UNIVERSITY OF MAIDUGURI
MAIDUGURI, NIGERIA
CENTRE FOR DISTANCE
LEARNING
MANAGEMENT SCIENCES
ECON 404:
Unit: 2
ECON
MACROECONOMICS II
404:
MACROECONOMICS II
UNIT: 2
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ECON 404:
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MACROECONOMICS II
Published
2010©
All rights reserved. No part of this work may be
reproduced in any form, by mimeograph or any other
means without prior permission in writing from the
University of Maiduguri.
This text forms part of the learning package for the
academic
programme
of
the
Centre
for
Distance
Learning, University of Maiduguri.
Further enquiries should be directed to the:
Coordinator
Centre for Distance Learning
University of Maiduguri
P. M. B. 1069
Maiduguri, Nigeria.
This text is being published by the authority of the
Senate, University of Maiduguri, Maiduguri – Nigeria.
ISBN:
978-8133-
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P R E FA C E
This study unit has been prepared for learners so that they
can do most of the study on their own. The structure of the
study unit is different from that of conventional textbook.
The course writers have made efforts to make the study
material rich enough but learners need to do some extra
reading for further enrichment of the knowledge required.
The learners are expected to make best use of library
facilities and where feasible, use the Internet. References are
provided
to
guide
the
selection
of
reading
materials
required.
The University expresses its profound gratitude to our course
writers and editors for making this possible. Their efforts
CDL, University of Maiduguri, Maiduguri
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will no doubt help in improving access to University
education.
Professor M. M. Daura
Vice-Chancellor
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HOW TO STUDY THE UNIT
You are welcome to this study Unit. The unit is
arranged to simplify your study. In each topic of the unit,
we have introduction, objectives, in-text, summary and selfassessment exercise.
The study unit should be 6-8 hours to complete. Tutors
will be available at designated contact centers for tutorial.
The center expects you to plan your work well. Should you
wish to read further you could supplement the study with
more information from the list of references and suggested
readings available in the study unit.
PRACTICE EXERCISES/TESTS
1. Self-Assessment Exercises (SAES)
This is provided at the end of each topic. The exercise
can help you to assess whether or not you have actually
studied and understood the topic. Solutions to the exercises
are provided at the end of the study unit for you to assess
yourself.
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2. Tutor-Marked Assignment (TMA)
This is provided at the end of the study Unit. It is a
form of examination type questions for you to answer and
send to the center. You are expected to work on your own in
responding to the assignments. The TMA forms part of your
continuous assessment (C.A.) scores, which will be marked
and returned to you. In addition, you will also write an end
of Semester Examination, which will be added to your TMA
scores.
Finally, the center wishes you success as you go through
the different units of your study.
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INTRODUCTION TO THE COURSE
This study unit is a continuation of learning in macro-economics from earlier
units based on the semester system. The aim of the course is to introduce students to
advanced theories in Macro economics having come through lower and intermediate
levels. The logic is to further expose students to some rigorous and deep analysis of
theories and models. Hence, exhaustive and regular reading and attendance is
encouraged to facilitate understanding. Students are also advised to engage in interactive sessions outside the class to consolidate on the classroom experience.
The topics to be covered are captured under three broad headings as follows:
1. Macroeconomic policies and optimal allocation of resources.
2. Theories of Money Price and Interest Rate, and
3. Introduction to models of economic growth
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ECON 404:
MACROECONOMICS II
UNIT: 2
TA B LE
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C O N TE N T S
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PREFACE
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HOW TO STUDY THE UNIT
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INTRODUCTION TO THE COURSE
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TOPIC:
1:
Macroeconomic
allocation of resources2:
policies
and
optimal
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Theories of money, price and interest rate -
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3:
Introduction to models of economic growth -
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SOLUTIONS TO EXERCISES
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TOPIC 1:
TABLE OF CONTENTS
1.1 TOPIC:
MACRO ECONOMIC POLICIES
AND OPTIMAL ALLOCATION
1.1 INTRODUCTION
1.2 OBJECTIVES
1.3 IN-TEXT
1.3.1
DISTINCTION
BETWEEN
MICRO
AND
MACRO ECONOMICS
1.3.2
IMPORTANCE OF MACROECONOMICS
1.3.3
LIMITATIONS OF MACROECONOMICS
1.3.4
MACROECONOMIC CONCEPTS
1.3.5
POLICIES AND OPTIMAL ALLOCATION OF
RESOURCES
1.3.6
EFFECTS OF CHANGES IN FISCAL POLICY
1.3.7
EFFECTS OF CHANGES IN MONETARY
POLICY
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1.4 SUMMARY
1.5 SELF- ASSESSMENT EXERCISES
1.6 REFERENCE
1.7 SUGGESTED READINGS
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1.0
MACROECONOMIC POLICIES AND OPTIMAL
TOPIC:
ALLOCATION OF RESOURCES
1.1
Introduction
Before we proceed to look into macro economic policies and optimal
allocation of resources, it will be pertinent to look at a number of issues and
concepts in macroeconomics. The Issues to be considered are, the
distinguishing features between microeconomics and macroeconomics; the
importance of macro economics; limitations of macroeconomics; and a review
of some concepts regularly used in macroeconomic analyses.
1.2
Objectives
The objective of this topic is to make students understand the implications of
macroeconomic policies, their application and how they can be used to ensure
optimal allocation of resources. Thus at the end of the topic students should
be able to fully explain the operation and applicability of various economic
policies and how they can be maximally used especially in underdeveloped
countries.
1.3
1.3.1
IN-TEXT
Distinction between Micro and Macro Economics
The distinction between micro and macro economics is much more than
the way the Greek prefixes “micro and macro” suggest for small and large
respectively. In fact, even the purpose of their analysis is quite different.
Microeconomics is the study of economic actions of individuals and small
groups of individuals such as household, firm, particular industry, commodity,
and e.t.c.
Macroeconomics is the study of aggregates or averages covering the entire
economy such as total employment, national income, national output, total
investment, total consumption, total saving, and e.t.c. (Jhingan, 2004). Unlike
microeconomics that deals with small units in the economy, macroeconomics
is the study of the economy as a system (Dornbusch, Fisher and Begg, 2003
The study of macroeconomics is also very crucial because it stresses
broad aggregates such as total demand for goods, total expenditure, etc. Macro
economics sacrifices details to study the whole.
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1.3.2
MACROECONOMICS II
Importance of Macroeconomics
The study of macro economics is significant for many reasons. First,
macro economic variables e.g. money, income, saving, investment etc allow
proper understanding of the working of the economy. Second,
macroeconomics is very useful as far as economic policies which confront
governments are concerned. E.g. overpopulation, inflation, unemployment,
etc. Third, macro economics is useful in understanding general unemployment
because Keynesian theory of employment primarily rests on macro economic
analysis of effective demand. Thus, macroeconomics provides the basis for
which causes, effects and remedies of unemployment could be known.
Fourth, Macroeconomic study provides a better glimpse of the performance
of the economy in terms of national income. Fifth, Economic growth is also a
study of macroeconomics. Sixth, Monetary problems are analyzed in terms of
macroeconomics. Seventh, having emerged as a formal subject after the Great
Depression, macroeconomics is important in analyzing causes of fluctuations,
business cycles and providing lasting remedies where necessary.
1.3.3
Limitations of Macroeconomics
Macroeconomics as a branch of economics has some limitations as follows:
1) Fallacy of composition: the total behaviour is a summation of individual
behaviour, but what is true for individual economic units may not be true
for the entire economy.
