Undergraduate Economist

Perspectives of an economics student

A Review of Banik’s The Indian Economy: A Macroeconomic Perspective

Posted by Alex M Thomas on 24th June 2015

Undergraduate economics education in India relies heavily on American textbooks, especially to teach Microeconomics and Macroeconomics. So it was a welcome change to see Nilanjan Banik’s The Indian Economy: A Macroeconomic Perspective published in 2015 by Sage Publishers. It is intended to be a Macroeconomics textbook for Indian students. As Banik writes in the Preface, ‘the available standard macroeconomic textbooks have limited information about how macroeconomics works for India.’ And therefore, ‘[t]his book is for anyone who wants to clear their concepts on Indian macroeconomy.’ This blog post critically reviews (only) Chapter 1 of this book titled ‘Introducing Macroeconomics’.

Banik starts Chapter 1 with an explanation of why macroeconomics – output, employment and inflation levels – is of significance to a ‘common man’. Here, basic macroeconomic concepts and their measurement are explained. Some discussion on the evolution of growth theories is also present. Economic prosperity of common person, according to Banik, is ‘encapsulated in a higher growth rate of GDP and lower inflation and unemployment rate, since these are the factors which directly or indirectly affect his/her well-being.’ But, we must also recognise that an individual’s employment and India’s overall unemployment rate are interdependent variables, and consequently we cannot draw a simple causal line of ‘prosperity’ running from overall employment rate to an individual’s well-being. [By interdependent, I mean that the aggregate employment rate is a summation of individual employments. Not only this, but also that the magnitude and trend of aggregate employment rate often impacts the rate of investment and therefore individual employment.] And, later, on p. 19, he draws a totally reverse causal line: ‘A summation of individual well-being gives us a sense about how an economy is doing.’

Output and employment levels are determined by factors affecting aggregate supply and demand. ‘Economy-wide demand and supply conditions are aggregation of all individual market conditions.’ Is this correct? Market supply and demand curves are an aggregating of individual market supply and demand curves. But, is it legitimate to extend this argument to aggregate supply and demand? Or, is Banik here making a microfoundations argument? A macroeconomic equilibrium is characterised by the equality between planned saving and investment and therefore of aggregate supply and demand. Banik is committing the fallacy of composition in the above quoted sentence wherein aggregate demand condition is seen as an aggregation of all the individual market demand conditions.

Subsequently, Banik starts the discussion on economic growth by clarifying to the reader that the growth rate of an economy refers to the growth rate of real gross domestic product (GDP) of that economy. ‘Supply of output is determined by the availability of factor endowments such as labour, capital, organization, and technology in the economy.’ Aggregate demand is made up of consumption, investment, government and foreign demand. The full-employment level of output, as in neoclassical economics, according to Banik, is determined by supply-side factors. Therefore, it follows that supply-side policies are to be undertaken in order to increase the full-employment level of output. Hence, he writes:

‘However, any policy measure to increase the supply of output requires time. … So managing supply-side components is not that effective in the short run; however, in the long run, components such as investment in education, health-care, and physical infrastructure will have an influence over the availability of future supply of output.’ (p. 6)

What is the role for demand-side policies in this growth framework? They are employed only to take care of ‘fluctuations’ for they have no role to play in determining the full-employment level of output. This is validated by the following excerpt from Banik.

‘Demand management policies would not have been important if there was no fluctuation in demand, taking the output away from the full employment level of output.’ (p. 7)

It suffices here to note that this is a contested assertion with the contestation emerging from the research on demand-led growth.

Among historians of economic thought and economists with a historical understanding, classical economists refer to Adam Smith, David Ricardo, Robert Malthus and Karl Marx, who, while distinguishing himself from their works also employed their framework – the surplus approach to value and distribution. However, in textbooks of Macroeconomics, pre-Keynesian economics is commonly, although incorrectly, classified as classical economics; Keynes is also responsible for this confusion. Banik has a very different understanding of classical economics or as he writes, the ‘classical school of economics’. For him, it comprises ‘particularly, the Austrian school of economists led by Hayek, Robbins, and Schumpeter’ (p. 7).

