UNIVERSITY OF MAIDUGURI CENTRE FOR DISTANCE … 1-5/ECO 404.pdf · At the end of the course module,...

ECO 404 Macroeconomics II Units: 2

of 76

UNIVERSITY OF MAIDUGURICENTRE FOR DISTANCE LEARNING

ECO 404: Macroeconomics II (2 Units)

Course Facilitator: Dr. F. F. Ahmed


of 76

STUDY GUIDE

Course Code/ Title: ECO 404: Macroeconomics II

Credit Units: 2

Timing: 26hrs

Total hours of Study per each course material should be twenty Six

hours (26hrs) at two hours per week within a given semester.

You should plan your time table for study on the basis of two hours per

course throughout the week. This will apply to all course materials you

have. This implies that each course material will be studied for two

hours in a week.

Similarly, each study session should be timed at one hour including all

the activities under it. Do not rush on your time, utilize them adequately.

All activities should be timed from five minutes (5minutes) to ten

minutes (10minutes). Observe the time you spent for each activity,

whether you may need to add or subtract more minutes for the activity.

You should also take note of your speed of completing an activity for the

purpose of adjustment.

Meanwhile, you should observe the one hour allocated to a study

session. Find out whether this time is adequate or not. You may need to

add or subtract some minutes depending on your speed.

You may also need to allocate separate time for your self-assessment

questions out of the remaining minutes from the one hour or the one

hour which was not used out of the two hours that can be utilized for


of 76

your SAQ. You must be careful in utilizing your time. Your success

depends on good utilization of the time given; because time is money, do

not waste it.

Reading:

When you start reading the study session, you must not read it like a

novel. You should start by having a pen and paper for writing the main

points in the study session. You must also have dictionary for checking

terms and concepts that are not properly explained in the glossary.

Before writing the main points you must use pencil to underline those

main points in the text. Make the underlining neat and clear so that the

book is not spoiled for further usage.

Similarly, you should underline any term that you do not understand its

meaning and check for their meaning in the glossary. If those meanings

in the glossary are not enough for you, you can use your dictionary for

further explanations.

When you reach the box for activity, read the question(s) twice so that

you are sure of what the question ask you to do then you go back to the

in-text to locate the answers to the question. You must be brief in

answering those activities except when the question requires you to be

detailed.

In the same way you read the in-text question and in-text answer

carefully, making sure you understand them and locate them in the main

text. Furthermore before you attempt answering the (SAQ) be sure of


of 76

what the question wants you to do, then locate the answers in your in-

text carefully before you provide the answer.

Generally, the reading required you to be very careful, paying attention

to what you are reading, noting the major points and terms and concepts.

But when you are tired, worried and weak do not go into reading, wait

until you are relaxed and strong enough before you engage in reading

activities.

Bold Terms:

These are terms that are very important towards

comprehending/understanding the in-text read by you. The terms are

bolded or made darker in the sentence for you to identify them. When

you come across such terms check for the meaning at the back of your

book; under the heading glossary. If the meaning is not clear to you, you

can use your dictionary to get more clarifications about the

term/concept. Do not neglect any of the bold term in your reading

because they are essential tools for your understanding of the in-text.

Practice Exercises

a. Activity: Activity is provided in all the study sessions. Each

activity is to remind you of the immediate facts, points and major

informations you read in the in-text. In every study session there is

one or more activities provided for you to answer them. You must

be very careful in answering these activities because they provide

you with major facts of the text. You can have a separate note book


of 76

for the activities which can serve as summary of the texts. Do not

forget to timed yourself for each activity you answered.

b. In-text Questions and Answers: In-text questions and answers

are provided for you to remind you of major points or facts. To

every question, there is answer. So please note all the questions

and their answers, they will help you towards remembering the

major points in your reading.

c. Self Assessment Question: This part is one of the most essential

components of your study. It is meant to test your understanding of

what you studied so you must give adequate attention in answering

them. The remaining time from the two hours allocated for this

study session can be used in answering the self- assessment

question.

Before you start writing answers to any questions under SAQ, you

are expected to write down the major points related to the

particular question to be answered. Check those points you have

written in the in-text to ascertain that they are correct, after that

you can start explaining each point as your answer to the question.

When you have completed the explanation of each question, you

can now check at the back of your book, compare your answer to

the solutions provided by your course writer. Then try to grade

your effort sincerely and honestly to see your level of performance.


of 76

This procedure should be applied to all SAQ activities. Make sure

you are not in a hurry to finish but careful to do the right thing.

e-Tutors: The eTutors are dedicated online teachers that provide

services to students in all their programme of studies. They are expected

to be twenty- four hours online to receive and attend to students

Academic and Administrative questions which are vital to student’s

processes of their studies. For each programme, there will be two or

more e-tutors for effective attention to student’s enquiries.

Therefore, you are expected as a student to always contact your e-tutors

through their email addresses or phone numbers which are there in your

student hand book. Do not hesitate or waste time in contacting your e-

tutors when in doubt about your learning.

You must learn how to operate email, because e-mailing will give you

opportunity for getting better explanation at no cost.

In addition to your e-tutors, you can also contact your course facilitators

through their phone numbers and e-mails which are also in your

handbook for use. Your course facilitators can also resolve your

academic problems. Please utilize them effectively for your studies.

Continuous assessment

The continuous assessment exercise is limited to 30% of the total marks.

The medium of conducting continuous assessment may be through

online testing, Tutor Marked test or assignment. You may be required to

submit your test or assignment through your email. The continuous


of 76

assessment may be conducted more than once. You must make sure you

participate in all C.A processes for without doing your C.A you may not

pass your examination, so take note and be up to date.

Examination

All examinations shall be conducted at the University of Maiduguri

Centre for Distance Learning. Therefore all students must come to the

Centre for a period of one week for their examinations. Your preparation

for examination may require you to look for course mates so that you

form a group studies. The grouping or Networking studies will facilitate

your better understanding of what you studied.

Group studies can be formed in villages and township as long as you

have partners offering the same programme. Grouping and Social

Networking are better approaches to effective studies. Please find your

group.

You must prepare very well before the examination week. You must

engage in comprehensive studies. Revising your previous studies,

making brief summaries of all materials you read or from your first

summary on activities, in-text questions and answers, as well as on self

assessment questions that you provided solutions at first stage of studies.

When the examination week commences you can also go through your

brief summarizes each day for various the courses to remind you of main

points. When coming to examination hall, there are certain materials that

are prohibited for you to carry (i.e Bags, Cell phone, and any paper etc).


of 76

You will be checked before you are allowed to enter the hall. You must

also be well behaved throughout your examination period.


of 76

DEPARTMENT OF ECONOMICS UNIVERSITY OF MAIDUGURI

ECO 404

Dr. Funmilola Fausat Ahmed


of 76

GENERAL INTRODUCTION

This course, ECO 404 Advanced Macroeconomics II is a two-credit unit, one semester core

course designed for fourth year economics students in the Department of Economics at the

Centre for Distance Learning. This course guide is built on prerequisite knowledge (that is, some

fundamental bedrock that is expected to have been learnt in the previous levels vis-à-vis ECO

301), however, its simplicity will make the student assimilate faster and practice question at the

end of each unit will also prepare the student for the examination purposes. It also provides users

with some guidance on your tutor marked assignments (TMAs) as contained herein.

