

Keynesian economics suggested that deficiency in aggregate demand could trigger a 1

recession and the remedy is to increase aggregate demand. Keynes advocated increased
government spending so that aggregate demand would increase simultaneously giving 1
income and emploment to people. We discussed consumption and saving functions 1
and investment multiplier, which are important concepts in Keynesian economics.
-
1.8 KEYWORDS
C
~ v e r a Propensity
~e to Consume The ratio of consumptionto income (- ).
Y ,
 Classical ard Keynesian
Classical Dichotomy The theoretical separation of real and nominal Approaches
variables in the economy. It assumesthat money
i s neutral and doea not influe- output and
employment levels.

Classical Model A model of the econorJlyderived Erom ideas of

the pre-Keynesian economists.It is based on
the:assumption that prices and wages adjust to
clear markets and that monetary policy does
not influen& real variables such as output and
employment.

Keynesian Model A model based on the ideas contained in

Keynes' General Theory. It assumes that
demand creates its own supply so long as
unemployment exists and that prices and wages
do not adjust instantaneouslyto clear markets.

Marginal Propensity to Consume The increase in consumptionresulting fiom a

one-Rupee increase in income. It is given by
AC

Menu Costs When a firm wants to change prices of

prodhcts, certain additional costs are to be
incurred.For example, restaurantsreprint theii
menu cards, shops print their price catalogues
and taxis adjust their meters. l[hesecosts may
be small but they take time and deter firmsh m
c m prices fiquently.

Multiplier The increase in output due to a unit increase in

certainexogenousvariable(such as investment,
government spendingand net exports).

Model A simplified representationof reality to show

the interaction among variables. It is presented
throughdiagramsor equations.
New Classical Economics The school of thought projecting the view that
economic fluctuation&be explained while
maintainingclassicalassumptions.
New Keynesian Economics n?e ~ h o oofl though which saysthat ecamqk
fhtwtion can be explained only by admitting
sticky prices and wage rate.

Open economy An economy that allows free trade with other

economies.it is-fiom ' c b s e d m m y '
where foreigntmcle is not allowed. In dworld
no economy is a closed one.
 I
TraditionalApproaches to i

Macroeconomics 1.9 SOME USEFUL BOOKS I

Mankiw, N. G, 2000, Macroeconomics, Fourth Edition, Macmillan, New Delhi.

Samuelson, P. A. and W. D. Nordhaus, 2005, Ecpnomics, Eighteenth Edition, Tata

McGraw Hill, Delhi.
- -

1.10 ANSWERSIHINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) See Sub-section 1.2.6 and fmd out the flows of goods, inputs and money between
households and f m through various markets. Draw a diagram similar to Fig. 1.2
and explainthe flows.
2) The difference between classical and Keynesian models can be explained in terms
of i) the relative importanceof supply and demand, ii) flexibility in price and wage
levels, and iii) the time period under consideration (short-run or long-run). Elaborate
these points.
Check Your Progress 2
1) Explain the behaviour ofAPC and MPC. Show the consumption function in terms
of a diagram. Go through Sub-section 1.4.2.
2) Explain the components of aggregate demand, viz., C, I and G Draw a diagram
i nthan@ in -gate
similar to Fig. 1.4. ~ x ~ l athe demand and its impact on output.
3) Go through Section 1.6. Take numerical value for MPC and level of investment.
Explain the process of increasein income at various rounds.
UNIT 2 NEOCLASSICAL SYNTHESIS
structure
2.0 Objectives
2.1 Introduction
2.2 Investment Function
2.3 Demands for and Supply of Money
2.4 Equilibrium in Real Sector - IS Curve
2.5 Equilibrium in Monetary Sector - LM Curve
2.6 Synthesis of Real and Monetary Sectors
2.7 Let Us Sum Up
2.8 Key Words
2.9 Some Usell Books
2.10 AnswersIHints to Check Your Progress Exercises

2.0 OBJECTIVES
AAer going through this unit you should be in a position to
explain the equilibrium in real and money markets in an economy;
explain the underlying ideas behind IS curve;
explain the underlying ideas behind LM curve;
explain the interaction of IS and LM curve; and
apprise the effectivenessof monetary and fiscal policies in an economy.

2.1 INTRODUCTION
In the previous Unit we discussed the classical and Keynesian views on the
determination of output and prices in an economy. According to the classical
economists supply creates its own demand and full employment prevails through
adjustments in prices and wage rate. The Keynesian view, however, assumes that
price level and wage rate are sticky in an economy due to various factors such as
labour contracts and labour laws so that adjustment to demand shocks takes place
not through adjustments in prices and wage rate but through changes in output and
employment levels. In fact, Keynesian economics presents a view opposite to the
classical economists that demand creates its own supply so long as unemployment
exists in the economy.

The classical economists assumed a dichotomy between the real and monetary sectors
of an economy. According to them an increase in money supply (M, ) in an economy
with output and employment levels unchanged, will translate into a proportionate
increase in prices. Therefore, through increase in price level and wage rate the
adjustment process will begin and full employment will be maintained.

711edifference in views betyee~classicaland Keynesian economistsis due primarily

to the time horizon considered. In the Keynesian view in the long run price level and
Traditional*ppmaehe~toA~~ wage rate will adjust to - , rum levels. But in the short run due to price and
.A,,

Macroeconomics wage rigidities ful' ,iilployment equilibrium will not be realised. The neocl-xical
economists, particularly Sir John Hicks, have attempted to combine the ideas
contained in both the schools of thought and to bring a synthesis between the real
sector and the monetary sector of the economy. 1
We should remember that the classical economists did not bother about the quantity
of money supplied, as it did not affect output and employment according to them.
The Keynesian economists, however, projected an active role for money supply as
it can influencethe levels of output and employment.

In continuation of the basic ideas presented in the previous Unit we discuss the
behaviour of investment function below.

2.2 INVESTMENT FUNCTION

The classical economists did not pay much attention to the increase in capital stock
due to investment taking place in an economy. We know that investment results in
atl increase in the level of capital input. In the production process the inputs are
transformed to output with the help of technology. It is an important featdre of capital
input that it is durable in nature, that is, it does not get exhausted in a single use
Ilowever, certain depreciation (that is, wear and tear) to capital stock is involved
when production takes place.
cf cqital stock increases when net investment (gross investment minzls
TL- I. l+, ,. ,.L~ I

depreciation)is incurred. We will look into the growth of capital stock and consequent
rise in output in Block 2.

Investment takes place in an economy because it provides certain returns to the

investor and there is a profit motive involved. The return to investment can be
measured by the marginal product of capital (MPK), which is defined as the increase
in output when capital stock increases by a single unit. Simultaneously, business
firms or households have to borrow by paying certain rate of interest in order to
undertake investment. Even in cases when a household or business firm do not
require borrowing, the implicit cost of the investment is the interest foregone. For
example, if I construct a new house (that is, I undertake some investment), I have
the option of taking a loan from a bank on the condition that I repay the principal
along with interest. Similarly, business firms undertake investments to produce goods
and services. In doing so they take intd account two factors: i) the return from
investment which is determined by MPK, and ii) prevailing rate of interest. If return
to investment is higher than interest rate they undertake the investment project,
otherwise it is not profitable to them. The equilibrium level of investment will be
achieved when the rate s f interest is equal to the rate of return from investment.

It is a common feature of the aggregate production function that as we increqse the

level of capital input the marginal productivity of capital decreases. Thus as merit
increases the return to investment decreases. Increased level ofbvestment, thereibre,
can be undertaken only when the rate of interest is relatively lower.

In Fig. 2.1 we present the investment fuhction as a downward sloping straight line.
We measure the level of investmefit (I) on x-axis and the rate of interest on y-axis.
When the rate of interest is r, the level of investment is I,. In case the rate of interest
declines to r2the level of investment increases to 12.
 Neoclassical Synthesis

I, 12
Fig. 2.1: Investment Function

Apart from the prevailing rate of interest (r) the decision to invert depends to a great
extant an expectations about future movements in prices, resources availability,
government policy, competition from rival firms and product, etc. Since investment
involves creation of capital stocks which remains in use for a longer creation of
capital stocks which remains in use for a longer period of time, the element of
uncertainty plays a vital role in investment decisions.

Economists have found it quite difficult to explain the pattern of investment spending.
There are several econonletric models to explain investment behaviour and none of
the models have been proved to be superior over others.

The accelerator model of investment short that rate of investment depends upon
changes in aggregate output. It statesthat desired level of capital stock in the economy
is a constant fraction of output level, that is, k = h Q. Thus, as output level changes
capital stock also changes. In periods of increasing economic activity, when growth
rate in GDP is higher, there is a sense of security in the minds of entrepreneursand
they undertake investments. On the other hand, in periods of recession, there in not
much increase in investment. Thus investment not only influences output (recall
multiplier model), it is influenced by the changes in output.
I

?'he adjustment cost model states that a firm undertakes feasibility studies, machines
analysis and financial arrangements before implementing as investment decision.
Secondly there is a cost involved in installation of now machinery, training of workers
to operate the new technology and disruption of production chain. These costs are
called adjustment costs and rise if the change is done in a short period of time. Thus
i firms make gradual changes in their capital stock even though the requirement is
I much higher. According to adjustment cost models of investment, there is always a
gap between desired level of capital stock and actual level of capital stock.
I
Traditional Approaches to
Macroeconomics 2.3 DEMAND FOR AND SUPPLY OF MONEY
Money serves three important functions in an economy, viz., medium of exchange,
unit of account, and store of value. In an economy without money it would be
extremely difficult to exchange goods and services through 'barter' as was the case
before 'paper money' was invented. Modem money has significantly eased the mode
of exchange - we can go to the market and buy or sell goods and services in
exchange for money. Secondly, money serves as a unit of account in the sense that
the value of goods and services are measured in terms of money. Thirdly, paper
money although does not have any intrinsic value it is stored because it commands
certain purchasing power in the market.

Demand for money ( M, ) arises as it performs the above-mentionedhctions -all of

us want to have more money. The classical economists put more importance on the
medium of exchange function of money and suggestedthat people demand for money,
as it is required to carry out transactions in the market. We receive our income on a
monthly or weekly basis (it can be highly irregular also) while we make purchases in a
routine manner. Thus there is no synchronisationbetween the time we receive our income
and we carry out monetary transactions'.
Keynes recognised that there are three types of demand for money, viz., transaction
demand, precautionary demand and speculative demand. People store money as a
precaution in order to meet exigenciesin day-to-day life, which is different h m transaction
demand. Precautionary demand for money depends upon the perception of the person
concerned with respect to periodicity of income, stability in income flow and uncertainty
in future income stream. Let us denote the sum of transactiondemand and precautionary
demand for money as M ; . We assume that Mf; is a constant proportion of total
income.

The third type of demand for money, according to Keynes, is the speculative demand
( M ; ), which is used largely for purchase of financial assets. These assets could be
interest-yielding bonds or dividend - yielding shares (of a fm).The speculativedemand
for money depends upon the portfolio of assets that we need to maintain. If we hold
money in the form of cash the return to money is zero. Moreover, if there is inflation in
the economy then there is a decline in purchasing power. However, if we put it in stocks
(that is, shares) there is considerable risk involved as stock prices vary and we lose part
of our money when stock prices decline. We can keep money in some fixed deposit or
fixed income-yieldingasset, but in that case we have to compromisewith liquidity in the
sense that it may not be possible to get back cash immediately.

According to classical economists, when there is excess of lonable funds (that is, saving ,

available-forinvestment) in the market compared to demand for it (that is, investment

requirement)then there is a decline in the rate of interest. The increase in money supply
by the central bank (for example, Reserve Bank of India) increases lonable hnd in the
economy. If there is no corresponding increase in demand for money, equilibrium in
money market can be achieved only through a decline in the rate of interest. In fact, the
classical economists assumed flexibility in interest rate for realisation of equilibrium in
I
money market.
' The demand for money according to classical economists was determined by the 'quantity 1
theory of money', according to which MV = PY, where M is money supply, V is velocity ofmoney,
P is price level and Y is output level. When V and Y are given, P is proportional to M. Thus when
money supply increases there is a proportional increase in price level.
 Neoclassical Synthesis

1
,

Fig. 2.2: Liquidity Trap

The precautionary and transaction demand for money may be a fixed proportion of
income and dependant upon certainpsychological factors apart from basic requirement.
The speculative demand for money ( M i ), on the other hand, depends upon rate of
interest. When rate of interest is high, people keep arelatively lower amount inthe form
of cash, as they would be losing out interest otherwise. On the other hand, when the rate
of interest is low people prefer to keep a relatively higher amount of cash with them.
Thus speculative demand for money is an inverse function of interest rate (see Fig. 2.2).
According to Keynes when rate of interest is sufficiently low (say r, in Fig. 2.2) people
prefer to keep their income in the form of cash with themselves instead of financial
assets. The loss due to interest that their income could have earned is minimal when
interest rate is very low.

In terms of Fig. 2.2 the curve representing speculative demand for money becomes ,
infinitely elastic (horizontal)when rate of interest is low. This segment is called 'liquidity
trap' because people prefer liquidity to keepingtheir money in financial assets.

Rccall from Unit 1 that income serves two purposes: it is either consumed or saved.
Thmfore, it is implicitly assumed that whatever is not saved is consumed.Thus a higher
saving means reduced consumption. Unless the higher saving translates into higher
investment there would be a decline in aggregate demand and consequently a fall in
output level. When Keynes talks of liquidity trap he means that there is an increase in
saving but there is no correspondingincrease in investment. Thus government policy of
injecting money intothe system or i n m i n g income ofpeople does not haw any impact,
as it is diverted towards saving without increase in consumption.

You may be wondering whether such situationstake place in reality. During late 1990s
Japanese economy went through severe recession with decline in output, prices and
interest rate. For quite some time in the year 2003 the rate of interest was 0.03 per cent
per annum. In such situationsmonetarypolicy becomes ineffective.

The supply of money constitutes the currency in circulation and deposits in banks.
Money is usually supplied by the central bank.of a country and there are various
measures of money supply depending upon its liquidity. In India for example we
TraditionalApproaches to
Macroeconomics have money supply measures such as MI, M2 and M3 which are distinct from each
other.

Check Your Progress 1

1) What are the types of demand for money? What are the factors on which the
demand for money is dependent upon? ~
1

2) Explain the concept of 'liquidity trap'? Why does monetary policy become ineffective
if the economy is on passing through a phase of liquidity kip? I

2.4 EQUILIBRIUM IN REAL SECTOR -IS CURVE

In Fig. 1.4 in Unit 1we have shown the equilibrium output at a level when aggregate
demand equals aggregatesupply. In a simple model -gate demand (AD) comprises
C+I, here we club government expenditure investment for simpler exposition, while
aggregate supply (AS) comprises C and S. Thus at the equilibrium level of output I = S.
In Fig. 1.4 we assume the level of investment to be fixed so that it is depicted as a
horizontal straight line. In Fig. 2.3 we present the inWaction of saving(S) and investment f

( I ) functions. When investment is I , and saving fimction is represented by S, then

equilibriumoutput is Y, .

We notice a basic difference between ex Fig. 2.1 and Fig. 2:3. In Fig. 2.1 investment
depends upon the rate of interest (r) such that more is invested when a lower interest
rate prevails in the economy. In Fig. 2.3 investment is shownto be a function of Y. Both
the saving 4 investment h t i o n s can he integr-dedso that we obtain equilibrium levels
of r and Y. The IS curve based on neoclassical ideas shows the cquilibriurn in the real
sector of the economy (see Fig. 2.4)
 Saving. investnient Neoclassical Synthesis

F
ig.23: Equilibrium Output Level

In order to explain Fig. 2.4 let us begin with the second quadrant (north-west comer of
the diagram). This represents the investmentcurve presented in Fig. 2.1. The only change
here is that we measure investment on x-axis in the opposite direction. The farther a
point to the left from the origin, higher is the level of investment. In the third quadrant
(that is, south-west comer) we measure I on x-axis and S on y-axis. We have drawn a
45O line so that S = I (implies equilibrium level of output) along this line. In the fourth
quadrant x-axis measures income (Y) and y-axis measures savings. ere d h a v e h w n
the saving function (Fig. 2.3 in inverted position) and it gives the level of saving for
different levels of in&e @member that x-axis measures income here). Thus once we
know the required level of saving we know the level of income fkom the saving function. 4

In the first quadrant (north-east comer) we have the IS curve, which we derive by using
the information contained in other three quadrants. In the first quadrant we have the rate
of interest on y-axis and income on x-axis.

S=I
Fig. 2.4: IS Curve
TraditionalApproaches to Now let us explain how we obtainedthe IS curve. Let us assume that investment is given
Macroeconomics to us (see second quadrant). By looking into the third quadrant we find the equilibrium
level of saving (since S should be equal to I at equilibrium). Next, if we look into the
fourth quadrant, given the required level of saving, we obtain thc equilibrium level of
h o m e by drawing aperjmdicularline fromthe savingfimctiontoihe x-axk. By c o m b i i
different levels of investment and saving we derive the IS curve. Thus every point on the
IS curve represents equilibrium levels of income and interest rate
When there is change in the level of investment there is a whole se~,, ie;lce of clianges -
the required level of saving will change, the required level of income will change. An
implication ofthe IS curve is that the goods market (real sector) can be at equilibrium in
any combination of lower interest rate and higher income, or a higher interest rate and
lower income.

2.5 EQUILIBRIUM IN MONETARY SECTOR - LM

CURVE
?'he derivationof LM curve utilises the Keynesian view that speculative demand and
transaction demand for money are separate. The LM curve is presented in Fig. 2.5.

n order to explain Fig. 2.5 we again begin with the second quadrant. Here we measure
interest rate on y-axis and speculativedemand for money on x-axis. It is a re-presentation
of Fig. 2.2 with the difference that M: is measured in the opposite direction. Thus
W e r a point h m the origin higher is the level of speculative demand for money. From
the speculativedemand hction, given the prevailing rate of interest, we can f i d out the
quantity of speculativedemand. The third quadrant shows thatequilibrium in the money
market can be achieved when demand for money is equal to supply of moiiey. Here we
measure M ; on y-axis and on x-axis. We know that total demand for money is

M:,Y

Fig. 2.5: L&l Curve

 Neoclassical Synthesis
given by Mf:+ M,'; . For equilibrium in the money market to be realised (that is,
M , = M , ) we have drawn a straight line, which touches y-axis at M ; (since MI: =

0 at this point) and touches x-axis at M ; (since M ; = 0at this point). If rate of interest
is low more money is demanded for speculativepurposes, which implies less money is
left for transaction demand. Recall that transaction demand for money is a constant
proportion of income. Thus higher level of M ; corresponds to higher level of Y. This
behaviour is represented in a straight line in the fourth quadrant.

In the first quadrant the LM curve is given which is upward sloping. Along y-axis we
measure the rate of interest while income is measured on the x-axis. Remember that
each point on the LM curve represents equilibrium in the money rnarket. An implication
of the LM curve is that money market equilibrium combines lower r with lowery and
higher r with higher Y

2.6 SYNTHESIS OF REAL AND MONETARY

SECTORS
Now let us combine IS and LM curves as shown in Fig. 2.6. Such integration of IS-LM
gives a unique combinationof r and Y, which represents equilibrium in both xal market
and rponey market. In Fig. 2 6 we find that r, and Y, is such a combination for the IS and
LM ekes. Remember that we have maintained fixed prices in the model, which is
simplistic but convenient. In this model it is not necessary that equilibrium income and
interest rate guarantee 111employment. In such a case the governmentneeds to intervene.

There could be two policy instruments for intervention by the gcivernrnent: fiscal policy
and monetary policy. Fiscal policy refers to taxation and expenditure measures by the
government. When the government increases its expenditure there is an increase in
investments,which results in an upward shift in the investment schedule. we h&e shown
in Fig. 2.4 a shift in the investment schedule by a dotted line. Due to the shift in the
investment schedulethere is an outward shifiin the IS curve also and equilibrium level of
output increases. We have shown such ashift in the IS curve in Fig. 2.4 by adotted line.
Another measure under fiscal policy is the reduction of tax rates on income. Such a
measure will change the nature of consumption h c t i o n (also saving function)and leave
people with more income. Such a measure will shift the IS curve upward. The opposite
effect takes place when government expenditure is curtailed or tax rates are increased.
Remember that changes in fiscal policy affects IS curve.

Monetary policy refers to changes in money supply in the economy by the central bank
(for example,Reserve Bank of India). It will effect a shift in the LM curve. When there
#
is an increase in money stipply, an increase in real balances takes place, which decreases
rate of interest.When rate of interest declines for each level of income there is a downward
shift in the LM curve (dotted line in Fig. 2.6) accordingly there will be a change in
equilibrium levels of r and Y (not shown in the figure).
'
Through appropriate changes in fiscal policy and monetpy policy the government can
I intervene and steer the economytowards fullemployment equilibrium level.
I
We have mentioned earlier in Section 2.3 that monetary policy becomes ineffective
i
when the economy is passing through a liquidity trap. In fact, the difference between the
classical and Keynesian positions can be shown through the IS-LM model.
I
TraditionalApproachesto
Macroeconomics

4 y2 Y
F
ig.2.6: ISLM Model

In Fig. 2.7 we have shown the classical and Keynesian range in the LM curve. We hav&
positioned the IS curve at different segments ofthe LM curve. Let us begin with the cast%
when the economy is operating at income level Y,. At this point LM curve is infinitely
elastic. Ifthe government increase its expenditure by borrowing from the market there i$
no increase in interest rate as there is sufficient idle speculativebalances in the econom)/.
There is an increase in income level due to shift in IS curve from IS, to IS', This is th$
Keynesian range where the economy is operating in a phase involving liquidity trap. Ifi
such situationsmonetary policy becomes ineffective and the government should intervent:
through appropriate fiscal measures.

", y2 u1

Fig. 2.7: Classical and Keynesian Range

Now let us look into the other exbremewhen the economy is operating at income level of Neoclassical Synthesis
Y,. At this level an increase in government expenditure results in a shift in the IS curve
from IS, to IS',. See that at this level the LM curve is perfectly inelastic, the rate of
interest is already very high, and real balances in the economy is low. When government
borrows from the market, it competes with private investment and there is an increase in
interest rate-income level does not increase. This is the classical range.

In practice, however, the economy usually operates at a moderate level of income, Y,.
At this level, the economy has not reached full employmentequilibriumlevel. When the
government borrows from the market it competes with private investment but it does not
'crowd out' private investment completely. As a result of increase in government
expenditure the IS curve shifts from IS, to IS',. There is an increase in the rate of interest
as well as the income.

Check Your Progress 2

1) Explain the process of detaminationof equilibrium in the real sector of the economy.

2) What does the LM curve signify? Why is it upward sloping? Explain throughsuitable
d i m .

3) Explain through IS-LM curve the ineffectivenessof monetary and h a 1policies.

lkaditionalApproaches to
Marrrrpcnnnmirr . 2.7 LET US SUMUP
There are three types of demand for money: transaction demand, precautionary demand I

and speculativedemand. While &insaction and precautionary demand are considered

to be dependent upon level of income, speculative demand for money depends upon
prevailing rate of interest. When rate of interest is too low, speculative demand is perfectly
elastic and additional income in the hands of people in the form of idle cash balances
without any increase in consumption expenditure. Such a situation is called liquidity trap
and interventionthrough monetarypolicy becomes ineffective and government should
I1
resort to appropriate fiscal policy.

Through the IS-LM model we determine auniquec o m b i i o n of interest rate and income
in the economywhere both real sector and monetary sector are in equilibrium. However,
such equilibrium may not be at 111employmentlevel. In order to bring in 1 1 1employment
.the government should intervene by increasing its expenditure. I
I
I
2.8 KEYWORDS
Liquidii h p A situation of very low rate of interest when people do
not increase consumption expenditureand additional
I
money income is saved. I

SpeculativeDemand That part of demand for money which depends upon

rate of inhest and used for investment in financialassets.
Inflation A period of sustained rise in overall prices.
Production Function The technical relationship between iriputs and output.
2.9 SOME USEFUL BOOKS
Mankiw, N. G,2000, Macroeconomics, Fourth Edition, Macmillan,New Delhi.

Samuelson, P. A. and W. D. Nordhaus, 2005, Economics, Eighteenth Edition, Tata

McGraw Hill, Delhi.

2.10 ANSWERShXINTS TO CHECK YOUR

PROGRESS EXERCISES
check Your Progress 1
. 1) Go through Section 2.3. Discuss transation, precautionary and speculative demand
for money.

2) See Section 2.3 and answer.

Check Your Progress2

1) s is cuss the method through which we obtain the IS curve. See Section 2.4.

2) LM curve signifieequilibriumin the money market. Explain Fig. 2.5.

3) Go through Section 2.6 and Explain Fig. 2.7.

: UNIT 3 THE SOCOW MODEL
i
; Structure
I

3.0 Objectives
3.1 Introduction
i
3.2 Features of the Solow nilode1
3.2.1 Supply of Goods
3.2.2 Demand for Good5
3.3 The Steady State
3 3.1 GrowthofGapital and Steady State
Gromth and Steady State
3.3.7 Populatio~~
-5.5.3 Ttctl;lological Progress and Steady State
34 7'heC;oldenRule
3.5 hasition to the Golden Rule Steady State
3.6 Let Us Sum Up
3.7 Key Wot'ds-
3.8 Son~eUseful Hooks
3.9 Answers/k-lintsto Check Your Progress Exercisec
-
30
r . OBJECTIVES
After going through this unit you should be in aposition to
explain the basic premises on which the neoclassical Solow i~lodelis based:
describc the properties of neoclassical production function;
identify the implicationsof Solow model; and
explain the steady state growth of an economy.

.3 .1 1NTROI)UCTION
Tn the previous block we ohsewed that when saving is translate(! illto investments,
accumulation ol"capita1stock takes place. Such accumulatiorn in capital stock implies
an increase in the level of capital itlput. A basic feature of capital input is that it does
not get exhausted in a single use, that is, it is durable in nature. However, capital
input undergoes wear and tear, generally termed depreciat ion, during the course of
produc~ion.Thus when we deduct depreciation from gross investment we obtain
net investment, which tantamount to addition to capital stock.

As you know, capital and labour are two primary inputs used iri production process
and with the aid of technology trans^; rin intermediate inputs into output. If we assume
no shortage of intermediate input? 'le production capaci ty of an economy depends
upon the quantity, quality and util 'tation of the primary inputs. We should note that
most of thc growth models are built upon the premise of.'assured availability of raw
materials.
Economic Growth The classical economists in general did not pay much attention to the long-run im act
of investment. In the classical framework the economy passed through the s me
cycle of production period after period. The post-Keynesian economists, padc arly '
Harrod and Domar, emphasized the increase in capital stock due to investment see
Block 1 of the course MEC-004: Economics of Growth and Development). ater
on neoclassical economist R. M. Solow presented a model of economic gro
1956 which continues to remain as a lardmark in growth theory. Subsequent grdwth
models have brought in refinements and innovations into the Solow model. s he
Solow model explains the effect of saving, population growth and mchnological
progress on the economy's output growth. We discuss below the basic featured and
implications ofthe Solow model.
in 1 I
'

-
3.2 FEATURES OF THE SOLOW MODEL
The Solow model considers an aggregate production function for the economJ/as a
whole such that a composite good is produced through a common tcchnolo y by
utilizing homogenous inputs, labour and capital. The first step to understan the
model is to study what determines the supply of and demand for goods i 1i the
economy.
1
3.2.1 Supply of Goods I

The supply of goods in the Solow model is determined by the production fundtion.
The production function has.three inputs (K, L, A ) and one output ( Y )variableb ancl
takes the form I

Y = output I

K = capital

L = labour

A =technology of pjroduction

The variable, in equation (3.1) denotes time that does not enter the model di
It implies that oveli time change in Ywill take place only due to change in
L and A ,
It is worthwhile to note that change in A occurs as a consequence of technol gical
progress. Labour and effectiveness of labour are introduced in the ode1 C
f
multiplicatively such that AL means effeclive labour. It meails that technol gical
progress is labour-augmenting, i.e., it increases the productivitj or efliciency of 1 bour.
Thus even if quantity of L remains unchanged, technological progress increa es the
quantity of effective labour (AL)in the economy.
I I
The production function d.escribed at (3.1) presents constant returns to scale ( ~ R s )

t
This assumption greatly simplifies the analysis and is often considered 'Fealist' . Tkic
presence of CRS implies ,that if we double all the inputs output will be dou led.

F(aK aAL)=aF(K, AL) ...(3.2

 where a can be my non-negative constant. The Solow Model

,The CRS assumption can be utilized to ccllvert the production function specified in
1
e$yition (3.1) to per effective labour terms. If o =-we can represent (3.1) as
'

AL
I

This form of the production function given at (3.3) is known as the intensive form. It
allows us to analyse all variables in the-economy relative to the size of effective labour
force.

K
Thus --- is capital expressed relative to effective labour, i.e,.,it is capital pa unit effective
AL
Y
labour. Moreover, F(% = - which is output unit effective labour. We
AL -

K Y
-
designate these in Iowercase letters such as - = k and - = Y andflk) = F(k, 1)
AL AL

so that the production h c t i o n in (3.3) can be written as

Y =f@) ...(3.4)
Fig. 3.1 illustrates the above production function

Fig. 3.1 :Neoclassical Production Function

I In Fig. 3.1 we measure k on the x-axls and y on the y-axis. Since k represents capital
/ labour ratio, as we move along x-axis the amount of capital available per unit of labour
I increases. A basic feature of (3.1) is that while CRS prevails, there is diminishing returns

i to capital input. It implies that when both K and L are increased proportionately there is
Economic Growlh CRS.On the other hand. if there is an increase in Kwhile keeping AI, constant, we

~
obtain diminishing returns to K. -

The slope of the producthn function gives the marginal productivity of capital (MPK)-
K
that shows the extra output per effecthe labour produced when - is increased by 1
AL
unit. MPK can be mathematically written as .

MPK -.flk+l) - 8 k ) ...(3.5)

The intensive form of production h c , ion given at (3.4)and depicted through Fig. 3.1
is assumed to satisfjithe following con&tions:

1) a) at k = 0, f(k) = f(0) = 0

b) MPK is positive, that is, f '(k) > 0

I
c) MPK declines as k rises, that is. f "(k) 4

2) The intensive form in addition is also assumed to satisfLingthe lnuu'u conditions.

(a) yz .f '(k) = ,which implies that when capital stock is too small the MPK
is very large.

(b) klim
- + y ~ -f '(k) =O, which implies that MPK is very small when the capital stock

is too large.

These conditions are much stronger than are needed to derive the results of the model
* and have been introduced to ensure that the growth path of the economy docs not
diverge.

Tt is evident from Fig. 3.1 that a tangent drawn at any point on the curc e has a positive
slope, but the slope of tangents is declining as we go towards the right (as k rises).
Hence MPK is positive but declining. Moreover at k = 0 the tangent to the production
function is a vertical line (which implies that MPK = a ) . As k rises the production
function becomes flatter and when k--+ we have MPK = 0. It is important to note
here that Solow model assumes other inputs beside K, L and A not to be important and
hence are not included in the production function.
I
3.2.2 Demand for Goods
In a Solow economy goods are demanded fitr consumption and investment purposes.
n1us

Tf we express (3.6) in per effective labour terms (that is, divide by

1
-)we obtain
AL ~
We omit government expenditure and net exports in (3.6) which are present in the
national income accounti identity (see Unit 1). While government expenditure is ignored
 for simplificationin presentation, net exports (that is, exports minus imports) is excluded The Solow Model
because the economy is assumed to be closed.

Each year people save a fraction s of their income. Thus s is the saving rate and it
assumesa value between 0and 1.The relationshipbetween output and saving is depicted.
in Fig. 3.2.

V. Output f(k)

Fig. 3.2: Output and Saving

Saving per effective labour = s y

Therefore, consumption c = (1 - s)y

asy=i ...(3.9)
L
Equation (3.9)shows that saving equal investment, a condition necessary for equilibrium
in the economy.

Check Your Progress 1

1) What are the basic assumptions on which the Solow model is based?

...........................................................................................................................
...........................................................................................................................
Economtc Growth

2) What is the basic equilibriumcondition depicted by the Solow model? I

.......

....................................................................................................................... i...

3.3 THE STEADY STATE

As seen in equation (3.9) investment per unit of effectivelabour equals savingper unitlof
effective labotir:
i = sy
Sincey =f(k) we can write equation (3.9) as

The above shows the relationshipbetween existing capital stock (k) and accumulatibn
of new capital (i) expressed in'per effectivelabour' tenn.
~
As you know, increase in capital stock is due to investment. Thus the diffaence betw&n
capital stock in two successive years is equal to investment that has taken place duribg
the year. In other words, the rate of growth capital stock is equal to the rate of investmebtt.
In per effective labour term, we can express (3.10) as

k = sf (k) ...(3.11)
where k refers to the growth rate in k (In general we put a dot over a variableto
represent its growth rate). I

The above equilibrium condition is true for an economy where there is no depreciatibn
to capital stock, there is no population growth and technological progress does not &e
place. Let us assume for the time being that there is no population growthand technologi
progress in the economy. We will relax these unrealistic assumptions later on. I

3.3.1 Growth of Capital and Steady State

I
The Solow model assumes that existing capital depreciates at the rate S.Thus each y
SK amount of capital is depreciated.

hivestment and depreciation act in opposite directionsand the growth in

net of the two quantities.

k(t) = i(t) - Sk(t) I

since i = sf(k(t)) i
 The Solow Model

Fig. 3.3: DepreciationRate

From (3.12) we infer that capital stock rises when sf k(t)) > &(t); falls when sf(k(t))
< &(t) and remains constant when sf(k(t)) = &(t).

Fig. 3.4 depicts equation (3.12) graphically.

v

1 Fig. 3.4: Steady State of an Economy

Ecoriomic Growth The two curves, saving and depreciation curves, intersect at point X, where capital
stock is k* and depreciationequals investment.At this point there is no growth in capital.
stock hence output also remains steady. k* is therefore known as the steady state level
of capital. There are two unique features of the steady state: (i) economy in steady sate
will remain there till there is change in any other variable, and (ii) economy will always
move towards the steady state. For example, if the economy starts at k, level of capital,
where k,< k* (see Fig. 3.4), investment exceeds depreciation.As a result, capital st&k
k, along with outputf(k) rises till kreaches k*. On the other hand, if the economy s W s
at k2level of capital, which is greater than k*, investment is less than depreciatibn.
Consequently there is a decline in capital stock and output in the economy until stekdy
state capital, that is, k* is reached.
Once the economy attains the steady state there is no pressure on k to increasd or
decrease hence the economy stays there. Thus the Solow model does not explhin
sustained economic growth.An economy with a high saving rate will have higher lev4 of
output and capital as compared to a country with low rate of saving. Thus saving date
is an important determinant of an economy's output and capital. This to some extbnt
explains the disparity in output across countries. Saving rate may vary across c o u n t h
due to plethora of reasons ';ke development of financial markets. tax policy. cultdral
differences,retirement policies, political stability and political institutions.Empidcal
evidence given by Mankiw comparing income per person with investment as percentage
of output of 84 countries confirmsthe association between high savinglinvestment date
and high level of income per person. ow ever 1.ecites the case of ~ e x i c and
o Zimbdwe
that have similar investment rates but income per person in Mexico is thrice ofthait in
Zimbabwe. This leads us to the question that besides saving and investment there hre
otherpotential factorsthat determine living standards.We study two ofthem below, diz..
population growth and technical change.

3.3.2 Population Growth and Steady State

To analysethe effect of population growthwe expand the Solowmodel. we now consiber
the case where population and the labour force grow at a constant rate n. When labur
force grows, additional capital is required to maintain the same level of k. Hence tthe
economy should have adequate investmentsto take care of depreciation (6k) as well as
I '
population growth (nk). In order to introduce n we modifjr equation (3.12) as

i ( t ) = sf (k(t)) - (n + 6)k(t) ...(3.13) ~

For steady state the amount of investment required must not only cover depreciadon
(a) but also provide new workers with capital (nk). Break-even investment now wo(u1d
be (n+ S)k. The steady sate is achieved at the point of intersection of investment b d
(n+ S)k curves. The line 2% in Fig. 3.4 accordingly is adjusted to represent (J+ n)k.

investment is greater than break even investment so k and y rise. On the other han I if
k,>k*, k declines till it reaches k*.
d'
The steady state is reached in a similar manner as discussed in earlier section. If k, k*

Population growth succeedsin explaining sustained economic grad in an econom .In

this framework, however, output per effective labour remains unchanged. Reme!n ber
that at the steady state we witness constant k andy But capital stock ( K ) and output)(v
keeps on growing at the rate n to keep k and y constant. Such a feature explainsthe
cross-country disparity in incomes. Let us assume that country I has population grab
of n, and country I1has n2such that n,>n2.Saving rate in both countries is assume1to
 The Solow Model

k,' -
Steady state
capital declines
k,'

-- State in Two Countries

Fig. 3.5: Steady
.

be the same.Accordingly, in Fig. 3.5 we draw a line (&n,)k with a slope greater than
that of (&n,)k.
We can easily comprehend from Fig. 3.5 that the country with high growth rate of
population n, has lower level of k* (the steady state level of k) and thus lowery. Empirical
evidence cited by Mankiw supports the above model. Thus it is often emphasized by
policy makers in India to conml population growth in order to attainhigher living standads.

3.3.3 Technological Progress and Steady State

To explain growth in output per effective labour, we need to introduce technological
progress in the Solow model. As stated earlier technological progress is assumed to be

(n + +6 )k

*
sf (k)

I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I

k' k
Fig. 3.6: Steady State
Economic Growth labow-augmenting.Thus technological progress increases the quantity of effective la+
(AL). Let us assume that the rate of technological progress is g.
I

The change in k over time is now modified as

~
k(t) = sf (k(t)) - (n + g + S)k(t) ...(3.14)
In fact, equation (3.14) is the key equation of the Solow model of growth. Fig. 31.6
explains the equation through a diagram.

As is evident, the analysisof sZeady state doesnot change withthe inclusion of technologiM
progress. But the break-even investment now is (n+g+S)dc. Out of total investrndnt
sf(k), is needed to cover depreciation and nk to maintain capital per effective labdur
constant. However, as aresult of technological progressy grows at arate ofg. ~ l t h o u b
n, g and S are not individually restricted, the sum is assumed to be positive in the modiel,
i.e., n + g + S> 0.As mentioned earlier, in the steady state capital per effective labdur
and output per effective labour remains unchanged. There is a growth in output der
effective labour at a rate g and total output grows at the rate (n+g). We see that
introduction of technological progress enables us to account for increase in output +r
worker.

We concludethat according to Solow model persistently rising living standards (~h)

can be explained only through technological progress.

3.4 THE GOLDEN RULE

Let us see the impact of variation in saving rate on steady state. Let us assume that
saving rate rises while n, g, and S remain unchanged (see Fig. 3.7). Since i = sf@)
idbe higher investmentwhich in turnwill lead to capital accumulationand output gm
and the economy will eventually reach to a new steady state with higher capital
output.

Fig. 3.7: Impact of Saving Rate

 When saving rate rises from s, to s, the investment curve shifts up fiom s,f(k) to s,f@). The Solow Model
Thus the ecoriomy reaches a new steady state k,' after going through the process of
capital accumulation as described above.

It may lead us to'thinkthat a high rate of saving is always desirable since higher saving
resultsin higher capital stock and output. You may think that if saving is 100% there will
be largest possible output and capital stock in the economy.At various levels of s different
steady state are achieved with different levels of capital accumulation.However, there is
an optimum level of capital accumulation which i2called the golden rule level of capital.

At the golden rule level of capital the level of s is such @at the consumption per effective
labour is maximum at the steady state. Why is consumption per effect~belabour
maximized? This is because individuals, who make up the economy, are not concerned
about the capital stock or total output of the economy. For them what is important is the
amount of output they consume. Among the various steady states one that maximizes
consumption per effective labour is thus the most desirable one and hence called the
'golden rule level'.
You know that income (which is equal to output) is allocated on consumption and savhg
(which is equal to investment), that is, Y = C + 1. . Steazfy state consumption is output
net of investment.Thus
c* = y* - 'i -
We can write the above as

As increase in steady state capital has contrasting effect on steady state consumption -
more capital leads to more output which contributes positively to consumption, but it
also means higher break even investment (n+g+gk.

Fig. 3 . 8 illustrates steady state y and break-even investment as a function of steady

state capital, k*.
(n + g +6)k*

sf [k')

I Fig. 3.8: Golden Rule Steady State

 I
Economic Growth Steady state consumption is the gap between the steady state output and steady statk
break-even investment, which is m ~ at kiOw
~level of capid
d p r effctive labo*.
Recall that the slope of the production function is the marginal product of capital MPd.
We notice in Fig. 3.8 that at cioMlevel of consumption (golden rule level) the slope df
production function equals the slope of break-even investment, that is,
MPK= ( n + g + S )
Or
( M P K - S ) = (iz +& ...(3.16)
At the golden rule level oicapital, the MPK net of depreciation is equal to the rate bf
growth oftotal output (n + g).

The golden rule steady state is not achieved automatically.It requires a particular rate df
saving sgo, as shown in Fig. 3.9.

Fig. 3.9: Golden Rule Saving

To achieve the golden rule steady state level of capital kioida saving rate of s,, 1s
I
required such that, consumptionis maximized at ciold. I

~ f>ssgold(equivalently, k* > ki0, ) the economy is said to be dynamically inefficiedt.

willincrease consumption. On the other h U ,
In this case a fall in saving fiom s to sgOld
if s < sgOld(equivalently,k* < ki0, ) a rise in saving will decrease consumption in tne
shortrun but will eventuallylead to higher consumptionin the long run. How the transitidn
to golden rule steady sate can be achieved by changing the saving rate fiom s to sgOld
/is
dealt with in the next Section.
 The Solow Model
3.5 TRANSITION TO THE GOLDEN RULE STEADY
STATE
Let us discuss the impact of change in saving rate to achieve golden rule level of
consump60n, investment and capital. there can be two situations: (i) when s > sgoldor
steady state capital per effective labour is more thanrequired for golden rule level, and
(ii) when s < sgoldor steady state capital per effective labour is less than the golden rule
level of k;,, .

Case 1: when s > sgdd

In this case to achieve the golden rule level the saving rate needs to be decreased to
s g 0 ,. When saving rate falls consumption per effective labour immediately rises and
investment declines. The economy is no longer in a steady state as investment is less than
break-even investment of (n + g + s) k*. This leads to a decline in capital stock per
effective labour. Output per effective labour is a function of k so that Y/AL also declines.
Since c =y- i we observe that consumption per effective labour also declines. These
variablesJ c and i fall till the economy reaches anew steady state which is the golden
rule steady state.

At this level consumption is higher than the earlier steady state although the levels of
output and investment are lower. Consumption per effective labour is higher in the entire
period oftransition to the golden rule steady state from the earlier level.

Case 2: when s < sgo,

When at a steady state s < sw we have kt < ki,,d. In this case s needs to be
increasedto achieve the golden rule steady state. When s rises there is arise in investment
which now exceeds break-even investment (n + g + 6) and the economy is in a state of
transition. There is accumulation of capital leading to rise in output per effective labour
(Y/AL). So when saving is increased consumption per effective labour declines
immediatelybut with rise in output per effective labour it rises to a level higher than the
level which initially prevailed.
I
The dilemma of whether to try to reach the golden rule steady state or not is a question
of choice between current and future consumers. It is a trade off between present and
i firture levelsof consumption. We will discussmore about the inta-tempomlconsumption
decisions in Block 4.
I
i Check Your Progress 2

I 1) What do you mean by steady State?

EconomicGrowth 2) Under what condition does &I economy realise steady state?

3) What is the golden rule steady state for an economy? I

LET US SUM UP
The Solow model explains long-term growth in per capita output experienced b
economies world over. It assumes a constant returns to scale production functionwhic 4
allows for diminishingretumsto scaleto capital input. The model depictsthat the econom
has a tendency tc; converge to a steady state where availability of capital per worke
mnainsunchanged. In its simplest form the solowmodel is built upon the equality
1
savingand investment. I
I
Investment results in increase in capital input which is durable in nature and undergoe$
depreciation during the course of production. In steady state as capital stock availabl4
per unit of labour remains unchanged,the economy should have just enough investme4
to take care of, i) depreciation, ii) population growth, and iii) technical progress.

and output, but no sustained output growth. Sustained growth in output is explained i
the model neither by higher saving nor bipopulation growth. ath her high populatiob
growth reduces the per capita availability of output and capital. According to thb
4
The Solow model concludes that saving has only a 'level effect' and no 'growth effect'.
It means that higher saving in an economy increases per capita availability of capi

Solow model sustained output growth is possible only through technological progress]

Higher saving rate, although it increases per capita output, is not always desirable. Thb
objectiveof an emnomy is to maximize consumption,not saving. The golden lule sugge&
that capital should be at that level where MPK net of kpreciation is equal to outp
growth.
 The Solow Model
3.7 KEYWORDS
Break-even Investment The amountof investmentjustm&to compensate
for the depreciationto tl% existing capital stock.

Capital Acumulation Capital input daes not get exhausted in a single use
and remains in use for a long period of time. Thus
due to investment in successive years, capital input
gets axmdated.

Depreciation Natural weal and tear undergone by capital inputs

(such as mechineries, buildig, etc.) when production
of goods and services take place.

Golden Rule The condition for obtainingthe steady state which

maximizes consumption. It is given by the equality
betwen MPK net of depreciation and output growth
rate, that is, (MPK - 6 = n + g).

Inada Conditions Two conditionsrequid forthe production function

to be well behaved, formulated by Ken-Ichi Inada
in 1961P'

Labour-augmenting Technical change that results in increasing the

Technical Change productivity or efficiency of labour.

Steady State A condition when the economy does not have to

change its capital-labour ratio.

Sustained Growth Growth in output on a sustained h i s , ova a longer

period of time.

3.8 SOME USEFUL BOOKS

e

,,
Solow, R. M., 1970, Growth Theory, Oxford University Press, Oxford.

Romer, D., 1996, Advanced Macroeconomics, McGraw Hill Company Ltd., New
York., Chapters 1,2,3.

f Mankiw, N.G, 2003, Macroeconomics (Fifth Edition), Worth Publishers, New York,
Chapters 7 & 8.
t
3.9 ANSWERSIHINTS TO CHECKYOUR PROGRESS
EXERCISES
Check Your Progress 1

I ) The basic assumptionspertain to properties of the classical production function.

en ti on these properties.Also mention that the r&delel appliesto a closed economy.

2) The supply demand equilibrium condition needs to be mentioned. Point out that
equilibriumis realized when saving =investment.
EconomicGrowth Check Your Progress 2

1) It refers to a state or condition when the economy does not need to change it6
capital stock relative to its labour force.

2) Go through Section 3.3 and explain the condition sf (k) = n + g + 6 through

diagram (similar to Fig. 3.4). Explain the process how the econon~yreverts back tb
the above equality in case there is deviation.

3) Go through Section 3.4 and answer.

UNIT 4 ENDOGENOUS GROWTH
MODEL
stmctllre
4.0 Objectives
4.1 Introduction
4.2 Solow Model as a Theory of Growth
4.3 Absolute and Conditional Convergence
4.3.1 Absolute Convergence

4.3.2 Conditional Convergence

4.4 Convergence and Growth Regression
4.5 Speed of Convergence
4.6 Quantitative Inlplicatioilsof the Solow Model
4.7 Critical Assessment of the Solow Model
4.8 Endogenous Growth Theory
4.9 The Basic AK Model .

4.1 0 Human Capital and R&D in Endogenous Growth Theory

4.1 1 Critical Assessment of the'~ e growth
w Theory
4.12 LetUsSumUp
4.13 Key Words
4.14 Some Useful Books
4.15 Answer/I-Iints to Check Your Progress Exercises

4.0 OBJECTIVES
After going through this Unit you will be in aposition to
explain the implications and predictions of the Solow model;
evaluate the Solow neoclassical model; and
explain the new or endogenous growth models.

INTRODUCTION
Economic growth is a critical factor in determining living standards in the long term. As
we observed in the previous unit, the standard tool for analysing long run growth in
macroeconomic 1ikmh.m has been the neoclassical model of economicgrowth developed
by Robert Solow. Using a few basic assumptions Solow demonstrated that in the long
mi an economywould tend toward an equilibriummarked by continual growth of output.
This equilibrium, know1 as steady state, is characterizedby constant levels of capital
per worker and output per worker. In case there is a deviation from the equilibrium level
of capital labour ratio the economy bounces back to the steady state. The Solow model,
however, is not free fi-om limitations,which has motivated new research. In recent years
Economic Growth
economis* have attempted to explain long-term growth through the endogenousgrowth
model, which we discuss in the present unit.

4.2 SOLOW MODELASATHEORY OFGROWTH

The neoclassical model as developed by Robert Solow (1956) and subsequently ~
applied by others constituted a giant step forward in the process of constructing a I
formal model of growth. The main features of the Solow model can be described as
folloms:
l
a) The assumption of diminishing marginal returns to capital leads the growth process ,
within the economy to reach the steady state. I

b) In the long nm,once the economies reach the steady state, output, capital and labour
grow at the same rate equalingthe exogenously given rate of technological progress.
This rate of growth is independent ofthe underlying parameters of the economies
(such as saving rateand population growth) and also independent of their initial
position.

c) The parameters of the economies determinethe steady state level per capita income,
which is positively related with saving rate and negatively related with population
growth and depreciation rate.

Thus saving and other parameters in the model have no effect on the rate of growth in
the long run but they have only the level effect. For example, a higher saving ratio
implies higher per capita income but does not influence long term growth rate of
output. Now we will discuss some important issues related to the Solow model.
I
I
4.3 ABSOLUTE AND CONDITIONAL I
CONVERGENCE
The major focus of recent empirical studies on economic growth has been on the issue
of convergence in growth rates across countries. We discuss below the convergence
hypothesis implied by the Solow model. There are two versions of the convergence
hypothesis: absolute convergence and conditional convergence.

4.3.1 Absolute Convergence

Let us have a group of countries having access to the same technology [f(.)], the same
population growth rate (n) and the same saving propensity (s) and they only differ in
terms of their initial capital-labour ratio (k). Then accordingto absolute convergence
hypothesis in the Solow model in the long run, all countries converge to the same steady
state capital-labour ratio, output per capita and consumption per capita and growth rate
(n). That is, there must be a convergence in income per capita in the long run.

Absolute convergence is shown in Fig. 4.1. In the diagram subscript 1 refers to poor
countries while subscript 2 refers to rich countries. Thus,
*
y,, k, = income per head and capital labour ratio of poor countries.

y,, k, = income per head and capital labour ratio of rich countries.
 Y= ,,
Y Endogenous Growth Model

Rich Country's
initial level of y T

Yl

Poor Country's
initial level of y

0 4 k'
Fig. 4.1 :Absolute Convergence

The two countries are assumed to be otherwise identical. The stability of'the Solow
model predicts that both the countries will reach the long runequilibrium point E with the
same capital -labour ratio k*as shown in Fig.4.1.

The obviousimplicationof this analysis is that the poor countries will grow relatively fast
(i.e., capital and output grow faster than population growth) while rich countries will
grow relatively slower (i.e., capital and output grow slower than population growth).

4.3.2 Conditional Convergence

The structural parameterslike technological progress, rate of savings, population growth
rate, and depreciation rate differ across countries. Given the assumption of diminishing
returns to capital conditional convergence states that each country will converge to its
own steady state rather than to a common steady state across countries. Conditional
convergence also is a prediction of neoclassical theory of growth.

4.4 CONVERGENCEAND GROWTH REGRESSION

IJsing the data from Maddison (1982), Baurnol(1986) examines convergence from
1870 to 1979 among 16 industrialized countries. Over this period of time Baumol
regressed output growth on a constant and initial income.

where

log Y/N -
-- log income per person

e - an error term
Economic Growth I -
- index of countries

1f&ergence prevailsthe value of b w

illbe negative implying that countries with higher
initial income have lower growth.

For perfect convergence the value of b will be -1 and for no convergence the value will
be 0.

The results of the estimation as obtained by Baumol are

log [ ( y m ),,,, , I - log [(Ym),,,,,,I = 8.457 - 0.995 log [(Y/N)i 1,

The estimated value of b is very close to -1 and the standard error of h is very low so
that it is statisticallysigrzlficant.

I-lowever, results such as the above have been criticized by economists like De Long
(1988).According to De Long there are two problems in Baumol's analysis, (i) sample
selection,and (ii) error of measurement, If we consider these two limitationsthen it will
undermine most of the support Baumol's estimates provide for convergence.

4.5 QUANTITATIVE IMPLICATIONS OF THE

SOLOW MODEL
In the Solow model discussed in the previous unit we observed that the economy will
reach a steady state in the long run in order to understand the quantitative implications of
the Solow model we need to describe the specific functional forms and values of the
parameters.

We see that (4.1) is the intensive form production function in the Solow model which
states output per unit of effective labour as a function of capital per unit of effective
labour where
f (k) = O
f'(k) > 0
f"(k) < 0
The production h c t i o n as specified by (4.1) also satisfies the 'Inada' conditions, viz.,
lim f(k) = oo
k+O
lim f(k)=O

Let us take +
..

v * = f(k*)= the level of output per unit of effective labour along the balanced growth
path. 1

k*= the value of k where actual investment and break-even investment [(n-+g+
6)k] are
equal, i.e., k ( t ) = 0 .
 EndogenousGrowth Model
Frorn the Solow model we know,

lf we take partial derivative of (4.2) with respect to s,we obtain the long run effect of a
rise in saving on output. Thus we can write t

ay' = f '(k
--- a ). ak*(s, n, g, 8) ...(4,3)
13s as
Therefore, in order to get - ay we need to know the second term, i.e., dk*
-term.
as as
From the definition of k* we find that at k*, k(t) = 0 .

