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Chapter – 2


National Income AND EMPLOYMENT

(Peter Diamond, Dale Mortenstern & Christopher Pissarides)


Richard Stone has done extensive work on National Income and Accounts. Along with James Meade, Stone wrote a book titled National Income and Expenditure which appeared first in 1944 and revised many times later on. In place of a fifth edition of the above book, Richard Stone (with Giovanna Stone) wrote a short book titled National Income and Expenditure.(1960) In their book, the authors define National Income as “the income which accrues to the inhabitants, or normal residents of Country from their participation in World production”. All such income is included, whether it is received by individuals in the form of wages, dividends interest, etc., or is retained in private businesses, or accrues to Government bodies as a consequence of their business activities. No other income is included, therefore, gifts, grants and benefits, which are not received for participation in production, are excluded and so is consumer’s debt interest. Income may come from production taking place within the Country concerned or from abroad. The income arising from the productive activity that takes place within the territorial boundaries of a Country is called Domestic income.

Hicks, in his book, The Social Framework, notes the relationship between Social (National) product and Social (National) Income.

      Net Social product = Wages + Profits = Social Income

Social Income = Consumption + Saving = Consumption +

Investment = Net Social Product

So National income can be computed by using production method (Value added method) or by Income method or by Expenditure Method      

National Income Analysis:- National Income Accounting, classified meaningfully provides the basis for Macro-Economic analysis. The division of output into factor payments (wages, etc.) on the production side provides a framework for studying aggregate supply. The division of income into Consumption and Investment on the demand side provides the framework for studying aggregate demand. Keynes is the leading architect of Macro-Economics and his book, General Theory of Employment, Interest and Money has revolutionized Macro-Economic thinking. Samuelson had described Keynes as the patron-saint of Macro-Economics.

We shall describe below the classical theory, Keynes theory, contributions made to Keynes theory by Samuelson and Hicks, and give a pre-view of the ideas of Monetarists and new classical economists, which are discussed in detail in Chapter Eleven.

J.B. Say, a French economist said that supply creates its own demand. Savings will get automatically invested. There cannot be any general over production. Classical economists starting from Adam Smith to Marshall and Pigou have subscribed to J.B. Say’s view. The classical economists assumed that prices and wages are flexible. If there is excess supply of goods over demand, prices fall resulting in increased demand for goods ultimately leading to more production and more employment. Equilibrium will be restored in both product and labor market. Due to the operation of the market forces, full employment will prevail. In their view, business cycles are temporary and self correcting.

We shall now describe Keynes theory of business cycles, using the concept of multiplier. The multiplier concept is first introduced by Khan, a contemporary of Keynes. The multiplier is the number by which the addition to investment must be multiplied in order to determine the resulting change in output. When aggregate income increases, consumption of house holds also will increase but not as much as real income. There must be an amount of current investment sufficient to absorb the excess of total output over what the consumers choose to consume. The equilibrium income (hear after income and output are used inter-changeably) is given by the equality of investment with that of savings. The multiplier is determined by the marginal propensity to consume (m.p.c.) and it is computed using the formula, 1/1-m.p.c. The denominator in the formula is the marginal propensity to save (m.p.s.). Let us calculate the multiplier, using simple examples. Suppose, the m.p.c. is 0.5. Then the m.p.s. is also 0.5. Using the multiplier formula, the multiplier is 2. Now, let us increase the m.p.c. (spending) to 0.8. The, the m.p.s. (saving) decreases to 0.2. The multiplier increases to 5. Thus, the multiplier increases, when spending increases and when saving decreases. The multiplier decreases when m.p.s. (saving) increases. Savings are considered as a leakage from the circular flow of income.

In Keynes theory, it is the investment that gives rise to increased income through the multiplier and income, in turn, determines savings. At the equilibrium level of output, the receipts of the investors are equal to the required receipts by them to invest sufficiently to produce equilibrium output. According to Keynes, investment depends on the rate of interest and the marginal efficiency of capital (expected rate of return). Output fluctuates due to volatility of investment. If the investment level is insufficient, the level of income falls. Consequently, savings fall such that they equal investment at a low level of income (output). The equilibrium level of output occurs at full employment (potential output), only by coincidence or design. There is no general rule that the equilibrium level will be at full employment level.

At the time when Keynes wrote his book, The General Theory, the great depression occurred. The competitive markets were caught in an under-employment equilibrium.

Keynes argued for enlargement of functions of Government to involve it in the task of adjusting to one another, the propensity to consume and the inducement to invest. While the classical economists want to leave everything to market forces, Keynes wants the Government’s intervention to save capitalism.