.


of 76

OBJECTIVES OF THE STUDY

At the end of the course module, the students are expected to:

Define capital.Explain different types of capital.Explain different types of modern capital.Discuss human capital theory.Explain the nature and definition of moneyDiscuss money and near moneyDistinguish between neutrality and non-neutrality of moneyExplain Irvin fisher's quantity theory of moneyHighlight the criticisms of fisher's theoryState the Cambridge equations: the cash balance approachCriticisms of cash balance approachDefine economic growthDiscuss Schumpeterian growth theoryDiscuss Marxian growth theoryDiscuss Classical growth theoryDiscuss Harrod-Domar growth modelDiscuss Neo-classical growth theoryExplain macroeconomic policiesDiscuss the effects of changes in fiscal policyDiscuss the Effects of changes in monetary policy


of 76

TABLE OF CONTENTS

PAGES

GENERAL INTRODUCTION

OBJECTIVES OF THE STUDY

STUDY SESSIONS:

1: CAPITAL THEORY

2: THEORIES OF MONEY, PRICE AND INTEREST

3: MODELS OF ECONOMIC GROWTH

4: MACROECONOMIC POLICES

5: OPTIMAL ALLOCATION OF RESOURCES


of 76

STUDY SESSION 1

CAPITAL THEORY

PAGES

INTRODUCTION

1.1 LEARNING OUTCOMES

1.2 IN-TEXT

1. DEFINTION OF CAPITAL

2. TYPES OF CAPITAL

3. MODERN TYPES OF CAPITAL

4. HUMAN CAPITAL THEORY

IN-TEXT QUESTIONS

IN-TEXT ANSWERS

1.3 ACTIVITY

1.4 SUMMARY

1.5 SELF ASSESSMENT QUESTIONS

1.6 REFERENCES

1.7 SUGGESTED READING


of 76

Study Session 1: Capital Theory

Introduction

This topic is aimed at introducing you to the subject matter of capital theory. You are

exposed to these definitions with the view of simplifying the basic concept, types of capital,

types of modern capital and human capital theory.

1.1. Learning Outcomes

At the end of this study session, you should be able to:

1. Define capital.

2. Explain different types of capital.

3. Explain different types of modern capital.

4. Discuss human capital theory.

BOLD TERMS

1.2. In-Text

1.2.1 Definition of Capital

Capital in economics ordinarily refers to physical capital, which consists of structures

and equipment used in business (machinery, factory equipment, computers and office equipment,

construction equipment, business vehicles, etc.). Up to a point increases in the amount of capital

per worker are an important cause of economic output growth. Capital is subject to diminishing

returns because of the amount that can be effectively invested and because of the growing burden

of depreciation.


of 76

In economics, capital goods, real capital, or capital assets are already-produced durable

goods or any non-financial asset that is used in production of goods or services.

Adam Smith defines capital as "That part of a man's stock which he expects to afford him

revenue". Capital is derived from the Latin word "caput" meaning head, as in "head of cattle".

The term "stock" is derived from the Old English word for stump or tree trunk. It has been used

to refer to all the moveable property of a farm since at least 1510. In Middle Ages France

contracted leases and loans bearing interest specified payment in heads of cattle.

How a capital good is maintained or returned to its pre-production state varies with the

type of capital involved. In most cases capital is replaced after a depreciation period as newer

forms of capital make continued use of current capital non profitable. It is also possible that

advances make an obsolete form of capital practical again.

Capital is distinct from land (or non-renewable resources) in that capital can be increased

by human labor. At any given moment in time, total physical capital may be referred to as the

capital stock (which is not to be confused with the capital stock of a business entity).

In a fundamental sense, capital consists of any produced thing that can enhance a person's

power to perform economically useful work—a stone or an arrow is capital for a caveman who

can use it as a hunting instrument, and roads are capital for inhabitants of a city. Capital is an

input in the production function. Homes and personal autos are not usually defined as capital but

as durable goods because they are not used in a production of saleable goods and services.

In Marxist political economy, capital is money used to buy something only in order to

sell it again to realize a financial profit. For Marx capital only exists within the process of


of 76

economic exchange—it is wealth that grows out of the process of circulation itself, and for Marx

it formed the basis of the economic system of capitalism. In more contemporary schools of

economics, this form of capital is generally referred to as "financial capital" and is distinguished

from "capital goods".

1.2.2. Types of Capital

Marxian economics distinguishes between different forms of Capital

constant capital, which refers to capital goods;

variable capital, which refers to labor-inputs, where the cost is "variable" based on the

amount of wages and salaries are paid throughout the duration of an employee's

contract/employment; and

fictitious capital, which refers to intangible representations or abstractions of physical

capital, such as stocks, bonds and securities (or "tradable paper claims to wealth")

Earlier illustrations often described capital as physical items, such as tools, buildings, and

vehicles that are used in the production process. Since at least the 1960s economists have

increasingly focused on broader forms of capital. For example, investment in skills and

education can be viewed as building up human capital or knowledge capital, and investments in

intellectual property can be viewed as building up intellectual capital. These terms lead to certain

questions and controversies discussed in those articles.


of 76

1.2.3. Types of Modern Capital

Detailed classifications of capital that have been used in various theoretical or applied

uses generally respect the following division:

Financial capital, which represents obligations, and is liquidated as money for trade, and

owned by legal entities. It is in the form of capital assets, traded in financial markets. Its

market value is not based on the historical accumulation of money invested but on the

perception by the market of its expected revenues and of the risk entailed.

Natural capital, which is inherent in ecologies and which increases the supply of human

wealth, e.g. trees.

Social capital, which in private enterprise is partly captured as goodwill or brand value,

but is a more general concept of inter-relationships between human beings having

money-like value that motivates actions in a similar fashion to paid compensation.

Instructional capital, defined originally in academia as that aspect of teaching and

knowledge transfer that is not inherent in individuals or social relationships but

transferrable. Various theories use names like knowledge or intellectual capital to

describe similar concepts but these are not strictly defined as in the academic definition

and have no widely agreed accounting treatment.

Human capital, a broad term that generally includes social, instructional and individual

human talent in combination. It is used in technical economics to define balanced growth

which is the goal of improving human capital as much as economic capital. A far less

common term, spiritual capital, refers to the power, influence and dispositions created by

a person or an organization’s spiritual belief, knowledge and practice, which is also an


of 76

aspect of human capital that may not be easily captured as a component social,

instructional or individual element.

1.2.4. Human Capital Theory

This is a modern extension of Adam Smith's explanation of wage differentials by the

so-called net (dis)advantages between different employments. The costs of learning the job

are a very important component of net advantage and have led economists such as Gary S.

Becker and Jacob Mincer to claim that, other things being equal, personal incomes vary

according to the amount of investment in human capital; that is, the education and training

undertaken by individuals or groups of workers. A further expectation is that widespread

investment in human capital creates in the labour-force the skill-base indispensable for

economic growth. The survival of the human-capital reservoir was said, for example, to

explain the rapid reconstruction achieved by the defeated powers of the Second World War.

Human capital arises out of any activity able to raise individual worker productivity. In

practice full-time education is, too readily, taken as the principal example. For workers,

investment in human capital involves both direct costs, and costs in foregone earnings.

Workers making the investment decisions compare the attractiveness of alternative future

income and consumption streams, some of which offer enhanced future income, in exchange

for higher present training costs and deferred consumption. Returns on societal investment in

human capital may in principle be calculated in an analogous way.