This implies, at k*,

Equation (4.4) holds for all values of s, n, g and 6.

Taking derivative of both sides of the equation (4.4) with respect to s we get (by using
multiplication law of derivatives),

Rearranging the terms in (4.5) we get,

Substituting(4.6) into (4.3) we obtain,

ay* - fl(k*)f(k*)
8s (n+g+8)-sfl(k*)
Now inultiplying both sides of (4.7) by sly' (to convert it to an elasticity) and using

sf(k*)= (n+g+8)k*for substituting s, we get

S ay- S f '(k*)f (k*) - (n + g + 8)k*f'(k*)
y' ' a s f(k*)'(n+g+6)-af'(k) f(k*).(n+g+8)-(n+g+8)
...(4.8)
= k*fl(k*)/f(k*) .,.(4.9)
1- [k*fl(k*)I f (k*)]

k'f '(kt)
is the elasticity of output with respect to capital at k = k'.
f (k*)
Let us take this elasticity as a,

Then equation (4.9) becomes,

We know from microeconomic theory that if there exists perfect competition in the
market with no externalities,capital will earn its marginal product. So the total amount
Economic Growth
received by capital (per unit of effective'labour)along the balanced growth path is
k*f(k*) or a, (k*).
f (k*)
Empirical studies showthat the share of income paid to capital is about one-third. Using
this as an estimate of a,(k*),we arrive at the result on the basis of (4.10) that the
elasticity of output with respect to saving rate in the long run is about one-half. So we
can easily concludethat sigrdicant changes in saving only have a moderate effect on the
level of output on the balankd growth path.

4,6 SPEED OF CONVERGENCE

Sometimes in addition to the information about the eventual effects of some changes
(e.g., change in saving rate) we are also interested in knowing the speed with which
those effectsoccur. In particular, we are interested in knowing how rapidly k approaches
to k*inthe Solow model framework.

For this we again recall equation (4.2) that

k(t) = sf (k(t)) - (n + g + 6) k(t)

So k = k(k).

And

at k = k*, k(t) = 0

Taking a first order Taylor seiies approximation of k(k) around k = k' we get,

k= [*I f3k k=k.] (k - k*)

i.e., 1; is approximatelyequal to the product of the difference between k and k*and

the derivative of k with respect to k at k*.

Taking a differentiation of equation (4.2) with respect to kand evaluating the result at
k = k*we get

- (n + g +6)k*ff(k*)
- -(n+g+6)
f (k*)
(n+g+S)
or, s =
f (k*)

k*f (k*)
and, a&=
f (k*)
Substituting (4.12) in (4.1 1)we get,

k(t) = -[1 -ak(k*)](n+ + 6) [k(t) - k*]

 Equation(4.13)has an important implicationthat,alongthe balanced growth path, capital EndogenousGrowth Model
per unit of effective labour will convergetoward k*at a speed proportional to its distance
from k'.

If we assume

x(t) = k(t) - k*, and

h=(1-a,) (n+g+S)

Then from (4.13) we can write

x(t) = hx(t)

The growth rate of x is constant and equals -1.

So the path of x is given by,

Where x(0) =the initial value ofx. Substituting the values of x = k(t)-k* back again we
get the path in terms of k,

We can also show that, y approachesy*at the same rate at which k approachesk*

Empirical finding has shown that (n + g + 6) is generally 6%. If we take capital share to
be roughly one-third, (l*) (n + g + 6) is roughly 4%.

This means k and y will travel 4% of the remaining distance toward k' and y' each year
and approximately it will take 18 years to reach half way to their balanced growth path
values. So changes in saving rate do not have any significant effect on the speed of
convergence.
- - -

4.7 CRITICAL ASSESSMENT OF THE SOLOW MODEL

The neoclassical growth theory, as developed by Solow (1956) and his followers has
t come under the fireof criticism since the late 1980s.The main objectionsto the traditional
neoclassical approach can be discussed under a few headings.

t 9 Technology
In the neoclassical Solow model technology plays the most dominant role since the
equilibrium rates of growth of the relevant variables depend on the rate of technological
I progress. But the model treats it as an exogenous variable and provides no explanation
of it.
P
In reality it is observed that expenditure on Research and Development, attainments of
Ii education and good health have a positive impact on the technological improvement.
I The Solow model does not include the motivation to invent new goods or invest on
human capital.
Economic Growth ii) Law of Diminishing Returns 1
I
I

The crucial assumption of the neoclassical model, i.e., the operation of the law of 1
diminishing returns to capital has been questioned. Economists have argued that if we
can broaden the concept of capital to include human capital (consisting of education,job
training, health care, etc.) in addition to physical capital, then assumptionof diminishing
returns can be relaxed.

i Homogenous Inputs

The third problem in the classical growth model is that is assumes all labour and capital
to be homogenous. It makes no room for differentiatingskilled or unskilled labour and
the capital in agriculture, industries or Mastructure. In reality,however, these differences
have significantimpact on economic growth.

iv) Constancy of Structural Parameters

'The Solow model assumes saving rate. the rate of growth of labour supply, the skill of
labour force and the pace oftechnological change to be constant. Thus it fails to take
into accountthe intrinsic characteristicsof economiesthat cause them to change.

v) Little Role for the Government

There is very little scope of Government or public policy in the Solow growth model to
influence growth rate. This scenario is incompatible with the real life situation.The model
is also built on the assumption of closed economy which is not realistic in today's world. ,

vi) Convergence Predictions

The model predicts that countries would converge around one another over time. But
empirical evidence has shown that it has not been the case. Growth rates of the poor
.countriesnot only remainlower than the richer countriesbut also fail to hit their respective
steady state per capita incomes.

All these inadequacies of the neoclassical model have inspired new research both
theoretical and empirical, and ks a consequence the concept of endogenous or new
growth theory has emerged.

Check Your Progress 1

1) Define the concepts of absolute and conditional convergence.

 2) Suppose a production function satisfies constant returns to scale and a diminishing Endogenous Growth Model
marginal product of thq inputs capital K and labor L. Explain both properties and
give an example of such a production function.

...........................................................................................................................
.$ .........................................................................................................................

...................... ....................................................................................................

...............................................................................................................................
3) Consider the Solow model. Derive the expression for the speed of convergence.

4) Critically evaluate the Solowmode1 of growth.

4.8 ENDOGENOUS GROWTH THEORY

The new growth theory provides atheoreticalh e w o r k for analyzing persistent growth
C
of output that is determined within the system governingthe production process. This is
done either by avoiding diminishing returns to capital or by explaining technical change
internally.
*
I
In the new growth theory models, there exist technological spillovers, externalitiesand
I increasing returns to scale. They do not expect convergence; they rather accept the fact
that disparities anlong countries can persist or even enlarge. 'l'hey emphasize on the
importance of investments in human capital and potential gains from technology
improvements-inventions and innovations.

We will start with the simplest and basic model of endogenous growth that is the AK
model. This model is important since other endogenous growth models can be thought
of as extensions or microfoundation of the basic one.
Economic Growth
THE BASIC AK MODEL
t

TheAK model is the simplestpossible endogenoh growth model. The pmduction function
is assumed to be linear in the only input capital. 1
1
Y,= f(k) =AK

where

A -
- an exogenous constant which reflects the level of technology
I
I
K = the aggregate capital broadly defined I

The production of function given at (4.17) displays both constant returns to scale and \
constant returns to capita..

Recall that the Solowmodel assumed diminishing returns to capital. The inexistence of
diminishing return to capital is the key difference between the AK model and the Solow i
model. - I
Now let us assume that a certain fraction of income is saved and invested, which remains i
collstant (s). I
7Ie capital accumulation equation can be written as

where i
i.e., change in capital stock equals investment(sY) minus depreciation (6K). 1

Y
[From (4.17) we know that -= A ]
K
I

Using (4.19) along with (4.17), i.e., Y =A K we can write after a little re-arrangement of j I

terms 1
i
Y K
--=-=sA-~ ...(4.20)
Y K i
Equation (4.20) shows the growth rate of output
6, the economy's output l income grows forev
exogenous technical progress.
and states that as long as sA >
without the assumption of
iI
~
The main results of the AK model can be summarized as follows:

1) The model allows for growth in output at a rate determined by (sA - 6).
I

2) Higher savings, higher level of technology Aand lower level of depreciation6 have
positive effects on the growth Ate of output. I

3) The model does not exhibit any convergence; it rather accepts divergence. I
4) Thereexist no transitionaldynam~cs:the growth ratejumps instantaneouslywhenever I
there is a change in parmeter value. I
 Endogenous GrowthModel
Before concluding we must say that, we cannot consider the AK model as a complete
model since all the results are based on the assumption of constant returns to capital. It
leaves unexplained why there are no diminishingreturns to capital. However, we must
acknowledge that the AK model highlights the key component required for any model of
endogenous growth, i.e., there must be constant returns to the factm (or factors) that
can be accumulated.

4.1 0 HUMAN CAPITALAND R&D IN ENDOGENOUS

GROWTH THEORY
The theories of endogenous growth can be broadly divided into two main parts

(i)where growth is driven by Research and Development (R&D), and

(li) where growth is driven by Human Capital Accumulation.

R&D based models originate from the work of Romer (I 990), and GrossrnanHelprnan
(199 1). In all these models economic growth is the result of technological change that
comes from purposive R&D activities by firms. Patents and blueprints are non-rival
goods that can be accumulated without bounds and so the diminishingreturns to capital
accumulation can be avoided and growth continues.

Human Capital based growth models are derived fiom the work of Lucas (1988).
These models place accumulationof human capital at the centre ofthe growth process.
If we accumulateboth physical arid human capital we can think of constant returns to the
broad concept of capital and as aresult the economic growth does not diminish.

4.11 CRITICAL ASSESSMENT OF THE NEW

GROWTH THEORY
The new growth theory is has been criticised mainly on two counts. First, it remains
dependent on some of the traditional neoclassical assumption that are inappropriate for
developingcountriessuch as the existence of a single production function, i.e., all sectors
are symmetrical. Secondly,economic growth in developingcountriesmost of the times
is impeded by inefficiencies arising fiom poor infrastructure: inadequate institutional
structures, imperfect capital and goods markets. The new growth theory, however: does
not consider these factors, and as a consequence its applicability to cross country
development comparison is limited.

Check Your Progress 2

1) What are the key defining properties of Endogenous models?

2) Why does the AK 111odi.1oi'cnciogenous grow-th not exhibit an) c~,rnel-gence?

3) Identi@the main difference of endogenous growth theory with that of neoclassical

Solow model?

In this unit we explained the principal implications or predictions of the Solow model.
We also made a critics1 assessment ofthe neoclassical model. Subsequently we s h i f ~ z
to the new paradigm of grow111 theory. i.e.,endogenous or new growth theorq: I ;rider
these theories we discussed one basic model in detail, that is the Ak model, to get an
idea oft hese kinds of models.

The Salow rnodel converges to a steady state primarily because of its assurnption of
dim inisling retunls to capital. A major conclusion of the Solow model that g c w t h in a1
economy is determined by exogenously given technolngical change. Thus g o ~ ~ r n r n e ~ i t
policy, R&D, or human capital has no influence on growth. empirical evidence across
countries,however, shows that these variables influence economic gowth in an economy
to a large extent. The endogenous growth theory takes into account these factors and
explains growth as a function endogenousvariables.

4.13 KEY WORDS

Returns to Scale It is the rate at which output increases as all
inputs are increased proportionately. If
output more (less) than doubles when inputs
are doubled here is increasing (dw,reaing)
returns to scale.

Marginal Product It measures the additional output as input

increases by one unit.

Law of Diminishing Marginal Returns The law statcs that when one or more inputs
I
are fixed a variable input is likely to have a I
marginal ~mduct that e\~cnhnllydin~inishes II
I
ac the level of input iacre;lses.
I
 Endogenous Growth Model
Spillover A spillover is an action taken by one person
or firm that affects another person or firm.

C:lassical Convergence The central idea is that diminishing returns

to investment cause the growth rate of a
country to decline as it approaches its
steady state level of capital per unit of
effective labour - implying that, ceteris
paribus, richer economiesgrow slowerthari
poorer economies.

Human Capital Investments that improves the quality of

'labour and renders it more productive.

4.1 4 SOME USEFUL BOOKS

Solow, R. M., 1970, Growth Theory,Oxford University Press, Oxford.

Rorner, D., 1996, Advanced Macroeconomics. McGraw Hill Compmy Ltd., New York.,
Chapters 1,2,3.

Mankiw, N.G. 2003, A.lacroeconornics (Fifth Edition), Worth Publishers, New York,
Chapters 7 & 8.

4.1 5 ANSWER/HINTS TO CHECKYOUR PROGRESS

EXERCISES
Check Your Progress 1

1) See Section 4.3 and answer. ,

2) See Section 4.15 and answer. Hint: CKS inlplies a situation where output doubles
when all inputs are doubled. ~n example of this kind of production fhnction is
Cohb l)ouglas production function gi\-en by F'(K,L) =AKaI? where a,\, < i and
both are constants. When a + b = 1 3 C.R.S. On the other haid, if a + h > (<)I
3 1RS (DKS).

3) See Section 4.5 and answer.

4) See Section 4.7and answer.
I

Check Your Progress 2

1) 'fie defining characteristicof the new models is that they generate growth of per
capita output endogenously, that is, without assuming that technological change
occurs outside of the model's frathework

2) Similar cou~triesint terms of parameters 'A, s, n and 6 grow atrhe same rate
regardless of their level of income. Therefore factor differences in income per capita
are constant over time and there is no tendency for countries to converge.
6

3) ' See Section 4.7.4.8 and answer to question 1.

 UNIT 5 RATIONAL EXPECTATIONS AND
ECONOMIC THEORY
Structure
5.0 Objectives
5.1 Introduction .

5.2 Keynes' Theory and Expectations

5.2.1 Non-existence of Objective Probability Distributions
5.2.2 Conventions as a Basis for Forming Expectations
5.2.3 The State of Confidence in Conventional Judgements
5.2.4 Nature of Expectations in Keynes' Theory
5.2.5 Implications for the Role of Ec~nomicTheory
5.2.6 The Nature of Policy-Making
5.3 Rational Expectations and Economic Theory
5.3.1 The Hypothesis of Rational Expectations
5.3.2 Phillips Curve and Inflation-UnemploymentTrade-off in Policy- Making
5.3.3 Inflation-Unemployment Trade-off under Adaptive Expeqtations
5.3.4 Inflation-UnemploymentTrade-off under Rational Expectations
5.4 Let us Sum Up
5.5 Key Words
5.6 Some Useful Books
5.7 Answers/Hints to Check Your Progress Exercises

5.0 OBJECTIVES
After going through this Unit you should be in a position to:
explain the nature of expectationsin Keynes' theory;
explain the rational expectations hypothesis;
identi@the implications of rational expectationsin macroeconomic policy- malung;
and
contrast rational expectations with alternativetheories of expectations formations.

Much of undergraduate macroeconomic theory is discussed on the assumption

that, in the short run, the expectationsof economic agents about the future values
of macroeconomic variables are given. The rationale for this treatment of
expectations in macroeconomic theory can be derived fiom Keynes' views on the
nature of expectations, including his discussion in the General Theory. While Keynes'
views on the nature of uncertainty and expectations form the basis for the writings
, of many Post-Keynesian economists, most of modern macroeconomictheory treats
uncertainty and expectations in a radically different manner. This latter approach
i
i
is characterised in economic theory by the assumption that economic agents
Raliorlal Expectations (housheholds, business firms and government) have rutionul expeclutions abL,
macroeconomic variables.
I
5.2 KEYNES' THEORYAND EXPECTATIONS 1
i
Expectationsplayed a major role in Keynes' theory of the determination of aggregat
output and employment in market economies in the short run. Expectations abou
future yields on investmentprojectsunderlie 'thenmgml eiEciency of capital' schedu1e.1
However, the volatile nature of these expectationsplays a major role in explaining why 1
1
investment expenditure and therefore output and employment in t~iarketeconorniesl
are subject to fluctuations. I

I
5.2.1 Non-existence of Objective Probability Distributions 1

Let us see why expectationsare volatilein nablre?According to Keynes (1936,pp. 149):

"Our knowledge of the factors which will govein the yield of an investmerit some years I
~
hence is usually very slight and often negligible." We can consider several exanples: j) (
p s i ble advances in production technology might make the currently installed machinery
obsolete, ii) appearance of new substitutes might atrect demand for output, jii) changes
in industrial, labour, trade and tax policies might affect revenues and costs, iv) wars,
trade embargoes and changing international relations might affect possibilities of
production and sale. One can, with a fair degree ofaccuracy, predict the pgssibility of
such events in the short term. However, such prediction becomes pr~gressivel>~ more 1
difficult, the farther ahead in the future is the time that such predictions relate to.

Such problems will, of course arise in making any decision about the future which 1
involves long-term expectations. One possible way of dealing with such proble~rlsis to
use a probability distributionover possible future outcomes. Keynes argued that in thz
case ofvariables like the future yields of an investmentproject there can be no objective
basis for the formation of aprobability distribution.

Let us explain the problem of forming a probability distributionthrough an example.

Suppose we have to find out the outcome ('head' or 'tail') of a single toss of a coin in
the future. We can repeatedly toss the same coin and observe outcomes. Alternatively
we can consider past experience of coin tosses for coins with almost identicalphysical
properties. Inthis way, we can obtain relative frequenciesof the outcomes ('head' and
'tail') in the case of these tosses.

What arethe factors presumably affecting tbe outcome of a single toss? Broadly, these
are the nature of the coin, the method of the toss and the physical envsonment in which
the toss is camed out. Certain factors can be broadly compared across different tosszs
and kept constant (so that only tosses under essentially similar conditions are studied),
viz., the nature of the coin and the method of the toss. Other factors which might
presumably affect the outcome are the exact initial position of the coin and the hand
tossing the coin, the exact initial impetus given to the coin, the exact velocity of the
wind blowing at the time the coin is tossed, and certain othzr factors in the physical
environment.All these minute details may matter, but there is no way in which we can
measure all these factors or keep them constant. For a particular coin the outcome
(that is, obtaining 'head' or 'tail') depends upon the configuration ofthese factors.

However, suppose we compare sufficientlylong sequences of coin tosses canied out' 1

under essentiallysimilar conditions. Depeilding upon the configuration of these ffacors
we can represent a sequence of coin tosses in the form of relative frequenciesfor the
I\
outcomes. It implies that given a combinationof factors the proportion of 'head' and Rational Expectations and
'tail' in a long sequence should remain the same. Economic Theory

In fact, it has often been empirically verified that for a sufficiently large number of
tosses of a coin under essentially similarconditions, the relative fiequenciesof different
outcomestend to stabilise around fixedvalues. For example, for coins whose physical
properties do not in any way appear to favour one outcome over the other,the relative
frequency of the outcomes 'head' and 'tail' would both tend towards the value %.
'Ihese long-run relative frequenciesthen represent the objectivebasis for the probabilities
assigned to different outcomes for a single toss of the coin in future.

Now, let us consider the case of an investment project. Certain pieces of information
relating to past and present time periods are currently available which are relevant for
forecasting possible future trends - for example, current yields on similar projects,
past and currenttrends in these yields, c m n t trends in science and technology (research
and developmeilt) in related areas, current political developments and past political
history. These, together with the nature of the investment project, can be considered
as the observable conditions under which the experiment of investing in a project
rather than tossing a coin is being made.

Unlike the case of coin tossing, we cannot undertake an investment project repeatedly
and study the distribution of relative fkquencies by outcomes. Therefore,one can only
obtain this distribution by studying instances in the past where essentially similar
conditions had prevailed. However, according to Keynes, there would be a very
large number of pieces of information available at present, which could be considered
relevant for predicting the long-run yields on any investment project. However, not all
of these pieces of infornlation are adequately quantifiable or comparable over time.
Therefore, it is difficult to obtain sufficiently large numbers of instances in the past
where investments have been made under essentially similar conditions.

Alternatively, suppose we wanted to use a limited number of quantifiable factors in

defining the conditionsunder which investment is being carried out. In this case there is
no reason why, if we consider sufficiently long sequences of these instances, it should
necessarily be truethat the distribution of relative fbquenciesof different cordlgurations
of the factors left out should be the same for all sequences.Science and technology or
politics (human or social phenomena) are hardly of the same nature as physical (natural)
phenomena. Consequentlyrelative frequencies in the past might not be a good guide
to relative fiequenciesin the future.

5.2.2 Conventions as a Basis for Forming Expectations

Since there is little objective basis for probability distributions about future yields,
decision-makers have to act on the basis of subjectivejudgments. It means there must
be some element of arbitminess involved in the formation of expectationsand therefore,
in the decisions taken on the basis of those expectations.In such situations individual
decision-makers,in forming their expectations,usually tend to fall back on practical
norms or conventions generally prevailing in society.

For example, one convention for estimatingthe expected rate of return on an investment
project may be as follows:Assume that an objective probability distribution for future
returns on an investment project can be determined fiom quantitativehistorical data.
Hence, estimate regression equations which have the rate of return on such projects as
the dependent variable and particular subsets of a set of variables as independent
Rational Expectations variables. Then, on the basis of some given statistical criterion (convention)choosethe
'best' estimatedregression equation. Use this, given values of the independentvariables.
to obtain an estimated probability distribution for the rate of return on the investment
project.

The tendency to rely on conventional wisdom might be due to a variety of reasons.

Individuals might feel that conventions reflect the collective wisdom of others who
~1
have been in similar positions and therefore would be less arbitrary as a guide to I

decision-making.Besides, individual decision-makers canjustify their decisions as

being of the same variety as that taken by many others placed in similar position. Inthis ,
I
case it appears less the outcome of individual whim or sentiment or prejudice. I

Mareover, in followingconventions,padcularlyin relation to the valuation of investments

or assets,the individual enkpreneur might minimisingrisks. If a majorityof investors
follow the same conventionsin calculatingvalues then the individualentrepreneurwould
have a good idea about the market value of his investment over the short tenn. Once
the investment has been made on the basis of such valuation, the entrepreneurwill be
exposed to the risk of a sigdicant loss. Since individualshave relatively greater certainty
about the near future,the chance of increasing losses over a short time period is small.

5.2.3 The State of Confidence in Conventional Judgements 1

While individuals fall back on conventionsto guide their behaviour in the face of I
uncertainty, they are also aware that these conventions might prove to be misleading
guides to the future, because the future might well be very different from the past.
Consequently, individual decision-makersdependingon their level of confidencedecide
whether or not to act on the basis of these conventions in the face of such uncertainty. I

Thus, while a particular convention or norm for estimating the future returns on an '
investmentproject might suggest that investment projects should be carried out in two
, different instances, the actual investment may be carried out in only one, if the state of
confidence is high in one and low in the other. In the latter case, the same predictions
about future yields using prevailing conventions would as it were be discounted by a
factor reflecting the decision-maker's confidence about whether the prediction would
actually be correct.

Thus, it is not only various 'objective' factors in the economy, which through prevailing
norms for forming long-term expectations, determinethe volume of investment in the
economy. The same set of values for the 'fundamental factors' (according to prevailing
conventions) can influence investment decisions in either direction,the relation of these
'fundamentals' to expectations about the future being governed by the prevailing
psychological state of businessmen and entrepreneurs. Thus, according to Keynes
(1936, p. 161)' a certain degree of optimism, "of animal spirits - of a spontaneous urge
to action rather than inaction," is necessary for enterprise and investment.

The preceding discussion assumes that the 'marginal efficiency of capital', which is
relevant to the decision to invest, is derived fiom the expectations of the professional
entrepreneuror businessman who actually undertakesthe investment. However, Keynes
believed that the rate of investment was significantly Influencedby movements in the
share market values of existing enterprises.According to him (Keynes, 1936,p. 151):
". ..there is no sense in building up a new enterprise at a cost greater than that at which
1~
a similar existing enterprise can be purchased; while there is an inducement to spend
on a new project what may seem an extravagant sum if it can be floated on the Stock 1
Exchange at an immediate profit." Thus, it is the marginal efficiency of capital Rational Expectations and I

correspond+g to the "average expectation of those who deal on the Stock Exchange Economic Theory
as revealed in the price of shares" which is actuallyrelevant in many cases.
.
In this case, the role played by psycholbpic~factors represented in the state of
confidence, increases with tbe share of tohl equity capita1 held by market investors
who (compared with professional entrepreneurs or businessmen) are relatively
uninformed. Since the factual basis underlying the expectations of the relatively
winformed investor is smaller, the level of confidence in these expectationsis also
subject to greater instability.

The volatility of expectations(and of investment) arises because the state of confidence

of investors is subject to waves of optimism and pessimism, sensitiveto the extent to
which even single small events seem to confirm or refute currently held expectations
based on existing conventions.According to Keynes (1936, pp. 153-4): "Day-to-day
fluctuationsin the profits of existing investments, which are obviously of an ephemerd
and nori-significant character, tend to have an altogetherexcessive, and even an absurd,
influence on the market."

'Also, nlajor events, which take place in the present and whose impact on future events
cannot be gauged to any adequate degree, increase the extent ofuncertainty and make
the state of confidence even more sensitive to the single sinall events. "In abnornlal
times in particular: when the hypotl~esisofan indefinite continuance of the existing state
of affairs is less plausible than usual even though there are no express grounds to
anticipate a definite change, the market will be subject to waves of optimistic and
pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no
solid basis exists for a reasonable calculation." [Keyi~es,1936,p. 154)
I

Nowadays, there is often reference in the media to the 'feel good' factor, whereby a .
set of unrelated but favourable events taking place elsewhere in society might induce a
high degree of c$nfidence in positivejudgments. Sirnilary], a sequenceof unrelated but
unfal ourable events might induce pessimism about positive judgments. In the words of
Keynes (1936, p. 162): ". .. economicprosperity is excessivelydependent on a political
and social atmosphere which is congenial to the average businessman. If the kar of a
Labour Government [a government favouring greater state intervention in the economy
and p t e r support for or$anised labour] or aNew Deal [apolicy programme involving
increased public intervention and expenditure] depresses enterprise, this need not be
the result either of a reasonable calculation or of a plot with a political intent -it is the
.
mere consequence of upsetting the delicate balance of spontaneous optimism."

5.2.4 Nature of Expectations in Keynes' Theory

The above discussion on the nature of expectations in Keynes' theory may be
summarised as follows:

1) In forming long-term expectations, there exists no basis for infening an objective

probability distribution over futureo-utcomeson the basis of past experience.

2) In forming long-term expectations, decision makers fall back on prevailing'

conventions. This could, for example, iticludethe convention of using an estimated
probability distribution from historical data for forming expectations about the
film.
Rational Expectations 3) Decision makers are however aware that these methods for forming expectations I
have evolved as conventions (maybe, because they have been more successful
on an average in the past compared to other methods). There is no objective
rationale for thinking that they would always form a more accurate basis for
judgments about the future.

4) The decision on whether or not to go by these conventionaljudgments depends

on the confidence that decision makers have in these conventionsas an adequate
. basis for forming expectations about the firmre. The state of confidence is a volatile
factor. Therefore expectations also become volatile as economic actors go by
~1
I

conventionaljudgments or discount them. I

5.2.5 Implications for the Role of Economic.Theory

Like the schedule for the marginal efficiency of capital, expectationsabout the future
market rate of interest underlie the liquidity preference schedule. In Keynes' analysis,
there are three factors which influence influence the level of output and employment in
the economy in the short-runsignificantly.These are i) the quantity of money in circulation,
ii) the money wage rate, and iii) certain hdamental psychological factors, namely, the
psychological propenL'tv to consume, the psychological attitude to liquidity and the
psychological expectation of future yield from capital assets.

In analysing the determinationof aggregate output, Keynes therefore takes the above ~
factors including 'the psychology of the public' as given. For example, he takes marginal
efficiencyof capital and liquiditypreference schedulesas given. Changes in these factors
are then studied separately in terms of their effect on output and employment.
~
1
I

Psychological factors do not necessarily denote random factors. These might depend
(though not necessarily reasonably) on specific social and political circumstances.
Two major implications follow fkom the fact that psychological factors are important in
the determination of output. First, the level of output and employment and other relevant
variables in the economy will not, in general, be predictable (in the form of an objective
probability distribution) on the basis ofhistoricaldata on a limited number of measurable
factors alone. Second, changes in independentvariables brought about as a measure
of policy may also lead to changes in other determining factors, but not necessarily in
a predictable manner. For example, Keynes recognises that monetary policy can have
different effects on output depending on its impact on expectations about future
monetary policy and therefore on the liquidity preference schedule. Similarly,there is
recognition (Keynes, 1936,p. 120)that a government programme of pub@ works
may "through its effect on 'confidence7,increase liquidity-preference or diminish the
mar& efficiency of capital, which, again, may retard other investment unless measures
are taken to offset it."

5.2.6 The Nature of Policy-Making

I
/

It follows that recommending policy must itself be a subjectiveexercise. The effects of

particular-policiesat aparticular historicaljuncture will depend not only on the values
of current measurable variables, but also on knowledge of the current psychology of
economic agents. Moreover, it will depend on how we organise and interpret the
historical evidence of different instances in the past in terms of the light they throw on
present circumstances.

According to Keynes, the role of economic theory was not to provide quantitative ~
predictions about the future.Rather, it provided a framework for thinking logically and Rational Expectationsand
in an organized manner about the problem under consideration. Past data on relevant Economic Theory
variables could then be studied to obtain an idea about the nature of quantitative
relationshipsthat had prevailed in the past. However, in using such data for predictions
about the future, it was necessary to make subjectivejudgments about the extent of
similarityor dissimilarity between the present time period and differenttime periods in
the past, not captured by objective measurable variables.

The above approach has two implications. First, choice between alternative models of
the economy for present purposes cannot be made on the basis of historical data on
measurable variables alone.That is, such choice cannot be'made onpurelyquantitative
grounds. Second, if there are few close parallels in history to present circumstances,
then there exists little basis for objective predictions about the future.

Check Your Progress 1

1) Explain how expectationscan be expressedin the form of a probabilitydistribution.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
2) How does expectations influence policy-making? '

...........................................................................................................................
....................................................................................................................."....
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
3) Write short notes on
i) conventional wisdom as a basis for expectation formation.
ii) Nature of expectationsin Keynes'theory.
...........................................................................................................................
...........................................................................................................................
?." .-
Rational Expectations

THEORY
We assumed above that the role of economic theory is not to provide quantitativ
predictions about the future. Suppose we assume instead that the primary role o i
economictheory is the prediction of future values of variables of interest.Also, give
this role of economic theory, suppose we stipulate that under any particular set o
circumstances,the choice amongst alternativetheoretical models should be possible(
4
on the basis of quantitative historical data alone. It implies that models should provide/
predictions in the form ~~'rc1ation.s
between objectively measurablevariables,predictions
I
which can be checked using past data on these variables. I

I
Note also that the above assumptionimplies any one af two things: i) the same relati04
between variables have prevailed for the times and places that the past data relates to1
and will prevail under the present circumstances,or ii) differences in time and space1
can bds a c c ~ u ~ ~ht re ads difTcrent values of quantifiable variables within the model.
1
i

Thcrefi~re,once a mcdel is chosen on tlis basis it can be asstuned to provide, together

bc it11 historical datacsn the variable5 in thc model. objective quantitative predictions.~
Traditionally. tl ris has meant that models have been used to yield predictions in the1
I
f m of~an o@ect:tiveprobability distribution foithe futilre values of dependent variables,~
given (conditioned on) current and past values of a set of vatiables. 1

This objecthv conditional probability distribution has been derived by econonlciricl

methods on the basis of past data on the variables appearing in relationships derivedl
from theo&. The basic assumption underlying such an approach is that either there isi
an objective conditional probability distribution relating these variables which does
not change with time and space or that time and space ban themselves be specified inl
terms of quantifiablevariables in the model.
t
I

/
! 5.3.1 The Hypothesis of Rational Expectations
\

In the General Theory (Keynes, 1936) we noted that the state of expectations was1
taken as given. There was, in addition, explicit recognition that changes in other
independent variabks including policy variables could lead to changes in expectations.
However, nbthing cduld be said in general about the nature and extent of such shifts
without specificknowiedge of the prevailing psychology ofthe economic agents, which
would be influeneed by hirailing social and political c i r c i i t n s ~ e S - ,
' I

1n a model that aims to provide aprobability distribution for dependent variables using
&$a on objective meastdrable variables, however, changes in expectations cannot be
~~
I

assumed to be dependent on non-quantihble factors outside the model. Expectations

themselves must therefore be explainablein terms of objective measurable variables. I
I
 Suppose economic agents are assumed to be rational in the sense that they seek to Rational Expertationsand
best achieve their objectives, subject to external constraintson their choice of actions. Economic ~he<sry
Suppok also that the degree of 'correctness' of the expectatioq on the basis of which
econolmo;igents act is a ~ufficiently'im~ortant factor determiningtheir welfire. Then
hdividui <=cisionmakers too, like the economists who make predictions on the basis
of ohjectzv4 conditional probability distributions,will try to learn about and make
decisions oq the basis of these objective conditional probability distributions.

The above ip the hypothesis of rational expectations. It implies that the subjective
(indiviciua))probability distributions that individual econoyic agents are assumed to
-;nsein making their decisions in an economic model are consistent with the objective
condityinal prebability distribution implied by the mbdel.

In most economic models, it is assumed that the decisions of economic agents are
dependent only on one or two parameters of the subjective probability distribution
they have for future values of relevant variables and not on the entire distribution.
OAen under the assumptions of amdel, only the mathematical expectation'orexpected
value of this probability distributionis =levant for decision-malung. In this m e , instead
-ofassuming that the subjective probability distributions that economic agents have
coincide with the objective probabilitydistrib~ltionhplied by the model, it is suflicient
to assume that the expectedv@es or expectations of these distributionsare equal.
-
The latter case may thereforebe called the weakversion of the rational expectations
hypothesis in contrast to the strong version, which assumesthat the entire objective
probabilitydistribution is known.

If a podel assumes a world of perfect certainty t h y it provides deterministicpredictions

nbdut dependent variables on the basis of values of independent variables. In the
context of such a world, the hypothesis of rational expectations implies that the
exptidons held by economic agents in the m~delmust be the m e as the predictions
of the model. Since the expectations held by different economic agents are the same,
it follows thatin a m d e l with perfect certainty, the assumption of rational expectations
is equivalent to the assumption ofperfectjoresight for economic agents.

5.3.2 Phillips Curve and Inflation-Unemployment Trade-off

--
in Policy-making #

171ehypothesis of rational expectations is beaer understood if we consider the debate

on the inlplication of the Phillips curve for macroeconomic policy making. Keynes, in
the General Theory, had explicitly recognised that increases in effectivedemand would
not only lead to inoreases in output but dso lead to increases in the money wage rate
and the price level, It followed,therefore, thatpolicies aimed at reducing unemployment
would also lead to some amopt of inflation in the economy. Policy-making would be
simpler if one knew that a given change in the unemployment ratewould be accompanied
by a given change in the rate of wage inilation;In that case, one could decide whether
-it was worthwhiebo pursue apolicy of reducing unemploymentgiven itscosts in terms
of an increased ratle of inflation.

In 1958,A. W. Phillips published the results of his empirical work on the relatiomhip
between the average rate of unemployment and the average rate of change of nomirl&
wages in a business cycle. His work was based on data for the united ~ i n ~ d oover
m
[heperiod 1 861-1 957. Phillips was interested in testing the hypothesisthat the lower
the rate of unemploymen~,the more rapidly would firms ha3e to increase wages in
Rational Expectations order to attract new workers and retain existing ones. He also hypothesised that thd
lower the initial rate of unemployment, the greater would be the rise in the rate of wagd
inflation corresponding to a given rise in the rate of unemployment. I

Phillips fitted a hyperbola relating the rate of nominal wage inflation to the rate of
unemployment for the UK economy for a ,ong period of almost a hundred years (1 8614
1957). The remarkably good fit of the data provided support for the hypothesis1
However, it is to be noted that Phillips excluded periods of high inflation from hid
estimates and analysis, since he felt that \%ageinflation during such periods would be)
explained more by the rise in the cost of 1:ving than the unemployment rate.

However, beginning with a famous paper by Samuelson and Solow(1960), the Phillip4
curve was subsequentlyinterpreted as representing a stable relationship between the/
. rate of wage inflation and the rate of unumployment over any particular businesd
cycle. Moreover, based on the assumption that the ratio between prices and nominal
wage nate is constant in the short run, the curve was also seen as providing the relatiori
between the rate of price inflation and the unemployment rare. Once this interpretatiod
of the curve became standard, Phillips e w e s were estimated for almost all
for which data were available and yielded similar inverse relationships between inflatio
and unemployment.

The Phillips curve was thus represented as a stable relation betwetn inflation and
unemployment over time, which provided a menu of policy choices.An economy
could choose whether to have a combination of relatively low unemployment and
~latively high inflation or acombination ofrelatively high unemployment and relativeld
low inflation.

5.3.3 Inflation-Unemployment Trade-off under Adaptive

Expectations I

By the late 1960s.the inverse relation between inflation and unemployment as wgge
by the Phillips curve was increasingly questioned, especially in the United States. I
was because prevailing rates ofunemplojment seemed to be associated with rates of
"c9
inflation much higher than would be expected on the basis ofPhillipscurves estimat
from the past. There was economicstagnation depicted through negligible GDP gro
on the one hand and high rate of inflation on the other, a situation termed in economi
jargon as "stagflation". In his presidential address to the AmericanFmnomicAssociatio~
in 1968,Milton Friedrnan advanced an argument as to why the Phillips curve might not
4
represent a stable exploitable trade-off for policy making. Subsequently, this argument
gained wide acceptance. -I
Friedrnan argued that workers, in making their labour supply decisions,were concern4

I
not with their money wage rates but with their real wage rates. Moreover, given th
structural characteristics of an economy, there was a unique equilibrium rate o
unemployment in the economy called the natural rate of unemployment. At this rat
of unemplojment, f m s and empl-oyedworkers would be satisfied with the real wag
rate paid for work done and it would not be desirable, given the constraints the
faced, for both f m and unemployed workers to establish an employment relationshi
P
at a lower real wage rate'.

'
'
there would be a natural tendency for not only the nominal wage rate but also for the rea
wage rate to decline in the economy.
t
Note that, unlike in Keynesian theory, the presumption is that at higher rates of unemploymen
~
It might be due, for example, to the fact that because of the heterogeneous nature of Rational Expectations and
jobs and the work force, some time is required by firms and workers to respectively Economic Theory
find information about and search for appropriate workers and jobs. Or, it might be
due to the fact that some unemployed workers due to costs of mobility (between
geographical places or occupations) or due to other labour market imperfections(such
as the actions of organised labour - trade unions) are not in a position to seek
employment by lowering wages. Other possible causes will be discussed later when
we consider theories of unemployment.

At rates of unemployment lower than the natural rate, firms, employing more labour,
would want to pay a real wage k t e lower than what they pay at the higher natural rate
of unemployment, while a higher,realwage rate must prevail in order for workers to
supply more labour. If workers and firms entered into an employment relationship in
terms of a stipulated real wage rate, then a rate of unemployment lower than the natural
rate would never prevail.

However, workers and firms actually enter into an employment relationship on the
basis of a stipulated nominal or money wage rate. Now, suppose that at a particular
time, workers when they make their decisions on whether to acceptjob offers at a
particular money wage rate, expect a lower future price level than firms expect when
they decide to make these offers. That is, workers expect a lower rate of price inflation
in the economy than do firms. Then a rateof unemployment lower than the natural rate
might prevail because the expected real wage rate for workers would be greater than
the expected real wage rate for firms. b

Suppose that firms correctly perceive the state of demand in the economy and the rate
of price inflation. Then. the actual real wage rate in the economy would always be
equal to the real wage rate on the basis of which firms decide how milch labour to
demand. Then, if the economy is to remain at a fixed rate of unemployment,the real
wage rate must be constant so that the rate of growth of the money wage rate must
equal the rate ofprice iflation. That is, if w(t) denotes the money wage rate andp(4
the price level in the economy in period t:
w(t)/p(t) = w(t+l)/p(t+l) = o ( a positive constant), so that

w(t + 1) - w(t)
Remember that gives the growth rate in nominal or money wage in
w(t)
period t.
-
However, suppose that the fixed rate of unemployment is lower than the natural rate.
Then, for the amount of labour corresponding to this rate of unemployment to be
supplied, suppose that a higher real wage rate o'must be expected by workers.
Workers therefore will supply the amount of labour corresponding to this rate of
unemployment,if and only if
w(t+l)/p'(t+l) = w', ...(5.2)
wherep"(t+I) denotes the price level expected by workers in period t + I.
By re-arranging terms in (5.2) we findthat
p'(t+ I)] = (l/o?w(t+ I) ...(5.3)
That is, [pe(t+l) -p(t)]//7(t) = (l/w?[w(t+l)/p(t)] -1
Rational Expectations That is, [pe(t+-I)-p(t)]/p(t) =: -I
(WIu~[p(t+lI~p(t)/
That is, (u'/w)[pe(i+l)-p(t)]/p(t) + [@'/w) - 11 =- [p(t+l) -p(l)]/p(t) ...(5.4)
Since u'/w> I it follows that the rate of growth ornominal demand in the economy
must be such that the actual rates of n o d wage and price inflation, given by [p(i+l)
--p(t)]/p(t),must always be greater than the expected rate of price inflation [p'@+l,,~
- ~(l)l/p(t).

If despite the actual rate of price inflation k i n g greater than the expected rate of piice
inflation,the workers expected that the hateof price inflation remain4 the same over
time, then the actual rate of price inflat-on required to maintain the given level of
unemployment would be constant over time. There would be a stablerelation between
.the rate of unemployment and the rate of inflation as given by the Phillips curve.

However, if the actual rate of price inflation in any period is greater than the expected
value there would be a natural tendency fo9 the expected rate of inflation to rise. For
example, if $0 and @(qrespectively denote the actual rate of inflation and the expected
rate of inflation in any period t, then a possible assuinption about formation of
expectations about the rate of inflation in period t + I , is given by

-
@(t+l) - @(t) /zlKi) - @(it)/, where 0 < i l l . ...(5.5)
The above equation shows that expectationsabout the rate of inflation d p t (completely
when i2 = 1 , or partially, when i2 < 1 ) to deviations of the actual value fiom the
expected value for the rate of inflation in the current period. In other words, expectations
for the next period adjust fgr the prediction error in the current period.

k i s hypothesis about formation of expectations is therefore knoun as the kypothesis

of aduptive expectations.The hypothesis implies that if the actual rate of inflation is
always greater than the expected rate, then the expected rate would be rising over
time. Therefore, in order to maintain a coastant rate of unemployment lower than the
natural rate, the actualrate of inflationmust be rising overtime. Otherwise, the difference
between the expected ieal wage rate of workers and the actual real wage rate (expcted
by firms) would be falling in the economy

In fact, substitutingfrom (5.4) for the ach1rl1rate of inflation &t) in (5.9, we can show
that

Since wYu> 1,the coefficient of @(t) in the above first-order difference equation is
greater than one and the constant tqm on the right hand side is positive. It can therefore
be easily shown that @@,I -+ mas t + a,.Hence, if the economy is to maintain a
constant rate of unemployment lower than the natural rate, the actual rate of inflation in
. the economywill not only be increasingbut will be increasingwlithout any upper bound.

l l e stablerelation between inflation and unemployment suggestedby the Phillips curve

is therefore illusory. The same rate of unemployment, if lower than the natural rate,
would be associated with increasingrates of inflation over time. Similarly, it can be
shown that a rate of unemployment greater than the natural rate;must, in the above
case be associated with an increasing rate of deflation over time. The only rate of
unemployment which can be maintained in the long runwith a constant rate of inflation
is the natural rate, where the actual rate of inflation is equal to the rate historicaily
expected by workers. Thus, it follows that there exists no policy trade-off between
inflationand unemployment in the sensethat a permanently lower rate of unemplojment
can be established through policy at the expense of a permanent but fixed increase in Rational Expectationsand
the rate of inflation in the economy. Economic Theory

5.3.4 Inflation-Unemployment Trade-off under Rational

Expectations
Robert Lucas (1972) pointed out another implicationof the above hypothesisof adaptive
expectations. Suppose in a particular period (say period 0) the unemployment rate is
lower than the natural rate. Then @), the actual rate of inflation in period 0 must have
been greater than @(0), the rate of inflation expected by workers. Now suppose that
the rate of growth of nominal demand is such that over time there is a constant rate of
inflation M). 'Ihen, from (5.5) it follows that for all t 20,

That is, @(t+l) - KO) - KO)]

(1 - IZ)[@(r) - ..,(5.7)
By solving equation (5.7), we get, @(t)- NO) = (1 - IZ)'[@(O) - NO)] ...(5.8)
Let us interpret the equation (5.8). If IZ < 1, it follows that, if @(O) < KO) then @(r) <
W;O) = Wi) for all t > 0. That is, if the expected rate of inflation is less than the actual
rate of inflationin m o d 0 it will continue to be so in all future time periods even though
the difference between the two rates converges to 0 as t -+a.

The implication is that together with a constant rate of inflation, the economy can have
a rising rate of unemployment(becausethe differencebetween the actual rate of inflation
and the rate of inflation expected by workers diminishes over time) but the rate of
unemployment can still be lower than the natural rate in every time period (becausethe
actual rate of inflation is always greater than the rate expected by workers). That is,
over the long run,together with a constant rate of inflation, the economy could still
have an average rate of unemployhient lower than the natural rate.

Moreover, the above solution alsd impliesthat eeterirprnibw the greater the value of
KO), the pater would be the W o n ofthe actual from the expected rate of inflation
in any tinie period. Therefore, the greater would be the deviationof the actual rate of
unemployment from the naturalratein any time period. Hence, the higher the constant
rate of inflation in the economy, the lower would be the long-run average rate of
1-0-
This implies that while macroeconomic policy cannot achieve a constant and
permanently lower rate of unemployment in an q n o m y by choosing a constant but I

pemmently higher rate of W o n , an inflation-unemploymenttrade-offstill exists. By 4

-
choosing a constant but permanently higher rate of inflation policy makers can still
achieve a permanently lower rate of unemployment in each period resulting in a lower
long-run average rate of unemployment.

Now, consider what happens if we suppose that workers have rational expectations
about the rate of inflation First, this impliesthat, dependq on informationavailableto
workers in any period t denoted by I@,it is possible to define an objective probability
distribution for the rate of inflation in the economy in period t + 1.Thus,there exists a
conditional probability density functionANt+l) II(r)). Let E[&+l) 1 I(r)] be the
expectationof this conditional probability distributiin.

The rational errpectation..hypothesis then impliesthat

Rational Expectations @(ti1) = EL &t + 1) I(t)J ...(5.9)
Suppose &@+I) represents the deviation of the actual rale of intlation in perinii r +- 1
from the rate of inflation expected by workers in pzriod /. That is, Hl+ 1I represents
the prediction error of workers about the rate of inflation in pcriotl t t I .

) #(
'That is, ~ ( t 4 - I= 1)i
-f@(ti-I).

It follows that E[&i + I) II(t)l - E[@(t+1) I) J(r)]

(l(si] + EL~tti- . ..(S.IO)
In (5. I 0) the first term on the right hand side gives the expectation, given the infoim&a~
set I(t), of the inflation rate in period t+ 1 which would be expected by xvorkcrs on @w,:
hasis of the same information set. Workers have a single-valucd expectation equal to i
~
@(t+l),which, given information set I(9, is always equal to El #+l)/I(tlj.
I
I
I
I
Therefore, E[@(t+1) 1 I(t)] = E[#+ 1)lI(t)]. I
I

Hence, E[E(t+l) (I(t)] = 0. ...(5.11)

~
I

Supposewe consider the conditional probability distribution of the prediction error for
the rate of inflation in period t - t l ,~ ( t I),
+ given that the set of' information /(t) is
available in period t. If, workers do not make systematic errors in prediction, like I
consistently predicting avalue higher than the actual or avalue lower than the actual,
then for a sufficientlylarge number of predictions based on the s m information set,
1
the average error in prediction must be zero. This is what is implied by the condition
E[E(t+I) JI{l)]-- 0, which, in turn is iln implication of our assumption that workers
I
have rational expectations about the rate of inflation. I
I

'Thus, if workers have rational expectations about the rate of &lation, the11the expe~tqd
rate of inflation of workers can never consistently undqrestirnate the actual rate of I
idation. In fdct, over the long run, the sum of positive prediction errors for workers 1
must be equal to the sum of negative prediction errors. I

The deviation of the actual rate of unemployrnent from the na~uralrate, according to
Friedman, is in the opposite direction to the prediction error for the inflation rate. I1
However, the absolute size of this deviation is positively related to the absolute size of
the prediction e m Therefore, over the long run, the sum of positive deviationsof the ~'
1

actual h m the natural rate of unemployment must equal thesum of negative +viatiom.
Hence, the long-run average rate of unemployment must equal the na~walrate of
unemployment. This is, in contrast to the case of adaptive expectations,where the
~
I

average rate of unemployment in the economy, wer the long could beklow the ~
natural rate of unemployment, 1
* I
The hypothesis of rational expectatiom, tagei+er with Friedman-sargup~entabout the
determinationof the rate of unemployment, &refore impliesthat the low-sun average
rate of unemployment cannot be anyhng other than the natural rate, whatever be the
nature of the government policy for controlling nominal demand. Thus, even if we
,
1

interpret the existence of a policy trade-~ffto mean that the economy can enjoy a
smaller long-run averagemte of unenqloyment~ 4 t ahhigher but constant rate of infl~lion
in the economy, this trade-offno longer exists once rational expectations are introduced
~
I
into the Friedman model. 1
* This will be exactly true if the deviation of the actual rate of unemployment from the natvalrate
is linearly related to the deviation ofthe actual rate of inflation hrn the expected ratq. Otherwise,
one has to consider this to be approximately true. However, there is no reason to argue that, in
general, the average rate would be either greater pg smaller [han the ngturahrate.
I
 More generally, our analysis sugests that any economic policy, which seeks to achieve Rational Expectationsand
its objectives over the long run on the.assumption that private economic actors can EconoihicTheory
make systematic errors in prediction, will fail to do so if economic actors satisfy the
hypothesis of rational expectations.

There is, however, a diEerent role that the government can play in the economy. Note
that the dispersion around the m a n of the conditional probability distribution of E(t+l),
given I&, gives an indication of the average magnitude or scale ofgrediction errors
(whether positive or negative). Ceterispuribus, one expects the measure of this
dispersion to be smaller the grcater is the extent of information avaihble to workers in
period I. Since. the size of deviations of the actual rate of unemployment from the
natural rate are related to the size of prediction errors by workers, it followsthat the
avemge rmgnitude of fluctuations in the actual rate of unemployment around the nahml
rate is smaller, the greater is the extent of information contained in I(0.

Suppose, given a natural (long-run average) rate of unemployment,social welfare is

greater for a smalleraverage fluctuation in the m e of unemployment aroundthis natural
rate. Then, thc above discussion suggeststhat the only poSdbla rok'f6r govahment
policy, given rational expectations, is to ensure that workers in the economy have as
much vlevant inforination as.wssible while forming their expectaf.ions - ...

1) Explain
,
1 ,, the rational expectatioF hypo~b~sis. *
! I * * '

2) ~ i s t i n ~ i&yeen
ss adaptiveexpectaiions and rational expcations.
rG .

i
/ . .- <. :,
I

.c ......................
;..........:.......:.i- ..... i;... ::A:
.
...............................................................
. ,., . , , > r .i
>c

...
k ,;>(.. / / >*- :+,,.*.is;,,'<..
Rational Expectations I
3) How do you explain the unemployment inflation trade-off on the basis of rational
expectations.

5.4 LET US SUM UP

Expectationsabout f&uevalues of macroeconomic variables play an importantrole in
determinationof output and employment. Economic agents such as households, business
h s and governmenttake decisionson the basis of current as well as expected future
values of relevant variables. Prediction of future values becomes increasingly difficult
as we attempt to predict farther into the future. To deal with such a problem we can
make use of an objective probability distribution based on past data, which of course
is quite dacult.

In this unit we discussed about the basis on which expectations formationtakes place.
The basis could be simple conventions or certain hypothesis such as adaptive
expectations and rational expectations. In adaptive expectations we assume that
economic agents use current and recent past informationto predict future values. On I
the other hand, in rational expedationswe assumethat economic agentsuse all possible ~
information including prospective policy changes to predict the future. We applied ,
both the types of expectations formationto a particular situation, that is, the trade-off I
betweenunemployment and inflation.
Historical data from market economies showsthat the avexage rate of unemployment
in a business cycle is negatively related to the average rate of nominal wage inflation.
The gmphicalrepmentation of this inverse relationship is called a Phillips curve. The
Phillips curve was initially interpreted as representing the possible combinations of
inflation and unemployment rate achievable through policy. The idea was that this
relationship between inflation and unemployment would remain stableeven when the
government sought to use this relationship as a basis fog policy-making.

Milton Friedman argued that there was only one real wage rate and one rate of
unemployment (the natural rate of unemployment)at which firms and workers would
be in equilibrium in the economy. In order to maintain a rate of unemployment lower
thanthis rate, there had to be a constapt positive differentialbetweenthe rate of inflation
expected by workem and the actual kte of inflation.

