Macroeconomics I — Econ 502 · Deep Notes समष्टि अर्थशास्त्र I — Econ 502 · विस्तृत नोट

1.1 What is macroeconomics?

Macroeconomics studies the economy as a whole — its overall output, employment, price level, interest rate, exchange rate — and how these aggregates interact with each other and with policy. Compare with microeconomics, which studies individual decision-makers (a single consumer, firm, market).

Macroeconomics ले अर्थतन्त्रलाई समग्र रूपमा अध्ययन गर्छ — कुल output, रोजगारी, मूल्य स्तर, ब्याजदर, विनिमय दर — र यी aggregate बीचको अन्तरक्रिया र नीतिसँगको सम्बन्ध। Micro ले व्यक्तिगत निर्णयकर्ता हेर्थ्यो।

Why a separate discipline? Because aggregation is not trivial. The economy as a whole behaves differently from the simple sum of its parts:

किन छुट्टै विषय? किनकि aggregation सरल छैन। समग्र अर्थतन्त्र भागहरूको योगभन्दा फरक व्यवहार गर्छ:

• Paradox of thrift: if one household saves more, that's good for that household. If all households save more simultaneously, aggregate demand falls and income falls, so total saving may not even rise. Micro logic fails at the aggregate level.Paradox of thrift: एक परिवारले बचत बढाउँदा राम्रो; तर सबैले एकैसाथ बढाए माग घट्ने, आय घट्ने, कुल बचत पनि नबढ्ने।
• Fallacy of composition: what is true for the part is not necessarily true for the whole.Fallacy of composition: भागको लागि सही, सम्पूर्णको लागि होइन।
• Aggregate demand can be deficient — markets may not clear at full employment without intervention (Keynes' main claim).Aggregate demand कम हुन सक्ने — हस्तक्षेप बिना पूर्ण रोजगारीमा बजार clear नहुने।

Evolution of macro thinking — a 90-second history

For Macro I you focus on classical (Unit III) and Keynesian (Units IV-VI) — the foundations. Macro II builds the rest.

Macro I मा classical (Unit III) र Keynesian (IV-VI) — आधार। बाँकी Macro II मा।

1.2 The seven key macroeconomic variables

1.3 Stocks vs flows — the most common confusion

Relationship: a flow changes a stock. Investment (flow) adds to capital stock. Saving (flow) adds to wealth. Budget deficit (flow) adds to public debt (stock). Net immigration (flow) adds to population (stock).

सम्बन्ध: flow ले stock लाई परिवर्तन गर्छ। Investment ले capital stock; बचतले सम्पत्ति; बजेट घाटाले सार्वजनिक ऋण।

Capital stock next period = current stock + gross investment − depreciation. This is the fundamental accounting identity that links the flow of investment to the stock of capital.

$K_{t+1} = K_t + I_t - \delta K_t$ — Investment flow र capital stock को identity।

1.4 Policy goals — Tinbergen's "magic square"

Macro policy traditionally pursues four objectives:

परम्परागत रूपमा चार लक्ष्य:

1. Full employment — low cyclical unemployment.
2. Price stability — low and predictable inflation.
3. Sustainable growth — rising real GDP per capita.
4. External balance — manageable current-account, stable exchange rate, adequate reserves.

Tinbergen's principle (1952): to hit $n$ independent targets, you need at least $n$ independent policy instruments. Two instruments (fiscal and monetary) cannot reliably hit four targets simultaneously — trade-offs are unavoidable.

Tinbergen को सिद्धान्त (१९५२): $n$ स्वतन्त्र लक्ष्य पुर्‍याउन $n$ instrument चाहिने। दुई instrument (fiscal, monetary) ले चार लक्ष्य एकैसाथ पुर्‍याउन सक्दैन।

Classic trade-offs:

• Inflation vs unemployment (Phillips curve) — at least in the short run.मुद्रास्फीति vs बेरोजगारी (Phillips curve)।
• Internal vs external balance — tight money raises exchange rate, hurts exporters.आन्तरिक vs बाह्य सन्तुलन।
• Growth vs stability — financial liberalization may speed growth but raise crisis risk.वृद्धि vs स्थायित्व।

1.5 Instability of output — why economies fluctuate

Real economies don't grow on a smooth path. They experience business cycles with four phases:

1. Expansion / boom — output rising, unemployment falling, often rising inflation.Expansion: output बढ्ने, बेरोजगारी घट्ने।
2. Peak — top of the cycle.Peak: शिखर।
3. Recession / contraction — output falling (NBER rule: 2 consecutive quarters of decline).Recession: output घट्ने (२ त्रैमास घटे)।
4. Trough — bottom; recovery begins.Trough: तल्लो विन्दु।

Sources of instability:

• Demand shocks: swings in consumer or business confidence, fiscal-monetary policy, export demand.Demand shock: उपभोक्ता/व्यवसायी विश्वास, नीति, निर्यात माग।
• Supply shocks: oil price spike, natural disasters, pandemics, trade disruptions.Supply shock: तेलको मूल्य, प्रकोप, महामारी।
• Financial shocks: credit crunches, asset-price bubbles, banking crises.Financial shock: credit crunch, asset bubble।
• Policy shocks: unexpected interest-rate moves, tax changes.Policy shock।

Nepal's growth volatility is high — the standard deviation of annual GDP growth is ~2 percentage points around a mean of ~4-5%. Drivers include monsoon performance (agriculture is ~25% of GDP and rain-fed), remittance flows (sensitive to Gulf labour-market shocks), and political events.