Even in economics, critics of human-capital theory point to the difficulty of measuring

key concepts, including future income and the central idea of human capital itself. Not all

investments in education guarantee an advance in productivity as judged by employers or the


of 76

market. In particular, there is the problem of measuring both worker productivity and the

future income attached to career openings, except in near-tautological fashion by reference to

actual earnings differences which the theory purports to explain. Empirical studies have

suggested that, though some of the observed variation in earnings is likely to be due to skills

learned, the proportion of unexplained variance is still high, and must be an attribute of the

imperfect structure and functioning of the labour-market, rather than of the productivities of

the individuals constituting the labour supply.

Human-capital theory has attracted much criticism from sociologists of education and

training. In the Marxist renaissance of the 1960s, it was attacked for legitimating so-called

bourgeois individualism, especially in the United States where the theory originated and

flourished. It was also accused of blaming individuals for the defects of the system, making

pseudo-capitalists out of workers, and fudging the real conflict of interest between the two.

However, even discounting these essentially political criticisms, human-capital theory can be

regarded as a species of rational-exchange theory and open to a standard critique, by

sociologists, of individualist explanations of economic phenomena.

ITQ

Explain types of modern capital.

ITA

Financial capital, which represents obligations, and is liquidated as money for trade, and

owned by legal entities. It is in the form of capital assets, traded in financial markets. Its


of 76

market value is not based on the historical accumulation of money invested but on the

perception by the market of its expected revenues and of the risk entailed.

Natural capital, which is inherent in ecologies and which increases the supply of human

wealth, e.g. trees.

Social capital, which in private enterprise is partly captured as goodwill or brand value,

but is a more general concept of inter-relationships between human beings having

money-like value that motivates actions in a similar fashion to paid compensation.

Instructional capital, defined originally in academia as that aspect of teaching and

knowledge transfer that is not inherent in individuals or social relationships but

transferrable. Various theories use names like knowledge or intellectual capital to

describe similar concepts but these are not strictly defined as in the academic definition

and have no widely agreed accounting treatment.

Human capital, a broad term that generally includes social, instructional and individual

human talent in combination. It is used in technical economics to define balanced growth

which is the goal of improving human capital as much as economic capital. A far less

common term, spiritual capital, refers to the power, influence and dispositions created by

a person or an organization’s spiritual belief, knowledge and practice, which is also an

aspect of human capital that may not be easily captured as a component social,

instructional or individual element.


of 76

1.3. Activity: Macroeconomics II

1. Explain human capital theory as proposed by Adam Smith.

1.4. Summary of Study Session 1

In this study session, you have learnt:

1. Definition of capital.

2. Different types of capital.

3. Different types of modern capital.

4. Human capital theory.

1.5. SAQ

SAQ (LO 1) Why is capital subject to diminishing returns

SAQ (LO 2) What is fictitious capital?

SAQ (LO 3) Define natural capital.

SAQ (LO 4) Human capital arises out of any activity able to raise individual worker ----------

1.6. References

Anyanwu, J.C. & Oaikhenan, H.E. (1995). Modern macroeconomics: Theory and

Applications in Nigeria. Joanee Educational Publishers Limited Onitsha- Nigeria

Dornbusch. R, Stanley, F. & Startz, R. (1985). Macroeconomics: Concepts, Theories

and Policies, McGraw-Hill, Book Company, New York.

Jhingan, M.L. (2005). The Economics of Development and Planning 38th Revised and

enlarged Edition, Punjabi Publication, India.


of 76

Jhingan, M.L. (2007). Macroeconomic theory, 11th Revised Edition, Punjabi

Publication, India.

http://www.economictheories.org/2008/11/j-s-mills-wages-fund-theory.html

"https://en.wikipedia.org/w/index.php?title=Classical_theory_of_growth_and_stagnation&oldid=719654983"

1.7. Suggested Reading

Parkin, M. (1982). Modern Macroeconomic, Prentice-Hall, Canada Inc, Ontario.

Shapiro, E. (1974). Macroeconomic Analysis, Third Edition. Harcourt Brace

Jovanovich, Inc. New York.


of 76

STUDY SESSION 1I

THEORIES OF MONEY, PRICE AND INTEREST

PAGES

INTRODUCTION


2.2 IN-TEXT

1. NATURE AND DEFINITION OF MONEY

2. MONEY AND NEAR MONEY

3. NEUTRALITY AND NON-NEUTRALITY OF MONEY

4. IRVIN FISHER'S QUANTITY THEORY OF MONEY

5. CRITICISMS OF FISHER'S THEORY

6. THE CAMBRIDGE EQUATIONS: THE CASH BALANCE APPROACH

7. CRITICISMS OF CASH BALANCE APPROACH

IN-TEXT QUESTIONS

IN-TEXT ANSWERS

2.3 ACTIVITY

2.4 SUMMARY


2.6 REFERENCES



of 76

Study Session 1I: Theories of Money, Price and Interest

Introduction

This study session is aimed at expanding your 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. You are

expected to know the original version of the quantity theory of money as developed by Irvin

Fisher and the Cambridge version as contained in the works of Marshall, Pigou, Robertson and

Keynes.



1. Explain the nature and definition of money

2. Discuss money and near money

3. Distinguish between neutrality and non-neutrality of money

4. Explain Irvin fisher's quantity theory of money

5. Highlight the criticisms of fisher's theory

6. State the Cambridge equations: the cash balance approach

7. Criticisms of cash balance approach

BOLD TERMS

2.2. In-Text

2.2.1 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


of 76

gold, cheques, coins, currency notes, bank drafts, ete. 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:

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 he 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.


of 76

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.

2.2.2. 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 no tic to the bank and incurring a

penalty. Before time deposits can be used as money they have to be converted into real money

that is, 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.

2.2.3. Neutrality and Non-neutrality of Money

One of the central analytical issues in macroeconomics is neutrality or non- neutrality 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.

2.2.4. Irvin Fisher's Quantity Theory of Money

The purchasing power of money is what represents the value of money.


of 76

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=l/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 + M1V1

Where: P = Price Level, l/P value of money

M = Total quantity of legal tender money

V = Velocity of circulation of M

M1 = Total quantity of credit money

V1 = Velocity of circulation of M'

T = Transactions performed by money.

The above equation equates the demand for money (PT) to supply of money (MV=

M1V1). The total volume of transactions multiplied by the price level (PI) represents the demand


of 76

for money. According to Fisher, PT = ∑PQ which means price level ‘p' times quantity purchased

'Q' by the community or society "I" 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 MY+ M1V1. This brings us to the equation of exchange PT = MV +

MIV1.

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 + M1V1)/T

According to Fisher the price level varies directly as the quantity of money (M1+M1) as

long as the volume of trade (T) and velocity of circulation V, V1) remain constant. This can be

clearly seen if we observe that doubling '1 and M' and holding V, VI and T constant and doubling

P also will reduce the value of money (l/P) to half. The following diagram explains Fishers

quantity theory of money more clearly.


of 76

Figure 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 450

In Figure 1, 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

P4

P2

P1

0

1/P

1/P2

1/P4

0

M1 M2 M4

Pef (M)

Panel A

Panel B


of 76

money is Ml, the value of money is 1/P. Doubling the quantity of money to M2 bring the value

of money to one-half (1 2) of what it was previously, that is, 1/P2. When the (quantity of money

further increases to M-t the value of money reduced to l/p4. This inverse relationship between

the quantity of money and the value of money is shown by downward sloping curve 1/ P = f (M)

Assumptions of Fishers Theory

i) P is passive in the equation of expression of exchange though other factors are active.

ii) Constancy of proportion of MI to M.

iii) Both V and V1 are assumed to be constant and independent of changes in M1and M.

iv) T also is constant and independent of M' to M, VI to V.

v) Demand for money is proportional to the value of transactions.

vi) Supply of money 1S exogenously determined and constant.

vii) The theory is applicable in the long run

viii) The theory is based on assumption of full employment I the economy.