2) Some aggregates are considered as homogeneous whereas they have
differences.
3) In some cases aggregate values may not be significant: for example,
increase in national income does not always means individual incomes
have increased.
4) Indiscriminate use of “macro” is misleading. Sometimes policy measures
for full employment are applied for the case of structural unemployment in
individual firms.
5) There are often a lot of statistical and conceptual differences in
measurement of macro economic variables.
1.3.4
Macroeconomic Concepts
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For the proper understanding of macro economic analyses a knowledge of
certain concept is necessary. The concepts considered in this study unit are as
follows:
i)
Macro Statics: The word static originated from Greek, meaning to bring
something to a halt or standstill. In economics it means a condition or
state of movement at a particular point without change. As Samuelson
puts it “economic static concern itself with simultaneous and
instantaneous or timeless determination of economic variables by mutually
interdependent relations”. Economic Statics has no future and no past
ii)
Macro Dynamics: Otherwise known as Economic Dynamics is the study
of change, of acceleration or deceleration. It is concerned with time lags,
rate of change, past and expected values of variables etc.
iii)
Comparative Statics: this is a method of analysis in which different
equilibrium situations are compared
iv)
Stock and Flow: stock refers to quantity of a commodity accumulated at a
point of time. Flow on the other hand refers to the quantity of current
production of a commodity which moves from a factory to the market.
Examples of stock are stock of capital, stock of cloth in the shop at a point
of time, etc. Examples of flow are income and output, consumption and
investment etc.
1.3.5
Policies and Optimal Allocation of Resources
Macroeconomic policies generally refer to monetary policy, fiscal policy,
income and expenditure policy etc, which are normally used by governments in
order to re-direct an economy towards a desired path of growth and
development. In other words, government adopts such policies to ensure speedy
growth of the economy, provide adequate employment opportunity for the
citizens leading to higher per capita income and welfare; while at the same time
tackling the menace of unemployment and inflation.
Monetary and fiscal policies are generally referred to as demand management
policies because countries use them largely to manage demand for goods and
services. The income policy leans towards the supply side of the economy. It
attempts to shift the aggregate supply curve via shifting labour supply through
shifting the nominal wage rate.
At this juncture we presume that students in this class have already treated ISLM Model extensively at the previous levels and hence are familiar with the
concepts and its usage. Therefore our analysis of macro economic policies will
build on the previous knowledge.
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We already know through the derivation of the IS-LM curve that the
commodity market is in equilibrium when:
Y = c (y – t(y) + i(r) + g
and the money market equilibrium condition is given as:
Lm = M/P = l(r) + k(y)
The above equations determine the equilibrium levels or values of y and r for
any given value of P. Changing the level of P changes the equilibrium values of y
and r via changes in real money supply M = M/P. Finally the economy’s
aggregate demand curve is arrived as follows:
Price level
P
D
P0
D
0
Y0
Y
Figure 1.1: Economy’s Aggregate Demand Curve
Similarly, supply is also derived from a consideration of demand and supply in
the labour market. It was clear that equilibrium output and employment depends on
the actual price level ‘P’.
Thus the aggregate supply could be derived from the analysis of labour market as well
as production function which relates the supply of output ‘y’ to employment ‘N’. The
aggregate supply derived is of the following feature:
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P
S
P1
P0
S
0
y0
Y
y1
Figure 1.2: Economy’s Aggregate Supply Curve
The demand side can be summarized in to the equilibrium condition of product
and money market as follows:
Y = c (y – t(y) + i(r) + g
Lm = M/P = l(r) + k(y)
The supply side combines a production function and labour market equilibrium
condition thus:
Production function: y = y(N, K)
Labour market: P.f(N) = Pe .g (N) = p(P).g(N)
The intersection of these two curves gives the equilibrium for the economy as a
whole. Traditionally, the IS-LM framework is the device used to show this
intersection which establishes the relationship between the expenditure and money
markets. Here, spending, interest rates, and income are determined jointly by
equilibrium in the expenditure and money markets. The curves drown in figure 1.1
and 1.2 can be brought together in a form of IS-LM curve to portray the equilibrium
level of income as shown below.
LM
r
E
re
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Figure 1.3: Economy’s Equilibrium Level of Income
Since the IS curve slopes downwards and the LM curve slopes upwards, the two
curves intersect in just one point, at re and Ye, depicted by “e” in the figure above. At
this point, two conditions for equilibrium are simultaneously satisfied. First, planned
savings equals planned investment. Second, the stock of money in existence equals
the stock of money demanded in the economy. The interest rate re and income level
Ye represent the only point at which those two equilibria are simultaneously satisfied.
This position is the equilibrium level of income and interest rate in the Hicks-Hansen
framework or neoclassical synthesis. In other words, at this point existing resources
are maximally utilized. Hence, output and income are at their highest peak.
1.3.6
Effects of Changes in Fiscal Policy
An increase in government spending generally, or a tax cut will shift the IS curve
from IS1 to IS2, implying a higher level of income (Y1 to Y2) and a higher interest rate
(r1 to r2). See figure below:
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Figure 1.4: Effect of changes in Fiscal Policy
Note that the flatter the LM curve, the more pronounced will be the effects of a
fiscal policy change on income and the smaller on the level of interest. On the
extreme, a horizontal LM curve will give rise to the highest possible expansion in
income and a zero change in the level of interest. Think of how the situation will look
like if the LM curve were to be vertical.
On the other hand, the flatter the IS curve, the smaller will be the effect of fiscal
policy on both interest rate and income.
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1.3.7
MACROECONOMICS II
Effects of Changes in Monetary Policy
A rise in the money stock shifts the LM curve to the right, lowering the rate of
interest and raising the level of income. See figure below:
Figure 1.5: Effect of changes in Monetary Policy
Also, the flatter the IS curve, the more pronounced will be the effects of a change
in money stock on the level of income, and the smaller on the rate of interest. A
horizontal IS curve therefore will give rise to the highest possible expansion in
income and leave the interest rate unchanged. Can you think of the effects of a
change in money stock on interest rate and income where the IS curve is vertical?
To conclude this analysis, the steeper the LM curve, the bigger will be the effects
of a change in the money supply on both the level of income and the rate of interest.
1.4
SUMMARY
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1.5
SELF ASSESSMENT EXERCISES
1.
2.
3.
4.
5.
6.
7.
1.6
MACROECONOMICS II
With the use of an appropriate diagram show how a shift of the IS
curve outward can affect the level of interest rate in an economy
What is the likely implication of additional government spending in an
economy?
With the use of an appropriate diagram show how a shift of the LM
curve outward can affect the level of interest rate in an economy
What is the likely implication of a higher interest rate on the level of
output in an economy?
Mention and explain the rationale for the adoption of government
policies in an economy.
Differentiate between Macroeconomics and Microeconomics
Why is the study of macroeconomics necessary?
Write short notes on each of the following:
a)
Demand side policy
b)
Supply side policy
c)
Fiscal policy
d)
Monetary policy
REFERENCES
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
HENDERSON & POOLE (1991) – PRINCIPLES OF ECONOMICS,
Revised Edition, Virinda Publications (P) Ltd.
