Macroeconomics: Theory and Policy

681 Pages·2010·36.676 MB·English

by  D.N. Dwivedi

MACROECONOMICS
Theory and Policy
Third Edition
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Theory and Policy
Third Edition
D N Dwivedi
Professor of Economics
Maharaja Agrasen
Institute of Management Studies
Delhi
Tata McGraw Hill Education Private Limited
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Preface
The objective of writing this book has been to provide a comprehensive and authentic textbook on
macroeconomics for undergraduate and postgraduate students. The way the earlier editions of this
book have been received by the students and teachers of the subject shows that my efforts have
been largely successful. However, no book is perfect for all times and for all purposes. There is
always a scope and need for improving the treatment and presentation of thoughts and theories with
the objective of making the subject easily comprehensible. Besides, feedback, suggestions and
comments about the usefulness of the book from subject experts, teachers and students provide
a good guidance for widening the scope and improving the treatment of the subject matter. Not only
that, the importance of macroeconomics as a subject of study has increased immensely over the
past two decades, most probably due to the persistence of macroeconomic problems—achieving
and maintaining a reasonably high growth rate, preventing growth of unemployment and promotion
of employment, restricting inflation to a desirable rate, and stabilising the financial market. The
recent global recession and the problems that it created for both developed and developing econo-
mies proves the point. In view of these facts, it was realised that there was a need for expanding
the scope of the book by adding discussions of some other important aspects of macroeconomics.
These factors prompted me to bring out the third edition of the book.
WHAT IS NEW IN THIS EDITION
Three New Chapters
• Chapter 2 – Macroeconomic Issues, Concepts and Model Building—has been added with
the objective of (i) giving the readers an overview of major macroeconomic issues that
constitute the subject matter of macroeconomics (ii) equipping them with some basic
concepts used in macroeconomic analysis and (iii) giving an idea of the need for and the
purpose of macroeconomic models.
• Chapter 21 – Theories of Economic Growth—has been added to this edition of the book.
Most macroeconomic theories discussed in the earlier editions of the book were presented
generally in a static equilibrium framework. In reality, however, most economies pass
vi Preface
regularly through dynamic conditions and have a tendency to grow in the long run. What
was missing in the earlier editions was the answer to the questions ‘what factors make the
economy grow’ and ‘what determines the growth rate’. In their effort to answer these
questions, economists have formulated their own theories of economic growth. A brief
discussion on the main theories of growth is the subject matter of this chapter.
• Chapter 22 – Theories of Business Cycle and Global Recession. Growing economies are
always open to the risk of economic downturn followed by recovery of the economy. This
has been proved by the India’s economic crisis of late 1960s and the early 1990s, the Asian
crisis of 1980s, the US economic recession in 1980s and again in 2008-09 which caused
a global recession. The regular uptrend and downturn in the economy is called business
cycle. Economists have attempted to explain why business cycles take place and what
measures can be adopted to control the business cycles. Their efforts have lead to the
emergence of the theories of business cycle. The theories of business cycles and a brief
discussion on the recent global recession constitute the subject matter of this chapter.
New Sections Added
• Chapter 1 – Two new sections have been added to this introductory chapter: (i) What is
Economics? containing a detailed explanation of what economics is about just to introduce
the subject to the students from non-economics disciplines and guide them to the study
Macroeconomics, and (ii) Use of Macroeconomics for Business Management for the
benefit of management students.
• Chapter 5 – The classical theory of demand for labour is the most important element of the
classical theory of employment, which was ignored in the earlier editions of the book. For
the sake completeness, therefore, a new section on the classical theory of demand for
labour is added in this edition.
• Chapter 9 – A new section on Consumption under Uncertainty: Robert Hall’s Random
Theory has been added to this chapter. Besides, empirical evidence based on Indian data has
been added to explain the concepts of average propensity to consume and average propensity
to save.
• Chapter 10 – The Introduction of the chapter to the theory of investment has been
reinforced with Indian data on trends in savings and investment as percentage of GDP. In
addition, a new section on the Rental Cost of Capital and Investment has been added
to this chapter.
• Chapter 12 – A new section RBI Measures of Money Supply has been added to show how
money supply is measured in India. Besides, the discussion on money supply has been
elaborated upon, with additional examples of empirical evidence.
• Chapter 15 – The section on the Baumol-Tobin Theory of Transaction Demand for
Money has been discussed in a much greater details with additional numerical examples.
Also, the discussion on most other theories of demand for money has been elaborated upon
with additional examples and algebraic treatment.
