[24/03, 11:37 am] HRITIK⚡: 1.2 CIRCULAR FLOW OF INCOME
The modern economy is a monetary economy, where money
is used in the process of exchange. The modern economy
performs economic activities such as production, exchange,
consumption and investment. In order to carry out these economic
activities people are involved in buying and selling of goods and
services. The transactions take place between different sectors of
the economy. The process of production and exchange generates
two kinds of flows.
1. Product or real flow, that is the flow of goods and services, and
2. Money flow.
Product and money flow in opposite direction in a circular
way. The product flow consists of a) factor flow, that is flow of factor
services and b) goods flow that is flow of goods and services. In a
monetized economy the flow of factor services generates money
flows in the form of factor payments which take the form of money
flows. The factor payments and expenditure on consumer goods
and services take the form of expenditure flow. Expenditure flow is
in the form of money flow. Both income and expenditure flow in a
circular manner in opposite direction. The entire economic system
can therefore be viewed as circular flows of income and
expenditure. The magnitude of these flows determines the size of
national income. We can explain how these flows are generated
and how they make the system work.
The economists, however use simplified models to explain
the circular flow of income and expenditure dividing the economy
into four sectors namely, I) Household sector, II) Business or Firms
sector , III) Government sector, and IV) Foreign sector. These
sectors are combined to make the following three models for the
purpose of showing the circular flow of income.
I) Two- sector model including the household and business
II) Three- sector model including the household, business and
government sectors; and
III) Four- sector model including the household, business,
government and the foreign sectors.
[24/03, 11:38 am] HRITIK⚡: 1.3 CIRCULAR FLOW OF INCOME AND
We begin with a simple hypothetical economy where there
are only two – sectors, the household and business firms which
represent a closed economy and there is no government and no
foreign trade. The household sector owns all the factors of
production that is land, labour, capital and enterprise. This sector
receives income in the form of rent, wages, interest and profit, by
selling the services of these factors to the business sector. The
business sector consists of producers who produce goods and sell
them to the household sector. The household sector consists of
consumers who buy goods produced by the business sector.
Thus in the first instance, money flows in the form of such
income payments as rent, wages, interest and profits from the
business sector to the household sector when the former buys the
services of the factors of production to produce goods. Money so
received is, in turn, spent by the household sector to buy goods
produced by the business sector. In this way money flows in a
circular manner form the business sector to the household sector
and from the household sector to the business sector in the
1. The economy consist of two sectors namely household and
business or firms;
2. Household sector spends their entire income received in the
form of rent, wages, interest and profits from the business
sector on buying of goods and services produced by the firms.
They do not hold or save any part of their income.
3. The business firms keep their production exactly equally to their
sales or as much as demanded by the households. There are
no changes in their inventories.
4. The business sector does not keep any undistributed money as
reserve. The money it receives by selling goods and services to
the household sector is fully spent in making payments as rent,
wages, interest and profits to the household sector.
5. There are no government operations.
6. There is no inflow or outflow of income or no foreign trade.
The two sector economy model consists of households and
business firms. But in a three sector economy additional sector is
government sector. Government affects the economy in many
ways. Here we will concentrate on its taxing, spending and
borrowing roles. In the modern economy government plays variety
of role. Government performs different functions. For this it requires
huge amount of income. Government receives income in the form
of taxes from households and business firms. Taxes are paid by the
households and business firms which not only reduces their
disposable income but also their expenditure and savings.
Governments’ spending includes expenditure on goods and
services, pension payments, unemployment allowance etc. Money
spent by Government is an injection of income into the economy
which further received by the households and business firms.
Another important method of financing Government
expenditure is borrowing from financial market. This is represented
by money flow from the financial market to the Government is
labeled as Government borrowing.
In a three sector economy we have the following three
economic agents.
1. Households and business firms
2. Financial sector
3. Government
Though different business cycles differ in duration and
intensity they have some common features which can explain
1. A business cycle is a wave like movement in macro economic
activity like income, output and employment which shows
upward and downward trend in the economy.
2. Business cycles are recurrent and have been occurring
periodically. They do not show some regularity.
3. They have some distinct phases such as prosperity, recession,
depression and recovery.
4. The duration of business cycles may vary from minimum of two
years to a maximum of ten to twelve years.