1.7
SUGGESTED READINGS
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
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TOPIC 2:
TABLE OF CONTENTS
2.0
TOPIC:
THEORIES OF MONEY, PRICE AND INTEREST
2.1
INTRODUCTION
2.2
STUDY OBJECTIVE
2.3
IN-TEXT
2.3.1 NATURE AND DEFINITION OF MONEY.
2.3.2 MONEY AND NEAR MONEY
2.3.3 NEUTRALITY AND NON-NEUTRALITY OF MONEY
2.3.4 IRVIN FISHER’S QUANTITY THEORY OF MONEY
2.3.5 ASSUMPTIONS OF FISHERS THEORY
2.3.6 CRITICISMS OF FISHER’S THEORY
2.3.7 THE CAMBRIDGE EQUATIONS/CASH BALANCE
APPROACH
2.3.8 CRITICISMS OF THE CASH BALANCE APPROACH
2.4
SUMMARY
2.5
SELF ASSESSMENT EXERCISES
2.6
REFERENCES
2.7
SUGGESTED READINGS
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2.0
THEORIES
TOPIC:
OF
MONEY,
PRICE
AND
INTEREST
2.1
INTRODUCTION
2.2
Study Objective
The objective of this topic is to expand student’s knowledge on the role of
money as an instrument of exchange and how it relates to the price level
through the mechanism of interest rate. Thus at the end of this topic students
are expected to know the original version of the quantity theory of money as
developed by Irvin Fisher and by the Cambridge version as contend in the
works of Marshall, Pigou, Robertson and Keynes. Thus at the end of this
topic students are expected to define the quantity theory of money developed
by Irvin Fisher and the Cambridge exchange equation as well as conduct a
critique of the two versions.
2.3
2.3.1
In-text
Nature and Definition of Money.
Money is among those terms in economics which generate a lot of controversies
and confusion over its meaning. Different scholars perceive money to refer to
different things with the common objective of which is exchange among people.
Professor Coulborn sees money as “the means of valuation and payment; as both the
unit of account and the generally acceptable medium of exchange. This is a general
definition because it includes concrete money such as gold, cheques, coins, currency
notes, bank drafts, etc. this generalization prompted scholars to define money
variously as follows: “ money is defined by its functions; anything is money which is
used as money; money is what money does”
The above definitions are functional definitions of money, but some economists
defined money in legal terms implying “anything which the state declares as money is
money”. But problem arises here because some people accept some other things as
money which is not legally defined as money. Others do not accept as money what
has been legally defined as money.
According to Professor Johnson five main schools can be distinguished as far as
definition of money is concerned. They are as follows:
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1) The Traditional Definition of Money: This is otherwise referred to as the
currency school view. Money is seen by this school as currency and demand
deposits and the most vital function of money is serving as medium of
exchange. Lord Maynard Keynes alluded to this school.
2) Friedman’s Definition of Money: This is known as the monetarists or
(Chicago) view. Money is seen by this school literally as “the quantity of
dollars people are carrying around in their pockets, the demand deposit (at
banks) and commercial banks time deposits. They see money as currency plus
all adjusted deposits in commercial banks.
3) The Radcliff Definition: this school defined money as notes plus bank
deposits. They see money as only those assets that can be accepted as media
of exchange. Here assets refer to liquid assets.
4) The Curley-Show Definition: This school regards substantial volume of liquid
assets held by financial intermediaries as close substitute for money which
provide “store of value”. To them proper money or currency and demand
deposits constitute only one liquid asset.
5) Pesek and saving Definition:- According to this school money includes
demand deposits of banks and money issued by government. They exclude
time and saving deposits from bank money. They distinguished money from
debt, because whereas money does not pay interest debt yields interest.
2.3.2
Money and Near Money
As already explained, money comprises of currency and bank deposits. The
currency notes issued by CBN of a country and the cheques of commercial banks are
liquid assets. As for time deposits they are not money but near money. The reason is
that they can only be withdrawn at the end of a fixed period or by giving a prior
notice to the bank and incurring a penalty. Before time deposits can be used as
money they have to be converted into real money i.e cash or demand deposits. Other
near money similar to time deposits are bonds, securities debentures, bills of
exchange, treasury bills, insurance policies etc. It should be noted therefore that near
money is not a legal tender.
2.3.3
Neutrality and Non-neutrality of Money
One of the central analytical issues in macroeconomics is neutrality or nonneutrality of money. Money is called neutral if monetary changes in the economy
have no impact on real economic activity. Some theories Labeled Keynesian or
Neoclassical presume that money does not influence real output and real interest
rates. Other theories labeled classical, treat money as approximately neutral. The
Keynesians and even post Keynesians such as Friedman, Metzler, all believe money is
non neutral.
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2.3.4
MACROECONOMICS II
Irvin Fisher’s Quantity Theory of Money
The purchasing power of money is what represents the value of money.
Therefore without fear of contradiction one can say the value of money is related to
the purchasing price level. But the relationship between the two is an inverse one. For
instance, if V represents the value of money and P price level, the relationship can be
expressed as:
V = 1/P
The Irvin Fishers Quantity Theory states that the quantity of money in circulation
is the main determinant of the price level or the value of money. A change in the
quantity of money produces an exactly proportionate change in the price level.
According to Fisher, other things remaining equal, if the quantity of money in
circulation increases, the price level also increases in direct proportion and the value
of money decreases and vice versa.
Fisher came up with the following equation of exchange:
PT = MV + MIVI
Where: P = Price Level, 1/P value of money
M = Total quantity of legal tender money
V = Velocity of circulation of M
MI = Total quantity of credit money
VI = Velocity of circulation of MI
T = Transactions performed by money.
The above equation equates the demand for money (PT) to supply of money
(MV= MIVI). The total volume of transactions multiplied by the price level (PT)
represents the demand for money. According to Fisher,
PT = ∑PQ which means price level ‘p’ times quantity purchased ‘Q’ by the
community or society “∑” gives the aggregate or total demand for money. This
equates the total supply of money in the community which is expressed as quantity of
actual money “M” and its velocity of circulation “V” added to or plus total quantity
of credit money “MI” and its velocity of circulation “VI”. Therefore the total value of
transactions or purchases in a year is denoted by the expression MV + M IVI. This
brings us to the equation of exchange PT = MV + MIVI.
To clearly show the effect of quantity of money on price level ‘P’ or value of
money, we re-write the equation as follows:
P = (MV + MIVI)/T
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According to Fisher the price level varies directly as the quantity of money
(M+MI) as long as the volume of trade (T) and velocity of circulation (V, VI) remain
constant. This can be clearly seen if we observe that doubling M and M I and holding
V, VI and T constant and doubling P also will reduce the value of money (1/P) to
half. The following diagram explains Fishers quantity theory of money more clearly.
Pe f (M )
P4
Pa ne l A
P2
P1
0
M 2
M
M 4
Panel B
1/P
1/P2
1/P4
0
M
M2
M4
Figure 2.1: Relationship between quantity of money and price
Panel A above shows the effect of changes in the quantity of money on the price
level. When the quantity of money is M the price level is P. When the quantity of
money doubled to M2, the price level also doubled to p2. When the quantity of
money is increased to four-fold, the price level quadrupled to P4. This relationship is
indicated by the curve P= f(M) which runs from the origin at 45o
In figure B, the inverse relationship between the quantity of money and the value
of money is depicted where the value of money is taken on the vertical axis. When
the quantity of money is M1, the value of money is 1/P. Doubling the quantity of
money to M2 bring the value of money to one-half (½) of what it was previously, i.e
1/P2. When the quantity of money further increases to M4 the value of money
reduced to 1/P4. This inverse relationship between the quantity of money and the
value of money is shown by downward sloping curve 1/p = f (M)
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2.3.5
MACROECONOMICS II
Assumptions of Fishers Theory
1) P is passive in the equation of expression of exchange though other factors are
active.