• Chapter 17 – Three new sections have been added to this chapter: (i) IS-LM model of a
simple economy, (ii) Derivation of the IS-curve with the government sector, and
(iii)an alternative graphical method of deriving IS-curve.
Preface vii
• Chapter 18 – A new section—Derivation of the IS Curve: An alternative Method—has
been added as an alternative algebraic method of deriving the curve. Besides, Sections 18.3
and 18.4 have been added with additional examples and explanation.
In addition, the discussion on India’s Monetary Policy in Chapter 30 and India’s Fiscal Policy
in Chapter 31 has been updated with recent monetary and fiscal data, respectively.
HOW THIS BOOK IS DIFFERENT FROM OTHER BOOKS
This book is different from other books in two important ways—one, in organisation of the subject
matter, and two, in explanation of macroeconomic theories. In most other books the organisation
of the subject matter is issue-based, i.e., based on such macroeconomic issues as economic
growth, monetary theory, government debt, inflation, employment, business cycles, etc. This kind
of approach gives an incoherent picture of macroeconomics. This approach sometimes does not
give the reader a comprehensive and complete view of macroeconomics as a separate branch of
economic science. It does not tell how economists’ thoughts have changed over time and how
changes in their thoughts and theories have led to the growth of macroeconomics. This kind of
treatment of the subject seems to assume that students have the basic knowledge of macroeconomics.
In contrast, the subject matter has been organised in this book on the basis of the different stages
of growth of macroeconomics—classical, Keynsian, post-Keynsian and then the issue related theo-
ries. It begins with an introduction of macroeconomics as a subject of study and then proceeds
to deal with subject matter in chronological order. First it deals with classical views on macroeco-
nomic issues and its failure to explain the origin of Great Depression. This gives the background
in which macroeconomics was born. Then it proceeds to deal with the Keynesian macroeconomics
which marks the foundation of macroeconomics. The explanation of the Keynesian macroeconom-
ics is followed by the post-Keynesian developments in macroeconomics. Next it deals with theories
of economic growth and business cycle problems. Finally, it discusses the policy measures of
macroeconomic management by the government, viz., monetary policy and fiscal policy. This
approach was adopted to give a complete and comprehensive view and clear understanding of
growth of macroeconomics as a subject of study, and the methods of macroeconomic management.
Secondly, this book is different from other books in respect of explanation and presentation of
macroeconomic theories. In exposition of the macroeconomic theories, it does not presume any
prior knowledge of macroeconomics. It begins with the basics and proceeds to explain macroeco-
nomic theories step-by-step by using graphics and algebraic examples.
I express my gratitude to all those who have contributed directly and indirectly to the preparation
of the third edition of the book. I acknowledge once again the guidance and suggestions that I have
received from Shri Rama Rao Suresh of Ramjas College (retd.), Dr. Ramji Narayanan of PGDAV
College, and Mrs. Kusum Gupta of Lady Sriram College, all of Delhi University. I am thankful also
to Mr. Tapas Kumar Maji of Tata McGraw Hill, for his feedback and inspiration for revising the
book. Comments and suggestions are always welcome and will be duly acknowledged.
D N D‡s†ihs
Contents
Preface v
€e‚„2I Introduction
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Introduction 3
1.1 What is Economics? 4
1.2 What is Macroeconomics? 7
1.3 Macroeconomics is both a Theoretical and a Policy Science 9
1.4 Microeconomics vs. Macroeconomics 10
1.5 Origin and Growth of Macroeconomics 12
1.6 Importance of Macroeconomics 16
1.7 Limitations of Macroeconomics 21
Suggested Readings 22
Questions for Review 22
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Introduction 23
2.1 Macroeconomic Issues 23
2.2 Some Concepts used in Macroeconomic Analysis 30
2.3 Macroeconomic Model Building 36
Questions for Review 39
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Introduction 40
3.1 Circular Flows in a Two-Sector Model 41
3.2 Circular Flows in Three-Sector Model: A Model with Government
Income and Expenditure 45
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3.3 Circular Flows in a Four-Sector Model: A Model with the
Foreign Sector 47
Suggested Readings 48
Questions for Review 48
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Introduction 50
4.1 Some Concepts Related to National Income 51
4.2 National Income Measures 55
4.3 Nominal and Real GNP 58
4.4 Methods of Measuring National Income 61