5. Business cycles are synchronic. That is they do not cause
changes in any single industry or sector but are of all embracing
character. For example, depression or contraction occurs
simultaneously in all industries or sectors of the economy.
Recession passes from one industry to another and chain
reaction continues till the whole economy is in the grip of
recession. Similar process is at work in the expansion phase or
6. There are different types of business cycles. Some are minor
and others are major. Minor cycles operate for a period of three
to four years and major business cycles operate for a period of
four to eight years. Though business cycles differ in timing, they
have a common pattern of sequential phases.
7. Expansion and contraction phases of business cycle are
cumulative in effect.
8. It has been observed that fluctuations occur not only in level of
production but also simultaneously in other variables such as
employment, investment, consumption, rate of interest and price
9. Another important feature of business cycles is that downswing
is more sudden than the changes in upswing.
10. An important feature of business cycles is profits fluctuate more
than any other type of income. The occurrence of business
cycles causes a lot of uncertainty for business and makes it
difficult to forecast the economic conditions.
11. Lastly, business cycles are international in character. That is
once started in one country they spread to other countries
through trade relations between.
[24/03, 11:42 am] HRITIK⚡: 2.3 PHASES OF BUSINESS CYCLES
Business cycles have shown distinct phases, the study of
which is useful to understand their fundamental causes. Generally,
a business cycle has four phases.
1. Prosperity (Expansion, Boom, or Upswing)
2. Recession (upper turning point)
3. Depression (Contraction or Downswing) and
4. Revival or Recovery (lower turning point)
The four phases of business cycle are shown in the following
figure. It starts from trough or lower turning point when the level of
economic activity is at the lowest level. Then it passes through
recovery and prosperity phase, but due to the causes explained
below the expansion cannot continue indefinitely, and after
reaching peak, recession and depression or downswing starts. The
downswing continues till the lowest turning point and reaches to
trough. It is important to note that no phase has any definite time
period or time interval. Similarly any two business cycles are not
the same.
The prosperity starts at trough and ends at peak. The
recession starts at peak and ends at trough. One complete period
of such movement is called as a trade cycle.
1. Prosperity – Prosperity is ‘a stage in which the money income,
consumption, production and level of employment are high or rising
and there are no idle resources or unemployed workers.’
This stage is characterized by increased production, high
capital investment, expansion of bank credit, high prices, high
profit, a high rate of interest, full employment income, effective
demand, inflation MEC, profits, standard of living, full employment
of resources, and overall business optimism etc.
The prosperity comes to an end when forces become weak
and therefore, bottlenecks start to appear at the peak of prosperity.
Due to high profit, inflation and over optimism make the
entrepreneurs to invest more and more. But because of shortage of
raw material and scarcity of factors of production prices of goods
and services rises. As a result there is fall in demand and profit,
business calculations go wrong. Thus their over optimism is
replaced by over pessimism. Thus prosperity digs its own grave.
2. Recession- When the phase of prosperity ends, recession
starts. Recession is an upper turning point. This is a phase of
contraction or slowing down of economic activities. Recession is
generally of a short duration.
After boom, demand falls, production becomes excess and
investment results in over investment. Finally, it leads to recession.
During this phase profit, investment and share prices falls
significantly, Because of lack of investment the demand for bank
credit, rate of interest, income employment, and demand for goods
and services falls.
If recession continues for a long period of time then finally, it
reaches to the phase of depression.
3. Depression – It is a period in which business or economic
activity in a country is far below the normal. Depression is ‘a stage
in which the money income, consumption, production and level of
employment falls, idle resources and unemployment increases.’
It is characterized by a sharp reduction of production, mass
unemployment, low employment, falling prices, falling profits, low
wages, and contraction of credit, fall in aggregate income, effective
demand, MEC, a high rate of business failure and atmosphere of all
round pessimism etc. The depression may be of a short duration or
may continue for a long period of time.
After a period of time, moderate increase in the demand for
goods and services helps to increase in investment, production,
employment, income and effective demand. Finally, it leads to
4. Recovery – Depression phase is generally followed by recovery.
Various exogenous and endogenous factors are responsible for
reviving the economy. When the economy enters the phase of
recovery, economic activity once again gathers momentum in terms
of income, output, employment, investment and effective demand.