2.2.5. Criticisms of Fisher's Theory

1) It is a truism. This is maintained by Keynes. But it cannot 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.


of 76

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 cannot 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.

2.2.6. 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 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 hold: 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 the real money income (PY) that people hold in cash and

demand deposits. .


of 76

p = the price level

y = the aggregate real income

Therefore,

P=M/KY,

And the value of money l/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 (l-C)}

Where ‘C' is the proportion of real income actually held by the community in legal tender

including coins, (l-C) is the proportion kept in banknotes and bank balances, and 'h' is the

proportion of actual legal tender that bankers keep against the notes and balances held by their

customers.


of 76

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:

Figure 2: Demand and Supply curve for Money

From the above we can see that the demand curve for money has a unitary elasticity. DDl

is the demand curve for money, Q1Ml, 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 OPl 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

OMl to OM3, the value of money is reduced exactly by one-third from OPl to OP3.

P1

P2

P3

0

M1 M2 M3

MD & MS

Q1

Q2

Q3

D

D1


of 76

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:

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:


of 76

n= pk

If 'K' is constant, a proportionate increase in en' (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 + rk1)

If 'k', k1 and r ate 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 (r) 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 en' and 'r'. It is also possible to regulate bank deposits

'k" by appropriate changes in the bank rate. So ‘p’ can be controlled by making appropriate

changes in ‘n’, ‘r’ and ‘k1’ so as to offset changes in ‘k’

2.2.7. 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 other factors

6) K and Y are not constant

7) The equation has failed to explain dynamic behavior of prices

8) Neglected the influence of interest rate

9) Demand for money is not interest elastic


of 76

10) Neglect of goods market

11) Neglect of real balance effect

12) Elasticity of money is not unity

13) Neglect of speculative demand for money

ITQ

List the assumptions of Fisher’s Theory

ITA











1.Discuss briefly Robertson's Equation

2.4. Summary of Study Session 1I


1. Nature and definition of money


of 76

2. Money and near money

3. Neutrality and non-neutrality of money

4. Irvin fisher's quantity theory of money

5. Criticisms of fisher's theory

6. Cambridge equations: the cash balance approach

7. Criticisms of cash balance approach

2.5. SAQ

SAQ (LO 1) Define money

SAQ (LO 2) Give examples of near money

SAQ (LO 3) When is money neutral?

SAQ (LO 4) The purchasing power of money is what represents the ------ of money

SAQ (LO 5) V cannot be said to be constant in real life situation. True or False

SAQ (LO 6) What is the determinant of value of money?

2.6. References








Publication, India.


of 76





"https://en.wikipedia.org/w/index.php?title=Price&oldid=735741756"


of 76

STUDY SESSION 1II

MODELS OF ECONOMIC GROWTH

PAGES

INTRODUCTION


3.2 IN-TEXT

1. CONCEPT OF ECONOMIC GROWTH

2. THE SCHUMPETERIAN GROWTH THEORY

3. THE MARXIAN GROWTH THEORY

4. THE CLASSICAL GROWTH THEORY

5. THE HARROD-DOMAR GROWTH MODEL

6. THE NEOCLASSICAL GROWTH THEORY

IN-TEXT QUESTIONS

IN-TEXT ANSWERS

3.3 ACTIVITY

3.4 SUMMARY


3.6 REFERENCES



of 76

Study Session 1II: Models of Economic Growth

Introduction

There are several theories or models of various aspects of economic growth and

development process. These models have at all times being the basis of policies aimed at helping

the development processes along. Our sole aim is to reveal these intellectual theories provided by

different scholars in the aspect of economic growth and development.

Although economic growth has been identified as one of the key macroeconomic goals of

society, issues of growth did not assume a dimension of prominence until the mid thirties. Two

events largely account for the outburst of interest in issues of growth. The first was the

publication of Keynes’ General Theory of Employment, Interest and Money in 1936, who

viewed deficiency in aggregate demand as the key factor to economy’s stagnation. The second

was the struggle to overcome the devastating effect of the World War II on war ravaged

economies. Interest in growth issues subsequently led to development of various theories of

growth each purporting to explain the mechanism growth each purporting to explain the

mechanics of growth.



1. Define economic growth

2. Discuss Schumpeterian growth theory

3. Discuss Marxian growth theory

4. Discuss Classical growth theory

5. Discuss Harrod-Domar growth model

6. Discuss Neo-classical growth theory


of 76

BOLD TERMS

3.2. In-Text

3.2.1 Economic Growth

Economic growth is the increase in the inflation-adjusted market value of the goods and

services produced by an economy over time. It is conventionally measured as the percent rate of

increase in real gross domestic product, or real GDP, usually in per capita terms. Growth is

usually calculated in real terms – i.e., inflation-adjusted terms – to eliminate the distorting effect

of inflation on the price of goods produced. Measurement of economic growth uses national

income accounting. Since economic growth is measured as the annual percent change of gross

domestic product (GDP), it has all the advantages and drawbacks of that measure.

In economics, "economic growth" or "economic growth theory" typically refers to grow

potential output, i.e., production at "full employment", as opposed to the study of economic

fluctuations around a long term trend.

An increase in growth caused by more efficient use of inputs (such as labor, physical

capital, energy or materials) is referred to as intensive growth. GDP growth caused only by

increases in the amount of inputs available for use (increased population, new territory) is called

extensive growth.

Measuring Economic Growth

Gross Domestic Product


of 76

Economic growth is generally calculated from data on GDP and population provided by

countries' statistical agencies, although independent scholarly estimates are also available.

Determinants of per capita GDP growth

In national income accounting, per capita output can be calculated using the following

factors: output per unit of labor input (labor productivity), hours worked (intensity), the

percentage of the working age population actually working (participation rate) and the

proportion of the working-age population to the total population (demography). "The rate of

change of GDP/population is the sum of the rates of change of these four variables plus their

cross products."

Productivity

Increases in labor productivity (the ratio of the value of output to labor input) have

historically been the most important source of real per capita economic growth. "In a famous

estimate, MIT Professor Robert Solow concluded that technological progress has accounted for

80 percent of the long-term rise in U.S. per capita income, with increased investment in capital

explaining only the remaining 20 percent."

(Note: There are various measures of productivity. The term used here applies to a broad

measure of productivity. By contrast, Total factor productivity (TFP) growth measures the

change in total output relative to the change capital and labor inputs. Many of the cited

references use TFP.) Increases in productivity lower the real cost of goods. Over the 20th century

the real price of many goods fell by over 90%.


of 76

Intensity (hours worked)

As a result of productivity the work week declined considerably over the 19th century.[39]

By the 1920s the average work week in the U.S. was 49 hours, but the work week was reduced to

40 hours (after which overtime premium was applied) as part of the National Industrial Recovery

Act of 1933.