नेपालको growth volatility उच्च — वार्षिक GDP growth को standard deviation ~२ प्रतिशत बिन्दु। कारण: मनसुन (कृषि GDP को ~२५%, वर्षामा निर्भर), remittance, राजनीतिक घटना।

2.1 The hierarchy of income aggregates

A common exam-time confusion. Memorize this hierarchy:

परीक्षामा प्रायः अल्मलिने ठाउँ। यो पदानुक्रम कण्ठ राख्ने:

Real vs Nominal

Nominal GDP = current-year prices × current-year quantities. Real GDP = base-year prices × current-year quantities. Real strips out price changes so we measure volume changes only.

Nominal: चालू मूल्य × चालू परिमाण। Real: आधार वर्ष मूल्य × चालू परिमाण।

The GDP deflator is the broadest price index, covering everything in the economy (unlike CPI, which is limited to a consumer basket). CBS Nepal currently uses 2010/11 as the base year for real GDP; revisions to 2018/19 base are underway.

GDP deflator सबभन्दा फराकिलो मूल्य index। CBS नेपालले हाल आधार वर्ष २०१०/११ प्रयोग गर्छ; २०१८/१९ मा सर्ने प्रक्रिया जारी।

2.2 Circular flow of income

Two-sector → Four-sector identities

The "twin deficits" identity: private saving-investment balance + public saving-investment balance = current-account balance. If a country runs a current-account deficit ($X < M$), it must be borrowing from abroad — either the private sector or the government (or both) is spending more than it earns.

"Twin deficits" identity: $(S-I)+(T-G)=(X-M)$। चालू खाता घाटा भए कुनै क्षेत्रले विदेशबाट उधारो लिएको।

2.3 Three measurement methods

The accounting identity "output = income = expenditure" implies all three give the same GDP. In practice they don't perfectly because of statistical discrepancy — the residual reported alongside.

"Output = आय = खर्च" identity ले तीनै विधिले उही GDP दिनुपर्ने। व्यवहारमा statistical discrepancy हुन्छ।

(a) Expenditure approach (most-used)

(b) Income approach

Sum of factor incomes (labour gets wages; land gets rent; capital gets interest; entrepreneurship gets profit) plus the wedge between factor cost and market price (indirect taxes net of subsidies) plus capital consumption.

कारक आय (श्रम-ज्याला, भूमि-rent, पुँजी-ब्याज, उद्यमी-मुनाफा) + factor cost र market price बीचको wedge + depreciation।

(c) Value-added (production) approach

Sum across all firms/sectors of value added = output value − intermediate input value. Avoids double counting.

Nepal's NSO uses the value-added approach as the primary method, reporting Gross Value Added (GVA) by 17 industry divisions, then adding net taxes on products to get GDP at market price.

नेपाल NSO ले मुख्यतया value-added विधि प्रयोग गर्छ — १७ industry मा GVA अनि net taxes थपेर GDP।

2.4 Sector accounts in the SNA 2008 framework

The UN's System of National Accounts 2008 partitions the economy into five institutional sectors and produces a full set of accounts for each: production, generation of income, allocation of primary income, secondary distribution, use of income, capital, financial, revaluation, balance sheets.

UN को SNA 2008 ले अर्थतन्त्रलाई पाँच क्षेत्रमा बाँडेर हरेकको पूर्ण account बनाउँछ।

All sector accounts consolidate to the national account: one sector's payment is another's receipt, so most intra-economy transactions cancel out.

सबै क्षेत्र account consolidate भएर राष्ट्रिय account।

2.5 Nepal's national income accounting practice

Five specific challenges in Nepal's measurement

1. Informal & subsistence economy. 70%+ of employment is informal; subsistence agriculture is partly imputed. NSO imputes own-account agricultural output, but household production (cooking, childcare, water-fetching) is excluded — biases GDP downward and inequality measures.Informal/subsistence economy — ७०%+ रोजगारी informal; घरधन्दा अलेखाङ्कित।
2. Remittances and the GDP-GNI gap. Worker income earned abroad is not Nepal's GDP (the worker produced in Qatar), but is Nepal's GNI (the worker is Nepali). Strictly, in SNA 2008 most remittance is recorded as current transfer in BoP (not in NFIA); labour-income remittance enters NFIA. The gap GNI − GDP can be ~25-28% of GDP for Nepal.Remittance र GDP-GNI gap — विदेशको कमाइ Nepal GDP होइन, GNI हो। GNI - GDP gap ~२५-२८%।
3. Federal disaggregation. Provincial GDP requires apportioning national totals to provinces — based on Population Census, Agriculture Census, and economic-establishment surveys. The methodology is still maturing.Provincial GDP: विधि अझै परिमार्जन हुँदै।
4. Cross-border activities. India-Nepal open border allows informal trade in goods (fuel smuggling especially active during fuel-price gaps) that escapes formal customs records. Estimates put informal cross-border trade at 30-40% of formal.सीमा पार गतिविधि: अनौपचारिक व्यापार ३०-४०%।
5. Natural disaster shocks. 2015 earthquake destroyed ~25% of physical capital; standard accounting captures the GDP flow impact but not the wealth stock loss directly.प्राकृतिक प्रकोप: २०१५ भूकम्पले ~२५% भौतिक पुँजी विनाश।