But the growth rate lies below the steady growth path.
Thus, a recovery phase starts which is called the lower
turning point. It is characterized by improvement in demand for
capital stock, rise in demand for consumption good, rise in prices
and profits, improvement in the expectations of the entrepreneurs,
slowing rising MEC, slowly increasing investment, rise in
employment, output and income, rise in bank credit, stock market
becomes more sensitive and revival slowly emerges etc.
The phase of recovery once started, it slowly takes the
economy on the path of expansion and prosperity. With this the
cycle repeats itself.
[24/03, 11:42 am] HRITIK⚡: 3.1 THEORY OF MULTIPLIER
The theory of multiplier was first developed by Prof. R.F.
Kahn in 1931. It explains the effects of initial increase in investment
on aggregate employment. Kahn’s multiplier was thus known as
‘employment multiplier.’
J.M. Keynes used the concept of multiplier to analyze the
effects of change in investment on income via changes in
consumption expenditure. Thus this multiplier came to be known as
the investment multiplier. It may be defined as “the ratio of the
change in income to the change in investment.” It is symbolically
expressed as, K = ΔY/ ΔI.
Where K = Stands for Multiplier, ΔY = change in income and ΔI=
change in investment.
In an economy, when there is a small increase in
investment, there would be multiplier increase in national income.
For example, if the investment is increased by Rs. 4 cro. and if as a
result, the national income increases by Rs. 20 cro. the value of ‘K’
(multiplier) will be 5. In other words, investment multiplier points out
that, national income will rise much more than the initial increase in
investment. A part of this additional income is spent on
consumption goods. Since, one man’s expenditure is another
man’s income. The consumption expenditure of the people at the
first round would become income of the people at the second round
and so on.
Currency in circulation and demand deposits are the main
constituents of money supply. While the demand deposits are
created by the commercial banks, currency is issued by the Central
Bank and the Government. The supply of money is determined by
the following factors:
1. Size of the Monetary Base: Money supply depends upon the
size of the monetary base. The monetary base refers to the
group of assets which empowers the monetary authorities to
issue currency money. Money supply changes with changes in
of monetary gold stock, reserve assets such as government
securities, bonds and bullion, foreign exchange reserve with the
central bank and the amount of central bank’s credit
outstanding. In the present times, gold stock is not considered
as part of the monetary base.
2. Community’s Choice: The relative amount of cash and
demand deposits held by the people also influences the supply
of money. If the people prefer to make check payments much
more than cash payments, the total money supply maintained
by a given monetary base would be larger and vice versa.
Since money deposited in commercial banks generates
derivative deposits and expand the supply of bank money
through the credit multiplier, people’s preference of bank money
to cash would increase the supply of money. However, the
choice of the community is determined by factors such as
banking habits, per capita income, availability of banking
facilities and the level of economic development. If these
factors are developed, the money supply would be larger and
vice versa.
3. Extent of Monetization: Monetization refers to the use of
money as a medium of exchange. The choice of the community
for money as a liquid asset depends upon the extent of
monetization of the economy. If monetization is high, demand
for money would be high and vice versa.
4. Cash Reserve Ratio: The Cash Reserve Ratio refers to the
ratio of a bank’s cash holdings to its total deposit liabilities. It
determines the coefficient of the credit multiplier. The CRR is
determined by the Central Bank of a country. The credit
multiplier (m) is determined as the reciprocal of the CRR (r).
Therefore m = 1/r. Excess funds with the commercial banks
multiplied by the credit multiplier will give us the extent of credit
creation by the commercial banks. Lower the CRR, greater will
be value of the credit multiplier and therefore greater will be the
supply of bank money and vice versa.
5. Monetary Policy of the Central Bank: Monetary policy is
defined as the policy of the Central Bank with regard to the cost
and availability of credit in the economy. The monetary policy of
the Central Bank of any country will be according to the macro-
economic conditions. Thus under inflationary conditions, the
Central Bank may follow restrictive monetary policy and thereby
reduce the supply of bank money by pursuing both qualitative
and quantitative measures of controlling money supply.
Similarly under recessionary conditions the Central Bank may
follow expansionary monetary policy and thereby raise the
supply of money in the economy.