Demographic changes

Demographic factors may influence growth by changing the employment to population

ratio and the labor force participation rate. Industrialization creates a demographic transition in

which birth rates decline and the average age of the population increases.

Women with fewer children and better access market employment tend to join the labor force in

higher percentages. There is a reduced demand for child labor and children spend more years in

school. The increase in the percentage of women in the labor force in the U.S. contributed to

economic growth, as did the entrance of the baby boomers into the work force.

Other Factors affecting Growth

Political institutions, property rights, and rule of law

“As institutions influence behavior and incentives in real life, they forge the success or failure of

nations.”

In economics and economic history, the transition to capitalism from earlier economic systems

was enabled by the adoption of government policies that facilitated commerce and gave

individuals more personal and economic freedom. These included new laws favorable to the


of 76

establishment of business, including contract law and laws providing for the protection of private

property, and the abolishment of anti-usury laws, When property rights are less certain,

transaction costs can increase, hindering economic development. Enforcement of contractual

rights is necessary for economic development because it determines the rate and direction of

investments. When the rule of law is absent or weak, the enforcement of property rights depends

on threats of violence, which causes bias against new firms because they cannot demonstrate

reliability to their customers.

In many poor and developing countries much land and housing is held outside the formal

or legal property ownership registration system. Much unregistered property is held in informal

form through various property associations and other arrangements. Reasons for extra-legal

ownership include excessive bureaucratic red tape in buying property and building. In some

countries it can take over 200 steps and up to 14 years to build on government land. Other causes

of extra-legal property are failures to notarize transaction documents or having documents

notarized but failing to have them recorded with the official agency.

Not having clear legal title to property limits its potential to be used as collateral to secure

loans, depriving many poor countries one of their most important potential sources of capital.

Unregistered businesses and lack of accepted accounting methods are other factors that limit

potential capital.

Businesses and individuals participating in unreported business activity and owners of

unregistered property face costs such as bribes and pay-offs that offset much of any taxes

avoided.


of 76

New products and services

Another major cause of economic growth is the introduction of new products and

services and the improvement of existing products. New products create demand, which is

necessary to offset the decline in employment that occurs through labor saving technology.

Growth phases and sector shares

Economic growth in the U.S. and other developed countries went through phases that affected

growth through changes in the labor force participation rate and the relative sizes of economic

sectors. The transition from an agricultural economy to manufacturing increased the size of the

high output per hour, high productivity growth manufacturing sector while reducing the size of

the lower output per hour, lower productivity growth agricultural sector. Eventually high

productivity growth in manufacturing reduced the sector size as prices fell and employment

shrank relative to other sectors. The service and government sectors, where output per hour and

productivity growth is very low, saw increases in share of the economy and employment during

the 1990s. The public sector has since contracted, while the service economy expanded in the

2000s.

3.2.2 Schumpeterian Growth Theory

Schumpeter appears to provide an answer to the problem raised by Keynes theory

through the very significant role he gives to the innovator or the entrepreneur. Instead of the

business minds expectation, Schumpeter talks about the innovator who undertakes new

combination of factors of production. This combination opens the way for profits in a statutory

state or during a down turn which then leads to an upswing. Also, instead of Keynes propensity


of 76

to save, Schumpeter holds that, the innovator/entrepreneurs secures the fund for his investment

from the banking sector - and the inflationary process which result from this, forced people to

save and higher capital accumulation is obtained. Instead of the propensity to consume, he

assumed that changes in taste are brought by the action of the entrepreneur, the lack of real

resources endangered by the inflationary process, the destructive competition that followed the

upswing or boom, the repayment of bank loan and the effects which the cessation of innovative

activity has on secondary investment, all combined to bring about the down turn. Schumpeter

believes that the economic system is full of uncertainties and risks that is inevitably discontinues

or moves in a speed.

This theory has won great admiration from economists, but the conclusions are not

generally accepted. The criticism is that, there are no longer innovators of the types assumed by

Schumpeter - there are instead large business units whose innovative activities and motivations

are not distinguishable from the ordinary business activities. Also view from the developing

countries point of view, Schumpeter type of innovation is strictly the type from the developed

world. Even if it exists in a developing country, its effects will be limited because of competition

from the developed countries. This considerably lessens the dynamism ascribed to innovation by

Schumpeter. In addition, large business units more easily absorb changes in economic

environment and plan for adjustment alone, therefore cannot explain the causes of down turn.

It should be noted however, that, Schumpeter emphasis on innovator and innovations is

very important in the consideration of factors responsible for economic growth. Equally

important is his idea that sources of investible funds is not just personal or corporate savings but

the banking system.


of 76

3.2.3. The Marxian Theory of Growth

One of the historical theories of economic growth, the Marxian theory of growth is

admixture of reasoning proceeding from economics and sociological perspectives. It proceeds by

viewing growth as a process of continue transformation of the society and social function and

political life. Such transformation can be traced to the society mode of production as well as the

property rights of the society, economic power and prestige seeking class. Marxian growth

theory asserts that growth is dependent on the rate of accumulation of labour surplus value by the

capitalists’ class, labour surplus value being the rate of profit in excess of labour’s true

remuneration which has however, been expropriated from the workers by their factors owners

(the capitalists). Thus, the Marxian theory of growth attributes growth to labour surplus value

which is the difference between subsistence wages paid to workers and the true value of labour

output, It is this difference that constitutes the sources of investible fund necessary to foster

economic growth. Therefore, the larger this difference is, the more rapid growth is expected to

be. However, the Marxian theory of growth points at the possibility of the eventual collapse of

the capitalist systems resulting from the intensification of the clash between the expropriators

and the expropriated.

3.2.4. The Classical Theory of Economic Growth and Development

Without doubt the best known name in economics is Adam Smith. His monumental work

- An Inquiry into Nature and the Causes of the Wealth of Nations (1776) has had tremendous

influences on scholars and policymakers alike. As the title of the book indicates, Smith was

mainly concerned with the problem of economic development. He wanted to discover how

economic growth came about and what factors impede it. It is interesting to know that no single

compressive theory of growth and development has emerged that has superseded the original


of 76

work by Smith. In his work, which most economists view as marking the beginning of the

Classical economics, Smith sets forth the Classical principles of economic development. These

principles are anchored on a governmental policy of laissez-faire. The principle of division of

labour and the increase productivity brought on by the division of labour but limited only by the

extent of the market. As a result, free trade was advocated as a way to promote this division of

labour by exploiting each nation’s comparative advantage in production.

Recention actions by less developed countries and policies advocated by some developed

economies are at odds with this laissez-faire principle. Their argument is that government must

direct the development process. Many of these opinions grew out of the experience of the 1930s

and the 1940s when Soviet Union was able to grow very rapidly by applying severe authoritarian

development techniques - as a result of this, the Soviet Union development process was very

successful given room for economies from the underdeveloped world to attack the laissez-faire

principles. They began to argue that “no policy of economic development can be carried out

unless the government has the capacity to adhere to it…” Quite often however, democratic

government loses touch and determination in the face of opposition. This is the dilemma of most

democratic government. It is here that Soviet countries have an immense advantage; their

totalitarian structure shields the government from rigorous and reactionary judgment of the

electorates.