2.6 Limitations of GDP as a welfare measure

1. Non-market production excluded. Cooking, child-rearing, fetching water, unpaid care work — overwhelmingly done by women in Nepal — don't appear in GDP. Switching from a homemaker to a paid maid raises GDP without changing real output.गैर-बजार उत्पादन छुट: घरधन्दा (नेपालमा महिलाद्वारा गरिने) GDP मा आउँदैन।
2. No deduction for environmental damage. Cutting down a forest adds to GDP; air pollution from brick kilns adds to GDP. The destruction of natural capital does not subtract.वातावरण विनाश घट्दैन: जङ्गल काट्दा GDP बढ्छ।
3. No measure of distribution. Two countries with same GDP per capita can have wildly different inequality.वितरण नदेखाउने।
4. No leisure value. A 60-hour working week and a 35-hour week produce different GDPs even if welfare is the same.फुर्सद नछोप्ने।
5. "Defensive expenditures" inflate GDP. Spending on police because of more crime, or on healthcare because of more pollution, raises GDP without raising well-being."Defensive" खर्च (प्रहरी, स्वास्थ्य) पनि GDP।
6. Quality changes hard to capture. A 2025 smartphone vs a 1995 phone — price barely changed, quality vastly improved.गुणस्तर परिवर्तन छुट्ने।
7. Illegal activities (smuggling, drug trade, sex work) typically excluded.अवैध गतिविधि छुट्ने।

Alternative welfare measures

• Human Development Index (HDI) — UNDP, 1990. Composite of life expectancy, education, and income (log PPP per capita). Nepal HDI 2022 ≈ 0.601, "Medium HD," rank 143/193.HDI: आयु, शिक्षा, आय। नेपाल HDI २०२२ ≈ ०.६०१।
• Multidimensional Poverty Index (MPI) — OPHI/UNDP, 2010. 10 indicators × 3 dimensions. Nepal MPI 2022: 17.4% multidimensionally poor.MPI: नेपालमा १७.४% multidimensionally गरिब।
• Gross National Happiness (Bhutan). Holistic index with 9 domains.GNH (भुटान): ९ डोमेन।
• Genuine Progress Indicator (GPI), Inclusive Wealth. Adjust GDP for inequality, environment, non-market work.GPI, Inclusive Wealth।

3.1 The classical labour market

Building blocks:

1. Aggregate production function:
   $$Y = F(L, \bar K)$$

   Capital fixed in the short run. $F_L > 0$ (positive marginal product), $F_{LL} < 0$ (diminishing returns).

   $Y = F(L, \bar K)$; $F_L > 0$, $F_{LL} < 0$।

2. Labour demand:

   Profit-maximizing firms hire $L$ until $W/P = F_L$ — real wage equals marginal product of labour. Since $F_L$ is decreasing in $L$, $L^d$ is a decreasing function of $W/P$.

   $$L^d = L^d(W/P), \quad \frac{\partial L^d}{\partial (W/P)} < 0.$$

   $W/P = MPL$; $L^d$ real wage सँग घट्दो।

3. Labour supply:

   Workers maximize utility over consumption and leisure. Higher real wage → substitution effect (work more) typically dominates income effect (work less). $L^s$ rises in $W/P$.

   $$L^s = L^s(W/P), \quad \frac{\partial L^s}{\partial (W/P)} > 0.$$

   $L^s$ real wage सँग बढ्दो।

Equilibrium and the full-employment level

Wages adjust freely. Equilibrium: $L^d = L^s$, defining $L^*$ (full employment) and $(W/P)^*$. Substituting $L^*$ back into the production function yields $Y^* = F(L^*, \bar K)$ — the full-employment output level.

$L^d = L^s$ बाट $L^*$ (full employment) र $(W/P)^*$। Production function बाट $Y^*$।

Crucial implication: $Y^*$ depends only on real factors (technology, capital, preferences) — not on the money supply, government spending, or demand. Aggregate supply is a vertical line at $Y^*$ in the long run.

मुख्य निष्कर्ष: $Y^*$ मात्र real factor (तकनिक, पुँजी, रुचि) माथि निर्भर — मुद्रा आपूर्ति, सरकारी खर्च, मागमा निर्भर होइन। दीर्घकालमा aggregate supply $Y^*$ मा vertical।

3.2 Say's Law — "supply creates its own demand"

Jean-Baptiste Say (Traité d'économie politique, 1803) argued: by producing goods worth $Y$, factors earn income worth $Y$, with which they can buy the goods worth $Y$. There may be temporary mismatches across sectors but no general deficiency of demand.

J.-B. Say (१८०३): $Y$ बराबरको वस्तु उत्पादन गर्दा कारकले $Y$ बराबर आय कमाउँछन्, जसले ती वस्तु किन्न पुग्छ। तसर्थ सामान्य माग कमी असम्भव।

Versions

• Strong Say's Law: $AD \equiv AS$ identically — no possibility of insufficient demand. True in a pure barter economy where you produce only to immediately exchange.Strong Say's Law: $AD \equiv AS$ — पूर्ण barter मा सत्य।
• Weak Say's Law: aggregate demand adjusts to aggregate supply eventually, through the interest rate (saving-investment market). In a money economy, this requires saving to be fully channeled into investment via $r$.Weak Say's Law: money economy मा ब्याजदरमार्फत saving-investment adjustment।

Why might Say's Law fail? Keynes' three attacks

1. Liquidity preference: people hold money for its own sake (speculative motive), not just to spend. Income may be saved as cash rather than channeled to investment.Liquidity preference: मानिसले पैसा होल्ड गर्ने।
2. Interest rate may not equilibrate $S$ and $I$: at low $r$, liquidity trap; at high $r$, no investment to absorb saving.$S = I$ adjustment विफल हुन सक्ने।
3. Pessimistic expectations: firms cut investment regardless of $r$; "animal spirits."निराशावादी अपेक्षा: animal spirits।

3.3 Classical theory of interest — loanable funds

In the classical view, the interest rate is determined in the loanable funds market. Saving is the supply of loanable funds, investment is the demand. The real interest rate adjusts to equate them.