Samuelson introduced the concept of accelerator, which says that a change in the rate of output induces a change in demand for investment in the same direction. The process of multiplier accelerator interaction results in continuous expansion of output until the economy reaches its full capacity level and then the growth rate of the economy slows down. The slower growth in turn, reduces investment and the process works in reverse direction. Thus, the multiplier-accelerator interaction results in business cycles.

In addition to the saving investment balance approach (also known as Keynesian multiplier model) discussed above, there is a second way of showing how output is determined. The method is called the consumption-plus-investment (or C + I) approach or aggregate spending approach. We can visualize a graph where total spending (C + I measured vertically) is graphed against total output (measured horizontally).

Draw a 45 degree line though the origin to help to identify the equilibrium output. The total spending (or C + I) shows the level of desired expenditure by consumers, and businesses. The economy is in equilibrium at the point where the C + I curve crosses the 45 degree line. Aggregate demand is equal to national income. If the aggregate demand, comprising of desired consumption and autonomous investment is less than the equilibrium output, producers will cut back production. If the aggregate demand (AD) is more than aggregate supply (AS), it will lead to more production as long as unused resources are there. Thus, output adjusts itself to changes in aggregate demand. The total output cannot increase beyond full employment level. Any increase in AD beyond full-employment level of output result in inflation. This approach to Keynes theory is also known as ‘Cross Approach’ as the AD curve crosses AS curve at the equilibrium point. The equilibrium indicates a balance between aggregate spending and actual output. The actual output may be different from the potential output.



Hicks well known article on Mr. Keynes and classics (1937) presents the gist of Keynes theory, compares it with the classical theory and synthesizes Keynes theory. Hicks condensed Keynes theory into three equations and derived the IS-LL curves. Later on, Hicks IS-LL curves came to be known as IS-LM curves. In many text books on economics, interest is presented on the vertical axis and income on the horizontal axis.

The IS curve presents a relation between income and interest. The marginal efficiency of capital schedule determines the value of investment at any given rate of interest and the multiplier tells us what level of income will be necessary to make savings equal to the value of investment. The curve IS shows the relation between income and interest that must be maintained in order to make saving equal to investment. With increased income saving will increase and that implies investment should increase and investment increases only at lower interest rate. As interest rates and income vary in opposite directions, the IS curve slopes downward.

The LM curve represents equality of money supply to demand for money. As income increases, the transactions demand for money increases. As money supply is fixed, the residual money supply for speculative purposes decreases. To make money supply equal to demand, the demand for investment (speculative purpose) should also decrease. It implies higher interest rates. Money market equilibrium implies that interest rates and levels of income vary together in the same direction. As such LM curve slopes upward.

The IS curve represents equilibrium in the goods market and LM curve in the money market. The points of intersection between IS and LM curves determine the equilibrium interest rate and equilibrium output.

There is another way of illustrating Keynes theory. The aggregate demand AD and aggregate supply (AS) curves may be depicted on a graph measuring price on the vertical axis output on the horizontal axis. The AS curve slopes upward and AD curve slopes downward. The pointer intersection of AS and AD curves determine the equilibrium price and output.

One important source of business fluctuations according to Keynes, is shocks to aggregate demand. These shocks occur when consumers, businesses and the Government change the total spending relative to productive capacity. If there is no change in supply of goods any adverse shock to aggregate demand shifts the AD curve to the left, causing prices and output to decline. Thus the adverse shocks results in a recession.


Differences in the Classical and Keynesian views arise from their assumptions about the Aggregate Supply Curve (A S). The Classicists assumed that there is always full employment of labor. According to them AS curve is vertical at the full employment level of work and changes in output take place in the long-run due to growth factors such as technological progress. Keynes assumed horizontal Aggregate Supply curve (AS), indicating that firms will supply whatever amount of goods demanded at the existing price level. They will be able to do so because of existing unemployment of labor. If prices are measured on vertical axis and output Y on horizontal axis, then AS curve is horizontal at the existing price level. Given a perfectly elastic supply, a fiscal expansion leads to shifting Aggregate Demand (AD) to the right causing output to increase but leave the equilibrium price level unchanged. According to Keynes, in the short run, output is determined by Aggregate Demand alone. If AD is above AS, then output expands and vice-versa.