Under the hypothesis that workers' expected rate of inflation followed the rule of
ada@ve ercpectations, Friedman showed thatmaintaining a of unemploymentlower
@%her)thanthe naturalrate would imply an unbounded increasein the rate of inflation
(deflation) in the economy. Macroeconomic policy could not secure a constahf and
permanently lower rate of unemployment in the economy at the expense of a fixed Rational Expectationsand
increase in the rate of inflation. Economic Theory

However, Robert Lucas showed that the hypothesis of adaptive expectations also
implied that macroeconomicpolicy could attain a permanently lower (though rising)
rate of unemployment in the economy at the expense of a fixed increase in the rate of
inflation in the economy. If the hypothesis of adaptive expectations is replaced with
that of rational expectations this policy trade-off no longer exists because the long-~un
avemge rate of unemployment must always be equal to the natural rate of unemployment.

5.5 KEYWORDS
Adaptive Expectations Expectations are said to be adaptive when
people form their expectations on the basis
of past behaviour.

Business Cycle Fluctuations in output, employment and

income which is widespread across all sectors
of the economy.

Deflation A sih;ation when general price level is falling.

Expectations It means views or beliefs about future macro

variables such as prices, interest rates, tax
rates, etc.

Natural Rate of Unemployment The rate of unemployment which prevails in

the long run.It varies across countries and
I over time. However, empirical studies
estimate it to be around 6 per cent for some
developed economies.

Price inflation Inflation is a situation when overall prices are

rising. We have used the term price inflation
to distinguish it from wage inflation. When
nonlinal wage rate is increasingon a sustained
basis we call it wage inflation.

Rational Expectations Expectationsare said to be rational when they

are formed on the basis of all available
information. Under this assumption,
expectations are never biased.

Wage inflation A situation when nominal wage rate, on an

average, is increasing.

5.6 SOME USEFUL BOOKS

For section 5.2, the basic readings are:
John Maynard Keynes (1936), The General Theory of Employment, Interest and
Monty, London :Macmillan, Chapter 12.
John Maynard Keynes (1937), "The General Theory of Employment," Quarterly
Journul of economic.^, 5 1, pp. 209-23.
Rational Expectations For further references as well as an idea about the current state of the discussion on
Keynes' treatment of expectations:
Jochen Runde and Sohei Mizuhara (eds.) The Philosophy of Keynes :F Economics, 1
I
London: Routledge, 2003. I

For section 5.3, the readings are:

Steven M. Sheffrin (I 983), Rational Expectations, Cambridge: Cambridge University I
Press, Chapter 1.
Paul.4. Samuelsonand Robert M. Solow (1960), "Analytical Aspects ofAnti-inflation
Policy," American Economic Review, 50(2), pp. 177-1 94.
Milton Friedrnan (1Q68), "The Role of Monetary Policy," Americun EconomicReview.
I
58(1), pp.1-17.
I

Robert E. Lucas, Jr. (1972), ccEconometric Testing of the Natural Rate Hypothesis,"
reprinted in Robert E. Lucas, Jr. (198 1) Studies in Business Cycle Theory, Oxford:
,
Basil Blackwell.

5.7 ANSWERSMINTS TO CHECKYOUR

PROGRESS EXERCISES I

Check Your Progress 1

1) Explain the formationof probability distribution through an example. In sub-section

5.2.1 we have given an example of tossing of a coin.

2) Go through sub-sections 5.2.5 and 5.2.6 and explain.

3) i) See sub-section 5.2.2.

ii) See sub-section 5.2.4.

Check Your Progress 2

I

1) Go through sub-section 5.3.1 and answer. Link your answer to the formation of
objective probability distribution of expectations. I

2) Bring out the point that in adaptive expectations we take into account past data
white in national expectationswe consider all available information.

3) Lender rational expectationseconomic policy is ineffective in bring out a trade-

off between unemployment and inflation and the prevailing rate of &mployment
in the long run hover around natural rate of unemployment. I
1
UNIT 6 POLICY-MAKING UNDER
UNCERTAINTY
Structure
6.0 Objectives
6.1 Introduction
6.2 The Lucas' Critiqueof Econometric Policy Evaluation
6.3 Significanceof the Lucas' Critique
. 6.3.1 Micro Foundations
6.2.2 Rational Expectations and Policy Rules
6.2.3 Some Qualifications
6.4 Rules versus Discretion
6.5 Let Us Sum lJp
6.6 Key Words
6.7 Some Useful Books
6.8 AnswerslHints to Check Your Progress Exercises

OBJECTIVES - -- -

After going through this Unit you should be in a position to:

explain the rationale behind Lucas' critique:
bring out the implications of Lucas' critique;
bxplain the significance of Lucas' critique; and
explain the need for microeconomic foundations of macroeconomic models.

6.1 INTRODUCTION
In most undergraduate courses in economics,the effect of governmentpolicy is studied
primarily as once-for-all changes in policy pammeters embeddedin hditional Keynesian
macsoeconomic models, like the IS-LM model. Since the 1970s, related to the
introduction and gradual acceptance of rational expectations as a hypothesis for the
formation of expectations, there has been increasing discussion about how the nature
of macroeconomic theory and macroeconomic models might facilitateor hinder proper
evaluation of alternative macroeconomic policies. A landmark in this discussion has
been Robert Lucas' criticism of traditional macroeconomic models as inadequate bases
for policy evaluation. Our discussion in this block therefore begins with the Lucas
critique in Section 6.2. Since the critique was addressed to the nature of traditional
macroeconomic theory, it had importantimplicationsfor rnacroemnomic methodology
- the way macroeconomic models should be constructed. The methodological
significance of the Lucas critique, its influence on the nature of macroec6nomic models
that were subsequently constructed, is considered in Section 6.3.

An important implication of the critique was that policy. should be evaluated not as
one-time changes in the vdae ofpolicy variables but as part ofpolicy rules which also
outline how future pcl~cywould be determined. T!>,-;L S b v i o u s costs associated
RationalExpectations with considering only rules-based-policy in terms of the failure to react to unfbreseen
eventualities or to correct for miscalculations already embodied in the rule. Despite
this additional arguments have been advanced in favour of adherence tcr polity rilles
and restriction of discretionary policy-making, U'c consider these arguments in sectiop4.
,
I

THE LUCASTCNITIQUE OF ECONOMETItIC

POLICY E.VALUATION 1
Keynes' General Theorywas the origin for the development of macroeconomics as a
branch of economics. Elowever, the teaching of macroeconomics as a subject, especially
in the United States, was based on a number of mathematical formalizations, which,
correctly or incorrectly, were widely perceived as containing the essence of Keynes'
economic doctrine. The simple Keynesian model, and the IS-I,M and AS-AD models
(see Block- I), provided the backbone of undergraduatemacroeconomictextbooks
for a very long period of time. These models also served as the basis for
r~lacroeconometricmodels, which were used in various countries to predict the impact
of alternativepolicies on targeted macroeconomic variables.' 7flloughKeynes himself
largelj disapproved of the use of suchnlodels h r policy evaluation. by the mid-1 960s
macroecenornicpolicies in most industrialized ewnomies utilized, in varying degrees,
such models for pollcy making.

In any macroeconomic model there are certain features of the econoiny which arc
assumed to remain constant. The whole coinplex of features that do not change is
called the economic struct~lreor simply,the stmct14reof the model.Nunierical constants
characterizing the structure are called structurulparumetcrs. Characteristicsof the
economy which are subject to change are the variables in the model and they can be
divided into two categories: endogeous and exogcnow fin,Iogenoals variables are
variables whose values are sought to be explained within the model whilc exogenous
va~lablesare those which can be assumed to be k n o w in ad\i:mce, being determined
outside the n~odel.

k t us consider the fi~llowingsimple model of income detemination for illuslration:

where c : aggregate real consumption expenditure, i : aggregate real investment

expenditure,y : real national income, and t : (real) revenue from direct taxes (less
government transfer payments) as a proportion of national income. Here u and b are I

positive constants (0 <a,h < I) which represent structural pararncters, c. and y are 1
endogenous variables and i and tare exogenous variables. In(6.2) M e can say that
(1--t)y is the personal disposable income.
I

The above is a deterministic model where the endogenous variables c and y are
entirely determined, given the values of the exogenous variables.-Since there are bvo
equations with two endogenous variables we can find out the equilibrium value of c I
and y. Thus, fiom (6.1) and (6.2) we get,
I

c ={a(l - t ) i + b } / { l- a ( ] - t)) .. . (6.4) IL

Probably the two most important tigures in the history of macroeconomstric modr%.-building
were the Dutch economist Jan Tinbergen and later, the American eco~~omist 1,awr~L;: Klein.
I Iowever, a deterministicmodel is usually used to isolatethe most important detmmmng
.. Policy-Making under
factors for the variables of interest; in this casey, and to represent the relationships Uncertainty
between the variables in the model in a simple and clear manner. These models therefore
are necessarily simplified representations of reality which do not take into account
ever?/factor which can affect the variables of interest. Therefore, economists accept
that deterministic equations (such as (6.2)) will not exacply describe the relationship
between endogenousvariables (such as c and y) and exogenous variables (such as i
and t) which is revealed by actual data.

The usual strategy, which is followed in order to relate deterministic economic models
to actual data, is to separatelyintroduce new variables invarious deterministic equations
of a modei. The new variable(s) corresponding to each equation is supposed to
encapsulatethe effats of all other factorswhich can affectthe exact relationshipbetween
\. ariables given by that kquation. 'The variables which are introduced are taken to be

random variables representing random disturbancesto the deterministicrelationship

between endogenous and exogenous variables in the model. Thus, the income-
determination model in (6.1X6.2) may be modified to

where u represents an additive disturbance term introduced into the exact relationship
given by (6.2). In contrast to ihe equation (6.2), which is deterministic,we call (6.2) a
stochastic equation as the stochastic or error term 'u' is added here. No disturbance
term is introduced in (6.1) because it is a definitional identity.

Equations (6.1) and (6.2') represent a very simple macroeconometric model, once the
variables are all dated (that is, it is specified whether these variables all correspond to
the same time period or whether lagged values of some variables should be taken) and
assumptions about the probability distribution of u are specified. Actual
macroeconometricmodels which are used for policy analysis in real economiesate, of
course, much larger, including many more variables and equations. For example, even
the classic macroeconometric model for the United States developed by L. R. Klein
and A. S. Goldberger in 1955,had twenty stochas~icequations,twenty endogenous
variables and 4ghteen exogenous variables.

In the simple income-determinationmodel we considered above, t is a policy variable.

If we assume that the random variable u is distributed with expected value 0, then fiom
(6.1) and (6.2') it follow$that the expected value ofy (given the values of i and t) is
given by

E(v) = (i + b)l{l - a(1- t))

In order to evaluate (assuming that i is known in advance) the impact of alternative
choices oft on the expected value of national income y in an economy, one needs to
obtain estimates for the structural parameters a and b for the economy. This can be
done through statisticallyestimatingthe parameters in the model (6.1H6.2') using
past d i k o n the variables in the model.

Broadly speaking, the statistical estimate of a gives us 'an estimate of the average
change in aggregate consuinptionexpenditure, which, in the past, has been associated
Gith a unit change in disposable income in the economy. Note that theories of
consumption like the life-cycle or the perrnanent-income theories (to be discussed in
Unit 7) imply that con,cumptionexpenditure in the economy depends not only on current
Rational Expectations disposable income but also on expected future levels of disposable income. Expected I
levels of disposable income depend in turn on expected future values of the variable
t . The way consumption expenditure reacts to changes in current tax rates and I

disposable income in a particular instance therefore depends crucially on how

expected values of tax rates and disposable income change in response to changes
in current values.
I
Therefore, the statistical estimate of a derived from data for a particular time period 1

tells us how consumptionexpenditure could be expected to change following a change

in tax rates and disposable income, but only in a context where current changes in tax
rates would have the same kind of impact on future expectations of tax rates as in the
period fiom which the data is taken.

Now, suppose that in the past the policy environment has been such that most tax rate
changes have been temporary in nature. Households, in this policy environment, will
have adjustedtheir expectations keeping in mind the nature of policy changes. Thus, in
the past, changes in current tax rates would have been interpreted by households as
implying little change in expected future tax rates and therefore little change in future
levels of disposable income. Hence, in such a policy environment, permanent incomes
of households and consumption expenditure in the economy would be weakly related
to changes in current tax rates and disposable income. The estimated value of a would
therefore be relatively small.

Suppose, however, the government now contemplates a more stable tax policy in
which changes in tax rates are to be of a more permanent nature. If households in the
economy understand this change in the policy environment, they will interpret any
change in current tax rates as having a significant implication for expected values of
future tax rates and disposable incomes.Any change in current tax rates will therefore
have a strong impact on the permanent incomes of households and on the level of
consumption expenditure in the economy. Hence, if policy makers use the statistical
estimate of a derived from past data they will underestimate the impact of tax policy
changes on consumption expenditure and income in the economy.

The problem with econometric policy evaluation of the above kind can be traced to
certain distinctive features which are also present in the above exercise. First, the
macroeconometric model used to evaluate policy [(6.1) and (6.2') in our example]
includes equations elating the behaviour of various aggregate variables. For example.
(6.2') relates -gate consumption expenditurein the economy to aggregatedisposable
income in the economy, Second, the actual behavioural relations between various
aggregate variables are the resultant of the multitude of decisions made by different
individual agents (households, f m s , etc.) in this economy. Thus, the actual relation
between aggregate consumptionexpenditure and disposable income in the economy
is the result of the consumption decisions made separately by different households.
Third, decisions made by individual economic agents are of an intertemporal nature.
That is, current decisions are made taking into account objectives and constraints
relating to future points in time. For example, in deciding on current consumption,
households might wish to considertrade-offs between current and future utility derived
from consumption and evaluate total consumptionpossibilities by taking account of
both current and future disposable income.

The relation between different aggregate variables will therefore depend on how
expected future values of variables change with current values. In particular, these
relations will depend on how expectationsabout future values of policy variables are
 affected by changes in current values of policy variables. Suppose the same change in Policy-Making under
the current value of a policy variable can induce, at two different points in time, different Uncertainty

effects on expectations of private economic actors about future values of the policy
variable.Then, the behavioural relations includingthe policy variable and other -gate
variables could be different at different points in time.

The implication is that the parametersof the behavioural equationswhich are assumed
to be unchanging over time in amacroeconometricmodel, forming a part of the structure
of the model, actually cannot be considered to be so. This, in essence, is Lucas' critique
of the use of macroeconometric models for policy evaluation.

L R US
~ illustratethe Lucas' critiquethrough our discussionofthe inflation-unemployment
trade-off in the previous unit. So long as the government does not attempt to manage
the level of nominal demand in the economy, workers accept that fluctuationsin growth
rates of nominal expenditure in the economy due to government policy arerandom in
- nature (not implying any systematiceffort on the part of the government to control the
level of demand) and continue to expect the same average growth rate of nominal
expendituresas in the past. Therefore, they have fixed expected rates of inflation and
the histoiical datarelating fluctuationsin ~nernplo~pent to actual fluctuationsin the rate .
of inflationtraces out a Phillips curve.

If workers now believe that there is a change in the policy regime and that the government
seeks to systematically exploit this trade-off by targeting a level of unemployment
lower than the natural rate, workers would expect a higher growth rate of nominal
expenditure and a higher rate of inflation in the future.Consequently, if the government
now tries to evalwte the effects of a higher rate of inflation on unemployment on the
basis of the Phillipscurve estimated h m past data, the government would overestimate
the effect of this policy on unemployment. This is because the rate of inflation expected
by workers would be higher than that in the previous policy regime.

Check Your Progress 1

I) Give an example of a simple stochastic macro econometric model.

2) What is the main criticism of macroeconometric models by Lucas?

Rational ~ x k t a t i o n s
6.3 SIGNIFICANCEOF THE LUCAS' CRITIQUE ~I
The developmentofmameqnomic theorysince the 1970swas significantly influenced
by the Lucas critique. This critique implies that we cannot apply econometricsusing'
macroeconomic models, which directly assumed certainbehavioural relations between
macroeconomic variables, in order to check the effects of alternative policies. The
basic problem lies in the fact that the parameters in these behavioural equationscannot
be assumed to be invariant with respect to policy if there are changes in the policy
environment as a whole. This is, in turn, because the reaction of individual economic
agents to policy changes usually differs under different pplicy environments orpolicy
regimes.

6.3.1 Micro Foundations

The Lucas critique implies that in order to correctly evaluate policies it is necessary
in macroeconomic models to take into account how differences in the policy regime
influence individual reactions to a particular policy. This can only be done if
macroeconomic models make explicit assumptions about how individual economic
agents make their decisions (including how current and future government policies
enter into their decision-making processes), how their expectations about the future
(including future government policies) are formed and how individual agents interact
in the economy to determine the values of macroeconomic variables. Any relation
between aggregate variables in the model must be derived from these
microeconomic assumptions. In other words, the Lucas critique implies that every
macroeconomic model must be endowed with microfoundations. Many of the
macroeconomic models that we will consider in the remainder of this course have
explicit rnicrofoundations.

There is another rationale for including micro foundations. Traditional

macrneconomic models such as the IS-LM model contain various behavioural
.relations such as the aggregate consumption function, the investment function and
the demand-for-money function. However, economists who used these models
have tried to justify the assumed behavioural relations between macroeconomic
variables in terms of inicroeconomic behaviour. For example, in the 1950s,William
Baumol and James Tobin tried to explain the form of the Keynesian demand-for-
money function by building models explaining the demand for transactionsbalances
in an economy and James Tobin tried to do the same by modeling the demand for
speculative balances in an e ~ o n o m y . ~

Thus, any traditional macroeconomic model can also be thought of as im~licitly

making a set of microeconomic assumptions. However, various behavioural
equations in a model (each probably justified independently by various economists
at various points in time) are not derived explicitly from exactly the same set of
assumptions about the microeconomic structure of the economy. The consistency
of these implicit microeconomic assumptions and of the behavioural relations in
the model, can therefore only be considered at a fairly superficial level. If one
desires a stricter check on the consistency of the assumptions in a macroeconomic

William J. Baumol(1952)"The Transaction Demand for Cash: An Inventory TheoreticApproach,"

Quarterly Journal ofEconomics, v.66, pp.545-66; James Tobin (1956)"The Interest-Elasticity
of the Transactions Demand for Cash," Review of Economics andStatistics, v.38, pp.241-47;
James 'robin (1958)"Liquidity Preference as Behavior Towards Risk," Review of Economic
Studies, v.25, pp.65-86.
model it becomes necessary to explicitly derive the behavioural equations in the Policy-Making under
model from the same set of assumptions about the microeconomic structure of the Uncertainty ,

economy. This would involve endowing all macroeconomic models with explicit
microfoundations.

6.3.2 Rational Expectations and Policy Rules

Supposewe have a macroeconomicmodel endowed with microfoundations. We know
that any plausible set of microfoundations must incorporate the fact that individual
economicagents make decisions basednot only on the current values ofpolicy variables
but also on expected future values of these variables. In order to predict the effect of
choosing a particular current value of a policy variable it is necessary to specifyhow
such a choice would affect expected futurevalues of the variable.

We have already discussed how, in order to reduce the dependence of economic

predictions on the subjectivejudgment of the policy maker, macroeconomic models
usually assume thateconomic agents have rational expectations. Rational expectations,
however, imply that there is an objectiveprobability distributionassociated with future
values of the policy variable, with at least the expected values of such distributions
being known.

Therefore, in order to evaluate policy using such a macromodel, the policy maker
himself must know the objectively expected value for the future value of the policy
variable. This implies that the policy maker himself must know the specific values of
the policy variable which will be targeted by policy under various circumstances in the
future. Therefore, in order to evaluate the effects of choosing a particular policy in the
current period, the policy maker must already have apolicy rule in mind. Thus, in
models endowed with microfoundations and assuming rational expectations, it is not
possible to evaluate the effects of a particular current policy but it is only possible to
evaluate the effects of a particular current policy as part of a particular policy rule.

For example, in such a model it will not be possible to evaluate the effect of a particular
rate of growth of money supply in the currentperiod. It will only be possible to evaluate
the effect of choosing, for example, arule that stipulates a particular constant rate of
growth of money supply in the current and in all relevant futureperiods, or a rule that
stipulatesa particular time path for money supply over a time horizon encompassing
the present and all relevant future time periods, or a rule which makes the rate of
growth of money supply a function of the rate of inflation and the rateof unemployment
in the previous period.

6.3.3 Some Qualifications

The requirement of microfoundations clearly imposes additional restrictions on
macroeconomic models. Only those sets of behavioural equations between aggregate
variables can be postulated for which every member of the set is derivable from the
same assumptions about the microeconomic structure of the economy. This suggests
that the set of models whichcan be constructed with microfoundationsat any given
point in time is dependent to a greater degree on the boundaries of mathematical
knowledge possessed by economists at that point in time. Since the tractability of
macroeconomic models - the ease with which assumptions in a model can be
manipulated to logically yield interestingimplications- is also adesirable feature, it
follows thatthere will be significant restrictions on the nature of microfoundationswith
which macroeconomic models can be endowed zit any given point in time.
Rational Expectations A possible coilsy uence of the above limitation is thateconomistsmight be c o d i e d in I1
their analysis to models with microeconomic structures far removed from reality. Note
thatthe possible policy alternativeswhich can be suggested by amodel and an evaluation
of the effects of these policies will be entirely determined by the model's microeconomic
structure. Therefore, even if such models successfully mimic the working of the real
economy over a period of time in the past, the policy conclusions of the model might
be seriously misleading for the real economy in the future. This implies that, while
macroeconomicmode@ withmicrofoundationsmay be a worthwhile endeavour,one
must always be alert to the possibility that in simplifjmg reality, microfoundatiorsmay
also distort reality to ah unacceptable degree.

Moreover, while macroeconomic models equipped with microfoundations might

perform better in time periods involving a change in policy regime, within a particular
policy regime there is no reason why they should perform better. Also, if individual
economic agents find it costly to gather and process information about changes in
policy regime or to make changes in decision making procedures, then they might
resort to using 'rules ofthumb' or procedures which are approximately satisfactory for
a large range of policy regimes instead of procedures which are designed optimally for
single policy regimes. In this case, unless changes in policy regimes are distirict in
nature, economic agentsmight ignore the impact of such changes on the relation between
current policy and expected future policy. The Lucas critique would in such
circumstances lose much of its significance.

6.4 RULES VERSUS DISCRETION

We saw earlier that in models endowed with microfoundations and assuming rational
expectations on the part of economic agents, choice amongst alternativepolicies took
the form of choice amongst alternative policy rules. However, such rules could also
take the form of choosing, at any given instant oftime, apolicy which is best according
to some well-defined criterion at that instant of time. What is required is that future
policy intentions be ~ ~ c i e n tunambiguous
ly so that policy makers themselves can
correctly gauge the (rational) expectationsof private economic actors (households,
business fitms) about future policy.

For example, suppose that a government in its choice of current and future policy is
entirely governed by what would be the effect of such policies on its electoral prospects
at the next general elections, subject to the constraint that as a result of these policies
it should not be forced out of office in the intervening years. Moreover, suppose it is
clear to the public which sequences ofpolicies the government feels would best serve
this purpose under alternative sequencesof relevant events in the intervening years. In
that case, private economic actors would rationally expect the government, depending
on the unfolding sequence of events, to follow the corresponding sequence of policies.
If there is an objectiveprobability distribution associated with the possible sequences
of relevant events, private economic agents would have an objective probability
distribution associated with the future sequence of policies.

First note that every sequence of events relevant for government action cannot be
anticipatedin advance. Therefore, in defining apolicy rule one necessarily rules out the
possibility of discretionary government action in the case of events, which are completely
unanticipated. Revision of policy rules within the time period for which they are
announced is a difficult matter because policy rules must be credible. The expectations
of private economic agents about future policy will be in accordance with the policy
rule announced by policy makers only if they believe that in the future the government
wil I stick to this rule. Therefore, the greater the deviation kom rules that a government Policy-Making under
displays in undertaking discretionary action even in circumstances where intervention Uncertainty
is unanimously demanded, the 1csswill be the credibility of policy rules announced by
the government in the future. Thus, even when faced with unanticipated eventualities
requiring policy intervention or even after realizing that announced policy rules were
h e d under certain mistaken assumptions, governments might be reluctant to revise
announced policy rules.

Note also that in order for an objective probability distributionto be associated by the
public with the possible sequence of relevant events and to know the desired policy
sequences corresponding to alternative sequences of relevant events, these alternative
sequencesmust be definable simply (not using too many characteristics)and precisely.
The possibility of government policies being designed very specifically according to
circumstances or according to qualitativejudgments about the economy is therefore
also eliminated if policy rules have to be followed.

While the inflexibilityimposed by the use of policy rules has obvious costs, some
ecor~omistshave argued that this inflexibility might have advantages as well. Milton
Friedman has been the most noted proponent of this view. In Friedman's opinion,
allowing governments flexibility in reacting to current circumstances is eounterprodhctive
because governments often abuse this discretion by framing policy for narrow short-
term political gains. oreo over, policy makers are tempted to fine tune the economy,
reacting to every short-term or small disturbance. This may be costly when there are
substantialtime lags between the recognition ofthe need for intervention and its ultimate
impact on the economy and when here is substantialuncertaintyas ~ g a r dthe s magnitude
and tinling of the impacts of various alkmative policies. Time lags may arise,for example,
froin the time required to draw up an appropriate policy, the time required to obtain
executive and legislative approval for the policy or the time required to adjust the
dninistrative mechanism for implementation of the new policy. Giventhe uncertainty
surrounding the effects of policies, Friedman suggeststhat discretionarypolicy actions
might themselves become the source of m d o m disturbances in the economy.

The credibility of an announced policy rule dependsnot only on past experience regardug
a government's ability to adhere to commitments but also on a rational evaluation
about the future possibility of a government adhering to a policy rule. From this
perspective, governments like private agents in the economy have objectives, which
they aim to achieve through policy actions. Suppose we define a policy rule to be
time-consistent or dynumically consistent if at every instant over a given time-horizon
the policy chosen under the rule is optimal for the remaining part of the time-horizon,
taking as given the policie&at have been chosen before that instant and assuming that
at every fi~tureinstant, policy will be similarly optimally chosen. Ifgovernments have
the discretion to change policy at future points in time then an announced policy rule
will not be cr$ible unless it issirneeamistent.If a policy rule is not time-consistent, at
some pint in time it will nbt be optimal forthe government to follow the policy dictated
by the rule. The government will then benefit by deviating from the rule at that point in
time.

A problem might arise because the policy rule which is optimal over the entire time
horizon may not be timeconsistent. This possibility was initially raised by Finn Kydland
and Edward Prescott in a research paper published in 1977. In a celebrated example,
Kydland and Prescott illustrate their argument by consideringthe case of policy designed
to safeguard against flood hazards. Suppose the socially desirable outcome is not to
have houses built in a flood-prone area but, if there already exist settlements there, to
Rational Expectations undertake certain costly flood-control measures involving the building of dams and 1
embankments. Ifthe government announcedthat it would never undertake flood control
measures in a currently uninhabited flood-prone area and if private agents believed
thatthe government would adhere to this policy rule then nobody would erect buildings
in that area However, the rational agent will not find this policy rule credible because
he knows that once he and others construct buildings in that area, the government w i11
find it optimal to take flood-control measures. Therefore, society will be forced to I

accept a sub-optimal outcome under which private agents erect buildings in the flood-
prone area and the government then steps in to build dams and embankments.

If we rule out the possibility of enactinga law to prevent the constructionof buildings
in the flood-prone area, then the only way that the government can make the policy
rule (that it is not going to ever undertake any flood-control measures in a currently
uninhabited flood-prone area) credible is to somehow bind itself to the implementation
of such a policy rule over time. The government must be able to convince that it is not
going to be able to pursue policies in the future which will be optimal for it to pursue at
futurepoints in time. Thus, accordingto this view, not only might policy rules allow for
more optimal outcomes than discretionary policy choices over time, the possibility of
using discretion in policy making must itselfbe restricted if optimal policy rules are to
be made credible.

An obvious way by which the government can commit to a particular policy rule is to
enact legislation making it costly to deviate from the rule in the future. However, it
might be cliflicultand timeansuming to amend this legislationifthere a r i s unanticipated
eventualitieswhich urgently require deviationh m the rule or if it is found that important
assumptions made in framing the rule are erroneous.An alternative way by which an
optimal policy rule may be made credible without losing the flexibilityfor using discretion
in emergencies is for the government to delegate responsibility for this policy to sonle
autonimousagency which the public perceives as having a different objective function.
Thus, often governments make monetary policy a responsibility of an independent
central bank, the idea being that a monetary policy rule aimed at lower inflation would
be more credible if it is executed by financiers known to be averse to inflation rather
than by politicians.

Ofcourse, some politicians or political parties might have longer time horizons over
which they wish to attain their objectives compared to others. In this case, they might
build up a reputation while in government for following policy rules. While initially
these politicians or parties might have to incur certain costs (people who build houses
expectingthe government to take floodcontrol measures might find their houses washed
away by floods), in the long run they might be able to benefit from being able to
enforce the socially desirable outcome (thepublic might begin to find the government's I
claim of never taking floodcontrol measures in currently uninhabited flood-coiltrol
areas credible and stop such building).

Check Your Progress 2

1) How does discretionresults in sub-optimal outcomes of apolicy even ifa time-

consistent policy is followed?
 ........................................................................................................................... Policy-Making under
Uncertainty

2) What is the rationale of including microfoundationsin policy making?

6.5 LET US SUM UP

In this Unit we discussed the issue of policy formulationgiven the uncertain nature of
~ u r economic
e environm&t. In most cases we resort to rnarroeconotnic model buildmg
on the basis of past data. Such models, however, implicitly assume that the past trend
is likely to continue in future also. When the economy is in transition or past policies
were ad hoc in nature then the estimates of macro econometric models may not give
reliable outcomes. Robert Lucas pointed out the limitations ofmacro econometric
model building which is known as Lucas' critique.

Another issuethat we discussedin this unit is the ~levanceof micmeconomic foundations

for macroeconomic models. We explained the concept of microeconomic foundation
through Keynesian consumptionfunction. Moreover,the role of rational expectations
should be taken into account while interpreting macroeconomic models.

In p~acticepolicy formulation needs to be based on certain rules or procedures.

However, there is a need for revision of policy rulesagainst unanticipated developments
which may be t i m e - w g and costly. In orderto tackle such eventualitiesthe government
can delegate the responsibility to some autonomousbody. The possibility of following
a sub-optimal policy over time cannot be ruled out.

6.6 KEYWORDS
Endogenous Variable The variables determined within the system
of equations.
Exogenous Variable The variables given from outside the model.
Microfoundations The procedure where macro-behaviour of a
model is based on micro-behaviour.
permanent Income That part of the current income that is
expected to remgn stable over the long run.
Rational Expectations The hypothesis that expectationsof people
i on the whole is unbiased.
Rational Expectations
6.7 SOME USEFUL BOOKS
The classic reference for Section 6.2 is the original paper by Lucas:
Robert E. Lucas, Jr. (1976) "Econometric Policy Evaluation: A Critique," in Karl
Brunner and Allan H. Meltzer (eds) 771ePhillips Curve and Labor Murkets, Camegie-
Rochester Conference Series on Public Policy, Vol. 1. Amsterdam: North-Holland.
Reprinted in Robert E. Lucas, Jr. (1 98 1) Studies in Business Cjrle Theory, Oxford:
Basil Blackwell, pp. 104-1 30.
See also Thomas J. Sargent (1980) "Rational Expectationsand the Reconstruction of
Macroeconomics," Federal Reserve Bank of Minneapolis Quarterly Review,
4(Summer). Reprinted in Preston J. Miller (ed.) The Rational Expectations ,
Revolution :Readingsj-om the Front Line, Cambridge, Mass.: The MIT Press,
pp.3 1-39.
An important reference for Section 6.3 is:
Robert E. Lucas, Jr. (1980) "Methods and Problems in Business Cycle Theory,"
Journal of Monej: Credit and Banking, 12(4, part 2). Reprinted in Robert E. Lucas,
Jr. (198 1) Studies in Business Cycle Theory. Oxford: Basil Blackwell, pp.27 1-296.
See also the discussion of Lucas' paper by Edwin Burmeister and James Tobin in the
same issue of Journal of Money, Credit and Banking and Sargent's paper cited
above.
A critical overview of the endeavour to introduce microfoundations is provided by:
Kevin D. Hoover (2001) The Methodology of Empirical Macroeconomics,
Cambridge: Cambridge University Press, Chapter 3.
For Section 6.4, refer to:
Milton Friedman (1948) "A Monetary and Fiscal Framework for Economic
Stabilization," American Economic Review, 38, pp.24544.
F. E. Kydland and E. C. Prescott (1977) "Rules Rather than Discretion: The
Inconsistency of Optimal Plans," Journal ofPolitica1 Economy, 85(3), pp.473-92.
David Romer (1996) Advbnced Macroeconomics, Singapore: McGraw-Hill,
t
Chapter 9.
6.8 ANSWERSIHINTS TO CHECKYOUR
PROGRESS EXERCISES

Check Your Progress 1 I

'
1) We have presented the simple model of income determination in section 6.2.
Think of another example. 1
2) ; Go through section 6.2, particularly pages 26 and 27.

Checkyour Progress 2

1) Go through section 6.4 and answer.

2) See sub-section 6.3.1 and aqswer.

1
 UNIT 7 CONSUMPTION AND ASSET PRICES
Structure
7.0 Objectives
7.1 Introduction
7.2 as Intertemporal Choice
~onsurn~tioh
,k
7.2.1 Life Cycle Hypothesis
72.2 Permanent Income Hypothesis
7.3 Consumption under Uncertainty: Random Walk Hypothesis
7.4 Consumption and RiskyAssets: Capital-AssetPricing Model
7.5 LetUsSumUp
7.6 Key Words
7.7 Some Useful Books
7.8 AnswerIHints to Check Your Progress Exercises

7.0 OBJECTIVES
M e r going through this Unit you should be able to explain
e the Fisherian idea of consumption as an outcome of households' intertemporal
choices;
the Life-cycle hypothesis of Modigliani and Brumbergand the PermanentIncome
hypothesis of Friedman;
e the Random Walk Hypothesis of Hall; and
e the asset price determination through the Consumption Asset Pricing Model
(CAPM).

7.1 INTRODUCTION
In Economics,there exist close links between the c w n t economic variablesand their
past and future values. As you have seen in Block 2 (on Economic Growth), past state
often determines the current state, just as the current state determines the future. But
there is also a link from future to the present. Future of course is often unknown.
However,expectations about futurevariables sometimesinfluence the current economic
decisions. In other words, the decision making process of an economic agent is often
'inter-temporal' in nature -involvingdifferent periods of time. Consumption and
savings are two prime examplesof such inter-temporal decision making.

How does a household decide upon how much to consumetoday and how much to
save? Keynes identified current incomeas the prime detembntof c m t consumption.
In its simplest form, a Keynesian consumption function can be represented by the
following linear equation:

C, = C + C I ; , ~ ? ~ O
O<c<I:,
, ...(7.1)

d e r e C, is current eonsumption and I; is current income. Notice that one important

Intertemporal
Decision-Making f m of this consumption function is that the uveragepmpmi~to consume (C, 1 )
falls as income rises.

Early empirical studies using cross-sectionalhousehold data found evidencein support

of decreasing average propensity to consume: it was found that richer households
(with higher Y,) indeed consumed a lower fixtion of their income. However, in 1940s
Simon Kuznets using long run time series data on aggregate consumption and income
found that the average propensity to consume remained more or less constant, even
though aggregate income increased substantially over the period under consideration.
This apparent puzzle led to the development of a number of theories ofhouseholds'
consumptionbehaviour, all of which focus on the intertemporal nature of consumption
expenditure. The following section discusses some of the important theories from this
literature.

7.2 CONSUMPTION AS INTERTEMPORALCHOICE

One of the earliest works that depicts households' consumption expenditure as an
outcome of households' intertemporaloptimization exercise is that of Irving Fisher
(1 930). The Fisherian idea can be easily explained in terms of a two period model of
consumeroptimization. Let us assumethat each member of a household lives for exactly
two periods1 and let C, and C, denote his consumption during the first and the second
period o k i s life respectively. The person derives utility h m both period's consumption
and his preferences are represented by the utility function U(C,,C 2 ). Let 1E; and Y,
be the income ofthe individual in the two periods respectively. Out of his first period
income, the person consumes C,and saves the rest ( S, = Y, - C ,) to earn an interest
income (1+ r)Sl in the next period. In Fisher's model, the only purpose of savings is
future consumption. Accordingly, consumption during second period is equal to
C2= Y, + (1 + r ) S , .

C =-
By re-arranging the terms in C, = Y2 + (1 + r)S,, we fmd that y2 + S, .
l+r l+r
c.2 1 2
Since S, = Y, - C ,, we have -C2 = L + (o Y r C l +;
- =-
~c+-.,)
l + r l+r l+r l+r
Thus the intertemporal budget constrain is given by I

The left hand side ofthe intertemporal budget constraint denotes the present discounted
value of the total consumption expenditure of the person, while the right hand side
measures the present discounted value of his total life-time income (p).The person
decides on the levels of C, and C2 by maximizing his utility U(C,, C 2 )subject to his
intertemporal budget constraint. Notice that the optimization exercise of the household
defines the current consumption as a function of the present discounted value of life
time income ( f ) as well as the rate of interest (r) on saving 2.
The time periods can be broadly defined so that the first time period covers his entire youth
and the second one covers his entire old age.
Strictly speaking, the rate of interest q is the 'expected' future rate of interest (which is expected
to prevail in period 2). We are assuming here that future is certain and known.
 h Fig. 7.1 we depict the optimal consumption choices. We measure C2on x-axis and Consumption and
C, on y-axis. The intertempora! budget constraint intersects the x-axis at Asset Prices

point (1 + r)Y, + Y, because when C,=0 in (7.2)we have C, = (1+ r)q + q .Similarly,
y
2
we find that C, = Y, +- when C, = 0.
l+r

Fig. 7.1: Intertermporal Utility Maximisation

It is now easy to analyze the impact of a change in current income ( Y,) on current
consumption ( C,). Under the assumption that consumption in both periods are normal
goods (i.e., associated with positive income effects), an increase in current income,
ceterisparibus, increases the life-time income and hence both C, and C, will increase.

The impact of a change in the intaest mte (r) on current consumption is more ambiguous.
Note that an increase in r implies a decline in the relative price offutureconsumption in
terms of current cons~mption.~ Such a change in the relative price is typically associated
with two effects: (i) an income efect, which in this case will lead to an increase in
consumption in both the periods (sincea decline in the price level implies the choice set
of the consumer becomes broader), and (ii) a substitution efect, which in this case
will lead to a fall in current consumption (since a decline in the relative price of future
consumption implies that people will substitute current consumption by fiture
consumption). The overall effect on an increase in r on current consumption depends
on the relative strength of the two effects. In ceterisparibus an increase in r leads to
an increase in C, if the income effect dominates the substitution effect; on the other
hand, an increase in r leads to a decrease in C, if the substitution effect dominatesthe
income effect. In this context also note thatin so far as S, = Y, - C,,an increase in the
rate of interest would also imply higher or lower savings depending on the relative
sttength ofthe income and the substitutioneffect.

This Fisherian view of looking at consumption as an outcome of an intertemporal

optimization exercise on the part of the households came to play a key role in the

' This is because for the same amount of current consumption foregone (in the form of savings),
one will now get higher amount of future consumption.
Intertemporat development of the subsequent influential theories of consumption, which are: (a) the
Decision-Making lye-cycle hypothesis of Modigliani and Brumberg (1954), and (b) the permanent
income hypothesis of Friedman (1957). Both these theories attempt to explain the
empirically observed discrepancy between the cross-sectional and time series evidence
on the relationship between the average propensity to consume and the income level.

7.2.1 Life Cycle Hypothesis

To explain the life-cycle and permanent income hypotheses, let us extend the two
period model that we have just discussed.to a T-period model where each person
lives for Tperiods (where T 2 2 ). The utility function of the representative member
of the household is again given by U(C,,C, ,C, ,........, C, ) .For expositionalsimplicity
let us assume an additive utility fimction of the form:

U(C,,C,,C, ,........,C,) =u(C,)+u(C,)+ ........ + u ( C , . ) = C u ( c 1 ) . (7.3)

The utilityhction (7.3) is well behaved in the sense that mar@ utility is positive (in
symbols uf > 0)and increases at a decreasing rate (implies that the second derivative
is negative, u" < 0 ).For simplicity let us also assume that the rate of interest is zero4
so that the intertemporal budget constraint of the household now becomes:

where Y,,Y, ,,......,Y,. are the incomes ofthe household in periods 1,2,. ....,Trespectively
and A, is the amount of initial level of wealth stock of this household. Maximization of
utility subject to the intertemporalbudget constraint will yield aLagrangianfunction of
the form:

where 2 is the associated Lagrangian multiplier. First order conditions for

optimization yield:

ur(C,) = R for t = 1,2,.. ..,T ,where ur(Cl) is the marginal utility in period r.

The above condition implies that ur(CI)= u1(C2)= *..a. = ur(C,.) = A , and
therefore C, = C, =...... = CT. Hence h m the intertemporal budget constraint (7.4)
we obtain

I
q a v i n g a positive rate of interest will not have any effect on the subsequent analysis.
 The term )?rithinthe parenthesis in the right hand side of (7.6) is the average value of the Consumption and
total life-time income of the individual. The optimization exercise indicates that Asset Prices
consumption in any period is determined the individual's total life-time income. Let us
denote the latter by f . Then consumptionat any point of timet is equal to (A, + f ) /T .
This phenomenon, whereby the individual divides his total life-time resources equally
among each period and consumption at different points of time are spread evenly over
the entire time horizon is called consumption smoothing.

At any particular point of time t, the actual income ofthat period Y, may exceed or fall
short of the average life-time income ( f / T ). Givcn initial wealth, since current
consumption depends only on the average life-time income, therefore any change in
current income will have an effect on current consumption only to the extent that it
impacts upon the average lre-time income. To be more precise, suppose at some
time period, say 1 = 'j , current income rises by an amount Zfor some reason. The
corresponding increase in average life-time income is equal to z / T and as a result,
consumption at period t = increases only by the amount z / T . By the same token,
if the current income at some period rises by an amount Z and the income at some
subsequent period falls by the same amount, so that the average life-time income remains
unchanged, then current consumption does not change in any period.

Notice that while changes in current income have limited impact on the consumption of
that period, current income plays a crucial role in determination of current savings.
Recall that savings at any time period t is defined as S, = Y, - C,.

1 A,
By using the result obtained at (7.6) we get st = *[&?]-, . ..(7.7)
,=I

An interpretation of (7.7) is that savings is high when current income is high relative to
the average life-time income. It is this idea which forms the basis of Modigliani-
Brumberg's life-cycle hypothesis.

1 According to Modigliani and Brumberg, income varies systematically over the life-
\ time of an individual and savings allow people to smoothen consumption over their
life-time, even when incomes in different periods are not equal. In other words, people
maintain an even stream of consumption over their life-time by saving more during high
income periods and saving less during the low income periods.
E
The life-cycle hypothesis postulates that an individual typically has an income stream
which is low during the beginning and towards the end of one's life, and high during the
middle years of one's life. This is because productivity of a person is typically low
during the early and the late years of his life, and productivityis at the peak during the
middle years. On the other hand, consumption at every period remains the same at

of the individual is represented by Fig. 7.2. We observe from Fig.7.2, that during the
early periods of one's life, an individual dissaves (by running down his initial wealth,
1
and/or by borrowing); he saves during the middle periods of his life and dissaves again
during the later years by running down his accumulated wealth.

i
I
)
'2
 Fig. 7.2: ConsumptionStream over Lifetime

Given that consumptionand savings are postulated to behave in this manner over the
life-cycleof a person, it is now easy to see how this hypothesiscan explain the apparent
disparity between cross-sectional and aggregate time series data on consumption
behaviour. Whenone is looking at the cross-sectional data for a particular point of
time, it is likely that in arandomlyselected sample of households(which are classified
according to income), the high income category will contain a higher-than-average
proportion of people belonging to middle phaw oftheir life cycle, and the low income
category will contain a higher-than-average proportion of people belonging to either
the early or the late phases of their life. Since during the middle phaseypeople have a
higher average propensity to save (i.e., a higher S, / Y, ratio) and correspondingly a
lower average propensity to consume (i.e., a lower C, / Y, ratio), the cross-sectional
datawillreflecta lower propensity to consume for the high incomecategory compared
to the low income category.

=-+-(A51
T T ,=I
~t~~ohtitinim~rtantton~teherethat~urrent~~m~tion~~
41
depends not only on the life-time income of the individual, but also on the initial stock

/ Ct( ~ o n Run)
g

Fig. 73: Short run and Long run Consumption

 Consumption and
of asset A,. In the short run (or at any particular point of time) the asset stock remains Asset Prices
constant, In Fig. 7.3 we diagrammatically depict the above relationship betweenC,
and Y, . We measure C, along the vertical axis and along the horizontal axis. We get
an upward sloping line (slope less thanunity) with apositive intercept, as sho& in Fig.
7.3. However, when we are looking at the time series data where income is increasing
over a long period of time, then the stock ofasset (which is positively correlated to the
level of income) id also increasing. Thus the intercept term on the line will keep on
increasing. In other words, the short run C, line will keep shifting upward over time
(see the dotted line in Fig. 7.3). Hence if we are examining the long run consumption
data to determine the long run relationship between C, and Y, , we will observe points
like A, B, C along successive short run consumption lines. In other words, the long run
consumption f i c t i o n will be steeper, where C, is proportional to Y,,as shown in Fig.
7.3. Note that along the long run consumption line, the average propensity to consume
( C, / Y,) remains constant.

7.2.2 Permanent Income Hypothesis

Friedman's permanent income hypothesis provides an alternativeexplanation to the
apparent discrepancy between cross-sectional and time series data on consumption.
The peimanent income hypothesisis also foundedon the Fisherian theory of consumption
as an intertemporal choice. However, unlike the life-cycle hypothesis, Friedrnan does
not postulate that income follow a regular pattern over the life cycle of an individual; he
instead argues that individualsexperience mndom and temporary changes in their income
fiom time to time. Accordingly, Friedman views the current income in any period ( Y, )
as consisting of two components: permanent income (Y,")and transitory income
(Y,"). Permanent income is that part of the income which we expect to prevail over
the long run. Friedman interprets this as the long nm average income of the individual,

. Transitory income is any random deviation fmm this average,

. Ap~iitivebansitory income implies that the current i n m e

exceeds the permanent income; a negative transitory income implies that the current
A 1
income is less than the permanent income. Since (; = + -
T T ,=I T
i.e., current consumption of the household depends only on the permanent income,
m y increase in the transitory part of the current income, which leaves the permanent
income unchanged, will have no impact on the lcvel ofcurrent consumption.

Let us now sce how Friedman's permanent income hypothesis solves the apparent
puzzle in the consumption data. According to Friedman's hypothesis, the average
propensity to consume ( C, / Y, ) depends on the ratio of permanent to current income
Y,"/ Y, . Thus when current income temporarily rises above the permanentincome the
average propensity to consume falls; the opposite happens when current income
Intertemporal temporarily falls below the permanent income. Now when we are looking at cross-
Decision-Making sectional data of different households at any point of time, typically the high income
group will contain some people with a high transitory income, who will have a lower
propensity to consume than the average. Similarly the low income group will contain
some people with a low m i t o r y income, who will have a higher propensity to consume
than the average. As a result, we will observe a falling average propensity to consume
as we move fiom the lower to the higher income group. On the other hand, when we
are considering long run time series data, the random fluctuationstend to even out so
that any increase in income in the log run reflects a permanent increase in the average
income level. Hence in the log run time series data we are likely to observe a constant
average propensity to consume.

CheekYourProgress 1

1) Explain the Fisherian idea of consumption as an intertemporal choice. What

the impact of a change in income and a change in the interest rate on current
consumption?

2) What is the puule in the consumption data that has been identified by Kuznets?
How do the Life-cycle hypothesis and permanent income hypothesis solve this
puzzle?
 Consumption and
7.3 CONSUMPTION UNDER UNCERTAI[NT'V: Asset Prices
RANDOM WALK HYPOTHESIS
In our discussion so far we have assumed that people know their average life-time
income (or the permanent part of the income) with certainty. What happens if there is
some degree of uncertainty with the permanent income as well? Obviously. in the
presence of uncertainty, people's expectation about the fiiture becomes important.
We can extend the logic of the permanent income hypothesis to argue that in the
presence of uncertainty, individuals maximize their expectedutility subject to the
constraint that the sum of total expectedconsurnptioncannot exceed the total value of
the expcctedlife-time income. In other words, the objective fimction of aconswner is
now given by

which he maximizes subject to ihe constraint

Note that since Future is uncertain, the expectation of people about future comes to
play an importantrole, and therefore how people fornl their expectation also becomes
important for the decision making process. You have earlier been introduced to the
rational expectation hypothesis in Block-3. Accordingto the rational expectationstheory
theoutcomes do not differ systematically from what people expected them to be;. The
extension ofthe permanent income hypothesis in the presence of uncertainty combined
with the assumption of rational expectation led to the theory of 'random walk
consunlption", as expounded by Robert Hall (1978).

Hall argued that if individual's consumption indeed depended on their expected average
life-time income, and if people had rational expectations, then changes in consumption
over time will be unpredictable, i.e., consumption will follow a 'random walk7.The
intuition behind this result is simple: if the life-time income is expected to change at
some future point of time and people have this information, then they will use this
information optimally (under rational expectation)and hill therefore immediately adjust
their consumption over differenttime periods (consumption smoothing)so that current
consumption would not change at the time when the actual income changes. Current
consumption can change only ifthere are surprises in the life-time income, which were
not anticipated. To put it differently, current consumption can only change due to events
which are unpredictable and as a result changes in consumption would also be
unpredictable.

Theoretically it is easy to see how this hypothesis follows fiom the above formulation
of individual's maximization problem, As we saw in (7.6) and (7.7) the individual

maximizes
7'

I=I
E[u(cl 11 subject to x
7'

r=l
E(Cl ) = 4 +
7'

I =I
Since the individual is

taking his decision at time t= 1, under rational expectations, all his expectations are
based on the information available at period 1. An optimizing agent will equate his
expected (as of period 1) marginal utilities in different periods. Now in period 1,
consumptionin period 1 is a certain event; hence E, [u' (C,)I = u' (C,) . On the other
Intertemporal hand, expected (as of period 1 ) marginal utility at any subsequent period is given
Decision-Ma king
by: E l [u'(C,)] ; t = 2,3,. ..., T. Thus the optimality condition implies:

u' ( C ,) = E, [u'(C, )] = El [u'(C,)] = - . . . = El [u'(C,.)] ...(7.10)

In order to explain (7.10) -further let us take a quadratic utility function of the
a
form: u(Cl) = C, - - C: for t = 1,2,....., T . Then the marginal utility fimction is linear
2
in C,, i.e., ul(Cl) = 1 - aC, for all I. Therefore,

Using this in the optimality condition we get:

On simplification,

The above condition implies that expectation as of period 1 about C', equals C,. ln
more general terms if expectations are formed at any period t about a future period
t+ 1, then optimality condition requires that expectationas of period I about C',,, equals
Cl, i.e., Cl = El [C,,, 1. Since under rational expectations the actual value of a variable
can differ from its expected value only by a random term, this would imply

= C I + el+,, ...(7.12)

where el,, is arandom tern whose expected value is zero. If you look carefully, equation
(7.12) says that consumption from period t to period t+l would remain unchanged,
except for an unpredictablerandom term. This is precisely the conclusion of the random
walk hypothesis. The hypothesis says that changes is consumption over time is
unpredictable, because they can only change due to the presence of unpredictable I

random events.

The random walk hypothesis has important implications from the point of view of
policy effectiveness. It implies that any government policy to influence consumption
(for example, a tax cut) can work only to the extent that it is not anticipated. For
example, ifthegovernment announcesa tax cut policy today, which will be implemented
h m next year, then mnsurners with rational expectationswill adjust their consumption
today itself, so that consumption would remain unchanged when the tax policy actually
becomes operative next year.

7.4 CONSUMPTION AND RISKY ASSETS: 1

CAPITAL-ASSET PRICING MODEL

whileanalysingconsumption under uncertainty in the previousSection, we had implicitly
assumed that the source of uncertainty is the households' income. In other words, we Consumptionand
had assumed that there was no uncertainty as far as the asset return is concerned:the Asset Pricea
return to asset (r) was treated as given. (Infact, for simplicity we had assumed that it
has a value equal to zero). If the return to asset is non-zero, but the exact return is
uncertainthen the optimalitycondition ofthe individual's utility maximirationwillinclude
an expected return term as shown below:

where t is the time period when expectationsare formed.

We h o w from the theorem for statistical expectation (operator E) for two events A
and B that E( AB) = E( A). E(B) + Cov(AB) (where Cov(AB) is the co-variance
between the two events A and B). We can visualize (7.13) as a case of two joint
events and write the optirnality condition as:

Now suppose there are two assets: i) one with a certain (risk-free) return given by
-
if+,,and ii) another with an uncertain risky return with an expected return value equal
to El (r,,, ) . For the risky asset application ofthe condition (7.1 4) implies that

1 + El [r,,, I =
w" ) - cov, [(I + r,,, ,ul(C,+,)I
i.e.,
El [uf(C,+,)I

For the risk-free asset, the return is certain and therefore is uncorrelated to C,,, . In
other words, for the risk-free asset Cov, [(I + <+,, u'(C,,,)] = 0. Hence for the risk-
free asset, the condition (7.14) implies that

Coinparing (7.1 5) and (7.16) we get:

The condition (7.17) gives us a way of determiningthe optimal (or equilibrium)expected

,
return of a risky asset. Note that a higher value of C',, implies a lower value of ur(C,, ) .
Therefore a positive co-variance between r,,, and C,,, implies a negative co-variance
between r,,, and ur(C',,,) . Hence (7.17) implies that the higher is the correlation
betweenr,,, and C,,, , the greater is the required expected retunl on arisky asset
compared to the return from the risk-free asset. To put it differently, the greater is the
covariance between r,,, and C,,, , the higher is the premium that an asset must offer
htertemporal relative to the risk-free rate. This model of determination of expected return of risky
Decision-Making assets is known as the Consumption Capital Asset Pricing Model (CAPM).