The velocity of circulation of money determines the flow of
money supply in an economy in a given period of time, normally
such a period is one year. The average number of times a unit of
money changes hands is known as the velocity of circulation of
money. The supply of money in a given period is obtained by
multiplying the money in circulation with the coefficient of velocity of
circulation i.e., M  V where M refers to the total amount of money
in circulation and V refer to the velocity of circulation of money in
the given period.
Factors Determining Velocity of Circulation of Money: The
velocity of circulation of money is determined by the following
1. Time Unit of Income Receipts: The more frequently people
receive income, the shorter will be the average time period of
holding money and greater will be the velocity of circulation of
money. Thus if in a given society large number of people
receive income on daily basis, the velocity of circulation of
money would be higher than the one in which people receive
income on weekly, fortnightly or monthly basis.
2. Method and Habits of Payment: The velocity of circulation
of money would be high if large number of people prefers to
make payment on installment basis. As a result, the same unit
of money will change hands more often than when payments
are made in full.
3. Regularity of Income Receipts: If in a society people receive
income on a regular basis, they will spend their current income
without bothering about future and hence the velocity of
circulation of money would be high. However, if future income
receipts are uncertain, people will not spend more money in
the present and hence the velocity will be less.
4. Saving Habits of the People: If the marginal propensity to
save is high in a society, then the people will be spending less
in the present and hence the velocity will be less. Similarly, if
the marginal propensity to consume is high the people will
spend more and the velocity of circulation of money will be
5. Income Distribution: Income distribution may be more equal
or more unequal in a society. If inequalities of income are high
in a society with the top 20 % taking away a major portion of
the national income, velocity of circulation of money would be
low because the richer sections of the society will be holding
more idle cash balances. However, if income distribution is
more equal or less unequal, the bottom 40% of the people will
receive more incomes and spend more thereby increasing the
velocity of circulation of money.
6. Development of Banking and Financial System: If the
banking and financial institutions in a country are well
developed, mobilization of savings can be effectively carried
out and more credit made available to the needy. This not
only prevents hoarding of cash balances but also increases
the velocity of circulation of both currency and bank money.
7. Business Cycle: During the prosperity phase of the business
cycle, investment, output, income, employment and prices
rise. Thus the velocity of circulation of money would be high
during the prosperity phase. However, during the downturn of
the business cycle, investment, output, income, employment
and prices begin to decline thereby reducing the velocity of
circulation of money.
8. Liquidity Preference of the People: If the liquidity preference
of the people is high i.e., if they wish to hold a greater part of
their income in the form of idle cash balances, the velocity of
circulation of money would be low and vice versa.
Keynes put forward his theory of demand for money in his
famous work “The General Theory of Employment, Interest and
Money” (1936). According to Keynes, people hold cash balances
on account of three reasons or motives. These are the transaction
motive, the precautionary motive and the speculative motive.
Accordingly the demand for money can be separated into three
parts namely transaction demand, precautionary demand and
speculative demand for money. The total demand for money or
cash balances can be divided into two namely; active and idle cash
Active Cash Balances:
Demand for active cash balances is divided into transaction
and precautionary demand for money. The transaction demand
for money arises due to the fact that money is a medium of
exchange. Further receipts and payments do not take place
simultaneously. There is always a time gap between two
successive receipts and payments are an ongoing affair in the
routine course. Hence people need to hold cash balances to pay
for their regular transactions. According to Keynes, transaction
motive for holding money is the need of cash for the current
transactions of personal and business expenditure. Therefore,
households and firms hold money on account of the transaction
motive. Their respective transactions motives can be referred to as
income and business motives. The income motive refers to the
transaction motive of households. Families hold cash balances to
execute routine transactions. Household demand for money
depends upon the following factors:
1. The Level of Income: Transaction demand for money by the
households is directly related to the level of income, i.e. higher
the level of income, higher will be the transaction demand for
money and vice versa.
2. The Price Level: Higher the price level, higher will be the
transaction demand for money and vice versa. When prices
rise, more money will be required to purchase the same quantity
of goods and services and hence the transaction demand for
money would rise when prices rise.
3. The Spending Habits: If the people in a society are thrifty,
they would require less money for transactions purposes.
However, if large number of persons in a society is spendthrift,
they would require more money for transaction purposes.