The Classical theory can be summarized as follows:

a) Laissez-faire Policy: The classical economics believes in the existence of an automatic

free market which is an economy free from government interference. It is the invisible

hand doctrine commonly associated with Adam smith which maximizes the material

income.


of 76

b) Capital accumulation. Capital accumulation was accepted as the key to economic

progress. All classicists regarded capital accumulation as the only way to economic

prosperity and by extension to political leaderships. They therefore, lay emphasis on large

saving.

c) Profits as an incentive to investment. Profits induce investment, the larger the profit the

larger the capital accumulation and investment.

Criticism of the Classical Theory of Growth

The simple and abstract classical theory of development is not free from criticism

i. Neglect of the public sector. To the classicists, the perfect competition and the

institution of the private sector were essentially prerequisite for economic

development. They have however, failed to realize the important of the public

sector in accelerating capital accumulation, so preached by the classical.

ii. They ignore the middle class. The whole classical analysis was based on socio

economic environment prevailing in Britain and certain part of Europe. It

assumed the existence of a rapid division of society between the capitalists and

the proletariat or labourers. It neglected the whole of middle class which provides

the necessary impetus to economic growth. It did not occur to the classical that

the major source of saving in an advanced society was the income receive and not

the property owners.

iii. Unrealistic growth process. The classical theory assumed a stationary stage in

which there was no change, but havoured around a point of equilibrium, even


of 76

where there was disturbances, such was transition and temporary and can be

restored through the automatic device.

3.2.5. The Harrod-Domar Growth Model

The model is a product of two scholars: Professor Roy Harrod of Britain (1939) and

Evsey Dommar of USA (1946). It is actually a growth theory and it emphasizes one of the

components of the big-push - capital which has always been considered important for economic

development. The source of capital is mainly saving consequently, in order to achieve economic

development; saving or capital formulation must increase over a period of time. This of course

should result in relative decrease in consumption which in turn is necessary if rapid economic

growth is to be achieved. A key objective of the Harrod-Domar Model is to overcome the

limitation inherent in the short-run nature of the simple Keynesian model. This model takes

cognizance of only one of the dual roles of investment in the economy, its role as a component of

aggregate demand. However, the dual role of investment as (1) a component of aggregate

demand and (2) as an addition to the stock of productive resources must be accommodated in any

long-run analysis for it to be meaningful. This is because net investment has both a demand and

supply effect.

The Harrod-Domar model is based on a number of simplified assumptions which include:

i. A closed economy with no foreign sector

ii. Homogeneity of labour that grows at a constant natural rate.

iii. Two factor inputs, labour and capital only exist in the economy with absence of

technical progress.


of 76

iv. Output increases (decreases) by the same proportion of input increases

(decreases). This is the assumption of constant returns to scale.

v. The production function is of the Leontief type characterized by fixed factor

proportions with L shaped isoquant.

vi. A Constant-Capital-Output-Ratio: The model assumes a constant capital output

ratio. It implies a production function with constant capital output coefficients.

Simply put, Harrod-Domar model assumes that national income is proportional to

the stock of capital.

Y = kK, (k > 0)………………………………… (1)

Where

Y = national output

K = total output for capital

k = output capital ratio

Since output-capital-ratio is assumed to be constant, any increase in national

output (ΔY) must be equal to k time’s ΔK, i.e.

ΔY = kΔK.. ………………………………………… (2)

It follows from equation (2) that the growth of national output per time unit depends on

and is limited by the growth of capital stock per time unit. If an economy is in equilibrium and

the existing stock of capital is fully employed, their capital output (K) can easily worked out.

Once k is known, then additional capital required for producing a given additional output can be

easily worked out by using equation (2). Since increase in capital stock (ΔK) in any given period

equals net investment (I) of that period, equation (2) may be written as:

ΔY = kI ………………………………………… (3)


of 76

vii. A Constant-Saving-Income-Ratio: It assumes that society saves a constant

proportion of the national income. i.e, total savings (S) is a function of income, Y

and the avings function can be written as:

S = s(Y) (s > o ) …………………………………… (4)

Where S = savings

s = constant propensity to save.

At equilibrium level of output, the desired savings must be equal to the desired

Investment, that is,

S = I = sY ……………………………………… (5)

Given the assumptions, the growth rate defined as ΔY/Y may be obtained as

follows:

ΔY/Y =Yt – Yt-1)/Yt

Where:

Yt-1 = national output in period t – 1

Yt = national output in period t

It may be infer from equation (6.3) that in period t,

ΔYt = kIt ………………………………………… (6)

By substitution, equation (6.6) may be written as:

Yt - Yt-1 = k. s Yt ………………………………… (7)

Equation (5) tells us that the Harrod-Domar model assumes that at equilibrium in

period t, It = St = Yt By substituting sYt for It in equation (7) we get:

Yt - Yt-1 = k. s Yt ………………………………… (8)


of 76

By dividing equation (8) by Yt, we get the growth rate ΔY/Y or what Harrod

calls the warranted growth rate Gw as:

Gw = Yt – Yt-1/Yt = ΔY/Y = k.s …………………… (9)

Where Gw is the warranted growth rate

Equation (9) shows that the rate of growth equals the output-capital-ratio times the

constant propensity to save. Since growth rate pertains to the condition that I = S, this may also

be called equilibrium growth rate which implies capacity utilization of capital. This growth rate

fulfilled the expectations of the entrepreneur. Therefore, this growth rate has been termed as

warranted growth rate.

Harrod-Domar defines Gw as that rate of growth which if it occurs, will leave all parties

satisfied that they have produced neither more nor less than the right amount. According to the

Harrod-Domar model, a target growth rate can be attained either by increasing the marginal

propensity to save and increasing simultaneously the stock of capital or by increasing the output-

capital-ratio.

Capital Accumulation and Labor Employment under Harrod Domar Model

We have so far discussed the Harrod-Domar model of growth with respect to only one

aspect of the model i.e. capital accumulation and growth. We now discuss another important

aspect of the model i.e. employment of labuor. In the Harrod-Domar model, labour can be

introduced to the model under the following assumptions:

1. That labour and capital are perfect compliment instead of being substitute for

one another.

2. And that capital-labor ratio is constant.


of 76

Under these assumptions, given the capital-labor-output-ratio, economic growth can take place

only so long as the potential labour force is not fully employed. This implies that a potential

labour supply imposes a limit to economic growth at the full employment level. This means:

(i). that growth rate will take place beyond the full employment only if supply of

labour increases.

(ii). that actual growth rate will be equal to a warranted growth rate (Gw) only if growth

of labor force equals the warranted growth rate (Gw). If labor force increases at a lower rate, the

only way to maintain the growth rate is to introduce the labor-saving technology. Under this

condition the long-term growth rate will depend on:

a. growth rate of Labour force ( ΔL/L)

b. the rate of progress in Labour-Saving technology

Thus the maximum growth rate that can be sustain in the long run will be equal to ΔL/L plus a

factor n i.e the rate at which capital substitute labour. Harrod calls this growth, the natural

growth rate (GN).

GN = ΔL/L + n …………………………………… (10)

Criticisms of Harrod-Domar Model

Harrod-Domar model was formulated primarily to protect the developed countries from

chronic unemployment, and was not meant for developing countries.

Most less developed countries lack sound financial system and therefore, increased

saving by households does not necessarily mean there will be greater funds available for firms to

borrow for invest.

Improving capital/output ratio is difficult to achieve in developing countries this is often

due to a poorly educated work force. New capital is often inefficiently used by labour.


of 76

Increasing the savings ratio in developing countries is not always easy. Majority of these

developing countries have low marginal propensities to save and low income.