Check Your Progress 2

1) Describe the Random Walk Hypothesisof consumption. What is the implication

of this hypothesis from the perspective of government policy?

2) Explain the Consumption Capital Asset Pricing rille for a risky asset.

7.5 LET US SUM UP

The present unit viewed consumption in a dynamic set up and introduced you lo the
problem of intertemporal utility maximization. In this context it discussed the issue of
consumption and savings when more than one time periods are considered. The Fishexian
idea that consumption is an outcome ofhousehold's intertempoml optimization cxercise
has been explained in the unit.

Empirical studies involving cross-section data find that richer households consume a
smaller fiaction of their income compared to poorer l~ouseholds.However, studies
based on time series data show that the proportion of consumption in income has
remained more or less the same although household income has increased manifold,
This apparent discrepancy has been attempted to be resolved through life-cycle
hypothesis and permanent income hypothesis. According to the life cycle hypothesis
the short run consumption fkction shows a declining average propensity to consume
(APC) while the long run consumption function exhibits constant APC due to increase
in asset base. On the other hand, the permanent income hypothesis explains the
discrepancy in terms of permanent income a d transitory income.

In the presenceof unertainty actual consumption behaviour may be dificult to predict.

In this situation consumptionmayfollow a random pattern. This theory ofconsumption,
known as the Random Walk Hypothesis, has been explained here. Finally, in the
presence of uncertaintythe price of the risky asset may follow a specific pattern which
16 has been explained in the discussion on the CAPM model. I

.8'
~
 Consumptionand
7.6 KEYWORDS Asset Prices

Average Propensity to Consume It is defined as the ratio oftotal consumption

C
(C) to total income (Y). Thus APC =-
Y

Ceteris Paribus It means 'every thingelse.remaining the ssu:neY.

Consumption Smoothing Even though the income of an individual

changes across time periods, he divid,es his
life time resources equally among each period
and consumption at different points of time
are spread evenly.

Expected Utility The total utility expected to be derived from

the future income stream.

Intertemporal Decision A decision which involved more than one time

period.

Permanent Income That part of the current income that is

expected to remain stable over the long run.

Rational Expectations The hypothesis that expectations sf people

on the whole is unbiased.

Transitory Income That part of the current income which is a

deviation fiom permanent iticome;.

7.7 SOME USEFUL BOOKS

Branson, William H., 1989, Macroeconomic Theory and Policy (3rd Edition), Harper
and Row, chapter 12.

Romer, David, 2001, Advanced Macroeconomics (2nd Edition), McGraw-Hill,

chapter 7.
b

I
-
7.8 ANSWERS/HINTSTO CHECKYOUR
1 PROGRESS EXERCISES -
Check Your Progress 1

1) Read Section 7.2 and write your answer.

2) Read Section 7.2 and write your answer.

Check Your Progress 2

*
1) Read section 7.3 and write your answer.

2) Read section 7.4 and write your answer.

 UNIT8 THE MSEY MODEL
Structure
Objectives
Introduction
Planner's Problem
Decentralized Households' Problem
Governmentin Ramsey Model and Ricardian Equivalence
Let Us Sum Up
Key Words
Some Usefhl Books
AnswerMints to Check Your Progress Exercises
8.9 Mathematical Appendix

8.0 OBJECTIVES
After going through this Unit you should be able to:
explain the Ramsey problem of optimal growth;
compare the optimal growth problem of the central planner and that of the
decentralized perfectly competitive economy;
0 explain the role of government in the optimal growth framework and the
correspondingconcept of Ricardian Equivalence;and
if you gothroughthe MathematicalAppendix cmfully you should be in a position
to solve any standard dynamic optimization exercise.

8.1 INTRODUCTION
In our discussion of household's intertemporal consumption and saving decisions in
the previous unit have, we consideredoptimization problems where the time horizon
was fuzite. While this is a valid assumption for an individual,a household (or for that
matter, the society as a whole) is generally infinitely lived. In other words, one can
think of a household as consisting of individual members, each of whom are fulitely
lived, but new members are born in each time period who are an exact replica ofthe
older members - so that the household as a dynasty continues to live forever.

An important economic question that is often asked in the context of an infinitelylived

household is the following: how should the household allocate its resources between
consumption and savings in every period so that the utility of each of its member are
- .
maxlrmzed?In other words, wfiat are the optimal consumptionpath and optimal savings
path forthis household?To put it more generally, in an economy consistingof identical
hfmitelylivedhousehold, whaf should be the optimal savingslaccumulationpatternthat
maximizesthe utility ofeach of dynastic household? This latter question was fmt tackled
by Frank Ramsey (1928), which was later generalized by Cass (1 965) and Koopmm
(1 965). The model has subsequently been known as the Ramsey-Cass-Koopmans
optimal growth model.
 The Rarnsey-Cass-Koopmansoptimal growth model essentially involves a dynamic The Ramsey ModBl
optimizationexercise whereby an agent maximizes its objective function defined over
aperiod of time (finite or infinite) subject to some constraints. The constmintsare also
d h i c in nature in the sense that they relate to values of the variables for different
time periods. The technique for solving such dynamicoptimization exercises lxisbeen
specified in the Mathematical Appendix at the end of the Unit. In the text w e shall
simply state the conditionsfor optimization(withoutgetting intothe underlyingtechnique)
and explain the ecdnomic intuition behind each of these conditions.
I

8.2 PLANNER'S PROBLEM

In the original Rarnsey formulation, the optimal growth problem was postulated as the
problem of a social planner who seeks to maximize the welfare of each household
subject to the economy's resource constraint at each point of time. The households
are all assumed to be identical in terms of preferences and their welfare is represented

by an infinite horizon utility fimction of the form = ["(cI ) ~ X P - ~dt' ,where c, is

0

the per capita consurnptwn in period 1, u(c,) is the associated instantaneous utility
in period t, and p is positive constant term which represents the subjective discount
rate of the household, or its rate oftimepreference. Before we proceed further, it is
important to explain the presence of the discount factor in the household's welfare
function. The positive discount factor reflects the household's preference for present
over future. In otha words, it impliesthat a household puts more weight on consumption
today vis-a-vis consumption tomorrow. Note that when t = 0 (i.e., the initial time
period) exp-P' = 1 . Subsequently when t = 1 , exp-P' = exp-P; when
t = 2 , exp-P' = exp-2pand so on, such that 1 > exp-P > exp-2~..... ... Therefore
+

in the infinite-tie utility function W, current utility at period zero is associated with the
highest weight (unity), and each subsequent utility term is associated with lower and
lower weights.

The social planner maximizes the integral W, but he is constrained by the fact that at
;r each point oftime,the economy's total consumption and total investment cannot exceed
dK
1 its total output.' To put it formally, c,+ -
dt
= ,where C, is aggregateconsumption

I dK
in period 1; - is the amount of investment in period I which augments the capital
dt
I

stock (K)of the economy and Y, is the total output produced in period 1.

Total population at time t is given by L, , which is assumed to grow at a positive

1 dL
exogenous rate n: - -= n .
L dl

Output at any point of time is produced using the existing capital and labour at that
point of time. Technology is represented by a neoclassical production fbnction
Y, = F ( K ,, L,) ,where Fis continuous, concave and exhibits constant returns to scale

' We rule out international borrowing here.

Intertemporal (CRS). We have explained the neoclassical production function in Unit 3, while
Decision-Ma king discussing Solow growth model. The CRS property ofthe production fiznction implies
that per capita output (y) can be written as the function of the capital-labour ratio (k)
in the following way:

Moreover the m a r d products of capital and labour can also written as the following
functions of the capital-labour ratio:

a~ a~
-= f'(k) ; -= f (k)- W ' ( k ).
aK aL

The continuity and concavity propertiesof F(L, K) ensure that f ( k ) is also continuous
and concave. Additionally we assume that f( 0 ) = 0 ; f ' ( 0 )= w, ;f '(a)= 0 . The
first of these assumptions implies that no production is possible with zero capital-
labour ratio. The last two assumptions are known as the Inada conditions which state
that when the capital-labour ratio tends to zero, the marginal product of capital tends,
to infinity, while an infinitely high capital-labour ratio implies that the corresponding
marginal product of capital approaches zero.

dK
The aggregate resource constraint for the economy is, C, + -= Y( . Dividing both
dt

sides by L, we can write it as 2C +

1dK
=
Y, dk
L,,i.e.,c, + -dr+ n k , = . f ( k , )where
the last equation denotes the resource constraint faced by the social planner in per
capita terms.

The economy starts with a given amount of capital stock and population; hence the
initial capital-labour ratio is given, denoted by k, . At every point of time the existing
capital and labour stocks are fully employed. Hence the capital-labour ratio k also
denotes the per capitacapital stock. While referring to k we shall use these two terms
interchangeably.

The complete dynamic optimization problem for the social planner can now be written
in terms ofthe two time dependent variables per capita consumption (c, ) and per
I
,
'
I

capita capital stock ( k, ):

M- W= F(c,)exp-''
0
dk
d t subjectto - = f (k,) - nk, - c,;k, given.
dt 1
>
i I
The correspondingHamiltonian function and the first order conditions in tern~softhe 1 ,

I I
See the Mathematical Appendix for the definitions of the Hamiltonian function, control,
state and co-state variables in a dynamic optimization problem. j !
I ;
iI
 control variable ( c, ), state variable ( k, ) and co-state variable (A, ) are given by:3 The Rarnsey dbael

H = ~ ( c , ) e x p - ~A,' +b ( k , ) - nk, - c,]

ia) ul(c,)e ~ p - =~ A,'

dA
iia) - = -A, (.f '(k, ) - n)
dt

Notice that A, is the shadow price of capital (as explained in the Appendix) or the
value of capital in utility terms. Hence condition (ia) states that along the optimal path
the present discounted value of marginal utility from consumption would be equal to
the shadow price ofcapital. The economic significanceof this condition would become
clear if you note that at any point of time one unit of output can be put to two different
uses - one can either consume it or invest it which augments the capital stock. Now
optimality condition requires that the returns in terms of utility from these two uses
should be equal, which is preciselywhat condition (ia) states. Conditions(iia) and (iiia)
respectively show how the co-state and the state variables change over time along the
optimal path. The fourth condition, known as the transversality condition, implies
that as the economy approachesits terminal time (which in this case is infmity), either
the'value of capital goes to zero (in which case it does not matter for the economy if it
leaves a I;ositive capital stock at the end), or, ifthe value ofthe capitai stock is positive,
then the economy uses up all its capital stock (i.e., kgoes to zero).

ith respect to t and using (iia) to eliminate A, ,we get the folowing
Differentiating(ia) w

differential equation: dI df '(kt - n - P ) . Noting that the

- cuW(c)-
term = * denotes the elasticity of marginal utility with respect to consumption,
u'(c>
the above equation can be written as:

Equations (iiia) and (va) together form a system of differential equations which, along
with the transversalitycondition, determine the movements of per capita consumption
and per capita capital stock of the economy along the optimal path. The qualitative
characterizationof this path is shown in the phase diagram given at Fig. 8.1.

dc dk
The phase diagram traces the litledcurvesalong which - = 0 and - = 0. The point
dt dt
of intersection of these two lines is called the steady slale.A steady state is equivalent
to long run equilibrium whereby the values of the variable remain constant overtime.
Intertemporal
dc
Decision-Making From (va),- = 0 implies eitherc = 0 or f '(k) = n + p . On the other hand, from
dt
dk
(iiia),- = 0 implies c = f (k) - nk . Plotting all these lines and curves in the c-k
dt
plane with c along the vertical axis and kalong the horizontal axis, we get a diagram as
shown in Fig. 8.1.

Fig. 8.1: Phase Diagram

The direction of arrows in the phase diagram shows the direction of movements of c
dc dk
and k when they are not on the- = 0 and - = 0 lines respectively. From Fig. 8.1 it
dt dt
is clear that there exits one steady state, denoted by point E in the diagram, which is
associated with positive values of c and k. It can be shown (though we make no
attempt to prove it here) that this steady state point is a 'saddle point' such that there
exits a unique path which approaches the steady state point; all the other paths move
away tiom the steady state point. This unique path is denoted by the dotted line in the
diagram.This is the only path which satisfies all the first order conditionsof optimality
(conditions (ia)-(iva)given above) including the transversalitycondition.This path is
therefore the optimal path which satisfies the social planner's dynamic optimization
problem. Given any initial capital-labourratio, the social planner will choose the initial
per capitaconsumptionso as to be on this optimal path, which will eventually take the
economy to its long runequilibrium (or steady state) point E.

At this juncture it is important to point out certain important features of the steady state
point E. As was mentioned before, at the steady state both the per capita capital
stock, k, and per capita consumption, c, are constant. Also, at this non-zero steady
state, the k-value and the corresponding c-value are defined respectively by the
equations: f'(k) = n + p and c = f(k) - nk . The condition that f '(k) = n + p is
called the modijledgolden rule. It states that the steady state value of the capital-
labour ratio is such that the marginal product of capital is eq* to the sum of the rate of
population growth and the rate of time preference. In any dynamic model of capital
accumulationand growth the concept of golden rule plays an important role (see Unit
3). Thegoldenrule itself refers to that steady state value of capital-labour ratio where
f'(k) = n , i.e., the rnarghlproduct of capital is exactly equal to the rate of growth of
I
population.The signiscam of tlae golden rule obtains h m the fact that it is that steady
I

1
1
state value of capital-labour ratio which corresponds to the maximum steady state MA+
value ofper capita consumption. Note that when households' rate oftime preference
is zero, the modified golden rule coincides with the golden rule and the steady state of
the Rarnsey model is attained at the golden rule point. However, when people have
positive rate of time preference, they are unwilling to sacrificecurrent consumptionfor
future consumption beyond a point; as a result they accumulate less and reach a lower
level of steady state consumption than in the golden rule.

8.3 DECENTRALISED HOUSEHOLDS' PROBLEM

The Rarnsey model described above can be easily transformed into the problem of a
decentralized competitive market economy consistingof many households -all with
identical preferences. We shall see that under certain assumptionsthe'optimal solution
path in the two cases turns out to be identical.

Instead of assumingthe existenceof a central planner, let us consider amarket economy

where the households are price takers. There are two competitive factor markets
which determinethe wage rate ( w,) and the inte~st rate or the rate of returnon capital
( r,) at each point of time.

the^ exist many identical competitivefirms whichhire in labour and capital h mthe
households at the above mentioned wage rate and rental rate. Using labourand capital
these firms produce the final output, using the same technology as the central planner.
Competition ensures that the wage rate andthe rental rate are equal to the respective
marginal products of labour and capital at full employment, i.e., r, = f '(k,) and

0 0 .

Each household maximizesits welfare givenas before by = J~(c

)t ex^"' dt. Esch
0

household starts with a certain amount of capital stock and labour stock. Additionally
householdscan borrow fiom one another. Let a, = k, - b, denote the per capita asset
stock of anhousehold at period t,which consists of the per capita capital stock owned
by the household at period t minus the amount of debt (per capita) at period t. (If the
household is a net lender, then b, would be negative).Arbitrage condition in the asset
market ensures that capital and lending earns the same rate of return. Hence
the per capita income of the household at period t is w, + r,a,,which the household
spends on consumption and fiuther asset accumulation. Thus the budget constraint
da
faced by the household in per capita terms is given by: Ct + -+ flat = W, + Cad .
dt
The completedynamic optimization problem for the household can now be written in
terms of the two time dependent variables per capita consumption( c,) and per capita
asset stock (a,):

W=
~awimize IU(C,)exp-"
o
da
subject to - = W , + (q - n)a, - C,;a, given.
dt 23
r-
Int./ertemporal The corresponding Hamiltonianfunctionand the first order conditions in tenns of @e
Fdecision-Making
control variable ( c, ), state variable (a, ) and co-state variable( il,) are given by:

ib) ur(c,) e ~ p -=~ A,

'

Note that these conditions look quite similarto the first order conditions that we obtained
for the central planner's problem (conditions (ia)-(iva) in the previoussection).However,
for the household's problemthereis an additional condition which has to be satisfied if
we want to get ameaningfhlsolution. This condition is called the No-Ponzi-Game
condition which we elaborate below. First note that we have allowed for intra-
household bo~~0wj.n~ which mea& that a householdcanmaintain a consumptionstream
above its income by borrowing. Now if a household could go on borrowing indefinitely
then it will be optimal for the hausehold to alwaysmaintain an idnitely high(or rmxhum
possible)consumption stream and finance such high level of consumption simply by
borrowing more and more. Of course, such a strategy would also imply that the net
per capitabornwingof the household would inc- exponentiallyat the rate( r, - n)
(since the household kcts to borrow not only for consumption, but also to pay back the
interest rate as well) and the present discounted value of the net debt of the household
will approach infinity.Such a financing scheme is called Ponzi-Gamefinancing4. In
order to rule o~lksuch idbite indebtedness by any family we specifLthe condition that
the even thqugh the household can be temporarily a net debtor (i.e., the present
discounfBCI~value of its asset is temporarilynegative), over a sufficientlylonger horizon,
it must eventually repay all its debt and hold non-negative asset stock. Formally, as t
goes to infinity, the present discounted value of the (per capita) asset stock of the
household must be non-negative:
I
-J(rr-n)dr
vb) limq exp
1-0
" 2 0.

condition (vb) is called the No-Ponzi-Gamecondition. For a decentralizedhousehold

conditions (ib)-(vb) specify the optimal path the solves the household's dynamic
optimizationproblem.

As before, differentiating(ib) with respect to t and using (iib) to eliminate A, , and 1

- cuR(c)-
noting that the term U,(C) = 0 denotes the elasticity of marginal utility with respect
..
Named afterCharles Ponzi (1 877-1 949) who raised considerable amount of money promising a
high rate of interest (50% for 45 days, 100% for 90 days). As long as new lenders were
attracted to these returns, he was able to repay previous debt. In eight months he ended up
with 10 milliondollars of certificates and 14 million of debt. Criminal charges were fulally levied
on him in the US and died a pauper.
 IT' 9 THE OVEIRLAPPING GENE IONS

Structure
9.0 Objectives
9.1 Introduction
9.2 Structure of the Model
9.3 Dynamic Inefficiency in OverlappingGenerationsModel
1
I 9.4 Social Security

I 9.5
9.6
Let Us Sum Up
Key Words
9.7 Some Useful Books
9.8 hswer/Hints to Check Your Progress Exercises

9.0 OBJECTIVES

I After going through this Unit you should be able to exlain:

I e

e
the standard two-period overlapping generations model with production;
the concept of dynamic efficiency and examine whether the dynamic efficiency
holds for an overlapping generationseconomy; and
the role of social security system in the overlapping generations framework in
eliminatingdynamic inefficiency.

9.1 INTRODUCTION
1 In the context of intertemporal decision making on the part of the households, you
have come across the optimal growth model in the previous unit. There is another
important h e w o r k that also considers households' intertemporal decision making -
although over finite time horizon. This h e w o r k is called the overlapping generations
framework. The framework was first developed by Samuelson (1954) which has
subsequently been widely used in macro dynamics.

In the overlappinggenerationsh e w o k individualshave a finite time horizon (in the

standard case, a two-period time horizon), but the society lives forever. The term
'overlapping generations' implies that at each point of time the life-time of two
generations overlaps. To clarifl, let us take the standard case where each generation
lives exactly for two periods. Thus for the cohort of individuals who are born at the
beginning of period 't', they are alive in period 'I' (when they k e young) and in period
't+l' (when they are old). On the other hand, a new set of individuals are born at the
beginning'of period t + l , who would be alive in period '1+lYand period 't+2'
respectively. Thus between the lifetimes ofthese two successive generations, there is
an exact overlapof one period. In the following discussion we shall concentrate on the
two-periodoverlapping generations M e w o r k only.

9.2 STRUCTURE OF THE MODEL

'

32 The set ofpeoplewho are born at the beginning of period t will be called 'generation t'.
Let us now look at the activities of a representative member of generation t. Each The Overlapping
person is born with an endowment of one unit of labor. In the first period of his life, Generations Model
when he is young, he works and earns a wage income of which he consumes a part
and saves (and invests) the rest. In the next period of his life, when he is old, he does
not work anymore. He nonetheless earns an interest income on his previous period's
savings (investment). He also gets back the principal amountthat he invested, which
he consumes in the second period along with the interest earning. Thus his first and
second period budget constraintsare respectively given by:

ii) cl1= (1 + ?+IIS, 9

where c,, and c, are the first and second period consumption of the representative
member of generation t, and w, and r,+, are the wage rate at period t and the rate of
interest at period t+I respective1y.l The representative member maximizes his two-
period utility h c t i o n U(c,,, c,, ) subject to these two budgetconstraints. Noting that
C2 1
S, = , we can combine the two budget constraints by eliminating s,, which
(1 + c + l )
gives us the following single equation that represents the lfe-time budget comtraint
C2 I
of the agent: C~~+ (1 + .,+]) = w f .

MaximizingU (c,,, c,, ) subject to the life-time budget constraintgeneratesthe following

two frrst order conditions:

From these two equations we can write the optimal c,, and c,, as hlctions of w,and

C2r
r,+, .Since = ,the optimal valueof s, also becomesa functionof w, and r,,, .
(1 + rt+*)
We shall assume that all members of all generations are identical in terms of tastes and
preferences, i.e., they have similar ~tilityhctions.~
Let us now look at the overall macroeconomic picture. As we have mentioned before,
at each period there are two generations who are simultaneouslyalive. Thus at period
t, there is a set of people who belong to generation t-1(these are the people who are
currently old) and a set of people who belong to generation t (these are the people
who are currentlyyoung). The generation t people are the workers in period t, each of
' Note that though the member of generation t made his saving and investment decision at
period t, he earns the interest on that savings only in the next period. Hence :+
is the
relevant rate of interest.
Similar, but not identical. To be more precise, the time subscripts in the utility function will
be different for different generations.
Intertemporal
Decision-Ma king
whom earn a wage income w, . The generation t- I people are the interest earners who
earn an interest income on their previous period's savings (i.e., savings made in period
t-1) at the rate r, .

Suppose the population in successive generations grows at a constant rate n. Thus

if L, denotes the number of people belonging to generation t, and L,-, denotes the
-,
number of people belonging to generation t-1,then L, = (1+ n) L, . Total population
in the economy at period t is given by L, + L,-,.

The production side of the economy is like any standard neoclassical growth model I

that you have seen before. A single final commodityis produced which is used both as
aconsumption good as well as an investment good. Technology for final comlnodity
production is given by a neoclassical production function: Y, = F(K,,L,) , where Fis 1

continuous, concave, exhibits constant returns to scale (CRS) with respect to its two
factors- capital (4and labour (L). As in the Ramsey model, the CRS property of the
production Eunction implies that per capita output Qcan be written as the h c t i o n of
the capital-labourratio (k) in the following way:

Moreover the marginal productsof capital and labour can also written as the following
hctions of the capital-labour ratio:

The continuityand concavitypropertiesof F(L, K) ensue thatf (k) is also continuous

and concave. Additionally we assume that the Inada conditions hold: f (0) = 0;

In a market economy with pedect competition, the wage rate and the rate of interest
are equated with the respective marginal products of labour and capital.
Thus w, = f(k,) - k,f '(kt) and r, = f '(kt).

For the economy as a whole, savings-investment equality (which generates goods

m e t equilibrium for the aggregate economy)tells us that Ct + I, = Y; = F(K,,L,) .
Noting that investment is nothing but the augmentationof the capital stock (assuming
no depreciation), i.e., I, = K,,, - K,,and also noting that due to the property of CRS
= w,L,+ r,K,,wecan write theabove s a v h p i n v equality
F(L,,Kt) ~ cbndition
as: C, + Kt+, - Kt = w, L, + r,K,. Noticethat C,denotes the aggregate consumption
at period t, which includes consumption by the old group and consumption by the
young p u p . There are L,-,
number of old people who are alive at period t and each
ofthem consume an amount c,,-, .3On the other hand, there are :L, number of people
-.
3
C,,, is the 2nd period cmsumption.ofthe mpmmtniive member of generation t-I.
at period t belonging to the young generation, each of them consumingan amount c,, The Overlapping
Generations Model
Hence C, = L,-,c2,-,+ L,c,,.
At this p i n t it is important to recall that each young person is born with m endowment
of one unit of labour. There is no bequest; therefore the young people do not o h any
capital stock at period t (capital stock being the only asset in this economy). Thus the
entire capital stockp owned by the older generation.And since the older generation is
going to die at the end of this period, they consume their entire interest earning plus the
capital stock (which, in the one good world, is directly consumable). Hence
L,-,c2,-, = K, + r, K, . Again, each young person earns a wage w,, of which he
consumes c,, and saves s,. Thus L,c,, = L,(w, - s, ) . Using all these information, we
can write the savings-investment equality condition as:

Simplifying, we get the goods market equilibriumcondition for the aggregate economy
as: Kt+,= L,s, .Recall thats, isafunctionofw,and r,+,. w, andr,,, are intumfunctions
of k, and k,+, respectively. Thus s, can be written as a function ofk, and kt+,
:
s(w(k,), r(k,+,)) . This allows us to write the goods market equilibrium condition in
terms ofthe capital labour ratio as follows:

This last line above represents the basic dynamicequation ofthis overlappinggenerations
model which specifiesthe relationship between the capital-labour ratio of today and
the capital-labourratio oftomorrow. Tracing this dynamic equation will tell us how the
capital-labour ratio of the economy changesover time. It is easy to see that this quation
is a first order non-linear difference equation in k. To characterizethe solution path we
shall use the phase diagram technique. The phase diagram plots k,,, on the vertical
axis and k, on the horizontal axis. The intersection ofthe kt+,line with the 45" line
denotes the steady state. Let us now determine the slope of this line. The slope is given
dk,+I
by the derivative -. As you can see, the LHS of the dynamic equation is also a
dk,
h c t i o n of kt,,. Hence total differentiating both sides,

dw dr
Noting that --- = -kfW(k)and - = f"(k)we can write the above equation as:
dk dk
Intertemporal
Notice that as yet we do not know the signs of s, and s, ; hence we cannot say
Decision-Making
whether the kt+,line is positively sloping or negatively sloping. It is easy to see that
under the assumption that consumption in both periods are normal goods (i.e., both
c, and c, increases withan increase in w), 0 < s, < 1. The sign of s, however is
ambiguous. Since an increase in r implies that the relative price of future consumption
in terms of current consumption falls. Hence due to substitution effect current
consumption should fall, which means that with unchanged wage rate, savings would
rise. However, a fall in relative price will also be associated with a positive income
e f f i ton current consumption. Thus whether current consumption increases due to an
i n c m in r depends cruciallyon whether the income effect dominates the substitution
effect. If the income effect dominates the substitution effect, thenc, rises and
consequently s, < 0 . Onthe other hand, ifthe substitutioneffect dominatesthe income
effect, then c, fils and consequently s, > 0 . We shall assume here that the latter holds,
i.e., s, > 0. Under this assumption the kt+,line is positively sloping. We still do not
know the curvature of this line. Depending on the c d a t u r e multiple equilibria (i.e.,
multiple steady states) are possible,as shown in Fig. 9.1.

k, , line

Fig. 9.1 : Multiple Steady State

Local stability of a steady state depends on whether the k,,, line intersects the 45" line
from above or fiom below. In Fig. 9.1 we find that k',where tlle kt+,line intersects the
45" line from above, is a locally stable equilibrium. On the other hand, k*', where
the kt+,line intersects the 45" line fiom below, is a locally unstable equilibrium.

9.3 DYNAMIC INEFFICIENCY IN OVER LAPPING

GENERATIONS MODEL
In the following discussion we shall assume that the parametricconditions are such that
there exists a unique equilibrium which is locally stable.

Even when the steady state is unique and stable, in an overlappinggeneration h e w o r k

36 the equilibrium can still be characterized by dynamic inefficiency. This is a serious
I
shortcoming of the overlapping generations framework in comparison to the optimal The Overlapping
growth fkamework. Before we elaborate this point firther it is important to know what Generations Model
we mean by dynamic efficiency or inefficiency.

The concept of dynamic efficiency is closely related to the concept ofPareto efficiency.
To understand the concept consider a situation where we are comparing between
various possible steady states or equilibrium points. Each ofthese steady states is
characterized by a different capital-labour ratio and correspondingsteady state leve 1s
of per capita consumption for the old and the young. Since utiIity depends on the
consumption during youth and during old-age, each of these steady states is therefore
associated with a different level of steady state utility. Now among all these steady
states, the one which provides maximum steadystate value of utility is called the 'golden
rule' point and the corresponding capital-labourratio is called the 'golden rule' capital
labour ratio. This point is the best possible steady state point which providesmaximum
life-time utility to each person. One can show that steady state utility is maximized at
the point where f '(k) = n . Thus golden rule capital-labour ratio is defined by k, such
that .f '(k,) = n . Fig. 9.2 depicts the golden rule capital labour ratio as the point
which maximizessteady state utility.

Dynamically inefficient region

k,

Fig. 9.2: Golden Rulecapital Labour Ratio

Now consider all the points which lie to the right of kg. Here the capital-labour ratio
is more than optimal. In other words people are over-saving and over-investing. If
instead of saving, people consume a part of their savings in the first period of their life,
then the capital-labour ratio will fall to k, and at the same time their life time utility will
increase. Thus all the points lying to the right ofk, are Pareto inferior to k, : one can
improvethe cutrent consumptionwithout reducing future co~?sumption and thus improve
total lie-time utility.Thesepoints are called dynamicallyinefficientpoints. Now consider
all the points to the left of k , . Here also the utility level is less than k, ;hence by
moving to kg one can improve the steady state value of utility. However such amove
is not costless anymore. If one wants to move fiom a point to the left ofk, to kg,then
he has to save more. In other words he has to forgo some a m o u t of currant
consumption. Thus his current utility wouldfall, even though he would be better off in
Intertemporal
Decision-Making
the future (once he reaches k , ). Since such a move from the left to right involves a
current utility loss, we cannot say for sure whether these points are better or worse
then k, .All these points are Pareto efficient or dynamically efficient.

We have seen that in the optimal growth framework the steady state is defined
by f '(k) = n + p . Thus the steady state point in that framework is always to the left
of the golden rule point and is therefore dynamically efficient. In the case of the
overlapping generations h e w o r k however dynamic efficiency ofthe equilibrium point
cannot be In fact under very reasonable parametric values the steady
state could be dynamically inefficient.

To see how, consider the following example where we assume a specific utility function
and aspecific production function. Let the utility function ofthe representative member
of generation t be U(c,,,c2,) E log c,, + log c,, .Also let the per worker production
h c t i o n be f ( k t )z Ak; , 0 < a < 1. Both the log utility function and the Cobb-
Douglas production h c t i o n are known to be well-behaved which satis@all the standard
neoclassical properties.

With the log utility b c t i o n as specified above, one caneasily verifLthat the first order
conditionsfor individual's utility maximization exerciseare given by:

These two first order conditions generate a savings function which is given by:
1
S, =- w,,Also, with Cobb-Douglas production function w,= (1 - a ) A k P . Thus
2
1
the basic dynamicequation in this example is given by: k,+, = -(1- a ) A k P .At
(1 + n)
steady state k, = k,,, = k*. Hence puttingk' at the LHS and RHS of the above
1 /(]-a)

equation, we can solve for the steady state value as: k' -

Let us now comparethis steady state value of capital-labourratio with the conresponding
golden rule capital labour ratio. Note that with the Cobb-Douglasproductionfimction,
the golden rule capital labour d o in this example is defined by: A a(k)"-' = n. Solving,

we getk, as: kg = . Thus whenever a: > -, n k* > kg,i.e.,

the steady state will be dynamically inefficient. For example, the equilibrium will be
dynamidyinefficientife = 1/ 4 and n = 1.

An obvious question that arises here is: why is it that the steady state could be
dynamicallyinefficient in the overlapping genedons b e w o r k , while such possibility The Overlapping
is ruled out in the optimal growth framework? The answer lies in the fact that in the Cenerstions Model
overlappinggenerations individualsare selfish (no bequest). Since they do not have to
share the benefits of their invesbnent withtheir successive genemtions(who are growing
at the rate n), when they consider the possible future return to their investment, the
return is not net of the population growth. TO 'put it differently, the relevant return for
them is not (f '(k) - n) but just f '(k) . Hence they would be interested in investing as
long as this returnlis positive, even if it falls short of n. This is the reason for their
possible over-saving.

Check Your Progress 1

1) Derive the basic dynamic equation of the standard two period overlapping
generations model with production. Explain the intuition behind this equation.

2) What is dynamic efficiency? Is the steady state under the overlapping generations
structure necessarily dynamically eficient? Give an example to elaborate your
answer.

9.4 SOCIAL SECLTFUTY

Given tlut the overlapping generations equilibriunlcould be characterized by dynamic
inefficiency,one can ask ifthere is any role for the government here. In other words,
does there exist any government policy which could check the over-saving by the
households? Typically the government could influence the savings decision through
some kind of social security programmes, What is a social security programme? A
social security programme is meant to provide some income to individuals afler
retirement. There are usually two types of social security programmes which are in
vogue - a fi~llyfunded system and a pay-as-you-go system,
Ihtertemporal In a fully funded system a stipulated amount is taken by the government from each
Decision-Making young person at period t as social security contribution. The same amount is invested
by the government and returned with interest to the old people at period t + l . Since
the young at period tare the old at period t+l, in a fully h d e d system the set of
people who made the contributionstoday and the set of people who will receive the
corresponding benefit tomorrow are the same. If dl is the contribution made by each
young person at period t, and b,,,is the benefit received by each old person at period

In an unfunded pay-as-you-go system, a stipulated amount is taken by the government

from each young person at period t and the entire amount is immediately distributed to
the old people at period t. Inother words, the pay-as-you-go system involves a transfer
of funds fiom the current young to the current youth. Note that populatioil is growing
at the rate n; therefore at eachpoint of time there are n more people belonging to the
c m n t l y young group compared to the currently old group. Thus if d, is the contribution
,
made by each young person at period t, and b, is the9benefitreceived by each old
person at period t,then b, = (1 + n)d,.

The type of social security system has important implications for the savings decisions
of the young. Note that in a filly funded system the government is doing part of the
savings on behalf of the individuals. The representative individual is effectively saving
an amount equal to (st + d,) and in the next period earning an interest income equal to
(1 + r,,, )(sf + d,) . Since each person knows that this is the amount that he would
receive in the next period, in his own savings decision, the individual will optimally
adjust (cut back) his own savings so that his total effectivesavings renlains the sameas
in the pre-social security economy. Thus a fidly funded social security system has no
impact on the total savingsand capital accumulation. Ifthe economy was in a dynamically
inefficient steady state in the pre-social security economy, it will remain so even after
inlroducinga l l l y h d e d social security system.

In contrast, in apay-as-you-go social security system, the relevant rate of return on

government securities for an individual is n. On the other hand, the rate of interest on
capital accumulationis r. Thus a s long as r<n, it pays to save less and contribute more
in the form of social security. Hence if the economy was in a dynamically inefficient
steady state in the pre-social security economy (which implies that r is indeed less than
n), introducing apay-as-you-go type of social security system will reduce private
savings and capital accumulation. As a result the economy will move to the dynamically
efficient region.

Check Your Progress 2

I ) Doesanytype of social securitysystem necessarily elinzinatethe dynamic inefficiency
problem in the overlapping generations framework? Elaborate your answer with
the two types of social security systems.
 The Overlapping
Generations Model

9.5 LET US S U M UP
In this unit, we discussed at the standard overlapping generations framework with
production. We have derived the basic dynamic equation which basically states that
the tomorrow's capital stock is equal to the savings by the young generations today.
We have derived the steady state conditions. It has been shown that the steady state
under the OLG fixmework may not be dynamically efficient. The government can play
an important role here to ensure dynamic efficiency by introducing a social security
system. Zlowever the type of the social security system is important: apay-as-you-go
type of social security system is effective in eliminating inefficiencywhile a l l I y h d e d
social security system is not effective.

Dynamic Efficiency The situation where an increase in future

consumption implies a fall in current
consumption so that future utility cannot be
increased without reducingcurrent utility.

Overlapping Generations A h e w o r k where agents have finite lifetime

and at every point of time more than one
generation of agents coexist.

Social Security System A provision for retirement benefit such that

an agent receives certain m o n e w benefit
from the government when he is old.

1 9.7 SOME USEFUL BOOKS

(
I
Blanchard, Olivier and Stanley Fischer,1989, Lectures on Macroeconomics, MIT
Press, chapter 2.

9.8 ANSWEWHINTS TO CHECKYOUR

PROGRESS EXERCISES
Check Your Progress 1
I

1) Read Section 9.2 and Mite your answer.

2) Read Section 9.3 and write your answer.

1
I
Check Your Progress 2

1) Read Section 9.4 and write your answer.

 UNIT 10 MONEY AND THE ROLE OF
MONETARY POLICY
Structure
10.0 Objectives
1 0.1 Introduction
10.2 Money in the Overlapping Generations Model
10.3 Cash-in-Advance Model
10.4 Money in the Utility Function
1 0.5 Policy Implications
10.6 LetUsSumUp
10.7 Key Words
1 0.8 Some Useful Books
10.9 Answermints to Check Your Progress Exercises

After going through this Unit you should be able to explain:

the role ofmoney in facilitating the transaction in a standard two period overlapping
generations model of exchange;
0 why money has positive value in an economy where money is the only medium of
exchange; and
0 the role of money in a model where people derive direct utility by holding money.

1 1 INTRODUCTION
As you know, money is the medium of exchange. In old days gold and silver were
used as the medium of exchange. These were commodity money, which had some
value apart from their role as medium of exchange. However, in the modern world,
money is typically paper money which does not have any worth on its own: its only
value is in terms ofthe commodities that you can buy in exchange.
Money also serves a second purpose. In so far as money is needed to cany out any
exchange, it is also usedasa store of value. However, as a storeof value, money is typically
dominated by all other assets in the sense that holding money involves zero return in
nominal terms, whereas all other assets carry some positive return in nominal terms.
Then why is paper money valued at all? Here we shall seek the answer to this question.
The neoclassicalgrowthmodelsthat you have studied so fhr are based on the assumption
thatthere is a singlefinalcommodity.Henceall payments-including the wagefate and
the rate of interest - are made in terms ofthis final commodity. There is no money. In
this chapter we shall see how the presence of money affectsthe real decisionsand the
dynamicequilibria in these models.

10.2 MONEY IN THE OVERLAPPING

GENERATIONS MODEL
For moneyto be valued it must facilitate the exchangepmess. Samuelson's overlapping
generations (henceforth OLG)set up can illusbatethe usefidness of money as a medium Money and the Role of
of exchange. Monetary Policy

Let us look at an OLG model of exchange. The structure ofthe model is very similar to
the OLG growth model that you have studied earlier. The only difference is that the
present model is an OLG model of exchange'-there is no production.

The household sidq of the story is exactly same as before. Each generation lives exactly
ifor two periods. Thus for the cohort of individuals who are born at the beginning of
period 't', they are alive in period 't' (when they are young) and in period 't+l' (when
they are old). On the other hand, a new set of individuals are born at the beginning of
period t+l, who would be alive in period 't+l' and period 't+2' respectively. The set
of people who are born at the beginning of period t will be called 'generation t'.
Population in successive generations grows at the rate n. We shall assume that the
initial stock of population ( Lo)was unity, so that number of people belonging to
generation t is given by: Lt = (1 + n)' .

The representativemember of generation t is endowed with one unit of a consumption

good when young and receives no endowment when old. This consumption good is
perishable; hence it cannot be stored forfuture consumption.On the other liand money
can be stored. Thus anybody who intends to consume in the next period must sell the
commodity in exchange of money in the first period and then again buy back the
commodity against money in the next period. The two-period utility function of the
representative member is given by U(c,,,c,, ) , where the utility function has all the
standard properties.

At any period the consumption possibilities fiom the society's point of view is shown in
the following diagram. The horizontal axis measures the per capita consumption of
young and the per capita consumption of the old. Note that at any point of time t, the
total endowment of goods is given by L, (since each young person receives 1 unit and
there are L, number of young personsin the economy at point t). Ifthe entireendowment
is consumed by the young, then each ofthem consume one unit, which is denoted by
point Aon the horizontal axis. If, on the other hand, the entire amount is consumed by
the old, then each of them consume (l+n) units, which is denoted by point B on the
vertical axis. The straight line joining these two points represents the society's
consumption possibility frontier: each point on this line representsa certain distribution
of the total endowment between the young and the old (see Fig. 10.1).

Fig. 10.1: Consumption Possibility Frontier

intertemporal Let us now see what is the best point fiom an individual's point of view. The individual
Decision-Making
has an utility function U(c,,,c,, ) . If he could choose between all the points on the
consumption possibility fiontier then he would have chosen the point which would
have maximized his life-time utility. This point is represented by point E in Fig. 10.2.

Fig. 10.2: Lifetime Utility Maximisation

It is however important to note that without money, this point is not reachable by
any individual. In other words, a simple trade between the current young and the
current old cannot ensure that point E is reached. Why not? The reason is the following.
In order to reach the point E the current young will have to give a part of their
endowment to the current old. In exchange they will have to be given part of the
endowment of tomorrow's young generation. Since tomorrow's young generation is
not present'yet, such a contract cannot be enforced on them tomorrow. So no trade
can take place.

Let us now see how introduction of money can help everybody to reach the optimal
point. Suppose at time t the government gives the current old generation an amount of
money, a, which is equally distributed among all the members ofthe current old
generation. Sup'pose everybody in the economy (including the future generations)
believes that they will be able to exchange money for goods at a certain price. The
price level can vary from time to time depending on the demand for and supply of
money. Let4 denote the price level at time t. It is obvious that the current old
generations are the suppliers of money. But who demands money? The demanders are
the current young. Why do they demand money? Since money is not perishable (while
the consumption good is perishable),the young generation can store the money and in
the next period (when they are old) can exchange it for goods so as to reach the
optimal pint. To see the argument more clearly, let us consider the maxinizationproblem
of a representative member of generation t. He will maximize his utility U(c,,, c,, )
subject to the following two constraints:

4 (1 - c,,)= M: ; and

where ~ , isdthe demand for money by the representativemember of generation t.

The underlying intuition behind these two constraints are quite straight forward. The
first constraint says that out ofhis endowment of one unit of h a 1good,the representative
member of generation t saves an amount (1 - c,,) when young. This amount he
exchanges for money at period t at the current price P, . Thus P, (1 - c,,) constitutehis
total demand for money in period t. In the next period he sells the stored money M: Money and the Role of
Monetary Policy
to the young members of generation 1+1 at a price <+,, to get a second period
consumption c,, = A4,d / <+,. Rearrangingthe terms we get the second constraint.
Eliminating M,! from the above two constraints,we can generate a single constraint:

Maximizing utility subject to this single constraint one can derive the following first
U1 (el, 1-
- U2
~ 2 t ( ~ 1 1 ~ 2 , )

4+1 . This firstorder conditionalong with one

5 5
order condition:
r:
of the constraints in turn defmes the optimal demand for money function in real terms

Next we characterize the equilibrium in the money market. At time reach of the current
young demands M,! amount ofmoney. Hence the total demand for moiley at time t is

givenby L,M,!,o~ + ($Iq< .On the other hand, the entire old generation
receives a money endowment equal to . Thus the total supply of money at period t
a
is given by . Equating demand and supply, we get the money market equilibrium
.conditionat period t as:

Note that LA)

<+I
is the rate of return on money in real terms. It has close link with the

rate of deflation. The latter concept is defined as? ,where (1 + nt 'I) ' LL)
<+I
. Thus
we can write the money market equilibrium condition at any period t in terms of the
current rate of deflation and the current price level in the following way:

Notice that the money market equilibriumcondition definesa short m equilibriumrate .

of deflation for every point of t h e . At time t the equilibriumrate of deflation is given by
(1 + n ) ~ ( l zr, a
+) = ,and at time t+l the equilibrium rate of deflation is given by
(1 + n)'+'L,.~(l+ ~ , + ~ )=4 + , a. Comparing the two we get:

Since there are only two commodities - the !kal good and money - money market equilibrium
in any period, by Walras' Law, implies that the goods market is also in equilibrium.
Intertemporal
Decision-Ma king -
i.e.,
+ )
( l + n , ) = ( l + n ) ~ ( 1 R,+,
. At the steady state (long run equilibrium) the rate
FO 1
+ n,

of deflation is constant which, fiom the above equation, implies that n, = n,,, = n .
That is, at the long run equilibrium, the rate of deflation is equal to the rate ofgrowth of
population.

.Witha rate of deflation equal to n, the budget line of an individual (which is represented
by the equation, 4 (1 - c,,) = P,,, .c,, ) coincideswith line AB in fig. 10.2 and therefore
the representativeindividual chooses the optimal point E, which maximizes his utility,
Thus introduction of money in this overlappinggenerationsmodel enables the members
to reach the optimal point which was earlier unattainable in the barter economy (without
money).

While the overlappinggenerations model highlights the usefulness of money, the model
is inadequate as atheory.ofmoney. In the OLG model discussed above, money is the
only asset which can be used as a store of value. Had there been any other asset (say,
physical capital) with areturn higher than money, money would have ceased to have
any positive value in this framework. Aproper theory of money must explain why
money continues to be valued despite being dominated in terrns of return by other
assets. We now turn to other theories of money which address this issue.

Check Your Progress 1

1) In a barter economy introduction of money may enable people to reach the socially
optimal outcome - do you agree? Elaborate in the context of a two-period
overlappinggenerations model of exchange.

10.3 CASH-IN-ADVANCEMODEL
The cash-in-advance model emphasizesthe role of money as a medium of exchange.
The model starts with the assumption that ''money buys goods, goods buy money but
goods do not buy goods".This assumption is known as the 'Clower' consba.int or the
'cash-in-advance' constraint. The term 'cash-in-advance' implies that to buy goods
one must accumulate some cash in advance; one cannot directly exchange goods for
goods.
In its simplest form the cash-in-advance model specifies that purchase of goods must Money and the Role of
be paid for with money held at the beginning of the period. The formal presentation of Monetary Policy
the model is as follows.

Let the utility functionof an infinitely lived representative agent be

where c l ,c 2 , ,.....,cn represent the consumption of goodl, good2, good 3, ..., good
n respectively. The agent cankeep his savings either in the form of money, which earns
zero nominal return, or in the form of bond which yields apositive nominal return
denoted by p . The agent starts with a certain stock of money and a certain stock of
bond. He also has an income Yat each period Hence the period t budget constraint of
the agent is given by:

It is easy to see that since bonds earns positive return while money earns zero return
(that is, money is dominated by bond), maximization of the utility function subject to
this budget constraint will generate an optimal solution where holdingof money will be
zero.

Now suppose we add a cash-in advance constraint to this framework. That is, we
n
specify an additional constraint ofthe form: 4 ' ~5:M I . This constraint says that
r=l

all the purchases must be carried out from the stock of money. One can show that the
solution to the Kuhn-Tucker maximization problem with this additional constraint will
imply the optimal money holding is no longer zero. In other words, adding a cash-in-
advance constraint immediately generates a demand for money.

Check Your Progress 2

1) What is Clower constraint? How does it ensure that money has positive value?
 -
intertemporal
Decision-Making 10.4 MONEY IN THE UTILITY FUNCTION
The cash-in-advance model described above highlights the transaction demand for
money. There exists a second approach which emphasizes the fact that money might
provide some utility on its own. In the latter approach money, or more precisely the
amount of real baIances, enters directly into individual's utility function. We describe
below amodel which uses this h e w o r k . The specific model that we shall consider
here is due to Sidrauski.The model is an extension of the Ramsey model which allows
for holding of money.

As is the Ramsey model we assume that at each point of time t the society consists
of L, number of infinitely lived individualswho have identical preferences. The utility
4)

functionof the representativeindividual is given by W = J U ( S = mt ) exp-" ,where 6,

0

and m, are respectively the per capita consumption and the per capita holding of real
balances in period t, u(c,) is the associated instantaneous utility in period t, and p is
the subjective discount rate of the agent. The instantaneous utility function is well-
behaved and has d l the standard properties: u,,u,, > 0; u,, ,u,, > 0 . The population
in this economy grows at a constant exogenous rate n.

People can hold their wealth either in the form of money or in the form of physical
capital. At each point of time the governmentdistributes certain amount of new money
stock equally among the households. These constitute transfers which in real terms is
denoted by X , . Accordingly the society's budget constraint at period t is given by:

capita capital stock and n is the rate of inflation, we can write the budget constraint in
per capita terms as:

Note that per capita household wealth is given by a = m + k . Therefore we can write
the above budget constraint in terms of per capita wealth as:

As in the Rarnsey model, the completedynamic optimizationproblem for the household

can now be writtenin terms of the three time dependent variables per capita consumption
( c, ), per capita real money balances holding ( m, ) and per capita asset stock ( a, ):

W = I U ( ~m,)exp"'
, dt
0
48
 da Money and the Role of
subject to - = w, + ( q - n)a, + x,- c, - (z, + r, )mt ;a, given.Also the household Monetary Policy
dl
treats the wage rate ( w,), the rate of interest ( r, ), the rate of inflation (z,)and the
transfer from government ('x, ) as exogenously given. Thus for the household now
there are two control variables, c, and m, , and one state variable a, .The corresponding
Harniltonian hnction and the first order conditions in terms of the control, state and
co-state variables are given by:*

lim A,a, = 0 .
/+m

Additioilally there is the No-Ponzi-Game condition given by

-l(rr-n)dr
~i) lim a, exp " 20
,+o

Finally notethat whilethe household treats: w,, r,,n,and x, as exogenous to its decision
making process, it nonetheless has perfect foresight so that it can exactlygrressthe
correct values of these variables at every point of time. Accordingly in equations (i)-
(vi) we can put w, = f (k,) - k, f '(k,) and r, = f '(k,) .Also as we have mentioned
before, the new money is distributed as government transfer (in real terms) to the

households, s o that XI = . We can write this latter term as

X =-' I -- (
I dM
LIP, M dt
1 "to, where o is therate ofgmwth ofnominal money stock.

Let us now look at the steady state of this economy. At steady state
da - dm
---=-= dA dm
0 . The condition-= 0 implies K = cr - n . Puttingthese and
dt dt dt dt
the other steady state conditions in equations (i)-(iv), we get the steady state per
capita capital stock and the steady state per capita consumptionas: f'(k ) = p + n ;
and c* = f (k*) - nk*. Comparing these values with the corresgondig steady state

To know the mathematical technique go back to the Mathematical Appendix o f Unit 9 where
the infinite horizon Rarnsey model has been discussed.
intertemporal
Decision-Making MONEY IN THE UTILITY FUNCTION
The cash-in-advance model described above highlights the transaction demand for
money. There exists a second approach which emphasizes the fact that money might
provide some utility on its own. In the latter approach money, or more precisely the
amount of real balances, enters directly into individual's utility function. We describe
below amodel which usesthis h e w o r k . The specific model that we shall consider
he^ is due to Sidrauski.The model is an extension of the Rarnsey model which allows
for holding of money.

As is the Rarnsey model we assume that at each point of time t the society consists
of L, number of infuzitely lived individuals wha have identical preferences.The utility
m

t ) exp-' ' dt ,where t,

fwction ofthe representaiiveindividualis given by W = J ~ ( c mf
9

and m, are respectively the per capita consumption and the per capita holding of real
balances in period t, u(c,) is the associated instantaneous utility in period t, and p is
the subjective discount rate of the agent. The instantaneous utility function is well-
behaved and has all the standard properties: u,, u,, > 0; u, , u,, > 0. The population
in this economy grows at a constant exogenous rate n.

People can hold their wealth either in the form of money or in the form of physical
capital. At each point of time the government distributes certain amount of new money
stock equally among the households. These constitute transfers which in real terms is
. Accordingly the society's budget constraint at period t is given by:
denoted by X,

1 dK dk 1 1 dM dm
Noting that - -=- +nk and -.-- = - + nm + m, where k is the per
L dt dt L P dt dt
capita capital stock and x is the rate ofinflation, we can write the budget constraint in
per capita terms as:

Note that per capita household wealth is given by 0 = m + k . Therefore we can write
the above budget constraint in terms of per capita wealth as:

As in the Ramsey model, the completedynamic optimizationproblem for the household

can now be written in terms ofthe three time dependent variables per capita consumption
(c, ),per capita real money balances holding ( m,) and per capita asset stock ( a, ):
 Money and the Role of
da
subject to - = W , + (r, - n)a,+ x,- c, - (n,+ r, )m,;a, given.Also the household Monetary Policy
dt
treats the wage rate ( w, ), the rate of interest ( r, ), the rate of inflation (n, ) and the
transfer from government (x, ) as exogenously given. Thus for the household now
there are two control variables, c,and m,, and one state variable a, .The corresponding
Hamiltonian function and the first order conditions interrns of the control, state and
co-state variables are given by:2

dA
-= -Af(a, - n)
dt

) limA,a,=O.
1 3 0 3

Additionally there is the No-Ponzi-Game condition given by

-I(
I

rr-n)itr
~) lima, exp 1 0 ..
,+o

Finally note that while the householdtreats: w,, r,,n,and x, asexogenousto its decision
making process, it nonetheless has perfect foresight so that it can exactly guess the
correct values of these variables at every point of time. Accordingly in equations (i)-
(vi) we can put w, = f(k,)- k,f'(k,) and r, = f '(k,) . Also as we have mentioned
before, the new money is distributed as government transfer (in real terms) to the

households, so that . We can write this latter term as

X
I
=--L
L, P, (--
I dt )
M liM m,c,where is the rate of growthof nominal money stock.