On Keynes’s principle of effective demand, Banik has the following to say. ‘

Keynes tried to explain the occurrence of an event like the Great Depression through his notion of effective demand. Effective demand is the quantity of goods and services that consumers buy at the current market price. According to Keynes, economic agents behave like animals – all of a sudden becoming optimistic or pessimistic about the future. When on average, economic agents become pessimistic about the future, then consumers start spending less money, firms cut down their production, and the economy enters into recession. In Keynesian model, the emphasis is on demand-side factors.’ (p. 7)

The principle of effective demand states that aggregate activity levels are determined by aggregate demand, and that planned saving adapts to planned investment. This principle was advanced in opposition to the neoclassical Say’s law which states that supply creates its own demand. Moreover, this principle works even without having recourse to animal spirits.

Following this, Banik presents a brief overview of Samuelson’s neoclassical synthesis, Lucas’s critique, real business cycle theory and new classical approach (pp. 10-11); and, he categorises the following economists within the ‘new Keynesian group’: ‘Gregory Mankiw, Lawrence Summers, Olivier Blanchard, Edmund Phelps, and John Taylor’ (p. 12). Such a classification of economists along with the overview of different macroeconomic schools is of much value to the student readers.

After carrying out a short empirical discussion on India’s macroeconomy and empirical definitions such as consumer durables, service exports, etc, Banik makes a fallacious statement regarding the relationship between saving (S) and investment (I).

‘…in a closed economy framework … one would expect domestic savings to be the only source of investment. Accordingly, what is saved is invested and hence investment is expected to be equal to savings. In the present context, however, there is a divergence between investment and savings components of GDP. This divergence is on account of the fact that we are considering an open economy framework where we allow for foreign transactions. Typically, the more open is the economy, the more is the extent of this divergence.’ (p. 17).

In a two-sector economy (with firms and households), the accounting identity S=I holds. But, what is the explanation or theory behind this? It is the principle of effective demand: planned saving adapts to planned investment (via changes in activity levels). The mainstream neoclassical view is that planned investment adapts to planned saving (via changes in a sufficiently sensitive rate of interest). In a three-sector economy (with firms, households and a government), the accounting identity becomes: S+T = I+G, where T is taxes and G is government expenditure. And, in a four-sector economy (with firms, households, a government and the foreign sector), the accounting identity is: S+T+M = I+G+X, where M is imports and X is exports. In other words, the above 3 identities reaffirm the condition for macroeconomic equilibrium: leakages must equal injections. Thus, in equilibrium, there can be no divergence between saving and investment in a two-sector economy and in general, in equilibrium, leakages equal injections. Banik appears to be confusing macroeconomic theory with accounting identities, and disequilibrium with equilibrium positions. The above statement of Banik is therefore conceptually incorrect.

Next, he presents a commentary on growth economics, with a focus on the Harrod-Domar and Solow growth models.

‘One of the earlier works in the area of supply-side economics was independently undertaken by two economists – Roy Harrod in 1939 and Evsey Domar in 1946. The relevance of the Harrod-Domar model lies in its ability to give a dynamic flavour to the Keynesian model. The Keynesian model is a static model putting emphasis on aggregate demand and its effect on the output gap in the short run.’ (p. 21)

In the mushrooming, although at a moderate pace, research on demand-led growth, the growth model of Harrod is a seen as an early contribution to demand-led growth and not supply-side growth. It is not clear why Banik places Harrod’s contribution under supply-side economics. He goes on to point out limitations of Harrod’s model.

‘Another limitation of the model is that it assumes that labour and capital and used in equal proportions (equal prices for labour and capital).’ (p. 22).

Here, he makes yet another incorrect statement because Harrod assumed that labour and capital are used in constant not equal proportions. With this glaring error, one cannot help but wonder whether this macroeconomics textbook went through any serious internal or external reviewing. Banik then goes on to discuss the Solow model and undertakes a very brief survey of the endogenous growth models of Paul Romer, discusses the work of Robert Hall and Charles Jones on social infrastructure, and Robert Fogel’s study of the positive association between health and economic growth. Next, the author moves on to issues involved in the measurement of GDP, and in this context clarifies the meaning of operating surplus and mixed incomes.

To conclude, whilst Banik’s macroeconomics book for Indian students contains serious conceptual errors, the design of the structure of chapter one (and the others) deserves some merit. There is indeed ample scope for improvement and enlargement of the contents. Yet, it is deeply disappointing to come across the errors, such as the ones mentioned in the preceding paragraphs, in a book such as this which is stated to be an advance over existing (foreign) macroeconomics textbooks.