2) Constancy of proportion of MI to M.
3) Both V and VI are assumed to be constant and independent of changes in MI
and M.
4) T also is constant and independent of MI to M, VI to V.
5) Demand for money is proportional to the value of transactions.
6) Supply of money is exogenously determined and constant.
7) The theory is applicable in the long run
8) The theory is based on assumption of full employment I the economy.
2.3.6
Criticisms of Fisher’s Theory
1) It is a truism. This is maintained by Keynes. But it can not be accepted that a
certain percentage change in quantity of money can lead to the same
percentage change in price level.
2) Other things are not equal. In real life, all the parameters included in the
theory are not constant as it was presumed.
3) Constant relate to a different time epoch. For example M relate to a point in
time and likewise V.
4) The theory fails to measure the value of money. It only measures cash
transactions.
5) It neglects the role of interest rate as a causative factor between money and
prices.
6) The assumption of long run situation and the neglect of short run factors is
also questionable.
7) V can not be said to be constant in real life situation
8) The theory also neglects the store of value function on money. Its assumption
of exogenous money supply and constant demand for money only considers
the medium of exchange function of money and ignores store of value. It is
one sided.
9) It is static and not dynamic.
2.3.6
The
Cambridge
Equations:
The
Cash
Balance
Approach
Cambridge economists such as Marshall, Pigou, Robertson and Keynes
formulated the cash balance approach. They opined that the value of money is
determined by two factors that determine the value of any other thing. Viz the
condition of demand and the quantity available. They opined that the supply of
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money is exogenously determined at a point of time by the banking system. They
discarded the concept of velocity of circulation and consider demand for money as
the main determinant of the value of money.
Marshall’s Equation:
Though Marshall did not put his theory in form of equation, he tried to show
that the amount of money one holds or wants to hold bears some relation to
one’s income since that determines the volume of purchases and sales in which
one is engaged. So the cash balances held by people can be expressed as total
fraction of their total income. Other economists express this theory in equation
form as follows:
M = KPY
Where M = money supply
K = the fraction of he real money income (PY) that people hold in
cash and demand deposits.
P = the price level
Y = the aggregate real income
Therefore,
P = M/KY,
And the value of money 1/P = KY/M
Pigou’s Equation:
He was the first economist of the Cambridge school to express the cash balance
approach in the form of an equation.
P = KR/M
Where P = purchasing power of money/value of money (1/P)
K = the proportion of total real resources or income (R)
R = the total resources of real income
M = number of actual units of legal tender money
The demand for money according to Pigou, consists not only of legal money or
cash but also banknotes and bank balances. To include bank notes and bank
balances in the demand for money, Pigou modifies his equation to the following
form:
P = KR/M { C + h (1-C)}
Where ‘C’ is the proportion of real income actually held by the community in
legal tender including coins, (1-C) is the proportion kept in banknotes and
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bank balances, and ‘h’ is the proportion of actual legal tender that bankers
keep against the notes and balances held by their customers.
According to Pigou when K and R in the equation P = KR/M and K, R, C and h
are taken as constants, then the two equations give the demand curve for legal
tender as a rectangular hyperbola as follows:
D
Q1
Q2
Q3
P1
P2
P3
0
D1
M1
M2
M3
M.D & MS
Figure 2.2 Demand and Supply curve for Money
From the above we can see that the demand curve for money has a unitary
elasticity. DD1 is the demand curve for money, Q1M1, Q2M2 and Q3M3 are the
supply curves of money fixed at a point of time. When the supply of money increases
from OM1 To OM2, the value of money is reduced from OP1 OP2. The fall in the
value of money by the area P1P2 exactly equals the increase in the supply of money
by M1M2. If the supply of money increases three times from OM1 to OM3, the value
of money is reduced exactly by one-third from OP1 to OP3.
Robertson’s Equation:
The only difference between Pigou’s equation and that of Robertson is that
instead of Pigou’s total real resources R, Robertson gave the total volume of
transaction T.
M = PKT or
P = M/KT
Where P is the price level, M is the total quantity of money, K is the
proportion of the total amount of goods and services (T) that people wish to
hold in the form of cash balances and T is the total volume of goods and
services purchased during a year by the community. If we take P as the value
of money instead of the price level as in Pigou’s equation, we will see that
Robert’s equation is perfectly similar to Pigou’s P = KT/M.
Keynes’s Equation:
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In 1923 Keynes formulated the Real Balances Quantity Equation with some
improvements over those of others in the Cambridge school. He opined that
people always want to have some purchasing power to finance their daily
transactions. The amount of this purchasing power (or demand for money)
depends on factors such as tastes, habits, wealth etc. He further buttressed that
demand for money is governed by and measured by consumption units. A
consumption unit is expressed as a basket of standard articles of consumption or
other items of expenditure.
Therefore, if ‘K’ is the number of consumption units in the form of cash, ‘n’ is
the total currency in circulation, and P is the price for consumption unit, then the
equations:
n = pk
If ‘K’ is constant, a proportionate increase in ‘n’ (quantity of money) will lead
to a proportionate increase in P (price level). The equation can be expanded
by taking into account bank deposits. For example let ‘K’ be the number of
consumption units in the form of bank deposits, and ‘r’ the cash reserve ratio
of banks, then the expanded equation is
n = p(k + rkI)
If ‘k’, kI and r are constants, ‘p’ will change proportionately to change in ‘n’.
Keynes considered this equation superior to other cash balances equations.
The other equations fail to point how price level (p) can be regulated. Because
it is difficult for monetary authorities to control the cash balances held by
people outside their control, ‘p’ can be regulated by controlling ‘n’ and ‘r’. It is
also possible to regulate bank deposits ‘kI’ by appropriate changes in the bank
rate. So ‘p’ can be controlled by making appropriate changes in ‘n’, ‘r’ and ‘k I’
so as to offset changes in ‘k’.
2.3.8 Criticisms of the Cash Balance Approach
1) Truism
2) Price level does not measure purchasing power
3) The equation accord more importance to total deposit
4) Neglect of other factors
5) Neglect of saving-investment effect.
6) K and Y are not constant
7) The equation has failed to explain dynamic behaviour of prices
8) Neglected the influence of interest rate.
9) Demand for money is not interest elastic.
10) Neglect of goods market
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11) Neglect of real balance effect
12) Elasticity of money is not unity
13) Neglect of speculative demand for money.
2.4
SUMMARY
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2.5
SELF ASSESSMENT EXERCISES
1.
2.
3.
2.6
MACROECONOMICS II
What do you understand by the value of money? What determines the
value of money according to the Cambridge School?
Critically examine Fisher’s Quantity Theory of Money
What major difference can you observe between Pigous equation and
Robertson’s equation?
REFERENCES
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
HENDERSON & POOLE (1991) – PRINCIPLES OF ECONOMICS,
Revised Edition, Virinda Publications (P) Ltd.