Let us now .look at the steady state of this economy. At steady state
da --dm -
-- d;l dm
--= 0 . The condition-= 0 implies n = a - n . Putting these and
dt dt dt dt
the other steady state conditions in equations (i)-(iv), we get the steady state per
capita capital stock and the steady state per capita consumption as: f'(k*) = p + n ;
and c' = f(k*)- &* . Comparing these values with the correspondingsteady state

To know the mathematical technique go back to the Mathematical Appendix of Unit 9 where
the infinite horizon Ramsey model has been discussed.
 Intertemporal values ofthe original Ramsey model without money (described in unit 9), we fmd that
Decision-Ma king they are exactly identical, Thus introduction ofmoney to the Ramsey model does not
affect the real equilibrium.
- --

POLICY IMPLICATIONS
We have so far discussed three different dynamic frameworks with money. Note that
the stock of money often constitutesan important policy variable in the hand of the
government. By varying the stock or the rate of growth of money the government may
influence the real decisions of the agents. Let us now examine the effectiveness of
monetary policy in these different frameworks.

Let us first consider the OLG framework. If the government increases the stock of
money in each period at a constant rate and distributes it as lurnpsum transfer to the
old generation, then that increases the second period endowment of the old. An increase
in the second period endowment will unambiguouslydecrease savings which in turn
will affect the price level and therefore the rate of inflation. Note that the negative of the
rate of inflation (i.e., the rate of deflation) is the real return on money holding. Hence a
change in the inflation rate implies a change in the real return to money, which will affect
the optimal decision about the other real variables as well. Thus in the OLG framework
money is not neutral.

In the Cash-in-advancemodel also increasing the supply of money eases the Clower
constraint and enables the householdsto buy more goods. Thus as long as the Clower
constraint is binding, money affects the real variables.

In the money-in-the-utility-function approach, on the other hand, the steady state values
of the real variables are unaffected by the introductionof money. To be more precise,
the rate ofgrowth ofmoney stock does not affect the real equilibrium. This result is
known as the 'supemeutrality' ofmoney. Thus monetary policy has no role to play in
this model.

li Check Your Progress 3

1) If one introduces money in the Ramsey model how does the long run equilibrium
values of the real variables change?

-------------------------------------------------------------------------------
2) Can change in the money supply have any impact on the real variables? Discuss
your answer in the context of the different model of money that you have studied
here.
 Money and the Roleof
Monetary Policy

10.6 LET US SUM UP

Inthis unit, we have lookedat the role of money in an economy. First we have introduced
money in the standard overlappinggenerations fbmeworkof exchange. We have seer1
that in this h e w o r k money allows the economy to reach its optimal point. We also
discuss the role of money in the presence of Clower constraint when all transactions
must be carried out in terms of money. We also discuss the role of money in a model
where people derive direct utility from money. This latter model is an extension of the
Ramsey model. We find that introduction of money has no impact on the real variables
in this model.

10.7 KEYWORDS
Clower Constraint A situation where money is the only medium
of exchange so that any transaction requires
money.

Super-neutralityof Money A situation where a change in the rate of

growth of money stock does not have any
impact on the equilibrium values of the real
variables in the economy.

10.8 SOME USEFUL BOOKS

Blanchard, Olivier and Stanley Fischer, 1989, Lectures on Macroeconomics, MIT
Press, chapter 2.

PROGRESS EXERCISES
Check Your Progress 1

1) Read Section 10.2 and write your answer.

Check Your Progress 2

1) Read Section 10.3 and write your answer.

Check Your Progress 3

1) Read Section 10.4 and write your answer.

2) Read Section 10.5 and write your answer.

UNIT 11 TRADITIONAL THEORIES OF
BUSINESS CYCLES
Structure
11.0 Objectives
11.1 Introduction
11.2 Schumpeter’s Views
11.3 Richard Goodwin
11.4 Michal Kalecki
11.4.1 A Three-Departmental Schema
11.4.2 The Political Business Cycle
11.5 Hyman Minsky
11.6 Let Us Sum Up
11.7 Key Words
11.8 Some Useful Books
11.9 Answers/Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After going through this Unit you should be in a position to:
• outline the views of Schumpter on economic fluctuations;
• analyse the ideas developed by Goodwin in terms of business cycles as an
outcome of class conflict;
• explain the three-departmental schema and political business cycle expounded by
Kalecki; and
• explain the process of business cycles viewed as an outcome of transitions in
financial optimism as suggested by Hyman Minsky.

11.1 INTRODUCTION
Two different theses about cycles in economic activity in the developed world
currently exist. One is the real business cycle (RBC) approach (to which you will be
introduced in Unit 12) and the other is generically referred to the classical business
cycle (CBC) orientation as an umbrella for all methodologies other than the RBC.
The first approach (RBC) proposes that fluctuations in economic activity are driven
by real shocks, while the latter body of work (CBC) suggests that a modern economy
is a monetary and financial system and, therefore, cycles are generated as economic
agents take positions in financial markets. For our purposes, it is sufficient to observe
that by quantitative testing, which is not necessarily theory-driven, the CBC
approaches are not inferior as explanations of fluctuations in the developed world. In
other words, it is not illegitimate to explain business cycles without recourse to so-
called first principles. This means that it is unnecessary to conduct the enquiry solely
on the basis of infinitely-lived agents optimising their intertemporal objective
functions. Secondly, the dichotomy between real sector and financial sector may not
apply. Note that business cycle is a feature of the capitalist economy. It turns out that
aggregate investment contributes to most of the fluctuations of GDP in most
developed economies.

A stylised fact is that both a long and a short cycle in aggregate output can be
discerned for both the prewar and the postwar period. The long cycle, of a length of
5
Economic Fluctuations six to nine years, is most pronounced for the structure of fixed investment. The short
cycle, of a duration of three to four years, dominates the cyclical structure of
inventory investment. The relative strength of these cycles is explained by the speed
with which the associated capital stock can be adjusted. The speed is naturally
greatest for inventories, intermediate for equipment and machinery, and the longest
for building and structures. The term business cycle here is taken to mean the
irregular periodic movement brought about by a first-order difference or differential
equation.

The traditional approach to business cycles by and large emphasized real factors.
Few and far between were the classical economists who satisfactorily (even to
themselves!) integrated monetary and financial factors into their study of the
rhythmic waves of activity that characterised capitalist economies. Thus, we record
below three important moments in the evolution of thought on business cycles
associated with landmarks in the subject. First is the seminal contributions of
Richard Goodwin who pioneered the tools and techniques of dynamic economic
analysis. Modern work in complex economic dynamics can be traced back to one or
other of his papers. His models were cast entirely in real terms. Secondly, springing
from the same Marxian stock, although developing his trade cycle by first grounding
his framework in the monopoly capitalism of his time, is the theory of Michal
Kalecki. We should note that Kelecki, the Polish economist-mathematical
statistician, is one of the founding fathers of modern macroeconomics. His long-term
dynamics, then, follows from his short-term dynamics. The rudimentary inclusion of
monetary elements are to be found here in the accommodating stance of the Central
Bank to any lead provided by the investment plans of businessmen. Finally, the veil
of money is completely torn asunder in the work of Hyman Minsky for whom the
capitalist economy is a financially layered entity prone to fluctuations in connected
financial and real activities. The list is, by no means, exhaustive. For example, the set
of non-RBC approaches to business fluctuations is dense. Dennis Robertson, for
instance, emphasised monetary factors in the genesis and propagation of cycles.
Another illustrious member of that tradition was Ralph Hawtrey who underscored
the importance of bank credit which is indispensable for carrying inventories.
Reductions in interest rates induce businessmen to carry larger inventories. Greater
orders, in their turn, encourage increased investment and, with a lag, investment in
fixed capital.

11.2 SCHUMPETER’S VIEWS

The work of Schumpeter, perhaps, best embodies the difficulty of moving from an
evenly rotating economy adequately described by the tools of the theory of value to a
punctuation of general equilibrium by innovation/by the heroic entrepreneur.
Schumpter assumed a private enterprise economy in which there is freedom of
contract. The individual is assumed to constitute the unit of analysis. The theory of
marginal utility is the demonstration that the fulcrum of wants and thereby the utility
character of commodities determine all aggregate phenomena. The theory of
imputation explains the values of all individual commodities. Quantities of
commodities and their values mutually determine one another (see MEC-001:
Microeconomic Analysis, particularly Block 6 on general equilibrium). Thus,
theorems about complements and substitutes and ratios of exchange, prices and the
law of supply and demand can be proved. The grand achievement of Walras was to
derive the conditions of general equilibrium. The system of exchange relationships
renews itself from period to period. Sellers of commodities reappear as buyers with
the wherewithal to purchase the commodities which would maintain their
consumption and capital intact in the subsequent period at the current level and so
on. The economy is dynamic in this sense. Each period is the basis of the next in that
it generates data that enable workers and capitalists to repeat the same process in the
next time interval. The economic system is thus stable.

6
Money can be incorporated into the capitalist dynamic. As with the means of Traditional Theories of
Business Cycles
production, there is no need to construct an independent exchange value of money as
it is no more than a temporary abode of purchasing power. Money is valued
according to the value of consumption goods which it commands. Walras’ analysis is
carried out for the case of a given quantity of fiat money. Money is no more than an
additional item in the initial endowment of households and firms. It has a price by
virtue of its marginal utility functions. The price, emerging in the capital market,
equates the demand for money with the available stock (of money).

Banking plays no role in this “circular flow”. “Development”, on the other hand, is
the emergence of surprises from within the “industrial and commercial” life of the
economy. Schumpeter, it is well known, laid stress on the institution of “new
combinations” by means of the creation of purchasing power by banks. All the same,
the annual growth of savings which is the resultant of previous “development” is no
less important. There are upper bounds to the possibility of financing entrepreneurs
with no prior savings. Schumpeter examines the case of a gold standard and the
institution of central banking. New commodities financed by the creation of fresh
purchasing power will flow after a time lag. In the short run, prices will rise and the
value of gold contained in the gold coin will exceed the value of the monetary unit.
Bank IOUs will be presented for redemption. The solvency of banks will be
threatened. If, in addition, there are constraints to the commodity complement of the
freshly-minted notes coming to the market on time, banks must intervene with the
savings of depositors. Thus, reserves are important both for commercial banks as
well as central banks.

11.3 RICHARD GOODWIN

Richard Goodwin developed the Marxian conception that the power of the working
class varies inversely with the size of the reserve army of labour. A militant working
class will agitate for and succeed in gaining an increasing share of wages in income.
However, the rise in wages has an adverse effect on the rate of accumulation and
thereby on the employment rate. A cycle is generated by the interaction between the
reserve army of labour, the distribution of income and the rate of accumulation.
Class conflict, thus, is homeostatic and distributive shares remain more or less
constant over the long run.

Goodwin invoked a predator-prey model involving distributive conflict between

capitalists and workers. He assumed full utilization of capacity and investment
determined by savings. The following account is drawn from Lance Taylor’s text
referred to in Section 11.7. Let K = κX , with κ as the capital-output ratio. The
symbol X stands for real output, a measure of production inclusive of intermediate
inputs and K stands for the aggregate capital stock. The employed labour force is
L = bX . Let the total population be denoted by N and the growth rate of N is n. The

employment ratio λ is λ = =
K
L b k
.
( ) The wage share is ψ and on the
N N
assumption that all profits are saved, the growth rate g of the capital stock becomes
g = (1 − ψ ) X K = (1 − ψ ) κ .

In the long run, the growth in the employment ratio is a function of the growth in
output and employment, dots on variables denoting time derivatives

λ&= λ ( g − n) = λ {[(1 − ψ ) κ ] − n}

Along the Phillips curve lines ( to be discussed in Block 6), the wage share is
assumed to rise in response to the employment ratio

7
Economic Fluctuations
ψ&= ψ (− A + Bλ )

At a stationary point, λ&= ψ&= 0, the Jacobian of the above system takes the form

⎡ 0 −λ ⎤
J =⎢ κ⎥
⎢⎣ βψ 0 ⎥⎦

The two state variables dampen fluctuations in one another with no intrinsic
dynamics of their own. They chase each other around a closed orbit in the (λ,ψ) plane
which encircles the stationary point (λ*, ψ*). The workers are the predators since the
labour share rises with λ. Economic activity and employment are the prey since a
higher value of ψ squeezes profits and reduces accumulation and growth.

The literature developing Goodwin’s insight has developed his idea that class
struggle takes place in the labour market. Investment is an accommodating variable
which adapts to the flow of saving. Saving is determined by income distribution
which is determined in the labour market. The weakness of his model (and the
strength of Kalecki’s as we will see later in the next Section) is paying no attention to
effective demand problems or, in Marx’s terms, the realisation problem. Relatedly,
Goodwin’s models are classics in the genre of completely real dynamical systems in
which money and finance play no role. From a financial perspective, it might be felt
that the conflict between workers and capitalists is misspecified. Rentiers are owners
of capital and the stock market needs to figure in any analytical description of a
financially complex economy. The traditional class conflict might apply to the
conflict between workers and the managers of firms. Besides, the parameters that
generate Goodwin-type and real models are ‘slow-moving’. The pace of changes in
variables such as real wages, and their inverse profits, is slow. The effective labour
force that feeds the reserve army grows steadily over time. These models cannot
explain the manias, panics, and crashes, to use the evocative title of Charles
Kindlelberger’s remarkable precursor to the next section, that distinguish the ebb and
flow of activity in a modern capitalist economy.

Check Your Progress 1

1) Describe Schumpeter’s account of the traverse from dynamics to development
as the outcome of the interaction of the entrepreneur and the bank.

…………………………………………………………………………………..

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…………………………………………………………………………………..

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…………………………………………………………………………………..

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8
2) Report on any later elaborations of Goodwin’s predator-prey model of the Traditional Theories of
Business Cycles
cycle.
…………………………………………………………………………………..

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…………………………………………………………………………………..

…………………………………………………………………………………..

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1.4 MICHAL KALECKI

The innovation associated with methodologies close to Keynes like that of Michał
Kalecki is to begin with the postulate that an oligopolistic market structure is an
adequate characterisation of a modern economy. Therefore, the price of the product
of an industry is the outcome of firms imposing a mark-up on average prime costs
which are assumed to be approximately constant up to full capacity. The mark-up,
synonymous with the degree of monopoly of the industry, determines the profit
margin and the share of profits in aggregate income. The level of profits is
determined by the level of investment that entrepreneurs implement. In other words,
pricing and investment behaviour determine the level of employment and output. The
mark-up rate is believed to be relatively insensitive to the state of demand.
Fluctuations in economic activity flow mainly from fluctuations in investment
expenditures.

11.4.1 A Three-Departmental Schema

Kalecki announces his Marxian pedigree by subdividing the economy into three
Departments; Department I producing investment goods, Department II producing
consumption goods for capitalists and Department III producing consumption goods
for workers. Suppose that in a certain period, the annual wage bill increases as a
result of increasing wage rates. Let the pre-change wage bills in the first two
Departments be denoted by wI and wII and the fraction by which wages change by α.
Thus the increment in the wage bill in the first two Departments is α(wI + wII).
Profits in these Departments decline correspondingly. However, the increment in the
wage bill of these Departments means an equal rise in profits of Department III.
Either output or prices or both will rise there. Total profits remain unaltered.

In the above framework the effect of a rise in wages is the rise in the prices of
investment goods and capitalist consumption goods. Since the volume of capitalist
investment and consumption is maintained in the short run, profits in the first two
Departments rise by 1+α. The production and consumption of wage goods remain
unchanged. As a result, profits in the third Department also rise by (1+α). Thus the
volume of production in all three Departments remains unaltered while the value in
each increases by (1+α).

Higher markups will encourage trade unions to bargain with their employers for
higher wages since firms can ‘afford’ to pay them. If their demands are granted but
other things remain the same, prices will also increase. A fresh round of demands for
higher wages would emanate and a price-wage spiral would ensue. However,
businessmen would be averse to making their goods more and more expensive. Thus,
trade union power restrains the magnitude of markups. If working class action is
9
Economic Fluctuations powerful, a redistribution of national income from profits to wages could take place.
In our example, profits in Department III increase in the same proportion as wage
rates. However, if there is a redistribution as a result of the reduction in markups
there, the wage bill in the third Department increases more than the wage rates.
There is a rise in output and employment there but not in the first two Departments.

11.4.2 The Political Business Cycle

The setting for the regime is parliamentary democracy. In such a milieu, the
government is sensitive to the electoral process. The elections are the outcomes of
business, working class and other group interests. The thrust of Kalecki’s theory is:
of whose interests does the government consider in making policy choices?

A government spending program could ensure full employment in a capitalist regime

if sufficient unutilised capacity to employ the labour force existed. However,
business would be averse to government intervention designed to deliver full
employment. The opposition to government intervention by the capitalist class is not
comprehensible at first glance. Because profits rise with full employment output.
Additional government spending is unaccompanied by increased taxation. However,
the fear of strengthening worker voice and of inflationary pressures is overpowering.
Under a capitalist system, business has an edge over government because private
investment, and the level of employment it determines, depends on the state of
confidence. However, once the government establishes itself as an employer of last
resort, it can be indifferent to investor optimism and pessimism. Thus, budget
deficits are viewed with hostility by the capitalist class. There is no complaint against
policies that strengthen profit-making activity like protectionist tariffs, regulation of
trade unions and so on. Short-lived and moderate cycles would emerge from a
situation where the government would stimulate the economy only to withdraw at the
first signs of an upswing under the guise of an unviable financial position and then
re-enter when unemployment approached alarming levels. Thus, there would be a
swing between combating employment and inflation.

The cycle is related to politics. Consider a party, earlier in opposition that is elected
to clamp down on a wage-price spiral. The new party in power implements a
deflationary package. The effects of the stance become eventually evident in growing
unemployment. Discontent resurfaces and the possibility of defeat at the next
election looms large. A sharp policy reversal is the result. In sum, the stop-go cycle
consists of two moments: overacting too late as a consequence of doing too little
earlier.

Kalecki foresaw increasing government encroachment in the areas traditionally

devoted to private enterprise. Initially, the government would enter spheres that did
not impinge on private activities like physical and social infrastructure. There would
be no protests from businessmen as the returns on private investments would not be
affected. However, the capitalist class feared that the next step would be the takeover
or nationalisation of transport and public utilities. Again, businessmen would not be
averse to government support of consumption by means of family allowances, price
subsidies for basics, children’s allowances and so on. Private enterprise is not
affected. However, a regime of permanent full employment would be resisted
strenuously. The confidence and demand of the working class would grow. While it
is true that with full employment, profits would rise, Kalecki believed that the
capitalist class would take a cut in profits in favour of power over the working class.
An additional reason is tacit: A purposeful stance towards full employment might
entail a redistribution of income. Incomes policies, then, would be energetically
opposed.

Can stimulating business optimism be adequate for pulling an economy out of a

recession? Kalecki thought not. While pro-cyclical interest rate policies might blunt
the duration and amplitude of the cycle, full employment will not be attained even in
10
the boom although the level of employment will fluctuate less. If the measure is Traditional Theories of
Business Cycles
repeated period after period, a situation can be envisaged when the rate of interest is
negative and a corporate income tax is transformed into a subsidy. None of these
have any bearing on the mood of businessmen whose behaviour is coloured by their
expectations of the future founded on the data of the present. During a particularly
severe downturn, investment plans would be immune to any fall in the interest rate.
Tax stimuli might be ineffective as the shift in the investment schedule is larger than
any movement along the curve. Consequently, it is not inconsistent with encouraging
private investment to induce public investment as well. The capitalist class would not
resist public investment financed by borrowing. What they would strenuously resist
is output generation by subsidising consumption and a regime of full employment.

Check Your Progress 2

1) Specify, in detail, the various components that, put together, generate the cycle
according to Michal Kalecki.

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11.5 HYMAN MINSKY

A fruitful transition from the short-run dynamics of a macroeconomic model and the
real-financial fluctuations associated with Hyman Minsky would be the probe of a
benchmark macroeconomic model offered by him below.
Minsky considers the following equations:
Y=C+I
C = C(Y)
I = I ( PIS ,W )

PK = L( M , K )

PID = PK

PIS = PID

MD = MS

The model is certainly familiar from introductory macroeconomics where the

exogenous variable M is money, and the subscripts D and S against it denote demand
and supply of money in the money market equilibrium condition. K and W are the
given capital stock and wage bill respectively, which are given. The ‘price’ of
money PM = 1. PIS is the supply price of a unit of investment, PK is the market price
of existing real capital and PID is the demand price of a unit of investment. The
explanatory sequence is as follows: The portfolio balance equation or the liquidity
11
Economic Fluctuations preference relation above yields a value of PK for every quantity of M. Given W, I
adjusts so that PIS = PK. Once I is given, C and Y are determined.

However, productivity of capital takes the form of expected future earnings (gross
profits after taxes) of an assembly of capital goods within a producing unit. Recall
the arithmetical relation from basic macroeconomics that the value of the capital
stock will necessarily equal the discounted value of a stream of future returns. The
discussion of the marginal efficiency of capital MEC is relevant here and can be
substituted for the equation for PK. Hence, this one is the unstable equation in the
system and shifts downwards whenever a wave of pessimism overcomes investors.
Changes in investors’ confidence can lead to potentially destabilising
macroeconomic cycles even when the interest rate is relatively stable in the face of
aggregate demand shocks. Building upon Keynes, Minsky argued that the
explanation for the level of aggregate demand must be sought in the financial
markets, in the financing of investment plans. Disequilibria therein affect the
valuation of capital assets relative to the price of current output and this price ratio
determines investment activity. Keynes’ General Theory, Minsky explained, was
concerned with how these two sets of prices (capital and financial assets, on the one
hand, and current output and wages, on the other) were determined in different
markets by different explanatory variables which gave rise to fluctuations in
economic activity.

In order to understand a modern economy from an appropriate Wall Street

perspective rather than through the metaphor of a village fair, the cash flows and
related balance sheets of categories of economic agents must be displayed. The flow
of funds accounts will depict consistent interlocking asset and liability positions of
different classes of receipts and payments. Positions held here determine the flows of
goods and services. Balance sheets for a Minsky-type financial instability model are
as follows where the details will be found in Lance Taylor’s text mentioned in
section 11.7.
Households Firms Banking System Government
M Ωh qPK Lh T M T

Lh Lb Lb

PvV PvV
Ωf

Corporate net worth Ω f is not restricted to be null and emerges as an endogenous

variable in the model. Government debt T is held only by the banking system. The
money supply rule is, therefore M = ζT where ζ is the money multiplier and the
supply of bank loans to firms is Lb = (ζ-1)T. The economy-wide wealth constraint is
Ω b + Ω f = qPK + T , where PK is the “replacement cost” of the capital stock and q
is Tobin’s q. Thus qPK would be the asset value of the capital stock. Given the
shares v and λ sh of their wealth Ω h that households hold in the form of equity and
loans to firms respectively, their balance sheet identity can be used to scale their net
worth to the money supply. Note that rentiers and workers can be distinguished
(recall the remarks made in connection with the appraisal of Goodwin) in the equity
value PvV of rentiers. We have
Ω b = M (1 − v − λsh ) = M µ
where µ is the share of Ω h held as money. The loan market equilibrium condition is

λd qZ − [(λsh µ )ζ + (ζ − 1)] = 0

where Z = PK T is the capital-debt ratio, the state variable.

12
Minsky suggested that the arguments of the loan demand function λd are the interest Traditional Theories of
Business Cycles
rate i and the expected profit rate re = r + ρ, where r is the observed rate of profit and
ρ is an indicator of business confidence. The share of money and loans in household
wealth are assumed to depend on the same explanatory variables and u, the capital-
output ratio as an indicator of the level of economic activity. The expected profit rate
also determines the capital asset valuation ratio q. The latter is set equal to re
capitalized by borrowing costs, q = ( r + ρ ) i . When businessmen are optimistic, the
investing community ratifies their confidence by increasing its estimates of corporate
wealth. From their balance sheet, the net worth of firms
Ω f = qPK − Lh − Lb − PvV follows endogenously from the level of q and loan and
equity market clearing. For given levels of ζ and Z, the excess demand for loans (the
loan market equilibrium condition above) will be a decreasing function of the interest
rate. An increase in Z steps up the demand for loans, thereby driving up i.
Conversely, an increase in the supply of loans, a higher ζ, lowers the interest rate.

Potential effects of changes in ρ or r on excess loan demand are more interesting.

The basic assumption here is that liquidity preference is high in conditions of
fundamental uncertainty. During a boom, the speculative demand for money
decreases more than the transactions demand goes up. This portfolio switch bids up
equity prices Pv in the equilibrium condition of that market

(v µ )ζT − PvV = 0

The relative supply of loans goes up. Excess loan demand becomes less sensitive to
changes in actual and anticipated profit rates. The slope of the “loan market” curve,
or the LM curve so to speak, in the (r,i) plane becomes more shallow at higher levels
of r. If investment demand depends on q, then the IS or “commodity market” curve
determines macroeconomic equilibrium. A higher level of confidence shifts the LM
schedule upward and the IS rightward, leading to a new equilibrium with higher
values of r and i. The shift in liquidity preference, however, means that the increase
in i relative to r will be greater at a low initial profit rate than at a high one.

In order to generate an oscillatory response, note that Z will evolve over time
according to
Z&= Z ( g − γ g Z )

where g is the rate of growth of the capital stock from the IS-LM model and γg is the
share of the fiscal deficit in the value of the capital stock. Since a higher value of Z
raises the interest rate, ∂g ∂Z < 0. Therefore, ∂Z& ∂Z < 0.

The other state variable is the state of confidence which, through positive feedbacks,
can generate cycles. A higher value leads to an increase in investment and the growth
rate. Thus, ∂Z&∂ρ > 0. Changes in ρ, as well, depend on the state of the economy.
For instance, confidence might increase when the actual profit rate r is high or the
interest rate i is low. Thus,
ρ&= f (r i )
where f is an increasing function.

The two equations above can generate a clockwise cycle. The system is potentially
unstable because a higher value of ρ can make the r i ratio go up, ∂ρ& ∂ρ > 0. A
higher Z raises the interest rate and reduces the level of economic activity and
profits. That is, ∂ρ& ∂Z < 0. A sudden loss of confidence at an initial steady state
means that ρ jumps downwards. Consider the stable case when the Jacobian of the
system above is positive. The “confidence” schedule, ρ&= 0, must be steeper than
13
 the “velocity” schedule, Z&= 0. It continues to decline, with Z also falling because
Economic Fluctuations

the interest rate is relatively high and investment is decreasing. After some time, Z
may fall far enough to reduce pressure on the loan market and permit the r i ratio to
rise. When the trajectory crosses the “confidence” schedule, ρ will begin to rise,
finally stimulating growth enough to allow Z&> 0. The upswing might last some
time, until the trajectory crosses the flattened “confidence” schedule at high values of
Z and ρ. Depending on the strength of the positive feedback to confidence, the
system may oscillate back to the original steady state, orbit it forever, or diverge on a
spiral path.

The swings in confidence might be dampened by the interventions of central banks.

Here ρ would be affected by shifting the interest rate through changes in the credit
multiplier. However, if the authorities step in to support confidence, ρ itself may
move upward over time leading to increasingly fragile financial positions.

Hyman Minsky’s cycle moves through the following stages: “Hedge financing” best
describes the tranquil period when the anticipated cash flows from operations are
adequate to meet future commitments on debts. Over a few such years, confidence
and optimism build to generate “speculative financing” wherein the present value of
cash flows over a finite horizon are not expected to meet payments commitment. As
a run of good years continues, “Ponzi financing” schemes are generated which are
outright pyramidal swindles where a subclass of individuals roll over their debt by
emitting fresh debt in a never-ending spiral. It is worth observing, as a footnote here,
that the standard infinite-horizon optimisation exercise includes the well-known “No
Ponzi Games condition” that excludes these schemes on the grounds of the
rationality of borrowers and lenders. At the euphoric peak of the cycle, as both short-
term and long-term interest rates drive speculative and Ponzi behaviour, the present
values of some Charles Ponzi-type investors will turn negative. Reneging on their
commitments will lead to the distress of their lenders who will encash other financial
assets. The prices of assets across the board will plummet precipitously impacting on
investment plans and profits. While the upper point of the cycle, then, is
characterised by a Keynes-type evaporation of the wave of optimism or animal
spirits, the lower turning point is a process of debt deflation leading to a stable
system with modest hedge funding of projects.

Check Your Progress 3

1) Provide the details of the movement of financial arrangements in a capitalist
economy from hedge to speculative to Ponzi financing in the theory of Hyman
Minsky.

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14
2) Write a Keynesian macroeconomic model with the key price ratios associated Traditional Theories of
Business Cycles
with Hyman Minsky. Discuss the stability properties of the model.

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11.6 LET US SUM UP

In this unit we discussed some of the early works on business cycles. Economic
fluctuations have been explained by economists from various schools of thought.
Some of the early works include that of Schumpter, Goodwin, Kelecki and Minsky.
Schumpeter’s work based on innovations as a cause of business cycle, as you will
observe in the next unit, laid foundation for recent models such as real business
cycles. The political business cycle of Kalecki, which divides the economy into
three departments, analyses the process of ups and downs in economic activity. The
model by Minsky, through rigorous mathematical analysis, shows the oscillation
around a steady state by invoking the inconsistencies in real and financial sectors.

11.7 KEY WORDS

Downswing : It refers to contractionary phase of business cycle.

Endogenous : A characteristic emanating from within the system.

Exogenous : A characteristic decided outside the system and taken as

given for the model.

Ponzi Financing : The method of financing where in order to repay

previous debt households take recourse to fresh
borrowing.

Upswing : It refers to the expansionary phase of business cycle.

11.8 SOME USEFUL BOOKS

Kalecki, Michal, 1953, Theory of Economic Dynamics, London: Allen and Unwin

Kalecki, Michal,1971, Selected Essays on the Dynamics of the Capitalist Economy:

1933-1970, Cambridge: Cambridge University Press
Schumpeter, J.A., 1951, The Theory of Economic Development, Cambridge: Harvard
University Press.
Skott, Peter, 1989, Conflict and effective demand in economic growth, Cambridge:
Cambridge University Press
Taylor, Lance, 2004, Reconstructing Macroeconomics, Cambridge, Massachusetts:
Harvard University Press
15
Economic Fluctuations Despite the proliferation of work building on Minsky’s insights, you can do worse
than refer to some of his books. For example, the following are representative
Minsky, Hyman, 1975, John Maynard Keynes, New York: Columbia University
Press
_____________, 1986, Stabilizing an Unstable Economy, New Haven: Yale
University Press.
For a business cycle model that connects the real and the financial sectors see
Boyd, Ian and John M. Blatt, 1988, Investment Confidence and Business Cycles,
Berlin: Springer-Verlag.

11.9 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) Your answer should be based on Section 11.2.

2) Read Section 11. 3 and answer.

Check Your Progress 2

1) Note that the expectation is that you fill in the equations and combine them and
deliver an unstable difference-differential equation.

Check Your Progress 3

1) Go through Section 11. 5 and answer.

2) Go through Section 11. 5 and answer.

16
UNIT 12 REAL BUSINESS CYCLES
Structure
12.0 Objectives
12.1 Introduction
12.2 New Classical Business Cycle Theory
12.3 Real Business Cycle Theory
12.3.1 An Island Economy
12.3.2 Imperfect Information
12.3.3 Cyclical Fluctuations
12.4 Let Us Sum Up
12.5 Key Words
12.6 Some Useful Books
12.7 Answers/Hints to Check Your Progress Exercises

12.0 OBJECTIVES
After going through this Unit you should be in a position to:
• explain the underlying ideas behind real business cycles theory;
• appreciate the importance of technological innovation; and
• appreciate the possibility of economic fluctuations due to supply shocks.

12.1 INTRODUCTION
The extent of this module is partly indicated in the title. It is about real business
cycle (RBC) theory. In addition, it exposes you to New Classical Business Cycle
theory, a specie which belongs to the same genus that spawns the RBC approach.
The literature in the field is technical, so we will work through some elementary, but
not trivial, treatments of the subject and strongly recommend plunging into the
classics in the area, once some quantitative skills have been imbibed.

The present Unit connects, as promised and naturally, from the study of business
cycles in the previous Unit. Intimately, however, the springs of this Unit are less
cycles as developed there and your exposure to the traditional theory of
unemployment, and more your education in microeconomics that ends with the
theory of general equilibrium. The perspective of the former is that business cycles
emerge naturally in the evolution of a capitalist economy as a system. Particularly,
the connection between the short-run dynamics of traditional theories of employment
and the cycles that emerge from their long-run extension would be written along
aggregative lines. The painstaking work of pioneers like Wesley Clair Mitchell and
others consisted in closely scrutinising the time series of important macroeconomic
magnitudes and tracing short and long cycles therein. The strategy of the latter, on
the other hand, is to develop the story of market-clearing over time to account for the
phenomenon of fluctuations and cycles. A distinction is made between the two
notions. Fluctuations might not present the periodicity indicated in the word ‘cycles’.
Real business cycles are fluctuations generated by shocks which might not reflect the
rhythms of ebb and flow of classical cycles. New Classical Business Cycle research,
on the other hand, is oriented towards explaining the familiar pattern of boom and
slump, one following the other in regular succession. Perhaps for this reason, the role
of money and finance in both approaches might be distinguished. In the former, the
shocks referred to are changes in technology and tastes. Money is a veil. On the other
17
Economic Fluctuations hand, money and finance are part of the model of expansion and contraction
developed by New Classical Business Cycle theorists.

12.2 NEW CLASSICAL BUSINES CYCLE THOERY

As mentioned earlier, the following exposition follows the elementary account in the
book:

Yang, Xioaokai, Economics: New Classical versus Neoclassical Frameworks,

Oxford: Blackwell Publishers. The book goes on to rigorously develop some models
and you are encouraged to follow them up.

One reason for natural unemployment in a new classical general equilibrium model
is changes in the structure of the division of labour (A brief idea about new classical
economics was given in Unit 1. Their views about unemployment will be discussed
in Block 6). Consider an economy with m consumer goods and n traded goods. Of
these goods, suppose the price of oil rises. The equilibrium values of m and n
changes. The demand for luxury sedans, say, might vanish as people stop consuming
inessentials. The producers of those goods will be unemployed. They are free to
move to sectors which do not face an impact of this exogenous shock. However,
since there is considerable educational capital that has been invested in mastering
the nuances of limousine manufacture and the costs of moving are invariably high,
these individuals will not be immediately productive as the correspondingly skilled
workers in the other sectors. In other words, an economy with a division of labour
into specialists will face the phenomenon of unemployment. In fact the two are
connected in a relationship: the more elaborate the division of labour, the greater will
be the level of unemployment as a response to shocks from without. The situation
would not occur in autarky. Since each individual consumes what she produces, any
stochastic shocks will be accommodated by an optimal reallocation across the
spectrum of goods consumed.

Some features distinguish New Classical features of business cycles from other
forms of business cycle. The extent of the division of labour and the level of
specialisation for each individual are grounded in dynamic microeconomic choices.
The model generates persistent, regular, endogenous, and efficient business cycles. It
also simultaneously generates endogenous, and efficient, unemployment. The model
is consistent with empirical phenomena like the fact that the output of durables
fluctuates more than the output of nondurables.

One insight is that the business cycle is inextricably linked with trade and financial
openness. In its modern form it is exemplified in developed economies with a
complex division of labour and high productivity. Let us consider an economy that
consists of many agents. Each individual can produce a perishable good called corn
and a durable good called tractors. A tractor is indivisible and each driver can drive
only one tractor as a capital input in the production of food at any point of time. Each
job is skill-specific and two types of cost will be incurred if an individual shifts
between activities. There is obsolescence of knowledge and memories will decay
when an individual moves from one activity to the other. There is also an entry cost,
a nontrivial investment in education that an individual has to incur before she enters
any activity. A tractor has a life of two years. Each individual’s utility function is
defined over consumption (food) and the objective is to maximise the present value
of total utility.

At least three possible equilibrium situations follow. The first is autarky. Each
individual divides her time between manufacturing a tractor and using it to produce
food in the first year, and produces only food in the second year. This structure is
cycle-free. Yet, such an economy cannot garner Smithian gains from the division of
labour. The second structure is one in which the division of labour is fully
accomplished. The population is divided between producers of food and producers of
18
capital goods. In each year, professionals drive tractors to produce food. The Real Business Cycles
producers of tractors manufacture them in the first year and are unemployed in the
next. Total output in the first year is higher than the second. Thus, we see a business
cycle of two years with unemployment in the second year. Learning by doing is
maximal here and the society is best poised for the accumulation of human capital.
The third structure is partial division of labour. Here, producers of tractors move to
the production of food in the second year. Thus, farmers are completely specialised
and can reap those economies whereas producers of tractors are not.

In the second structure, producers of tractors sell tractors and buy food in odd years.
The value of tractors sold must be in excess of the value of food that is produced.
The difference is required as a wherewithal for tractor specialists to buy food in even
years when they are unemployed. Since corn is perishable and tractor producers face
the problem of the double coincidence of wants in even years, the institution of fiat
or credit money is indispensable for exchange to take place. Since the discounted
optimisation problem is carried out for a representative agent, the present value of
real income between farmers and manufacturers of the capital good must not be
different. In the light of the earlier considerations, this means that income in the
tractor goods-producing sector must be higher than the income in the corn-producing
sector by an amount that compensates for unemployment in the sector producing
durable goods in the recession.

It has already been indicated that the non-autarkic economies cannot operate without
fiat or credit money. For example, in the second structure, farmers sell food but do
not purchase goods in even years, while tractor manufacturers buy food but do not
sell goods in even years. Then, tractor producers must save some of the income
generated from selling their vehicles in odd years to eat in the following even years.
Savings cannot be in the form of goods, so a commodity money will not solve the
problem. The only redressal is the introduction of an entity outside the system that
has the power to print intrinsically worthless pieces of paper whose value is
determined by the price level in the process of exchange. It is equally possible for a
bank to mediate between agents and across time, induced by arbitrage opportunities,
offering its own ‘inside’ money. It can be shown that rules of allocation and even
accumulation can be obeyed with these monetary arrangements. Indeed, without
money the models with exchange cannot be in dynamic general equilibrium even if
they are Pareto superior to autarky.

To generalise, the following elements accentuate cycles: the division of labour, the
length of the roundaboutness of production, the durability of goods, the income share
of durable goods, the costs of moving between jobs, transaction costs, and the degree
of learning by doing. Correspondingly, countercyclical factors are: a decrease in the
roundaboutness of production, a decrease in the level of the division of labour, a
decrease in the durability of goods, decreases in transaction costs and a decrease in
the degree of learning by doing.

Check Your Progress 1

1) Explain the basic tanets of the new classical business cycle theory. What are
the factors that accentuate cycles?

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19
Economic Fluctuations
12.3 REAL BUSINESS CYCLE THEORY
The parable that motivates this discussion originated with Edmund Phelps and
invites you to think that all men (and women) are islands. They have perfect
information about the prices of goods and services on their islands but cannot sample
the prices on other islands except by rowing there, a costly activity. Consequently,
they can only form estimates of the general price level, the average of all prices.
Thus, an increase in the general price level will be misperceived as an increase in the
price of goods on the island, a (small) subset and, therefore, sub optimal decisions
about consumption, production, and investment will be taken. In the spirit of the
earlier section, the following account in the next is drawn from the book:

Barro, Robert, Macroeconomics, New York: John Wiley & Sons, Inc.

12.3.1 An Island Economy

Consider an economy as a sea with islands of local markets. Each household
produces goods and sells them on one and only one of the arrays of these markets.
Goods differ according to location, physical characteristics, and so on. Accordingly,
we index goods by the symbol z, where z = 1,2,…,n. The index might specify a
location or be associated with an assemblage of characteristics of goods, methods of
production etc. pt(z) is the price of a good or, indeed, a basket of commodities of type
z during period t. Thus, the RELATIVE PRICE pt ( z ) pt ( z ′) is the price of
commodities of type or location z relative to commodities of type or location z′.
Distinct is the GENERAL PRICE LEVEL pt which is the average of the prices in the
islands at date t. If pt(z) > pt, then locale z appears relatively attractive to sellers in the
given period. There will be a rush of productive resources from other employments
to island z. The increased supply of goods in our market will, in the familiar manner,
drive down the local price to the average price. Similar reasoning applies to a case
when the price of the commodity/at the location z is less than the general price level.
Assuming freedom of entry and exit, the average of all prices will be an efficient
estimator of the local price.

At the beginning of period t, a producer in market z has a stock of capital kt-1(z).

Assuming a production function f with standard properties, the quantum of goods
produced is given by yt(z) = f(kt-1(z),lt(z)). Total revenue earned by sellers from sales
is the product of this quantity with the local price. However, people typically shop at
different locations and the variable of interest to them will be pt, the index of
generalized purchasing power. In that case, people will calculate the real value of the
revenue from production which is ( pt ( z ) pt ). f ( k t −1 ( z ), lt ( z )).

Thus, an increase in the relative price above, physical output remaining constant,
means a greater value of sales. From the perspective of a producer, this increase is no
different from a corresponding upward shift in the production function. Earlier, when
deciding how much to work and produce, workers and producers looked at the
physical marginal product of labour. Now, in order to calculate the effect on real
sales revenue, producers multiply that number by the relative price to get the real
value of the marginal product of labour. Then, as earlier, a shift in one component of
the product, the relative price, appears identical to a proportional shift in labour’s
physical marginal product schedule. Consequently, producers respond in the familiar
fashion.

Coming to the inducement to invest, the amount of investment is determined by the

marginal product of capital. However, the marginal product of this factor determines
the flow of next period’s output as a result of an increase in this period’s capital
stock. According to the standard definition, it takes one period for investment to raise
productive capacity. Thus, the real value of capital’s marginal product which
20
determines investment decisions is defined as the product of this period’s marginal Real Business Cycles
product and next period’s relative price pt +1 ( z ) pt +1 .

How would producers respond to a rise in pt ( z ) pt ? There are two possibilities.

This hike is temporary and confined to the present period. In other words, people do
not expect a similar increase in the future. Then, as discussed earlier, the change is
tantamount to an upward shift in the schedule of labour’s marginal product in t but
not in later periods. Two kinds of substitution effects are implied. In the first case,
within the time period, there is a movement away from leisure and towards
consumption. In addition, there is also an intertemporal substitution effect in a shift
away from today’s leisure and towards tomorrow’s leisure. The second effect suggest
that the impact on current work and production will be strong.

A second possibility attendant on a high relative price today is an increase in the

expected relative price pt +1 ( z ) pt +1 . In that case, there is a positive effect on
investment today. Producers will purchase additional capital from other markets in
order to capitalise on the higher relative price for goods sold later in location z. The
first impulse would be an increase in the demand for local resources in market z
albeit at the high current relative price. Apart from the technical assumption that
goods and services on hand tend to be needed first, the high prospective relative
price tomorrow can induce investors to spend at a high relative price today. A high
prospective relative price means that the high current relative price is no more an
opportunity to reap present rewards. The intertemporal substitution effects referred to
will become weak. In other words, there might be a negligible response on work
effort and the supply of goods today.

A high relative price cannot persist. The increased investment that results increases
productive capacity in that market. The augmented supply of goods in future will
exert downward pressure on future relative prices. Thus, the high relative price must
persist long enough to generate positive effects on investment. If not, the
intertemporal substitution effect will remain strong. We regard the nominal interest
rate as a system-wide variable determined on a centralised credit market.
Correspondingly, the real interest rate rt is an economy-wide variable as well. Buyers
who visit island z will be deterred in their consumption ctd (z ) and investment
demands itd (z ) by a high relative price. Given the latter, a high real interest rate
means a greater supply of goods to market z but reduced demands for consumables
and investment goods there. Clearing of the local market is given by the equation:

Yt s ( z )[ pt ( z ) pt , pt +1 ( z ) pt +1 , rt ,...] = C td ( z )[ pt ( z ) pt , rt ,...] + I td ( z )[ pt ( z ) pt , pt +1 ( z ) pt +1 , rt ,...]

+ − + − − − + −

12.3.2 Imperfect Information

Buyers and sellers are perfectly informed about the local price but must form
estimates about the average of all prices. At the outset, let us assume that there is no
reason for buyers and sellers in market z to believe that their local market is in any
sense different from the average market anywhere. Thus, as a preliminary estimate,
the local price is not assumed to be different from the expected general price level.
We assume RATIONAL EXPECTATIONS in its weak form, which implies that
people do not make systematic forecasting errors. In addition, we assume that the
information set of all agents is identical. Thus, the PRIOR of the future general price
level, pte , is the same across all agents. When interval t actually unfolds, the selling
price, pt(z), will empirically be known. It is unlikely that this price will be equal to
the earlier estimate of the general price level. Since the information set has at least
one additional element now, the actual local price, the estimate of the general price
level can be updated with this new data. For instance, if the local price turns out to be
higher than expected, it is likely that the average of all prices also exceeds the earlier
21
Economic Fluctuations
estimate. Call pte (z ) the EX POST price expectation, the notation signifying that
this estimate differs from the prior due to an updating formula triggered by the
arrival of information about the local market z. The simplest algorithm is to give a
weight of θ to the local price and, therefore, a weight 1-θ to the prior general price
level in forming the new estimate of the general price level. Thus,
pte ( z ) = θpt ( z ) + (1 − θ ) pte . Clearly, people will set a high value of θ if their
market differs little from other markets in price space. On the other hand, the weight
on the general price level would be higher in the absence of aggregate shocks that
change the general price level over time. For instance, we would attach limited
credence to the general price level if the environment is buffeted by unpredictable
changes in money and factors that influence the demand for money.

A person’s ex post expectation of the average price level will determine her
perception of her relative price. Call pt ( z ) pte ( z ) the PERCEIVED relative price
that determines demand and supply functions in market z. The interaction of both
schedules determines equilibrium price and output pt(z) and yt(z). Now, an increase
in the PRICE RATIO pt ( z ) pte leads to an increase in the perceived relative price.
However, by virtue of the updating formula, the ex post price expectation rises by a
fraction, theta, of the increase in the local price. Thus, the perceived relative price
rises by less than the price ratio. For example, suppose the prior expectation of the
price level is 100 and θ = ¼. Then, if the local price is 104, pt ( z ) pte = 1.04. In
that case, pte ( z ) = 1 / 4.104 + 3 / 4.100 = 101.

Hence, pt ( z ) pte ( z ) = 104 / 101 ≈ 1.03. That is to say, if the weight placed on the
local price is one fourth, the perceived relative price responds by approximately
twenty five percent less than the price ratio. In general, the higher is the weight, the
lower is the reaction. The local market clears when the price ratio equals one. By the
same token, the market-clearing perceived relative price is unity as well.

Suppose, now, there is a surprise increase in the stock of money Mt. People did not
anticipate this change when they formed their priors. Suppose the local price rises in
a typical market. The prior being given, the price ratio goes up. Therefore, the
perceived relative price increases as well. Thus, the typical individual believes that
she is operating in a market where the relative price is high. This belief is false
because, by definition, the general price level is the average of the local prices across
markets. However, since the average price level and the quantity of money are not
elements of the information set, the representative individual underestimates the rise
in the general price level/overestimates the relative price in her local market.
Consequently, people increase their supplies of goods and lower their demands.

An increase in the perceived relative price raises the relative price people expect in
the local market for the next period. Thus, investment demand today rises and the
supply of goods falls. The demand and supply curves now combine two effects of
changes in the price ratio. First, there is the effect from the current perceived relative
price making the supply curve more positively sloped. Second, there are the effects
from the change in the prospective relative price, pt +1 ( z ) pt +1 , reducing the
negative slope of the demand curve. Let us assume that the latter effect is stronger.
The promise of favourable prospective returns far outweighs the high perceived
current-relative-price, leading to aggressive expansion plans. Secondly, there are
effects on the real interest rate. The supply of goods exceeds the demand in the
typical market. Thus, in the aggregate, desired savings exceeds net investment
demand. The expected real interest rate falls to bring the two into equality. That is,
the aggregate demand curve shifts rightward and the supply curve shifts leftward.
The lower expected real interest rate motivates people to consume and invest more
but to work and produce less.

22
What is the outcome on output in the typical market? The high price ratio stimulates Real Business Cycles
supply but depresses consumption and investment demand. Also, the anticipation of
a high prospective relative price encourages investment but reduces the supply of
present commodities. Lastly, the fall in the expected real interest rate increases
investment and consumption demand but weakens supply. Then, the conclusion that
output increases in the typical market depends upon the powerful positive effect of
the hike in the prospective relative price on local investment demand. In that case,
the monetary disturbance would stimulate local investment, output, and work effort.
Since the analysis is conducted for the representative market, the general result is an
increase in aggregate investment, output and work.

The steps following from the surprise increase in money and prices to increased
work, output and investment are as follows. In the first place, a rise in the general
price level appears no different from a rise in the relative price to suppliers in market
z. They work more and increase production because they confuse a change in the
general price level with a local change that would warrant an increase in activity.
Secondly, the change in the price ratio makes people believe that the favourable
condition in the local market will persist. They, therefore, raise their expectations of
the future relative price. Once again, people are fooled into believing that there is a
change in local demand and increase investment. These plans show up in the current
purchase of goods and services at the local price. Despite the high relative price,
investors proceed with their projects in order to avail of the expected high returns
later.

The misperceptions would not arise if people had perfect information about money
and prices. Suppose everyone correctly anticipates a once-and-for-all increase in the
quantity of money from the last period to the present. Then the higher value of Mt
today will result in a one-to-one increase in pte . The actual prices and the prior
expectations increase in the same proportion. There will be no effects on the supply
of and demand for commodities in market z and, consequently, no effects on work
and production and the real interest rate. In conclusion, fully anticipated increases in
money and prices are neutral. The theory does not support the case for using
monetary policy to smooth out business fluctuations.

Now, during period t, producers are unlikely to find that the actual price at which
their goods sell locally equals the prior expectation pte . There are two possibilities,
once again. Some special reason like a shift in the demand in market z might have
caused a shift in the relative price of local goods. Besides, the forecast of the general
price level is unlikely to be precise. The general price level will be higher or lower
than the prior expectation of its level. We continue to assume that the process of
shopping is less than complete, that agents will continue to operate with data about a
small sample of extant prices. When information is incomplete, the perfect
information about the local price is informative about the general price level.

Suppose people predict the general price level with a high level of accuracy. The
situation can be explained by the authorities pursuing a monetary policy that
provides perfect stability. In other words, there would not be unpredictable shifts in
the quantity of money, Mt, from period to period. Then, buyers and sellers would not
need to make discontinuous adjustments to their priors when they observe the local
price. They would believe that movements in pt(z) signaled changes in pt ( z ) pt ,
rather than movements in pt. The greater the confidence in the credibility and
reputation of the monetary authorities, the greater the implications of being fooled by
monetary surprises. Still, by rational expectations, people infer that they are right on
average. They will regard changes in pt(z) as evidence that pt ( z ) pt has changed.
Consequently, they will substantially change their demands and supplies. In other
words, a surprise increase in the money supply induces a large increase in output.

23
Economic Fluctuations On the other hand, consider an economy in which the monetary authorities are
capricious, changing the money supply widely from period to period. As a result, the
general price level diverges sharply from the forecasted level. Here, people have less
confidence that a change in the local price reflects a change in the relative price.
They would believe that a high local price signaled a more than proportionate
expected general price level. In that case, pt ( z ) pte and, therefore, demands and
supplies are relatively unresponsive to observed changes in the local price. In this
case, a monetary surprise has small output effects. The conclusion is that the greater
the volatility of the time series of money, the smaller the real effect of monetary
shocks. A greater volatility of money induces agents to associate increases in local
prices with surprisingly high general price levels. The authorities will find it more
difficult, in these circumstances, to fool people into believing that relative prices
have changed.

Fundamentally, at stake here might be the much-vaunted efficacy of the price system
as the most efficient and parsimonious signaling device. A great fluctuation in
money supply from one interval of time to the next means that prices become less
responsive to changes in local prices. In other words, agents make fewer mistakes
when price changes are a reflection of unexpected changes in money and the general
price level. However, the flip side is that people make larger mistakes when relative
prices change. The greater the uncertainty about money and the general price level,
the less prices become useful as the conveyor of information par excellence. Thus,
the economy becomes less responsive to changes in fundamentals, shifts in tastes and
technology, that require optimising and efficient reallocation of resources. In
conclusion, while changes in variations in the average growth of money are neutral,
changes in the predictability of money have real effects. Thus, the best monetary
policy is one that is most predictable.

12.3.3 Cyclical Fluctuations

Consider a situation where the value of money above trend indicates an unexpectedly
high level of money in the recent past. The model predicts that this excess above
trend would induce a higher level of output, work effort, and investment, all relative
to trend. That is to say, money, employment, and investment would vary
procyclically. These predictions correspond to the data. On the other hand, some
predictions generated by the model fit the data less tightly. A monetary shock would,
according to the theory, lead to an increase in the general price level and a fall in the
expected interest rate. The evidence seems to not to support the proposition that the
rise in the price level is procyclical and the expected real interest rate is
countercyclical. Since the production function is assumed not to change, and the
capital stock is given in the short run, the increase in the employment of labour
implies that the marginal and average products of labour fall. The theory predicts that
labour productivity and the real wage rate would be low when the volume of output
and labour input are high. That is to say, labour productivity and the real wage rate
vary counter-cyclically. This proposition, again, is not consistent with the data.