Classical मा ब्याजदर loanable funds बजार मा निर्धारित: saving आपूर्ति, investment माग।

$S$ rises in $r$ (higher reward to saving), $I$ falls in $r$ (higher cost of borrowing). Equilibrium at $r^*$.

$S$ $r$ सँग बढ्दो; $I$ घट्दो; equilibrium $r^*$ मा।

Crowding out in the classical view

Government deficit $G - T$ borrows from the loanable funds market. The supply available to private investment falls. $r$ rises until private investment falls by an equal amount. Full crowding out in the long run: $\Delta G = -\Delta I$, total output unchanged. Fiscal policy is impotent.

सरकारी घाटाले funds बजारबाट उठाउँछ → $r$ बढ्छ → निजी $I$ घट्छ। दीर्घकालमा full crowding out: $\Delta G = -\Delta I$, output नफेरिने। Fiscal policy बेकार।

3.4 Quantity Theory of Money

The classical theory of the price level. Two formulations, mathematically equivalent.

मूल्य स्तरको शास्त्रीय सिद्धान्त। दुई रूप।

(a) Fisher's transactions equation

$M$ = nominal stock of money. $V$ = transactions velocity (number of times each rupee changes hands per period). $P$ = average price level. $T$ = volume of transactions (total real spending).

$M$ मुद्रा stock; $V$ velocity; $P$ मूल्य; $T$ कारोबार परिमाण।

Classical assumptions: $V$ is institutionally determined and slow-moving (depends on payment habits, banking technology). $T$ corresponds to full-employment output $Y^*$, hence fixed. So

Doubling $M$ doubles $P$. Money is neutral in the long run.

$V$ संस्थागत; $T = Y^*$ स्थिर। तसर्थ $P = MV/Y^*$। $M$ दोब्बर पारे $P$ दोब्बर — money neutral।

(b) Cambridge cash-balance equation

Marshall, Pigou. Same content, different framing — emphasizes the demand for money.

$k$ = fraction of nominal income that people choose to hold as money. $k = 1/V$. The cash-balance approach is closer to modern monetary economics — people want to hold money for liquidity.

Cambridge: $M = kPY$, $k = 1/V$।

Friedman's restatement (1956) — modern QTM

Friedman reframed QTM as a theory of money demand: $M^d / P = L(Y, r, \pi^e, w)$ — depending on real income $Y$ (transactions), nominal interest rate $r$ (opportunity cost), expected inflation $\pi^e$, and wealth $w$. Money supply changes by central bank are the dominant driver of nominal magnitudes (P, $\pi$) in the long run.

Friedman (१९५६) ले QTM लाई money demand को theory को रूपमा reformulate गरे।

3.5 The complete classical system — five-equation block

The classical dichotomy: real variables ($Y$, $L$, $r$, $W/P$) are determined by the first three blocks independently of money. The money block then determines only the price level. Money is a veil.

Classical dichotomy: real चर पहिले तीन block बाट, मुद्राबाट स्वतन्त्र। मुद्राले मात्र मूल्य।

Applicability and limitations

4.1 Keynes' attacks on the classical chain

4.2 The consumption function — APC, MPC, properties

Keynes' "fundamental psychological law" (Ch. 8 of GT):

$a$ = autonomous consumption (consumption at $Y = 0$, financed by dis-saving). $b$ = marginal propensity to consume (MPC) = $dC/dY$.

$a$ autonomous उपभोग; $b$ marginal propensity to consume (MPC) = $dC/dY$।

APC vs MPC

Saving function (residual)

Determinants of MPC: income level (poorer households higher MPC), wealth, expected future income, age, interest rate, distribution of income (more inequality → lower aggregate MPC). For Nepal, household survey estimates put MPC in poorer quintiles at ~0.85, richer at ~0.6 — making redistributive transfers a more powerful stimulus than across-the-board tax cuts.

MPC का निर्धारक: आय स्तर, सम्पत्ति, उमेर, ब्याजदर, वितरण। नेपालमा गरिब quintile को MPC ~०.८५, धनी ~०.६ — पुनर्वितरण transfer सबभन्दा शक्तिशाली stimulus।

4.3 Two-sector model — equilibrium and multiplier

Setup

Saving = Investment alternative

Subtract $C$ from $Y = C + I$: $S = I$. Solve $S = -a + (1-b) Y = \bar I$ for $Y^*$ — same answer.

$S = I$ बाट उही $Y^*$ निकाल्न मिल्ने।

The simple investment multiplier

If MPC = 0.75, multiplier = 4: every Re 1 of autonomous investment raises equilibrium income by Rs 4.