2.7
SUGGESTED READINGS
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
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TOPIC 3:
TABLE OF CONTENTS
3.0
TOPIC:
INTRODUCTION TO MODELS OF ECONOMIC
GROWTH
3.1
INTRODUCTION
3.2
STUDY OBJECTIVES
3.3
IN-TEXT
3.3.1 THE STYLIZED FACTS ABOUT GROWTH
3.3.2 ASSUMPTIONS OF THE HARROD AND DOMAR MODELS
3.3.3 THE DOMAR MODEL
3.3.4 THE HARROD MODEL
3.3.5 THE H-D MODELS AND UNDERDEVELOPED COUNTRIES
3.3.6 LIMITATIONS OF H-D MODELS IN UNDER-DEVELOPED
COUNTRIES
3.3.7 THE LIMIT TO GROWTH MODEL
3.3.8 CRITICISMS OF THE LIMIT TO GROWTH MODEL
3.4
SUMMARY
3.5
SELF ASSESSMENT EXERCISES
3.6
REFERENCES
3.7
SUGGESTED READINGS
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3.0
INTRODUCTION TO MODELS OF ECONOMIC
TOPI:
GROWTH
3.1
Introduction
Generally, the theory of economic growth is concerned with
economy’s long run trend or in other words growth path (Branson, 1989). If
the monetary and fiscal authorities successfully keep the economy near full
employment, then the basic question is to find out what determines the height
and growth of the potential growth path. The slope of the long run growth
path (rate of growth of potential output) is related to rate of growth of labour
force and productivity. Thus the height of the growth path is related to the
amount of accumulated capital per worker in the economy and to the saving
rate. According to Branson (1989: 542) a growth path can be illustrated as
follows:
1300
1100
t
Po
900
lG
ia
t
en
NP
Aa tual GNP
700
0
1960 62 64
66 68 70
72 74
76
Time
Figure 3.1: Growth Path in an Economy
The growth models as we shall see will deal with relationship between
capital and labour inputs, investment and consumption demand, real wage rate
and profit. It is good to take note that capital letters are used when dealing
with aggregate real magnitudes while small letters denote per capita real
magnitudes. Consequently as Branson (1989:561-562) puts it:L = Labour input, in terms of worker-hour per unit of time.
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K = Capital input, in terms of machine-hour per unit of time.
Q = Real output per unit of time, in general Q = f (K,L)
W = Total real wages
K = Amount of capital per person or the capital-labour ratio (K/L = K)
q = output per worker, or productivity, so that Q/L = q
w = wage rate, that is, W/L = w
It is also good to note that in this analysis, it is assumed that rates of
utilization of the labour force and capital stock are constant such that ‘L’ can
be used replace ‘K’ and vice versa.
With the above discussion, we can distinguish between four kinds of
growth as follows:
GNP
.
.
.
.
.
Q2 .
.
q1 A .
0.
.
0
B
t0
.
.
.
.
.
.
.
.
.
.
t1
.
2 .
.
.
.
.
.
.
.
.
Q2
q1
t2
Time
Figure 3.2: Equilibrium Growth Paths
From the above we can see two long run equilibrium growth path q1q1
and Q2Q2 and the path of output per person in a hypothetical economy from
point ‘0’ at time ‘to’ upward to different point as time progresses.
The long run growth path q1q1 and Q2Q2 represent trend growth
paths of output per worker with a slope given by the rate of growth of labour
force productivity q, which is the same as y/L. Long run path has a lower
saving rate and thus is below long run path Q2Q2. The dash path AB shows
full employment growth path of the hypothetical economy as it grows up to
its long run path like q1q1. The solid path from ‘0’ to ‘2’ shows the movement
of the hypothetical economy from an initial point of less than potential output
first, up to full employment as it joins the AB path, then to a long run steady
state growth path q1q1which it joins at point B. At time t1 we assume that the
economy’s saving rate increases so that its long run path shifts up to Q2Q2.
By maintaining full employment, the economy then flows through path 1-2 to
attend the new long run path at time t2.
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In brief, we can say that the above scenario reveals four different kinds
of growth thus:1) Movement from point ‘0’ to AB is growth associated with the
elimination of unemployment.
2) Movement along the full-employment path AB towards a long run
steady –state path like q1q1.
3) Movement along the steady-state path once the economy gets onto
the path at point B.
4) Movement between two steady-state paths, normally as a result a
change in the saving rate. This is shown by movement from point 1
to 2.
3.2
Study Objectives
The objective of this topic is to introduce students to economic growth models.
Within this plan, students will be exposed to some of the models that have become
popular and hence are used by different countries, especially the advanced world.
3.3
3.3.1
In-text
The Stylized Facts about Growth
Professor Kaldor in 1958 grouped six factors that have led to the growth of
advanced industrial economies. He termed them as “stylized facts” which a growth
model explains. These factors are:
i)
The growth rate of real output per man-hour is fairly constant over long
periods of time.
ii)
The growth rate of capital stock is fairly constant but greater than the
growth rate of labour.
iii)
The growth rate of capital stock and the growth rate of real output is about
the same.
iv)
The profit rate, defined as the ratio of profit (P) to the capital stock (K) is
fairly constant over the long run. With a constant capital output ratio, it
means constant relative shares of labour and capital in national output.
v)
The growth rate of output per man can change considerably from one
country to another.
vi)
Those economies with high share of profits in income tend to have a high
ratio of investment to output.
An economy growing according to the first four ‘stylize facts’ is said to be in a
steady state because the last two facts relate to comparisons between different
countries. These stylized facts relate to the long run regularities in the relationships
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that seem to appear in the majority of advanced industrial countries. We discuss them
as follows:First, take the growth rate of labour force L = (dL/dt)/L which is fairly constant
over time. The growth rate of output is defined as the sum of average labour
productivity Q/L and the total labour force, i.e. Qt = (Q/L)t . Lt. The trend growth
rate of output is given by the trend growth rates of labour productivity and the
available labour force. Thus, the trend growth rate of output is Q = L, where Q =
(dQ/dt)/Q. This implies that the growth rates of output and labour force are fairly
constant, with Q > L, so that the growth of output per worker or productivity, q > 0.
The second stylized fact of growth relate to the growth rate of capital stock, K =
(dK/dt)/K which is fairly constant but greater than the growth rate of labour force,
L, that is, K > L. It also concerns the capital labour ratio k = K/L which increases
through time.
The third stylized fact concerns the quantity of the growth rate of capital stock K
and the growth rate of output Q so that the capital-output ratio, v = K/Q, is
constant over time.
According to the last stylized fact, if both the profit rate P/K and the capital
output ratio are fairly constant over the long run, the share of profits in national
output (or income) P/Q is constant. The share of wages in national output being
W/Q = I-P/Q, a constant share of profit in national output lead to a constant share
of wages. Thus with a constant capital output ratio v, the relative shares of profits
and wages in national output are constant
All these facts have been confirmed to hold true for the economy of the US
during the period 1970 to 1980s. Thus, in terms of these stylized facts an economy is
said to be in a steady state when its output, employment and capital stock grow
exponentially, and its capital output ratio is constant.
Steady state growth – Meaning.
The concept of steady state growth is the counterpart of long run equilibrium in
static theory. It is consistent with the concept of equilibrium growth. In a steady state
growth all variables, such as output, population capital stock, saving, investment, and
technical progress, either grow at constant exponential rate, or are constant.