The conclusion is that there might be limitations to a model constructed to explain

business fluctuations driven entirely by monetary surprises. Incorporating shifts in
the production function and assigning monetary shocks a secondary role might be a
superior strategy.

Check Your Progress 2

1) Real business cycle models explain fluctuations in output by means of
exogenous shocks. The outcome is irregular fluctuations. Elaborate upon the
difference between such random movements and the periodicity of cycles.

…………………………………………………………………………………..

24
 ………………………………………………………………………………….. Real Business Cycles

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

Compare and contrast new classical models and real business cycle models of
fluctuation with the models of cycles and unemployment in your module on
cycles.

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

2) Can there be surprise changes in the quantity of money when expectations are
rational? In that case, do the monetary authorities possess the weapon of
counteracting business cycles through unexpected increases in the quantity of
money?

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

3) When expectations are rational, agents cannot make mistakes on average in

forecasting the price level. How, then, do we explain persistent deviations of
aggregate output from trend?

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..

…………………………………………………………………………………..
25
Economic Fluctuations
12.4 LET US SUM UP
In this unit we discussed real business cycles which asserts that economic
fluctuations are an outcome of real shocks to the economy. It is based on the
assumption of rational expectations and shows that monetary policy has no real
effects and shift in aggregate demand is not an important cause of fluctuations in
output and employment.
The new classical business cycle theory puts emphasis on the changes in the
structure of the division of labour. International trade and financial openness have
made modern economics highly specialised with respect to division of labour and
there is greater roundaboutness in production. Along with this there is an in-built
force causing fluctuations in output and employment.
In real business cycle theory emphasis is given on real shocks such on technological
change which shifts the production function. A productivity shock changes the level
of output produced by given amount of inputs. The new classical economists,
however, have not been able to convince all and the new-Keynesion economists still
believe in the importance of aggregate demand in economic fluctuations. We will
learn more about new-Keynesion view in Block-6.

12.5 KEY WORDS

Division of Labour : A method of organizing production in such a manner
that each labour specializes in a part of the production
process. It was Adam Smith who emphasized on the
gains to the economy due to division of labour.
Learning by Doing : It refers to the improvement in efficiency of labour
through experience.
Pareto Efficiency : It refers to allocation of resources in such a manner that
further change in the allocation pattern cannot improve
the utility or satisfaction of one individual with out
reducing that of another.
Transaction costs : The additional costs, apart fromm price of the
commodity, required to carry out a transaction/ exchage.

12.6 SOME USEFUL BOOKS

Barro, Robert, Macroeconomics, New York: John Wiley & Sons, Inc.
Dornbusch, R., S. Fischer, and R. Startz, 2004, Macroeconomics, Take McGraw-
Hill, New Delhi, Chapter 20.
Yang, Xioaokai, Economics: New Classical versus Neoclassical Frameworks,
Oxford: Blackwell Publishers.

12.7 ANSWER/HINTS TO CHECK YOUR

PROGRSS EXERCISES
Check Your Progress 1
1) Read Section 12. 2 and answer.
Check Your Progress 2
1) Go through Section 12.3 and answer.
2) Go through Section 12.3 and answer.
3) Go through Section 12.3 and answer.
26
 UNIT 13 TRADITIONAL THEORIES
[ Structure
13.0 Objectives
13.1 Introduction
13.2 Types of Unemployment
I
13.3 Classical View on Unemployment
I 13.4 Keynesian view on Unemployment
13.5 Phillips Curve
13.6 Costs of Unemployment and Inflation
I 13.7 Non-Accelerating Inflation Rate of Unemployment (NAIRU)
I 13.8 Let Us Sum Up
I
I
13.9 Key Words
I
13.10 Some Useful Books
t 13.11 Answers1 Hints to Check Your Progress Exercises
I
I
13.0 OBJECTIVES
After going through this unit you should be able to:
identify different types of unemployment;
1 explain the classical and Keynesian views on unemployment;
b

I establish a relationship between unemployment and inflation; and

identify the costs of unemployment and inflation.

13.1 INTRODUCTION
Labour is demanded by firms as it contributes to production of goods and
services. In return of its contribution, labour is rewarded with wages. In the
market for labour the wage rate is determined at a level where supply of and
demand for labour are equal. While human beings supply more labour at higher
wage rate, firms demand lower quantity of labour when wage rate is high. Thus
supply of labour has a positive relationship with wage rate (implying upward
sloping supply curve) while demand for labour has a negative relationship with
wage rate (implying downward sloping demand curve).
A fact that has perturbed everyone, no less economists, is that total labour force
is not fully employed at the prevailing wage rate. Certain percentage, which
fluctuates over time, of the labour force remains unemployed at.any point of
time. The nature of and the reasons behind unemployment in the economy have
been put to much debate in economics. Economists have come up with varied
explanations of unemployment, which we will consider in this unit.

13.2 TYPES OF UNEMPLOYMENT

A person can be either in the labour force or not in the labour force of an
economy. The person not included in the labour force includes those who are
retired, too ill to work, keeping the house, or simply not looking for work. On
the other hand, persons counted under the category labour force includes those
who are employed or unemployed. By employed persons we mean those who
perform any paid work (thus housewives are not included) and those who have
jobs. On the other hand, the unemployed as a category includes people who are
Unemployment
not employed but are actively looking for work. Thus while considering
unemployment we do not take into account those who are not in the labour
force.
There are three kinds of unemployment, viz., frictional, structural and cyclical.
Fictional unemployment takes place because people switch over from one job to
another. In many cases the tenure of job gets over and workers remain
unemployed till they get another job. In other cases workers migrate from one
region to another in search of better jobs or opt to remain out of job for short
time periods. Frictional unemployment takes place because in an economy with
imperfect information job search and matching is not smooth and there are
frictions in the economy. Structural unemployment, on the other hand, results
from the mismatch between supply and demand for different kinds of jobs. For
example, in India in early 1990s, when the information technology sector
witnessed a surge in growth, there was a scarcity of computer professionals. In
recent years, in response to policy changes, a number of private airlines have
come up in India and there is an acute shortage of pilots. Structural
unemployment takes place largely due to structural shifts in an economy and
adjustments ,to such shifts take time. Cyclical unemployment arises due to
fluctuations in aggregate demand. When aggregate demand declines, there is
simultaneous decline in the demand for labour and consequent increase in
unemployment. On the other hand, a general boom in the economy increases
demand for labour and unemployment decreases. Thus overall employment is
pro-cyclical in nature.
Empirical data shows that the labour force in an economy is much less than the
total population in the working age group. In the US, for example, for which
data are readily.available, labour force constitutes about two-third of the adult
population. The percentage of population in the labour force, however, varies
across countries and depends upon the level of development and social
traditions. The rate of unemployment u is defined as the ratio of unemployed
persons to total labour force. The rate of unemployment varies across countries
and for a country, over time.

13.3 CLASSICAL VIEW ON UNEMPLOYMENT

- - - --

The classical economists. as we observed in Unit 1 of this course, were of the

view that full employment prevailed in the economy all the time. This was
consistent with the view that whatever amount of labour was supplied got
demanded by firms. A basic assumption in the classical framework was the
flexibility in wage rate and prices. Thus the gap between supply of and demand
for labour got wiped out through adjustments in wage rate.

L I w
0 L* labour
Fig. 13.1: Equilibrium Level of Employment
In Fig. 13.1 we measure real wage rate (w) on y-axis and quantity of labour (L)
on x-axis. The equilibrium wage rate reached through interaction of supply of
6
 -

labour (L,) and demand for labour (Ld) is W* and quantity of labour employed is 'raditional Theorks
L*, which represents full employment.
As we learnt in Unit 1, the aggregate supply curve according to classical
economists is a vertical straight line at the full employment output level. At the
equilibrium wage rate everyone seeking employment gets engaged. If the wage
rate is above w (see Fig. 13.1) there is excess supply of labour compared to its
demand. In their efforts to get employed some of the currently unemployed
workers will be willing to work at a wage lower than the prevailing one and in
the process will bring down the wage rate till it reaches w*. On the other hand,
when wage rate is below w* there will be excess demand compared to supply.
Due to shortage of labour firms will compete with each other and will be willing
to pay higher wage, as a result of which wage rate will increase. Remember that
classical economists were concerned with real wage in the economy, which is
W
defined as the ratio of nominal wage (W)to price level (P) such that w = -.
P
Thus flexibility in real wage assured that a rise in price level is accompanied by
a proportionate rise in nominal wage. In fact the dichotomy between real and
monetary sectors of the economy, as envisaged in classical model, ensures such
proportional changes. The classical economists did not rule out the possibility of
decrease in nominal wage rate. Nonetheless, it was always in response to
decrease in money supply and price level.
In theory, the classical model appears to have a sound base. When compared
with reality, however, it does not explain the obvious phenomenon of
unemployment in the economy. As we will see below, there is much rigidity in
the economy, which does not allow smooth and instantaneous changes in wage
rate. Moreover, some amount of frictional unemployment is always present in
an economy as workers switch over from one job to another. The neoclassical
economists recognized the limitations of classical model and made amendments
to the classical position of zero unemployment. They assumed that the economy
in normal times has certain minimum unemployment called 'natural rate of
unemployment'.

13.4 KEYNESIAN VIEW ON UNEMPLOYMENT

Keynes in his General Theory presented a view that fluctuations in aggregate
demand (AD) influences the equilibrium level of output. Thus the economy is
not necessarily at the full employment output level all the time and equilibrium
can be realized at a level of output below full employment and corresponding to
that level, part of the labour force remains unemployed. Recall that the
Keynesian view emerged on the aftermath of the Great Depression when there
was widespread unemployment in the economy accompanied by declining
prices and output. At this point Keynes analysed the problem in the short run
context and assumed that the aggregate supply (AS) curve is horizontal. It
implies that AS is infinitely elastic and any level of output can be supplied
without increase in prices so long as unemployment persisted. Keynes
diagnosed the problem during the Great Depression to be a result of demand
deficiency and suggested that AD should be increased, may be through
increases in government expenditure. In fact, fiscal policy through appropriate
designing of tax rates and government expenditure emerged as a major policy
instrument largely due to the pioneering work of Keynes.
In Fig. 13.2 we present an infinitely elastic AS curve and a downward sloping
AD curve, the intersection of which provides us with equilibrium output (f)
and prices (P*). In response to a decliae in aggregate demand there is a
downward shift in AD to ADI. Corresponding to this shift there is a decline in
equilibrium output from (Y*)to (Y,'). Note that price level remains unchanged
in the above model. In synchronization with the level of output, the quantity of
labour used in production varies. For example, corresponding to a decline in
equilibrium output the quantity of labour decreases. Simultaneously there is an
increase in unemployment.

Fig. 13.2: Equilibrium Output in Keynesian Model

On the behaviour of wage rate, Keynes assumed that there is downward rigidity
in nominal wage in the sense that workers oppose decline in the money wage, as
they perceive it to be a decline in their income. During periods of recession
when there is a decline in price level, real wage increases in spite of the fact that
W
nominal wage remains fixed. Recall that we defined real wage as w = -;hence
P
decline in P would increase w when W is constant. The basic idea behind the
simplest Keynesian model is that w varies inversely with P as W remains fixed.
Thus in periods of boom, when there is an increase in prices, real wage tend to
decline. Consequently, firms hire more labour and unemployment in the
economy is lower.
<

In Fig. 13.2 we discussed the extreme Keynesian case where AS curve is

horizontal. On the basis of Keynesian ideas, economists analyse the
unemployment issue by resorting to an upward sloping AS curve. As mentioned
above, real wage falls when prices increase, as a result of which more labour is
demanded. The outcome of such an increase is production of more output. Thus
as price level increases we have increasing level of output, implying an upward
sloping AS curve. The change in level of employment due to change in price
level can be explained through the following diagram.
Fig. 13.3 comprises three segments. In panel-a we have described a production
h c t i o n such that corresponding to each level of output we can find out the
level of employment. Thus when output produced is at full employment level
(QJ we have corresponding level of employment at Lj In panel-b we plot the
AS curve which depicts the output supplied (Q)at each price level (P). Thus
when Qfis the output produced prevailing prices is Pj. In panel-c we depict real
wage (W/P)on y-axis and employment level on x-axis. Note that we assume
nominal rigidity in prices so that W is fixed. Thus real wage (w)increases as P
decreases. Through the interaction of L, and Ld we have full employment (Lj)in
the economy corresponding to real wage Wf W/Pj Thus we assume the initial
position of the economy to be full employment corresponding to Qj; Lj,Pf and
W/Pj
 Traditional Theories

Fig. 13.3: Unemployment in Keynesian Model

Suppose there is a decline in AD (not given in the figure). Consequen;ly, there
is a decline in equilibrium output fiom QI to Ql and decline in prices fiom Pj to
PI (see Fig. 13.3 (b)). Corresponding to the new output level Ql, the level of
employment is Ll, which is less then Lf. In fig. 13.3(c) we see that a decrease in
prices from P, to PI leads to an increase in real wage from W/P, to W/P1. At this
level of real wage there is excess supply of labour compared to its demand.
Thus unemployment to the extent 'U' (as shown in Fig. 13.3(c)) takes place.
In Fig. 13.2 where we assumed the short run AS curve to be horizontal, upward
shift in AD resulted in increase in output, keeping prices unchanged. In Fig.
13.3, on the other hand, AS is assumed to be upward-sloping and shift in AD
influenced both output and prices.
We observe that nominal wage is not completely sticky in an economy. Keynes
in fact recognized that nominal wage would adjust to the requirement of labour
market equilibrium. However, such adjustments would be too slow so that full
employment may not prevail always. Adjustments in nominal wage in response
to price changes is always with a lag. For example, if nominal wage adjusts in
period 2 but prices increase in period 1, there is a decline in real wage in period
1. In period 2, however, nominal wage can be increased proportionately and real
wage at the previous level be maintained. Salary indexation followed in India
on a six-monthly basis is an example of such a lag in wage adjustments.
When we compare the classical and Keynesian positions we find that rigidity in
wage rate gives rise to unemployment in the economy. We will learn more
about real and nominal rigidities and their implications on unemployment in
Unit 15.
Check Your Progress 1
1) Under certain basic assumptions the classical economists could rule out
the possibility of unemployment. Elaborate.
9
Unemployment

2) In the Keynesian model why does unemployment take place?

PHILLIPS CURVE
The Phillips curve, named after A. W. Phillips, describes the relationship
between unemployment and inflation. In 1958 Phillips, then professor at
London School of Economics, took time series data on the rate of
unemployment and the rate of increase in nominal wage rate for the United
Kingdom for the period 1861-1957 and attempted to e'stablish a relationship. He
took a simple linear equation of the following form:

where w is the rate of wage increase, a and b are constants and u is the rate of
unemployment. He found that there exists an inverse relationship between w
and u, with the implication that lower rate of unemployment is associated with
higher rate of wage increase. The policy implication of such a result was
astounding - an economy cannot have both low inflation and low
unemployment simultaneously. In order to contain unemployment an economy
has to tolerate a higher rate of wage increase and vice versa.
Subsequent to the publication of the results by Phillips, economists followed
suit and attempted similar exercises for other countries. Some of the studies
carried out refinements to the simple equation estimated by Phillips such as the
use of inflation (the rate of increase in prices) instead of wage rate increase. 1n/
many cases the scatter of plot of variables appeared to be a curve, convex to the/
origin. As empirical studies reinforced the inverse relationship between the rate:
of inflation and the rate of unemployment the Phillips curve soon became an:
important tool of policy analysis. The prescription was clear: during periods of?
high unemployment the government should follow an expansionary monetary
policy which leaves more money in the hands of people. It may accelerate the
rate of inflation while lowering unemployment.

13.6 COSTS OF UNEMPLOMENT AND

INFLATION
In an economy both unemployment and inflation have adverse effects and
policy makers formulate policy instruments to contain both the problems. The
costs of unemployment at the macro level could be loss of potential output and
wastage of valuable resources (manpower). At the household level it is a loss of
income and consequent deterioration in standard of living of the household. It is
difficult to measure the human cost of unemployment with precision as social
stigma and psychological trauma of the problem are also involved. On the
whole, policy makers and political leaders see to the fact that the cost of
unemployment is minimal. Ideally the economy should not have a rate of
unemployment higher than the natural rate of unemployment.
Inflation is defined as a situation of persistent price rise. While the rate of Traditional Theories
inflation varies over time and across countries there is much debate on
permissible rate of inflation. While inflation rate has been moderately high in
certain countries, there are instances of hyperinflation in some countries where
rate of inflation has been more than 1,000 per cent per year (for example, Latin
American countries in 1980s and former socialist economies in 1990s).
Inflation is widely considered as a social evil. Policy makers are always on the
look out for price trend so that high inflation can be checked through
appropriate policy measures. General public also are widely vigilant about price
movements so that pressure can be exerted on the government if there is
acceleration in inflation rate. During inflation money loses its purchasing power
and nominal costs of goods and services increase. Moreover, there is a reduction
in real income of fixed income groups (salaried class, for example), as their
income does not change at the same pace as price rise. When there is a price rise
borrowers gain in fixed interest rate environment as the value money they return
is lower than anticipated at the time of borrowing. On the other hand, lenders
stand to lose as the value of money they receive after a lapse of time gets
eroded.
During periods of high inflation, there is fair chance that government revenue is
much less than government expenditure resulting in huge fiscal deficits. In order
to finance the deficit the government has three options: borrow from public, run
down on foreign exchange reserve, and print money. Usually a government
running huge deficit is already under heavy debt and paying a high amount of
interest. Hence, further borrowing becomes difficult. Moreover, such
governments also have low foreign exchange reserve and therefore, printing
money becomes an easy option which fuels the rate of inflation fiuther. You can
recall the Indian condition in 1990-91 when it was loaded with heavy debt,
foreign exchange reserve was abysmally low and there was double-digit
inflation. In general, high inflation put the economy out of gear aid it becomes
difficult to maintain economic stability.
When inflation is anticipated correctly then individuals take precaution and
adjust their future paymentslreceipts keeping the rate of inflation in mind.
However, unexpected inflation provokes income re-distribution between income
groups. Usually the wage earning class who have a fixed nominal wage are the
looser as real wage gets deteriorated due to price rise while profit earning class
gain handsomely.

13.7 NON-ACCELERATING INFLATION RATE OF

UNEMPLOYMENT
-- - - - - - - - ----- -

During 1970s economists encountered a puzzle in the sense that inflation and
unemployment data did not fit into the Phillips curve for many developed
economies. In fact many countries witnessed 'stagflation' - a combination of
stagnation (a situation of high unemployment) and high inflation. The instability
in the Phillips curve prompted economists to look into the possible reason of
high inflation in spite of high unemployment in the economy.
A limitation of the Phillips curve is that both workers and employers take
decisions on the basis of real wage, not nominal wage. As we mentioned earlier
when we enter into a contract on a hture date we incorporate expected inflation
into it. Milton Friedman and Edmund Pheips suggested that since real wage is
what matters, the change in nominal wage has to be corrected by inflationary
expectations. In the short-run the Phillips curve is stable but in the long run it
shifts from one level to another, which makes the long run. Phillips curve a
vertical-straight line. We explain the process through which shifts in Phillips
curve takes place in Fig. 13.4.

Fig. 13.4: Shift in Phillips Curve

In order to explain the long run Phillips curve (LRPC) we take an example from
Samuelson (2005). Let us assume an economy which is operating at the natural
rate of unemployment (u*). The economy is operating at point A with low
inflation rate I1 as in Fig. 13.4. People expect inflation rate to continue at I, in
the next period also.
In the second period suppose the government follows an expansionary policy so
that unemployment declines and is lower than u*. In this environment firms
compete with each other to hire workers as a result of which wage rate
increases. With little scope for further expansion in output the expansionary
policy results in an increase in wage rate and prices so that the economy moves
to point B on SRPCl in Fig. 13.4. We note that inflation expectation has not
changes so far and the economy is operating on SRPC I .
In the period 3 workers and employers perceive that there is an unexpected
increase in inflation rate. Such a surprise prompts them to revise their
inflationary expectations and they incorporate inflation at the rate I2 into their
decisions. This results in an upward shift in the short run Phillips curve from
SRPCnto SRPC2. Note that we have drawn SRPCz with inflation rate 13 which
is equal to 12. With inflation at the rate 4, there is a decline in demand for labour
the unemployment rate starts increasing and the economy moves to point C in
Fig. 13.4.
The outcome of the above process- is that the economy ends up with higher
inflation rate although the rate of unemployment remains the same. Real GDP
of the economy remains unchanged while nominal GDP is higher.
The natural unemployment rate mentioned above is called non-accelerating
inflation rate of unemployment (NAIRU). When unemployment is equal to
NAIRU there will be stability in the rate of inflation. When unemployment
departs from NAIRU, there is acceleration or deceleration in inflation rate. Thus
if actual unemployment is less than u*, inflation will continue to accelerate-
higher and higher in subsequent years. The concept of NAIRU and expectations
formation explains the hyperinflation witnessed by some Latin American
countries. Unless unemployment returns to its natural rate inflation spiral will
keep on accelerating. The recessionary trend can also be explained by NAIRU.
When unemployment is more than u*, inflation will tend to fall as long as
unemployment is above u*. You have already read about expectations formation
in Unit 5, Block 3 of this course. The details of inflation-unemployment trade
off under adaptive and rational expectations have been given there. We have
recapitulated the basic results in this Unit.
Researchers have attempted to estimate NAIRU for certain couniries. It is
-
Traditional Theories
observed that NAIRU varies across countries, and over time for the same
country.
Check Your Progress 2
1) What are the policy implications of Phillips curve?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
......................................................................................
2) What do you mean by NAIRU? What are its implications?

13.8 LET US SUM UP

Unemployment results in loss of not only potential output at the macro level but
also in income at the individual level. Many a time widespread unemployment
culminates into a crisis situation in the economy. The social sigma and
psychological trauma associated with unemployment often compels policy
makers to cut down on the rate of unemployment.
The classical economists assumed flexibility in real wage and prices, which
ensured h l l employment in the economy for all the time. Keynesian
economists, however, contest such an assumption and speak about rigidities in
wage rate and prices. In case of sticky prices there is a possibility of
'
unemployment as per the Keynesian model.
Phillips curve describes the inverse relationship between i~flation and
unemployment. It shows the possibility, or rather the compulsion on the part of
policy makers, that unemployment can be reduced at the cost of higher inflation.
Empirical observation from some economies, however, shows that Phillips
curve is not stable in the long run. Due to change in inflationary expectations on
the part of workers and employers there is a possibility of shifts in the Phillips
curve. While short run Phillips curve is convex to the origin, the long run
Phillips curve is vertical straight line at an unemployment rate equal to NAIRU.

13.9 KEY WORDS

Aggregate Demand: It tantamount to the sum of expenditure on consumption,
investment, government expenditure and net exports. In symbols, AD = C' + I +
G + (X-M).
Fiscal Policy: The policy of a government with respect to government
expenditure and taxation.
Labour Force: The sum of population who are willing to work, and either
employed or unemployed.
NAIRU: It is the abbreviation for non-accelerating inflation rate of
unemployment. It is an unemployment rate that is consistent with a constant
inflation rate. The NAIRU is the uilemployment rate at which the long-run
Phillips curve is vertical.
Phillips Curve: It is a graph named after A. W. Phillips, which shows the trade
off between unemployment and inflation.
Real Wage: Nominal wage divided by price level.

13.10 SOME USEFUL BOOKS

Dombusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition,
Tata McGraw-Hill, New Delhi.
Sachs, Jeffrey. D. and Felipe Larrain B., Macroeconomics in the Global
Economy, Prentice Hall lnc., New York.
Samuelson, P. A. and W. D. Nordhaus, 2005, Economics, Eighteenth Edition,
Tata McGraw Hill, Delhi.

1cl1 *NS=R/HINTS TO CHECK YOUR

-
PROGRESS EXERCISES
- -

Check Your Progress 1

1) The basic assumptions underlying classical approach is flexibility in real
wage and prices. Elaborate on the classical model based on Section 13.3
2) Keynes assumes rigidity in nominal wage rate. In the even of decline in
prices, the're is an increase in real wage, which does not clear the market
for labour. Excess supply of labour compared to demand results in
unemployment. Go through section 13.4.
Check Your Progress 2
1) Go through Section 13.5 and answer. You have to explain the nature of
trade-off between inflation and unemployment.
2) Go through Section 13.7 and answer.
UNIT 14 SEARCH 1THEORY AND
- - -- - - --

UNEMPLOYMENT
Structure 1
14.0 Objectives
14.1 Introduction
14.2 Search Theory and Theories of Unemployment
14.3 Search Theories - A Brief Historical Overview
14.4 A Search and Matching Model
14.4.1 Model Specification
14.4.2 Model Solution and the Equilibrium Rate of Unemployment
14.4.3 Optimality o f the Equilibrium Unemployment Rate
14.4.4 Dynamics of Unemployment and Real Wages through Productivity
Shocks
14.5 Some Alternative Search Models
14.6 Significance of the Concept and Theory of Search Unemployment
14.7 Let Us Sum Up
14.8 Keywords
14.9 Some Useful Books
14.10 Answers1 Hints to Check Your Progress Exercises

14.0 OBJECTIVES
After going through this unit you should be in a position to
explain the basic difference between Walrasian and non-Waliasian theories
of unemployment;
appreciate that the search and matching models are an extension of the
neoclassical/monetarist theories of employment and unemployment;
appreciate the context in which the search theory of unemployment was
developed;
explain the use of a specific search and matching model to determine
unemployment and its variation over time; and
explain some alternative search and matching models.

14.1 INTRODUCTION
Traditional theories of aggregate employment and output can broadly be
classified into two categories:
a) Neoclassical/ Monetarist theories
b) Keynesian theories
The neoclassical/ monetarist theories are elegant, but have the drawback that
they are unable to explain prolonged periods of involuntary unemployment that
characterise the real world. In these theories the prevailing unemployment is
always voluntary unemployment. Keynesian theories, on the other hand, explain
the real world phenomenon of unemployment as involuntary tinemployment by
invoking the idea of deficiency of aggregate demand, but these theories lack the
elegance of the neoclassical/monetarist models of employment and output. In
particular, the models do not provide microeconomic foundations for the
rigidities in prices and wages that are postulated to show the existence of
involuntary unemployment in the economy.
In this and the next two units of this block we will examine further
developments of these traditional theories. The main difference between the
developments based on the neoclassical theories and the developments
springing from the Keynesian theories is that the former are based on the
Walrasian general equilibrium model of perfectly competitive markets, whereas
the latter are based on some non-Walrasian features introduced into the analysis,
e.g., imperfect competitior,. In a Walrasian general equilibrium model, labour
market is, like all other markets in the economy is a perfectly competitive one
and there is no reason why the market should not clear. Involuntary
unemployment is inconsistent with a Walrasian setting, so that if unemployment
exists, it must be due to some non-Walrasian characteristics of the labour
market.
The search theory that we are going to study in this unit becomes important
because it shows that unemployment can evist as an equilibrium phenomenon
even in a Walrasian setting of perfectly competitive labour markets. We begin,
in Section 14.2, placing the search theory in the context of other theories of
unemployment that you have studied, or are going to study in this block.

14.2 SEARCH THEORY AND THEORIES OF

UNEMPLOYMENT
You must understand the search and matching theories of unemployment in the
context of other theories of unemployment. With this objective in view, we
classify, in this section, the theories of unemployment that we are studying into
four kinds. The classification is based on Chapter 9, Section 9.1, of Romer
(2001).
If there is unemployment in a Walrasian labour market, unemployed workers
would immediately bid down wages until supply and demand for labour are
again in balance. If this process of bidding down wages is not working freely,
there must be distinct reasons for it. We classify the theories of unemployment
according to whether the process of wage adjustment is working or not, and
according to the reason why it is not working in cases where it does not work.
In particular, consider an unemployed worker, who claims to be identical to a
firm's current workers, and who offers to work for the firm at a marginally
lower wage than the one the firm is currently paying to its workers. There are
four possible responses of the firm, giving us four kinds of theories of
unemployment. These responses are:
i) If the firm accepts the worker's offer, we can conclude that the market for
labour is Walrasian. In this view all observed unemployment is voluntary
unemployment - unemployment of people moving between jobs and of
those who are ready to work only at wages higher than the prevalent wage
rate. This is really the neoclassical model of unemployment referred to
above.
ii) Secondly, the firm can respond to the unemployed worker's offer by saying
that it does not accept the premise that the unemployed worker is identical
to the firm's current employees. In this view, the labour market is not a
market for a homogenous commodity, but is characterised by heterogeneity.
Each job is unique and requires the unique skills that are embodied in an
individual. The unemployed workers are matched with existing vacancies
not through the market, but through a complex process of search and match.
The models of unemployment that postulate such a process are called search
and matching models.
iii) Thirdly, the firm can respond by saying that, even though it would like to Search Theory and
Unemployment
cut the wages and employ the additional worker, it cannot do this because it
is bound by implicit and explicit agreements with its workers, arrived at
through collective bargaining, regarding the wages that have to be paid.
Wages are thus institutionally determined in these models k n o w as
contracting models.
iv) Lastly, the firm may respond by saying that it does not want to,reduce real
wages - it believes that the benefits accruing to it from higher wages are
more than the costs of maintaining wages high. Theories that build up on
this idea are called eflciency-wage theories in an obvious reference to the
fact that higher wages impart benefits to the employing firm by improving
the efficiency of labour.
In this unit, you will study in detail one of the search and matching models of
unemployment referred to in (ii) above. You will study the contracting models
and the efficiency-wage theories of unemployment, referred to respectively in
(iii) and (iv) above, under the rubric of the New Keynesian Theories of
Unemployment in Unit 16.
Check Your Progress 1
1) Why is a Walrasian general equilibrium model inconsistent with
unemployment?

2) Suggest a classification of theories of unemployment based on the

postulated responses of a f m to an offer by an unemployed worker to
work for it at a slightly lower wage.

14.3 SEARCH THEORIES - A BRIEF' HISTORICAL

OVERVIEW
A search theory of unemployment is found even in the writings of A. C. Pigou
in the inter-war period. To explain the high unemployment prevalent at that
time Pigou used an idea you are very familiar with - that workers are
unemployed because wages are too high. Keynes contested this idea in the
development of his General Theory of Employment, Interest and Money. But
initially Pigou had tried to explain the high unemployment of the inter-war
period with reference to another idea - the idea of frictional unemployment,
where unemployment arises as workers shift between jobs, moving to jobs
where their productivity is higher. Search and matching unemployment is
actually a form of frictional unemployment - unemployment which arises
because of the frictions in shifting between jobs generated by the fact that skills
are to be matched with vacancies in the job 'market'. Pigou himself was aware
though that jobs were not shifting around too much in the 1920s, so that he
ultimately banked more on 'workers pricing themselves out of the market
through trade union activities' as an explanation for the inter-war
unemployment.
The idea of search unemployment was subsequently formalised in the 1970s
and 1980s to make the neoclassical Walrasian model accord with the reality of
the empirically observed and varying unemployment in the labour market, as
has been indicated to you in the introductory section. The importance of search
in decentralised markets was first emphasized in an influential book edited by
Edmund Phelps in 1970 (Microeconomic Foundations of Employment and
Inflation Theory, Norton, New York). This book contains some of the first
formal models using search theory to explain unemployment as an equilibrium
phenomenon. Lucas and Prescott presented in 1974 a general equilibrium model
of unemployment. In this model stochastic sectoral shocks induce workers to
move between sectors, but there is a one-period lag by workers in moving
between sectors, brought about through search and matching kind of
considerations. Unemployment is generated in the model by this lag.
In the 19d0s, search models were built up as .continuous time general
equilibrium models, in the tradition of the models built under the real business
cycle theory. Noteworthy amongst these are the models by Peter Diamond: the
paper titled "Mobility Costs, Frictional Unemployment, and Efficiency"
published in the Journal of Political Economy in 1981, and by Christopher
Pissarides: the paper titled "Short-Run Equilibrium Dynamics of
Unemployment, Vacancies, and Real Wages" published in the American
Economic Review in 1985. We have reproduced the titles of the papers for you
because they provide a flavour of the concepts and mechanisms used to
rationalize unepployment as an equilibrium phenomenon in a Walrasian model.
We will examine, very briefly, the model by Pissarides in Section 14.5. Before
that, however, let us develop a more complete model of search unemployment
in the next section.
Check Your Progress 2
1) Why was it necessary to augment the neoclassical/ monetarist theory of
employment through search and matching kind of models?

........................................... ............................ ...............

2) What is frictional unemployment?

1 4 . 4 SEARCH
~ AND MATCHING MODEL
It should be clear to you fiom the earlier section that there are a variety of
models under the rubric of search theory. In this section we examine o,ne such
model at close quarters. Peter Howitt originally developed the model as Search Theory and
Unemployment
"Business Cycles with Costly Search and Recruiting" in the Quarterly Journal
of Econometrics in 1988. The exposition here is based on Blanchard and Fischer
(2000). Unlike in other sections of this unit, the exposition in this section is
necessarily more technical. It is important to follow it through, perhaps with the
help of the book, in order to get a flavour of the kind of analysis that you will
find in the literature today. The approach is descriptive and the use of equations
is minimised. Going through equations, however, can add to the. understanding
of the expounded ideas and you are advised to follow the equations-based
exposition of the model in Blanchard and Fischer (2000).
14.4.1 Model Specificstion
We proceed with the model specification in the following steps.
1) The economy is composed of competitive firms (F in number) and identical
workers (N in number). In each discrete time period a fraction 6 of the
employed is laid off and joins the unemployment pool. The fraction 6 is
called the 'rate of separation' in the literature. Firms hire workers from the
pool, not directly from other firms.
2) The marginal cost of hiring for each firm is an increasing fimction of its
level of hiring. This captures the idea that a high rate of hiring may force
firms to increase their search intensity or, in a more general model with
heterogeneous workers, to accept poor matches between workers and jobs.
The marginal cost is also a decreasing function of aggregate unemployment
- high aggregate unemployment makes it easier and cheaper for the firm to
find willing and competent workers.
3) Since each firm chooses the rate of hiring by equating the marginal cost of
hiring to the net marginal benefit of hiring, it is important to-determine, in
the model, the marginal benefit of hiring to the firm. Assuming a firm to be
risk neutral, the marginal value to the firm of a worker hired in this period is
the expected present value of his marginal product so long as he works with
the firm.The marginal value, denoted by q,, is therefore an infinite sum of
discounted marginal productivities from the present period onwards to
infinity. Two discounting factors are used on each term: one, as usual, to
take account of time and the other to take account of the probability that a
given worker will have left the job by time (t + i).
4) The net marginal benefit of hiring is equal to this marginal value minus the
discounted present value of wages to be paid to the worker who is newly
hired. It is in the spirit of search and matching models to assume that there is
no labour market in which the wage is set -job matches require an explicit
search process. The wage is set through bargaining so as to divide the
surplus from the job between the worker and the firm. To simpli'fy matters,
it is assumed in the present model that the worker experiences neither costs
nor benefits from unemployment, so that the total surplus from the job is
just the marginal value determined in paragraph 3 above. It is assumed that
the worker obtains a share 5 of the surplus and the firm gets (1 - 6) with the
size of 5 reflecting the bargaining power of the worker. Thus the marginal
benefit of hiring to the firm is given as a fraction of the marginal value qt:

5) Each firm chooses the rate of hiring, h,, by equating the marginal benefit of
hiring specified in paragraph 4 above with the marginal cost of hiring
determined in paragraph 2 above
Unemployment
14.4.2 Model Solution and the Equilibrium Rate of
Unemployment
Given the above specification, the model can be solved for the marginal benefit
of hiring, &, and the hiring rate, h,. If the employment in the firm is denoted by
n,, it follows that n, = (I - 6j.n I. + h , since employment in period t is given by
employment in period (t - l), as adjusted for the rate of separation and the rate
of hiring. Assuming that there are F identical firms in the economy, the
unemployment rate, denoted by ul, is given by 1 - (F.nt)/N, where N is the total
number of workers in the economy. These four equations for I,, h , n, and u, can
be solved to obtain the equation characterising the dynamics of the equilibrium
unemployment rate:

In the above equation, G is a parameter in the cost of hiring function, such that a
larger parameter value denotes higher difficulty of locating workers. The
equation clearly shows that the unemployment rate depends on its own lagged
value and the constant rate of separation, 6. It also depends on the state of
technology via its dependence on the net marginal benefit of hiring, I,, since the
latter depends on the marginal product of worker.
When the marginal productivity of labour is postulated to have zero variance,
the natural rate of unemployment is given by

A clear result emerges from this equation: the larger the separation rate, 6, and
the larger the parameter G (reflecting the difficulty of locating workers), the
higher is the rate of unemployment.
14.4.3 Optimality of the Equilibrium Unemployment Rate
The above model rigorously rationalizes the existence of unemployment. As we
will see below, shocks to productivity can also be used to explain the variability
of the equilibrium rate of unemployment over time. You should, however
appreciate that the equilibrium rate of unemployment obtained in the above
model is unlikely to be socially optimal. This is so for two reasons:
1) Hiring decision by a firm is beneficial to it to the extent that the net
marginal benefit of hiring is positive, but it imposes a cost on other firms, an
externality that is not taken into account by the hiring firm. By hiring an
extra worker, the firm decreases unemployment, and since the marginal cost
of hiring is a decreasing function of aggregate unemployment, the marginal
cost of hiring to other firms is increased. This effect leads to too much
hiring compared to the social optimum, and thus to too low an equilibrium
rate of unemployment.
2) There is also a divergence between the social and private marginal benefit of
hiring: the former is given by qt, whereas the latter (the private benefit to the
hiring firm) is given by a fraction (1 - 6) of q,, depending on the bargaining
power of the worker vis-&is the hiring firm. Since the private benefit is
less than the social benefit (5 > 0), there is too little hiring and thus too high
an equilibrium rate of unemployment.
The two effects, in (1) and (2) above, work in opposite directions, one tending
to increase the equilibrium rate above the socially optimum rate and the other
tending to keep it below the social optimum. The net effect on the equilibrium
rate of unemployment vis-h-vis the socially optimum rate is ambiguous in the
model.
14.4.4 Dynamics of Unemployment and Real Wages through k r c h Theory and
Unemployment
Productivity Shocks
The model that you are studying here is in the tradition of the real business
cycle theory that you have studied in earlier units. As you know, this kind of a
model works out the implications of shocks to productivity. The model k;as the
following implications to employment and wages.
1) A temporary qverse shock to productivity decreases hiring (as it decreases
the marginal productivity of labour and hence the benefit of hiring the
marginal unit of labour) and increases unemployment. As the shock is, by
definition, temporary, productivity and the net marginal value of labour
return to their original level, but, it can be shown that the unemployment
rate only slowly returns to normal through increased hiring. Moreover, since
it is cheaper for the firm to hire when there are more unemployed, a
productivity shock has greater effect on unemployment when it is high than
when it is low. This is, of course, implicit in the non-linearity of the
equation explaining u*, the natural rate of unemployment.
2) The model explains why fluctuations in employment may be associated with
smaller fluctuations in real wages. This will happen if 6,the share obtained
by workers, is constant, as is assumed in the model, and small. Real wages
vary in the model with productivity and high rates of hiring are Associated
with high real wages. The model thus explains the observed empirical fact
of a pro-cyclical increase in real wages, but to a smaller extent than the
increase in employment, if the share obtained by workers is small in relation
to that obtained by the hiring firms.
Check Your Progress 3
1) Explain why introduction of searchand matching introduces equilibrium
unemployment in a Walrasian model.

3) Why is the equilibrium unemployment rate obtained in the Howitt (1988)

model unlikely to be socially optimal?

......................................................................................
4) How does the Howitt (1988) model explain
a) An increase in unemployment
b) A smaller pro-cyclical response of real wages in relation to
employment?
14.5 SOME ALTERNATIVE SEARCH MODELS
In this section we look, briefly, at two more papers emphasizing frictions arising
due to search and matching considerations: one by Pissarides that has been
already referred to and another by David Lilien. The exposition here is again
based on Blanchard and Fischer (2000).
The model developed in Section 14.4 is just one of the many search and
matching models developed in the literature. In this section we examine, briefly,
some alternative search and matching models. One of the shortcomings of the
Howitt (1988) model. that was discussed in Section 14.4 is that it simply
postulates that search and matching is undertaken by workers and firms, but
does not specify the search technology and the matching process used by
workers and firms. Also the Howitt model takes the share of workers parameter,
6, as given. Pissarides developed a closely related model in 1985 wherein these
shortcomings were addressed. The model clearly shows that unemployment
emerges as an equilibrium phenomenon in an otherwise neoclassical model th&
is characterised by workers moving from one job to another and remaining
unemployed in the interim during their search for the right kind of job as a
replacement for the job they have discarded. The approach shows explicitly the
dependence of the rate of hiring on the characteristics of the labour markets.
Moreover, unlike in the Howitt model, the Pissarides model helps in thinking
about what determines the share of workers parameter 6 in the bargaining
process between the workers and the firms - the parameter value depends on the
option that the workers have in turning down the match and looking for another
match.
Models have' also been developed to capture the effects of sectoral shocks -
changes in relative productivity or changes in relative demand for goods - on
aggregate equilibrium unemployment. David Lilien emphasized frictions arising
due to the inability of labour to relocate instantaneously and costlessly between
sectors in a paper titled "Sectoral Shifts and Cyclical Unemployment" published
in the Journal of Political Economy in 1982. Consider an economy with two
sectors. Labour is immobile between sectors within periods but fully mobile
across sectors over periods. Workers in each sector supply one unit of labour
inelastically if the wage exceeds a reservation wage. Assume that the wage is
sufficiently higher than the reservation wage in both sectors and that labour is
fully employed between the two sectors. Assume further that labour demand
shifts away from sector 1 toward sector 2, so that within the period wage
increases in sector 2 and falls in sector 1. Since labour cannot shift from sector 1
to sector 2 within the period, employment cannot increase in sector 2, but falls
in sector 1 due to the decrease in labour demand. The sectoral shift hence
increases unemployment in the current period. In the following period labour
reallocates itself and aggregate employment returns to normal.

14.6 SIGNIFICANCE OF THE CONCEPT AND

'

THEORY OF SEARCH UNEMPLOYMENT

From what has been said earlier, you understand the significance of the theory
of search unemployment as an attempt to endow realism to the elegant
neoclassical model of employment and output. You should also understand the
practical significance of the concept of search unemployment as it has worked
itself out in the United States and in some of the countries of the European
Union.
The idea of search unemployment gained importance in the US economy in the
1990s when the social security system was being restructured in that country. It
is easily understandable that the ability and desire of a person to keep looking Scarch Theory and
Unemployment
for a better job and to remain unemployed in the mean time depends in part on
the availability of unemployment benefits under such a system. The
unemployment that arises when a person quits a job to have more time to look
for a better job, or when an unemployed delays accepting a job in the hope of
finding a better one, is of course the search unemployment that we have been
discussing. If all jobs are the same, an unemployed person will take the first one
offered. If some jobs are better than others, it is worthw@le.searching and
waiting for a good one. The higher the unemployment benefits, the more likely
people are to keep searching for a better job, and the more likely they are to quit
their current job to try to find a better one. It was consideration of these kinds
that prompted the United States to restructure their unemployment benefits
system in the 1990s. If unemployment rates in the European Union are by and
large higher than those prevailing in the United States in recent years, part of
the explanation is the fact that it is not as easy, as in the countries of the
European Union, to obtain unemployment benefits in the United States after the
revamping of their unemployment benefits system.
Check Your Progress 4
1) Explain briefly the ways in which the search model of Pissarides goes
beyond the Howitt model.

Why should a sectoral shift in labcur demand generate higher aggregate

unemployment?

How will you use the concept of search unemployment to explain the
differences between the United States and the European Union vis-a-vis
their unemployment rates?

LET US SUM UP
The neoclassical theory of employment and output is theoretically elegant, but
does not accord with the empirically observed fact of prolonged periods of high
unemployment. The search theory of unemployment attempts to remedy this
drawback of the neoclassical theory. The existence of unemployed workers in
the context of the neoclassical model would imply a fall in wages in the market
for labour. In the context of search and matching models, though, the labour
market is not a market for a homogenous commodity, but is characterised by
heterogeneity. Each job is unique and requires the unique skills that are
embodied in an individual worker. Unemployed workers are matched with
---1
_A:.- - A LL L ~ 1 - -_--a__*
^ l--_* *L---_-L - _--_-1--_ -C
Unemployment
search and match. This generates a frictional kind of unemployment. Indeed the
origins of the search and matching models can be traced all the way back to
Pigou's explanation of the inter-war unemployment as the unemployment of
workers moving between jobs. More recent approaches to the theory involve
construction of models wherein the unemployment emerges as an equilibrium
phenomenon when, for example, firms decide on hiring by equating the
marginal benefits and costs of hiring, where the costs include search costs. Such
an equilibrium rate of unemploy&ent is not a social optimum due to the
divergence between, e.g., private and social benefits of hiring. Such models can
be used to explain variation of unemployment over time by postulating shocks
to productivity, as in the models of real business cycles. Unemployment can
also emerge in models where sectoral, as versus aggregate, shocks are
postulated to productivity/ demand, in the context of frictions in moving from
one job to another.
-----
14.8 KEY WORDS
Adverse Shock to Productivity: A decline in productivity
Equilibrium Unemployment: Unemployment that emerges in a model wherein
agents (workers and firms) optimise in the context of a process of search and
matching.
Frictional Unemployment: Unemployment of workers who are moving
between jobs. Frictions in the job market, e.g., due to the process of matching
the requirements of a vacancy with the skills of an unemployed, imply that
those who give up a job do not find a new job instantaneously and are
unemployed in the interim. Such unemployment is frictional unemployment.
Natural Rate of Unemployment: Equilibrium unemployment (as defined
above) as a percentage of the labour force.
NeoclassicaUMonetarist theory of Employment/Output: Theory of
employment/ aggregate output in the Walrasian general equilibrium set-up
wherein markets clear through price adjustments.
Pro-cyclical Increase in Real Wages: Real wage increase accompanying the
upward phase of a business cycle.

Search Theory: Theory of unemployment wherein each vacancy has unique

features and requires unique skills that are embodied in individual workers. The
frictions in the process of matching vacancies with the unemployed generate
unemployment.
Voluntary Unemployment: Unemployment of workers who are not ready to
work at the going wage for a similar job.

14.9 SOME USEFUL BOOKS

Blanchard, O.J. and S. Fischer, 2000, Lectures on AA4acroeconomics,Prentice-
Hall of India, New Delhi
Dornbusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition,
Tata McGraw-Hill, New Delhi.
Romer, D., 2001, Advanced Macroeconomics, Second Edition, McGraw-Hill
International, New Delhi
 Search Theory and
p p

ANSWERS1 HINTS TO CHECK YOUR Unemployment

PROGRESS EXERCISES
Check Your Progress 1
1) Walrasian general equilibrium model is inconsistent with involuntary
unemployment. Labour market in this model is assumed to be competitive
and it always, clears through wage adjustments at a point where labour
demand is equal to labour supply. Any unemployment in the model is
hence voluntary, i.e., of those who do not want to supply labour at the
going wage rate.
Your answer to this question should be based on Section 14.2. If the firm
accepts the offer of the outside worker and employs himher at a lower
wage, you are in the realm of the neoclassical model. If the firm believes
that the outsider-workers do not necessarily possess the skills of the
insider-workers you are postulating a search and matching model. If the
firm is unable to lower the wage fixed through collective bargaining, in
spite of the firm wanting to accept the outsider worker's offer to work at
the lower wage, you are subscribing to a contracting theory of
unemployment. Finally, if you postulate that the firm does not reduce
wage because it believes that its benefits exceed the cost of'paying a
higher wage, then you are working in the realm of New Keynesian
theories like the efficiency-wage theory.
Check Your Progress 2
1) The neoclassical model was theoretically elegant, but did not accord with
the observed phenomenon of high and varying unemployment in the real
world. It was hence necessary to augment the model to bring it more in
tune with reality. The search theory attempts to do this by modelling
unemployment as an equilibrium phenomenon.
2) Frictional unemployment is unemployment of workers moving between
jobs. In the search models workers are unemployed because they do not
take up the first job that is offered to them and keep searching to find the
best job that matches their skills. The unemployment is frictional, in as
much as workers and jobs are not continuously matched.
Check Your Progress 3
1) You will have to explain this by using the model expounded in Sub-
sections 14.4. 1 and 14.4.2. Alternatively, you could use ideas fiom two or
three different search models to explain why unemployment occurs as an
equilibrium phenomenon in such models. You will be helped further in
this by the alternative models in Section 14.5.
2) Answer to this question is in Sub-section 14.4.3. Hiring generates a
private benefit, but imposes a social cost to other firms that is not
accounted for by the hiring firm. There is also a divergence between the
private and social benefits generated by hiring.
3) Refer to Sub-section 14.4.4 to be able to answer these questions. The
variability in unemployment is explained by productivity shocks that
change the benefit of hiring and hence generate more or less
unemployment in equilibrium. The pro-cyclical response of real wages is
explained by the fact that, in the model, workers obtain a constant share,
and an increase in productivity leads to an increase in real wages. Real
wages increase to a smaller extent if the share of the workers is smaller
compared to the share of firms in output.
Cheek Your Progress 4
1) Unlike the Howitt model, the Pissarides model specifies the search
technology used by the workers and firms. Further, the Pissarides model
also helps in understanding the factors determining the share of workers in
output.
2) In a frictionless world, a sectoral shift in demand cannot generate
unemployment because a decrease in employment in the declining sector
is made up for by an increase in employment in the expanding sector.
However, if, for example, it takes time for labour to relocate perhaps due
to search and matching considerations, labour released fiom the declining
sector can be unemployed in the interim that it locates itself in the
expanding sector firms.
3) You will have to explain the difference in the unemployment rates
between the US and the EU with reference to the differences in the two
regarding obtaining unemployment benefits. The more liberal scheme in
the EU means that a larger number of workers can remain unemployed
over lbnger period of time in search for a better job. However, this is not
the full explanation of the observed differences in the unemployment
rates.
UNIT 15 NOMINAL AND REAL RIGIDITIES
Structure
15.0 Objectives
1 5.1 Introduction
15.2 New Classical School versus New Keynesian School
15.3 Nominal Rigidities versus Real Rigidities
15.4 Nominal Rigidities and Menu Costs
15.4.1 Menu Costs
15.4.2 Mankiw Model of Nominal Rigidities
15.5 Real Rigidities
15.5.1 Real Rigidities in the Goods Market
15.5.2 Real Rigidities in the Credit Market
15.5.3 Real Rigidities in the Labour Market
15.6 Let Us Sum Up
15.7 Key Words
15.8 Some Useful Books
15.9 Answers/ Hints to Check Your Progress Exercises

15.0 OBJECTIVES
After going through this unit you should be in a position to:
explain the characteristics of New Keynesian Macroeconomics as distinct
from the New Classical Macroeconomics;
a distinguish between the two schools in their conclusions about the
possibility of booms and busts in the real world;
a distinguish between nominal and real rigidities;
0 explain why prices need not be flexible in the real world;
identify the different kinds of rigidities in the real world goods, credit and
labour markets; and
explain why nominal and real rigidities have macroeconomic consequences
like unemployment.

15.1 INTRODUCTION
The classical theory of the macro economy assumes that the economy is
perfectly competitive and that wages and prices are perfectly flexible. It is this
characteristic of perfect flexibility of wages and prices that enables the classical
economists to conclude that the perfectly competitive economy will always be
at full employment irrespective of aggregate demand conditions. According to
the classical and, subsequently, the new classical schools, when aggregate
demand goes up it is the aggregate price level that increases because the
economy is at full employment and the aggregate output cannot increase. On the
other hand, when demand falls at the full employment level of output, wages
and prices fall in the goods and the labour markets, respectively. The aggregate
price level falls and the employment of labour is not affected.
The Keynesians, on the other hand, & postulate rigidity of wages andlor prices.
Suppose the economy is at full employment and aggregate demand goes down.
The adjustment in the economy happens not through a downward adjustment of
wages/ prices, but through a fall in employment and output. It is this different
response of the economy to changes in aggregate demand that is at the basis of
the different conclusions that the classical and the Keynesian economists reach
about the possibility of the existence of persistent unemployment in the
economy. The flexibility versus rigidity of prices and wages hence becomes an
important theoretical issue in determining whether an economy can exhibit
persistent unemployment. In practice, since prices will neither be fully rigid nor
perfectly flexible, the issue reduces to the rate of adjustment of wages and
prices to changes in aggregate demand
This basic difference between the classical and the Keynesian economists
continues to exist between the New Classicals and the New Keynesians. In this
unit we study how the New Keynesians rationalise the rigidity of prices and
wages in a modern economy and how they thereby conclude that an economy
will be subjected to booms and busts. We begin by understanding the important
differences between the New Classical and the New Keynesian Schools.