MPC = ०.७५ भए multiplier = ४: $\bar I$ Re १ बढ्दा $Y^*$ Rs ४ बढ्ने।

Interactive Keynesian cross

4.4 Three-sector model — adding government

(a) Lump-sum tax $T$

(b) Proportional income tax

More realistic. Let $T = tY$ where $t$ is the marginal tax rate (0 < t < 1). Then $Y_d = Y - tY = (1-t) Y$, so $C = a + b(1-t)Y$.

Proportional कर $T = tY$ भए $C = a + b(1-t)Y$।

Multiplier becomes $1/[1 - b(1-t)]$. Higher $t$ shrinks the multiplier — proportional tax is a built-in automatic stabilizer.

Multiplier $1/[1 - b(1-t)]$। $t$ बढ्दा multiplier सानो — proportional कर built-in automatic stabilizer।

The five government-related multipliers

4.5 Four-sector model — open economy

Add exports $X$ (exogenous) and imports $M = \bar M + m Y$ where $m$ is the marginal propensity to import (MPM).

निर्यात $X$ (exogenous), आयात $M = \bar M + m Y$।

Multiplier = $\dfrac{1}{1 - b(1-t) + m}$. Higher MPM further shrinks the multiplier — imports are a leakage just like saving and taxes.

Multiplier $\dfrac{1}{1-b(1-t)+m}$। MPM बढ्दा multiplier घट्ने — आयात एउटा leakage।

4.6 Multiplier as a time path

The multiplier is an equilibrium concept — it shows where $Y$ ends up. The path between old and new equilibria takes time, because consumption responds to last period's income.

Multiplier equilibrium concept; नयाँ equilibrium मा पुग्न समय लाग्ने — उपभोग पछिल्लो अवधिको आयमा प्रतिक्रिया।

Starting from old equilibrium, a one-shot increase $\Delta I$ at $t = 1$ raises $Y_1$ by $\Delta I$. At $t = 2$, consumption rises by $b \Delta I$, so $Y_2$ rises by $\Delta I + b \Delta I$. At $t = n$:

For MPC = 0.7, ~78% of the multiplier is realized in the first 4 periods, ~95% within 8. Real-world fiscal stimulus typically takes 1-2 years to play out fully — a key reason for "implementation lag" in fiscal policy.

MPC = ०.७ मा ४ अवधिमा ~७८%, ८ अवधिमा ~९५% प्रभाव। यथार्थमा १-२ वर्ष लाग्ने — fiscal policy को "implementation lag।"

4.7 Paradox of thrift

Keynes' most famous counter-intuitive result. If one household saves more, that's good for that household. But if everyone tries to save more simultaneously:

Keynes को सबभन्दा counter-intuitive नतिजा।

Why? Higher desired saving means less consumption, which means less demand, which means firms cut output, which means less income — and with less income, households end up saving the same amount they were saving before. The attempt to save more cancels itself out at the aggregate level. (Strictly, $S^*$ is unchanged only when $I$ is autonomous; with sensitive $I$, $S^*$ may even fall.)

किन? बचत बढाउन खोज्दा खर्च घट्ने → माग घट्ने → output घट्ने → आय घट्ने → पहिलेकै बचत। Aggregate मा रद्द।

Policy lesson: in a recession, household frugality worsens the slump. Government must fill the demand gap via fiscal stimulus. This was the most-debated implication of the General Theory in 1936-45.

नीति पाठ: मन्दीमा परिवारको मितव्ययिताले मन्दी थप बिगार्ने; सरकारले fiscal stimulus दिएर माग पुर्ति।

4.8 Effective demand & underemployment equilibrium

Effective demand = the level of aggregate demand at which firms' expectations of total sales (which drives their hiring and production) are exactly realized. In Keynes' framework, output settles where aggregate demand meets aggregate supply regardless of whether labour markets clear at full employment.

Effective demand: फर्मको कुल बिक्री अपेक्षा वास्तविक हुने aggregate demand स्तर। यो ठाउँमा output बस्ने — श्रम बजार full employment मा clear हुँदैन हुन सक्छ।

Underemployment equilibrium = a stable equilibrium where $Y^* < Y^{FE}$ and involuntary unemployment persists. The economy can sit here indefinitely; there is no automatic mechanism to push it back to full employment. This is the defining Keynesian claim.

Underemployment equilibrium: $Y^* < Y^{FE}$ मा स्थिर equilibrium; full employment मा फर्किने स्वत: संयन्त्र छैन।

5.1 Goods market equilibrium — deriving IS

In the basic Keynesian model, investment was autonomous. Now make it interest-sensitive:

Solving for $Y$:

Rearrange:

IS curve — properties

• Downward sloping in $(Y, r)$ space. Higher $r$ depresses $I$, lowering equilibrium $Y$.$(Y, r)$ मा तल झर्ने।
• Slope $= -(1 - b(1-t))/h$.Slope = $-(1-b(1-t))/h$।

Shifters of IS

Anything that changes equilibrium $Y$ at a given $r$:

• $\Delta G$ (government spending) → right$\Delta G$ → IS दायाँ
• $\Delta a$ (autonomous consumption) → right$\Delta a$ → IS दायाँ
• $\Delta I_0$ (autonomous investment, "animal spirits") → right$\Delta I_0$ → IS दायाँ
• $\Delta T$ (autonomous tax) → left$\Delta T$ → IS बायाँ
• $\Delta X$ (exports) → right$\Delta X$ → IS दायाँ

5.2 Money supply process & the money multiplier

Before deriving LM, we need to understand where the money supply comes from. The central bank doesn't directly print all the money you and I hold; it issues high-powered money (the monetary base $H$), and the banking system multiplies it through fractional-reserve lending.