For simplifying our analysis, we have used a two-sector model, consisting of consumers and business persons and their expenditure on consumption and investment respectively. In the simple model, there is no government sector and the rest of the world sector. Actually, the components of aggregate demand (AD) comprises of expenditures of four sectors. The expanded version can be broken down as follows:

Y = C + I + G + X

Where C is consumption, I is investment, G is government expenditure and X is net exports. Treating each variable as an endogenous one, others constant, we can calculate multipliers for the endogenous variable.

For the graphic presentation of the above AD – AS curves, I.S. – LM curves, BP (Balance payments curve discussed in Chapter 13) and such others, one may consult any relevant text book referred in the Appendix.

Samuelson, Galbraith, Hansen and Harris in U.S.A. and Hicks, Joan Robinson & Kaldor in U.K., have welcomed Keynes ideas. They are called neo-classical synthesizers or neo- keynesians (some call them early Keynesians.) The early Keynesian theory is called New Economics and the Keynesian policies to stabilize the economies held sway up to the middle of 1970’s.

The monetarists and new-classical economists like Lucas, have challenged Keynes ideas. Lucas argued that Keynesian policies of demand management are ineffective. The ideas of monetarists and the new-classical economists are discussed in Chapter 11. Based on the Lucas model (1977), the Dynamic Stochastic General Equilibrium (D.S.G.E.) models have been used in Macro economics. The D.S.G.E. models are predicated on the assumption of perfect markets and rational expectations.

The later day Keynesians, termed new Keynesians, such as Krugman, Stigltz, and Akerloff have been focusing on market imperfections and less on price and wage rigidities emphasized by early Keynesians.

Commenting on the crisis facing the world in 2008-09, Krugman observes that we are in a liquidity trap situation and monetary policy cannot be effective. He argues for fiscal stimulus policies. In his book, The Return of Depression Economics, (2010), Krugman opines that ‘Keynes is more relevant than ever’.


Amartya Sen is also a keynegian. Amartya Sen says that austerity is not an effective way to reduce public debt. Austerity is essentially anti-growth (as Keynes noted). We need economic growth and not austerity which created joblessness. (www.theStatesmancom.politics the economic consequences of austerity).

In a commemorative lecture delivered on 20th December, 2008 at the Institute of Social Sciences at Delhi, Stiglitz observed that the world economic crisis of 2008 has been precipitated by a failure of the American financial sector. America needs to do something to save the world from the worst economic crisis. In that context, stiglitz, observes that “We are all Keynesians Now”. In his latest book titled Free Fall (2010, Stiglitz commented that economic downturn, the free fall has discredited the many policy prescriptions of main stream economists and their belief in perfect markets and market efficiency. He emphasized the need for government intervention. He says that economies need a balance between the role of markets and the role of government. Stiglitz declares that he is in the tradition of John Maynard Keynes’.

Wide adoption of Keynesian policies of fiscal stimulus and monetary easing policies by the governments have put the economies of the industrialized nations on the path of recovery from the Recession. Though the great recession ended technically by the end of 2009, there is still high unemployment.

There is significant empirical evidence that macro-economic fluctuations are dominated by shocks with permanent effects. Since aggregate demand shocks do not have permanent effects, some argue that aggregate demand fluctuations are less important than aggregate supply fluctuations. Aggregate supply fluctuations are caused by shocks to technology. An alternative view is that there are occasional periods of large permanent aggregate supply shocks, but between these periods, aggregate demand shocks, such as changes in money supply and tax policies predominate. It is observed that temporary shocks move output around a stochastic trend, that itself contributes to movements in Gross National Product (G.N.P).

The general Auto-Regressive Moving Average (A.R.I.M.A) is found to be useful in studying business cycles. Econometricians are interested in the effect of shocks and transfer mechanisms. Econometrics use lagged values of explanatory variables among Regressors and their effect on the dependent variable (say output), distributed over time are estimated. It is observed that the Time-series methods and Econometric methods complement each other in the analysis of business cycles.

Production requires inputs such as labor, land and capital. Since employment of labor need some clarification of concepts, we shall examine some of the concepts of employment of labor and its empirical relation to production.

We have discussed above the theories of business cycles. Unemployment usually moves in tandem with output over a business crisis. Cyclical unemployment is pretty high during a period of recession. As aggregate demand (AD) falls output falls, unemployment rises every where.

According to the traditional business cycle approach, the trend level of output corresponds to the output producible by workers at full employment level, which s termed potential output. Fluctuations of output around trend level are called business cycles. The gap between the actual output and the potential output is termed output gap.