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Posted in Book reviews, Economics, India, Macroeconomics | No Comments »

Introductory Macroeconomics: On Crowding Out

Posted by Alex M Thomas on 30th June 2012

Macroeconomics textbooks and journalists write in earnest about the crowding out effects of fiscal policy. Government expenditure is widely believed to displace private investment by raising interest rates which increases entrepreneurs’ borrowing costs. On this basis, governments have been ordered to cut down expenditure. Government deficits are identified as the cause of decreasing private investment as well as for creating inflationary pressures in the economy. This blog post argues that crowding out occurs under special circumstances – (1) when the economy is at full employment and (2) money supply is exogenous. In fact, when the economy operates at less than full employment and money supply is endogenous (that is, the central bank conducts monetary policy by adjusting the interest rates and the quantity of money endogenously adjusts to the demand for money at that set interest rate) government expenditure results in crowding in.

The crowding out argument can be represented with the help of the IS-LM diagram. IS refers to equilibrium in the goods market (quantity demanded = quantity supplied). LM refers to equilibrium in the money market (money demand = money supply). The intersection of the IS and LM curves gives us the equilibrium output and interest.

When government expenditure increases, IS curve shifts outwards. Both output and interest rates increase in an exogenous money model (upward sloping LM curve). The automatic increase in interest rate because of government expenditure is then said to result in crowding out of private investment.

Next, we look at interest setting monetary policy (with endogenous money) using the framework of IS-LM. In this case, LM is horizontal because the interest rates are set by the monetary authorities keeping in mind their inflationary target. This scheme is more realistic given the role played by Central Banks today. Interest setting monetary policy can be represented in an IS-LM framework as follows.

The goods market is also referred to as the real sector and the money market as the financial sector. We additionally assume (as is the case with not only the Indian economy but many other economies) the economy to be in a less than full employment position. If the economy operates at full-employment, increase in government expenditure will undoubtedly lead to inflation. In fact, an increase in private expenditure will also create inflation in a full employment set-up. In this realistic model, let us see what happens when there is an increase in government expenditure.

The diagram above clearly shows that an increase in government expenditure, represented as a shift in the IS curve does not raise the interest rates. The entire increase of government expenditure translates into increase in equilibrium income. That is, there is zero crowding out in this case as the economy operates at less than full employment. The increase in demand for money is met by endogenous increase in the supply of money through credit creation. In short, fiscal policy has no systematic effect on interest rates in a setting wherein the interest rates are set by monetary policy.

Therefore, it is clear that the basis of crowding out argument rests on the unrealistic assumptions of (1) full-employment positions and/or (2) exogenous money. Ordering the Indian government or other governments to cut back their expenditure by the IMF or by the ‘top’ economists therefore lacks a sound basis. The role of the government in aiding an economy towards its full-employment levels therefore can never be reiterated enough. Moreover, it is an argument which is based on sound economic principles.

Reference

Smith, Matthew (2012), ‘ECOS 2002: Intermediate Macroeconomics’, Lecture Notes, University of Sydney.

 

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Posted in Economics, Economics Education/Teaching, Government, India, Inflation, Macroeconomics, Neoclassical Economics | 2 Comments »

Sraffa: Production as a Circular Process

Posted by Alex M Thomas on 10th March 2010

This is the second in the series of posts on Sraffa. The objective of this post is to clarify the assumption of scarce resources made frequently in neoclassical economics. This is then contrasted with the notion of mass-production in capitalist economies. This facet of capitalism is understood by concepts such as ‘circular production’ and ‘production of commodities by means of commodities’ in Classical Economics.

A brief look at the history of micro and macroeconomics becomes essential. Elements of Marshall and Walras are found in modern microeconomics. Specifically, partial equilibrium analysis comes from Marshall; whereas, Walras contributed ‘general equilibrium analysis’ to economics. Usually, emergence of macroeconomics is considered to have originated with the work of Keynes. This has been contested and it has been shown with considerable evidence that William Petty (1623-1687) was the first macroeconomist. [See Murphy 2009] And that economists like Adam Smith, David Ricardo and Karl Marx were talking about macroeconomics when they discussed production, distribution and accumulation. Neoclassical macroeconomics can be loosely said to comprise New Classical Economics, Neo-Keynesian Economics, variants of Computable General Equilibrium Models (CGE), etc. One of the unifying features of the above mentioned neoclassical schools/models is the assumption of ‘scarce factors’. It is owing to the assumption that factors are scare, that optimization is carried out.