Using different variables some of the Neo-classical economists have given their
interpretation of what the concept of steady state growth implies. According to
Harrod, an economy is in a state of steady growth when Gw = Gn. Joan Robinson
described the condition of steady state growth as Golden Age of accumulation thus
indicating a “mythical state of affairs not likely to obtain in any actual economy” but
it is a situation of stationary equilibrium. According to Meade, in a state of steady
growth, the growth rate of total income and the growth rate of income per head are
constant with population growing at a constant proportionate rate, with no change in
the rate of technical progress. Solow in his model demonstrates steady growth paths
as determined by an expanding labour force and technical progress.
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Assumptions of the Harrod and Domar Models
The Harrod and Domar models are based on the following assumptions.
i)
Existence of an initial full employment equilibrium level of income.
ii)
Absence of government intervention
iii)
Closed economy with no international trade
iv)
No lags in adjustment between investment and creation of productive
capacity.
v)
Average propensity to save (APS) is equal to marginal propensity to save
(MPS)
vi)
MPS is constant
vii)
The capital coefficient, i.e. the ratio of capital stock to income is assumed
to be fixed.
viii) Savings and investment relate to income of the same year.
ix)
There is no depreciation of capital goods in the economy.
x)
The general price level is constant. ie money income and real income are
the same.
xi)
No changes in interest rates.
xii)
There is a fixed proportion of capital and labour in the productive process.
xiii) Fixed and circulating capital are lumped together under capital.
xiv) Lastly, there is only one type of product in the economy.
3.3.3
The Domar Model
Domar worked to find solution to the question that since investment generates
income on the one hand and increases productive capacity on the other, at what rate
should investment be increased so as to make the increase in income equal to the
increase in productive capacity in order to maintain full employment.
He provides answer to this question by creating a link between aggregate supply
and aggregate demand through investment.
Increase in Productive Capacity
He explains the supply side in terms of the increase in productive capacity.
According to him the annual rate of investment is represented by ‘I’ while the
annual productive capacity per dollar of newly created capital is ‘S’. Therefore the
productive capacity of ‘I’ dollar invested will be I.S dollar. This can be
total net potential increase in output of the economy and is known as the sigma
effect. In Domar’s words this “is the increase in output which the economy can
produce,” it is the “supply side of our system”
Increase in Aggregate Demand
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The demand side is explained by the Keynesian multiflier. Let the annual increase
in income be denoted by ∆Y and the annual increase in investment by ∆I and the
Equilibrium
To maintain full employment equilibrium level of income, aggregate demand
should be equal to aggregate supply. This brings us to the fundamental equation
of the model:
This equation shows that to maintain full employment, the growth rate of
save times the productivity of capital). This is the rate at which investment must
grow to ensure the use of potential capacity in order to maintain a steady growth
rate of the economy at full employment.
be maintained in the economy an amount equal to 150x12/100= 18 billion
s
times, i.e., by 150 x12/100 x25/100= 4.5 billion Naira, and the national income
will have to rise by the same amount. But the relative rise in income will equal the
absolute increase divided by the income itself, i.e.
150 x (12/100 x 25/100)/150
=
(12/100 x 25/100)
Thus in order to maintain full employment, income must grow at a rate of
3 percent per annum. This is the equilibrium rate of growth. Any divergence
from this “golden path” will lead to cyclical fluctuations. When ∆I/I is greater
than
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3.3.4 The Harrod Model
Professor R.F Harrod also tried to show in his model how steady (i.e.
equilibrium) growth may occur in the economy. Once the steady growth rate is
interrupted and the economy falls into disequilibrium, cumulative forces tend to
perpetuate this divergence thereby leading to either secular deflation or secular
inflation.
The Harrod model is based upon three distinct rate of growth. Firstly, there is the
actual growth rate represented by ‘G’ which is determined by the saving ratio and the
capital output ratio. It shows short run cyclical variations in the rate of growth.
Secondly, there is the warranted growth rate represented by ‘Gw’ which is the full
capacity growth rate of income of an economy. Lastly, there is the natural growth rate
represented by ‘Gn’ which is regarded as ‘the welfare optimum’ by Harrod. It may
also be called the potential or the full employment rate of growth.
The Actual Growth Rate
The first fundamental equation of the Harrodian model is:
GC = s
Where G is the rate of growth of output in a given period of time and can be
expressed as ∆Y/Y; C is the net addition to capital and is defined as the ratio
of investment to the increase in income, i.e. I/∆Y and s is the average
propensity to save, i.e. S/Y. Substituting These ratios in the above equation
we get:
(∆Y/Y)(I/ ∆Y) = S/Y or I/Y = S/Y or I = S
This equation is simply a restatement of the truism that expost (actual or
realized) savings equals expost investment. This relationship is disclosed by
the behaviour of income. Whereas ‘S’ depends on ‘Y’, ‘I’ depends on the
increment in income (∆Y).
The Warranted Rate of Growth
The warranted rate of growth is, according to Harrod, the rate “at which
producers will be content with what they are doing”. It is the “entrepreneurial
equilibrium; it is the line of advance which, if achieved, will satisfy profit takers
that they have done the right thing”. Thus this growth rate is primarily related to
the behaviour of businessmen in an economy. At the warranted rate of growth
demand is high enough for businessmen to sell what hey have produced and they
will continue to produce at the same percentage rate of growth. Thus, it is the
path on which the supply and demand for goods and services will remain in
equilibrium, given the propensity to save. The equation for the warranted rate is
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GwCr =s
Where Gw is the “warranted rate of growth” or the full capacity rate of
growth of income which will fully utilized a growing stock of capital that will
satisfy the entrepreneurs with the amount of investment actually made. It is
the value of ∆Y/Y . Cr, the ‘capital requirements’, which denotes the amount
of capital needed to maintain the warranted rate of growth, i.e. required capital
output ratio. It is the value of ∆I/Y, or C.s which is the same as in the first
equation. i.e., S/Y.
The above equation states that if the economy is to advance at the steady rate
of Gw that will fully utilized its capacity, income must grow at the rate of s/Cr
per year, i.e., Gw = s/Cr. If income grows at the warranted rate, the capital
stock of the economy will be fully utilized and entrepreneurs will be willing to
continue to invest the amount of savings generated at full potential income.
Gw is therefore a self-sustaining rate of growth and if the economy continues
to grow at this rate it will follow the equilibrium path.
Saving &
Investment
S
I2 I3
I1
s3
s2
S1
0
Y1 y2
y3
y4
Income
Figure 3.3: Equilibrium Paths in an Economy
Above is an equilibrium path. The horizontal axis represents income and
the vertical axis shows the level of saving and investment. A change in income
from y1 to y2 causes I1 to equal saving ‘S1’ at A. This investment in turn raises
income to y3 which causes I2 to equal ‘S2’ at point B. The I2 in turn raises
income to y3 which induces I3 to equal ‘S3’ at C (at y4 income level). In this
manner the economy moves along the growth path. The point of intersection
of the investment line (I) and the line parallel to the y-axis indicates the
required investment that is forthcoming.
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Long run equilibria
For the attainment of full employment growth, the actual growth rate
G must equal Gw, the warranted rate of growth that would give steady
advance to the economy and C (the actual capital goods) must equal Cr (the
required capital goods for steady growth).