केन्द्रीय बैंकले सीधै सबै पैसा छाप्दैन; high-powered money ($H$) निकाल्छ, र बैंकिङ system ले fractional reserve मार्फत गुणन गर्छ।

Definitions

• $H$ (high-powered money, monetary base, reserve money): currency in circulation + commercial bank reserves at the central bank.
• $M_1$: currency held by public + demand deposits.
• $M_2$: $M_1$ + savings deposits + small time deposits.
• $M_3$ (broad money): $M_2$ + large time deposits + foreign currency deposits. NRB's headline money supply measure for Nepal.

Deriving the money multiplier

Let $c = C/D$ (currency-deposit ratio chosen by public) and $r = R/D$ (reserve-deposit ratio chosen by banks, with the regulator setting a minimum CRR).

$c$ = currency-deposit ratio, $r$ = reserve-deposit ratio।

If $c = 0.1$ and $r = 0.1$, multiplier = $1.1/0.2 = 5.5$. A Rs 100 crore injection of high-powered money expands broad money by ~Rs 550 crore.

$c = 0.1$, $r = 0.1$ भए multiplier = ५.५। $H$ Rs १०० करोड बढ्दा $M$ Rs ५५० करोड।

Tools of monetary policy

5.3 Money demand — three motives (liquidity preference)

Keynes' big innovation: people demand money for three reasons.

Liquidity trap: at very low $r$, bond holders expect $r$ can only rise (and bond prices fall), so they hold any extra money instead of bonds. $L$ becomes infinitely elastic in $r$. Monetary policy loses traction. Japan in the 1990s-2000s is the textbook real-world example.

Liquidity trap: धेरै कम $r$ मा $L$ flat। Monetary policy काम नगर्ने। Japan १९९०s।

5.4 LM curve — money market equilibrium across $Y$

Money market clears when $L = M/P$. For different $Y$ levels, what $r$ clears?

Upward sloping in $(Y, r)$. Higher $Y$ raises transactions demand for money; with fixed $M^s$, $r$ must rise to choke off the excess demand.

$(Y, r)$ मा माथि उक्लने। $Y$ बढ्दा transactions माग बढ्ने; निश्चित $M^s$ मा $r$ बढ्नुपर्ने।

Three regions of LM

Shifters of LM

• $M^s \uparrow$ (expansionary monetary policy) → LM right$M^s$ बढ्दा LM दायाँ।
• $P \uparrow$ → real money supply $M/P$ falls → LM left.$P$ बढ्दा LM बायाँ।
• Money demand exogenous shift (e.g., financial innovation reduces $k$) → LM right.Money demand घट्दा LM दायाँ।

5.5 IS-LM equilibrium and policy

Policy summary — comparative statics

The crowding-out spectrum

6.1 Deriving the AD curve

Hold all IS-LM exogenous variables (G, T, M nominal) fixed; vary $P$ only. A higher $P$ shrinks real money supply $M/P$, shifting LM left. The new IS-LM intersection has lower $Y$ and higher $r$. Plot $(Y, P)$: as $P$ rises, $Y$ falls. AD slopes down.

$P$ बढ्दा $M/P$ घट्ने → LM बायाँ → $Y$ घट्ने। AD तल झर्ने।

Three channels making AD slope down

1. Keynes effect (real money balance): higher $P$ → lower $M/P$ → higher $r$ → lower $I$ → lower $Y$. (This is the IS-LM channel above.)Keynes effect: $P$ बढ्दा $M/P$ घट्ने → $r$ बढ्ने → $I$ घट्ने।
2. Pigou (real wealth) effect: higher $P$ → real value of household financial wealth falls → $C$ falls.Pigou effect: $P$ बढ्दा real सम्पत्ति घट्ने → $C$ घट्ने।
3. Foreign-trade (Mundell-Fleming) effect: higher domestic $P$ → exports more expensive abroad → $X$ falls; imports cheaper → $M$ rises → net exports fall → $Y$ falls.Foreign-trade effect: $P$ बढ्दा निर्यात महंगो, आयात सस्तो → $X-M$ घट्ने।

Shifters of AD

Anything that shifts IS or LM at given $P$:

$P$ स्थिर मा IS वा LM सार्ने जे पनि:

• $\Delta G \uparrow$, $\Delta T \downarrow$ → AD right
• $\Delta M^s \uparrow$ → AD right
• Improved confidence, $\Delta I_0 \uparrow$ → AD right
• Higher net exports $X - M$ → AD right
• Higher autonomous consumption (wealth effect from asset prices) → AD right

6.2 Aggregate supply — three cases

AS depends on how prices and wages respond to demand. Three cases:

SR vs LR aggregate supply

Modern textbook practice: short-run AS (SRAS) is upward sloping; long-run AS (LRAS) is vertical at $Y^*$. Both relevant for any economy. The economy may operate below $Y^*$ in the SR (recession with negative output gap) or above $Y^*$ briefly (overheating, positive output gap).

आधुनिक पाठ्यपुस्तकमा SRAS माथि उक्लने, LRAS $Y^*$ मा vertical। दुवै सान्दर्भिक।

6.3 AD-AS equilibrium and shocks

Demand shock (e.g., monetary expansion)

AD shifts right. SR: $Y \uparrow$, $P \uparrow$. Mechanism over time: workers eventually demand higher money wages to restore real wages → SRAS shifts left → $Y$ returns to $Y^*$, $P$ ends higher only. LR neutrality: a demand shock has no permanent effect on $Y$, only on $P$.