15.2 NEW CLASSICAL SCHOOL VERSUS NEW

We know that Keynesian economics was propounded as a revolution against the

then prevailing orthodoxy of the classical school. In time, however, the
Keynesians themselves established orthodoxy. The Keynesians were helped in
establishing their own orthodoxy, initially through the neoclassical synthesis of
the classical and Keynesian schools involving the IS-LM model, and then
through the AS-AD model. You have studied these models in Block 1. This
latter synthesis through the AS-AD curves produced a model that had
Keynesian properties in the short-run and classical properties in the long run. As
aggregate demand falls, the downward rigidities of prices and wages produces
unemployment in the short-run, but full employment is restored in the long run
as prices and wages adjust slowly. The Keynesian revolution was appropriated
within the mainstream through the AS-AD model.
The ideas of rational expectations (see Block 3) and real business cycles (see
Block 5) that came up in the 1970s developed into the New Classical School.
This School was a revolution against the Keynesian orthodoxy that had by now
established itself. It propounded wage-price flexibility in a perfectly competitive
setting of optimising individuals so that there was no basis for the existence of
Keynesian unemployment even in the short run.
The New Classical ideas, though theoretically elegant and intellectually
appealing, flew in the face of empirical realities in a world characterised by
periodic booms and busts. The Keynesian ideas, on the other hand, attempted to
explain the real world, but did not rely on the tools of mainstream economics
like optimisation in the context of individuals who form expectations rationally.
We can say that the microeconomic foundations underlying the Keynesian
macroeconomics were weak.
Thus, a question could be asked to the Keynesians: Why would rational firms
not increase product prices when money supply is known to have increased,
since economic theory predicts that prices would ultimately increase as a
consequence of increase in money supply and rationally formed expectations
require the individuals to increase prices? We understand this particular
question to a greater extent in Sections 15.3 and 15.4. It suffices to say, for now,
that the New Keynesian School emerged in the 1980s as a counter-revolution
against the New Classical ideas of the 1970s. The New Keynesians attempted to
construct models that were empirically well grounded in the sense that they
made more realistic assumptions about the macroeconomic world. Moreover,
these models were theoretically elegant in that they explained through models
of rational optimising individuals why firms would not, increase prices in the Nominal and Real
Rigidities
face of increased money supply. Upward rigidity in prices would prevail in spite
of the fact that not increasing prices could, apparently at least, lead to a fall in
profits.
You should note two characteristics of the New Keynesian School at this. point.
The first makes it very different and the second not so different, from the New
Classicals:
i) We have beenlasking questions like why do firms not change prices. This
presumes that the firm have the power not to change prices if they so wish,
i.e., they have the power to set prices. Unlike in the New Classical world,
the New Keynesian firms are operating in markets with some degree of
monopoly power. That is an important difference between the two schools:
the New Classicals assume perfect competition and the New Keynesians
work in the context of imperfectly competitive markets. We also had this in
mind when we said that the New Keynesian models are empirically well
grounded.
ii) Yet when it comes to the use of analytical tools, the New Keynesians are no
different from the New Classicals. They build models to show why
optimising, rational individuals do hold prices fixed when macroeconomic
conditions demand that prices be changed. In setting up their counter-
revolution, the New Keynesians meet the New Classicals on their home
grounds, using the same tools of optimising behaviour of individuals in their
models. You must note, in this context, that though we have associated the
rational expectations revolution (along with the real business cycle theory)
with the New Classical School, there is nothing intrinsic about rationally-
formed expectations that make them any closer to the New Classical way of
doing things than to the New Keynesian. The New Keynesian models can as
much be propelled by individuals who are not only rational in the sense that
they optimise, but also in the sense that they form expectations rationally.
Check Your Progress 1
I) Why is the distinction between flexibility and rigidity of prices important
in macroeconomic theory?

2) Based on your answer to Question 1 above, bring out a few points of

distinction between the New Classicals and the New Keynesians.

15.3 NOMINAL RIGIDITIES VERSUSREAL

RIGIDITIES
Before we proceed further we must make an important distinction - that
between nominal and real rigidities. In Section 15.2 above, we have been
refqrring to nominal rigidities. Nominal rigidities are said to exist when nominal
-

Unemployment prices and wages do not change in the face of conditions that call for their
change. As you have seen in earlier units, this will lead to Keynesian
unemployment. But unemployment can also come about because of certain real
rigidities in the economy. Such rigidities can exist in the goods market, the
labour market or even the market for credit.
Thus, as we will see in Unit 18, there could exist reasons why the real wage
paid in the labour market is higher than the market-clearing wage. This will, of
course, lead to unemployment of some of those who are willing to work at a
lower (market-clearing) wage. We are not talking here about the nominal wage
not changing when it needs to change, but about firms rationally and voluntarily
deciding to pay higher real wages to their workforce because they find it to their
advantage in some way. We will explain this concept of real rigidities better
when we list out all such rigidities in Section 15.5 and the sub-sections therein.
The New Keynesian economists stress both the nominal and real rigidities to
explain the presence of booms and bust/ persistent unemployment in the real
world. We explain nominal rigidities further in Section 15.4 and then consider
real rigidities in greater detail in Section 15.5.
Check your Progress 2
1) Distinguish between nominal and real rigidities.

15.4 NOMINAL RIGIDITIES AND MENU COSTS

In this section we examine a simplified New Keynesian model to understand
why rational profit-maximising firms would not want to change prices in the
face of macroeconomic conditions that call for such a change, a rise in money
supply. For example, a firm would not increase prices in the event of a rise in
money supply.
These kinds of models owe their existence to the work of the likes of N.
Gregory Mankiw ("Small Menu Costs and Large Business Cycles: A
Macroeconomic Model of Monopoly", Quarterly Journal of Economics, May
1985); and George A. Akerlof and Janet L. Yellen ("A Near Rational Model of
the Business Cycle, With Wage and Price Inertia", Quarterly Journal of
Economics, Supplement, 1985). As indicated above, these papers use the
analytical tools of the New Classicals to arrive at Keynesian conclusions. As the
title of Mankiw's paper indicates, an important concept in understanding the
nominal price rigidity is the concept of 'menu costs'. We examine the concept,
briefly, before we explain the model proper.
15.4.1 Menu Costs
Why do firms not change their prices very frequently? Obviously, the costs of
changing prices at frequent intervals and in small amounts must be more than
the benefits obtained from such a change. Firms prefer to wait before they make
price changes in relatively large amounts and in the mean time absorb the losses
that they would suffer by not changing prices. This of course presumes that the
firms have some monopolistic price setting power and the losses referred to
above include lower profits than would have been possible if prices had been Nominal and Real
raised, and not necessarily actual out-of-pocket losses. Rigidities

It is easy to understand this behaviour of monopolistically competitive firms

through the example of restaurants competing with each other. The term 'menu
costs' immediately becomes meaningful as the costs that would be incurred in
changing the menu cards every time there is a change in the prices of items on
the menu. These printing costs are surely negligible, but the more important
costs are in terms of the loss of customers that a firm would face if it subjects its
clientele to the 'irritability' of continuous, small changes in prices.
The concept of menu costs in a modem economy is indeed broad. It is also
widely applicable, given the proliferation of automatic dispensers (e.g., coffee
machines) and pay telephones that operate on coins. It is easy to imagine the
cost that would be incurred by the suppliers if these ubiquitous machines were
to be adjusted every time a price change is effected. The firms would rather not
change their prices. It is this idea of weighing the costs of changing prices
against the benefits obtained from changing prices that is formalised in the
Mankiw model that we consider below.
15.4.2 Mankiw Model of Nominal Rigidities
There are two related reasons for which firms do not frequently change prices.
First, as we saw in the discussion on menu costs, the costs of price changes are
not negligible and could exceed the private benefits that can be obtained by the
firms in the form of increased profits. More importantly, however, the benefits
to be reckoned from price changes are not so much in the private realm, but in
the social realm. Price rigidity leads to unemployment, the social costs of which
are much higher than the private costs reckoned by the firms in terms of menu
costs. The microeconomics -based models by Mankiw, and Akerlof and Yellen
clearly show that the private benefits of changing a price can be much smaller
than the social benefits if there is substantial monopoly power in the economy.
We follow Dornbusch, Fischer and Startz (2004) in presenting a simplified
version of the formal Mankiw model. The model relies on the fact that in
monopolistic markets firms face a downward-sloping (less than infinitely
elastic) demand curve and can set a price that deviates from the optimum profit-
maximising price without a large swing in demand away from the firm. This is
not possible in a perfectly competitive market, where every firm faces a
horizontal (infinitely elastic) demand curve - a small deviation from the optimal
price can in this situation lead to a large swing demand and profits away from
the firm. Even if a competitive firm faces the same kind of menu costs as an
imperfectly competitive firm, the loss of profits by not changing the price can
be big enough to outweigh the menu costs. A competitive firm is not, of course,
a price setter.
Not so for the imperfectly competitive firm. Mankiw shewed that the potential
profits from raising prices could be very small for such firms especially if the
elasticity of demand for firm's output is low, i.e., if monopoly power of the firm
is high, and if the deviation of the actual price from the optimal profit-
maximising price is small. The menu cost could well be higher than the
potential profits in such a case and the firm does not change its price. Other
firms are likely to be similar and they too leave their prices unchanged, with the
result that the nominal price level remains unchanged.
The Keynesian conclusion of an increase in money supply on output rather than
on prices follows from this. An increase in money supply, prices remaining
unchanged, leads to an increase in real money supply. This leads to an increase
in aggregate output, either through a decrease in the rate of interest ( B la
Unemployment Keynes) or through a real-balance effect. You should note that there would have
been no output effects in a classical model if prices were free to vary. An
important difference between the classicals and the Keynesians is hereby
established.
As Dornbusch, Fischer and Startz (2004, p. 566) put it about the papers of
Mankiw, and Akerlof and Yellen:
This work provides a rigorous microeconomic justification for nominal price
stickiness. Since New Classical economists attack the rigcr of the underpinnings
of Keynesian models, such justification is a key piece of Keynesian response to
rational expectations and real business cycle models. Not everyone agrees on
the empirical significance of the formulation by Mankiw and by Akerlof and
Yellen, but the work is certainly a mile stone in the New Keynesian
counterrevolution.
Check Your Progress 3
1) What are menu costs?

2) How can the concept of menu costs be used to rationalise nominal price
rigidities?

15.5 REAL RIGIDITIES

As we brought out in Section 15.3, the New Keynesian economists rely both on
nominal and real rigidities to arrive at their conclusion that nominal changes in
money supply have real, and not merely nominal, effects on the economy. As
we indicated in Section 15.4, an increase in money supply can lead to a rise in
the aggregate output and not in the price level. The flip side of this is, of course,
that a fall in the money supply can lead to a fall in output and an increase in
unemployment.
There is, however, a view that introducing price-setting in imperfectly
competitive markets and menu costs into an economy is however not enough to
generate substantial nominal rigidity at the micro level. Further, as per this
view, menu costs can have important macroeconomic effects only in the
presence of real instead of nominal, rigidities. This is so because it can be
shown that for realistic values of elasticity of labour supply and elasticity of
output demand, price-setting finns have strong incentives to change price when
aggregate demand changes even by incurring menu costs required for changing
nominal prices. Thus if the elasticity of demand for a firm's output is high, say
5, and the elasticity of labour supply is low, say 0.1, then Romer (2001) shows
that, for a 3 per cent fall in output, the increase in profits by changing the price
is about one-fourth of the revenue. This clearly suggests that firms will be ready
to bear even up to one-fourth of the revenue as menu costs needed for changing
the prices, if the elasticity of output demand is high and the elasticity of labour
supply is low. If these elasticity values are realistic, then the existence of menu
costs for changing prices cannot be used as a rationale for nominal price rigidity
Nominal and Real
Rigidities I
tind consequent unemployment. Some other factors have to be invoked to
explain the constancy of nominal prices, in the face of, e.g., changes in money
supply.
The other factors that have been invoked have to do with the characteristics of
the goods, labour and credit markets. These markets differ in important ways
from the competitjve model. In particular, the goods and labour markets appear
to be such that shifts in demand translate into a smaller variation in prices and a
larger variation in quantities than would be predicted in a competitive set-up. In
the goods market, for example, shifts in demand for goods, in an imperfectly
competitive set-up, are not accompanied by changes in mark-ups but by changes
in output. Again, in the labour market, shifts in the demand for labour lead to
large changes in employment and small changes in real wages. Here we are
referring the rigidity in real prices in relation to quantities. Such rigidities
occumng because of specific characteristics of the goods, labour and credit
markets are referred to as real rigidities.
The argument in Section 15.4 was based on nominal rigidities in the price level.
In this section we look at real rigidities in the goods, credit and labour markets
to examine how these can translate into less than full employment output. The
characteristics of the labour market that produce unemployment are eltarnined in
M h e r details in Unit 18.
15.5.1 Real Rigidities in the Goods Market
The most important factor associated with real rigidity in the goods market is
the existence of imperfect competition. Imperfect competition enables
producers to be price-setters and generates rigidity in real prices in relation to
quantities.
Under imperfect competition price is set, not equal to marginal cost, but as a
mark-up over cost. The mark-up covers fixed costs of production including
profits. One of the important propositions of the New Keynesian economics is
that the mark-up behaves in a countercyclical fashion, i.e., it decreases during
booms and increases over the downward phase of a business cycle. It is these
countercyclical movements of the mark-up that produce rigidity in prices of
goods. An increase in aggregate demand translates, not into an increase in
prices, but into an increase in quantities of goods produced, and thereby of
employment.
Why do mark-ups behave in a countercyclical manner? Several reasons have
been postulated:
i) Higher level of economic activity during booms reduces the importance of
costs of acquiring and disseminating information and thus makes markets
more competitive. This has been referred to in the literature as "thick-
market" effects. -
ii) It has been suggested that increased profits created by greater economic
activity make it difficult for oligopolists to maintain collusion - incentives
are generated to break away from oligopolistic structures. This puts
downward pressures on mark-ups.
iii) It has also been suggested that mark-up is countercyclical because marginal
costs are pro-cyclical. Marginal costs are considered to be pro-cyclical
because overtime paid to workers is highly pro-cyclical and hence expensive
to firms. This, however, begs the question about why prices are rigid in the
goods market. The argument here seems to be that, because prices are rigid,
.the mark-up is compressed as marginal costs rise. We have been attempting
Unemployment
to explain the rigidity of prices by postulating that mark-ups fall over booms
in spite of costs rising (and not because of increase in costs) for reasons
independent of the rise in costs.
When price rigidities exist in imperfectly competitive goods markets, the impact
of increase (decrease) in aggregate demand is borne by quantities leading to an
increase (decrease) in aggregate output and employment.
15.5.2 Real Rigidities in the Credit Market
You have seen in Section 15.5.1 how imperfections in the goods markets enable
firms to set prices so as to generate price rigidities, e.g., because of
countercyclical mark-ups used in setting the prices oligopolistically. You know
that such price rigidities have macroeconomic consequences, e.g., changes in
aggregate demand influence output and employment rather than prices.
Imperfections in the credit market too similarly have macroeconomic
consequences. The imperfections in the credit market which have
macroeconomic consequences are broadly classified as rigidities in the credit
market. In this sub-section we examine some of the macroeconomic
consequences of these credit-market rigidities.
~m~erfectidns arise in the credit market primarily because of asymmetric
information between lenders and borrowers. Borrowers are better informed than
-the lenders about the quality of their investment projects and even the
probability of success of the projects. It has been shown that these type of
information asymmetries can have important microeconomic consequences like
equilibrium credit rationing, need for financial intermediation, and need for
government intervention.
But, more importantly for us, credit market imperfections such as information
asymmetries have macroeconomic consequences. It has been shown that in the
monetary policy transmission mechanism
i) credit channel is more important than money supply channel, and
ii) credit-rationing is more important than rise in interest rate in the
implementation of a restrictive monetary policy.
Thus when a restrictive monetary policy reduces reserve money, i.e., the
quantity of bank reserves, the ability of the banks to lend is affected. The
shortfall in credit is not necessarily made up by other lenders, given the
imperfections in the credit market in the form of information asymmetries
between lenders and borrowers. Banks are actually in a better position than
many of the other lenders to overcome the adverse effects of information
asymmetries through their role of a financial intermediary. Thus, the
transmission mechanism operates largely through availability of loans. The
process of credit rationing that takes place when loans are curtailed become
more important in reducing aggregate demand than the process initiated by an
increase in the rate of interest through the reduction of money supply.
Given this importance of credit markets, credit-market imperfections can
propagate and magnify the effects of real disturbances. Shocks that act initially
to reduce output or to redistribute wealth from borrowers to lenders cause credit
markets to function less efficiency which leads to a further decline in output
through the credit channel. It has been shown that disturbances that would have
mild effects with Walrasian credit markets (e.g., with no asymmetries of
information between lenders and borrowers) can cause a financial collapse in
the presence of such imperfections because of the magnification effects.
15.5.3 Real Rigidities in the Labour Market
New Keynesian theories of the labour market help in explaining the existence of
involuntary unemployment. The theories also attempt to explain why changes in
aggregate demand lead to larger changes in employment and relatively smaller Nominal and Real
Rigidities
changes in the real wage in the labour market. One of the reasons postulated for
the existence of unemployment in the labour market is that firms voluntarily pay
higher real wages, as compared to the market-clearing wage, to the workers on
their rolls with a view to increasing their efficiency and1 or with a view to
providing them the incentives not to shirk work in a situation where the effort
level of the workers cannot be perfectly monitored. The imperfections caused
thereby in the labour market lead to unemployment. We will qonsider efficiency
wage model postulated in New Keynesian theories of unemployment in greater
details in the next unit (Unit 18).
Check Your Progress 4
1) Why do real rigidities occur in the following markets?
i) Goods market
ii) Labour market
iii) Credit market

15.6 LET US SUM UP

The distinction between the Classical and the Keynesian school revolves around
their assumption about flexibility/ rigidity of wage and prices. The Classicals
assumed prices to be flexible and thereby postulated full employment of
resources, whereas the Keynesians assumed wage/ price rigidiiy and thereby
rationalised the existence of persistent unemployment. This distinction between
the Classicals and the Keynesians continues between the New Classicals and the
New Keynesians.
The New Keynesian theory largely rationalises existence of unemployment
through the existence of nominal and real rigidities. Nominal rigidities refer to
the inflexibility of nominal wages and prices. Real rigidities refer to
imperfections in the goods, credit and labour markets which lead to the relative
prices and real wages being different from what would be predicted by a
competitive Walrasian model.
Mankiw builds up a model to show why nominal rigidity exists and why it
could lead to large macroeconomic consequences like aggregate unemployment.
The concept used in showing this is that of menu costs - the costs incurred in
changing prices in a situation where the firm has a price-setting power. Such
costs are large in relation to incremental profits obtained by changing the price
especially when the elasticity of demand is low and the deviation of the actual
price from the profit-maximising optimal price is not too high. The nominal
price rigidity that follows leads to unemployment.
Macroeconomic consequences like unemployment also follow from
imperfections in the goods, credit and labour markets. Such imperfections are
referred to as real rigidities. In the labour market they occur because, for
example, the real wage paid is higher than the market clearing wage for reasons
that will be dealt with in details in Unit 18. In the goods market, the real rigidity
follows from, e.g., countercyclical mark-ups used by price-setting firms,
whereas in the credit market the imperfections occur basically because of
information asymmetries.
Unemployment
15.7 ' KEY WORDS
Countercyclical behaviour of the Mark-up: The behaviour whereby the price'
mark-up ratio decreases during the upward phase of a business cycle and
increases during the downward phase.
Efficiency wage: A wage higher than the market-clearing wage voluntarily paid
by firms to their workers to increase their efficiency and to prevent them fiom
shirking.
Information asymmetry (in the credit market): A situation wherein
borrowers have more information than the lenders about the characteristics of
their investment projects. This generates inefficiencies in the credit market that
leads to credit-rationing and may call-for government intervention.

Mark-up: Ratio of price to marginal cost -

(LC)
Menu cost: A small fixed cost of changing a nominal price. The name comes
fiom the costs incurred by restaurants to print new menu cards when nominal
prices increase.
Microeconomic Foundations of Keynesian Economics: Derivation of
macroeconomic relatioaships and results of Keynesian economics by
postulating optimising behaviour by rational individuals.
Nominal price rigidity: The state of prices not changing as much as they
would have changed in money terms under competitive conditions.
Real rigidity: The state wherein relative prices in the goods market and real
wages in the labour market do not change as much as would be expected under
competitive conditions. Quantities change more than prices in response to, e.g.,
changes in aggregate demand. This happens because of certain imperfections of
the markets concerned.
Transmission mechanism: The mechanism through which monetary policy-
induced changes affect the economy in general and output and employment in
particular.

I§.$ SOME USEFUL BOOKS

Blanchard, O.J. and S. Fischer, 2000, Lectures on Macroeconomics, Prentice-
Hall of India, New Delhi
Dornbusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition,
Tata McGraw-Hill, New Delhi. See Chapter 20, Section 6
Romer, D., 2001, Advanced Macroeconomics, Second Edition, McGraw-Hill
International, New Delhi

15.9 ANSWERS1 HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) The distinction between flexibility and rigidity of prices is important
because the assumption of flexibility leads to the classical conclusion of
full employment, whereas the assumption of rigidity leads to the
Keynesian conclusion of existence of persistent unemployment. The two
assumptions give us two different ways of looking at macroeconomic
phenomenon.
2) The New Classicals assume price flexibility and hence perfect Nominal and Real
competition, whereas the New Keynesians assume price-setting power for Rigidities
firms in the context of imperfect competition. There is no distinction,
though in the analytical tools of the two schools: both use optimisation
models peopled by rational individuals.
Check Your Progress 2
1) Nominal rigidities exist when prices in money teims do not change as
much as they would under competitive conditions. Real rigidities, on the
other hand, refer to certain imperfections in the goods, labour and credit
markets which prevent relative prices and real wages from changing as
much as they would under Walrasian conditions.
Check Your Progress 3
1) Menu costs are costs incurred by price-setting firms in changing the price
that they charge. Such costs can be quite high in absolute terms if, for
example, price changes require costly adjustments to automatic dispensing
machines.
2) Even if menu costs are not high in absolute terms they may turn out to be
higher in relation to the private benefit that would be obtained in terms of
increased profits by changing the price.
3) The distinction between private and social benefits becomes important in
the context of the Mankiw model because, .under certain conditions
defined by, inter alia, the elasticity of demand, not much of private
benefits are obtained by a price-setting firm in terms of higher profits by
changing the price. If menu costs are higher than these private benefits,
the firms do not change the price. The price rigidity that this entails leads
to unemployment. If only the price had been changed the social benefit
obtained by way of reduction in unemployment would perhaps be higher
than the menu costs.
Check Your Progress 4
1) Real rigidities occur in goods market because, in an imperfectly
competitive set-up, firms do not change prices - they accept instead a
change in the mark-up that they charge to fix the price. In credit markets,
rigidities occur ultimately because of the existence of imperfections in the
form of information asymmetries - borrowers being more informed of
their investment projects than lenders. Rigidities exist in the labour market
in as much as real wages paid are higher than the market-clearing wage.
This could happen because of efficiency wage considerations.
UNIT 16 NEW -KEYNESIAN THEONES OF
UNEMPLOYMENT
Structure
16.0 Objectives
1 6.1 Introduction
Keynesian and New-Keynesian Theories of Unemployment and the
Behaviour of Real Wages
Efficiency-Wage Theories of Unemployment
Efficiency-Wage Model: An Example
16.4.1 Specification of the Model
16.4.2 Solution of the Model
16.4.3 Implications of the Model Solution
16.4.4 Possible Extensions of the Model
Conpacting and Insider-Outsider Models of Unemployment
Let Us Sum Up
Key Words
Some Useful Books
Answers1 Hints to Check Your Progress Exercises

16.0 OBJECTIVES
After going through this unit you should be in a position to:
explain clearly what is meant by non-Walrasian features of the labour
market;
appreciate that, empirically, real wages behave moderately pro-cyclically;
explain some reasons why efficiency of workers could increase when firms
pay higher than market-clearing wages;
develop an efficiency-wage model and examine its solution;
indicate the directions for extending the efficiency wage model;
explain why real wage rigidity and unemployment can emerge because of
contracting; and
find out the implications to unemployment of the existence of employed
workers (insiders) along with unemployed workers (outsiders).

16.1 INTRODUCTION
In this unit we consider in detail some New Keynesian theories of
unemployment. These theories are essentially non-Walrasian theories of
unemployment. This means that the observed phenomenon of unemployment is
not brushed aside as the working out of unimportant frictions as workers move
between jobs; or even as involuntary unemployment of workers who are ready
to work only at a higher wage than that which is available on the market. You
have already looked at the difference between Walrasian and non-Walrasian
theories of unemployment in Section 14.2 of Unit 14 where we considered an
unemployed worker, who claimed to be identical to a firm's current workers,
and who offered to work for the firm at a marginally lower wage than the one
the firm is currently paying its workers. At this stage, you are advised to revise
the four possible responses of the firm that were considered in Section 14.2. The
2) The New Classicals assume price flexibility and hence perfect Nominal and Real
competition, whereas the New Keynesians assume price-setting power for
firms in the context of imperfect competition. There is no distinction,
though in the analytical tools of the two schools: both use optimisation
models peopled by rational individuals.
Check Your Progress 2
1) Nominal rigidities exist when prices in money teims do not change as
much as they would under competitive conditions. Real rigidities, on the
other hand, refer to certain imperfections in the goods, labour and credit
markets which prevent relative prices and real wages fiom changing as
much as they would under Walrasian conditions.
Check Your Progress 3
1) Menu costs are costs incurred by price-setting firms in changing the price
that they charge. Such costs can be quite high in absolute terms if, for
example, price changes require costly adjustments to automatic dispensing
machines.
2) Even if menu costs are not high in absolute terms they may turn out to be
higher in relation to the private benefit that would be obtained in terms of
increased profits by changing the price.
3) The distinction between private and social benefits becomes important in
the context of the Mankiw model because, under certain conditions
'

defined by, inter alia, the elasticity of demand, not much of private
benefits are obtained by a price-setting firm in terms of higher profits by
changing the price. If menu costs are higher than these private benefits,
the firms do not change the price. The price rigidity that this entails leads
to unemployment. If only the price had been chmged the social benefit
obtained by way of reduction in unemployment would perhaps be higher
than the menu costs.
Check Your Progress 4
1) Real rigidities occur in goods market because, in an imperfectly
competitive set-up, firms do not change prices - they accept instead a
change in the mark-up that they charge to fix the price. In credit markets,
rigidities occur ultimately because of the existence of imperfections in the
form of information asymmetries - borrowers being more informed of
their investment projects than lenders. Rigidities exist in the labour market
in as much as real wages paid are higher than the market-clearing wage.
This could happen because of efficiency wage considerations.
UNIT 16 NEW KEYNESIAN THEORIES OF
UNEMPLOYMENT
Structure
Objectives
Introduction
Keynesian and New-Keynesian Theories of Unemployment and the
Behaviour of Real Wages
Efficiency-Wage Theories of Unemployment
Efficiency-Wage Model: An Example
16.4.1 Specification of the Model
16.4.2 Solution of the Model
16.4.3 Implications of the Model Solution
16.4.4 Possible Extensions of the Model
Coqtracting and Insider-Outsider Models of Unemployment
Let Us Sum Up
Key Words
Some Useful Books
Answers1 Hints to Check Your Progress Exercises

16.0 OBJECTIVES - - -

After going through this unit you should be in a position to:

explain clearly what is meant by non-Walrasian features of the labour
market;
appreciate that, empirically, real wages behave moderately pro-cyclically;
explain some reasons why efficiency of workers could increase when firms
pay higher than market-clearing wages;
develop an efficiency-wage model and examine its solution;
indicate the directions for extending the efficiency wage model;
explain why real wage rigidity and unemployment can emerge because of
contracting; and
find out the implications to unemployment of the existence of employed
workers (insiders) along with unemployed workers (outsiders).

16.1 INTRODUCTION
In this unit we consider in detail some New Keynesian theories of
unemployment. These theories are essentially non-Walrasian theories of
unemployment. This means that the observed phenomenon of unemployment is
not brushed aside as the working out of unimportant frictions as workers move
between jobs; or even as involuntary unemployment of workers who are ready
to work only at a higher wage than that which is available on the market. You
have already looked at the difference between Walrasian and non-Walrasian
theories of unemployment in Section 14.2 of Unit 14 where we considered an
unemployed worker, who claimed to be identical to a firm's current workers,
and who offered to work for the firm at a marginally lower wage than the one
the firm is currently paying its workers. At this stage, you are advised to revise
the four possible responses of the firm that were considered in Section 14.2. The
 labour market can be considered to be Walrasian in the first response, whereby New Keynesian Theories
the firm accepts the worker's offer - any unemployment leads to a decrease in or Unemplovment
the real wage. The observed unemployment in this case is purely frictional or
involuntary. The remaining sections of Unit 14 dealt with search and matching
models of unemployment, which explained persistent unemployment as the
equilibrium response of a heterogeneous labour market wherein specialised
vacancies in a firm were matched with unemployed workers with specific skills
through an elaborate search process. We considered there the second response
of the firm whereby the firm did not accept that the unemployed are
homogenous vis-h-vis the employed.
In this unit we deal with the third and the fourth responses of the firm (see
sectionl4.2 of Unit 14). The third response was that the firm was not in a
position to cut wages and employ additional workers, however much it would
have liked to do this, because it was bound by implicit and explicit agreements
with its workers, arrived at through collective bargaining, regarding the wages
that have to be paid. This leads us to institutionally determined wages in models
known as contracting models. The fourth response, on the other hand, was that
the firm did not want to reduce real wages - it believed that the benefits
accruing to it from higher wages were more than the costs of maintaining wages
at a higher level. The higher wages paid are referred to as efficiency wages and
the theories rationalising such wages are called efficiency-wage theories.
Section 16.3 deals with efficiency wage theories, whereas Section 16.4 deals
with contracting models. We will evaluate these theories on the basis of the
extent to which the theories help to explain empirical realities. In particular we
would like our theories to explain the following two observed empirical facts
about the labour markets in developed capitalist economies:
i) Existence of persistent unemployment
ii) The moderately pro-cyclical behaviour of real wages
The very purpose of the theories is to explain persistent unemployment. The
theories should, however, also explain the observed behaviour of real wages.
We deal with this latter point below in Sectionl6.2.

I 16.2 KEYNESIAN AND NEW-KEYNESIAN

I THEORIES OF UNEMPLOYMENT AND THE
BEHAVIOUR OF REAL WAGES
I
7 As mentioned above, two phenomena about the labour market need to be
explained: the persistence i f unemployment and the moderately pro-cyclical
behaviour of real wages. When aggregate demand increases, labour markets
respond typically by a larger increase in employment and a relatively smaller
increase in real wages, i.e., quantities respond more than prices. But real wages
A= do respond cyclically, however moderately.
This point helps us to understand the difference between Keynesian and New-
Keynesian theories of unemployment. Though both kinds of theories help
J explain persistent unemployment, it is only some of the new-Keynesian theories
that explain why wages behave pro-cyclically, though only moderately so. The
Keynesian theory clearly implies that wages behave counter-cyclically. This
follows from the assumption of a constant nominal wage. Given the nominal
wage rate W, the real wage W/P falls during an expansion as the price level P
gradually increases. It is this fall in the real wage that induces firms to employ
more labour and produce higher output as aggregate demand increases. During
contraction, on the other hand, real wages rise as prices fall, nominal wages
remaining unchanged. The Keynesian model thus implies a counter-cyclical
Unemployment
behaviour of real wages. This is not in accordance with the empirically
observed behaviour of real wages. In real world we see that real wage increases
during periods of boom and decreases during recession.
The new-Keynesian models imply an advance over the Keynesian model to the
extent that they imply a pro-cyclical behaviour for real wages, in accordance
with empirical observations.
Check Your Progress 1
1) Show that the Keynesian model implies a counter-cyclical movement of
real wages.

16.3 EFFICIENCY-WAGE THEORIES OF

UNEMPLOYMENT
Efficiency wage theories are clearly non-Walrasian theories in as much as they
postulate payment of wages that are higher than market-clearing wages. The
persistence of unemployment follows as a direct consequence of higher wages.
The efficiency wage theories rationalise the existence of higher than market
clearing real wages.
Broadly speaking, firms pay higher than market-clearing real wages because the
benefits accruing from higher wages are more than the cost of paying higher
wages. The higher benefits can accrue for the following reasons:
i) At a very basic level, higher wages enable higher consumption for workers,
including higher nutrition, and this is expected to increase the work capacig
of the hired workers. The point is more valid at lower levels of standards of
living than are prevalent in the developed economies.
ii) Higher wages may get into the pool of workers with a higher reservation
wage, i.e., the minimum wage that should be offered to a worker to induce
him to supply his labour on the market. Workers with a higher reservation
wage are expected to have superior abilities along directions that cannot be I
directly observed and duly compensated for on the market. These higher
abilities in the pool of employed workers are expected to benefit the firm.
iii) A higher than market wage can build loyalg and a sense of belonging
among workers and induce higher effort. This point is better understood in
the context of the opposite situation of a lower wage, which is expected to
have effects like generating anger and a desire for revenge, thereby leading 1
even to a sabotage by the workers.
iv) At a more sophisticated level, a higher wage generates incentives for
workers to avoid work-shirking behaviour in situations where the firms c
cannot monitor the work effort perfectly. Workers do not want to be caught
shirking in such valuable jobs, for they could be fired if caught shirking and
may be able to replace the job, if at d l , by one which pays only a market-
clearing and hence a lower wage. I

Some of the above ideas have been developed into more formal models in the
literature. In the next Section you will go through one such model that analyses i
the determination s f efficiency wages.
40 I
I
 New ~ e ~ n e s ' i Theories
an
16.4 EFFICIENCY WAGE MODEL: AN EXAMPLE of Unemployment

As you know, we construct a model by making many simplifying assumptions.

We specify the model, indicate its solution, and bring out all the implications of
the solution. In this section we present an efficiency wage model in line with of
Romer (200 1).
16.4.1 Specification of the Model
We consider a tqodel with M firms and analyse a representative firm. We
pecify a simple neoclassical production function with a single input, labour.
However labour enters the production function, not in physical units, but in
efficiency units. The production function for a representative firm is hence of
the form:
Y = F(e. L)
Y is the total output produced. L is the number of physical units of labour hired
by the firm. e.L is the efficiency units of labour. You can look upon e.L as the
total effort undertaken by the L units of hired labour. Higher the index of effort,
e, exerted by individual units of labour, higher the total labour input in
efficiency units.
By saying that the production function is of the neoclassical kind, we mean that
the total output increases as the efficiency units of labour used increase, but at a
decreasing rate. In other words, marginal product of the efficiency units of
labour is positive but decreases as the total labour effort expended in the
production process increases. In symbols it amounts to the standard assumptions
you have seen in Unit 3, that is, F'>O;F'<O
The model further specifies that the individual effort, e, depends on the wage
rate - higher the wage rate, w, higher is the effort exerted by individual physical
unit of labour. The effort function can be specified as:
e = e(w)
It is also assumed that there are N workers in the economy, each supply one unit
of labour inelastically: an increase in wage rate leads, not to an increase in
physical labour supplied by an individual worker, but to an increase in the effort
expended.
16.4.2 Solution of the Model
The model is solved by making the usual behaviouristic assumption about the
firm: that the firm hires labour so as to maximise its profits. The profits of the
firm are defined as:
n=Y- W.L

w is the real wage paid by the firm and, as you have seen above, Y is the total
output of the firm. L is of course the number of units of physical labour hired by
the firm.
After substituting for Y in the above profit function, the problem reduces to the
following two-variable maximisation problem in calculus, viz., determine L and
w so as to maximise z = F(e(w).L) - w.L. Following the usual calculus
techniques to solve a maximisation problem, this problem is solved by taking
the partial derivatives of z respectively with respect to w and L and equating
each of these to zero. This gives us two equations in two unknowns, w and L,
which can be solved simultaneously to obtain the equilibrium, profit
maximising, values of w and L.
Instead of obtaining the solution explicitly, we can characterise it by examining
the first of the above two equations obtained by equating the partial derivative
-r' - ... :cL ,
,,,
- + +- I ,* .In,.,,
, T h P P"l,lt;n,-, , . P ~ l I C . P E t(,
1 Unemployment

e'(w) is the deridative of the effort function with respect to w, giving the
increase in effort per unit increase in the red wage, for infinitely small increases
in the wage rate. You will be able to recognise the L.H.S. expression of the
above equation as the elasticity of the effort function e0v) with respect to the
real wage rate w. What the equation states is that, at the optimum, the elasticity
of effort with respect to wage is unity, i.e., the real wage rate is so determined
that, at the optimum, a one per cent increase in the wage rate leads to one
percent increase in effort. This means that, at the optimum, the ratio w/e(w)
remains constant, for infinitely small changes in w. This suggests that the ratio
w/e(w) is at its minimum at the optimum.
What do you think is the economic interpretation of this ratio being a minimum
at the optimum real wage? When a firm buys one physical unit of labour at the
cost given by w, it is effectively buying e units of labour, since one physical unit
of labour expends e units of effort. That is why we said above that L physical
units of labour effectively provide e.L eficiency units of labour. The ratio'
w/e(w) hence gives the per unit cost of effective units of labour. The firm sets
the real wage so as to minimise this per unit cost of effective units of labour that
it obtains by buying physical labour on the market. This means that the firm sets
the real wage rate so as to maximise the effective labour obtained for a given
outlay, assuming that the effort expended by labour is an increasing function of
the real wage. It is presumed here that, as the real wage increases, the effort
increases, first at an increasing rate and subsequently at a decreasing rate. The
real wage is set such that the rate of increase of effort with respect to the wage
is just equal to the wage. For wage rates below the optimum wage, increasing
the wage leads to a larger increase in effort; whereas for wage rates above the
optimum, increasing the wage any further leads to a lower increase in effort. At
the optimum, the marginal product of effective labour equals its cost.
16.4.3 Implications of the Model Solution
Let w* and L* be the optimum levels of the real wage and physical units of
labour hired obtained as a solution to the model for the representative firm.
Since there are M such firms, the total demand for labour is given by M L *. We
bring out some of the implications of this solution.
i) The solution clearly implies that workers could remain unemployed in the
model when the wage rate is set at w*. We have assumed above in the
specification of the model that the total number of workers in the model is
M. Unemployment can exist if M > At L*, where M.L* is the total demand
for labour when the real wage rate is the efficiency wage w*. On the other
hand, if M.L* turns out to be larger than M,then the wage is bid up above
the eficiency wage up to the point that demand M for and supply of labour
are in balance and there is no unemployment
ii) The model implies that the increase in aggregate demand does not lead to an
increase in real wage. This is because the efficiency wage is determined
entirely by the properties of the effort function e = e(w) and there is no
reason for w* to change when aggregate demand increases. The model
hence comes close to rationalizing the empirically observed fact that in
cyclical upswings, it is employment, and not real wage, that increases - the
real wage is only moderately pro-cyclical.
iii) Rigidity of prices is also implied in the model. The fact that real wage and,
hence, effort do not change during cyclical upswings means that the labour
costs of firms do not change and hence price-setting firms do not have
incentives to adjust prices. You must connect this up with the conclusions
 about price rigidity that were reached in the new Keynesian models of Unit New Keynesian Theories
15. of Unemployment

We thus see that the efficiency wage model not only explains the possibility of
the existence of persistent unemployment, but also suggests why the burden of
adjustment falls on employment rather than on the real wage during cyclical
changes in business activity.
16.4.4 Possible Extensions of the Model
The efficiency wage model that we considered above, however, has an
important drawback: it is unable to distinguish between short-run cyclical
effects and long run secular effects. In the real world, though the short run effect
is in terms'of increased employment and hence decreased unemployment, the
long run is characterised, not by a trend decrease in unemployment, but by a
trend increase in the real wage. The model is not able to make this transition
from the short to the long run.
The efficiency wage rnodel can however be extended to deal with the above
problem. We enly indicate the directions in which such an extension can take
place and do not develop the extended model in details. The extension is
basically given effect to through modifications in the effort function. The effort
function in the earlier model was e = e(w). It is now extended as:

The real wage paid in the representative firm is w, whereas e is the effort. The
real wage available to the workers in alternative firms is denoted by w' and the
unemployment rate in the economy is u. The inclusion of w ' and u in addition to
w as arguments in the effort function can be rationalised by examining some of
the reasons we set out at the beginning of Section 16.3 for the payment of
higher (i.e., efficiency) wages. If higher wages are paid to induce workers not to
shirk and to exert greater effort in situations where the effort cannot be
continuously monitored, then the higher wages will lead to the desired effect of
workers not shirking only if the wage rate obtained in other firms is lower and
the unemployment rate is high. If the wage rate obtained in other firms is as
high and if the unemployment rate in the economy is low then the worker will
not mind getting caught shirking because he can, with a high probability, obtain
an alternative job which is as paying as his current one. A higher (i.e.,
efficiency) wage will not, in such a situation, induce him to exert greater effort.
Effort e depends positively on w, given w' and u. Effort e, however, depends
negatively on w' and positively on u. We can similarly work out the rationale
behind the extended effort function if reasons for paying a higher (i.e.,
efficiency) wage have to do with tapping higher unobserved abilities or with
engendering loyalty or avoiding sabotage by disgruntled workers.
Such an extension of the effort function again leads to a similar solution for the
efficiency wage as in the above model with a simpler effort function. Here too
the elasticity of effort with respect to the real wage is unity at the optimum real
wage. The wage paid by any of the firms has however to be necessarily equal to
that paid by the representative firm, i.e., w = w' in the solution. Unemployment
can also emerge in this model if, at this common efficiency wage, the total
demand for physical units of labour by the firms falls short of the total supply of
physical units of labour.
Such an extended model can account for both, a larger effect of increased
aggregate demand on employment as compared to real wage in the short run
and an absence in trend unemployment in the long run. This is shown with the
help of an example in Romer (2001). Interested learners are advised to follow
the original.
Unemployment Check Your Progress 2

1) Why do firms pay higher than market-clearing wages? List out some of
the reasons.

2) How would you interpret the first-order condition for optimum, viz., that
the elasticity of effort with respect to the wage is unity, in the efficiency-
wage model that you studied above?

.......................................................................................
3) Show how unemployment can emerge in an efficiency-wage model.

4) Why does an increase in demand for labour have a larger effect on

employment than on the real wage in the efficiency wage model
constructed above?

5) Bring out an important drawback of the efficiency wage model that uses a
simple effort hnction.

16.5 CONTRACTING AND INSIDER-OUTSIDER

MODELS OF UNEMPLOYMENT
The models in Section 16.3 departed from the Walrasian assumption of a
market-clearing wage on efficiency considerations - it was postulated that a
higher than market-clearing wage leads to increased efficiency of workers for New Keynesian Theories
one reason or another. In this section we consider briefly some models wherein of Unemployment

the wage differs from the Walrasian wage because of long-term relations
between workers and firms. We consider here, very briefly, two kinds of models
- contracting models and insider-outsider models.

The rationale underlying the contracting .models is that firms do not hire
workers afresh each period. Workers continue to work for a firm for a large
number of years because many jobs involve firm-specific skills that are not
valued as much outside the firm and also because firms would find it costly to
trbin new workers in these skills afresh each period. Workers are content to stay
in their current jobs so long as their expected earnings over a much longer
period than just, say, the current year are more than the opportunities that the
workers would have outside the firm, even if in the current year their earnings
are low. A worker in the United States, for example, lasts in a job, on an
average, for ten years. In such a situation wages do not have to adjust every
period to clear the labour market and the labour market clearly becomes non-
Walrasian.
The relationships between workers and firms are determined in such cases by
long-term contracts, arrived at through collective bargaining between worker
unions and firms. We can consider two kinds of contracts. The first kind is a
fixed-wage contract under which the wage is pre-determined and the film is free
to choose the level of employment that it provides depending on the itate of the
economy that emerges in each period. Workers agree to supply all the labour
demanded by the firm. Wage rigidity and unemployment emerge immediately
in such a model. A fall in labour demand does not affect the real wage because
of the contract. The labour supply too cannot fall. The only thing that can
happen when labour demand falls is that firms reduce employment at the fixed
real wage.
The problem with this type of fixed-wage, variable employment contract is,
however, that it is not an efficient contract because, under it, the marginal
product of labour is generally not equal to the marginal disutility of work, and
so it is possible to make both parties to the contract better OK You should
recollect from your microeconomics units that contracts are said to be efficient
if it is not possible to make one of the parties better off without making the
other one worse off (pare to efficiency). This takes us to the idea of implicit
contracts, which are efficient contracts unlike the simple fixed-wage contracts.
Implicit contracts are contracts between the firm and workers wherein the firm
specifies the real wage and the employment that it will provide for each possible
state of the economy. The contracts are so called because actual contracts in the
real world do not explicitly specify employment and wage as a h c t i o n of the
state of the economy. Not only are these contracts efficient, but also imply real
wage rigidity and the consequences of real wage rigidity that we have examined
in other contexts.
The insider-outsider models are a development on the contracting models,
wherein three categories of agents are recognised, viz., the firms, the workers
that are employed (insiders), and the unemployed workers (outsiders). It is in
the interest of the unemployed workers that the firms and the insider workers
sign contracts providing for lower real wages and higher employment. But the
unemployed, being outsiders, are not on the bargaining table. The real wage
rigidity, that is implied, provides a non-Walrasian characteristic to the labour
market and explains the existence of unemployment. Rich models have been
built up in the literature analysing the interactions between the three categories
of agents to explain some of the empirically observed characteristics of the
labnur market.
Check Your Progress 3
1) Why are fixed-wage contracts inefficient?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
2) What is the difference between wage contracts and implicit contracts?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
......................................................................................
3) How do insider-outsider models explain the existence of unemployment?
......................................................................................
......................................................................................
......................................................................................
......................................................................................
......................................................................................

16.6 LET'US SUM UP

The new Keynesian theories of unemployment are non-Walrasian theories - the
real wage in the new Keynesian models is generally not a market-clearing wage.
Most of the new Keynesian models however accord with the empirically
observed fact of a moderately pro-cyclical real wage. This is unlike the
Keynesian theory of unemployment, where real wage is counter-cyclical. In
most of the new Keynesian models, an increase in aggregate demand and in the
demand for labour has a larger effect on employment and a smaller effect on the
real wage in the short run.
The new Keynesian models of unemployment include models such as the
efficiency wage models, the contracting models and insider-outsider models.
The efficiency wage models postulate and rationalise a higher than market-
clearing wage on the ground that the benefits accruing from higher wages are
more than the costs of maintaining wages at a higher level. The benefits come
from increased efficiency of workers. The increased efficiency could be due to
increased physical efficiency of workers obtaining higher wages, or due to the
engendering of a sense of loyalty and belonging among workers, or even due to
avoidance of work shirking by workers who do not want to lose high paying
jobs if caught shirking. The efficiency wage model not only rationalises the
existence of persistent unemployment, but also produces a larger effect on
employment in the short run. The shortcoming of an efficiency wage model
using a simple version of the effort function is that it implies that there is no
increasing trend in the real wage even in the long run. This is contrary to
empirically observed facts. The shortcoming can be easily remedied by using a
more complex effort function.
The contracting and insider-outsider models rationalise wage rigidity with
ref~rpnretn the fgrt thslt wnoec nrp d ~ t ~ r m i n ehv
d lnno term cnntrslcts hetween
workers and firms, and are not necessarily set at the market-clearing level in New Keynesian Theories
o f Unemployment
each period. This immediately rationalises wage rigidity and unemployment.
The insider-outsider models provide the insight that though it is in the interest
of the unemployed workers (outsiders) that wages are contracted to be low so
that employment is higher, the unemployed in a non-competitive economy have
no power in the matter, as wages are determined through bargaining between
the employed workers (insiders interested in higher wages) and firms.

16.7 KEY WORDS

Efficiency Units of Labour: Units of labour that take into account both the
physical units and the 'effort' expended by the physical units. If each of L units
of physical labour expends e units of effort, the total number of efficiency units
is e.L.
Effort Function: The relationship showing the dependence of work effort on,
e.g., the real wage. The arguments of the effort function can also include the
real wage available in alternative jobs and the unemployment rate.
Fixed-wage Contract: A contract between firms and workers under which the
wage is pre-determined and the firm is free to choose the level of employment
that it provides depending on the state of the economy that emerges in each
period.
Implicit Contract: A contract between firms and workers under which both the
wage paid and employment provided are specified as a function of the state of
the economy. Since actual contracts do not explicitly specify wage and
employment as functions of the state, such contracts are called implicit
contracts.
Insiders: Workers employed in a firm.
outsiders: Unemployed workers.
Pro-cyclical Real Wage: Real wage that increases during the expansionary and
decreases during the contractionary phase of a business cycle.
Reservation Wage: The minimum wage that must be offered to a worker to
induce her to supply her labour on the market.
Shirking: Tendency on the part of workers to avoid work in situations where
the employers cannot monitor the work effort perfectly. It pays the firms in such
situations to offer higher than market .wages, so that the workers have an
incentive not to shirk - they could lose a valuable job if caught shirking and
they may not be able to get a higher than market-clearing wage in their next job.

16.8 SOME USEFUL BOOKS

Dornbusch, R., S. 'Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition, .
Tata McGraw-Hill, New Delhi.
Romer, D., 200 1, Advanced Macroeconomics,, Second Edition, McGraw-Hill
International, New Delhi.
Blanchard, O.J. and S. Fischer, 2000, Lectures on Macroeconomics, Prentice-
Hall of India, New Delhi.

16.9 ANSWERS1 HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Keynesian models assume constancy of nominal wages. Prices rise during
cyclical expansions. This implies a fall in real wages. Such a fall in real
-
Unemploy
wages is necessary in Keynesian models to induce firms to employ more
labour during phases of increase in aggregate demand.
Check Your Progress 2
Firms pay higher than market-clearing wages because the benefits from
higher wages could outweigh their costs. The benefits come from
increasing the work-capacity of the workers, from bringing in workers
with higher reservation wage who are expected to have higher abilities
along some unobservable dimensions, from engendering a sense of loyalty
among workers, and, above all, from generating incentives for workers to
avoid shirking in situations where the work effort cannot be perfectly
monitored.
2) The condition is interpreted by understanding that when the elasticity is
equal to one, the firm minimises the per unit cost of buying effective
labour, i.e., the firm sets the real wage so as to get the maximum per unit
of effective labour at a given cost. The firm can do such a thing because
we assume that the effort expended by labour is an increasing function of
the real wage.
3) In answering this question, you will have to fully specifL an efficiency
wage model and characterise its solution. Unemployment can arise in such
a model if, at the efficiency wage (which is expected to be higher than the
market clearing wage) the total demand for physical units of labour by the
firms is less than the total available supply of physical units of labour.
4) Increase in labour demand has no effect on the real wage in the model
because the real wage is determined in the model only by the
characteristics of the effort function and not by labour demand conditions.
These latter conditions, hence, only affect employment.
5) Simple effort function refers to the function wherein effort depends only
on the real wage. The efficiency wage model that uses a simple effort
function is not able to distinguish between the short run and the long run
effects of increase in demand for labour. We need a model that has a
relatively larger effect on employment in the short run and on the real
wage in the long run, which is what accords with empirical reality. The
model that we have developed in details has uniformly larger effect on
employment both in the short and the long run.
Check Your Progress 3
1) Fixed-wage contracts are inefficient because, under these contracts, the
marginal product of labour is not equal to the marginal disutility of
workers, so that it is possible to make both parties to the contract better
off.
2) An important difference between a wage contract and an implicit contract
is that the former is generally inefficient, whereas the latter is efficient.
Both kinds of contracts, however, imply real wage rigidity and the usual
consequences of such real wage rigidity.
3) Insider-outsider models explain the existence of unemployment by
reference to the fact that in imperfectly competitive economies, the
unemployed workers have no power to influence the wage bargains
between the employed workers and the firms. Real wages are hence not
low enough for employment to increase.
 Sluggish Price Adjustment
UNIT 17 FLEXIBLE EXCHANGE RATE SYSTEM

Structure
17.0 Objectives
17.1 Introduction
17.2 Balance of Payments
17.3 Exchange Rate
17.4 Determination of Flexible Exchange Rate
17.4.1 Derivation of Demand Schedule for Rupees
17.4.2 Derivation of the Supply Schedule of Rupees
17.4.3 Equilibrium Exchange Rate
17.5 Factors Affecting Flexible Exchange Rate
17.6 Let us Sum Up
17.7 Key Words
17.8 Some Useful Books
17.9 Answers/Hints to Check Your Progress Exercises

17.0 OBJECTIVES
After going though this unit, you should be able to:
• explain the basic concepts of international transactions, balance of payments and
exchange rate;
• explain how exchange rates are determined;
• explain the concept of flexible exchange rate and its implications; and
• analyse the relationship between flexible exchange rate and trade in goods and
capital flows.

17.1 INTRODUCTION
A country is linked to other countries through two broad channels: trade flows and
financial flows. Trade flows pertain to movement of goods and services between
countries and thus facilitate exchange of products between countries, commonly
known as exports and imports. When countries produce more than what they can
domestically consume, they export. Similarly, when countries consume more than what
they can produce, they import.
Thus, there would be balancing of production surpluses and deficit when trade takes
place between countries.
The implications of the above formulations, (i.e., trade flows) on the components of
aggregate demand (AD) would be to include net exports [i.e., exports(X) – imports
(M)] such that
AD = C + I + G + X – M
where,
C: Consumption
I: Investment
G: Government Expenditure
S: Savings
This would mean that
• if AD > output, then imports rise
• if AD < output, then exports rise 5
Open-Economy Macro- Let us look into financial flows. The international linkages through financial flows
Modelling shift the assets between countries.
That is, if
• domestic I < S domestic savings are exported, i.e., foreign investment
abroad is financed by domestic savings.
• domestic I > S foreign savings are imported, i.e., domestic investment
is financed by foreign savings.
Often we come across the term foreign direct investment (FDI) in India. It implies that
excess savings in foreign countries is getting invested in India. Recall from Unit 1 of
this course that an increase in investment results in an increase in aggregate output.
Thus, the transactions in the asset market affect income, interest rate and exchange
rate.