If G and Gw are not equal, the economy will be in disequilibrium. For
instance, if G exceeds Gw, then C will be less than Cr. As such there will be
shortage in the economy. Such a situation leads to secular inflation because
actual income grows at a faster rate than that allowed by the growth in the
productive capacity of the economy. This will further lead to a deficiency of
capital goods, the actual amount of capital goods being less than the required
capital goods (C<Cr). Under the circumstances, desired, (ex-ante) investment
would be greater than saving and aggregate production would fall short of
aggregate demand. There would thus be chronic inflation. This is illustrated in
the figure below:
GROWTH RATES
G Gw
Gw
E
Y0
E
Y0
G
0
A
T1
t2
t3
t4
0
TI M E
T1
t2
t3
t4
B
Figure 3.4: Actual, Warranted and Natural Rate of Growth
In panel A of the above figure the rate of income is shown on the
vertical axis and time on the horizontal axis. Starting from the initial full
employment level of income Y0, the actual growth rate G follows the
warranted growth path Gw up to point E through period t2. But from this
point onwards, G deviates from Gw and becomes higher. The deviation
between the two becomes larger and larger towards the extreme right.
If, on the other hand, G is less than Gw as shown in panel B of the
figure, than C is greater than Cr. Such a situation leads to secular depression
because actual income grows more slowly than what is required by the
productive capacity of the economy leading to an excess of capital goods
(C>Cr). This means that desired investment is less than saving and that the
aggregate demand falls short of aggregate supply. The result will be a fall in
output, employment and income. There will thus be chronic depression.
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Harrod states that once G departs from Gw as shown in both panel A
& B , it will depart further and further away from equilibrium. Thus the
equilibrium between G and Gw is a knife-edge equilibrium. For once it is
distorted, it is not self correcting. It follows that one of the major tasks of
public policy is to ring G and Gw together in order to maintain long run
stability. For this purpose, Harrod introduce his third concept of the natural
rate of growth.
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The Natural Rate of Growth
This is defined as the rate of advance which the increase in population and
technological improvements allow in an economy. It thus depends on macro
variables like population, technology, natural resources and capital equipment.
In other wards, it is the rate of increase in output at full employment as
determined by a growing population and the rate of technological progress.
The equation for the natural rate of growth is
Gn = Cr or s
Here Gn is the natural or full employment rate of growth.
Divergence of G, Gw and Gn. For full employment equilibrium the three must
balance in a form of equation. But this is a knife-edge balance. For once there is any
divergence between natural, warranted and actual rates of growth, conditions of
secular stagnation of inflation would be generated in the economy. If G > Gw,
investment increases faster than saving and income rises faster than Gw. If G < Gw,
saving increases faster than investment and rise of income is less than Gw. Thus
Harrod points out that if Gw > Gn, secular stagnation will develop. In such a
situation Gw is also greater than G because the upper limit to the actual rate is set by
the natural rate as shown as shown in panel A of the figure below.
GROWTH RATES
G
Gn
Gw
Gw
Gn
E
Y0
Y0
E
G
0
T1
t2
t3
t4
A
0
TI M E
T1
t2
t3
t4
B
Figure 3.5: Actual, Warranted and Natural Rate of Growth
When Gw exceeds Gn, C > Cr and there is an excess of capital goods due to a
shortage of labour. The shortage of labour keeps the rate of increase in output to a
level less than Gw. Machines become idle and there is excess capacity. This further
dampens investment, output, employment and income. Thus the economy will be in
a grip of chronic depression. Under such conditions saving is a vice.
If Gw < Gn, Gw is also less than G as shown in panel B of the figure. The
tendency is for secular inflation to develop in the economy. When Gw is less than
Gn, C < Cr. There is a shortage of capital goods and labour is in surplus. Profits are
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high since desired investment is greater than realized investment and the businessmen
have a tendency to increase their capital stock. This will lead to secular inflation. In
such a situation saving is a virtue for it permits the warranted rate to increase.
In conclusion the Harrod model of growth sees saving as a virtue in an
inflationary gap economy and a vice in an economy characterized with deflationary
gap. Thus in an advanced economy, s has to be moved up or down as the situation
demands to ensure smooth growth and balanced development.
3.3.5
The
Harrod-Domar
Models
and
Underdeveloped
countries
Growth theories in advanced economics have been associated with three
principal concepts: the saving function, the investment functions and the productivity
of capital. The Harrod Domar models are based on these concepts and were
primarily developed in order to illuminate secular stagnation that was threatening the
advanced economies in the post-war period. The application of these models has now
been extended to the development problems of underdeveloped economies. As
Hirschman writes: “The Domar model in particular, has proved to be remarkably
versatile, it permits us to show not only the rate at which the economy must grow if it
is to make full use of the capacity created by new investment but inversely, the
required savings and the capital-output ratios if income is to attain a certain target
growth rate. In such exercises, the capital-output ratio is usually assumed at some
value between 2.5 and 5; sometimes several alternative projections are under taken;
with given growth rates, overall or per capita, and with given population projections,
total capital requirements for five or ten year plans are then easily derived.
The major question here is whether the application of the Harrod and Domar
model has fared well in underdeveloped economies like Nigeria. The answer to this
question can be obtained by looking at the following limitations of the models.
3.3.6
Limitations
of
H-D
Models
in
Under-developed
countries
i]
ii]
Different Conditions: The Harrod and Domar analysis was evolved under
different set of conditions. It was meant to defend advanced
economies from the possible effects of secular stagnation. It was never
intended to guide economies to the path of industrialization.
Saving Ratio: These models were developed on the presumption that a
high possibility exist for the citizens to generate the necessary saving
required. This is not so in underdeveloped countries where the decision
to save and invest are both undertaken by the same group of persons.
The vast majority of people in the underdeveloped countries lives in
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iii]
iv]
v]
vi]
vii]
viii]
3.3.7
MACROECONOMICS II
abject poverty and thus can hardly save anything from their meager
income.
Capital-output Ratio: Similarly, it is difficult to have a correct estimate of
the capital output ratio where normal productivity is often inhibited by
shortages and bottlenecks.
Disguised Unemployment: These models start with the full employment
level of income which is hardly found in underdeveloped countries.
There always exists disguised unemployment in such economies which
the Harrod and Domar models cannot remove.
Government Intervention: The Harrod and Domar models are based on the
assumption that there is no government intervention in economic
activities. This assumption is not applicable to underdeveloped
countries because they cannot develop without government
intervention. In such countries the role of the state as a pioneer
entrepreneur in starting large industries and in regulating and directing
private enterprise has been increasingly recognized.
Foreign Trade and Aid: The Harrod and Domar models are based on the
assumption of closed economy. But underdeveloped countries are
opened rather than being closed where foreign trade and aid play very
crucial roles in their economic development. In fact, these factors are
the bases of their economic progress.
Price Changes: These models are based on the unrealistic assumption of a
constant price level. But in underdeveloped countries price changes
have been very rampant.
Institutional Changes: Institutional factors have been assumed to be given
in these models. But in reality, not even in the developed world are
institutions static.
The Limit to Growth Model
Since the times of Malthus Ricardo and Mill, economist like Galbraith,
Mishan Carson Boulding Commoner and the rest have shown increasing concern
about the harmful effects of economic growth on the environment. They are of the
view that growth has produced pollution and wasteful consumption of trivia that
contribute nothing to human happiness. According to them, the objectives of
economic growth are to be reviewed because it has negatively affected the quality of
life, pollution of the environment; waste of natural resources and its failure to solve
socio-economic problems.
Thus in 1968, a group of about seventy five persons belonging to
different strata of society from around the world founded the club of Rome. This
group believed that the possibilities of continuous growth have been exhausted and
timely action is therefore essential in order to avert a planetary collapse. This and
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other subsequent gatherings gave birth to the “Limit to Growth Theory” which we
shall briefly study below.