Demand shock: SR मा $Y, P$ बढ्ने; पछि कामदारले wage बढाउँदा SRAS बायाँ → LR मा $Y$ $Y^*$ मा फर्किने, $P$ मात्र बढी।

Supply shock (e.g., oil-price spike)

SRAS shifts left. SR: $Y \downarrow$, $P \uparrow$ — stagflation. Policy dilemma: tighten to fight $P$ (worsens $Y$) or loosen to support $Y$ (worsens $P$). Classic 1970s OPEC episode.

Supply shock: SRAS बायाँ; $Y$ घट्ने, $P$ बढ्ने — stagflation। नीतिगत dilemma।

6.4 Cost-push vs demand-pull inflation

How to tell them apart: demand-pull → $P$ and $Y$ rise together. Cost-push → $P$ rises but $Y$ falls. Nepal's inflation in 2022 (food + fuel + INR depreciation against USD) was largely cost-push.

छुट्याउने तरिका: demand-pull $P, Y$ सँगै बढ्ने; cost-push $P$ बढ्ने $Y$ घट्ने। नेपालको २०२२ inflation cost-push।

6.5 The Phillips curve — inflation vs unemployment trade-off

A. W. Phillips (1958) documented an empirical inverse relationship between UK money-wage growth and unemployment over 1861-1957. Samuelson & Solow (1960) restated it as an inflation-unemployment trade-off and called it a "menu" for policy. The classical Phillips curve became the cornerstone of 1960s policy: pick a point on the curve (lower $u$ via higher $\pi$, or vice versa).

A. W. Phillips (१९५८) ले UK मा ज्याला वृद्धि र बेरोजगारी बीच विपरीत सम्बन्ध भेटे। Samuelson-Solow (१९६०) ले inflation-बेरोजगारी "menu" भने।

Friedman-Phelps critique (1968)

If workers care about real wages, money-wage demands respond to expected inflation. Trying to push $u$ below the natural rate $u^*$ creates only temporary gains — once workers update $\pi^e$, the SRPC shifts up, and we're back at $u = u^*$ but with higher $\pi$. In the long run, no trade-off — LRPC is vertical at $u^*$.

Friedman-Phelps (१९६८): कामदारले real wage हेर्छन्; $\pi^e$ update हुँदा SRPC माथि सर्ने। LRPC vertical at $u^*$।

NAIRU and policy implications

NAIRU = Non-Accelerating Inflation Rate of Unemployment = $u^*$ in the model. If $u < u^*$, inflation rises (and accelerates if expectations are adaptive). If $u > u^*$, inflation falls.

NAIRU = $u^*$ — यो भन्दा कम बेरोजगारीमा inflation बढ्ने।

• Adaptive expectations (Friedman 1968): $\pi^e = \pi_{t-1}$. Disinflation is costly — must run $u > u^*$ for a while.Adaptive: $\pi^e = \pi_{t-1}$; disinflation costly।
• Rational expectations (Lucas 1972, Sargent 1981): if a credible disinflation is announced, $\pi^e$ falls immediately — disinflation can be costless. Empirically debated.Rational: विश्वसनीय disinflation भए $\pi^e$ तुरुन्तै घट्ने।

7.1 Keynes' Absolute Income Hypothesis (AIH)

Fundamental psychological law (GT ch. 8): "as a rule and on the average, men are disposed to increase their consumption as their income increases, but not by as much as the increase in their income." Formally:

आधारभूत मनोवैज्ञानिक नियम: आय बढ्दा उपभोग बढ्छ, तर आय बराबर होइन।

• $MPC = b$ (constant).MPC स्थिर।
• $APC = a/Y + b$ — declining in $Y$.APC घट्दो।
• "Absolute" because $C$ depends only on the household's own current income — not on past income, future income, peers, or wealth."Absolute" — आफ्नो वर्तमान आयमा मात्र निर्भर।

Strengths: simple, intuitive, fits cross-section data, drives the Keynesian multiplier. Weakness: falls flat against Kuznets' long-run finding. We need richer theories.

शक्ति: सरल; cross-section मा फिट। कमजोरी: Kuznets को दीर्घकाल विरुद्ध।

7.2 Duesenberry's Relative Income Hypothesis (RIH, 1949)

James Duesenberry's Income, Saving, and the Theory of Consumer Behavior: consumption depends on (i) the household's relative position in the income distribution, and (ii) its own past peak income.

Duesenberry (१९४९): उपभोग (i) आय वितरणमा परिवारको relative स्थान र (ii) आफ्नो विगत peak आयमा निर्भर।

Two effects

Resolution of the Kuznets puzzle

Along the secular trend, everyone is moving up together — relative positions are roughly unchanged → $APC$ stays constant. In cyclical downturns, ratchet keeps $C$ high while $Y$ falls → $APC$ rises (and is high in the lowest-Y year). Within a cross-section at a point in time, those temporarily below their peak income save little; those well above save more → cross-section APC declining.

दीर्घ trend मा सबै सँगै माथि → APC स्थिर। मन्दीमा ratchet ले $C$ टाँसिएको → APC बढ्ने। Cross-section मा peak बाट तल भएकाले कम बचत, माथि भएकाले बढी।

7.3 Friedman's Permanent Income Hypothesis (PIH, 1957)

Milton Friedman, A Theory of the Consumption Function: decompose measured income $Y$ into permanent $Y^P$ (long-run expected) and transitory $Y^T$ (random deviations).