4. The Time Interval: If the time interval between two successive
income receipts is big, then the people will hold larger cash
balances under transaction motive and vice versa.
[24/03, 11:47 am] HRITIK⚡: 6.3 CAUSES OF INFLATION
The causes of inflation are classified into two categories.
They are demand side and supply side factors. These factors are
discussed in this section.
Demand side Factors Causing Inflation:
Inflation is caused by a rise in aggregate demand over
aggregate supply. Factors causing in aggregate demand over
aggregate supply are as follows.
1. Increase in Public Expenditure: Public expenditure has been
increasing by leaps and bounds since the emergence of the
Welfare State in the second half of the 20th century. Particularly
in mixed economies with a pre-dominant public sector, the rise
in public expenditure has been phenomenal. The interventionist
role of the State has increased over time and the governments
are seen to be responsible for building social and economic
2. Deficit Financing: There is no surplus or even a balanced
budget. Governments do not spend according to their incomes.
Government budgets are always deficit budgets which means,
government expenditure is always greater than income.
Increasing fiscal deficit is a general feature of the government
budgets of developing countries. In order to finance the budget
deficit, governments take recourse to public borrowing and also
borrowing from their Central Banks. In order to raise resources
for repaying public debt, governments may raise the existing tax
rates or raise new taxes. Deficit financing leads to rise in public
expenditure and hence rise in aggregate demand, thereby
causing inflatio
3. Increase in Money Supply: Increase in money supply over
and above the quantity of output produced in the economy
would result in price rise. Irving Fisher’s quantity theory of
money explains how increase in money supply without a
proportionate increase in output leads to rise in prices and fall in
the value of money. Commenting on the effect of money supply
on prices, Dr. C Rangarajan, former Governor of the Reserve
Bank of India states that “Money has an impact on both output
and price. The process of money creation is a process of credit
creation. Money comes into existence because credit is given
either to the government or the private sector or the foreign
sector. Since credit facilitates the production process, it has
favorable impact on output. But at the same time the increased
money supply raises the demand with an upward pressure on
prices”. Dr. Rangarajan has therefore accepted the fact in
India, price effect of money supply is greater than output effect.
4. Corruption and Black Money: Financial corruption leads to
creation of black money. Corruption by public servants and
ministers amounts to unearned income and leakages in the
system. Any leakage in the flow of production would reduce the
total quantity of output and increase in aggregate demand.
Further unreported incomes or black money would also cause
rise in prices. Although unreported incomes are not entirely
unearned incomes, they do contribute to excessive consumption
expenditure and therefore cause rise in prices.
Inflation is the result of excess demand over the supply of
goods and services. Inflation management, however, needs both
demand and supply management as well. Both monetary and
fiscal measures can be adopted to control inflation.
Attempt to control inflation in India was made for the first
time in the early sixties after experiencing rapid rise in prices during
the second five year plan. However, measures taken by the
government were not effective to control inflation. Prices continued
to rise throughout the planning era except the first five year plan.
One of the important tasks of the government was to maintain price
stability under the new economic policy. Accordingly, the
government undertook various measures to control inflation in the
country. These measures were as follows:
The Central Bank’s policy with regard to cost and availability of
credit is known as monetary policy. The RBI can raise the rate of
interest and increase the cost of credit and also reduce the
availability of credit. Quantitative instruments of credit control such
as the bank rate, the cash reserve ratio and the statutory liquidity
ratio can be used to reduce aggregate demand in the economy.
Increase in the bank rate by the RBI will increase the market
interest rate in the country. This will reduce the demand for credit
and further lead to reduction in aggregate demand. Similarly, if the
CRR and SLR are increased, the banks will have less money at
their disposal to give loans and advances to the borrowers.
Monetary expansion due to rising foreign exchange reserves was
controlled by sterilization of foreign exchange reserves.
Commenting on the effect of money supply on prices, Dr. C
Rangarajan, former Governor of the Reserve Bank of India states
that “Money has an impact on both output and price. Since credit
facilitates the production process, it has favorable impact on output.
But at the same time the increased money supply raises the
demand with an upward pressure on prices”. Dr. Rangarajan has
therefore accepted the fact in India that price effect of money
supply is greater than output eff