The Model
The limit to growth model was first contained in a book written by Jay Forrester,
entitled “World Dynamics” published in 1971. The model is an attempt to investigate
the interplay of such highly aggregated variables as world population, industrial world
production, food supply, pollution and natural resources still remaining in the world.
Using the ‘System Dynamics’ methodology of Forrester, the authors of the limit to
growth presented a large and new type of model designed to predict the future
development of five global inter related variables – population food production,
industrial production, non-renewable resources and pollution.
Predictions of the model
The model is based on the thesis that “continued growth leads to infinite
quantities that just do not fit into a finite world”. This basic thesis can be analyzed as
follows:
i)
The future world population level, food production and industrial
production will first grow exponentially, become increasingly
unmanageable, and then collapse during the 21st century.
ii)
The collapse is inevitable because the world economy will reach its
physical limits in terms of non-renewable resources, agricultural
land and the earth’s capacity to absorb excessive pollution which
are finite
iii)
Eleven vital minerals such as copper, gold, lead, mercury, natural
gas, oil, silver, tin, and zinc are being exhausted. If, in addition,
industrial production continues to increase, that too will give rise to
catastrophic results.
iv)
If the present growth trends in the world population,
industrialization, pollution levels food problem and resource
depletion continue unchanged, the limits to growth on this plant
will be reached within the next one hundred years. The most
probable results will be a rather sudden and incontrollable decline
in both population and industrial capacity sometime before the
2010.
v)
Since technological progress can not expand physical resources
infinitely, it will be prudent to put limit on our future growth rather
than take the risk and await the doomsday within the coming 50 or
100 years.
vi)
This catastrophe can be averted by controlling the growth rate of
output and population, reducing the pollution levels, and thus
achieving a global equilibrium with zero growth.
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Thus the limit to growth stresses that pollution, high population growth rate, and
shortages of food and resources make the future prospects of the world bleak which
will lead to catastrophic results. Since the resources are finite and are likely to be
depleted within 50 or 100 years, people should change their attitude towards the use
of resources, their reproduction and pollution levels so as to save the world from
collapse.
3.3.8 Criticisms of the Limit to Growth Model
There is no gain saying that the limit to growth was an alarming report predicting
the collapse of the world economy in the 21 st century. It had made considerable
impact on economic and political thinking and had provided an impetus to anti
growth sentiments around the world. In fact the world community is divided into two
groups: the resource pessimists and the resource optimists. The former accepted the
predictions of the report and the later criticized them o he following grounds:
1) Static reserve index. The model has been criticized for assuming that the nonrenewable resources are scarce and are likely to be exhausted in the year 2100.
This conclusion is based on the static reserve index (i.e. reserve to use ratio)
which is the ratio of current reserve to current consumption. The current
reserves represent known resources that are economically extractable. The
index expresses the number of years until the resources are depleted, given
that there will be no additions to the known resources and also that the future
annual use of the reserves remain at the current level. This contention is
flawed because it neglects technological development in recycling and reuse of
resources and the possibility of substituting scarce material for abundant
resources. Further, the discoveries of new deposits of Oil, Gas, etc, the size of
reserve may increase overtime despite continued exploitation.
2) Technological development. This model neglects technological developments in
resource extraction, use and substitution. In fact, the size of reserve of nonrenewable resources has been increasing due to rapid technological
development. Moreover, scarcity of resources has led to technological
developments in new resources such as atomic energy, bio-gas, etc. for
industrial use. According to Giddens, it is a world of endless change and
endless expansion which the limit to growth theory overlooked completely.
3) Food production. The model assumes the availability of limited land for
agricultural production and subsequent decline in food production. According
to Kahn, whenever certain limits are reached, new technologies are
introduced. These technologies effectively either removed the limit or as time
passes a subsequent technology remove it. An example is the expansion of
food production following the invention of fertilizers which has greatly helped
in minimizing the world food problems.
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4) Population growth. The model predicted that the world population growing at an
exponential rate would be 7 billion in 2000. if the mortality rate continues to
decline without lowering the fertility rate, it will be 14.4 billion in 2030. But
this did not happen this way as the world population was 6 billion in 2000, as
against the 7 billion predicted in the model. Highly populated countries like
China and India have slowed down their population growth rates by
encouraging birth control measures. Moreover, empirical studies have shown
that economic growth accompanied by rising incomes lowers the fertility rate.
5) Pollution. The model assumes that the level of pollution is increasing
exponentially in the world due to growth in agricultural and industrial
activities. Consequently the degradation of the environment will adversely
affect the quality and existence of human life, flora and fauna. No doubt
pollution is a serious problem, yet both developed and developing countries
are tying to bring down pollution levels by using cleaner technologies. So there
is no need for pessimism that pollution will bring the doomsday nearer.
However, pollution can be reduced by a judicious choice of economic and
environmental policies and environmental investments. This is only possible
through economic growth rather than by zero economic growth, as the model
emphasizes.
6) Zero Economic Growth. The LTG report suggests a zero rate of economic
growth in order to stop the rise in the pollution level. Critics point out that if a
positive rate of growth will lead to doom, a zero rate will do the same but on a
smaller time table. Instead, they argue that economic growth, especially in the
developing countries, will provide more resources that can be used to reduced
pollution by supplying portable water, sanitation facilities, better housing
facilities and reducing congestion in urban centers. Moreover, economic
growth is the only hope for developing countries to bring people out of the
vicious circle of poverty and raise their standard of living. Thus the very idea
of zero rate of economic growth is fanciful.
7) Price system. The LTG model neglects the price system and the dynamics of the
market system. The model predicted that unlimited economic growth will lead
to the depletion of non-renewable resources. But resource optimist
economists do not agree with this view. According to them, as the scarcity of
resources increases, their prices will rise which will, in turn, affect
nonrenewable resources in different ways:
a) With the rise in prices, their direct consumption will decline
b) The use of high-price resources in production will fall by substituting
techniques that are less intensive in their use.
c) High prices of non-renewable resources will encourage the search for
new sources such as atomic energy for power generation.
d) Their high prices will provide incentives for the development of
substitutes for these resources through new technologies such as biogas for power and the series of experimentations currently taking place
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in the US on the countries over reliance on crude oil. Thus the
efficiency of the market mechanism seems to be one reason why the
gloomiest predictions for the depletion of non-renewable resources
have failed.
3.4
SUMMARY
3.5
SELF ASSESSMENT EXERCISES
1.
2.
3.
3.6
“The Harrod model of growth sees saving as a virtue in an inflationary
gap economy and a vice in an economy characterized with deflationary
gap”. Explain this statement.
Analyze the main thesis of the Limit to Growth Model.
Mention and explain the major criticisms labeled against the Limit to
Growth Model
REFERENCES
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
HENDERSON & POOLE (1991) – PRINCIPLES OF ECONOMICS,
Revised Edition, Virinda Publications (P) Ltd.
3.7
SUGGESTED READINGS
M. L. JHINGAN (2007) – MACRO ECONOMIC THEORY, 11TH Revised
Edition, Punjabi Publication, India.
M. L. JHINGAN (2005) – The Economics of Development and Planning 38TH
Revised and enlarged Edition, Punjabi Publication, India.
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SOLUTIONS TO EXERCISE
TOPIC 1
TOPIC 2
TOPIC 3
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TUTOR-MARKET ASSIGNMENT (TMA)
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