Friedman (१९५७): आयलाई $Y^P$ (permanent) र $Y^T$ (transitory) मा विभाजन।

Consumption depends only on permanent income. Transitory income is mostly saved. The MPC out of permanent income is high ($k \approx 0.9$); out of transitory income, near zero.

उपभोग permanent आयमा मात्र निर्भर। Transitory अधिकांश बचत।

Forming permanent income — adaptive expectations

A geometric weighted average: this year's income gets weight $\lambda$; past expectations get $(1-\lambda)$. Households update their permanent-income estimate gradually.

यो वर्षको आयलाई $\lambda$, विगत अपेक्षालाई $(1-\lambda)$ weight दिने।

Resolution of the Kuznets puzzle

In cross-section, a "rich" $Y$ sample contains people with high transitory income that year (lucky bonuses, asset sales) — their $Y^P < Y$, so their $C/Y < k$ — apparent low APC. A "poor" $Y$ sample contains people with negative transitory components — their $Y^P > Y$, $C/Y > k$ — apparent high APC. APC appears to fall in cross-section even though $C = kY^P$ has constant proportionality.

In time-series long run, transitory averages out: $Y \approx Y^P$, so $C/Y \to k$ — constant. Kuznets finding explained.

Cross-section मा "धनी" sample मा high $Y^T$ धेरै; $C/Y < k$ देखिने। दीर्घकालमा $Y \approx Y^P$, $C/Y = k$ स्थिर। Kuznets पहेली हल।

Policy implications of PIH

• One-time tax rebate (perceived transitory): small effect on $C$ — mostly saved.एक पटक कर छुट: $C$ मा सानो असर।
• Permanent tax cut: full effect — $Y^P \uparrow$ permanently, $C$ rises by $k \cdot \Delta Y^P$.स्थायी कर कटौती: पूर्ण असर।
• Anticipated future income: households start consuming now in anticipation. Forward-looking.अपेक्षित भविष्य आय: अहिले नै उपभोग सुरु।

7.4 Modigliani-Brumberg-Ando Life-Cycle Hypothesis (LCH, 1954, 1963)

Franco Modigliani & Richard Brumberg (1954); Albert Ando & Modigliani (1963): households plan consumption over their entire lifetime, smoothing $C$ across years of high and low income.

Modigliani-Brumberg (१९५४): परिवारले जीवनभरको योजना बनाएर $C$ smooth गर्ने।

Setup

Assume:

• $T$ working years, $L$ total life years ($L > T$).
• Constant labour income $Y$ during working years, zero after.
• Initial wealth $W_0$. No bequest at $L$.
• Constant consumption $C$ over life (perfect smoothing).

Lifetime resources = $T \cdot Y + W_0$. Spread over $L$ years:

Aggregate over population (mix of ages and wealth levels):

The hump-shaped saving profile

Young (no wealth, low income): borrow to consume. Working age (peak income): save heavily — accumulate wealth. Retired (no income): dissave — draw down wealth. Saving rate is hump-shaped over the life cycle.

युवा: ऋण लिने। काम गर्ने उमेर: बचत। बुढेसकाल: सम्पत्ति खर्च। बचत hump-shaped।

Resolution of the Kuznets puzzle

Cross-section: young and old (low $Y$, but consuming from wealth or borrowing) have high APC; middle-aged (high $Y$) have low APC. APC appears to fall with $Y$. Long run: as long as $W/Y$ ratio is stable across decades, $APC = C/Y = \alpha + \beta(W/Y)$ remains constant.

Cross-section: युवा र वृद्ध high APC; मध्यम कम। दीर्घकालमा $W/Y$ स्थिर भएमा APC स्थिर।

Policy implications of LCH

• Wealth tax (estate tax, asset tax) has bigger effect on $C$ than an income tax — because it cuts $W$ directly.सम्पत्ति कर ले $C$ मा बढी असर।
• Demographic shifts: aging population → falling aggregate saving (more retirees dissaving). Relevant for Nepal post-2050 as the dividend ends.वृद्ध जनसंख्या बढ्दा aggregate saving घट्ने।
• Stock-market wealth effect: wealth $W$ rises → $C$ rises by $\beta \cdot \Delta W$.Share बजार सम्पत्ति बढ्दा $C$ बढ्ने।

7.5 Visual comparison — the three theories

Summary table

7.6 Modern refinements (brief)

• Hall's random walk hypothesis (1978): if PIH + rational expectations, $C_{t+1} = C_t + \varepsilon_{t+1}$. Future consumption changes are unpredictable. Empirical violations spawned a huge literature.Hall (१९७८): $C_{t+1} = C_t + \varepsilon$ — random walk।
• Liquidity constraints: households can't borrow as much as they want → $C$ tracks current income more than PIH/LCH predict. Important in developing-country contexts.Liquidity constraint: उधारो सीमित भएमा $C$ चालू आय पछ्याउने।
• Precautionary saving: uncertainty → extra saving beyond LCH prediction.Precautionary saving: अनिश्चितता ले अतिरिक्त बचत।
• Behavioural: mental accounting, hyperbolic discounting, default-effect on retirement saving (Thaler-Sunstein).Behavioural: mental accounting, hyperbolic discounting।

7.7 Consumption demand in Nepal