4.5 Treatment of Net Income from Abroad 65
4.6 Double Entry System of Accounting 66
4.7 Measurement of National Income in India 67
Suggested Readings 74
Questions for Review 74
€e‚„2P Product Market Analysis: Theory of National Income Determination
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Introduction 79
5.1 The Classical Postulates 80
5.2 Say’s Law: The Foundation of Classical Macroeconomics 81
5.3 Classical Theory of Employment: A Formal Model of Say’s Law 83
Suggested Readings 90
Questions for Review 91
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Introduction 92
6.1 The Concepts and Functions 93
6.2 Income Determination in Simple Economy Model 99
6.3 The Change in Aggregate Demand and the Multiplier 104
6.4 A Simple Model of Investment Multiplier 107
6.5 Static and Dynamic Multiplier 110
6.6 The Uses and Limitations of Multiplier 112
6.7 Applicability of Multiplier Theory to LDCs 113
6.8 The Paradox of Thrift and the Multiplier 115
Suggested Readings 116
Questions for Review 116
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Introduction 118
7.1 Income Determination with the Government Sector 118
7.2 The Fiscal Multipliers 127
Suggested Readings 131
Questions for Review 131
Contents xi
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Introduction 133
8.1 Exports, Imports and the Aggregate Demand 134
8.2 National Income Equilibrium in a Four-Sector Model 136
8.3 A Complete Four-Sector Model of Income Determination 138
Suggested Readings 140
Questions for Review 140
€e‚„2Q Theories of Consumption and Investment
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Introduction 145
9.1 The Absolute Income Hypothesis: Keynesian Theory of Consumption 146
9.2 The Relative Income Hypothesis: Duesenberry’s Theory 150
9.3 The Permanent Income Hypothesis: Friedman’s Theory of Consumption 153
9.4 The Life-Cycle Theory of Consumption: The Life-cycle Hypothesis 158
9.5 Consumption Under Uncertainty: Robert Hall’s Random-Walk Theory 161
9.6 Concluding Remarks on Consumption Theories 163
9.7 Non-Income Factors Affecting Consumption 163
Suggested Readings 168
Questions for Review 169
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Introduction 170
10.1 Some Basic Concepts 172
10.2 Methods of Investment Decision 173
10.3 The Marginal Efficiency of Investment (MEI) and Aggregate Demand for Capital 177
10.4 The Theory of Capital Accumulation 179
10.5 Income and Investment: The Accelerator Theory of Investment 183
10.6 The Rental Cost of Capital and Investment 188
10.7 Tobin’s q Theory of Investment: Stock Market and Investment 188
Suggested Readings 189
Questions for Review 190
€e‚„2R Money Market Analysis: Theory of Money and Interest
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Introduction 193
11.1 Definition of Money 193
11.2 The Kinds of Money 196
11.3 The Functions of Money 198
11.4 The Significance of Money in Modern Economy 199
Suggested Readings 202
Questions for Review 202
xii Contents
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Introduction 203
12.1 The Sources of Money Supply 203
12.2 The Measures of Money Supply in India 211
12.3 The Theory of Money Supply 213
12.4 Monetary Expansion and the Money Multiplier: A Simplified Model 218
12.5 Monetary Expansion, Currency Drain and Deposit Multiplier 220
Suggested Readings 221
Questions for Review 221
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Introduction 222
13.1 The Classical Quantity Theory of Money 222
13.2 The Cambridge Version of Quantity Theory of Money 226
13.3 The Classical Theory of Interest 227
13.4 Keynes’s Criticism of Classical Theory of Interest 228
Suggested Readings 230
Questions for Review 230
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Introduction 232
14.1 The Classical and Neoclassical Views on Holding Money: A Precursor 232
14.2 The Keynesian Theory of Demand for Money 233
14.3 The Keynesian Theory of Interest and Money Market Equilibrium 240
14.4 Changes in the Money Market and the Interest Rate 241
14.5 Criticism of the Keynesian Theory of Interest 244
Suggested Readings 245
Questions for Review 245
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15.1 An Overview 246
15.2 Portfolio Theories of Demand for Money 247
15.3 Baumol–Tobin Approach to Transaction Demand for Money 249
15.4 Tobin’s Theory of Speculative Demand for Money: the Portfolio
Optimisation Approach 253
15.5 Friedman’s Quantity Theory of Money 258
Suggested Readings 261
Questions for Review 262
€e‚„2S Integration of Product and Money Market Equilibrium
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Introduction 265
16.1 The Interdependence of Product and Money Markets 266
16.2 The IS-LM Model: An Elementary Exposition 267
16.3 Algebraic Version of the IS-LM Model 274
16.4 From Disequilibrium to Equilibrium—The Dynamics of Adjustment 278