Lionel Robbins defined economics as “the science which studies human behaviour as the relationship between ends and scarce means which have alternative uses.” Here, scarce means refers to scarce factors of production – land, labour and capital. Yes, land can be considered scarce in an economy where the pressure of population is high (or for environmental reasons). But, wouldn’t labour be scarce in some countries and abundant in others? Now for the tricky ‘capital’. Capital is understood as produced means of production. That is, tools, machinery, plants, conveyor belts, electrical appliances, tractors, etc are ‘capital goods’. Are they scarce? They would be scarce if nobody produced them. Usually, in a capitalist or quasi-capitalist economy, capital goods are produced by the private sector, the government and often, imported from abroad. Therefore, a priori, we have no reason to maintain that capital is a scarce factor. Or for that matter, even labour.

Marshall provided a theoretical partition through which one could say that factors are scarce. He introduced the concept of ‘short period analysis’. Till Marshall, the early classicals and neoclassicals analysed economies using the ‘long period method’. Through the short period, Marshall introduced an imaginary period wherein one factor is fixed (usually, capital) and the other factor (labour) is variable. In this period, it is as if one factor is scarce. In a later post, it will be shown that this sort of analysis is an improper generalisation of Ricardo’s theory of rent.

Sraffa’s Production of Commodities by Means of Commodities deals with ‘value and distribution’. That is, he focuses on the relationship between relative prices, wages/profits and technique of production. Throughout the whole analysis, output/quantity is treated as given. This is in tune with the ‘sequential analysis’ of classical economics. Value & distribution is one level of analysis or the ‘core’, as was popularised by Garegnani. Once, the foundation is well-established, the next level is growth & accumulation. In the first level, quantities are treated as given and in the second level, prices are assumed to be given. This is done keeping in view the complexity of the economic processes. Whereas, as we know, in neoclassical theory of general equilibrium, there is a simultaneous determination of quantity, price, wage rate, employment, rate of interest and quantity of capital. That is, all kinds of prices and quantities are simultaneously determined.

A set of equations from classical and neoclassical production theory is given below. This is so as to bring out the differences in a clear way.

Production function: Ya = f(La, Ka)

Sraffa’s equations:
(AaPa + BaPb + … + KaPk) (1 + r) + LaW = APa
(AbPa + BbPb + … + KbPk) (1 + r) + LbW = BPb
. . . . . .
(AkPa + BkPb + … + KkPk) (1 + r) + LkW = KPk

where A, B …. K are the output produced in various industries, L is the labour employed in each industry, Pa refers to price/value of output A and Pk refers to value of output K, r is the rate of profit. [As these are for purposes of illustration alone, some conditions have not been mentioned]

In the first case, it represents the transformation of inputs – labour and capital into an output Y. Let me reproduce what Sraffa writes about his particular conception of production: “It is of course in Quesnay’s Tableau Economique that is found the original picture of the system of production and consumption as a circular process, and it stands in striking contrast to the view presented by modern theory, of a one-way avenue that leads for ‘Factors of production’ to ‘Consumption goods’.” [Sraffa 1960, 93]

The concept of circular production also brings to the fore the web of connections between different production structures. Both classical and neoclassical economics attempts at reducing the complexity of economic phenomena. Neoclassical economics, at the outset abstracts away from interrelated production structures through the concept of ‘representative firm’ in microeconomics. In a similar way, in the area of consumption, man as a social being is reduced to man as an individual whose utility does not depend on that of others. Classical economics carries out its analysis by taking prices as given so as to analyse interrelated production structures.

References

Sraffa, P (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press.

Murphy, A (2009), The Genesis of Macroeconomics: New Ideas from Sir William Petty to Henry Thornton, New York: Oxford University Press.

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Posted in Alfred Marshall, Classical Political Economy, Economics, Francois Quesnay, Neoclassical Economics, Piero Sraffa, Sraffa, Sraffian Economics, William Petty | 5 Comments »