Research and Development needed to improve the capital/output ratio is often

underfunded in developing countries.

The model fails to address the nature of unemployment which exists in different

countries. In developed countries, the unemployment is ‘cyclical unemployment’, which is due

to insufficient effective demand; whereas in developing countries, there is high level of

‘disguised unemployment’ in the urban informal sector and rural agricultural sector.

Finally, the model failed to recognise the effect of government programs on economic

growth.

Importance and Limitations of the Harrod Domar Model

Importance

The Harrod-Domar model like we have been taught was formulated to maintain the

steady growth rate in developed economies of the world and not to address the problem of

vicious cycle faced by the developing countries. Be that as it may, the model could still be used

to aid in analysing the growth process in less developed countries. The importance of this model

to the developing countries is explained below.

The Harrods-Domar models are based on three principal concepts: the saving function,

autonomous vs. induced investment, and the productivity of capital. These concepts were

primarily developed in order to illuminate secular stagnation that was threatening the advanced

economies in the post-war period. The models show us the rate at which the economy must grow

if it is to make full use of the capacity create by new investment and it gave a projection of


of 76

capital-output ratio of between 2.5 and 5, this rate can also be applied in less developed

countries.

Limitations

1. Unrealistic assumptions: The Harrod-Domar propositions that savings will always

increase to match with investment need is based on the assumption that the warranted growth

rate is equal to the actual growth rate. This is possible only under the following simplified

assumption of the model.

i. MPC remains constant

ii. Output capital ratio (k) is constant

iii. The technology of production is given

iv. The economy is initially in equilibrium

v. There is no government expenditure and no foreign trade

vi. There are no lags in adjustment between

a. demand and supply

b. savings and investment

Since these assumptions make the modern economy unrealistic, the warranted or expected

growth rate may not always be equal to the actual or realized growth rate. And if warranted and

actual growth rate are not equal there will be economic instability.

2. Another major defect of the model is that the parameters used namely: capital output

ratio, marginal propensity to save, growth rate of labour force, progress rate of labour saving

technology are all determined independently out of the model. The model therefore, does not

ensure the equilibrium growth rate in the long run. Even the slightest change in the

parameters will make the economy deviate from the path of equilibrium.


of 76

In spite of these limitations, the Harrod-Domar model had been used in development

planning of many countries. Besides, it has a great analytical power. One key policy implications

of the Harrod-Domar model is that the growth rate of the economy can be influenced by policy

markers by tinkering with components of the warranted growth rate. This means that by

designing policies to influence the saving rate or enacting policies to reduce the output-capital-

ratio say, by investment in human capital, productivity of capital can be increased hence the

growth rate of the economy can be considered a policy variable.

3.2.6. The Neoclassical Growth Model

In one sense, neoclassical growth theory stands at an opposite extreme from Harrod-

Domar. In place of the Harrod-Domar assumption of a single production process that imposes a

fixed ratio between capital and labour is the assumption of an indefinitely large number of

production processes, one shading off from another in a way that permits any combination of

labour and capital to be employed. Capital is thus regarded as a unique, abstract agent of

production that can be adjusted at any time to absorb into employment a labor force of any size.

With the combination of labour and capital capable of varying in this way, it follows that, instead

of the fixed ratio between output and capital employed by Harrod-Domar, the output capital ratio

is also capable of varying continuously. Thus, the larger the labour force absorbed into

employment with a given stock of capital, the greater will be the output capital ratio, or the

productivity of capital and the smaller will be the output-labour ratio or the productivity of

capital and the higher the productivity of labour. These results follow simply as a matter of

diminishing returns.

In order to explain the model, it begins by pointing out the differences and similarities

between the assumptions of the Harrod-Domar and Classical growth models.


of 76

1. While the production function implicitly in the Harrod-Domar model contains

only one factor i.e. capital, the neoclassical growth model assumes a multifactor

production function including capital, labor and technology.

2. In the Harrod Domar, labour and capital are deemed to be perfect complement

of one another where as in the Neoclassical model, capital and labour are

assumed to be substitute for one another.

3. While Harrod-Domar model assumes a constant capital output ratio, the

neoclassical model assumes a variable capital output coefficient. Incidentally,

both models assume that capital and labor are subject to the law of diminishing

marginal returns to scale.

4. In addition, the neoclassical model assumes perfect competition where factor

prices equal their marginal revenue productivity.

According to the neo-classical model, rate of economic growth depends on growth rate of:

- Capital, K;

- Labour supply, and

- Technological progress over time, T.

The relationship between the national output and these variables maybe expressed in the

form of a production function i.e:

Y = f (K, L, T) ………………………………………… (11)

Where:

Y= national output

L = Labour supply

K = stock of capital


of 76

T = the scale of technological progress

If technology assumes to remain constant for the sake of simplicity, then the growth rate

depends on K and L. The production function then takes the following form:

Y = f ( K, L ) ………………………………………… (12)

Given the assumption of constant returns to scale, if the increase in L is not very great in

the period in question, the increase in Y will be approximately equal to the increase in L times

the marginal physical product of L, or ΔY = MPPL. ΔL in which MPPL is the marginal physical

product of labour or the increase in Y that accompanies a unit increase in L with K held constant.

If we had assumed an increase in K with no change in L, under the same assumptions, we would

have had ΔY = MPPK.ΔK in which MPPK is the marginal physical product of capital or the

increase in K with L held constant. Finally, for changes in both K and L in a given time period

we may write:

ΔY = MPPK.ΔK + MPPL.ΔL ………………………… (13)

Dividing both sides by Y, we have:

ΔY/Y = (MPPK)/Y.ΔK + (MPPL)/Y.ΔL

This may also be written as:

ΔY/Y = (MPPK/Y.K)ΔK/K + (MPPL/Y.L) ΔL/L ………… (14)

If we recall the assumption noted earlier of perfect competition markets and now adopt

the marginal productivity theory of factor pricing, each unit of a factor will be paid its marginal

product, and the total earnings of capital and Labour will equal to MPPK.K and MPPL.L

respectively. Given that factors are paid their marginal products, the total earnings of capital and

labour will exactly absorb the total output in the case of the present production functions with

constant returns to scale that is:


of 76

MPPK.K + MPPL.L = Y………………………………… (15)

Since:

MPPK.K/Y + MPPL.L/Y = Y/Y = 1………………………… (16),

We may substitute b for the first term on the left and (1 – b) for the second term and rewrite

equation (6.14) in the following form:

ΔY/Y = b (ΔK/K) + (1-b) (ΔL/L) ………………………… (17)

The magnitude of b indicates the proportion of the total product or of total income that would be

received as a return on capital if capital were paid its marginal product. This is the same as

saying that b measures the elasticity of output with respect to changes in the amount of capital

used. The same kind of statement may of course be made for labour by making the appropriate

substitutions in the second preceding sentence.

Assuming a value for b = 0.25, we may read from equation (17) the percentage change in

output that will follow from a given percentage change in capital, labor or both. If both K and L

rise by 3 percent, output also rises by 3 percent, for the underlying production function is one

with constant returns to scale. In this case, we have:

ΔY/Y = 0.25 X 3 + 0.75 X 3 = 3

Like the Harrod-Domar model, the neoclassical growth model implies that the path and peed of

an economy’s growth are endogenous policy variables that are within the ambit of policy

makers.