17.2 BALANCE OF PAYMENTS

The record of all transactions (trade and financial) of the residents of one country with
the rest of the world is Balance of Payments (BoP). The direction of money flows
determines whether a particular transaction is a Credit or Debit item. For example,
exports of goods is a credit item as money flows into the economy. Similarly, import of
goods is a debit item as money flows out of the country. Investment abroad (i.e., export
of saving) is a debit item as the transaction results in out flow of money while foreign
investment in a country is a credit item.

The BoP has two accounts: Current and Capital accounts. All current/revenue
expenditure transactions (such as exports and imports of goods, transfer payments,
non-factor payments, etc.) are recorded in current account. The current account balance
reflects whether there is a surplus (+) or deficit (–) in this account.

All transactions, (export and import) that influence country’s capital assets are recorded
in capital account. For example, if a country borrows capital from foreign sector, it
would be recorded as credit item and if the country lends capital to the foreign sector, it
would be recorded as debit item in capital account. The net surplus (+) or deficit (–) in
capital account is recorded in capital account balance. The components of current and
capital accounts are presented in table 17.1.

Table 17.1:Composition of Current and Capital Accounts

A) CURRENT ACCOUNT
1. Exports and Imports of
Merchandise/Goods Surplus (+)
2. Exports and Imports of Services Exports of goods and services >
(Invisibles) Imports of goods and services
• Non-Factor Services
Vice versa for Deficit (–)
• Investment Income
• Private Transfers
• Official Grants
3. Current Account Balance (Net of 1+2)

B) CAPITAL ACCOUNT
1. Direct Investments (Net) Surplus (+)
2. Portfolio Investment (Net) The demand for domestic assets >
3. External Assistance (Net) domestic demand for foreign assets
4. Commercial Borrowings (Net)
5. NRI Deposits (Net) Vice versa for Deficit (–)
6. Capital account balance
(1+2+3+4+5)

6
BoP equilibrium is achieved when the sum of current account balance and capital account Sluggish Price Adjustment
balance is a zero, i.e., surplus in current account is exactly matched by deficit in capital
account. If the addition of these two accounts results in a surplus (deficit) then it is
indicated as BoP surplus (deficit).

17.3 EXCHANGE RATE

By definition, exchange rate is the price of one currency in terms of another currency,
i.e., number of units of domestic currency that can be exchanged for one unit of foreign
currency. For example, Rs.45/$.

The demand for foreign currency arises when a country imports goods and services
from another country. For example, when an Indian tourist visits the US, there is a need
to exchange Rupees for US$. Similarly, when a domestic firm imports (raw material or
machinery) from another country or when investments are made abroad foreign exchange
is required.

The supply of foreign currencies takes place when a country exports its goods and
services. For example, when a foreign tourist visits India (i.e., export of tourism services)
foreign currency is exchanged for domestic currency. Similarly, when a domestic firm
exports to a firm in another country, foreign currency flows into the country.

Putting together, a country pays for its imports of goods and services from the foreign
exchange earnings of exports. Thus, if the total demand for foreign exchange exceeds
the total foreign exchange earnings, the rate at which currencies exchange for one
another will change. Thus, the demand for and supply of foreign currencies will
determine the exchange rate. If the value of one currency (in terms of another) increases,
then the currency appreciates. On the other hand, if value of the currency decreases,
the currency depreciates. For example, assume the exchange rate between Rs. and $ to
be Rs. 40/$. If the exchange rate changes to Rs. 45/$, then rupee is becoming cheaper
relative to $, hence rupee is depreciating against $. Similarly, if the exchange rate
changes to Rs. 35/$, then rupee is becoming dearer relative to $, hence rupee is
appreciating against $.

Exchange rate can be determined either by market forces (i.e., supply of and demand
for foreign currency or by the government. Accordingly we have flexible exchange
rate or fixed exchange rate.

17.4 DETERMINATION OF FLEXIBLE EXCHANGE RATE

The demand and supply schedules of foreign currencies will determine the exchange
rate. For simplicity, let us assume that India and US are trade partners and the exchange
rate between Rs and $ is to be determined.

17.4.1 Derivation of Demand Schedule for Rupees

As mentioned above, demand for Rupees arises in the US when India exports certain
goods and services. In return, there is supply of US $ to India. Thus, in a two-country
model, derivation of demand schedule for Rs. is the same as derivation of supply schedule
of US $.

Assume a situation where India is exporting product X to the US, the price of which is
Rs. 100. Given an exchange rate of 0.06 ($/Re), the dollar price of Product X is $6. At
this price, assume the demand for product X to be 1500 units in the US. For the
transaction to be completed, the demand for Indian Rupees would be Rs.1, 50,000
(=1500 × 100) while supply of foreign currency would be $9000 (=1,50,000 × 0.06).
With a falling exchange rate (or rupee depreciating), the dollar price of the product
7
Open-Economy Macro- decreases. Simultaneously the demand for product X (in the US) increases thereby
Modelling increasing the demand for Indian rupees (or supply of foreign currency).

Table 17.1: Derivation of Demand for Rupees (Supply of $)

Price of Exchange Price of Qty. of Indian Demand for Supply of
Indian Export Rate ($/Re) Indian Export Export (XI) Indian Rupees Foreign
good in Rs. good (X) in $ (Rs.) Exchange($)
100 0.06 (17.94) 6.0 1500 1,50,000 9000
100 0.04 (24.47) 4.0 1800 1,80,000 7200
100 0.03 (30.65) 3.0 2000 2,00,000 6000
100 0.029 (33.45) 2.9 2050 2,05,000 5945
100 0.023 (42.07) 2.3 2500 2,50,000 5750
100 0.022 (45.68) 2.2 2600 2,60,000 5720

Note: Figures in parenthesis are (RS/$)

The relationship between exchange rate and the demand for Rupees is highlighted below
in Fig. 17.1. Corresponding to the above, the supply of foreign currency can be drawn
which will be upward sloping (see Fig. 17.2).

0.07
0.06
0.05
$/Re

0.04
0.03
0.02
0.01
0
1,50,000 1,80,000 2,00,000 2,05,000 2,50,000 2,60,000
Rs ('00)

Fig. 17.1: Demand Schedule for Indian Rupees

Fig. 17.2: Supply Schedule for Foreign Currency

From Fig. 17.1, it is evident that the relationship between the exchange rate and the
demand for rupee is negative. This implies that as rupee depreciates (or price in $ terms
8
decreases), the demand for rupee currency increases. In terms of foreign currency, i.e., Sluggish Price Adjustment
$, the relationship between exchange rate and supply of foreign currency is positive.
Thus, exports determine the relationship between exchange rate and the demand for
Indian rupees or supply of foreign currency.

17.4.2 Derivation of the Supply Schedule of Rupees

Assume a situation where India is importing Product Y from the US, the price of which
is $10. Given an exchange rate of Rs. 17.94/$ (or $ 0.06/Re.), the rupee price of
Product Y is Rs. 179.40. At this price, assume that demand for import of Product Y is
100 units. To complete the transaction, the corresponding supply of Indian rupees is
Rs. 17,940 and the demand for foreign currency is $ 1000. With a falling exchange
rate (or rupee depreciating), imports become more expensive in the domestic market,
thereby leading to a fall in import demand and hence a fall in supply of rupees.
Conversely, if rupee were to appreciate, the rupee price of product Y falls thereby
increasing the demand and increasing the supply of rupees.

Table17.2: Derivation of Supply Schedule of Rupees

(India importing from US)
Price of Exchange Price of US Qty. of Indian Demand for Supply of
Indian Import Rate (Rs/$) Import good Import (Y) $ (Rs.)
good (Y) in $ (Y) in Rs.

10 17.94 (0.06) 179.40 10 1000 17,940

10 24.47 (0.04) 244.70 60 600 14,682
10 30.65 (0.03) 306.50 45 450 13,792
10 33.45 (0.029) 334.50 40 400 13,380
10 42.07 (0.023) 420.70 30 300 12,621
10 45.68 (0.022) 456.80 25 250 11,420
10 37.16 (0.027) 371.60 35 350 13,006
Note: Figures in brackets are ($/Re.)

The relationship between exchange rate and the supply of rupees (and the demand for
foreign currency) is highlighted in Fig. 17.3.

Supply Schedule of Indian Rupees

0.07
0.06
0.05
$/Re

0.04
0.03
0.02
0.01
0
11420 12621 13380 13792 14682 17940

Rs. ('00)

Fig. 17.3: Supply Schedule of Indian Rupees

From Fig.17.3, it is evident that the relationship between exchange rate and supply of
rupees is positive. It implies that as rupee appreciates (depreciates), imports become
cheaper (dearer) and the supply of rupees increases (decreases). In terms of the foreign
currency, the relationship between exchange rate and demand for foreign currency is
9
Open-Economy Macro- negative. Thus, imports determine the relationship between exchange rate and the
Modelling supply of Indian rupees or demand for foreign currency.

50

40

30
Rs./$

20

10

0
250 300 350 400 450 600 1000
$

Fig. 17.4: Demand Schedule of Foreign Currencies

17.4.3 Equilibrium Exchange Rate

The theory of exchange rate determination explains how demand and supply of foreign
exchange interact and jointly determine the equilibrium exchange rate.

SFC
DFC S1
D1 SRs
DRs
$/Re Rs/$

R1* R2
R * R1*

Rs $

Fig. 17.5: Equilibrium Exchange Rate

As seen earlier, the demand schedule for Indian rupees (or supply schedule of foreign
currency) arises from the foreign demand for Indian exports. Similarly, the supply
schedule of Indian rupees (or demand schedule for foreign currency) arises from the
Indian demand for foreign goods or imports. Together, they determine the equilibrium
exchange rate (R*)

Suppose there is an exogenous increase in income in the US and therefore an increase

in demand for Indian goods. Correspondingly, the demand schedule for Indian rupees
shifts to D1 (see fig. 17.5 (a)). The resultant equilibrium exchange rate (R*1 ) indicates
that the Rupee has appreciated against the dollar. Similarly, if Indian imports increase
(relative to the exports) then the supply curve (SRs) shifts to the right (see Fig. 17.5(b))
resulting in the depreciation of Indian rupee from R2 to (R*1 ).

Thus, in a flexible exchange rate regime, market demand for and supply of a country’s
currency determines the changes in exchange rate. As the demand and supply schedules
10
for currency are determined by many forces, there would be a tendency for high volatility Sluggish Price Adjustment
of exchange rates in this regime. As there would be no intervention by the Central
Bank in determining the exchange rate, the BoP will always be in equilibrium. It means
that the exchange rate adjusts to make the balances in current and capital accounts sum
to zero.

17.5 FACTORS AFFECTING FLEXIBLE EXCHANGE

RATE
Shifts in the demand and supply schedules for foreign currency take place on account
of a number of factors. Some of them are enumerated below.

If economic growth in India increases relative to the US, then Indian demand for US
goods increases (imports rise). It shifts the supply schedule of Indian rupees to the right
thereby depreciating rupee as against the dollar.

Second, if the inflation rate in India rises faster than that in the US, imports become
cheaper. It leads to more imports resulting in supply schedule of rupees shifting to the
right thereby depreciating the rupee against the dollar.

Third, if interest rate in India increases relative to that in the US, capital inflows rise.
With an increase in demand for investment in demand, the demand schedule (for rupees)
shifts to the right resulting in rupee appreciating against the dollar.

Fourth, expectations also affect the exchange rate. Speculations about interest rates,
growth rates, etc. influence the supply and demand forces, which in turn, influence the
exchange rate.

Check Your Progress 1

1) Fill in the Blanks:

a) If the Indian economy is growing more rapidly than other economies, India’s
...................................... are likely to grow more rapidly than its
............................................. . Thus India’s demand for foreign currency
will ...................................................... . Consequently, the rupee is likely
to ............................................................ .

b) When country A’s currency becomes more valuable relative to country B’s
currency, country A’s currency is said to ................................... relative to
that of country B, and country B’s currency is said to ......................... relative
to that of country A.

2) State whether True or False and explain briefly:

a) The balance of payments accounts always balances under flexible exchange
rate regime.
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
11
Open-Economy Macro- b) When currency depreciates, imports tend to increase.
Modelling
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................

c) When exports rise currency appreciates.

.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
3) A can of soda costs $0.75 in the United States and 12 pesos in Mexico. What
would the peso-dollar exchange rate be if purchasing-power parity holds? If a
monetary expansion caused all prices in Mexico to double, so that soda rose to 24
pesos, what would happen to the peso-dollar exchange rate?
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................

17.6 LET US SUM UP

All transactions with the foreign sector are recorded under BoP accounts. The direction
of money flows determines whether a particular transaction is a credit or debit item.
For example, export of goods is a credit item as the money flows into the economy.
But, investment abroad (i.e., export of savings) is a debit item as the transaction results
in money flowing out of the country.
The BoP has two accounts: current and capital accounts. All current revenue/
expenditure transactions (like exports and imports of goods and services) are recorded
in current account. The current account balance reflects whether there is a surplus (+)
or deficit (–) in this account. BoP equilibrium is achieved when addition of current
account balance and capital account balance results in a zero, i.e., surplus in current
account is exactly matched by deficit in capital account.
By definition, exchange rate is the price of one currency in terms of another currency,
i.e., number of units of domestic currency that can be exchanged for foreign currency.
For e.g., Rs./$ or $/Re. The demand and supply schedules of currency determines the
exchange rate. The demand curve of currency is derived from the demand for exports.
The supply curve of currency is derived from the demand for imports. In a flexible
exchange rate regime, changes in market demand for and supply of a country’s currency
determines the changes in exchange rate.

17.7 KEY WORDS

Capital : Here, in this Block, the word connotes financial capital.
Currency : The sum of outstanding paper money and coins.
Depreciation : A fall in the value of a currency relative to other
12 currencies in the foreign exchange market.
Devaluation : An action by the Central Bank to reduce the value of Sluggish Price Adjustment
domestic currency vis à vis foreign currencies.
Exchange Rate : The rate at which domestic currency is exchanged with
foreign currencies.
Exports : Goods and services sold to foreign countries.
Flow : A variable measured as a quantity per unit of time. This
is different from stock, which is quantity of a variable
measured at a particular point of time.
Fixed Exchange Rate : An exchange rate that is set by the Central Bank under
the condition that it is willing to buy and sell foreign
exchange at that rate.

17.8 SOME USEFUL BOOKS

Mankiw, N. G., 2000, Macroeconomics, Fourth Edition, Macmillan, New Delhi.
Baumol, W. J. and Alan S. Blinder, 1999, Economics: Principles and Policy, Harcourt
College Publishers, Chapter 36.
Sachs, Jeffrey. D. and Felipe Larrain B., Macroeconomics in the Global Economy,
Prentice Hall Inc., New York.
Salvalore, D., 2001, International Economics, John, Wiley and Sons, Chapters 13-14.

17.9 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) a) If the Indian economy is growing more rapidly than other economies, India’s
Imports are likely to grow more rapidly than its Exports. Thus India’s demand
for foreign currency will Increase. Consequently, the rupee is likely to
depreciate.
b) When country A’s currency becomes more valuable relative to country B’s
currency, country A’s currency is said to appreciate relative to that of country
B, and country B’s currency is said to depreciate relative to that of country A.
2) a) True:
Equilibrium in BoP = Current Account balance + Capital Account balance.
Surplus in current and/or capital account implies demand for domestic currency
(eg., Indian rupees) increases. As such, the demand schedule shifts to the
right resulting in currency appreciation. The converse is true for deficit
situation. Under flexible exchange rate regime, these exchanges rate
adjustments take place until the BoP is in equilibrium.
b) False:
When currency depreciates, the domestic price of imports increases. Hence,
the demand for imports falls.
c) True:
When exports rise (relative to imports) the demand schedule for domestic
currency shifts to the right. Assuming, unchanging supply schedule, this results
in the appreciation of the equilibrium exchange rate.

3) The Peso-dollar exchange rate is 16 (12 ÷ $0.75). If prices in Mexico double, the
new peso-dollar exchange rate is 32 (2÷$0.75). This implies that if inflation in
one trading partner is higher, then the currency depreciates. 13
Open-Economy Macro-
Modelling UNIT 18 FIXED EXCHANGE RATE SYSTEM

Structure
18.0 Objectives
18.1 Introduction
18.2 Determination of Fixed Exchange Rate
18.3 Price Adjustments under Fixed Exchange Rate
18.4 Understanding Exchange Rate Movements
18.4.1 Real vs Nominal Exchange Rate
18.4.2 Purchasing Power Parity (PPP)
18.4.3 NEER vs REER
18.5 Let Us Sum Up
18.6 Key Words
18.7 Some Useful Books
18.8 Answers/Hints to Check Your Progress Exercises

18.0 OBJECTIVES
After going though this unit, you should be able to
• explain the meaning and determination of fixed exchange rate;
• analyse the relationship between fixed exchange rate and BoP;
• analyse how changes in fixed exchange rate are brought about; and
• construct and interpret exchange rate indices.

18.1 INTRODUCTION
National currencies are generally acceptable within the geographical boundaries of a
country. As such, trade between countries typically involves exchange of one country’s
currency for that of another. For example, if India were to import from the US, payments
are to be made in US$. For making this international payment, India needs to earn the
US$ (through exports) or buy the same from the foreign exchange market. How many
Indian rupees need to be paid to purchase US$ depends on the value of dollar or exchange
rate.

As you know, a rise (fall) in the external value of Rupee is called an appreciation
(depreciation). For example, if the exchange rate between Rupee-US dollar is Rs.35/$
which changes to Rs 32/$, then the value of Rupee in terms of dollar has increased.
Hence, Rupee has appreciated against the dollar. Conversely, had the exchange rate
changed to Rs 38/$ then the value of Rupee in terms of dollar would have decreased. In
this case, Rupee has depreciated against the dollar.

Assuming a simple situation where only two countries trade with one another,
international transactions take place between two currencies. Exchange rate, in this
situation, is determined by the demand for and supply of the two currencies. Because
the exchange rate is expressed as the value of one currency in terms of another, when
one currency appreciates, the other depreciates.

However, when a country has multiple trading partners, exchange rate between two
currencies will also be influenced by the changes in the value of other currencies. For
example, consider India’s major trading partners to be the US, EU, Japan and China.
The exchange rate between US$ and Indian rupee will not only be influenced by the
14
export and import flows between these two countries but also by the value of Euro, Yen Sluggish Price Adjustment
and Yuan. If the exchange rate between US$ and Yen changes, this also will influence
the exchange rate between US$ and Rupee. These dynamics of exchange rate changes
are analyzed with appropriate exchange rate indices, namely, nominal effective exchange
rate (NEER) index and real effective exchange rate (REER) index.

Exchange rate changes are also a function of the exchange rate regime followed by a
country, which is of two types, viz., flexible and fixed exchange rates. When the exchange
rate is determined by the equality between demand and supply for foreign currency,
then we have flexible or floating exchange rate regime. When official intervention (by
monetary authorities or government) is used to maintain the exchange rate at a particular
value, then we have fixed or pegged exchange rate regime. Between these two regimes,
there are many possible intermediate cases, such as, adjustable peg and managed float.
Under the adjustable peg, governments maintain the par values for the exchange rates
but explicitly identify the conditions under which the par value can change. In a managed
float, the government seeks to have some stabilizing influence on the exchange rate but
does not fix the exchange rate at a pre determined par value.

18.2 DETERMINATION OF FIXED EXCHANGE RATE

In the flexible exchange rate regime, exchange rates are highly volatile which leads to
uncertainties in the international payments/transactions. For most developing countries,
such uncertainties are unacceptable especially considering their development agenda.
Therefore, stability in exchange rate is maintained through government intervention.

Let us consider a simplified analysis of how a fixed exchange rate system operates. As
given in Fig. 18.1, S is the supply curve and D1 and D2 are the demand curves for
foreign exchange (say, dollar). The equilibrium exchange rate with respect to S and D2
is Rs.30/$. Assume that the government intervenes to ensure that the exchange rate is
maintained at Rs. 25/$. When exchange rate is Rs.25/$ demand for dollar is higher
than supply of dollar. In order to ensure that the exchange rate does not rise to Rs. 30
per dollar (which is required by supply-demand equilibrium), the government needs to
sell Q1Q2 dollars. On the other hand, suppose prevailing demand conditions are depicted
by the demand curve D1, where equilibrium exchange rate dictated by supply-demand
condition is Rs.20/$. In this case, the government needs to buy Q1Q3 dollars from the
foreign exchange market to ensure that the exchange rate is maintained at Rs. 25/$.

Rs/$
D2
S
D1

30
25
20

Q3 Q1 Q2 Qty. of $ ('000)

Fig. 18.1: Determination of Fixed Exchange Rate

15
Open-Economy Macro- The buying/selling of the foreign exchange to maintain a given exchange rate implies
Modelling that the government maintains foreign exchange reserves. (By definition, foreign
exchange reserves include foreign currencies, gold reserves and SDRs). For example,
BoP deficit (i.e., the demand for foreign currency (imports) is higher than the supply of
foreign currency (exports)), is adjusted against the foreign exchange reserves maintained
by the country. As such, the monetary authorities will suffer a loss of reserves. Similarly,
a BoP surplus implies that there is a rise in the country’s foreign exchange reserves.
Recall from previous unit that in a flexible exchange rate regime, BoP surplus/deficit
results in exchange rate appreciation/depreciation.

At any given point in time the foreign exchange reserves of a country are limited.
Therefore, continuous disequilibrium between demand for and supply of foreign
exchange cannot be sustained. In such situations, currency is devalued (in the case of
deficit) and revalued (in the case of surplus). When devaluation takes place, exports
become cheaper (i.e., rise in supply of foreign currency) and imports become expensive
thereby initiating a balance between demand and supply forces.

18.3 PRICE ADJUSTMENTS UNDER FIXED EXCHANGE

RATE
In a flexible exchange rate regime trade deficits (surpluses) are automatically corrected
by a depreciation (appreciation) of a country’s currency. On the other hand, in a fixed
exchange rate regime, disequilibrium conditions are corrected by changes in domestic
prices. A deficit reduces the country’s money supply which in turn reduces the prices.
The reduction in the country’s money supply will tend to increase the interest rate,
which in turn dampens the investment and thereby reduces aggregate demand.
Consequently, price level will fall which will encourage exports and discourage imports.
At the same time, higher interest rate induces capital inflows that would help in financing
the deficit.

The process of price adjustment under the fixed exchange rate regime is similar to that
of the price adjustment under the gold standard, i.e., price-specie-flow-mechanism.
Under gold standard, a country’s currency is defined by the gold content. This is to say
that a country will be ready to buy or sell any amount of gold at that price. Further, as
the gold content in one unit of currency is fixed, exchange rates will also be fixed. For
example, assume that a £1 gold coin in the UK contains 113.0016 grains of pure gold,
while a $1 gold coin in the US contains 23.22 grains of gold. This implies that the
exchange rate ($/£) is 4.87 (i.e., 113.0016 ÷ 23.22). Assuming no shipping costs,
exchange rate will be stable unless there is a change in the gold reserves of any country.
This is because no one will be willing to pay more than $4.87 for a £1 coin as gold
worth of $4.87 can be purchased in the US and exchange it for £1 in the UK. Similarly
gold worth £1 can be purchased in the UK and exchanged for $4.87 in the US.

These gold outflows/inflows measure the size of Balance of Payment deficit/surplus.

In a deficit situation, the automatic adjustment mechanism is as follows: With gold
outflows under trade deficit, country’s money supply will fall, which in turn, triggers a
fall in internal prices. As a result, exports will be encouraged and imports will be
discouraged until the deficit in BoP is eliminated.

This adjustment mechanism operates in a similar manner even if a country is not

following a gold standard. The foreign exchange reserves held by a country is akin to
the gold reserves. As such, disequilibrium in trade flows will be reflected in the changes
in the foreign exchange reserves which in turn influences the money supply and thereby
the domestic prices.

16
 Sluggish Price Adjustment
18.4 UNDERSTANDING EXCHANGE RATE MOVEMENTS
18.4.1 Real vs Nominal Exchange Rate
As discussed in the earlier sections, exchange rate movements are influenced by the
relative prices in the trading countries. As such, we differentiate between nominal and
real exchange rate. The real exchange rate is defined as the nominal exchange rate
adjusted for the ratio of foreign to domestic prices (R).
Pf
R = ——
P
Pf = Price level in foreign country
P = price level in domestic counry
If R > 1, foreign prices are higher than domestic prices. That is, goods abroad are more
expensive at home. Similarly, if R<1, it implies that domestic prices are higher than
foreign prices, i.e., goods at home are more expensive than goods abroad. Thus, the
real exchange rate measures a country’s competitiveness in international market.

Table 18.1: Construction of Nominal, Real Exchange Rate Index

Period Nominal Nominal Indian US Real
Exchange Exchange Price Price Exchange
Rate (Rs/$) Rate Index Index Index Rate Index
1 18 100 100 100 100.0

2 25 139 120 100 166.8

3 30 167 120 120 167.0

4 30 167 130 115 189.0

5 35 194 140 110 247.0

6 28 156 150 105 222.9

From Table 18.1 it is evident that the real exchange rate is higher than the nominal
exchange rate when domestic prices are higher than foreign prices. Further, the changes
in nominal exchange rate are largely on account of the disequilibrium in the trade flows
between countries. In Table 19.1 we observe that Indian price index has increased
faster than US Price index. As a result real exchange rate index, which is obtained as
the ratio of Indian price index to US price index, has increased from 100 in period 1 to
222.9 in period 6. The nominal exchange rate index (which is simply the nominal
exchange rate converted to index number) has increased from 100 in period 1 to 156 in
period 6.

18.4.2 Purchasing Power Parity (PPP)

The exchange rate is determined by the relative purchasing power of currency within
each country. For example, if a product X costs Rs. 100 in India and costs $2 in USA,
then the rupee – dollar exchange rate is Rs. 50 per $. This illustrates the theory of
Purchasing Power Parity (PPP) wherein two currencies are at purchasing power parity
when a unit of domestic currency can buy the same basket of goods at home or abroad.

There are two versions of PPP, the Absolute PPP and the Relative PPP. The Absolute
PPP postulates that the equilibrium exchange rate between two currencies is equal to
the ratio of price levels in the two countries. Specifically,
P1
R = ——
P2
17
Open-Economy Macro- Where P1 is the price level in the home country and P2 is the price level in the foreign
Modelling country.

The Relative PPP postulates that the change in exchange rate is equal to the difference
in changes in the price levels in the two countries. Specifically,

R´ = P´1 – P´2

Thus, the percentage change in exchange rate (R´) will be equal to the percentage
change in domestic prices (P´1 ) minus the percentage change in foreign prices (P´2 ).
This would be true as long as there are no changes in transportation costs, obstruction
to trade (tariff and non-tariff barriers) and the ratio of traded to non-traded goods.
Since trade and commodity arbitrage respond sluggishly (due to the above factors),
relative PPP can be approximated in the long run.

Thus, in the long run, the real exchange rate will return to its average level. In other
words, if real exchange rate is above long run average level, PPP implies that the
exchange rate will fall.

18.4.3 NEER Vs REER

In a situation where there are multiple trade partners, the effect of cross–currency
movements are judged by nominal effective exchange rate (NEER) and real effective
exchange rate (REER). The construction of export weighted NEER index is shown in
the Table 18.2.

Table 18.2: Construction of NEER Index

Period Nominal Exchange Nominal Exchange Nominal Effective

Rate Index(Rs/£) Rate Index (Rs/$) Exchange Rate Index

1 100 (x0.3) 100 (x0.7) 100

2 100 (x0.3) 90 (x0.7) 93
3 120 (x0.3) 90 (x0.7) 99
4 90 (x0.3) 80 (x0.7) 83

We make the following assumptions:

i) India’s trading partners are the UK and the US
ii) Share of the US in India’s trade = 70%
iii) Share of the UK in India’s trade = 30%
The NEER index is the trade weighted average of the trade flows between India and the
UK, and between India and the US. For example, for period 2 the NEER index is
100 × 0.3 + 90 × 0.7 = 93. With unchanging trade shares, when rupee-dollar nominal
exchange rate falls by 10%, NEER falls by 7%(that is, 70% of 10%). When the Rupee-
pound nominal exchange rate increases by 20%, then NEER increases by 6% (that is,
30% of 20%). Thus, the exchange rates of the major trading partners influence the
movements of NEER.

When NEER is adjusted for the differences in relative prices between trading partners,
the trade weighted REER is obtained. Table 18.3 presents the comparative NEER and
REER indices of India for the period 1991-2003. We find that rupee has been
strengthening against the currencies of major trading partners. A comparison with the
REER shows that the except for 1996-97 and 2003-04, the percentage increase in
domestic prices has been more than that in the major trading partners. However, this
has been neutralized, to some extent, by the rupee depreciation against the dollar.
18
 Table 18.3: NEER and REER Indices of India (Base: 2000–01=100) Sluggish Price Adjustment

Year Exchange NEER REER

Rate (Rs/$) (5-Country index) (5-Country index)

1991-1992 24.47 180.40 103.72

1992-1993 30.65 148.29 95.58
1993-1994 31.37 136.74 92.11
1994-1995 31.40 132.59 95.78
1995-1996 33.45 121.25 95.17
1996-1997 35.50 118.43 97.60
1997-1998 37.16 118.49 102.26
1998-1999 42.07 104.87 98.25
1999-2000 43.33 100.99 96.94
2000-2001 45.68 99.54 96.17
2001-2002 47.69 98.47 99.36
2002-2003 48.40 93.13 96.89
2003-2004 45.95 92.07 101.21

Source: Economic Survey, 2004-05

The REER and NEER indices in Table 18.3 are export-weighted indices with weights
based on direction of India’s exports during 1992-97. The 5-Country index includes:
USA, Japan, UK, Germany and France.

Check Your Progress 1

1) If PPP holds and if a basket of goods is priced at $100 in the US costs in £80 UK,
what will be exchange rate between £ and $?
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................

2) Suppose if UK prices rise by 10% while the US prices rise by 5%, what will be the
new exchange rate?
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................

3) Following a BoP crises in 1990-91, the Indian government devalued the rupee by
over 30%. Explain why.
.................................................................................................................................
.................................................................................................................................
.................................................................................................................................
19
Open-Economy Macro- 4) Explain the following:
Modelling
a) To maintain a fixed exchange rate regime, foreign exchange reserves have to
deplete.
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................

b) Fixed exchange rate regime always leads to a rise in domestic prices.

.........................................................................................................................
.........................................................................................................................
.........................................................................................................................

5) Select the appropriate alternative and explain:

i) If the United States fixes its exchange rate, such as four Belgian francs per
dollar, then to keep it fixed at the four-francs-per-dollar rate,
a) Belgian and American exporters and importers must agree to keep their
mutual trade in balance.
b) Belgain and American exporters and importers must agree not to trade at
any other exchange rate.
c) The U.S. government does the exporting and importing for the United
States.
d) Both the U.S. and Belgian governments do the exporting and importing
for their respective countries.
e) The U.S. government must buy and sell U.S. dollars on the foreign
exchange market.
ii) The nominal effective exchange rate is
a) an unweighted index of several bilateral exchange rates.
b) a weighted index of several bilateral exchange rates.
c) a lateral exchange rate that is adjusted for inflation.
d) a bilateral exchange rate that is unadjusted for inflation.
iii) The real effective exchange rate is
a) a weighted index of several bilateral exchange rates, adjusted for inflation.
b) a weighted index of several bilateral exchange rates, unadjusted for
inflation.
c) a bilateral exchange rate that is adjusted for inflation.
d) bilateral exchange rate that is unadjusted for inflation.
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
.........................................................................................................................
20
 Sluggish Price Adjustment
18.3 LET US SUM UP
Under the fixed exchange rate regime fluctuations in exchange rate are managed through
intervention by the government or kept fixed. The implications are that in spite of
changes in export and import trends, the exchange rate remains fixed. In this regime,
adjustments in exchange rate are made through policy on devaluation and revaluation
of domestic currency.

If a country’s imports rise relative to exports, the supply of domestic currency will be
higher relative to the demand for domestic currency. This leads to BoP deficit.
Adjustments in BoP deficit are made against the foreign exchange reserves maintained
by a country. In deficit situation, reserves deplete and in surplus situation they rise. If
the imbalances persist,currency devaluation or revaluation takes place to facilitate
adjustments. Trade imbalances also gets adjusted through changes in domestic prices.
In a deficit situation, money supply reduces thereby initiating a fall in domestic prices.
Similarly, a surplus situations leads to rise in domestic prices.

Various measures are used to analyze the exchange rate movements. The price difference
between the domestic and foreign countries is reflected in the difference between nominal
and real exchange rates. Thus, the real exchange rate highlights the competitiveness of
domestic goods in the foreign markets. With multiple trade partners, the effect of cross
currency volatility can be examined through the NEER and REER indices. These
indices are trade weighted indices with respect to major trading partners.

18.4 KEY WORDS

Depreciation : A fall in the value of a currency relative to other currencies in the
foreign exchange market.
Devaluation : An action by the Central Bank to reduce the value of domestic
currency vis à vis foreign currencies.
Exchange Rate : The rate at which domestic currency is exchanged with foreign
currencies.

18.5 SOME USEFUL BOOKS

Baumol, W. J. and Alan S. Blinder, 1999, Economics: Principles and Policy, Harcourt
College, Publishers, Chapter 36.
Dornbusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition, Tata
McGraw-Hill, New Delhi
Mankiw, N. G., 2000, Macroeconomics, Fourth Edition, Macmillan, New Delhi.
Salvatore, D., 2005, Introduction to International Economics, John, Wiley & Sons,
New York, Chapter 13 & 4.

18.8 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISESSS
Check Your Progress 1
1) Exchange rate between £ and $
R= £ 0.8 / $
110
2) New Exchange rate = 0.8 × = 0.838
105
Thus R’ = £0.838/$
21
Open-Economy Macro- 3) BoP crisis implies BoP deficit. Under a fixed/pegged exchange rate regime, BoP
Modelling deficit is adjusted against the available foreign exchange reserves. With depletion
in foreign exchange reserves, disequilibrium in the BoP can be corrected through
currency devaluation whereby exports become cheaper and imports become
costlier.
4) i) In a fixed exchange rate regime, BoP deficit leads to depletion of foreign
exchange reserves while a BoP surplus leads to a rise in reserves. Therefore,
this statement will be true only under conditions of deficit.
ii) Under a fixed exchange rate regime, BoP surplus leads to an increase in
money supply and therefore leads to a rise in domestic prices. BoP deficit,
on the other hand, leads to a fall in domestic prices.
5) i) The U.S. government must buy and sell U.S. dollars on the foreign exchange
market.
ii) The nominal effective exchange rate is a weighted indeed of several bilateral
exchange rates.
iii) The real effective exchange rate is a weighted index of several bilateral
exchange rates, adjusted for inflation.

22
 Sluggish Price Adjustment
UNIT 19 SLUGGISH PRICE ADJUSTMENT

Structure
19.0 Objectives
19.1 Introduction
19.2 Income Determination in an Open Economy
19.2.1 Domestic Spending Vs Spending on Domestic Goods.
19.2.2 Determinants of Net Exports
19.2.3 International Capital Movements
19.2.4 Trade and Income Determination
19.3 Internal and External Balance with Fixed Exchange Rates
19.3.1 Monetary Policy
19.3.2 Fiscal Policy
19.4 Internal and External Balance under Flexible Exchange Rate
19.4.1 Monetary Policy
19.4.2 Fiscal Policy
19.5 Price Adjustment
19.5.1 Fixed Exchange Rate and Fiscal Policy
19.5.2 Flexible Exchange Rate and Monetary Policy
19.6 Let Us Sum Up
19.7 Key Words
19.8 Some Useful Books
19.9 Answers/Hints to Check Your Progress Exercises

19.0 OBJECTIVES
After going though this unit, you should be able to:
• explain how the equilibrium level of income is determined in an open economy;
• identify the policy mix for achieving internal and external balance with flexible
exchange rates;
• identify the mix for achieving internal and external balance with fixed exchange
rates; and
• explain aggregate supply factors and price adjustment in short run and long run.

19.1 INTRODUCTION
International factors affect real demand in an economy and therefore influence the
level of equilibrium output. Various disturbances in income and trade factors affect the
macroeconomic output determination. A closer look at the implications of trade factors
is necessary because we need to understand how:
• international influences affect the domestic macroeconomic policy decisions.
• how macro policy choices change with changes in exchange rate regime.
• how transmission mechanism works in a globalized economy.

19.2 INCOME DETERMINATION IN AN OPEN ECONOMY

In Unit 2 of this course we explained the derivation of IS-LM curves for a closed
economy. In this section we extend the IS-LM framework to include foreign trade.
The assumptions made for deriving the Aggregate Demand (AD) curve continues, i.e.,
23
Open-Economy Macro- price level is given and output demanded is supplied (perfectly elastic Aggregate Supply
Modelling (AS) curve). Before discussing the determination of equilibrium level of income, a
brief introduction to how inclusion of trade modifies the analysis of aggregate demand
is given.

19.2.1 Domestic Spending Vs. Spending on Domestic Goods

In a closed economy, all domestic output is consumed internally. Against this, in an
open economy, part of the domestic output is sold to foreigners (exports). Similarly,
part of the domestic consumption/spending is on foreign goods (imports).

This definitional change implies that domestic spending no longer determines domestic
output. Instead, spending on domestic goods determines domestic output. Spending
on domestic goods includes foreign demand for domestic goods and leakages in the
form of domestic demand for foreign goods. The effect of these external transactions
on demand for domestic output is as follows:

AD (Spending on Domestic goods) = C + I + G + X – M ...(19.1)

Spending on domestic goods is equal to:
• total spending by domestic residents less spending on imports; plus
• foreign demand for domestic goods.
At the aggregate level, this formulation will imply trade surplus/deficit (i.e. positive
net exports) plus spending on domestic goods by domestic residents. In terms of
rotations:
AD = C + I + G + NX
where NX is net exports.

19.2.2 Determinants of Net Exports

Exports rise when the foreign demand for domestic goods increases. The determinants
of foreign demand are: foreign income (Yf ) and exchange rate (R).
X = f (Yf, R,) ...(19.2)
Note that Yf is an exogenous factor in the sense that the domestic country has no control
over the level of foreign income.

Imports rise when the domestic demand for foreign goods increase. Changes in exchange
rate also influence the demand for imports.

M = f (Y, R) ...(19.3)

Thus, NX = (X – M) = f (Yf, Y, R). From this, we can derive the NX function (see Fig.
19.1). In Fig. 19.1 we assumed exports to be exogenously given while imports is a
linear function in GDP. Thus X is depicted as a horizontal straight line while M=M̄+mY.
When GDP is at a level of Y1, there is balance of trade and X=M. When Y<Y1, we have
a positive net exports (since X>M). On the other hand, when Y>Y1 we have negative
net exports (since X<M).

The negative relationship between net exports and GDP is due to the following
reason:

As income increases imports rise whereas exports are exogenously determined. Shifts
in NX function take place with exchange rate changes. A depreciation will increase
exports and decrease imports and thus shift the NX curve to the right.

24
 Sluggish Price Adjustment

Imports &
Exports M = M̄ + mY

X=M X<M
X>M X = X̄

NX

Fig. 19.1: Derivation of Net Export Curve

19.2.3 International Capital Movements

During 1950s most countries had fixed exchange rate and international flow of goods
and services was quite important compared to capital flows. Gradually, however flexible
exchange rate became the rule and capital flows gained prominence.

International capital movements (i.e., trade in assets and liabilities) also influence the
BoP. As discussed earlier, for BoP equilibrium, net capital flows (i.e., inflows adjusted
for outflows) must equal current account balance. If net capital flows are positive,
there is BoP surplus, which may in turn influence the exchange rate, especially in
flexible exchange rate regime.

Capital flows also matter for macroeconomy management as they influence the domestic
interest rate. The size of capital flows is a function of differential interest rates between
domestic and foreign countries. If free capital mobility is allowed, capital inflows will
be higher where real interest rate is high. Moreover, capital outflows take place when
interest rate falls. Thus, there would be a tendency for the domestic interest rate to
move towards world interest rate. In effect, the domestic economy will be a price taker
in the global financial markets.

19.2.4 Trade and Income Determination

The AD function for an open economy is AD = C + I + G + (X – M).

25
Open-Economy Macro-
Modelling Exports (X) are exogenously determined, i.e. X = X while imports are a function of
Y, i.e., M = M + mY. By substituting the same in the AD function, the equilibrium
income1 is

1
Y * = (C + I + X – M ). ... (19.4)
1 – [(1 – t )c + m ]

1
The trade multiplier, in this case is 1 − [ (1 − t ) c + m]] . As compared to the closed

economy, the multiplier is reduced by the factor ‘m’ (or marginal propensity to import).
With a lower trade multiplier, induced changes in equilibrium income will also be
smaller.
Changes in Investment (∆I), government expenditure (∆G) and exports (∆X) will induce
a positive change on equilibrium income. The size of this change in income will be
equal to ∆I or ∆G or ∆X times the trade multiplier.

The equilibrium condition in an open economy can also be explained from the income
approach.

C+I+G+(X-M) = C+S+TA

By re-arranging terms in the above, we obtain

(X-M) = (S-I) + (TA-G) ...(19.5)

From the above, it is clear that imbalances in the external sector can also be a result of
imbalances in the internal sector. For example, an external deficit condition (X < M)
can be on account of Savings-Investment deficit (i.e., S<I) and/or government deficit
(i.e., TA < G). This would mean that to achieve external (BoP) equilibrium and internal
(full employment) balance, monetary and fiscal policies would have to be used
appropriately.

19.3 INTERNAL AND EXTERNAL BALANCE WITH FIXED

EXCHANGE RATES
We mentioned earlier in Sub-section 19.2.3 that interest rate in home country will be
equal to global interest rate in an open economy. In case there is a difference between
domestic interest rate (r) and global interest rate (r*) capital movement will take place.

The analysis of open economy macro economic adjustments under perfect capital
mobility is provided by the Mundell-Flemming model. In this model the standard IS-
LM framework (see Unit 2) is extended to include the BP curve which is horizontal. In
Fig. 19.1 we present the IS-LM curves as we had derived in Unit 2. In addition we

1
The calculation of equilibrium income in a closed economy is on the following basis:
AD = C + I + G = Y*
By substituting we get C = C + cYd
I= I
(C + I + G ) + c(1–t) Y
AD = 1 4 2 4 3 G= G
A TA = ty (taxes)
AD = A + c(1–t) Y TR = 0
Yd = Y – TA + TR
1
26 Y* = AD = Y = A .
1 − [(1 − t ) c]
draw a horizontal line BP which shows the global interest rate, r*. When r = r* there is Sluggish Price Adjustment
no capital mobility and there is external balance or equilibrium for the economy.

To trace the effects of monetary and fiscal policy changes under Mundell-Flemming
model, we start from a position of full employment equilibrium, where Y=Y*. To correct
a disequilibrium that has been caused by some exogenous shock, how the adjustment
mechanism works will be analyzed below:

19.3.1 Monetary Policy

Fig. 19.2: IS-LM Framework

We start with a condition of full employment, i.e., equilibrium in goods market (IS
curve), money market (LM curve), and external sector (BP curve). The interest rate
and income corresponding to the equilibrium condition is r* and Y*. Suppose there is
an expansionary monetary policy such that money supply (Ms) increases. Consequently
the LM Curve shifts downward to the right (LM1). The process of adjustment will be
as follows:

Fig. 19.3: Effect of Increase in Money Supply

With increase in money supply (Ms), interest rate falls in the home economy which
leads to capital outflow (as global interest rate is higher at r*), which results in
deteriorating of capital account balance. At the same time, fall in interest rate stimulates
domestic investments and income through the multiplier process. This induces imports
to rise and thus a deterioration of the current account balance. With both current and
capital account worsening, there will be BoP deficit, leading to depletion of foreign
exchange reserves. This implies a reduction in money supply or shifting of LM curve
from LM1 to LM. Thus, expansionary monetary policy is ineffective under fixed
exchange rate regime.

27
Open-Economy Macro-
Expansionary
Modelling Interest rate Capital flows out Overall
Monetary Policy: falls Balance of
Money supply is Payment
increased Deficit
Investment Current
and income account worsens
rise worsens

Money supply
Monetary falls in order to
Policy maintain fixed
ineffective exchange rate

Source: Salvatore Dominic (2005), “Introduction to International Economics”

Fig. 19.4 : Monetary Policy is Ineffective Under Fixed Exchange Rates

19.3.2 Fiscal Policy

Suppose instead of expansionary monetary policy, a country uses fiscal policy to address
recessionary trends. The process of adjustment will be as follows:

Fig. 19.5: Shift in IS Curve

Expansionary fiscal policy implies either increased government spending(G) or reduction

in taxes(T). As a result of increased government spending, the IS curve shifts upward
to the right from IS to IS1. Consequently there is a rise in domestic interest rate, which
induces more capital inflows. At the same time, income also rises whereby imports
increase leading to worsening of current account balance. Assuming that the surplus in
capital account is greater than the deficit in current account, there would be BoP surplus.
It implies an increase in Ms thereby shifting the LM curve to LM1. As such, the
equilibrium income increases to. Thus, expansionary fiscal policy is quite effective
under fixed exchange rate.
Expansionary Fiscal Interest rate Capital flows in Overall Balance of
Policy: Gov’t rises Payments may
spending rises improve
and/or taxes fall
Production Current account worsens
and income
rise

Fiscal Policy more Money supply

effective falls to defend
fixed exchange
rate

Source: Salvatore Dominic (2005), “Introduction to International Economics”

28 Fig. 19.6: Fiscal Policy is Effective Under Fixed Exchange Rates
Note that in a fixed exchange rate there little scope of maneuvering exchange rate. Sluggish Price Adjustment
Rather the adjustment takes place through changes in fiscal policy.

19.4 INTERNAL AND EXTERNAL BALANCE UNDER

FLEXIBLE EXCHANGE RATE
In flexible exchange rate regime, disequilibrium in BoP will be adjusted through the
changes in exchange rate. A BoP deficit will lead to currency depreciation and BoP
surplus will lead to currency appreciation.
19.4.1 Monetary Policy
Suppose a country (with flexible exchange rate) uses expansionary monetary policy to
correct recessionary trends. The process of adjustment will be as follows:

Fig. 19.7: Effect of Monetary Policy

Increase in money supply will lead to downward shift in LM curve from LM to LM1,
which will result in a fall in interest rate. A lower r leads to capital outflows and thus
deficit in capital account. At the same time, a higher Y leads to increase in imports and
thus worsening of current account deficit. With a deficit in capital and current accounts,
there will be a BoP deficit.
The deterioration in BoP results in currency depreciation. As such, net exports rise
(exports rise and imports fall) and IS curve shifts to the right from IS to IS1.
Correspondingly, the new equilibrium output is . Thus, monetary policy, in this case, is
effective and results in an increase in aggregate output of the economy.
19.4.2 Fiscal Policy
Suppose instead of monetary policy, the country uses expansionary fiscal policy to
correct recessionary trends. The process of adjustment will be as follows:

29
Fig. 19.8: Effect of Fiscal Policy
Open-Economy Macro- Increase in government spending will shift the IS curve to IS1. As such interest rate
Modelling rises, capital inflows increase and the overall BoP will improve. With a BoP surplus,
currency appreciates and net exports fall (exports fall and imports rise) resulting in
shifting of IS1 to IS. Thus, fiscal policy is ineffective under flexible exchange rates.

19.5 PRICE ADJUSTMENT

In the Keynesian framework, supply curve in the short-run is assumed to be horizontal.
This indicates that any output up to potential can be supplied at the existing price level.
Thus, the output produced is primarily determined by the position of the aggregate
demand curve.

P AD

AS (short run)
•.

Y*1 Y
Fig. 19.9: Equilibrium Output Determination

The assumption underlying the horizontal AS curve, however, is that average cost does
not change. If we relax the assumption that unit costs will remain constant over the
output range, we have a supply curve that is upward sloping. It implies that as output
increase, unit cost tends to rise. With productivity/efficiency of inputs falling beyond
an output range, profit maximizing firms will not want to increase production unless
these higher unit costs are recovered through higher prices.
As you know, macroeconomic equilibrium occurs at the intersection of the AD and AS
curves and determines the value of GDP and price level. At the equilibrium level, the
spending (demand) behaviour is consistent with the production (supply) activity. At
all other points, AD and AS are inconsistent. For instance, at P1, AD (spending) is
higher than the production (supply) to the extent of (Y1-Y2) in Fig. 19.9. As such,
prices tend to increase till P* when AD=AS. Similarly, shifts in AD will induce higher
equilibrium prices (P**).

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Fig. 19.10: Impact of Change in Aggregate Demand
19.5.1 Fixed Exchange Rate and Fiscal Policy Sluggish Price Adjustment

Starting with full employment equilibrium, an increase in government spending

stimulates production activity in the economy and results in a shift in the IS curve from
IS to IS1 (see panel-a of Fig. 19.10). Given the LM curve, the equilibrium rate of interest
is higher than before.

(a) (b)
Fig. 19.11: Impact of increase in Government Spending

The increase in government spending shifts the IS curve to IS1. As a result, r rises,
capital inflows increase leading to BoP surplus. Surplus BoP, under fixed exchange
rate, increases domestic money supply thereby shifting the LM curve to LM1.

The combined effect of IS and LM curves is that the AD shifts to the right to AD1. The
increase in aggregate demand causes the GDP to increase to Y1 when price level is held
unchanged at P*. In the short run, aggregate demand and aggregate supply are in
equilibrium at Y2 corresponding to higher prices. However, in the long run, with full
adjustment in supply factors, aggregate supply shifts to AS, which corresponds to initial
equilibrium (Y*) but with higher prices (P1).

19.5.2 Flexible Exchange Rate and Monetary Policy

Starting with a full equilibrium, a monetary expansion stimulates production activity
in the short run but causes higher prices in the long run.

(a) (b)

Fig. 19.12: Impact of increase in Money Supply

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Open-Economy Macro- With an increase in money supply, LM curve shifts to LM1 following which, the interest
Modelling rate falls leading to capital outflows. This causes BoP deficit and currency depreciation.
The net exports rise and the IS shifts to IS1 leading to a higher equilibrium output at.

The combined effect of these shifts in goods and money markets results in AD function
moving upwards to AD1. GDP increases to initially with marginal increase in prices.
However, with complete adjustment in the supply factors, in the long run, the real
output shifts back to Y* but with a higher corresponding price level.

Check Your Progress 1

1) How does a country use fiscal and monetary policies to correct a recession or
unemployment with flexible exchange rates? (Assume perfect capital mobility)
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2) Enumerate the conditions wherein a country opts for currency devaluation.

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3) Starting with an equilibrium condition, explain wheat happens to the price level
and real GDP in the short run and long run for the following situation:

a) increase in export demand

b) increase in crude oil prices

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19.6 LET US SUM UP

The macroeconomic income determination model that includes foreign sector has an
additional component in the aggregate demand function, i.e., net exports. While exports
have a positive influence, imports have a negative effect on aggregate demand. At the
equilibrium level GDP, desired aggregate spending equals national output. The effect
of an exogenous change in the components of aggregate demand on equilibrium output
will be determined by the multiplier, which is lower (by factor of ‘m’) when compared
to the closed economy multiplier.
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The imbalances in the external sector, if any, can also be a result of the imbalances in Sluggish Price Adjustment
the internal sector (i.e., S ≠ I and TA ≠ G). To bring about external (BoP) equilibrium
and internal balance (full employment) fiscal and monetary policies can be used
depending on the exchange rate regime, i.e., fixed and flexible exchange rates. With
the perfect capital mobility and a fixed exchange rate regime, monetary policy has no
real impact. However, fiscal policy results in equilibrium output expansion.
With perfect capital mobility and a flexible exchange rate, fiscal policy has no real
impact but monetary policy results in output expansion. Given a short-run supply curve
(AS) which is positively sloped and assuming perfect capital mobility condition, shifts
in aggregate demand on account of increased government spending under fixed exchange
rate and expansionary monetary policy under flexible exchange rate creates inflationary
gap in the long run.

19.7 KEY WORDS

Capital : Here, in this Block, the word connotes financial capital.
IS Curve : The negative relationship between interest rate and aggregate
output. Each paint on the IS Curve depicts equilibrium in the
real sector of the economy.
LM Curve : The positive relation between interest rate and aggregate
income that arises in the money market of the economy.

19.8 SOME USEFUL BOOKS

Baumol, W.J. and ALan S. Blinder, 1999, Economics: Principles and Policy, harcourt
College Publishers, Chapter 36.
Dornbusch, R., S. Fischer and R. Startz, 2004, Macroeconomics, Ninth Edition, Tata
McGraw-Hill, New Delhi.
Mankiw, N. G., 2000, Macroeconomic, Fourth Edition, Macmillan, New Delhi.
Salvatore, D., 2005, Introduction to International Economics, John Wiley & Sons,
New York, Chapter 13 & 14.

19.9 ANSWERS/HINTS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) See Section 19.4 and answer.
2) Currency devaluation is an option under fixed exchange rate regime. The conditions
wherein currency devaluation takes place are:
a) Imports are in excess of exports. This disequilibrium continues for a
considerably long period of time.
b) Foreign exchange reserves deplete.
3) a) An increase in export demand leads to a rightward shift of IS curve and AD
curve. With AS curve unchanging, in the short run, prices and output increase.
However in the long run, assuming potential supply to remain constant,
adjustment in supply factors take place and GDP will revert to the initial
equilibrium but at higher price level.
b) Oil being a critical production input, an increase in oil prices will lead to a
leftward shift in AS curve. Assuming the AD curve to be unchanging, this
results in increase in price level in the short run. However, in the long run,
demand and supply adjustments take place and equilibrium GDP is at a lower
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level.