Okun codified an empirical relation between unemployment and output, and it is named after him, Okun’s law states that every 2 percent that the gross domestic product (GDP) falls relative to potential GDP the unemployment rate rises about 1 percentage point. Okun’s law provides the vital link between the output market and the labor market in the short run. One percent more of employment will produce 2 percent more of GDP.

There are other kinds of unemployment, such as frictional unemployment and structural unemployment. Frictional unemployment results from increasing mobility of people between regions and jobs or through different stages of the life cycle. Because frictionally unemployed workers are often moving between jobs, or looking for better jobs, they are treated as voluntarily unemployed.

Structural unemployment signifies a mismatch between the supply and demand for workers among different sectors. We often see structural unbalances across occupations or regions as certain sectors grow while others decline.

The Nobel Prize for 2010 is awarded jointly to three labor Economists – Professors Peter A. Diamond, Dale T. Mortensen and Christopher A. Pissarides. According to them (let us term their work as DMP model) labor markets do not function smoothly as assumed by traditional theory. According to traditional theory, job seekers find available jobs and labors market ensures matching between the two. The three Nobel Laureates have contributed significantly to the search theory and matching theory which facilitates the analysis of job search and job matching issues. The typical job seeker keeps in touch with employers who might offer a suitable jobs and waits until one opens up. The employer considers applicants quickly and makes a hire. Job seekers remain unemployed until they win suitable jobs. The optimal strategies that workers should follow in seeking employment is known as search theory. One of the basic assumptions in search theory is that wages and working conditions vary across jobs. A job seeker would not accept readily the first job that is offered. Instead, a job seeker compares the benefit of accepting the first job right away against the benefit of taking a better job that comes along later net of cost of waiting and takes a decision in favour of the larger benefit. Christopher Pissarides deals with the optimal search problems in his book, Equilibrium Unemployment Theory, (Basil Blackwell 1990). Peter Diamond discusses labor markets issues in his books on Social Security Reform (O.U.P. 2002) and Pension Reforms. Mortensen analyzes wages in his book Wage Dispersion (M.I.T Press 2004).

























Chapter – 3


(Frisch, Tinbergen, Klein, Stone, Havelmo, Heckman, Mcfadden, Engle, Granger and Sims)


Samuelson, Koopmans and Stone, in a report about the Journal, Econometrica, have said: “Econometrics may be defined as the Quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation, related by appropriate methods of inference”. In his well-known Text- Book, An Introduction to Econometrics, Klein observed, “Econometrics is a branch of Economics in which measurement of the relationships discussed in apriory Economic analysis is studied”. Econometric theory mainly deals with establishing statistical properties of estimators and the development of tests, while applied econometrics uses statistical methods to test and evaluate economic theories, and to forecast future values of the variables. When the Nobel Prize in Economics was first introduced in 1969, it was awarded to the pioneers in Econometrics, Ragnar Frisch and Jan Tinbergen.

Ragnar Frisch

Frisch first coined the term Econometrics and he had made rich contributions to Multi-Colliniarity problems in Econometrics. The term Multi-colliniarity is used by Frisch in his book on Statistical Confluence Analysis. The term refers to the existence of perfect or an exact linear relationship among some or all-explanatory variables in a Regression model. Today the term Multi-Colliniarity is used in a broad sense to include the case of perfect Multi-Colliniarity as well as the case where the explanatory variables are inter-correlated but not perfectly.

It refers to the tendency of many economic series to move together overtime. Economic theory of Demand tells us that relative prices and income are the explanatory variables in Demand function. However, the Statistician will not be able to isolate their separate contributions if they move together in a Time-series sample.

If there is Multi-Colliniarity among explanatory variables, the standard errors of the estimated parameters will be large. Frisch devised his Confluence Analysis to tackle such problems.


Tinbergen’s significant contributions relate to the analysis of Business Cycles. His Statistical Testing of Business Cycle Theories is a landmark in that area of Research. Tinbergen formulated the first macro econometric model, Business Cycles in the United States of America, 1919-32. Another notable contribution of Tinbergen relates to designing Development Policy for National economy. For evaluating Government’s policies, Tinbergen has suggested instrument target approach. According to Tinbergen, there are four main economic variables, which a policy maker has to take into account. They are the targets, or objectives of economic policy, instruments available to achieve the targets, non-controllable variables and irrelevant or neutral variables. He advocates that the Government should use policy instruments in such a way as to achieve the desired levels of the Target variables as closely as possible despite the fact that the time paths of the Target variables are strongly influenced by factors which are, for the policy maker, non-controllable.