ITQ

Explain the criticism of classical growth theory


of 76

ITA

i. Neglect of the public sector. To the classicists, the perfect competition and the

institution of the private sector were essentially prerequisite for economic

development. They have however, failed to realize the important of the public

sector in accelerating capital accumulation, so preached by the classical.

ii. They ignore the middle class. The whole classical analysis was based on socio

economic environment prevailing in Britain and certain part of Europe. It

assumed the existence of a rapid division of society between the capitalists and

the proletariat or labourers. It neglected the whole of middle class which provides

the necessary impetus to economic growth. It did not occur to the classical that

the major source of saving in an advanced society was the income receive and not

the property owners.

iii. Unrealistic growth process. The classical theory assumed a stationary stage in

which there was no change, but havoured around a point of equilibrium, even

where there was disturbances, such was transition and temporary and can be

restored through the automatic device.


1. Using the concept of the Harrod-Domar model, explain the barriers to growth that may be

faced by developing countries.

3.4. Summary of Study Session 1I


1. Schumpeterian growth theory


of 76

2. Marxian growth theory

3. Classical growth theory

4. Harrod-Domar growth model

5. Neo-classical growth theory

3.5. SAQ

SAQ (LO 1) What is economic growth?

SAQ (LO 2) State one of the believes of Schumpeter’s theory of growth.

SAQ (LO 3) How does Marx view growth?

SAQ (LO 4) All classicists regarded capital accumulation as the only way to economic

prosperity and by extension to political leaderships. True or False

SAQ (LO 5) Homogeneity of labour that grows at a constant natural rate. True or False

SAQ (LO 6) According to the neo-classical model, rate of economic growth depends on growth

rate of population. True or False

3.6. References


Jhingan, M. L. (2007). The Economics of Development and Planning.

(39th ed.). Delhi: Vrinda Publications (P) Ltd.

Olajide, O. T. (2004). Theories of Economic Development and Planning.

Lagos: Pumark Nigeria Ltd.


Todaro, M. P. & Smith, S. C. (2011). Economic Development. (11th ed.). England:

Pearson Education Ltd.


of 76

www.preservearticles.com/..../what-are-the uses-of-harrod-domar model.

Accessed on the 4/9/2016

en.wikipedia.org/wiki/Harrod–Domar_model . Accessed on the 4/9/2016

http://www.econlib.org/library/Enc/bios/Harrod.html. Accessed on the

4/9/2016


of 76

STUDY SESSION 1V

MACROECONOMIC POLICIES AND OPTIMAL ALLOCATION OF

RESOURCES

PAGES

INTRODUCTION


4.2 IN-TEXT

1. MACROECONOMIC POLICIES

2. EFFECTS OF CHANGES IN FISCAL POLICY

3. EFFECTS OF CHANGES IN MONETARY POLICY

IN-TEXT QUESTIONS

IN-TEXT ANSWERS

4.3 ACTIVITY

4.4 SUMMARY


4.6 ` REFERENCES



of 76

Study Session 1V: Macroeconomic Policies and Optimal Allocation of

Resources

Introduction

This study session is aimed at expanding your knowledge on macroeconomic policies and

optimal allocation of resources in an economy. Also, the effects individual policies on economic

growth was considered.



1. Explain macroeconomic policies

2. Discuss the effects of changes in fiscal policy

3. Discuss the Effects of changes in monetary policy

BOLD TERMS

4.2. In-Text

4.2.1 Macroeconomic Policies

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.


of 76

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 IS LM 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.

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:

Figure 3: Economy's Aggregate Demand Curve

DP

PO

OYO Y

D


of 76

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:

Figure 4: 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) + key)

The supply side combines a production function and labour market equilibrium condition thus:

P1

P

PO

P

OY0 Y1 Y

S

P S


of 76

Production function: y = y(N, K)

Labour market: P.f(N) = pe.g (N) = p(P).g(N)

Where:

y = supply of output i = investment

r = interest rate g = growth rate

N = employment P = price level

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 3 and 4 can be brought together in a form of IS-LM curve to portray

the equilibrium level of income as shown below.

Figure 5: Economy's Equilibrium Level of Income

r

re

0 Ye Y

IS

LM

E


of 76

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 r, 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.

4.2.2. Effects of Changes in Fiscal Policy

An increase in government spending generally, or a tax cut will shift the IS curve

from 1S1 to IS2, implying a higher level of income (Y1 to Y2) and a higher interest rate (r1 to r2)

as shown in Figure 6.

r

r2

0 Y2Y1

r1

LM

S2

Y

S1


of 76

Figure 6: 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.

4.2.3. 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 as shown in Figure 7.

Figure 7: 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

r

r2

0 Y2

LM1

r1

Y1 Y

S2

LM2


of 76

therefore will give rise to the highest possible expansion in income and leaving 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?

ITQ

List the assumptions of Fisher’s Theory

ITA











of 76


1. 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

4.4. Summary of Study Session 1V


1. Macroeconomic policies

2. Effects of changes in fiscal policy

3. Effects of changes in monetary policy

4.5. SAQ

SAQ (LO 1) Monetary and fiscal policies are generally referred to as demand management

policies. Why?

SAQ (LO 2) What will be the effect of government spending on the economy?

SAQ (LO 3) State the implication of rise in money stock.

4.6. References







of 76



Publication, India.






of 76

Solution to SAQs

Study Session I

SAQ (LO 1): Capital is subject to diminishing returns because of the amount that can be

effectively invested and because of the growing burden of depreciation.

SAQ (LO 2): Fictitious capital refers to intangible representations or abstractions of physical

capital, such as stocks, bonds and securities (or "tradable paper claims to wealth")

SAQ (LO 3): Natural capital is inherent in ecologies and increases the supply of human wealth,

e.g. trees.

SAQ (LO 4): Productivity

Study Session II

SAQ (LO 1): Professor Coulborn sees money as "the means of valuation and payment; as both

the unit of account and the generally acceptable medium of exchange.

SAQ (LO 2): The currency notes issued by CBN of a country and the cheques of commercial

banks.

SAQ (LO 3): Money is called neutral if monetary changes in the economy have no impact on

real economic activity.

SAQ (LO 4): Value


of 76

SAQ (LO 5): True

SAQ (LO 6): Demand for money

Study Session III

SAQ (LO 1): Economic growth is the increase in the inflation-adjusted market value of the

goods and services produced by an economy over time

SAQ (LO 2): Schumpeter believes that the economic system is full of uncertainties and risks that

is inevitably discontinues or moves in a speed.

SAQ (LO 3): Marx views growth as a process of continue transformation of the society and

social function and political life.

SAQ (LO 4): True

SAQ (LO 5): True

SAQ (LO 6): False

Study Session IV

SAQ (LO 1): Monetary and fiscal policies are generally referred to as demand management

policies because countries use them largely to manage demand for goods and services.

SAQ (LO 2): An increase in government spending generally, or a tax cut will shift implies a

higher level of income and a higher interest rate.

SAQ (LO 3): A rise in the money stock lowers the rate of interest and raises the level of income.


of 76

UNIVERSITY OF MAIDUGURI CENTRE FOR DISTANCE … 1-5/ECO 404.pdf · At the end of the course module,...

Documents

Transcript of UNIVERSITY OF MAIDUGURI CENTRE FOR DISTANCE … 1-5/ECO 404.pdf · At the end of the course module,...